THE BALANCE SHEET: Represents a picture taken on a specific date that shows a firms assets and how those

assets are financed (debt or equity). The firms common stockholders equity, or net worth, = total assets total liabilities. Assets are listed in order of liquidity. Liabilities & equity are listed in the order in which they must be paid. THE INCOME STATEMENT: When comparing the operations of 2 firms, examine the Net Operating Income (NOI), aka EBIT, b/c this figure represents the result of normal operations before considering the effects of the firms financing choices (financial structure). 2 firms have the same NOI/EBIT. Firm 1 uses debt & equity & firm 2 uses only equity. Firm 2 will have higher NI b/c the dividends paid ARE NOT tax deductible but interest paid to debt holders is tax deductible. Firm 2 will also have higher ROE if the NI is NEGATIVE & a lower ROE if NI is POSITIVE. EBITDA Depreciations = NOI = EBIT Interest = EBT Taxes = Net Income STATEMENT OF CASH FLOWS: Designed to show how the firms operations have affected its cash position Examines investment decisions (uses of cash) & examines financing decisions (sources of cash). STATEMENT OF RETAINED EARNINGS: Changes in the common equity accounts between balance sheet dates. Beg Balance + NI dividends paid = End Balance

Liquidity Ratios: is the firm able to meet its current obligations Current Ratio

Quick Ratio =

Asset management: is the firm effectively managing its assets Total Assets Turnover = Turnover = Inventory Turnover = DSO = Fixed Assets

How effectively theyre using their plant & equipment to help generate sales.

Debt management: does the firm have the right mix of debt and equity Debt Ratio = = The %age of their assets that are financed by borrowing (loans). Measures the extent to which their EBIT (NOI) can decline before these

Times Interest Earned =

earnings are no longer enough to cover annual interest costs.

Profitability: the combined effects of liquidity, asset and debt management ROA = Profit Margin X Total Assets Turnover: The return that theyre getting on its investments in assets, which is the average return thats generated on funds provided by both creditors & stockholders.

Profit Margin = ROE =

Profit per $1 of sales. ROE = ROA X Equity Multiplier= ( ) ( )

ROE measures the return that they generate on the funds provided by only common stockholders. Market values: relates the firms stock price to its earnings and the book value per share Price/Earnings Ratio = How much were willing to pay for their stock for each $1 of profit

they make. Its higher for companies with high growth prospects & lower for riskier firms. Market/Book Ratio = the stocks of companies with relatively high rates of return on

equity generally sell at higher multiples of BV than do those with low returns.

Operating Cash Flow = NI + Depreciation Free Cash Flow = Operating Cash Flow Investments EVA = (1 - T) NOI [(Invested Capital) X (After-tax cost of capital as a %)] EPS = Net working capital = Current assets Current liabilities

PRESENT VALUE OF A LUMP SUM: PV will be lower when interest is higher OR when time is greater. SEMI-ANNUAL & OTHER COMPOUNDING PERIODS: New interest rate = Effective Annual Rate (EAR) = (1 + 1

EFFECTIVE RATE OF RETURN: *If compounding occurs more than once per year, the effective annual rate > the simple interest rate.

Realized Return / Yield = The cost of debt capital = The Interest Rate

The cost of equity capital = Return on Equity = Dividends + Capital Gains Prevailing interest rate = risk free rate Yield = rate of return Nominal Interest Rate = Rate of Return (Est.) Interest Rate = Avg. expected inflation + real risk-free rate + MRP. Rate of Return = Risk-Free Rate + Risk Premium R = + RP

RATE OF RETURN (R): The quoted, or nominal rate of interest RISK-FREE RATE ( ): Nominal risk-free rate on safe investment (T-Bills).

RISK PREMIUM (RP): The rate that exceeds the risk-free rate & thus represents payment for the risk associated with an investment. Included in RP is MRP, LP, & DRP. Risk-free Rate = Real Risk-Free Rate + Inflation Premium = r* + IP

R* is the rate of interest if inflation was expected to be 0 during the life of an investment. Its the IR that would exist on a default-free Treasury security if no inflation were expected. IP is = to the average inflation rate expected over the life of the security. The yield on any bond is the average of the annual IRs during its life: YIELD ON A 2-YEAR BOND =

Expected inflation rate each year (IP) = Nominal IR expected to occur during the year (rRF) r*

Principal = FV = Maturity Value = Par Value. The amount of money due on the maturity date. Coupon Payment: The specified # of dollars of interest paid each period, generally each 6 months, on a bond. RD = annual required rate of return (yield) on a debt instrument, quoted as APR N = number of years before the bond matures INT = coupon payment = dollars of interest paid each year (Coupon rate x Par value)

M = par or face, value of the bond to be paid off at maturity I/Y = Reqd rate of return

BOND VALUE FOR SEMIANNUAL COUPON BOND: Coupon payment is made every half a year and should equal INT/2 Use periodic return = rd /2 Number of periods = N x 2 M = same as with annual coupon bond

Discount bonds: Value of bonds (Price) < Face Value or M. Reqd rate of return (YTM) > coupon OR stated rate. Premium bonds: Value of bonds / Price > Face Value. Reqd rate of return (YTM) < coupon OR stated rate. Interest rate price riskchange in bond value in response to interest rate change. This risk is higher in bonds with longer maturities. As maturity , interest price risk . This risk is one of the risks incorporated in maturity risk premium. This is why L-T bonds carry higher yields. Yield to Maturity: The average rate of return earned per year on a bond if it is held to maturity. The calculators answer represents yield per interest payment period, so you have to multiply it by 2. Yield To Call: The average rate of return earned on a bond if it is held until the first call date. When the bonds are called, they are redeemed at a call price that is usually greater than bonds face value. PV = current sell price. Computation is same as YTM except we substitute the call price of the bond for the FV, & the # of years until it can be called for the years of maturity. Multiply I/Y by 2. Whenever the going rate of interest, RD, equals the coupon rate, a bond will sell at its par value An in interest rates makes the price (value) of an outstanding bond to . A in interest rates makes the price The market value of a bond will always approach its par value as its maturity date approaches.

Perpetuities: If selling at a premium, the value of the bond < value of the perpetuity. If selling at a discount, the value of the bond > value of the perpetuity. Value of perpetual bonds = (INT/PMTrD, i/y, rror)

The next dividend expected to be paid & it will be paid at the end of this year. = The actual market price (value) of the stock today

^Pt = the expected price at the end of each Year t. An investor should buy the stock only if ^P0 P0. ^P0 = the intrinsic, or theoretical, value as seen by the investor ^P1 = the price expected at the end of Year 1 RS = the reqd rate of return on a stock that investors demand. ^ RS = Expected rate of return. What the investor expects to receive. They should only buy the stock if ^RS RS. G = Expected growth rate in dividends as predicted by an average investor. If we assume that dividends are expected to grow at a constant rate, then G is also = to the expected growth rate in the stocks price. G =

Expected Dividend Yield =

Expected Capital Gains Yield =

Valuing Stocks with Constant, or Normal, Growth (g): Plowed back = reinvested (Ex. Rate of Return) =

^DT = D0

(Ex. Dividend Yield) + G (Ex. Growth Rate/Capital Gains Yield) All future dividends will be the same as the most recently

Special Case of Constant Growth: G = 0: ^P0 =

paid dividend, which means that D0 = ^D1 = D. This equation can be used to determine the value of preferred stock, b/c the constant dividend represents a perpetuity.

P/E Ratio =

EPS.

Dollar Amount of each Dividend = PV Of =

PV of each Dividend =
VALUING STOCKS WITH NON-CONSTANT GROWTH

1. Compute the value of the dividends that experience non-constant growth, and then find the PV of these dividends, 2. Find the price of the stock at the end of the non-constant growth period, at which time it has become a constant growth stock, and discount this price back to the present, and 3. Add these two components to find the intrinsic value of the stock P0.

Expected Value / Expected Rate of Return: The rate of return expected to be realized from an investment. ^R = (probability X r) + (probability X r)

Standard Deviation measures total OR stand-alone risk of an asset. Some of this risk is reduced when the asset is part of a portfolio. Standard Deviation = Return Volatility. The smaller the s.d., the tighter the probability distribution, and the lower total risk associated with the investment. Beta measures systematic OR relevant risk of an asset, the risk that directly contributes to the risk of portfolio. Coefficient of Variation: A standard measure of the risk per unit of return. CV = Risk / Return = standard deviation / expected value. Because CV captures the effects of both risk & return, it is a better measure than the s.d. for evaluating total stand-alone risk in situations where investments differ with respect to both their amounts of total risk & their expected returns. Portfolios: Expected return on a portfolio is the weighted average expected returns on stocks held in the portfolio. When 2 perfectly positively correlated stocks with the same risk are combined, the portfolio risk is the same as the risk associated with the individual stocks. If more randomly selected stocks were added to the portfolio: the S.D. of the portfolio would remain constant only if the correlation coefficient were +1.0. The S.D. of the portfolio would decline to 0 if the correlation coefficient = -1. Any other correlation coefficient would still make the S.D. of the portfolio decline, though not as much as it would if it =d -1. The weaker (lower) the positive correlation OR the stronger (higher) the negative correlation 2 stocks exhibit, the more risk can be reduced when theyre combined in a portfoliothat is, the greater the diversification effect. Firm-Specific Risk: That part of a securitys risk that affects a single firm. It includes impact of such unexpected events as CEO turnover, new product developments, labor strikes, etc. This risk is also called diversifiable risk, unique risk, or unsystematic risk and it can be eliminated through proper diversification. Market Risk: That part of a securitys risk that cannot be eliminated through diversification because it is associated with economic, or market factors that systematically affect all firms. Examples include unexpected unemployment increases, interest rate changes, etc. This risk is also called systematic or non-diversifiable risk. Suppose you hold a diversified portfolio consisting of a $7,500 investment in each of 20 different common stocks. The portfolio beta is equal to 1.12. You have decided to sell one of the stocks in your portfolio with a beta equal to 1.0 for $7,500 and to use the proceeds to buy another stock for your portfolio. Assume that the new stocks beta is equal to 1.75. Calculate your portfolios new beta. 1. Old portfolio beta = 1.12 = (0.05)1 + (0.05)2 +...+ (0.05)20 1.12 = (j)(0.05) j = 1.12/0.05 = 22.4 New portfolio beta = (22.4 - 1.0 + 1.75)(0.05) = 1.1575 = 1.16 2. j excluding the stock with the beta equal to 1.0 is 22.4 1.0 = 21.4, so the beta of the portfolio excluding this stock is = 21.4/19 = 1.1263. The beta of the new portfolio is:

1.1263(0.95) + 1.75(0.05) = 1.1575 = 1.16 Susans investment portfolio currently has 3 stocks that have a total value of $100,000 & the beta of the portfolio = 1.5. She is considering investing an additional $50,000 in a stock that has a beta = to 3. After she adds this stock, what will be the portfolios new beta? The beta of the portfolio = the weighted average betas of investment A + investment B. To calculate the average return on a portfolio: Add all the numbers for the 50/50 portfolio up then divide by the # of years. To estimate beta with a financial calculator, use stock R returns as the x-variable & market returns for the y-variable. Net Present Value (NPV): NPV is the PV of an assets future cash flows minus its purchase price (initial investment).

NPV = sum of

= expected net cash flow in period T

If NPV is positive, then the asset (project) is considered an acceptable investment. PAYBACK PERIOD = (# of years just BEFORE full recovery +( A project is acceptable if PB < n*--the recovery period that the firm has determined is appropriate. Discounted Payback Period (DPB): DPB is the length of time it takes for a projects discounted cash flows to repay the cost of the investment. A project is acceptable if DPB < Projects useful life. A CHANGE IN THE REQD RATE OF RETURN PRODUCES A CONFLICT BETWEEN THE NPV & IRR RANKINGS OF TWO PROJECTS: NPV assumes that cash flows can be reinvested at the cost of capital, whereas IRR assumes reinvestment at the projects IRR. The high reinvestment rate assumption under IRR makes early cash flows especially valuable, and hence short-term projects look better under IRR. Crossover Rates: Compute the differences in the annual cash flows, all of them. Then input these differences into the financial calculator as the annual cash flows and ask the calculator to compute IRR. This rate is the cross over rate. As long as r> the cross-over rate, both the NPV &IRR methods lead to the same choice. If r < the cross over rate, the 2 methods lead to different choices & a conflict exists. When a conflict exists, the NPV method must be used. For mutually exclusive projects, choose the one with the higher NPV. For independent projects, choose the one with the higher IRR. A projects IRR is unaffected by changes in the reqd rate of return. The NPV s as the reqd rate of return s. IRR = I/Y A project is acceptable is IRR, which is its expected return, is > r. Modified Internal Rate of Return (MIRR)

MIRR is the discount rate at which the PV of a projects cash outflows is = to the PV of its terminal value, where the terminal value is found as the sum of the FVs of the cash inflows compounded at the firms reqd rate of return & the PV of the cash outflows is found using the same reqd rate of return. The discount rate that forces the PV of the TV to = the PV of the costs is defined as the MIRR. A project's terminal value is determined by computing the future value of the expected cash inflows. PV of cash outflows = A project is acceptable if MIRR > r. Net Income + Depreciation

An Assets Operating Cash Flows: Net Cash Flow =

= Return on Capital +Return of Capital

Opportunity Costs: Included in the initial investment outlay. Externalities: The effect accepting a project will have on the cash flows in other parts of the firm. Externalities such as people visiting your new store instead of your old store (the exact same amount) shouldnt be included in the analysis of the new capital budgeting project. Shipping & Installation Costs: Theyre added to the invoice price of the assets when the total cost of the project is determined. Theyre included in the incremental CF for an expansion project. Inflation: It should be recognized in capital budgeting decisions. Incremental Operating Cash Flow: the changes in day-to-day cash flows that result from the purchase of a capital project and continue until the firm disposes of the asset. Terminal Cash Flow Includes: 1. Positive SV net of taxes, OR Negative SV net of taxes, AND 2. The tax impact associated with the disposal of the project. EXPANSION: INITIAL: new asset price + change in NWC INCREMENTAL: (1-T) before-tax savings in operating costs + T (Depreciation Ex.) TERMINAL: + Positive SV Negative SV + Tax Savings from Gain Tax Loss from loss + Change in NWC REPLACEMENT:

INITIAL: new asset price + change in NWC cash from sale of old asset + tax from gain tax from loss INCREMENTAL: [ (increase in sales + decrease in operating expenses) X (1-T) ] + Depreciation Tax Savings TERMINAL: new machine SV cash recd taxes from sale + change in NWC opp. Cost of old machine (SV could have received from the old asset if they didnt buy the new asset) opp. Cost of tax savings on old machine Net After-Tax Cash Flow From Disposal = Cash Recd Taxes. Tax on SV = (SV BV by year sold) X T Tax savings From Sale of Old Asset = Capital Loss Resulting from Sale of Asset x t (marginal tax rate). Tax Loss from Sale of Old Asset = Capital GAIN from sale of asset X t. Capital Loss/Gain = (current BV cash they can get if they sell old asset today) Depreciation Tax Savings = Change in Depreciation X T RDT = RD (1-T) = after tax cost of debt Cost of C.E. (R.E.) the CAPM Approach: Cost of Common Equity - the Discounted Cash Flow Approach: When dividends expect to grow at constant growth rate forever, we can estimate cost of equity as RPS = cost of preferred stock:

+G

WACC =