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8/11/2019 FM Studyguide
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EBITDA = Gross Profit
EBIT = Operating Income
Earnings after Taxes/Interest = Net Income
Strengths and Weaknesses of Evaluation Techniques
An evaluation techniue shoul! consi!er"A# All future incremental pro$ect cash flo%s
"B# The time value of mone&
"'# (ncertaint& associate! %ith future cash flo%s
Pa&)ac* Perio! + + +
,trengths
Eas& to use(seful if firm is short on cash
(seful in high ris* situations %here either assets rapi!l& )ecome o)solete
or in!ustr& is ver& competitive
-ea*nessesEmphasi.es liui!it& over profita)ilit&
Ignores cash flo%s occurring after the pa&)ac* perio!Ignores ris* associate! %ith cash flo%s "Discounte! Pa&)ac*#
Net Present alue "A# "B# "'#,trengths
NPs are a!!itive "sum of NP of in!ivi!ual pro$ects = NP of 0irm#
Assumes cash flo%s are reinveste! at the hur!le rate
-ea*nessesNot expresse! as a percentage "Profita)ilit& In!ex#
Doesn1t consi!er the scale of pro$ects Doesn1t consi!er the life of the pro$ect
Internal 2ate of 2eturn "A# "B# "'#
,trengthsIn!icates %hether an investment increases a firm1s value
-ea*nesses
Assumes cash flo%s are re+investe! at I22
3ultiple I22s ma& exist if there are positive an! negative cash flo%s3a& not give value maximi.ing !ecision if comparing mutuall& exclusive
pro$ects or %hen un!er capital rationing4
3o!ifie! I22 "3o!if& reinvestment rate#
'ompoun! for%ar! all cash inflowsat the reinvestment rate
Discount )ac* all cash outflowsat the opportunit& cost of capital,olve for rate that euali.es 0 of cash inflo%s %ith P of cash outflo%s4
3I22 = 5 " 0 of Inflo%s# / "P of Outflo%s# 6 7 "8/9ol!ing Perio!# : 8
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Intuition; Operating lease pa&ments are treate! as an or!inar& operating
expense even though it is a financing cost analogous to interest< so %e a!!
it )ac*4
,tep ; Estimating the Terminal alue
,alvage alue : Boo* alue = Taxa)le Gain,alvage alue : Taxes@Taxa)le Gain = After+tax Terminal alue
,tep C; Estimating the Incremental 0'00'ash flo% availa)le to all investors in the firm< after pa&ing taxes an! meeting
an& net investment nee!sJ it is pre+!e)t< )ut after+tax4
Operating 'ash 0lo%
+ Net -or*ing 'apital "An increase = 'ash Outflo%#+ 'apital Expen!itures
After+tax 0'00
Net -or*ing 'apital = 'urrent assets : 'urrent lia)ilities
2euire! to cover expenses that arise< initial inventories< etc4Exclu!e !e)t< excess cash
T&picall& all recovere! at en! of pro$ect life
'apital Expen!itures = Net initial investmentTreate! as 'apital outla&s< not expenses
'apitali.e!< an! !epreciate! over time4
5'hange in N-' ? 'apital Expen!itures6 = Net Investment nee!e! to generateO'0
0'00 = EBIT +or+ 0'0E
?Depreciation ?Interest Expense@"8+#+'apital Expen!itures ?Principal 2epa&ments
+-or*ing 'apital +Ne% De)t Issues?Preferre! Divi!en!s
Types of Cash Flows to the Fir
3aximi.e value to the firm< not value to the euit& hol!ers
EBITDA %hen 'apEx = H< -' = -' = H
Discount 2ate Before Tax -A''EBIT@"8+# %hen 'apEx = H
Discount 2ate After Tax -A''
Net Income@"8+# %hen 'apEx=DepreciationNon+Operating !on1t recur
Discount 2ate After Tax -A''
0'00 %hen 'apEx?-' = Expenses for Gro%thDiscount 2ate After Tax -A''
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EA"Econ Profit# %hen 0inance 'osts are treate! as Expenses
Discount 2ate After Tax -A''
Types of Cash Flows to Equity
Divi!en!s "DP,# %hen DP, = 0'0E< 0'0E har! to estimate",toc* repurchases are treate! as !ivi!en!s#
Discount rate 'ost of Euit&
Earnings %hen DP, = EP,< or 2OE = 'ost of Euit&Discount rate 'ost of Euit&
0'0E %hen DP, K 0'0E< DP, L MH0'0E< DP,
(navaila)le
Discount rate 'ost of Euit&
(se Euit& aluation;
0or firms %ith sta)le leverage
If euit& is )eing value!(se 0irm aluation;
0or firms %ith too high/lo% leverage an! expect to change over time40or firms having onl& partial information on !e)t
If valuing the firm rather than the euit&
(se Nominal 0lo%s;If inflation is lo% "Taxes are )ase! on nominal income#
If using nominal !iscount rate
(se 2eal 0lo%s
If using real !iscount rate
0'0E ; Operating 'ash 0lo% : 'ash Expenses Nee!e! for Gro%th
Pure Euit& 0irm0'0E = Net Income
?Depreciation
+'apital Expen!itures
+-'
evere! 0irm "De)t< Euit&< preferre! Euit
0'0E= Net Income?Depreciation
+Principal 2epa&ment of De)t
+Preferre! Divi!en!s?Procee!s from Ne% De)t Preferre! offerings
+'apital Expen!itures
+-'
,ta)le everage "0inancing !one at a fixe! !e)t ratio " De)t / 5De)t?Euit&6 #0'0E= Net Income
+"8+#@"'apital Expen!itures : Depreciation#
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+"8+#@-or*ing 'apital"see page 130)
Impact of Inflation
Nominal 'ash 0lo%s an! Nominal Discount 2ate
Incorporate expecte! inflation into future cash flo% estimates an! the!iscount rate
+or+
2eal 'ash 0lo%s an! 2eal Discount 2ateEstimate cash flo%s in real !ollars an! !iscount at a real !iscount rate
2eal 'ash 0lo%t= Nominal 'ash 0lo%t/ 5 8 ? Expecte! Inflation 2ate#t
8 ? 2eal Discount 2ate = 58 ? Nominal 2ate6 / 58 ? Expecte! Inflation 2ate6(see pages 113, 137: Inflation affects sales, cost savings, WC)
Project Analysis and Evaluation! Addressing "isk "page 8>#
2is*; 9o% much uncertaint& exists< the !egree of uncertaint&Drivers of (ncertaint&
Economic 'on!itions 3ar*et 'on!itionsTaxes Interest 2ates "cost of raising future capital#
International 'on!itions
2euire! 2ate of 2eturn = 'ompensation for Time ? 'ompensation for 2is*
(see page 150, standard deviation)
'oefficient of ariation = ,tan!ar! Deviation / Expecte! alue
(nit of 2is* per (nit of alue
3easuring a Pro$ect1s 3ar*et 2is*8# Pro$ect 2is* = 3ar*et 2is*-hen the firm is in one line of )usiness
-hen the firm ta*es on similar pro$ects
A!vantage; Doesn1t reuire ris* estimation for each pro$ectimitation; 3a& not appl& to firms in multiple lines of )usiness
# Pure Pla& Approach
-hen there are pu)licl& tra!e! firms in the same line of )usiness3etho!; I!entif& )usiness of each !ivision or pro$ect
I!entif& pu)lic firms involve! primaril& in the )usiness
O)tain mar*et ris* parameters for these compara)les'orrect mar*et ris* for financial leverage
Estimate cost of euit& for the !ivision or pro$ect
B = B(@ " 8?"8+#@D/E #(se mar*et values of De)t/Euit&
># Accounting Betas< 2egress earnings
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Pitfalls; ,moothe! )etas< non+operating factors< EP, is once uarterl&
2egress EP, of mar*et %ith EP, of ,PCHHTreat ,lope as )eta
# Beta from 'ross+sectional regressions
' in Operating IncomeDe)t/Euit& 2atio
Earning Gro%th
Total Assets
2egress !ata %ith compara)les4
'ommon errors0ailure to consi!er ris*
Dou)le counting the same ris* using more than one ris* a!$ustment
Appl&ing an incorrect ris* profile
'onsi!ering !iversifia)leF ris* in anal&sis
#ncorporating Project "isk
2is* A!$uste! 2ates
alue = 52is*& 'ash 0lo%st/ "8 ? 2is* A!$uste! 2ate#t6
2is* A!$uste! 2ate = 2f? "2m+ 2f#3etho!; Discount 'ash 0lo%s using 2is* A!$uste! 2ate
,um for NP
'ertaint& euivalents
alue = 5'ertaint& Euivalent 'ash 0lo%st/ " 8?2f #6
'E 'ash 0lo%t= 2is*& 'ash 0lo%t 5 "8?2f# / "8?2is* A!$uste! 2ate # 6t= "8?rf#t/ "8?*e#t
3etho!; Discount 'ash flo%s using 2is* A!$uste! 2ate
+an!+3o!if& "multipl )& 2is* 0ree 2ate
2esulting 'ash 0lo%s are 'ertaint& Euivalents
Discount 'E 'ash 0lo%s using 2is* 0ree 2ate,um for NP
ualitative AssessmentPorter1s 0ive 0orces
Threat of Ne% Entrants< Threat of ,u)stitutes