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CORPORATE FINANCE MANAGEMENT 2. Master Course VŠFS Fall 201 2 Irena Jind ř ichovsk á irena.jindrichovska @mail.vsfs.cz. Literatur e. Brigham, E and Ehrhardt, M (2004) Financial management: theory and practice, 13th ed., Thomson Learning ISBN-10: 0324259689; ISBN-13: 9780324259681

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Corporate finance management 2

CORPORATE FINANCEMANAGEMENT 2

Master Course VŠFS

Fall 2012

IrenaJindřichovská

[email protected]

Corporate Finance Management 2


Corporate finance management 2

Literature

  • Brigham, E and Ehrhardt, M (2004) Financial management: theory and practice, 13th ed., Thomson Learning ISBN-10: 0324259689; ISBN-13: 9780324259681

  • Other recommended sources:

  • Brealey, R., Myers, S. and Allen, F. (2006) Corporate Finance, 8th international ed., McGraw-Hill ISBN: 0-07-111795-4

  • Ross, Westerfield & Jaffe; Fundamentals of Corporate Finance, 4th edition

  • Bender and Ward: Corporate Financial Strategy, 3rd ed. Butteworth-Heinemann, 2009

  • More sources may be recommended in lectures

Corporate Finance Management 2


Corporate finance management 2

Teaching plan

  • Regular studies:

    12 hours lectures6 hours excercises+ presentation of own work

  • Assignment conditions- essay on topic given +active participation in seminars

  • Exam: Written exam consisting of short essays and calculations

Corporate Finance Management 2


Corporate finance management 2

Outline of the course

Introduction to Corporate finance management

Mergers and acquisitions

Cost of capital and capital structure

Strategy and tactics of financing decisions - investment decision making

Capital Restructuring and Multinational Fin. Management

Lease Financing and Working Capital Management

Risk Management and Real Options

Corporate Finance Management 2


Corporate finance management 2

INTRODUCTION TO CORPORATE FINANCEMANAGEMENT

Corporate Finance Management 2


Outline lecture 1

Outline Lecture 1

  • Introduction

  • Capital structure

  • Company lifecycle

  • Role of financial manager

  • Financial markets

  • Agency theory

  • Stakeholders’ theory

  • Summary, exercises, references

Corporate Finance Management 2


Introduction to corporate finance

Introduction toCorporate Finance

  • Basic questions not only from corporate finance:

  • What long-term investment strategy should a company take on?

  • How can cash be raised for the required investments?

  • How much short-term cash flow does a company need to pay its bills?

Corporate Finance Management 2


The balance sheet model of the firm

Current assets

Net working capital

Fixed assets

Tangible fixed assets

Intangible fixed assets

Current liabilities

Long term debt

Shareholders’ equity

The Balance-Sheet Model of the Firm

Corporate Finance Management 2


Capital structure

Capital Structure

  • Financing arrangements determine how the value of the firm is sliced up.

  • The firm can then determine its capital structure.

  • Capital structure changes in the lifetime of the firm

Corporate Finance Management 2


Capital structure1

Capital Structure

  • The firm might initially have raised the cash to invest in its assets by issuing more debt than equity;

  • Later again it can consider changing that mix by issuing more equity and using the proceeds to buy back some of its debt

Corporate Finance Management 2


Life cycle of the company and its funding

Life Cycle of the company and its funding

  • Boston Consulting Group Matrix

  • Axes

    • horizontal: speed of growth of the market share

    • vertical: market share

  • Start-up

  • Growth

  • Maturity

  • Decline

  • Each phase requires different approach to financial management – according to generated Cash Flow

Corporate Finance Management 2


Life cycle of the company ii

Life Cycle of the company II

Corporate Finance Management 2


Role of the financial manager

Role of the Financial Manager

1. The firm should try to buy assets that generate more cash than they cost.

2. The firm should sell bonds and stocks and other financial instruments that raise more cash than they cost.

Corporate Finance Management 2


Role of the financial manager1

Role of the Financial Manager

  • The firm must create more cash flow than it uses.

  • The cash flows paid to bondholders and stockholders of the firm should be higher than the cash flows put into the firm by the bondholders and stockholders.

Corporate Finance Management 2


Financial markets

Financial Markets

  • Primary and secondary markets

  • Spot and forward markets

  • Money markets

  • Equity markets

  • Organized and over-the-counter markets

    • LSE, AMEX, NYSE; NASDAQ

  • Derivative markets

    • LIFFE, CBOT

Corporate Finance Management 2


Primary and secondary markets1

Primary and secondary markets1

  • Help to get financing for companies

  • Investment companies

  • Pool together and manage the money of many investors

  • Arrange corporate borrowings and security issues

    • Issuing process

Corporate Finance Management 2


Primary and secondary markets2

Primary and secondary markets2

  • Establish the price of securities through supply and demand

  • Execute and settle the transaction

  • Guarantee the settlement through the ‘Clearing house’- a special institution connected with each Stock Exchange

    • There is also a securities exchange commission (SEC ) setting the standards and rules of listing

Corporate Finance Management 2


Agency theory

Agency Theory

  • There are two groups with different interest in each corporation – Shareholders and Managers

  • Goals of shareholders and managers are not the same

  • Jensen and Meckling (1976): Theory of the Firm: Managerial Behavior,Agency Costs and Ownership Structure, JFE 1976

  • Defined Principal – Agent relation

Corporate Finance Management 2


Principal agent

Principal - Agent

  • Owners i.e. Shareholders are Principals

  • Managers are Agents

  • Shareholders want value of their firm to be maximized

  • Managers should act on principals’ behalf but have different goals

Corporate Finance Management 2


Management goals

Management Goals

  • Survival - avoid risky business decisions

  • Selfsufficiency – prefer internal financing to issuance of new stock

  • Shareholders need to control management – Agency Costs –

    • Monitoring costs

    • Incentive fees to convince management to act in shareholders’ interest

Corporate Finance Management 2


Control methods

Control methods

  • Directors are voted by Shareholders and management is selected by directors

  • Management compensation methods

    • Stock option plan

    • Bonuses

    • Performance shares

  • Threat of takeovers

  • Competition on management labor market

Corporate Finance Management 2


Stakeholders theory

Stakeholders’ theory

  • All interested parties that have some relation to the company

    • Shareholders

    • Employees

    • Creditors

    • Banks

    • Suppliers

    • Clients

    • Environment

    • Municipalities

Corporate Finance Management 2


Summary

Summary

1.The goal of financial management in a for-profit business is to make decisions that increase the value of the stock, or, more generally, increase the market value of the equity.

2.Business finance has three main areas of concern:

a. Capital budgeting. What long-term investments should the firm take?

b. Capital structure. Where will the firm get the long-term financing to pay for its investments? In other words, what mixture of debt and equity should we use to fund our operations?

c. Working capital management. How should the firm manage its everyday financial activities?

Corporate Finance Management 2


Summary 2

Summary 2

3.The corporate form of organization is superior to other forms when it comes to raising money and transferring ownership interests, but it has the significant disadvantage of double taxation.

4.There is the possibility of conflicts between stockholders and management in a large corporation. We call these conflicts “agency problems” and discussed how they might be controlled and reduced.

Corporate Finance Management 2


Exercise problems

Exercise problems

  • Define and compare the three forms of organisation a proprietorship, a partnership and a corporation.

  • Explain the agency problem and discuss the relationship between managers and shareholders

    • What are the two types of agency costs?

    • How are managers bonded to shareholders?

    • Can you recall some managerial goals?

    • What is the set-of-contracts perspective?

Corporate Finance Management 2


Useful web source

Useful web source

  • On Agency theory – A review paper

  • http://classwebs.spea.indiana.edu/kenricha/Oxford/Archives/Oxford%202006/Courses/Governance/Articles/Eisenhardt%20-%20Agency%20Theory.pdf

Corporate Finance Management 2


Recomended readings

RECOMENDED READINGS

  • Brigham and Houston: Fundamentals of Financial Management, 12th ed, Ch 1

  • Ross, Westerfield & Jaffe; Fundamentals of Corporate Finance, 4th edition Ch 1 and 2

  • Bender and Ward: Corporate Financial Strategy, 3rd ed. Butteworth-Heinemann, 2009, Ch 2

Corporate Finance Management 2


Corporate finance management 2

COST OF CAPITAL AND CAPITAL STRUCTURE

Corporate Finance Management 2


Outline

Outline

  • Introduction

  • Sources of long term financing

  • Debt versus equity

  • Long term debt

  • Preferred shares

  • Retained earnings

  • Newly issued shares,

    • Gordon model, debt plus risk premium, CAPM approach

  • WACC

  • Value of a company

  • Summary, exercises, references

Corporate Finance Management 2


Equity versus debt

Equity versus debt

Corporate Finance Management 2


Long term debt

Long term debt

  • Loans and bonds

    • Loans (interest is paid before taxes – creation of tax shield, that lowers the cost of L/T debt); T = tax rate

    • Bonds (yield to maturity)

Corporate Finance Management 2


Preferred shares

Preferred shares

  • Perpetuity P = C/r; i.e.

    kp= C / P

  • May need to take in consideration issuance cost (flotation cost F)

    kp= C / (P-F)

Corporate Finance Management 2


Cost of retained equity

Cost of retained equity

  • Using Gordon model of growing perpetuity:

  • P=D1/ (r-g);i.e.

    ks = (D1 / P) + g

Corporate Finance Management 2


Cost of new equity

Cost of new equity

  • Using Gordon model of growing perpetuity taking in consideration flotation cost:

    ke = (D1 / (P-F)) + g

Corporate Finance Management 2


The capm approach

The CAPM approach

  • Estimate using the CAPM

    • Estimate of risk free rate rRF

    • Estimate the market premium RPM

    • Estimate the stock’s beta coefficient bs

    • Substitute in the CAPM equation:

Corporate Finance Management 2


Bond yield plus risk premium approach

Bond yield plus risk premium approach

  • Some analysts us an ad hoc procedure to estimate the firms cost of common equity

  • Adding a judgmental risk premium (3-5%)

    rs = bond yield + bond risk premium

  • It is logical to think that firms with risky, low rated high-interest-rate debt will also have risky high-cost equity

Corporate Finance Management 2


Corporate finance management 2

WACC

  • Weighted average cost of capital – one way of measuring cost of capital of a company

    WACC=wd*kd + wp*kp + ws(e)* ks(e)

  • Another way may be estimating through market model (SML) – ex-post valuation

Corporate Finance Management 2


Factors that affect the weighted average cost of capital

Factors that affect the weighted average cost of capital

  • Factors that firm cannot control

    • The level of interest rates

    • Market risk premium

    • Tax rates

  • Factors the firm can control

    • Capital structure policy

    • Dividend policy

    • Investment policy

Corporate Finance Management 2


Summary1

Summary

  • Earlier chapters on capital budgeting assumed that projects generate riskless cash flows. The appropriate discount rate in that case is the riskless interest rate. Of course, most cash flows from real-world capital-budgeting projects are risky. This chapter discusses the discount rate when cash flows are risky.

  • A firm with excess cash can either pay a dividend or make a capital expenditure. Because stockholders can reinvest the dividend in risky financial assets, the expected return on a capital-budgeting project should be at least as great as the expected return on a financial asset of comparable risk.

Corporate Finance Management 2


Summary 21

Summary 2

3. The expected return on any asset is dependent upon its beta. Thus, we showed how to estimate the beta of a stock. The appropriate procedure employs regression analysis on historical returns.

  • We considered the case of a project whose beta risk was equal to that of the firm.

  • If the firm is unlevered, the discount rate on the project is equal to RF+( M -RF)*ß

    where M is the expected return on the market portfolio and RF is the risk-free rate. In words, the discount rate on the project is equal to the CAPM’s estimate of the expected return on the

Corporate Finance Management 2


Exercise questions

Exercise questions

  • Describe the various sources of capital.

  • Describe the ”optimal” capital structure.

  • Explain the concept: weighted average cost of capital (WACC).

  • Explain how to calculate a value of a firm using WACC.

Corporate Finance Management 2


Exercise problem 1

Exercise problem 1

  • 12.13 RWJ

  • Calculate the weighted average cost of capital for the Luxury Porcelain Company.

  • The book value of Luxury’s outstanding debt is $60 million. Currently, the debt is trading at 120 percent of book value and is priced to yield 12 percent. The 5 million outstanding shares of Luxury stock are selling for $20 per share. The required return on Luxury stock is 18 percent. The tax rate is 25 percent.

Corporate Finance Management 2


Exercise problem 2

Exercise problem 2

  • 12.14 RWJ

  • First Data Co. has 20 million shares of common stock outstanding that are currently being sold for $25 per share. The firm’s debt is publicly traded at 95 percent of its face value of $180 million. The cost of debt is 10 percent and the cost of equity is 20 percent. What is the weighted average cost of capital for the firm? Assume the corporate tax rate is 40 percent.

Corporate Finance Management 2


Useful web sources

Useful web sources

  • Online Tutorial #8: How Do You Calculate A Company's Cost of Capital?

  • http://www.expectationsinvesting.com/tutorial8.shtml

  • And a video lecture (rather easy)

  • http://www.youtube.com/watch?v=JKJglPkAJ5o

Corporate Finance Management 2


Recomended readings1

RECOMENDED READINGS

  • Fundamentals of Corporate Finance, Ross, Westerfield and Jaffe, 6 th edition. Ch 12

  • Brigham and Houston: Fundamentals of Financial Management, 12th ed, Ch 10

Corporate Finance Management 2


Corporate finance management 2

MERGERS AND TAKEOVERS

Corporate Finance Management 2


Outline1

Outline

  • Introduction

  • Mergers ad acquisition rationale

  • Underling principles

  • Business motives for acquisitions

  • Financial strategy

  • Price reaction n acquisition announcement

  • Takeover defense

  • Summary, exercises, references

Corporate Finance Management 2


Mergers and acquisitions

Mergers and Acquisitions

  • Mature companies try to reverse or accelerate the life cycle through dynamic changes in the structure of the business by mergers or acquisitions

  • Two businesses combine into one

  • Mergers are rare  Acquisitions

  • Larger and smaller company  acquirer and target company

Corporate Finance Management 2


Underlying principles

Underlying principles

  • Combined future CF’s are bigger than sum of CF’s of two individual companies

  • Not in case of large premium paid to shareholders of the target

    • (90%-125% of exp. value of the synergy has been paid to the sellers) - better to be seller then buyer

Corporate Finance Management 2


M a s market imperfections

M&A’s = “market imperfections”

  • Asymmetric price reaction on acquisition announcement:

  • Target company is undervalued in the market (inefficient market)

  • Participants do not agree on the price of the target company stock

  • ? Synergy effect (2+2=5)

Corporate Finance Management 2


Source of synergy from acquisitions

Source of synergy from acquisitions

  • Revenue Enhancement

    • Marketing Gains

    • Strategic Benefits

    • Market or Monopoly Power

  • Cost Reduction

    • Economies of Scale

    • Economies of Vertical Integration

    • Complementary Resources

    • Elimination of Inefficient Management

Corporate Finance Management 2


Source of synergy from acquisitions 2

Source of synergy from acquisitions 2

  • Tax Gains

    • Net Operating Losses

    • Unused Debt Capacity

    • Surplus Funds

  • The Cost of Capital

Corporate Finance Management 2


Two bad reasons for mergers

Two “bad” reasons for mergers

  • Earnings Growth

    • EPS Game

  • Diversification

    • Systematic variability cannot be eliminated by diversification, so mergers will not eliminate this risk at all. By contrast, unsystematic risk can be diversified away through mergers.

Corporate Finance Management 2


Influence of innovative products

Influence of innovative products

  • Management may forget the underlying principles justifying M&A

  • Target company must be worth more than it will cost the acquirer

Corporate Finance Management 2


Cash versus common stock

Cash versus Common Stock

  • Whether to finance an acquisition by cash or by shares of stock is an important decision.

  • The choice depends on several factors, as follows:

  • 1. Overvaluation. If in the opinion of management the acquiring firm’s stock is overvalued, using shares of stock can be less costly than using cash.

  • 2. Taxes. Acquisition by cash usually results in a taxable transaction. Acquisition by exchanging stock is tax free.

Corporate Finance Management 2


Cash versus common stock 2

Cash versus Common Stock 2

  • 3. Sharing Gains. If cash is used to finance an acquisition, the selling firm’s shareholders receive a fixed price. In the event of a hugely successful merger, they will not participate in any additional gains. Of course, if the acquisition is not a success, the losses will not be shared and shareholders of the acquiring firm will be worse off than if stock were used.

Corporate Finance Management 2


Financial strategy in acquisitions

Financial strategy in acquisitions

  • Financial role - to evaluate the synergy effect

  • Strategy - change the financial structure of target company  leverage the company

  • Target company with cash surpluses (mature group)  Corporate raider acquires the company, strips it off the cash and leverages the company

Corporate Finance Management 2


Diversified companies

Diversified companies

  • Diversified group should be valued at minimum weighted average P/E applicable to its component businesses

  • If the company does not perform well after acquisition  sell parts of the group for higher P/E – divestiture, spin-offs,…

Corporate Finance Management 2


Greenmailing

“Greenmailing”

  • Significant minority impacts on the corporate strategy

  • Raider buys a significant part of the co. which he considers undervalued and “greenmails” the management, asserting that the company is badly managed

  • Management buys him out  cash drain

Corporate Finance Management 2


Eps game

EPS game

  • Growth in P/E is automatically created by an equity funded acquisition if P/E of bidder > P/E of target

  • If companies have the same P/E multiple

  • And financial structure of target company is changed  debt instead of equity

  • EPS of the group 

  • However, increased growth prospects are offset by  financial risk due to  debt

Corporate Finance Management 2


Eps game1

EPS game

Company A is considering acquiring companies B, C, and D but it wishes to ensure that each deal increases EPS.Finance can be raised through equity or debt or through any other financial mechanism. After-tax cost of debt = 5%.

Corporate Finance Management 2


Corporate finance management 2

Corporate Finance Management 2


Higher growth companies

Higher growth companies

  • EPS bidding < EPS target

  • P/E bidding < P/E target

  • Post-acquisition P/E  to appropriate weighted average of the original businesses

  • EPS  because bidding company is larger than target company

Corporate Finance Management 2


Takeover defense

Takeover defense

  • Pre-offer defense

    • Shark repellent

    • Staggered board

    • Quorum

    • Poison pills

    • Re-capitalization with special right shares

  • Post offer defense

    • Pacman defense

    • Violation of antitrust law

    • Change of asset structure

    • Change of liabilities structure

Corporate Finance Management 2


Summary2

Summary

  • The synergy from an acquisition is defined as the value of the combined firm (VAB) less the value of the two firms as separate entities (VAand VB), or Synergy VAB - (VA +VB)

    The shareholders of the acquiring firm will gain if the synergy from the merger is greater than the premium.

  • The three legal forms of acquisition are merger and consolidation, acquisition of stock, and acquisition of assets.

  • Mergers and acquisitions require an understanding of complicated tax and accounting rules

Corporate Finance Management 2


Summary 22

Summary 2

4.The possible benefits of an acquisition come from:

a. Revenue enhancement, b. Cost reduction, c. Lower taxes, d. Lower cost of capital

The reduction in risk from a merger may help bondholders and hurt stockholders.

5.The empirical research on mergers and acquisitions is extensive. Its basic conclusions are that, on average, the shareholders of acquired firms fare very well, while the shareholders of acquiring firms do not gain much.

Corporate Finance Management 2


Exercise problems1

Exercise problems

  • Do M&As create value at all?

  • Who are the main beneficiaries of M&A in the short term / long term?

  • In an efficient market with no tax effects, should an acquiring firm use cash or stock?

  • Explain the Japanese Keiretsu, how does it function?

  • M&A valuation problem – on separate sheet

Corporate Finance Management 2


Useful web sources1

Useful web sources

  • A book on Mergers and acquisitions by Weston and Weaver (2001) - book preview

  • http://www.google.com/books?hl=cs&lr=&id=Y2Mz7tOuJBgC&oi=fnd&pg=PP9&dq=mergers+and+acquisitions&ots=85kGKKGutc&sig=iY_Ztx8tQY42Kzmw2-UrVp25rTM#v=onepage&q=mergers%20and%20acquisitions&f=true

Corporate Finance Management 2


Useful web source 2

Useful web source 2

  • Characteristics of takeover defense strategies

  • http://www.investopedia.com/articles/stocks/08/corporate-takeover-defense.asp#axzz29MjA54dw

Corporate Finance Management 2


Recomended readings2

RECOMENDED READINGS

  • Fundamentals of Corporate Finance, Ross, Westerfield and Jaffe, 4th edition. Ch 29

  • Brigham and Houston: Fundamentals of Financial Management, 12th ed, Ch 15

Corporate Finance Management 2


Corporate finance management 2

CAPITAL STRUCTURE

Corporate Finance Management 2


Outline2

Outline

  • Capital structure concept – maximizing value

  • Optimal capital structure

  • M&M Theory of Independence

  • M&M Theory of Dependence

  • Taxes and financial leverage

  • Cost of financial distress and agency costs

  • EBIT-EPS analysis

  • Summary, exercises, references

Corporate Finance Management 2


Goal of capital structure management

Goal of capital structure management

  • Maximize the share price

  • Minimize the weighted average cost of capital

  • Too big financial leverage can bring firm to bankruptcy

  • Too small financial leverage leads to undervaluing of share price

Corporate Finance Management 2


Miller modigliani 1958

Miller & Modigliani (1958)

  • The Cost of Capital, Corporation Finance and the Theory of Investment, American Economic Review 48: 261-297

Corporate Finance Management 2


Importance of capital structure

Importance of capital structure

  • Cost of capital is one of the cost and therefore influence dividends

  • If the cost of capital are minimized, the payments to shareholders is maximized

  • If the cost of capital can be determined by corporate capital structure then the capital structure management is an important part of firm management

Corporate Finance Management 2


Assumptions

Assumptions

  • The share price is a perpetuity: P0 = Dt/Kc

  • The firm pays constant dividends

  • Dividend-Pay-Out = 100%, i.e. no retained earnings

  • There are no taxes

  • Capital structure consists of Debt & Equity only

Corporate Finance Management 2


Further assumptions

Further assumptions

  • Financial structure is modified by issuing new shares to buy out debt or the other way around

  • EBIT is assumed to remain constant

  • Shares and other securities are traded on efficient market

Corporate Finance Management 2


Proposition i independence hypothesis

Proposition I.Independence Hypothesis

  • The cost of capital of the firm (K0) and share price P0 are both independent on capital structure (financial leverage)

  • Total market value of the firm securities stays unchanged disregarding the degree of leverage (picture)

  • The basic relation of Independence Hypothesis: Percentage change of cost of equity Kc = Percentage change in dividends Dt

Corporate Finance Management 2


Proposition ii dependence hypothesis

Proposition II.Dependence Hypothesis

  • Both the cost of capital (K0) and share price (P0) are influenced by firm’s capital structure

  • Weighted average cost of capital (K0) will decrease as the D/E increases, and the share price (P0) increases with growing leverage, therefore companies should use as high leverage as possible (picture)

Corporate Finance Management 2


Dependence hypothesis

Dependence Hypothesis

  • According to Dependence Hypothesis: Percentage change of cost of equity Kc= 0, however, percentage change in dividends Dt > 0

  • Percentage change of price = percentage change of dividends

Corporate Finance Management 2


Taxes and financial leverage

Taxes and financial leverage

  • The interest is deductible from the tax base

  • Use of debt in capital structure should lead to increased market value of firm securities

  • The middle view assumes that interest tax shied has its market value which increases total market value of the firm

Corporate Finance Management 2


Cost of financial distress

Cost of financial distress

  • The probability of bankruptcy increases with increasing leverage.

  • The firm has the highest costs if it gets bankrupt –

    • Assets are liquidated for lower than market price

    • Banks refuse to lend

    • Suppliers refuse to grant commercial credit

    • Dividend payments are stopped

  • At certain point the expected bankruptcy costs outweigh the tax shield and the firm has to change the capital structure (Pictures)

Corporate Finance Management 2


Further topics

Further topics

  • Optimal financial structure

  • EBIT-EPS analysis

  • Point of financial indifference

  • Implicit cost cost of debt – increased risk

  • Practical measures of capital structure management

Corporate Finance Management 2


Capital structure theories

Capital structure theories

  • The trade-off theory

    • The trade-off between benefits and costs of debt

    • Small debt – small tax shield but more financial flexibility

  • Pecking order theory

    • Different types of capital have different costs -the least expensive source is used first

Corporate Finance Management 2


Summary 1

Summary 1

  • In general, a firm can choose among many alternative capital structures.

  • It can issue a large amount of debt or it can issue very little debt.

  • It can issue floating-rate preferred stock, warrants, convertible bonds, caps, and callers.

  • It can arrange lease financing, bond swaps, and forward contracts.

Corporate Finance Management 2


Summary 23

Summary 2

  • Because the number of instruments is so large, the variations in capital structures are endless.

  • We simplify the analysis by considering only common stock and straight debt in this chapter.

  • We examine the factors that are important in the choice of a firm’s debt-to-equity ratio.

Corporate Finance Management 2


Exercise questions1

Exercise questions

  • Explain the concept of capital structure

  • Define the optimal capital structure

  • Explain the logic of M&M Theory of independence

  • Explain M&M Theory of dependence

  • Explain the role of taxes in financial structure

  • Explain the cost of financial distress and agency costs

Corporate Finance Management 2


Exercise problem 11

Exercise problem 1

  • Gearing Manufacturing, Inc is planning a $ 1 000 000 expansion of its production facilities. The expansion could be financed by the sale of $1 250 000 in 8% notes or by the sale of $ 1 250 000 in capital stock. Which would raise the number of shares outstanding from 50 000 to 75 000. Gearing pays income taxes at a rate of 30%.

  • Suppose that income from operations is expected to be $ 550 000 per year for the duration of the proposed debt issue, Should Gearing be financed with debt or stock? Explain your answer.

Corporate Finance Management 2


Useful web sources2

Useful web sources

  • Financing decisions: Capital Structure and cost of capital

  • http://www.slideshare.net/meowbilla/4a304-capital-structure

  • CFA 1 Materials

  • http://www.investopedia.com/exam-guide/cfa-level-1/corporate-finance/mm-capital-structure-versus-tradeoff-leverage.asp#axzz1sgRpYOfd

Corporate Finance Management 2


Recomended readings3

RECOMENDED READINGS

  • Fundamentals of Corporate Finance, Ross, Westerfield and Jaffe, 6 th edition. Ch 12

  • Brigham and Houston: Fundamentals of Financial Management, 12th ed, Ch 10

Corporate Finance Management 2


Corporate finance management 2

STRATEGY AND TACTICS OF FINANCING DECISIONS

- INVESTMENT DECISION MAKING

Corporate Finance Management 2


Outline3

Outline

  • Introduction

  • Investment decision making

  • Nature of projects and incremental cash flows

  • Project phases and relevant cash flows

  • Decision making methods incl. pros and cons

  • Comparing different projects

  • Summary, exercises, references

Corporate Finance Management 2


Investment projects

Investment Projects

  • Nature of project

  • Profit generating projects

    • Increasing capacity, new equipment

    • Replacement projects

  • Ecological projects – minimizing loss

Corporate Finance Management 2


Long term nature of projects

Long-term nature of projects

  • Analyzing - incremental cash flows

    • Changes of the firms cash flow that occur as a direct consequence of accepting the project

  • Costs vs. Cash flows

  • Sunk costs

  • Opportunity costs (potential revenues form alternative uses are lost)

  • Side effects - transfers

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Project phases

Project Phases

1. Investment phase

2. Operating phase (income and taxes)

3. Liquidating phase (sometimes included in operating phase)

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Investment decision making methods

Investment decision making methods

Net Present Value - NPV

Internal Rate of Return - IRR

Payback Period - PP

Profitability Index - PI

Modified Internal Rate of Return - IRR*

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Net present value

Net Present Value

  • The most frequently used decision making method

  • Discounts individual positive and negative cash flows to the present – finding their present value

  • Projects with positive net present value are accepted

  • This method is sensitive to the discount rate used in the process of calculation

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Internal rate of return

Internal Rate of Return

  • The discount rate of the project that forces its net present value to equal zero

  • NPV = 0

  • Positive and negative cash flows are discounted at rate IRR. APPROXINMATION of this rate can be found using iterations or linear interpolation

  • Advantage - comparison with cost of capital

  • STRONG ASSUMPTION - cash inflows are reinvested at a rate IRR

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Payback period

Payback Period

  • Non-discounted method

  • Discounted method

  • Cumulated cash flows

  • ASSUMPTION- evenly distributed cash flows during the course of each period

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Profitability index

Profitability index

  • Present value of cash inflows to present value of cash outflows

  • Decision rule: PI > 1

  • The same decisions as NPV

  • Profitability indexes of two projects can not be added, whereas the NPVs can

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Modified internal rate of return

Modified Internal Rate of Return

  • Removes the strong assumption about reinvesting cash inflows for the high IRR

  • Maintains the advantage - easy comparison with cost of capital – the appropriate discount rate

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Modified irr formula

Modified IRR* - formula

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Comparing projects

Comparing projects

Conflict between NPV and IRR

Projects with irregular cash flows

Projects with several negative cash flows

Comparing projects with different time horizon

Crossover rate

Capital Asset Pricing Model - CAPM

application in capital budgeting

Corporate Finance Management 2


Summary3

Summary

  • Investment decision making must be placed on an incremental basis - sunk costs must be ignored, while both opportunity costs and side effects must be considered.

  • Inflation must be handled consistently. One approach is to express both cash flows and the discount rate in nominal terms.

  • When a firm must choose between two machines of unequal lives, the firm can apply either the matching cycle approach or the equivalent annual cost approach. Both approaches are different ways of presenting the same information.

Corporate Finance Management 2


Summary 24

Summary 2

  • In this chapter we cover different investment decision rules. We evaluate the most popular alternatives to the NPV: the payback period, the accounting rate of return, the internal rate of return, and the profitability index. In doing so, we learn more about the NPV.

  • The specific problems with the NPV for mutually exclusive projects was discussed. We showed that, either due to differences in size or in timing, the project with the highest IRR need not have the highest NPV. Hence, the IRR rule should not be applied. (Of course, NPV can still be applied.)

Corporate Finance Management 2


Exercise questions2

Exercise questions

  • What are the difficulties in determining incremental cash flows?

  • Define sunk costs, opportunity costs, and side effects.

  • What are the items leading to cash flow in any year?

  • Why is working capital viewed as a cash outflow?

  • Discuss the pros and cons of investment decision making methods

  • What is the difference between the nominal and the real interest rate and nominal and real cash flow?

  • Discuss the problems of IRR method

Corporate Finance Management 2


Useful web sources3

Useful web sources

  • http://www.studyfinance.com/lessons/capbudget/

  • http://www.capitalbudgetingtechniques.com/

  • What is capital budgeting - text

  • http://www.exinfm.com/training/capitalbudgeting.doc

  • Impact of inflation on investment decision making

  • http://www.studyfinance.com/jfsd/pdffiles/v9n1/mills.pdf

Corporate Finance Management 2


Recomended readings4

RECOMENDED READINGS

  • Fundamentals of Corporate Finance, Ross, Westerfield and Jaffe, 4th edition. Ch 7

  • Brigham and Houston: Fundamentals of Financial Management, 12th ed, Ch 9, 10

Corporate Finance Management 2


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