1-1 Corporate Valuation: A Guide for Brokers, Managers and Investors Dr. Mounther Barakat Al Omari...

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Corporate Valuation: A Guide for Brokers, Managers and

Investors

Dr. Mounther Barakat Al Omari

Securities and Commodities AuthorityAbu Dhabi - UAE

December - 2006

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تحليل الشركات وتسعير االسهمدليل للوسطاء والمدراء

والمستثمرين

د. منذر بركات العمري

هيئة االوراق المالية والسلع – ابو ظبيدولة االمارات العربية المتحدة

2006

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Introductionمقدمة

The following is an important introduction for stock analysts and

evaluators.This introduction is intended to provide stock analysts with the tools they need

to carryout their analysis.فيما يلي مقدمة هامة للمحللين الماليين ولمسعري

الشركاتتحوي هذه المقدمة على ادوات هامة ال يستطيع

المحلل المالي ان يقوم بوظيفته بدونها

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Financial Goals of the Corporationالشركة هدف

The primary financial goal is shareholder wealth maximization, which translates to maximizing stock price. Do firms have any responsibilities to

society at large? Is stock price maximization good or

bad for society? Should firms behave ethically?

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Is stock price maximization the same as profit maximization?االرباح؟ تعظيم هو المساهمين ثروة تعظيم يعتبر هل

No, despite a generally high correlation amongst stock price, EPS, and cash flow.

Current stock price relies upon current earnings, as well as future earnings and cash flow.

Some actions may cause an increase in earnings, yet cause the stock price to decrease (and vice versa).

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Factors that affect stock priceالسهم بسعر تؤثر التي العوامل

Projected cash flows to shareholders

Timing of the cash flow stream

Riskiness of the cash flows

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Basic Valuation Modelاالولي التسعير نموذج

To estimate an asset’s value, one estimates the cash flow for each period t (CFt), the life of the asset (n), and the appropriate discount rate (k)

Throughout the course, we discuss how to estimate the inputs and how financial management is used to improve them and thus maximize a firm’s value.

n

1tt

t

nn

22

11

.k)(1

CF

k)(1CF

k)(1CF

k)(1CF

Value

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Factors that Affect the Level and Riskiness of Cash Flowsالنقدية التدفقات وتوقيت وخطورة بقيمة المؤثرة العوامل

Decisions made by financial managers: Investment decisions Financing decisions (the relative use of debt

financing) Dividend policy decisions

The external environment

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Financial Statements, Cash Flow, and Taxesوالضرائب النقدية التدفقات المالية، القوائم

Balance sheet Income statement Statement of cash flows Accounting income vs. cash flow MVA and EVA The tax system

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The Annual Reportالسنوي التقرير

Balance sheet – provides a snapshot of a firm’s financial position at one point in time.

Income statement – summarizes a firm’s revenues and expenses over a given period of time.

Statement of retained earnings – shows how much of the firm’s earnings were retained, rather than paid out as dividends.

Statement of cash flows – reports the impact of a firm’s activities on cash flows over a given period of time.

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Balance Sheet: Assetsاالصول - المالي المركز قائمة

CashA/RInventories

Total CAGross FALess: Dep.

Net FATotal Assets

20027,282

632,1601,287,3601,926,8021,202,950 263,160 939,7902,866,592

200157,600

351,200 715,2001,124,000

491,000 146,200 344,8001,468,800

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Balance sheet: Liabilities and Equityالملكية – وحقوق الخصوم المالي المركز قائمة

Accts payableNotes payableAccruals

Total CLLong-term debtCommon stockRetained earnings

Total EquityTotal L & E

2002524,160

636,808 489,6001,650,568

723,432460,000

32,592 492,5922,866,592

2001145,600200,000

136,000481,600323,432460,000

203,768 663,7681,468,800

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Income statementالدخل قائمة

SalesCOGSOther expenses

EBITDADepr. & Amort.

EBITInterest Exp.EBTTaxesNet income

20026,034,000

5,528,000 519,988

(13,988) 116,960(130,948) 136,012(266,960) (106,784) (160,176)

20013,432,0002,864,000 358,672

209,328 18,900

190,428 43,828

146,600 58,640

87,960

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Other dataأخرى معلومات

No. of sharesEPSDPSStock price

2002100,000-$1.602

$0.11$2.25

2001100,000

$0.88$0.22$8.50

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Did the expansion create additional net operating after taxes (NOPAT)?

الضريبة بعد التشغيلي الدخل حسابات

NOPAT = EBIT (1 – Tax rate)

NOPAT02 = -$130,948(1 – 0.4)

= -$130,948(0.6)= -$78,569

NOPAT01 = $114,257

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What effect did the expansion have on net operating working capital?

العمل المال رأس صافي حسابات

NOWC = Current - Non-interest

assets bearing CL

NOWC02 = ($7,282 + $632,160 + $1,287,360) – ( $524,160 + $489,600)

= $913,042

NOWC01 = $842,400

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What effect did the expansion have on operating capital?

التشغيلي المال رأس حسابات

Operating capital = NOWC + Net Fixed Assets

Operating Capital02 = $913,042 + $939,790

= $1,852,832

Operating Capital01 = $1,187,200

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What is your assessment of the expansion’s effect on operations?

التشغيل حسابات من مالحظات

Sales

NOPAT

NOWC

Operating capital

Net Income

2002 $6,034,000

-$78,569$913,042

$1,852,832-$160,176

2001 $3,432,00

0$114,257$842,400$1,187,20

0$87,960

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What effect did the expansion have on net cash flow and operating cash flow?

النقدية التدفقات حسابات

NCF02 = NI + Dep = ($160,176) + $116,960

= -$43,216

NCF01 = $87,960 + $18,900 = $106,860

OCF02 = NOPAT + Dep

= ($78,569) + $116,960

= $38,391

OCF01 = $114,257 + $18,900

= $133,157

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What was the free cash flow (FCF) for 2002?الحر النقدي التدفق حساب

FCF = OCF – Gross capital investment

- OR -

FCF02 = NOPAT – Net capital investment

= -$78,569 – ($1,852,832 - $1,187,200)

= -$744,201

Is negative free cash flow always a bad sign?

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Economic Value Added (EVA)المضافة القيمة حساب

EVA = After-tax __ After-tax

Operating Income Capital costs

= Funds Available __Cost of

to Investors Capital Used

= NOPAT – After-tax Cost of Capital

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EVA Conceptsالمضافة االقتصادية القيمة مفهوم

In order to generate positive EVA, a firm has to more than just cover operating costs. It must also provide a return to those who have provided the firm with capital.

EVA takes into account the total cost of capital, which includes the cost of equity.

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What is the firm’s EVA? Assume the firm’s after-tax percentage cost of capital was 10% in 2000 and 13% in 2001.

المضافة االقتصادية القيمة حساب

EVA02 = NOPAT – (A-T cost of capital) (Capital)

= -$78,569 – (0.13)($1,852,832)

= -$78,569 - $240,868

= -$319,437

EVA01 = $114,257 – (0.10)($1,187,200)

= $114,257 - $118,720

= -$4,463

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Did the expansion increase or decrease MVA?المضافة السوقية القيمة حساب

MVA = Market value __ Equity capital of equity supplied

During the last year, the stock price has decreased 73%. As a consequence, the market value of equity has declined, and therefore MVA has declined, as well.

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Corporate and Personal Taxesقيمة على وأثرها واالفراد الشركات ضرائب

وأسهمها الشركة

Have a progressive structure (the higher the income, the higher the marginal tax rate).

Corporations Rates are at 0% unless there are special provisions for

certain companies like Oil and foreign ones. Individuals

Rates 0% for individuals, again unless there are special provisions.

Inexistence of taxes does not change the mechanics of our work, it will change the results.

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Tax treatment of various uses and sources of fundsوالخارجة الداخلة النقدية التدفقات على الضرائب أثر

Interest paid – tax deductible for corporations (paid out of pre-tax income), but usually not for individuals.

Interest earned - taxable Dividends paid – paid out of after-tax income. Dividends received – not taxed individuals (“double

taxation”). Capital gains not taxable

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Calculating Key Multipliersالمضاعفات مثال - حساب

P/E = Price / Earnings per share= $12.17 / $1.014 = 12.0x

P/CF = Price / Cash flow per share= $12.17 / [($253.6 + $117.0) ÷ 250]= 8.21x

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Calculating Key Multipliersمثال - المضاعفات حساب

M/B = Mkt price per share / Book value per share= $12.17 / ($1,952 / 250) = 1.56x

2003 2002 2001 Ind.

P/E 12.0x -1.4x 9.7x 14.2x

P/CF 8.21x -5.2x 8.0x 11.0x

M/B 1.56x 0.5x 1.3x 2.4x

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Analyzing the multipliersالمضاعفات تحليل

P/E: How much investors are willing to pay for $1 of earnings.

P/CF: How much investors are willing to pay for $1 of cash flow.

M/B: How much investors are willing to pay for $1 of book value equity.

For each ratio, the higher the number, the better. P/E and M/B are high if ROE is high and risk is

low.

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Trend analysisالنمطية تحليل

Analyzes a firm’s financial ratios over time

Can be used to estimate the likelihood of improvement or deterioration in financial condition.

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Potential uses of freed up cashالحر النقدي التدفق استخدامات

Repurchase stock Expand business Reduce debt All these actions would likely improve the

stock price.

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The Financial Environment:المراد للشركة المالية البيئة

وتقييمها تحليلها

Financial markets Types of financial institutions Determinants of interest rates Yield curves

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What is a market?السوق هو ما

A market is a venue where goods and services are exchanged.

A financial market is a place where individuals and organizations wanting to borrow funds are brought together with those having a surplus of funds.

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Types of financial marketsالمالية االسواق أنواع

Physical assets vs. Financial assets Money vs. Capital Primary vs. Secondary Spot vs. Futures Public vs. Private

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How is capital transferred between savers and borrowers?

الى الفائض وحدات من االموال تحويلالعجز وحدات

Direct transfers Investment banking house Financial intermediaries

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Types of financial intermediariesالماليين الوسطاء أنواع

Commercial banks Savings and loan associations Mutual savings banks Credit unions Pension funds Life insurance companies Mutual funds

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Physical location stock exchanges vs. Electronic dealer-based markets

والغير المنظمة السوق بين الفرقمنظمة

Auction market vs. Dealer market (Exchanges vs. OTC)

Differences are narrowing

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The cost of moneyالمال رأس تكلفة

The price, or cost, of debt capital is the interest rate.

The price, or cost, of equity capital is the required return. The required return investors expect is composed of compensation in the form of dividends and capital gains.

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What four factors affect the cost of money?المال رأس تكلفة في تؤثر التي العوامل

Production opportunities Time preferences for consumption Risk Expected inflation

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“Nominal” vs. “Real” ratesوالحقيقي االسمي العائد

k = represents any nominal rate

k* = represents the “real” risk-free rate of interest, if there was no inflation. Typically ranges from 1% to 4% per year.

kRF = represents the rate of interest on Treasury securities.

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Determinants of interest rates( العائد ( الفائدة سعر محددات

k = k* + IP + DRP + LP + MRP

k = required return on a debt security

k* = real risk-free rate of interest

IP = inflation premium

DRP = default risk premium

LP = liquidity premium

MRP = maturity risk premium

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Premiums added to k* for different types of debtالمختلفة المخاطر عالوات مقارنة

IP MRP

DRP LP

S-T Treasury L-T Treasury

S-T Corporate

L-T Corporate

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Yield curve and the term structure of interest ratesباالستحقاق الفائدة وعالقة العائد منحنى

Term structure – relationship between interest rates (or yields) and maturities.

The yield curve is a graph of the term structure.

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Hypothetical yield curveافتراضي عائد منحنى

An upward sloping yield curve.

Upward slope due to an increase in expected inflation and increasing maturity risk premium.

Years to Maturity

Real risk-free rate

0

5

10

15

1 10 20

InterestRate (%)

Maturity risk premium

Inflation premium

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The Yield Curveالعائد منحنى

Corporate yield curves are higher than that of Treasury securities, though not necessarily parallel to the Treasury curve.

The spread between corporate and Treasury yield curves widens as the corporate bond rating decreases.

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The Yield Curveالعائد منحنى

0

5

10

15

0 1 5 10 15 20

Years toMaturity

Interest Rate (%)

5.2%5.9%

6.0%TreasuryYield Curve

BB-Rated

AAA-Rated

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Risk and Rates of Returnوالعائد المخاطر

Stand-alone risk Portfolio risk Risk & return: CAPM / SML

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Investment returnsاالستثمار على العائد

The rate of return on an investment can be calculated as follows:

(Amount received – Amount invested)

Return = ________________________

Amount invested

For example, if $1,000 is invested and $1,100 is returned after one year, the rate of return for this investment is:

($1,100 - $1,000) / $1,000 = 10%.

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What is investment risk?االستثمار مخاطر

Two types of investment risk Stand-alone risk Portfolio risk

Investment risk is related to the probability of earning a low or negative actual return.

The greater the chance of lower than expected or negative returns, the riskier the investment.

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Probability distributionsاالحتمالي التوزيع

A listing of all possible outcomes, and the probability of each occurrence.

Can be shown graphically.

Expected Rate of Return

Rate ofReturn (%)100150-70

Firm X

Firm Y

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Risk: Calculating the standard deviationاالنحراف باستخدام المخاطر حساب

المعياري

deviation Standard

2Variance

i

2n

1ii P)k̂k(

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Standard deviation as a measure of riskللخطورة كمقياس المعياري االنحراف

Standard deviation (σi) measures total, or stand-alone, risk.

The larger σi is, the lower the probability that actual returns will be closer to expected returns.

Larger σi is associated with a wider probability distribution of returns.

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Coefficient of Variation (CV)التشتت للخطورة معامل كمقياس

A standardized measure of dispersion about the expected value, that shows the risk per unit of return.

^

k

Meandev Std

CV

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Investor attitude towards riskللمخاطر المستثمرين تحمل درجة

Risk aversion – assumes investors dislike risk and require higher rates of return to encourage them to hold riskier securities.

Risk premium – the difference between the return on a risky asset and less risky asset, which serves as compensation for investors to hold riskier securities.

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Illustrating diversification effects of a stock portfolio

المخاطر على التنويع اثر

# Stocks in Portfolio10 20 30 40 2,000+

Company-Specific Risk

Market Risk

20

0

Stand-Alone Risk, p

p (%)35

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Breaking down sources of riskالمخاطر مصادر

Stand-alone risk = Market risk + Firm-specific risk

Market risk – portion of a security’s stand-alone risk that cannot be eliminated through diversification. Measured by beta.

Firm-specific risk – portion of a security’s stand-alone risk that can be eliminated through proper diversification.

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Capital Asset Pricing Modelالرأسمالية االصول تسعير نموذج

Model based upon concept that a stock’s required rate of return is equal to the risk-free rate of return plus a risk premium that reflects the riskiness of the stock after diversification.

Primary conclusion: The relevant riskiness of a stock is its contribution to the riskiness of a well-diversified portfolio.

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Betaبيتا للخطورة معامل كمقياس

Measures a stock’s market risk, and shows a stock’s volatility relative to the market.

Indicates how risky a stock is if the stock is held in a well-diversified portfolio.

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Calculating betasباستخدام بيتا معامل Excelحساب

Run a regression of past returns of a security against past returns on the market.

The slope of the regression line (sometimes called the security’s characteristic line) is defined as the beta coefficient for the security.

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Illustrating the calculation of betaباستخدام - بيتا معامل حساب مثال

Excel

See PADICO-PALTEL.XLS

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Comments on betaبيتا معامل على مالحظات

If beta = 1.0, the security is just as risky as the average stock.

If beta > 1.0, the security is riskier than average. If beta < 1.0, the security is less risky than

average. Most stocks have betas in the range of 0.5 to 1.5.

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Can the beta of a security be negative?سالبا يكون قد بيتا معامل

Yes, if the correlation between Stock i and the market is negative (i.e., ρi,m < 0).

If the correlation is negative, the regression line would slope downward, and the beta would be negative.

However, a negative beta is highly unlikely.

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Beta coefficientsبيتا معامل مقارنة

ki

_

kM

_

-20 0 20 40

40

20

-20

Firm X: β = 1.30

T-bills: β = 0

Firm Y: β = -0.87

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The Security Market Line (SML):السوق خط

SML: ki = kRF + (kM – kRF) βi

Assume kRF = 8% and kM = 15%.

The market (or equity) risk premium is RPM

= kM – kRF = 15% – 8% = 7%.

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What is the market risk premium?السوق مخاطر عالوة هي ما

Additional return over the risk-free rate needed to compensate investors for assuming an average amount of risk.

Its size depends on the perceived risk of the stock market and investors’ degree of risk aversion.

Varies from year to year, but most estimates suggest that it ranges between 4% and 8% per year.

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Time Value of Moneyللنقود الزمنية القيمة

Future value Present value Annuities Rates of return

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Time linesانت؟ – اين الزمن خط

Show the timing of cash flows. Tick marks occur at the end of periods, so Time

0 is today; Time 1 is the end of the first period (year, month, etc.) or the beginning of the second period.

CF0 CF1 CF3CF2

0 1 2 3

i%

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Time linesمثال – الزمن خط

100 100100

0 1 2 3i%

3 year $100 ordinary annuity

100

0 1 2

i%

$100 lump sum due in 2 years

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Time linesمثال – الزمن خط

100 50 75

0 1 2 3

i%

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Uneven cash flow stream

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Future value (FV)المستقبلية القيمة

Finding the FV of a cash flow or series of cash flows when compound interest is applied is called compounding.

FV can be solved by using the arithmetic, financial calculator, and spreadsheet methods.

FV = ?

0 1 2 3

10%

100

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Future value (FV)المستقبلية القيمة

After 1 year: FV1 = PV ( 1 + i ) = $100 (1.10)

= $110.00 After 2 years:

FV2 = PV ( 1 + i )2 = $100 (1.10)2

=$121.00 After 3 years:

FV3 = PV ( 1 + i )3 = $100 (1.10)3

=$133.10 After n years (general case):

FVn = PV ( 1 + i )n

1-72PV = ? 100

Present value (PV)الحالية القيمة

Finding the PV of a cash flow or series of cash flows when compound interest is applied is called discounting (the reverse of compounding).

The PV shows the value of cash flows in terms of today’s purchasing power.

0 1 2 3

10%

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Present value (PV)الحالية القيمة

Solve the general FV equation for PV: PV = FVn / ( 1 + i )n

PV = FV3 / ( 1 + i )3

= $100 / ( 1.10 )3

= $75.13

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Ordinary annuity and an annuity dueوآخرها الفترة اول المنتظمة الدفعات

Ordinary Annuity

PMT PMTPMT

0 1 2 3i%

PMT PMT

0 1 2 3i%

PMT

Annuity Due

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PV of uneven cash flow stream?منتظمة غير لدفعات الحالية القيمة

0

100

1

300

2

300

310%

-50

4

90.91247.93225.39 -34.15530.08 = PV

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Bonds and Their Valuationوتسعيرها السندات

Key features of bonds Bond valuation Measuring yield Assessing risk

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What is a bond?السند؟ هو ما

A long-term debt instrument in which a borrower agrees to make payments of principal and interest, on specific dates, to the holders of the bond.

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What is a bond?السند؟ هو ما

Par value – face amount of the bond, which is paid at maturity (assume $1,000).

Coupon interest rate – stated interest rate (generally fixed) paid by the issuer. Multiply by par to get dollar payment of interest.

Maturity date – years until the bond must be repaid. Issue date – when the bond was issued. Yield to maturity - rate of return earned on

a bond held until maturity (also called the “promised yield”).

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The value of financial assets ( المالية ( االصول سعر قيمة

nn

22

11

k)(1CF

... k)(1

CF

k)(1CF

Value

0 1 2 nk

CF1 CFnCF2Value

...

1-80

What is the opportunity cost of debt capital?السندات تكلفة حساب

The discount rate (ki ) is the opportunity cost of capital, and is the rate that could be earned on alternative investments of equal risk.

ki = k* + IP + MRP + DRP + LP

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Bond valuation – an exampleمثال - السندات تسعير

$1,000 V$385.54 $38.55 ... $90.91 V

(1.10)$1,000

(1.10)$100

... (1.10)$100

V

B

B

10101B

0 1 2 nk

100 100 + 1,000100VB = ?

...

1-82

What is the YTM on a bond?سند على المطلوب العائد حساب

Must find the kd that solves this model.

10d

10d

1d

Nd

Nd

1d

B

)k(11,000

)k(1

90 ...

)k(190

$887

)k(1M

)k(1

INT ...

)k(1INT

V

1-83

Definitionsتعريفات

CGY

Expected

CY

Expected YTM return total Expected

price Beginningprice in Change

(CGY) yieldgains Capital

priceCurrent payment coupon Annual

(CY) eldCurrent yi

1-84

An example: Current and capital gains yieldمثال - سند على العائد حساب

Find the current yield and the capital gains yield for a 10-year, 9% annual coupon bond that sells for $887, and has a face value of $1,000.

Current yield = $90 / $887

= 0.1015 = 10.15%

1-85

An example: Current and capital gains yieldمثال - سند على العائد حساب

YTM = Current yield + Capital gains yield

CGY = YTM – CY

= 10.91% - 10.15%

= 0.76%

Could also find the expected price one year from now and divide the change in price by the beginning price, which gives the same answer.

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Evaluating default risk: Bond ratingsخطورتها حسب السندات تصنيف

Bond ratings are designed to reflect the probability of a bond issue going into default.

Investment Grade Junk Bonds

Moody’s

Aaa Aa A Baa Ba B Caa C

S & P AAA AA A BBB BB B CCC D

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Factors affecting default risk and bond ratingsالسندات خطورة على تؤثر التي العوامل

Financial performance Debt ratio TIE ratio Current ratio

Bond contract provisions Secured vs. Unsecured debt Senior vs. subordinated debt Guarantee and sinking fund provisions Debt maturity

1-88

Factors affecting default risk and bond ratingsالسندات خطورة على تؤثر التي العوامل

Earnings stability Regulatory environment Potential antitrust or product liabilities Pension liabilities Potential labor problems Accounting policies

1-89

Priority of claims in liquidationالتصفية عند االولوية له من

1. Secured creditors from sales of secured assets.

2. Trustee’s costs3. Wages, subject to limits4. Taxes5. Unfunded pension liabilities6. Unsecured creditors7. Preferred stock8. Common stock

1-90

The Cost of Capitalالمال رأس تكلفة

Sources of capital Component costs WACC Adjusting for flotation costs Adjusting for risk

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Sources of capitalالمال رأس مصادر

Long-Term CapitalLong-Term Capital

Long-Term DebtLong-Term Debt Preferred StockPreferred Stock Common StockCommon Stock

Retained EarningsRetained Earnings New Common StockNew Common Stock

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Calculating the weighted average cost of capitalالمال لرأس المرجح المعدل حساب

WACC = wdkd(1-T) + wpkp + wcks

The w’s refer to the firm’s capital structure weights.

The k’s refer to the cost of each component.

1-93

Should our analysis focus on before-tax or after-tax capital costs?

وليس الضريبة بعد المال رأس تكلفة تحسبقبلها

Stockholders focus on A-T CFs. Therefore, we should focus on A-T capital costs, i.e. use A-T costs of capital in WACC. Only kd needs adjustment, because interest is tax deductible.

1-94

Should our analysis focus on historical (embedded) costs or new (marginal) costs?

الجديدة ( االموال على أي حديا المال رأس تكلفة تحسب( القديمة وليس

The cost of capital is used primarily to make decisions that involve raising new capital. So, focus on today’s marginal costs (for WACC).

1-95

How are the weights determined?االوزان حساب


Use accounting numbers or market value (book vs. market weights)?

Use actual numbers or target capital structure?

1-96

Component cost of debtالدين تكلفة حساب


kd is the marginal cost of debt capital. The yield to maturity on outstanding L-T

debt is often used as a measure of kd.

Why tax-adjust, i.e. why kd(1-T)?

1-97

Component cost of debtالدين تكلفة حساب

Interest is tax deductible, so

A-T kd = B-T kd (1-T)

= 10% (1 - 0.40) = 6% Use nominal rate. Flotation costs are small, so ignore them.

1-98

Component cost of preferred stockالممتازة االسهم تكلفة حساب


kp is the marginal cost of preferred stock. The rate of return investors require on the

firm’s preferred stock.

1-99


The cost of preferred stock can be solved by using this formula:

kp = Dp / Pp

= $10 / $111.10

= 9%

1-100


Preferred dividends are not tax-deductible, so no tax adjustments necessary. Just use kp.

Nominal kp is used. Our calculation ignores possible flotation

costs.

1-101

Preferred stock riskالممتازة االسهم خطورة

More risky; company not required to pay preferred dividend.

However, firms try to pay preferred dividend. Otherwise, (1) cannot pay common dividend, (2) difficult to raise additional funds, (3) preferred stockholders may gain control of firm.

1-102

Component cost of equityالعادية االسهم تكلفة حساب


ks is the marginal cost of common equity using retained earnings.

The rate of return investors require on the firm’s common equity using new equity is ke.

1-103

Why is there a cost for retained earnings?المحجوزة االرباح تكلفة حساب

Earnings can be reinvested or paid out as dividends.

Investors could buy other securities, earn a return. If earnings are retained, there is an opportunity

cost (the return that stockholders could earn on alternative investments of equal risk). Investors could buy similar stocks and earn ks. Firm could repurchase its own stock and earn ks. Therefore, ks is the cost of retained earnings.

1-104


CAPM: ks = kRF + (kM – kRF) β

DCF:ks = D1 / P0 + g

Own-Bond-Yield-Plus-Risk Premium:

ks = kd + RP

1-105

Component cost of equityمثال - العادية االسهم تكلفة حساب

If the kRF = 7%, RPM = 6%, and the firm’s beta is 1.2, what’s the cost of common equity based upon the CAPM?

ks = kRF + (kM – kRF) β

= 7.0% + (6.0%)1.2 = 14.2%

1-106

Component cost of equityالعادية - االسهم تكلفة حساب

مثالIf D0 = $4.19, P0 = $50, and g = 5%, what’s the cost of common equity

based upon the DCF approach?

D1 = D0 (1+g)

D1 = $4.19 (1 + .05)

D1 = $4.3995

ks = D1 / P0 + g = $4.3995 / $50 + 0.05= 13.8%

1-107

What is the expected future growth rate?النمو معدل حساب

The firm has been earning 15% on equity (ROE = 15%) and retaining 35% of its earnings (dividend payout = 65%). This situation is expected to continue.

g = ( 1 – Payout ) (ROE)= (0.35) (15%)= 5.25%

Very close to the g that was given before.

1-108


مثال If kd = 10% and RP = 4%, what is ks using the own-bond-

yield-plus-risk-premium method?

This RP is not the same as the CAPM RPM. This method produces a ballpark estimate

of ks, and can serve as a useful check.

ks = kd + RP

ks = 10.0% + 4.0% = 14.0%

1-109


مثال

Method Estimate

CAPM 14.2%

DCF 13.8%

kd + RP 14.0%

Average 14.0%

1-110


Why is the cost of retained earnings cheaper than the cost of issuing new common stock?

When a company issues new common stock they also have to pay flotation costs to the underwriter.

Issuing new common stock may send a negative signal to the capital markets, which may depress the stock price.

1-111

Component cost of equityمثال - العادية االسهم تكلفة حساب

15.4%

5.0% $42.50

$4.3995

5.0% 0.15)-$50(1

)$4.19(1.05

g F)-(1P

g)(1D k

0

0e

If issuing new common stock incurs a flotation cost of 15% of the proceeds, what is ke?

1-112

Flotation costsاالصدار تكاليف

Flotation costs depend on the risk of the firm and the type of capital being raised.

The flotation costs are highest for common equity. However, since most firms issue equity infrequently, the per-project cost is fairly small.

We will frequently ignore flotation costs when calculating the WACC.

1-113

Ignoring floatation costs, what is the firm’s WACC?

االصدار تكاليف بدون المال رأس تكلفة


= 0.3(10%)(0.6) + 0.1(9%) + 0.6(14%)

= 1.8% + 0.9% + 8.4%

= 11.1%

1-114

The Hamada Equationحمادة العالم معادلة

βL = βU[ 1 + (1 - T) (D/E)]

Suppose, the risk-free rate is 6%, as is the market risk premium. The unlevered beta of the firm is 1.0. If the total assets are $2,000,000.

1-115

The Hamada Equationمثال - حمادة العالم معادلة

If D = $250,

βL = 1.0 [ 1 + (0.6)($250/$1,750) ]

βL = 1.0857

ks = kRF + (kM – kRF) βL

ks = 6.0% + (6.0%) 1.0857

ks = 12.51%

1-116

Calculating levered betas and costs of equityبيتا معامل على المالي الرفع استخدام عالقة

االسهم وتكلفة

Amount borrowed

$ 0

250

500

750

1,000

D/A ratio

0.00%

12.50

25.00

37.50

50.00

Levered Beta

1.00

1.09

1.20

1.36

1.60

D/E ratio

0.00%

14.29

33.33

60.00

100.00

ks

12.00%

12.51

13.20

14.16

15.60

1-117

Determining the minimum WACC المال لرأس تكلفة أقل تحديد

D/A ratio

0.00%

12.50

25.00

37.50

50.00

WACC

12.00%

11.55

11.25

11.44

12.00

E/A ratio

100.00%

87.50

75.00

62.50

50.00

ks

12.00%

12.51

13.20

14.16

15.60

kd (1 – T)

0.00%

4.80

5.40

6.90

8.40

Amount borrowed

$ 0

250

500

750

1,000

* Amount borrowed expressed in terms of thousands of dollars

1-118

Determining the stock price maximizing capital structure

اعلى ينتج الذي المال رأس هيكل تحديدللسهم سعر

AmountBorrowed DPS ks P0

$ 0 $3.00 12.00% $25.00

250,000 3.26 12.51

500,000 3.55 13.20

26.03

26.89

750,000 3.77 14.16 26.59

1,000,000 3.90 15.60 25.00

1-119

Financial Planning and Forecastingاساسيات – المالي والتخطيط التنبؤ

التسعير

Forecasting sales Projecting the assets and internally

generated funds Projecting outside funds needed Deciding how to raise funds

1-120

Comprehensive exampleالتنبؤ مثال في

Cash & sec. $ 20 Accts. pay. & accruals $ 100

Accounts rec. 240 Notes payable 100Inventories 240 Total CL $ 200

Total CA $ 500 L-T debt 100Common stock 500

Net fixed Retained assets 500 earnings 200

Total assets $1,000 Total claims $1,000

Balance sheet (2002), in millions of dollars

1-121

Comprehensive exampleالتنبؤ في مثال

Sales $2,000.00Less: Var. costs (60%) 1,200.00

Fixed costs 700.00EBIT $ 100.00

Interest 16.00EBT $ 84.00

Taxes (40%) 33.60Net income $ 50.40

Dividends (30%) $15.12Add’n to RE $35.28

Income statement (2002), in millions of dollars

1-122

Key assumptionsمعطيات

Operating at full capacity in 2002. Each type of asset grows proportionally with sales. Payables and accruals grow proportionally with

sales. 2002 profit margin (2.52%) and payout (30%) will

be maintained. Sales are expected to increase by $500 million.

(%DS = 25%)

1-123

Determining additional funds needed AFNاضافي تمويل الى الحاجة حساب

AFN = (A*/S0)ΔS – (L*/S0) ΔS – M(S1)(RR)

= ($1,000/$2,000)($500)

– ($100/$2,000)($500)

– 0.0252($2,500)(0.7)

= $180.9 million.

1-124

How shall AFN be raised?االضافية االموال على الحصول كيفية

The payout ratio will remain at 30 percent (d = 30%; RR = 70%).

No new common stock will be issued. Any external funds needed will be raised as

debt, 50% notes payable and 50% L-T debt.

1-125

Forecasted Income Statement (2003)الدخل بقائمة التنبؤ

Sales $2,000 1.25 $2,500Less: VC 1,200 0.60 1,500

FC 700 0.35 875 EBIT $ 100 $ 125Interest 16 16 EBT $ 84 $ 109Taxes (40%) 34 44Net income $ 50 $ 65

Div. (30%) $15 $19Add’n to RE $35 $46

ForecastBasis

2003Forecast2002

1-126

20031st Pass

Forecasted Balance Sheet (2003) - Assetsالمالي المركز بقائمة االصول - التنبؤ

2002Forecast

Basis

Cash $ 20 0.01 $ 25Accts. rec. 240 0.12 300Inventories 240 0.12 300 Total CA $ 500 $ 625Net FA 500 0.25 625 Total assets $1,000 $1,250

1-127

20031st Pass2002

ForecastBasis

Forecasted Balance Sheet (2003) - Liabilities and Equity

وحقوق – الخصوم المالي المركز بقائمة التنبؤالملكية

AP/accruals $ 100 0.05 $ 125Notes payable 100 100 Total CL $ 200 $ 225L-T debt 100 100Common stk. 500 500Ret.earnings 200 +46* 246 Total claims $1,000 $1,071

* From income statement.

1-128

What is the additional financing needed (AFN)?

اضافي تمويل الى الحاجة حساب

Required increase in assets = $ 250 Spontaneous increase in liab. = $ 25 Increase in retained earnings = $ 46 Total AFN = $ 179

NWC must have the assets to generate forecasted sales. The balance sheet must balance, so we must raise $179 million externally.

1-129

How will the AFN be financed?االضافي التمويل تحديد كيفية

Additional N/P 0.5 ($179) = $89.50

Additional L-T debt 0.5 ($179) = $89.50

But this financing will add to interest expense, which will lower NI and retained earnings. We will generally ignore financing feedbacks.

1-130

20032nd Pass

20031st Pass AFN

Forecasted Balance Sheet (2003) - Assetsالمالي المركز بقائمة حساب - التنبؤ بعد االصول

االضافي التمويل

Cash $ 25 - $ 25Accts. rec. 300 - 300Inventories 300 - 300 Total CA $ 625 $ 625Net FA 625 - 625 Total assets $1,250 $1,250

1-131

20032nd Pass

20031st Pass AFN

Forecasted Balance Sheet (2003) - Liabilities and Equityحساب – بعد الملكية وحقوق الخصوم المالي المركز بقائمة التنبؤ

االضافي التمويل

AP/accruals $ 125 - $ 125Notes payable 100 +89.5 190 Total CL $ 225 $ 315L-T debt 100 +89.5 189Common stk. 500 - 500Ret.earnings 246 - 246 Total claims $1,071 $1,250

1-132

Why do the AFN equation and financial statement method have different results?

Equation method assumes a constant profit margin, a constant dividend payout, and a constant capital structure.

Financial statement method is more flexible. More important, it allows different items to grow at different rates.

1-1 Corporate Valuation: A Guide for Brokers, Managers and Investors Dr. Mounther Barakat Al Omari...

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