Business Finance Lecture Notes

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Business Finance Lecture Notes
BUSINESS FINANCE (University of Surrey)
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Business Finance Lecture Notes

Lecture 1: Introduction to Corporate Finance (1,2)
1.1 Corporate Finance and the Financial Manager
The three pillars of corporate finance
No matter what type of business you start, you would have to answer the following
questions in one way or another:
1. What long term investments should you make? For example, what lines of business
will you be in, and what sort of buildings, machine and equipment would you need?
2. Where will you get the long-term financing to pay for your investment? Will you bring
in other owners, or will you borrow the money?
3. How will you manage your everyday financial activities, such as collecting from
customers and paying suppliers? (i.e. liquidity)
Broadly speaking, corporate finance is the study of ways to answer these questions.
Investment: what do you need to start a firm?
Capital budgeting
Capital budgeting — the process of planning and managing a firm’s long-term

investments.
In capital budgeting, the financial manager tries to identify investment opportunities that
are worth more to the firm than they cost to acquire. This means that the value of the
cash flow generated by an asset exceeds the cost of that asset. Evaluating the size,
timing and risk of future cash flows is the essence of capital budgeting. For example, the
decision for Tesco to open up another store would be an important capital budgeting
decision.
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Financing
Cash invested in assets must be matched by an equal amount

of cash raised by financing, as shown on the figure to the left.
The balance figure represents that both accounts need to be

balanced appropriately.
Capital structure
Capital structure — the mixture of long-term debt and equity

maintained by a firm.
The second question that needs to be answered concerns ways in which the firm obtains
and manages the long-term financing it needs to support its long term investments. The
financial manager needs to consider how much it should borrow (debt and equity) and
what the least expensive sources of funds are. In addition to that, he/she need to decide
exactly how and where to raise the money.
Liquidity
Liquidity — the availability of cash. Having sufficient cash to meet your obligations.
Working capital management
Working capital — a firm’s short-term assets and liabilities.
Managing the firm’s working capital is a day-to-day activity which ensures that the firm
has sufficient resources to continue its operations and avoid costly interruptions. The
financial manager should answer questions like:
• How much cash and inventory should we keep on hand?
• Should we sell on credit, and if so, what terms will we offer, and to whom will we extend
them?
• How will we obtain any needed short-term financing?
Who makes the decisions? The Financial Manager
A striking feature of large corporations is that the owners (shareholders) are not usually
directly involved in making business decisions, especially on a day-to-day basis. Instead,
the corporation employs managers to represent the owners’ interests and make decisions
on their behalf. In a large corporation the financial manager would be in charge of
answering the three questions raised earlier.
The financial management function is usually associated with a top officer of the firm,
such as a finance director (FD) or chief financial officer (CFO).
Typical company reporting structure
Below is a simplified organisational chart that highlights the finance activity in a large firm.
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The diagram highlights that:

• The finance director (chief financial officer) coordinates the activities of the treasurer and
the controller
• The controller’s office handles cost and financial accounting, tax payments and
management information systems
• The treasurer’s office is responsible for managing the firm’s cash and credit, its financial
planning, and its capital expenditures
Difference between finance and accounting functions
The accounting function takes all the financial information and data that arises as a result
of ongoing business activities, and presents this in ways that allow management to
assess the performance and risk of their firm (financial accounting) and make informed
decisions on future corporate activity (management accounting).
Responsibilities of a financial manager
Maximise value from cash:
• Buy assets that earn more cash than they cost
• Choose long-term investments that increase firm value
• Raise cheap external financing
• Ensure efficient tax policy
Case study
Jessica Uhl became Shell’s CFO in March 2017. Her responsibilities include:
• Business and Corporate Finance
• Planning and Appraisal
• Internal Audit
• Tax
• Business Integrity
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1.2 The Goal of Financial Management
Why are you starting a firm?
For for-profit businesses, the main goal of financial management is to make money or add
value for the owners.
Showing value — the balance sheet
Equity— the amount of money raised by the firm that comes

from the owners’ (shareholders’) investments.
Equity = shares. If you were to invest some money in a

business in the form of shares, the money you put in would be
called equity.
Different goals in practice
• Survive
• Maximise profits
• Minimise costs
• Maximise sales
• Avoid financial distress and bankruptcy
• Maintain steady earnings growth
• Beat the competition/be the best
The financial manager acts in the shareholders’ best interests by making decisions that
increase the value of the equity. Hence, there is one overriding aim for businesses:
maximising firm value/current value per share of the existing equity.
1.3 Financial Markets and the Corporation
Financial markets play a fundamental role in the operations of large corporations. The
stock market will always be important because it can inform management the
performance of their competitors, suppliers, customers and the economy as a whole. The
primary advantage of financial markets is that they facilitate the flow of money from those
that have surplus cash to those that need financing.
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Different sources of financing
• Private investors
• Bank loans
• Equity (shares)
• Bonds (tradable and interest, return of money in the end)
• Short-term financing
Primary vs. secondary markets
Primary markets
Primary markets — the original sale of securities by governments and corporations;

where you initially raised the money. E.g. when you first issue a bond.
The corporation is the seller, and the transaction raises money for the corporation. These
can occur in two types of transactions: public offerings and private placements.
Secondary markets
Secondary markets — those in which securities are bought and sold after the original
sale. E.g. when you sell a bond to someone else, it goes on the secondary market.
Involves one owner or creditor selling to another. Therefore the secondary markets
provide the means for transferring ownership in corporate securities.
Dealer versus auction markets
In secondary markets, there exists two types of markets: dealer and auction. In a dealer
market, the dealer buys and sells for himself, at his own risk.
Example: If dealer A has ample inventory of XYZ stock — which is quoted in market by
other makers at $10/$10.05 — and wishes to offload some of its holdings, it can post its
bid-ask quote as $9.98/$10.03. Rational investors looking to buy this company would
then take Dealers A’s offer price of $10.03, since it is 2 cents cheaper than the $10.05
price at which it is offered by other market makers. Conversely, investors looking to sell
XYZ’s stock (shares) would have little incentive to “hit the bid” of $9.98 posted by Dealer
A, since it is 2 cents less than the $10 price that other dealers are willing to pay for the
stock. **stocks = shares
Auction markets differ from dealer markets firstly because they have a physical location.
Second, most of the buying and selling is done by the dealer. However, the primary
purpose of an auction market is to match those who wish to sell with those who wish to
buy. Dealers play a limited role.
Example: Imagine that four buyers want to buy a share of XYZ and make the following
bids: $10.00, $10.02, $10.03 and $10.06. Conversely, there are four sellers that desire to
sell XYZ, and they submitted offers to sell their shares at the following prices: $10.06,
$10.09, $10.12 and $10.13. In this scenario, the individuals that made bids/offers for XYZ
at $10.06 will have their orders executed. All remaining orders will not immediately be
executed, and the current price of XYZ will then be $10.06.
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Trading in corporate securities
The equity of most large firms trade in organised auction markets. NASDAQ is one of
such which is one of the world’s largest. Because of globalisation, financial markets have
reached the point where trading in many investments never stops; it just travels around
the world.
Listing
Securities that trade on an organised exchange are said to be listed on that exchange. To
be listed, firms must meet certain minimum criteria concerning, for example, asset size
and number of shareholders. These criteria differ from one exchange to another.
2.1 Corporate Governance
Corporate governance — concerned with how firms manage themselves, and the way in
which this performance is monitored.
When shareholders hire professional managers to run their company, it is important to

ensure that business decisions are made that maximise the wealth of shareholders, and
not the personal wealth of managers.
Forms of business organisation
There are three different legal forms of business organisation:
Sole proprietorship — a business owned by a single individual.
Partnership — a business formed by two or more individuals or entities.
Corporation — a business created as a distinct legal entity composed of one or more

individuals or entities.
Sole Proprietorship Partnership Limited Corporation
• Owned and managed by one • Easy to form

• Articles and memorandum of
person
• Requires a partnership incorporation required — i.e.
• Very easy to form
agreement
more complicated than other
• Profits taxed as personal • Limited and unlimited partners
forms of business organisation
income
• Partnership is terminated when • Limited liability
• Unlimited liability
a partner dies or leaves the firm
• Profits taxed at corporate tax
• Life of company linked to life of • Difficult to raise cash
rate
owner
• Profits taxed as personal • Board of directors
• Amount of funding is limited by income

• Life of company is
owner’s personal wealth and • Controlled by general partners hypothetically unlimited
limited options of capital
— sometimes votes are
required on major business
decisions
Memorandum of Association — the rules by which the corporation is organised. For

example the memorandum describes how directors are elected.
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Articles of Incorporation:
• Name of the corporation
• Intended life of the corporation (it may be forever)
• Business purpose
• Number of shares that the corporate is authorised to issue with a statement of

limitations and rights of different classes of shares
• Nature of the rights granted to shareholders
• Number of members of the initial board of directors
Partnership Corporation
Liquidity and marketability Restricted trading Traded easily, sometimes on

exchange
Voting rights Partners have control Each share gives a voting right
Taxation Profits taxed at personal tax rate Profits taxed at corporate tax rate
Reinvestment and dividend All profits allocated to partners Total freedom in dividend
payout decisions
Liability General Partners have unlimited Shareholders have limited liability

liability
Continuity of existence Limited life Unlimited life
2.2 The Agency Problem and Control of the Corporation
Type I agency relationships
These are relationships between managers and shareholders. Such a relationship exists
whenever someone (the principal) hires another (the agent) to represent his or her
interests. In all such relationships, there is a possibility there may be a conflict of interest
between the principal and the agent, i.e. a type I agency problem.
Management goals
Managers want to maximise their own wealth and power, while shareholders want
managers to maximise the value of the company.
Type I agency costs
Agency costs — the cost of the conflict of interest between shareholders and
management, which can be direct or indirect.
Direct costs — corporate expenditure that benefits managers at the expense of

shareholders.
Indirect costs — corporate expenditure to monitor and control manager activities.
Type I agency problem — the possibility of conflict of interest between the shareholders
and management of a firm.
Examples: private jet, payment of auditors, large administrative tiers.
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Do managers act in shareholders’ interests?
Whether managers will, in fact, act in the best interests of shareholders depends on two
factors. First, how closely are management goals aligned with shareholder goals?
Second, can managers be replaced if they do not pursue shareholder goals? There are a
number of reasons to think that, even in the largest firms, management have a significant
incentive to act in the interests of shareholders.
• Managerial compensation — management will frequently have a significant economic

incentive to increase share value for two reasons. Firstly, managerial compensation is
usually tied to financial performance, especially at the top. Secondly, better performers
within the firm will tend to get promoted.
• Control of the firm — are shareholders powerful? Control of the firm usually rests with
shareholders. They elect the board of directors, who in turn hire and fire managers: e.g.
when working at Apple, shareholders decided that Steve Jobs should be fired, and so
he was.
• Shareholder rights — do shareholders have a facility to call managers to account? The

conceptual structure of the corporation assumes that shareholders elect directors, who
in turn hire managers to carry out their directives. Shareholders therefore control the
corporation through the right to elect the directors. Voting exists in two forms:
cumulative and straight voting.
It is important to note that each share of equity has one vote, e.g. the owner of 10,000
shares will have 10,000 votes.
Cumulative voting
Cumulative voting — a procedure in which a shareholder may cast all votes for one
member of the board of directors.
• To permit minority participation
• Directors are elected all at once
If there are N directors up for election, then 1/(N + 1) x 100 of the shares + 1 share will
guarantee you a seat. For example, let’s say there are 4 directors up for election:
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N=4
1/(4+1) = 0.2 x 100 (20%)
20% + 1 share = 21
Hence, the more seats that are up for election at one time, the easier (and cheaper) it is to
win one.
Straight voting
Straight voting — a procedure in which a shareholder may cast all votes for each member
of the board of directors.
• Directors are elected one at a time
• The only way to guarantee a seat is to own 50% + 1 share
Let’s say that Smith has 20 shares and Jones has 80 shares. Each time voting occurs,
Smith can cast 20 votes and Jones can cast 80. As a consequence, Jones will elect all of
the candidates. For example, let’s say a company has 100 shares in issue and there are
two director vacancies. How many shares do you need to vote in one director under
straight voting?
50% x 100 = 50
50 + 1 = 51 shares
However, straight voting can ‘freeze out’ minority shareholders: that is why many
companies have mandatory cumulative voting. In companies where cumulative voting is
mandatory, devices have been worked out to minimise its impact.
• Proxy voting — a grant of authority by a shareholder allowing another individual to vote

his or her shares. For convenience, much of the voting pin large public corporations is
actually done by proxy.
• Classes of shares — some firms have more than one class of ordinary equity; often the
classes are created with unequal voting rights. A primary reason for creating dual or
multiple classes of equity capital has to do with the control of the firm. If such shares
exist, management of a firm can raise equity by issuing non-voting or limited-voting
shares while maintaining control.
• Pre-emptive rights — a company that wishes to sell equity must first offer it to the
existing shareholders before offering it to the general public; the purpose is to give
shareholders the opportunity to protect their proportionate ownership in the
corporation.
• Dividends — payments by a corporation to shareholders, made in either cash or shares.

Dividends paid to shareholders represent a return on the capital directly or indirectly
contributed to the corporation by the shareholders.
Type II agency relationships
These relationships exist between shareholders who own a significant amount of a

company’s shares (controlling/majority shareholders) and other shareholders who own
only a small proportional amount (minority shareholders).
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Type II agency costs
Type II agency problem — the possibility of conflict of interest between controlling and
minority shareholders.
Such a relationship exists whenever a company has a concentrated ownership structure.

When an investor owns a large percentage of a company’s shares, they have the ability to
remove or install a board of directors through their voting power. This means that,
indirectly, they can make the firm’s objectives align to their own personal objectives,
which may not be the same as that of other shareholders with a smaller proportionate
stake.
Related party transaction — when a dominant shareholder may benefit more from having
one of her firms trading at advantageous prices with another firm she owns.
However, a controlling shareholder may need cash for an investment in company A, and
wish to take the cash from company B through an extraordinary dividend. This will
obviously not be in the interests of company B’s other shareholders, but in aggregate the
action may be more profitable for the controlling shareholder of company B if it stands to
make more money from an investment in company A.
2.3 International Corporate Governance
Different countries will deal with corporate governance in different ways due to variations
in economic, social and religious cultures. The main areas of importance in international
corporate governance include:
• Investor protection (different from country to country)
• The financial system (e.g. Sharia Law in Islamic countries)
• Control mechanisms (different hierarchical structures within the business)
• Firm corporate governance systems
Financial systems: legal systems around the world
The figure to the right demonstrates

countries that follow different legal
systems. Many countries do not follow
one system alone, and the exact legal
environment can be a hybrid of two
systems.
• In a common law system, the law

evolves as a result of the judgement
decisions of courts
• In a civil law system, judges interpret

the law; they cannot change it (UK,
Ireland)
• Under religious law, specific religious

principles form the basis of legal
decisions
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Investor protection
What are the country-level legal rights of shareholders?
• Proxy vote by mail is allowed
• Votes are not blocked before the annual general meeting
• Cumulative voting or proportional representation exists
• Oppressed minorities mechanisms exist
• Pre-emptive rights exist
• There is a minimum percentage to call an extraordinary shareholders’ meeting
Many countries have strong regulations but very weak law enforcement. To what extent
does a government enforce its laws? There are two issues to consider:
1. The efficiency of the judicial system
2. Is the rule of law and order followed?
The financial system
Bank-based systems Market-based systems
• Banks play a major role in facilitating the flow of • Financial markets take on the role of the main
money between investors with surplus cash and financial intermediary
organisations that require funding

• Debates on whether corporations in these
• Countries with this system have very strong systems have a shorter-term focus than in bank-
banks that actively monitor corporations and are based countries, due to emphasis on share price
often involved in long-term strategic decisions
and market performance
• Germany and Japan are examples • However, they have been argued to be more
efficient at funding companies than bank systems
• US and UK are examples
Control mechanisms: ownership structure
The ownership structure is the makeup and constitution of shareholdings in a firm.
Widely Held Firms Closely Held Firms
• No single investor has a large ownership stake in • Where governments, families and banks are the
the firm
main shareholders in firms
• Type I agency relationships dominate (agency • Type II agency relationships dominate (agency
issues between managers and shareholders)
issues between controlling and non-controlling
• Separation between ownership and control
shareholders)
• Exit investment strategies

• Manager and shareholder incentives aligned)
• Many companies in the US and UK are widely • Voice investment strategies

held
The table below presents a breakdown of the ownership structure of the 20 largest
corporations in a number of selected companies across the world. Ownership structure
has a massive impact on corporate objectives. Whereas all shareholders wish to
maximise the value of their investment, how value is assessed differs according to the
individual.
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In summary:
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Lecture 2: Financial Statement Analysis

3.1 The Annual Report
Every year, a company will release its annual report. In addition to information relating to
the performance and activities of the firm over the previous year, the annual report
presents three financial statements:
• The statement of financial position (balance sheet)
• The income statement
• The statement of cash flows
Who reads the annual reports and why?
• Investors: corporate governance information on how the company is being run and its
performance (primary purpose)
• Agency relationships:
• Type I Agency relationship: shareholders v management
• Type II Agency relationship: dominant/controlling shareholder versus shareholders

with smaller ownership stakes
• Suppliers: short-term solvency
• Lenders: longer-term solvency
• Potential investors: performance, growth potential
• Government: growth, performance, solvency, potential tax revenues
• Analysts/advisors: performance, solvency, growth, risk
• Competitors: trends in performance
3.1.1 The Statement of Financial Position (Balance Sheet)
Statement of financial position (balance sheet) — financial statement showing a firm’s

accounting value on a particular date.
The statement of financial position is a snapshot of the firm. It is a convenient means of

organising and summarising what a firm owns (its assets), what the firm owes (its
liabilities), and the difference between the two (the firm’s equity) at a given point in time.
The figure below demonstrates how the statement of financial position is constructed.
The left side lists the assets of the firm, and the right side lists the liabilities and equity.
Left side: total value of assets.
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Assets: the left side
Assets are classified as either current or non-current.
Non-current assets (or fixed assets)

• A non-current asset has a relatively long life (12+ months)
• It can be either tangible, e.g. a truck or computer, or intangible, e.g. a trademark or

patent
Current assets
• A current asset has a life of less than 1 year, meaning the asset will convert to cash
within 12 months
• For example, inventory would normally be purchased and sold within a years and is
thus classified as a current asset
• Cash itself is a current asset
• Trade receivables (money owed to the firm by its customers) are also current assets
Liabilities and owners’ equity: the right side
The firm’s liabilities are the first thing listed on the right side of the statement of financial
position. They are classified as either current or non-current:
Current liabilities:
• Like current assets, they have a life of less than one year (and hence must be paid
within the year)
• Usually listed before non-current liabilities
• Trade payables (money the firm owes to its suppliers) are an example of a current
liability
Non-current liabilities:
• A debt that is not due in the coming year is classified as a non-current liability e.g. a
loan that needs to be paid off in 5 years
• Bond and bondholders is used generically to refer to long-term debt and long-term
creditors
Owners’ equity
The difference between the total value of the assets (current and non-current) and the
total value of the liabilities (current and non-current) is the
shareholder’s equity (or ordinary equity or owners’ equity)
This feature of the statement of financial position is Liabilities

intended to reflect the fact that if the firm were to sell all of
its assets and use the money to pay off its debts, then
whatever residual value remained would belong to the Assets
shareholders. So, the balance sheet ‘balances’ because
the value of the left side always equals to the value on the
right side. That is, the value of the firm’s assets is equal to Equity
the sum of its liabilities and shareholder’s equity:
NCA + CA = CL + NCL + E (Assets = Liabilities + Shareholders’ equity)

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Net working capital
Net working capital — current assets less current liabilities.
Net working capital is positive when current assets exceed current liabilities. It is
important to ensure that net working capital is positive. Positive net working capital
means that enough cash will be available to pay off liabilities arising. This is not always
true however, as it depends on the industry.
Examples
Lecture example 1: a company has total assets of £170, current liabilities of £30, non-
current liabilities of £50. What is its equity?
NCA + CA = CL + NCL + E
170 = 30 + 50 + x
170 = 80 + x
90 = x
Lecture example 2: a company has a net working capital of £70, non-current assets of
£50, and equity equal to £80. What are the non-current liabilities?
NCA + CA = CL + NCL + E
—> NWC = CA — CL
NCA + (CA — CL) = NCL + E
50 + 70 = x + 80
120 — 80 = x
x = 40
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Notes:
• Retained earnings are what we have not paid as dividends
• “Retained earnings” for sole proprietorships goes to personal income
• We assume that non current liabilities is debt throughout this unit
Market value vs. book value
International Accounting Standards (IAS) — the common set of standards and procedures
by which audited financial statements are prepared in Europe and many other countries.
The values shown in the statement of financial position for the firm’s assets are book
values, and generally not normally what the assets are actually worth. Henceforth,
whenever we speak of the value of an asset or the value of the firm, we shall normally
mean its market value. For example, when we say the goal of the financial manager is to
increase the value of the equity, we mean the market value of the equity.
Book value Market value
• Accounting figures drawn from accounting • Value based on prices or market valuations
standards
• Value of a company = share price x number of
• Therefore the balance sheet will not always show shares in issue
market valuations
3.1.2 The Income Statement (Statement of Profit and Loss and

Consolidated Income)
Income statement — financial statement summarising a firm’s performance over a period

of time.
The income statement measures performance over Revenues
some period of time, usually a quarter, six months or a Net Income

year. The income statement equation is:
(Profit for
the year)
Net income (profit for the year) = revenues — expenses
Expenses
If you think of the statement of financial position as a
snapshot, then you can think of the income statement
as a video recording covering the period between
before and after pictures.
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Notes:
• Profit for the year is the same as net income.
• Profit before interest and tax can also be seen in certain income statements
• EBIT can also be seen, which is earnings before interest and tax
Contents of income statement
• The first thing reported in an income statement would usually be revenue and expenses
from the firm’s principal operations
• Subsequent parts include, among other things, financing expenses such as interest
paid.
• Taxes paid are reported separately as well for example
• The last item to be included is net income (the so-called both line)
• Net income is often expressed on a per-share basis and called earnings per share (EPS)
Important considerations
When looking at an income statement, the financial manager needs to keep two main
things in mind: International Accounting Standards (IAS) and cash versus non-cash items.
IAS and the income statement
An income statement prepared using IAS will show revenue when it accrues, which is not
necessarily when the cash comes in. The general rule (the recognition or realisation
principle) is to recognise revenue when the earnings process is virtually complete, and
the value of an exchange of goods or services is known or can be reliably determined. In
practice, this principle usually means that revenue is recognised at the time of sale, which
need not be the same as the time of collection.
Expenses shown on the income statement are based on the matching principle. The
basic idea here is to first determine revenues as described previously and then match
those revenues with the costs associated with producing them. So, if we manufacture a
product and then sell it on credit, the revenue is realised at the time of sale. So, if we
manufacture a product and then sell it on credit, the revenue is realised at the time of
sale. The production and other costs associated with the sale of that product will likewise
be recognised at that time.
As a result of the way revenues and expenses are realised, the figures shown on the
income statement may not be at all representative of the actual cash inflows and outflows
that occurred during a particular period.
Non-cash items
Non-cash items — expenses charged against revenues that do not directly affect cash
flow, such as depreciation.
A primary reason why accounting income differs from cash flow is that an income
statement contains non-cash items, the most important of which is depreciation.
Suppose a firm purchases an asset for £5,000 and pays in cash. Obviously, the firm has a
£5,000 cash outflow at the time of purchase. However, instead of deducting the £5,000 as
an expense, an accountant might depreciate the asset over its lifetime.
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If the depreciation is straight-line and the asset is written down to zero over that period,
then £5,000/5 = £1,000 will be deducted each year as an expense. The important thing to
recognise is that this £1,000 deduction isn’t cash — it’s an accounting number. The actual
cash outflow occurred when the asset was purchased.
Taxes
Taxes can be one of the largest cash outflows a firm will experience. The size of a
company’s tax bill is determined by the tax code in each country that it operates, and
these are regularly changed by individual governments.
Corporate tax rates
An overview of corporate tax

rates for a sample of countries
that were in effect for 2013 is
shown to the right. Almost all
countries in the world allow
firms to carry forward losses
they make in previous years to
offset their tax bill in the future.
Average tax rates

• This is the percentage of your
income that is paid in taxes
• Your tax bill divided by your

taxable income
• Average tax rate = tax paid

divided by operating profit
Marginal tax rate

• The tax you would pay (in percent) if you earned one more unit of currency
• Put another way, marginal tax rates apply to the part of income int eh indicated range
only, not all income
Cash Flow Statement
Operating cash flow — cash generated from a firm’s normal business activities.
Total cash flow — the total of cash flow from operating activities, investing activities and
financing activities.
Cash flow is the most important item to take from financial statements. It is NOT the
same as net income. By cash flow we mean the difference between the cash that came in
and the cash that went out.
Cash flows that arise because of the firm’s core operations are known as operating cash
flow/activities. When a company buys or sells a warehouse, this is a long-term
investment that will span many years , and a cash flow of this type relates to the firm’s
long-term investing activities. Finally, if a firm raises cash in the form of equity or debt,
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the cash flow would be part of its financing activities. Any cash flow that occurs can be
identified as one of these three components:
Total cash flow
= Cash flow from operating activities
+ Cash flow from investing activities
+ Cash flow from financing activities
Below is a comprehensive example of a statement of cash flows.
• Interest received for example, is in investing activities
• Dividends paid for example is in financing activities
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Cash flow from operating activities
Operating cash flow refers to the cash flow that results from the firm’s day to day
activities of producing and selling. Certain aspects are not included in this, for example:
• Expenses associated with the firm’s financing of its assets or the purchase of buildings
are not included
• Depreciation is also not included
• Interest is not included
The only ‘financial’ exception that can be entered into the section is when we are
considering the accounts of a financial institution, such as a bank, where interest
payments and receipts relate directly to operating income. Also, Taxes are included
because they are paid in cash.
Operating cash flow is an important number because it tells us on a basic level whether a
firm’s cash inflows from its business operations are sufficient to cover its everyday cash
outflows. Hence, a negative operating cash flow is a bad sign.
Cash flow from investing activities
Cash flow from investing activities is cash generated or expended from a firm’s long-term
investments. It is the money spent on non-current assets less money received from the
sale of non-current assets. Examples of entries that go in this section include:
• PPE (property, plant and equipment)
• Interest received
Cash flow from investing activities can be positive if the firm sold off more assets than it
purchased.
Cash flow from financing activities
Cash flow from financing activities is cash generated or expended as a result of its debt
and equity choices. The last major component of a firm’s cash flow comes from any
actions it has taken during the year to raise cash from investors. The company may also
have paid back outstanding borrowings, or repurchased its own shares. Cash flow from
financing activities can be substantial.
Net cash flow
Given the figures we've come up with, we’re ready to calculate cash flow for the firm. The
total cash flow is found by adding the cash flow from operating activities, to the cash
flows from investing and financing activities.
3.2 Ratio Analysis
Financial ratios — relationships determined from a firm’s financial information and used
for comparison purposes.
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One of the main ways to understand how healthy a company is and how well it has
performed is to carry out a ratio analysis and compare them to the ones of competitors.
There are many types of ratios:
• Liquidity ratios
• Financial leverage ratios
• Turnover ratios
• Profitability ratios
• Market value ratios
1. Liquidity ratios/short-term solvency ratios
These are intended to provide information about the firm’s liquidity, and these ratios are
sometimes called liquidity measures. The primary concern is the firm’s ability to pay its
bills over the short run without undue stress. They focus on current assets and current
liabilities. Liquidity ratios are particularly interesting to short-term creditors.
The higher the liquidity ratio:
• The more liquid/solvent the company is in the short-term
• Less risk of financial distress in the short-term
The ‘norm’ will vary by industry. For example, a supermarket chain will have low accounts
receivable (because customers pay for goods before leaving the store) but high accounts
payable and inventories.
Current ratio
Current ratio = current assets
current liabilities
Current ratio for UK supermarkets
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Quick or acid-test ratio
Quick ratio = (current assets — inventory)
current liabilities
Inventory is often the most illiquid current asset. Relatively large inventories are often sign
of short-term trouble. The firm may have overestimated sales, and overbought or
overproduced as a result. In this case, the firm may have a substantial portion of its
liquidity tied up in slow-moving inventory.
Cash ratio
Cash ratio = cash and cash equivalents
current liabilities
Example
Workings are for 20X2:
Current ratio = 10,118 / 7,413
= 1.36
Quick ratio = (10,118 — 4,812) / 7,413
= 0.7
Cash ratio = 1,559 / 7,413
= 0.21
2. Financial leverage/long-term solvency ratios
Long-term solvency ratios are intended to address the firm’s long-term ability to meet
its obligations, or, more generally, its financial leverage.
The lower the debt ratio of debt-equity ratio and the higher the equity multiplier or interest
cover ratios:
• The more liquid/solvent the company is in the long-term
• Less risk of financial distress in the long-term
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These ratios are of particular interest to banks and other potential bond investors or when
bidding for a long-term contract.
Total debt ratio
Total debt ratio = total assets — total equity
total assets
The total debt ratio takes into account all debts of all maturities to all creditors.
Debt-to-equity ratio
Debt-equity ratio = total debt
total equity
Equity multiplier
Equity multiplier = total assets
total equity
Interest cover ratio/times interest earned ratio
Interest cover ratio = EBIT
interest
Operating profit is also known as earnings before interest and taxes (EBIT). As the name
suggests, this ratio measures how well a company has its interest obligations covered,
and it is often called the interest coverage ratio.
Cash coverage
Cash coverage ratio = EBIT + depreciation
interest
A problem with the TIE ratio is that it is based on operating profit, which is not really a
measure of cash available to pay interest. The reason is that depreciation and other non-
cash expenses have been deducted out. Because interest is definitely a cash outflow (to
creditors), one way to define the cash coverage ratio is like above.
The ‘EBITDA’ (earnings before interest, taxes, depreciation and amortisation) or

‘EBITD’ (earnings before interest, taxes and depreciation) is a basic measure of the firm’s
ability to generate cash from operations, and it is frequently used as a measure of cash
flow available to meet financial obligations.
3. Turnover ratios/asset utilisation ratios
The ratios in this section can all be interpreted as measures of turnover. What they are
intended to describe is how efficiently or intensively a firm uses it assets to generate
sales.
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Inventory and asset turnover:

• As long as we are not running out of stock and thereby foregoing sales, the higher this
is, the more efficiently we are managing inventory
Receivables and inventory days

• The lower this is, the lower the cash tied up in receivables/inventory and the quicker
customers pay/inventory is sold
Inventory turnover
Inventory turnover = cost of goods sold
inventory
Days’ sales in inventory
Days’ sales in inventory = 365 days
inventory turnover
If we know the inventory turnover, we can immediately figure out how long it took us to
turn it over on average.
Receivables turnover
Receivables turnover = sales
trade receivables
This ratio allows us to see how fast we collect on our sales. However, this ratio may make
more sense if we covert it to days:
Days’ sales in receivables
Days’ sales in receivables = 365 days
receivables turnover
Sometimes this ratio is also called the average collection period (ACP).
Total asset turnover

Total asset turnover = sales
total assets
4. Profitability ratios
In one form or another, they are intended to measure how efficiently a firm uses its
assets and manages its operations. The focus in this group is on the bottom line, net
income.
Profit margin
Profit margin = net income
sales
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A relatively high profit margin is obviously desirable. This situation corresponds to low
expense ratios relative to sales. However, we hasten to add that other things are often not
equal. For example, lowering our sales price will usually increase unit volume, but will
normally cause profit margins to shrink. Total profit (or more important, operating cash
flow) may go up or down; so the fact that margins are smaller isn’t necessarily bad.
However, high volume companies can be profitable with small profit margins.
Return on assets
Return on assets (ROA) = net income
total assets
ROA is a measure of profit per unit cash of assets.
ROA varies according to industry
Return on equity
Return on equity (ROE) = net income
total equity
ROE is a measure of how the shareholders fared during the year. Because benefiting
shareholders is our goal, ROE is the true bottom-line measure of performance in an
accounting sense.
5. Market value ratios
This final group of measures is based, in part, on information not necessarily contained in
financial statements — the market price per share of equity. They measure the long term
success of the company and shareholders value/returns.
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Earnings per share
Earnings per share = earnings (=net income)
shares in issue
This ratio measures return per share to shareholders.
Price-earnings (P/E) ratio
Price-earnings (P/E) ratio = price per share
earnings per share
The P/E ratio is simply net income divided by the number of shares. This measures how
much investors are willing to pay per unit (e.g. per GBP 1 or EUR 1) of current earnings.
Higher P/E can indicate expectation of strong future growth.
Market-to-book ratio
Market-to-book ratio = market value per share
book value per share
This gives an indication of how successful the company has been over time in creating
value for its shareholders. In a loose sense, this compares the market value of the firm’s
investments with their cost. A value less than 1 could mean that the firm has not been
successful overall in creating value for its shareholders. This ratio focuses on historical
costs, which are less relevant however.
PEG ratio
PEG ratio = P/E ratio
earnings growth rate
This gives an indication of whether shares are under-valued (PEG > 1) or over-valued
(PEG < 1) against projected growth rates.
Tobin’s Q
Tobin’s Q = market value of firm’s assets (=debt+equity)
replacement cost of firm’s assets
This is the market value of the firm’s assets divided by their replacement cost. It is
superior to the market-to-book ratio because it focuses on what the firm is worth today
relative to what it would cost to replace it today. Firms with high Q ratios tend to be those
with attractive investment opportunities or significant competitive advantages (or both).
Q ratios are difficult to calculate with accuracy, because estimating the replacement cost
of a firm’s assets is not an easy task. Also, market values for a firm’s debt are often
unobservable.
Note: firm value is located as equity plus debt value this time.
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3.3 The Du Pont Identity
Du Pont Identity — popular expression breaking ROE into three parts: operating
efficiency, asset use efficiency, and financial leverage.
The Du Pont Identity tells us that ROE is affected by:
• Operating efficiency (as measured by profit margin)
• Asset use efficiency (as measured by total asset turnover)
• Financial leverage (as measured but eh equity multiplier)
To begin, let’s recall the definition of ROE:
ROE = net income
total equity
If we were so inclined, we could multiply this ratio by assets / assets without changing
anything:
ROE = net income = net income x assets
total equity total equity assets
= net income x assets
assets total equity
Notice that we have expressed the ROE as the product of two other ratios — ROA and
the equity multiplier:
ROE = ROA x equity multiplier
= ROA x (1+debt-equity ratio)
The difference between ROE and ROA can be substantial, particularly for certain
businesses that have borrowed a lot of money. We can further decompose ROE by
multiplying the top and bottom by total sales:
ROE = sales x net income x assets
sales assets total equity
If we rearrange this a bit, ROE looks like this:
ROE = net income x sales x assets
sales assets total equity
return on assets
= profit margin x total asset turnover x equity multiplier
What we have done now is to partition ROA into its two component parts: profit margin
and total asset turnover. The last expression of the preceding equation is called the Du
Pont identity, after the Du Pont Corporation, which popularised its use.
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3.4 Using Financial Statement Information
• Time trend analysis — looks at the same ratio over a number of years.
• Peer group analysis — compares ratio with similar firms/companies in the same
industry (check SIC code).
• Inappropriate peers — some companies operate in several industries and have different
accounting standards.
• Aspirant analysis — you may want to compare your firm with the best in the industry, or
choose similar firms which are at the top of the industry
• Sources of information — financial websites e.g. Yahoo, Finance, Reuters, FT.com..etc.

Company accounts can be downloaded from their websites.
Problems with financial statement analysis
• There is no underlying theory to help us identify which quantities to look at or guide us

in establishing benchmarks
• There is not much help in terms of financial guidance for making judgements about
value and risk e.g. we can’t say which ratios matter the most
• Differences between financial statements outside of Europe makes it hard to compare

financial statements with companies that are across national borders
• Different firms use different accounting procedures
• Different firms end their fiscal years at different times
• Firms in seasonal businesses will have difficulty comparing statements because of

fluctuations throughout the year
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Lecture 3: Financial planning
3A.1 Understanding financial planning
A lack of effective long-range planning is a commonly Creating Growth

cited reason for financial distress and failure/
value
Financial planning helps plan for the future and helps

to establish guidelines for change and growth in a
firm. An example would be looking at the Identify new Model future
consequences of a growth strategy by modelling financing financial
financial statements.
needs statements
What can planning accomplish?
• Examine interactions— the financial plan must make explicit the linkages between
investment proposals for the different operating activities of the firm and its available
financing choices. In other words, if the firm is planning on expanding and undertaking
new investments and projects, where will the financing be obtained to pay for this
activity?
• Explore options — the financial plan allows the firm to develop, analyse and compare
many different scenarios in a consistent way. Various investment and financing options
can be explored, and their impact on the firm’s shareholders can be evaluated.
Questions concerning the firm’s future lines of business and optimal financing
arrangements are addressed. Options such as marketing new products or closing plans
might be evaluated.
• Avoid surprises — financial planning should identify what may happen to the firm if
different events take place. In particular, it should address what actions the firm will take
if things go seriously wrong or errors are made.
• Ensure feasibility and internal consistency — at times, the linkages between the
business’ various goals and different aspects of the business are difficult to see. A
financial plan makes these linkages explicit and imposes a unified structure for
reconciling goals and objectives, hence the goals are made consistent and feasible.
3A.2 Financial planning models
A simple example (example 1)
We begin with a simple case, Chute SA has the following statements:
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Unless otherwise stated, the financial planners at Chute assume that all variables are tied
directly to sales, and current relationships are optimal. This means that all items will grow
at exactly the same rate as sales. This is obviously oversimplified, we use this assumption
only to make a point.
What happens if Chute increases its sales by 20% in the next year?
 
We will assume all the items increase the same percentage as
sales, so:
• Sales: 1,000 x 120% = 1,200
• Costs: 800 x 120% = 960
• Net profit: 1,200-960 = 240
In the same way, we increase each balance sheet item by 20% in the example.
• Assets: 500 x 120% = 600
• Debt and equity: 250 x 120% = 300
(The numbers in the parentheses

show the increase in money)
Results analysed
• Net profit/income = £240
• Increase in equity = £50
Now we have to reconcile these two pro formas. How, for example, can net profit be
equal to £240 and equity increase by only £50? The answer is that Chute must have paid
out the difference of £240-£50 = £190. This difference must be dividend paid.
Net income of £240 = retained earnings for the year of £50 + dividend of £190.
The increase in assets by £100 can be funded by the new debt of £50, or Chute could
raise new equity.
Net income: retained earnings and dividend payout
‘Retained
Retention ratio (b)
earnings’ added
to equity and = Retained earnings
reinvested in the Net income
Net business
income Dividend payout ratio
= Dividend paid
Dividend Net income
Note: Retention ratio plus dividend payout ratio = 1
Net income must either be retained in the business or be payed out as dividends in
company statements (this is not the case for sole proprietorships):
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• Dividend payout ratio — the amount of cash paid out to shareholders divided by net
income. This is the percentage of income that is paid out as dividends, e.g. 60% means
that 60% of net income has been paid into dividends.
• Retention ratio — the addition to retained earnings divided by net income. It is the
percentage of income that we retain in the business, e.g. 70% means that 70% of net
income has been retained in the business.
We just described a simple planning model in which every item increased at the same rate
as sales. Now let us assume only some variables are tied to sales growth, as this is more
realistic. In tutorial/exam questions, the question will usually say, “Assume assets vary
with sales”.
Example 2: This time “assume assets vary with sales”
(a) What is the dividend payout ratio for Hoffman in 20X1 below?
(b) If sales increase by 25% over the year and assets vary with sales and the dividend
payout ratio remains the same, what new external financing is required?
Income statement 20X1 Statement of financial position 20X1
£ £ £
Sales 500 Assets 500 Total liabilities 250
Costs including 434 Equity 250

tax
Net income 66 Total 500 Total 500
Dividends 22
Retained 44
earnings
Answer to part (a):
Dividend payout ratio = 22/66 = 33%
Retention rate, b = 44/66 = 66%
Answer to part (b):
Step 1: All sales, costs and assets are increased by 25%.
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Dividends and retained earnings can be calculated in two ways in this example. In order
to obtain the new values for 20X2, you can do:
1. 22 x 1.25 (dividends times the increase of 25%) or
2. 33% x 82 (dividend payout ratio times net income for 20X1)
Additionally, retained earnings need to be added to equity for 20X2: £250 + £55= £305.
This is because retained earnings go back into the business as equity.
Step 2: Identify the funding problem. Here, this is that total assets are larger than total
liabilities. So, this requires new external financing:
£625-£555 = £70
This means that the company will now need £70 of external financing:
Note that the new financing can be raised by:
• Reducing or waiving (getting rid of) the dividend
• New borrowings, such as short-term or long-term
• New external equity financing (issuing shares)
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3A.3 Understanding links between growth, dividend policy and

performance
Growth, dividend policy and performance (EFN and growth)
External financing needed (EFN) and growth are obviously related. All other things staying
the same, the higher the rate of growth in sales or assets, the greater will be the need for
external financing.
In example 2, we had a financing gap to fill. Remember, if you grow the business, you will
need to reinvest in assets and need to pay for that investment.
Growth > 10% Our assets grew by 125
requires new
external
financing EFN = 70
We retained 55 earnings (=
internal financing)
Our example
Growth => increase in assets (diagonal line above)
If the increase in assets > retained earnings, you need external financing
Financial policy and growth
Internal growth rate (IGR)
Internal growth rate (IGR)— the maximum growth rate that can be financed solely by
retained earnings, not using external financing.
In figure 3A.1, this internal growth rate is represented by the point where the two lines
cross. At this point, the required increase in assets is exactly equal to the addition to
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retained earnings, and EFN is therefore zero. This occurs when the growth rate is slightly
less than 10%. This growth rate can be defined as:
IGR = ROA x b
(1 - ROA x b)
Where:
b = retention rate
ROA = return on assets
If you increase the retention rate, the top half will get bigger, the bottom half will get
smaller, and overall the result will get bigger. Our growth rate hence can get larger.
Example:
Company A has a net income of £66, total assets of £500, the company has declared a
dividend of £22, what is the IGR of company A assuming this dividend payout ratio is not
likely to change in the future?
Answer:
ROA = 66 = 13.2%
500
Dividend payout ratio = 22 = 1/3 (33%)
6 6
Retention ratio (b) = 1 - dividend payout ratio
= 1 - 1/3
= 2/3 (66%)
IGR = ROA x b
(1 - ROA x b)
= 13.2% x 2/3
(1-13.2% x 2/3)
= 9.65%
The sustainable growth rate (SGR)
Sustainable growth rate (SGR) — the maximum growth rate we can achieve without
taking out any new external equity financing while maintaining a constant debt-equity
ratio.
We have seen that if company A wishes to grow more rapidly than at a rate of 9.65% per
year, external financing must be arranged. Now, suppose that we are happy to raise some
new borrowings, as long as the debt-equity ratio stays the same. So, for example, if
equity increases by 10% after adding retained earnings to the opening balance, we are
also happy to increase borrowings (debt) by 10% by taking out new external debt finance.
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(Equity goes up by 10% and debt by 10% and hence means that the debt-equity ratio
can stay the same).
SGR = ROE x b
(1-ROE x b)
Where:
b = retention rate
ROE = return on equity
This will result in slightly greater growth as we are allowing debt to increase.
Example:
Company A has a net income of £66, total assets of £500, total liabilities of £250 and has
declared a dividend of £22, what is the SGR of company A assuming this dividend payout
ratio is not likely to change in the future?
Answer:
Equity = £500-£250
= £250
ROE = 66 = 26.4%
250
Dividend payout ratio = 22 = 1/3 (33%)
66
Retention ratio (b) = 1-dividend payout ratio
= 1-1/3
= 2/3 (66%)
SGR = ROE x b
(1-ROE x b)
= 26.4% x 2/3
(1-26.4% x 2/3)
= 21.63%
Thus, company A can expand at a maximum rate of 21.36% per year without external
equity financing.
Determinants of growth
We have seen that ROE can be decomposed into its various components using the Du
Pont Identity. Because ROE appears so prominently in the determination of the
sustainable growth rate, it is obvious that the factors important in determining ROE are
also important determinants of growth. We know that ROE can be written as the product
of 3 factors:
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ROE = PM (profit margin) x TAT (total asset turnover) x EM (equity multiplier)
If we examine our expression for the SGR, we see that anything that increases ROE will
increase the SGR by making the top bigger and the bottom smaller. Increasing the
plowback ratio will have the same effect. Hence, a firm’s ability to sustain growth
depends explicitly on the following 4 factors:
• Profit margin (PM) — an increase in profit margin will increase the firm’s ability to
generate funds internally and thereby increase its sustainable growth.
• Total asset turnover (TAT) — an increase in the firm’s total asset turnover increases the
sales generated for each pound in assets. This decreases the firm’s need for new assets
as sales grow and thereby increase the sustainable growth rate. Notice that increasing
total asset turnover is the same thing as decreasing capital intensity.
• Financial policy — an increase in the debt-equity ratio increases the firm’s financial
leverage. Because this makes additional debt financing available, it increases the SGR.
• Dividend policy — a decrease in the percentage of profit attributable to shareholders

(net income) paid out as dividends will increase the retention ratio. This increases
internally generated equity and thus increases sustainable growth.
Hence:
• Increased PM, TAT and debt/equity promote growth
• Higher dividend payout reduces growth
Example
A firm wishes to maintain an internal growth rate of 8% and a dividend pay-out ratio of
26%. The current profit margin is 5%. The firm uses no external financing sources. What
must total asset turnover be?
Step 1
The question mentions PM and TAT, so we can guess that Du Pont will come in useful.
ROA = PM x TAT
= 5% x TAT
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So if we can find ROA, we can calculate TAT.
Step 2
Calculate ROA using the internal growth rate formula.
IGR = (ROA x b)
(1-ROA x b)
Dividend payout ratio = 26%
b = 1-26%
= 74%
Hence:
0.08 = (ROA x 0.74)
1 - (ROA x 0.74)
0.08 = (0.05 x TAT x 0.74)
ROA = 0.1001
Step 3
Substitute back into the extended ROA formula above:
ROA = 5% x TAT
TAT = ROA
0.05
= 0.1001
0.05
= 2 times
Summary
The SGR is a very useful planning number. What it illustrates is the explicit relationship
between th firm’s four major areas of concern: operating efficiency as measured by profit
margin, its asset use efficiency as measured by total asset turnover, its dividend policy as
measured by the retention ratio, and its financial policy as measured by the debt-equity
ratio. Given values for all four of these, there is only one growth rate that can be achieved.
Hence:
If a firm does not wish to sell new equity and its profit margin, dividend policy, financial
policy and total asset turnover (or capital intensity) are all fixed, then there is only one
possible growth rate.
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Important caveats in financial planning
Financial planning models do not always ask the right questions. A primary reason is that
they tend to rely on accounting relationships and not financial relationships. In particular,
the three basic elements of the firm value tend to get left out — cash flow size, risk and
timing. Because of this, financial planning models sometimes do not produce meaningful
clues about what strategies will lead to increases in value. Instead, they divert the user’s
attention to questions concerning the debt-equity ratio and firm growth for example.
Additionally, financial models are often too simple. The ones being used are accounting
based models at heart, which are useful for pointing out inconsistencies and reminding us
of financial needs, but they offer little guidance concerning what needs to be done about
these problems.
Lastly, financial planning is an iterative process. Plans are created, examined and
modified over and over, and processed by different parties in different departments,
where employees all have different plans on how to reach a certain goal. The final plan
therefore will contain different goals in different areas, and also satisfy many constraints.
Hence, such a plan doesn't need to be a dispassionate assessment of what we think the
future will bring, but instead a means of reconciling the planned activities of different
groups and a way of setting common goals for the future.
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Lecture 4: Introduction to Valuation: The Time Value of

Money
4.1 Future value and compounding
Investing for a single period
Future value (FV) — the amount an investment is worth after one or more periods.
Year 0 • You invest £100 at 10%
• Your money grows

Year 1 to £100 + 10% of
£100 = £110
So:
V1 = V0 (1 + r)
Where V1 is the value after 1 period; r is the interest/discount rate for one period.
*One period = one year
Example
What is the future value for an investment for more than one period at a compound
interest rate of 10%?
£100 —> £110 —> £121 —> £133.10
+ £10 + £11 + £12.10
Where:
£100 x 1.10 = £110
£110 — £100 = £10 (interest you earn in period)
£110 x 1.10 = £100 x 1.102 = £121
£121 — £110 = £11 (interest you earn in period)
£121 x 1.10 = £100 x 1.103 = £133.10
£133.10 — £121 = £12.10 (interest you earn in period)
Investing for more than one period
Compounding — the process of accumulating interest on an investment over time to earn

more interest.
Interest on interest — interest earned on the reinvestment of previous interest payments.
Simple interest — interest earned only on the original principal amount invested.
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Compound interest — interest earned on both the initial principal and the interest
reinvested from prior periods.
In general:
Vt = V0 x (1 + r)t
Where Vt is the value after t periods; r is the interest/discount rate for one period.
We call Vt the FUTURE VALUE at the end of t periods of compound interest r.
We call V0 the PRESENT VALUE at the start of the time period being considered.
Note: PV may not be TODAY.
The formula on your mid-term test formula sheet is written:
FV = PV x (1+r)t
Example 2a
What was the interest on interest in period 2 in example 1?
£10 (interest you earn in period 2) x 10% (interest rate paid)
= £1
Interest on interest in period 2 was £1. Without compounding, period 2 interest would
have been £10. The extra £1 is interest on interest, being 10% x the original interest of
£10.
Example 2b
What was the interest on interest in period 3 in example 1?
£21 (interest earned up to the end of period 2: £10 + £11) x 10% (interest rate paid)
= £2.10
Without compounding, period 3 interest would have been £10. The extra £2.10 is interest
on interest, being 10% x the interest earned up to the end of period 2, being £21 (where
£21 = £10 + £11).
Example 3
What would the interest payment have been in period 3 in example 1 if simple interest
had been paid?
Interest is simply 10% of the original amount invested. That is, interest is £10 every
period.
£100 —> £110 —> £120 —> £130, etc
+ £10 + £10 + £10
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The interest on interest is growing every period: e.g. period 1 = 0, period 2 = 1, period 3 =
2.10, period 4 = 3.31, etc.
Future value of £1 for different periods and rates Growth of £100 original amount at 10%
per year. The orange shaded area shows
the simple interest. The green shaded
area represents the portion of the total
that results from compounding of

interest.
Future values depend critically on the assumed

interest rate, particularly for long-lived investments.
Figure 4.2 illustrates this relationship by plotting the
growth of £1 for different rates and lengths of time.
Notice that the future value of £1 after 10 years is
about £6.20 at a 20% rate but it is only about £2.60
Figure 4.2: Future value of £1 for different periods and rates at 10%. In this case, doubling the interest rate

more than doubles the future value.
To solve future value

problems, you can use a
table that contains future
value factors for some
common interest rates and
time periods.
4.2 Present value and discounting
Present value — the current value of future cash

flows discounted at the appropriate discount rate.
• Receive £1,
Year 1 interest
rate is 10%
Discount — calculate the present value of some
future amount.
• What is the
Year 0
Present value x 1.1 = £1
Present value = £1 / 1.1

Year 0 equivalent
value of £1
received in
= £0.909
Year 1?
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The present value of future cash flows is equal to:
PV (V0) = Vt
(1+r)t
Where Vt is the same value at time t; r is the interest rate used, sometimes called the
DISCOUNT RATE.
Example 4a
What is £100 payable in one year’s time worth today at a n interest rate of 10%?
Note: interest rates should be assumed to be compound rates unless the question says
‘simple interest rate’.
PV = 100 / (1+10%)
= 100/1.10
= £90.91
This time, DIVIDE by (1+r), that is, divide by 1.10 in this example as r = 10% = 0.10.
So £100 in one year’s time is worth 100/1.10 = £90.91 today.
Example 4b
What is £100 payable in two year’s time worth today at an interest rate of 10%?
PV = 100 / (1+10%)2
= 100/1.102
= £82.64
Divide by 1.102 in one step. So £100 in two year’s time is worth 100/1.102 = £82.64 today.
4.3 More about present and future values
Discount rate — the rate used to calculate the present value of future cash flows.
Discounted cash flow (DFC) valuation — calculating the present value of a future cash
flow to determine its value today.
General rule:
PV = FVt
(1+r)t
That is, present values are smaller than future values (as long as r is a positive number). In
order to get to this formula, you have to derive the PV formula from the FV formula:
PV x (1+r)t = FVt
PV = FVt / (1+r)t
= FVt x [1/(1+r)t]
= FVt x (1+r)-t
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Calculating t (finding the number of periods)
So far, we have just calculated PV or FV from values we have been given for r and t. You
may also be asked to calculate r or t.
Example 5
You've been saving up to buy Godot Ltd. The total cost will be £10 million. You currently
have about £2.3 million.
(a) If you can earn 5% on your money, how long will you have to wait?
(b) At 16%, how long must you wait?
(a) From the basic present value equation:
Use PV = FV / (1+r)t
PV = £2.3 million
FV = £10 million
r = 5%
£2.3 million = £10 million / 1.05t
£10 million / £2.3 million = 1.05t
1.05t = 4.35
Now we need to solve for t. Using trial and error:
Try t = 10, 1.05^10 = 1.629
Try t = 20, 1.05^20 = 2.653
Try t = 30, 1.05^30 = 4.322
Try t = 31, 1.05^31 = 4.533
So the best answer is 30 years.
(b) Now assume r = 16%, what is t? How many years before you have £10 million?
Use PV = FV / (1+r)t
PV = £2.3 million
FV = £10 million
r = 16%
£2.3 million = £10 million / 1.16t
£10 million / £2.3 million = 1.16t
So, 1.16t = 4.35
Now solve for t using trial and error:
Try t = 10, 1.16^10 = 4.41
Try t = 9, 1.16^9 = 3.80
So, the best answer is 9 years.
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Calculating r
We often need to calculate the return that the investment has generated. That is, calculate
the implicit interest rate, r.
Use the following formula, which is on your formula sheet:
r = (FV/PV)(1/t) - 1
Proof: PV = FV
(1+r)t
Solve for r:
(1 + r)t x PV = FV
So, (1 + r)t = FV/PV
So, 1 + r = (FV/PV)(1/t)
So, r = (FV/PV)(1/t) - 1
Example 6
You invested £10,000 five years ago and your investment is now worth £15,000. What
was the annual return (interest) earned on your investment?
Use r = (FV/PV)(1/t) - 1
Where FV = value at the end of the investment: £15,000
PV = value at the start of the investment: £10,000
t = 5 years
Solve for r:
r = (15,000/10,000)(1/5) - 1
r = 1.5^0.2 - 1
r = 1.08447 - 1
r = 0.08447
= 8.447%
Answer, to 2 decimal places = the annual return earned on the investment was 8.45%
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Lecture 5: Discounted Cash Flow Valuation

Future and present values of multiple cash flows
Present value with multiple cash flows
Example 1
Suppose you receive £1,000 in one year and £2,000 in 2 years. If you can earn 9% on
your money, how much do you have to deposit today to exactly cover these amounts in
the future? In other words, what is the present value of the two cash flows at 9%? This
method involves calculating the present values individually and adding them up.
Payment of £1,000 in one year:
PV = FV / (1+r)t
= £1,000 / 1.091
= £1,000 / 1.09
= £917.43
Payment of £2,000 in two years:
PV = FV / (1+r)t
= £2,000 / 1.092
= £2,000 / 1.1881
= £1,683.36
Therefore, £917.43 + £1,683.36
= £2,555.79
Answer: you need to deposit £2,555.79 now to cover these two payments.
Example 2
Suppose you receive £1,000 a year for five years. If you can earn 6% on your money, how
much do you have to deposit today to exactly cover these amounts in the future? In other
words, what is the present value of the two cash flows at 6%? This method involves
discounting back to the present, one period at a time.
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This is very time consuming for any longer periods of time. Fortunately, there is a
shortcut: we can use ANNUITY and PERPETUITY formulas where we have the same cash
flow every period for a number of periods (annuity) or forever (perpetuity).
Annuity — a level stream of cash flows for a fixed period of time.
Perpetuity — a level stream of cash flows forever.
Annuity: present values
The present value of an annuity of £C (or any other currency) per period for t period when
the rate of return or interest rate is r given by:
Present value of annuity = C x [1 — present value factor]
C x {1—[1/(1+r)t] }
C x {1— 1 }
r r(1+r)t
C x Annuity factor (r%, t)
Annuity tables
You can find annuity factors in annuity tables. However, these do not give very accurate
results, and so are often not appropriate in practice. It is important to learn how to use the
formulas instead and, for example, build these into EXCEL spreadsheets.
Example 3
Let’s do example 2 again, but this time use the annuity formula. Suppose you receive
£1,000 a year for five years. If you can earn 6% on your money, how much do you have to
deposit today to exactly cover these amounts in the future? In other words, what is the
present value of the five cash flows at 6%? (It is annuity because it is the same value
every period and it has a finite life).
Reminder: present value of an annuity = C x {1—[1/(1+r)t] }
= C x {1— [ 1 ]}
r (1+r)t
= C x {1— [1+r]-t}
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We know that:
C = £1,000
r = 0.06
t = 5 years
So, PV (annuity) = (£1,000 / 0.06) x (1 — 0.06-5)
= (£16,666.67) x (1 — 0.747258)
= £16,666.67 x 0.25274
= £4,212.36
We therefore arrived at the same answer, but this time in one step using the PV (annuity)
formula.
Perpetuity
A perpetuity is a series of cash flows, C, paid indefinitely into the future. An example of a
perpetuity: dividends payable on preference shares that do not have a redemption date.
Present value of a perpetuity = C/r
Example 4
Now let’s assume that the £1,000 annual payments continue forever (this means it is a
perpetuity, not an annuity). What is the present value of such a perpetuity at a constant
interest rate of 6%? What is the present value now?
Present value of a perpetuity = C/r
We know that:
C = £1,000
r = 0.06
So, the present value of the perpetuity = £1,000 / 0.06
= £16,666.67
Discussion point
Why is the answer to example 4 (£1,000 in

perpetuity) £16,666.67 rather than infinity?
Note that £1,000 in perpetuity is worth
£16,666.67 today and five annual payments
of £1,000 are worth £4,212.36.
The increase in present value decreases

each period until it is negligible as this graph
illustrates. The curve merges to the
horizontal. Hence, the reason why the end
value is not infinity is because eventually
when t = a great value, it makes the total
value much smaller, almost equal to zero
(because t is a power).
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Future value with multiple cash flows
Example 5
Now, let’s look at the future value of multiple cash flows. Suppose you receive £15,000 a
year for four years. If you can earn 6% on your money, how much will your investment be
worth in four years’ time? In other words, what is the future value of the four cash flows at
6%?
Receive £15,000 at time 1, time 2, time 3 and time 4.
FV (payment at time 1) = £15,000 x 1.063 = £17,865.24
FV (payment at time 4) = £15,000.00
Total = £17,865.24 + £16,854 + £15,900 + £15,000
= £65,619.24
Annuity: future values
Alternatively, we could use the future value of an annuity formula to solve example 5. The
future value formula is similar to the present value formula, but this time uses the future
value factor as its base:
Future value of annuity = C x {Future value factor — 1}
= C x {(1+r) — 1}
= C x [(1+r)t — 1]
r
Example 5
Now, let’s rework example 5 using the annuity formula.
FV (annuity) = C x {(1+r)t — 1}
Where:
C = £15,000
t = 4
r = 6% (0.06)
What is the FV of the four cash flows?
FV = (£15,000 / 0.06) x (1.064 — 1)
= £250,000 x 0.262477
= £65,619.24
Check: yes, this is the same answer as the calculation done with the other, more
complicated method.
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Timing of cash flows
A note about cash flow timing
In present and future value problems, cash flow timing is critically important. In almost all
such calculations, it is implicitly assumed that the cash flows occur at the end of each
period. All the formulas we have discussed, all the numbers in a standard present value or
future value table, and (very important) al the preset (or default) settings in a spreadsheet
assume that cash flows occur at the end of each period. Unless you are explicitly told
otherwise, you should always assume that this is what is meant!
Annuities due
Annuities due — an annuity for which the cash flows occur at the beginning of the period.
PV of an annuity due = (1+r) x PV of an annuity
FV of an annuity due = (1+r) x FV of an annuity
Because each cash flow occurs one period earlier than with an ordinary annuity. Almost
any type of arrangement in which we have to prepay the same amount each period is an
annuity due. Suppose an annuity due has five payments of £400 each, and the relevant
discount rate is 10%. The timeline looks like this:
Example 6
Find the PV of a 3 year annuity that will make a series of $100 payments at the beginning
of year for next three years. The discount rate is 10%.
PV of an annuity = C x {[1 — (1/1.103)]/0.10}
= 100 x 2.487
= 248.7
PV of annuity due = 248.7 x (1+0.10)
= $273.6
Summary
We have looked at:
1. How to calculate the present value or future value of multiple cash flows, whether they
are different or the same.
2. How to use annuity formulae when the cash flow is the same in every period.
3. How to use present value (perpetuity) formula when the cash flows continue forever.
A reminder of the key formulas
For individual cash flows that are each different
PV = C
(1+r)t
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FV = C x (1+r)t
For cash flows that are of the same value every period
PV of an annuity = C x [1 — ( 1 )]
r (1+r)t
PV of a perpetuity = C (where cash flows continue forever)
FV of an annuity = C x [(1+r)t —1]
Quick link between annuity and annuity due values
PV of annuity due = (1+r) x PV of annuity
FV of annuity due = (1+r) x FV of annuity
Compounding more than once a year
This subject causes a fair amount of confusion, because rates are quoted in many
different ways. Sometimes the way a rate is quoted is the result of tradition, and
sometimes it’s the result of legislation. Unfortunately, at times, rates are quoted in
deliberately deceptive ways to mislead borrowers and investors.
What if interest compounds monthly, quarterly, or semi-annually rather than one a year?
All the formulas for PV of a single cash flow, FV of a single cash flow, PV of an annuity, FV
of an annuity, PV of a perpetuity are still valid. However, we need to restate ‘r’ and ’t’ to
give:
• The interest rate per period (for ‘r’), and
• The number of periods (for ’t’)
Calculating ‘r’ for a period less than a year
Remember that ‘r’ is the interest rate for a PERIOD. Also, market convention is that the
quoted rate (QR) is always an annual rate unless stated otherwise. So:
r = QR / m
Where, QR = quoted rate
m = the number of times the interest rate is compounded in one year
Example 7
(a) Interest compounds semi-annually. That is, 2 times in one year. So:
m = 2
r = 15% / m
= 15% / 2
= 7.50%
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In time value of money calculations, we therefore use r = 0.075.
(b) Interest compounds monthly. That is, 12 times in one year. So:
m = 12
r = 15% / 12
= 1.25%
In time value of money calculations, we therefore use r = 0.0125.
Calculating ‘t’ where compounding is for periods of less than a year
In time value of money formulas, ‘t’ is the number of PERIODS. So:
t = years x m
Where: m = the number of times the interest rate is compounded in one year.
Example 8
You have invested £1,000 for 5 years in a deposit account that pays annual interest of
4%, compounded quarterly. What is the value of your investment at the end of 5 years?
r = 4% / 4
= 1% = 0.0100
where m = 4
t = years x m
= 5 x 4
= 20 periods
FV = PV x (1+r)t
= £1000 x (1.01)20
= £1,000 x 1.22019
= £1,220.19
Comparing rates using EAR
Rates
Nominal Interest Rate — the interest rate expressed in terms of the interest payment
made each period. Also known as the state or quoted interest rate.
Effective Annual Percentage Rate (EAR) — the interest rate expressed as if it were
compounded once per year.
EAR = [1+ (quoted rate/m)]m — 1
Example 9
Which of these is the best if you are thinking of opening a savings account? Which of
these is best if they represent loan rates?
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a) Bank 1 offers 15% compounded daily
EAR = [1+ (Quoted rate / m)]m – 1
= [1+ (0.15 / 365)]365 – 1
= 16.18%
b) Bank 2 offers 15% compounded monthly
= [1+ (0.15 / 12)]12 – 1
= 16.08%
c) Bank 3 offers 15.5% compounded quarterly
= [1+ (0.155 / 4)]4 – 1
= 16.42%
d) Bank 4 offers 15.5% compounded semi-annually
= [1+ (0.155 / 2)]2 – 1
= 16.10%
e) Bank 5 offers 16% compounded annually
EAR = 16%
Answer: depositor: c, a, d, b, e
borrower: e, b, d, a, c
Loan types and loan amortisation

 
Loan types
Whenever a lender extends a loan, some provision will be made for repayment of the
principal (the original loan amount). A loan might be repaid in equal instalments, for
example, or it might be repaid in a single lump sum. There are an unlimited number of
possibilities:
Pure discount loans — where the borrower receives money today, and repays a single
lump sum at some time in the future (e.g. some financial instruments such as treasury
bills and commercial paper).
Interest-only loans — where the borrower pays interest each period, and reaps the whole
principal (the original loan amount) at some point in the future (e.g. bonds). Note that if
there is only one period, a pure discount loan and an interest-only loan are the same.
Amortised loans — where the borrower repays parts of the loan amount over time (e.g.
mortgages). The process of providing a loan to be paid off by making regular principal
reductions is called amortising the loan.
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Example 10
A T-bill (treasury bill) is a promise by the US government to repay a fixed amount at some
time in the future — for example, in 3 months or 12 months. If a T-bill promises to repay
£10,000 in 12 months, and the market interest rate is 7%, how much will the bill sell for in
the market?
Current market price = Present value
= £10,000/1.07
= £9,345.79
Amortised loans
There are two approaches:
• Fixed principal payment — repay the principal in equal instalments plus all interest due
on the outstanding amount.
• Fixed total payment — the borrower makes a single, fixed payment every year. Most
consumer loans (e.g. car loans) and mortgages are amortised following this approach.
The payment includes repayment of principal and also interest.
Example 11: an amortised loan with fixed annual payment
You borrow £10,000 for four years. The bank will lend you the money at 8% interest rate
and will require that the loans are paid-off in four equal (end-of-year) instalment
payments.
a) What are the annual loan payments that the company will have to make to re-pay the
loan?
Present value of annuity = C x {1—[1/(1+r)t] }
Where:
r = 0.08
t = 4 periods
PV (loan) = £10,000
So:
£10,000 = (C/0.08) x (1 — 1/1.084)
£10,000 = C x 3.31213
C = £10,000 / 3.31213
= £3,019.21
b) How much interest and principal will be repaid each year?
Period Beginning Balance Payment Interest Principal Ending Balance

1 £10,000.00 £3,019.21 £800.00 £2,219.21 £7,780.79
2 £7,780.79 £3,019.21 £622.46 £2,396.75 £5,384.04
3 £5,384.04 £3,019.21 £430.72 £2,588.49 £2,795.56
4 £2,795.57 £3,019.21 £223.65 £2,795.56 £0.00
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Interest payment period 1 = 10,000 x 8% = £800
Principal payment period 1 = 3,019.21 — 800 = £2,219.21
Ending balance period 1 = 10,000 — 2,219.21 = £7,780.79
Example 12: an amortised loan with fixed monthly payment
Suppose we have a €100,000 commercial mortgage with an effective monthly interest

rate of 1% and a 20 year (240-month) amortisation. What will the fixed monthly payment
be for the 20 year period?
The monthly payment can be calculated based on an ordinary annuity with a present
value of €100,000.
Where:
r = 0.01
t = 240 periods
PV (loan) = €100,000
Present value of annuity = C x {1—[1/(1+r)t] }
So:
€100,000 = C x [(1 — 1/1.01240)/.01]
€100,000 = C x 90.8194
C = €100,000 / 90.8194
= €1,101.09
Answer: the regular monthly payment needed on the loan is €1,101.09.
Note: your amortisation table will have one period per line instead of one year per line.
There are two ways to determine the balloon payment:
1. Hard way — amortise the loan for 60 months to see what the balance is at that time.
2. Easy way — recognise that after 60 months, we have a 240 x 60 = 180 month loan. Th
payment is still €1,101.09 per month, and the interest is still 1% per month.
The loan balance is the present value of the remaining payments:
Loan balance:
= €1,101.09 x [(1 — 1/1.01180)/.01]
= €1,101.09 x 83.3217
= €91,744.69
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Lecture 6: Bond valuation

What is a bond and what are its key features?
What is a bond?
A bond is a type of loan. When a company wishes to borrow money from the public (not
from banks) on a long-term basis, it does so by selling (issuing) debt securities called
bonds. There is a bigger market for bonds than there is for shares.
A typical bond has a fairly simple structure:

• The investor loans a company some money
• The company pays you interest every period
• The company repays the amount it borrowed at the end of the loan
• Usually bonds have an active secondary market
A typical bond structure
The company issues a £1,000 bond. The investors loan the company £1,000 and receives
interest of £80 every year. After 10 years, the company repays the £1,000 borrowed.
Summary of key terms
Amount of
Date of Issue Maturity Face Value
Issue
Annual Coupon
Offer Price Security
Coupon Payment Dates
Sinking Fund Call Provision Call Price Rating
Coupon — the stated interest payment made on a bond. Typically paid on an annual or
semi-annual basis.
Face value — the principal amount of a bond that is repaid at the end of the term. Also
called par value or maturity value.
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Coupon rate — the annual coupon divided by the face value of a bond (percentage).
Maturity — the specified date on which the principal amount of a bond is paid.
Yield to maturity (YTM) — the rate required in the market on a bond.
Note: YTM or current market interest rates are used as the discount rate in bond valuation
calculations. This value represents what else you could do with the rest of the money.
Current yield — a bond’s annual coupon divided by its price.
Security — bonds are normally unsecured (unlike bank borrowings that are often secured
on assets such as property).
Call provision — an agreement allowing the company to repurchase (or “call”) part or all
of the bond issue at stated prices over a specified time.
Sinking fund — an account managed by the bond trustee for early bond redemption.
The indenture
Indenture — the written agreement between the corporation and the lender detailing the
terms of the debt issue.
Usually, a trustee is appointed by the corporation to represent the bondholders. The trust
company must:
1. Make sure the terms of the indenture are obeyed.
2. Manage the sinking fund.
3. Represent the bondholders in default — that is, if the company defaults on its
payment to them.
Includes: the basic terms of the bonds; the total amount of bonds issued; a description of
property used as security; the repayment arrangements; the call provisions; details of the
protective covenants.
Example
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How to calculate bond value/price
The bond has two main types of cash flow:
1. A final repayment of face
2. A fixed coupon payment every period
Bond value/price = the present value of the future cash

flows.
PV of
Face
Value
We calculate the present value of each of the two main
types of cash flow separately.
Bond
Bond value/price = PV (coupons paid every period + PV
Value
PV of
(final repayment of face value)
Annuity
• Use the PV of annuity formula to calculate the PV of

the coupons (as these are the same repeated cash flow for a finite period)
• Use simple PV of a single future cash flow formula to calculate the PV of the final
repayment of face value.
So, bond value =
Where:
• F is the face value repaid at maturity
• C is the coupon paid each period
• t is the number of periods to maturity
• r is the YTM or yield or current market interest rate for a period
Example 1: Bond value on issue date
Pixie PLC plan to issue a 10 year £1,000 annual coupon 8% bond with 10 years to
maturity. Similar bonds have a yield to maturity of 8%.
Required:
a) What are the bond cash flows?
b) What would this bond sell for?
Step 1: Draw a timeline
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Coupon payment = 8% x £1,000 every year = £80 every year
Final payment = face value (F) = £1,000
Step 2: Draw up a data table
F = £1,000
C = £80
r = 8%
t = 10 years
Step 3: Use the bond formula to calculate the bond value
Bond value = PV (coupon cash flow annuity) + PV (face value repaid at maturity)
= 1000 x 0.53681 + 463.19
= 536.81 + 463.19
= £1,000
Answer: the bond price is £1,000. This is the same as face value so the bond is trading at
‘par’.
More terms
Par bond — a bond that is selling at face value.
Discount bond — a bond that is selling at a price below its face value.
Premium bond — a bond that is selling at a price more than its face value.
Example 2: Bond value after issue date and where coupons are paid semi-annually
rather than annually
Company Q has issued a 10 year £1,000 semi-annual 6% bond that now has 2 years left
to maturity. The bond is trading at 8% (that is, its yield to maturity, or ‘quoted yield’ is 8%.
Required:
a) What are the bond cash flows?
b) What would this bond sell for?
c) Is the bond trading at par, premium or discount?
Step 1: Draw a timeline.
6 mths 1 year 18 mths 2 years

6% x £1,000 every year = £60, hence
£30 £30 £30 £30
£30 are being paid every 6 months.
£1000
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Step 2: Draw up a data table.
Answer to a):
F = £1,000, i.e. the amount repaid on maturity
C = £30, i.e. the regular coupon payments being made every 6 months (coupon rate r x F
= 0.04 x 1000)
Other useful data for part b):
r = QR/m —> 8%/2 = 4% the discount rate
t = years x m —> 2x2 = 4 periods
C (coupon rate) IS NOT THE SAME AS R (yield).
Step 3: Use the bond formula to calculate bond value
= 750 x 0.145195 + 854.80
= 108.90 + 854.80
= £963.70
Answer to b): the bond price is £963.70
Answer to c): the bond price is £963.70 and the face value is £1,000.
The current market price is lower than face value, so the bond is selling for less than face
value and is said to be trading at a discount.
Calculating yield to maturity (YTM) if given the bond price
You can use the same formula and solve for r. Use trial and error.
Today’s price is £1,200. What is the yield?
Bond price Yield
F = £1,000
C (6%)
……
Try 5%
…… trial and error until you get £1,200 Try 6%

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The link between interest rates and bond value
Recall lecture examples 1 and 2
In example 1, the bond was issued at par and face value = bond price. Also, yield =
coupon rate.
In example 2, the bond price was £963.70, lower than the face value of £1,000 and the
yield of 8% was higher than the coupon rate of 7%. That is, as interest rates rise, prices
fall. This is the normal pattern.
If YTM = coupon rates, then bond price = face value
If YTM > coupon rate, then bond price < face value
—> Bond is trading at a “discount”
If YTM < coupon rate, then bond price > face value
—> Bond is trading at a “premium”
Note that there is an inverse relationship between interest rates and bond value.
INTEREST RATES BOND PRICE
Interest rate risk
The sensitivity of the bond value to interest rates is called interest rate risk. If you invested
in a bond and interest rates rise, your bond will fall in value and you will lose value.
Coupon Rate > YTM, then Price > Face Value: bond is selling at premium
Coupon Rate < YTM, then Price < Face Value: bond is selling at discount
Coupon Rate = YTM, then Price = Face Value: bond is selling at “par”
$1,600.00
$1,400.00 $1,359.30
$1,200.00 $1,162.22
V
$1,000.00
a $1,000.00
l $865.80
u $800.00 $754.22
e $660.99
$582.71
$600.00
$400.00
$200.00
$0.00 60 of 117
2% 4% 6% 8% 10% 12% 14%
YTM
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The graph shows how the value of a bond changes with a change in market interest rates
for two bonds with different time to maturity (remaining life):
Note that the 30-year bond had greater interest rate risk than the 1 year bond. This is
because the further away the cashflows, the greater the impact on the PV calculations of
a change in interest rates because the current market interest rate is used as the discount
rate. The longer the remaining maturity of the bond, the greater the interest risk, (assuming
the coupon and face value are the same).
1. All other things being equal, the longer the time to maturity, the greater the
interest rate risk.
Longer-term bonds have greater interest rate sensitivity, because a large portion of a
bond’s value comes from the face amount. The present value of this amount isn’t greatly
affected by a small change in interest rates if the amount is to be received in the short-
term (e.g. one year). However, once the value is compounded for 30 years, a small
change in the interest rate can have a significant effect on the present value (see next
figure).
2. All other things being equal, the lower the coupon rate, the greater the interest
rate risk.
The bond with the higher coupon has a larger cash flow early in its life, so its value is less
sensitive to changes in the discount rate.
Bond markets and ratings
Different types of bonds
Bond market structure is in a dealer market.
Government Zero Coupon

Bonds Bonds
Floating Rate
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Government bonds — bonds bought by the government.
Zero coupon bonds — a bond that makes no coupon payments and is thus initially priced
at a deep discount. They are also called pure discount bond s.
Floating rate bonds — where coupon payments are adjustable. The adjustments are tied
to an interest rate index, and the value of the bond depends exactly on how the coupon
payment adjustments are defined.
Exotics — options which are generally much more complex than plain vanilla options,
such as calls and puts that trade on an exchange.
Bond markets
Bond Market Bond Price

Structure Reporting
Clean and
Dirty Prices
Bond market structure
Most trading in bonds takes place over the counter, or OTC, which means there is no
particular place where buying and selling occur. Instead, dealers around the world stand
ready to buy and sell. The various dealers are connected electronically.
Bond price reporting
In recent years, transparency in the corporate bond market has improved dramatically.
The advent of high-speed Internet connections has allowed real-time updates on bond
prices and trading volumes directly from the stock exchange. As seen in the table below,
stock exchanges provide a daily snapshot of trading in the most active issues. The
information shown is largely self-explanatory.
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Explanation of clean and dirty price

Last Payment Next Payment
Total Period
Settlement date
Interest Earned by Seller Interest Earned by Buyer

(Accrued interest)
Accrued interest — when the bond is sold between coupon payment dates, part of the
next coupon payment belongs to the seller. This is known as the accrued interest.
Clean price — the price of a bond net of accrued interest. This is the price that is typically
quoted.
Dirty price — the price of a bond including accrued interest, also known as the full or
invoice price. This is the price the buyer actually pays.
Bond ratings
To be successful, a bond issue must be rated by credit rating agencies prior to issue.
Investors will pay more for a bond with a higher rating. That is, bonds with a higher credit
rating can be issued at par at a lower coupon rate than bonds with a lower credit rating.
Bond ratings are constructed from information supplied by the corporation. The highest
rating a firm can have is AAA or Aaa, and such debt is judged to the best quality and
lowest level of risk.
Example ratings
• Aaa and AAA — highest rating, capacity to pay interest and principal is extremely
strong.
• Baa and BBB — adequate capacity to pay interest and repay principal.
• BB, Ba, Ca, CC and C — predominantly speculative with respect to capacity to pay
interest and repay principal in accordance with the terms of the obligation.
• D — in default and payment of interest and/or payment of principal is in arrears.
Bond details, including ratings
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How inflation/other factors affect bond price/yield
Key terms
Nominal rate (quoted rate) — interest rate or rate of return that has not been adjusted for
inflation. The percentage change in the amount of cash that you have.
Real rate — interest rate or rate of return that has been adjusted for inflation. The
percentage change in how much you can buy with your cash, i.e., your buying power.
The Fisher Effect
The fisher effect — the relationship between nominal returns, real returns and inflation.
1 + R = (1 + r ) x (1 + h)
where h is the inflation
rate
R is the nominal rate
r is the real rate
Approximation: R ≈ r + h
Example 3: Using the Fisher Effect to calculate a nominal rate
Investors require a 10% real rate of return, and the inflation rate is 8%.
Required:
a) What is the approximate nominal rate?
b) What is the exact nominal rate?
Answer: From the fisher effect, we have:
1 + R = (1+r) x (1+h)
= 1.10 x 1.08
= 1.1880
a) Approximate nominal rate = 18%
b) Exact nominal rate = 18.8%
Term structure of interest rates
Term structure of interest rates — the relationship between nominal interest rates on
default-free, pure discount securities and item to maturity; that is, the pure time value of
money for different lengths of time.
The relationship between short and long-term investments is known as the term structure
of interest rates. To be more precise, it tells us what nominal interest rates are on default
free, pure discount bonds of all maturities. These rates are, in essence, ‘pure’ interest
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rates, because they involve no risk of default and single, lump sum future payment. In
other words, the term structure tells us the pure time value of money for different lengths
of time.
When long-term rates are higher (lower) than short-term rates, the structure is upward
(downward) sloping.
Typical term structure of interest rates
You would expect a higher return for your money if you invest in higher risk investments.
The term structure of interest rates represents the combined effect of the:
• Real rate of interest — the compensation that investors demand for forgoing the use of
their money.
• Inflation premium — the portion of a nominal interest rate that represents compensation
for expected future inflation.
• Interest rate risk premium — the compensation that investors demand for bearing
interest rate risk.
Bond yields represent the combined effect of:
• Real rate of interest (as before)
• Expected future inflation (as before)
• Interest rate risk premium (as before)
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• Default risk premium — the portion of a nominal interest rate or bond that represents
compensation for the possibility of default.
• Taxability premium — the portion of a nominal interest rate or bond yield that represents
compensation for unfavourable tax treatment.
• Liquidity premium — the portion of a nominal interest rate or bond yield that represents
compensation for lack of liquidity. So bonds with longer period to maturity carry greater
liquidity premium.
Typical term structure of interest rates:
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Lecture 8: Equity Valuation

Share valuation
Difficulties
• With equity, not even the promised cash flows are certain in advance
• Life of investment is uncertain because an equity can theoretically last forever (no
maturity)
• Difficult to measure the expected return the market requires
Share prices are highly volatile
FTSE 100 Index Data Source: Yahoo
FTSE100 Close Index 1996-2016

7,500.00
7,000.00
6,500.00
6,000.00
5,500.00
5,000.00
4,500.00
4,000.00
3,500.00
3,000.00
Jun 10, 1997
Jun 27, 2002
Jun 19, 2009
Jun 27, 2016

Nov 13, 2002
Nov 27, 2007
Nov 10, 2009
Nov 11, 2016

Oct 27, 1997
Oct 21, 2004
Oct 25, 2011

Apr 10, 1996
Apr 26, 2001
Apr 18, 2008
Apr 27, 2015

Mar 17, 1998
Mar 11, 2005
Mar 31, 2010
Mar 14, 2012

Dec 4, 2000
Dec 2, 2014
Feb 25, 2000
Sep 14, 2001
Sep 29, 2006

Feb 19, 2007
Feb 24, 2014
Sep 15, 2015

Aug 6, 1998
Aug 2, 2005
Aug 6, 2012
Jul 18, 2000
Jul 11, 2007
Jul 16, 2014

Dec 23, 1998
Jun 4, 2004
Dec 19, 2005
Jun 8, 2011
Dec 21, 2012

Jan 17, 1997
Jan 14, 2004
Jan 27, 2009
Jan 14, 2011

May 19, 1999
May 12, 2006
May 16, 2013

Aug 29, 1996
Aug 26, 2003
Aug 25, 2010

Oct 6, 1999
Oct 4, 2013
Apr 3, 2003
Feb 4, 2002
Sep 8, 2008
Feb 4, 2016
The present value of equity
In general, the price today of a share of equity, P0, is the present value of all of its future
dividends, D1, D2, D3,…:
Where R is the investor required return (dividend yield, dividend payout, capital gain).
Proof that share value = PV of future dividends
First, look one period ahead:
0 1
Div 1
PV = ?
Price 1
Divt +1 Pt +1
Pt = +
1+ r 1+ r
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The value of the share today (P0) is:
Div1 P
P0 = + 1
1+ r 1+ r
The value the share one year from today (P1) is:
Div2 P
P1 = + 2
1+ r 1+ r
Substitute P1 into the formula for P0:
Div1 Div2 P2
P0 = + +
1 + r (1 + r )2 (1 + r )2
Continue adding a period and substituting the result into the original equation, to obtain:
Conclusion: the value of a share is the present value of all future dividends. It does NOT
matter when you intend to sell the share.
Three scenarios
Scenario 1: Constant dividend (zero growth)
The case of zero growth is one we’ve already seen. A share of equity in a company with a
constant dividend is much like a preference share. For a zero-growth share of equity, this
implies that:
D1 = D2 = D3 = D = constant (assuming that the dividend is constant, and there is no

change).
Zero growth: dividends are expected to be the same forever.
Approach: because the dividend is always the same and there is no growth, the share
price can be viewed as an ordinary perpetuity with a cash flow equal to D every period.
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If the dividend is expected to be constant and the required rate of return is R, the present
value of future dividend cash flows is:
D D D D D
P0 = 1
+ 2
+ 3
+ 4
+ +L
(1 +(1R) (1 + R) (1 + R) (1 + R) (1 + R)5
D
P0 = D
R
Lecture example 1
A company pays a dividend of $2 per share per year. If investors require a 10% return,
what is a share price?
D = 2 D = 2 D = 2
0 1 2 3
Answer:
P = D/r
= $2/0.10
= $20
Scenario 2: Constant growth in dividend (constant growth)
Constant growth: dividends are expected to grow forever at a constant rate (g).
D3 ……….
D2
D1
D0
0 1 2 3 ……….

Approach: we would use the growing perpetuity formula, because dividends grow forever
at a constant rate.
Assume the dividends grow at constant growth rate of g and required rate of return is R.
Then the share price will be:
D0 ´ (1 + g ) D g) D1
When D1 is unknown, we use: P 0 = = otherwise,
= we use:
P0 =
R-g - - R-g
Note: g cannot be > R
You have to use the dividend at time T + 1 when looking at the present value today. You
should always assume that C are the cash flows in 1 year’s time.
Lecture example 2
The required rate of return on the stock of J&P PLC is 8.8%. You expect that the current
dividend of £0.50 will grow at a steady rate of 6% per year. A dividend of £0.50 has just
been paid.
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Required:
a) Calculate the stock value for J&P PLC.
b) The current market price of J&P PLC stock is £23. Is the stock fairly valued,
undervalued or overvalued?
Answers:
D0 will be the dividend just paid, and g will be the constant growth rate:
D0 = 0.50
R = 0.088
g = 0.06
a) P0 = D0 (1+g) / (R-g)
= (£0.50 x 1.06) / (0.088-0.06)
= £18.93
b) The intrinsic value (price at which the share should be selling for) for J&P, £18.93 <
market price of £23. So, stock is overvalued according to the constant growth model.
Summary:
D0 ´ (1 + g ) D
P0 = = 1
R-g R-g
Relationship of price, P, with growth rate and required rate of return:
P, with growth rate and req

Growth rate
g => P0
Required rate of return

rn, R => P0
Constant growth model — ‘the dividend valuation model’
Advantages
• The dividend valuation model is often useful for valuing stable-growth, dividend-paying
companies
• It is often useful for valuing broad-based equity indexes
• The model features simplicity and clarity; it is useful for understanding the relationship
among value and growth, required rate of return, and pay-out ratio
• It provides an approach to estimating the expected rate of return given efficient prices
(for stable-growth, dividend-paying companies)
Scenario 3: Non-constant growth in dividend (differential growth)
Differential growth: dividends have different growth rates in different time periods.
The main reason for considering this case is to allow for ‘supernormal’ growth rates over
some finite length of time. To avoid the problem of having to forecast and discount an
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infinite number of dividends, we shall require that the dividends start growing at a
constant rate at some time in the future.
Examples:
• No dividend for the first few years (Type I)
• Non-constant growth in the first few years and then constant growth later on in
perpetuity (Type II)
• Growth rate 1 for the first few years and then a different growth rate 2 for remaining
years in perpetuity (Type III)
 
Valuation approach: split the problem into sections according to the growth rate in
different time periods.
Lecture example 3 (Non-constant growth in dividend — Type I)
A company is not expected to pay a dividend until three years’ time. The dividend will
then be EUR 2.50 and increase each year by 5%. If the required return is 10%, what is
the share price today?
Step 1: Draw a timeline PV (growing perpetuity)
Step 2: Calculate the price at time 3 (valuing the perpetuity)
g = 5%
D3 = 2.50
R = 10%
P3 = D3 x (1 + g) / (R — g)
= 2.50 x 1.05 / (0.10 – 0.05)
= € 52.50
Step 3: Calculate the present value of the price at time 0
PV = FV / (1+r)t
P0 = € 52.50 / 1.103 = € 39.44
Lecture example 4 (Non-constant growth in dividend — Type II)
A company pays dividends of EUR 1 in one year, EUR 2 in two years and EUR 2.50 in
three years’ time. Dividends are then expected to grow at a constant rate of 5% from then
on in perpetuity. If the required return is 10%, what is the share price today?
Step 1: Draw a timeline PV (growing perpetuity)
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For this problem, the constant growth starts at time 3. This means that we can use our
constant growth model to determine the share price at time 3, P3. The most common
mistake in this situation is to incorrectly identify the start of the constant growth phase
and, as a result, calculate the future share price at the wrong time.
Step 2: Calculate the price at time 2
As always, the share price is the present value of all the future dividends. To calculate this
present value, we first have to compute the present value of the share price 3 years down
the road, just as we did before.
P3 = D3 x (1 + g) / (R — g)
= (2.50 x 1.05) / (0.10 – 0.05)
= € 52.50 (as in example 3)
Step 3: Calculate the price at time 0, working out the present value of each cash flow
separately, including the present value of the price at time 3.
$1 $2 $3 !3
!0 = + + +
(1 + ()1 (1 + ()2 (1 + ()3 (1 + ()3
1 2 2.50 52.50
!0 = + + + = € 43.88
1.10 1.102 1.103 1.103
When there are two growth rates, the idea is that the dividend will grow at a rate of g1 for
for t years and then grow at a rate of g2 thereafter forever.
$1 1 + (1 . !.
!0 = × *1 − + - /+
& − (1 1+& (1 + &).

Notice that the first term in our expression is the present value of a growing annuity. In
this first stage, g1 can be greater than R. The second part is the present value of the share
price once the second stage begins at time t. We can calculate Pt as follows:
Dt +1 D0 ´ (1 + g1 )t ´ (1 + g 2 )
Pt = =
R - g2 R - g2
Lecture example 5
Royal Hotel SA just paid a dividend of €2.35 per share. The dividends are expected to
grow at 26% a year for the next eight years and then level off to an 8% annual growth
rate indefinitely. If the required return is 15%, what is the share price today?
Step 1: Calculate the price at time:
Dt +1 D0 ´ (1 + g1 )t ´ (1 + g 2 )
Pt = =
R - g2 R - g2
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So:
2.35 × (1 + 0.26)8 × (1 + 0.08)
𝑃8 = = 230.33
0.15 − 0.08
Step 2: Calculate the price today, including P8 just calculated:
𝐷1 1 + 𝑔1 𝑡 𝑃𝑡
𝑃0 = × *1 − + - /+
𝑅 − 𝑔1 1+𝑅 (1 + 𝑅)𝑡

Where D1 = D0 x (1 + g)
So:
2.35 × (1 + 0.26) 1 + 0.26 8 230.33

𝑃0 = × /1 − 0 1 3+ = 104.28
0.15 − 0.26 1 + 0.15 (1 + 0.15)8
The two-stage model:
• This is very useful because many scenarios exist in which a company can achieve a
supernormal growth rate for a few years, after which time the growth rate falls to a more
sustainable level.
• For example, a company may achieve supernormal growth due to a patent, first mover
advantage, or another reason that provides a temporary lead in a specific marketplace.
Later, earnings growth must decline to a level thats more consistent with competition
and the growth in the overall economy.
• Using a two-stage model, we can model the extraordinary growth for a few years, and
the normal growth thereafter.
Calculating implied growth
Non-constant growth in dividend
The dividend growth rate influences the estimated value of a stock using the constant
growth model. Thus, differences between estimated values of a stock and its actual
market value might be explained by different growth rate assumptions.
Lecture example 6
The required rate of return for the stock of BBA PLC is 12.2%. The current dividend is $2.
What dividend growth rate would be required to justify a $40 price?
Answer:
P0 = D0 x (1 + g) / (R — g)
R = 0.122
D0 = $2
P0 = $40
So, 40 = [2 x (1 + g)] / (0.122 — g)
40 x (0.122 – g) = 2 + 2g
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4.88 – 40g = 2 + 2g
2.88 = 42g
g = 2.88 / 42
= 0.0686
= 6.86%
Components of shareholder return
When shareholders receive cash:
• The company pays dividends
• You sell your shares either to another investor in the market or back to the company
As with bonds, the price of a share is the present value of these expected cash flows.
Capital
Dividend Total
Gains
Yield Return
Yield
Dividend yield — an equity’s expected cash dividend divided by its current price.
Capital gains yield — the dividend growth rate, or the rate at which the value of an
investment grows.
R = Dividend yield + Capital gains yield

R = D1/P0 + g
Proof:
P0 = D1/(R – g)
So, P0 x (R – g) = D1
So, P0 x R – P0 x g = D1
So, P0 x R = D1 + P0 x g
So, R = D1/P0 + g
Strengths of the Gordon Growth Model
• The Gordon growth model is often useful for valuing stable-growth, dividend-paying
companies
• is often useful for valuing broad-based equity indexes
It
• The model features simplicity and clarity; it is useful for understanding the relationship
among value and growth, required rate of return, and pay-out ratio
• It provides an approach to estimating the expected rate of return given efficient prices
(for stable-growth, dividend-paying companies)
Understanding stock markets and preference shares
Comparing ordinary and preference shares
Ordinary equity — this is equity without priority for dividends or in bankruptcy.
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Preference shares — equity with dividend priority over ordinary shares, normally with a
fixed dividend rate, sometimes without voting rights.
Ordinary equity is equity that has no special preference either in receiving dividends or in
bankruptcy. Preference shares differ from ordinary equity because they have preference
over ordinary equity in the payment of dividends, and in the distribution of corporation
assets in the event of liquidation. Preference just means that the holders of the preference
shares must receive a dividend before holders of ordinary shares are entitled to anything.
Other features of preference shares
• Holders of preference shares sometimes have no voting privileges
• Preference shares have a stated liquidating value (e.g. 100 per share) and the cash
dividend is described as a percentage of stated value
• Dividends payable on preference shares are either cumulative or non-cumulative, most

are cumulative, (i.e. if not paid in a particular year, they will be carried forward)
• Are preference shares equity or debt?
Market terms
Primary market — the market in which new securities are originally sold to investors.
Secondary market — the market in which previously issued securities are traded among
investors.
Dealer — an agent who buys and sells securities from inventory.
Broker — an agent who arranges security transactions among investors.
Thus, when we speak of used car dealers and real estate brokers, we recognise that the
used car dealer maintains an inventory, whereas the real estate broker does not.
Summary
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Lecture 9: Net present value and other investment criteria

Net present value
Terms
Net present value — the difference between an investment’s market value and its cost.
Discounted cash flow valuation — the process of valuing an investment by discounting its
future cash flows.
Mutually exclusive investments — a situation where taking one investment prevents

taking the other.
Lecture example 1
• Cash revenues from a fertiliser business will be £20,000 per year
• Cash costs (including taxes) will be £14,000 per year
• We shall wind down the business in 8 years
• Plant, property and equipment will be worth £2,000 as salvage at that time
• The project costs £30,000 to launch
• We used 15% discount rate on new projects such as this one
Step 1: Draw a timeline and add cash flow data
Step 2: Choose appropriate formula to discount the cash flows
Annuity for 78 years Final

single
cash
flow
£2
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Step 3: Calculate present value and then NPV
The total present value of future cash flows is:
PV annuity + PV single cash flow:

PV of an annuity (present value of future cash flows) = C/r x [(1 — (1/(1+r)^t]
PV = FV/(1+r)^t
:. C/r x [(1 — (1/(1+r)^t] + FV/(1+r)^t
£6,000 x [1 — (1/1.158)]/0.15 + (2,000/1.158)
= (£6,000 x 4.4873) + (2,000/1.158)
= £26,924 + 654
= £27,578
When we compare this to the £30,000 estimated cost, we see that the NPV is:
NPV = —£30,000 + £27,578
= —£2,422
The NPV is negative, so you would have to REJECT the project.
The NPV decision
• NPV is greater
Accept than zero
• NPV is less than

Reject zero
Strengths of NPV
• Uses cash flows — cash flows are better than earnings.
• Uses ALL cash flows — other approaches ignore cash flows beyond a certain date.
• Discount cash flows — fully incorporates the time value of money.
The most important strength of NPV is that it gives you a figure for the value created for
shareholders. This is important as businesses’ main aim is to maximise shareholder value.
The Payback Rule
Payback period— the amount of time required for an investment to generate cash flows
sufficient to recover its initial cost.
The payback decision
• Payback period is less

Accept than benchmark
• Payback period is
Reject greater than benchmark
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In order to find at what specific time money is being paid back, you must do:
Sum of all cash flows until year it is being repaid/sum in year after repayment + number of
years.
Lecture example 2
A company only accepts projects with a payback period of 2 years or less. The company
is evaluating a project which has the following cash flows:
Initial investment (time 0): £62,000
Cash inflow year 1: £30,000
a) Should this project be accepted based on the payback criteria?
b) Calculate the payback period for this project.
Remember: Unless told otherwise, cash flows should be assumed to arise at the end of
the year in all discounted cash flow questions.
Step 1: Draw a timeline
- £62,000
£62,000
Answer:
a) After 2 years, the project has only repaid £50,000 of the initial outlay of £62,000, so it
has to be REJECTED.
b) The payback period for this project is between 3 and 4 years. After 3 years, the
amount outstanding is £2,000 (062K + 30K + 20K = —2K). The next cash inflow in
year 4 is £5,000. So the payback period is 3 years + £2,000/£5,000 = 3.4 years.
Comparing projects using payback
Payback decisions
Accept the project(s) with the shortest payback, as long as the payback is within the
company’s maximum payback limit.
Lecture example 3
Evaluate the following projects using the payback period rule for a company that does not
accept projects with a payback above 4 years.
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Accept project A as it has a playback period of 2.6 years. (2 years + 30/50 = 2.6 years).
Projects C and D have a longer payback period of 4 years. If the projects are mutually
exclusive (meaning only one can be accepted), accept project A as it has a lower payback
period. Projects B and E never repay the amount invested, so reject.
Advantages and disadvantages of the payback period rule
Advantages Disadvantages
1. Easy to understand
1. Ignores the time value money — does not
2. Adjusts for uncertainty of later cash flows — i.e. consider discounted values
adjusts for the extra riskiness of later cash flows 2. Requires an arbitrary cut-off point — there is no
(‘wiggle room’)
guide to how to pick the cut off point, so it ends
3. Biased towards liquidity — it favours up being arbitrarily chosen
investments that free up cash for other uses 3. Ignores cash flows beyond the cut-off point —
quickly there might be profitable long-term investments
in a later period
4. Biased against long-term projects, such as

research and development, and new projects
The Discounted Payback
Definition
Discounted payback — the length of time required for an investment’s discounted cash
flows to equal its initial cost.
The discounted payback method is a variation of the payback period, and was developed
to fix the problem of time-value which is ignored in the normal payback calculation.
Discount payback rule
• Discounted payback
Accept period is less than
benchmark
• Discounted payback
Reject period is greater than
benchmark
Lecture example 4
Project 2 has an initial outlay of $300,000. It is expected to generate the following cash
flows:
Year 1 $150,000
Year 2 $120,000
Year 3 $80,000
Year 4 $40,000
Year 5 $30,000
Year 6 $20,000
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Required:
Evaluate the project using discounted payback. The company uses a cut-off point of 4
years and has a cost of capital of 10%.
In order to find the discounted net cash flows and then the present values, you must
divide the net cash flow by the discount factor.
Answer: under discounted payback, the funds are repaid in year 3, so ACCEPT. The
discounted payback period is 2.86 years (2 + 64.46 / 75.13 = 2.86).
Advantages and disadvantages of discounted payback rule
1. Includes time value of money (i.e. discounted 1. My reject positive NPV investments
values)
2. Requires an arbitrary cut-off point — there is no
2. Easy to understand
guide to how to pick the cut off point, so it ends
3. Does not accept negative estimated NPV up being arbitrarily chosen
investments
3. Ignores cash flows beyond the cut-off point —
4. Biased towards liquidity — it favours there might be profitable long-term investments
investments that free up cash for other uses in a later period
quickly 4. Biased against long-term projects, such as

research and development, and new projects
The Average Accounting Return
Average Accounting Return — an investment’s average net income divided by its average
book value.
There are a number of different definitions used for average accounting return (ARR).
AAR is always:
Some measure of average accounting profit
Some measuring of average accounting value
AAR = Average net income
Average book value
Lecture example 5
Decision on whether or not to open a new store. The required investment in

improvements is £500,000. Other relevant information:
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• The store has a 5 year life, reverts to mall owners after this
• The required investment would be 100% depreciated (straight-line) over 5 years:

= £500,000/5 = £100,000 per year
• The tax rate is 25%
• The projected revenues and expenses are specified in the table below
Average book value will be the initial cost of the investment (500,000) + the value at the
end of period (0). Hence, the answer for this as shown above, will be £250,000. As long
as we use straight-line depreciation, the average investment will always be one-half of the
initial investment.
 
From the table, we can also see that net income is £100 in year 1, £150,000 in year 2,
£50,000 in year 3, 0 in year 4 and —£50,000 in year 5. Hence:
[£100,000+£150,000+£50,000+0—£50,000]/5
= £50,000
Answer: AAR = Average net income = £50,000 = 20%
Average book value £250,000
AAR decision rule
• Average accounting
Accept return is greater than
target return
• Average accounting
Reject return is less than
target return
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Advantages and disadvantages of AAR
1. Easy to calculate
1. Not a true rate of return; time value of money is
2. Needed information will usually be available ignored (i.e. discounted values when calculating
the average net income)
2. Uses an arbitrary benchmark cut-off rate
3. Based on accounting (book) values, not cash

flows and market values
The Internal Rate of Return
Definition
Internal rate of return — the discount rate that makes the NPV of an investment zero.
With the IRR, we try to find a single rate of return that summarises the merits of a project.
Furthermore, we want this rate to be an ‘internal’ rate in the sense that it depends only on
the cash flows of a particular investment, not on rates offered elsewhere. Using this
method allows businesses to have some flexibility as it leaves some wiggle room.
Unknown discount values
For these types of calculations, it will often be the case that the discount rate is unknown.
This presents a problem, but we can still ask how high the discount rate would have to be
before this project was deemed unacceptable. We know that we are indifferent between
taking and not taking this investment when its NPV is just equal to zero. In other words,
the investment is economically a break-even proposition when the NPV is zero, because
value is neither created nor destroyed. To find the break-even discount rate, we set NPV
equal to zero and solve for R.
Decision rules for internal rate of return (IRR)
• Internal rate of
Accept return is greater than
discount rate
• Internal rate of
Reject return is less than
discount rate
Lecture example 6
An investment costs £100 and has a cash flow of £60 per year for 2 years. What is the
investment’s internal rate of return?
Find the discount rate ‘IRR’ where the NPV is zero. That is, solve for ‘IRR’ in the equation
below:
NPV = —£100 + [60/(1+IRR)] + [60/(1+IRR)2]
0 = —£100 + [60/(1+IRR) + [60/(1+IRR)2]
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Answer: IRR is between 10% and 15% (hint: try 13% and 14% next and choose the
answer where NPV is closest to zero).
Alternatively: solve for IRR using a financial calculator:
Multiple rates of return (non-conventional cash flows)
Multiple rates of return — the possibility that more than one discount rate will make the
NPV of an investment zero.
Rule of thumb — the maximum number of IRRs there can be is equal to the number of
times that the cash flows change sign from positive to negative and/or negative to
positive.
Example
Suppose we have a strip mining project that requires a

€60 investment. Our cash flow in the first year will be
€155. In the second year the mine will be depleted, but
we shall have to spend €100 to restore the terrain. This
means that both the first and third cash flows are
negative.
To find the IRR, we van calculate the NPV at various

rates:
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As seen in the diagram here, the NPV appears to be behaving in a peculiar fashion. The
NPV is zero when the discount rate is 25% and also when it is 33.3%. Both or neither
answers are correct in this case, as there is no unambiguously correct answer. This
denotes the multiple rates of return issue.
Mutually exclusive investments
Mutually exclusive investment decisions — a situation in which taking one investment

prevents the taking of another.
Even if there is a single IRR, another problem can arise concerning mutually exclusive
investment decisions. If two investments, X and Y, are mutually exclusive, then taking one
of them means that we cannot take the other. Two projects that are not mutually exclusive
are said to be independent. For example, if we own one corner lot, then we can build a
petrol staton or an apartment building, but not both. These are mutually exclusive
alternatives.
Lecture example 7
Which of these projects should a company accept assuming that the projects are
mutually exclusive? Consider IRR and NPV results when arriving at your answer.
The IRR for A is 24% ad the IRR for B is 21%. Because these investments are mutually
exclusive, we can take only one of them. Simple intuition suggests that investment A is
better because of its higher return. Unfortunately, this is not always correct.
One must always consider NPV first! NPV results at different discount rates are shown
below:
Next consider IRR! Use trial and error or a financial calculator to calculate IRR. A
graphical approach can also help. The IRR for a (24%) is larger than the IRR for B (21%).
However, if you compare the NPVs, you’ll see that which investment has the higher NPV
depends on our required return. B has greater total cash flow, but it pays back more
slowly than A. As a result, it has a higher NPV at lower discount rates.
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In our example, the NPV and IRR rankings conflict for some discount rates. If our required
return is 10%, for instance, then B has the higher NPV and is thus better of the two. If the
required return is 15%, then there is no ranking conflict: A is better. NPV results show that
project B is favourable at a discount rate of 0% to 10% and that project A is favourable at
a discount rate of 15% and above. We need to do further calculations to determine the
most attractive project for discount rates between 10% and 20%.
In this case, the IRR for A is 24%, and the IRR for B is 21%. Because the investments are
mutually exclusive, we can take only one of them, so the IRR rule says that we should
choose project A. This is a different answer than when we used the NPV rule. What is
going on here?
• Project B is preferable for a discount rate above 11.1%
• Project A is preferable for a discount rate below 11.1%
The conflict between the IRR and NPV for mutually exclusive investments can be
illustrated by plotting the investment’s NPV profiles:
This example illustrates that when we have mutually exclusive projects, we shouldn’t rank
them based on their returns. More generally, whenever we are comparing investments to
determine which is best, looking at IRRs can be misleading. Instead, we need to look at
the relative NPVs to avoid the possibility of choosing incorrectly. Remember, we’re
ultimately interested in creating value for shareholders, so the option with the higher NPV
is preferred, regardless of the relative returns. Hence, we can say:
Where IRR and NPV give conflicting results, use the NPV rule.
NPV ad IRR in financing decisions — mirror images
Below, project B is an investment decision and project A is a financing decision.
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In this case, the NPV and IRR decision rules disagree. The figure shows the NPV profile
for each project — the NPV profile for B is upward sloping. This means that the project
should be accepted if the required return is greater than 30%.
When a project has cash flows like investment B’s, the IRR is really a rate that you are
paying, not receiving. For this reason, we say that the project has financing-type cash
flows, whereas investment A has investing-type cash flows. You should take a project
with financing-type cash flows only if it is an inexpensive source of financing, meaning
that its IRR is lower than your required return.
Advantage and disadvantages of IRR
1. Closely related to NPV, often leading to identical 1. May result in multiple answers, or not deal with
decisions
non-conventual cash flows
2. Easy to understand and communicate — 2. May lead to incorrect decisions in comparisons

especially because it is calculated as a of mutually exclusive investments
percentage as opposed to a value
The Profitability Index
Definition
The Profitability Index (PI) — the present value of an investment’s future cash flows
divided by its initial cost. It can also be called the benefit-cost ratio.
The profitability index thus measures the value created per cash unit invested. For this
reason, it is often proposed as a measure of performance for government or other not-for-
profit investments. Also, when capital is scarce, it may make sense to allocate it to
projects with the highest PIs.
Using PI
• PI > 1
Accept
• PI < 1
Reject
Lecture example 8
Evaluate the following potential project using PI:
• Initial investment: $100
• Cash inflows: $80 a year for three years
Answer
PI = present value of future cash flows
initial cost
PI > 1, therefore accept the project
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Advantages and disadvantages of PI
1. Closely related to NPV, generally leading to 1. May lead to incorrect decisions in comparisons
identical decisions
of mutually exclusive investments
2. Easy to understand and communicate
3. May be useful when available investment funds

are limited
4. PI is used in capital rationing situations, where

capital is limited
The practice of capital budgeting
Importance of capital budgeting
• Long-term effect — capital, or long-term funds, raised by the firms are used to invest in
assets that enable the firm to generate revenues several years into the future
• Timing of a decision is important — decisions impact the firm for several years
Good decision criteria
• Provide information on whether we are creating value for the firm
• Adjust for the time value of money
• Take risk in account (e.g. how quickly the investment is repaid)
An international perspective
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Lecture 10: Short-term financial planning and management

(Chpt. 17)
Managing cash
Reasons for holding cash
The speculative motive — the need to hold cash to take advantage of additional
investment opportunities, such as bargain purchases, attractive interest rates and
favourable exchange rate fluctuations.
The precautionary motive — the need to hold cash as a safety margin to act as a financial
reserve.
The transaction motive — the need to hold cash to satisfy normal disbursement (payment
of wages and salaries, trade debts, taxes and dividends) and collection activities (from
product sales, the selling of assets and new financing) associated with a firm’s ongoing
operations.
Discussion point
Is there a potential conflict of interest between managers, creditors and shareholders

about how much cash a company should hold?
• Managers: prefer large amounts of cash to give maximum flexibility to take advantage
of investment opportunities that might arise (speculative motive).
• Creditors: prefer large amounts of cash to give security (precautionary motive).
• Shareholders: prefer moderate amounts of cash as they want the cash back to invest a
greater return elsewhere.
To determine the appropriate cash balance, the firm must weigh the benefits of holding
cash against the costs of them.
Float
Float — the difference between book cash and bank cash, representing the net effect of
cheques in the process of clearing.
A firm’s cash balance as reported in its financial statements (book cash or ledger cash) is
not the same thing as the balance shown in its bank account (bank cash or collected
bank cash). The difference between bank cash and book cash is called float, and
represents the net effect of cheques in the process of clearing (moving through the
banking system).
Cheques written by a firm generate disbursement float, causing a decrease in the firm’s
book balance but no change in its available balance. Cheques received by the firm create
collection float. Collection float increases book balances but does not immediately
change available balances.
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Float management
Float management involves controlling the collection and disbursement of cash:
• Cash collection — the aim is to speed up collections and reduce the lag between the
time customers pay their bills and the time the cash becomes available.
• Cash disbursement — the aim is to control payments and minimise the firm’s costs
associated with making payments.
The size of the float depends on both the cash levels and the time delay involved.
Lecture example 1: daily float
You make a bank transfer of $500 to another country each month. It takes two days for
the order to go through clearing. What is your average daily disbursement float?
Answer:
You have a $500 float for 2 days. So we say that the total float is 2 x $500 = $1,000.
Assuming 30 days in the month, the average daily float is: $1,000/30 = $33.33.
Managing seasonal cash demands
Firms have temporary cash surpluses for various reasons. Two of the most important are
the financing of seasonal or cyclical activities of the firm and the financing of planned or
possible expenditures.
Some firms have a predictable cash

flow pattern. They have surplus cash
flows during part of the year and deficit
cash flows for the rest of the year. For
example, Toys R Us has a seasonal
cash flow pattern influenced by the
holiday season. A firm like this may buy
marketable securities when surplus
cash flows occur, and sell marketable
securities when deficits occur. Of
course, bank loans are another short-
term financing device. The use of bank
loans and marketable securities to
meet temporary financing needs is
illustrated below, where the firm is
following a compromise working capital
policy.
Planned or possible expenditures
Firms frequently accumulate temporary investments in marketable securities to provide

the cash for a plant construction programme, dividend payment or other large
expenditure. Thus firms may issue bonds and shares before the cash is needed, investing
the proceeds in short-term marketable securities and then selling the securities to finance
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the expenditures. Also, firms may face the possibility of having to make a large cash
outlay. An obvious example would involve the possibility of losing a large lawsuit. Firms
may build up cash surpluses against such a contingency.
Discussion point: please list companies or industry sectors that are likely to have
seasonal cash patterns.
Managing a target cash balance
Target cash balance — a firm’s desired cash level as determined by the trade-off between
carrying costs and shortage costs.
Carrying (or opportunity) costs — the interest that could be earned by investing the cash
elsewhere.
Shortage (or adjustment) costs — the costs associated with holding too little cash.
The basic idea: What is the optimum starting cash balance?
The figure represents the cash management

problem for a firm that has a flexible capital
policy. If a firm tries to keep its cash
holdings too low, it will find itself running out
of cash more often than is desirable, and
thus selling marketable securities (and
perhaps later buying marketable securities
to replace those sold) more frequently than
would be the case if the cash balance were
higher. Thus, trading costs will be high when
the cash balance is small. These costs will
fall as the cash balance becomes larger.
In contrast, the opportunity costs of holding

cash are low if the firm holds little cash.
These costs increase as the cash holdings
rise, because the firm is giving up more
interest that could have been earned.
In the figure shown here, the sum of the costs is given by the total cost curve. As shown,
the minimum total cost occurs where the two individual cost curves cross at point C*. At
this point, the opportunity costs and trading costs are equal. This point represents the
target cash balance, and it is the point the firm should try to find.
BAT model
The Baumol-Allais-Tobin (BAT) model is a classic means of analysing cash management

problems. It determines the (optimal) target cash balance (C*) by minimising total costs. It
considers a company that requires regular net cash outflows to pay for operating
expenses. Cash in the bank account is replenished by selling marketable securities.
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Opportunity costs
Opportunity costs — opportunity cost is interest missed by keeping cash on current

account, earning zero interest, rather than investing in marketable securities.
To determine the opportunity costs of holding cash, we have to find out how much
interest is foregone:
= average bank cash balance x interest rate on marketable securities
= initial cash balance x interest rate on marketable securities
:. opportunity costs = (C/2) x R
Trading costs
Trading costs — trading costs is the cost of selling marketable securities to replenish
bank balance, assumed to be a fixed cost per trade.
To determine the total trading costs for the year, we need to know how many times the
firm will have to sell marketable securities during the year:
= number of times replenish cash x cost of sale
= (amount of cash needed in planning period / initial cash balance needed) x cost of one
trade
:. trading costs = (T/C) x F
Total cost
Optimum starting cash position C* is where the two lines cross on the graph given earlier,
where: opportunity costs = trading costs. That is: (C*/2) x R = (T/C*) x F
(&' × ))
That is:
!∗ = $
+

Where:
F = the fixed cost of selling securities to replenish cash
T = the total amount of new cash needed for transaction purposes over the relevant
planning period — usually, one year
R = the opportunity cost of holding cash; this is the interest rate on marketable securities
Lecture example 2: BAT
Golden Socks begins week 0 with a cash balance in its bank account (non-interest
bearing current account) of £1.2 million. Cash outflows exceed by £600,000 a week.
Interest on marketable securities is 10% and each trade costs £1,000.
(a) How long will it take to reduce the bank account to £0?
(b) How many times does the company need to sell marketable securities to replenish the
cash in one year?
(c) What is the optimum initial cash balance?
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Answer (a): 2 weeks (£1.2m / £600,000 per week)
Answer (b): 52 weeks / 2 weeks = 26 times a year
Answer (c): T = total net cash outflows in one year
(&' × ))
!∗ = $
= £1.2m x 26
+
= £31.2m

(& × -., &00, 000 × ., 000)

F = cost per trade
= $
0. .0
= £1,000

R = interest rate on marketable securities

=£ 789,937
= 10%
Final answer = £789,937
Assumptions:
• The model assumes that the firm has a constant disbursement rate
• The model assumes that there are no cash receipts during the projected period
• No safety stock is allowed
Miller-Orr Model
This model is a more sophisticated model because, unlike BAT, it allows:
• Daily fluctuation in net cash flows, including net cash outflows
• Includes a measure of uncertainty, σ2
To determine whether we need to use Miller Orr for the question (as opposed to using
BAT), variance must be mentioned in the question.
The figure here shows how the system works. It operates in terms of an upper limit (U*)
and a lower limit (L) to the amount of cash, as well as a target cash balance (C*). The firm
allows its cash balance to wander around between the lower and upper limits. As long as
the cash balance is somewhere between U* and L, nothing happens.
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Upper control limit

When the cash balance reaches its upper limit – invest, returning balance to C*
(U*), as it does at point X, the firm moves U* —
C* cash out of the account and into marketable
securities. This action moves the cash balance
down to C*. In the same way, if the cash balance
falls to the lower limit (L), as it does at point Y,
the firm will sell C* — L worth of securities and
deposit the cash in the account. This action
Lower control limit
takes the cash balance up to C*.
- Sell marketable securities to
replenish cash to C*
Using the model
To get started, management sets the lower limit

(L). This limit essentially defines a safety stock, so where it is set depends on how much
risk of a cash shortfall the firm is willing to tolerate. Alternatively, the minimum might just
equal a required compensating balance.
As with the BAT model, the optimal cash balance depends on trading costs and
opportunity costs. Once again, the cost per transaction of buying and selling marketable
securities, F, is assumed to be fixed. Also, the opportunity cost of holding cash is R, the
interest rate period on marketable securities. The only extra piece of information that is
needed is σ2, the variance of the net cash flow per period. For our purposes the period
can be anything — a day, or a week for example — as long as the interest rate and the
variance are based on the same length of time. As a result, the formulas are as follows:
Cash balance target:
C* = L + (3/4 x F x σ2/R)(1/3)
Upper limit:
U* = 3 x C* — 2 x L
Average cash balance:
A* = (4 x C* — L)/3
Where:
C* = target cash balance
L = the lower limit (given in the question)
F = fixed cost per transaction
σ2 = variance of the period’s net cash flows
R = interest rate on marketable securities
Lecture example 3: Miller-Orr
Short term securities yield is 0.02% per day. It costs the company £1 each time it buys or
sells securities. The daily variance of cash flows is £4. You require a £10 minimum
checking (current) account balance. What is the target balance, upper limit and average
cash balance according to the Miller-Orr model?
All of the values are for one day/daily rate (as opposed to monthly):
R = 0.0002
F = 1
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σ2 = 4
L = 10
So, the optimum target cash balance is:
𝟑𝟑 𝝈 𝟐 𝟑 𝟑 𝟒
𝑪∗ = 𝑳 + & × 𝑭 × 𝑹 = 𝟏𝟎 + & × 𝟏 × =£34.66
𝟒 𝟒 𝟎.𝟎𝟎𝟎𝟐
Upper cash limit:
U* = (3 x C*) — (2 x L)
= (3 x £34.66) — (2 x £10)
= £83.99
Average cash balance:
A* = (4 x C* — L)/3
= [(4 x £34.66) — £10]/3
= £42.88
Comparison of the BAT and Miller-Orr models
These two models differ in complexity, but they have some similar implications:
• The greater the interest rate, the lower is the target cash balance
• The greater the order cost, the higher is the target balance
The advantage of the Miller-Orr model is that it improves our understanding of the
problem of cash management by considering the effect of uncertainty, as measured by
the variation in net cash inflows.
Factors influencing the target cash balance
The firm obtains cash by selling marketable securities. Another alternative would be to
borrow cash. However, this introduces additional considerations for cash management:
• Borrowing is likely to be more expensive than selling marketable securities, because the
interest rate is likely to be higher
• The need to borrow will depend on management’s desire to hold low cash balances —
a firm is more likely to borrow to cover an unexpected cash outflow with greater cash
flow variability and lower investment in marketable securities
Secondly, for large firms, the trading costs of buying and selling securities are small when
compared with the opportunity costs of holding cash (compensating balance). Suppose a
firm has £1 million in cash that wont be needed for 24 hours. Should the firm invest the
money or leave it sitting?
Suppose the firm can invest the money at an annualised rate of 7.57% per year. The daily
rate in the case is about two basis points (0.02% or 0.0002). The daily return earned on
£1 million is thus 0.0002 x £1 million = £200. In many cases, the order cost will be much
less than this; so a large firm will buy and sell securities very often before it will leave
substantial amounts of cash idle.
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Managing credit
When a firm sells goods and services, it can demand cash on or before the delivery date,
or it can extend credit to customers and allow some delay in payment. Granting credit is
making an investment in a customer — an investment tied to the sale of a product or
service.
Why do firms grant credit? Not all do, but the practice is extremely common. The obvious
reason is that offering credit is a way of stimulating sales. The costs associated with
granting credit are not trivial. First, there is a chance that the customer will not pay.
Second, the firm has to bear the costs of carrying the receivables. The credit policy
decision thus involves a trade-off between the benefits of increased sales and the costs
of granting credit.
Key terms
Terms of sale — the conditions under which a firm sells its goods and services for cash or
credit (e.g. credit period, cash discount and discount period, and the type of credit
instrument)
Credit analysis — the process of determining the probability that customers will not pay.
Collection policy — the procedures followed by a firm in collecting trade receivables.
Credit period — the period for which credit is granted.
Cash discount — ‘2/10, net 30’ for example means: take a 2% discount from the full price
if you pay within 10 days (i.e. the cash discount period), or else pay the full amount in 30
days (i.e. the net credit period).
The credit policy
If a firm decides to grant credit to its customers, then it must establish procedures for
extending credit and collecting. In particular, the firm will have to deal with the terms of
sale, credit analysis and collecting policy.
The cash flows from granting credit
The trade receivables period is the time it takes to collect on a sale. There are several
events that occur during this period. These events are the cash flows associated with
granting credit, as seen in the diagram above. As our time line indicates, the typical
sequence of events when a firm grants credit is as follows:
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1. The credit sale is made
2. The customer sends a cheque to the firm
3. The firm deposits the cheque
4. The firm’s account is credited for the amount of the cheque
Terms of sale
Credit Cash
As mentioned earlier, the terms of sale are made up of three Period Discounts
distinct elements: the credit period, the cash discount and
the type of credit instrument.
Credit
Instruments
The credit period
The credit period is the basic length of time for which credit is granted, which varies from
industry to industry. However, it is almost always between 30 and 120 days. If a cash
discount is offered, then the credit period has two components: the net credit period (the
length of time the customer has to pay) and the cash discount period (the time during
which the discount is available).
The invoice date is the beginning of the credit period. With EOM dating, all sales made
during a particular month are assumed to be made at the end of that month. MOM, for
middle of month, is another variation.
There are a number of factors that influence the credit period. Many of these also
influence our customer’s operating cycles; so, once again, these are related subjects.
Among the most important are these:
1. Perishability and collateral value — perishable items have relatively rapid turnover and
relatively low collateral value. Credit periods are thus shorter for such goods. For
example, a food wholesaler selling fresh fruit and produce might use net seven days.
2. Consumer demand — products that are well established generally have more rapid
turnover. Newer or slow-moving products will often have longer credit periods
associated with them to entice buyers. Also, sellers may choose to extend much
longer credit periods for off-season sales (when customer demand is low).
3. Cost, profitability and standardisation — relatively inexpensive goods tend to have

shorter credit periods. The same is true for relatively standardised goods and raw
materials. These all tend to have lower mark-ups and higher turnover rates, both of
which lead to shorter credit periods. However, there are exceptions: car dealers
generally pay for the vehicles as they are received for example.
4. Credit risk — the greater the credit risk of the buyer, the shorter the credit period is
likely to be (if credit is granted at all).
5. Size of the account — if an account is small, the credit period may be shorter
because small accounts cost more to manage, and the customers are less important.
6. Competition — when the seller is in a highly competitive market, longer credit periods
may be offered as a way of attracting customers.
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7. Customer type — a single seller might offer different credit terms to different buyers. A
food wholesaler, for example, might supply groceries, bakeries and restaurants. Each
group would probably have different credit terms. More generally, sellers often have
both wholesale and retail customers, and they frequently quote different terms to the
two types.
Cash discounts
As we have seen, cash discounts are often part of the terms of sale. One reason why they
are offered is to speed up the collection of receivables. This will have the effect of
reducing the amount of credit being offered, and the firm must trade this off against the
cost of the discount.
Lecture example 4: cash discount
A buyer is purchasing an item at a price of £1,000. The seller is considering offering a

discount quoted as: ‘2/10, 30’. Interest rates are 10%. Should the seller offer the
discount?
2/10, 30 means that the buyer has a choice between:
• Paying the full price of £1,000 in 30 days
• Taking a 2% discount and pay in 10 days, paying £980 now, 20 days earlier
If the buyer takes the discount, the seller has effectively borrowed £980 from the buyer for
20 days and paid £20 interest.
Is this a good rate of interest?
• You borrow 20/980 every 20 days (the interest rate for the period)
• For 365/20 periods in a year, so m = 365/20
So, EAR = (1 + 20/980)^(365/20)
= 44.6%
Conclusion: This discount is really expensive for the seller as they are effectively
borrowing at 44.6% from the buyer but can borrow at 10% from the bank. On the other
hand, it is really attractive to the buyer as they are earning interest of 44.6% from the
seller when market interest rates are 10%.
Credit instruments
Credit instrument — the evidence of indebtedness.
Most trade credit is offered on open account — this means that the only formal
instrument of credit is the invoice, which is sent with the shipment of goods and which
the customer signs as evidence that the goods have been received. Afterwards, the firm
and its customers record the exchange on their books of account.
Analysing credit policy: credit policy effects
In evaluating credit policy, there are five basic factors to consider:
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1. Revenue effects — if the firm grants credit, then there will be a delay in revenue
collections as some customers take advantage of the credit offered and pay later.
However, the firm may be able to charge a high price if it grants credit, and it may be
able to increase the quantity sold. Total revenues may thus increase.
2. Cost effects — although the firm may experience delayed revenues if it grants credit,
it will still incur the costs of sales immediately. Whether the firm sells for cash or
credit, it will still have to acquire or produce the merchandise (and pay for it).
3. Cost of debt — when the firm grants credit, it must arrange to finance the resulting
receivables. As a result, the fir’s cost of short-term borrowing is a factor in the
decision to grant credit.
4. Probability of non-payment — if the firm grants credit, some percentage of the credit
buyers will not pay. This can’t happen, of course, if the firm sells for cash.
5. The cash discount — when the firm offers a cash discount as part of its credit terms,
some customers will choose to pay early to take advantage of the discount.
Credit analysis: When should credit be granted?
Once a firm decides to grant credit to its customers, it must then establish guidelines for
determining who will and who will not be allowed to buy on credit. Credit analysis refers to
the process of deciding whether or not to extend credit to a particular customer. It usually
involves tow steps: gathering relevant information, and determining creditworthiness.
Firms will need to evaluate different scenarios, such as:
• One time sale
• Repeat business
Collection policy
Ageing schedule — a compilation of trade receivables by the age of each account.
Collection policy is the final element in credit policy. Collection policy involves monitoring
receivables to spot trouble, and obtaining payment on past-due accounts.
Monitoring receivables
To keep track of payments by customers, most firms will monitor outstanding accounts.
First of all, a firm will normally keep track of its average collection period (ACP) through
time. If a firm is in a seasonal business, the ACP will fluctuate during the year; but
unexpected increases in the ACP are a cause for concern. Either customers in general are
taking longer to pay, or some percentage of trade receivables are seriously overdue.
The ageing schedule is a second basic tool for monitoring receivables. To prepare one,
the credit department classifies accounts by age. Suppose a firm has £100,000 in
receivables. Some of these accounts are only a few days old, but others have been
outstanding for quite some time. The following is an example of an ageing schedule:
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If the firm has a credit period of 60 days, then 25% of its accounts are late. Whether or
not this is serious depends on the nature of the firm’s collections and customers. It is
often the case that accounts beyond a certain age are almost never collected. Monitoring
the age of accounts is very important in such cases.
Collection effort
A firm usually goes through the following sequence of procedures for customers whose
payments are overdue:
1. Send out a delinquency letter informing the customer of the past-due status of the
amount
2. Make a telephone call to the customer
3. Employ a collection agency
4. Take legal action against the customer
At times, a firm may refuse to grant additional credit to customers until arrears are cleared
up. This may antagonise a normally good customer, which points to a potential conflict
between the collections department and the sales department. In probably the worst
case, the customer files for bankruptcy. When this happens, the credit-granting firm is
just another unsecured creditor. The firm can simply wait, or it can sell its receivable.
Managing inventory
Like receivables, inventories represent a significant investment for many firms.
Key elements
• The Financial Manager and

Inventory Policy
Inventory
Management • Inventory Types
• Inventory Costs
The financial manager and inventory policy
Despite the size of a typical firm’s investment in inventories, the financial manager of a
firm will not normally have primary control over inventory management. Instead, other
functional areas such as purchasing, production and marketing will usually share
decision-making authority regarding inventory.
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Inventory types
For a manufacturer, inventory is normally classified into one of three categories: raw
materials, work in progress or finished goods.
Inventory costs
Two basic types of costs are associated with current assets in general, and with inventory
in particular. The first of these is carrying costs. Here, carrying costs represent all of the
direct and opportunity costs of keeping inventory on hand, which include:
• Storage and tracking costs
• Insurance and taxes
• Losses due to obsolescence, deterioration, or theft
• The opportunity cost of capital on the invested amount
The other type of costs associated with inventory is shortage costs. These are associated
with having inadequate inventory on hand. The two components of shortage costs are
restocking costs and costs related to safety reserves. Depending on the firm’s business,
restocking or order costs are either the costs of placing an order with suppliers or the
costs of setting up a production run. The costs related to safety reserves are opportunity
losses such as lost sales and loss of customer goodwill that results from having
inadequate inventory.
A basic trade-off exists in inventory management, because carrying costs increase with
inventory levels, whereas shortage or restocking costs decline with inventory levels. The
basic goal of inventory management is thus to minimise the sum of these two costs.
Inventory management techniques
ABC approach
The ABC approach is a simple approach in which the basic idea is to divide inventory into
three (or more) groups. The underlying rationale is that a small portion of inventory in
terms of quantity might represent a large portion in terms of inventory value. For example,
this situation would exist for a manufacturer that uses some relatively expensive, high-
tech components and some relatively inexpensive basic materials in producing its
products. This can be mapped out on a graph, where the percentage of inventory items
vs. the percentage of inventory value are compared.
The economic order quantity model (EOQ)
The economic order quantity (EOQ) model is the best-known approach for explicitly
establishing an optimal inventory level. The basic idea is illustrated below, which plots the
various costs associated with holding inventory (vertical axis) against inventory levels
(horizontal axis). As shown, inventory-carrying costs rise and restocking costs decrease
as inventory levels increase. From seen earlier, the general shape of the total inventory
cost curve is familiar. With the EOQ model, we can attempt to specifically locate the
minimum total cost point, Q*.
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An important point to keep in mind is that

the actual cost of the inventory itself is not
included. The reason is that the total
amount of inventory the firm needs in a
given year is dictated by ales. What we are
analysing here is how much the firm
should have on hand at any particular
time. More precisely, we are trying to
determine what order size the firm should
use when it restocks its inventory.
To develop the EOQ, we shall assume that

the firm’s inventory is sold off at a steady
rate until it hits zero. At that point, the firm
restocks its inventory back to some
optimal level.
Optimum order quantity is where carrying costs = restocking costs.
Total carrying cost
= average inventory x 2 carrying costs per unit
= (starting inventory / 2) x carrying costs per unit per period
= (Q/2) x CC
Total restocking cost
= fixed cost per order x number of orders
= fixed cost per order x (total required per period/order quantity)
= F x (T/Q)
Total costs
= carrying costs x restocking costs
= (Q/2) x CC + F x (T/Q)
Finding the minimum point
To find the minimum point we have to set the two costs equal to each other and solve for
optimum order quantity (EOQ)Q*:
%& × (
!∗ = $
))

Where:
Q* = Economic Order Quantity (EOQ);
Q = Quantity ordered each time or restocking quantity
CC = Carrying cost per unit per year
F = Fixed cost per order
T = Firm’s total unit of sales per year
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Lecture example 5: EOQ
Black and White PLC:
• Orders a total of 40,000 units of caps for the year
• The restocking cost is £150 per order
• The carrying cost is £12 per unit per year
You may assume that the firm’s inventory is sold off at a steady rate until it hits zero. At
that point, the firm restocks its inventory back to a given level.
Calculate:
(a) The restocking quantity that minimises the total inventory costs
(b) The total restocking costs per year at the optimum order quantity
(c) The total carrying costs per year at the optimum order quantity
Answers:
T = 40,000
F = £150
CC = £12
(a) Q* = (2T x F / CC)^0.5
= (2 x 40,000 x 150/12)^0.5
= 1,000 units
(b) Total restocking costs = fixed costs per order x number of orders at Q*
= F x (T/Q)
= 150 x (40,000/1,000)
= £6,000
(c) Total carrying costs = average inventory x carrying costs per unit at Q*
= (Q*/2) x CC
= (1,000/2) x 12
= £6,000
Note: as expected, at Q*, total restocking costs are the same as total carrying costs.
Extensions to the EOQ model
Thus far we have assumed that a company will let its inventory run down to zero and then
reorder. In reality, a company will wish to reorder before its inventory goes to zero, for two
reasons. First, by always having at least some inventory on hand, the firm minimises the
risk of a stock-out and the resulting losses of sales and customers. Second, when a firm
does reorder, there will be some time lag before the inventory arrives. Thus, we consider
tow extensions to EOQ:
• Safety stocks — a safety stock is the minimum level of inventory that a firm keeps on
hand. Inventories are reordered whenever the level of inventory falls to the safety stock
level. Notice that adding a safety stock simply means that the firm does not run its
inventory all the way down to zero.
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• Reorder points — to allow for delivery time, a firm will place orders before inventories
reach a critical level. The reorder points are the times at which the firm will actually
place its inventory orders. The reorder points simply occur some fixed number of days
(or weeks or months) before inventories are projected to reach zero.
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Week 11: Revision

The exam
Exam content and weighting
The exam is 2 hours long and carriers a 60% weighting
It contains five questions, each carrying 40 marks
You choose any three questions
Each question = 40 minutes = 40 marks = 1 mark per minute
Scope
The exam only covers the material in teachings week 5, 6, 8, 9, 10. However, weeks 5 to
10 build on weeks 1 to 4, and as you will have observed, in recent weeks I have often
referred back to the basic concept and simple PV/FV calculations taught in weeks 1 to 4,
so some basic knowledge of undermining concepts is expected.
 
The exam will cover:
• Theory (e.g. definitions and understanding and concepts), and
• Calculations
Each question is largely focused on one topic (question 1 on week 5, etc). There is also
some overlap between topics and so, sometimes more than one topic may be examined
in any one question.
Exam technique
Important: marks are given for method, so SHOW ALL WORKINGS CLEARLY. Marks are
only deducted for the part of a calculation that is incorrect, follow-on marks are awarded
for subsequent calculations, so SHOW ALL WORKINGS CLEARLY.
Interpreting command verbs
State/list — simply give the answer or information required.
Define — provide a precise definition of the term. This is NOT meant to be in your own
words, it is best to repeat a standard definition from the lecture or textbook.
Describe — first define and then give some additional information to help the reader
better understand the item/concept, etc.
Calculate — an obvious command verb! Show your answer clearly and give the correct
currency or other unit.
Explain — give your reasons for the answer given.
Illustrate your answer or draw a graph/diagram/chart — draw a graph/diagram/chart (e.g.

a time line or cash balance diagram) to help explain our answer. A rough sketch in your
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answer book is sufficient. REVISE THE GRAPHS/DIAGRAMS/CHARTS. It is important to

remember a ruler in the exam!
Discuss — consider the arguments for (and against if appropriate) a particular course of
action.
Help available during the revision period
One-to-one help and answer to discussion board questions will be available up to the
date of the exam with the exception of a break from:
Friday 22nd December 2017 to Sunday 7th January 2018.
Drop-in sessions and office hours for week 12 (beginning 8th January 2018) will be
adverted on SurreyLearn and by emails once finalised.
Revision
Week 5: Discounted cash flow valuation
You need to:

• Interpret a question in order to choose the correct formula
• Explain the concept of present/future value
Calculate:
• PV and FV for annuities and perpetuities (including growth)
• Fixed cash flow, C, for a given PV or FV (loan amortisation for example)
• Implied interest rate, r, for a given PV or FV and C
• Working with time
• Also, work in periods of less than a year
Present value with multiple cash flows
Take the present value of each cash flow separately (as below) or use annuity/perpetuity
formulas to speed up the calculation.
This diagram is wrong: you divide by 1+R!! (Look at uploads later to add correct diagram)
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Present or future value with multiple cash flows
Annuity Perpetuity
Cash flow, C, for a fixed Same cash flow, C,

number of time periods. forever
No growth (= constant C) No growth (= constant C)
PV(annuity) PV(perpetuity)
! # !
= " x [1 – ] = "
(# & ")(
FV of an annuity
!
= " x [(1 + r)t – 1]
FV (annuity) — savings |—|—|—| £ SAVINGS is the term used in this type of question.
1 2 3 4
Example 1:
You wish to save as much as possible for your retirement in 10 years’ time. If you invest
£500 every month, at an interest rate of 2%, how much will you have in retirement savings
in 10 years’ time?
FV (annuity) = C/r x [1(1+r)t —1]
C = £500
t = 10 x 12 (number of years x m) = 120
r = QR/m = 0.02/12
PV (annuity) — the price/value today of future cash flows (not forever). An example would
be valuing a share for 20 years and then deciding to shut the company down after this
amount of time. BORROWINGS is the term used in these type questions.
Example 2:
After carefully going over your budget, you have worked out that you can afford to pay
EUR 500 a month towards a new car. You search the internet to find the best personal
finance deal is at an interest rate of 12% over a 60 month period, with interest
compounding monthly. How much can you borrow?
Borrowings |—|—|—| £
1 2 3 4
PV (annuity) = C/r x [1— (1/(1+r)t]
C = £500
t = 60 (doesn’t need to be adjusted because t is calculated in terms of months initially)
r = QR/m = 0.15/12 = 0.01
This type of question could also ask you to find the value of C, or the number of years the
loan will need to be repaid for.
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PV (perpetuity) — any example that mentions ‘forever’.
Present value with multiple cash flows — including growth
Growing Growing
annuity perpetuity
Cash flows increasing at Cash flows increasing at

growth rate g growth rate g
C = the cash flow one C = the cash flow one
period later period later
PV(growing annuity) PV(growing perpetuity)

!
! ()* , = (# %&)
= (# %&) x 1 – ()+
Useful formula
Dealing with periods of less than one year
R = QR/m where m is the number of periods in one year
t = years x m to give the number of periods
QR = quoted rate, or nominal rate
EAR =
Amortised loans
There are two approaches: fixed principal payment and fixed total payment.
Fixed principal payment — repay the principal in equal instalments plus all interest due on
the outstanding amount.
Fixed total payment — the borrower makes a single, fixed payment every year. Most
consumer loans (e.g. car loans) and mortgages are amortised following this approach.
The payment includes repayment of principal and also interest.
Example of an amortised loan with fixed annual payment
You borrow £10,000 for four years. The bank will lend you the money at 8% interest rate
and will require that the loans are paid-off in four equal (end-of-year) instalment
payments.
a) What are the annual loan payments that the company will have to make to repay the
loan?
b) How much interest and principal will be repaid each year?
Example answer a:
Present value of annuity =
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Where:
r = 0.08
t = 4 periods
PV (loan) = £10,000
So: £10,000 = (C/0.08) x (1-1/1.084)
£10,000 = C x 3.31213
C = £10,000/3.31213
C = £3,019.21
Once this has been calculated, C will be put into the loan amortisation table under the
‘payment’ every year.
Example answer b: Loan amortisation table
Period Beginning Balance Payment Interest Principal Ending Balance

1 £10,000.00 £3,019.21 £800.00 £2,219.21 £7,780.79
2 £7,780.79 £3,019.21 £622.46 £2,396.75 £5,384.04
3 £5,384.04 £3,019.21 £430.72 £2,588.49 £2,795.56
4 £2,795.57 £3,019.21 £223.65 £2,795.56 £0.00
Total £12,077 £2,077 £10,000
Interest payment period 1 = 10,000 x 8% = £800 (r is used, not quoted rate!!)
Principal payment period 1 = 3,019.21 — 800 = £2,219.21
Ending balance period 1 = 10,000 — 2,219.21 = £7,780.79
Here, periods are used as opposed to years for time. So if you had to a payment every 6
months, each 6 months would be a separate period. There are also more examples of
loan amortisation where the same amount of principal would be paid each period, e.g.
2,500 every period, and you have to calculate the other factors around it.
Week 6: Bond valuation
You need to:

Learn the definitions and use of each key term
Understand:
• Link between interest rates and bond prices, including interest rate risk
• Term structure of interest rates
• Factors affecting bond yields and prices
Calculate:
• Price/value of bond
• Yield/YTM of a bond
• Real and nominal rates of interest, taking inflation into account
A typical bond structure:

 
The company issues a £1,000 bond. The investors loan the company £1,000 and receive
interest of £80 a year. After 10 years, the company repays the £1,000 borrowed.
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Some key terms picked up from the lecture slides
• Secondary market
• Yield/YTM
• Dirty price
• Amount of issue
• Semi-annual
• Bond ratings
• Coupon
• Par value
• Real rates
• Offer price
• Trading at par
• Nominal rates
• Maturity
• Trading at a discount
• Fisher effect
• Call provision
• Trading at a premium
• Term structure of interest
• Sinking fund
• Interest rate risk
rates
• Face value
• Government bonds
• Inflation premium
• Security
• Zero coupon bonds
• Interest rate premium
• Rating
• Floating rate bonds
• Default risk premium
• Protective covenants
• Bond market structure
• Taxability premium
• Current yield
• Clean price
• Liquidity premium 
Bond value/price = the present value of future cash flows
We calculate the present value of each of the two main types of cash flow separately.
PV of
Face
Value
Bond
Value
PV of
Annuity
Bond value/price
= PV (coupons paid every period + PV (final repayment of face value)
= PV (annuity re coupons) + PV (single cash flow re face value)
So, bond value =
Where:
• F is the face value repaid at maturity
• C is the coupon paid each period
• t is the number of periods to maturity (if semi annual, divide by two)
• r is the YTM or yield or current market interest rate for a period
The indenture
The indenture — the written agreement between the corporation and the lender detailing
the terms of the debt issue.
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Usually, a trustee is appointed by the corporation to represent the bondholders. The trust
company must:
1. Make sure the terms of the indenture are obeyed
2. Mange the sinking fund
3. Represent the bondholders in default — that is, if the company defaults on its
payments to them.
Includes: the basic terms of the bonds; the total amount of bonds issued; a description of
property used as security; the repayment arrangements; the call provisions; details of the
protective covenants.
Note that there is an inverse relationship between interest rates and bond value.
Coupon rate > YTM, then price > face value: bond is selling at premium
Coupon rate < YTM, then price < face value: bond is selling at discount
Coupon rate = YTM, then price = face value: bond is selling at “par”
$1,600.00
$1,400.00 $1,359.30
$1,200.00 $1,162.22
V
$1,000.00
a $1,000.00
l $865.80
u $800.00 $754.22
e $660.99
$582.71
$600.00
$400.00
$200.00
$0.00
2% 4% 6% 8% 10% 12% 14%
YTM
Monday, 11 December 2017 27
Interest rate risk
The sensitivity of the bond value to interest rates is called interest rate risk. If you invested
in a bond and interest rate rise, your bond will all in value and you will lose value.
• All other things being equal, the longer the time to maturity, the greater the interest rate
risk
• All other things being equal, the lower the coupon rate, the greater the interest rate risk
Other factors affecting bond yields
Bond yields represent the combined effect of:
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• Real rate of interest — the return required after removing the effect of inflation
• Expected future inflation
• Interest rate risk premium
• Default risk premium — the portion of a nominal interest rate or bond yield that
represents compensation for the possibility of default
• Taxability premium — the portion of a nominal interest rate or bond yield that represents
compensation for unfavourable tax treatment
• Liquidity premium — the portion of a nominal interest rate or bond yield that represents
compensation for lack of liquidity. So bonds with longer period to maturity carry greater
liquidity premium.
Week 8: Equity valuation
You need to:

• Learn the definitions and use of each key term (e.g. preference shares versus ordinary
shares)
• Understand the key concepts covered in the lectures
Calculate:
• Share price
• Rate of return, dividend yield and capital gains yield
Valuing equity
In general, the price today of a share equity, P0, is the present value of all of its future
dividends, D1, D2, D3,…:
Where R is the investor required return.
Valuing shares
Three scenarios:
• Zero growth
• Constant growth
• Differential growth
Constant dividend
 
Zero growth: dividends are expected to be the same forever.
Approach: use the zero growth perpetuity formula.
If the dividend is expected to be constant and the required rate of return is R, the present
value of future dividend cash flows is:
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Constant growth
Constant growth: dividends are expected to grow forever at a constant rate (g).
Approach: use the growing perpetuity formula.
Assume the dividends grow at constant growth rate of g and required rate of retune is R.
Then the share price will be:
D0 ´ (1 + g ) D1
P0 = =
R-g R-g
Non-constant growth
Differential growth: dividends have different growth rates in different time periods.
Valuation approach: split the problem into sections according to the growth rate in
different time periods.
Ordinary shares versus preference shares
Key differences:
• Type of dividend
• Priority in payment of dividend
• Voting rights
• Priority in wind-up of the company
• Are preference shares equity or debt?
Key terms in relation to preference shares:

• Redeemable or irredeemable
• Cumulative or non-cumulative
Are preference shares classified as debt or equity in the financial statements?
Components of required rate of return
Capital
Dividend Total
Gains
Yield Return
Yield
R = Dividend yield + Capital gains yield

R = (D1/P0) + g
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Week 9: Net present value and other criteria
You need to:

• Learn the definitions and use of each key term
• Understand the key concepts covered in the lectures
Calculate and interpret/discuss the results of:

NPV, payback period, discounted payback period, IRR, AAR, PI
Net present value (NPV)
Method
Net present value (NPV)
= — initial cost + PV (future cash flows generated by the project)
Rule
Accept if NPV > 0
Reject if NPV < 0
Main advantages:
• Gives a monetary value or the added value created for shareholders by the project,
taking time value of money into account
• Ties back to the main purpose of corporate finance (generating value) and capital
budgeting (choosing investments that generate the most value for a given risk profile)
Payback period method
Method
The amount of time required for an investment to generate cash flows sufficient to recover
its initial cost.
Rule
Accept: payback period is less than the cut-off time
Reject: payback period is greater than the cut-off time
Main advantages:
• Short payback means lower risk (as later cash flows are more risky)
• Short payback means better liquidity (more cash received back sooner and can be used
elsewhere)
• Easy to understand
Average Accounting Return (AAR)
Average accounting return (AAR) = average net income / average book value
Where:
• Average net income = sum of the net income for each period divided by the number of
periods
• Average book value = (initial cost + scrap value) / 2
Main advantage: links back to company target ROA.
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Internal rate of return
Method
• IRR: the discount rate that makes the NPV of an investment zero
• It gives the effective rate of return on the project
• Solve for R in NPV = 0 by trial and error or using a financial calculator
Rule:
Accept: IRR > required rate of return
Reject: IRR < required rate of return
Main advantage: it gives the effective rate of return on the project, which is easy to
understand and gives an indication of risk (by comparing IRR to required return).
Profitability Index
Method
• The present value of an investment’s future cash flows divided by its initial cost
• It is also called the benefit-cost ratio
• It gives the PV of future cash flows per £1 invested
Rule:
Accept if profitability index > 1
Reject if profitability index < 1
Main advantage: the PI is useful if can carry out a project more than once or in capital
rationing situations and a choice of many different projects.
Week 10: Short-term financial planning and management
You need to know:
Managing cash
• Reasons for holding cash
• How float arises and how to calculate what it scouts
• Managing seasonal cash demands
• Managing a target balance, including the BAT and Miller-Orr models
Managing credit/receivables
• Terms of a sale
• Managing receivables — credit policy, analysis and collection
• Evaluating cash discounts for early payment
Managing inventory
• Inventory management techniques in general
• The EOQ model
Managing cash: reasons for holding cash
• The speculative motive — the need to hold cash to take advantage of additional
investment opportunities, such as bargain purchases.
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• The precautionary motive — the need to hold cash as a safety margin to act as a
financial reserve.
• The transaction motive — the need to hold cash to satisfy normal disbursement and
collection activities associated with a firm’s ongoing operations.
Managing cash: float
Float — the difference between book cash and bank cash, representing the net effect of
cheques in the process of clearing.
Disbursement float — cheques written by a firm generate disbursement float, causing a

decrease in the firm’s book balance but no change in its available balance.
Collection float — cheques received by the firm create collection float. Collection float
increases book balances but does not immediately change available balances.
Total (or net) float = disbursement float + collection float
Average daily float = total float / total days
Managing cash: managing seasonal cash demands
Managing cash: the BAT model
Cash in the bank account is replenished

by selling marketable securities.
Calculate the optimal starting cash

balance using the following formula:
(&' × ))
!∗ = $
+

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The optimal cash balance, C*, is where: opportunity costs = trading costs.
Opportunity cost is interest missed out on by holding cash in the bank rather than in
marketable securities
= average bank balance x interest rate
= (C/2) x R
Trading costs is the cost of buying or selling marketable securities
= number of transactions x fixed cost
= (T/C) x R
Upper control limit

– invest, returning balance to C*
Lower control limit

- Sell marketable securities
to replenish cash to C*
Managing receivables: cash discount
Cash discount:
’2/10, net 30’ for example means: take a 2% discount from the full price if you pay within
10 days (i.e. the cash discount period), or else pay the full amount in 30 days (i.e. the net
credit period).
Managing receivables: credit policy
1. Perishability and collateral value
2. Consumer demand
3. Cost, profitability and standardisation
4. Credit risk
5. Size of the account
6. Competition
7. Customer type
Managing receivables: credit policy effects
• Revenue effects
• Cost effects
• Cost of debt
• Probability of non-payment
• The cash discount
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Managing receivables: monitoring and collection
Monitoring receivables
• Average collection period (ACP)
• Ageing schedule
Collection effort
• Send out a delinquency letter informing the customer of the past-due status of the
account
• Make a telephone call to the customer
• Employ a collection agency
• Take legal action against the customer
Managing inventory: the economic order quantity model (EOQ)
Carrying costs
• Storage and tracking costs
• Insurance and taxes
• Losses due to obsolescence, deterioration or theft
• The opportunity cost of capital on the invested amount
Restocking costs
• Either the costs of placing an order with suppliers or the costs of setting up a
production run
Managing inventory: EOQ extensions
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Business Finance Lecture Notes

BUSINESS FINANCE (University of Surrey)

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Business Finance Lecture Notes

The three pillars of corporate ﬁnance

Investment: what do you need to start a ﬁrm?

Capital budgeting — the process of planning and managing a ﬁrm’s long-term

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Cash invested in assets must be matched by an equal amount

The balance ﬁgure represents that both accounts need to be

Capital structure — the mixture of long-term debt and equity

Working capital management

Working capital — a ﬁrm’s short-term assets and liabilities.

• How much cash and inventory should we keep on hand?

• How will we obtain any needed short-term ﬁnancing?

Who makes the decisions? The Financial Manager

Typical company reporting structure

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The diagram highlights that:

Diﬀerence between ﬁnance and accounting functions

Responsibilities of a ﬁnancial manager

Maximise value from cash:

• Buy assets that earn more cash than they cost

• Choose long-term investments that increase ﬁrm value

• Raise cheap external ﬁnancing

• Ensure eﬃcient tax policy

• Business and Corporate Finance

• Planning and Appraisal

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1.2 The Goal of Financial Management

Why are you starting a ﬁrm?

Showing value — the balance sheet

Equity— the amount of money raised by the ﬁrm that comes

Equity = shares. If you were to invest some money in a

Diﬀerent goals in practice

• Avoid ﬁnancial distress and bankruptcy

• Maintain steady earnings growth

• Beat the competition/be the best

1.3 Financial Markets and the Corporation

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Diﬀerent sources of ﬁnancing

• Bonds (tradable and interest, return of money in the end)

Primary vs. secondary markets

Primary markets — the original sale of securities by governments and corporations;

Dealer versus auction markets

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Trading in corporate securities

2.1 Corporate Governance

When shareholders hire professional managers to run their company, it is important to

Forms of business organisation

There are three diﬀerent legal forms of business organisation:

Sole proprietorship — a business owned by a single individual.

Partnership — a business formed by two or more individuals or entities.

Corporation — a business created as a distinct legal entity composed of one or more

Sole Proprietorship Partnership Limited Corporation

• Owned and managed by one • Easy to form

• Amount of funding is limited by income