CHAPTER 1 An Overview of Financial Management

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Financial Analysts Awareness Training Program
(6)

• Dr. Mounther Barakat
• Securities and Commodities Authority

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Capital Asset Pricing Model

• Model based upon concept that a stocks required
  rate of return is equal to the risk-free rate of
  return plus a risk premium that reflects the
  riskiness of the stock after diversification.
• Primary conclusion The relevant riskiness of a
  stock is its contribution to the riskiness of a
  well-diversified portfolio.

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Beta

• Measures a stocks market risk, and shows a
  stocks volatility relative to the market.
• Indicates how risky a stock is if the stock is
  held in a well-diversified portfolio.

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Calculating betas

• Run a regression of past returns of a security
  against past returns on the market.
• The slope of the regression line (sometimes
  called the securitys characteristic line) is
  defined as the beta coefficient for the security.

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Illustrating the calculation of beta
See Excel file
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Can the beta of a security be negative?

• Yes, if the correlation between Stock i and the
  market is negative (i.e., ?i,m lt 0).
• If the correlation is negative, the regression
  line would slope downward, and the beta would be
  negative.
• However, a negative beta is highly unlikely.

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Beta coefficients
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Comparing expected return and beta coefficients

• Security Exp. Ret. Beta
• A 17.4 1.30
• M 15.0 1.00
• C 13.8 0.89
• T-Bills 8.0 0.00
• B 1.7 -0.87
• Riskier securities have higher returns, so the
  rank order is OK.

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The Security Market Line (SML)

• SML ki kRF (kM kRF) ßi
• Assume kRF 8 and kM 15.
• The market (or equity) risk premium is RPM kM
  kRF 15 8 7.

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What is the market risk premium?

• Additional return over the risk-free rate needed
  to compensate investors for assuming an average
  amount of risk.
• Its size depends on the perceived risk of the
  stock market and investors degree of risk
  aversion.
• Varies from year to year, but most estimates
  suggest that it ranges between 4 and 8 per year.

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Calculating required rates of return

• kA 8.0 (15.0 - 8.0)(1.30)
• 8.0 (7.0)(1.30)
• 8.0 9.1 17.10
• kM 8.0 (7.0)(1.00) 15.00
• kC 8.0 (7.0)(0.89) 14.23
• kT-bill 8.0 (7.0)(0.00) 8.00
• kB 8.0 (7.0)(-0.87) 1.91

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Expected vs. Required returns
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Illustrating the Security Market Line
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Other Methods to calculate the Cost of Equity

• Dividend discount model
• Cost of debt plus a premium
• Arbitrage pricing theory and its various versions
• The reciprocal of the PE ratio
• Intertemporal CAPM
• FF 2 and three factor models
• Implied cost of equity from the B-S option
  pricing model
• Other Methods

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Cost of Debt

• It is the marginal cost of new money raised
  through debt.
• See XLS example

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The three basic concepts of valuation

• Investors can only spend cash so "Cash is good
  and more cash is better."
• Cash today is worth more than cash tomorrow.
• Risky cash flows are worth less than safe cash
  flows.
• These three imply the value of a company depends
  on the size, timing, and riskiness of its cash
  flows.

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Valuation of a Simple Company

• Investors are
• Debtholders
• Stockholders

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Valuation example

• Simple Co.s shares of stock also compete in the
  market for investors.
• Stockholders are the owners of the firm, and the
  value of ownership is the value of the asset,
  less any debt that is owed.
• For example Suppose Simple Co. is worth 501
  million. It owes 150 million to debtholders.
  So Simple Co.s equity is worth 501 150 351
  million.

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The Corporate Valuation Model

• PV of cash flows available to all
  investorscalled free cash flows (FCFs).
• Discount free cash flows at the average rate of
  return required by all investorscalled the
  weighted average cost of capital (WACC)

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Steps in the corporate value model

• Determine weighted average cost of capital
• Estimate expected future free cash flows
• Find value of company

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Estimating the Weighted Average Cost of Capital
(WACC)

• Company has two types of investors
• Debtholders
• Stockholders
• Each type of investor expects to receive a return
  for their investment
• The return an investor receives is a cost of
  capital from companys viewpoint.

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Cost of Debt

• Simple Co.s cost of debt rD 9.
• But Simple Co. can deduct interest, so cost to
  Simple Co. is after-tax rate on debt.
• If tax rate is 40, then after-tax cost of debt
  is
• After-tax rD 9(1-0.4) 5.4.

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Cost of Equity

• Cost of equity, rs, is higher than cost of debt
  because stock is riskier.
• Simple Co. rs 12

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Weighted Average Cost of Capital

• WACC is average of costs to all investors,
  weighted by the target percent of firm that is
  financed by each type.
• For Simple Co., target percent financed by
  equity
• wS 70
• For Simple Co., target percent financed by debt
• wD 30

(More.)
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WACC (Continued)

• WACC wD rD (1-T) wS rS
• 0.3(9)(1 - 0.4) 0.7(12)
• 10.02

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Free Cash Flow (FCF)

• FCF is the amount of cash available from
  operations for distribution to all investors
  (including stockholders and debtholders) after
  making the necessary investments to support
  operations.
• A companys value depends upon the amount of FCF
  it can generate.

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Calculating FCF

• FCF net operating profit after taxes minus
  investment in operating capital

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Operating Current Assets

• Operating current assets are the CA needed to
  support operations.
• Op CA include cash, inventory, receivables.
• Op CA exclude short-term investments, because
  these are not a part of operations.

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Operating Current Liabilities

• Operating current liabilities are the CL
  resulting as a normal part of operations.
• Op CL include accounts payable and accruals.
• Op CA exclude notes payable, because this is a
  source of financing, not a part of operations.

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Balance Sheet Assets

• 2005 2006 2007
• Op. CA 162,000.0 168,000.0 176,400.0
• Total CA 162,000.0 168,000.0 176,400.0
• Net PPE 199,000.0 210,042.0 220,500.0
• Tot. Assets 361,000.0 378,042.0 396,900.0

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Balance Sheet Claims

• 2005 2006 2007
• Op. CL 57,911.5 62,999.7 66,150.0
• Total CL 57,911.5 62,999.7 66,150.0
• L-T Debt 136,253.0 143,061.0 150,223.0
• Total Liab. 194,164.5 206,060.7 216,373.0
• Equity 166,835.5 171,981.3 180,527.0
• TL Eq. 361,000.0 378,042.0 396,900.0

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Income Statement

• 2005 2006 2007
• Sales 400,000.0 420,000.0 441,000.0
• Costs 344,000.0 361,994.2 374,881.6
• Op. prof. 56,000.0 58,005.8 66,118.4
• Interest 11,678.7 12,262.8 12,875.5
• EBT 44,321.3 45,743.0 53,242.9
• Taxes (40) 17,728.4 18,297.2 21,297.2
• NI 26,592.7 27,445.8 31,945.7
• Dividends 21,200.0 22,300.0 23,400.0
• Add. RE 5,392.7 5,145.8 8,545.7

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NOPAT (Net Operating Profit After Taxes)

• NOPAT is the amount of after-tax profit generated
  by operations.
• NOPAT is the amount of net income, or earnings,
  that a company with no debt or interest-income
  would have.
• NOPAT (Operating profit) (1-T)
• EBIT (1-T)

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Calculating NOPAT

• NOPAT (Operating profit) (1-T)
• EBIT (1-T)
• NOPAT07 66.1184 (1-0.4) 39.67104 million.

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Calculating Operating Capital

• Operating capital (also called total operating
  capital, or just capital) is the amount of assets
  required to support the companys operations,
  less the liabilities that arise from those
  operations.
• The short-term component is net operating working
  capital (NOWC).
• The long-term component is factories, land,
  equipment.

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Net Operating Working Capital

• NOWC Operating current assets
• Operating current liabilities
• This is the net amount tied up in the things
  needed to run the company on a day-to-day basis.

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Net Operating Working Capital

• NOWC Operating CA Operating CL
• NOWC07 176.4 66.15
• 110.25 million

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Operating Capital

• Operating capital
• Net operating working capital (NOWC) plus
• Long-term capital, such as factories, land,
  equipment.

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Operating Capital

• Operating Capital NOWC LT Op. Capital
• Capital07 110.25 220.50
• 330.75 million
• This means in 2007 Simple Co. had 330.75 million
  tied up in capital needed to support its
  operations. Investors supplied this money. It
  isnt available for distribution.

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Investment in Operating Capital

• Operating capital in 2006 was 315.0423 million
• Operating capital in 2007 was 330.75 million
• Simple Co. had to make a net investment of
  330.75 315.0423 15.7077 million in
  operating capital in 2007.

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Calculating FCF

• FCF NOPAT Investment in operating capital
• FCF07 39.67104 (330.75 315.0423)
• 39.67104 15.7077
• 23.96334 million

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Uses of FCF

• There are five ways for a company to use FCF
• 1. Pay interest on debt.
• 2. Pay back principal on debt.
• 3. Pay dividends.
• 4. Buy back stock.
• 5. Buy nonoperating assets (e.g., marketable
  securities, investments in other companies, etc.)

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• Non-operating income

• NOPAT

• Dividends

• Working Capital

• Buy back stock

• Pay interest

• Fixed Assets

• Buy non-op assets

• Pay principal

Free Cash Flow
Reinvestmen
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How Did Simple Co. use its FCF?

• Paid dividends 23.4 million
• Paid after-tax interest of 12,875.5 (1-0.4)
  7.7253 million
• For a total of 31.1253 million! This is 7.162
  million more than the 23.9 million FCF
  available! Where did it come from?
• Simple Co. increased its borrowing by 150.223
  143.061) 7.162 million to make up the
  difference.

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Corporate Valuation

• Forecast financial statements and use them to
  project FCF.
• Discount the FCFs at the WACC
• This gives the value of operations

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Value of Operations
Of course, this requires projecting free cash
flows out forever.
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Constant growth

• If free cash flows are expected to grow at a
  constant rate of 5, then this is easy
• 2007 2008 2009 20010 201 2012
• FCF 23.963 25.161 26.419 27.740 29.127 30.584
• There is an easy formula for the present value of
  free cash flows that grow forever at a constant
  rate

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Constant Growth Formula

• The summation can be replaced by a single formula

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The value of operations
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Value of Equity

• Sources of Corporate Value
• Value of operations 501.225 million
• Value of non-operating assets 0 (in this case)
• Claims on Corporate Value
• Value of Debt 150.223 million
• Value of Equity ?
• Value of Equity 501.225 - 150.223 351.002
  million, or just 351 million.

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Value of Equity

• Price per share
• Equity / of shares
• 351 million / 10 million shares
• 35.10 per share

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A picture of the breakdown of Simple Co.s value
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Return on Invested Capital (ROIC)

• ROIC can be used to evaluate Simple Co.s
  performance
• ROIC NOPAT / Total operating capital in place
  at the beginning of the year

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Return on Invested Capital (ROIC)

• ROIC07 NOPAT07 / Capital06
• ROIC07 39.67104 / 315.0423 12.6.
• This is a good ROIC because it is greater than
  the return that investors require, the WACC,
  which is 10.02. So Simple Co. added value
  during 2007.

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Economic Value Added (EVATM) (also called
Economic Profit)

• EVA is another key measure of operating
  performance.
• EVA is trademarked by Stern Stewart, Inc.
• It measures the amount of profit the company
  earned, over and above the amount of profit that
  investors required.
• EVA NOPATt WACC(Capitalt-1)

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Calculating EVA

• EVA NOPAT- (WACC)(Begng. Capital)
• EVA07 NOPAT07 (0.1002)(Capital06)
• EVA07 39.67104 (0.1002)(315.0423)
• 39.67104 31.56742
• 8.1038 million

(More)
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Economic profit

• This shows that in 2007 Simple Co. earned about
  8 million more than its investors required.
• Another way to calculate EP is
• EVAt (ROIC WACC)Capitalt-1
• (0.125923 0.1002)315.0423
• 8.1038 million

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Intuition behind EVA

• If the ROIC WACC spread is positive, then the
  firm is generating more than enough profit, and
  is increasing value. But, if the ROIC WACC
  spread is negative, then the firm is destroying
  value, in the sense that investors would be
  better off taking their money and investing it
  elsewhere.

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Fundamental Analysis Practice Examples

• See XLS