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Title: CHAPTER 1 An Overview of Financial Management


1
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2
Financial Analysts Awareness Training Program
  • Dr. Mounther Barakat
  • Securities and Commodities Authority

3
Pure 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?

4
Spot 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.

5
Spot 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.

6
Returns
  • 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.

7
What 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.

8
Probability distributions
  • A listing of all possible outcomes, and the
    probability of each occurrence.
  • Can be shown graphically.

9
The 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
  • .

10
Return comparisons
11
T-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.

12
Asset 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.

13
Calculating expected returns.
14
Summary 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?

15
Risk Calculating the standard deviation
16
Risk Calculating the standard deviation
17
Risk Calculating the standard deviation
18
Standard 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.

19
Comparing Risk and Return
20
Coefficient of Variation (CV)
  • A standardized measure of dispersion about the
    expected value, that shows the risk per unit of
    return.

21
Risk 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.

22
Investor 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.

23
Illustrating diversification effects of a stock
portfolio
24
Breaking 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.

25
Capital 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.

26
Beta
  • 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.

27
Calculating 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.

28
Illustrating the calculation of beta
See Excel file
29
Comments 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.

30
Can 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.

31
Beta coefficients
32
Comparing 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.

33
The 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.

34
What 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.

35
Calculating 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

36
Expected vs. Required returns
37
Illustrating the Security Market Line
38
The 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.

39
Valuation of a Simple Company
  • Investors are
  • Debtholders
  • Stockholders

40
Valuation 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.

41
The 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)

42
Steps in the corporate value model
  • Determine weighted average cost of capital
  • Estimate expected future free cash flows
  • Find value of company

43
Estimating 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.

44
Cost 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.

45
Cost of Equity
  • Cost of equity, rs, is higher than cost of debt
    because stock is riskier.
  • Simple Co. rs 12

46
Weighted 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.)
47
WACC (Continued)
  • WACC wD rD (1-T) wS rS
  • 0.3(9)(1 - 0.4) 0.7(12)
  • 10.02

48
Free 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.

49
Calculating FCF
  • FCF net operating profit after taxes minus
    investment in operating capital

50
Operating 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.

51
Operating 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.

52
Balance 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

53
Balance 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

54
Income 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

55
NOPAT (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)

56
Calculating NOPAT
  • NOPAT (Operating profit) (1-T)
  • EBIT (1-T)
  • NOPAT07 66.1184 (1-0.4) 39.67104 million.

57
Calculating 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.

58
Net 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.

59
Net Operating Working Capital
  • NOWC Operating CA Operating CL
  • NOWC07 176.4 66.15
  • 110.25 million

60
Operating Capital
  • Operating capital
  • Net operating working capital (NOWC) plus
  • Long-term capital, such as factories, land,
    equipment.

61
Operating 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.

62
Investment 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.

63
Calculating FCF
  • FCF NOPAT Investment in operating capital
  • FCF07 39.67104 (330.75 315.0423)
  • 39.67104 15.7077
  • 23.96334 million

64
Uses 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.)

65
  • Non-operating income
  • NOPAT
  • Dividends
  • Working Capital
  • Buy back stock
  • Pay interest
  • Fixed Assets
  • Buy non-op assets
  • Pay principal

Free Cash Flow
Reinvestmen
66
How 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.

67
Corporate Valuation
  • Forecast financial statements and use them to
    project FCF.
  • Discount the FCFs at the WACC
  • This gives the value of operations

68
Value of Operations
Of course, this requires projecting free cash
flows out forever.
69
Constant 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

70
Constant Growth Formula
  • The summation can be replaced by a single formula

71
The value of operations
72
Value 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.

73
Value of Equity
  • Price per share
  • Equity / of shares
  • 351 million / 10 million shares
  • 35.10 per share

74
A picture of the breakdown of Simple Co.s value
75
Return 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

76
Return 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.

77
Economic 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)

78
Calculating 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)
79
Economic 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

80
Intuition 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.

81
Fundamental Analysis Practice Examples
  • See XLS
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