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Lecture Series #3 Financial Risk Management Chris Droussiotis October 2011 Table of Contents 2 Managerial Strategies Return, Risk, Asset Allocation and Time Fundamental Analysis Technical Analysis Behavioral Analysis Managerial Strategies – Value Creation Economic Environment EXIT POINT Exit Point •Terminal Value ENTRY POINT 3 VALUE CREATION – MANAGERIAL / INVESTMENT STRATEGIES Entry Point •Startup – Build •Economic Studies •Acquiring Initial Funds (Equity/Debt) •The Right Price / Cost as compared to Future Cash Flows •Going Private/Public Determinants of Value Cash Flow Timing of Cash Flow Risk Managerial Strategies – Value Creation Risk #1: Volatility Standard Deviation (σ) EXIT POINT Standard Deviation (σ) ENTRY POINT 4 Value Creation - Managerial Strategies Operating Strategies – – Transactional Strategies – – – – Refinancing / Optimum Structure Foreign Exchange Strategies – Hedge against FX moves – International Lease or Buy (Equipment, Buildings, Trucks) Social Responsibility / Ethical – Corporate Governance – – – – 5 Grow through acquisitions Joint Ventures Financial Strategies – Grow internally – manage Revenue, Expenses & Cash Flow – Manage Systematic Risk / Credit Risk / Market Risk / Operational Risk – Shareholders Employees Community Bankers/Creditors Environmental Financial Risk Management 6 Seeking Return Identifying Risk Achieving Diversification via Asset Allocation Time is important Seeking Return - Return Basic Analysis RISK RETURN – Traditionally, when you define return you refer to a bank savings account (risk free) plus a risky portfolio of US stocks. Today, investors have access to a variety of asset classes and financial engineered investments HPR = (Ending Price – Beg. Price + Div) / Beg. Price Example: Current Price = $100, expected price to increase to $110 in a year. Within the year you are expected to receive $4 dividend, therefore the HPR=(110-100+4)/$100 = 14% 7 RISK and Return HOW DO WE QUANTIFY THE UNCERTAINTY OF INVESTMENT To summarize risk with a single number we find VARIANCE, the expected value of the squared Deviation for the mean, first. (I.e. the expected value of the squared “surprise”: across scenarios.) 8 RISK and Return HOW DO WE QUANTIFY THE UNCERTAINTY OF INVESTMENT STANDARD DEVIATION DEFINITION: The Standard Deviation (σ) is a measure of how spreads out numbers are. (Note: Deviation just means how far from the normal). So, using the Standard Deviation we have a "standard" way of knowing what is normal, and what is extra large or extra small. 9 VOLATILITY vs RETURN Sharpe Ratio: Risk Premium over the Standard Deviation of portfolio excess return (E(r p) – r f ) / σ 8% / 20% = 0.4x. A higher Sharpe ratio indicates a better reward per unit of volatility, in other words, a more efficient portfolio 10 VOLATILITY Vs RETURN and ASSET ALLOCATION Building the Optimal Portfolio + Optimal Risky Portfolio (P) + Proportion of the Investment budget (Y) to be allocated to it. + The remaining portion (1-Y) is to be invested is the Risk-free Asset (rf) + Actual risk rate of return by rp on P by E(rp) and Standard Deviation + The rate on risk-free asset is denoted a rf + The portfolio return is E(rc) E (rp) = 15% σ = 22 % Rf =7% E(rp – rf) = 8% 11 RISK,RETURN, ASSET ALLOCATION AND DIVERSIFICATION 12 DIVERSIFICATION AND PORTFOLIO RISK From one stock to two stocks to three stocks….. sensitivity to external factors (i.e. oil, non-oil stocks) – But even extensive diversification cannot eliminate risk – MARKET RISK Other Names for Market risk: Systematic risk, non-diversifiable risk The Risk that can be eliminated by diversification is called: – Unique Risk – Firm-specific risk – Non-systematic risk – Diversifiable risk RISK,RETURN, ASSET ALLOCATION, DIVERSIFICATION AND CORRELETION Relationship between the return of two assets (-1 TO 1) Tandem Opposition 13 E(rb) = 6.0% E(rs) = 10% σb= 12% σs= 25% Pbs = 0 Wb=0.5 Ws=0.5 σp^2= (Wb*σb)^2 + (Ws*σs)^2 + 2 (Wb*σb) (Ws*σs)* Pbs σp^2=(0.5*12)^2 + (0.5*25)^2 + 2(0.5*12)(0.5*25)*0 σp = SqRt of 192.25 = 13.87% RISK,RETURN, ASSET ALLOCATION, DIVERSIFICATION AND CORRELETION 10 6 2 5 1 2 Minimum Variance Stocks Bonds 14 100% Stocks 10.00 0 Portfolio Weights Ws Wb 0.0 1.0 0.1 0.9 0.2 0.8 0.3 0.7 0.4 0.6 0.5 0.5 0.6 0.4 0.7 0.3 0.8 0.2 0.9 0.1 1.0 0.0 18.7256% 81.2744% E(r) Vs Std Dev with 0 correlation 12.00 Stocks 18.73% Bonds 81.27% Exp Return E(rp) % 6.00 6.40 6.80 7.20 7.60 8.00 8.40 8.80 9.20 9.60 10.00 Std Dev. σp % 12.00 11.09 10.82 11.26 12.32 13.87 15.75 17.87 20.14 22.53 25.00 8.00 E (r) Parameters E (rs) = E (rb) = σs = σb= Psb = 100% Bonds 6.00 4.00 2.00 0.00 0.00 5.00 Ws=(σb^2 - σb σs p) / (σs^2 + σb^2 - 2*σb σs p) W b = 1 - W s 10.00 15.00 Std Dev 20.00 25.00 30.00 WHAT ARE THE IMPLICATIONS OF PERFECT POSITIVE CORRELATION BETWEEN BONDS & STOCKS?? • Let’s say the correlation is 1 or Pbs = 1 (so far we used 0 correlation) σp^2 = Wb^2 σb ^2 + Ws^2 σs^2 + 2 Wb*σb Ws*σs * 1 = Wb*σb + Ws*σs 15 WHAT ARE THE IMPLICATIONS OF PERFECT POSITIVE CORRELATION BETWEEN BONDS & STOCKS?? • Let’s say the correlation is 1 or Pbs = - 1 σp^2 = (Wb*σb – Ws*σs)^2 16 WHAT ARE THE IMPLICATIONS OF PERFECT POSITIVE CORRELATION BETWEEN BONDS & STOCKS?? THE OPTIMAL RISKY PORTFOLIO W/ A RISK-FREE ASSET • Let’s add Risk Free in our portfolio (bringing what we discussed before regarding CAL line) 17 Comparing Volatility to the Market: BETA COEFFICIENT First Step: understanding CAPM: E(rs) = rf + b * p + e The model that predicts the relationship between the risk and equilibrium expected returns on risky assets Second Step: Defining Beta 18 Comparing Volatility to the Market: BETA COEFFICIENT Defining Beta 19 Comparing Volatility to the Market: BETA COEFFICIENT Defining Beta 20 Valuation Methods – Private Company DCF Analysis – Transaction Sources & Uses Capital markets – – – Initial Valuation – purchase price / Cost of investment WACC / CAPM concepts Debt Schedule Payments Principal & Interest – – 21 Debt (Loans. Mezzanine and Corporate Bonds) Equity (Private & Public) Floating Rate Fixed Rate DCF Analysis – Transaction Sources & Uses TRANSACTION SOURCES & USES Sources: Bank Loan Mezzanine Note Total Debt Equity Total Sources Uses: Purchase Price (EV - including Debt) Transaction Fees & Expenses Total Uses 22 Debt Capacity (EBITDA x) 2.5x 4.0x 1st Year's EBITDA Multiple 6.0x 3.0% Amount 50,000,000 30,000,000 80,000,000 43,600,000 123,600,000 % Capital 40.5% 24.3% 64.7% 35.3% 100.0% 120,000,000 % of Total Uses 97.1% 3,600,000 123,600,000 2.9% 100.0% Amount Expected Return Expected Return (After Tax) 5.364% 9.000% 3.433% 5.760% 20.00% 20.00% WACC (After Tax) EBITDA Multiple 1.39% 1.40% 2.79% 7.05% 9.84% 2.5x 1.5x 4.0x 2.2x 6.2x WACD = 4.305% Tax Rate= 36.0% DCF Analysis – Applying CAPM : E (re) = rf - β . Pe + ε COST OF DEBT AND EQUITY CALCULATIONS COST OF BANK DEBT CALCULATION (Floaring Rate) 3M-LIBOR Assumptions 0.30% Loan Spread 4.00% Equity Risk Premiums (1926-2006) (CAPM Model) Initial All -In Decile 4.30% 1 524,351 7.03% 2 10,344 8.05% 3 4,144 8.47% 4 2,177 8.75% 5 1,328 9.03% COST OF MEZZANINE NOTE CALCULATION 9.00% COST OF EQUITY CALCULATION E (re) = rf - β . Pe + e Risk Prem. 6-year Treasury Note [ rf ] 1.95% 6 840 9.18% Beta for Publicly Traded Hotel [ β ] 1.633x 7 538 9.58% 11.05% 8 333 9.91% 0.0% 9 193 10.43% 20.00% 10 85 11.05% Equity Premium [ Pe ] 23 Mkt Cap $MM Firm Specific Risk Premium [e] Cost of Equity DCF Analysis – Debt Schedules Debt Money Terms: • Amount • Interest Rate (Floating – LIBOR Rate and Fixed Rate) • Maturity • Amortization DEBT ASSUMPTIONS & RETURN ANALYSIS Bank Loan Information Amount Outstanding (End of Year) Schedule Principal Payments Interest Payment (Calc based on last Year's Outs) Total Financing Payment LIBOR RATE LIBOR Rate Increase Assumptions Corporate Bond Information Amount Outstanding Schedule Principal Payments Interest Payment (Calc based on last Year's Outs) Total Financing Payment Total Financing Total Debt Outstanding 24 Debt IRR 5.364% 9.000% Terms 50,000,000 7 years 5.36% (50,000,000) 0.30% 2010 47,000,000 3,000,000 2,150,000 5,150,000 0.30% 0.00% 2011 42,000,000 5,000,000 2,256,000 7,256,000 0.80% 0.50% 2012 37,000,000 5,000,000 2,226,000 7,226,000 1.30% 0.50% 2013 31,000,000 6,000,000 2,331,000 8,331,000 2.30% 1.00% 2014 24,000,000 7,000,000 1,953,000 8,953,000 2.30% 0.00% 2015 15,000,000 9,000,000 1,512,000 10,512,000 2.30% 0.00% 2016 30,000,000 10 Years 9.00% (30,000,000) 30,000,000 2,700,000 2,700,000 30,000,000 2,700,000 2,700,000 30,000,000 2,700,000 2,700,000 30,000,000 2,700,000 2,700,000 30,000,000 2,700,000 2,700,000 30,000,000 2,700,000 2,700,000 30,000,000 2,700,000 2,700,000 7,850,000 77,000,000 9,956,000 72,000,000 9,926,000 67,000,000 11,031,000 61,000,000 11,653,000 54,000,000 13,212,000 45,000,000 18,645,000 30,000,000 15,000,000 945,000 15,945,000 2.30% 0.00% DCF Analysis – Building up the Projections CASH FLOW & EQUITY RETURN ANALYSIS Company Projections Operating Assump. 5.00% 35.0% 15.0% 50.0% 3.00% 7 Revenues Cost of Revenues Operating Costs EBITDA Less Depreciation Less Amortization of Fees EBIT Less Interest (Unlevered for DCF Analysis) EBT Less Taxes (adj out Interest Exp) Plus Depreciation & Amortization Less Working Capital Less Capex Cash Flow Before Financing (CFBF) Entry Year 2009 growth % of Revenue % of Revenue % of Revenue years 36.0% % of EBT 1.00% % of Revenue 3.00% % of Revenue Less Financing ( P + I ) Equity Cash Flows Terminal Value EBITDA Multiple Method (initial purchase multiple) Perpetuity Method (using WACC + growth) Year 1 2010 40,000,000 (14,000,000) (6,000,000) 20,000,000 (1,200,000) (514,286) 18,285,714 18,285,714 (6,582,857) 1,714,286 (400,000) (1,200,000) 11,817,143 Year 2 2011 42,000,000 (14,700,000) (6,300,000) 21,000,000 (1,260,000) (514,286) 19,225,714 19,225,714 (6,921,257) 1,774,286 (420,000) (1,260,000) 12,398,743 Year 3 Year 4 2012 2013 44,100,000 46,305,000 (15,435,000) (16,206,750) (6,615,000) (6,945,750) 22,050,000 23,152,500 (1,323,000) (1,389,150) (514,286) (514,286) 20,212,714 21,249,064 20,212,714 21,249,064 (7,276,577) (7,649,663) 1,837,286 1,903,436 (441,000) (463,050) (1,323,000) (1,389,150) 13,009,423 13,650,637 Year 5 2014 48,620,250 (17,017,088) (7,293,038) 24,310,125 (1,458,608) (514,286) 22,337,232 22,337,232 (8,041,403) 1,972,893 (486,203) (1,458,608) 14,323,912 Exit Year 2015 2016 51,051,263 53,603,826 (17,867,942) (18,761,339) (7,657,689) (8,040,574) 25,525,631 26,801,913 (1,531,538) (1,608,115) (514,286) 23,479,808 25,193,798 23,479,808 25,193,798 (8,452,731) (9,069,767) 2,045,824 1,608,115 (510,513) (536,038) (1,531,538) (1,608,115) 15,030,850 15,587,992 (7,850,000) 3,967,143 (9,956,000) 2,442,743 (9,926,000) (11,031,000) 3,083,423 2,619,637 (11,653,000) 2,670,912 (13,212,000) (18,645,000) 1,818,850 (3,057,008) Growth 6.0x 153,153,788 3.50% 9.84% 245,812,934 Average Terminal Value Debt Outstanding Equity Value (TV - Debt) 199,483,361 45,000,000 154,483,361 Equity Cash Flows 25 (43,600,000) $ 1 PV Table (Expected Equity Rate) PV Table (Expected Equity Rate) 20.00% 61,471,300 Initial Investment NPV= (43,600,000) 17,871,300 IRR= 27.9% 3,967,143 x 0.8333398 3,305,978 2,442,743 x 0.6944552 1,696,376 3,083,423 x 0.5787172 1,784,430 2,619,637 x 0.4822680 1,263,367 2,670,912 x 0.4018931 1,073,421 156,302,211 x 0.3349135 52,347,728 Equity Return Scenarios Given Different EBITDA Multiples 5.5x 6.0x 6.5x 7.0x 36.4% 27.9% 22.1% 17.9% Based on Next Y Reviewing Financial Risk Management Fundamental Analysis – – Financial Ratio Analysis DCF Valuation Analysis Technical Analysis – Portfolio Analysis Approach 26 Historical Returns / Standard Deviation / Correlations Behavioral Analysis Behavioral Analysis Concepts ARE MARKETS EFFICIENT? EMH Concept Looking for behavioral motivations for buying/selling: • High Exposure • Risk Appetite • Tax motivation • Resource allocation Behavioral Finance - People are people and they make decisions differently “Irrational Exuberance” – Greenspan 12/2006 – affected the stock markets around the world after he mention that word (Tokyo was down 3.0%, Hong Kong was down 2.0%, UK down 3.0%, U.S. down 2.0%) 27 Behavioral Analysis Concepts ARE MARKETS EFFICIENT? EMH Concept INFORMATION PROCESSING • Forecasting Errors – High multiples • Overconfidence – “Irrational Exuberance” • Conservatism – the article of banks – in Leverage Cycle BEHAVIORAL BIASES • Bluffing – Game theory – “All-in” has nothing, betting slow could have a good hand. • Mental Accounting – managing other people’s money versus your own • Regret Avoidance – unconventional choices Vs. acceptable choices when wrong • Prospect theory - as wealth increases more risk averse. 28