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Overview
The Balance Sheet
Definition Financial statements that show the value of the firms
assets and liabilities at a particular point in time (from an accounting perspective).
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
The Balance Sheet
3
The Main Balance Sheet Items Current Assets Cash & Securities Receivables Inventories
+ Fixed Assets Tangible Assets Intangible Assets
} Current Liabilities Payables Short-term Debt
+ Long-term Liabilities
+ Shareholders Equity
{=
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Market Value vs. Book Value
Book Values are determined by GAAP Market Values are determined by current values Equity and Asset Market Values are usually higher than their
Book Values
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
The Income Statement
Definition Financial statement that shows the revenues,
expenses, and net income of a firm over a period of time (from an accounting perspective).
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
The Income Statement
Earnings Before Income & Taxes (EBIT) EBIT = - total Revenues - costs - deprecation
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
The Statement of Cash Flows
Definition Financial statement that shows the firms cash
receipts and cash payments over a period of time.
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Taxes
Taxes have a major impact on financial decisions Marginal Tax Rate is the tax that the individual pays on each
extra dollar of income. Average Tax Rate is the total tax bill divided by total income.
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Future Values
Future Value - Amount to which an investment will grow after earning interest.
Compound Interest - Interest earned on interest. Simple Interest - Interest earned only on the original
investment.
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Future Values
Future Value of $100 = FV
FV r t= +$100 ( )1
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Present Values
Present Value
Value today of a future cash
flow.
Discount Rate
Interest rate used to compute
present values of future cash flows.
Discount Factor
Present value of a $1 future payment.
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Present Values
Present Value = PV
PV = Future Value after t periods (1+r) t
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Present Values
Discount Factor = DF = PV of $1 Discount Factors can be used to compute the present value of
any cash flow.
DFr t
=+1
1( )
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Time Value of Money (applications)
The PV formula has many applications. Given any variables in the equation, you can solve for the remaining variable.
PV FVr t
= +1
1( )
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
PV of Multiple Cash Flows
PVs can be added together to evaluate multiple cash flows.
PV Cr
Cr
= + ++ +
11
221 1( ) ( )
....
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Perpetuities & Annuities
Perpetuity A stream of level cash payments that never ends.
Annuity
Equally spaced level stream of cash flows for a limited period of time.
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Perpetuities & Annuities
PV of Perpetuity Formula C = cash payment r = interest rate
PV Cr=
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Perpetuities & Annuities
PV of Annuity Formula C = cash payment r = interest rate t = Number of years cash payment is received
[ ]PV C r r r t= +1 11( )
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Perpetuities & Annuities
PV Annuity Factor (PVAF) - The present value of $1 a year for each of t years.
[ ]PVAF r r r t= +1 11( )
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Perpetuities & Annuities
Applications Value of payments Implied interest rate for an annuity Calculation of periodic payments
Mortgage payment Annual income from an investment payout Future Value of annual payments
[ ]FV C PVAF r t= +( )1
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Inflation
Inflation - Rate at which prices as a whole are increasing.
Nominal Interest Rate - Rate at which money invested grows.
Real Interest Rate - Rate at which the purchasing power of an investment increases.
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Inflation
1 + real interest rate = 1+nominal interest rate1+inflation rate
approximation formula
Real int. rate nominal int. rate - inflation rate
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Effective Interest Rates
Annual Percentage Rate - Interest rate that is annualized using simple interest.
Effective Annual Interest Rate - Interest rate that is annualized using compound interest.
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Bonds
Terminology Bond - Security that obligates the issuer to make specified
payments to the bondholder. Coupon - The interest payments made to the bondholder. Face Value (Par Value or Principal Value) - Payment at the
maturity of the bond. Coupon Rate - Annual interest payment, as a percentage of face
value.
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Bond Pricing The price of a bond is the Present Value of all cash flows
generated by the bond (i.e. coupons and face value) discounted at the required rate of return.
PV cpnr
cpnr
cpn parr t
=+
++
+ +++( ) ( )
.... ( )( )1 1 11 2
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Bond Cash Flows
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Bond Pricing Example (continued) Q: How did the calculation change, given semi-annual coupons
versus annual coupon payments?
Time Periods
Paying coupons twice a year, instead of once
doubles the total number of cash flows to be discounted
in the PV formula.
Discount Rate
Since the time periods are now half years, the discount rate is also
changed from the annual rate to the half year rate.
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Bond Yields Current Yield - Annual coupon payments divided by bond
price. Yield To Maturity - Interest rate for which the present value
of the bonds payments equal the price.
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Bond Yields Calculating Yield to Maturity (YTM=r) If you are given the price of a bond (PV) and the coupon rate,
the yield to maturity can be found by solving for r.
PV cpnr
cpnr
cpn parr t
=+
++
+ +++( ) ( )
.... ( )( )1 1 11 2
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Bond Yields Rate of Return - Earnings per period per dollar invested.
Rate of return = total incomeinvestment
Rate of return = Coupon income + price changeinvestment
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Nominal and Real rates
0
2
4
6
8
10
12
14
85 86 87 88 89 90 91 92 93 94 95 96 97 98 9920
0020
0120
0220
0320
0420
05
Year
Perc
ent
Yield on UK nominal bonds
Yield on UK indexed bonds
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Default Risk Credit risk Default premium Investment grade Junk bonds
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Corporate Bonds Zero coupons Floating rate bonds Convertible bonds
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Stocks & Stock Market Primary Market - Place where the sale of new stock first
occurs. Initial Public Offering (IPO) - First offering of stock to the
general public. Seasoned Issue - Sale of new shares by a firm that has
already been through an IPO
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Stocks & Stock Market Common Stock - Ownership shares in a publicly held
corporation. Secondary Market - market in which already issued securities
are traded by investors. Dividend - Periodic cash distribution from the firm to the
shareholders. P/E Ratio - Price per share divided by earnings per share.
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Stocks & Stock Market Book Value - Net worth of the firm according to the balance
sheet. Liquidation Value - Net proceeds that would be realized by
selling the firms assets and paying off its creditors. Market Value Balance Sheet - Financial statement that uses
market value of assets and liabilities.
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Valuing Common Stocks Expected Return - The percentage yield that an investor
forecasts from a specific investment over a set period of time. Sometimes called the holding period return (HPR).
Expected Return = = + r Div P PP
1 1 0
0
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Valuing Common Stocks The formula can be broken into two parts.
Dividend Yield + Capital Appreciation
Expected Return = = + r DivP
P PP
1
0
1 0
0
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Valuing Common Stocks Dividend Discount Model - Computation of todays stock
price which states that share value equals the present value of all expected future dividends.
H - Time horizon for your investment.
P Divr
Divr
Div Pr
H HH0
11
221 1 1
=+
++
+ ++
+( ) ( )...
( )
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Valuing Common Stocks If we forecast no growth, and plan to hold out stock
indefinitely, we will then value the stock as a PERPETUITY.
Perpetuity P Divr
or EPSr
= =01 1
Assumes all earnings are paid to shareholders.
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Valuing Common Stocks Constant Growth DDM - A version of the dividend growth
model in which dividends grow at a constant rate (Gordon Growth Model).
P Divr g0
1=
Given any combination of variables in the equation, you can solve for the unknown variable.
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Valuing Common Stocks If a firm elects to pay a lower dividend, and reinvest the
funds, the stock price may increase because future dividends may be higher.
Payout Ratio - Fraction of earnings paid out as dividends Plowback Ratio - Fraction of earnings retained by the firm.
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Valuing Common Stocks Growth can be derived from applying the return on equity to
the percentage of earnings plowed back into operations. g = return on equity X plowback ratio
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Valuing Common Stocks Present Value of Growth Opportunities (PVGO) - Net present
value of a firms future investments. Sustainable Growth Rate - Steady rate at which a firm can
grow: plowback ratio X return on equity.
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Random Walk Theory The movement of stock prices from day to day DO NOT
reflect any pattern. Statistically speaking, the movement of stock prices is
random (skewed positive over the long term).
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Another Tool Fundamental Analysts Research the value of stocks using NPV and other
measurements of cash flow
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Efficient Market Theory Weak Form Efficiency
Market prices reflect all historical information
Semi-Strong Form Efficiency Market prices reflect all publicly available information
Strong Form Efficiency Market prices reflect all information, both public and private
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Net Present Value
Net Present Value - Present value of cash flows minus initial investments.
Opportunity Cost of Capital - Expected rate of return given up by investing in a project
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Net Present Value NPV = PV - required investment
NPV C Crt
t= + +0 1( )
NPV C Cr
Cr
Crt
t= + ++
++ +
+01
12
21 1 1( ) ( )...
( )
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Net Present Value Terminology C = Cash Flow t = time period of the investment r = opportunity cost of capital
The Cash Flow could be positive or negative at any time period.
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Net Present Value Net Present Value Rule Managers increase shareholders wealth by accepting all
projects that are worth more than they cost. Therefore, they should accept all projects with a positive net
present value.
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Payback Method
Payback Period - Time until cash flows recover the initial investment of the project.
The payback rule specifies that a project be accepted if its
payback period is less than the specified cutoff period.
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Other Investment Criteria Internal Rate of Return (IRR) - Discount rate at
which NPV = 0. Rate of Return Rule - Invest in any project offering a
rate of return that is higher than the opportunity cost of capital.
Rate of Return = C - investmentinvestment
1
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Equivalent Annual Annuity
Equivalent Annual Cost - The cash flow per period with the same present value as the cost of buying and operating a machine.
factorannuity flowscash of luepresent va=annuity annual Equivalent
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Annuity Factor
trt, r)(11
r1=FactorAnnuity
+
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Profitability Index
ProfitabilityProject PV Investment NPV Index
J 4 3 1 1/3 = .33K 6 5 1 1/5 = .20L 10 7 3 3/7 = .43M 8 6 2 2/6 = .33N 5 4 1 1/4 = .25
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Capital Budgeting Techniques
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Capital Budgeting Process Capital Budget - The list of planned investment projects. The Decision Process 1 - Develop and rank all investment projects 2 - Authorize projects based on:
Outlays required by law of company policy Maintenance of cost reduction Capacity expansion in existing business Investment for new products
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Capital Budgeting Process Capital Budget - The list of planned investment projects. The Decision Process 1 - Develop and rank all investment projects 2 - Authorize projects based on:
Outlays required by law of company policy Maintenance of cost reduction Capacity expansion in existing business Investment for new products
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
How To Handle Uncertainty Sensitivity Analysis - Analysis of the effects of changes in sales,
costs, etc. on a project. Scenario Analysis - Project analysis given a particular
combination of assumptions. Simulation Analysis - Estimation of the probabilities of different
possible outcomes. Break Even Analysis - Analysis of the level of sales (or other
variable) at which the company breaks even.
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Operating Leverage Operating Leverage- The degree to which costs are fixed.
Degree of Operating Leverage (DOL) - Percentage change in profits given a 1 percent change in sales.
salesin change %profitsin change %=DOL
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Operating Leverage The percentage of fixed costs in a company's cost
structure. Generally, the higher the operating leverage, the more a company's income is affected by fluctuation in sales volume.
The higher income vs. sales ratio results from a smaller portion of variable costs, which means the company does not have to pay as much additional money for each unit produced or sold.
The more significant the volume of sales, the more beneficial the investment in fixed costs becomes.
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Rates of Return
20.2%or .202=
31.12.825.47 =Return Percentage +
Percentage Return = Capital Gain + Dividend Initial Share Price
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Rates of Return
Dividend Yield = Dividend Initial Share Price
Capital Gain Yield = Capital GainInitial Share Price
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Rates of Return
Nominal vs. Real
1+ real ror = 1 + nominal ror1 + inflation rate
%4.16ror real 164.1=ror real+1 .033 + 1 .202 + 1
=
=
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Market Indexes
Dow Jones Industrial Average (The Dow) Value of a portfolio holding one share in each of 30 large industrial firms.
Standard & Poors Composite Index (The S&P 500) Value of a portfolio holding shares in 500 firms. Holdings are proportional to the number of shares in the issues.
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Rate of Return
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Measuring Risk
Variance - Average value of squared deviations from mean. A measure of volatility.
Standard Deviation - Average value of squared
deviations from mean. A measure of volatility.
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Risk and Diversification
Diversification - Strategy designed to reduce risk by spreading the portfolio across many investments.
Unique Risk - Risk factors affecting only that firm. Also called diversifiable risk.
Market Risk - Economy-wide sources of risk that affect the overall stock market. Also called systematic risk.
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Risk and Diversification
Portfolio rateof return
=fraction of portfolioin first asset
xrate of returnon first asset
+fraction of portfolioin second asset
xrate of returnon second asset
((
((
))
))
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Risk and Diversification
05 10 15
Number of Securities
Port
folio
sta
ndar
d de
viat
ion
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
05 10 15
Number of Securities
Port
folio
sta
ndar
d de
viat
ion
Market risk
Uniquerisk
Risk and Diversification
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Topics Covered Measuring Market Risk
Beta
Risk and Return CAPM
Capital Budgeting and Project Risk
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Measuring Market Risk Market Portfolio - Portfolio of all assets in the economy. In
practice a broad stock market index is used to represent the market.
Beta - Sensitivity of a stocks return to the return on the market
portfolio.
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Portfolio Betas Diversification decreases variability from unique risk, but not
from market risk. The beta of your portfolio will be an average of the betas of
the securities in the portfolio.
If you owned all of the S&P Composite Index stocks, you would have an average beta of 1.0
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Risk and Return
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Risk and Return
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Measuring Market Risk Market Risk Premium - Risk premium of market
portfolio. Difference between market return and return on risk-free Treasury bills.
0
2
4
6
8
10
12
14
0 0,2 0,4 0,6 0,8 1
Beta
Expe
cted
Ret
urn
(%) .
Market Portfolio
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Measuring Market Risk CAPM - Theory of the relationship between risk and
return which states that the expected risk premium on any security equals its beta times the market risk premium.
Market risk premium = r - rRisk premium on any asset = r - r
Expected Return = r + B(r - r )
m f
f
f m f
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Measuring Market Risk Security Market Line - The graphic representation of
the CAPM.
Beta
Expe
cted
Ret
urn
(%) .
Rf
Rm
Security Market Line
1.0
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Security Market Line Return
BETA
rf 1.0
SML
SML Equation = rf + B ( rm - rf )
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Capital Asset Pricing Model
R = rf + B ( rm - rf )
CAPM
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Testing the CAPM Avg Risk Premium 1931-2002
Portfolio Beta 1.0
SML 30
20
10
0
Investors
Market Portfolio
Beta vs. Average Risk Premium
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Capital Budgeting & Project Risk The project cost of capital depends on the use to which the
capital is being put. Therefore, it depends on the risk of the project and not the risk of the company.
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Cost of Capital Cost of Capital - The return the firms investors could expect
to earn if they invested in securities with comparable degrees of risk.
Capital Structure - The firms mix of long term financing
and equity financing.
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
WACC Weighted Average Cost of Capital (WACC) - The expected
rate of return on a portfolio of all the firms securities.
Company cost of capital = Weighted average of debt and equity returns.
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
WACC
V)r x (E+)r x (D
assetsequitydebtr =
( ) ( )equityVEdebtVDassets rx rx r +=
sinvestment of valueincome total
assets =r
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
WACC Taxes are an important consideration in the company
cost of capital because interest payments are deducted from income before tax is calculated.
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
WACC Weighted -average cost of capital=
[ ] [ ]WACC = x (1 - Tc)r + x rDV debt EV equity
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
WACC Three Steps to Calculating Cost of Capital 1. Calculate the value of each security as a proportion of the
firms market value. 2. Determine the required rate of return on each security. 3. Calculate a weighted average of these required returns.
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
WACC Issues in Using WACC Debt has two costs. 1)return on debt and 2)increased cost of equity
demanded due to the increase in risk
Betas may change with capital structure
Corporate taxes complicate the analysis and may change our decision
[ ] [ ]B = x B + x Bassets DV debt EV equity
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Measuring Capital Structure In estimating WACC, do not use the Book Value of securities. In estimating WACC, use the Market Value of the securities. Book Values often do not represent the true market value of a
firms securities.
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Measuring Capital Structure
Market Value of Bonds - PV of all coupons and par value discounted at the current interest rate.
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Measuring Capital Structure
Market Value of Bonds - PV of all coupons and par value discounted at the current interest rate.
Market Value of Equity - Market price per share multiplied by the number of outstanding shares.
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Required Rates of Return Bonds
r = YTMd
r = CAPM= r + B(r - r )
e
f m f
Common Stock
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Required Rates of Return Dividend Discount Model Cost of Equity
Perpetuity Growth Model = solve for re
P = Divr - g0
1
e
r = DivP
+ ge 10
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Required Rates of Return Expected Return on Preferred Stock
Price of Preferred Stock = solve for preferred
P = Divr0
1
preferred
r = DivPpreferred
1
0
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Free Cash Flows Treat the whole company as one big project and discount the
companys cash flows by the weighted-average cost of capital. The operating cash flow less investment expenditures is the
free cash flow, which is the amount of cash that the business can pay out to investors after paying for all investments necessary for growth.
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
* FCF and PV * Free Cash Flows (FCF) should be the theoretical basis for all
PV calculations. FCF is a more accurate measurement of PV than either Div
or EPS. The market price does not always reflect the PV of FCF. When valuing a business for purchase, always use FCF.
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Capital Budgeting Valuing a Business
The value of a business or project is usually computed as the discounted value of FCF out to a valuation horizon (H).
The valuation horizon is sometimes called the terminal value and is calculated like PVGO.
HH
HH
rPV
rFCF
rFCF
rFCFPV
)1()1(...
)1()1( 22
11
++
+++
++
+=
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Capital Budgeting Valuing a Business or Project
HH
HH
rPV
rFCF
rFCF
rFCFPV
)1()1(...
)1()1( 22
11
++
+++
++
+=
PV (free cash flows) PV (horizon value)
Slide Number 1The Balance SheetThe Balance SheetMarket Value vs. Book ValueThe Income StatementThe Income StatementThe Statement of Cash FlowsTaxesFuture ValuesFuture ValuesPresent ValuesPresent ValuesPresent ValuesTime Value of Money(applications)PV of Multiple Cash FlowsPerpetuities & AnnuitiesPerpetuities & AnnuitiesPerpetuities & AnnuitiesPerpetuities & AnnuitiesPerpetuities & AnnuitiesInflationInflationEffective Interest RatesBondsBond PricingBond Cash FlowsBond PricingBond YieldsBond YieldsBond YieldsNominal and Real ratesDefault RiskCorporate BondsStocks & Stock MarketStocks & Stock MarketStocks & Stock MarketValuing Common StocksValuing Common StocksValuing Common StocksValuing Common StocksValuing Common StocksValuing Common StocksValuing Common StocksValuing Common StocksRandom Walk TheoryAnother ToolEfficient Market TheoryNet Present ValueNet Present ValueNet Present ValueNet Present ValuePayback MethodOther Investment CriteriaEquivalent Annual AnnuityAnnuity FactorProfitability IndexCapital Budgeting TechniquesCapital Budgeting ProcessCapital Budgeting ProcessHow To Handle UncertaintyOperating LeverageOperating LeverageRates of ReturnRates of ReturnRates of ReturnMarket IndexesRate of ReturnMeasuring RiskRisk and DiversificationRisk and DiversificationRisk and DiversificationRisk and DiversificationTopics CoveredMeasuring Market RiskPortfolio BetasRisk and ReturnRisk and ReturnMeasuring Market RiskMeasuring Market RiskMeasuring Market RiskSecurity Market LineCapital Asset Pricing ModelTesting the CAPMCapital Budgeting & Project RiskCost of CapitalWACCWACCWACCWACCWACCWACCMeasuring Capital StructureMeasuring Capital StructureMeasuring Capital StructureRequired Rates of ReturnRequired Rates of ReturnRequired Rates of ReturnFree Cash Flows* FCF and PV *Capital BudgetingCapital Budgeting
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