In Summary …

1

What should be
management’s primary
objective?

The primary objective should be
shareholder wealth maximization,
which translates to maximizing the
fundamental stock price.

2

What three aspects of cash
flows affect an investment’s
value?

Amount of expected cash flows
(bigger is better)
Timing of the cash flow stream
(sooner is better)
Risk of the cash flows (less risk is
better)

3

Free Cash Flows (FCF)

Free cash flows are the cash flows
that are available (or free) for
distribution to all investors
(stockholders and creditors).
FCF = sales revenues - operating
costs - operating taxes - required
investments in operating capital.
4

value? Intrinsic value is the sum of all the future expected free cash flows when converted into today’s dollars: Value = FCF1 (1 + WACC)1 + FCF2 (1 + WACC)2 +… FCF∞ (1 + WACC)∞ 5 .What determines a firm’s fundamental. or intrinsic.

2. investments in other companies. marketable securities. 5. 3. Pay back principal on debt. Buy back stock.What are the five uses of FCF? 1. Pay dividends. Pay interest on debt. Buy nonoperating assets (e.. 4.g. etc.) 6 .

Net investment in operating capital 7 .Free Cash Flow (FCF) FCF = NOPAT .

Return on Invested Capital (ROIC) ROIC = NOPAT / operating capital 8 .

Economic Value Added (EVA) EVA = NOPAT.(WACC)(Capital)  9 .

Market Value Added (MVA)    MVA = Market Value of the Firm Book Value of the Firm Market Value = (# shares of stock) (price per share) + Value of debt Book Value = Total common equity + Value of debt (More…) 10 .

Financial Planning and Forecasting Financial Statements 11 .

Steps in Financial Forecasting       Forecast sales Project the assets needed to support sales Project internally generated funds Project outside funds needed Decide how to raise funds See effects of plan on ratios and stock price 12 .

what is AFN? AFN = (A*/S0)∆S .M(S1) (RR) 13 .(L*/S0)∆S .

increases AFN.How would increases in these items affect the AFN?  Higher sales:   Increases asset requirements. (More…) 14 . increases AFN. Higher dividend payout ratio:  Reduces funds available internally.

decreases AFN.  Higher profit margin:   Higher capital intensity ratio.What affects AFN . Increases asset requirements. A*/S0:   Increases funds available internally. increases AFN. increases AFN.. Pay suppliers sooner:  Decreases spontaneous liabilities. 15 .

Implications of AFN   If AFN is positive. Buy short-term investments. then you have more financing than is needed. 16 . Buy back stock. If AFN is negative. then you must secure additional financing.    Pay off debt.

Projecting Pro Forma Statements with the Percent of Sales Method   Project sales based on forecasted growth rate in sales Forecast other items as a percent of the forecasted sales 17 .

Working Capital Management 18 .

Deferral . Period Cycle Period Period 19 .Cash Conversion Cycle The cash conversion cycle focuses on the time between payments made for materials and labor and payments received from sales: Cash Inventory Receivables Payables Conversion =Conversion + Collection .

Attracts new customers and reduces DSO. Credit Period: How long to pay? Shorter period reduces DSO and average A/R. but it may discourage sales.Elements of Credit Policy   Cash Discounts: Lowers price. (More…) 20 .

Credit Policy (Continued)   Credit Standards: Tighter standards reduce bad debt losses. Collection Policy: Tougher policy will reduce DSO. but may damage customer relationships. Fewer bad debts reduces DSO. but may reduce sales. 21 .

22 . especially for small firms.What is trade credit?    Trade credit is credit furnished by a firm’s suppliers. Trade credit is often the largest source of short-term credit. Spontaneous. easy to get. but cost can be high.

X buys $506. gross purch.  Net daily purchases = $506. net 30. and pays on Day 40.985/365 = $1.01) =$512.106 23 .389.985/(1-0.985 net.= $506.  Ann. on terms of 1/10.

Total trade credit Free trade credit Costly trade credit = $55.890 = $41.560.890.389(10) = $13.389(40) = $55.Free and Costly Trade Credit Payables level if discount is taken: Payables = $1.560 = 13.670 24 . Payables level if discount not taken: Payables = $1.

121 is paid all during the year. so: rNom = $5.121 = 0. 25 .106) = $5.670 But the $5. not at year-end.670 in extra trade credit.01($512.29%.1229 = 12.Nominal Cost of Costly Trade Credit Buyer loses 0. so EAR rate is higher. $41.121 of discounts to obtain $41.

1229 = 12.29% Pays 1. 1/10.167 times per year. net 40 rNom = Discount % 1 .0101 × 30 12.Discount % 1 = 99 × 365 days Days Discount Taken - Period 365 × = 0. 26 .Nominal Cost Formula.1667 = 0.01% 12.

27 .01%. Periods/year = 365/(40 – 10) = 12. net 40    Periodic rate = 0. EAR = (1 + Periodic rate)n – 1.01%.Effective Annual Rate.0101)12.1667.0 = (1. 1/10.99 = 1.0 = 13.01/0.1667 – 1.

Time Value of Money 28 .

Ordinary Annuity vs. Annuity Due Ordinary Annuity 0 I% 1 2 3 PMT PMT PMT 1 2 3 PMT PMT Annuity Due 0 I% PMT 29 .

FV Annuity Formula  The future value of an annuity with N periods and an interest rate of I can be found with the following formula: = PMT = 100 (1+I)N-1 I (1+0.10)3-1 0.10 = 331 30 .

PV Annuity Formula  The present value of an annuity with N periods and an interest rate of I can be found with the following formula: = PMT 1 − I 1 I (1+I)N 31 .

Daily interest (365 days) 32 . and quoted by banks and brokers. Not used in calculations or shown on time lines Periods per year (M) must be given.Nominal rate (INOM)     Stated in contracts. Quarterly 8%. Examples:   8%.

Periodic rate (IPER )  IPER = INOM/M. M = 4 for quarterly. and 360 or 365 for daily compounding.  Used in calculations. 33 .  8% daily (365): IPER = 8%/365 = 0. 12 for monthly. shown on time lines.021918%.  Examples:  8% quarterly: IPER = 8%/4 = 2%. where M is number of compounding periods per year.

FV Formula with Different Compounding Periods FVN = PV 1 + INOM M MN 34 .

Effective Annual Rate (EAR = EFF%)  The EAR is the annual rate which causes PV to grow to the same FV as under multi-period compounding. 35 .

EFF% = 12. semiannual: FV = PV(1 + INOM/M)M  FV = $1 (1.Effective Annual Rate Example  Example: Invest $1 for one year at 12%.36%.06)2 = 1.36% annual compounding. because $1 invested for one year at 12% semiannual compounding would grow to the same value as $1 invested for one year at 12. 36 .1236.

37 .Comparing Rates  An investment with monthly payments is different from one with quarterly payments. Must put on EFF% basis to compare rates of return. Use EFF% only for comparisons.

compounded semiannually EFF% = 1 = 1 INOM 1 + M M 0.1.0 = 0.36%.06)2 . − 2 − 38 .EFF% for a nominal rate of 12%.1236 = 12.12 1 + 2 = (1.

i. EFF% will always be greater than the nominal rate. 39 ..Can the effective rate ever be equal to the nominal rate?   Yes. If M > 1. if M = 1. but only if annual compounding is used.e.

Bond Valuation 40 .

What would happen to its value over time if the required rate of return remained constant. 41 . Suppose the bond was issued 20 years ago and now has 10 years to maturity.

Bond Value ($) vs Years remaining to Maturity M 1.000 30 25 20 15 10 5 0 42 .

    At maturity. the value of any bond must equal its par value. 43 . The value of a premium bond would decrease to $1.000. A par bond stays at $1. The value of a discount bond would increase to $1.000 if rd remains constant.000.

” It assumes the bond will not default. Also called “promised yield. 44 .What’s “yield to maturity”?   YTM is the rate of return earned on a bond held to maturity.

Definitions Annual coupon pmt Current yield = Current price Capital gains yield = Change in price Beginning price Exp total = YTM = Exp Exp cap + return Curr yld gains yld 45 .

then (1) coupon > rd.When is a bond callable   In general. if a bond sells at a premium. expect to earn:   YTC on premium bonds. YTM on par & discount bonds. 46 . So. so (2) a call is likely.

and the Capital Asset Pricing Model 47 .Risk. Return.

Probability Distribution: Which stock is riskier? Why? 48 .

 stock ≈ 35% Many stocks ≈ 20% 49 .

Risk vs. Number of Stocks in Portfolio p Company Specific (Diversifiable) Risk 35% 20% Market Risk 0 10 20 30 40 2.000 stocks 50 .

51 . Firm-specific.Stand-alone risk = Market risk + Diversifiable risk   Market risk is that part of a security’s stand-alone risk that cannot be eliminated by diversification. or diversifiable. risk is that part of a security’s stand-alone risk that can be eliminated by diversification.

M i) / M 52 . which is relevant for stocks held in well-diversified portfolios. For stock i.How is ‘relevant’ risk measured?    Market risk. It is measured by a stock’s beta coefficient. its beta is: bi = (i. is defined as the contribution of a security to the overall riskiness of the portfolio.

Using a Regression to Estimate Beta   Run a regression with returns on the stock in question plotted on the Y axis and returns on the market portfolio plotted on the X axis. or b. is defined as the stock’s beta coefficient. 53 . which measures relative volatility. The slope of the regression line.

stock is riskier than average. If b < 1. If b > 1.5.0.How is beta interpreted?     If b = 1.0.5 to 1. stock is less risky than average.0. 54 . stock has average risk. Most stocks have betas in the range of 0.

55 .  RPM = (rM .Use the SML to calculate required return.  SML: ri = rRF + (RPM)bi .rRF) = 15% .  Assume rRF = 8%.8% = 7%. rM = rM = 15%.  The Security Market Line (SML) is part of the Capital Asset Pricing Model (CAPM).

5 Risk. bi 56 .5 1.0 1.Impact of Inflation Change on SML r (%) New SML  I = 3% SML2 SML1 18 15 Original situation 11 8 0 0.

Impact of Risk Aversion Change r (%) After change SML2 SML1 18  RPM = 3% 15 Original situation 8 1. bi 57 .0 Risk.

Portfolio Theory 58 .

Attainable Portfolios: rAB = +1 AB = +1.  30% 40% p 59 .0: Attainable Set of Risk/Return Combinations Expected return 20% 15% 10% 5% 0% 0% 10% 20% Risk.

Attainable Portfolios: rAB = -1  AB = -1.0: Attainable Set of Risk/Return Combinations Expected return 20% 15% 10% 5% 0% 0% 10% 20% 30% 40% Risk.  p 60 .

Attainable Portfolios with Risk-Free Asset (Expected risk-free return = 5%) Attainable Set of Risk/Return Combinations with Risk-Free Asset Expected return 15% 10% 5% 0% 0% 5% 10% Risk. p 15% 20% 61 .

Feasible and Efficient Portfolios Expected Portfolio Return. rp Efficient Set Feasible Set Risk.  p 62 .

rp IA2 IA1 IB2 I B1 Optimal Portfolio Investor B Optimal Portfolio Investor A Risk  p 63 .Optimal Portfolios Expected Return.

Efficient Set with a RiskFree Asset Expected Return. . B A . rp Z M ^r M rRF . M The Capital Market Line (CML): New Efficient Set Risk. 64 p .

Portfolios below the CML are inferior. 65 .What is the Capital Market Line?   The Capital Market Line (CML) is all linear combinations of the risk-free asset and Portfolio M.   The CML defines the new efficient set. All investors will choose a portfolio on the CML.

rRF M Slope  p.The CML Equation ^ rp = rRF + Intercept ^ rM . Risk measure 66 .

. M R R = Optimal Portfolio rRF   Risk.  p 67 .Capital Market Line I2 Expected Return. rp ^r M ^r R I1 CML .

Stock Valuation 68 .

Different Approaches for Valuing Common Stock   Dividend growth model Using the multiples of comparable firms 69 .

g 70 .g D1 = rs . then: ^ D0(1+g) P0 = rs .For a constant growth stock: D1 = D0(1+g)1 D2 = D0(1+g)2 Dt = D0(1+g)t If g is constant and less than rs.

Pick a measure.   V/EBITDA V/Sales 71 . For example.Using Entity Multiples  The entity value (V) is:     the market value of equity (# shares of stock multiplied by the price per share) plus the value of debt. Calculate the average entity ratio for a sample of comparable firms. Sales. etc. such as EBITDA.

Using Entity Multiples
(Continued)

Find the entity value of the firm in
question. For example,


Multiply the firm’s sales by the V/Sales
multiple.

The result is the total value of the firm.
Subtract the firm’s debt to get the total
value of equity.
Divide by the number of shares to get
the price per share.

72

Problems with Market
Multiple Methods

It is often hard to find comparable firms.
The average ratio for the sample of
comparable firms often has a wide
range.

73

Initial Public Offerings,
Investment Banking

74

Why would a company
consider
going public?

Advantages of going public




Current stockholders can diversify.
Liquidity is increased.
Easier to raise capital in the future.
Going public establishes firm value.
Makes it more feasible to use stock as
employee incentives.
(More...)
75

76 . Managing investor relations is timeconsuming. A small new issue may not be actively traded.Disadvantages of Going Public       Must file numerous reports. Officers must disclose holdings. Operating data must be disclosed. Special “deals” to insiders will be more difficult to undertake. so market-determined price may not reflect true value.

What are the steps of an IPO?      Select investment banker File registration documents with regulators Choose price range for preliminary (or “red herring”) prospectus .DRHP Go on roadshow Set final offer price in final prospectus 77 .

Later offerings easier if first goes well. to make it easy to sell the issue. There is an inherent conflict of interest. Firm would like price to be high. Note that original owners generally sell only a small part of their stock. they benefit. so if price increases. 78 . because the banker has an incentive to set a low price:      to make brokerage customers happy.

the IPO offer price is too low. On average.What are the long-term returns to investors in IPOs?   Two-year return following IPO is lower than for comparable non-IPO firms. 79 . and the first-day run-up is too high.

etc. accountants.What are the direct costs of an IPO?   Underwriter usually charges a 35% spread between offer price and proceeds to issuer. 80 . Plus direct costs to lawyers. printers.

What are the indirect costs of an IPO?   Money left on the table Preparing for IPO consumes most of management’s attention during the pre-IPO months. 81 .