Debt Ratio 

= Total Debt   

  Total Assets

Current Assets + Long Term Assets

Cash or assets what will be converted into cash within the next year. Commonly current asset includes:

Cash

Marketable Securities

Accounts Receivable

Inventories

Obligations that require cash in the next year. Generally includes:

Accounts payable

Notes payable

Accruals 

Includes:

Common stock

Additional paid in capital

Retained Earnings

Retained Earnings:

Money generated from the the operations of the company that is plowed back ( or retained ) in the business.

Income Statement:

Revenues

- Cost of Goods Sold

= Gross Profit

- Operating Expenses

=  Earnings before Interest and Taxes (EBIT)

-  Interest Expenses

=  Earning before taxes (EBT )

-  Tax Expenses

=   Net Income

New Retained Earnings:

Cash flow from Operations

+ Cash flow from Investing

+ Cash flow from Financing

=  Change in Cash

+  Beginning Cash

= End Cash

Net Income

+ Non cash expense

( Depreciation and Amortization)

+ Decrease in current assets ( other than Cash)

-  Increase in current assets ( other than Cash)

+ Increase in current liabilities ( other than notes payable)

- Decrease in current liablities ( other than notes payable)

= CFO

Calculation:

Old RE + Net Income - New RE

Current Ratio

Quick Ratio

Average Collection Period

Account Receivable turnover

Inventory Turnover 

Current Ratio:

Current Assets - Inventory

_____________________________

Current Liabilities

Average Receivables

________________________

Daily Credit Sales

Credit Sales

___________________

Accounts Receivable

Cost of Goods Sold

Inventory

Total Asset Turnover

= Sales / Total Assets

Fixed Asset Turnover

= Sales / Fixed Asset

OIROI 

= Operating Income / Total Assets

( also used as profitability ratio)

Debt Ratio: 

Total Debt / Total Assets

Times Interest Earned:

EBIT / Interest Expense

ROA = Net Income / Total Asssets

ROE = Net Income / Total Equity

Gross Margin = Gross Profit / Sales

Net Margin = Net Income / Sales

= Net Profit Margin × Asset Turnover × Leverage Multiplier

= Net Income × Sales     ×  Assets 

Sales Assets Equity

Accounts on the income statement and balance sheet that change automatically in proportion with sales.

Includes:

Most Current Assets

Accounts Payable

Accruals ( Accrued Wages, accrued taxes)

Notes Payable

Long term financing accounts

Common Stock

= Projected Assets 

- Projected Liabilities

- Projected Owner's Equity

Only growth rate which allows the firm to maintain its present financial ratios and avoid the sale of new equity.

= ROE (1- Dividends/ Net Income)

SGR is a function of :

Profitability ( Net Margin)

Asset usage Efficiency (Asset Turnover)

Leverage (Assets / Equity)

Plow back (Dividends)

1. Slow sales growth

2. Examine capacity constaints

3. Lower dividend payment

4. Increase net margin

By increasing price, a firm can slow sales growth.

a. High price decreases sales,

 high price increase net margin

b. Lower sales decreases forecasted assets in the pro forma balance sheet

Both decreases DFN

Bonds with a rating of BB or below. 

More likely to default.

If the coupon rate = discount rate , the bond will sell at par value

If the coupon rate > discount rate , the bond will sell at premium

If the coupon rate < discount rate , the bond will sell at discount

Inverse relationship between prices and yields.

  If Interest rate ↑, price of existing bond falls

 If Interest rate ↓, price of existing bond falls

An index of price sensitivity.

Literally a weighted Average time to maturity.

Interpreted as the % change in price for 1% change in rates.

Residual claim on the earnings and the assets of the company.

Value of stock (V₀)

(Single Holding period)

V₁ + D_{1  /} ( 1 + K_cs)

Here V₀ and V₁ are value of the stock at time 0 and time 1, respectively, D₁ is the dividend paid in time 1 and K_cs is the required rated of return

Gordon Growth Model [ V₀ ]

( also Constant Dividend Growth Model)

D₀ ( 1 + g) / ( K_cs - g)

Here V₀ and V₁ are value of the stock at time 0 and time 1, respectively, D₁ is the dividend paid in time 1 and K_cs is the required rated of return

and g is the constant growth rate

Estimate cash flows of two different growth stages

Stage1 : Dividends grow at above-average rates

Stage 2: Dividends grow at the industry average rate

Value

(Two Stage Growth):

= Present Value ( Stage 1) +

    Present Value (Stage 2)

Generally reported as an annualized percentage.

( P₁ - P₀ + CF₁ )   360

______________   × ______

                P_{0  Holding}

      _Period      

Calculate the standard deviation of returns.

Greater SD means higher risk of security. 

√ ∑ ( R_{i -} R_mean) ² × P_i

where P represent possibility

Unexpected Change in interest rates

Unexpected change in cash flows due to tax changes

Business Cycle Changes

A company's labor force goes on strike

A company's top management dies in a plane crash

An oil tank brusts and floods a company's production area

 Co-relation refers to the way two variables (e.g. the return of two stocks) co-move.

The driving principle behind the common wisdom of diversification is co-relation.

Facts about Beta (ß):

• If b > 1.0 , the security moves more than the market when the market moves
• If b < 1.0, the security moves less than the market when the market moves.
• So, if b > 1.0, the asset has more risk relative to the market portfolio and if b < 1.0, the asset has less risk relative to the market portfolio. 
• Since all risk is measured relative to the market portfolio, the beta of the market is 1.0.

Example: Find the beta on a stock XYZ given that its expected return is 12%, the risk-free rate is 4%, and the expected return on the market portfolio is 10%.

SML(graphical representation):

Alternative to CAPM:

Build up method

Required rate of return:

Bond yield

+ Equity Risk Premium

+ Micro-cap risk premium

+ Start-up risk premium

Cost of Capital

Also referred as weighted cost of capital (WACC)

Every company has a capital structure - a general understanding of what percentage of debt comes from retained earnings, common stocks, preferred stocks, and bonds. By taking a weighted average, we can see how much interest the company has to pay for every dollar it borrows. This is the weighted average cost of capital.

Generally cost of debt is cheaper than debt.

After tax cost of Debt = Before tax cost of debt - tax savings

= Before tax cost of debt × (1- tax rate)

Equity Risk Premium(Rerp) =

Exp. Return on Market(Rm) - Risk Free Rate(Rf)

Example of WACC:

Weight of Debt: 60%
Cost of Debt: 10%

Weight of Equity (Common Stock): 40%

Cost of Equity (Common Stock): 18%

Tax Rate: 35%

t

WACC = Weight of Debt * Cost of Debt (1-Tax Rate) + Weight of Equity * Cost of Equity

= (.6) * (.1)*(1-.35) + (.4) * (.18)
= .111 or 11.1%

1. Operating Leverage

2. Financial Leverage

Operating Leverage is the use of fixed operating costs (rent, property tax, administrative salaries) as opposed to variable operating costs.

Firm with high fixed cost has  high operating leverage.

Financing Leverage:

Use of fixed cost sources of financing ( debt, preferred stock) rather than variable cost sources of financing ( common stock)

Firms with lots of fixed cost (debt) will have high financial leverage.

1. Operating (Business) risk: Variability associated with operating income

2. Financial Risk: Risk of distress or bankruptcy due to use of fixed cost financing

Percent change in EBIT over the percent change in sales. 

DOL= (Sales - Variable Costs)/ EBIT

If a firm has DOL of 1 then 1% change in sales will change EBIT by 1%.

Similarly, if DOL is 2, 1 % change in sales will change EBIT by 2%

Degree of Financial Leverage (DFL):

DFL = EBIT/( EBIT -1)

= DOL × DFL

OR

= (Sales - Variable Cost)/ (EBIT -1)

Capital Budgeting 

Decision Criteria

Criteria for the ideal evalutation:

- includes all cash flows that occur during the life of the projects

- consider the time value of money

- incorporate the required rate of return

Number of years required to recover the initial cash outlay.

Payback method is subject to 

- reject a good project

-accept a bad project

Not a good method for capital budgeting

1. Net Present Value (NPV)

2. Internal Rate of Return (IRR)

Internal Rate of Return (IRR) :

- If IRR is greater than or equal to required rate of return, Accept

- If IRR is less than the required rate of return, Reject

Cash flows that result from accepting a project.

In short, Incremental cash flows are additional cash minus additional cash out when we are looking at the company as a whole.

Irretrievable cost.

If the cost incurred the cost in the past, and nothing can be done to 

MACRS: 

Depreciation Expense = Cost × % determined by life

Straight Line:

Depreciation Expense = (Cost - Salvage) / Life period

Calculate Book Value = Cost - Accumulated Depreciation

If Book Value < sale price , then tax on gain

If Book Value > sales price , then taxable loss

( for future tax back)

1. Evaluate the cash flows

2. Assess project risk

3. Accept or reject the project

Initial Outlay

Purchase Price of the Asset

+ Shipping and installation Costs

Depreciable Assets 

+Investment in working capital

+/- After tax proceeds from sale of old asset

= Net Initial Outlay

Evaluating cash flow (Cont):

Differential Cash Flows:

For each year of projects life, calculate

Incremental Revenue

- Incremental Costs

- Depreciation on project

= Incremental Earnings before Taxes (EBT)

- Tax on incremental EBT

  Incremental Earnings after taxes (NI)

+ Depreciation reversal

= Annual Cash Flows

Terminal Cash Flows:

Terminal Cash Flow

Realizable salvage Value

+/- Tax effects of capital gain/loss

+Recapture of Net Working Capital

= Terminal Cash Flow

Cash flow at the end of the life of the project:

Last year's differential cash flow + Terminal cash flow

1. Replacement cost

2. Discounted Cash flow

3. Comparable Multiples

Discounted Cash Flow Method:

Discounted cash flow (DCF) analysis uses future free cash flow projections and discounts them (most often using the weighted average cost of capital) to arrive at a present value, which is used to evaluate the potential for investment.

         T

                                         V_firm = ∑    FCFF_t / (1+ WACC)^t

             _t=1

Calculated as: 
[image]
Or:

          T

                                         V_firm = ∑    FCFF_t / (1+ WACC)^t

                _t=1