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Financial Management...

100 Slides
Cash

Raw materials
Receivables inventory

Finished goods
inventory

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Key Words...
Financial Market – Present Value – Perpetuity –
Annuity – Compound Interest – Inflation – Bond
Yield – Share Value – Free Cash Flow – IRR –
Risk Valuation – Markowitz – SML – CAPM –
Beta Risk – APT – Portfolio Theory – Economic
Profit – Call Option – Straddle – Option Pricing
Theory – Leverage Ratio – Liquidity – Du Pont –
Private Equity – Volatility – Working Capital –
Valuation – Value Drivers – Risk/Return –
Diversification – Corporate Finance – Yield –
NPV – Cash Transfer – Accounting
The Dual Functions of Financial Markets

The financial markets

The primary market The secondary market

cash cash

The firm Investors Investors Investors


newly issued outstanding
securities securities
Present Value

Present Value Discount Factor


Value today of a Present value of a $1
future cash flow. future payment.

Discount Rate
Interest rate used to
compute present values
of future cash flows.

DF =
Present Value = PV 1
PV = discount factor × C 1 ( 1+ r ) t

C1
PV = DF × C 1 =
1 + r1
Net Present Value

NPV = PV - required investment

C1
NPV = C 0 +
1+ r
Perpetuity

Perpetuity - Financial concept in which a cash flow is


theoretically received forever.

cash flow cash flow


Return = PV of Cash Flow =
present va lue discount rate
C
= C1
r= PV
PV r
Annuity

Annuity - An asset that pays a fixed sum each year for


a specified number of years.

1 1 
PV of annuity = C ×  − t 
 r r (1 + r ) 
Compound Interest

18
16
10% Simple
14
10% Compound
12
10
FV of $1

8
6
4
2
0
0

12

18

24

30
15

21

27
Number of Years
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.

1 + real interest rate = 1+nominal interest rate


1+inflation rate
Bond Prices and Yields

1600
1400

1200
1000
Price

800
600

400
200
0
0 2 4 6 8 10 12 14 Yield
5 Year 9% Bond 1 Year 9% Bond
Valuing Common Stocks I

Div P - P
Expected Return = r = 1+ 1 0
P P
0 0

= P0 = Div 1
Capitalization Rate
r- g
= r = Div 1 + g
P0
Valuing Common Stocks II

Return Measurements

Div 1
Dividend Yield =
P0

Return on Equity = ROE


EPS
ROE =
Book Equity Per Share
Valuing Common Stocks III

If we forecast no growth, and plan to hold out stock


indefinitely, we will then value the stock as a
PERPETUITY.

Div1 EPS1
Perpetuity = P0 = or
r r
Assumes all earnings are
paid to shareholders.
FCF and PV

FCF1 FCF2 FCFH PVH


PV = + + ... + +
(1 + r )1 (1 + r ) 2 (1 + r ) H (1 + r ) H

PV (free cash flows) PV (horizon value)


NPV and Cash Transfers

Cash

Investment Investment opportunities


opportunity (real (financial assets)
Firm Shareholder
asset)

Invest Alternative: pay Shareholders invest


dividend to for themselves
shareholders
Internal Rate of Return

2500

2000

1500

1000
NPV (,000s)

500

-500

70
10

20

30

40

50

60

80

90

0
10
-1000

-1500

-2000 Discount rate (%)


Rate of Return 1926 - 1997

60

40
Percentage Return

20

-20
Common Stocks
Long T-Bonds
-40
T-Bills

-60 30 35 40 45 50 55 60 65 70 75 80 85 90 95
26
Year
Measuring Risk

Portfolio standard deviation

Unique
risk

Market risk
0
5 10 15

Number of Securities
Portfolio Risk I

The variance of a two stock portfolio is the sum of these


four boxes:

Stock 1 Stock 2
2 2 x 1x 2σ 12 =
Stock 1 xσ1 1
x 1 x 2ρ 12σ 1σ 2
x 1x 2σ 12 = 2 2
Stock 2 xσ2 2
x 1x 2ρ 12σ 1σ 2
Portfolio Risk II

Expected Portfolio Return = (x r ) + ( x r )


1 1 2 2

Portfolio Variance = x 2 σ2 + x 2 σ2 + 2 ( x x ρ σ σ )
1 1 2 2 1 2 12 1 2
Portfolio Risk III

The shaded boxes contain variance terms; the remainder contain


covariance terms.

1
2
3
To calculate
STOCK 4 portfolio variance
5 add up the boxes

N
1 2 3 4 5 6 N
STOCK
Beta and Unique Risk

Expected
σ stock
B = im return
i σ 2
m beta
+10%

- 10% +10% Expected


market
-10% return
Markowitz Portfolio Theory

Price changes vs. Normal distribution

600

500

400
(frequency)
# of Days

300

200

100

0
-10% -8% -6% -4% -2% 0% 2% 4% 6% 8% 10%

Daily % Change
Efficient Frontier I

Return Expected
Return (%)

B
A
Risk
Standard
deviation
Efficient Frontier II

Expected Return (%)


T

d ing ing
n
Le rrow
Bo
rf

S
Standard deviation
Efficient Frontier III

Return

Low Risk High Risk


High Return High Return

Low Risk High Risk


Low Return Low Return

Risk
Security Market Line I

Return

Market Return = rm
.
Efficient Portfolio
Risk Free
Return = rf

Risk
Security Market Line II

Return

Market Return = rm
.
Efficient Portfolio
Risk Free
Return = rf

BETA
1.0
Security Market Line III

Return

SML

rf

1.0 BETA

SML Equation = rf + B ( rm - rf )
Capital Asset Pricing Model (CAPM)

Expected return

Security market line

Market portfolio rate

Rm = 13.5%

Rf = 5%
Treasury bill rate

Beta
0 1

R = rf + B ( rm - rf )
Beta vs. Average Risk Premium

Avg Risk Premium

30 1966-91

20
SML
Investors

10

Market
0 Portfolio
1.0 Portfolio Beta
Consumption Betas vs. Market Betas

Stocks Stocks
(and other risky assets) (and other risky assets)

Wealth is uncertain
Standard Consumption
Market risk
makes wealth CAPM Wealth CAPM
uncertain.
Consumption is uncertain

Wealth = market
portfolio Consumption
Arbitrage Pricing Theory

Alternative to CAPM

Expected Risk
Premium = r - rf
= Bfactor1 (rfactor1 - rf) + Bf2 (rf2 - rf) + …

Return = a + bfactor1 (rfactor1 ) + bf2 (rf2 ) + …


Portfolio Risk

Specific company return (%)


Market return (%)
Capital Structure & COC

Expected Returns and Betas prior to refinancing

Expected 20
return (%)

Requity = 15
Rassets = 12.2

Rdebt = 8

0
0 0.2 0.8 1.2
Bdebt Bassets Bequity
Risidual Income & EVA

Residual Income or EVA = Net Dollar return after


deducting the cost of capital.

EVA = Residual Income


= Income earned - Income required
= Income earned - [Cost of Capital× Investment]
Economic Profit

Economic Profit = capital invested multiplied by the spread


between return on investment and the cost of capital.

EP = Economic Profit
= ( ROI − r ) × Capital Invested
Accounting Measurement

ECONOMIC ACCOUNTING
Cash flow + Cash flow +
INCOME
change in PV = change in book value =
Cash flow - Cash flow -
economic depreciation accounting depreciation

Economic income Accounting income


RETURN
PV at start of year BV at start of year
M&M Proposition

r
rE

rA

rD
D
E
Risk free Risky
debt debt
WACC (traditional and M&M view)

r r
rE
rE
WACC
rE =WACC

rD rD
D D
V V

r
rE

WACC

rD
D
V
Financial Distress

Maximum value of firm

Costs of
financial distress

PV of interest
tax shields
Value of levered firm

Value of
unlevered
firm

Optimal amount
Debt of debt
Call Option (long)

Call option value given a $85 exercise price.


Call option value

$20

85 105

Share Price
Put Option (long)

Put option value given a $85 exercise price.


Put option value

$5

80 85

Share Price
Call Option (short)

Call option payoff (to seller) given a $85 exercise price.


Call option $ payoff

85
Share Price
Put Option (short)

Put option payoff (to seller) given a $85 exercise price.


Put option $ payoff

85
Share Price
Protective Put

Long stock and long put

Long Stock

Protective Put
Position Value

Long Put

Share Price
Straddle

Long call and long put


- Strategy for profiting from high volatility
Position Value

Straddle

Share Price
Black-Scholes Option Pricing Model

Ps v2
ln + (r + )t
S 2
(d1) =
v t

N(d1)=

32 34 36 38 40
Binomial vs. Black Scholes

Expanding the binomial model to allow


more possible price changes

1 step 2 steps 4 steps


(2 outcomes) (3 outcomes) (5 outcomes)
etc. etc.
Straight Bond vs. Callable Bond

Value of
bond Straight bond

100

Bond Callable
75
at 100

50

25
Value of
straight bond
25 50 75 100 125 150
Exchange Rate Relationship

1 + rforeign 1 + i foreign
equals
1 + r$ 1 + i$
equals equals

f foreign /$ E(sforeign / $)
equals
S foreign /$ S foreign / $
Leverage Ratios I

long term debt


Long term debt ratio =
long term debt + equity

long term debt + value of leases


Debt equity ratio =
equity
Leverage Ratios II

total liabilities
Total debt ratio =
total assets

EBIT
Times interest earned =
interest payments

EBIT + depreciation
Cash coverage ratio =
interest payments
Liquidity Ratios I

Net working capital net working capital


=
to total assets ratio total assets

current assets
Current ratio =
current liabilities
Liquidity Ratios II

cash + marketable securities + receivables


Quick ratio =
current liabilities

cash + marketable securities


Cash ratio =
current liabilities

cash + marketable securities + receivables


Interval measure =
average daily expenditures from operations
Efficiency Ratios I

sales
Asset turnover ratio =
average total assets

sales
NWC turnover = average net working capital
Efficiency Ratios II

cost of goods sold


Inventory turnover ratio =
average inventory

average inventory
Days' sales in inventory =
cost of goods sold / 365

average receivables
Average collection period =
average daily sales
Profitability Ratios I

EBIT - tax
Net profit margin =
sales

EBIT - tax
Return on assets =
average total assets

earnings available for common stock


Return on equity =
average equity
Profitability Ratios II

dividends
Payout ratio =
earnings

earnings - dividends
Plowback ratio =
earnings
= 1 - payout ratio

earnings - dividends
Growth in equity from plowback =
earnings
Market Value Ratios I

stock price
PE Ratio =
earnings per share

P Div 1 1
Forecasted PE ratio = 0 = x
aveEPS EPS r - g
1 1

dividend per share


Dividend yield =
stock price
Market Value Ratios II

Div
Price per share = P = 1
0 r - g

stock price
Market to book ratio =
book value per share

market value of assets


Tobins Q =
estimated replcement cost
Du Pont System I

sales EBIT - taxes


ROA = x
assets sales

asset profit
turnover margin
Du Pont System II

assets sales EBIT - taxes EBIT - taxes - interest


ROE = x x x
equity assets sales EBIT - taxes

leverage asset profit debt


ratio turnover margin burden
Firm‘s Cumulative Capital Requirement

Dollars
A
B
C

Cumulative capital
requirement

Year 1 Year 2 Time

Strategy A: A permanent cash surplus


Strategy B: Short-term lender for part of year and borrower for remainder
Strategy C: A permanent short-term borrower
Working Capital

Simple Cycle of operations

Cash

Raw materials
Receivables inventory

Finished goods
inventory
Inventories & Cash Balances I

Total costs
Carrying costs

Total order costs

Optimal Order size


order size
Inventories & Cash Balances II

Cash balance
($000)
25

Average
12.5 inventory

0 1 2 3 4 5 Weeks

Value of bills sold = Q =

2 x annual cash disbursement x cost per sale


interest rate
Private Equity Partnership

Investment Phase Payout Phase

General Partner put up 1% General Partner get carried


of capital interest in 20% of profits

Mgmt fees
Limited partners Limited partners
put in 99% of get investment
capital
Partnership Partnership back, then 80%
of profits

Company 1
Company 2
Investment in Sale or IPO of
diversified companies
portfolio of
companies
Company N
Increase in the Cash Flows from Assets

Debtholders

They have fixed claims on


these cash flows

Assets Cash flows form assets


Shareholders
They have residual claims on
these cash flows so that the
larger the cash flows, the
more value created
A Simplified View of the Financial
Accounting Process

The rest
The firm Financial transactions
of the world

Financial accounting process

The income statement


The balance sheet Records revenues and expenses
Records assets and liabilities over a period of time. Their
at the date of the balance sheet. difference, which represents an
Their difference is the book value increase or a decrease in the book
of equity at that date. value of equity, is the profit or
loss for the period.
Sources of Risk That Increase Profit
Volatility

• Economic conditions + 31%


• Political & social environment + 26%
+ 10%

Less variable Less fixed


Earnings
and interest Earnings
SALES fixed before interest expenses after taxes
expenses and taxes and variable
tax expenses
- 10%
- 26%
• Market structure - 31%
• Firm‘s competitive position

ECONOMIC RISK OPERATIONAL RISK

BUSINESS RISK FINANCIAL RISK


The Link Between the Balance Sheets
and the Income Statement
Balance Sheet Income Statement Balance Sheet
December 31, 2001 Year 2002 December 31, 2002

Liabilities Liabilities
Assets $100 $113
Assets
$170
$190
Owner‘s equity
$70 Owner‘s equity
Expenses $77
Revenues $469.8
$480

Net Profit
$10.2
Retained earnings
$7
Dividends
$3.2
The Managerial Balance Sheet Versus
the Standard Balance Sheet

The Managerial Balance Sheet The Standard Balance Sheet

Invested capital Liabilities


or net assets Capital employed Total assets and owner‘s equity

Cash Cash
Short-term debt Short-term debt
Working capital Operating assets
requirement Accounts receivable Operating liabilities
(WCR) plus Accounts payable
Operating assets Inventories plus
less plus Accrued expenses
Operating liabilities Prepaid expenses
Long-term financing
Long-term debt
plus Long-term financing
Owner‘s equity Long-term debt
Net fixed assets Net fixed assets plus
Owner‘s equity
The Firm‘s Operating Cycle and Its
Impact on the Firm‘s Balance Sheet

Payments for nonoperating


Cash activities

Impact on the balance sheet: Impact on the balance sheet:

• Accounts receivable Sales Procurement • Accounts payable


• Finished goods inventory • Raw material inventory

Production

Impact on the balance sheet:

• Raw materials inventory


• Work in progress inventory
• Finished goods inventory
Sources of Cash Inflow and Cash Outflow
Sources of cash inflow

Operating activities Investing activities Financial activities


• Sale of goods and services • Sale of fixed assets • Issuance of stocks and bonds
• Sale of long-term financial assets • Long-term borrowings
• Collection of interest and • Short-term borrowings
dividend income
• Collection of loans mad
$2

$472 $13
CASH
$460.8 $18.2
Sources of cash outflow

$12

Operating activities Investing activities Financial activities


• Purchase of supplies • Capital expenditures and • Repurchase of stocks and bonds
• Selling, general, and administrative acquisitions • Repayment of long-term debt
expenses • Long-term financial investments • Repayment of short-term debt
• Tax expense • Interest payment
• Dividend payment

Net cash flow from operating New cash flow from investing New cash flow from financing
activities activities activities
$11.2 ($10) ($5.2)
The Drivers of Return on Equity
Return on equity
Earnings after tax
ROE = Owner‘s equity

Return on invested capital


Earnings before interest and tax Financial leverage multiplier Tax effects
ROIC =
Invested capital

Operating profit margin Capital turnover Financial structure ratio Financial cost ratio Tax effect ratio
Earnings before interest and tax Sales Invested capital Earnings before tax Earnings after tax
Sales Invested capital Owner‘s equity Earnings before interest and tax Earnings before tax

Sales Invested capital Owner‘s equity Cost of debt Tax rate

Cash
Operating costs
Working Capital
requirement

Fixed assets
The Financial System
Intermediation via CASH
institutional investors
Insurance policies PRIVATE
Insurance companies, pension funds, PLACEMENT
Retirement plans
Shares in funds Investment funds & venture capitalists
S
U CASH CASH CASH
Money Market
P SHARES BONDS Instruments
P
L CASH CASH
The equity market
I
SHARES (Trading in shares of common stocks)
E SHARES F
R CASH CASH I
The corporate market
S R
(Trading in corporate bonds)
BONDS BONDS M
OF CASH CASH S
The money market
(Trading in money market instruments)
F Commercial Commercial
paper paper
U
N Bank certificates
CASH
of deposit (CD)
D
S
BANK
DEPOSITS
Intermediation via DEBT OWED
TO BANKS
banks
CASH and other lending institutions CASH
Alternative Equity Valuation Models
Market multiples model Dividend valuation model
Firm‘s earnings, cash Future expected
flows, or book value dividends

multiplied by the
Equity discounted at the
value
Corresponding
Cost of equity
market multiple
equals

Present value
Discounted cash flow model of debt
Adjusted present value model
Cash flows
from assets
less the Unlevered
Firm‘s earnings, cash discounted at the
asset value
flows, or book value
Levered Unlevered
discounted at the asset value cost of equity

Corresponding
market multiple Tax
savings
Present value
discounted at the
of tax savings

Cost of debt
The Drivers of Value Creation
EBIT
Operating margin = Sales EBIT
Invested capital
(pretax ROIC)
Sales
Capital turnover = Invested capital Expected after tax
ROIC
Tax effect = (1 – Taxe rate)
Return spread
Percent of (ROIC – WACC)
debt financing Market Value Added (MVA)
Aftertax cost of debt Weighted average
cost of capital If the present value of the future stream of
WACC expected return spreads is positive, MVA is
Estimated cost of equity Percent of positive and the higher the growth, the more
equity financing value created.

If the present value of the future stream of


Economic, political, and expected return spreads is negative, MVA is
social environments negative and the higher the growth, the more
value destroyed.
Sustainability
Market structure
of growth

Competitive advantages and


core competencies

EBIT = Earnings before interest and taxes (operating profit before tax);
Invested capital = Cash + Working capital requirement + net fixed assets;
WACC = (%Debt)(After tax cost of debt) + (%Equity)(Cost of equity).
Capital-Budgeting Simulation
Step 1: Develop probability distributions for key factors.

Step 2: Randomly select values from these distributions.

Market Selling Fixed

Probability
size price costs

Value range
Market Investment Residual
growth required value of
rate investment

Share Operating Useful life


of market costs of facilities

Step 3: Combine these factors and determine a net present value.

Step 4: Continue to repeat this process until a clear portrait of


the results is obtained.
Probability

Net present value

Step 5: Evaluate the resultant probability distribution.


Cash Flow Diagram
Supplies
and
Saleable Credit sales
materials
product (accounts
purchased
(inventory) receivable)
using trade
credit

Suppliers Payment
Payment Payment Bad
for fixed
for wages for heat debts
asset
and salaries and power
Payments purchases
for credit
purchases

Cash Cash Collections


Cash from
dividends sales
credit
sales

Proceeds from Payment


Proceeds from
sale or issuance of taxes
sale or issuance
of notes and
of stock
bonds
Interest
and
principal

Stockholders Creditors Government


Aggressive Financing Strategy:
Permanent Reliance on Short-Term
Financing

Permanent dependence
on short-term financing Temporary (short-term)
financing

Permanent
DOLLAR current assets
AMOUNT Current
assets
Permanent plus
spontaneous financing

Fixed
assets

TIME
Cash and Marketable Securities
Management

Irregular cash inflows


Bond sales
Other debt contracts
Preferred stock sales
Common stock sales
In
Irregular outflows
Out Purchase
Dividends Cash Marketable
Interest
balance Sale securities
Principal on
debt
Share repurchase
Taxes Purchase Labor and material

Credit
sales
Fixed assets Inventory Receivables
Depreciation

Sale Cash sales Collections


Three Ways to Transfer Financial Capital
in the Economy
(1) (2) (3)
Direct transfer Indirect transfer Indirect transfer
of funds using the investment using the financial
banker intermediary
The business The business The business
firm (a savings firm (a savings firm (a savings
deficit unit) deficit unit) deficit unit)

Firm‘s
Securities Funds Funds
securities

Firm‘s
Funds Marketable Marketable
securities
(dollars of
(stocks, securities securities
savings)
bonds)

Intermediary‘s
Securities Funds Funds
securities

Savers Savers Savers


(savings (savings (savings
surplus units) surplus units) surplus units)
Key Metrics Required for Different
Company Situations
High

Multiyear
Growth of
DCF of
net
Need for long-term view economic
income
• High probability of significant change of profit
- Technology
- Regulation Operating
- Competition
• Long life of investments value drivers
• Complexity of business portfolio Net
ROIC-WACC,
income,
economic
return on
profit (one year)
Low sales

Low High
Capital intensity (need for
balance sheet focus)
• Working capital
• Property, plant, and equipment
Various Levels of Value Driver
Identification
LEVEL 1 LEVEL 2 LEVEL 3
Examples Examples
• Customer mix • Percent
• Sales force accounts
productivity revolving
Margin (expense: • Dollars per
revenue) visit
Margin • Unit revenues
Invested • Fixed cost/ • Billable hours
allocations to total payroll
capital
• Capacity hours
management • Percent capacity
ROIC • Operational utilized
yield • Cost per
delivery
Margin
• Accounts
Invested receivable
capital terms & timing
Invested • Accounts
payable terms
capital & timing

Business-unit Operating
Generic
specific value drivers
Customer Servicing – Human Expense
Flowchart
Call volume % time on board
% time in training
Number of % time on breaks
Percent occupancy
people % time on vacation
Personal
cost Average work % time paid
Cost per person Absence/other
time per call

Number of
Hourly rate
stations per SDC
Number of Benefits
Equipment
Service SDCs
cost per station
Delivery
Center Station Equipment, Annual salary
expense cost maintenance
Cost per SDC experse per Benefits
Total station
CS-
human Other equipment Span of control
Headquaters
expense expense
expense
Number of employees
Overhead Regional Salary expense
expense center Supervisory Utilities
expenses cost Number of
Area staff supervisors Other
center
expense Building operating
expense Number of employees
Allocated Overhead
G&A cost Building Equipment
maintanance
expense Materials

Other
Six Conditions for Excellent Value-Based
Management
Performance
Driven
5
4
3
Low cost Value-based
2
Highest level
1 Good
Medium
Sup par
Lowest
Strong Managed
self-reinforcement bottom up
process as well as
top down

Two-way
communications
Simple Entity Valuation of a Single-
Business Company
Operating
free cash flow130 140 150 160

100
90
70

Cash flow 85
Debt 80
to debtholders 74
value 69

36 43
20

Operating
value
Cash flow
to equity owners
Equity 75
66 70
value 61
54 57
50
Entity Valuation of a Multibusiness
Company
1,750
Excess Corporate
marketable 150 250 overhead
securities
Market value:
Unit D 200 • Of debt
300 • Of preferred stock

Unit C 300
100

Unit B 400
1,500

1,100

Unit A 700

Total value Total Common


before company equity
subtracting value value
corporate
overhead
Steps in Valuation

(1) • Calculate NOPLAT and invested capital


Analyze • Calculate value drivers
historical • Develop an integrated historical perspective
performance • Analyze financial health

• Understand strategic position


(2) • Develop performance scenarios
Forecast • Forecast individual line items
performance • Check overall forecast for reasonableness

(3) • Develop target market value weights


Estimate • Estimate cost of noequity financing
cost of capital • Estimate cost of equity financing

• Select appropriate technique


(4)
• Select forecast horizon
Estimate
• Estimate the parameters
continuing
• Discount continuing value to present
value
(5) • Calculate and test results
Calculate • Interpret results within decision context
and interpret
results
Business System Analysis

Product
Sales and
Design and Procurement Manufacturing Marketing
Distribution
Development

Issues • Product • Access to • Costs • Pricing • Sales


attributes sources • Cycle time • Advertising/ effectiveness
• Quality • Costs • Quality promotion • Costs
• Time to • Outsourcing • Packaging • Channels
market • Brands • Transportation
• Proprietary
technology
Structure-Conduct-Performance Model

Industry Producers

External
STRUCTURE CONDUCT PERFORMANCE
Shocks

Feedback Feedback

Cooperation vs. Rivalry


Rates of Return Implied by Alternative
Continuing-Value Formulas

Average ROIC

NOPLAT
CV =
WACC - g
Aggressive
formula

Convergence
formula

NOPLAT
CV =
WACC
WACC

Time
Forecast Continuing-value period
period
Impact of Continuing-Value Assumptions

$3,000 g = 8%

$2,000
g = 6%

CONTINUING
VALUE ($) g = 4%
g = 2%
$1,000 g = 0%

0
10% 12 14 16 18 20

RETURN ON NET NEW INVESTED CAPITAL


Relative Positions of Selected Industries
Along Continuing-Value Parameters
> Inflation
Entertainment Growing

Sporting
goods
Not economic

Most Information Soft


firms processing drinks
EARNINGS
= Inflation CONSUMPTION
GROWTH

Tobacco
Not economic
Defense

Steel
< Inflation Declining
< WACC = WACC > WACC
RETURN ON NEW CAPITAL

Factors Low Entry costs High


affecting Many Substitutes Few
returns Short Life cycle Long
High Price elasticity Low
A Forecast Period that Will Result in a
Poor Valuation of a Cyclical Business

NOPLAT

Date of End of
valuation forecast period
TIME
Risk/Return Trade-Offs of Hedging
Programs

E (Return) E (Return)

Beta A
unchanged
A Beta
B unchanged

Beta
Rf B Rf decreased
Beta
decreased

Total risk
Beta (undiversifiable risk)
Framework for Evaluating the Value of an
Acquisition

Stand- Stand-alone Value Transaction Combined Value of Value of Price paid Net value
alone value of of costs value next best target to including gained
value of target synergies alternative acquiror premium from
acquiror (without acquisition
(pre-merger) any
takeover
premium)
Patent Valuation: DCF Method Overview

Value (NPV) of technology/project/product

NPV = Estimation of present value of a


business using discounted cash flows

Maximal value of technology =


NPV x Max Protection Factor Max Protection Factor = Empirical
factor indicating maximal impact of
patents on NPV

Value of patents =
NPV x Pfmax x PPF Patent Protection Factor = Measure of
the quality of the patent protection
Patent Valuation: Maximal Protection
Factor
Maximal
Protection
Factor

30%

Empirical curve

5%

Age of
Technology Mature Technology
under R&D Technology

Patent-Value = Maximal-Protection-Factor x Patent-Protection-Factor x NPVtec


Pval = Pmax x PPF x NPVtec
Acquisition of Real Options

Alliance
High Big bets
leverage

LEVEL OF INVESTMENT
(OPTION PRICE)

Low
Entry Risk
stakes pooling

Internal External

SOURCE OF OPTIONS
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