Accounting And Finance Skills

Understanding More Complex Financial Concepts




1. Weighted Average Cost of Capital (WACC)

Definition:

WACC represents the average rate of return a company must pay to finance its assets, combining the costs of debt and equity. It’s used in valuation models like Discounted Cash Flow (DCF).

Formula:

[ {WACC} = \left( \frac{E}{E + D} * r_e \right) + \left( \frac{D}{E + D} * r_d * (1 - t) \right) ] Where: - (E): Market value of equity. - (D): Market value of debt. - (r_e): Cost of equity (calculated using CAPM). - (r_d): Cost of debt (interest rate on loans or bonds). - (t): Corporate tax rate.

Key Concept:

  • Cost of Equity: The return shareholders expect for their investment.
  • Cost of Debt: The effective interest rate a company pays on borrowed funds.

Example:

  • Equity = $500M, Debt = $200M, Cost of Equity = 10%, Cost of Debt = 5%, Tax Rate = 30%. [ {WACC} = \left( \frac{500}{500 + 200} * 0.10 \right) + \left( \frac{200}{500 + 200} * 0.05 * (1 - 0.30) \right) ] [ {WACC} = 0.0714 + 0.0100 = 7.14\% ]

Practical Use: A company with a WACC of 7.14% should aim to generate returns exceeding this threshold to create value.

2. Enterprise Value (EV)

Definition:

Enterprise Value is the total value of a company, considering its equity, debt, and cash. It reflects what it would cost to acquire the entire business.

Formula:

[ {EV} = {Market Capitalization} + {Total Debt} - {Cash and Cash Equivalents} ]

Example:

  • Market Capitalization = $1B, Total Debt = $300M, Cash = $50M. [ {EV} = 1,000 + 300 - 50 = 1,250 \, {(in millions)} ]

Key Insight: EV provides a more comprehensive valuation than market cap alone, as it factors in debt and cash, which affect the cost of acquisition.

3. Free Cash Flow (FCF)

Definition:

Free Cash Flow is the cash a company generates after accounting for capital expenditures (CapEx) needed to maintain or expand operations.

Formula:

[ {FCF} = {Operating Cash Flow} - {CapEx} ]

Example:

  • Operating Cash Flow = $200M, CapEx = $50M. [ {FCF} = 200 - 50 = 150 \, {(in millions)} ]

Why It’s Important:

  • FCF measures a company’s ability to generate cash to pay dividends, reduce debt, or reinvest in growth.
  • Used in valuation models like Discounted Cash Flow (DCF).

4. Capital Asset Pricing Model (CAPM)

Definition:

CAPM calculates the cost of equity, reflecting the return investors expect based on the risk of the investment.

Formula:

[ r_e = r_f + \beta * (r_m - r_f) ] Where: - (r_e): Cost of equity. - (r_f): Risk-free rate (e.g., government bond yield). - (\beta): Stock’s sensitivity to market movements. - (r_m): Expected market return.

Example:

  • Risk-Free Rate = 3%, Beta = 1.2, Market Return = 8%. [ r_e = 0.03 + 1.2 * (0.08 - 0.03) ] [ r_e = 0.03 + 0.06 = 9\% ]

Key Insight: Higher beta indicates greater risk and, thus, a higher expected return.

5. Economic Value Added (EVA)

Definition:

EVA measures a company’s ability to generate returns above its cost of capital, indicating true economic profit.

Formula:

[ {EVA} = {Net Operating Profit After Taxes (NOPAT)} - ({Capital Employed} * {WACC}) ]

Example:

  • NOPAT = $50M, Capital Employed = $300M, WACC = 10%. [ {EVA} = 50 - (300 * 0.10) ] [ {EVA} = 50 - 30 = 20 \, {(in millions)} ]

Key Insight: Positive EVA shows the company is creating value for shareholders.

6. Return on Invested Capital (ROIC)

Definition:

ROIC measures how effectively a company uses its capital to generate returns.

Formula:

[ {ROIC} = \frac{{NOPAT}} / {{Invested Capital}} ] Where: - Invested Capital: Equity + Debt - Cash.

Example:

  • NOPAT = $40M, Equity = $300M, Debt = $100M, Cash = $50M. [ {Invested Capital} = 300 + 100 - 50 = 350 ] [ {ROIC} = \frac{40}{350} = 11.4\% ]

Insight: ROIC > WACC indicates value creation.

7. Terminal Value (TV)

Definition:

Terminal Value represents the value of a business beyond the forecast period in a DCF model.

Formula (Perpetuity Growth Method):

[ {TV} = \frac{{FCF}{n+1}}{r - g} ] Where: - ( {FCF}{n+1} ): Free Cash Flow in the first year after the forecast period. - ( r ): Discount rate (WACC). - ( g ): Long-term growth rate.

Example:

  • FCF in Year 6 = $50M, WACC = 10%, Growth Rate = 3%. [ {TV} = \frac{50}{0.10 - 0.03} = 714.3 \, {(in millions)} ]

Key Insight: TV often makes up the majority of a company’s valuation in a DCF.

8. Leveraged vs. Unpowerd Free Cash Flow

Definition:

  • Unpowerd FCF: Cash flow before considering debt payments; used in enterprise valuation.
  • Leveraged FCF: Cash flow after debt payments; used to measure equity value.

Key Difference:

Unpowerd FCF is discounted using WACC, while powerd FCF is discounted using the cost of equity.

9. Contribution Margin

Definition:

Contribution margin measures the portion of revenue remaining after variable costs, which contributes to fixed costs and profit.

Formula:

[ {Contribution Margin} = \frac{{Revenue} - {Variable Costs}} / {{Revenue}} * 100 ]

Example:

  • Revenue = $1M, Variable Costs = $400,000. [ {Contribution Margin} = \frac{1,000,000 - 400,000}{1,000,000} * 100 = 60\% ]

Key Insight: A higher contribution margin indicates better cost control relative to revenue.

10. Altman Z-Score (Financial Distress Indicator)

Definition:

The Altman Z-Score predicts the likelihood of bankruptcy for a company.

Formula (For Public Companies):

[ Z = 1.2A + 1.4B + 3.3C + 0.6D + 1.0E ] Where: - ( A = \frac{{Working Capital}} / {{Total Assets}} ) - ( B = \frac{{Retained Earnings}} / {{Total Assets}} ) - ( C = \frac{{EBIT}} / {{Total Assets}} ) - ( D = \frac{{Market Value of Equity}} / {{Total Liabilities}} ) - ( E = \frac{{Revenue}} / {{Total Assets}} )

Key Score Ranges:

  • Z > 2.99: Safe zone.
  • 1.8 < Z < 2.99: Gray zone.
  • Z < 1.8: Distress zone.
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