Exam 2 PDF

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Total Assets (TA) = Current Assets (CA) + Fixed Assets (FA) Total Liabilities (TL) = Current Liabilities (CL) + Long-term Liabilities (LL) Total Equity (EQ) = Common Stocks (CS) + Preferred Stocks (PS) + Retained Earnings (RE) Common Equity (CE or BE)= CS+RE TA = TL + EQ Net P&E = Gross P&E – Accumulated Depreciation RE(t)=RE(t-1) +Net Income(t)-Payout(t) BE(t)=RE(t) +CS(t) BE(t)=BE(t-1) + Net Income(t) – Payout (t), assuming CS(t) = CS(t-1) Op CA=CA – ST investment Op CL= CL – “interest bearing current liabilities”=Current non-interest bearing liability NOWC= Operating CA – Operating CL TNOC=(Total assets) – (ST investment) – (non-interest bearing liability) NOPAT = EBIT*(1 – Tax Rate) FCF = NOPAT - Net investment in TNOC ROIC = NOPAT / TNOC EVA = NOPAT - (WACC) x TNOC = TNOC x (ROIC – WACC)

Total Risk (Stand-alone risk) = Undiversifiable risk + Diversifiable Risk Beta measures the responsiveness of a security to movements in market return i.e. systematic risk. Stock X has a beta of 2 – twice as sensitive to systematic risk as mkt portfolio

30% for 3 years, 6% constant g thereafter D at t=0 is $2 and r = 13%

Eg: Stock paid dividend of $2. Growth is 0%. Risk free rate is 2%, Beta is 2. MRP is 5% r = 2% + 2 (5%) => MRP is RM - RF r = 12% Share Price = 2/0.12 = $16.67 To price a stock using CAPM: 1) Forecast CF next period, 2) Figure out constant growth rate, 3) Figure out ‘r’ For CAPM model, use 30 year T-bond rate as risk free rate, Beta will be given and MRP will be given. If MRP is not given, it is usually between 5% - 6%.

Stock Prices are Volatile because: 1) D 1 could change, 2) R could change due to beta changing, inflation expectation, risk aversion or company risk, 3) g could change

Profitability Ratios Profit Margin: profit per dollar sales Gross Profit Margin = GP/Sales Operating Profit Margin = EBIT/Sales Profit Margin = Net income/Sales Basic Earning Power (BEP) Ratio: EBIT per dollar assets BEP = EBIT/Total assets Return on assets & Return on equity ROA = Net Income/Total assets ROE = Net Income/Common Equity ROIC=NOPAT/TNOC

FCF = NOPAT – Net Investment in TNOC NOPAT = EBIT*(1 – Tax Rate) TNOC= Op Assets – Op Liab = Net Operating WC + Net Oper. Long Term Assets Net Operating WC = (Cash + AR + Inv.) – (AP + Accruals) Net Oper. Long Term Assets = Long Term Assets – Long Term Oper. Liab. ST Investments not incl. in Net Oper. WC or TNOC TNOC = (Total assets) – (ST investment) – (non-interest-bearing liability) ROIC = NOPAT / TNOC ROE = NI / TA (Equity)

Forecasting: 1) Sales 2) B.S, as ratios of sales 3) Investor supplied capital – TA – A/P & Accruals Debt => ST Debt & LT Bonds & Equity => PS & CE 4) Op. Cost as % of sale & D&A as % of Net P&E 5) Interest and Pref. Div. and Payout 6) FCF for N Years and Terminal Value.

COST OF EQUITY METHOD: CAPM 1) Estimate Risk Free Rate – Use 10/20/30 Treasury Bonds 2) Use 6% for Market Risk Premium 3) Estimating Beta 4) Apply CAPM

Eg: Beta: 1.5, RF = 3%, RM = 10% Ri = 3% + 1.5 (10% - 3%) = 13.5% METHOD 2: Judgmental Risk Premium – gives a ballpark

Pros and Cons of three approaches

Forecasting: Total Value = Vop + Value of Non Op Assets ST Investments are Non Op Assets

A mature company with stable, predictable dividend DDM is the easiest Use EVA and FCF approaches for a company that pays no dividend or pays irregular dividends Use EVA approach if the company’s investment in TNOC is irregular, e.g., investment in fixed asset is drastically different from the depreciation of fixed asset.

NPV Decision Rules: If projects are independent, choose with NPV > 0, if mutually exclusive, choose higher NPV. IRR Decision Rules: If projects are independent, choose projects with IRR > r, if mutually exclusive, choose higher IRR. NPV should be used to choose between mutually exclusive projects. MIRR is Modified Internal Rate of Return = Terminal Value / (1+MIRR)^n Use MIRR for non-normal cash flows. Typically go with NPV when conflicts occur as it takes size of gain into account.

Business Risk: When Firm has zero debt. Financial Risk: When Firm starts acquiring debt. ROIC is pure measure of operational performance. Financial Risk is SD (ROE) – SD (ROIC)...