Class Notes Buffet Acquisition Criteria 1 Large purchases at least 75 million of pre tax earnings make an impact on portfolio 2 Demonstrated consistent earning power future projections are of no interest to us proven track record performance metric 3 Businesses earning good returns on equity while employing little or no debt debt ties up cash flow performance metric 4 Management in place we can t supply it 5 Simple business won t understand technology Do I understand the business Simple business highlights the need for an investor to understand what makes the business work 6 An offering price Net Present Value Discount rates usually the cost of capital to the firm time value consider all cash flows weighted average cost of capital WACC assumes returns are reinvested at the cost of capital IRR alternative internal rates time value consider all cash flows investment annuity PVIFA then proceed to App D Payback no time value ignores cash flow beyond payback simple difficult for larger investments small businesses still use this method b c of liquidity and limited capital Capital Allocation Process Has a decision point Someone has to say yes or no The well being of our company depends upon which answer it is and the results of it performing people Mattel s Monster High dolls clothes jewelry costumes story lines offspring of classical monsters high school like odd ball tweens 7 10 y o girls full blown product line no increments Not R D source packaging origination home grown no licensing fees Beta 1 0 market risk stock with betas 1 0 are riskier than the market vice versa measures the volatility of returns on an individual stock relative to the stock market index of returns such as S P s 500 stock index investors use beta to assess expected level of return for a given stock an investor s portfolio relative to the balance of bonds stocks and gold a project s relationship to the market level of risk Risk aversion doesn t mean risk avoidance Risk management tells us what we value the most Risk management tells us what our parameters are Ten Keys to Diversification 1 risk management technique that minimizes the impact of any one security on overall portfolio performance 2 spread the risk 3 balance your assets so they don t all increase or decrease in value at the same time 4 allows you to take advantage of the whole investment market stocks bonds treasuries mutual funds 5 Lets you take adv Of the broad range of Co s and industries available to investors 6 large amount of diversification can be found investing in a small handful of companies 7 large cap US stock fund should be the anchor to your mutual fund portfolio 8 Mutual fund investors should hold a variety of funds to protect themselves against changes in the market 9 Dont worry too much about overlaps in holding among your mutual funds 10 Div can be a way to make yourself invest consistently throughout the year How does diversification work to lower risk lowers business risk doesn t do much to market risk maturity risk only affects bonds Kraft s Cadburys Acquisition Strategic mature emerging growth Financial Buffett s objection dilution Cultural International presence US Brits Proctor and Gamble Divests divests itself of all food and coffee businesses JM Smuckers expands w Jif Crisco and Folgers How can a small company buy a larger company spin off followed by merger Crisco and Jif into Crisco Jif LLC immediately merged into Smuckers after the merger Smuckers was owned 54 by P G shareholders spin off is another way to divest often it benefits all parties Terms of Exchange cash only stock for stock combinations of cash and stock impact on earnings per share ability to build shareholder value goodwill isn t always good Price is THE central piece premium to market price is common basis in economic value required price beyond economic value creates a loss Homework Cash flow is used in capital budgeting b c cash rather than income is used to purchase new machines cash outlays need to be evaluated in terms of the present value of the resultant cash inflows depreciation is added back to profit Capital budgeting is primarily concerned with evaluating investment alternatives firm should accept all investment proposals with positive NPV unless mutually exclusive if an investment project has positive NPV then the IRR is greater than the cost of capital Qualitative risk classes repair to old machinery new equipment addition to normal product line new product in related market completely new market new product in foreign market risk may be integrated into capital budgeting decisions by adjusting the discount rate Using the risk adjusted discount rate approach the firm s weighted average cost of capital is applied to projects with normal risk When considering the efficient frontier financial managers should adhere to all of the following guidelines maximize return for a given level of risk minimize risk for a given level of return select the projects on the leftmost sector of the possible projects Chapter 12 Selection Strategy if mutually exclusive one investment will preclude its alternative reinvestment assumption IRR all inflows can be reinvested at the yield from a given investment for investment w very high IRR unrealistic so NPV makes more conservative assumption Modified IRR combines reinvestment assumption of the NPV w the IRR replacement decisions sell old machine for new one if old machine sells for more than book value then some of the cash inflow from the sale will be taxable if sold less than book value this will be considered a loss and will provide a tax benefit Chapter 13 Risk averse for a given situation investors would prefer relative certainty to uncertainty that the greater the risk the higher the expected return must be expected value weighted average of the outcomes D times their probabilities P Standard Dev measure of dispersion or variability around the expected value generally the larger the St Dev the greater the risk D expected value 2P X Square root of X St Dev coefficient of variation generally the larger the CoV the greater the risk St Dev Expected Value CoV risk adjusted discount rates use different discount rates for proposals w different risk levels investments carrying greater than normal risk are discounted at a higher rate Portfolio effect impact of a given investment on the overall risk of the firm highly correlated investments do little or nothing to diversify away risk negatively correlated projects those