Chapter 8 Common Stock Difficult to value b/c future CFs unknown; investment life is forever; and no easy way to observe required rate of return. P0 = ∑ { Dn / (1+R) n } + Pn/ (1+R) n Zero Growth – D is constant Per Share value P0 = D / R Constant Growth – D is growing Dt = D0 (1+g) t Pt = [Dt *(1 + g)] / (R - g) = Dt+1 / (R - g) Non-Constant Growth P0 = [D1/(R – g1)]+..+[Dt/(1+R) t]+[Pt/(1+R) t] Two Stage Growth – dividend grows at g1 for t periods, then g2 forever (gs) P0 = [D1/(R – g1)]*{1– [(1 + g1)/(1+R)]t} + Pt /(1+R)t Pt = Dt+1/(R - g2) = [D0*(1+g1)t * (1+g2)]/(R-g2) Required Return – discount rate Dividend Growth Model – R = (D1 / P0) + g = Dividend yield + Capital Gains Yield Dividend Yield –expected cash dividend divided by current price Capital Gains Yield – the dividend growth rate Dividend Payout Ratio DPR =Div / E (Earnings) E0 * (1 + DPR) = E1 gs = ROE * (1 – DPR) Common stock – equity without priority for dividends or in bankruptcy Cumulative voting – shareholder may cast all votes for one member of the board of directors: votes = # of shares * # of directors to be elected Straight vote – shareholder may cast all votes for each member of the board of directors: votes = # of shares; multiple elections Proxy voting – grant authority to allow another to vote on owner’s behalf Proxy fight – vote by proxy in an attempt to replace any management Unequal common stock – different types reflect different voting strength, keeps founders and owners in office Rights - to share proportionally in dividends paid; in liquidation, to share assets, after paid liabilities; to vote; preemptive right to own = % of shares after new offering Dividends – not firm’s liability; not business expense, not tax deductable; receiving dividends is income and taxable Preferred stock – equity; cumulative – declared dividends carried over; non-cumulative – not carried over; often callable, convertible, given ratings, like bonds Stock Markets Primary – original IPO sold Secondary – prev. issued securities traded Dealer – maintains inventory, buys and sells Bid Price – what dealer is willing to pay Ask Price – what dealer is willing to spend Spread – Dealer’s profit, Ask-Bid Broker – brings buyers and sellers together NYSE – member is an owner of a trading license on NYSE (1366) Commission broker – member who executes customer orders to buy and sell stock transmitted to exchange floor (500) Specialist – dealer of small # of securities Floor Brokers – executes orders for commission brokers on a fee basis $2 SuperDOT system – allows orders go directly to specialists Floor traders – traders of their own accounts Order flows – flow of customer orders Specialist post – fixed place on exchange floor where specialist operates, diff coats NASDAQ Dealer market – OTC no physical location Electronic Communications Network (ECN) Inside quotes – high and low ask quotes Yield % = Div/Close, PE = Close/Ann EPS Chapter 9 Net Present Value – Investment’s PV Advantages: accounts for TVM, maximizing NPV maximizes shareholder value. Is additive. Capital Budgeting – create value by identifying an investment worth more in market then cost for acquisition Discounted Cash Flow (DCF) valuation Rule: Positive NPV means we should invest Annuity PV = C * {1 – [1/ (1 + r)t ] /r} NPV/ Outstanding Shares = adjust value/share Payback Period – acceptable investment if the payback is within predetermined timeline, amount of time investment generates positive cash flows, non discounted, fractions Advantages: cost of analysis low, great for short term; liquidity bias frees cash quick; cash may come unexpectedly later Problems: ignores TVM, ignores differences in risk; no objective basis for a cut off period; cash flows after disregarded; short term bias Answers: time to recover from investment, break even, not investment worthy Discounted Payback Period – same as payback period but with discounted CFs, fractions OK Advantages: Includes TVM; easy to understand; doesn’t accept -(NPV), bias towards liquidity Problems: may reject +(NPV) installments; arbitrary cut off, ignores future CFs, biased against long term projects Average Accounting Return (AAR) Acceptable if AAR > target average return AAR = Average NI / Average Book Value Average Book Value = (sum of costs)/ # costs Advantages: easy to calculate; needful information will usually be available Disadvantages: not true rates of return, TVM ignored; arbitrary cut off; based on accounting book values, not market values Internal Rate of Return (IRR) NPV of investment = 0 Rule: investment is acceptable if the IRR > the required return, rejected otherwise Economic Break-Even when NPV = 0 Calc: PV=-(investment), +PMT, FV=0, CPT R DCF return graph: R (x), NPV (y), lines invests, Intersection – crossover point, x-inters IRR Larger number of points called NPV Profile IRR decision = NPV decision when: cash flows are conventional, projects are mutually ex. Advantages: closely related to NPV, identical decisions(except in non-conventional cash flows and mutually exclusive projects); easy to understand Disadvantages: poss. multiple answers when non-conventional CFs; can lead to incorrect decisions in comparing mutually exclusive investments, taking one prevents taking another; not as productive as NPV in long run, not additive, no $$ measure Modified Internal Rate of Return (MIRR) Method 1: Discount Approach Discount all (-) CFs to PV then sum them up and add to the initial cost, then get IRR Method 2: Reinvestment Approach Compound all CFs (+ and -) except first out to the end of the project’s life, then get IRR Method 3: Combination Approach (-) CFs are discounted to present, (+) CFs are compounded to the end, IRR, highest IRR Advantages: adjust for TVM, only 1 answer Disadvantages: no clear best method; if we have relevant R, why not take NPV; not truly based on “internal” b/c not based on CFs Profitability Index – PI or benefit-cost ratio PI = PV of future CFs / initial cost (greater then) 1 for (+) NPV, < 1 for (-) NPV Advantages: closely related to NPV; easy to understand; maybe useful when available investment funds are limited Disadvantages: may lead to incorrect decisions about mutually exclusive investments Chapter 10 Project CF – a relevant CF for a project is a change in the firm’s overall future CFs that comes about as a direct consequence of the decision to take the project Incremental CF – difference between a firm’s future CFs with a project and those without a project, any CF that exists regardless of taking the project is not relevant. Stand Alone Principle – assumption that evaluation of a project may be based on the project’s incremental CFs Common Mistakes for Incremental CFs Sunk costs – cost that has already been incurred and cannot be removed therefore should not be considered, ex fees Opportunity cost – should include the most valuable alternative given up if an investment it taken up, ex sales price of in use building Side Effects – erosion: include cash flows of a new project that comes as an expense of a firm’s existing project, relevant only when sales would not otherwise be lost, if competitor makes same effect don’t include Net Working Capital – additional investment in NWC at beginning of a project and recovered at the end when NWC is sold Financing Costs – do not include interest paid or payments of dividends because we only want cash flows generated by asset Other Issues – interested in only measuring each cash flow not when it is accrued, interested in after tax flow because taxes are a cash flow, always after tax Pro Forma Financial Statements and CF Financial statements projecting future years operations estimates: unit sales, selling price, variable cost, total fixed cost, organized without interest expense Sales Net Sales - Variable Cost - COGS Subtotal - Depreciation - Fixed Cost EBIT - Yearly Depreciation - interest not rel. EBIT Taxable Income - Taxes (at tax rate) - Taxes (at rate) Net Income Net Income Total Investment = NWC + Net Fixed Assets Total (Projected) Cash Flows = (Projected) Operating cash flows - (Projected) Change in NWC - (Projected) Capital Spending Total (Projected) Operating Cash Flows = EBIT + Depreciation - Taxes Change in NWC = - (NWC) at investment Capital Spending = Investment of asset at beg. Sales – Cost = Net Income A/R (+ inventory) – A/P = NWC Beg NWC – End NWC = Total change in NWC Projected Total Cash Flow (NPV) = Total Projected Cash Flow at Beg + Discounted Total Cash Flow Revenues = Unit Sales * Unit Price EBIT = Rev – VC – FC – Dep OCF = EBIT + Dep - Taxes Cash income = Sales – increase in A/R Cash costs = Costs – increase in A/P Cash flow = cash inflow – cash outflow = OCF – change in NWC Depreciation – non cash deduction, has cash flow consequences, influences tax bill, ACRS accelerated depreciation under US law Include Shipping and Installation costs Modified ACRS (MACRS) every asset of a particular class determined life and dep Land not depreciated Dep Tax Savings = D * Marg. T CF = OCF + Dep Tax Savings – change NWC When asset is sold taxes taken from: Capex = (MV - BV) * tax rate If MV > BV, the difference is tax liability If MV < BV, the difference is a loss for tax OCF methods: Bottom Up OCF = NI + Dep Top Down OCF = Sales – Costs – Taxes Tax-shield approach OCF = (Sales – Costs)*(1-taxes) + D*T OCF = ((P-v)Q – FC)*(1-T) + TD Decreased Operating Cost OCF = Decrease in Oper Cost * (1 – Marg. T) Chapter 11 Project Analysis and Evaluation Forecasting Risk – the possibility that errors in projected cash flows will lead to incorrect decisions (estimation risk) Base Case – initial set up of projected CFs, based on average of Lower Bound and UB Scenario Analysis – the determination of what happens to NPV estimates when we ask what if questions, determining LB and UB Sensitivity Analysis – investigations of what happens to NPV when 1 variable is changed Simulation Analysis – combination of scenario and sensitivity, considers interrelationship Forecasting risk high when analysis is volatile Break Even Analysis – relationship between sale volume and profitability Variable Cost – costs that change when the quantity of output changes VC = Q * v, v = variable cost per unit Fixed cost – costs that do not change when the quantity of output changes, LT all costs var Total Cost TC = VC + FC, TC = Q *v + FC Marginal, or incremental, costs – change in cost that occurs when there is a small change in output = line slope, revenue as well Accounting Break Even – the sales level that results in 0 project net income Contribution margin per unit = selling price- VC Accounting expenses cover FC and Dep Quantity of output/sales volume (x), sales and costs/$ (y), lines: total revenue, TC NI = (Sales – VC – FC – Dep)*(1-Taxes) If NI=0, then T=0, solve for Q Q = (FC + D) / (P – v) Easy to calc; shows effect on tot earnings; breaking even only loses on financial or OC Acct B-E, EBIT = T = 0, OCF = D, IRR = 0 Payback = life of the project if same every year OCF = Q*(P – v) – FC Cash B-E