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Corporate Financial Management 1. Jan Vlachý <[email protected]> Brigham, E.F., Ehrhardt, M.C. Financial Management : Theory and Practice, 13 th Edition. Basic Concept s. Chapter s 1-3. Corporate Financial Management Is t he Art/Science of Creating and Maintaining the Value of a Company.

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Corporate financial management 1

Corporate Financial Management 1

Jan Vlachý<[email protected]>

Brigham, E.F., Ehrhardt, M.C. Financial Management: Theory and Practice, 13th Edition


Basic concept s

Basic Concepts

Chapters1-3

  • Corporate Financial Management

    • Isthe Art/Science of Creating and Maintaining the Value of a Company.

    • Gives a Firm its Common Language.

  • It Consists of

    • Investment Decisions

    • Financing Decisions

    • Managerial Decisions

Corporate Financial Management 1


Investment vehicle model

Money × Real Assets

Money × Financial Assets

The World

The Firm

Financial

Markets

Investors

Financial

Intermed.

Financ-ing

Invest-ments

Corporate Financial Management

Financial Markets

Investments

F I N A N C E

Investment Vehicle Model

The Set of Contracts Model recognises imperfections and includes the assumption of both explicit and implicit contracts, incl. Corporate Organization.

Corporate Financial Management 1


The financial environment

The Financial Environment

  • Competitive Economic Environment

    • Two-Sided Transactions (Buyer×Seller Equil.)

    • Risk-Return Tradeoff

    • Signalling/ Behavioral Principle

      <= Market Efficiency (Information, Transactions)

  • Value (How can some people become rich?)

    • New Ideas, Expertise

    • Options

    • Time Value of Money

Financial transactions create an equilibrium; Real investments create value

Corporate Financial Management 1


Accounting cash flows taxes

Accounting, Cash Flows & Taxes

  • Purposes of an Accounting System

    • Reporting the Firm’s Financial Activities to Stakeholders

    • Providing Information to Firm’s Decision Makers

  • Financial Management strives to use and interpret the information

    • Accounting - historical view

    • Finance - current and future

Corporate Financial Management 1


Limitations of accounting

Limitations of Accounting

  • Why don’t shares trade at Book Val.?

  • Market×Book Value of Assets/Liabs

    • Historical Accounting (depreciation)

    • Inflation (value benchmarks have changed)

    • Liquidity (can it readily be sold?)

    • Time Value of Money (relates to Maturity and Terms)

      Note: Finance prefers to deal with cash flows in a time perspective.

Corporate Financial Management 1


Taxes

Taxes

  • Income Tax

    • Make analyses on after-tax basis

    • For financial decisions, use marginal tax rate(relavant if tax is progressive or unsymmetrical on negative base)

  • Capital Gains Tax

  • Dividend/Interest Income Treatment

  • System Biases (Loss Carry-forwards, Exemptions, Deductions)

Corporate Financial Management 1


Time value of money

Time Value of Money

Chapter 4

  • Future goods are not valued so highly as the same goods available at an immediate moment of time, nor do they allow their owners to achieve the same utility. For this reason, it must be considered that they have a more reduced value in accordance with justice. (Giles Lessines, 1285)

    ... i.e.

  • People generally prefer having any amount of money at their disposal earlier rather than later.

    ... i.e.

  • Investors require positive returns as compensation for the inconvenience.

Corporate Financial Management 1


On present and future values

On Present and Future Values

  • You deposit $1,000 today with a bank that pays 5% interest per year.

  • FV1= PV+r×PV= PV(1+r)= $1,000×1,05= $1,050 (Simple Interest)

  • FV2= FV1(1+r)= PV(1+r)×(1+r)= PV(1+r)2= $1,102.50 (Compound Interest)

Discounted Cash Flow Framework

FVt= PV(1+r)tPV= FVt / (1+r)t

Corporate Financial Management 1


Return net present value

C0

C1

C2

C3

C4

t

Return, Net Present Value

  • Return of an Investment (Rate of Return, Yield):

  • NPV= Present Value of expected cash flows (+positive-negative)

Corporate Financial Management 1


Practical issues

Practical Issues

  • Distinguish:

    • Realized Return

    • Expected Return (<= Risk)

    • Required Return (<= Unperfect Mkts)

  • Financial securities are usually priced “fairly” (Market Equilibrium).

  • Investment projects (and other entrepreneurial decisions) should bring value, i.e. have positive NPV.

Corporate Financial Management 1


Valuing single cash flows ex

Valuing Single Cash Flows (Ex.)

  • What is the Future Value of $2,000 invested at 3% per year for five years?

  • What is the Present Value of CZK 10m to be received two years from now if the required return is 4% per year?

  • What is the Expected Return for an investment costing €10,000 today and offering €12,000 in three years?

Corporate Financial Management 1


Valuing multiple cash flows

t Ct PV(Ct)

0$ -10,000-10,000.00

1$ 2,000 1,818.18

2$ 8,000 6,611.57

3$ 5,000 3,756.57

Total PV:$ 2,186.33

Valuing Multiple Cash Flows

  • You can invest $10,000. As a result, you expect to get $2,000, $8,000, and $5,000 over the next three years, respectively. If the required return is 10%, what is the NPV of your investment?

  • What is the return if you know the NPV?

Corporate Financial Management 1


Annuities

Annuities

  • Types of Annuity

    • Ordinary Annuity (Payments at end of period)

    • Annuity Due (Payments at beginning of period)

    • Deferred Annuity (First repayment more than one period after drawing)

FVAn = PVAn(1+r)n; PVAn[due]= PVAn(1+r);

PVAn[defd]= PVAn/(1+r)d

Corporate Financial Management 1


Amortization schedules

Amortization Schedules

  • A $1,000 loan yielding 8% requires equal payments at the end of the next three yrs. How much principal will be rpd. in Year 2?

    PMT = $1,000×[.08(1.08)3/(1.083-1)] = $388.03

P2 = V1 - V2 = |PMT2| - I2 = $332.67

Corporate Financial Management 1


Perpetuities

Perpetuities

Problem 4-27

PV = $100 / 7% = $1,428.57

Growth Perpetuities:

PMTt = PMT0(1+g)t

PVgrowth = PMT1/(r-g) (... r > g)

Corporate Financial Management 1


Compounding frequency 1

Compounding Frequency (1)

  • Compare annual return on deposit with 6% interest paid annually and monthly.

  • FVA = PV×(1 + 6%) = PV×1.06

  • rA = (FVA-PV) / PV = .06×PV/PV = 6%

  • FVM = PV×(1 + 6%/12)12 = PV×1.00512 = PV×1.0617

  • rM = (FVM-PV) / PV = 6.17%

Corporate Financial Management 1


Compounding frequency 2

Compounding Frequency (2)

  • Compare the cost of a 6% (nominal rate) loan with monthly and quarterly interest.

  • Nominal Rate×Effective Annual Rate

  • NR = m×rm

  • EAR = (1 + rm)m - 1

  • EARM = 1.00512 - 1 = 6.17%

  • EARQ = 1.0154 - 1 = 6.14%

Corporate Financial Management 1


Bond and stock valuation

Bond and Stock Valuation

Chapters 5,7

  • Main sources of capital for Company

    • Bond: Debt Capital

    • Stock: Equity Capital

  • Claim on fut. cash flows for Investor

    • Bond: Contractual interest and princi-pal payments (or proceeds of sale)

    • Stock: Dividends (theoretically forever) or proceeds of sale

Corporate Financial Management 1


Valuation p rocedure

Valuation Procedure

  • Based on discounted cash flow concept:

    • Estimate expected future cash flows

    • Determine required return (depending on the riskiness of the expected cash flows)

    • Compute the present value

  • Other possibilities: Market price of same or comparable asset

Corporate Financial Management 1


Features of bonds stocks

Features of Bonds/ Stocks

  • Par (Face, Princ.) Value

  • Coupon (Interest) Rate

  • Coupon Payment Frequency

  • Maturity: Original (Issue), Remaining(Residual)

  • Terms of Repayment: Bullet, Sinking Fund, Zero-Coupon (Pure Discount)

  • Call Provision (Option); other Rights; Junior/Senior

  • ???

  • Dividends

  • Dividend Payment Frequency

  • N/A

  • N/A

  • Common/Preferred

  • Rights(Warrants, Convertibles)... See Chapt. 19, Hybrid Financing

Corporate Financial Management 1


Bond valuation

Bond Valuation

Problem 5-1

t

1

2

3

4

...

8

9

10

11

12

Ct

$ 80

$ 80

$ 80

$ 80

...

$ 80

$ 80

$ 80

$ 80

$1,080

r= 9%

PV

$ 73.39

$ 67.33

$ 61.77

$ 56.67

...

$ 40.15

$ 36.83

$ 33.79

$ 31.00

$ 383.98

$ 928.39

For bond w/semi-annual coupons n=24, Ct=$40.

To put required return on same basis as annual bond, one should assume EAR= 9% = (1+rS)2 - 1, i.e. rS = \/1.09 - 1 = 4.4%.

Corporate Financial Management 1


Yield to maturity yield to call 1

Yield to Maturity/ Yield to Call (1)

  • Assume Johnson Co. has a bond with a face value of $1,000 that matures in 12 years, has a coupon rate of 8%, and is currently selling for $928.39. What is the required return to buy the bond (YTM = 9.00%)?

  • Assume it can be called in 10 years at a call price of $1,100. What would be therequired return to buy the bond if we knew the option would be excercised (YTC = 9.79%)?

Corporate Financial Management 1


Yield to maturity yield to call 2

Yield to Maturity/ Yield to Call (2)

  • Yield to Maturity= Promised Return

  • Yield to Call= Return if Called

  • N=12; PV=-928.39; PMT=80; FV=1,000 => I (YTM) = 9.00%

  • N=10; FV=1,100 => I (YTC) = 9.79%

  • Expected Return= YTM minus Risk

    • Credit (Default) Risk <= Rating

    • Interest Rate Risk/ Reinvestment Risk

    • FX Risk, Liquidity Risk...

Corporate Financial Management 1


Market interest rates yield curve

Market Interest Rates/Yield Curve

Corporate Financial Management 1


Stock valuation

Stock Valuation

Problem

  • Value a share which is expected to pay dividends of $2.72 and $3.10, respectively, over the next two years, and sold thereafter for $48, if the required return is 10%?

  • V=$2.72/(1.1)+$3.10/(1.1)2+$48/(1.1)2= $44.70

  • But... How did I estimate the market price in 2 years?

  • Let us assume constant dividends of $4.80 after Year 2.

  • Using perpetuity valuation: V2=$4.80/10%= $48

Corporate Financial Management 1


Constant growth model

Constant Growth Model

  • Dt = D0(1+g)t

  • V = D1/(r-g) (... r > g)

  • e.g.V = $36(1.05)/(13%-5%) = $472.5

  • e.g.r = $1.30/$21.25 + 6% = 12.12%

  • CG formula can also be used for determining a horizon (terminal)value or for valuing declining growth stock.

  • For erratic or supernormal growth stock, split cash flows into two parts.

Corporate Financial Management 1


Risk and return

Risk and Return

Chapters 6, 7

  • Risk refers to the chance that some unexpected event would occur.

  • In business, that would mean the decrease of value of the firm, in financial markets any change in the value of financial instruments etc.

  • In other words, actual returns will differ from expected returns.

  • The expected return should therefore compensate an investor for the perceived risk.

Corporate Financial Management 1


Investments with risk

Economy

Prob.

T-Bill

Eq 1

Eq 2

Gold

Bond

Recession

0.10

5.0%

-25.0%

-15.0%

20.0%

10.0%

Below avg.

0.20

5.0

-5.0

-5.0

7.0

7.0

Average

0.40

5.0

15.0

10.0

0.0

6.0

Above avg.

0.20

5.0

25.0

20.0

-2.0

5.0

Boom

0.10

5.0

50.0

30.0

-10.0

2.0

1.00

Investments with Risk

Problem

Corporate Financial Management 1


Expected return

Expected Return

  • E(r) = Σwiri

  • E(rEQ1) = .10(-25%) + .20(-5%) + .40(15%) + .20(25%) + .10(50%) = 12.5%

  • Eq 1 has the highest expected return.

  • Is it the best investment?

Corporate Financial Management 1


Stand alone risk

Stand-Alone Risk

  • σ = \/Σ(wi(ri-E(r))2

  • σEQ1 = \/[.10(-25-12.5)2 + .20(-5-12.5)2 + .40(15-12.5)2 + .20(25-12.5)2 + .10(50-12.5)2] = 19.4%

Volatility

Corporate Financial Management 1


Probability distributions

Prob.

T-bill

Eq 2

Eq 1

HT

0

5

12.5

8.5

Actual Return (%)

Probability Distributions

Corporate Financial Management 1


Portfolio risk 1

Economy

Prob.

Eq 1

Gold

Port.

Recession

0.10

-25.0%

20.0%

-2.5%

Below avg.

0.20

-5.0

7.0

1.0

Average

0.40

15.0

0.0

7.5

Above avg.

0.20

25.0

-2.0

11.5

Boom

0.10

50.0

-10.0

20.0

Portfolio Risk (1)

  • Assume portfolio with 50% invested in Eq 1, and 50% in Gold.

  • E(rP) = 7.25%

  • σP = 6.1%

Corporate Financial Management 1


Portfolio risk 2

Portfolio Risk (2)

  • p(=6.1%) is much lower than:

    • either Eq 1 (19.4%) or Gold (7.5%).

    • average of Eq 1 and Gold (13.5%).

  • The portfolio offers a decent return (average of Eq 1 and Gold returns) with low risk.

  • The key is low (actually negative) correlation between Eq 1 and Gold returns, facilitating diversification.

Corporate Financial Management 1


Managing portfolio risk

Managing Portfolio Risk

  • Systematic and Specific Risk [Law of Large Numbers] (Insurance, Consumer Credit)

  • Equilibrium Theories, e.g. Capital Asset Pricing Model [Sharpe, Lintner] (Equity Markets, Capital Investments)

  • Portfolio Theory [Markowitz] (Market Portfolios), based on function σP=ƒ(w1,w2,w3,..,σ1,σ2,σ3,..,ρ12, ρ13, ρ23,..)

Corporate Financial Management 1


Effect of diversification

 (%)

Specific (Diversifiable) Risk

35

Total Risk

20

0

Systematic Risk

102030 40

N

Effect of Diversification

Corporate Financial Management 1


Capital asset pricing model

Capital Asset Pricing Model

  • In an efficient market, the required return will equal the expected return.

    • efficient market => equilibrium price

    • transactional, informational efficiency

    • efficient market  arbitrage

  • An asset’s required return is the sum of the riskless return and an asset-specific risk premium.

  • Beta (β) is a measure of the asset’s market (systematic, undiversifiable) risk.

  • SML: ri = rF + β(rM - rF)

Corporate Financial Management 1


Beta as a sensitivity measure

β = 1

ri

0 < β < 1

β = 0

rF

45°

rM

Beta as a Sensitivity Measure

ri = rF + β (rM - rF)

Corporate Financial Management 1


Capm utilization

CAPM Utilization

Problem

  • Two shares (in the same market) with known rF, βA, βB, rA, looking for rB.

  • rA = rF + βA (rM - rF)

  • rB = rF + βB (rM - rF)

  • 14% = 6% + 1.4(rM-6%) => rM= 11.7%

  • rB = 6% + 1.1(11.7%-6%) = 12.3%

    Note: The beta of a portfolio equals the weighted average of its component betas (VPbP = VAbA + VBbB + ...)

Corporate Financial Management 1


Options

Options

Chapter 8

  • Option = Right (Financial and Embedded Options, i.e. Contracts) or Opportunity (Real Options)

  • Financial options are traded contracts, derivatives of Underlying Assets (Equities, FX, Bonds, Commodities, Indices...)

  • Financial Derivatives include Options, Warrants, Forwards, Futures, Swaps, Repos...

  • Financial Derivatives are used primarily for Risk Management (Hedging, Speculation) ... See Chapt. 23

Corporate Financial Management 1


Applications

Applications

  • Financial Options

    • American vs. European Options

    • Call vs. Put Options

    • Exotic Options (various terms of exercise, caps, floors; exchange options, compound options,...)

  • Embedded Options... Constitute Contracts

  • Real Options... In Business Decisions ... See Chapts. 11,25

Corporate Financial Management 1


The value of options

Intrinsic Value (Call Option)

Total Value (Call Option)

V

V

out-of-the-money

in-the-money

p

S

p

Time Value

at-the-money

The Value of Options

  • Intrinsic Value (would the option be executed if nothing changed till excercise date?) = ƒ(p; r; t) ...usually easy to assess; can be used for designing option strategies

  • Time Value = ƒ(t; s) ...calculated by means of models (using market equilibrium assumption and replication)

Corporate Financial Management 1


Using the replication principle

Using the Replication Principle

Call Option: S = $40, p = $32, d = $16 or u = $64 at time t; rt = 2%.

d: Option out of the money, i.e. Vd = 0

u: Uption in the money, i.e. Vu = 64 - 40 = $24

  • Income structure can be replicated with N forward transactions. These must have zero value if underlying asset costs $16, and must therefored be issued with forward price F = $16. Their present value is VF = p - F/(1+rt) = $16.31.

  • Value of N forward transactions at settlement if underlying asset costs u is Vu = N(u - F). To replicate u = 64  Vu = 24, N = 24/(64-16) = 0.5.

  • The option value is thus VC = 0.5×16.31 = $8,16.

Corporate Financial Management 1


Numerical model binomial crr

F = 1 100; N = 1

VF = 1157,63 - 1100e-0,25×5% = 71,29

VC = NVF = 71,29

F = 1 000

N = (u - S)/(u - d) = 2,50/102,5 = 0,0244

VF = 1050 - 1000e-0,25×5% = 62,42

VC = NVF = 1,52

N = 0 => VC =0

Numerical Model (Binomial, CRR)

  • Call Option S = 1 100; p = 1 000; r = 5%; 4 periods

Corporate Financial Management 1


Analytical model black scholes

Analytical Model (Black-Scholes)

VC = p N(d1) - S e-rt N(d2)

d1 = [ln(p/S) + (s2/2) t] / (st)

d2 = d1 - st

p= $500; S= $510; r= 3%; t= 3months (=0,25); s =20%

d1 = [ln(500/510)+(0,04/2)×0,25]/(0,2×0,5) = -0,0730

d2 = -0,0730 - 0,2×0,5 = -0,1730

N(d1) = N(-0,0730) = 0,4709; N(d2) = N(-0,1730) = 0,4313 (cummulative distribution function for a standardised normal random variable)

VC = 500×0,4709 - 510×e-20%×0,25×0,4313 = $17,12

VP = VC - p + Se-rt = 17,12-500+510×e-3%×0,25 = $23,31 (using put-call parity)

Corporate Financial Management 1


Cost of capital

Cost of Capital

Chapter 9

  • Cost of Capital = Required Return for Capital Budgeting Project

  • 2 possible approaches

    • Use CAPM

    • Firm Value = Equity Value + Debt Value.

  • In a perfect market, a company cannot affect its value by changing the way it is financed - it just influences the distribution of risks and returns between different classes of investors.

Corporate Financial Management 1


Risk return of real assets

Risk/Return of Real Assets

  • CAPM can be extended to include real assets (i.e. capital budgeting projects)

    • Pure Play Method (Finding single-product companies in the same line of business as project being evaluated)

    • Accounting Beta Method (Regression of return of assets against average return on assets in the whole market)

Corporate Financial Management 1


Weighted average cost of capital

Weighted Average Cost of Capital

  • WACC = (1-L)re + L(1-T)rd

    • L = D/(D+E)... Leverage

    • T... Marginal Income tax Rate

  • Always based on opportunity, not historical costs and values!

  • After-tax cost must be used for all components!

  • Correct risk assumptions have to be made for individual projects!

Corporate Financial Management 1


Corporate financial management 1

WACC

Problems9-4, 9-7

  • r = $3.6 / $70 = 5.14%

  • c = $3.6 / ($70×(1-5%)) = 5.41%

  • WACC = 30%×6%×(1-40%)+ 5%×5.8%+ 65%×12% = 9.17%

Corporate Financial Management 1


Component cost of equity

Component Cost of Equity

  • Ways to estimate required return:

    • DCF Method

    • CAPM Approach (b of equity, not project!)

    • Bond Yield + Risk Premium Method

  • Equity for new projects may come from retained earnings or new issue.

  • New issues incur flotation costs. In this case, the component cost of capital is higher than required return.

Corporate Financial Management 1


Application of dcf method

Application of DCF Method

  • QST stock is trading at $30 a share. QST will pay a $3 dividend at the end of the year and expects 5% annual growth. Costs of flotation amount to 10%. What is the required return and cost for new equity?

  • r = D1/V + g = $3/$30 + 5% = 15%

  • Vnet = V(1-F) = $30(1-10%) = $30×90% = $27

  • re = D1/[V(1-F)] + g = $3/[$30(1-10%)] + 5% = 16.1%

Corporate Financial Management 1


Risk leverage beta and wacc

Risk, Leverage, Beta and WACC

  • Operating Leverage: influences rA, i.e. both rE and rD<=> an increase in operating risk increases bA and WACC.

  • Financial Leverage: in efficient markets, an increase should increase bd, but leave bA and WACC unchanged.

    (1-TL)bA = L(1-T)bD + (1-L)bE(= portfolio)

    Assuming low risk of debt, it is possible to approximate bA = bE (1-L)/(1-TL)

    ... on Leverage more in Chapt. 15

Corporate Financial Management 1


Distinguish risks

Profit

Shldr. Return

L = 0

Units Sold

Co. Return

L = 50%

Distinguish Risks

  • Operating (Business) Risk (depends on structure of firm’s assets, not structure of financing) <= Operating Leverage

  • Financial Risk (based on firm’s capital structure) <= Fin. Leverage

Corporate Financial Management 1


Basics of capital budgeting

Basics of Capital Budgeting

Chapter 10

  • Generate ideas

  • Estimate the expected future cash flows from the project.

  • Assess the risk and determine a required return(cost of capital, hurdle rate, discount rate).

  • Compute present value of cash flows; if project has a positive NPV, it creates value => should be accepted.

    Alt.: Find market price or compare with similar asset

Corporate Financial Management 1


Types of projects

Types of Projects

  • Capital budgeting projects include:

    • New products and new businesses

    • Maintenance projects

    • Cost saving/ revenue enhancement

    • Capacity expansion

    • Projects required by regulation/ policy

  • Independent/Exclusive Projects

  • Conventional/Nonnormal Cash Flows

Corporate Financial Management 1


Alternative budgeting measures

Alternative Budgeting Measures

  • Net Present Value

  • Internal Rate of Return (=Expected Rtrn)

  • Profitability Index

  • Modified IRR(includes cost of capital)

  • Payback... ignores time value of money and cash flows beyond payback

  • Discounted Payback

Corporate Financial Management 1


Investment criteria

Investment Criteria

Problem

  • PB = 2 + (10,000/30,000) = 2.3 years

  • DPB = 2 + (17,934/22,539) = 2.8 years

  • NPV = ΣDCF = $18.266

  • PI = ΣDCF[1-4] / |CF0| = 1.26

  • IRR = 22.24%

  • MIRR = (129,230/70,000)1/4 - 1 = 16.56%

Corporate Financial Management 1


Issues

Issues

  • IRR brings same results as NPV with independent and conventional projects only

  • Unequal lives of exclusive projects, e.g. replacement projects ... use common horizon calculation or Equivalent Annual Annuities(EAA = NPV[r(1+r)n/(1+r)n-1])

  • It is realistic to assume some kind of capital budget constraint ... use artificially high discount rate or capital rationing (e.g. ranking by Profitability Index)

Corporate Financial Management 1


Estimating cash flows

Estimating Cash Flows

Chapter 11

  • Cash flow  income (includes e.g. depreciation, ignores time value)

  • Measure on incremental(marginal) basis

  • Only future expenditures/revenues are relevant (avoid sunk costs)

  • Include taxes; not financing costs(they are reflected in cost of capital)

Corporate Financial Management 1


Types of budgeting cash flows

Types of Budgeting Cash Flows

  • Net Initial Investment Outlay

    • new assets purchase, old assets sale, increase in net working capital

  • Net Operating Cash Flow

  • Nonoperating Cash Flows

    • overhauls, changes in working capital

  • Net Salvage (Termination) Value

  • Tax Adjustment (Capitalizing×Expensing)

Corporate Financial Management 1


Est cash flows

Est. Cash Flows

Problems 11-1,2,3

Corporate Financial Management 1


Budgeting cash flows

Problem 11-9

Budgeting Cash Flows

NPV= - 7,160 + 2,000/1.15 + 2,384/1.152 + 1,968/1.13 + 1,744/1.154+ 1,712/1.155+ 3,232/1.156 = $921.36

Note: Different remaining lives, working capital investment

Corporate Financial Management 1


Analyzing risk

Analyzing Risk

  • Market Risk

    • Measured by b (see CAPM) impacts discount rate

  • Stand-Alone Risk

    • Break-even Analysis

    • Sensitivity Analysis

    • Scenario Analysis

    • Monte Carlo Simulation

Corporate Financial Management 1


Simple example

Simple Example

Project costs $100,000, expected sales 1,000 units, price $80/unit, cash op. exp. $40/unit, 5-year life, fully amortized, terminal value $10,000. Cap. cost 12%, tax rate 25%. What is its NPV?

V = -I + [N×(P-U)×(1-T)+D×T][((1+r)n-1) /r(1+r)n] + [F×(1-T)]/(1+r)5 = -100,000 + [30,000+5,000]×3.60 + 7,500/1.76 = $ 30,423

Corporate Financial Management 1


Break even analysis sales

Break-even Analysis (Sales)

V = -I + [N×(P-U)×(1-T)+D×T]×3.60 + [F×(1-T)]/(1+r)5

What N* would result in V = 0?

-I + [N*×(P-U)×(1-T)+D×T]×3.60 + [F×(1-T)]/(1+r)5 = 0

N* = [(100,000-7,500/1,76)/3.60-5,000]/30 = 720 pcs.

i.e. the project breaks even at 720 units sold.

Usually easier to use numerical iteration.

Corporate Financial Management 1


Sensitivity analysis price

Sensitivity Analysis (Price)

V = -I + [N×(P-U)×(1-T)+D×T]×3.60 + [F×(1-T)]/(1+r)5

V/P = [N×(1-T)]×3.60 = 750×3.60 = $ 2,700

i.e. a price cut of $1 will result in a project value decrease by $ 2,700.

Almost always easier to use numerical simulation.

Corporate Financial Management 1


Scenario analysis sales u cost

Scenario Analysis (Sales, U.Cost)

Corporate Financial Management 1


Real options

Real Options

  • Flexibility to adjust plans based on newly acquired information may increase NPV.

    • Growth/development options

    • Contraction/abandonment options

    • Investment timing options

    • Exchange options

  • Valuation methods:

    • Closed-form (analogy w/B-S)... rare

    • Decision trees

    • Monte Carlo

      ... further reading in Chapt. 25

Corporate Financial Management 1


Financial planning

Financial Planning

Chapter 12

  • Pro-Forma Financial Statements

    • Forecast the amount of external financing that will be required

    • Evaluate the impact that changes in the operating plan have on the value of the firm

    • Set appropriate targets for compensation plans

Corporate Financial Management 1


Steps in financial forecasting

Steps in Financial Forecasting

  • Forecast sales

  • Project the assets needed to support sales

  • Project internally generated funds

  • Project outside funds needed

  • Decide how to raise funds

  • See effects of plan on ratios and stock price

Corporate Financial Management 1


Additional funds needed

Cash

$360

Accts. pay.

$1,200

Accruals

600

Accounts rec.

2,400

S.-Term Loan

800

Inventory

1,800

Total CL

$2,600

Total CA

$4,560

L-T debt

1,000

Net FA

3,000

Equity

3,960

Total assets

$7,560

Tot. liab.&eq.

$7,560

Problem

Additional Funds Needed

Sales = $12,000; M = NI/Sales = 6%; P = D/NI = 25%.

Corporate Financial Management 1


Key assumptions

Key Assumptions

  • Operating at full capacitylast year.

  • Each type of asset grows proportionally with sales.

  • Payables and accruals (i.e. current liabilities) grow proportionallywith sales.

  • Existing profit margin (6%) and payout (25%) will be maintained.

  • Sales are expected to increase by $3 million. (%S = 25%)

Corporate Financial Management 1


Graphical illustration

Assets

Assets = 0.63 × Sales

9,450

Assets =

(A/S)×Sales

= 0.63($3,000)

= $1,890

7,560

Sales

0

12,000

15,000

Graphical Illustration

A/S= $7,560/$12,000 = 0.63 = $9,450/$15,000

(i.e. Capital Intensity Ratio remains unchanged)

Corporate Financial Management 1


Calculating afn

Calculating AFN

AFN = Required Increase in Assets - Spontaneous Increase in Liabilities - Increase in Retained Earnings

AFN= A×(ΔS/S0)- L*×(ΔS/S0)- M×S1(1-P) = $7,560×25% - $1,800×25% - 6%×$15,000×75% = $1,890-$450-$675 = $765,000

Corporate Financial Management 1


Projected balance sheet

Cash

$450

Accts. pay.

$1,500

Accruals

750

Accounts rec.

3,000

S.-Term Loan

1,565

Inventory

2,250

Total CL

$3,815

Total CA

$5,700

L-T debt

1,000

Net FA

3,750

Equity

4,635

Total assets

$9,450

Tot. liab.&eq.

$9,450

Projected Balance Sheet

DR0=3,600/7,560=48%; DR1=4,815/9,450=51%

CR0=4,560/2,600=1.75; CR1=5,700/3,815=1.49

Corporate Financial Management 1


Corp valuation governance

Corp. Valuation & Governance

Chapter 13

  • Corporate Valuation Model (×Dividend Growth Model)

    • Based on Free Cash Flow Estimation (instead of dividends)

    • Can be used when dividends are not paid (e.g. startups, subunits of firm)

    • Estimate the Value of Operations (discount FCF = NOPAT – Required Net Operating Working Capital)

    • Add Value of Nonoperating Assets and Growth Options

Corporate Financial Management 1


Value based management

Value Based Management

  • Value-based Management involves the systematic use of the corporate valuation model to evaluate a company‘s decisions.

  • Value drivers:

    • Growth rate of sales

    • Operating profitability (NOPAT/Sales)

    • Capital requirements (Operating Capital/Sales)

    • WACC

  • Company creates value when EROIC (i.e. NOPAT/Capital) > WACC

Corporate Financial Management 1


Corporate governance

Corporate Governance

  • Shareholder wealth may be adversely influenced by management behavior (agency problem)

  • Corporate governance is a set of laws, rules and procedures influencing managers in a way that maximizes the firm‘s intrinsic value.

    • Monitoring

    • Litigation

    • Threat of removal

    • Compensation plans

    • Hostile takeovers (avoid managerial entrenchment)

Corporate Financial Management 1


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