lecture 6 - i——‘—fiteaure5 : ...... __M. ....

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Unformatted text preview: i——‘—fiteaure5 : ...... __M. . “653931 feature 5 _ e 31 -- F t E HNANCIAL PLANNING Pro orma S atements (An xample) I Balance Sheet ?{0kdlm 201 1 2012 forecast S ' : “QM ales Forecasnng We] Sales = Sales forecast = > Used to develop proforma statements. $1,000,000 $3,000,000 > Used to determine total external financing required. AFN Assets Cash $5,000 0.5 ‘70 is .000 , Eon-a0 Sales Forecast techniques: Marketable 10.000 Leia Secur't’ 5 I la 8—25 00 Accounts Receivable 27,500 .2 .751. 1. Internal forecasts : t 7 500 157; 12.500 _ nven ory . 0- a. Sub ective f i—h— ‘- J orecaSts_ Total Current Assets $50,000 .5 40“! iS'me b. Based on past experience and intuition Net fixed assets 125 000 1251 £35,015“ 6' seat 9f the pants” approaCh Total Assets $175,000 K rm}: 8‘ 15 ,m 2. External forecasts Liabimies CMQ in 0550i” : W fi"w'j “W a. Correlation forecasts 8: ECIUi’Ey t 19°99" V’er “w 370.00% b. Base sales forecast on one or more Accounts Payable $20'000 2 '01 601m . other vanables e ' is Interest rates. population) ( 9-. sales as a function ofgl Taxes Payab‘e 51000 _g M 1m Bank Notes Payable 0 Total Current $25,000 m ' QPro Form Stat ‘ Liabimies a ements With percent—of-sales forecasting Long—term Debt 100.000 NA Total Liabilities $125,000 NA Proflforinas Stangv'tlthe Sales forecast Why is a sales forecast requ d? 5 r ' in 3 me . Me n h“ L” M) “5% 4‘ iiiim Common Stock 40,000 NA Retained Earnings 10,000 NA Total Common $50,000 NA _ Equity A firm has two sources of financin g for these . 1. Debt, and assets gets: Liabilities & $175,000 NA . qU' Y 2. EqUIty. kw“, w— m I A 9"} EAT $50,000 501 (so, ow To = ‘ ——u+r— ta ssatfvfgbt + Equ'ty "Note: Dividend ratio = 40% of earnings NA = not applicable (indicates that these items do not change proportionately with sales) Managers need a way to esti mate how in : financing (debt or equity) can b "ch assets wili i . e arr "crease - W ; anged. When sales increase 99 . 0— Richard T. Bliss, Babsm University and Tony D. Nixon, Miami University 0 - Rwhl‘d T. Bibs, FiN 301 AB — Fall 2011 “We”? 9- N‘m . 2' 31 Fm 391 A3 - Fan 2011 50": Requirements: 1. Current (most recent) balance sheet 2. Sales forecast Steps: 1. Forecast increase in total assets = total financing required ______,__._.____ 2. Forecast funds that will be generated internally. 3. Additionai funds needed (AFN) = External financing What if a change in asset efficiency is expected? For example, what it management decides that new forecast fors too great and that the year 2011 dollar quantity of current assets can support the pew sales figure? How much total financing would be required in the year 2012? MW 953d- CW asset- 90W 004 (155st 375:9” an m 4W .. last: Sources of Fina mgr“ = total financing required minus internal financing. The dollar quantity of finanCWO-v 0” ' 5m5h1wd I’M a If no cfiar? 1 fi- sums 2011 Sales $1,000,000 Current Assets $50,000 Fixed Assets $125,000 Total Assets $175,000 gum? 415mm 1330,0150 FIN 301 AB — Fall 2011 99 in asset emCienCV is expected. then percent of sales forecasting works as it! ing IS now known (estimated). The following two categories of financing exist. ©Forecasting external financing requirements gives managers time to make the best dedl1- Intema' company‘s shareholders. a) Spontaneous liabilities (SIL) / b) Addition to Retained eamings/ % of sales 2012 “meal External $33 3) Short-tenn and Long—term Debt . b) New common stock 3.91 lefig tLSi 3‘5‘00’4‘ ___'___'_____—_,.——-—-" 35:0“ Spontaneous Liabilities: total financing required for this firm in 2012? 9Short—term debt that arises in the normal course of company operations such as accounts payable, taxes payable, and accrued wages; mug“ (geriatric 2011 % of sates 2012 (forecast) Sales $1 ,000,000 $3,000,000 1 I one Accounts Payable $20,000 1 FL °°' _ mg ran-o Taxes Payable 5.000 0.514 , 7am“ Current Liabilities $25000 ,5 9 - Richard T. Bliss. Babson University and Terry D. Nixon, Miami University © - Ricl'nsd T. Bliss. i '“d T” 9‘ NM 33 FIN 301 A,B . Fair 2011 _:_ " '_ TW’JEEI I Lecture 6 [ 9399 35 [ Additional spontaneous liabilities = 1310,? 7/5 0% 50 m ‘ i Addition to Retained Earnings: .u f” T .b -)EAT — Dividends = Net income — Dividends DN‘MV \‘ y‘im : talents} 130-, my 1_ Wan _ Me 2011 % of sales 2012 (forecat Sales $1,000,000 $3.01! EAT 50,000 5 .01 is 0,0" Assuming the dividend payout ratio (40%) stays consistent: 2012 Dividends = -'-tLISOiW) = 1:70er Addition to Retained eami = E a rigs Ml Dim)»me p\0“‘m1.\'- iMfithMi. fl It’s now time to put everything together_ Steps 1 Forecast increase in total assets “ t - \ ~ otal financmg required 3. Additional funds needed (AFN) 35mm «Home L‘H‘i ' __, a net] WW . 9"” \ FIN 301 A,B - Faii 2011 $9“ {1‘35 {stools} —- 3" I lNTEREST RATES IN THE ECQNOMY Questions that we hope to answer from this chapter: 1. What are determinants of market interest rates? 2. How does the length to maturity affect interest rates on securities of equivalent risk? The Cost-i! %i)of Money Money (funds) can be raised either through the issuance of debt or equity. In this section, we will discuss interest rates. When discussing interest rates, we are implicitly referring to debt as only debt pays interest to its holders. _ The Financial System and the Structure of Interest Rates . - .i-r-yrao; O busmess sector lid-3T Ji-uimutéo! V. l «-‘.‘ ._ .L it #1 5*.i+'-)“£:..t s - 1.4. y .' Jug/t mijlij “b- l household sector set What do houselholds do with their savings and where can businesses go to borrow? F-Li‘ifu‘nii'i» stain 1, :‘l Li!» N » . _. xi ‘ LlUI‘ilEJ'JL "VF-i045” “ht” self“ V) 5‘ “9&5 NUT—"1i “mi ‘3: 1‘ Q: What determines the amount businesses want to borrow and households wish to save/lend, i.e., the supply and demand for capital? .' a; 4 ‘3’ r-‘rfii-A girl“ ’ .‘ © - Richard T. Bliss, Babson University and Tory D, Nixon, Miami University 35 FIN 301 AB a Fall 2011 Interest Rate (1') % Low—Risk High'RjSk H. Dollars Supply and Demand for funds (investment capital) in capital markets (high-risk, low-risk etc.) interact to determine interest rates. Once again, the above diagrams iliustrate th return in capital markets. tend : All else constant, how would a busrness rec~e_ssion Impact interest rates In our economy1 I 'l’ “x ‘ f/ I {MHZ r, “2‘; \ ,1- ? _"“-\.,__ _) “Eh—Ti J All else constant, how would a “loosenin ” ' interest rates in the economy? ‘9 Of Bred“ by the Federal Reserve impala [/3 q @5135 RR. / R} ' : xix i- .”I 7.7%.“ A Z x’fi'y "\ . J/ M mad—u- Are credit markets such as the ‘ _ - . other? Egg—13$" and 'fl‘tflisfi markets independent of eéCh ._-:I‘( 13(,:FA_:ILH <‘__r_ W A"! 1 I ii—iai‘i; '- “wise; we 99:23: 4:324: [ad-- I“ ""1" u I {(WDLJQ £me in an; 13:5- Maggi? .3“. I’M!“ my “gym 9-RichsrdT.Bliss,BM_ md‘t'ury o.mxm.Mi-m FIN 301 AB - Fall 2011 ,3; Short-term and Long-term interest rates (see Figure 6-2 on page 187) Historically. are long-term rates generally higher or lower than short-term rates? (We'll explain this result later.) 'm‘wm at?) we? “Wu-‘1‘»; airtime? they” Jami YEW“. Historically, do short-term or long-term interest rates exhibit greater variability? Why? dietitian moles We WE “(Elma We flit-'3?» “W. film-‘3!“ 4" 5‘“ “3%? Mating: 7&2. 535.1 Finally, what is the historical relationship (since 1972) between actual annual inflation rates and long—term interest rates (T-Bills}? See Figure 6—3 on page 188. Mi ‘ M _ _ r r .na-i «2:31 1. mm; with «:r { :tjlii fu'gfijfl J t I” 1‘34“? fliifi'wfii m’ © - Richard T. Bliss, Babson University and Tang D. Nixon, Miami Univenity 37 FIN 301 AB - Fat! 2011 HR 301 AB — Fall 2911 The Determinants of Market Interest Rates ' ' 5' I-lrr) fill \ 7 , nominal rate. 1w: {firhgmwl . “EEG r ; VL' real rate: ‘2147 t'. 7‘" I“. ‘. I . Wm M». .V':‘ ' “r. r::v .\ Iii-fl —I_\ ' “4m 1'4 la -v-\\ WM. lmlql-‘iicugdim Note that real return is what we are concerned with since it is what determines what we can actually buy, or our purchasing Ewen e - Richard I Bliss, WM?“ and Terry D. Nixon. MW 33 Nominal (Quoted) Interest Rate =13: r* + IP + RP = r* + IP + DRP + LP + MRP Where: if: the nominal, quoted, rate of interest r* = the [eel risk-free rate of interest ’10 -"'9'f'L“ll.‘.**" grv. if» P = inflation premium Risk Prgmig (RP; qeL I DRP = default .tisk premium ;_ min-jg 35” 7 . _ LP = liquidity premium .«— a 1; .l'l" ‘ ‘e‘y; ‘ “‘1 ,J‘i-I“. :L tit-i. MRP = maturity risk premium i. I“ 1,411), u.” I M. in"? j] Li 1:12}? _ 1 ‘ ‘. -i _. ~ .. . ‘ .41 .7“, ‘ ; rs. ill? ‘ ‘.;"‘>‘ i}, Np“? -" l - Remember the Guiding Principles of Finance...risk and*expected “return. Whenever we see a nominal rate of interest (99.9% of quoted rates are nominal), the rate incorporates all of the expected risk of borrowing or investing. 9 - Richard T. Bliss, Babson University and Tcnjr D. Nixon, Miami University 39 FIN 301 AB — Fall 2011 _ - fer—— ' = ' - + Ex ected lnflationfi- Risk Premia Nominal interest Rate W P _ ,- (liquidity mammy'em k.) 7- v = Nominal Risk-free rate + Risk Premia The nominal risk-free rate represents the pure time value of money on a short-term government security tie, an US. Treasury bill). The risk premia for this security Is practically zero. The Term Structure of Interest Rates Lawn trait-iii ii'ror- I; . ‘ rigid. MLENIL-‘L '\l‘ Term structure of interest rates “A ‘ ’ } a This is the relationship between bond yields and maturities. All other bond characteristics are held constant as possible. d M The graphical de icgifihfiof the term structure of interest rates. l ; daixnimlt,_ L¥ M he will raw:- Competing Theories on the Shape of the YieldJ Curve v:- The Pure Expectations Hypothesis 6 ~ Richard T. Bliss and Terry- D. Nixon. Mini *3 FIN 301 AB - Fall 2011 40 Led??? Example: A bond with 2 years to maturity is currently yielding 8% per year for the next 2 years. You also know that the currently yield on a bond with 1 year to maturity is 6%. if the pure expectations hypothesis is correct, what should be the yield on a bond with 1 year to maturity 1 year tom today? a x ‘(7 . _...——_——a-~~ - M lxlfihiw.‘ .q ‘ ‘ow 9H -,__ "I... 7_ln4 H1 'u’r 4 3-731 4|}; ifi'é-‘Ullht Example: The yield on a bontl with 4 years to maturity is 7% per year for the next 4 years. The current yield‘on a bond with 1 year to maturity is 6%. The yield on a bond with 1 year to maturity one year from today is expected to be 9%. Finally, the yield on a bond with 1 year to maturity two years from today is expected to be 8%. (1) What is the expected yield on a bond with 1 year to maturity three years from today? (2) What is the annual expected yield on a two—year bond issued two years from today? 0 . w a, ~ 3W4 ‘ .s- L If ‘r—J —+ 7 M ii»! LZI‘ _l M34 (5 ._—.—-._f 7/ ‘1 A", r) 7 7 {a}: What does an upward sloping yield curve imply per the pure expectations hypothesis? N6 Q‘Rfi 5W4? Rm “@541 int-Farah tic Note: We will use arithmetic average for caICUIations relating to the pure expectations hypothesis, NOT geometnc aVerages. © — Richard T. Bliss, Babson University and Terry D. Nixon. Miami Univclsity 41 FIN 301 AB -' Fall 2011 -:- Liquidity Preference Hypothesis This theory indicates that investors (lenders) prefer short-term bonds and are willing to accept a lower rateot retumon short-term bonds relative to long-term bonds due to this preference. ' investors view short-term bonds as being less risky relative to longer-term bonds. Borrowers, on the other hand, prefer making long-term loans as they are able to avoid refinancing risk. They are therefore willing to pay a higher rate of return for long-term bonds than shorter-term bonds. Whatflsggpi gust the yietd curve take under the liquidity preference hypothesis? Ll v. \ g | In general. which then is W “morth by IOHQ- and short-term bonds yields? 48m “"5 fiflmailt} H emit/rim claw) m WWW g e-RichuureiissWMU'P anchrry o. NixorLMl'a‘ FlN 301A,B-Fall2011 In Lecture T .._ _.. e 43 TIME VALUE OF MONEY What we want to be able to do: - determine how much we must invest today to obtain a specified amount in the future (saving for retirement or for college) - determine the expected rate of return on an investment when we know (or estimate) the future cash flows (return on a bond or project? 0 determine the periodic payment on an amortizing loan (mortgage, student loan, or automobile loan) 0 compare investment opportunities with different cash flow characteristics {bank CD3, stocks, projects) 0 determine the number of years needed to accumulate a certain amount or to pay off a loan (saving for a down payment on a home or for a new car) 3 Critical Variables principal truism [new] 0" L”de n n n l :--.«1 _ u g UP Pl/Uiflw M "Win: lid VJ MN. sir'ahlg'p time wk irth hinfipni is invade; Compound Interest We use compounding, earn interest on interest. or compound interest to reflect the fact that many investments TM: ‘J 9% Haitian l TVM problems...it will make your life easrerll WP, Q” Use alimelinekfor at G - Richard T; Bliss, Babson University and Terry D. Nixon, Miami University 43 FIN 301 AB - Fall 2011 ...
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