AHBETE

[miniMBA_04] Financial Management

Valuation Methods

One of most important roles of financial intermediaries (banks, investment banks, and private equity) is to allocate capital

…between those who have money to lend

• individual investors
• retail investors
• institutional investors and
• university foundations

…and those who need money

• entrepreneurs who are trying to start a business
• corporations who are trying to expand existing business

2 Questions to Efficiently Allocate Capital

1. “What is the value of the business?”
2. “What’s the riskiness of the firm?”

4 Valuation Methods

1. Discounted Cash Flow Analysis (DCF) - This is the most theoretically correct model whereby the company’s worth equals the current value of future cash flow it will generate.
2. Comparable Firm Analysis (Comps) - This is the most commonly used and easiest to perform model. It has two elements, including multiple (standardized measure of price) and comparable firms/assets, and can also be used to value non-cashflow-generating assets.
3. Precedent Transaction Analysis (M&A Comps) - This model is similar to the Comparable Firm Analysis but with the addition of a control premium. If the buyer acquires a majority stake, they assume control, providing more flexibility options to create value; therefore, when control is transferred, a control premium is typically paid.
4. Leveraged Buyout Analysis (LBO) - Leveraging is an investment strategy of using borrowed money to increase the potential return of an investment. This is because the cost of debt is cheaper than the cost of equity.

Capital Budgeting

• Capital budgeting is the process of analyzing investment decisions faced by firms to determine if an investment is a good idea.
• Cash flow is a key concern in capital budgeting, rather than accounting statements.

Reasons for Discounting Cash Flows

• Consumption today is generally preferred over consumption in the future.
• The purchasing power of a dollar generally declines as time progresses and the price level in the economy rises.
• Uncertainty about the likelihood of your investment being repaid in the future represents risk.

Making Investment Decisions

The Net Present Value (NPV) is the main value used to decide if an investment is good or bad. Net Present Value is equal to the present value (future cash flows) minus the required investment. It is important to note that investments can take many forms.

Types of Investments

• Research and Development (R&D) - wages, expense of research facilities, etc.
• Capital Assets - factories, machinery, etc.
• Purchasing and Inventory

Capital Budgeting Pitfalls

• Optimism - accuracy is key in an analysis and too much optimism can ruin your analysis
• Sunk Costs - continuing to invest in a project based on the past costs in an effort to make the past investment work out
• Risk of a Project - properly identifying the risk in order to apply the appropriate discount rate
• Negative NVP Projects - distressed firms invest in negative NVP projects on the unlikely event one aspect of the project can save the rest of the firm.

Investment Risk and Return

Expected and unexpected returns

• The expected component of returns is the forecasted component.
• The unexpected component of returns is the surprise which can be either positive (good news) or negative (bad news).
• Announcements and news are not the same thing. Announcements are only news if they tell you something new. A good announcement that also contains an unexpected component can still negatively affect your stock prices.

Systematic and unsystematic risk

• Systematic risk is a risk that affects a very large number of securities. Also called market risk or non-diversifiable risk.
• Unsystematic risk is a risk that affects only a limited number of securities. It is independent risk. Other names include unique risk firm, specific risk, idiosyncratic risk, or diversifiable risk.

Diversification

• A diversified portfolio is invested in several different sectors or asset classes, not just holding a lot of assets.
• Diversification can substantially reduce the variability of returns without an equivalent reduction in expected returns.
• Risk is higher when diversification is lower. Overall, as you add more and more assets into your portfolio, risk is reduced but not eliminated.
• Total risk is a sum of systematic risk and unsystematic risk. The unsystematic risk can be eliminated. The systematic risk will not be eliminated. The standard deviation of returns is a measure of total risk.