331NS-1 FIN 331 in a Nutshell Financial Management I Review.

331NS-1 FIN 331 in a Nutshell Financial Management I Review

Index 331NS-2 FIN 331 in a Nutshell - Index Financial Statements, Ratios, & AFN Financial Statements, Ratios, & AFN Time Value of Money Time Value of Money Bond Valuation Bond Valuation Risk & Return (SML/CAPM) Risk & Return (SML/CAPM) Stock Valuation Stock Valuation WACC WACC NPV, IRR, MIRR NPV, IRR, MIRR Cash Flow Estimation Cash Flow Estimation Click on the selected topic to go directly to that section

331NS-3 Financial Statements, Cash Flow, and Taxes Key Financial Statements Balance sheet Income statements Statement of cash flows Index

331NS-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

Index 331NS-5 Sample Balance Sheet Assets = Liabilities + Owners Equity

Index 331NS-6 Sample Income Statement Net income=Dividends + Retained earnings

Index 331NS-7 Allied Food Products

Index 331NS-8 Allied 2005 Per-Share Ratios RatioFormula & Calculation Earnings per Share (EPS) Dividends per Share (DPS) Book Value per Share (BVPS) Cash flow per Share (CFPS)

Index 331NS-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

Index 331NS-10 Statement of Cash Flows Reconciles the change in Cash & Equivalents

Index 331NS-11

Index 331NS-12 Statement of Cash Flows 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 Why is it important???

Index 331NS-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

Index 331NS-14 Deficits Covered by new debt and cash

Index 331NS-15 Net Operating Working Capital If the Asset side had included Short-term investments they would have been excluded as well.

Index 331NS-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

Index 331NS-17 Net Operating Profit after Taxes (NOPAT) & Operating Cash Flow NOPAT = EBIT(1 - Tax rate) NOPAT 05 = $283.8(1 - 0.4) = $170.3 m OCF 05 = NOPAT + Deprec + Amort = $170.3 + $100 = $270.3

Index 331NS-18 Free Cash Flow (FCF) for 2005 EBIT = $283.8 m T = 40% Depreciation = $100 m Capital Expenditures = FA + Deprec = $130+$100 = $230 NOWC = $800 - $650 = $150 m FCF = [$283.8(1-.4)+$100] [$230-$150] = -$109.7 m

331NS-19 Analysis of Financial Statements Ratio Analysis Limitations of ratio analysis Qualitative factors Index

331NS-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)

Index 331NS-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

Index 331NS-22 Liquidity Ratios CR = Current Ratio = CA/CL QR = Quick Ratio or Acid-Test = (CA-INV)/CL

Index 331NS-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

Index 331NS-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)

Index 331NS-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

Index 331NS-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

Index 331NS-27 The 5 Major Categories of Ratios and What Questions They Answer Ratio CategoryQuestions Answered LiquidityCan we make required payments? Asset ManagementRight amount of assets vs. sales? Debt ManagementRight mix of debt and equity? ProfitabilityDo sales prices exceed unit costs Are sales high enough as reflected in PM, ROE, and ROA? Market ValueDo investors like what they see as reflected in P/E and M/B ratios

Index 331NS-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

Index 331NS-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

Index 331NS-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?

331NS-31 Financial Planning and Forecasting Forecasting sales Projecting the assets and internally generated funds Projecting outside funds needed Deciding how to raise funds Index

331NS-32 The AFN Formula If ratios are expected to remain constant: AFN = (A*/S 0 )S - (L*/S 0 )S - M(S 1 )(RR) Required Assets Spontaneously Liabilities Retained Earnings

Index 331NS-33 Variables in the AFN Formula A* = Assets tied directly to sales S 0 = Last years sales S 1 = Next years projected sales S = Increase in sales; (S 1 -S 0 ) L* = Liabilities that spontaneously increase with sales

Index 331NS-34 Variables in the AFN Formula A*/S 0 : assets required to support sales; Capital Intensity Ratio L*/S 0 : spontaneous liabilities ratio M: profit margin (Net income/sales) RR: retention ratio; percent of net income not paid as dividend

Index 331NS-35 Key Factors in AFN S=Sales Growth A*/S 0 =Capital Intensity Ratio L*/S 0 =Spontaneous Liability Ratio M=Profit Margin RR=Retention Ratio

Index 331NS-36 Time Value of Money Timelines Future Value Present Value Present Value of Uneven Cash Flows

Index 331NS-37 Time Lines: Timing of Cash Flows 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 0 CF 1 CF 3 CF 2 0123 I% +CF = Cash INFLOW -CF = Cash OUTFLOW PMT = Constant CF

Index 331NS-38 Basic Definitions Present Value (PV) The current value of future cash flows discounted at the appropriate discount rate Value at t=0 on a time line Future Value (FV) The amount an investment is worth after one or more periods. Later money on a time line

Index 331NS-39 FV = PV(1 + I) N Future Value: General Formula 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: y x key on your calculator

Index 331NS-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

Index 331NS-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 ( x ) when you cant remember the exact formula

Index 331NS-42 Future Values Example Suppose you invest $100 for 5 years at 10% How much would you have? Formula Solution: FV=PV(1+ I ) N =100(1.10) 5 =100(1.6105) =161.05

Index 331NS-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

Index 331NS-44 Future Value: Important 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

Index 331NS-45 Future Value Important Relationship 2 For a given time period: The higher the interest rate, The larger the future value For a given N, as I increases, FV increases FV = PV(1 + I ) N

Index 331NS-46 Present Values The current value of future cash flows discounted at the appropriate discount rate Value at t=0 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?

Index 331NS-47 Present Values FV = PV(1 + I) N Rearrange to solve for PV PV = FV / (1+ I ) N PV = FV(1+ I ) -N Discounting = finding the present value of one or more future amounts

Index 331NS-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(0.07,1,0,10000) PV = 10,000(1.07) -1 = 9,345.79

Index 331NS-49 Present Value: Important 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

Index 331NS-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

Index 331NS-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

Index 331NS-52 Multiple Cash Flows Present Value The Basic Formula The TI BA II+ Using the PV/FV keys Using the Cash Flow Worksheet Excel

Index 331NS-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 4 th year. You can earn 12% on similar investments. What is the most you should pay for this investment?

Index 331NS-54 What is the PV of this uneven cash flow stream? 0 200 1 400 2 600 3 12% 800 4 -178.57 -318.88 -427.07 -508.41 -1,432.93 = PV

Index 331NS-55 Present Value of an Uneven Cash Flow Stream: Formula

Index 331NS-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

Index 331NS-57 Clear all: Press CF Then 2 nd And CLR WORK (above CE/C) CF 0 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 Multiple Uneven Cash Flows Using the TI BAIIs Cash Flow Worksheet

Index 331NS-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.

Index 331NS-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

Index 331NS-60 TI BAII+: Uneven Cash Flows CF C000 ENTER C01200 ENTER F011 ENTER C02400 ENTER F021 ENTER C03600 ENTER F031 ENTER C04800 ENTER F041 ENTER NPV I12 ENTER NPV CPT 1432.93 Cash Flows: CF0= 0 CF1=200 CF2=400 CF3=600 CF4=800

Index 331NS-61 Excel PV of multiple uneven CFs

331NS-62 Bonds and Their Valuation Interest rates Bond valuation Measuring yield Index

331NS-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 r RF = Rate on Treasury securities Proxied by T-bill or T-bond rate

Index 331NS-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 r RF =

Index 331NS-65 Premiums Added to r* for Different Types of Debt ST Treasury ST IP LT Treasury LT IP MRP ST Corporate ST IP DRP LP LT Corporate LT IP DRP MRP LP Debt Instrument IP DRP MRP LP

Index 331NS-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

Index 331NS-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

Index 331NS-68 The Bond-Pricing Equation PV(Annuity) PV(lump sum) C = Coupon payment; F = Face value

Index 331NS-69 Texas Instruments BA-II Plus FV = future value/face value/par value PV = present value=bond value/price I/Y = period interest rate = YTM N = number of periods to maturity PMT = coupon payment N I/Y PV PMT FV

Index 331NS-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)

Index 331NS-71 Pricing Specific Bonds TI BA II+ Bond Worksheet [2 nd ] 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

Index 331NS-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

Index 331NS-73 What is the YTM on a 10-year, 9% annual coupon, $1,000 par value bond, selling for $887? Must find the r d that solves this model:

Index 331NS-74 Using a financial calculator to solve for the YTM YTM =10.91% Bond sells at a discount because YTM > coupon rate INPUTS OUTPUT NI/YRPMTPVFV 10 10.91 901000- 887

Index 331NS-75 Coupon rate = 9% Annual coupons Par = $1,000 Maturity = 10 years Price = $887 Using the calculator: N = 10 PV = -887 PMT = 90 FV = 1000 CPT I/Y = 10.91 Solving for YTM =RATE(10,90,-887,1000) YTM on a 10-year, 9% annual coupon, $1,000 par value bond selling for $887

Index 331NS-76 Find YTM, if the bond price is $1,134.20 YTM = 7.08% Bond sells at a premium because YTM < coupon rate INPUTS OUTPUT NI/YRPMTPVFV 10 7.08 901000 -1134.2

Index 331NS-77 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 Solving for YTM =RATE(10,90,-1134.20,1000) YTM on a 10-year, 9% annual coupon, $1,000 par value bond selling for $1,134.20

Index 331NS-78 Semiannual bonds 1. Multiply years by 2: number of periods = 2N. 2. Divide nominal rate by 2: periodic rate (I/YR) = r d / 2. 3. Divide annual coupon by 2: PMT = ann cpn / 2. INPUTS OUTPUT NI/YRPMTPVFV 2Nr d / 2cpn / 2OK

Index 331NS-79 What is the value of a 10-year, 10% semiannual coupon bond, if r d = 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 INPUTS OUTPUT NI/YRPMTPVFV 206.5501000 - 834.72

Index 331NS-80 Valuing a Semiannual Bond Coupon rate = 10% Annual coupons Par = $1,000 Maturity = 10 years YTM = 13% Using the formula: Using the calculator: N = 20 I/Y = 6.5 PMT = 50 FV = 1000 CPT PV = -834.72 =PV(0.065, 10, 50, 1000)

Index 331NS-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?

Index 331NS-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 = 4%*2 = 8% Result = YTM NOTE: Solving a semiannual payer for YTM will result in a 6-month YTM answer Calculator solves what you enter.

331NS-83 Risk and Rates of Return Stand-alone Risk Portfolio Risk Risk & Return: CAPM / SML Index

331NS-84 The Expected Rate of Return r hat = expected return r i = expected return in i th state of the economy P i = Probability of i th state occurring

Index 331NS-85 Calculating the Expected Return

Index 331NS-86 The Standard Deviation of Returns = Standard deviation = Variance = 2

Index 331NS-87 Standard deviation for each investment

Index 331NS-88 Standard Deviation of HTs Returns

Index 331NS-89 Risk versus Return: Do we know enough now? SecurityExpected return, r Risk, T-bills5.5%0.0% HT12.4%20.0% Coll1.0%13.2% USR 9.8%18.8% Market10.5%15.2% ^

Index 331NS-90 Coefficient of Variation (CV) CV = Standard deviation/expected return = Risk per unit of return =

Index 331NS-91 r p = weighted average w i = % of portfolio in stock i r i = return on stock i ^ Portfolio Expected Return

Index 331NS-92 Portfolio Expected Return Assume a two-stock portfolio is created with $50,000 invested in both HT and Collections r p = 0.5(12.4%) + 0.5(1.0%) = 6.7% ^

Index 331NS-93 Portfolio Return Portfolio = (50% x HT) + (50% x Coll) Portfolio Return = Prob x Portfolio

Index 331NS-94 Portfolio Risk Portfolio Standard deviation is NOT a weighted average of the standard deviations of the component assets

Index 331NS-95 Calculating portfolio standard deviation and CV

Index 331NS-96 Portfolio Standard Deviation

Index 331NS-97 Portfolio Risk & Return p = 3.4% is much lower than the of either stock p = 3.4% is lower than the weighted average of HT and Coll.s (16.6%) The portfolio provides the average return of component stocks, but lower than the average risk Why? Negative correlation between stocks

Index 331NS-98 Covariance of Returns Measures how much the returns on two risky assets move together

Index 331NS-99 Covariance vs. Variance of Returns

Index 331NS-100 Covariance Covariance (HT:Coll) = -0.0264

Index 331NS-101 Correlation Coefficient Correlation Coefficient = (rho) Scales covariance to [-1,+1] -1 = Perfectly negatively correlated 0 = Uncorrelated; not related +1 = Perfectly positively correlated

Index 331NS-102 Two-Stock Portfolios If = -1.0 Two stocks can be combined to form a riskless portfolio If = +1.0 No risk reduction at all In general, stocks have 0.35 Risk is lowered but not eliminated Investors typically hold many stocks

Index 331NS-103 of n-Stock Portfolio Subscripts denote stocks i and j i,j = Correlation between stocks i and j i and j =Standard deviations of stocks i and j ij = Covariance of stocks i and j

Index 331NS-104 Portfolio Risk-n Risky Assets i jfor n=2 11w 1 w 1 11 = w 1 2 1 2 12w 1 w 2 12 21w 2 w 1 21 22w 2 w 2 22 = w 2 2 2 2 p 2 = w 1 2 1 2 + w 2 2 2 2 + 2w 1 w 2 12

Index 331NS-105 Portfolio Risk-2 Risky Assets

Index 331NS-106 Capital Asset Pricing Model (CAPM) Links risk and required returns Security Market Line (SML): A stocks required return equals the risk- free return (r RF ) plus a risk premium (RP M 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.

Index 331NS-107 The SML and Required Return The Security Market Line (SML) is part of the Capital Asset Pricing Model (CAPM) r RF = Risk-free rate RP M = Market risk premium = r M r RF

Index 331NS-108 The Market Risk Premium (r M r RF = RP M ) 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

Index 331NS-109 Required Rates of Return Assume:r RF = 5.5%RP M = 5% r HT = 5.5% + (5.0%)(1.32) = 5.5% + 6.6%= 12.10% r M = 5.5% + (5.0%)(1.00)= 10.50% r USR = 5.5% + (5.0%)(0.88)= 9.90% r T-bill = 5.5% + (5.0%)(0.00)= 5.50% r Coll = 5.5% + (5.0%)(-0.87)= 1.15%

Index 331NS-110 Expected vs Required Returns ExpectedRequired Return HT 12.40 12.10 Undervalued Market 10.50 Fairly valued USR 9.80 9.90 Overvalued T-bills 5.50 Fairly valued Coll 1.00 1.15 Overvalued Required by the market Expected by YOU

Index 331NS-111 Illustrating the Security Market Line.. Coll.. HT T-bills. USR SML r M = 10.5 r RF = 5.5 -1 0 1 2. SML: r i = 5.5% + (5.0%) i r i (%) Risk, i

Index 331NS-112 Portfolio Beta Where: w i = weight (% dollars invested in asset i) i = Beta of asset i p = Portfolio Beta

331NS-113 Stocks and Their Valuation Constant growth stock valuation Non-constant growth stock valuation Corporate value model Index

331NS-114 Constant growth stock Dividends expected to grow forever at a constant rate, g: D 1 = D 0 (1+g) 1 D 2 = D 0 (1+g) 2 D t = D 0 (1+g) t Dividend growth formula converges to:

Index 331NS-115 Constant Growth Model Needed data: D 0 = Dividend just paid D 1 = Next expected dividend g = constant growth rate r s = required return on the stock

Index 331NS-116 Expected Value at time t Value at t=0 Value at t

Index 331NS-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

Index 331NS-118 Valuing common stock with nonconstant growth r s = 13% g = 30% g = 6% P 0.06 $66.54 4.658 0.13 2.301 2.647 3.045 46.114 54.107 = P 0 01234 D 0 = 2.00 2.600 3.380 4.394... 4.658

Index 331NS-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

Index 331NS-120 Applying the corporate value model Market value of firm: (MV F ) = PV(future FCFs) MV of common stock: = MV F MV of debt Intrinsic stock value: = MV CS /# shares

Index 331NS-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 (TV N ) = value of firm at the point that growth becomes constant

Index 331NS-122 Firms Intrinsic Value g = 6% r = 10% 21.20 01234 -5 10 20... 416.942 -4.545 8.264 15.026 398.197 21.20 530 = = TV 3 0.100.06 - Long-run g FCF = 6%WACC = 10%

Index 331NS-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

Index 331NS-124 Firm multiples method Often used by analysts to value stocks P / EPrice-earning P / CFPrice-cash flow P / SalesPrice-sales Method: Estimate appropriate ratio based on comparable firms Multiply estimate by expected metric to estimate stock price

331NS-125 The Cost of Capital Cost of equity WACC Adjusting for risk Index

331NS-126 WACC Weighted Average Cost of Capital Where: w D = % of debt in capital structure w P = % of preferred stock in capital structure w C = % of common equity in capital structure r D = firms cost of debt r P = firms cost of preferred stock r C = firms cost of equity T = firms corporate tax rate Weights Component costs WACC = w d r d (1-T) + w p r p + w c r s

Index 331NS-127 Three ways to determine the cost of equity, r s : 1.DCF: r s = D 1 /P 0 + g 2.CAPM: r s = r RF + (r M - r RF ) i = r RF + (RP M ) i 3.Own-Bond-Yield-Plus-Risk Premium: r s = r d + Bond RP

Index 331NS-128 DCF Approach: Inputs 1.Current stock price (P 0 ) 2.Current dividend (D 0 ) 3.Growth rate (g)

Index 331NS-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

Index 331NS-130 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 Should the company use the composite WACC as the hurdle rate for each of its projects?

Index 331NS-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 separate discount rates

Index 331NS-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%

Index 331NS-133 Divisional Risk and the Cost of Capital Rate of Return (%) WACC Rejection Region Acceptance Region Risk WACC H L F 0 Risk L H Acceptance Region Rejection Region

Index 331NS-134 Subjective Approach Consider the projects risk relative to the firm overall If project risk > firm risk project discount rate > WACC If project risk < firm risk project discount rate < WACC

Index 331NS-135 Subjective Approach - Example Risk LevelDiscount Rate Very Low RiskWACC 8% 7% Low RiskWACC 3% 12% Same Risk as FirmWACC 15% High RiskWACC + 5% 20% Very High RiskWACC + 10% 25%

331NS-136 The Basics of Capital Budgeting Independent vs. mutually exclusive CFs Normal vs. non-normal CFs NPV IRR MIRR PB DPB Index

331NS-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 NPV>0 and/or IRR>WACC

Index 331NS-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

Index 331NS-139 NPV: Sum of the PVs of all cash flows. Cost often is CF 0 and is negative NPV = n t = 0 CF t (1 + r) t. NPV = n t = 1 CF t (1 + r) t - CF 0 NOTE: t=0

Index 331NS-140 TI BAII+: Uneven Cash Flows CF C00100 +/- ENTER C0110 ENTER F011 ENTER C0260 ENTER F021 ENTER C0380 ENTER F031 ENTER NPV I10 ENTER NPV CPT $18.78 Cash Flows: CF0= -100 CF1=10 CF2=60 CF3=80

Index 331NS-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

Index 331NS-142 NPV vs IRR IRR: Enter NPV = 0, solve for IRR = NPV n t = 0 CF t (1 + r) t = 0 n t = 0 CF t (1 + IRR) t NPV: Enter r, solve for NPV

Index 331NS-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

Index 331NS-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

Index 331NS-145 Multiple IRRs Descartes Rule of Signs Polynomial of degree n n roots 1 real root per sign change Rest = imaginary (i 2 = -1)

Index 331NS-146 0 12 -800,0005,000,000-5,000,000 PV outflows @ 10% = -4,932,231.40 TV inflows @ 10% = 5,500,000.00 MIRR = 5.6% The Pavillion Project: Non-normal CFs and MIRR

Index 331NS-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

Index 331NS-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 @ 10% = -$4,932.2314. TV of inflows @ 10% = $5,500. MIRR = 5.6%. Do not accept Project P. NPV = -$386.78 < 0. MIRR = 5.6% < WACC = 10%.

Index 331NS-149 Excel Functions

331NS-150 Cash Flow Estimation and Risk Analysis Relevant cash flows Net salvage value Inflation Sensitivity analysis Scenario analysis Real options Index

331NS-151 Relevant Cash Flows: Incremental Cash Flow for a Project Projects incremental cash flow is: Corporate cash flow with the project Minus Corporate cash flow without the project

Index 331NS-152 Relevant Cash Flows Changes in Net Working CapitalY Interest/Dividends ....N Sunk Costs .. N Opportunity Costs .Y Externalities/Cannibalism ..Y Tax Effects ....Y

Index 331NS-153 Tax Effect on Salvage Net Salvage Cash Flow = SP - (SP-BV)(T) Where: SP = Selling Price BV = Book Value T = Corporate tax rate

Index 331NS-154 Including inflation when estimating cash flows Nominal r > real r The cost of capital, r, includes a premium for inflation Nominal CF > real CF Nominal cash flows incorporate inflation If you discount real CF with the higher nominal r, then your NPV estimate is too low

Index 331NS-155 INFLATION Real vs. Nominal Cash flows Nominal Real

Index 331NS-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

Index 331NS-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

Index 331NS-158 Sensitivity Analysis

Index 331NS-159

Index 331NS-160 Sensitivity Analysis

Index 331NS-161 Sensitivity Graph Unit Sales Variable Cost Fixed Cost

Index 331NS-162 Sensitivity Ratio %NPV = (New NPV - Base NPV)/Base NPV %VAR = (New VAR - Base VAR)/Base VAR If SR>0 Direct relationship If SR

331NS-1 FIN 331 in a Nutshell Financial Management I Review.

Documents

cash slide

flow of cash

cash flow nopat

cash inflows

generation of cash

cash equivalents

earnings slide

income statement data