Finance 2 (les)
8 important questions on Finance 2 (les)
The use of the statement projections is twofold:
- To convince investors to finance your venture
- To value your business
In the end, you might want to sell your business in order to harvest your hard work. In order to know what your work is worth you will need to value your business. One of the most common ways of valuing a business is by using the "Discounted Cash Flow Method"
What about the time value of money? (1/3)
You want your money back today, because it's more worth it than in the future.
What are the steps of the Top-Down method?
- Estimate terminal market share
- Estimate the growth rate needed to get there in x years
- Estimate terminal growth rate (after the fast growth period is over)
- Use the percentage of sales method to project the financial statements and obtain the cash flows
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There are 2 types of free cash flows
- Free cash flow to the firm (FCFF) --> free cash flow to all owners
- Free cash flow to equity (FCFE) --> free cash flow left for equity holders
The cost of debt: the risk-free rate
- The return to debt holders also depends on the riskiness of the company they are lending money
- If there would be no risk at all, the cost of debt would be the so-called risk-free rate
- The risk-free rate is what an investor would charge for lending out his/her money when it is 99,99% sure that they will get their money back
- What would be a good proxy for the risk-free rate? A good proxy would be the interest on the short term (3-month) government bonds from 'safe' countries
Cost of equity formula (CAPM)
Ke = Rf + Beta * (Rm-Rf)
Rf = risk free rate
Beta = beta (systematic/non diversifiable risk)
Rm = expected rate of return on equities (return of broad market portfolio)
Rm - Rf = risk premium --> historical average since 1963: 5,5%
Beta is affected by: operating leverage (fixed costs) and financial leverage (capital structure)
What is the formula of the WACC?
- E = market value of equity (total amount of equity in the company)
- D = market value of debt (total amount of debt in a company)
- Ke = cost of equity
- Kd = cost of debt
- T = corporate tax rate
There are three scenarios to calculate the future cash flows:
- Zero growth model
- Constant growth model
- Variable growth model
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