Overview

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).
}{
The Balance Sheet
The Main Balance Sheet Items
Current Assets
Cash & Securities
Receivables
Inventories
Fixed Assets
Tangible Assets
Intangible Assets
3
McGraw-Hill/Irwin
Current Liabilities
Payables
Short-term Debt
+
Long-term Liabilities
+
Shareholders Equity
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved
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
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).
McGraw-Hill/Irwin
The Income Statement

Earnings Before Income & Taxes (EBIT)
EBIT =
McGraw-Hill/Irwin
- total Revenues
- costs
- deprecation
The Statement of Cash Flows

Definition
Financial statement that shows the firms cash
receipts and cash payments over a period of
time.
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.
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.
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Future Values
Future Value of $100 = FV
FV = $100 (1 + r )
McGraw-Hill/Irwin
Present Values
Present Value
Discount Factor
Value today of a
future cash
flow.
Present value of
a $1 future
payment.
Discount Rate
Interest rate used

to compute
present values of
future cash flows.
McGraw-Hill/Irwin
Present Values
Present Value = PV
PV =
McGraw-Hill/Irwin
Future Value after t periods

(1+r) t
Present Values
Discount Factor = DF = PV of $1
DF =
1
t
(1+ r )
Discount Factors can be used to compute the present value of
any cash flow.
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 = FV
McGraw-Hill/Irwin
1
(1+ r ) t
PV of Multiple Cash Flows

PVs can be added together to evaluate multiple cash flows.
PV =
McGraw-Hill/Irwin
C1
(1+ r )
+ (1+ r ) 2 +....
C2
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.
McGraw-Hill/Irwin

PV of Perpetuity Formula
PV =
C
r
C = cash payment
r = interest rate
McGraw-Hill/Irwin

PV of Annuity Formula
PV = C
1
r
1
t
r (1+ r )
C = cash payment
r = interest rate
t = Number of years cash payment is received
McGraw-Hill/Irwin

PV Annuity Factor (PVAF) - The present value of $1 a year for
each of t years.
PVAF =
McGraw-Hill/Irwin
1
r
1
t
r (1+ r )

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 ] (1 + r )
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.
McGraw-Hill/Irwin
Inflation
1+nominal interest rate
1 + real interest rate =
1+inflation rate
approximation formula
Real int. rate nominal int. rate - inflation rate
McGraw-Hill/Irwin
Effective Interest Rates

Effective Annual Interest Rate - Interest rate
that is annualized using compound interest.
Annual Percentage Rate - Interest rate that is annualized using

simple interest.
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.
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.
cpn
cpn
(cpn + par )
PV =
+
+....+
1
2
t
(1 + r ) (1 + r )
(1 + r )
McGraw-Hill/Irwin
Bond Cash Flows
McGraw-Hill/Irwin
Bond Pricing
Example (continued)
Q: How did the calculation change, given semi-annual coupons
versus annual coupon payments?
Time Periods
Discount Rate
Paying coupons twice a

year, instead of once
doubles the total number of
cash flows to be discounted
in the PV formula.
Since the time periods are

now half years, the
discount rate is also
changed from the annual
rate to the half year rate.
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.
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.
cpn
cpn
(cpn + par )
PV =
+
+....+
1
2
t
(1 + r ) (1 + r )
(1 + r )
McGraw-Hill/Irwin
Bond Yields
Rate of Return - Earnings per period per dollar invested.
total income
Rate of return =
investment
Coupon income + price change
Rate of return =
investment
McGraw-Hill/Irwin
Nominal and Real rates

14
12
Yield on UK
nominal bonds
Percent
10
Yield on UK
indexed bonds
99
20
00
20
01
20
02
20
03
20
04
20
05
98
97
96
95
94
93
92
91
90
89
88
87
86
85
Year
McGraw-Hill/Irwin
Default Risk
Credit risk
Default premium
Investment grade
Junk bonds
McGraw-Hill/Irwin
Corporate Bonds
Zero coupons
Floating rate bonds
Convertible bonds
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
McGraw-Hill/Irwin

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.
McGraw-Hill/Irwin

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.
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).
Div1 + P1 P0
Expected Return = r =
P0
McGraw-Hill/Irwin

The formula can be broken into two parts.
Dividend Yield + Capital Appreciation
Div1 P1 P0
Expected Return = r =
+
P0
P0
McGraw-Hill/Irwin

Dividend Discount Model - Computation of todays stock
price which states that share value equals the present
value of all expected future dividends.
Div1
Div2
Div H + PH
P0 =
+
+...+
1
2
H
(1 + r ) (1 + r )
(1 + r )
H - Time horizon for your investment.
McGraw-Hill/Irwin

If we forecast no growth, and plan to hold out stock
indefinitely, we will then value the stock as a
PERPETUITY.
EPS1
Div1
Perpetuity = P0 =
or
r
r
Assumes all earnings are
paid to shareholders.
McGraw-Hill/Irwin

Constant Growth DDM - A version of the dividend growth
model in which dividends grow at a constant rate (Gordon
Growth Model).
Div1
P0 =
rg
Given any combination of variables in the
equation, you can solve for the unknown variable.
McGraw-Hill/Irwin

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.
McGraw-Hill/Irwin

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
McGraw-Hill/Irwin

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.
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).
McGraw-Hill/Irwin
Another Tool
Fundamental Analysts
Research
the value of stocks using NPV and other

measurements of cash flow
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
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
McGraw-Hill/Irwin
Net Present Value

NPV = PV - required investment
Ct
NPV = C0 +
t
(1 + r )
C1
C2
Ct
NPV = C0 +
+
+...+
t
1
2
(1 + r ) (1 + r )
(1 + r )
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.
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.
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.
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.
C1 - investment
Rate of Return =
investment
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.
present value of cash flows
Equivalent annual annuity =
annuity factor
McGraw-Hill/Irwin
Annuity Factor
1
1
Annuity Factort,r =
t
r (1 + r)
McGraw-Hill/Irwin
Profitability Index
Project
J
K
L
M
N
McGraw-Hill/Irwin
PV
4
6
10
8
5
Investment NPV
3
1
5
1
7
3
6
2
4
1
Profitability
Index
1/3 = .33
1/5 = .20
3/7 = .43
2/6 = .33
1/4 = .25
Capital Budgeting Techniques
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
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
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.
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.
DOL =
McGraw-Hill/Irwin
% change in profits
% change in sales
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.
McGraw-Hill/Irwin
Rates of Return
Percentage Return =
Capital Gain + Dividend

Initial Share Price
5.47 + .82
Percentage Return =
31.12
= .202 or 20.2%
McGraw-Hill/Irwin
Rates of Return
Dividend Yield =
Capital Gain Yield =
McGraw-Hill/Irwin
Dividend
Initial Share Price
Capital Gain
Initial Share Price
Rates of Return
Nominal vs. Real
1+ real ror =
1 + nominal ror
1 + inflation rate
1 + real ror =
1 + .202
1 + .033
= 1.164
real ror = 16.4%

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.
McGraw-Hill/Irwin
Rate of Return
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.
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.
McGraw-Hill/Irwin
(
(
)(
)(
Portfolio rate
fraction of portfolio
=
x
of return
in first asset
rate of return
on first asset
)
)
fraction of portfolio
rate of return
+
x
in second asset
on second asset
McGraw-Hill/Irwin
Portfolio standard deviation
0
5
10
15
Number of Securities
McGraw-Hill/Irwin
Portfolio standard deviation
Unique
risk
Market risk
0
5
10
15
Number of Securities
McGraw-Hill/Irwin
Topics Covered
Measuring Market Risk
Beta
Risk and Return

CAPM
Capital Budgeting and Project Risk
McGraw-Hill/Irwin

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.
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
McGraw-Hill/Irwin
Risk and Return
McGraw-Hill/Irwin
Risk and Return
McGraw-Hill/Irwin
Market Risk Premium - Risk premium of market

portfolio. Difference between market return and return
on risk-free Treasury bills.
14
Expected Return (%) .
12
Market
Portfolio
10
8
6
4
2
0
0
0,2
0,4
0,6
0,8
Beta
McGraw-Hill/Irwin
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 = rm - rf

Risk premium on any asset = r - rf
Expected Return = rf + B(rm - rf )
McGraw-Hill/Irwin
Expected Return (%) .
Security Market Line - The graphic representation of

the CAPM.
Security Market Line

Rm
Rf
Beta
McGraw-Hill/Irwin
1.0
Security Market Line

Return
SML
rf
1.0
BETA
SML Equation = rf + B ( rm - rf )
McGraw-Hill/Irwin
Capital Asset Pricing Model

R = rf + B ( r m - rf )
CAPM
McGraw-Hill/Irwin
Testing the CAPM
Beta vs. Average Risk Premium
Avg Risk Premium

1931-2002
30
20
SML
Investors
10
Market
Portfolio
1.0
McGraw-Hill/Irwin
Portfolio Beta
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.
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.
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.
McGraw-Hill/Irwin
WACC
rassets =
rassets =
total income
value of investments
(D x rdebt ) + (E x requity )
V
rassets = ( x rdebt ) + ( x requity )

D
V
McGraw-Hill/Irwin
E
V
WACC
Taxes are an important consideration in the company
cost of capital because interest payments are deducted

from income before tax is calculated.
McGraw-Hill/Irwin
WACC
Weighted -average cost of capital=
WACC =
McGraw-Hill/Irwin
D
V
] [
x (1 - Tc)rdebt +
E
V
x requity
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.
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
Bassets =
D
V
] [
x Bdebt +
E
V
x Bequity
Corporate taxes complicate the analysis and may change our
decision
McGraw-Hill/Irwin
Measuring Capital Structure

In estimating WACC, do not use the Book Value of securities.
In estimating WACC, use the MarketValue of the securities.
Book Values often do not represent the true market value of a
firms securities.
McGraw-Hill/Irwin

Market Value of Bonds - PV of all coupons
and par value discounted at the current
interest rate.
McGraw-Hill/Irwin

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.
McGraw-Hill/Irwin
Required Rates of Return

Bonds
rd = YTM
Common Stock
re = CAPM
= rf + B(rm - rf )
McGraw-Hill/Irwin

Dividend Discount Model Cost of Equity
Perpetuity Growth Model =
Div1
P0 =
re - g
solve for re
Div1
re =
+ g
P0
McGraw-Hill/Irwin

Expected Return on Preferred Stock
Price of Preferred Stock =
P0 =
Div1
rpreferred
solve for preferred
rpreferred
McGraw-Hill/Irwin
Div1
=
P0
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.
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.
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.
FCF1
FCF2
FCFH
PVH
PV =
+
+ ... +
+
1
2
H
(1 + r ) (1 + r )
(1 + r )
(1 + r ) H
McGraw-Hill/Irwin
Capital Budgeting
Valuing a Business or Project
FCF1
FCF2
FCFH
PVH
PV =
+
+ ... +
+
1
2
H
(1 + r ) (1 + r )
(1 + r )
(1 + r ) H
PV (free cash flows)
McGraw-Hill/Irwin
PV (horizon value)

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Overview

The Balance Sheet

The Balance Sheet

The Main Balance Sheet Items

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved

Market Value vs. Book Value

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved

The Income Statement

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved

The Income Statement

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved

The Statement of Cash Flows

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved

Interest rate used

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved

Future Value after t periods

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved

Discount Factors can be used to compute the present value of

any cash flow.

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved

Time Value of Money

The PV formula has many applications. Given any variables

in the equation, you can solve for the remaining variable.

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved

PV of Multiple Cash Flows

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved

Perpetuities & Annuities

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved

Perpetuities & Annuities

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved

Perpetuities & Annuities

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved

Perpetuities & Annuities

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved

Perpetuities & Annuities

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved

Real int. rate nominal int. rate - inflation rate

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Effective Interest Rates

Annual Percentage Rate - Interest rate that is annualized using

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Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved

Bond Cash Flows

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Paying coupons twice a

Since the time periods are

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Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved

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Nominal and Real rates

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Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved

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Stocks & Stock Market

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Stocks & Stock Market

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved

Stocks & Stock Market