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Definitions of the formulas with explanations

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FCF (Free Cash Flows) - The cash that is actually available to distribute to investors after the

company has made all investments in working capital and fixed assets necessary to sustain ongoing

business operations. You would see this as dividends in a cash flow statement.

DCF (Discounted Cash Flows) - A way of measuring the intrinsic value of a company, (or asset or

project proposal), It's purpose is to figure out the company value now based upon projections of all the

cash it could potentially make available to investors in the future. The purpose of "discounting" is to take

into consideration the time value of money.

The expected return of a stock consists of it's dividend yield, (dividends paid to the stockholder

expressed as a % of the share price - ex: Apple has a dividend yield of 1.8%), and it's price

appreciation, (EX: I bought it for $10/share and I expect it to appreciate to $11/share - 10%) is

related to risk.

In the above definition/example, the expected return of this stock would be 1.8% + 10% = 11.8%

Risk averse investors must be compensated with higher returns in proportion to the higher risk

they bear. In other words, the higher the risk, the higher the expected return. One source of risk

for an investor is in the capital structure of the company - the debt portion. Investors must have a

means by which to measure this risk associated with financial leverage (debt) and it's impact on

the cost of equity capital, (in other words - what's the increase in debt going to cost the

stockholders)

With an increase in debt to the firm's capital structure comes an increase in the risk borne by it's

shareholders. The risk of financial distress increases with an increase in debt. A secondary

source, (or ripple effect), of risk is the effect this financial leverage has on the volatility of the

stock price/shareholder's returns. Additionally, if the firm has higher fixed expenses, then the

resulting volatility of the increase in debt will be even more evident in their operating cash flows.

In order for investors to bear the risk associated with increased financial leverage of the firm,

they must be compensated - this is the risk premium. Therefore, we can think of the the expected

return on the company's stock to look like this:

Expected Return = risk free rate + risk premium

*Note: On your Forecasting Models Worksheet - this is what Model #3 is trying to

communicate. The first part of the equation: rf is the "risk free rate" - the rate associated with

Treasury Bond yield. What this is being added to, the second part of the equation that includes

beta is the "risk premium" - your worksheet gives it as the market risk premium = 6%.

https://youtu.be/77ivvN2Uk28

Part 2 is applied to a real firm.

https://youtu.be/ijpPg8eAhv4

Hi Class,

I hope you find this attachment helpful. I break down each of the formulas and valuation

definitions on your worksheet that we will be completing this Tuesday. Remember, this

worksheet is "conceptual" in nature, so the questions are looking to see your understanding of the

formulas. No calculations are being done for the worksheet. At the bottom of the attachment,

I've included some links for some basic videos on investopedia.com to exemplify understanding.

Worksheet and Milestone 2

Weighted Average Cost of Capital, (WAAC): (Related to Question 1 on your

Forecasting Worksheet); A Company needs to invest in assets in order to generate

revenue. In order to do this, the firm will raise equity capital through stock issuance

and/or incur debt through Bond Issuance, bank loans, and other financing

arrangements. The WAAC is the relative portion of debt and equity used by the firm

to invest in assets to the firms overall capital structure. This is the minimum rate

of return the firm must receive for its investments. An increase in any input here,

such as increase in debt or increase in the cost of debt, will increase this rate, as

well as the firms beta, and will reduce the intrinsic value of the firm.

For Example: Firm A has Debt, (this can be from bond issuance or LT debt such as

bank loans), as 40% of their capital structure and 60% Equity Ownership, (capital

provided by stock issuance). Also assume Firm As cost of debt is 6% and cost of

equity ownership, (rate of return to stockholders), of 5%.

The proportion, (or weighted average), of debt is then Debt .40 & Equity .60. We

then multiply the weighted average by the cost and add them together.

Debt = .40 x 6% + Equity .60 x 5% = 2.4% + 3% = 5.4%.

Now assume an increase in the cost of debt to 8%. This would cause an increase in

the WAAC from 5.4% to 6.2%.

If we assume an increase of the cost of debt to 8% and an increase in the amount of

debt, (increase in proportion to the overall capital structure), from 40% to 50%.

Debt weight = .50 and Equity weight = .50

This would increase the WAAC to 6.5%.

Capital Asset Pricing Model, (CAPM): (Related to Question 3 on your

Forecasting Worksheet);

An idealized representation of how capital markets price securities, (aka: stock

prices), and therefore calculate expected returns. The CAPM relates systemic risk,

(risk related to the firm), with expected return. The article also refers to this as the

Industry Cost of Equity. Because CAPM represents the risk/return tradeoff in the

market, it can be used to determine the impact of increased financial leverage on

the stock price of the firm. An impact on the stock price of the firm has an impact

bearing the increased risk.

see that the expected return is equivalent to the risk free rate added to the market

premium as it relates to the firms beta. Therefore, as we see above in the WAAC

description, that an increase in an input here results in an increase in the WAAC

rate, which therefore increases the risk of the firm increasing the firms beta. When

the firms beta increases, we relate it to the market premium required by investors

for bearing risk beyond the risk free rate in the CAPM, and we can measure the

increase in systemic risk, that is, that risk related directly to the firm within the

industry in which it operates.

Risk Free Rate: (Intermediate rate of return on Treasury Bonds historical yield on

treasury bills) / Rate of return on Treasury Bills

Market Risk Premium: The premium required by investors for accepting risk

above and beyond the risk free rate.

Abnormal Earnings Model: (See question 2 on your Forecasting Worksheet);

Also known as the Residual Earnings Model. To understand this model, lets first

understand the difference between the Book Value of the firm and the Market

Value of the firm. The book value of the firm is an accounting value. Broadly

stated, it is calculated from the firms balance sheet as follows: Assets Liabilities =

Equity, (Book Value). What this is saying is the Equity section of the balance sheet

is effectively the book value of the firm.

The market value of the firm is the valuation of the firms stock price by the market.

Effectively the stock price.

If the book value of the firm is lower than the market value of the firm, then the firm

is valued higher than its stated value, which is good for investors. If the book value

of the firm is greater than the market value, then the market is valuing the firm for

less than its stated value, which is not good for investors. In other words, the

market doesnt believe or have faith that the firm can generate the cash flow and

profits required by investors.

Conceptually, every stock is worth the book value per share if an investor expects to

receive a normal rate of return. A rate of return that is unexpected will cause a

deviation in the firms stock price.

This deviation is typically attributed to

management whether they are over or under delivering profitability results based

upon their operation of the business. The Abnormal Earnings model attempts to

arrive at a real value of the stock based upon these deviations from the normal

return.

Now lets look at the model 3(b) formula on your worksheet. This is also known as

the clean surplus relation. This formula is calculating the Book Value for the firm

at the end of the period. Book Value at the end of the year, B t, is equal to the book

value of the firm at t-1, (which is the BV at the beginning of the period), plus the

earnings in year t less the dividends paid to stock holders.

Moving to model 3(a), we can evaluate the Abnormal Earnings, (AE). AE t = Xt-rEBt-1

Abnormal Earnings at time t, (end of the period), is equal to the earnings in year t,

(earnings at the end of the period) less the expected return on the Book Value at

time t-1 (meaning book value at the beginning of the period).

The result of this formula tells us the amount of earnings we can attribute to

management performance over or under the normal expected return.

Now looking to model 3, we see that the market value of the firm at F, (the forecast

period), is equal to the book value of the the firm at time F plus the sum of AE t

divided by (1+rE)t, (Abnormal Earnings at time t divided by 1 + the expected return

to the power of time t.)

http://www.investopedia.com/video/play/understanding-enterprise-value/

http://www.investopedia.com/video/play/compound-annual-growth-rate/

http://www.investopedia.com/video/play/return-on-equity/

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