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CORPORATE FINANCE SESSION 1

AGENDA

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Basic Discounting NPV, IRR
Valuation of Bonds Yield Curves

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Valuation of Stock DDM, FCF, P/E, etc

Risk Return

Portfolio Theory CAPM, SML

Market Efficiency

2
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BASIC DISCOUNTING
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PRESENT VALUE

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Present Value = PV

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PV = discount factor C1
Discount Factor = DF = PV of $1

DF 1
(1 r ) t
4
SHORT CUTS

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Annuity - An asset that pays a fixed sum each year for
a specified number of years.

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1 1
PV of annuity C t
r r 1 r

5
RATE OF RETURN RULE

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Accept investments that offer rates of return in
excess of their opportunity cost of capital

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NET PRESENT VALUE RULE
Accept investments that have positive net present
value
Example
You can purchase a turbo powered machine tool gadget for
$4,000. The investment will generate $2,000 and $4,000 in
cash flows for two years, respectively. What is the IRR on
this investment?
2,000 4,000
NPV 4,000 6

(1 r ) (1 r )
1 2
INTERNAL RATE OF RETURN

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The discount rate often used in capital budgeting
that makes the net present value of all cash flows
from a particular project equal to zero.

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Example
You can purchase a turbo powered machine tool gadget for
$4,000. The investment will generate $2,000 and $4,000 in
cash flows for two years, respectively. What is the IRR on
this investment?

2,000 4,000
NPV 4,000 0
(1 IRR ) (1 IRR )
1 2 7
INTERNAL RATE OF RETURN

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2500
2000
1500

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IRR=28%
1000
NPV (,000s)

500
0
-500
10

20

30

40

50

60

70

80

90

0
10
-1000
-1500
-2000
Discount rate (%)
8
INTERNAL RATE OF RETURN - PITFALLS

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Lending or Borrowing?
Multiple rates of return

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Mutually Exclusive Projects
Term Structure Assumption

9
INFLATION

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Inflation - Rate at which prices as a whole are
increasing.

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Nominal Interest Rate - Rate at which money invested
grows.

Real Interest Rate - Rate at which the purchasing


power of an investment increases.

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INFLATION

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1+nominal interest rate
1 real interest rate = 1+inflation rate

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approximation formula

Real int. rate nominal int. rate - inflation rate

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INFLATION

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INFLATION RULE

Be consistent in how you handle

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inflation!!
Use nominal interest rates to discount
nominal cash flows.
Use real interest rates to discount real
cash flows.
You will get the same results, whether
you use nominal or real figures 12
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BOND & YIELD CURVES
13
VALUING A BOND

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Example continued
If today is October 2002, what is the value of the following bond?
An IBM Bond pays $115 every Sept for 5 years. In Sept 2007 it pays an

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additional $1000 and retires the bond.

The bond is rated AAA (WSJ AAA YTM is 7.5%)

115 115 115 115 1,115


PV
1.075 1.075 1.075 1.075 1.0755
2 3 4

$1,161.84
14
Source: Brealey & Myers
11/10/2017
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YIELD CURVE
BOND PRICES AND YIELDS

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1600

1400

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1200

1000
Price

800

600

400

200

0
0 2 4 6 8 10 12 14 Yield
16
5 Year 9% Bond 1 Year 9% Bond
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VALUATION OF STOCKS
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VALUING COMMON STOCKS

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Expected Return - The percentage yield
that an investor forecasts from a specific

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investment over a set period of time.
Sometimes called the market
capitalization rate.

Div1 P1 P0
Expected Return r
P0
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VALUING COMMON STOCKS

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Return Measurements

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Div 1
Dividend Yield
P0

Return on Equity ROE


EPS
ROE
Book Equit y Per Share
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VALUING COMMON STOCKS

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Dividend Discount Model - Computation of
todays stock price which states that share

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value equals the present value of all
expected future dividends.

Div1 Div2 Div H PH


P0 ...
(1 r ) (1 r )
1 2
(1 r ) H

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H - Time horizon for your investment.
VALUING COMMON STOCKS

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If we forecast no growth, and plan to hold
out stock indefinitely, we will then value

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the stock as a PERPETUITY.

Div1 EPS1
Perpetuity P0 or
r r
Assumes all earnings are paid to
shareholders.

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ASSUMPTIONS

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Any stock is ultimately worth no more than what it
will provide investors in current and future dividends
The next big assumption that the DDM makes is that

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dividends are steady, or grow at a constant rate
indefinitely
Another sticking point with the DDM is that no one
really knows for certain the appropriate expected rate
of return to use
If the company's dividend growth rate exceeds the
expected return rate, you cannot calculate a value -
because you get a negative denominator in the
formula
In fact, even if the growth rate does not exceed the
expected return rate, growth stocks, which don't pay
dividends, are even tougher to value using this model
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Ex: Microsoft
VALUING COMMON STOCKS

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Constant Growth DDM - A version of the
dividend growth model in which dividends

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grow at a constant rate (Gordon Growth
Model).

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VALUING COMMON STOCKS

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Ifa firm elects to pay a lower dividend,
and reinvest the funds, the stock price

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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.
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VALUING COMMON STOCKS

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Growth can be derived from applying the return
on equity to the percentage of earnings plowed
back into operations.

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g = return on equity X plowback ratio

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VALUING COMMON STOCKS

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Example
Our company forecasts to pay a $5.00 dividend next year,
which represents 100% of its earnings. This will provide

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investors with a 12% expected return. Instead, we decide to
blow back 40% of the earnings at the firms current return
on equity of 20%. What is the value of the stock before and
after the plowback decision?
No Growth With Growth

5
P0 $41.67
.12

26
VALUING COMMON STOCKS

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Example
Our company forecasts to pay a $5.00 dividend next year,
which represents 100% of its earnings. This will provide

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investors with a 12% expected return. Instead, we decide to
blow back 40% of the earnings at the firms current return
on equity of 20%. What is the value of the stock before and
after the plowback decision?
No Growth With Growth

5 g .20.40 .08
P0 $41.67
.12
3
P0 $75.00
.12 .08 27
VALUING COMMON STOCKS

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Present Value of Growth Opportunities (PVGO) -
Net present value of a firms future investments.

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Sustainable Growth Rate - Steady rate at which a
firm can grow: plowback ratio X return on equity.

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FREE CASH FLOW

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A measure of financial performance calculated as
operating cash flow minus capital expenditures.
In other words, free cash flow (FCF) represents

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the cash that a company is able to generate
after laying out the money required to maintain
or expand its asset base
It is defined as :

PAT + All non cash expenditure Changes in


working capital Capital expenditure
Different from normal Cash Flow

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FCF AND PV
Valuing a Business

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The value of a business is usually computed
as the discounted value of FCF out to a

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valuation horizon (H).
The valuation horizon is sometimes called
the terminal value and is calculated like
PVGO.
FCF1 FCF2 FCFH PVH
PV ...
(1 r ) (1 r )
1 2
(1 r ) H
(1 r ) H
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OTHER METHODS

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P/E, P/B
Trailing and Forward

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Method of comparables ARPU, EV/Tonnes,
EV/EBITDA
Recent transactions

31
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RISK & RETURN
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MEASURING RISK

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Diversification - Strategy designed to
reduce risk by spreading the portfolio

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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.

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MEASURING RISK

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Portfolio standard deviation

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Unique
risk

Market risk
0
5 10 15
Number of Securities

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PORTFOLIO RISK

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Expected Portfolio Return (x 1 r1 ) ( x 2 r2 )

Portfolio Variance x12 12 x 22 22 2( x1x 2 12 1 2 )

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BETA AND UNIQUE RISK

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1. Total risk =
Expected
diversifiable risk +
stock
market risk

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return
2. Market risk is
measured by beta,
beta
the sensitivity to
market changes +10%
-10%

- 10% + 10% Expected


market
-10% return

36

Copyright 1996 by The McGraw-Hill Companies, Inc


BETA AND UNIQUE RISK

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Market Portfolio - Portfolio of all assets in the
economy. In practice a broad stock market

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index, such as the S&P Composite, is used
to represent the market.

Beta - Sensitivity of a stocks return to the


return on the market portfolio.

37
Source: Brealey & Myers
11/10/2017
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38
im
m
Bi 2
BETA AND UNIQUE RISK
BETA AND UNIQUE RISK

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im
Bi 2
m

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Covariance with the
market

Variance of the market

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MARKOWITZ PORTFOLIO THEORY

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Combining stocks into portfolios can reduce
standard deviation, below the level obtained from
a simple weighted average calculation.

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Correlation coefficients make this possible.
The various weighted combinations of stocks that
create this standard deviations constitute the set
of efficient portfolios.

40
ASSUMPTIONS

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Investors seek to maximize the expected return
of total wealth.

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All investors have the same expected single
period investment horizon.
All investors are risk-adverse, that is they will
only accept greater risk if they are compensated
with a higher expected return.
Investors base their investment decisions on the
expected return and risk (i.e. the standard
deviation of an assets historical returns).
All markets are perfectly efficient (e.g. no taxes
41
and no transaction costs).
MARKOWITZ PORTFOLIO THEORY

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Expected Returns and Standard Deviations vary given
different weighted combinations of the stocks

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Expected Return (%)

Reebok

35% in Reebok

Coca Cola

Standard Deviation 42
EFFICIENT FRONTIER
Each half egg shell represents the possible weighted combinations for two

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stocks.
The composite of all stock sets constitutes the efficient frontier

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Expected Return (%)

43
Standard Deviation
EFFICIENT FRONTIER
Lending or Borrowing at the risk free rate (rf) allows us to exist outside the

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efficient frontier.

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Expected Return (%) T

rf

Standard Deviation 44