In Summary

What should be
managements primary
objective?

The primary objective should be

shareholder wealth maximization,
which translates to maximizing the
fundamental stock price.

What three aspects of cash

flows affect an investments
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)

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

What determines a firms

fundamental, or intrinsic,
value?
Intrinsic value is the sum of all the
future expected free cash flows when
converted into todays dollars:
Value
=

FCF1
(1 +
WACC)1

FCF2
(1 +
WACC)2

FCF
(1 + WACC)

What are the five uses of

FCF?
1.
2.
3.
4.
5.

Pay interest on debt.

Pay back principal on debt.
Pay dividends.
Buy back stock.
Buy nonoperating assets (e.g.,
marketable securities, investments
in other companies, etc.)
6

Free Cash Flow (FCF)

FCF = NOPAT - Net investment in
operating capital

Return on Invested Capital

(ROIC)
ROIC = NOPAT / operating capital

Economic Value Added

(EVA)
EVA = NOPAT- (WACC)(Capital)

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 - (L*/S0)S - M(S1)
(RR)

13

How would increases in

these items affect the
AFN?

Higher sales:

Increases asset requirements,

increases AFN.

Higher dividend payout ratio:

Reduces funds available internally,

increases AFN.
(More)
14

What affects AFN ..

Higher profit margin:

Higher capital intensity ratio, A*/S0:

Increases funds available internally,

decreases AFN.
Increases asset requirements, increases
AFN.

Pay suppliers sooner:

Decreases spontaneous liabilities, increases

AFN.
15

Implications of AFN

If AFN is positive, then you must

secure additional financing.
If AFN is negative, then you have
more financing than is needed.

Pay off debt.

Buy back stock.
Buy short-term investments.
16

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

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 - Deferral
.
Period
Cycle
Period
Period

19

Elements of Credit Policy

Cash Discounts: Lowers price.

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.
(More)
20

Credit Policy (Continued)

Credit Standards: Tighter

standards reduce bad debt losses,
but may reduce sales. Fewer bad
debts reduces DSO.
Collection Policy: Tougher policy
will reduce DSO, but may damage
customer relationships.
21

What is trade credit?

Trade credit is credit furnished by a

firms suppliers.
Trade credit is often the largest
source of short-term credit,
especially for small firms.
Spontaneous, easy to get, but cost
can be high.
22

X buys $506,985 net, on terms of

1/10, net 30, and pays on Day 40.

Net daily purchases = $506,985/365

= $1,389.

Ann. gross purch.= $506,985/(1-0.01)

=$512,106

23

Free and Costly Trade

Credit
Payables level if discount is taken:
Payables = $1,389(10) = $13,890.
Payables level if discount not taken:
Payables = $1,389(40) = $55,560.
Total trade credit
Free trade credit
Costly trade credit

= $55,560
= 13,890
= $41,670

24

Nominal Cost of Costly

Trade Credit
Buyer loses 0.01($512,106) = $5,121 of
discounts to obtain $41,670 in extra
trade credit, so:
rNom =

$5,121 = 0.1229 = 12.29%.

$41,670

But the $5,121 is paid all during the year,

not at year-end, so EAR rate is higher.
25

Nominal Cost Formula,

1/10, net 40
rNom = Discount %
1 - Discount
%
1
=
99

365 days
Days
Discount
Taken

Period

365

= 0.0101
30 12.1667

= 0.1229 = 12.29%

Pays 1.01% 12.167 times per year.

26

Effective Annual Rate,

1/10, net 40

Periodic rate = 0.01/0.99 = 1.01%.

Periods/year = 365/(40 10)
= 12.1667.
EAR
= (1 + Periodic rate)n 1.0
= (1.0101)12.1667 1.0
= 13.01%.
27

Time Value of Money

28

Ordinary Annuity vs. Annuity

Due
Ordinary Annuity
0

I%

PMT

PMT

PMT

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)N

31

Nominal rate (INOM)

Stated in contracts, and quoted by

banks and brokers.
Not used in calculations or shown on
time lines
Periods per year (M) must be given.
Examples:

8%; Quarterly
8%, Daily interest (365 days)
32

Periodic rate (IPER )

IPER = INOM/M, where M is number of

compounding periods per year. M = 4 for
quarterly, 12 for monthly, and 360 or 365 for
daily compounding.

Used in calculations, shown on time lines.

Examples:

8% quarterly: IPER = 8%/4 = 2%.

8% daily (365): IPER = 8%/365 = 0.021918%.

33

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

Effective Annual Rate

Example

Example: Invest $1 for one year at 12%,

semiannual:
FV = PV(1 + INOM/M)M

FV = $1 (1.06)2 = 1.1236.
EFF% = 12.36%, 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% annual compounding.
36

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.

37

EFF% for a nominal rate of

12%, compounded
semiannually
EFF% =
1
=
1

INOM
1 +
M

0.12
1 +
2

= (1.06)2 - 1.0
= 0.1236 =
12.36%.

38

Can the effective rate ever

be equal to the nominal
rate?

Yes, but only if annual

compounding is used, i.e., if M = 1.
If M > 1, EFF% will always be
greater than the nominal rate.

39

Bond Valuation

40

Suppose the bond was issued 20

years ago and now has 10 years to
maturity. What would happen to
its value over time if the required
rate of return remained constant.

41

Bond Value ($) vs Years

remaining to Maturity

1,000

30

25

20

15

10

42

At maturity, the value of any bond

must equal its par value.
The value of a premium bond
would decrease to $1,000.
The value of a discount bond would
increase to $1,000.
A par bond stays at $1,000 if rd
remains constant.
43

Whats yield to
maturity?

YTM is the rate of return earned on

a bond held to maturity. Also
called promised yield.
It assumes the bond will not
default.

44

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

When is a bond callable

In general, if a bond sells at a

premium, then (1) coupon > rd, so
(2) a call is likely.
So, expect to earn:

YTC on premium bonds.

YTM on par & discount bonds.

46

Risk, Return, and

the Capital Asset Pricing
Model

47

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

Stand-alone risk = Market

risk + Diversifiable risk

Market risk is that part of a

securitys stand-alone risk that
cannot be eliminated by
diversification.
Firm-specific, or diversifiable, risk is
that part of a securitys stand-alone
risk that can be eliminated by
diversification.
51

How is relevant risk

measured?

Market risk, which is relevant for

stocks held in well-diversified
portfolios, is defined as the
contribution of a security to the
overall riskiness of the portfolio.
It is measured by a stocks beta
coefficient. For stock i, its beta is:
bi = (i,M i) / M
52

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.
The slope of the regression line,
which measures relative volatility,
is defined as the stocks beta
coefficient, or b.
53

How is beta interpreted?

If b = 1.0, stock has average risk.

If b > 1.0, stock is riskier than
average.
If b < 1.0, stock is less risky than
average.
Most stocks have betas in the
range of 0.5 to 1.5.
54

Use the SML to calculate

required return.

The Security Market Line (SML) is

part of the Capital Asset Pricing
Model (CAPM).

SML: ri = rRF + (RPM)bi .

Assume rRF = 8%; rM = rM = 15%.

RPM = (rM - rRF) = 15% - 8% = 7%.

55

Impact of Inflation Change

on SML
r (%)

New SML

I = 3%

SML2
SML1

18
15

Original situation

11
8
0

0.5

1.0

1.5

Risk, bi

56

Impact of Risk Aversion

Change

r (%)

After change

SML2
SML1

18

RPM = 3%

15

Original situation

1.0

Risk, bi 57

Portfolio Theory

58

Attainable Portfolios: rAB =

+1
AB = +1.0: Attainable Set of Risk/Return
Combinations

Expected return

20%
15%
10%
5%
0%
0%

10%

20%
Risk,

30%

40%

59

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

Optimal Portfolios
Expected
Return, rp

IA2
IA1

IB2 I
B1

Optimal
Portfolio
Investor B
Optimal Portfolio
Investor A

Risk p

63

Efficient Set with a RiskFree Asset

Expected
Return, rp

Z
M

^r
M

rRF

The Capital Market

Line (CML):
New Efficient Set
Risk, 64
p

What is the Capital Market

Line?

The Capital Market Line (CML) is all

linear combinations of the risk-free
asset and Portfolio M.
Portfolios below the CML are
inferior.

The CML defines the new efficient set.

All investors will choose a portfolio on
the CML.
65

The CML Equation

^
rp =

rRF +

Intercept

^
rM - rRF

M
Slope

p.

Risk
measure
66

Capital Market Line

I2

Expected
Return, rp

^r
M
^r

I1

CML

.
.

R = Optimal
Portfolio

rRF

Risk, p

67

Stock Valuation

68

Different Approaches for

Valuing Common Stock

Dividend growth model

Using the multiples of comparable
firms

69

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, then:

^
D0(1+g)
P0 =
rs - g

D1
=
rs - g
70

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.

Pick a measure, such as EBITDA, Sales,

etc.
Calculate the average entity ratio for a
sample of comparable firms. For
example,

V/EBITDA
V/Sales
71

Using Entity Multiples

(Continued)

Find the entity value of the firm in

question. For example,

Multiply the firms sales by the V/Sales

multiple.

The result is the total value of the firm.

Subtract the firms 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

Disadvantages of Going
Public

Must file numerous reports.

Operating data must be disclosed.
Officers must disclose holdings.
Special deals to insiders will be more
difficult to undertake.
A small new issue may not be actively
traded, so market-determined price may not
reflect true value.
Managing investor relations is timeconsuming.
76

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

There is an inherent conflict of interest,

because the banker has an incentive to
set a low price:

to make brokerage customers happy.

to make it easy to sell the issue.

Firm would like price to be high.

Note that original owners generally sell
only a small part of their stock, so if
price increases, they benefit.
Later offerings easier if first goes well.
78

What are the long-term

returns to investors in
IPOs?

Two-year return following IPO is

lower than for comparable non-IPO
firms.
On average, the IPO offer price is
too low, and the first-day run-up is
too high.

79

What are the direct costs

of an IPO?

Underwriter usually charges a 35% spread between offer price and

proceeds to issuer.
Plus direct costs to lawyers,
printers, accountants, etc.

80

What are the indirect costs

of an IPO?

Money left on the table

Preparing for IPO consumes most
of managements attention during
the pre-IPO months.

81