FM Flashcards
What is the formula for dividends based approach of valuation
Used for valuing a minority interest, as the investor cannot control dividend policy, therefore income will depend on the dividends that the company is likely to pay out
Formula:
Present value of future expected dividend payments discounted at Ke
Ke - (cost of equity)
D0 - (the latest dividend)
D1 - (upcoming dividend or latest dividend × projected growth)
G - (growth)
Present value = (d1 x 1/Ke - g)
Or
Yield = Dividend/Price
If we can estimate the yield by looking at similar companies we can estimate the price as
Price = Dividend/Yield
Pros and cons:
Mainly revolve around the estimates used
What is Yield?
Yield is the debt holders’ required rate of return. (Referred to as ‘r’)
R = i/P 0
Where
i = annual interest starting in one year’s time
P 0 = original price
Excel formula yield on debt
=RATE(number of time periods, interest payment, market value, redemption value)
General letter abbreviations
i = annual interest starting in one year’s time
r = debt holders’ required return (yield)
Kd = cost of debt
Ke = cost of equity
T = corporation tax rate
P = price
NPV = Net present value
Excel formulas
Yield on debt
=RATE(number of time periods, interest payment, market value, redemption value)
NPV =NPV(discount rate %, NCFs from T1 onwards) + initial cash flow
Growth =Power(most recent fig./oldest fig, 1/number of years)
Capital Asset Pricing Model (CAPM)
A way of estimating the rate of return that a FULLY DIVERSIFIED equity shareholder would require from a particular investment
Formula:
Rj = Rf + B (Rm - Rf)
Rj = required return from an investment
Rf = risk free rate -> assumed to be the rate on Treasury Bills
Rm = average return on the market
(Rm - Rf) = equity risk premium
B (BETA) = systematic risk of the investment compared to market and therefore amount of the premium needed
Dividend yield method
Used to value minority interests
Cum div
&
Ex div
Cum div = share price before the dividend payment
Ex div = share price after the dividend payment
Cum div share price - dividend due = Ex div share price
Earnings based method
If a controlling share is held, the owner can access earnings generated - so earnings based method is used
Problems with Earnings based method
Erratic or manipulated earnings - unusually high or low earnings in previous year could distort values
Could mitigate by
- excluding one-off items
- use and average of the last few years earnings
Accounting policies can be used to manipulate earnings like: a change in depreciation policy could suggest the company’s earnings are artificially growing
Difficult to find similar listed companies to compare to
Listed companies tend to be overvalued
It is worth 1 Mark in the exam to say that a limited company should be reduced in values because of lack of marketability
PE multiple valuation
PE ratio = price per share/earnings per share
Or
PE ratio = total share value/total earnings
Rearranged
Price per share = PE ratio x Earnings per share
Or
Total share value = PE ratio x total earnings
Earnings = suitable earnings available to shareholders
One off values in questions must be excluded
PE ratios are only available for listed companies
For limited companies, an approximation must be used
EBITDA multiple
Takes away from controversial accounting policies like depreciation and amortisation and gives an approximation for cash earned per year. Cash is more factual than profit so better for measuring
Enterprise (EBITDA) multiple = Enterprise value/EBITDA
Enterprise value = the market value of all types of finance.
Calculated as:
Equity + debt - cash - short term investments
Cash flow based approach
Also used for majority ownership
Value of equity = PV of cash flow to infinity discounted at WACC - MV of debt
Discounted cash flow approach
Most detailed approach to value controlling interests
Equity = PV of pre-interest cash flows discounted @ WACC + Value of investments - Value of debt
Calculate perpetuity
Present value of perpetuity cashflow = Perpetuity cashflow* 1/discount rate
1÷discount factor %, * annuity discount factor for the previous year.
I.e. if calculating perpetuity for T4, use annuity decimal from T3
Or for a Growing Continuing Value:
(After tax cash flows for last known year * intended growth rate)/(discount factor - intended growth rate)
Or
1/(1+r)^n
r = discount rate % n = number of periods
What is WACC
Weighted average cost of capital
It is an average of Ke (cost of equity), Kp (cost of preference shares) and Kd (cost of debt) weighted according to the current market values of equity, preference and debt within a company’s capital structure
Foward
A binding agreement to buy or sell something in the future at a price fixed today
Tailor made and difficult to cancel
Could turn out to be advantageous or disadvantageous
Future
Standardised exchange traded contract to buy or sell something at an agreed price on a future date
Set sizes and for set dates
Easy to buy or sell on exchange like shares are bought
Usually closed out before due date
An Option
Gives the right but not obligation to buy or sell a specific quantity of an item at a predetermined price
Over the counter options:
Attached to forward contracts, pric agreed upfront. Tailor made
Traded options:
As futures are traded on exchange and option on futures is a traded option.
Standardised
Simulations
strengths and weaknesses
Strengths
Useful for problems that cannot be solved analytically
Can consider changes to multiple variables
Take into account probability of variables changing
Weaknesses
They do not suggest a correct decision
Expensive and time consuming ti create
Info on probabilities may be unreliable
Trade risks
Physical risk (loss or damage require replacement costs)
Political risk (region based restrictions/taxes)
Liquidity risk (inability to finance credit or pay debts)
Credit risk (risk of customers defaulting)
Cultural risk (incompatibility with cultural preferences)
Human error
Market efficiency
How stock market prices react to events
Weak form - share prices reflect info about past price mvmt, and future price mvmt cannot be predicted from past mvmts
Semi-strong form - Share prices incorporate all publicly available info rapidly and accurately. The market cannot be beaten by analysing publicly available info
Strong form - Share prices reflect all info whether published or not. Insider dealing has no value
London stock exchange is usually semi-strong efficient
Semi strong markets react to press releases
Strong markets do not react to press releases bc the info is already reflected in stock prices
Bankruptcy
Very high gearing (I.e. very high reliance on debt) puts a business at risk of bankruptcy
Gearing theory
Traditional view = low gearing (I.e. low reliance on debt = decrease in WACC = company value rises
High gearing (I.e. High reliance on debt) = cost of debt rises = WACC rises = company value drops
Modigliani and Miller 1963- company WACC and company value is not affected by level of gearing other than through effects of tax relief. Tax relief =fall in WACC = company value rises
Pros and cons of loan finance
Traditional view
Loan finance is cheap because it is low risk to lenders and loan interest is tax deductible
This means gearing increases, so WACC decreases, so company value rises
Shareholders and lenders are relatively inconcerned about increased risk at low level of gearing
Higher gearing = Higher risk = Higher returns demanded by shareholders and lenders = Higher wacc = lower company value
Modigliani and Miller view
Shareholders are immediately concerned by any gearing
Gearing (loan finance) is only beneficial because of tax relief
Modern view
M&M probably right about gearing only being beneficial bc of tax
High gearing = Shareholders worry about bankruptcy = Higher returns demanded=wacc up= Business value down
Optimum gearing = WACC is minimised and company value is maximised
Underwriting
Advantage
Form of insurance which ensure that all funds required are raised/sold
Disadvantage
Can signal lack of confidence in the product/service/projects ability to sell/succeed.
Market appetite may be less than expected.
Underwriting is expensive to procure (1 - 2% of funds raised)
Shareholder Value analysis (SVA)
Alternative method of calculating company value based on future cash flows and 7 ‘value drivers’ which are manageable by the company:
Length of project Sales growth rate Profit margin Fixed assets investment Working capital investment Tax rate Discount rate
Shareholder value analysis
Process of analysing business activities to identify how they will result in increasing sharhokder wealth:
Are these drivers being maximised: Sales growth rate Op profit margin Investment in working capital Cost of capital Life of projected cash flows Corporation tax rate
Systemic vs unsystemic risk
Systemic- risk that all companies are exposed to no matter which market sectors, e.g. war, economic crash etc.
It cannot be eliminated through diversification
Unsystemic- rusks which are specific to a particular market sector
It can be reduced through diversification
Inflation
When discount rate is given at ‘real cost’ it must be multiplied by inflation rate, then -1 to find the usable discount rate
The ‘money rate’ is the discount rate including inflation
Adjusted present value (APV)
Useful when gearing changes and therefore financial risk changes
Apv used when financial risk changes regardless of chang in business risk.
Step 1 calculate base case cash flow:
Project cashflow*CAPM Ke(using industry asset beta).
This equals NPV as if the firm had no debt finance
Step 2 calculate pv of finance side effects:
Costs involved discounted for relevant number of periods.
APV = step 1 + step 2
Data analytics
Predictive analytics:
Regression analytics- quantifies relationship between 2 variables. I.e. if weather improves, more people will pay for outdoor activities
Decision trees- used to consider multiple decisions and their impacts.
Prescriptive analytics:
Combining AI, statistical tools and Predictive analytics to calculate optimum outcomes for business decisions.
E.g. identifying optimal production levels considering factors like demand, supplier lead times and use of machinery
Real options
Delay- postpone a project to wait for a favourable situation or see how another company succeeds with a similar project.
Abandon - reject the project before starting or part way through if sales are lower than expected, costs higher, competition steeper.
Follow on - expand the project if it performs well
Growth - implement the project incrementally over time, rather than the full scale of the plan from the start.
Flexibility - making strategic amendments to the project during its life cycle to maximise profits
Sensitivity analysis
Exam tip(if something is effected by sales volume and price, it means contribution)
CF Sensitivity = NPV/PV of flow under consideration (after tax)
Discount rate sensitivity=difference between cost if capital and IRR
IRR= DF1+(NPV/(NPV@DF1+NPV@DF2))*(DF2-DF1)
Project life sensitivity= the time when the cumulative present value of cf goes from positive to negative (in reverse order)
Strengths:
Relatively straightforward
Identifies critical success area fpr the project e.g. sales volume, materials price
Facilitates subjective judgement
Weaknesses:
Ignores probability
Does not suggest a correct decision
Assumes changes in variables can be made independently
Irr calculation (incomplete)
Formula
Df1[given in q] + (PV of df1/(pv of df1 - pv of df2))*(df2-df1)
Interest rate parity
Interest rate parity claims that the difference between the spot and the future exchange rates is equal to the differential between interest rates available in the two currencies
Otherwise risk free gains could be made
Used by banks to calculate forward rate quoted for a currency
Forward rate= current spot rate*((1+if)/(1+iuk))
iF = foreign currency interest rate for period
iUK = UK interest rate for period
DVM vs CAPM
DVM shareholders benefit from owning a share by receiving dividend into the future and capital gain on value of the shares.
The pv of this benefit creates the current price of the shares this share price is determined by expected future dividends discounted at investors required rate of return.
CAPM specific/unsystematic risk can be diversified away by investors so it is assumed investors are rational and have a diversified portfolio. Systematic risk cannot be diversified away - micro economic factors. A company’s beta is calculated from the performance of its share price against the market average and is taken as a measure of the market’s view of the risk attached to the security in question. The higher the perceived risk then the higher the beta figure and thus the higher the equity return required by investors
Portfolio effect
Portfolio effect
A portfolio of investments helps spread risk.
Investors can usually spread risk themselves - they don’t need managers to do it for them. Limitations come if the area a company is diversifying into requires skills and knowledge that the business does not have as this would increase the risk of the investment failing
Purchasing power parity (PPP)
PPP caims that the rate of exchange between two currencies depends on the relative inflation rates within the respective countries
The country with higher inflation is subject to a depreciation in its currency
In equilibrium, identical goods will cost the same in any currency
Future spot rate= current spot rate*((1+inflF)/(1+inflUK))
Index options
Expiry date (closest date after transaction happens)
No. of contracts = value of portfolio/ (current index size*£10)
Calculate option premium= points associated to chosen call or put option£10number of contracts
When receiving
Gain if your chosen index is higher than the hypothetical
When paying
Gain When the hypothetical is higher than your index
