CORPORATE FINANCE FOUNDATION

Transcription

1 CORPORATE FINANCE FOUNDATION Capital Budgeting > > 2-4 Cost of Capital > > 5-6 Marginal Costing > > 7 Working Capital Management > > 8-12 Primer on Bond Valuation > >13-14 Budgetary Control > >15-16 Measures of Leverage > > Corporate Governance of Listed Companies > > 20 1

2 CORPORATE FINANCE Corporate finance is the area of finance dealing with monetary decisions that business enterprises make and the tools and analysis used to make these decisions. The primary goal of corporate finance is to maximize shareholder value. Although it is in principle different from managerial finance which studies the financial decisions of all firms, rather than corporations alone, the main concepts in the study of corporate finance are applicable to the financial problems of all kinds of firms. The discipline can be divided into long-term and short-term decisions and techniques. Capital investment decisions are long-term choices about which projects receive investment, whether to finance that investment with equity or debt, and when or whether to pay dividends to shareholders. On the other hand, short term decisions deal with the short-term balance of current assets and current liabilities the focus here is on managing cash, inventories, and short-term borrowing and lending (such as the terms on credit extended to customers). The terms corporate finance and corporate financier are also associated with investment banking. The typical role of an investment bank is to evaluate the company's financial needs and raise the appropriate type of capital that best fits those needs. Thus, the terms corporate finance and corporate financier may be associated with transactions in which capital is raised in order to create, develop, grow or acquire businesses. CAPITAL BUDGETING Capital Budgeting is the process by which the firm decides which long-term investments to make. Capital Budgeting projects, i.e., potential long-term investments, are expected to generate cash flows over several years. The decision to accept or reject a Capital Budgeting project depends on an analysis of the cash flows generated by the project and its cost. A Capital Budgeting decision rule should satisfy the following criteria: Must consider all of the project's cash flows. Must consider the Time value of money. Must always lead to the correct decision when choosing among Mutually Exclusive Projects. The following three Capital Budgeting decision rules will be presented: 1. Payback period method. 2. Net present value method. 3. Internal rate of return method. 2

3 1. Payback Period The Payback Period isn't a very good method. After all, it doesn't use the time value of money principle, making it the weakest of the methods that we will discuss here. However, it is still used by a large number of companies, so we'll include it in our list of popular methods. For example, to recover $30,000 at the rate of $10,000 per year would take 3.0 years. Companies that use this method will set some arbitrary payback period for all capital budgeting projects, such as a rule that only projects with a payback period of 2.5 years or less will be accepted. (At a payback period of 3 years in the example above, that project would be rejected.) The payback period method is decreasing in use every year and doesn't deserve extensive coverage here. 2. Net Present Value Using a minimum rate of return known as the hurdle rate the net present value of an investment is the present value of the cash inflows minus the present value of the cash outflows. A more common way of expressing this is to say that the net present value (NPV) is the present value of the benefits (PVB) minus the present value of the costs (PVC) NPV = PVB - PVC By using the hurdle rate as the discount rate, we are conducting a test to see if the project is expected to earn our minimum desired rate of return. Here are our decision rules: If the NPV is: Benefits vs. Costs Should we expect to earn at least our minimum rate of return? Accept the investment? Positive Benefits > Costs Yes, more than Accept Zero Benefits = Costs Exactly equal to Indifferent Negative Benefits < Costs No, less than Reject Remember that we said above that the purpose of the capital budgeting analysis is to see if the project's benefits are large enough to repay the company for (1) the asset's cost, (2) the cost of financing the project, and (3) a rate of return that adequately compensates the company for the risk found in the cash flow estimates. Therefore, if the NPV is: Positive, the benefits are more than large enough to repay the company for (1) the asset's cost, (2) the cost of financing the project, and (3) a rate of return that adequately compensates the company for the risk found in the cash flow estimates. 3

4 Zero, the benefits are barely enough to cover all three but you are at breakeven - no profit and no loss, and therefore you would be indifferent about accepting the project. Negative, the benefits are not large enough to cover all three, and therefore the project should be rejected. 3. Internal Rate of Return The Internal Rate of Return (IRR) is the rate of return that an investor can expect to earn on the investment. Technically, it is the discount rate that causes the present value of the benefits to equal the present value of the costs. According to surveys of businesses, the IRR method is actually the most commonly used method for evaluating capital budgeting proposals. This is probably because the IRR is a very easy number to understand because it can be compared easily to the expected return on other types of investments (savings accounts, bonds, etc.). If the internal rate of return is greater than the project's minimum rate of return, we would tend to accept the project. NPV, IRR Comparison: The NPV is better than the IRR. It is superior to the IRR method for at least two reasons: 1. Reinvestment of Cash Flows: The NPV method assumes that the project's cash inflows are reinvested to earn the hurdle rate; the IRR assumes that the cash inflows are reinvested to earn the IRR. Of the two, the NPV's assumption is more realistic in most situations since the IRR can be very high on some projects. 2. Multiple Solutions for the IRR: It is possible for the IRR to have more than one solution. If the cash flows experience a sign change (e.g., positive cash flow in one year, negative in the next), the IRR method will have more than one solution. In other words, there will be more than one percentage number that will cause the PVB to equal the PVC. When this occurs, we simply don't use the IRR method to evaluate the project, since no one value of the IRR is theoretically superior to the others. The NPV method does not have this problem. 4

5 Cost of capital Capital is a term used in the field of financial investment to refer to the cost of a company's funds (both debt and equity), or, from an investor's point of view "the shareholder's required return on a portfolio company's existing securities". It is used to evaluate new projects of a company as it is the minimum return that investors expect for providing capital to the company, thus setting a benchmark that a new project has to meet. For an investment to be worthwhile, the expected return on capital must be greater than the cost of capital. The cost of capital is the rate of return that capital could be expected to earn in an alternative investment of equivalent risk. If a project is of similar risk to a company's average business activities it is reasonable to use the company's average cost of capital as a basis for the evaluation. A company's securities typically include both debt and equity; one must therefore calculate both the cost of debt and the cost of equity to determine a company's cost of capital. However, a rate of return larger than the cost of capital is usually required. The cost of debt is relatively simple to calculate, as it is composed of the rate of interest paid. In practice, the interest-rate paid by the company can be modeled as the risk-free rate plus a risk component (risk premium), which itself incorporates a probable rate of default (and amount of recovery given default). For companies with similar risk or credit ratings, the interest rate is largely exogenous. The cost of equity is more challenging to calculate as equity does not pay a set return to its investors. It varies from year to year. Similar to the cost of debt, the cost of equity is broadly defined as the risk-weighted projected return required by investors, where the return is largely unknown. The cost of equity is therefore inferred by comparing the investment to other investments (comparable) with similar risk profiles to determine the "market" cost of equity once cost of debt and cost of equity have been determined, their blend, the weighted-average cost of capital (WACC), can be calculated. This WACC can then be used as a discount rate for a project's projected cash flows. Cost of debt The cost of debt is computed by taking the rate on a risk free bond whose duration matches the term structure of the corporate debt, then adding a default premium. This default premium will rise as the amount of debt increases (since, all other things being equal, the risk rises as the amount of debt rises). Since in most cases debt expense is a deductible expense, the cost of debt is computed as an after tax cost to make it comparable with the cost of equity (earnings are after-tax as well). Thus, for profitable firms, debt is discounted by the tax rate. The formula can be written as (Rf + credit risk rate) (1-T), where T is the corporate tax rate and Rf is the risk free rate. The yield to maturity can be used as an approximation of the cost of debt. 5

6 Cost of equity Cost of equity = Risk free rate of return + Premium expected for risk Cost of equity = Risk free rate of return + Beta x (market rate of return- risk free rate of return) where Beta= sensitivity to movements in the relevant market Where: E s=the expected return for a security R F=the expected risk-free return in that market (government bond yield) βs=the sensitivity to market risk for the security R M=the historical return of the stock market/ equity market (R M-R f) The risk premium of market assets over risk free assets. The risk free rate is taken from the lowest yielding bonds in the particular market, such as government bonds. An alternative to the estimation of the required return by the CAPM as above is the use of the Fama French threefactor model. Expected return The expected return (or required rate of return for investors) can be calculated with the "dividend capitalization model", which is K cs = {Dividend (payment/share)/price Market) +Growth rate 6

7 Marginal Costing Marginal costing, as one of the tools of management accounting helps management in making certain decisions. It provides management with information regarding the behavior of costs and the incidence of such costs on the profitability of an undertaking. Marginal costing is defined as the ascertainment of marginal costs and of the effect on profit of changes in volume or type of output by differentiating between fixed costs and variable costs. Marginal costing is not a separate costing. It is only a technique used by accountants to aid management decision. It is a costing technique where only variable cost or direct cost will be charged to the cost unit produced. Marginal costing also shows the effect on profit of changes in volume/type of output by differentiating between fixed and variable costs. Salient Points: Marginal costing involves ascertaining marginal costs. Since marginal costs are direct cost, this costing technique is also known as direct costing; In marginal costing, fixed costs are never charged to production. They are treated as period charge and is written off to the profit and loss account in the period incurred; Once marginal cost is ascertained contribution can be computed. Contribution is the excess of revenue over marginal costs. The marginal cost statement is the basic document/format to capture the marginal costs. 7

8 Working Capital Management A managerial accounting strategy focusing on maintaining efficient levels of both components of working capital, current assets and current liabilities, in respect to each other. Working capital management ensures a company has sufficient cash flow in order to meet its short-term debt obligations and operating expenses. Working capital management is the device of finance. It is related to manage of current assets and current liabilities. After learning working capital management, commerce students can use this tool for fund flow analysis Working capital is very significant for paying day to day expenses and long term liabilities. Concept of Working Capital and its management Working capital is that part company of company s capital which is used for purchasing raw material and involve in sundry debtors. We all know that current assets are very important for proper working of fixed assets. Suppose, if you have invested your money to purchase machines of company and if you have not any more money to buy raw material, then your machinery will no use for any production without raw material. From this example, you can understand that working capital is very useful for operating any business organization. We can also take one more liquid item of current assets that is cash. If you have not cash in hand, then you can t pay for different expenses of company, and at that time, your many business works may delay for not paying certain expenses. If we define working capital in very simple form, then we can say that working capital is the excess of current assets over current liabilities. Types of Working Capital: 1. Gross working capital Total or gross working capital is that working capital which is used for all the current assets. Total value of current assets will equal to gross working capital. 2. Net Working Capital Net working capital is the excess of current assets over current liabilities. Net Working Capital = Total Current Assets Total Current Liabilities This amount shows that if we deduct total current liabilities from total current assets, then balance amount can be used for repayment of long term debts at any time. 8

9 3. Permanent Working Capital Permanent working capital is that amount of capital which must be in cash or current assets for continuing the activities of business. 4. Temporary Working Capital Sometime, it may possible that we have to pay fixed liabilities, at that time we need working capital which is more than permanent working capital, then this excess amount will be temporary working capital. In normal working of business, we don t need such capital. In working capital management, we analyze following three points: what is the need for working capital? After study the nature of production, we can estimate the need for working capital. If company produces products at large scale and continues producing goods, then company needs high amount of working capital. What is optimum level of Working capital in business? Have you achieved the optimum level of working capital which has invested in current assets? Because high amount of working capital will decrease the return on investment and low amount of working capital will increase the risk of business. So, it is very important decision to get optimum level of working capital where both profitability and risk will be balanced. For achieving optimum level of working capital, finance manager should also study the factors which affect the requirement of working capital and different elements of current assets. If he will manage cash, debtor and inventory, then working capital will automatically optimize. What are main Working capital policies of businesses? Policies are the guidelines which are helpful to direct business. Finance manager can also make working capital policies. Liquidity policy under this policy, finance manager will increase the amount of liquidity for reducing the risk of business. If business has high volume of cash and bank balance, then business can easily pays his dues at maturity. But finance manger should not forget that the excess cash will not produce and earning and return on investment will decrease. So liquidity policy should be optimized. 9

10 Profitability policy under this policy, finance manger will keep low amount of cash in business and try to invest maximum amount of cash and bank balance. It will sure that profit of business will increase due to increasing of investment in proper way but risk of business will also increase because liquidity of business will decrease and it can create bankruptcy position of business. So, profitability policy should make after seeing liquidity policy and after this both policies will helpful for proper management of working capital. Investment in working capital: Investment in working capital means to invest money in liquid and current assets. We all know that working capital is important, if we want to operate our fixed assets more efficiently. Like investment in fixed capital decision, investment in working capital decision is also important. In working capital investment, we keep our some money in cash. We also invest our some money in the form of inventory, debtors and short term securities. Value of these investments must be more than our current liabilities. Many factors affect investment in working capital: 1. Inventory Cycle We need investment of working capital for buying raw material. We have to calculate inventory conversion period. It will tell us when our inventory cycle will complete. According to this, we think to invest our money in working capital. 2. Creditor Conversion Period we have to save some money for paying our creditors. Both long term and short term creditors' payment is from cash. Our creditor conversion period will explain when we have to pay them next. 3. Debtor Conversion Period we also expect that our debtor will give our money after some time but when they will give our money. Up to that time, we need to invest money in debtors, after completing debtor conversion period; we need not to invest money in debtors. Suppose, our debtor will pay after 60 days. It means only for 60 days, we need money to buy goods and paying other expenses. But after 60 days, we will get money from debtors, it means no need to invest extra amount in cash because same cash we will get from debtors. 4. Unexpected Expenses 10

11 Some expenses, we do not expect due to uncertainty. Suppose, our employee is doing our company's duty and in the market, if he faces accident and he has no money for treatment, it is the duty of company to pay his treatment bill. But company is not NGO which will help. But taking it as social responsibility, company can pay in the form of loan to employee. But for this, company has to take decision to invest his working capital for such unexpected expenses. 5. Our Approaches some company invest in working capital on approaches basis. For example, according to matching approach, company will invest long term finance in long term fixed assets and short term finance in short term current assets. But its opposite is conservative approach in which company invest his long term finances in long term fixed assets and also in short term current assets. Inventory management: Inventory s other names are goods, stock or products of company 80% of business transactions are relating to purchasing and selling of inventories. Inventory can divide in raw material, work in progress and finished goods. For continuing production, it is very necessary to manage inventory management because without inventory management, it may possible that there is no stock in store and without stock of raw material our production may delay. But the sense of inventory management in finance or financial management is advance and it is the part of working capital management. In finance, it is the money of investment. So, proper inventory management is very helpful to provide good return on the investment in inventory. I want to take your attention on following facts which are needed for proper inventory management. 1. In inventory management, we maintain the stock register which used to track what quantity is sold at what price. 2. We have to calculate proper financial statement by using first in first out method of calculation the value of inventory or any other method of valuation of inventory. 3. Proper inventory management tells you different stock items closing stock at its cost. Some decisions are also taken relating to reducing the stock conversion period in inventory management. Stock conversion period is the period when stock is converted into sales. Fewer periods is better from financial point of view. 11

12 Importance of Inventory Management Inventory management is very important for making company s sales, strategic, production and financial planning. An inventory manager should aware that inventory, its quantity, its cost, its rates and price because inventory is effected large number of factors. So, it should be based on flexible approach, so that company can change its design according to changes in inventory market. With effective inventory management, production and sales department can work to know inflow and outflow of material. This information can be very useful for management to reduce working capital in the form of inventory, because raw material, work in progress or finished stocks are the block of money and fund. But management should not forget that at the time of inflation to purchase high quantity can give us earning due to increasing prices of same raw material within short period of time. With proper inventory management, we can create balance between supply of raw material and demand of raw material. Main Techniques of Inventory Management 1. Material requirement planning 2. Inventory Control 3. Warehouse Management techniques 4. Purchase management 5. Sales Management 6. Product Expiry dates and obsolescence management 12

13 Primer on Bond Valuation Main features of bonds A bond is a negotiable debt security under which the issuer borrows a given amount of money, called the principal amount. In exchange, the borrower agrees to pay fixed amounts of interests, also called the coupons, during a specific period of time. Everything is well defined by the bond contract: the coupon rate is the interest rate that the issuer pays to the bondholder and the coupon dates are the dates on which the coupons are paid. Besides the issuer will repay the total amount of the principal when the bond will reach what is called maturity (or maturity date).in short, a bond is a securitized loan. First, we can mention the most relevant point that makes bond so attractive, especially in gloomy periods for stock markets. Indeed, the regular payments of interest and are repaid the principal value at maturity date. Bonds with maturity of one year or less are referred to as short-term bonds or debt. Bonds with maturity of one year to ten years are referred to as intermediate bonds or intermediate notes. The long-term bonds are issued with a maturity of at least ten years and commonly up to 30 years. A second important aspect is that all characteristics of bond are well defined in advance and the market offers different choices for each of them: coupon rate (also called coupon yield), coupon date, maturity date can vary from one bond to another but are known when investing into the given bond. It allows the investor to fit its investment strategy with its risk and return acceptable levels. Let consider the following example: for a bond with a principal value of 1000$, a yearly coupon rate of 5% and a maturity of 2 years. As the yearly coupon rate is 5%, the issuer of those bonds agrees to pay $50 (5% x $1000) in annual interest per bond. The second year, the bondholder will receive (per bond) 50$+1000$, the coupon and the repayment of the principal value. I is exactly what you can expect if you have bought the bond as defined in this example and if the issuer of the bond The risks of investing in bonds Investing in bonds is not without risks. In fact, every investment in bonds carries some risks, although the degree of risk varies with the type of debt and the issuer. The main risk is the credit risk (or default risk). In this scenario, the issuer is not be able to pay the interests and repay the principal in the pre-established dates. The credit risk is then a function of the credit trust of the issuer of the debt. The creditworthiness refers to the ability that the issuer has in making scheduled payments and repaying the principal at maturity date. Obviously, the credit risk 13

14 varies with bond issuers. US Treasury issues carry virtually no risk of default because of the full faith and credit of the US Government guarantees interest and principal payments. As a direct consequence, US Government bonds will offer a lower yield than more risky bond issuers. Indeed, US Government bonds are "absolutely" safe with no risk, and then no big returns can be expected. Another risk consists in the interest rate risk, only if you do not keep your bond till maturity. We have already mentioned this process in the previous section of this document: bond values are varying with the interest rates in a simple way. During the high period of the interest, if you sell your bonds (purchased at lower yield), you will lose some money, only if you sell before maturity. For bond holder (till maturity), a major risk is obviously driven by a rising inflation, as it will have a corrosive impact on your bond investment. Indeed, you lock up your money for a long period, and then inflation plays against you. Of course, the longer the maturity, the larger the impact of inflation. Then, we expect some pair trades to be active between short term and long term maturities during rising inflation periods. The shape of the yield curve is changing on a daily basis with the changes in yield because of fluctuations in the rates of interest market. Then, you can decide whether you are willing to invest in long or shortterm maturity bonds, based on the shape of the yield curve. The purchasing process of bonds : Bonds are quoted in hundreds, but negotiated in denominations of thousands. A bond price quote of $86 ¾ means that the bond is negotiated not at $86.75, but rather at $ per bond. The bid price is the highest price that a buyer would pay for a bond. For example, when someone sells a bond whose market price is 94 ½, the highest point that a buyer would offer would be $ per bond. The ask price is the lowest price offered for a bond buy the seller. For example, an investor that buys a bond with a bid of 94 ½ and an ask price of $94 5/8 would pay for the bond $ (the lowest price that a seller of this bond will accept). The spread is the difference between the bid and the ask price of the bond, part of which is a commission to pay to the broker or dealer. A large spread indicates a bond inactively traded. Bonds are bought in similar way as stocks. Although a large part of the bonds is bought and sold through brokerage firms, one can purchase some bonds through banks or directly from issuers. 14

15 The different type of purchase orders (market and limit orders) used to buy stocks are also applicable to purchase bonds. Note that finding current bid and ask prices of a bond can be difficult because the bond market is a dealer market in which the same bonds can be offered at different prices. For example, a dealer offers a General Motors bond with a maturity date of 2028 at a price of $ and other dealer asks for $900 for the same bond. Budgetary Control Definition: Budget is a financial and /or quantitative statement, prepared and approved prior to a defined Period of time of the policy to be pursued during that period for the purpose of attaining a given objective. It may include income, expenditure and employment of capital. Features: 1. Financial and/or Quantitative Statement. 2. Futuristic prepared and approved prior to a defined period of time. 3. Goal Oriented for the purpose of attaining a given objective. 4. Components Income. Budgetary Control is defined as "the establishment of budgets, relating the Responsibilities of executives to the requirements of a policy, and the continuous comparison of actual with budgeted results either to secure by individual action the objective of that policy or to provide a base for its revision. Budgets may be classified on the following bases 1. Time Period a. Long-term Budget b. Short-term Budget 2. Conditions a. Basic Budget and b. Current Budget 3. Capacity a. Fixed Budget and b. Flexible Budget 4. Coverage a. Functional Budget and b. Master Budget The performance of Budgeting is: 15

16 1. To encourage self-study in all aspects of a Company's operations. 2. To get all members of management to put their heads to the basic question of how the business hold be run, to make them of a co-ordinate team operating in unison towards clearly defined objectives. 3. To promote the planning process and provide a sense of direction to every member of the organization. 4. To force a definition and crystallization of Company policies and aims. 5. To increase the effectiveness with which people and capital are employed. 6. To disclose areas of potential improvement in the Company s operations. 7. To stimulate study of relationship of the Company to its external economic environment for improving the effectiveness of its direction. 8. To direct and coordinate business activities and units to achieve stated targets of performance. 9. To facilitate the control process, by comparing actual results with plan, and provide feedback to the employees about their performance. Different steps in preparation of budgets 1. Definition of objectives A budget being a plan for the achievement of certain operational objectives, it is desirable that the same are defined precisely. The objectives should be written out; The areas of control demarcated; And items of revenue and expenditure to be covered by the budget stated. This will give a clear understanding of the plan and its scope to all those who must co-operates to make it a success. 2. Location of the key (or budget) factor There is usually one factor (sometimes there may be more than one) which sets a limit to the total activity. For instance, in India today sometimes non availability of power does not allow production to increase inspite of heavy demand. Similarly, lack of demand may limit production. Such a factor is known as key factor. For proper Budgeting, it must be located and estimated properly. 3. Appointment of controller Formulation of a budget usually required whole time services of a senior executive; He must be assisted in this work by a Budget Committee, consisting of the entire heads of department along with the Managing Director as the Chairman. The Controller is responsible for coordinating and development of budget programmed and preparing the manual of instruction, Known as Budget manual. The Budget manual is a schedule; document or booklet which shows, in written forms the budgeting organization and procedures. The manual should be well written and indexed so that a copy thereof may be given to each departmental head for guidance. 4. Budget Period The period covered by a budget is known as budget period. There is no general rule governing the selection of the budget period. In practice the budget committee determines the length of the budget period suitable for the business. Normally, a calendar year or a period coterminous with the financial year is adopted. The budget period is then subdivided into shorter period site months or quarters or such periods as coincide with period of trading activity. 16

17 5. Standard of activity or output For preparing budgets for the future, past statistics cannot be completely relied upon, for the past usually represents as combination of good and bad factors. Therefore, though results of the past should be studied but these should only be applied when there is a likelihood of similar conditions repeating in the future. Also, while setting the targets for the future, it must be remembered that in a progressive business, the achievement of a year must Exceed those of earlier years. Therefore what was good in the past is only fair for the current year. Leverage Measures The amount of debt of a company affects its profitability and its ability to grow. Debt also incurs risk for both creditors and stockholders because of the potential for default, especially in hard economic times, since the interest on the debt must be paid regardless of hardships. A high debt load can also increase the future cost of credit for the company since it will be less creditworthy. Since many companies refinance maturing short- and long-term debt by issuing more debt, a worse scenario can occur if the availability of credit declines because of economic turmoil, such as during the credit crisis of 2007 and 2008, when even short-term debt couldn t even be refinanced. Indeed, the credit crisis has forced many companies into bankruptcy. Of course, the amount of debt by itself is not a useful guide in selecting companies, since it must be compared to the company s profit and stockholders equity to be a meaningful gauge of a company s solvency. Debt-Equity Ratios The debt-equity ratio measures the proportion of funds provided by creditors and stockholders. There are at least 3 different versions of this ratio that differ mostly in the numerator. The 1 st ratio, often called the debt ratio divides total liabilities by stockholders equity. This ratio would be of most interest to bondholders, since it shows how much value there would be in a liquidation of the company. Debt Ratio Formula Debt Ratio = Total Liabilities Stockholders Equity Example For its fiscal year ending January, 2008, Wal-Mart had total liabilities of $98,906,000,000 and total stockholder equity of $64,608,000,000. Therefore: 17

18 Debt Ratio = 98,906 / 64, Another debt-to-equity ratio that is commonly used divides long-term debt by stockholders equity, which is a measure of the leverage of a company. This ratio disregards current liabilities, since such liabilities are shortterm and involve day-to-day operations, such as payroll and interest payments. Long-term debt is used to finance major capital expenditures, such as equipment or buildings, to hopefully increase future revenues and profits which will increase the return on stockholders equity. Debt-Equity Ratio Formula Long-Term Debt Debt-Equity Ratio or Leverage = Stockholders Equity Extending the above example, Wal-Mart had long-term debt of $40,452,000,000 in Therefore: Debt-to-Equity Ratio = 40,452 / 64, Another debt-to-equity ratio compares the amount of securities where interest or dividends are paid to common stock. Debt-to-Equity Ratio = Long-Term Debt + Preferred Stock Common Stock Fixed-Charge Coverage Ratio A company must have enough earnings to pay its interest expense; otherwise it will eventually fail. Because earnings rise and fall depending on market and economic conditions, it would be preferable if the company s earnings were much higher than interest expense in most years; otherwise, investing in the company would incur significant risk when the economy falters, as it always does eventually. The amount of safety desired depends on the stability of the company s earnings, and how cyclical the company s sector is. A company whose earnings rise and fall significantly with economic cycles should have a greater margin of earnings over interest payments. The fixed-charge coverage ratio (aka times interest earned) is earnings before interest (EBIT) plus taxes divided by the interest expense of long-term debt and other liabilities. 18

19 Fixed-Charge Coverage Ratio Formula Earnings before Interest and Taxes Fixed-Charge Coverage Ratio = Interest Expense of Long-Term Debt Since interest is a tax-deductible expense, the full amount of earnings can be used to pay interest. Some firms, in reporting their results, use earnings before interest, taxes, depreciation, and amortization (EBITDA), because it makes the company's financial picture look better than using EBIT, especially if it is a capitalintensive business. This is because depreciation and amortization are accrual charges that reduce earnings, but are not actually paid during the period. Companies argue that this gives a better picture of their cash flow. The problem with using EBITDA is that although depreciation and amortization are not actual expenses during the reporting period, the company will eventually need money to replace their capital goods eventually, so it shouldn't really be considered as money that can be used to cover interest payments except for the short term. Even intangible assets, such as goodwill, can be problematic in ascertaining a company's ability to pay its interest expense. Hence, it is better to stick with using EBIT rather than EBITDA in calculating fixed-charge coverage ratio. Example For its fiscal year ending in January, 2008, Wal-Mart earned $22,301,000,000 before interest and taxes, and had an interest expense of $2,103,000,000. Therefore: Fixed-Charge Coverage Ratio = 22,301 / 2,

20 Corporate Governance of Listed Companies Corporate governance is the system of internal controls and procedures by which individual Companies are managed. It provides a framework that defines the rights, roles and responsibilities of different groups management, Board, controlling Shareowners and minority or non-controlling Shareowners within an organization. This system and framework is particularly important for Companies with a large number of widely dispersed minority Shareowners. At its core, corporate governance is the arrangement of checks, balances, and incentives a Company needs to minimize and manage the conflicting interests between insiders and external Shareowners. Its purpose is to prevent one group from expropriating the cash flows and assets of one or more other groups. 20