investment management 24 th november 2009. page 2 topics to be covered weighted average cost of...

Investment Management

24th November 2009

Topics to be covered

Weighted average cost of capital (WACC)

Ratios

Multiple Factor Model

Security analysis

Equity share valuation

Weighted Average Cost of Capital (WACC)

How do firms estimate the cost for raising money? By calculating Weighted Average Cost of Capital (WACC) WACC is the risk adjusted discount rate that is used to

evaluate investment opportunities

Definition: A calculation of the overall cost of capital used by an

enterprise, made by totalling the cost of each source of capital used multiplied by its proportional share of the total capital used

What do investors expect?

Holders of Equity and debt expect positive returns

In case of debt the required rate of return is Explicit and easy to find because required rate of return on debt is nothing but interest charged by debt holder to company

In case of equity the required rate of return is Implicit because it has combination of growth and earnings (dividends and capital gains), so it is difficult to calculate required rate of return on equity

WACC

WACC = Ke (% of equity)+Kp (% of pref.)+Kd (1-t) (%of debt)

where,

Ke = Cost of equity

Kp = Cost of preference share

Kd = Cost of debt

t = corporate tax rate

% represents fraction of total capital invested in each component and it should total to 100%

Example: Pantaloon Retail

Following is the data related to Pantaloon Retail Proportions of various sources in total capital Equity = 0.60, Debt = 0.30, Preference shares = 0.10 The cost of each financing option is as follows: Equity 15%, Debt 12%, Preference 10% Tax rate is 30% Find out WACC for pantaloon.

WACC= Ke (% of equity)+Kp (% of pref.)+Kd (1-t) (%of debt)

= 15% (0.60) + 10% (0.10) + 12% (1-0.30) (0.30)

= 12.52%

RATIOS

Ratios

Ratios

Ratio Analysis: One of the techniques of financial analysis where ratios are

used as a yardstick for evaluating the financial condition and performance of a firm

Ratio Notations : Times Percentage

Classification Ratios

Profit and Loss Account Ratio: Ratios calculated or the basis of the item of title Profit and

Loss account only, e.g. gross profit ratio, stock turnover ratio, etc.

Balance Sheet Ratio: Ratios calculated on the basis of the figures of Balance

Sheet only, e.g. current ratio, debt-equity ratio, etc.

Composite Ratio or Inter-statement Ratio: Ratios based on figures Profit and Loss account as well as

the Balance Sheet, e.g. fixed asset turnover ratio, overall profitability ratio, etc.

Categories of Ratios

Liquidity or Working Capital Ratio

(i) Current Ratio

(ij) Liquidity Ratio

(iii) Net Working Capital/ Net Sales

(iv) Net Working Capital/ Bank Credit

Assets Utilization Ratio

(i) Net Sales/ Total Capital employed

(ii) Net Sales/ Fixed Assets

(iii) Net Sales/ Current Assets


Profitability Ratios:

(i) Operating Ratio

(ii) Net Profit Ratio

(iii) Gross Profit Ratio

(iv) ROI (Return on Investment)

(v) EPS (Earning per share)

Appropriation Ratios:

(i) Depreciation Provision/ Gross Block

(ii) Depreciation Provision/ Net Block

(iii) Tax Provision/ Pre-tax Profit


Capitalization Ratios:

(i) Pref. Capital + Debentures/ Equity Capital

(ii) Debentures/ Net Worth + Debentures

(iii) Preference Capital/ Net Worth + Debentures

(iv) Equity Capital + Reserves/ Net Worth + Debentures

Coverage of Senior Charges:

(i) Fixed Interest Cover

(ii) Fixed Dividend Cover


Financial Stability Ratios:

(i) Net Worth/ Total Outside Liabilities

(ii) Net Worth/ Debt

(iii) Net Worth/ Institutional Borrowings

(iv) Net Worth/ Bank Credit

(v) Net Worth/ Other Liabilities

(vi) Net Worth/ Fixed Assets

(vii) Net Worth + Term Liabilities/ Fixed Assets + Misc. Assets

(viii) Net Worth/ Net Sales

Advantage and Limitation of Ratios

Advantages: Simplifies Financial Statements Facilitates Inter-firm Comparison Makes Intra-firm Comparison possible Helps in Planning Success or failure

Limitations: Comparative Study Required Limitations of Financial Statements Ratios alone are not adequate Window Dressing Problems of Price Level Changes No Fixed Standards

MULTIPLE FACTOR ANALYSIS

Multiple Factor Analysis

Multiple Factor Analysis

Exploratory Factor Analysis:

Exploratory factor analysis (EFA) can be described as orderly simplification of interrelated measures

EFA traditionally, has been used to explore the possible underlying factor structure of a set of observed variables without imposing a preconceived structure on the outcome (Child, 1990). By performing EFA, the underlying factor structure is identified

Confirmatory factor analysis (CFA): CFT is a statistical technique used to verify the factor structure of a set

of observed variables

CFA allows the researcher to test the hypothesis that a relationship between observed variables and their underlying latent constructs exists. The researcher uses knowledge of the theory, empirical research, or both, postulates the relationship pattern a priori and then tests the hypothesis statistically

Portfolio Theory

Modern Portfolio Theory introduced the idea of diversification as a tool to lower the risk of the entire portfolio without giving up high returns

Diversification: A risk management technique that mixes a wide variety of investments within a portfolio. The rationale behind this technique contends that a portfolio of different kinds of investments will, on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio

Asset Allocation: Asset is the strategy an investor uses to distribute his or her

investments among various classes of investment vehicles like:» Equities» Fixed-income» Cash and equivalents » Real estate» Commodities

Security Analysis

Meaning: About valuing the assets, debt, warrants, and equity of companies from

the perspective of outside investors using publicly available information

There are mainly two types of values:

Equity Value and Enterprise Value

Basic accounting equation states that: Assets = Net Liabilities + Equity

Main valuation methods use to value enterprise are: Value the cash flow to equity Value the cash flow to the enterprise

Free Cash Flow (FCF)

Calculated by starting with the profits after taxes, then adding back depreciation that reduced earnings even though it was not a cash outflow, then adding back after-tax interest (since we are interested in the cash flow from operations), and adding back any non-cash decrease in net working capital (NWC) and capital expenditures

FCF = PAT+ NCC+ Interest (1-t) +- Change in working capital-capex

Free Cash Flow Calculation

Revenues

less Expenses

= Earnings before interest, taxes, depreciation and amortization (EBITDA)

less Depreciation and amortization

= Earnings before interest and taxes

less Taxes

= Net Operating Profit after tax (PAT)

Add back depreciation and amortization

less Capital Expenditures

less New Net Working Capital

= Free Cash Flow

Leverage VL is value of Levered firm and VU is value of unlevered firm VL = VU + tcD, Where tc = marginal corporate tax rate After-tax income = ( debt income ) (1 – td )

For equity holders, After-tax income = ( equity income )( 1 – tc )( 1 – te )

The relative advantage (if any) of equity to debt can be expressed as: Relative Advantage (RA) = ( 1 – tc )( 1 – te ) / ( 1 – td ) RA > 1 signifies a relative advantage for equity financing RA < 1 signifies a relative advantage for debt financing One can define T as the net advantage of debt: T = 1 – RA For T positive, there is a net advantage from using debt; for T negative there is a

net disadvantage Empirical evidence suggests that T is small; in equilibrium T = 0. This is known

as Miller's equilibrium and implies that the capital structure does not affect enterprise value (though it can affect equity value, even if T=0)

SHARE VALUATION

Share Valuation

Objectives of Share Valuation

In the time of disposition of the share by the shareholders

When a private company wishes to go to public by

obtaining a stock exchange quotation

When there some companies which have a proposal for

merges or takeover involving private company

The objective is to have a basis for levying relevant taxes,

i.e. capital gains, capital transfer tax, stamp duty, etc.

Bases of Share Valuation

Income based valuation Dividend Income Total income: Dividend + capital gains Dividend income + (Ending share price - begaining share price)

Begaining share price

Book value based valuation BV per Share = (Total Assets - Total Liabilities)/# com stock

shares

Discounted cash flow method

Types of Analysis

Fundamental Analysis A method of security valuation which involves examining the

company's financials and operations, especially sales, earnings, growth potential, assets, debt, management, products, and competition

Technical Analysis Technical analysis is a security analysis discipline for forecasting the future

direction of prices through the study of past market data

It is based on market action through chart study, moving averages, volume, open interest, formations and other technical indicators

Fundamental analysis takes into consideration only those variables that are directly related to the company itself, rather than the overall state of the market or technical analysis data

Process of Fundamental Analysis

Top down approach

Economic Forecast: forecast of future interest rate, inflation, growth rate etc.

Industry analysis: entry barriers, growth rate, competition

Company analysis: Business plan

Management

Financial analysis

The final valuation will consider all the above factors together.

Technical Analysis

The field of technical analysis is based on three assumptions:

1. The market discounts everything

2. Price moves in trends

3. History tends to repeat itself

Support and Resistance These support and resistance levels are seen as important in terms of market

psychology and supply and demand Support and resistance levels are the levels at which a lot of traders are willing

to buy the stock (in the case of a support) or sell it (in the case of resistance) When these trend lines are broken, the supply and demand and the psychology

behind the stock's movements is thought to have shifted, in which case new levels of support and resistance will likely be established

Technical Analysis

Trends: In any given chart, you will probably notice that prices do

not tend to move in a straight line in any direction, but rather in a series of highs and lows. In technical analysis, it is the movement of the highs and lows that constitutes a trend

There are two types of trends: Uptrend: When every peak is higher then previous peak Down trends: when every trough is lower then previous

trough

Chart

A chart is simply a graphical representation of a series of prices over a set time frame. For example, a chart may show a stock's price movement over a one-year period, where each point on the graph represents the closing price for each day the stock is traded

The main types of charts are: Line chart Bar Chart Candlestick Charts Point and Figure Charts

Types of Charts

Line Chart Bar Charts

Candlestick Charts Point and Figure Charts

Thank You !

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