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Definitions |
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SML(graphical representation):
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Security market line
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Chapter 6:
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Bond Valuation: describes the basic valuation model to bonds and the impact of required return and time to maturity on bond's value
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Chapter 3
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Ratio Analysis
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Equity
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Includes:
Common stock
Additional paid in capital
Retained Earnings
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Chapter 7
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Stock Valution: helps to understands how investors value corporate stocks
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Depreciation:
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MACRS:
Depreciation Expense = Cost × % determined by life
Straight Line:
Depreciation Expense = (Cost - Salvage) / Life period
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Chapter 9
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Cost of Capital
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Liquidity Ratios:
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Current Ratio
Quick Ratio
Average Collection Period
Account Receivable turnover
Inventory Turnover
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Quick Ratio:
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Current Assets - Inventory
_____________________________
Current Liabilities
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Diversification
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Spreading your investments in different assets to reduce the risk and this depends on the relation between the different assets in the portfolio. (correlation)
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Duration
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An index of price sensitivity.
Literally a weighted Average time to maturity.
Interpreted as the % change in price for 1% change in rates.
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Chapter 2
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Accounting and Financial Statement Review
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DuPont Decomposition
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= Net Profit Margin × Asset Turnover × Leverage Multiplier
= Net Income × Sales × Assets
Sales Assets Equity
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Assets
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Current Assets + Long Term Assets
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Returns
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Generally reported as an annualized percentage.
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Income Statement:
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Income statement describes the revenues and expenses associated with company's operations for a given period of time.
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Example of using the SML to identify overvalued and undervalued assets:
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In the CAPM , inflation shifts SML upward and risk aversion shifts SML downward.
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Terminal Cash Flows:
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Terminal Cash Flow
Realizable salvage Value
+/- Tax effects of capital gain/loss
+Recapture of Net Working Capital
= Terminal Cash Flow
Cash flow at the end of the life of the project:
Last year's differential cash flow + Terminal cash flow
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Total Risk
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Calculate the standard deviation of returns.
Greater SD means higher risk of security.
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Income Statement:
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Revenues
- Cost of Goods Sold
= Gross Profit
- Operating Expenses
= Earnings before Interest and Taxes (EBIT)
- Interest Expenses
= Earning before taxes (EBT )
- Tax Expenses
= Net Income
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Beta ß
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Measures the amount of systematic risk inherent in comparison with the market
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Retained Earnings:
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Money generated from the the operations of the company that is plowed back ( or retained ) in the business.
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Calculation of DCF:
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Calculated as: Or:
T
Vfirm = ∑ FCFFt / (1+ WACC)t
t=1
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The process of finding the present value of some future amount is often called:
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discounting PV= FV/(1+r)
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Unsystematic Risk
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A company's labor force goes on strike
A company's top management dies in a plane crash
An oil tank brusts and floods a company's production area
Business , financial risk (diversifiable) . Which mean we can decrease this risk by choosing the right combination of assets.
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Equity:
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Residual claim on the earnings and the assets of the company.
Residual claims are money that the company should pay back to the stock holders.
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Cost of Equity:
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Equity Risk Premium(Rerp) =
Exp. Return on Market(Rm) - Risk Free Rate(Rf)
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SML continued:
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(In previous graph) If we compare required returns to expected returns, investments A and B are undervalued and investments C and D are overvalued. Graphically, this means investments A and B plot above the security market line and investments C and D plot below the security market line
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Risks
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Market risk ( systematic risk) + Firm Systematic (or non- systematic risk)
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Examine Capacity Constraints
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Lowering the amount of assets deceases DFN
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Increase Net Margin:
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Higher earnings lead to more cash earning per dollar of sales and more cash retention
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Discretionary Financing Needed:
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= Projected Assets
- Projected Liabilities
- Projected Owner's Equity
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CAPM continue:
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The CAPM says that the expected return of a security or a portfolio equals the rate on a risk-free security plus a risk premium. If this expected return does not meet or beat the required return, then the investment should not be undertaken.
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Financing Leverage:
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Use of fixed cost sources of financing ( debt, preferred stock) rather than variable cost sources of financing ( common stock)
Firms with lots of fixed cost (debt) will have high financial leverage.
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Standard Deviation (σ )
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√ ∑ ( Ri - Rmean) 2 × Pi
where P represent possibility
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Junk Bonds:
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Bonds with a rating of BB or below.
More likely to default.
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Efficiency Ratios:
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Measure how well the company uses its assets to generate sales or profits.
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Net Present Value (NPV):
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The sum of the present values (PVs) of the individual cash flows. Sum of (CF/(1+r)^t )-initial investment
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Degree of Financial Leverage (DFL):
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DFL = EBIT/( EBIT -1)
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If you invest money today and you want it to grow for retirement, what process are you counting on?
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compounding
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What does a nonrevolving line of credit entail?
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Fixed-rate (non-adjustable) pre-arranged financing from a bank.
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Cost of Capital
Also referred as weighted cost of capital (WACC)
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Every company has a capital structure - a general understanding of what percentage of debt comes from retained earnings, common stocks, preferred stocks, and bonds. By taking a weighted average, we can see how much interest the company has to pay for every dollar it borrows. This is the weighted average cost of capital.
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Degree of Financial Leverage (DFL):
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With high financial leverage (high DFL) a small change in operating income is magnified into a large change in net income and earnings per share
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Sustainable Growth Rate (SGR):
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SGR is a function of :
Profitability ( Net Margin)
Asset usage Efficiency (Asset Turnover)
Leverage (Assets / Equity)
Plow back (Dividends)
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Sustainable Growth Rate:
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Only growth rate which allows the firm to maintain its present financial ratios and avoid the sale of new equity.
= ROE (1- Dividends/ Net Income)
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Tax on Sales Equipment:
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Calculate Book Value = Cost - Accumulated Depreciation
If Book Value < sale price , then tax on gain
If Book Value > sales price , then taxable loss
( for future tax back)
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Security Market Line (SML):
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The securities market line (SML) is a straight line that graphs the relationship between risk and return.The X-axis represents the risk (beta), and the Y-axis represents the expected return. The market risk premium is determined from the slope of the SML.
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Statement of Cash Flows:
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Explains the sources and uses of cash for the company
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Weighted cost of capital:
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A calculation of a firm's cost of capital in which each category of capital is proportionately weighted. All capital sources - common stock, preferred stock, bonds and any other long-term debt - are included in a WACC calculation.
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Degree of Operating leverage (DOL):
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Percent change in EBIT over the percent change in sales.
DOL= (Sales - Variable Costs)/ EBIT
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Four possible ways to decreasing DFN:
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1. Slow sales growth
2. Examine capacity constaints
3. Lower dividend payment
4. Increase net margin
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Price- Yield Relationship:
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If the coupon rate = discount rate , the bond will sell at par value
If the coupon rate > discount rate , the bond will sell at premium
If the coupon rate discount
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The retention ratio is calculated as:
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the additions to retained earnings divided by net income
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What is the difference between the DuPont breakdown of ROE and SGR?
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SGR includes the dividend policy
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IRR Decison Rules:
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- If IRR is greater than or equal to required rate of return, Accept
- If IRR is less than the required rate of return, Reject
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Any external financing need is generally covered by:
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adjusting the level of debt or equity
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Value of stock (V0)
(Single Holding period)
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V1 + D1 / ( 1 + Kcs)
Here V0 and V1 are value of the stock at time 0 and time 1, respectively, D1 is the dividend paid in time 1 and Kcs is the required rated of return
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Example: What will be the required return on a stock given that the risk-free rate is 8%, the expected return on the market portfolio is 12%, and the beta of the stock is 2?
CAPM
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r = Rf + beta x (Km - Rf)
r = 8% + 2 x (12% - 8%)
r = 16 %
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The sustainable growth rate of a firm is best described as the:
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maximum growth rate achievable without using any external equity financing, and while maintaining a constant debt-equity ratio
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Example of WACC:
Weight of Debt: 60%Cost of Debt: 10%
Weight of Equity (Common Stock): 40%
Cost of Equity (Common Stock): 18%
Tax Rate: 35%
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t
WACC = Weight of Debt * Cost of Debt (1-Tax Rate) + Weight of Equity * Cost of Equity
= (.6) * (.1)*(1-.35) + (.4) * (.18)= .111 or 11.1%
So, WACC was 11.1%
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