Corporate Finance Final

Fisher Effect

(1+real) = (1+nominal) / (1+inflation) (1+R)(1+i) = (1+N) Classical Theory of Interest Rates (Economics) Developed by Irving Fisher Nominal Interest Rate = The rate you actually pay when you borrow money Real Interest Rate = The theoretical rate you pay when you borrow money, as determined by supply and demand

Bankruptcy

*Chapter 7*: A proceeding in federal court liquidating the debtor's assets by sale to pay off their debts. *Chapter 11*: Reorganization of a business where company can operate with pre-bankruptcy management in place while the entitlement of lenders and investors are reorganized to replace a failed capital structure. *Workouts*: An alternative to Bankruptcy Code Chapter 11. An out-of-court agreement of how parties can work out a payment plan. *Alternative Bankruptcy Procedures*: In some countries the bankruptcy system is even more friendly to debtors. For example, in France the primary duties of the bankruptcy court are to keep the firm in business and preserve employment. Only once these duties have been performed does the court have a responsibility to creditors. Creditors have minimal control over the process. The U.K. is just about at the other end of the scale. When a British firm is unable to pay its debts, the control rights pass to the creditors. Most commonly, a designated secured creditor appoints a receiver, who assumes direction of the firm, sells sufficient assets to repay the secured creditors, and ensures that any excess funds are used to pay off the other creditors according to the priority of their claims. Davydenko and Franks, who have examined alternative bankruptcy systems, found that banks responded to these differences in the bankruptcy code by adjusting their lending practices. Nevertheless, as you would expect, lenders recover a smaller proportion of their money in those countries that have a debtor-friendly bankruptcy system.

Options

*Decision trees* - Diagram of sequential decisions and possible outcomes Decision trees help companies determine their *Options* by showing the various choices and outcomes The option to avoid a loss or produce extra profit has value. The ability to create an option thus has value that can be bought or sold --- Derivatives - Any financial instrument that is derived from another. (e.g.. options, warrants, futures, swaps, etc.) Option - Gives the holder the right to buy or sell a security at a specified price during a specified period of time. Call Option - The right to buy a security at a specified price within a specified time. Put Option - The right to sell a security at a specified price within a specified time. Option Premium - The price paid for the option, above the price of the underlying security. Intrinsic Value - Diff between the strike price and the stock price. Time Premium - Value of option above the intrinsic value Exercise Price - (Striking Price) The price at which you buy or sell the security. Expiration Date - The last date on which the option can be exercised. American Option - Can be exercised at any time prior to and including the expiration date. European Option - Can be exercised only on the expiration date. Note: all options usually act like European options b/c you make more money if you sell the option before expiration rather than exercise it.

Financial Alchemy

*Masochists' Strategy* - long stock and short call. *Protective Put* - long stock and long put *Straddle* profit from high volatility - long call and long put *Put Alternative* - buy a call, deposit PV(exercise price) in bank, sell stock will give you the same result as if you had bought a put

Ten Unsolved Problems in Finance

1) What determines project risk and present value? 2) Risk and return - what have we missed? 3) How important are the exceptions to the efficient market theory? 4) Is management an off-balance-sheet liability? 5) How can we explain the success of new securities and new markets? 6. How can we resolve the payout controversy? 7. What risks should a firm take? 8. What is the value of liquidity? 9. How can we explain merger waves? 10. Why are financial systems so prone to crisis?

Seven Most Important Ideas in Finance

1. Net Present Value: This is the simple idea behind net present value (NPV). When we calculate an investment project's NPV, we are asking whether the project is worth more than it costs. We are estimating its value by calculating what its cash flows would be worth if a claim on them were offered separately to investors and traded in the capital markets. 2. Capital Asset Pricing Model (CAPM): the crucial distinction between diversifiable and nondiversifiable risks 3. Efficient Capital Markets: The weak form (or random-walk theory) says that prices reflect all the information in past prices. The semistrong form says that prices reflect all publicly available information, and the strong form holds that prices reflect all acquirable information. 4. Value Additivity & Law: The principle of value additivity states that the value of the whole is equal to the sum of the :values of the parts. It is sometimes called the law of the conservation of value. When we appraise a project that produces a succession of cash flows, we always assume that values add up. 5. Conservation of Value: If the law of the conservation of value works when you add up cash flows, it must also work when you subtract them.5 Therefore, financing decisions that simply divide up operating cash flows don't increase overall firm value. 6. Capital Structure Theory: This is the basic idea behind Modigliani and Miller's famous proposition 1: In perfect markets changes in capital structure do not affect value. As long as the total cash flow generated by the firm's assets is unchanged by capital structure, value is independent of capital structure. The value of the whole pie does not depend on how it is sliced.: 7. Option Theory: In finance option refers specifically to the opportunity to trade in the future on terms that are fixed today. Smart managers know that it is often worth paying today for the option to buy or sell an asset tomorrow. Black-Scholes Formula 8. Agency Theory: The shareholders (the principals) want managers (their agents) to maximize firm value. In the United States the ownership of many major corporations is widely dispersed and no single shareholder can check on the managers or reprimand those who are slacking. So, to encourage managers to pull their weight, firms seek to tie the managers' compensation to the value that they have added.

Perpetuity

A cash flow that will be received every period, indefinitely. Return = Cash Flow / Present Value r = C / PV PV = C / r Ex: What is the present value of $100 every year forever if r = 10%? PV = $100/0.10 = $1,000 What if the investment does not start making money for three years? PV = $100/0.10 * 1/1.10^3 = $751.31

Bond

A financial security that obligates the issuer to make specified payments to the bondholder *Face value* (par value or principal value) - Payment at the maturity of the bond. *Coupon* - The interest payments made to the bondholder. *Coupon rate* - Annual interest payment, as a percentage of face value. Note: the coupon rate is NOT the discount rate used to find the price of the bond (present value). Coupon rate only tells you the interest paid every period.

Private Equity Partnership

A private-equity investment fund is a partnership, not a corporation. The general partner sets up and manages the partnership. The limited partners put up almost all of the money. Limited partners are generally institutional investors, such as pension funds, endowments, and insurance companies. Wealthy individuals may also participate. The limited partners have limited liability, like shareholders in a corporation, but do not participate in management. The general partners get a management fee, usually 1% or 2% of capital committed,24 plus a carried interest in 20% of any profits earned by the partnership. In other words, the limited partners get paid off first, but then get only 80% of any further returns. The general partners therefore have a call option on 20% of the partnership's total future payoff, with an exercise price set by the limited partners' investment. Private equity buys, fixes, and sells. By selling (cashing out), private equity avoids the problems of managing the conglomerate firm and running internal capital markets.27 You could say that private-equity partnerships are temporary conglomerates. You can see some of the advantages of private-equity partnerships: ∙ Carried interest gives the general partners plenty of upside. They are strongly motivated to earn back the limited partners' investment and deliver a profit. ∙ Carried interest, because it is a call option, gives the general partners incentives to take risks. Venture capital funds take the risks inherent in start-up companies. Buyout funds amplify business risks with financial leverage. ∙ There is no separation of ownership and control. The general partners can intervene in the fund's portfolio companies any time performance lags or strategy needs changing. ∙ There is no free-cash-flow problem: Limited partners don't have to worry that cash from a first round of investments will be dribbled away in later rounds. Cash from the first round must be distributed to investors.

Rate of Return Rule

Accept investments that offer rates of return in excess of their opportunity cost of capital Return = profit / investment

Leveraged Buyout (LBO)

Acquisition of a company's publicly traded stock, using funds that are primarily borrowed, usually with the intent of using some of the acquired assets to pay back the loans used to acquire the company Unique Features: - large part of buyout financed by debt - shares of the LBO are no longer traded on the open market! company is taken private The three main characteristics of LBOs: 1. High debt 2. Incentives to management 3. Private ownership Corporate control -- The power to make investment and financing decisions. Corporate governance -- The role of the Board of Directors, shareholder voting, proxy fights, etc. and to actions taken by shareholders to influence corporate decisions. Financial architecture -- The financial organization of the business.

Common Size Balance Sheet

All items in the balance sheet are expressed as a percentage of total assets

Net Present Value Rule

An investment should be accepted if the net present value is positive and rejected if it is negative.

Sources of Short-Term Borrowing

Bank loan (features) - Commitment - Maturity - Rate of interest Syndicated loans Loan sales and CDOs Secured loans Commercial paper Medium term notes

Cash versus Credit

Cash does not pay interest Move money from cash accounts into short term securities "Sweep programs" Concentration banking Lock-box system Electronic Funds Transfer (EFT) Automated Clearinghouse (ACH) International cash management - SWIFT Compensating balances

Collection Policy

Collection Policy - Procedures to collect and monitor receivables. Aging Schedule - Classification of accounts receivable by time outstanding. Factoring - Arrangement whereby a financial institution buys a company's accounts receivable and collects the debt.

Inventory Management

Components of Inventory - Raw materials - Work in process - Finished goods Goal = Minimize amount of cash tied up in inventory Tools used to minimize inventory - Just-in-time - Lean manufacturing As the firm increases its order size, the number of orders falls and therefore the order costs decline. However, an increase in order size also increases the average amount in inventory, so that the carrying cost of inventory rises. The trick is to strike a balance between these two costs. Optimal Order Size: minimize total costs where carrying cost intersects order cost. *EOQ* - economic order quantity = sqrt(2*annual sales*cost per order / carrying cost)

Option Price

Components of the Option Price: 1 - Underlying stock price = Ps 2 - Striking or exercise price = S 3 - Volatility of the stock returns (standard deviation of annual returns) = v 4 - Time to option expiration = t = days/365 5 - Time value of money (discount rate) = r 6 - PV of dividends = D = (Div)e^-rt

Capital Investment Decisions

Decisions that determine which projects a business will invest in, how the investment(s) will be financed, and whether or not to pay dividends to shareholders. *Capital Budget* - a list of investment projects under consideration by a firm *Post-Audit* - a review of the project to see how closely it met forecasts

Default Risk

Default or Credit Risk - The risk that a bond issuer may default on its bonds Default premium - The additional yield on a bond that investors require for bearing credit risk Investment grade - Bonds rated Baa or above by Moody's or BBB or above by Standard & Poor's Junk bonds - Bond with a rating below Baa or BBB

Earnings Per Share (EPS)

EPS = net income/shares outstanding Payout Ratio - Fraction of earnings paid out as dividends Plowback Ratio - Fraction of earnings retained by the firm Present Value of Growth Opportunities (PVGO) - Net present value of a firm's future investments. Sustainable Growth Rate - Steady rate at which a firm can grow: plowback ratio X return on equity. d

Term Structure

Expectations Theory Term structure and capital budgeting CF should be discounted using term structure info When rate incorporates all forward rates, use spot rate that equals project term Take advantage of arbitrage Spot Rate - The actual interest rate today (t = 0) Forward Rate - The interest rate, fixed today, on a loan made in the future at a fixed time Future Rate - The spot rate that is expected in the future Yield To Maturity (YTM) - The IRR on an interest bearing instrument

Sovereign Bonds Risk

Foreign currency debt: Default occurs when foreign government borrows dollars If crisis occurs, governments may run out of taxing capacity and default Affects bond prices, yield to maturity USA/home currency debt: Less risky than foreign currency debt Governments can print money to repay bonds Eurozone debt: Can't print money to service domestic debts Money supply controlled by European Central Bank

Fusion and Fission

In the market for corporate control, fusion—that is, mergers and acquisitions—gets most of the attention and publicity. But fission—the sale or distribution of assets or operating businesses— can be just as important

Annual Percentage Rate (APR)

Interest rate that is annualized using simple interest APR = monthly rate * 12 months

Financial Ratios

Measuring Performance: *Market-to-Book Ratio* = market value of equity / book value of equity *Market Capitalization* = #shares * price per share *Market Value Added* = market capitalization - book value of equity *Economic Value Added* aka residual income is = (aftertax interest + net income) - (cost of capital * total capital) ----- Measuring Profitability *Return on Capital* = (aftertax interest + net income)/(total capital) *Return on Equity* = (net income)/(total equity) *Return on Assets* = (aftertax interest + net income)/(total assets) ----- Measuring Efficiency *Asset Turnover Ratio* = sales/(total assets at start of year) = (sales)/(average total assets) *Inventory Turnover Ratio* = COGS/(inventory year start) *Average Days in Inventory* = (inventory year start)/(COGS)/365 *Receivables Turnover* = sales/(receivables year start) *Average Collection Period* = (receivables year start)/(average daily sales) --- Measuring Leverage *Long-Term Debt Ratio* = (long-term debt)/(LTD + equity) *Debt-Equity Ratio* = LTD/Equity *Total Debt Ratio* = total liabilities/total assets *Times Interest Earned* = EBIT/interest-payments *Cash Coverage Ratio* = (EBIT+depreciation)/interest-payments --- Liquidity Ratios *NWC to Total Assets Ratio* = (net working capital)/(total assets) *Current Ratio* = current assets/current liabilities *Quick Ratio* = (cash + marketable-securities + receivables)/(current liabilities) *Cash Ratio* = (cash + marketable-securities)/(current liabilities) *Interval Measure* = (cash + marketable-securities + receivables)/(average daily expenditures from operations)

Credit Agreements

Open account Promissory note Commercial draft Sight draft Time draft Trade acceptance Banker's acceptance Irrevocable letter of credit Conditional sale

Operating Leverage

Operating leverage - The degree to which costs are fixed Degree of operating leverage (DOL) - Percentage change in profits given a 1 percent change in sales DOL = %change profit / %change sales DOL = 1 + fixed cost/profit

Time Decay and Volatility

Option prices decline, ceteris paribus, when the time to expiration declines. Similar to time decay, the value of an option will be higher when more volatility exists

Real Options

Option to expand Option to abandon Production options Timing options

Common Stock

Ownership shares in a publicly held corporation Traded in *primary market* (market for sale of new securities) and then traded on *secondary market* (market in which previously issued securities are traded among investors) *Electronic Communication Networks (ECNs)* - A number of computer networks that connect traders with each other *Exchange-Traded Funds (ETFs)* - Portfolios of stocks that can be bought or sold in a single trade *SPDRs (Standard & Poor's Depository Receipts or "spiders")* - ETFs, which are portfolios tracking several Standard & Poor's stock market sub-indexes *Book Value* - Net worth of the firm according to the balance sheet *Dividend* - Periodic cash distribution from the firm to the shareholders *P/E Ratio* - Price per share divided by earnings per share *Market Value Balance Sheet* - Financial statement that uses market value of assets and liabilities

Constant Growth Perpetuity

PV0 = C1 / (r-g) PVt = Ct+1 / (r-g)

Private v. Public

Private Equity Fund: - widely diversified, investment in unrelated industries - limited-life partnership forces sale of portfolio companies - no financial links or transfers between portfolio companies - general partners "do the deal," then monitor; lenders also monitor - managers' compensation depends on exit value of company Public Conglomerate: - widely diversified, investment in unrelated industries - public corporations designed to operate divisions for the long run - internal capital market - hierarchy of corporate staff evaluates divisions' plans and performance - divisional managers' compensation depends mostly on earnings: "smaller upside, softer downside"

The Investment Timing Decision

Problem 1: Investment Timing Decision Some projects are more valuable if undertaken in the future Examine start dates (t) for investment and calculate net future value for each date Discount net values back to present Net present value of investment if undertaken at date 𝑡= (net future value at date 𝑡)/(1+𝑟)^𝑡

Equivalent Annual Cost (EAC)

Problem 2: The Choice between Long- and Short-Lived Equipment Equivalent Annual Cash Flow - The cash flow per period with the same present value as the actual cash flow as the project. EAC (annuity) = present value of cash flows / annuity factor Annuity Factor =1/r*(1-1/(1+r)^t)

Replace Machine Problem

Problem 3: When to Replace an Old Machine Example A machine is expected to produce a net inflow of $4,000 this year and $4,000 next year before breaking. You can replace it now with a machine that costs $15,000 and will produce an inflow of $8,000 per year for three years. Should you replace now or wait a year?

Cost of Excess Capacity

Problem 4: Cost of Excess Capacity Example A computer system costs $500,000 to buy and operate at a discount rate of 6% and lasts five years. Equivalent annual cost of $118,700 Undertaking project in year 4 has a present value of 118,700/(1.06)4, or about $94,000

Credit Analysis

Procedure to determine the likelihood a customer will pay its bills. Credit agencies such as Dun & Bradstreet provide reports on the credit worthiness of a potential customer. Financial ratios can be calculated to help determine a customer's ability to pay its bills *Credit Policy* - Standards set to determine the amount and nature of credit to extend to customers. *Credit Scoring* - What your lender won't tell you. Extending credit gives you the probability of making a profit, not the guarantee. There is still a chance of default. Denying credit guarantees neither profit or loss. BREAK-EVEN PROBABILITY OF COLLECTION p = PV(cost)/PV(revenue) EXPECTED PROFIT E(P) = p* PV(rev-cost) - (1-p)*PV(cost)

DuPont Identity

ROE = profit margin x total asset turnover x equity multiplier *Profit Margin* = (net income)/sales *Operating Profit Margin* = (aftertax interest + net income)/sales ---- ROA = Asset Turnover x Operating Profit Margin *Asset Turnover* = sales/assets ---- ROE = leverage ratio x asset turnover x operating profit margin x debt burden *leverage ratio* = assets/equity *asset turnover* = sales/assets *debt burden* = (net income)/(net income + interest)

Call Option

Right to buy an asset at a specified exercise price on or before the exercise date Long: right to buy Short: obligation to sell

Put Option

Right to sell an asset at a specified exercise price on or before the exercise date Long: right to sell Short: obligation to buy

Applying NPV Rule

Rule 1: Only Cash Flow Is Relevant: - *Capital Expenses*: Record capital expenditures when they occur. To determine cash flow from income, add back depreciation and subtract capital expenditure - *Working Capital*: Difference between company's short-term assets and liabilities Rule 2: Estimate Cash Flows on an Incremental Basis - Remember to include taxes or have taxes specifically excluded - Do not confuse average with incremental payoffs - Include all incidental effects - Forecast sales today and recognize after-sales cash flows to come later - Include opportunity costs - Forget sunk costs - Beware of allocated overhead costs - Remember salvage value Rule 3 - Treat Inflation Consistently - Be consistent in how you handle inflation!! - Use nominal interest rates to discount nominal cash flows - Use real interest rates to discount real cash flows - You will get the same results, whether you use nominal or real figures Rule 4: Separate Investment and Financing Decision - You should neither subtract the debt proceeds from the required investment nor recognize the interest and principal payments on the debt as cash outflows.

Analysis Types

Sensitivity Analysis - Analysis of the effects of changes in sales, costs, etc. on a project Scenario Analysis - Project analysis given a particular combination of assumptions Simulation Analysis - Estimation of the probabilities of different possible outcomes Break-Even Analysis - Analysis of the level of sales (or other variable) at which the company breaks even (NPV = 0)

Other Privatization

Spin off -- Debut independent company created by detaching part of a parent company's assets and operations. Carve-out-- Similar to spin off, except that shares in the new company are not given to existing shareholders but sold in a public offering. Privatization -- The sale of a government-owned company to private investors. Motives for Privatization 1. Increased efficiency 2. Share ownership 3. Revenue for the government

Valuing an Office Building

Step 1: Forecast cash flows Step 2: Estimate opportunity cost of capital (required return or WACC) Step 3: Discount future cash flows back to the present Step 4: Calculate NPV

Bond Valuation

The price of a bond is the present value of all cash flows generated by the bond (i.e. coupons and face value) discounted at the market rate of return. PV = cpn/(1+r) + cpn/(1+r)^2 + ... (cpn + par value)/(1+r)^t

Option Value

The value of an option at expiration is a function of the stock price and the exercise price As stock price rises, call value rises, put value decreases. (put when you expect stock price to fall below strike) As time goes on, call value decreases, put value rises (you want to put closer to maturity)

Common Stock Valuation

The value of any stock is the present value of its future cash flows. This reflects the DCF formula. Dividends represent the future cash flows of the firm. PV(stock) = PV(future dividends) P0 = Div1 / (r-g) *Expected Return* - The percentage yield that an investor forecasts from a specific investment over a set period of time. Sometimes called the *market capitalization rate* or the *cost of equity capital*. r = Div1/P0 + g *dividend yield* is div/P0 (don't put growth factor in) *Dividend Discount Model* - computation of today's stock price which states that share value equals the present value of all expected future dividends P0 = (Div_h + P_h) / (1+r)^h h is horizon value

Monte Carlo Simulation

a risk analysis technique in which probable future events are simulated on a computer, generating estimated rates of return and risk indexes Modeling Process: Step 1: Modeling the project Step 2: Specifying probabilities Step 3: Simulate the cash flows Step 4: Calculate present value

Annuity Due

a series of equal regular deposits, starting immediately (period 0). PVad = PVannuity *(1+r) FVad = FVannuity *(1+r)

Annuity

a series of equal regular deposits, starting one period from now (period 1). PV = C/r * (1 - 1/(1+r)^t) Present Value Annuity Factor: PVAF = (1/r - 1/r*(1+r)^t) = (1/r)*(1 - 1/(1+r)^t) FV = C/r * [(1+r)^t - 1]

Dividend Growth Rate

can also be derived from applying the return on equity to the percentage of earnings plowed back into operations. g = return on equity × plowback ratio

Terms of Sale

credit, discount, and payment terms offered on a sale 2/10 net 30 2 -> 2% discount for early payment 10 -> number of days that discount is available net 30 -> number of days before final payment is due (no discount) A firm that buys on credit is in effect borrowing from its supplier. It saves cash today but will have to pay later. This, of course, is an implicit loan from the supplier. We can calculate the implicit cost of this loan EAR = (1+ discount/discountedprice)^{365/(net30 - 10)} - 1

Working Capital

current assets - current liabilities

Future Value

the amount an investment is worth after accruing interest for a specified number of periods = C*(1+r)^t Ex: What will the value of $100 be after two years if interest is compounded annually at a rate of 7%?

Effective Annual Rate (EAR)

the interest rate expressed as if it were compounded once per year EAR = (1+monthly rate)^12 months - 1

Net Present Value (NPV)

the sum of the present values of expected future cash flows from an investment, minus the cost of that investment = C0 + C1/(1+r) ... + Ct/(1+r)^t = PV - required investment Note: C0 is usually the cost of the investment and will be negative

Present Value

the value today of a future cash flow. = C/(1+r)^t Ex: What is the value today of $100 received two years from now if the discount rate is 7%?