presentace cfm2 ij 1

Doc. Irena JindrichovskaCorporate Finance Management 2*CORPORATE FINANCE MANAGEMENT 2Master Course VFSFall 2013

Doc. Ing. Irena Jindichovsk, [email protected]

Corporate Finance Management 2

Doc. Irena JindrichovskaCorporate Finance Management 2*LiteratureBrigham, 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: 0-07-111795-4Ross, Westerfield & Jaffe; Fundamentals of Corporate Finance, 4th editionBender and Ward: Corporate Financial Strategy, 3rd ed. Butteworth-Heinemann, 2009Jindrichovsk I. (2013) Finann management. 1. ed.C.H.Beck Praha, 320 s., ISBN 978-80-7400-052-2 (in Czech)More sources may be recommended in lectures. Presentation will be updated during the course


Doc. Irena JindrichovskaCorporate Finance Management 2*Teaching planRegular studies: 12 hours lectures 6 hours excercises+ presentation of own workAssignment conditions- essay on topic given M&A case study + active participation in seminars more details - Ing. Kateina KalinovExam: Written exam consisting of short essays and calculations


Doc. Irena JindrichovskaCorporate Finance Management 2*Outline of the courseIntroduction to Corporate finance managementMergers and acquisitionsCost of capital and capital structureStrategy and tactics of financing decisions - investment decision making Capital Restructuring and Multinational Fin. Management Lease Financing and Working Capital ManagementRisk Management and Real Options


Doc. Irena JindrichovskaCorporate Finance Management 2*INTRODUCTION TO CORPORATE FINANCE MANAGEMENT


Doc. Irena JindrichovskaCorporate Finance Management 2*Outline Lecture 1IntroductionCapital structureCompany lifecycleRole of financial managerFinancial marketsAgency theoryStakeholders theorySummary, exercises, references


Doc. Irena JindrichovskaCorporate Finance Management 2*Introduction toCorporate FinanceBasic 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?


Doc. Irena JindrichovskaCorporate Finance Management 2*The Balance-Sheet Model of the FirmCurrent assets

Net working capital

Fixed assetsTangible fixed assetsIntangible fixed assetsCurrent liabilities

Long term debt

Shareholders equity


Doc. Irena JindrichovskaCorporate Finance Management 2*Capital StructureFinancing 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


Doc. Irena JindrichovskaCorporate Finance Management 2*Capital StructureThe 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


Doc. Irena JindrichovskaCorporate Finance Management 2*Life Cycle of the company and its fundingBoston Consulting Group MatrixAxes horizontal: speed of growth of the market sharevertical: market share

Start-up GrowthMaturity Decline

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


Doc. Irena JindrichovskaCorporate Finance Management 2*Life Cycle of the company II

MaturityLow investment needHigh CF generatedGrowthHigh investment needHigh CF generatedDeclineLow investment needLow CF generatedStart upHigh investment need Low CF generated


Doc. Irena JindrichovskaCorporate Finance Management 2*Role of the Financial Manager1. 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.


Doc. Irena JindrichovskaCorporate Finance Management 2*Role of the Financial ManagerThe 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.


Doc. Irena JindrichovskaCorporate Finance Management 2*Financial MarketsPrimary and secondary marketsSpot and forward marketsMoney marketsEquity marketsOrganized and over-the-counter marketsLSE, AMEX, NYSE; NASDAQDerivative marketsLIFFE, CBOT


Doc. Irena JindrichovskaCorporate Finance Management 2*Primary and secondary markets1Help to get financing for companiesInvestment companies Pool together and manage the money of many investorsArrange corporate borrowings and security issuesIssuing process


Doc. Irena JindrichovskaCorporate Finance Management 2*Primary and secondary markets2Establish the price of securities through supply and demandExecute and settle the transactionGuarantee the settlement through the Clearing house- a special institution connected with each Stock ExchangeThere is also a securities exchange commission (SEC ) setting the standards and rules of listing


Doc. Irena JindrichovskaCorporate Finance Management 2*Agency TheoryThere are two groups with different interest in each corporation Shareholders and ManagersGoals of shareholders and managers are not the sameJensen and Meckling (1976): Theory of the Firm: Managerial Behavior,Agency Costs and Ownership Structure, JFE 1976Defined Principal Agent relation


Doc. Irena JindrichovskaCorporate Finance Management 2*Principal - AgentOwners i.e. Shareholders are PrincipalsManagers are AgentsShareholders want value of their firm to be maximized

Managers should act on principals behalf but have different goals


Doc. Irena JindrichovskaCorporate Finance Management 2*Management GoalsSurvival - avoid risky business decisionsSelfsufficiency prefer internal financing to issuance of new stock

Shareholders need to control management Agency Costs Monitoring costsIncentive fees to convince management to act in shareholders interest


Doc. Irena JindrichovskaCorporate Finance Management 2*Control methodsDirectors are voted by Shareholders and management is selected by directors Management compensation methodsStock option planBonusesPerformance sharesThreat of takeoversCompetition on management labor market


Doc. Irena JindrichovskaCorporate Finance Management 2*Stakeholders theoryAll interested parties that have some relation to the companyShareholdersEmployeesCreditorsBanksSuppliersClientsEnvironmentMunicipalities


Doc. Irena JindrichovskaCorporate Finance Management 2*Summary1.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?


Doc. Irena JindrichovskaCorporate Finance Management 2*Summary 23.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.


Doc. Irena JindrichovskaCorporate Finance Management 2*Exercise problemsDefine 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 shareholdersWhat 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?


Doc. Irena JindrichovskaCorporate Finance Management 2*Useful web sourceOn Agency theory A review paperhttp://classwebs.spea.indiana.edu/kenricha/Oxford/Archives/Oxford%202006/Courses/Governance/Articles/Eisenhardt%20-%20Agency%20Theory.pdf


Doc. Irena JindrichovskaCorporate Finance Management 2*RECOMENDED READINGSBrigham and Houston: Fundamentals of Financial Management, 12th ed, Ch 1Ross, Westerfield & Jaffe; Fundamentals of Corporate Finance, 4th edition Ch 1 and 2Bender and Ward: Corporate Financial Strategy, 3rd ed. Butteworth-Heinemann, 2009, Ch 2


Doc. Irena JindrichovskaCorporate Finance Management 2*COST OF CAPITAL AND CAPITAL STRUCTURE


Doc. Irena JindrichovskaCorporate Finance Management 2*OutlineIntroductionSources of long term financingDebt versus equityLong term debtPreferred sharesRetained earningsNewly issued shares, Gordon model, debt plus risk premium, CAPM approachWACCValue of a companySummary, exercises, references


Doc. Irena JindrichovskaCorporate Finance Management 2*Equity versus debt

Feature:EquityDebtIncome:DividendsInterestTax status:Taxed as personal income. Are not business expenseTaxed as personal income. Are business expenseControl:Common stocks (sometimes preferred) usually have voting rightControl is exercised with loan agreementDefault:Firms cannot become bankrupt for nonpayment of dividendsUnpaid debt is a liability. Nonpayment results in bankruptcyBottom line:Tax status favours debt, but default favours equity.Control features of debt and equity are different but one is not better than other


Doc. Irena JindrichovskaCorporate Finance Management 2*Long term debtLoans and bondsLoans (interest is paid before taxes creation of tax shield, that lowers the cost of L/T debt); T = tax rate

Bonds (yield to maturity)


Doc. Irena JindrichovskaCorporate Finance Management 2*Preferred sharesPerpetuity P = C/r; i.e. kp= C / P

May need to take in consideration issuance cost (flotation cost F)kp= C / (P-F)


Doc. Irena JindrichovskaCorporate Finance Management 2*Cost of retained equityUsing Gordon model of growing perpetuity:P=D1/ (r-g); i.e.

ks = (D1 / P) + g


Doc. Irena JindrichovskaCorporate Finance Management 2*Cost of new equityUsing Gordon model of growing perpetuity taking in consideration flotation cost:

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


Doc. Irena JindrichovskaCorporate Finance Management 2*The CAPM approachEstimate using the CAPMEstimate of risk free rate rRFEstimate the market premium RPMEstimate the stocks beta coefficient bsSubstitute in the CAPM equation:


Doc. Irena JindrichovskaCorporate Finance Management 2*Bond yield plus risk premium approachSome 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 premiumIt is logical to think that firms with risky, low rated high-interest-rate debt will also have risky high-cost equity


Doc. Irena JindrichovskaCorporate Finance Management 2*WACCWeighted 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


Doc. Irena JindrichovskaCorporate Finance Management 2*Factors that affect the weighted average cost of capitalFactors that firm cannot controlThe level of interest ratesMarket risk premiumTax ratesFactors the firm can controlCapital structure policyDividend policyInvestment policy


Doc. Irena JindrichovskaCorporate Finance Management 2*SummaryEarlier 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.


Doc. Irena JindrichovskaCorporate Finance Management 2*Summary 23. 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)*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 CAPMs estimate of the expected return on the


Doc. Irena JindrichovskaCorporate Finance Management 2*Exercise questionsDescribe 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.


Doc. Irena JindrichovskaCorporate Finance Management 2*Exercise problem 112.13 RWJ Calculate the weighted average cost of capital for the Luxury Porcelain Company. The book value of Luxurys 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.


Doc. Irena JindrichovskaCorporate Finance Management 2*Exercise problem 212.14 RWJ First Data Co. has 20 million shares of common stock outstanding that are currently being sold for $25 per share. The firms 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.


Doc. Irena JindrichovskaCorporate Finance Management 2*Useful web sourcesOnline Tutorial #8: How Do You Calculate A Company's Cost of Capital? http://www.expectationsinvesting.com/tutorial8.shtmlAnd a video lecture (rather easy)http://www.youtube.com/watch?v=JKJglPkAJ5o


Doc. Irena JindrichovskaCorporate Finance Management 2*RECOMENDED READINGSFundamentals of Corporate Finance, Ross, Westerfield and Jaffe, 6 th edition. Ch 12 Brigham and Houston: Fundamentals of Financial Management, 12th ed, Ch 10


Doc. Irena JindrichovskaCorporate Finance Management 2*MERGERS AND TAKEOVERS


Doc. Irena JindrichovskaCorporate Finance Management 2*OutlineIntroductionMergers ad acquisition rationaleUnderling principlesBusiness motives for acquisitionsFinancial strategyPrice reaction n acquisition announcement Takeover defenseSummary, exercises, references


Doc. Irena JindrichovskaCorporate Finance Management 2*Mergers and AcquisitionsMature 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 AcquisitionsLarger and smaller company acquirer and target company


Doc. Irena JindrichovskaCorporate Finance Management 2*Underlying principlesCombined future CFs are bigger than sum of CFs of two individual companiesNot 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


Doc. Irena JindrichovskaCorporate Finance Management 2*M&As = market imperfectionsAsymmetric 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)


Doc. Irena JindrichovskaCorporate Finance Management 2*Source of synergy from acquisitionsRevenue EnhancementMarketing GainsStrategic BenefitsMarket or Monopoly PowerCost ReductionEconomies of ScaleEconomies of Vertical IntegrationComplementary ResourcesElimination of Inefficient Management


Doc. Irena JindrichovskaCorporate Finance Management 2*Source of synergy from acquisitions 2Tax GainsNet Operating LossesUnused Debt CapacitySurplus FundsThe Cost of Capital


Doc. Irena JindrichovskaCorporate Finance Management 2*Two bad reasons for mergersEarnings GrowthEPS GameDiversificationSystematic 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.


Doc. Irena JindrichovskaCorporate Finance Management 2*Influence of innovative productsManagement may forget the underlying principles justifying M&A

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


Doc. Irena JindrichovskaCorporate Finance Management 2*Cash versus Common StockWhether 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 firms 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.


Doc. Irena JindrichovskaCorporate Finance Management 2*Cash versus Common Stock 23. Sharing Gains. If cash is used to finance an acquisition, the selling firms 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.


Doc. Irena JindrichovskaCorporate Finance Management 2*Financial strategy in acquisitionsFinancial role - to evaluate the synergy effectStrategy - change the financial structure of target company leverage the companyTarget company with cash surpluses (mature group) Corporate raider acquires the company, strips it off the cash and leverages the company


Doc. Irena JindrichovskaCorporate Finance Management 2*Diversified companiesDiversified group should be valued at minimum weighted average P/E applicable to its component businessesIf the company does not perform well after acquisition sell parts of the group for higher P/E divestiture, spin-offs,


Doc. Irena JindrichovskaCorporate Finance Management 2*GreenmailingSignificant minority impacts on the corporate strategyRaider buys a significant part of the co. which he considers undervalued and greenmails the management, asserting that the company is badly managedManagement buys him out cash drain


Doc. Irena JindrichovskaCorporate Finance Management 2*EPS gameGrowth in P/E is automatically created by an equity funded acquisition if P/E of bidder > P/E of targetIf companies have the same P/E multipleAnd financial structure of target company is changed debt instead of equityEPS of the group However, increased growth prospects are offset by financial risk due to debt


Doc. Irena JindrichovskaCorporate Finance Management 2*EPS gameCompany 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%.


Doc. Irena JindrichovskaCorporate Finance Management 2*

AcquirerAno of shares10 000 000Ano of shares10 000 000Ano of shares10 000 000Ano of shares10 000 000share price ()1share price ()1share price ()1share price ()1PAT ()1 000 000PAT ()1 000 000PAT ()1 000 000PAT ()1 000 000EPS ()0,1EPS ()0,1EPS ()0,1EPS ()0,1P/E10P/E10P/E10P/E10TargetBno of shares5 000 000Cno of shares10 000 000Dno of shares1 000 000Dno of shares1 000 000share price ()1share price ()0,5share price ()5,0share price ()5,0PAT ()1 000 000PAT ()500 000PAT ()250 000PAT ()250 000EPS ()0,2EPS ()0,05EPS ()0,25EPS ()0,25P/E5P/E10P/E20P/E20P/EA > P/EBP/EA = P/ECP/EA < P/EDInvert the transaction !DealA issues 5 mil shares at 1A issues 5 mil debt for (5%)A issues 5 mil shares at 1D issues 2 mil shares at 5 structureand buys Band buys Band buys Dand buys ANew shares5 000 000New shares0New shares5 000 000New shares2 000 000New debt5 000 000cost of debt250 000ResultABno of shares15 000 000ACno of shares10 000 000ADno of shares15 000 000DAno of shares3 000 000PAT ()2 000 000PAT ()1 250 000PAT ()1 250 000PAT ()1 250 000EPS ()0,133EPS ()0,125EPS ()0,083EPS ()0,417P/E7,5P/E10P/E12P/E12share price ()1,00share price ()1,25share price ()1,00share price ()5,00


Doc. Irena JindrichovskaCorporate Finance Management 2*Higher growth companiesEPS bidding < EPS target P/E bidding < P/E target

Post-acquisition P/E to appropriate weighted average of the original businessesEPS because bidding company is larger than target company


Doc. Irena JindrichovskaCorporate Finance Management 2*Takeover defensePre-offer defenseShark repellentStaggered boardQuorumPoison pillsRe-capitalization with special right sharesPost offer defensePacman defenseViolation of antitrust lawChange of asset structureChange of liabilities structure


Doc. Irena JindrichovskaCorporate Finance Management 2*SummaryThe synergy from an acquisition is defined as the value of the combined firm (VAB) less the value of the two firms as separate entities (VA and 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


Doc. Irena JindrichovskaCorporate Finance Management 2*Summary 24.The possible benefits of an acquisition come from: a. Revenue enhancement, b. Cost reduction, c. Lower taxes, d. Lower cost of capitalThe 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.


Doc. Irena JindrichovskaCorporate Finance Management 2*Exercise problemsDo 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


Doc. Irena JindrichovskaCorporate Finance Management 2*Useful web sourcesA book on Mergers and acquisitions by Weston and Weaver (2001) - book previewhttp://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


Doc. Irena JindrichovskaCorporate Finance Management 2*Useful web source 2Characteristics of takeover defense strategieshttp://www.investopedia.com/articles/stocks/08/corporate-takeover-defense.asp#axzz29MjA54dw


Doc. Irena JindrichovskaCorporate Finance Management 2*RECOMENDED READINGSFundamentals of Corporate Finance, Ross, Westerfield and Jaffe, 4th edition. Ch 29 Brigham and Houston: Fundamentals of Financial Management, 12th ed, Ch 15


Doc. Irena JindrichovskaCorporate Finance Management 2*CAPITAL STRUCTURE


Doc. Irena JindrichovskaCorporate Finance Management 2*OutlineCapital structure concept maximizing valueOptimal capital structureM&M Theory of IndependenceM&M Theory of DependenceTaxes and financial leverageCost of financial distress and agency costsEBIT-EPS analysisSummary, exercises, references


Doc. Irena JindrichovskaCorporate Finance Management 2*Goal of capital structure managementMaximize the share priceMinimize the weighted average cost of capital

Too big financial leverage can bring firm to bankruptcyToo small financial leverage leads to undervaluing of share price


Doc. Irena JindrichovskaCorporate Finance Management 2*Miller & Modigliani (1958)The Cost of Capital, Corporation Finance and the Theory of Investment, American Economic Review 48: 261-297


Doc. Irena JindrichovskaCorporate Finance Management 2*Importance of capital structureCost of capital is one of the cost and therefore influence dividendsIf the cost of capital are minimized, the payments to shareholders is maximizedIf the cost of capital can be determined by corporate capital structure then the capital structure management is an important part of firm management


Doc. Irena JindrichovskaCorporate Finance Management 2*AssumptionsThe share price is a perpetuity: P0 = Dt/KcThe firm pays constant dividendsDividend-Pay-Out = 100%, i.e. no retained earningsThere are no taxesCapital structure consists of Debt & Equity only


Doc. Irena JindrichovskaCorporate Finance Management 2*Further assumptionsFinancial structure is modified by issuing new shares to buy out debt or the other way aroundEBIT is assumed to remain constantShares and other securities are traded on efficient market


Doc. Irena JindrichovskaCorporate Finance Management 2*Proposition I.Independence HypothesisThe 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


Doc. Irena JindrichovskaCorporate Finance Management 2*Proposition II.Dependence HypothesisBoth the cost of capital (K0) and share price (P0) are influenced by firms 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)


Doc. Irena JindrichovskaCorporate Finance Management 2*Dependence HypothesisAccording to Dependence Hypothesis: Percentage change of cost of equity Kc= 0, however, percentage change in dividends Dt > 0Percentage change of price = percentage change of dividends


Doc. Irena JindrichovskaCorporate Finance Management 2*Taxes and financial leverageThe interest is deductible from the tax baseUse of debt in capital structure should lead to increased market value of firm securitiesThe middle view assumes that interest tax shied has its market value which increases total market value of the firm


Doc. Irena JindrichovskaCorporate Finance Management 2*Cost of financial distressThe 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 lendSuppliers refuse to grant commercial creditDividend payments are stoppedAt certain point the expected bankruptcy costs outweigh the tax shield and the firm has to change the capital structure (Pictures)


Doc. Irena JindrichovskaCorporate Finance Management 2*Further topicsOptimal financial structureEBIT-EPS analysisPoint of financial indifferenceImplicit cost cost of debt increased riskPractical measures of capital structure management


Doc. Irena JindrichovskaCorporate Finance Management 2*Capital structure theoriesThe trade-off theoryThe trade-off between benefits and costs of debtSmall debt small tax shield but more financial flexibilityPecking order theoryDifferent types of capital have different costs -the least expensive source is used first


Doc. Irena JindrichovskaCorporate Finance Management 2*Summary 1In 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.


Doc. Irena JindrichovskaCorporate Finance Management 2*Summary 2Because 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 firms debt-to-equity ratio.


Doc. Irena JindrichovskaCorporate Finance Management 2*Exercise questionsExplain the concept of capital structureDefine the optimal capital structureExplain the logic of M&M Theory of independenceExplain M&M Theory of dependenceExplain the role of taxes in financial structureExplain the cost of financial distress and agency costs


Doc. Irena JindrichovskaCorporate Finance Management 2*Exercise problem 1Gearing 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.


Doc. Irena JindrichovskaCorporate Finance Management 2*Useful web sourcesFinancing decisions: Capital Structure and cost of capitalhttp://www.slideshare.net/meowbilla/4a304-capital-structureCFA 1 Materialshttp://www.investopedia.com/exam-guide/cfa-level-1/corporate-finance/mm-capital-structure-versus-tradeoff-leverage.asp#axzz1sgRpYOfd


Doc. Irena JindrichovskaCorporate Finance Management 2*RECOMENDED READINGSFundamentals of Corporate Finance, Ross, Westerfield and Jaffe, 6 th edition. Ch 12 Brigham and Houston: Fundamentals of Financial Management, 12th ed, Ch 10


Doc. Irena JindrichovskaCorporate Finance Management 2*STRATEGY AND TACTICS OF FINANCING DECISIONS

- INVESTMENT DECISION MAKING


Doc. Irena JindrichovskaCorporate Finance Management 2*OutlineIntroductionInvestment decision makingNature of projects and incremental cash flowsProject phases and relevant cash flowsDecision making methods incl. pros and consComparing different projectsSummary, exercises, references


Doc. Irena JindrichovskaCorporate Finance Management 2*Investment ProjectsNature of projectProfit generating projectsIncreasing capacity, new equipmentReplacement projectsEcological projects minimizing loss


Doc. Irena JindrichovskaCorporate Finance Management 2*Long-term nature of projectsAnalyzing - incremental cash flowsChanges of the firms cash flow that occur as a direct consequence of accepting the projectCosts vs. Cash flowsSunk costsOpportunity costs (potential revenues form alternative uses are lost)Side effects - transfers


Doc. Irena JindrichovskaCorporate Finance Management 2*Project Phases1. Investment phase2. Operating phase (income and taxes)3. Liquidating phase (sometimes included in operating phase)


Doc. Irena JindrichovskaCorporate Finance Management 2*Investment decision making methodsNet Present Value - NPVInternal Rate of Return - IRRPayback Period - PPProfitability Index - PIModified Internal Rate of Return - IRR*


Doc. Irena JindrichovskaCorporate Finance Management 2*Net Present ValueThe most frequently used decision making methodDiscounts individual positive and negative cash flows to the present finding their present valueProjects with positive net present value are acceptedThis method is sensitive to the discount rate used in the process of calculation


Doc. Irena JindrichovskaCorporate Finance Management 2*Internal Rate of ReturnThe 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


Doc. Irena JindrichovskaCorporate Finance Management 2*Payback PeriodNon-discounted methodDiscounted methodCumulated cash flowsASSUMPTION- evenly distributed cash flows during the course of each period


Doc. Irena JindrichovskaCorporate Finance Management 2*Profitability indexPresent value of cash inflows to present value of cash outflowsDecision rule: PI > 1The same decisions as NPVProfitability indexes of two projects can not be added, whereas the NPVs can


Doc. Irena JindrichovskaCorporate Finance Management 2*Modified Internal Rate of ReturnRemoves the strong assumption about reinvesting cash inflows for the high IRRMaintains the advantage - easy comparison with cost of capital the appropriate discount rate


Doc. Irena JindrichovskaCorporate Finance Management 2*Modified IRR* - formula


Doc. Irena JindrichovskaCorporate Finance Management 2*Comparing projectsConflict between NPV and IRRProjects with irregular cash flowsProjects with several negative cash flowsComparing projects with different time horizonCrossover rateCapital Asset Pricing Model - CAPM application in capital budgeting


Doc. Irena JindrichovskaCorporate Finance Management 2*SummaryInvestment 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.


Doc. Irena JindrichovskaCorporate Finance Management 2*Summary 2In 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.)


Doc. Irena JindrichovskaCorporate Finance Management 2*Exercise questionsWhat 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 methodsWhat is the difference between the nominal and the real interest rate and nominal and real cash flow?Discuss the problems of IRR method


Doc. Irena JindrichovskaCorporate Finance Management 2*Useful web sourceshttp://www.studyfinance.com/lessons/capbudget/http://www.capitalbudgetingtechniques.com/What is capital budgeting - texthttp://www.exinfm.com/training/capitalbudgeting.docImpact of inflation on investment decision makinghttp://www.studyfinance.com/jfsd/pdffiles/v9n1/mills.pdf


Doc. Irena JindrichovskaCorporate Finance Management 2*RECOMENDED READINGSFundamentals of Corporate Finance, Ross, Westerfield and Jaffe, 4th edition. Ch 7 Brigham and Houston: Fundamentals of Financial Management, 12th ed, Ch 9, 10


Doc. Irena JindrichovskaCorporate Finance Management 2*RISK AND RETURN RELATIONSHIP


Doc. Irena JindrichovskaCorporate Finance Management 2*PORTFOLIO RISK AND RETURN Risk and risk aversionInvestors attitudesDiversificationCapital asset pricing model and SMLBeta coefficientArbitrage pricing theoryExercises, web-sources and recommended readings


Doc. Irena JindrichovskaCorporate Finance Management 2*INVESTMENTS AND RISK VS RETURNThe investment process consists of two broad tasks. One task is to find security and market analysis, by which we assess the risk and expected-return attributes of the entire set of possible investment vehicles. The second task is the formation of an optimal portfolio of assets, which involve the determination of the best risk-return opportunities available from feasible investment portfolios and the choice of the best portfolio from the feasible set*


Doc. Irena JindrichovskaCorporate Finance Management 2*RISK AND RISK AVERSIONThe presence of risk means that more than one outcome is possible. A simple prospect is an investment opportunity in which a certain initial wealth is placed at risk, and there are only two possible outcomes.*


Doc. Irena JindrichovskaCorporate Finance Management 2**PORTFOLIO MANAGEMENTRisk and return relation (figures)Diversificationnot perfect correlation of assetsinvestor is able to obtain higher return whilst maintaining the same risk


Doc. Irena JindrichovskaCorporate Finance Management 2**PORTFOLIO RETURNReturn on n-asset portfolioE(Rp)Expected return of the portfolioE(Ri)Expected return of the i-th assetxi Weight (proportion) of i-th assetwithin a portfolio

nNumber of assets in the portfolio


Doc. Irena JindrichovskaCorporate Finance Management 2**PORTFOLIO RISKRisk of the n-asset portfoliopStandard deviation of a portfolioijCovariance of i-th and j-th assetsxi and xj Weight (proportion) of i-th and j-th assetswithin a portfolio nNumber of assets in a portfolio


Doc. Irena JindrichovskaCorporate Finance Management 2**CAPITAL MARKET LINE (CML) Market portfolio Market return (RM) Risk-free return (Rf) Risk of the market (M)All efficient portfolios will lie on the new efficient frontier Return of the portfolio (Rp) Risk of the portfolio (p)


Doc. Irena JindrichovskaCorporate Finance Management 2**BETA COEFFICIENTA measure of volatilityStandardized measure of risk, - relative risk compared to the market portfolioi risk of the i-th asseti,M covariance of the i-th asset with the market portfolioM2 variance of the market portfolio


Doc. Irena JindrichovskaCorporate Finance Management 2**SECURITY MARKET LINE (SML) Return on the i-th security Market return (RM ) Risk-free return (Rf ) Security beta (i ) Market premium (RM - Rf )The expected return on any security can be estimated using theCapital Asset Pricing Model


Doc. Irena JindrichovskaCorporate Finance Management 2**CAPITAL ASSET PRICING MODEL (CAPM)All assets can be organized on the Security market line (SML)in the Risk - Return space

Expected return of i-th asset can be calculated as:


Doc. Irena JindrichovskaCorporate Finance Management 2**ASSUMPTIONS OF CAPM (1)No transaction costsAll assets are infinitely divisible No taxationNo single investor can affect the price (perfect market)Investors make decisions solely in terms of expected returns and standard deviationsUnlimited short sales are allowed


Doc. Irena JindrichovskaCorporate Finance Management 2**ASSUMPTIONS OF CAPM (2)Unlimited lending and borrowing of funds at the (the same) riskless rateHomogeneous expectations concerning the mean and variance of assetsAll investors have identical expectations with respect to the portfolio decision inputs (1.exp. returns, 2.variances, 3.correlations)All assets (eg, including human capital) are marketable


Doc. Irena JindrichovskaCorporate Finance Management 2**CHARACTERISTIC LINESML can be rewritten as:(Ri - Rf ) Excess return of the security(RM - Rf ) Excess return of the market


Doc. Irena JindrichovskaCorporate Finance Management 2**BETA ESTIMATESEstimating beta from historical returns using regressionBeta is a slope of a characteristic line of i-th security


Doc. Irena JindrichovskaCorporate Finance Management 2*Beta koeficientStandardized measure of risk- Relative risk compared to Market portfolioi risk of i-th asseti,M covariance of i-th asset with market portfolioM2 variance of market portfolio


Doc. Irena JindrichovskaCorporate Finance Management 2**ALPHAAn investor can be convinced, that the security is wrongly pricedaccording to CAPM.His estimate will differ by I If i > 0 the investor believes that the security is undervaluedIf i < 0 the investor believes that the security is overvalued


Doc. Irena JindrichovskaCorporate Finance Management 2**IMPACT ON THE CHARACTERISTIC LINE Excess return of the security (Riinvestor - Rf ) is composed from:

1)difference between investors estimate and CAPM estimate (i)2)excess return of the market times beta (RM - Rf ) *i3)an error (i)


Doc. Irena JindrichovskaCorporate Finance Management 2**ARBITRAGE PRICING THEORY (APT)New and different approach to determining the asset pricesMore general then CAPM which takes into account means and variances of security returnsLaw of one price: two assets that are the same can not sell at different prices


Doc. Irena JindrichovskaCorporate Finance Management 2**FACTOR (INDEX) MODELSReturn on any security is related to a set of factors, eg:growth of real GDP real interest ratesunexpected inflationcommodities pricesgrowth of populationNot only to the market excess return


Doc. Irena JindrichovskaCorporate Finance Management 2**SINGLE FACTOR MODEL - RETURNUncertain return on an i-th security is determined by:Funcertain value of a factoraiexpected value of i-th security in casethe value of factor F = 0bisensitivity of i-th security to factor Feiuncertain error term


Doc. Irena JindrichovskaCorporate Finance Management 2**FACTOR MODEL - ASSUMPTIONSerror term and factor are not correlatederror terms of any two assets are not correlatedreturns of assets are correlated since they depend on the same factor


Doc. Irena JindrichovskaCorporate Finance Management 2*SummarySpeculation is the undertaking of a risky investment for its risk premium. The risk premium has to be large enough to compensate a risk-averse investor for the risk of the investment.Hedging is the purchase of a risky asset to reduce the risk of a portfolio. *


Doc. Irena JindrichovskaCorporate Finance Management 2*Summary 2The negative correlation between the hedge asset and the initial portfolio turns the volatility of the hedge asset into a risk-reducing feature..When a hedge asset is perfectly negatively correlated with the initial portfolio, it serves as a perfect hedge and works like an insurance contract on the portfolio.*


Doc. Irena JindrichovskaCorporate Finance Management 2*Exercise problemRiskless rate is 8 per cent and market rate is 12 per cent. You investigate the following three investment opportunities:

Portfolio BetaA 0,6B 1C 1,4

a) Calculate for each of the three portfolios the expected return consistent with CAPMb) Show graphically the expected portfolio returns c) Indicate on the graph what would happen to the capital market line in (a) if the expected return on the market portfolio were 10 percent. d) Explain various implications of such movement.


Doc. Irena JindrichovskaCorporate Finance Management 2*Useful web sourceThe website listed below has an online journal entitled Efficient Frontier: An OnlineJournal of Practical Asset Allocation. The journal contains short articles about various investment strategies that are downloadable in Adobe format.http://www.efficientfrontier.com

*


Doc. Irena JindrichovskaCorporate Finance Management 2*RECOMENDED READINGSFundamentals of Corporate Finance, Ross, Westerfield and Jaffe, 4th edition. Ch 9 and 10Bodie, Z., Kane, A and Marcus, A. Investments 5th Ed., Mc Graw Hill. 2001 ch 6 and 7Sharpe, W., Alexander, G., Bailey, J.: Investments, 6th ed Ch. 6-9*


Doc. Irena JindrichovskaCorporate Finance Management 2*BONDS AND SHARES


Doc. Irena JindrichovskaCorporate Finance Management 2*OUTLINEIntroductionDebt securities, characteristics and riskDifferent types of bondsBond ratingEquity valuationDebt vs. equitySummary, exercises, references


Doc. Irena JindrichovskaCorporate Finance Management 2*DEBT SECURITIES - BONDSBbond priceCtfixed coupon, ccoupon rateMprincipal (nominal value)y.yield, or discount rate ( r )


Doc. Irena JindrichovskaCorporate Finance Management 2*RISK CHARACTERISTICS OF BONDSBonds are perceived as a safer investment alternative than stocksLong term bonds are more sensitive to the changes in interest rates than short term bonds Types of riskdefault risk & time risk interest rate risk & reinvestment risk


Doc. Irena JindrichovskaCorporate Finance Management 2*MATURITY AND VOLATILITYPrices and returns for long-term bonds are more volatile than those for shorter term bondsInterest rate risk


Doc. Irena JindrichovskaCorporate Finance Management 2*DIFFERENT TYPES OF BONDSPlain vanillabondsFloating rate bondsDeep discount bondsIncome bonds (dependent on income)Convertible bondsBonds with warrants


Doc. Irena JindrichovskaCorporate Finance Management 2*BOND RATINGMoodys Investor ServiceStandard and PoorsRating default riskInvestment Grade, Non-investment grade lower grade bonds below BBB for S&P and below Ba for ModysJunk Bonds in 1970s Michael Milkin in Drexel Burnham Lambert developed the high yield junk bond market


Doc. Irena JindrichovskaCorporate Finance Management 2*YIELD TO MATURITY

Coupon bond: B=C/(1+r)+C/(1+r)2++C/(1+r)n+M/(1+r)n,Consol (perpetuity) r=C/Pc ) Discount bond (1 year) r= (M-Pd)/Pd)

Current bond prices and interest rates are negatively related: When interest rate rises, the bond price rise falls and vice versa


Doc. Irena JindrichovskaCorporate Finance Management 2*EQUITY - VALUATIONPresent value of future cash flows (dividends)

Preference sharesCommon sharesZero growthConstant growth (Gordon Model)Supernormal growth


Doc. Irena JindrichovskaCorporate Finance Management 2*NEW ISSUEApproval from BODFile the Registration statement with SECdetails of financial information (50 pages)Preliminary prospectus distributed to potential investorsAfter approval by SEC the price of new issue is added and selling beginsCompare with rights offer


Doc. Irena JindrichovskaCorporate Finance Management 2*EQUITY VERSUS DEBT

Feature:EquityDebtIncome:DividendsInterestTax status:Taxed as personal income. Are not business expenseTaxed as personal income. Are business expenseControl:Common stocks (sometimes preferred) usually have voting rightControl is exercised with loan agreementDefault:Firms cannot become bankrupt for nonpayment of dividendsUnpaid debt is a liability. Nonpayment results in bankruptcyBottom line:Tax status favours debt, but default favours equity.Control features of debt and equity are different but one is not better than other


Doc. Irena JindrichovskaCorporate Finance Management 2*SummaryPure discount bonds and perpetuities can be viewed as the polar cases of bonds. The value of a pure discount bond (also called a zero-coupon bond, or simply a zero) isPV =F/(1+r)T2.The value of a perpetuity (also called a consol) is PV = C/r


Doc. Irena JindrichovskaCorporate Finance Management 2*Summary 23.Ordinary bonds can be viewed as an intermediate case. The coupon payments form an annuity and the principal repayment is a lump sum. The value of this type of bond is simply the sum of the values of its two parts.4. The yield to maturity on a bond is that single rate that discounts the payments on the bond to its purchase price.


Doc. Irena JindrichovskaCorporate Finance Management 2*Summary 35.A stock can be valued by discounting its dividends. We mention three types of situations:a. The case of zero growth of dividends.b. The case of constant growth of dividends.c. The case of differential growth.6.An estimate of the growth rate of a stock is needed for formulas (b) or (c) above. A useful estimate of the growth rate isG = Retention ratio * Return on retained earnings


Doc. Irena JindrichovskaCorporate Finance Management 2*Exercise (1)Consider two bonds, bond A and bond B, with equal rates of 10 percent and the same face values of $1,000. The coupons are paid annually for both bonds. Bond A has 20 years to maturity while bond B has 10 years to maturity.a. What are the prices of the two bonds if the relevant market interest rate is 10 percent?b. If the market interest rate increases to 12 percent, what will be the prices of the two bonds?c. If the market interest rate decreases to 8 percent, what will be the prices of the two bonds?


Doc. Irena JindrichovskaCorporate Finance Management 2*Exercise (2)Consider a bond that pays an $80 coupon annually and has a face value of $1,000.Using excel calculate the yield to maturity if the bond hasa. 20 years remaining to maturity and it is sold at $1,200.b. 10 years remaining to maturity and it is sold at $950.


Doc. Irena JindrichovskaCorporate Finance Management 2*USEFUL WEB SOURCESOn financial instruments http://www.investopedia.com/terms/f/financialinstrument.asp#axzz1e50d197VCorporate finance a practical approach - Clayman, Fridson, Troughton - CFA institute (incl. examples and calculations) Ch 4?http://www.google.com/books?hl=cs&lr=&id=PwyqVX3H1YkC&oi=fnd&pg=PT10&dq=corporate+finance+a+practical+approach&ots=r4Lk6fqqou&sig=zrTrbFmB1KiNKIun2Jxgey24XGU#v=onepage&q=bond&f=false


Doc. Irena JindrichovskaCorporate Finance Management 2*RECOMENDED READINGSFundamentals of Corporate Finance, Ross, Westerfield and Jaffe, 4th edition. Ch 5 Brigham and Houston: Fundamentals of Financial Management, 12th ed, Ch 6


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