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Financial Management Test 3
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Gravity
Terms in this set (58)
Cash Flows in a typical project (3)
1. initial outlay (purchase equipment, initial development costs, increase in net working capital)
2. on-going cash flows (incremental revenues, incremental costs, taxes, change in net working capital)
3. terminal cash flows (sale of equipment, shut-down costs, decrease in net working capital)
Depreciation
-depreciation expenses do not correspond to actual cash outflows
-Straight-line depreciation
Factors to consider when estimating a project's revenues and costs (3)
1. a new product typically has lower sales initially
2. the average selling price of a product and its cost of production will generally change over time
3. for most industries, competition tends to reduce profit margins over time
Incremental revenue and cost estimates
-the evaluation is on how the project will CHANGE the cash flows of the firm (thus, focus is on incremental revenues and costs)
Incremental Earnings Before Interest and Taxes (EBIT) = Incremental Revenue - Incremental Costs - Depreciation
Marginal corporate tax rate
the tax rate a firm will pay on an incremental dollar of pre-tax income
Income Tax = EBIT * The Firm's Marginal Corporate Tax Rate
Incremental earnings forecast
Incremental Earnings = (Incremental Revenues -
Incremental Costs - Depreciation) * (1 - Tax Rate)
-incremental earnings are an intermediate step on the way to calculating the incremental cash flows that would form the basis of any analysis
Converting from earnings to free cash flow
-free cash flow: the incremental effect of a project on a firm's available cash
-capital expenditures and depreciation
Net working capital
Net Working Capital = Current Assets Current Liabilities
= Cash + Inventory + Receivables - Payables
Calculating the NPV
to compute a project's NPV, one must discount its free cash flow at the appropriate cost of capital
Other effects on incremental free cash flows
-opportunity costs
-project externalities (cannibalization)
-sunk costs (fixed overhead expenses, past research and development)
Liquidation or salvage value
when an asset is liquidated, any capital gain is taxed as income
Sensitivity analysis
a capital budgeting tool that determines how the NPV varies as a single underlying assumption is changed
Break even
the level of a parameter for which an investment has an NPV of zero
Real option
the right, but not the obligation, to take a particular action
Comparison of discounted cash flow models of stock valutation
present value of DIVIDEND PAYMENTS determine the STOCK PRICE to get stock price estimate NO ADJUSTMENT NECESSARY
present value of TOTAL PAYOUTS (ALL DIVIDENDS AND REPURCHASES) determines the EQUITY VALUE to get stock price estimate DIVIDE BY SHARES OUTSTANDING
present value of FREE CASH FLOW (CASH AVAILABLE TO PAY ALL SECURITY HOLDERS) determines the ENTERPRISE VALUE to get stock price estimate SUBTRACT WHAT DOES NOT BELONG TO EQUITY HOLDERS (DEBT AND PREFERRED STOCK), ADD BACK CASH AND MARKETABLE SECURITIES, AND DIVIDE BY SHARES OUTSTANDING
The discounted free cash flow model - connection to capital budgeting
free cash flow is the sum of the free cash flows from the firm's current and future investments, so enterprise value is the sum of the present value of existing projects and the NPV of future new ones
-NPV of any investment represents its contribution to the firm's enterprise value
-to maximize share price, we should accept projects that have a positive NPV
Method of comparables
estimate the value of the firm based on the value of other, comparable firms or investments that we expect will generate very similar cash flows in the future
The valuation principle
implies that two securities with identical cash flows must have the same price
-if two firms will generate identical cash flows, we can use the market value of the existing company to determine the value of the new firm
-we can adjust for scale differences using valuation multiples
Valuation multiples
a ratio of a firm's value to some measure of the firm's scale or cash flow
-price-earnings ratio
-enterprise value multiples
-multiples of sales
-price-to-book value of equity
-industry-specific ratios
Price-earnings ratio
most common valuation multiple (usually included in basic statistics computed for a stock)
-share price divided by earnings per share
Valuation based on comparable firms
We can compute a firm's P/E ratio using:
-Trailing earnings
-Forward earnings
The resulting ratio is either:
-Trailing P/E
-Forward P/E
For valuation purposes, the forward P/E is generally preferred, as we are most concerned about future earnings.
Limitations of multiples
-firms are not identical
-differences in multiples can be related to difference in expected future growth rate, risk (cost of capital), differences in accounting conventions between countries
-comparables provide only information regarding the value of the firm relative to other firms in the comparison set
-cannot help determine whether an entire industry is overvalued (internet boom example)
Comparison with discounted cash flow methods
-valuation multiple does not take into account material differences between firms (talented managers, more efficient manufacturing process, patents on new technology)
-discounted cash flow methods allow us to incorporate specific information about cost of capital or future growth (potential may be more accurate)
Information in stock prices
-for a publicly traded firm, market price should already provide very accurate information regarding the true value of its shares
-a valuation model is best applied to tell us something about future cash flows or cost of capital, based on current stock price
The valuation triad
3 corners: share value, future cash flows, cost of capital
for valuation model
Efficient markets hypothesis
implies that securities will be fairly prices, based on their future cash flows, given all information that is available to investors
Public, easily available information
information available to all investors includes info. in news reports, financial statements, corporate press releases, or other public data
Consequences for investors
-must have some competitive advantage
-expertise or access to info. known to only a few people
-lower trading costs than others
-if stocks are fairly prices according to valuation models, then investors who buy stocks can expect fair compensation for the risk they take
Implications for corporate managers
-cash flows paid to investors determine value
-focus on NPV and free cash flows
-avoid accounting illusions
-use financial transactions to support investment
The efficient markets hypothesis versus no arbitrage
an arbitrage opportunity is a situation in which two securities with identical cash flows have different prices
-because anyone can earn a sure profit in this situation by buying the low-priced security and selling the high-priced one, we expect investors to immediately exploit and eliminate these opportunities (thus, in a normal market, arbitrage opportunities will not be found)
The efficient market hypothesis
states that securities with equivalent risk should have the same expected return
-different investors may perceive risks and returns differently (based on info/preferences)
-idealized approximation for highly competitive markets
Individual biases and trading
-excessive trading and overconfidence
-hanging on to losers and the disposition effect
-mood affects investment behavior
-put too much weight on their own experience rather than considering historical evidence
Overconfidence hypothesis
tendency of individual investors to trade too much based on the mistaken belief that they can pick winners and losers better than investment professionals
-investors who trade more will not earn higher returns (performance will actually be worse)
Disposition effect
investors tend to hold on to stocks that have lost value and sell stocks that have risen in value
-arises due to investors' increased willingness to take on risk in the face of possible losses
-reluctance to admit a mistake by taking the loss
-costly behavioral tendency
Computing historical returns
-realized returns
-individual investment realized returns
Individual investment realized returns
for quarterly returns (or any four compounding periods that make up an entire year) find the annual realized return
The returns of large portfolios
investments with higher volatility, as measured by standard deviation, tend to have higher average returns
The returns of individual stocks
-larger stocks have lower volatility overall
-even the largest stocks are typically more volatile than a portfolio of large stocks
-the standard deviation of an individual security doesn't explain the size of its average return
-all individual stocks have lower returns and/or higher risk than the portfolios
Types of risk
-common risk
-independent risk
-diversification
Diversification in stock portfolios
-unsystematic versus systematic risk
-stock prices are impacted by two types of news:
1. company or industry specific news
2. market-wide news
Systematic risk versus unsystematic risk
-systematic risk is NOT diversifiable and DOES require a premium
-unsystematic risk IS diversifiable and DOES NOT require a premium
The importance of systematic risk
-the risk premium of a security is determined by its systematic risk and does not depend on its diversifiable risk
-there is no relationship between volatility and average returns for individual securities
Portfolio weights
the relative investment in your portfolio
-the fraction of the total investment in the portfolio held in each individual investment in the portfolio
Return on a portfolio
the total return earned on your portfolio, accounting for the returns of all of the securities in the portfolio and their weights
-the weighted average of the returns on the investments in the portfolio, where the weights correspond to portfolio weights
Expected return of a portfolio
the return you can expect to earn on your portfolio, given the expected returns of the securities in that portfolio and the relative amount you have invested in each
-the weighted average of the expected returns of the investments within it, using the portfolio weights
-weights are used in computing both a portfolio's return and expected return
The volatility of a portfolio
the total risk, measured as standard deviation, of the portfolio
-some risk is eliminated through diversification when we combine stocks in a portfolio
-the amount of risk that will remain depends upon the degree to which the stocks share common risk
Correlation
a barometer of the degree to which the returns share common risk
-closer to +1, the more the returns tend to move together as a result of common risk
-correlation = 0, the returns are uncorrelated
-correlation = -1, the more the returns tend to move in opposite directions
-unless the stocks all have a perfect positive correlation of +1, the risk of the portfolio will be lower than the weighted average volatility of the individual stocks
The volatility of a large portfolio
-volatility declines as number of stocks in the portfolio grows
-nearly half the volatility of the individual stocks is eliminated in a large portfolio from diversification
-systematic risk still remains
Equally weighted portfolio
the same amount of money is invested in each stock
Market portfolio
portfolio of all risky investments, held in proportion to their value
-contains more of the largest companies and less of the smallest companies
Market capitalization
total market value of its outstanding shares
-investment in each security is proportional to its market capitalization
Market proxy
a portfolio whose return should track the underlying, unobservable market portfolio (most common = market indexes used to represent the performance of the stock market)
Market index
reports the value of a particular portfolio of securities
Dow Jones Industrial Average
most familiar index in USA; consists of a portfolio of 30 large, industrial stocks
Beta
a measure of the sensitivity of an investment to the fluctuations of the market portfolio
-For each 1% change in the market portfolio's excess return, the investment's excess return is expected to change by beta () percent due to risks that it has in common with the market.
-beta of overall market portfolio is 1
-beta of 1 = average exposure to systematic risk
-differences in betas by industry are related to the sensitivity of each industry's profits to the general health of the economy
-the beta of a portfolio is the weighted average beta of the securities in the portfolio
Excess returns
the difference between the security's return and risk-free rate
Capital asset pricing model (CAPM)
the equation for the expected return of any investment
-implies that there is a linear relation between a stock's beta and its expected return
-line is called the security market line (SML)
-relation between risk and return for individual securities is only evident when we measure market risk rather than total risk
-The CAPM marks the culmination of our examination of how investors in capital markets trade-off risk and return. It provides a powerful and widely-used tool to quantify the return that should accompany a particular amount of systematic risk. The Valuation Principle tells us to use this cost of capital to discount the future expected cash flows of the firm to arrive at the value of the firm. Thus the cost of capital is an essential input to the financial manager's job of analyzing investment opportunities and so knowing this overall cost of capital is critical to the company's success at creating value for its investors.
Required return
the minimum amount of return to prompt investors to invest
;