BAFI355 Final Concepts

GAAP Financial Accounting Cash Flow

Used for regulatory financial reporting and compliance purposes

Unlevered Free Cash Flow

used for valuation and project evaluation purposes

EBITDA

proxy for cash flow, used for valuation purposes and for credit analysis

GAAP Cash Flow

can be compiled if you have the income statement and beginning and ending balance sheets - you can reconcile the change i the Cash account by accounting for changes in all other accounts

Cash from Operations

Net Income + Non-Cash Charges - Changes in Net Working Capital

Cash from Investment

Capital expenditures and asset sales and acquisitions

Cash from Financing

change i debt, dividends, stock issued/repurchased

Debtholders

have fixed claims on cash flows from assets

Shareholders

have residual claims on cash flows from assets so that the larger the cash flows, the more value created

EBITDA

Operating Income + Depreciation and Amortization - used for valuation and credit analysis. serves as a proxy for cash flow but is NOT cash flow. all items re on ehte income statement, omits capital costs

Working Capital (Textbook)

Current Assets - Current Liabilities | is the capital a firm uses in its day-to-day operations

Working Capital (Industry)

Operating Current Assets - Operating Current Liabilities | sometimes referred to as New Working Capital, excludes cash and short-term investments since they are not directly part of a company’s core operations

Cash Conversion Cycle

DIO + DSO - DPO | |measures how long in days each net input dollar is tied up in the production and sales process before it gets converted into cash received. assessed how efficiently a company is managing its working capital - the shorter the cycle, the better the company is at selling inventoryies and recovering cash from sales while paying suppliers

Financial Ratio Analysis

can be used to better understand aspects of the business with key ratios being: returns in the business cycle, liquidity, credit analysis

Return on Equity (ROE)

Net Income / Shareholders’ Equity | shows the return to shareholders, where net income shows the amount left after everyone else is paid and shareholders’ equity is what has been culminating from shareholders’ investments and also retained earnings

Profitability

whats left for sharheolders after everyone else is paid

Productivity

how many sales dollars result from a dollar investment in net assets

Leverage

net assets leveraged by owners’ equity

Current Ratio

Current Assets / Current Liabilities

Acid Test

(Cash + A/R)/Current Liabilities

Cash Ratio

Cash & Equivalents/Current Liabilities

Elements of Financial Planning

Investment in New Assets - determined by capital budgeting decisions

Degree of Financial Leverage - determined by capital structure decisions

Cash Paid to Shareholders - determined by dividend policy decisions

Liquidity Requirements - determined by net working capital decisions

Role of Financial Planning

Examine Interactions - help management see the interactions between decisions

Explore opportunities - give management a systematic framework for exploring opportunities

Avoid surprises - help management identify possible oucomes and plan accordingly

Ensure feasibility and internal consistency - help management determine if goals can be accomplished and if various goals of the firm are consistent with one another

Financial Planning Model Ingredients

Sales Forecast - many cash dlows depend on the level of sales (often estimated using sales growth rate)

Pro Forma Statements - setting up the plan using projected financial statements allows for consistency and ease of interpretation

Asset Requirements - the additional assets that will be required to meet sales projections

Financial Requirements - the amount of financing needed to pay for the required assets

Plug Variable - determined by management, deciding what type of financing will be used to make the balance sheet balance

Economic assumptions - explicit assumptions about the coming economic environment

Systematic Risk

those that influence all stocks

Unsystematic Risk

those that influence a specific stock or idiosyncratic risk

diversification

since unsystematic risk is unique to each stock, there is nor correlation between this aspect of surprise/variability and other stocks. adding more companies can reduce aggregate surprise when its E moves in an opposite direction relative to existing holders (systematic risk does not decrease because it affects the whole system)

IPO

Initial Public Offering | refers to the process of offering shares of a private corporation to the public in new stock issuance for the first time, allows a company to raise equity capital from investors

Primary Market

refers to share sales by the company

Secondary Markey

refers to the selling/trading of those shares between investors after the company has already sold them (occurs in the stock market)

Absolute (Intrinsic) Valuation

attempt to find the intrinsic value of an investment based only on fundamentals (dividends, cash dlow, growth rate, etc.)

Relative Valuation

operate by comparing the company in question to other similar companies and involves calculating multiples and ratios

Valuing a Bond

relatively easy due to

known contractual cash flows

finite life of the investment

observable rate of return

Dividend Discount Model of Stock Valuation

if you buy a share of stock, you can reeive cash when the company pays a dividend or when you sell your shares either to another investor or back to the company - the price of a stock is the present value of these expected cash flows

Constant Dividend

the firm will pay a constant dividend forever, like preferred stock - price is compute using a perpetuity formula

Constant Dividend Growth

the firm will increase the dividend by a constant percent every period - price is computed using the dividend growth model

Supernormal Growth

dividend growth is not consistent initially, but settles down to constant growth eventually - price is computed using multistage model

Price to Earnings Ratio

Stock Price/EPS or Market Capitalization / (Net Income + Preferred Dividends) | analysts consider P/E as a price tag on earnings, where a high P/E ratio meaning that investors are anticipating higher growth in the future, thus giving the company a higher valuation, lower P/E ratio means that you’re paying ;ess for the samel level or earnings

Enterprise Value

measure of a company’s total value, which is the theoretical takeover price if a company were to be gought

Enterprise Value / EBITDA

the ratio of EV/EBITDA is used to compare the entire vallue of a business with the amount of EBITDA it earns on an annual basis, tells investors how many times EBITDA they would have to pay if they were to acquire the entire business

Why are EBITDA multiples so commonly used?

adds back the largest non-cash charges (Depreciation & Amortization), and information is readily availble from a company’s financial statements

Why is P/E used?

the P/E ratio does a better job at reflecting the level of debt a firmhas since it uses Earnings in its denomicator and Earnings is a metric otained after interest expense has been paid

Cost of Capital

also known as WACC, is the discount rate used to bring future calculated cash flows to the present - required after-tax return on all capital delpoyed (debt & equity)

What is WACC used for?

evalutating projects, determining whether divisions or an overall company is generating sufficient earnings relative to capital deployed, whether stock price is fairly valued

Components of Cost of Capital

relative weights of debt v. equity, cost of debt, tax rate, cost of equity

WACC

discount rate used to calculate the PV of cash flows

Determining Weights

values of net debt and equity should be based on market values

Advantages of Bottom Up beta

bottom-up beta has a lower standrad error than the regression beta because it caculates and industry beta and then derives the company beta; can be used for a relatively neew public company that has little historical data, for a private company, or for subdivisions

Disadvantages of Botton-Up Beta

cumbersome and time-consuming to calculate; could be hard to identify a larger set of comparable companies that operatin in the industry where the company operates to calculate a prepresentative industry beta

Capital Asset Pricing Model

CAPM describes the measures of systematic risk of an asset rlative to the market

Theoretcal and Practical Considerations

risk-free rtae is supposed to be a very short-term rate but most people use a 10-year US Treasury yield in practice; beta and the market risk premium are supposed to be forward looking models

Beta

measure of volatility of a security compared to the market as a whole (usually the SP500 which has a beta of 1.0) - stocks with a beta higher than 1.0 are considered more volatile than the SP500

Bottom-Up beta

beta for a company calculated from the group up rather than by using regression analysis, derived from the regression beta of the industry based on the business the company is in and the leverage rate chose

Issues with CAPM beta

high standard of error, so beta coefficient could be wrong; reflects the firm’s business mix over the period of the regression, not the current mix; reflects the firm’s average financial leverage over the period than the current leverage; how the regression is set up will impact the beta; even regressions which look good can be misleading