lecture 1
TRANSCRIPT
Presentation
• PhD-student with thesis on credit risk and portfolio analysis. Visiting scholar at UC Berkeley in 2010.
• Lectured for Statoil AS on the topic.• Investment analysis for local companies
real estate and project analysis.• Teach MIN100 (Investment Analysis) and
BIP190 (Bedriftsøkonomi).
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MIN 100 – Investment Analysis
• A course in economic investment analysis• Focus on uncertainty/risk• Not an accounting course• Not a course with heavy emphasis on
management and organisation of projects
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Literature
• Corporate FinanceCore Principles & ApplicationsGlobal edition of 3rd edition
• ISBN: 9780071221160• Available at SIS Bok and
online at Amazon.com etc.• Will be covering most of
the first 4 parts in addition to parts of chapter 17.
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MIN 100 – Investment AnalysisWeek / date Chapters / Topic Note
35 – 29.08.2011 1-3 / Introduction and basic concepts.
Part 1: Overview
36 – 12.09.2011 4-5 / Net present value, bonds, markets
Part 2: Valuation and Capital budgeting
37 – 19.09.2011 6-7 / Stocks, NPV and other investment rules
38 – 26.09.2011 8-9 / Cash flow and capital budgeting, decision tree, sensitivity, Monte Carlo
39 – 03.10.2011 10-11 / Return and Risk, expected return, CAPM
Part 3: Risk and Return
40 – 10.10.2011 11-12 / CAPM, Risk, Cost of Capital
41 Mandatory assignment
42 – 24.10.2011 13-14 / Financing, capital structure, Modigliani & Miller
Part 4: Capital Structure and Dividend Policy
43 – 31.10.2011 15-16 / Use of debt, leverage, dividends
44 – 07.11.2011 17 / Financial and Real Options. Part 5: Special topics
Lectures
• Lecture hours set from 12:15 to 16:00 on Wednesdays at KE E-101, and will usually finish the lecture around 15:00 or earlier
• Every presentation will be available at It’s Learning.
• Schedule plan includes one backup date (week 41) in case of changes.
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Mandatory assignment
• One mandatory assignment given after the 6th lecture, when we have finished part 1, 2 and 3.
• Will be exam examples , giving you feedback on your progress.
• Must pass in order to take the exam.
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Exam
• 3 hours • Calculator allowed• Date: Not set.
Updates will be given, but check the student web prior to the exam.
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Today
• Introduction• Motivation• Quick review of chapter 1 – 3, introducing
some business and economical terms.
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Motivation
What is an investment?
• When investing you are putting money into a project which will give you a future payoff.
• According to the risk of the project, you can be more or less certain of the outcome.
• Our goal in this course is to assess how much a project is worth, when addressing issues like:– Inflation/Interest (Net Present Value)– Risk– Capital structure– Options (Real and Financial)
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What is an investment?
• When purchasing a good you evaluate its cost and compare it to its future payoff.
• And basically, if you believe the cost is less than the future payoff, it’s a good purchase. – Is buying a book for around 600 NOK, when it
gives you an edge in the job interview worth a yearly salary of 350 000 NOK, a good investment?
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What is an investment?
• Investments are everywhere:– Fixed assets (1): A new house, new car,
machinery, etc.. It is divided into:• Intangible assets (1): education, patents,
franchises, goodwill, etc.• Tangible assets (2): currencies, buildings, real
estate, etc.– Current assets (2): Cash, cash equivalent,
inventory, etc.– (1) is difficult to sell/valuate, (2) is easier to
sell/valuate. 13
How do we evaluate investments?
• We will learn some great tools to evaluate and compare investments and projects:– Net Present Value (NPV)– Internal Rate of Return (IRR)– Payback method– Capital asset pricing model (CAPM)– Portfolio theory, diversification– Option valuation, mixing options– Sensitivity analysis– Monte Carlo analysis– Decision tree– ...
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Introduction to Corporate Finance
Chapter 1
© 2011 McGraw-Hill/Irwin
1-16
• Know the three main concerns of corporate financial management
• Grasp the goal of financial management
Key Concepts and Skills
1-17
1.1 What is Corporate Finance?1.2 The Corporate Firm1.3 The Importance of Cash Flows1.4 The Goal of Financial Management1.5 The Agency Problem and Control of the
Corporation1.6 Regulation
Chapter Outline
1-18
Economic resources are required to establish and maintain a firm:◦ Funds enable materials and processes for
delivering salable goods and services◦ Funds are essential for assembling a workforce◦ Funds are required to purchase long-lived assets
such as equipment and buildingsThe Balance Sheet offers insight into the
array of decisions, activities and objectives of the Financial Manager
1.1 What Is Corporate Finance?
Balance Sheet Model of the Firm
Current Assets
Fixed Assets
1 Tangible
2 IntangibleShareholders’
Equity
Current Liabilities
Long-Term Debt
Total value of assets = Total value of the firm to investors 1-19
1-20
…the top three concerns of corporate finance:1. What long-term investments should the
firm choose?2. How should the firm raise funds for the
selected investments?3. How should current assets be managed
and financed?
The Balance Sheet Reveals…
1-21
The Capital Budgeting Decision
Current Assets
Fixed Assets
1 Tangible
2 IntangibleShareholders’
Equity
Current Liabilities
Long-Term Debt
What long-term investments should the firm choose?
1-22
The Capital Structure Decision
How should the firm raise funds for the selected investments?
Current Assets
Fixed Assets
1 Tangible
2 IntangibleShareholders’
Equity
Current Liabilities
Long-Term Debt
1-23
Short-Term Asset Management
How should short-term assets be managed and financed?
Net Working Capital
Shareholders’ Equity
Current Liabilities
Long-Term Debt
Current Assets
Fixed Assets
1 Tangible
2 Intangible
1-24
• If the firm is to prosper, it must:– Buy assets that generate more cash than they
cost– Sell financial instruments that raise more cash
than they cost
• The successful firm generates more cash than it uses
1.3 The Importance of Cash Flow
1-25
The Conceptual Flow of Cash
1-26
Investment cash flows • Initial investment (I0)
– Total investment expenditure in year 0• Investment revenues (Rt)
– Annual future revenues from the projects• Investment expenditures (Et)
– All future outlays related to the investment project• Annual cash flow (Ct)
– Annual revenues minus annual outlays• Ct = Rt - Et
1-27
Cash-flows from investment
Year 0 Year 1 Year 2 Year 3
Time
Revenue (R1)- Expenditure (E1)
= Cash-flow (C1)
Revenue (R2)- Expenditure (E2)
= Cash-flow (C2)
Revenue (R3)- Expenditure (E3)
= Cash-flow (C3)
- Investment (I0)
= Cash-flow (C0)
1-28
More on the initial investment • Cost of procurement
– The costs of the investment object, including start-up costs (i.e., transport, assembling, and training)
• Extra working capital– Liquid assets tied by the project is included in the initial
investment• Cash, customer claims, inventories etc.
• Other factors– Any measure which implies immediate payment should be
included in the initial investment (e.g., marketing activities)
1-29
• What is the correct goal?– Maximize profit?– Minimize costs?– Maximize market share?– Maximize shareholder wealth?
1.4 The Goal of Financial Management
1-30
Corporate goals
• Key objective is to maximise shareholder value, short-term and longer term
Shareholder approach Stakeholder approach
The company
Management Owners
Suppliers
Community
EmployeesBanks
Customers
• Key objective is to seek compromises which balance different interests
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Corporate goals: Survey results
0 50 100
J apan
Germany
France
UnitedKingdom
UnitedStates
All stakeholders
The shareholders
Shareholders vs. stakeholdersWhose company is it?
Investors vs. employeesWhose company is it?
0 50 100
J apan
Germany
France
UnitedKingdom
UnitedStates
J ob security
Dividends
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The cash allocation challenge
Cash
Investment opportunity(real asset)
Dividends to shareholders
Investment opportunity
(financial asset)
Company
Pay dividendto shareholders
Invest
Financial Statements and Cash Flow
Chapter 2
© 2011 McGraw-Hill/Irwin
• Understand the information provided by financial statements
• Differentiate between book and market values
• Grasp the difference between accounting income and cash flow
• Calculate a firm’s cash flow
Key Concepts and Skills
2-36
2.1 The Balance Sheet
2.2 The Income Statement
2.3 Taxes
2.4 Net Working Capital
2.5 Financial Cash Flow
2.6 The Accounting Statement of Cash Flows
Chapter Outline
2-37
2.1 The Balance Sheet
An accountant’s snapshot of the firm’s accounting value at a specific point in time
The Balance Sheet Identity is:Assets ≡ Liabilities + Stockholders’ Equity
2-38
Balance Sheet Model of the Firm
Current Assets
Fixed Assets
1 Tangible
2 IntangibleShareholders’
Equity
Current Liabilities
Long-Term Debt
Total value of assets = Total value of the firm to investors 1-39
2-40
U.S. Composite Corporation Balance Sheet
• Assets exactly equal liabilities + equity• Assets are listed in order of liquidity
– The amount of time it would take to convert them to cash in an operating business
• Obviously cash and A/R are more liquid than property plant and equipment.
• Liabilities are listed in the order in which they come due
Take Notice !(on the previous Balance Sheet)
2-41
• When analyzing a balance sheet, the Finance Manager should be aware of three concerns:
1. Accounting liquidity2. Debt versus equity3. Value versus cost
Balance Sheet Analysis
2-42
• Refers to the ease and quickness with which assets can be converted to cash—without a significant loss in value
• Current assets are the most liquid.• Some fixed assets are intangible.• The more liquid a firm’s assets, the less
likely the firm is to experience problems meeting short-term obligations.
• Liquid assets frequently have lower rates of return than fixed assets.
Accounting Liquidity
2-43
• Creditors generally receive the first claim on the firm’s cash flow.
• Shareholders’ equity is the residual difference between assets and liabilities.
• Debt and equity have different costs; the relationship between them has impact on the firm’s profitability
Debt versus Equity
2-44
• Under Generally Accepted Accounting Principles (GAAP), financial statements of firms in the U.S. carry assets at historical cost.
• Market value is the price at which the assets, liabilities, and equity could actually be bought or sold, which is a completely different concept from historical cost.
Value versus Cost
Net Working Capital ≡ Current Assets – Current Liabilities
NWC usually grows with the firm
2.4 Net Working Capital
U.S. Composite Corporation Balance Sheet
Net Working Capital ≡ Current Assets – Current Liabilities
In 2009: NWC = $707 - $455 = $252In 2010: NWC = $761 - $486 = $275
Here we see NWC grow to $275 million in 2010 from $252 million in 2009.
This increase of $23 million is an investment of the firm.
2-47
• In finance, the most important item that can be extracted from financial statements is the actual cash flow of the firm.
• Cash flow received from the firm’s assets must equal the cash flows to the firm’s creditors and stockholders.
CF(A)≡ CF(B) + CF(S) • In other words, the cash generated by assets
enables the firm to pay its debts and provide a return to shareholders.
• Accounting cash flow and financial cash flow are not necessarily equal.
2.5 Financial Cash Flow
2-48
2.5 Financial Cash Flow
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CF(A)Firm
generates cash flow(make money)
CF(B)Loanholders
receive interest
CF(S)Stockholders
receive dividend
CF(A)≡ CF(B) + CF(S)
U.S.C.C. Financial Cash Flow
Note: CF(A)≡ CF(B) + CF(S). $ 42 = $ 36 + $ 6
2-50
Operating cash flow is generated by business activities, including sales of goods and services. It reflects payment, not financing, capital spending or changes in net working capital.From the income statement we find operating cash flow:
Earnings before interest and taxes (EBIT) + depreciation + current taxes= $ 219 + $ 90 - $ 71= $ 238
U.S.C.C. Financial Cash Flow
2-51
Capital spending involves changes in fixed assets, including acqusition of fixed assets and sales of fixed assets. USCC bought/acquired new assets worth $ 198 and sold assets of $ 25 in 2010. This gives us:Capital spending = Acquisiton of fixed assets – sales of fixed assets= $ 198 - $ 25 = $ 173
Note that this number can be found in the balance sheet:Change in net fixed assets + depreciation= ($ 1 118 - $ 1 035) + ($ 90) = $ 173
U.S.C.C. Financial Cash Flow
2-52
U.S.C.C. Financial Cash Flow
We have previously calculated Net Working Capital ≡ Current Assets – Current Liabilities
In 2009: NWC = $ 707 - $ 455 = $ 252In 2010: NWC = $ 761 - $ 486 = $ 275
The difference equals additions to NWC = $ 275 - $ 252 = $ 23
2-53
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U.S.C.C. Financial Cash Flow
The cash flow to the creditors are the sum of interest paid plus changes in net borrowing, which can be found by substracting new debt from repaid debt during the last year. USCC paid $ 49 in interest, repaid $ 73 in old debt and acquired new long-term debt of $ 86:Interest + repaid debt - new debt = $49 + $ 73 - $86 = $ 36.
It can also be calculated by using interest paid from the income statement, and changes in long-term debt found in the balance sheet.Interest paid – Net new borrowing = Interest paid – (End LT Debt – Beg LT Debt)
= $ 49 – ($ 471 - $ 458) = $ 36
U.S.C.C. Financial Cash Flow
The cash flow to the stockholders are the sum of dividends paid plus repurchase of equity, minus new equity financing. In the case of USCC in 2010, dividends paid to stockholders (found in income statement) were $ 43, and the firm repurchased stock of $ 6. In total this provides $ 49 in cash to the stockholders.
In addition the firm issued/sold stocks for $ 43, which makes the total cash flow to stockholders: ($ 43 + $ 6) - $ 43 = $ 49 - $ 43 = $ 6.
2-55
The cash flow received from the firm’s assets must equal the cash flows to the firm’s creditors and stockholders:CF(A)≡ CF(B) + CF(S) = $ 42 = $ 36 + $ 6 = $ 42
U.S.C.C. Financial Cash Flow
2-56
Financial Statements Analysis and Financial Models
Chapter 3
© 2011 McGraw-Hill/Irwin
• Standardize financial statements for comparison purposes
• Compute and interpret important financial ratios including the DuPont Identity
• Discern how capital structure and dividend policies affect a firm’s ability to grow
Key Concepts and Skills
3-58
(3.1 Financial Statements Analysis)(3.2 Ratio Analysis)3.3 The Du Pont Identity3.4 Financial Models3.5 External Financing and Growth3.6 Some Caveats Regarding Financial
Planning Models
Chapter Outline
3-59
3.1 – 3.3 Financial statements and analysis
• The book covers several methods to analyze the progress of a company, by looking at numbers in its financial statements. The Common-Size Balance Sheet compute all accounts as a
percent of total assets. Common-Size Income Statements compute all line items as a
percent of sales. Ration analysis
• Standardized statements make it easier to compare financial information, particularly as the company grows.
• They are also useful for comparing companies of different sizes, particularly within the same industry.
3-60
3.1 – 3.3 Financial statements and analysis
• Ratios compliment common size analysis and allow for deeper comparison through time or between dissimilar companies.I. Short-term solvency or liquidity ratiosII. Long-term solvency or financial leverage ratiosIII. Asset management or turnover ratiosIV. Profitability ratiosV. Market value ratios
Following Examples all Based on Tables 3.1 & 3.4
3-61
Computing Profitability Measures
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Profit margin =Net income / sales = 363 / 2311 = 15,7%
EBITDA Margin = EBITDA / Sales = 967 / 2311 = 41,8%
Return on Asset (ROA) = Net income / Total Assets =363 / 3588 = 10,1%
Return on Equity (ROE) = Net income / Total Equity =363 / 2591 = 14,0%
• Ratios are not very helpful by themselves: they need to be compared to something
• Time-Trend Analysis– Used to see how the firm’s performance is
changing through time• Peer Group Analysis
– Compare to similar companies or within industries
– Go to www.reuters.com/finance/stocks • Use the ratios link to get comparative ratios for many
companies
Using Financial Ratios
3-63
Summary of Ratio Formulae
3-64
• Popularized by the DuPont Corporation• A more sophisticated method of evaluating
return• Illustrates the interaction between profit, assets
and leverage• Holds that ROE is actually a function of 3
measures:– Operating Efficiency (Profit Margin)– Asset Use Efficiency (Total Asset Turnover)– Financial Leverage (Equity Multiplier)
3.3 The DuPont Identity
3-65
• ROE = NI / TE• Multiply by 1 and then rearrange:
– ROE = (NI / TE) (TA / TA)– ROE = (NI / TA) (TA / TE) = ROA * EM
• Multiply by 1 again and then rearrange:– ROE = (NI / TA) (TA / TE) (Sales / Sales)– ROE = (NI / Sales) (Sales / TA) (TA / TE)– ROE = PM * TAT * EM
Derivation of The Du Pont Identity
3-66
• ROE = PM * TAT * EM– Profit margin is a measure of the firm’s
operating efficiency – how well it controls costs.
– Total asset turnover is a measure of the firm’s asset use efficiency – how well it manages its assets.
– Equity multiplier is a measure of the firm’s financial leverage.
Using the Du Pont Identity
3-67
• ROA = 10.1% and EM = 1.39– ROE = 10.1% * 1.385 = 14.0%
• PM = 15.7% and TAT = 0.64– ROE = 15.7% * 0.64 * 1.385 = 14.0%
Calculating the Du Pont Identity
3-68
• There is no underlying theory, so there is no way to know which ratios are most relevant.
• Benchmarking is difficult for diversified firms.• Globalization and international competition
makes comparison more difficult because of differences in accounting regulations.
• Firms use varying accounting procedures.• Firms have different fiscal years.• Extraordinary, or one-time, events
Potential Problems in Financial Analysis
3-69
Lecture summary
• Chapter 1 – Introduction to Corporate Finance– Business organization– Goal of financial management– Agency problems
• Chapter 2 – Financial statements and Cash Flow– Book and market value– Accounting income and cash flow
• Chapter 3 – Financial Statements Analysis and Financial Models– Common-Size evaluation and ratio analysis.– Du Pont Identity 70