What is the difference between a financial and a real asset

Real assets: create goods and services, reflects productive capacity of the economy. Eg land, building, machines, IP. Generate net income in the economy.

Financial assets: do not contribute directly to the productive capacity of the economy. Eg shares and bonds. Means by which individuals hold claim on real assets. Financial assets define allocation of income or wealth

Fixed income or debt securities

Promise a fixed stream of income or a stream of income determined by a specific formula

Equity, shares, common stock

An ownership share in a corporation. Not promised a particular payment. Receive any dividends paid and prorated ownership of real assets.

Derivatives

Provide payoffs dependent on the prices of other assets such as stock and bond prices

Price weighted average calculation of an index

Add up all stock prices and divide by number of stocks

Higher priced stocks will dominate the value. Eg DJIA 30 stock index

Adjustments have been made to DJIA to reflect stock slits etc. the divisor may be adjusted to leave the overall index value unaffected. DJIA has also been adjusted over time for change in industry make up.

Nikkei 225 is also price weighted

Market value weighted index

Uses market value weighting of shares

Unaffected by stock splits

Higher weight to the stock with the higher value

Equally weighted index

Place equal weight on each stock’s return

Unlike price and value weighted indices, this is not appropriate for buy and hold approach because of adjustments that need to be made to maintain an equal weight.

Number of stocks is fixed, but composition can change

Total return index

Also known as accumulation index, includes dividends

Calculate S&P/ASX price index

Today’s closing price index = yest’ closing price index x today’s closing AMV/ yest closing AMV

Market weighted, so larger companies have a greater influence.

For total return calculation, include dividends in the numerator

Value in use

Value of an asset is derived from the future cashflows expected from owning it. Every asset, financial and real, has a value

Valuation myths

Since valuation models are quantitative, valuation is objective

A well researched and well done valuation is timeless

A good valuation provides a precise estimate of value

Te more quantitative the model, the better the valuation

To make money on valuation, you need to assume markets are inefficient

Product of valuation ie the value, is what matters, the process of valuation is not important

Time value of money

Discounted cash flow

Discounted cash flow:

Sum of CF/(1+r)^t

Time value of money is due to opportunity of investing today at a positive rate of return. $1 can be invested at 1.00 x (1+r)

Equity valuation

Value just the equity stake in the business

Calculate value of equity

discount cashflows to equity at the cost of equity

Calculate Value of Firm

Discount cashflows to the firm at the cost of capital (WACC)

Weighted Average Cost of Capital

WACC = Cost eq x (Eq/D+E)) + Cost debt (D / (D+E))

Relative Valuation definition; uses ratios such as:

RV determines the value of an asset by relating it to the known value of comparable assets

Ratios include:

P/E, P/Sales; P/BV

Contingent Claim Valuation

Many assets have option like features from: - trazding options - financial claims (eg equity) - real options EG - technology company with patents

Contingency Claim Valuation - why not used for all assets?

- Inputs difficult to estimate

- How to estimate strike prices

Real options valuation

Apply option pricing methods to the valuation of capital investments in real assets.

Situations where DCF is difficult to apply (7)

this is exam tip

- Firms in trouble (-ve earnigns & CFs)
- Cyclical firms (need to smooth CFs for the cycycle)
- Firms with unutilised assets
- Firms with patents or product options
- Firms in process of restructuring (change in CF profile)
- Firms involved in acquisitions (is there synergy / can this be estimated, impact of changing mgmt)
- Private firms (availabiltiy of information)

Studies in Real Options

this is an exam tip

- Abandonment (option to stop use of the assets, realising the salvage value)
- Flexibility to switch (option to alter output or input mixes in repsonse to changes in prices or demand
- Enter and exit (Option to exit an investment activity and reenter as conditions become more favourable
- Right to defer (option to delay invetsment outlays until such time that the investment is profitable
- STaged Investment (Option to make investment outlays in successive stages with the right to abandon the project as more information becomnes available
- Growth (option to capitalise on an earlier investment, such as one in research and development, to enter into related invedstment projects
- Interacting options (multiple options, including the option to defer, expand and switch)

What determines market rate of interest (4)

- Expected real rate of interest
- Expected inflation rate
- Expected risk premium
- Expected liquidity premium

Define expected real rate of interest (component of market rate of interest)

The rate which equates supply with demand for fundcs (in the absence of inflation & risk).

Define expected inflation rate (component of market rate of interest)

Compensation for any loss in purchasing power

eg 4% = interest, 5% = inflation. Therefore require: (100 x 1.04) x (1.05) = 109.2 to cpmpensate for $100n lent. Rate of nnominal interestn = 109.2/100-1 = 9.2%

Define expected risk premium (component of market interest rate)

Specific risk (operating, financial, management, collateral); and market risk

Define expected liuqiditry premium (component of market interest rate)

The effect of the term of the loan on the nominal interest rate

Borrowers prefer to lend long to avoipd need to frequently roll over borrowings. To avoid the risk, will pay higher yields

Standard deviation (define)

Symmetrical measure of dispersion; how far away from the mean we can expect our results to be

Risk premium (define_)

Risk premium is compensation for lending funds / investing. Reflects the risk that the return will be different from what is promised or expected

Excess return (define)

Return earned above a risk free rate

Calculate value of equity

discount cashflows to equity at the cost of equity

Calculate Value of Firm

Discount cashflows to the firm at the cost of capital (WACC)

Weighted Average Cost of Capital

WACC = Cost eq x (Eq/D+E)) + Cost debt (D / (D+E))

Relative Valuation definition; uses ratios such as:

RV determines the value of an asset by relating it to the known value of comparable assets

Ratios include:

P/E, P/Sales; P/BV

Contingent Claim Valuation

Many assets have option like features from: - trading options - financial claims (eg equity) - real options EG - technology company with patents

Contingency Claim Valuation - why not used for all assets?

- Inputs difficult to estimate

- How to estimate strike prices

Real options valuation

Apply option pricing methods to the valuation of capital investments in real assets.

Situations where DCF is difficult to apply (7)

this is exam tip

- Firms in trouble (-ve earnigns & CFs)
- Cyclical firms (need to smooth CFs for the cycycle)
- Firms with unutilised assets
- Firms with patents or product options
- Firms in process of restructuring (change in CF profile)
- Firms involved in acquisitions (is there synergy / can this be estimated, impact of changing mgmt)
- Private firms (availabiltiy of information)

Studies in Real Options

this is an exam tip

- Abandonment (option to stop use of the assets, realising the salvage value)
- Flexibility to switch (option to alter output or input mixes in repsonse to changes in prices or demand
- Enter and exit (Option to exit an investment activity and reenter as conditions become more favourable
- Right to defer (option to delay invetsment outlays until such time that the investment is profitable
- STaged Investment (Option to make investment outlays in successive stages with the right to abandon the project as more information becomnes available
- Growth (option to capitalise on an earlier investment, such as one in research and development, to enter into related invedstment projects
- Interacting options (multiple options, including the option to defer, expand and switch)

What determines market rate of interest (4)

- Expected real rate of interest
- Expected inflation rate
- Expected risk premium
- Expected liquidity premium

Define expected real rate of interest (component of market rate of interest)

The rate which equates supply with demand for fundcs (in the absence of inflation & risk).

Define expected inflation rate (component of market rate of interest)

Compensation for any loss in purchasing power

eg 4% = interest, 5% = inflation. Therefore require: (100 x 1.04) x (1.05) = 109.2 to cpmpensate for $100n lent. Rate of nnominal interestn = 109.2/100-1 = 9.2%

Define expected risk premium (component of market interest rate)

Specific risk (operating, financial, management, collateral); and market risk

Define expected liuqiditry premium (component of market interest rate)

The effect of the term of the loan on the nominal interest rate

Borrowers prefer to lend long to avoipd need to frequently roll over borrowings. To avoid the risk, will pay higher yields

Standard deviation (define)

Symmetrical measure of dispersion; how far away from the mean we can expect our results to be

Risk premium (define_)

Risk premium is compensation for lending funds / investing. Reflects the risk that the return will be different from what is promised or expected

Excess return (define)

Return earned above a risk free rate

Different valuation methods, name 3

- Discounted cashflow
- Relative valuation
- Contingent claims (options)