Key Investment Concepts: Cash Flow, Time Horizon, and Valuation
Key Investment Concepts
The financial dimension of an investment refers to the cash flows required to fund the fixed assets, working capital, and initial losses until the project starts to generate positive cash flows.
The time horizon of an investment refers to the time from the first cash flow of the project until the final cash flow occurs.
An investment project is a stream of cash flows over the time horizon of the investment.
Valuation Models and Concepts
Capital Asset Pricing Model (CAPM): The CAPM uses the return required by the market for an investment based on the risk assumed compared to the risk-free rate and the market average.
Dividend Discount Model: It considers the shares of the company as an investment, in which the cash flows are the share price as an initial outflow and the dividends to be received as cash inflows.
The Weighted Average Cost of Capital (WACC) considers both the cost of each financing source and the percentage of each financing source in the financial structure of the company.
Cost of Equity is the rate of return a company pays out to equity investors. A firm uses cost of equity to assess the relative attractiveness of investments, including both internal projects and external acquisition opportunities. Companies typically use a combination of equity and debt financing, with equity capital being more expensive.
Capital Structure Theories
Modigliani-Miller (with no taxes): The value of a firm is constant regardless of the capital structure (debt/equity ratio). The theory is formulated based on the following assumptions: No taxes, No transaction costs, No costs of bankruptcy, All agents are able to borrow.
Expected Market Return: This value is typically the average return of the market (which the underlying security is a part of) over a specified period of time.
Dividend Capitalization Model: The Dividend Capitalization Model only applies to companies that pay dividends, and it also assumes that the dividends will grow at a constant rate.
Current Share Price: The share price of a company can be found by searching the ticker or company name on the exchange that the stock is being traded on, or by simply using a credible search engine.
Dividend Growth Rate: The Dividend Growth Rate can be obtained by calculating the growth (each year) of the company’s past dividends and then taking the average of the values.
Traditional Theory: A moderate leverage increased the rate of return on equity. When debt increased after a certain point, equity investors perceived a higher risk and demanded a higher return, increasing their requirements and increasing the WACC. The optimal capital structure is that where the WACC is minimum. If WACC is minimized, the market value of the firm is maximized.
Cost of Capital and Financing
Cost of Capital: Weighted average of the cost of different sources of financing. It should be used as a discount rate to evaluate investment decisions.
Debt and Taxes: Interest on debt is tax deductible, so when considering the cost of debt compared to the cost of equity, we should consider the tax shield we would get.
Free Cash Flow: is the cash generated to pay owners (equity) and lenders (debt).