Corporate Finance Test 1

Ask about Monte Carlo

(1) Modeling the Project Model interdependence between different periods For example, market size in year 1 is related to, but likely different than, market size in year 2 Model interdependence between different variables For example, specify how price varies with marketsize (2) Specify probabilities for forecast errors (3) Simulate the cash flows of the project (4) Calculate net present value of simulated cashflows

Real Discount Rate

(1+Nominal Discount Rate/1+ Inflation Rate)-1

You are evaluating a project to build a newmanufacturing site, which is already owned byyour company and contains existing buildings.Determine which of the following cash flows are incremental.

(a) Market value of the site and existing buildings(b) Demolition costs and site clearance(c) Future depreciation of the new plant(d) Inventory investment in raw materials(e) Proportion of CEO's salary

Breakeven

0 NPV

Pitfalls of IRR

1: Lending (NPV decreases as discount rate increases) or Borrowing (NPV increases as discount rate decreases) 2: Multiple IRR (hump graphs) or No IRRs 3: Mutually Exclusive Projects (Pick project with higher NPV) 4: Term structure differences from cash flow being long period of time or short period of time 5: Relative vs Absolute Returns (check to be sure outlays are same...if not then misleading!)

Your friend notices that recent IPOs, such as techfirms, do not pay dividends. She argues that anydividends can be ignored when valuing thesestocks. True or false?

?

Credit Ratings and Convenants

After BB+, number of covenants jumps to 10

Traditionalist View

Argument: Usually rD<rE, then the first unit of debt lowers the weighted average cost of capital because debt is less risky, and thus has lower cost:rA=DD+ErD+ED+ErE Eventually, the average cost starts to rise because the risk of both the debt and equity are rising Good financial management finds the minimum This reasoning is wrong:rA reflects the riskiness of the assets - not how debt and equity are divided

MMII Graph

As D/E increases, Return on Equity increases, return on debt increases but RA stays constant

Agency costs

Assume managers act interest of shareholders Separation of ownership and control might create agency problems "GE Board Was Kept in the Dark About CEO's ExtraPlane" (NYT, 10/29/17)

Is a decision to acquire a company an investment or financing decision?

BOTH!

Junk Bonds

Below BBB/Baa

Debt

Book value is equivalent if :i) Interest rates at issuance are similar to today, and ii) Firm's credit rating at issuance are similar to today Excess cash reduces debt Accounts payable Usually incorporated into net working capital (NWC) in project analysis Other liabilities For example, "borrowing" from the pension fund and hybrid securities Considered debt if:i. Senior to equity, andii. Non-payment leads to bankruptcy

Salvage value:

Book value of an asset equals initial investment minus its cumulative depreciation Tax consequences if sale price of assets does not equal its book value: If you sell an asset and the sales price is above the book value, the difference constitutes a taxable book gain If you sell an asset and the sales price is below the book value, the difference constitutes a book loss, which gives rise to a tax credit

Beta

COV (asset to market)/Var to market

Change in Networking Capital

Calc Net working Capital and subtract from prior year

MM 1

Capital structure does not affect the firm value Changing a firm's capital structure leaves the total firm cash flows (and total value) unchanged Affects how pie is sliced, but not total size of the pie Investors can "undo" capital structure changes through trading "Homemade" leverage (capital structure changes) -analogous to homemade dividends In our M&M world, perfect capital markets allow our investors to do this costlessly What is the firm doing that investors cannot do on their own? If nothing, then it's a zero NPV project - doesn't increase current owners' wealth

Merger Arb Cash Deal

Cash Deal Purchase target's stock Hold until deal closes and receive cash

Scenario

Change multiple variables

Basics about Stocks

Companies are owned by its common stockholders What do you receive as a stockholder? Cash-flow rights: Residual claim on firm's assets and cash flows - after debt holders are paid! Control rights: Residual right of control for operating and investment decisions Diverse ownership of equity Can be held directly by individual investors or by financial intermediaries (such as mutual funds or pension funds)

Smart Beta

Compare market cap portfolio to other factors Equal-Weight: Provides the same weight to every stock in a given index Low-Volatility: Weights stocks based on their level of volatility over a specified period, such as one year Momentum: Weights stocks based on their price momentum over a specified period Quality: Weights stocks based on strong balance sheets (low debt), consistent earnings and high levels of profit measures such as return on equity Fundamental: Weights stocks based on economic factors such as sales, cash flow, and dividends plus buybacks

Board of Directors

Control rights usually are limited to vote on board of directors Often vote for entire board each year Classified board: Only a third of directors are elected each year Entrenches management since it is more difficult for activists to change board Details about voting: Generally elect board using majority voting: Each director voted on separately and one share equals one vote for each director Cumulative voting allows shareholders to allocate all votes to just one candidate Some decisions, such as mergers, require a supermajority vote (more than 50%) for approval

Corporate Inversions

Corporate inversions occur when companies relocate to a foreign country to reduce its tax burden, often through a merger Recent trend in U.S. to avoid relatively high corporate tax rate

Big Mac Index

Created by The Economist in 1986 Compares price in US dollars of Big Mac indifferent countries Based on idea of Purchasing power parity (PPP): Exchange rates should adjust so that the price (in the same currency) should be equalized for the same good Big Mac is standardized across countries Suggests which currencies are over valued or undervalued Currencies might not adjust because of untradable inputs, such as rent and wages

Why Do Covenants Exist?

Dividend payments: Firm could pay equity holders and leave bondholders with nothing Claim dilution: Additional debt could be issued that dilutes current bondholders Risk shifting or asset substitution: Equity holders might prefer riskier projects, particularly during distress Underinvestment: Firm might reject positive NPVprojects if the benefits accrue to the bondholders

Break Even for EBIT and EPS

EBIT/# of Shares = (EBIT - Interest)/# of Shares on this side

Cash Flows vs. Earnings

Earnings might be recorded in different periods than when cash flows occur For example, capital expenditures could happen at the start of the project, but are often deducted in several periods for accounting measures Principles governing accounting earnings measurement: Show revenues when products and services are sold or provided, not when they are paid for Show expenses associated with these revenues rather than cash expenses Only expenses associated with creating revenues in the current period should be treated as operating expenses Expenses that create benefits over several periods are written off over multiple periods (depreciation)

Efficient Markets Hypothesis

Efficient markets hypothesis (EMH) states that current prices fully reflect all available information Under the EMH, prices react to news immediately and always are at the "fair" level Information is reflected in prices immediately because of competition Price changes are unpredictable because tomorrow's information is unknown today

Company Cost of Capital

Expected return on a portfolio of all the company's existing securities It is the opportunity cost of capital for investment in the firm's assets Appropriate discount rate for the firm's average-risk projects Only helpful if the project's risk are similar to the firm as a whole (e.g. expansion of existing capacity) If the risks of the project are different,don't use the firm's cost of capital•Evaluate projects incrementally- Treat each project as a mini-firm

M&M Proposition 2: Intuition

Expected return on equity reflects (non diversifiable) risk from operations and financing With unlevered firm, equity demands return of rA Adding leverage, equity requires additional premium of(rA−rD)DEI Compensation for additional risk since debt holders get paid first Any increase in expected return is exactly offset by an increase in financial risk and the shareholders require rate of return (cost of equity)

Factors Are

Factors are: Market factor: Return on market minus risk-free rate Size factor: Return on small-firm stocks less return on large-firm stocks Book-to-market factor: Return on high book-to-market stocks less return on low book-to-market stocks

Financial Markets and Intermediaries

Financial markets and intermediaries are critical for corporate financing Facilitate origination of new securities Provides secondary market for purchase and sale of stocks and bonds previously issues

Hard rationing

Firm passes up positive NPV projectsbecause it is unable to raise additional capital

MM Assumptions

For the M&M proposition to be true, it requires several critical assumptions: Perfect and complete capital markets No taxes No cost of bankruptcy Capital structure does not affect investment decisions or cash flows No informational frictions

Opportunity Costs

Forgone cash flows that are lost if the project is undertaken Relevant comparison is cash flow with or without project (not before versus after) Opportunity costs include: Rental income or revenue from selling property(whichever is higher) Previously purchased equipment used for project Cannibalized profits from other parts of branches or nearby stores If resource is freely traded, use the market price

Opportunity Cost

Given Market and Book Rate and they don't equal, do the SV Thing!

What is the difference between the IRR and opportunity cost of capital?

IRR is project specific, while the opportunity cost of capital is determined by capital markets and is expected return on similarly risky projects

Most popular rule for investment decisions

IRR, NPV, Hurdle Rate

Promised Yield vs. Expected Yield

If a bond has an annual probability of default of d,assuming no recovery, the relationship between promised yield y and the expected yield ye is 1+y=1+ye/1−d

Break even

If we expect EBIT to be greater than the break-even point, then leverage is beneficial to our stockholders•If we expect EBIT to be less than the break-even point, then leverage is detrimental to our stockholders

WACC

Interest, dividends, and their tax consequences do not enter in the determination of the free cash flows Accordingly, the tax benefits from debt are factored into the discount rate since we use the after-tax cost of debt Discounting FCFs at such a WACC makes sense only if the leverage (debt-to-value) ratio stays constant over time

IRR Rule

Invest in project if its IRR is greater than the opportunity cost of capital

Crowdfunding Raises capital through many dispersed investors How is this similar to financing a company using debt orequity? How is it different?

Investing. Remember who's the person doing it (YOU ARE SO YOU ARE INVESTING!)

What are the two main decisions in corporate finance?

Investment decisions: A company's decision to invest capital in tangible or intangible assets Financing decisions: Raise capital for investments

Credit Rating Shopping

Issuers of debt often solicit rating agencies for credit ratings Credit rating shopping is the practice by issuers to hire the agency that offers the "best" rating By finding the best credit rating, a firm could lower its cost of debt Evidence suggests that this might have contributed to the financial crisis

The most recent Big Mac Index reports that a BigMac in the United States is more expensive thanthe same Big Mac in Japan. What does this imply about the value of the Japanese yen relative to the US dollar?

It indicates that the Japanese yen is relatively undervalued relative to the US dollar

Firm Leverage

Long Term Debt/(Long Term Debt + Equity)

Homemade Leverage

M&M Proposition 1 argues that firm value is not affected by its choice of capital structure Homemade leverage is an implication (and way of proving) this proposition Suppose that investors prefer a different capital structure than that of the firm In the M&M world, investors can borrow and lend on their own to achieve any desired capital structure ("homemade leverage") Rests on assumption of perfect capital markets

MM 1 Takeaways

M&M Proposition 1: Financing decisions have no effect on firm value, under these assumptions: Perfect and complete capital markets No taxes No bankruptcy costs Capital structure does not affect investment decisions No informational frictions Are these reasonable assumptions? (Are they consistent with reality?) No, but provides a valuable framework for thinking about financing decisions Where are the violations of M&M that make financing matter?

Soft rationing

Management-imposed limitations to aid in financial control Rapid growth might impose strains on management and organization

Beta

Measure a stock's sensitivity to the market using beta (β) An increase of 1% in the market on average has led to a β% increase in the asset

Merger Arb

Merger arbitrage is an investment strategy based on differences in the stock price of a target and the price offered in the merger agreement between deal announcement and close

Source of Funds for U.S. Corporations

Most of the capital for investments are generated internally Largely comes from retained earnings (earnings not paid out as dividends) Capital can also be raised by issuing debt or equity Net equity issuance has been negative over the past 25 years Firms can repurchase shares, which is considered negative equity issuance

Debt in Disguise

Obligations of a company can be similar to debt Accounts payable: Amount owed for goods or services already provided, similar to short-term debt Leases: Promise to make a series of fixed payments over a specified period of time Pensions: Obligations to retired employees of a fixed payment

warrants

Option to purchase a set number of shares at a particular price by a certain date

Overhead Expenses

Overhead expenses include supervisory salaries, rent, heat and light How should overhead expenses be allocated to the project? Accountants might want to find ways to allocate overhead to project Remember incremental cash flows: only include extra expenses incurred because of the project

Seeking Alpha

Part of the financial industry is focused on seeking alpha Sell-side analysts: Search for positive alpha assets through fundamental analysis α >0: Firm is undervalued=⇒Buy recommendation α <0: Firm is overvalued=⇒Sell recommendation Quants: Search for positive alpha through regression analysis

Equity in Disguise

Partnerships: Equity ownership by individuals of an organization Share in profits of business and receive periodic cash distributions from firm (dividends) Avoid corporate income tax Doctors and lawyers often use this form of organization REITS: Real estate investment trusts (REITs) facilitate equity investment in commercial real estate Traded as common stocks Not taxed if at least 95% of earnings are distributed to owners

Payback Rule

Payback rule Accept the project if the initial investment is recoverable within some specified cutoff period For example, a payback rule of four years for a $100 million investment is that, if the project provides cash flows of $100 million in the first four years, it is accepted Pitfalls: Arbitrary choice of payback period Cash flows not discounted!

Weak Form Efficiency

Prices reflect all information in the history of past prices Information set is the previous price patterns Technical analysis attempts to find patterns in the history of a stock's prices to predict future price movements Weak form efficiency implies technical analysis does not work

Strong Form Efficiency

Prices reflect all information, including both public and private information Idea: If you have tomorrow's newspaper today,you can beat the market Evidence suggests that private information earns abnormal returns Examples: Prosecutions for insider trading Managers' trades Market specialists

Semi-Strong Form Efficiency

Prices reflect all publicly information Includes past prices, earnings announcements,dividend changes, merger news, Federal Reserve announcements, etc. Stock prices should adjust instantaneously to news events or public announcements Evidence suggests that abnormal returns to trading on publicly available information are zero on average•Markets appear to be semi-strong form efficient

Debt Convenants

Provisions or restrictions in debt contracts imposed by the lender and agreed to by the borrow Violation of a debt covenant leads to technical default Often resolved through rating downgrades or renegotiation

Walgreens just announced that it will acquireAnthem, a health insurance company, usingstock. The deal is scheduled to be close in aboutsix months. The current price of Anthem is belowthe price offered by Walgreen. You are an analystat a hedge fund and your boss would like you topropose a merger arbitrage strategy. What is your proposal?

Purchase Anthem's stock and short Walgreen's stock to capture the difference between the current price ofAnthem's stock and the offer price by Walgreen

Arbitrage Pricing Theory

Rather than starting with market portfolio, arbitrage pricing theory (APT) assumes that a stock's expected return depends on macroeconomic influences (or "factors") Compensated for exposure to these systematic risks based on:E[rit] =a+β1(rfactor1) +β2(rfactor2) +···+βN(rfactorN) +εit Diversification continues to remove idiosyncratic risk

What's Real?

Real Measured in units of account with a constant purchasing power Nominal Measured in units of account with purchasing power that depends on inflation

Portfolio Returns and CAPM

Relationship between β and average risk premia has become weaker since mid-60s•In particular, stocks with the highestβ'shave performed poorly

Types of Debt Convenants

Restrictions on a firm's production or investment policy Restrictions on payment of dividends Restrictions on financing policy Restrictions on changing how debt holder get paid

FCF Cacs

Revenue-Cost-Depreciation...you know the rest! Opportunity Costs Included!

Proxy Fights

Shareholders elect board of directors to monitor management and replace them if needed If the current board is lax, shareholders can elect a new board When a group of investors would like to do this, they launch a proxy fight (also called proxy contest or contested proposal) A proxy is the right to vote on behalf of another shareholder In a proxy fight, dissident shareholders try to obtain enough proxies to elect their own board of directors Once elected, these board of directors can replace management and change company policies

What is Smart Beta? How does its performance compare to holding the value-weighted market portfolio?

Smart Beta is a trading strategy of forming portfoliosbased on company characteristics. Its relative performance has varied based by factor and year, with the size (equal-weighted) factor performing the best.

Returns are "noisy"

Standard deviation of average stock is about 50% This variation might bias tests of the CAPM

Merger Arb Stock Deal

Stock Deal Purchase target's stock Short shares of acquirer's stock When deal closes, investor receives stock that covers the short position

Incremental cash flows

Tax shields from depreciation Include opportunity costs Forget sunk costs Only include incremental overhead expenses Consider terminal values, such as salvage value Calculate cash flows from changes in net working capital Deduct corporate taxes Do not include financing cash flows

Three Forms of Market Efficiency

There are three forms of market efficiency:(1) Weak form efficiency Prices reflect all information in past prices (2) Semi-strong form efficiency Prices reflect all publicly available information (3) Strong form efficiency Prices reflect all relevant information (including in side information)

What should be the goal of the manager?

To maximize shareholder value

Systematic risk

Variation in asset returns that contributes to the variability of well-diversified portfolios

Idiosyncratic risk:

Variation that can be eliminated through diversification—through the Law of Large Numbers

Corporate Finance Questions

What real assets should firm invest in? Investment Decisions How should it pay for its investments?Financing decisions

Incremental Free Cash Flow

When making an investment decision or evaluating a project: Focus on cash flows from project and when they occur Consider the incremental(or marginal) effects of the project (relative to those without project) Remember any opportunity costs Be consistent with units Present vs. future values, nominal vs. real, $ vs .e

SML

Y=Expected Returns, X=Beta

CAPM Assumptions

are rational and use portfolio theory to form portfolios have homogenous expectations can buy and short-sell any asset cannot affect security prices have access simultaneously to all information pay no taxes and transaction costs Investors dislike risk and require compensation for holding a risky asset Only the systematic component requires compensation The idiosyncratic component can be diversified away and does not require a risk premium Then, according to the CAPM, the expected return on any asset is based on the sensitivity of the asset returns to the market returns

Cumulative preferred stock

means that a firmmust pay all past preferred dividends beforepaying common stockholders

Expected Return 1 Period from Now (also r in DDM)

r=DIV1 + P1-Po)/Po

If the CAPM holds, then

αp=0 for each portfolio

Investment Decision

•A company's decision to invest capital in tangible or intangible assets •Often called capital budgeting or capital expenditure decisions

IRR vs. Opportunity Cost of Capital

•Both are a discount rate •What is the difference between them? IRR is project specific, and is a profitability measure that depends solely on the amount and timing of the project cash flows Opportunity cost of capital is a standard of profitability that we use to calculate how much a project is worth Opportunity cost of capital is determined by capital markets It is the expected rate of return offered by other assets with the same (non-diversifiable) risk as the project

CF Reminder

•Discounting cash flows (CFs) moves them back in time •We can add/subtract these CFs because they are in the same timeunits (date 0) •These are present values of future CFs as of today End = the year it states! Growth Period when he says starting today...CF*(1+G)...look at Slide 32 Lecture 1!

Seasoned Equity Offering

•Initial public offering (IPO) occurs when a company first offers its equity on public markets What happens when a firm issues stock after itsIPO? Seasoned equity offering, or SEO, occurs when a publicly traded firm issues additional equity to the public What could this signal about a firm's value? Information of manager relative to equity holder

Capital Rationing

•Previous discussion focused on accepting every project that has a positive net present value Limitations might prevent a firm from undertaking all of these projects Referred to as capital rationing Select highest-NPV projects if firm is capital constrained

Financing Decision

•Raise capital for investments Equity: Fractional ownership of a company, and receive proportional claim to future cash flows distributed by firm Debt: Lenders provide capital, and expect to receive it plus an interest rate Capital structure: Firm's mix of debt and equity