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Cash
Raw materials
Receivables inventory
Finished goods
inventory
cash cash
Discount Rate
Interest rate used to
compute present values
of future cash flows.
DF =
Present Value = PV 1
PV = discount factor × C 1 ( 1+ r ) t
C1
PV = DF × C 1 =
1 + r1
Net Present Value
C1
NPV = C 0 +
1+ r
Perpetuity
1 1
PV of annuity = C × − t
r r (1 + r )
Compound Interest
18
16
10% Simple
14
10% Compound
12
10
FV of $1
8
6
4
2
0
0
12
18
24
30
15
21
27
Number of Years
Inflation
1600
1400
1200
1000
Price
800
600
400
200
0
0 2 4 6 8 10 12 14 Yield
5 Year 9% Bond 1 Year 9% Bond
Valuing Common Stocks I
Div P - P
Expected Return = r = 1+ 1 0
P P
0 0
= P0 = Div 1
Capitalization Rate
r- g
= r = Div 1 + g
P0
Valuing Common Stocks II
Return Measurements
Div 1
Dividend Yield =
P0
Div1 EPS1
Perpetuity = P0 = or
r r
Assumes all earnings are
paid to shareholders.
FCF and PV
Cash
2500
2000
1500
1000
NPV (,000s)
500
-500
70
10
20
30
40
50
60
80
90
0
10
-1000
-1500
60
40
Percentage Return
20
-20
Common Stocks
Long T-Bonds
-40
T-Bills
-60 30 35 40 45 50 55 60 65 70 75 80 85 90 95
26
Year
Measuring Risk
Unique
risk
Market risk
0
5 10 15
Number of Securities
Portfolio Risk I
Stock 1 Stock 2
2 2 x 1x 2σ 12 =
Stock 1 xσ1 1
x 1 x 2ρ 12σ 1σ 2
x 1x 2σ 12 = 2 2
Stock 2 xσ2 2
x 1x 2ρ 12σ 1σ 2
Portfolio Risk II
Portfolio Variance = x 2 σ2 + x 2 σ2 + 2 ( x x ρ σ σ )
1 1 2 2 1 2 12 1 2
Portfolio Risk III
1
2
3
To calculate
STOCK 4 portfolio variance
5 add up the boxes
N
1 2 3 4 5 6 N
STOCK
Beta and Unique Risk
Expected
σ stock
B = im return
i σ 2
m beta
+10%
600
500
400
(frequency)
# of Days
300
200
100
0
-10% -8% -6% -4% -2% 0% 2% 4% 6% 8% 10%
Daily % Change
Efficient Frontier I
Return Expected
Return (%)
B
A
Risk
Standard
deviation
Efficient Frontier II
d ing ing
n
Le rrow
Bo
rf
S
Standard deviation
Efficient Frontier III
Return
Risk
Security Market Line I
Return
Market Return = rm
.
Efficient Portfolio
Risk Free
Return = rf
Risk
Security Market Line II
Return
Market Return = rm
.
Efficient Portfolio
Risk Free
Return = rf
BETA
1.0
Security Market Line III
Return
SML
rf
1.0 BETA
SML Equation = rf + B ( rm - rf )
Capital Asset Pricing Model (CAPM)
Expected return
Rm = 13.5%
Rf = 5%
Treasury bill rate
Beta
0 1
R = rf + B ( rm - rf )
Beta vs. Average Risk Premium
30 1966-91
20
SML
Investors
10
Market
0 Portfolio
1.0 Portfolio Beta
Consumption Betas vs. Market Betas
Stocks Stocks
(and other risky assets) (and other risky assets)
Wealth is uncertain
Standard Consumption
Market risk
makes wealth CAPM Wealth CAPM
uncertain.
Consumption is uncertain
Wealth = market
portfolio Consumption
Arbitrage Pricing Theory
Alternative to CAPM
Expected Risk
Premium = r - rf
= Bfactor1 (rfactor1 - rf) + Bf2 (rf2 - rf) + …
Expected 20
return (%)
Requity = 15
Rassets = 12.2
Rdebt = 8
0
0 0.2 0.8 1.2
Bdebt Bassets Bequity
Risidual Income & EVA
EP = Economic Profit
= ( ROI − r ) × Capital Invested
Accounting Measurement
ECONOMIC ACCOUNTING
Cash flow + Cash flow +
INCOME
change in PV = change in book value =
Cash flow - Cash flow -
economic depreciation accounting depreciation
r
rE
rA
rD
D
E
Risk free Risky
debt debt
WACC (traditional and M&M view)
r r
rE
rE
WACC
rE =WACC
rD rD
D D
V V
r
rE
WACC
rD
D
V
Financial Distress
Costs of
financial distress
PV of interest
tax shields
Value of levered firm
Value of
unlevered
firm
Optimal amount
Debt of debt
Call Option (long)
$20
85 105
Share Price
Put Option (long)
$5
80 85
Share Price
Call Option (short)
85
Share Price
Put Option (short)
85
Share Price
Protective Put
Long Stock
Protective Put
Position Value
Long Put
Share Price
Straddle
Straddle
Share Price
Black-Scholes Option Pricing Model
Ps v2
ln + (r + )t
S 2
(d1) =
v t
N(d1)=
32 34 36 38 40
Binomial vs. Black Scholes
Value of
bond Straight bond
100
Bond Callable
75
at 100
50
25
Value of
straight bond
25 50 75 100 125 150
Exchange Rate Relationship
1 + rforeign 1 + i foreign
equals
1 + r$ 1 + i$
equals equals
f foreign /$ E(sforeign / $)
equals
S foreign /$ S foreign / $
Leverage Ratios I
total liabilities
Total debt ratio =
total assets
EBIT
Times interest earned =
interest payments
EBIT + depreciation
Cash coverage ratio =
interest payments
Liquidity Ratios I
current assets
Current ratio =
current liabilities
Liquidity Ratios II
sales
Asset turnover ratio =
average total assets
sales
NWC turnover = average net working capital
Efficiency Ratios II
average inventory
Days' sales in inventory =
cost of goods sold / 365
average receivables
Average collection period =
average daily sales
Profitability Ratios I
EBIT - tax
Net profit margin =
sales
EBIT - tax
Return on assets =
average total assets
dividends
Payout ratio =
earnings
earnings - dividends
Plowback ratio =
earnings
= 1 - payout ratio
earnings - dividends
Growth in equity from plowback =
earnings
Market Value Ratios I
stock price
PE Ratio =
earnings per share
P Div 1 1
Forecasted PE ratio = 0 = x
aveEPS EPS r - g
1 1
Div
Price per share = P = 1
0 r - g
stock price
Market to book ratio =
book value per share
asset profit
turnover margin
Du Pont System II
Dollars
A
B
C
Cumulative capital
requirement
Cash
Raw materials
Receivables inventory
Finished goods
inventory
Inventories & Cash Balances I
Total costs
Carrying costs
Cash balance
($000)
25
Average
12.5 inventory
0 1 2 3 4 5 Weeks
Mgmt fees
Limited partners Limited partners
put in 99% of get investment
capital
Partnership Partnership back, then 80%
of profits
Company 1
Company 2
Investment in Sale or IPO of
diversified companies
portfolio of
companies
Company N
Increase in the Cash Flows from Assets
Debtholders
The rest
The firm Financial transactions
of the world
Liabilities Liabilities
Assets $100 $113
Assets
$170
$190
Owner‘s equity
$70 Owner‘s equity
Expenses $77
Revenues $469.8
$480
Net Profit
$10.2
Retained earnings
$7
Dividends
$3.2
The Managerial Balance Sheet Versus
the Standard Balance Sheet
Cash Cash
Short-term debt Short-term debt
Working capital Operating assets
requirement Accounts receivable Operating liabilities
(WCR) plus Accounts payable
Operating assets Inventories plus
less plus Accrued expenses
Operating liabilities Prepaid expenses
Long-term financing
Long-term debt
plus Long-term financing
Owner‘s equity Long-term debt
Net fixed assets Net fixed assets plus
Owner‘s equity
The Firm‘s Operating Cycle and Its
Impact on the Firm‘s Balance Sheet
Production
$472 $13
CASH
$460.8 $18.2
Sources of cash outflow
$12
Net cash flow from operating New cash flow from investing New cash flow from financing
activities activities activities
$11.2 ($10) ($5.2)
The Drivers of Return on Equity
Return on equity
Earnings after tax
ROE = Owner‘s equity
Operating profit margin Capital turnover Financial structure ratio Financial cost ratio Tax effect ratio
Earnings before interest and tax Sales Invested capital Earnings before tax Earnings after tax
Sales Invested capital Owner‘s equity Earnings before interest and tax Earnings before tax
Cash
Operating costs
Working Capital
requirement
Fixed assets
The Financial System
Intermediation via CASH
institutional investors
Insurance policies PRIVATE
Insurance companies, pension funds, PLACEMENT
Retirement plans
Shares in funds Investment funds & venture capitalists
S
U CASH CASH CASH
Money Market
P SHARES BONDS Instruments
P
L CASH CASH
The equity market
I
SHARES (Trading in shares of common stocks)
E SHARES F
R CASH CASH I
The corporate market
S R
(Trading in corporate bonds)
BONDS BONDS M
OF CASH CASH S
The money market
(Trading in money market instruments)
F Commercial Commercial
paper paper
U
N Bank certificates
CASH
of deposit (CD)
D
S
BANK
DEPOSITS
Intermediation via DEBT OWED
TO BANKS
banks
CASH and other lending institutions CASH
Alternative Equity Valuation Models
Market multiples model Dividend valuation model
Firm‘s earnings, cash Future expected
flows, or book value dividends
multiplied by the
Equity discounted at the
value
Corresponding
Cost of equity
market multiple
equals
Present value
Discounted cash flow model of debt
Adjusted present value model
Cash flows
from assets
less the Unlevered
Firm‘s earnings, cash discounted at the
asset value
flows, or book value
Levered Unlevered
discounted at the asset value cost of equity
Corresponding
market multiple Tax
savings
Present value
discounted at the
of tax savings
Cost of debt
The Drivers of Value Creation
EBIT
Operating margin = Sales EBIT
Invested capital
(pretax ROIC)
Sales
Capital turnover = Invested capital Expected after tax
ROIC
Tax effect = (1 – Taxe rate)
Return spread
Percent of (ROIC – WACC)
debt financing Market Value Added (MVA)
Aftertax cost of debt Weighted average
cost of capital If the present value of the future stream of
WACC expected return spreads is positive, MVA is
Estimated cost of equity Percent of positive and the higher the growth, the more
equity financing value created.
EBIT = Earnings before interest and taxes (operating profit before tax);
Invested capital = Cash + Working capital requirement + net fixed assets;
WACC = (%Debt)(After tax cost of debt) + (%Equity)(Cost of equity).
Capital-Budgeting Simulation
Step 1: Develop probability distributions for key factors.
Probability
size price costs
Value range
Market Investment Residual
growth required value of
rate investment
Suppliers Payment
Payment Payment Bad
for fixed
for wages for heat debts
asset
and salaries and power
Payments purchases
for credit
purchases
Permanent dependence
on short-term financing Temporary (short-term)
financing
Permanent
DOLLAR current assets
AMOUNT Current
assets
Permanent plus
spontaneous financing
Fixed
assets
TIME
Cash and Marketable Securities
Management
Credit
sales
Fixed assets Inventory Receivables
Depreciation
Firm‘s
Securities Funds Funds
securities
Firm‘s
Funds Marketable Marketable
securities
(dollars of
(stocks, securities securities
savings)
bonds)
Intermediary‘s
Securities Funds Funds
securities
Multiyear
Growth of
DCF of
net
Need for long-term view economic
income
• High probability of significant change of profit
- Technology
- Regulation Operating
- Competition
• Long life of investments value drivers
• Complexity of business portfolio Net
ROIC-WACC,
income,
economic
return on
profit (one year)
Low sales
Low High
Capital intensity (need for
balance sheet focus)
• Working capital
• Property, plant, and equipment
Various Levels of Value Driver
Identification
LEVEL 1 LEVEL 2 LEVEL 3
Examples Examples
• Customer mix • Percent
• Sales force accounts
productivity revolving
Margin (expense: • Dollars per
revenue) visit
Margin • Unit revenues
Invested • Fixed cost/ • Billable hours
allocations to total payroll
capital
• Capacity hours
management • Percent capacity
ROIC • Operational utilized
yield • Cost per
delivery
Margin
• Accounts
Invested receivable
capital terms & timing
Invested • Accounts
payable terms
capital & timing
Business-unit Operating
Generic
specific value drivers
Customer Servicing – Human Expense
Flowchart
Call volume % time on board
% time in training
Number of % time on breaks
Percent occupancy
people % time on vacation
Personal
cost Average work % time paid
Cost per person Absence/other
time per call
Number of
Hourly rate
stations per SDC
Number of Benefits
Equipment
Service SDCs
cost per station
Delivery
Center Station Equipment, Annual salary
expense cost maintenance
Cost per SDC experse per Benefits
Total station
CS-
human Other equipment Span of control
Headquaters
expense expense
expense
Number of employees
Overhead Regional Salary expense
expense center Supervisory Utilities
expenses cost Number of
Area staff supervisors Other
center
expense Building operating
expense Number of employees
Allocated Overhead
G&A cost Building Equipment
maintanance
expense Materials
Other
Six Conditions for Excellent Value-Based
Management
Performance
Driven
5
4
3
Low cost Value-based
2
Highest level
1 Good
Medium
Sup par
Lowest
Strong Managed
self-reinforcement bottom up
process as well as
top down
Two-way
communications
Simple Entity Valuation of a Single-
Business Company
Operating
free cash flow130 140 150 160
100
90
70
Cash flow 85
Debt 80
to debtholders 74
value 69
36 43
20
Operating
value
Cash flow
to equity owners
Equity 75
66 70
value 61
54 57
50
Entity Valuation of a Multibusiness
Company
1,750
Excess Corporate
marketable 150 250 overhead
securities
Market value:
Unit D 200 • Of debt
300 • Of preferred stock
Unit C 300
100
Unit B 400
1,500
1,100
Unit A 700
Product
Sales and
Design and Procurement Manufacturing Marketing
Distribution
Development
Industry Producers
External
STRUCTURE CONDUCT PERFORMANCE
Shocks
Feedback Feedback
Average ROIC
NOPLAT
CV =
WACC - g
Aggressive
formula
Convergence
formula
NOPLAT
CV =
WACC
WACC
Time
Forecast Continuing-value period
period
Impact of Continuing-Value Assumptions
$3,000 g = 8%
$2,000
g = 6%
CONTINUING
VALUE ($) g = 4%
g = 2%
$1,000 g = 0%
0
10% 12 14 16 18 20
Sporting
goods
Not economic
Tobacco
Not economic
Defense
Steel
< Inflation Declining
< WACC = WACC > WACC
RETURN ON NEW CAPITAL
NOPLAT
Date of End of
valuation forecast period
TIME
Risk/Return Trade-Offs of Hedging
Programs
E (Return) E (Return)
Beta A
unchanged
A Beta
B unchanged
Beta
Rf B Rf decreased
Beta
decreased
Total risk
Beta (undiversifiable risk)
Framework for Evaluating the Value of an
Acquisition
Stand- Stand-alone Value Transaction Combined Value of Value of Price paid Net value
alone value of of costs value next best target to including gained
value of target synergies alternative acquiror premium from
acquiror (without acquisition
(pre-merger) any
takeover
premium)
Patent Valuation: DCF Method Overview
Value of patents =
NPV x Pfmax x PPF Patent Protection Factor = Measure of
the quality of the patent protection
Patent Valuation: Maximal Protection
Factor
Maximal
Protection
Factor
30%
Empirical curve
5%
Age of
Technology Mature Technology
under R&D Technology
Alliance
High Big bets
leverage
LEVEL OF INVESTMENT
(OPTION PRICE)
Low
Entry Risk
stakes pooling
Internal External
SOURCE OF OPTIONS
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