A Guide for Managers Worldwide Summary of Ming-Jer Chen’s Book Note: The following text is a summary of part of Ming-Jer Chen’s book. We recommend that you purchase the book in order to benefit from the full depth of the author’s own words. Chapter 1. Introduction: Who (and Where) are the Chinese? Many non-Chinese find the behavior of Chinese business people to be difficult to understand. To understand it, one must understand Chinese culture. While China is a diverse country, it also has a large degree of unity. While there are 200 dialects, there is a common written language. 90% of the population belongs to a single ethnic group called the Han. Perhaps the most important source of unity is Confucianism, which has endured for more than 2500 years. Confucianism governs every relationship, including business ones. Even when the Chinese emigrate from China and become citizens of other countries, most still consider themselves to be Chinese, even after several generations. Many of those who left China before the 1949 revolution consider themselves more Chinese than those in China today because the emigrants did not experience the communist assaults on their traditional values. Chinese culture and institutions seem vastly different to Westerners,…

Arguably, the role of a corporation’s management is to increase the value of the firm to its shareholders while observing applicable laws and responsibilities. Corporate finance deals with the strategic financial issues associated with achieving this goal, such as how the corporation should raise and manage its capital, what investments the firm should make, what portion of profits should be returned to shareholders in the form of dividends, and whether it makes sense to merge with or acquire another firm. Balance Sheet Approach to Valuation If the role of management is to increase the shareholder value, then managers can make better decisions if they can predict the impact of those decisions on the firm’s value. By observing the difference in the firm’s equity value at different points in time, one can better evaluate the effectiveness of financial decisions. A rudimentary way of valuing the equity of a company is simply to take its balance sheet and subtract liabilities from assets to arrive at the equity value. However, this book value has little resemblance to the real value of the company. First, the assets are recorded at historical costs, which may be much greater than or much less their present market…

Continue reading …Security analysis is about valuing the assets, debt, warrants, and equity of companies from the perspective of outside investors using publicly available information. The security analyst must have a thorough understanding of financial statements, which are an important source of this information. As such, the ability to value equity securities requires cross-disciplinary knowledge in both finance and financial accounting. While there is much overlap between the analytical tools used in security analysis and those used in corporate finance, security analysis tends to take the perspective of potential investors, whereas corporate finance tends to take an inside perspective such as that of a corporate financial manager. Equity Value and Enterprise Value The equity value of a firm is simply its market capitalization; that is, the market price per share multiplied by the number of outstanding shares. The enterprise value, also referred to as the firm value, is the equity value plus the net liabilities. The enterprise value is the value of the productive assets of the firm, not just its equity value, based on the accounting identity: Assets = Net Liabilities + Equity Note that net values of the assets and liabilities are used. Any cash and cash-equivalents would…

Continue reading …A firm’s performance can be evaluated using financial ratios. Referencing these ratios to those of other firms allows a comparison to be made. The following is a listing of some useful ratios. Leverage : Assets / Shareholder’s Equity Gross Margin = Gross Profit / Sales. Gross margin measures the profitability considering only variable costs and is a measure of the percentage of revenue that goes to fixed costs and profit. Net Profit Margin = Net Income / Sales Total Asset Turnover = defined as Sales / Total Assets Return on Assets (ROA) = Net Income / Assets ROA is a measure of the return on money provided by both owners and creditors, and is a measure of how efficiently all resources are managed. Return on Equity (ROE) = defined as Net Income / Equity where the equity value is the shareholder’s equity at the end of the period in which the income was earned. ROE is a measure of the return on money provided by the firm’s owners. ROE can be calculated indirectly as: ROE = ( Net Income / Total Assets ) ( Total Assets / Equity ) ROE also can be calculated using DuPont analysis : ROE = …

Continue reading …When valuing the operations of a firm using a discounted cash flow model, the operating cash flow is needed. This operating cash flow also is called the unlevered free cash flow (UFCF). The term “free cash flow” is used because this cash is free to be paid back to the suppliers of capital. Calculating Free Cash Flow For a particular year, the unlevered free cash flow is calculated as follows: 1. Start with the annual sales and subtract cash costs and depreciation to calculate the earnings before interest and taxes (EBIT). The EBIT also is referred to as the operating income and represents the pre-tax earnings without regard to how the business is financed. 2. Calculate the earnings before interest and after tax (EBIAT) by multiplying the EBIT by one minus the tax rate. Note that the EBIAT represents the after-tax earnings of the firm as if it were financed entirely with equity capital. 3. To arrive at the UFCF, add the depreciation expense back to the EBIAT, and subtract capital expenditures (CAPEX) that were not charged against earnings and subtract any investments in net working capital (NWC). The free cash flow calculation in equation form: Operating Income (EBIT) =…

Continue reading …In a discounted cash flow valuation, the cash flow is projected for each year into the future for a certain number of years, after which unique annual cash flows cannot be forecasted with reasonable accuracy. At that point, rather than attempting to forecast the varying cash flow for each individual year, one uses a single value representing the discounted value of all subsequent cash flows. This single value is referred to as the terminal value. The terminal value can represent a large portion of the valuation. The terminal value of a piece of manufacturing equipment at the end of its useful life is its salvage value, typically less than 10% of the present value. In contrast, the terminal value associated with a business often is more than 50% of the total present value. For this reason, the terminal value calculation often is critical in performing a valuation. The terminal value can be calculated either based on the value if liquidated or based on the value of the firm as an ongoing concern. Terminal Value if Liquidated If the firm is to be liquidated, the liquidation value can be based on book value, salvage value, or break-up value, but liquidation…

Continue reading …In the enterprise model of valuation, the firm’s equity value is calculated by subtracting the value of the firm’s debt from the enterprise value. Debt valuation then becomes an important component of a valuation of the firm’s equity. A company’s debt is valued by calculating the payoffs that debt holders can expect to receive, taking into account the risk of default. The default risk is addressed by considering the probability of default and the amount that could be recovered in that event. For modeling purposes, one may assume that the cash flow from the recovered amount is realized at the end of the year of default. Debt valuation may take one of the following two approaches: Discount the expected cash flow at the expected bond return; or Discount the scheduled bond payments at the rating-adjusted yield-to-maturity. Debt Valuation – Method 1 Discount the expected cash flow at the expected bond return Under this method, the value of the bond is the sum of the expected annual cash flows discounted at the expected bond return: Value = the sum for each year t of E(cash flow)t / ( 1 + rdebt )t where E(cash flow)t = expected cash flow…

Continue reading …(pre-merger value of both firms + synergies) = pre-merger stock price post-merger number of shares The above equation then can be solved for the value of the minimum required synergies. The success of a merger is measured by whether the value of the acquiring firm is enhanced by it. The practical aspects of mergers often prevent the forecasted benefits from being fully realized and the expected synergy may fall short of expectations.

Continue reading …In their 1973 paper, The Pricing of Options and Corporate Liabilities, Fischer Black and Myron Scholes published an option valuation formula that today is known as the Black-Scholes model. It has become the standard method of pricing options. The Black-Scholes formula calculates the price of a call option to be: C = S N(d1) – X e-rT N(d2) where C = price of the call option S = price of the underlying stock X = option exercise price r = risk-free interest rate T = current time until expiration N() = area under the normal curve d1 = [ ln(S/X) + (r + σ2/2) T ] / σ T1/2 d2 = d1 – σ T1/2 Put-call parity requires that: P = C – S + Xe-rT Then the price of a put option is: P = Xe-rT N(-d2) – S N(-d1) Assumptions The Black-Scholes model assumes that the option can be exercised only at expiration. It requires that both the risk-free rate and the volatility of the underlying stock price remain constant over the period of analysis. The model also assumes that the underlying stock does not pay dividends; adjustments can…

Continue reading …Stock indexes are useful for benchmarking portfolios, for generalizing the experience of all investors, and for determining the market return used in the Capital Asset Pricing Model (CAPM). A hypothetical portfolio encompassing all possible securities would be too broad to measure, so proxies such as stock indexes have been developed to serve as indicators of the overall market’s performance. In addition, specialized indexes have been developed to measure the performance of more specific parts of the market, such as small companies. It is important to realize that a stock price index by itself does not represent an average return to shareholders. By definition, a stock price index considers only the prices of the underlying stocks and not the dividends paid. Dividends can account for a large percentage of the total investment return. Weighting One characteristic that varies among stock indexes is how the stocks comprising the index are weighted in the average. Even if no explicit weighting is applied when calculating an average, there may be an implicit one. While a one dollar price change in one stock in a simple stock price index will have the same effect as a one dollar change in any other stock, a given…

Continue reading …The cost associated with trading securities can have a non-negligible impact on portfolio return. Trading costs include the following: Explicit costs – commissions, fees, and taxes. Market maker spread – difference between the bid and ask prices that the specialist sets for a stock; the specialist keeps the difference as compensation for providing immediacy. For less liquid stocks, the specialist has greater exposure to adverse price movements and likely will make the spread larger. Market impact – results when high volume trades influence the market price. Market impact can be broken into two components – a temporary one and a permanent one. The temporary component is due to the need for liquidity to fill the order. The permanent impact is due to the change in the market’s perception of the security as a result of the block trade. Opportunity cost – the effective cost of price movements that occur before the trade executes. NYSE specialists sometimes may appear to have a monopoly on trading their respective securities, creating a larger than necessary spread between bid and ask. However, there is more competition than is initially obvious. First, there is competition for the specialist positions, providing the specialist incentive to price…

Continue reading …Some investment managers and individual investors attempt to improve their performance by timing the market and adjusting their portfolio according to predictions about the market or specific sectors. Examples of market timing include switching among sectors, switching among different countries’ securities, switching between stocks and bonds, or switching between stocks and risk-free treasury bills. The effect of correctly timing the market would be to increase the portfolio beta in up markets and decrease it in down markets. For the purpose of this discussion, an up market is one in which the market return exceeds the risk-free rate, and a down market is one in which the market return is less than the risk-free rate. Proponents of market timing may argue that the market timer does not have to be correct 100% of the time in order to benefit from timing. Some even may argue that for market timing to be worthwhile, the timer simply must be right more often than wrong. Opponents to market timing may argue that the financial markets are fairly efficient, and therefore there is little to be gained from attempting to time them. Furthermore, there are transaction costs and tax implications associated with buying and selling…

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