Saturday, October 20, 2012

Managerial Finance concepts summary

(Thirteenth Edition, Lawrence J. Gitman, Chad J. Zutter), 2012

  • 1.       The internal rate of return( IRR) is the rate that causes The net present value( NPV) to be zero
  • 2.       Discounted cash flow method and Net Present value method means the same, it’s a tool in capital investment budgeting.
  • 3.       The slop of yield curve is affected by
    -1)interest rate expectation
    -2)liquidity preference
    -3)the comparative of supply and demand in the short and long term market segment .
  • 4.       Inverted yield curve Vs normal yield curve.
  • 5.       Market efficiency means the flow of new information is almost constant, stock price fluctuate and continuously moving toward a new equilibrium that reflex the most recent information available.
    Market efficiency has 3 stage:
    2.Semi-strong form
  • 6.       The value of a share of common stock is equal to the present value of all future cash flow( dividends ) that is expected to provide.
    -basic commons stock valuation model
    1)zero- growth model
    2)constant growth model or Gordon growth model
    3)variable-growth model
  • 7.       Alternative way to value a share of common stock is Free cash flow valuation model

    -it determines the value of an entire company as the present value of its expected future free cash flows discounted at its weighted average cost of capital which is its expected average future cost of funds over the long run.
  • 8.       Other approaches to common stock valuation is:
    -Book value per share
    -Liquidation value per share
    -price/ earning (P/E) ratio
  • 9.      Two Categories of Valuation Models:

    1)Absolute valuation models attempt to find the "true" value of an investment based only on fundamentals such as dividends, cash flow and growth rate for a single company, and not worry about any other companies. The Valuation models include the dividend discount model, discounted cash flow model, residual income models and asset-based models.

    2) Relative valuation models operate by comparing the company in question to other similar companies. These methods involve calculating multiples or ratios, such as the price-to-earnings multiple, and comparing them to the multiples of other comparable firms. For instance, if the P/E of the firm you are trying to value is lower than the P/E multiple of a comparable firm, that company may be said to be relatively undervalued. Generally, this type of valuation is a lot easier and quicker to do than the absolute valuation methods that are why many investors and analysts start their analysis with this method.
  • 1.       A decrease in the required return will increase the share value, whereas an increase in the required return will decrease share value.
  • 2.       -Risk is a measure of an uncertainty surrounding the return that an investment will earn.
    Example: $1000 government bond that guarantee it's holder 5$ interest after 30 days have no risk, but $1000 invest in common stock, the value of it within 30 days may move up or down a great deal and is very risky because the high variability of its return.
  • 3.       A risk- adverse investor will not make a riskier investment unless it offers a high expected return to compensate investor for bearing additional risk.
  • 4.       However, a risk- neutral investor will always choose the investment with the higher expected return regardless of its risk.
  • 5.       Finally, a risk seeking investor is the one who prefer investment with higher risk and may sacrifice the expected return. such as Gambler,Casinoer ...
  • 6.       -Fiscal policy is conducted by a nation's government such as Expansionary fiscal policy is to increase government spending and/or decreases the tax rates, while contractionary policy is the opposite (lower government spending and/or higher tax rates).

    -Monetary policy is handled by a country's central banks, in the U.S it is largely conducted through three mechanisms – open market operations, reserve requirements and interest rates (in the form of discount rates)
  • 7.       The most common statistical indicator of asset's risk is standard deviation; it measures the dispersion around expected return.
    -the expected value of a return (r) is the average returns that an investment is expected to produce over time.
  • 8.       -The higher the standard deviation, the greater the risk.
    -A higher coefficient of variation means an investment have more volatility relative to its expected return.
  • 9.       -When assets are perfectly negatively correlated ,the combination of the two assets result the portfolio's returns are risk free, it’s suitable a risk- averse investor
    - however, combining two assets that are perfectly positively correlated, because they always move together in a portfolio does nothing to reduce the risk.
  • 10.   Total security risk= diversifiable risk (unsystematic risk) + nondiversifiable risk (systematic risk).
    -the capital assets pricing (CAPM) model links nondiversifiable risk to expected return.
  • 11.   The security market line (SML) is the line that reflects an investment's risk versus its return, the line begins with the risk-free rate (with zero risk) and moves upward to the right

    -An investor with a low risk would choose an investment at the beginning of the security market line. An investor with a higher risk would choose an investment higher along the security market line.

    -If the risk premium required by investors was to change, the slope of the SML would change also. The risk premium such as Expected real growth in the economy, Capital market conditions and Expected inflation rate.
  • 12.   Cost of capital is the minimum required rate of return that a project must earn to increase firm value and is derived from the expected average future cost of fund over the long run.

    -source cost of fund such as
    1)cost of long term debt( sale of corporate bond)
    2)cost of preferred stock
    3)cost of common stock, it is the return required by investors in market place and there're two form of common stock financing:
    -retained earning
    -new issues of common stock

    Two technique to measure cost of common stock:
    -constant dividend growth ( Gordon ) model
    -Capital asset pricing model(CAPM)
    1.       Weighted average cost of capital (WACC) is the expected average future cost of capital (cost of long term debt, cost of preferred stock, and cost of common stock...) and it depends on the firm capital structure.
    2.       NPV = (present value of cash outflow - present value of cash inflow) and EVA (economic value added) = (project cash flow - (cost of capital)*invested capital) method reach the same conclusion.
    3.       Risk and cash inflow
    -to access the risk of a proposed capital expenditure, the analyst need to evaluate the probability that the cash inflow will be large enough to produce a positive NPV; the tools to evaluate are scenario analysis and simulation.
    4.       One of the Most common scenario analysis approach is to estimate the NPV, associated with pessimistic (worse) ,most likely( expected),and optimistic( best) estimates of cash inflow. The rang is determined by subtracting from pessimistic-outcome NPV and optimistic-outcome NPV
    5.       International risk that affect capital budgeting are: exchange rate risk and political risk
    - the approach for dealing with these risk is to determine risk-adjusted discounted rate( is the rate of return that must be earn on a given project to compensate the firm's owners adequately , that is to maintain the firm share price)
    6.       The higher the risk of a project, the higher risk adjusted discount rate (RADR), so the lower the net present value for a future stream of cash inflow.
    7.       CAPM (capital asset pricing model) and SML (securities market line) in capital budgeting

    CAPM (require return on asset) =risk free rate of return + beta coefficient for asset*(rate of return on market portfolio of assets -risk free rate of return)

    -If any Project have IRR above SML would be accepted because its IRR exceed the require return on assets (CAPM), but would be rejected if IRR below SML.

    -in terms of NPV any project that NPV above SML would have a positive NPV, but if it fall below SML would be negative NPV.
    8.       Project analysis techniques

    Sensitivity Analysis
    Scenario Analysis
    Break Even Analysis
    Decision Trees


    -annualized net present value (ANPV) approach: An approach to evaluating unequal-lived projects that converts the net present value of unequal-lived, mutually exclusive projects into an equivalent annual amount (in NPV terms)

    Step 1 Calculate the net present value of each project j, NPVj, over its life, nj,
    using the appropriate cost of capital, r.

    Step 2 Convert the NPVj into an annuity having life nj. That is, find an annuity
    that has the same life and the same NPV as the project. 
    Step 3 Select the project that has the highest NPV.
  • 1.       The greater the IRR above cost of capital, the desire for the project is..

    - when a firm pays a dividend, the stock price should fall by exactly
    the amount of the dividend rate.

    - if the firm buys back shares at the going market price, the reduction in cash
    is exactly offset by the reduction in the number of shares outstanding, so the market
    price of the stock should remain the same.
    3.       3 methods of buying back shares by corporation
    -Open market share repurchase
    -Tender offer repurchase
    -Dutch auction repurchase
    4.      When the stock begin trading ex dividend , the stock usually fall exactly the same amount of dividend because the cash formerly held by the firm now in the hand of investor( asset of the firm fall)

    -Example: firm have asset 1$ billion, share outstanding 10 millions => each share worth (1$ billion /10,000,000)=$100
    Suppose company pay 1$/share of 10 million share outstanding ,so total dividend payout is 10$ million =>asset of the company fall to 990$ million with the same outstanding share 10 million, each share should worth 99$ or stock price should fall by 1$ exactly the amount of dividend

    However, the stock price react to cash dividend payout ( share price fall) may be different than an announcement of an upcoming dividend payout ( Example: firm announce it will increase its dividend ,so share price increase by the news)
    5.       Dividend payout policy
    -residual theory of dividend (the amount left-over after acceptable investment was undertaken)
    -dividend irrelevant theory (the firm value is unaffected by dividend policy)
    -dividend relevant theory( direct relationship between a firm's dividend policy and its market value)
    -bird-in-the-hand argument (investor see current dividend as less risky than future dividend or capital gain)
    6.       Factors affect dividend policy
    -Legal constrain
    - contractual constrain
    -The firm's Growth prospect
    -Owner consideration
    -Market consideration
    7.       Types of dividend policy
    -Constant -pay-out ratio
    -Regular dividend policy
    -Low-regular-and-extra dividend policy
    8.       The goal of working capital ( or short term financial ) management is to manage the firm current assets(inventory, account receivable, marketable security, and cash) And current liability( account payable ,accrual, note payable) to achieve a balance between profitability and risk that contribute to the firm's value .
    9.       Cash conversion cycle (CCC)
    The length of time required for a company to convert cash invested in its operation to cash received as a result of its operation.

    CCC=Average age inventory(AAI)+average collection period(ACP) - Average payment period(APP)
    10.   Strategies for managing the cash conversion cycle

    1)Turn over inventory as quickly as possible without stockouts that result in lost sale
    2) collect account receivable as quickly as possible
    3) Manage mail, processing and clearing time to reduce them collecting from customer and to increase them when paying suppliers
    4) Pay account payable as slowly as possible without the firm credit rating
    11.   Common technique of inventory management

    1)ABC system ( divide into A,B,C by its important and level of important on the basis of dollar investment each.

    2) Economic order quantity model (EOQ) model (to determine optimal item order size, which is the size that minimize its order cost and carry cost.

    3) Just in time inventory
    4) computerized for resource control
    12.   - Hybrid security (Preferred stock, financial leases, convertible
    securities, and stock purchase warrants) A form of debt or equity financing that possesses characteristics of both debt and equity financing.

    -Derivative security A security that is neither debt nor equity but derives its value from an underlying asset that is often another security; called “derivatives,” for short.

    13 .Strategic merger versus Financial merger

    - Strategic merger :A merger transaction undertaken to achieve economic of scale and synergies ( ex. Intel + McAfee) both high tech firm , (Norwest and wells Fargo ) both bank

    -Financial merger:A merger transaction undertaken with the goal of restructuring the acquired company to improve it cash flow and unlock its unrealized value.

    14  Four types of merger

    - horizontal merger: A merger of two firms for the same line of business ( this merger may eliminate the competitor)

    - vertical merger: when a firm acquire a supplier or customer( increase control over raw material or the distribution of finished product)

    -con-generic merger: A merger that one firm acquire another firm that in the same general industry but is neither in the same line of business nor a supplier or customer( increase ability to use the same sale and distribution channel to reach customers of both business )

    -Conglomerate merger: A merger combine unrelated business (to reduce risk by merging firm that have different seasonal or cyclical sales pattern or earnings)

    15 -Leverage buy out(LBO)

    The acquisition of another company using a significant amount of borrowed money (bonds or loans) to meet the cost of acquisition. Often, the assets of the company being acquired are used as collateral for the loans in addition to the assets of the acquiring company

    -Divestiture  The selling some of the firm's asset for various strategic reason

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