University College Dublin Michael Smurfit Graduate School of Business MASTER OF BUSINESS ADMINISTRATION 2006/07

Financial Markets & Valuation

Review of Lecture Slides (Topic 1, 2, & 4) Fall 2006

FMV Slides Review

Table of Contents
1 FMV Overview..................................................................................................................... 1 2 Financial Forecasting........................................................................................................1
2.1 Projected IS & BS (Long Term)........................................................................................... 1 2.2 Cash flow forecasting (Short Term).....................................................................................1

3 Project investment appraisal.............................................................................................1

3.1 Methods of investment appraisal......................................................................................... 2
3.1.1 Accounting rate of return (ARR)...........................................................................................2 3.1.2 Payback Period (PP)............................................................................................................2 3.1.3 Net Present Value (NPV).....................................................................................................2 3.1.4 Internal Rate of Return (IRR)...............................................................................................3

3.2 Investment decision making in practice...............................................................................3

3.2.1 Risk- sensitivity analysis......................................................................................................3 3.2.2 Scenario analysis................................................................................................................. 4 3.2.3 Simulations..........................................................................................................................4 3.2.4 Risk- adjusted discount rate.................................................................................................4 3.2.5 Expected NPV......................................................................................................................4 3.2.6 Investors risk preferences...................................................................................................5 3.2.7 Event trees...........................................................................................................................5 3.2.8 Risk & standard deviation....................................................................................................5

3.3 Incremental analysis between 2 projects.............................................................................5

4 Dividend Policy.................................................................................................................. 6
4.1 Factors in determining dividend policy.................................................................................6 4.2 Modigliani- Miller approach.................................................................................................. 6 4.3 Alternatives to cash dividends............................................................................................. 7
4.3.1 Share dividends................................................................................................................... 7 4.3.2 Share repurchase................................................................................................................ 7

Full Time MBA 06-07

Date: 03/12/2006

FMV Slides Review

1 FMV Overview
3 key decisions: Investment decision (higher NPV more value of firm) Financing decision (capital structure decision) o MM approach: doesnt matter how firm financed assets side of BS determines value of company not financing (liab + equity) Dividend decision Tips: Look at questions before reading case

2 Financial Forecasting
Purpose of financial plan is to ensure sufficient funds (cash) available for mgmt to achieve objectives.

2.1 Projected IS & BS (Long Term)

Most data comes from sales forecast: (e.g. P1s8,10,11; P1s12-16) 1. total mkt size 2. mkt trends 3. competitive intensity in industry 4. historical sales performance 5. anticipated mkt share 6. potential production capacity include depreciation exclude activities that have not yet occurred (even if they are paid for)

2.2 Cash flow forecasting (Short Term)

4 steps: (e.g. P1s8-9; P1s12-16) 1. establish anticipated cash inflow (from cash sales & collections from debtors) 2. establish anticipated cash outflow a. creditors b. fixed & var expenses (wages, admin, gen. exp., tax, dividends) 3. establish net cashflow (in-out) 4. cumulative cashflow (closing balance) add opening balance for period Depreciation is not a cash expense! Poor working capital if current assets current liabilities < 0

3 Project investment appraisal

Capital budgeting selection of long term investments; only incremental costs are relevant

FMV Slides Review

3.1 Methods of investment appraisal

3.1.1 Accounting rate of return (ARR)
Also called the simple rate of return Advantages: o Easily get data from accounting statements o Easily understandable (%) o Easy to calculate o Similar to ROCE measure (return on capital employed topic 3) Disadvantages: o Based on accounting income rather than cashflows (need cash to pay!) o Average ignores time value of money o Profits can be subject to manipulation ARR = Average annual profit x 100% Avg. investment to earn that profit

3.1.2 Payback Period (PP)

Time required to recover the initial cost of investment Commonly used method of investment appraisal Advantages: o Simple to calculate/apply (just look at cashflows) o Measure of risk - The longer the payback period the greater the risk o Avoids forecasting far into the future o Emphasises importance of liquidity (cash) Disadvantages: o PP cannot distinguish between those projects that pay back a significant amount early (big cash burn factor) o Ignores cashflows after PP o Ignores time value of money o Ignores wealth maximization (more concerned with break-even)

3.1.3 Net Present Value (NPV)

Cashflows are discounted to the present value using the required rate of return (cost of financing) Accept if Positive NPV - means you are generating a return greater than the required return (or cost of finance); Negative means you have less cash coming in than you have going out bad investment. Advantages: o Accounts for time value of money o Reflects risk, interest lost, inflation o Uses cash flows Disadvantages: o More complicated to calculate o No percentage If comparing projects with 2 different timelines, either:
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FMV Slides Review

o Bring both to same time span (i.e. Proj1 = 2 yrs, Proj2 = 3 yrs, NPV over 6 years) or o Bring both to 1 year (equivalent annual annuity) NPV = C1 + + Cn - Coutflow 1 n (1 + K) (1 + K)

Where: Cn = free cash flow at end of year n K = required rate of return If same amount (C) every year (perpetuity) can use limit: PV = C/K

3.1.4 Internal Rate of Return (IRR)

The rate of return which equates the present value of all cash outflows with the present value of all cash inflows (i.e. rate where NPV = 0) Most frequently applied method Accept project if IRR > K (cost of capital) (exceptions P2s28-30) To approx. find IRR graphically find two ks such that one NPV is +ve and the other is ve. Plot k vs. NPV and find point where NPV is zero (see P2s26) o Use similarity of triangles to calculate (P2s27) Advantages over NPV: o Percentage better understood Disadvantages: o Does not distinguish between borrowing and lending (NPV does) (P2s28-30) Use NPV to determine go or no-go o Multiple rates of return (change in sign of cashflows produces two possible IRRs) (P2s32-33) Look at NPV o Mutually exclusive projects (P2s34-35) Consider incremental costs between too projects (G-F) o IRR gives preference to projects that payback sooner unreliable (P2s36) NPV is the best technique for independent projects o Term structure of interest rates Where there is a different K for each period what is the appropriate IRR? IRR = Kpos + [(difference between rates) NPVpos x 100%] [ NPVpos + NPVneg ] Where Kpos = interest rate that generated the positive NPV Kneg = interest rate that generated the negative NPV Note: NPVneg does not include the ve sign

3.2 Investment decision making in practice

3.2.1 Risk- sensitivity analysis
P2s42-45

FMV Slides Review

Advantages: o Managers get better understanding of risk o Identify most sensitive variables Disadvantages: o Judgement required o Static analysis (variables are usually interlinked)

3.2.2 Scenario analysis

Look at 3 scenarios: optimistic, pessimistic, most likely Disadvantages: o Only looking at 3 scenarios (others?) o What is the likelihood of these scenarios?

3.2.3 Simulations
Step1: identify the key variables and their interrelations Step 2: specify the possible values for each variable Step 3: carry out repeated trials to get prob. Distribution for project cash flows Advantages: o Managers are forced to build a model o Distribution of project outcomes Disadvantages: o Costly and time consuming o More complex (modelling relationships)

3.2.4 Risk- adjusted discount rate

3.2.5 Expected NPV

e.g. P2s49-51 Use the probability to weigh the income

FMV Slides Review

Get NPV and subtract initial investment to get ENPV Disadvantages: o Not good indicator of risk

3.2.6 Investors risk preferences

Investors in practice will be interested in downside risk

3.2.7 Event trees

P2s54-56

3.2.8 Risk & standard deviation

Large num. of possible outcomes Calculate the prob. Distributions of NPVs Shape of curve will vary according to nature of project Standard deviation measures how variable possible returns are from expected value

Figure 5.10 Probability distribution of two projects with the same expected value

The figure shows the probability distribution for two projects which have the same expected value. We can see, the distribution for each project around the expected value is quite different. Project A has a much tighter distribution than Project B. This means that Project A has less 'downside' risk but also has less 'upside' potential.

3.3 Incremental analysis between 2 projects

e.g. P2s60-63 & P2s64-

FMV Slides Review

4 Dividend Policy
Objective of financial mgmt is to max. shareholder weather (i.e. share price) empire building mgmt engage in activities rather that whats best for the company (SH value maximization) o Retained earnings are sometimes used for empire building (dont have to convince SH to raise capital) Dividend cover = (Profit after tax) / (Dividend) OR (EPS) / (DPS) o High DC indicates profits would have to drop a lot before you lost your dividend o DC < 1 means earnings cannot cover dividend o Inverse is dividend payout ration proportion of profits paid out as dividends Dividend per share and Dividend payout ratio measures of dividend patterns Pick a dividend policy and stick with it (predictable, no surprises, no unwanted signals) Dividend increases should keep with inflation

4.1 Factors in determining dividend policy

1. Liquidity and avail. of cash to pay dividends 2. Avail. of investment opportunities (+ve NPV projects) yielding a rate of return > K (allow companys cash to earn revenue) 3. Avail. of long term funds in equity or debt; cap. market conditions favourable for raising capital 4. Nature of SH (private or institutions) and their requirement for dividends or cap. growth incl. ref. to tax aspects (i.e. dividend may require you to pay income tax where as cap. gain shares can get cap. tax rate) 5. Implications to control of company (i.e. whether paying dividends will result in dilution of the rights of existing SH) 6. Information content of dividends to market (signalling) 7. Future stability of dividends (hard to cut dividends once a trend has been established) 8. Future inflation 9. Conditions imposed by the constitutions of a company or restrictive covenant agreements (found in loan agreements) 10. Law of distributable profits (cannot pay out dividend if dont have profits (incl. retained earnings)) 11. Reduction of agency costs (???) 12. Threat of takeover for firms with very high or low dividends (high not investing money wisely; low empire building?) 13. Inside info by management (dividends signalling device for future) 14. Dividend policy of other firms

4.2 Modigliani- Miller approach

A change in the location of funds should not affect shareholder (SH) wealth (wealth = amount inside and outside company)

FMV Slides Review

o In theory, whether a company pays a dividend or not the SH wealth does not change o If the company didnt issue a dividend but he wanted to receive one he could sell a portion of shares. Change the # of shares of SH but not SH wealth o If the company issued a dividend and issued more shares to compensate, the SH wealth would not change Assumptions: o No share issue costs o No transaction costs for: Selling proportion of shares Selling shares in unlisted companies (dont have to worry about finding buying or discounting price) o No tax

4.3 Alternatives to cash dividends

4.3.1 Share dividends
Dividends paid in the form of additional shares rather than cash (particularly when liquidity problems). Net assets and market price remain unchanged by bonus issue Advantages: o Cash retained in business o Almost same informational content as dividends (signalling) o Better than giving up dividend all together o Where liquidity is an issue, maintains perceived stability of dividend stream and preserves market image of company o Increase # of shares in issue improves marketability of shares o Effective way for those wishing to increase holdings in company while avoiding brokers and other costs

4.3.2 Share repurchase

Advantages: o Can improve liquidity of firm (company is willing to buy shares) o Signal future of company is good can handle more financing o Remaining shares increase in value (see P4s19); capital gain instead of dividend o Control of company passes onto the remaining shareholders o Protection of minority interest