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WEEK

2: FINANCIAL STATEMENT ANALYSIS

WEEK 2: RATIO ANALYSIS


OCF=EBIT+ Depr

EPS = NI # shares outstanding


PER approach - valuaEon
own EPS x PER u want
In i/s - deduct int ex before taxing
> EBIT is operaEng income (sales - ops cost - depr)

Leverage: use debt > equity

Just bought security (pays $500 every six months). Security


lasts 10y. Another security (equal risk) also has maturity of
10y, and pays 10% comp mthly. Price of security u should pay?
- Start by calc EFF on 2nd security. Then, convert EFF to a
semiann rate, then calc the value of the 1st security
WEEK 4: BONDS AND VALUATION

WEEK 3: TIME VALUE OF MONEY


X deposited 10 in bank acct that has 12% nom int rate, int compounded mthly. X also plans to
cont another 10 to the acct 1y from now and 20, 2y from now. How much will be in the account
3y from now?
- Calc FV of ea contribuEon and add tgt
X is planning to make 36 cont to her acct at beg of ea of the next 36y. 1st cont will be made today
(t=0) and nal cont will be made 35y from today (t = 35). 10% int. If each cont she makes is 30,
how much will be in the reErement account 35 years from now (t = 35)?
- Calc FV of 35 payments and + 30 to ans for the last payment

convertible feature; sinking


fund lower required ror
(coup rate), but call feature
raise rate

For annuity just 1st pt


Face value of $1,000 means FV = $1,000. If no FV menEoned, FV = $1,000

YTM = expected CY + expected CGY


Solving for YTC = same as YTM but Eme to call (N) call prem (FV)
Fischer eect: real int rate = nom int rate - expected inaEon rate
All else constant, a bond will sell at disc when the coupon rate is < the yield to maturity
If interest rate = 5% but coupon rate 10%, will call bond
If interest rates decline, the price of both bonds will increase, but the 15-year (8%) bond will have
a larger percentage increase in price (than 10-year (12%))
Expect to earn YTC (prem bonds), YTM (par/disc bonds); eg. bonds are selling @ premium, i/r
have fallen since the bonds were originally issued. Assuming i/r dont change from the present
level, expect YTC/YTM
A 10-year corporate bond has an annual coupon payment of 9 percent. The bond is currently
selling at par. d a. The bonds YTM, current yield is 9%
- If the bonds YTM remains constant, the bonds price will remain at par
All else equal, long-term bonds have more interest rate risk than short-term bonds
All else equal, high-coupon bonds have more reinvestment rate risk than low-coupon bonds
- RelaEve to coupon-bearing bonds, zero coupon bonds have more interest rate risk but less
reinvestment rate risk
All else equal, short-term bonds have more reinvestment rate risk than do long-term bonds
Since YTM remains unchanged, the bondholders total return over the next year is the YTM and
we have the following equaEon: total return = CY + CGY = YTM. Since this is a disc bond, coupon
rate < current yield < YTM. So CGY has to be posiEve, i.e., bond price will appreciate over next yr.
As it gets closer to maturity date, bond price will approach par value. Since this is a disc bond, the
price has to go up if the YTM is kept constant
WEEK 4: INTEREST RATES
r<nom/quoted rate>(corp) = r*(real rF) + inaEon (expected) + default risk prem (0 for US treasury
but incr as riskiness of issuer incr) + liquidity prem + maturity risk prem
- rF = r* + inaEon
r (treasury) = r*+ inaEon (expected) + maturity risk prem
(1+inom) <inom aka equil ror> = (1+ireal)(1+in) = 1 + ireal + in + irealin <cross prod term,
mostly negligible>. inom = ireal + in (+ ireal x in)
Term structure = r/s btw LT& ST int rate (btw yields and maturiEes). Generally LT > ST (due to
MRP) > norm upward-sloping curve. Lower int more ppl borrow, spend more in incr

ie. FV = PV(1.06<EAR>)N

FV(ann due) = FV<ord>(1+i)

FV <PV nt given> = compound ea


CF

<used for comparison>


di rates/ comp periods

What is remaining bal on loan aQ making 30th pmt (remaining loan balance)? (1) Find PMT using
TVM (2) Enter the PMT no: eg. AMORT (30 > P1 & P2) (3) Enter, scroll down to bal
- To nd amt going towards repayment of int/prin - key in the exact Eme eg. 3, 3 for (3rd mth)
30y, $165 mortgage, mthly PMT and iNOM of 8%. What is total $ of int paid in 1st 3Y of
mortgage? (1) Find PMT using TVM (2) Enter the PMT no 3y=36mth eg. AMORT (1 for P1 & 36 for
P2)(3) Enter, scroll down to int
AmorEsaEon table
Uneven CF stream

FV of lump sum larger if


compounded more oQen
ie. ann income from investment as proporEon of original invest

expected ret: just take each return x prob


variance = SD2
[shows standalone risk]
ie. if 5 numbers, divide by 4

SML > raise inaEon line shiQ up. incr risk-aversion grad incr

diversiable up to 40 stocks - SD of
porxolio tends to converge > 20%

WEEK 9: STOCK MARKETS AND THEIR VALUATION


If g>rs, -ve stock price:
DDM (gordons constant growth model)
Not reasonable for a rm to grow indenitely at a rate
Constant growth stock:
higher than its required return. Such a stock, in theory,
would become so large that it would
eventually overtake the whole economy
If g=rs, undened stock price
Both do not make sense
> DDM can only be used if rs>g, g expected to be
> value of the stock is not dependent
constant forever
upon the holding period

Supernormal growth stock (also for non-constant):

Dividend yield:

Capital Gains yield

Total return (rs)


Div yield + cap gains yield

WEEK 10: THE COST OF CAPITAL


!"## < % >= !! !! < % > 1 ! < !"# > + !! !! + !! !!

Weight depends on what is the target capital structure


Reects risk of avg proj taken by rm
Cost of debt (aXer tax)
!! (1 !)

Interest rate on new debt; tax deducAble


Component cost of preferred stock

MV LT debt = BV

MV common eq = mkt price x # of share

rd > YTM

EPS1 = EPS0 (1 + g <dec>) = $5.40(1.03)

Not tax-deducAble
Sustainable growth rate/expected future growth rate
g = (1 - payout<dec>)(ROE<%>)
Only applicable for long term; situaAon expected to cont
Component cost of equity (reasonable est. take avg of the 3)/ cost of RE
1. CAPM (rs)
2. DCF (DDM eqn making r the subject)
ans change to %
3. Bond yield + risk prem


Premise: cost of equity > cost of debt; since coupon rate xed by contract
Cost of issuing new stock
Corporate valuaAon (FCF) model
Add otaAon cost (cost of issue ie. fees to IB, underwriAng fee)
Horizon value (HV): similar to DDM aka D1
P0/D1 model
Factors inuencing WACC
MV of equity = MV of rm - MV of
Market cond, capital structure, div policy, investment policy (riskier proj higher WACC)
debt
Use debt 1st unAl opAmal pt where thereager rm may not be able to meet debt
Pecking order: managers prefer to use RE > debt > new equity (may send -ve signal and depress
Gain on sale = 5-4=1
Value/share = MV of equity # of
stock price)
Tax on gain = 1(0.4) =0.4
shares
AT salvage value = 5-0.4 = 4.6
WEEK 11: CAPITAL BUDGETING AND PROJECT ANALYSIS
WEEK 11: CASH FLOW ESTIMATION AND RISK ANALYSIS
Tax SV always, may incur cost in disposiAon of
Normal CF (-ve followed by posi6ve CF); non-normal (2 or more sign changes)
NOWC = CA - CL (excl n/p)
asset (if SV -ve then tax +)
1. NPV
Best method since it address directly the central goal of maximising shareholder wealth
Sum of the PVs of all cash inows and ouIlows of a proj
Choose NPV > IRR
exclude: research
(The conict between NPV and IRR
for project last
occurs due to the dierence in the
year *sunk cost
(PV of inows - cost = net gain in wealth)
size of the projects.
OR
Project B is 3X larger than Project A)
Add CFs into calc CF; enter I/R <%>; press NPV
Then nd ops cash ow like SCF
INT
BONDS
Independent proj - CF of 1 unaected by acceptance of other
Accept if NPV > 0
Dependent proj - CF of 1 can be adversely aected by other > each of the projects is
equally risky and as risky as the
Accept proj with highest +ve NPV
SL dont take into acc salvage val
rms other assets
2. IRR
Disc rate that forces PV of inows to be = cost; NPV = 0. Cannot use for non-normal since >1 IRRs
Ways to nd g: take arithmeAc/
weighted avg, forecast nancial
statements

Enter CFs in calc, press IRR to get ans <%>


Indep: accept if IRR > WACC (returns > costs). Mutually ex: accept higher IRR (and IRR > WACC)
> if = sAll can take on cos may have future benets
3. MIRR

!! = !! + !!

PEH - shape of yield curve dep


on investors exp of future in
rates. Term struc = r/s btw int
rate (yields) & maturiAes YTM

Finally, enter CFs into calc and I = WACC <%>. Press NPV
SensiAvity analysis
Eect of changes in a variable on projects NPV
ConsideraAons:
- +/- ( )% risk adjustment - for eg. cost of capital, +/- to get new NPV dep on whether low or high
NPV
risk proj
- Financing eects like div and int ex should not be incl (alr in WACC)
If we have unlimited capital, we
would just choose
Sunk costs irrelevant, only take into acc incremental CF
- Opp costs, erosion costs relevant
project 1 since it oers higher NPV.
- CannibalisaAon (ager-tax) and complementary CF relevant and should be considered
Since we have limited capital, we
- Consider subj risk factors - potenAal for lawsuit, whether assets can be redeployed or sold,
look at the total
NPV that $2000 can generate (eg.
country/poliAcal/currency risk
other investment opp)
WEEK 12: DERIVATIVES - FI whose value depends on value of underlying instrument (bond/share)
4. Regular payback
Leverage - pay low amt but potenAal payos high
Payback period: no. of years required to recover projs cost
Call opAon
NPV proles
Incr stock price - incr opAon value | incr ex price - decr | incr Ame to exp - incr | incr rF - incr | incr
Graphical rep of proj NPVs at di costs of
stock ret variance - incr
capital > downward sloping
- Why NPV proles cross? size (smaller free Comparisons
- Forward vs futures: asset exchanged at specied Ame in future at prices specied today (simi).
funds at t=0 for invest) and Ame (faster
Fut standardised trading on organised exchanges w daily rese^lement through clearinghouse
payback more CF earlier invest) di
- Call: right to buy; put: right to sell | short = sell; long = buy
5. Discounted payback
- Call: Spot (mkt) > strike (exercise) - in the money; put: s < x - in the money
- Call: bullish, can gain unlimited but limited downsides risk, put: bearish, max gain strike price -
cost of put but loss also limited to price paid for put
- PV dividends = (Div)e-rt
ST
- Black-Scholes OPM assumpAons: stock underlying call opAon no div during call opAon life, no
LT
transact costs, rF known and constant during op life, buyers can borrow any frac of purch price @
Comparing
ST rF rate, no penalty for short sell, call opAon only exercised on expiraAon date
NPV v IRR: indep proj 2 methods same decision(also when WACC > crossover rate). If < di decision Payback period
MIRR v IRR: MIRR assumes cash inows reinvested at WACC, IRR at projs IRR. MIRR avoids mulAple Strengths: Provides indicaAon of projects risk and liquidity, easy to calc and understand. Weakness:
ignores TVM. Requires arbitrary cuto point, ignores CFs occurring ager payback period - proj can
IRR prob when 2 or more sign changes in CF
have low CF in earlier yrs
In situaAon where there is non-normal CF (can also use for normal). IRR (but not MIRR) can relate to
NPV. Disc rate ^ causes PV of proj terminal value = PV of costs