FINANCIAL MANAGEMENT

Complete Course Notes & Exam Preparation Guide

Compiled from Lectures 1–10 (NUML) — Time Value of Money, Financial Markets, Valuation of Bonds & Stocks,
Capital Budgeting, Capital Structure/WACC, and Financial Statement & Ratio Analysis

Prepared with explanatory additions and worked examples where the original slides were incomplete (clearly marked 📌
throughout).
A Note on the Uploaded Files
Fourteen files were uploaded. Twelve of them are the actual Financial Management (FM) lecture decks (Lectures
1–10, with two files for Lecture 8 and two for Lecture 9), and this guide is built from all of them.
Two of the uploaded files are NOT Financial Management content, and have been excluded from these notes:
● "Lec_09_Location_Strategies_MBA_Lecture.pdf" — this is an Operations Management & Supply Chain
lecture on Location Strategy (labor productivity, exchange rates, political risk, clustering, Pakistan case
studies like Faisalabad textiles and Sialkot surgical instruments). It does not belong to the Financial
Management course, despite the similar file-naming pattern to "Lec 9".
● "Forecasting_lecture_slides_(part_1_and_2).pptx" — this is also an Operations Management topic
(demand forecasting), not Financial Management.
If you actually need notes on those two topics as well, let me know and I will prepare a separate Operations
Management guide — mixing them into this document would make the FM exam guide confusing.

Where the FM slides jumped straight to formulas/examples without spelling out a definition, or where a topic
was clearly promised in a lecture's outline but not finished in the slides (e.g., some Capital Structure theories,
and several ratio categories in Lecture 10), the missing explanation has been added and clearly flagged with a 📌
note so you know it is supplementary, not from your teacher's slides verbatim.
Contents
● Lecture 1 — The Role of Financial Management
● Lecture 2 — Financial Markets
● Lecture 3 — Time Value of Money (Single Sums)
● Lecture 4 — Time Value of Money (Annuities & EAR)
● Lecture 5 — Valuation Concepts: Loans & Bonds
● Lecture 6 — Bond Valuation & Yield to Maturity
● Lecture 7 — Stock (Equity) Valuation
● Lecture 8 — Capital Budgeting Techniques
● Lecture 9 — Capital Structure & Cost of Capital (WACC)
● Lecture 10 — Financial Statement & Ratio Analysis
● Exam Guide — Master Formula Sheet
● Exam Guide — Likely Question Bank & Model Answers
● Exam Guide — Common Mistakes & Final Tips
Lecture 1 — The Role of Financial Management
1.1 What is Financial Management?
Financial Management is concerned with the acquisition, financing, and management of an organization's
assets, with some overall goal in mind (maximizing shareholder wealth). Every decision a business makes has
financial implications — any decision that affects the firm's finances is a corporate finance decision.

1.2 The Three Core Decisions of Financial Management

(a) Investment Decisions
The most important of the three. Concerned with: what is the optimal firm size, which specific assets should be
acquired, and which assets (if any) should be reduced or eliminated.
(b) Financing Decisions
Determine how assets (left-hand side of balance sheet) will be financed (right-hand side). Key questions: best
type of financing, best financing mix (debt vs equity), best dividend policy, and how funds will be physically
raised.
(c) Asset Management Decisions
Concerned with how existing assets are managed efficiently. The financial manager has varying operating
responsibility over assets, with greater emphasis on current asset management (cash, receivables, inventory)
than fixed assets.

1.3 The Goal of the Firm

The goal of financial management is Maximization of Shareholder Wealth — value creation occurs when the firm
maximizes the current share price for its shareholders.
Why not Profit Maximization or EPS Maximization?
● Profit Maximization: maximizing after-tax earnings. Problem — it can increase current profits while
harming the firm long-term (e.g., deferring maintenance, or issuing stock to buy T-bills just to boost the
numerator); it also ignores changes in the firm's risk level.
● EPS Maximization: maximizing earnings after tax ÷ shares outstanding. Problem — it does not specify
the timing or duration of expected returns, ignores risk, and would call for a zero-payout dividend policy
(since paying dividends doesn't raise EPS).
Shareholder Wealth Maximization is superior because it accounts for current AND future profits/EPS, the timing,
duration, and risk of those profits, dividend policy, and all other relevant factors — so the share price becomes a
real-time barometer of business performance.

1.4 Corporate Governance & Agency Theory

In the Modern Corporation, ownership (shareholders) is separated from control (management). Management
acts as an agent for the owners (principals).
Agency Theory (Jensen & Meckling):
A branch of economics studying the relationship between principals and agents. Because managers (agents) may
not always act in shareholders' (principals') best interest, principals must provide incentives — stock options,
perquisites, bonuses — and then monitor results, to align management's behavior with shareholder wealth
maximization.
Corporate Governance is the overall system by which corporations are directed and controlled, involving
shareholders, the board of directors, and senior management.
Corporate Social Responsibility (CSR) does not conflict with wealth maximization — a firm can be socially
responsible while still pursuing shareholder wealth as its governing goal, viewing itself as producing both private
and social goods. Sustainability means meeting present needs without compromising the ability of future
generations to meet their own needs.

1.5 Forms of Business Organization

Sole Proprietorship
An unincorporated business owned by one person — the simplest form (≈80% of businesses worldwide by
count).
● Advantages: easy & inexpensive to form; few government regulations; no corporate income tax (only
personal tax on the proprietor).
● Limitations: difficult to raise large capital; unlimited personal liability for business debts; limited life (tied
to the owner's life).
Partnership
Two or more persons conducting a non-corporate business (registered or unregistered); no separate legal
identity from its partners.
● Advantages: low cost, ease of formation.
● Limitations: unlimited liability, limited life, difficulty transferring ownership, difficulty raising large
capital.
Corporation (Company)
A separate legal entity distinct from its owners/managers, registered by the government; can be Private Limited
(Pvt. Ltd.) or Public Limited (may be listed on a stock exchange). Corporations control roughly 80% of global sales
of goods & services.
● Advantages: unlimited life (continues beyond any owner's death); easy transferability of ownership
(shares); limited liability (shareholders lose at most their investment — personal assets are protected).
● Limitations: double taxation (profits taxed at the corporate level, then dividends taxed again as
shareholder income); more complex/costly legal formalities to set up.

1.6 Business Environment

Internal Environment
● Finance
● Marketing
● Human Resources
● Operations (Production/Manufacturing)
● Technology
● Other functions — Logistics, Communications
External Environment
● Customers
● Suppliers
● Competitors
 ● Government/Legal agencies & regulations
● Macro-economy/markets
● Technological revolution
SWOT Analysis
A framework used to assess a business: Strengths and Weaknesses are internal to the organization;
Opportunities and Threats are external.
🎯 Exam tip: A very common short-answer question is "Why is Shareholder Wealth Maximization preferred over
Profit Maximization and EPS Maximization?" — structure your answer around timing, risk, and dividend policy,
exactly as above.
Lecture 2 — Financial Markets
2.1 What Are Financial Markets?
Financial markets are places where financial instruments are bought and sold — the economy's "central nervous
system." They let firms and individuals find financing for their activities and promote economic efficiency by
making sure resources reach those who can use them best, while keeping transaction costs low.
Roles of Financial Markets
● Liquidity — allow owners to buy/sell instruments cheaply, keeping transaction costs low.
● Information — pool and communicate information about issuers of financial instruments.
● Risk sharing — provide a place for individuals to buy and sell risk.

2.2 Direct vs Indirect Finance

● Direct Finance: borrowers borrow directly from lenders by selling financial instruments (claims on the
borrower's future income/assets) in the financial markets.
● Indirect Finance: borrowers borrow via financial intermediaries (banks, etc.) who source both loanable
funds and loan opportunities.

2.3 Money Market vs Capital Market

Feature Money Market Capital Market
Maturity ≤ 1 year > 1 year
Instruments traded T-Bills, Commercial Paper, Stocks (equity) and Bonds
Bankers' Acceptance, CDs, (debt)
Repos
Purpose Short-term liquidity Long-term capital formation &
management investment

Pakistan's capital market structure is regulated by the Securities and Exchange Commission of Pakistan (SECP) —
the apex regulator — with the Pakistan Stock Exchange (PSX, formed from the merger of the three former stock
exchanges), Mercantile Exchanges, the Central Depository Company (CDC), and the National Clearing Company
of Pakistan Limited handling clearing & settlement.
Money Market Instruments
Instrument Issuer Key characteristic
Treasury Bills Government (e.g., US Discount paper; "full faith and
Treasury) credit" of government
Commercial Paper Corporations Short-term corporate debt
Banker's Acceptance Banks Finances self-liquidating trade
transactions
Certificate of Deposit Banks Interest paid at maturity; bank
borrowing from investors
Federal Funds Banks Banks borrowing from other
banks
Repurchase Agreement (Repo) Money market dealers Borrowing against collateral to
re-lend at a higher rate
("pawnshop model")
2.4 Capital Market
The capital market is where long-term investment instruments — bonds, equities, mortgages — are traded. Its
primary role is channeling funds from investors with a surplus to those running a deficit, offering both long-term
and overnight funds. Instruments traded include equity instruments, credit market instruments, insurance
instruments, foreign exchange instruments, and hybrid instruments.
Nature of the Capital Market
● Has two segments (primary & secondary)
● Deals in long-term securities
● Performs a trade-off function (risk vs return)
● Creates dispersion in business ownership
● Helps in capital formation
● Helps in creating liquidity
Primary Market (New Issue Market)
Where shares, debentures and other securities are sold for the FIRST time to raise long-term capital. Funds flow
from savers to borrowers (industry), directly aiding capital formation. Proceeds are typically used to modernize
plant/machinery, expand business, or set up new units.
Features:
● Related to new issues only
● Has no particular physical place
● Methods of raising capital: (i) Public Issue, (ii) Offer for Sale, (iii) Private Placement, (iv) Rights Issue, (v)
Electronic-IPO
● Comes before the Secondary Market
Secondary Market
Where previously issued securities are bought and sold, generally through a stock exchange. Its chief purpose is
to create liquidity — an investor who bought a security can resell it via a broker on the stock exchange. Pakistan
formerly had multiple regional exchanges (the slides note historically up to 24 stock exchanges referenced in a
broader sense; today trading is consolidated on the PSX).
Features:
● Creates liquidity
● Comes after the primary market
● Has a particular physical/electronic place (the exchange)
● Encourages new investment (because investors know they can exit later)

2.5 Capital Market Institutions in Pakistan

● SECP — apex regulator
● Pakistan Stock Exchange (PSX) — merger of Karachi, Lahore & Islamabad exchanges
● Mercantile Exchanges
● Central Depository Company (CDC) — electronic custody of securities
● National Clearing Company of Pakistan Limited (NCCPL) — clearing & settlement
● Brokers — intermediaries who execute transactions on investors' behalf
2.6 Ways of Raising Capital / Instruments
Private Placement
Sale of an entire issue of unregistered securities (usually bonds) directly to one purchaser or a small group (often
insurance companies, pension funds, bank trust departments), eliminating the underwriting function of an
investment bank.
● Advantages: raises funds more quickly; eliminates timing risk; eliminates SEC/registration-type
regulation of the security; terms can be tailored to the borrower's needs; flexibility to borrow smaller
amounts more frequently.
Initial Public Offering (IPO)
A company's first offering of common stock to the general public — often prompted by venture capitalists
wanting a cash exit, or by founders wanting to establish a market value for their firm. IPOs carry greater price
uncertainty than seasoned (already-listed) stock issues.
Debentures / Bonds
Debt instruments giving holders the right to regular interest payments plus principal repayment at maturity.
Unlike equity dividends, bond interest is compulsory even if the company makes a loss, and bondholders rank
ahead of both preference and common shareholders during liquidation.
Eurobonds
A bond issued offshore by a government or corporation, denominated in a currency other than that of the
issuer's home country — usually long-term, and typically denominated in USD.
Mutual Funds
Pool money from many small investors and invest it across equity, commodity and debt markets. Investors
receive "units" whose price moves with the market value of the underlying portfolio. Total return = capital
appreciation + income distributed; note the value of units can also fall, causing a loss to the unit-holder.
Common vs Preferred Stock
Feature Common Stock Preferred Stock
Voting rights Yes Usually none
Dividend Variable, board discretion Usually fixed
Priority on liquidation Last (residual claim) Ahead of common, behind
debt
📌 Added for completeness (not explicit in the slides): The slides show a comparison graphic for Common vs
Preferred stock without the accompanying text; the table above captures the standard distinction covered in
your recommended textbooks (Van Horne / Brigham).
Lecture 3 — Time Value of Money (Single Sums)
3.1 Core Concept
The Time Value of Money (TVM) is the principle that a sum of money today is worth more than the same sum in
the future, because of its earning potential in the meantime. A rupee/dollar in hand today can be invested to
earn a return, so it is worth more than a rupee/dollar promised later. TVM is also called present discounted
value — it is a core principle of finance.
Why does money have time value? (Determinants of TVM)
● Risk & uncertainty — the future is uncertain; cash inflows depend on others (debtors, banks), so a
certain cash amount now is preferred to an uncertain amount later.
● Inflation — money today has more purchasing power than the same amount in the future, in an
inflationary economy.
● Consumption preference — individuals generally prefer current consumption to future consumption.
● Investment opportunities — a rupee received today can be invested to grow into a larger amount later,
so it is worth more than a rupee received later.

3.2 Key Terms

Term Meaning
Future Value (FV) The amount an investment is worth after one
or more periods.
Present Value (PV) The current value of a future cash flow,
discounted at the appropriate rate.
Compounding Accumulating interest on an investment over
time so interest also earns interest — moves
cash flows FORWARD in time.
Discounting The reverse of compounding — moves cash
flows BACK in time to find present value.
Simple Interest Interest earned only on the original principal.
Compound Interest Interest earned on both principal and
previously earned (reinvested) interest.
Discount Rate The rate used to bring a future cash flow back
to its present value.

3.3 Simple Interest

SI = P0 × i × n
where SI = simple interest, P0 = principal (original amount), i = interest rate per period, n = number of periods.
Example — Simple Interest
Deposit $100 at 8% simple interest for 10 years. SI = 100 × 0.08 × 10 = $80.
FVn = P0 [1 + (i × n)] (Simple-interest future value)
Example — Simple-interest FV
FV10 = $100 + [100 × 0.08 × 10] = $180.
PV0 = FVn / [1 + (i × n)] (Simple-interest present value)
3.4 Compound Interest
Compound interest is "interest on interest" — previously earned interest is added to the principal and itself
earns interest going forward. If you are borrowing, you want interest compounded as infrequently as possible; if
investing, you want it compounded as often as possible.
FVn = P0 (1 + i)^n
Example — Astor's Land (classic textbook problem)
In 1790, $58 invested at 5% compounded annually for 219 years: FV = 58 × (1.05)^219 = 58 × 43,692.26 ≈
$2,534,151.08 — illustrating the enormous power of long-run compounding.

3.5 Present Value of a Single Sum

PV0 = FVn / (1 + r)^n = FVn × [1/(1+r)^n]
The bracketed term [1/(1+r)^n] is the Present Value Interest Factor, PVIF(r,n). Likewise (1+r)^n is the Future
Value Interest Factor, FVIF(r,n).
Example — FV of a single sum
PV0 = $1,000 invested for 2 years at r = 12% → FV2 = 1,000 × (1.12)^2 = $1,254.40.
Example — PV of a single sum
A cash flow of $25,000 to be received in 3 years, discounted at 9%: PV0 = 25,000 / (1.09)^3 = $19,604.59.

3.6 Nominal (Stated) vs Periodic Interest Rate

Compounding frequency matters. If interest is calculated over a period shorter than a year, that period's rate is
the periodic rate. If a rate is quoted per year but compounds more than once a year (e.g., "12% compounded
monthly"), it is the stated (nominal) annual rate — you must convert it to a periodic rate before using it in TVM
formulas (periodic rate = nominal rate ÷ compounding frequency).
🎯 Exam tip: Most student errors in TVM problems come from mixing nominal and periodic rates. Always check:
is the rate already "per period," or does it need dividing by the number of compounding periods per year first?

3.7 Present Value of Multiple (Uneven) Cash Flows

When cash flows differ each period, discount each one back individually to time 0 at the given rate, then sum
the present values:
PV = CF1/(1+r)^1 + CF2/(1+r)^2 + ... + CFn/(1+r)^n
This is the technique used, for example, to value a project's uneven annual cash flows, or a bond's mixed
coupon-plus-principal final payment (covered in later lectures).
Lecture 4 — Time Value of Money: Annuities & Effective Annual Rate
4.1 Effective Annual Rate (EAR)
When interest compounds more than once a year, the Effective Annual Rate (EAR) is the true annual rate of
return an investor earns, once compounding is accounted for.
EAR = (1 + i/m)^m − 1
where i = stated (nominal) annual rate and m = number of compounding periods per year.
Example — EAR from monthly compounding
12% compounded monthly: EAR = (1 + 0.12/12)^12 − 1 = 12.68%.
Example — Reverse EAR problems
Given EAR = 14%, find the equivalent periodic rate for different frequencies: Semiannual: (1.14)^(1/2) − 1 =
6.77% per 6 months Quarterly: (1.14)^(1/4) − 1 = 3.33% per quarter Monthly: (1.14)^(1/12) − 1 = 1.10% per
month

4.2 What is an Annuity?

An annuity is a series of equal payments or receipts (called "rents") occurring at regular intervals, with interest
compounding once each interval.
● Ordinary Annuity: payments/receipts occur at the END of each period (most common: loan instalments,
bond coupons).
● Annuity Due: payments/receipts occur at the BEGINNING of each period (e.g., rent paid in advance).

4.3 Future Value of an Ordinary Annuity

FVAn = R × [((1+i)^n − 1) / i] = R × FVIFA(i,n)
where R = the periodic payment/receipt ("rent"), i = interest rate per period, n = number of periods.
Example — FV of an ordinary annuity
Five $5,000 year-end deposits at 12%: FVIFA(12%,5) = 6.35285 FVA5 = 5,000 × 6.35285 = $31,764.
Example — FV of an ordinary annuity (2)
$30,000 deposited at year-end for 8 years at 12%: FVIFA(12%,8) = 12.29969 FVA8 = 30,000 × 12.29969 =
$368,991.
Example — Solving for the required annual saving
Need $50,000 after 10 years, bank pays 8% compounded annually. $50,000 = R × FVIFA(8%,10) = R × 14.486
R = 50,000 / 14.486 = $3,452 per year.

4.4 Present Value of an Ordinary Annuity

PVAn = R × [(1 − (1+i)^−n) / i] = R × PVIFA(i,n)
Example — PV of an ordinary annuity
$1,000 for 3 years at 8%: PVIFA(8%,3) = 2.577 PVA3 = 1,000 × 2.577 = $2,577.
Example — Retirement/annuity withdrawal problem
Inheritance of $25,000 invested at 6% for 12 years, wanting equal year-end withdrawals leaving a zero
balance: $25,000 = R × PVIFA(6%,12) = R × 8.384 R = 25,000 / 8.384 = $2,982 per year (total withdrawn over
12 years ≈ $35,784).
Example — PV of rental receipts
$6,000 per year for 5 years at 12%: PVIFA(12%,5) ≈ 3.605 PVA5 = 6,000 × 3.605 ≈ $21,630 (present value of
the rental stream).

4.5 Perpetuity
A perpetuity is an ordinary annuity whose payments continue forever.
PVA∞ = R / i
Example — Perpetuity
$100 received every year forever at 8%: PV = 100 / 0.08 = $1,250.
This same formula reappears for perpetual bonds (Lecture 5/6) and preferred stock / zero-growth common
stock valuation (Lecture 7) — it is one of the most-used shortcuts in the whole course.

4.6 Annuity Due

Because every payment in an annuity due occurs one period earlier than in an ordinary annuity, its value is
simply the ordinary-annuity value multiplied by (1+i):
FVADn = R × FVIFA(i,n) × (1 + i)
PVADn = R × PVIFA(i,n) × (1 + i) [equivalently: R×PVIFA(i,n−1) + R]
Because each cash flow gets one extra period to earn/save interest, an annuity due is always worth more than
an equivalent ordinary annuity.

4.7 Compounding More Than Once a Year — the General FV Formula

FVn = PV0 (1 + i/m)^(m×n)
As m (compounding frequency) → ∞, this converges to continuous compounding:
FVn = PV0 × e^(i×n)
Example — Comparing compounding frequencies ($100 at 10% for 10 years)
Annual: 100×(1.10)^10 = $259.40 Semiannual: 100×(1.05)^20 = $265.30 Quarterly: 100×(1.025)^40 =
$268.50 Continuous: 100×e^(0.10×10) = $271.83 → More frequent compounding always yields a (slightly)
higher future value for the same nominal rate.
🎯 Exam tip: Learn to recognize the 4 building-block formulas instantly: (1) FV/PV of a single sum, (2) FV/PV of an
ordinary annuity, (3) FV/PV of an annuity due, (4) PV of a perpetuity. Almost every numerical question on the
exam is one of these four, or a combination (e.g., a bond = ordinary annuity of coupons + single sum of face
value).
Lecture 5 — Valuation Concepts: Loans & Bonds
5.1 What is "Value"?
● Liquidation value — what could be realized if the firm's assets were sold off separately, outside the
operating business.
● Going-concern value — what the firm could be sold for as a continuing, operating business.
● Intrinsic value — the price a security "ought to have," based on all qualitative, quantitative and
perceptual factors that analysts build into valuation models. There is no single universal formula for it.

5.2 Book Value vs Market Value

Book Value of a Company = Total Assets − Total Liabilities
Book value is the value per the company's own accounts/financial statements — roughly what shareholders
would receive if all assets were sold and all liabilities paid off (per the books, not actual market prices).
Market Value (Market Capitalization) = Shares Outstanding × Current Market Price per Share
Market value reflects what the market is actually willing to pay today, driven by investor perception of future
prospects, supply and demand — and can differ substantially from book value.

5.3 Loans and Their Types

A loan is a sum borrowed from a bank/financial institution to manage planned or unplanned needs, with the
borrower agreeing to repay principal plus interest over an agreed period; the lender may require collateral.
(a) Secured vs Unsecured Loans
● Unsecured loan: no collateral required; lenders assess repayment capacity closely (e.g., credit cards,
education loans, personal loans).
● Secured loan: backed by collateral (property, stock, vehicle); usually larger amounts, lower interest
rates, stricter limits, longer terms (e.g., mortgage, auto loan, machinery-backed business loan).
(b) Open-End vs Closed-End Loans
● Open-end: borrower can draw, repay, and re-draw repeatedly up to a credit limit (e.g., credit cards, an
overdraft facility).
● Closed-end: a fixed amount borrowed once; must be fully repaid before borrowing again from scratch
(e.g., a car loan or student loan).
(c) Conventional Loans
A mortgage-type loan from a private, non-government lender (not insured by a government housing agency);
terms (eligibility, rate, tenure, down payment) vary by lender.

5.4 Amortization Schedule

A table showing, for each period, how a fixed instalment payment splits between interest and principal
repayment, until the loan balance reaches zero at maturity. This is simply an application of the present value of
an ordinary annuity formula, solved for R:
PV0 (loan amount) = R × PVIFA(i,n) ⟹ R = PV0 / PVIFA(i,n)
Example — Loan amortization
 Borrow $22,000 at 12% for 6 years, equal year-end payments: R = 22,000 / PVIFA(12%,6) = 22,000 / 4.111 ≈
$5,351 per year. Each year's payment is split: Interest portion = i × (opening balance); Principal portion =
payment − interest; the balance carries forward reduced by the principal portion, until it reaches $0 after
the final (6th) payment.
Example — Monthly instalment loan
$8,000 borrowed for 36 months at 1% per month: R = 8,000 / PVIFA(1%,36) = 8,000 / 30.108 = $265.71 per
month.

5.5 Bond Valuation — Building Blocks

Key terms
● Bond: a long-term debt instrument issued by a corporation or government.
● Maturity/Face/Par Value (MV): the amount repaid at maturity (commonly Rs 1,000 or $1,000).
● Coupon rate: the stated annual interest rate; Annual Coupon = Coupon rate × Par value.
● Discount rate (kd): the required rate of return, driven by the bond's risk (risk-free rate + risk premium).
Discounting is the process of finding the present value of a future payment or stream of payments — the higher
the risk of an investment's cash flows, the higher the discount rate applied to them.
(a) Perpetual Bond (never matures)
V = I / kd
(I = annual interest/coupon payment; this is treated like equity, e.g. Additional Tier-1 / perpetual TFCs issued by
banks for regulatory capital.)
Example — Perpetual bond
Face value $1,000, 8% annual coupon (I = $80), kd = 10%: V = 80/0.10 = $800.
(b) Coupon-Paying Bond with a Finite Life
V = I × PVIFA(kd, n) + MV × PVIF(kd, n)
(The value is the PV of the coupon annuity PLUS the PV of the lump-sum face value repaid at maturity.)
Example — Coupon bond
Face value $1,000, 8% annual coupon for 30 years, kd = 10%: V = 80×PVIFA(10%,30) + 1,000×PVIF(10%,30) =
80×9.427 + 1,000×0.057 = $754.16 + $57.00 = $811.16.
(c) Zero-Coupon Bond
Pays no periodic interest; sold at a deep discount to face value, with the investor's return coming entirely from
price appreciation to par at maturity (e.g., Pakistani T-Bills — buy at Rs 950, redeem at Rs 1,000).
V = MV × PVIF(kd, n)
Example — Zero-coupon bond
Face value $1,000, 30-year life, kd = 10%: V = 1,000 × PVIF(10%,30) = 1,000 × 0.057 = $57.00.
📌 Added for completeness (not explicit in the slides): Pakistan market examples given in the slides:
perpetual TFCs (Allied Bank, Bank Alfalah — Additional Tier-1 capital instruments); coupon bonds (OGDCL
TFCs, Pakistan Energy Sukuk, Pakistan Investment Bonds/PIBs); zero-coupon instruments (SBP Treasury
Bills).
🎯 Exam tip: Notice the pattern across all three bond types: they are all just applications of PV-of-single-sum and
PV-of-annuity from Lectures 3–4. If a bond has both a coupon AND a maturity value, you need BOTH formulas
added together.
Lecture 6 — Bond Valuation & Yield to Maturity (YTM)
6.1 Recap: Bond Terms
A bond is a Direct Claim Security — a legal contractual paper whose value is secured by real assets of the issuer.
It is issued by the Issuer/Borrower to the Bondholder/Lender/Investor in exchange for cash. Both individuals,
companies and governments can be issuers or holders.
● Maturity/Tenure — measured in years (6 months to 10+ years); at maturity the issuer redeems the
bond, returning principal + final coupon.
● Par/Face Value — the principal amount printed on the bond (e.g., Rs 1,000), returned at maturity.
Different from Market Value (price set by supply/demand) and Intrinsic/Fair Value (from the PV bond-
pricing formula).
● Coupon Interest Rate — % of par value paid as interest regardless of market-value changes. Coupon
Receipt = Coupon Rate × Par Value. Contrast with the market interest rate, which is macro-economic
and changes over time.
In Pakistan, bonds commonly take the form of Term Finance Certificates (TFCs), traded on the stock exchange,
with par value typically Rs 1,000. Government examples include Defense Saving Certificates, Treasury Bills (T-
Bills, short-term) and Federal Investment Bonds/PIBs (long-term).

6.2 Bond Ratings & Risk

Bonds are rated by credit rating agencies — internationally Moody's and S&P; in Pakistan, PACRA and VIS Credit
Rating Company. Rating scale (best to worst): AAA, AA, A, BBB, BB, B, CCC, CC, C, D — with "+" better and "−"
worse within a grade (so A+ > A > A−).
Bond risk increases with:
● Operating losses (check the cash flow statement & P&L)
● Excessive borrowing/debt (check the balance sheet)
● Large variability of income
● Small firm size
● Country and foreign-exchange-rate risk

6.3 Yield to Maturity (YTM)

YTM is the most common way to compare the overall rate of return across different bonds. It is the single
discount rate (kd) that, when used to discount all of a bond's remaining cash flows (coupons + final principal),
makes the present value equal to the bond's current market price.
P0 = I×PVIFA(kd,n) + MV×PVIF(kd,n) — solve for kd = YTM
Because kd appears inside the discount factors, YTM cannot be isolated algebraically — it is found by trial and
error (try a rate, see if PV matches the price; adjust and retry), then refined using linear interpolation between a
rate that gives too high a PV and one that gives too low a PV.
Interpolation formula
YTM = Lower rate + [ (PV at lower rate − Target Price) / (PV at lower rate − PV at higher rate) ] × (Higher
rate − Lower rate)
Example — YTM by trial & interpolation
Basket Wonders bond: 10% annual coupon, 15 years to maturity, current market price $1,250. Try 9%: PV =
100×8.061 + 1,000×0.275 = 806.10+275.00 = $1,081.10 (too low a rate → PV too high... actually shows price
too high vs market, meaning try higher discount rate) Try 7%: PV = 100×9.108 + 1,000×0.362 =
 910.80+362.00 = $1,272.80 Interpolating between 7% (PV=$1,273) and 9% (PV=$1,081) for a target of
$1,250: X = (23/192) × 0.02 = 0.0024 YTM = 0.07 + 0.0024 = 7.24%.
Example — Bond priced from a market-required return (reverse direction)
Gonzalez Electric: 10% coupon, $1,000 face value, 3 years to maturity, required return = 14%. Interest =
1,000 × 10% = $100/year. PV = 100×PVIF(14%,1) + 100×PVIF(14%,2) + 1,100×PVIF(14%,3) = 100×0.877 +
100×0.769 + 1,100×0.675 ≈ $87.70 + $76.90 + $742.50 = $907.10 → price Suresafe should realize on sale.
Why does a bond trade at a discount or premium?
● Market Price < Par Value → the bond sells at a DISCOUNT. Usually because market interest rates have
risen above the bond's fixed coupon rate, so investors demand a lower price to get an equivalent yield.
● Market Price > Par Value → the bond sells at a PREMIUM. Usually because market interest rates have
fallen below the bond's fixed coupon rate.
📌 Added for completeness (not explicit in the slides): This inverse bond price / interest rate relationship is
one of the most frequently tested concepts in Financial Management exams — make sure you can explain
WHY (fixed coupon vs moving market rate), not just state the rule.

6.4 General Steps to Calculate Any Yield/Rate of Return

● 1. Determine the expected cash flows of the instrument.
● 2. Replace the intrinsic value (V) in the valuation formula with the actual market price (P0).
● 3. Solve for the discount rate that equates the present value of those cash flows to the market price —
this rate IS the yield/YTM/expected return.
Lecture 7 — Stock (Equity) Valuation
7.1 What is a Stock?
Stocks are equity paper representing ownership — shareholders are part owners of the company. On the
balance sheet, share capital appears on the liabilities/equity side when issued by the company (a source of
financing); shares purchased BY the company (as an investment in another firm) would instead appear as an
asset (marketable securities).
Shares differ fundamentally from bonds: shares represent ownership, bonds represent debt. Par value is the
value at issuance; market value fluctuates with investors' perception of the company's future prospects and
supply/demand.

7.2 Why Raise Money Through Equity Rather Than Debt?

Equity financing gives flexibility — there is no obligation to make regular fixed payments. With debt/bonds, the
firm has promised a fixed interest (mark-up) payment; failing to pay on time makes the firm a defaulter, and
lenders can force asset sales to recover their money. With equity, dividends are paid only out of net income, at
the board's discretion — there is no fixed legal obligation to pay a dividend.
A shareholder's expected cash flows are: (1) dividends received, and (2) capital gains from eventually selling the
share.

7.3 Preferred Stock Valuation

Preferred stock promises a (usually) fixed dividend, but payment is technically at the board's discretion; it has
preference over common stock for both dividends and claims on assets. It combines features of equity
(ownership stake) and debt (fixed payment), which is why its valuation looks like a bond/perpetuity formula
rather than a common-stock formula.
V = DivP / kP
(This is exactly the perpetuity formula from Lecture 4 — a fixed payment forever.)
Example — Preferred stock valuation
8%, $100 par preferred stock; discount rate kP = 10%. DivP = 100 × 8% = $8.00 V = 8.00 / 0.10 = $80.
Yield on Preferred Stock
kP = DivP / P0
Example — Preferred stock yield
Annual dividend $10, current price $100: kP = 10/100 = 10%.

7.4 Common Stock Valuation — the Dividend Valuation Model

The basic model values a share as the present value of ALL future dividends the shareholder expects to receive:
V = Σ [ Divt / (1+ke)^t ] for t = 1 to ∞
ke = the equity investor's required rate of return.
Adjusted model (finite holding period + eventual resale)
V = Div1/(1+ke)^1 + Div2/(1+ke)^2 + ... + (Divn + Pricen)/(1+ke)^n
where Pricen is the expected sale price in year n, when the investor plans to sell.
Because forecasting every future dividend individually is impractical, three simplifying growth-pattern
assumptions are used:
(a) Constant (Gordon) Growth Model
Assumes dividends grow forever at a constant rate g:
V = D1 / (ke − g) where D1 = D0 (1 + g)
Example — Constant growth
Just-paid dividend D0 = $3.24, expected growth g = 8%, ke = 15%. D1 = 3.24 × 1.08 = $3.50 V = 3.50 / (0.15 −
0.08) = 3.50/0.07 = $50.
(b) Zero-Growth Model
Assumes dividends never grow (g = 0) — this reduces to a straight perpetuity:
V = D1 / ke
Example — Zero growth
D0 = $3.24, g = 0%, ke = 15%. D1 = 3.24. V = 3.24/0.15 = $21.60.
(c) Growth Phases (Multi-Stage) Model
📌 Added for completeness (not explicit in the slides): The slides list "Growth Phases" as one of the three
dividend-growth assumptions but do not work a numerical example. In practice: you value the high (or non-
constant) growth dividends individually year-by-year using PV of a single sum, then value all subsequent
dividends (once growth becomes constant) using the Constant Growth Model as of that later year, and
finally discount that lump-sum "terminal value" back to today. This is the standard two-stage / multi-stage
dividend discount model used in equity valuation.

7.5 Yield (Required Return) on Common Stock

Rearranging the constant growth model to solve for ke gives the two components of a shareholder's total
expected return: the dividend yield, plus the capital-gains yield (growth rate):
ke = (D1 / P0) + g
Example — Common stock required return
Expected dividend D1 = $3, current price P0 = $30, expected growth g = 5%. ke = (3/30) + 0.05 = 10% + 5% =
15%.
🎯 Exam tip: Any question giving you a stock's current price, expected next dividend, and growth rate is testing
the SAME formula rearranged — either solve for V (given ke) or solve for ke (given price). Recognize which
variable is missing.
Lecture 8 — Capital Budgeting Techniques
8.1 Overview
Capital budgeting is the process of evaluating and selecting long-term investment projects. Four main evaluation
techniques are used:
● Payback Period (PBP)
● Internal Rate of Return (IRR)
● Net Present Value (NPV)
● Profitability Index (PI)
A project is Independent if accepting/rejecting it has no bearing on whether other projects can also be accepted
(as opposed to Mutually Exclusive projects, where accepting one automatically rules out the others).
📌 Added for completeness (not explicit in the slides): "Mutually exclusive" vs "independent" projects, and
"capital rationing" (limited funds forcing a company to choose among positive-NPV projects) were listed in
the Lecture 8 outline but not elaborated numerically in the slides — the definitions above fill that gap, since
exam questions often ask you to distinguish these terms.

8.2 Running Example (used throughout this lecture)

Basket Wonders (BW) is evaluating an independent project: Initial outlay = $40,000. After-tax cash flows: Year 1
= $10,000; Year 2 = $12,000; Year 3 = $15,000; Year 4 = $10,000; Year 5 = $7,000.

8.3 Payback Period (PBP)

PBP = the length of time required for cumulative cash inflows to equal ("pay back") the initial cash outflow.
Shorter payback = more attractive.
PBP = a + (b − c) / d
where a = last full year BEFORE payback is reached, b = initial investment, c = cumulative cash inflow through
year a, d = cash inflow during the year payback is completed.
Example — Payback period
Cumulative inflows: Yr1=$10K, Yr2=$22K, Yr3=$37K, Yr4=$47K, Yr5=$54K. Initial outlay $40K falls between
year 3 ($37K cumulative) and year 4. PBP = 3 + (40−37)/10 = 3 + 0.3 = 3.3 years. If BW's maximum
acceptable payback is 3.5 years → ACCEPT (3.3 < 3.5).
Strengths & Weaknesses of PBP
Strengths Weaknesses
Easy to use and understand Ignores the time value of money
Useful measure of liquidity/risk Ignores cash flows occurring after the cutoff
Short-term flows easier to forecast than long- The cutoff period itself is subjective
term

8.4 Net Present Value (NPV)

NPV brings every future cash flow back to the present (at the firm's required rate/cost of capital) and nets out
the initial investment. It is generally regarded as the single most theoretically sound capital budgeting
technique.
NPV = −ICO + Σ [ CFt / (1+k)^t ] for t = 1 to n
Example — NPV of the BW project at k = 13%
NPV = 10,000(.885)+12,000(.783)+15,000(.693)+10,000(.613)+7,000(.543) − 40,000 =
8,850+9,396+10,395+6,130+3,801 − 40,000 = 38,572 − 40,000 = −$1,428. Decision: REJECT — negative NPV
means the project would destroy shareholder wealth.
Decision rule
● NPV > 0 → Accept (increases shareholder wealth)
● NPV < 0 → Reject (decreases shareholder wealth)
● NPV = 0 → Indifferent (project earns exactly the required return)
Strengths & Weaknesses of NPV
Strengths Weaknesses
Accounts for time value of money May ignore managerial/real options embedded
in a project
Considers ALL cash flows over the project's life Requires an accurate, sometimes subjective,
discount rate
Assumes reinvestment at the (realistic)
hurdle/required rate
Example — NPV of a simple 1-year investment
Invest Rs 100,000 in a savings certificate; after 1 year receive Rs 12,000 profit plus your Rs 100,000 principal
back; required return i = 10%. NPV = −100,000 + 12,000/1.10 + 100,000/1.10 = −100,000 + 10,909 + 90,909 =
+Rs 1,818 → Accept. (Note PV of total future inflows = NPV + Io = 1,818+100,000 = Rs 101,818.)

8.5 Internal Rate of Return (IRR)

IRR is the discount rate that makes the NPV of a project exactly zero — i.e., the rate at which the PV of future
cash inflows equals the initial outlay. Unlike NPV (where the discount rate is specified externally as the firm's
opportunity cost of capital), IRR is derived entirely from the project's own cash flow pattern — it is the project's
intrinsic/forecasted rate of return.
ICO = Σ [ CFt / (1+IRR)^t ] for t = 1 to n (solve for IRR)
Example — IRR by trial & interpolation (BW project)
Try 10%: PV of inflows = 9,090+9,912+11,265+6,830+4,347 = $41,444 (too high → discount rate too low) Try
15%: PV of inflows = 8,700+9,072+9,870+5,720+3,479 = $36,841 (too low → discount rate too high)
Interpolate: X = (1,444/4,603) × 0.05 = 0.0157 IRR = 0.10 + 0.0157 = 11.57%.
Decision rule
● IRR ≥ Hurdle rate (required return) → Accept
● IRR < Hurdle rate → Reject
In the BW example, hurdle rate = 13% > IRR (11.57%) → REJECT (consistent with the negative NPV found above
— NPV and IRR agree for a simple independent project).
Strengths & Weaknesses of IRR
Strengths Weaknesses
Accounts for time value of money Assumes cash flows are reinvested AT the IRR
itself (can be unrealistic for very high IRRs)
Considers all cash flows Can produce multiple IRRs when cash flow signs
change more than once
Less subjective than payback Can give misleading rankings vs NPV when
 comparing mutually exclusive projects of
different scale/timing

8.6 Profitability Index (PI)

PI is the ratio of the present value of future cash inflows to the initial cash outflow — useful for comparing
projects of different sizes.
Method 1: PI = [ Σ CFt/(1+k)^t ] / ICO
Method 2: PI = 1 + (NPV / ICO)
Example — PI of the BW project
PI = 38,572 / 40,000 = 0.9643 → REJECT, since PI < 1.00 (not profitable).
Decision rule
● PI ≥ 1.00 → Accept
● PI < 1.00 → Reject
Strengths & Weaknesses of PI
Strengths Weaknesses
Same theoretical soundness as NPV Same limitations as NPV (subjective discount
rate, forecasts)
Useful for comparing projects of different scale Gives only relative (not absolute) profitability
(capital rationing) — can conflict with NPV ranking for mutually
exclusive projects

8.7 Worked Practice Problems (Lecture 8b)

Example — Problem 1 — NPV & PI
Project cost $50,000; cash inflows $20,000, $15,000, $25,000, $10,000 over 4 years; discount rate 10%.
Total PV of inflows = $56,175 NPV = 56,175 − 50,000 = $6,175 → Accept (NPV positive) PI = 56,175/50,000 =
1.1235 → Accept (PI > 1.0)
Example — Problem 2 — Payback & NPV comparison of two machines
Machines A and B each cost $80,000; discount rate 10%. Payback: Machine A ≈ 2.6 years; Machine B ≈ 3.33
years → Machine A preferred (shorter payback). NPV: Machine A = $104,616 − 80,000 = $24,616; Machine B
= $103,784 − 80,000 = $23,784 → Machine A preferred (higher NPV). Both methods agree: choose Machine
A.
🎯 Exam tip: If NPV and IRR disagree when ranking two MUTUALLY EXCLUSIVE projects, NPV is the technique to
trust — it directly measures the added dollar value to shareholders, while IRR's reinvestment assumption can
distort rankings, especially with different project sizes or cash-flow timing.
Lecture 9 — Capital Structure & Cost of Capital (WACC)
9.1 What is Capital Structure?
Capital structure is the mix of a company's long-term debt, specific short-term debt, common equity and
preferred equity used to finance its operations and growth. Analyzing it assumes investment and asset-
management decisions are held constant, focusing purely on the debt-vs-equity financing choice.
Equivalently: capital structure = mix of owned capital (equity, reserves & surplus) and borrowed capital
(debentures, bank/FI loans). Because shareholder wealth maximization is the ultimate goal, firms aim for an
OPTIMAL capital structure — the mix that best balances shareholders' risk/return expectations against the firm's
capital needs. Capital structure planning is described as a highly psychological, complex and qualitative process.

9.2 Key Considerations in Planning Capital Structure (the "RCRCFC" factors)

● Return — ability to maximize EPS and market price per share.
● Cost — minimize WACC; debt is generally cheaper than equity because interest is tax-deductible (a "tax
shield"), while dividends are not.
● Risk — higher debt raises insolvency/bankruptcy risk (fixed interest obligations regardless of
profitability).
● Control — issuing new equity can dilute existing owners' control, so debt may be preferred to protect
management/ownership control.
● Flexibility — ability to alter the capital structure later without excessive cost or delay.
● Capacity — the firm's ability to generate enough profit/cash flow to service interest and principal
repayments.

9.3 Value of the Firm

Value of Firm = Earnings (EBIT) / WACC
Firm value is directly linked to shareholder wealth maximization: it rises when earnings rise, or when the cost of
capital (WACC) falls, or both. Capital structure itself cannot change a firm's total operating earnings (EBIT), but it
DOES affect how much of the residual earnings actually reach shareholders (because interest is a prior claim).

9.4 Capital Structure Theories

The Lecture 9 outline promises four theories — Net Income approach, Net Operating Income approach, the
Modigliani-Miller (MM) theorem, and the Traditional approach — but the uploaded slides move directly into
WACC mechanics without detailing these theories. A concise, standard summary of each (as typically required
for this topic) is given below.
📌 Added for completeness (not explicit in the slides): The four capital-structure theories below are added in
full, since the slide deck's outline lists them as "Coverage" but the corresponding content slides were not
included in the uploaded file.
(a) Net Income (NI) Approach
Assumes the cost of debt (kd) and cost of equity (ke) remain CONSTANT regardless of the debt-equity mix. Since
debt is cheaper than equity, increasing the proportion of debt continuously LOWERS the WACC and continuously
INCREASES firm value — implying an optimal structure of (theoretically) 100% debt. Criticized as unrealistic
because it ignores rising financial risk as leverage increases.
(b) Net Operating Income (NOI) Approach
The opposite extreme: assumes WACC is CONSTANT regardless of the debt-equity mix, because any benefit from
cheaper debt is exactly offset by a rise in ke (equity holders demand a higher return as financial risk/leverage
rises). Under this view, capital structure is IRRELEVANT to firm value — there is no optimal mix.
(c) Traditional Approach
A middle ground: WACC initially falls as debt is introduced (since debt is cheap and moderate leverage doesn't
yet worry equity holders much), reaches a MINIMUM at some optimal debt-equity mix, and then RISES again as
excessive debt increases financial risk enough that both kd and ke rise sharply. This implies there IS an optimal
capital structure, at the point where WACC is minimized (and firm value maximized).
(d) Modigliani-Miller (MM) Theorem
Modigliani & Miller's famous 1958 proposition, under restrictive assumptions (no taxes, no bankruptcy costs, no
transaction costs, perfect information):
● MM Proposition I (no taxes): Firm value is INDEPENDENT of capital structure — a firm cannot change its
total value simply by changing how it is financed (same conclusion as the NOI approach, but derived
from an arbitrage argument).
● MM Proposition II (no taxes): The cost of equity RISES linearly with the debt-to-equity ratio, exactly
offsetting the benefit of using more (cheaper) debt — so WACC stays constant.
● MM WITH corporate taxes: Because interest is tax-deductible, debt creates a valuable "interest tax
shield." Under this extension, firm value INCREASES with more debt (Value of Levered Firm = Value of
Unlevered Firm + PV of Tax Shield), theoretically favoring maximum debt — but in reality, this is
balanced against bankruptcy/financial-distress costs (the "trade-off theory"), which brings us back
toward an optimal, moderate level of debt similar to the Traditional approach.

9.5 Weighted Average Cost of Capital (WACC)

WACC is the average rate of return a firm must earn on its investments to satisfy ALL of its capital providers
(debt holders, preferred shareholders, and common shareholders) simultaneously. It is the discount rate
typically used for a project of average/typical firm risk in NPV and DCF valuation.
WACC = (E/V)×Re + (P/V)×Rp + (D/V)×Rd×(1 − Tc)
where E = market value of equity; D = market value of debt; P = market value of preferred stock; V = E+D+P =
total firm financing; Re, Rp, Rd = cost of equity, preferred stock, and debt respectively; Tc = corporate tax rate
(applied only to debt, since interest is tax-deductible while equity/preferred returns are not).
Generally, a LOWER WACC is preferred (indicates lower risk & cheaper financing). "Good" WACC benchmarks
vary by industry — utilities (stable cash flows, lower risk) tend to have lower WACC; technology/biotech firms
(volatile earnings, higher risk) tend to have higher WACC. WACC is also influenced by the economic environment
(interest rates), company-specific factors (leverage, earnings stability), and industry risk.
(a) Cost of Equity (Re / ke)
The hardest input to estimate, since it cannot be directly observed. Two standard approaches:
● Dividend Growth Model (Gordon Growth) approach:
Re = (D1 / P0) + g
● Security Market Line (SML / CAPM) approach:
Re = Rf + β × (Rm − Rf) [Market Risk Premium = Rm − Rf]
Example — Cost of equity — both approaches
 Alpha Air Freight: β=1.2, market risk premium=8%, risk-free rate=6%, last dividend=$2 (growing at 8%
forever), current price=$30. SML: Re = 6% + 1.2×8% = 15.6% Dividend Growth: D1 = 2×1.08 = $2.16; Re =
(2.16/30) + 0.08 = 7.2%+8% = 15.2% (Slides average the two estimates ≈ 15.4% as the final estimate — a
reasonable cross-check when the two methods diverge slightly.)
(b) Cost of Debt (Rd / kd)
The interest rate the firm must pay on NEW borrowing. If the firm has bonds already trading, its YTM (from
Lecture 6) IS the market-required cost of debt. Because interest is tax-deductible, the AFTER-TAX cost of debt
used in WACC is:
After-tax Rd = Rd × (1 − Tc)

(c) Cost of Preferred Stock (Rp)

Preferred stock pays a fixed dividend forever, making it a perpetuity — so its cost is simply:
Rp = DivP / P0
Example — Cost of preferred stock
Alabama Power preferred: pays $1.30/share, trades at $21.05 → Rp = 1.30/21.05 = 6.18%. (A second issue
paying $1.46, priced at $24.35 → Rp = 1.46/24.35 = 6.00%. Either or an average could be used depending on
which issue is representative.)

9.6 The Capital Structure Weights

● E (equity) = number of shares outstanding × current share price
● D (debt) = market price of a single bond × number of bonds outstanding (for long-term debt)
● P (preferred) = number of preferred shares × current preferred share price
● V = D + E + P = total market value of financing
Always use MARKET values (not book values) for these weights — market value reflects what it would actually
cost to replace that financing today.
Example — Full WACC calculation — Titan Mining Corporation
8 million common shares @ $32 (β=1.15); 0.5 million preferred shares @ $67 (annual dividend $6); 100,000
bonds, 9% semiannual coupon, par $1,000, 15 years to maturity, selling at 91% of par. Market risk
premium=10%; risk-free rate=5%; tax rate=35%. Step 1 — Market values & weights: MVD =
100,000×$1,000×0.91 = $91M MVE = 8M×$32 = $256M MVP = 500,000×$67 = $33.5M V = 91+256+33.5 =
$380.5M D/V=0.2392, E/V=0.6728, P/V=0.0880 Step 2 — Cost of each component: Re (SML) = 5% +
1.15×10% = 16.50% Bond priced at 91% of par ($910), 4.5% semiannual coupon ($45), 30 semiannual
periods → solving gives a semiannual rate R=5.092%, so YTM = 10.18% (annualized) Rd (after-tax) =
(1−0.35)×10.18% = 6.6191% Rp = $6/$67 = 8.96% Step 3 — WACC: WACC = 0.1650×0.6728 + 0.0896×0.0880
+ 0.06619×0.2392 ≈ 13.47%. This 13.47% is the discount rate Titan Mining should use for a new project of
AVERAGE firm risk.
🎯 Exam tip: WACC questions are almost always multi-step: (1) find market values & weights, (2) find each
component cost (often needing a mini CAPM, dividend-growth, or YTM calculation buried inside), (3) plug into
the WACC formula. Work through each cost of capital separately before combining them — don't try to do it in
one line.
Lecture 10 — Financial Planning & Financial Ratio Analysis
10.1 Budgetary Control
Budgetary control means relating the responsibilities of executives to the requirements of a policy, through
continuous comparison of actual results against budgeted results (to sustain or improve performance). Steps
involved:
● Prepare detailed budgets for all segments, sections, departments and divisions.
● Communicate the approved budget and related responsibilities to all departments.
● Develop an internal MIS (Management Information System) to generate periodic actual-vs-budget
variance reports.
● Require concerned officials to explain the causes of variances.
● Use those explanations to drive better decisions or corrective action.

10.2 Financial Analysis & Financial Statements

Financial analysis assesses a firm's past, present, and (by extension) likely future financial condition, to identify
its financial strengths and weaknesses. The primary tools are the financial statements and financial ratios
(compared against the firm's own history, its industry, and its sector).
The Four Core Financial Statements
● Balance Sheet — the firm's financial position (assets, liabilities, equity) at one specific point in time.
● Income Statement — summarizes revenues and expenses over an accounting period, ending in net
profit/loss.
● Statement of Cash Flows — shows actual cash generated/used during the period (which can differ
substantially from accounting profit), split into Operating, Investing, and Financing activities.
● Statement of Retained Earnings — reports how much of cumulative earnings has been kept in the
business (to fund growth) versus paid out as dividends; retained earnings is a claim against assets, not a
pile of cash itself.

10.3 Objectives and Users of Ratio Analysis

● Standardize financial information for comparison across time/firms
● Evaluate current operations and study operating efficiency
● Compare performance against the firm's own past, and against other firms/industry standards
● Study the risk of operations
Key users: Managers (analyze, control and improve operations), Credit analysts (assess ability to repay debts),
Stock/equity analysts (assess efficiency, risk and growth potential).

10.4 Limitations of Ratio Analysis

● A firm's exact industry category can be hard to pin down, especially for diversified/conglomerate firms.
● Published industry averages are only guidelines, not hard targets — merely being "average" isn't
necessarily good; industry LEADERS' ratios may be more meaningful benchmarks.
● Accounting practices differ across firms (e.g., inventory valuation method, depreciation method),
distorting comparisons.
● Inflation can distort balance sheet figures over time.
● Seasonality affects ratios (e.g., inventory levels) — using monthly averages can help.
 ● "Window dressing" — firms can manage the timing/presentation of transactions to make period-end
statements look better than the underlying reality.
● It's often hard to say whether a specific ratio value is inherently "good" or "bad" (e.g., a very high
current ratio could mean strong liquidity OR too much idle, non-earning cash).
● Different ratios can send conflicting signals about the same firm — analysts must weigh the overall/net
picture, not a single ratio in isolation.

10.5 Category 1 — Liquidity Ratios (Short-Term Solvency)

Liquidity means how quickly assets can be converted to cash to meet short-term obligations. These ratios show
whether a firm CAN meet its current liabilities — but not how efficiently it manages its cash resources.
(a) Current Ratio
Current Ratio = Current Assets / Current Liabilities
Ideal/rule-of-thumb level ≈ 1.5:1 to 2:1 (context varies by industry). A very high ratio may mean too much capital
is tied up unproductively (e.g., excess inventory); a ratio below 1 suggests a real risk of being unable to pay
short-term obligations as they fall due.
Example — Current ratio
Current assets Rs 5,00,000; current liabilities Rs 2,00,000. Current Ratio = 500,000/200,000 = 2.5:1.
(b) Quick / Acid-Test Ratio
Quick Ratio = (Current Assets − Inventory) / Current Liabilities
Ideal level ≈ 1:1. Excludes inventory (the least liquid current asset, and hardest to value quickly), giving a stricter
test of whether truly liquid assets can cover current liabilities. A ratio of 3:1 is very healthy; a ratio of 0.5:1
means liabilities are twice the readily-available liquid assets — a warning sign, though not automatically fatal.
📌 Added for completeness (not explicit in the slides): The slides also mention an "Absolute Liquid Ratio" (or
Cash Position Ratio) as a third liquidity measure, without giving its formula. Standard definition, added here:
Absolute Liquid Ratio = (Cash + Marketable Securities) / Current Liabilities
This is the strictest liquidity test — it excludes even receivables, looking only at cash and near-cash items relative
to current liabilities. An ideal norm is often cited as around 0.5:1.

10.6 Category 2 — Profitability Ratios

Profitability measures how much profit a firm generates relative to sales or the capital invested. Gross profit =
revenue − variable/cost of sales; Net profit = revenue − all costs (variable + fixed/overheads).
(a) Gross Profit Ratio
Gross Profit Ratio = (Gross Profit / Net Sales) × 100
A higher ratio indicates stronger core profitability and effective cost/pricing management on the product itself.
(b) Operating Ratio
Operating Ratio = (Total Operating Expenses / Net Sales) × 100
(Total operating expenses = cost of goods sold + administrative expenses + selling & distribution expenses.) This
shows how much of every sales rupee is consumed by running the business — a LOWER operating ratio is
generally better.
(c) Operating Profit Ratio
Operating Profit Ratio = (Operating Profit / Net Sales) × 100 [equivalently, ≈ 100% − Operating Ratio]
Indicates the firm's core operational efficiency, independent of financing (interest) and tax effects.
📌 Added for completeness (not explicit in the slides): The uploaded Lecture 10 file is explicitly titled "Part-
1," and stops after covering only two ratio categories (Liquidity and part of Profitability) in detail — the
outline on slide 18 promises several more profitability ratios (Net Profit Ratio, ROI, ROCE, EPS, Dividend
Payout Ratio, Dividend Yield Ratio, P/E Ratio, Net Profit to Net Worth Ratio) plus, in a standard FM syllabus,
Leverage/Solvency Ratios and Activity/Turnover Ratios, none of which appear in the file. Since a complete
ratio-analysis exam guide needs them, they are added below with standard formulas.
(d) Remaining Profitability Ratios (added)
Net Profit Ratio = (Net Profit after Tax / Net Sales) × 100
Return on Investment (ROI) / Return on Assets = (Net Profit / Total Assets) × 100
Return on Capital Employed (ROCE) = (EBIT / Capital Employed) × 100 [Capital Employed = Total Assets
− Current Liabilities]
Earnings Per Share (EPS) = (Net Profit available to Common Shareholders) / (Number of Common Shares
Outstanding)
Dividend Payout Ratio = (Dividend per Share / EPS) × 100 = (Total Dividends / Net Profit) × 100
Dividend Yield Ratio = (Dividend per Share / Market Price per Share) × 100
Price-Earnings (P/E) Ratio = Market Price per Share / EPS
Net Profit to Net Worth Ratio = (Net Profit / Shareholders' Equity) × 100 [this is Return on Equity, ROE]

10.7 Category 3 — Leverage / Solvency Ratios (added)

These measure the extent to which a firm uses debt financing, and its ability to meet long-term (not just short-
term) obligations — a natural bridge back to the Capital Structure topic in Lecture 9.
Debt-to-Equity Ratio = Total Debt / Shareholders' Equity
Debt Ratio = Total Debt / Total Assets
Interest Coverage (Times Interest Earned) Ratio = EBIT / Interest Expense
A higher interest coverage ratio means the firm can more comfortably meet its interest obligations from
operating earnings — a key input into the bond-rating and "political/financial risk" discussions from earlier
lectures.

10.8 Category 4 — Activity / Turnover (Efficiency) Ratios (added)

These show how efficiently a firm uses its assets to generate sales.
Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory
Receivables (Debtors) Turnover Ratio = Net Credit Sales / Average Accounts Receivable
Average Collection Period = 365 / Receivables Turnover Ratio
Total Asset Turnover Ratio = Net Sales / Total Assets
Higher turnover ratios generally indicate more efficient use of assets/inventory/credit to generate sales, though
extremely high turnover can also signal too little safety stock or overly aggressive collections.
🎯 Exam tip: A classic Financial Statement Analysis exam question gives you a mini balance sheet + income
statement and asks you to compute 5–8 ratios across categories, then comment on the firm's liquidity,
profitability, leverage and efficiency together. Practice moving fluently between all FOUR ratio categories, not
just the two the slides finished covering.
Exam Guide — Master Formula Sheet
A single-page-style reference of every formula used across the ten lectures, grouped by topic, for quick revision
before the exam.

A. Time Value of Money

Simple Interest: SI = P0 × i × n
FV (simple): FVn = P0[1+(i×n)]
FV (compound), single sum: FVn = P0(1+i)^n
PV, single sum: PV0 = FVn / (1+i)^n
Effective Annual Rate: EAR = (1 + i/m)^m − 1
FV of Ordinary Annuity: FVAn = R × [((1+i)^n−1)/i]
PV of Ordinary Annuity: PVAn = R × [(1−(1+i)^−n)/i]
Annuity Due: FVADn / PVADn = (Ordinary Annuity Value) × (1+i)
Perpetuity: PV = R / i
General compounding: FVn = PV0(1+i/m)^(mn); continuous: FVn=PV0×e^(in)

B. Bond Valuation
Perpetual bond: V = I / kd
Coupon bond (finite life): V = I×PVIFA(kd,n) + MV×PVIF(kd,n)
Zero-coupon bond: V = MV × PVIF(kd,n)
YTM: solve kd in P0 = I×PVIFA(kd,n) + MV×PVIF(kd,n), via trial & interpolation
Interpolation: rate = LowerRate + [(PV@Lower − Target)/(PV@Lower − PV@Higher)] × (Higher−Lower)

C. Stock Valuation
Preferred stock: V = DivP / kP ; Yield: kP = DivP/P0
Common stock, general: V = Σ Divt/(1+ke)^t
Constant growth (Gordon): V = D1/(ke−g), D1=D0(1+g)
Zero growth: V = D1/ke
Required return on common stock: ke = (D1/P0) + g

D. Loans
Instalment (amortization): PV0 = R × PVIFA(i,n) ⟹ R = PV0/PVIFA(i,n)

E. Capital Budgeting
Payback Period: PBP = a + (b−c)/d
NPV = −ICO + Σ CFt/(1+k)^t
IRR: solve rate where ICO = Σ CFt/(1+IRR)^t
PI = [Σ CFt/(1+k)^t] / ICO = 1 + (NPV/ICO)

F. Cost of Capital / WACC

WACC = (E/V)Re + (P/V)Rp + (D/V)Rd(1−Tc)
 Cost of equity (SML/CAPM): Re = Rf + β(Rm−Rf)
Cost of equity (Dividend Growth): Re = (D1/P0)+g
Cost of preferred: Rp = DivP/P0
After-tax cost of debt: Rd(1−Tc)
Value of Firm = EBIT / WACC

G. Ratio Analysis
Current Ratio = Current Assets / Current Liabilities
Quick Ratio = (Current Assets − Inventory)/Current Liabilities
Absolute Liquid Ratio = (Cash+Marketable Securities)/Current Liabilities
Gross Profit Ratio = Gross Profit/Net Sales × 100
Operating Ratio = Total Operating Expenses/Net Sales × 100
Net Profit Ratio = Net Profit/Net Sales × 100
ROI = Net Profit/Total Assets × 100 ; ROCE = EBIT/Capital Employed × 100
EPS = Net Profit to Common Shareholders / No. of Common Shares
Dividend Payout = DPS/EPS × 100 ; Dividend Yield = DPS/Market Price × 100
P/E Ratio = Market Price/EPS ; ROE (Net Profit to Net Worth) = Net Profit/Equity × 100
Debt-Equity Ratio = Total Debt/Equity ; Interest Coverage = EBIT/Interest
Inventory Turnover = COGS/Avg Inventory ; Asset Turnover = Sales/Total Assets
Exam Guide — Likely Question Bank & Model Answers
Below are the kinds of questions this material typically produces, organized by lecture, with short model
answers or the approach to use. Numerical questions echo the worked examples above — practice
reconstructing them without looking.

Conceptual / Theory Questions

● Q: Why is Shareholder Wealth Maximization preferred over Profit Maximization or EPS Maximization as
the goal of the firm? A: It accounts for timing, duration and risk of returns, and for dividend policy —
none of which the alternatives capture; share price becomes a real-time performance barometer.
● Q: Explain Agency Theory and how firms address the agency problem. A: Managers (agents) may not
always act in shareholders' (principals') interest; firms mitigate this with incentives (stock options,
bonuses, perquisites) and monitoring (boards, audits).
● Q: Distinguish Money Market from Capital Market. A: Maturity (≤1 year vs >1 year), instruments traded
(T-bills/CP/CDs vs stocks/bonds), and purpose (short-term liquidity vs long-term capital formation).
● Q: Distinguish Primary Market from Secondary Market. A: Primary = new issues, funds go to the issuing
company, no fixed location; Secondary = trading of existing securities via an exchange, creates liquidity,
comes after the primary market.
● Q: Why does a bond's market price fall when market interest rates rise? A: The bond's coupon is fixed at
issuance; when new bonds offer higher coupons, an existing lower-coupon bond must sell at a discount
so its effective yield (YTM) matches the new market rate.
● Q: Compare NPV, IRR and Payback Period as capital budgeting techniques. A: Payback ignores TVM and
cash flows after cutoff; IRR and NPV both account for TVM and all cash flows, but IRR assumes
reinvestment at the IRR itself (can be unrealistic) and can conflict with NPV ranking for mutually
exclusive projects — NPV is the theoretically preferred criterion.
● Q: Explain the Modigliani-Miller (MM) theory of capital structure (with and without taxes). A: Without
taxes, MM shows firm value is independent of capital structure (Proposition I) because any advantage
from cheaper debt is offset by a rising cost of equity (Proposition II). With corporate taxes, interest tax-
deductibility creates a tax shield, so more debt raises firm value — up to the point where
bankruptcy/financial-distress costs start to dominate (trade-off theory).
● Q: What are the limitations of ratio analysis? A: Industry classification difficulties, industry averages as
only guidelines, differing accounting practices, inflation distortion, seasonality, window dressing, and
difficulty judging whether a ratio is inherently "good" or "bad."

Typical Numerical Question Patterns

● Given wage rate/interest rate scenarios: compute simple or compound interest, FV or PV of a single
sum.
● Given equal periodic deposits/receipts: compute FV or PV of an ordinary annuity or annuity due;
sometimes reversed to solve for the required periodic payment (e.g., loan instalment, required savings).
● Given a bond's coupon, face value, maturity and required return: compute its intrinsic value (perpetual /
coupon / zero-coupon cases).
● Given a bond's market price, coupon and maturity: estimate YTM by trial and interpolation.
● Given a preferred or common stock's dividend, growth rate and required return: compute its value, OR
given its price, compute the required return.
● Given a project's initial outlay and multi-year cash flows: compute Payback, NPV, IRR and PI, then state
Accept/Reject for each and compare conclusions.
● Given a firm's capital structure (shares, bonds, preferred stock, prices, betas, tax rate): compute market-
value weights and WACC.
● Given a simplified balance sheet/income statement: compute and interpret a set of liquidity,
profitability, leverage and turnover ratios.
Exam Guide — Common Mistakes & Final Tips
Common Mistakes to Avoid
● Mixing nominal (stated) and periodic interest rates — always convert to a periodic rate matching the
compounding frequency before using it in a TVM formula.
● Using an ordinary annuity formula for an annuity due (or vice-versa) — remember the annuity due value
is always (1+i) times the ordinary annuity value.
● Forgetting to add the maturity/face value's present value on top of the coupon annuity when valuing a
coupon-paying bond.
● Confusing coupon rate (fixed, stated on the bond) with YTM/market required return (changes with
market conditions) — a bond trades at a discount or premium precisely because these two differ.
● In NPV/IRR/PI problems, forgetting to subtract the initial cash outlay, or discounting it when it's already
at time 0 (it shouldn't be discounted).
● Using BOOK values instead of MARKET values when computing capital-structure weights for WACC.
● Applying the tax shield adjustment (1−Tc) to the cost of equity or preferred stock by mistake — it applies
ONLY to the cost of debt.
● Treating IRR as always agreeing with NPV — for mutually exclusive projects of different scale or timing,
the two can rank projects differently; NPV is the safer criterion when they conflict.
● Not showing intermediate/interpolation steps in YTM or IRR problems — examiners typically award
partial credit for correctly setting up the trial-and-error/interpolation method even if the final rounding
is slightly off.

Final Revision Strategy

● Master the 4 TVM "building blocks" first (single sum FV/PV, ordinary annuity FV/PV, annuity due,
perpetuity) — nearly every other formula in the course (bonds, stocks, loans, capital budgeting) is a
direct application or combination of these.
● For every valuation formula, be able to say in one sentence WHAT cash flow stream is being discounted
and WHY (e.g., "a coupon bond = an annuity of coupons + a single lump sum of face value").
● Practice at least one full worked problem in each of: TVM, bond valuation & YTM, stock valuation,
NPV/IRR/PI, and WACC — these are the five numerical pillars most exams draw from.
● For ratio analysis, be ready to compute across all four categories (liquidity, profitability, leverage,
activity) from one financial statement, and to comment on what the ratios mean together, not just
calculate them.
● Revisit the qualitative sections too (Lecture 1's goal of the firm and agency theory; Lecture 2's market
structure; Lecture 9's capital structure theories) — these are common short-answer/theory questions
worth guaranteed marks if well understood.

Good luck with your exam preparation!