Financial Management

(Formulas from chapter 1—22)

1. Fundamental Accounting Equation and
Double Entry Principle.
• Assets +Expense = Liabilities + Shareholders’
Equity + Revenue

Liabilities = Equity = Net Worth

Revenue – Expense = Income

1. Statement of Retained Earnings or

Shareholders’ Equity Statement
Total Equity = Common Par Stock Issued + Paid In
Capital + Retained Earnings

2. Current Ratio:
= Current Assets / Current Liabilities

3. Quick/Acid Test ratio:

= (Current Assets – Inventory) / Current Liabilities

4. Average Collection Period:

= Average Accounts Receivable /(Annual Sales/360)

5. PROFITABILITY RATIOS:
Profit Margin (on sales):
= [Net Income / Sales] X 100
Return on Assets:
= [Net Income / Total Assets] X 100
Return on equity:
= [Net Income/Common Equity]

6. ASSET MANAGEMENT RATIOS

Inventory Turnover:
= Sales / inventories
Total Assets Turnover:
= Sales / Total Assets

7. DEBT (OR CAPITAL STRUCTURE) RATIOS:

Debt-Assets:
= Total Debt / Total Assets
Debt-Equity:

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 Financial Management
(Formulas from chapter 1—22)
= Total Debt / Total Equity
Times-Interest-Earned:
= EBIT / Interest Charges
8. Market Value Ratios:
Price Earning Ratio:
= Market Price per share / *Earnings per share
Market /Book Ratio:
= Market Price per share / Book Value per share
*Earning Per Share (EPS):
= Net Income / Average Number of Common Shares
Outstanding

9. M.V.A (Market Value Added):

MVA (Rupees) = Market Value of Equity – Book Value
of Equity Capital

10. E.V.A (Economic Value Added):

EVA (Rupees) = EBIT (or Operating Profit) – Cost of
Total Capital

11. Interest Theory:

• Economic Theory:

i = iRF + g + DR + MR + LP + SR
– i is the nominal interest rate generally quoted in
papers. The “real” interest rate = i – g
Here i = market interest rate
g = rate of inflation
DR = Default risk premium
MR = Maturity risk premium
LP = Liquidity preference
SR = Sovereign Risk
The explanation of these determinants of interest
rates is given as under:

12. Market Segmentation:

• Simple Interest (or Straight Line):
F V = PV + (PV x i x n)

• Discrete Compound Interest:

Annual (yearly) compounding:
F V = PV x (1 + i) n
Monthly compounding:
F V = PV x (1 + (i / m) mxn

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 Financial Management
(Formulas from chapter 1—22)
• Continuous (or Exponential) Compound
Interest:

• F V (Continuous compounding) = PV x e ixn

13. Estimated current assets for the

next year
= [Current assets for the current year/Current sales]
x Estimated sales for the next year

14. Expected Estimated retained

earnings
= estimated sales x profit margin x plowback ratio

15. Estimated discretionary financing

= estimated total assets – estimated total liabilities –
estimated total equity

16. G (Desired Growth Rate)

= return on equity x (1- pay out ratio)

17. CASH FLOW STATEMENT

Net Income
Add Depreciation Expense

Subtract Increase in Current Assets:

Increase in Cash
Increase in Inventory

Add Increase in Current Liabilities:

Increase in A/c Payable

Cash Flow from Operations

Cash Flow from Investments
Cash Flow from Financing
Net Cash Flow from All Activities

18. Interest Rates for Discounting

Calculations
• Nominal (or APR) Interest Rate = i nom
• Periodic Interest Rate = i per
It is defined as
iper = ( i nominal Interest rate) / m

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 Financial Management
(Formulas from chapter 1—22)
Where
m = no. of times compounding takes place in 1 year
i.e.
If semi-annual compounding then m = 2

• Effective Interest Rate = i eff

i eff = [1 + ( i nom / m )]m – 1

19. Calculating the NPV of the Café

Business for 1st Year:
NPV = Net Present Value (taking Investment outflows
into account)
NPV = −Initial Investment + Sum of Net Cash Flows
from Each Future Year.
NPV = − Io +PV (CF1) + PV (CF2) + PV (CF3) + PV
(CF4) + ...+ ∞

20. Annual Compounding (at end of

every year):
FV = CCF (1 + i) n – 1
Annual Compounding (at end of every year)
PV =FV / (1 + i ) n . n = life of Annuity in
number of years

21. Multiple Compounding:

Future Value of annuity =CCF (constant cash
flow)*(1+ (i/m) m*n-1/i/n
Multiple Compounding:
PV =FV / [1 + (i/m)] mxn
22. Future value of perpetuity:
=constant cash flow/interest rate

23. Future value by using annuity

formula
FV =CCF [(1+i) n - 1]/ i

24. Return on Investments:

ROI= (ΣCF/n)/ IO

25. Net Present Value (NPV):

NPV= -IO+ΣCFt/ (1+i) t
Detail
NPV = -Io + CFt / (1+i)t = -Io + CF1/(1+i) + CF2/
(1+i) 2 + CF` /(1+i) 3 +..
-IO= Initial cash outflow
i=discount /interest rate

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 Financial Management
(Formulas from chapter 1—22)
t=year in which the cash flow takes place

26. Probability Index:

PI = [Σ CFt / (1+ i) t ]/ IO

27. Internal Rate Of Return(IRR)

Equation:
NPV= -IO +CF1/ (1+IRR) + CF2/ (1+IRR) 2
28. Internal Rate of Return or IRR:
The formula is similar to NPV
NPV = 0 = -Io + CFt / (1+IRR)t = -Io + CF1/(1+IRR) +
CF2/(1+IRR) 2 + ..

29. Modified IRR (MIRR):

(1+MIRR) n = Future Value of All Cash Inflows….
Present Value of All Cash Outflows
(1+MIRR) n = CF in * (1+k) n-t
CF out / (1+k) t

30. Equivalent Annual Annuity

Approach:
EAA FACTOR = (1+ i) n / [(1+i) n -1]
Where n = life of project & i=discount rate

BONDS’ VALUATION

The relationship between present value and net

present value
31. NPV = -Io + PV

32. Present Value formula for the bond:

n
PV= Σ CFt / (1+rD)t =CF1/(1+rD)+CFn/(1+rD)2 +..
+CFn/ (1+rD) n +PAR/ (1+rD) n
t =1
In this formula
PV = Intrinsic Value of Bond or Fair Price (in rupees)
paid to invest in the bond. It is the Expected or
Theoretical Price and NOT the actual Market Price.
rD = it is very important term which you should
understand it care fully. It is Bondholder’s (or
Investor’s) Required Rate of Return for investing in
Bond (Debt).As conservative you can choose

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 Financial Management
(Formulas from chapter 1—22)
minimum interest rate. It is derived from
Macroeconomic or Market Interest Rate. Different
from the Coupon Rate!

Recall Macroeconomic or Market Interest

Theory: i = iRF + g + DR + MR + LP + SR
CF = cash flow = Coupon Receipt Value (in Rupees)
= Coupon Interest Rate x Par Value. Represents cash
receipts (or in-flow) for Bondholder (Investor). Often
times an ANNUITY pattern Coupon Rate derived from
Macroeconomic or Market Interest Rate. The Future
Cash Flows from a bond are simply the regular
Coupon Receipt cash in-flows over the life of the
Bond. But, at Maturity Date there are 2 Cash In-flows:
(1) the Coupon Receipt and (2) the Recovered Par or
Face Value (or Principal)
n = Maturity or Life of Bond (in years)
In the next lectures, you would study that how the
required rate of return is related to market rate of
return

33. Calculate the PV of Coupons from

the FV Formula for Annuities (with
multiple compounding within 1 year):
FV = CCF (1 + rD/m )nxm - 1/rD/m

Use Monthly Basis for this example. n = 1 year m =

12 months
CCF = Constant Cash Flow = Rs 1,000 = Monthly
Coupon
rD = Annual Nominal Required Rate of Return for
investment in Bond (Debt) = 10% pa.
Periodic Monthly Required Rate of Return is rD/m =
10/12 = 0.833 % = 0.00833 p.m.
m = 12 months

34. YTM =Total or Overall Yield:

= Interest Yield + Capital Gains Yield

35. Interest Yield or Current Yield:

= Coupon / Market Price

36. Capital Gains Yield:

= YTM - Interest Yield

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 Financial Management
(Formulas from chapter 1—22)
37. FV=CCF[(1+rD/m)n*m-1]/rD/m
N=1 year ,m= no. of intervals in a year =12
CCF=constant cash flow
n = Maturity or Life of Bond (in years)

38. Call:
=par value +I, year copoun receipts

Another thing to keep in mind is that YTM has two

components first is

39. YTM:
=interest yield on bond +capital gain yield on bond

1. INTEREST YIELD =annual copoun interest /market

price
2. CAPITAL YIELD =YTM –INTEREST YIELD

40. Perpetual Investment in Preferred

Stock
– PV = DIV 1 / r PE

41. Perpetual Investment in Common

Stock:
PV = DIV1/(1+rCE) +DIV2/(1+rCE)2 +…..+ DIVn/
(1+rCE)n + Pn/(1+rCE)n
PV = Po* = Expected or Fair Price = Present Value of
Share, DIV1= Forecasted Future Dividend at end of
Year 1, DIV 2 = Expected Future Dividend at end of
Year 2, …, Pn = Expected Future Selling Price, rCE =
Minimum Required Rate of Return for Investment in
the Common Stock for you (the investor). Note that
Dividends are uncertain and n = infinity
42. PV (Share Price) = Dividend Value +
Capital Gain.
Dividend Value is derived from Dividend Cash Stream
and Capital Gain / Loss from Difference
between Buying & Selling Price.

43. Simplified Formula (Pn term removed

from the equation for large investment
durations i.e. n =
infinity):

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 Financial Management
(Formulas from chapter 1—22)
PV = DIV1/ (1+rE) + DIV2/ (1+rE) 2 + … DIVn/
(1+rE)n
= DIVt / (1+ rE) t. t = year. Sum from t =1 to n

44. Fair Value. Dynamic Equilibrium.

If Market Price > Fair Value then Stock is Over
Valued
Share Price Valuation -Perpetual Investment in
Common Stock:

45. Zero Growth Dividends Model:

DIV1 = DIV 2 = DIV3

46. The Formula for common stock

PV = Po*= DIV1 / (1+ rCE) + DIV1 / (1+ rCE) 2 +
DIV1 / (1+ rCE) 3 + ... +...
= DIV 1 / rCE

47. Dividends Cash Flow Stream grows

according to the Discrete Compound Growth
Formula
DIVt+1 = DIVt x (1 + g) t.
t = time in years.

48. Zero Growth Model Pricing

PV = Po* = DIV1 / rCE
49. Constant Growth Model Pricing
PV = Po* = DIV1 / (rCE -g)

50. Dividends Pricing Models:

Zero Growth: Po*=DIV1 / rCE (Po* is being
estimated)
51. rCE*= DIV1 / Po (rCE* is being
estimated)
Similarly,

52. Constant Growth: Po*= DI V1/ (rCE -g)

rCE*= ( DIV 1 / Po) + g

use this formula to calculate the required rate

of return.
53. Gordon’s Formula:
rCE*= (DIV 1 / Po) + g

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 Financial Management
(Formulas from chapter 1—22)
In this the first part
(DIV 1 / Po) is the dividend yield
g is the Capital gain yield.

54. Earning per Share (EPS) Approach:

PV = Po* = EPS 1 / rCE + PVGO
Po = Estimated Present Fair Price,
EPS 1 = Forecasted Earnings per Share in the next
year (i.e. Year 1),
rCE = Required Rate of Return on Investment in
Common Stock Equity.
PVGO = Present Value of Growth Opportunities. It
means the Present Value of Potential

Growth in Business from Reinvestments in New

Positive NPV Projects and Investments PVGO is
perpetuity formula.
The formula is
PVGO = NPV 1 / (rCE - g) = [-Io + (C/rCE)] / (rCE
-g)
In this PVGO Model: Constant Growth “g”. It is the
growth in NPV of new Reinvestment Projects (or
Investment).g= plowback x ROE
Perpetual Net Cash Flows (C) from each Project (or
reinvestment).
Io = Value of Reinvestment (Not paid to share
holders)
= Pb x EPS
Where Pb= Plough back = 1 – Payout ratio
Payout ration = (DIV/EPS) and

55. EPS Earnings per Share= (NI - DIV) /

# Shares of Common Stock Outstanding
Where NI = Net Income from P/L Statement and DIV
= Dividend, RE1= REo+ NI1+ DIV1
ROE = Net income /# Shares of Common Stock
Outstanding.

56. NPV 1 = [-Io + (C/rCE)] / (rCE -g)

If we compare it with the traditional NPV formula
-Io = Value of initial investment
(C/rCE) = present value formula for perpetuities
where you assume that you are generating the net
cash
inflow of C every year.

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 Financial Management
(Formulas from chapter 1—22)
C = Forecasted Net Cash Inflow from
Reinvestment = Io x ROE
Where ROE = Return on Equity = NI / Book Equity of
Common Stock Outstanding

57. Range of Possible Outcomes,

Expected Return:
Overall Return on Stock = Dividend Yield + Capital
Gains Yield (Gordon’s Formula)

58. Expected ROR = < r > = pi ri

Where pi represents the Probability of Outcome “i”
taking place and ri represents the Rate of Return
(ROR) if Outcome “i” takes place. The Probability
gives weight age to the return. The Expected or Most
Likely ROR is the SUM of the weighted returns for ALL
possible Outcomes.

59. Stand Alone Risk of Single Stock

Investment:
Risk = Std Dev = ( r i - < r i > )2 p i . = Summed over
each possible outcome “ i ” with return “r i ” and
probability of occurrence “p i .” < r I > is the
Expected (or weighted average) Return

60. Possible Outcomes Example

Continued:
Measuring Stand Alone Risk for Single Stock
Investment
Std Dev = δ = √ Σ (r i - < r i >) 2 p i.

61. Coefficient of Variation (CV):

= Standard Deviation / Expected Return.
CV = σ/ < r >.
< r > = Exp or Weighted Avg ROR = pi ri

62. Risk Basics

Risk = Std Dev = σ = √ ( r i - < r i > )2 p i . =
“Sigma”

63. Types of Risks for a Stock:

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 Financial Management
(Formulas from chapter 1—22)
Types of Stock-related Risks which cause Uncertainty
in future possible Returns & Cash Flows:
Total Stock Risk = Diversifiable Risk + Market
Risk

64. Portfolio Rate of Return

Portfolio Expected ROR Formula:
rP * = r1 x1 + r2 x2 + r3 x3 + … + rn xn .

65. Stock (Investment) Portfolio Risk

Formula:
p = √ XA2 σ A 2 +XB2 σ B 2 + 2 (XA XB σ A σ B AB)

66. Efficient Portfolios:

rP * = xA rA + xB rB + xC rC

67. 3-Stock Portfolio Risk

Formula
3x3 Matrix Approach

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 Financial Management
(Formulas from chapter 1—22)

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