For financial managers

1. Lecture 7 – Interest Rates and Bond Valuation Class notes
School of Business and Economics
Department: Projects Management
Bachelor Degree program
Year: 2014 November
Phase: two
Assignment No: Eight
Course Name: Financial Management
Student name: Choldit Kiir Ngor
Student ID No: UB33793BPR42367
Student profile: South Sudan

2. Lecture 7 – Interest Rates and Bond Valuation Class notes
Introduction
Financial Management is the art and science of financial planning, directing, estimating,
auditing costing and controlling strategies in the company.
Financial ManagementDuties
 Capital Budgeting – The process of planning and managing a firm’s long-term
investments.
 Capital Structure – The specific mixture of long-term debt and equity the firm uses
to finance it operations.
 Working Capital Management – Managing the firm’s short-term assets and liabilities
Financial Officers
•Chief Financial Officer– oversees the treasurer and controllerand sets overall financial
strategy.
•Treasurer – responsible for financing, cash management, and relationships with financial
markets and institutions.
•Controller – responsible forbudgeting, accounting, and auditing.
Formsof BusinessOwnership
•Proprietorship – An unincorporated business owned by a single individual.
Advantages
 Easily and inexpensively formed.
 Few government regulations.
 Avoids corporate income taxes.
Disadvantages
 Unlimited liability forthe owner.
 Limited to the life of the owner.
 Illiquid.
 Difficulttoobtain large amounts of capital.
•Partnership – Business owned by twoor more persons whoare personally responsible for
all its liabilities.
Advantages
 Easily and inexpensively formed.
 Few government regulations.

3. Lecture 7 – Interest Rates and Bond Valuation Class notes
 Avoids corporate income taxes.
Disadvantages
 Unlimited liability forgeneral partners.
 Limited life forthe organization.
 Difficulttotransfer ownership.
 Difficulttoobtain large amounts of capital.
•Corporation – A business that is legally distinct from its owners.
Advantages
 Unlimited life.
 Easy to transfer ownership.
 Limited liability.
Disadvantages
 Doubletaxation.
 Complex legal requirements.
Hybrid Forms of Organization
 Limited partnership – Certain partners are designated general partners, who have
unlimited liability. Other owners are limited partners because their liability is
limited.
 Professional Corporation – A type of corporationcommon among professionals. An S
corporation has 75 or fewer shareholders.
TheGoal ofFinancial Management
•Maximize Shareholder Wealth – Mangers workon behalf of shareholders and should
pursue policies that enhance shareholder value.
•Social Responsibility – The conceptthat businesses should be actively concernedwith the
welfare of society at large.
AgencyProblemsandControl oftheCorporation
•Agency Problem – The conflictof interest between the firm’s owners and
managers.

4. Lecture 7 – Interest Rates and Bond Valuation Class notes
•Management Goals – Managers have a tendency to increase their ownperks or to
increase the size of the organization in an attempt to increase their power.
•Methods to EnticeManagers to Actin the Best Interests of Stockholders
•The threat of firing
•The threat of takeovers
•Managerial compensation
•Direct Intervention by Shareholders
•Ownership Structure outside the U.S. – in some countries, ownership is more
concentrated, creating separate problems.
Financial Statements, Taxes,and CashFlow
•Review the income statement, balance sheet, and cash flow statement.
•Emphasize cash flowsand the difference between accounting accruals.
IncomeStatement
•Income Statement – Shows how profitable a firm has been over some period of
time.
•GAAP – Revenues appear when they accrue, not when they are collected. Expenses
are matched with the revenues that appear.
•Noncash items – Depreciation.
•Taxes – The marginal tax rate is the most relevant when evaluating projects.
BalanceSheet
•Balance Sheet – Presents a snapshot of the firm’s assets, liabilities, and owner’s
equity.
•Assets – Listed in order of their liquidity on the left-hand side of the statement.
•Current Assets – life of less than one year.
•Fixed Assets – lifelonger than one year.
•Liabilities and Owners’ Equity – The claims against assets.
•Current Liabilities – life of less than one year.
•Long-term Liabilities – debt (financialleverage) that is not due in the next year.
•Owners’ Equity – value of the capital supplied by common stockholders.
•BookValues vs. Market Values – assets must be shownon the balance sheet at their
historical cost adjusted for depreciation. These are not market values.
CashFlowAnalysis
•Cash Flows Analysis – shows the firm’s cash receipts and cash payments overa
period of time.
•Cash Flow from Operations – begins withnet income and adjusts fornon-cash
items.

5. Lecture 7 – Interest Rates and Bond Valuation Class notes
•Cash Used for Investments – money spent on fixed assets and received fromsales
of fixed assets.
•Cash Flow from Financing Activities
•Cash flow to creditors – interest paid minus net new borrowing.
•Cash flow to stockholders – dividends paid minus net new equity
Ratio Analysis
•Introduce the analysis of financial statements through the use or ratios.
•Review the uses and limitations of ratios.
•Ratio Analysis – designed to help evaluate financial statements.
•Liquidity Ratios
•Asset Management Ratios
•Long-Term Solvency (Debt) Ratios
•Profitability Ratios
•Market Value Ratios
•Liquidity Ratios – show the relationship of a firm’s cash and other current assets to
its current liability.
•Current Ratio – indicates the extent to whichcurrent liabilities are covered by
those assets expected tobe convertedto cash in the near future.
•QuickRatio – a measure of the firm’s ability to pay off short-term obligations
without relying on the sale of inventories.
•Cash Ratio – a very short-term measure of liquidity.
•Asset Management – A set of ratios which measure how effectively afirm is
managing its assets.
•Inventory Turnover – the number of times per year that the firm fills up and
completely empties its inventory.
•Days’ Sales in Inventory – the number of days it wouldtake to sell off the firm’s
current level of inventory.
•Receivables Turnover – measures how fast sales are collected.
•Days Sales in Receivables – the average length of time the firm must waitafter
making a credit sale before receiving cash.
•Fixed Asset Turnover– measures how effectively thefirm uses its plant and
equipment.
•Total Asset Turnover – measures how effectively the firm uses all of its assets.
Ratio Analysis

6. Lecture 7 – Interest Rates and Bond Valuation Class notes
•Long-Term Solvency (Debt) Ratios – The extent to whicha firm uses debt financing.
It has three implications:
•Stockholders maintain control while limiting their investment.
•Risks of the firms is transferred to creditors.
•Return on the owner’s equity is magnified.
•Total Debt Ratio – measures the percentage of funds provided by creditors.
•Times-Interest-Earned – measures the ability of the firm to meet its annual interest
payments.
•Profitability Ratios – show the combined effects of liquidity, asset management,
and debt on operating results.
•ProfitMargin – measures income per dollar of sales.
•Return on Assets (ROA) – measure of profit per dollar of assets.
•Return on Equity (ROE) – measures the rate of return on common stockholders’
investment.
•Market Value Ratios – relates the firm’s stockprice to its earnings and bookvalue
per share.
•Price-Earnings (P/E)Ratio – shows how much investors are willing to pay per
dollar of reported profits.
•Market-to-BookRatio – the ratio of a stock’s market price to its bookvalue and
gives an indication of how investors regard the company.
Financial Statement Uses
•Internal Uses – evaluate management and planning for the future.
•External Uses – Investors and creditors find the information useful in their decision
making.
•Time-Trend Analysis – Examine whether there is a strengthening or weakening
position.
•Peer Group Analysis – Compare a particular company with a group of ‘benchmark’
companies.
Limitations of Ratio Analysis
•Not as useful for large, diverse companies.
•Inflation distorts balance sheets.
•Seasonal factors distort ratio analysis
•‘Window dressing’ techniques distort financial statements.
•Differentaccounting practices can distort comparisons.
•No objectivestandard on what is good and bad
Long-TermFinancial PlanningandGrowth
•Examine the reasons for financial planning.

7. Lecture 7 – Interest Rates and Bond Valuation Class notes
•Outline the process for developing a budget.
•Present some common problems.
Financial Planning objectives
• Basic Policy Elements
• Needed investment in new assets.
• Degree of financial leverage the firm uses.
• Firm’s dividend policy.
• Working capital policy.
Financial Planning Process
•Analyzing the investment and financing choices.
•Projecting the future consequences of current decisions.
•Deciding which alternatives to undertake.
•Measuring subsequent performance against goals.
Dimensions of Financial Planning – focus is on capital budgeting for the next two
to five years.
•Worst case scenario – planning for lean economic times.
•Normal growth – firm grows with its markets.
•Aggressive growth – rapid growth with market or exceeding market.
Planning Accomplishments
•Examining interactions
•Explore options
•Avoid surprises
•Ensure feasibility and internal consistency
Determinants of Growth
 Profit margin – higher profits support higher growth.
 Dividend policy – lower dividend provide more internal funds for growth.
 Financial policy – debt can be used for growth.
 Total asset turnover – increases allow for higher growth. Current assets would
support increased sales

8. Lecture 7 – Interest Rates and Bond Valuation Class notes
Interest Rates and Bond Valuation
Bonds
• Bond – simply a long-term loan.
• Treasury Bond – issued by the federal government.
• Corporate Bond – issued by corporations.
• Municipal Bonds – issued by state and local governments.
• Foreign Bonds – issued by either foreign governments or foreign corporations.
Bonds Characteristics
• Par Value – the face value of the bond.
• Coupon – the specified number of dollars of interest paid each period.
• Coupon Rate – the annual coupon divided by the face value of a bond.
• Maturity – the date on which the principal amount of a bond is paid.
• Yield to Maturity – the rate of return earned on a bond if it is held to maturity.
• Current Yield – annual coupon payments divided by bond price.
Alternative Types of Bonds
• Floating Rate Bond – a bond whose interest rate fluctuates with shifts in the general
level of interest rates.
• Zero Coupon Bond – a bond that pays no annual interest but is sold at a discount
below par.
• Convertible Bond – A bond that is exchangeable, at the option of the holder, for
common stock of the issuing firm.
• Income Bond – A bond that pays interest only if the interest is earned.
• Indexed Bond – A bond that has interest payments based on an inflation index so as to
protect the holder from inflation.
Bond Features
• Call Provisions – gives the issuing corporation the right to call the bonds for
redemption
 Call Premium – the additional sum the company must pay the bondholders to call
the bonds.
 Deferred Call – Bonds are often not callable until several years after they were
issued.
 Refunding Operation – issuing lower-yielding securities and using the proceeds to
retire a previous higher-rate issue.
• Sinking Funds – a provision in a bond contract that requires the issuer to retire a
portion of the bond issue each year.
 The company can call in for redemption a certain percentage of the bonds each
year.
 The company may buy the required number of bonds on the open market.

9. Lecture 7 – Interest Rates and Bond Valuation Class notes
Bond Valuation
• Bond Valuation – the value of any financial asset is simply the present value of the
cash flows the asset is expected to produce.
• Changing Bond Values Over Time – The value (price) of bonds drop when interest
rates rise and vice-versa.
 Par bond – Whenever the going rate of interest is equal to the coupon rate, a fixed
rate bond will sell at its par value.
 Discount bond – Whenever interest rates rise above the coupon rate, a fixed-rate
bond’s price will fall below its par value.
 Premium bond – Whenever interest rates fall below the coupon rate, a fixed-rate
bond’s price will rise above its par value.
 The market value of a bond will always approach its par value as its maturity date
approaches.
• Semiannual Adjustment
 Divide the annual coupon interest payment by two to determine the amount of
interest paid each six months.
 Multiply the years to maturity by two to determine the number of semiannual
periods.
 Divide the nominal interest rate by two to determine the periodic semiannual
interest rate.
Bond Risks
• Interest Rate Risk – the risk of a decline in a bond’s price due to an increase in interest
rates
• Reinvestment Rate Risk – the risk that a decline in interest rates will lead to a decline
in income from a bond portfolio.
• Default Risk – the likelihood that the issuers will not be able to make payments.
Corporate Bonds
• Mortgage Bonds – a bond backed by fixed assets.
• Debentures – a bond that is not secured by a mortgage on specific property.
• Subordinate Debentures – a bond having a claim on assets only after the senior debt
has been paid off in the event of liquidation.
Bond Ratings
• Bond Ratings – Bonds have been assigned quality ratings that reflect their probability
of going into default.
 Investment Grade Bonds – rated triple-B or higher.
 Junk Bonds – A high-risk, high-yield bond. Double-B and lower bonds.
 Importance
 Has a direct, measurable influence on the bond’s interest rate and cost of capital.

10. Lecture 7 – Interest Rates and Bond Valuation Class notes
 Many institutions are restricted to investment-grade securities.
Bond Markets
• Corporate bonds are traded primarily in the over-the-counter market.
• Most bonds are owned by and traded among large financial institutions.
• Over-the-counter bond dealers arrange transfers of large blocks of bonds among the
relatively few holders of the bonds.
Term Structure of Interest Rates
• Term Structure – the relationship between bond yields and maturities.
 Upward Sloping – rates are lower in the short-term and higher in the long-term.
 Downward Sloping – rates are higher in the short-term and lower in the long-term.
Yield Curve Explanations
• Expectations Theory – the shape of the yield curve depends on investors’ expectation
about future interest rates.
• Liquidity Preference Theory – the preference for more liquid short-term securities
places upward pressure on the slope of a yield curve.
• Segmented Markets Theory – investors and borrowers choose securities with
maturities that satisfy their forecasted cash needs.

11. Lecture 7 – Interest Rates and Bond Valuation Class notes
Stock Valuation
Common Stock Valuation
• Common Stock – Valued the same as any other asset – by discounting all expected future cash
flows. The cash flow comes in two forms:
 Dividends
 Capital Gains
• Cash Flows – the basic stock valuation equation Value of stock = P0 = PV of future
dividends
• Zero Growth – a common stock whose future dividends are no expected to grow at all.
P0 = D/k
• Constant Growth – a common stock whose growth is expected to continue into the foreseeable
future at a constant rate.
 Constant Growth Model – a model used to find the value of a constant growth stock. Total
return is comprised of a capital gains return and a dividend return. P0 = D1/(k – g)
• Non-constant (supernormal) Growth – a company which grows much faster for a specified
period of time
• Capital Asset Pricing Model (CAPM) – theory where the expected return of a security equals
its beta times the market risk premium.
Expected rates of return depend on two things:
1. Compensation for the time value of money.
2. A risk premium, which depends on beta and the market risk premium.
Expected return = risk-free rate + risk premium
ks = kRF + âs(kM – kRF)
Common Stock Features
• Control of the firm – the right to elect directors who appoint officers to manage the business.
 Proxy – a document giving one person the authority to act for another, typically the power
to vote shares of common stock.
 Proxy Fight – An attempt by a person or group to gain control of a firm.
 Takeover – an action whereby a group succeeds in ousting a firm’s management and
taking control of the company.
• Preemptive Right – a provision that gives common stockholders the right to purchase new
issues of common stock.
• Dividends – Payments by a corporation to shareholders, made in either cash or stock.
Preferred Stock Features
• Preferred Stock – stock with dividend priority over common stock, normally with a fixed
dividend and without voting rights.
 Stated Value – normally $100 per share.
 Cumulative Dividends – Preferred dividends must be paid in full prior to the payment of
common dividends.

12. Lecture 7 – Interest Rates and Bond Valuation Class notes
Capital Budgeting
Project Classifications (Investments)
• Replacement: maintenance of business.
• Replacement: cost reduction.
• Expansion of existing products or markets.
• Expansion into new products or markets.
• Safety and environmental projects.
• Other
Capital Budgeting Evaluation Techniques
• Net Present Value (NPV) – a measure of how much value is created or added today by
undertaking an investment.
 Estimating NPV – Discounted Cash Flow Valuation
 Find the present value of each cash flow
 Sum these discounted cash flows
 If the NPV is positive, the project should be accepted.
• Payback – time until cash flows recover the initial investment of the project.
 Benefits
 Quick and simple analysis
 Biased towards liquidity
 Adjusts for illiquidity of distant cash flows
 Drawbacks
- Ignores the time value of money
- Ignores cash flows received after the payback period
- Fails to consider risk differences
- No obvious criterion
• Discounted Payback – the length of time required for an investment’s cash flows, discounted
at the cost of capital, to cover its costs.
Remaining issues
 Easy to understand analysis
 Still ignores cash flows after the payback period
 No obvious decision criterion
• Internal Rate of Return – the discount rate that makes the NPV of an investment zero.
Problems

13. Lecture 7 – Interest Rates and Bond Valuation Class notes
 Nonconventional Cash Flows
Mutually Exclusive Investments
Capital Investment Decisions
Project Cash Flows
• Relevant Cash Flows – the specific cash flows that should be considered in a capital
budgeting decision.
¤ Based on cash flows, not accounting income.
¤ Only incremental cash flows are relevant.
• Stand-Alone Principal – assumption that the evaluation of a project may be based on the
project’s incremental cash flows.
• Actual Cash Flows
¤ Initial Investment – occurs at the beginning.
¤ Working Capital – current assets minus current liabilities. Occurs at beginning and end of
project.
¤ Operating Cash Flows – cash flows produced by the project. EBIT + Depr – Taxes
¤ Salvage Value – occurs at the end. Sale of the equipment or project.
-Capital Gain – taxes must be paid on gain.
-Capital Loss – tax shelter has been created.
-Calculation – After tax cash = MV – (MV – BV)(t)
Incremental Cash Flows
• Sunk Costs – a cash outlay that has already been incurred and which cannot be recovered
regardless of whether the project is accepted or rejected.
• Opportunity Costs – the return on the best alternative use of an asset.
• Side Effects – the effects of a project on cash flows in other parts of the firm.
¤ Erosion – the cash flows of a new project that come at the expense of a firm’s existing
projects.
• Net Working Capital – the increased current assets resulting from a new project, minus the
increase in accounts payable and accruals.
• Other issues
¤ Interested only in project cash flows when it actually occurs, not when it accrues.
¤ Interested in after-tax cash flow.
¤ Beware of allocated overhead costs.
Pro Forma Statements and Project Cash Flow
• Pro Forma Financial Statement – financial statements projecting future years’ operations.
• Project Cash Flows – operating cash flows minus change in net working capital and capital
spending.

14. Lecture 7 – Interest Rates and Bond Valuation Class notes
• Depreciation – accounting depreciation is a noncash deduction. Therefore, depreciation has
cash flow implications because it influences taxes.
¤ Modified Accelerated Cost Recovery System (MACRS)
¤ Book Value versus Market Value
Operating Cash Flow
• Operating Cash Flow – cash generated from the operation. Generally calculated as EBIT +
DEPR – TAX
¤ Bottom-Up Approach – NI + DEPR
¤ Top-Down Approach – Sales minus relevant costs
Tax-Shield Approach – (sales – costs)(1 – TAX) + (DEPR)(TAX
Conclusion
The financial management is the key aspect to be consider when making and designing the
programs, so in this scenario financial management is the cornerstone for basic program to
operate and functionalized the whole system
References
University of North Carolina Wilmington
Cameron Schoolof Business
Department of Economics & Finance
PRINCIPLES OF FINANCIAL
MANAGEMENT
Prepared by Dr. David P. Echevarria

15. Lecture 7 – Interest Rates and Bond Valuation Class notes