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## Financial Management model for powerpoint presentations

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**Cash**Raw materials inventory Receivables Finished goods inventory Financial Management... 100 Slides Powered by www.drawpack.com. All rights reserved.**Key Words...**Financial Market – Present Value – Perpetuity – Annuity – Compound Interest – Inflation – Bond Yield – Share Value – Free Cash Flow – IRR – Risk Valuation – Markowitz – SML – CAPM – Beta Risk – APT – Portfolio Theory – Economic Profit – CallOption – Straddle – Option Pricing Theory – Leverage Ratio – Liquidity – Du Pont – Private Equity – Volatility – Working Capital – Valuation – Value Drivers – Risk/Return – Diversification – Corporate Finance – Yield – NPV – Cash Transfer – Accounting**The financial markets**The secondary market The primary market The firm Investors Investors Investors cash cash newly issued securities outstanding securities The Dual Functions of Financial Markets**Present Value**Value today of a future cash flow. Discount Factor Present value of a $1 future payment. Discount Rate Interest rate used to compute present values of future cash flows. Present Value = PV = 1 DF t ( 1 ) r + ´ PV = discount factor C 1 C = = 1 PV DF C ´ 1 + 1 r 1 Present Value**required**investment NPV = PV - C + 1 NPV = C 0 + 1 r Net Present Value**Perpetuity - Financial concept in which a cash flow is**theoretically received forever. cash flow cash flow = = PV of Cash Flow Return present va lue discount rate C C = 1 PV = r r PV Perpetuity**Annuity - An asset that pays a fixed sum each year for a**specified number of years. é ù 1 1 = ´ - PV of annuity C ê ú ( ) t + r r 1 r ë û Annuity**18**16 10% Simple 14 10% Compound 12 10 FV of $1 8 6 4 2 0 0 3 6 9 12 15 18 21 24 27 30 Number of Years Compound Interest**Inflation - Rate at which prices as a whole are increasing.**Nominal Interest Rate - Rate at which money invested grows. Real Interest Rate - Rate at which the purchasing power of an investment increases. 1 + nominal in terest rat e + 1 real inter est rate = 1 + inflation rate Inflation**1600**1400 1200 1000 800 Price 600 400 200 0 0 2 4 6 8 10 12 14 Yield 5 Year 9% Bond 1 Year 9% Bond Bond Prices and Yields**-**P P Div 1 0 Expected R eturn = = + 1 r P P 0 0 Div = = 1 Capitaliza tion Rate P 0 - r g Div = = + 1 r g P 0 Valuing Common Stocks I**Return Measurements**Div = 1 Dividend Yield P 0 = Return on Equity ROE EPS = ROE Book Equit y Per Share Valuing Common Stocks II**If we forecast no growth, and plan to hold out stock**indefinitely, we will then value the stock as a PERPETUITY. Div EPS = = 1 1 Perpetuity P or 0 r r Assumes all earnings are paid to shareholders. Valuing Common Stocks III**PV (free cash flows)**PV (horizon value) FCF and PV**Cash**Investment opportunity (real asset) Investment opportunities (financial assets) Firm Shareholder Invest Alternative: pay dividend to shareholders Shareholders invest for themselves NPV and Cash Transfers**2500**2000 1500 1000 500 NPV (,000s) 0 10 20 30 40 50 60 70 80 90 -500 100 -1000 -1500 Discount rate (%) -2000 Internal Rate of Return**60**40 20 Percentage Return 0 -20 Common Stocks Long T-Bonds -40 T-Bills 30 35 40 45 50 55 60 65 70 75 80 85 90 95 -60 26 Year Rate of Return 1926 - 1997**Portfolio standard deviation**Unique risk Market risk 0 5 10 15 Number of Securities Measuring Risk**The variance of a two stock portfolio is the sum of these**four boxes: Stock 1 Stock 2 = x x σ 2 2 1 2 12 Stock 1 x σ 1 1 x x ρ σ σ 1 2 12 1 2 = x x σ 2 2 1 2 12 Stock 2 x σ 2 2 x x ρ σ σ 1 2 12 1 2 Portfolio Risk I**=**+ Expected Portfolio Return (x r ) ( x r ) 1 1 2 2 = 2 2 + 2 2 + σ x σ x 2 ( x x ρ σ σ ) 2 2 1 1 1 2 12 1 2 Portfolio Variance Portfolio Risk II**The shaded boxes contain variance terms; the remainder**contain covariance terms. 1 2 3 To calculate portfolio variance add up the boxes 4 STOCK 5 6 N 1 2 3 4 5 6 N STOCK Portfolio Risk III**Expected**s stock im = return B i s 2 beta m +10% Expected - 10% + 10% market return -10% Beta and Unique Risk**Price changes vs. Normal distribution**600 500 400 # of Days (frequency) 300 200 100 0 -10% -8% -6% -4% -2% 0% 2% 4% 6% 8% 10% Daily % Change Markowitz Portfolio Theory**Return**Expected Return (%) B A Risk Standard deviation Efficient Frontier I**Expected Return (%)**T Lending Borrowing rf S Standard deviation Efficient Frontier II**Return**Low Risk High Return High Risk High Return Low Risk Low Return High Risk Low Return Risk Efficient Frontier III**Return**. Market Return = rm Efficient Portfolio Risk FreeReturn = rf Risk Security Market Line I**Return**. Market Return = rm Efficient Portfolio Risk Free Return = rf BETA 1.0 Security Market Line II**Return**SML rf BETA 1.0 SML Equation = rf + B ( rm - rf ) Security Market Line III**Expected return**Security market line Market portfolio rate Rm = 13.5% Rf = 5% Treasury bill rate Beta 1 0 R = rf + B ( rm - rf ) Capital Asset Pricing Model (CAPM)**Avg Risk Premium**1966-91 30 20 10 0 SML Investors Market Portfolio Portfolio Beta 1.0 Beta vs. Average Risk Premium**Stocks**(and other risky assets) Stocks (and other risky assets) Wealth is uncertain Standard CAPM Consumption CAPM Market risk makes wealth uncertain. Wealth Consumption is uncertain Wealth = market portfolio Consumption Consumption Betas vs. Market Betas**Alternative to CAPM**Expected Risk Premium = r - rf = Bfactor1(rfactor1 - rf) + Bf2(rf2 - rf) + … Return = a + bfactor1(rfactor1) + bf2(rf2) + … Arbitrage Pricing Theory**Specific company return (%)**Market return (%) Portfolio Risk**Expected Returns and Betas prior to refinancing**Expected return (%) 20 Requity= 15 Rassets= 12.2 Rdebt= 8 0 0 0.2 0.8 1.2 Bdebt Bassets Bequity Capital Structure & COC**=**EVA Residual Income = Income earned - Income required = ´ [ ] Income earned - Cost of Capital Investment Risidual Income & EVA Residual Income or EVA = Net Dollar return after deducting the cost of capital.**Economic Profit = capital invested multiplied by the spread**between return on investment and the cost of capital. = EP Economic Profit = - ´ ( ROI r ) Capital Invested Economic Profit**ECONOMICACCOUNTING**Cash flow + Cash flow + change in PV = change in book value = Cash flow - Cash flow - economic depreciation accounting depreciation Economic income Accounting income PV at start of year BV at start of year INCOME RETURN Accounting Measurement**r**rE rA rD D E Risk free debt Risky debt M&M Proposition**r**r rE rE WACC rE =WACC rD rD D V D V r rE WACC rD D V WACC (traditional and M&M view)**Maximum value of firm**Costs of financial distress PV of interest tax shields Value of levered firm Value of unlevered firm Optimal amount of debt Debt Financial Distress**Call option value given a $85 exercise price.**Call option value $20 85 105 Share Price Call Option (long)**Put option value given a $85 exercise price.**Put option value $5 80 85 Share Price Put Option (long)**Call option payoff (to seller) given a $85 exercise price.**Call option $ payoff 85 Share Price Call Option (short)**Put option payoff (to seller) given a $85 exercise price.**Put option $ payoff 85 Share Price Put Option (short)**Long stock and long put**Long Stock Protective Put Position Value Long Put Share Price Protective Put**Long call and long put**- Strategy for profiting from high volatility Straddle Position Value Share Price Straddle**Ps**S v2 2 ln + ( r + ) t (d1) = v t N(d1)= 32 34 36 38 40 Black-Scholes Option Pricing Model**Expanding the binomial model to allow more possible price**changes 1 step 2 steps 4 steps (2 outcomes) (3 outcomes) (5 outcomes) etc. etc. Binomial vs. Black Scholes**Value of**Straight bond bond 100 Bond Callable at 100 75 50 25 Value of straight bond 25 50 75 100 125 150 Straight Bond vs. Callable Bond