Fundamentals of Financial Management Weston by Brigham 1

PAGENERAL FRAMEWORK OF FINANCIAL ADMINISTRATION

LTHE RESPONSIBILITY OF THE FINANCIAL MANAGER

The task of the financial manager is to acquire and use funds with a view to
maximize the value of the company. They are specific activities that intervene in this
task:
1- Preparation of forecasts and planning.
2- Decisions financial and major investment importance: it must help to
determine the optimal sales growth rate and also help to decide on the
specific assets that will need to be acquired and the best way to finance them
assets.
3- Coordination and control: all business decisions have implications
financial, so they must be taken into account by the financier.
4- Shape to deal with financial markets: every company is affected and affects
through the general financial markets, from which funds are obtained, one
they negotiate the values of a company and are rewarded or punished
investors.

LTHE COMPANY'S GOALS

We operate under the assumption that the main goal of management is to
maximization of shareholder wealth, which translates into the maximization of
price of the company's common stock.
Shareholders are the owners of the company and are the ones who choose the team of
administrators. It is expected that the administrators, for their part, operate having in
mind the interests of the shareholders.
We know that the managers of a company operating in a market
competitive will be required to carry out those actions that are reasonable
consistent with the maximization of shareholder wealth. If they deviate from this
they run the risk of being fired from their jobs due to an acquisition
hostile corporate takeover or through a power appropriation lawsuit.
A hostile takeover consists of the purchase that a company makes of the
actions of another company even against the opposition of its administrators, while a
The appropriation dispute involves an attempt to gain control of a company.
making the shareholders vote for a new manager. Both actions are seen
facilitated by the existence of low stock prices; therefore, for
preserve its position, management will try to maintain the value of its shares at
highest possible level.
The same courses of action that maximize stock prices also
They benefit society. First//, maximizing the stock price requires
of the installation of efficient industrial plants capable of operating at a low cost and
that produce high-quality goods and services at the lowest possible cost. Second, the
maximizing the stock price requires the development of those products that
consumers want and need. Ultimately, the maximization of stock prices
requires an efficient and diligent service, of the adequate existence of
merchandise and well-located business establishments. Consequently, those
courses of action that help maximize a company's stock price
they are also beneficial for society on a large scale. Whenever the administration
finance plays a fundamental role in the operation of successful companies and
since prosperous companies are absolutely essential for achieving one
 Fundamentals of Financial Management – Weston y Brigham 2

healthy and productive economy, it is easy to see why finances are

important from a social point of view.

RDELEGATION OF AUTHORITY RELATIONSHIP

Onedelegation of authority relationshipexists when one or more people (directors)
they hire another person (an agent) to perform a service and to
later// authority is delegated for decision-making.
Shareholders versus managers
A potential problem of delegation of authority arises whenever the administrator
of a company owns less than 100% of its share capital. If a company is
established as a natural person and is managed by its own owner, the
owner-manager will presumably operate in such a way that improves his own
personal well-being. However, if the owner-manager becomes a
corporation, immediate// a potential conflict of interest arises.
Various mechanisms are usually used to motivate administrators to take action.
in the best interests of the shareholders. These can be: 1) the threat of a
despido, 2) la amenaza de una adquisición empresarial y 3) una compensación
administrative.
Shareholders versus creditors
A second problem of delegation of authority has to do with the conflicts that
emerge among the shareholders and creditors. The creditors are those who lend funds to the
company with interest rates based on: 1) the risk of the current assets of the
company, 2) the expectations regarding the level of risk of future additions to
assets, 3) the existing capital structure in the company and 4) the expectations
regarding future changes in the capital structure.
It is deduced that the goal regarding the maximization of shareholder wealth
requires honest performance towards creditors; the wealth of shareholders
it depends on the ability to have continuous access to capital markets
and such access depends on the existence of honest practices and adherence to the content
literal and the spirit of credit contracts. The administrators as agents of the
creditors and shareholders must act in a way that reflects a balance
suitable to the interests of these two classes of security holders.

AADMINISTRATIVE ACTIONS AIMED AT MAXIMIZING WEALTH OF THE

SHAREHOLDERS
If the management is truly interested in the well-being of its shareholders
currently, it should focus on earnings per share (EPS) more than on the
total corporate utilities.
The opportunity in time is an important reason to focus on wealth.
as it is measured by the stock price more than by the earnings
considered isolated//.
The degree of risk associated with the projected UPA also depends on how
that the company is financed. Consequently, although the use of financing through
debts can increase the projected UPA, debts also increase the
risk of projected future profits.
Another point of interest is related to the payment of dividends to shareholders.
versus retaining profits and reinvesting them within the company. The manager
The financial must precisely decide how much of the profits from each period should be
they should pay as dividends instead of retaining them and reinvesting them in the company,
 Fundamentals of Financial Management Weston and Brigham 3

which is known as the dividend policy decision. The optimal policy of

Dividends are those that maximize the company's stock price.
In summary, we can observe that the price of the company's shares depends on
the following factors:
1- UPA projected.
2- Opportunities from the profit streams.
3rd Grade of the projected earnings risk.
4- Use of debt.
5- Policy of dividends.

FINANCIAL STATEMENT ANALYSIS

EFINANCIAL STATEMENTS AND REPORTS

From the various reports that corporations issue for their shareholders, the report
annual is likely// the most important. This report provides two types of information.
First, there is a verbal section, which often appears as a
letter from the presidentof the company (report), which describes the operational results
that were observed during the immediate previous year and then presents the new ones
developments that will affect future operations.
Second, the annual report presents fourbasic financial statementsTaken in
together, these documents provide an accounting overview regarding the
business operations and its financial position.
Financial statements report what has actually happened to profits and to the
dividends over the past few years, while verbal statements deal
to explain the reason why things turned out the way they did.
The information contained in an annual report is used by investors to
to form expectations about future currents of profits and dividends.
Accounting income versus cash flow
When studying the income statement, the emphasis tends to fall on the determination
from the company's net income. In finance, the focus is on cash flows (CFs).
The value of an asset (or of the entire company) is determined by the cash flow it generates.
Net income is important but cash flow is more important, as cash,
besides being essential for the normal operation of the business, it is required for the
payment of dividends.
The goal of a company should be the maximization of the stock price. Every time
that the value of any asset, even that of a capital stock, depends on the FdeF
produced by the asset, the managers must strive to maximize the FdeF
available in the long term (LT) for shareholders. The FdeF are equal to cash.
derived from sales, minus cash operating costs, minus charges for
interest and less taxes.
Depreciation is a charge that does not represent a cash outflow; therefore, it must
add new// to the net income to obtain an estimate of the FdeF coming from the
operations.
The FdeF provided by an action is equal to the expected dividend flow in
the future and this stream of dividends provides the fundamental basis for calculating the
value of a share.
Companies can be conceived as institutions that have two bases of value that
are separated but related to each other: theexisting assetswhich
they provide the utilities and the FdeF and thegrowth opportunities, which
 Fundamentals of Financial Management Weston and Brigham 4

they represent opportunities to make new investments capable of increasing the

future utilities and the FdeF.
It is useful to divide the FdeF into two fundamental classes: 1) FdeF in operations and 2) others
FdeF. TheFdeF in operationsthey come from normal operations
and, in essence, they are equal to the difference between sales revenue and expenses
cash disbursements, including taxes paid. Theother FdeFthey are those
proceeding from the issuance of shares, from the request for loans or from the sale of
fixed assets.
Operating cash flows may differ from accounting profits for two reasons.
main:
1- Everyone the taxes reported in the income statement may not have to
to be paid during the current year.
2- Sales can be on credit, so they may not represent cash and
some of the expenses, deducted from sales to determine profits,
they may not constitute cash costs.
The cash flow cycle
As a company carries out its operations, it makes sales which
they lead to: 1) a reduction in inventories, 2) an increase in cash, and 3) if the
The selling price exceeds the cost of the item sold for a profit. These transactions
they cause the balance sheet to change and are also reflected in the income statement.
The purpose of financial analysis is to examine the accounting figures to
determine the degree of efficiency with which a company is producing and selling its
products.
Several factors make financial analysis difficult. One of them is
represented by the variations that exist between the accounting methods used by the
companies. The different methods of valuation and depreciation of inventories can
lead to differences in reported earnings for the case of companies, than for another
the shapes would be identical. Another factor is one that includes the opportunity in time, it is
to say when the effects can be measured accurately.
Utilities and dividends
In addition to the four financial statements, most annual reports also
they present a summary of the profits and dividends collected over the last
years.
Thedividends per share(DPA) represent the basic FdeFs that have been transmitted
from the company to the shareholders. The DPAs of any given year may be greater than
the UPA, but in LP the dividends are paid from the profits; consequently, the
DPA general// they are smaller than the UPA. The percentage of profits paid as
dividend, or the ratio of DPA to UPA, is known asreason for payment of dividends.

AFINANCIAL RATIO ANALYSIS

From an investor's perspective, financial statement analysis serves
unique// for predicting the future, while from the point of view of the
administration, the analysis is useful as a way to anticipate future conditions and
as a starting point for the planning of those operations that are to
influence the future course of events.
Liquidity reasons
Oneliquid assetit is one that can easily be converted into cash at a fair value of
market and theliquidity positionThe company's is one that answers whether the company
 Fundamentals of Financial Management Weston and Brigham 5

will be able to meet current obligations. A comprehensive liquidity analysis

requires the use of cash budgets, but when relating the amount of cash and
of other current assets with the company's current liabilities, the analysis
provides a liquidity measure that is quick to apply and very easy to use.
Current ratio
It is calculated by dividing current assets by current liabilities. Because the
current ratio provides the best individual indicator of the extent to which the
short-term creditors' rights (CP) are covered by the assets that are
wait to be converted into cash in a very short term, is the measure of solvency in the short term that
it is used more frequently.
Assets
Reason circulating
circulating Liabilities
circulating
Quick reason or acid test reason
It is calculated by deducting the inventories of current assets and then dividing.
the rest of the current liabilities. Inventories are generally the least liquid of
current assets, therefore represent the assets on which it is more likely
that losses occur in the event of a liquidation.
Current assets -
Reason
Inventories
fast
Current liabilities
Reasons for asset management
They measure the effectiveness with which the company is managing its assets, these ratios
they have been designed to respond to the question raised regarding the volume
of c/ asset.
Inventory turnover
It is defined as the division of sales by inventories. It is proposed as an alternative,
in order to transform it into a more accurate indicator, take an average of the inventories,
since this way the problem of seasonality is solved; likewise, it is
it is advisable to take values at the same moment, that is, if sales are at value of
the market value of the inventories should be taken into account or if on the contrary the
inventories cannot be evaluated at their market value, take both at their value
historical, taking the cost of sales as the numerator.
Inventory excesses are unproductive and represent an investment with a rate
low or zero performance. Low inventory turnover leads to doubts about the
current ratio.
Cost of
Rotation of
sales
inventories
Inventories
Days Sales Outstanding (DSO)
Also referred to asaverage collection period(ACP), is used to evaluate
Accounts receivable is calculated by dividing average daily sales by accounts.
to be collected, this allows determining the number of days of sales that are present
included in accounts receivable. They represent the average time period that a
the company has to wait to receive cash after making a sale.
The days pending collection can also be evaluated by making a comparison.
against the terms under which the company sells its goods.
 Fundamentals of Financial Management Weston and Brigham 6

Accounts receivable
DSO
Average sales
=
daily
Rotation of fixed assets
It measures the effectiveness with which the company uses its plant and equipment. It is calculated as the
ratio of sales to fixed assets, net of depreciations.
Sales
Asset turnover
Fixed assets
fixed =
grandchildren

Total asset turnover

It is the conclusive reason for asset management, it measures the turnover of all the
Company assets are calculated by dividing sales by total assets.
Sales
Asset Turnover
Assets
totales
totals
Reasons for debt management
The extent to which a company uses financing through debts, or its
financial leverage has three important implications: 1) when obtaining
funds through debts, the current shareholders maintain control of the company
with a limited investment; 2) creditors consider equity capital, or funds
provided by the owners, to have a margin of safety; 3) if the
the company achieves better performance on investments financed with debt than the
interest paid on them, the return on capital for the owners is affected
increased or leveraged.
Financial leverage increases the expected rate of return for the
shareholders for two reasons: 1) whenever interest is a deductible expense, the use of
debt financing reduces the amount of taxes and allows for a
the majority of the operating income is available to shareholders; 2) if the
expected rate of return on assets exceeds the interest rate on debt
so a company can use debt to finance assets, to pay for the
interests and to ensure that something is left for the shareholders as a form of reward.
However, financial leverage is a double-edged sword. If sales are
lower and the costs are higher than expected, the yield on assets
it will also be lower than expected. Under these circumstances, the performance
leveraged against the equity decreases in a special way // sharp and
losses arise. Consequently, when everyday operations are
they generate sufficient operating income capable of providing the cash that is
needs to cover interest payments, cash will be exhausted and the company
likely// will need to obtain additional funds.
In this way, we see that companies that have reasons for relative indebtedness//
high yields are also expected to be higher when the economy is normal,
but they run the risk of incurring losses when the economy is in recession. For that reason
Thus, companies with low debt reasons are less risky,
but they also stop leveraging up the return on their equity.
Decisions about the use of debts require companies to seek a point of
balance between the possibility of obtaining higher returns and taking on risk
incremental.
 Fundamentals of Financial Management Weston and Brigham 7

Reason for indebtedness

Measures the percentage of funding provided by creditors. The creditors
they prefer low debt-to-equity ratios, because the lower that ratio is,
The larger it will be the cushion against creditors' losses in case of liquidation. For
On the other hand, owners can benefit from leveraging, because this
increases the profits
Reason for
Total debt
Assets
indebtedness
totals
Interest to profit rotation (TIE)
Measures the point to which the operating income can decrease before the
the company became unable to meet its annual interest costs
Income
TIE Operations
= Charges for
interests
Coverage of fixed charges
It is similar to the ratio of interest rotation to profits, but its nature is more
it expands as it recognizes that many companies rent assets and must make payments to their
amortization fund. Leasing has spread in certain industries, making
may this reason be preferable. Interest payments and leasing charges are
they are made before taxes, while those made to the amortization fund
they must be done after taxes, these must be divided by 1 plus the tax rate,
to determine the income, before tax, that will be required to meet the
fixed charges.
Operating Income + payments for
Coverage of positions leases
fixed = Cargoes Payments for
Payments to the fund

for
rental
interest amortization
os
s 1-t
Profitability reasons
Profitability is the net result of various policies and decisions. The reasons for
profitability shows the combined effects of liquidity and management of
assets and debt management regarding operating results
Profit margin on sales
It is calculated by dividing net income by sales, showing the profit obtained by
selling dollar
Income
Profit margin s/
Grandsons
sales
Sales
Basic Earning Generation (BEP)
It is calculated by dividing earnings before interest and taxes (EBIT) by the assets.
totals. It shows the basic potential for generating profits from the assets of the
company before the effect of taxes and financial leverage, is of great
tool to compare companies that have different tax situations and different
degrees of financial leverage.
EBIT
BEP
 Fundamentals of financial management Weston and Brigham 8

Return on Assets (ROA)

The net income to total assets ratio measures the return on investment.
total, after interest and taxes.
Income
Grandchildren
ROA =
Assets
totals
Return on common equity (ROE)
The net income to common equity ratio measures the return on investment.
of the shareholders.
Income
Grandsons
ROE =
Capital
accountant
Market value reasons
A final group of reasons relates the stock prices to their book values.
These reasons provide management with a hint of what investors
they think about the company's past performance and its future prospects.
Price/Earnings Ratio (PER)
Show the amount that investors are willing to pay per dollar of
reported utilities. This ratio is higher for companies that have prospects of
high growth while keeping other elements constant, and it is lower for
risky companies.
Price by
PER = action
UPA
Market value / book value ratio (M/B)
Provide another clue about how investors view the
company. Companies that have a relative rate of return // high in relation to the capital
they are sold at higher multiples than their book value, compared to
those with low yields.
Price per share
M/B = Value of books by
action
The Du Pont graph
TheDu Pont graphshows the relationships that exist between performance and
investment, asset turnover, profit margin, and leverage. The side
the left side of the graph shows the profit margin on sales. The various items of
expenses are presented in the form of a list and then summed to obtain the costs
totals, which are subtracted from sales to obtain net income. If the margin of
utility is low or if it shows a declining trend, the items can be examined
individual expense statements to identify and correct later // the problems.
The right side lists the various categories of assets, obtains their total and afterwards
divide the sales by the total assets to find the number of times it has rotated
the asset.
The reason that multiplies the profit margin by the turnover of total assets is
know howDu Pont equationand provides the rate of return on the investment.
 Fundamentals of Financial Management Weston by Brigham 9

Income Sales
ROA = Grandchildren
)
)
( Sales ( Assets
totals
If the company were financed solely with equity capital, the ROA and ROE rates
they would be the same, because total assets would be equal to the amount of equity.
If it were not so, the ROA rate must be multiplied by themultiplier of equity capital,
which is equal to the ratio of total assets to equity.
Assets
Capital multiplier totals
accountable Capital
accountant
In this way, combining the two equations, the ROE rate is obtained.
Income Sales Assets
ROE = Grandsons ) totals
)( )
( Sales ( Assets Capital
totals accounting
The Du Pont equation shows how the profit margin, asset turnover, and the
use of debts, interact to determine the investment return of the
owners.

THE FINANCIAL ENVIRONMENT

THE FINANCIAL MARKETS

Individuals and organizations that wish to apply for loan funds
jointly with those who have excess funds. Such conjunction occurs in the
financial markets. Each market deals with a somewhat different type of instrument in
 Fundamentals of financial management Weston by Brigham 10

terms of maturity of each instrument and of the assets that back it. Also
different markets cater to different classes of customers, or operate in different
parts of the country.
Thephysical asset marketsthey are those in which real products circulate (wheat,
real estate, machinery, etc). Thefinancial asset marketsthey deal with rights
real assets (obligations, stocks, mortgages, etc).
Theintermediate term marketsand thefutures marketsthey are terms that refer
the fact of whether an asset was bought or sold for immediate delivery or in
some future date.
Themoney marketsthey are those in which values that represent circulate
debts with maturities of less than one year. Thecapital marketsthey are those
in which debts to LP and corporate actions circulate.
Themortgage marketsthey are about the loans granted against real estate
residential, commercial and industrial, and on agricultural land. The
credit markets for consumersinclude the loans granted for the
purchase of goods, as well as loans for cultural or recreational purposes.
We also have theglobal markets, national, regionalylocales.
Theprimary marketsthey are those in which corporations obtain capital
new. Thesecondary marketsare those in which the existing values, that
They are already in circulation, they are traded between investors, these markets provide liquidity to
the titles.
A healthy economy depends on efficient transfers of funds that go from
individuals who are net savers to the companies and individuals who need
capital. Without efficient transfers, the simple economy could not function.

LFINANCIAL INSTITUTIONS
Thecapital transfersthey occur in three different forms:
1- By means of direct transfers of money and securities: occur when a business
sells its shares or its debts directly to savers, without requiring them
services from any type of financial institution.
2- Through investment bankswhich acts as an intermediary
and facilitates the issuance of securities. The company sells its shares or bonds to the
investment bank, which in turn sells the same securities to savers.
3- Through financial intermediariesin this case, the intermediary obtains funds from
the savers issue their own securities in exchange for them and later use the
money to buy and maintain business assets.
The direct transfers of funds that go from savers to businesses are
possible and in fact occur occasionally //, but generally a more efficient measure
It consists of a business hiring the services of an investment bank.
Such organizations help corporations design values that bring together the
characteristics that are more attractive to investors at any moment, buy
these values to the corporations and sell them again to the savers. Although such
values are sold twice, this process is a primary nature transaction, in
the investment banker acts as an intermediary as the transfer takes place
capital of savers to businesses.
Financial intermediaries do more than just transfer money and securities.
companies and savers, literally// create new financial products. On the other hand, a
The financial intermediaries system can encourage savings capital to make
something more than just obtaining interests.
The main types of financial intermediaries are:
 Fundamentals of Financial Management Weston and Brigham 11

1- The commercial banksthey cater to a wide variety of savers and those who
They need funds. They are different from investment banks, as they lend.
money
2- Thesavings and loan associations, they take the funds from many small ones.
savers and later// lend that money to home buyers and others
types of borrowers. Perhaps the most significant economic function is to create a
liquidity that would not otherwise exist.
3- The mutual savings banksthey are similar to savings and loan associations,
they accept savings initially from individuals and make loans to the
consumers based on a foundation of LP.
4- Thecredit unionsthey are cooperative associations whose members have a
common link. Their savings are lent only among themselves, with
frequency, they are the most economical source of available funds for borrowers
individuals.
5- The pension fundsconsist of retirement plans funded by the
corporations or by government agencies for their workers. They invest
principal// in obligations, actions, mortgages, and real estate.
6- Theinsurance companiesthey capture the savings in the form of annual premiums, and
they invest these funds in securities or real estate, they make the payments
corresponding to the beneficiaries.
7- Themutual fundsThey are corporations that accept money from savers and
They use these funds to buy various securities. These organizations
They pool the funds and thus reduce risk through diversification.

LTHE STOCK MARKETS

The most important and active secondary market for financial managers is
the stock market. This is where the prices of the stocks are established.
companies. There are two types of stock markets: organized exchanges and the market for
sales over the counter.
The stock exchanges
The organized Stock Exchanges consist of physical and tangible entities. Each of the
larger ones occupy their own building, have specific designated members and have a
elected governing body. It is said that the members have seats on the Stock Exchange; these
seats, which are subject to being transferred, provide their holder with the
right to make transactions on the stock exchange.
Most of the largest investment houses operate brokerage departments.
which have seats on the Exchanges and designate one or more of their officials
as members. The Stock Exchanges remain open every business day, during the
which members meet to carry out the negotiations.
The Stock Exchanges operate as auction markets.
The over-the-counter sales market
The over-the-counter sales market is a complex and intangible organization. It
define as one that includes all the facilities needed to carry out
it refers to securities transactions that are not conducted on organized exchanges.
These facilities consist of the few traders that maintain
inventories of negotiable values on the counter and of those who are said to create a
market with these values, the thousands of runners who act as agents in
connect these merchants with the investors and the set of technology that
They provide a communication link between the negotiators and the brokers.
 Fundamentals of Financial Management Weston and Brigham 12

In terms of emission numbers, most of the actions are traded based on the
counter. However, because the actions of the largest companies are
they are registered in the Stock Exchanges, approximately two-thirds of the volume in
Dollars from stock transactions occur in stock exchanges.

DDETERMINANTS OF MARKET INTEREST RATES

Generally speaking, the quoted interest rate (or nominal) is based on a value that
represents a debt, k, is made up of a real risk-free interest rate, k*,
more various premiums that reflect inflation, the degree of risk of the value, and the level of
commerciality of value
k = k* + IP + DRP + LP + MRP
Where:
k = Nominal or quoted interest rate.
k* = Real risk-free interest rate.
IP Inflationary prompt.
kRFRate of quoted interest and risk-free (kRF= k* + IP).
DRP = Premium for default risk.
LP = liquidity or marketability premium.
MRP = Maturity risk premium.
The risk-free real rate (k*)
The real risk-free interest rate is defined as the interest rate that would exist without
a risk-free value if no inflation is expected, and can be conceived as the rate
of interest that would exist regarding the short-term values of the Treasury in a world free of inflation.
The real risk-free rate is not static; it changes over time depending on
the economic conditions, especially of: 1) the rate of return that the
Corporations and other borrowers can expect to obtain from/ the productive assets and 2)
of individuals' time preferences in terms of current consumption versus
future consumption.

The nominal or quoted interest rate, risk-free (kRF)

The nominal rate, or risk-free quoted rate, is equal to the risk-free rate plus a
expected inflation rate. To be strict//correct, it should represent the rate of
interest on a total value// risk-free, that is, one that would not have any risk of
non-compliance, expiration risk, liquidity risk, nor loss risk if
inflation will increase. There is no such value, and therefore there is no risk-free rate.
true// observable. However, there is a value that is free from the
majority of risks, a certificate from the US Treasury (T-bill), which is a security
a CP issued by the government.
In general, the rate of thetreasury certificatesfor an approach to the
risk-free rate at CP and the rate of theTreasury bondsfor an approximation to the
risk-free rate at long term.

Inflation premium (IP)

Inflation has a greater impact on interest rates because it erodes purchasing power.
purchase of the dollar and why the real rate of return on investments decreases.
Investors include a premium for inflation that is equal to the expected rate of
inflation throughout the life of value. It is important to note that the inflation rate
included in the interest rates is equal to the expected inflation rate in the future and not to
the rate experienced in the past. Note also that the inflation rate that is
it reflects the average expected inflation rate over the life of the value.
 Fundamentals of financial management Weston by Brigham 13

Expectations about future inflation are narrow.

related to the rates that have been experienced in the past. It should be noted
Note that this correlation is very close but not perfect.
Default Risk Premium (DRP)
The risk that a borrower defaults in relation to a
loan, it also affects the market interest rate based on a value, the larger it is
the higher the risk of default, the higher the interest rate that lenders will charge.
In the case of corporate obligations, the higher the rating of the
obligation, the lower its risk of default will be and, consequently, the lower it will be
its interest rate.
The difference between the interest rate quoted on a Treasury bond and a bond.
corporate with maturity, liquidity and other similar characteristics is known as
default risk premium.
Liquidity premium (LP)
The general liquidity is defined as the ability to convert an asset into cash.
a fair market value. Assets have different degrees of liquidity, which
depend on the characteristics of the market in which they are traded. Most of the
Financial assets are considered more liquid than real assets.
Short-term financial assets are generally more liquid than long-term financial assets.
Every time liquidity is important, investors assess that aspect and
they include liquidity premiums when stock market rates are established.
Maturity Risk Premium (MRP)
The price of long-term bonds decreases sharply whenever interest rates rise.
interest rates and, since interest rates can increase and occasionally
They all have bonds to LP, including those from the Treasury, have an element of risk.
what is calledinterest rate riskAs a general rule, bonds of any
organizations are subject to a greater interest rate risk as
increase the maturity of the bond. Consequently, a premium must be included for
risks of expiration in the required interest rates and this will be higher as
that increases the number of years to maturity.
The effect of the risk premiums at maturity is to increase the rates of
interest on long-term bonds compared to short-term bonds. This premium will increase when
interest rates are more volatile and uncertain and will decrease when they tend to be more
established.
It should be mentioned that, although short-term bonds have little exposure to risk of the
interest rate, they are exposed toreinvestment rate risk. When the
certificates at CP expire and the funds are reinvested or renewed, a decrease in
the interest rates would require reinvestment at a lower rate and therefore
would lead to a decrease in interest income. Although investing short
preserves the principal of the investor, the interest income it provides will vary from
one year to another, depending on the reinvestment rates.

LTHE STRUCTURE OF THE INTEREST RATE TERMS

The relationship that exists between short-term and long-term interest rates, which is known as
structure of interest rate termsit is important for treasurers
corporate entities, who must decide on the advisability of requesting funds as a loan
through the issuance of short-term or long-term debts and for the investors, who must decide
the convenience of the period in which they will place their capital. Therefore, it is important
 Fundamentals of Financial Management Weston y Brigham 14

understand: 1) the way that CP and LP rates relate to each other and 2) what is it that
because their relative positions change.
The dataset applicable to a specific date, when graphed, is known as
yield curveThe yield curve changes over time in both its
position as its slope.

Historically, long-term rates have been above short-term rates. For this reason, one
curve with a positive slope is called a normal yield curve, while the
that have a downward slope, is called an abnormal yield curve or
inverted.
The main reason for this situation is that short-term values are less risky than
the values at LP; consequently//, the rates at CP are usually lower than the rates at
LP.
Several theories have been proposed that aim to explain the shape of the curve of
performance. Among them, the three main ones are: 1) market segmentation theory, 2)
liquidity preference theory and 3) the expectations theory.
Several tests of these theories have been conducted, and those tests have indicated that each one
of the three theories, there are valid elements. In this way, at any moment in
the time the yield curve can be affected by: 1) the conditions
existing in the short-term and long-term markets, 2) preferences regarding liquidity and 3) the
expectations about future inflation.
Market segmentation theory
It states that every borrower and every lender has a preferred maturity.
the fundamental meaning of the theory is that the yield curve depends on the
conditions of supply and demand that prevail in the markets in the short term and long term. For
consequently, according to this theory, the yield curve could at any
moment to be flat, ascending or descending. An ascending yield curve
it would occur when there was a wide supply of short-term funds in relation to the demand,
but with a shortage of funds at LP. Similarly, a downward curve would indicate
a strong demand in the market for CP compared to that of the market for
LP. A flat curve would indicate an equilibrium between the two markets.

Liquidity preference theory

It states that long-term bonds normally have a higher yield than short-term bonds.
principal// for two reasons. 1) General investors// prefer to hold securities in the short term,
because such values are more liquid; therefore, investors accept
ordinary lower yields s/ CP values, and this leads to relative CP rates
drops. 2) Borrowers generally prefer long-term debt, as short-term debt
 Fundamentals of Financial Management Weston and Brigham 15

exposes the risk of having to pay off the debt under adverse conditions. In
As a consequence, borrowers are willing to pay a higher rate,
keeping everything else constant, for funds to LP as for funds to CP, and
this also leads to relatively low CP rates.
Therefore, the preferences of lenders and borrowers both operate from
the way that short-term rates are lower than long-term rates. Taken globally,
these two sets of preferences indicate that under normal conditions there will be a
positive risk premium at maturity, and that it will increase depending on the number
of years to maturity, causing the yield curve to show a
ascending slope.
Theory of expectations
He states that the yield curve depends on expectations regarding future interest rates.
inflation. Here k* is the risk-free real interest rate and IP is an inflation premium
equal to the average expected inflation rate over t years until the bond
yield. Under this theory, the risk premium at maturity is assumed to be zero and, in
in the case of treasury values, the default risk premium and the premium of
liquidity is also equal to zero.
According to the theory, as long as it is expected that the annual rate will decrease
inflation, the yield curve should show a downward slope, while
that its slope should be upward when inflation is expected to increase.

FADDITIONAL ACTORS THAT INFLUENCE S/ THE LEVEL OF INTEREST RATES

Other factors also influence the overall level of interest rates and the way
of the yield curve. The four most important factors are: 1) the policy of the
Federal Reserve, 2) the level of the national budget deficit, 3) the balance of the balance
commercial and 4) the level of business activity.
Federal Reserve Policy
The money supply has a fundamental effect on the level of activity.
Economic as without the rate and inflation. If the goal is to stimulate the economy, it will increase.
the growth in the money supply, the initial effect will be that interest rates
they decrease, however, a broader money offer can also lead to a
increase in the expected inflation rate, which in turn could push upwards
the level of interest rates. The opposite will occur if the money supply tightens.
During the periods when the Reserve actively intervenes in the markets, the curve of
performance will be distorted, short-term rates will be temporarily very low, if the
Credit is becoming easier to obtain, and too high if it is being restricted. The rates at
LP are not as affected by the intervention of the Reserve.
Fiscal deficit
If the national government spends more than it receives in tax revenue, it
You will have to face a deficit, and that deficit must be covered either by requesting
funds in loan or issuing money. If the government requests funds in loan the
additional demand for funds will push interest rates up. If it issues money,
this will increase expectations of future inflation and drive up the
interest rates. Therefore, the higher the fiscal deficit, while keeping everything else constant,
the more constant, the higher the level of interest rates will be.
Whether the short-term or long-term rates are more affected will depend on how they are
finance the deficit.
 Fundamentals of Financial Management Weston and Brigham 16

Trade balance
If more is bought than is sold (if imports exceed exports)
It is said that the country is undergoing an external trade deficit. When does this happen?
trade deficits must be financed, and the main source of financing
it is the acquisition of debts. Therefore, the larger the trade deficit,
the greater the amount that must be requested as a loan, and as it increases
The requested amount will push interest rates up.
Moreover, foreigners will be willing to keep debts with him.
country if and only if the interest rate on such debts is competitive with the rates of others
countries. Consequently, if the Reserve attempts to lower interest rates, the
foreigners will sell the country's bonds, which will depress the price of the bonds and the
The final result will be the existence of higher rates in the country.
It can be concluded that the existence of a deficit in the trade balance hinders the
Congress's ability to combat a recession by lowering rates of
interest.
Business activity
Interest rates decrease during a recession as a consequence of policy
from the Reserve that attempts to increase the money supply to address the
decrease in the demand for money and inflation. The existence of higher interest rates
lowering should stimulate investment in businesses and consumer spending and, in
consequence, putting an end to the recession.
During recessions, short-term rates decrease more sharply than the
rates to LP. This occurs because 1) the Reserve operates mainly in the CP sector and
therefore its intervention has a stronger effect here, and 2) the rates at LP reflect the
average expected inflation rate over the next 10, 20, or 30 years, and
this general expectation// does not change much, even when the current inflation rate is
low due to a recession.

LTHE LEVELS OF INTEREST RATES AND STOCK PRICES.

Interest rates have two effects on corporate profits: 1) because the
interest represents a cost, the higher the interest rate, the lower the
utilities of a company, if the rest of the elements remain constant. 2) the rates
they affect the level of activity and this affects corporate profits.
As is obvious, interest rates affect stock prices, due to their
effects on the profits but, there is also another influence which comes from the
competition that exists in the market e/ stocks and bonds. If interest rates
they increase sharply, investors can obtain higher returns in
the bond market, which induces them to sell stocks and transfer funds from the
stock market to the bond market. Logically, the price of stocks will be depressed.
due to the sale. A total reverse process will occur when rates decrease.

RISK AND RETURN RATES

ETHE RISK OF THE PORTFOLIO AND THE VALUATION MODEL OF CAPITAL ASSETS

Risk and return of a portfolio

Most financial assets are not held in isolation, rather they are
they are maintained as part of a portfolio. If this is the case, from the perspective of a
Investor, the fact that a particular stock goes up or down is not very important,
 Fundamentals of financial management Weston and Brigham 17

what really matters is the performance of your portfolio and the risk of the portfolio.
Logic//, then, the risk and return of an individual security should be
analyzed in terms of how that value affects the risk and return of
the wallet in which it is kept.
Portfolio performance
The expected return of a portfolio (kpit's simply the weighted average of
the returns that are expected on the individual stocks of a portfolio, where the
The weighting is given by the fraction of the total portfolio invested in each stock.
kp= wiki
Indeed, the rates of real returns, based on individual stocks,
they will almost always differ from their expected values.

Portfolio risk
Unlike returns, the risk of a portfolio, in general, is not an average.
weighted standard deviations of the individual values that make up said
portfolio, the risk of the portfolio will be much smaller. In fact, it could be theoretical.
possible to combine two actions that were individual//risky as they were measured
its standard deviations and form a portfolio that will be complete // free of
risk.
This is due to the correlation that exists between the actions. The trend between two variables to
moving together is known ascorrelationand thecorrelation coefficient
(pijmeasures that trend.
In statistical terms, it is said that two returns exhibit acorrelation
perfect negativewith pij=-1. The opposite, a perfect positive correlationoccurs
when pij1. The returns of two stocks that correlate in a way
perfect positive would move up and down together, and one
a portfolio consisting of two such stocks would be exactly the same level of risk as the
individual actions.
As a general rule, the degree of risk of a portfolio will be reduced as
increase the number of shares in that portfolio. The extent to which adding shares
to a portfolio reduce the risk, it will depend on the correlation coefficient that exists
the actions; the smaller the positive correlation coefficient, the lower it will be
risk of a large portfolio.
Specific risk versus market risk
It is very difficult, if not impossible, to find stocks whose expected returns are not
find positive // correlated, most stocks tend to perform
well when the national economy is strong and tends to perform poorly when it is
weak.
As shown in the graph, generally, the risk of a portfolio consisting of
Average stock market actions tend to decrease and approach some limit.
as it increases the size of the wallet.
 Fundamentals of financial management Weston y Brigham 18

Therefore, almost half of the inherent risk in an average individual stock can
eliminate if such action remains in a reasonable // diversified portfolio. Without
embargo there is always some risk and therefore it is virtually impossible to diversify the
effects of the broad movements of the stock market, which affects almost all
actions.
The part of the risk of a stock that can be eliminated is known howrisk
diversifiable, specific to the company or non-systematicthat part that cannot be
eliminated is known asnon-diversifiable, market or systematic risk.
According to the CAPM, the degree of risk of an individual stock should be measured by
its contribution to the risk of a well-diversified portfolio, this is the relevant risk
for the investor.
The concept of beta
The tendency of a stock to move with the market is reflected in its
beta coefficient( ), which is a measure of a stock's volatility in relation
with that of an average action.
Oneaverage risk actionis defined as that which tends to move towards
up or down in conjunction with the market in general and in accordance with
any index. By definition, such action will have a beta equal to one.
If an action with a beta higher than average is added to a portfolio with equal beta
the average, then the beta of the portfolio, and consequently// its degree of risk
will increase. Conversely, if an action with a lower beta is added, the beta of the
the portfolio and its risk will decrease.
Therefore, since the beta of a stock measures its contribution to the level of risk
From a portfolio, beta is the theoretical measure of the risk of a portfolio.

RRELATIONSHIP BETWEEN RISK AND RETURN RATES

Themarket risk premium(RPMIt depends on the degree of aversion that the
investors have the risk. If the market risk premium and the risk of
the action as he measures it the risk premium of the stock could be found as
the product of both:
RPi= (RPM)
where:
RPifirst of the risk of the i-th action, (kMRF) i.
RPMfirst of market risk, (kM- kRF).
The required return on any investment can be expressed in terms
generals such as:
Required return = Risk-free return + Risk premium
 Fundamentals of Financial Management Weston and Brigham 19

According to this expression, the required return for action i can

to write oneself as
ki= kRF+ (kM- kRF)
i
where
ki= required rate of return of the i-th stock.
kRF= rate risk-free return
kM= required rate of return on an average portfolio
i= beta coefficient of the i-th stock
The previous equation of the equilibrium price-setting model equation of the
CAPM, general // is known asStock market line.

VALUATION OF SHARES AND BONDS

VALUATION OF OBLIGATIONS
The value of any asset is based on the present value of the expected cash flows.
produce that asset. In the case of a bond, the cash flows consist of the interest payments.
obtained during the life of the bond plus a yield on the principal amount taken in
loan, general// the par value, when the bond matures.
Value of the bond = VB
Int Amount
(1 + + (1 + kd)
= n
kd)t
The graph shows the value of the bond over time. It can be appreciated
As long as the current interest rate is equal to the coupon rate, a bond is
it will sell at its par value. Normal// the coupon rate is set to be equal to the
current interest rate when a bond is issued and therefore initially// sold at the
par.
2- Interest rates change over time, but the coupon rate
remains fixed after the bond has been issued.
3- Always when the interest rate is greater than the coupon rate, the price of a bond
will decrease below its par value. Such a bond is known asbonus.
4- Always that the interest rate is lower than the coupon rate, the price of a bond
will rise above its par value. Such a bond is known asbonus of
discount.
5- The the market value of a bond will always approach its par value as it
that approaches its expiration date, as long as the company does not fall into
bankruptcy.
 Fundamentals of financial administration Weston y Brigham 20

Bondholders may incur capital losses or gains, depending on

if interest rates increase or decrease after the bond has been purchased.
Any change in the prevailing interest rates has two separate effects and
opposed, regarding the bondholders, 1) changes the current values of their portfolios
(interest rate price risk) and 2) change the rates of return at which
the FdeF coming from their portfolios can be reinvestedinterest rate risk
reinvestment of the interest rateThe longer the maturity of a bond
their price changes will be greater in response to a given change in the rates of
interest.

VVALUATION OF PREFERRED STOCK

Preferred shares are a hybrid, they are similar to bonds in some aspects.
aspects and to common actions in others. Preferred dividends are similar to
the interest payments on bonds in the sense that they are a fixed amount, without
Embargo, unlike interest payments, do not constitute deductible costs.
Most preferred stocks give their owners the right to receive payments.
of regular and fixed dividends, as well as cumulative. Like preferred stock.
they do not expire, but can be withdrawn by the issuer, it is considered that the
the issuance will be a perpetuity.
DivP
Value of the preferred stock =
S
VPS=
kPS

VVALUATION OF COMMON STOCKS

The value of a share is found the same way as the value of other assets
financial, that is, like the present value of the expected cash flow in the
future. The expected FdeF are composed of two elements: 1) the dividends that are
they expect in the year and 2) the price that investors expect to receive when they sell the
actions. The expected final price for the stock includes the return on investment
plus a capital gain.
The basic equation for stock valuation is similar to the bond equation. It
what changes are the components of the FdeF. First, think of an investor who
Buy a stock with the intention of holding it forever. In this case, everything ...
what he will receive is a stream of dividends, and the value of the stock today is
calculate as the present value of an infinite stream of dividends.
Divt
 Fundamentals of Financial Management Weston and Brigham 21

Value of the share = (1 +

P0= k)t
For any individual investor, the expected FdeF consists of the dividends.
expected more the expected selling price for the stock. However, the price of
The return that the ordinary investor receives will depend on the dividends expected.
future investor. Therefore, for all current and future investors in
In total, the expected FdeF should be based on the expected future dividends. Therefore,
that the equation is valid regardless of what destination is planned for the action
current investor.
The equation is a generalized model for stock valuation in the sense that the
time pattern of Divtit can be subjected to any behavior. However, with
the projected stream of dividends often follows a systematic pattern, in
whose case a simplified version of the valuation models can be developed
actions.
Valuation of non-growth stocks
Assume that dividends are not expected to grow at all but that
remain constant. In this case, there would be a zero growth action,
for which the dividends expected in future years are equal to some amount
constant. Therefore, an action without growth is a perpetuity.
The value of any perpetuity simply consists of the corresponding payment divided
the discount rate. Thus, the present value of a stock is reduced to:
Value of the stock = Div1
P0= k
Valuation of stocks with normal or constant growth
Expected growth rates vary from one company to another, but generally e
wait for dividend growth to continue in the foreseeable future approximately// to
the same rate as GDP. Therefore, if the last dividend of the company with a
constant growth, which would have already been paid, would be equal to Div0, its dividend in
any future year t could be predicted as DivtDiv0(1 + g)t, where g is the rate
expected constant growth.
Using this method for estimating future dividends, it can be determined
the VA of the action. It is possible to find the FdeF current, calculate the VA of each payment and
finally// sum them to find the value of the share. So if g is constant:
Value of the share = Div1
P0= ks- g
This model is common// known asGordon ModelIt is observed that one
the necessary condition for deriving the simplified form is thatk ssea
greater than g.
The growth of dividends primarily occurs as a result of growth in the
UPA. The growth in profits, in turn, results from various factors, including which
included are: 1) inflation, 2) the amount of profits that the company retains and
reinvests (1 - dividend rate) and 3) the rate of return that the company earns on/
its equity, that is to say its ROE.
Necessary assumptions of the Gordon Model:
The dividend grows forever at a constant rate g.
2- He the stock price grows at the same rate.
3- The expected dividend yield is constant.
4- He the expected yield from capital gains is constant and equal to g.
 Fundamentals of Financial Management Weston y Brigham 22

Valuation of stocks with supernormal or non-constant growth

Typical // companies go through life cycles, during the first part of their life their
much faster growth than that of the economy as a whole; later// it
adjust to the growth of the economy, end// its growth is much slower than him
of the economy. Companies that are in the first stage are calledcompanies of
supernormal or non-constant growth.
In these cases, the expected growth rate is not a constant; it decreases at the end.
during the supernormal growth period. To find the value of any stock of
non-constant growth, proceeding through three steps. 1) find the VA of the
dividends during the period of non-constant growth; 2) find the price of the
action at the end of the supernormal growth period (VA at the time of growth
constant) and subtract that price to the present; 3) add these two components
to find the intrinsic value of the stock.

ETHE EQUILIBRIUM OF THE STOCK MARKET

The required return on an action can be found through the SML, such
how it develops the CAPM.
The CAPM establishes that two conditions must be kept in balance:
1- The expected rate of return, as conceived by an investor
marginal, it must be equal to the required rate of return (ks= k's).
2- He the real market price of the stock must be equal to its intrinsic value as it is
estimate a marginal investor (P0P'0).
Certainly, some investors may think that k'is greater than kand what P´0
is greater than P0and therefore they will invest the majority of their funds in the stock,
while other investors may have an opposing perspective and would sell
all their actions. However, it is the marginal investor who sets the price
market reality and for this investor the conditions are met. If this condition
It does not hold, negotiations will continue until they are maintained.
The efficient market hypothesis
A certain harbor of theories known asefficient market hypothesis(EMH)
maintains that: 1) actions are always in balance and 2) it is impossible for a
investor beats the market in a consistent way. This implies that if it breaks
the first condition, the stock price will adjust almost immediately // for
reflect the existence of any new development.
General finance theorists define three forms or levels of efficiency of
market
1- The weak form of the EMH states that all information contained in the
previous price movements are fully reflected in the current prices of
market. Therefore, the information about recent trends in the
Prices are of no use for the selection of values.
2- The the semi-strong form of the EMH asserts that the current market price reflects all
public information // available. This indicates that returns cannot be earned.
abnormalities through action analysis.
3- The The strong form of the EMH asserts that current market prices reflect all
the relevant information, regardless of whether it is public or available
keep confidential. This implies that even for internal staff of the
It would be impossible for the company to earn abnormal returns.
Since the price of the actions seems to reflect public information, the majority
the actions seem to be valued in a fair manner. This does not mean that the
 Fundamentals of Financial Management Weston y Brigham 23

new developments could not cause the prices of a stock to rise or

they descended suddenly, but it does mean that the actions, in general, are not present
neither overvalued nor undervalued, are at a fair price and in balance.
Empirical tests have shown that the EMH is valid in both its weak form
as in its semi-strong form. Therefore, it is generally safe to assume an equilibrium,
and that the actions will align with the SML graph.

THE FINANCIAL FORECAST

ETHE FINANCIAL FORECAST

Well-managed companies base their operational plans on a set of
projected financial statements. The planning process begins with a forecast
of sales for the coming years. Subsequently, the assets that are
will be required to meet the sales level and a decision is made regarding the
the way in which the required assets will be financed. At that time, the projections for the
financial statements, profits and dividends.
Any forecast about financial requirements involves 1) determining what
the amount of funds the company will need during a specific period, 2) determine
what amount of money will the internal company generate during that same period and 3)
subtract the funds generated from the funds required to determine the
external financial requirements.
Two methods are used to estimate external requirements: the balance method.
projected or pro forma and the formula method.

ETHE PROJECTED BALANCE SHEET METHOD

Step 1: Income statement
The method starts with a sales forecast, then a forecast is made for a
income statement, which allows for an estimation of the amount of profits
retained that the company will generate during the fiscal year. This will require the preparation
from various assumptions about the reason for operational costs, the tax rate, the charges
for interests and the reason for paying dividends. The objective of this part of the analysis
it consists of determining the amount of income that the company will earn and that later//
will retain them for reinvestment within the business during the forecasted year.
Step 2: Balance sheet
If the company is operating at full capacity, the increase in sales needed
it will require increasing the assets. On the other hand, the increase in assets must be
financed, making it necessary // liabilities and/or equity will increase. Some
the increases in assets can be financed by spontaneous increases in the
accounts payable and accrued expenses, as well as retained earnings, any
the deficit will need to be financed through external sources.
Step 3: Additional funds
The financial manager will base his financing decision on several factors,
including the effect of short-term loans on their current ratio, the conditions
existing in the debt markets and equity funds, and the restrictions
imposed by the current contracts.
Step 4: Funding Feedback
A complexity that arises when preparing forecasts is related to the
feedback on financing. The external funds obtained to settle
 Fundamentals of Financial Management Weston y Brigham 24

new assets create additional expenses that must be reflected in the statement of
results, and that decrease the initial // forecasted addition to retained earnings.
To manage the feedback process, first the additional spending is forecast.
interest and any additional dividend that is paid as a result of the
external financing.
Step 5: project analysis
The forecast, as it developed, is the first stage of the process; next, the
projected financial statements must be analyzed to determine if the forecast
satisfies the financial goals of the company as outlined in the financial plan. Yes
the financial statements do not meet such goals, then some must be changed
of the elements of the forecast.
The formulation of a forecast is an iterative process, both in the way in
that the states are generated as in the way the financial plan is developed.
For planning purposes, the staff in the finance department develops a
preliminary forecast based on a continuation of the policies and trends of the
past. This provides executives with a starting point for the formulation of a
tentative forecast.
Next, the model is modified to study the effects that the plans would have.
alternative operations regarding the company's profits and financial condition. This gives
as a result a revised forecast.
Alternative-type operational plans are examined under different scenarios of
growth rates. The model is used to assess both the dividend policy and
Capital structure decisions can also be used to evaluate policies.
working capital alternatives.

ETHE FORMULA METHOD

The formula method is a quick and easy way to forecast funds.
necessary additional funds (AFN). Its basis is that the additional funds are equal to
the difference between the increase in investment and spontaneous financing means.
Funds Increase Increase Increase in
additional = required in – spontaneous in – utilities
necessary assets liabilities retained
AFN = (A*/S) S – (L*/S) S – M S1(1 - d)
where
A*/S = assets that should increase if sales go up; they are expressed as
a percentage of sales or as the required increase in dollars of
assets per c/ marginal increase in sales. Note that A designates the
total assets and A* designates those assets that should increase if sales
they increase. When the company is operating at full capacity, A* =
A. However, frequently A* and A are not equal, and the equation must be
modified or the financial statement forecasting method should be used.
L*/S = liabilities that spontaneously increase with sales as a percentage of the
same or spontaneous financing // generated by each marginal increase in
sales. Again, L represents the total liabilities and L* represents those
spontaneous liabilities that increase//, are generally less than L.
S1sales total projected for the period.
S = change in sales.
M = margin or rate of profit per dollar of sales.
d = percentage of profits paid as common dividends or payment ratio of
dividends.
 Fundamentals of financial management Weston and Brigham 25

The application of the formula involves the acceptance of certain assumptions. These are: 1) c/
The active account must increase in direct proportion to sales increases, 2)
the designated liability accounts also grow at the same rate as sales and 3) the
profit margin is constant.
Obviously, these assumptions do not always hold, therefore, the formula does not always
produce reliable results. Consequently, this formula is used to obtain
main an approximate and simple forecast of the financial requirements and how
a supplement to the proforma states method.
The faster the sales growth rate, the greater the need for
obtain additional financing. This involves four important points.
1- Planning financial: at low growth rates, it may not be necessary to have a
external financing, in fact, it could even be in a position to still generate a
excess cash. However, if the company grows very quickly, it should be obtained
capital from external sources. If the management sees some difficulties in the
obtaining capital, then the feasibility of the plans should be reconsidered
of expansion.
2- Effect from the dividend policy according to financing needs: e/ higher
the reason for paying dividends, the smaller the addition to profits will be.
retained, therefore the requirements for external capital will be greater. Thus, if the
the administration anticipates the onset of difficulties in obtaining capital,
you may be interested in considering a reduction in the dividend payout rate.
In any case, before making this decision, the effects should be evaluated.
there would be this change in the stock prices.
3- Intensity of capital. The amount of assets required per dollar of sales,
is frequently referred tocapital intensity ratioThis reason has an effect.
according to the capital requirements per unit of sales growth. If the
the capital intensity ratio is low, sales can grow quickly // without great
amount of external capital. However, if the company has requirements
intensive capital, even a small increase in production will require a large
amount of new external capital.
4- Margin Of utility: the higher the profit margin, the smaller they will be.
funding requirements, keeping everything else constant. Due to the
relationship that exists between profit margins and capital requirements
Additionally, some rapidly growing companies do not need a large
amount of external capital.

FFORM OF FORECASTING WHEN BALANCE REASONS ARE SUBJECT TO CHANGES

Both the formula for the additional funds needed and the balance method.
pro forma, it is assumed that the reasons for the balance sheet of assets and liabilities remain
constants over time, which in turn requires the assumption that each item
spontaneous assets and liabilities increase at the same rate as sales. In form
graph this implies a relationship that: 1) is linear and 2) passes through the origin.
This assumption becomes inappropriate when any of these situations exist:
1- Economies of scale. In the use of many types of assets, there are so-called
economies of scaleand when this happens, it is likely that the financial reasons
they change over time as the size of the company increases.
2- Assets in bulk. In many industries, technological considerations dictate that if
a company must be competitive, it should add fixed assets in large units and
discrete, such assets are often referred tobulk assets. The assets to
 Fundamentals of Financial Management Weston y Brigham 26

bulk have a greater effect on the fixed asset turnover ratio at different
sales levels, and consequent// of the financial requirements.
3- Excess assets caused by forecasting errors. Actual sales
frequent // they differ from the projected sales, and the asset turnover ratio for
a period can therefore be total// different from the planned relationship.
Simple linear regression
If the relationship between a certain type of asset and sales is linear, then it can be used
the techniques of simple linear regression to estimate the requirements for this type of
active, in terms of any increase in sales.
This allows calculating the requirements based on past trends. Its
the main advantage is that it does not consider financial ratios as constant, but rather does it
based on the average. This way, the forecast can be extended to more periods
long
Adjustment techniques for excess capacity
This method allows for forecasting when the installed capacity is not being
used in its entirety. It is based on the premise that when this happens, sales can
to increase even without the need for external requirements.
Asset requirements arise from the combination of the results of three formulas.
basics.
Sales Real sales
all = % of capacity at which they operated
capacity the assets
Fixed assets
Rotation of
real
fixed assets =
Sales all
(meta)
capacity
Level Fixed asset turnover
requested from = (meta)
fixed assets Projected sales
Theoretical//, the set of formulas could be used to determine the level of any
active. However, in practice, they are mainly used to determine the levels
requirements for fixed assets and inventories, since they are usually the assets where one can
there is an excess of capacity.

PLANNING AND FINANCIAL CONTROL

PPROCESSES OF PLANNING AND FINANCIAL CONTROL

Thefinancial planningit involves the preparation of sales, income, and projections
assets based on alternative production and marketing strategies, and
later// deciding how the financial requirements will be met.
Thefinancial controlit refers to the execution phase, related to the process of
feedback and adjustment required to ensure that plans are followed and to
modify existing plans in response to changes in the environment
operational.
 Fundamentals of Financial Management – Weston and Brigham 27

ABREAK-EVEN ANALYSIS
The relationship that exists between sales volume and profitability is explored in the
planningcost-volume-profit, or in thebreak-even analysis The analysis of
break-even point is a method used to determine the moment when
sales will exactly cover the costs, that is to say the point at which the company
it will balance, but it also shows the magnitude of the company's profits or losses
when sales exceed or fall below this point.
This analysis is important in the planning process because the cost-benefit relationship-
Volume-utility can significantly be influenced by the proportion of the investment
in fixed assets, and the changes in the ratio fixed assets to variable assets,
They are determined at the moment the financial plans are established.
Break-even point graph
The fundamental elements of the analysis can be presented graphically. Here
the units produced and sold are shown on the horizontal axis and the income and
Costs are measured on the vertical axis. It is assumed that the number of units sold is
equal to the number of units produced

At the point where the total revenue line intersects the operating cost line
total, the total revenues of the company are exactly equal to its costs and in that
volume the company reaches its break-even point. Before this point, the company
it will suffer losses, but after that point, it will obtain operating profits increasingly.
great as sales increase.
Break-even point volume in sales
The breakeven point could be calculated algebraically, instead of estimating it.
graph//. Based on the provided data, the total income (S) from sales is equal to
price (P) per the quantity of units sold (Q). Similarly, the total cost (TC)
it will be equal to the sum of fixed costs (F) plus total variable costs, the latter
It arises from the product of the unit variable costs (V) by the quantity of units.
At the break-even point (Q BE), total revenues are equal to operating costs
totals. Therefore, the functions of sales and costs are equal to each other, and by isolating the
the equation finds the volume of the breakeven point
QBE F
= P-V
When the break-even analysis is based on sales dollars instead of
Production units are very useful for determining the break-even volume.
for a company that sells many products at different prices. This analysis requires
only that total sales, fixed costs, and total variable costs (VT) are
 Fundamentals of Financial Management Weston y Brigham 28

they know even a given level of sales. Therefore, the break-even volume is
calculate as:
F
SBE= 1 – (VT /
S)
When planning a project, it is relatively easy to estimate fixed costs and
variables associated with said project. However, once the company is in
in operations, it is much more difficult to separate fixed and variable costs to calculate the level
from the break-even point,
The analysis of the break-even point can shed some light regarding three
important types of business decisions: 1) when making decisions s/
new products, as it can help determine how large they should be
sales for the company to be profitable; 2) to study the effects of a
general expansion at the operational level, which will cause an increase in the
cost levels, which allows to see if it is worthwhile given the increase in sales; 3)
when the company is considering modernization and automation projects, in
those whose level of fixed costs increases to reduce the level of variable costs.
Limitations of break-even analysis
1- The The total revenue function is based on the assumption that the price per unit is
remains constant, independent of the volume of sales and production.
2- The variable costs per unit remain constant regardless of the level of
production.
3- Any modification in the price, unit variable cost fixed costs, implies a
new analysis.
These considerations indicate that the probable cost curve would not be linear.
increasing at a declining rate over a range in which there are economies of
scale, increasing at a constant rate and final // at an increasing rate, indicating with
Hello the emergence of diseconomies of scale. If the cost curve is not linear, it could
to have a situation where the company had a loss at low sales levels,
will generate a profit over a range of sales volumes and thereafter
it had another loss at very high sales volumes.

AOPERATING LEVERAGE
If a high percentage of a company's total costs is fixed, it is said that the
the company has a high degree of operating leverage. In the terminology of the
high businessdegree of operating leverage(DOL), remaining constant
everything else means that a small change in relative sales will result in
result a great change in income in operations.
Operating leverage can be defined more precisely in terms
in the way a specific change in volume affects the EBIT. To measure
the resulting effect of a change in volume regarding profitability is calculated using the DOL, which
it is defined as the percentage change in EBIT associated with a certain change
percentage in sales.
Percentage change in
EBIT / EBIT
DOL EBIT
=
= Percentage change in
Q/Q
sales
The DOL can also be calculated as:
Q (P - V)
 Fundamentals of financial management Weston and Brigham 29

DOL Q (P – V) –
= F
or taking sales in dollars as the basis instead of units
DOL S – VT
= S – VT – F
The higher the DOL, the more profits will fluctuate, both upward
as a descendant, as a response to changes in sales volume. It should
It should be noted that the DOL of a given company is specific to the initial level of
sales
In general, if a company is operating at a level close to its break-even point, the
DOL will be high, but it will decline as the baseline sales level is higher relative to the point.
of sales equilibrium.

ACASH BREAK-EVEN ANALYSIS

Every time some of the company's fixed costs do not represent a physical outlay of
money, it is useful for management to know what the financial break-even point will be (or in
cash).
An equation can be derived for this calculation, starting from the equation for the point.
of equilibrium in operations. The only change that will be required will consist of reducing the
fixed costs in an amount equal to the disbursements that do not represent physical outflows of
cash (A).
QBE F - A
= P-V
If the disbursements that do not constitute physical cash outflows constitute a
a high percentage of total fixed costs, the financial breakeven point will be much
lower than the break-even point in operations.
The analysis of the financial break-even point is a useful tool capable of
provide an overview of the FdeF arising from operations.
So if the risk of insolvency is small, a company may be willing to
increase the use of operating leverage in the hope of achieving greater
utilities.

ETHE CASH BUDGET

The company estimates its cash needs as an integral part of its budget.
integral of its general budget or its forecasting process. First, it forecasts its
requirements for fixed assets and inventories along with the dates by which they must
make the payments. This information is combined with projections about the
delay in the collections of accounts receivable, the payment dates of taxes,
the payment dates of interest and dividends and similar. All this information is
summarize the cash budget, which shows the projected inflow of cash
and cash outflow of the company over a specific period.
The cash budget provides much more detailed information regarding
with the company's cash flows that the projected financial statements.

WORKING CAPITAL POLICY

ETHE CASH CONVERSION CYCLE

Thecash conversion cycle modelit focuses on the time period that runs
from the time the company makes payments until it receives cash inflows.
 Fundamentals of financial management Weston and Brigham 30

It mainly focuses on four periods.

1- The inventory conversion periodconsists of the average period of time that
will be required to convert the materials into finished products and thereafter// for
to sell those goods. It is calculated by dividing the inventory by the daily sales.
Inventory
Conversion period of the
Sales by
inventory
day
2- The collection period of accounts receivableconsists of the average term of
time required to convert accounts receivable into cash
company; that is, to collect the cash. It is also known as DSO and
calculate by dividing accounts receivable by the average credit sales per day.
Accounts receivable
Collection period of the accounts
to be collected Credit sales by
day
3- Thedeferral period for accounts payableit consists of the average term of
time that elapses during the purchase, both of materials and labor, and the
cash payment of the invoice.
Accounts payable
Deferred period of accounts
Credit purchases
to be paid
per day
4- Hecash conversion cycleit is the same as the period of time that elapses between the
actual cash expenses of the company incurred to pay for resources
productive and cash inflows from product sales. Due to
the cycle is equal to the average period of time during which a dollar remains
invested in current assets
Period of Period of Period of
Cycle of
conversion collections of deferred of
conversion = + -
del the accounts for the accounts for
in cash
inventory to charge to pay
The company's goal should be to shorten its cash conversion cycle.
as long as it is possible without harming operations. This would improve profits because e/ more
the longer the cycle lasts, the greater the need for external financing would be, with
the costs that this implies.

The cash conversion cycle can be reduced: 1) by reducing the

inventory conversion period through faster processing and sales
efficient of the products, 2) by reducing the collection period of the
accounts receivable through greater speed in collections or 3) through the
expansion of the deferred period for accounts payable through the
 Fundamentals of Financial Management Weston y Brigham 31

delaying their own payments. To the extent that these can be executed
operations without increasing costs or depressing sales should be carried out.

PWORKING CAPITAL POLICY

The working capital policy involves two basic aspects: 1) appropriate level of the
current assets, both in total and in specific accounts and 2) form of
finance current assets.
Investment policies in current assets
Essentially, investment policies in current assets differ in that
Different amounts of current assets are maintained to support any level.
Sales data. Chart // this will represent three lines with different slopes.

The line that has the steepest slope represents an investment policy.
relaxed, in which relatively large amounts of cash and securities are maintained.
negotiables and inventories and sales are stimulated by the use of a policy
of credit that provides liberal financing for clients and a level
corresponding // high accounts receivable. Conversely, under a policy
restricted, the maintenance of cash, negotiable securities, and inventories is seen
minimized. The moderate policy is found between both extremes.
Under conditions of certainty, all companies would maintain unique // minimum levels of
current assets. However, the scenario changes when the
uncertainty. In this case, the company will require a minimum amount of cash.
and inventories based on expected payments, on expected sales, on the
expected timeframes for periods and other similar aspects, plus others
additional quantities, or safety margins. Similarly, the levels of
Accounts receivable are determined by the credit terms, and the stricter ones.
the lower these terms are, the lower the volume of accounts receivable will be for any
given level of sales. Under a restricted investment policy, the company would maintain
minimum levels of safety margins, both in cash and in inventories, and
it would have a restrictive credit policy even if it meant having to run the
risk of losing some sales.
A general restricted policy provides the highest expected return over the
investment, but it entails a greater risk, while the opposite occurs with a
relaxed policy. Moderate policy falls at the midpoint between the extremes, in
terms of risk and expected return.
In terms of the conversion cycle, a restricted policy would tend to reduce the
inventory and collection conversion periods, resulting in a cycle of
relative conversion//short. Conversely, a relaxed policy would create higher levels
 Fundamentals of financial management Weston by Brigham 32

high inventory and accounts receivable, and longer conversion periods. A

Moderate policy would produce a conversion cycle that would fall between the two extremes.

Financing policies for current assets.

Virtual // all businesses must accumulate current assets when the economy is
strong, but when the economy is weak they have to liquidate their inventories and adhere to
net reductions of accounts receivable. However, current assets are rarely
they reduce to zero, and such fact has led to the development of the idea ofcurrent assets
permanentsytemporary or seasonal current assets.
The way in which current assets are financed is known as funding policy.
financing of current assets.
Self-assessment approach or coordination of deadlines
This procedure requires coordinating the maturities of the assets and the
liabilities. This strategy minimizes the risk that the company will be unable to settle its
obligations as they mature. Ultimately, a company could try to coordinate
in exact form the structure of the maturities. Of course, this is almost impossible
mainly due to two factors: 1) there is uncertainty about the life of the assets and 2)
some equity capital resources should be used and these resources do not have
expiration.

Aggressive approach
Finance the entirety of its fixed assets with long-term capital, but it also finances a
part of its permanent current assets with short-term credits of a non-nature
spontaneous. Natural// there can be different degrees of aggressiveness. The problem with
this approach is that the company would be subject to great dangers coming from the
increase in interest rates as well as various renewal issues
loans. However, short-term debt is often cheaper than long-term debt and
some companies are willing to sacrifice security for the opportunity to
obtain higher profits.
 Fundamentals of financial management Weston y Brigham 33

Conservative approach
Permanent capital is being used to finance all asset requirements.
permanent and meet some or all seasonal needs. The company uses
a small amount of non-spontaneous credit to LP to meet their highest levels
high requirements, but it also meets a part of their needs
seasonal storing liquidity in the form of tradable securities during the
weak season.

CAPITAL BUDGETING TECHNIQUES

IIMPORTANCE OF CAPITAL BUDGETING

A number of factors combine to make budget decisions
Capital may be the most important decisions that managers have to make.
financial. First, due to the fact that the results of capital decisions
they continue for many years, whoever makes the decisions loses a part of their
flexibility.
Opportunity is also an important consideration in capital budgeting.
since capital assets must be ready to go into action when they are
I needed.
Finally, the preparation of the capital budget is also important because the
Asset expansion generally implies very high costs, and before a
the company can spend a large amount of money, it must have sufficient funds
available.
 Fundamentals of Financial Management Weston and Brigham 34

CCLASSIFICATION OF PROJECTS
Companies generally classify projects in six categories, each of them
which requires a particular analysis.
1- Replacement projects - business maintenance. It consists of those expenses
that will be necessary to replace the worn or damaged equipment. They are
necessary when operations must continue. The decisions of
normal maintenance// they are taken without the need to develop a process
detailed decision.
2- Replacement projects - cost reduction. It includes those expenses that are
They will need to replace the usable equipment that is already obsolete. The
The goal is to reduce costs. These decisions are of a nature
discretionary, and generally requires a more detailed analysis.
3- Expansion projects – existing products or markets. They include expenses.
necessary to increase the production of current products or to expand
the channels or distribution facilities in the markets being served
They require an explicit forecast regarding the growth of the
demand. A detailed analysis is required, and the decision is made at the highest level.
4- Expansion projects - new markets or products. They refer to the expenses.
necessary to develop a new product or to expand into a new
geographical. They involve strategic decisions and usually require the expenditure of
large sums of money over very long periods. This way
Inevitably, a very detailed analysis will be required.
5- Projects for safety and/or environmental protection. They refer to the necessary expenses
to comply with government regulations, labor contracts or
with insurance policies. These expenses are often referred to as investments.
mandatory or non-revenue generating projects. The way they are managed
it will depend on its magnitude.
6- Various projects - include buildings, parking lots, and other assets
similar. Its handling varies between companies.

TTECHNIQUES FOR CAPITAL BUDGETING VALUATION

Recovery period (RP)

It is defined as the expected number of years required to recover a
original investment. The process is simple, just add the expected future cash flows.
from c/ year until the initial cost of the project is at least covered. The amount
total time required to recover the original invested amount, including the
fraction of a year if appropriate is equal to the payback period.
The shorter the recovery period, the better the results will be.
Discounted payback period (DPP)D)
It is similar to the common PR, except because the expected FdeF are discounted through the
project capital cost. Thus, the PRDis defined as the number of years that
It is necessary to recover an investment from the net discounted cash flows.
Unlike the common method, the PRDYes, take into account the costs of capital, show.
the year in which the break-even point will occur after costs have been covered
attributable to debts and the cost of capital.
Although both recovery methods have serious drawbacks as criteria for
project classification, provide information about the time frame during
 Fundamentals of Financial Management Weston and Brigham 35

which the funds will remain committed to a project. Therefore, e/ shorter

if PR remains constant, the liquidity of the project will be greater.
These methods are frequently used as an indicator of the level of risk of a
project.
Net Present Value (NPV)
The NPV is based on discounted cash flow techniques. Its implementation consists of
several steps. First, the VA of each flow must be found, including both inflows
like the outgoing, discounted at the project's cost of capital. Second, they must
add these cash flows to obtain the NPV of the project.
Flow
VAN =
Nett
(1 + k)t

If the NPV is positive, the project should be accepted, whereas if it is negative

It should be rejected.
A VAN equal to zero means that the project's NPV is just/sufficient to
reimburse the invested capital and to provide the required rate of return
this capital. If a project has a positive NPV, then it will be generating more
cash needed to reimburse your debt and to provide the
required return to shareholders, and this excess cash will accumulate
exclusive // for the company's shareholders. Therefore, if the company makes a
project with positive NPV, the shareholders' position will be improved.
Internal Rate of Return (IRR)
The IRR is defined as the discount rate that equalizes the PV of the cash flows.
expected entries of a project with the VA of its expected costs (be careful with the
definition since it does not match the one proposed by the chair - Professor Alonso.
See input flows = VA costs of
investment
Flow
VAN = 0 =
Nett
(1 + IRR)t
Note that the formula for the IRR is simple // the formula for the NPV, solved to obtain
the specific discount rate that makes the NPV equal to zero.
Mathematics// the NPV and IRR methods will always lead to the same decisions
of acceptance, in the case of independent projects. However, the NPV and the IRR
they can lead to conflicts when applied to mutually exclusive projects.
If the IRR is higher than the cost of the funds used to finance the project,
there will be a surplus after the capital has been paid, and that surplus will
it will accumulate for the shareholders. This characteristic of the break-even point is precise.
What makes IRR useful when evaluating capital projects.
Comparison of the methods
That graph relating the NPV of a project with the discount rate that is
used for the calculation of that value is defined as thepresent net value profile
of a project.
To build it, we must note that at a discount rate of zero, the NPV is
simple// equal to the total of the non-discounted FdeF from the project. These values are graphed.
like the intercepts of the vertical axis. Next, we calculate the NPV at different rates
 Fundamentals of Financial Management Weston y Brigham 36

and these values are graphed. The point where the profile of your NPV crosses the horizontal axis
it will indicate the IRR of a project.
By plotting the data points, we obtain the VAN profiles.

There are two basic conditions that can cause the profiles to intersect with each other.
consequent// lead to conflicting results in the NPV and IRR: 1) when there are
differences in size(or on the scale) of the project, which will mean that the cost of
one project is greater than the other or 2) when they existopportunity differences, which
it will mean that the opportunity of the FdeF coming from the two projects will differ from
such a way that the majority of the project FdeF are presented in the first
years and most of the FdeF from the other project are presented in the final years.
The NPV method implicitly assumes the rate at which it can be reinvested.
the cash flows will be equal to the cost of capital, while the IRR method
it implies that the company will have the opportunity to reinvest at the IRR.

Modified Internal Rate of Return (MIRR)

Despite the existence of a strong academic preference for NPV, surveys
studies indicate that business executives prefer the IRR. Given this fact
we can modify the IRR and turn it into a better indicator of relative profitability,
which could provide better information for the capital budget.
It goes from the costs VA of the value
terminal
FdeFEt(1 +
FdeFSt
= TIR)n - t
(1 + k)t
(1 + TIRM)n
The term on the left is simple// the VA of the disbursements of the investments
when they are discounted to the cost of capital, and the numerator of the term on the right is the
VF of the inflows, assuming that the flows are reinvested at the cost of capital
(Note, Alonso argues that this rate is not the appropriate one, because it would fall into the
implicit assumptions of NPV, something that should be avoided). The discount rate that makes
that the present value of the cash inflows is equal to the present value of the costs is defined as
TIRM.
The IRR has a significant advantage over the MIRR, as it assumes that the cash flows are
they reinvest at the cost of capital while the IRR assumes they reinvest at the own IRR
of the project. Since reinvestment at the cost of capital is more correct, the MIRR is a
better indicator of the true profitability of a project.
If two projects have the same magnitude and the same lifespan, then the NPV and the IRR
they will always lead to the same decision. Also, if the projects are of equal magnitude
 Fundamentals of Financial Management – Weston and Brigham 37

but they differ in their lives, the IRR will lead to the same decision as the NPV, if
both are calculated using the longest project lifespan as the terminal year. Without
embargo, if the projects differ in terms of their magnitude, then they can still occur.
conflicts.
It is argued that the IRR is a better indicator than the MIRR of the true
project profitability, but the NPV method is even better for making choices.
competitive projects that differ in terms of their magnitude, since it provides a
better indicator of the degree to which each project will increase the value of the company.
The NPV does not contain information about the inherent margin of safety for the
forecasts of FdeF of a project or about the amount of capital that is available
subject to risk, but the IRR does provide information about the margin of safety.
Observe, however, that the IRR has all the virtues of the IRR, but also
incorporate the correct assumption of the reinvestment rate.

THE COST OF CAPITAL

LTHE LOGIC OF WEIGHTED AVERAGE COST OF CAPITAL

It is possible to fully finance a company with equity funds. In this case, the
the cost of capital used to analyze capital decisions should be equal to
required return on the company's equity. However, most of
companies obtain a substantial portion of their capital as long-term debt, and many of
they also use preferred shares. In the case of these companies, their cost of
capital must reflect the average cost of the various sources of funds to LP that are
use.
The items that appear on the right side of a company's balance sheet are its
capital components. Any increase in total assets must be financed.
through an increase in one or more of these components.
Components of the cost of capital
Cost of debt, kd(1 - t)
It is the interest rate on the debt kdminus the tax savings resulting from
the interest is deductible.
The value of the company's shares depends on the after-tax cash flows.
since interest is a deductible expense, it produces tax savings that reduce the
cost of debt component.
Note that the cost of debt is equal to the interest rate on new debts.
no to the interest of debts that are contracted and pending payment; in others
words, the marginal cost of debts is considered.
Cost of preferred shares, kp
It is equal to the preferred dividend Div.p, divided by the net price of the issue (P - Cf) or the
price that the company will receive after deducting flotation costs
Branchp
kp
P (1 -
=
Cf)
Cost of retained earnings, ks
The cost of retained earnings, like the other components, is based on
required yields, in this case in the rate of return that the
shareholders regarding the equity capital that the company obtains by retaining earnings.
 Fundamentals of Financial Management Weston by Brigham 38

The reason why a cost of capital should be assigned to retained earnings is

relates to the principle of opportunity cost. Retained earnings belong to
to the shareholders, therefore when a company retains earnings it should
earn at least as much as what its shareholders could earn on investments of
comparable risk.
Since normal stocks are in equilibrium, the expected rate should be equal to
the required rate, otherwise, dividends should be paid to the shareholders to
allow them to invest the funds in some other asset that does provide this
performance.
Generally, three methods are used to calculate the cost of retained earnings.
1- The CAPM approach: part of the SLM equation, which shows that the estimation
of the ksstarts with the risk-free rate to which a risk premium is added that
is set equal to the risk premium applicable to an average stock, which can
increase or decrease to reflect the particular risk of a stock as measured
due to its beta coefficient.
ks= kRF+ (kM– kRF) i
It should be noted that although the CAPM approach seems to produce
accurate and precise estimates of ks, there are actually several issues with it.
First, if a company's shareholders are not well diversified,
they may be interested in total risk instead of only studying market risk,
in this case, the true investment risk of the company will not be measured by its
beta and the CAPM procedure will underestimate the correct value of ksFurthermore, still
if the method is valid, it is difficult to obtain correct estimates of the inputs that
will be required to make it operational.
2- Approach of return on bonds plus the risk premium: essentially, it is about a
subjective and ad hoc procedure. It is calculated by adding a risk premium of three.
five percentage points to the interest rate on the company's long-term debt. The
the problem is that whenever the risk premium is an estimate of judgment, the value
estimated for ksit is also the product of judgment, so everything it can do
it's getting closer to the right area.
ks= kdRisk premium
dear
3- Discounted FdeF approach: it is based on the general valuation formula of
actions and in the particular case of constant growth. In such a way, the
investors expect to receive a return from dividends plus a gain from
capital, to achieve a total expected return of kand, in balance, this
expected return is equal to required return. In this method it is relative
It is easy to establish the dividend yield, but it is very difficult to establish the rate.
adequate growth.
Div
ks +
t
= g
P0
If the previous rates of growth in earnings and dividends have been relative//
stable, then g could be based on the company's historical rate. However,
if the historical growth of the company has been abnormal// high or low, then the
investors will not project the historical rate into the future.
Cost of recently issued common stock kc
The cost of external equity capital is higher than the cost of retained earnings.
due to the existence of the implicit flotation costs in the sale of new shares
 Fundamentals of financial management Weston y Brigham 39

common. In general, it is calculated similarly to ks, although costs are deducted.

of flotation.
Divt
kc +
P0
= g
Cf)
In this case, Cfit is the percentage of flotation incurred when selling the new one
issuance of common shares, therefore P0(1 - Cfis the net price per share that is received
the company.
Weighted Average Cost of Capital (WACC)
C/ company has an optimal capital structure, which is defined as that
financing mix that leads to the maximization of its stock price. By
Thus, a rational company whose goal is to maximize its value will establish
an optimal capital structure and later// will obtain new capital in such a way
that the real structure of its capital remains at the level set as a goal throughout.
of time.
The optimal proportions of the different sources of financing, along with the
cost of capital components are used to calculate the WACC or cost of capital
composed.
WACC = kiwI
Where kirepresents each of the different sources of funding and wiit is yours
relative participation in the total structure. The relative weights could be based on the
accounting values or in the corresponding market values.

ETHE MARGINAL COST OF CAPITAL(MCC)

The marginal cost of any item is the cost resulting from obtaining one unit.
additional to that article. In this way, the MCC is defined as the cost of the last dollar of
new capital obtained by the company and the marginal cost will increase as it
obtain more and more capital over a specified period.
That graph that show how the WACC changes as it is obtained
more and more new capital in a given year is known asMCC program.
As a practical rule, as a company obtains amounts
additional funds over a specified period, the costs of the
capital components will begin to increase, and as this happens, the
The weighted average cost of each new dollar will also increase.
A certain amount of capital x is sought, which is known aspoint of
ruptureand what represents the total financing that can be obtained from sources
before being required to increase the other sources. In general, there will be a
break-even point whenever the cost of one of the capital components increases.
Point Total amount of certain capital of
of lowest cost of a given type
=
break Fraction of this type of capital
a within the capital structure
It can be seen, then, that numerous breaking points can occur. In the limit, it
I could think of an MCC program that had a large number of breaking points.
and for that reason it will increase in an almost continuous manner beyond a given level
new financing.
Note that the WACC will increase after each breakpoint.
 Fundamentals of Financial Management Weston y Brigham 40

FHOW TO COMBINE MCC WITH IOS

It is possible to use the MCC program to find the cost of capital that will allow
determine the NPV of the projects.
In practice, the cost of capital used in the capital budgeting process is
determine at that point where the MCC and IOS programs intercept (program of
investment opportunities). If the cost of capital that appears at the intersection is used,
then the company will make the correct decisions of acceptance or rejection, and its
The level of financing and investment will be optimal.
Note that the cost of capital used in the capital budget is seen
influenced both by the MCC curve and by the available set of projects.

CAPITAL STRUCTURE AND LEVERAGE

THE CAPITAL STRUCTURE SET AS A GOAL

The capital structure policy involves a trade-off between risk and
performance
• Using a greater amount of debt increases the level of risk of the current.
company profits.
• A higher level of debt leads to an expected rate of return
higher.
Therefore, the optimal capital structure is one that produces a balance in the
risk and return in such a way that the stock price is maximized.
There are four fundamental factors that influence structural decisions.
capital
 Fundamentals of financial management Weston by Brigham 41

1-Business risk of the companythat is, the risk that would appear in the form
inherent to the operations if debt were not used. The bigger the risk of
business, the lower the debt-to-equity ratio will be.
2-Fiscal position of the companyone of the main reasons for using debt is
that the interest is deductible, which reduces the effective cost of debts. Without
embargo, if a large part of the company's income is protected against the
taxes, its tax rate will be low and in this case the debt will not be as advantageous
how would it be for a company with a high effective tax rate.
3-Fiscal flexibilitythat is to say, the company's ability to raise low capital
reasonable terms in adverse conditions. The greater the needs
probable future of capital funds and the worse the consequences of a
lack of capital, the balance sheet must be stronger.
4-Degree of risk aversion of the managersalthough this factor does not influence
directly // not on the optimal capital structure, but rather on the structure that the
company sets as a goal.
These four points largely determine the optimal capital structure, but
Of course, operational conditions may cause the actual structure to differ.
with respect to the optimal at any given moment.

ECOMMERCIAL RISK AND FINANCIAL RISK

In addition to the natural risk that all companies face (market risk), the
investors of any particular company face two risks which are
specific to the company. Commercial risk and financial risk.
Thecommercial riskdenotes the level of risk of the company's operations
indistinct// of the use of debts. Thefinancial riskit is the additional risk that is assumed by the
common shareholders as a result of the company's decisions to use debt.
Commercial risk
Commercial risk is defined as the inherent uncertainty in projections of the
future returns on assets (ROA), or returns on equity
(ROE) if the company does not use debt, and it is the most important individual determinant of the
capital structure.
Commercial risk depends on several factors, but the most important are:
1- Demand variability (unit sales). The more stable the sales are
unit sales of a company's products, keeping everything else constant,
the lower the risk will be.
2- Variability of the selling price. The more volatile the market in which
the more you commercialize, the greater the risk will be.

3- Variability of input costs. The more uncertain the prices of the

the more inputs, the higher the level of risk.
4- Capacity to transfer the increases of costs. The greater the capacity
to adjust prices to changes in the cost of inputs, less exposure is
will have the risk.
5- Degree of operating leverage. The higher the percentage of fixed costs,
Regarding the total, the higher the degree of risk.
Each of these factors is determined in part by the characteristics of the industry, but
each of them is also controllable to a certain extent by the administration.
Financial risk
Financial leverage refers to the use of fixed income securities (debts and
preferred shares) and financial risk consists of the additional risk that falls on
 Fundamentals of Financial Management Weston and Brigham 42

as common shareholders as a result of the use of financial leverage. From

from a conceptual point of view, the company has a certain amount of inherent risk to its
operations, when debts and/or preferred shares are used the company concentrates its
commercial risk regarding the shareholders.

FFORM OF DETERMINING THE OPTIMAL CAPITAL STRUCTURE

Analysis of the effects of financial leverage

Changes in the use of debts, mainly //, cause variations in the UPA and, therefore
consequently, in the price of the shares.
The figures of the UPA can be obtained using the following formula.
(S – CF – VT – Int) (1 (EBIT - Interest) (1 - tax rate)
UPA
– t) =
=
Actions Actions
where, S is the sales level, Int are the interest charges, Shares corresponds to
the outstanding shares, CF are the total fixed costs, VT are the variable costs
totals and t is the tax rate.
If observed, different degrees of financial leverage will result in
different UPA. In fact, with greater indebtedness there will be greater profits,
keeping everything else constant, since while the interests (Int) increase,
the number of shares over which the net profits are distributed is smaller.
However, it should be taken into account that higher indebtedness also increases the
risk, since with a decrease in EBIT, the net earnings to be distributed will be
much lower.

In the real world, unlike what is presented by the theories, the capital structure
sometimes affects EBIT. First, if the levels of indebtedness are excessive, the
likely company // will not be able to finance itself when profits are low in a
the moment when interest rates are high. This could lead to the halt of the
construction and research and development programs, as well as the need for
abandon good investment opportunities. Second, a weak financial condition,
could cause a company to lose its sales. Third, strong companies
financial institutions are able to negotiate intensely // while weaker companies
they have to give in simply // because they do not have the financial resources that are needed to
carry out that fight. End//, a company that has so much debt that it goes bankrupt.
It poses a serious threat and will have difficulties attracting and retaining human resources.
 Fundamentals of financial management Weston and Brigham 43

or it will have to pay preferential salaries. For all these reasons, it is not entirely correct.
to state that a company's financial policy has no effects on its operating income.
analysis of indifference of earnings per share
Theindifference point of the UPAit is the sales level at which the UPA will be the
same indistinct// from its financing structure. This analysis allows considering the
information on different structures of financing.
This point can be found by equating the equations of the UPA for different
financing structures and clearing the sales level.
(SBECF - VT - Int1(1 - t) SBECF - VT - Int2) (1 –
=
UPA1= = translatedText
UPA2
Actions1 Actions2
In this case, UPA1and UPA2the UPA at the two levels of indebtedness, SBEit is the
break-even point in sales, Int 1Int2they are the interest charges at the two levels of
indebtedness and Actions1and Actions2corresponds to the outstanding shares under
the two financing structures, CF are the total fixed costs and VT are the costs
total variables, where v is the percentage of variable costs. When solving for SBEis obtained
the expression
Actions1Int1Actions2 1
SBE= Int2
+F)
( Actions1Actions2 1-
v
At low sales levels, the UPAs will be higher if actions are used instead of debts.
However, the capital structure with higher debt has a steeper slope, which
which indicates that if debts are used, the UPA will rise faster with the increases in
sales.

Effect of capital structure

The optimal capital structure is one that maximizes the stock price of the
company and this will require a debt ratio that is lower than that which
maximize the expected earnings per share. At that point, the stock price is
maximum and the minimum WACC.
 Fundamentals of financial management Weston and Brigham 44

LEVERAGE RATIO
The two types of leverage are interrelated. If a company
reduce its operational leverage, this would likely lead to an increase in its
optimal use of financial leverage. On the other hand, if you decided to increase your
operating leverage, its probable optimal capital structure would require a
lower amount of debts.
Degree of Operating Leverage (DOL)
The DOL is defined as the percentage change in EBIT associated with a change.
percentage determined in sales. In fact, the DOL is an index number, which
measures the effect of a change in sales on operating income.
It is important to note that the DOL is defined for a specific level of sales.
Q (P - V)
DOLQ
Q (P – V) –
=
F
Or based on valued sales
S - VT
DOLS
=
F
In general, when a company is operating at a level close to its break-even point
balance, the DOL will be high, and it will decrease as the basic sales level is higher
regarding the breakeven point level.
When evaluated at increasingly higher levels, the DOL progressively decreases.
 Fundamentals of financial management Weston and Brigham 45

Degree of financial leverage (DFL)

The DFL is defined as the percentage change in UPA resulting from a change.
percentage given in EBIT.
EBIT
DFL = EBIT -
Int
Financial leverage begins when operating leverage ends.
amplifying even more the effects on the UPA resulting from the changes in the
sales level. For this reason, operational leverage is sometimes referred to as
howfirst stage leverageand to financial leverage as
second stage leverage.
Degree of total leverage (DTL)
It has been observed that, 1) the higher the DOL (or the level of fixed costs in operation), the more
sensible will be the EBIT to changes in sales and 2) the greater the DFL (or the level of
fixed financial costs) will be more sensitive to changes in EBIT. For what
so, if a company uses a considerable amount of both leverages, even the
smaller changes in sales will lead to wide fluctuations in EPS.
The equations of DOL and DFL can be combined to produce the equation
corresponding to the DTL, which shows how a given change in sales
will affect the UPAs.
DTL = DOL DFL
Q (P - V)
DTL =
Q (P – V) – F –
Int
The DTL can also be used to find the new UPA for any increase.
percentage given in sales.
UPA1UPA0(1 + DTL % S)

TTHEORY OF CAPITAL STRUCTURE

Theory of intercompensation
They demonstrated, under a set of assumptions very restrictive, due to the
Tax deductibility of interest on debt will increase the value of a company.
continues // as more debt is used and therefore its value will be maximized when
finance almost entirely with debts.
The assumptions of MM included:
1- No there are brokerage fees.
2- No there are personal taxes.
Investors can apply for funds in loans at the same rate as the
corporations.
4- Investors have the same information as management regarding the
future investment opportunities of the company.
All of the company's debt is risk-free, regardless of the level of
indebtedness.
6- The EBIT is not affected by the use of debt.
Given the restrictive nature of the assumptions, later// other studies were conducted that
They tended to expand the basic theory by relaxing the assumptions. The graph presents a
summary of the theoretical and empirical research conducted.
 Fundamentals of Financial Management Weston Brigham 46

The fact that interest is a deductible expense makes debts less.

more expensive than common or preferred stocks. The use of debt causes a
most of the EBIT flows to investors, therefore the higher the level of
the higher the indebtedness of a company, the higher its value and the higher the price of its
actions.
The assumptions of MM do not hold in reality. First, the interest rates.
increase as the debt ratio increases. Second, the EBIT
decrease to extreme levels of leverage. Third, the expected tax rates
They decrease to high levels of indebtedness and this also reduces the expected value of
tax protection against debts. And fourth, the probability of bankruptcy increases.
as the debt ratio increases.
Is there a basic level of indebtedness, below which the described effects
they are insignificant. However, beyond that point, the costs related to the
bankruptcies are becoming increasingly important and reduce the tax benefits of the debt to
a growing rate. In the range from this point to the optimal structure, the
bankruptcy-related costs increase but do not completely eliminate the
tax benefits of debt, therefore the price of common stocks increases,
but at a decreasing rate, as the debt-to-equity ratio increases.
Beyond the optimal structure, the costs related to bankruptcy will exceed the
tax benefits, so that increasing the debt ratio will decrease the
value of the shares.
Signaling Theory
MM assumed that investors have the same information as the managers.
about the prospects of a company, this is referred to as symmetrical information. Without
embargo, it is known in fact that the managers have better information about
its companies that external investors. This asymmetric information has
important effects on the optimal capital structure.
One could expect that a company with very favorable prospects would try to
avoid selling shares and instead obtain any new capital through
other means, including the use of debts beyond the optimal structure. For the
on the contrary, a company that had unfavorable prospects would be interested in
sell shares, as this would mean bringing new investors to the company
to share the losses.
Thus, the announcement of a stock offering made by a mature company that seems
having financing alternatives is taken as a signal in the sense that the
 Fundamentals of Financial Management Weston y Brigham 47

prospects are not very bright. Therefore, the stock price would tend to
decrease.
In normal times, companies should maintain a capacity for request
reserve loans, which could be used in case some arise
special investment opportunities// good. This would mean that in normal times,
Companies should use less debt than what would remain.
indicated by the intercompensation of tax benefits and insolvency costs.

DIVIDEND POLICY

TTHEORY ABOUT DIVIDEND POLICIES

Dividend Irrelevance Theory

It has been argued that the dividend policy has no effect on the price of
the actions or s/ their cost of capital. The main proponents of this theory are MM.
They argued that the value of a company is determined solely through its
basic capacity to generate profits and through its commercial risk.
they assumed that 1) there are no taxes on personal or corporate income, 2) no
there are flotation costs of the shares or transactional costs, 3) leverage
financial does not have effects on the cost of capital, 4) the investors and the
Administrators have the same information about the future prospects of the
companies, 5) the distribution of income and dividends and retained earnings no
it has an effect on the cost of equity capital and 6) the capital budgeting policy of
a company is independent of its dividend policy. Obvious// these assumptions are not
they remain in reality.
Bird in the hand theory
The fifth assumption of the irrelevance theory states that dividend policy does not
affects the required rate of return for investors. This assumption in
this has been hotly debated in academic circles. Gordon and Lintner
they argued that the required rate by investors decreases as
increases the dividend payout ratio because investors are less certain
to receive the capital gains that should result from retained earnings, which
to receive dividend payments.
Gordon and Lintner stated that investors value a dollar of dividends.
expected in a higher way than a dollar in capital gains because the
component of the dividend yield Div1/P0it is less risky than the component
of g in the expected total yield equation.
They referred to Gordon and Lintner's argument as the bird in hand fallacy.
because, under the MM approach, most investors plan to reinvest their
dividends in the shares of the same company or similar companies and, in any
in this case, the risk of the company's FdeF to LP for investors is determined as such
only by the level of risk of their financial derivatives in operation and not through their policy of
payment of dividends.

Theory of tax preference

There are three tax-related reasons that support the fact that
investors may prefer a low dividend payout ratio instead of a
high reason: 1) remember that capital gains are taxed at a maximum rate
lower than the effective rate of dividends; therefore, wealthy investors
they might prefer that companies retained and reinvested their profits within the
 Fundamentals of financial management Weston y Brigham 48

business. 2) Capital gains taxes are not paid until they are sold.
actions, due to the value of money over time, one dollar of tax that is
Payment in the future will have a lower effective value than a dollar paid now.
current events. 3) If an individual holds a stock until their death, no harm will be caused.
no tax on capital gains.
Due to these tax advantages, investors may prefer that companies
retain most of their profits. If this is the case, investors would be
willing to pay a higher amount for companies that had a low ratio
of dividend payments that by other similar companies that had a high ratio of
dividend payment.
Illustration of the theories
If the MM irrelevance theory were correct, neither the stock price nor the
the cost of equity capital would be affected by the dividend payment policy,
both will remain constant.
If the bird in the hand theory were true, investors prefer dividends and, e/
the greater the amount of dividends paid by the company, the higher the price of its
actions and lower their cost of capital.
If the theory of tax preference were correct, investors would prefer that the
companies retain their profits and thus provide returns under the
capital gains form. So an increase in the dividend payout ratio
would cause the stock price to decrease and the cost of capital
will increase.

Other discussion points regarding the dividend policy

Hypothesis of the content of the information
The fact that substantial increases in dividends generally cause increases
in the stock prices is for some an indication that investors, in
set, prefer dividends instead from capital gains.
However, MM presented a different argument. For them, this means that a
increase in dividends higher than expected is interpreted by investors
as a signal that indicates that the management has forecasted an improvement in the
future utilities, while a reduction in dividends indicates a forecast of
deficient utilities. In such a way, MM claimed that the reactions of investors
the changes in dividend payments do not prove the fact that investors
they prefer dividends instead of retained earnings; rather, the price changes
simple// indicate that dividend announcements contain important information. This
The theory is known as the hypothesis of the content of information or of signaling.
 Fundamentals of Financial Management – Weston y Brigham 49

Clientele effect
They also suggested that a clientele effect could exist and that, in case of being.
Thus, this could help explain why stock prices change afterwards.
from the announcement of changes in the dividend policy.
MM concluded that those investors who desired a current income for
dividends should buy shares in companies that had a high ratio of
payment of dividends, while those who do not need current income,
they should invest in companies with a low dividend payout ratio.
This indicates that each company should establish the specific policy that it
The administration will judge to be more appropriate and subsequently // should allow that the
shareholders who do not like this policy will sell their shares to others
investors who were satisfied with it.
However, changing investors is expensive mainly due to: 1) the costs
of brokerage, 2) the probability that the shareholders making the sale will have to pay
taxes on their capital gains and 3) a possible shortage of investors that
They sympathize with the new dividend policy adopted by the company. This means
that companies should not frequently change dividend policies
because such changes will result in net losses.

LTHE DIVIDEND POLICY IN PRACTICE

Residual dividend policy

It states that a company must follow a series of steps to determine its reason for
dividends. Firstly, the optimal capital budget must be determined, to
The amount of capital needed for financing will need to be determined.
this budget. Retained earnings will be used to supply the component of
capital as far as it is possible and final//, pay dividends only// if available
an excess amount needed to provide support for the optimal capital budget.
The basis of residual policy lies in the fact that investors prefer
make the company retain and reinvest its profits instead of being paid out as
dividends if the rate of return that the company can earn on profits
retained is higher than the rate that investors, on average, could obtain s/
other comparable risk investments.
The problem lies in the fact that if the IOS programs vary year by year, strict adherence
the policy will result in variability in dividends, even when maintained
constant the level of profits. Similarly, the existence of fluctuating profits
it will also lead to variable dividends even if the investment opportunities were
stable
Constant or uniformly growing dividends
Many companies have established a specific annual dividend in dollars per share and
they have kept it, and have only increased it when it has seemed clear to them that
future earnings will be sufficient to allow for the new dividend to
keep
Obvious // profits must be growing at a reasonable // steady rate so that
this policy is feasible, but when such a policy can be adopted it will provide to the
investors a real and stable income. The advantages are mainly two. First, that
Given that there is the idea of the content of the information or of the indication, a policy
this will not generate uncertainty in the stock price. Second, given that
generate a constant flow for the shareholder, they can allocate this to their expenses
currents.
 Fundamentals of financial management Weston and Brigham 50

Constant dividend payout ratio

Would it be possible for a company to pay a constant percentage of its profits as
dividends, but since it is almost certain that profits will fluctuate, this policy would mean
that the amount in dollars would vary.
Many times, what companies do is set a target ratio and move closer to it.
they when the profits can be maintained.
Regular dividend under more extra dividends
This policy represents a middle ground between the two previous policies, combining
a low dividend that provides a stable and constant income to investors,
with an extra dividend when profits have been high.
Effects that influence dividend policy
Politicians choose a particular policy based on their beliefs.
administration about which dividend theory will be the most correct, in addition to one
a large multitude of other factors. All those factors can be summarized in four
grupos: 1) restricciones s/ los pagos, 2) oportunidades de inversión, 3) disponibilidad y
cost of alternative sources of capital and 4) effects of a dividend policy on the
cost of capital
Restrictions
1- Bond contracts. Frequent debt contracts limit payments of
dividends, stipulate frequently// that no dividend can be paid unless
that the current ratio, the turnover ratio of earned interests and other ratios
exceed the stipulated minimums.
2- Rule of capital deterioration. Dividend payments cannot exceed the
Line item of the balance sheet known as retained earnings. This restriction
legal, it has been designed in guarantee of the creditors.
3- Availability in cash. Cash dividends can only be paid with
money, therefore, a cash shortfall could restrict dividend payments.
The ability to request loan funds may override this factor.
Investment opportunities
1- Location of the IOS program. If the typical program of a company is located.
far to the right, this will tend to produce a low optimal ratio of
payment of dividends and the opposite will happen when the IOS is very far away
to the left.
2- Possibility to speed up or delay projects. The ability to speed up or
delaying projects will allow a company to adhere in a more
tightens its dividend policy set as a goal.
Alternative sources of capital
Cost from the sale of new shares. If flotation costs are high, the cost of
new equity capital will be significantly above the cost of profits
retained, and with that it will be more convenient to set a low payment rate for
dividends and financing through profit retention.
2- Capacity to substitute debts for equity. If the company can adjust its
reason for debt without costs rising sharply, may
maintain a constant dividend, even if profits fluctuate. The shape of the curve
WACC determines the practical measure by which the ratio can vary
indebtedness. If the curve is relative// flat then a high possibility is more feasible.
reason for paying dividends.
 Fundamentals of Financial Management Weston Brigham 51

3- Control. If management is interested in maintaining control, it can

become reluctant to sell new shares and, therefore, retain a part
important of the profits. However, if the shareholders wish to retain
higher dividends, and if a power of attorney lawsuit is filed, then the
dividends will increase.
Effects of the dividend policy
The effects of the dividend policy on stock performance can
to be considered in terms of 4 factors: 1) the desire to obtain current income versus
futures, 2) the perceived risk in dividends versus the risk of earnings from
capital, 3) the tax advantages of capital gains vs. dividends and 4) the
content of dividend information.
The importance of each factor varies from company to company, depending on the way of
to be of its current and future shareholders.

DDIVIDENDS IN SHARES AND SHARE PARTICIPATIONS

Stock Partitioning
Although there is no empirical evidence, a widespread belief has been observed.
financial circles that there is an optimal price range for stocks. This
would imply that if the price is within that optimal range, the PER ratio and therefore
both the value of the company would be maximized.
Consequently, if the price of the shares were to increase above this range, the
probable administration // would declare a stock split, in such a way as to carry
new // the stock price at that range, without decreasing the market value. With the
stock split, earnings per share will also decrease, however, the
The value obtained per investor will remain constant.
Dividends in shares
Stock dividends are similar to stock splits in the sense of
that divide the cake into smaller slices, without affecting the fundamental position of
the current shareholders.
The total number of shares is increasing, therefore the profits, the
dividends and the price per share will be reduced.
Dividends per share are typically used on a regular annual basis to maintain the
price of the shares more or less restricted, unlike the partition that is used
general// after a sharp increase in price.
Effects on the balance
Although the economic effects of these techniques are virtually identical, they are about
a somewhat different way. In the case of the partitions, the actions are the actions in
circulation has increased and the par value of the shares has decreased in the
same percentage by which the number of shares increased.
With dividends in stock, the par value is not reduced but transferred.
retained earnings to the common stock account.
Effects on the price
Investors take the share splits and stock dividends for what they are,
simple// additional pieces of paper.
If stock dividends and distributions are accompanied by additional profits
high and through cash dividends, then investors will offer a greater
number for the price of the share. However, if they are not accompanied by
 Fundamentals of Financial Management Weston by Brigham 52

increases, the dilution of profits and EPS will cause the stock price
decrease by the same percentage as the stock dividend or split.
In this way, the fundamental determinants of price are basic utilities and the
cash dividends per share.

COMMON STOCKS AND INVESTMENT BANKING PRICE

EVALUATION OF COMMON SHARES AS A SOURCE OF FUNDING

Financing through shares must be analyzed from various perspectives.
view
Corporate point of view
Its advantages are:
1- It does not obligate the company to make payments to shareholders, only when the company
it generates utilities and when it does not have urgent internal needs for such
Utilities will pay a dividend. That is, it is a discretionary decision.
2- The common stocks do not have a fixed expiration date, they never have to be
refunded.
They provide a safety cushion against potential losses from creditors, the
the sale of shares increases the company's creditworthiness. This in turn,
it increases the rating of its bonds, reduces the cost of its debts and
increases its future capacity for the use of debts.
4- Frequent // shares can be sold based on better terms than those that
they would offer the debts.
5- The Managers prefer common equity capital to maintain their
loan request reserve capacity.
However, it has against it:
Provides voting rights and perhaps even a greater degree of control for
the new shareholders.
2- Grant the new owners the right to participate in the income of the
company.
3- The insurance and distribution costs of the shares are generally// higher
than those from other sources.
4- The Dividends are not deductible for tax purposes.
Social perspective
From a social standpoint, they make businesses less vulnerable to
consequences of decreases in sales or profits, as it does not imply the payment of
fixed financing charges. From the economic point of view, if a number
too many companies will use an excessive amount of debt, the fluctuations of
businesses would be amplified.

ETHE COMMON STOCK MARKET

The shares of smaller publicly owned companies are not registered.
In the stock market, they are traded in the sales market over the counter, and it is said that
These companies and their shares are not registered or listed on the stock exchange.
The largest and publicly owned companies// request your
registration in an organized stock exchange.
Types of transactions in the stock market
Stock market transactions can be classified into three categories:
 Fundamentals of Financial Management Weston y Brigham 53

1- Negotiations can be made with outstanding shares of companies.

established, with publicly held capital: the secondary market.
2- Actions additional ones sold by established companies, with owned capital with
public capital: the primary market.
3- New public offerings from companies with capital held in form
private: the primary market. This type of transaction is known as conversion
the public company.
The advantages of becoming a public company are: 1) it facilitates the diversification of the
accionistas, 2) incrementa la liquidez, 3) hace más fácil la obtención de efectivo nuevo
for the corporation and 4) establishes the value of a company.
Its disadvantages are: 1) the cost of meeting information requirements, 2) the
revelation of internal information, 3) the impossibility of self-negotiation of the
administrators, 4) if the market is inactive, prices will be low and 5)
There is greater pressure that undermines the control of the managers.

ETHE PROCESS OF INVESTMENT BANKING

Decisions of Phase I
Magnitude of the issuance or the loan.
2. Types of values that will be used.
3. Type of launch (competitive offers / negotiated operations).
Selection from an investment banker.
Decisions of phase II. These are made jointly by the banker and the company.
Reassessment of the initial decisions.
2. Type of issuance. In abest effort arrangementthe investment banker does not
ensures that the values will be sold or that the company will obtain the
cash that is needed. In ainsurance arrangementthe certain company
it obtains a guarantee, therefore the investment banker assumes a risk
significant in such an offer.
3. Costs of the issuance. Both in terms of their amounts and the way to pay it.
4. Setting the offer price. If the company is already owned in such a way
public, the price will be based on the market price

LONG-TERM DEBTS

FFACTORS INFLUENCING LONG-TERM FINANCING DECISIONS

A large number of factors influence long-term financing decisions of a
company. The relative importance of the factors varies among companies in any
moment in time and for any given company over time. Without
embargo, any company that is planning to obtain new capital in LP should
consider each of these points.
Optimal capital structure
Companies typically establish optimal capital structures, and one of the
the most important considerations in any financing decision is the way in
that the real structure is compared to its optimal structure. However, few
companies are financed with exact year // according to their optimal structures, because
By strictly adhering to these structures, it will increase their flotation costs.
Small emissions have higher proportional flotation costs, the companies
They tend to use debts one year and stocks the following year.
 Fundamentals of Financial Management Weston y Brigham 54

It is noteworthy that the small fluctuations around the optimal capital structure
it has a small effect on the cost of debts and equity or on its overall cost
of capital. Therefore, even when companies tend to finance themselves in the long term according to
with their optimal structures, flotation costs have a very defined influence on
the specific financing decisions in any given year.
Coordination and coupling of deadlines
A financing strategy commonly used by companies consists of
Coordinate the debt maturities with the life of the assets they finance.
This factor has a great influence on the type of debt that is used.
Interest rate levels
The administrators also consider the levels of interest rates, both
both absolute and relative, when they make their financing decisions.
Current and future conditions of the company
If the company's financial condition is poor, its managers may
refuse to issue new long-term debts because a new issuance may trigger
a review by the evaluation agencies and by the cost involved in issuing
risky debt.
In such a way, a company that is in a weakened position but that is
predicting an improvement would be inclined to delay financing
permanent until things improve. Conversely, a company that had
actually // a strong position but whose forecasts were not promising, would be seen
motivated to finance quickly// to LP.
The company's profit outlook and the extent to which forecasts of
Higher UPA will be reflected in stock prices, it will also have an effect on the
selection of values.
Restrictions in current contracts
The restrictions imposed on the current ratio, the debt ratio, and others
financial regulations may also restrict a company's ability to use
different types of financing. At a given moment.
Availability of collateral guarantees
A secured debt at LP will generally be less expensive than an unsecured debt.
guaranteed. Therefore, companies that have large amounts of assets
fixed for general purposes likely// use a greater relative amount of debts,
special// mortgage bonds. Additionally//, the financing decisions for each year are
will be influenced by the amount of newly acquired assets that are available
as collateral guarantee for the new bonds.

OREFUND OPERATIONS
Reimbursement decisions are similar to capital budgeting decisions, and
the NPV method is the fundamental tool. Essentially, the costs of undertaking the
refund operation is compared to the VA the interest that will be saved if the bond with
the high interest rate is reimbursed and replaced with a new bond at a rate of
lowest interest. If the NPV of the repayment is positive, then it should be done.
refund.
The operation costs mainly consist of the reimbursement premium based on the issuance.
old bonds and the flotation costs associated with the sale of a new one
emission.
 Fundamentals of Financial Management Weston and Brigham 55

The benefits related to the FdeF mainly consist of interest expenses that
They save if the company replaces high-cost debts with low-cost debts.
The discount rate that will be used to find the present value of interest savings will be
equal to the after-tax cost of the new debt.

INTERMEDIATE FINANCING

ARENTAL
A lease is comparable to a loan in that it requires that
the company makes a specific series of payments, and failing to make these payments can
result in a bankruptcy. Therefore, it is much more appropriate to compare the cost
of financing through leasing with financing through
debts.
Leasing takes three different forms: sale and leasing, leasing
operational and financial leasing.
Sale and subleasing
Under a sale and leaseback contract, a company that owns land and buildings
or equipment sells the property and simultaneously executes a contract to re-lease it
property for a specific period and under defined terms.
The company that is selling the property (tenant) receives the price immediately.
of purchase provided by the buyer (landlord). At the same time, the company
seller retains the use of the property as if funds had been requested in
loan and mortgaged the property to secure the loan.
Payments are set in such a way that they yield the purchase price for the investor.
landlord while providing a specific rate of return on the investment
current of the landlord.
Operating lease
Operating leases, sometimes known as leasing of
services provide both financing and maintenance. Usually, these
leases require that the lessor maintain and service the leased equipment, and
the cost of the supply of maintenance is included within the payments of
lease.
Another important feature is the fact that they are not amortized frequently in form.
total, in other words the payments required under the lease agreement do not
are sufficient to recover the total cost of the equipment. However, the contract is
draft for a considerable period // shorter than the expected economic life
of the leased equipment, and the lessor expects to recover all costs
from the investment through successive renewals, new leases or the sale of the
team.
Another feature is that they frequently have a cancellation clause, which
provides the tenant the option to terminate the contract before its expiration.
This is an important consideration for the tenant, as it means that the equipment
it can be returned if it becomes obsolete due to technological changes or if it stops being
necessary due to a decrease in business activities.
Financial leasing
Also referred to as capital leasing, it is different from leases.
operational in three aspects, do not provide maintenance services, are not
cancellable and final//, are total// amortizable.
 Fundamentals of Financial Management Weston y Brigham 56

In a typical lease agreement, the company that will use the equipment
(lessor) selects the specific items needed and negotiates the price and the
terms of delivery with the producer. Later//, negotiate the terms with a
leasing company and makes the necessary arrangements for the acquisition.
Leasing contracts are similar to sales and replacement contracts,
the main difference being that the leased equipment is new and that the lessor
buy from a producer or distributor.
A lease should be classified as a capital lease whenever there is any
from the following situations:
1- By virtue of the terms of the lease, the ownership of the leased property is
transfers effectively from the landlord to the tenant.
2- The tenant can purchase the property or renew the contract for an amount
below its fair market price when the lease expires.
3- He the lease is granted for a period equal to or greater than seventy-five percent
from the life of the asset.
4- The present value of the lease payments is equal to or greater than ninety percent.
one hundred percent of the initial value of the asset.

OOPTIONS
An option is a contract that gives its holder the right to buy (or
sell an asset at a predetermined price within a specific period.
The formula value of an option is defined as the difference between the current price and the
equilibrium price. Generally, options are sold at a price higher than their value.
by formula, for which the real market price of the option will be found above
from its formula value to all common stock prices, however, the premium
decreases as the stock price increases. This happens due to the appeal
speculative of the actions; they provide an investor with a high degree of
leverage. The amount of the premium is determined by the potential for earnings of
capital, combined with loss limitation.
The premium decreases as the stock price increases, partly due to the fact
regarding leverage and the characteristic of loss protection
decrease to high stock prices. The potential loss on the option is much
mayor when the option is sold at a high price. These two factors (the effect of
declining leverage and the growing danger of incurring losses) help to
explain why the premium decreases as the price of the common stock increases.
In addition to the stock price and the equilibrium price, the value of an option
it also depends on 1) the option's expiration period and 2) the price variability
basic of the action.
The longer the period of time during which an option is in effect,
the greater its value will be, and larger its premium. A stock that is extremely volatile will be worth
more than an option s/ a very stable action, due to the fact that the losses s/ the
options are limited, significant decreases in the price of a stock are not
they have a corresponding negative effect on option holders. Therefore, the
volatility in the stock price can only increase the value of an option.

CCERTIFICATES OF SHARES
A stock certificate is an option issued by a company, which provides to
your holder has the right to purchase a stipulated number of shares of the capital of the
company at a stipulated price. Generally, stock certificates are
They are distributed along with the debts, and are used to induce investors to buy the
 Fundamentals of Financial Management Weston and Brigham 57

debt to LP of a company at a lower interest rate than would be required

another way.
Price paid for a Value of the bond Value of the
voucher with certificate = as debt + certificates of
of guarantees ordinary actions
The fundamental aspect that must be taken care of when establishing the terms of an offer.
bonds with certificates consists of finding the value of the certificates. The pure value of
The bond debt can be estimated very precisely, however, it is much more difficult.
estimate the value of the certificates. If their price is seen as overvalued in relation to their
true market value, it will be difficult to sell the issue at its par value. In this way
opposite, if the value of the certificates turns out to be undervalued, investors will receive a
unexpected utility because they will be able to sell the certificates in the market for a
amount higher than what they paid for them implicitly, and this unexpected profit
would come from the current shareholders.
Stock certificates are generally used by small companies. and from
rapid growth, those who use them as sweeteners to facilitate debt sales
or preferred shares. Such companies are often considered high-risk,
your bonds can only be sold when companies are willing to pay rates
of relative interest// high and to accept very restrictive clauses in the contracts of
issue.
Obtaining stock certificates along with bonds enables investors to
share the growth of a company if this company is indeed growing and thriving;
consequently, investors are willing to accept a higher interest rate
lower on the bonds and less restrictive clauses.
Currently, virtually all stock certificates are detachable, which
This means that such certificates can be detached and traded in a manner
separate from the bond that protects them. Furthermore, when these certificates are exercised, the
bonds will continue to circulate. In this way, the certificates bring with them capital.
additional accounting while producing very low interest rate debts.
The exercise price of the certificates is generally set between ten and thirty percent.
above the market price of the shares on the date the bond is issued. If
the company grows truly // and thrives, and if the price of its shares increases by
above the exercise price of the certificates, the holders will exercise them
documents. However, if there is no incentive, many certificates will never be.
exercised only up until just before their expiration. Their market value would be higher than the
value of the formula, or its exercise value and therefore the holders would sell their
certificates instead of exercising them.
There are three conditions that motivate holders to exercise their certificates.
of shares: 1) the secure holders will exercise their certificates and will buy shares if
These certificates are about to expire, with the market price of the
action above the exercise price; this means that if a company wants its
certificates should be exercised soon to obtain capital, a date must be set for
relative expiration // short. 2) The holders will tend to exercise voluntarily // their
documents and to buy shares if the company raises the dividend based on the capital in a
sufficient amount; since no type of rent is paid according to the certificate
investors will have an incentive to exercise them, so if the company wants it to
quick exercises // can increase the dividend per its common stock. 3) Sometimes the
stock options have staggered exercise prices, which incentivize their
owners to exercise them, it works as the expiration date, e/ more
The shorter the time frame, the lower the exercise price will be.
 Fundamentals of Financial Management Weston y Brigham 58

VCONVERTIBLE LOANS
Convertible bonds consist of preferred bonds that can be exchanged for
common stocks at the option of the holder. Unlike the exercise of certificates of
actions, the conversion does not bring additional capital. Of course, this reduction of the
debt or preferred stock will strengthen the company's balance sheet and will make
easier to obtain additional capital.
One of the most important features of a convertible bond is the ratio of
conversion (CR), which is defined as the number of shares that the holder receives in
the moment of conversion. A point that is intimately related to CR is
the conversion prices (PC), which represents the effective price paid for the
common shares obtained through conversion.
Value at par of
PC= good
CR
Like the exercise price of a certificate, PCit sets a characteristic // e/ a ten and
thirty percent above the market price of common shares that
prevail in the market at the time the issuance is sold. Generally, the
the price and the rate are set for the entire life of the bond, although sometimes they
they use tiered pricing.
Another factor that can cause a change in PCand CR is a standard feature
that almost all convertible securities have: that clause that protects the value
convertible against dilution resulting from stock partitions, from the
dividends in shares and from the sale of shares at prices lower than the conversion.
The typical clause states that if common shares are sold at a lower price,P C
it should be reduced to the level of the price at which the new share was issued.
Also, if a partition is made or dividends in shares are declared, PCmust
to decrease in the same percentage of the partition or the dividend.
The value of the debt at the time of issuance (B0) is calculated as the current of
future income plus the value at maturity.
Int Value to
B0= expiration
+
(1+ ( 1 + kd)N
kd) t

The formula works for any period following the issuance.

The value that the holder would expect to receive if they made the conversion, (Ct) would be
CtPrice initial of the action (1 + g)tCR
The value of the pure convertible debt will be initially lower than the par value of the bond, but
will increase over time getting closer and closer to this. At the moment of the
issue Ctit will be less than the value of the pure debt, but it will increase if the price of the
action increases, even above par value.
The actual market price must be equal to or greater than the price, higher than its value of
pure debt or CtThe conjunction of these lower limits will form the price curve.
basic.
The general market price will be higher than the basic price, for the same reasons that
the price of an option or a stock certificate is higher than the formula price. The
investors are willing to pay a premium over the pure debt value given the
possibility of obtaining significant capital gains when the stock prices
shoots up. This is due to the Ctit's safer than the action, since even if
profits decrease and the price declines, the value of the bond will never be less than its
value of pure debt.
 Fundamentals of Financial Management Weston y Brigham 59

The space that exists between the market price and the basic value, or the premium that the
investors are willing to pay, declines over time. This decrease
it happens so much due to the increase in dividends, which increases the cost of
opportunity for conversion, as per the refund clause, since the value of
bond market logic// cannot exceed the highest value whether the price of
refund (value of the pure debt) or the conversion price after the bond is
refundable.
The expected return can be found based on the convertible value by finding the value.
of kcin the following equation
Int Ct
Initial price =
(1+ + (1+
kd)t kd)n
Convertible bonds offer three important advantages from the point of view of
issuer. First, they allow the company to sell debt at a higher interest rate
lower and with less restrictive agreements than ordinary bonds. Second general// it
they subordinate mortgage bonds, bank loans, and others
senior type debts, therefore it leaves the company with access to the debt
ordinary intact. Third, they provide a way to sell shares at a higher price
higher than those that prevail in the market.
Its main disadvantages are: 1) the use of a real convertible value.
provide the issuer the opportunity to sell shares at a higher price, without
embargo if the stock price increases significantly, likely// the
the company would be in a better position if it had used ordinary debts, to
despite its higher interest rate, and later // I would have sold shares to
reimburse the debt. 2) If the company really wishes to obtain equity and if the price
If the action does not increase enough after the bond issuance, the company will face
flooded with debts. 3) Convertible bonds typically have a low coupon rate,
an advantage that will be lost when the conversion occurs

J. FRED WESTON AND EUGENE C. BRIGHAM, Fundamentals of Financial Management,

McGraw-Hill Publishing. Mexico 1994.