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Chapter One - Introduction To Corporate Finance

Corporate finance is the study of a business's money-related decisions, which are essentially all of a business's decisions. Despite its name, corporate finance applies to all businesses, not just corporations. The primary goal of corporate finance is to figure out how to maximize a company's value by making good decisions aboutinvestment, financing and dividends. In other words, how should businesses allocate scarce resources to minimize expenses and maximize revenues? How should companies acquire these resources - through stock or bonds, owner capital or bank loans? Finally, what should a company do with its profits? How much should it reinvest into the company, and how much should it pay out to the business's owners? This walkthrough will explore each of these business decisions in greater depth.

Chapter One - Forms Of Business Organization


A business can be organized in one of several ways, and the form its owners choose will affect the company's and owners' legal liability and income tax treatment. Here are the most common options and their major defining characteristics. Sole Proprietorship The default option is to be a sole proprietor. With this option there are fewer forms to file than with other business organizations. The business is structured in such a manner that legal documents are not required to determine how profit-sharing from business operations will be allocated. This structure is acceptable if you are the business's sole owner and you do not need to distinguish the business from yourself. Being a sole proprietor does not preclude you from using a business name that is different from your own name, however. In a sole proprietorship all profits, losses, assets and liabilities are the direct and sole responsibility of the owner. Also, the sole proprietor will pay selfemployment tax on his or her income. Sole proprietorships are not ideal for high-risk businesses because they put your personal assets at risk. If you are taking on significant amounts of debt to start your business, if you've gotten into trouble with personal debt in the past or if your business involves an activity for which you might potentially be sued, then you should choose a legal structure that will better protect your personal assets. Nolo, a company whose educational books make legal information accessible to the average person, gives several examples of risky businesses, including businesses that involve child care, animal care, manufacturing or selling edible goods, repairing items of value, and providing alcohol. These are just a few examples. There are many other activities that can make your business high risk. If the risks in your line of work are not very high, a good business insurance policy can provide protection and peace of mind while allowing you to remain a sole proprietor. One of the biggest advantages of a sole proprietorship is the ease with which business decisions can be made. LLC An LLC is a limited liability company. This business structure protects the owner's personal assets from financial liability and provides some protection against personal liability. There are situations where an LLC owner can still be held personally responsible, such as if he intentionally does something fraudulent, reckless or illegal, or if she fails to adequately separate the activities of the LLC from her personal affairs. This structure is established under state law, so the rules governing LLCs vary depending on where your business is located. According to the IRS, most states do not allow banks, insurance companies or nonprofit organizations to be LLCs. Because an LLC is a state structure, there are no special federal tax forms for LLCs. An LLC must elect to be taxed as an individual, partnership or corporation. You will need to file paperwork with the state if you want to adopt this business structure, and you will need to pay fees that usually range from $100 to $800. In some states, there is an additional annual fee for being an LLC.

You will also need to name your LLC and file some simple documents, called articles of organization, with your state. Depending on your state's laws and your business's needs, you may also need to create an LLC operating agreement that spells out each owner's percentage interest in the business, responsibilities and voting power, as well as how profits and losses will be shared and what happens if an owner wants to sell her interest in the business. You may also have to publish a notice in your local newspaper stating that you are forming an LLC. Corporation Like the LLC, the corporate structure distinguishes the business entity from its owner and can reduce liability. However, it is considered more complicated to run a corporation because of tax, accounting, record keeping and paperwork requirements. Unless you want to have shareholders or your potential clients will only do business with a corporation, it may not be logical to establish your business as a corporation from the start - an LLC may be a better choice. The steps for establishing a corporation are very similar to the steps for establishing an LLC. You will need to choose a business name, appoint directors, file articles of incorporation, pay filing fees and follow any other specific state/national requirements. (Find out how becoming a corporation can protect and further your finances. SeeShould You Incorporate Your Business?) There are two types of corporations: C corporations (C corps) and S corporations (S corps). C corporations are considered separate tax-paying entities. C corps file their own income tax returns, and income earned remains in the corporation until it is paid as a salary or wages to the corporation's officers and employees. Corporate income is often taxed at lower rates than personal income, so you can save money on taxes by leaving money in the corporation. If you're only making enough to get by, however, this won't help you because you'll need to pay almost all of the corporation's earnings to yourself. If the corporation has shareholders, corporate earnings become subject to double taxation in the sense that income earned by the corporation is taxed and dividends distributed to shareholders are also taxed. However, if you are a one-person corporation, you don't have to worry about double taxation. S corporations are pass-through entities, meaning that their income, losses, deductions and credits pass through the company and become the direct responsibility of the company's shareholders. The shareholders report these items on their personal income tax returns, thus S corps avoid the income double taxation that is associated with C corps. All shareholders must sign IRS form 2553 to make the business an S corp for tax purposes. The IRS also requires S corps to meet the following requirements: Be a domestic corporation Have only allowable shareholders, including individuals, certain trusts and estates Not include partnerships, corporations or non-resident alien shareholders Have no more than 100 shareholders Have one class of stock Not be an ineligible corporation (i.e., certain financial institutions, insurance companies and domestic international sales corporations)

General Partnerships, Limited Partnerships (LP) and Limited Liability Partnerships (LLP) A partnership is a structure appropriate to use if you are not going to be the sole owner of your new business. In a general partnership, all partners are personally liable for business debts, any partner can be held totally responsible for the business and any partner can make decisions that affect the whole business. In a limited partnership, one partner is responsible for decision-making and can be held personally liable for business debts. The other partner merely invests in the business. Although the general

structure of limited partnerships can vary, each individual is liable only to the extent of their invested capital. LLPs are most commonly used by professionals such as doctors and lawyers. The LLP structure protects each partner's personal assets and each partner from debts or liability incurred by the other partners. Different states have varying regulations regarding these establishments of which business owners must take note. Partnerships must file information returns with the IRS, but they do not file separate tax returns. For tax purposes, the partnership's profits or losses pass through to its owners, so a partnership's income is taxed at the individual level. LPs and LLPs are also state entities and must file paperwork and pay fees similar to those involved in establishing an LLC. Regardless of the way a business is structured, its owners will have the same overarching goals when it comes to the company's financial management.

Chapter One - Goals Of Financial Management


All businesses aim to maximize their profits, minimize their expenses and maximize their market share. Here is a look at each of these goals.

Maximize Profits A company's most important goal is to make money and keep it. Profit-margin ratios are one way to measure how much money a company squeezes from its total revenue or total sales. There are three key profit-margin ratios: gross profit margin, operating profit margin and net profit margin. 1. Gross Profit Margin The gross profit margin tells us the profit a company makes on its cost of sales or cost of goods sold. In other words, it indicates how efficiently management uses labor and supplies in the production process.

Gross Profit Margin = (Sales - Cost of Goods Sold)/Sales


Suppose that a company has $1 million in sales and the cost of its labor and materials amounts to $600,000. Its gross margin rate would be 40% ($1 million - $600,000/$1 million). The gross profit margin is used to analyze how efficiently a company is using its raw materials, labor and manufacturing-related fixed assets to generate profits. A higher margin percentage is a favorable profit indicator. Gross profit margins can vary drastically from business to business and from industry to industry. For instance, the airline industry has a gross margin of about 5%, while the software industry has a gross margin of about 90%. 2. Operating Profit Margin By comparing earnings before interest and taxes (EBIT) to sales, operating profit margins show how successful a company's management has been at generating income from the operation of the business:

Operating Profit Margin = EBIT/Sales


If EBIT amounted to $200,000 and sales equaled $1 million, the operating profit margin would be 20%.

This ratio is a rough measure of the operating leverage a company can achieve in the conduct of the operational part of its business. It indicates how much EBIT is generated per dollar of sales. High operating profits can mean the company has effective control of costs, or that sales are increasing faster than operating costs. Positive and negative trends in this ratio are, for the most part, directly attributable to management decisions. Because the operating profit margin accounts for not only costs of materials and labor, but also administration and selling costs, it should be a much smaller figure than the gross margin. 3. Net Profit Margin Net profit margins are those generated from all phases of a business, including taxes. In other words, this ratio compares net income with sales. It comes as close as possible to summing up in a single figure how effectively managers run the business:

Net Profit Margins = Net Profits after Taxes/Sales


If a company generates after-tax earnings of $100,000 on its $1 million of sales, then its net margin amounts to 10%. Often referred to simply as a company's profit margin, the so-called bottom line is the most often mentioned when discussing a company's profitability. Again, just like gross and operating profit margins, net margins vary between industries. By comparing a company's gross and net margins, we can get a good sense of its non-production and non-direct costs like administration, finance and marketing costs. For example, the international airline industry has a gross margin of just 5%. Its net margin is just a tad lower, at about 4%. On the other hand, discount airline companies have much higher gross and net margin numbers. These differences provide some insight into these industries' distinct cost structures: compared to its bigger, international cousins, the discount airline industry spends proportionately more on things like finance, administration and marketing, and proportionately less on items such as fuel and flight crew salaries. In the software business, gross margins are very high, while net profit margins are considerably lower. This shows that marketing and administration costs in this industry are very high, while cost of sales and operating costs are relatively low. When a company has a high profit margin, it usually means that it also has one or more advantages over its competition. Companies with high net profit margins have a bigger cushion to protect themselves during the hard times. Companies with low profit margins can get wiped out in a downturn. And companies with profit margins reflecting a competitive advantage are able to improve their market share during the hard times, leaving them even better positioned when things improve again. Like all ratios, margin ratios never offer perfect information. They are only as good as the timeliness and accuracy of the financial data that gets fed into them, and analyzing them also depends on a consideration of the company's industry and its position in the business cycle. Margins tell us a lot about a company's prospects, but not the whole story. Minimize Costs Companies use cost controls to manage and/or reduce their business expenses. By identifying and evaluating all of the business's expenses, management can determine whether those costs are reasonable and affordable. Then, if necessary, they can look for ways to reduce costs through methods such as cutting back, moving to a less expensive plan or changing service providers. The cost-control process seeks to manage expenses ranging from phone, internet and utility bills to employee payroll and outside professional services.

To be profitable, companies must not only earn revenues, but also control costs. If costs are too high, profit margins will be too low, making it difficult for a company to succeed against its competitors. In the case of a public company, if costs are too high, the company may find that its share price is depressed and that it is difficult to attract investors. When examining whether costs are reasonable or unreasonable, it's important to consider industry standards. Many firms examine their costs during the drafting of their annual budgets. Maximize Market Share Market share is calculated by taking a company's sales over a given period and dividing it by the total sales of its industry over the same period. This metric provides a general idea of a company's size relative to its market and its competitors. Companies are always looking to expand their share of the market, in addition to trying to grow the size of the total market by appealing to larger demographics, lowering prices or through advertising. Market share increases can allow a company to achieve greater scale in its operations and improve profitability. The size of a market is always in flux, but the rate of change depends on whether the market is growing or mature. Market share increases and decreases can be a sign of the relative competitiveness of the company's products or services. As the total market for a product or service grows, a company that is maintaining its market share is growing revenues at the same rate as the total market. A company that is growing its market share will be growing its revenues faster than its competitors. Technology companies often operate in a growth market, while consumer goods companies generally operate in a mature market. New companies that are starting from scratch can experience fast gains in market share. Once a company achieves a large market share, however, it will have a more difficult time growing its sales because there aren't as many potential customers available.

Chapter One - The Agency Problem


An agency relationship occurs when a principal hires an agent to perform some duty. A conflict, known as an "agency problem," arises when there is a conflict of interest between the needs of the principal and the needs of the agent. In finance, there are two primary agency relationships: Managers and stockholders Managers and creditors

1. Stockholders versus Managers If the manager owns less than 100% of the firm's common stock, a potential agency problem between mangers and stockholders exists. Managers may make decisions that conflict with the best interests of the shareholders. For example, managers may grow their firms to escape a takeover attempt to increase their own job security. However, a takeover may be in the shareholders' best interest.

2. Stockholders versus Creditors Creditors decide to loan money to a corporation based on the riskiness of the company, its capital structure and its potential capital structure. All of these factors will affect the company's potential cash flow, which is a creditors' main concern. Stockholders, however, have control of such decisions through the managers. Since stockholders will make decisions based on their best interests, a potential agency problem exists between the stockholders and creditors. For example, managers could borrow money to repurchase shares to lower the corporation's share base and increase shareholder

return. Stockholders will benefit; however, creditors will be concerned given the increase in debt that would affect future cash flows. Motivating Managers to Act in Shareholders' Best Interests There are four primary mechanisms for motivating managers to act in stockholders' best interests: Managerial compensation Direct intervention by stockholders Threat of firing Threat of takeovers

1. Managerial Compensation Managerial compensation should be constructed not only to retain competent managers, but to align managers' interests with those of stockholders as much as possible. This is typically done with an annual salary plus performance bonuses and company shares. Company shares are typically distributed to managers either as: o Performance shares, where managers will receive a certain number shares based on the company's performance o Executive stock options, which allow the manager to purchase shares at a future date and price. With the use of stock options, managers are aligned closer to the interest of the stockholders as they themselves will be stockholders.

2. Direct Intervention by Stockholders Today, the majority of a company's stock is owned by large institutional investors, such as mutual funds and pensions. As such, these large institutional stockholders can exert influence on mangers and, as a result, the firm's operations. 3. Threat of Firing If stockholders are unhappy with current management, they can encourage the existing board of directors to change the existing management, or stockholders may re-elect a new board of directors that will accomplish the task. 4. Threat of Takeovers If a stock price deteriorates because of management's inability to run the company effectively, competitors or stockholders may take a controlling interest in the company and bring in their own managers.

Chapter One - Types Of Financial Institutions And Their Roles


A financial institution is an establishment that conducts financial transactions such as investments, loans and deposits. Almost everyone deals with financial institutions on a regular basis. Everything from depositing money to taking out loans and exchanging currencies must be done through financial institutions. Here is an overview of some of the major categories of financial institutions and their roles in the financial system. Commercial Banks Commercial banks accept deposits and provide security and convenience to their customers. Part of the original purpose of banks was to offer customers safe keeping for their money. By keeping physical cash at home or in a wallet, there are risks of loss due to theft and accidents, not to mention the loss of possible income from interest. With banks, consumers no longer need to keep large amounts of currency on hand; transactions can be handled with checks, debit cards or credit cards, instead. Commercial banks also make loans that individuals and businesses use to buy goods or expand business operations, which in turn leads to more deposited funds that make their way to banks. If

banks can lend money at a higher interest rate than they have to pay for funds and operating costs, they make money. Banks also serve often under-appreciated roles as payment agents within a country and between nations. Not only do banks issues debit cards that allow account holders to pay for goods with the swipe of a card, they can also arrange wire transfers with other institutions. Banks essentially underwrite financial transactions by lending their reputation and credibility to the transaction; a check is basically just a promissory note between two people, but without a bank's name and information on that note, no merchant would accept it. As payment agents, banks make commercial transactions much more convenient; it is not necessary to carry around large amounts of physical currency when merchants will accept the checks, debit cards or credit cards that banks provide. Investment Banks The stock market crash of 1929 and ensuing Great Depression caused the United States government to increase financial market regulation. The Glass-Steagall Act of 1933 resulted in the separation of investment banking from commercial banking. While investment banks may be called "banks," their operations are far different than depositgathering commercial banks. An investment bank is a financial intermediary that performs a variety of services for businesses and some governments. These services include underwriting debt and equity offerings, acting as an intermediary between an issuer of securities and the investing public, making markets, facilitating mergers and other corporate reorganizations, and acting as a broker for institutional clients. They may also provide research and financial advisory services to companies. As a general rule, investment banks focus on initial public offerings (IPOs) and large public and private share offerings. Traditionally, investment banks do not deal with the general public. However, some of the big names in investment banking, such as JP Morgan Chase, Bank of America and Citigroup, also operate commercial banks. Other past and present investment banks you may have heard of include Morgan Stanley, Goldman Sachs, Lehman Brothers and First Boston. Generally speaking, investment banks are subject to less regulation than commercial banks. While investment banks operate under the supervision of regulatory bodies, like the Securities and Exchange Commission, FINRA, and the U.S. Treasury, there are typically fewer restrictions when it comes to maintaining capital ratios or introducing new products. Insurance Companies Insurance companies pool risk by collecting premiums from a large group of people who want to protect themselves and/or their loved ones against a particular loss, such as a fire, car accident, illness, lawsuit, disability or death. Insurance helps individuals and companies manage risk and preserve wealth. By insuring a large number of people, insurance companies can operate profitably and at the same time pay for claims that may arise. Insurance companies use statistical analysis to project what their actual losses will be within a given class. They know that not all insured individuals will suffer losses at the same time or at all. Brokerages A brokerage acts as an intermediary between buyers and sellers to facilitate securities transactions. Brokerage companies are compensated via commission after the transaction has been successfully completed. For example, when a trade order for a stock is carried out, an individual often pays a transaction fee for the brokerage company's efforts to execute the trade. A brokerage can be either full service or discount. A full service brokerage provides investment advice, portfolio management and trade execution. In exchange for this high level of service, customers pay significant commissions on each trade. Discount brokers allow investors to perform their own investment research and make their own decisions. The brokerage still executes the investor's trades, but since it doesn't provide the other services of a full-service brokerage, its trade commissions are much smaller. Investment Companies

An investment company is a corporation or a trust through which individuals invest in diversified, professionally managed portfolios of securities by pooling their funds with those of other investors. Rather than purchasing combinations of individual stocks and bonds for a portfolio, an investor can purchase securities indirectly through a package product like a mutual fund. There are three fundamental types of investment companies: unit investment trusts (UITs), face amount certificate companies and managed investment companies. All three types have the following things in common: An undivided interest in the fund proportional to the number of shares held Diversification in a large number of securities Professional management Specific investment objectives

Let's take a closer look at each type of investment company. Unit Investment Trusts (UITs) A unit investment trust, or UIT, is a company established under an indenture or similar agreement. It has the following characteristics: The management of the trust is supervised by a trustee. Unit investment trusts sell a fixed number of shares to unit holders, who receive a proportionate share of net income from the underlying trust. The UIT security is redeemable and represents an undivided interest in a specific portfolio of securities. The portfolio is merely supervised, not managed, as it remains fixed for the life of the trust. In other words, there is no day-to-day management of the portfolio.

Face Amount Certificates A face amount certificate company issues debt certificates at a predetermined rate of interest. Additional characteristics include: Certificate holders may redeem their certificates for a fixed amount on a specified date, or for a specific surrender value, before maturity. Certificates can be purchased either in periodic installments or all at once with a lump-sum payment. Face amount certificate companies are almost nonexistent today.

Management Investment Companies The most common type of investment company is the management investment company, which actively manages a portfolio of securities to achieve its investment objective. There are two types of management investment company: closed-end and open-end. The primary differences between the two come down to where investors buy and sell their shares - in the primary or secondary markets and the type of securities the investment company sells. Closed-End Investment Companies: A closed-end investment company issues shares in a one-time public offering. It does not continually offer new shares, nor does it redeem its shares like an open-end investment company. Once shares are issued, an investor may purchase them on the open market and sell them in the same way. The market value of the closed-end fund's shares will be based on supply and demand, much like other securities. Instead of selling at net asset value, the shares can sell at a premium or at a discount to the net asset value. Open-End Investment Companies: Open-end investment companies, also known as mutual funds, continuously issue new shares. These shares may only be purchased from the investment company and sold back to the investment company. Mutual funds are discussed in more detail in the Variable Contracts section.

Nonbank Financial Institutions The following institutions are not technically banks but provide some of the same services as banks. Savings and Loans Savings and loan associations, also known as S&Ls or thrifts, resemble banks in many respects. Most consumers don't know the differences between commercial banks and S&Ls. By law, savings and loan companies must have 65% or more of their lending in residential mortgages, though other types of lending is allowed. S&Ls emerged largely in response to the exclusivity of commercial banks. There was a time when banks would only accept deposits from people of relatively high wealth, with references, and would not lend to ordinary workers. Savings and loans typically offered lower borrowing rates than commercial banks and higher interest rates on deposits; the narrower profit margin was a byproduct of the fact that such S&Ls were privately or mutually owned. Credit Unions Credit unions are another alternative to regular commercial banks. Credit unions are almost always organized as not-for-profit cooperatives. Like banks and S&Ls, credit unions can be chartered at the federal or state level. Like S&Ls, credit unions typically offer higher rates on deposits and charge lower rates on loans in comparison to commercial banks. In exchange for a little added freedom, there is one particular restriction on credit unions; membership is not open to the public, but rather restricted to a particular membership group. In the past, this has meant that employees of certain companies, members of certain churches, and so on, were the only ones allowed to join a credit union. In recent years, though, these restrictions have been eased considerably, very much over the objections of banks. Shadow Banks The housing bubble and subsequent credit crisis brought attention to what is commonly called "the shadow banking system." This is a collection of investment banks, hedge funds, insurers and other non-bank financial institutions that replicate some of the activities of regulated banks, but do not operate in the same regulatory environment. The shadow banking system funneled a great deal of money into the U.S. residential mortgage market during the bubble. Insurance companies would buy mortgage bonds from investment banks, which would then use the proceeds to buy more mortgages, so that they could issue more mortgage bonds. The banks would use the money obtained from selling mortgages to write still more mortgages. Many estimates of the size of the shadow banking system suggest that it had grown to match the size of the traditional U.S. banking system by 2008. Apart from the absence of regulation and reporting requirements, the nature of the operations within the shadow banking system created several problems. Specifically, many of these institutions "borrowed short" to "lend long." In other words, they financed long-term commitments with shortterm debt. This left these institutions very vulnerable to increases in short-term rates and when those rates rose, it forced many institutions to rush to liquidate investments and make margin calls. Moreover, as these institutions were not part of the formal banking system, they did not have access to the same emergency funding facilities. (Learn more in The Rise And Fall Of The Shadow Banking System.)

Chapter One - Types Of Financial Markets And Their Roles


A financial market is a broad term describing any marketplace where buyers and sellers participate in the trade of assets such as equities, bonds, currencies and derivatives. Financial markets are typically defined by having transparent pricing, basic regulations on trading, costs and fees, and market forces determining the prices of securities that trade. Financial markets can be found in nearly every nation in the world. Some are very small, with only a

few participants, while others - like the New York Stock Exchange (NYSE) and the forex markets trade trillions of dollars daily. Investors have access to a large number of financial markets and exchanges representing a vast array of financial products. Some of these markets have always been open to private investors; others remained the exclusive domain of major international banks and financial professionals until the very end of the twentieth century. Capital Markets A capital market is one in which individuals and institutions trade financial securities. Organizations and institutions in the public and private sectors also often sell securities on the capital markets in order to raise funds. Thus, this type of market is composed of both the primary and secondary markets. Any government or corporation requires capital (funds) to finance its operations and to engage in its own long-term investments. To do this, a company raises money through the sale of securities - stocks and bonds in the company's name. These are bought and sold in the capital markets. Stock Markets Stock markets allow investors to buy and sell shares in publicly traded companies. They are one of the most vital areas of a market economy as they provide companies with access to capital and investors with a slice of ownership in the company and the potential of gains based on the company's future performance. This market can be split into two main sections: the primary market and the secondary market. The primary market is where new issues are first offered, with any subsequent trading going on in the secondary market. Bond Markets A bond is a debt investment in which an investor loans money to an entity (corporate or governmental), which borrows the funds for a defined period of time at a fixed interest rate. Bonds are used by companies, municipalities, states and U.S. and foreign governments to finance a variety of projects and activities. Bonds can be bought and sold by investors on credit markets around the world. This market is alternatively referred to as the debt, credit or fixed-income market. It is much larger in nominal terms that the world's stock markets. The main categories of bonds are corporate bonds, municipal bonds, and U.S. Treasury bonds, notes and bills, which are collectively referred to as simply "Treasuries." (For more, see the Bond Basics Tutorial.) Money Market The money market is a segment of the financial market in which financial instruments with high liquidity and very short maturities are traded. The money market is used by participants as a means for borrowing and lending in the short term, from several days to just under a year. Money market securities consist of negotiable certificates of deposit (CDs), banker's acceptances, U.S. Treasury bills, commercial paper, municipal notes, eurodollars, federal funds and repurchase agreements (repos). Money market investments are also called cash investments because of their short maturities. The money market is used by a wide array of participants, from a company raising money by selling commercial paper into the market to an investor purchasing CDs as a safe place to park money in the short term. The money market is typically seen as a safe place to put money due the highly liquid nature of the securities and short maturities. Because they are extremely conservative, money market securities offer significantly lower returns than most other securities. However, there are risks in the money market that any investor needs to be aware of, including the risk of default on securities such as commercial paper. (To learn more, read our Money Market Tutorial.) Cash or Spot Market Investing in the cash or "spot" market is highly sophisticated, with opportunities for both big losses and big gains. In the cash market, goods are sold for cash and are delivered immediately. By the same

token, contracts bought and sold on the spot market are immediately effective. Prices are settled in cash "on the spot" at current market prices. This is notably different from other markets, in which trades are determined at forward prices. The cash market is complex and delicate, and generally not suitable for inexperienced traders. The cash markets tend to be dominated by so-called institutional market players such as hedge funds, limited partnerships and corporate investors. The very nature of the products traded requires access to far-reaching, detailed information and a high level of macroeconomic analysis and trading skills. Derivatives Markets The derivative is named so for a reason: its value is derived from its underlying asset or assets. A derivative is a contract, but in this case the contract price is determined by the market price of the core asset. If that sounds complicated, it's because it is. The derivatives market adds yet another layer of complexity and is therefore not ideal for inexperienced traders looking to speculate. However, it can be used quite effectively as part of a risk management program. (To get to know derivatives, read The Barnyard Basics Of Derivatives.) Examples of common derivatives are forwards, futures, options, swaps and contracts-fordifference (CFDs). Not only are these instruments complex but so too are the strategies deployed by this market's participants. There are also many derivatives, structured products and collateralized obligations available, mainly in the over-the-counter (non-exchange) market, that professional investors, institutions and hedge fund managers use to varying degrees but that play an insignificant role in private investing. Forex and the Interbank Market The interbank market is the financial system and trading of currencies among banks and financial institutions, excluding retail investors and smaller trading parties. While some interbank trading is performed by banks on behalf of large customers, most interbank trading takes place from the banks' own accounts. The forex market is where currencies are traded. The forex market is the largest, most liquid market in the world with an average traded value that exceeds $1.9 trillion per day and includes all of the currencies in the world. The forex is the largest market in the world in terms of the total cash value traded, and any person, firm or country may participate in this market. There is no central marketplace for currency exchange; trade is conducted over the counter. The forex market is open 24 hours a day, five days a week and currencies are traded worldwide among the major financial centers of London, New York, Tokyo, Zrich, Frankfurt, Hong Kong, Singapore, Paris and Sydney. Until recently, forex trading in the currency market had largely been the domain of large financial institutions, corporations, central banks, hedge funds and extremely wealthy individuals. The emergence of the internet has changed all of this, and now it is possible for average investors to buy and sell currencies easily with the click of a mouse through online brokerage accounts. (For further reading, see The Foreign Exchange Interbank Market.) Primary Markets vs. Secondary Markets A primary market issues new securities on an exchange. Companies, governments and other groups obtain financing through debt or equity based securities. Primary markets, also known as "new issue markets," are facilitated by underwriting groups, which consist of investment banks that will set a beginning price range for a given security and then oversee its sale directly to investors. The primary markets are where investors have their first chance to participate in a new security issuance. The issuing company or group receives cash proceeds from the sale, which is then used to fund operations or expand the business. (For more on the primary market, see our IPO Basics Tutorial.)

The secondary market is where investors purchase securities or assets from other investors, rather than from issuing companies themselves. The Securities and Exchange Commission (SEC) registers securities prior to their primary issuance, then they start trading in the secondary market on the New York Stock Exchange, Nasdaq or other venue where the securities have been accepted for listing and trading. (To learn more about the primary and secondary market, read Markets Demystified.) The secondary market is where the bulk of exchange trading occurs each day. Primary markets can see increased volatility over secondary markets because it is difficult to accurately gauge investor demand for a new security until several days of trading have occurred. In the primary market, prices are often set beforehand, whereas in the secondary market only basic forces like supply and demand determine the price of the security. Secondary markets exist for other securities as well, such as when funds, investment banks or entities such as Fannie Mae purchase mortgages from issuing lenders. In any secondary market trade, the cash proceeds go to an investor rather than to the underlying company/entity directly. (To learn more about primary and secondary markets, read A Look at Primary and Secondary Markets.) The OTC Market The over-the-counter (OTC) market is a type of secondary market also referred to as a dealer market. The term "over-the-counter" refers to stocks that are not trading on a stock exchange such as the Nasdaq, NYSE or American Stock Exchange (AMEX). This generally means that the stock trades either on the over-the-counter bulletin board (OTCBB) or the pink sheets. Neither of these networks is an exchange; in fact, they describe themselves as providers of pricing information for securities. OTCBB and pink sheet companies have far fewer regulations to comply with than those that trade shares on a stock exchange. Most securities that trade this way are penny stocks or are from very small companies. Third and Fourth Markets You might also hear the terms "third" and "fourth markets." These don't concern individual investors because they involve significant volumes of shares to be transacted per trade. These markets deal with transactions between broker-dealers and large institutions through over-the-counter electronic networks. The third market comprises OTC transactions between broker-dealers and large institutions. The fourth market is made up of transactions that take place between large institutions. The main reason these third and fourth market transactions occur is to avoid placing these orders through the main exchange, which could greatly affect the price of the security. Because access to the third and fourth markets is limited, their activities have little effect on the average investor. Financial institutions and financial markets help firms raise money. They can do this by taking out a loan from a bank and repaying it with interest, issuing bonds to borrow money from investors that will be repaid at a fixed interest rate, or offering investors partial ownership in the company and a claim on its residual cash flows in the form of stock.

Chapter 2 Financial Statements - Introduction


Financial reporting is the method a firm uses to convey its financial performance to the market, its investors, and other stakeholders. The objective of financial reporting is to provide information on the changes in a firms performance and financial position that can be used to make financial and operating decisions. In addition to being a management aid, this information is used by analysts to forecast the firms ability to produce future earnings and as a means to assess the firms intrinsic value. Other stakeholders, such as creditors, will use financial statements as a way to evaluate the companys economic and competitive strength. The timing and the methodology used to record revenues and expenses may also impact the analysis and comparability of financial statements across companies. Financial statements are prepared in most cases on the basis of three basic premises:

1. The company will continue to operate (going-concern assumptions). 2. Revenues are reported as they are earned within the specified accounting period (revenuesrecognition principle). 3. Expenses should match generated revenues within the specified accounting period (matching principle). Furthermore, financial statements are prepared using one of two basic accounting methods: 1. Cash-basis accounting - This method consists of recognizing revenue (income) and expenses when payments are made (when checks are issued) or when cash is received (and deposited in the bank). 2. Accrual accounting - This method consists of recognizing revenue in the accounting period in which it is earned, that is, when the company provides a product or service to a customer, regardless of when the company gets paid. Expenses are recorded when they are incurred instead of when they are paid for. Financial statements dont fit into a single mold. Many articles and books on financial statement analysis take a one-size-fits-all approach. The less-experienced investor then gets lost when he or she encounters a presentation of accounts that falls outside the so-called "typical" company. Remember that the diverse nature of business activities results in different financial statement presentations. The balance sheet is particularly likely to be presented differently from company to company; the income and cash flow statements are less susceptible to this phenomenon. Knowing how to work with the numbers in a company's financial statements is an essential skill. The meaningful interpretation and analysis of balance sheets, income statements and cash flow statements to discern a company's investment qualities is the basis for smart investment choices.

Financial Statements - The Balance Sheet


The balance sheet provides information on what the company owns (its assets), what it owes (its liabilities) and the value of the business to its stockholders (the shareholders' equity) as of a specific date. It's called a balance sheet because the two sides balance out. This makes sense: a company has to pay for all the things it has (assets) by either borrowing money (liabilities) or getting it from shareholders (shareholders' equity). Assets are economic resources that are expected to produce economic benefits for their owner Liabilities are obligations the company has to outside parties. Liabilities represent others' rights to the company's money or services. Examples include bank loans, debts to suppliers and debts to employees. Shareholders' equity is the value of a business to its owners after all of its obligations have been met. This net worth belongs to the owners. Shareholders' equity generally reflects the amount of capital the owners have invested, plus any profits generated that were subsequently reinvested in the company. The balance sheet must follow the following formula:

Total Assets = Total Liabilities + Shareholders' Equity


Each of the three segments of the balance sheet will have many accounts within it that document the value of each segment. Accounts such as cash, inventory and property are on the asset side of the

balance sheet, while on the liability side there are accounts such as accounts payable or long-term debt. The exact accounts on a balance sheet will differ by company and by industry, as there is no one set template that accurately accommodates the differences between varying types of businesses. A balance sheet looks like this:

Source: http://www.edgar-online.com
Here are the entries youll find on a balance sheet and what each one means. Total Assets Total assets on the balance sheet are composed of the following: Current Assets - These are assets that may be converted into cash, sold or consumed within a year or less. These usually include: Cash - This is what the company has in cash in the bank. Cash is reported at its market value at the reporting date in the respective currency in which the financials are prepared. Different cash denominations are converted at the market conversion rate. Marketable securities (short-term investments) - These can be both equity and/or debt securities for which a ready market exists. Furthermore, management expects to sell these investments within one year's time. These short-term investments are reported at their market value. Accounts receivable - This represents the money that is owed to the company for the goods and services it has provided to customers on credit. Every business has customers that will not pay for the products or services the company has provided. Management must estimate which customers are unlikely to pay and create an account called allowance for doubtful accounts. Variations in this account will impact the reported sales on the income statement. Accounts receivable reported on the balance sheet are net of their realizable value (reduced by allowance for doubtful accounts).

Notes receivable - This account is similar in nature to accounts receivable but it is supported by more formal agreements such as a "promissory notes" (usually a short-term loan that carries interest). Furthermore, the maturity of notes receivable is generally longer than accounts receivable but less than a year. Notes receivable is reported at its net realizable value (the amount that will be collected). Inventory - This represents raw materials and items that are available for sale or are in the process of being made ready for sale. These items can be valued individually by several different means, including at cost or current market value, and collectively by FIFO (first in, first out), LIFO (last in, first out) or average-cost method. Inventory is valued at the lower of the cost or market price to preclude overstating earnings and assets. Prepaid expenses - These are payments that have been made for services that the company expects to receive in the near future. Typical prepaid expenses include rent, insurance premiums and taxes. These expenses are valued at their original (or historical) cost.

Long-Term assets - These are assets that may not be converted into cash, sold or consumed within a year or less. The heading "Long-Term Assets" is usually not displayed on a company's consolidated balance sheet. However, all items that are not included in current assets are considered long-term assets. These are: Investments - These are investments that management does not expect to sell within the year. These investments can include bonds, common stock, long-term notes, investments in tangible fixed assets not currently used in operations (such as land held for speculation) and investments set aside in special funds, such as sinking funds, pension funds and plan-expansion funds. These long-term investments are reported at their historical cost or market value on the balance sheet. Fixed assets - These are durable physical properties used in operations that have a useful life longer than one year. This includes: o Machinery and equipment - This category represents the total machinery, equipment and furniture used in the company's operations. These assets are reported at their historical cost less accumulated depreciation. o Buildings or Plants - These are buildings that the company uses for its operations. These assets are depreciated and are reported at historical cost less accumulated depreciation. o Land - The land owned by the company on which the company's buildings or plants are sitting on. Land is valued at historical cost and is not depreciable under U.S. GAAP. Other assets - This is a special classification for unusual items that cannot be included in one of the other asset categories. Examples include deferred charges (long-term prepaid expenses), non-current receivables and advances to subsidiaries. Intangible assets - These are assets that lack physical substance but provide economic rights and advantages: patents, franchises, copyrights, goodwill, trademarks and organization costs. These assets have a high degree of uncertainty in regard to whether future benefits will be realized. They are reported at historical cost net of accumulated depreciation.

Total Liabilities Liabilities have the same classifications as assets: current and long term. Current liabilities - These are debts that are due to be paid within one year or the operating cycle, whichever is longer. Such obligations will typically involve the use of current assets, the creation of another current liability or the providing of some service. Usually included in this section are: Bank indebtedness - This amount is owed to the bank in the short term, such as a bank line of credit. Accounts payable - This amount is owed to suppliers for products and services that are delivered but not paid for. Wages payable (salaries), rent, tax and utilities - This amount is payable to employees, landlords, government and others.

Accrued liabilities (accrued expenses) - These liabilities arise because an expense occurs in a period prior to the related cash payment. This accounting term is usually used as an allencompassing term that includes customer prepayments, dividends payables and wages payables, among others. Notes payable (short-term loans) - This is an amount that the company owes to a creditor, and it usually carries an interest expense. Unearned revenues (customer prepayments) - These are payments received by customers for products and services the company has not delivered or for which the company has not yet started to incur any cost for delivery. Dividends payable - This occurs as a company declares a dividend but has not yet paid it out to its owners. Current portion of long-term debt - The currently maturing portion of the long-term debt is classified as a current liability. Theoretically, any related premium or discount should also be reclassified as a current liability. Current portion of capital-lease obligation - This is the portion of a long-term capital lease that is due within the next year.

4. Long-term Liabilities - These are obligations that are reasonably expected to be liquidated at some date beyond one year or one operating cycle. Long-term obligations are reported as the present value of all future cash payments. Usually included are: Notes payables - This is an amount the company owes to a creditor, which usually carries an interest expense. Long-term debt (bonds payable) - This is long-term debt net of current portion. Deferred income tax liability - GAAP allows management to use different accounting principles and/or methods for reporting purposes than it uses for corporate tax fillings to the IRS. Deferred tax liabilities are taxes due in the future (future cash outflow for taxes payable) on income that has already been recognized for the books. In effect, although the company has already recognized the income on its books, the IRS lets it pay the taxes later due to the timing difference. If a company's tax expense is greater than its tax payable, then the company has created a future tax liability (the inverse would be accounted for as a deferred tax asset). Pension fund liability - This is a company's obligation to pay its past and current employees' post-retirement benefits; they are expected to materialize when the employees take their retirement for structures like a defined-benefit plan. This amount is valued by actuaries and represents the estimated present value of future pension expense, compared to the current value of the pension fund. The pension fund liability represents the additional amount the company will have to contribute to the current pension fund to meet future obligations. Long-term capital-lease obligation - This is a written agreement under which a property owner allows a tenant to use and rent the property for a specified period of time. Long-term capital-lease obligations are net of current portion.

Financial Statements - The Income Statement


The income statement measures a company's financial performance over a specific accounting period. Financial performance is assessed by giving a summary of how the business incurs its revenues and expenses through both operating and non-operating activities. It also shows the net profit or loss incurred over a specific accounting period, typically over a fiscal quarter or year. The income statement is also known as the "profit and loss statement" or "statement of revenue and expense." The income statement is divided into two parts: the operating items section and the non-operating items section. The operating items section discloses information about revenues and expenses that are a direct result of the regular business operations. For example, if a business creates sports equipment, then the operating items section would talk about the revenues and expenses involved with the production of sports equipment.

The non-operating items section discloses revenue and expense information about activities that are not tied directly to a company's regular operations. For example, if the sport equipment company sold a factory and some old plant equipment, then this information would be in the non-operating items section. Income statements can be presented in one of two ways: multi-step and single-step. Both single and multi-step formats conform to GAAP standards. Both yield the same net income figure; the main difference is how they are formatted, not how figures are calculated. The two formats are illustrated below in two simplistic examples:

Multi-Step Single-Step Format Format Net Sales Net Sales Cost of Sales Materials and Production Gross Income* Marketing and Administrative Selling, General Research and Development and Administrative Expenses(R&D) Expenses (SG&A) Operating Other Income & Expenses Income* Other Income & Pretax Income Expenses Pretax Income* Taxes Taxes Net Income Net Income (after -tax)*
Sample Income Statement Now let's take a look at a sample income statement for company XYZ for Fiscal Year (FY) ending 2008 and 2009. Expenses are in parentheses.

Income Statement For Company XYZ FY 2008 and 2009

(Figures USD) Net Sales Cost of Sales Gross Income Operating Expenses (SG&A) Operating Income Other Income (Expense) Extraordinary Gain (Loss) Interest Expense Net Profit Before Taxes (Pretax Income) Taxes Net Income

2008 1,500,000 (350,000) 1,150,000 (235,000) 915,000 40,000 (50,000) 905,000 (300,000) 605,000

2009 2,000,000 (375,000) 1,625,000 (260,000) 1,365,000 60,000 (15,000) (50,000) 1,360,000 (475,000) 885,000

Here are some of the different entries that may be found on the income statement and what each one means.

Sales - These are defined as total sales (revenues) during the accounting period. Remember these sales are net of returns, allowances and discounts. Cost of Goods Sold (COGS) - These are all the direct costs that are related to the product or rendered service sold and recorded during the accounting period. (Reminder: matching principle.) Operating expenses - These include all other expenses that are not included in COGS but are related to the operation of the business during the specified accounting period. This account is most commonly referred to as "SG&A" (sales general and administrative) and includes expenses such as selling, marketing, administrative salaries, sales salaries, maintenance, administrative office expenses (rent, computers, accounting fees, legal fees), research and development (R&D), depreciation and amortization, etc. Other revenues & expenses - These are all non-operating expenses such as interest earned on cash or interest paid on loans. Income taxes - This account is a provision for income taxes for reporting purposes.
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The Components of Net Income: Operating income from continuing operations - This comprises all revenues net of returns, allowances and discounts, less the cost and expenses related to the generation of these revenues. The costs deducted from revenues are typically the COGS and SG&A expenses. Recurring income before interest and taxes from continuing operations - In addition to operating income from continuing operations, this component includes all other income, such as investment income from unconsolidated subsidiaries and/or other investments and gains (or losses) from the sale of assets. To be included in this category, these items must be recurring in nature. This component is generally considered to be the best predictor of future earnings. However, non-cash expenses such as depreciation and amortization are not assumed to be good indicators of future capital expenditures. Since this component does not take into account the capital structure of the company (use of debt), it is also used to value similar companies. Recurring (pre-tax) income from continuing operations - This component takes the company's financial structure into consideration as it deducts interest expenses. Pre-tax earnings from continuing operations - Included in this category are items that are either unusual or infrequent in nature but cannot be both. Examples are an employeeseparation cost, plant shutdown, impairments, write-offs, write-downs, integration expenses, etc. Net income from continuing operations - This component takes into account the impact of taxes from continuing operations.

Non-Recurring Items Discontinued operations, extraordinary items and accounting changes are all reported as separate items in the income statement. They are all reported net of taxes and below the tax line, and are not included in income from continuing operations. In some cases, earlier income statements and balance sheets have to be adjusted to reflect changes. Income (or expense) from discontinued operations - This component is related to income (or expense) generated due to the shutdown of one or more divisions or operations (plants). These events need to be isolated so they do not inflate or deflate the company's future earning potential. This type of nonrecurring occurrence also has a nonrecurring tax implication and, as a result of the tax implication, should not be included in the income tax expense used to calculate net income from continuing operations.That is why this income (or expense) is always reported net of taxes. The same is true for extraordinary items and cumulative effect of accounting changes (see below).

Extraordinary items - This component relates to items that are both unusual and infrequent in nature. That means it is a one-time gain or loss that is not expected to occur in the future. An example is environmental remediation. Cumulative effect of accounting changes - This item is generally related to changes in accounting policies or estimations. In most cases, these are non cash-related expenses but could have an effect on taxes.
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Unusual or Infrequent Items Included in this category are items that are either unusual or infrequent in nature but they cannot be both.

Examples of unusual or infrequent items: Gains (or losses) as a result of the disposition of a company's business segment including: o Plant shutdown costs o Lease-breaking fees o Employee-separation costs Gains (or losses) as a result of the disposition of a company's assets or investments (including investments in subsidiary segments) including: o Plant shut-down costs o Lease-breaking fees Gains (or losses) as a result of a lawsuit Losses of operations due to an earthquake Impairments, write-offs, write-downs and restructuring costs Integration expenses related to the acquisition of a business

Extraordinary Items Events that are both unusual and infrequent in nature are qualified as extraordinary expenses.

Example of extraordinary items: Losses from expropriation of assets Gain (or losses) from early retirement of debt

Discontinued Operations Sometimes management decides to dispose of certain business operations but either has not yet done so or did it in the current year after it had generated income or losses. To be accounted for as a discontinued operation, the business must be physically and operationally distinct from the rest of the firm. Keep in mind these basic definitions: Measurement date This is the date when the company develops a formal plan for disposing. Phase-out period This is the time between the measurement date and the actual disposal date.

The income or loss from discontinued operations is reported separately, and past income statements must be restated, separating the income or loss from discontinued operations. On the measurement date, the company will accrue any estimated loss during the phase-out period and estimated loss on the sale of the disposal. Any expected gain on the disposal cannot be reported until after the sale is completed (the same rule applies to the sale of a portion of a business segment).

Accounting Changes Accounting changes occur for two reasons: 1. As a result of a change in an accounting principle. 2. As a result of a change in an accounting estimate. The most common form of a change in accounting principle is the switch from the LIFO inventory accounting method to another method such FIFO or average cost basis. The most common form of a change in accounting estimates is a change in depreciation method for new assets or change in depreciable lives/salvage values, which is considered a change in accounting estimates and not a change in accounting principle. Note that past income does not need to be restated from the LIFO inventory accounting method to another method such FIFO or average cost basis. In general, prior years' financial statements do not need to be restated unless it is a change in: Inventory accounting methods (LIFO to FIFO) Change to or from full-cost method (This is used in oil and gas exploration. The successfulefforts method capitalizes only the costs associated with successful activities while the full-cost method capitalizes all the costs associated with all activities.) Change from or to percentage-of-completion method (see revenue-recognition methods) All changes just prior to a company's IPO

Prior Period Adjustments These adjustments are related to accounting errors. These errors are typically not reported in the income statement but are reported in retained earnings (found in changes in retained earnings). These errors are disclosed as footnotes explaining the nature of the error and its effect on net income.

Financial Statements - Cash Flow


The statement of cash flow reports the impact of a firm's operating, investing and financial activities on cash flows over an accounting period. The cash flow statement shows the following: How the company obtains and spends cash Why there may be differences between net income and cash flows If the company generates enough cash from operation to sustain the business If the company generates enough cash to pay off existing debts as they mature If the company has enough cash to take advantage of new investment opportunities

Segregation of Cash Flows The statement of cash flows is segregated into three sections: Operating activities Investing activities Financing activities

1. Cash Flow from Operating Activities (CFO) CFO is cash flow that arises from normal operations such as revenues and cash operating expenses net of taxes. This includes:

Cash inflow (+) 1. Revenue from sale of goods and services 2. Interest (from debt instruments of other entities) 3. Dividends (from equities of other entities) Cash outflow (-) 1. Payments to suppliers 2. Payments to employees 3. Payments to government 4. Payments to lenders 5. Payments for other expenses

2. Cash Flow from Investing Activities (CFI) CFI is cash flow that arises from investment activities such as the acquisition or disposition of current and fixed assets. This includes: Cash inflow (+) 1. Sale of property, plant and equipment 2. Sale of debt or equity securities (other entities) 3. Collection of principal on loans to other entities Cash outflow (-) 1. Purchase of property, plant and equipment 2. Purchase of debt or equity securities (other entities) 3. Lending to other entities

3. Cash flow from financing activities (CFF) CFF is cash flow that arises from raising (or decreasing) cash through the issuance (or retraction) of additional shares, or through short-term or long-term debt for the company's operations. This includes: Cash inflow (+) 1. Sale of equity securities 2. Issuance of debt securities Cash outflow (-) 1. Dividends to shareholders 2. Redemption of long-term debt 3. Redemption of capital stock

A cash flow statement looks like this:

Reporting Non-Cash Investing and Financing Transactions Information for the preparation of the statement of cash flow is derived from three sources: 1. Comparative balance sheets 2. Current income statements 3. Selected transaction data (footnotes) Some investing and financing activities do not flow through the statement of cash flow because they do not require the use of cash. Examples Include: Conversion of debt to equity Conversion of preferred equity to common equity Acquisition of assets through capital leases Acquisition of long-term assets by issuing notes payable Acquisition of non-cash assets (patents, licenses) in exchange for shares or debt securities

Though these items are typically not included in the statement of cash flow, they can be found as footnotes to the financial statements.

Taxes - Types Of Taxes


A business must pay a variety of taxes based on the companys physical location, ownership structure and nature of the business. Business taxes can have a huge impact on the profitability of businesses and the amount of business investment. Taxation is a very important factor in the financial investment decision-making process because a lower tax burden allows the company to lower prices or generate higher revenue, which can then be paid out in wages, salaries and/or dividends. Business may be required to remit the following types of taxes: Federal Income Tax: A tax levied by a national government on annual income. State and/or Local Income Tax: A tax levied by a state or local government on annual income. Not all states have implemented state level income taxes. Payroll Tax: A tax an employer withholds and/or pays on behalf of their employees based on the wage or salary of the employee. In most countries, including the United States, both state and federal authorities collect some form of payroll tax. In the United States, Medicare and Social Security, also called FICA, make up the payroll tax. Unemployment Tax: A federal tax that is allocated to state unemployment agencies to fund unemployment assistance for laid-off workers. Sales Tax: A tax imposed by the government at the point of sale on retail goods and services. It is collected by the retailer and passed on to the state. Sales tax is based on a percentage of the selling prices of the goods and services and is set by the state. Technically, consumers pay sales taxes, but effectively, business pay them since the tax increases consumers costs and causes them to buy less. Foreign Tax: Income taxes paid to a foreign government on income earned in that country. Value-Added Tax: A national sales tax collected at each stage of production or consumption of a good. Depending on the political climate, the taxing authority often exempts certain necessary living items, such as food and medicine from the tax.

Taxes - Types Of Credits


Businesses can reduce their tax liability with deductions and credits. The IRS allows businesses to deduct expenses that are considered ordinary and necessary for that line of business, and it provides credits to encourage specific business activities. Deductions reduce the amount of income on which a company must pay tax, while credits directly reduce a companys tax liability. In other words, a deduction might mean that a company pays tax on $750,000 instead of $1,000,000; a credit might mean that a company can subtract $50,000 from its $250,000 tax bill. Some common business deductions and credits include the following: Cost of Goods Sold: The amount spent to purchase inventory, including products purchased for resale, raw materials, freight, storage, labor and factory overhead. Indirect costs such as rent, interest and administrative costs must be capitalized. Capital Expenses: Major expenses for ongoing business assets, including startup costs and improvements, must be capitalized. However, up to $5,000 in startup costs can be deducted in the year the business is opened. Rent: The cost of leasing a place of business is tax deductible. Interest: The cost of borrowing money for business activities can be deducted.

Employees Pay: The salaries and wages paid to employees are tax deductible. So are retirement contributions for employees, directors and officers. Taxes: Business taxes paid to state, local and foreign tax authorities are tax deductible. Insurance: Premiums for business insurance such as property, casualty and liability insurance are tax deductible. IRS Publication 535, Business Expenses, provides more detail about tax deductible business expenses. Source: IRS Offical Website Credits The IRS offers various tax credits for business activities it wants to promote. These include research, oil recovery, reforestation, starting a pension plan, providing low-income housing, employing a member of a targeted group such as veterans or ex-felons, providing employment in an urban empowerment zone, and a number of other activities. All qualifying credits are tallied up and claimed on General Business Tax Credit Form 3800.

Capital Cost Allowance And Depreciation - Types Of Depreciation


The capital cost allowance (CCA) is a rate of depreciation used for income tax purposes only. This term primarily relates to Canadian taxation. The CCA rate that can be claimed depends on the asset itself; for example, computer software has a much higher CCA rate than buildings or furniture. The CCA is essentially a business tax deduction that helps Canadian businesses reduce their taxes. Depreciation Accounting In the United States, businesses can take a deduction for depreciation. Depreciation is the reduction in an assets value caused by the passage of time due to use or abuse, wear and tear. Depreciation is a method of cost allocation. The cost allocation can be based on a number of factors, but it is always related to the estimated period of time the product can generate revenues for the company, also known as the assets economic life. Depreciation expense is the amount of cost allocation within an accounting period. Only items that lose useful value over time can be depreciated. Depreciation can be calculated in more than one way. Straight-line Depreciation The simplest and most commonly used method, straight-line depreciation is calculated by taking the purchase or acquisition price of an asset, subtracting the salvage value (value at which it can be sold once the company no longer needs it) and dividing by the total productive years for which the asset can reasonably be expected to benefit the company (or its useful life). Example: For $2 million, Company ABC purchased a machine that will have an estimated useful life of five years. The company also estimates that in five years, the company will be able to sell it for $200,000 for scrap parts.

Depreciation Expense = Total Acquisition Cost Salvage Value / Useful Life

Straight-line depreciation produces a constant depreciation expense. At the end of the assets useful life, the asset is accounted for in the balance sheet at its salvage value. Unit-of-Production Depreciation This method provides for depreciation by means of a fixed rate per unit of production. Under this method, one must first determine the cost per one production unit and then multiply that cost per unit with the total number of units the company produced within an accounting period to determine its depreciation expense.

Depreciation Expense = Total Acquisition Cost - Salvage Value / Estimated Total Units
Estimated total units = the total units this machine can produce over its lifetime Depreciation expense = depreciation per unit * number of units produced during an accounting period Example: Company ABC purchased a machine for $2 million that can produce 300,000 products over its useful life. The company estimates that this machine has a salvage value of $200,000.

Unit-of-production depreciation produces a variable depreciation expense and is more reflective of production-to-cost (see matching principle). At the end of its useful life, the assets accumulated depreciation is equal to its total cost minus its salvage value. Furthermore, its accumulated production units equal the total estimated production capacity. One of the drawbacks of this method is that if the units of products decrease (due to slowing demand for the product, for example), the depreciation expense also decreases. This results in an overstatement of reported income and asset value.
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Hours-of-Service Depreciation This is the same concept as unit of production depreciation except that the depreciation expense is a function of total hours of service used during an accounting period. Accelerated Depreciation

Accelerated depreciation allows companies to write off their assets faster in earlier years than the straight-line depreciation method and to write off a smaller amount in the later years. The major benefit of using this method is the tax shield it provides. Companies with a large tax burden might like to use the accelerated-depreciation method, even if it reduces the income shown on the financial statement. This depreciation method is popular for writing off equipment that might be replaced before the end of its useful life if it becomes obsolete ( computers, for example). Companies that have used accelerated depreciation will declare fewer earnings in the beginning years and will seem more profitable in the later years. Companies that will be raising financing (via an IPO or venture capital) are more likely to use accelerated depreciation in the first years of operation and raise financing in the later years to create the illusion of increased profitability (and therefore higher valuation). The two most common accelerated-depreciation methods are the sum-of-year (SYD) method and double-declining-balance method (DDB): Sum-of-Year Method:

Depreciation In Year i = ((n-i+1) / n!) * (total acquisition cost - salvage value)


Example: For $2 million, Company ABC purchased a machine that will have an estimated useful life of five years. The company also estimates that in five years, the company will be able to sell it for $200,000 for scrap parts. n! = 1+2+3+4+5 = 15 n=5

The sum-of-year depreciation method produces a variable depreciation expense. At the end of the useful life of the asset, its accumulated depreciation is equal to the accumulated depreciation under the straight-line depreciation. Double-Declining-Balance Method The DDB method simply doubles the straight-line depreciation amount that is taken in the first year, and then that same percentage is applied to the un-depreciated amount in subsequent years.
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DDB In year i = (2 / n) * (total acquisition cost - accumulated depreciation) n = number of years

Example For $2 million, Company ABC purchased a machine that will have an estimated useful life of five years. The company also estimates that in five years the company will be able to sell it for $200,000 for scrap parts.

The double-declining-balance method produces a very aggressive depreciation schedule. The asset cannot be depreciated beyond its salvage value.

Capital Cost Allowance and Depreciation - Other Depreciation Considerations


Change in Useful life or Salvage Value All depreciation methods estimate both the useful life of an asset and its salvage value. As time passes the useful life of a company's equipment may be cut short (due to new technology, for example), and its salvage value may also be affected. Once this happens there is asset impairment. Companies can do two things: 1) They can accelerate the asset's depreciation and fix the reduction in useful life or salvage value over time. 2) They can do the recommended thing, which is to recognize the impairment and report it on the income statement right away. Changes in useful life and salvage value are considered changes in accounting estimates, not changes in accounting principle. As a result, there is no need to restate past financial statements. Sale, Exchange or Disposal of Depreciable Assets Companies that are in the business of exploring, extracting and/or transforming natural resources such as timber, gold, silver, oil and gas are known as "natural resource companies." The main assets these companies have are their inventory of natural resources. These assets must be reported at their carrying cost (or cost of carry). The carrying costs for natural resources include the cost of acquiring the lands or mines, the cost of timber-cutting rights and the cost of exploration and development of the natural resources. These costs can be capitalized or expensed. The costs that are capitalized are included in the cost of carry. The cost of carry does not include the cost of machinery and equipment used in the extraction process. When a resource company purchases a plot of land, it not only pays for the physical asset but also pays a large premium because of what is contained in the plot of land. However, once a company starts extracting the oil or natural resource from the land, the land loses value, because the natural resources extracted from a plot of land will never regenerate. That loss in value is called "depletion." That is why cost of carry is depleted over time. The depletion of these assets must be included in the income statement's accounting period. This is the only time land can be depleted.

The carrying costs of natural resources are allocated to an accounting period by means of the unitsof-production method. Example: A company acquired cutting rights for $1 million. With these cutting rights, the company will be able to cut 5,000 trees. In its first year of operation, the company cut 200 trees. Journal entries:

Certain types of assets are amortized rather than depreciated. Amortization describes the deduction of capital expenses over a specific period of time (usually over the asset's life). More specifically, this method measures the consumption of the value of intangible assets, such as a patent or a copyright. What is the difference between amortization and depreciation? Because very few assets last forever, one of the main principles of accrualaccounting requires that an asset's cost be proportionally expensed based on the time period over which the asset was used. Depreciation and amortization (as well as depletion) methods are used to prorate the cost of a specific type of asset to the asset's life. Remember, these methods are calculated by subtracting the asset's salvage value from its original cost. Amortization usually refers to spreading an intangible asset's cost over that asset's useful life. For example, a patent on a piece of medical equipment usually has a life of 17 years. The cost involved with creating the medical equipment is spread out over the life of the patent with each portion being recorded as an expense on the company's income statement. Depreciation, on the other hand, refers to prorating a tangible asset's cost over that asset's life. For example, an office building can be used for a number of years before changes in circumstances result in it being sold. The cost of the building is spread out over the predicted life of the building, with a portion of the cost being expensed each accounting year. Depletion refers to the allocation of the cost of natural resources over time. For example, an oil well has a finite life before all of the oil is pumped out. Therefore, the oil well's setup costs are spread out over the predicted life of the oil well. It is important to note that in some countries, such as Canada, the terms amortization and depreciation are often used interchangeably to refer to both tangible and intangible assets. Here is an example of how amortization works. Suppose XYZ Biotech spent $30 million dollars on a piece of medical equipment and that the patent on the equipment lasts 15 years. The business would record $2 million each year as an amortization expense. While amortization and depreciation are often used interchangeably, technically this is an incorrect practice because amortization refers to intangible assets and depreciation refers to tangible assets. Amortization can be calculated easily using most modern financial calculators, spreadsheet software packages such as Microsoft Excel, or amortization charts and tables.

Cash Flow And Relationships Between Financial Statement - The Relationship Between Financial Statements
The income statement, balance sheet and cash flow statement are all interrelated. The income statement describes how the assets and liabilities were used in the stated accounting period. The cash flow statement explains cash inflows and outflows, and it will ultimately reveal the amount of cash the company has on hand, which is also reported in the balance sheet. By themselves, each financial statement only provides a portion of the story of a companys financial condition; together, they provide a more complete picture. The Relationship Between the Financial Statements

Stockholders and potential creditors analyze a companys financial statements and calculate a number of financial ratios with the data they contain to identify the companys financial strengths and weaknesses and determine whether the company is a good investment/credit risk. Managers use them to aid in decision making. (To learn more, check out Reading The Balance Sheet, Understanding The Income Statement and The Essentials Of Cash Flow.) One important way the financial statements are used together is in the calculation of free cash flow (FCF). Smart investors love companies that produce plenty of free cash flow. It signals a company's ability to pay debt and dividends, buy back stock and facilitate the growth of business - all important undertakings from an investor's perspective. However, while free cash flow is a great gauge of corporate health, it does have its limits and is not immune to accounting trickery. (For background reading, see Analyzing Cash Flow The Easy Way.)

Cash Flow And Relationships Between Financial Statement - Free Cash Flow
By establishing how much cash a company has after paying its bills for ongoing activities and growth, FCF is a measure that aims to cut through the arbitrariness and "guesstimations" involved in reported earnings. Regardless of whether a cash outlay is counted as an expense in the calculation of income or turned into an asset on the balance sheet, free cash flow tracks the money.

To calculate FCF, make a beeline for the company's cash flow statement and balance sheet. There you will find the item cash flow from operations (also referred to as "operating cash"). From this number, subtract estimated capital expenditure required for current operations:

Cash Flow From Operations (Operating Cash) - Capital Expenditure ---------------------------= Free Cash Flow
To do it another way, grab the income statement and balance sheet. Start with net income and add back charges for depreciation and amortization. Make an additional adjustment for changes in working capital, which is done by subtracting current liabilities from current assets. Then subtract capital expenditure (or spending on plants and equipment):

Net income + Depreciation/Amortization - Change in Working Capital - Capital Expenditure ---------------------------= Free Cash Flow
It might seem odd to add back depreciation/amortization since it accounts for capital spending. The reasoning behind the adjustment is that free cash flow is meant to measure money being spent right now, not transactions that happened in the past. This makes FCF a useful instrument for identifying growing companies with high up-front costs, which may eat into earnings now but have the potential to pay off later. What Does Free Cash Flow Indicate? Growing free cash flows are frequently a prelude to increased earnings. Companies that experience surging FCF - due to revenue growth, efficiency improvements, cost reductions, share buy backs, dividend distributions or debt elimination - can reward investors tomorrow. That is why many in the investment community cherish FCF as a measure of value. When a firm's share price is low and free cash flow is on the rise, the odds are good that earnings and share value will soon be heading up. By contrast, shrinking FCF signals trouble ahead. In the absence of decent free cash flow, companies are unable to sustain earnings growth. An insufficient FCF for earnings growth can force a company to boost its debt levels. Even worse, a company without enough FCF may not have the liquidity to stay in business. Is Free Cash Flow Foolproof? Although it provides a wealth of valuable information that investors really appreciate, FCF is not infallible. Crafty companies still have leeway when it comes to accounting sleight of hand. Without a regulatory standard for determining FCF, investors often disagree on exactly which items should and should not be treated as capital expenditures. Investors must therefore keep an eye on companies with high levels of FCF to see if these companies are under-reporting capital expenditure and R&D. Companies can also temporarily boost FCF by stretching out their payments, tightening

payment collection policies and depleting inventories. These activities diminish current liabilities and changes to working capital, but the impacts are likely to be temporary. The Trick of Hiding Receivables Let's look at yet another example of FCF tomfoolery, which involves specious calculations of the current accounts receivable. When a company reports revenue, it records an account receivable, which represents cash that has yet to be received. The revenues then increase net income and cash from operations, but that increase is typically offset by an increase in current accounts receivable, which is then subtracted from cash from operations. When companies record their revenues as such, the net impact on cash from operations and free cash flow should be zero since no cash has been received. What happens when a company decides to record the revenue, even though the cash will not be received within a year? The receivable for a delayed cash settlement is therefore "non-current" and can get buried in another category like "other investments." Revenue is still recorded and cash from operations increases, but no current account receivable is recorded to offset revenues. Thus, cash from operations and free cash flow enjoy an unjustified boost. Tricks like this one can be hard to catch. (For more insight, see 5 Tricks Companies Use During Earnings Season.) Finding an all-purpose tool for testing company fundamentals still proves elusive. Like all performance metrics, FCF has its limits. On the other hand, provided that investors keep their guard up, free cash flow is a very good place to start hunting.

Chapter 3

Time Value Of Money - Introduction To The Time Value Of Money


In addition to being able to understand financial statements, it's important to be able to estimate the value of an investment in the present and in the future. The idea that money available at the present time is worth more than the same amount in the future due to its potential earning capacity is called the time value of money. This core principle of finance holds that, provided money can earn interest, any amount of money is worth more the sooner it is received. Thus, at the most basic level, the time value of money demonstrates that, all things being equal, it is better to have money now rather than later. But why is this? A $100 bill now has the same value as a $100 bill one year from now, doesn't it? Actually, although the bill is the same, you can do much more with the money if you have it now because over time you can earn more interest on your money. By receiving $10,000 today (Option A), you are poised to increase the future value of your money by investing and gaining interest over a period of time. If you receive the money three years down the line (Option B), you don't have time on your side, and the payment received in three years would be your future value. To illustrate, we have provided a timeline:

If you choose Option A, your future value will be $10,000 plus any interest acquired over the three years. The future value for Option B, on the other hand, would only be $10,000. So how can you calculate exactly how much more Option A is worth compared to Option B? Let's take a look. Future Value Basics If you choose Option A and invest the total amount at a simple annual rate of 4.5%, the future value of your investment at the end of the first year is $10,450, which is calculated by multiplying the principal amount of $10,000 by the interest rate of 4.5% and then adding the interest gained to the principal amount:

Future value of investment at end of first year: = ($10,000 x 0.045) + $10,000 = $10,450
You can also calculate the total amount of a one-year investment with a simple manipulation of the above equation: Original equation: ($10,000 x 0.045) + $10,000 = $10,450 Manipulation: $10,000 x [(1 x 0.045) + 1] = $10,450 Final equation: $10,000 x (0.045 + 1) = $10,450

The manipulated equation above is simply a removal of the like-variable of $10,000 (the principal amount) by dividing the entire original equation by $10,000. If the $10,450 left in your investment account at the end of the first year is left untouched and you invested it at 4.5% for another year, how much would you have? To calculate this, you would take the $10,450 and multiply it again by 1.045 (0.045 +1). At the end of two years, you would have $10,920:

Future value of investment at end of second year: = $10,450 x (1+0.045) = $10,920.25


The above calculation is then equivalent to the following equation:

Future Value = $10,000 x (1+0.045) x (1+0.045)


Think back to math class and the rule of exponents, which states that the multiplication of like terms is equivalent to adding their exponents. In the above equation, the two like terms are (1+0.045), and the exponent on each is equal to 1. Therefore, the equation can be represented as the following:

We can see that the exponent is equal to the number of years for which the money is earning interest in an investment. So, the equation for calculating the three-year future value of the investment would look like this:
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This calculation means that we don't need to calculate the future value after the first year, then the second year, then the third year, and so on. If you know how many years you would like to hold a present amount of money in an investment, the future value of that amount is calculated by the following equation:

Time Value Of Money - Future Value And Compounding


There are two ways to calculate Future Value (FV): 1) For an asset with simple annual interest: = Original Investment x (1+(interest rate*number of years)) 2) For an asset with interest compounded annually: = Original Investment x ((1+interest rate)^number of years) Consider the following examples: 1) $1000 invested for five years with simple annual interest of 10% would have a future value of $1,500.00. 2) $1000 invested for five years at 10%, compounded annually has a future value of $1,610.51. When planning investment strategy, it's useful to be able to predict what an investment is likely to be worth in the future, taking the impact of compound interest into account. This formula allows you (or your calculator) to do just that:

Pn = P0(1+r)n Pnis future value of P0 P0 is original amount invested r is the rate of interest n is the number of compounding periods (years, months, etc.)
Note in the example below that when you increase the frequency of compounding, you also increase the future value of your investment.

P0 = $10,000 Pn is the future value of P0 n = 10 years r = 9% Example 1- If interest is compounded annually, the future value (Pn) is $23,674. Pn = $10,000(1 + .09)10 = $23,674 Example 2 - If interest is compounded monthly, the future value (Pn) is $24,514. Pn = $10,000(1 + .09/12)120 = $24,514

Time Value Of Money - Present Value And Discounting


Present value, also called "discounted value," is the current worth of a future sum of money or stream of cash flow given a specified rate of return. Future cash flows are discounted at the discount rate; the higher the discount rate, the lower the present value of the future cash flows. Determining the appropriate discount rate is the key to properly valuing future cash flows, whether they are earnings or obligations. If you received $10,000 today, the present value would be $10,000 because present value is what your investment gives you if you were to spend it today. If you received $10,000 in a year, the present value of the amount would not be $10,000 because you do not have it in your hand now, in the present. To find the present value of the $10,000 you will receive in the future, you need to pretend that the $10,000 is the total future value of an amount that you invested today. In other words, to find the present value of the future $10,000, we need to find out how much we would have to invest today in order to receive that $10,000 in the future. To calculate present value, or the amount that we would have to invest today, you must subtract the (hypothetical) accumulated interest from the $10,000. To achieve this, we can discount the future payment amount ($10,000) by the interest rate for the period. In essence, all you are doing is rearranging the future value equation above so that you may solve for P. The above future value equation can be rewritten by replacing the P variable with present value (PV) and manipulating the equation as follows:

Let's walk backwards from the $10,000 offered in Option B. Remember, the $10,000 to be received in three years is really the same as the future value of an investment. If today we were at the two-year mark, we would discount the payment back one year. At the two-year mark, the present value of the $10,000 to be received in one year is represented as the following:

Present value of future payment of $10,000 at end of year two:

Note that if we were at the one-year mark today, the above $9,569.38 would be considered the future value of our investment one year from now. At the end of the first year we would be expecting to receive the payment of $10,000 in two years. At

an interest rate of 4.5%, the calculation for the present value of a $10,000 payment expected in two years would be the following:

Present value of $10,000 in one year:

Of course, because of the rule of exponents, we don't have to calculate the future value of the investment every year counting back from the $10,000 investment at the third year. We could put the equation more concisely and use the $10,000 as the future value. So, here is how you can calculate today's present value of the $10,000 expected from a three-year investment earning 4.5%:

The present value of a future payment of $10,000 is worth $8,762.97 today if interest rates are 4.5% per year. In other words, choosing Option B is like taking $8,762.97 now and then investing it for three years. The equations above illustrate that Option A is better not only because it offers you money right now but because it offers you $1,237.03 ($10,000 - $8,762.97) more in cash! Furthermore, if you invest the $10,000 that you receive from Option A, your choice gives you a future value that is $1,411.66 ($11,411.66 - $10,000) greater than the future value of Option B. Present Value of a Future Payment Let's add a little spice to our investment knowledge. What if the payment in three years is more than the amount you'd receive today? Say you could receive either $15,000 today or $18,000 in four years. Which would you choose? The decision is now more difficult. If you choose to receive $15,000 today and invest the entire amount, you may actually end up with an amount of cash in four years that is less than $18,000. You could find the future value of $15,000, but since we are always living in the present, let's find the present value of $18,000 if interest rates are currently 4%. Remember that the equation for present value is the following:

In the equation above, all we are doing is discounting the future value of an investment. Using the numbers above, the present value of an $18,000 payment in four years would be calculated as the following:

Present Value

From the above calculation we now know our choice is between receiving $15,000 or $15,386.48 today. Of course we should choose to postpone payment for four years! (For related reading, see Anything But Ordinary: Calculating The Present And Future Value Of Annuities.) These calculations demonstrate that time literally is money - the value of the money you have now is not the same as it will be in the future and vice versa. It is important to know how to calculate the time value of money so that you can distinguish between the worth of investments that offer you returns at different times.

3.2 Discounted Cash Flow Valuation - Introduction To Discounted Cash Flow Valuation
Discounted cash flow (DCF) is a valuation method used to estimate the attractiveness of an investment opportunity. DCF analysis uses future free cash flow projections and discounts them (most often using the weighted average cost of capital, which well discuss in section 13 of this walkthrough) to arrive at a present value, which is then used to evaluate the potential for investment. If the value arrived at through DCF analysis is higher than the current cost of the investment, the opportunity may be a good one. The formula for calculating DCF is usually given something like this:

Where: PV = present value CFi = cash flow in year i k = discount rate TCF = the terminal year cash flow g = growth rate assumption in perpetuity beyond terminal year n = the number of periods in the valuation model including the terminal year

PV = CF1 / (1+k) + CF2 / (1+k)2 + [TCF / (k - g)] / (1+k)n-1

There are many variations when it comes to what you can use for your cash flows and discount rate in a DCF analysis. For example, free cash flows can be calculated as operating profit + depreciation + amortization of goodwill - capital expenditures - cash taxes - change in working capital. Although the calculations are complex, the purpose of DCF analysis is simply to estimate the money you'd receive from an investment and to adjust for the time value of money. Discounted cash flow models are powerful, but they do have shortcomings. DCF is merely a mechanical valuation tool, which makes it subject to the axiom "garbage in, garbage out." Small changes in inputs can result in large changes in the value of a company. Instead of trying to project the cash flows to infinity, terminal value techniques are often used. A simple annuity is used to estimate the terminal value past 10 years, for example. This is done because it is harder to come to a realistic estimate of the cash flows as time goes on. At a time when financial statements are under close scrutiny, the choice of what metric to use for making company valuations has become increasingly important. Wall Street analysts are emphasizing cash flow-based analysis for making judgments about company performance. DCF analysis is a key valuation tool at analysts' disposal. Analysts use DCF to determine a company's current value according to its estimated future cash flows. For investors keen on gaining insights on what drives share value, few tools can rival DCF analysis. Accounting scandals and inappropriate calculation of revenues and capital expenses give DCF new importance. With heightened concerns over the quality of earnings and reliability of standard valuation metrics like P/E ratios, more investors are turning to free cash flow, which offers a more transparent metric for gauging performance than earnings. It is harder to fool the cash register. Developing a DCF model demands a lot more work than simply dividing the share price by earnings or sales. But in return for the effort, investors get a good picture of the key drivers of share value: expected growth in operating earnings, capital efficiency, balance sheet capital structure, cost of equity and debt, and expected duration of growth. An added bonus is that DCF is less likely to be manipulated by aggressive accounting practices. DCF analysis shows that changes in long-term growth rates have the greatest impact on share valuation. Interest rate changes also make a big difference. Consider the numbers generated by a DCF model offered by Bloomberg Financial Markets. Sun Microsystems, which in 2012 traded on the market at $3.25, is valued at almost $5.50, which makes its price of $3.25 a steal. The model assumes a long-

term growth rate of 13%. If we cut the growth rate assumption by 25%, Sun's share valuation falls to $3.20. If we raise the growth rate variable by 25%, the shares go up to $7.50. Similarly, raising interest rates by one percentage point pushes the share value to $3.55; a 1% fall in interest rates boosts the value to about $7.70. Investors can also use the DCF model as a reality check. Instead of trying to come up with a target share price, they can plug in the current share price and, working backwards, calculate how fast the company would need to grow to justify the valuation. The lower the implied growth rate, the better less growth has therefore already been "priced into" the stock. Best of all, unlike comparative metrics like P/Es and price-to-sales ratios, DCF produces a bona fide stock value. Because it does not weigh all the inputs included in a DCF model, ratio-based valuation acts more like a beauty contest: stocks are compared to each other rather than judged on intrinsic value. If the companies used as comparisons are all over-priced, the investor can end up holding a stock with a share price ready for a fall. A well-designed DCF model should, by contrast, keep investors out of stocks that look cheap only against expensive peers. DCF models are powerful, but they do have shortcomings. Small changes in inputs can result in large changes in the value of a company. Investors must constantly second-guess valuations; the inputs that produce these valuations are always changing and are susceptible to error. Meaningful valuations depend on the user's ability to make solid cash flow projections. While forecasting cash flows more than a few years into the future is difficult, crafting results into eternity (which is a necessary input) is near impossible. A single, unexpected event can immediately make a DCF model obsolete. By guessing at what a decade of cash flow is worth today, most analysts limit their outlook to 10 years. Investors should watch out for DCF models that project to ridiculous lengths of time. Also, the DCF model focuses on long-range investing; it isn't suited for short-term investments. Investors shouldnt base a decision to buy a stock solely on discounted cash flow analysis - it is a moving target, full of challenges. If the company fails to meet financial performance expectations, if one of its big customers jumps to a competitor, or if interest rates take an unexpected turn, the model's numbers have to be re-run. Any time expectations change, the DCF-generated value is going to change. While many finance courses espouse the gospel of DCF analysis as the preferred valuation methodology for all cash flow generating assets, in practice, DCF can be difficult to apply in the valuation of stocks. Even if one believes the gospel of DCF, other valuation approaches are useful to help generate a complete valuation picture of a stock. Alternative Methodologies Even if one believes that DCF is the final word in assessing the value of an equity investment, it is very useful to supplement the approach with multiple-based target price approaches. If you are going to project income and cash flows, it is easy to use the supplementary approaches. It is important to assess which trading multiples (P/E,price/cash flow, etc.) are applicable based on the company's history and its sector. Choosing a target multiple range is where it gets tricky. While this is analogous to arbitrary discount rate selection, by using a trailing earnings number two years out and an appropriate P/E multiple to calculate a target price, this will entail far fewer assumptions to "value" the stock than under the DCF scenario. This improves the reliability of the conclusion relative to the DCF approach. Because we know what a company's P/E or price/cash flow multiple is after every trade, we have a lot of historical data from which to assess the future multiple possibilities. In contrast, the DCF model discount rate is always theoretical, and we do not really have any historical data to draw from when calculating it.

Discounted Cash Flow Valuation - Annuities And The Future Value And Present Value Of Multiple Cash Flows
At some point in your life you may have had to make a series of fixed payments over a period of time (such as rent or car payments) or you may have received a series of payments over a period of time, such as bond coupons. These are called annuities. If you understand the time value of money and have an understanding of future and present value, you're ready to learn about annuities and how their present and future values are calculated. What Are Annuities? Annuities are essentially series of fixed payments required from you or paid to you at a specified frequency over the course of a fixed period of time. The most common payment frequencies are yearly (once a year), semi-annually (twice a year), quarterly (four times a year) and monthly (once a month). There are two basic types of annuities: ordinary annuities and annuities due. Ordinary Annuity: Payments are required at the end of each period. For example, straight bonds usually pay coupon payments at the end of every six months until the bond's maturity date. Annuity Due: Payments are required at the beginning of each period. Rent is an example of annuity due. You are usually required to pay rent when you first move in at the beginning of the month and then on the first of each month thereafter.

Since the present and future value calculations for ordinary annuities and annuities due are slightly different, we will first discuss the present and future value calculation for ordinary annuities. Calculating the Future Value of an Ordinary Annuity If you know how much you can invest per period for a certain time period, the future value of an ordinary annuity formula is useful for finding out how much you would have in the future by investing at your given interest rate. If you are making payments on a loan, the future value is useful for determining the total cost of the loan. Let's now run through Example 1. Consider the following annuity cash flow schedule:

In order to calculate the future value of the annuity, we have to calculate the future value of each cash flow. Let's assume that you are receiving $1,000 every year for the next five years, and you invested each payment at 5%. The following diagram shows how much you would have at the end of the fiveyear period:

Since we have to add the future value of each payment, you may have noticed that, if you have an ordinary annuity with many cash flows, it would take a long time to calculate all the future values and then add them together. Fortunately, there's a formula that serves as a short cut for finding the accumulated value of all cash flows received from an ordinary annuity:

C = Cash flow per period i = interest rate n = number of payments If we were to use the above formula for Example 1 above, this is the result:

= $1000*[5.53] = $5525.63 Note that the one cent difference between $5,525.64 and $5,525.63 is due to a rounding error in the first calculation. Each of the values of the first calculation must be rounded to the nearest penny - the more you have to round numbers in a calculation the more likely rounding errors will occur. So, the above formula not only provides a short-cut to finding the future value (FV) of an ordinary annuity but also gives a more accurate result. (Now that you know how to do these on your own, check out our Future Value of an Annuity Calculator for the easy method.)
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Calculating the Present Value of an Ordinary Annuity If you would like to determine today's value of a series of future payments, you need to use the formula that calculates the present value (PV) of an ordinary annuity. This is the formula you would use as part of a bond pricing calculation. The PV of ordinary annuity calculates the present value of the coupon payments that you will receive in the future. For Example 2, we'll use the same annuity cash flow schedule as we did in Example 1. To obtain the total discounted value, we need to take the present value of each future payment and, as we did in Example 1, add the cash flows together.

Again, calculating and adding all these values will take a considerable amount of time, especially if we expect many future payments. As such, there is a mathematical shortcut we can use for the PV of an ordinary annuity.

C = Cash flow per period i = interest rate n = number of payments The formula provides us with the PV in a few easy steps. Here is the calculation of the annuity represented in the diagram for Example 2:

= $1000*[4.33] = $4329.48 Now that you know the long way to get present value of an annuity, you can check out our Present Value of an Annuity Calculator.

Calculating the Future Value of an Annuity Due When you are receiving or paying cash flows for an annuity due, your cash flow schedule would appear as follows:

Since each payment in the series is made one period sooner, we need to discount the formula one period back. A slight modification to the FV-of-an-ordinary-annuity formula accounts for payments occurring at the beginning of each period. In Example 3, let's illustrate why this modification is needed when each $1,000 payment is made at the beginning of the period rather than the end (assuming the interest rate is still 5%):

Notice that when payments are made at the beginning of the period, each amount is held for longer at the end of the period. For example, if the $1,000 was invested on January 1st rather than December 31st of each year, the last payment before we value our investment at the end of five years (on December 31st) would have been made a year prior (January 1st) rather than the same day on which it is valued. The future value of annuity formula would then read:
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Therefore,

= $1000*5.53*1.05 = $5801.91 Check out our Future Value Annuity Due Calculator to save some time.

Calculating the Present Value of an Annuity Due For the present value of an annuity due formula, we need to discount the formula one period forward as the payments are held for a lesser amount of time. When calculating the present value, we assume that the first payment was made today. We could use this formula for calculating the present value of your future rent payments as specified in a lease you sign with your landlord. Let's say for Example 4 that you make your first rent payment at the beginning of the month and are evaluating the present value of your five-month lease on that same day. Your present value calculation would work as follows:

Of course, we can use a formula shortcut to calculate the present value of an annuity due:

Therefore,

= $1000*4.33*1.05 = $4545.95 Recall that the present value of an ordinary annuity returned a value of $4,329.48. The present value of an ordinary annuity is less than that of an annuity due because the further back we discount a future payment, the lower its present value as each payment or cash flow in ordinary annuity occurs one period further into future. Now you can see how annuity affects how you calculate the present and future value of any amount of money. Remember that the payment frequencies (or number of payments) and the time at which these payments are made (whether at the beginning or end of each payment period) are all variables you need to account for in your calculations.

Discounted Cash Flow Valuation - Perpetuities


A perpetuity is a constant stream of identical cash flows with no end. The formula for determining the present value of a perpetuity is as follows:

A delayed perpetuity is perpetual stream of cash flows that starts at a predetermined date in the future. For example, preferred fixed dividend paying shares are often valued using a perpetuity formula. If the dividends are going to originate (start) five years from now, rather than next year, the stream of cash flows would be considered a delayed perpetuity. Although it may seem a bit illogical, an infinite series of cash flows can have a finite present value. Because of the time value of money, each payment is only a fraction of the last. The net present value (NPV) of a delayed perpetuity is less than a comparable ordinary perpetuity because, based on time value of money principles, the payments have to be discounted to account for the delay. Retirement products are often structured as delayed perpetuities. Examples of Perpetuities The perpetuity is not as abstract a concept as you may think. The British-issued bonds, called consols, are a great example of a perpetuity. By purchasing a consol from the British government, the bondholder is entitled to receive annual interest payments forever. Another example is a type of government bond called an undated issue that has no maturity date and pays interest in perpetuity. While the government can redeem an undated issue if it so chooses, since most existing undated issues have very low coupons, there is little or no incentive for redemption. Undated issues are treated as equity for all practical purposes due to their perpetual nature, but are also known as perpetual bonds. Perhaps the best-known undated issues are the U.K. government's undated bonds or gilts, of which there are eight issues in existence, some of which date back to the 19th century. The largest of these issues presently is the War Loan, with an issue size of 1.9 billion and a coupon rate of 3.5% that was issued in the early 20th century. Perpetuities and the Dividend Discount Model The concept of a perpetuity is used often in financial theory, particularly with the dividend discount model (DDM). Unfortunately, the theory is the easy part. The model requires a number of assumptions about a company's dividend payments, growth patterns and future interest rates. Difficulties spring up in the search for sensible numbers to fold into the equation. Here we'll examine this model and show you how to calculate it. The basic idea is that any stock is ultimately worth no more than what it will provide investors in current and future dividends. Financial theory says that the value of a stock is worth all of the future cash flows expected to be generated by the firm, discounted by an appropriate risk-adjusted rate. According to the DDM, dividends are the cash flows that are returned to the shareholder. To value a company using the DDM, calculate the value of dividend payments that you think a stock will generate in the years ahead. Here is what the model says:

Where: P= the price at time 0 r= discount rate For simplicity's sake, consider a company with a $1 annual dividend. If you figure the company will pay that dividend indefinitely, you must ask yourself what you are willing to pay for that company. Assume the expected return (or the required rate of return) is 5%. According to the dividend discount model, the company should be worth $20 ($1.00 / .05). How do we get to the formula above? It's actually just an application of the formula for a perpetuity:

The obvious shortcoming of the model above is that you'd expect most companies to grow over time. If you think this is the case, then the denominator equals the expected return less the dividend growth rate. This is known as the constant growth DDM or the Gordon model after its creator, Myron Gordon. Let's say you think the company's dividend will grow by 3% annually. The company's value should then be $1 / (.05 - .03) = $50. Here is the formula for valuing a company with a constantly growing dividend, as well as the proof of the formula:

The classic dividend discount model works best when valuing a mature company that pays a hefty portion of its earnings as dividends, such as a utility company. The Problem of Forecasting Proponents of the dividend discount model say that only future cash dividends can give you a reliable estimate of a company's intrinsic value. Buying a stock for any other reason - say, paying 20 times the company's earnings today because somebody will pay 30 times tomorrow - is mere speculation. In truth, the dividend discount model requires an enormous amount of speculation in trying to forecast future dividends. Even when you apply it to steady, reliable, dividend-paying companies, you still need to make plenty of assumptions about their future. This model is only as good as the assumptions it is based upon. Furthermore, the inputs that produce valuations are always changing and susceptible to error. The first big assumption that the DDM makes is that dividends are steady or grow at a constant rate indefinitely. But even for steady, utility-type stocks, it can be tricky to forecast exactly what the dividend payment will be next year, never mind a dozen years from now. (Find out some of the reasons why companies cut dividends inYour Dividend Payout: Can You Count On It?) Multi-Stage Dividend Discount Models To get around the problem posed by unsteady dividends, multi-stage models take the DDM a step

closer to reality by assuming that the company will experience differing growth phases. Stock analysts build complex forecast models with many phases of differing growth to better reflect real prospects. For example, a multi-stage DDM may predict that a company will have a dividend that grows at 5% for seven years, 3% for the following three years and then at 2% in perpetuity. However, such an approach brings even more assumptions into the model - although it doesn't assume that a dividend will grow at a constant rate, it must guess when and by how much a dividend will change over time. What Should Be Expected? Another sticking point with the DDM is that no one really knows for certain the appropriate expected rate of return to use. It's not always wise simply to use the long-term interest rate because the appropriateness of this can change. The High-Growth Problem No fancy DDM model is able to solve the problem of high-growth stocks. If the company's dividend growth rate exceeds the expected return rate, you cannot calculate a value because you get a negative denominator in the formula. Stocks don't have a negative value. Consider a company with a dividend growing at 20% while the expected return rate is only 5%: in the denominator (r-g) you would have -15% (5%-20%)! In fact, even if the growth rate does not exceed the expected return rate, growth stocks, which do not pay dividends, are even tougher to value using this model. If you hope to value a growth stock with the dividend discount model, your valuation will be based on nothing more than guesses about the company's future profits and dividend policy decisions. Most growth stocks do not pay out dividends. Rather, they reinvest earnings into the company with the hope of providing shareholders with returns by means of a higher share price. Consider Microsoft, which did not pay a dividend for decades. Given this fact, the model might suggest the company was worthless at that time, which is completely absurd. Remember, only about one-third of all public companies pay dividends. Furthermore, even companies that do offer payouts are allocating less and less of their earnings to shareholders. The dividend discount model is by no means the be-all and end-all for valuation. However, learning about the dividend discount model does encourage critical thinking. It forces investors to evaluate different assumptions about growth and future prospects. If nothing else, the DDM demonstrates the underlying principle that a company is worth the sum of its discounted future cash flows. Whether or not dividends are the correct measure of cash flow is another question. The challenge is to make the model as applicable to reality as possible, which means using the most reliable assumptions available.

Discounted Cash Flow Valuation - The Effect Of Compounding


Compounding is the ability of an asset to generate earnings, which are then reinvested in order to generate their own earnings. In other words, compounding refers to generating earnings from previous earnings. Suppose you invest $10,000 into Cory's Tequila Company (ticker: CTC). The first year, the shares rises 20%. Your investment is now worth $12,000. Based on good performance, you hold the stock. In Year 2, the shares appreciate another 20%. Therefore, your $12,000 grows to $14,400. Rather than your shares appreciating an additional $2,000 (20%) like they did in the first year, they appreciate an additional $2,400, because the $2,000 you gained in the first year grew by 20% too. If you extrapolate the process out, the numbers can start to get very big as your previous earnings start to provide returns. In fact, $10,000 invested at 20% annually for25 years would grow to nearly $1,000,000 - and that's without adding any money to the investment! Interest is often compounded monthly, quarterly, semiannually or annually. With continuous compounding, any interest earned immediately begins earning interest on itself. Albert Einstein allegedly called compound interest "the greatest mathematical discovery of all time." We think this is

true partly because, unlike the trigonometry or calculus you studied back in high school, compounding can be applied to everyday life. The wonder of compounding (sometimes called "compound interest") transforms your working money into a highly powerful income-generating tool. Compounding is the process of generating earnings on an asset's reinvested earnings. To work, it requires two things: the reinvestment of earnings and time. The more time you give your investments, the more you are able to accelerate the income potential of your original investment. To demonstrate, let's look at another example: If you invest $10,000 today at 6%, you will have $10,600 in one year ($10,000 x 1.06). Now let's say that rather than withdraw the $600 gained from interest, you keep it in there for another year. If you continue to earn the same rate of 6%, your investment will grow to $11,236.00 ($10,600 x 1.06) by the end of the second year. Because you reinvested that $600, it works together with the original investment, earning you $636, which is $36 more than the previous year. This little bit extra may seem like peanuts now, but let's not forget that you didn't have to lift a finger to earn that $36. More importantly, this $36 also has the capacity to earn interest. After the next year, your investment will be worth $11,910.16 ($11,236 x 1.06). This time you earned $674.16, which is $74.16 more interest than the first year. This increase in the amount made each year is compounding in action: interest earning interest on interest and so on. This will continue as long as you keep reinvesting and earning interest. Starting Early Consider two individuals; we'll name them Pam and Sam. Pam and Sam are the same age. When Pam was 25 she invested $15,000 at an interest rate of 5.5%. For simplicity, let's assume the interest was compounded annually. By the time Pam reaches 50, she will have $57,200.89 ($15,000 x [1.055^25]) in her bank account. Pam's friend, Sam, did not start investing until he reached age 35. At that time, he invested $15,000 at the same interest rate of 5.5% compounded annually. By the time Sam reaches age 50, he will have $33,487.15 ($15,000 x [1.055^15]) in his bank account. What happened? Both Pam and Sam are 50 years old, but Pam has $23,713.74 ($57,200.89 $33,487.15) more in her savings account than Sam, even though he invested the same amount of money. By giving her investment more time to grow, Pam earned a total of $42,200.89 in interest and Sam earned only $18,487.15. The following chart shows Pam and Sam's earnings:

You can see that both investments start to grow slowly and then accelerate, as reflected in the increase in the curves' steepness. Pam's line becomes steeper as she nears her 50s not simply because she has accumulated more interest, but because this accumulated interest is itself accruing more interest. Pam's line gets even steeper (her rate of return increases) in another 10 years. At age 60 she would have nearly $100,000 in her bank account, while Sam would only have around $60,000 - a $40,000 difference!

The effect of compound interest depends on frequency. Assume an annual interest rate of 12%. If we start the year with $100 and compound only once, at the end of the year, the principal grows to $112 ($100 x 1.12 = $112). If we instead compound each month at 1%, we end up with more than $112 at the end of the year. Specifically, we end up with $100 x 1.01^12 at $112.68. The final amount is higher because the interest compounded more frequently. Compounding amplifies the growth of your working money and maximizes the earning potential of your investments - but remember, because time and reinvesting make compounding work, you must keep your hands off the principal and earned interest. (For related reading, see Overcoming Compounding's Dark Side. For a more advanced discussion of compound interest, read Accelerating Returns With Continuous Compounding.

3.3 Loans And Amortization - Introduction To Loans


Businesses often need to borrow money to finance business investment activities. Here are some of the types of loans a business might take out. Basic Loans A commercial loan is a debt-based funding arrangement that a business can set up with a financial institution. The proceeds of commercial loans may be used to fund large capital expenditures and/or operations that a business may otherwise be unable to afford. This type of loan is usually short-term in nature and is almost always backed with some sort of collateral. Commercial loans usually charge flexible rates of interest that are tied to the bank prime rate or else to the London Interbank Offered Rate (LIBOR). Many borrowers must file regular financial statements, usually at least annually. Lenders also usually require proper maintenance of the loan collateral property. Due to expensive upfront costs and regulation-related hurdles, smaller businesses do not typically

have direct access to the debt and equity markets for financing purposes. Therefore, they must rely on financial institutions to meet their financing needs. A term loan is a loan from a bank for a specific amount that has a specified repayment schedule and a floating interest rate. Term loans almost always mature between one and 10 years. Businesses use term loans for month-to-month operations or to purchase fixed assets such as production equipment. An unsecured loan is issued and supported only by the borrower's creditworthiness, rather than by some sort of collateral. Generally, a borrower must have a high credit rating to receive an unsecured loan. Commercial paper is an example of an unsecured loan. A secured loan is backed by collateral; if it is not repaid, the lender can seize the collateral and sell it to recover the funds it lent. An acquisition loan helps a company purchase a specific asset that is determined before the loan is granted. Acquisition loans are sought when a company wants to complete an acquisition for an asset but does not have enough liquid capital to do so. The company may be able to get more favorable terms on an acquisition loan because the assets being purchased have a tangible value, as opposed to capital being used to fund daily operations or release a new product line. The acquisition loan is typically only available to be used for a short window of time and only for specific purposes. Once repaid, funds available through an acquisition loan cannot be re-borrowed as with a revolving line of credit at a bank. Revolving Credit Revolving credit is another way businesses can borrow money, but the structure is a bit different than an ordinary loan. A line of credit establishes a maximum loan balance that the bank will permit the borrower to maintain. The borrower can draw down on the line of credit at any time, as long as he or she does not exceed the maximum set in the agreement. The advantage of a line of credit over a regular loan is that interest is usually charged only on the part of the line of credit that is used, and the borrower can draw on the line of credit at any time. Depending on the agreement with the financial institution, the line of credit may be classified as a demand loan, which means that any outstanding balance will have to be paid immediately at the financial institution's request. Revolving credit may also be called an evergreen loan or a standing loan. Credit cards are also a type of revolving credit. More Complex Loans A self-liquidating loan is a type of short or intermediate-term credit that is repaid with money generated by the assets purchased. The repayment schedule and maturity of a self-liquidating loan are designed to coincide with the timing of the assets' income generation. These loans are intended to finance purchases that will quickly and reliably generate cash. A business might use a self-liquidating loan to purchase extra inventory in anticipation of the holiday shopping season. The revenue generated from selling that inventory would be used to repay the loan. Self-liquidating loans are not always a good credit choice. For example, they do not make sense for fixed assets, such as real estate, or depreciable assets, such as machinery. Another type of loan related to a businesss assets is an asset-conversion loan, a short-term loan that is typically repaid by converting an asset, usually inventory or receivables, into cash. For example, let's say the TSJ Sports Conglomerate is short on cash it needs to pay its employees this month. One option they might explore is trying to get an asset-conversion loan to fill that short-term cash void. Another type of loan that can help a business meet its day to day needs is a cash flow loan. Reasons for needing a cash flow loan could be seasonal-demand changes, business expansion or changes in the

business cycle. Cash-flow loans can help in temporary situations, but if cash flow problems persist then companies need to improve their cash conversion cycle and get customers to pay faster. A working capital loan can also be used to finance everyday operations of a company. It is not used to buy long-term assets or investments, but rather to clear up accounts payable, pay wages and salaries, and so on. A company can also pledge its accounts receivable (AR) as collateral for a loan. A non-notification loan is a type of full-recourse loan that is securitized by accounts receivable. Customers making accounts-receivable payments are not notified that their account/payment is being used as collateral for a loan. They continue making payments to the company that rendered services or made the original loan, and the company then uses those payments to repay their lender for financing obtained. If customers do not pay accounts receivable, the company is still liable for repaying the loan it obtained using the AR as security. A bridge loan, also known as "interim financing," "gap financing" or a "swing loan," is a short-term loan that is used until a company secures permanent financing or removes an existing obligation. This type of financing allows the user to meet current obligations by providing immediate cash flow. The loans are short term (up to one year) with relatively high interest rates and are backed by some form of collateral such as real estate or inventory. As the term implies, these loans "bridge the gap" between times when financing is needed. They can be customized for many different situations. For example, let's say that a company is doing a round of equity financing that is expecting to close in six months. A bridge loan could be used to secure working capital until the round of funding goes through. This is not an exhaustive list of the types of loans available to businesses, but it gives a general idea of the different options available. Businesses should shop around at different institutions to determine which lender offers the best terms for the loan.

Loans And Amortization - Alternatives To Loans


When conventional credit markets get tight, individuals and businesses are pushed to seek alternative lenders to obtain financing. Some of these alternative financing sources have been around for a long time, but the 2007-2008 credit crunch spawned some new potential financing sources for business owners and individuals, as well as some new ways to access them. Here are seven unconventional ways businesses can borrow money and the benefits, dangers and drawbacks of each. 1. Factoring Factoring (also known as accounts receivable financing) is one of the oldest methods of in-house financing. Simply put, factoring is when a business sells its accounts receivable to a financial institution or "factor." The factor will advance funds on a portion of the receivables, usually 75-80% of their face value. The remaining 20-25% is known as the "reserve" and is initially held by the factor. The amount of the reserve will vary with the quality of the receivables and the historical average of the payers. Historically late payers will increase the amount of the required reserve. (For more on factoring, see Taking The Sting Out Of Receivables.) The factor handles the transactions, administers the accounts, conducts credit assessments and handles collections. For these services and the funds advance, the factoring costs to the borrower may exceed 20% of the face value of the receivables. Once the accounts are paid, the borrower receives the difference between the face value and the reserve. The factor usually gets a 2-3% fee for the first 30 days, with late charges ranging from 0.0670.125% per day thereafter. The benefits of factoring include quick access to cash (usually within 10 days) and the fact that with a growing business, more accounts receivable will be coming in. There are now some online accounts receivable markets in which factors bid on a business's accounts receivable.

The dangers of factoring can be exacerbated when business owners do not know who they are dealing with. Deal only with well-known, reputable factors. Although it may be convenient, it is inadvisable to factor too many of your accounts receivable as it is expensive and may get in the way of establishing a track record with conventional lenders. Also, some factors may require that your customers make their payables checks out to the factor. This may give your customers a negative view of the state of your business. Fortunately, this requirement can often be negotiated away if addressed at the outset. 2. Hedge-Fund Lenders According to an August 2008 Businessweek article, hedge fund lenders are being referred to as "the new corporate ATMs." Hedge funds will often loan money into higher risk businesses, such as asset or technology-concept backed companies; the size of the loan will depend on the quality of the pitch made by the borrower. The decision to lend is usually made after some due diligence but with greater flexibility than that experienced with conventional lenders. The benefit of hedge fund loans is that access to funds is usually quick. The dangers include high borrowing costs and prepayment penalties. Some hedge funds have been known to fund risky loans to exploit the internal information gained in the process, which can benefit their other trading. (For related reading, see A Brief History Of The Hedge Fund.) 3. Peer-to-Peer Lenders Peer-to-peer lenders may include family, friends and even strangers who are interested in your success. This can be a formal or informal arrangement. The benefits of this type of loan are quick access to cash and flexibility in the repayment requirements. This financing source may also have a downside: non-business issues and non-financial paybacks can get intertwined with the lending situation. Loans from family and friends may come with expectations of employment or free or discounted products from you or your business. Another peer-to-peer credit source is the online social lending marketplace, such as that found at Prosper. The benefits of social online lending sources can include a loan at relatively low rates for high-risk business ventures and more flexible terms than those offered from other lending sources. In this scenario, you place your lending needs online and potential lenders bid on your loan by agreeing to provide the requested loan at a given interest rate. The borrower will usually accept the lowest rate offered with the best repayment terms. This lending source accounts for a very small volume of business loans, only $200-$300 million per year nationwide. Dangers and drawbacks include not knowing your lender, making your loan requirements public and not establishing a credit history with one lender. (For more on this type of loan, read Peer-To-Peer Lending Opens Doors For Lenders/Borrowers.) 4. Customer Lenders Borrowing from business customers started in the early 2000s with community supported agricultural loans (CSAs). In CSAs, farmers' customers loaned money prior to the planting season and took payment in harvested product at discounted prices. This model expanded, especially in some retail arenas like local food markets. One Boston neighborhood specialty food market used it successfully in 2008 to pay for store upgrades, according to a May 2005 article in Businessweek. The owner accepted needed cash from a number of customers and agreed to supply them with a given dollar amount of food every week for the coming year at a discount from store retail prices. To participate in customer lending, a business must be well-established in the neighborhood, possess a good list of customers and have earned the trust of those customers. Dangers and drawbacks include customers wanting uneven amounts of product and/or non-stocked products, and customers dropping out of the repayment-with-product program and demanding cash

back. 5. Credit Card Lenders Often used by owners to start a business, financing from credit cards has the benefit of easy and early access to cash if your credit history is good. This method has several dangers and drawbacks, however. Credit card financing is usually limited in the amount available to borrowers based on the borrower's demonstrated ability to earn and repay the loan. Because this is the only collateral, credit card rates are high and subject to huge rate penalties for delayed or missed payments on any outstanding bills. For example, a delayed payment on a utility bill might send your credit card rate soaring, affecting all other aspects of your credit and financial status. (For related reading, see Six Major Credit Card Mistakes.) 6. Convertible Debt Instruments Convertible debt instruments are essentially asset-backed loans that can require the business owner to give up some future equity in the business if the lender wishes to convert the debt to an equity position in the company. One of the benefits is that the lender incurs less risk in making this type of loan and therefore is more likely to make the loan. It is also less risky for the lender than a straight equity investment if the lender just wants to be paid back with a return and does not want ownership. This may occur if the company's bottom line growth is not performing as anticipated. The dangers and drawbacks to the borrower are the potential loss of future equity if the company does well. Conversely, the owner may be required to pay back unconverted debt if the company is performing below budget. (To learn more about this type of financing, read Why Companies Issue Convertible Bonds.) 7. Venture-Capital-Backed Company Loans Although limited to a small group of qualifying companies (and usually geographically concentrated in California and the Boston area), this bank-based lending source has significant benefits for qualifying companies. This arrangement allows companies with previous backing from venture capital companies that have established relationships with certain banks to access bank lending based primarily on the bank's reliance on the due diligence done by the previous venture capital firms. With these loans, borrowers have access to bank lenders previously unavailable to the company, quicker access due to the pre-screening by the venture capital firm and access to bank financing with a higher risk threshold than a stand-alone bank loan. This bank lending comes with a high interest rate and probable future stock warrant coverage requirements, which allows the lender to purchase shares in the borrowing company at a future date at a specified fixed price or a price under current market price at the time of purchase. It is also currently limited to a small percentage of borrowers. (For more on how venture capitalists operate, read Cashing In On The Venture Capital Cycle.) Availability and choice of alternative lender(s) will be governed by the unique variables inherent in the needs, capacities and credit history of the borrowing business. These will include timing requirements, asset bases, geographic location, risk tolerances and the ability to pitch the soundness and success potential of the business, among others. If thorough and competent credit market shopping and evaluation is done, businesses may still be able to get the financing they need when the bank says "no."

Loans And Amortization - Amortization


There are two types of amortization. One relates to the way certain business expenses are deducted, which we discussed in Section 2. The other relates to the way a loan is repaid, which well discuss here. Amortization describes the paying off of debt in regular installments over a period of time. An amortized loan has scheduled periodic payments of both principal and interest. With a self-amortizing loan, the periodic payments consist of both principal and interest in an amount such that the loan will be paid off by the end of a scheduled term. Assuming the loan is a fixed-rate loan, the amount of each

payment and the breakdown of the principal and the interest that comprise each payment can be known in advance. If the loan is an adjustable-rate loan, it can still be self-amortizing, but because the interest rate is subject to change, the amount and breakdown of each payment cannot be known in advance. Borrowers who choose fully amortized loans are less likely to experience "payment shock" than borrowers who choose loans that are not fully amortized. Payments on loans that are not initially fully amortized must at some point become amortized over the remaining term of the loan in order for the outstanding principal balance to be repaid. The shorter the remaining term, the larger the increase required in the periodic payments to amortize the loan over the remaining term. With a fully amortizing loan, the principal balance decreases with each payment. With a negatively amortizing loan, the principal balance increases each month because the payments fail to cover the interest due. The unpaid interest, called deferred interest, is added to the loan's principal, which ultimately causes the borrower to owe more money. For example, consider a loan with an 8% annual interest rate, a remaining principal balance of $100,000, and a provision that allows the borrower to make $500 payments at a certain number of scheduled payment dates. The interest due on the loan at the next scheduled payment would be: 0.08 / 12 x 100,000 = $666.67. If the borrower makes a $500 payment, $166.67 in deferred interest ($666.67 - $500) will be added to the principal balance of the loan for a total remaining principal balance of $100,166.67. The next months interest charge would be based on this new principal balance amount, and the calculation would continue each month leading to increases in the loan's principal balance or negative amortization. Negative amortization cannot continue indefinitely. At some point, the loan must start to amortize over its remaining term. Typically, negatively amortizing loans have scheduled dates when the payments are recalculated, so that the loan will amortize over its remaining term, or they have a negative amortization limit which states that when the principal balance of the loan reaches a certain contractual limit the payments will be recalculated. With a non-amortizing loan, payments on the principal are not made, while interest payments or minimum payments are made regularly. As a result, the value of principal does not decrease at all over the life of the loan. The principal is then paid as a lump sum at the maturity of the loan. Examples of non-amortizing loan agreements are balloon mortgages and deferred interest programs. An amortization schedule is a chart showing a complete breakdown of periodic blended loan payments. It shows the amount of principal and the amount of interest that comprise each payment so that the loan will be paid off at the end of its term. Early in the schedule, the majority of each periodic payment is interest. Later in the schedule, the majority of each periodic payment is put toward the principal. If you know the term of a loan and the total periodic payment, an easy way to calculate an amortization schedule is to do the following: Starting in month one, multiply the loan balance by the periodic interest rate. This will be the interest amount of the first month's payment. Subtract that amount from the total payment, which will give you the principal amount. To calculate the next month's interest and principal payments, subtract the principal payment made in month one from the loan balance, and then repeat the steps from above. As an alternative, you can let a loan amortization calculator do the work for you.

3.4 Bonds - Introduction To Bonds


Companies may issue bonds to finance operations. Most companies can borrow from banks, but view direct borrowing from a bank as more restrictive and expensive than selling debt on the open market through a bond issue. The costs involved in borrowing money directly from a bank are prohibitive to a number of companies.

In the world of corporate finance, many chief financial officers (CFOs) view banks as lenders of last resort because of the restrictive debt covenants that banks place on direct corporate loans. Covenants are rules placed on debt that are designed to stabilize corporate performance and reduce the risk to which a bank is exposed when it gives a large loan to a company. In other words, restrictive covenants protect the bank's interests; they're written by securities lawyers and are based on what analysts have determined to be risks to that company's performance. Here are a few examples of the restrictive covenants faced by companies: they can't issue any more debt until the bank loan is completely paid off; they can't participate in any share offerings until the bank loan is paid off; they can't acquire any companies until the bank loan is paid off, and so on. Relatively speaking, these are straightforward, unrestrictive covenants that may be placed on corporate borrowing. However, debt covenants are often much more convoluted and carefully tailored to fit the borrower's business risks. Some of the more restrictive covenants may state that the interest rate on the debt increases substantially should the chief executive officer (CEO) quit or if earnings per share drop in a given time period. Covenants are a way for banks to mitigate the risk of holding debt, but for borrowing companies they are seen as an increased risk. Simply put, banks place greater restrictions on what a company can do with a loan and are more concerned about debt repayment than bondholders. Bond markets tend to be more forgiving than banks and are often seen as being easier to deal with. As a result, companies are more likely to finance operations by issuing bonds than by borrowing from a bank. What Is a Corporate Bond? Similar to a mortgage with a bank, bonds are an issue by a borrower to a lender. When you buy a corporate bond, you are loaning your money to a corporation for a predetermined period of time (known as the maturity). In most cases, the bond's par value is $1,000. This is the face value of the bond and the amount the company (the borrower) will repay the lender (you) once the bond matures. Of course, you're not going to loan your money for free. The borrower must also pay you a premium, known as a "coupon," at a predetermined interest rate in exchange for using your money. These interest payments are usually made every six months until the bond reaches maturity. There are three important factors to consider before buying a bond. The first is the issuer. The second is the interest (or coupon) you will receive. The third is the maturity date, the day when the company must repay your principal. Objectives and Risks Corporate bonds offer a slightly higher yield because they carry a higher default risk than government bonds. Corporate bonds are not the greatest for capital appreciation, but they do offer an excellent source of income, especially for retirees. Corporate bonds are also highly useful for tax-deferred retirement savings accounts, which allow you to avoid taxes on the semiannual interest payments. The risks associated with corporate bonds depend entirely on the issuing company. Purchasing bonds from well-established and profitable companies is much less risky than purchasing bonds from firms in financial trouble. Bonds from extremely unstable companies are called junk bonds and are very risky because they have a high risk of default. Strengths Many corporate bonds offer a higher rate of return than government bonds for only slightly more risk. The risk of losing your principal is very low if you only buy bonds in well-established companies with a good track record. This may take a bit of research. Weaknesses Fixed interest payments are taxed at the same rate as income. Corporate bonds offer little protection against inflation because the interest payments are usually a fixed amount until maturity.
High Yield Money Market

Three Main Uses 1. Capital Appreciation

2. Income 3. Safe Investment How to Buy Or Sell a Corporate Bond Corporate bonds can be purchased through a full service or discount broker, a commercial bank or other financial intermediaries. The best time to buy a corporate bond is when interest rates are relatively high. You can also open an account with a bond broker, but be warned that most bond brokers require a minimum initial deposit of $5,000. If you cannot afford this amount, we suggest looking at a mutual fund that specializes in bonds (or a bond fund). If you do decide to purchase a bond through your broker, he or she may tell you that the trade is commission free. Don't be fooled. What typically happens is that the broker will mark up the price slightly; this markup is really the same as a commission. To make sure that you are not being taken advantage of, simply look up the latest quote for the bond and determine whether the markup is acceptable.

Bonds - Types Of Bonds


This section describes the various types of bonds that a company might issue. (To learn about government-issued bonds, read Basics Of Federal Bond Issues, Savings Bonds For Income And Safety and 20 Investments: Municipal Bonds.) Corporate Bonds A company can issue bonds just as it can issue stock. Large corporations have a lot of flexibility as to how much debt they can issue: the limit is whatever the market will bear. Generally, a short-term corporate bond has a maturity of less than five years, intermediate is five to 12 years and long term is more than 12 years. Corporate bonds are characterized by higher yields because there is a higher risk of a company defaulting than a government. The upside is that they can also be the most rewarding fixed-income investments because of the risk the investor must take on. The company's credit quality is very important: the higher the quality, the lower the interest rate the investor receives. Variations on corporate bonds include convertible bonds, which the holder can convert into stock, and callable bonds, which allow the company to redeem an issue prior to maturity. Convertible Bonds A convertible bond may be redeemed for a predetermined amount of the company's equity at certain times during its life, usually at the discretion of the bondholder. Convertibles are sometimes called "CVs." Issuing convertible bonds is one way for a company to minimize negative investor interpretation of its corporate actions. For example, if an already public company chooses to issue stock, the market usually interprets this as a sign that the company's share price is somewhat overvalued. To avoid this negative impression, the company may choose to issue convertible bonds, which bondholders will likely convert to equity should the company continue to do well. From the investor's perspective, a convertible bond has a value-added component built into it: it is essentially a bond with a stock option hidden inside. Thus, it tends to offer a lower rate of return in exchange for the value of the option to trade the bond into stock. Callable Bonds Callable bonds, also known as "redeemable bonds," can be redeemed by the issuer prior to maturity. Usually a premium is paid to the bond owner when the bond is called. The main cause of a call is a decline in interest rates. If interest rates have declined since a company

first issued the bonds, it will likely want to refinance this debt at a lower rate. In this case, the company will call its current bonds and reissue new, lower-interest bonds to save money. Term Bonds Term bonds are bonds from the same issue that share the same maturity dates. Term bonds that have a call feature can be redeemed at an earlier date than the other issued bonds. A call feature, or call provision, is an agreement that bond issuers make with buyers. This agreement is called an "indenture," which is the schedule and the price of redemptions, plus the maturity dates. Some corporate and municipal bonds are examples of term bonds that have 10-year call features. This means the issuer of the bond can redeem it at a predetermined price at specific times before the bond matures.
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A term bond is the opposite of a serial bond, which has various maturity schedules at regular intervals until the issue is retired. Amortized Bonds An amortized bond is a financial certificate that has been reduced in value for records on accounting statements. An amortized bond is treated as an asset, with the discount amount being amortized to interest expense over the life of the bond. If a bond is issued at a discount - that is, offered for sale below its par (face value) - the discount must either be treated as an expense or amortized as an asset. As we discussed in Section 4, amortization is an accounting method that gradually and systematically reduces the cost value of a limited life, intangible asset. Treating a bond as an amortized asset is an accounting method in the handling of bonds. Amortizing allows bond issuers to treat the bond discount as an asset until the bond's maturity. (To learn more about bond premium amortization, read Premium Bonds: Problems And Opportunities.) Adjustment Bonds Issued by a corporation during a restructuring phase, an adjustment bond is given to the bondholders of an outstanding bond issue prior to the restructuring. The debt obligation is consolidated and transferred from the outstanding bond issue to the adjustment bond. This process is effectively a recapitalization of the company's outstanding debt obligations, which is accomplished by adjusting the terms (such as interest rates and lengths to maturity) to increase the likelihood that the company will be able to meet its obligations. If a company is near bankruptcy and requires protection from creditors (Chapter 11), it is likely unable to make payments on its debt obligations. If this is the case, the company will be liquidated, and the company's value will be spread among its creditors. However, creditors will generally only receive a fraction of their original loans to the company. Creditors and the company will work together to recapitalize debt obligations so that the company is able to meet its obligations and continue operations, thus increasing the value that creditors will receive. Junk Bonds A junk bond,also known as a "high-yield bond" or "speculative bond," is a bond rated "BB" or lower because of its high default risk. Junk bonds typically offer interest rates three to four percentage points higher than safer government issues. Angel Bonds Angel bonds are investment-grade bonds that pay a lower interest rate because of the issuing company's high credit rating. Angel bonds are the opposite of fallen angels, which are bonds that have been given a "junk" rating and are therefore much more risky. An investment-grade bond is rated at minimum "BBB" by S&P and Fitch, and "Baa" by Moody's. If the

company's ability to pay back the bond's principal is reduced, the bond rating may fall below investment-grade minimums and become a fallen angel.

Bonds - Bond Valuation


The fundamental principle of bond valuation is that the bond's value is equal to the present value of its expected (future) cash flows. The valuation process involves the following three steps: 1. Estimate the expected cash flows. 2. Determine the appropriate interest rate or interest rates that should be used to discount the cash flows. 3. Calculate the present value of the expected cash flows found in step one by using the interest rate or interest rates determined in step two. Determining Appropriate Interest Rates The minimum interest rate that an investor should accept is the yield for a risk-free bond (a Treasury bond for a U.S. investor). The Treasury security that is most often used is the on-the-run issue because it reflects the latest yields and is the most liquid. For non-Treasury bonds, such as corporate bonds, the rate or yield that would be required would be the on-the-run government security rate plus a premium that accounts for the additional risks that come with non-Treasury bonds. As for the maturity, an investor could just use the final maturity date of the issue compared to the Treasury security. However, because each cash flow is unique in its timing, it would be better to use the maturity that matches each of the individual cash flows. Computing a Bond's Value First, we need to find the present value (PV) of the bond's future cash flows. The present value is the amount that would have to be invested today to generate that future cash flow. PV is dependent on the timing of the cash flow and the interest rate used to calculate the present value. To figure out the value, the PV of each individual cash flow must be found. Then, just add the figures together to determine the bond's price.

PV at time T = expected cash flows in period T / (1 + I) to the T power


After you calculate the expected cash flows, you will need to add the individual cash flows:

Value = present value @ T1 + present value @ T2 + present value @Tn


Let's throw some numbers around to further illustrate this concept. Example: The Value of a Bond Bond GHJ matures in five years with a coupon rate of 7% and a maturity value of $1,000. For simplicity's sake, let's assume that the bond pays annually and the discount rate is 5%. The cash flow for each of the years is as follows: Year One = $70 Year Two = $70 Year Three = $70

Year Four = $70 Year Five = $1,070 Thus, the PV of the cash flows is as follows: Year Year Year Year Year One = $70 / (1.05) to the 1st power = $66.67 Two = $70 / (1.05) to the 2nd power = $ 63.49 Three = $70 / (1.05) to the 3rd power = $ 60.47 Four = $70 / (1.05) to the 4th power = $ 57.59 Five = $1,070 / (1.05) to the 5th power = $ 838.37

Now to find the value of the bond: Value = $66.67 + $63.49 + $60.47 + $57.59 + $838.37 Value = $1,086.59 How Does the Value of a Bond Change? As rates increase or decrease, the discount rate that is used also changes. Let's change the discount rate in the above example to 10% to see how it affects the bond's value. Example: The Value of a Bond when Discount Rates Change PV of the cash flows is: Year One = $70 / (1.10) to the 1st power = $ 63.63 Year Two = $70 / (1.10) to the 2nd power = $ 57.85 Year Three = $70 / (1.10) to the 3rd power = $ 52.63 Year Four = $70 / (1.10) to the 4th power = $ 47.81 Year Five = $1,070 / (1.10) to the 5th power = $ 664.60
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Value = 63.63 + 57.85 + 52.63 + 47.81 + 664.60 = $ 886.52 As we can see from the above examples, an important property of PV is that for a given discount rate, the older a cash flow value is, the lower its present value. We can also compute the change in value from an increase in the discount rate used in our example. The change = $1,086.59 - $886.52 = $200.07. Another property of PV is that the higher the discount rate, the lower the value of a bond; the lower the discount rate, the higher the value of the bond.

Look Out! If the discount rate is higher than the coupon rate the PV will be less than par. If the discount rate is lower than the coupon rate, the PV will be higher than par value.
How Does a Bond's Price Change as it Approaches its Maturity Date? As a bond moves closer to its maturity date, its price will move closer to par. There are three possible scenarios: 1.If a bond is at a premium, the price will decline over time toward its par value. 2. If a bond is at a discount, the price will increase over time toward its par value. 3. If a bond is at par, its price will remain the same. To show how this works, let's use our original example of the 7% bond, but now let's assume that a year has passed and the discount rate remains the same at 5%. Example: Price Changes Over Time

Let's compute the new value to see how the price moves closer to par. You should also be able to see how the amount by which the bond price changes is attributed to it being closer to its maturity date. PV of the cash flows is: Year One = $70 / (1.05) to the 1st power = $66.67 Year Two = $70 / (1.05) to the 2nd power = $ 63.49 Year Three = $70 / (1.05) to the 3rd power = $ 60.47 Year Four = $1,070 / (1.05) to the 4th power = $880.29 Value = $66.67 + $63.49 + $60.47 + $880.29 = $1,070.92 As the price of the bond decreases, it moves closer to its par value. The amount of change attributed to the year's difference is $15.67. An individual can also decompose the change that results when a bond approaches its maturity date and the discount rate changes. This is accomplished by first taking the net change in the price that reflects the change in maturity, then adding it to the change in the discount rate. The two figures should equal the overall change in the bond's price.
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Computing the Value of a Zero-coupon Bond A zero-coupon bond may be the easiest of securities to value because there is only one cash flow - the maturity value. The formula to calculate the value of a zero coupon bond that matures N years from now is as follows:

Maturity value / (1 + I) to the power of the number of years * 2 Where I is the semi-annual discount rate.
Example: The Value of a Zero-Coupon Bond For illustration purposes, let's look at a zero coupon with a maturity of three years and a maturity value of $1,000 discounted at 7%. I = 0.035 (.07 / 2) N=3 Value of a Zero-Coupon Bond = $1,000 / (1.035) to the 6th power (3*2) = $1,000 / 1.229255 = $813.50 Arbitrage-free Valuation Approach Under a traditional approach to valuing a bond, it is typical to view the security as a single package of cash flows, discounting the entire issue with one discount rate. Under the arbitrage-free valuation approach, the issue is instead viewed as various zero-coupon bonds that should be valued individually and added together to determine value. The reason this is the correct way to value a bond is that it does not allow a risk-free profit to be generated by "stripping" the security and selling the parts at a higher price than purchasing the security in the market. As an example, a five-year bond that pays semi-annual interest would have 11 separate cash flows and would be valued using the appropriate yield on the curve that matches its maturity. So the markets implement this approach by determining the theoretical rate the U.S. Treasury would have to pay on a zero-coupon treasury for each maturity. The investor then determines the value of all the different payments using the theoretical rate and adds them together. This zero-coupon rate is

the Treasury spot rate.The value of the bond based on the spot rates is the arbitrage-free value. Determining Whether a Bond Is Under or Over Valued What you need to be able to do is value a bond like we have done before using the more traditional method of applying one discount rate to the security. The twist here, however, is that instead of using one rate, you will use whatever rate the spot curve has that coordinates with the proper maturity. You will then add the values up as you did previously to get the value of the bond. You will then be given a market price to compare to the value that you derived from your work. If the market price is above your figure, then the bond is undervalued and you should buy the issue. If the market price is below your price, then the bond is overvalued and you should sell the issue. How Bond Coupon Rates and Market Rates Affect Bond Price If a bond's coupon rate is above the yield required by the market, the bond will trade above its par value or at a premium. This will occur because investors will be willing to pay a higher price to achieve the additional yield. As investors continue to buy the bond, the yield will decrease until it reaches market equilibrium. Remember that as yields decrease, bond prices rise. If a bond's coupon rate is below the yield required by the market, the bond will trade below its par value or at a discount. This happens because investors will not buy this bond at par when other issues are offering higher coupon rates, so yields will have to increase, which means the bond price will drop to induce investors to purchase these bonds. Remember that as yields increase, bond prices fall.

Bonds - Bond Ratings


A bond rating is a grade given to a bond that indicates its credit quality. Private independent rating services provide these evaluations of a bond issuer's financial strength or its ability to pay a bond's principal and interest in a timely fashion. Bond ratings are expressed as letters ranging from "AAA," which is the highest grade, to "C" or "D" ("junk"), which is the lowest grade. Different rating services use the same letter grades, but use various combinations of upper and lower-case letters to differentiate themselves. The bond rating system helps investors determine a company's credit risk. Think of a bond rating as the report card for a company's credit rating. Blue-chip firms, which are safer investments, have a high rating, while risky companies have a low rating. The chart below illustrates the different bond rating scales from the major rating agencies in the United States: Moody's, Standard and Poor's and Fitch Ratings.

Bond Rating Moody's Aaa Aa A Baa Ba, B Caa/Ca/C C

S&P/ Fitch AAA AA A BBB BB, B CCC/CC/C D

Grade Investment Investment Investment Investment Junk Junk Junk

Risk Highest Quality High Quality Strong Medium Grade Speculative Highly Speculative In Default

Notice that if the company falls below a certain credit rating, its grade changes from investment quality to junk status. Junk bonds are aptly named: they are the debt of companies in some sort of financial difficulty. Because these bonds are so risky, they have to offer much higher yields than any other debt. Bonds are not inherently safer than stocks. Certain types of bonds can be just as risky, if not riskier, than stocks.

Rating the creditworthiness of a bond issuer, despite the number crunching, is as much an art form as it is a science. While companies like Moody's and A.M. Best gather and analyze mountains of data, the rating itself comes down to the informed opinion of an analyst or a rating committee. The organizations that rate bonds look at an issuer's assets, debts, income, expenses and financial history. In addition, they give special attention to the trustworthiness of a company to repay previous bond issues on time and in full. Rating agencies regularly review bond ratings every six to 12 months. However, a bond may be reviewed at any time the agency deems necessary for reasons including missed or delayed payments to investors, issuance of new bonds, changes to an issuer's underlying financial fundamentals, or other broad economic developments. (For more on this subject, read The Debt Ratings Debate.) Institutional and individual investors rely on bond rating agencies and their in-depth research to make investment decisions. Rating agencies play an integral role in the investment process and can make or break a company's success in both the primary and secondary bond markets. While the rating agencies provide a robust service and are worth the fees they earn, the value of such ratings has been widely questioned since the 2008 financial crisis, and the agencies' timing and opinions have been criticized when dramatic downgrades have come very quickly. Investors should not rely solely on the bond rating agency's rating and should supplement the ratings with their own research. It's also important to frequently review the ratings over the life of a bond. (Read more in Bond Rating Agencies: Can You Trust Them? and Why Bad Bonds Get Good Ratings.) Occasionally, firms will not have their bonds rated, in which case it is solely up to the investor to judge a firm's repayment ability. Because the rating systems differ for each agency and change from time to time, it is prudent to research the rating definition for the bond issue you are considering

Bonds - The Bond Market


The bond market is where debt securities are issued and traded. The bond market primarily includes government-issued securities and corporate debt securities, and it facilitates the transfer of capital from savers to the issuers or organizations that requires capital for government projects, business expansions and ongoing operations. The bond market is alternatively referred to as the debt, credit or fixed-income market. Although the bond market appears complex, it is really driven by the same risk and return tradeoffs as the stock market. Most trading in the bond market occurs over the counter through organized electronic trading networks and is composed of the primary market (through which debt securities are issued and sold by borrowers to lenders) and the secondary market (through which investors buy and sell previously issued debt securities among themselves). Although the stock market often commands more media attention, the bond market is actually many times bigger and is vital to the ongoing operation of the public and private sectors. The bond market can essentially be broken down into three main groups: issuers, underwriters and purchasers. The issuers sell bonds or other debt instruments in the bond market to fund the operations of their organizations. This area of the market is mostly made up of governments, banks and corporations. The biggest of these issuers is the government, which uses the bond market to help fund a country's operations. Banks are also key issuers in the bond market, and they can range from local banks up to supranational banks such as the European Investment Bank. The final major issuer is the corporate bond market, which issues debt to finance corporate operations. The underwriting segment of the bond market is traditionally made up of investment banks and other financial institutions that help the issuer to sell the bonds in the market. In general, selling debt is not as easy as just taking it to the market. In most cases, millions if not billions of dollars are transacted in

one offering. As a result, a lot of work needs to be done to prepare for the offering, such as creating a prospectus and other legal documents. In general, the need for underwriters is greatest for the corporate debt market because there are more risks associated with this type of debt. The final players in the bond market are those who buy the debt. Buyers basically include every group mentioned as well as any other type of investor, including the individual. Governments play one of the largest roles in the market because they borrow and lend money to other governments and banks. Furthermore, governments often purchase debt from other countries if they have excess reserves of that country's money as a result of trade between countries. For example, Japan is a major holder of U.S. government debt. Getting bond quotes and general information about a bond issue is considerably more difficult than researching a stock or a mutual fund. There is not a lot of individual investor demand for the information; most bond information is available only through higher level tools that are not accessible to the average investor. In most cases, if you have a brokerage account, you will have access to that firm's research tools, which may include bond quotes and other information. Your brokerage is therefore the first place that you should look for bond information. However, there are also free tools available online that provide some basic information such as the bond's current price, coupon rate, yield to maturity (YTM), bond rating and other pertinent information. Online services can be limited, however, if they do not give you the volume of bonds that trade hands or a bid-ask spread, making it difficult to measure the true price of the bond.

Bonds - How Inflation And Interest Rates Affect Bonds


Ownership of a bond is the ownership of a stream of future cash payments. Those cash payments are usually made in the form of periodic interest payments and the return of principal when the bond matures. In the absence of credit risk (the risk of default), the value of that stream of future cash payments is simply a function of your required return based on your inflation expectations. In this section we'll break down bond pricing, define the term "bond yield" and demonstrate how inflation expectations and interest rates determine the value of a bond. Measures of Risk There are two primary risks that must be assessed when investing in bonds: interest rate risk and credit risk. Though our focus is on how interest rates affect bond pricing, otherwise known as interest rate risk, it's also important that a bond investor be aware of credit risk. (Read Managing Interest Rate Risk to learn more about the risk that comes with changing rates.) Interest rate risk is the risk of changes in a bond's price due to changes in prevailing interest rates. Changes in short-term versus long-term interest rates can affect various bonds in different ways, which we'll soon discuss. Credit risk, meanwhile, is the risk that the bond's issuer will not make scheduled interest and/or principal payments. The probability of a negative credit event or default affects a bond's price. The higher the risk of a negative credit event occurring, the higher the interest rate investors will demand for assuming that risk. In this section, we'll focus on interest-rate risk. (To learn about credit risk, read Corporate Bonds: An Introduction To Credit Risk.) Calculation of a Bond's Yield and Price To understand how interest rates affect a bond's price, you must understand the concept of yield. While there are several different types of yield calculations, for the purposes of this article we will use the yield-to-maturity (YTM) calculation. A bond's YTM is simply the discount rate that can be used to make the present value of all of a bond's cash flows equal to its price. In other words, a bond's price is the sum of the present value of each cash flow where the present value of each cash flow is calculated using the same discount factor. This discount factor is the yield. When a bond's yield rises, by

definition, its price falls, and when a bond's yield falls, by definition, its price increases. (To learn more on this concept, be sure to read Get Acquainted With Bond Price/Yield Duo.) A Bond's Relative Yield The maturity or term of a bond largely affects its yield. To understand this statement, you must understand what is known as the yield curve. The yield curve represents the YTM of a class of bonds (in this case U.S. Treasury bonds). In most interest rate environments, the longer the term to maturity, the higher the yield will be. This should make intuitive sense because the longer the period of time before a cash flow is received, the more chance there is that the required discount rate (or yield) will move higher. (Be sure to read Bond Yield Curve Holds Predictive Powers to learn more about this measure of economic activity, inflation levels and interest rate expectations.)
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Inflation Expectations Determine Investors' Yield Requirements Inflation is a bond's worst enemy. Inflation erodes the purchasing power of a bond's future cash flows. Put simply, the higher the current rate of inflation and the higher the (expected) future rates of inflation, the higher the yields will rise across the yield curve, as investors will demand this higher yield to compensate for inflation risk. Short-Term and Long-Term Interest Rates, and Inflation Expectations Inflation - and expectations of future inflation - are a function of the dynamics between short-term and long-term interest rates. Worldwide, short-term interest rates are administered by nations' central banks. In the United States, the Federal Reserve Board's Open Market Committee (FOMC) sets the federal funds rate. Historically, other dollar-denominated short-term interest rates such as LIBOR are highly correlated with the fed funds rate. The FOMC administers the fed funds rate to fulfill its dual mandate of promoting economic growth while maintaining price stability. This is not an easy task for the FOMC; there is always much debate about the appropriate fed funds level, and the market forms its own opinions on how well the FOMC is doing. Central banks do not control long-term interest rates. Market forces (supply and demand) determine equilibrium pricing for long-term bonds, which set long-term interest rates. If the bond market believes that the FOMC has set the fed funds rate too low, expectations of future inflation increase, which means long-term interest rates increase relative to short-term interest rates - the yield curve gets steeper. If the market believes that the FOMC has set the fed funds rate too high, the opposite happens, and long-term interest rates decrease relative to short-term interest rates, flattening the yield curve. (Whenever you hear the latest inflation update on the news, chances are that interest rates are mentioned in the same breath. Read the Inflation And Interest Rates section of our Inflation Tutorial to learn more about their relationship.)
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The Timing of a Bond's Cash Flows and Interest Rates The timing of a bond's cash flows is important. This includes the bond's term to maturity. If market participants believe that there is higher inflation on the horizon, interest rates and bond yields will rise (and prices will decrease) to compensate for the loss of the purchasing power of future cash flows. Those bonds with the longest cash flows will see their yields rise and prices fall the most. This should be intuitive if you think about a present value calculation - when you change the discount rate used on a stream of future cash flows, the longer until a cash flow is received, the more its present value is affected. The bond market has a measure of price change relative to interest rate changes; this important bond metric is known as duration. (To learn more about duration, be sure to check out the Duration section of our Advanced Bond Concepts Tutorial.) Summing It Up Interest rates, bond yields (prices) and inflation expectations have a correlation to each other. Movements in short-term interest rates, as dictated by a nation's central bank, will affect different bonds with different terms to maturity differently depending on the market's expectations of future levels of inflation.

For example, a change in short-term interest rates that does not affect long-term interest rates will have little effect on a long-term bond's price and yield. However, a change (or no change when the market perceives that one is needed) in short-term interest rates that affects long-term interest rates can greatly affect a long-term bond's price and yield. Put simply, changes in short-term interest rates have more of an effect on short-term bonds than long-term bonds, and changes in long-term interest rates have an effect on long-term bonds, but not short-term bonds. The key to understanding how a change in interest rates will affect a certain bond's price and yield is to recognize where on the yield curve that bond lies (the short end or the long end) and to understand the dynamics between short- and long-term interest rates. With this knowledge, you can use different measures of duration andconvexity to become a seasoned bond market investor.

Bonds - Duration
Bond duration is a measure of the sensitivity of the price (the value of principal) of a fixed-income investment to a change in interest rates. Duration is expressed as a number of years. Rising interest rates mean falling bond prices, while declining interest rates mean rising bond prices. The duration number is a complicated calculation involving present value, yield, coupon, final maturity and call features. Fortunately for investors, this indicator is a standard data point provided in the presentation of comprehensive bond and bond mutual fund information. The bigger the duration number, the greater the interest-rate risk or reward for bond prices. It is a common misconception among non-professional investors that bonds and bond funds are riskfree. They are not. As you learned in the last section, investors need to be aware of two main risks that can affect a bond's investment value: credit risk (default) and interest rate risk (rate fluctuations). The duration indicator addresses the latter issue. The term duration has a special meaning in the context of bonds. It is a measurement of how long, in years, it takes for the price of a bond to be repaid by its internal cash flows. It is an important measure for investors to consider, as bonds with higher durations carry more risk and have higher price volatility than bonds with lower durations. For each of the two basic types of bonds the duration is the following: 1. Zero-Coupon Bond - Duration is equal to its time to maturity. 2. Vanilla Bond - Duration will always be less than its time to maturity. Let's first work through some visual models that demonstrate the properties of duration for a zerocoupon bond and a vanilla bond. Duration of a Zero-Coupon Bond

The red lever above represents the four-year time period it takes for a zero-coupon bond to mature. The money bag balancing on the far right represents the future value of the bond - the amount that will be paid to the bondholder at maturity. The fulcrum, or the point holding the lever, represents duration, which must be positioned where the red lever is balanced. The fulcrum balances the red lever at the point on the time line at which the amount paid for the bond and the cash flow received from the bond are equal. The entire cash flow of a zero-coupon bond occurs at maturity, so the fulcrum is located directly below this one payment. Duration of a Vanilla or Straight Bond Consider a vanilla or straight bond that pays coupons annually and matures in five years. Its cash flows consist of five annual coupon payments and the last payment includes the face value of the bond.

The money bags represent the cash flows you will receive over the five-year period. To balance the red lever at the point where total cash flows equal the amount paid for the bond, the fulcrum must be farther to the left, at a point before maturity. Unlike the zero-coupon bond, the straight bond pays coupon payments throughout its life and therefore repays the full amount paid for the bond sooner.
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Factors Affecting Duration It is important to note, however, that duration changes as the coupons are paid to the bondholder. As the bondholder receives a coupon payment, the amount of the cash flow is no longer on the time line, which means it is no longer counted as a future cash flow that goes towards repaying the bondholder. Our model of the fulcrum demonstrates this: as the first coupon payment is removed from the red lever and paid to the bondholder, the lever is no longer in balance because the coupon payment is no longer counted as a future cash flow.

The fulcrum must now move to the right in order to balance the lever again:

Duration: Other Factors Besides the movement of time and the payment of coupons, there are other factors that affect a bond's duration, including the coupon rate and its yield. Bonds with high coupon rates and, in turn, high yields will tend to have lower durations than bonds that pay low coupon rates or offer low yields. This makes empirical sense, because when a bond pays a higher coupon rate or has a high yield, the holder of the security receives repayment for the security at a faster rate. Types of Duration There are four main types of duration calculations, each of which differ in the way they account for factors such as interest rate changes and the bond's embedded options or redemption features. The four types of durations are Macaulay duration, modified duration, effective duration and key-rate duration.

Macaulay Duration The formula usually used to calculate a bond's basic duration is the Macaulay duration, which was created by Frederick Macaulay in 1938, although it was not commonly used until the 1970s. Macaulay duration is calculated by adding the results of multiplying the present value of each cash flow by the time it is received and dividing by the total price of the security. The formula for Macaulay duration is as follows:

n = number of cash flows t = time to maturity C = cash flow i = required yield M = maturity (par) value P = bond price Remember that bond price equals:

So the following is an expanded version of Macaulay duration:

Example 1: Betty holds a five-year bond with a par value of $1,000 and coupon rate of 5%. For simplicity, let's assume that the coupon is paid annually and that interest rates are 5%. What is the Macaulay duration of the bond?

= 4.55 years Fortunately, if you are seeking the Macaulay duration of a zero-coupon bond, the duration would be equal to the bond's maturity, so there is no calculation required.

Modified Duration Modified duration is a modified version of the Macaulay model that accounts for changing interest rates. Because they affect yield, fluctuating interest rates will affect duration, so this modified formula shows how much the duration changes for each percentage change in yield. For bonds without any embedded features, bond price and interest rate move in opposite directions, so there is an inverse relationship between modified duration and an approximate 1% change in yield. Because the modified duration formula shows how a bond's duration changes in relation to interest rate movements, the formula is appropriate for investors wishing to measure the volatility of a particular bond. Modified duration is calculated as the following:

OR

Let's continue to analyze Betty's bond and run through the calculation of her modified duration. Currently her bond is selling at $1,000, or par, which translates to a yield to maturity of 5%. Remember that we calculated a Macaulay duration of 4.55.

= 4.33 years Our example shows that if the bond's yield changed from 5% to 6%, the duration of the bond will decline to 4.33 years. Because it calculates how duration will change when interest increases by 100 basis points, the modified duration will always be lower than the Macaulay duration. Effective Duration The modified duration formula discussed above assumes that the expected cash flows will remain constant, even if prevailing interest rates change; this is also the case for option-free fixedincome securities. On the other hand, cash flows from securities with embedded options or redemption features will change when interest rates change. For calculating the duration of these types of bonds, effective duration is the most appropriate method. Effective duration requires the use of binomial trees to calculate the option-adjusted spread (OAS). There are entire courses built around just those two topics, so the calculations involved for effective duration are beyond the scope of this section. There are, however, many

programs available to investors wishing to calculate effective duration. Key-Rate Duration The final duration calculation to learn is key-rate duration, which calculates the spot durations of each of the 11 "key" maturities along a spot rate curve. These 11 key maturities are at the threemonth and one, two, three, five, seven, 10, 15, 20, 25, and 30-year portions of the curve. In essence, key-rate duration, while holding the yield for all other maturities constant, allows the duration of a portfolio to be calculated for a one-basis-point change in interest rates. The key-rate method is most often used for portfolios such as the bond ladder, which consists of fixed-income securities with differing maturities. Here is the formula for key-rate duration:

The sum of the key-rate durations along the curve is equal to the effective duration.
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Duration and Bond Price Volatility We have established that when interest rates rise, bond prices fall, and vice versa. But how does one determine the degree of a price change when interest rates change? Generally, bonds with a high duration will have a higher price fluctuation than bonds with a low duration. But it is important to know that there are also three other factors that determine how sensitive a bond's price is to changes in interest rates. These factors are term to maturity, coupon rate and yield to maturity. Knowing what affects a bond's volatility is important to investors who use duration-based immunization strategies, which we discuss below, in their portfolios.

Factors 1 and 2: Coupon Rate and Term to Maturity If term to maturity and a bond's initial price remain constant, the higher the coupon, the lower the volatility, and the lower the coupon, the higher the volatility. If the coupon rate and the bond's initial price are constant, the bond with a longer term to maturity will display higher price volatility and a bond with a shorter term to maturity will display lower price volatility. Therefore, if you would like to invest in a bond with minimal interest rate risk, a bond with high coupon payments and a short term to maturity would be optimal. An investor who predicts that interest rates will decline would best potentially capitalize on a bond with low coupon payments and a long term to maturity, since these factors would magnify a bond's price increase. Factor 3: Yield to Maturity (YTM) The sensitivity of a bond's price to changes in interest rates also depends on its yield to maturity. A bond with a high yield to maturity will display lower price volatility than a bond with a lower yield to maturity, but a similar coupon rate and term to maturity. Yield to maturity is affected by the bond's credit rating, so bonds with poor credit ratings will have higher yields than bonds with excellent credit ratings. Therefore, bonds with poor credit ratings typically display lower price volatility than bonds with excellent credit ratings.
All three factors affect the degree to which bond price will be altered in the face of a change in prevailing interest rates. These factors work together and against each other.

So, if a bond has both a short term to maturity and a low coupon rate, its characteristics have opposite effects on its volatility: the low coupon raises volatility and the short term to maturity lowers volatility. The bond's volatility would then be an average of these two opposite effects. Immunization As we mentioned in the above section, the interrelated factors of duration, coupon rate, term to maturity and price volatility are important for those investors employing duration-based immunization strategies. These strategies aim to match the durations of assets and liabilities within a portfolio for the purpose of minimizing the impact of interest rates on the net worth. To create these strategies, portfolio managers use Macaulay duration. For example, say a bond has a two-year term with four coupons of $50 and a par value of $1,000. If the investor did not reinvest his or her proceeds at some interest rate, he or she would have received a total of $1,200 at the end of two years. However, if the investor were to reinvest each of the bond cash flows until maturity, he or she would have more than $1,200 in two years. Therefore, the extra interest accumulated on the reinvested coupons would allow the bondholder to satisfy a future $1,200 obligation in less time than the maturity of the bond. Understanding what duration is, how it is used and what factors affect it will help you to determine a bond's price volatility. Volatility is an important factor in determining your strategy for capitalizing on interest rate movements. Furthermore, duration will also help you to determine how you can protect your portfolio from interest rate risk.

3.5 Stock Valuation - Introduction To Stock Valuation


When trying to figure out which valuation method to use to value a stock for the first time, most investors will quickly discover the overwhelming number of valuation techniques available to them today. There are the simple-to-use ones, such as the comparables method, and there are the more involved methods, such as the discounted cash flow model. Which one should you use? Unfortunately, there is no one method that is best suited for every situation. Each stock is different, and each industry sector has unique properties that may require varying valuation approaches. Here, we'll provide an overview of the two basic categories of stock - common and preferred - and then discuss how to value each.

Stock Valuation - Common Stock Features


Stock is sometimes referred to as shares, securities or equity. Simply put, common stock is ownership in part of a company. For every stock you own in a company, you own a small piece of the office furniture, company cars and even that lunch the boss paid for with the company credit card. More importantly, you are entitled to a portion of the company's profits and any voting rights attached to the stock. With some companies, the profits are typically paid out in dividends. The more shares you own, the larger the portion of the company (and profits) you own. (For related reading, see 10 Dividend Aristocrats.) Common stock is just that: common. The majority of stocks trading today take this form. Common stock represents ownership in a company and a portion of profits (dividends). Investors also have voting rights (one vote per share) to elect the board members who oversee the major decisions made by management. In the long term, common stock, by means of capital growth, yields higher rewards than other forms of investment securities. This higher return comes at a cost, as common stock entails the most risk. Should a company go bankrupt and liquidate, the common shareholders will not receive money until the creditors, bondholders and preferred shareholders are paid. (To learn more about stocks, see our Stock Basics Tutorial.) Objectives and Risks Over the long term, no investment provides better returns at a reasonable risk than common stock.

History dictates that common stocks average 11-12% per year and outperform just about every other type of security including bonds and preferred shares. Stocks provide potential for capital appreciation and income and offer protection against moderate inflation. The risks associated with stocks can vary widely, and they usually depend on the company. Purchasing stock in a well-established and profitable company means there is much less risk you'll lose your investment, whereas purchasing a penny stock increases your risks substantially. If you use margin, you can also dramatically increase your leverage in a stock, but this is only recommended for experienced investors. (For more on stock investing, read Buffett: Penny Stocks, Day Trading Are My Real Key To Wealth.) How to Buy or Sell It The most common method for buying stocks is to use a brokerage, either full service or discount. There is no minimum investment for most stocks (other than the price per share), but many brokerages require clients to have at least $500 to open an account. Dividend reinvestment plans (DRIPs) and direct investment plans (DIPs) are two ways individual companies allow shareholders to purchase stock directly from them for a minimal cost. DRIPs are also a great way to invest money at regular intervals.

Strengths

Common stock is very easy to buy and sell. Thanks in large part to the growth of the Internet, it is very easy to find reliable information on public companies, making analysis possible. There are over 11,000 public companies in North America to choose from.

Weaknesses Your original investment is not guaranteed. There is always the risk that the stock you invest in will decline in value, and you may lose your entire principal. Your stock is only as good as the company in which you invest - a poor company means poor stock performance. Three Main Uses 1. Capital Appreciation 2. Income 3. Liquidity

Stock Valuation - Preferred Stock Features


Within the vast spectrum of financial instruments, preferred stocks (or preferreds) occupy a unique place. Because of their characteristics, they straddle the line between stocks and bonds. Technically, they are equity securities, but they share many characteristics with debt instruments. Some investment commentators refer to them ashybrid securities. In this article, we provide a thorough overview of preferred shares and compare them to some better-known investment vehicles.

Because so much of the commentary about preferreds compares them to bonds and other debt instruments, let's first look at the similarities and differences between preferreds and bonds. Bonds and Preferreds: Similarities Interest Rate Sensitivity Preferreds are issued with a fixed par value and pay dividends based on a percentage of that par at a fixed rate. Just like bonds, which also make fixed payments, the market value of preferred shares is sensitive to changes in interest rates. If interest rates rise, the value of the preferred shares would need to fall to offer investors a better rate. If rates fall, the opposite would hold true. However, the relative move of preferred yields is usually less dramatic than that of bonds. (For further reading, check out Trying To Predict Interest Rates.) Callability Preferreds technically have an unlimited life because they have no fixed maturity date, but they may be called by the issuer after a certain date. The motivation for the redemption is generally the same as for bonds; a company calls securities that pay higher rates than what the market is currently offering. Also, as is the case with bonds, the redemption price may be at a premium to par to enhance the preferred's initial marketability. (To read more, see Call Features: Don't Get Caught Off Guard.) Senior Securities Like bonds, preferreds are senior to common stock; however, bonds have more seniority than preferreds. The seniority of preferreds applies to both the distribution of corporate earnings (as dividends) and the liquidation of proceeds in case of bankruptcy. With preferreds, the investor is standing closer to the front of the line for payment than common shareholders, although not by much. Convertibility As with convertible bonds, preferreds can often be converted into the common stock of the issuing company. This feature gives investors flexibility, allowing them to lock in the fixed return from the preferred dividends and, potentially, to participate in the capital appreciation of the common stock. (For further reading, see Introduction To Convertible Preferred Shares and Convertible Bonds: An Introduction.) Ratings Like bonds, preferred stocks are rated by the major credit rating companies, such as Standard & Poor's and Moody's. The rating for preferreds is generally one or two tiers below that of the same company's bonds because preferred dividends do not carry the same guarantees as interest payments from bonds and they are junior to allcreditors. (For more insight, read What Is A Corporate Credit Rating?) Bonds and Preferreds: Differences Type of Security As observed earlier, preferred stock is equity; bonds are debt. Most debt instruments, along with most creditors, are senior to any equity. Payments Preferreds pay dividends. These are fixed dividends, normally for the life of the stock, but they must be declared by the company's board of directors. As such, there is not the same array of guarantees that are afforded to bondholders. This is because bonds are issued with the protection of an indenture. With preferreds, if a company has a cash problem, the board of directors can decide to withhold preferred dividends; the trust indenture prevents companies from taking the same action on bonds. Another difference is that preferred dividends are paid from the company's after-tax profits, while bond interest is paid before taxes. This factor makes it more expensive for the issuing company to issue and pay dividends on preferred stocks. (To read more, see How And Why Do Companies Pay Dividends?)
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Yields Computing current yields on preferreds is similar to performing the same calculation on bonds: the

annual dividend is divided by the price. For example, if a preferred stock is paying an annualized dividend of $1.75 and is currently trading in the market at $25, the current yield is: $1.75/$25 = 7%. In the market, however, yields on preferreds are typically higher than those of bonds from the same issuer, reflecting the higher risk the preferreds present for investors. Volatility While preferreds are interest rate sensitive, they are not as price sensitive to interest rate fluctuations as bonds. However, their prices do reflect the general market factors that affect their issuers to a greater degree than the same issuer's bonds. Accessibility for the Average Investor Information about a company's preferred shares is easier to access than information about the company's bonds, making preferreds, in a general sense, easier to trade (and perhaps more liquid). The low par values of the preferred shares also make investing easier because bonds, with par values around $1,000, often have minimum purchase amounts (i.e. five bonds). Common and Preferred Stocks: Similarities Payments Both common and preferred stocks are equity instruments that pay dividends from the company's after-tax profits. Common and Preferred Stocks: Differences Payments Preferreds have fixed dividends and, although they are never guaranteed, the issuer has a greater obligation to pay them. Common stock dividends, if they exist at all, are paid after the company's obligations to all preferred stockholders have been satisfied. Appreciation This is where preferreds lose their luster for many investors. If, for example, a pharmaceutical research company discovers an effective cure for the flu, its common stock will soar, while the preferreds in the same company might only increase by a few points. The lower volatility of preferred stocks may look attractive, but preferreds will not share in a company's success to the same degree as common stock. (To learn more, read 5 Signs Of A Market-Beating Stock.)
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Voting Whereas common stock is often called voting equity, preferred stocks usually have no voting rights. Types of Preferred Stock Although the possibilities are nearly endless, these are the basic types of preferred stocks: Cumulative: Most preferred stock is cumulative, meaning that if the company withholds part (or all) of the expected dividends, these are considered dividends in arrears and must be paid before any other dividends. Preferred stock that doesn't carry the cumulative feature is called straight, or noncumulative, preferred. Callable: The majority of preferred shares are redeemable, giving the issuer the right to redeem the stock at a date and price specified in the prospectus. Convertible: The timing for conversion and the conversion price specific to the individual issue will be laid out in the preferred stock's prospectus. Participating: Preferred stock has a fixed dividend rate. If the company issues participating preferreds, those stocks gain the potential to earn more than their stated rate. The exact formula for participation will be found in the prospectus. Most preferreds are non-participating. Adjustable-Rate Preferred Stock (ARPS): These relatively recent additions to the spectrum pay dividends based on several factors stipulated by the company. Dividends for ARPSs are keyed

to yields on U.S. government issues, providing the investor limited protection against adverse interest rate markets. Why Preferreds? A company may choose to issue preferreds for a couple of reasons:

Flexibility of payments: Preferred dividends may be suspended in case of corporate cash problems. Easier to market: The majority of preferred stock is bought and held by institutions, which may make it easier to market at the initial public offering.

Institutions tend to invest in preferred stock because IRS rules allow U.S. corporations that pay corporate income taxes to exclude 70% of the dividend income they receive from their taxable income. This is known as the dividend received deduction, and it is the primary reason why investors in preferreds are primarily institutions. The fact that individuals are not eligible for such favorable tax treatment should not automatically exclude preferreds from consideration. In many cases, the individual tax rate under the new rules is 15%. That compares favorably with paying taxes at the ordinary rate on interest received from corporate bonds. However, because the 15% rate is not an across-the-board fact, investors should seek competent tax advice before diving into preferreds. Preferred Stock Pros Higher fixed-income payments than bonds or common stock Lower investment per share compared to bonds Priority over common stocks for dividend payments and liquidation proceeds Greater price stability than common stocks Greater liquidity than corporate bonds of similar quality

Preferred Stock Cons Callability Lack of specific maturity date makes recovery of invested principal uncertain Limited appreciation potential Interest rate sensitivity Lack of voting rights

An individual investor looking into preferred stocks should carefully examine both their advantages and drawbacks. There are a number of strong companies in stable industries that issue preferred stocks that pay dividends above investment-grade bonds. The starting point for research on a specific preferred is the stock's prospectus, which you can often find online. If you're looking for relatively safe returns, you shouldn't overlook the preferred stock market.

Stock Valuation - Common Stock Valuation


Valuation methods typically fall into two main categories: absolute and relative. Two Categories of Valuation Models Absolute valuation models attempt to find the intrinsic or "true" value of an investment based only on fundamentals. Looking at fundamentals simply means you would only focus on such things as dividends, cash flow and growth rate for a single company, and you wouldn't worry about any other companies. Valuation models that fall into this category include the dividend discount model, discounted cash flow model, residual income models and asset-based models.

In contrast to absolute valuation models, relative valuation models operate by comparing the company in question to other similar companies. These methods generally involve calculating multiples or ratios, such as the price-to-earnings multiple, and comparing them to the multiples of other comparable firms. For instance, if the P/E of the firm you are trying to value is lower than the P/E multiple of a comparable firm, that company may be said to be relatively undervalued. Generally, this type of valuation is a lot easier and quicker to do than the absolute valuation methods, which is why many investors and analysts start their analysis with this method. Let's take a look at some of the more popular valuation methods available to investors, and see when it is appropriate to use each model. (For related reading, see Top Things To Know For An Investment Banking Interview.) 1. Dividend Discount Model (DDM) The dividend discount model (DDM) is one of the most basic absolute valuation models. The dividend model calculates the "true" value of a firm based on the dividends the company pays its shareholders. The justification for using dividends to value a company is that dividends represent the actual cash flows going to the shareholder, thus valuing the present value of these cash flows should give you a value for how much the shares should be worth. So, the first thing you should check if you want to use this method is if the company actually pays a dividend. Secondly, it is not enough for the company to just a pay dividend; the dividend should also be stable and predictable. The companies that pay stable and predictable dividends are typically mature bluechip companies in mature and well-developed industries. These type of companies are often best suited for this type of valuation method. For instance, take a look at the dividends and earnings of company XYZ below and see if you think the DDM model would be appropriate for this company:

2005 Dividends Per $0.50 Share Earnings Per Share $4.00

2006 $0.53 $4.20

2007 $0.55 $4.41

2008 $0.58 $4.63

2009 $0.61 $4.86

2010 $0.64 $5.11

In this example, the earnings per share are consistently growing at an average rate of 5%, and the dividends are also growing at the same rate. This means the firm's dividend is consistent with its earnings trend which would make it easy to predict for future periods. In addition, you should check the payout ratio to make sure the ratio is consistent. In this case the ratio is 0.125 for all six years, which is good, and makes this company an ideal candidate for the dividend model. (For more on the DDM, see Digging Into the Dividend Discount Model.) 2. Discounted Cash Flow Model (DCF) What if the company doesn't pay a dividend or its dividend pattern is irregular? In this case, move on to check if the company fits the criteria to use the discounted cash flow model. Instead of looking at dividends, the DCF model uses a firm's discounted future cash flows to value the business. The big advantage of this approach is that it can be used with a wide variety of firms that don't pay dividends, and even for companies that do pay dividends, such as company XYZ in the previous example.
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The DCF model has several variations, but the most commonly used form is the Two-Stage DCF model. In this variation, the free cash flows are generally forecasted for five to ten years, and then a terminal value is calculated to account for all of the cash flows beyond the forecast period. So, the first requirement for using this model is for the company to have predictable free cash flows, and for the free cash flows to be positive. Based on this requirement alone, you will quickly find that many small high-growth firms and non-mature firms will be excluded due to the large capital expenditures these companies generally face. For example, take a look at the simplified cash flows of the following firm:

2005 Operating Cash Flow Capital Expenditures Free Cash Flow 438 785 -347

2006 789 995 -206

2007 1462 1132 330

2008 890 1256 -366

2009 2565 2235 330

2010 510 1546 -1036

In this snapshot, the firm has produced increasingly positive operating cash flow, which is good. But you can see by the high level of capital expenditures that the company is still investing a lot of its cash back into the business in order to grow. This results in negative free cash flows for four of the six years, making it extremely difficult (nearly impossible) to predict the cash flows for the next five to ten years. So, in order to use the DCF model most effectively, the target company should generally have stable, positive and predictable free cash flows. Companies that have the ideal cash flows suited for the DCF model are typically the mature firms that are past the growth stages. (To learn more about this method, see Taking Stock of Discounted Cash Flow.) 3. Comparables Method The last method we'll look at is sort of a catch-all method that can be used if you are unable to value the company using any of the other models, or if you simply don't want to spend the time crunching the numbers. The method doesn't attempt to find an intrinsic value for the stock like the previous two valuation methods do; it simply compares the stock's price multiples to a benchmark to determine if the stock is relatively undervalued or overvalued. The rationale for this is based off of the Law of One Price, which states that two similar assets should sell for similar prices. The intuitive nature of this method is one of the reasons it is so popular.
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This method can be used in almost all circumstances because of the vast number of multiples that can be applied, such as the price-to-earnings (P/E), price-to-book (P/B), price-to-sales (P/S), price-to-cash flow (P/CF) and many others. Of these ratios, the P/E ratio is the most commonly used one because it focuses on the earnings of the company, which is one of the primary drivers of an investment's value. (For more on this subject, see 6 Basic Financial Ratios And What They Reveal.) When can you use the P/E multiple for a comparison? You can generally use it if the company is publicly traded because you need the price of the stock, and you need to know the earnings of the company. Secondly, the company should be generating positive earnings because a comparison using a negative P/E multiple would be meaningless. And lastly, the earnings quality should be strong; earnings should not be too volatile and the accounting practices used by management should not drastically distort the reported earnings. (Companies can manipulate their numbers, so you need to learn how to determine the accuracy of EPS. Read How To Evaluate The Quality Of EPS.) These are just some of the main criteria investors should look at when choosing which ratio or multiples to use. If the P/E multiple cannot be used, simply look at using a different ratio such as the price-to-sales multiple. No one valuation method is perfect for every situation, but by knowing the characteristics of the company, you can select the valuation method that best suits the situation. In addition, investors are not limited to just using one method. Often, investors will perform several valuations to create a range of possible values or average all of the valuations into one.

Stock Valuation - Preferred Stock Valuation


Preferred shares have the qualities of both a stock and a bond, which makes valuation a little different than a common share. The owner of the preferred share is part owner of the company, just like a common shareholder. The stake in the company is in proportion to the held stocks. Also, there is a fixed payment which is similar to a bond issued by the company. The fixed payment is in the form of a

dividend and will be the basis of the valuation method for a preferred share. These payments could come quarterly, monthly or yearly, depending on the policy stated by the company. Valuation Preferred stocks have a fixed dividend, which means we can calculate the value by discounting each of these payments to the present day. This fixed dividend is not guaranteed in common shares. If you take these payments and calculate the sum of the present values into perpetuity, you will find the value of the stock. For example, if ABC Company pays a 25 cent dividend every month and the required rate of return is 6% per year, then the expected value of the stock, using the dividend discount approach, would be $0.25/0.005 = $50. The discount rate was divided by 12 to get 0.005, but you could also use the yearly dividend of (0.25*12) $3 and divide it by the yearly discount rate of 0.06 to get $50. The point is that each issued dividend payment in the future needs to be discounted back to the present and each value is then added together.

Where: V = the value D1 = the dividend next period r = the required rate of return Considerations Although the preferred shares give a dividend, which is usually guaranteed, the payment can be cut if there are not enough earnings to accommodate a distribution. This risk of a cut payment needs to be accounted for. This risk increases as the payout ratio (dividend payment compared to earnings) gets higher. Also, if the dividend has a chance of growing, the value of the shares will be higher than the result of the constant dividend calculation, given above.

Preferred shares usually lack the voting rights of common shares. This might be a valuable feature to individuals who own large amounts of shares, but for the average investor this voting right does not have much value. However, it still needs to be accounted for when evaluating the marketability of preferred shares.

Preferred shares have an implied value similar to a bond. This means the value will also move inversely with interest rates. When the interest rate goes up, the value of the preferred shares will go down, holding everything else constant. This is to account for other investment opportunities and is reflected in the discount rate used.

Callable If the preferred shares are callable, the company gains a benefit and the purchaser should pay less, compared to if there was no call provision. The call provision allows the company to basically take the shares off of the market at a predetermined price. A company might add to this if the current market interest rates are high (requiring a higher dividend payment) and the company expects the interest

rates to go down. This is a benefit to the issuing company, because they can essentially issue new shares at a lower dividend payment. (Due to their lowered price, callable shares pose risk: read Bond Call Features: Don't Get Caught Off Guard.)

Growing Dividend If the dividend has a history of predictable growth, or the company states a constant growth will occur, you need to account for this. The calculation is known as the Gordon Growth Model.
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The added g is the growth of the payments. By subtracting the growth number, the cash flows are discounted by a lower number resulting in a higher value.

Preferred shares are a type of equity investment, which provide a steady stream of income and potential appreciation. Both of these features need to be taken into account when attempting to determine value. Calculations using the dividend discount model are difficult because of the assumptions involved, such as the required rate of return and the growth or length of higher returns. The dividend payment is usually easy to find; the difficult part comes when this payment is changing or potentially could change in the future. Also, finding a proper discount rate is very difficult and if this figure is off, it could drastically change the calculated value of the shares. When it comes to classroom homework, these numbers will be simply given, but in the real world we are left to estimate the discount rate or pay a company to do the calculation.

Stock Valuation - Stock Market Reporting


One of the primary tools for reporting stock market activity is the ticker tape. You've seen them on business programs or financial news networks: a flashing series of baffling letters, arrows and numbers scrolling along the bottom of your TV screen. (For a short history of the letters, read The Evolution Of Ticker Symbols and Wall Street History: Windows 1.0 And Ticker-Tape Parades.) While many people simply block out the ticker tape, others use it to stay on top of market sentiment and track the activity of certain stocks. But what exactly is that cryptic script reeling by? It obviously tells us something about stocks and the markets, but how does one understand the ticker tape and use it to his or her advantage? Brief History Firstly, a tick is any movement, up or down, however small, in the price of a security. Hence, a ticker tape automatically records each transaction that occurs on the exchange floor, including trading volume, onto a narrow strip of paper, or tape. The first ticker tape was developed in 1867, following the advent of the telegraph machine, which allowed for information to be printed in easy-to-read scripts. During the late 19th century, most brokers who traded at the New York Stock Exchange (NYSE) kept an office near it to ensure they were getting a steady supply of the tape and thus the most recent transaction figures of stocks. These

latest quotes were delivered by messengers, or "pad shovers," who ran a circuit between the trading floor and brokers' offices. The shorter the distance between the trading floor and the brokerage, the more up-to-date the quotes were. Ticker-tape machines introduced in 1930 and 1964 were twice as fast as their predecessors, but they still had about a 15-20 minute delay between the time of a transaction and the time it was recorded. It wasn't until 1996 that a real-time electronic ticker was launched. It is these up-to-the-minute transaction figures - namely price and volume - that we see today on TV news shows, financial wires and websites. And while the actual tape has been done away with, it has retained the name. (See How Has The Stock Market Changed? to learn more about the evolution of trading.) Due to the nature of the markets, investors from all corners of the globe are trading a variety of stocks in different lots and blocks at any given time. Therefore what you see one minute on a ticker could change the next, particularly for those stocks with high trading volume, and it could be some time before you see your ticker symbolappear again with the latest trading activity. Reading the Ticker Tape Here's an example of a quote shown on a typical ticker tape:

The unique characters used to identify the company. The volume for the trade being quoted. Abbreviations are Shares Traded K = 1,000, M = 1,000,000 and B = 1,000,000,000. The price per share for the particular trade (the Price Traded lastbid price). Shows whether the stock is trading higher or lower than Change Direction the previous day's closing price. Change Amount The difference in price from the previous day's close. Ticker Symbol
Throughout the trading day, these quotes will continually scroll across the screen of financial channels or wires, showing current, or slightly delayed, data. In most cases the ticker will quote only stocks of one exchange, but it is common to see the numbers of two exchanges scrolling across the screen. You can tell where a stock trades by looking at the number of letters in the stock symbol. If the symbol has three letters, the stock likely trades on the NYSE or American Stock Exchange (AMEX). A four-letter symbol indicates the stock likely trades on the Nasdaq. Some Nasdaq stocks have five letters, which usually means the stock is foreign. This is designated by an 'F' or 'Y' at the end of the stock symbol. To learn more, see Why do some stock symbols have three letters while others have four?
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On many tickers, colors are also used to indicate how the stock is trading. Here is the color scheme most TV networks use:

Greenindicates the stock is trading higher than the previous day's close.

Redindicates the stock is trading lower than the previous day's close. Blue or white means the stock is unchanged from the previous closing price.
Before 2001, stocks were quoted as a fraction, but with the emergence of decimalization all stocks on the NYSE and Nasdaq trade as decimals. The advantage to investors and traders is that decimalization allows investors to enter orders to the penny (as opposed to fractions like 1/16). Which Quotes Get Priority? There are literally millions of trades executed on more than 10,000 different stocks each and every day. As you can imagine, it's impossible to report every single trade on the ticker tape. Quotes are selected according to several factors, including the stocks' volume, price change, how widely they are held and if there is significant news surrounding the companies. For example, a stock that trades 10 million shares a day will appear more times on the ticker tape than a small stock that trades 50,000 shares a day. Or if a smaller company not usually featured on the ticker has some ground-breaking news, it will likely be added to the ticker. The only times the quotes are shown in predetermined order are before the trading day starts and after it has finished. At those times, the ticker simply displays the last quote for all stocks in alphabetical order. Constantly watching a ticker tape is not the best way to stay informed about the markets, but many believe it can provide some insight. Tick indicators are used to easily identify those stocks whose last trade was either an uptick or a downtick. This is used as an indicator of market sentiment for determining the market's trend. So next time you're watching TV or surfing a website with a ticker, you'll understand what all those numbers and symbols scrolling across your screen really mean. Just remember that it can be near impossible to see the exact price and volume at the precise moment it is being traded. Think of a ticker tape as providing you with a general picture of a stock's "current" activity.
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Stock tables are another source of stock market reporting. Open any financial paper and you will see stock quotes that look something like the image below. In this section, we'll explain how to make sense of these tables so that you can use the information to your advantage. Let's take a look at the stock/quotes table:

Columns 1 & 2: 52-Week High and Low. These are the highest and lowest prices at which a stock has traded over the past 52 weeks (one year). This typically does not include the previous day's trading.

Column 3: Company Name and Type of Stock. This column lists the name of the company. If there are no special symbols or letters following the name, it is common stock. Different symbols imply different classes of shares. For example, "pf" means the shares are preferred stock. Column 4: Ticker Symbol. This is the unique alphabetic name which identifies the stock. If you watch financial TV, the ticker tape will quote the latest prices alongside this symbol. If you are looking for stock quotes online, you always search for a company by the ticker symbol. If you don't know a particular company's ticker symbol, you can search for it at sites like Investopedia. Column 5: Dividend Per Share. This indicates the annual dividend payment per share. If this space is blank, the company does not currently pay out dividends. Column 6: Dividend Yield. This is the percentage return on the dividend. Dividend yield is calculated as annual dividends per share divided by price per share. Column 7: Price/Earnings Ratio (P/E ratio). This is calculated by dividing the current stock price by earnings per share from the last four quarters. (For more on how to interpret this, see Understand The P/E Ratio.) Column 8: Trading Volume. This figure shows the total number of shares traded for the day, listed in hundreds. To get the actual number traded, add two zeros to the end of the number listed. Column 9 & 10: Day High and Low. This indicates the price range in which the stock has traded throughout the day. In other words, these are the maximum and the minimum prices that people have paid for the stock. Column 11: Close. The close is the last trading price recorded when the market closed on the day. If the closing price is more than 5% above or below the previous day's close, the entire listing for that stock is bold-faced. Keep in mind, you are not guaranteed to get this price if you buy the stock the next day because the price is constantly changing, even after the exchange is closed for the day. The close is merely an indicator of past performance and, except in extreme circumstances, it serves as a ballpark of what you should expect to pay. Column 12: Net Change. This is the dollar value change in the stock price from the previous day's closing price. When you hear about a stock being "up for the day," it means the net change was positive. Quotes on the Internet Nowadays, it's far more convenient for most people to get stock quotes off the internet. This method is superior because most sites update throughout the day and give you more information, news, charting and research.

Chapter 4 Net Present Value And Internal Rate Of Return - Introduction To Net Present Value And Internal Rate Of Return
Net present value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows. NPV compares the value of a dollar today to the value of that same dollar in the future, taking inflation and returns into account. NPV analysis is sensitive to the reliability of future cash inflows that an investment or project will yield and is used in capital budgeting to assess the profitability of an investment or project. NPV is calculated using the following formula:

If the NPV of a prospective project is positive, the project should be accepted. However, if NPV is negative, the project should probably be rejected because cash flows will also be negative. For example, if a retail clothing business wants to purchase an existing store, it would first estimate the future cash flows that store would generate, then discount those cash flows into one lump-sum present value amount, say $565,000. If the owner of the store was willing to sell his business for less than $565,000, the purchasing company would likely accept the offer as it presents a positive NPV investment. Conversely, if the owner would not sell for less than $565,000, the purchaser would not buy the store, as the investment would present a negative NPV. (Sometimes losing investments aren't what they seem. Learn more in How To Profit From Investment "Losers".) Internal rate of return (IRR) is the discount rate often used in capital budgeting that makes the net present value of all cash flows from a particular project equal to zero. Generally speaking, the higher a project's internal rate of return, the more desirable it is to undertake the project. As such, IRR can be used to rank several prospective projects a firm is considering. Assuming all other factors are equal among the various projects, the project with the highest IRR would probably be considered the best and undertaken first. You can think of IRR as the rate of growth a project is expected to generate. While the actual rate of return that a given project ends up generating will often differ from its estimated IRR rate, a project with a substantially higher IRR value than other available options would still provide a much better chance of strong growth. IRRs can also be compared against prevailing rates of return in the securities market. If a firm can't find any projects with IRRs greater than the returns that can be generated in the financial markets, it may simply choose to invest its retained earnings into the market. (For related reading, see The Top New Investment: Doing Nothing.) Differences between NPV and IRR and Their Uses Both NPV and IRR are primarily used in capital budgeting, the process by which companies determine whether a new investment or expansion opportunity is worthwhile. Given an investment opportunity, a firm needs to decide whether undertaking the investment will generate net economic profits or losses for the company. To do this, the firm estimates the future cash flows of the project and discounts them into present value amounts using a discount rate that represents the project's cost of capital and its risk. Next, all of the investment's future positive cash flows are reduced into one present value number. Subtracting this number from the initial cash outlay required for the investment provides the net present value (NPV) of the investment.
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Let's illustrate with an example: suppose JKL Media wants to buy a small publishing company. JKL determines that the future cash flows generated by the publisher, when discounted at a 12% annual rate, yield a present value of $23.5 million. If the publishing company's owner is willing to sell for $20 million, then the NPV of the project would be $3.5 million ($23.5 - $20 = $3.5). The $3.5 million dollar NPV represents the intrinsic value that will be added to JKL Media if it undertakes this acquisition. So, JKL Media's project has a positive NPV, but from a business perspective, the firm should also know what rate of return will be generated by this investment. To do this, the firm would simply recalculate the NPV equation, this time setting the NPV factor to zero, and solve for the now-unknown discount rate. The rate that is produced by the solution is the project's internal rate of return (IRR). For this example, the project's IRR could, depending on the timing and proportions of cash flow

distributions, be equal to 17.15%. Thus, JKL Media, given its projected cash flows, has a project with a 17.15% return. If there were a project that JKL could undertake with a higher IRR, it would probably pursue the higher-yielding project instead. Thus, you can see that the usefulness of the IRR measurement lies in its ability to represent any investment opportunity's return and to compare it with other possible investments.

Net Present Value And Internal Rate Of Return - Net Present Value
The net present value approach is the most intuitive and accurate valuation approach to capital budgeting problems. Discounting the after-tax cash flows by the weighted average cost of capital allows managers to determine whether a project will be profitable or not. And unlike the IRR method, NPVs reveal exactly how profitable a project will be in comparison to alternatives. The NPV rule states that all projects which have a positive net present value should be accepted while those that are negative should be rejected. If funds are limited and all positive NPV projects cannot be initiated, those with the high discounted value should be accepted. In the two examples below, assuming a discount rate of 10%, project A and project B have respective NPVs of $126,000 and $1,200,000. These results signal that both capital budgeting projects would increase the value of the firm, but if the company only has $1 million to invest at the moment, project B is superior.

Investment Year 0 -1,000,000

Inflows Year 1 300,000

Year 2 300,000

Year 3 300,000

Year 4 300,000

Year 5 300,000

Investment Year 0 -1,000,000

Inflows Year 1 300,000

Year 2 -300,000

Year 3 300,000

Year 4 300,000

Year 5 3,000,000

Some of the major advantages of the NPV approach include the overall usefulness and easy understandability of the figure. NPV provides a direct measure of added profitability, allowing one to simultaneously compare multiple mutually exclusive projects and even though the discount rate it subject to change, a sensitivity analysis of the NPV can typically signal any overwhelming potential future concerns. Although the NPV approach is subject to fair criticisms that the value-added figure does not factor in the overall magnitude of the project, the profitability index (PI), a metric derived from discounted cash flow calculations, can easily fix this concern. We'll discuss the profitability index in a later section. (It's never too early to start learning about money. Read 5 Ways To Teach Your Kids The Value Of A Dollar.) Here is another example of how companies use NPV.

Using the company's cost of capital, the net present value (NPV) is the sum of the discounted cash flows minus the original investment.

Projects with NPV > 0 increase stockholders' return Projects with NPV < 0 decrease stockholders' return

Example: Net Present Value Assume Newco is deciding between two machines (Machine A and Machine B) in order to add capacity to its existing plant. Using the cash flows in the table below, let's calculate the NPV for each machine and decide which project Newco should accept. Assume Newco's cost of capital is 8.4%. Expected after-tax cash flows for the new machines

Calculation and Answer: NPVA = -5,000 + 500 + 1,000 + 1,000 + 1,500 + 2,500 + 1,000 = $469 (1.084)1 (1.084)2 (1.084)3 (1.084)4 (1.084)5 (1.084)6 NPVB = -2,000 + 500 + 1,500 + 1,500 + 1,500 + 1,500 + 1,500 = $3,929 (1.084)1 (1.084)2 (1.084)3 (1.084)4 (1.084)5 (1.084)6 Given that both machines have NPV > 0, both projects are acceptable. However, for mutually exclusive projects, the decision rule is to choose the project with the greatest NPV. Since the NPVB > NPVA, Newco should choose the project for Machine B. We'll discuss additional applications of NPV in the following pages.

Net Present Value And Internal Rate Of Return - Payback Rule


When a firm is presented with a capital budgeting decision, one of its first tasks is to determine whether the project will prove to be profitable. The net present value (NPV), internal rate of return (IRR) and payback period (PB) methods are the most common approaches to project selection. Although an ideal capital budgeting solution is such that all three metrics will indicate the same decision, these approaches will often produce contradictory results. Depending on managements' preferences and selection criteria, more emphasis will be put on one approach over another. The payback rule, also called the payback period, is the length of time required to recover the cost of an investment. The payback period is calculated as follows: Cost of Project Annual Cash Inflows All other things being equal, the better investment is the one with the shorter payback period. For example, if a project costs $100,000 and is expected to return $20,000 annually, the payback period will be $100,000 / $20,000, or five years. (Learn more about payback's applications to personal finance in How Long Until Your Hybrid Pays Off? and Cheap Home Renovations That Pay Off.)

Here is another example. If a capital budgeting project requires an initial cash outlay of $1 million, the PB reveals how many years are required to for the cash inflows to equate to the one million dollar outflow. A short PB period is preferred as it indicated that the project will "pay for itself" within a smaller time frame. In the following example, the PB period would be three and one-third of a year, or three years and four months.

Investment Inflows Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 -1,000,000 300,000 300,000 300,000 300,000 300,000
Payback periods are typically used when liquidity presents a major concern. If a company only has a limited amount of funds, they might be able to only undertake one major project at a time. Therefore, management will heavily focus on recovering their initial investment in order to undertake subsequent projects. Another major advantage of using the PB is that it is easy to calculate once the cash flow forecasts have been established. While the payback rule appears very straightforward, there are two significant problems with this method. 1. It ignores the time value of money. 2. It ignores any benefits that occur after the payback period and therefore does not measure profitability. Because of these reasons, other methods of capital budgeting like net present value, internal rate of return or discounted cash flow are generally preferred. Let's take [E1] a closer look at the two major drawbacks to using the PB metric to determine capital budgeting decisions. Firstly, the payback period does not account for time value of money (TVM). Simply calculating the PB provides a metric which places the same emphasis on payments received in year one and year two. Such an error violates one of the basic fundamental principles of finance. Luckily, this problem can easily be amended by implementing a discounted payback period model. Basically, the discounted PB period factors in TVM and allows one to determine how long it take for the investment to be recovered on a discounted cash flow basis.
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The second problem is more serious. Both payback periods and discounted payback periods ignore the cash flows that occur towards the end of a project's life, such as the salvage value. Thus the PB is not a direct measure of profitability. The following example has a PB period of four years, which is worse than that of the previous example, but the large $15,000,000 cash inflow occurring in year five is ignored for the purposes of this metric.

Investment Inflows Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 -1,000,000 250,000 250,000 250,000 250,000 15,000,000
Since the payback period does not reflect the added value of a capital budgeting decision, it is usually considered the least relevant valuation approach. However, if liquidity is a vital consideration, PB periods are of major importance. The Discounted Payback Period Model The discounted payback period model is the capital budgeting procedure used to determine the profitability of a project. In contrast to an NPV analysis, which provides the overall value of a project, a discounted payback period gives the number of years it takes to break even from undertaking the initial expenditure. Future cash flows are considered are discounted to time "zero." This procedure is

similar to a payback period; however, the payback period only measure how long it take for the initial cash outflow to be paid back, ignoring the time value of money. Projects that have a negative net present value will not have a discounted payback period, because the initial outlay will never be fully repaid. This is in contrast to a payback period where the gross inflow of future cash flows could be greater than the initial outflow, but when the inflows are discounted, the NPV is negative. (Can a negative ever be a positive? Read more in How Negative Demographics Can Help The Economy.) Example: Discounted Payback Period Going back to our earlier example of Newco and the decision about which machine to purchase, let's determine the discounted payback period for Machine A and Machine B, and determine which project Newco should accept. Recall that Newco's cost of capital is 8.4%. Discounted Cash Flows for Machine A and Machine B

Calculation and Answer: Payback period for Machine A = 5 + 147 = 5.24 616 Payback period for Machine B = 2 + 262 = 2.22 1178 Machine A violates management's maximum payback period of five years and should thus be rejected. Machine B meets management's maximum payback period of five years and has the shortest payback period.

Net Present Value And Internal Rate Of Return - Average Accounting Return
Average accounting return, also called accounting rate of return or ARR, is an accounting method used for the purposes of comparison with other capital budgeting calculations, such as NPV, PB period and IRR. ARR provides a quick estimate of a project's worth over its useful life. ARR is calculated by finding a capital investment's average operating profits before interest and taxes but after depreciation and amortization (also known as "EBIT") and dividing that number by the book value of the average amount invested. It can be expressed as the following: ARR = Average Profit / Average Investment The result is expressed as a percentage. In other words, ARR compares the amount invested to the profits earned over the course of a project's life. The higher the ARR, the better. The major drawbacks of ARR are as follows: 1. It uses operating profit rather than cash flows. Some capital investments have high upkeep and

maintenance costs, which bring down profit levels. 2. Unlike NPV and IRR, it does not account for the time value of money. By ignoring the time value of money, the capital investment under consideration will appear to have a higher level of return than what will occur in reality. The capital investment may appear to be more lucrative than the alternatives, such as investing in the financial markets, when it is actually less lucrative. Here is a simple example of an ARR calculation: A project requiring an average investment of $1,000,000 and generating an average annual profit of $150,000 would have an ARR of 15%. While ARR is easy to calculate and can be used to gauge the results of other capital budgeting calculations, it is not the most accurate metric.

Net Present Value And Internal Rate Of Return - Internal Rate Of Return
The internal rate of return (IRR) is frequently used by corporations to compare and decide between capital projects. The IRR is the interest rate (also known as the discount rate) that will bring a series of cash flows (positive and negative) to a net present value (NPV) of zero (or to the current value of cash invested). Using IRR to obtain net present value is known as the discounted cash flow method of financial analysis. (For more insight, read the Discounted Cash Flow Analysis tutorial.) For example, a corporation will evaluate an investment in a new plant versus an extension of an existing plant based on the IRR of each project. In such a case, each new capital project must produce an IRR that is higher than the company's cost of capital. Once this hurdle is surpassed, the project with the highest IRR would be the wiser investment, all other factors (including risk) being equal. Calculation Complexities The IRR formula can be very complex depending on the timing and variances in cash flow amounts. Without a computer or financial calculator, IRR can only be computed by trial and error. One of the disadvantages of using IRR is that all cash flows are assumed to be reinvested at the same discount rate, although in the real world these rates will fluctuate, particularly with longer term projects. IRR can be useful, however, when comparing projects of equal risk, rather than as a fixed return projection. Calculating IRR Many accounting software programs now include an IRR calculator, as do Excel and other programs. A handy alternative for some is the good old HP 12c financial calculator, which will fit in a pocket or briefcase. (Check out the Investopedia Calculators.) The simplest example of computing an IRR is a mortgage with even payments. Assume an initial mortgage amount of $200,000 and monthly payments of $1,050 for 30 years. The IRR (or implied interest rate) on this loan annually is 4.8%. Because the stream of payments is equal and spaced at even intervals, an alternative approach is to discount these payments at a 4.8% interest rate, which will produce a net present value of $200,000. Alternatively, if the payments are raised to, say $1,100, the IRR of that loan will rise to 5.2%. The formula for IRR, using this example, is as follows: Where the initial payment (CF1) is $200,000 (a positive inflow) Subsequent cash flows (CF 2, CF 3, CF N) are negative $1,050 (negative because it is being paid out) Number of payments (N) is 30 years times 12 = 360 monthly payments Initial Investment is $200,000 IRR is 4.8% divided by 12 (to equate to monthly payments) = 0.400%

Using the numbers from this example, the formula for calculating IRR is as follows:

IRR = .400%
Power of Compounding IRR is also useful in demonstrating the power of compounding. For example, if you invest $50 every month in the stock market over a 10-year period, that money would turn into $7,764 at the end of the 10 years with a 5% IRR. In other words, to get a future value of $7,764 with monthly payments of $50 per month for 10 years, the IRR that will bring that flow of payments to a net present value of zero is 5%. Compare this investment strategy to investing a lump-sum amount; to get the same future value of $7,764 with an IRR of 5%, you would have to invest $4,714 today, in contrast to the $6,000 invested in the $50-per-month plan. So, one way of comparing lump-sum investments versus payments over time is to use the IRR.
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Other IRR Uses Another common use of IRR is in the computation of portfolio, mutual fund or individual stock returns. In most cases, the advertised return will include the assumption that any cash dividends are reinvested in the portfolio or stock. Therefore, it is important to scrutinize the assumptions when comparing returns of various investments. What if you don't want to reinvest dividends, but need them as income when paid? And if dividends are not assumed to be reinvested, are they paid out or are they left in cash? What is the assumed return on the cash? IRR and other assumptions are particularly important on instruments like whole life insurance policies and annuities, where the cash flows can become complex. Recognizing the differences in the assumptions is the only way to compare products accurately. (Learn more about life insurance in 5 Things You Didn't Know About Life Insurance and Does Spiderman Need Life Insurance?) In capital budgeting, the IRR rule is as follows: IRR > cost of capital = accept project IRR < cost of capital = reject project In the example below, the IRR is 15%. If the firm's actual discount rate for discounted cash flow models is less than 15%, the project should be accepted.

Investment Inflows Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 -1,000,000 300,00 300,000 300,000 300,000 300,000

The primary advantage of implementing the internal rate of return as a decision-making tool is that it provides a benchmark figure for every project that can be assessed in reference to a company's capital structure. The IRR will usually produce the same types of decisions as net present value models, and it allows firms to compare projects on the basis of returns on invested capital. Although IRR is easy to compute with either a financial calculator or computer software, there are some downfalls to using this metric. Similar to the PB method, the IRR does not give a true sense of the value that a project will add to a firm - it simply provides a benchmark figure for what projects should be accepted based on the firm's cost of capital. The internal rate of return does not allow for an appropriate comparison of mutually exclusive projects; therefore managers might be able to determine that project A and project B are both beneficial to the firm, but they would not be able to decide which one is better if only one may be accepted.
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Another error arising with the use of IRR analysis presents itself when the cash flow streams from a project are unconventional, meaning that there are additional cash outflows following the initial investment. Unconventional cash flows are common in capital budgeting since many projects require future capital outlays for maintenance and repairs. In such a scenario, an IRR might not exist, or there might be multiple internal rates of return. In the example below two IRRs exist - 12.7% and 787.3%.

Investment Year 0 -1,000,000

Inflows Year 1 10,000,000

Year 2 -10,000,000

Year 3 Year 4 Year 5 0 0 0

The IRR is a useful valuation measure when analyzing individual capital budgeting projects, not those which are mutually exclusive. It provides a better valuation alternative to the PB method, yet falls short on several key requirements.

Net Present Value And Internal Rate Of Return - Advantages And Disadvantages Of NPV and IRR
Now that you're familiar with both NPV and IRR and understand the shortcomings of PB period and ARR, let's compare the advantages and disadvantages of NPV and IRR. Advantages: The NPV method is a direct measure of the dollar contribution to the stockholders. The IRR method shows the return on the original money invested.

Disadvantages: The NPV method does not measure the project size. The IRR method can, at times, give you conflicting answers when compared to NPV for mutually exclusive projects. The "multiple IRR problem" can also be an issue, as discussed below.

The Multiple IRR Problem A multiple IRR problem occurs when cash flows during the project lifetime are negative (i.e. the project operates at a loss or the company needs to contribute more capital). This is known as a "non-normal cash flow," and such cash flows will give multiple IRRs. Why Do NPV and IRR Methods Produce Conflicting Rankings? When a project is an independent project, meaning the decision to invest in a project is independent of any other projects, both the NPV and IRR will always give the same result, either rejecting or accepting a project.

While NPV and IRR are useful metrics for analyzing mutually exclusive projects - that is, when the decision must be one project or another - these metrics do not always point you in the same direction. This is a result of the timing of cash flows for each project. In addition, conflicting results may simply occur because of the project sizes. The timing of cash flows as well as project sizes can produce conflicting results in the NPV and IRR methods. Example: NPV and IRR Analysis Assume once again that Newco needs to purchase a new machine for its manufacturing plant. Newco has narrowed it down to two machines that meet its criteria (Machine A and Machine B), and now it has to choose one of the machines to purchase. Further, Newco has assumed the following analysis on which to base its decision:

We first determine the NPV for each machine as follows: NPVA = ($5,000) + $2,768 + $2.553 = $321 NPVB = ($10,000) + $5,350 + $5,106 = $456 According to the NPV analysis alone, Machine B is the most appropriate choice for Newco to purchase. The next step is to determine the IRR for each machine using our financial calculator. The IRR for Machine A is equal to 13%, whereas the IRR for Machine B is equal to 11%. According to the IRR analysis alone, Machine A is the most appropriate choice for Newco to purchase. The NPV and IRR analysis for these two projects give us conflicting results. This is most likely due to the timing of the cash flows for each project as well as the size difference between the two projects.

Net Present Value And Internal Rate Of Return - Profitability Index


A profitability index attempts to identify the relationship between the costs and benefits of a proposed project. The profitability index is calculated by dividing the present value of the project's future cash flows by the initial investment. A PI greater than 1.0 indicates that profitability is positive, while a PI of less than 1.0 indicates that the project will lose money. As values on the profitability index increase, so does the financial attractiveness of the proposed project. The PI ratio is calculated as follows: PV of Future Cash Flows Initial Investment A ratio of 1.0 is logically the lowest acceptable measure for the index. Any value lower than 1.0 would

indicate that the project's PV is less than the initial investment, and the project should be rejected or abandoned. The profitability index rule states that the ratio must be greater than 1.0 for the project to proceed. For example, a project with an initial investment of $1 million and present value of future cash flows of $1.2 million would have a profitability index of 1.2. Based on the profitability index rule, the project would proceed. Essentially, the PI tells us how much value we receive per dollar invested. In this example, each dollar invested yields $1.20. The profitability index rule is a variation of the net present value (NPV) rule. In general, if NPV is positive, the profitability index would be greater than 1; if NPV is negative, the profitability index would be below 1. Thus, calculations of PI and NPV would both lead to the same decision regarding whether to proceed with or abandon a project. However, the profitability index differs from NPV in one important respect: being a ratio, it ignores the scale of investment and provides no indication of the size of the actual cash flows. The PI can also be thought of as turning a project's NPV into a percentage rate.

Net Present Value And Internal Rate Of Return - Capital Budgeting


Capital budgeting is the process of planning for projects on assets with cash flows of a period greater than one year. These projects can be classified as: Replacement decisions to maintain the business Existing product or market expansion New products and services Regulatory, safety and environmental Other, including pet projects or difficult-to-evaluate projects Additionally, projects can be classified as mutually exclusive or independent: Mutually exclusive projects are potential projects that are unrelated, and any combination of those projects can be accepted. Independent projects indicate there is only one project among all possible projects that can be accepted. The Importance of Capital Budgeting Capital budgeting is important for many reasons: - Since projects approved via capital budgeting are long term, the firm becomes tied to the project and loses some of its flexibility during that period. - When making the decision to purchase an asset, managers need to forecast the revenue over the life of that asset. - Lastly, given the length of the projects, capital-budgeting decisions ultimately define the strategic plan of the company. (To learn about the importance of budgeting on a personal level, read 6 Reasons Why You NEED A Budget and 11 Most Common Budgeting Mistakes.) In capital budgeting, there are a number of different approaches that can be used to evaluate any given project, and each approach has its own distinct advantages and disadvantages. All other things being equal, using internal rate of return (IRR) and net present value (NPV) measurements to evaluate projects often results in the same findings. However, there are a number of projects for which using IRR is not as effective as using NPV to discount cash flows. IRR's major

limitation is also its greatest strength: it uses one single discount rate to evaluate every investment. Although using one discount rate simplifies matters, there are a number of situations that cause problems for IRR. If an analyst is evaluating two projects, both of which share a common discount rate, predictable cash flows, equal risk and a shorter time horizon, IRR will probably work. The catch is that discount rates usually change substantially over time. For example, think about using the rate of return on a T-bill in the last 20 years as a discount rate. One-year T-bills returned between 1- 12% in the last 20 years, so clearly the discount rate is changing. Without modification, IRR does not account for changing discount rates, so it's just not adequate for longer-term projects with discount rates that are expected to vary. Another type of project for which a basic IRR calculation is ineffective is a project with a mixture of multiple positive and negative cash flows. For example, consider a project for which marketers must reinvent the style every couple of years to stay current in a fickle, trendy niche market. If the project has cash flows of -$50,000 in year one (initial capital outlay), returns of $115,000 in year two and costs of $66,000 in year three because the marketing department needed to revise the look of the project, a single IRR can't be used. Recall that IRR is the discount rate that makes a project break even. If market conditions change over the years, this project can have two or more IRRs, as seen below.
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Thus, there are at least two solutions for IRR that make the equation equal to zero, so there are multiple rates of return for the project that produce multiple IRRs. The advantage to using the NPV method here is that NPV can handle multiple discount rates without any problems. Each cash flow can be discounted separately from the others. Another situation that causes problems for users of the IRR method is when the discount rate of a project is not known. In order for the IRR to be considered a valid way to evaluate a project, it must be compared to a discount rate. If the IRR is above the discount rate, the project is feasible; if it is below, the project is considered infeasible. If a discount rate is not known, or cannot be applied to a specific project for whatever reason, the IRR is of limited value. In cases like this, the NPV method is superior. If a project's NPV is above zero, then it is considered to be financially worthwhile. So, why is the IRR method still commonly used in capital budgeting? Its popularity is probably a direct result of its reporting simplicity. The NPV method is inherently complex and requires assumptions at each stage - discount rate, likelihood of receiving the cash payment, etc. The IRR method simplifies projects to a single number that management can use to determine whether or not a project is economically viable. The result is simple, but for any project that is long-term, that has multiple cash flows at different discount rates or that has uncertain cash flows - in fact, for almost any project at all - simple IRR isn't good for much more than presentation value.

4.2 Capital Investment Decisions - Introduction To Capital Investment Decisions

Capital investments are funds invested in a firm or enterprise for the purposes of furthering its business objectives. Capital investment may also refer to a firm's acquisition of capital assets or fixed assets such as manufacturing plants and machinery that are expected to be productive over many years. Sources of capital investment are manifold and can include equity investors, banks, financial institutions, venture capital and angel investors. While capital investment is usually earmarked for capital or long-life assets, a portion may also be used for working capital purposes. Capital investment encompasses a wide variety of funding options. While funding for capital investment is generally in the form of common or preferred equity issuance, it may also be through straight or convertible debt. Funding may range from an amount of less than $100,000 in seed financing for a start-up to amounts in the hundreds of millions for massive projects in capital-intensive sectors like mining, utilities and infrastructure. In this section, we'll examine various components of a company's capital investment decisions, including project cash flows, incremental cash flows and more.

Capital Investment Decisions - Project Cash Flows


When beginning capital-budgeting analysis, it is important to determine a project's cash flows. These cash flows can be segmented as follows: 1. Initial Investment Outlay These are the costs that are needed to start the project, such as new equipment, installation, etc. 2. Operating Cash Flow over a Project's Life This is the additional cash flow a new project generates. 3. Terminal-Year Cash Flow This is the final cash flow, both the inflows and outflows, at the end of the project's life; for example, potential salvage value at the end of a machine's life. Example: Expansion Project Newco wants to add to its production capacity and is looking closely at investing in Machine B. Machine B has a cost of $2,000, with shipping and installation expenses of $500 and a $300 cost in net working capital. Newco expects the machine to last for five years, at which point Machine B will have a book value (BV) of $1,000 ($2,000 minus five years of $200 annual depreciation) and a potential market value of $800. With respect to cash flows, Newco expects the new machine to generate an additional $1,500 in revenues and costs of $200. We will assume Newco has a tax rate of 40%. The maximum payback period that the company has established is five years. Let's calculate the project's initial investment outlay, operating cash flow over the project's life and the terminal-year cash flow for the expansion project. Answer: Initial Investment Outlay: Machine cost + shipping and installation expenses + change in net working capital = $2,000 + $500 + $300 = $2,800 Operating Cash Flow: CFt = (revenues - costs)*(1 - tax rate) CF1 = ($1,500 - $200)*(1 - 40%) = $780 CF2 = ($1,500 - $200)*(1 - 40%) = $780 CF3 = ($1,500 - $200)*(1 - 40%) = $780 CF4 = ($1,500 - $200)*(1 - 40%) = $780 CF5 = ($1,500 - $200)*(1 - 40%) = $780

Terminal Cash Flow:

Tips and Tricks The key metrics for determining the terminal cash flow are salvage value of the asset, net working capital and tax benefit/loss from the asset.
The terminal cash flow can be calculated as illustrated: Return of net working capital +$300 Salvage value of the machine +$800 Tax reduction from loss (salvage < BV) +$80 Net terminal cash flow $1,180 Operating CF5 +$780 Total year-five cash flow $1,960 For determining the tax benefit or loss, a benefit is received if the book value of the asset is more than the salvage value, and a tax loss is recorded if the book value of the asset is less than the salvage value.

Capital Investment Decisions - Incremental Cash Flows


Incremental cash flow is the additional operating cash flow that an organization receives from taking on a new project. A positive incremental cash flow means that the company's cash flow will increase with the acceptance of the project. There are several components that must be identified when looking at incremental cash flows: the initial outlay, cash flows from taking on the project, terminal cost (or value) and the scale and timing of the project. A positive incremental cash flow is a good indication that an organization should spend some time and money investing in the project. Incremental Cash Flow and Capital Budgeting When determining incremental cash flows from a new project, several problems arise: sunk costs, opportunity costs, externalities and cannibalization. 1. Sunk Costs These are the initial outlays required to analyze a project that cannot be recovered even if a project is accepted. As such, these costs will not affect the future cash flows of the project and should not be considered when making capital-budgeting decisions. Suppose Newco is considering whether to make an addition to its current plant to increase production. To determine if the new addition is worthwhile, Newco hired a consulting firm for $50,000 to analyze the addition and the effect it will have on production. The $50,000 is considered a sunk cost. If the project is rejected, the $50,000 will still be paid, and if the project is accepted, the $50,000 will not affect the future cash flows of the addition. 2. Opportunity Cost This is the cost of not going forward with a project or the cash outflows that will not be earned as a result of utilizing an asset for another alternative. For example, the opportunity cost of Newco's new addition considered above is the cost of the land on which the company is considering putting the new plant addition. As such, it should be included in the analysis of the project. 3. Externality In the consideration of incremental cash flows of a new project, there may be effects on the existing

operations of the company to consider, known as "externalities." For example, the addition to Newco's plant is for the purpose of producing a new product. It must be considered whether the new product may actually take away or add to sales of the existing product. 4. Cannibalization Cannibalization is the type of externality where the new project takes sales away from the existing product. Changes in Net Working Capital A change in net working capital is essentially the changes in current assets minus changes in current liabilities. Within the capital-budgeting process, a project typically adds to current assets given additional inventories or potential increases in accounts receivables from new sales. The increases to current assets, however, are offset by current liabilities needed to finance the new project. Overall, there may be a change to net working capital from the new project. If the change in net working capital is positive, the change to current assets outweighs the change in the current liabilities. If, however, the change in net working capital is negative, the change to current liabilities outweighs the change in current assets.

Capital Investment Decisions - Pro Forma Financial Statements Many companies issue pro-forma financial statements in addition to generally accepted accounting principles (GAAP) -adjusted statements as a way to provide investors with a better understanding of operating results. In legitimate cases, pro forma financial statements take out one-time charges to smooth earnings. However, companies can also manipulate their financial results under the guise of pro-forma financial statements to provide a picture that is rosier than reality. Let's take a closer look at what pro-forma financial statements are, when they are useful and how companies can use them to dupe investors. What Are Pro-Forma Earnings? Pro-forma earnings describe a financial statement that has hypothetical amounts, or estimates, built into the data to give a "picture" of a company's profits if certain nonrecurring items were excluded. Pro-forma earnings are not computed using standard GAAP and usually leave out one-time expenses that are not part of normal company operations, such as restructuring costs following a merger. Such an expense can be rightfully viewed as a one-time item that does not contribute to the company's representative valuation. Essentially, a pro-forma financial statement can exclude anything a company believes obscures the accuracy of its financial outlook, and it can be a useful piece of information to help assess a company's future prospects. Every investor should stress GAAP net income, which is the "official" profitability determined by accountants, but a look at pro-forma earnings can also be an informative exercise. Pro forma earnings figures are inherently different for different companies. There are no universal guidelines that companies must follow when reporting pro forma earnings, which is why the distinction between pro forma and earnings reported using GAAP is very, very important. GAAP enforces strict guidelines that companies must follow when reporting earnings, but pro forma figures are better thought of as "hypothetical," computed according to the estimated relevance of certain events and conditions experienced by the company. Basically, companies use their own discretion in calculating pro forma earnings, including or excluding items depending on what they feel accurately represents the company's true performance. For example, net income does not tell the whole story when a company has one-time charges that are irrelevant to future profitability. Some companies therefore strip out certain costs that get in the way. This kind of earnings information can be very useful to investors who want an accurate view of a

company's normal earnings outlook, but by omitting items that reduce reported earnings, this process can make a company appear profitable even when it is losing money. We like to call pro forma the "everything-but-the-bad-stuff earnings." The problem, however, is that there isn't nearly as much regulation of pro-forma earnings as there is of financial statements falling under GAAP rules, so sometimes companies bend or even abuse the rules to make earnings appear better than they really are. Because traders and brokers focus so closely on whether the company beats or meets analyst expectations, the headlines that follow a company's earnings announcements can mean everything. And, if a company missed non-pro-forma expectations but stated that it beat the pro-forma expectations, its stock price will not suffer as badly; it might even go up - at least in the short term. Problems with Pro Forma Despite the positive reasoning behind pro-forma statements, there are many ways in which pro-forma earnings can be manipulated. Items often left out of pro forma figures include the following: depreciation, goodwill, amortization, restructuring and merger costs, interest and taxes, stock-based employee pay, losses at affiliates and one-time expenses. The theory behind excluding non-cash items such as amortization is that these are not true expenses and therefore do not represent the company's actual earnings potential. Amortization, for example, is not an item that is paid for as a part of cash flow. But under GAAP, amortization is considered an expense because it represents the loss of value of an asset. (See What is the difference between amortization and depreciation? to learn more.) One-time cash expenses are often excluded from pro forma because they are not a regular part of operations and are therefore considered an irrelevant factor in the performance of a company's core activities. Under GAAP, however, a one-time expense is included in earnings calculations because, even though it is not a part of operations, a one-time expense is still a sum of money that exited the company and therefore decreased income. Sometimes companies even take unsold inventory off their balance sheets when reporting pro-forma earnings. Ask yourself this: does producing that inventory cost money? Of course it does, so why should the company simply be able to write it off? It is bad management to produce goods that can't be sold, and a company's poor decisions shouldn't be erased from the financial statements. The Securities and Exchange Commission (SEC) will investigate companies suspected of trying to deceive investors in the pro-forma modification of earnings. (Read more about how companies are regulated in Compliance: The Price Companies Pay.) This isn't to say companies are always dishonest with pro-forma earnings; pro forma doesn't mean the numbers are automatically being manipulated. But by being skeptical when reading pro-forma earnings, you may end up saving yourself big money. To evaluate the legitimacy of pro-forma earnings, be sure to look at what the excluded costs are and decide whether these costs should be considering impactful. Intangibles like depreciation and goodwill are okay to write down occasionally, but if the company is doing it every quarter, the reasons for doing so might be less than honorable. (For further reading, see Impairment Charges: The Good, The Bad and The Ugly.) The dotcom era of the late 1990s saw some of the worst abusers of pro-forma earnings manipulations. Many Nasdaq-listed companies utilized pro-forma earnings management to report more robust proforma numbers. Taken cumulatively, the difference between GAAP earnings and pro-forma earnings for the dotcom sector during its heyday exceeded billions of dollars. One of the more notable occurrences of this phenomenon is Network Associates. The company went so far as to exclude its dotcom department's operating earnings. The dotcom department wasn't making or spending pretend money, so why did the company exclude these numbers? No doubt the department was losing money and decided to hide those numbers that reflected poor company strategy from investors. (Learn about dotcom companies that made it in 5 Successful Companies That Survived The Dotcom Bubble.) Benefits of Pro-Forma Analysis Pro-forma figures are supposed to give investors a clearer view of company operations. For some companies, pro-forma earnings provide a much more accurate view of their financial performance and

outlook because of the nature of their businesses. Companies in certain industries tend to use proforma reporting more than others, as the impetus to report pro-forma numbers is usually a result of industry characteristics. For example, some cable and telephone companies almost never make a net operating profit because they are constantly writing down big depreciation costs. In cases where pro-forma earnings do not include non-cash charges, investors can see what the actual cash profit is. For example, recall AOL Time Warner's massive goodwill write-off of about $54 billion in 2002 to reflect the value of AOL's merger with Time Warner in the previous year. With accounting charges nearing $100 billion, Time Warner's GAAP earnings for the year probably would not have been a very good predictor of future prospects - those extraordinary expenses would probably never occur again. Analysis of pro-forma earnings is an important exercise to undertake before considering an investment in a company that reports pro-forma numbers, so be sure to do so. Also, when a company undergoes substantial restructuring or completes a merger, significant one-time charges can occur. These types of expenses do not compose part of the business's ongoing cost structure and therefore can unfairly weigh on short-term profit numbers. An investor concerned with valuing the long-term potential of the company would do well to analyze pro-forma earnings, which exclude these non-recurring expenses. Pro-forma financial statements are also prepared and used by corporate managers and investment banks to assess the operating prospects for their own businesses in the future and to assist in the valuation of potential takeover targets. They are useful tools to help identify a company's core value drivers and analyze changing trends within company operations. GAAP Manipulation Aside from misusing pro-forma income statements, companies can also mislead investors by creatively classifying their income in several ways, including the following: Operating income is not strictly defined under the GAAP because classification lines are often subject to discretion. Items that are classified into this element can be selectively chosen by management. For example, non-recurring income such as special charges, shareholder class action settlements and unusual events may be included or omitted within the metric to present a value that will please shareholders. Sales and gross profits can also be manipulated in many ways within the constraints of the GAAP. For example, companies can classify sales as either the gross amount billed to a customer or expected amounts to be received. Furthermore, sales can also depend on whether or not shipping and handling is treated as a part of revenues. Finally, gross margins can be manipulated by moving certain expenses between SG&A and other costs of sales. In the end, these changes create artificially higher or lower income-statement metrics that can mislead shareholders. The Bottom Line To sum up, pro-forma earnings are informative when official earnings are blurred by large amounts of asset depreciation and goodwill. But, when you see pro forma, it's up to you to dig deeper to see why the company is treating its earnings as such. Remember that when you read pro-forma figures, they have not undergone the same level of scrutiny as GAAP earnings and are not subject to the same level of regulation. Although a company reporting pro forma earnings is not doing anything fraudulent or dishonest (because it does report exactly what is and what is not included), it is very important for investors to know and evaluate what went into the company's pro forma calculation, as well as to compare the pro forma figure to the GAAP figure. Often, companies can have a positive pro forma earnings figure while having a negative GAAP earnings figure. A final cautionary note for when you are analyzing pro forma figures: because companies' definitions of pro forma vary, you must be very careful when comparing pro forma figures between different companies. If you are not aware of how the companies define their pro forma figures, you may be inadvertently comparing apples to oranges.

Do your homework and maintain a balanced perspective when reading pro-forma statements. Try to identify the key differences between GAAP earnings and pro-forma earnings and determine whether the differences are reasonable or if they are only there to make a losing company look better. You want to base your decisions on as clear a financial picture as possible.

Capital Investment Decisions - Operating Cash Flow And Alternative Definitions Of Operating Cash Flow
The cash flow statement summarizes a business's cash inflows and outflows over a period of time. It is important because it is very difficult for a business to manipulate its cash situation. There is plenty that aggressive accountants can do to manipulate earnings, but it's tough to fake cash in the bank. For this reason, some investors use the cash flow statement as a more conservative measure of a company's performance. Operating cash flow (OCF) is found on the cash flow statement and is calculated through a series of adjustments to net income. OCF is arguably a better measure of a business's profits than earnings because a company can show positive net earnings on the income statement and still not be able to pay its debts. Cash flow is what pays the bills, and OCF can serve as a check on the quality of a company's earnings. If a firm reports record earnings but negative cash, it may be using aggressive accounting techniques. Overview of the Statement of Cash Flows The statement of cash flows for non-financial companies consists of three main parts: 1. Operating flows - The net cash generated from operations (net income and changes in working capital). 2. Investing flows - The net result of capital expenditures, investments, acquisitions, etc. 3. Financing flows - The net result of raising cash to fund the other flows or repaying debt. By taking net income and making adjustments to reflect changes in the working capital accounts on the balance sheet (receivables, payables, inventories) and other current accounts, the operating cash flow section shows how cash was generated during the period. It is this translation process from accrual accounting to cash accounting that makes the operating cash flow statement so important. Accrual Accounting vs. Cash Flows The key differences between accrual accounting and real cash flow are demonstrated by the concept of the cash cycle. A company's cash cycle is the process that converts sales (based upon accrual accounting) into cash as follows: - Cash is used to make inventory. -Inventory is sold and converted into accounts receivables (because customers are given 30 days to pay). -Cash is received when the customer pays (which also reduces receivables). There are many ways that cash from legitimate sales can get trapped on the balance sheet. The two most common are for customers to delay payment (resulting in a buildup of receivables) and for inventory levels to rise because the product is not selling or is being returned. For example, a company may legitimately record a $1 million sale but because that sale allowed the customer to pay within 30 days, the $1 million in sales does not mean the company made $1 million cash. If the payment date occurs after the close of the end of the quarter, accrued earnings will be greater than operating cash flow because the $1 million is still in accounts receivable. Harder to Fudge Operating Cash Flows Not only can accrual accounting give a rather provisional report of a company's profitability, but under

GAAP it allows management a range of choices to record transactions. While this flexibility is necessary, it also allows for earnings manipulation. Because managers will generally book business in a way that will help them earn their bonus, it is usually safe to assume that the income statement will overstate profits rather than understate them. An example of income manipulation is called "stuffing the channel." To increase their sales, a company can provide retailers with incentives such as extended terms or a promise to take back the inventory if it is not sold. Inventories will then move into the distribution channel and sales will be booked. Accrued earnings will increase, but cash may actually never be received because the inventory may be returned by the customer. While this may increase sales in one quarter, it is a short-term exaggeration and ultimately "steals" sales from the following periods (as inventories are sent back). (Note: While liberal return policies, such as consignment sales, are not allowed to be recorded as sales, companies have been known to do so quite frequently during a market bubble.) The operating cash flow statement will catch these gimmicks. When operating cash flow is less than net income, there is something wrong with the cash cycle. In extreme cases, a company could have consecutive quarters of negative operating cash flow and, in accordance with GAAP, legitimately report positive earnings per share (EPS). In this situation, investors should determine the source of the cash hemorrhage (inventories, receivables, etc.) and whether this situation is a short-term issue or longterm problem. (For more on cash flow manipulation, see Cash Flow On Steroids: Why Companies Cheat.) Cash Exaggerations While the operating cash flow statement is more difficult to manipulate, there are ways for companies to temporarily boost cash flows. Some of the more common techniques include delaying payment to suppliers (extending payables); selling securities; and reversing charges made in prior quarters (such as restructuring reserves). Some view the selling of receivables for cash - usually at a discount - as a way for companies to manipulate cash flows. In some cases, this action may be a cash flow manipulation; but it can also be a legitimate financing strategy. The challenge is being able to determine management's intent. Cash Is King A company can only live by EPS alone for a limited time. Eventually, it will need cash to pay suppliers and, most importantly, the bankers. There are many examples of once-respected companies who went bankrupt because they could not generate enough cash. Strangely, despite all this evidence, investors are consistently hypnotized by EPS and market momentum and ignore the warning signs. Investors can avoid a lot of bad investments if they analyze a company's operating cash flow. It's not hard to do, but it is important to do because the talking heads and analysts are all too often focused on EPS. Alternative Methods of Calculating OCF The bottom-up approach to operating cash flow takes the company's bottom line--that is, its net income--and adds back non-cash expenses such as depreciation and amortization. OCF = N + D The top-down approach starts with total sales and subtracts only cash expenses (primarily fixed costs, variable costs and taxes), leaving out non-cash expenses such as depreciation and amortization. OCF = S - C - T Because depreciation is tax deductible, it reduces a firm's tax liability. The tax shield method of computing operating cash flow takes this fact into account by multiplying the company's depreciation expense by its tax rate.

OCF = (S - C) x (1 - T) + D x T Each of these three methods yields the same number for OCF.

Capital Investment Decisions - Cost Cutting And Asset Replacement


In Section 4 of this walkthrough, we discussed the use of discounted cash flow as a valuation method for estimating the attractiveness of an investment opportunity. We showed how DCF analysis uses future free cash flow projections and discounts them to arrive at a present value, and how if the present value is higher than the current cost of the investment, the opportunity may be a good one. In this section, we'll discuss how DCF analysis can be used to determine the value of cost cutting and asset replacement projects under a company's consideration. (Read more about the importance of evaluating the cost effectiveness of new projects in 5 Of The Most Adaptive Companies and 5 Big Companies' Biggest Blunders.) Cost Cutting Cost cutting refers to measures implemented by a company to reduce its expenses and improve profitability. Cost cutting measures may include laying off employees, reducing employee pay, switching to a less expensive employee health insurance program, downsizing to a smaller office, lowering monthly bills, changing hours of service, restructuring debt or upgrading to more efficient systems. Let's say a company wants to upgrade its computer system to improve efficiency. While the new computer system will cost money, its purpose is to cut costs. But will it cut costs enough to make the purchase worthwhile? To find out, we can use DCF analysis. (Learn more about the importance of computer software in Most Costly Computer Hacks Of All Time.) Assume the following: Cost of new computer system: $100,000 Annual savings from improved efficiency: $25,000 Lifespan of new computer system: 5 years Corporate tax rate: 35% Depreciation: straight-line basis to zero System value in 5 years: $25,000 Discount rate: 10%

Step 1: Identify capital spending. In this case, it is $100,000. Step 2: Identify the salvage value of the new computer system using the following calculation: Salvage Value x (1 -0 35) Salvage Value = $25,000 x (0.65) = $16,250 Step 3: Calculate the actual annual savings from improved efficiency, taking taxes and depreciation into account. The computer system upgrade will save $25,000 a year. In other words, it will increase operating cash flow by $25,000 a year. On the plus side, the additional depreciation expense of $20,000 a year ($100,000 / 5). Subtracting the depreciation deduction from the increase in operating income gives us $25,000 - $20,000 = $5,000, or earnings before interest and taxes (EBIT). This $5,000 increase in cash flow will be taxed at the company's 35% tax rate, yielding $5,000 x 0.35 = $1,750 in additional tax liability for the company each year. EBIT + Depreciation - Taxes = OCF, so $5,000 + $20,000 - $1,750 = $23,250. (Learn more about depreciation in Depreciation: Straight-Line Vs. Double-Declining Methods.) Step 4: Calculate the annual cash flows from undertaking the system upgrade. Year 0:

-$100,000 Years 1 - 4: $23,250/yr. = $23,250 x 4 = $93,000 Year 5: $23,250 + $16,250 salvage value = $39,500 Total: -$100,000 + $93,000 + $39,500 = $32,500 Step 5: Calculate the net present value (NPV) using the discount rate, project life, initial cost and each year's cash flows using an NPV calculator and determine if the upgrade is truly cost-saving. In this case, the discount rate is 10%, the project life is five years, the initial cost is $100,000 and each year's cash flows are provided in step 4. The result is an NPV of -$1,774,24, so the system upgrade would actually not cut costs and thus should not be undertaken. (For related reading, see Should computer software be classified as an intangible asset or part of property, plant and equipment? and Lady Godiva Accounting Principles.) Asset Replacement Earlier in this section, we discussed how to determine a project's cash flows. Here, we'll consider how to analyze those cash flows to determine whether a company should undertake a replacement project. Replacement projects are projects that companies invest in to replace old assets in order to maintain efficiencies. Assume Newco is planning to add new machinery to its current plant. There are two machines Newco is considering, with cash flows as follows: Discounted Cash Flows for Machine A and Machine B

Calculate the NPV for each machine and decide which machine Newco should invest in. As calculated previously, Newco's cost of capital is 8.4%. Formula:

Answer: NPVA = -5,000 + 500 + 1,000 + 1,000 + 1,500 + 2,500 + 1,000 = $469 (1.084)1 (1.084)2 (1.084)3 (1.084)4 (1.084)5 (1.084)6 NPVB = -2,000 + 500 + 1,500 + 1,500 + 1,500 + 1,500 + 1,500 = $3,929 (1.084)1 (1.084)2 (1.084)3 (1.084)4 (1.084)5 (1.084)6 When considering mutually exclusive projects and NPV alone, remember that the decision rule is to invest in the project with the greatest NPV. As Machine B has the greatest NPV, Newco should invest in Machine B.

Example: Replacement Project Now, let us assume that rather than investing in an additional machine, as in our earlier expansion project example, Newco is exploring replacing its current machine with a newer, more efficient machine. Based on the current market, Newco can sell the old machine for $200, but this machine has a book value of $500. The new machine Newco is looking to invest capital in has a cost of $2,000, with shipping and installation expenses of $500 and $300 in net working capital. Newco expects the machine to last for five years, at which point Machine B would have a book value of $1,000 ($2,000 minus five years of $200 annual depreciation) and a potential market value of $800. With respect to cash flows, Newco expects the new machine to generate an additional $1,500 in revenues and costs of $200. We will assume Newco has a tax rate of 40%. The maximum payback period that the company established is five years. As required in the LOS, calculate the project's initial investment outlay, operating cash flow over the project's life and the terminal-year cash flow for the replacement project. Answer: Initial Investment Outlay Computing the initial investment outlay of a replacement project is slightly different than the computation for an existing project. This is primarily because of the expected cash flow a company may receive on the sale of the equipment to be replaced. Value of the old machine = sale value + tax benefit/loss = $200 + $120 = $320 Sale of old equipment + machine cost + shipping and installation expenses + change in net working capital = $320 + $2,000 + $500 + $300 = $3,120

In the analysis of either an expansion or a replacement project, the operating cash flows and terminal cash flows are calculated the same.
Operating cash flow: CFt = (revenues - costs)*(1 - tax rate) CF1 = ($1,500 - $200)*(1 - 40%) = $780 CF2 = ($1,500 - $200)*(1 - 40%) = $780 CF3 = ($1,500 - $200)*(1 - 40%) = $780 CF4 = ($1,500 - $200)*(1 - 40%) = $780 CF5 = ($1,500 - $200)*(1 - 40%) = $780 Terminal Cash Flow: The terminal cash flow can be calculated as illustrated: Return of net working capital +$300 Salvage value of the machine +$800 Tax reduction from loss (salvage < BV) +$80 Net terminal cash flow $1,180 Operating CF5 +$780 Total year 5 cash flow $1,960

4.3 Project Analysis And Valuation - Introduction To Project Analysis And Valuation
Valuation analysis is used to evaluate the potential merits of an investment or to objectively assess the value of a business or asset. Valuation analysis is one of the core duties of a fundamental investor, as valuations (along with cash flows) are typically the most important drivers of asset prices over the long term. Valuation analysis should answer the simple yet vital question: what is something worth? The analysis is then based on either current data or projections of the future. In this section, we'll consider how companies can value any projects they're considering to determine whether they are worth undertaking. (For related reading, see 5 Crazy Corporate Valuations That Proved Too Low and Valuing Private Companies.) For the purposes of this lesson, projects can be divided into two categories: 1. Expansion projects are projects companies invest in to expand the business's earnings. 2. Replacement projects are projects companies invest in to replace old assets and maintain efficiencies. Determining a Project's Cash Flows When beginning capital-budgeting analysis, it is important to determine the cash flows of a project. These cash flows can be segmented as follows: 1. Initial Investment Outlay These are the costs that are needed to start the project, such as new equipment, installation, etc. 2. Operating Cash Flow over a Project's Life This is the additional cash flow a new project generates. 3. Terminal-Year Cash Flow This is the final cash flow, both the inflows and outflows at the end of the project's life, such as potential salvage value at the end of a machine's life.

Project Analysis And Valuation - Scenario / What-If Analysis


Scenario analysis evaluates the expected value of a proposed investment or business activity. The statistical mean is the highest probability event expected in a certain situation. By creating various scenarios that may occur and combining them with the probability that they will occur, an analyst can better determine the value of an investment or business venture, and the probability that the expected value calculated will actually occur. Determining the probability distribution of an investment is equal to determining the risk inherent in that investment. By comparing the expected return to the expected risk and overlaying that with an investor's risk tolerance, you may be able to make better decisions about whether to invest in a prospective business venture. This article will present some simple examples of various ways to conduct scenario analysis and provide rationale for their use. (To learn more about probability distributions, read Find The Right Fit With Probability Distributions.) Overview Historical performance data is required to provide some insight into the variability of an investment's performance and to help investors understand the risk that has been borne by shareholders in the past. By examining periodic return data, an investor can gain insight into an investment's past risk. For example, because variability equates to risk, an investment that provided the same return every

year is deemed to be less risky than an investment that provided annual returns that fluctuated between negative and positive. Although both investments may provide the same overall return for a given investment horizon, the periodic returns demonstrate the risk differentials in these investments. (For more insight, read Measure Your Portfolio's Performance.) Strict regulations over the calculation and presentation of past returns ensure the comparability of return information across securities, investment managers and funds. However, past performance does not provide any guarantee about an investment's future risk or return. Scenario analysis attempts to understand a venture's potential risk/return profile; by performing an analysis of multiple pro-forma estimates for a given venture and denoting a probability for each scenario, one begins to create a probability distribution (risk profile) for that particular business enterprise. Examples Scenario analysis can be applied in many ways. The typical method is to perform multi-factor analysis (models containing multiple variables) in the following ways: Creating a Fixed Number of Scenarios o Determining the High/Low Spread o Creating Intermediate Scenarios

Random Factor Analysis o Numerous to Infinite Number of Scenarios o Monte Carlo Analysis

Many analysts will create a multivariate model (a model with multiple variables), plug in their best guess for the value of each variable and come up with one forecasted value. The mean of any probability distribution is the one that has the highest probability of occurrence. By using a value for each variable that is expected to be the most probable, the analyst is in fact calculating the mean value of the potential distribution of potential values. Although the mean has informational value, as previously stated, it does not show any potential variation in the outcomes. Risk analysis is concerned with trying to determine the probability that a future outcome will be something other than the mean value. One way to show variation is to calculate an estimate of the extreme and the least probable outcomes on the positive and negative side of the mean. The simplest method to forecast potential outcomes of an investment or venture is to produce an upside and downside case for each outcome and then to speculate the probability that it will occur. The figure below uses a three scenario method evaluating a base case (B) (mean value), upside case (U) and a downside case (D).
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For example a simple two factor analysis: Value V= Variable A + Variable B, where each variable value is not constrained. By assigning two extreme upside and downside values for A and B, we would then get our three scenario values. By assigning the probability of occurrence, let us assume: 50% for Value (B) = 200 25% for Value (U) = 300 25% for Value (D) =100 When assigning probabilities the sum of the probabilities assigned must equal 100%. By graphing these values and their probabilities we can infer a rather crude probability distribution - the distribution of all calculated values and the probability of those values occurring. By forming the upside and downside cases we begin to get an understanding of other possible return outcomes, but there are many other potential outcomes within the set bounded by the extreme upside and downside already estimated. The figure below presents one method for determining the fixed number of outcomes between the two extremes. Assuming that each variable acts independently, that is, its value is not dependent on the value of any other variable, we can conduct an upside, base and downside case for each variable. In the simplistic two factor model, this type of analysis would result in a total of nine outcomes. A threefactor model using three potential outcomes for each variable would end up with 27 outcomes, and so forth. The equation for determining the total number of outcomes using this method is equal to (YX),

where Y= the number of possible scenarios for each factor and X= the number of factors in the model. (For more, see Modern Portfolio Theory Stats Primer.)

In Figure 2, there are nine outcomes but not nine separate values. For example, the outcome for BB could be equal to the outcome DU or UD. To finalize this study, the analyst would assign the probabilities for each outcome and then add those probabilities for any like values. We would expect that the value corresponding to the mean, in this case being BB, would appear the most times since the mean is the value with the highest probability of occurring. The frequency of like values increases the probability of occurrence. The more times values do not repeat, especially the mean value, the higher the probability that future returns will be something other than the mean. The more factors one has in a model and the more factor scenarios one includes, the more potential scenario values are calculated resulting in a robust analysis and insight into the risk of a potential investment.
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Drawbacks of Scenario Analysis The major drawback for these types of fixed outcome analyses are the probabilities estimated and the outcome sets bounded by the values for the extreme positive and negative events. Although they may be low probability events, most investments, or portfolios of investments, have the potential for very high positive and negative returns. Investors must remember that although they don't happen often, these low probability events do happen and it is risk analysis that helps determine whether these potential events are within an investor's risk tolerance. (For related reading, see Personalizing Risk Tolerance and Risk Tolerance Only Tells Half The Story.) A method to circumvent the problems inherent in the previous examples is to run an extreme number of trials of a multivariate model. Random factor analysis is completed by running thousands and even hundreds of thousands of independent trials with a computer to assign values to the factors in a random fashion. The most common type of random factor analysis is called "Monte Carlo" analysis, where factor values are not estimated but are chosen randomly from a set bounded by the variable's own probability distribution. (To learn more about this analysis, read Introduction To Monte Carlo Simulation.) Standards set for reporting investment performance ensure that investors are provided with the risk profile (variability of performance) for past performance of investments. Because past performance does not have any bearing on future risk or return, it is up to the investor or business owners to

determine the future risk of their investments by creating pro-forma models. The output of any forecast will only produce the expected or mean value of that initiative - the outcome that the analyst believes has the highest probability of occurrence. By conducting scenario analysis an investor can produce a risk profile for a forecasted investment and create a basis for comparing prospective investments.

Project Analysis And Valuation - Break-Even Analysis


Break-even analysis is used to determine the point at which revenue received equals the costs associated with receiving the revenue. Break-even analysis calculates what is known as a margin of safety, the amount that revenues exceed the break-even point. This is the amount that revenues can fall while still staying above the break-even point. Break-even analysis is a supply-side analysis; it only analyzes the costs of the sales. It does not analyze how demand may be affected at different price levels. For example, if it costs $50 to produce a widget and there are fixed costs of $1,000, the break-even point for selling the widgets would be: If selling for $100: 20 Widgets (Calculated as 1000/(100-50)=20) If selling for $200: 7 Widgets (Calculated as 1000/(200-50)=6.7) In this example, if someone sells the product for a higher price, the break-even point will come faster. What the analysis does not show is that it may be easier to sell 20 widgets at $100 each than seven widgets at $200 each. A demand-side analysis would give the seller that information. The break-even point is the point at which gains equal losses. Reaching the break-even point is a business's first step toward profitability. In conducting a break-even analysis, you need to know what your costs are. There are three types of costs: fixed, variable and semi-variable. A fixed cost is a cost that does not change with an increase or decrease in the amount of goods or services produced. Fixed costs are expenses that a company must pay independent of any business activity. These costs are one of the main components of the total cost of a good or service. An example of a fixed cost would be a company's lease on a building. If a company has to pay $10,000 each month to cover the cost of the lease but does not manufacture anything during the month, the lease payment is still due in full. In economics, a business can achieve economies of scale when it produces enough goods to spread fixed costs. For example, the $100,000 lease spread out over 100,000 widgets means that each widget carries with it $1 in fixed costs. If the company produces 200,000 widgets, the fixed cost per unit drops to 50 cents. Variable costs are dependent on production output. They rise as production increases and fall as production decreases. Variable costs differ from fixed costs such as rent, advertising, insurance and office supplies, which tend to remain the same regardless of production output. Variable costs can include direct material costs or direct labor costs necessary to complete a certain project. For example, a company may have variable costs associated with the packaging of one of its products. As the company moves more of this product, the costs for packaging will increase. Conversely, when fewer of these products are sold, the costs for packaging will decrease. Semi-variable costs, also called semi-fixed costs, comprise a mixture of fixed and variable components. Costs are fixed for a set level of production or consumption then become variable after that level is exceeded. With semi-variable costs, greater levels of production increase total cost, but if no production occurs, then a fixed cost is still incurred.
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Labor costs in a factory are semi-variable. The fixed portion is the wage paid to workers for their regular hours. The variable portion is the overtime pay they receive when they exceed their regular hours. The next step in break-even analysis is determining what price to charge for your good or service. Let's look at some of the pricing strategies companies use. With competition-driven pricing, the seller establishes its prices based on what its competitors charge. Competition-driven pricing focuses on determining a price that will achieve the most profitable market share and does not always mean that the price is identical to the competitions'. Determining how to profitably achieve the greatest market share without incurring excessive costs requires strategic decision making. The firm must focus not only on obtaining the largest market share, but in finding the combination of margin and market share that will be the most profitable in the long run.

Penetration pricing is a marketing strategy firms use to attract customers to a new product or service. This strategy means offering a low price for a new product or service during its debut in order to attract customers away from competitors. The goal of this pricing strategy is to make customers aware of the new product due to its lower price in the marketplace relative to rivals. When applied correctly, penetration pricing can increase both market share and sales volume. High sales volume may then lead to lower production costs and higher inventory turnover, both of which are positive for any firm with fixed overhead. The chief disadvantage of penetration pricing is that the increase in sales volume may not lead to a profit if prices are kept too low. As well, if the price is only an introductory campaign, customers may leave the brand once prices begin to rise to levels more in line with competitors' prices. Variable cost-plus pricing is a pricing method in which the selling price is established by adding a markup to total variable costs. The expectation is that the markup will contribute to meeting all or a part of fixed costs and generate some level of profit. Variable cost-plus pricing is especially useful in competitive scenarios such as contract bidding, but is not suitable in situations where fixed costs are a major component of total costs.
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For example, assume total variable costs for manufacturing one unit of a product are $10 and a markup of 50% is added. The selling price as determined by this variable cost-plus pricing method would be $15. If the contribution to fixed costs per unit is estimated at $4, then profit per unit would be $1.

With customer-driven pricing, the seller makes a pricing decision based on what the customer can justify paying given the value of the product or service from the consumer's perspective. To optimize this pricing strategy, companies need to consider how to best segment the market so that prices reflect the differences in value perceived by different types of consumers. Companies must ensure that there is a comprehensive understanding of the customer and what he or she values. A company will make the most money if they can figure out the maximum each customer will pay and charge them that amount. Companies can charge high prices on some products relative to their production costs and consumers will still buy them. For example, movie theater popcorn is dramatically marked up compared to the grocery store equivalent, and bottled water is exponentially more expensive than tap water. Other products have very thin profit margins. (For more on this topic, see 6 Outrageously Overpriced Products.)

To learn more about pricing strategies, read 4 Pricing Strategies That Increase Your Spending, 2 Key Tactics Retailers Use To Increase Sales and The Pros And Cons Of Price Wars. Once you know a company's production costs and its pricing strategy, you can project when it is likely to break even and when it is likely to generate a profit. If the product or service is new, it can be difficult to predict demand, which is a third factor in break-even analysis. If the company must sell 1,000 units to break even, there has to be a demand for 1,001 units before the company will see a profit. If expected demand is only 200 units, the product or service may be a bad investment. If the company is established and has a history of selling the same product or service, it may be able to predict demand more accurately and thus perform a more accurate break-even analysis.

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