331NS-1

1
FIN 331 in a Nutshell

• Financial Management I Review

2
FIN 331 in a Nutshell - Index

• Financial Statements, Ratios, AFN
• Time Value of Money
• Bond Valuation
• Risk Return (SML/CAPM)
• Stock Valuation
• WACC
• NPV, IRR, MIRR
• Cash Flow Estimation

Click on the selected topic to go directly to
that section
3
Financial Statements, Cash Flow, and Taxes

• Key Financial Statements
• Balance sheet
• Income statements
• Statement of cash flows

Index
4
The Annual Report

• Balance sheet
• Snapshot of a firms financial position at a
  point in time
• Income statement
• Summarizes a firms revenues and expenses over a
  given period of time
• Statement of cash flows
• Reports the impact of a firms activities on cash
  flows over a given period of time

5
Sample Balance Sheet
Assets Liabilities Owners Equity
6
Sample Income Statement
Net incomeDividends Retained earnings
7
Allied Food Products
8
Allied 2005 Per-Share Ratios
Ratio Formula Calculation
Earnings per Share (EPS)
Dividends per Share (DPS)
Book Value per Share (BVPS)
Cash flow per Share (CFPS)
9
Statement of Cash Flows

• Provides information about cash inflows and
  outflows during an accounting period
• Required since 1988
• Developed from Balance Sheet and Income Statement
  data

10
Statement of Cash Flows
Reconciles the change in Cash Equivalents
11
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12
Statement of Cash Flows
Why is it important???

• Reconciles the Income Statement and Balance Sheet
  to the flow of cash
• The Matching Principle requires estimates and
  accruals to prepare Financial statements
• Financial Analysis is concerned with Cash Flow

13
Statement of Cash Flows

• A positive net income on the income statement
  is ultimately insignificant unless a company can
  translate its earnings into cash, and the only
  source in financial statement data for learning
  about the generation of cash from operations is
  the statement of cash flows

14
Deficits
Covered by new debt and cash
15
Net Operating Working Capital
If the Asset side had included Short-term
investments they would have been excluded as
well.
16
Operating Capital (also called Total Net
Operating Capital)

• Operating Capital
• NOWC Net fixed assets
• Operating Capital
• (2005) 800 1,000 1,800 million
• (2004) 650 870 1,520 million
• Net Investment in Operating Capital
• Op Cap (2005) Op Cap (2004)
• 1,800 - 1,520 280 million

17
Net Operating Profit after Taxes (NOPAT)
Operating Cash Flow

• NOPAT EBIT(1 - Tax rate)
• NOPAT05 283.8(1 - 0.4) 170.3 m
• OCF05 NOPAT Deprec Amort
• 170.3 100
• 270.3

18
Free Cash Flow (FCF) for 2005

• EBIT 283.8 m T 40 Depreciation
  100 m
• Capital Expenditures ?FA Deprec 130100
  230
• ?NOWC 800 - 650 150 m
• FCF 283.8(1-.4)100 230-150
• -109.7 m

19
Analysis of Financial Statements

• Ratio Analysis
• Limitations of ratio analysis
• Qualitative factors

Index
20
Five Major Categories of Ratios

• Liquidity
• CR - Current Ratio
• QR - Quick Ratio or Acid-Test
• Asset management
• Inventory Turnover
• DSO Days sales outstanding
• FAT - Fixed Assets Turnover
• TAT - Total Assets Turnover
• Debt management
• Debt Ratio
• TIE Times interest earned
• EBITDA coverage (EC)

21
Five Major Categories of Ratios

• Profitability
• PM - Profit margin on sales
• BEP Basic earning power
• ROA Return on total assets
• ROE Return on common equity
• Market value
• P/E Price-Earnings ratio
• P/CF Price cash flow ratio
• M/B Market to book

22
Liquidity Ratios

• CR Current Ratio
• CA/CL
• QR Quick Ratio or Acid-Test
• (CA-INV)/CL

23
Asset Management Ratios

• Inventory Turnover Sales/Inventories
• DSO Days sales outstanding
• Receivables /(Annual sales/365)
• FAT Fixed Assets Turnover
• Sales/Net Fixed Assets
• TAT Total Assets Turnover
• Sales/Total Assets

24
Debt Management Ratios

• Debt Ratio Total Liabilities/Total Assets
• TIE Times interest earned
• EBIT/Interest
• EBITDA coverage EC
• (EBITDA lease pmts) .
• (Interest principal pmts lease pmts)

25
Profitability Ratios

• PM Profit margin on sales
• NI/Sales
• BEP Basic earning power
• EBIT/Total Assets
• ROA Return on total assets
• NI/Total Assets
• ROE Return on common equity
• NI/Common Equity

26
Market Value Metrics

• P/E Price-Earnings ratio
• Price per share/Earnings per share
• P/CF Pricecash flow ratio
• Price per share/Cash flow per share
• M/B Market to book
• Market price per share
• Book value per share

27
The 5 Major Categories of Ratios and What
Questions They Answer
Ratio Category Questions Answered
Liquidity Can we make required payments?
Asset Management Right amount of assets vs. sales?
Debt Management Right mix of debt and equity?
Profitability Do sales prices exceed unit costs Are sales high enough as reflected in PM, ROE, and ROA?
Market Value Do investors like what they see as reflected in P/E and M/B ratios
28
Potential Problems and Limitations of Ratio
Analysis

• Comparison with industry averages is difficult if
  the firm operates many different divisions
• Average performance ? necessarily good
• Seasonal factors can distort ratios
• Window dressing techniques

29
Problems and Limitations (Continued)

• Different accounting and operating practices can
  distort comparisons
• Sometimes difficult to tell if a ratio value is
  good or bad
• Different ratios give different signals
• Difficult to tell, on balance, whether a company
  is in a strong or weak financial condition

30
Qualitative Factors

• Revenues tied to a single customer?
• Revenues tied to a single product?
• Reliance on a single supplier?
• Percentage of business generated overseas?
• Competitive situation?
• Legal and regulatory environment?

31
Financial Planning and Forecasting

• Forecasting sales
• Projecting the assets and internally generated
  funds
• Projecting outside funds needed
• Deciding how to raise funds

Index
32
The AFN Formula

• If ratios are expected to remain constant
• AFN (A/S0)?S - (L/S0)?S - M(S1)(RR)

Required ? Assets
? Retained Earnings
Spontaneously ? Liabilities
33
Variables in the AFN Formula

• A Assets tied directly to sales
• S0 Last years sales
• S1 Next years projected sales
• ?S Increase in sales (S1-S0)
• L Liabilities that spontaneously
  increase with sales

34
Variables in the AFN Formula

• A/S0 assets required to support sales
• Capital Intensity Ratio
• L/S0 spontaneous liabilities ratio
• M profit margin (Net income/sales)
• RR retention ratio percent of net
• income not paid as dividend

35
Key Factors in AFN

• ?S Sales Growth
• A/S0 Capital Intensity Ratio
• L/S0 Spontaneous Liability Ratio
• M Profit Margin
• RR Retention Ratio

36
Time Value of Money

• Timelines
• Future Value
• Present Value
• Present Value of Uneven Cash Flows

37
Time Lines Timing of Cash Flows
0
1
2
3
I
CF0
CF1
CF3
CF2

• Tick marks occur at the end of periods
• Time 0 today
• Time 1 the end of the first period or the
  beginning of the second period

CF Cash INFLOW -CF Cash OUTFLOW PMT
Constant CF
38
Basic Definitions

• Present Value (PV)
• The current value of future cash flows discounted
  at the appropriate discount rate
• Value at t0 on a time line
• Future Value (FV)
• The amount an investment is worth after one or
  more periods.
• Later money on a time line

39
Future Value General Formula
FV PV(1 I)N

• FV future value
• PV present value
• I period interest rate, expressed
• as a decimal
• N number of periods
• Future value interest factor (1 I)N
• Note yx key on your calculator

40
Texas Instruments BA-II Plus

• FV future value
• PV present value
• PMT periodic payment
• I/Y period interest rate
• N number of periods

One of these MUST be negative
N I/Y PV PMT FV
41
Excel Spreadsheet Functions

• FV(rate,nper,pmt,pv)
• PV(rate,nper,pmt,fv)
• RATE(nper,pmt,pv,fv)
• NPER(rate,pmt,pv,fv)
• Use the formula icon (ƒx) when you cant remember
  the exact formula

42
Future Values Example

• Suppose you invest 100 for 5 years at 10
• How much would you have?

Formula Solution FV PV(1I)N 100(1
.10)5 100(1.6105) 161.05
43
Future Value Example

• Suppose you invest 100 for 5 years at 10. How
  much would you have?

• Calculator Solution
• 5 N
• 10 I/Y
• -100 PV
• 0 PMT
• CPT FV 161.05

44
Future ValueImportant Relationship 1

• For a given interest rate
• The longer the time period,
• The higher the future value
• FV PV(1 I)N

For a given I, as N increases, FV increases
45
Future Value Important Relationship 2

• For a given time period
• The higher the interest rate,
• The larger the future value

FV PV(1 I)N
For a given N, as I increases, FV increases
46
Present Values

• The current value of future cash flows discounted
  at the appropriate discount rate
• Value at t0 on a time line
• Answers the questions
• How much do I have to invest today to have some
  amount in the future?
• What is the current value of an amount to be
  received in the future?

47
Present Values

• FV PV(1 I)N
• Rearrange to solve for PV
• PV FV / (1I)N
• PV FV(1I)-N
• Discounting finding the present value of one
  or more future amounts

48
Present Value One Period Example

• You need 10,000 for the down payment on a new
  car
• You can earn 7 annually.
• How much do you need to invest today?

1 N 7 I/Y 0 PMT 10000 FV CPT PV -9345.79
PV 10,000(1.07)-1 9,345.79
PV(0.07,1,0,10000)
49
Present ValueImportant Relationship 1

• For a given interest rate
• The longer the time period,
• The lower the present value

For a given I, as N increases, PV decreases
50
Present Value Important Relationship 2

• For a given time period
• The higher the interest rate,
• The smaller the present value

For a given N, as I increases, PV decreases
51
The Basic PV Equation - Refresher

• PV FV / (1 I)N
• There are four parts to this equation
• PV, FV, I and N
• Know any three, solve for the fourth
• If you are using a financial calculator, be sure
  and remember the sign convention

CF Cash INFLOW -CF Cash OUTFLOW
52
Multiple Cash FlowsPresent Value

• The Basic Formula
• The TI BA II
• Using the PV/FV keys
• Using the Cash Flow Worksheet
• Excel

53
Multiple Uneven Cash Flows Present Value

• You are offered an investment that will pay
• 200 in year 1,
• 400 the next year,
• 600 the following year, and
• 800 at the end of the 4th year.
• You can earn 12 on similar investments.
• What is the most you should pay for this
  investment?

54
What is the PV of this uneven cash flow stream?
-1,432.93 PV
55
Present Value of an Uneven Cash Flow Stream
Formula
56
Multiple Uneven Cash Flows PV

• Year 1 CF 1 N 12 I/Y 200 FV CPT PV
  -178.57
• Year 2 CF 2 N 12 I/Y 400 FV CPT PV
  -318.88
• Year 3 CF 3 N 12 I/Y 600 FV CPT PV
  -427.07
• Year 4 CF 4 N 12 I/Y 800 FV CPT PV
  -508.41
• Total PV -1,432.93

57
Multiple Uneven Cash Flows Using the TI BAIIs
Cash Flow Worksheet

• Clear all
• Press CF
• Then 2nd
• And CLR WORK (above CE/C)
• CF0 is displayed and is 0
• Enter the Period 0 cash flow
• If it is an outflow, hit /- to change the sign
• To enter the figure in the cash flow register,
  press ENTER

58
TI BAII Uneven CFs

• Press the down arrow (?) to move to the next cash
  flow register.
• Enter the cash flow amount, press ENTER and then
  down arrow to move to the cash flow counter (Fn).
• The default counter value is 1.
• To accept the value of 1, press the down arrow
  again.
• To change the counter, enter the correct count,
  press ENTER and then the down arrow.

59
TI BAII Uneven CFs

• Repeat for all cash flows, in order.
• To find NPV
• Press NPV I appears on the screen
• Enter the interest rate, press ENTER and the down
  arrow to display NPV.
• Press compute CPT

60
TI BAII Uneven Cash Flows

• CF
• C00 0 ENTER ?
• C01 200 ENTER ?
• F01 1 ENTER ?
• C02 400 ENTER ?
• F02 1 ENTER ?
• C03 600 ENTER ?
• F03 1 ENTER ?
• C04 800 ENTER ?
• F04 1 ENTER ? NPV
• I 12 ENTER ?
• NPV CPT
• 1432.93

Cash Flows CF0 0 CF1 200 CF2 400 CF3 600
CF4 800
61
Excel PV of multiple uneven CFs
62
Bonds and Their Valuation

• Interest rates
• Bond valuation
• Measuring yield

Index
63
Nominal vs. Real rates

• r Any nominal rate
• r The real risk-free rate
• T-bill rate with no inflation
• Typically ranges from 1 to 4 per year
• rRF Rate on Treasury securities
• Proxied by T-bill or T-bond rate

64
r r IP DRP LP MRP

• Here
• r Required rate of return on a debt
  security
• r Real risk-free rate
• IP Inflation premium
• DRP Default risk premium
• LP Liquidity premium
• MRP Maturity risk premium

rRF
65
Premiums Added to r for Different Types of Debt
Debt Instrument IP DRP MRP LP

• ST Treasury ST IP
• LT Treasury LT IP MRP
• ST Corporate ST IP DRP LP
• LT Corporate LT IP DRP MRP LP

66
Discount Rate YTM

• The discount rate (YTM) is
• The opportunity cost of capital
• The rate that could be earned on alternative
  investments of equal risk
• Required return
• For debt securities
• YTM r IP LP MRP DRP

67
Bond Value

• Bond Value PV(coupons) PV(par)
• Bond Value PV(annuity) PV(lump sum)
• Remember
• As interest rates increase present values
  decrease as YTM ? ? PV ?
• As interest rates increase, bond prices decrease
  and vice versa

68
The Bond-Pricing Equation
PV(lump sum)
PV(Annuity)
C Coupon payment F Face value
69
Texas Instruments BA-II Plus

• FV future value/face value/par value
• PV present valuebond value/price
• I/Y period interest rate YTM
• N number of periods to maturity
• PMT coupon payment

70
Spreadsheet Functions

• FV(Rate,Nper,Pmt,PV,0/1)
• PV(Rate,Nper,Pmt,FV,0/1)
• RATE(Nper,Pmt,PV,FV,0/1)
• NPER(Rate,Pmt,PV,FV,0/1)
• PMT(Rate,Nper,PV,FV,0/1)

• Inside parens (RATE,NPER,PMT,PV,FV,0/1)
• 0/1 Ordinary annuity 0 (default)
• Annuity Due 1 (must be entered)

71
Pricing Specific Bonds

• TI BA II
• Bond Worksheet 2nd BOND
• SDT CPN RDT RV ACT 2/Y YLD PRI
• Excel
• PRICE(Settlement,Maturity,Rate,Yld,Redemption,
  Frequency,Basis)
• YIELD(Settlement,Maturity,Rate,Pr,Redemption,
  Frequency,Basis)
• Settlement and maturity need to be actual dates
• Redemption and Pr need to given as of par value

72
Yield to Maturity (YTM)

• The market required rate of return for bonds of
  similar risk and maturity
• The discount rate used to value a bond
• Return earned if bond held to maturity
• Usually coupon rate at issue
• Quoted as an APR
• The IRR of a bond

73
What is the YTM on a 10-year, 9 annual coupon,
1,000 par value bond, selling for 887?

• Must find the rd that solves this model

74
Using a financial calculator to solve for the YTM

• YTM 10.91
• Bond sells at a discount because YTM gt coupon rate

10
90
1000
- 887
INPUTS
N
I/YR
PMT
PV
FV
OUTPUT
10.91
75
Solving for YTM
YTM on a 10-year, 9 annual coupon, 1,000 par
value bond selling for 887
Using the calculator N 10 PV -887 PMT
90 FV 1000 CPT I/Y 10.91

• Coupon rate 9
• Annual coupons
• Par 1,000
• Maturity 10 years
• Price 887

RATE(10,90,-887,1000)
76
Find YTM, if the bond price is 1,134.20

• YTM 7.08
• Bond sells at a premium because YTM lt coupon rate

10
90
1000
-1134.2
INPUTS
N
I/YR
PMT
PV
FV
OUTPUT
7.08
77
Solving for YTM
YTM on a 10-year, 9 annual coupon, 1,000 par
value bond selling for 1,134.20

• Coupon rate 9
• Annual coupons
• Par 1,000
• Maturity 10 years
• Price 1,134.20

Using the calculator N 10 PV -1134.20 PMT
90 FV 1000 CPT I/Y 7.08
RATE(10,90,-1134.20,1000)
78
Semiannual bonds

1. Multiply years by 2 number of periods 2N.
2. Divide nominal rate by 2 periodic rate (I/YR)
   rd / 2.
3. Divide annual coupon by 2 PMT ann cpn / 2.

2N
rd / 2
cpn / 2
OK
OK
INPUTS
N
I/YR
PMT
PV
FV
OUTPUT
79
What is the value of a 10-year, 10 semiannual
coupon bond, if rd 13?

1. Multiply years by 2 N 2 10 20
2. Divide nominal rate by 2 I/YR 13 / 2 6.5
3. Divide annual coupon by 2 PMT 100 / 2 50

20
6.5
50
1000
INPUTS
N
I/YR
PMT
PV
FV
OUTPUT
- 834.72
80
Valuing a Semiannual Bond

• Coupon rate 10
• Annual coupons
• Par 1,000
• Maturity 10 years
• YTM 13

Using the calculator N 20 I/Y 6.5 PMT
50 FV 1000 CPT PV -834.72
Using the formula
PV(0.065, 10, 50, 1000)
81
YTM with Semiannual Coupons

• Suppose a bond with a 10 coupon rate and
  semiannual coupons, has a face value of 1000, 20
  years to maturity and is selling for 1197.93.
• Is the YTM more or less than 10?
• What is the semiannual coupon payment?
• How many periods are there?

82
YTM with Semiannual Coupons

• Suppose a bond with a 10 coupon rate and
  semiannual coupons, has a face value of 1000, 20
  years to maturity and is selling for 1197.93.
• N 40
• PV -1197.93
• PMT 50
• FV 1000
• CPT I/Y 4
• YTM 42 8
• ? Result ½ YTM

NOTE Solving a semi-annual payer for YTM will
result in a 6-month YTM answer
Calculator solves what you enter.
83
Risk and Rates of Return

• Stand-alone Risk
• Portfolio Risk
• Risk Return CAPM / SML

Index
84
The Expected Rate of Return
r hat expected return ri expected return in
ith state of the economy Pi Probability of
ith state occurring
85
Calculating the Expected Return
86
The Standard Deviation of Returns
s Standard deviation
s v Variance v s2
87
Standard deviation for each investment
88
Standard Deviation of HTs Returns
89
Risk versus ReturnDo we know enough now?
Security Expected return, r Risk, s
T-bills 5.5 0.0
HT 12.4 20.0
Coll 1.0 13.2
USR 9.8 18.8
Market 10.5 15.2

90
Coefficient of Variation (CV)

• CV Standard deviation/expected return
• Risk per unit of return

91
Portfolio Expected Return

rp weighted average wi of portfolio in
stock i ri return on stock i
92
Portfolio Expected Return

• Assume a two-stock portfolio is created with
• 50,000 invested in both HT and Collections

rp 0.5(12.4) 0.5(1.0) 6.7
93
Portfolio Return
Portfolio (50 x HT) (50 x
Coll) Portfolio Return Prob x Portfolio
94
Portfolio Risk

• Portfolio Standard deviation is NOT a weighted
  average of the standard deviations of the
  component assets

95
Calculating portfolio standard deviation and CV
96
Portfolio Standard Deviation
97
Portfolio Risk Return
?

• sp 3.4 is much lower than the s of either
  stock
• sp 3.4 is lower than the weighted average of
  HT and Coll.s s (16.6)
• ?The portfolio provides the average return of
  component stocks, but lower than the average risk
• Why? Negative correlation between stocks

98
Covariance of Returns

• Measures how much the returns on two risky assets
  move together

99
Covariance vs. Variance of Returns
100
Covariance
Covariance (HTColl) -0.0264
101
Correlation Coefficient

• Correlation Coefficient ? (rho)
• Scales covariance to -1,1
• -1 Perfectly negatively correlated
• 0 Uncorrelated not related
• 1 Perfectly positively correlated

102
Two-Stock Portfolios

• If r -1.0
• Two stocks can be combined to form a riskless
  portfolio
• If r 1.0
• No risk reduction at all
• In general, stocks have r 0.35
• Risk is lowered but not eliminated
• Investors typically hold many stocks

103
s of n-Stock Portfolio

• Subscripts denote stocks i and j
• ri,j Correlation between stocks i and j
• si and sj Standard deviations of stocks i and j
• sij Covariance of stocks i and j

104
Portfolio Risk-n Risky Assets

• i j for n2
• 1 1 w1w1?11 w12?12
• 1 2 w1w2?12
• 2 1 w2w1?21
• 2 2 w2w2?22 w22?22
• ?p2 w12?12 w22?22 2w1w2 ?12

105
Portfolio Risk-2 Risky Assets
106
Capital Asset Pricing Model (CAPM)

• Links risk and required returns
• Security Market Line (SML)
• A stocks required return equals the risk-free
  return (rRF) plus a risk premium (RPM x ?) that
  reflects the stocks risk after diversification
• Primary conclusion
• The relevant riskiness of a stock is its
  contribution to the riskiness of a
  well-diversified portfolio.

107
The SML and Required Return

• The Security Market Line (SML) is part of the
  Capital Asset Pricing Model (CAPM)
  
• rRF Risk-free rate
• RPM Market risk premium rM rRF

108
The Market Risk Premium (rM rRF RPM)

• Additional return over the risk-free rate to
  compensate investors for assuming an average
  amount of risk
• Size depends on
• Perceived risk of the stock market
• Investors degree of risk aversion
• Varies from year to year
• Estimates suggest a range between 4 and 8 per
  year

109
Required Rates of Return

• Assume rRF 5.5 RPM 5
• rHT 5.5 (5.0)(1.32)
• 5.5 6.6 12.10
• rM 5.5 (5.0)(1.00) 10.50
• rUSR 5.5 (5.0)(0.88) 9.90
• rT-bill 5.5 (5.0)(0.00) 5.50
• rColl 5.5 (5.0)(-0.87) 1.15

110
Expected vs Required Returns
Required by the market
Expected by YOU
Expected Required
Return Return
HT 12.40 12.10 Undervalued
Market 10.50 10.50 Fairly valued
USR 9.80 9.90 Overvalued
T-bills 5.50 5.50 Fairly valued
Coll 1.00 1.15 Overvalued
111
Illustrating the Security Market Line
SML ri 5.5 (5.0) ?i
ri ()
SML
.
HT
.
.
rM 10.5 rRF 5.5
.
USR
T-bills
.
Risk, ?i
-1 0 1 2
Coll.
112
Portfolio Beta

Where wi weight ( dollars invested in asset
i) ßi Beta of asset i ßp Portfolio Beta
113
Stocks and Their Valuation

• Constant growth stock valuation
• Non-constant growth stock valuation
• Corporate value model

Index
114
Constant growth stock

• Dividends expected to grow forever at a constant
  rate, g
• D1 D0 (1g)1
• D2 D0 (1g)2
• Dt D0 (1g)t
• Dividend growth formula converges to

115
Constant Growth Model
Needed data D0 Dividend just paid D1 Next
expected dividend g constant growth rate rs
required return on the stock
116
Expected Value at time t
Value at t0
Value at t
117
Supernormal Growth

• What if g 30 for 3 years before achieving
  long-run growth of 6?
• Constant growth model no longer applicable
• But - growth constant after 3 years

118
Valuing common stock with nonconstant growth

P
119
Corporate Value Model

• Free Cash Flow method
• Value of the firm present value of the firms
  expected future free cash flows
• Free cash flow after-tax operating income less
  net capital investment
• FCF NOPAT Net capital investment

120
Applying the corporate value model

• Market value of firm
• (MVF) PV(future FCFs)
• MV of common stock
• MVF MV of debt
• Intrinsic stock value
• MVCS / shares

121
Issues regarding the corporate value model

• Often preferred to the dividend growth model
• Firms that dont pay dividends
• Dividends hard to forecast
• Assumes at some point free cash flow growth rate
  will be constant
• Terminal value (TVN) value of firm at the
  point that growth becomes constant

122
Firms Intrinsic Value
Long-run gFCF 6 WACC 10
123
If the firm has 40 million in debt and has 10
million shares of stock, what is the firms
intrinsic value per share?

• MV of equity MV of firm MV of debt
• 416.94 - 40
• 376.94 million
• Value per share MV of equity / of shares
• 376.94 / 10
• 37.69

124
Firm multiples method

• Often used by analysts to value stocks
• P / E Price-earning
• P / CF Price-cash flow
• P / Sales Price-sales
• Method
• Estimate appropriate ratio based on comparable
  firms
• Multiply estimate by expected metric to estimate
  stock price

125
The Cost of Capital

• Cost of equity
• WACC
• Adjusting for risk

Index
126
WACCWeighted Average Cost of Capital

• WACC wdrd(1-T) wprp wcrs

Where wD of debt in capital structure wP
of preferred stock in capital structure wC
of common equity in capital structure rD
firms cost of debt rP firms cost of preferred
stock rC firms cost of equity T firms
corporate tax rate
Weights
Component costs
127
Three ways to determine the cost of equity, rs
1. DCF rs D1/P0 g 2. CAPM rs rRF
(rM - rRF)ßi rRF (RPM)ßi 3. Own-Bond-Yiel
d-Plus-Risk Premium rs rd Bond RP
128
DCF Approach Inputs

1. Current stock price (P0)
2. Current dividend (D0)
3. Growth rate (g)

129
Four Mistakes to Avoid

• Current (YTM) vs. historical (Coupon rate) cost
  of debt
• Mixing current and historical measures to
  estimate the market risk premium
• Book weights vs. Market Weights
• Use Target weights
• Use market value of equity
• Book value of debt reasonable proxy for market
  value.
• Incorrect cost of capital components
• Only investor provided funding

130
Should the company use the composite WACC as the
hurdle rate for each of its projects?

• NO!
• A firms composite WACC reflects the risk of an
  average project
• WACC hurdle rate for an average risk project
• Different divisions/projects may have different
  risks
• Division or project WACC should be adjusted to
  reflect appropriate risk

131
Divisional and Project Costs of Capital

• Using the WACC as the discount rate is only
  appropriate for projects that are the same risk
  as the firms current operations
• If considering a project that is NOT of the same
  risk as the firm, then an appropriate discount
  rate for that project is needed
• Divisions also often require separatediscount
  rates

132
Using WACC for All Projects - Example

• What would happen if we use the WACC for all
  projects regardless of risk?
• Assume the WACC 15

133
Divisional Risk and the Cost of Capital

Rate of Return

()

Acceptance Region

WACC

WACC


H
Acceptance Region
Rejection Region


WACC

F

Rejection Region
WACC

L

Risk

0

Risk


Risk

L
H
134
Subjective Approach

• Consider the projects risk relative to the firm
  overall
• If project risk gt firm risk ? project discount
  rate gt WACC
• If project risk lt firm risk ? project discount
  rate lt WACC

135
Subjective Approach - Example
Risk Level Discount Rate
Very Low Risk WACC 8 7
Low Risk WACC 3 12
Same Risk as Firm WACC 15
High Risk WACC 5 20
Very High Risk WACC 10 25
136
The Basics of Capital Budgeting

• Independent vs. mutually exclusive CFs
• Normal vs. non-normal CFs
• NPV
• IRR
• MIRR
• PB
• DPB

Index
137
Steps to capital budgeting

1. Estimate CFs (inflows outflows)
2. Assess riskiness of CFs
3. Determine appropriate cost of capital
4. Find NPV and/or IRR
5. Accept if NPVgt0 and/or IRRgtWACC

138
Independent vs. Mutually Exclusive Projects

• Independent
• The cash flows of one are unaffected by the
  acceptance of the other
• Mutually Exclusive
• The acceptance of one project precludes
  acceptance of the other

139
NPV Sum of the PVs of all cash flows.
NOTE t0
Cost often is CF0 and is negative
140
TI BAII Uneven Cash Flows

• CF
• C00 100 /- ENTER ?
• C01 10 ENTER ?
• F01 1 ENTER ?
• C02 60 ENTER ?
• F02 1 ENTER ?
• C03 80 ENTER ?
• F03 1 ENTER? NPV
• I 10 ENTER ?
• NPV CPT
• 18.78

Cash Flows CF0 -100 CF1 10 CF2 60 CF3 80

141
Internal Rate of Return (IRR)

• IRR discount rate that forces PV of inflows
  equal to cost, and NPV 0
• Solving for IRR with a financial calculator
• Enter CFs in CFLO register
• Press IRR

142
NPV vs IRR
NPV Enter r, solve for NPV
IRR Enter NPV 0, solve for IRR
143
Modified Internal Rate of Return (MIRR)

• MIRR discount rate which causes the PV of a
  projects terminal value (TV) to equal the PV of
  costs
• TV inflows compounded at WACC
• ?MIRR assumes cash inflows reinvested at WACC

144
Normal vs. Non-normal Cash Flows

• Normal Cash Flow Project
• Cost (negative CF) followed by a series of
  positive cash inflows
• One change of signs
• Non-normal Cash Flow Project
• Two or more changes of signs
• Most common Cost (negative CF), then string of
  positive CFs, then cost to close project
• For example, strip mine

145
Multiple IRRs

• Descartes Rule of Signs
• Polynomial of degree n?n roots
• 1 real root per sign change
• Rest imaginary (i2 -1)

146
The Pavillion ProjectNon-normal CFs and MIRR
1
2
0
-800,000
5,000,000
-5,000,000
PV outflows _at_ 10 -4,932,231.40
TV inflows _at_ 10 5,500,000.00
MIRR 5.6
147
MIRR versus IRR

• MIRR correctly assumes reinvestment at
  opportunity cost WACC
• MIRR avoids the multiple IRR problem
• Managers like rate of return comparisons, and
  MIRR is better for this than IRR

148
When to use the MIRR instead of the IRR? Accept
Project P?

• When there are nonnormal CFs and more than one
  IRR, use MIRR.
• PV of outflows _at_ 10 -4,932.2314.
• TV of inflows _at_ 10 5,500.
• MIRR 5.6.
• Do not accept Project P.
• NPV -386.78 lt 0.
• MIRR 5.6 lt WACC 10.

149
Excel Functions
150
Cash Flow Estimation and Risk Analysis

• Relevant cash flows
• Net salvage value
• Inflation
• Sensitivity analysis
• Scenario analysis
• Real options

Index
151
Relevant Cash FlowsIncremental Cash Flow for
a Project

• Projects incremental cash flow is
• Corporate cash flow with the project
• Minus
• Corporate cash flow without the project

152
Relevant Cash Flows

• Changes in Net Working Capital Y
• Interest/Dividends .... N
• Sunk Costs .. N
• Opportunity Costs .Y
• Externalities/Cannibalism .. Y
• Tax Effects .... Y

153
Tax Effect on Salvage
Net Salvage Cash Flow SP - (SP-BV)(T) Where
SP Selling Price BV Book Value T
Corporate tax rate
154
Including inflation when estimating cash flows

• Nominal r gt real r
• The cost of capital, r, includes a premium for
  inflation
• Nominal CF gt real CF
• Nominal cash flows incorporate inflation
• If you discount real CF with the higher nominal
  r, then your NPV estimate is too low

155
INFLATION Real vs. Nominal Cash flows
Real
Nominal
156
INFLATION Real vs. Nominal Cash flows

• 2 Ways to adjust
• Adjust WACC
• Cash Flows Real
• Adjust WACC to remove inflation
• Adjust Cash Flows for Inflation
• Use Nominal WACC

157
Sensitivity Analysis

• Shows how changes in an input variable affect NPV
  or IRR
• Each variable is fixed except one
• Change one variable to see the effect on NPV or
  IRR
• Answers what if questions

158
Sensitivity Analysis
159
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160
Sensitivity Analysis
161
Sensitivity Graph
Variable Cost
Unit Sales
Fixed Cost
162
Sensitivity Ratio
14-162

• ?NPV (New NPV - Base NPV)/Base NPV
• ?VAR (New VAR - Base VAR)/Base VAR

• If SRgt0 ? Direct relationship
• If SRlt0 ? Inverse relationship

163
Sensitivity Ratio
14-163
Change from Resulting NPV (000s)
Base Level Unit Sales FC VC

• -30 -62 54 266
• 0 20 20 20
• ?NPV (-62-20)/20 (54-20)/20
  (266-20)/20 -4.1
  1.7 12.3
• ?VAR -30 -30
  -30
• SR 13.74
  -5.72 -41.22

164
Sensitivity Graph
Variable Cost -41.22
Unit Sales 13.74
Fixed Cost -5.72
165
Results of Sensitivity Analysis

• Steeper sensitivity lines greater risk
• Small changes ? large declines in NPV
• The Variable Cost line is steeper than unit sales
  or fixed cost so, for this project, the firm
  should focus on the accuracy of variable cost
  forecasts.

166
Sensitivity AnalysisWeaknesses

• Does not reflect diversification
• Says nothing about the likelihood of change in a
  variable
• i.e. a steep sales line is not a problem if sales
  wont fall
• Ignores relationships among variables

167
Sensitivity AnalysisStrengths

• Provides indication of stand-alone risk
• Identifies dangerous variables
• Gives some breakeven information

168
Scenario Analysis

• Examines several possible situations, usually
• Worst case
• Base case or most likely case, and
• Best case
• Provides a range of possible outcomes

169
Scenario Example
170
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171
Problems with Scenario Analysis

• Only considers a few possible out-comes
• Assumes that inputs are perfectly correlated
• All bad values occur together and all good
  values occur together
• Focuses on stand-alone risk

172
Monte Carlo Simulation Analysis

• Computerized version of scenario analysis using
  continuous probability distributions
• Computer selects values for each variable based
  on given probability distributions

173
Monte Carlo Simulation Analysis

• Calculates NPV and IRR
• Process is repeated many times (1,000 or more)
• End result Probability distribution of NPV and
  IRR based on sample of simulated values
• Generally shown graphically

174
Histogram of Results
175
Advantages of Simulation Analysis

• Reflects the probability distributions of each
  input
• Shows range of NPVs, the expected NPV, sNPV, and
  CVNPV
• Gives an intuitive graph of the risk situation

176
Disadvantages of Simulation Analysis

• Difficult to specify probability distributions
  and correlations
• If inputs are bad, output will be badGarbage
  in, garbage out

177
Disadvantages of Sensitivity, Scenario and
Simulation Analysis

• Sensitivity, scenario, and simulation analyses do
  not provide a decision rule
• Do not indicate whether a projects expected
  return is sufficient to compensate for its risk
• Sensitivity, scenario, and simulation analyses
  all ignore diversification
• Measure only stand-alone risk, which may not be
  the most relevant risk in capital budgeting

178
Real Options

• When managers can influence the size and risk of
  a projects cash flows by taking different
  actions during the projects life in response to
  changing market conditions
• Alert managers always look for real options in
  projects
• Smarter managers try to create real options

179
Types of Real Options

• Investment timing options
• Growth options
• Expansion of existing product line
• New products
• New geographic markets
• Abandonment options
• Contraction
• Temporary suspension
• Flexibility options

180
FIN 331 in a Nutshell

• Financial Management I Review

Index