MIN 100 Investment Analysis

Roy Endr Dahl University of Stavanger E-mail: roy.e.dahl@uis.no

Presentation
PhD-student with thesis on credit risk and portfolio analysis. Visiting scholar at UC Berkeley in 2010. Lectured for Statoil AS on the topic. Investment analysis for local companies real estate and project analysis. Teach MIN100 (Investment Analysis) and BIP190 (Bedriftskonomi).
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MIN 100 Investment Analysis

A course in economic investment analysis Focus on uncertainty/risk Not an accounting course Not a course with heavy emphasis on management and organisation of projects

Literature
Corporate Finance Core Principles & Applications Global edition of 3rd edition ISBN: 9780071221160 Available at SIS Bok and online at Amazon.com etc. Will be covering most of the first 4 parts in addition to parts of chapter 17.
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MIN 100 Investment Analysis

Week / date
35 29.08.2011 36 12.09.2011 37 19.09.2011 38 26.09.2011 39 03.10.2011 40 10.10.2011

Chapters / Topic
1-3 / Introduction and basic concepts. 4-5 / Net present value, bonds, markets 6-7 / Stocks, NPV and other investment rules 8-9 / Cash flow and capital budgeting, decision tree, sensitivity, Monte Carlo 10-11 / Return and Risk, expected return, CAPM 11-12 / CAPM, Risk, Cost of Capital

Note
Part 1: Overview Part 2: Valuation and Capital budgeting

Part 3: Risk and Return

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42 24.10.2011 43 31.10.2011 44 07.11.2011

Mandatory assignment
13-14 / Financing, capital structure, Modigliani & Miller 15-16 / Use of debt, leverage, dividends 17 / Financial and Real Options. Part 5: Special topics Part 4: Capital Structure and Dividend Policy

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Lectures
Lecture hours set from 12:15 to 16:00 on Wednesdays at KE E-101, and will usually finish the lecture around 15:00 or earlier Every presentation will be available at Its Learning. Schedule plan includes one backup date (week 41) in case of changes.

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Mandatory assignment
One mandatory assignment given after the 6th lecture, when we have finished part 1, 2 and 3. Will be exam examples , giving you feedback on your progress. Must pass in order to take the exam.

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Exam
3 hours Calculator allowed Date: Not set. Updates will be given, but check the student web prior to the exam.

Today
Introduction Motivation Quick review of chapter 1 3, introducing some business and economical terms.

Motivation

What is an investment?
When investing you are putting money into a project which will give you a future payoff. According to the risk of the project, you can be more or less certain of the outcome. Our goal in this course is to assess how much a project is worth, when addressing issues like:
Inflation/Interest (Net Present Value) Risk Capital structure Options (Real and Financial)
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What is an investment?
When purchasing a good you evaluate its cost and compare it to its future payoff. And basically, if you believe the cost is less than the future payoff, its a good purchase.
Is buying a book for around 600 NOK, when it gives you an edge in the job interview worth a yearly salary of 350 000 NOK, a good investment?
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What is an investment?
Investments are everywhere:
Fixed assets (1): A new house, new car, machinery, etc.. It is divided into:
Intangible assets (1): education, patents, franchises, goodwill, etc. Tangible assets (2): currencies, buildings, real estate, etc.

Current assets (2): Cash, cash equivalent, inventory, etc. (1) is difficult to sell/valuate, (2) is easier to sell/valuate.

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How do we evaluate investments?

We will learn some great tools to evaluate and compare investments and projects:
Net Present Value (NPV) Internal Rate of Return (IRR) Payback method Capital asset pricing model (CAPM) Portfolio theory, diversification Option valuation, mixing options Sensitivity analysis Monte Carlo analysis Decision tree ...
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Chapter 1
Introduction to Corporate Finance

2011 McGrawHill/Irwin

Key Concepts and Skills

Know the three main concerns of corporate financial management Grasp the goal of financial management

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Chapter Outline
1.1 What is Corporate Finance? 1.2 The Corporate Firm 1.3 The Importance of Cash Flows

1.4 The Goal of Financial Management

1.5 The Agency Problem and Control of the Corporation 1.6 Regulation
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1.1 What Is Corporate Finance?

Economic resources are required to establish and maintain a firm:
Funds enable materials and processes for delivering salable goods and services Funds are essential for assembling a workforce Funds are required to purchase long-lived assets such as equipment and buildings

The Balance Sheet offers insight into the array of decisions, activities and objectives of the Financial Manager
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Balance Sheet Model of the Firm

Current Assets Current Liabilities Long-Term Debt Fixed Assets 1 Tangible

2 Intangible

Shareholders Equity

Total value of assets

Total value of the firm to investors

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The Balance Sheet Reveals

the top three concerns of corporate finance:
1. What long-term investments should the firm choose? 2. How should the firm raise funds for the selected investments? 3. How should current assets be managed and financed?
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The Capital Budgeting Decision

Current Liabilities
Long-Term Debt

Current Assets

Fixed Assets 1 Tangible 2 Intangible

What longterm investments should the firm choose?

Shareholders Equity
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The Capital Structure Decision

Current Liabilities
Long-Term Debt

Current Assets

Fixed Assets 1 Tangible 2 Intangible

How should the firm raise funds for the selected investments?

Shareholders Equity
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Short-Term Asset Management

Current Liabilities
Net Working Capital

Current Assets

Long-Term Debt

Fixed Assets 1 Tangible 2 Intangible

How should short-term assets be managed and financed?

Shareholders Equity
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1.3 The Importance of Cash Flow

If the firm is to prosper, it must:
Buy assets that generate more cash than they cost Sell financial instruments that raise more cash than they cost

The successful firm generates more cash than it uses

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The Conceptual Flow of Cash

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Investment cash flows

Initial investment (I0)
Total investment expenditure in year 0

Investment revenues (Rt)

Annual future revenues from the projects

Investment expenditures (Et)

All future outlays related to the investment project

Annual cash flow (Ct)

Annual revenues minus annual outlays
Ct = Rt - Et
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Cash-flows from investment

Year 0 Year 1 Year 2 Year 3

Investment (I0) = Cash-flow (C0)

Revenue (R1) Expenditure (E1) = Cash-flow (C1)

Revenue (R2) Expenditure (E2) = Cash-flow (C2)

Revenue (R3) Expenditure (E3) = Cash-flow (C3)

Time

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More on the initial investment

Cost of procurement
The costs of the investment object, including start-up costs (i.e., transport, assembling, and training)

Extra working capital

Liquid assets tied by the project is included in the initial investment
Cash, customer claims, inventories etc.

Other factors
Any measure which implies immediate payment should be included in the initial investment (e.g., marketing activities)

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1.4 The Goal of Financial Management

What is the correct goal?
Maximize profit? Minimize costs? Maximize market share? Maximize shareholder wealth?

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Corporate goals
Shareholder approach Stakeholder approach
Management Owners Banks Employees

The company

Community Customers Suppliers

Key objective is to maximise shareholder value, short-term and longer term

Key objective is to seek compromises which balance different interests

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Corporate goals: Survey results

Shareholders vs. stakeholders
Whose company is it?
All stakeholders The shareholders United States United Kingdom France United States United Kingdom France

Investors vs. employees

Whose company is it?
Job security Dividends

Germany

Germany

Japan 0 50 100

Japan 0 50 100

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The cash allocation challenge

Cash
Pay dividend to shareholders

Investment opportunity (real asset)

Company

Dividends to shareholders

Invest

Investment opportunity
(financial asset)

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Chapter 2
Financial Statements and Cash Flow

2011 McGrawHill/Irwin

Key Concepts and Skills

Understand the information provided by financial statements Differentiate between book and market values Grasp the difference between accounting income and cash flow Calculate a firms cash flow
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Chapter Outline
2.1 The Balance Sheet 2.2 The Income Statement 2.3 Taxes

2.4 Net Working Capital

2.5 Financial Cash Flow

2.6 The Accounting Statement of Cash Flows

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2.1 The Balance Sheet

An accountants snapshot of the firms accounting value at a specific point in time The Balance Sheet Identity is: Assets Liabilities + Stockholders Equity

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Balance Sheet Model of the Firm

Current Assets Current Liabilities Long-Term Debt Fixed Assets 1 Tangible

2 Intangible

Shareholders Equity

Total value of assets

Total value of the firm to investors

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U.S. Composite Corporation Balance Sheet

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Take Notice ! (on the previous Balance Sheet)

Assets exactly equal liabilities + equity Assets are listed in order of liquidity
The amount of time it would take to convert them to cash in an operating business

Obviously cash and A/R are more liquid than property plant and equipment. Liabilities are listed in the order in which they come due
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Balance Sheet Analysis

When analyzing a balance sheet, the Finance Manager should be aware of three concerns:
1. Accounting liquidity 2. Debt versus equity 3. Value versus cost

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Accounting Liquidity
Refers to the ease and quickness with which assets can be converted to cash without a significant loss in value Current assets are the most liquid. Some fixed assets are intangible. The more liquid a firms assets, the less likely the firm is to experience problems meeting short-term obligations. Liquid assets frequently have lower rates of return than fixed assets. 2-43

Debt versus Equity

Creditors generally receive the first claim on the firms cash flow. Shareholders equity is the residual difference between assets and liabilities. Debt and equity have different costs; the relationship between them has impact on the firms profitability

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Value versus Cost

Under Generally Accepted Accounting Principles (GAAP), financial statements of firms in the U.S. carry assets at historical cost. Market value is the price at which the assets, liabilities, and equity could actually be bought or sold, which is a completely different concept from historical cost.

2.4 Net Working Capital

Net Working Capital Current Assets Current Liabilities NWC usually grows with the firm

U.S. Composite Corporation Balance Sheet

Net Working Capital Current Assets Current Liabilities In 2009: NWC = $707 - $455 = $252 In 2010: NWC = $761 - $486 = $275 Here we see NWC grow to $275 million in 2010 from $252 million in 2009.

This increase of $23 million is an investment of the firm.

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2.5 Financial Cash Flow

In finance, the most important item that can be extracted from financial statements is the actual cash flow of the firm. Cash flow received from the firms assets must equal the cash flows to the firms creditors and stockholders. CF(A) CF(B) + CF(S) In other words, the cash generated by assets enables the firm to pay its debts and provide a return to shareholders. Accounting cash flow and financial cash flow are not necessarily equal.
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2.5 Financial Cash Flow

CF(A)
Firm
generates cash flow (make money)

CF(B)
Loanholders receive interest

CF(S)
Stockholders receive dividend

CF(A) CF(B) + CF(S)

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U.S.C.C. Financial Cash Flow

Note:

CF(A) CF(B) + CF(S). $ 42 = $ 36 + $ 6

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U.S.C.C. Financial Cash Flow

Operating cash flow is generated by business activities, including sales of goods and services. It reflects payment, not financing, capital spending or changes in net working capital. From the income statement we find operating cash flow: Earnings before interest and taxes (EBIT) + depreciation + current taxes = $ 219 + $ 90 - $ 71 2-51 = $ 238

U.S.C.C. Financial Cash Flow

Capital spending involves changes in fixed assets, including acqusition of fixed assets and sales of fixed assets. USCC bought/acquired new assets worth $ 198 and sold assets of $ 25 in 2010. This gives us: Capital spending = Acquisiton of fixed assets sales of fixed assets = $ 198 - $ 25 = $ 173 Note that this number can be found in the balance sheet: Change in net fixed assets + depreciation = ($ 1 118 - $ 1 035) + ($ 90) = $ 173

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U.S.C.C. Financial Cash Flow

We have previously calculated Net Working Capital Current Assets Current Liabilities In 2009: NWC = $ 707 - $ 455 = $ 252 In 2010: NWC = $ 761 - $ 486 = $ 275 The difference equals additions to NWC = $ 275 - $ 252 = $ 23
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U.S.C.C. Financial Cash Flow

The cash flow to the creditors are the sum of interest paid plus changes in net borrowing, which can be found by substracting new debt from repaid debt during the last year. USCC paid $ 49 in interest, repaid $ 73 in old debt and acquired new long-term debt of $ 86: Interest + repaid debt - new debt = $49 + $ 73 - $86 = $ 36. It can also be calculated by using interest paid from the income statement, and changes in long-term debt found in the balance sheet.
Interest paid Net new borrowing = Interest paid (End LT Debt Beg LT Debt) 54 = $ 49 ($ 471 - $ 458) = $ 36

U.S.C.C. Financial Cash Flow

The cash flow to the stockholders are the sum of dividends paid plus repurchase of equity, minus new equity financing. In the case of USCC in 2010, dividends paid to stockholders (found in income statement) were $ 43, and the firm repurchased stock of $ 6. In total this provides $ 49 in cash to the stockholders. In addition the firm issued/sold stocks for $ 43, which makes the total cash flow to stockholders: ($ 43 + $ 6) - $ 43 = $ 49 - $ 43 = $ 6.
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U.S.C.C. Financial Cash Flow

The cash flow received from the firms assets must equal the cash flows to the firms creditors and stockholders: CF(A) CF(B) + CF(S) = $ 42 = $ 36 + $ 6 = $ 42

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Chapter 3
Financial Statements Analysis and Financial Models

2011 McGrawHill/Irwin

Key Concepts and Skills

Standardize financial statements for comparison purposes Compute and interpret important financial ratios including the DuPont Identity Discern how capital structure and dividend policies affect a firms ability to grow

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Chapter Outline
(3.1 Financial Statements Analysis) (3.2 Ratio Analysis) 3.3 The Du Pont Identity

3.4 Financial Models

3.5 External Financing and Growth 3.6 Some Caveats Regarding Financial Planning Models
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3.1 3.3 Financial statements and analysis

The book covers several methods to analyze the progress of a company, by looking at numbers in its financial statements. The Common-Size Balance Sheet compute all accounts as a percent of total assets. Common-Size Income Statements compute all line items as a percent of sales. Ration analysis Standardized statements make it easier to compare financial information, particularly as the company grows. They are also useful for comparing companies of different sizes, particularly within the same industry.

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3.1 3.3 Financial statements and analysis

Ratios compliment common size analysis and allow for deeper comparison through time or between dissimilar companies.
I. II. III. IV. V. Short-term solvency or liquidity ratios Long-term solvency or financial leverage ratios Asset management or turnover ratios Profitability ratios Market value ratios

Following Examples all Based on Tables 3.1 & 3.4

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Computing Profitability Measures

Return on Asset (ROA) = Net income / Total Assets = 363 / 3588 = 10,1% Return on Equity (ROE) = Net income / Total Equity = 363 / 2591 = 14,0%

Profit margin = Net income / sales = 363 / 2311 = 15,7% EBITDA Margin = EBITDA / Sales = 967 / 2311 = 41,8%

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Using Financial Ratios

Ratios are not very helpful by themselves: they need to be compared to something Time-Trend Analysis Used to see how the firms performance is changing through time Peer Group Analysis Compare to similar companies or within industries Go to www.reuters.com/finance/stocks
Use the ratios link to get comparative ratios for many companies
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Summary of Ratio Formulae

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3.3 The DuPont Identity

Popularized by the DuPont Corporation A more sophisticated method of evaluating return Illustrates the interaction between profit, assets and leverage Holds that ROE is actually a function of 3 measures:
Operating Efficiency (Profit Margin) Asset Use Efficiency (Total Asset Turnover) Financial Leverage (Equity Multiplier)
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Derivation of The Du Pont Identity

ROE = NI / TE Multiply by 1 and then rearrange:
ROE = (NI / TE) (TA / TA) ROE = (NI / TA) (TA / TE) = ROA * EM

Multiply by 1 again and then rearrange:

ROE = (NI / TA) (TA / TE) (Sales / Sales) ROE = (NI / Sales) (Sales / TA) (TA / TE) ROE = PM * TAT * EM
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Using the Du Pont Identity

ROE = PM * TAT * EM
Profit margin is a measure of the firms operating efficiency how well it controls costs. Total asset turnover is a measure of the firms asset use efficiency how well it manages its assets. Equity multiplier is a measure of the firms financial leverage.
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Calculating the Du Pont Identity

ROA = 10.1% and EM = 1.39
ROE = 10.1% * 1.385 = 14.0%

PM = 15.7% and TAT = 0.64

ROE = 15.7% * 0.64 * 1.385 = 14.0%

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Potential Problems in Financial Analysis

There is no underlying theory, so there is no way to know which ratios are most relevant. Benchmarking is difficult for diversified firms. Globalization and international competition makes comparison more difficult because of differences in accounting regulations. Firms use varying accounting procedures. Firms have different fiscal years. Extraordinary, or one-time, events
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Lecture summary
Chapter 1 Introduction to Corporate Finance
Business organization Goal of financial management Agency problems

Chapter 2 Financial statements and Cash Flow

Book and market value Accounting income and cash flow

Chapter 3 Financial Statements Analysis and Financial Models Common-Size evaluation and ratio analysis. Du Pont Identity

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