corporate finance 101

7/31/2019 Corporate Finance 101

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CFA Level 1


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CompoundingYou Lend me Rs.2,00,000 @ 10% p.a. for 2 years, how much do I return?

Discounting

You need Rs.2,00,000 at the end of 2 years from now. 2 year Term deposit rates are 8%p.a. How much do you deposit?

Amortizing LoansYou need Rs.2,00,000 to purchase a motorbike. SBI offers you auto loan @ 10% rate, 5Equated Annual Installments. What is the EAI?

Non-Amortizing Loans (Bullet Payments)Bonds


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Rs.2,00,000 loan10% interest rate5 EAIs

t = 0 t = 1 t = 2 t = 3 t = 4 t = 5

-2,00,000 X X X X X

200000 = (X/1.1) + (X/1.1^2) + (X/1.1^3) + (X/1.1^4) + (X/1.1^5)

X is Rs.52,759.49


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Year Principal EAI InterestComponent PrincipalComponent PrincipalOutstanding1 200000 52759 20000 32759 1672412 167241 52759 16724 36035 1312053 131205 52759 13121 39639 915664 91566 52759 9157 43603 479635 47963 52759 4796 47963 0

Every payment wipes a little bit off the Principal Outstanding!


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Types of Projects Expansion Projects Replacement Projects New Product Development Mandatory Projects Other Projects

5 key Principles of Capital Budgeting1. Cash flows only, not accounting income2. Cash flows are based on opportunity

costs

3. Cash flows should be timed properly4. Cash flows are always after-tax5. Financing costs are reflected in

required rate of return

Independent Projects Project decisions are unrelated to each otherMutually Exclusive Projects Only one of the projects can be doneCapital Rationing Firm should maximize shareholder value with the limited capitalavailable


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Year Project A Project B

0 -2000 -2000

1 1000 200

2 800 600

3 600 800

4 200 1200

2 mutually exclusive projects with given after-tax cash flow estimates.

Cost of Capital is 10%

NPV of Project A = $157.64NPV of Project B = $98.36Solution Go with Project A!

Rule with NPV MethodIf NPV > 0, project increasesshareholder value, hence AcceptIt


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Year Project A Project B

0 -2000 -2000

1 1000 200

2 800 600

3 600 800

4 200 1200



IRR of Project A = 14.48%IRR of Project B = 11.79%Solution Go with Project A!

Rule with IRR MethodIf IRR > Cost of Capital, accept the projectIf IRR < Cost of Capital, reject the project


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Year Project A Cum. Cash

Flows of A

Project B Cum. Cash

Flows of B0 -2000 -2000 -2000 -2000

1 1000 -1000 200 -1800

2 800 -200 600 -1200

3 600 400 800 -400

4 200 600 1200 800



Payback Period of A = 2 + (200/600) = 2.33 yearsPayback Period of B = 3 + (400/1200) = 3.33 years

Discounted PaybackMethod takesdiscounted cash flows

into account


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Profitability Index = 1 + (NPV / CF0)

If PI > 1, accept the project

If PI < 1, reject the project


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NPV assumes cash flows are re-invested at the cost of capital

NPV does not take project size into consideration

Multiple IRR / No IRR arise when sign of cash flows change more than once

Each method has its advantages and disadvantages

When faced with a conflict between NPV and IRR, always go with NPV

European firms prefer PBP and DPBP methods

Larger firms prefer NPV and IRR methods Public firms prefer NPV & IRR. Private firms prefer PBP

Firms run by MBAs and CFAs prefer NPV and IRR


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A firms capital has 3 main components Common Equity Preferred Equity Debt

Weighted Average Cost of Capital (WACC) is:

WACC = {Wd * kd * (1-tax)} + {We * ke} + {Wpe * kpe}

Cost of Preferred EquityKpe isgiven by preferred dividend

CMP of preferred equity

Cost of DebtCost of debt is straight-forward.Kd is always multiplied by (1-tax rate)

Cost of Equity 3 methods CAPM Method DDM Method Bond yield plus risk premium approach


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Capital Asset Pricing ModelCost of equity = RFR + Beta*(Expected market returns RFR)

Dividend Discount ModelCost of equity = (Next year Dividend / CMP) + growth rate

growth rate = ROE * RR

Bond yield plus risk premium approachCost of equity = bond yield + risk premium


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What is Beta measures the systematic risk of a stock Beta formula = covariance (stock, market)

variance (market)

What if the beta is not available Pure PlayMethod

De-levered Beta = Beta (1 / [1+(1-t)*D/E])Re-levered Beta = D-L Beta * (1+(1-t)*D/E)

Sometimes CRP is multiplied with beta andadded

CRP = sovereign yield spread * (annualized sd of equity index / annualized sd of sovereignbond market in terms of developed market currency


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Marginal Cost of Capital shows the WACC fordifferent amounts of financing

Break Point = amt. of capital at which components cost of capital changesweight of the component in the capital structure

Include floatation costs in the numerator, never

along with the discount rate


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Degree of Operating Leverage - % change in operating income for a given % changein sales

DOL = (change in EBIT / EBIT) / (change in sales / sales) DOL = Q*(P-V) / Q*(P-V) F

Degree of Financial Leverage - % change in EPS for a given % change in EBIT DFL = EBIT / EBIT Interest

Degree of Total Leverage = DOL * DFL

corporate finance 101

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