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MANAGEMENT CERTIFICATE PROGRAM Fisher College of Business The Ohio State University CORPORATE FINANCIAL ANALYSIS Bernadette A. Minton, PhD.

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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

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Two-pronged attack 1.Discussion 2.Real world application problems

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

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Financial managers Firm’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

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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

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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

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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

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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.

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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

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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

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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

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For Mr. Morris

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AEP Proxy Statements strong value- based incentives -12/31/08 Michael Morris - CEO Salary1,259,615 Stock awards -43,132 Option awards0 Non-equity incentive planned comp1,654,071 Deferred comp 330,564 Other compensation 818,438 Total compensation4,019,556 Shares & Stock Equivalents 473,647 Stock options Stock awards

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Market Efficiency

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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

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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

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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

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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

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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

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

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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) 27 th November 1997

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May 3 rd 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”

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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?

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Reality: EntreMed’s Stock Price

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November 12 th 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)

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Oh Dear!!

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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)

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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

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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.

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Valuation Procedures The Tools

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Timeline of Cash Flows $150$10,150 8/15/098/15/108/15/118/15/128/15/138/15/14 $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).

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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

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Multiple Period Cash Flows $150$10,150 8/15/098/15/108/15/118/15/128/15/138/15/14 $150

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Multiple Period Cash Flows Let R = 0.045

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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?

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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

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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

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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.

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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?

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Present Value Problem

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Perpetuities and Annuities

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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.

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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).

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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.

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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

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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?

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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).

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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?

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

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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?

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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?

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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

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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.

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Investment Timing Decisions Years until Purchase Scanner Cost Net benefit at Purchase Date Net benefit Today 0400.00 +368.67 – 400 = (31.33) 1320.00 = 0.8*420 368.67 – 320 = 48.67 48.67/1.10 = 44.25 2256.00112.6793.12 3204.80163.87123.12 4163.84204.83139.90 5131.07237.60147.53 6104.86263.81148.91 783.89284.78146.14 The best time to purchase the scanner is the number of years associated with the largest discounted net benefit.

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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?

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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?

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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.

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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?

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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.

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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.

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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:

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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?

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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?

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Formulas R = Discount Rate

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Discounted Cash Flow Valuation Chapter 4 Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin.

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