FINA 410 – Section AA – Summer 2021

ØDepartment of Finance, John Molson School of Business, Concordia University

ØCourse Title: Investment Analysis
ØTextbook: Damodaran (2012) Investment Valuation: Tools and Techniques for
Determining the Value of any Asset, Wiley; 3rd edition

• Session 2 – Wednesday, May 12th

oChapter 03 (Understanding Financial Statements)

• Instructor: Moein Karami (Email: moein.karami@concordia.ca)

0
Agenda

1. Basic Examples of Valuation

2. From Fundamentals to Valuation: A Review Example
3. CH 03: Understanding Financial Statements
4. A Review of Capital Asset Pricing Model (CAPM)

Moein Karami (FINA 410/AA - Summer 2021 - Session 2) 1

 1. Basic
Examples of
Valuation

2
Example 1

ØFind the present value (PV0) of the investment with the following set of projections and
assumptions:
• Projected Free Cash Flow (FCF) at the end of year 1: $320,000
• FCFs are expected to grow at a constant rate of 4%, thereafter in perpetuity.
• Discount rate for the project considering the risk of the investment is estimated at 12%.
g = 0.04
CF1=320,000

k = 0.12

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Example 1-continued

• This is a growing perpetuity:

!"# ()*,***
• PV0 = = = $4,000,000
$ %& *.#)%*.*-

CF1=320,000 g = 0.04

k = 0.12

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Example 2

ØFind the present value (PV0) of the investment with the following set of projections and
assumptions:
• Projected Free Cash Flow (FCF) for the next five years:
FCF1=$125,000; FCF2=$136,350; FCF3=$150,000; FCF4=$168,000; FCF5=$200,000
• FCFs are expected to grow at a constant rate of 5%, thereafter in perpetuity.
• Discount rate considering the risk of the investment is estimated at 12%.

g=0.05
CF1 CF2 CF3 CF4 CF5
CF6=200,00(1+0.05)=210,000

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Example 2-continued

• First, reduce the growing perpetuity (starting from t=6) to a single cash flow at t=5 (this is
called, Terminal Value).
!"# ()*,***
• TV5 (i.e., PV5 of the growing perpetuity starting from 6) = = = $3,000,000
$%& *.)(%*.*-
!") !"( !"6 !"8 !"- ;<-
• PV0 = + 5 + 7 + 9 + : + = $2,249,604.5
)1$ ()1$) ()1$) ()1$) ()1$) ()1$):

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Example 3
ØFind the present value (PV0) of the investment with the following set of projections and
assumptions:
• Projected Free Cash Flow (FCF) for the next five years:
FCF1=$125,000; FCF2=$136,350; FCF3=$150,000; FCF4=$168,000; FCF5=$200,000
• Terminal Value = $3,000,000.
• Discount rate considering the risk of the investment is estimated at 12%.
Terminal Value=3,000,000

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Example 3-continued

• We should discount the cashflows one by one to t=0:

!"# !"' !"+ !"- !"/ 12/
• PV0 = + + + + + = $2,249,604.5
#$% (#$%)* (#$%), (#$%). (#$%)0 (#$%)0

Terminal Value=3,000,000

Moein Karami (FINA 410/AA - Summer 2021 - Session 2) 8

 Example 3-continued
• Financial Calculator (Press “CF”), then CF0=0 appears:
• CF0=0, Enter, Down arrow
• C01=125,000, Enter, Down, F01=1, Down
• C02=136,350, Enter, Down, F02=1, Down
• C03=150,000, Enter, Down, F03=1, Down
• C04=168,000, Enter, Down, F04=1, Down
• C05=3,200,000(200,000+3,000,000), Enter, Down, F05=1
• Press NPV, I=12, Enter, Down, (Shows NPV=0), Press CPT
• PV0=$2,249,604.5
Terminal Value=3,000,000

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 2. From
Fundamentals
to Valuation:
A Review
Example

10
Review Example 1
ØFind the present value (PV0) of the investment with the following set of projections and
assumptions:
• Projected sales (i.e. revenues) for the next year (at the end of year 1): Sales1=$1,250,000
• Sales are expected to grow at a constant rate of 5% until year 5.
• Cost of sales is estimated to be 80% of revenues of each year.
• Depreciation and Amortization Expenses for first year is estimated at $50,000 and is
expected to grow at a constant rate of 5% until year 5.
• Tax rate= 30%.
• NWC required in the first year is estimated at $5,000; second year is $7,000; third year is
$4000; fourth year is $2,000; and fifth year is 3,000.
• FCFs are expected to grow at a constant rate of 3% after year 5.
• Discount rate considering the risk of the investment is estimated at 12%.

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Review Example 1 - Solution
Y1 Y2 Y3 Y4 Y5
g=0.05
Revenues 1,250,000 1,312,500 1,378,125 1,447,031.2 1,519,382.7
- Costs (@80% of sales) 1,000,000 1,050,000 1,102,500 1,157,624.9 1,215,506.1
EBITDA 250,000 262,500 275,625 289,406.25 303,876.5
- Dep. & Amort. 50,000 g=0.05 52,500 55,125 57,881.25 60,775.3
EBIT (pre-tax net income) 200,000 210,000 220,500 231,525 243,101.2
- Taxes (@30%) 60,000 63,000 66,150 69,457.5 72,930.37
After-tax net income 140,000 147,000 154,350 162,067.5 170,170.8
+Dep. & Amort.(added back) 50,000 52,500 55,125 57,881.25 60,775.3
NWC (to calculate below) 5,000 7,000 4,000 2,000 3,000
+ Changes in NWC -5,000 -2,000 3,000 2,000 -1,000
Net Cash Flow 185,000 197,500 212,475 221,948.7 229,946.1

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Review Example 1 - Solution - continued

!"# ()#,+,,.,+
• TV5 = = = $2,631,605.3
$%& ../(%...)

!"/ !"( !") !", !"> @A>

• PV0 = + + + + + (Calculate)
/7$ (/7$); (/7$)< (/7$)= (/7$)? (/7$)?
• Confirm your answer, using financial calculator.

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Review Example 2
ØFind the present value (PV0) of the investment with the following set of projections and
assumptions:
• Given values (assumptions) are specified in the next slide Table (blue) [The rest of the
values are calculated based on assumptions].
• Assume we are now 6 months into year 1, i.e., the first FCF is within 6 month (end of
year 1).
• Depreciation and Amortization Expenses are expected to grow at a rate equal to
revenues growth rate until year 6.
• Tax rate= 35%.
• FCFs are expected to grow at a constant rate of 3% after year 5.
• Discount rate considering the risk of the investment is estimated at 23%.

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Review Example 2
Solution
Excel

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Review Example 2 – Solution - continued
!"# (,*++,(*,
• TV6 = = = $17,556,750
$%& ,..(%,.,(
• Remember we are at “month6”, so we discount everything back to there (using effective
annual rate as “k”, and fraction of years to discount as “N”).
!"+ !". !"( !"= !"* !"@ AB@
• PV0 = + + + + + + (Calculate)
(+6$)8.9 (+6$);.9 (+6$)<.9 (+6$)>.9 (+6$)?.9 (+6$)9.9 (+6$)9.9
• You can alternatively, use financial calculator, discount everything back to t=0, and then
compound it as a single cash flow to N=0.5 (after 6 months) by multiplying (1+k)^0.5.

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Firm Value and Equity Value

Discount CF to Firm at Cost of Capital to get value of firm.

Discount CF to Equity (subtract out debt) at Cost of Equity to get value of equity.

• Never mix and match cash flows and discount rates.

• The key error to avoid is mismatching cashflows and discount rates, since discounting
cashflows to equity at the weighted average cost of capital will lead to an upwardly
biased estimate of the value of equity, while discounting cashflows to the firm at the
cost of equity will yield a downward biased estimate of the value of the firm.

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 3. CH 03:
Understanding
Financial
Statements

18
Financial Statements
• Financial statements provide the fundamental information that we use to analyze and answer
valuation questions. It is important, therefore, that we understand the principles governing these
statements by looking at four questions:
1. How valuable are the assets of a firm? The assets of a firm can come in several forms—assets
with long lives such as land and buildings, assets with shorter lives such as inventory, and intangible
assets that nevertheless produce revenues for the firm such as patents and trademarks.
2. How did the firm raise the funds to finance these assets? In acquiring assets, firms can use the
funds of the owners (equity) or borrowed money (debt), and the mix is likely to change as the assets
age.
3. How profitable are these assets? A good investment is one that makes a return greater than the
cost of funding it. To evaluate whether the investments that a firm has already made are good
investments, we need to estimate what returns these investments are producing.
4. How much uncertainty (or risk) is embedded in these assets? While we have not yet directly
confronted the issue of risk, estimating how much uncertainty there is in existing investments, and
the implications for a firm, is clearly a first step.

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The Basic Accounting Statements

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The Basic Accounting Statements - continued

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Accounting Principles underlying Asset Measurement
An asset is any resource that has the potential either to generate future cash inflows or
to reduce future cash outflows.

The accounting view of asset value is to a great extent grounded in the notion of historical
cost, which is the original cost of the asset, adjusted upward for improvements made to
the asset since purchase and downward for the loss in value associated with the aging of
the asset. This historical cost is called the book value.

While the generally accepted accounting principles (GAAP) for valuing an asset vary across
different kinds of assets, three principles underlie the way assets are valued in accounting
statements.

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Accounting Principles underlying Asset Measurement
1. An abiding belief in book value as the best estimate of value. Accounting estimates of
asset value begin with the book value, and unless a substantial reason is given to do
otherwise, accountants view the historical cost as the best estimate of the value of an
asset.
2. A distrust of market or estimated value. When a current market value exists for an asset
that is different from the book value, accounting convention seems to view this market
value with suspicion. The market price of an asset is often viewed as both much too
volatile and too easily manipulated to be used as an estimate of value for an asset. This
suspicion runs even deeper when a value is estimated for an asset based on expected
future cash flows.
3. A preference for underestimating value rather than overestimating it. When there is
more than one approach to valuing an asset, accounting convention takes the view that the
more conservative (lower) estimate of value should be used rather than the less
conservative (higher) estimate of value. Thus, when both market and book value are
available for an asset, accounting rules often require that you use the lesser of the two
numbers.

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Financial Ratios

Financial statements have long been used as the basis for estimating financial ratios that
measure profitability, risk, and leverage. Earlier, the section on earnings looked at two of
the profitability ratios—return on equity and return on capital. This section looks at some
of the financial ratios that are often used to measure the financial risk in a firm.

The current ratio is the ratio of the firm's current assets (cash, inventory, accounts
receivable) to its current liabilities (obligations coming due within the next period).

A current ratio below 1, for instance, would indicate that the firm has more obligations
coming due in the next year than assets it can expect to turn into cash. That would be an
indication of liquidity risk.

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Financial Ratios - continued

The quick or acid test ratio is a variant of the current ratio. It distinguishes current assets
that can be converted quickly into cash (cash, marketable securities) from those that
cannot (inventory, accounts receivable).

Interest coverage ratios measure the capacity of the firm to meet interest payments, but
do not examine whether it can pay back the principal on outstanding debt. Debt ratios
attempt to do this, by relating debt to total capital or to equity. There are also two variants:

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4. A Review of Capital Asset Pricing Model (CAPM)

26
Example
A stock has an expected return of 10.2 percent, the risk-free rate is 4.5 percent, and
the market risk premium is 7.5 percent. What must the beta of this stock be?

!" = "$ + &. !"()*+,- − "$

Careful! Don’t mistake M.P. for !"()*+,-
(!"()*+,- − "$) is also called: Market Risk premium(M.P.). so we can re-write the
formula as:

!" = "$ + &. (E. F. )

Here: 0.102 = 0.045 + &. 0.075 So:
0.075 & = 0.102 − 0.045
0.075 & = 0.057 à & = 0.76

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Quick review of formulas:
./& 01 +22 "'$/",3 ∑,#=1 "#
!"#$ℎ&'$#( *'+, = =
$0$+2 ,/&4'" 01 043'"5+$#0,3 ,

∑3.=1(-. − -̅ )2
!"#$%&' = *
3−1
,

!"#$%&$' )$&*+, = !) = .(+0 1+230 )

0=1

!
"#$%&' = *∑%1=1(-./0 1 ) (. 1 −"4 1 )2

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Quick review of formulas:

n
COVAB = å Prob(rA,i - ERA )(rB ,i - ERB )
i =1

!",$% = ()$2 !$2 + )%2 !%2 + 2)$ )% ,-.$%

!"#$% = ($,% *$ *%

s P = wA2s A2 + wB2s B2 + 2wA wB r ABs As B

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Example - Question

Using the following returns, calculate the arithmetic average returns, the variances, and the standard
deviations for X and Y.

Year X (returns) % Y(returns) %

1 8 16
2 21 38
3 17 14
4 -16 -22
5 9 26

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Example - Solution

Here we are dealing with Ex-Post formulas meaning that some returns that are
already happened (i.e., some exact numbers, there is no uncertainty, future,
expected return, probability etc.)
∑(
%&' )% +.+-.+./0.+.012+.03.+.+4
Arithmetic mean X = "! = = = 7.80%
* 5
∑(
%&' ;% +.03.+.<-.+.0=2+.//.+./3
Arithmetic mean Y = :! = *
= 5
= 14.40%

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Example - Solution(continue)

Variance

Standard deviation is the square root of variance.

S.D.

"
BTW: ! is same thing as saying !
#

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Example
Consider the following information about two stocks:

a- If the portfolio is invested 40 percent in A and 60 percent in B, what is the

portfolio expected return? The variance? The standard deviation?
b- If the expected T-bill rate is 3.80 percent, what is the expected risk premium on
the portfolio?
c- If beta of stock A is 0.87 and beta of stock B is 1.2, what is the portfolio beta?

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Example - solution
a- Before calculating expected return of portfolio, we need to calculate expected
return of each stock separately:
1

!"#$%&$' ($&)(* + = - 2(34. ×(.6 = 0.20 ∗ 0.24 + 0.55 ∗ 0.17 + 0.25 ∗ 0.00 = 0.1415 = 14.15%
./0
1

!"#$%&$' ($&)(* A = - 2(34. ×(.B = 0.20 ∗ 0.36 + 0.55 ∗ 0.13 + 0.25 ∗ −0.28 = 0.0735
./0
= 7.35%
Weights are Given: U6 =0.40 UB = 0.60

!VWXYZ[X\.X = U6 . !V6 + UB . !VB

!VWXYZ[X\.X = 0.40×0.1415 + 0.60×0.0735 = 0.1007 = 10.07%

Moein Karami (FINA 410/AA - Summer 2021 - Session 2) 34

Example – solution - continued
To calculate variance of portfolio we need weights (which we have), variance of each stock and the
covariance(A,B).
Lets first calculate variance of each single stock (variance is squared of standard deviation, so the formula
is standard deviation formula without the square root), and also the covariance between A and B:

!"# = 0.20 ∗ 0.24 − 0.1415 # + 0.55 ∗ 0.17 − 0.1415 # + 0.25 ∗ 0.00 − 0.1415 # = 0.007392 = 0.7392%

!2# = 0.20 ∗ 0.36 − 0.0735 # + 0.55 ∗ 0.13 − 0.0735 # + 0.25 ∗ −0.28 − 0.0735 # = 0.04941 = 4.941%

Covariance(A,B): 567",2 = ∑=:;< >?6@: ∗ (?",: − BC" )( ?2,: − BC2 )

567",2 : 0.20 ∗ 0.24 − 0.1415 0.36 − 0.0735 + 055 ∗ 0.17 − 0.1415 0.13 − 0.0735 + 0.25
∗ 0 − 0.1415 −028 − 0.0735
= 0.0190 = 1.90%

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Example – solution - continued
Now we have everything to calculate the variance of the portfolio!
The formula for variance of portfolio is:

)
!"#$%&#'(# = +,)!,) + +.)!.) + 2+, +. 012,,. = 0.0280 = 2.80%

Standard deviation of portfolio is square root of variance of portfolio, so:

!"#$%&#'(# = 0.0280 = 0.1673 = 16.73%

(also, try to do it using our shortcut method and get the same answer)

Moein Karami (FINA 410/AA - Summer 2021 - Session 2) 36

Example – solution - continued
b- Expected risk premium is expected return minus risk free rate:
So, expected risk premium on this portfolio = !"#$%&'$()$ − "+ = 10.07% −
3.80% =6.27%
We got the 10.07% in part a. T-bill rate = risk free rate.

c- The formula for beta of portfolio is:

4#$%&'$()$ = 56 . 46 + 58 . 48

4#$%&'$()$ = 0.40 ∗ 0.87 + 0.60 ∗ 1.2 = 1.068

Moein Karami (FINA 410/AA - Summer 2021 - Session 2) 37

 Good Luck!

Moein Karami (FINA 410/AA - Summer 2021 - Session 2) 38