Free Cash Flow (Solution)

a. NOPAT = EBIT × (1 − t)
NOPAT = $2,700 × (1 − 0.40) = $1,620
b. OCF = NOPAT + depreciation
OCF = $1620 + $1,600
OCF = $3,220
c. FCF = OCF − net fixed asset investment* − net current asset investment**
FCF = $3,220 − $1,400 − $1,400
FCF = $420
* Net fixed asset investment = change in net fixed assets + depreciation
Net fixed asset investment = ($14,800 − $15,000) + ($14,700 − $13,100)
Net fixed asset investment = –$200 + $1,600 = $1,400
** Net current asset investment = change in current assets − change in
(accounts payable and accruals)
Net current asset investment = ($8,200 − $6,800) − ($100 − $100)
Net current asset investment = $1,400 − 0 = $1,400

Valuing a firm Comprehensive Example(DCF)

In the face of disappointing earnings results and increasingly assertive institutional stockholders, Canon
was considering a major restructuring in 2013. As part of this restructuring, it was considering the sale of its
health division, which earned P560 million in earnings before interest and taxes in 2013, on revenues of
P5.285 billion. The expected growth in earnings was expected to moderate to 6% between 2014 and 2018,
and to 4% after that. Capital expenditures in the health division amounted to P420 million in 2013, while
depreciation was P350 million. Both are expected to grow 4% a year in the long term. Working capital
requirements are negligible.
The average beta of firms competing with Canon's health division is 1.15. The expected market return is
12.5%. While Canon has a debt ratio (D/(D+E)) of 50%, the health division can sustain a debt ratio
(D/(D+E)) of only 20%, which is similar to the average debt ratio of firms competing in the health sector. At
this level of debt, the health division can expect to pay 7.5% on its debt, before taxes. (The tax rate is 40%,
and the treasury bond rate is 7%.)

1. Estimate the cost of capital for the division.

2. Estimate the value of the division.
3. Why might an acquirer pay more than this estimated value?
Common Characteristics of Common Stocks

Common Stock

Common stock represents ownership in a corporation. As a part owner, you are entitled to your pro rata
share of anything paid out by the company, and you have the right to vote on important matters regarding
company. If the company were to be sold or liquidated, you would receive your share of whatever was left
over after all of the company's debts and other obligations (such as wages) were paid.
The potential benefits from owning common stock come primarily in two forms. First, many companies (but
not all) pay cash dividends to their shareholders. However, neither the timing nor the amount of any
dividend is guaranteed. At any time, it can be increased, decreased, or omitted altogether. Dividends are
paid strictly at the discretion of a company’s board of directors, which is elected by the shareholders.
The second potential benefit from owning stock is that the value of your stock may rise because share
values in general increase or because the future prospects for your particular company improve (or both).
The downside is just the reverse: your shares may lose value if either the economy or your particular
company falters. Both the potential rewards and the risks from owning common stock have been
substantial, particularly shares of stock in smaller companies.

Advantages of Stock Ownership:

• Provide opportunity for higher returns than other investments

• Over past 50 years, stocks averaged 11% and high-grade corporate bonds averaged 6%
• Good inflation hedge since returns typically exceed the rate of inflation
• Easy to buy and sell stocks
• Price and market information is easy to find in financial media
• Unit cost per share of stock is low enough to encourage ownership

Disadvantages of Stock Ownership

• Stocks are subject to many different kinds of risk:

–Business risk
–Financial risk
–Market risk
–Event risk

• Hard to predict which stocks will go up in value due to wide swings in profits and general stock market
performance
• Low current income compared to other investment alternatives

Basic Characteristics of Common Stock

• Equity Capital: evidence of ownership position in a firm, in the form of shares of common stock. This is
why stocks are sometimes called “equities”
• Publicly Traded Issues: shares of stock that are readily available to the general market and are
bought and sold in the open market
• Public Offering: an offering to sell to the investing public a set number of shares of a firm’s stock at a
specified price
• Rights Offering: an offering of a new issue of stock to existing stockholders, who may purchase new
shares in proportion to their current ownership
• Stock Spin-Off: conversion of one of a firm’s subsidiaries to a stand-alone company by distribution of
stock in the new company to existing shareholders
• Stock Split: when a company increases the number of shares outstanding by exchanging a specified
number of new shares of stock for each outstanding share
• Treasury Stock: shares of stock that were originally sold by the company and have been repurchased
by the company. Share repurchases are often called “buybacks.”
• Classified Common Stock: common stock issued in different classes, each of which offers different
privileges and benefits to its holders

Common Stock Values

• Par Value: the stated, or face, value of a stock
• Book Value: the amount of stockholders’ equity
• Market Value: the current price of the stock in the stock market
• Market Capitalization: the overall current value of the company in the stock market
• Investment Value: the amount that investors believe the stock should be trading for, or what they think
it’s worth.

Types of Dividends

Normally, companies pay dividends in the form of cash. Sometimes they pay dividends by issuing
additional shares of stocks. The first type of distribution is known as a cash dividend; the second is called
a stock dividend.
Cash Dividends
More firms pay dividends than any other type of dividends. A convenient way of of assessing the amount of
dividends received is to measure the stock dividend's dividend yield.

• Dividend Yield: a measure to relate dividends to share price on a percentage basis.

Dividend Yield = Annual dividends received per share/current market price of the stock
To put dividend yields into perspective, it is helpful to look at a company's dividend payout ratio.

• Dividend Payout Ratio: the portion of earnings per share (EPS) that a firm pays out as dividends

Dividend Payout Ratio = Dividends per share/Earnings per share

Stock Dividends
Occasionally, a firm may declare a stock dividend. A stock dividend simply means that the dividend is paid
in additional shares of stocks. For instance, if the board declares a 10% stock dividend, then each
shareholder will receive one new share of stock for each ten shares currently owned.
Types of Stocks
• Blue Chip Stocks: financially strong, high-quality stocks with long and stable records of earnings and
dividends
• Income Stocks: stocks with long and sustained records of paying higher-than average dividends
• Growth Stocks: stocks that experience high rates of growth in operations and earnings
• Tech Stocks: stocks representing the technology sector of the market
• Speculative Stocks: stocks that offer potential for substantial price appreciation, usually due to some
special situation such as a new product
• Cyclical Stocks: stocks whose earnings and overall market performance are closely linked to the
general state of the economy
• Defensive Stocks: stocks that tend to hold their value, and even do well, when the economy starts to
falter
• Small-Cap Stocks: small companies with market capitalizations less than $1 billion
• Mid-Cap Stocks: medium-sized companies with market capitalizations between $1 billion and $4 or $5
billion
• Large-Cap Stocks: large companies with market capitalizations over $4 or $5 billion

Security Analysis

“The process of gathering and organizing information and then using it to determine the intrinsic value of a
share of
common stock.”
The three major parts of security analysis are economic analysis, industry analysis, and fundamental
analysis. Security analysis is important because it enables the investor to establish the expected return and
risk for a stock and to evaluate its desirability in a logical, rational manner.
Intrinsic value

• The end product of security analysis, is the measure of the underlying worth of a stock and provides a
standard for helping investors to judge whether a particular stock is undervalued, fairly priced, or
overvalued.
• If the intrinsic value of a stock is more than the market price, then the stock might be a good buy under
the assumption that the stock will rise up to its intrinsic value. The converse would be true if the intrinsic
value is less than the stock price. The stock might be a good sell.

The Three Steps in Security Analysis

• The three steps in security analysis should enable investors to identify satisfactory investment vehicles.
• A satisfactory investment vehicle is one which offers an expected return, from the combination of
current income and capital gains, that is commensurate with its perceived exposure to risk.

1. Economic analysis assesses the general state of the economy and its potential effects on security
returns.
2. Industry analysis examines specific industries and the characteristics and outlook of those industries.
3. Fundamental analysis looks at the financial condition and operating results of a particular company in
depth.

Economic Analysis

• Involves studying the underlying nature of the economic environment in which a firm operates.
• Economic analysis also helps the investor form expectations about the future course of the economy.
• Such an analysis could be a detailed examination of the economy, sector by sector, or it may be done
on a very informal basis.

Business Cycle

• The behavior and current state of the economy is captured in it which measures the change in total
economic activity over time.
• When economic prospects are strong (the business cycle is on an upswing), security returns should do
well. If economic prospects are poor (the business cycle is on a downswing), the returns from most
stocks will deteriorate as well.

(a) Gross Domestic Product (GDP): This is the broadest measure of an economy’s performance. GDP is
an estimate of the total value of all goods and services produced in a country over the period of a year.
(b) Leading Indicators: This is an index that combines the behavior of a dozen key measures, each of
which tends to be an indication of things to come in the economy. The index of leading indicators is a single
number that is supposed to “predict” the direction of the economy.
(c) Money Supply: This is a measure of the amount of money in circulation as reported by the Federal
Reserve.
(d) Producer Prices: This is a measure of price behavior at the “wholesale” level. It shows the rate of
change in prices at various stages of production, and is supposed to be a harbinger of things to come at the
consumer price level (i.e., future inflation rates).

Industry Analysis

• Is the part of the security analysis process involving the study of stocks in terms of their industry
groupings.
• Industry analysis is important because stock prices are influenced, at least in part, by industry effects.
• Industry analysis can be used to establish the competitive position for a particular industry and to
assess the nature of the opportunity the industry offers for the future. It also enables the investor to
identify promising firms in an industry.

Some important aspects of industry analysis include:

(a) The nature of the industry: whether it is monopolistic or competitive.
(b) The extent of regulation: whether regulation is minimal or intense.
(c) The role of big labor: the status of contract talks and general labor regulations.
(d) Technological progress: are any technological breakthroughs likely?
(e) Financial and operating characteristics: considerations involving labor, material, and capital.

The four stages of an industry’s growth cycle are:

Initial Development—product introduction
Rapid Expansion—everyone wants one
Mature Growth—almost everyone has one
Stability or Decline—there are other things to want

The rapid expansion phase offers the biggest payoff to investors. At this stage, the industry’s products have
gained acceptance, investors can foresee the industry’s future more clearly, and economic variables have
little to do with the industry’s overall performance. The mature growth stage is most influenced by the
economic cycle.

Fundamental Analysis

Fundamental analysis is the study of the financial affairs of a business. It is essential to the valuation
process to the extent that the value of a stock is influenced by the performance of the company that issues
the stock. An equivalent statement is that the value of a security depends not only on return, but also on
risk — both of which are affected to a large extent by the operating characteristics and financial condition of
the firm. Fundamental analysis helps to capture insights to these dimensions from financial statements and
other information about a company and incorporates them in the valuation process.
Historical Analysis

• Provides some insight, along with economic and industry figures, for formulating expectations about the
future growth prospects and profitability of a company.
• In particular, historical analysis helps the investor to learn the strengths and weaknesses of a company,
identify underlying trends and developments, and evaluate the company’s operating efficiency.
Ratio analysis

• Is the study of relationships that exist among and between various financial statement accounts. Ratio
analysis provides a different perspective on the operating results and financial condition of the firm by
expanding the information content of the financial statements. The most significant contribution of ratio
analysis is that it enables the investor to thoroughly assess the firm’s past and present financial
condition and operating results.
• When historical standards are used, the company’s ratios are compared and studied from one period
to the next. Industry standards involve a comparison of a company’s ratios to that of other companies
in the same line of business. In the first case, the investor is looking for developing trends; in the
second case, the investor wants to see how the company stacks up to its competitors.
• Cross-sectional comparisons are made by comparing similar ratios for firms within the same industry,
or to an industry average, as of some point in time. Time-series comparisons are made by comparing
similar ratios for a firm measured at various points in time. Benchmarking is the term used to describe
this cross-sectional comparison with competitor firms.

CAUTIONS ABOUT USING RATIO ANALYSIS

Before discussing specific ratios, we should consider the following cautions about their use:
1. Ratios that reveal large deviations from the norm merely indicate the possibility of a problem. Additional
analysis is typically needed to determine whether there is a problem and to isolate the causes of the
problem.
2. A single ratio does not generally provide sufficient information from which to judge the overall
performance of the firm. However, if an analysis is concerned only with certain specific aspects of a firm’s
financial position, one or two ratios may suffice.
3. The ratios being compared should be calculated using financial statements dated at the same point in
time during the year. If they are not, the effects of seasonality may produce erroneous conclusions and
decisions.
4. It is preferable to use audited financial statements for ratio analysis. If they have not been audited, the
data in them may not reflect the firm’s true financial condition.
5. The financial data being compared should have been developed in the same way. The use of differing
accounting treatments—especially relative to inventory and depreciation—can distort the results of ratio
comparisons, regardless of whether cross-sectional or time-series analysis is used.
6. Results can be distorted by inflation, which can cause the book values of inventory and depreciable
assets to differ greatly from their replacement values. Additionally, inventory costs and depreciation write-
offs can differ from their true values, thereby distorting profits. Without adjustment, inflation tends to cause
older firms (older assets) to appear more efficient and profitable than newer firms (newer assets). Clearly,
in using ratios, you must be careful when comparing older to newer firms or a firm to itself over a long
period of time.
Illustrative Example: Financial Statement Analysis

Use the Income Statement and Balance Sheets below to Compute the different Financial Ratios:

H Company
Comparative Balance Sheet
(in thousands of Pesos)
December 31, 2011, 2012, and 2013
2013 2012 2011
ASSETS
Current Assets
Cash 300 350 350
Accounts Receivable 200 150 100
Marketable Securities 200 150 50
Inventory 500 450 500
Total Current Assets 1200 1100 1000
Plant Assets 1000 900 850
Total Assets 2200 2000 1850
LIABILITIES
Current Liabilities 554 500 520
Long-term Liabilities 800 750 700
Total Liabilities 1354 1250 1220
Stockholder's Equity
Common Stock 450 450 450
Retained Earnings 396 300 180
Total Stockholder's Equity 846 750 630
Total Liabilities and
Stockholder's Equity 2200 2000 1850

H Company
Comparative Balance Sheet
(in thousands of Pesos)
December 31, 2011, 2012, and 2013
2013 2012 2011
Sales 1000 1100 500
Sales Returns and Allowances 200 80 30
Net Sales 800 1020 470
Cost of Goods Sold 500 600 250
Gross Profit 300 420 220
Operating Expenses
Selling Expenses 110 130 80
General Expenses 40 70 40
Total Operating Expenses 150 200 120
Income from Operations 150 220 100
Non operating Income 30 0 10
Income Before Interest
expense and taxes 180 220 110
Interest Expense 20 20 10
Income before taxes 160 200 100
Income Taxes 64 80 40
Net Income 96 120 60

Requirements:
Prepare a Trend Analysis
Prepare a Common Size Balance Sheet and Income Statements
Compute the Ratios Below:

Ratio Formula
Liquidity
Net Working Capital = current assets - current liabilities
Current Assets
Current Ratio =
Current Liabilities

= cash+marketabke
Quick Ratio securities+receviable
current liabilities
Activity Ratio/Asset Utilization
Ratio
Net Sales
Accounts Receivable Turnover =
Average Accounts Receivable
365
Average Collection Period =
Accounts Receivable Turnover
Cost of Goods Sold
Inventory Turnover =
Average Inventory
365
Average Age of Inventory =
Inventory Turnover
Average Collection Period
Operating Cycle =
+ average age of inventory
Net Sales
Fixed Asset Turnover =
Fixed Assets
Net Sales
Total Asset Turnover =
Total Assets
Leverage/Debt Utilization Ratio
Total Debt
Debt Ratio =
Total Asset
Total Liabilities
Debt/equity Ratio =
Stockholder's Equity
Income Before Interest and Taxes
Times Interest Earned =
Interest Expense
Income Before Fixed Charges and
Fixed Charge Coverage = Taxes
Fixed Charges
Profitability Ratio
 Gross Profit
Gross Profit Margin =
Net Sales
Net Income
Profit Margin =
Net Sales
Net Income
Return on Asset =
Average Total Assets
Net Income x Net Sales
or Net Sales Average Total
Assets
Net Income
Return on Equity =
Stockholder's Equity
Return on Assets
or
(1-Debt/Assets)
Market Value Ratio
Net income - preferred dividends
Earnings per share =
common stock outstanding
Market Price per Share
Price/Earnings Ratio =
Earnings per share
Stockholders' equity-preferred stock
Book value per share =
Common stock outstanding
Dividends per share
Dividend Yield =
Market price per share
Dividends per share
Dividend payout =
Earnings per share
Illustrative Example: Financial Statement Analysis Suggested Answer