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Corporate Finance in a Day An Analysis of Grace Kennedy . Aswath Damodaran Home Page : www.stern.nyu.edu/~adamodar www.stern.nyu.edu/~adamodar/New_Home_Page/cfshdesc.html E-Mail : adamodar@stern.nyu.edu. Stern School of Business. A Financial View of the Firm… . First Principles.

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corporate finance in a day an analysis of grace kennedy

Corporate Finance in a DayAn Analysis of Grace Kennedy

Aswath Damodaran

Home Page: www.stern.nyu.edu/~adamodar

www.stern.nyu.edu/~adamodar/New_Home_Page/cfshdesc.html

E-Mail: adamodar@stern.nyu.edu

Stern School of Business

first principles
First Principles
  • Invest in projects that yield a return greater than the minimum acceptable hurdle rate.
    • The hurdle rate should be higher for riskier projects and reflect the financing mix used - owners’ funds (equity) or borrowed money (debt)
    • Returns on projects should be measured based on cash flows generated and the timing of these cash flows; they should also consider both positive and negative side effects of these projects.
  • Choose a financing mix that minimizes the hurdle rate and matches the assets being financed.
  • If there are not enough investments that earn the hurdle rate, return the cash to stockholders.
    • The form of returns - dividends and stock buybacks - will depend upon the stockholders’ characteristics.

Objective: Maximize the Value of the Firm

the objective in decision making
The Objective in Decision Making
  • In traditional corporate finance, the objective in decision making is to maximize the value of the business you run (firm).
  • A narrower objective is to maximize stockholder wealth. When the stock is traded and markets are viewed to be efficient, the objective is to maximize the stock price.
  • All other goals of the firm are intermediate ones leading to firm value maximization, or operate as constraints on firm value maximization.
the classical objective function
The Classical Objective Function

STOCKHOLDERS

Hire & fire

managers

- Board

- Annual Meeting

Maximize

stockholder wealth

No Social Costs

Lend Money

Managers

BONDHOLDERS

SOCIETY

Protect

bondholder

Interests

Costs can be

traced to firm

Reveal

information

honestly and

on time

Markets are

efficient and

assess effect on

value

FINANCIAL MARKETS

what can go wrong
What can go wrong?

STOCKHOLDERS

Managers put

their interests

above stockholders

Have little control

over managers

Significant Social Costs

Lend Money

Managers

BONDHOLDERS

SOCIETY

Bondholders can

get ripped off

Some costs cannot be

traced to firm

Delay bad

news or

provide

misleading

information

Markets make

mistakes and

can over react

FINANCIAL MARKETS

when traditional corporate financial theory breaks down the solution is
When traditional corporate financial theory breaks down, the solution is:
  • To choose a different mechanism for corporate governance. Japan and Germany have corporate governance systems which are not centered around stockholders.
  • To choose a different objective - maximizing earnings, revenues or market share, for instance.
  • To maximize stock price, but reduce the potential for conflict and breakdown:
    • Making managers (decision makers) and employees into stockholders
    • Providing lenders with prior commitments and legal protection
    • By providing information honestly and promptly to financial markets
    • By converting social costs into economic costs.
the only self correcting objective
The Only Self Correcting Objective

STOCKHOLDERS

Managers of poorly

run firms are put

on notice.

1. More activist

investors

2. Hostile takeovers

Protect themselves

Corporate Good Citizen Constraints

Managers

BONDHOLDERS

SOCIETY

1. Covenants

2. New Types

1. More laws

2. Investor/Customer Backlash

Firms are

punished

for misleading

markets

Investors and

analysts become

more skeptical

FINANCIAL MARKETS

looking at grace kennedy s top stockholders
Looking at Grace Kennedy’s top stockholders

Top 10 stockholders

Jamaica Producers Group

Luli Limited

J.K. Investments

Grace Kennedy Pension

Life of Jamaica Equity Fund 1

National Insurance Fund

James S. Moss Solomon

Scojampen Limited

Joan E. Belcher

Celia Kennedy

first principles11
First Principles
  • Invest in projects that yield a return greater than the minimum acceptable hurdle rate.
    • The hurdle rate should be higher for riskier projects and reflect the financing mix used - owners’ funds (equity) or borrowed money (debt)
    • Returns on projects should be measured based on cash flows generated and the timing of these cash flows; they should also consider both positive and negative side effects of these projects.
  • Choose a financing mix that minimizes the hurdle rate and matches the assets being financed.
  • If there are not enough investments that earn the hurdle rate, return the cash to stockholders.
    • The form of returns - dividends and stock buybacks - will depend upon the stockholders’ characteristics.

Objective: Maximize the Value of the Firm

what is risk
What is Risk?
  • Risk, in traditional terms, is viewed as a ‘negative’. Webster’s dictionary, for instance, defines risk as “exposing to danger or hazard”. The Chinese symbols for risk, reproduced below, give a much better description of risk
  • The first symbol is the symbol for “danger”, while the second is the symbol for “opportunity”, making risk a mix of danger and opportunity.
the riskfree rate
The Riskfree Rate
  • For an investment to be riskfree, i.e., to have an actual return be equal to the expected return, two conditions have to be met –
    • There has to be no default risk, which generally implies that the security has to be issued by the government. Note, however, that not all governments can be viewed as default free.
    • There can be no uncertainty about reinvestment rates, which implies that it is a zero coupon security with the same maturity as the cash flow being analyzed.
  • Using a long term default-free government rate (even on a coupon bond) as the riskfree rate on all of the cash flows in a long term analysis will yield a close approximation of the true value.
estimating riskfree rates in jamaican and us
Estimating Riskfree Rates in Jamaican $ and US $
  • The ten-year treasury bond rate in the US on May 28, 2004 was 4.70%. This would be the riskfree rate in US dollars.
  • The riskfree rate in Jamaica is much more difficult to estimate.
    • The Bank of Jamaica lowered the one-year open market rate to 16.4% from 16.9% on May 6, 2004.
    • The most recent debentures issued by the Government of Jamaica have coupon rates of between 16 and 17%. The most recent 6-month T.Bill rate is 15.09%.
    • On May 27, investors in savings accounts in Jamaica could expect to earn 11.37%. The riskfree rate should be higher than this number.

My guess: The long term riskfree rate in Jamaican $ is about 15%.

the risk premium what is it
The Risk Premium: What is it?
  • The risk premium is the premium that investors demand for investing in an average risk investment, relative to the riskfree rate.
  • Assume that stocks are the only risky assets and that you are offered two investment options:
    • a riskless investment (say a Government Security), on which you can make 5%
    • a mutual fund of all stocks, on which the returns are uncertain

How much of an expected return would you demand to shift your money from the riskless asset to the mutual fund?

  • Less than 5%
  • Between 5 - 7%
  • Between 7 - 9%
  • Between 9 - 11%
  • Between 11 - 13%
  • More than 13%
one way to estimate risk premiums look at history
One way to estimate risk premiums: Look at history

Arithmetic average Geometric Average

Stocks - Stocks - Stocks - Stocks -

Historical Period T.Bills T.Bonds T.Bills T.Bonds

1928-2003 7.92% 6.54% 5.99% 4.82%

1963-2003 6.09% 4.70% 4.85% 3.82%

1993-2003 8.43% 4.87% 6.68% 3.57%

What is the right premium?

  • Go back as far as you can. Otherwise, the standard error in the estimate will be large. (
  • Be consistent in your use of a riskfree rate.
  • Use arithmetic premiums for one-year estimates of costs of equity and geometric premiums for estimates of long term costs of equity.

Data Source: Check out the returns by year and estimate your own historical premiums by going to updated data on my web site.

adjusted equity risk premium
Adjusted Equity Risk Premium
  • Start with the U.S. historical risk premium as a base (4.82%)
  • Add the default spread of the country in which you plan to operate to the U.S. risk premium to arrive at an equity risk premium for that market.
    • Jamaica Equity Risk Premium = 4.82% + 3% = 7.82%
    • Trinidad Equity Risk Premium = 4.82% + 1.20% = 6.02%
    • Barbados Equity Risk Premium = 4.82% + 0.95% = 5.77%
estimating beta
Estimating Beta
  • The beta of a stock measures the risk in a stock that cannot be diversified away. It is determined by both how volatile a stock is and how it moves with the market.
  • The standard procedure for estimating betas is to regress stock returns (Rj) against market returns (Rm) -

Rj = a + b Rm

where a is the intercept and b is the slope of the regression.

  • The slope of the regression corresponds to the beta of the stock, and measures the riskiness of the stock.
us dollar cost of equity by division and by investment region in us dollar terms
US Dollar Cost of Equity: By division and By investment region (In US dollar terms)

Division Jamaica Trinidad Barbados United States

Food Trading 11.51% 9.95% 9.73% 8.90%

Retailing 11.35% 9.82% 9.60% 8.80%

Financial Services 9.51% 8.41% 8.25% 7.67%

Maritime 7.90% 7.16% 7.06% 6.67%

Information Services 11.35% 9.82% 9.60% 8.80%

Grace Kennedy 10.16% 8.90% 8.73% 8.07%

Riskfree rate used = US dollar riskfree rate of 4.70%

Risk premium = 7.82% for Jamaica

6.02% for Trinidad

5.77% for Barbados

4.82% for US

from cost of equity to cost of capital
From Cost of Equity to Cost of Capital
  • The cost of capital is a composite cost to the firm of raising financing to fund its projects.
  • In addition to equity, firms can raise capital from debt. To get to the cost of capital, we need to
    • First estimate the cost of borrowing money
    • And then weight debt and equity in the proportions that they are used in financing.
  • The cost of debt for a firm is the rate at which it can borrow money today. It should a be a direct function of how much risk of default a firm carries and can be written as
    • Cost of Debt = Riskfree Rate + Default Spread
default spreads and bond ratings
Default Spreads and Bond Ratings
  • Many firms in the United States are rated by bond ratings agencies like Standard and Poor’s and Moody’s for default risk. If you have a rating, you can estimate the default spread from it.
  • If your firm is not rated, you can estimate a “synthetic rating” using the financial characteristics of the firm. In its simplest form, the rating can be estimated from the interest coverage ratio

Interest Coverage Ratio = EBIT / Interest Expenses

  • For Grace Kennedy, the interest coverage ratio in 2003 is estimated from the operating income of 1986.292 million J$ and the interest expenses of 321.902 million J$.

Interest Coverage Ratio = 1986/322 = 5.00

interest coverage ratios ratings and default spreads
Interest Coverage Ratios, Ratings and Default Spreads

If Interest Coverage Ratio is Estimated Bond Rating Default Spread(2004)

>12.50 AAA 0.35%

9.5-12.5 AA 0.50%

7.5-9.5 A+ 0.70%

6-7.5 A 0.85%

4.5-6 A– 1.00%

4-4.5 BBB 1.50%

3.5-4 BB+ 2.00%

3-3.5 BB 2.50%

2.5-3 B+ 3.25%

2-2.5 B 4.00%

1.5-2 B – 6.00%

1.25-1.5 CCC 8.00%

0.8-1.25 CC 10.00%

0.5-0.8 C 12.00%

<0.5 D 20.00%

6 grace kennedy s cost of debt
6 Grace Kennedy’s Cost of Debt
  • Based upon the interest coverage ratio of 5, we would assign a bond rating of A- to Grace Kennedy, leading to a default spread of 1% over a US dollar riskfree rate. Since the riskfree rate in Jamaica is roughly three times higher, we will triple this default spread, leading to a pre-tax cost of debt of
    • Cost of debt = Riskfree Rate + Default Spread = 15% + 3% = 18%
    • Cost of debt (US $) = Riskfree Rate + Default spread =4.70% + 1% = 5.70%
  • With a tax rate of 33.33%, the after-tax cost of debt can be computed:
    • Aftet-tax cost of debt in J$ = 18% (1-.3333) = 12%
    • After-tax cost of debt in US $ = 5.70% (1-.3333) = 3.80%
estimating market value weights
Estimating Market Value Weights
  • Market Value of Equity should include the following
    • Market Value of Shares outstanding
    • Market Value of Warrants outstanding
    • Market Value of Conversion Option in Convertible Bonds
  • Market Value of Debt is more difficult to estimate because few firms have only publicly traded debt. There are two solutions:
    • Assume book value of debt is equal to market value
    • Estimate the market value of debt from the book value
us dollar cost of capital by division and by investment region in us dollar terms
US Dollar Cost of Capital: By division and By investment region (In US dollar terms)

Division Jamaica Trinidad Barbados United States

Food Trading 10.73% 8.67% 9.73% 8.90%

Retailing 10.58% 8.57% 9.60% 8.80%

Financial Services 8.16% 7.58% 8.25% 7.67%

Maritime 7.48% 6.57% 7.06% 6.67%

Information Services 10.58% 8.57% 9.60% 8.80%

Grace Kennedy 9.51% 7.90% 8.73% 8.07%

first principles32
First Principles
  • Invest in projects that yield a return greaterthan the minimum acceptable hurdle rate.
    • The hurdle rate should be higher for riskier projects and reflect the financing mix used - owners’ funds (equity) or borrowed money (debt)
    • Returns on projects should be measured based on cash flows generated and the timing of these cash flows; they should also consider both positive and negative side effects of these projects.
  • Choose a financing mix that minimizes the hurdle rate and matches the assets being financed.
  • If there are not enough investments that earn the hurdle rate, return the cash to stockholders.
    • The form of returns - dividends and stock buybacks - will depend upon the stockholders’ characteristics.

Objective: Maximize the Value of the Firm

measures of return earnings versus cash flows
Measures of return: earnings versus cash flows
  • Principles Governing Accounting Earnings Measurement
    • Accrual Accounting: Show revenues when products and services are sold or provided, not when they are paid for. Show expenses associated with these revenues rather than cash expenses.
    • Operating versus Capital Expenditures: Only expenses associated with creating revenues in the current period should be treated as operating expenses. Expenses that create benefits over several periods are written off over multiple periods (as depreciation or amortization)
  • To get from accounting earnings to cash flows:
    • you have to add back non-cash expenses (like depreciation)
    • you have to subtract out cash outflows which are not expensed (such as capital expenditures)
    • you have to make accrual revenues and expenses into cash revenues and expenses (by considering changes in working capital).
measuring returns right the basic principles
Measuring Returns Right: The Basic Principles
  • Use cash flows rather than earnings. You cannot spend earnings.
  • Use “incremental” cash flows relating to the investment decision, i.e., cashflows that occur as a consequence of the decision, rather than total cash flows.
  • Use “time weighted” returns, i.e., value cash flows that occur earlier more than cash flows that occur later.

The Return Mantra: “Time-weighted, Incremental Cash Flow Return”

earnings versus cash flows a proposed grace kennedy investment american roti
Earnings versus Cash Flows: A Proposed Grace Kennedy Investment - American Roti
  • Grace Kennedy is planning to introduce a new line of frozen Jamaican dinners and snacks under the brand name American Roti and aimed at broad US market. It has already spent $ 5 million in market testing and collecting information.
  • To make the investment, Grace Kennedy believes that it will need to invest $ 50 million upfront and that this investment can be depreciated straight line over 5 years down to a salvage value of $ 10 million. In addition, it will need to maintain a working capital investment equal to 20% of its revenues, with the investment at the beginning of each year.
  • The market testing has yielded potential market share estimates and revenues (shown on the next page). Grace Kennedy will allocate 20% of its General and administrative expenses to this investment, though 60% of this cost is fixed.
currency conversions
Currency Conversions
  • If you wanted to convert these US dollar cashflows into Jamaican dollar cashflows, what exchange rate would you use?
  • The current exchange rate
  • Expected future exchange rates

Why?

would lead use to conclude that
Would lead use to conclude that...
  • Do not invest in American Roti. The US $ return on capital of 8.62% is lower than the US$ cost of capital for food division investments in the United States of 8.90% This would suggest that the project should not be taken.
  • Given that we have computed the average over an arbitrary period of 5 years, while the investment would have a life greater than 5 years, would you feel comfortable with this conclusion?
  • Yes
  • No
the cash flow view of this project
The cash flow view of this project..
  • To get from income to cash flow, we
  • added back all non-cash charges such as depreciation
  • subtracted out the capital expenditures
  • subtracted out the change in non-cash working capital
depreciation methods
Depreciation Methods
  • We used straight line depreciation to estimate the cashflows. Assume that you had been able to depreciate more of the asset in the earlier years and less in later years (though the total depreciation would remain unchanged). Switching to an accelerated depreciation method would
  • Increase earnings in the early years and decrease the cashflows
  • Decrease earnings in the early years but increase the cashflow
  • Decrease both earnings and cashflow in the early years
  • Increase both earnings and cashflow in the early years
the incremental cash flows on the project
The incremental cash flows on the project
  • To get from cash flow to incremental cash flows, we
  • Ignore the investment in market testing because it has occurred already and cannot be recovered.
  • Add back the non-incremental allocated costs (in after-tax terms)
to time weighted cash flows
To Time-Weighted Cash Flows
  • Net Present Value (NPV): The net present value is the sum of the present values of all cash flows from the project (including initial investment).

NPV = Sum of the present values of all cash flows on the project, including the initial investment, with the cash flows being discounted at the appropriate hurdle rate (cost of capital, if cash flow is cash flow to the firm, and cost of equity, if cash flow is to equity investors)

    • Decision Rule: Accept if NPV > 0
  • Internal Rate of Return (IRR): The internal rate of return is the discount rate that sets the net present value equal to zero. It is the percentage rate of return, based upon incremental time-weighted cash flows.
    • Decision Rule: Accept if IRR > hurdle rate
which makes the argument that
Which makes the argument that..
  • The project should be accepted. The positive net present value suggests that the project will add value to the firm, and earn a return in excess of the cost of capital.
  • By taking the project, Grace Kennedy will increase its value as a firm by $40.31 million.
the irr suggests
The IRR suggests..
  • The project is a good one. Using time-weighted, incremental cash flows, this project provides a return of 22%. This is greater than the cost of capital of 8.90%.
  • The IRR and the NPV will yield similar results most of the time, though there are differences between the two approaches that may cause project rankings to vary depending upon the approach used.
the role of sensitivity analysis
The Role of Sensitivity Analysis
  • Our conclusions on a project are clearly conditioned on a large number of assumptions about revenues, costs and other variables over very long time periods.
  • To the degree that these assumptions are wrong, our conclusions can also be wrong.
  • One way to gain confidence in the conclusions is to check to see how sensitive the decision measure (NPV, IRR..) is to changes in key assumptions.
side costs and benefits
Side Costs and Benefits
  • Most projects considered by any business create side costs and benefits for that business.
  • The side costs include the costs created by the use of resources that the business already owns (opportunity costs) and lost revenues for other projects that the firm may have.
  • The benefits that may not be captured in the traditional capital budgeting analysis include project synergies (where cash flow benefits may accrue to other projects) and options embedded in projects (including the options to delay, expand or abandon a project).
  • The returns on a project should incorporate these costs and benefits.
first principles51
First Principles
  • Invest in projects that yield a return greater than the minimum acceptable hurdle rate.
    • The hurdle rate should be higher for riskier projects and reflect the financing mix used - owners’ funds (equity) or borrowed money (debt)
    • Returns on projects should be measured based on cash flows generated and the timing of these cash flows; they should also consider both positive and negative side effects of these projects.
  • Choose a financing mix that minimizes the hurdle rate and matches the assets being financed.
  • If there are not enough investments that earn the hurdle rate, return the cash to stockholders.
    • The form of returns - dividends and stock buybacks - will depend upon the stockholders’ characteristics.
debt the trade off
Debt: The Trade-Off

Advantages of Borrowing

Disadvantages of Borrowing

1. Tax Benefit:

1. Bankruptcy Cost:

Higher tax rates --> Higher tax benefit

Higher business risk --> Higher Cost

2. Added Discipline:

2. Agency Cost:

Greater the separation between managers

Greater the separation between stock-

and stockholders --> Greater the benefit

holders & lenders --> Higher Cost

3. Loss of Future Financing Flexibility:

Greater the uncertainty about future

financing needs --> Higher Cost

a hypothetical scenario
A Hypothetical Scenario
  • Assume you operate in an environment, where
    • (a) there are no taxes
    • (b) there is no separation between stockholders and managers.
    • (c) there is no default risk
    • (d) there is no separation between stockholders and bondholders
    • (e) firms know their future financing needs
the miller modigliani theorem
The Miller-Modigliani Theorem
  • In an environment, where there are no taxes, default risk or agency costs, capital structure is irrelevant.
  • The value of a firm is independent of its debt ratio.
an alternate view the cost of capital can change as you change your financing mix
An Alternate View : The cost of capital can change as you change your financing mix
  • The trade-off between debt and equity becomes more complicated when there are both tax advantages and bankruptcy risk to consider. When debt has a tax advantage and increases default risk, the firm value will change as the financing mix changes. The optimal financing mix is the one that maximizes firm value.
  • The cost of capital has embedded in it, both the tax advantages of debt (through the use of the after-tax cost of debt) and the increased default risk (through the use of a cost of equity and the cost of debt)
  • Value of a Firm = Present Value of Cash Flows to the Firm, discounted back at the cost of capital.
  • If the cash flows to the firm are held constant, and the cost of capital is minimized, the value of the firm will be maximized.
wacc and debt ratios
WACC and Debt Ratios

Weighted Average Cost of Capital and Debt Ratios

11.40%

11.20%

11.00%

10.80%

10.60%

WACC

10.40%

10.20%

10.00%

9.80%

9.60%

9.40%

0

20%

10%

30%

40%

50%

60%

70%

80%

90%

100%

Debt Ratio

current cost of capital grace kennedy
Current Cost of Capital: Grace Kennedy
  • Equity
    • Cost of Equity = 10.16%
    • Market Value of Equity = 29,076.75 million J$
    • Equity/(Debt+Equity ) = 89.8%
  • Debt
    • After-tax Cost of debt = 5.70% (1-.3333) = 3.80%
    • Market Value of Debt = 3,303 million J$
    • Debt/(Debt +Equity) = 10.2%
  • Cost of Capital = 10.16%(.898)+ 3.80%(.102) = 9.51%
mechanics of cost of capital estimation
Mechanics of Cost of Capital Estimation

1. Estimate the Cost of Equity at different levels of debt:

Equity will become riskier -> Beta will increase -> Cost of Equity will increase.

Estimation will use levered beta calculation

2. Estimate the Cost of Debt at different levels of debt:

Default risk will go up and bond ratings will go down as debt goes up -> Cost of Debt will increase.

To estimating bond ratings, we will use the interest coverage ratio (EBIT/Interest expense)

3. Estimate the Cost of Capital at different levels of debt

4. Calculate the effect on Firm Value and Stock Price.

estimating cost of equity from betas grace kennedy at different debt ratios
Estimating Cost of Equity from Betas: Grace Kennedy at different debt ratios

Current Beta = 0.70 Unlevered Beta = 0.65

Market premium = 7.82% T.Bond Rate = 4.70% t= 33.33%

Debt Ratio Beta Cost of Equity

0% 0.65 9.79%

10% 0.70 10.17%

20% 0.76 10.64%

30% 0.84 11.24%

40% 0.94 12.05%

50% 1.12 13.46%

60% 1.43 15.86%

70% 1.90 19.59%

80% 2.98 28.04%

90% 5.97 51.37%

a framework for getting to the optimal
A Framework for Getting to the Optimal

Is the actual debt ratio greater than or lesser than the optimal debt ratio?

Actual > Optimal

Actual < Optimal

Overlevered

Underlevered

Is the firm under bankruptcy threat?

Is the firm a takeover target?

Yes

No

Yes

No

Reduce Debt quickly

Increase leverage

Does the firm have good

Does the firm have good

1. Equity for Debt swap

quickly

projects?

projects?

2. Sell Assets; use cash

1. Debt/Equity swaps

ROE > Cost of Equity

ROE > Cost of Equity

to pay off debt

2. Borrow money&

ROC > Cost of Capital

ROC > Cost of Capital

3. Renegotiate with lenders

buy shares.

Yes

No

Yes

No

Take good projects with

1. Pay off debt with retained

Take good projects with

new equity or with retained

earnings.

debt.

earnings.

2. Reduce or eliminate dividends.

Do your stockholders like

3. Issue new equity and pay off

dividends?

debt.

Yes

No

Pay Dividends

Buy back stock

grace kennedy applying the framework
Grace Kennedy: Applying the Framework

Is the actual debt ratio greater than or lesser than the optimal debt ratio?

Actual > Optimal

Actual < Optimal

Overlevered

Underlevered

Is the firm under bankruptcy threat?

Is the firm a takeover target?

Yes

No

Yes

No

Reduce Debt quickly

Increase leverage

Does the firm have good

Does the firm have good

1. Equity for Debt swap

quickly

projects?

projects?

2. Sell Assets; use cash

1. Debt/Equity swaps

ROE > Cost of Equity

ROE > Cost of Equity

to pay off debt

2. Borrow money&

ROC > Cost of Capital

ROC > Cost of Capital

3. Renegotiate with lenders

buy shares.

Yes

No

Yes

No

Take good projects with

1. Pay off debt with retained

Take good projects with

new equity or with retained

earnings.

debt.

earnings.

2. Reduce or eliminate dividends.

Do your stockholders like

3. Issue new equity and pay off

dividends?

debt.

Yes

No

Pay Dividends

Buy back stock

designing debt the fundamental principle
Designing Debt: The Fundamental Principle
  • The objective in designing debt is to make the cash flows on debt match up as closely as possible with the cash flows that the firm makes on its assets.
  • By doing so, we reduce our risk of default, increase debt capacity and increase firm value.
design the perfect financing instrument
Design the perfect financing instrument
  • The perfect financing instrument will
    • Have all of the tax advantages of debt
    • While preserving the flexibility offered by equity
first principles69
First Principles
  • Invest in projects that yield a return greater than the minimum acceptable hurdle rate.
    • The hurdle rate should be higher for riskier projects and reflect the financing mix used - owners’ funds (equity) or borrowed money (debt)
    • Returns on projects should be measured based on cash flows generated and the timing of these cash flows; they should also consider both positive and negative side effects of these projects.
  • Choose a financing mix that minimizes the hurdle rate and matches the assets being financed.
  • If there are not enough investments that earn the hurdle rate, return the cash to stockholders.
    • The form of returns - dividends and stock buybacks - will depend upon the stockholders’ characteristics.
questions to ask in dividend policy analysis
Questions to Ask in Dividend Policy Analysis
  • How much could the company have paid out during the period under question?
  • How much did the the company actually pay out during the period in question?
  • How much do I trust the management of this company with excess cash?
    • How well did they make investments during the period in question?
    • How well has my stock performed during the period in question?
can you trust grace kennedy s management
Can you trust Grace Kennedy’s management?
  • During the period 2002-2203, Grace Kennedy
    • Had an average return on equity of 18.7% on projects taken
    • Saw it’s stock almost double between 2002 and 2003
    • Faced a cost of equity of about 20.46%
    • Has accumulated a cash balance of 24,805 million J$

If you were a Grace Kennedy stockholder, would you be comfortable with it’s dividend policy?

  • Yes
  • No
the bottom line on grace kennedy dividends
The Bottom Line on Grace Kennedy Dividends
  • Grace Kennedy could have afforded to pay more in dividends during the period of the analysis.
  • It chose not to, and has accumulated the cash.
  • Whether it can continue to hold this cash will depend upon how well it invests in the coming years.
a practical framework for analyzing dividend policy
A Practical Framework for Analyzing Dividend Policy

How much did the firm pay out? How much could it have afforded to pay out?

What it could have paid out

What it actually paid out

Net Income

Dividends

- (Cap Ex - Depr’n) (1-DR)

+ Equity Repurchase

- Chg Working Capital (1-DR)

= FCFE

Firm pays out too little

Firm pays out too much

FCFE > Dividends

FCFE < Dividends

Do you trust managers in the company with

What investment opportunities does the

your cash?

firm have?

Look at past project choice:

Look at past project choice:

Compare

ROE to Cost of Equity

Compare

ROE to Cost of Equity

ROC to WACC

ROC to WACC

Firm has history of

Firm has history

Firm has good

Firm has poor

good project choice

of poor project

projects

projects

and good projects in

choice

the future

Give managers the

Force managers to

Firm should

Firm should deal

flexibility to keep

justify holding cash

cut dividends

with its investment

cash and set

or return cash to

and reinvest

problem first and

dividends

stockholders

more

then cut dividends

first principles79
First Principles
  • Invest in projects that yield a return greater than the minimum acceptable hurdle rate.
    • The hurdle rate should be higher for riskier projects and reflect the financing mix used - owners’ funds (equity) or borrowed money (debt)
    • Returns on projects should be measured based on cash flows generated and the timing of these cash flows; they should also consider both positive and negative side effects of these projects.
  • Choose a financing mix that minimizes the hurdle rate and matches the assets being financed.
  • If there are not enough investments that earn the hurdle rate, return the cash to stockholders.
    • The form of returns - dividends and stock buybacks - will depend upon the stockholders’ characteristics.

Objective: Maximize the Value of the Firm

the paths to value creation
The Paths to Value Creation
  • Using the DCF framework, there are four basic ways in which the value of a firm can be enhanced:
    • The cash flows from existing assets to the firm can be increased, by either
      • increasing after-tax earnings from assets in place or
      • reducing reinvestment needs (net capital expenditures or working capital)
    • The expected growth rate in these cash flows can be increased by either
      • Increasing the rate of reinvestment in the firm
      • Improving the return on capital on those reinvestments
    • The length of the high growth period can be extended to allow for more years of high growth.
    • The cost of capital can be reduced by
      • Reducing the operating risk in investments/assets
      • Changing the financial mix
      • Changing the financing composition
first principles83
First Principles
  • Invest in projects that yield a return greater than the minimum acceptable hurdle rate.
    • The hurdle rate should be higher for riskier projects and reflect the financing mix used - owners’ funds (equity) or borrowed money (debt)
    • Returns on projects should be measured based on cash flows generated and the timing of these cash flows; they should also consider both positive and negative side effects of these projects.
  • Choose a financing mix that minimizes the hurdle rate and matches the assets being financed.
  • If there are not enough investments that earn the hurdle rate, return the cash to stockholders.
    • The form of returns - dividends and stock buybacks - will depend upon the stockholders’ characteristics.

Objective: Maximize the Value of the Firm