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Conceptual Tools. The creation of new and improved financial products through innovative design or repackaging of existing financial instruments.
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Conceptual Tools • The creation of new and improved financial products through innovative design or repackaging of existing financial instruments. • Financial engineers use various mathematical tools in order to create new investment strategies. The new products created by financial engineers can serve as solutions to problems or as ways to maximize returns from potential investment opportunities.
Conceptual Tools The financial engineering methodologies usually apply social theories, engineering methodologies and quantitative methods to finance. It is normally used in the securities, banking, and financial management and consulting industries, or as quantitative analysts in corporate treasury and finance departments of general manufacturing and service firms.
BOOK VALUE Is the per – share dollar value that would be received if the assets were liquidated for the values at which the assets are kept on the books, minus the monies that must be paid to liquidate the liabilities and preferred stock. Also called as shareholder’s equity, net worth, or net asset value.
BOOK VALUE One use of book value is to provide a floor value, with the true value of the company being some amount higher. The value is based on the original cost of the asset less any depreciation, amortization or impairment costs made against the asset.
LIQUIDATION VALUE Is another benchmark of the company’s floor value. It is a measure of the per – share value that would be derived if the firm’s assets were liquidated and all liabilities and preferred stock as well as liquidation costs were paid. Liquidation value may be a more realistic measure than book value.
LIQUIDATION VALUE Is the likely price of an asset when it is allowed insufficient time to sell on the open market, thereby reducing its exposure to potential buyers. Liquidation value is typically lower than fair market value. The liquidation value of a company is an estimate of the value of a company’s assets if all assets were sold for cash.
Discounted Future Cash Flow When the investment that is required to purchase the target firm is deducted from the discounted future cash flow or earnings, this amount becomes the net present value or discounted cash flow (DCF). The DCF approach to valuing a business is based on projecting the magnitude of the future monetary benefits that a business will generate.
Discounted Future Cash Flow Where : FB i = future benefit in year i R = discount rate Io = investment at time 0
Discounted Future Cash Flow One of the key decisions in using the DCF approach is to select the proper discount rate. This rate must be one that reflects the perceived level of risk in target company. A firm's weighted average cost of capital (after tax) is often used, but many people believe that it is appropriate to use higher discount rates to adjust for risk for riskier projects or other factors. A variable discount rate with higher rates applied to cash flows occurring further along the time span might be used to reflect the yield curve premium for long-term debt.
CONTINUING VALUE Represents the value that the business could be expected to be sold for at the end of the specific forecast period. This continuing value (CV ) measured by treating it as a perpetuity and capitalizing the remaining cash flows, which we assumed were going to grow at a certain growth rate.
CONTINUING VALUE It should be noted that when measuring the CV using the perpetuity calculation, the value that results is quite sensitive to the growth rate that is used. Different growth rate assumptions can change the resulting value significantly.
Free Cash Flows Free cash flows are those cash flows, as measured by EBITDA, that are available to all capital providers, both equity holders as well as debt holders, after necessary deductions have been made for the capital expenditures (CE) that are needed to maintain the continuity of the cash flow stream in the future.
Free Cash Flows Free cash flow reflects the cash from a business that is available to make payments to shareholders and long term debt holders. FCF = EBITDA – CE – CWC – CTP Where : EBITDA : Earning Before Interest, Tax, Depreciation and Amortization CE : Capital Expenditure CWC : Changes in Working Capital CTP : Cash Taxes Paid
Choice of the Discount Rate The choice of the appropriate discount rate to calculate the present value of the projected cash flows requires that the riskiness of the target and the volatility of its cash flow be assessed. If a project were judged to be without risk, the appropriate discount rate would be the rate offered on T- bills, which are short-term government securities with a maturity of up to one year.
Choice of the Discount Rate The riskier the investment, the higher the discount rate that should be used; the higher the discount rate, the lower the present value of the projected cash flows. However, a firm methodology for matching the risk with the discount rate needs to be established.
Choice of the Discount Rate As should now be clear, that no set discount rate exists; many different interest rates are available to choose from. The overall market for capital consists of many submarkets. The rate within each market is determined by that market’s supply and demand for the capital. Markets are differentiated on the basis of risk level.
