Corporate Valuation: A Guide for
Brokers, Managers and Investors
Dr. Mounther Barakat Al Omari
Securities and Commodities Authority
Abu Dhabi - UAE
December - 2006
1-1
‫تحليل الشركات وتسعير االسهم‬
‫دليل للوسطاء والمدراء والمستثمرين‬
‫د‪ .‬منذر بركات العمري‬
‫هيئة االوراق المالية والسلع – ابو ظبي‬
‫دولة االمارات العربية المتحدة‬
‫‪2006‬‬
‫‪1-2‬‬
Introduction
‫مقدمة‬
The following is an important introduction
for stock analysts and evaluators.
This introduction is intended to provide
stock analysts with the tools they need
to carryout their analysis.
‫فيما يلي مقدمة هامة للمحللين الماليين ولمسعري الشركات‬
‫تحوي هذه المقدمة على ادوات هامة ال يستطيع المحلل‬
‫المالي ان يقوم بوظيفته بدونها‬
1-3
Financial Goals of the Corporation
‫هدف الشركة‬

The primary financial goal is
shareholder wealth maximization,
which translates to maximizing stock
price.



Do firms have any responsibilities to
society at large?
Is stock price maximization good or bad
for society?
Should firms behave ethically?
1-4
Is stock price maximization the same as profit maximization?
‫هل يعتبر تعظيم ثروة المساهمين هو تعظيم االرباح؟‬



No, despite a generally high correlation
amongst stock price, EPS, and cash flow.
Current stock price relies upon current
earnings, as well as future earnings and cash
flow.
Some actions may cause an increase in
earnings, yet cause the stock price to
decrease (and vice versa).
1-5
Factors that affect stock price
‫العوامل التي تؤثر بسعر السهم‬

Projected cash flows to shareholders

Timing of the cash flow stream

Riskiness of the cash flows
1-6
Basic Valuation Model
‫نموذج التسعير االولي‬
CF1
CF2
CFn
Value 


1
2
(1  k)
(1  k)
(1  k)n
n
CFt

.
t
t 1 (1  k)


To estimate an asset’s value, one estimates the cash flow
for each period t (CFt), the life of the asset (n), and the
appropriate discount rate (k)
Throughout the course, we discuss how to estimate the
inputs and how financial management is used to
improve them and thus maximize a firm’s value.
1-7
Factors that Affect the Level and Riskiness of Cash Flows
‫العوامل المؤثرة بقيمة وخطورة وتوقيت التدفقات النقدية‬


Decisions made by financial managers:

Investment decisions

Financing decisions (the relative use of debt
financing)

Dividend policy decisions
The external environment
1-8
Financial Statements, Cash Flow, and Taxes
‫ التدفقات النقدية والضرائب‬،‫القوائم المالية‬






Balance sheet
Income statement
Statement of cash flows
Accounting income vs. cash flow
MVA and EVA
The tax system
1-9
The Annual Report
‫التقرير السنوي‬




Balance sheet – provides a snapshot of a firm’s
financial position at one point in time.
Income statement – summarizes a firm’s revenues
and expenses over a given period of time.
Statement of retained earnings – shows how much
of the firm’s earnings were retained, rather than
paid out as dividends.
Statement of cash flows – reports the impact of a
firm’s activities on cash flows over a given period
of time.
1-10
Balance Sheet: Assets
‫ االصول‬- ‫قائمة المركز المالي‬
Cash
A/R
Inventories
Total CA
Gross FA
Less: Dep.
Net FA
Total Assets
2002
7,282
632,160
1,287,360
1,926,802
1,202,950
263,160
939,790
2,866,592
2001
57,600
351,200
715,200
1,124,000
491,000
146,200
344,800
1,468,800
1-11
Balance sheet: Liabilities and Equity
‫قائمة المركز المالي – الخصوم وحقوق الملكية‬
Accts payable
Notes payable
Accruals
Total CL
Long-term debt
Common stock
Retained earnings
Total Equity
Total L & E
2002
524,160
636,808
489,600
1,650,568
723,432
460,000
32,592
492,592
2,866,592
2001
145,600
200,000
136,000
481,600
323,432
460,000
203,768
663,768
1,468,800
1-12
Income statement
‫قائمة الدخل‬
Sales
COGS
Other expenses
EBITDA
Depr. & Amort.
EBIT
Interest Exp.
EBT
Taxes
Net income
2002
6,034,000
5,528,000
519,988
(13,988)
116,960
(130,948)
136,012
(266,960)
(106,784)
(160,176)
2001
3,432,000
2,864,000
358,672
209,328
18,900
190,428
43,828
146,600
58,640
87,960
1-13
Other data
‫معلومات أخرى‬
No. of shares
EPS
DPS
Stock price
2002
100,000
-$1.602
$0.11
$2.25
2001
100,000
$0.88
$0.22
$8.50
1-14
Did the expansion create additional net
operating after taxes (NOPAT)?
‫حسابات الدخل التشغيلي بعد الضريبة‬
NOPAT
= EBIT (1 – Tax rate)
NOPAT02 = -$130,948(1 – 0.4)
= -$130,948(0.6)
= -$78,569
NOPAT01 = $114,257
1-15
What effect did the expansion have on
net operating working capital?
‫حسابات صافي رأس المال العمل‬
NOWC = Current - Non-interest
assets
bearing CL
NOWC02 = ($7,282 + $632,160 + $1,287,360)
– ( $524,160 + $489,600)
= $913,042
NOWC01 = $842,400
1-16
What effect did the expansion have on
operating capital?
‫حسابات رأس المال التشغيلي‬
Operating capital = NOWC + Net Fixed Assets
Operating Capital02 = $913,042 + $939,790
= $1,852,832
Operating Capital01 = $1,187,200
1-17
What is your assessment of the expansion’s
effect on operations?
‫مالحظات من حسابات التشغيل‬
Sales
NOPAT
NOWC
Operating capital
Net Income
2002
$6,034,000
-$78,569
$913,042
$1,852,832
-$160,176
2001
$3,432,000
$114,257
$842,400
$1,187,200
$87,960
1-18
What effect did the expansion have on net
cash flow and operating cash flow?
‫حسابات التدفقات النقدية‬
NCF02 = NI + Dep = ($160,176) + $116,960
= -$43,216
NCF01 = $87,960 + $18,900 = $106,860
OCF02 = NOPAT + Dep
= ($78,569) + $116,960
= $38,391
OCF01 = $114,257 + $18,900
= $133,157
1-19
What was the free cash flow (FCF) for 2002?
‫حساب التدفق النقدي الحر‬
FCF = OCF – Gross capital investment
- OR FCF02 = NOPAT – Net capital investment
= -$78,569 – ($1,852,832 - $1,187,200)
= -$744,201
Is negative free cash flow always a bad sign?
1-20
Economic Value Added (EVA)
‫حساب القيمة المضافة‬
EVA =
After-tax
__
After-tax
Operating Income
Capital costs
= Funds Available __ Cost of
to Investors
Capital Used
= NOPAT – After-tax Cost of Capital
1-21
EVA Concepts
‫مفهوم القيمة االقتصادية المضافة‬


In order to generate positive EVA, a firm
has to more than just cover operating
costs. It must also provide a return to
those who have provided the firm with
capital.
EVA takes into account the total cost of
capital, which includes the cost of equity.
1-22
What is the firm’s EVA? Assume the firm’s after-tax percentage
cost of capital was 10% in 2000 and 13% in 2001.
‫حساب القيمة االقتصادية المضافة‬
EVA02 = NOPAT – (A-T cost of capital) (Capital)
= -$78,569 – (0.13)($1,852,832)
= -$78,569 - $240,868
= -$319,437
EVA01 = $114,257 – (0.10)($1,187,200)
= $114,257 - $118,720
= -$4,463
1-23
Did the expansion increase or decrease MVA?
‫حساب القيمة السوقية المضافة‬
MVA = Market value __
of equity
Equity capital
supplied
During the last year, the stock price has
decreased 73%. As a consequence, the
market value of equity has declined, and
therefore MVA has declined, as well.
1-24
Corporate and Personal Taxes
‫ضرائب الشركات واالفراد وأثرها على قيمة الشركة وأسهمها‬



Have a progressive structure (the higher the income,
the higher the marginal tax rate).
Corporations
 Rates are at 0% unless there are special provisions
for certain companies like Oil and foreign ones.
Individuals
 Rates 0% for individuals, again unless there are
special provisions.
 Inexistence of taxes does not change the mechanics
of our work, it will change the results.
1-25
Tax treatment of various uses and sources of funds
‫أثر الضرائب على التدفقات النقدية الداخلة والخارجة‬





Interest paid – tax deductible for corporations (paid
out of pre-tax income), but usually not for individuals.
Interest earned - taxable
Dividends paid – paid out of after-tax income.
Dividends received – not taxed individuals (“double
taxation”).
Capital gains not taxable
1-26
Calculating Key Multipliers
‫ مثال‬- ‫حساب المضاعفات‬
P/E
= Price / Earnings per share
= $12.17 / $1.014 = 12.0x
P/CF = Price / Cash flow per share
= $12.17 / [($253.6 + $117.0) ÷ 250]
= 8.21x
1-27
Calculating Key Multipliers
‫ مثال‬- ‫حساب المضاعفات‬
M/B = Mkt price per share / Book value per share
= $12.17 / ($1,952 / 250) = 1.56x
P/E
P/CF
M/B
2003
12.0x
8.21x
1.56x
2002
-1.4x
-5.2x
0.5x
2001
9.7x
8.0x
1.3x
Ind.
14.2x
11.0x
2.4x
1-28
Analyzing the multipliers
‫تحليل المضاعفات‬





P/E: How much investors are willing to pay for
$1 of earnings.
P/CF: How much investors are willing to pay
for $1 of cash flow.
M/B: How much investors are willing to pay
for $1 of book value equity.
For each ratio, the higher the number, the
better.
P/E and M/B are high if ROE is high and risk
is low.
1-29
Trend analysis
‫تحليل النمطية‬


Analyzes a firm’s
financial ratios over
time
Can be used to estimate
the likelihood of
improvement or
deterioration in financial
condition.
1-30
Potential uses of freed up cash
‫استخدامات التدفق النقدي الحر‬




Repurchase stock
Expand business
Reduce debt
All these actions would likely improve the
stock price.
1-31
The Financial Environment:
‫البيئة المالية للشركة المراد تحليلها وتقييمها‬




Financial markets
Types of financial institutions
Determinants of interest rates
Yield curves
1-32
What is a market?
‫ما هو السوق‬


A market is a venue where goods and
services are exchanged.
A financial market is a place where
individuals and organizations wanting to
borrow funds are brought together with
those having a surplus of funds.
1-33
Types of financial markets
‫أنواع االسواق المالية‬





Physical assets vs. Financial assets
Money vs. Capital
Primary vs. Secondary
Spot vs. Futures
Public vs. Private
1-34
How is capital transferred between
savers and borrowers?
‫تحويل االموال من وحدات الفائض الى وحدات العجز‬



Direct transfers
Investment banking house
Financial intermediaries
1-35
Types of financial intermediaries
‫أنواع الوسطاء الماليين‬







Commercial banks
Savings and loan associations
Mutual savings banks
Credit unions
Pension funds
Life insurance companies
Mutual funds
1-36
Physical location stock exchanges vs.
Electronic dealer-based markets
‫الفرق بين السوق المنظمة والغير منظمة‬


Auction market vs. Dealer market (Exchanges
vs. OTC)
Differences are narrowing
1-37
The cost of money
‫تكلفة رأس المال‬


The price, or cost, of debt capital is the
interest rate.
The price, or cost, of equity capital is the
required return. The required return
investors expect is composed of
compensation in the form of dividends and
capital gains.
1-38
What four factors affect the cost of money?
‫العوامل التي تؤثر في تكلفة رأس المال‬




Production opportunities
Time preferences for consumption
Risk
Expected inflation
1-39
“Nominal” vs. “Real” rates
‫العائد االسمي والحقيقي‬
k
= represents any nominal rate
k* = represents the “real” risk-free rate of
interest, if there was no inflation.
Typically ranges from 1% to 4% per
year.
kRF = represents the rate of interest on
Treasury securities.
1-40
Determinants of interest rates
)‫محددات سعر الفائدة (العائد‬
k = k* + IP + DRP + LP + MRP
k
=
k* =
IP =
DRP =
LP =
MRP =
required return on a debt security
real risk-free rate of interest
inflation premium
default risk premium
liquidity premium
maturity risk premium
1-41
Premiums added to k* for different types of debt
‫مقارنة عالوات المخاطر المختلفة‬
IP
S-T Treasury

L-T Treasury

S-T Corporate

L-T Corporate

MRP DRP
LP






1-42
Yield curve and the term structure of interest rates
‫منحنى العائد وعالقة الفائدة باالستحقاق‬


Term structure –
relationship between
interest rates (or yields)
and maturities.
The yield curve is a
graph of the term
structure.
1-43
Hypothetical yield curve
‫منحنى عائد افتراضي‬
Interest
Rate (%)
15

Maturity risk premium

10
Inflation premium
5
An upward sloping
yield curve.
Upward slope due to
an increase in
expected inflation and
increasing maturity
risk premium.
Real risk-free rate
0
1
10
Years to
20 Maturity
1-44
The Yield Curve
‫منحنى العائد‬


Corporate yield curves are higher than that
of Treasury securities, though not
necessarily parallel to the Treasury curve.
The spread between corporate and Treasury
yield curves widens as the corporate bond
rating decreases.
1-45
The Yield Curve
‫منحنى العائد‬
Interest
Rate (%)
15
BB-Rated
10
AAA-Rated
5
Treasury
6.0% Yield Curve
5.9%
5.2%
Years to
0
Maturity
0
1
5
10
15
20
1-46
Risk and Rates of Return
‫المخاطر والعائد‬



Stand-alone risk
Portfolio risk
Risk & return: CAPM / SML
1-47
Investment returns
‫العائد على االستثمار‬
The rate of return on an investment can be calculated as
follows:
Return =
(Amount received – Amount invested)
________________________
Amount invested
For example, if $1,000 is invested and $1,100 is returned
after one year, the rate of return for this investment is:
($1,100 - $1,000) / $1,000 = 10%.
1-48
What is investment risk?
‫مخاطر االستثمار‬

Two types of investment risk




Stand-alone risk
Portfolio risk
Investment risk is related to the probability of
earning a low or negative actual return.
The greater the chance of lower than expected or
negative returns, the riskier the investment.
1-49
Probability distributions
‫التوزيع االحتمالي‬


A listing of all possible outcomes, and the
probability of each occurrence.
Can be shown graphically.
Firm X
Firm Y
-70
0
15
Expected Rate of Return
100
Rate of
Return (%)
1-50
Risk: Calculating the standard deviation
‫حساب المخاطر باستخدام االنحراف المعياري‬
  Standard deviation
  Variance  2

n
 (k
i1
 k̂ ) Pi
2
i
1-51
Standard deviation as a measure of risk
‫االنحراف المعياري كمقياس للخطورة‬



Standard deviation (σi) measures total,
or stand-alone, risk.
The larger σi is, the lower the
probability that actual returns will be
closer to expected returns.
Larger σi is associated with a wider
probability distribution of returns.
1-52
Coefficient of Variation (CV)
‫معامل التشتت كمقياس للخطورة‬
A standardized measure of dispersion about the
expected value, that shows the risk per unit of
return.
Std dev 
CV 
 ^
Mean
k
1-53
Investor attitude towards risk
‫درجة تحمل المستثمرين للمخاطر‬


Risk aversion – assumes investors dislike
risk and require higher rates of return to
encourage them to hold riskier securities.
Risk premium – the difference between
the return on a risky asset and less risky
asset, which serves as compensation for
investors to hold riskier securities.
1-54
Illustrating diversification effects of a
stock portfolio
‫اثر التنويع على المخاطر‬
p (%)
35
Company-Specific Risk
Stand-Alone Risk, p
20
Market Risk
0
10
20
30
40
2,000+
# Stocks in Portfolio
1-55
Breaking down sources of risk
‫مصادر المخاطر‬
Stand-alone risk = Market risk + Firm-specific risk


Market risk – portion of a security’s stand-alone risk
that cannot be eliminated through diversification.
Measured by beta.
Firm-specific risk – portion of a security’s standalone risk that can be eliminated through proper
diversification.
1-56
Capital Asset Pricing Model
‫نموذج تسعير االصول الرأسمالية‬


Model based upon concept that a stock’s required
rate of return is equal to the risk-free rate of return
plus a risk premium that reflects the riskiness of
the stock after diversification.
Primary conclusion: The relevant riskiness of a
stock is its contribution to the riskiness of a welldiversified portfolio.
1-57
Beta
‫معامل بيتا كمقياس للخطورة‬


Measures a stock’s market risk, and shows a
stock’s volatility relative to the market.
Indicates how risky a stock is if the stock is
held in a well-diversified portfolio.
1-58
Calculating betas
Excel ‫حساب معامل بيتا باستخدام‬


Run a regression of past returns of a
security against past returns on the market.
The slope of the regression line (sometimes
called the security’s characteristic line) is
defined as the beta coefficient for the
security.
1-59
Illustrating the calculation of beta
Excel ‫ حساب معامل بيتا باستخدام‬- ‫مثال‬
See PADICO-PALTEL.XLS
1-60
Comments on beta
‫مالحظات على معامل بيتا‬




If beta = 1.0, the security is just as risky as the
average stock.
If beta > 1.0, the security is riskier than average.
If beta < 1.0, the security is less risky than
average.
Most stocks have betas in the range of 0.5 to 1.5.
1-61
Can the beta of a security be negative?
‫معامل بيتا قد يكون سالبا‬



Yes, if the correlation between Stock i and the
market is negative (i.e., ρi,m < 0).
If the correlation is negative, the regression
line would slope downward, and the beta
would be negative.
However, a negative beta is highly unlikely.
1-62
Beta coefficients
‫مقارنة معامل بيتا‬
40
_
ki
Firm X: β =
1.30
20
T-bills: β = 0
-20
0
20
_
kM
40
Firm Y: β = 0.87
-20
1-63
The Security Market Line (SML):
‫خط السوق‬
SML: ki = kRF + (kM – kRF) βi


Assume kRF = 8% and kM = 15%.
The market (or equity) risk premium is RPM
= kM – kRF = 15% – 8% = 7%.
1-64
What is the market risk premium?
‫ما هي عالوة مخاطر السوق‬



Additional return over the risk-free rate needed
to compensate investors for assuming an
average amount of risk.
Its size depends on the perceived risk of the
stock market and investors’ degree of risk
aversion.
Varies from year to year, but most estimates
suggest that it ranges between 4% and 8% per
year.
1-65
Time Value of Money
‫القيمة الزمنية للنقود‬




Future value
Present value
Annuities
Rates of return
1-66
Time lines
‫خط الزمن – اين انت؟‬
0
1
2
3
CF1
CF2
CF3
i%
CF0


Show the timing of cash flows.
Tick marks occur at the end of periods, so Time
0 is today; Time 1 is the end of the first period
(year, month, etc.) or the beginning of the
second period.
1-67
Time lines
‫خط الزمن – مثال‬
$100 lump sum due in 2 years
0
1
2
i%
100
3 year $100 ordinary annuity
0
1
2
3
100
100
100
i%
1-68
Time lines
‫خط الزمن – مثال‬
Uneven cash flow stream
0
1
2
3
100
75
50
i%
-50
1-69
Future value (FV)
‫القيمة المستقبلية‬


Finding the FV of a cash flow or series of cash
flows when compound interest is applied is
called compounding.
FV can be solved by using the arithmetic,
financial calculator, and spreadsheet methods.
0
1
2
3
10%
100
FV = ?
1-70
Future value (FV)
‫القيمة المستقبلية‬




After 1 year:
 FV1 = PV ( 1 + i ) = $100 (1.10)
= $110.00
After 2 years:
2
2
 FV2 = PV ( 1 + i ) = $100 (1.10)
=$121.00
After 3 years:
3
3
 FV3 = PV ( 1 + i ) = $100 (1.10)
=$133.10
After n years (general case):
n
 FVn = PV ( 1 + i )
1-71
Present value (PV)
‫القيمة الحالية‬


Finding the PV of a cash flow or series of cash
flows when compound interest is applied is
called discounting (the reverse of compounding).
The PV shows the value of cash flows in terms
of today’s purchasing power.
0
1
2
3
10%
PV = ?
100
1-72
Present value (PV)
‫القيمة الحالية‬

Solve the general FV equation for PV:

PV = FVn / ( 1 + i )n

PV = FV3 / ( 1 + i )3
= $100 / ( 1.10 )3
= $75.13
1-73
Ordinary annuity and an annuity due
‫الدفعات المنتظمة اول الفترة وآخرها‬
Ordinary Annuity
0
i%
1
2
3
PMT
PMT
PMT
1
2
3
PMT
PMT
Annuity Due
0
i%
PMT
1-74
‫?‪PV of uneven cash flow stream‬‬
‫القيمة الحالية لدفعات غير منتظمة‬
‫‪4‬‬
‫‪3‬‬
‫‪2‬‬
‫‪1‬‬
‫‪-50‬‬
‫‪300‬‬
‫‪300‬‬
‫‪100‬‬
‫‪10%‬‬
‫‪0‬‬
‫‪90.91‬‬
‫‪247.93‬‬
‫‪225.39‬‬
‫‪-34.15‬‬
‫‪530.08 = PV‬‬
‫‪1-75‬‬
Bonds and Their Valuation
‫السندات وتسعيرها‬




Key features of bonds
Bond valuation
Measuring yield
Assessing risk
1-76
What is a bond?
‫ما هو السند؟‬

A long-term debt instrument in which a
borrower agrees to make payments of
principal and interest, on specific dates, to
the holders of the bond.
1-77
What is a bond?
‫ما هو السند؟‬





Par value – face amount of the bond, which
is paid at maturity (assume $1,000).
Coupon interest rate – stated interest rate
(generally fixed) paid by the issuer. Multiply by
par to get dollar payment of interest.
Maturity date – years until the bond must be
repaid.
Issue date – when the bond was issued.
Yield to maturity - rate of return earned on
a bond held until maturity (also called the
“promised yield”).
1-78
The value of financial assets
‫قيمة (سعر) االصول المالية‬
0
1
2
k
Value
n
...
CF1
CF2
CFn
CF1
CF2
CFn
Value 

 ... 
1
2
n
(1  k)
(1  k)
(1  k)
1-79
What is the opportunity cost of debt capital?
‫حساب تكلفة السندات‬

The discount rate (ki ) is the opportunity
cost of capital, and is the rate that could
be earned on alternative investments of
equal risk.
ki = k* + IP + MRP + DRP + LP
1-80
Bond valuation – an example
‫ مثال‬- ‫تسعير السندات‬
0
1
2
k
VB = ?
n
...
100
100
100 + 1,000
$100
$100
$1,000
VB 
 ... 

1
10
10
(1.10)
(1.10)
(1.10)
VB  $90.91  ...  $38.55  $385.54
VB  $1,000
1-81
What is the YTM on a bond?
‫حساب العائد المطلوب على سند‬

Must find the kd that solves this model.
INT
INT
M
VB 
 ... 

1
N
N
(1  k d )
(1  k d )
(1  k d )
90
90
1,000
$887 
 ... 

1
10
10
(1  k d )
(1  k d )
(1  k d )
1-82
Definitions
‫تعريفات‬
Annual coupon payment
Current yield (CY) 
Current price
Change in price
Capital gains yield (CGY) 
Beginning price
 Expected   Expected 
  

Expected total return  YTM  
 CY
  CGY 
1-83
An example: Current and capital gains yield
‫ مثال‬- ‫حساب العائد على سند‬

Find the current yield and the capital gains
yield for a 10-year, 9% annual coupon bond
that sells for $887, and has a face value of
$1,000.
Current yield
= $90 / $887
= 0.1015 = 10.15%
1-84
An example: Current and capital gains yield
‫ مثال‬- ‫حساب العائد على سند‬
YTM = Current yield + Capital gains yield
CGY = YTM – CY
= 10.91% - 10.15%
= 0.76%
Could also find the expected price one year from
now and divide the change in price by the beginning
price, which gives the same answer.
1-85
Evaluating default risk: Bond ratings
‫تصنيف السندات حسب خطورتها‬
Investment Grade
Junk Bonds
Moody’s
Aaa Aa A Baa
Ba B Caa C
S&P
AAA AA A BBB
BB B CCC D

Bond ratings are designed to reflect the
probability of a bond issue going into default.
1-86
Factors affecting default risk and bond ratings
‫العوامل التي تؤثر على خطورة السندات‬
 Financial performance




Debt ratio
TIE ratio
Current ratio
Bond contract provisions




Secured vs. Unsecured debt
Senior vs. subordinated debt
Guarantee and sinking fund provisions
Debt maturity
1-87
Factors affecting default risk and bond ratings
‫العوامل التي تؤثر على خطورة السندات‬






Earnings stability
Regulatory environment
Potential antitrust or product liabilities
Pension liabilities
Potential labor problems
Accounting policies
1-88
Priority of claims in liquidation
‫من له االولوية عند التصفية‬
1.
2.
3.
4.
5.
6.
7.
8.
Secured creditors from sales of secured
assets.
Trustee’s costs
Wages, subject to limits
Taxes
Unfunded pension liabilities
Unsecured creditors
Preferred stock
Common stock
1-89
The Cost of Capital
‫تكلفة رأس المال‬





Sources of capital
Component costs
WACC
Adjusting for flotation costs
Adjusting for risk
1-90
Sources of capital
‫مصادر رأس المال‬
Long-Term Capital
Long-Term Debt
Preferred Stock
Common Stock
Retained Earnings
New Common Stock
1-91
Calculating the weighted average cost of capital
‫حساب المعدل المرجح لرأس المال‬
WACC = wdkd(1-T) + wpkp + wcks


The w’s refer to the firm’s capital structure
weights.
The k’s refer to the cost of each component.
1-92
Should our analysis focus on before-tax or
after-tax capital costs?
‫تحسب تكلفة رأس المال بعد الضريبة وليس قبلها‬

Stockholders focus on A-T CFs. Therefore,
we should focus on A-T capital costs, i.e.
use A-T costs of capital in WACC. Only kd
needs adjustment, because interest is tax
deductible.
1-93
Should our analysis focus on historical (embedded)
costs or new (marginal) costs?
)‫تحسب تكلفة رأس المال حديا (أي على االموال الجديدة وليس القديمة‬

The cost of capital is used primarily to
make decisions that involve raising new
capital. So, focus on today’s marginal costs
(for WACC).
1-94
How are the weights determined?
‫حساب االوزان‬
WACC = wdkd(1-T) + wpkp + wcks


Use accounting numbers or market value
(book vs. market weights)?
Use actual numbers or target capital
structure?
1-95
Component cost of debt
‫حساب تكلفة الدين‬
WACC = wdkd(1-T) + wpkp + wcks



kd is the marginal cost of debt capital.
The yield to maturity on outstanding L-T
debt is often used as a measure of kd.
Why tax-adjust, i.e. why kd(1-T)?
1-96
Component cost of debt
‫حساب تكلفة الدين‬



Interest is tax deductible, so
A-T kd = B-T kd (1-T)
= 10% (1 - 0.40) = 6%
Use nominal rate.
Flotation costs are small, so ignore them.
1-97
Component cost of preferred stock
‫حساب تكلفة االسهم الممتازة‬
WACC = wdkd(1-T) + wpkp + wcks


kp is the marginal cost of preferred stock.
The rate of return investors require on the
firm’s preferred stock.
1-98
Component cost of preferred stock
‫حساب تكلفة االسهم الممتازة‬

The cost of preferred stock can be solved by
using this formula:
k p = Dp / P p
= $10 / $111.10
= 9%
1-99
Component cost of preferred stock
‫حساب تكلفة االسهم الممتازة‬



Preferred dividends are not tax-deductible,
so no tax adjustments necessary. Just use
kp.
Nominal kp is used.
Our calculation ignores possible flotation
costs.
1-100
Preferred stock risk
‫خطورة االسهم الممتازة‬

More risky; company not required to pay
preferred dividend.

However, firms try to pay preferred
dividend. Otherwise, (1) cannot pay
common dividend, (2) difficult to raise
additional funds, (3) preferred stockholders
may gain control of firm.
1-101
Component cost of equity
‫حساب تكلفة االسهم العادية‬
WACC = wdkd(1-T) + wpkp + wcks


ks is the marginal cost of common equity
using retained earnings.
The rate of return investors require on the
firm’s common equity using new equity is
ke.
1-102
Why is there a cost for retained earnings?
‫حساب تكلفة االرباح المحجوزة‬



Earnings can be reinvested or paid out as
dividends.
Investors could buy other securities, earn a
return.
If earnings are retained, there is an opportunity
cost (the return that stockholders could earn on
alternative investments of equal risk).



Investors could buy similar stocks and earn ks.
Firm could repurchase its own stock and earn ks.
Therefore, ks is the cost of retained earnings.
1-103
Component cost of equity
‫حساب تكلفة االسهم العادية‬

CAPM: ks = kRF + (kM – kRF) β

DCF:

Own-Bond-Yield-Plus-Risk Premium:
ks = kd + RP
ks = D1 / P0 + g
1-104
Component cost of equity
‫ مثال‬- ‫حساب تكلفة االسهم العادية‬
If the kRF = 7%, RPM = 6%, and the firm’s beta is
1.2, what’s the cost of common equity based upon
the CAPM?
ks = kRF + (kM – kRF) β
= 7.0% + (6.0%)1.2 = 14.2%
1-105
Component cost of equity
‫ مثال‬- ‫حساب تكلفة االسهم العادية‬
If D0 = $4.19, P0 = $50, and g = 5%, what’s the cost of common equity
based upon the DCF approach?
D1
D1
D1
ks
= D0 (1+g)
= $4.19 (1 + .05)
= $4.3995
= D1 / P0 + g
= $4.3995 / $50 + 0.05
= 13.8%
1-106
What is the expected future growth rate?
‫حساب معدل النمو‬

The firm has been earning 15% on equity (ROE =
15%) and retaining 35% of its earnings (dividend
payout = 65%). This situation is expected to
continue.
g = ( 1 – Payout ) (ROE)
= (0.35) (15%)
= 5.25%

Very close to the g that was given before.
1-107
Component cost of equity
‫ مثال‬- ‫حساب تكلفة االسهم العادية‬

If kd = 10% and RP = 4%, what is ks using the own-bondyield-plus-risk-premium method?

This RP is not the same as the CAPM RPM.
This method produces a ballpark estimate of
ks, and can serve as a useful check.

ks = kd + RP
ks = 10.0% + 4.0% = 14.0%
1-108
Component cost of equity
‫ مثال‬- ‫حساب تكلفة االسهم العادية‬
Method
CAPM
DCF
kd + RP
Average
Estimate
14.2%
13.8%
14.0%
14.0%
1-109
Component cost of equity
‫حساب تكلفة االسهم العادية‬

Why is the cost of retained earnings cheaper than the cost of issuing
new common stock?

When a company issues new common stock
they also have to pay flotation costs to the
underwriter.
Issuing new common stock may send a negative
signal to the capital markets, which may depress
the stock price.

1-110
Component cost of equity
‫ مثال‬- ‫حساب تكلفة االسهم العادية‬

If issuing new common stock incurs a flotation cost
of 15% of the proceeds, what is ke?
D 0 (1  g)
ke 
g
P0 (1 - F)
$4.19(1.05 )

 5.0%
$50(1 - 0.15)
$4.3995

 5.0%
$42.50
 15.4%
1-111
Flotation costs
‫تكاليف االصدار‬



Flotation costs depend on the risk of the firm and
the type of capital being raised.
The flotation costs are highest for common equity.
However, since most firms issue equity
infrequently, the per-project cost is fairly small.
We will frequently ignore flotation costs when
calculating the WACC.
1-112
Ignoring floatation costs, what is the
firm’s WACC?
‫تكلفة رأس المال بدون تكاليف االصدار‬
WACC = wdkd(1-T) + wpkp + wcks
= 0.3(10%)(0.6) + 0.1(9%) + 0.6(14%)
= 1.8% + 0.9% + 8.4%
= 11.1%
1-113
The Hamada Equation
‫معادلة العالم حمادة‬
βL = βU[ 1 + (1 - T) (D/E)]

Suppose, the risk-free rate is 6%, as is
the market risk premium. The unlevered
beta of the firm is 1.0. If the total assets
are $2,000,000.
1-114
The Hamada Equation
‫ مثال‬- ‫معادلة العالم حمادة‬
If D = $250,
βL = 1.0 [ 1 + (0.6)($250/$1,750) ]
βL = 1.0857
ks = kRF + (kM – kRF) βL
ks = 6.0% + (6.0%) 1.0857
ks = 12.51%
1-115
Calculating levered betas and costs of equity
‫عالقة استخدام الرفع المالي على معامل بيتا وتكلفة االسهم‬
Amount
borrowed
$
0
D/A
ratio
D/E Levered
ratio
Beta
0.00%
0.00% 1.00
ks
12.00%
250
12.50
14.29
1.09
12.51
500
25.00
33.33
1.20
13.20
750
37.50
60.00
1.36
14.16
1,000
50.00
100.00
1.60
15.60
1-116
Determining the minimum WACC
‫تحديد أقل تكلفة لرأس المال‬
Amount D/A ratio
borrowed
0.00%
$
0
12.50
250
25.00
500
37.50
750
50.00
1,000
E/A
ratio
ks
kd (1 – T) WACC
100.00% 12.00% 0.00%
12.00%
87.50
12.51
4.80
11.55
75.00
13.20
5.40
11.25
62.50
14.16
6.90
11.44
50.00
15.60
8.40
12.00
* Amount borrowed expressed in terms of thousands of dollars
1-117
Determining the stock price maximizing
capital structure
‫تحديد هيكل رأس المال الذي ينتج اعلى سعر للسهم‬
Amount
Borrowed
DPS
ks
P0
0
$3.00
12.00%
$25.00
250,000
3.26
12.51
26.03
500,000
3.55
13.20
26.89
750,000
3.77
14.16
26.59
1,000,000
3.90
15.60
25.00
$
1-118
Financial Planning and Forecasting
‫التنبؤ والتخطيط المالي – اساسيات التسعير‬




Forecasting sales
Projecting the assets and internally
generated funds
Projecting outside funds needed
Deciding how to raise funds
1-119
Comprehensive example
‫مثال في التنبؤ‬
Balance sheet (2002), in millions of dollars
Cash & sec.
Accounts rec.
Inventories
Total CA
Net fixed
assets
Total assets
$
20 Accts. pay. &
accruals
240 Notes payable
240
Total CL
$ 500 L-T debt
Common stock
Retained
500 earnings
$1,000
Total claims
$ 100
100
$ 200
100
500
200
$1,000
1-120
Comprehensive example
‫مثال في التنبؤ‬
Income statement (2002), in millions of dollars
Sales
Less:
Var. costs (60%)
Fixed costs
EBIT
Interest
EBT
Taxes (40%)
Net income
Dividends (30%)
Add’n to RE
$2,000.00
1,200.00
700.00
$ 100.00
16.00
$ 84.00
33.60
$ 50.40
$15.12
$35.28
1-121
Key assumptions
‫معطيات‬





Operating at full capacity in 2002.
Each type of asset grows proportionally with sales.
Payables and accruals grow proportionally with
sales.
2002 profit margin (2.52%) and payout (30%) will
be maintained.
Sales are expected to increase by $500 million.
(%DS = 25%)
1-122
Determining additional funds needed AFN
‫حساب الحاجة الى تمويل اضافي‬
AFN = (A*/S0)ΔS – (L*/S0) ΔS – M(S1)(RR)
= ($1,000/$2,000)($500)
– ($100/$2,000)($500)
– 0.0252($2,500)(0.7)
= $180.9 million.
1-123
How shall AFN be raised?
‫كيفية الحصول على االموال االضافية‬



The payout ratio will remain at 30 percent (d =
30%; RR = 70%).
No new common stock will be issued.
Any external funds needed will be raised as
debt, 50% notes payable and 50% L-T debt.
1-124
Forecasted Income Statement (2003)
‫التنبؤ بقائمة الدخل‬
2002
Sales
Less: VC
FC
EBIT
Interest
EBT
Taxes (40%)
Net income
$2,000
1,200
700
$ 100
16
$ 84
34
$ 50
Div. (30%)
Add’n to RE
$15
$35
Forecast
Basis
2003
Forecast
1.25
0.60
0.35
$2,500
1,500
875
$ 125
16
$ 109
44
$ 65
$19
$46
1-125
Forecasted Balance Sheet (2003) - Assets
‫ االصول‬- ‫التنبؤ بقائمة المركز المالي‬
2002
Cash
Accts. rec.
Inventories
Total CA
Net FA
Total assets
$
20
240
240
$ 500
500
$1,000
Forecast
Basis
0.01
0.12
0.12
0.25
2003
1st Pass
$
25
300
300
$ 625
625
$1,250
1-126
Forecasted Balance Sheet (2003) - Liabilities
and Equity
‫التنبؤ بقائمة المركز المالي – الخصوم وحقوق الملكية‬
2002
AP/accruals
Notes payable
Total CL
L-T debt
Common stk.
Ret.earnings
Total claims
$ 100
100
$ 200
100
500
200
$1,000
Forecast
Basis
2003
1st Pass
0.05
$ 125
100
$ 225
100
500
246
$1,071
+46*
* From income statement.
1-127
What is the additional financing needed
(AFN)?
‫حساب الحاجة الى تمويل اضافي‬




Required increase in assets
Spontaneous increase in liab.
Increase in retained earnings
Total AFN
= $ 250
= $ 25
= $ 46
= $ 179
NWC must have the assets to generate forecasted
sales. The balance sheet must balance, so we must
raise $179 million externally.
1-128
How will the AFN be financed?
‫كيفية تحديد التمويل االضافي‬

Additional N/P


Additional L-T debt


0.5 ($179) = $89.50
0.5 ($179) = $89.50
But this financing will add to interest expense,
which will lower NI and retained earnings. We
will generally ignore financing feedbacks.
1-129
Forecasted Balance Sheet (2003) - Assets
‫ االصول بعد حساب التمويل االضافي‬- ‫التنبؤ بقائمة المركز المالي‬
2003
1st Pass
Cash
Accts. rec.
Inventories
Total CA
Net FA
Total assets
$
25
300
300
$ 625
625
$1,250
AFN
-
2003
2nd Pass
$
25
300
300
$ 625
625
$1,250
1-130
Forecasted Balance Sheet (2003) - Liabilities and Equity
‫التنبؤ بقائمة المركز المالي – الخصوم وحقوق الملكية بعد حساب التمويل االضافي‬
2003
1st Pass
AP/accruals
Notes payable
Total CL
L-T debt
Common stk.
Ret.earnings
Total claims
$ 125
100
$ 225
100
500
246
$1,071
AFN
+89.5
+89.5
-
2003
2nd Pass
$ 125
190
$ 315
189
500
246
$1,250
1-131
Why do the AFN equation and financial
statement method have different results?


Equation method assumes a constant profit
margin, a constant dividend payout, and a
constant capital structure.
Financial statement method is more flexible.
More important, it allows different items to
grow at different rates.
1-132