CFA Level 1 - Corporate Finance
Average Accounting Rate of Return (AAR)
AAR = average net income/average book value -easy to understand -based on accounting numbers not CFs, does not account for time value of money, does not differentiate between profitability since there is no benchmark for acceptable AARs
Liquidity Management
Ability of a company to generate cash when required.
Number of days of payables
Accounts Payable / Average day's purchases Accounts Payable / purchases / 365 Purchases = EI + COGS - BI
Number of days receivables
Accounts receivable/Average day's sales on credit Accounts receivable/sales on credit/365 How many days it takes to collect receivables from customers, keep close to industry average
Factoring
Actual sale of receivables at a discount from their face values. Size of discount will depend on how long it is until the receivables are due, creditworthiness of firms credit customers, and firms collection history on receivables.
Estimating Beta
An analyst must estimate beta to use CAPM. Can use regression of stock against market returns which will yield Ri = a + bRmt (company's stock return = estimate of intercept plus estimated slope of regression (beta) times index/market returns over period Beta estimates are sensitive so consider: -based on historical returns so consider length of estimation period -smaller standard errors are found when using small return intervals (daily returns) -sensitive to choice of market index against which stocks are regressed -believed to revert towards 1 over time (mean reversion) -small-cap stocks have greater risks and returns compared to large-cap stocks so may adjust small-cap upward Company and project betas are exposed to systematic (nondiversifiable) risks: business risk (sales and operating risks = unpredictability of revenues and operating cost structure) and financial risk (uncertainty of profits and cash flows because of fixed-cost financing sources such as debt and leases)
Trade discounts
An early payment discount must be availed if the savings from paying suppliers early are greater than the returns that could have been earned by investing the funds instead or greater than the firm's cost of borrowing. Implicit rate = Cost of trade credit = (1 + Discount/(1 - Discount)) ^ (365/number of days beyond discount period) - 1 "2/10 net 30" means that 2% discount is available if the amount owed is paid within 10 days, otherwise the full amount is due by the 30th" Number of days payable = accounts payable/average day's purchases = 365/payables turnover
Project beta
Asset beta x [ 1 + ((1-t) D/E) ] D/E of subject company t marginal tax rate of subject company Reflects business and financial risk
Current ratio
Current assets/current liabilities -higher means better positioned to meet ST obligations
Audit Committee
Ensures that the financial information presented to shareholders by the company is complete, accurate, reliable, relevant, and timely. Hires external auditors and ensures that auditors are independent and everything is prepared/presented. All board members on the audit committee must be independent.
Renumeration Committee
Ensures that various forms of compensation offered to executives encourage them to behave in a manner that enhances the company's long term performance and profitability. Eliminate conflicts of interest, report to shareholders regularly, establish clear mechanisms in compensation packages for recouping incentive pay if earned through fraud, understand all aspects of compensation packages, compensation packages are appropriate, disclosed, etc. All board members on the committee must be independent.
Holder-of-record date
The date on which the shareholder listed in company records will be entitled to receive the upcoming dividend. In the US, trades settle T + 3 so there is a 2 day gap between the ex-date and holder-of-record date.
Ex-dividend date
The first day a share of stock trades without a dividend. Anyone holding stock on the ex-dividend date or who purchased it before the date is entitled to receive the dividend. Occurs two business days before the holder-of-record date. If buy a share on or after the ex-dividend date, you will not receive the dividend. Also known as ex-date.
Break Point
amount of capital at which components cost of capital changes / weight of component in capital structure
Surplus
difference between projected growth in assets and projected growth in liabilities and stockholders equity
Externalities
effects the acceptance of a project may have on other firm cash flows.
Pro-forma balance sheets / IS
forward-looking financial statements that are constructed based on specific assumptions about future business conditions and firm performance. (don't confuse with proforma financial statements)
Operating Cycle formula
Operating cycle = number of days of inventory + number of days receivable
Cost of trade credit =
(1 + (% discount / 1 - % discount)) ^ (365/days past discount) - 1
Quick ratio/acid test
(Cash + ST marketable investments + receivables)/current liabilities excludes inventory
EPS after buyback =
(total earnings - after-tax cost of funds) / shares outstanding after buyback
Issues in estimating cost of debt
-Fixed rate versus floating rate debt: floating rate is more difficult to estimate -Debt with option-like features: embedded options make things harder -Nonrated debt: no debt outstanding or yields on existing debt may be unavailable -Leases: if leases are a source of finance, the cost of leases should be included in the cost of capital
Internal rate of return
-The discount rate that makes the sum of the PV of future after-tax CFs equal to the initial investment outlay -The discount rate that equates PV of after tax CFs for a project to zero -The discount rate at which NPV equals zero sum(CF(t)/(1+IRR)^t = outlay sum(CF(t)/(1+IRR)^t - outlay = 0
Fixed versus variable costs
-Variable costs vary with the level of production and sales -Fixed costs remain the same irrespective of the level of production and sales The higher the fixed costs (both operating and financial), the higher earnings volatility The greater degree of leverage for a company, the steeper the slope of the line representing net income.
Approaches to short-term borrowing
-ensure there is sufficient capacity to handle peak cash needs -maintain sufficient sources of credit to fund ongoing cash requirements -ensure the rates obtained for these borrowings are cost effective -diversify to have abundant options and don't rely on one lender -have the ability to manage different maturities efficiently
NPV profiles
-graphical illustrations of NPV at different discount rates -downward sloping because as cost of capital increases, the NPV of an investment falls -NPV on y-axis, cost of capital on x-axis -NPV of two projects are equal at the cost of capital, this is where the NPVs of the two projects are the same and their profiles intersect. Called the crossover rate. -Crossover rate can be calculated by subtracting cash flows of one project from the other and calculating the IRR of the difference -IRR is where the NPV profile intersects the x-axis -higher y-axis intersection means higher total CF over life
Capital budgeting projects can be classified as
-replacement projects - maintain normal business -expansion projects - increase size of business -new products and services -regulatory, safety, and environmental projects - may be mandatory -other projects
Constructing Sales Driven Pro Forma Financial
1 - estimate relation tween changes in sales and changes in sales-driven income statement and bal sheet items 2 - Estimate future tax rate, i rate on debt, lease payments 3 - Forecast sales for period of interest 4 - Estimate fixed operating costs and fixed financial costs 5 - Integrate these estimates into pro forma financial statements for period of interest
Capital Budgeting Principles/assumptions
1) Decisions are based on actual cash flows - only incremental cash flows and externalities, not sunk costs 2) Cash flows based on opportunity costs - projects are evaluated on the incremental CF they bring in, over and above what would be generated in the next best alternative (opportunity cost) 3) Cash flows are on an after-tax basis - impact of taxes should always be considered before making a decision 4) Timing of cash flows is important - CF received earlier in the life of project are worth more 5) Financing costs are ignored from calculation of operating cash flows - financing costs are reflected in the required rate of return so don't double count 6) Accounting net income is not used as cash flows for capital budgeting - because it is subject to noncash charges (depreciation) and financing charges (interest expense)
Calculating before-tax cost of debt capital
1) YTM approach: Yield measures return on bond and it equates PV of bond's CF to current market price P0 = sum(PMT/(1 + rd/2)^t) + FV/(1 + rd/2)^n -Yield is on BEY basis, then multiply I/Y by 2 for full YTM/before-tax cost of debt 2) debt rating approach When reliable current market price for the company's debt is not available the before-tax cost of debt can be estimated using the yield on similarly rated bonds that have similar terms to maturity as existing debt. May have to adjust comparable company cost of debt for seniority, etc.
Capital Budgeting Steps
1) idea generation - most important 2) analyzing individual project proposals - feasibility 3) create the firm-wide capital budget - fit firm's overall strategy 4) monitoring decisions and conducing a post-auditing - actual to expected, improve accuracy going forward, generate new ideas
Capital budgeting tells us about management
1) the extent to which management pursues the goal of shareholder wealth maximization 2) managements effectiveness in pursuit of this goal
Net Profit Margin
= NI / Sales = EBT x (1 - t) / Sales
Country Risk Premium
Added to market risk premium when using CAPM for stocks in developing countries. re = Rf + B * [E(Rm) - Rf + CRP] where CRP = Sovereign yield spread * (annualized standard deviation of equity index/annualized standard deviation of sovereign bond market in terms of the developed markets currency) Sovereign yield spread = general risk of developing country = difference between developing country's government bond yield and the yield of a similar maturity bond issued by the developed country
Dividend reinvestment plans (DRPs)
Allows investors to reinvest all or a portion of cash dividends received from a company in shares of the company. Can be open market, new-issues, or hybrid. Advantages to company -encourage diversified shareholder base -encourage long-term investment in the company -new issue allows raising equity capital Advantages to shareholder -can accumulate shares in the company using dollar-cost averaging which is the technique of buying a fixed dollar amount of a particular investment on a regular schedule regardless of share price -cost-effective means for small investors -no transaction costs -sometimes offered at discount Disadvantages to shareholder -investors must keep record of capital gains/losses -cash dividends are fully taxed in the year they are received (even if reinvested) so paying taxes on cash you don't receive -new share issuances will dilute shareholders that do not participate
Short-term financing - Uncommitted line of credit
Bank extends an offer of credit for certain amount but may refuse to lend if circumstances change
Short-term financing - Committed (regular) line of credit
Bank offers credit that it "commits to" for some period of time. Formal commitment.
Bond yield plus risk premium approach
Based on the assumption that the cost of capital for riskier cash flows is higher than that of less risky cash flows. re = rd + risk premium
Reverse Stock Splits
Opposite of stock splits. Increases share price and reduces the number of shares outstanding. Tries to bring price into more reasonable range.
Inventory turnover
COGS/Average inventory How often inventory is created and sold, keep close to industry average
Stock vs cash dividends
Cash dividends reduce assets (cash) and shareholder's equity (retained earnings), deteriorating liquidity and leverage ratios. Stock dividends do not have impact on capital structure, retained earnings fall by the value of the stocks paid but there is an offsetting increase in contributed capital so no change in equity.
Pulls in liquidity
Cash leaves the company too quickly. -making payments early instead of waiting until the due date to make them, reduced credit limits, limits on short-term lines of credit, low existing liquidity levels
Share repurchases - Repurchase by direct negotiation
Companies may negotiate directly with large shareholder to buy back a block of shares, usually at a premium to the market price. Will reduce number of shares out, and increase EPS
Share repurchases - Buy in open market
Companies may repurchase stock in open market at the prevailing market price. Most flexible because you can do it when prices are attractive.
Share repurchases - Buy a fixed number of shares at a fixed price
Company may repurchase stock by making a fixed price tender offer to repurchase a specific number of shares at a price that is usually at a premium to the current market price.
Marginal Cost of Capital and break points
Cost of the last additional dollar of capital a firm raises. As firm raises more and more capital, the costs of difference sources of financing will increase. Raising additional capital increases WACC. It shows WACC for different amounts of financing. It is upward sloping. The amount of capital at which the WACC changes is referred to as a break point: Amount of capital at which a component's cost of capital changes / proportion of new capital raised from the component
Terms of credit
Credit policy has huge impact on sales, some terms of credit include ordinary terms, cash before delivery, cash on delivery, bill-to-bill, monthly billing. Credit managers use credit scoring models to evaluate customers' credit worthiness.
Accounts receivable turnover
Credit sales/average receivables How many times AR are created by credit sales and collected over a given period, keep close to average ratio
Payment Date
Date the dividend checks are mailed out - sent electronically
Working Capital management
Deals with short-term aspects of corporate finance activities, ensures that a company has ready access to funds needed for everyday expenses and that it invests its assets in the most productive manner.
DFL
Degree of financial leverage Sensitivity of cash flows available to owners to changes in operating income = Percentage change in net income / percentage change in operating income DFL = [Q * (P - V) - F] /[Q * (P - V) - F - C] Q = number of units sold P = price per unit V = variable cost per unit F = fixed operating cost C = fixed financial cost -no fixed cost => DFL = 1 => no leverage -Higher the use of fixed financing, the greater the sensitivity of net income to changes in operating income => more risk -DFL is different at different levels of operating income -usually determined by a company's management and capital structure may vary greatly across companies -companies with high ratio of tangible assets to total assets or those with revenues that have below-average business cycle sensitivity are able to use more financial leverage because stable revenue streams and assets that can be used as collateral make lenders more comfortable
DOL =
Degree of operating leverage = percentage change in operating income / percentage change in sales DOL = Q * (P-V) / Q * (P-V) - F Q = number of units sold P = price per unit V = variable cost per unit F = fixed operating cost Q * (P - V) = contribution margin (amount that units sold contribute to covering fixed costs) (P - V) = contribution margin per unit "at X units, a y% change in units sold will result in a DOL change in operating income" -no fixed cost => DOL = 1 => no operating leverage DOL is different at different sales levels. If the company is making operating profits, the sensitivity of operating income to changes in units sold decrease at higher sales volumes. -DOL is negative when operating income is negative and is positive when the company is earning profits -Operating income is most sensitive to changes in sales around the point where the company makes zero operating income -DOL is undefined when operating income is zero
DTL
Degree of total leverage Looks at the combined effect of operating and financial leverage (sensitivity of net income to changes in units produced and sold). DTL = percentage change in net income/percentage change in the number of units sold DTL = DOL x DFL DTL = Q * (P - V) / [Q * (P - V) - F - C] = (%ΔEBIT/%Δsales) x (%ΔEPS / %ΔEBIT) = (%ΔEPS / %Δsales)
Drag on liquidity delay
Delay in cash coming into the company that reduces cash inflows, or increase borrowing costs -uncollected receivables and bad debts, obsolete inventory, tight credit Handle by enforcing strict credit and collection policies
Risk of creditors and owners
Differ because of the different rights and responsibilities associated with their investment in the company. Creditors claims are senior to equity holders and returns are predefined, even if company does well they do not participate in upside. Owners only have claim on what is leftover after all the financial obligations have been met. In return for the lower priority claims, equity holders enjoy decision-making power and participate in upside when company does well.
Three approaches for determining cost of common equity
Difficult due to uncertainty of future cash flows that common stockholders will receive in terms of amount and timing. 1. CAPM 2. Dividend Discount Model approach 3. Bond Yield Plus Risk Premium approach Will get three different values so use judgment for what is appropriate given the project
Key advantage of NPV
Direct measure of the expected increase in the value of the firm. Assumes CFs are reinvested at required rate of return. -Main weakness doesn't take consideration of project size -When IRR and NPV conflict, go with NPV -positive NPV projects should increase share price
Pure-play to estimate beta
Equity beta of a publicly traded firm that is engaged in a business similar to, and with risk similar to, project under consideration, adjusted for differences in financial leverage. 1) find comparable company and estimate company's beta, varies with financial risk 2) remove all elements of financial risk from the beta "unlever" the beta. Unlevered beta reflects only the business risk of comparable and is known as asset beta 3) adjust unlevered beta of comparable for level of financial risk (leverage) in project or company
Asset beta
Equity beta x [ 1 / 1 + ((1-t) D/E) ] D/E: comparable company's debt-to-equity ratio t : marginal tax rate of comparable company Reflects business risk only
NPV decision rule
Evaluate single capital project that is independent NPV = sum(CF(t)/(1+r)^t) - Outlay r = required rate of return for the investment = firm's cost of capital after adjusting for risk in project, CF is after tax -NPV>0 => increase shareholder wealth => take on project -NPV<0 => decrease shareholder wealth => do not take on project -NPV=0 => no impact on shareholder wealth -whichever project has higher NPV should be undertaken
Voting Rules
Examine structure of voting rights to see if the majority is given to different shareholders. How do rights vary, who has inferior voting, etc. -Proxy voting = fundamental right of any shareholder. If a company makes it difficult to vote, it limits ability to express views and influence company. Shouldn't require presence at annual meetings, should permit proxy voting by paper ballots, electronic, etc. -Should use third party to count shareholder votes to keep confidentiality -cumulative voting = shareholders can cast cumulative votes allotted to their shares in favor of a limited number of board nominees => improves chances of being heard -Determine what other changes shareholders vote on, such as corporate structure, by-laws, change in provisions, voting in sale of company, executive compensation voting, anti-takeover measures, share buy-back programs, issuance of new capital
Special Dividends
Favorable circumstances allow the firm to make a one-time cash payment to shareholders, in addition to any regular dividends the firm pays.
Accounts Payable management
Guidelines: Firm's centralization Number, size, location of vendors Trade credit and cost of borrowing or alternative cost Control of disbursement float Inventory management E-commerce and electronic data interchange
IRR decision rule
IRR > required rate return => NPV is positive => accept IRR < required rate return => NPV is negative => reject
Target Capital Structure
Ideally we would use proportion of debt and equity used to fund specific project. However, assuming company has target capital structure and will raise capital in line with this structure. It is the capital structure the company aims to maintain. Given debt to equity ratio (D/E), transform into weights by: (D/E)/(1 + D/E) = D/(D+E) = wd wd + we = 1 Use current capital structure and the weights of the components are based on market values.
Asset-based loans
If not qualified for unsecured loan, use loan that is collateralized by the company's assets
Share repurchase impacts
Impact balance sheet and income statement. If financed with cash, assets and equity decline and increase in reported debt ratios. On the income statement, repurchases can increase or decrease EPS depending on at what cost the repurchase is financed. -If funds were generated internally, it will increase EPS only if funds would not have earned the company's cost of capital if they were retained in the company -If borrowed funds were used and the after-tax cost of borrowing is greater than earnings yield, EPS will fall -If borrowed funds were used and the after-tax cost of borrowing is less than earnings yield, EPS will rise Total return on stock is capital gains + dividends. All else equal, share repurchase is the same as cash dividend in terms of impact on shareholder's wealth
Marginal Cost of Capital (MCC)
Increases as it raises additional capital because most firms must pay a higher cost to obtain increasing amounts of capital (borrow more means greater risk of repaying therefore higher required return). Profitability of a company's investment opportunities decreases as company makes additional investments. Company's attack higher IRR Projects first so the additional investment opportunities are less rewarding => investment opportunity schedule is downward-sloping.
Independent versus mutually exclusive projects
Independent projects are those whose cash flows are unrelated Mutually exclusive projects compete directly with each other for acceptance
Typical elements of cash flow forecasts
Inflows -receipts from operations -funds transfer from subsidiaries, JVs and third parties -maturing investments -debt proceeds -other income items (interest) -tax refunds Outflows -Payables and payroll disbursements -Funds transfers to subsidiaries -Investments made -Debt repayments -Tax payments -Interest and dividend payments
Share repurchases - dutch auction
Instead of specifying fixed price for all shares, the company can specify a range of acceptable prices and shareholders can specify their selling price. Company accepts lowest bids first and then higher until it has repurchased the desired number of shares.
Number of days of inventory
Inventory/Average day's COGS Inventory/COGS/365 Length of time inventory remains with the firm before being sold, keep close to industry average
Nominations Committee
Is responsible for recruiting new board members with appropriate qualities and experience, examining performance, independence, skills, expertise of existing board members, creating nominations policies and procedures, preparing for succession of executive management and the board. Understand board members and composition of the board, how recruiting is done, etc.
Other Shareholder Rights issues
Legal rights - whether shareholders can take legal action to protect their ownership rights Takeover defenses - evaluate impact on share value in normal market and in the event of a takeover bid, these defenses hurt a potential acquirer's ability to succeeed and may prevent takeovers that could actually benefit shareholders.
Computing costs of borrowing
Line of credit cost = (interest + commitment fee)/loan amount Banker's acceptance cost = interest/net proceeds = interest/(loan amount - interest) Commercial paper cost = (interest + dealer's commission + Backup cost) / (loan amount - interest)
Inventory management
Maintain a level of inventory that ensures smooth delivery of sales without having more than necessary invested in inventory. Basic approaches are economic order quantity and just-in-time. May hold inventory intentionally if planned manufacturing activity, avoid stock-out losses, speculative. Inventory turnover = COGS/average inventory Number of days of inventory = 365/inventory turnover = inventory/average days COGS
Project sequencing
Many projects can only be undertaken in a specific order so investing in one project creates the opportunity to invest in other projects in the future
Key advantage of IRR
Measures profitability as a percentage, showing the return on each dollar invested. Provides info on margin of safety that NPV does not. Assumes CFs are reinvested at IRR which might be inappropriate. Disadvantages - 1) possibility of producing rankings of mutually exclusive projects different from NPV analysis 2) possibility are multiple IRRs (more than one sign change) or no IRR for project
Float factor
Measures the performance for check deposits, which gives the average number of days it takes for deposited checks to clear Float factor = average daily float/average daily deposit float = amount of money that is in transit between payments made by customers and funds that can be used by the company average daily deposit = total amount of check deposited/number of days
Yields on short-term investments
Money market yield = (FV - Price)/Price * (360/Days) = holding period yield * (360/days) Bond equivalent yield = (FV - Price)/Price * (365/Days) = holding period yield * (365/days) Discount basis yield = (FV - Price)/FV * (360/Days) = % discount * (360/days)
Short-term financing - Revolving line of credit
More reliable source of short-term financing than a committed line. Typically for longer terms than committed, sometimes as long as years.
Cash conversion cycle or net operating cycle
Net operating cycle = Number of days of inventory + Number of days of receivables - Number of days of payables Usually shorter cycles are desired otherwise too much invested in working capital
Break even point of a company
Occurs at the number of units produced and sold at which its net income equals zero. Point where revenues equal total costs and the company goes from making losses to making profits. PQ = VQ + F + C => quantity to break even = Qbe = (F + C)/(P - V) Operating break even uses operating profit rather than net income so revenues equal operating costs => PQobe = VQobe + F Qobe = F/(P - V) The farther unit sales are from the break even point for high-leverage companies, the greater the magnifying effect of leverage.
Optimal Capital Budget
Occurs at the point where the marginal cost of capital intersects the investment opportunity schedule Return/cost on y-axis and new capital on x-axis Company should raise capital at the given MCC and undertake all projects to earn given IRR to the left of the intersection point because these projects enhance shareholder wealth given the cost of financing them. To raise capital in excess of the optimal capital budget (to the right) would mean incurring a cost of capital that is greater than the return available on the investments.
Share repurchase
Occurs when a company buys back its own shares. Shares that are repurchased are known as Treasury shares and are not considered for dividends, voting, or calculating earnings per share. Cash outflow from the company. Can announce and not follow through. Send message that company's stock is undervalued or that management will support stock price, offer flexibility in its cash distributions, tax advantage because capital gains are taxed at a lower rate than dividends, limit the increase in number of shares outstanding when employee stock options have been exercised.
Stock dividends
Or bonus issue occurs when a company issues additional common shares in the company (instead of cash) to the shareholders. They do not affect an investor's proportionate ownership of a company. It basically just divides the MV of a firm's equity into smaller pieces but the percentage owned by each shareholder remains the same as well as the MV of the holdings. Not taxable. Advantages: more shares outstanding broadens shareholder base, could bring stock price into "optimal range" (between 20 and 80)
Other board committees
Overseeing M&A, risk management, etc. Board should communicate with shareholders and so should management to address any concerns.
Dividend Discount Model
P0 = D1/(re - g) D1 = next years dividends re = required rate of return on common equity g = constant growth rate on dividends => re = D1/P0 + g g can be calculated using forecasted growth rates from published sources or vendors OR use companies sustainable growth rate = RR * ROE = (1 - D/EPS) * ROE where 1 - D/EPS = earnings retention rate
Profitability Index (PI)
PI = PV of future cash flows/initial investment PI = 1 + NPV/Initial Investment PI is the ratio of discounted future CFs to initial investment while NPV is the difference between discounted future CFs and the initial investment. It is the value we receive in exchange for one unit of currency invested Also known as benefit-cost ratio PI > 1 => NPV positive => accept PI < 1 => NPV negative => reject
Cash management investment strategies
Passive = limited number of transactions, pays little attention to yield Active = constant monitoring to exploit opportunities (matching CFs with maturities, mismatching, laddering) Need formal written policies with a purpose, identification of authority, and restrictions
Creditworthiness
Perceived ability of a borrower to satisfy the payment terms on a borrowing in a timely manner. Liquidity contributes to creditworthiness.
Secondary sources of liquidity
Provide liquidity at a higher cost than primary sources. Include liquidating short-term or long-lived assets, negotiating debt agreements or filing for bankruptcy and reorganizing the company. May lead to significant changes in a company's financial structure and operations and may indicate that the financial position is deteriorating.
Accounts payable turnover
Purchases/Average trade payables How many times the company theoretically pays off creditors, keep close to industry average
Leverage & ROE
ROE is higher using leverage than without. Also increases the rate of change for ROE. ROE varies directly with the change in EBIT.
Flotation Costs
Refer to the fees charged by investment bankers to assist a company in raising new capital. Not usually incorporated in estimating cost of debt and preferred stock because it is so small. Two ways to account for: re = [D1/P0(1-f)] +g f is flotation costs as a percentage of the issue price -These costs are a part of initial outlay and shouldn't be baked into the cost of capital because all CFs will be impacted Instead, adjust the CF used in the valuation by adding the estimated dollar of flotation costs to the initial outlay.
Leverage
Refers to a company's use of fixed costs in conducting business, including operating leverage (rent and depreciation) and financial costs (interest expense). -Greater leverage leads to greater volatility of the firms after-tax operating earnings and cash flow -more leverage = more risk and higher discount rate -highly leveraged companies magnified
Cost of capital
Refers to the rate of return that the suppliers or providers of capital require to contribute their capital to the firm -The opportunity cost of funds for the providers of capital To raise capital a firm can either issue equity or debt. An instrument used to obtain financing is called a component and each has a different required rate of return which is the component cost of capital. Weighted average cost of capital and marginal cost of capital is the weighted average costs of the various components used to finance operations.
Business risk
Risk associated with a company's operating earnings because total revenues and costs of sales are both uncertain. A company has more control over operating risk than sales risk. Sales risk = uncertainty associated with total revenue, which is impacted by economic conditions, industry dynamics, government regulation, and demographics Operating risk = associated with a company's operating cost structure (fixed), generally depends on type of industry and production methods, more difficult to adjust operating costs to changes in sales, examine using degree of operating leverage (DOL) -Industries that require a significant initial investment but less expenditure to make and distribute the product have a higher portion of fixed costs and higher operating leverage (pharmaceuticals) -Industries with significant variable costs have low operating leverage (retail)
Code of ethics
Set standards for ethical conduct based on integrity, trust, honesty. -Guidance for addressing conflicts of interest. -Ethical code with a designated person responsible for enforcing it. -Regularly audit policies and procedures.
Shareholder proposals
Shareholder-sponsored board nominations prevents erosion in shareholer value. Shareholder-sponsored resolutions for consideration in annual general meeting (what majority is needed). Advisory or Binding shareholder proposals - is board and management required to implement proposals?
Board members
Should be independent of management and report activity regularly to shareholders. They should hire external consultants to make decisions. Shareholders should vote and elect members every year or stagger over years and can vote to remove members. Ensure they have not had material relationships with subsidiaries, influential groups, executive managers, company advisors (auditors). Evaluate qualifications of board members based on skills and experience, ethics, track record, how many boards to they serve on.
Stock Splits
Similar to stock dividends in that they increase total number of shares outstanding and have no economic effect on the company. Company issues dividend without spending cash, MV of company does not change, investors average cost per share falls but the total cost remains unchanged. 2-1 stock split has same effect as 100% stock dividend but the difference is that stock dividend transfers retained earnings to contributed capital, whereas stock split has no impact on any shareholder equity accounts. Typically announces split when price has appreciated significantly to bring price down, many investors see this as a signal for future price appreciation.
Primary source of Liquidity
Sources of cash it uses in its normal day-to-day operations, such as cash balances and short-term funds. This generally does not result in a change in a company's operations.
Capital budgeting concepts
Sunk costs - costs that cannot be recovered once they have been incurred, these are ignored in capital budgeting because it's only based on current and future cash flow Opportunity costs - value of the next best alternative that is foregone in making the decision to pursue a particular project, these should be included in project costs Incremental cash flow - additional CF realized as a result of a decision, equals CF with a decision less CF without decision Externality - effect of an investment decision on things other than the investment (can be positive or negative) Conventional versus nonconventional cash flow stream - conventional consists of an outflow followed by a series of inflows, only one sign change; unconventional means initial outflow is not followed by inflows only and sign of CF changes more than once
Corporate governance
System of internal controls and procedures through which companies are managed. Defines rights, roles, and duties of management, board members, and shareowners. Aims to minimize conflicts of interest between insiders and shareholders. Good practice ensures: -board members act in best interest of shareholders -company acts in lawful and ethical manner -shareholders have same right to participate in governance of the company, fair treatment -board and committees are structured to act independently from management -appropriate controls and procedures to cover management's activities -governance activities are reported to shareowners in fair, accurate, verifiable, etc. manner
Short-term investments
Temporary store for funds that are not needed for financing daily operations, low risk, high liquidity: T-bills, federal agency securities, CDs, banker's acceptance BAs, eurodollar time deposits, bank sweep services, repurchase agreements, commercial paper, mutual funds, money market funds, tax-advantaged securities.
Weighted Average Cost of Capital
The WACC is the expected rate of return that investors demand for financing an average risk investment of the company (opportunity cost). WACC = wd*rd*(1-t) + wp*rp + we*re wd = proportion of debt used to raise new funds rd = before-tax marginal cost of debt t = marginal tax rate for company wp = proportion of preferred stock used to raise new funds rp = marginal cost of preferred stock we = proportion of equity (common stock) used to raise new funds re = marginal cost of equity Taxes => The company is allowed to recognize interest expense for tax purposes to reduce taxable income. Tax shield = (1-t)* interest expense. Tax savings are only realized on payments to holders of debt instruments.
Declaration Date
The date on which a company announces a particular dividend, the holder of record date, and the payment date.
Discounted payback period
The number of years it takes for cumulative discounted cash flows from the project to equal the project's initial investment outlay. This will always be greater than its payback period because payback period does not discount the CFs. Advantages = counts for time value of money and risks associated with project CFs Drawback = ignores cash flows that occur after the payback period is reached so it does not consider the overall profitability of the project
Capital Budgeting process
The process that companies use for making long-term investment decisions in projects. Important because: 1) a significant amount of capital is usually tied up in long-term projects so the success of these investments has a significant influence on the future prospects of the firm 2) The principles of capital budgeting can also be used in making other operating decisions (investment in working capital and M&A) 3) the valuation principles used in capital budgeting are also applied in security analysis and portfolio management 4) sound capital budgeting decisions maximize shareholder wealth
Financial Risk
The risk associated with how a company chooses to finance its operations (debt or leases = higher fixed costs versus retained earnings or equity issuance = lower fixed costs).
Payback period
Time it takes for the initial investment for the project to be recovered through after tax CF from the project. The best investment is the one with the shortest payback period. Advantages = simple, can indicate liquidity Disadvantages = ignores risk of project, CF not discounted at rate of return, ignores CFs that occur after payback period is reached, does not measure profitability so it cannot be used in isolation Can calculate on calculator
Ways company can distribute cash to shareholders
Two ways that, which represent the company's payout over the year: 1) Dividends -cash dividends -stock dividends -stock splits 2) Share repurchases
Regular cash dividends
Typically paid out quarterly or semiannually or annually. Companies strive to maintain or increase dividend payouts because it tells investors that we are profitable, doing well and willing to share profits (high investment quality), and positive impact on share prices.
Cost of noncallable, non-convertible preferred stock
Vp = Dp/rp pays dividends at fixed rate and no maturity => rp = Dp/Vp
WACC MCC and NPV
WACC reflects average risk of the company, we assume the project has average risk and the project will have a constant capital structure which equals company's target throughout the life. If the risk of the project is above or below average risk, an adjustment is made to the WACC or MCC: -project has more risk than average => adjust WACC upward -project has less risk than average => adjust WACC downward
Liquidating dividends
When a company goes out of business and distributes the net assets to shareholders, or if a company sells off a portion of its business, or a company pays out a dividend greater than its retained earnings. Treated as a return of capital and amounts over the investors tax basis are taxed as capital gains.
Unlimited funds versus capital rationing
When the company has no constraints on the amount of capital it can raise, it will invest in all capital projects that increase shareholder wealth. Most companies have limited funds to invest so it must allocate funds only to the most lucrative projects to ensure shareholder wealth is maximized.
How to determine if shr repurchase will cause EPS to increase/decrease
if after-tax cost of debt < earnings yield = EPS increases if after-tax cost of debt > earnings yield = EPS decreases
Commercial paper
large creditworthy companies can issue short-term debt securities called commercial paper. Firm sells paper directly to investors (direct placement) or sells through dealers (dealer-placed paper), interest costs slightly less than rate can get from bank
Unconventional Cash flow patter
more than one sign change.
Payback period
number of years takes to recover initial cost of investment
Capital Asset Pricing Model
re = Rf + Bi * [E(Rm) - Rf] [E(Rm) - Rf] = equity risk premium can be estimated using survey approach by averaging forecasts Rm = expected return on market Bi = beta of stock Rf = risk free rate re = expected return on stock (Cost of equity)
Conventional Cash Flow Patter
sign on the cash flows changes only once, with one or more cash outflows followed by one or more cash inflows
Nonbank finance companies
smaller firms or firms with poor credit use for short-term funding
Bankers acceptances
used by firms that export goods. Guarantee from bank of firm that has ordered goods stating that a payment will be made upon receipt of goods
Cannibalization
when a new project takes sales from an existing product