Title: CHAPTER 1 An Overview of Financial Management
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2Financial Analysts Awareness Training Program
- Dr. Mounther Barakat
- Securities and Commodities Authority
3Pure Expectations
- Maturity Yield
- 1 year 6.0
- 2 years 6.2
- 3 years 6.4
- 4 years 6.5
- 5 years 6.5
- If PEH holds, what does the market expect will be
the interest rate on one-year securities, one
year from now? Three-year securities, two years
from now?
4Spot and forward rates
- 6.2 (6.0 x) / 2
- 12.4 6.0 x
- 6.4 x
- PEH says that one-year securities will yield
6.4, one year from now.
5Spot and forward rates
- 6.5 2(6.2) 3(x) / 5
- 32.5 12.4 3(x)
- 6.7 x
- PEH says that one-year securities will yield
6.7, one year from now.
6Returns
- The rate of return on an investment can be
calculated as follows - (Amount received Amount invested)
- Return ________________________
-
Amount invested - For example, if 1,000 is invested and 1,100 is
returned after one year, the rate of return for
this investment is - (1,100 - 1,000) / 1,000 10.
7What is Risk?
- Two types of investment risk
- Stand-alone risk
- Portfolio risk
- Investment risk is related to the probability of
earning a low or negative actual return. - The greater the chance of lower than expected or
negative returns, the riskier the investment.
8Probability distributions
- A listing of all possible outcomes, and the
probability of each occurrence. - Can be shown graphically.
9The average and the standard deviation
- Average Standard
- Return Deviation
- Small-company stocks 17.3 33.2
- Large-company stocks 12.7 20.2
- L-T corporate bonds 6.1 8.6
- L-T government bonds 5.7 9.4
- Treasury bills 3.9 3.2
- .
10Return comparisons
11T-Bills and their risk and return.
- T-bills will return the promised 8, regardless
of the economy. - No, T-bills do not provide a risk-free return, as
they are still exposed to inflation. Although,
very little unexpected inflation is likely to
occur over such a short period of time. - T-bills are also risky in terms of reinvestment
rate risk. - T-bills are risk-free in the default sense of the
word.
12Asset and market returns.
- A Moves with the economy, and has a positive
correlation. This is typical. - B Is countercyclical with the economy, and has
a negative correlation. This is unusual.
13Calculating expected returns.
14Summary Calculating expected returns.
- Exp return
- A 17.4
- M 15.0
- C 13.8
- T-bill 8.0
- B 1.7
- A has the highest expected return, and appears to
be the best investment alternative, but is it
really? Have we failed to account for risk?
15Risk Calculating the standard deviation
16Risk Calculating the standard deviation
17Risk Calculating the standard deviation
18Standard Deviation as a Measure of Risk
- Standard deviation (si) measures total, or
stand-alone, risk. - The larger si is, the lower the probability that
actual returns will be closer to expected
returns. - Larger si is associated with a wider probability
distribution of returns.
19Comparing Risk and Return
20Coefficient of Variation (CV)
- A standardized measure of dispersion about the
expected value, that shows the risk per unit of
return.
21Risk rankings, by coefficient of variation
- CV
- T-bill 0.000
- A 1.149
- B 7.882
- C 1.362
- M 1.020
- B has the highest degree of risk per unit of
return. - A, despite having the highest standard deviation
of returns, has a relatively average CV.
22Investor attitude towards risk
- Risk aversion assumes investors dislike risk
and require higher rates of return to encourage
them to hold riskier securities. - Risk premium the difference between the return
on a risky asset and less risky asset, which
serves as compensation for investors to hold
riskier securities.
23Illustrating diversification effects of a stock
portfolio
24Breaking down sources of risk
- Stand-alone risk Market risk Firm-specific
risk - Market risk portion of a securitys stand-alone
risk that cannot be eliminated through
diversification. Measured by beta. - Firm-specific risk portion of a securitys
stand-alone risk that can be eliminated through
proper diversification.
25Capital Asset Pricing Model
- Model based upon concept that a stocks required
rate of return is equal to the risk-free rate of
return plus a risk premium that reflects the
riskiness of the stock after diversification. - Primary conclusion The relevant riskiness of a
stock is its contribution to the riskiness of a
well-diversified portfolio.
26Beta
- Measures a stocks market risk, and shows a
stocks volatility relative to the market. - Indicates how risky a stock is if the stock is
held in a well-diversified portfolio.
27Calculating betas
- Run a regression of past returns of a security
against past returns on the market. - The slope of the regression line (sometimes
called the securitys characteristic line) is
defined as the beta coefficient for the security.
28Illustrating the calculation of beta
See Excel file
29Comments on beta
- If beta 1.0, the security is just as risky as
the average stock. - If beta gt 1.0, the security is riskier than
average. - If beta lt 1.0, the security is less risky than
average. - Most stocks have betas in the range of 0.5 to 1.5.
30Can the beta of a security be negative?
- Yes, if the correlation between Stock i and the
market is negative (i.e., ?i,m lt 0). - If the correlation is negative, the regression
line would slope downward, and the beta would be
negative. - However, a negative beta is highly unlikely.
31Beta coefficients
32Comparing expected return and beta coefficients
- Security Exp. Ret. Beta
- A 17.4 1.30
- M 15.0 1.00
- C 13.8 0.89
- T-Bills 8.0 0.00
- B 1.7 -0.87
- Riskier securities have higher returns, so the
rank order is OK.
33The Security Market Line (SML)
- SML ki kRF (kM kRF) ßi
- Assume kRF 8 and kM 15.
- The market (or equity) risk premium is RPM kM
kRF 15 8 7.
34What is the market risk premium?
- Additional return over the risk-free rate needed
to compensate investors for assuming an average
amount of risk. - Its size depends on the perceived risk of the
stock market and investors degree of risk
aversion. - Varies from year to year, but most estimates
suggest that it ranges between 4 and 8 per year.
35Calculating required rates of return
- kA 8.0 (15.0 - 8.0)(1.30)
- 8.0 (7.0)(1.30)
- 8.0 9.1 17.10
- kM 8.0 (7.0)(1.00) 15.00
- kC 8.0 (7.0)(0.89) 14.23
- kT-bill 8.0 (7.0)(0.00) 8.00
- kB 8.0 (7.0)(-0.87) 1.91
36Expected vs. Required returns
37Illustrating the Security Market Line
38The three basic concepts of valuation
- Investors can only spend cash so "Cash is good
and more cash is better." - Cash today is worth more than cash tomorrow.
- Risky cash flows are worth less than safe cash
flows. - These three imply the value of a company depends
on the size, timing, and riskiness of its cash
flows.
39Valuation of a Simple Company
- Investors are
- Debtholders
- Stockholders
40Valuation example
- Simple Co.s shares of stock also compete in the
market for investors. - Stockholders are the owners of the firm, and the
value of ownership is the value of the asset,
less any debt that is owed. - For example Suppose Simple Co. is worth 501
million. It owes 150 million to debtholders.
So Simple Co.s equity is worth 501 150 351
million.
41The Corporate Valuation Model
- PV of cash flows available to all
investorscalled free cash flows (FCFs). - Discount free cash flows at the average rate of
return required by all investorscalled the
weighted average cost of capital (WACC)
42Steps in the corporate value model
- Determine weighted average cost of capital
- Estimate expected future free cash flows
- Find value of company
43Estimating the Weighted Average Cost of Capital
(WACC)
- Company has two types of investors
- Debtholders
- Stockholders
- Each type of investor expects to receive a return
for their investment - The return an investor receives is a cost of
capital from companys viewpoint.
44Cost of Debt
- Simple Co.s cost of debt rD 9.
- But Simple Co. can deduct interest, so cost to
Simple Co. is after-tax rate on debt. - If tax rate is 40, then after-tax cost of debt
is - After-tax rD 9(1-0.4) 5.4.
45Cost of Equity
- Cost of equity, rs, is higher than cost of debt
because stock is riskier. - Simple Co. rs 12
46Weighted Average Cost of Capital
- WACC is average of costs to all investors,
weighted by the target percent of firm that is
financed by each type. - For Simple Co., target percent financed by
equity - wS 70
- For Simple Co., target percent financed by debt
- wD 30
(More.)
47WACC (Continued)
- WACC wD rD (1-T) wS rS
- 0.3(9)(1 - 0.4) 0.7(12)
- 10.02
48Free Cash Flow (FCF)
- FCF is the amount of cash available from
operations for distribution to all investors
(including stockholders and debtholders) after
making the necessary investments to support
operations. - A companys value depends upon the amount of FCF
it can generate.
49Calculating FCF
- FCF net operating profit after taxes minus
investment in operating capital
50Operating Current Assets
- Operating current assets are the CA needed to
support operations. - Op CA include cash, inventory, receivables.
- Op CA exclude short-term investments, because
these are not a part of operations.
51Operating Current Liabilities
- Operating current liabilities are the CL
resulting as a normal part of operations. - Op CL include accounts payable and accruals.
- Op CA exclude notes payable, because this is a
source of financing, not a part of operations.
52Balance Sheet Assets
- 2005 2006 2007
- Op. CA 162,000.0 168,000.0 176,400.0
- Total CA 162,000.0 168,000.0 176,400.0
- Net PPE 199,000.0 210,042.0 220,500.0
- Tot. Assets 361,000.0 378,042.0 396,900.0
53Balance Sheet Claims
- 2005 2006 2007
- Op. CL 57,911.5 62,999.7 66,150.0
- Total CL 57,911.5 62,999.7 66,150.0
- L-T Debt 136,253.0 143,061.0 150,223.0
- Total Liab. 194,164.5 206,060.7 216,373.0
- Equity 166,835.5 171,981.3 180,527.0
- TL Eq. 361,000.0 378,042.0 396,900.0
54Income Statement
- 2005 2006 2007
- Sales 400,000.0 420,000.0 441,000.0
- Costs 344,000.0 361,994.2 374,881.6
- Op. prof. 56,000.0 58,005.8 66,118.4
- Interest 11,678.7 12,262.8 12,875.5
- EBT 44,321.3 45,743.0 53,242.9
- Taxes (40) 17,728.4 18,297.2 21,297.2
- NI 26,592.7 27,445.8 31,945.7
- Dividends 21,200.0 22,300.0 23,400.0
- Add. RE 5,392.7 5,145.8 8,545.7
55NOPAT (Net Operating Profit After Taxes)
- NOPAT is the amount of after-tax profit generated
by operations. - NOPAT is the amount of net income, or earnings,
that a company with no debt or interest-income
would have. - NOPAT (Operating profit) (1-T)
- EBIT (1-T)
56Calculating NOPAT
- NOPAT (Operating profit) (1-T)
- EBIT (1-T)
- NOPAT07 66.1184 (1-0.4) 39.67104 million.
57Calculating Operating Capital
- Operating capital (also called total operating
capital, or just capital) is the amount of assets
required to support the companys operations,
less the liabilities that arise from those
operations. - The short-term component is net operating working
capital (NOWC). - The long-term component is factories, land,
equipment.
58Net Operating Working Capital
- NOWC Operating current assets
- Operating current liabilities
- This is the net amount tied up in the things
needed to run the company on a day-to-day basis.
59Net Operating Working Capital
- NOWC Operating CA Operating CL
- NOWC07 176.4 66.15
- 110.25 million
60Operating Capital
- Operating capital
- Net operating working capital (NOWC) plus
- Long-term capital, such as factories, land,
equipment.
61Operating Capital
- Operating Capital NOWC LT Op. Capital
- Capital07 110.25 220.50
- 330.75 million
- This means in 2007 Simple Co. had 330.75 million
tied up in capital needed to support its
operations. Investors supplied this money. It
isnt available for distribution.
62Investment in Operating Capital
- Operating capital in 2006 was 315.0423 million
- Operating capital in 2007 was 330.75 million
- Simple Co. had to make a net investment of
330.75 315.0423 15.7077 million in
operating capital in 2007.
63Calculating FCF
- FCF NOPAT Investment in operating capital
- FCF07 39.67104 (330.75 315.0423)
- 39.67104 15.7077
- 23.96334 million
64Uses of FCF
- There are five ways for a company to use FCF
- 1. Pay interest on debt.
- 2. Pay back principal on debt.
- 3. Pay dividends.
- 4. Buy back stock.
- 5. Buy nonoperating assets (e.g., marketable
securities, investments in other companies, etc.)
65Free Cash Flow
Reinvestmen
66How Did Simple Co. use its FCF?
- Paid dividends 23.4 million
- Paid after-tax interest of 12,875.5 (1-0.4)
7.7253 million - For a total of 31.1253 million! This is 7.162
million more than the 23.9 million FCF
available! Where did it come from? - Simple Co. increased its borrowing by 150.223
143.061) 7.162 million to make up the
difference.
67Corporate Valuation
- Forecast financial statements and use them to
project FCF. - Discount the FCFs at the WACC
- This gives the value of operations
68Value of Operations
Of course, this requires projecting free cash
flows out forever.
69Constant growth
- If free cash flows are expected to grow at a
constant rate of 5, then this is easy - 2007 2008 2009 20010 201 2012
- FCF 23.963 25.161 26.419 27.740 29.127 30.584
- There is an easy formula for the present value of
free cash flows that grow forever at a constant
rate
70Constant Growth Formula
- The summation can be replaced by a single formula
71The value of operations
72Value of Equity
- Sources of Corporate Value
- Value of operations 501.225 million
- Value of non-operating assets 0 (in this case)
- Claims on Corporate Value
- Value of Debt 150.223 million
- Value of Equity ?
- Value of Equity 501.225 - 150.223 351.002
million, or just 351 million.
73Value of Equity
- Price per share
- Equity / of shares
- 351 million / 10 million shares
- 35.10 per share
74A picture of the breakdown of Simple Co.s value
75Return on Invested Capital (ROIC)
- ROIC can be used to evaluate Simple Co.s
performance - ROIC NOPAT / Total operating capital in place
at the beginning of the year
76Return on Invested Capital (ROIC)
- ROIC07 NOPAT07 / Capital06
- ROIC07 39.67104 / 315.0423 12.6.
- This is a good ROIC because it is greater than
the return that investors require, the WACC,
which is 10.02. So Simple Co. added value
during 2007.
77Economic Value Added (EVATM) (also called
Economic Profit)
- EVA is another key measure of operating
performance. - EVA is trademarked by Stern Stewart, Inc.
- It measures the amount of profit the company
earned, over and above the amount of profit that
investors required. - EVA NOPATt WACC(Capitalt-1)
78Calculating EVA
- EVA NOPAT- (WACC)(Begng. Capital)
- EVA07 NOPAT07 (0.1002)(Capital06)
- EVA07 39.67104 (0.1002)(315.0423)
- 39.67104 31.56742
- 8.1038 million
(More)
79Economic profit
- This shows that in 2007 Simple Co. earned about
8 million more than its investors required. - Another way to calculate EP is
- EVAt (ROIC WACC)Capitalt-1
- (0.125923 0.1002)315.0423
- 8.1038 million
80Intuition behind EVA
- If the ROIC WACC spread is positive, then the
firm is generating more than enough profit, and
is increasing value. But, if the ROIC WACC
spread is negative, then the firm is destroying
value, in the sense that investors would be
better off taking their money and investing it
elsewhere.
81Fundamental Analysis Practice Examples