FIN 331 in a Nutshell. Financial Management I Review. FIN 331 in a Nutshell  Index. Financial Statements, Ratios, & AFN Time Value of Money Bond Valuation Risk & Return (SML/CAPM) Stock Valuation WACC NPV, IRR, MIRR Cash Flow Estimation.
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Financial Management I Review
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Key Financial Statements
Balance sheet
Income statements
Statement of cash flows
Index
Net income=Dividends + Retained earnings
Reconciles the change in Cash & Equivalents
Why is it important???
“A positive net income on the income statement is ultimately insignificant unless a company can translate its earnings into cash, and the only source in financial statement data for learning about the generation of cash from operations is the statement of cash flows”
Covered by new debt and cash
If the Asset side had included “Shortterm investments” they would have been excluded as well.
= NOWC + Net fixed assets
= Op Cap (2005) – Op Cap (2004)
= $1,800  $1,520 = $280 million
NOPAT05 = $283.8(1  0.4) = $170.3 m
OCF05 = NOPAT + Deprec + Amort
= $170.3 + $100
= $270.3
Net Operating Profit after Taxes (NOPAT) & Operating Cash FlowEBIT = $283.8 m T = 40% Depreciation = $100 m
Capital Expenditures = FA + Deprec = $130+$100 = $230
NOWC = $800  $650 = $150 m
FCF = [$283.8(1.4)+$100] –[$230$150]
= $109.7 m
Free Cash Flow (FCF) for 2005Ratio Analysis
Limitations of ratio analysis
Qualitative factors
Index
= CA/CL
= (CAINV)/CL
= Receivables /(Annual sales/365)
= Sales/Net Fixed Assets
= Sales/Total Assets
= EBIT/Interest
(EBITDA + lease pmts) .
(Interest + principal pmts + lease pmts)
= NI/Sales
= EBIT/Total Assets
= NI/Total Assets
= NI/Common Equity
= Price per share/Earnings per share
= Price per share/Cash flow per share
= Market price per share
Book value per share
Forecasting sales
Projecting the assets and internally generated funds
Projecting outside funds needed
Deciding how to raise funds
Index
If ratios are expected to remain constant:
AFN = (A*/S0)∆S  (L*/S0)∆S  M(S1)(RR)
Required Assets
Retained Earnings
Spontaneously Liabilities
“Capital Intensity Ratio”
income not paid as dividend
0
1
2
3
I%
CF0
CF1
CF2
CF3
+CF = Cash INFLOWCF = Cash OUTFLOWPMT = Constant CF
Present Value(PV)
Future Value(FV)
FV = PV(1 + I)N
FV = future value
PV = present value
PMT = periodic payment
I/Y = period interest rate
N = number of periods
One of these MUST be negative
N I/Y PV PMT FV
=FV(rate,nper,pmt,pv)
=PV(rate,nper,pmt,fv)
=RATE(nper,pmt,pv,fv)
=NPER(rate,pmt,pv,fv)
Suppose you invest $100 for 5 years at 10%
How much would you have?
Formula Solution:
FV =PV(1+I)N
=100(1.10)5
=100(1.6105)
=161.05
Suppose you invest $100 for 5 years at 10%. How much would you have?
Calculator Solution
For a given interest rate:
FV = PV(1 + I)N
For a given I, as N increases, FV increases
For a given time period:
FV = PV(1 + I)N
For a given N, as I increases, FV increases
FV = PV(1 + I)N
PV = FV / (1+I)N
PV = FV(1+I)N
PV = 10,000(1.07)1 = 9,345.79
=PV(0.07,1,0,10000)
For a given interest rate:
For a given I, as N increases, PV decreases
For a given time period:
For a given N, as I increases, PV decreases
PV = FV / (1 + I)N
There are four parts to this equation
+CF = Cash INFLOWCF = Cash OUTFLOW
4 Answer
0
1
2
3
12%
200
400
600
800
178.57
318.88
427.07
508.41
What is the PV of this uneven cash flow stream?1,432.93 = PV
Year 1 CF: 1 N; 12 I/Y; 200 FV; CPT PV = 178.57
Year 2 CF: 2 N; 12 I/Y; 400 FV; CPT PV = 318.88
Year 3 CF: 3 N; 12 I/Y; 600 FV; CPT PV = 427.07
Year 4 CF: 4 N; 12 I/Y; 800 FV; CPT PV = 508.41
Total PV = $1,432.93
Clear all:
CF0 is displayed and is 0
Enter the Period 0 cash flow
To enter the figure in the cash flow register, press ENTER
CF
C000ENTER
C01200 ENTER
F011 ENTER
C02400 ENTER
F021 ENTER
C03600 ENTER
F031 ENTER
C04 800 ENTER
F04 1 ENTER NPV
I12 ENTER
NPV CPT
1432.93
Cash Flows:
CF0 = 0
CF1 = 200
CF2 = 400
CF3 = 600
CF4 = 800
r = Any nominal rate
r* = The “real” riskfree rate
≈ Tbill rate with no inflation
Typically ranges from 1% to 4% per year
rRF = Rate on Treasury securities
Proxied by Tbill or Tbond rate
Here: Answer
r = Required rate of return on a debt security
r* = Real riskfree rate
IP = Inflation premium
DRP = Default risk premium
LP = Liquidity premium
MRP = Maturity risk premium
r = r* + IP + DRP + LP + MRPrRF=
ST Treasury ST IP
LT Treasury LT IP MRP
ST Corporate ST IP DRP LP
LT Corporate LT IP DRP MRP LP
Debt Instrument IP DRP MRP LP
The discount rate (YTM) is:
For debt securities:
YTM = r* + IP + LP + MRP + DRP
N I/Y PV PMT FV Answer
Texas Instruments BAII PlusFV(Rate,Nper,Pmt,PV,0/1)
PV(Rate,Nper,Pmt,FV,0/1)
RATE(Nper,Pmt,PV,FV,0/1)
NPER(Rate,Pmt,PV,FV,0/1)
PMT(Rate,Nper,PV,FV,0/1)
10
 887
90
1000
INPUTS
N
I/YR
PV
PMT
FV
OUTPUT
10.91
YTM on a 10year, 9% annual coupon, $1,000 par value bond selling for $887
=RATE(10,90,887,1000)
10
1134.2
90
1000
INPUTS
N
I/YR
PV
PMT
FV
OUTPUT
7.08
YTM on a 10year, 9% annual coupon, $1,000 par value bond selling for $1,134.20
=RATE(10,90,1134.20,1000)
2N
rd / 2
OK
cpn / 2
OK
INPUTS
N
I/YR
PV
PMT
FV
OUTPUT
20
6.5
50
1000
INPUTS
N
I/YR
PV
PMT
FV
OUTPUT
 834.72
Using the formula:
=PV(0.065, 10, 50, 1000)
N = 40
PV = 1197.93
PMT = 50
FV = 1000
CPT I/Y = 4%
YTM = 4%*2 = 8%
Result = ½ YTM
NOTE: Solving a semiannual payer for YTM will result in a 6month YTM answer
Calculator solves what you enter.
r “hat” = expected return
ri = expected return in “ith” state of the economy
Pi = Probability of “ith” state occurring
^
CV = Standard deviation/expected return
= Risk per unit of return
=
^
Assume a twostock portfolio is created with
$50,000 invested in both HT and Collections
^
rp = 0.5(12.4%) + 0.5(1.0%) = 6.7%
“Portfolio” = (50% x HT) + (50% x Coll)
“Portfolio Return” = Prob x “Portfolio”
Portfolio Standard deviation is NOT a weighted average of the standard deviations of the component assets
Measures how much the returns on two risky assets move together
Covariance (HT:Coll) = 0.0264
If r = 1.0
If r = +1.0
In general, stocks have r≈ 0.35
Investors typically hold many stocks
i j for n=2
1 1 w1w111 = w1212
1 2 w1w212
2 1 w2w121
2 2 w2w222 = w2222
p2= w1212 + w2222 + 2w1w2 12
Assume: rRF = 5.5% RPM = 5%
= 5.5% + 6.6% = 12.10%
SML: ri = 5.5% + (5.0%) i
ri (%)
SML
.
HT
.
.
rM = 10.5
rRF = 5.5
.
USR
Tbills
.
Risk, i
1 0 1 2
Coll.
Where:
wi =weight (% dollars invested in asset i)
βi = Beta of asset i
βp=Portfolio Beta
Constant growth stock valuation
Nonconstant growth stock valuation
Corporate value model
Index
D1 = D0 (1+g)1
D2 = D0 (1+g)2
Dt = D0 (1+g)t
Needed data:
D0 = Dividend just paid
D1 = Next expected dividend
g = constant growth rate
rs = required return on the stock
0 if r
1
2
3
4
rs = 13%
...
g = 30%
g = 30%
g = 30%
g = 6%
D0 = 2.00 2.600 3.380 4.394
4.658
2.301
2.647
3.045
4.658
=
=
$66.54
46.114

0.13
0.06
54.107 = P0
Valuing common stock with nonconstant growth$
P
Market value of firm:
MV of common stock:
Intrinsic stock value:
0 if r
1
2
3
4
r = 10%
...
g = 6%
5 10 20
21.20
4.545
8.264
15.026
21.20
398.197
530= = TV3
0.10

0.06
416.942
Firm’s Intrinsic ValueLongrun gFCF = 6% WACC = 10%
= $416.94  $40
= $376.94 million
= $376.94 / 10
= $37.69
Cost of equity
WACC
Adjusting for risk
Index
WACC = wdrd(1T) + wprp + wcrs
Where:
wD = % of debt in capital structure
wP= % of preferred stock in capital structure
wC= % of common equity in capital structure
rD = firm’s cost of debt
rP= firm’s cost of preferred stock
rC= firm’s cost of equity
T = firm’s corporate tax rate
Weights
Component costs
1. DCF: rs = D1/P0 + g
2. CAPM: rs = rRF + (rM  rRF)βi
= rRF + (RPM)βi
3. OwnBondYieldPlusRisk Premium:
rs = rd + Bond RP
Rate of Return
(%)
Acceptance Region
WACC
WACC
H
Acceptance Region
Rejection Region
WACC
F
Rejection Region
WACC
L
Risk
0
Risk
Risk
L
H
Independent vs. mutually exclusive CFs
Normal vs. nonnormal CFs
NPV
IRR
MIRR
PB
DPB
Index
n for each of its projects?
CFt
.
∑
NPV =
(1 + r)t
t = 0
n
CFt
∑
 CF0
NPV =
(1 + r)t
t = 1
NPV: Sum of the PVs of all cash flows.NOTE: t=0
Cost often is CF0 and is negative
CF
C00100 +/ENTER
C0110 ENTER
F011 ENTER
C0260 ENTER
F021 ENTER
C0380 ENTER
F031 ENTER NPV
I10 ENTER
NPV CPT
$18.78
Cash Flows:
CF0 = 100
CF1 = 10
CF2 = 60
CF3 = 80
IRR = discount rate that forces PV of inflows equal to cost, and NPV = 0:
Solving for IRR with a financial calculator:
n for each of its projects?
CFt
∑
= NPV
(1 + r)t
t = 0
n
CFt
∑
= 0
(1 + IRR)t
t = 0
NPV vs IRRNPV: Enter r, solve for NPV
IRR: Enter NPV = 0, solve for IRR
Normal Cash Flow Project:
Nonnormal Cash Flow Project:
The Pavillion Project: for each of its projects?Nonnormal CFs and MIRR
1
2
0
800,000
5,000,000
5,000,000
PV outflows @ 10% = 4,932,231.40
TV inflows @ 10% = 5,500,000.00
MIRR = 5.6%
Relevant cash flows
Net salvage value
Inflation
Sensitivity analysis
Scenario analysis
Real options
Index
Project’s incremental cash flow is:
Corporate cash flow with the project
Minus
Corporate cash flow without the project
Changes in Net Working Capital…… Y
Interest/Dividends …………..………….. N
“Sunk” Costs ………………………………….. N
Opportunity Costs ………………………….Y
Externalities/Cannibalism …………….. Y
Tax Effects ………………………..………….. Y
Net Salvage Cash Flow
= SP  (SPBV)(T)
Where:
SP = Selling Price
BV = Book Value
T = Corporate tax rate
Nominal r > real r
The cost of capital, r, includes a premium for inflation
Nominal CF > real CF
Nominal cash flows incorporate inflation
If you discount real CF with the higher nominal r, then your NPV estimate is too low
2 Ways to adjust for each of its projects?
Adjust WACC
Cash Flows = Real
Adjust WACC to remove inflation
Adjust Cash Flows for Inflation
Use Nominal WACC
INFLATION
Real vs. Nominal Cash flows
Shows how changes in an input variable affect NPV or IRR
Each variable is fixed except one
Change one variable to see the effect on NPV or IRR
Answers “what if” questions
%NPV = (New NPV  Base NPV)/Base NPV
%VAR = (New VAR  Base VAR)/Base VAR
14162
30% $ 62 $54 $266
0 20 20 20
%NPV (6220)/20 (5420)/20 (26620)/20 4.1% 1.7% 12.3%
%VAR 30% 30% 30%
SR 13.74 5.72 41.22
14163
Change from Resulting NPV (000s)
Base Level Unit Sales FCVC
Steeper sensitivity lines = greater risk
Small changes → large declines in NPV
The Variable Cost line is steeper than unit sales or fixed cost so, for this project, the firm should focus on the accuracy of variable cost forecasts.
Does not reflect diversification
Says nothing about the likelihood of change in a variable
i.e. a steep sales line is not a problem if sales won’t fall
Ignores relationships among variables
Provides indication of standalone risk
Identifies dangerous variables
Gives some breakeven information
Examines several possible situations, usually:
Worst case
Base case or most likely case, and
Best case
Provides a range of possible outcomes
Only considers a few possible outcomes
Assumes that inputs are perfectly correlated
All “bad” values occur together and all “good” values occur together
Focuses on standalone risk
Computerized version of scenario analysis using continuous probability distributions
Computer selects values for each variable based on given probability distributions
Calculates NPV and IRR
Process is repeated many times (1,000 or more)
End result: Probability distribution of NPV and IRR based on sample of simulated values
Generally shown graphically
Reflects the probability distributions of each input
Shows range of NPVs, the expected NPV, σNPV, and CVNPV
Gives an intuitive graph of the risk situation
Difficult to specify probability distributions and correlations
If inputs are bad, output will be bad:“Garbage in, garbage out”
Sensitivity, scenario, and simulation analyses do not provide a decision rule
Do not indicate whether a project’s expected return is sufficient to compensate for its risk
Sensitivity, scenario, and simulation analyses all ignore diversification
Measure only standalone risk, which may not be the most relevant risk in capital budgeting
When managers can influence the size and risk of a project’s cash flows by taking different actions during the project’s life in response to changing market conditions
Alert managers always look for real options in projects
Smarter managers try to create real options
Investment timing options
Growth options
Expansion of existing product line
New products
New geographic markets
Abandonment options
Contraction
Temporary suspension
Flexibility options