Corporate Finance Outline – Mitchell – Spring 2011 I. Limited Liability’s Effect on Corporate Finance
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- C. Quantitative Methods of Valuation
- 1. Balance Sheet Valuation: Book Value
- 2. Income Statement Valuation: 1. Capitalized Earnings Method
- Adjustments in a Close Corporation
- Add back all non-cash expenses: Deferred Taxes and Depreciation
- Capitalization Rate (See Discount Rate
- Cap Rate is the rate of risk we determine a company represents, and rate we demand to get the future earnings
- Make adjustments depending on future risks, or indicators in the past of potential issues
- Flaws with Income Statement Valuation
- 3. Cash Flow Methods of Valuation
- 1. The Dividend Discount Model (Gordon Model)
- Note: Discount Rate can be solved for K= D/V Constant Growth Stock
- Non-Constant Growth/Terminal Value Model/Horizon Model
- 2. Discounted Cash Flow Analysis
- 4. Capital Budgeting and Managerial Finance
- Internal Rate of Return
- Risk Averse
- So diversification can allow an investor to reduce unsystematic risks and only focus on Systematic risks
- The Capital Asset Pricing Model (CAPM)
- The return on a stock should exceed the risk free rate by an amount proportional to beta Flaws of CAPM
- If these assumptions have issues, then CAPM has issues
Future Value: FV = x (1+ K/M) ^ mn Where: X= principle amount K= Interest Rate M= number of times interest compounds N= Years So: Investing $100 with semi annual interest at 8% for 1 year = 100(1+ .08/2) ^2*1 =$104 Present Value: Lump Sum: PV= Xn / (1+k/m) ^ mn Where: X=Principle K=discount rate M= number of times compounding N=Years So: 100$ received in 2 years with 8% discount rate compounded semi-annually 100/ (1+.08/2) ^ 2*2 =85.48 Annuity: Paid at the end of each period For Simple Interest: Xn/ (1+k)^n For Compounded Interest: 1. Calculate Effective Annual Interest Rate (EAIR) (1+k/m)^m – 1 2. Use PV formula, plugging EAIR into k Annuity Due: Paid at the beginning of each period So: [Xn/ (1+k)^n ] * [1+k] Risk and Probability: 1. Generally, risk is a function of the probability of something occurring Risk: Quantifiable thing we know may occur Uncertainty: thing we do not know of 2. A Portfolio or Expected return on a stock, then can be calculated by: The Risk weighted average return of a stock/portfolio = Sum of Weight of (Chance) of Economic Outcome or Return x Return 3. Continuous Probability Distribution: Assign a probability of every possible state of economy and rate of return for stock in each economy Taking weighted average return of each gives us a distribution of returns Standard Deviation: Technically a probability weighted average deviation of expected return Way of quantifying expected deviation from the expected return Greater Standard Deviation= Greater Risk C. Quantitative Methods of Valuation: Generally: There are two types of valuation: Fundamental: Evaluating the particular aspects of a company, without regard to the market Market Value: Value comes from the market, and the ‘castles in the air’ theory See Smith Drug Stores I 1. Balance Sheet Valuation: Book Value: BV per Share = BV/# of shares BV= TA-TL Flaws: Restricted by the accounting conventions Historic Cost not reflective of current values Due to focus on Balance Sheet, which is ‘snap shot’ Does not look at earnings or cash flow Does not include intangible value market attributes to it Overall Value is skewed focuses on the liquidation value instead of Going Concern (Income Generation and earnings) Adjusted Book Value: Attempts to avoid focus on historic cost by increasing certain assets to reflect market value Process: 1. Assets on Balance Sheet restated to show current market value 2.Then BV=TA-TL Flaws: Still focuses on liquidation value rather then the value of a going concern, or ability to generate income Net Asset Value: Generally: Tries to avoid reliance on balance sheet and historic cost, by valuing as a going concern Considers the costs associated with establishing name recognition, training, developing products, creating brands, customer base, earnings potential Reflecting “Going Concern” Goodwill: Reflects the value of a target company, and values as a going concern Some intangible value above and beyond the assets Typically arises in a corporate acquisition Process: If an acquirer purchases a company at greater then Book Value, there must be something else they are acquiring, above the asset value that value is considered the going concern value of the future earnings Donahue v. Draper (infra): Goodwill = value above net tangible assets 1. X= Earnings x Multple (representing goodwill value) 2. Goodwill= X-Net Tangible Assets 3. Good will= amount greater then net assets (BV) Market to Book Ratio: Use: An evaluation of the price of a share, and how much greater that share is above the book value Can be used to give measure of how investors regard the subject company compared to others Process: 1. Calculate Book Value 2. Calculate market Value 3. Market Value per share / Book Value per share Comparison of Private to Public Corporation: Could take the M/B ratio of public company to determine comparison For instance, if industry average M/B = 5 and your BV=2…2x5= 10/share mv So, can be used for valuation purposes Meaning: > 1: shows a measure of market value that is greater then book value…and valuation of a going concern and goodwill May show value above book value, and thus more accurately depict going concern value Overall Flaws with Balance Sheet Valuation: Accounting Conventions reliance on historical cost Even with NAV, and Adjusted book value, unless we are valuing a company for its liquidation value, we don’t want to know what the assets cost, or what the company is worth if sold now… We want to know what the corporation, going concern, can do for us in the future 2. Income Statement Valuation: 1. Capitalized Earnings Method: Process: 1. Come up with earnings 2. Choose capitalization rate Earnings Estimate: Earnings may mean the bottom line Flaw: Accounting Conventions Earnings have, subtracted out of them, both cash and non cash items Non-Cash items= Depreciation and deferred taxes Changes in accounting methods may significantly alter earnings Adjustments in a Close Corporation: Expenses of a corporation, such as executive compensation, can be too high in some close-corporations…If they are too high, and method of self-dealing is occurring these could be thought of as lost earnings for the company and added back in to determine earnings value Focus on Past, Present Future: Past gives indication of, perhaps, what may occur in future But future is what will, if occurs, bring us earnings in the future So, forecast earnings into the future Adjustments to Earnings: Adjusted Earnings: In order to avoid accounting conventions that deal with non-cash items, Restate: Add back all non-cash expenses: Deferred Taxes and Depreciation Normalized Earnings: Process by which we take the average of earnings over the past x number of years Avoids extraordinary, and abnormal earnings Capitalization Rate (See Discount Rate, infra): Evaluates risks of company, and industry Used in order to discount the future value of earnings at a fixed percent to the present value Cap Rate is the rate of risk we determine a company represents, and rate we demand to get the future earnings Premium, or interest rate you would expect to earn on that risky asset if you acquired it now Methods to Develop Capitalization Rate: 1. Create your own based on risk profile, comparable companies, industry, specific company issues, Make adjustments depending on future risks, or indicators in the past of potential issues Low Risk: ~12.5% Moderate Risk: ~ 15-25% High Risk: >~ 25% Adjusted per your company specific issues 2. Reciprocal of P/E Ratio: 1/ P/E = Capitalization Rate P/E is a multiple of the price at which a share of stock is sold for, relative to the earnings that share is worth Idea that current Price reflects risks, and issues with the future earnings Higher reflects market belief that positive events are to come Note: If a close corporation is in question, then the P/E of comparable companies can be used to value a share Comparable Companies: Size, industry, growth rate, history… Issue: Assure comparable companies when using P/E to determine capitalization rate Finding a like company is key to accurately portraying a share price Issues: Introduces market valuation into a fundamental approach However, argument should be that we should introduce market valuation into it, at least some, to determine a fair market value 3. CAPM See infra 4. WACC 5. Gordon Model: K= (D1/V) + G Formulas: 1. Value of Share= E/R 2. Value of Share = Earnings x P/E Flaws with Income Statement Valuation: 1. Also limited to accounting conventions Non-cash items are excluded 2. Prediction of Future earnings and capitalization rate make it subject to subjective interpretation 3. Fails to address what will occur with the cash flows created from earnings Dividends and/ or Retained Earnings 4. Comparison Issues are also subjective 3. Cash Flow Methods of Valuation: General: As income statement and balance sheet valuation methods fail to take into account the present value of future dividend streams, what shareholder may be entitled to, cash-flow valuation fills this void A stock’s worth, and value derive from the expected stream of future dividends—paid in cash Premise: DDM assumes you will not sell, and are not trading day-to-day, but rather holding for the long term Because earnings are made up of what can be plowed back and paid out, there is no contradiction Earnings, thus, are not counted specifically—would double count—as you are including the portion of the earnings a shareholder is entitled to…i.e., the pay out of the earnings in the form of dividends…what part of earnings you receive 1. The Dividend Discount Model (Gordon Model): Premise: That a share of common stock is equal to the expected flow of dividends it produces, discounted to present value Process: Step 1: Forecast Future Dividends Remember: Payable at Board of Directors’ discretion Legal Capital Rules apply Growth, financial position and future prospects So predicting future dividends are not easy Step 2: Choose a Discount Rate Will incorporate, as aforementioned, a time value of money and adjusted risk for a particular corporation Can Use: 1. CAPM 2. WACC 3. Capitalization Rate 4. Create your own 5. Use DDM to do so adjusted for particular company in question Step 3: Apply No-Growth, Constant Growth, or Variable Growth Rate, per your model The Model of Equation: No-Growth Stock: Applicable if there is no expected growth in the dividend in the future D V = K Where: D= Dividend K=Discount Rate Note: Discount Rate can be solved for K= D/V Constant Growth Stock: Applicable where a dividend of a company is predicted to grow at a constant rate in future V = D1 / (k-g) Where: D1 = Dividend x (1+g) or Dividend of next year K= Discount Rate g= Rate of growth of dividend The Discount Rate: Again, there are methods that are different which can be employed to create the discount rate: The discount rate is a premium, or interest rate you would expect to earn on that risky asset if you acquired it now So, we discount the future value of a share, or dividend by that ‘interest’ rate, or discount rate A modified interest rate for that particular stock 1. Create it 2. CAPM 3. Reciprocal of P/E 4. Gordon Model to Calculate K K= (D1/v) + g Finding Value of the stock using comparable companies at future point in time 5. WACC The Growth Rate: A dividend is attributable to a board of directors’ decision of what to do with Income Income can be 1. Pay Out Ratio Amount paid out, in % of earnings, to shareholders in form of dividend Payout Ratio= Dividends /Earnings 2. Plow Back Ratio Plowing back means the amount of net income that the board decides to reinvest in the company Ends up in Retained Earnings 1-Payout Ratio Method 1 of determining Growth Rate: 1. Take the Payout Ratio 2. Take Return on Equity (ROE) ROE= EPS/BVS Growth then, means that the company will pay out a portion of its return on the equity in the company to shareholders, while the remaining portion is plowed back into the company Makes Sense BV=TA-TL, which = Shareholder’s Equity in Balance Sheet equation (SE=TA-TL), so return on that is return on shareholder’s equity Method 2: Calculate average change in dividend over last x number of years Non-Constant Growth/Terminal Value Model/Horizon Model: Applicable when the growth rate of the future dividends is inconsistent General: When calculating DDM, there is inherently value left on the table from failing to calculate the horizon value of all future dividends This formula establishes the dividends through a definite period of time, and after that point, utilizes a horizon value to predict the value of all future dividends Process: Step 1: Calculate the present value of the expected future dividends where there is inconsistent growth/non-constant growth Step 2: Use Constant Growth rate DDM formula for time period you believe constant growth will begin at Take Present Value of that Step 3: Add the two together Formula: 1. Calculate the present value of the projected dividends whether constant or non-constant growth 2. Terminal/Horizon Value calculation [1 / (1+k) ^ n ] x [Dn / (k-g)] Where: n=the last year for which dividends have been discounted This calculation takes the present value of the terminal value of stock Or Terminal Value can be calculated by: Vn / (1+k) ^n Which gives you the present value of future terminal value Where: n= Calculate Value at year n, by using comparable mature companies P/E and multiplying by your projected earnings in that year Flaws: this method succumbs to issues of Income statement valuation, comparability, and prediction 3. Add the present value of your projected dividends to your selected terminal value Flaws of DDM: 1. May miss out on future receipt of dividends throughout horizon time 2. Understates value then, as terminal value is not wholly accurate 3. May be subject to analyst’s subjective interpretations and judgment 4. Inapplicable to companies who do not pay dividends 2. Discounted Cash Flow Analysis Applicable for many valuation forms, especially if company does not pay dividends Process: 1. Forecast company’s net cash flows each year into future and growth 2. Estimate a terminal value of the company at the end of your holding period Use same calculation for horizon value as DDM Terminal Cash Flow / (1+k)^n 3. Discount at an appropriate discount rate the present value of each 4. Add the discounted cash flows and discounted terminal value Flaws: Forecasting of future cash flows is subjective Choice of discount rate is subjective Estimating the terminal value is not wholly accurate 4. Capital Budgeting and Managerial Finance: General: The same concepts, above, are used by mangers daily to determine the value of projects and the return and discount rates they will apply to these projects to determine their value to the company Two common methods: IRR and NPV Net Present Value: Simply forecast the future values of a project Discount all back to present value utilizing a discount rate Weighted Average Cost of Capital: [Weight x ROE] + [Weight x Debt] Effect: If positive the company should always accept the project as it adds value If negative company should decline as it decreases value Internal Rate of Return: The rate of a return a series of projected future cash flows will produce 5. Market Based Valuation: Modern Portfolio Theory, Efficient Frontier, and CAPM: Market Based Valuation: While the above formulas largely deal with the fundamental quantitative data a particular going concern exhibits, and the specific corporation’s attributes Note: Some market information (Such as P/E) does creep into fundamental valuation Market based valuation, in contrast focuses on the market The market assigns a value to the corporation based on all things that effect it Modern Portfolio Theory: Risk Profile: Generally speaking, the higher the risk an investment bears, the higher return an investor will demand Risk Averse: Will not accept increased risk without increased return Risk Neutral: Solely focuses on the return, and does not care about risk needed Risk Seeking: actually accepts lower return for increased risk…small chance of big success Diversification: The idea of creating a portfolio of stocks, which include different returns and probabilities in different states of the economy—idea of combining securities to reduce risks of 1 security If you buy two securities, and both react exactly opposite, you’ve diversified 3 Beliefs: 1. Expected return of a security is the weighted average of all possible returns 2. Expected return of portfolio is weighted sum of return on individual securities 3. The risk is not necessarily the weighted sum of all risks Systemic and Non-Systemic Risk: Out of Modern Portfolio theory, and diversification, we see that there are two types of risk we need to worry about Specific Risk to that company and risk of the system Firm-Specific Risk: Diversifiable, unique, specific, unsystematic risk Because we see that diversification can be done between particular stocks, the particular risk can be, theoretically, negated So diversification can allow an investor to reduce unsystematic risks and only focus on Systematic risks Non-Firm Specific Risk: Systematic Risk ßeta Risk of the Market, of things we simply cannot predict or diversify against The risk of the system’s effect on your particular stock The risk that should be focused on, then, to maximize return The risk you seek return for Beta—ß: A statistical measure of how a particular stock reacts to market risk Correlation of stocks movement to markets movement ß of 1: There is a 1:1 return with the market ß of >1: Return will be Greater then market (More Risk) ß of <1: Return will be less then market (Less Risk) Efficient Frontier: A graphical showing of possible portfolios with different risk profiles Maximizes expected return for risk The Capital Asset Pricing Model (CAPM) Because we should only be compensated for systematic risk, or a companies sensitivity to the system, the value of a share should show this See Smith Drug Stores V Components: ß (Beta): the measure of relationship between risk of individual security and risk of system or market Note: A higher ß means a higher level of risk Correlation is higher to market changes, so they are more sensitive and varying a (Alpha): A measure of the accuracy of CAPM =Stock’s Actual Return – CAPM Expected Return > 0: Shows greater then what was expected < 0: Shows less then expected RF (Risk Free Rate): The return one could get risk-free, through for instance, T-bills RM (Return on Market): The standard return of the market CAPM: Expected Return= RF+ ß [Rm-Rf] Premium: Market Premium Rm-Rf The premium return you are gaining above taking the risk free rate Risk Premium for Particular Stock ß (Rm-Rf) The premium return you are gaining above the market premium, proportional to particular stock beta Beta adjusted return on market for particular stock’s correlated risk to the market The return on a stock should exceed the risk free rate by an amount proportional to beta Flaws of CAPM: 1. Assumptions: Assumes Risk averse investors measure risk in terms of ß Assumes all investors have a common time frame for investment Probably not true, as many people buy and sell often So, if time horizons are different, return and risk would change too Assumes all investors have same expectations of future Systematic Risks No Transaction Costs, no taxes Assumes ECMH If these assumptions have issues, then CAPM has issues 2. Lack of use of fundamental valuation: Unlike fundamental valuation, here no fundamentals are used We only look at the stock price relevant to the market Does not look at what a company is doing as a going concern Even though Beta may reflect this somewhat, not largely included Counter Argument: CAPM merely gives you an ‘expected rate of return’ for a stock That rate, discount rate, or cap rate, can then be used in any of the fundamental valuation equations to take a hybrid approach of fundamental and market valuation 3. Fosters Irresponsibility: By focusing on market, and not on what a company does, who its composed of or what it offers you don’t care about corporate responsibility, but instead stock price By focusing on CAPM, has increased volatility Stock turnover is much greater “Stock owners” are not common, and short term return is king Therefore, accountability of who is running corporation is hurt, and no one really pays attention to who is running it Creates Corporate governance issues and consequences for overall market then 4. Business Judgment Rule: CAPM and Modern Portfolio Theory create an argument for BJR If an investor can diversify against any one particular stock’s or company’s risk, then the law should encourage continued deference of courts and weaker oversight by courts of director actions Stock holders don’t need the protection, in essence—protect themselves Directory: outlines outlines -> Chabot College Fall 2010 Course Outline for Computer Application Systems 60 business software applications/general accounting outlines -> Adil Khan Contracts Midterm outline- waldron outlines -> Remedies for breach of promise (1) The Interests Protected outlines -> Basic Process for Assessing Damages: 97 Select interest that deserves vindication 97 a. Restitution 97 outlines -> Chapter Five: Written Documents 1 Unsigned Documents 1 outlines -> Cases and Materials on Contracts outlines -> College of Science and Health outlines -> Evidence outline outlines -> 2. Act, Omission, Status or Circumstances 4 Consequences and Causation 8 Introduction to Mens Rea and Intent 10 Levels of Fault 11 Download 0.63 Mb. Share with your friends:
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