CHAPTER 1 An Overview of Financial Management

1
?????? ????? ???????

• ?. ???? ????? ??????
• ???? ??????? ??????? ??????

2
Interest Rates and Money Supply????? ???????
??????? ???????

• Interest is the rent of money
• Equal to the real growth rate of GDP plus the
  expected inflation rate plus a premium to
  compensate for the riskness of the company being
  analyzed.
• Money supply is the amount of liquidity that is
  being allowed by the UAE central bank. The
  company being analyzed benefits if the amount of
  liquidity is near the healthy level.
• Both interest rates and money supply have a great
  effect on the performance and value of the
  company and need to be taken into consideration
  in any financial analysis.

3
Function of Financial Markets and
Institutions????? ??????? ????????? ???????

• Allows transfers of funds from person or business
  without investment opportunities (i.e.,
  Lender-Savers) to one who has them (i.e.,
  Borrower-Spenders)
• ????? ??????? ??? ???????? ??? ?? ?????????
• Improves economic efficiency
• ????? ???????? ??????????

4
Segments of Financial Markets

• Direct Finance
• Borrowers borrow directly from lenders in
  financial markets by selling financial
  instruments which are claims on the borrowers
  future income or assets
• ??????? ???????
• Indirect Finance
• Borrowers borrow indirectly from lenders via
  financial intermediaries (established to source
  both loanable funds and loan opportunities) by
  issuing financial instruments which are claims on
  the borrowers future income or assets
• ??????? ??? ???????

5
Function of Financial Markets ??? ?????? ?????
?????? ???????
Flow of Funds Through the Financial System
6
Classifications of Financial Markets?????
??????? ??? ???????

• Primary Market ????? ???????
• New security issues sold to initial buyers
• Secondary Market ????? ????????
• Securities previously issued are bought and sold

7
Classifications of Financial Markets?????
??????? ??? ???????

• Exchanges ??????? ??????? (????????)
• Trades conducted in central locations (e.g.,
  ADSM, DFM, .)
• Over-the-Counter Markets ??????? ????? ?????
• Dealers at different locations buy and sell

8
Function of Financial Intermediaries??? ???????
???????

• Financial Intermediaries ??????? ????????
• Engage in process of indirect finance
• More important source of finance than securities
  markets
• Needed because of transactions costs and
  asymmetric information

9
Function of Financial Intermediaries??? ???????
???????

• Transactions Costs ?????? ?????????
• Financial intermediaries make profits by reducing
  transactions costs
• Reduce transactions costs by developing expertise
  and taking advantage of economies of scale and
  scope.

10
Function of Financial Intermediaries??? ???????
???????

• A financial intermediarys low transaction costs
  mean that it can provide its customers with
  liquidity services, services that make it easier
  for customers to conduct transactions ?????
  ??????? ??? ?????? ??? ????? ??????? ????????
• Banks provide depositors with checking accounts
  that enable them to pay their bills easily
• Depositors can earn interest on checking and
  savings accounts and yet still convert them into
  goods and services whenever necessary without
  having to discontinue and liquidate investments

11
Function of Financial Intermediaries??? ???????
???????

• Another benefit made possible by the FIs low
  transaction costs is that they can help reduce
  the exposure of investors to risk, through a
  process known as risk sharing
• ????? ???????
• FIs create and sell assets with lesser risk to
  one party in order to buy assets with greater
  risk from another party (e.g. banks)
• This process is referred to as asset
  transformation, because in a sense risky assets
  are turned into safer assets for investors

12
Function of Financial Intermediaries??? ???????
???????

• Adverse Selection ???????? ?? ?????????
• Before transaction occurs
• Potential borrowers most likely to produce
  adverse outcome are ones most likely to seek loan
  and be selected brokers and financial analysts
  can prevent that by studying the credit
  worthiness of the borrowers

13
Function of Financial Intermediaries??? ???????
???????

• Moral Hazard ???????? ?????? ?????
• After transaction occurs
• Hazard that borrower has incentives to engage in
  undesirable (immoral) activities making it more
  likely that won't pay loan back

14
Function of Financial Intermediaries??? ???????
???????

• Financial intermediaries reduce adverse selection
  and moral hazard problems, enabling them to make
  profits. How they do this is covered in many of
  the topics to come.
• ???????? ??????? ???? ?? ??? ???????

15
Regulation of Financial Markets

• Reasons for Regulation ????? ??????? ??????
• Increase Information to Investors
• Protect investors and their investments
• Ensure the Soundness of Financial Intermediaries
• Improve Monetary Control

16
Regulation Reason Increase Investor
Information????? ???? ?????????

• Asymmetric information in financial markets means
  that investors may be subject to adverse
  selection and moral hazard problems that may
  hinder the efficient operation of financial
  markets and may also keep investors away from
  financial markets
• The Securities and Commodities Authority (SCA)
  requires corporations issuing securities to
  disclose certain information about their sales,
  assets, and earnings to the public and restricts
  trading by the largest stockholders (known as
  insiders) in the corporation.

17
Regulation Reason Increase Investor
Information????? ???? ?????????

• Such government regulation can reduce adverse
  selection and moral hazard problems in financial
  markets and increase their efficiency by
  increasing the amount of information available to
  investors

18
Regulation Reason Ensure Soundness of Financial
Intermediaries ????? ???????

• Because providers of funds to financial
  intermediaries may not be able to assess whether
  the institutions holding their funds are sound or
  not, if they have doubts about the overall health
  of financial intermediaries, they may want to
  pull their funds out of both sound and unsound
  institutions, with the possible outcome of a
  financial panic that produces large losses for
  the public and causes serious damage to the
  economy

19
Regulation Reason Ensure Soundness of Financial
Intermediaries ????? ???????

• To protect the public and the economy from
  financial panics, six types of regulations are
  needed
• Restrictions on Entry - soundness
• Disclosure transparency
• Restrictions on Assets and Activities no
  dummies
• Deposit Insurance peace of mind
• Limits on Competition no price wars
• Restrictions on Interest Rates no usury

20
Regulation Restriction on Entry ????? ??????

• Restrictions on Entry
• Very tight regulations as to who is allowed to
  set up a financial intermediary
• Individuals or groups that want to establish a
  financial intermediary, such as a bank or an
  insurance company, must obtain a charter from the
  government
• Only if they are upstanding citizens with
  impeccable credentials and a large amount of
  initial funds will they be given a charter.

21
Regulation Disclosure ???????

• Disclosure Requirements
• There are stringent reporting requirements for
  financial intermediaries
• Their bookkeeping must follow certain strict
  principles,
• Their books are subject to periodic inspection,
• They must make certain information available to
  the public.

22
Regulation Restriction on Assets and Activities
????? ????????

• There are restrictions on what financial
  intermediaries are allowed to do and what assets
  they can hold
• Before you put your funds into a bank or some
  other such institution, you would want to know
  that your funds are safe and that the bank or
  other financial intermediary will be able to meet
  its obligations to you

23
Regulation Restriction on Assets and Activities
????? ????????

• One way of doing this is to restrict the
  financial intermediary from engaging in certain
  risky activities
• Another way is to restrict financial
  intermediaries from holding certain risky assets,
  or at least from holding a greater quantity of
  these risky assets than is prudent

24
Regulation Deposit Insurance???????

• The government can insure people providing funds
  to a financial intermediary from any financial
  loss if the financial intermediary should fail

25
Regulation Past Limits on Competition ????
???????

• Although the evidence that unbridled competition
  among financial intermediaries promotes failures
  that will harm the public is extremely weak, the
  government needs to impose many restrictive
  regulations
• The purpose is to prevent financial
  intermediaries from competing to the point where
  the integrity of the financial system is
  compromised.

26
Regulation Past Restrictions on Interest Rates
???? ?????? ???????

• Competition must also be inhibited by regulations
  that impose restrictions on interest rates that
  can be paid on deposits
• These regulations need to be instituted because
  of the widespread belief that unrestricted
  interest-rate competition help encourage bank
  failures

27
Regulation Reason Improve Monetary Control
?????? ??????? ???????

• Because banks play a very important role in
  determining the supply of money (which in turn
  affects many aspects of the economy), much
  regulation of these financial intermediaries is
  intended to improve control over the money supply
• One such regulation is reserve requirements,
  which make it obligatory for all depository
  institutions to keep a certain fraction of their
  deposits in accounts with the central bank (the
  PMA)
• Reserve requirements help the PMA exercise more
  precise control over the money supply well, we
  do not have a currency nor can we control the
  used ones

28
The cost of money????? ??? ?????

• The price, or cost, of debt capital is the
  interest rate.
• The price, or cost, of equity capital is the
  required return. The required return investors
  expect is composed of compensation in the form of
  dividends and capital gains.

29
What four factors affect the cost of
money???????? ???? ???? ?? ????? ??? ?????

• Time preferences for consumption (sacrifice)
• Expected inflation (loss in purchasing power)
• Risk (worry)

30
Nominal vs. Real rates?????? ?????? ????????

• k represents any nominal rate
• k represents the real risk-free rate of
  interest, if there was no inflation. Typically
  ranges from 1 to 4 per year.
• kRF represents the rate of interest on Treasury
  securities.

31
Determinants of interest rates?????? ??? ???????
(??????)

• k k IP DRP LP MRP
• k required return on a debt security
• k real risk-free rate of interest
• IP inflation premium
• DRP default risk premium
• LP liquidity premium
• MRP maturity risk premium

32
Premiums added to k for different types of
debt?????? ?????? ??????? ????????
33
Yield curve and the term structure of interest
rates????? ?????? ?????? ??????? ??????????

• Term structure relationship between interest
  rates (or yields) and maturities.
• The yield curve is a graph of the term structure.

34
Hypothetical yield curve????? ???? ???????

• An upward sloping yield curve.
• Upward slope due to an increase in expected
  inflation and increasing maturity risk premium.

35
The Yield Curve????? ??????

• Corporate yield curves are higher than that of
  Treasury securities, though not necessarily
  parallel to the Treasury curve.
• The spread between corporate and Treasury yield
  curves widens as the corporate bond rating
  decreases.

36
The Yield Curve????? ??????
Interest Rate ()
15
10
Treasury Yield Curve
6.0
5.9
5
5.2
Years to Maturity
0
0
1
5
10
15
20
37
The Term Structure of Interest Rates????? ???
??????? ??????

• The Yield Curve
• Spot and forward rates
• Theories of the Term Structure

38
The Term Structure of Interest Rates????? ???
??????? ??????

• bonds with the same characteristics,
• but different maturities
• focus on Treasury yields
• same default risk
• similar liquidity
• many choices of maturity

39
Treasury securities????? ??????? ??????? ??????
??????? ??????? ??????

• Tbills
• 4, 13, 26, and 52 weeks
• zero coupon
• Tnotes
• 2, 5, and 10 years
• Tbonds
• 30 years
• Tnotes and Tbonds are coupon

40
Relationship between yield maturity is NOT
constant ????? ??????? ?? ??? ??? ??????? ??????
????? ??????? ?????????? ????????

• sometimes short-term yields are highest,
• most of the time long-term yields are highest

41
The Yield Curve????? ??????

• plot of maturity vs. yield
• slope of curve indicates relationship between
  maturity and yield

42
Upward Sloping

• yields rise w/ maturity (common)

43
downward sloping (inverted)

• yield falls w/ maturity (rare)

44
flat

• yields similar for all maturities

45
humped

• intermediate yields are highest

46
Theories of the term structure?????? ??????? ???
????? ?????? ???????

• explain relationship between yield and maturity
• what does the yield curve tell us?

47
The Pure Expectations Theory

• Assume
• bond buyers do not have any preference about
  maturity
• i.e.
• bonds of different maturities are perfect
  substitutes
• LT long-term
• ST short-term

48
The Pure Expectations Theory

• if assumption is true,
• then investors care only about expected return
• if expect better return from ST bonds, only hold
  ST bonds
• if expect better return from LT bonds, only hold
  LT bonds

49
The Pure Expectations Theory

• but investors hold both ST and LT bonds
• so,
• must EXPECT similar return
• LT yields
• average of the expected
• ST yields

50
The Pure Expectations Theory

• slope of yield curve tells us direction of
  expected future ST rates

51
why?

• if expect ST rates to RISE,
• then average of ST rates will be gt
• current ST rate
• so LT rates gt ST rates
• so yield curve SLOPES UP

52
The Pure Expectations Theory

• if expect ST rates to FALL,
• then average of ST rates will be lt
• current ST rate
• so LT rates lt ST rates
• so yield curve slopes DOWN

53
The Pure Expectations Theory

• if expect ST rates to STAY THE SAME,
• then average of ST rates will be
• current ST rate
• so LT rates ST rates
• so yield curve is FLAT

54
Is this True?

• not quite.
• FACT yield curve usually slopes up
• but expectations theory would predict this only
  when ST rates are expected to rise
• 50 of the time

55
what went wrong?

• back to assumption
• bonds of different maturities are perfect
  substitutes
• but this is not likely
• long term bonds have greater price volatility
• short term bonds have reinvestment risk
• assumption is too strict
• so implication is not quite correct

56
Liquidity Theory

• assume
• bonds of different maturities are imperfect
  substitutes,
• and investors PREFER ST bonds

57
Liquidity Theory

• so if true,
• investors hold ST bonds
• UNLESS
• LT bonds offer higher yield as incentive
• higher yield liquidity premium

58
Liquidity Theory

• IF LT bond yields have a liquidity premium,
• then usually LT yields gt ST yields
• or yield curve slopes up.

59
Problem

• How do we interpret yield curve?
• slope due to 2 things
• (1) exp. about future ST rates
• (2) size of liquidity premium
• do not know size of liq. prem.

60
yield curve
small liquidity premium

• if liquidity premium is small,
• then ST rates are expected to rise

61
yield curve
large liquidity premium

• if liquidity premium is larger,
• then ST rates are expected to stay the same

62
Preferred Habitat Theory

• assume
• bonds of different maturities are imperfect
  substitutes,
• and investor preference for ST bonds OR LT bonds
  is not constant

63

• liquidity premium could be positive or negative
• yield curve very difficult to interpret
• do not know size or sign of liquidity premium

64
Segmented Markets Theory

• assume
• bonds of different maturities are NOT
  substitutes at all

65
Segmented Markets Theory

• if assumption is true,
• separate markets for ST and LT bonds
• slope of yield curves tells us nothing about
  future ST rates
• unrealistic to assume NO substitution bet. ST and
  LT bonds
• unrealistic to assume NO substitution

66
The Annual Report??????? ??????

• Balance sheet provides a snapshot of a firms
  financial position at one point in time.
• Income statement summarizes a firms revenues
  and expenses over a given period of time.
• Statement of retained earnings shows how much
  of the firms earnings were retained, rather than
  paid out as dividends.
• Statement of cash flows reports the impact of a
  firms activities on cash flows over a given
  period of time.

67
Balance Sheet Assets????? ?????? ?????? - ??????

• Cash
• A/R
• Inventories
• Total CA
• Gross FA
• Less Dep.
• Net FA
• Total Assets

68
Balance sheet Liabilities and Equity?????
?????? ?????? ?????? ????? ???????

• Accts payable
• Notes payable
• Accruals
• Total CL
• Long-term debt
• Common stock
• Retained earnings
• Total Equity
• Total L E

69
Income statement????? ?????

• Sales
• COGS
• Other expenses
• EBITDA
• Depr. Amort.
• EBIT
• Interest Exp.
• EBT
• Taxes
• Net income

2006 6,034,000 5,528,000
519,988 (13,988) 116,960 (130,948)
136,012 (266,960) (106,784) (160,176)
2005 3,432,000 2,864,000 358,672 209,328
18,900 190,428 43,828 146,600 58,640
87,960
70
Other data??????? ????

• No. of shares
• EPS
• DPS
• Stock price

71
Did the expansion create additional net operating
after taxes (NOPAT)??????? ????? ???????? ???
???????

• NOPAT EBIT (1 Tax rate)
• NOPAT06 -130,948(1 0.4)
• -130,948(0.6)
• -78,569
• NOPAT05 114,257

72
What effect did the expansion have on net
operating working capital??????? ???? ??? ?????
?????

• NOWC Current - Non-interest
• assets bearing CL
• NOWC06 (7,282 632,160 1,287,360) (
  524,160 489,600)
• 913,042
• NOWC05 842,400

73
What effect did the expansion have on operating
capital??????? ??? ????? ????????

• Operating capital NOWC Net Fixed Assets
• Operating Capital06 913,042 939,790
• 1,852,832
• Operating Capital05 1,187,200

74
What is your assessment of the expansions effect
on operations???????? ?? ?????? ???????

• Sales
• NOPAT
• NOWC
• Operating capital
• Net Income

2006 6,034,000 -78,569 913,042 1,85
2,832 -160,176
2005 3,432,000 114,257 842,400 1,187,200
87,960
75
What was the free cash flow (FCF) for 2002?????
?????? ?????? ????

• FCF06 NOPAT Net capital investment
• -78,569 (1,852,832 - 1,187,200)
• -744,201
• Is negative free cash flow always a bad sign?

76
Economic Value Added (EVA)???? ?????? ???????

• EVA After-tax __ After-tax
• Operating Income Capital costs
• Funds Available __ Cost of
• to Investors Capital Used
• NOPAT After-tax Cost of Capital

77
EVA Concepts????? ?????? ?????????? ???????

• In order to generate positive EVA, a firm has to
  more than just cover operating costs. It must
  also provide a return to those who have provided
  the firm with capital.
• EVA takes into account the total cost of capital,
  which includes the cost of equity.

78
What is the firms EVA? Assume the firms
after-tax percentage cost of capital was 10 in
2000 and 13 in 2001.???? ?????? ??????????
???????

• EVA06 NOPAT (A-T cost of capital) (Capital)
• -78,569 (0.13)(1,852,832)
• -78,569 - 240,868
• -319,437
• EVA05 114,257 (0.10)(1,187,200)
• 114,257 - 118,720
• -4,463

79
Did the expansion increase or decrease MVA?????
?????? ??????? ???????

• MVA Market value __ Equity capital
• of equity supplied
• It measures the value added to the company from
  its activities since its inception.
• Can not tell who did what.

80
Calculating Key Multipliers???? ????????? - ????

• P/E Price / Earnings per share
• 12.17 / 1.014 12.0x
• P/CF Price / Cash flow per share
• 12.17 / (253.6 117.0) 250
• 8.21x

81
Calculating Key Multipliers???? ????????? - ????

• M/B Mkt price per share / Book value per share
• 12.17 / (1,952 / 250) 1.56x

82
Analyzing the multipliers????? ?????????

• P/E How much investors are willing to pay for 1
  of earnings.
• P/CF How much investors are willing to pay for
  1 of cash flow.
• M/B How much investors are willing to pay for 1
  of book value equity.
• For each ratio, the higher the number, the
  better.
• P/E and M/B are high if ROE is high and risk is
  low.

83
Trend analysis????? ???????

• Analyzes a firms financial ratios over time
• Can be used to estimate the likelihood of
  improvement or deterioration in financial
  condition.

84
Potential uses of freed up cash????????? ??????
?????? ????

• Repurchase stock
• Expand business
• Reduce debt
• All these actions would likely improve the stock
  price.