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1. BU 383 Final Exam Aid
2. Laurier SOS Sponsor The Embassy Bar & Grill “Come as you are, stay for a while!”
3. Laurier SOS raised over $15 000 last year to build a primary school in Cero del Padre, Nicaragua. This could not have been done without generous donations like yours. “Kevin and James are the sons of the community leader, Jose Domingo. They became like brothers to the volunteers who participated on this outreach trip. The affection among their whole family was inspiring and made the volunteers feel more than welcome, like they too were part of the community.” – Laura & Charlie, SOS Outreach volunteers, 2011 Contact: Trip@LaurierSOS.com for more information about these amazing outreach opportunities!
4. Laurier SOS raised over $15 000 last year to build a primary school in Cero del Padre, Nicaragua. This could not have been done without generous donations like yours. “The volunteers relied on and supported one another throughout the trip. These ties have lasted beyond their stay, and remain strong to this day. Together they are able to remember the life changing experience they all shared in Nicaragua.” – Alison & Suki, SOS Outreach volunteers, 2011 Contact: Trip@LaurierSOS.com for more information about these amazing outreach opportunities!
5. Laurier SOS raised over $15 000 last year to build a primary school in Cero del Padre, Nicaragua. This could not have been done without generous donations like yours. “Every SOS trip has the opportunity to go on valuable excursions over the weekend. These trips allow the volunteers to spend quality time with one another. These excursions give volunteers the opportunity to experience the country outside of the community they live in”-– Lauren & Mark, SOS Outreach volunteers, 2011 Contact: Trip@LaurierSOS.com for more information about these amazing outreach opportunities!
6. Laurier SOS raised over $15 000 last year to build a primary school in Cero del Padre, Nicaragua. This could not have been done without generous donations like yours. “These boys were the true inspiration of the trip. They motivated the volunteers to wake up early and work as hard as they could in the limited time that they had in the community. Their enduring passion for life and positive attitude has made an impact on the volunteers forever.” – Kelly & Scott, SOS Outreach volunteers, 2011 Contact: Trip@LaurierSOS.com for more information about these amazing outreach opportunities!
7. Laurier SOS raised over $15 000 last year to build a primary school in Cero del Padre, Nicaragua. This could not have been done without generous donations like yours. “Upon arrival we were welcomed by the community of Cero del Pedre with open arms. Their amazing spirits allowed us to see just how deserving the community was, and motivated us to work as hard as we possibly could.” – Erica & Traci, SOS Outreach volunteers, 2011 Contact: Trip@LaurierSOS.com for more information about these amazing outreach opportunities!
8. Stocks Ch 4: Stock Valuation
9. Stocks Common Shares Typically don’t have a par value or fixed dividend rate Last to receive dividend payments – bear greatest portion of company’s risk Voting rights
10. Stocks Preferred Shares Preference over common shares in terms of dividend payments Most have a maturity date and face value (par value) Not entitled to vote
11. Intrinsic Value and Market Price Intrinsic Value (IV) – value at which investors believe stock is actually worth (fair market price) BUT stock’s current market price (MP) will not always be equal to IV IV > MP Buy IV < MP Sell/Sell Short IV = MP Hold
12. Intrinsic Value 3 methods to determine IV of given stock: Dividend Discount Model PV of all future cash flows generated discounted back to time 0 If all dividends are equal in value, it can be made simpler:
13. Intrinsic Value Dividend Discount Model Annual dividends that grow at constant rate of gforever (growing perpetuity)
14. Intrinsic Value Price/Earnings Ratios Compares current and estimated future ratios to historical ratios P/E = Price/EPS EPS = Net income/# total shares outstanding Thus, IV = P/E * EPS
15. Illustration P= current price E= current EPS EPS= forecasted EPS E>EPS: Forecasted P/E will be higher, so stock price is expected to increase accordingly E<EPS: Forecasted P/E will be lower, so stock price is expected to decrease accordingly
16. Intrinsic Value Price/Earnings Ratios When share generates annual dividends that grow at constant rate, g forever IV = P/E * EPS = [p/(r-g)] * EPS - where p is payout ratio
17. Intrinsic Value Market-to-Book Ratios Determines value of company by comparing its market value to its book value MV/BV If MV/BV < 1 stock is undervalued If MV/BV > 1 stock is overvalued
18. Enterprise Value Determines theoretical cost of acquiring a company EV = Market Cap + Total Debt – Cash Market cap = Total shares outstanding * Price per share EV/EBITDA determines cost of purchasing $1 of operating cash inflows of company
19. Portfolio Theory Ch 6: Portfolio Theory
20. Portfolio Theory Maximize portfolio returns given certain level of market risk The higher the risk, the higher the expected return
21. Returns Returns is the total amount appreciated in commodity value and cash flow from time t to t +1 Rt+1=(Pt+1+Dt+1-Pt)/Pt =(Pt+1-Pt)/Pt + Dt+1/Pt Expected Returns is the sum of all possible returns across all states of nature
22. Risk Measured by the variance and standard deviation which represents the spread of the outcomes around the mean of returns
23. Risk There are two types of risk: Systematic Risk  Market risk that affects the company externally Unsystematic Risk  firm specific risk that affects the company internally
24. Covariance and Correlation Covariance is a measure of how much two variables change together Correlation is the measure of relationship between two variables
25. Portfolio Theory Consider portfolio with 1 risky asset and 1 risk-free asset Risky asset  fluctuates and have variance Risk-free asset  constant rate of return and have variances of 0
26. Portfolio Theory Has weight, w invested in risky asset and remainder, (1 – w) invested in risk-free asset, so return on portfolio is: E(rp) = wE(rr) + (1 – w)Rf Standard deviation of portfolio: BUT in this case, risk free asset has variance of 0 so, σp = wσr
27. Example The Horizons Bull Plus Fund seeks daily investment results that endeavour to correspond to two times (200%) the daily performance of the S&P/TSX60 Index. The expected return on the S&P index is 8.5%, and the expected return on T-Bills (the risk free rate) is 4%. If you wanted to build a portfolio out of T-Bills and the S&P index to mimic the performance of the Bull Plus Fund, then what is the portfolio weight S&P Index (risky asset)? (Answer in percentage form to two decimal points)
28. Solution Horizon Bull Plus FundE(r) = 2 * 0.085E(r) = 0.17New PortfolioE(r) = wx*0.085 + (1-wx)*0.040.17 = wx*0.085 + (1-wx)*0.040.17 - 0.04 = 0.085wx - 0.04wx0.13 = 0.045wxwx = 2.8889wx = 288.89%
29. Capital Market Line Determines return on entire portfolio based on risk free rate of return and level of risk associated with market portfolio Relationship between risk and return using standard deviation
30. Capital Market Line Think of CML as a linear function with risk (standard deviation) as x-axis and rate of return as y-axis Slope of efficient portfolio is the Sharpe Index
31. Beta Beta (β) Measure of how the certain of the stock in the portfolio contributes to the overall risk of portfolio and volatility of stock with respect to market index Market index always has beta value = 1 Beta value of portfolio of stocks  sum of weighted betas of all individual stocks:
32. Treynor Index Treynor Index Return on portfolio by measuring return per unit of portfolio volatility
33. Security Market Line Security Market Line (SML) Relationship between risk and return using Beta value Slope of SML including market portfolio: all treynor indexes are same for every stock Thus, expected return for any stock, i in efficient portfolio:
34. Example Consider the data on expected returns and betas for a variety of assets in the table below. What is the expected return on shares of VersaLife Corporation using the SML?
35. Solution Rf = 4% E(Rm) = 8%E(r) = Rf + B * (E(Rm) – Rf ) E(r) = 0.04 + 0.5 * (0.08 - 0.04)E(r) = 6%
36. Futures and Options Ch 8: Futures and Options
37. Futures and Forwards Futures Contract: agreement in which buyer agrees with seller on purchase price of commodity today, but cash transaction occurs at future date Hedging on future outcome by buying or selling short the contract Reduce pre-existing price exposure
38. Futures and Forwards In a forwards contract: Short Hedge – speculates that price of commodity will Long Hedge – speculates that price of commodity will
39. Example Farmer Brown sold 20 wheat futures contracts back in May. The contracts are for November delivery at a price of $5.3525/bu. Farmer Brown sold the contracts to protect against a drop in wheat prices. As an alternative to what Farmer Brown did, which of the following transactions would have most helped him hedge the risk of a price drop in wheat? Sell wheat call option contracts  Buy wheat put option contracts  Sell wheat put option contracts  Buy wheat call option contracts
40. Solution If you buy wheat put option contracts, you can sell your wheat at a guaranteed price if the price were to fall. If the price doesn't fall below the strike price, then don't exercise the options and just sell at the market price. The largest possible loss is the price of the options and you are guaranteed to sell at the strike price or higher.If you were to take a long position in a call option and the prices were to drop, you would only profit the price of the call option. However, if the price were to rise, the person in the short position would exercise the option and you could lose an infinite amount of money.Buying call options and selling put options are useless if you expect the price to fall.
41. Options Gives option owner right to buy (calls) or sell (puts) at fixed price before a certain date in future Option positions:
42. Options Payoffs and profits by all 4 positions: ST = Stock price at T E = Exercise Price 0 = Current time Payoff = All proceeds from exercising option Profit = Payoff – purchase price of option (premium) Note: Payoff of 0 is when holder chooses to not exercise option
43. Example You buy 15 wheat futures contracts when the futures price is $2.61 per bushel (each contract is worth 5,000 bushels).  The price on the maturity date is $2.07.  What is your payoff?
44. Solution We are forced to exercise the future upon its expiry and, unfortunately, the price has gone down, so we still have to pay the $2.61 even though the market price is $2.07.Price if bought before = 5000*15*2.61 = $195750Price if bought at current price = 5000*15*(2.07) = $155250Difference = $155250 - $195750Difference = $-40500So we pay an extra $40,500 because we held the futures contract upon its expiry.
45. Example Shares in Vandelay Industries are trading for $13.47. Call options on Vandelay Industries shares which expire in six months with a strike price of $22.39 are trading for $4.5. Put options on Vandelay Industries shares which expire in six months with a strike price of $22.39 are trading for $11.53. Consider an investor who buys one put and sells one call. What is the profit for the combined position if the stock price is $15.36 at maturity? Assume that there is one share per contract. Assume that the options are exercised at maturity and the stocks, if any, are sold at that price.
46. Solution Profit for Short Call = -1 * MAX[0, Pricet - Strike)] + Call PremiumProfit for Short Call = [4.5,2]Profit for Long Put = MAX[0, Strike – Pricet)] – Put PremiumProfit for a Long Put: -4.5Profit from combined position: Profit for Short Call + Profit for Long PutProfit from combined position: 0
47. Intrinsic Value and Time Premium IV of option is its payoff IV of Call = MAX(0, ST – E) IV of Put = MAX(0, E – ST) Time premium (TP) is Premium less IV for both call and put
48. Cash Flow Ch 9: Cash Flow
49. Liquidity Ability to generate cash and pay bills and debts on time Liquidity is critical – need cash to support operations; If insolvent, firm is a likely candidate for bankruptcy
50. Free Cash Flow Amount of money a company would have if they were the sole owner and lender of the company FCF consists of three components: Operating Cash Flow Capital Expenditures Net Change in Working Capital FCF = Operating CF – Net Capital Expenditure – Net Change in Working Capital
51. Operating Cash Flow Amount of cash generated from day to day business activities Can be calculated in two ways: 1) Operating CF = Sales – (COGS + Selling , General, Administrative Expenses + Taxes) 2)Operating CF = EBIT (Earnings before Interest and Tax) + Depreciation - Taxes
52. Capital Expenditure Purchases of LT assets such as machinery and equipment Net Asset Value (Nett) = Past Net Asset Value (Nett-1) – Depreciationt Capital Expenditure at time t (CapExt) = Nett - Nett-1 + Depreciation
53. Net Change in Working Capital Working Capital Measure of the ability of the company to cover its ST debt obligations A positive change in working capital signifies the use of cash A negative change in working capital signifies the addition of cash NWC = (Current Assets – Cash) – (Current Liabilities – ST Debt – Current Portion of LT Debt)
54. Free Cash Flow Positive Free Cash Flow  can be placed into cash, given to stockholders through dividends, or to lenders through interest and principal repayment Negative Free Cash Flow  signifies that company requires bank loan or issuance of new debt/equity to finance operations
55. Cash Budgets Ch 10: Cash Budgets
56. Cash Budgets Estimation of cash inflows and outflows for specific period of time Used to assess whether entity has sufficient cash to: Meet on-going obligations Meet contingencies Invest when attractive opportunities arise Should tie in with pro forma financial statements
57. 5 Steps to Creating Cash Budget Develop a sales and production scenario for the future based on explicit assumptions. - Forecast sales, costs and equipment/capital needs Determine cash inflows from operations -Total Cash Inflows = cash sales per period + credit sales collected that period Determine cash outflows from operations -Total Cash Ouflows= Total purchases made in a specified period Determine net capital expenditures -Net Cash from Operations = Total cash inflow – total cash outflow Determine financing needed to support plan (or excess generated) -Cash Flow = Net CF from Operations – Other CF
58. Ch 11: Pro Forma Financial Statements
59. Percentage of Sales Method MODEL INPUTS Forecast of next year’s sales Asset Requirements – Investment needed to support sales growth Plug Variables – designated sources of external financing ; Reflect s the amount of debt and equity that a company is willing to take on for the following year
60. Pro Forma Financial Statements Cost of Goods Sold and General & Admin. Expenses  % of sales Interest and Depreciation  % of debt at end of current year Depreciationst= (Nett+CapExt+1)(Avg. Depreciation Rate) Dividends and R/E  assuming historical ratio remains constant Current assets and current liabilities  % of sales Net Fixed Assets Net Fixed Assetst+1=(Net Fixed Assetst+ CapExt+1) * (1 - Avg. Depreciation Rate)
61. Ratio Analysis Ratio Analysis
62. Liquidity Ratios Measure company’s ability to pay off its short term financial obligations Current Ratio = Current Assets/Current Liabilities; Rule of Thumb is 3:1 Quick Ratio = (Current Assets – Inventory)/ Current Liabilities; Rule of Thumb is 2:1 Net Working Capital to Total Capital Ratio = (Current Assets – Current Liabilities)/(Total Assets – Current Liabilities); Rule of Thumb is industry avg
63. Liquidity Ratios Inventory Turnover = Sales (or COGS)/Inventory; Rule of Thumb is industry avg Day’s Inventory = Inventory / (COGS/365) Accounts Receivable Turnover = Sales / Accounts Receivable; Rule of Thumb is industry avg Day’s Receivable = Accounts Receivable / (Sales/365)
64. Liquidity Ratios Accounts Payable Turnover = COGS/Accounts Payable; Rule of Thumb is industry avg Day’s Payable = Accounts Payable/(COGS/365)
65. Example Your firm's banker is getting nervous about your liquidity. Which of the following actions would increase the firm's current ratio (which is presently 0.6) and ease the bank's concern? A cash sale of inventory at cost.  Sell 30-year bonds to purchase fixed assets.  Sell some of the firm's long-term bonds and purchase marketable securities.  Allow preferred shareholders to convert into commonholders.  File for bankruptcy.
66. Solution The current ratio is calculated as current assets/current liabilities.  Any action to increase current assets and/or decrease current liabilities will improve the ratio. The correct answer in this case is the choice of selling the long-term bonds and purchasing marketable securities as it is the option that results in the best net change in either of the current ratio variables (in this case current assets).
67. Profitability Ratios Measure a company’s ability to generate earnings compared to expenses incurred during a specified period Return on Equity = Net Income/Equity Return on Assets = Net Income/Total Assets Profit Margin = Net Income / Sales Gross Margin = (Sales – COGS) / Sales Cost Ratio = Cost / Sales
68. Debt Management Ratios Analyzes company’s ability to pay interest and repay principal; how leveraged the company is Debt Ratio = (LT Debt + ST Debt)/Total Assets Debt to Total Capital Ratio = Total Debt/(Total Debt + Equity) Debt to Equity Ratio = Total Debt/Equity Times Interest Earned Ratio = EBIT/Interest
69. Debt Management Ratios Asset Coverage Ratio =LT Tangible Assets/ Total Debt where LT Tangible Assets = Total Assets – Intangible Assets – (Current Liabilities – ST Debt) Cash Flow to Debt = Cash Flow / Total Debt
70. Asset Management Ratios Measure how quickly a company can convert its assets into cash Total Asset Turnover = Sales/Total Assets Net Working Capital Turnover = Sales / NWC Fixed Asset Turnover = Sales/Net Fixed Assets
71. Market Ratios Measure how attractive investors believe a company’s stock is Price-Earnings Ratio (P/E) = Price per share/Earnings per share Market to Book Ratio = Book Value/Market Value; Rule of Thumb: >1 implies the stock is undervalued and <1 implies the stock is overvalued
72. Market Ratios Dividend Payout = Dividends/Net Income Dividends Yield = Dividends per Share / Market Price
73. Operating and Cash Conversion Cycle Operating Cycle = Day’s Inventory + Day’s Receivable Cash Conversion = Operating Cycle – Day’s Payable
74. DuPont Analysis It breaks up ROE into three parts, in order to determine which part of the business is underperforming Operating Efficiency (Profit Margin) Asset Use Efficiency (Total Asset Turnover) Financial Leverage (Equity Multiplier) ROE = Profit Margin x Total Asset Turnover x (1+Debt/Equity)
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76. ANY QUESTIONS??