MANAGEMENT CERTIFICATE PROGRAM Fisher College of Business The

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

Value-Based Approach (2) AEP Financial managers Firm’s operations (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 Equity markets & Bond markets

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. Annual Incentive Targets. “AEP provides annual incentive compensation to executive officers to drive the achievement of annual performance objectives that are critical to AEP’s success”. 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 Safety Performance Operations Performance Regulatory Performance Strategic Initiatives Total Score EPS Score Avg Performance Score Final Composite Score Weight 25% 25% 25% 25% 2008 Score 181.6% of target 66.6% of target 125% of target 100.9% of target 118.5% of target 136.20% 133.90% 120.5 (118.5%x136.2%/133.9%)

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

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

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.

Theory: Levels of Market Efficiency Weak Form Efficiency Semi-Strong Form Efficiency Stock prices reflect all information contained in the history of past prices 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

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

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: Price reaction in an efficient market Beliefs (and prices) change with the arrival of relevant new information 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 Many financial transactions involve a stream of cash flows 150 150 150 8/15/09 8/15/10 8/15/1 1 8/15/12 150 8/15/13 10,15 0 8/15/14 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 1,000 4/15/09 4/15/10 Present value of the 1,000 to be received in one year equals: Present value Future value (1 discount rate)1 Suppose the discount rate 4.5%, then 1,000 Present value 956.94 1 1.045

Multiple Period Cash Flows 150 150 150 8/15/09 8/15/10 8/15/1 1 8/15/12 Present Value 150 8/15/13 10,15 0 8/15/14 150 150 150 150 10,150 (1 R ) (1 R)2 (1 R)3 (1 R) 4 (1 R)5

Multiple Period Cash Flows Let R 0.045 150 150 150 150 10,150 Present value 2 3 4 (1.045) (1.045) (1.045) (1.045) (1.045)5 143.54 137.36 131.44 125.78 8,144.88 8,683.01

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 PV 25 35 45 92.52 2 3 (1.06) (1.06) (1.06) Cost 90.00 Value to you 92.52 – 90.00 2.52 Net Present value (NPV) Create value by selecting positive NPV investments

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 Yield-to-maturity on a bond Opportunity cost of debt capital Expected return on equity Risk-free securities 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 Need discount rates Involves forecasting sometimes 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 PV - 3 4 1.085 PV - 3 0.2 0.2 0.2 0.2 4.2 1.08 1.082 1.083 1.084 1.085

Perpetuities and Annuities

Perpetuities & Annuities Streams of cash flows can have certain characteristics that make their analysis computationally simple. PERPETUITY ANNUITY An infinite stream of level, equally spaced cash flows. 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 Periodic Cash Flow PV Periodic Interest Rate 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).

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? Cash Flow 45,750 A perpetual income of 45,750 will represent 7% return on PV a653,571 an initial (one-time) investment of 0.07 653,571. Discount Rate

Growing Perpetuities First Cash Flow PV Periodic Interest Rate - Periodic Growth Rate PV is the present value of the future stream of cash flows. First Cash Flow Periodic Interest Rate the amount earned or paid at the end of the first period (e.g., first month). 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

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? First Cash Flow 45,750 PV 1,830,000 Discount rate - Growth rate 0.07 - 0.045

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: Payment 1 PV(ordinary annuity) 1 T R ( 1 R) 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).

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? 0 PV 1200 1200 1200 1200 1 2 3 4 1,200 1 1 4,064.65 4 0.07 (1.07)

PV of an Ordinary Annuity Example 4,064.65 Today Payments 4,349.18 1 1,200.00 3,369.62 2 1,200.00 2,321.50 3 1,200.00 1,200.00 4 1,200.00 Ending Balance 3,149.18 2,169.62 1,121.50 0.00 4,349.18 4,064.65*1.07 3,369.62 3,149.18*1.07

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? 1200 0 1200 1 1200 2 1200 3 4 1200 1 PV 1200 1 4,349.18 3 0.07 (1.07)

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 60 1 Cash Flows from scanner 1 10 0.10 (1.10) 368.67

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 1 year from today, t 1: Do not buy today 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. Net benefit today Net benefit purchase date T (1.10)

Investment Timing Decisions Years until Purchase 0 1 2 Scanner Cost Net benefit at Purchase Date 368.67 – 400 400.00 (31.33) 368.67 – 320 320.00 0.8*420 48.67 256.00 112.67 Net benefit Today (31.33) 48.67/1.10 44.25 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: Most residential mortgage loans are amortizing loans: 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. 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%: 0.00527083 0.06325 12 Your monthly mortgage payment can be found by solving the following expression (ordinary annuity) for PMT: PMT 1 160,000 1 , 180 0.005271 (1.005271) where 180 number of monthly payments In this expression, PMT equals 1,378.43.

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: PMT FV (1 R) T 1 R where PMT, R and T have all been defined previously. Substituting the values from our retirement savings problem yields: FV 300 (1.0063125360 1 410,355.71 0.0063125

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 Future Value 1 R t T Cash Flow t PV t 0 1 R t Cash Flow PV(Perpetuity) R Cash Flow PV(Growing Perpetuity) R - growth rate PV PMT 1 PV(Annuity) 1 T R 1 R PMT T FV(Annuity) 1 R - 1 R R Discount Rate