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Reviewer in Financial Management

Chapter 1

Finance can be defined as the science and art of managing money.

At the personal level, finance is concerned with individuals decisions about

how much of their earnings they spend, how much they save, and how they invest
their savings.

In a business context, finance involves the same types of decisions: how firms
raise money from investors, how firms invest money in an attempt to earn a profit,
and how they decide whether to reinvest profits in the business or distribute them
back to investors.
Financial Services is the area of finance concerned with the design and delivery of
advice and financial products to individuals, businesses, and governments.

Career opportunities include banking, personal financial planning,

investments, real estate, and insurance.
Career Opportunities in Finance: Managerial Finance
Managerial finance is concerned with the duties of the financial manager
working in a business.

Financial managers administer the financial affairs of all types of

businessesprivate and public, large and small, profit-seeking and not-for-profit.

They perform such varied tasks as developing a financial plan or budget,

extending credit to customers, evaluating proposed large expenditures, and raising
money to fund the firms operations.
Professional Certifications in Finance:

Chartered Financial Analyst (CFA) Offered by the CFA Institute, the

CFA program is a graduate-level course of study focused primarily on
the investments side of finance.

Certified Treasury Professional (CTP) The CTP program requires

students to pass a single exam that is focused on the knowledge and
skills needed for those working in a corporate treasury department.

Certified Financial Planner (CFP) To obtain CFP status, students must

pass a ten-hour exam covering a wide range of topics related to
personal financial planning.

American Academy of Financial Management (AAFM) The AAFM

administers a host of certification programs for financial professionals
in a wide range of fields. Their certifications include the Charter
Portfolio Manager, Chartered Asset Manager, Certified Risk Analyst,
Certified Cost Accountant, Certified Credit Analyst, and many other

Professional Certifications in Accounting Most professionals in the

field of managerial finance need to know a great deal about accounting
to succeed in their jobs. Professional certifications in accounting
include the Certified Public Accountant (CPA), Certified Management
Accountant (CMA), Certified Internal Auditor (CIA), and many programs.

Legal Forms of Business Organization

A sole proprietorship is a business owned by one person and operated for

his or her own profit.

A partnership is a business owned by two or more people and operated for


A corporation is an entity created by law. Corporations have the legal

powers of an individual in that it can sue and be sued, make and be party to
contracts, and acquire property in its own name.

Stakeholders are groups such as employees, customers, suppliers,

creditors, owners, and others who have a direct economic link to the firm.

A firm with a stakeholder focus consciously avoids actions that would prove
detrimental to stakeholders. The goal is not to maximize stakeholder wellbeing but to preserve it.

Such a view is considered to be "socially responsible."

The role of Business Ethics

Business ethics are the standards of conduct or moral judgment that apply
to persons engaged in commerce.

Violations of these standards in finance involve a variety of actions: creative

accounting, earnings management, misleading financial forecasts, insider
trading, fraud, excessive executive compensation, options backdating,
bribery, and kickbacks.

Negative publicity often leads to negative impacts on a firm

Robert A. Cooke, a noted ethicist, suggests that the following questions be used
to assess the ethical viability of a proposed action:

Is the action arbitrary or capricious? Does the action unfairly single out
an individual or group?

Does the action affect the morals, or legal rights of any individual or

Does the action conform to accepted moral standards?

Are there alternative courses of action that are less likely to cause actual or
potential harm?
Ethics programs seek to:

reduce litigation and judgment costs

maintain a positive corporate image

build shareholder confidence

gain the loyalty and respect of all stakeholders

The expected result of such programs is to positively affect the firms share price.

Marginal costbenefit analysis is the economic principle that states that

financial decisions should be made and actions taken only when the added
benefits exceed the added costs

Marginal cost-benefit analysis can be illustrated using the following simple


The firms finance and accounting activities are closely-related and generally

In small firms accountants often carry out the finance function, and in large
firms financial analysts often help compile accounting information.

One major difference in perspective and emphasis between finance and

accounting is that accountants generally use the accrual method while in
finance, the focus is on cash flows.

Whether a firm earns a profit or experiences a loss, it must have a sufficient

flow of cash to meet its obligations as they come due.

Now contrast the differences in performance under the accounting method

(accrual basis) versus the financial view (cash basis):

Finance and accounting also differ with respect to decision-making:

Accountants devote most of their attention to the collection and

presentation of financial data.

Financial managers evaluate the accounting statements, develop

additional data, and make decisions on the basis of their assessment of
the associated returns and risks.

Corporate governance refers to the rules, processes, and laws by which

companies are operated, controlled, and regulated.

It defines the rights and responsibilities of the corporate participants such as

the shareholders, board of directors, officers and managers, and other
stakeholders, as well as the rules and procedures for making corporate

Governance and Agency

Individual investors are investors who own relatively small quantities of

shares so as to meet personal investment goals.

Institutional investors are investment professionals, such as banks,

insurance companies, mutual funds, and pension funds, that are paid to
manage and hold large quantities of securities on behalf of others.

Unlike individual investors, institutional investors often monitor and directly

influence a firms corporate governance by exerting pressure on management
to perform or communicating their concerns to the firms board.

Government regulation generally shapes the corporate governance of all


During the recent decade, corporate governance has received increased

attention due to several high-profile corporate scandals involving abuse of
corporate power and, in some cases, alleged criminal activity by corporate

A principal-agent relationship is an arrangement in which an agent acts

on the behalf of a principal. For example, shareholders of a company
(principals) elect management (agents) to act on their behalf.

Agency problems arise when managers place personal goals ahead of the
goals of shareholders.

Agency costs arise from agency problems that are borne by shareholders
and represent a loss of shareholder wealth.

Incentive plans are management compensation plans that tie management

compensation to share price; one example involves the granting of stock

Performance plans tie management compensation to measures such as

EPS or growth in EPS. Performance shares and/or cash bonuses are used as
compensation under these plans.
The Threat of Takeover

When a firms internal corporate governance structure is unable to keep

agency problems in check, it is likely that rival managers will try to gain
control of the firm.

The threat of takeover by another firm, which believes it can enhance the
troubled firms value by restructuring its management, operations, and
financing, can provide a strong source of external corporate governance.

Chapter 2
Financial Institutions & Markets
Firms that require funds from external sources can obtain them in three ways:
1. through a financial institution
2. through financial markets
3. through private placements

Financial institutions are intermediaries that channel the savings of

individuals, businesses, and governments into loans or investments.

The key suppliers and demanders of funds are individuals, businesses, and

In general, individuals are net suppliers of funds, while businesses and

governments are net demanders of funds.

Commercial Banks, Investment Banks, and the Shadow Banking System

Commercial banks are institutions that provide savers with a secure place
to invest their funds and that offer loans to individual and business

Investment banks are institutions that assist companies in raising capital,

advise firms on major transactions such as mergers or financial
restructurings, and engage in trading and market making activities.

The shadow banking system describes a group of institutions that engage

in lending activities, much like traditional banks, but these institutions do not
accept deposits and are therefore not subject to the same regulations as
traditional banks.

Financial Institutions & Markets: Financial Markets

Financial markets are forums in which suppliers of funds and demanders of

funds can transact business directly.

Transactions in short term marketable securities take place in the money

market while transactions in long-term securities take place in the capital

A private placement involves the sale of a new security directly to an

investor or group of investors.

Most firms, however, raise money through a public offering of securities,

which is the sale of either bonds or stocks to the general public.

The primary market is the financial market in which securities are initially
issued; the only market in which the issuer is directly involved in the

Secondary markets are financial markets in which preowned securities

(those that are not new issues) are traded.

The money market is created by a financial relationship between suppliers

and demanders of short-term funds.

Most money market transactions are made in marketable securities which

are short-term debt instruments, such as U.S. Treasury bills, commercial
paper, and negotiable certificates of deposit issued by government, business,
and financial institutions, respectively.

Investors generally consider marketable securities to be among the least

risky investments available.

The capital market is a market that enables suppliers and demanders of

long-term funds to make transactions.

The key capital market securities are bonds (long-term debt) and both
common and preferred stock (equity, or ownership).

Bonds are long-term debt instruments used by businesses and

government to raise large sums of money, generally from a diverse
group of lenders.

Common stock are units of ownership interest or equity in a


Preferred stock is a special form of ownership that has features of

both a bond and common stock.

Broker markets are securities exchanges on which the two sides of a transaction,
the buyer and seller, are brought together to trade securities.

Trading takes place on centralized trading floors.

Examples include: NYSE Euronext, American Stock Exchange

Dealer markets are markets in which the buyer and seller are not brought
together directly but instead have their orders executed by securities dealers that
make markets in the given security.

The dealer market has no centralized trading floors. Instead, it is made

up of a large number of market makers who are linked together via a
mass-telecommunications network.

The Nasdaq market is one example

As compensation for executing orders, market makers make money on the spread
(bid price ask price).
The Role of Capital Markets

From a firms perspective, the role of capital markets is to be a liquid market

where firms can interact with investors in order to obtain valuable external
financing resources.

From investors perspectives, the role of capital markets is to be an efficient

market that allocates funds to their most productive uses.

An efficient market allocates funds to their most productive uses as a result

of competition among wealth-maximizing investors and determines and
publicizes prices that are believed to be close to their true value.

Advocates of behavioral finance, an emerging field that blends ideas from

finance and psychology, argue that stock prices and prices of other securities
can deviate from their true values for extended periods.

These people point to episodes such as the huge run up and subsequent
collapse of the prices of Internet stocks in the late 1990s, or the failure of
markets to accurately assess the risk of mortgage-backed securities in the
more recent financial crisis, as examples of the principle that stock prices
sometimes can be wildly inaccurate measures of value.

The Ethics of Insider Trading

Martha Stewart was convicted of conspiracy, obstruction, and making

false statements to federal investigators and served 5 months in jail, 5
months of home confinement, 2 years of probation, and a $30,000 fine.

Laws prohibiting insider trading were established in the United States

in the 1930s. These laws are designed to ensure that all investors have
access to relevant information on the same terms.

However, many market participants believe that insider trading should

be permitted.

If efficiency is the goal of financial markets, is allowing or disallowing

insider trading more unethical?

Does allowing insider trading create an ethical dilemma for insiders?

The Financial Crisis: Financial Institutions and Real Estate Finance

Securitization is the process of pooling mortgages or other types of loans

and then selling claims or securities against that pool in a secondary market.

Mortgage-backed securities represent claims on the cash flows generated

by a pool of mortgages and can be purchased by individual investors, pension
funds, mutual funds, or virtually any other investor.

A primary risk associated with mortgage-back securities is that homeowners

may not be able to, or may choose not to, repay their loans.

The Financial Crisis: Spillover Effects and the Great Recession

As banks came under intense financial pressure in 2008, they tightened their
lending standards and dramatically reduced the quantity of loans they made.

Corporations found that they could no longer raise money in the money
market, or could only do so at extraordinarily high rates.

As a consequence, businesses began to hoard cash and cut back on

expenditures, and economic activity contracted.

Business Taxes

Both individuals and businesses must pay taxes on income.

The income of sole proprietorships and partnerships is taxed as the income of

the individual owners, whereas corporate income is subject to corporate

Both individuals and businesses can earn two types of incomeordinary

income and capital gains income.

A capital gain is the amount by which the sale price of an asset exceeds the
assets purchase price.

In calculating taxes, corporations may deduct operating expenses and

interest expense but not dividends paid.

This creates a built-in tax advantage for using debt financing as the following
example will demonstrate.

As the example shows, the use of debt financing can increase cash flow and
EPS, and decrease taxes paid.

The tax deductibility of interest and other certain expenses reduces their
actual (after-tax) cost to the profitable firm.

It is the non-deductibility of dividends paid that results in double taxation

under the corporate form of organization.

Chapter 3
The Four Key Financial Statements: The Income Statement

The income statement provides a financial summary of a companys

operating results during a specified period.

Although they are prepared quarterly for reporting purposes, they are
generally computed monthly by management and quarterly for tax purposes.

The balance sheet presents a summary of a firms financial position at a

given point in time.

The statement balances the firms assets (what it owns) against its financing,
which can be either debt (what it owes) or equity (what was provided by

The statement of retained earnings reconciles the net income earned

during a given year, and any cash dividends paid, with the change in retained
earnings between the start and the end of that year.

The statement of cash flows provides a summary of the firms operating,

investment, and financing cash flows and reconciles them with changes in its
cash and marketable securities during the period.

This statement not only provides insight into a companys investment,

financing and operating activities, but also ties together the income
statement and previous and current balance sheets.

Ratio analysis involves methods of calculating and interpreting financial

ratios to analyze and monitor the firms performance.

Current and prospective shareholders are interested in the firms current and
future level of risk and return, which directly affect share price.

Creditors are interested in the short-term liquidity of the company and its
ability to make interest and principal payments.

Management is concerned with all aspects of the firms financial situation,

and it attempts to produce financial ratios that will be considered favorable
by both owners and creditors.

Cross-sectional analysis is the comparison of different firms financial

ratios at the same point in time; involves comparing the firms ratios to those
of other firms in its industry or to industry averages

Benchmarking is a type of cross-sectional analysis in which the firms ratio

values are compared to those of a key competitor or group of competitors
that it wishes to emulate.

Comparison to industry averages is also popular, as in the following example.

Time-series analysis is the evaluation of the firms financial performance

over time using financial ratio analysis

Comparison of current to past performance, using ratios, enables analysts to

assess the firms progress.

Developing trends can be seen by using multiyear comparisons.

The most informative approach to ratio analysis combines cross-sectional and

time-series analyses.

Using Financial Ratios: Cautions about Using Ratio Analysis

1. Ratios that reveal large deviations from the norm merely indicate the
possibility of a problem.
2. A single ratio does not generally provide sufficient information from which to
judge the overall performance of the firm.
3. The ratios being compared should be calculated using financial statements
dated at the same point in time during the year.
4. It is preferable to use audited financial statements.
5. The financial data being compared should have been developed in the same
6. Results can be distorted by inflation.

Liquidity Ratios
Current ratio = Current assets Current liabilities

Determinants of liquidity needs

Large enterprises generally have well established relationships with

banks that can provide lines of credit and other short-term loan
products in the event that the firm has a need for liquidity.

Smaller firms may not have the same access to credit, and therefore
they tend to operate with more liquidity.

Activity Ratios
Inventory turnover = Cost of goods sold Inventory
Average Age of Inventory = 365 Inventory turnover

Total asset turnover = Sales Total assets

Debt ratio = Total liabilities Total assets
Times interest earned ratio = EBIT interest
Fixed-Payment coverage Ratio (FPCR)

Profitability Ratios

Operating profit margin = Operating profits sales

Net profit margin = Earnings available for common stockholders Sales

Return on total assets (ROA) = Earnings available for common stockholders Total
Return on Equity (ROE) = Earnings available for common stockholders Common
stock equity
Price Earnings (P/E) Ratio = Market price per share of common stock Earnings per

Market Ratios


DuPont System of Analysis

The DuPont system of analysis is used to dissect the firms financial

statements and to assess its financial condition.

It merges the income statement and balance sheet into two summary
measures of profitability.

The Modified DuPont Formula relates the firms ROA to its ROE using the
financial leverage multiplier (FLM), which is the ratio of total assets to
common stock equity:

The DuPont system first brings together the net profit margin, which
measures the firms profitability on sales, with its total asset turnover, which
indicates how efficiently the firm has used its assets to generate sales.
ROA = Net profit margin Total asset turnover

Substituting the appropriate formulas into the equation and simplifying

results in the formula given earlier,

The modified DuPont Formula relates the firms return on total assets to its
return on common equity. The latter is calculated by multiplying the return on
total assets (ROA) by the financial leverage multiplier (FLM), which is the
ratio of total assets to common stock equity:


Chapter 4

Cash flow (as opposed to accounting profits) is the primary ingredient in

any financial valuation model.

From an accounting perspective, cash flow is summarized in a firms

statement of cash flows.

From a financial perspective, firms often focus on both operating cash flow,
which is used in managerial decision-making, and free cash flow, which is
closely monitored by participants in the capital market.

Depreciation is the portion of the costs of fixed assets charged against

annual revenues over time.

Depreciation for tax purposes is determined by using the modified

accelerated cost recovery system (MACRS).

On the other hand, a variety of other depreciation methods are often used for
reporting purposes.

Under the basic MACRS procedures, the depreciable value of an asset is its
full cost, including outlays for installation.

No adjustment is required for expected salvage value.

For tax purposes, the depreciable life of an asset is determined by its MACRS
recovery predetermined period.

The statement of cash flows summarizes the firms cash flow over a given
period of time.

Firms cash flows fall into three categories:

Operating flows: cash flows directly related to sale and production of

the firms products and services.

Investment flows: cash flows associated with purchase and sale of

both fixed assets and equity investments in other firms.

Financing flows: cash flows that result from debt and equity
financing transactions; include incurrence and repayment of debt, cash
inflow from the sale of stock, and cash outflows to repurchase stock or
pay cash dividends.

Interpreting Statement of Cash Flows

The statement of cash flows ties the balance sheet at the beginning of the
period with the balance sheet at the end of the period after considering the
performance of the firm during the period through the income statement.

The net increase (or decrease) in cash and marketable securities should be
equivalent to the difference between the cash and marketable securities on
the balance sheet at the beginning of the year and the end of the year.

A firms operating Cash Flow (OCF) is the cash flow

a firm generates from normal operationsfrom the production and sale of its
goods and services.

OCF may be calculated as follows:

Free cash Flow

Free cash flow (FCF) is the amount of cash flow available to investors
(creditors and owners) after the firm has met all operating needs and paid for
investments in net fixed assets (NFAI) and net current assets (NCAI).


The Financial Planning Process

The financial planning process begins with long-term, or strategic, financial

plans that in turn guide the formulation of short-term, or operating, plans and

Two key aspects of financial planning are cash planning and profit planning.

Cash planning involves the preparation of the firms cash budget.

Profit planning involves preparation of pro forma statements.

The Financial Planning Process:

Long-Term (Strategic) Financial Plans

Long-term (strategic) financial plans lay out a companys planned financial

actions and the anticipated impact of those actions over periods ranging from
2 to 10 years.

Firms that are subject to high degrees of operating uncertainty, relatively

short production cycles, or both, tend to use shorter planning horizons.

These plans are one component of a companys integrated strategic plan

(along with production and marketing plans) that guide a company toward
achievement of its goals.

Long-term financial plans consider a number of financial activities including:

Proposed fixed asset investments

Research and development activities

Marketing and product development

Capital structure

Sources of financing

These plans are generally supported by a series of annual budgets and profit

The Financial Planning Process:

Short-Term (Operating) Financial Plans

Short-term (operating) financial plans specify short-term financial actions

and the anticipated impact of those actions.

Key inputs include the sales forecast and other operating and financial data.

Key outputs include operating budgets, the cash budget, and pro forma
financial statements.

Cash Planning: Cash Budgets

The cash budget or cash forecast is a statement of the firms planned

inflows and outflows of cash that is used to estimate its short-term cash

Typically, the cash budget is designed to cover a 1-year period, divided into
smaller time intervals.

The more seasonal and uncertain a firms cash flows, the greater the number
of intervals.

A sales forecast is a prediction of the sales activity during a given period,

based on external and/or internal data.

The sales forecast is then used as a basis for estimating the monthly cash
flows that will result from projected sales and from outlays related to
production, inventory, and sales.

The sales forecast may be based on an analysis of external data, internal

data, or a combination of the two.

An external forecast is a sales forecast based on the relationships observed

between the firms sales and certain key external economic indicators.

An internal forecast is a sales forecast based on a buildup, or consensus, of

sales forecasts through the firms own sales channels.

Profit Planning:
Pro Forma Statements

Pro forma financial statements are projected, or forecast, income

statements and balance sheets.

The inputs required to develop pro forma statements using the most common
approaches include:

Financial statements from the preceding year

The sales forecast for the coming year

Key assumptions about a number of factors

The development of pro forma financial statements will be demonstrated

using the financial statements for Vectra Manufacturing.

A simple method for developing a pro forma income statement is the

percent-of-sales method.

This method starts with the sales forecast and then expresses the cost
of goods sold, operating expenses, interest expense, and other
accounts as a percentage of projected sales.

Clearly, some of the firms expenses will increase with the level of
sales while others will not.

the use of past cost and expense ratios generally tends to understate
profits when sales are increasing. (Likewise, it tends to overstate
profits when sales are decreasing.)

The best way to generate a more realistic pro forma income statement
is to segment the firms expenses into fixed and variable components,
as illustrated in the following example.

The judgmental approach is a simplified approach for preparing the

pro forma balance sheet under which the firm estimates the values of
certain balance sheet accounts and uses its external financing as a
balancing, or plug, figure.

Evaluation of Pro Forma Statements

The major weaknesses of the approaches to pro forma statement

development outlined above lie in two assumptions:

That the firms past financial performance will be replicated in the


That certain variables (such as cash, accounts receivable, and

inventories) can be forced to take on certain desired values.

These assumptions cannot be justified solely on the basis of their ability to

simplify the calculations involved.
However pro forma statements are prepared, analysts must understand how
to use them to make financial decisions.

Financial managers and lenders can use pro forma statements to

analyze the firms inflows and outflows of cash, as well as its liquidity,
activity, debt, profitability, and market value.

Various ratios can be calculated from the pro forma income statement
and balance sheet to evaluate performance.

Cash inflows and outflows can be evaluated by preparing a pro forma

statement of cash flows.

After analyzing the pro forma statements, the financial manager can
take steps to adjust planned operations to achieve short-term financial

Chapter 5
The Role of Time Value in Finance

Most financial decisions involve costs & benefits that are spread out over

Time value of money allows comparison of cash flows from different periods.

The answer depends on what rate of interest you could earn on any money
you receive today.

For example, if you could deposit the $1,000 today at 12% per year, you
would prefer to be paid today.

Alternatively, if you could only earn 5% on deposited funds, you would be

better off if you chose the $1,100 in one year.

The cash inflows and outflows of a firm can be described by its general

The three basic patterns include a single amount, an annuity, or a mixed


Future Value of a Single Amount

Future value is the value at a given future date of an amount placed on

deposit today and earning interest at a specified rate. Found by applying
compound interest over a specified period of time.

Compound interest is interest that is earned on a given deposit and has

become part of the principal at the end of a specified period.

Principal is the amount of money on which interest is paid.

We use the following notation for the various inputs:

FVn = future value at the end of period n

PV = initial principal, or present value

r = annual rate of interest paid. (Note: On financial calculators, I is

typically used to represent this rate.)

n = number of periods (typically years) that the money is left on


The general equation for the future value at the end of period n is

FVn = PV (1 + r)n
Present Value of a Single Amount

Present value is the current dollar value of a future amountthe amount of

money that would have to be invested today at a given interest rate over a
specified period to equal the future amount.

It is based on the idea that a dollar today is worth more than a dollar

Discounting cash flows is the process of finding present values; the inverse
of compounding interest.

The discount rate is often also referred to as the opportunity cost, the
discount rate, the required return, or the cost of capital.

The present value, PV, of some future amount, FVn, to be received n periods
from now, assuming an interest rate (or opportunity cost) of r, is calculated as

An annuity is a stream of equal periodic cash flows, over a specified time period.
These cash flows can be inflows of returns earned on investments or outflows of
funds invested to earn future returns.

An ordinary (deferred) annuity is an annuity for which the cash flow

occurs at the end of each period

An annuity due is an annuity for which the cash flow occurs at the
beginning of each period.

An annuity due will always be greater than an otherwise equivalent

ordinary annuity because interest will compound for an additional

Finding the Future Value of an Ordinary Annuity

You can calculate the future value of an ordinary annuity that pays an annual
cash flow equal to CF by using the following equation:

As before, in this equation r represents the interest rate and n represents the
number of payments in the annuity (or equivalently, the number of years
over which the annuity is spread).

Finding the Present Value of an Ordinary Annuity

You can calculate the present value of an ordinary annuity that pays an
annual cash flow equal to CF by using the following equation:

As before, in this equation r represents the interest rate and n represents the
number of payments in the annuity (or equivalently, the number of years
over which the annuity is spread).

Finding the Future Value of an Annuity Due

You can calculate the present value of an annuity due that pays an annual
cash flow equal to CF by using the following equation:

As before, in this equation r represents the interest rate and n represents the
number of payments in the annuity (or equivalently, the number of years
over which the annuity is spread).

Finding the Present Value of an Annuity Due

You can calculate the present value of an ordinary annuity that pays an
annual cash flow equal to CF by using the following equation:

As before, in this equation r represents the interest rate and n represents the
number of payments in the annuity (or equivalently, the number of years
over which the annuity is spread).

Finding the Present Value of a Perpetuity

A perpetuity is an annuity with an infinite life, providing continual annual

cash flow.

If a perpetuity pays an annual cash flow of CF, starting one year from now,
the present value of the cash flow stream is

Future Value of a Mixed Stream

If the firm expects to earn at least 8% on its investments, how much will it
accumulate by the end of year 5 if it immediately invests these cash flows when
they are received?
This situation is depicted on the following time line.

Present Value of a Mixed Stream

If the firm must earn at least 9% on its investments, what is the most it should pay
for this opportunity?
This situation is depicted on the following time line.

Compounding Interest More Frequently Than Annually

Compounding more frequently than once a year results in a higher effective

interest rate because you are earning on interest on interest more frequently.

As a result, the effective interest rate is greater than the nominal (annual)
interest rate.

Furthermore, the effective rate of interest will increase the more frequently
interest is compounded.

A general equation for compounding more frequently than annually

Nominal and Effective Annual Rates of Interest

The nominal (stated) annual rate is the contractual annual rate of interest
charged by a lender or promised by a borrower.

The effective (true) annual rate (EAR) is the annual rate of interest
actually paid or earned.

In general, the effective rate > nominal rate whenever compounding occurs
more than once per year

Special Applications of Time Value: Deposits Needed to Accumulate a

Future Sum

The following equation calculates the annual cash payment (CF) that wed have to
save to achieve a future value (FVn):

Special Applications of Time Value: Loan Amortization

Loan amortization is the determination of the equal periodic loan payments

necessary to provide a lender with a specified interest return and to repay the
loan principal over a specified period.

The loan amortization process involves finding the future payments, over the
term of the loan, whose present value at the loan interest rate equals the
amount of initial principal borrowed.

A loan amortization schedule is a schedule of equal payments to repay a

loan. It shows the allocation of each loan payment to interest and principal.

The following equation calculates the equal periodic loan payments (CF)
necessary to provide a lender with a specified interest return and to repay the
loan principal (PV) over a specified period:

It is often necessary to calculate the compound annual interest or growth rate

(that is, the annual rate of change in values) of a series of cash flows.

The following equation is used to find the interest rate (or growth rate)
representing the increase in value of some investment between two time

Chapter 8
Risk and Return Fundamentals

In most important business decisions there are two key financial

considerations: risk and return.

Each financial decision presents certain risk and return characteristics, and
the combination of these characteristics can increase or decrease a firms
share price.

Analysts use different methods to quantify risk depending on whether they

are looking at a single asset or a portfolioa collection, or group, of assets.

Risk is a measure of the uncertainty surrounding the return that an

investment will earn or, more formally, the variability of returns associated
with a given asset.

Return is the total gain or loss experienced on an investment over a given

period of time; calculated by dividing the assets cash distributions during the
period, plus change in value, by its beginning-of-period investment value.

The expression for calculating the total rate of return earned on any asset
over period t, rt, is commonly defined as


actual, expected, or required rate of return during period t


cash (flow) received from the asset investment in the time period t 1 to t


price (value) of asset at time t (ending value)

Pt 1

price (value) of asset at time t 1 ( beg. Value)

Risk Preferences

Economists use three categories to describe how investors respond to risk.

Risk averse is the attitude toward risk in which investors would

require an increased return as compensation for an increase in risk.

Risk neutral is the attitude toward risk in which investors choose the
investment with the higher return regardless of its risk.

Risk seeking is the attitude toward risk in which investors prefer

investments with greater risk even if they have lower expected returns.

Risk of a Single Asset:

Risk Assessment

Scenario analysis is an approach for assessing risk that uses several

possible alternative outcomes (scenarios) to obtain a sense of the variability
among returns.

One common method involves considering pessimistic (worst), most

likely (expected), and optimistic (best) outcomes and the returns
associated with them for a given asset.

Range is a measure of an assets risk, which is found by subtracting the

return associated with the pessimistic (worst) outcome from the return
associated with the optimistic (best) outcome.

Probability is the chance that a given outcome will occur.

A probability distribution is a model that relates probabilities to the

associated outcomes.

A bar chart is the simplest type of probability distribution; shows only a

limited number of outcomes and associated probabilities for a given event.

A continuous probability distribution is a probability distribution showing

all the possible outcomes and associated probabilities for a given event.

Beware of the Black Swan

Is it ever possible to know for sure that a particular outcome can never
happen, that the chance of it occurring is 0%?

In the 2007 best seller, The Black Swan: The Impact of the Highly
Improbable, Nassim Nicholas Taleb argues that seemingly improbable
or even impossible events are more likely to occur than most people
believe, especially in the area of finance.

The books title refers to the fact that for many years, people believed
that all swans were white until a black variety was discovered in

Taleb reportedly earned a large fortune during the 20072008 financial crisis by
betting that financial markets would plummet

Risk Measurement

Standard deviation ( r) is the most common statistical indicator of an

assets risk; it measures the dispersion around the expected value.

Expected value of a return (r) is the average return that an investment is

expected to produce over time.


return for the jth outcome


probability of occurrence of the jth outcome

number of outcomes considered

The expression for the standard deviation of returns, r, is

In general, the higher the standard deviation, the greater the risk

Norman Companys past estimates indicate that the probabilities of the pessimistic,
most likely, and optimistic outcomes are 25%, 50%, and 25%, respectively. Note
that the sum of these probabilities must equal 100%; that is, they must be based on
all the alternatives considered

Table 8.4 The Calculation of the Standard Deviation of the Returns for
Assets A and B (Cont).

Matter of fact
All Stocks Are Not Created Equal

Stocks are riskier than bonds, but are some stocks riskier than others?

A recent study examined the historical returns of large stocks and

small stocks and found that the average annual return on large stocks
from 1926-2011 was 9.8%, while small stocks earned 11.9% per year
on average.

The higher returns on small stocks came with a cost, however.

The standard deviation of small stock returns was a whopping 32.8%,

whereas the standard deviation on large stocks was just 20.5%.

Coefficient of Variation

The coefficient of variation, CV, is a measure of relative dispersion that is

useful in comparing the risks of assets with differing expected returns.

A higher coefficient of variation means that an investment has more volatility

relative to its expected return.

Risk of a Portfolio

In real-world situations, the risk of any single investment would not be viewed
independently of other assets.

New investments must be considered in light of their impact on the risk and
return of an investors portfolio of assets.

The financial managers goal is to create an efficient portfolio, a portfolio

that maximum return for a given level of risk.

Risk of a Portfolio: Portfolio Return and Standard Deviation

The return on a portfolio is a weighted average of the returns on the individual

assets from which it is formed.


proportion of the portfolios total dollar value represented by asset j


return on asset j

Risk of a Portfolio: Correlation

Correlation is a statistical measure of the relationship between any two

series of numbers.

Positively correlated describes two series that move in the same


Negatively correlated describes two series that move in opposite


The correlation coefficient is a measure of the degree of correlation

between two series.

Perfectly positively correlated describes two positively correlated

series that have a correlation coefficient of +1.

Perfectly negatively correlated describes two negatively correlated

series that have a correlation coefficient of 1.

To reduce overall risk, it is best to diversify by combining, or adding to the

portfolio, assets that have the lowest possible correlation.

Combining assets that have a low correlation with each other can reduce the
overall variability of a portfolios returns.

Uncorrelated describes two series that lack any interaction and therefore
have a correlation coefficient close to zero.

International Diversification

The inclusion of assets from countries with business cycles that are not highly
correlated with the U.S. business cycle reduces the portfolios responsiveness
to market movements.

Over long periods, internationally diversified portfolios tend to perform better

(meaning that they earn higher returns relative to the risks taken) than purely
domestic portfolios.

However, over shorter periods such as a year or two, internationally

diversified portfolios may perform better or worse than domestic portfolios.

Currency risk and political risk are unique to international investing.