Description
Financial Analysis
Liquidity – the ability to pay current liabilities from current assets as they become due
Solvency – the ability to shoulder debt
Turnover – efficiency in turning over working capital
Profitability – profit generation on sales
Market Values – market values as a ratio of certain financial information
Time Value of Money
Basic formula PV = FV / ((1 + I) ^ n
Single payments: discounting and compounding
PV, FV, n, i
Annuities
PMT, PV, FV, n, i
Ordinary annuities and annuities due
Ordinary annuity payments come at the end of the period
Annuity due payments come as the beginning of the period
Perpetuities with and without a growth factor
With a growth factor:
PMT X (1 + g) / (I – g)
Without a growth factor:
PMT/ i
Changing compounding periods
Switching from annual to semi-annual requires that you adjust a) the number of periods in a year b) the amount of the payment made semi-annually
Effective Annual Rates
EAR = ((1 + i/n) ^ n) -1, given an annual interest rate
Amortizing loans
Determine the PMT, allocate out the PMT between principal and interest (multiply the outstanding loan amount by the interest rate), the outstanding loan amount is reduced by the principal portion and then the calculation is repeated
Free Cash Flow are “free for distribution to debt and equity holders” – represent cash which is generated by the firm independent of how it is financed
Stock valuation
Two methods for stock valuation
1) Enterprise valuation model: take the present values of future Free Cash Flows at a given Weighted Average Cost of Capital
2) Dividend discount model: take the present value of future dividend payments at a given cost of equity
Use the CF function of your calculator as this is quickest way to do this calculation, i.e. enter cash flows in their sequence and then solve for Net Present Value.
Enterprise valuation:
Market value of the firm = Market value of the debt and Market value of the equity
You can determine the Market Value of Equity as follows = Market Value of the Firm – Market Value of Debt
Dividend discount model
Interest rate components
R = real risk-free rate plus
IRP = inflation premium plus
LP = liquidity premium plus
DRP = default risk premium plus
MRP = maturity risk premium
Government debt securities have no liquidity premium and default risk premium but other debt securities do. Government debt securities are subject to the Inflation premium and longer maturity securities are subject to a maturity risk premium
Risk and return go hand in hand: low risk = low return, high risk = high return
Define risk-free and risk aversion
Risk -free means zero standard deviation, an expected yield is equal to its actual yield
Risk aversion means that individuals are willing to take on risk if they are compensated adequately for the incremental risk they take on
Bonds:
Two types of problems:
Bond valuation: PV = ?, given FV, I, n and PMT
Yield to Maturity (YTM) : I = ?, given FV, PV, n and PMT
Yield to call: reflect bond cash flows until the date of the call which usually means that a bond is called at a call premium. When is a bond likely to be called?
Par, discount and premium bonds: Please review definitions and know how to adjust the valuation calculation
Interest rate risk versus reinvestment risk
Yield curve interpretation: what does a normal yield curve imply? What does an inverted yield curve imply?
Capital Budgeting
Simple payback: determine the point in the cash flow diagram at which the cumulative positive cash flows payback the initial negative cash flow – this is not adjusted for time value of money
Discounted payback: Discount all future cash flows and determine the point in the cash flow diagram at which the cumulative discounted positive cash flows payback the initial negative cash flow – this is adjusted for time value of money
NPV: net all of the discounted cash flows and determine if the NPV is greater, equal or less than zero:
IRR: Solve for the discount rate at which the NPV of the discounted cash flows is zero.
MIRR: Take the intermediate FCF and compound them forwards to the last year of the cash flow diagram, Sum the FV and solve for the implied investment rate given: PV, FV and n
Advantages and disadvantages of each method
What are their decision criteria?
Calculating project FCF
EBIT X (1 – t) plus depreciation – changes in working capital – additions to fixed asests
Calculating depreciation
Portfolio Theory
Standard deviation as a measure of risk
Beta as a measure of risk of a stock in a portfolio
Diversification results from assets having different correlation coefficients with respect to each other
Interpreting beta and standard deviation of a portfolio: : the average stock has a standard deviation of 35% while a portfolio of a certain size has a standard deviation of 20%
Separating diversifiable from non-diversifiable risk
Diversifiable risk goes away via diversification leaving us with only non-diversifiable risk or what is called market risk
All stocks have market risk.
The Capital Asset Pricing Model (CAPM)
R = rf + Beta (rm- rf)
R = required rate of return
rf = the risk free rate
Beta = a measure of the stock’s 3rate of return sensitivity to changes in the
rm = the market rate of return
(rm – rf) = the market risk premium
The CAPM equation plots out the Securities Market Line (SML)
Weighted Average Cost of Capital (WACC)
WACC = wd X kd X (1 – t) + we X ke
Kd = cost of debt
Wd = weight of debt to total capital
T = tax rate
We = weight of equity to total capital
Ke = cost of equity
Note that the weights of debt and equity to total capital are based on market values and not book values.
Whereas the cost of debt is always lower than the cost of equity because a) it is less risky, b) interest is tax deductible, one cannot automatically assume that taking on more debt will lower the WACC.
If you take on more debt, you also assume financial risk on top of normal business risk. A firm with no debt only has business risk.
Taking on debt increases the riskiness of the equity so both debt and equity get more expensive as financial risk is added on to a firm.
The result is that although initially the WACC will decline as you take on more debt, when it gets beyond a certain point both the cost of debt and the cost of equity will rise and the WACC will rise.
The level of debt which is optimal for a firm is that which brings its WACC down to the lowest possible level.
A firm’s reason for existence is to create wealth for shareholders. It can achieve this by raising Free Cash Flows or by lowering the WACC to its lower possible level.
The Hamada equation is a way of determining the cost of equity with no debt (the unlevered cost of equity reflecting only business risk) and at different levels of debt (in other words including financial risk on top of business risk)
Beta L = the levered beta
Beta U = the unlevered beta
T = income tax rate
D/E = the ratio of debt to equity in the firm
This equation allows us to transform levered betas to unlevered betas and vice versa and therefore allow us to determine the cost of equity at different levels of debt.
The Efficient Markets Hypothesis: all of the information available about a firm is reflected in its current stock price. Stocks are, therefore, always correctly priced. What are the implications of EMH?
