1

Investment Analysis Project

Aston Business School
May, 4
th
, 2011
Dr Cesario MATEUS
www.cesariomateus.com
2
Aim
Conduct an in-depth investment analysis case study on a single
company drawn from FTSE 100 and been listed at least for the last
three years. The case study exercise aims to provide students with
the opportunity to demonstrate, in the development of a detailed
analyst's company report, the skills and knowledge acquired in the
area of investment analysis
In the project the students should address besides others the
following questions/issues:
Introductory Material: Company Description, Ticker Symbol,
Industry (Type of the industry), officers/Directors Holdings, Partners,
etc.
3
Corporate Governance Analysis: Is this a company where there is a
separation between management and ownership?
Economy Analysis: Discuss the general economy, Economic life cycle,
Economic indicators, Macro-economic forecast and the future
expectations from an economy
Industry Analysis: Discuss the industry of the company, Industry life
cycle, Macro and micro level of industry forecast and future expectations
from an industry.
Company Information: Copy of any relevant articles that appear in the
written media, summarize the listed articles and discuss the effects of the
articles to the companys financial structure. Follow the company news
and information presented to the Stock Exchange, discuss the effects of
the news to the companys stock price.
4
Stockholder Analysis: Who is the average investor in this stock?
(Individual or pension fund, small or large, domestic or foreign)
Risk and Return: Is the risk of the coming from market, firm,
industry or currency? What return would you have earned investing in
this company's stock? Would you have under or outperformed the
market? How risky is this company's equity? Why? What is its cost of
equity? How risky is this company's debt? What is its cost of debt?
What is this company's current cost of capital
Capital Structure Choices: What types of financing that this
company has used to raise funds. Advantages or disadvantages for
the firm in using debt. Does your firm have too much or too little debt
comparing with the industry and the market?
5
Dividend Policy: How has this company returned cash to its owners?
How would you recommend that they return cash to stockholders?
Financial Information: Monthly Stock Prices of the last 3 years.
Adjusted and Unadjusted. Monthly Stock Price Graph of the last 3 years,
compare it to the FTSE 100 monthly returns. Fundamental Values with
fundamental analysis (Last 3 years balance sheet and income statement
with the most important accounts and headings, discuss the companys
past performance in-terms of financial statements).
Valuation: What type of cash flow would you choose to discount for this
firm? What is your estimate of value of equity in this firm? How does this
compare to the market value? What is the value of the firm? Is the firm
over or undervalued?
6
Most recent: Market Value, Book Value, Beta, ROE, ROA, ROI, Profit
Margin, Current Ratio, Dividends, P/E approach, and other important
ratios of your choice from Leverage, Liquidity, Efficiency, Profitability, and
Market-Value approaches.
Timetable
Date Hours
May, 4
th
Lecture 10-13
May, 4
th
Lecture 14-17
May, 25
th
Lecture 10-13
May, 25
th
Office Hours 14-17
June, 22
nd
Lecture 10-13
June, 22
nd
Office Hours 14-17
7
Last year results
Nr Students 46
Average Mark 63.8
Median Mark 64
Std deviation 9.84
Maximum 88
Minimum 45
8
Risk Analysis and CAPM
9
Security Market Line
Return
Risk
Risk Free Return
Efficient Portfolio
10
Unsystematic and Systematic Risk
Adding securities reduces portfolio risk, if they are not perfectly
positively correlated.
No. of securities in portfolio
Unsystematic risk (unique risk)
Total
risk
Systematic risk (market
risk)
11
Efficient Risky Portfolios
Variance of return - a poor measure of risk
Investors can only expect compensation
for systematic risk
Asset pricing models aim to define and
quantify systematic risk
Begin developing pricing model by asking:
Are some portfolios better than others?
12
Beta ()
j
Covariance of asset j with market portfolio
Beta of Asset
Variance of the market portfolio
=
( )
2
Cov Rj, Rm

m
|
o
=
In the CAPM, a stocks systematic risk is captured by beta
The higher the beta, the higher the expected return on the stock
13
Beta ()
The basic features of Beta are:
= 1 A 1% change in the market index leads to a 1% change
in the return on a specific share.
0< <1 A 1% change in the market index leads to a less than
1% change in the return on a specific share.
>1 A 1% change in the market index leads to a greater than
1% change in the return on a specific share.
14
Beta And Expected Return
Beta measures a stocks exposure to market risk
The market risk premium is the reward for bearing market
risk:
R
m
- R
f
E(R
i
) = R
f
+ [E(R
m
) R
f
]
Return for bearing
no market risk
Stocks exposure
to market risk
Reward for bearing
market risk
15
Security Market Line
Return
Risk Free Return
BETA
Security Market Line
(SML)
16
Security Market Line
Return
BETA
f
1.0
SML
SML Equation = r
f
+ B ( r
m
- r
f
)
Rf
17
The Security Market Line
Plots the relationship between expected return and betas
In equilibrium, all assets lie on this line
If stock lies above the line
Expected return is too high
Investors bid up price until expected return falls
If stock lies below the line
Expected return is too low
Investors sell stock, driving down price until
expected return rises
18
The Security Market Line
|
i
E(R
P
)
R
F
SML
Slope = E(R
m
) - R
F
= Market
Risk Premium (MRP)

A - Undervalued

R
M
| =1.0

B - Overvalued
19
Estimating Betas
Collect data on a stocks returns and returns on a market index
Plot these points on a graph
Yaxis measures stocks return
X-axis measures markets return
Plot a line (using regression) through the points
Slope of line equals beta
R-square value measures the percentage of risk that is systematic
20
Measuring Betas
Dell Computer
Slope determined from plotting the
line of best fit.
Price data Aug 88- Jan 95
Market return (%)
D
e
l
l

r
e
t
u
r
n

(
%
)
R
2
= .11
= 1.62
21
Measuring Betas
Dell Computer
Slope determined from plotting the
line of best fit.
Price data Feb 95 Jul 01
Market return (%)
D
e
l
l

r
e
t
u
r
n

(
%
)
R
2
= .27
= 2.02
22
Classifying shares by their beta
Aggressive shares (i.e. such shares rise faster in a bull market
and fall more in a bear market): >1
Defensive shares (i.e. such shares enjoy less of a rise than
the market in a bull market and fall less in a bear market): <1
Neutral shares (i.e. share price fluctuates in line with the
market): = 1
23
Basic Valuation Models
Core Concepts
1. Apply dividend discount models (DDM) to equity valuation.
2. Apply relative valuation models to equity valuation ( P/E, P/BV
& P/CF)
3. Explain the components of an investors required rate of
return and the process for determining the inputs in the DDM
including the required rate of return and expected dividend
growth rate.
24
Estimating the Intrinsic Value
Most investment valuation involves:
Estimating the amount and timing of the cash flows
Interest, dividends, and capital gains
Estimating the growth rate of returns
common stock / Real estate
(Can grow over time)
Preferred Stock / Bonds
(fixed)
Applying an appropriate discount rate to the cash flows to estimate
the investments intrinsic value
The required return for the risk assumed Amount & timing of cash flow
Comparing the intrinsic value to the market price
If estimated intrinsic value > market price, then BUY!
25
Discounted Cash Flow Models
Preferred Stock
pdf
P
DIV
P
r
=
Fixed/Perpetual Income-never matures
Market Rate
Common Stock
1 2
2
...
(1 ) (1 ) (1 )
n
CS
cs
n
CE CE
DIVn P
DIV DIV
P
R R RCE
+
= + + +
+ + +
Projected (not fixed)
1
n
DIV
r g
+

=
Constant (Gordon) Growth DDM
g s g economy
1
CS
CE DIV
DIV
P
R g
=

0
(1 ) DIV g +
1
Payout Rate EPS
Retention Rate ROE
26
Robert Tolson is valuing a preferred stock issued by XYZ Corporation. The preferred
stock has a rating of AA and pays an annual 8% dividend on a $25 par value. Robert
estimates that the required return on a share of XYZs common stock is 14%. The 1-
year Treasury bill is currently yielding 3%. Also, Robert has the following market
information on otherwise equivalent preferred stock issuances:
Company Rating Yield
Pacific and Northern Inc. AA 7.0%
Great Widgets Inc. AA+ 6.2%
Spacely Rockets Corp. AA 6.5%
Amalgamated Combined Inc. AAA 6.7%
Based on this information, Roberts best estimate of the value of one share of the XYZ
preferred stock to be:
a. $14.29
b. $30.77
c. $66.67
d. $25.00
27
Choice b is correct. Absent any other information such as information that call
options or convertibility options are embedded in the preferred stock), this preferred
stock can be valued as a perpetuity. A perpetuity is an instrument that pays a
constant, regularly scheduled payment that continues forever. In this case, the
regular payment is the annual dividend payment. The applicable formula for the
value of a perpetuity is:
Where: Div
1
is the annual dividend payment, and rp is the required return on the
preferred stock. The annual dividend payment is equal to the dividend rate multiplied
by the par value, or:
DIV
1
= .08 $25 = $2.0
In this problem, the correct required return to use is the market yield on the most
similar preferred stock, which in this case is the AA Spacely Rockets Corp.
preferred stock with a yield in the market of 6.5%
Plugging in the values, the price is calculated as:
1
$2
$30.77
0.65
P
DIV
P
r
= = =
28
Marie Aparecida is valuing the stock of a mature company, XYZ corp.
Maria has the following estimates and market information about XYZ
corp:
Estimated Earnings per share at t=1 $1.65
Estimated Dividend per share at t=1 $0.95
Current Market Price per share $13.40
Required Return 12%
Estimated Dividend Growth rate 3.0%
Current risk free rate 3.5%
Using the Gordon constant growth dividend discount model, what value
does Marie place on a share of XYZ stock.
a. $7.92
b. $13.40
c. $18.33
d. $10.55
29
Choice d is the correct. The constant growth model uses the simplifying
assumption that dividends grow at a constant rate forever. The formula for the
constant growth model is a compact way of calculating the present value today of
all these future dividend payments that extend out of infinity. The formula is:
1
CS
CS DIV
DIV
P
R G
=

1
$0.95
$10.55
.12 .03
CS
CS DIV
DIV
P
R G
= = =

Where DIV
1
is the dividend the company is expected to pay in one year (t=1)
R
CE
is the required return on common equity
g
DIV
is the estimated sustainable dividend growth rate
Choice a is incorrect. This result ignores the dividend growth rate and simply
divides the expected dividend by the required return.
30
Choice b is incorrect. This is the market price of the stock. Note that Marie is
using the constant growth model to make her own estimation of the value of the
stock. Using the constant growth model, Marie has estimated the stock to be
worth $10.55 per share ; however, it is selling in the market at $13.40. in this
case, XYZ stock is overvalued in the market and Marie would not buy the
security.
Choice c is incorrect. This is the result if the expected earnings per share are
used in the numerator. The expected dividend per share should be used
because the dividends reflect the actual cash flows made to the shareholder.
31
Jane Wakeman is using the constant Growth Dividend Discount Model to value a
share common stock issued by National Amalgamated Corp. She has made the
following estimates regarding the stock and market rates;
Estimated Dividend Growth Rate: 3%
Expected Return on the Market 9%
Risk-free Rate 4%
Expected Dividend at t=1 $1.75
Beta 1.2
If Jane changes the risk-free rate in her valuation calculations from 4% to 5% and
the market risk premium expected to remain constant, then Janes estimate of the
value of National Amalgamated Corp. will most likely:
a. Decrease by $3.13
b. Increase by $0.74
c. Decrease by $0.75
d. Stay the same
32
Choice a is correct. The first step is to find the value of the stock when the risk-
free rate is 4%. Give the information provided, use the Security Market Line (SML)
of the Capital Asset Pricing Model (CAPM) to determine the stocks required of
return. The basic equation for finding a stocks required return, E(R
i
), using the
SML is:
Where R
F
is the risk-free rate

i
is the stocks beta
R
M
is the expected return on the market
Plugging in the numbers to the SML equation, one gets:
Next, use the estimated required return of 10% (along with the other inputs) in the
Gordon Growth Model to arrive to the value
( )
CE F M F
r R R R | = +
( )
CE F M F
r R R R | = +
.04 1.2(.09 .04) 10% = + =
$1.75
$25.00
.10 .03
CS
P = =

33
The next step is to find the value of a share of National Amalgamated Corp. if the
risk free rate shifts to 5%. However, the fact pattern in the problem indicates that
the market risk premium remains constant. Therefore, the return on the market
must increase to 10% to keep R
M
-R
F
constant at 5%. Using a risk free rate of 5%,
the required rate of return is now:
( )
CE F M F
r R R R | = +
.05 1.2(.10 .05) 11% = + =
Next, use the revised estimated required return of 11% (along with the other
inputs) in the Gordon Growth Model to arrive at a value of:
$1.75
$21.875
0.11 .03
CS
P = =

Comparing the value of the stock when the risk-free rate is 4% ($25.00) to the
value when the risk-free rate is 5% ($21.875), it is seen that the value has
decreased by $3.13.
34
Supernormal Growth
Two-Stage dividend Discount Model
Compute the dividends based on the growth rate during the
supernormal growth period finite period
DIV
1
= DIV
0
(1+g
HIGH
)
DIV
2
= DIV
1
(1+g
HIGH
)
Periods of
supernormal growth
Compute the terminal value of the stock
- GGM can be applied
once constant growth has
been reached
4
3
CE LOW
DIV
P
r g
=

= DIV
3
=(1+g
normal
)
= Normal/Sustainable/Infinite
35
Discount the cash flows to determine the current stock value
3 3 1
CS
2
2 3
CE CE CE
DIV +P DIV DIV
+ +
(1+r ) (1+r ) (1+r
P
)
=
36
Jason Cicatello is analysing the stock XYZ International. Jason estimates that XUZ
International will experience a period of supernormal growth of 20% for the next
two years. Thereafter, the growth rate will be the long-run growth rate. Jason has
the following estimates and market information about XYZ International.
Current market price per share $16.75
Dividend per share at t=0 $1.10
Historical 1-year return on equity (ROE) 15%
Estimated cost of equity capital 14%
Estimated supernormal dividend growth rate 20%
Current risk-free rate 4.0%
Estimated long-run dividend growth rate 3.5%
Using these estimates and the two stage dividend discount model. What is the
value of a share of YZ international?
a. $14.40
b. $12.92
c. $13.13
d. $11.65
37
Step 1:
GGM can be applied after two years
Dividend per share at t=0 current dividend
1.10 1.20 = 1.32 DIV
1
1.321.20 = 1.584 DIV
2
Estimated long-run dividend growth rate 3.5%
1.5841.035 = 1.64 DIV
3
Step 2:
Step 3:
$1.32 CF
1
$1.584 + $15.62 =$17.20 CF
2
Estimated cost of equity capital 14%
NPV = $14.39
3
2 CS
DIV
P
r g
=

2
1.64
$15.62 Terminal Value
14% 3.5%
CS
P = =

38
Relative Valuation Approaches
If the multiple is less than the mean for the peer group, stock
appears relatively undervalued
Earnings Multiplier Approach
0
1
P
E
Net Income-Preferred Dividends
# Common Shares Outstanding
=
Lower side of the peer group the stock is relatively undervalued
Based on the principle that dividends are paid out of earnings
DIV
t
= K E
t
Payout rate
39
1 1
CS
CE DIV CE E
DIV K E
P = =
r -g r -g
1
CE E
K
P/E =
r -g
= justifiable / appropriate P/E
1
multiple
P/E
1
EPS
1
= intrinsic value
Limitations:
Accounting Methods / non-recurring items
Management Bias / Estimates
Earnings tend to be Volatile / Negative
40
Other Multiples
Price-to-Cash Flow
Harder for management to manipulate than earnings
t
i
t+1
P
P/CF=
CF
Projected CF per Common Share
Lower side of the peer group the stock is relatively undervalued
Price-to-Book
t
i
t+1
P
P/BV=
BV
Assets-Liabilities-Preferred Stock
# CSO
=
Projected
Better for companies with liquid assets that reflect current
values (e.g. Banks) Less volatile & Cant be negative
41
Price-to-Sales
t
i
t+1
P
P/S =
S
1
1
Sales
=
# CSO
Sales are more stable than earnings and can be used to
value early-stage companies not yet earning profits
Sales:
Cant be negative
Less management bias general rule (everybody is using
accrual basis)
42
Tony Fong is estimating the appropriate P/E ratio for Slate Quarry Inc, a
mature, open-pit mining company. Tony has made the following
estimates about Slate Quarry Inc:
Required return 14%
Past 1-year return on equity 16%
Dividend growth rate 3%
Earnings retention rate 30%
Current stock price / share $8.00
Based on this data and an applying the constant growth dividend
discount model, an appropriate P/E ratio for the Slate Quarry is:
a. 2.7
b. 5.4
c. 6.4
d. 2.3
43
Choice c is the correct. The key to converting the constant growth model
(CGM) to a P/E model is to recognize that the dividend at t=1 (DIV
1
) will equal
the dividend payout ratio K times the t=1 earnings. In general:
Thus, assuming the dividend payout ratio is constant over time, KE
1
can be
substituted for DIV
1
. The CGM is now rewritten as:
Next, to turn the formula into a P/E ratio, divide both sides by E
1
Note that this problem provides the retention ratio (1-k) and not the payout ratio.
The payout ratio is 70% (1-30%).
t t t
DIV =K +E
1 1
CS
CE E CE E
DIV KE
P = =
r -g r -g
1
CE E
K
P/E =
r -g
44
The formula can now be used for Slate Querry:
Tony could then multiply this P/E estimate by his year 1 estimated earnings to
arrive at a stock price today. This value will be the same number as if Tony simply
computed the stocks value using the basic CGM and substituting his estimate of
KE
1
for DIV
1
.
Choice a is incorrect. This answer incorrectly uses the retention rate in the
numerator (instead of the dividend payout ratio).
Choice b is incorrect. This answer incorrectly uses the past 1-year ROE in the
denominator (instead of the required return). The past ROE does not indicate the
return investors will require on the stock going forward.
Choice d is incorrect. This answer incorrectly uses both the past 1-year ROE in
the denominator (instead of the required return) and the retention rate in the
numerator (insteda of the dividend payout ratio)
1
70%
P/E = =6.4%
0.14-0.03
45
Estimating the inputs to Valuation Models
Memorizing the models is easy, correctly estimating the inputs
is more challenging.
CE F ERP
r =(1+R )(1+r )-1
Equity Risk Premium-Compensate for market
risk and business risk, financial liquidity, country,
currency, etc
The discount rate is the nominal risk-free rate plus a risk premium
The growth rate is a function of ROE and earnings retention
E
g =ROE(1-K)
Payout rate
0
0
DIV
EPS
| |
|
\ .
Profit Margin + Asset Turnover + Financial Leverage (Dupont Model)
46
Janet Schoettinger is estimating the required return to use in valuing the
stock of Flintrock Industries. Janet has the following estimates about the
stock and the interest rates:
Flintrocks stock beta 0.8
Real risk-free rate 2%
Expected inflation rate 3%
Flintrocks equity risk premium 6%
Based on this information and using a build-up approach, the exact
discount rate Janet should use for Flintrock Industries is:
a. 9.18%
b. 11.36%
c. 9.86%
d. 8.12%
47
Choice b is the correct. The stocks required return will be based on the three
components:
Real risk-free rate
Expected inflation rate
Equity risk premium
In finding the required return for the stock, one can think of building up from the
base real risk-free rate. In this building up process, the real risk-free rate and the
expected inflation rate are first combined to get the nominal risk-free rate. This is
done as follows:
F F
r =(1+rr )[1+E(INFL)]-1
(1.02)(1.03) 1
0.0506 5.06% =
Where r
F
, is the nominal interest rate, rr
F
is the real risk-free rate E(INFL) is the
expected inflation rate.
48
Next, the nominal risk free rate and the equity risk premium (r
ERP
) are then
combined to arrive at r
CE
, the required return (or, cost of common equity) for
Flintrock stock:
CE F ERP
r =(1+r )(1+r )-1
=(1.0506)(1.06)-1
=0.1136=11.36%
Note that the approximate answer would simply be the sum of the three numbers:
Approximate
CE F ERP
r =rr +E(INFL)+r
=.02+.03+.06
=.11=11%
49
Market and Industry Analysis
Core Concepts
A. Explain the process of valuing a stock market using
fundamental analysis
B. Identify the investment opportunities associated with the
business cycle stages.
C. Discuss the impact of the industry life cycle, competitive
structure and risk considerations on global industry
analysis
D. Explain the relationship between company analysis and
stock selection.
Top/Down Approach
50
Summarize
1. Analyze macroeconomic data to identify favorable
countries
2. Identify favorable markets and industry growth prospects
3. Select individual companies for investment
51
Analysing the Stock Market
Based on a broad market index like the S&P 500
The goal is to forecast the earnings for the index:
Relate sales to a macroeconomic variable like GDP (IV)
Regression analysis
Estimate profitability by relating margin (EBITDA) to
macroeconomic profitability margins
Capacity utilization, unit labor costs
1
% Sales Index = + (% GDP) o A A
0 1
Sales (1+% Sales) = Sales
52
Forecast the indexs earnings based on the sales forecast, the
margin forecast, and estimation of depreciation and interest
expenses:
1
[Sales EBITDA margin]- Depr.-Interest (1-tax rate)
Projected net Income
Divided by nr shares outstanding to have EPS
Finally, estimate a growth rate based on ROE and payouts ratios
for the index:
INDEX
g = ROE (1 - K)
1
EPS Payout
Value Index =
r g

53
Jae Kim, an equity strategist, is estimating the next years average sales
per share for a major stock market index. He has the following estimates
including the results of index regression analysis (based on 20 years of
annual data).
1 N
1
% Sales Index = + (% GDP )
= 3.2 and = 1.25
Where GDP
N
is the nominal gross domestic product
Average Index ROE (last five years) 13.5%
Nominal 1-year GDP growth (estimate) 3%
Average GDP growth (last five years) 2%
Index current average sales per share $400
Average Index Retention Rate 55%
Based on Jaes regression analysis, what is the 1-year estimated average sales
per share for the index?
a. $422.60, b. $427.80, c. $429.70 or d. $415.00
54
Choice b is correct. Jaes approach first uses regression analysis and the historical
data to estimate the relationship between GDP growth and sales growth for the
index. Historically, the relationship between the percentage change in average sales
brought about by the percentage change in GDP is:
N
% Sales Index = 3.2 + 1.25 (% GDP ) A A
Note that the regression estimate should be based on data that cover between
one and five complete business cycles.
Plugging in the estimate for nominal GDP growth (3%), the estimated
percentage change in average sales is:
% Sales Index = 3.2 + 1.25 (3) = 6.95% A
With an expected growth rate in sales of 6.95%, the average sales for next year is
estimated to be:
Estimated average sales next year = (current average sales) (1+ estimated growth rate)
$400 (1+ 0.0695) = $427.80
55
Choice a is incorrect. This answer is found by using the average GDP growth rate
over the last five years (instead of the estimate for next years GDP growth)
Choice c is incorrect. The provided answer is found by using the estimated growth
earnings: g = retention rate ROE. This growth rate is not applicable to sales.
Choice d is incorrect. This answer omits the intercept in the regression equation.
56
Keith Miller, an equity market strategist, is attempting to estimate the expected
P/E ratio of the Russel 2000. Keiths approach is to use the Gordon Growth model
and the Capital Asset Pricing Model to estimate the earnings multiplier. Keith has
made the following estimates.
Russel 2000: Projected average effective rate 20%
Long term treasury bond yield 10%
Russel 2000: Projected average ROE 15%
Russel 2000: expected Index market risk premium 5%
Russel 2000: Projected pretax earnings per share $100
Based on this information, the expected P/E ratio for Russel 2000 is closest to,
a. 4.4
b. 4.0
c. 10.0
d. 6.7
57
Choice d is correct. For this problem, the constant growth dividend discount
model is:
R2000
R2000
R2000
CE
DIV
V =
r -g
The dividend at any period will be equal to:
t t t
DIV = K E
Given this, and assuming that the dividend payout ratio is constant over time KE
R2000
can be substituted for DIVR2000 and then the CGM model is rewritten as:
R2000 R2000
R2000 R2000
R2000
CE CE
DIV KE
V =
r -g r -g
=
To turn the formula into a P/E ratio, divide both sides by E
R2000
:
R2000
R2000 R2000 R2000
CE
K
V /E =P/E =
r -g
58
Next, to use the formula, the various inputs need to be calculated:
The average dividend payout ratio is 1 minus the average retention rate:
1-0.4 = 0.6
The required return on the Russel 2000 is computed using CAPM and recognizing
that the beta estimate of the Russel 2000 is 1:Thus:
R2000
CE f R2000 R2000
r =r +Beta (Market Premium )=.10+1(.05)=15%
The estimated dividend growth rate will equal:
R2000 R2000 R2000
g =ROE Retention Ratio =.15.4=6%
Plugging in these numbers the estimated P/E ratio is:
R2000
R2000
CE
K .6
P/E = = = 6.7
r -g .15-.6
59
Industry Life Cycle
Stage 1: Low Volume / No profits (Pioneering Development) Price to
sales
Stage 2: High Profits ( Rapid Accelerating Growth)
Stage 3: More Competition (Mature Growth) Profit Margin goes down
Stage 4: Small Margins (Stabilization an Market Maturity) - Longest
Gordon Growth Model Applies growth s GDP
Stage 5: Consolidation (Deceleration of Growth and Decline)
Economies of Scale Large firms survive
Small Firms Liquidation Value Small firms will worth more dead
than alive (Price to book value)
Stages 2, 3 and 4 3 stage DDM
60
Competitive Structure
As number of competitors goes up, rivalry intensify goes up and
profit margins goes down
N-Firm Concentration ratio
The sum of the n largest firms percentage market shares
As ratio rivalry EBITDA margins
Herfindhal Index (H) The sum of the squares of the market shares
of the firms that constitute the industry
2
1
H = (M )
n
i
i=

H = more concentrated the industry, rivalry PM

61
Reciprocal of the index gives the equivalent number of firms within the
industry if each had an equal share
1
= Equivalente # of firms
H
Rivalry PM
62
Risk Considerations - Porters 5 Forces
Threat of new entrants - Barriers to entry
Pure competition none
Monopoly Competition low
Oligopoly / Monopoly - high
High profits attract new competitors
Rivalry among firms within the industry
Price wars low concentration
Availability of substitutes
Price elasticity
Bargaining power to customers
Pushes down prices Thus, profit margins goes down
Bargaining power of suppliers
Pushes up costs - Thus, profit margins goes down
D
% Q
=e e 1 elastic
% P
,
Affect Firms Competitive structure
63
SWOT Analysis
SWOT analysis is a strategic planning method used to evaluate the
Strengths, Weaknesses, Opportunities, and Threats involved in a project
or in a business venture. It involves specifying the objective of the
business venture or project and identifying the internal and external
factors that are favorable and unfavorable to achieve that objective
Strengths: characteristics of the business or team that give it an
advantage over others in the industry.
Weaknesses: are characteristics that place the firm at a disadvantage
relative to others.
Opportunities: external chances to make greater sales or profits in the
environment.
Threats: external elements in the environment that could cause trouble for
the business.
64
PESTEL Analysis of the macro-environment
There are many factors in the macro-environment that will effect the
decisions of the managers of any organization. Tax changes, new laws,
trade barriers, demographic change and government policy changes are
all examples of macro change. To help analyze these factors managers
can categorize them using the PESTEL model. This classification
distinguishes between:
Political factors
Economic factors
Social factors
Technological
Environmental
65
Company Analysis and Stock Selection
Good companies do not necessarily make
good stocks
Is it already
priced in the
stock?
i.e. undervalued
Growth companies vs. Growth Stock
Sales Stock Price
Defensive company vs. Defensive stock
Stable Earnings
Stable Price
Low Beta
Cyclical company vs. cyclical stock
Earnings
correlated with
Business Cycle
Volatile Price
High Beta
66
What is the stocks intrinsic value?
Forecast Sales
1
% Sales = + (X) o A
1 0
Sales Sales (1+% Sales) =
Forecast Profit Margin - Competitive Structure
Forecast Earnings (EPS)
1
1
Sales [EBITDA margin]- Depr.-Interest (1-tax rate)
Estimate Multiplier (P/E
1
)
K
r g
Value the Stock
1 1
V = EPS +P/E
If V > P
market
= BUY
Plots above SML - undervalued
67
Bob Michaels, an equity analyst, has information on four different industries
Industry Average of: Industry 1 Industry 2 Industry 3 Industry 4
R&D Expenses as a percentage of sales 1% 4% 1.5% 2%
Percentage of Industry market share held 8% 70% 65% 38%
Fixed expenses/Variable Expenses 5:1 4:1 2:1 1:1
Average Sales Growth over last four years 3% 12% 11% 8%
Based on this information and Porters Five Forces, which industry should
have lowest average EBITDA margin?
a. One
b. Two
c. Three
d. Four
68
Step 1: Thus - most competition / intense rivalry
R&D Expenses as a percentage of sales
Industry 1
R&D barriers to enter Competition lower margins
% competition lower margins
Fixed costs barriers to exit rivalry competition lower margins
Growth rate rivalry competition lower margins
Choice a is correct
69
Regina Flemming, a portfolio manager, is analyzing the stock of a large
consumer durables manufacturer, XYZ Inc. Regina has summarized XYZs
business as follows:
XYZ manufacturers a limited range of luxury consumer-durable goods. The
company enjoys an excellent reputation for innovation and customer service.
Historically, sales have been strongly correlated with fluctuations in the
economy, as sales decline in economic downturns and increase in economic
upturns. The firms operations and finances continue to be among the strongest
in the industry with minimal debt, high liquidity, low operating leverage, and a
stock beta of 0.85. The long-run prospects for this company is very strong.
Based on this information, which of the following is true about XYZ company
and XYZ stock?
a. Cyclical; Cyclical
b. Non-Cyclical; Cyclical
c. Cyclical, Non-Cyclical
d. Non-Cyclical; Non-Cyclical
70
Choice c is the correct. The key point is that the analyst needs to distinguish
between the company and the stock. A cyclical companys sales and earnings will
rise and fall with the business cycle. As described, XYZ is clearly a cyclical
company. Note that the extent of the cyclicality of the companys earnings will be
affected by the extent of the companys fixed costs (operating leverage) and the
extent of its debt expenses (financial leverage).
As described, XYZs stock is not cyclical. A cyclical stock is one with changes in
returns that are greater than the markets changes in return. For instance, if the
market is up 10%, a cyclical stock will be up more than 10%. Or, for example, if
the market is down 12%, a cyclical stock will be down more than 12%. Given, that
XYZ has a beta of 0.85 (less than one), XYZ is not considered a cyclical stock.
In summary, XYZ is a cyclical company but not a cyclical stock.
71
What is Financial Leverage?
What mix of debt and equity (ordinary shares) should be used to finance
a firms operations?
How much financial leverage should a firm have in its capital structure?
The main questions we address are
Can the firms value be affected by its capital structure choices?
Does the value of the firms cash flows depend on how it is divided
between payments to shareholders and debtholders?
Is there an optimal capital structure that maximizes the value of the
firm?
72
What is Financial Leverage?
Two main risks faced by firms
Business (or operational) risk
The variability of future net cash flows attributed to the nature of the
firms operations
It is the risk faced by shareholders if the firm is financed only by
equity
Financial risk
The risk attributed to the use of debt as a source of financing a firms
operations
73
Do Managers Care About Leverage?
Source: Damodaran Online, pages.stern.nyu.edu/~adamodar. Based on survey
of CFOs of large US firms who ranked the factors that they considered important
in their financing decisions. A 0 is least important and a 5 is most important.
74
What Managers Use
Source: Damodaran Online, pages.stern.nyu.edu/~adamodar. Based on
survey of CFOs of large US firms who ranked the sources of long term
capital used by their firm.
75
Effects of Financial Leverage
Financial risk exists if the firms operations are financed using debt, that
is, when there is financial leverage
How much debt and equity does the firm have in its capital
structure?
Measured as the debt-to-equity or the debt-to-total-assets ratios
Effects of financial leverage?
Expected rate of return on equity increases
The variability of returns to shareholders also increases
Increasing leverage involves a trade-off between risk and return
Note that leverage varies both within and between industries
76
Effects of Financial Leverage
77
Key Concepts
Business risk is the variability of future net cash flows attributed to the
nature of the firms operations
Financial risk is the risk attributed to the use of debt as a source of
financing a firms operations
The level of financial leverage varies across firms in the same industry
as well as across firms in different industries
Modigliani and Millers proposition 1 states that the market value of a
firm is independent of its capital structure
78
Key Relationships/Formula Sheet
79
Capital Structure
80
Can a firm increase its value by choosing the right mix of debt and
equity (i.e., the right capital structure) to finance its operations?
Capital structures vary across firms, industries, and countries.
Is debt better than equity because it is cheaper?
Is equity better than debt because firms that borrow may go
bankrupt?
Capital Structure
81
1) More profitable firms tend to use less leverage.
2) High-growth firms borrow less than mature firms do.
3) Firms product market strategies and asset bases influence capital structure
choice.
4) Stock market generally views leverage-increasing events positively.
5) Tax deductibility of interest gives firms an incentive to use debt.
Evidence on Capital Structure
82
Theoretical Models of Capital Structure
Modigliani and Millers (M&M) capital structure model
The agency cost/tax shield trade-off model
The pecking order theory
The signaling model
83
MM and Market Imperfections
Modigliani and Millers original analysis ignores capital market
imperfections including
Corporate and personal taxes
Transaction costs
Costs associated with financial distress
Different cost of borrowing for firms and individuals
Changing cost of debt due to changing risk
Agency costs
We focus on the major market imperfections of taxes, financial
distress and agency costs
84
MM and Corporate Taxes
The value of the leveraged firm, V
L
now is
V
L
= V
U
+ PV (Tax shield)
V
L
= V
U
+ (t
c
D k
D
)/k
D
VL = V
U
+ t
c
D
Implication?
With the introduction of corporate taxes in the MM analysis the
existence of debt matters!
The natural conclusion is that firm should maximize the level of
debt in their capital structure as this will maximize the value of
the firm
Does this make sense (especially in the current market
environment)?
Whats missing from this analysis?
85
MM with Corporate and Personal Taxes
Corporate taxes is only part of the tax picture
The existence of personal taxes on interest income can reduce
the tax advantage associated with debt financing
Firms save on corporate taxes via the interest tax shield by
increasing the debt-to-equity ratio
However, investors will pay additional personal taxes and will
require higher rates of return to compensate them for this and for the
higher risk associated with debt
Under a classical tax system, the tax advantage of debt
at the firm level may be reduced or even eliminated at the
shareholder level!
86
MM and Other Market Imperfections
There are non-tax factors that can cause a firms value to depend
on its capital structure as well
Financial distress and bankruptcy costs
Agency costs
Financial distress is the state where a firm is in breach of its debt
obligations, which may not necessarily result in bankruptcy
Note also that the following analysis assumes a classical tax
system
87
MM and Other Market Imperfections
Direct costs of financial distress
Fees associated with advisors, lawyers, accountants, etc.
Indirect costs of financial distress - Financial distress leads a
range of stakeholders to behave in ways that can disrupt a firms
operations and reduce its value
Effect of lost sales
Reduced operating efficiency
Cost of managerial time devoted to averting failure
Indirect costs are typically much higher than the direct costs
The case of Enron
Direct costs estimated as high as $500 million
Indirect costs in terms of lost market value exceeded $25
billion!
88
Agency Costs of Capital Structure
Agency costs arise from the potential for conflicts of interest
between the parties forming the contractual relationships of the firm
Management may make decisions that transfer wealth from
debtholders to shareholders
The sources of potential conflict are
Dilution of claims
Dividend payout
Asset substitution
Underinvestment
89
Agency Costs of Capital Structure
Dilution of claims
A firm may issue new debt which ranks higher than existing
debt The claim of old debtholders on the firms assets now less
secure
New debtholders earn what theyre promised so theres a
wealth transfer from old debtholders to shareholders
Dividend payout
A firm may significantly increase its dividend payout which
decreases the firms assets and increases the riskiness of its
debt
Wealth transfer from debtholders to shareholders
90
Agency Costs of Capital Structure
Asset substitution
A firms incentive to undertake risky (and even negative NPV)
investments increases with the use of debt there is limited
ilability associated with equity
If risky investments are successful most of the benefits go to
shareholders
If risky investments fail most of the costs are borne by
debtholders
Undertaking such (negative NPV) investments will result in total
firm value falling, but the relative value of equity will rise and the
value of the debt will fall
Wealth transfer from debtholders to shareholders
91
Agency Costs of Capital Structure
Underinvestment
A firm may potentially reject low risk investments even if they are
positive NPV investments
With risky debt, it may not be in the interest of shareholders to
contribute additional capital to finance these new (positive NPV)
investments
Although the investments are profitable and will increase firm
value, shareholders may still lose because the risk of the debt will
fall and its value will increase
92
An Optimal Capital Structure
Incorporating the benefits and costs of debt, leads to the following
expression of the value of a leveraged firm
The present value of expected bankruptcy costs depends on the
probability of bankruptcy and present value of costs incurred if
bankruptcy occurs
The trade-off theory of capital structure
The possibility of a trade-off between the opposing effects of
the benefits of debt finance and the costs of financial distress
may imply that an optimal capital structure exists
Management should aim to maintain a target debt-equity ratio
93
Key Concepts
Modigliani and Millers proposition 2 states that the expected return
on equity of a leveraged firm increases in direct proportion to its debt-
to-equity ratio
With corporate taxes, the MM analysis shows that the higher the
level of debt the higher the firms value
Under the imputation tax system, introducing personal taxes may
result in a tax neutrality between debt and equity or even a bias
towards those shareholders whose personal tax rates are higher than
the corporate tax rate
Introducing bankruptcy costs and agency costs results in a
trade-off between the costs and benefits associated with debt
and an optimal capital structure
94
Key Relationships/Formula Sheet
95
the weighted average cost of capital
Estimate the weighted average cost of capital
Use the weighted average cost of capital in capital
budgeting
Examine the limitations of the weighted average cost of
capital
Weighted Average Cost of Capital
96
The Weighted Average Cost of Capital
The weighted average cost of capital (WACC or k
0
) is the
benchmark required rate of return used by a firm to evaluate its
investment opportunities
The discount rate used to evaluate projects of similar risk to
the firm
It takes into account how a firm finances its investments
How much debt versus equity does the firm employ?
The WACC depends on
Qualitative factors
The market values of the alternative sources of funds
The market costs associated with these sources of funds
97
Estimating the WACC
The main steps involved in the estimation of the WACC are
Identify the financing components
Estimate the current (or market) values of the financing
components
Estimate the cost of each financing component
Estimate the WACC
We will consider each step for typical financing components
98
Identify the Financing Components
Debt
Identify all externally supplied debt items
Do not include creditors and accruals as these costs are
already included in net cash flows
Ordinary shares
Obtain number of issued shares from the balance sheet
Do not include reserves and retained earnings
Preference shares
Obtain number of issued shares from the balance sheet
99
Valuing the Financing Components
Use market values and not book values
Value coupon paying debt using the following pricing relation
100
Valuing Long Term Debt
Example: BLD Ltd has 10,000 bonds outstanding and each bond
has a face value of $1,000 with two years remaining to maturity.
The bonds pay coupons (or interest) at a rate of 10% p.a. every
six months. If the market interest rate appropriate for the bond is
15% p.a., what is the current price of each bond? What is the total
market value of debt in BLD Ltds capital structure?
101
Valuing Long Term Debt
Coupon (or interest) payments are made every six months
Number of payments, n = 4, semi-annual payments
Annual interest payments = 0.10(1000) = $100.00
So, semi-annual interest payments = $50.00
Repayment of principal at the end of year 2 = $1000.00
Required return on debt, k
d
= 15% p.a.
So, semi-annual required return on debt, k
d
= 7.5%
102
Valuing Long Term Debt
The price of the bond is
P
0
= $916.27
So, total value of debt = 10000(916.27) = $9,162,700
Note: As the coupon rate is lower than the market rate, the
price is less than the face value, that is, the bond is selling at a
discount to face value
If the coupon rate is greater than the market rate,
the price would be at a premium to face value
103
Valuing Ordinary Shares
Example: ABC Ltd has 300,000 shares on issue which each have
a par value of $1.00. If the shares are currently trading at $3.50
each what is the total market value of ABCs ordinary shares?
There are 300,000 shares on issue with a market value of $3.50
per share
Market value of equity = 300000 3.50 = $1,050,000
The par (or book) value of shares is not relevant here
104
Valuing Preference Shares
Preference shares pay a fixed dividend at regular intervals
If the shares are non-redeemable, then the cash flows
represent a perpetuity and the market value can be computed
as
P
0
= D
p
/k
p
Where
P
0
= The current market price
D
p
= Value of the periodic dividend
k
p
= Required return on preference shares
105
Valuing Preference Shares
Example: Assume the preference shares of XYZ Ltd pay a
dividend of $0.40 p.a. and the cost of preference shares is 10%
p.a. What is the price of the preference shares? If XYZ Ltd has
500,000 preference shares outstanding, what is the market value
of these shares?
The cash flows from the preference shares are
D
p
= $0.40 per share
So, P
0
= 0.40/0.10 = $4.00
Market value of shares = 500000 4.00 = $2,000,000
106
Estimating the Costs of Capital
The costs of a firms financing instruments can be obtained as
follows
Use observable market rates - may need to be estimated
Use effective annual rates
For the cost of debt use the market yield
Focus here is on the costs of debt, ordinary shares and
preference shares
Note: We ignore the complications of flotation costs and
franking credits associated with dividends (sections 15.5.3 and
15.5.5 of the text)
107
Cost of Debt
Example: The bonds of ABD Ltd have a face value of $1,000 with
one year remaining to maturity. The bonds pay coupons at the rate
of 10 percent p.a. If the current market price of the bonds is
$1,018.50, what is the firms cost of debt?
The annual interest (coupon) paid on the debt is
1000 0.10 = $100
So, 1018.50 = (1000 + 100)/(1 + kd)
k
d
= (1100/1018.50) 1 = 8.0%
108
Cost of Ordinary Shares
It is common to use CAPM to estimate the cost of equity capital,
where the cost of equity is
Note that the equity beta is the estimate of the firms relative
risk compared to movements in the market portfolio
The market risk premium is typically estimated using
historical market data
The riskfree rate is typically based on the long term
government bond rate
109
Cost of Ordinary Shares
Example: Assume that the risk free rate is 6 percent, the expected
market risk premium is 8 percent and the equity beta of XYW Ltds
equity is 1.2. What is the firms cost of equity capital?
Using the CAPM, we have
Note: Can also use the dividend discount models covered in Lecture 4
(but not commonly used by managers)
110
Cost of Preference Shares
Recall that, P
0
= D
p
/k
p
Thus, k
p
= D
p
/P
0
Example: The preference shares of DBB Ltd pay a dividend of $0.50
p.a. If the preference shares are currently selling for $4.00 per share,
what is the cost of these shares to the firm?
The cost of preference shares is given as
k
p
= D
p
/P
0
So, k
p
= 0.50/4.00 = 12.5%
111
Weighted Average Cost of Capital
The weighted average cost of capital (ko) uses the cost of each
component of the firms capital structure and weights these according to
their relative market values
Assuming that only debt and equity are used, we have
112
Weighted Average Cost of Capital
Assuming that preference shares are used as well as debt and equity
Be careful of rounding errors in initial calculations
Be careful to work in consistent terms
Calculations in percentages versus decimals
Check your answers with some common sense logic
113
Taxes and the WACC
Under the classical tax system
Interest on debt is tax deductible
Dividends have no tax effect for the firm
The after-tax cost of debt, k'
d
= (1 t
c
) k
d
where t
c
corporate tax rate
The cost of equity (ke) is unaffected
The after-tax WACC is defined as
114
Calculating and Using the WACC
Example: You are given the following information for BCA Ltd. Note that
book values are obtained from the firms balance sheet while market
values are based on market data.
The firms marginal tax rate is 30%. Estimate the firms before-tax and
after-tax weighted average costs of capital
115
Calculating and Using the WACC
Before-tax weighted average cost of capital
WACC weights are based on market values so book values are not
relevant
Note: Weight in bonds, D/V = 50/150 = 0.333, and so on
Before-tax cost of capital = 11.47%
116
Calculating and Using the WACC
The after-tax cost of capital requires the after tax cost of debt
Note: Weight in bonds, D/V = 50/150 = 0.333, and so on
After-tax cost of capital = 10.67%
117
Calculating and Using the WACC
Example: Assume that a firm is financed by 60 percent equity, 10
percent preference shares and the remainder by debt. The
corporate tax rate is 30 percent. The costs of capital for debt,
preference and equity capital are 10 percent, 12 percent and 15
percent, respectively. What is the firms after-tax weighted
average cost of capital? If the firm is considering three
independent projects with IRRs of 10%, 12% and 14% which of
these projects should it accept?
118
Calculating and Using the WACC
The debt ratio is
D/V = 1 0.60 0.10 = 0.30
k
0
= [0.10 (1 0.30) 0.30] + (0.12 0.10) + (0.15 0.60)
k
0
= 12.3%
The firm should accept all projects with an IRR greater than the cost of
capital (why?)
Accept the project with an IRR of 14%
Reject the projects with IRRs of 10% and 12%
119
Calculating and Using the WACC
Example: ASL Ltd has a debt-to-equity ratio of 25%. The cost of debt is
8 percent and the corporate tax rate is 30 percent. If the after-tax
weighted average cost of capital is 20 percent, what is the firms cost of
equity?
The cost of equity can be obtained using the weighted average cost of
capital relationship
Note that were given a D/E ratio of 0.25
We need the D/V = D/(D + E) ratio
120
Calculating and Using the WACC
D/E = 0.25 implies
D = 0.25(E)
So, D/(D + E) = 0.25(E)/[0.25(E) + E] = 0.25(E)/1.25(E)
D/(D + E) = 0.20 and E/(D + E) = 1 0.20 = 0.80
The weighted average cost of capital is
k
0
= 0.20 = 0.08(1 0.30)(0.20) + k
e
(0.80)
So, k
e
= [0.20 0.08(1 0.30)(0.20)]/(0.80)
k
e
= 23.6%
121
Limitations on Using the WACC
Recall: The weighted average cost of capital is the discount rate
that is used to evaluate projects of similar risk to the firm
The WACC cannot be used in the following situations
If the project alters the operational (or business) risk of the
firm
If the project alters the financial risk of the firm by
dramatically altering its capital structure
Examples of risk altering projects?
What should the firm do if the WACC cannot be used?
122
Key Concepts
The weighted average cost of capital is the discount rate that is
used to evaluate projects of similar risk to the firm
There are four main steps involved in the estimation of the
weighted average cost of capital
Identify the financing instruments
Estimate the current (or market) values of the financing
components
Estimate the cost of each financing component
Estimate the weighted average cost of capital
The WACC cannot be used to evaluate projects that alter the
business or financial risks of the firm
123
Key Relationships/Formula Sheet
124
Dividend Fundamentals
Announcement
date
The day the firm announces the dividend,
dividend record, and payment dates
Date of record
All persons recorded as stockholders on
this date receive the declared dividend.
Relevant dates for dividend payments
Ex dividend date
The persons that buy the stock before ex
dividend date will receive the current
dividend.
Several business days before date of
record
125
Types of Dividends
Regular Cash Dividend
Special Cash Dividend
National Differences in payment Methods
Constant Payout Ratio Policy
Constant Nominal Payments (Standard
Worldwide)
Low Regular and Extra Dividend
Stock Dividend: Payment of a Dividend in the Form of
Stock
Stock Splits affect firms shares similarly to Stock
Dividends
Buying shares on the market
Tender Offer to Shareholders
Private Negotiation (Green Mail)
Cash Dividends
Types of Dividend Policies
Stock Dividends
and Stock Slits
Stock
Repurchases
126
Patterns In Dividend Policies Worldwide
Companies in common law countries have
higher payouts than those from civil law
countries.
US companies are now near global average
The same worldwide
Profitable firms in mature industries tend to
pay out much larger fractions of their earnings
Within industries, dividend payout tends to be directly related to asset
intensity and the presence of regulation.
Almost all firms maintain constant nominal dividend payments per share for
long periods of time.
Distinct national
patterns
Pronounced industry
patterns
127
Patterns Observed In Dividend Policies Worldwide
The stock market reacts positively to dividend increases and
negatively to decreases or cuts.
It is unclear how dividends affect the required return on a firm's
common stock.
Taxes influence dividend payouts, but the net effect is
ambiguous.
Firms paid dividends before and after income tax.
Empirical evidence shows that tax increases lead to higher
payouts, rather than lower.
128
Models Of Dividend Payments
Several competing theories are advanced to explain observed
patterns in dividend policies.
The Agency Cost /
Contracting Model
The Signaling Model
Mainstream favorite: the agency cost/contracting model
The signaling model of dividends: firms pay dividends to burn
money, separate from weaker rivals
129
The Agency Cost / Contracting Model Of Dividend
Payments
Dividends exist to overcome agency problems between
managers and shareholders.
Managers commit to paying out free cash flow as dividends.
Based on ownership structure: private and closely held firms
rarely pay dividends; big public firms have high payouts.
Based on investment opportunity set: mature firms have high
payout; high-growth firms have low payouts.
130
Dividends Increase Value
Market Imperfections and Clientele Effect
There are natural clients for high-payout stocks, but it does not
follow that any particular firm can benefit by increasing its
dividends. The high dividend clientele already have plenty of
high dividend stock to choose from.
These clients increase the price of the stock through their
demand for a dividend paying stock.
131
Dividends Increase Value
Dividends as Signals
Dividend increases send good news about cash flows and
earnings.
Dividend cuts send bad news.
Because a high dividend payout policy will be costly to firms that
do not have the cash flow to support it, dividend increases
signal a companys good fortune and its managers confidence
in future cash flows.
132
Dividends Decrease Value
Tax Consequences
Companies can convert dividends into capital gains by shifting
their dividend policies. If dividends are taxed more heavily
than capital gains, taxpaying investors should welcome such a
move and value the firm more favorably.
In such a tax environment, the total cash flow retained by the
firm and/or held by shareholders will be higher than if dividends
are paid.
133
Taxes and Dividend Policy
Since capital gains are taxed at a lower rate than dividend
income, companies should pay the lowest dividend possible.
Dividend policy should adjust to changes in the tax code.
134
Next session:
Financial Analysis
Financial performance
Financial Reporting Analysis
Balance sheet
Income statement
Cash flow statement
Ratio Analysis
Liquidity
Profitability
Debt
Performance
Cash Flow
Investment
135
Valuation
Concept
Scenarios
The financial Model
Assumptions underlying the financial Model
Risk
Risk Free Rate & Market risk Premium
Cost of Equity
Cost of Debt
Weighted average Cost of Capital
136
Intrinsic Valuation
Abnormal Earnings
Dividend Discount Model
Discounted Cash Flow Model
Black Scholes option Pricing Model
Relative Valuation
Trading Multiples
137
Dr Cesario Mateus
Senior Lecturer in Finance and Banking
Programme Leader Msc Financial Management
Email: c.mateus@greenwich.ac.uk
Skype ID: cmateus1