MANAGEMENT CERTIFICATE PROGRAM

Fisher College of BusinessThe 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 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

Two-pronged attack

1. Discussion

2. Real world application problems

Value Based Approach

AEP –5/4/09$26.94 per share

# Shares outstanding: 476.76 milTotal equity investment: $12.84 billion

Management: CEO: Michael G. Morrisand 21,912 employees

Agency Problems

$14.4 billion Revenue in 2008

Financial & OtherManagement

Market Efficiency

Financial

managersFirm’s

operations

Equity markets

& Bond

markets

(1) Cash raised from investors

(1)

(2) Cash invested in firm

(2)

(3) Cash generated by operations

(3)

(4a) Cash reinvested

(4a)

(4b) Cash returned to investors

(4b)

Value-Based Approach

AEP

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

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

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

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.

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

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

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

Performance Category Weight 2008 ScoreSafety Performance 25% 181.6% of targetOperations Performance 25% 66.6% of targetRegulatory Performance 25% 125% of targetStrategic Initiatives 25% 100.9% of target

Total Score 118.5% of targetEPS Score 136.20%Avg Performance Score 133.90%Final Composite Score 120.5 = (118.5%x136.2%/133.9%)

For Mr. Morris

2008 Base Earnings 1,247,885.00$ Annual Incentive Target 110%Overall Performance Score 120.50%Calculated Bonus Opportunity 1,654,071.57$ Actual Award 1,654,071.57$

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

Market Efficiency

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

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.

Theory: Efficient Market Hypothesis

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

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

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

A case study on market efficiency

EntreMed hits the headlines:

Front cover of Nature

27th Nov 1997

The New York Times also ran a small article on page A28

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

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”

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?

Reality: EntreMed’s Stock Price

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)

Oh Dear!!

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)

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

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.

Valuation Procedures

The Tools

Timeline of Cash Flows

$150 $10,150

8/15/09 8/15/10 8/15/11

8/15/12 8/15/13 8/15/14

$150 $150$150

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).

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

$956.94 1.045

1,000 value Present

then 4.5%, rate discount the Suppose

rate) discount (1

value Future value Present

1

1

Multiple Period Cash Flows

$150 $10,150

8/15/09 8/15/10 8/15/11

8/15/12 8/15/13 8/15/14

$150 $150$150

5432 R) (1

10,150

R) (1

150

R) (1

150

R)(1

150

)(1

150 ValuePresent

R

Multiple Period Cash Flows

Let R = 0.045

$8,683.01

8,144.88 125.78 131.44 137.36 143.54

.045) (1

10,150

(1.045)

150

(1.045)

150

(1.045)

150

)045.(1

150 value Present

5432

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?

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

52.92(1.06)

45(1.06)

35(1.06)

25 PV 32

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

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.

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?

Present Value Problem

5432

5

1.08

4.2

1.08

0.2

1.08

0.2

1.08

0.2

1.08

0.2 3- PV

1.08

4 3- PV

Perpetuities and Annuities

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.

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).

Rate Interest PeriodicFlow Cash Periodic

PV

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.

653,571 $ 0.07

45,750

Rate Discount

Flow Cash PV

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

RateGrowth Periodic- ateInterest R Periodic

FlowCashFirst PV

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?

1,830,000 $ 0.045 -0.07

45,750

rate Growth - rateDiscount

FlowCashFirst PV

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).

TR)1(

11

R

Payment annuity)y PV(ordinar

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?

$4,064.65 (1.07)

11

0.07

1,200 PV

4

1200 1200 1200 1200

0 1 2 3 4

PV of an Ordinary Annuity Example

$4,349.18 = $4,064.65*1.07

$3,369.62 = $3,149.18*1.07

$4,064.65 $4,349.18 $3,369.62 $2,321.50 $1,200.00Today 1 2 3 4

Payments $1,200.00 $1,200.00 $1,200.00 $1,200.00

Ending Balance $3,149.18 $2,169.62 $1,121.50 $0.00

PV of an Annuity Due Example

Now, how much would you need to deposit, if you changed your mind and wanted the first payment due today?

$4,349.18 (1.07)

11

0.07

1200 1200 PV

3

1200 1200 1200 1200

0 1 2 3 4

Investment Timing Decisions: Annuity Example

You can purchase an new optical scanner today for $400. The scanner provides benefits worth $60 a year. The scanner’s expected life is 10 years. Scanners are expected to decline in price by 20%

a year. The discount rate (“hurdle rate) for scanners is

10%.

Should you purchase the scanner today, or wait? When is the best time to purchase the scanner?

Investment Timing Decisions:Annuity Example

Determine the cost of the scanner for each of the next 10 years (the price drops by 20% annually). Today: 400 1 year from today: 0.8x420 = 320 …..

Compute the Present Value of the benefits from the scanner purchase

368.67

(1.10)

11

0.10

60scanner from Flows Cash

10

Investment Timing Decisions: Annuity example

The net benefit of the scanner = Benefits from scanner – Cost Calculate each year Today:

Net Benefit = $368.67 – $400 = -31.33 => Do not buy today

1 year from today, t =1: Net Benefit = 368.67 – 320 = 48.67

Because the net benefits are future values, you need to discount them to the present, using the 10% discount rate.

T

date purchasetoday

(1.10)

benefit Netbenefit Net

Investment Timing Decisions

Years until Purchase

Scanner CostNet benefit at

Purchase DateNet benefit

Today

0 400.00+368.67 – 400 =

(31.33)(31.33)

1 320.00 = 0.8*420368.67 – 320

= 48.6748.67/1.10 = 44.25

2 256.00 112.67 93.12

3 204.80 163.87 123.12

4 163.84 204.83 139.90

5 131.07 237.60 147.53

6 104.86 263.81 148.91

7 83.89 284.78 146.14

The best time to purchase the scanner is the number of years associated with the largest discounted net benefit.

Present Value Problem

A local bank advertises the following deal: “pay us $100 a year for 10 years and then we will pay you or

your beneficiaries $100 a year forever” Is this a good idea if the interest rate available on

other deposits is 6% per year?

Home office investment problem

A home office costs you $25,000 to set up to use for your part-time consulting business.

You forecast that you can generate after-tax cash flows of $6,250 a year and you plan to be in this business for five years?

If the discount rate is 7.5% per year, is this a good investment?

Mortgage Loan

The most common type of residential mortgage loan: has a fixed rate of interest, and calls for the payment of interest and the repayment of

principal over a fixed period of time, in equal (monthly) installments.

Most residential mortgage loans are amortizing loans: They have level, equally spaced payments. Each payment includes interest and repayment of

principal. The mix of interest and principal repayment varies over the

life of the mortgage; early payments contain more interest.

Owing to the level, equally spaced cash flows, an amortizing loan represents an annuity.

Mortgage Loan

To determine the monthly payment on a fixed-rate mortgage used to finance the purchase of a house, we need: the purchase price of the house; the amount of the purchase price to be financed; and the terms of the mortgage loan (APR, payment

frequency and loan duration).

Example: You buy a $200,000 house in Granville with 20% down and finance the balance at 6.325% APR, compounded monthly, over 15 years.

What is your monthly mortgage payment?

Mortgage Loan

With 20% down, the amount financed is $160,000.

160,000 = (1 – 0.20)x(200,000) The monthly rate of interest on your loan is 0.5271%:

Your monthly mortgage payment can be found by solving the following expression (ordinary annuity) for PMT:

In this expression, PMT equals $1,378.43.

12

06325.0 00527083.0

paymentsmonthly ofnumber 180 where

,.005271)1(

11

0.005271

PMT 160,000

180

FV of an Ordinary Annuity

Suppose you start saving $300 a month at age 25, with the intention of leaving the workforce at age 55 to pursue other interests.

You plan to use your accumulated funds to help meet living expenses after 55 .

Your investment portfolio earns 7.575% APR, compounded monthly.

Monthly interest rate = 0.07575/12 = 0.0063125 If your first $300 monthly installment is due one month

from today, how much will you have 30 years down the road – at age 55?

We want the FV of this stream of cash flows.

FV of an Ordinary Annuity

The FV of an ordinary annuity is given by the expression:

where PMT, R and T have all been defined previously.

Substituting the values from our retirement savings problem yields:

1R)1(R

PMT FV T

71.355,410$10063125.1(0.0063125

300 FV 360

Retirement Planning Problem

A couple will retire in 25 years. They plan to spend $120,000 a year in retirement They estimate that they will live for 20 years after

they retire. They estimate that they will earn 4.5% per year on

their retirement savings. If they can invest in a fund which earn 8.25%

per year during the next 25 years, how much do they need to save each year to meet their retirement goals?

Retirement Planning Problem

Part 1: How much do they need for retirement?

Part 2: How much do they need to invest each year to get to their retirement goal?

Formulas

1 - R1R

PMT )FV(Annuity

R1

1 - 1

R

PMT )PV(Annuity

rate growth - R

FlowCash y) PerpetuitPV(Growing

R

FlowCash ity)PV(Perpetu

R 1

FlowCash PV

R 1

Value Future PV

T

T

T

0t tt

t

R = Discount Rate