FINANCECAPCI Flashcards
What is the value of a company?
Value of Assets = Debt + Equity
What is the Value of Debt?
Value of debt = the book value of debt(or… if its market value if the debt is traded)
What are the four most commonly used valuation techniques?
- Discounted Cash Flow Analysis
- Multiples Method
- Market Valuation
- Comparable Transactions Method
==> this is valuation of equity.
What are the four basic financial statements?
- Balance Sheet
- Income Statement
- Cash flow statement
- Retained Earnings statement
What is the equation of the balance sheet?
Assets = Liabilities + Shareholder’s equity
What are the three ways in which a company can obtain the economic resources necessary to operate its business?
- Obtain debt (debt)
- Seek new investors (equity)
- Operations (profit)
When is something an asset vs. expense?
Asset;
- Future value or economic benefit to the company.
Expense;
- Relate only to the current period.
What does the statement of retained earnings show?
Essentially the amount of profit that is re-invested into the company and hence not used to pay back debt or distribute to shareholders as dividend.
Why is the cash flow statement important?
Liquidity.
Profit / Net income is not necessarily meaning positive cash flows.
How is the cash flow statement divided?
- Cash flow from operating activates (income statement included here)
- Cash flow from investing activities (balance sheet included here with investments, accounts payable, accounts receivable and other asset and liability accounts)
- Cash flows from financing activities (retained earnings also included)
How does the technique of “market valuation” work?
The value of publicly traded firms is easy to calculate.
==>
Company’s stock price * Number of shares
P * Q
(Market capitalization)
What is an acquisition premium?
The premium price paid per stock / per share of equity while acquiring a company.
A premium is paid due to demand/supply factors.
Acquisition Premiums are decided by the perception of synergies resulting from the purchase or meger.
What are the two different DCF method ways?
The most thorough valuation model.
TWO WAYS;
- Adjusted present value method (APV)
- Weighted average cost of capital method (WACC)
What is NPV?
Net present value of cash flows at a given discount rate
Time value of money = A dollar today is worth more than a dollar tomorrow.
Why is a dollar today worth more than a dollar tomorrow?
- You can invest that dollar at a risk-free interest rate (US government bonds)
- Inflation diminishes value
What is the difference between opportunity cost and discount rate?
Opportunity cost = a measure of the opportunity lost
Discount rate = a measure of the risk
What is CAPM?
Capital Asset Pricing Model
==> Calculating the appropriate discount rate)
Re = Rf + Beta*(Rm –Rf)
Re = discount rate
Beta = the relative volatility of the given investment with respect to market.
Rf = risk-free rate (treasury bill)
Rm = market return
Rm – Rf = excess market return
In CAPM, how volatile is the investment if Beta = 0.5?
Half as volatile as the market
In CAPM, how volatile is the investment if Beta = 1.2?
More volatile than the market
How can you easily explain beta in CAPM?
Volatility of the investment with respect to the market.
Hence, if the crypto market goes up or down 20 % tomorrow, but Bitcoin is expected to go up or down only 10 %, then Beta < 1.
How do you find a company’s beta?
If publicly traded, check “Value Line” or “Yahoo! Finance” etc.
If not publicly traded, find a company with similar balance sheet and income statement that is publicly traded.
EQUITY BETA – not asset beta
What if you have only been given the Asset Beta? (CAPM)
Equity Beta can be calculated as
Beta equity = Beta Asset * (D + E) / E
Due to…
What is EBIT?
Earnings Before Interest and Taxes
What is EBITDA?
Earnings Before Interest, Taxes, Depreciation and Amortization
What is Free Cash flows (FCF)?
For an ALL EQUITY FIRM è FCF = the cash flows
What is terminal year?
The terminal year represents the year (usually 10 years in the future) when the growth of the company is considered stabilized
In other words….
The cash flows of the first 10 years are determined by company management and financial analysts = predictions and forecasts.
After the terminal year, the cash flow is assumed to have a constant growth rate “g”.
What are the methods to calculate discount rate?
- WACC = Weighted Average Cost of Capital
- APV = Adjusted Present Value
What is the key difference between WACC and APV?
WACC = discount rate for leveraged equity (reL) using CAPM
Vs.
APV = discount rate for an all-equity firm (reU)
Which discount rate is used in APV and how is it calculated?
ReUnleveraged
Which discount rate is used in WACC and how is it calculated?
ReLeveraged
- RdWACC = Find WACC
- Use ReLeveraged from CAPM
What must you remember when using APV method?
When you calculate a discount rate using Adjusted Present Value (APV), you calculate ReUnleveraged.
Hence, you have not taken the tax shield on debt into account in your valuation.
Thus, you must add the “debt tax shield” DTS into your valuation;
APV + DTS
Where
DTS = (tax rate) * (average interest rate on debt, Rd) * (Debt amount)
What is tricky about DTS?
The Debt Tax Shield (DTS) value must also be discounted due to risk
The discount rate that should be used depends on the perceived risk involved with DTS.
What is a good BOE way to calculate DTS? (debt tax shield value)
DTS = (APV without DTS) * (Leverage ratio; D/(D+E)) * (tax rate)
APV = Average present value
Leverage ratio = D/(D+E) = Long-term debt rate (L)
What is the long-term debt rate?
A synonym for Leverage ratio.
Simply, D/(D+E)
What are the names for D/(D+E)?
Long-term debt rate (L)
Leverage ratio
What is the academic issue with WACC?
It takes a “target” debt-to-equity ratio to calculate the discount rate and this “target” debt-to-equity ratio is not reached until a few years in the future.
Hence, it is essentially wrong in the beginning but it makes a super small difference.
Most investment banks use the WACC method anyway.
What is the method to calculate value of a company with APV?
- Assumptions
- Find cash flows; FCF = EBIT (1-t) + Depreciation – CAPex – Change in NWC
- Calculate discount rate ==> APV
- Calculate Beta unleveraged using Beta leveraged
- Use Beta unleveraged to calculate ReUnleveraged
- Calculate Terminal Value
- Take NPV of all cash flows
- Remember to add TY FCF to the last Year FCF
- Add DTS (BOE method) = (APV without DTS) * (Leverage ratio D/(D+E)) * tax rate
What is the method to calculate value of a company with WACC?
- Assumptions
- Find cash flows; FCF = EBIT (1-t) + Depreciation – CAPex – Change in NWC
- Calculate discount rate è APV
- Calculate Beta Leveraged using beta unleveraged
- Use Beta leveraged to calculate ReLeveraged = Rf + Beta leverage *(Rm – Rf)
- Use ReLeverage to calculate R-WACC = E/(D+E)*ReLeveraged + D/(D+E)*(1-t)*(Rd)
- Calculate Terminal Value
- Take NPV of all cash flows
- Remember to add TY FCF to the last Year FCF
How does the “Comparable Transactions” method work?
You use the multiples and ratios from previous transactions that have taken place in the industry.
What are important factors when using the Comparable Transactions method?
Were the companies valued as a multiple of EBIT, EBITDA, revenue or some other parameter?
How does the “multiples method” work?
Quite often, there is not enough information to determine the valuation using the comparable transactions method.
In these cases, we value companies using available information online such as;
- Price/Earning ratios
- EBITDA multiples
- Revenue multiples
Say you knew a company’s net income. How would you figure out its “free cash flow”?
Net Income + Depreciation and Amortization
– CapitalExpenditures
– Increase (or + decrease) in net working capital
= Free Cash Flow (FCF)
What is the formula for CAPM? Capital Asset Pricing Model
How do you calculate the terminal value of a company?
If all else is equal, why can the P/E multiples of a company in U.K. be different than that of an equal company in USA?
Explained by difference in the way earnings are recorded.
What are the different multiples that can be used to value a company?
P/E
EBITDA or EBIT (heavy industry)
Revenue (especially in tech)
How do you get the discount rate for an all-equity firm?
You use the Capital Asset Pricing Model, or CAPM.
Can you apply CAPM in Asia?
CAPM is developed for the U.S. markets.
BUT… it is presently the best known tool for calculating discount rates and is used globally.
What is the difference between the APV and WACC?
WACC incorporates the effect of tax shields into the discount rate used to calculate the present value of cash flows. WACC is typically calculated using actual data and numbers from balance sheets for companies or industries.
APV adds the present value of the financing effects (most commonly, the debt tax shield) to the net present value assuming an all-equity value, and calculates the adjusted present value. The APV approach is particularly useful in cases where subsidized costs of financing are more complex, such as in a leveraged buyout.
What is Beta?
Beta is the value that represents a stock’s volatility with respect to overall market volatility.
What is the risk of a portfolio in a nutshell?
The standard deviation of the portfolio’s expected returns.
So… volatility of the expected returns.
How is correlation used in the stock market?
If two stock’s move in similar patterns, they have a high correlation
Correlation coefficient = -1 to 1
- High correlation = close to 1 (1 = identical)
- No correlation = 0
- Opposite patterns = -1
How is diversification used in investing?
Portfolio management
Having different asset classes decreases risk + within same asset class fx stocks in both tech, biomedicine, industry, airlines etc.
Especially stocks and bonds because they have a low correlation or rather inverse correlation.
What is technical vs. fundamental analysis?
- Technical ==> Looking at charts and patterns of a stock
- Fundamental ==> Focusing on the fundamentals of the business, its growth opportunities, financials, growth and balance sheet,
How do you value stocks?
- Essentially as valuing a company ==> Multiples + DCF analysis is classical AND
- Financial ratio analysis
- Solvency:
- Quick ratio
- Current ratio
- Cash ratio
- Debt to equity
- Current liabilities to inventory
- Total liabilities to net worth
- Solvency:
Efficiency ratios
- Collection period
- Inventory turnover
- Sales to assets
- Sales to net working capital
- Gross profit margin
- Return on assets
- Return on equity
Gotham Energy just released second quarter financial results. Looking at its balance sheet you calculate that it’s Current Ratio went from 1.5 to 1.2. Does this make you more or less likely to buy the stock?
Less likely. This means that the company is less able to cover its immediate liabilities with cash on hand and other current assets than it was last quarter.
Current Assets (cash, account receivable etc.) / Current liabilities (accounts payable and other short-term liabilities)
Is the book value of equity and the market value the same?
No. most often not.
Market value = Price per stock * #Shares outstanding
Is there any difference TAX-wise for preferred and common stock?
- Preferred stockholders are only taxed on 30 % of the dividend received
- Common stockholders are taxed on 100 % of the dividend received
Why does price increases of stocks happen at stock buybacks?
- P/E is expected to go up as the number of shares decreases ==> earnings are divided between fewer stocks
- Signal effect ==> The management know the company the best. Hence, if they invest in their own company by buying back shares, they must expect that the stock is undervalued
- Debt Tax Shield is the third reason as the net debt increases (net debt = debt – cash) and cash goes down when buying back shares.
Why does the price of stock decrease at new issuances?
- Issuing new shares dilutes earnings per share ==> earnings are divided between more stocks
- Signal effect ==> they issue equity rather than debt. Hence, management may believe that the stock price is too high/inflated
- Debt Tax Shield ==> Equity to finance investments means less debt to do so. Hence net debt decreases and the value of DTS decreases
What kind of stocks would you issue for a startup?
A startup typically has more risk than a well-established firm. The kind of stocks that one would issue for a startup would be those that protect the downside of equity holders while giving them upside. Hence the stock issued may be a combination of common stock, preferred stock and debt notes with warrants (options to buy stock).
When should a company buy back stock?
When it believes the stock is undervalued, has extra cash, and believes it can make money by investing in itself. This can happen in a variety of situations. For example, if a company has suffered some decreased earnings because of an inherently cyclical industry (such as the semiconductor industry), and believes its stock price is unjustifiably low, it will buy back its own stock. On other occasions, a company will buy back its stock if investors are driving down the price precipitously. In this situation, the company is attempting to send a signal to the market that it is optimistic that its falling stock price is not justified. It’s saying: “We know more than anyone else about our company. We are buying our stock back. Do you really think our stock price should be this low?”
Why would an investor buy preferred stock?
1) An investor that wants the upside potential of equity but wants to minimize risk would buy preferred stock. The investor would receive steady interest-like payments (dividends) from the preferred stock that are more assured than the dividends from common stock. 2) The preferred stock owner gets a superior right to the company’s assets should the company go bankrupt. 3) A corporation would invest in preferred stock because the dividends on preferred stock are taxed at a lower rate than the interest rates on bonds.
You are on the board of directors of a company and own a significant chunk of the company. The CEO, in his annual presentation, states that the company’s stock is doing well, as it has gone up 20 percent in the last 12 months. Is the company’s stock in fact doing well?
Another trick stock question that you should not answer too quickly. First, ask what the Beta of the company is. (Remember, the Beta represents the volatility of the stock with respect to the market.) If the Beta is 1 and the market (i.e. the Dow Jones Industrial Average) has gone up 35 percent, the company actually has not done too well compared to the broader market.
What is the face value of a bond?
This is the total amount the bond issuer will commit to pay back at the end of the bond maturity period (when the bond expires).
What is default risk associated with bonds?
The risk that the company issuing the bond may go bankrupt, and default on its loans
What is the default premium associated with bonds?
The difference between the promised yields on a corporate bond and the yield on an otherwise identical government bond. In theory, the difference compensates the bondholder for the corporation’s default risk.
What are some major bond types?
- Government bonds (US treasury bills, notes etc.)
- Investment grade bonds (think Microsoft, Apple, GE)
- Junk bonds (poor credit rating. Relatively high interest rates)
How much is a bond worth?
What is HPR?
Holding Period Return (with bonds)
The income earned over a period as a percentage of the bond price at the start of the period, assuming that the bond is sold at the end of the period.
How can a national bank change the money supply?
- Open market operations ==> the national bank buys securities and thus increases money supply by buying back government bonds in the market
- Changing interest rates ==> Lower interest rate = more money will be borrowed
- Lower Reserve requirements (the requirements of banks to have a minimum balance in a reserve account at the national bank).
How is bond prices affected by interest rates and economic events?
Interest rate up = Bond prices down.
Inverse relationship between bond prices and interest rates.
What is the relationship between a bond’s price and its yield?
They are inversely related. That is, if a bond’s price rises, it’s yield falls, and vice versa. Simply put, current yield = interest paid annually / market price * 100%.
What major factors affect the yield on a corporate bond?
The short answer: 1) interest rates on comparable U.S. Treasury bonds, and 2) the company’s credit risk.
