BEC Ch 51- Financials/Stocks

BONDS
Zero Coupon- Must still recognize interest income/expense thru bond’s life
• No annual cash outflows

Serial Bonds- Maturities are staggered over number of years

• Purchases can select maturity that best matches their financial goals
• Used when financing is needed at regular intervals

Convertible Bonds- Purchaser has option to convert to stock @ specified price

• Investors accecpt less restrictive covenants than regular bonds
• Convertibles have lower interest rates than non convertibles
• Risk: Stock price too low-> won’t convert-> regular interest payments

Debentures – Secured only by issuer’s “full faith and credit” (NO COLLATERAL)
Junk Bonds – Rated less than investment grade

Income Bonds – Require interest payments only when earnings are sufficient

Bond Indentures – Set of covenants that typically restrict the amount of debt a bond issuer may carry
and the dividends that it can pay

Discounted Note Example:

• Borrow $ with stated 6% rate and face amt of $400K, whats the effective rate?
• Interest = 6% * 400K = 24K
• Cash rec = 400K – 24K = 376K
• EFF Rate = 24K/376K = 6.38%
Price = PV PMTS + PV of face value
• r = market rate which investors would pay for similar bond
• If Price > Face, Coupon Rate is > discount rate
• Premium

YTM = rate which causes price of the bond to equal PV of cash flows
• Always expressed in annualized terms
• Equal to 2x semi-annual yield
• = to ‘r’ in equations
• If PV, FV, pmts, nperiods is known: Solve for ‘r’

If Price < Face (discount)

• Coupon Rate < YTM

Zero-Coupon Bonds
• Price = FV / (1 + r)t

• r = # semi-annual periods
• t = # semi-annual periods
• Duration = Time to maturity
Business Risk = Riskiness of entity’s operations w/o debt (i.e. inherent in operations)
Financing Risk = Additional risk owners bear due to an entity’s carrying of debt

Interest Rate Risk

• If IR increase, bond prices decrease
• If IR decrease, bond prices increase
• Factors determining sensitivity to IR changes (Duration)
• 1) Maturity (longer time is more sensitive)**most important**
• 2) Coupon Rates (lower coupon rates is more sensitive)
• 3) YTM (lower YTM are more sensitive)

Callable Bond -> issuer may repurchase from owner of bond @ will
Call Price = Par + call premium
• Must offer higher yield than on non-callable bond to compensate purchaser for risk
• Call when…..
• Int rates decrease
• Issuer’s bond rating increases
• Issuer wants to remove covenants

Yield to Call -> More important than YTM if call is likely

Convertible Bond -> Conversion to predetermined # shares @ bondholder’s option

• Worth converting bond if stock price increases
• Yield < non-convertible bond
• Price > non-convertible bond

Yield Curve (graph of term structure of interest rates)

• X axis -> Time till maturity
• Y axis -> YTM
• Upward Sloping if LT int rates > ST int rates **Most common**
• Downward Sloping if ST int rates > LT int rates **Recession**
• Flat if IR’s are expected to remain the same
PV of Annuity = (Cash PMT ) * (Annuity Factor “PVIFA”)

PV of Annuity Due = PV of ordinary annuity * (1 + r)

PV of ordinary annuity for (t -1) periods + C(initial cash PMT)

FV of Annuity = PMT * FVIFA

Growing Annuity
• Cash flows increase at a constant rate for finite number of periods

Growing Perpetuity
• Increases at same rate forever
• PV = C / (r – g) = [C * (1 + g)] / (r – g)
o 1 0
Mortgage Calculations
• If monthly PMTS -> Divide APR by 12 to get monthly rate
• N for 30 year mortgage = 360 months
periods

• Assume 7.5% APR, $200,000 mortgage

• PVIFA (360, 0.625%) = 143.018
• PV = PMT * PVIFA
• $200,000 = PMT * 143.018
• PMT = $1,393

PVIF = (1 / FVIF)
• Reciprocal relationship!!!

PVA (t, x%) – PVA (t-1, x%) = PV (t, x%)

PVA (t, x%) – PVA (t-1, x%) = PV (t-1, x%)
due due

Example
PVA (10 yr, 5%) – PVA (9 yr, 5%) = PV (10 yr, 5%)
PVA (10 yr, 5%) – PVA (9 yr, 5%) = PV (9, 5%)
due due

Economic Rate of Return = “total return” = (Divs + change in stock price) / Price paid by investor
Bonds
Premium: Coupon rate is > than market rate
Discount: Market rate is > coupon rate

P/E Ratio (multiple)

• (Price per share) / (EPS)

TIE Ratio = (EBIT / interest pmts)

Fixed Charge Coverage Ratio = [(EBIT + lease payments) / {interest payments + lease payments +
(sinking fund payment / (1 – tax rate))}]

EPS = (Earnings available to common S/H’s) / # shares outstanding

• Subtract P/S divs to arrive at earnings

Short Sale
• Must pay divs to person you borrowed the stock from if holding open position

Stock Price
• Return = r = (Div + P – P0) / P0
1 1

• Div + capital gain

• Div1 & P1 are expected values at T 0

• Equals required rate of return

• Expected dividend yield = (D / P ) 1 0

• Capital gains yield = (P – P ) / P 1 0 0

• P = (D + P ) / (1 + r)
0 1 1

• What does the price need to be in order to achieve the required rate of return?
• P = (D + P ) / (1 + r)
1 2 2
 • Etc……
• To solve for P using “Dividend Discount Model”
0

• Equal to present value of future cash flows (dividends)

• No future stock prices in model
• Terminal Stock Price Assumption options
• 1) Divs will cease at some point
• 2) Divs continue at perpetuity
• P=D /r
t t+1

• 3) Divs continue as growing perpetuity

• P = D / (r – g)
t t+1

• Assuming constant growth from Day one -> “Gordon Growth Model”
• PV = D / (r – g)
0 1

• r = D / (P + g)
1 0

• Assumes constant growth forever

Free Cash Flow

• = Earnings before interest but after taxes
• Cash available to stockholders and creditors
Discounting FCF
• Use WACC to discount
• Subtract total market value of debt
• Divide by # shares outstanding
• Result = Equity price per share

Comparables
• Uses market/accounting ratio
• P/E ratio
• M/B (Market to Book ratio) -> really Price/Book
• Find “appropriate” ratio by observing comparable firms
• Multiply this ratio to P/E ratio or M/B ratio to get price

Preferred Stock
• Works like perpetuity, pays same dividend every period
• Usually non-voting
• Dividend is not guaranteed (usually cumulative)
• Risk hierarchy: Debt > P/S > C/S
• Convertible P/S -> holder of the P/S can convert to C/S at will
• Has preferential tax treatment if owned by a corporation
• Thus, more likely to be owned by corporations

Net Working Capital = CA – CL

NWC policies:
• Most conservative: finance all current assets(permanent & fluctuating) w/ LT debt
 • Risky: finance all current assets w/ ST debt

Quick Ratio (acid test) = (Cash + Marketable securities + A/R) / CL

Cash Flow Cycle

• Measures length of time entity pays for INV to the time it receives cash from INV sales
• = Avg days in A/R (+) Avg days in INV (-) Avg days in A/P

Economic Order Quantity (EOQ) – AKA “Economic Lot Size”

• Minimizes total of INV order costs and INV carrying costs
• EOQ = sqrt[(2* order cost * annual demand) / (INV carrying cost per unit)]
• Safety stock -> NO EFFECT on EOQ
• Also known as ‘optimal production run’
• Annual demand / EOQ = # of production runs per year

Agency Securities = ST securities issued by fed’l govt agencies or corporations (Fannie Mae)

Bank Lockbox Gain = (rate * daily receipts * total days saved) – (yearly cost of lockbox)
Zero-Balance Account -> subsidiary account that is maintained at a specified balance (usually zero)
and is linked electronically to a master account; when funds are needed to pay checks drawn on the
zero-balance account, they are transferred from the master account (control over disbursements)

A/R Turnover = (net sales) / (avg. A/R)

Factoring Receivables = using A/R as collateral

Est daily credit sales = yearly credit sales / 360

Avg A/R balance = (est daily credit sales) * (Avg collection period)

INVENTORY
Reorder Point = (Avg daily usage) * (Lead time in days)
Carrying Costs -> handling, insurance, interest on invested capital, storage, spoilage, obsolescence
Ordering Costs -> quantity discounts lost, shipping costs, purchasing costs, and, in a manufacturing
facility, set-up costs for production runs.

INV Turnover = COGS / Avg INV

Avg INV = COGS / INV Turnover

Stock Out Costs:

• (# units * Stock out cost per unit) * expected stock outs per year
• Expected Stock outs per year = (annual orders * stock out % probability)

Trade Credit = Accounts Payable = most common source of financing for small biz

Derivatives -> Divides financial risk into elements that can be exchanged between entities
• Clearinghouse “marks-to-market” and standardizes contracts to reduce counterparty risk
CAPITAL BUDGETING METHODS
Accounting rate of return = (Avg annual increase in NI / Avg investment in the project)
= (avg annual oper expense savings – depreciation) / (total project cost / # of project yrs)
• **Subtract depreciation & incremental income taxes to arrive at NI
• ***Also adjust denominator to take depreciation into account

Payback Period
Payback period = (initial investment / after-tax yearly cash flow)

Profitability Index = PV / Initial Investment

cf

Cost of Capital Summary…………down

**For Debt interest exp -> Use effective rate, not stated rate

ROI = (NI / sales) * (Sales / Capital Investment)

ROA = (net profit margin) * (asset turnover)

ROA = NI / (avg assets for the period)

Interest Rates
• Short term generally LOWER than long term rates
• Exception: ST rates HIGHER if future interest rates are expected to decrease
• i.e. inflationary periods

Underwriting Spread = Difference between the price that an investment banker pays for a security
and the price that a subsequent investor pays for the security

Imputed Interest -> Not recognized by GAAP, but required to make decisions
• Ex: Interest on internally generated cash used to purchase fixed assets

Common Stock
Book Value = (Par + APIC + R/E) / # outstanding shares
Par Value = Liability ceiling for shareholders

Preferred Stock
Cost of Capital = (Annual Cost) / (Funds received)
• Ex: MKT value = $107, Face = $100, Underwriting costs = $5, Annual Divs = $10
• Solution: Cost of Capital = $10 / ($107 - $5) = 9.8%

Degree of Operating Leverage = (Contribution Margin / EBIT)

• Small change in sales resulting in large change in EBIT -> HIGH leverage
• High leverage = high fixed costs, low variable costs

Degree of Financial Leverage (DFL) = EBIT / (EBIT – interest)

• Small change in EBIT results in large change to C/S return -> HIGH DFL
• Greater leverage -> greater business risk

Cost of Debt = (Annual coupon pmt) / (Bond Proceeds, net of float costs)
Business Risk = Riskiness of operations without any debt

CAPM Model
Dividend Policy
Residual Theory – Corporations should…
1. Determine optimal cash budget
2. Calculate equity needed to finance budget
3. Supply that from R/E as far as possible
4. Pay divs with residual R/E

Assumptions
1. Corp can reinvest earnings at higher rate of return than investors @ comparable risk
2. Investors prefer to have corp reinvest earnings
3. Rate of return investors require is not affected by dividend policy

Active Dividend Policy -> Assumes dividends are relevant to investor decisions, hence divs are not set
mechanically.
• Dividends are relevant to investor decisions (i.e. the amount of divs is relevant)

Warrants -> Rights to purchase common stock at specified price (i.e. options)
• Typically attached to LT debt or P/S to make securities more attractive to wider range of
investors, increasing supply and ultimately decreasing the cost of capital
• Warrants decrease EPS if exercised
• Do not provide cash inflows until exercised