FIN 200 Corporate Financial Management
Section A
One of the most common criticisms of DCF models is that any forecast beyond a couple of years is questionable. Investors, therefore, are alleged to be better off using more certain, near-term earnings forecasts. Such reasoning makes no sense, for at least two reasons. First, a key element in understanding a business’s attractiveness involves knowing the set of financial expectations the price represents. The market as a whole has historically traded at a price-to-earnings multiple in the mid-to-high teens. Simple math shows today’s stock prices reflect expectations for value-creating earnings and cash flows many years in the future. The mismatch between a short forecast horizon and asset prices that reflect long-term cash flows leads to the second problem: investors have to compensate for the undersized horizon by adding value elsewhere in the model. The prime candidate for the value dump is the continuing, or terminal, value. The result is often a completely non-economic continuing value. This value misallocation leaves both parts of the model—the forecast period and continuing value estimate—next to useless. Some investors swear off the DCF model because of its myriad assumptions. Yet they readily embrace an approach that packs all of those same assumptions, without any transparency, into a single number: the multiple. Many companies require over ten years of value-creating cash flows to justify their stock prices. Ideally, the explicit forecast period should capture at least one-third of corporate value with clear assumptions about projected financial performance. While the range of possible outcomes certainly widens with time, we have better analytical tools to deal with an ambiguous future than to place an uncertain multiple on a more certain near-term earnings per share figure. We address the uncertainty issue below. In reference to the hostile bid of €694 million, what the free cash flow model tells us is that the company is valued around €788 million. The hostile bid from Ryan air is massively undervalued. We must bear in mind that this is only one model and for a complete analysis, we must look at different models and compare.
Section B
Analysts like to use the free cash flow valuation model whenever one or more of the following conditions are present: * The firm is not dividend paying,
* The firm is dividend paying but dividends differ significantly from the firm’s capacity to pay dividends, * Free cash flows align with profitability within a reasonable forecast period with which the analyst is comfortable, or * The investor takes a control perspective.
Free cash flow to the firm (FCFF) is the cash flow available to the firm’s suppliers of capital after all operating expenses have been paid and necessary investments in working capital and fixed capital have been made. The FCFF valuation approach estimates the value of the firm as the present value of future FCFF discounted at the weighted average cost of capital (WACC)
What other models out there?
The Price / Earning Ratio (P/E)
P/E =Current Share Price
Earnings Per Share (EPS)
The advantages of the P/E Ratio are that it is simple to calculate. It is always widely used throughout the financial world by investors and firms. It could be considered a decent proxy for the present value of future cash flows. It is also a better indicator of share’s value than market price alone. The disadvantages are that the ratio includes no thought of the risk factor. Differing versions of the calculation (trailing P/E/trailing P/E from continued operations or Forward P/E) can make analysis difficult. The ratio doesn’t take into account the time value of money. It also uses accounting information, which can change or be misinterpreted and is only really useful when compared with the industry and competitors.
Book Value Calculation
Historical cost of assets (adjusted for depreciation) – liabilities = Book Value
The advantages of the Book Value Calculation are that it is very easy to calculate, the information is readily available on the internet via the annual report. It also takes into account depreciation. The disadvantages are that the calculation is based on historical data and therefore it has no real consideration of market value. It also doesn’t take into account the firms potential to generate future values and doesn’t take into account risk or the time value of money. It also uses financial information, which can change or can be misinterpreted.
Enterprise Value (EV) to EBITDA Calculation
Enterprise Value (EV)
EBITDA
Where;
EV = the sum of a company’s market value of equity and debt, less excess cash EBITDA = Earnings Before Interest, Taxes, Depreciation and Amortization (A measure of a company’s Operating Cash Flow) This valuation method is often used in conjunction with the P/E method
The advantages of this method is that is ignores depreciation and amortisation which are non-cash items – consistent with view that investors are mainly interested in cash flows Popular tool in mergers and acquisitions analysis as it is not affected by capital structure. The disadvantages are that it does not include risk consideration and it is harder to calculate that P/E. It also does not incorporate the time value of money or taxation. It also rejects the cost of assets.
Liquidation Value Calculation
Assets sold – Liabilities paid = Cash remaining or Liquidation Value The advantages of this method is that all the information is readily available via the annual report. The disadvantages is that it is difficult to estimate the marketability of assets and it doesn’t incorporate a firm’s potential to generate future cash flows, and again it doesn’t consider risk or the time value of money.
The flaw in valuation models is that no valuation approach is perfect and it would be unwise to use any approach in isolation to value a company or prior to making an investment decision.
Section C
Cost of Capital is the return the investors in the company require. CAPM changed the way in which financial portfolios were constructed. It contributed to the strengthening of the notions of stock market efficiency (the idea that the stock market correctly prices shares). The minimum level of return required by investors occurs when the actual return is the same as the expected return, so that there is no risk at all of the return on the investment being different from the expected return. This minimum level of return is called the ‘risk-free rate of return’. The formula for the CAPM,
E(ri) = Rf + βi(E(rm) - Rf)
In the real world, there is no such thing as a risk-free asset. Short-term government debt is a relatively safe investment, however, and in practice, it can be used as an acceptable substitute for the risk-free asset. In order to have consistency of data, the yield on UK treasury bills is used as a substitute for the risk-free rate of return when applying
the CAPM to shares that is traded on the
UK capital market. Note that it is the yield on treasury bills, which is used here, rather than the interest rate. The yield on treasury bills is the cost of debt of the treasury bills. The equity risk premium reflects fundamental judgments we make about how much risk we see in an economy/market and what price we attach to that risk. Rather than finding the average return on 
the capital market, E(rm), research has concentrated on finding an appropriate value for (E(rm) - Rf), which is the difference between the average return on the capital market and the risk-free rate of return. This difference is called the equity risk premium, since it represents the extra return required for investing in equity (shares on the capital market as a whole) rather than investing in risk-free assets. In the short term, share prices can fall 
as well as increase, so the average return on
a capital market can be negative as well as positive. To smooth out short-term changes
in the equity risk premium, a time-smoothed moving average analysis can be carried out over longer periods of time, often several decades. In the UK, when applying the CAPM to shares that are traded on the UK capital market, an equity risk premium of between 3.5% and 5% appears reasonable at the current time2. Beta is an indirect measure, which compares the systematic risk associated with a company’s shares with the systematic risk of the capital market as a whole. If the beta value of a company’s shares is 1, the systematic risk associated with the shares is the same as the systematic risk of the capital market as a whole. Beta can also be described as ‘an index of responsiveness of the returns on a company’s shares compared to the returns on the market as a whole’. For example, if a share has a beta value of 1, the return on the share will increase by 10% if the return on the capital market as a whole increases by 10%. If a share has a beta value of 0.5, the return on the share will increase by 5% if the return on the capital market increases by 10%, and so on. Beta values are found by using regression analysis to compare the returns on a share with the returns on the capital market. When applying the CAPM to shares that are traded on the UK capital market, the beta value for UK companies can readily be found on the Internet. The Beta Value I have used is 0.62. this value was found on the financial times. This risk free return can be quantified with reference to the return (yield) associated with government bonds. On 26 October 2012 The Financial Times quoted a return / yield of 0.86% for a UK Government bond maturing in 2017 (5 years time). If an investor can get a return of 0.86% on this particular government bond ‘risk free’, then shares, which are much riskier, must give a higher or extra return to be attractive to investors For the Risk Premium (EXMR – RF) I personally believe that the assumed equity risk premium (ERP) estimate of 6% is too high. The analysis by Dimson, Marsh and Staunton (DMS) shows that the average ERP for a world index, comprising 16 countries, over the period 1900-2000 is 4.6% using a geometric average and 5.6% using annual arithmetic averages. If there were any mean reversion in equity returns then the annual arithmetic average would overstate the appropriate forward-looking ERP. The DMS dataset shows that the arithmetic ERP on the world index over rolling ten-year periods is 4.7%. This indicates that there is mean reversion in equity returns and this evidence would suggest an ERP value of around 5% is appropriate. We also note that the UK Competition Commission in the UK used a value of 3.5% for the ERP in the calculation of the cost of capital for BAA (British Airways Airlines) So I have used 5%.
CAPM = E(ri) = Rf + βi(E(rm) - Rf)
= 0.86 + (0.62 x 5)
= 3.96%
The CAPM and its applications are based on a number of assumptions and empirical studies of CAPM have produced mixed results. The Estimated expected future market returns, Determining the most appropriate estimate of the risk-free rate and Determining the best estimate of an assets future beta, given that measures of beta have been shown to be unstable over time are seen as problems. As Frama and French note that empirical evidence is poor, poor enough to invalidate the way it is used in applications. Due to its simplicity it is still used. Research has shown the CAPM to stand up well to criticism, although attacks against it have been increasing in recent years. Until something better presents itself, however, the CAPM remains a very useful item in financial management.
One of the most common criticisms of DCF models is that any forecast beyond a couple of years is questionable. Investors, therefore, are alleged to be better off using more certain, near-term earnings forecasts. Such reasoning makes no sense, for at least two reasons. First, a key element in understanding a business’s attractiveness involves knowing the set of financial expectations the price represents. The market as a whole has historically traded at a price-to-earnings multiple in the mid-to-high teens. Simple math shows today’s stock prices reflect expectations for value-creating earnings and cash flows many years in the future. The mismatch between a short forecast horizon and asset prices that reflect long-term cash flows leads to the second problem: investors have to compensate for the undersized horizon by adding value elsewhere in the model. The prime candidate for the value dump is the continuing, or terminal, value. The result is often a completely non-economic continuing value. This value misallocation leaves both parts of the model—the forecast period and continuing value estimate—next to useless. Some investors swear off the DCF model because of its myriad assumptions. Yet they readily embrace an approach that packs all of those same assumptions, without any transparency, into a single number: the multiple. Many companies require over ten years of value-creating cash flows to justify their stock prices. Ideally, the explicit forecast period should capture at least one-third of corporate value with clear assumptions about projected financial performance. While the range of possible outcomes certainly widens with time, we have better analytical tools to deal with an ambiguous future than to place an uncertain multiple on a more certain near-term earnings per share figure. We address the uncertainty issue below. In reference to the hostile bid of €694 million, what the free cash flow model tells us is that the company is valued around €788 million. The hostile bid from Ryan air is massively undervalued. We must bear in mind that this is only one model and for a complete analysis, we must look at different models and compare.
Section B
Analysts like to use the free cash flow valuation model whenever one or more of the following conditions are present: * The firm is not dividend paying,
* The firm is dividend paying but dividends differ significantly from the firm’s capacity to pay dividends, * Free cash flows align with profitability within a reasonable forecast period with which the analyst is comfortable, or * The investor takes a control perspective.
Free cash flow to the firm (FCFF) is the cash flow available to the firm’s suppliers of capital after all operating expenses have been paid and necessary investments in working capital and fixed capital have been made. The FCFF valuation approach estimates the value of the firm as the present value of future FCFF discounted at the weighted average cost of capital (WACC)
What other models out there?
The Price / Earning Ratio (P/E)
P/E =Current Share Price
Earnings Per Share (EPS)
The advantages of the P/E Ratio are that it is simple to calculate. It is always widely used throughout the financial world by investors and firms. It could be considered a decent proxy for the present value of future cash flows. It is also a better indicator of share’s value than market price alone. The disadvantages are that the ratio includes no thought of the risk factor. Differing versions of the calculation (trailing P/E/trailing P/E from continued operations or Forward P/E) can make analysis difficult. The ratio doesn’t take into account the time value of money. It also uses accounting information, which can change or be misinterpreted and is only really useful when compared with the industry and competitors.
Book Value Calculation
Historical cost of assets (adjusted for depreciation) – liabilities = Book Value
The advantages of the Book Value Calculation are that it is very easy to calculate, the information is readily available on the internet via the annual report. It also takes into account depreciation. The disadvantages are that the calculation is based on historical data and therefore it has no real consideration of market value. It also doesn’t take into account the firms potential to generate future values and doesn’t take into account risk or the time value of money. It also uses financial information, which can change or can be misinterpreted.
Enterprise Value (EV) to EBITDA Calculation
Enterprise Value (EV)
EBITDA
Where;
EV = the sum of a company’s market value of equity and debt, less excess cash EBITDA = Earnings Before Interest, Taxes, Depreciation and Amortization (A measure of a company’s Operating Cash Flow) This valuation method is often used in conjunction with the P/E method
The advantages of this method is that is ignores depreciation and amortisation which are non-cash items – consistent with view that investors are mainly interested in cash flows Popular tool in mergers and acquisitions analysis as it is not affected by capital structure. The disadvantages are that it does not include risk consideration and it is harder to calculate that P/E. It also does not incorporate the time value of money or taxation. It also rejects the cost of assets.
Liquidation Value Calculation
Assets sold – Liabilities paid = Cash remaining or Liquidation Value The advantages of this method is that all the information is readily available via the annual report. The disadvantages is that it is difficult to estimate the marketability of assets and it doesn’t incorporate a firm’s potential to generate future cash flows, and again it doesn’t consider risk or the time value of money.
The flaw in valuation models is that no valuation approach is perfect and it would be unwise to use any approach in isolation to value a company or prior to making an investment decision.
Section C
Cost of Capital is the return the investors in the company require. CAPM changed the way in which financial portfolios were constructed. It contributed to the strengthening of the notions of stock market efficiency (the idea that the stock market correctly prices shares). The minimum level of return required by investors occurs when the actual return is the same as the expected return, so that there is no risk at all of the return on the investment being different from the expected return. This minimum level of return is called the ‘risk-free rate of return’. The formula for the CAPM,
E(ri) = Rf + βi(E(rm) - Rf)
In the real world, there is no such thing as a risk-free asset. Short-term government debt is a relatively safe investment, however, and in practice, it can be used as an acceptable substitute for the risk-free asset. In order to have consistency of data, the yield on UK treasury bills is used as a substitute for the risk-free rate of return when applying
the CAPM to shares that is traded on the
UK capital market. Note that it is the yield on treasury bills, which is used here, rather than the interest rate. The yield on treasury bills is the cost of debt of the treasury bills. The equity risk premium reflects fundamental judgments we make about how much risk we see in an economy/market and what price we attach to that risk. Rather than finding the average return on 
the capital market, E(rm), research has concentrated on finding an appropriate value for (E(rm) - Rf), which is the difference between the average return on the capital market and the risk-free rate of return. This difference is called the equity risk premium, since it represents the extra return required for investing in equity (shares on the capital market as a whole) rather than investing in risk-free assets. In the short term, share prices can fall 
as well as increase, so the average return on
a capital market can be negative as well as positive. To smooth out short-term changes
in the equity risk premium, a time-smoothed moving average analysis can be carried out over longer periods of time, often several decades. In the UK, when applying the CAPM to shares that are traded on the UK capital market, an equity risk premium of between 3.5% and 5% appears reasonable at the current time2. Beta is an indirect measure, which compares the systematic risk associated with a company’s shares with the systematic risk of the capital market as a whole. If the beta value of a company’s shares is 1, the systematic risk associated with the shares is the same as the systematic risk of the capital market as a whole. Beta can also be described as ‘an index of responsiveness of the returns on a company’s shares compared to the returns on the market as a whole’. For example, if a share has a beta value of 1, the return on the share will increase by 10% if the return on the capital market as a whole increases by 10%. If a share has a beta value of 0.5, the return on the share will increase by 5% if the return on the capital market increases by 10%, and so on. Beta values are found by using regression analysis to compare the returns on a share with the returns on the capital market. When applying the CAPM to shares that are traded on the UK capital market, the beta value for UK companies can readily be found on the Internet. The Beta Value I have used is 0.62. this value was found on the financial times. This risk free return can be quantified with reference to the return (yield) associated with government bonds. On 26 October 2012 The Financial Times quoted a return / yield of 0.86% for a UK Government bond maturing in 2017 (5 years time). If an investor can get a return of 0.86% on this particular government bond ‘risk free’, then shares, which are much riskier, must give a higher or extra return to be attractive to investors For the Risk Premium (EXMR – RF) I personally believe that the assumed equity risk premium (ERP) estimate of 6% is too high. The analysis by Dimson, Marsh and Staunton (DMS) shows that the average ERP for a world index, comprising 16 countries, over the period 1900-2000 is 4.6% using a geometric average and 5.6% using annual arithmetic averages. If there were any mean reversion in equity returns then the annual arithmetic average would overstate the appropriate forward-looking ERP. The DMS dataset shows that the arithmetic ERP on the world index over rolling ten-year periods is 4.7%. This indicates that there is mean reversion in equity returns and this evidence would suggest an ERP value of around 5% is appropriate. We also note that the UK Competition Commission in the UK used a value of 3.5% for the ERP in the calculation of the cost of capital for BAA (British Airways Airlines) So I have used 5%.
CAPM = E(ri) = Rf + βi(E(rm) - Rf)
= 0.86 + (0.62 x 5)
= 3.96%
The CAPM and its applications are based on a number of assumptions and empirical studies of CAPM have produced mixed results. The Estimated expected future market returns, Determining the most appropriate estimate of the risk-free rate and Determining the best estimate of an assets future beta, given that measures of beta have been shown to be unstable over time are seen as problems. As Frama and French note that empirical evidence is poor, poor enough to invalidate the way it is used in applications. Due to its simplicity it is still used. Research has shown the CAPM to stand up well to criticism, although attacks against it have been increasing in recent years. Until something better presents itself, however, the CAPM remains a very useful item in financial management.
References.
Arnold, G. (2008) Corporate Financial Management, Financial Times Prentice Hall
McGuigan, J. , Kretlow, W. , & Moyer, C. (2009) Contemporary Corporate Finance, South-Western CENGAGE Learning
Lumby, S. , Jones, C. (2011) Corporate Finance Theory & Practice, South-Western CENGAGE Learning
Megginson, W. , Smart, S. , & Lucey, B. (2008) Introduction to Corporate Finance, South-Western CENGAGE Learning
Brealey, R. , Myers, S. , & Marcus, A. (2001) Fundamentals of Corporate Finance, McGraw-Hill Irwin
Fraser-Sampson, G. (2011) No Fear Finance, Kogan Page
Arnold, G. (2008) Corporate Financial Management, Financial Times Prentice Hall
McGuigan, J. , Kretlow, W. , & Moyer, C. (2009) Contemporary Corporate Finance, South-Western CENGAGE Learning
Lumby, S. , Jones, C. (2011) Corporate Finance Theory & Practice, South-Western CENGAGE Learning
Megginson, W. , Smart, S. , & Lucey, B. (2008) Introduction to Corporate Finance, South-Western CENGAGE Learning
Brealey, R. , Myers, S. , & Marcus, A. (2001) Fundamentals of Corporate Finance, McGraw-Hill Irwin
Fraser-Sampson, G. (2011) No Fear Finance, Kogan Page
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