1 / 65

MANAGEMENT CERTIFICATE PROGRAM Fisher College of Business The Ohio State University

MANAGEMENT CERTIFICATE PROGRAM Fisher College of Business The Ohio State University. CORPORATE FINANCIAL ANALYSIS. Bernadette A. Minton, PhD. Topics. I. First Class Market Value: Concepts & Assumptions Financial Manager and Shareholders Market Efficiency Valuation Procedures

glain
Download Presentation

MANAGEMENT CERTIFICATE PROGRAM Fisher College of Business The Ohio State University

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript

  1. MANAGEMENT CERTIFICATE PROGRAMFisher College of BusinessThe Ohio State University CORPORATE FINANCIAL ANALYSIS Bernadette A. Minton, PhD.

  2. Topics I. First Class • Market Value: Concepts & Assumptions • Financial Manager and Shareholders • Market Efficiency • Valuation Procedures • Applications of Valuation Principles II. Second Class • Financial Ratio Analysis & Capital Budgeting as Valuation • Financial ratio analysis • Practical Issues in Capital Budgeting • Project Evaluation Techniques

  3. Two-pronged attack • Discussion • Real world application problems

  4. Value Based Approach AEP –5/4/09 $26.94 per share # Shares outstanding: 476.76 mil Total equity investment: $12.84 billion Market Efficiency Agency Problems $14.4 billion Revenue in 2008 Management: CEO: Michael G. Morris and 21,912 employees Financial & Other Management

  5. (2) (1) (4a) (4b) (3) (1) Cash raised from investors (2) Cash invested in firm (3) Cash generated by operations (4a) Cash reinvested (4b) Cash returned to investors Value-Based Approach AEP Equity markets& Bond markets Financial Firm’s operations managers

  6. Financial Management’s Goal Maximize the Current Market Value of Shareholders’ Equity • Managers must select and fund investments that increase the wealth of shareholders! • Caveat for non-profits: • Non-profit mission statements guide financial and investment decisions • Think of donors as the major shareholders

  7. Corporate Goals & Agency Problems • Important questions: • Do managers really maximize the current market value of shareholder wealth? • Do managers ever stray from this objective? • A firm has many “stakeholders” • Managers often have many constituents to satisfy • GM • Agency Problems • Represent the conflict of interest between a firm’s owners and its non-owner managers

  8. Resolving Agency Problems • Compensation Plans • Performance-based compensation • Board of Directors • Increase representation among outside directors • US versus Germany • German boards are comprised of stakeholders • Takeover Market • Specialist Monitoring • Auditors • Legal and Regulatory Requirements

  9. AEP Board of Directors and SOX (2002) • In 2008, 12 board members. • A majority of the Board members are independent of AEP and its management. • All members of the Audit Committee, Human Resources Committee and the Committee on Directors and Corporate Governance are independent. • The non-management members of the Board meet regularly without the presence of management, and the independent members of the Board meet at least once a year.

  10. AEP’s executive compensation programs are designed to • Maximize shareholder value by: • emphasizing performance-based compensation over base salary • providing a substantial percentage of total compensation opportunity in the form of stock-based compensation • requiring executive officers to meet stock ownership requirements Source: 2008 Proxy

  11. AEP compensation includes: • Base salary • Annual Incentive Compensation. • “AEP provides annual incentive compensation to executive officers to drive the achievement of annual performance objectives that are critical to AEP’s success”. • Annual Incentive Targets. • 110 percent for Michael Morris • Annual Performance Objectives. • In January 2008 the HR Committee established AEP’s 2008 ongoing earnings guidance of $3.10- $3.30 per share as the funding measure for AEP’s annual incentive compensation program. • 3.10: 20% target and award pool • 3.20: 100% target and award pool • 3.30: 200% target and award pool

  12. AEP compensation – Incentive Pay • In 2008 AEP produced ongoing EPS of $3.24, which was in the higher end $3.10 – 3.30 range. • This resulted in a 2008 ongoing EPS score of 136.2% of target

  13. For Mr. Morris

  14. AEP Proxy Statements strong value-based incentives -12/31/08 Michael Morris - CEO • Salary 1,259,615 • Stock awards -43,132 • Option awards 0 • Non-equity incentive planned comp 1,654,071 • Deferred comp 330,564 • Other compensation 818,438 • Total compensation 4,019,556 • Shares & Stock Equivalents 473,647 • Stock options • Stock awards

  15. Market Efficiency

  16. Theory: Efficient Market Hypothesis • Prices of stocks should fully reflect all the available information • New information (unexpected news) can affect a stock’s price: • Good news precipitates a positive price reaction • Increased cash flows to investors • Lower discount rates • Higher future growth rates • Bad news precipitates a negative price reaction • Reduced cash flows to investors • Higher discount rates • Lower future growth rates

  17. Theory: Efficient Market Hypothesis • New information is, by definition, unpredictable • If new information was predictable it would already be incorporated in stock prices • Stock prices that change in response to new unpredictable information must move unpredictably • Random Walk Theory • Changes in stock prices should be random and unpredictable • Prices are equally likely to offer a high return or low return on any particular day regardless of what has occurred on previous days.

  18. Theory: Levels of Market Efficiency • Weak Form Efficiency • Stock prices reflect all information contained in the history of past prices • Semi-Strong Form Efficiency • Stock prices reflect all publicly available information • Strong Form Efficiency • Stock prices reflect ALL information, both public and private

  19. Summary: Efficient Market Hypothesis • Stocks should trade at the risk-adjusted present value of their expected future cash flows to investors • Problem: • Expected Future Cash Flows to investors are not observable • Discount and growth rates are not observable • Solution: • Investors form beliefs about future cash flows, discount and growth rates • Beliefs change with the arrival of relevant new information • Prices change as beliefs change

  20. A case study on market efficiency • Ticker: ENMD • Small Biotech Company • Focus: Potential Cancer Cures • In 1997 their research team was led by a distinguished Harvard scientist – Dr Judah Folkman • Company is still trading today

  21. EntreMed hits the headlines: Front cover of Nature 27th Nov 1997 The New York Times also ran a small article on page A28

  22. What happened to ENMD’s stock price? “The results (of the tests) are unprecedented and could herald a new era of cancer treatment. But that era could be years away” - Nature (Nov 1997) 27th November 1997

  23. May 3rd 1998 • New York Times Special Report • Front Page of the Sunday Paper • A Potential Cure for Cancer - EntreMed • The information in the special report was the same information covered by Nature and the NYT in November 1997 • Most quotes from experts are cautionary • “Interesting, but let’s wait see” • But • Dr James D. Watson (Nobel Laureate) • “Judah is going to cure cancer in two years … He will be remembered as someone who permanently altered civilization”

  24. What should happen to EntreMed’s Price? • Recall: • Beliefs (and prices) change with the arrival of relevant new information • Price reaction in an efficient market • EntreMed’s price should not change as there is no new information • What happens when we take the theory to the data?

  25. Reality: EntreMed’s Stock Price

  26. November 12th 1998 • Wall Street Journal • Front Page Report • Other labs failed to replicate the results reported in Nature in 1997 by EntreMed. • What should happen to EntreMed’s stock price? • The initial news from the Nature article has been shown to be incorrect • Rationality: Prices should revert to their pre-Nov 1997 prices (between $8-$14)

  27. Oh Dear!!

  28. Prices and information • No new News can move stock prices • Does not fit comfortably with the concept of market efficiency • Maybe the New York Times special report was new News to many investors • No new News can have a permanent impact on stock prices • Prior to November 1997 Entremed’s stock price was $10 • After November 1998 Entremed’s stock price was over $20 • Entremed are no closer to finding a cure for cancer • But, maybe the events changed investors’ beliefs regarding how likely Entremed are to find a cure for cancer • Entremed is only one example where the market might have made a mistake. There are not many such examples • Entremed is currently trading at $0.41 (5/4/09)

  29. Market Efficiency in the US • On average, evidence suggests that US markets are close to semi-strong form efficiency • This does not mean that all stocks are priced perfectly • Some stocks will be under-priced • Some stocks will be over-priced • Some stocks will be correctly priced • On average, stocks are correctly priced • Insiders can still make money using private information

  30. Value of an Efficient Market It is important that markets are efficient • To encourage share buying • Investors need to know they are paying a fair price and that they will be able to sell at a fair price • To give correct signals to company managers • Managers want to have value maximizing decisions accurately signaled to shareholders through a rise in the share price. • It is important that managers receive feedback on their decisions from the share market so that they are encouraged to pursue shareholder wealth strategies.

  31. Valuation Procedures The Tools

  32. Timeline of Cash Flows Many financial transactions involve a stream of cash flows The value/price of these cash flows is the present value of the future cash flows discounted back to the present day (i.e., today). $150 $150 $150 $150 $10,150 8/15/09 8/15/10 8/15/11 8/15/12 8/15/13 8/15/14

  33. Simple Case: One-period cash flow • Present value of the 1,000 to be received in one year equals: 1,000 4/15/09 4/15/10

  34. Multiple Period Cash Flows $150 $150 $150 $150 $10,150 8/15/09 8/15/10 8/15/11 8/15/12 8/15/13 8/15/14

  35. Multiple Period Cash Flows • Let R = 0.045

  36. Present Value Example • Suppose you were offered three payments of $25, $35 and $45, with the first one due one year from today. • Suppose further that you can earn 6% annual interest on your money. • Now, suppose someone were to offer you the chance to buy this series of 3 cash payments today for $90. Would you buy the series of cash flows?

  37. Present Value Example • Present value = $92.52 • Cost = $90.00 • Value to you = 92.52 – 90.00 = $2.52 = Net Present value (NPV) • Create value by selecting positive NPV investments

  38. The Discount Rate • An interest rate or rate of return • Reflects the risk of the cash flows • Represents the opportunity cost of capital • Some Candidates • US Treasury rates • Risk-free securities • Yield-to-maturity on a bond • Opportunity cost of debt capital • Expected return on equity • Opportunity cost of equity capital • Firm’s cost of raising capital • Opportunity cost of the firm’s capital • May include both debt and equity

  39. Present Value Summary • Need a series of cash flows • Involves forecasting sometimes • Need discount rates • Discount rate should reflect the risk of the cash flows that you are discounting • Need timing of cash flows • Need Calculators or spreadsheets • Always draw a timeline to clarify cash flows and timing.

  40. Present Value Problem • You can buy property today for $3 million and sell it in 5 years for $4 million. • If the interest rate is 8% per year what is the present value of the sale price? • Is the property investment attractive to you? Why or why not? • Would your answer change if you also could earn $200,000 per year rent on the property?

  41. Present Value Problem

  42. Perpetuities and Annuities

  43. Perpetuities & Annuities • Streams of cash flows can have certain characteristics that make their analysis computationally simple. • PERPETUITY • An infinite stream of level, equally spaced cash flows. • ANNUITY • a finite stream of level, equally spaced cash flows. • The unit of time can be anything – a year, a month, a week, a quarter – as long as it remains constant.

  44. Perpetuities • PV is the present value of the future stream of cash flows. • Periodic Cash Flow • the constant amount earned or paid at the end of each future time period (e.g., each month). • Periodic Interest Rate • the rate of interest earned or paid during each future time period (e.g., each month).

  45. Perpetuity Example – Setting Up an Endowment • You decide to endow a scholarship program at Ohio State to support students interested in the biomedical sciences. • You want the endowment to continue indefinitely in the future (“in perpetuity”). OSU indicates that the endowment will need an annual income of $45,750 to cover all the expenses. • If the University can earn 7% annually on endowment funds, how much do you need to give OSU today to provide the full $45,750 annual income – forever? • A perpetual income of $45,750 will represent a 7% return on an initial (one-time) investment of $653,571.

  46. Growing Perpetuities • PV is the present value of the future stream of cash flows. • First Cash Flow • the amount earned or paid at the end of the first period (e.g., first month). • Periodic Interest Rate • the rate of interest earned or paid during each future time period (e.g., each month). • Periodic Growth Rate • the rate of growth of the periodic cash flow

  47. Growing Perpetuity Example – Setting Up an Endowment • You decide to endow a scholarship program at Ohio State to support students interested in the biomedical sciences. • You want the endowment to continue indefinitely in the future (“in perpetuity”). • OSU indicates that the endowment will need an initial annual income of $45,750 to cover all the expenses and that the income will need to grow at the rate inflation (4.5% per year) • If the University can earn 7% annually on endowment funds, how much do you need to give OSU today to provide the endowment?

  48. Annuity • Unlike a perpetuity, an annuity covers a fixed (finite) period of time (e.g., a 7-year annuity has a lifespan of 7 years). • When the cash flows fall at the end of each time period, we call the stream of cash flows an ordinary annuity: • PV of a stream of cash flows forming an ordinary annuity: Where Payment is the constant (level) cash flow; R is the periodic rate of interest (discount rate); and T is the length of the annuity (number of time periods – e.g., years, quarters, months).

  49. PV of an Ordinary Annuity Example • You decide to establish an annuity to provide a $1,200 annual textbook allowance for college. • You want the annuity to make the $1,200 payment at the end of each of the next four years. • You fund the annuity today with a single deposit. • The first installment payment is due one year from today. • If your annuity account earns interest at 7% a year, how much do you need to deposit today?

  50. PV of an Ordinary Annuity Example $4,349.18 = $4,064.65*1.07 $3,369.62 = $3,149.18*1.07

More Related