Corporate Finance
Explain the Modigliani-Miller propositions regarding capital structure, including the effects of leverage, taxes, financial distress, agency costs, and asymmetric information on a company's cost of equity cost of capital, and optimal capital structure
A company's capital structure refers to the combination of debt and equity it uses to finance the business. The aim of financing is to minimize the weighted average costs of capital (WACC). The MM propositions state that given the assumptions listed below and no taxes, changes in capital structure do not affect a company's value. Assumptions include a investors having homogenous expectations, capital markets being perfect, no agency costs, investors can borrow at risk free rate. Further, under this proposition, the value of a leveraged company (Vl) is the same as the value of an unleveraged company (Vu). so Vl = Vu. The importance of this proposition is that it implies that a manager cannot create value just by altering the capital structure of a firm. Another MM proposition (Proposition II) is that MM asserts that a company's cost of capital does not depend on capital structure, but depends on business risk. An increase in leverage increases the probability of default, and this risk is borne by equity holders. Think Beta. Therefore, as the proportion of debt in the company's capital structure increases (D/E), the firms equity beta (Be) also increases. MM proposition can be shown with or without taxes. It reflects that taxes decrease that cost of equity for a company (it is a tax shield) as interest of is a tax write-off thus decreasing the cost of equity and thus decreasing the overall WACC. With taxes in the WACC a company will be more valuable, compared to the WACC without taxes. Cost of Financial distress: The expected cost of financial distress and bankruptcy has two components: direct costs - actual cash expenses such as legal fees incurring during a bankruptcy; and indirect costs - forgone investment opportunities and impaired ability to conduct business. Agency costs; costs that arise due to conflicts on interest when management (agent) makes decisions for shareholders (principals). The smaller the stake that management has in the company, the lower its share in bearing the costs of excessive "prequisite consumption" aka the cost of not running a company to the best of its ability. Shareholders are aware of this, and take action to minimize agency costs. Agency costs include: monitoring costs (cost of monitoring actions of management), Bonding costs (costs incurred by management to assure that they are working for shareholder interest), and Residual loss (costs that are incurred despite adequate monitoring and bonding provisions). Agency theory predicts that higher use of debt relative to equity in a capital structure reduces net agency costs. This is the basis of "Jensen's free cash flow hypothesis" which states that higher debt levels force managers to use company funds efficiently. Cost of Asymmetric information: the fact that managers generally have more information about the firm's performance than do outsiders (shareholders, creditors, etc.) which gives rise to asymmetric information. This is relatively high with company's that have complex products, less transparency in financial accounting, and lower levels of institutional ownership. "Pecking order theory" states that managers prefer modes of financing that offer the lease info to outsiders. The optimal capital structure (the static trade-off tehory). In the earlier analysis of the MM proposals, we concluded that with taxes (and ignoring financial distress) the best capital structure is 100% debt. Practically speaking, the value enhancing effects of debt (tax-shield) must be balanced against the potential value-reducing effects (financial distress). This is the idea behind the "static trade-off theory of capital structure".
Explain the common reason for restructuring and explain the basic forms of restructuring
A corporate restructure is basically when a company gets smaller (opposite of a merger where a company grows). When a company sells, liquidates or spins off a division or a subsidiary, it is referred to as a "divestiture". Common reasons for restructure: (1) change in strategic focus - sell divisions that are outside of the company's focus (2) Poor fit - sell a division if a company does not have proper resources to feed division (3) Reverse Synergy - a division may be worth more if separated from the company. (4) Financial or cash flow needs Basic forms of restructuring are: (1)Equity carve-out: company separates one of its divisions to create a new legal entity and offer shares in the entity to outsiders. (2) Spin-Off: Company separates one of its divisions to create a new legal entity but shares are only issued to current shareholders. (3) Split-Off: Company separates one of its divisions to create a new legal entity and offer current shareholders shares in the new entity in exchange for shares of the parent. (4) Liquidation: The company, division, or subsidiary is broken up and sold piecemeal. Most of the time this is due to a bankruptcy.
Evaluate a takeover bid and calculate the estimated post-acquisition value of an acquirer
An acquirer must pay target shareholders a premium over its market price to induce them to give up control of the company. Target shareholders' gain = takeover premium. The only reason that any acquirer would be willing to pay a takeover price in excess of the target's market value is because they believe that the benefits will outweigh the costs. These benefits are known as synergies (merger is excepted to reduce costs in some way) so the Acquirer's gain = Synergies created - takeover premium paid When evaluating a merger offer, the minimum bid that target shareholders would accept is the pre-merger market value of the target company. On the other hand, the maximum amount an acquirer would be willing to pay is the pre-merger market value of the target + value of potential synergies of the merger.
explain how inflation affects capital budgeting
Analysts must decide whether to perform the analysis in nominal terms or in real terms. Nominal cash flows reflect the effects of inflation, while real cash flows are adjusted to remove the effects of inflation.
explain bootstrapping of EPS and calculate a company's post-merger EPS
Bootstrapping Earnings: occurs when a company's EPS increases as a result of the merger transaction, not due to economic benefits of the business combination. This effect occurs when shares of the acquirer trade at a higher P/E ratio than shares of the target and the acquirer's P/E does not fall after the merger. If company A wants to buy company B: find the market value of company B and then calc how many new shares company A must issue to get this market value. Then your new EPS is the combined earnings of both A and B and your outstanding shares are company A and newly issued company A shares (company B shares go away).
Level 1 recap: explain capital budgeting and the steps in capital budgeting
Capital Budgeting: used to determine whether long-term investments such as acquiring new machinery, replacing current machinery, launch new products, and spending on R&D, are worth pursuing. Steps in capital budgeting: 1. generating ideas 2. analyzing individual proposals 3. planning the capital budget 4. monitor and post-auditing Principles of capital budgeting: 1. decisions are based on actual cash flows (only incremental cash flow is relevant). Sunk costs are ignored completely. 2. Timing of cash flow is important: cash received earlier is worth more than cash received later on. 3. cash flows are based on opportunity costs as projected as evaluated on incremental cash flow they bring in above the next best alternative use. 4. Financing costs are ignored from calculations of operating cash flows: finance costs are reflected in the required rate of return from a project, so cash flows are not adjusted for these costs. Independent vs mutually exclusive projects: independent projects are those whose cash flows are unrelated. Mutually exclusive projects compete with one another for acceptance. For independent projects, accept if the NPV is greater than 0 and accept if the IRR is greater than the cost of capital. For mutually exclusive projects, accept the one with the highest NPV.
describe target capital structure and explain why a company's actual capital structure may fluctuate around its target. Also explain the role debt ratings play in capital structure
Company's typically have a target capital structure; however, there may be periods of time where they deviate from their target for the following reasons: (1) It may sometimes make sense for a company to exploit short-term opportunities in a particular source of financing i.e. low interest rates. (2) capital structure weights are determined by market value of debt and equity, thus market value changes in either one can affect the company's capital structure. (3) At times it may be impractical for the company to issue securities to maintain a certain target capital structure. Credit Rating agencies (Moody's, S&P, Fitch) assess a company's ability to satisfy obligations. Increased leverage from a company in turn increases their credit risk and may cause a downgrade in their rating. Lower ratings lead to higher required returns for both equity and debt holders, which makes it more expensive for a company to raise capital.
We previously mention the 2-stage DCF, besides this we have the comparable company and comparable transaction analyses for valuing a target company, including the advantage and disadvantage of each
Comparable Company Analysis: Under this approach, "relative valuation measures" are used to estimate the market value of the target company, and then a "takeover premium" is added to determine a fair acquisition price. The following steps are followed in comparable company analysis: 1. Identify a set of comparable companies 2. Calculate different relative value measures based on current market prices of comps (this is typically based on enterprise value multiples). 3. Calculate specific relative value metrics and apply these to the target firm. 4. Estimate the takeover premium. Advantages: provides a approximate value of target based on values of similar comps. Data is easily available, and values are based on actual observed values unlike DCF that utilitizes assumptions and estimates. Disadvantages are that this method is susceptible to market mispricing (during periods where companies are overvalued such as tech in mid 2018 you will get an inflated value for the target). Comparable Transaction analysis: This approach utilizes recent merger transactions involving comparable companies to determine a fair acquisition price. Steps: 1. Identification of relevant merger transactions 2. Based on completed deals, relative valuation metrics are calculated for the companies in the sample. 3. Apply multiples to the target company. Advantage: The key with this method is there is no need to calculate a takeover premium as it is naturally built into the transaction prices use to calculate valuation multiples. Also actual market prices are used to come-up with the target's price. Disadvantage is that market prices can be skewed based on market conditions. Also, merger synergies cannot be taken into account.
Describe corporate governance and and attributes on an effective corporate governance system
Corporate governance: the system of principles, policies, procedures, and responsibilities and accountabilities used by stakeholders to overcome the conflicts of interest inherent in the corporate form. Essentially, minimize and manage conflicts of interest in an organization. 2 major objectives of corporate governance: ' (1) eliminate or reduce conflicts of interest between managers and shareholders, and (2) ensure that the company's assets are used in the best interest of the investors and stakeholders. Effective corporate governance does the following: clearly describe the rights of shareholders, defines responsibilities of managers, identifies measurable accountabilities of performance, ensures fairness and transparency in dealings between managers and stakeholders.
compare dividend discount model, free cash flow, and residual income as inputs to a DCF (advantages and disadvantages)
Dividend discount model: dividends are less volatile than earnings which makes DDM values less sensitive to fluctuations. Disadvantages are that it is difficult to apply to company's that don't pay out dividends. It is appropriate for company's that are stable and have a history of dividend payouts. Free cash flow: (both types) FCFF: essentially reflects cash flow available to all firm's investors, bondholders and shareholders are operational and reinvestment needs have been met. think Pre-Debt cash flows FCFE: essentially cash flow available to the firm's common shareholders after operational and reinvestment needs have been met, and all payments to bondholders have been made. Think Post-Debt cash flows. Advantages are that you can use these for most companies (even company's that pay dividends, analysts would prefer cash flow method). Disadvantages are that cash flow may be negative when a company heavily reinvests. This method is appropriate when a firm does not pay dividends, or when a firm's free cash flow is related to its profitability. Residual Income Model: calculated as the excess of a firm's earnings for a given period over its investor's required return on a beginning of period investment. Advantages are that can always be calculated so it can be used for dividend paying and non-dividend paying companies. It can also be used for companies that are expecting negative free cash flows. Disadvantages are that you have to have detailed knowledge of accrual accounting and there can be errors is disclosures are not good enough.
Compare residual income models to dividend discount and free cash flow models
Dividend discount models and free cash flow models compute the intrinsic value of a stock by discounting a stream of expected future cash flows at the required rate of return. The RI model beings with a book value of equity and adjusts its value by adding the present value of expected future residual income. The RI model relies on current book value for a large portion of the valuation, which is easliy calculated and pretty certain. While the DDM and FCF models rely on the terminal value for a large portion of the value, which is susceptible to forecast error (due to projections of cash flows far into the future and high sensitivity to assumptions of r and g).
Effective tax rates of corporate earnings under double taxation, dividend imputation, and split-rate tax systems
Double taxation: taxes are enforced at corporate level (effective corporate tax rate), and taxes are also enforced on the shareholder level if dividends are distributed (marginal tax rate on dividends). If a company's net income before taxes is $100K and corporate tax rate is 30%, the earnings after tax is $70K, if 100% of earnings are paid out as dividends and tax rate on dividends is 15%, the investor's after-tax dividend is $59,500 and the effective tax rate is 40.5%. Dividend imputation tax system: corporate earnings are first taxed at the corporate level. When these earnings are paid out to shareholders as dividends, shareholders may either receive a tax credit or have to pay additional taxes depending on their marginal tax rates. If an investor's marginal tax rate is lower than the corporate tax rate, investor will receive a tax credit (aka "franking credit") for the taxes paid by the company on distributed earnings. If investor's marginal tax rate is higher than corporate tax rate, investor must pay additional taxes so taxes are in-line with investor's tax rate. Split-Rate tax system: earnings still taxed twice, but lower rate on earnings that are distributed. Under this system, earnings distributed as dividends by the company are taxed at a lower rate than earnings that are retained by the company.
justify the use of earnings yield (E/P) the reciprocal of (P/E)
E/P ratio is used when a company has zero or negative earnings, as with a P/E ratio in these cases, the P/E ratio will be negative and thus useless in analysis.
distinguish among the economic profit, residual income, and claims valuation models for capital budgeting and evaluate a capital project using each
Economic Profit: measures the profit earned by the company above and beyond the cost of capital invested in the project. The cost of capital reflects the amount that the company must earn in order to pay debt and equity holders their required rates of return. residual income focuses on returns to equity. Residual income approach only calculates value from the perspective of equity holders only. Therefore, future residual income is discounted at the required rate of return on equity to calculate NPV. Claims valuation: values a firm as the sum of the values of claims of debt and equity holders against the firm's assets. first separate the cash flows available to debt and equity holders, and then discount them at the cost of debt, while cash flows available to equity holders are discounted at the cost of equity. The present value of the two cash flow streams are added to calculate the total value of the company.
Compare the FCFE model and the dividend discount models
FCFE takes the ownership perspective of a controlling interest as FCFE reflects cash flow that can be redeployed by the controlling interest without affecting company capital investments. The DDM approach takes the ownership perspective of a minority shareholder who does not have any control over timing and amount of dividends paid. Analysts may prefer free cash flow valuation to DDM based on the following reasons: some companies pay little or no dividends, as just because a company pays dividends doesn't mean that are sustainable for a long term period.
Compare the Friedman doctrine, Utilitarianism, Kantian Ethics, and Rights and Justice Theories as approaches to ethical decision making
Friedman Doctrine: states that the only social responsibility of business is to increase profits, as long as the company is within the rules of law. Company has no responsibility to make social investments, if stakeholders what to with their own money they can, but company must strictly focus on profit. However, company must be ethical and stay within the rules of the game. Utilitarian Ethics: States that the best decisions are those that produce the greatest good for the greatest number of people. Thus social benefits of business decisions must be compared and actions where benefits outweigh costs must be pursued. However, this theory is flawed in the sense that measuring benefits and costs is not always straightforward, and the fact that good for the greatest number of people will tend to leave out the minority of the population in its decisions. Kantian Ethics: based on philosophy that people should be treated as ends and never purely as a means to the ends of others. This argument is accepted but is an incomplete ethical framework. Rights Theory: Asserts that people have certain fundamental rights that take precedence over a collective good. These rights form the basis for the "moral compass". Justice Theory: Asserts that there should be a fair distribution of economic goods and services. Most famous theory is by John Rawls. Rawls said that each person is permitted to basic liberty (freedom of speech, voting rights, free thought, etc). After this is ensured, he said that inequality in social goods (income, wealth) is acceptable only if it benefits the least advantaged person aka "differencing principle".
Explain the going-concern assumption and contrast a going-concern value to a liquidation value
Going concern value: this value means that we assume that the company will continue its business operations for the foreseeable future. Liquidation value: this value is the value of the company if the company were to dissolve and all its assets sold off individually. the difference between these 2 values depends on the amount of value created by the application of human capital to the assets' productive capacity.
Calculate the value of a noncallable fixed-rate perpetual preferred stock
Gordon Growth model can be used to value noncallable fixed-rate perpetual preferred stock. These securities are not callable, have a specified fixed dividend, do not have a maturity date. For this type of value you must slightly modify the Gordon Growth Model, by removing g (because you have no growth in the dividends). Formula: Vo = D / r remember this formula anytime you have a question that asks for the current value of a security that is "fixed-rate perpetual stock".
Calculate and interpret the Herfindahl-Hirschman Index (HHI), and evaluate the likelihood of an antitrust challenge for a given business.
HHI index (see formula sheet for formula) results are as follows: less than 1,000 = no concentration; no gov't action 1000-1800 = moderate concentration and a rise of 100 points or more; possible action more than 1800 = high concentration; gov't challenge is HHI rises by 50 points or more in the merger.
distinguish among holding period return, expected holding period return, required return, return from convergence of price to intrinsic value, discount rate, and internal rate of return
Holding period return: return on investment over the entire investment horizon (Whatever it may be). Required Return: the minimum rate of return required by an investor to invest in an asset over a specific period of time (given its level of risk). The difference between an asset's expected return and its required return is known as "expected alpha" Expected Alpha= expected return - required return If an asset's current price equals its perceived intrinsic value then the expected and required return should be the same and alpha equals zero. Return from convergence of price to value: is simply the intrinsic value - current market price / current market price. Discount rate: the rate used by investors to calculate the present value of a future cash flow. The discount rate is based on investment characteristics of the asset however there may be subjective adjustments to reflect investor expectations. Internal Rate of Return (IRR): is the discount rate that equates the present value of expected cash flows from the assets to its price.
Define intrinsic value and explain sources of perceived mispricing
Intrinsic value of an asset refers to its "true" value based on a hypothetical complete understanding of its investment characteristics. Each investors intrinsic value estimate for a given asset may be different as it would be subjective. "Efficient market theory" asserts that an asset's market price is the best available estimate of its intrinsic value. Some argue this is not always the case, and any deviation of a market price from an investors estimate of intrinsic value is known as "perceived mispricing". An active portfolio manager aims to earn a positive excess risk-adjusted return (aka alpha) by trading on perceived mispricing. "True mispricing" is the difference between the actual intrinsic value and the market price. An "error in the estimate of intrinsic value" refers to the difference between estimated intrinsic value and actual intrinsic value. so, Perceived mispricing = true mispricing + error in estimate of intrinsic value.
Classify merger and acquisition (M&A) activities based on forms of integration and relatedness of business activities
M&A activities can be classified on the basis of: (1) Form of integration: The manner in which the business combination takes place (2) Business activities of companies: the manner in which business activities of the companies are related to each other. Form of integration: can be 3 forms - (1) statutory merger: the legal identity of the target company ceases to exist following the amalgamation of all its assets and liabilities into the acquirer; (2) subsidiary merger: target becomes subsidiary of the acquirer; (3) Consolidation: both target and acquirer merge into a newly formed company so both previous legal entities cease to exist. Business Activities: can be either a "horiztonal merger" (combining companies are the same line of business i.e. 2 oil companies), or a "vertical merger" (combining companies hail from same production chain). A part of this is also "backward integration" where a company buys a target that is part of its supply chain i.e. soda company buys sugar company. There can also be a "forward integration" (buying ahead of your supply chain i.e. cloth company buys a fashion retailer).
Explain the MACRS accelerated depreciation method
MACRS: (modified accelerated cost recovery system), is an accelerated depreciation system commonly used in the U.S. MACRS uses the double decline method for the initial years of an asset's life, then switches to straight line depreciation when optimal (when the straight-line depreciation would be at least as large as the depreciation under declining balance method used in the initial years).
Calculate value of a private company based on market approach methods. (Only for small private companies)
Market Approach: values a private company based on price multiples obtained from public companies, or sales of comps. The market approach has the following variations: (1)Guideline public company method (GPCM): calculates value based multiples of comparable public companies. (2) Guideline transaction method (GTM): calculates value based on multiples obtained from prices at which similar private or public companies were acquired. (3) Prior transaction method (PTM): values a private company based on actual transactions in its own stock.
Explain and calculate the discount rate based on the market risk method, to use in valuing a capital project
Market risk: depends depends not only on the variation of a project's cash flows but also on how those cash flows correlate with market returns. When using market risk measures, the applicablke discount rate should reflect the rate of return required by a diversified investor, and the risk premium should only reflect factors that are prices in the marketplace Analysts typically use the CAPM to calculate this discount rate; the CAPM breaks down total risk into: (1) systematic risk: that is related to the market and is nondiversifiable. It is typically measured by Beta (b). Only systematic risk is priced into the market. Diversified investors demand a risk premium for bearing systematic risk. (2) Unsystematic risk: is a nonmarket risk that can be diversified away. The security market line (SML) expresses the asset's required rate of return as a function of Beta (systematic risk). According to the SML, the required rate of return aka hurdle rate varies with each project according to its systematic risk (Beta). The required rate of return can be used to calculate NPV's and evaluate IRR's which can then be used to make capital budgeting decisions.
distinguish between the method of comparables and the method based on forecasted fundamentals as approaches to using price multiple in valuation
Method of comparables: Refers to valuation based on multiples of comparable companies. This method is based on the "law of one price" which states that similar assets should be price similarly. Method based on forecasted fundamentals: Refers to valuation based on multiples that are derived from forecasts of the company's fundamentals (characteristics of the business such as profitability, growth, or financial strength. a "justified price multiple" for a stock refers to the estimate of the fair value of a price multiple that can be justified, either on the basis of the method of comps, or on the basis of the method of forecasted fundamentals. Basically, the justified price multiple is the value that the multiple would take where the stock currently trading at its fair value. If the justified price multiple is larger than the actual current multiple of the stock, the stock is undervalued, and vice versa.
describe approaches for forecasting FCFF and FCFE; and explain how dividends, share repurchase, and changes in leverage may affect future FCFF and FCFE
One approach is to calculate the current cash flow and apply a simply growth rate to make future projections. The second approach is more complex, and that is to forecast each individual variable of to come up with future cash flows. Dividends, share repurchase, and share issuance do not show up in any cash flow formulas. They represent uses of free cash flow. Changes is leverage impact FCFE (increased financing in-turn increases net borrowing).
Describe competition and judge competitive position of a company using "Porter's 5 forces analysis"
Porter's 5 forces: analysts use this tool when evaluating how competition will affect company performance. Think about how each one affects profitability of a company. (1) Threat of substitutes (2) Intensity of rivalry among incumbent companies (3) Bargaining power of suppliers (4) Bargaining power of customers (5) Threat of new entrants
Distinguish among post-offer takeover defense mechanisms
Post-Offer takeover defense mechanisms: Just say no defense: target simply declines the offer and hopes that the acquirer will raise its offer. Litigation: target may take acquirer to court over alleged violations of antitrust or securities laws. Greenmail: target is allowed to repurchase its shares from the acquirer at a premium to market price. not used much as there is a 50% tax on acquirers profits realized through greenmail. Share repurchase: target may repurchase its shares from shareholders, which will essentially increase the costs of a takeover. This can be a "leveraged recapitalization" if a large amount of debt is issued to finance a substantial share. Crown jewel defense: target sells of a valuable asset to make firm less attractive for purchase. This could be deemed illegal is the sale is initiated after a hostile bid.- Pac man defense: target attempts a hostile takeover of the acquirer's company. this is rare as the target is usually smaller than the acquirer. White Knight defense: target encourages another 3rd party company to acquire the target. Management might prefer the 3rd party company must more than the original acquirer. White squire defense: third party purchases a substantial minority stake, large enough to block a takeover, in the target.
Distinguish among pre-offer takeover defense mechanisms
Pre-Offer defense mechanisms: Poison pills - grants a company the right to issue stock options to existing shareholders enabling them to purchase additional shares of stock at significantly discounted prices. They effectively make it expensive for the acquirer to take over the target without approval of the board of directors. In addition, a "flip-in pill" gives target shareholders the right to buy the target's shares at a discount. This gives target shareholders the right to buy shares of the acquirer at a discount. You can also have "poison puts" which is the right of the target to sell their bonds back to the target at a pre-specified price in the event of a takeover. Incorporate in a state with restrictive takeover laws: certain states are very target friendly and give target company's power to defend. Staggered board of directors: election of board members are scheduled at staggered times so an acquirer would have to take several years to complete the acquisition. Supermajority voting provisions: require 80% of shareholder approval for mergers versus the typical 51%. Restricted voting rights: target companies may adopt a mechanism that stops certain shareholders that own large amounts of share from having the ability to vote. Fair price amendments: changes to the corporate charter that only allow mergers if the offer price is above a certain threshold. this also protects against "two-tiered tender offers" where acquirer initially quotes a price then threats to go with a lower price if not accepted.
explain the advantages and disadvantages of various price multiples in valuing a company
Price to Earnings ratio: Advantages: earnings are key driver of value. according to empirical research, differences in P/E ratios are significantly related to long term average stock returns. Disadvantages are that when a company has losses the P/E is negative and a negative P/E is useless information. Also, earnings of some companies are very volatile which can lead to misleading P/E. A "trailing P/E ratio" is calculated by dividing the company's current stock price by earnings over the last four quarters. used when future earnings are expected to be volatile. A "leading P/E ratio" is calculated by dividing the company's current stock price by next year's expected earnings. You can use earnings over: (1) next 4 quarters (2) next 12 months or (3) next fiscal year. Price to book ratio (P/B): (also called Tobin's Q) Advantages: Book value usually remains positive even when the company reports negative earnings unlike P/E ratio. book value is usually more stable over time compared to reported earnings. P/B is more significant for financial companies that typically have large holdings of liquidity. Disadvantages are book values ignore nonphysical assets such as the quality of a company's human capital and brand image. accounting differences can impair the ability to compare P/B across different companies. Price to sales ratio (P/S): Advantages: sales are less prone manipulation by management than earnings or book value. more stable than earnings. Disadvantages are sales does not tell you how profitable a company is. Also no info on company operating efficiency Price to cash flow (P/CF): cash flow is less prone to management manipulation compared to earnings. P/CF is more stable than P/E. Disadvantages are that while FCFE is better for valuing a company, it is more frequently negative than CFO. Dividend yield: Advantages: Is a component of total return. Dividend yield can be calculated by "trailing dividend yield" (for companies paying quarterly dividends, the dividend rate equals most recent quarterly dividend * 4). You can also calculate dividend yield by the "leading dividend yield" which is next year's forecasted dividends per share by the current market price of the stock.
Residual Income Valuation: Compare residual income, economic value added, and market value added
Residual income: deducts a charge for equity capital to determine whether a company is earnings an abnormal return (a return in excess of opportunity costs) for equity investors. a standard net income statement only accounts for interest expense which is why residual income goes one step further to account for the equity charge. Economic Value added (EVA): is a variation of residual income. Market Value Added (MVA): equals the difference between the market values of the company's debt and equity and the book values of debt and equity. IT measures the value created by management for the company's investors by generating economic profits over the life of the company.
describe how analysts determine the safety of a dividend
Safety of a dividend is evaluated through the dividend payout ratio which = dividends/net income, or its inverse, the dividend coverage ratio = net income/dividends. Another way to evaluate dividend safety is the free cash flow to equity (FCFE) and FCFE coverage ratio which = FCFE / (Dividends + Share Repurchases)
Share repurchases: Compare methods of share repurchases.
Share repurchase: company buys back its own shares. These shares are known as treasury shares. They are not considered for dividends, voting, or computing earnings per share (thus EPS goes up as number of shares outstanding goes down) Types of repurchase methods: (1) buy in open market: offers flexibility as company does not have a legal obligation to go through with the entire purchase once it has been authorized. Cost effective as company can execute when stock price is attractive. (2) Buy back fixed number of shares at a fixed price: company offers to buy back a fixed number of shares at a fixed price (typically at a premium). (3) Dutch auction: company will specify a range of acceptable prices, and shareholders who are interested in selling will specify a price and number of shares. Company accept lowest bids first all the way up until they reached their intended number of shares to repurchase. (4) repurchase by direct negotiation: Company directly negotiates with a majority shareholder to buy back their shares. this may occur when a large shareholder wants to sell of their shares or the company wants to buy out a large shareholder so that they don't gain representation on the company's board of directors.
Dividends: compare stable dividend, constant dividend payout ratio, and residual dividend payout policies.
Stable dividend policy: company aims to pay a regular stream of dividends, and increases only happen when the expected future profitability suggests that the increase is sustainable. Constant dividend payout ratio policy: company aims to keep a constant dividend payout ratio. (DPS/EPS) will equal the same % every year. Residual dividend policy: a company first utilizes internally generated funds to finance investments in positive NPV projects consistent with its target capital structure. Remaining funds (if any) are distributed in the entire amount as dividends to shareholders.
Describe "sum of the parts valuation" and conglomerate discounts
Sum of parts valuation is a way to value a company by estimating a value for each of its different businesses individually as going-concerns and then aggregate those values to arrive at a value for the entire company. when using this approach it is sometimes appropriate to apply a "conglomerate discount" for the company's lack of focus to one specific business, and inefficiencies in capital allocations.
Compare the discounted cash flow, and (in future notes) comparable company and comparable transaction analyses for valuing a target company, including the advantage and disadvantage of each
Target Company Valuations: Discounted cash flow analysis: This approach determines the value of the target as the present value of its expected future free cash flow to the firm (FCFF). FCFF represents cash available to all the company's investors (shareholders and bondholders) after paying for all expenses and investments required to maintain operations. The two-stage DCF requires the following steps: (1) development of pro forma financial statements\ (2) Conversion of pro forma net income info pro forma FCFF (3) Calculation of present values of: the company's yearly FCFF in the first stage and the company's terminal value which represents the PV of second stage FCFF. (4) adding the present value of the two FCFF streams to determine company value. The analyst must use judgement to estimate items in the pro forma financial statement.. Terminal value can be calculated using the "constant growth model" or the "relative valuation model". Advantage of DCF: allows the ability to include expected changes to cash flows to the model. model can be customized. Disadvantage is difficulties arise should free cash flow be negative. Also, small changes to WACC or growth rate dramatically effect the target's value.
Calculate and interpret accounting income and economic income in the context of capital budgeting
evaluation of capital projects may also be based on: economic income and accounting income, economic profit evaluation, residual income valuation, claims valuation. Economic income equals the profit realized from an investment. for a given year, economic profits equals sum of after-tax operating cash flow plus the increase in the investment's market value. The "economic rate of return" is calculated as the economic income divided by beginning market value. the economic rate of return should equal the required rate of return. Accounting income: refers to a company's net income. It differs from economic income in the following ways: economic income ignores interest expense, whereas accounting income subtracts interest expense to arrive at new income. Economic depreciation is based on changes in the market value of the investment (ending market value - beginning market value), whereas accounting depreciation is based on the original cost of the investment.
interpret present value of growth opportunities calculation
present value of growth opportunities: Vo = (E1 / r) + PVGO This formula states that the value of a stock can be broken down into 2 parts: (E1 / r) is the no-growth value per share, where E1 is the expected EPS at the end of year 1. The 2nd part is the PVGO, which is the present value of growth opportunities. which is what you essentially solve for after you get no-growth value per share. Re-format the equation to be current market price - no growth value per share = PVGO. IF you have a negative PVGO that means the current investment strategy is expected to destroy value.
describe types of real options and evaluate a capital project using real options
real options are capital budgeting options that give managers the right but not the obligation to make a capital budgeting decision in the future. these decisions have the potential to alter the value of capital budgeting decisions made today. They offer flexibility to managers and increase the NPV of projects. Types of real options: (1) timing options: gives company an option to delay making an investment (until improved information becomes available that facilitates better decision making). (2) Sizing options: which include, Abandonment options - which gives the company an option to abandon the project. Growth options - gives company an option to expand project. (3) Flexibility options: which include, Price-Setting - gives company an option to change prices. Production-Flexibility options: gives company an option to change output quantities. (4) Fundamental options: options embedded in the project itself. i.e. is oil prices are low, oil company will halt projects that drill for oil. Common pitfalls of capital budgeting listed on page 24.
Explain how sensitivity analysis, scenario analysis, and monte carlo simulation can be used to assess the stand-alone risk of a capital project.
sensitivity analysis: determines the impact on NPV of changes in one input variable at a time holding all other input variables constant. this enables the analyst to identify the most significant and influential variables as they relate to the NPV. Scenario Analysis: while sensitivity analysis allows us to evaluate the impact of a change in one input variable to the NPV, scenario analysis calculates the NPV of a project in a number of different scenarios where each scenario consists of changes in several input variables. The greater the dispersion in NPV across the given scenarios, the higher the risk of the project. Monte Carlo Simulation analysis: the simulation can be run thousands of times to come up with a distribution for possible values of NPV and IRR, which includes more scenario's than scenario analysis which is typically just pessimistic, most likely, and optimistic.
calculate and interpret the justified leading and trailing P/Es using the Gordon Growth Model
the Gordon Growth Model can be used to develop an expression for the P/E ratio in terms of company fundamentals. A P/E ratio determined in this manner is known as a "Justified" P/E ratio as it is based on fundamentals. A "leading P/E ratio" or a "Forward P/E ratio" is calculated as the price of a stock divided by expected earning over the next 12 months (symbolized by E1). this E1 can be incorporated into the Gordon Growth Model to find Vo and this is known as the "justified leading P/E multiple". The trailing P/E is calculated as the price of the stock divided by earnings over the last 12 months (symbolized by E0). This E0 can be incorporated into the Gordon Growth Model to find Vo and this is known as "justified trailing P/E multiple".
financial modeling: compare top down, bottom up, and hybrid approaches for developing inputs to future revenues of equity valuation models
top down approach: analyst begins with the overal economy then move to a more narrow focus (sector, industry, or specific product) before eventually arriving at a revenue forecast for a particular company. There are 2 common approaches: (1) growth relative to GDP growth, which means = gdp growth * (1+company growth above GDP). (2) market growth and market share approach, which means first forecast growth for a particular market * the growth in market share for that company. Bottom-Up approach: analysts start at the individual company level or unit level of the company, then aggregate those forecasts to project total revenue for the company. Bottom up approaches to forecast revenue include (1) time series: forecast based on historic growth aka time series analysis, (2) return on capital: forecasts based on balance sheet accounts, (3) capacity-based measures: same-store sales growth or sales related to new stores in the retail industry. The Hybrid approach: is any combination/mix of the 2 approaches.
Explain methods of normalizing earnings per share (EPS) and how to calculate normalized EPS
when calculating trailing P/E, the following issues must be considered in determining the EPS used in the denominator 1. Potential dilution in EPS 2. nonrecurring components of earnings that are company specific 3. transitory components of earnings that can be attributed to business or industry cyclicality. 4. Differences in accounting methods used by companies being compared. Potential dilution of earnings are easy to spot as companies are required to disclose basic and diluted EPS on the face of the income statement. "Company-specific nonrecurring items are removed in order to be able to calculate "underlying earnings" (earnings that exclude nonrecurring items). Analysts also adjust for "business or industry specific influences on earnings". All these play a role in normalizing earnings. Under the method of historical average EPS: Normalized EPS is calculated as average EPS over the most recent full cycle. Under the method of average return on equity: normalized EPS is calculated as the current book value per share times the average return on equity over the most recent full cycle.