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Finance Final Concepts
Terms in this set (178)
2 Main Learning Objectives for Stock Valuations
1. Calculate value of common stock and preferred stock using basic valuation models:
- Single-Period Model
- Constant Growth Model
- Two-Stage Model
2. Understand How Stock Markets Work
Preferred Stock, Common Stock
Voting: Cumulative, Straight, Proxy
Dividend Discount Model
Constant Growth Model [aka Gordon Growth Model]
Primary Market vs. Secondary Market
Dealer vs. Broker
Stock Valuation Overview
1. Firm owners - Common stock represents ownership in a firm
2. Residual claim on BK - CS holders have a residual claim on firm earnings and assets
3. Equity Valuation approximate - We use basic models to value equity. This is sometimes difficult given the uncertainty associated with equity cash flows.
Intrinsic Value of an Asset
the present value of the stream of expected cash flows discounted at an appropriate required rate of return.
Preferred Stock (How is it a Hybrid Security?)
1. Like Common Stock - No fixed maturity
2. Like Debt - Preferred Dividends are Fixed
(Missing a preferred dividend does not constitute default or count as debt, but preferred dividends are usually cumulative)
Preferred Stock Dividends
Fixed and often quoted as a percentage of Par. [The dividend payment is calculated using the par value]
Preferred Stock Characteristics
1. Non Voting
2. Non Participating
3. May carry credit ratings (like bonds)
4. Sometimes convertible
5. Often Callable
6. Liquidation priority: Lower than debt, higher than common stock
Value of Pref Stock (Like Perpetuity)
Vps=Div per year/Req rate of return
Annual Return on Pref Stock
Annual Div/Current Selling Price
Common Stock Characteristics
1. CS is a variable-income security [i.e. dividends may be increased or decreased at management's discretion]
2. Represents equity [i.e. ownership].
3. Includes voting rights.
4. May have preemptive rights.
5. Liquidation Priority: Lowest [lower than everybody including all debt, preferred stock, etc.].
Other CS Rights
a. Right to share proportionately in dividends paid.
b. Right to share proportionately in assets remaining after liabilities are paid in a liquidation.
c. Right to vote on stockholder matters of great importance, such as a merger. Voting is usually done at the annual meeting or a special meeting.
d. Sometimes have right to share proportionally in any new stock sold. This is called the preemptive right. Essentially, a preemptive right means that a company that wishes to sell stock must first offer it to the existing stockholders before offering it to the general public. The purpose is to give stockholders the opportunity to protect their proportionate ownership in the corporation.
Conceptual Structure of Public Corporations
Shareholders ----> Elect BOD ---->Hire Mgmt Team ----> Responsible for Running Company ----> Report to shareholders
Board of Directors Elections
1. BOD Elected Each Year at Annual Meeting
- One Share = One Vote [Generally]
2. Some Corporations have Multiple Classes of Shares with Unequal Votes
3. Proxy Voting Used for Most Large Public Co.
Voting Procedures: 2 Potential Methods
1. Cumulative Voting
2. Straight Voting
Permits Minority Participation
Total # Votes for Each Shareholder is Determined First [Vote Calculation: # Shares x # Directors to be Elected]
Directors are Elected All at Once and Shareholder May Distribute Votes Any Way He/She Wishes
Directors are Elected One at a Time
Prevents Minority Influence
Each Shareholder Receives Full # Votes for Each BOD Seat [Vote Calculation: # Shares = # Votes]
CS Valuation - Why CS is more Difficult to value than a bond
1. Cash Flow Unpredictability:
- promised cash flows are not known in advance
2. No Maturity Date:
- life of investment is forever
3. Market Rate Disagreement:
- no way to easily observe the rate of return the market requires
Gordon Growth - Constant Growth Model
Assumes common stock dividends will grow at a constant rate into the future.
2 Stage Growth Model - Additional Info Needed
1) Growth rate during super-normal period
2) Industry average growth rate
3) Length of super-normal period
4) Required return
5) Recent dividend
an agent who buys and sells securities from own inventory
price the dealer is willing to pay.
price the dealer is willing to sell.
difference between bid and asked price; represents dealer profit.
an agent who arranges security transactions among investors; does not sell from own accounts.
NPV and other Investment Criteria
3 Learning Objectives for NPV and other Investment Criteria
1. Articulate the desired attributes of a capital budgeting methodology.
2. Determine whether a project is acceptable based on Payback Period, NPV, PI, and IRR.
3. Discuss the drawbacks of payback period and IRR so that NPV is the preferred evaluation technique.
Key Words/Concepts - NPV and other Inv Criteria
1. Capital Budgeting
2. Payback Period
3. Net Present Value (NPV)
4. Profitability Index (PI)
5. Internal Rate of Return (IRR)
6. Cash Flow Patterns
Why is Capital Budgeting so Important?
1. Balance Sheet Evolution:
firm's current balance sheet is the result of past capital budgeting decisions.
2. Project Enhance/Destroy Company Value?
Managers must evaluate each capital project and choose to accept or reject based on expectations for it enhancing or destroying company value.
3. Many Potential Methods of Analysis:
various methods used independently or concurrently to make capital budgeting decisions
Current and Fixed Assets
Liabilities and Equity
process of planning for purchase of long-term assets.
Ideal CB decision making - Evaluates 3 things
1) Includes all cash flows that occur during the life of the project.
2) Considers the time value of money
3) Incorporates the required rate of return [i.e. risk] of the project.
[Remember INVERSE relationship!]
7 Capital budgeting decision-making methods
1. Payback Period
*2. Discounted Payback Period
3. Net Present Value (NPV)
4. Profitability Index (PI)
*5. Average Accounting Return (AAR)
6. Internal Rate of Return (IRR)
*7. Modified Internal Rate of Return (MIRR)
(* = not ideal)
the number of years needed to recover the initial cash outlay.
How long will it take for the project to generate enough cash to pay for itself [not considering the time value of money]?
Payback Period Analysis
Potential Question to analyze:
Question 1: Is a 5.1 year payback period good?
Question 2: Is 5.1 years acceptable?
Answer: Firms using this method will compare the payback period calculation to some standard set by the firm.
Drawbacks of the Payback Period
1) Subjectivity: firm time cutoffs are subjective.
2) Ignores TVM: Not consider time value of money.
3) Ignores IRR: Not consider any required rate of return.
4) Ignores Some CF: Not consider all cash flows of the project [creates bias against LT projects and/or new projects].
Two Kinds Of Mistakes Can Be Made With Capital Budgeting Decisions:
1) Reject a Good Project
2) Accept a Bad Project
Payback Period is Subject to Both!
Payback Period Redemption
Minor Decisions: despite shortcomings, payback period is often used by large and sophisticated firms to make relatively minor decisions.
Many decisions simply do not warrant detailed analysis because cost of analysis > potential loss from mistake
Three Positive Features of Payback Period:
1. Simplicity in Concept
2. Bias Toward ST Projects [Liquidity Bias]
3. Later CFs More Uncertain; Payback Adjusts for Riskiness of Later CFs by Ignoring Them
Net Present Value Formula
the total PV of the annual net cash flows less the initial outlay.
Is what we are receiving worth more today than what we have to give up? [Inflows:+; Outflows: -]
NPV Basic Decision Rule
If NPV is positive = ACCEPT
If NPV is negative = REJECT
Unfortunately, every rule has an exception...
Sometimes qualitative factors lead to the decision to ACCEPT a negative NPV project.
Partial Investment Recovery, Technology Changes, Employee Safety/Morale, etc.
Product Bundling, Market Share Maintenance, Future Capacity, etc.
Market Potential, Government Trends, International Competition, etc.
NPV vs Ultimate Goal of the firm
Question: What is the Ultimate Goal of the Firm?
Answer: To Maximize Shareholder Wealth!
Capital Budgeting Decisions: a clear achievement of this goal to "maximize shareholder wealth" cannot be realized without maintaining a long-term perspective.
PI: helps interpret NPV. It allows the analyst to control [scale] for the initial outlay to give management the sense of return. [Accept if PI>1.]
Calculate NPV with IO=0, then divide the NPV by the actual IO.
If PI = 1.104 what does that mean?
This means that for every $1 the firm invests, it earns a $0.104 return.
Internal Rate of Return (IRR)
the rate of return the firm earns on its capital projects.
Considered differently, the IRR is the rate of return that makes the NPV equal to ZERO [cash inflows = cash outflows].
IRR is the rate of return that makes the PV of the cash flows equal to the initial outlay.
This looks very similar to our Yield to Maturity formula for bonds...
In fact, YTM is the IRR of a bond.
Internal Rate of Return (IRR) Decision Rules
If IRR is > or = to the required rate of return: ACCEPT.
If IRR is < the required rate of return: REJECT.
IRR Caution: Additivity Problem
Many firms operate in Capital-Constraint Environments.
IRR Limitation for Mutually-Exclusive Projects: IRR cannot be used to choose between mutually-exclusive projects!
Maximize Firm Value: must use NPV to select combination of projects that yield the greatest $$$ for firm owners.
IRR Caution: CF Patterns
IRR is a good decision-making tool as long as cash flows are conventional .
Example: (- + + + + +)
Problem: If there are multiple sign changes in the cash flow stream, we could get multiple IRRs.
Example: (- + + - + +)
IRR Redeeming Qualities
Popularity: IRR very popular in practice despite flaws
Preference for Comparison: People in general [and financial analysts in particular], prefer talking about % rates of return when discussing potential benefits rather than providing $ value returns.
IRR Advantage Over NPV: no discount rate requirement for calculation.
Making Capital Investment Decisions
What must we do before evaluating CFs?
Estimate cash flows
4 Learning Objectives
1. Develop an understanding of which cash flows are important in the capital budgeting process.
2. Calculate depreciation expense and impact of various taxes.
3. Estimate the free cash flows from a potential investment project.
4. Given appropriate data, determine if an investment project will increase the overall value of the firm.
Key Words/Concepts Chapter 10
1. Costs [i.e. Incremental Costs, Incidental Costs, Sunk Costs, Opportunity Costs, etc.]
3. Straight-line and MACRS Depreciation
4. Taxes: 1) Income 2) Sales 3) Asset Sale [i.e. Gain or Loss]
5. Initial Outlay, Annual CFs, Terminal CFs
6. Working Capital Changes
7. Capital Rationing
8. Equivalent Annual Cost (EAC)
Relevant Cash Flows
Incremental CFs: additional cash in minus additional cash out. Capital budgeting focuses on the INCREMENTAL cash flows! Remember "Stand-Alone Principle."
1) Incidental CFs—Consider
Directly and indirectly related; "cannibalization"
2) Sunk Costs—Ignore
Do NOT consider; irrelevant to decision, irretrievable
3) Opportunity Costs—Consider
MUST consider; relevant to decision; finite capacity
Capital Budgeting - 3 step process
1. Evaluate Cash Flows
2. Evaluate Risk
3. Make Decision
[i.e. ACCEPT or REJECT]
Evaluate Cash Flows Part 1 - Initial Outlay
(Purchase Price of the Asset)
+ (Sales Tax)
+ (Shipping and Installation Costs)
+ (Maintenance Costs)
= (Depreciable Asset)
+ (Investment in Working Capital)
+ After-Tax Proceeds from Sale of Old Asset
=(Net Initial Outlay)
Evaluate Cash Flows Part 2 - Annual Cash Flows
- Incremental Costs
- Depreciation on Project
= Incremental Earnings Before Taxes (EBT)
- Tax on Incremental EBT
=Incremental Earnings After Taxes (or NI)
+ Depreciation Reversal
=Annual Cash Flow
Evaluate Cash Flows Part 3 - Terminal Cash Flow
What is the cash flow at the end of the project's life?
Use the Annual Cash Flows slide and also include:
+/- Tax Effects of Sale Gain/Loss
+ Recapture of Net Working Capital
Terminal Cash Flow
Capital Budgeting Overview - OCF Formula
OCF = (Sales - Costs)
(1-Tax Rate) + (Depreciation
Tax Rate) +/- Change in NWC
Capital Budgeting Overview - Beginning
(Capitalize only expenses related to the new project)
Gain/Loss on Sale of Old Equipment
Capital Budgeting Overview - Middle
Annual Cash Flows [Use Formula]
Gain/Loss on Sale of Old Equipment
Potential Missed Old Depreciation
Change in NWC
Capital Budgeting Overview - Ending
Annual Cash Flow
ALL Terminal Cash Flows:
Gain/Loss on Sale of Old Equipment
Gain/Loss on Sale of New Equipment
Return of NWC
2 Methods of Depreciation
2. Straight Line
MACRS [Modified Accelerated Cost Recovery System]
Depreciation = cost x percentage
Cost [i.e. basis] NEVER changes
Percentage determined by life [see tax code]
Half Year Convention Adds ONE year to life
Depreciation = [(cost - salvage)/ life]
Cap Budgeting - NWC
Many projects require an increase in net working capital (inventory, cash, A/R, A/P, etc.) at the outset of a new venture [i.e. time zero].
Capital budgeting decisions often involve a new machine, which usually produces either 1) a new product or 2) an improved product so the necessary inputs are not readily available.
Standard Convention for Treatment of NWC:
Net working capital (NWC) is included in the calculation of initial outflow and is reversed at the end of the project.
Note: NWC build-up or liquidation has NO tax effect.
Capital Budgeting: Taxes
Three Tax Situations:
1. Income Tax: usually a fixed marginal rate
2. Sales Tax: included in initial outlay and capitalized
3. Tax on Sale of Equipment: calculate book value (BV)
(BV = Cost - Accumulated Depreciation)
If BV < sale price, then there is a taxable gain
If BV > sale price, then there is a taxable loss
If BV = sale price, then there is no tax impact
Tax on Sale of Equipment
Three Steps to Solve:
1) Calculate Current Book Value
2) Compare Book Value to Selling Price
-If BV > Selling Price = Loss [BV-Sales Price=Loss]
-If BV < Selling Price = Gain [Sales Price-BV=Gain]
3) Calculate Tax Shield
-Uncle Sam demands his portion.
-Loss: Cash Benefit; INFLOW
-Gain: Cash Deduction; OUTFLOW
Capital Rationing Issues
1) Risk Evaluation: LT projects are inherently risky [$ committed longer, potential variance from assumptions, etc.].
2) Marginal Cost Varies: all investment dollars not same cost [rate may increase as initial size increases, time lengthens, capital structure changes, # of projects expand, etc.]
3) Patient Capitalism Focus: must always evaluate whether goal to maximize shareholder wealth is being accomplished [wait for better opportunity to be available].
Capital Rationing Steps
Step 1: Rank Projects By IRR
Step 2: Compare Marginal Cost of Capital to IRR
Step 3: Choose Project if IRR > Marginal Cost of Capital
2 Problems with Project Ranking
1) Size Disparity Problem: mutually exclusive projects of unequal size.
2) Time Disparity Problem: mutually exclusive projects of unequal lives.
Size Disparity Problem
Conflicting Answers for "Best" Option: your evaluation of multiple potential projects using more than one method of capital budgeting analysis has conflicting answers on the "best" option.
NPV, IRR & PI Disagreement: NPV decision may not agree with IRR or PI because the project with largest NPV may not also have highest the IRR or the highest PI.
What Should You Do?
Solution: Select the projects with the largest NPV.
Why do you want big NPV instead of IRR
Point: They'd rather make more money than have higher profit margins! Cash is KING!
Likewise, large NPV is better than a large IRR!!!
Time Disparity Problem
TVM principles negate direct comparison of NPV if two capital budgeting projects have differing lives.
Since NPV is Our Preferred Method, What Should We Do?
Replacement Chain Assumption: indefinite commitment to a specific technology under consideration allows the conversion of NPV to a comparable annuity format.
Mutually Exclusive Investments with Unequal Lives
Equivalent Annual Cost (EAC): good method to evaluate and rank projects.
EAC Process: similar to solving for PMT when doing regular TVM calculation.
EAC Interpretation: simply means you will be getting that dollar payment amount as an inflow each year or period.
EAC Decision: choose HIGHEST value.
How to solve for EAC?
Step 1: Calculate NPV of each project
Step 2: EAC Method
If we assume that each project will be replaced an infinite number of times in the future [i.e. replacement chain], we can convert each NPV to an annuity.
Then the projects' EACs can be compared to determine which is the best project!
Equivalent Annual Cost (EAC): Simply find the annuity payment that has the same PV [i.e. NPV], life, and discount rate as the project.
Key to EAC Solution: Spread the NPV over the life of the project.
Capital Budgeting: Reinvestment Assumptions
1) NPV and PI: assume CFs reinvested at project's required rate of return [rate you select].
2) IRR: assume CFs reinvested at IRR.
Result: NPV ranking may not agree with the IRR ranking.
What Should You Do?
Conservative Estimates: Due to LT nature of capital budgeting analysis use conservative "heroic assumptions" for future.
Solution: Select project with largest NPV.
Project Analysis and Evaluation
5 Learning Objectives
1. Understand the methods of what-if analysis used for evaluating NPV estimates.
2. Develop an understanding of what creates operating and financial leverage.
3. Describe the impact of leverage on operating profits and net income/EPS.
4. Distinguish between operating leverage and financial leverage.
5. Predict the impact of changes in sales or changes in operating profits.
Key Words/Concepts Chapter 11
What-If Analysis: Scenario, Sensitivity, Simulation
Real Option Analysis
Leverage: Financial, Operating
DOL, DFL, DCL
Fixed Cost, Variable Cost
Evaluating NPV Estimates
Must Estimate Project's Market Value: MV of a project cannot easily be observed so we must estimate value.
NPV: if estimate results in NPV it's a good sign project will create value for the firm.
Caution: anything can happen in the future to the projected cash flow!
Only Correct on Average: even though our NPV may be correct on average, it will not be exactly right in any one case.
Measure Forecasting Risk
Projected Future Cash Flows: key inputs in a DCF analysis.
Guard Against Bad Decision Making: we must understand Forecasting Risk [i.e. Estimation Risk] inherent in our analysis.
Forecasting Risk: How sensitive is our NPV to changes in cash flow estimates?
more sensitive to CF = more forecasting risk
Analyze sources of value
Critical Question: What is it about this project that leads to a positive NPV?
What Sources of Value Potentially Create a Positive NPV Project?
Product differentiation—make it better than existing products.
Economies of scale or ability to manufacture at a lower cost.
Better logistics and distribution.
Entering an undeveloped market niche.
First mover advantage to gain control of the market.
We must be aware of both competition and potential competition.
Before pursuing a positive NPV project we must adjust our CF inputs using What-If Analysis.
Two Goals for What-If Analysis:
1. Assess Degree of Forecasting Risk
Gut Check: Economic "reasonableness" of our CF estimates to avoid being too optimistic or too pessimistic about the future.
2. Identify Most Critical Components of Success/Failure of an Investment
Key Variable Identification: determine what variable[s] have greatest impact on NPV calculation
Scenario Analysis: What happens to the NPV under different cash flow scenarios?
Begin with most likely CF estimates [base case], then apply an upper bound and lower bound on the various components of the project.
Base Case: most likely revenues and costs
Best Case [Optimistic]: high revenues, low costs
Worst Case [Pessimistic]: low revenues, high costs
Important Note: Best case and worst case are not necessarily probable, but they can still be possible.
Sensitivity Analysis: What happens to NPV when we freeze all variables and then change only one variable at a time?
The GREATER the volatility in NPV in relation to a specific variable...
The LARGER the forecasting risk associated with that variable, and...
The MORE attention we need to pay to its estimation.
Note: Sales level is typically the most difficult CF component to forecast. Further market research may be warranted to reduce the degree of forecasting risk from sales unpredictability.
Simulation Analysis: expanded sensitivity and scenario analysis that considers a large number of potential scenarios; computer assistance is typically needed.
Monte Carlo Simulation: estimates thousands of possible outcomes based on conditional probability distributions and constraints for each of the variables.
Simulation Output: probability distribution for NPV with an estimate of the probability of obtaining a positive net present value.
Caution: simulation analysis only works as well as the information entered. Very bad decisions can be made if interaction between variables is not carefully analyzed.
Beware: Paralysis of Analysis
What-If Analysis: helps determine a range of possible values and gauges potential disaster.
It will not tell you whether to undertake a new project!
Eventually you must make a decision!
Accept: if majority of scenarios have positive NPVs, then you may feel comfortable accepting the project.
Reject: if small changes in estimates for a crucial variable leads to a negative NPV, then you may want to reject the project.
Real Options Analysis
Real option analysis is a different way of thinking about investment values.
Cross between decision-tree analysis and pure option-based valuation.
Real option valuation provides framework to analyze managerial decisions that deviate from strict DCF.
What "Real Options" should be considered for potential capital budgeting projects?
Four Alternatives Considered in Real Options Analysis
1. Option to Defer
2. Option to Abandon
3. Option to Alter Capacity
4. Option to Start Up or Shut Down
Leverage: magnification of operating or financial results due to use of fixed costs.
2 Types of Leverage
2 Primary Sources of Risk
1. Business (aka Operating) Risk: Variability or uncertainty associated with operating income (i.e. EBIT).
Specific Industry: influences business risk.
2. Financial Risk: Risk of distress or bankruptcy due to use of fixed cost financing.
Management: influences financial risk with VC vs. FC decisions.
Factors that influence business risk
Sales Volume Variability
Domestic & Foreign Competition
Operating Leverage: use of fixed production costs rather than variable production costs.
Fixed Operating Costs
Fixed Operating Costs (FC): constant, regardless of output, over some time period.
FC Examples: administrative salaries, insurance, rent, property taxes, etc.
Variable Operating Costs
Variable Operating Costs (VC): cost varies with level of output [VC = quantity*cost per unit].
VC Examples: materials, labor, utilities, packaging, sales commissions, income taxes, etc.].
Total Costs = Fixed Costs + Variable Costs
Operating Leverage Dilemma
What happens if a firm increases its fixed operating costs and reduces [or eliminates] its variable costs?
the firm has a higher breakeven point. If sales are not high enough, the firm will not meet its fixed expenses!
Breakeven Point: when revenue received equals the costs associated with receiving the revenue.
Supply-Side Analysis: only analyzes costs of sales, not how demand is affected at different price levels.
Key Insight Gained = Firm's Margin of Safety
Degree of Operating Leverage (DOL)
High Operating Leverage:
with high fixed operating costs, small changes in sales revenue are magnified into larger changes in operating income [EBIT].
Stop to Note: This is the top area of income statement from sales to EBIT.
Degree of Operating Leverage (DOL): multiplier effect between sales and EBIT.
% change in EBIT
% change in sales
Sales - Variable Costs/EBIT
Example #1: DOL = 2
A 1% increase in sales will result in a 2% increase in operating income (EBIT).
Financial Risk: variability or uncertainty of a firm's earnings per share (EPS) and increased probability of insolvency due to firm use of financial leverage.
Primarily Management Influence: financial risk is impacted by management decisions.
Financial Leverage: use of fixed cost sources of financing [i.e. debt or preferred stock] rather than variable cost sources [i.e. common stock].
Degree of Financial Leverage (DFL): multiplier effect of small change in operating income [EBIT] magnified into larger change in EPS.
Degree of Financial Leverage (DFL): multiplier effect of small change in operating income [EBIT] magnified into larger change in EPS.
Example #1: DFL = 3.4
A 1% increase in operating income (EBIT) will result in a 3.4% increase in earnings per share (EPS).
Key point of Financial Leverage
Key Point: Leverage Magnifies Returns and Losses!
% change in EPS
% change in EBIT
EBIT/EBIT - Interest
Degree of Combined Leverage (DCL)
Combined Leverage: by using operating leverage and financial leverage, a small change in sales is magnified into a larger change in earnings per share.
Degree of Combined Leverage (DCL): multiplier effect between sales and EPS.
Degree of Combined Leverage (DCL) Formula
DCL = DOL*DFL
% change in EPS
% change in Sales
Sales - Variable Costs / EBIT - I
Example #1: DCL = 3.18
A 1% increase in sales will result in a 3.18% increase in earnings per share (EPS).
Return, Risk, and the Security Market Line
6 Learning Objectives
1. Understand risk for both an individual security and a portfolio.
2. Calculate expected return and standard deviation.
3. Demonstrate understanding of diversification and correlation.
4. Articulate the difference among systematic [market] risk, nonsystematic [firm specific] risk and total risk.
5. Describe the beta calculation.
6. Calculate CAPM required return.
Key Words/Concepts - Ch 13
Risk-Return Tradeoff [2 Tailed Concept]
Expected vs. Actual Return
Systematic vs. Nonsystematic Risk
Capital Asset Pricing Model (CAPM)
Security Market Line (SML)
in order to increase potential return on an investment the corresponding risk must also increase. This line levels off rather than increasing forever due to the ability of an investor to diversify away firm-specific risk. Taking on greater risk does not guarantee greater return. Two-Tailed Concept: Taking on more risk can lead to greater losses rather than greater gains.
Expected Return: the anticipated estimate of return calculated in advance based on the probabilities of possible outcomes. "Expected" means average if the process is repeated many times.
Actual Return: The actual gain or loss of an investor during a specific period of time (e.g. a quarter or year) relative to the investment's initial value. This can be expressed in the following formula: expected return (ex-ante) plus the effect of firm-specific and economy-wide news.
Required Return: return an investor requires on an asset given its particular risk.
Standard Deviation: A measure of the dispersion of a set of data from its mean. The more spread apart the data, the higher the deviation. Standard deviation is calculated as the square root of variance.
Correlation: refers to the way two variables co-move. It is a unitless measure bounded by +1 and -1.
Diversification: a portfolio strategy designed to reduce exposure to risk by combining a variety of investments, such as stocks, bonds, and real estate, which are unlikely to all move in the same direction. The goal of diversification is to reduce the risk in a portfolio. Volatility is limited by the fact that not all asset classes or industries or individual companies move up and down in value at the same time or at the same rate. Diversification reduces both the upside and downside potential and allows for more consistent performance under a wide range of economic conditions.
Systematic Risk: market risk; cannot be diversified away.
Nonsystematic Risk: firm specific risk; can be diversified away.
Beta: a quantitative measure of the volatility of a given stock, mutual fund, or portfolio, relative to the overall market, usually the S&P 500. A beta above 1 is more volatile than the overall market, while a beta below 1 is less volatile.
Capital Asset Pricing Model (CAPM)
Capital Asset Pricing Model (CAPM): an economic model for valuing stocks by relating risk and expected return. Based on the idea that investors demand additional expected return (called the risk premium) if asked to accept additional risk.
Security Market Line (SML)
Security Market Line (SML): plots the results of the CAPM for all different risks (betas). Linear relationship between an investment's hurdle rate and its market risk. In an efficient market every stock should lie on the SML line. As risk increases the return for that stock increases along this line.
Build up method
Build-Up Method: method for valuing equity that is usually applied to closely held companies where betas are not readily available. Build-Up Method uses risk-free rate + equity risk premium + size premiumi + specific-company premiumi.
3 Evaluations of Risk
1) How to Measure Risk
(variance, standard deviation, beta)
2) How to Reduce Risk
3) How to Price Risk
(security market line, CAPM, Build-Up)
Efficient Market Assumption
Market "Discounts" Expected News: lower impact on price because market already knew and adjusted for this information to determine expected return for stock
Surprise Affects Stock's Price and Return: occurs when actual news differs from forecast or future info is revealed; can be good news or bad news.
3 Features of Unexpected Return
1) New [Unexpected] Information: source of uncertain or risky return
2) Positive or Negative Impact: interpretation of information matters
3) Average Unexpected Component = Zero: on average actual return EQUALS expected return.
Expected Return Definition
Expected Returns: based on the probabilities of possible outcomes.
"Expected" means average if the process is repeated many times.
"Expected" return does not even have to be a possible return.
What is Risk?
1) Actual Expected Return: possibility that our actual return will differ from our expected return.
2) Multiple Possible Outcomes:
uncertainty in the distribution of possible outcomes [measured by standard deviation].
How to find Standard Deviation
Step 1: Solve for each individual variance from the mean expected return ( k ). Add each individual variance together for the Total Variance.
Step 2: Solve for Standard Deviation. Take the square root of the total variance σ = Sqrt of Total Variance.
2 Extreme Examples of Correlation
Correlation = +1
-"perfect positive correlation"
-Variables move in perfect tandem
Correlation = -1
-"perfect negative correlation"
-Variables move in exactly opposite directions
How to reduce risk in portfolio?
The LOWER the correlation among assets in a portfolio (i.e. closer to -1) the GREATER the risk reduction possibilities for the portfolio.
Diversification: 2 Relationships
Diversification: investing in more than one security to reduce risk.
Escape the "Phantom Egg Crusher."
Perfectly Positively Correlated:
diversification has no effect on risk.
Perfectly Negatively Correlated:
portfolio can be perfectly diversified and basically eliminate nonsystematic [i.e. firm specific] risk.
Key Takeaway: Two RISKY assets can create a "riskless" portfolio if the two RISKY assets are perfectly negatively correlated.
Market "systematic" risk
Market [i.e. Systematic] Risk: also called non-diversifiable risk. This risk cannot be diversified away.
Firm specific "Non systematic" risk
Firm Specific [i.e. Nonsystematic or Idiosyncratic] Risk: also called diversifiable risk. This risk can be reduced through diversification.
Market Risk Examples
Unexpected changes in interest rates
Unexpected changes in inflation
Unexpected changes in cash flows due to:
Foreign Exchange Rate Changes
Tax Rate Changes
Firm Specific Risk Examples
1) A company's labor force goes on strike.
2) A company's top management dies in a plane crash.
3) Proprietary information vs. patent protection lawsuit.
4) Obsolescence of a firm's unique products occurs sooner than anticipated.
5) A huge oil tank bursts and floods a company's production area
Six Potential Methods of International Diversification
Type of Securities
Size of Capitalization
Stage of Development
Why should you add lots of stocks to your portfolio?
As you add stocks to your portfolio, firm-specific [nonsystematic] risk is reduced.
Do some firms have more market risk than others?
Example: An economic slowdown affects all firms, but which would be more affected:
b) Insulin Manufacturer
What type of risk does the market compensate you for?
The market only compensates investors for accepting market risk.
Firm-specific risk can and should be diversified away!
That's the mystery element—how much market risk does a security have?
Beta: used to measure market risk
Beta: measure of market risk.
Quantifies Variation: measures how an individual stock's returns vary with market returns.
Sensitivity to Market Changes: beta measures the "sensitivity" of an individual stock's returns to changes in the market.
Summary of Tools
We know how to measure risk, using standard deviation for overall risk and beta for market risk.
We know how to reduce overall risk, using diversification so we are left with only market risk in our portfolio.
STILL NEEDED: How to price risk so we will know how much extra return we should require for accepting extra risk.
This linear relationship between risk and required return is known as the Capital Asset Pricing Model (CAPM).
Application: used in pricing of risky securities.
Analysis Behind CAPM: investors need to be compensated in two ways: time value of money and risk.
Theoretically, where should every security lie?
security should lie
on the SML
If every stock
is on the SML,
investors are being fully
compensated for risk.
If security is above SML
If security is below SML
Cost of Capital
5 Learning Objectives Ch 14
Discuss tax implications of raising funds with debt vs. equity.
Understand difference between internal and external equity funds.
Apply CAPM and Build-Up Method for equity cost calculations.
Calculate the Weighted Average Cost of Capital (WACC).
Discuss when the WACC is an appropriate discount rate for potential investment projects.
Key Words/Concepts Ch 14
Internal vs. External Equity
Capital Asset Pricing Model [CAPM]
WACC [Cost of Capital]
Cost of Capital
Opportunity Costs Matter: to determine whether a capital investment will increase the value of a firm, you need to understand the opportunity cost of the capital.
Cost of Capital Comparison:
If ROA > C of C INCREASE value
If ROA < C of C DECREASE value
How can firms raise capital?
Three Main Methods:
1) Debt [Bonds, ST or LT Bank Loans]
2) Preferred Stock
3) Equity [Common Stock, Retained Earnings]
How do they decide which type is best?
Investor Expectations on Rate of Return
Existing vs. Target Capital Structure
Respective Costs of Each [WACC]
FRICTO Analysis [Flexibility, Risk, Income, Control, Timing, Other]
Three Forecasted Items Necessary for Debt Calculation
1) Interest Rates: forecast of relevant interest rates for the next few years.
2) Debt Capital Structure: proportions of various classes of debt [and corresponding cost] the firm expects to use.
3) Corporate Income Tax Rate: determines the weighted average after-tax cost of debt [relevant cost].
Adjustments to Cost of Debt
Cost of Debt: [for firm] rate of return required by lender, adjusted for two things:
Taxes: positive impact on debt financing sources due to interest expense and subsequent tax shield. Taxes have NO effect on common stock.
Flotation Costs: any costs associated with obtaining new debt [transaction fees, government fees, costs of printing certificates, paying underwriters, etc.].
Initial Public Offering (IPO)
Initial Public Offering (IPO): first public issue of a firm's equity shares
Features of an (IPO):
Form underwriting and syndication group
Publish detailed prospectus [13 months]
IPO typically represents 15%-25% ownership [but as low as 6%-8% possible]
Later issues considered "seasoned offerings"
Public issuance of shares requires greater public disclosure—ongoing costs and competitive implications
2 Sources of Common Equity
1) Internal Common Equity
(i.e. retained earnings)
2) External Common Equity
(i.e. new common stock issue)
Cost of Equity: External
In the absence of flotation costs, internal and external equity have the same cost.
Increase Growth Rate Potential: In order to grow faster than the sustainable or internal growth rate, a firm must raise external funds.
External Equity: adds flotation costs as well as the "gross [i.e. underwriting] spread" paid to an investment bank for their assistance
Role of Investment Bank
Official Advisor Role: early appointment of an investment bank is often key for firm success.
Interact with potential investors and know current requirements.
Provide "Reality Check" and Help Navigate:
Preparation of Stock Prospectus
Pricing of Equity Issue
Aftermarket to Maintain Initial Price
External Equity Gross Spread
Gross [Underwriting] Spread: difference between underwriting price received by firm and actual price offered to investing public.
Gross [Underwriting] Spread Components:
1. Takedown: underwriter compensation for selling issue [i.e. commission].
2. Management Fee: paid to lead manager of a syndicate for investment banking services, managing affairs of syndicate and/or structuring the new issue.
3. Underwriter Expenses: miscellaneous fees (counsel, CUSIP, wire, electronic order monitoring, day loan, road show, etc.)
Cost of Equity: Internal
Two Methods for Calculating Cost of Internal Equity
1) Capital Market Analysis (CAPM)
Investors compensated for TVM [risk free rate] and Risk [equity risk premium]
2) Build-Up Method
Used for closely held company where beta not readily available
3 Steps to Calculate WACC
1) Determine before tax cost of each individual source of financing.
Stock: CAPM or Build-Up Method
Debt: Borrowing rate(s)
Tip: Leave the cost of each source as a whole # rather than converting to decimal to avoid rounding issues!
2) Estimate weight for different financing sources as a portion of total financing.
3) Calculate weighted average of after tax cost of each source.
Multiply weights by the cost for each component
Weights should be based on market values!
Optimal Financial Structure
How does a firm decide?
Two Reasons to adjust Optimal Financial Structure
1. Threat of Bankruptcy and Taxes [M&M]: optimal mix of debt and equity minimizes firm's cost of capital for a given level of business risk.
2. New Projects with Different Business Risk: optimal mix of debt and equity changes to recognize tradeoffs between business and financial risks if business risk of new projects differs from existing projects.
: the possibility of inadequate profits or even losses due to uncertainties e.g., changes in tastes, preferences of consumers, strikes, seasonality of projects, increased competition, change in government policy, obsolescence, etc. Every business organization contains various risk elements while doing the business. Business risks implies uncertainty in profits or danger of loss and the events that could pose a risk due to some unforeseen events in future, which causes business to fail.
risks associated with the financial structure and transactions of the particular industry
Debt vs Equity Optimization
Relative Cost Analysis: identifying optimal mix requires knowing relative costs of each.
Finance Theorists Consensus: 1) Optimal financial structure exists 2) Firms use systematic method to identify optimal mix
3 Determinants of a Firm's Debt Ratio
1) Industry of Firm
2) Volatility of Sales & Operating Income
3) Collateral Value of Assets
Multiples Method Process
Valuation Using Multiples: estimate asset value by comparing values assessed by the market for similar or comparable assets.
Multiples Method 3 Step Process
1) Identify Peers: identify peer group comparable assets and obtain market value of peer group assets.
2) Create Valuation Multiple: convert market values into standardized values relative to key statistic since absolute prices cannot be compared.
3) Apply Multiple: apply valuation multiple to key statistic of asset being valued; control for differences between asset and peer group that may affect multiple.
Common Ratio Comparables
-Earnings considered value driver
-Inverse of P/E Ratio
-Small # if earnings get close to zero to avoid P/E distortion
-Used when negative earnings [dot.com Companies]
5) EBITDA/Price Ratio
Peer Group Analysis
Three Keys to Peer Group Identification:
Compete in Same Markets
Have Similar Assets
Operate in Similar Ways
Problems with Comparables Method
1) What is the correct comparison group?
2) Is the comparison group correctly valued?
3) Should the target have a different multiple?
4) Biggest Problem: What are the earnings of Walmart?
Capital Structure Differences
Business Cycle Influences
3 Valuation Caveats
1) Salary Considerations
Mostly relevant to small firms
Should be a deduction from FCF
2) Liquidity Discounts
Public Co: data disclosure, observable stock price, passed test of IPO, etc.
Privately held? [40%-50% discount]
3) Control Premium
Control is valuable!
30%-35% premium in takeovers
Replacement Cost Approach
Replacement Cost Approach: determine expense to recreate identical firm
Assets [Left Side of BS]:
Tangibles: appraised/estimated value
Intangibles: patents, trademarks, brand equity, customer list, reputation, synergies, etc.
Liabilities & Owners Equity
[Right Side of BS]:
Refinancing Cost: issue equity, debt, etc.
How easy is it to create an identical copy of the firm?
Are Assets Separable?
Are Assets Marketable?
Mature vs. Growth Firm
Key Takeaway: Intangibles difficult to value and may be impossible to replace.
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