CFA Level 1 - Corporate Finance

Beta Project =

Basset [ 1 + ((1-t) D/E) ]

Externalities

effects the acceptance of a project may have on other firm cash flows.

Qbe (break even quantity) =

(fixed operating costs + Fixed financing costs) / (Price - variable cost per unit)

Beta Asset =

Bequity x [ 1 / 1 + ((1-t) D/E) ] D/E: comparable company's debt-to-equity ratio t : marginal tax rate

Bond yield + risk premium Kce =

Bond yield + Risk Premium

Cost of trade credit =

(1 + (% discount / 1 - % discount)) ^ (365/days past discount) - 1

DBY (discount-basis yield)

(Face - purchase price / Face) x 360 / DTM DTM = days to maturity

WACC =

(Wd)[Kd(1-t)] + (Wps)(Kps) + (Wce)(Kce) Wd = % of debt in cap structure Wps = % preferred stock in cap structure Wce = % C/S in cap structure

EPS after buyback =

(total earnings - after-tax cost of funds) / shares outstanding after buyback

After splits or dividends - trend

- stock prices tend to rise after - price increases appear because splits are taken as a positive signal from mgmnt about future earnings -If no good earning report, stock prices revert to original levels -tend to reduce liquidity due to higher percentage brokerage fees on lower-priced stocks Create more shares but do not increase shareholder value

Beta

-estimated using historical returns data -estimate is affected by which index is chosen to represent market return -revert toward 1 over time, and estimate may need to be adjusted for this tendency -estimates for small-cap firms may need to be adjusted upward to reflect risk inherent in small firms

Constructing Sales Driven Pro Forma Financial

1 - estimate relation tween changes in sales and changes in sales-driven income statement and bal sheet items 2 - Estimate future tax rate, i rate on debt, lease payments 3 - Forecast sales for period of interest 4 - Estimate fixed operating costs and fixed financial costs 5 - Integrate these estimates into pro forma financial statements for period of interest

Capital Asset Pricing Model

1) Estimate RFR. yield on default risk-free debt such as U.S Treasure notes are usually used. 2) Estimate stocks beta, B. Risk measure 3) Estimate the expected rate of return on market 4) CAPM to estimate the required rate of return Kcs = RFR +B [E(Rm) - RFR]

The Compensation Committee should ...

1) Link compensation with LT objectives

Cap Budgeting Principals

1) decisions based on cash flows, not accounting income 2) Cash flows based on opportunity costs & taxes 3) timing of cash flows is important 4) Cash flows are analyzed on a after-tax basis 5) financing costs are reflected in the projects required rate of return

Capital Budgeting Steps

1) idea generation 2) analyzing project proposals 3) create the firm-wide capital budget 4) monitoring decisions and conducing a post-audti

Net Profit Margin

= NI / Sales = EBT x (1 - t) / Sales

# days of payables =

Accounts Payable / Average days purchases

Factoring

Actual sale of receivables at a discount from their face values. Size of discount will depend on how long it is until the receivables are due, creditworthiness of firms credit customers, and firms collection history on receivables.

Kd (1-t)

After-tax cost of debt. t is firms marginal tax rate. The after tax component cost of debt, Kd (1-t) is used to calc WACC

Average days purchases =

Annual purchases / 365

BVPS

BVPS will decrease if the purchase price is greater than the original BVPS and increase if the repo price is less than the original BVPS

Buy a fixed number of shares at a fixed price

Company may repurchase stock by making a tendor offer to repurchase a specific number of shares at a price that is usually at a premium to the current market price.

Operating Breakeven Quantity of Sales

Consider only fixed operating costs and ignore fixed financing costs. Qobe = fixed operating costs / (price - variable cost per unit)

Look back at formulas for DOL and DFL

Convince yourself if no fixed costs, DOL = 1 and if no interest cost DFL = 1. Values of 1 mean no leverage.

Kce

Cost of common equity. Required rate of return on common stock and is generally difficult to estimate

Kps

Cost of preferred stock

Payment Date

Date the dividend checks are mailed out - sent electronically

Kps =

Dps / P Preferred dividends / market price preferred

Revised Capm with country risk premium

Kce = Rf + B [E (Rmkt) - Rf + CRP]

Crossover rate

NPV's are equal

PI Decision Rule

PI > 1, accept project PI < 1, reject project

Profitability Index (PI)

PV of a projects future cash flows divided by the initial cash outlay

PI =

PV of future cash flows / CFo also 1+ (NPV / CFo)

Dividend Discount Model Kce =

Po = D1 / Kce - g Kce = (D1 / Po) + g (D1 / Po) +g

Leverage & ROE

ROE is higher using leverage than without. Also increases the rate of change for ROE. ROE varies directly with the change in EBIT.

Country Risk Premium =

Sovereign Yield Spread x (annualized std of equity index of developing country / annualized std of sovereign bond mkt in terms of developed mkt currency)

Pulls in liquidity

accelerate cash outflows. -paying vendors sooner

NPV decision rule (independent projects)

accept any project with positive NPV and to reject any project with a negative NPV

Country Risk Premium

added to market risk premium when using CAPM

Financial Risk

additional risk that a firm's common stockholders must bear when a firm uses fixed cost (debt) financing. LT leases also introduce risk.

Operating Risk

additional uncertainty about operating EARNINGS caused by fixed operating costs.

Break Point =

amount of capital at which components cost of capital changes / weight of component in capital structure

Leverage

amount of fixed costs a firm has. ex) operating expenses, building, equipment leases -Greater leverage leads to greater variability of the firms after-tax operating earnings and net income

Flotation costs

are a cash outflow that occurs at the initiation of a project and affect the project NPV by increasing the initial cash flow. Correct way to account for flotation costs is to adjust the initial project cost.

Uncommitted line of credit

bank extends an offer of credit for certain amount but may refuse to lend if circumstances change

Committed (regular) line of credit

bank offers credit that it "commits to" for some period of time.

DTL =

combines the degree of operating leverage and financial leverage. DTL measures the sensitivity of EPS to change in sales = DOL x DFL = (%ΔEBIT/%Δsales) x (%ΔEPS / %ΔEBIT) = (%ΔEPS / %Δsales)

Repurchase by direct negotiation

companies may negotiate directly with large shareholder to buy back a block of shares, usually at a premium to the market price. Will reduce number of shares out, and increase EPS

Buy in open market

companies may repurchase stock in open market at the prevailing market price.

Marginal Cost of Capital

cost of the last new dollar of capital a firm raises. As firm raises more and more capital, the costs of difference sources of financing will increase. Raising additional capital increases WACC. Shows WACC for differenc amounts of financing

Holder-of-record date

date on which the shareholders of record are designated to receive the dividend.

Declaration Date

date the board of directors approves payment of the dividend

IRR decision rule

determine required rate of return for given project. IRR > required rate return, accept IRR < required rate return, reject

Contribution margin

difference between price and variable cost per unit, is available to help cover fixed costs.

Surplus

difference between projected growth in assets and projected growth in liabilities and stockholders equity

Key advantage of NPV

direct measure of the expected increase in the value of the firm. main weakness doesn't take consideration of project size

Internal rate of return

discount rate that makes the PV of the expected incremental after-tax cash inflows just equal to the initial cost of the project. PV (inflows) = PV (outflows)

Stock Splits

divide each existing share into multiple shares, thus creating more shares. No change in wealth

Pure-play

equity beta of a publicly traded firm that is engaged in a business similar to, and with risk similar to, project under consideration.

Special Dividends

favorable circumstances allow the firm to make a one-time cash payment to shareholders, in addition to any regular dividends the firm pays.

Flotation Costs

fees charged by investment bankers when a company raises external equity capital. incorrect treatment increase the WACC by a fixed percentage and will be a factor for the duration of the project because future project cash flows are discounted at this higher WACC to determine NPV

Ex-dividend date

first day a share of stock trades without a dividend. Occurs two business days before the holder-of-record date. If buy a share on or after the ex-dividend date, you will not receive the dividend

Pro-forma balance sheets / IS

forward-looking financial statements that are constructed based on specific assumptions about future business conditions and firm performance. (don't confuse with proforma financial statements)

Payback period =

full years until recover + (unrecovered cost at beginning of last year / cash flow during last year)

Sovereign yield spread

general risk of developing country. Difference in yields between the developing countrys government bonds and T bonds of similar maturity.

Capital Budgeting process

identifying and evaluating capital projects....projects where the cash flow to the firm will be received over a period longer than a year.

How to determine if shr repurchase will cause EPS to increase/decrease

if after-tax cost of debt < earnings yield = EPS increases if after-tax cost of debt > earnings yield = EPS decreases

Secondary sources of liquidity

include liquidating short-term or long-lived assets, negotiating debt agreements or filing for bankruptcy and reorganizing the company.

After-tax cost of debt (Kd)

interest rate at which firms can issue new debt net of the tax savings from the tax deductibility of interest. kd (1-t)

Optimal Capital Budget

intersection of investment opportunity schedule with the marginal cost of capital curve identifies amount.

Commercial paper

large creditworthy companies can issue short-term debt securities called commercial paper. Firm sells paper directly to investors (direct placement) or sells through dealers (dealer-placed paper), interest costs slightly less than rate can get from bank

Weighted Average Cost of Capital

marginal cost of capital (MCC) - discount rate cost of financing firms assets. View as opportunity cost.

Key advantage of IRR

measures profitability as a %, showing the return on each dollar invested. Provides info on margin of safety that NPV does not. Disadvantages - 1) possibility of producing rankings of mutuall exclusive projects different from NPV analysis 2) possibility are multiple IRRs or no IRR for project

Revolving line of credit

more reliable source of short-term financing than a committed line. Typically for longer terms than committed, sometimes as long as years.

Unconventional Cash flow patter

more than one sign change.

Payback period

number of years takes to recover initial cost of investment

Break Points

occur at any time the cost of one of the components of the company's WACC changes

Reverse Stock Splits

opposite of stock splits. Fewer shares outstanding but higher priced stock.

DOL =

percentage change in EBIT / percentage change in sales Q (P-V) / Q (P-V) - F ------------------------------------------- S - TVC / S - TVC - F S - sales

Breakeven quantity of Sales

quantity of sales for which revenues equal total costs, so net income is zero.

Kd

rate at which the firm can issue new debt

DFL =

ratio of the percentage change in net income (or EPS) to the percentage change in EBIT % change in EPS / % Sales or EBIT / EBIT - interest

Drag on liquidity delay

reduce cash inflows, or increase borrowing costs -uncollected receivables and bad debts, obsolete inventory

Cost of equity capital

required rate of return on the firms common stock.

Business risk

risk associated with firms operating income and is result of uncertainty about a firms revenues and expenditures necessary to produce those revenues.

Corporate governance

set of internal controls, processes, and procedures by which firms are managed.

Share repurchase if after-tax cost of borrowing is less than earnings yield (vice versa)

share repo will increase company's EPS (vice versa)

Conventional Cash Flow Patter

sign on the cash flows changes only once, with one or more cash outflows followed by one or more cash inflows

Nonbank finance companies

smaller firms or firms with poor credit use for short-term funding

Primary source of Liquidity

sources of cash it uses in its normal day-to-day operations.

Share repurchase

transaction in which a company buys back shares of its own common stock.

Sales Risk

uncertainty about firms sales

Bankers acceptances

used by firms that export goods. Guarantee from bank of firm that has ordered goods stating that a payment will be made upon receipt of goods

Discounted payback period

uses present values of the projects estimated cash flows. Number of years takes a project to recover its initial investment in a PV term and must be greater than the payback period without discounting.

Liquidating dividends

when a company goes out of business and distributes the proceeds to shareholders. Treated as a return of capital and amounts over the investors tax basis are taxed as capital gains

Cannibalization

when a new project takes sales from an existing product