Basics of Corporate Finance May 1994 Basics of Corporate Finance Warning These workbook and computer-based materials are the product of, and copyrighted by, Citi- bank N.A. They are solely for the internal use of Citi-bank, N.A., and may not be used for any other purpose. It is unlawful to reproduce the contents of these materials, in whole or in part, by any method, printed, electronic, or other- wise; or to disseminate or sell the same without the prior written consent of the Professional Development Center of Latin America Global Finance and the Citibank Asia Pacific Banking Institute. Please sign your name in the space below. Table of Contents v05/15/94 v-1.1 p01/14/00 TABLE OF CONTENTS Introduction: Basics of Corporate Finance Course Overview xi Course Objectives xiv The Workbook xv Unit 1: Financial Statement Analysis Introduction 1-1 Unit Objectives 1-1 Balance Sheet 1-2 Assets 1-2 Short-term Assets 1-3 Long-term Assets 1-3 Liabilities (Debt) and Equity 1-4 Debt vs. Equity 1-4 Liability / Equity Accounts 1-5 Assets Equal Liabilities Plus Equity 1-6 Summary 1-8 Progress Check 1.1 1-9 Income Statement 1-13 Shareholder Return on Investment 1-15 Depreciation 1-16 Summary 1-17 Progress Check 1.2 1-19 Cash Flow Statement 1-21 Operating Activities 1-23 Sources 1-23 Uses 1-24 Financing Activities 1-25 Summary 1-27 ii TABLE OF CONTENTS v-1.1 v05/15/94 p01/14/00 Unit 1: Financial Statement Analysis (Continued) Progress Check 1.3 1-29 Financial Ratios 1-33 Liquidity Ratios 1-35 Current Ratio 1-35 Quick (Acid-Test) Ratio 1-36 Asset Management Ratios 1-36 Inventory Turnover Ratio 1-36 Average Collection Period 1-37 Fixed Assets Turnover Ratio 1-38 Total Assets Turnover Ratio 1-38 Debt Management Ratios 1-39 Total Debt to Total Assets Ratio (Debt Ratio) 1-40 Times Interest Earned (TIE) Ratio 1-41 Fixed Charge Coverage Ratio 1-41 Profitability Ratios 1-42 Profit Margin Ratio 1-42 Basic Earnings Power Ratio 1-42 Return on Total Assets Ratio 1-43 Return on Common Equity Ratio 1-43 Market Value Ratios 1-44 Price / Earnings Ratio 1-44 Market / Book Ratio 1-45 Using Ratios 1-45 Unit Summary 1-46 Progress Check 1.4 1-49 Unit 2: Financial Markets and Interest Rates Introduction 2-1 Unit Objectives 2-1 Overview of Financial Markets 2-2 TABLE OF CONTENTS iii v05/15/94 v-1.1 p01/14/00 Unit 2: Financial Markets and Interest Rates (Continued) Market Players 2-2 Types of Financial Markets 2-2 Money Markets 2-3 Capital Markets 2-3 Interest Rates 2-5 Calculating Interest Rates 2-6 Pure Interest Rate 2-7 Inflation 2-7 Risk 2-8 Term Structure of Interest Rates 2-10 Yield Curve 2-10 Normal Yield Curve Theories 2-12 Effect on Stock Prices 2-14 Unit Summary 2-14 Progress Check 2 2-17 Unit 3: Time Value of Money Introduction 3-1 Unit Objectives 3-1 Future Value 3-2 Calculating Interest Payments 3-2 Simple Interest 3-3 Practice Exercise 3.1 3-5 Compound Interest 3-9 Discrete Compounding for Annual Periods 3-9 Discrete Compounding for Nonannual Periods 3-11 Continuous Compounding 3-12 Summary 3-16 Practice Exercise 3.2 3-17 Present Value 3-21 iv TABLE OF CONTENTS v-1.1 v05/15/94 p01/14/00 Unit 3: Time Value of Money (Continued) Discrete Discounting 3-22 Continuous Discounting 3-24 Practice Exercise 3.3 3-27 Annuities 3-31 Future Value of an Annuity 3-31 Present Value of an Annuity 3-32 Perpetuities 3-33 Uneven Payment Streams 3-34 Practice Exercise 3.4 3-37 Unit Summary 3-41 Progress Check 3 3-43 Unit 4: Valuing Financial Assets Introduction 4-1 Unit Objectives 4-1 Bonds 4-1 Bond Terminology 4-2 Process for Issuing Bonds 4-3 Pricing Bonds 4-4 Common Stock 4-7 Valuing Common Stock 4-7 Preferred Stock 4-11 Pricing Preferred Stock 4-11 Unit Summary 4-12 Progress Check 4 4-15 Unit 5: Introduction to Capital Budgeting Introduction 5-1 Unit Objectives 5-1 Nominal and Effective Rates 5-2 Calculating Effective Interest Rates 5-2 [...]... . 7-1 Unit Objectives 7-1 Sources of Capital and Their Costs 7-1 Cost of Debt 7-2 Cost of Preferred Stock . 7-3 Cost of Common Stock (Equity) 7-4 Dividend Valuation Model 7-5 Capital Asset Pricing Model (CAPM) 7-6 Summary 7-8 Practice Exercise 7.1 . 7-9 Weighted Average Cost of Capital . 7-1 5 Capital Structure 7-1 7 Flotation... 1 0-3 Payoff Profile for Calls and Puts 1 0-4 Call Options 1 0-4 Put Options 1 0-6 Summary 1 0-9 Swaps 1 0-9 Interest Rate Swaps 1 0-9 Currency Swaps 1 0-1 4 Unit Summary 1 0-1 5 Progress Check 10 1 0-1 7 Appendix Glossary G-1 Index v05/15/94 p01/14/00 v-1.1 x TABLE OF CONTENTS (This page is intentionally blank) v-1.1... Decisions 5-1 8 Payback Period 5-1 8 Profitability Index (PI) 5-2 0 Practice Exercise 5.3 5-2 3 Unit Summary 5-2 7 Progress Check 5 5-2 9 Unit 6: Corporate Valuation Risk Introduction to Units 6, 7, and 8 – Corporate Valuation 6-1 Introduction . 6-3 Unit Objectives 6-3 Calculating Expected Cash Flows 6-4 Expected Return 6-4 Expected... Costs 7-1 8 Summary 7-1 9 Practice Exercise 7.2 7-2 1 v-1.1 v05/15/94 p01/14/00 TABLE OF CONTENTS vii Unit 8: Corporate Valuation – Estimating Corporate Value Introduction . 8-1 Unit Objectives 8-1 Forecasting Cash Flows 8-1 Free Cash Flow Calculation 8-2 Assumption-based Cash Flow Forecasting 8-4 Residual Value 8-7 Perpetuity Method... 9-1 4 Summary 9-1 5 Practice Exercise 9.2 9-1 7 Eurobonds 9-1 9 Other Bonds 9-2 1 Accrued Interest 9-2 1 Bond Price Quotes 9-2 3 Treasury Bill Quotes 9-2 3 Treasury Note and Bond Quotes 9-2 5 Summary 9-2 7 Practice Exercise 9.3 9-2 9 Duration 9-3 3 Factors That Affect Bond Prices 9-3 3 Duration of a Bond... Summary 6-3 0 Practice Exercise 6.3 6-3 1 Beta 6-3 3 Summary 6-3 7 Practice Exercise 6.4 6-3 9 Symbols and Definitions 6-4 1 Risk vs Return 6-4 2 Required Rate of Return 6-4 2 Capital Asset Pricing Model (CAPM) 6-4 5 Practice Exercise 6.5 6-4 9 Unit Summary 6-5 3 Unit 7: Corporate Valuation – Cost of Capital Introduction... 9-1 Introduction to Bond Pricing and Yield Mathematics 9-2 U.S Treasury Bills . 9-2 Pricing U.S Treasury Bills 9-3 Calculating the Discount Rate 9-4 Rate of Return 9-4 Summary 9-6 Practice Exercise 9.1 . 9-9 U.S Treasury Notes 9-1 1 Pricing U.S Treasury Notes 9-1 1 Calculating Yield to Maturity 9-1 3 U.S Treasury Bonds 9-1 4 Call... Expected Cash Flows 6-7 Practice Exercise 6.1 . 6-9 Measuring Risk . 6-1 1 Variance 6-1 3 Standard Deviation 6-1 6 Summary 6-1 8 Practice Exercise 6.2 6-1 9 Portfolio Risk 6-2 1 Portfolio Diversification 6-2 1 Systematic and Unsystematic Risk . 6-2 7 v05/15/94 p01/14/00 v-1.1 vi TABLE OF CONTENTS Unit 6: Corporate Valuation – Risk... 8-2 4 Dividend Value 8-2 4 Other Ratios . 8-2 5 Factors Affecting Value 8-2 6 Market Liquidity . 8-2 6 Country Conditions 8-2 7 Industry Conditions 8-2 8 Synergies 8-2 8 Unit Summary 8-2 9 Progress Check 8 8-3 1 v05/15/94 p01/14/00 v-1.1 viii TABLE OF CONTENTS Unit 9: Fixed Income Securities Introduction . 9-1 Unit... Introduction INTRODUCTION: BASICS OF CORPORATE FINANCE COURSE OVERVIEW Basics of Corporate Finance serves as an introductory course for students beginning their study of finance and financial markets The ideas and calculations presented in this workbook serve as the foundation for continued study in the areas related to corporate finance and the capital and derivative markets The purpose of this course is to . Basics of Corporate Finance May 1994 Basics of Corporate Finance Warning These workbook and computer-based materials are the product of, and copyrighted by, Citi- bank N.A. They. 7-1 Sources of Capital and Their Costs 7-1 Cost of Debt 7-2 Cost of Preferred Stock 7-3 Cost of Common Stock (Equity) 7-4 Dividend Valuation Model 7-5 Capital Asset Pricing Model (CAPM) 7-6 Summary 7-8 Practice. blank) Introduction v05/15/94 v-1.1 p01/14/00 INTRODUCTION: BASICS OF CORPORATE FINANCE COURSE OVERVIEW Basics of Corporate Finance serves as an introductory course for students beginning their study of finance and