Corporate Finance MID SEM

Valuation models - Stock

Can also have D(1+g) on top

Analysing the project

Cash flow estimates subject to significant uncertainty- assess forecasting risk and identify drivers of value - asses project's unique risks by modelling upside/ downside variations in cash flows rather than adjusting the discount rate

Determining Free Cash Flow

Compute free cash flow from incremental earnings by eliminating all non-cash expenses and including all capital investment - add back depreciation, amortisation and any other non-cash deductions -deduct actual capital expenditures, including increases in net working capital (NWC) > NWC = current assets- current liabilites = cash +receivables + inventory - payables > cash only included in NMC where firm required to maintain minimum cash balance to meet unexpected expenditures

Types of Corporate Bonds

Coupon bearing instruments - typically pay coupons semi-annually: - Face value (principal) denominated in standardised increments (usually $1000/bond) -Sold at par- coupon rate set to equal investors' required return Variants: -zero coupon bond -original issue discount bond - subordinated debentures -lower priority claim - asset-backed securities (ABS)- security's cash flows come from cash flows of underlying financial assets (securitisation) > Mortgage-backed securties (MBS) >Collateralised debt obligations (CDO)

Asset Structure Ratios

FATO= Sales/Fixed Assets Inventory Turnover = COGS/ Inv DaysRec= Sale/Debtors FATO: Fixed asset turnover

Financial Markets

Financial markets facilitate the flow of funds between corporations and investors - money vs capital markets -primary vs secondary markets

Investment objective

To maximise shareholder wealth - compare decision based on alternative rules to illustrate circumstances in which certain decision rules lead to incorrect investment decisions All decisions rules based on cash flows Categorise projects based on nature of investment decision - independent - mutually exclusive - contingent Analyse project selection when firm faces capital or other resource constraint

Asset Turnover

ATO=Sales/Assets Driven by: ability to generate sales from fixed assets

Affects on Financial Performance

Ability to: -generate sales from an asset -turn sales into profitable sales - manage the distribution between equity, debt, and government (capital structure) -grow at a rate commensurate with capital and to finance assets effectively -expand through profitable investment in assets and acquisitions -avoid being taken over

Free Cash Flow

Adjust unlevered net income for non-cash deductions, capital expenditures and increases in NWC. The equation assumes all value increase as result of accepting project Note that = change in NCF= (R-C-Dep)x(1-t)+Dep-CapEx-NWC

Payback Period Advantages & Disadvantages

Advantages: -Simple to calculate, easy to understand and communicate - Emphasises liquidity (key risk factor) -Offers method of coping with forecasting error as time horizon increases Disadvantages: -Ignores cash flows after payback period achieved -Ignores TVM -Does not allow for project size -No theoretical basis on which to set required payback period

Payback Period

Amount of time it takes to pay back the initial investment - accept project if PB is less than or equal to pre-specified period -Assume cash flows come at the end of each yeah when discounting within NPV and IRR analysis - Customary to work with fractional years if payback occurs between two identified cash flows - assume cash flow paid uniformly throughout the year

Agency relationship

An arrangement in which one entity (principal) legally appoints another (agent) to act on its behalf

Risk management

Area of finance dealing with obtaining and allocating capital resources to increase a firm's value to its sharheholder

Financial Balance Sheet of the Firm

Assets: -assets in place: exisiting investments generate cash flows today includes long-lived (fixed) and short-lived (working capital) assets - growth assets: expected value that will be created by future investments Liabilities - debt: fixed claim on cash flows, little or no role in management, fixed maturity, tax-deductible - equity: residual claim on cash flows, significant role in management, perpetual lives

Ways to calculate ratios

Average bases (denominators): to assess long run performance End of year bases: to highlight changes from year to year

Fundamental propositions

1. Corporate finance has an internal consistency 2. Corporate finance must be viewed as an integrated whole 3. Corporate finance matters to everybody

Axioms of Finance

1. Time value of money 2. Diversification 3. Arbitrage

Sales Growth Ratio

=(SALESt+1/salest)-1

ROA

=EBIT/Assets Driven by: asset turnover ATO and OPM

Expense Percentage

=Expenses/sales

Gross Profit Margin Ratio

=Gross Profit/ Sales

Valuation Principle

- An asset's value to the firm or its investors is determined by its competitive market price - the benefits and costs of a decision should be evaluated using market prices - when the value of the benefits exceeds the value of the costs, the decision will increase the value of the firm - a market value balance sheet demonstrates the difference between the value of an asset (PV) and the shareholder wealth changes as a result of acquiring an asset (NPV) - assume markets are efficient and in equilibrium

Methods to assess uncertainty

- Break-even analysis: level of input parameter that makes project's NPV equal to zero -Sensitivity analysis: vary one input parameter at a time to explore effects of errors in project's NPV estimate - Scenario analysis: considers the effect of changing multiple parameters simultaneously

Financial managers must

- Build quantitative decision models that evaluate costs vs benefits and accounting for amount, but also timing and risk. -Risk has to be rewarded, cash flows matter more than accounting income, markets are not easily fooled, and every decision a firm makes has an effect on its value

Investment decision rules

- Net Present Value -Internal Rate of Return - Payback Period

NPV the 'right rule'

- directly provides measure relative to objective - can be used for cost only or revenue 'only' projects -theoretically superior (TVM) - single solution - deliberately assess required rate of return disadvantages: not as easily understood

Market Analysis: Market Based Ratios

-Market data can be used to help interpret the accounting data -Market value provides base against which to compare earnings - More relevant to market participants- shareholders -Reflects market assessment of risk & growth prospects for firm relative to market

First principles

-Maximise the value of the firm shareholder wealth - The investment decision: invest in projects that yield a return greater that the minimum acceptable hurdle rate - The financing decision: choose a financing mix that maximises the value of the projects taken, and matches the assets being financed - the dividend decision: if there are not enough investments that earn the hurdle rate, return the cash to the owners - Hurdle rate: should be higher for riskier projects and reflect the financing mix used - debt or equity - Returns: should be time-weighted cash flow based, incremental returns, reflection all side costs and benefits - Financing mix: includes debt and equity, and can affect both the hurdle rate and the cash flow - Financing type: should be as close as possible to the asset being financed - How much? Excess cash after meeting all business needs have been met. - What form? Whether the cash should be returned as dividends, or stock buybacks or spin offs will depend upon taxes and the stockholder preferences

Five main categories of ratios

-Profitability: evaluate degree to which activities result in profits to owners -Activity: evaluate level of asset commitment and efficiency of asset usuage -Leverage: evaluate the use of debt financing -Liquidity: measures ability to meet future maturing obligations -Market based: measures accounting variable relative to market

Interest rate concepts

-Real vs nominal interest rate -simple vs compound interest -effective annual rate vs annual (nominal) percentage rate

Forecasting ROA

-Research McNamara & Duncan -Predicting ROA -Explained 78% of ROA variance: >Prior years Sales Turnover > Prior years change in GDP >Two year lag in interest rates > Last year aggregate corporate profits

What is Corporate Finance?

-Set of 1st principles that Govern how we run a business - Strategy, valuation, governance

Earnings Per Share EPS

Basic EPS- for firms without convertibles in the capital structure EPS= (Net income-pref. dividends/weighted no. ord shares outstanding) Denominator reflects daily average of ordinary shares issued adjusted for new issues and bonus issues Problems: EPS alone doe snot consider the investment required Difficult to compare across firms Either relate to price or asset backing per share (scale so comparable

Quoting debt securities on ASX

Benefits: - access to capital for growth - diversifying funding sources from traditional bank lending - strong public and investor profile of the ASX -access to a range of investors (institutional and retail)

Opportunity Cost of Capital

Best available return offered in the market on an investment of comparable risk and term to the cash flow being discounted

Price to Book Value (PB)

PB= Market Price per share/ NAB One more way to get value and supported by Fama and French

Debt VS Equity

Debt is not an ownership interest in the firm (no voting rights) Payment of interest on debt is fully tax-deductible (payment of dividends not considered a business expense, therefore paid out of after-tax profits) Unpaid debt is a liability of the firm - creditors may legally claim assets of firm where debt is unpaid -corporations cannot become bankrupt because of non-payment of dividends

Role of IRR

Do not need to know cost of capital to calculate IRR - need to know the cost of capital in order to apply IRR decision rule We observe in all examples, for any discount rate, a project only has one NPV - Calculation of NPV profile does not require cost of capital and has distinct advantage over IRR of being more informative and reliable in demonstrating impact on shareholder wealth -IRR provides useful information regarding sensitivity of project's NPV to errors in estimate of cost of capital -Difference between cost of capital and IRR is maximum estimation error in cost of capital that can exist without altering investment decision

Differences in scale

Double project = double NPV does not equal double IRR - IRR relative measure of project performance (E(r)), whereas NPV absolute measure (increase in wealth) Consider: book store vs coffee shop - IRR B=24% - IRR C=23% Both projects have same cost of capital (8%), therefore can infer them to be of equal risk -C has lower IRR but higher NPV because it is a larger scale project than B

Unlevered Net Income

Equal to incremental revenue less costs and depreciated, evaluated on an after-tax basis Note that the equation assumes all values increase as result of accepting project

Taxes

Estimate taxes using marginal tax rate, based on net income generated by rest of firm's operation - marginal tax rate- tax rate payable in next dollar of pre-tax income Are taxes relevant when EBIT is negative? - assumes firm has positive earnings in current period to offset project loss in any given year - can use tax loss carryback or carryforward to preserve value of tax loss, but need to explicitly account for timing of tax benefit > tax loss carryback - allows firm to receive refund for back taxes in current year > tax loss carryforward - used to offset future taxable income

Differences in Timing

Even when projects have same horizon, the pattern of cash flows over time will differ Consider C v M - IRR C =23% - IRR M = 26% Both projects have same cost of capital (8%), therefore can infer them to be of equal risk - C has lower IRR but higher NPV because it has higher growth rate than M - C has higher long run CFs, making it effectively a longer-term investment

Price-Earnings Ratio

PE= Market Value per share/ EPS Problems: A low value for one of these ratios could indicate either 1. Numerator is inflated or transient 2. denominator is inflated or transient

Resource constraints

Firm should accept all positive NPV projects to maximise SH wealth - limitations on scarce resources apply in practice so firm must choose best set of investments given RC Profitability Index (PI) - value created in terms of NPV per unit of resource consumed; accept if PI is greater than or equal to 0 (note: cut-off is 0, not 1) - assess efficiency of resource utilisation Two conditions must be satisfied: - set of projects accepted must completely exhaust the available resource - there is only a single relevant resource constraint

WACC

Firm uses multiple sources of capital to finance its operations and investments - sources of capital include debt, equity and hybrids - each source represents a unique risk/return trade-off to investors, imposes a unique cost to issuing firm Firm can use its Weighted Average Cost of Capital to evaluated investment opportunities only if the investments under consideration have the same risk and same mis of financing as the firm's assets in general - calculation of WACC weights the firm's component capital costs based on relative market values

Risk Analysis

Focus of debt holders and to some extent managers Business and financial risk Both unsystematic quantitive risk models- use weighted ratios Profitability, liquidity & leverage to predict risk and failure

Terminal Value

Free cash flow may also include terminal (continuation) value if project continues beyond forecast horizon - required for projects with an indefinite life, such as expansion of firm -include additional one-time cash flow at end of forecast horizon- amount represents market value (as of last forecast period) of free cash flow from project at all future dates -common to explicitly calculate free cash flow over short horizon, then assume cash flows grow at some constant rate beyond the forecast horizon

Disposals of Assets

Free cash flow must include after-tax liquidation or salvage value of any assets disposed of throughout project life - project may require disposal of surplus assets at start (inc. with net investment) as well as disposal of acquired assets at termination - firm recovers any investment in net working capital at termination of project - tax is due on difference between sale price and asset's net book value -some assets may have negative liquidation value i.e. firm incurs cost to remove and dispose of used equipment

Managing the agency issue

Good corporate governance, BOD is important

Call option

Has value to issuing firm, so must pay for this right either through lower price at issue or higher coupon rate through life of debt

Internal Rate of Return IRR

IRR= average expected return earned by accepting an investment opportunity - accept project if IRR is greater than or equal to cost of capital When considering independent projects, IRR will give same accept/ reject decision as NPW in many- but not all- situation - IRR only gives correct investment signal is project's CF follow a conventional pattern i.e. negative CF precede positive cash flows -Non-conventional pattern in CF: there can be as manny IRRs as the number of times the project's cash flows change sign over time

Law of one price

If equivalent investment opportunities trade simultaneously in different competitive markets, then they must trade for the same price in both markets - If Law of One Price violation = arbitrage opportunity

Capital Asset Pricing Model

If the market portfolio is efficient, systematic risk can be measured as a function of beta - beta of a security gives the expected % change in its return given a 1% change in the return of the market portfolio - beta therefore measures sensitivity of a security's return to the return of the overall market Cost of capital for a risky investment equals the risk-free rate plus a risk premium CAPM states that the risk premium is a function of the investment's beta and the expected return is given by (photo)

Economic Analysis

Inflation Interest Rates Exchange Rates Economic cycles Commodity Prices Aggregate Economy, Global Political Considerations Lead and lag relationships

Valuing Multiple Cash Flows

Perpetuity: PV= PMT/r Perpetuity with constant growth: PV= C/(r-g) - Identify the amount and timing of each cash flow (risk constant throughout the analysis period)

Firm Value

Is driven by the interactions among the investment, financing and dividend decisions and the conflicts of interest that arise among the different players in the game - managers, stockholders and lenders who do not always read from the same script

Repayment Provisions

Issuer can reduce public debt outstanding prior to maturity via a number of different mechanisms 1. Repurchase fraction of outstanding bonds at prevailing market prices 2. Tender offer to repurchase an entire debt issue 3. Exercise a cal provision to repurchase bonds at predetermined price If the call provision offers a cheaper way to retire bonds, issuer will forgo the option of purchasing the bonds in the open market and call the bonds instead - market price of bond will rise above predetermined call price only in an environment where interest rates (RR) are falling

NPV Profile: Nonexistent IRR

It is possible for an NPV profile to plot entirely below the x-axis

Discounted Payback Period

Length of time required for an investment's discounted cash flows to equal its initial cost - if project ever pays back on discounted basis, then it must have a positive NPV (assuming conventional cash flow pattern) - would not lead to acceptance of negative NPV projects, but may reject positive NPV opportunities -Not simple t calculate, still subject to arbitrary cut-off point, and ignores cash flows after that point

Capital Structure Ratio

Leverage = Debt/assets

Debt financing

Long term V short term (maturity matching principle)

Depreciation

Method used for accounting and tax purposes to allocate the original purchase cost of the asset over its economic life Possible that firm may use different dep. methods for accounting vs tax purposes - depreciation only impacts on free cash flow through depreciation tax shield, so use tax-based depreciation method only Firm should generally use the most accelerated depreciation schedule allowable for tax purposes - understand concept of accelerated depreciation but only required to apply straight-line method in project evaluation

Discounting ->

Moving backward in time

Net Asset Backing NAB

NAB: (Shareholders' Equity -Pref. Shares)/No ordinary shares

NPV Profile & IRR Problems

NPV of project depends on appropriate cost of capital -how do we handle uncertainty regarding discount rate> NPV Profile-> graphical representation of relationship between NPV and discount rate -IRR is discounted rate that sets NPV of project's cash flows equal to zero - As for NPV, IRR considers amount, timing and risk of cashflows Discount rate is assumed reinvestment rate for projected cash flow - for IRR to be realised, cash flows need to be reinvested at the project's unique IRR for the full term of the project

Mutually Exclusive Investments

NPV- accept project with highest positive NPV - Constant chain of replacement assumption- each project is assumed to be replaced at the end of its economic life by an identical project Annual equivalent benefit (AEB) - solve for unknown payment on an annuity that has the same life as the project and a present value equal to the project's NPV -accept project with highest AEB, provided both projects have the same risk and therefore the same required return IRR cannot be compared meaningfully if project differ in terms of scale of investment, timing of cash flows or riskiness

Core Value Driver Ratios

OPM, ATO, ROA

Operating profit margin

OPM=EBIT/sales Driven by: -Sales growth -Gross profit margin- (sales-cost of sales/sales) -Expense management The profit before finance costs and taxes

Project Cash Flows

Objective is to consider, the process of estimating a project's cash flows - expected future cash flows key input to discounted cash flow analysis, but subject to forecasting error -demonstrate how to compute sensitivity of NPV to uncertainty in cash flow forecasts Compute free cash flow from incremental earnings (whats changed) by eliminating all non-cash expenses and including all capital investments - apply NPV decision criteria and identify drivers of project value

Corporate Long-Term Debt

Obligation to pay a specific amount of money to another party Characteristics: -Security- secured (mortgage) v unsecured (debenture) -Maturity- short term vs long term -Interest rate- fixed vs floating -Market- domestic vs foreign Agency relationship between bondholder (principal) and shareholders (agent) -asymmetric information, specifically moral hazard -managed through provisions within indenture- protective covenants (positive v negative)

Call Provision

Option for issuing firm to refinance debt -NPV of call provision at issue is zero: firm prefers to issue callable debentures only if there is an asymmetric issue in issuing firm's favour not priced into security by investor (lender)

Sources of short term debt

Overdraft, bank bills, commercial bills, factoring

Cost of capital=r

P=E/r = ROE x SHF/r -SHF: Shareholders funds (assets= liabilities+owners equity shareholders funds) -ROE: Return on equity (driven by ROA less leakages to taxes and interest to debt)

Time Value of Money

Principle of value additivity - we can only add/ subtract or compare cash flows if they are valued at the same point in time - requires us to understand the abstract notions of PV and FV - having identified an appropriate discount rate that reflects the degree of risk (uncertainty) associated with the cash flow being evaluated, we can move the value of a CF through time in order to determine the net benefit accruing to the firm as a result of the proposed decision - accept the decision alternative that offers the highest positive net benefit > application to valuation

Capital Budgeting

Process of allocating firm's capital for investment - connects strategic objectives to tactical implementation - critical decision-making process: difficult to reverse decision due to long-lived, high value and often specialised, assets

Return on Equity

ROE= Net Profit/ Total Equity

Differences in Risk

Ranking projects by IRR (E(r)) ignores risk differences Consider E IRR E = 28% E has the highest IRR of the four alternatives but the lowest NPV -investment in E is riskiest, seen through its higher cost of capital -despite higher IRR, it is not sufficiently profitable to be as attractive as the safer alternatives

Financial Instruments

Represent legal agreements involving some sort of monetary value - equity based (stock) representing ownership of the asset -debt based (bonds) representing loans made by the investor to the owner of the asset

Risk VS Return

Risk equates to uncertainty. - need to identify all possible future outcomes and assign a probability to each outcome in order to formulate expectations - given a probability distribution of returns, can compute: expected return, variance and standard deviation or return (absolute risk) Observe a positive trade-off between risk and return as investors seek to maximise utility (satisfaction) - investors are rational, risk-averse suppliers of loanable funds

Portfolio Theory

Riskier investments must offer investors higher expected returns to compensate them for the extra risk they are taking on Diversification (As function of correlation) can eliminated idiosyncratic (unique) risk but does not elimination systematic (market) risk - investors require a risk premium for being exposed to systematic risk as it cannot be diversified away

Separation Principle

Security transactions in a perfectly competitive market neither create nor destroy value on their own - therefore, we can evaluated the net benefit of na investment decision separately form decisions the firm makes regarding how to finance the investment Financial transactions are not sources of value but instead serve to adjust the timing and risk of cash flows to best suit the needs of the firm or its investors - assuming transactions occur in a perfectly competitive market

Ownership vs Control

Separation of ownership and control: an agency relationship between shareholders, debt holders and management

Project Revenues and Costs

Sunk costs - unrecoverable cost already incurred- has been or will be paid regardless of the decision about whether or not to proceed - does not meet definition of incremental earnings so excluded from analysis Opportunity costs - cost of using existing asset, measured by value asset would have provided in its next best alternative use -must be included within incremental earnings for project evaluation - ensure that cost is measured at current opportunity value and not past acquisition (sunk cost) value Externalities - CF that occur when project affects other areas of the firm's business, including erosion - cannibalisation: CF of new project that come at expense of firm's exisiting projects - only included within incremental earnings to the extent that they are unique to project acceptance Other complexities - new product adoption rates -average selling price and cost of production change over time- impact of inflation, competition, and changes in technology

Net Present Value NPV

The Basics NPV= PV(cash inflows) - PV (cash outflows) -considers magnitude and timing of cash flows over entire project -cash flows discounted at cost of capital to incorporate explicit assessment of risk -> assumes cash flows reinvest at cost of capital -great weight given to less risky earlier cash flows NPV= change in shareholder wealth today as result of accepting project - accept project if NPV greater than or equal to $0 -provides absolute estimate of wealth created by investment, measured in dollars

Incremental IRR

The IRR of the incremental cash flows that would result from replacing one project with another. -alternative to comparing IRRs of mutually exclusive projects -discount rate at which it becomes profitable to switch from one project to the other Effectively evaluation a single project - the decision to switch - rather than evaluating two mutually exclusive alternatives - assumes incremental cash flows follow a conventional pattern - assumes projects have same cost of capital - same limitations apply to incremental IRR as they do to the absolute IRR methodology If IRR of two projects is graphed, the cross-over point =incremental IRR

Incremental earnings

The amount by which the firm's earnings are expected to change as a result of the investment decision Assume revenues and costs occur at the end of each year Need to forecast unlevered net income: 1. non-cash expenses such as depreciation and amortisation are allowable tax deductions, so tax (a real outflow) is a function of earning as opposed to cash flow 2. Interest and financing costs are excluded from evaluation in order to assess the investment decision independently of the financing decision

Interest Rates

The discount rate must match the time period of cash flows, and should reflect the actual return that could be earned over that time period

Effective annual rate

The frequency with which interest is compounded will affect the value of a given cash flow, holding all else constant - effective rate/ compounding period (i) -> valuation (i=inom/m) -effective rate/year (ieff) -> comparison (photo) WACC requires all component capital costs to be measured with same compounding frequency before they can be averaged for application in decision models - equivalent to rate that would need to be paid/ earned if interest were compounded only once per year

Arbitrage

The practice of buying and selling equivalent goods or portfolios to take advantages of a price difference - opportunity to generate profit without risk or investment - buy low, sell high

Agency problem

When managers, despite being hired as the agents of shareholders, put their own self-interest ahead of the interests of shareholders

Indenture

Written agreement between corporation and lender (investor) detailing terms of the debt issue: - basic terms of issue -amount of debt -description of property as security -repayment arrangements -call provisions -details of protective covenants Trustee appointed by corporation to represent debt holders: - ensure compliance wiht terms of trust deed -manage sinking fund -represent debt holders in event of default

Call premium

amount by which call price exceeds face value

Compounding ->

moving forward in time (Future Value)

Sources of long term debt

term loan/mortgage, leasing corporate bonds hybrid securities (convertible notes, warrants)