comm1180 exam notes part 2 PDF

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Value Capture – pricing and CVP: 

Pricing tripod – illustrates that an organisation has to balance value to customers, cost of providing the good or service, and the pricing of competitors.

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Value based pricing –Value-based pricing is the method of setting a price by which a company calculates and tries to earn the differentiated worth of its product for a particular customer segment when compared to its competitor. A firm must have a value orientation which means the organisation should focus needs to be firmly on the value created for customers, and the process of capturing this value. -

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PV- price paid = customers incentive to buy Price paid – COGS = organisations incentive to sell

Value pricing thermometer:

 Customer value Perceived value: total benefits – total cost (time, money and effort) ACTUAL PRICE + TIME AND EFFORT + PERCIVED RISKS: SOCIAL, PSYCHOLOGICAL AND PHYISCAL

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Competition-based pricing in its simplest form means monitoring competitors' prices and acting accordingly. Competitors' prices shape where in the viable price range between price floor (COGS) and price ceiling (perceived value) an organisation sets its price.

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Fixed costs are constant regardless of activity level, variable costs change proportionately with output and mixed costs are a combination of both.

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Cost Volume Profit Analysis - is a management accounting technique the help managers determine the sales quantity required to break even and start creating shareholder value/profit. PROFIT = TOTAL REVENUE – TOTAL COSTS PROFIT = [SALES PRICE * SALES QUANTITY] – TOTAL COSTS Costs is something that is given, needed or lost in order to gain a particular thing - Predicting costs – forecasting, budgeting, panning and CVP analysis - Managing costs – ensure costs reflect value creation and increase profitability

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Break-even point - This is the point where your total revenue (sales or turnover) equals total costs. It can be calculated in total sale quantity or total sales revenue. PROFIT = TOTAL REVENUE – (VARIABLE COSTS + FIXED COSTS) Single product: BREAK EVEN => SALES QUANITITY = TOTAL FIXED COSTS . CONTRIBUTION MARGIN RATIO CONTRIBUTION MARGIN RATIO = SALES PRICE PER UNIT – VARIBALE COST PER UNIT SALES PRICE PER UNIT Multiple products: BREAK EVEN => TOTAL SALES QUANITITY = TOTAL FIXED COSTS . WEIGHTED AVERAGE CONTRIBUTION MARGIN PER UNIT

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CVP – Targeted net profit CVP relies on forecast of expected revenues and costs. Using the break-even point formula to determine sales quantity of sales revenue required to achieve a target net profit. Single product: TARGET SALES QUANTITY = TOTAL FIXED COSTS + TARGET PRE TAX PROFIT CONTRIBTUTION MARGIN PER UNIT Multiple products: . TARGET SALES QUANTITY = TOTAL FIXED COSTS + TARGET PRE TAX PROFIT WEIGHTED AVERAGE CONTRIBTUTION MARGIN PER UNIT TARGET PRE-TAX = TARGET AFTER – TAX PROFIT 1 – TAX RATE Assumptions: rule out fluctuations in revenue or costs that might be caused by common business factors such as supplier volume discounts, leaning curves, changes in production efficiency or special customer discounts.

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Influence of competitors (competition-based pricing) -

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Increased competitors Increased substituting offers Wide distribution of competitor and/ or substation offers Increased surplus capacity in the industry

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Non-price related costs of using competitors are high Personal relationships matter High switching costs Tine and location specificity

Margin of safety – is the excess of an organisation’s expected future sales (in either revenue or units) above the breakeven point MARGIN OF SAFTEY IN UNITS = ACTUAL/EXPECTED UNITS OF ACTIVITY – UNITS AT BREAKEVEN POINT MARGIN OF SAFTEY IN REVENUE = ACTUAL OR EXPECTED REVENUE – REVENUE AT BREAKEVEN POINT

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Value adding vs nonvalue adding - Customer perspective (six sigma definition) Moves the products one step closer to completion – the activity produces a change of state that was not achievable by preceding activities Increase service potential to customers and they are willing to pay more The activity needs to be done right the first time. -

Business perspective Essentials to the functioning of the business e.g. audits, required filings at ATO

Investment decisions and rules: 

The investment decision process is part of capital budgeting. The capital budgeting is concerned with the generation, evaluation and selection of investment proposals, the management of capital expenditures during implementation as well as control of audit functions later on. -

Identify and forecast relevant cash flows Establish investment decision rules Apply investment decision rules to select the best project

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Interdependence among projects - Mutually exclusive projects - Accepting one requires the rejection of all others (i.e., due to indivisibility or exclusivity of resources) - Budget constraints - Mean that there is limited capital for all projects at once, projects may need to be ranked and chosen jointly to maximise overall wealth creation given the budget. - Scalability – when project has a higher NPV and IRR but another project could be easily scaled up

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Net Present Value – is the sum of the present values of all cash flows (positive or negative; costs and revenues; from today until infinity) that arise from the project over time.

Simple projects and most financial investments incur negative cash flows at time 0 (upfront costs or paying the market) and expected positive cash flows from then on. This is called have ‘standard’ cash flows, alternatively writing:

Notice the difference in starting point at i. NVP measures the $ value that is added or created today by investing in the project. Given a NPV number, the decision rule is straightforward: -

ACCEPT projects with NPV > 0 REJECT projects with NPV < 0 When choosing among several, generally choose the highest NPV

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Choice of discount rate 1. Use the companywide average cost of capital (i.e., required rate of return by all investors). It represents the cost of the next dollar of financing assuming the relative capital structure is maintained. 2. The discount rate should adequately reflect the risk involved in executing the project on a stand-alone basis, regardless of the cost of capital to the firm. It could be inferred by looking at opportunities with similar risk (opportunity cost).

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Internal Rate of Return (IRR) – used to estimate the profitability of a potential investment. (which discount rate �E (the internal rate of return) makes the projects NPV equal to zero/ how large can the true discount rate be before the project becomes a loser)

Or equivalently, with explicit mentioning of the cost:

IRR decision rule (for projects with standard cash flows): - ACCEPT the project if IRR > required rate of return - REJECT the project If IRR < required rate of return - When choosing among mutually exclusive projects, the IRR recommends the one with the higher IRR 

Yield to Maturity (YTM) – the unique interest rate (applied to all cash flows) that makes the present value of (the bonds) future cash flows equal to its price observed in the market. This is an annualised rate, assumed to be semi-annually compounded so the r = YTM/2.

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Accounting Rate of Return –relates the initial investment to subsequent incremental accounting profits that occur due to a project under consideration.

The ARR decision rule simply ACCEPTS any project with an ARR exceeding a certain required accounting rate of return. It also recommends accepting a project with the higher ARR when they are mutually exclusive.

Accounting profits can be potentially quite different from free cash flow measures due to differences in timing of the recognition of revenue and costs. This is mostly on treatment of capital expenses and depreciation: EBIT = REVENUE – COSTS – DEPRECIATION NET INCOME = EBIT * (1 - TC) FCFF = EBIT * (1 - TC) + DEPRECIATION – CapEx Example: in a project with all capital expenditures taking place at time 0, followed by n year's od constant cash flows and income (and linear depreciation):

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Repeat investments – items are purchased at the start of the first period; benefits/costs accrue at the end of each period until the item breaks.

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Equivalent Annual Annuity (EAA) – is used in capital budgeting to show the net present value of an investment as a series of equal cash flows for the length of investment. EAA amortizes the initial cost (at time 0) over the lifetime of the project/ purchase but adjusts for the time value of money.

1. Compute the NPV (including the time 0 cost). 2. Compute the constant annuity payment over the same horizon with the NPV using the same discount rate, but no cash flow at time 0. Assume a project with one-time upfront costs followed by constant cash flows for the duration of the project of n years. Then:

EAA analysis (has the assumption that you will be able to replace the investment/product With an identical item at the same cost) - Required life - Replacement cost - Technological obsolesce/speed of innovation 

Comparing NPV, IRR and EAA - NPV measures a total benefit – favours large scale and long-lasting investments - IRR favours high average returns relative to the initial cost and favours a cheap purchase with high relative returns to cost - Neither considers an average $ benefit per year - Neither measure is able to incorporate the cost from frequently having to replace the investment. - EAA has these characteristics by assuming that you will repeatedly invest in the same project (amortized per year basis)

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Profitability index (or benefit-cost ratio of project i):

Or,

Risk, Return and Cost of Capital: 

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Historical returns - Lie in the past - Are also called actual or realized returns - Can be measured with certainty - Can be used to compute historical averages Expected returns - Lie in the future - Are uncertain and hoped for - Are random variable - Requires assumptions (or knowledge) about probabilities of possible future outcomes. Holding Period of Returns (HPR) – this is the return that either has been achieved (given historical prices) over some period of time during which the investor held/holds the asset. For assets that simply compound or grow value (without dividends) we use:

(This formula is valid for any length of time) For dividing paying assets, the dividend is part calculated on the return experience. We may refer to the return as a period return (I.e., t +1)

Technically there is a time lag between the date on which the dividend ‘leaves’ the share price. However, you will be credited with a position called ‘dividend receivable’. 

Variability in Returns – very different levels or returns as well as different degrees of variability. Investors prefer investments that have higher return with less variability. - Degree of variability is important in assessing risk. Risk is measured by the dispersion, spread or volatility of returns over time (both realized and expected)

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The average annual return (or arithmetic average return) – of an investment during some historical period compute the simple average over the actual year-by-year sequences of annual returns. The average returns are useful to make statements about the likelihood return of a given investment in any one-year period (e.g. Expected returns)

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Historical variance and volatility - Historical variance �2 of returns of assets i over n periods is defined as the sum squared deviations from the mean R, divided by n-1.

The standard deviation or volatility � of realized returns is the square root of the variance.

If returns are in percent, volatility will be in percent which is intuitive. Variance is %squared, which is not. 

Expected returns – expected returns are unknown however we can form expectations about a range of possible outcomes and their respective possibility of occurring.

1. There is exactly one historical price path and one sequence of returns that lead to the present point in time. The future is unknown.

2. Infinitely many possible paths between now and next month result in a continuous probability distribution.

3. We sometimes focus on a small number of high probability events (i.e., recessions either small, moderate or severe)

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Risk-Return Trade-Off – the level of return to be earned from an investment should increase the level of risk goes off. (risk and return are positively related) - Risk premium – is the investment return an asset is expected to yield in excess of the risk-free rate of return.

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Market risk premium (MRP) – is the rate of return on a risky investment. The difference between expected and return and risk-free rate will give you the market risk premium.

Systematic vs. idiosyncratic risk - Idiosyncratic risk – is the inherent factors that can negatively impact individual securities or a very specific group of assets - Systematic risk – refers to the broader trends that impact the overall financial systems or a very broad market. TOTAL RISK = SYSTEMATIC RISK + IDIOSYNCRATIC RISK

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Diversification – is a risk management strategy that mixes a wide variety of investments in a portfolio. A diversified portfolio contains a mix od distinct asset types and investment vehicles in an attempt at limiting exposure to any single asset or risk. - However, there is a limit the macroeconomic risk that every stock brings into the portfolio is a function of the same major economic drivers like interest rate, growth, trade etc.

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Investors who hold the market are exposed to systematic risk that they cannot avoid. Therefor will demand compensation for this risk. (more compensation means a higher discount rate �� , which means a lower price in the present, holding future cash flows constant)

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In equilibrium only systematic risk will be compensated

Portfolios - Building a portfolio of n individual assets. While each asset is allocated to a certain dollar amount Ai, it is a lot easier to formulate everything in terms of relative ‘portfolio weights’, that is the fraction of total portfolio wealth allocated to asset i:

Each member of the portfolio experienced (or is expected to experience) return Ri over some periods, during which the composition of the portfolio was not changed. Then the corresponding portfolio return for that period is:

We can replace realized returns with expected returns about future periods. 

Correlation – is the measure that expresses the degree of co-movement in returns between 2 financial assets (the overlap in terms of the risk factors that drive the returns of both assets). - � = + 1 means perfect correlation. The two assets co-move perfectly. - � = 0 means no correlation. The two assets move completely to their own tunes and are affected by disjoint sets of risks. - � = −1 means perfect negative correlation.

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Portfolio risk – correlations are the primary driver of the degree of diversification that can be achieved. In a 2-asset portfolio, portfolio variance takes the following form:

where � � are the portfolio weights and �� are the volatilities of the components. The pairwise correlation between the two assets �1,2 drives the behaviour of the last term: perfect correlation makes this term maximally positive and leads to zero diversification. 

Market portfolio - The beta of the market portfolio is 1, and all other assets have betas that tell us how much systematic risk they contain relative to the market. The beta of asset I can be computed as:

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Expected returns in equilibrium and CAPM

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he expected return for any individual asset therefore should be related to the beta loading on the market return. This is called the capital asset pricing model

it allows investors to assign fair expectation to the returns of all assets as a function of three things: 1. the risk-free rate (time value of money) 2. reward for bearing systematic risk, i.e., market premiums 3. the assets exposure to systematic risk, measured by beta. 

Geometric Average Returns – signifies that annual compound rate that is necessary for an investment to grow from an initial balance into its final balance some periods later.

Remember that we get from a starting investment of PV to a final wealth of FV by compounding the actual returns in each period:

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Arithmetic average returns – will consider the actual year-by-year sequence of annual returns and compute the simple average over the sequence.

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Cost of equity – RE : is the minimum (required) rate of return necessary to induce investors to buy or hold the firm’s stock. It reflects the riskiness of an investment as equity holders have only a residual claim on cooperate income and face the greatest risk. - Dividend growth model – uses historical growth rates or forecasts of earnings and dividends. the decomposition into dividend yield and capital gains, given earnings growth rate g.

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Applying CAPM

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Cost of preferred equity – Rpref - Preference shares generally pay a constant dividend every period and are often issued without maturity date, it can be valued as the following perpetuity:

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Cost of debt – RD - is the return that lenders would demand to finance a project/firm of this level of risk. - Compute the current yield to maturity (YTM) on existing debt of the firm - Use estimates of current rates based on the bond rating expected for new debt Note: interest expenses are TAX-DEDUCTIBLE.

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Weighted average cost of capital (WACC) Where the firm value is V = E + P + D,

The cost of capital that reflect the combined risk (equity + debt) of the business. What effects the WACC: - Market conditions (market risk premium, risk-free rates, tax rates) - Capital structure - The riskiness of the investment 

Discounted cash flow model We estimate firm’s value by computing the present value of the firms forecasted free cash flows up to some horizon together with a terminal value:

it is the same way as we did DDMs if assuming a constant growth rate of gFCF for free cash flows:

1. Free cash flow measures the cash generated by the firm before any payments to debt or equity, that is cash flow to be paid to both debt and equity holders. (use WACC which reflects the overall risk. In DDMs we use RE. if a firm has no debt then WACC = RE.)

2. Where in this valuation does the interest tax shield enter? (it’s in the WACC not the FCFF, otherwise we would be double counting)

(Share price from firm value)...