Corporate finance
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Corporate Finance. Bachelor ESC Toulouse 3rd Year – Yvon SCHOLLAERT : [email protected] Luc ELMAN : elmanluc @ aol.fr. Course objectives. Understand the financial environment & markets Understand the finance function in firms Analyse financial situation

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Corporate finance

Corporate Finance

Bachelor ESC Toulouse 3rd Year–

Yvon SCHOLLAERT : [email protected]

Luc ELMAN : [email protected]


Course objectives

Course objectives

  • Understand the financialenvironment & markets

  • Understand the finance function in firms

  • Analyse financial situation

  • Makefinancialdecision & optimisingchoices, resources & investments

  • Definefinancialpolicies & strategies

  • Understand value creation


How we will work

How wewillwork

  • Notes / hand outs / [email protected]

  • Participation

  • Emulation vs. competition

  • Books :

    • Main book: Brealeyet al. (2008), Principles of Corporate Finance, McGraw Hill, 9th Edition

    • Other : Berk & Demarzo (2011), Corporate Finance, Pearson, 2nd Edition


Exams grade

EXAMS & GRADE

  • 1 quiz + 1 group assignment (term paper) + 1 mid-term 50%

  • Final exam : case study 50%


Chap i a framework for financial decision 1 1 the finance function

Chap I. A framework for financial decision1.1. The finance function

  • In a well-organized business  each section arranges its activities to maximize its contribution to the corporate goals

  • Objectives of those who work in the finance function  plan, raise and use funds in an efficient manner

  • Two central activities:

    • Providing the link between the business and wider financial envir.

    • Investment and financial analysis and decision-making


Chap i a framework for financial decision 1 1 the finance function1

Chap I. A framework for financial decision1.1. The finance function

  • The financial function provides:

    • Involvement in investment and financial decisions  called “Investment decision” or “capital budgeting decision” : to acquire assets

      • Real assets : tangible (land, building, equipment, stocks) or intangible (patents, trademarks, know-how)

      • Financial assets: shares of other companies, lending to banks

    • Dealing with the financial markets

    • Forecasting, coordinating and controlling cash flows


Chap i a framework for financial decision 1 1 the finance function2

Chap I. A framework for financial decision1.1. The finance function

  • The financial function in a large organization


Chap i a framework for financial decision 1 2 cash the lifeblood of the business

Chap I. A framework for financial decision1.2. Cash – the lifeblood of the business

  • In the center of finance  the generation and management of cash

  • Cash – the lifeblood of the business


Chap i a framework for financial decision 1 2 cash the lifeblood of the business1

Chap I. A framework for financial decision1.2. Cash – the lifeblood of the business

  • Sources and uses of cash

    • Shareholder’s funds (or equity capital)

      • Largest portion of long-term finance

      • Main source of new money

      • In return shareholders  participate in the business by voting in general meetings and receive dividends out of profits

    • Retained profits

      • Profits remaining after deduction of operating costs, interest payments, taxation and dividends

      • Reinvested in the business  to create new value for the owners


Chap i a framework for financial decision 1 2 cash the lifeblood of the business2

Chap I. A framework for financial decision1.2. Cash – the lifeblood of the business

  • Sources and uses of cash

    • Loan capital

      • Money lent to a business by third parties

      • Is generally on a long-term basis  loan stocks (debentures)

      • Must be paid back with additional interest

    • Government

      • Can provide various financial incentives and grants

      • Companies also give money to governments  taxation


Chap i a framework for financial decision 1 3 emergence of financial management

Chap I. A framework for financial decision1.3. Emergence of financial management

  • Big evolution of financial management  during the last century because of:

    • Economic and external events (inflation and technological development)

  • Consequence  globalization of finance and need to concentrate on more strategic ways of doing business:

    • dividing large organizations into smaller, more strategically compatible departments


Chap i a framework for financial decision 1 4 the financial department in the firm

Chap I. A framework for financial decision1.4. The financial department in the firm

  • The structure of the financial department varies according to the size and the activity of the company

  • The financial manager’s tasks are generally:

    • Making strategic investment and financial decisions -> raising the finance to fund growth and decide what are the key future projects

    • Dealing with the capital markets -> develop good links with the company’s bankers and other major financiers + knowing of the appropriate sources of finance

    • Managing exposure to risk managing adverse movements in interest and exchange rates (reducing exposure = hedging)

    • Forecasting, coordination and control of all activities that have an important impact on cash flow


Chap i a framework for financial decision 1 5 the financial objective

Chap I. A framework for financial decision1.5. The financial objective

  • In finance  the objective of the firm is to maximize shareholder value (create wealth)

  • Earning per share (EPS)  focuses on the shareholder, instead of the company’s performance, by calculating the earnings (profits after taxes) given to each equity share

  • Other secondary goals used:

    • Profit retention  ex: distributable profits must be at least 3 times bigger than dividends

    • Borrowing levels  ex: long-term borrowing should not be more than 50 % of total capital used

    • Profitability  ex : return on capital used should be at least 18 %

    • Non financial goals  recognizes that shareholders are not the only people interested in the company’s success. Acknowledges trade creditors, banks, employees, the government and management


Chap i a framework for financial decision 1 5 the agency problem

Chap I. A framework for financial decision1.5. The Agency problem

  • However  potential conflicts arise because the majority of shareholders are not always the same people who manage the business day to day

  • This can develop managerialism  self-serving behavior by managers at the shareholders’ expense (ex: spending more for bigger offices and company cars, etc.)

  • Agency costs  difference between the return expected from the “contract” between managers and shareholders, and the actual return


Chap i a framework for financial decision 1 5 the agency problem1

Chap I. A framework for financial decision1.5. The Agency problem

  • Ways of dealing with the agency problem:

    • Incentives and controls are recommended  but all of them are costly

      • bonuses linked to profits (called profit-related pay), share options (useful when share market is high)

      • Other types of control :

        • audited accounts of the company

        • Management audits and additional reporting requirements

        • Restrictive rules imposed by lenders (ex: not exceeding a certain amount of dividend payable, etc.)


Chap i a framework for financial decision 1 6 social responsibility and shareholder wealth

Chap I. A framework for financial decision1.6. Social responsibility and shareholder wealth

  • The vast majority of firms  look for long term gains instead of short-term unethical activities

  • Because  shareholder wealth rests:

    • on companies building long-term relationships with suppliers, customers and employees

    • Promoting a reputation for honesty, financial integrity and corporate social responsibility  company’s most important asset : Reputation / Brand Name recognition / Culture…

    • Environmental concerns  in recent years has also become an important consideration


Chap i a framework for financial decision 1 7 the corporate governance debate

Chap I. A framework for financial decision1.7. The corporate governance debate

  • Because of various scandals and collapses (ie, Enron)  some committees have decided to create The Combined Code on Corporate Governance  which include rules concerning:

    • Directors and the boards’ responsibilities

    • Directors’ remuneration

    • Accountability and audit

    • Relations with shareholders


Chap i a framework for financial decision 1 8 the risk dimension interest rates

Chap I. A framework for financial decision1.8. The risk dimension : interest rates


Chap i a framework for financial decision 1 8 the risk dimension

Chap I. A framework for financialdecision 1.8. The risk dimension

  • Risk dimension is a significant issue for Finance since :

    • Many potential risks concern Finance area (see infra)

    • Any occurring risk has an immediate impact on Company profit

       direct loss or accrual (if strongly proved future materialization)

  • Main risk factors:

    • Economic (general activity or market competitors changes)

    • Commercial (client losses, invoicing errors, pricing, image, claims)

    • Industrial (damages to plants, quality, delays, technologic changes)

    • Social (security, accidents at work, diseases , HR development)

    • Operating (procedures, area confusions, obsolescent/lost inventory)

    • Financial (currency, interest rate, credit, solvability, market, tax)

    • IT (vulnerable, not documented, unsecured, heavy, multiple DB)

    • Regulatory (legal changes, law complexity, advisory costs)

    • Environmental (pollution, politics abroad, commodities prices, cultural changes vs products demand)


Chap i a framework for financial decision 1 8 the risk dimension1

Chap I. A framework for financialdecision 1.8. The risk dimension

  • How to reduce Risks ?

  • Collect & identify potential risks

    • From past experience and surveys with operations

    • Segregate risk factors, criticity & organization vulnerability

    • Show internal/external risks

  • Set up a risk cartography showing how:

    • Each risk is critical for the company and it is satisfactorily managed

    • High are the potential costs

  • Define a appropriate strategy against selected risks

    • Prevent, avoid activity, insure, outsource, correct, possibly accept


Chap i a framework for financial decision 1 8 the risk dimension2

Chap I. A framework for financialdecision 1.8. The risk dimension

  • Improve the organization

    • Hire a Risk manager (Blue Chips, Mid Caps)

    • Implement strong internal control (risk analysis & questionnaires)

  • Set up a risk cartography

    • Economic (general activity or market competitors changes)

    • Commercial (client losses, invoicing errors, pricing, image, claims)

    • Industrial (damages to plants, quality, delays, technologic changes)

    • Social (security, accidents at work, diseases , HR development)

    • Operating (procedures, area confusions, obsolescent/lost inventory)

    • Financial (currency, interest rate, credit, solvability, market, tax)

    • IT (vulnerable, not documented, unsecured, heavy, multiple DB)

    • Regulatory (legal changes, law complexity, advisory costs)

    • Environmental (pollution, politics abroad, commodities prices, cultural changes vs products demand)


Major financial assets and risk return levels

Major financialassets and risk / return levels


Chap i a framework for financial decision 1 8 the risk dimension3

Chap I. A framework for financial decision1.8. The risk dimension

  • According to the type of financial decisions the risk can be low or high

    • Ex: low risk  investing in government stocks because interest is known

    • Ex: high risk  investing in shares

  • The more risk there is  the greater the return expected by investors: The risk-return trade off

    • A : long-term fixed interest corporate bond

    • B : a portfolio of ordinary shares in major

      listed companies

    • C : a more speculative investment

      (ex: non-quoted shares)

    • D : investment in highly profitable capital

      projects with little risk

    • E : investment in low profitable capital

      projects with high risk

    • Risk premium : relationship between risk and

      Intended use of funds


Chap i a framework for financial decision 1 8 the risk dimension4

Chap I. A framework for financial decision1.8. The risk dimension


Ratings an illustration of the risk cost return relation ship

Ratings : an illustration of the risk/cost/return relation-ship


Chap i a framework for financial decision 1 9 the strategic dimension

Chap I. A framework for financial decision1.9. The strategic dimension

  • Strategic management : a systematic approach to positioning the business according to its environment  to ensure continued success and offer as much security as possible

  • 3 levels of strategy:

    • Corporate strategy  concerned with the broad issues (ex: company’s activities) . Strategic finance is important here  ex : decision to enter or exit a certain market (through acquisition, organic growth, divestment or buy-outs)

    • Business or competitive strategy  concerned with how strategic business units compete in particular markets

    • Operational strategy  concerned with how various operations contribute to corporate and business strategies


Chap i a framework for financial decision 1 9 the strategic dimension1

Chap I. A framework for financial decision1.9. The strategic dimension

  • Main elements in strategic planning


Chap i a framework for financial decision 1 9 the strategic dimension2

Chap I. A framework for financial decision1.9. The strategic dimension

  • Strategic planning and value creation

    • Importance of competitive forces important in determining shareholder wealth  because determine:

      • the price at which goods and services can be sold,

      • the quantities sold

      • the cost of production

      • the level of required investment

      • the risks inherent in the business

    • Are also very important :

      • Market share

      • Quality

      • Capacity utilization

      • Capital investment strategies


Chap i a framework for financial decision 1 9 the strategic dimension3

Chap I. A framework for financial decision1.9. The strategic dimension

  • Strategic planning and value creation

    • The firm will develop corporate, business and operating strategies  to exploit economic opportunities and create competitive advantage

    • Operating and investment strategies  create cash flows for the business

    • Financial decisions  influence the cost of capital

      => value of the firm depends on these two elements


Chap i a framework for financial decision 1 9 the strategic dimension4

Chap I. A framework for financial decision1.9. The strategic dimension

  • Strategic planning and value creation

    • Factors influencing the value of the firm


Chap i a framework for financial decision 1 9 the strategic dimension5

Chap I. A framework for financial decision1.9. The strategic dimension


Chap i a framework for financial decision 1 9 the strategic dimension6

Chap I. A framework for financial decision1.9. The strategic dimension

  • Strategic planning and value creation

    • Decisions of a financial nature have 5 common elements:

      • Clearly defined goals

      • Well defined courses of action to achieve these objectives

      • Assembling information relevant to the decision

      • Evaluation  analyzing and interpreting assembled info is the heart of financial analysis

      • Monitoring effects of the decision taken  feedback on the performance of past decisions to better future decision-making


Chap ii the financial environment 2 1 financial markets

Chap II. The financial environment2.1. Financial markets

  • Financial market = mechanism for trading assets or securities

  • Main financial markets:

    • Money market:

      • channels of funds, usually for less than a year, from lenders borrowers

      • Largely dominated by the major banks and other financial institutions

      • Also used by local government and large companies for short-term lending and borrowing

    • Securities or capital markets

      • Deals with long-dated securities such as shares and loan stock

      • Best know institution : London Stock Exchange

      • Other important markets : bond market and Eurobond market


Chap ii the financial environment 2 1 financial markets1

Chap II. The financial environment2.1. Financial markets

  • Main financial markets:

    • Foreign exchange market :

      • For buying and selling one currency against another

      • Deals are either on a spot basis (transactions are settled immediately) or on a forward basis (for future settlement at a price specified now)

    • London International Futures an Options Exchange (LIFFE) :

      • Provides various means of hedging (protecting) or speculating against movements in curries and interest rates :

        • Derivatives : securities that are traded separately from the assets from which they are derived

        • Futures : tradable contract to buy or sell a specified amount of an asset at a specified price at a specified future date

        • Options : the right but not the obligation to buy or sell a particular asset


Chap ii the financial environment 2 1 financial markets2

Chap II. The financial environment2.1. Financial markets

  • The financial markets function in two important ways:

    • Primary market : providing new capital for business and other activities, in the form of shares issued to new or existing shareholders (equity) or loans

    • Secondary markets: trading existing securities when desired


Chap ii the financial environment 2 1 financial markets3

Chap II. The financial environment2.1. Financial markets

  • The financial markets promote savings and investments by providing mechanisms with which financial needs of lenders (suppliers of funds) and borrowers (users of funds) can be met

  • Financial institutions act as financial intermediaries  collect funds from savers to lend to their corporate and other customers through money and capital markets, or directly through loans, leasing, etc.


Chap ii the financial environment 2 1 financial markets4

Chap II. The financial environment2.1. Financial markets

  • Financial markets, institutions, suppliers and users


Chap ii the financial environment 2 1 financial markets5

Chap II. The financial environment2.1. Financial markets

  • Financial institutions provide essential services:

    • Re-packaging, or pooling, finance: gathering small amounts of savings from a large number of people and re-packaging them into large blocks for lending to businesses ( mainly done by banks)

    • Risk reduction: placing small amounts from numerous people in large, well-diversified investment portfolios (such as unit trusts)

    • Liquidity transformation : bringing together short-term savers and long-term borrowers

    • Cost reduction: minimizing transaction costs  providing convenient and relatively inexpensive services

    • Financial advice: providing advice and other services for both lender and borrowers


Chap ii the financial environment 2 2 financial services sector

Chap II. The financial environment2.2. Financial services sector

  • 3 groups:

    • Deposit-taking institutions :

      • Clearing banks : operate on national payments systems by clearing and receiving and paying out notes and coins (retail banking)

      • Wholesale banks : made of Accepting houses (take care of Bills of Exchange), Discount houses (bid for issues of short term government securities), Merchant banks (arrange specialist financial services like mergers and acquisition funding)

    • Institutions engaged in contractual savings:

      • Pension funds : manage the pension plans of large firms

      • Insurance companies : guarantee to protect clients against various risks


Chap ii the financial environment 2 2 financial services sector1

Chap II. The financial environment2.2. Financial services sector

  • 3 groups:

    • Other investment funds:

      • Investment trusts : limited companies whose shares are quoted on the Stock Exchange and who are set up to invest in securities

      • Unit trusts : investment syndicates within the companies

      • Disintermediation: business to business lending that eliminates the banking intermediaries

        Securitization: the capitalization of a future group of income into a single capital value that is sold on the capital market for immediate cash

        => both have permitted larger companies to create alternative, more flexible forms of finance  forces banks to become more competitive in their services


Chap ii the financial environment 2 3 different stock exchanges

Chap II. The financial environment2.3. Different Stock Exchanges

Two principle economic functions of all stock exchanges:

  • Enable companies to raise new capital (primary market)

  • Facilitate the trading of existing shares (secondary market) through negotiation of a price

    The London Stock Exchange

  • Operates on two levels:

    • The Mains list (created in 1773) for larger established companies: long-term securities are issued and traded

    • The Alternative Investment market (created in 1995)  takes care of very young companies by limiting the cost of entry and membership  keeping rules and application process as simple as possible

  • Has the most foreign companies listed


  • Chap ii the financial environment 2 3 different stock exchanges1

    Chap II. The financial environment2.3. Different Stock Exchanges

    Euronext

    • Formed in 2000  merger of the Amsterdam, Brussels and Paris Stock Exchanges

      New York Stock Exchange

    • The largest in terms of market value

      Nasdaq

    • Exchange for young companies

    • Has the most companies listed


    Chap ii the financial environment 2 4 the efficient market hypothesis emh

    Chap II. The financial environment2.4. The Efficient Market Hypothesis (EMH)

    • 3 levels

      • Weak form efficient share market : does not allow investors to look back at past share price movements and identify repetitive patterns

      • Semi-strong efficient share market : incorporates newly released information accurately and quickly into the structure of share prices

      • Strong efficient share market : all information including inside information is built into share prices


    Chap ii the financial environment 2 5 market efficiency for corporate managers

    Chap II. The financial environment2.5. Market efficiency for corporate managers

    • Quoted companies, managers and investors  are directly linked through stock market prices, because corporate actions are rapidly reflected in share prices

    • Therefore:

      • Investors do not easily believe in nicely presented financial reports that show good reported earnings but not the reality of the cash flow

      • The timing of new issues of securities is not critical  market prices are a fair reflection of the information available and they reflect the degree of risk in shares

      • When corporate managers have information not yet released to the market  gives them the opportunity to influence prices


    Chap ii the financial environment 2 5 market efficiency for corporate managers1

    Chap II. The financial environment2.5. Market efficiency for corporate managers

    • It is essential that all participants have about the same access to price-sensitive information

    • Before  big companies with online data had information, and therefore a competitive advantage, before smaller companies

    • Now with the Internet  all types of companies can have:

      • Electronic reporting of Company information: enables better corporate governance by giving key determinants of value of various companies (ex: customer satisfaction, market penetration  become part of the performance measurement system)

      • Market information: with thousands of Web pages which give advice about investment and personal finance


    Chap ii the financial environment 2 6 criticisms of the emh

    Chap II. The financial environment2.6. Criticisms of the EMH

    • It is not sure whether investors:

      • react correctly to new information

      • Make systematic errors by over or under reacting (being overly optimistic or overly pessimistic)

    • Size may effect share trading:

      • Market efficiency seems to be less evident in smaller firms  smaller firms outperform larger firms because of the higher risk and trading costs when dealing with smaller companies

    • Timing may effect share trading:

      • In the long term  disparities in share returns correct themselves : a share can perform poorly one year but do well the next

      • Seasonal effects have also been observed : share performance is related to the day of the week or time of the day (ex: prices rise during the last fifteen minutes of the day’s trading; there are a lot of shares sold during the first hour of Monday trading)

    • Stock market can go through rough changes in the short term:

      • in an efficient market it is difficult to predict these changes


    Chap ii the financial environment 2 7 taxation and financial decisions

    Chap II. The financial environment2.7. Taxation and financial decisions

    • Most financial decisions are taxable  Corporate and personal taxation affect:

      • The cash flow received by companies

      • The dividend income received by shareholders

    • Financial managers need to understand the tax consequences of investment and financing decisions


    Chap ii the financial environment 2 7 taxation and financial decisions1

    Chap II. The financial environment2.7. Taxation and financial decisions

    • Taxation is important in 3 key areas of financial management:

      • Raising finance : there are tax benefits when raising finance by issuing debt rather than capital  interest on borrowings brings tax deductions vs a dividend payment on equity capital does not bring taxes down

      • Investment in fixed assets: spending on certain types of fixed assets can bring less taxes (capital allowance)  intended to stimulate certain types of investments

      • Paying dividends : in certain countries company profits are taxed twice  first on the profits achieved and then on those profits paid to shareholders in form of dividends (In UK the taxation system is more neutral  the same tax bill is paid regardless of the dividend policy)


    Chap ii the financial environment 2 7 credit management

    Chap II. The financial environment 2.7. Credit Management

    • Credit control is a significant area of Finance because:

      • Creditors accounts freeze high values in Working Capital (especially if payments are delayed)

      • Cash is rare today (impact of crisis & credit crunch)

      • Any loss (customer bankruptcy) directly impacts Net Result

    • Necessity to optimize cash collecting process:

      • Implement customer’s accounting cell with ad-hoc routines

      • Monitor Aged Balance with Sales & Orders Departments

      • Define credit limits for prospects & weak customers (linked to financial health & past incidents)

      • Indicate credit policy in selling contracts & payment terms

      • Do not hesitate to block deliveries in case of credit incidents

      • Regularly collect delayed payment by all appropriate means (phone, reminding letters, legal threats, suits)

      • Use export insurance & guaranty tools (Coface)

      • Delegate customer payment risk (factoring, cash collecting firms)


    Appendix i working with financial statements

    Appendix I : Working with financial statements

    • Income statement = what you earn

      • Profits = Sales – Costs

      • EBIT = Operating profit

      • Net earnings = what you earn

        • Can be distributed as dividends

        • Can be reinvested in the firm (retained earnings in balance sheet)

    • Basically the net earnings is the cash generated by the firm’s activity in one year


    Appendix i working with financial statements1

    Appendix I : Working with financial statements

    • Break-even analysis


    Income statement

    Income statement


    Appendix i working with financial statements2

    Appendix I : Working with financial statements

    • Balance Sheet :

      • Assets = Liabilities + Equity

      • Assets = what yow own

      • Liab = what you owe

      • Basically : the firm invests in assets and finance its investments with liabilities

    • Assets :

      • Fixed : tangible vs intangibles, financial assets (buyouts, external growth)

      • Current = less than a year : cash, inventory & stocks, account receivables (debtors)

    • Liabilities :

      • Equity = stockholders funds

      • Long term debt (>1y) = borrowings, bonds, financial debt

      • Short term debt (<1y) = account payables, creditors


    Appendix i working with financial statements3

    Appendix I : Working with financial statements

    • Cash flow statement :

      • Measures increases and decreases of balance sheets accounts

      • Cash inflow = cash generated

      • Cash outflow = cash spent

    • Sources of cash inflows coming from

      • Income statement = Net profit + depreciation

      • Balance sheet : financing activities (borrowings, equity raising); disinvesting activities (sales of assets)

    • Cash consumption (cash outflow) coming from :

      • Losses from Income statement (net losses)

      • Investment activities (acquisitions); debt reimbursement


    Appendix i working with financial statements4

    Appendix I : Working with financial statements

    • More generally from year N to N+1 :

      • Any decrease in assets or any increase in liabilities = CASH INFLOW

      • Any increase in asset or any decrease in liabilities = CASH OUTFLOW


    Appendix 1 income statement profitability ratios

    Appendix 1 : Income statement-profitability ratios


    Appendix 1 income statement profitability ratios1

    Appendix 1 : Income statement-profitability ratios


    Appendix i income statement ratios exemple

    Appendix I : Income Statement ratios : exemple

    • 1) Based on Income statement of ABC, compute profitability and activity ratios. What can you conclude?

    • 2) # shares are 900 000 in 2003 and 1 210 000 in 2004. ABC distributed $120 000 in 2003 and $50 000 in 2004. Stock price was $1.9 in 2003 and $7.5 in 2004. Compute investors ratio.


    Appendix 1 computing analysing ratios

    Appendix 1 : Computing & analysing ratios


    Appendix 1 balance sheet analysis

    Appendix 1 : Balance sheetanalysis


    Appendix 1 balance sheet analysis1

    Appendix 1 : Balance sheetanalysis


    Appendix 1 balance sheet analysis2

    Appendix 1 : Balance sheetanalysis


    Appendix i balance sheet ratios exemple

    Appendix I : Balance sheet ratios : exemple

    • 1) Based on balance sheet of ABC, compute B/S ratios and analyze the firm


    Appendix 1 balance sheet analysis3

    Appendix 1 : Balance sheetanalysis


    Corporate finance

    Chap III : Long Term Financing decisions – Part 1

    1) Introduction : Main financing modes

    • Internally :

      • Self financing (operating cash)

      • Available cash

      • Sales of assets

    • Externally :

      • Equityraising

      • Debt and loans


    Corporate finance

    Chap III : Long Term Financing decisions – Part 1

    1) Introduction : Internal financing

    • Productivity,  costs,

    •  sales

    Finance investments and

    short termneeds

    Pay back debt

    Dividends to shareholders


    Corporate finance

    • Chap III : Long Term Financing decisions – Part 1

      1) Introduction : Main financing modes

    • Using internal financing :

      • Easier and safer

      • “Costless” (no interest charges)…

      • But cash is rare and needed for short term operations (WCR)

      • Using too much internal cash for long term financing may require to borrow short term

    • Sales of assets

      • May be relevant (sale of a non profitable segment)

      • Becomes problematic when the asset is strategic


    Corporate finance

    • Chap III : Long Term Financing decisions – Part 1

      2) Using external financing : equity funds

    • Raising equity for listed companies :

      • Allows to raise cash quickly

      • But also cost money :

        • Intermediaries

        • Dividends yields required by investors

        • Value creation and return on investment maximization

    • Access to equity funds depends then :

      • on the liquidity of the stock

      • on the attractiveness of the company, its projects and strategy

      • on capital gains expected by investors

      • on the financial market situation (bull vs bear market)


    Corporate finance

    • Chap III : Long Term Financing decisions – Part 1

      2) Using external financing : equity funds

    • Why is it so delicate to manage equity financing :

      • Dividends paid out means less self financing available, so less ability to reinvest in the company…

      • … meanwhile investors require value creation (capital gains) which requires investments (thus self financing, equity or debt financing)

      • Raising too much equity means “dilution effect”


    Corporate finance

    • Chap III : Long Term Financing decisions – Part 1

      2) Using external financing : equity funds

    • What are equityinvestors’ criteria :

      • ROE performance

      • EPS and DPS performance

      • Value creation ROI > WACC

      • Capital gains expectations and maximization

      • An appropriaterisk/return relationship

    • This implieshigh pressure on short term performances of the firm :

      • Financinghighreturnsprojects (riskyprojects)

      • Maximizing ROE throughdebtfinancing (financialleverage), implyinghigherfinancialrisk


    Corporate finance

    • Chap III : Long Term Financing decisions – Part 1

      2) Using external financing : equity funds


    Corporate finance

    • Chap III : Long Term Financing decisions – Part 1

      3) Using external financing : debt funds

    • Debtfinancing :

      • Classicalloans and debt : eachyearwepay back interest + capital

      • Bonds tools : wepay back coupons (interest) eachyear, but the initial capital ispaid back to maturity (end of the loan)

      • Bonds are riskier, so the cost of debtrequired by bond investorswillbehigher


    Corporate finance

    • Chap III : Long Term Financing decisions – Part 1

      3) Using external financing : debt funds

    • What are debt providers requiring :

      • An appropriaterisklevel ratings (Standard & Poors, Coface ratings)

      • The higher the risk, the higher the interest rate required

      • AppropriateDebt/Equity ratio

      • AppropriateDebt/Operating Cash ratio

      • Appropriate cash level

      •  expected cash-flows, coporateplaning (projections), capacity to pay back

      • Guaranties and assetbacked, mortgages


    Corporate finance

    • Chap III : Long Term Financing decisions – Part 1

      3) Equity vs debt : conflicting decisions


    Corporate finance

    Chap III : Long Term Financing decisions – Part 1

    3) Equity vs debt : conflicting decisions, with management too!


    Corporate finance

    • Chap III : Long Term Financing decisions – Part 1

      3) Equity vs debt : conflicting decisions, with management too!


    Corporate finance

    • Chap III : Long Term Financing decisions – Part 1

      3) Equity vs debt : hopefully, they have common interests!

    Secure profits

    • + grow= Sustain


    Corporate finance

    • Chap III : Long Term Financing decisions – Part 1

      4) Understanding financial leverage

    • Relationship between ROE, ROI and financialleverage


    Understanding value drivers for roi

    Understanding value drivers for ROI


    Corporate finance

    ROE components

    Net Profit

    Equity

    ROE=

    Financial decisions

    Financial

    leverage

    (L)

    .

    Leverage

    Gearing:

    D

    E

    (ROI - i)

    Operating decisions

    ROI


    Corporate finance

    • Chap III : Long Term Financing decisions – Part 1

      4) Understanding financial leverage

    • A positive financialleverageoccurswhen :

      • ROE > ROI

      • ROI > after taxes interest rate on debt

      • As long as ROI isgreaterthaninterest rate, itisworthusingdebtfinancing

      • This meansthat the companyshould use debtfinancing to increase ROE performance…

      • … and thusshareholder’s return maximization


    Corporate finance

    • Chap III : Long Term Financing decisions – Part 1

      4) Understanding financial leverage

    • A negativefinancialleverageoccurswhen :

      • ROE < ROI

      • ROI < after taxes interest rate on debt

      • This meansthatdebtbecomes a burdenbecause of toohighinterestexpenses

      • … and thusitsdecreases net profit and ROE

      • Weshouldthenrecommendusingequity or self financing to pay back debtuntil the financialleveragerecovers to a positive figure


    Corporate finance

    Chap III : Long TermFinancing decisions

    Application : Understanding financial leverage

    • In 2009, youneed to finance a 100 K€ investment and youthinkthatyouwillget an EBIT of 30 K€. This means net profit of 20 K€ for thatyear (with a corporatetax rate of 33.33%).

    • You have two options :

      • 1) Finance 100 K€ withequityonly

      • 2) Finance 50 K€ withequity and 50 K€ withdebt

    • 1) Imagine in a fictive world, bankers do not charge interest on debt. Computethen ROE and ROI for the twofinancing options. Whatis the financialleverage?

    • 2) Stop dreaming! Bankerwill charge you a 10% interest rate on debt. Computethen ROE and ROI for bothfinancing option. Whatcanyouconclude?


    Corporate finance

    • Chap III : Long Term Financing decisions – Part 1

      Application : Understanding financial leverage


    Corporate finance

    • Chap III : Long Term Financing decisions – Part 1

      Application : Understanding financial leverage

    • ANSWERS AND COMMENTS :

    • Question 1 : Wecan use debtfinancingsince :

      • If we finance 100% equity, ROE is 20 / 100 = 20%

      • If we finance half & half, ROE increases to20 / 50 = 40%!

    • Usingdebtallowsinvestors to double ROE and to maximizefundsinvested by shareholders

    • Usingdebt, wecreatedfinancialleverage, the gearingallowedequityholders to increasereturns on equityinvested


    Corporate finance

    • Chap III : Long Term Financing decisions – Part 1

      Application : Understanding financial leverage

    • 2) Question 2 : in a real world, withinterest charges, we have a limiteddebtcapacity

      • With 10% interest rate, thatis 5 €, ROE decreases((30-5)*(2/3))/50 = 16,67/50 = 33.3%

      • Notice that ROI remainsat 20% whatever option youchoose (weneutralizedinterestexpenses)

      • But debt ressources willbelimitedsincebankerwill refuse to finance toomuchdebtbecauseheexpects :

        • That a highgearinglimits chances to beingpaid back

        • Interestburdenwill affect capacity to pay back debt

        • Myexpected net profit (20 K€) isuncertain, thusrisky


    Corporate finance

    • Chap III : Long Term Financing decisions – Part 1

      Application : Understanding financial leverage

    • As firms use maximum debtfinancing to finance theirinvestmentprojects :

      • It maximizes ROE : itinvestsless for a givenexpected profit level

      • But itcreatesfinancialrisklinked to the debtcapacity. The more it uses debt, the higher the interest charges thatwilldecreaseexpected net profit and debtpay back capacity (self financing or operating profit)


    Corporate finance

    • Chap III : Long Term Financing decisions – Part 1

      5) Conclusions : limits to financial leverage


    Corporate finance

    • Chap III : Long Term Financing decisions – Part 1

      5) Conclusions : limits to financial leverage

    Positive cycle

    Vicious cycle


    Corporate finance

    • Chap III : Long Term Financing decisions – Part 1

      5) Conclusions : limits to financial leverage

    Equilibrium/trade-off


    Corporate finance

    • Chap III : Long Term Financing decisions – Part 1

      5) Surveillance and indicators to optimize the financial structure


    Corporate finance

    • Chap III : Long Term Financing decisions – Part 1

      5) Debt and the firm’s value : what impact?


    Corporate finance

    • Chap III : Long Term Financing decisions – Part 1

      5) Surveillance and indicators to prevent from financial risk

    • How to cure an overdebt situation (too high leverage or gearing)

      • Increase profits through costs restructuration (resizing)  generate more internal cash

      • Raise large amouts of equity  but dilution effect

      • Sale of non-strategic assets to generate cash decreases capacity (resizing strategy) but optimize ROA and productivity


    Weighted average cost of capital wacc

    Weighted Average Cost Of Capital - WACC

    • A calculation of a firm's cost of capital in which each category of capital is proportionately weighted.

    • All capital sources - common stock, preferred stock, bonds and any other long-term debt - are included in a WACC calculation.


    Weighted average cost of capital wacc1

    Weighted Average Cost Of Capital - WACC

    • Where: Re = cost of equity Rd = cost of debt E = market value of the firm's equity D = market value of the firm's debt V = E + D E/V = percentage of financing that is equity D/V = percentage of financing that is debt Tc = corporate tax rate Businesses often discount cash flows at WACC to determine the Net Present Value (NPV) of a project, using the formula: NPV = Present Value (PV) of the Cash Flows discounted at WACC.


    Weighted average cost of capital wacc2

    Weighted Average Cost Of Capital - WACC

    • Broadly speaking, a company’s assets are financed by either debt or equity.

    • WACC is the average of the costs of these sources of financing, each of which is weighted by its respective use in the given situation.

    • By taking a weighted average, we can see how much interest the company has to pay for every dollar or euro it finances.

    • A firm's WACC is the overall required return on the firm as a whole and, as such, it is often used internally by company managers to determine the economic feasibility of expansionary opportunities and mergers.

    • It is the appropriate discount rate to use for cash flows with risk that is similar to that of the overall firm


    Corporate finance

    • Chap III : Long Term Financing decisions – Part 1

      5) Debt and the firm’s value : what impact?


    Corporate finance

    • Chap III : Long Term Financing decisions – Part 1

      5) Debt and the firm’s value : what impact?


    Corporate finance

    • Chap III : Long Term Financing decisions – Part 1

      5) Debt and the firm’s value : what impact?


    Corporate finance

    • Chap III : Long Term Financing decisions – Part 1

      5) Surveillance and indicators to prevent from financial risk

    • Why do they use so much debt then? (among others)

      • Reason #1 : fiscal incentives : interest expenses are corporate tax deductible, not dividends

      • Reason #2 : equity raising dilutes shareholders : power dilution, EPS & DPS dilution

      • Reason #3 : Linked to reason #2, debt raising improves ROE & financial leverage

      • Reason #4 : cost of debt much cheaper than the cost of equity (risk/return relationship)


    Application case devplus

    Application : CASE Devplus

    • Objectives :

    • Measure the financialleverage

    • Check the impact of financingdecisions on:

      • The net profits from I/S

      • ROE and ROI

      • Financial Riskfrom B/S

    • Understand the limits of gearing:

      • Negativefinancialleverage

      • Destroying ROE and value creation to shareholders


    Chap iv present values and financial arithmetic 3 1 measuring wealth

    Chap IV. Present values and financial arithmetic3.1 Measuring wealth

    • A successful business  creates value for its owners

    • Wealth is created when the market value of the outputs is higher than the market value of its inputs  benefits are higher than costs

    • Mathematically :

      • Vj = Bj – Cj Vj => value created by decision j

        Bj => benefits attributable to the decision

        Cj => Costs attributable to the decision

    • Simple concept but  important to analyze more deeply how benefits and costs are measured and valued

    • Problem:

      • Benefits and costs  occur at different times and over a number of year => must consider the Time-Value of money


    Chap iv present values and financial arithmetic 3 2 time value of money

    Chap IV. Present values and financial arithmetic3.2 Time-value of money

    • The value of money depends on when the cash flow occurs (ex: 100 $ now  worth more than 100 $ at some future time)

    • Reasons for this:

      • Risk : 100 $ now is certain but 100 $ received next year is uncertain  this uncertainty affects many financial managers

      • Inflation : under inflationary conditions  the value of money declines (in terms of purchasing power of goods and serves)

      • Personal consumption preference : everyone has prefers to consume now than to wait for late consumption


    Chap iv present values and financial arithmetic 3 2 time value of money1

    Chap IV. Present values and financial arithmetic3.2 Time-value of money

    • More importantly is the notion that Money has a price :

      • If a business holds unnecessarily high cash balances  it incurs an opportunity cost (loss of opportunity to earn money by investing it to earn a higher return)

      • This implies :

        • The risk-free rate of return  rewarding investors putting off immediate consumption

        • Compensation for risk and loss of purchasing power


    Chap iv present values and financial arithmetic 3 3 financial arithmetic for capital growth

    Chap IV. Present values and financial arithmetic3.3 Financial arithmetic for capital growth

    • Simple and compound interest

      • The future value (FV) of an amount of money invested at a given annual rate of interest  depends on whether:

        • the interest is paid only on the original investment (simple interest (Ex: 1 000 £ invested at 10 % for five years  future value will be on 1000 £ + five years’ interest of 100 £ /year = total future value of 1,500 £)

        • Or if it is calculated on the original investment + accrued interest (compound interest) Ex: Compound interest on 1000 £ over 5 years


    Chap iv present values and financial arithmetic 3 3 financial arithmetic for capital growth1

    Chap IV. Present values and financial arithmetic3.3 Financial arithmetic for capital growth

    • Compound interest

      • compounding general formula :FV = PV (1+r)n

    • To calculate more frequent compounding and to obtain the closing balance :

      FVn = PV ( 1 + ( r / t) )nt

      With :

      FV = Final Value; n = number of years; PV = original value (present value)

      i = Interest rate; t = interval time of calculation


    Chap iv present values and financial arithmetic 3 4 present value

    Chap IV. Present values and financial arithmetic3.4 Present value

    • Discounting : reverse process  what is today’s value of a future amountPV = FV / (1 + r)n

    • NB : this implies that interest is compounded

    • Note we can compute also interest rate:r = (FV / PV)1/n - 1


    Chap iv present values and financial arithmetic 3 4 present value1

    Chap IV. Present values and financial arithmetic3.4 Present value

    • The effect of discounting : time, interest and PV

    • This table summarizes the discount factors for 3 rates of interest


    Chap iv present values and financial arithmetic 3 4 present value2

    Chap IV. Present values and financial arithmetic3.4 Present value

    • The effect of discounting : time, interest and PV

      • This figure shows  how the discounting process affects present values at different rates of interest between 0 and 20 per cent :

        • The value o f 1 £ decreases significantly as the rate and period increase  after 10 years (for an interest rate of 20 %) the present value of a cash flow is only a small fraction of its nominal value


    Chap iv present values and financial arithmetic 3 5 present value arithmetic

    Chap IV. Present values and financial arithmetic3.5 Present value arithmetic

    • Future value - exemple 1.1 : you are 18 and your grand’ma is giving you $5000 for financing your studies in 5 years. As a wise investor you decide to deposit the money on a saving account @ 10%/y compounded annually. How much will you get in 5 years from now?

    • 1.2 : Same deal, but you decide to withdraw each year’s interest to party with your friends. How much will you get in 5 years from now?

    • 1.3 : Imagine now that Superbank, Inc proposes you to invest the $5000 @ 10%/y but compounded twice a year. How much will you get in 5 years?


    Chap iv present values and financial arithmetic 3 5 present value arithmetic1

    Chap IV. Present values and financial arithmetic3.5 Present value arithmetic

    • Answers :


    Chap iv present values and financial arithmetic 3 5 present value arithmetic2

    Chap IV. Present values and financial arithmetic3.5 Present value arithmetic

    • Exemple 2: Who wants to be a millionaire? Everyone of course! Imagine you are dreaming to be a millionaire 25 years from now. Il you invest $10000 now, what should be the yearly interest rate to achieve your dream (and fly to Caïman Islands).


    Chap iv present values and financial arithmetic 3 5 present value arithmetic3

    Chap IV. Present values and financial arithmetic3.5 Present value arithmetic

    • Answer ex 2:


    Chap iv present values and financial arithmetic 3 6 annuity

    Chap IV. Present values and financial arithmetic3.6 Annuity

    • Annuity : constant payment for a given # of years

    • Perpetuity : an infinite annuity


    Chap iv present values and financial arithmetic 3 6 annuities perpetuities

    Chap IV. Present values and financial arithmetic3.6 Annuities & perpetuities

    • Exemple 3 : Imagine you quit smoking today. You were smoking 1 pack a day, that is $5 of expenses for your cigarettes per day. If you are proposed to save what you usually spent in smoking for the next five years, how much will you get then? NB : Interest rate = 10%; savings are compounded twice a year = 360 days.

    • Anti-tabacco propaganda you may think?  just get the numbers and you would be surprised!


    Chap iv present values and financial arithmetic 3 6 annuities perpetuities1

    Chap IV. Present values and financial arithmetic 3.6 Annuities & perpetuities

    • Answer Exemple 3 :


    Chap iv present values and financial arithmetic 3 7 valuing bonds

    Chap IV. Present values and financial arithmetic 3.7 Valuing Bonds

    • Bonds = financial security = long term loans that pays each year interest (coupon) and repay principal (face value) at maturity (end of loan)

    • Ex : a 5 years bond paying 10% coupon rate with a face value of $1000 :

      • Pays $100 of coupon interest per year

      • Pays back $1000 in 5 years

    • If the market expected return (r) = coupon rate = 10%, (as when a bond is issued) what should be its present value then?


    Chap iv present values and financial arithmetic 3 7 valuing bonds1

    Chap IV. Present values and financial arithmetic 3.7 Valuing Bonds

    Pays coupon C = i x face valueC = 10% x 1000 = $100

    C = $100

    + principal = $1000

    C = $100

    • Imagine interest rate is 10% then :

    • PV = C1/(1+r) + C2/(1+r)² + (C3 + P)/(1+r)3PV = 100/1.1 + 100/1.1² + 1100/1.13PV = 90.90 + 82.65 + 826.45 = $1000

    • When market expected return = coupon rate, bonds is valuated at its par (initial) value

    Present value= today’s price?

    Year 1

    Year 2

    Year 3


    Chap iv present values and financial arithmetic 3 7 valuing bonds2

    Chap IV. Present values and financial arithmetic 3.7 Valuing Bonds

    Pays coupon C = c x face valueC = 10% x 1000 = $100

    C = $100

    + principal = $1000

    C = $100

    Present value= today’s price?

    Year 1

    Year 2

    Year 3

    • PV = C1/(1+r) + C2/(1+r)² + (C3 + P)/(1+r)3PV = 100/1.12 + 100/1.12² + 1100/1.123PV = $951.96

    • When market expected return > coupon rate, bond is valuated under its par (initial) value, since it pays 10% when the market can expect 12%  the bond price falls

    • If r = 8%, the bond will be valued at $1051.54 (at a premium)


    Chap iv present values and financial arithmetic 3 7 valuing bonds3

    Chap IV. Present values and financial arithmetic 3.7 Valuing Bonds

    • When expected return falls, bond price rises

    • When expected return goes up, bond price fall

    • When expected return level is above coupon rate, the bond sells at discount (below its par value)

    • When expected return is below coupon rate, the bond sells at premium (above its par value)


    Chap iv present values and financial arithmetic 3 8 net present value npv

    Chap IV. Present values and financial arithmetic 3.8 Net Present Value (NPV)

    • NPV = net present value

    • Imagine you invest $100 @10% you get $110 in a year then you can say :

      • PV = FV / (1+r) = 110 / 1.1 = 100

      • It means that your investment breaks even with the present value of your expected cash flows

      • NPV = FV/(1+r) – PV = 100-100 = 0


    Chap iv present values and financial arithmetic 3 8 net present value npv1

    Chap IV. Present values and financial arithmetic 3.8 Net Present Value (NPV)

    • Imagine now that you invest $100 for an uncertain future cash flows (risky) of $120 coming in a year. If the discounting rate (cost of capital) is 10%.

    • NPV = 120 / (1.1) – 100 = $9.09

    • This means that you are willing to make this investment if and only if you may get a net present value of $9.09 that will reward you for the extra risk you take (uncertainty of future cash flows).

    • In other words, you are expecting a 12% internal rate of return (IRR) since @12% the investment breaks even (NPV=0)


    Chap iv present values and financial arithmetic 3 8 net present value npv2

    Chap IV. Present values and financial arithmetic 3.8 Net Present Value (NPV)

    Today

    Choice 1 : Year 3

    Choice 2 : Year 5

    InvestmentIo = -10000

    Expected cash flowCF = 16000

    Expected cash flowCF = 15000

    • Exemple : imagine you are thinking to invest $10 000 in a new machine that will help you to produce a greater future cash flow, let us say $15 000 in year 3 from now. On the other hand you have also an opportunity to choose an alternate investment of $10 000 that will bring $16 000 in 5 years

    • Let us say that you estimate that both projects are equally risky the expected return on both project @ 10%

    • Which one should you choose?


    Chap iv present values and financial arithmetic 3 8 net present value npv3

    Chap IV. Present values and financial arithmetic 3.8 Net Present Value (NPV)

    Today

    Year 5

    Year 3

    InvestmentIo = -$10000

    • NPV project1 =

    • NPV project2 =

    Expected cash flowCF 5 = $16000

    Expected cash flowCF 3 = $15000

    PV of CF3 = $15000/ (1+0,1)3

    PV of CF3 =

    PV of CF3 = $16000 / (1+0,1)5

    PV of CF5 =


    Chap iv present values and financial arithmetic 3 8 net present value npv4

    Chap IV. Present values and financial arithmetic 3.8 Net Present Value (NPV)

    • General formula :

    • NB : CFn may be positive or negative


    Chap iv present values and financial arithmetic 3 8 net present value npv5

    Chap IV. Present values and financial arithmetic 3.8 Net Present Value (NPV)

    • Some important points about NPV :

      • Time dimension : The closer the cash flow from now, the higher the present value : $100 now is safer then $100 in one year

      • Risk dimension : The higher the risk, the lower the PV of a future cash flow : you prefer to invest $100 than brings $110 with no risk than to get $110 that are very uncertain (risky investment)

    • Managers want to choose projects that optimize NPV and reject projects with negative NPV


    Chap v making investment decisions introduction

    Chap V : Making Investment decisionsIntroduction

    • Because the firm has limited resources  must choose in between projects the most profitable one

    • What cash flow to consider? : the project’s

    • NPV rules? : not the only criteria

    • IRR (internal rate of return)

    • Profitability, paypack…


    Chap v making investment decisions i what cash flow to consider

    Chap V : Making Investment decisionsI. What cash flow to consider?

    • Project’s free cash flow =CF of firm with project – CF of firm w/o project

    • Free Cash Flows (FCF) =Net profit + depreciation– increase in WCR (or + decrease in WCR) – investments


    Chap v making investment decisions ii computing npv

    Chap V : Making Investment decisionsII. Computing NPV

    • Compute NPV of projects  reject any project where NPV < 0


    Chap v making investment decisions ii computing npv1

    Chap V : Making Investment decisionsII. Computing NPV

    • NPV Application : In dec 31st 2008, the CashCow company is willing to implement a new equipment. This project has an estimated life of 5 years. It would require 750 K€ of investment to be depreciated (residual value = 0) on 5 years basis.

    • The project should yield 150 K€ net profit in 2009, and the net profit would increase 50 K€ per year from 2010 to 2013

    • Management estimates that WCR increase would consume 175 K€ of cash per year from 2009 to 2013

    • Question : compute the Net Present Value of this project knowing that the required rate of return is 10% (discount rate)


    Chap v making investment decisions ii computing npv2

    Chap V : Making Investment decisionsII. Computing NPV

    • Answer to NPV Application :


    Chap v making investment decisions iii why using irr

    Chap V : Making Investment decisionsIII. Why using IRR?

    • Internal Rate of Return : IRR

    • Imagine 2 projects having the same NPV  IRR is the only way to make good decision

    • IRR = discount rate at which NPV = 0

    • We only choose projects where IRR > discount rate

    • The greater the IRR, the better


    Chap v making investment decisions iii how to compute irr

    Chap V : Making Investment decisionsIII. How to compute IRR?

    • Need either a calculator or “guess” technique

    • If NPV strongly positive  IRR is far above discount rate

    • Linear interpolation formula :


    Chap v making investment decisions iii how to compute irr1

    Chap V : Making Investment decisionsIII. How to compute IRR?

    • Application 2 : OPTIMAX company is implementing a project that yields 100 K€ of FCF in year 1, and 200 K€ in year 2 and 300 K€ in year 3. Investment is 400 K€ in year 0 and the discount rate (r) is 10%

    • Question 1 : compute NPV of the project

    • Question 2 : compute IRR


    Chap v making investment decisions iii how to compute irr2

    Chap V : Making Investment decisionsIII. How to compute IRR?

    • Answer to application 2 : NPV


    Chap v making investment decisions iii why using irr1

    Chap V : Making Investment decisionsIII. Why using IRR?

    • Answer to application 2 : IRR

    • Step 1 : Compute NPV for the project @ 10%

    • We know that NPV >0  we should expect IRR to be > to 10%


    Chap v making investment decisions iii why using irr2

    Chap V : Making Investment decisionsIII. Why using IRR?

    • Answer to application 2 : IRR (continued)

    • Step 2 : try Round 1 : take a guess at r=20%  NPV =

    • Step 3 : try Round 2 : let us guess at r=18%  NPV =

    • Step 4 : apply formula using linear interpolation:IRR =


    Chap v making investment decisions iii irr graphically

    Chap V : Making Investment decisionsIII. IRR graphically…


    Chap v making investment decisions iv using other indicators

    Chap V : Making Investment decisionsIV. Using other indicators

    • Profitability index = NPV / PV of outflows

    • In our example PI = 81.6 / 400 = 20.4%


    Chap v making investment decisions iii understanding irr and pi

    Chap V : Making Investment decisionsIII. Understanding IRR and PI

    IRR Concept

    Year 3

    Year 0


    Chap v making investment decisions iii understanding irr and pi1

    Chap V : Making Investment decisionsIII. Understanding IRR and PI

    Present value =

    -400

    PI Concept

    Present value = 90.9

    Present value = 165.3

    Present value = 225.4

    • PI meansthat if i aminvesting 400 K€, I get 481.6 K€ (sumn of FCF’s PV) now

    • I get 81.6 K€ of net gains now (NPV)

    • Global return on myinvestment (PI) is

    • 81.6 / 400 = 20.4%

    NPV= 81.6 K€


    Chap v making investment decisions iv using other indicators1

    Chap V : Making Investment decisionsIV. Using other indicators

    • Payback period : period of time taken to “break even” the project’s investment

    • Look at cumulative present value of FCF (as in our example):

    • PB = 2 years + (143.8/225.39) x 12 = 2 years and 8 months


    Chap v making investment decisions v npv or irr

    Chap V : Making Investment decisionsV. NPV or IRR?

    • NPV : ignores the profitability, only considers the inflows and outflows

    • IRR : ignore the size of the project  it could tell it is better to invest in a project of 1000 € that yields IRR of 60% than in a project of 1 000 000 € that yields 30% for example…

    • …but the 1 000 000 € project may be more strategic for the company

    •  rational dimension of investment decision : the last call should be the manager’s


    Npv irr pi and payback summarized

    NPV, IRR, PI and PaybackSummarized


    Chap v making investment decisions v npv or irr1

    Chap V : Making Investment decisionsV. NPV or IRR?

    • Application / Case : Lara vs Carla – 2 projects consisting in investing in a machine that will provide cost savings (increasing productivity). Expected FCF are as follow :


    Chap v making investment decisions v npv or irr2

    Chap V : Making Investment decisionsV. NPV or IRR?

    • Questions : which project should we choose? Use NPV, IRR, Profitability indexes and payback period as criteria to make your decision


    Chap v making investment decisions v npv or irr3

    Chap V : Making Investment decisionsV. NPV or IRR?

    • Answer  NPV criteria : Carla wins shortly… (difference is only 37.8 €!)


    Chap v making investment decisions v npv or irr4

    Chap V : Making Investment decisionsV. NPV or IRR?

    • IRR : Lara wins


    Chap v making investment decisions v npv or irr5

    Chap V : Making Investment decisionsV. NPV or IRR?

    • Profitability index and Payback : still LARA


    Chap v making investment decisions v npv or irr6

    Chap V : Making Investment decisionsV. NPV or IRR?

    • Prof index, Payback : still LARA


    Chap v making investment decisions v npv or irr7

    Chap V : Making Investment decisionsV. NPV or IRR?

    • Conclusion :


    Chap v making investment decisions v npv or irr8

    Chap V : Making Investment decisionsV. NPV or IRR?


    Value creation how do we create value

    Value Creation : How do we create value?


    V alue creation how do we compute value creation

    Value Creation : How do we compute value creation?

    • EVA Formula

    • EVA = Capital Invested x (ROI – WACC)

    • If ROI > WACC then value iscreated

    • If ROI < WACC then value isdestroyed


    Value creation value drivers

    Value Creation : Value drivers


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