FIMO BSAIS 4-YA-1 MIDTERMS REVIEWER

CHAPTER 8 outflows to be acceptable. The cash flows,

generally, are as follows:
CAPITAL BUDGETING
a. The initial investment which is the initial
Capital budgeting is the process of allocating
cash outlay needed to undertake the
financial resources to new long-term investment
investment.
projects. Engaging in profitable activities such as
b. The annual cash returns which are
new investments determines a firm's sustainability
computed by adding the non-cash
in the future. Such engagements involve a
expenses to the firm's rather than the net
considerable amount of money so a firm has to be
income. Included also in the cash returns
cautious before making them. However, with
are the increase or decrease in net income
increased financial risks, it can expect to yield
after tax. In capital budgeting, firms are
benefits for years. The success of a firm is
more concerned with the cash inflow the
ultimately attributed to its ability to make wise
working capital over the entire life of the
capital budgeting decisions.
project.
c. The terminal cash flow which is associated
with the termination of the project. For
Importance of Capital Budgeting example, the scrap value of the equipment
purchased and used which is added to the
Here are some reasons why capital budgeting is
firm's cash inflows at its discounted
important:
amount.
1. Capital budgeting involves investments of
2. The estimated cost of capital or the weighted
different amounts. Normally, capital expenditure
average cost of capital. A firm’s cost of capital
entails a substantial amount of resources.
plays a vital role when financial decisions are
However, regardless of the amount involved, a firm
made, i.e., the project with the lowest cost of
must have a high chance of success in undertaking
capital is preferred. Moreover, the lower the cost
such an investment. Thus, the benefit must be
of capital, the more projects the firm can accept.
greater than its cost.
3. The acceptance criteria which are the rules that
2. It limits a firm's flexibility. Capital expenditure
enable a firm to resolve issues concerning long-
restricts a firm's flexibility because it requires the
term e criteria are the methods used to evaluate
commitment of funds. If a wrong decision is made,
the "attractiveness" of an investment proposal.
resources are tied up for a long period in an
investment that may not be profitable. Conversely,
if a right decision is made, a firm will be benefited
for a long time. Framework of Capital Budgeting

3. It defines a firm's strategic direction. Firms that The basic concept underlying capital budgeting is
want to penetrate new markets or develop new A the cost-benefit analysis. As illustrated below, the
firm's strategy affects products and/or services cost and benefit of an investment proposal has to
have to undertake the capital budgeting process. be weighed. A firm has to determine if the
its future. benefits, in the form of net cash inflows or cost
savings, outweigh the costs. Thus, if the benefits
4. It is concerned with the planning and control of of an investment proposal are greater than the
investments. Capital budgeting involves the cost of investment, the investment proposal is
upgrading of machinery and equipment, acceptable. On the contrary, if the cost of the
acquisition of new product lines, and expansion. investment exceeds the benefits, the investment
proposal is not acceptable.

To arrive at a long-term investment decision, a

firm needs to identify the following:

1. The estimated cash flows which are the inflows

and outflows over the entire life of the investment
proposal. The cash inflows must exceed the cash
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 FIMO BSAIS 4-YA-1 MIDTERMS REVIEWER

Present If the payback period > required payback

Value of → reject the project
Required
Investment Expected
Cash Inflows
Example (Even Cash Inflow):
Minimum
Required Cost Savings
Mr. Batungbakal plans to purchase a piece of
Rate of Expected
Rate of equipment which amounts to P180,000 in
Return
Return accordance with an investment proposal from a
(Cost of Methods
Capital)
member of his staff. If the equipment is bought, it
Payback Period is expected to generate an annual cash inflow of
Discounted Payback
P30,000. A five-year payback period is acceptable
Period Accounting
Rate of Return
to Mr. Batungbakal. Payback period
Net Present Value 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 − 𝑆𝑐𝑟𝑎𝑝 𝑉𝑎𝑙𝑢𝑒
Internal Rate of
𝐴𝑛𝑛𝑢𝑎𝑙 𝑎𝑓𝑡𝑒𝑟 − 𝑡𝑎𝑥 𝑐𝑎𝑠ℎ 𝑠𝑎𝑣𝑖𝑛𝑔𝑠
Return
Profitability Index 180,000
30,000
Payback Period = 6 years
A capital budgeting technique that does not Decision: The investment proposal should be
consider the time value of money, the payback rejected. The six-year payback period exceeds the
period method measures the length of time it five-year payback period set by Mr. Batungbakal.
takes to recover a project's initial investment.
Example (Uneven Cash Inflows):
This method adopts the most direct approach to
an investment problem, i.e., it measures the Assume the same set of facts in the preceding
length of time it will take before the receipts from example for the annual cash inflows which have
the investment are sufficient to recover the cost of now been changed as follows:
the investment. The receipts from the investment
are measured as the net cash flows resulting from First year 20,000
the project being undertaken. If the annual cash Second year 30,000
inflow is even, the payback period is computed by Third year 40,000
dividing the initial cash outlay by the annual cash Fourth year 50,000
inflow. Fifth year 50,000
Sixth year 40,000
If the annual cash inflow is uneven, the payback
period is computed by deducting the annual cash
inflow per year from the amount of the investment The payback period is as follows:
until it becomes zero. Cash
Balance Years
Inflows
The acceptance criterion under the payback period 180,000
is dependent on the firm's minimum or required First year 20,000 160,000 1
Second
payback. An investment proposal whose payback year
30,000 130,000 1
period is less than or equal to the firm's required Third year 40,000 90,000 1
payback is accepted and an investment proposal Fourth year 50,000 40,000 1
whose payback period is greater than the standard 40,000/
Fifth year 50,000 0 0.80
50,000
set by the firm is rejected. Sixth year 40,000

Decision: The investment proposal should be

Thereby:
accepted. The payback period (4.80 years) is less
If the payback period < required payback than the standard of 5 years. The remaining
→ accept the project balance of P40,000 at the end of the fourth year is
divided by the amount of P50,000 in year 5 to get

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 FIMO BSAIS 4-YA-1 MIDTERMS REVIEWER

the period of time in which the balance is acceptance criterion and computation are similar
recovered in the fifth year. to those of the regular payback period except that
the annual cash inflows are discounted by the
firm's cost of capital.
Advantages

The advantages of the payback period method are

Example
as follows:
Mr. Orsoa plans to put up a small stall in front of
1. It is simple to compute and easy to understand.
his house. The overall cost of the construction is
While simplicity is valuable, however, it should not
P150,000. The stall is expected to generate annual
be considered the principal factor when deciding
cash inflows of $40,000 for 7 years. A four-year
on alternative investments.
discounted payback period is acceptable to Mr.
2. It handles investment risks well. The idea Otsoa. The cost of capital is at 12%
behind this method is that cash inflows in the far
The discounted payback period is as follows:
future are riskier than those in the near future. The
payback period method focuses its attention on Annual
Present Discounted Balance of
Cash
early cash inflows and requires that the project's Returns
Value Value Investment
payback period be within a span of time which is 150,000
acceptable to the company. The result is that risky First
40,000 (1.12)-1
35,714 114,286
year
projects are easily avoided and the risk of incurring Second (1.12)-2
40,000 31,888 82,398
loss is year
Third (1.12)-3
40,000 28,471 53,927
year
Fourth (1.12)-4
40,000 25,421 28,506
Disadvantages year
Fifth (1.12)-5
40,000 22,697 5,809
The disadvantages of the payback period method year
Sixth (1.12)-6
are as follows: year
40,000 20,265 0
Seventh (1.12)-7
1. It does not recognize the time value of money. year
40,000 18,094
In this method, the value of the money (whether
in the present or in the future) does not matter to
the decision-maker. He/She does not consider the 4 years = 4
fact that the purchasing power of money changes 5th year: 1
over time. 5,809/20,265 = 0.29

2. It ignores the impact of cash inflows received

after the payback period. Essentially, cash flows Decision: The plan of putting up a small stall in
after the payback period determine the front of Mr. Otsoa's house should be rejected since
profitability of an investment. the discounted payback period of 5.29 years is
longer than the acceptable payback period of 4
3. There is a possibility of lower return. The years.
payback period method is biased towards risky
assets. Thus, by demanding rapid payback, In some cases, the decision arising from the
companies incline towards risky projects. It is very regular payback period and the discounted
seldom that a higher return is received for projects payback period becomes ambivalent because it is
with a lesser risk. accepted using the regular payback period but
rejected under the discounted payback period. The
4. There is no rational way of determining the reason is that the annual cash return under the
payback period. discounted payback period is smaller than that of
the regular payback period.
Discounted Payback Period
In the same manner, the advantages and
The discounted payback period method refers to
disadvantages of the discounted payback method
the number of years in which the investment may
are the same as those of the regular payback
be recovered at its discounted cash inflows. The
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 FIMO BSAIS 4-YA-1 MIDTERMS REVIEWER

received except that the former recognizes the If ARR < required ARR ➡ reject the project
time value of money. If ARR > required ARR ➡ accept the project

Advantages
Accounting Rate of Return
The advantages of using this method are the
The accounting rate of return (ARR) is sometimes
following:
called the average rate of return. It is determined
by dividing the average accounting profit (after 1. It is easy to understand. Similar to the payback-
taxes) expected from the project by the period method, it is straightforward. 2. It is simple
investment. Although the ARR is more to compute. The variables needed in the formula
advantageous than the payback-period method in are easily obtained.
that it takes into account the profits over the entire
life of the project, it suffers from a number of 3. It recognizes the profitability factor. It uses the
shortcomings, eg, this method does not consider net income (after tax) obtained from the income
the time value of money on the non-cash expenses statement.
related to the project.

Disadvantages
Accounting rate of return =
The disadvantages of using this method are the
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑎𝑛𝑛𝑢𝑎𝑙 𝑝𝑟𝑜𝑓𝑖𝑡 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥𝑒𝑠 following:
𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 1. It ignores the time value of money.

2. It uses accounting income instead of cash

Example: inflows. The cash generated is far more important
than the net income to attain the main objective
Initial investment P8,000 of the firm. It is cash, not the net income, that is
Estimated life 20 years used in investment.
Cash inflow per year P1,000
Depreciation per year P400 3. It is difficult to determine the minimum
acceptable rate of return. It allows the decision-
makers to manipulate the appraisal of investments
Answer: for personal gain or interest.

1,000−400 4. It does not take into account the amount of the

𝐴𝑅𝑅 = = 7.5% investment. For instance, it could be possible that
8,000
an accounting rate of return of 20% on P20,000
may be more preferable than a rate of return of
In other variants of this method, the investment is 12% on P100,000.
"averaged" by dividing the initial investment by 2

Thus, the ARR is

Net Present Value
1,000−400
𝐴𝑅𝑅 = = 15.0% The net present value (NPV) method is obtained
4,000 by getting the present value of all the cash inflows
After computing the accounting rate of return, a the cost of capital less the initial investment. As
firm must then compare it with the required AR if far as advantages are concerned, this method
the calculated average is less than the required recognizes the time value of money and it is easy
ARR, the investment proposal is rejected. Thus, to compute whether the cash flows form an
the rule on investments is: annuity or vary from period to period. Any positive
net-present-value is acceptable.

In situations where all projects are independent

and there are no constraints on the level of
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 FIMO BSAIS 4-YA-1 MIDTERMS REVIEWER

investments to be made, a firm should undertake projects with the highest internal rates of return
projects which are consistent with its goals. This are accepted. This method is very tedious because
involves greenlighting all projects in which the NPV there is no exact formula.
is positive. Such projects will increase shareholder
Computing the internal rate of return presents two
wealth and can be considered profitable given the
complications. First, the actual internal rate of
firm’s cost of capital.
return will most likely not coincide with the rates
available in the present value tables. In other
words, it is unlikely that the actual rate of return
The formula for even future cash flows is:
will exactly be 15% or 20%. The actual rate of
return will probably lie somewhere between two
1 − (1 + i)−𝑛 rates of return included in the table. A fair
𝑃𝑉 = estimation of the internal rate of return can be
𝑖
determined by means of trial and error and the
mathematical process known as interpolation.
Second, the cash flows may be unequal.
The formula for uneven future cash flows is:
Computing the internal rate of return then
becomes a "hir-or-miss" proposition.
𝑃𝑉 = (1 + 𝑖)−𝑛

Detailed computer routines ease the

Example:
computational drudgery. Manually, the process is
Kim Corporation invested P6,85-4 in a 4-year burdensome, ie., one simply tries a rate, and then
project. Kim's cost of capital is 8%. Additional bits tries another, until the applicable rate is finally
of information on the project are as follows: determined.

Decision rule:
After-tax
Year Present Value Present
Cash Inflow If IRR < required rate of return → reject the
at 8% Value
of P1 project
1 2,000 0.926 1,852
2 2,200 0.857 1,885
3 2,400 0.794 1,906 If IRR > required rate of return → required rate
4 2,600 0.735 1,911 of return → accept the project
7,554
Less:
6,854 Advantages
Investment
NPV 700
The advantages of using the internal rate of return
method are as follows:
Using the cost of capital as the reinvestment rate
is theoretically correct when directly measuring 1. It acknowledges the time value of money. Cash
the increase in value that the proposed project is inflow and cash outflow are translated into their
expected to produce. However, using the NPV present values using the computed IRR before
method is difficult for people without formal arriving at a decision.
training in business, especially when the concept 2. It is more exact and realistic than the ARR.
of the time value of money is involved.
3. If not constantly changing, the streams of cash
flows can provide a rate of return that is useful is
Internal Rate of Return making a decision.

The internal rate of return is the rate of return that 4. It provides a decision similar to the NPV if the
equates the present value of all the cash inflows to project is independent.
the initial investment. In other words, it is the
interest rate that causes the net present value to
be zero. The rule in decision-making is that

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Disadvantages If the cash inflows are unequal, firstly, complete

the sum of the present value of all the cash
The disadvantages of using the internal rate of
inflows; secondly, proceed to the trial-and-error
return method are as follows:
procedure; and lastly, interpolate.
1. It requires a lot of time to compute especially
when the cash inflows are not even.
Modified Internal Rate of Return
2. It provides multiple IRRs in situations where the
movement of cash flows is erratic. One of the major problems encountered with the
IRR is the reinvestment-rate assumption. This
3. Under mutually exclusive projects, the IRR may
thinking assumes that the firm is able to earn the
provide results conflicting with the NPV.
IRR every time the cash inflow is reinvested. Thus,
it results in a major distortion between the NPV
and the IRR. The NPV's assumption is that the
Example: reinvestment rate is equal to the cost of capital
while the IRR uses the cost of capital as a basis of
Assume that:
making decisions for it to accept or reject a
Initial investment P12,950 proposal, i.e., the IRR should not be less than the
Estimated life 10 years cost of capital. Reinvesting cash inflow in the firm's
Annual cash inflows P 3,000 IRR is usually an unrealistic assumption. A more
Cost of capital 12.0% likely situation is that the cash inflow will be
reinvested at a rate equal to or greater than the
firm's cost of capital.
Answer: Trial and error
Another problem with the IRR is that projects with
At 18% alternating positive and negative cash flows result
in more than one IRR, leading to confusion and
1 − (1 + 18)−10 ambiguity.
𝑃3,000 =
0.18
To resolve the problems regarding IRR, the
concept of modified internal rate of return (MIRR)
is introduced. No matter how many positive and
P13,482.26
negative cash flows are provided by a project, only
one value is used to compare with the firm's cost
of capital.
At 20%
The MIRR is computed as follows:
1 − (1 + 20)−10
𝑃3,000 = 𝑴𝑰𝑹𝑹
0.20
𝑛 𝐹𝑉 (𝑃𝑜𝑠𝑖𝑡𝑖𝑣𝑒 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤𝑠, 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑐𝑎𝑝𝑖𝑡𝑎𝑙)
P12,577.42 = √ −1
𝑃𝑉 (𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑜𝑢𝑡𝑙𝑎𝑦𝑠, 𝑓𝑖𝑛𝑎𝑛𝑐𝑖𝑛𝑔 𝑐𝑜𝑠𝑡)

Where:
By interpolation:
n = number of periods
13,482.26 13,482.26 at 18% initial
FV = the future value of cash inflows
investment
PV = initial cash outlay
12,950.00
12,577.42 at 20%
532.256 904.84 The formula adds all the negative cash flows after
discounting them to time zero using the external
cost of capital. Then, it adds all the positive cash
IRR = 18.0% + 532.26 / 904.84 (0.02) flows (including the proceeds of reinvestment at
the external reinvestment rate to the final period).
= 19.18%
Lastly, it works out what rate of return will cause

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the magnitude of the discounted negative cash attractiveness. If the profitability index is greater
flows at time zero to be equivalent to the future than 1, the project is accepted.
value of the positive cash flows at the final time
A profitability ratio of 1 is logically the lowest
period.
acceptable measure on the index. Having a value
For example, a 5-year project with an initial outlay of 1 simply means that the present value of the
of P18,000 and a cost of capital of 14% will future cash flows is equal to the investment. Thus,
produce an annual cash return of P5,600. The IRR any value lower than 1 indicates that the project's
of the project is 16.80% so the net present value PV is less than the initial investment. As the value
(NPV) = 0. of the profitability index increases, so does the
financial attractiveness of the proposed project.

To compute the MIRR:

Mutually Exclusive Projects

0 1 2 3 4 5 Projects are mutually exclusive if they compete

with other projects in such a way that the
-18,000 5,600 5,600 5,600 5,600 5,600
acceptance of one precludes the acceptance of the
others. It must be noted that mutually-exclusive
6,384.00 projects are not independent from accept-or-
reject decisions.
7,277.76
If a firm is choosing among mutually exclusive
8,296.65 investments, the NPV and IRR methods may result
in contradicting results. The contradiction may
9,458.18 occur on the following conditions:
37,016.59
1. The size and life of the project being studied are
common. A 10-year project with an initial
Moreover, assume that the positive cash flows will investment of P100,000 can hardly be compared
be reinvested at the 14% cost of capital. The with a small 3-year project costing P10,000
future value of the positive cash flows as shown Actually, the large project could be thought of as
above is P37,016.59. Divide the future value of the 10 small projects. Thus, if the IRR and the NPV
cash flows by the present value of the initial outlay methods are used to compare a big, long-term
(P18,000) and find the geometric return for 5 project with a small, short-term project, different
periods. selection results are produced.

2. The projects whose cash flows are erratic. The

37,016.59
5 cash flow of one project may continuously increase
𝑀𝐼𝑅𝑅 = √( )−1 over time while the cash flow of the others may
18,000
increase, decrease, stop, or become negative.
= 15.51% Erratic cash flows provide more than one IRR. In
comparison, the NPV provides only one value.
The 15.51% MIRR is lower than the IRR of
16.80%. In this case, the IRR provides a too 3. The timing is problematic. This is evident in
optimistic picture of the potential of the project projects that require the same initial investment
while the MIRR gives a more realistic evaluation. and last for the same number of years whose cash
flows, however, are timed differently.

Profitability Index

The profitability index is the ratio of the total PV of

future cash inflows to the initial investment, ie, %.
It is used to rank projects in a descending order of

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 FIMO BSAIS 4-YA-1 MIDTERMS REVIEWER

Example: acceptable projects that will provide the highest

overall NPV. Unlike mutually exclusive projects,
Assume the following:
capital rationing without losing the opportunity to
Project A Project B undertake other projects as long as the capital is
Year 0 (P1,000) (P1,000) available.
1 0 450
In capital rationing, the profitability index and the
2 50 350
same information used in the NPV method to
3 100 300
arrive at a decision are applied. The only difference
4 200 200
is that for each project, the sum of the discounted
5 1,500 100
future cash flows is divided by its corresponding
investment to establish the profitability ranked
The cost of capital is 10%. index of the projects that must be from highest to
lowest to satisfy the objective of capital rationing.
Computing the IRR and NPV at 10% provides the
following rankings: A common problem encountered in the use of the
profitability index in capital rationing is the lack of
IRR NPV training among finance managers in its use.
Project A 14.1% 184.44
Project B 15.9% 122.44

Example:
The NPVs plotted against the appropriate discount
rate form a graph called the NPV profile. A company with a fixed budget of P300,000 needs
to select a combination of acceptable projects from
the following:

At a discount rate larger than 12.5%, B has a Projects Initial Present NPV Profitability Ranking
Outlay Value (P) Index
higher NPV than A. Therefore, B should be
(P)
selected. At discount rate less than 12.5%, A has A 90,000 112,500 22,500 1.250 3
a higher NPV than B. Therefore, A should be B 80,000 90,000 10,000 1.125 4
selected. The correct decision is to select the C 120,000 180,000 60,000 1.500 2
D 80,000 80,000 0 1.000 5
project with the higher NPV since the NPV method E 40,000 30,000 10,000 0.750 6
assumes a more realistic a reinvestment rate, i.e., F 50,000 90,000 40,000 1,800 1
the cost of capital.
Based on the ranking using the profitability index,
The contradicting results between the NPV and IRR
the company should select projects F, C, and A for
also arise from the assumptions made with respect
having an overall combined NPV of P122,500.
to the reinvestment rate on the cash flows from
the projects. The NPV method assumes that the
reinvestment rate is based on the cost of capital
while the IRR method relies on the computed IRR. Replacement Decision

The NPV method generally gives a correct ranking, The replacement decision is the process by which
since the cost of capital is a more realistic the management will decide on whether to replace
reinvestment rate. an existing fixed asset with a new one. The
analysis differs from that of a proposed acquisition
of a new unit in that the old asset still generates
cash inflows which need to be compared with the
Capital Rationing
cash inflows to be generated by the new one. The
When a firm's ability to invest is constrained by its difference on the cash flows between the new
limited capital, the firm should choose among the asset and the old asset is used in making the
project proposals those which will give it the replacement decision.
highest return, be it a mix of acceptable projects
or not. This is where capital rationing comes in.
Capital rationing deals with the combination of

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Formula for the Net Investment Cash inflow and savings

Cost of asset Net proceeds from sale of

Purchase price xxx old machine – market P48,000
Delivery cost xxx value
Installation cost xxx xxx Add: Tax benefit on loss
Incremental working capital xxx 4,200
(60,000-48,000) x 35%
Immediate cost savings (xxx)
P52,200
Proceeds from sale of an asset (xxx)
Taxes on sale of old asset – gain xxx Savings – cost on
or taxes on sale of old asset - loss (xxx) immediate repairs
Net Investment xxx needed on old machine, 6,500 58,700
net of tax P10,000 x (1-
Incremental Cash Returns 35%)
Net Investment P121,300
Increase in revenues after tax xxx
Increase in cash charges (xxx)
Increase in depreciation xxx Incremental cash returns
Incremental cash returns xxx
Incremental net income
Increase in annual revenue
P100,000
Example: (P200,000-P100,000)
Increase in out-of-pocket
The following data are given on a new machine and operating cost (P100,000- (20,000)
an old one that is intended to be replaced: P80,000)

New Old Increase in depreciation

Cost (life - 5 years) P150,000 charges
150,000 60,000 (18,000)
Book value (remaining P 60,000 −
life - 5 years) 5 𝑦𝑒𝑎𝑟𝑠 5 𝑦𝑒𝑎𝑟𝑠
Market value 48,000 Incremental income before
P62,000
Working capital 50,000 20,000 income tax
requirement Incremental income tax
(21,700)
Annual revenue 200,000 100,000 (35%)
Annual out-of-pocket 100,000 80,000 Incremental net income P40,300
operating costs Add: Incremental
Immediate repairs on old 10,000 18,000
depreciation
machine to Incremental cash returns P58,300
operate efficiently
Income tax rate 35.0%
After getting the incremental cash return, the
different capital budgeting methods may now be
Required: Compute the net investment and applied.
incremental cash returns.
For the purpose of illustration, use the NPV to
determine the acceptability of the project. Assume
Net investment further that the cost of capital is 12%.

Cash outflow: 1 − (1 + 𝑖)−𝑛

𝑁𝑃𝑉 = 𝐼𝑛𝑐𝑟𝑒𝑚𝑒𝑛𝑡𝑎𝑙 𝑐𝑎𝑠ℎ 𝑟𝑒𝑡𝑢𝑟𝑛
𝑖
Cost of new machine P150,000 − 𝑁𝑒𝑡 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
Incremental working
30,000 P 180,000 1−(1.12)−5
capital = 58,300 ( ) − 𝑃121,300
0.12

= 58,300 (3.6048) - 121,300

= P88,859.84

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 FIMO BSAIS 4-YA-1 MIDTERMS REVIEWER

Since the NPV is positive P88,859.84, the project 0 1 2 3 1 2 3

is accepted.

-20,000 7,000 13,000 12,000

-20,000 7,000 13,000 12,000
Capital Budgeting Decisions on Projects with
Unequal Lives
NPV = P5,155 NPV = P5,155 (1.12)-3
Decision-making on projects that are independent
from one another is not complex. Decisions can be + 3,669
made independently as long as the projects meet P8,824
the demands of the firm regardless of their
respective lives. However, if projects are mutually Based on the given example, Project B has a life
exclusive and have unequal lives, the impact of the of 3 years while project A has a life of 6 years.
different lives must be considered over Since the two proposals have unequal lives and it
comparable periods. is not proper to compare their NPVs based on the
original life of B, it is assumed that project B is
replaced with a similar investment at the end of 3
The approaches are as follows:
years. Thus, Project B is viewed as two Project Bs.
1. Replacement chain (common life) approach
The NPV of the first Project B was P5,155 and upon
2. Annualized net present value (ANPV) approach
replacement, the second Project B created the NPV
of P3,669. The figure is obtained by computing the
Replacement Chain (Common Life) Approach present value of the first NPV. Since the total NPV
of Project B is P8,824 and Project A has an NVP of
The replacement chain (common life) approach is
P6,941, Project B should be accepted because it
a process in which projects with unequal lives are
has a higher NPV.
compared using their respective NPVs. It assumes
that at the end of the life of the projects, a Assume that the life of project A is 10 years and
replacement is made until the project proposals Project B is 6 years. The replacement cycle for
arrive at a common terminal date. The same Project A is 3 times and that of Project B is 5 times,
amount of initial investment, cash inflows, cost of 30 being their least common denominator.
capital, and life of the project are used. The NPV
of each proposal is determined and one or more
iterations can be completed to create comparable Annualized Net Present Value (ANPV)
time frames for the proposals. Thus, the short- Approach
lived project proposal is reinvested at the required
rate of return until it is equal to the longer-lived The annualized net present value (ANPV) approach
project proposal. By comparing the proposals over is used when comparing mutually exclusive
like periods of time, the accept-reject information projects that have an unequal duration. The ANPV
for the various proposals becomes more reliable. method is an efficient method to convert the NPVs
of projects with unequal durations into an ANPV for
each specific project which can then be compared.
The ANPV is determined by dividing the NPV of
Example:
each project over its life using the appropriate cost
The costs of capital for two mutually exclusive of capital. The projects with a negative NPV are
projects are as follows: disregarded. Those with a positive NPV are divided
by the present value factor for an annuity at the
Project A
given cost of capital and the project's life in order
0 1 2 3 4 5 6 to get the annualized NPV. The project proposal
with the highest ANPV is chosen.

-40,000 8,000 14,000 13,000 12,000 11,000 10,000

From the cash flows presented above, the NPV is

determined at P6,491.
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 FIMO BSAIS 4-YA-1 MIDTERMS REVIEWER

Example: Compute the NPV of Project Y:

Anna Pova Corporation has two mutually exclusive NPVy =

projects, X and Y, in which it can invest. The initial
investments required for project X and Y are 1 − (1 + 𝑖)−𝑛
𝐼𝑛𝑐𝑟𝑒𝑚𝑒𝑛𝑡𝑎𝑙 𝑐𝑎𝑠ℎ 𝑟𝑒𝑡𝑢𝑟𝑛
P150,000 and P200,000, respectively. The 𝑖
duration of Project X is 4 years and that of Project − 𝑁𝑒𝑡 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
Y is 3 years. The incremental cash return from
Project X is P50,000 and that from Project Y is 1 − (1 + 1.09)−3
𝑃90,000 − 𝑃200,000
P90,000. The cost of capital of Anna Pova 0.09
Corporation is 9% and both projects have an
average risk which means that the alteration for
𝑃90,000 (2.531) − 𝑃200,000
risk-adjusted discount rate is not required. 𝑃27,790

What is the ANPV for Projects X and Y? After getting the NPV of Project Y, compute its
ANPV.

ANPVy =
Answer: 𝑁𝑃𝑉
1 − (1 + 𝑖)−𝑛
First, compute the NPV of Project X:
𝑖
NPVx =
=
−𝑛 𝑃27,790
1 − (1 + 𝑖)
𝐼𝑛𝑐𝑟𝑒𝑚𝑒𝑛𝑡𝑎𝑙 𝑐𝑎𝑠ℎ 𝑟𝑒𝑡𝑢𝑟𝑛 1 − (1.09)−4
𝑖
− 𝑁𝑒𝑡 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 0.09
1 − (1 + 1.09)−4 =
𝑃50,000 − 𝑃150,000 𝑃27,790
0.09
2.531
𝑃50,000 (3.2397) − 𝑃150,000
=
𝑃11,985 𝑃10,979.85
After obtaining the NPV of Project X, compute the
value of its ANPV: Since the ANPV of Project Y is P10,979.85 which is
higher than that of Project X at P3,699.42, Project
ANPVx = Y is selected.
𝑁𝑃𝑉
1 − (1 + 𝑖)−𝑛
𝑖
=
𝑃11,985
1 − (1.09)−4
0.09
=
𝑃11,985
3.2397
=
𝑃3,699.42

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 FIMO BSAIS 4-YA-1 MIDTERMS REVIEWER

CHAPTER 4 What the proper combination of long-term debts

and equity in a company should be type of
LONG-TERM FINANCING: DEBTS
organization and credit availability and the after-
Debts tax cost of financing. If a firm had of financial
leverage, it can take steps to minimize other
Usually paid on installment, long-term debts are corporate risks.
obligations that mature in 2 to 20 years. Firms
without access to the financial market approach Debt-financing is advisable in the following
commercial banks, insurance companies, or other situations:
financial institutions as an alternative even if the
1. The firm's revenues and earnings are stable.
latter's interest rates are considerably higher.
2. The firm has adequate liquidity and
Long- term debts are incurred to purchase capital
determinable cash inflows.
assets such as land, buildings, and machinery or
3. The firm has a low debt-to-equity ratio.
equipment. They are obtained for the purpose of
4. Inflation is expected.
expansion or payment of mature obligations.
5. The indentures on the debt contract are not
Similar to a bond. a long-term debt is sometimes
burdensome.
collateralized by real estate or chattel. In some
instances, however, bonds do not require any
A firm whose default risk is higher than others
security.
incur a higher borrowing cost to compensate the
The advantages of issuing long-term debts level of risk the lender assumes.
include the following.
Long-term debts are expected to be repaid in a
1. Unlike dividends declared, the interest can span of not less than a year. Firms that issue are
serve as a "tax shield." expected to pay the principal upon maturity and to
make timely interest payments on t balance for a
2. Long-term debts help increase a firm's EPS. certain period. Examples of long-term debts are
mortgages, bond issuances, and lease-
3. The repayment of a long-term debt (in pesos)
is cheaper during times of inflation. These obligations are classified in the balance
sheet under long-term liabilities.
4. The outstanding shares of stock are not diluted
because new shares of stock are not issued. There are two major forms of long-term debts:
5. The issuer of the bonds enjoys financial 1. Publicly-issued obligations are, as the term
flexibility because of the call provision in the bond itself indicates, obligations which are issued
indenture. A call provision permits a firm to Common examples include the issuances of bonds
redeem the bonds before the maturity date. and long-term commercial papers.
The disadvantages of issuing a long-term debt 2. Direct or private placement are obligations
include the following: placed by individuals directly to a company
purpose of lending money. The money placed with
1. A scheduled interest payment is required
the firm earns interest according agreement. A
regardless of the firm's actual earnings.
document, such as a promissory note or a
2. A firm with a considerable amount of certificate, is issued by the firm lender as a proof
outstanding loans does not project a "healthy" of ownership. This type of obligation is not offered
financial position. to the public as the conditions are settled between
the borrowing firm and the lending individuals.
3. Companies with high financial leverage normally Usually, the rate offered by the firm is higher than
pay a higher interest due to their low credit rating. the interest rate offered by a banking institution.
4. A covenant provision in the indenture which However, this type of placement has a higher risk
subjects a firm to certain constraints is very of default.
common.

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 FIMO BSAIS 4-YA-1 MIDTERMS REVIEWER

Mortgages 2. less covenants on financing

3. extended maturity dates on the payment of the
Mortgages are obligations granted by banks or
principal and interest
other financial institutions to the borrower that
estate or movable assets as collateral. The
At times, the collateral on an outstanding
borrower is called as the mortgagor and the lender
mortgage is used as a collateral to secure a second
is the signing a deed of assignment. As a rule, a
mortgage. In this case, the first mortgage is
mortgage can cover only fixed assets. When real
termed as the senior or first mortgage while the
estate takes place when the owner of the property
second mortgage is the junior or second
conveys the title to the mortgagee by signing a
mortgage. In case a conflict between the senior or
deed of assignment. As a rule, a mortgage can
junior mortgage arises, the senior mortgage is
cover only fixed assets. When real estate is
prioritized.
collateral, the mortgage is called a real estate
mortgage, but when an automobile or a piece of
equipment used, the mortgage is called a chattel
Requisites of a Mortgage
mortgage.
The following are the requisites of a mortgage
contract:
The collateral which is the subject of the mortgage
1. The mortgage is constituted to secure the
still belongs to the mortgagor. It serves security on
fulfillment of the obligation.
the mortgagee, i.e., in case of non-payment of the
obligation by the mortgagor, the may foreclose 2. The absolute owner of the property to be
and then sell the property mortgaged. The mortgaged is the mortgagor himself/herself.
proceeds from the sale are then applied
obligations and the expenses associated with the 3. The mortgagor has the free disposal of the asset
sale and preservation of the property while in the to be mortgaged.
of the mortgagee. If the mortgagor is able to
comply with the agreement as mentioned in the
contract, however, the mortgagor has all the right Bonds
to demand the full title to the property mortgagor.
A bond is a long-term debt in which the
Mortgages are issued to help the borrower finance corporation that issued the bonds owes the
the acquisition of capital assets, construction of bondholders a debt and is obliged to repay the
plants, and expansion of operations. However, the principal at its face value on the maturity date or
amount of the loan is always below the appraised to make periodic interest payments until the
value selling the property. Normally, the value principal is paid.
ranges from 70%-90% of the appraised value of
the collateral. In addition, the real estate serving Market participants normally use "bonds" for large
as a collateral should be located in the city and issues offered to a wide public and "notes" for
considered a prime lot. An individual or an entity small issues originally sold to a limited number of
can apply for a mortgage with life insurance investors. There are no clear demarcations
companies or other financial institutions, aside between the two. "Bills" usually denote fixed-
from banks. income securities within three years or less from
the date of issue pose the to the date of maturity.
A mortgage may have a closed-end provision that Bonds have the highest risk; notes come as the
prohibits the firm from issuing additional debts of next high risk; and bills lowest risk. This difference
the same priority against the mortgaged property. is due to a statistical measure called duration,
If the mortgage is open-ended, the company can which states that the shorter the duration, the
issue additional first-mortgage bonds against the lesser the risk (e.g., a short-term debt is less risky
property. than a long-term one because of its shorter
duration).
Among the advantages of using a mortgage are
the following: When a firm needs a large sum to finance its
activities, it may have to borrow from the general
1. lower interest rate
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 FIMO BSAIS 4-YA-1 MIDTERMS REVIEWER

investing public by using a bond issue. Prior to the A bond indenture is a legal document that contains
issuance, the approval of the Securities and the rights of the bondholders and de Some of the
Exchange Commission (SEC) must be obtained. possible provisions in a bond indenture are as
Bonds are used primarily by corporations and follows:
government agencies. In case the issuer becomes
1. details of the terms of the bonds issued
insolvent, the bondholders have a priority of claim
2. covenants
on the firm's assets and dividends over the
3. call provision
preferred and common stockholders.
4. conversion provision
5. retirement provision
6. sinking-fund provision
Features of a Bond Issue

1. A bond indenture or deed of trust is a detailed

Details of the Terms of the Bond Issued
document which contains the essential regarding
the bond issued. It also includes the rights and The following are the details of the terms of the
duties of the borrower and parties to the contract. bond issued:

2. A bond certificate which represents a portion of 1. The nominal rate or principal or face
the total loan is used. The denomination in amount of the bond issuance is the agreement
business practice is P1,000 although smaller the nominal rate to be used when computing the
denominations are interest and principal to be paid on date.

3. If property is pledged as a security for the bond 2. The issue price is the price with which
issue, a trustee who will hold the de denomination investors can buy the bonds when they are d net
in business practice is P1,000 although smaller proceeds the issuer receives are computed as the
denominations a serving as the security is issue price less the issuance fees consist of the
identified. The trustee acts as the representative present value of the face value of the value
of the is usually a bank or trust company. payments.

4. A bank or trust company is appointed as the 3. The maturity date is the date on which the
registrar or disbursing agent. The issuing the issuer has to repay the nominal amount. As long
interest and principal payments to the disbursing as all the payments are made, the issuer no longer
agents who will then distribute the bondholders. has any other obligation to the bondholders after
In other words, the bank or trust company is the the term or maturity of a bond. The maturity can
one which e terms and covenants indicated in the be of any length of time, although debt securities
indentures are followed strictly by the issuing the maturity date. The length of time from the
firms. start up to the maturity date is often referred to
as with a term of less than one year are generally
designated as money-market instruments rather
Bond Indentures than bonds. Most bonds have a term of up to 30
years. Some bonds are issued with maturities of
the features of the bond issuance. The bond up to 100 years. In fact, some do not even mature
indenture is sometimes called a deed of s The at all.
terms and conditions in a bond issuance are
determined in the bond indenture intermediary,
normally a bank, acts as a trustee and represents
Covenants
the bondholders. Thus, d ensure that the
stipulations in the bond indenture are diligently Covenants are the part of bond indentures that
followed; the sinking find and the bondholders (in restricts certain actions of the issuer, eg., incurring
case the issuing company defaults on its additional obligations. There are two types of
payments) are represented trustee acts as an covenants:
agent of the bondholders, the issuing company
1. Protective covenants state the actions or
chooses who the trustee will bonds are issued.
conditions which a company should do. Listed
below are some examples:

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 FIMO BSAIS 4-YA-1 MIDTERMS REVIEWER

a. A specified working capital ratio or a e. A restriction on investing which reduces

specified level of working capital is a the cash in the company's books and,
covenant that recognizes the importance of therefore, increases the risk of non-
having a sound current position. payment, is also common.

b. The accounting records must be f. A restriction on merging with another

maintained in accordance with the company is also common because a merger
International Accounting Standards and may impair the rights of the bondholders.
International Financial Reporting
Standards. Financial statements must be
timely audited and submitted to the Call Provision
trustee.
The call provision provides the issuer of the bonds
c. The security used as the collateral must with the right to redeem the bonds previous before
be maintained in good order and running the maturity date, thus enabling the corporation to
condition. pay off the bonds due. Corporations right the
moment they see an opportunity to reduce cost by
2. Negative covenants state the actions or
paying off obligations early. A call thus, works to
conditions which a company should not do. Listed
the best interest of the issuer. If the interest rate
below are some examples:
declines, the issuer is provided financial flexibility
a. The acceleration clause states that if any because it can buy back the bonds at the price
of the conditions in the bond indenture is based on the agreement. With the of the bonds
breached, the trustee may declare a previously issued, the firm may now issue a new
default, causing the entire amount of the set of bonds with a lower Although the price of the
principal along with the interest that has bond increases due to the decline in the interest
accrued all due and demandable. A grace rate, the firm saves more issuance of coupon
period is usually allowed to remedy the payment which it regularly pays.
breach. However, upon the expiration of
In general, the call price is greater than the par
the grace period, the trustee is authorized
value of the bond. The difference between price
to take legal action against the issuer of the
and the par value is called the call premium. The
bonds to protect the bondholders.
call premium becomes smaller as the callable
b. A prohibition on making additional loans bonds approaches.
protects the bondholders from the risk of
Bondholders oppose the inclusion of a call
not being paid.
provision for obvious reasons. If the interest rate
c. By disallowing the collateral to be used de bondholders will have a limited gain due to the
in obtaining additional loans, existing possibility of the bonds being called. As such, the
bondholders are protected from the dilution taking into consideration the call provision, now
of the asset coverage of the bond issue. has to ask for a higher coupon rate or a lower so
Although the senior mortgagor has the first that in case of a decline in the interest rate, he/she
claim over the assets collateralized, this is somehow benefited by the capital appreciate the
set-up avoids the possibility of having bond while enjoying a high coupon rate and at the
another creditor who can claim the asset. same time holding the callable bond.

d. A limitation on the amount of dividends Normally, call provisions are not operative during
which can be declared avoids excessive the early years of the callable bonds. He safe for
dividends from being distributed to the bondholders to purchase such, although a
stockholders. Without this limitations, provision is sometimes included in the bond
stockholders can "bleed" the corporation by prohibiting the call provision for a certain period of
withdrawing exorbitant dividends, putting time. In this case, the call is called a deferred the
at risk the ability of the firm to pay the bond is call protected.
bondholders. The same covenant is applied
to stock repurchase which also reduces
cash.
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 FIMO BSAIS 4-YA-1 MIDTERMS REVIEWER

Conversion Provision price of the bonds declines below face value; thus,
firms prefer to use the sinking fund to purchase
To make a bond issue more attractive to investors,
bonds in the open market. Consequently, if the
the issuing corporation provides investors option
interest rate decreases after the date of issuance,
of converting the bonds purchased into other
the market price of the bonds exceeds the bond's
forms of security such as a preferred or common.
face value, then firms prefer to pay the bonds at
The conversion privilege becomes less attractive their call price.
as the maturity date approaches. For instant year,
$100,000-bond may be convertible into 2,000
shares of common stock during the first 5 years Sale of Bonds
the date of issue, 1,000 shares for the next 5
Bonds are usually too expensive to sell to only a
years, 500 from the 10th year to the 15th year,
few investors. Thus, a borrower may split a bond
and may be convertible during the last 5 years of
issuance into many small units of, say, P1,000,
its life.
P10,000, or P100,000, so that many investors can
Convertible bonds issued at a premium or discount afford to buy the bonds. Each of these units is a
are amortized from the time they the date of note payable to the investors who bought the
maturity instead of the date of conversion. This bonds and in less grants a loan to the issuing
scheme makes sense because the conversion company. Often, bonds are sold in equal
bonds into their intended security is too difficult to denominations for convenience Each of the bonds
forecast. Moreover, there is no guaranty that issued is evidenced by a certificate called a bond
privilege will even be exercised by the bondholder. certificate. Thus, a P1000,000 face-value bond
when sold can be divided into 10 bond certificates
with P100,000-denominations per certificate. A
Retirement Provision bondholder looks for a financial intermediary who
will assume responsibility for the sale of the bonds.
The bond indenture also includes how the bonds
issued are to be repaid. The retirement of bonds The bonds issued may either be an interest-
can be done in several ways: bearing bond or a non-interest-bearing bond. An
in bearing bond is a bond that earns interest on
1. payment on the maturity date specific intervals, normally a period of six months.
2. conversion, if the bonds issued are convertible The inte payment to the bondholder is called the
3. call, if the bonds have a call feature nominal interest which is the interest on the face
4. periodic payment, if the bonds issued of the bond. It is equal to the coupon or nominal
interest rate multiplied by the face value of the
bond. The interest on the bond is tax deductible;
Sinking-fund Provision
hence, firms prefer to issue bonds rather than new
A sinking-fund provision is a provision which shares of mock because bonds function as a tax
requires the issuing corporation to se pay off the shield.
bond issuances. This amount is given for
The bond issuance is not free from cost. When
safekeeping to the tree who despa the debt in part
bonds are issued, printing, engraving, and
or in full.
promotional costs; legal, accounting, commission,
The sinking fund provision may take two forms and registration fees; and other similar charges
are paid. The cof the bond issues are added to the
1. The trustee receives cash payment from the bond discount or deducted from the bond premium
corporation that led the bod received, the trustee and ad the entire life of the bond.
then calls the bonds the sinking fund call price
When bonds are issued between the dates of
2. The bonds are purchased in the open market. interest payment, the accrued interest is charged
As earlier mentioned, the issuing corporation may against the bondholder. When a bond is sold below
either buy back the bonds in the mazer o CARICA its face value, the bond is considered sold at a
its right to make a call. In this context, if the discount. A bond sold above its face value is
interest rate increases after the date of the mate considered issued at a premium. Both the amount

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 FIMO BSAIS 4-YA-1 MIDTERMS REVIEWER

of the discount and the premium are amortized Types of Bonds

from the time the bond is acquired up to the time
The common characteristics of the various types
the bond matures. The bond issue costs, also a
of bonds are as follows:
tax-deductible expense, must also be amortized
over the life of the bond. 1. Term bonds are bonds that mature on a single
date. They usually require that firms establish a
sinking fund so that upon maturity, they will not
Security to a Bond Issuance encounter any difficulty in paying off the maturing
obligation. A term bond is the same as a straight
In a legal sense, what distinguishes bonds from
bond.
the other types of debt instruments is the
collateral (i.e., the assets "backing up" the loan) 2. Serial bonds are bonds in which the principal
and the rights attendant to it. Most bonds do not amount matures in a series of payments rather
have any specific security attached to them and than a single payment. Thus, serial bonds allow a
should really be called unsecured debentures. company to pay off its obligations on installment,
Thus, in case of default, the bondholders are not i.e., a fraction of the total is paid until the time the
prioritized over the unsecured creditors. Since bonds reach their final maturity. The individual
governments do not pledge specific securities, bonds in this type of arrangement may bear
most government bonds are actually debentures. different coupon interest rates. It can be expected
An unsecured debenture usually has a negative that bond issues with a short life have lower
pledge which prevents the issuer from having coupon interest rates than those issued with a long
assets secured ahead of that issue. Any bond life. In a sense, serial bonds favor investors
issues which have senior issues are subordinate. because they let investors pick the maturities that
satisfy their requirements. Firms with temporary
A secured debenture is so-called because
idle cash prefer serial bonds with a short life while
particular assets are attached to it, e.g., a factory,
companies with long-term interests or concerns
building, or shopping center. If a real estate
prefer those with long life. However, bonds with
collateral is involved, these bonds are known as
serial maturities are seldom used in corporate
mortgage bonds. A mortgage bond is different
mortgage and debenture issues. Examples of
from a mortgage, which is a legal document
serial bonds are equipment trust certificates and
registered against a particular real estate asset. A
municipal bonds.
mortgage bond is a bond with a trust indenture
which secures its collateral by way of a mortgage. 3. Secured bonds are bonds issued with fixed
A first- mortgage bond has the first mortgage and assets pledged as collateral. Lenders or investors
senior claim on an asset or a group of assets. prefer that the firm's fixed assets, particularly land
and building, be attached to the bond issuance. An
example is mortgage bonds. At times, firms use
Intermediary to a Bond Issuance the same property in several bond issuances. If
one of the issues is favored or mortgaged for the
Firms that want to issue bonds do not have to sell first time, it is called a first mortgage (also closed-
directly to the investors. They usually ask the help end mortgage bond) and the one with a less
of a third party or intermediary to facilitate the favored or mortgaged for the second second
issuance and sale of bonds. Investment banks mortgage. In case of default, the bondholders of
perform the tasks of the intermediary. They are the first mortgage bonds have over the property
responsible for studying how the investor and pledged over the bondholders of the second
issuer can benefit from the bonds about to be mortgage.
issued. Similar to a good debtor-individual, a firm
has to follow all of the stipulations indicated in the Another type of mortgage bond is the open-end
bond indenture. mortgage bond. This type of bond is not accepted
by bondholders because it treats the claims of the
second mortgagee and the first mortgagee
equally.

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 FIMO BSAIS 4-YA-1 MIDTERMS REVIEWER

The property mortgaged contains a full description payment can be skipped under income bonds
so that in case of default, the can easily locate whenever the firm incurs losses. These bonds are
which assets can satisfy its claim. When a property rarely issued by firms to cre at times of
is mortgaged, the value asset is pegged higher reorganization under bankruptcy proceedings.
than the amount of the bond. A bond's value
5. A registered bond requires that the name of
covers around 70%- the appraised value of the
the bondholders be registered in the books the
property to protect the interests of the
corporation. A registered bond bears the name of
bondholders in times value of the asset (in addition
the owner on its face value and the stipulation
to the cost of selling the property) fluctuates. Once
promises to make principal and interest payments.
the bondholders are satisfied, the excess proceeds
The corporation or the, keeps the record of the
from the sale of the property are returned to
owners of the registered bonds which constantly
issuer.
changes whenever transfer takes place. If the
Many firms, as part of their investment, own owner wants to sell or transfer the registered
stocks and bonds of other corporation investment bond, an endorsement must be made on the bank
securities owned by a firm can be used as a certificate in favor of the buyer or transferee. The
collateral of the issuing firm. This bond is also new owner of the bond will bend them to the
called a collateral trust bond. Here, the quality of issuing company for cancellation and will receive a
the security is highly depending the quality of the new registered bond payable so his/her name. A
pledged stocks and bonds. common advantage of a registered bond is its
security from the loss or theft of the bond
If the equipment is used as a collateral to a bond
certificate.
issuance, it is called an equipment bond.
6. Coupon or bearer bonds are bonds where a
4. Unsecured bonds are bonds issued without
sheet of coupons is attached to the bond
collateral. An example is a debenture bond. Alt
certificate. Each coupon represents an interest
securities to a bond issuance are of prime
payment to be made from the date of issue to the
importance to bondholders, the firm's liquidity
date of maturity. Unlike in registered bonds, the
dete the "attractiveness" of the bond in the final
issuing company does not know who the
assessment. Only firms with a high bond ra
bondholders are or when the bonds are sold or
allowed to issue debenture bonds.
transferred. Thus, the interest on coupon bonds is
A debenture may include a negative pledge clause paid to the bearer.
or an equal and ratable security clause a negative
7. The holders of convertible bonds can
pledge clause, the issuer is restricted from
exchange the bonds for a predetermined number
pledging assets to secure another debt the
of shares of corporate stock. Bondholders of this
debenture bondholders give their approval. In this
type of bond can either receive interest payments
case, the bond contract has to be amended. Under
in addition to the face value of the bond on its
an equal and ratable security clause, bondholders
maturity date or at the instance of a sudden
allow the issuer to attach fixed ass pledge to
increase in the company's stock price, trade the
secure another debt, provided that equal rights are
bonds for the appreciated stock. Investors prefer
given to them on the claims the assets pledged.
this kind of securities and are usually willing to
A subordinated bond is another example of a accept interest rates lower than those of bonds
debenture bond. The claims under this bond are which are not convertible.
inferior to the claims of the other creditors
8. Callable bonds are bonds which may be called
enumerated in the bond indenture. Using they are
for redemption prior to the maturity date. If
subordinated to straight debentures or unsecured
interest rates go down, the company may not want
bank debts. The borrowing subordinated bonds is
to be saddled with the higher cost obligations. As
higher than those of other debts because of the
such, they can escape the obligations by calling
higher risk the investment willing to take.
the debt.
An income bond is also an unsecured bond.
9. Guaranteed bonds are made when a company
Bondholders of this kind of bond receive only when
or individual (other than the issuing company)
the firm has a sufficient income. Thus, interest
accepts the obligation to pay the interest and

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 FIMO BSAIS 4-YA-1 MIDTERMS REVIEWER

principal in case of default. The one who accepts Bond Refunding

the guarantee of payment is called the guarantor.
Also known as bond refinancing, bond refunding
A guaranteed bond is issued to make the issuance
refers to issuance of new bonds to pay off
more "attractive" to investors. The credit position
outstanding bonds. The payment is done long
of the issuer is probably relatively weak; without
before the maturity date of the outstanding bonds
any guarantee from an outside party, the bond
and when the interest rate is expected to decline.
issuance may not be a good potential investment.
Bond refunding may be done through either the
10. Junk bonds are high-risk, high-yield bonds issuance of a serial bond or the exercise of a call
issued by companies that have numerous provision in the bond.
outstanding obligations or that are in a weak
A call provision in the bond issue is included in the
financial condition. Likewise, they can be issued by
bond indenture and recommended when the
companies that once had high credit ratings but
interest rate in the future is expected to decline.
have fallen on hard times; emerging growth
Such a provision enables the firm to take
companies that lack an adequate cash flow, credit
advantage of a decreasing interest rate by buying
history, or diversification; and companies
back the higher-interest bond and issuing bonds
undergoing restructuring, often in conjunction
with lower interest rate. The call price on the bond
with a leveraged buyout. This kind of bond gained
is usually higher than the face value of the bond.
popularity in the 1980s.
Thus, a premium must be paid to enable the
11. Floating-rate bonds are a type of bond bondholders to resell their bonds to the issuer
where the interest payment changes due to the before the maturity date. A bondholder receiving
fluctuations in the interest rate. A conventional a high yield of interest is less likely to sell his/her
bond has a fixed rate specified in the face of the bondholding unless the face value of the bonds has
certificate which serves as the basis when a premium.
computing periodic interests. A floating-rate bond
is normally used by banks at times when the
inflation rate, together with the interest rate, is
relatively uncertain.

Bond Ratings

When a company decides to go public when issuing

bonds, a rating agency, such as PhilRatings, rates
its bonds qualitatively and quantitatively. The
ratings obtained characterize the estimated
possibility of default by the issuer. Firms declaring
the scheduled offering of bonds are thoroughly
investigated by the rating agencies whose report
considerably affects the salability of the bond
issuance and the interest to be required. There is
an inverse relationship between the quality of a
bond issue and its yield, ie, low-quality bonds have
a higher yield than high-quality bonds. Thus, the
bondholder is subjected to a risk-return trade- off.
Bond ratings are important to financial
management because they influence marketability
of, and the costs associated with the bond issue.

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 FIMO BSAIS 4-YA-1 MIDTERMS REVIEWER

FINANCIAL STATEMENT ANALYSIS goods sold refers to the direct cost of production
and does not include operating expenses, interest,
Financial statement analysis or taxes. In other words, the gross profit margin
➢ is the process of reviewing key financial is a measure of profitability, specifically for a
documents to gain a better understanding of product or item line, without accounting for
how the company is performing. While there overheads.
are many different types of financial Gross Profit Margin = (Revenue - Cost of
statements that can be analyzed as part of Sales) / Revenue * 100
this process, some of the most important,
especially to managers.

It includes the: 2. Net Profit Margin

Net profit margin is a profitability ratio that
1. Balance Sheet: A statement that lists a measures what percentage of revenue and other
business’s assets, liabilities, and owners’ income is left after subtracting all costs for the
equity at a specific point in time. business, including costs of goods sold, operating
2. Income Statement: A statement that expenses, interest, and taxes. Net profit margin
summarizes a business’s revenues, expenses, differs from gross profit margin as a measure of
and profits over a period. profitability for the business in general, taking into
3. Cash Flow Statement: A statement that account not only the cost of goods sold but all
captures how cash flow is affected by other related expenses.
activities from the balance sheet and income
statement, categorized into operating, Net Profit Margin = Net Profit / Revenue *
investing, and financing activities. 100
4. Annual Report: A document that describes
the company’s operations and financial
conditions, and typically includes the 3. Working Capital
documents listed above, in addition to other Working capital is a measure of the business’s
insights and narratives from key figures within available operating liquidity, which can be used to
the company. fund day-to-day operations.

Working Capital = Current Assets - Current

Financial KPIs (key performance indicators) Liabilities
are metrics organizations use to track, measure,
and analyze the financial health of the company.
These financial KPIs fall under a variety of 4. Quick Ratio
categories, including profitability, liquidity, The quick ratio, also known as an acid test ratio, is
solvency, efficiency, and valuation. another type of liquidity ratio that measures a
business’s ability to handle short-term obligations.
By understanding these metrics, you can be better
The quick ratio uses only highly liquid current
positioned to know how the business is performing
assets, such as cash, marketable securities, and
from a financial perspective. You can then use this
accounts receivables, in its numerator. The
knowledge to adjust the goals of your department
assumption is that certain current assets, like
or team and contribute to critical strategic
inventory, are not necessarily easy to turn into
objectives.
cash.

Quick Ratio = (Current Assets -Inventory) /

12 FINANCIAL PERFORMANCE MEASURES TO Current Liabilities
MONITOR

1. Gross Profit Margin

5. Leverage
Gross profit margin is a profitability ratio that
Financial leverage, also known as the equity
measures what percentage of revenue is left after
multiplier, refers to the use of debt to buy assets.
subtracting the cost of goods sold. The cost of
If all the assets are financed by equity, the
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 FIMO BSAIS 4-YA-1 MIDTERMS REVIEWER

multiplier is one. As debt increases, the multiplier 10.Return on Assets

increases from one, demonstrating the leverage Return on assets, or ROA, is another profitability
impact of the debt and, ultimately, increasing the ratio, similar to ROE, which is measured by
risk of the business. dividing net profit by the company’s average
assets. It’s an indicator of how well the company
Leverage = Total Assets / Total Equity
is managing its available resources and assets to
net higher profits.

6. Debt-to-Equity Ratio ROA = Net Profit / (Beginning Total Assets +

The debt-to-equity ratio is a solvency ratio that Ending Total Assets) / 2
measures how much a company finances itself
using equity versus debt. This ratio provides
insight into the solvency of the business by 11. Operating Cash Flow
reflecting the ability of shareholder equity to cover Operating cash flow is a measure of how much
all debt in the event of a business downturn. cash the business has as a result of its operations.
This measure could be positive, meaning cash is
Debt to Equity Ratio = Total Debt / Total
available to grow operations, or negative, meaning
Equity
additional financing would be required to maintain
current operations. The operating cash flow is
usually found on the cash flow statement and can
7. Inventory Turnover be calculated using one of two methods: direct or
Inventory turnover is an efficiency ratio that indirect.
measures how many times per accounting period
the company sold its entire inventory. It gives
insight into whether a company has excessive 12. Seasonality
inventory relative to its sales levels. Seasonality is a measure of how the period of the
year is affecting your company’s financial numbers
Inventory Turnover = Cost of Sales / and outcomes. If you’re in an industry that’s
(Beginning Inventory + Ending Inventory / affected by high and low seasons, this measure
2) will help you sort out confounding variables and
see the numbers for what they truly are.

8. Total Asset Turnover

Total asset turnover is an efficiency ratio that VERTICAL AND HORIZONTAL ANALYSIS
measures how efficiently a company uses its
assets to generate revenue. The higher the Horizontal Analysis
turnover ratio, the better the performance of the
Also known as trend analysis, this method is used
company.
to analyze financial trends that occur across
Total Asset Turnover = Revenue / (Beginning multiple accounting periods over time—usually by
Total Assets + Ending Total Assets / 2) the quarter or year. It’s often used when analyzing
the income statement, balance sheet, and cash
flow statement.
9. Return on Equity Generally speaking, the greatest utility of
Return on equity, more commonly displayed as horizontal analysis lies in mining insights gleaned
ROE, is a profitability ratio measured by dividing from comparing changes to specific line items over
net profit over shareholders’ equity. It indicates time, identifying and targeting both opportunities
how well the business can utilize equity and potential disasters, and reacting accordingly.
investments to earn profit for investors.
Horizontal analysis can be used to examine (for
ROE = Net Profit / (Beginning Equity + example) the company’s profit margins over time,
Ending Equity) / 2 and create strategic spend projections to match
projected revenue growth or hedge against
seasonality or increased cost of materials.
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 FIMO BSAIS 4-YA-1 MIDTERMS REVIEWER

YOU CAN EXAMINE THE DATA FROM Using the same approach, we can do the same for
HORIZONTAL ANALYSIS IN A NUMBER OF 2019:
WAYS:
$6,000,000 – $4,500,000 = $1,500,000
Direct Comparison $1,500,000 ÷ $4,500,000 x 100 = 33.33%
revenue growth from 2017 to 2019.
A straightforward comparison of two periods to
one another in the original format (e.g., dollar
Horizontal analysis can be very useful in answering
amounts). So, if revenue for Q1 of 2019 was
common questions whose answers are critical to
$4,700,000 and Q2 revenue was $3,200,000, the
strategic planning and effective use of working
difference of $1,500,000 is where you would start
capital, including:
looking for answers (e.g., does the business have
a strong seasonal component, have costs risen or • Is net income growing or shrinking?
sales fallen due to disruptions, etc.) • Has the cost of goods sold (COGS) risen or
fallen?
Useful in establishing positive or negative changes
• How much has revenue grown compared to
between periods based on comparison to the
last quarter? Last year?
average of the squared difference from the mean
• Which areas of our business have changed the
for the total time measured.
most in the past quarter/year/etc.?
Let’s say you’re analyzing revenue for a three-year • Is our company managing liquidity well enough
period. to cover our outstanding debts?
• 2017 revenue was $4,500,000.
• 2018 revenue was $5,300,000.
• 2019 revenue was $6,000,000 Vertical Analysis

Variance Like horizontal analysis, vertical analysis is used

The mean of these three values is $5,266,700. to mine useful insights from your financial
After squaring the differences and adding them up, statements. It can be applied to the same
then dividing by the total number of items, we find documents, but is exclusively percentile-based
that the variance is $5,633,400. Taking the square and travels (as the name implies) vertically within
root of that, we get the standard deviation, which each period across periods, rather than
is $750,600. The average growth over the period horizontally across periods.
measured is $750,600 each year. This method is So, for example, when analyzing an income
particularly useful for both internal analyses to statement, the first line item, sales, will be
identify areas of growth and external analysis by established as the base value (100%), and all
investors or lenders who want to see demonstrable other account balances below it will be expressed
growth before committing their resources to your as a percentage of that number.
business.
XYZ Incorporated Vertical Analysis

2017 2018 2019

Percentage
Sales 25,000 27,500 35,000
Provides the option for greater granularity within
COGS 12,500 14,000 19,000
a horizontal analysis. Using this approach, the first
value measured is considered the “base period” GROSS PROFIT 12,500 13,500 16,000
value, and all other values are compared against
it, line by line. Salaries 4,500 4,800 6,000

By calculating the difference and converting it to Marketing 1,100 1,100 1,900

percentages, we can quickly create a thumbnail Rent 2,000 2,000 2,000
snapshot of revenue growth or contraction. Utilities 300 300 300
Misc. Expenses 500 750 680
$5,300,000 – $4,500,000 = $800,000
$800,000 ÷ $4,500,000 x 100 = 17.8% revenue TOTAL EXPENSES 8,400 8,950 10,880
growth from 2017 to 2018 NET INCOME 4,100 4,550 5,120

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 FIMO BSAIS 4-YA-1 MIDTERMS REVIEWER

2017 2018 2019

Sales 100% 100% 100%
COGS 50% 51% 54%
GROSS PROFIT 50% 49% 46%

Salaries 18% 17.5% 17.2%

Marketing 4.4% 4% 5.5%
Rent 8% 7.3% 5.8%
Utilities 1.2% 1% 0.9%
Misc. Expenses 2% 2.7% 1.9%
TOTAL EXPENSES 33.6% 32.6% 31.3%
NET INCOME 16.4% 16.4% 14.7%

Horizontal vs Vertical Analysis

Horizontal analysis is a
procedure in the
Vertical analysis is the
fundamental analysis
method of analysis of
in which the amounts
financial statements
of financial information
where each line item is
over a certain period of
listed as a percentage
time is compared line
of another item to
by line in order to
assist decision making.
make related
decisions.
Main Purpose
The main purpose of
Main purpose of
horizontal analysis is
vertical analysis is to
to compare line items
compare changes in
to calculate the
percentage terms.
changes over time.
Usefulness
Horizontal analysis
Vertical analysis is
becomes more useful
more useful in
when comparing
comparing company
company results with
results with other
previous financial
companies.
years.

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