Financial Management...

100 Slides
Price 99 $

Cash

Raw materials
inventory

Receivables

Finished goods
inventory

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Key Words...
Financial Market Present Value Perpetuity
Annuity Compound Interest Inflation Bond
Yield Share Value Free Cash Flow IRR
Risk Valuation Markowitz SML CAPM
Beta Risk APT Portfolio Theory Economic
Profit Call Option Straddle Option Pricing
Theory Leverage Ratio Liquidity Du Pont
Private Equity Volatility Working Capital
Valuation Value Drivers Risk/Return
Diversification Corporate Finance Yield
NPV Cash Transfer Accounting

The Dual Functions of Financial Markets

The financial markets

The primary market

The secondary market

cash

The firm

cash

Investors
newly issued
securities

Investors

Investors
outstanding
securities

Present Value
Present Value

Discount Factor

Value today of a future

cash flow.

Present value of a $1
future payment.

Discount Rate
Interest rate used to
compute present values
of future cash flows.

Present Value = PV
PV = discount factor C 1

PV

= DF C 1 =

DF
C1
1 + r1

1
(1 r ) t

Net Present Value

NPV = PV - required investment

C1
NPV = C 0
1 r

Perpetuity
Perpetuity - Financial concept in which a cash flow is
theoretically received forever.
cash flow
Return
present va lue
C
r=
PV

PV of Cash Flow

cash flow
discount rate

C1
=
PV
r

Annuity
Annuity - An asset that pays a fixed sum each year for
a specified number of years.

1
1
PV of annuity C
t
r r 1 r

Compound Interest
18
16

10% Simple

14

10% Compound

10
8
6
4
2

Number of Years

30

27

24

21

18

15

12

0
0

FV of $1

12

Inflation
Inflation - Rate at which prices as a whole are increasing.
Nominal Interest Rate - Rate at which money invested
grows.
Real Interest Rate - Rate at which the purchasing power
of an investment increases.

1 real interest rate

= 1+nominal interest rate

1+inflation rate

Bond Prices and Yields

1600
1400
1200

Price

1000
800
600
400
200
0
0

5 Year 9% Bond

10

1 Year 9% Bond

12

14

Yield

Valuing Common Stocks I

Expected Return

P - P
Div
0
= r =
1+ 1
P
P
0
0

Capitalization Rate

Div
1
= P0 =
r- g
= r = Div 1 + g
P0

Valuing Common Stocks II

Return Measurements

Dividend Yield =

Div 1
P0

Return on Equity = ROE

EPS
ROE =
Book Equity Per Share

Valuing Common Stocks III

If we forecast no growth, and plan to hold out stock
indefinitely, we will then value the stock as a
PERPETUITY.

Div1
Perpetuity = P0 =
r
Assumes all earnings are
paid to shareholders.

or

EPS1
r

F
C
F
C
F
C
P
V
1
2
H
P
V
(1r)(1r).(1r)(1rH)
FCF and PV

PV (free cash flows)

PV (horizon value)

NPV and Cash Transfers

Cash

Investment
opportunity

Firm

Shareholder

(real asset)

Investment
opportunities
(financial assets)

Invest

Alternative: pay
dividend to
shareholders

Shareholders invest
for themselves

Internal Rate of Return

2500
2000
1500

500

-1000
-1500
-2000

Discount rate (%)

0
10

90

80

70

60

50

40

30

-500

20

0
10

NPV (,000s)

1000

Rate of Return 1926 - 1997

60

Percentage Return

40
20
0
-20
Common Stocks
Long T-Bonds

-40
-60

T-Bills

26

30

35

40

45

50

55

60

Year

65

70

75

80

85

90

95

Portfolio standard deviation

Measuring Risk

Unique
risk
Market risk
0
5

10

Number of Securities

15

Portfolio Risk I

The variance of a two stock portfolio is the sum of these

four boxes:
Stock 1
Stock 1
Stock 2

2
1

2
1

x 1x 2 12
x 1x 2 12 1 2

Stock 2

x 1x 2 12
x 1x 2 12 1 2
2
2

2
2

Portfolio Risk II

Expected Portfolio Return (x r ) ( x r )

1 1

2 2

Portfolio Variance x 2 2 x 2 2 2 ( x x
1

1 2 12 1

Portfolio Risk III

The shaded boxes contain variance terms; the remainder contain
covariance terms.
1
2
3
STOCK

To calculate
portfolio variance
add up the boxes

4
5
6

N
1

STOCK

Beta and Unique Risk

im
2
m

Expected
stock
return
beta
+10%

- 10%

+10%
-10%

Expected
market
return

Markowitz Portfolio Theory

Price changes vs. Normal distribution
600

# of Days
(frequency)

500
400
300
200
100
0
-10% -8% -6% -4% -2%

0%

2%

Daily % Change

4%

6%

8%

10%

Efficient Frontier I

Return

Expected
Return (%)

B
A
Risk
Standard
deviation

Efficient Frontier II

Expected Return (%)

T
ing ing
d
n
Le rrow
Bo

rf

S
Standard deviation

Efficient Frontier III

Return

Low Risk

High Risk

High Return

High Return

Low Risk

High Risk

Low Return

Low Return

Risk

Security Market Line I

Return

Market Return = rm

.
Efficient Portfolio

Risk Free
Return = rf
Risk

Security Market Line II

Return

Market Return = rm

.
Efficient Portfolio

Risk Free
Return = rf

1.0

BETA

Security Market Line III

Return

SML

rf
1.0

SML Equation = rf + B ( rm - rf )

BETA

Capital Asset Pricing Model (CAPM)

Expected return

Security market line

Market portfolio rate
Rm = 13.5%

Rf = 5%
Treasury bill rate

R = rf + B ( rm - rf )

Beta

Beta vs. Average Risk Premium

Avg Risk Premium
30 1966-91

20

SML

Investors
10

Market
Portfolio

0
1.0

Portfolio Beta

Consumption Betas vs. Market Betas

Stocks
(and other risky assets)

Stocks
(and other risky assets)
Wealth is uncertain

Market risk
makes wealth
uncertain.

Wealth = market
portfolio

Standard
CAPM

Consumption

Wealth
Consumption is uncertain

Consumption

CAPM

Arbitrage Pricing Theory

Alternative to CAPM
Expected Risk
Premium = r - rf
= Bfactor1(rfactor1 - rf) + Bf2(rf2 - rf) +
Return = a + bfactor1(rfactor1) + bf2(rf2) +

Portfolio Risk
Specific company return (%)

Market return (%)

Capital Structure & COC

Expected Returns and Betas prior to refinancing
Expected
return (%)

20

Requity= 15
Rassets= 12.2
Rdebt= 8

0
0

0.2

0.8

Bdebt

Bassets

1.2

Bequity

Residual Income & EVA

Residual Income or EVA = Net Dollar return after

deducting the cost of capital.
EVA Residual Income
Income earned - Income required
Income earned - Cost of Capital Investment

Economic Profit

Economic Profit = capital invested multiplied by the spread

between return on investment and the cost of capital.
EP Economic Profit
( ROI r ) Capital Invested

Accounting Measurement

INCOME

RETURN

ECONOMIC

ACCOUNTING

Cash flow +

Cash flow +

change in PV =

change in book value =

Cash flow -

Cash flow -

economic depreciation

accounting depreciation

Economic income

Accounting income

PV at start of year

BV at start of year

M&M Proposition
r
rE

rA

rD
Risk free
debt

Risky
debt

D
E

WACC (traditional and M&M view)

r

r
rE

rE
WACC

rE =WACC
rD
D
V

rD
D
V

r
rE
WACC
rD

D
V

Financial Distress

Maximum value of firm

Costs of
financial distress
PV of interest
tax shields

Value of levered firm

Value of
unlevered
firm

Debt

Optimal amount
of debt

Call Option (long)

Call option value

Call option value given a $85 exercise price.

$20

85

Share Price

105

Put Option (long)

Put option value

Put option value given a $85 exercise price.

$5
80 85
Share Price

Call Option (short)

Call option $ payoff

Call option payoff (to seller) given a $85 exercise price.

85
Share Price

Put Option (short)

Put option $ payoff

Put option payoff (to seller) given a $85 exercise price.

85
Share Price

Protective Put
Long stock and long put
Long Stock
Position Value

Protective Put

Long Put
Share Price

Straddle

Position Value

Long call and long put

- Strategy for profiting from high volatility

Straddle

Share Price

Black-Scholes Option Pricing Model

ln
(d1) =

Ps
S

+ (r +

v2
2

)t

N(d1)=

32

34

36

38

40

Binomial vs. Black Scholes

Expanding the binomial model to allow
more possible price changes

1 step

2 steps

4 steps

(2 outcomes)

(3 outcomes)

(5 outcomes)

etc. etc.

Straight Bond vs. Callable Bond

Value of
bond

Straight bond

100

Bond Callable
at 100

75

50
25
Value of
straight bond
25

50

75

100

125

150

Exchange Rate Relationship

1 + rforeign
1 + r$

equals

equals

1 + i foreign
1 + i$
equals

f foreign

/$

S foreign

/$

equals

E(sforeign / $)
S foreign / $

Leverage Ratios I

Long term debt ratio

Debt equity ratio =

long term debt

long term debt + equity

long term debt + value of leases

equity

Leverage Ratios II

Total debt ratio

total assets

Times interest earned

Cash coverage ratio

total liabilities

EBIT
interest payments

EBIT

+ depreciation

interest payments

Liquidity Ratios I

Net working capital

to total assets ratio

Current ratio

net working capital

total assets

current assets
current liabilities

Liquidity Ratios II

Quick ratio

cash

current liabilities

Cash ratio

Interval measure

+ marketable securities + receivables

cash

+ marketable securities
current liabilities

cash + marketable securities

+ receivables

average daily expenditures from operations

Efficiency Ratios I

Asset turnover ratio

sales
average total assets

sales
NWC turnover

average net working capital

Efficiency Ratios II

Inventory turnover ratio

Days' sales in inventory

average inventory

average inventory

Average collection period

cost of goods sold

cost of goods sold / 365

average receivables
average daily sales

Profitability Ratios I

Net profit margin

Return on assets

Return on equity

EBIT - tax
sales

EBIT

- tax

average total assets

earnings available for common stock

average equity

Profitability Ratios II

Payout ratio

Plowback ratio

=
=

Growth in equity from plowback

dividends
earnings

earnings - dividends
earnings
1 - payout ratio

earnings - dividends
earnings

Market Value Ratios I

PE Ratio

Forecasted PE ratio

Dividend yield

stock price
earnings per share

0
=
aveEPS
1

Div 1
EPS
1

dividend per share

stock price

1
r - g

Market Value Ratios II

Price per share

Market to book ratio

Tobins Q

P
0

Div

1
r - g

stock price
book value per share

market value of assets

estimated replcement cost

Du Pont System I

ROA

sales
assets

asset
turnover

EBIT

sales

profit
margin

taxes

Du Pont System II

ROE =

assets
equity

sales
assets

leverage
asset
ratio
turnover

EBIT - taxes
sales

profit
margin

EBIT - taxes - interest

EBIT - taxes

debt
burden

Firms Cumulative Capital Requirement

Dollars

A
B
C
Cumulative capital
requirement

Year 1
Strategy A:
Strategy B:
Strategy C:

Year 2

Time

A permanent cash surplus

Short-term lender for part of year and borrower for remainder
A permanent short-term borrower

Working Capital
Simple Cycle of operations
Cash

Raw materials
inventory

Receivables

Finished goods
inventory

Inventories & Cash Balances I

Total costs
Carrying costs

Total order costs

Optimal
order size

Order size

Inventories & Cash Balances II

Cash balance
($000)
25

Average
inventory

12.5

Value of bills sold = Q =

2 x annual cash disbursement x cost per sale
interest rate

Weeks

Private Equity Partnership

Investment Phase

Payout Phase

General Partner put up 1%

of capital

General Partner get carried

interest in 20% of profits

Mgmt fees
Limited partners
put in 99% of
capital

Partnership

Partnership

Company 1
Investment in
diversified
portfolio of
companies

Company 2

Company N

Sale or IPO of
companies

Limited partners
get investment
back, then 80%
of profits

Increase in the Cash Flows from Assets

Debtholders
They have fixed claims on
these cash flows

Assets

Cash flows form assets

Shareholders
They have residual claims on
these cash flows so that the
larger the cash flows, the
more value created

A Simplified View of the Financial

Accounting Process

The firm

Financial transactions

The rest
of the world

Financial accounting process

The balance sheet

Records assets and liabilities
at the date of the balance sheet.
Their difference is the book value
of equity at that date.

The income statement

Records revenues and expenses
over a period of time. Their
difference, which represents an
increase or a decrease in the book
value of equity, is the profit or
loss for the period.

Sources of Risk That Increase Profit

Volatility

Economic conditions
Political & social environment

+ 31%
+ 26%
+ 10%
Less variable
Earnings
and
before interest
fixed
and taxes
expenses

SALES
- 10%

Less fixed
interest
expenses
and variable
tax expenses

Earnings
after taxes

- 26%

Market structure
Firms competitive position

ECONOMIC RISK

- 31%

OPERATIONAL RISK

BUSINESS RISK

FINANCIAL RISK

The Link Between the Balance Sheets

and the Income Statement
Balance Sheet
December 31, 2001

Assets
$170

Income Statement
Year 2002

Liabilities
$100

Balance Sheet
December 31, 2002

Assets
$190

Owners equity
$70
Revenues
$480

Expenses
$469.8

Liabilities
$113
Owners equity
$77

Net Profit
$10.2
Retained earnings
$7
Dividends
$3.2

The Managerial Balance Sheet Versus

the Standard Balance Sheet
The Managerial Balance Sheet
Invested capital
or net assets
Cash

Capital employed

Short-term debt

Working capital
requirement
(WCR)
Operating assets
less
Operating liabilities

The Standard Balance Sheet

Total assets
Cash

Short-term debt

Operating assets

Long-term financing

Accounts receivable
plus
Inventories
plus
Prepaid expenses

Long-term debt
plus
Owners equity

Net fixed assets

Liabilities
and owners equity

Operating liabilities
Accounts payable
plus
Accrued expenses

Long-term financing
Net fixed assets

Long-term debt
plus
Owners equity

The Firms Operating Cycle and Its

Impact on the Firms Balance Sheet

Cash

Payments for nonoperating

activities

Impact on the balance sheet:

Accounts receivable
Finished goods inventory

Impact on the balance sheet:

Sales

Procurement

Production
Impact on the balance sheet:
Raw materials inventory
Work in progress inventory
Finished goods inventory

Accounts payable
Raw material inventory

Sources of cash inflow

Sources of Cash Inflow and Cash Outflow

Operating activities
Sale of goods and services

Investing activities
Sale of fixed assets
Sale of long-term financial assets
Collection of interest and
dividend income
Collection of loans mad

Financial activities
Issuance of stocks and bonds
Long-term borrowings
Short-term borrowings

$2
$472

$13

CASH
$18.2

Sources of cash outflow

$460.8
$12

Operating activities

Investing activities

Financial activities

Purchase of supplies
Selling, general, and administrative
expenses
Tax expense

Capital expenditures and

acquisitions
Long-term financial investments

Repurchase of stocks and bonds

Repayment of long-term debt
Repayment of short-term debt
Interest payment
Dividend payment

Net cash flow from operating

activities
$11.2

New cash flow from investing

activities
($10)

New cash flow from financing

activities
($5.2)

The Drivers of Return on Equity

Return on equity
Earnings after tax
ROE = Owners equity

Return on invested capital

ROIC =

Earnings before interest and tax

Invested capital

Financial leverage multiplier

Operating profit margin

Capital turnover

Financial structure ratio

Earnings before interest and tax

Sales

Sales
Invested capital

Invested capital
Owners equity

Invested capital

Owners equity

Sales
Operating costs

Cash
Working Capital
requirement
Fixed assets

Financial cost ratio

Tax effects

Tax effect ratio

Earnings before tax

Earnings after tax
Earnings before interest and tax Earnings before tax

Cost of debt

Tax rate

The Financial System

Intermediation via
institutional investors
S
U
P
P
L
I
E
R
S

Insurance policies
Retirement plans
Shares in funds

CASH

Insurance companies, pension funds,

Investment funds & venture capitalists
CASH

CASH
SHARES

CASH
BONDS

Money Market
Instruments

CASH

The equity market

SHARES

(Trading in shares of common stocks)

CASH

The corporate market

BONDS

(Trading in corporate bonds)

OF

CASH

The money market

F
U
N
D
S

Commercial
paper

(Trading in money market instruments)

CASH

PRIVATE
PLACEMENT

CASH
SHARES
CASH
BONDS
CASH
Commercial
paper

Bank certificates
of deposit (CD)

BANK
DEPOSITS

Intermediation via
banks

DEBT OWED
TO BANKS

CASH

and other lending institutions

CASH

F
I
R
M
S

Alternative Equity Valuation Models

Market multiples model

Dividend valuation model

Firms earnings, cash

flows, or book value
multiplied by the
Corresponding
market multiple

Discounted cash flow model

Firms earnings, cash

flows, or book value
discounted at the

Future expected
dividends

Equity
value

discounted at the
Cost of equity

equals
Present value
of debt
less the

Adjusted present value model

Cash flows
from assets
Unlevered
asset value

discounted at the
Unlevered
cost of equity

Levered
asset value

Corresponding
market multiple

Tax
savings
Present value
of tax savings

discounted at the
Cost of debt

The Drivers of Value Creation

EBIT
Operating margin = Sales
Sales
Capital turnover = Invested capital

EBIT
Invested capital
(pretax ROIC)
Expected after tax
ROIC

Tax effect = (1 Taxe rate)

Aftertax cost of debt
Estimated cost of equity

Percent of
debt financing

Percent of
equity financing

Return spread
(ROIC WACC)
Weighted average
cost of capital
WACC

Competitive advantages and

core competencies
EBIT = Earnings before interest and taxes (operating profit before tax);
Invested capital = Cash + Working capital requirement + net fixed assets;
WACC = (%Debt)(After tax cost of debt) + (%Equity)(Cost of equity).

If the present value of the future stream of

expected return spreads is positive, MVA is
positive and the higher the growth, the more
value created.
If the present value of the future stream of
expected return spreads is negative, MVA is
negative and the higher the growth, the more
value destroyed.

Economic, political, and

social environments
Market structure

Market Value Added (MVA)

Sustainability
of growth

Capital-Budgeting Simulation
Step 1: Develop probability distributions for key factors.

Probability

Step 2: Randomly select values from these distributions.

Market
size

Selling
price

Fixed
costs

Market
growth
rate

Investment
required

Residual
value of
investment

Share
of market

Operating
costs

Useful life
of facilities

Value range

Step 3: Combine these factors and determine a net present value.

Probability

Step 4: Continue to repeat this process until a clear portrait of

the results is obtained.

Net present value

Step 5: Evaluate the resultant probability distribution.

Cash Flow Diagram

Supplies
and
materials
purchased
using trade
credit
Suppliers

Payments
for credit
purchases
Cash
dividends

Saleable
product
(inventory)

Payment
for fixed
asset
purchases

Payment
for wages
and salaries

Cash

Proceeds from
sale or issuance
of stock

Credit sales
(accounts
receivable)

Bad
debts

Payment
for heat
and power

Cash
sales

Collections
from
credit
sales

Payment
of taxes

Proceeds from
sale or issuance
of notes and
bonds
Interest
and
principal

Stockholders

Creditors

Government

Aggressive Financing Strategy:

Permanent Reliance on Short-Term
Financing
Permanent dependence
on short-term financing

DOLLAR
AMOUNT

Temporary (short-term)
financing

Permanent
current assets
Current
assets

Permanent plus
spontaneous financing

Fixed
assets

TIME

Cash and Marketable Securities

Management
Irregular cash inflows
Bond sales
Other debt contracts
Preferred stock sales
Common stock sales
In

Irregular outflows
Dividends
Interest
Principal on
debt
Share repurchase
Taxes

Out

Cash
balance
Purchase

Fixed assets

Sale

Purchase

Marketable
securities

Sale

Labor and material

Depreciation

Inventory

Cash sales

Credit
sales

Receivables

Collections

Three Ways to Transfer Financial Capital

in the Economy
(1)

(2)

(3)

Direct transfer
of funds

Indirect transfer
using the investment
banker

Indirect transfer
using the financial
intermediary

The business
firm (a savings
deficit unit)

The business
firm (a savings
deficit unit)

The business
firm (a savings
deficit unit)

Securities

Firms
securities
(stocks,
bonds)

Funds
(dollars of
savings)

Marketable
securities

Securities

Savers
(savings
surplus units)

Funds

Funds

Savers
(savings
surplus units)

Firms
securities

Funds

Marketable
securities
Intermediarys
securities

Funds

Savers
(savings
surplus units)

Key Metrics Required for Different

Company Situations
High

Need for long-term view

High probability of significant change of
- Technology
- Regulation
- Competition
Long life of investments
Complexity of business portfolio

Low

Growth of
net
income

Multiyear
DCF of
economic
profit

Operating
value drivers
Net
income,
return on
sales

ROIC-WACC,
economic
profit (one year)

Low

High

Capital intensity (need for

balance sheet focus)
Working capital
Property, plant, and equipment

Various Levels of Value Driver

Identification
LEVEL 1

Margin
Margin
Invested
capital
ROIC

LEVEL 2

LEVEL 3

Examples

Examples

Customer mix
Sales force
productivity
(expense:
revenue)

Percent
accounts
revolving
Dollars per
visit
Unit revenues

Fixed cost/
allocations
Capacity
management
Operational
yield

Billable hours
to total payroll
hours
Percent capacity
utilized
Cost per
delivery

Margin
Invested
capital

Generic

Accounts
receivable
terms & timing
Accounts
payable terms
& timing

Invested
capital

Business-unit
specific

Operating
value drivers

Customer Servicing Human Expense

Flowchart
Call volume
Personal
cost

Service
Delivery
Center
expense
Total
CShuman
expense

Number of
SDCs

Cost per SDC

Regional
center
expenses

Station
cost

Cost per person

Average work
time per call

Number of
stations per SDC

Hourly rate
Benefits

Equipment,
maintenance
experse per
station

Annual salary

Other equipment
expense

Span of control

Benefits

Number of employees
Salary expense
Supervisory
cost

Area staff
center
expense
Allocated
G&A

Percent occupancy

Equipment
cost per station

Headquaters
expense
Overhead
expense

Number of
people

Overhead
cost

Utilities
Number of
supervisors

Other

Building operating
expense

Number of employees

Building
maintanance
expense

Equipment
Materials
Other

% time on board
% time in training
% time on breaks
% time on vacation
% time paid
Absence/other

Six Conditions for Excellent Value-Based

Management
Performance
Driven
5
4
Low cost

3
2

Value-based
Highest level

Good
Medium
Sup par
Lowest

Strong
self-reinforcement
process

Managed
bottom up
as well as
top down
Two-way
communications

Simple Entity Valuation of a SingleBusiness Company

Operating
free cash flow130
70

Debt
value

69
36

150 160

100

Cash flow
to debtholders
20

Operating
value

90

140

74

80

85

43

Cash flow
to equity owners
Equity
value
50

54

57

61

66

70

75

Entity Valuation of a Multibusiness

Company
1,750
Excess
marketable
securities

150

Unit D

200

250

Corporate
overhead

Market value:
300

Unit C

300

Unit B

400

100

1,500
1,100

Unit A

700

Total value
before
subtracting
corporate
overhead

Total
company
value

Common
equity
value

Of debt
Of preferred stock

Steps in Valuation
(1)
Analyze
historical
performance

Calculate NOPLAT and invested capital

Calculate value drivers
Develop an integrated historical perspective
Analyze financial health

(2)
Forecast
performance

Understand strategic position

Develop performance scenarios
Forecast individual line items
Check overall forecast for reasonableness

(3)
Estimate
cost of capital

Develop target market value weights

Estimate cost of noequity financing
Estimate cost of equity financing

(4)
Estimate
continuing
value
(5)
Calculate
and interpret
results

Select appropriate technique

Select forecast horizon
Estimate the parameters
Discount continuing value to present
Calculate and test results
Interpret results within decision context

Business System Analysis

Product
Design and
Development
Issues Product
attributes
Quality
Time to
market
Proprietary
technology

Procurement

Access to
sources
Costs
Outsourcing

Manufacturing

Costs
Cycle time
Quality

Marketing

Pricing
Advertising/
promotion
Packaging
Brands

Sales and
Distribution
Sales
effectiveness
Costs
Channels
Transportation

Structure-Conduct-Performance Model

Industry

External
Shocks

Producers

STRUCTURE

CONDUCT

Feedback

PERFORMANCE

Feedback

Cooperation vs. Rivalry

Rates of Return Implied by Alternative

Continuing-Value Formulas
Average ROIC
CV =

NOPLAT
WACC - g

CV =

NOPLAT
WACC

Aggressive
formula

Convergence
formula

WACC

Forecast
period

Continuing-value period

Time

Impact of Continuing-Value Assumptions

g = 8%

$3,000

$2,000
g = 6%
CONTINUING
VALUE ($)

g = 4%
g = 2%
g = 0%

$1,000

0
10%

12

14

16

18

RETURN ON NET NEW INVESTED CAPITAL

20

Relative Positions of Selected Industries

Along Continuing-Value Parameters
> Inflation

Growing

Entertainment
Sporting
goods
Not economic

EARNINGS
GROWTH

Most Information Soft

firms processing drinks
= Inflation

CONSUMPTION

Tobacco
Not economic
Defense
Steel
< Inflation

Declining
= WACC

< WACC

> WACC

RETURN ON NEW CAPITAL

Factors
affecting
returns

Low
Many
Short
High

Entry costs
Substitutes
Life cycle
Price elasticity

High
Few
Long
Low

A Forecast Period that Will Result in a

Poor Valuation of a Cyclical Business
NOPLAT

Date of
valuation
TIME

End of
forecast period

Risk/Return Trade-Offs of Hedging

Programs
E (Return)

E (Return)
A

Beta
unchanged
A

Rf

B
Beta
decreased
Total risk

Rf

Beta
unchanged

Beta
decreased

Beta (undiversifiable risk)

Framework for Evaluating the Value of an

Acquisition

Standalone
value of
acquiror
(pre-merger)

Stand-alone
value of
target
(without
any
takeover
premium)

Value
Transaction
of
costs
synergies

Combined
value

Value of
next best
alternative

Value of
target to
acquiror

Price paid
including
premium

Net value
gained
from
acquisition

Patent Valuation: DCF Method Overview

Value (NPV) of technology/project/product

NPV = Estimation of present value of a

business using discounted cash flows
Maximal value of technology =
NPV x Max Protection Factor

Value of patents =
NPV x Pfmax x PPF

Max Protection Factor = Empirical

factor indicating maximal impact of
patents on NPV

Patent Protection Factor = Measure of

the quality of the patent protection

Patent Valuation: Maximal Protection

Factor
Maximal
Protection
Factor

30%
Empirical curve

5%

Technology
under R&D

Mature
Technology

Age of
Technology

Patent-Value = Maximal-Protection-Factor x Patent-Protection-Factor x NPVtec

Pval = Pmax x PPF x NPVtec

Acquisition of Real Options

High

Big bets

Alliance
leverage

Low

Entry
stakes

Risk
pooling

LEVEL OF INVESTMENT
(OPTION PRICE)

Internal

External

SOURCE OF OPTIONS

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