Class Notes:Buffet Acquisition Criteria1.Large purchases (at least 75 million of pre-tax earnings) -make an impact on portfolio2. Demonstrated consistent earning power (future projections are of no interest to us) -proven track record -performance metric3.Businesses earning good returns on equity while employing little or no debt -debt ties up cash flow -performance metric4.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 work6.An offering priceNet 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 capitalCapital 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 peopleMattel’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 areTen Keys to Diversification1. risk management technique that minimizes the impact of any one security on overall portfolio performance2. spread the risk3.balance your assets so they don’t all increase or decrease in value at the same time4.allows you to take advantage of the whole investment market: stocks, bonds, treasuries, mutual funds5. Lets you take adv. Of the broad range of Co’s and industries available to investors6.large amount of diversification can be found investing in a small handful of companies7.large-cap US stock fund should be the anchor to your mutual fund portfolio8. Mutual fund investors should hold a variety of funds to protect themselves against changes in the market9.Dont worry too much about overlaps in holding among your mutual funds10. 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 bondsKraft’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 mergedinto 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 goodPrice is THE central piece:-premium to market price is common-basis in economic value required-price beyond economic value creates a lossHomework:-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 projectsChapter 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 benefitChapter 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