CFA Level I - Corporate Finance
Sell-Out Rights
protect minority shareholders in acquisition situations by forcing acquirers to buy out minority shareholders at a fair price, even if those shareholders initially voted against the acquirer's offer.
Goal of Managing Net Daily Cash is to:
keep enough cash for routine needs, but not so much that we unnecessarily forego interest income.
The decision rule for IRR
1st: Determine the Required Rate of Return (Usually the firm's cost of capital, but may be higher or lower than the firm's cost of capital to adjust for differences between project risk and the firm's average project risk) 2nd: If IRR > the required rate of return, accept the project. If IRR < the required rate of return, reject the project.
Two Tier Board of Directors
2 separate and distinct boards 1. Supervisory Board 2. Management Board Regulators generally prohibit members of the management board from serving on the supervisory board or limit the number of individuals serving on both boards.
Debt Incurrence Test
A financial covenant made in conjunction with existing debt that restricts a company's ability to incur additional debt at the same seniority based on one or more financial tests or conditions.
Why would the cost of capital change as more capital is raised? (2 reasons)
1. Existing debt with bond covenants limiting or eliminating a firm's ability to issue more debt, forcing the firm to raise capital via equity (which is more expensive). 2. A deviation from the target capital structure due to "lumpiness" of security issuance because of economies of scale (bulk issuance benefits).
NPV & Stock Prices: (4 Critical Implications)
1. A company's stock price is a function of the present value of its expected future earnings stream. 2. Changes in the stock price will result more from changes in expectations about a firm's positive NPV projects. 3. If the market expects lower future profitability from capital projects (acquisitions, etc.) than the company calculates, the stock price could drop. 4. If the market expects higher future profitability from capital projects than the company calculates, the stock price could rise.
Short-term investment strategies can be grouped into two types:
1. Active 2. Passive Most short-term investors seek "reasonable" returns and do not want to take on substantial risk.
Which type of firms have the ability for greater financial leverage?
1. Firms with a higher ratio of Tangible Assets to Total Assets (i.e. more collateral) 2. Firms with lower sensitivity to business cycles
3 Approaches of Target Capital Structure Estimation
1. Assume the company's current capital structure, at market value weights for the components, represents the company's target capital structure. 2. Examine trends in the company's capital structure or statements by management regarding capital structure policy to infer the target capital structure. 3. Use averages of comparable companies' capital structures as the target capital structure.
Adjusting the discount rate used for projects of various risk: (3 ways)
1. Average Risk: The WACC is the appropriate discount rate for projects that have approximately the same level of risk as the firm's existing projects. 2. Greater Risk: To evaluate a project with greater than (the firm's) average risk, a discount rate greater than the firm's existing WACC should be used. 3. Below Average Risk: Projects with below-average risk should be evaluated using a discount rate less than the firm's WACC.
External Factors Affecting Working Capital Management (5)
1. Banking services 2. Interest rates 3. New technologies and new products 4. The economy 5. Competitors
3 "Cost of Common Equity" Models
1. CAPM 2. Dividend Discount Model 3. Bond Yield + Risk Premium Model
Internal Factors Affecting Working Capital Management (4)
1. Company size and growth rates 2. Organizational structure 3. Sophistication of working capital management 4. Borrowing and investing positions/activities/capacity
6 Main Liquidity Ratios
1. Current Ratio = CA / CL 2. Quick Ratio = CA - Inventory / CL 3. Cash Ratio = Cash+Mktbl Sec / CL 4. Receivables Turnover = Credit Sales / Avg. A/R 5. Inventory Turnover = COGS / Avg. Inventory 6. Payables Turnover = Purchases / Avg. A/P 7. Days of Receivables = 365 / Receivables Turnover 8. Days of Inventory = 365 / Inventory Turnover 9. Days of Payable = 365 / Payables Turnover
5 key principles of the capital budgeting process:
1. Decisions are based on cash flows, not accounting income. a) incremental cash flows considered b) sunk costs not included c) externalities due to project included 2. Cash flows are based on opportunity costs a) Opportunity costs included in project costs. 3. Cash flows are analyzed on an after-tax basis a) Firm value is based on cash flows they get to keep, not those they send to the government. 4. Financing costs reflected in required rate of return a) Financing costs not included in incremental cash flow calculation because discount rate does it for you. 5. The timing of cash flows is important a) must account for the time value of money, which means that cash flows received earlier are worth more than cash flows to be received later.
3 Reasons Sound Capital Budgeting is Critical:
1. Decisions may determine a firms future success/failure 2. Scope of subsequent decisions needed to execute (working capital management, m&a, etc.) 3. Good capital budgeting decisions = max. shareholder value
Factors Influencing Liquidity
1. Effectiveness of cash management (is cash concentrated in one bank account earning great interest or spread across accounts earning low interest?) 2. Centralization of collections (centralized is better) 3. Liquidity of short-term and long-term assets
5 Key Beta Estimation Issues to Consider:
1. Estimation period 2. Period of return interval used 3. Market index selection 4. Use of a smoothing technique 5. Small-cap stock adjustments
6 Types of Capital Budgeting Projects
1. Replacement projects to maintain the business 2. Replacement projects for cost reduction 3. Expansion projects 4. New product or market development 5. Mandatory projects 6. Other Projects (Mgmt. pet projects / r&d)
4 Major ESG Org's / Frameworks
1. Global Sustainable Investing Alliance (GSIA) 2. Global Reporting Initiative (GRI) 3. Principles of Responsible Investment (PRI) 4. Sustainability Accounting Standards Board (SASB)
3 Rules of Leverage (Firm Characteristics)
1. High fixed costs = high operating leverage 2. High debt ratio = high financial leverage 3. High fixed costs + high debt ratio = high total leverag
3 Equity Risk Premium Estimate Models:
1. Historical equity risk premium 2. Dividend discount model 3. Survey
Importance of Analyzing a Company's Use of Leverage (3 reasons)
1. Identify Risk & Return Characteristics: Degree of leverage tells us how sensitive an investment might be. 2. Future Prospects & Management Decision Quality: Use of operating and financial leverage can imply qualitative insights. 3. Company Valuation: Forecasting cash flows and the discount rate used to calculate NPV of a firm are impacted by its degree of leverage.
Having the ability to take on debt and increase financial leverage allows a company to do what?
1. Increase ROE 2. Increase Stock Price
What are the 4 reinvestment assumptions of the NPV method?
1. It is implicitly assumed that project cash flows can be reinvested at the discount rate used to calculate NPV (cost of capital) 2. Project cash flows could be used to reduce the firm's capital requirements. 3. Project cash flows allow the firm to avoid the cost of capital on its capital (borrowing) requirements. 4. By reducing its equity capital and debt, the firm could "earn" its cost of capital on funds used to reduce its capital requirements.
4 Infrastructures of Stakeholder Management
1. Legal (laws) 2. Contractual (rights and responsibilities) 3. Organizational (governance procedures) 4. Governmental (regulation firm is subject to)
Non-Market Factors Affecting Stakeholder Relationships
1. Legal Environment 2. Communications Channels (social media as a tool for shareholders to influence public opinion) 3. 3rd-Party Ratings of Governance (RIMM, etc.)
Sources of Short Term Financing
1. Lines of Credit (committed, revolving, uncommitted) 2. Commercial Paper (corporate t-bills) 3. Bankers Acceptances (import/export - tradeable) 4. Factoring (selling A/R) 5. Nonbank finance company (distressed lenders)
Market Factors Affecting Stakeholder Relationships
1. Pressure from activist investors -> activist investors want to buy majority shares to make changes, they believe, will increase the value of the firm. Hedge funds are among the most predominant shareholder activists. 2. Threat of hostile takeover -> entire company is purchased, taken private and usually re-organized (new management, debt re-structuring, etc.) to optimize efficiency and value of the company. The goal is usually to go public again, and make a lot more money after the firm has increased in value.
Key Investment Policy Framework
1. Purpose (incl. strategy and security types) 2. Authorities (people and procedures) 3. Limitations & Restrictions (gen. types of sec + amts) 4. Quality (credit rating) 5. Other Items
5 Major Sources of Stakeholder Conflict of Interest
1. Shareholders vs. Managers/Directors 2. Majority vs. Minority Shareholders 3. Creditors vs. Shareholders (debt vs dividends) 4. Shareholders vs. Customers or 5. Shareholders vs. Governments
2 Key Issues concerning the calculation of the WACC:
1. Taxes 2. Selection of weights
2 Implicit Assumptions when using WACC:
1. The project has the same risk as the average-risk project of the company 2. The project will have a constant target capital structure throughout its useful life.
The highly liquid short-term investments most often used to invest excess cash are:
1. US T-Bills 2. Short-Term federal agency securities (freddie/fannie) 3. Bank COD's 4. Time Deposits 5. Repurchase Agreements (Repo's) 6. Commercial Paper (corporate t-bills) 7. Money market mutual funds 8. Adjustable rate preferred stock
6 Key Qualitative ESG Analysis Questions
1. What is the shareholder ownership & voting structure? 2. Who represents shareholders on the board? 3. What are the main drivers of the management team's remuneration and incentive structure? 4. Who are the significant investors in the company? 5. How robust are shareholder rights? relative to peers? 6. How effectively is the company managing long-term risks, such as securing access to necessary resources, managing human capital, exhibiting integrity and leadership, and strengthening the long-term sustainability of the enterprise?
two methods to estimate the before-tax cost of debt:
1. yield-to-maturity approach 2. debt-rating approach
Discount Basis Yield (bank discount) (360 days)
= % Discount * (360 / days until maturity)
Bond Yield Discount % Formula
= (Face Value - Price) / Face Value
Weighted Average Collection Period
= Avg. Collection Days * Weight (%) where: Avg. coll. days = days per bucket in aging schedule. Weight = % of total outstanding receivables Example for total in attached image. Indicates average days outstanding per dollar of receivables
Cash Conversion Cycle (CCC) (net operating cycle)
= Avg. Days Receiv. + Avg. Days Inv. - Avg. Days Paybl. The length of time it takes to turn the firm's cash investment in inventory back into cash, in the form of collections from the sales of that inventory. Avg. Days Payables reduces amount of cash tied up in working capital because A/P doesn't reduce cash since no cash was actually paid. A conversion cycle that is too high implies that the company has an excessive amount of investment in working capital.
Sovereign Yield Spread Formula (simple)
= EM yield - DM yield where: EM Yield = denominated in DM currency EM = developing country DM = developed country An estimate of the country spread (country equity premium) for a developing nation that is based on a comparison of bonds yields in country being analyzed and a developed country. However, this approach may be too coarse for the purposes of risk premium estimation.
Money Market Yield (MMY) (360 days)
= HPY * (360/days until maturity)
Profitability Index Formula
= Present Value of Net Cash Flows / Initial Investment or = 1 + (NPV / CF0) Decision Rules: If PI > 1.0, accept the project. (positive NPV, IRR > RRR) If PI < 1.0, reject the project. (negative NPV, IRR < RRR) Closely related to NPV because: 1. NPV is difference between PV and Initial Investment 2. PI is the ratio of PV and Initial Investment Although the PI is used less frequently than the NPV and IRR, it is sometimes used as a guide in capital rationing. The PI is usually called the profitability index in corporations, but it is commonly referred to as a "benefit-cost ratio" in governmental and not-for-profit organizations.
CAPM + Country Risk Formula
= Rf + β(market risk premium + country risk premium) kce = Rf + β[E(RMKT) − Rf + CRP]
Covenant
The terms and conditions of lending agreements that the issuer must comply with; they specify the actions that an issuer is obligated to perform (affirmative covenant) or prohibited from performing (negative covenant).
Country Equity Premium
= Sovereign yield spread * (Annualized σ of equity index/Annualized σ of the sovereign bond market in terms of the developed market currency) Key Elements (it's simple) 1. Sovereign Yield Spread (developed currency terms) 2. σ of equity index (developing market), annualized 3. σ of the sovereign bond market, annualized (developed currency terms) Where: "sovereign bond in developed currency" = dollar-denominated 10-year government bond note: developing country must have bonds denominated in (usually) us-dollars or euro's for this calculation to work. This is just one way of doing this. The logic of this calculation is that the sovereign yield spread captures the general risk of the country, which is then adjusted for the volatility of the stock market relative to the bond market. This country risk premium is then used in addition to the equity premium estimated for a project in a developed country.
Contribution Margin (Total Contribution Margin)
= Total Sales - Total Variable Costs The amount available for fixed costs and profit after paying variable costs; revenue minus variable costs.
Cost of Trade Credit
= [1 + (%discount / 1 - % discount)]^(365/days past dis.pr) - 1 The implicit rate (of return) that is represented by the trade discount offer; that is, it is the equivalent return to the customer of an alternative investment.
Comparable Company (Re: Pure Play Method)
A company that has similar business risk; usually in the same industry and preferably with a single line of business. An easy way of identifying a comparable for a project is to find a company in the same industry that is in that single line of business. For example, if the analyst is examining a project that involves drug stores, appropriate comparables in the United States may be Walgreens, CVS Corporation, and Rite Aid Corporation.
ERISA Act of 1974 (Pension Fund Fiduciary Duty)
A fiduciary must act solely in the interest of pension plan participants and beneficiaries. Accepting lower returns or assuming greater risk in a private pension plan to promote environmental, social, or public policy causes would violate fiduciary duty and is prohibited by ERISA. In a series of bulletins issued in October 2015, December 2016, and May 2018, the US Department of Labor (DOL) determined that certain ESG-related investment practices do not violate ERISA or fiduciary duty. These practices include the addition of the consideration of ESG factors in investment policy statements; the integration of ESG factors in the evaluation of an investment's risk or return; and the use of ESG considerations as determining factors, or "tie-breakers," when choosing among investments that have equivalent economic benefits for a pension plan.
Risk Factor / Risk Premium Investing (re: esg)
Treat ESG factors as a source of systematic risk
Laddering Strategy (in reference to short-term cash management)
A form of active strategy which entails scheduling maturities on a systematic basis within the investment portfolio such that investments are spread out equally over the term of the ladder. A laddering strategy falls somewhere between a matching and a passive strategy. Laddering strategies have been used effectively in managing longer-term investment portfolios, but laddering also should be an effective short-term strategy.
NPV Profile
A graph that shows a project's NPV for different discount rates. The discount rates are on the x-axis of the NPV profile, and the corresponding NPVs are plotted on the y-axis.
Investment Opportunity Schedule
A graphical depiction of a company's investment opportunities ordered from highest to lowest expected return. A company's optimal capital budget is found where the investment opportunity schedule intersects with the company's marginal cost of capital.
Q. Two years ago, a company issued $20 million in long-term bonds at par value with a coupon rate of 9 percent. The company has decided to issue an additional $20 million in bonds and expects the new issue to be priced at par value with a coupon rate of 7 percent. The company has no other debt outstanding and has a tax rate of 40 percent. To compute the company's weighted average cost of capital, the appropriate after-tax cost of debt is closest to: A. 4.2%. B. 4.8%. C. 5.4%.
A is correct. The relevant cost is the marginal cost of debt. The before-tax marginal cost of debt can be estimated by the yield to maturity on a comparable outstanding. After adjusting for tax, the after-tax cost is 7(1 − 0.4) = 7(0.6) = 4.2%.
Pure Play Method
A method for estimating a private company or individual projects Beta using a comparable publicly traded company's beta and adjusting it for financial leverage differences. Step 1: Select the comparable Step 2: Estimate comparable's Equity β Step 3: Calculate Asset β (un-lever equity β) Step 4: Lever the beta for the project's financial risk Result: We then use this β in our CAPM estimate of the component cost of equity for the project and, combined with the cost of debt in a weighted average, provide an estimate of the cost of capital for the project.
Target Cash Balance
A minimum level of cash to be held available—estimated in advance and adjusted for known funds transfers, seasonality, or other factors.
Say on Pay
A process whereby shareholders may vote on executive remuneration (compensation) matters.
One Tier Board of Directors
A single board of executive and non-executive directors. Executive (or internal) directors are employed by the company and are typically members of senior management. Non-executive (or external) directors provide objective decision making, monitoring, and performance assessment
What does a steeper NPV profile slope, relative to another project being considered, indicate?
A steeper NPV profile slope indicates that as the discount rate increases, future cash inflows will come later in a projects life. A project can have higher total nominal cash flows than another project under consideration, but those greater cash flows may come later in the projects life. The decision rule then becomes: Left of the crossover rate, select project A or Right of the crossover rate, select project B
Cumulative Voting
A system where a shareholder can accumulate all of his or her votes and vote them all for one board candidate or split them among several board candidates. As a result, greater minority shareholder representation on the board compared to majority voting, can be achieved.
Stakeholder Theory
A theory that holds that social responsibility is paying attention to the interest of every affected stakeholder in every aspect of a firm's operation
Weighted Average Cost of Capital (WACC)
A weighted average of the component costs of common equity, preferred stock and after-tax debt. WACC = (wd)[Kd(1 − t)] + (wps)(Kps) + (wce)(Kce) where: wd = % of debt in the capital structure Kd = The rate at which the firm can issue new debt. This is the yield to maturity on existing debt. This is also called the before-tax component cost of debt. kd(1 − t) = The after-tax cost of debt. The after-tax component cost of debt, kd(1 − t), is used to calculate the WACC. wps = % of preferred stock in the capital structure Kps = Required rate of return on preferred stock ( cost of preferred stock) wce = % of common stock in the capital structure kce = The required rate of return on common stock (cost of common equity) and is generally difficult to estimate.
Green Finance
Achieve economic growth while reducing pollution
Matching Strategy (in reference to short-term cash management)
An active investment strategy that includes intentional matching of the timing of cash outflows with investment maturities. is the more conservative of the two and uses many of the same investment types as are used with passive strategies.
Mis-Matching Strategy (in reference to short-term cash management)
An active investment strategy whereby the timing of cash outflows is not matched with investment maturities. is riskier and requires very accurate and reliable cash forecasts. These strategies usually use securities that are more liquid, such as T-bills, so that securities can be liquidated if adverse market conditions arise.
Equity Risk Premium Estimation Model 2: Dividend Discount Model (aka implied risk premium approach)
An approach for estimating a country's equity risk premium which is implemented using the Gordon growth model (also known as the constant-growth dividend discount model). For developed markets, corporate earnings often meet, at least approximately, the model's assumption of a long-run trend growth rate. We extract the premium by analyzing how the market prices an index. P0 = D1 / (Kce - g) where: P0 = current value of a stock (or market index price) D1 = next year's dividend Kce = cost of common equity (firm or market index rrr) g = firm's expected constant growth rate (must estimate) estimate the expected growth rate, g. This can be done by: g = (1 − payout rate)(ROE)
Equity Risk Premium Estimation Model 1: Historical Approach
An estimate of a country's equity risk premium that is based upon the historical averages of the risk-free rate and the rate of return on the market portfolio. To calculate, find the: 1. Avg. rate of return of a country's market portfolio 2. Avg. rate of return for the risk-free rate in that country 3. Complete market business cycle dates Note: Arithmetic mean The unbiased estimate of the expected single-period equity risk premium geometric mean Better reflects growth rate over multiple periods. Limitations: 1. Level of risk of the stock index may change over time. 2. Risk aversion of investors may change over time. 3. Estimates are sensitive to the method of estimation & the historical period covered.
Passive Strategy (In reference to short-term cash management)
An investment strategy characterized by simple decision rules for making daily investments.
Bond Yield + Risk Premium Approach (Kce = )
Analysts often use an ad hoc approach to estimate the required rate of return. They add a risk premium (three to five percentage points) to the market yield on the firm's long-term debt. Kce = bond yield + risk premium Based on the fundamental tenet in financial theory that the cost of capital of riskier cash flows is higher than that of less risky cash flows. We often estimate risk premium using historical spreads between bond yields and stock yields. In developed country markets, a typical risk premium added is in the range of 3 to 5 percent.
Green Bonds
Are issued to fund environmental projects.
Principal-Agent Conflict
Arises because an agent is hired to act in the interest of the principal, but an agent's interests may not coincide exactly with those of the principal.
Equity Risk Premium Estimation Model 3: Survey Approach
Ask a panel of finance experts for their estimates and take the mean response. For example, survey of US CFOs in December 2017 found that the average expected US equity risk premium over the next 10 years was 4.42 percent and the median was 3.63 percent. Once we have an estimate of the equity risk premium, we fine-tune this estimate for the particular company or project by adjusting it for the specific systematic risk of the project using the CAPM
Asset Beta vs. Equity Beta (think: leverage)
Asset Beta reflects systematic risk of the business without leverage (un-levered), whereas Equity Beta is a levered measure of a company or project. Asset Beta The un-levered beta; reflects the business risk of the assets; the asset's systematic risk. Equity Beta the levered beta of the company or project.
Collateral
Assets or financial guarantees underlying a debt obligation that are above and beyond the issuer's promise to pay.
Q. Wang Securities had a long-term stable debt-to-equity ratio of 0.65. Recent bank borrowing for expansion into South America raised the ratio to 0.75. The increased leverage has what effect on the asset beta and equity beta of the company? A. The asset beta and the equity beta will both rise. B. The asset beta will remain the same and the equity beta will rise. C. The asset beta will remain the same and the equity beta will decline.
B is correct. Asset risk does not change with a higher debt-to-equity ratio. Equity risk rises with higher debt.
Q. An analyst gathered the following information about a company that expects to fund its capital budget without issuing any additional shares of common stock: Capital Structure Long Term Debt: 50% of capital structure, 6% marginal after tax cost Preferred Stock: 10% of capital structure, 10% marginal after tax cost Common Equity: 40% of capital structure, 15% marginal after tax cost IRR of Two Independent Projects Warehouse project = 8% Equipment project = 12% If no significant size or timing differences exist among the project(s) and both projects have the same risk as the company's existing projects, which project(s) should be accepted? A. The warehouse project only B. The equipment project only C. Both projects
B is correct. The company's weighted average cost of capital (WACC) is calculated as WACC = 0.5(6%) + 0.1(10%) + 0.4(15%) = 10%. In this scenario, the company should accept projects that have an internal rate of return greater than the cost of capital. The equipment project's IRR exceeds the WACC. The warehouse project does not.
Bond Equivalent Yield (BEY) (365 days)
BEY = HPY * (365 / days until maturity) Returns on the firm's short-term securities investments should be stated as bond equivalent yields. The return on the portfolio should be expressed as a weighted average of these yields.
What is the only acceptable project ranking criteria?
Because NPV measures the expected increase in wealth from undertaking a project, NPV is the only acceptable criterion when ranking projects.
Break Point
Break Point = Amount($) where the source's cost of capital changes Proportion of new capital raised from the source In the context of the weighted average cost of capital (WACC), a break point is the amount of capital at which the cost of one or more of the sources of capital changes, leading to a change in the WACC.
How to Realistically get the DOL:
By looking at changes in operating income in relation to changes in sales for the entire company: 1st: regress changes in operating income (the variable to be explained) on changes in sales (the explanatory variable) over a recent time period. 2nd: Calculate the slope coefficient 3rd: Compare the slope coefficient to competitors Note: A visual comparison of slopes should not be relied upon because the scales of the x- and y-axes are different in diagrams for the two regressions.
Per Unit Contribution Margin
CM / Unit = Price Per Unit - Variable Cost per Unit The amount that each unit sold contributes to covering fixed costs—that is, the difference between the price per unit and the variable cost per unit.
5 Common Features of Preferred Stock: (think: options, dividends, convertibility)
Features include: 1. Call Options 2. Cumulative Dividends 3. Participating Dividends 4. Adjustable-Rate Dividends 5. Convertibility into common stock
Payback Period, NPV & Profitability
Often: 1. Projects with shorter payback periods are often less profitable 2. Projects with longer payback periods have higher NPV's.
Proxy Contest
Corporate takeover mechanism in which shareholders are persuaded to vote for a group seeking a controlling position on a company's board of directors.
Tender Offer(tender = sale)
Corporate takeover mechanism which involves shareholders selling their interests directly to the group seeking to gain control.
Opportunity Gap in WACC Estimation
Cost of capital for a specific investment vs. Cost of capital for the company Many analysts will estimate a projects costs of capital based mainly on company assumptions, whereas using more project specific assumptions can provide an opportunity to spot gaps between the companies estimated cost of capital (and implications) and the project cost of capital (and implications).
Degree of Financial Leverage (DFL)
DFL = DOL = [Q(P - V) - F] / [Q(P-V)-F-I] where: Q = Quantity of Units Sold P = Price per Unit V = Variable cost per unit F = Total Fixed Costs I = Total Interest Costs DFL = (% Change in EPS) / (% Change in EBIT) DFL = (EBIT) / (EBIT - Interest) DFL depends on the level of operating earnings: DFL is highest at low operating earnings levels DFL is lowest at high operating earnings levels A DFL of 1 = zero leverage
Priced Risk vs. Non-Priced Risk
Systematic Risk Factors: - Risk that affects all assets are "systematic risk factors" and should be priced - Investors should earn a return for non-diversifiable (unavoidable) risk factors via priced risk Un-Systematic Risk Factors: - A risk that does not affect many assets (unsystematic) can be diversified away and is not priced -Investors should not be rewarded for non-priced risk
Degree of Operating Leverage (DOL) (the operating income elasticity)
DOL = Q(P - V) / Q(P-V)-F where: Q = Quantity of Units Sold P = Price per Unit V = Variable cost per unit F = Total Fixed Costs DOL = (Sales - TVC) / (Sales - TVC - Fixed) DOL = (% Change in EBIT) / (% Change in Sales) DOL depends on the level of sales: DOL is highest at low levels of sales DOL is lowest at high levels of sales A DOL of 1 = zero leverage You can estimate the % change in EBIT from a % change in sales by: %chg EBIT = DOL * %chg Sales example: If Company A has a 3% increase in sales, its EBIT will increase by 2.2727(DOL) × 3% = 6.82%.
Degree of Total Leverage (DTL)
DTL = DOL * DFL or DTL = Q(P - V) / Q(P - V) - F - I where: Q = Quantity of Units Sold P = Price per Unit V = Variable cost per unit F = Total Fixed Costs I = Total Interest Costs Example: If Company A has a 10% increase in sales, earnings per share will increase by 3.5714(DTL) × 10% = 35.714%.
Staggered Board of Director Election
Election process whereby directors are typically divided into multiple classes that are elected separately in consecutive years—that is, one class every year. This election process limits shareholders ability to effect a major change of control at the company. Not as common.
General Practice for Board of Director Elections
Elections occur simultaneously and for specified terms (three years, for example)
Material Environmental ESG Considerations
Environmental: 1. natural resource management 2. pollution prevention 3. water conservation 4. energy efficiency 5. reduced emissions 6. the existence of carbon assets, and 7. adherence to environmental safety and regulatory standards
Flotation Costs
Fees charged to companies by investment bankers and other costs associated with raising new capital. Incorrect Way to Integrate: increase cost of equity Correct Way to Integrate: Adjust initial cash outflow to include flotation costs when computing NPV When raising: 1. Debt + Preferred Stock: --> no flotation costs involved in calculating WACC because costs are small and usually less than 1% 2. Equity --> the flotation costs may be substantial, so we should consider these when estimating the cost of external equity capital. Typically from 2% to 7%
Financial Leverage
Financing Fixed costs (interest expense) create financial leverage.
How should a firm forecast cash flows:
Estimate cash inflows and outflows by category (wages, interest expense, etc.) over the following time horizons: 1. Short-Term (daily/weekly balances for several weeks) 2. Medium-Term (monthly balances for next 12 months) 3. Long-Term (multi-year balances)
Cost of Floating Rate Debt
Estimated using the yield curve and debt rating. example: Debt yield for AAA rated 10-year bonds Find the AAA debt yield curve and identify the interest rate at the intersection of the 10-year time horizon.
Negative ESG Investment Screening
Excluding companies or sectors based on ESG factors: - mining, oil drilling (extractive industries) - gun manufacturers - tobacco companies - etc.
Net Present Value (NPV)
Expected change in the value of the firm, in current (PV) dollars, from the project. Accepting projects with NPV > 0 is expected to increase shareholder wealth. for Finite Cash Flows NPV = CF0 + [CF1/(1 + K)^1] + [CF1/(1 + K)^2] + [CF1/(1 + K)^n] for Perpetual Cash Flows NPV = Cash Inflow / discount rate where: CF0 = initial cash outlay (negative) CFt = after-tax cash flow at time t k = required rate of return (aka hurdle rate) The discount rate used is the firm's cost of capital, adjusted for the risk level of the project. Advantage: direct measure of exp. increase in firm value Disadvantage: does not consider size of investment
How are the Payback Period, IRR and NPV used together when evaluating projects in reality?
Firms with limited access to additional liquidity often impose a maximum payback period and then use a measure of profitability, such as NPV or IRR, to evaluate projects that satisfy this maximum payback period constraint.
Material Governance ESG Considerations
Governance: 1. ownership structure 2. board independence and composition 3. compensation
Holding Period Yield (HPY)
HPY = (Face Value - Price) / Price where: "price" = purchase price of the security
How do tax rates affect the after-tax cost of debt?
Higher taxes decrease the after-tax cost of debt Lower taxes increase the after-tax cost of debt
Best-In-Class / Relative ESG Investing Approach
Identify companies in each industry with best ESG practices, scores. Can preserve industry weights across investing universe (index) but still allow for improved ESG profile throughout portfolio.
Positive ESG Investment Screening
Identify companies with positive practices related to ESG factors, but might lead to a concentration in certain industries: Includes relative/best-in-class approach: Identify companies in each industry with best ESG practices
Subordinate Debt
In finance, subordinated debt is debt which ranks after other debts if a company falls into liquidation or bankruptcy. Such debt is referred to as 'subordinate', because the debt providers have subordinate status in relationship to the normal debt.
Beta Estimation Issues to Consider -> Estimation Period
In general: Longer estimation periods are applied to companies with a long and stable operating history, and Shorter estimation periods are used for companies that have undergone significant structural changes in the recent past (such as restructuring, recent acquisition, or divestiture) or changes in financial and operating leverage.
Leverage
In the context of corporate finance, leverage refers to the use of fixed costs within a company's cost structure.
Full ESG Integration in Investment Analysis
Including ESG factors in fundamental analysis
Thematic ESG Investing in Investment Analysis
Investing based on a specific ESG related goal.
Dividend Discount Model (Kce = )
Kce = (D1 *g) / P0) + g where: P0 = current value of a stock (or market index price) D1 = next year's dividend Kce = cost of common equity (firm or market index rrr) g = firm's expected constant growth rate (must estimate) estimate the expected growth rate, g. This can be done by: g = (1 − payout rate)(ROE) Note: this is re-arrangeable to find the equity risk premium, as mentioned in the flashcard "Equity Risk Premium Estimation Model 2: Dividend Discount Model"
Capital Asset Pricing Model (CAPM) (Kce, cost of common equity)
Kce = Rf + β[E(Rm) − Rf] where: Kce = cost of common equity Rf = risk-free rate (Note: U.S. Treasury notes are usually used. The most appropriate maturity to choose is one that is close to the useful life of the project.) β = Beta, the return sensitivity of stock to changes in the market return (must estimate) E(Rm) = expected market risk (must estimate) E(RM) − RF = the expected market risk premium; aka equity risk premium Based on the proposition that any stock's required rate of return is equal to the risk-free rate of return plus a risk premium that reflects only the risk remaining after diversification.
Indenture
Legal contract that describes the form of a bond, the obligations of the issuer, and the rights of the bondholders. Also called the trust deed.
The Marginal Cost of Capital increases or decreases as additional funds are raised?
MCC increases as more and more funds are raised whereas returns to a company's investment opportunities are generally believed to decrease as the company makes additional investments
Overlay / Portfolio Tilt Strategies (re: esg)
Manage ESG characteristics of overall portfolio, i.e. "tilt portfolio towards green energy".
Information Asymmetries between Management and Shareholders
Managers have more and better information about the functioning of the firm and its strategic direction than shareholders do thus decreasing ability for shareholders to evaluate whether managers are acting in their best interest.
Active Strategy (In reference to short-term cash management)
Monitoring and attempting to capitalize on market conditions to optimize the risk and return relationship of short-term investments. May Involve: 1. matching strategy 2. mismatching strategy 3. laddering strategy
Crossover Rate (point)
NPV profiles of projects under consideration intersect at the discount rate for which NPVs of the projects are equal. This rate at which the NPVs are equal is called the crossover rate. The NPV profiles for projects intersect because of differences in the timing of the cash flows.
Fixed Rate Perpetual Preferred Stock
Nonconvertible, noncallable preferred stock that has a fixed dividend rate and no maturity date. Use the normal "cost of preferred stock" formula: Kps = Dps / P where: Kps = cost of preferred stock Dps = dividend of preferred stock P = price of preferred stock
Operating Leverage
Operating Fixed costs (depreciation or rent) create operating leverage.
Preferred Stock Valuation Model
P = Dps / Kps where: Dps = Dividends of preferred stock Kps = cost of preferred stock P = market price.
Primary Sources of Liquidity (def + 6)
Primary Sources = from normal operations 1. Cash & Cash Equivalents 2. Collections 3. Investment Income 4. Trade Credit 5. Bank Lines of Credit 6. Short-term investment portfolios
Matrix Pricing
Process of estimating the market discount rate and price of a bond based on the quoted or flat prices of more frequently traded comparable bonds.
Shareholder Theory (Milton Friedman)
Purpose of organizations: maximize shareholder wealth.
Sales Risk
Risk associated with respect to the quantity of goods and services that a company is able to sell and the price it is able to achieve; Affected by: 1. elasticity of product demand 2. revenue cyclicality 3. structure of competition in the industry
Multi-Factor Priced Risk Model
Risk for which investors demand compensation for bearing (e.g. equity risk, company-specific factors, macroeconomic factors). E(Ri) = Rf+βi1(Factor risk premium)1 + βi2(Factor risk premium)2 +...βij(Factor risk premium)j where βij = stock i's sensitivity to changes in the j-th factor (Factor risk premium)j = expected risk premium for the jth factor The basic idea behind these multifactor models is that the CAPM beta may not capture all the risks, especially in a global context, which include inflation, business-cycle, interest rate, exchange rate, and default risks.
Secondary Sources of Liquidity
Secondary Sources = may significantly change firm 1. Renegotiation of debt 2. Liquidation of assets 3. Bankruptcy
Stakeholder Groups
Shareholders Board of Directors Senior Managers Employees Creditors Suppliers Customers Gov't Regulators
Beta Estimation Issues to Consider -> Small-Cap Stock Adjustments
Small-capitalization stocks have generally exhibited greater risks and greater returns than large-capitalization stocks over the long run. Roger Ibbotson, Paul Kaplan, and James Peterson argue that betas for small-capitalization companies be adjusted upward.
Material Social ESG Considerations
Social: 1. human capital management 2. human rights and welfare concerns in the workplace 3. product development 4. community impact 5. Staff turnover 6. worker training and safety 7. employee morale 8. ethics policies 9. employee diversity 10. supply chain management
Beta Estimation Issues to Consider -> Use of a Smoothing Technique
Some analysts adjust historical betas to reflect the tendency of betas to revert to 1. As an example, the expression βi,adj = 0.333 + 0.667βi adjusts betas above and below 1.0 toward 1.0.
"Other" Capital Projects
Some projects are not easily analyzed through the capital budgeting process. Such projects may include a pet project of senior management (e.g., corporate perks) or a high-risk endeavor that is difficult to analyze with typical capital budgeting assessment methods (e.g., research and development projects).
Project Sequencing
Some projects must be undertaken in a certain order, or sequence, so that investing in a project today creates the opportunity to invest in other projects in the future. If the first project is successful, a firm will invest in the second. If the first project is a failure, a firm will not invest in the second.
Flotation Cost Adjustment Formula
Step 1: Find the weights of debt & equity Step 2: Calculate the cost of debt & equity Step 3: Calculate the WACC Step 4: Adjust CFO for NPV by adding flotation cost (note: make sure CF0 is negative in calculator) Step 5: Calculate NPV using the WACC for Int. Rate.
If provided with Forecasted book and market debt + equity values, as well as Current book and market debt + equity values, which set of numbers would you use for forecasting the capital structure?
The Forecasted Market Debt + Equity Values.
Liquidity Management
The ability of an organization to generate cash when and where it is needed. For the most part, we associate liquidity with short-term assets and liabilities, yet longer-term assets can be converted into cash to provide liquidity.
What does [yield-to-maturity * (1-tax rate)] rate mean?
The after tax cost of debt: For example, if a company's only debt is a bond it has issued with a 5% rate, its pre-tax cost of debt is 5%. If its tax rate is 40%, the difference between 100% and 40% is 60%, and 60% of the 5% is 3%. The after-tax cost of debt is 3%.
Beta Estimation Issues to Consider -> Market Index Selection
The choice of market index affects the estimate of beta.
Optimal Capital Budget
The intersection of the investment opportunity schedule with the marginal cost of capital curve. This identifies the optimal capital budget amount.
Marginal Cost of Debt Financing (After-Tax Cost of Debt)
The cost of debt after considering the allowable deduction for interest on debt based on the country's tax law. It is important that you realize that the cost of debt is the market interest rate (YTM) on new (marginal) debt, not the coupon rate on the firm's existing debt. CFA Institute may provide you with both rates, and you need to select the current market rate. = Kd * (1 - t) If interest cannot be deducted for tax purposes, the tax rate applied is zero so that the effective marginal cost of debt is equal to rd in Equation 1. If interest can be deducted in full, the tax deductibility of debt reduces the effective marginal cost of debt to reflect the income shielded from taxation and the marginal cost of debt is Kd * (1 - t). Note: can use either of the formulas below, depending on the information given. = interest expense * (1 - t) ; or = interest % * (1 - t)
Marginal Cost of Capital (same as WACC)
The 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 the WACC. MCC shows the WACC for different amounts of financing
Cost of Preferred Stock (think: dividend is included in price)
The dividend yield that a company must commit to pay preferred stockholders: (remember: dividends are not tax-deductible, so no tax adjustment) Kps = Dps / P where: Kps = cost of preferred stock Dps = preferred dividends P = market price of preferred Example: Cost of preferred stock Suppose Dexter, Inc., has preferred stock that pays an $8.50 dividend per share and sells for $100 per share. What is Dexter's cost of preferred stock? Kps = $8.50 / $100 = 0.085 = 8.5% Note 1: The equation Kps = Dps / P is just a rearrangement of the preferred stock valuation model P = Dps / Kps, where P is the market price. Note2: The current terms thus prevail over the past terms when evaluating the actual cost of preferred stock.
Equity Risk Premium (market risk premium)
The expected return on equities minus the risk-free rate; the premium that investors demand for investing in equities. = E(RM) − RF When using the CAPM to estimate the cost of equity, in practice we typically estimate beta relative to an equity market index. In that case, the market premium estimate we are using is actually an estimate of the equity risk premium (ERP).
Internal Rate of Return (IRR)
The expected return on the project Technically, the IRR is the discount rate that results in an NPV of zero for a project. Projects with IRRs above this rate will be accepted, while those with IRRs below this rate will not be accepted. ex. to make NPV = 0, the IRR = 19.44% Advantage: 1. measures profitability as % per $ invested 2. implies margin of safety (how much below the IRR the project could fall before having a negative NPV) Disadvantages: 1. Rankings of mutually exclusive multiple projects could differ than NPV method ranking 2. Project could have a) multiple IRR or b) no IRR
Annual General Meeting vs. Extraordinary General Meeting
The key difference is that extraordinary general meetings can be called anytime there is a resolution about a matter that requires a vote of the shareholders.
Discounted Payback Period (DPB)
The length of time it takes for a project's discounted (PV of) cash flows to repay the initial cost of the investment & a measure of project liquidity. (but never a good measure of profitability) DPB < Project's Life = Accept DPB = Full years until recovery + (discounted unrecovered $ beg. of RY / cash flow during RY) where; RY = Recovery Year Project decisions should not be made on the basis of their payback periods because: 1. Doesn't account for cash flows beyond payback prd. (which means salvage value not considered)
Breakeven Quantity of Sales
The level of sales that a firm must generate to cover all of its fixed and variable costs Qbe = total fixed costs / contribution margin per unit or Qbe = (fixed operating costs + fixed financing costs) / (price - variable costs per unit) where: fixed operating + fixed financing = total fixed costs price - variable cpu = contribution margin per unit
Operating Breakeven Quantity of Sales
The level of sales that a firm must generate to cover only its fixed operating costs, where we consider only fixed operating costs and ignore fixed financing costs. Qobe = Fixed Operating Costs / (price - variable cpu) where: Qobe = quantity of operating break even
Working Capital Management
The management of a company's short-term assets (such as cash, A/R, inventory) and short-term liabilities (such as money owed to suppliers).
Required Rate of Return (RRR)
The minimum annual percentage that must be earned by a project before a company chooses to invest ("hurdle rate") Usually the firm's cost of capital, but may be higher or lower than the firm's cost of capital to adjust for differences between project risk and the firm's average project risk
Dual Class Structures
The most common way that voting power is decoupled from economic ownership. Common shares divided into two classes: 1. Share Class A: carries one vote per share and is publicly traded 2. Share Class B: carries several votes per share and is held exclusively by company insiders or family members. Board Election rights can be divided as well: 1. Share Class A: Rights to elect majority of board seats 2. Share Class B: Rights to elect minority of board seats
Payback Period (PBP)
The number of years it takes to recover the initial cost of an investment & a measure of project liquidity. (but never a good measure of profitability) PBP = Full years until recovery + (unrecovered $ beg. of RY / cash flow during RY) where; RY = Recovery Year Project decisions should not be made on the basis of their payback periods because: 1. Doesn't account for time value of money 2. Doesn't account for cash flows beyond payback prd. (which means salvage value not considered)
Target Capital Structure
The optimal mix of debt, preferred stock, and common equity with which the firm plans to finance its investments. - May change over time - Trade-off between risk and return to achieve goal of maximizing the price of the stock.
Credit worthiness
The perceived ability of the borrower to pay what is owed on the borrowing in a timely manner; it represents the ability of a company to withstand adverse impacts on its cash flows.
Capital Budgeting Process
The process of identifying and evaluating projects where the cash flow to the firm will be received over a period longer than a year, i.e. any corporate decisions with an impact on future earnings (capital projects). Step 1: Idea generation - most important Step 2: Analyzing project proposals (cash flow forecast) Step 3: Create the firm wide capital budget (cash flow timing, resources, strategy -> all considered) Step 4: Monitoring decisions, conducting a post-audit (compare forecast/actual results, explain differences)
Component Cost of Capital
The rate of return required by suppliers of capital for an individual source of a company's funding, such as debt or equity.
Cost of Common Equity Capital (Kce)
The required rate of return on the firm's common stock. The rationale here is that the firm could avoid part of the cost of common stock outstanding by using retained earnings to buy back shares of its own stock.
Cost of Capital of a company
The required rate of return that investors demand for the average-risk investment of a company.
Business Risk
The risk associated with operating EBIT, affected by operating leverage Business risk refers to the risk associated with a firm's operating income and is the result of uncertainty about a firm's revenues and the expenditures necessary to produce those revenues. Business risk is the combination of sales risk and operating risk.
Financial Risk
The risk associated with the use of debt financing that has a fixed cost (such as debt and leases) and its impact on net income and net cash flows. Variability of EPS from fixed interest costs of debt financing (Use EBT earnings) A company that relies heavily on debt financing instead of equity financing is assuming a great deal of financial risk. the additional risk that the firm's common stockholders must bear when a firm uses fixed cost (debt) financing. When a company finances its operations with debt, it takes on fixed expenses in the form of interest payments. The greater the proportion of debt in a firm's capital structure, the greater the firm's financial risk.
Operating Risk
The risk attributed to the operating cost structure, in particular the use of fixed costs in operations; the greater the fixed operating costs, relative to variable operating costs, the greater the uncertainty of income and cash flows from operations. Affected by: 1. Mix of fixed and variable costs 2. ESG factors
Yield to Maturity Approach (of estimating pre-tax debt cost)
The yield, Kd, that equates the present value of the bond's promised payments to its market price: Kd * (1 - t); if Kd is not given, you can solve using PV on calculator to get the rate (Kd), then plug the rate into the after-tax debt formula. ex: Valence Industries issues a bond to finance a new project. It offers a 10-year, $1,000 face value, 5 percent semi-annual coupon bond. Upon issue, the bond sells at $1,025. What is Valence's before-tax cost of debt? If Valence's marginal tax rate is 35 percent, what is Valence's after-tax cost of debt? PV = 1025, FV = -1000, PMT = 25, N = 20, CPT -> I/Y then, Multiply I/Y * 2 (semi-annual to annual) and plug into formula: Kd * (1 - t) = 3.37%
Fixed Operating Costs (5 major)
These costs include: 1. Depreciation 2. Rent 3. Interest on debt (interest expense) 4. Insurance 5. Wages for salaried employees
What industries tend to have low operating leverage?
Those that have a higher mix of variable than fixed costs, for example: Retailers have low operating leverage because much of the cost of goods sold is variable.
What industries tend to have high operating leverage?
Those that invest up front to produce a product but spend relatively little on making and distributing it. - Software developers - pharmaceutical companies
Daily Cash Position
Uninvested cash balances a firm has available to make routine purchases and pay expenses as they come due.
Beta Estimation Issues to Consider -> Period of Return Interval
Use Daily returns. Relative to monthly, weekly, etc., researchers have observed smaller standard error in beta estimated using smaller return intervals, such as daily returns.
Engagement/Active Ownership for ESG
Using share ownership to promote ESG goals through proxy voting and contact with managers and directors.
Majority Voting
Voting in which each share of stock allows the shareholder one vote and each position on the board of directors is voted on separately. As a result, a majority of shares has the power to elect the entire board of directors.
How is cost of capital usually calculated in reality?
What is often done is to estimate the cost of capital for the company as a whole and then adjust this overall corporate cost of capital upward or downward to reflect the risk of the contemplated project relative to the company's average project.
Pull on Liquidity
When disbursements are paid too quickly or trade credit availability is limited, requiring companies to expend funds before they receive funds from sales that could cover the liability. 1. Making payments early 2. Reducing credit limits 3. Limits on short-term lines of credit 4. Low liquidity positions
Drag on Liquidity
When receipts lag, creating pressure from the decreased available funds. 1. Uncollected receivables 2. Obsolete inventory 3. Tight credit conditions
Unconventional Cash Flow Pattern
a cash flow pattern in which the sign on the cash flows changes more than once. For example: A project might have an initial investment outflow, a series of cash inflows, and a cash outflow for asset retirement costs at the end of the project's life.
Conventional Cash Flow Pattern
a cash flow pattern in which the sign on the cash flows changes only once
Cost Reduction Capital Projects
a fairly detailed analysis is required. Key consideration: 1. Should usable but obsolete equipment be replaced?
Ordinary Resolution
a resolution adopted by the general meeting and passed by a simple majority
Simple Trick for converting D/E into a weight:
a simple way of transforming a debt-to-equity ratio into a weight is to divide D/E by (1 + D/E). example: Suppose Gewicht Corp. announces that a debt-to-equity ratio of 0.7 reflects its target capital structure. What weights should you use in the cost of capital calculations? Weight of Debt = 0.7 / (1 + 0.7) = 0.4118 or 41% Weight of Equity = 1 - 0.4118 = 0.5882 or 59%
Expansion Capital Projects
a very detailed analysis is required due to implicit need to forecast future conditions. Key considerations: 1. Expected future demand? 2. Expected future business growth via project?
New Product / Market Development Capital Projects
a very detailed analysis is required due to implicit need to forecast future conditions. Key considerations: 1. Expected future demand? 2. Expected future business growth via project?
The decision rule for Net Present Value
accept projects with positive net present values. reject projects with negative net present values.
Claw-back provision
allow companies to recover executive remuneration under certain circumstances, to the benefit of all shareholders.
Business Maintenance Capital Projects
are normally made without detailed analysis. Key considerations: 1. Should existing operations continue? 2. Should existing procedures or processes be maintained?
a callable bond would have a yield greater than a similar noncallable bond of the same issuer because:
bondholders want to be compensated for the call risk associated with the bond.
How does a financial analyst estimate a beta for a company or project that is not publicly traded?
by using the Pure Play Method
Covenants with Indentures
covenants are the terms and conditions of lending agreements, enabling creditors to specify the actions an issuer is obligated to perform or is prohibited from performing. They are put in place to protect creditors.
Variability in net income is greater for:
firm's with higher fixed costs, because higher fixed costs magnify changes in sales both positively and negatively. Graph Example: As the number of units sold changes, Impulse Robotics experiences a greater change in net income than does Malvey Aerospace for the same change in units sold.
Senior Debt
in the event of liquidation of a firm, senior debt holders must be paid first
the put feature of a bond, which provides the investor with an option to sell the bond back to the issuer at a predetermined price, has the effect of:
lowering the yield on a bond below that of a similar non-putable bond.
Mandatory Capital Projects
may be required by a governmental agency or insurance company and typically involve safety-related or environmental concerns. These projects typically generate little to no revenue, but they accompany new revenue-producing projects undertaken by the company.
Operating Cycle
operating cycle = days of invent. + days of receivables The average number of days that it takes to turn raw materials into cash proceeds from sales:
Business risk is associated with:
operating earnings. Operating earnings are affected by sales risk (uncertainty with respect to price and quantity), and operating risk (the operating cost structure and the level of fixed costs).
Special Resolution
resolution on major decisions of a company (such as changing the company's articles or reducing its share capital) at a general meeting that must be passed by a certain majority, usually 75%
If a project has unconventional cash flows:
the NPV method will give the appropriate accept/reject decision.
If a market YTM is not available because the firm's debt is not publicly traded:
the analyst may use the rating and maturity of the firm's existing debt to estimate the before-tax cost of debt. If, for example, the firm's debt carries a single-A rating and has an average maturity of 15 years, the analyst can use the yield curve for single-A rated debt to determine the current market rate for debt with a 15-year maturity. If any characteristics of the firm's anticipated debt would affect the yield (e.g., covenants or seniority), the analyst should make the appropriate adjustment to his estimated before-tax cost of debt.
Cost of Capital
the price of borrowing money or the rate of return that borrowers pay investors. the rate of return that the suppliers of capital—bondholders and owners—require as compensation for their contribution of capital.
The beta of a company or project is affected by:
the systematic components of business risk and financial risk, both of which affect the uncertainty of the cash flows of the company or project.
Cross-Shareholding
when a company, particularly a publicly listed one, holds a large, passive, minority stake in another company. Such holdings generally help to protect management from shareholder pressures because implicit in a cross-shareholding arrangement is the guarantee that the owner of the shares will support management on all voting issues. In effect, these shareholdings act as takeover defenses. Usually two firms hold large stakes in the others company.