FIN 331 in a Nutshell

Financial Management I Review

for FIN 431

331NS-1

Time Value of Money

Timelines
Future Value
Present Value
Present Value of Uneven Cash Flows

331NS-2

Time Lines: Timing of Cash Flows

0

CF1

CF2

CF3

I%

CF0

Tick marks occur at the end of periods

Time 0 = today
Time 1 = the end of the first period or the
beginning of the second period

+CF = Cash INFLOW -CF = Cash OUTFLOW

PMT = Constant CF
331NS-3

Basic Definitions

Present Value

The current value of future cash flows

discounted at the appropriate discount
rate
Value at t=0 on a time line

Future Value

(PV)

(FV)

The amount an investment is worth

after one or more periods.
Later money on a time line
331NS-4

Future Value: General Formula

FV = PV(1 + I)N

FV = future value
PV = present value
I = period interest rate, expressed
as a decimal
N = number of periods
Future value interest factor = (1 + I)N
Note: yx key on your calculator
331NS-5

Texas Instruments BA-II Plus

FV = future value One of these MUST

be negative
PV = present value
PMT = periodic payment
I/Y = period interest rate
N = number of periods
I/Y

PV

PMT

FV

331NS-6

Excel Spreadsheet Functions

=FV(rate,nper,pmt,pv)

=PV(rate,nper,pmt,fv)

=RATE(nper,pmt,pv,fv)

=NPER(rate,pmt,pv,fv)

Use the formula icon (x) when you

cant remember the exact formula

331NS-7

Future Values Example

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
331NS-8

Future Value Example

Suppose you invest $100 for 5

years at 10%. How much would
you have?
Calculator Solution

5
N

10
I/Y

-100 PV

0
PMT

CPT FV
= 161.05

331NS-9

Future Value:
Important Relationship 1
For a given interest rate:
The longer the time period,
The higher the future value

FV = PV(1 + I)N
For a given I, as N increases, FV increases

331NS-10

Future Value
Important Relationship 2
For a given time period:

The higher the interest rate,

The larger the future value

FV = PV(1 +
I)N

For a given N, as I increases, FV increases

331NS-11

Present Values

The current value of future cash flows

discounted at the appropriate discount
rate
Value at t=0 on a time line
Answers the questions:

How much do I have to invest today to have

some amount in the future?
What is the current value of an amount
to be received in the future?

331NS-12

Present Values

FV = PV(1 + I)N

Rearrange to solve for PV

PV = FV / (1+I)N
PV = FV(1+I)-N

Discounting = finding the present

value of one or more future amounts
331NS-13

Present Value: One Period

Example

You need
$10,000 for the
down payment
on a new car
You can earn 7%
annually.
How much do
you need to
invest today?

1 N;
7 I/Y;
0 PMT;
10000 FV;
CPT PV = -9345.79

PV = 10,000(1.07)-1 = 9,345.79

=PV(0.07,1,0,10000)

331NS-14

Present Value:
Important Relationship 1
For a given interest rate:

The longer the time period,

The lower the present value

FV
PV
N
( 1 I )

For a given I, as N increases, PV decreases

331NS-15

Present Value
Important Relationship 2
For a given time period:

The higher the interest rate,

The smaller the present value

FV
PV
N
( 1 I )
For a given N, as I increases, PV decreases
331NS-16

The Basic PV Equation Refresher

PV = FV / (1 + I)N
There are four parts to this equation

PV, FV, I and N

Know any three, solve for the fourth

If you are using a financial calculator,

be sure and remember the sign
convention
+CF = Cash INFLOW -CF = Cash OUTFLOW
331NS-17

Multiple Cash Flows

Present Value

The Basic Formula

The TI BA II+

Using the PV/FV keys

Using the Cash Flow Worksheet

Excel

331NS-18

Multiple Uneven Cash Flows

Present Value

You are offered an investment that

will pay

$200 in year 1,
$400 the next year,
$600 the following year, and
$800 at the end of the 4th year.
You can earn 12% on similar investments.
What is the most you should pay for this
investment?
331NS-19

What is the PV of this

uneven cash flow stream?
0

200

400

600

800

12%

-178.57
-318.88
-427.07
-508.41
-1,432.93 = PV
331NS-20

Present Value of an Uneven

Cash Flow Stream: Formula

1
PV CFt

1 I
t 1
N

PV CFt 1 I

t 1

331NS-21

Multiple Uneven Cash Flows PV

Year
Year
Year
Year

1
2
3
4

CF:
CF:
CF:
CF:

1
2
3
4

N;
N;
N;
N;

12
12
12
12

I/Y;
I/Y;
I/Y;
I/Y;

200
400
600
800

FV; CPT
FV; CPT
FV; CPT
FV; CPT
Total PV

PV
PV
PV
PV

=
-178.57
=
-318.88
=
-427.07
=
-508.41
= -$1,432.93

331NS-22

Multiple Uneven Cash Flows

Using the TI BAIIs Cash Flow Worksheet

Clear all:

Press CF
Then 2nd
And CLR WORK (above CE/C)

CF0 is displayed and is 0

Enter the Period 0 cash flow

If it is an outflow, hit +/- to change the sign

To enter the figure in the cash flow register,

press ENTER
331NS-23

TI BAII+: Uneven CFs

Press the down arrow () to move to the

next cash flow register.
Enter the cash flow amount, press ENTER
and then down arrow to move to the cash
flow counter (Fn).
The default counter value is 1.

To accept the value of 1, press the down

arrow again.
To change the counter, enter the correct count,
press ENTER and then the down arrow.
331NS-24

TI BAII+: Uneven CFs

Repeat for all cash flows, in order.

To find NPV:
Press NPV: I appears on the screen

Enter the interest rate, press ENTER and

the down arrow to display NPV.
Press compute CPT

331NS-25

TI BAII+: Uneven Cash Flows

Cash Flows:
CF0

CF1

200

CF2

400

CF3

600

CF4

800

C00
C01
F01
C02
F02
C03
F03
C04
F04
I
NPV

CF
0 ENTER
200 ENTER
1 ENTER
400 ENTER
1 ENTER
600 ENTER
1 ENTER
800 ENTER
1 ENTER NPV
12 ENTER
CPT
1432.93
331NS-26

Excel PV of multiple uneven CFs

331NS-27

CHAPTER 3
Financial Statements, Cash
Flow, and Taxes

Key Financial Statements

Balance sheet
Income statements
Statement of cash flows

331NS-28

The Annual Report

Balance sheet

Income statement

Snapshot of a firms financial position at a

point in time
Summarizes a firms revenues and
expenses over a given period of time

Statement of cash flows

Reports the impact of a firms activities on

cash flows over a given period of time
331NS-29

Sample Balance Sheet

Assets =
Liabilities +
Owners Equity

331NS-30

Sample Income Statement

Net income=Dividends + Retained earnings

331NS-31

Allied Food Products

331NS-32

Allied 2005 Per-Share Ratios

Ratio
Earnings per
Share (EPS)
Dividends per
Share (DPS)
Book Value per
Share (BVPS)
Cash flow per
Share (CFPS)

Formula & Calculation

Net Income
$117 .5

$2.35
Shares Outstanding
50
Common dividends $57.5

$1.15
Shares Outstanding
50

Shareholder Equity $940.00

$18.80
Shares Outstanding
50
Operating Cash Flow $217.5

$4.35
Shares Outstanding
50
331NS-33

Statement of Cash Flows

Provides information about cash

inflows and outflows during an
accounting period
Required since 1988
Developed from Balance Sheet and
Income Statement data

331NS-34

Statement of Cash Flows

Reconciles the change in Cash & Equivalents

331NS-35

331NS-36

Statement of Cash Flows

Why is it important???

Reconciles the Income Statement

and Balance Sheet to the flow of
cash

The Matching Principle requires

estimates and accruals to prepare
Financial statements
Financial Analysis is concerned with
Cash Flow
331NS-37

Statement of Cash Flows

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

331NS-38

Deficits

Covered
by new
debt and
cash

331NS-39

Net Operating Working Capital

331NS-40

Operating Capital

(also called Total Net Operating Capital)

Operating Capital
= NOWC + Net fixed assets

Operating Capital

(2005) = $800 + $1,000 = $1,800 million

(2004) = $650 + $870 = $1,520 million

Net Investment in Operating Capital

= Op Cap (2005) Op Cap (2004)
= $1,800 - $1,520 = $280 million

331NS-41

Net Operating Profit after Taxes

(NOPAT) & Operating Cash Flow
NOPAT

= EBIT(1 - Tax rate)

NOPAT05 = $283.8(1 - 0.4) = $170.3

m
OCF05

= NOPAT + Deprec + Amort

= $170.3 + $100
= $270.3
331NS-42

Free Cash Flow (FCF) for 2005

FCF EBIT(1 T) Deprec & Amort

Capital Expenditures NOWC

OCF - Investment in Operating Capital

EBIT = $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
331NS-43

CHAPTER 4
Analysis of Financial
Statements

Ratio Analysis
Limitations of ratio analysis
Qualitative factors

331NS-44

Five Major Categories of Ratios

Liquidity

Asset management

CR - Current Ratio
QR - Quick Ratio or Acid-Test
Inventory Turnover
DSO Days sales outstanding
FAT - Fixed Assets Turnover
TAT - Total Assets Turnover

Debt management

Debt Ratio
TIE Times interest earned
EBITDA coverage (EC)
331NS-45

Five Major Categories of Ratios

Profitability

PM - Profit margin on sales

BEP Basic earning power
ROA Return on total assets
ROE Return on common equity

Market value

P/E Price-Earnings ratio

P/CF Price cash flow ratio
M/B Market to book

331NS-46

Liquidity Ratios

CR

= Current Ratio

= CA/CL

QR = Quick Ratio or Acid-Test

= (CA-INV)/CL

331NS-47

Asset Management Ratios

Inventory Turnover = Sales/Inventories

DSO = Days sales outstanding

= Receivables /(Annual
sales/365)

FAT = Fixed Assets Turnover

= Sales/Net Fixed Assets

TAT = Total Assets Turnover

= Sales/Total Assets
331NS-48

Debt Management Ratios

Debt Ratio = Total Liabilities/Total Assets

TIE

= Times interest earned

= EBIT/Interest

EBITDA coverage = EC
(EBITDA + lease pmts)
.
(Interest + principal pmts + lease pmts)

331NS-49

Profitability Ratios

PM

= Profit margin on sales

= NI/Sales

BEP = Basic earning power

= EBIT/Total Assets

ROA = Return on total assets

= NI/Total Assets

ROE = Return on common equity

= NI/Common Equity
331NS-50

Market Value Metrics

P/E = Price-Earnings ratio

= Price per share/Earnings per share

P/CF = Pricecash flow ratio

= Price per share/Cash flow per

share

M/B = Market to book

= Market price per share

Book value per share

331NS-51

The 5 Major Categories of Ratios and

What Questions They Answer
Ratio Category
Liquidity

Questions Answered
Can we make required payments?

Asset Management Right amount of assets vs. sales?

Debt Management Right mix of debt and equity?
Profitability

Market Value

Do sales prices exceed unit costs

Are sales high enough as reflected in
PM, ROE, and ROA?
Do investors like what they see as
reflected in P/E and M/B ratios
331NS-52

Potential Problems and

Limitations of Ratio Analysis

Comparison with industry averages is

difficult if the firm operates many
different divisions
Average performance necessarily
good
Seasonal factors can distort ratios
Window dressing techniques

331NS-53

Problems and Limitations

(Continued)

Different accounting and operating

practices can distort comparisons
Sometimes difficult to tell if a ratio
value is good or bad
Different ratios give different signals

Difficult to tell, on balance, whether a

company is in a strong or weak financial
condition

331NS-54

Qualitative Factors

Revenues tied to a single customer?

Revenues tied to a single product?
Reliance on a single supplier?
Percentage of business generated
overseas?
Competitive situation?
Legal and regulatory environment?

331NS-55

CHAPTER 16

Financial Planning and Forecasting

Forecasting sales
Projecting the assets and internally
generated funds
Projecting outside funds needed
Deciding how to raise funds

331NS-56

The AFN Formula

If ratios are expected to remain constant:
AFN = (A*/S0)S - (L*/S0)S - M(S1)(RR)
Required Assets
Spontaneously
Liabilities

Retained
Earnings

331NS-57

Variables in the AFN Formula

A* = Assets tied directly to sales

S0 = Last years sales

S1 = Next years projected sales

S = Increase in sales; (S1-S0)

L* = Liabilities that spontaneously

increase with sales

331NS-58

Variables in the AFN Formula

A*/S0: assets required to support

sales;
Capital Intensity Ratio

L*/S0: spontaneous liabilities ratio

M: profit margin (Net income/sales)

RR: retention ratio; percent of net
income not paid as dividend

331NS-59

Key Factors in AFN

S
=
A*/S0 =

Sales Growth
Capital Intensity Ratio

L*/S0 =
Ratio
M
=
RR
=

Spontaneous Liability
Profit Margin
Retention Ratio

331NS-60

CHAPTER 6
Interest Rates

331NS-61

Nominal vs. Real rates

r

= Any nominal rate

r*

= The real risk-free rate

T-bill rate with no inflation
Typically ranges from 1% to 4% per
year

rRF

= Rate on Treasury securities

Proxied by T-bill or T-bond rate
331NS-62

r = r* + IP + DRP + LP + MRP
Here:
r

rRF

r*
IP
DRP
LP
MRP

=Required rate of return on a

debt security
=
Real risk-free rate
=
Inflation premium
=
Default risk premium
=
Liquidity premium
=
Maturity risk premium

331NS-63

Premiums Added to r* for

Different Types of Debt
Debt Instrument

IP

DRP

ST Treasury

ST IP

LT Treasury

LT IP

ST Corporate

ST IP

DRP

LT Corporate

LT IP

DRP

MRP LP
MRP
LP
MRP

LP

331NS-64

CHAPTER 7
Bonds and Their Valuation

Bond valuation
Measuring yield

331NS-65

Discount Rate = YTM

The discount rate (YTM) is:

The opportunity cost of capital

The rate that could be earned on
alternative investments of equal risk
Required return

For debt securities:

YTM = r* + IP + LP + MRP + DRP

331NS-66

Bond Value

Bond Value = PV(coupons) + PV(par)

Bond Value = PV(annuity) + PV(lump sum)
Remember:
As interest rates increase present values
decrease as YTM PV
As interest rates increase, bond prices
decrease and vice versa

331NS-67

The Bond-Pricing Equation

1
1
(1 YTM) t
Bond Value C
YTM

F

t
(1

YTM)

PV(lump sum)
PV(Annuity)
C = Coupon payment; F = Face value
331NS-68

Texas Instruments BA-II Plus

FV
PV
I/Y
N
PMT

= future value/face value/par value

= present value=bond value/price
= period interest rate = YTM
= number of periods to maturity
= coupon payment

I/Y

PV

PMT

FV

331NS-69

Spreadsheet Functions
FV(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)
Inside

parens: (RATE,NPER,PMT,PV,FV,0/1)
0/1 Ordinary annuity = 0 (default)
Annuity Due = 1 (must be entered)
331NS-70

Pricing Specific Bonds

TI BA II+

Bond Worksheet [2nd] BOND

SDT CPN RDT RV ACT 2/Y YLD PRI

Excel:

PRICE(Settlement,Maturity,Rate,Yld,Redemption,
Frequency,Basis)

YIELD(Settlement,Maturity,Rate,Pr,Redemption,
Frequency,Basis)

Settlement and maturity need to be actual dates

Redemption and Pr need to given as % of par value

331NS-71

Yield to Maturity (YTM)

The market required rate of return for

bonds of similar risk and maturity
The discount rate used to value a bond
Return earned if bond held to maturity
Usually = coupon rate at issue
Quoted as an APR
The IRR of a bond

331NS-72

What is the YTM on a 10-year, 9% annual

coupon, $1,000 par value bond, selling for $887?

Must find the rd that solves this model:

INT
INT
M
VB
...

1
N
N
(1 rd )
(1 rd )
(1 rd )
90
90
1,000
$887
...

1
10
10
(1 rd )
(1 rd )
(1 rd )

331NS-73

Using a financial calculator to

solve for the YTM

YTM =10.91%
Bond sells at a discount because YTM >
coupon rate

INPUTS

10
N

OUTPUT

I/YR

- 887

90

1000

PV

PMT

FV

10.91
331NS-74

Solving for YTM

YTM on a 10-year, 9% annual coupon,
$1,000 par value bond selling for $887

Coupon rate = 9%
Annual coupons
Par = $1,000
Maturity = 10 years
Price = $887

Using the calculator:

N = 10
PV = -887
PMT = 90
FV = 1000
CPT I/Y = 10.91

=RATE(10,90,-887,1000)
331NS-75

Find YTM,
if the bond price is $1,134.20

YTM = 7.08%
Bond sells at a premium because YTM <
coupon rate

INPUTS

10
N

OUTPUT

I/YR

-1134.2

90

1000

PV

PMT

FV

7.08
331NS-76

Solving for YTM

YTM on a 10-year, 9% annual coupon,
$1,000 par value bond selling for $1,134.20

Coupon rate = 9%
Annual coupons
Par = $1,000
Maturity = 10 years
Price = $1,134.20

Using the calculator:

N = 10
PV = -1134.20
PMT = 90
FV = 1000
CPT I/Y = 7.08

=RATE(10,90,-1134.20,1000)
331NS-77

Semiannual bonds
2.

Multiply years by 2 : number of periods = 2N.

Divide nominal rate by 2 : periodic rate (I/YR) =
rd / 2.

3.

Divide annual coupon by 2 : PMT = ann cpn / 2.

1.

INPUTS

2N

rd / 2

OK

cpn / 2

OK

I/YR

PV

PMT

FV

OUTPUT
331NS-78

What is the value of a 10-year, 10%

semiannual coupon bond, if rd = 13%?
1.
2.
3.

Multiply years by 2 : N = 2 * 10 = 20
Divide nominal rate by 2 : I/YR = 13 / 2 = 6.5
Divide annual coupon by 2 : PMT = 100 / 2 = 50

INPUTS
OUTPUT

20

6.5

I/YR

PV

50

1000

PMT

FV

- 834.72
331NS-79

Valuing a Semiannual Bond

Coupon rate = 10%

Annual coupons
Par = $1,000
Maturity = 10 years
YTM = 13%

Using the formula:

Using the calculator:

N = 20
I/Y = 6.5
PMT = 50
FV = 1000
CPT PV = -834.72

1000
(1.065)20
B 50

20
0.065

(1.065 )

=PV(0.065, 10, 50, 1000)

331NS-80

YTM with Semiannual Coupons

Suppose a bond with a 10% coupon

rate and semiannual coupons, has a
face value of $1000, 20 years to
maturity and is selling for $1197.93.

Is the YTM more or less than 10%?

What is the semiannual coupon payment?
How many periods are there?

331NS-81

YTM with Semiannual Coupons

Suppose a bond with a 10% coupon rate and

semiannual coupons, has a face value of
$1000, 20 years to maturity and is selling for
$1197.93.
N = 40
PV = -1197.93
NOTE: Solving a semiPMT = 50
annual payer for YTM
FV = 1000
will result in a 6-month
CPT I/Y = 4%
YTM answer
YTM = 4%*2 = 8%
Result = YTM
Calculator solves what you enter.

331NS-82

CHAPTER 8
Risk and Rates of Return

Stand-alone Risk
Portfolio Risk
Risk & Return: CAPM / SML

331NS-83

The Expected Rate of Return

r ri Pi
i 1

r hat = expected return

ri = expected return in ith state of the economy
Pi = Probability of ith state occurring
331NS-84

Calculating the Expected Return

^

r expected rate of return

^

r ri Pi
i 1

r HT (-27%) (0.1) (-7%) (0.2)

(15%) (0.4) (30%) (0.2)
(45%) (0.1) 12.4%
331NS-85

The Standard Deviation of Returns

= Standard deviation
= Variance = 2

(
r

r
i ) Pi
2

i 1

331NS-86

Standard deviation for each investment

i1

(ri r )2 Pi

1
2

(5.5 - 5.5) (0.1) (5.5 - 5.5) (0.2)

2

T bills (5.5 - 5.5) (0.4) (5.5 - 5.5) (0.2)

(5.5 - 5.5) 2 (0.1)

T bills 0.0%
Coll 13.2%
HT 20.0%
USR 18.8%
M 15.2%
2

331NS-87

Standard Deviation of HTs Returns

331NS-88

Risk versus Return:

Do we know enough now?

Security

Expected
return, ^
r

Risk,

5.5%

0.0%

HT

12.4%

20.0%

Coll

1.0%

13.2%

USR

9.8%

18.8%

10.5%

15.2%

T-bills

Market

331NS-89

Coefficient of Variation (CV)

CV

= Standard deviation/expected return

= Risk per unit of return
= / r

Standarddeviation
CV

Expectedreturn
r

331NS-90

Portfolio Expected Return

^
rp = weighted average
wi = % of portfolio in stock i
ri = return on stock i
n

rp w i ri
i 1

331NS-91

Portfolio Expected Return

Assume a two-stock portfolio is created with
$50,000 invested in both HT and Collections

rp w i ri
i 1

^rp = 0.5(12.4%) + 0.5(1.0%) = 6.7%

331NS-92

Portfolio Return

Portfolio = (50% x HT) + (50% x Coll)

Portfolio Return = Prob x Portfolio
331NS-93

Portfolio Risk

Portfolio Standard deviation is

NOT a weighted average of the
standard deviations of the
component assets

331NS-94

Calculating portfolio standard

deviation and CV
0.10 (0.0 - 6.7)

1
2

0.20 (3.0 - 6.7)

p 0.40 (7.5 - 6.7)2

0.20 (9.5 - 6.7)2

2
0.10 (12.0 - 6.7)
2

3.4%

3.4%
CVp
0.51
6.7%
331NS-95

Portfolio Standard Deviation

331NS-96

Portfolio Risk & Return

p = 3.4% is much lower than the of either

stock
p = 3.4% is lower than the weighted average of
HT and Coll.s (16.6%)
The portfolio provides the average return of
component stocks, but lower than the average
risk

331NS-97

Covariance of Returns

Measures how much the returns on

two risky assets move together

Cov (a , b ) ab

ab rai ra rbi rb Pi
i

331NS-98

Covariance vs. Variance of Returns

Cov (a , b ) ab

ab rai ra rbi rb Pi
i

Var (a ) aa

2
a

a2 rai ra rai ra Pi
i

331NS-99

Covariance

Covariance (HT:Coll) = -0.0264

331NS-100

Correlation Coefficient

Correlation Coefficient = (rho)

Scales covariance to [-1,+1]

-1 = Perfectly negatively correlated

0 = Uncorrelated; not related
+1 = Perfectly positively correlated

ab
ab
a b
331NS-101

Two-Stock Portfolios

If = -1.0

If = +1.0

No risk reduction at all

In general, stocks have 0.35

Two stocks can be combined to form a

riskless portfolio

Risk is lowered but not eliminated

Investors typically hold many stocks

331NS-102

 of n-Stock Portfolio
n

w i w j i j ij
2
p

i 1 j 1
n

ab
ab
a b

2p w i w j ij
i 1 j 1

Subscripts denote stocks i and j

i,j = Correlation between stocks i and j
i and j =Standard deviations of stocks i and j
ij = Covariance of stocks i and j

331NS-103

Portfolio Risk-n Risky Assets

n

w i w j ij
2
p

i j
1
1
2
2

i 1 j 1

for n=2
1
w1w1 11 = w12 12
2
w1w2 12
1
w2w1 21
2
w2w2 22 = w22 22

p2 = w12 12 + w22 22 + 2w1w2 12

331NS-104

Portfolio Risk-2 Risky Assets

331NS-105

Capital Asset Pricing Model (CAPM)

Links risk and required returns

Security Market Line (SML):

A stocks required return equals the riskfree return (rRF) plus a risk premium (RPM
x ) that reflects the stocks risk after
diversification

Primary conclusion:

The relevant riskiness of a stock is its

contribution to the riskiness of a welldiversified portfolio.
331NS-106

The SML and Required Return

The Security Market Line (SML) is part of the

Capital Asset Pricing Model (CAPM)

ri rRF rM rRF i
ri rRF RPM i

rRF

= Risk-free rate

RPM = Market risk premium = rM rRF

331NS-107

The Market Risk Premium

(rM rRF = RPM)

Additional return over the risk-free rate

to compensate investors for assuming an
average amount of risk
Size depends on:

Perceived risk of the stock market

Investors degree of risk aversion

Varies from year to year

Estimates suggest a range between 4% and

8% per year

331NS-108

Required Rates of Return

Assume:

rRF = 5.5%

RPM = 5%

rHT

= 5.5% + (5.0%)(1.32)

rM

= 5.5% + 6.6%
= 12.10%
= 5.5% + (5.0%)(1.00) = 10.50%

rUSR

= 5.5% + (5.0%)(0.88) =

rT-bill = 5.5% + (5.0%)(0.00) = 5.50%

rColl

9.90%

= 5.5% + (5.0%)(-0.87) = 1.15%

331NS-109

Expected vs Required Returns

Expected
by YOU

Required by
the market

Expected

Required

Return

Return

HT

12.40

12.10

Undervalued

Market

10.50

10.50

Fairly valued

USR

9.80

9.90

T-bills

5.50

5.50 Fairly valued

Coll

1.00

1.15 Overvalued

Overvalued

331NS-110

Illustrating the
Security Market Line
SML: ri = 5.5% + (5.0%) i
ri (%)

SML

.
..

HT
rM = 10.5
rRF = 5.5
-1

Coll.

. T-bills

USR
1

Risk, i
331NS-111

Portfolio Beta
n

p wi i
i 1

Where:
wi = weight (% dollars invested in
asset i)

i = Beta of asset i
p = Portfolio Beta
331NS-112

CHAPTER 9
Stocks and Their Valuation

331NS-113

Constant growth stock

Dividends expected to grow forever at a

constant rate, g:
D1 = D0 (1+g)1
D2 = D0 (1+g)2
Dt = D0 (1+g)t

Dividend growth formula converges to:

D0 (1 g)
D1
P0

rs - g
rs - g
^

331NS-114

Constant Growth Model

D0 (1 g)
D1
P0

rs - g
rs - g
^

Needed data:
D0 = Dividend just paid
D1 = Next expected dividend
g = constant growth rate
rs = required return on the stock
331NS-115

Expected Value at time t

D1

P0
rs g

D
t 1

Pt
rs g

Value at
t=0

Value at t

331NS-116

Supernormal Growth

What if g = 30% for 3 years before

achieving long-run growth of 6%?

Constant growth model no longer

applicable
But - growth constant after 3 years

331NS-117

Valuing common stock with

nonconstant growth
0 r = 13% 1
s
g = 30%

D0 = 2.00
4.394
2.301

2
g = 30%

2.600

3
g = 30%

...

g = 6%

3.380

4.658

2.647
3.045
46.114
54.107

= P0

P 3

4.658
0.13 0.06

$66.54
331NS-118

Corporate Value Model

= Free Cash Flow method

Value of the firm = present value of the

firms expected future free cash flows

Free cash flow =after-tax operating

income less net capital investment
FCF = NOPAT Net capital investment

331NS-119

Applying the corporate value model

Market value of firm:

MV of common stock:

(MVF) = PV(future FCFs)

= MVF MV of debt

Intrinsic stock value:

= MVCS /# shares
331NS-120

Issues regarding the corporate

value model

Often preferred to the dividend growth

model

Firms that dont pay dividends

Dividends hard to forecast

Assumes at some point free cash flow

growth rate will be constant
Terminal value (TVN) = value of firm at
the point that growth becomes constant

331NS-121

Firms Intrinsic Value

Long-run gFCF = 6%
0 r = 10%

1
-5

-4.545
8.264
15.026
398.197
416.942

2
10

WACC = 10%
3

20

g = 6%

...

21.20

21.20

530 =

0.10

0.06

= TV3
331NS-122

If the firm has $40 million in debt and has 10

million shares of stock, what is the firms
intrinsic value per share?

MV of equity

= MV of firm MV of debt
= $416.94 - $40
= $376.94 million
Value per share= MV of equity / # of shares
= $376.94 / 10
= $37.69

331NS-123

Firm multiples method

Often used by analysts to value stocks

P / E
Price-earning
P / CF
Price-cash flow
P / Sales
Price-sales
Method:

Estimate appropriate ratio based on

comparable firms

Multiply estimate by expected metric to

estimate stock price

331NS-124

CHAPTER 10
The Cost of Capital

Cost of equity
WACC
Adjusting for risk

331NS-125

WACC

Weighted Average Cost of Capital

WACC = wdrd(1-T) + wprp + wcrs

Where:

Weights

wD = % of debt in capital structure

wP= % of preferred stock in capital structure
wC= % of common equity in capital structure

Component
costs

rD = firms cost of debt

rP= firms cost of preferred stock
rC= firms cost of equity
T = firms corporate tax rate
331NS-126

Three ways to determine

the cost of equity, rs:
1. DCF:

rs = D1/P0 + g

2. CAPM:

rs

= rRF + (rM - rRF)i

= rRF + (RPM)i

3. Own-Bond-Yield-Plus-Risk Premium:
rs = rd + Bond RP
331NS-127

DCF Approach: Inputs

1.

Current stock price (P0)

2.

Current dividend (D0)

3.

Growth rate (g)

331NS-128

Four Mistakes to Avoid

Current (YTM) vs. historical (Coupon rate) cost of

debt
Mixing current and historical measures to estimate
the market risk premium
Book weights vs. Market Weights

Use Target weights

Use market value of equity

Book value of debt = reasonable proxy for

market value.
Incorrect cost of capital components

Only investor provided funding

331NS-129

Should the company use the composite WACC

as the hurdle rate for each of its projects?

NO!

A firms composite WACC reflects the risk of

an average project

WACC = hurdle rate for an average risk project

Different divisions/projects may have different

risks

Division or project WACC should be adjusted to

reflect appropriate risk

331NS-130

Divisional and Project Costs of

Capital

Using the WACC as the discount rate is

only appropriate for projects that are the
same risk as the firms current operations

If considering a project that is NOT of the

same risk as the firm, then an appropriate
discount rate for that project is needed

Divisions also often require separate

discount rates
331NS-131

Using WACC for All Projects - Example

What would happen if we use the WACC for all

projects regardless of risk?
Assume the WACC = 15%

331NS-132

Divisional Risk and the Cost of

Capital
Rate of Return
(%)

Acceptance Region
WACC

WACC H

Acceptance Region
Rejection Region

WACC F
Rejection Region

WACC L

Risk L

Risk H

Risk

331NS-133

Subjective Approach

Consider the projects risk relative

to the firm overall

If project risk > firm risk project

discount rate > WACC
If project risk < firm risk project
discount rate < WACC

331NS-134

Subjective Approach - Example

Risk Level

Discount Rate

Very Low Risk

WACC 8%

7%

Low Risk

WACC 3%

12%

Same Risk as Firm

WACC

15%

High Risk

WACC + 5%

20%

Very High Risk

WACC + 10%

25%

331NS-135

CHAPTER 11

The Basics of Capital Budgeting

Should we
build this
plant?

331NS-136

Steps to capital budgeting

1.
2.
3.
4.
5.

Estimate CFs (inflows & outflows)

Assess riskiness of CFs
Determine appropriate cost of capital
Find NPV and/or IRR
Accept if NPV>0 and/or IRR>WACC

331NS-137

Independent versus Mutually Exclusive

Projects

Independent:

The cash flows of one are unaffected by

the acceptance of the other

Mutually Exclusive:

The acceptance of one project precludes

acceptance of the other

331NS-138

NPV: Sum of the PVs of all cash

flows.
n

NPV =

t=0

CFt .
(1 + r)t
NOTE: t=0

Cost often is CF0 and is negative

n

NPV =

t=1

CFt
(1 + r)t

- CF0
331NS-139

TI BAII+: Uneven Cash Flows

Cash Flows:
CF0

-100

CF1

10

CF2

60

CF3

80

C00
C01
F01
C02
F02
C03
F03
I
NPV

CF
100 +/- ENTER
10 ENTER
1 ENTER
60 ENTER
1 ENTER
80 ENTER
1 ENTER NPV
10 ENTER
CPT
$18.78

331NS-140

Internal Rate of Return (IRR)

IRR = the discount rate that forces PV of

inflows equal to cost, and the NPV = 0:
N

t0

CFt
t
( 1 IRR )

Solving for IRR with a financial calculator:

Enter CFs in CFLO register

Press IRR:

331NS-141

NPV vs IRR
NPV: Enter r, solve for NPV
n CF
t
= NPV
(1 + r)t
t=0

IRR: Enter NPV = 0, solve for IRR

n

t=0

CFt
=0
(1 + IRR)t
331NS-142

Modified Internal Rate of

Return (MIRR)

MIRR = discount rate which causes

the PV of a projects terminal value
(TV) to equal the PV of costs

TV = inflows compounded at WACC

MIRR assumes cash inflows

reinvested at WACC

331NS-143

Normal vs. Non-normal Cash Flows

Normal Cash Flow Project:

Cost (negative CF) followed by a series of

positive cash inflows
One change of signs

Non-normal Cash Flow Project:

Two or more changes of signs

Most common: Cost (negative CF), then string
of positive CFs, then cost to close project
For example, nuclear power plant or strip mine

331NS-144

Multiple IRRs

Descartes Rule of Signs

n

CFt

t
t 0 ( 1 IRR )

Polynomial of degree nn roots

1 real root per sign change

Rest = imaginary (i2 = -1)
331NS-145

The Pavillion Project:

Non-normal CFs and MIRR
0
-800,000

1
5,000,000

2
-5,000,000

PV outflows @ 10% = -4,932,231.40

TV inflows @ 10% = 5,500,000.00
MIRR = 5.6%
331NS-146

MIRR versus IRR

MIRR correctly assumes reinvestment at

opportunity cost = WACC

MIRR avoids the multiple IRR problem

Managers like rate of return

comparisons, and MIRR is better for this
than IRR

331NS-147

When to use the MIRR instead of the

IRR? Accept Project P?

When there are nonnormal CFs and

more than one IRR, use MIRR.

PV of outflows @ 10% = -$4,932.2314.

TV of inflows @ 10% = $5,500.
MIRR = 5.6%.

Do not accept Project P.

NPV = -$386.78 < 0.

MIRR = 5.6% < WACC = 10%.
331NS-148

Excel Functions

331NS-149

CHAPTER 12

Cash Flow Estimation

and Risk Analysis

331NS-150

Relevant Cash Flows:

Incremental Cash Flow for a Project

Projects incremental cash flow is:

Corporate cash flow with the project
Minus
Corporate cash flow without the project

331NS-151

Relevant Cash Flows

Changes in Net Working Capital Y

Interest/Dividends .... N
Sunk Costs .. N
Opportunity Costs .Y
Externalities/Cannibalism ..Y
Tax Effects .... Y

331NS-152

Tax Effect on Salvage

Net Salvage Cash Flow
= SP - (SP-BV)(T)
Where:
SP = Selling Price
BV = Book Value
T = Corporate tax rate
331NS-153

Including inflation when estimating cash

flows

Nominal r > real r

Nominal CF > real CF

The cost of capital, r, includes a premium

for inflation
Nominal cash flows incorporate inflation

If you discount real CF with the

higher nominal r, then your NPV
estimate is too low
331NS-154

INFLATION
Real vs. Nominal Cash flows

CFt
NPV
t
t 0 1 WACC

Real

Nominal
331NS-155

INFLATION
Real vs. Nominal Cash flows

2 Ways to adjust

Adjust WACC

Cash Flows = Real

Adjust WACC to remove inflation

Adjust Cash Flows for Inflation

Use Nominal WACC

331NS-156

Sensitivity Analysis

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

331NS-157

Sensitivity Analysis

331NS-158

331NS-159

Sensitivity Analysis

331NS-160

Sensitivity Graph
Variable
Cost
Fixed
Cost

Unit
Sales

331NS-161

14-162

Sensitivity Ratio

%NPV = (New NPV - Base NPV)/Base NPV

%VAR = (New VAR - Base VAR)/Base VAR

%NPV
SR
%VAR
If SR>0 Direct relationship
If SR<0 Inverse relationship
331NS-162

14-163

Sensitivity Ratio
Change from
Base Level
-30%
0
%NPV

Resulting NPV (000s)

Unit Sales
FC
$ -62$54
2020

%VAR

(-62-20)/20
-4.1%
-30%

SR

13.74

VC

$266
20
(54-20)/20
1.7%
-30%
-5.72

(266-20)/20
12.3%
-30%
-41.22

331NS-163

Sensitivity Graph
Variable
Cost
Fixed
Cost

-41.22

Unit
Sales
13.74

-5.72

331NS-164

Results of Sensitivity Analysis

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.
331NS-165

Sensitivity Analysis:
Weaknesses

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 wont fall

Ignores relationships among variables

331NS-166

Sensitivity Analysis:
Strengths

Provides indication of stand-alone risk

Identifies dangerous variables
Gives some breakeven information

331NS-167

Scenario Analysis

Examines several possible situations,

usually:

Worst case
Base case or most likely case, and
Best case

Provides a range of possible

outcomes

331NS-168

Scenario Example

331NS-169

331NS-170

Problems with Scenario Analysis

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 stand-alone risk

331NS-171

Monte Carlo Simulation Analysis

Computerized version of scenario

analysis using continuous probability
distributions
Computer selects values for each
variable based on given probability
distributions

331NS-172

Monte Carlo Simulation Analysis

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

331NS-173

Histogram of Results

331NS-174

Advantages of Simulation Analysis

Reflects the probability distributions

of each input
Shows range of NPVs, the expected
NPV, NPV, and CVNPV
Gives an intuitive graph of the risk
situation

331NS-175

Disadvantages of Simulation Analysis

Difficult to specify probability

distributions and correlations
If inputs are bad, output will be bad:
Garbage in, garbage out

331NS-176

Disadvantages of Sensitivity, Scenario

and Simulation Analysis

Sensitivity, scenario, and simulation

analyses do not provide a decision rule

Do not indicate whether a projects expected

return is sufficient to compensate for its risk

Sensitivity, scenario, and simulation

analyses all ignore diversification

Measure only stand-alone risk, which may

not be the most relevant risk in capital
budgeting

331NS-177

Real Options

When managers can influence the size

and risk of a projects cash flows by
taking different actions during the
projects life in response to changing
market conditions

Alert managers always look for real options in

projects

Smarter managers try to create real options

331NS-178

Types of Real Options

Investment timing options

Growth options

Abandonment options

Expansion of existing product line

New products
New geographic markets
Contraction
Temporary suspension

Flexibility options
331NS-179

FIN 331 in a Nutshell

Financial Management I Review
for FIN 338

331NS-180