MIN 100 Investment Analysis

Roy Endr Dahl University of Stavanger E-mail: roy.e.dahl@uis.no Klikk for redigere undertittelstil i malen

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Week / date

MIN 100 Investment Analysis

Chapters / Topic Note
1-3 / Introduction and basic concepts. Part 1: Overview 4-5 / Net present value, bonds, Part 2: Valuation and Capital markets budgeting 6-7 / Stocks, NPV and other investment rules 8-9 / Cash flow and capital budgeting, decision tree, sensitivity, Monte Carlo 10-11 / Return and Risk, expected return, CAPM Mandatory assignment 11-13 / CAPM, Risk, Cost of Capital Workshop. Applying part 2 and 3 Workshop. to a Real Estate company. 14-15/ Capital structure, Part 4: Capital Structure and Modigliani & Miller, use of debt, Dividend Policy leverage. Review of chapter 4-12. + 1415. Review. Part 3: Risk and Return

35 29.08.2012 37 12.09.2012 38 19.09.2012 39 26.09.2012 40 03.10.2012 41 42 17.10.2012 43 24.10.2012 44 31.10.2012 49 05.12.2012

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Co v

Cor r=

W CA AC PM C Discount rate r (Ch. 12)

Equity vs. Debt MM I & II (Ch. 14)

Paybac k Period Method (Ch. 7) Profitabi lity Index (Ch. 7) Internal Rate of Return (Ch. 7)

Increme ntal Cash Flows (Ch. 8)

Va Y) r(r E(r ) Return variance ) Risk averse (Ch. 10)

(X,

Portfolio (Ch. 11)

Capital Structure (Ch. 1415)

Debt limits (Ch. 15)

Risk and return (Ch. 1012)

Real Options (Ch. 9)

Monte Carlo (Ch. 9)

Breakeven (Ch. 9)

Investmen t rules (Ch. 7-8)

Bonds (Ch. 5) Net Present Value (Ch. 7)

Investmen t analysis (Ch. 9)

Present Value Future Value (Ch. 4-6)

Scenari o Analysis (Ch. 9) Sensitiv ity Analysis (Ch. 9)

Discou nting (Ch. 4)

Dividen d Growth Model (Ch. 6)

Decisio n tree (Ch. 9)

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Basic concepts (Ch. 4 6)

Discounting Present and Future Value

Simplifications: Perpetuity and annuity

Bonds and bond valuation Valuate a company with the Dividend Growth Model (DGM)

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Discounting (Ch. 4)

Chapter 4 introduced discounting: value of money today > value of money tomorrow

In order to compare cash flows, we calculate either the present or the future value.

Present Value: The value today of a payment to be received in the future. 55 Future Value: The value in the future of a

Present and Future Value (ch. 4)

The relationship between present and future value can be found with the following equation:

Rearranging the formula we can calculate r and t:

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Present and Future Value (ch. 4)

Now, we can answer the following questions:

What is $1 000 worth in one year if the discount rate is 10%? Is $100 today worth more than $110 in two years if the interest rate is 7%?

How long will it take for $1 to double at 5% interest rate?

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Simplifications PV (Ch. 4)
When we are calculating the present value of a future cash flow, there are several simplifications that can make this easier: Perpetuity

A constant stream of cash flows that lasts forever A stream of cash flows that grows at a constant rate forever A stream of constant cash flows that lasts for a fixed number of periods A stream of cash flows that grows at a constant rate for a fixed number of periods

Growing perpetuity

Annuity

Growing annuity

Perpetuity vs annuity
3 12 2.5 10

1.5

0.5

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Bonds (Ch. 5)

Bonds are issued by companies and governments in order to raise capital. A bond buyer is guaranteed interest payment and repayment of the bonds face value. Face value is the value of the bond when sold (i.e. the money you lend). Coupon rate is the interest rate the bond pays. Remember, bonds are rated 1010 according

Bonds (Ch. 5)

A bond can be traded (sold and bought) after it has been issued (like a stock). If the market interest rate (adjusted for by risk) is

Equal to the coupon rate, the bond trades at par (seller receives the same money as it was originally purchased for = face value). Lower than the coupon rate, the bond trades at a premium (the bond is more worth due to its high interest rate, seller receives more money than face value). Higher than the coupon rate, the bond trades at a discount (the bond is less worth due to its low interest rate, seller receives less money than face 1111 value).

Bond valuation

Remember that any financial assets value is the present value of its future cash flows. A bonds cash flow can typically be represented by:
C C C C C C C C +F

Given a face value (F), the market interest rate (r), number of years (t) and the yearly cash flow (C) we can calculate the value of a bond:
Annui ty Discount ed face value 1212

The yearly cash flow is fixed and specified by the bond.

Dividend Growth Model (Ch. 6)

Remember that any financial assets value is the present value of its future cash flows. A stock provides the shareholders with a cash flow from dividends. In order to valuate a company, we can therefore use this cash flow and calculate a perpetuity since we assume the dividends will be paid forever.
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3 approaches to DGM (Ch. 6)

Zero growth = Perpetuity

Constant growth (g) = Growing perpetuity

Differential growth = T-year annuity at rate g1 + growing perpetuity at g2

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Extra notice

A firm may repurchase stock, which in effect is an extra dividend payout (although only to certain shareholder). As a result the total payout is higher than the dividends alone, increasing the cash flow. A company seldom pays out the entire earnings as dividends. Something is retained for future investments and Net Present Value of Growth Opportunities (NPVGO). A companys value = DGM + NPVGO Companies that dont pay out dividend (Apple), can replace DGM by taking Earnings Per Share (EPS) and divide it by the discount 1515 rate. For the total value, NPVGO should be

Dividend and capital gains yield (Ch. 6)

By using the growth case of DGM, we can derive some useful information about a companys yields (or returns):

Dividen d yield

Capital gains yield 1616

Investment rules (Ch. 7-8)

Investment rules Incremental cash flows Operating cash flow Unequal lives

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Investment rules (Ch. 7)

Investment rules let you evaluate whether you will make money from an investment. All investment rules need an estimate for:

Initial costs Future Cash Flow Discount rate Decision criteria Comparison criteria

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Investment rules (Ch. 7)

Rule Net Present Value (NPV) Calculation Accept Ranking NPV > Highest 0 NPV

Payback Period Find number of years T, s.t.: T <= Lowest T Method Cutoff period Discounted Find number of years T, s.t.: T <= Lowest T Payback Period Cutoff Method period Internal Rate of Return (IRR) Profitability Index IRR > r Highest IRR PI > 1 1919 Highest PI

Ranking the projects

Project Investment CF CF CF CF CF Year Year Year Year Year 1 2 3 4 5 A -150 200 100 50 40 30 10 % B -250 180 140 140 120 80 C -150 50 40 80 140 200

Discount rate

Which project should we choose?

C Ranking B>C> A A>B> C A>B> C

Rule NPV Payback Period Discounted Payback IRR

197,98 266,16 208,42 0,75 0,89 85 % 1,5 1,75 52 % 2,75 3,12

A>B> 43 % C

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Comparison of rules

Several of the rules have flaws that we need to be aware of, and if possible adjust our estimates accordingly. Discounted Payback Period disregards cash flow after cutoff and is based on an arbitrary cutoff period. Simple Payback Period also ignores the time-value of money. IRR has several pitfalls, and in our case both scaling and timing of future cash flows makes our estimates problematic.

In addition IRR might have problems with differentiating between lending and borrowing, in addition to multiple IRRs.

PI has a scaling problem. In order to avoid the problems with IRR and PI, we can
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Crossover rates
1) We should compare the crossover rate going from project A to C in order to evaluate the timing issue. 2) To remedy the size issue when comparing the PI, we should calculate the incremental PI going from C to B.

1. Crossover rate (A C) = 11.92% If the discount rate is lower than 11.92%, we should choose project C over project A. 2. PI (B C) = 1.58 Since PI > 1, we are creating more value by going from project C to project B (small to big project). We should therefore choose project B over2222 project C.

Investment rules (Ch. 7)

In general NPV provides the most accurate answer. If there is no capital rationing, every project with a positive NPV should be accepted. If there is capital rationing, both IRR and PI can help you compare. But, be aware of the pitfalls concerning size and timing (and multiple IRRs and borrowing/lending).
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Incremental Cash Flows (Ch. 8)

When evaluating an investment you should only care about the extra cash flows generated to the firm by the project. Several examples of what you need to be aware of:

Sunk cost Opportunity cost Side effects (synergy, cannibalism) Taxes

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Operating Cash Flow (Ch. 8)

2010 Revenue Costs Depreciation EBIT Taxes (30%) Net Income 2 000 800 200 1 000 300 700 OCF = EBIT + Depreciation Taxes OCF = 1 000 + 200 300 = 900 Bottom-Up: OCF = Net Income + Depreciation OCF = 700 + 200 = 900 Top-Down: OCF = Sales Costs Taxes OCF = 2 000 800 300 = 900 Tax Shield Approach: OCF = (Sales Costs)(1-Tc) + Depreciation * Tc OCF = (2 000 800)(1-0.3) + 200*0.3 = 900 2525

Unequal lives (Ch. 8)

When comparing projects with different lifespan we should adjust our estimates by taking this difference into account. 1. Replacement Chain

Copy projects until their lives are equal. Calculate the annual cost for each project. Uses the formula for annuity in order to find the annual cash flow:

2.

Equivalent Annual Cost (EAC)

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Unequal lives (Ch. 8)

Cash flow Year 0 Year 1 Year 2 Year 3 Year 4 NPV (discounted @10%) Project A Project B -100 -40 -40 -200 -10 -10 -10 -10 -169.42 -217.36
The NPV is most positive for project A. But that is before we account for the projects different lifespan.

EACA < EACB,

Should therefore choose project B.

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Investment Analysis (Ch. 9)

Decision trees Sensitivity analysis (What-if?) Scenario analysis Break even analysis Monte Carlo simulation Real options

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Decision Trees

Decisi on node

Decision trees helps us consider several probable outcomes. We differentiat between: q a decision node, you decide what branch to invest in. State of Decision o nature 1 a chance node, probability decides what is most A likely.
Decisio n branch es Chan ce node
State of nature 2

Decision B

Chance branch es

2929 We calculate NPV for each outcome, and compare the outcomes starting from the back of the decision tree.

Decision tree
Success 20 % Chan ce Invest NPV = 20.0 NPV = 20.0 * 0.2 + (- 4.0) * 0.8 NPV = 0.8

Decisio n

Failure 80 %

NPV = 4.0

Do not invest

NPV = 0.0

NPVINVEST > NPVNOT INVEST

Should therefore choose to invest

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Real Options

Decision trees are particularly good to illustrate and evaluate a real option (value of flexibility). A real option provides an opportunity (but no obligation) to:

Expand Abandon Delay

Provides a positive addition to NPV. If not, it would be ignored. NPV Real Option = NPV With3131 Option NPV Without option.

Sensitivity Analysis

The assumptions made about certain key variables (sales, interest rate, cost, development time etc.) is seldom certain. To evaluate the uncertainty about the project outcome, we can get some extra information by doing sensitivity analysis. A sensitivity analysis varies one factor, while the rest of the factors are fixed. Consequently, we can see the effect one factor has on the outcome of the project. By doing this for several variable, we can compare the variables with a spider diagram.
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Sensitivity Analysis

The variable with the steepest climb affects the project most, and we should consider taking actions in order to reduce its uncertainty. Remember that this does not say3333 anything about the likelihood of a change.

Scenario Analysis

Since a sensitivity analysis only changes one variable at a time, it does not capture possible interrelationship between the underlying factors. A scenario analysis compares the project outcome in certain scenarios, where typically more than one key factors change (and interrelate). E.g. comparing the outcome of the project dependent on the economy (recession normal boom) By using a probability for each scenario, we can calculate the expected NPV. 3434

Break even analysis

What must sales, price, cost etc. be to break even? Use different key variables and see what level the project needs to reach in order to break even.

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Monte Carlo simulation

1.

2.

3.

4.

5.

So far our estimates have only used discrete distributions (decision tree, sensitivity, scenario). With Monte Carlo we can use any distribution when specifying how a factor varies. Set up the formula for your decision rule (e.g. NPV). Estimate/Assume probability distribution for your variable, including variation and expected value. Draw a number from each probability distribution. Calculate NPV (or other measures) using values from (3) Replicate (3) and (4) many times, e.g. 10 000 3636 times.

Monte Carlo Simulation

Can provide extra information (e.g. what are the possible outcomes that account for the 80% most likely outcomes?). However, model may be complex.

Difficult to estimate underlying probability distribution for each variable. Difficult to model interactions between variables.

Highly dependent on the data you use when estimating.

GIGO principle: Garbage in, garbage out

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Risk and Return (Ch. 10 12)

Expected return and variance Risk aversion Portfolio

Covariance Correlation Beta

Capital Asset Pricing Model (CAPM) Weighted Average Cost of Capital 3838 (WACC)

Risk Aversion (extra)

Differentiate between 3 risk profiles:
Risk neutral
100% rational and indifferent between certain outcomes and uncertain outcomes with equal outcomes. Will bet according to statistics.

Risk averse
Will valuate certain outcomes higher than uncertain outcomes, even though they provide the same expected payoff.

Risk loving
Will valuate uncertain outcomes higher than certain outcomes, even though they provide the same

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Statistics (Ch. 10)

Calculate the expected return and variance from historical data.

High variance high uncertainty high risk

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Portfolio (Ch. 11)

In order to calculate the expected return and variance of a portfolio we need the following characteristics of the underlying assets:

Expected Return

Variance and Standard Deviation

Covariance and Correlation (to another security or index)

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Portfolio (Ch. 11)

The rate of return on the portfolio is a weighted average of the returns on the stocks and bonds in the portfolio:

The variance of the portfolio is found by the following formula:

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Portfolio (Ch. 11)

While covariance can be any positive and negative number, correlation standardizes this measure and provides us with more intuition and information. Correlation is always within -1 and 1, and the result differentiate between:

= 0 means there are no correlation, and the two assets compared vary randomly. = 1 means there are positive correlation, and the two assets will vary equally. = -1 means there are negative correlation, and the two assets will vary opposite each other.
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The Efficient Set

The goal for a portfolio manager is to maximize return while minimizing risk. Some portfolios are better than others. They have higher returns for the same level of risk (or less). These combinations are called Minimum Variance Opportunity Set (MVOS) or the Efficient Set. 12.05 10.05 The Minimum Variance Portfolio is defined by 8.05 the portfolio with the 6.05 4.05 lowest risk (green dot). 100
Expected return
2.05 0.05 0 2 4 6

100 % stoc ks

% bond s 8

10

12

Risk (standard deviation)

Capital Market Line (CML)

When we combine assets into a portfolio we can create an efficient set. By combining these alternative portfolios with a risk free borrowing/lending rate, we can create the Capital Market Line (CML). The slope of this
curve will from the CMLAs all investors is the line tangent to the efficient set starting then be risk free hold this will rate. r(m)- rf /(m) portfolio, this will L M 100% be the market C

retur n

portfolio.

stocks

r(m )

rf
( m)

100% bonds

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Capital Asset Pricing Model (CAPM)

CAPM is derived from the fact that market equilibrium equals CML = Efficient Set.

A low (high) beta indicates low (high) risk. An asset with a beta = 2, will have twice as much risk compared to the market portfolio. If the market rise by 1%, the asset will rise by 2%. If the market falls by 2%, the asset will fall by 4%. An asset with a beta = 0.5, will have half as much risk compared to the market portfolio.
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Discount rate r (Ch. 12)

We can find the discount rate r in 3 ways:

1.

2.

Inflation, to find changes in purchasing power as money lose value over time. r on equity

Dividend Growth Model

CAPM
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WACC

Remember to use aftertax cost of debt. WACC is used to show Modigliani and Miller proposition I and II (ch. 14 and 15). Can calculate weighted average beta the same way:

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Beta in CAPM

High high uncertainty higher required return. Important to adjust of a project to the projects risk. Problems of :

Stability over time Sample size error Change in financial leverage Cyclicality of revenues Operating Leverage Financial Leverage

Determinants

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Financial Leverage

Use weighted average .

Recognize that debt is close to 0 (no risk).

Rearrange:

Since equity > asset for a levered firm, there is a higher risk on equity return.
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Capital Structure (Ch. 14 15)

Modigliani & Miller proposition I & II

With and without taxes Financial distress Selfish strategies Trade-off theory Signaling The Pecking-order theory
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Limits to the use of debt

Capital Structure (Ch. 14)

Capital structure defines how the company is financed. It may be financed either by equity (stocks), debt (borrowed money) or a combination of these two. This combination equals a companys capital structure. D S E The market value V of a company is V=D+E where D is the market value of debt and E is the market value of equity. Value of the Remember that debt and equity gives Firm

MM Proposition I (No taxes)

According to Modigliani and Millers proposition I (MM I), the market value of any firm is independent of its capital structure. MM proves this by using a homemade leverage, showing that an investor can create leverage or undo company leverage (borrowing/lending). Therefore the company should be worth the same. VL = VU
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MM Proposition II (No taxes)

Leverage increases the risk and return to stockholders To prove this, we can use the Weighted Average Cost of Capital, and rearrange it to see how leverage (debt / equity) affects the cost of equity.

Rs = R0 + (B / S) (R0 - RB)
RB is the interest rate (cost of debt) 5454 RS is the return on (levered) equity (cost of equity)

Summary of the M&M Model Assumptions

Homogeneous Expectations Homogeneous Business Risk Classes Perpetual Cash Flows Perfect Capital Markets:
Perfect competition Firms and investors can borrow/lend at the same rate Equal access to all relevant information No transaction costs No taxes

Results
Prop. I: VL = VU (Value of levered firm equals value of unlevered firm.) Prop. II: RS = R0 + (B/S)(R0 - RB)

Intuition
Prop. I: Through homemade leverage, individuals can either duplicate or undo the effects of corporate leverage. 5555 Prop. II: The cost of equity rises with leverage, because the risk to equity rises with leverage.

14.5 MM Propositions I & II (With Taxes)

Proposition I (with Corporate Taxes)

Firm value increases with leverage VL = VU + tC B

Proposition II (with Corporate Taxes)

Some of the increase in equity risk and return is offset by the interest tax shield

RS = R0 + (B/S)(1-tC)(R0 - RB)
RB is the interest rate (cost of debt) RS is the return on equity (cost of equity) R0 is the return on unlevered equity (cost of capital) B is the value of debt S is the value of equity

Example 14.4 expected return

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Notice how WACC decreases with the increase of debt. Also, notice how the cost of equity (expected return) rises with leverage, but at a lower rate with taxes than without.

Limits to the use of debt (Ch. 15)

According to MM a company should increase their leverage, since the tax shield will increase the firm value. Why dont companies use 100% debt? As real world examples tells us daily, there are several reasons why debt can reduce the value of a company. 5858

Trade-off theory

Financial distress can create the following costs:

Direct costs Indirect costs Agency costs (selfish strategies)

These costs reduce the value of the company, and when a company decides on the debt-equity ratio, it typically must consider the tradeoff between interest rate tax shield and cost related to possible financial distress. This is the trade-off theory.
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Because of the trade-off it is possible to find an optimal debt-equity rate. At this rate, WACC will be minimized.

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Other theories

Signaling

Firms with a high anticipated profit will issue more debt in order to take advantage of the tax shield. Therefore a firm taking on more debt, provides a positive signal about its future earnings. The opposite is also true.

Agency cost of equity (free cash flow hypothesis)

By reducing the free cash flow, it is possible to reduce a managers opportunity to spend cash on perks or bad projects. Free cash flow can be reduced by paying out dividend or taking on loans (issuing bonds).
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Other theories cont.

The Pecking-order theory

Because of the possible signals given to the market when issuing stocks and/or debt, a firm should:

Rule 1 Use internal financing first Rule 2 Issue debt next, new equity last.

The pecking-order theory is at odds with the others:

No target D/E-ratio, compared to MM tradeoff. Profitable firms use less debt (finance internally first), compared to MM theory of high leverage in order to take advantage of tax shield. Companies like financial slack in order to finance internally, compared to the free cash flow hypothesis (agency cost).
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Lecture summary

Chapter 4-12 and 14-15. See slide 3.

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