10/5/2013

Financial i i l Management (Part 3 - Valuation) by Dr.Sahanon Tungbenchasirikul

Financial Management by Dr. Sahanon Tungbenchasirikul ©

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Copyrights With regard to Copyright Act B.E. 2537 (1994): • All elements in the presentation (i.e., words, clauses, sentences, pictures, symbols, tables, and trademarks) are obtained from textbooks, academic journals, websites, and other sources of knowledge. These have been claimed to have copyrights. • The presentation is solely used for academic, academic not for any commercial, purposes.

Financial Management by Dr. Sahanon Tungbenchasirikul ©

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Part 3 - Valuation • Risk and Return • Time Value of Money • Cost of Capital or Required Rate of Return • Asset Price Valuation

Financial Management by Dr. Sahanon Tungbenchasirikul ©

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Risk and Return

by Dr.Sahanon Tungbenchasirikul

Financial Management by Dr. Sahanon Tungbenchasirikul ©

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10/5/2013

Risk and Return

At the heart of risk-return proposition “The higher g the expected p cash flows of a venture project, the greater the risk. The greater the risk, the higher the required rate of return. To maximize the value of the company’s stock, financial managers must balance risk and return in order to find the highest present value of cash flows.”

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Risk and Return All financial assets are expected to produce cash flows, and the risk of an asset is judged in terms of the risk of its cash flows. The risk of an asset can be considered in two ways: • A stand-alone basis, where the asset’s cash flows are analyzed by themselves. • A portfolio context, where the cash flow from a set of assets t are combined bi d and d then th the th consolidated lid t d cash h flow fl are analyzed. • An asset that has a great deal of risk if held by itself may be much less risky if it is held as part of a larger portfolio. Financial Management by Dr. Sahanon Tungbenchasirikul ©

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Risk and Return: Investment Returns Investment Returns: 1.

Money Return. The money return is simply the total money received from the investment less the amount invested:

2.

•

Money Return = amount received – amount invested

•

$1,000 = $2,500 - $1,500

Rate of Return. We can express investment results as rate of return or percentage returns. For example, the rate of return on the 1 year retail shop investment: •

Rate of Return = [amount received – amount invested]/amount invested x 100%

•

Rate of Return = [2,500 – 1,500]/1,500 x 100%

•

Rate of Return = 1,000/1,500 x 100% = 66.67% 7

Financial Management by Dr. Sahanon Tungbenchasirikul ©

Risk and Return: Stand-Alone Risk •

An asset’s stand-alone risk is the risk an investor would face if he/she held only one asset.

•

If the expected rate of return is high enough to compensate the investor for the p perceived risk of investment,, investment should be undertaken.

•

We can calculate expected rate of return of an asset by adopting the following formula:

N

k Pi k i P1 k1 P2 k 2 .... Pn k n

(1)

i 1

k Expected rate of return Pi Pr obability of event i k i Rate of return , if event i takes place. Financial Management by Dr. Sahanon Tungbenchasirikul ©

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Stand Alone Asset: Expected Rate of Return Economic Situation (1)

Probability (2)

Rate of Return (3)

Expected Yield (2) X (3)

Good

0.3

12%

3.6%

Medium

0.4

8%

3.2%

Bad

0.3

4%

1.2%

By adopting formula --------------------- (1):

N

k Pi k i P1 k1 P2 k 2 .... Pn k n

(1)

i 1

Expected rate of return equals 8%

N

k Pi k i 0.3 x 12% 0.4 x 8% 0.3 x 4% i 1

k 3.6% 3.2% 1.2% 8% 9

Financial Management by Dr. Sahanon Tungbenchasirikul ©

Calculating the Risk of A Stand-Alone Asset Step 1: reckon the deviation of a stand-alone asset: Economic Situation (1)

Probability (2)

Rate of Return (3)

Expected Rate of Return (4)

Deviation (3) – (4)

Good

0.3

12%

8%

+ 4%

Medium

0.4

8%

8%

0%

Bad

0.3

4%

8%

- 4%

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Calculating the Risk of A Stand-Alone Asset Step 2: calculate the standard deviation of a stand alone asset:

S tan dard Deviation (ki k ) 2 Pi (2) S tan dard Deviation (12% 8%) 2 (0.3) (8% 8%) 2 (0.4) (4% 8%) 2 (0.3) S tan dard Deviation (4%) 2 (0.3) ( 4%) 2 (0.3) S tan dard Deviation [(4%) 2 ( 4%) 2 ] (0.3) S tan dard Deviation [0.16% 0.16%] (0.3) S tan dard Deviation 0.096% S tan dard Deviation 0.0396 or 3.096%

Standard Deviation around 3.1% Financial Management by Dr. Sahanon Tungbenchasirikul ©

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Calculating the Risk of A Stand-Alone Asset Step 3: calculate the coefficient variation of a stand alone asset:

Coefficient of Variation (CV )

(3) k 3.1% Coefficient of Variation (CV ) 8% Coefficient of Variation (CV ) 0.3875 0.4 The coefficient of variation shows the risk per unit of return. In this example the Coefficient of Variation (CV) around 0.4. example, 04

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Risk in a Portfolio Context Most financial assets are actually held as part of a portfolio. Banks, insurance companies, mutual funds, and other financial institutes are required by law to hold diversified portfolios.

Portfolio Returns The expected return on a portfolio is simply the weighted average of the expected returns on the individual assets in the portfolio as follows:

N

k p w i k i w1 k1 w 2 k 2 .... w n k n (4) i 1

k p The weighted average of the exp ected rate of return on a portfolio w i The proportion of asset i in the portfolio

k i The exp ected return on the individual stock 13

Financial Management by Dr. Sahanon Tungbenchasirikul ©

An Example of Portfolio Return Financial Asset (1)

Weight (2)

Expected Return (3)

Microsoft Share

0.25

12.0%

GE Share

0.25

11.5%

Pfizer Share

0.25

10.0%

Coca-Cola Share

0.25

9.5%

N

k p w i k i w1 k1 w 2 k 2 .... w n k n (4) i 1

k p 0.25 (12%) 0.25(11.5%) 0.25(10%) 0.25(9.5%)

k p 3% 2.875% 2.5% 2.375%

k p 10.75% Financial Management by Dr. Sahanon Tungbenchasirikul ©

The expected rate of return on a portfolio. 14

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Portfolio Risk & Diversification • A portfolio is a combination of several financial assets. Investors will diversify their asset investments to minimize portfolio risk as much as possible. • The tendency of the expected return of 2 financial assets to move together is called “Correlation”. Correlation coefficient (r) can measure this tendency: - The value of correlation coefficient must be in the range -1 ≤ r ≤ 1. - If r of 2 assets equals - 1, the portfolio shows a perfectly negative correlation. Risk is perfectly diversified. - If r of 2 assets equals 1, the portfolio shows a perfectly positive correlation. Such portfolio will be as risky as individual asset investment.

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Financial Management by Dr. Sahanon Tungbenchasirikul ©

Example of Portfolio Risk & Diversification 2 Financial Asset s

Correlation Coefficient (r)

Microsoft & GE

-0 12 -0.12

Microsoft & Pfizer

0.50

Microsoft & Coca-Cola

0.54

GE & Pfizer

-0.12

GE & Coca G Coca-Cola Co a

-0.15 0 5

Pfizer & Coca-Cola

0.72

Financial Management by Dr. Sahanon Tungbenchasirikul ©

Low negative correlation (low diversification). The high positive correlation (risky investment).

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Time Value of Money

by Dr.Sahanon Tungbenchasirikul

Financial Management by Dr. Sahanon Tungbenchasirikul ÂŠ

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Time Value of Money The principle of time value analysis have many applications, ranging from setting up schedules for paying off loans to decisions about whether to acquire new equipment.

In fact, of all the concepts used in finance, none is more important than the time value of money, which is also called discount cash flow (DCF) analysis.

Financial Management by Dr. Sahanon Tungbenchasirikul ÂŠ

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Time Value of Money Types Types

Definition

Compounding The process of determining the future value (FV) of a cash flow or a series of cash flows. The compounding amount, or future value, is equal to the beginning amount plus the interest earned. Discounting

The process of finding the present value (PV) of the future cash flow or a series of cash flows; discounting is reciprocal, or reverse, of compounding.

Annuity &

A series of equal periodic payment (PMT) for a specified number of periods. Amortized loan is p paid off in equal q payments p y over a specified period. An amortization schedule shows how much of each payment constitutes interest, how much is used to reduce the principal, and the unpaid balance at each point in time.

Amortization

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Financial Management by Dr. Sahanon Tungbenchasirikul ÂŠ

Time Value of Money: Time Line Time line is used to visualize what is happening in a particular problem and then to help setting up the solution. To illustrate the time line concept, we consider the following diagram:

Time

0 Today y

1 The end of period i d1

2 The end of period i d2

Financial Management by Dr. Sahanon Tungbenchasirikul ÂŠ

3 The end of period i d3

4 The end of period 4

5 The end of period 5

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Time Value of Money: Time Line If we invest 1,000 today (time 0): we will earn interest x% by the end of year 1 – 5, we will earn xx from year 1 – 5.

Time

0

XX x%

XX X%

1

XX X%

2

XX X%

3

XX X%

4

5

1000

Initial investment = 1,000 Total wealth at the end of year 5 = 1,000 + xx + xx + xx + xx +xx

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Financial Management by Dr. Sahanon Tungbenchasirikul ©

Compounding (Future Value) - A dollar in hand today is worth more than a dollar to be received in the future because if we had it now, we can invest it, earn interest, and end up with more than one dollar in the future. - The process of going from today’s values, or present values (PVs) to future values (FVs) is called compounding. Compounding formula is as follows:

FVn PV(1 i) n PV (FVIFi ,n )

(5)

FVn = future value, or ending amount, of our account at the end of n years. PV = the present value i

= interest rate received from investment per year.

FVIFi , n = Future Value Interest Factor for i and n = (1 + i)n

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An Example of Compounding (Future Value) If we invest 100 today (time 0) and earn interest 5% equally for 5 years, by the end of year 5, what is FV5 ?

Time

5%

0

100 + 5

5%

1

105 + 5.25

5%

2

110.25 + 5.51

5%

3

115.76 + 5.79

5%

121.55 + 6.08

4

5

100

FVn PV(1 i) n PV (FVIFi ,n )

(5)

PV = 100 FV5 = PV(1 + i)5

= 100(1+0.05)5

FV5 = PV(FVIF5%, 5) = 100(1.2763)

= 127.63

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Discounting (Present Value) - In general, the present value of a cash flow due n years in the future is the amount which, if it was on hand today, would grow to equal the future amount. - Finding present value (PV) is called discounting and it is the reverse of compounding. Discounting formula is as follows:

PV

1 FVn FVn n (1 n ) 1

n FVn ( PVIFi ,n ) (6) i

PV = the present value FVn = future value, or ending amount, of our account at the end of n years. i

= interest rate received from investment per year.

PVIFi , n = Present Value Interest Factor for i and n = (1 + i)n Financial Management by Dr. Sahanon Tungbenchasirikul ©

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An Example of Discounting (Present Value) If we know the future value of invest in year 5 equal 127.63 with the interest 5% equally for 5 years, we want to know what is PV?

Time

105 5%

110.25 5%

0

115.76 5%

1

121.55 5%

2

3

127.63 5%

4

5

100

PV

1 FVn FVn n (1 n ) 1

PV = FV5/(1 + i)5

n FVn (PVIFi ,n ) (6) i

= 127.63/(1+0.05)5

PV = FV5 (PVIF5%, 5) = 127.63(0.7835)

= 100

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Annuity (Future Value) - An annuity is a series of equal payments made at fixed intervals for a specified number of periods. The payments are given the symbol PMT. Payments on mortgage, car loans, and student loans are the example of annuity - Finding the future value of the annuity (FVAn) can be made by the following formula: n

FVA n PMT (1 i) n t PMT ( t 1

(1 i) n 1 ) PMT (FVIFAi ,n ) (7) i

FVA n PMT (1 i) n 1 PMT (1 i) n 2 ... PMT (1 i) 0

FVAn

= the th ffuture t value l off th the annuity it

PMT

= equal investment/payment in every period

i

= interest rate received from investment per year.

FVIFAi,n = Future Value Interest Factor for an Annuity i & n Financial Management by Dr. Sahanon Tungbenchasirikul ©

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Example of Annuity (Future Value) If we deposit 100 Baht (PMT = 100) at the end of year 1 – 5 with the interest rate of 5% equally for 5 years, we want to know what is FVA5?

Time

100

100

5%

5%

0

1

100 5%

2

100 5%

3

100 5%

4

5 552.56

n

FVA n PMT (1 i) t 1

nt

PMT (FVIFA i ,n ) (7)

FVA5 = 100(1+0.05)4 + 100(1+0.05)3 + … + 100(1+0.05)0 FVA5 = 100[(1+0.05)4 - 1]/0.05 FVA5 = 100 (FVIFA 5%, 5) = 100 (5.5256) = 552.56

Financial Management by Dr. Sahanon Tungbenchasirikul ©

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Annuity (Present Value) - Finding the present value of the annuity (PVAn) can be made by the following formula: n 1 t PVA n PMT ( ) PMT (PVIFAi ,n ) (8) t 1 1 i

1 1 1 2 1 n PVA n PMT ( ) PMT ( ) ... PMT ( ) 1i 1i 1 i 1 1 (1 i) n PVA n PMT ( ) i

PVAn

= the th presentt value l off th the annuity it

PMT

= equal investment/payment in every period

i

= interest rate received from investment per year

PVIFAi,n = Present Value Interest Factor for an Annuity i & n Financial Management by Dr. Sahanon Tungbenchasirikul ©

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Example of Annuity (Present Value) If we deposit 100 Baht (PMT = 100) at the end of year 1 – 5 with the interest rate of 5% equally for 5 years, we want to know what is PVA5? Time

100 5%

0

100 5%

1

100 5%

2

100 5%

100 5%

3

4

5

432.95 n 1 t PVA n PMT ( ) PMT (PVIFAi , n ) (8) t 1 1 i

PVA5 = 100[1/(1+0.05)]1 + 100[1/(1+0.05)]2 + … + 100[1/(1+0.05)]5 PVA5 = 100 (PVIFA 5%, 5) = 100 (4.3295) = 432.95

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Financial Management by Dr. Sahanon Tungbenchasirikul ©

An Example of Amortization - If a loan to be repaid in equal periodic amounts (monthly, quarterly, or annually), it is said to be an amortized loan. - Example, if we borrow money to build a house and monthly repay debt for 100 Baht / 24 months (PMT = 100) with the interest rate of 5%, we want to know what is PVA24? Time

0

100 5%

100 5%

1

100 5%

2

100 5%

……………………..

100 5%

24

1,379.86 n 1 t PVA n PMT ( ) PMT (PVIFAi , n ) (8) 1 i t 1

PVA24 = 100[1/(1+0.05)]1 + 100[1/(1+0.05)]2 + … + 100[1/(1+0.05)]24 PVA24 = 100 (PVIFA 5%, 24) = 100 (13.7986) = 1,379.86 Financial Management by Dr. Sahanon Tungbenchasirikul ©

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Cost of Capital / Required Rate of Return

by Dr.Sahanon Tungbenchasirikul

Financial Management by Dr. Sahanon Tungbenchasirikul ©

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Cost of Capital & WACC Most firms employ several types of capital, called capital components, with common and preferred stock, along with debt, being the three most frequently used types. All capital components have one feature in common: The investors who

provided the funds expect to receive a return on their investment.

The required rate of return on each capital component is called its component cost, and the cost of capital used to analyze capital budgeting decisions should be a weight average of various components’ costs. We call this weight average just that, the weight average cost of capital (WACC).

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Cost of Capital & WACC The cost of capital used in capital budgeting is a weight average of the types of capital the firm uses, typically debt, preferred stock, and common equity. Each firm has a target capital structure, defined as the mix of debt, preferred stock, and common equity that minimizes its weight average cost of capital (WACC):

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

One of the most important formula in financial management. 33

Financial Management by Dr. Sahanon Tungbenchasirikul ÂŠ

Cost of Capital & WACC Debt Capital (Business Loan)

Equity Capital (Preferred & Common Stocks)

Capital Employed Capital employed must be remunerated.

Interests remunerate bankers/creditors.

Financial Management by Dr. Sahanon Tungbenchasirikul ÂŠ

Dividends remunerate shareholders.

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Cost of Capital & WACC The Firm’s Balance Sheet

Liabilities

Debt Capital (Bankers/Creditors)

Total Assets Equities

Equity Capital (Preferred & Common Stock Holders)

Total Assets = Liabilities + Equities Financial Management by Dr. Sahanon Tungbenchasirikul ©

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Cost of Debt - To estimate the cost of debt, we need to calculate or obtain the rate of return required by bankers/creditors or (kd). - The h after f tax cost off d debt b capital, l kd(1-T), ( ) is used d to calculate l l WACC and it is the interest rate on debt, kd, less tax saving, because interest is deductible. Hence, cost of debt is written as the following formula: After tax cost of debt = Interest rate – Tax saving After-tax After-tax cost of debt = kd – kdT After-tax cost of debt = kd(1– T) ------- (14) Financial Management by Dr. Sahanon Tungbenchasirikul ©

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An Example of Cost of Debt John Lion borrows money from the bank at an interest rate of 11% (kd = 11%) and if it has a tax rate of 30% (T = 0.3), What is after after-tax tax cost of debt (kd(1 (1-T)) T)) ? After-tax cost of debt = kd(1– T) ------- (14) After-tax cost of debt = 11%(1– 0.3) After-tax cost of debt = 11%(0.7) After-tax cost of debt = 7.7% 7 7%

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Cost of Preferred Stock A number of firms use preferred stock as part of their permanent financing mix. Preferred dividends are not tax deductible. Hence, the companies bear their full cost, and no tax t adjustment dj t t iis used d when h calculating l l ti the th costt off preferred stock. Cost of preferred stock is displayed as the following formula: Component cost of preferred stock = kp = Dp/Pp------- (15)

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Cost of Preferred Stock John Lion issues preferred stocks and sells them to investors with the price of 100/share (pp), and he promises dividend payment of 10% per year (Dp = 10), What is component cost of preferred stock (kp) ?

Component cost of preferred stock = kp = Dp/Pp------- (15) Component cost of preferred stock = kp = 10/100 = 10%

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Cost of Common Stock The cost of common stock (ks) is the rate of return required by the firm’s stockholders. Cost of common stock (ks) can be estimated by three methods: 1. Capital Asset Pricing Model (CAPM) approach 2. The dividend-yield-plus-growth-rate (DCF) approach 3. The bond-yield-plus-risk-premium approach

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Cost of Common Stock: CAPM Approach To use CAPM Approach, one needs to pursue three calculating steps: - Step 1, estimates the firm’s beta. - Step 2, multiples this beta by the market risk premium to determine the fi firm’s m’s risk isk p premium. emi m - Step 3, add the firm’s risk premium to the risk-free rate to obtain the cost of common stock

CAPM Approach can be written in the following formula:

ks = krf + (km – krf ) bi ------- (16) ks = cost of common stock krf = the risk-free rate (yield on government bond or treasury bill) km = the firm’s risk premium bi = the firm’s beta Financial Management by Dr. Sahanon Tungbenchasirikul ©

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An Example of CAPM Approach John Lion issues common stocks and sells them to investors. He knew that the firm’s beta is 1.2 (bi = 1.2), the firm’s risk premium equals 7.5% (km = 7.5%) and the risk-free rate (government bond yield) equals 5% (krf = 5%) What is the cost of stock (ks) ?

ks = krf + (km – krf ) bi ------- (16) ks = 5% + (7.5% – 5%) x (1.2) ks = 5% + 3% ks = 8%

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Cost of Common Stock: DCF Approach To use DCF Approach, one adds the firm’s expected dividend growth rate or capital gain yield. Hence, DFC Approach can be

written in the following formula: ks = D1/P0 + g ------- (17) ks

= cost of common capital

P0 = the purchasing price of a common share D1 = annual dividend payment at time 1 g

= expected dividend growth rate or capital gains yield

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An Example of DCF Approach John Lion issues common stocks and sells them to investors at 2,700/share. The common share promises dividend 100 (D0 = 100; D1 = 100(1.08) = 108) and the investors expect dividend growth at 8% per year (g = 8%). What is the cost of stock (ks) ?

ks = D1/P0 + g ------- (17) ks = 100(1.08)/2,700 + 8% ks = 108/2,700 + 8% = 4% + 8% ks = 12%

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Cost of Common Stock: Bond-Yield-Plus-RiskPremium (BYPRP) Approach To use BYPRP Approach, one adds the a risk premium of 3-5% to the firm’s interest rate on long-term debt. Hence, BYPRP

Approach can be written in the following formula:

ks = Bond Yield + Risk Premium ------- (18) ks

= cost of common capital

Bond Yield

= the rate of return for risk-free assets.

Risk Premium = the mark-up interest rate

Financial Management by Dr. Sahanon Tungbenchasirikul ©

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An Example of BYPRP Approach John Lion issues common stocks and sells them to investors at 2,700/share. The investor expect the return on their investment based on government bond yield 5% plus risk premium 4%. What is the cost of stock (ks) ?

ks = Bond Yield + Risk Premium ------- (18) ks = 5% + 4% = 9%

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Weight Average Cost of Capital (WACC) Each firm has a target capital structure, defined as the mix of debt, preferred stock, and common equity that minimizes its weight average cost of capital (WACC). We can wire the WACC formula as follows:

WACC = wdkd (1-T) + wpkp + wsks --------- (19) WACC = Weight Average Cost of Capital Kd(1-T) = After-tax cost of debt kp

= cost o of p preferred e e ed stoc stock

ks

= cost of common capital

wd wp & ws= the weights used for debt, preferred, and common stock, respectively. It is important to note that wd + wp + ws = 1 Financial Management by Dr. Sahanon Tungbenchasirikul ÂŠ

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An Example of WACC Calculation John Lion forms a retail company. He has a target capital structure that the ratio of debt, preferred stock, and common stock is 30%, 20%, and 50% (wd = 0.3, wp = 0.2, ws = 0.5). The bankers expect John to pay interest for 7% per year (kd = 7%) and tax rate equals 30% of profit (T = 0.3). Preferred stockholders expect John to provide dividend of 8% per year (kp = 8%) . and the common shareholders request John to pay dividend of 7% per year (ks = 7%). What is WACC ?

WACC = wdkd (1-T) + wpkp + wsks --------- (19) )( )( ) + ((0.2)(8%) )( ) + ((0.5)(7%) )( ) WACC = ((0.3)(7%)(1-0.3) WACC = 2.1%(0.7) + 1.6% + 3.5% WACC = 1.47% + 1.6% + 3.5% WACC = 6.57% Financial Management by Dr. Sahanon Tungbenchasirikul ÂŠ

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Factors That Affect WACC Controllable 1. Capital Structure Policy 2 Dividend Policy 2. 3. Investment Policy

Non Controllable 1. The Level of Interest Rate 2 Market Risk Premium 2. 3. Tax Rates

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Asset Price Valuation

by Dr.Sahanon Tungbenchasirikul

Financial Management by Dr. Sahanon Tungbenchasirikul ÂŠ

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Valuation Models Valuation includes: Rationales of Valuation Discount Rate & Required Rate of Return as Opportunity Cost Bond Valuation Model Common Stock Valuation Model Preferred Stock Valuation Model Corporate Valuation Model

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Bond Valuation Bond is a long-term debt instrument issued by a business or governmental unit, and provides a fixed stream of interest payments and a lump sum at maturity. In other words, the bond issuer will receive money (cash) in exchange for promising to make interest payments and to repay the principal at maturity. When an investor purchases a company’s bonds, that investor is providing the company with capital. Hence, when a firm

issues bonds, the return that investors receive represents the cost of debt financing for the issuer.

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Bond Valuation To talk about bonds, we must first define several vital terms: • The p par value,, or face value,, is the amount to be repaid at maturity.

• The coupon interest rate is the percentage of par value that a company or governmental units promises to pay the bondholder each interest period. • The coupon payment, or interest payment is the amount that must be payment, paid each period. • The maturity date is the time when the last interest payment and the lump sum (par value) are paid. Financial Management by Dr. Sahanon Tungbenchasirikul ©

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Bond Valuation Model The value of a bond (VB) and other financial assets (stock, lease, physical asset) is simply the present value of the cash flows the asset is expected to produce. In other words, VB is the present value of its interest and principal payments when discounted at the discount rate.

VB

INT INT INT P .... (9) 1 2 n (1 k d ) (1 k d ) (1 k d ) (1 k d )1

VB

(1 k

N

INT

t 1

d

)

t

N

P

(1 k t 1

d

)N

INT(PVIFA k d , N ) P(PVIFk d , N )

VB

= the value of a bond (Valuation)

INT

= annuall interest payment

kd

= discount rate (required annual rate of return)

PVIFA

kd,n

= present value interest factor for an annuity kd & n

PVIF kd,n = present value interest factor kd & n Financial Management by Dr. Sahanon Tungbenchasirikul ©

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An Example of Bond Valuation John Lion is interested in finding the value of a 30 year ABC Corporation bond that he recently purchased. The newly issued bond has a 12% annual coupon interest rate (INT = 120) and a 1,000 par value (P = 1,000). Bonds of similar risk have a 10% required annual rate of return (kd = 10%). What is VB ? VB = 1,188.528 1 188 528

Time

120

10%

0

120

10%

1

VB

N

10%

2

INT t t 1 (1 k d )

N

P

(1 k t 1

d

)N

120

3

10%

120

…………

24

10%

1,000

24

INT N (PVIFA V V kd , N ) k d , N ) P ( PVIF

VB = 120[1/(1+0.10)]1 + 120[1/(1+0.10)]2 + … + 120[1/(1+0.10)]30 + 1,000[1/(1+0.10)]30 VB = 120 (PVIFA 10%, 30) + 1000(PVIF10%, 30) VB = 120 (9.4269) + 1,000 (0.0573)

= 1131.228 + 57.3 = 1,188.528

Financial Management by Dr. Sahanon Tungbenchasirikul ©

55

Perpetual Bond Valuation Model The value of a perpetual bond (VB) offers interest payments forever (an infinite sequence) and do not provide a lump sum at any point. They are not callable in the future. The formula of perpetual bond valuation model is:

VB

INT kd

(10)

VB

= the value of a bond (Valuation)

INT

= annual interest payment

kd

= discount rate or required annual rate of return

Financial Management by Dr. Sahanon Tungbenchasirikul ©

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10/5/2013

An Example of Perpetual Bond Valuation John Lion is interested in finding the value of a perpetual bond that he recently purchased. The bond provides 120 annual coupon interest (INT = 120) and a 1,000 par value (P = 1,000). Bonds of similar risk have a 10% required annual rate of return (kd = 10%). What is VB ? VB = 1,200

Time

10%

0

120

10%

1

VB

120

120

10%

2

3

10%

…………

120

1,20

10%

…………

100

∞

INT kd

VB = 120/0.10 (10% = 0.10) VB = 1,200 57

Financial Management by Dr. Sahanon Tungbenchasirikul ©

The Risks of Bond 1.

2 2.

3.

Interest Rate Risk is the risk of decline in bond values due to rising interest rate. Reinvestment Rate Risk is the risk of an income decline due to a drop in interest rate.

Bond Value at Maturity Interest Rate Risk Illustration

Short-term Bond < 1 Year

100

Default Risk is the risk caused by issuer defaults. Hence, investors receive less than the promised return on the bond contract. contract

Long-term Bond > 1 Year

0

5%

Discount Rate (kd)

The higher the discount rate, the lower the bond par value. The longer the bind maturity, the higher the potential of value decline. Financial Management by Dr. Sahanon Tungbenchasirikul ©

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Common Stock Valuation Common Stock is a long-term capital/equity instrument issued by a corporation to raise capital used for asset investments. In other words, the common stock issuer will receive money (cash) in exchange for promising to make dividend payments. The common stockholders are the owners of a corporation, and as such they have certain rights and privileges as follows: • Control of the firm (e.g. elect or take the position of the

chairman, director, CEO, managing director, senior manager)

• The preemptive right (e.g. purchase any additional shares sold by the firm) to maintain control and prevent a wealth transfer from current stockholders to new stockholders.

Financial Management by Dr. Sahanon Tungbenchasirikul ©

59

Common Stock Market Common Stock can be sold via OTC (private market) and Stock Exchange (public market). Common Stock Transactions: • Primary Market • Private Placement (PP) • Initial Public Offering (IPO) • Secondary Market See Details in Chapter 2

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Common Stock Valuation Model The value of a common stock (Vs) is the present value of the cash flows, which are expected to produce. In other words, Vs is the present value of its future dividend payments when discounted at the discount rate.

VS

D1 D2 D .... (10) (1 k s )1 (1 k s ) 2 (1 k s )

VS

(1 k )

Dt

t 1

t

s

VS = the value of a common share (Valuation) Dt = annuall dividend d d d payment ks

= discount rate (required annual rate of return)

61

Financial Management by Dr. Sahanon Tungbenchasirikul ©

An Example of Common Stock Valuation John Lion is interested in finding the value of ABC Corporation common stock that he recently purchased. The newly issued common share displays 1,000 / share (P = 1,000) and pays dividend 150 annually for 30 years (Dt = 150) . Another common share of similar risk have a 10% required annual rate of return e u ((ks = 10%). 0%) What a iss VS ? VS = 1,414.035

Time

0

10%

150

10%

1

150

10%

2

150

10%

3

150

4

10%

…………

150

30

VS = 150[1/(1+0.10)]1 + 150[1/(1+0.10)]2 + … + 150[1/(1+0.10)]30 VS = 150 (PVIFA 10%, 30) VS = 150 (9.4269)

= 1,414.035

Financial Management by Dr. Sahanon Tungbenchasirikul ©

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10/5/2013

Constant Growth Stock Valuation Model If the dividend payments of a common share is constant overtime and investor expects a constant growth rate every year, the value of that common share (VS) will be calculated in terms of the constant growth model:

VS

D 0 (1 g )1 D 0 (1 g ) 2 D 0 (1 g ) .... (11) (1 k s )1 (1 k s ) (1 k s ) 2 (1 g ) t t t 1 (1 k s )

VS D 0 VS

D 0 (1 g ) D1 kS g ks g

Assume: g < ks

VS = the value of a common share (Valuation) D0 = annual dividend payment at time 0, D1 at time 1 g

= expected dividend growth rate

ks

= discount rate (required annual rate of return) 63

Financial Management by Dr. Sahanon Tungbenchasirikul ©

An Example of Constant Growth Stock John Lion is interested in finding the value of ABC Corporation common stock that has a constant annual dividend growth. The common share pays dividend 100 (D0 = 100), the required rate of return 12% (ks = 12%), and the investor expects dividend growth at 8% per year (g = 8%), What is VS ? VS = 2,700 100(1.08)2

100(1.08)1 12%

0

VS

12%

1

100(1.08)4

100(1.08)3 12%

2

12%

3

100(1.08)∞ 12%

4

…………

∞

D 0 (1 g ) D1 (11) kS g ks g

VS = 100(1.08)1 /(0.12 – 0.08) VS = 108/0.04 VS = 2,700

Financial Management by Dr. Sahanon Tungbenchasirikul ©

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Required Rate of Return on A Constant Growth Stock Required annual rate of return = Expected dividend yield + Expected growth rate, or capital gains yield. As the formula displays:

k s D1 / P0 g (12) ks

= required annual rate of return

P0 = the purchasing price of a common share D1 = annual ann al di dividend idend payment pa ment at time 1 g

= expected dividend growth rate or capital gains yield

Financial Management by Dr. Sahanon Tungbenchasirikul ©

65

An Example of Required Rate of Return on A Constant Growth Stock John Lion purchases ABC Corporation common stock 2,700/share (P0 = 2,700). The common share pays dividend 100 (D0 = 100, D1 = 100(1.08)) and the investor expects dividend growth at 8% per year (g = 8%), What is kS ?

k s D1 / P0 g (12) kS = 100(1.08)1 /2,700 + 8% kS = 108/2,700 + 8% VS = 4% + 8% = 12%

Financial Management by Dr. Sahanon Tungbenchasirikul ©

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Preferred Stock Valuation Preferred Stock is a hybrid security having some characteristics of debt and some of equity. Most preferred stocks are perpetuities, and the value of a share of perpetual preferred stock (VP) is found as the dividend divided by the required annual rate of return (discount rate). Hence, Preferred Stock Valuation Model is displayed in the following formula:

VP

DP (13) kP

VP

= the value of a bond (Valuation)

DP

= annual dividend payment

kP

= discount rate (required annual rate of return)

67

Financial Management by Dr. Sahanon Tungbenchasirikul ©

An Example of Preferred Stock Valuation John Lion is interested in finding the value of a perpetual preferred stock that he recently purchased. The stock provides annual dividend payment 100 (DP = 100). Investors expect required annual rate of return 10% (kP = 10%). What is VP ? VP = 1,000

Time

10%

0

VP

100

10%

1

100

10%

2

100

3

10%

…………

100

100

10%

…………

100

∞

DP (13) kP

VP = 100/0.10 (10% = 0.10) VP = 1,000 Financial Management by Dr. Sahanon Tungbenchasirikul ©

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Corporate Valuation 1.

The corporate valuation model shows how corporate decisions affect stockholders.

2.

In the context of corporate valuation, corporate assets consists off operating ti assets t and d fi financial, i l or non-operating, ti assets. t •

Operating assets take two forms: asset-in-place & growth options

Asset-in-place includes the land, buildings, machines, and inventory that the firm uses in its operations to produce products and services.

Growth options refer to opportunities the firm has to increase sales. These include opportunities arising from R&D expenditures, customer relationships, and the like.

Financial Management by Dr. Sahanon Tungbenchasirikul ©

69

Corporate Valuation 2.

In the context of corporate valuation, corporate assets consists of operating assets and financial, or non-operating, assets. •

3.

Financial, or non-operating, assets are distinguished from operating ti assets t and d iinclude l d items it such h as investment i t t in i marketable securities and non-controlling interests in the stock of other companies

The value of non-operating assets is usually close to the figure reported on the balance sheet.

Financial Management by Dr. Sahanon Tungbenchasirikul ©

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Corporate Valuation Key drivers of corporate value include:

1. Return on Invested Capital (ROIC): A calculation used to assess a company's efficiency at allocating the capital under its control t l tto profitable fit bl investments. i t t Th The return t on iinvested t d capital it l measure gives a sense of how well a company is using its money to generate returns. Comparing a company's return on capital (ROIC) with its cost of capital (WACC) reveals whether invested capital was used effectively. The general equation for ROIC is as follows:

ROIC

Financial Management by Dr. Sahanon Tungbenchasirikul ©

71

Corporate Valuation Key drivers of corporate value:

2. Revenue Growth: The firm, which can keep revenue growth

year-over-year, would boost its EBITDA, and in turn, generate positive iti nett cash h fl flow. R Revenue growth th implies i li the th firm’s fi ’ competitiveness either cost advantage or differentiation advantages or both. On this ground, the Top Management pays much attention on creating and executing strategies that aim to gain sustainable competitiveness to ensure its revenue growth and positive net cash flow.

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Corporate Valuation Model 4.

The value of operations is the present value of all the future free cash flow expected from operations when discounted at the weight average cost of capital (WACC = discount rate). Hence, The value of operations is display in the following formula: VOP

FCF FCF1 FCF2 .... ( 20) (1 WACC) (1 WACC)1 (1 WACC) 2

VOP

(1 WACC)

FCFt

t 1

t

VOP

= the value of operations (Valuation)

FCFt

= free cash flow generated at time t

WACC = Weight Average Cost of Capital

73

Financial Management by Dr. Sahanon Tungbenchasirikul ©

An Example of Corporate Valuation John Lion, the owner of a large local retail store, is interested in evaluating the value of company operations (VOP). He projected the free cash flow (FCF) for the future 5 years as follows: 112, 115, 130, 145, & 160(i.e. FCF1 - FCF 5). He calculated the value of WACC ~ 7%. What is VOP ?

VOP

FCF1 FCF2 FCF5 .... (20) (1 WACC)5 (1 WACC)1 (1 WACC) 2

535.9357

Time

0

7%

112

1

7%

115

7%

2

130

3

7%

145

4

7%

160

5

VOP = 112[1/(1.07)]1 + 115[1/(1.07)]2 + 130[1/(1.07)]3 + 145[1/(1.07)]4 + 160[1/(1.07)]5 VOP = 112(0.9346) + 115(0.8734) + 130(0.8163) + 145(0.7629) + 160(0.7130) VOP = 104.6752 + 100.441 + 106.119 + 110.6205 + 114.05 VOP = 535.9357 (The Present Value of VOP at time 0) Financial Management by Dr. Sahanon Tungbenchasirikul ©

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Stabilized FCF and Constant FCF Growth 5.

When the firm FCF stabilized and begin to grow at a constant rate. The value of operations (VOP) at time N can be displayed in the following formula: VOP (att time ti N)

FCFt (21) tN t N 1 (1 WACC)

VOP (at time N )

FCFN 1 FCFN (1 g ) WACC g WACC g

VOP (at time N) = the value of operations at time N (Valuation) FCFN

= free cash flow g generated at time N

g

= FCF growth rate

WACC

= Weight Average Cost of Capital

VOP (at time N) is called the company’s terminal, or horizon, value, because it is the value at the end of the forecast period. It is also called continuing value. 75

Financial Management by Dr. Sahanon Tungbenchasirikul ©

An Example of Corporate Valuation John Lion, the owner of a large local retail store, is interested in evaluating the value of company operations at time N (VOP at time N). He projected the free cash flow (FCF) ~ 1,000 to be the same for the future (i.e. FCF = 1000). He also expect that FCF will growth at the constant rate of 5%. He ahs calculated ca cu a ed the e value a ue o of WACC CC ~ 7%. % What a iss VOP a at time e N?

VOP (at time N)

Time

0

7%

1,000

1

FCFN 1 FCFN (1 g ) (21) WACC g WACC g

7%

1,000

7%

2

1,000

3

7%

1,000

4

7%

…………

1,000

∞

VOP (at time N) = 1,000(1.05)/(7% – 5%) = 1,050/0.02 VOP (at time N) = 52,500 (the terminal value, John can sell (at time N) his company at the price of 52,500). Financial Management by Dr. Sahanon Tungbenchasirikul ©

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Total Value of A Company & Price Per Share Calculation 6.

The total value of a company (total value) is the value of its operations plus the value of its non-operating assets, as display i the in th formula f l (22)

7.

Price Per Share (PPS) equals the total value of equity divided by the number of common stock.

Total Value = VOP + Non-Operating Asset Value --------- (22) PPS = Total Value of Equity/the Number of Common Share --(23) (23)

Financial Management by Dr. Sahanon Tungbenchasirikul ÂŠ

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An Example of Total Value of A Company & Price Per Share Calculation 1. John Lion calculated VOP at time N ~ 52,500 and non-operating value ~ 10,000. What is the total value of his company? A Answer T t l value Total l off his hi company = 52,500 52 500 + 10,000 10 000 = 62,500 62 500 2. John Lion calculated the total value of equity ~ 12,000 and the number of common share ~ 1,000 share. What is PPS? Answer PPS = 12,000 / 1,000 = 12/share

Financial Management by Dr. Sahanon Tungbenchasirikul ÂŠ

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