fm studyguide

8/11/2019 FM Studyguide

1/18

EBITDA = Gross Profit

EBIT = Operating Income

Earnings after Taxes/Interest = Net Income

Strengths and Weaknesses of Evaluation Techniques

An evaluation techniue shoul! consi!er"A# All future incremental pro$ect cash flo%s

"B# The time value of mone&

"'# (ncertaint& associate! %ith future cash flo%s

Pa&)ac* Perio! + + +

,trengths

Eas& to use(seful if firm is short on cash

(seful in high ris* situations %here either assets rapi!l& )ecome o)solete

or in!ustr& is ver& competitive

-ea*nessesEmphasi.es liui!it& over profita)ilit&

Ignores cash flo%s occurring after the pa&)ac* perio!Ignores ris* associate! %ith cash flo%s "Discounte! Pa&)ac*#

Net Present alue "A# "B# "'#,trengths

NPs are a!!itive "sum of NP of in!ivi!ual pro$ects = NP of 0irm#

Assumes cash flo%s are reinveste! at the hur!le rate

-ea*nessesNot expresse! as a percentage "Profita)ilit& In!ex#

Doesn1t consi!er the scale of pro$ects Doesn1t consi!er the life of the pro$ect

Internal 2ate of 2eturn "A# "B# "'#

,trengthsIn!icates %hether an investment increases a firm1s value

-ea*nesses

Assumes cash flo%s are re+investe! at I22

3ultiple I22s ma& exist if there are positive an! negative cash flo%s3a& not give value maximi.ing !ecision if comparing mutuall& exclusive

pro$ects or %hen un!er capital rationing4

3o!ifie! I22 "3o!if& reinvestment rate#

'ompoun! for%ar! all cash inflowsat the reinvestment rate

Discount )ac* all cash outflowsat the opportunit& cost of capital,olve for rate that euali.es 0 of cash inflo%s %ith P of cash outflo%s4

3I22 = 5 " 0 of Inflo%s# / "P of Outflo%s# 6 7 "8/9ol!ing Perio!# : 8


2/18


3/18

Intuition; Operating lease pa&ments are treate! as an or!inar& operating

expense even though it is a financing cost analogous to interest< so %e a!!

it )ac*4

,tep ; Estimating the Terminal alue

,alvage alue : Boo* alue = Taxa)le Gain,alvage alue : Taxes@Taxa)le Gain = After+tax Terminal alue

,tep C; Estimating the Incremental 0'00'ash flo% availa)le to all investors in the firm< after pa&ing taxes an! meeting

an& net investment nee!sJ it is pre+!e)t< )ut after+tax4

Operating 'ash 0lo%

+ Net -or*ing 'apital "An increase = 'ash Outflo%#+ 'apital Expen!itures

After+tax 0'00

Net -or*ing 'apital = 'urrent assets : 'urrent lia)ilities

2euire! to cover expenses that arise< initial inventories< etc4Exclu!e !e)t< excess cash

T&picall& all recovere! at en! of pro$ect life

'apital Expen!itures = Net initial investmentTreate! as 'apital outla&s< not expenses

'apitali.e!< an! !epreciate! over time4

5'hange in N-' ? 'apital Expen!itures6 = Net Investment nee!e! to generateO'0

0'00 = EBIT +or+ 0'0E

?Depreciation ?Interest Expense@"8+#+'apital Expen!itures ?Principal 2epa&ments

+-or*ing 'apital +Ne% De)t Issues?Preferre! Divi!en!s

Types of Cash Flows to the Fir

3aximi.e value to the firm< not value to the euit& hol!ers

EBITDA %hen 'apEx = H< -' = -' = H

Discount 2ate Before Tax -A''EBIT@"8+# %hen 'apEx = H

Discount 2ate After Tax -A''

Net Income@"8+# %hen 'apEx=DepreciationNon+Operating !on1t recur


0'00 %hen 'apEx?-' = Expenses for Gro%thDiscount 2ate After Tax -A''


4/18

EA"Econ Profit# %hen 0inance 'osts are treate! as Expenses


Types of Cash Flows to Equity

Divi!en!s "DP,# %hen DP, = 0'0E< 0'0E har! to estimate",toc* repurchases are treate! as !ivi!en!s#

Discount rate 'ost of Euit&

Earnings %hen DP, = EP,< or 2OE = 'ost of Euit&Discount rate 'ost of Euit&

0'0E %hen DP, K 0'0E< DP, L MH0'0E< DP,

(navaila)le

Discount rate 'ost of Euit&

(se Euit& aluation;

0or firms %ith sta)le leverage

If euit& is )eing value!(se 0irm aluation;

0or firms %ith too high/lo% leverage an! expect to change over time40or firms having onl& partial information on !e)t

If valuing the firm rather than the euit&

(se Nominal 0lo%s;If inflation is lo% "Taxes are )ase! on nominal income#

If using nominal !iscount rate

(se 2eal 0lo%s

If using real !iscount rate

0'0E ; Operating 'ash 0lo% : 'ash Expenses Nee!e! for Gro%th

Pure Euit& 0irm0'0E = Net Income

?Depreciation

+'apital Expen!itures

+-'

evere! 0irm "De)t< Euit&< preferre! Euit

0'0E= Net Income?Depreciation

+Principal 2epa&ment of De)t

+Preferre! Divi!en!s?Procee!s from Ne% De)t Preferre! offerings

+'apital Expen!itures

+-'

,ta)le everage "0inancing !one at a fixe! !e)t ratio " De)t / 5De)t?Euit&6 #0'0E= Net Income

+"8+#@"'apital Expen!itures : Depreciation#


5/18

+"8+#@-or*ing 'apital"see page 130)

Impact of Inflation

Nominal 'ash 0lo%s an! Nominal Discount 2ate

Incorporate expecte! inflation into future cash flo% estimates an! the!iscount rate

+or+

2eal 'ash 0lo%s an! 2eal Discount 2ateEstimate cash flo%s in real !ollars an! !iscount at a real !iscount rate

2eal 'ash 0lo%t= Nominal 'ash 0lo%t/ 5 8 ? Expecte! Inflation 2ate#t

8 ? 2eal Discount 2ate = 58 ? Nominal 2ate6 / 58 ? Expecte! Inflation 2ate6(see pages 113, 137: Inflation affects sales, cost savings, WC)

Project Analysis and Evaluation! Addressing "isk "page 8>#

2is*; 9o% much uncertaint& exists< the !egree of uncertaint&Drivers of (ncertaint&

Economic 'on!itions 3ar*et 'on!itionsTaxes Interest 2ates "cost of raising future capital#

International 'on!itions

2euire! 2ate of 2eturn = 'ompensation for Time ? 'ompensation for 2is*

(see page 150, standard deviation)

'oefficient of ariation = ,tan!ar! Deviation / Expecte! alue

(nit of 2is* per (nit of alue

3easuring a Pro$ect1s 3ar*et 2is*8# Pro$ect 2is* = 3ar*et 2is*-hen the firm is in one line of )usiness

-hen the firm ta*es on similar pro$ects

A!vantage; Doesn1t reuire ris* estimation for each pro$ectimitation; 3a& not appl& to firms in multiple lines of )usiness

# Pure Pla& Approach

-hen there are pu)licl& tra!e! firms in the same line of )usiness3etho!; I!entif& )usiness of each !ivision or pro$ect

I!entif& pu)lic firms involve! primaril& in the )usiness

O)tain mar*et ris* parameters for these compara)les'orrect mar*et ris* for financial leverage

Estimate cost of euit& for the !ivision or pro$ect

B = B(@ " 8?"8+#@D/E #(se mar*et values of De)t/Euit&

># Accounting Betas< 2egress earnings


6/18

Pitfalls; ,moothe! )etas< non+operating factors< EP, is once uarterl&

2egress EP, of mar*et %ith EP, of ,PCHHTreat ,lope as )eta

# Beta from 'ross+sectional regressions

' in Operating IncomeDe)t/Euit& 2atio

Earning Gro%th

Total Assets

2egress !ata %ith compara)les4

'ommon errors0ailure to consi!er ris*

Dou)le counting the same ris* using more than one ris* a!$ustment

Appl&ing an incorrect ris* profile

'onsi!ering !iversifia)leF ris* in anal&sis

#ncorporating Project "isk

2is* A!$uste! 2ates

alue = 52is*& 'ash 0lo%st/ "8 ? 2is* A!$uste! 2ate#t6

2is* A!$uste! 2ate = 2f? "2m+ 2f#3etho!; Discount 'ash 0lo%s using 2is* A!$uste! 2ate

,um for NP

'ertaint& euivalents

alue = 5'ertaint& Euivalent 'ash 0lo%st/ " 8?2f #6

'E 'ash 0lo%t= 2is*& 'ash 0lo%t 5 "8?2f# / "8?2is* A!$uste! 2ate # 6t= "8?rf#t/ "8?*e#t

3etho!; Discount 'ash flo%s using 2is* A!$uste! 2ate

+an!+3o!if& "multipl )& 2is* 0ree 2ate

2esulting 'ash 0lo%s are 'ertaint& Euivalents

Discount 'E 'ash 0lo%s using 2is* 0ree 2ate,um for NP

ualitative AssessmentPorter1s 0ive 0orces

Threat of Ne% Entrants< Threat of ,u)stitutes

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