presented by: the northern trust company elizabeth v. hasten,ctp

© 2012 Northern Trust Corporation

Presented by: The Northern Trust CompanyElizabeth V. Hasten,CTP

Windy City Summit CTP Review

Chapter 13

Service Expertise Integrity

IntegrityExpertiseService2 Windy City Summit CTP Review

Chapter 12

Financial Decisions and Management


Importance of Finance and Treasury

Objectives for Treasury Professionals

Short-term – to sustain organizations operations

Long-term – to sustain organizations overall financial objectives and mission


For-profit

• Managers work for owners.

• Maximize firm’s long term value = value of common stock

• Generate returns greater than cost of funds.

Not-for-profit

• Managers work toward goals set by charter.

• Using best resources available as efficiently as possible, to provide maximum benefits.

Government

• Managers work for the public.

• Similar to Not-for-Profit - provide maximum benefit as defined by legal responsibilities.

Financial Objectives for Different Types of Organizations:



The Finance Function

Accounting Responsible for accurately recording assets, liabilities, revenues, expenses

Funding Determines overall cost of capital and capital structure

Capital Budgeting Quantitatively evaluates projects and estimates relative returns; then qualitatively evaluates projects

Financial Planning Determines need for present and future funding

Risk Management Includes financial, credit, counter-party and other types of risk



Key Capital Financial Decision Financing Decisions

How much capital to raise outside the company? How fast will organization grow?

Capital Structure DecisionsHow much short-term and long-term debt is to be used vs. equity capital?

Determine mix with lowest cost with flexibility. Asset Investment Decisions

Which projects or acquisitions to fund? How much to invest in strategic assets (compete for funding)?



Key Capital Financial Decisions Dividend Decisions

How much dividends should the company pay or not pay and reinvest? Many factors:

Board of directors, in its role as the “voice” of stockholders, decides whether to pay a dividend

Decision is guided by shareholder or, in some cases, analyst expectations

May also depend on a company’s industry, stage of development, dividend payment history and/or covenants



Raising and Managing Long-Term Capital

Why Private Placement is preferred over Public Issuance:

Less covenants

Smaller issue size

Reduced time

Minimal reporting requirements or disclosures

IPOs require disclosure of ownership, financial statements, etc…

Lower costs

Of reporting and disclosure

Price can fluctuate due to economy, technology, government regulations or public perception of company

Control over who holds debt


Managing Outstanding Capital

Manage Legal and Payment Requirements

Manage Trustee Relationships

Disbursing Agent· Shareholders – dividends· Bondholders – P&I payments· Other obligations under covenants

Investor Relations

Maintain shareholder lists

Send financial statements, annual reports, other filings

Communicate with share- and bond-holders

Answer investors’ questions

Raising and Managing Long-Term Capital


Primary sources of capital are L-T debt (bonds) and equity (stock and retained earnings)

Cost of Debt:

Relevant cost is After-Tax

Pre-tax cost of bond is Yield to Maturity (YTM), or the rate of return over the bond’s remaining life based on market price when measured. TYM is converted to an after-tax rate using the following equation:

Cost of Capital and Firm Value

After-Tax rD = After-tax cost of debt

rD = Yield to maturity on newly issued debt (before tax)

T = Company’s marginal income tax rate

After-Tax rD = rD (1-T)


Cost of Debt example: Marginal tax rate = 30% and a YTM = 5% on a newly issued debt.


After-Tax rD = rD (1-T)

After-Tax rD =.05 (1-0.30) = .035 = 3.5%



Primary sources of capital are L-T debt (bonds) and equity (stock and retained earnings)

Cost of Common Equity:

CAPM – Capital Asset Pricing Model (Chapter 12)

Cost that applies to equity funds that are obtained through retained earnings.

r E= r RF = (rM – r RF) β

rE = Required rate of return on stockholder’s equity

rRF = Expected rate of return on the Risk-Free asset (T-Bill)

rM = Expected rate of return on the market portfolion (S&P 500)

β = Beta value for the company’s stock


Cost of Equity Capital example: Risk Free Rate (T-bill) = 4.0%, return on overall market is 10.0%, beta is 1.2.

r E= r RF = (rM – r RF) β


rE = .04 + (0.10 - 0.04)(1.2) = 0.112 or 11.2%

The cost of equity capital is 11.2%, which means that the equity raised through retained earnings costs the company 11.2%, and the stockholders require a rate of return of 11.2% from the company


Weighted Average Cost of Capital (WACC)

Calculates weighted average of the costs of long-term debt and equity where the weights represent the proportion of each in long-term financing.


WACC = WDrD(1 – T) + WErE

WACC = Weighted Average Cost of Capital

W = % (weight) of each source of financing in relation to the sum of debt and equity financing

D = Debit

E= Equity

(rD)(1 – T) = After-tax cost of debt

rE = Cost of equity (common stock and retained earnings)


WACC example: 1/3 or 33.3% of financing provide by debit and 2/3 or 66.7% provided by equity.

WACC = WDrD(1 – T) + WErE


WACC = 0.333 x 0.05 x (1 – 0.3) + (0.667 x 0.112) = 8.64%

The WACC or overall cost of capital is 8.64%, which is an estimate of the market’s expected return for this company.



Firm Value

Economic value added (EVA) emphasizes a rate of return on assets that exceeds the cost of capital to create shareholder value. Assume that $50,000,000 of capital is employed, the company generated an operating profit of $6,800,000, and WACC is 8.64%.

EVA = EBIT (1 – Tax Rate) – (WACC)(Long-Term Debt + Equity)

= $6,800,000(1 – 0.30) – (.0864)($50,000,000)

= $4,760,000 - $4,320,000 = $440,000

Positive EVA will cause share price to increase .


Debt Financing and Management

Costs of BorrowingInterest expenseCredit enhancements (guarantees or letters of credit)Rating agency feesLegal feesCommitment and facility feesBroker/Dealer feesMonitoring, negotiating (soft $ cost), and maintaining loan covenants


Basic Components in Interest Rates

r*RF Real risk-free rate of interest

Rate demanded by savers to compensate for delaying use of money today, absent risk or inflation, for 1-year maturity.

IP Inflation premium The real-risk free rate plus the inflation premium matches the T-bill rate in the U.S.

DP Default premium For investments other than government securities, a risk-return premium is added.

LP Liquidity premium While markets for most securities of large governments are highly liquid, other markets have lower liquidity.

MP Maturity premium Longer-term investments have more price risk and thus a maturity premium.



Base Rates

Economic conditions and yield curves (Ch 11) impact base rates

LIBOR – London Interbank Offer Rate

Fed Funds (Federal Reserve) Rate

Prime Rate

Short- vs. Long-Term Borrowing

Risks of Short-Term Borrowing

Fluctuation of rates – companies use derivatives to reduce risk (Long-Term Borrowing uses fixed rates)

Availability of funds – may not always be available from lenders – mitigated by using multi-year lines of credit




Advantages of Short-Term Borrowing: Ease of access:

· No Fed reserve requirements < 365 days· Less-restrictive covenants

Flexibility for future borrowing Ability to finance seasonal credit needs efficiently Can be obtained from spontaneous sources:

· A/P· Accrued expenses


Disadvantages of Short-Term Borrowing: Continuing need to roll over financing Lender may not renew:

· Changes in financial variables in the firm· Changes in general economic conditions

Clean-up periods on lines of credit Downsides to secured borrowing:

· Asset monitoring· Asset key ratios· Limited to percentage of asset value




Loan Agreements and Covenants Impose restrictions (covenants) or obligations on management, which

have an impact on decision makingRestrictions could include:

Ability to sell certain assetsRight of an organization to issue additional bondsUse of second or junior mortgagesKey ratios that limit flexibility in financial decision makingPayment of dividends



Credit Rating Agencies

National Recognized Statistical Rating Organizations (NRSRO) ratings are not investment recommendations but an assessment of the potential downside loss.

Generally have access to firm’s internal information (widely accepted).

Dodd-Frank Act rating agency changes: Rating agencies must provide greater disclosure of rating models

and methodologies. Subject to greater liability. SEC given two years to eliminate conflicts of interest between

rating agencies and the organizations they regulate.Classes:

Issuer – Issuer’s overall capacity to meet financial obligations Issue-Specific – Consider the specific terms of the issue


Ratings Process – quantitative and qualitative analysis

Reviews of Ratings – usually once per year

Credit Rating Scales

Scales used for bonds recognized by SEC

Short-Term credit uses different system since Long-Term debt has more variables that affect ratings

Long-Term Bond Credit Ratings (page 491)

Short-Term Credit Ratings (page 492)



Lease Financing and Management

Capital Asset Acquisition process:

Acquisition - capital budget decision already made prior to leasing decision

Finance - borrowing or leasing Why Companies Lease -

Lessor receives lease payments from lessee; both get a tax benefit

Direct substitute for debtGood for when there is a high uncertainty for future demand or for

items outside firm’s area of expertise



Types of Leases Sale and leaseback

Give company cash infusion For companies that cannot take advantage of depreciation tax

benefits

Operating or service leases Lessor maintains, retains asset at end Often OBSA Shorter duration than life of asset

Capital Asset Acquisition process:

Acquisition - capital budget decision already made prior to leasing decision

Finance - borrowing or leasing



Capital or financial leases Alternative to borrowing funds and purchasing asset

Residual value is estimated value at end of lease (lessee maintains asset and pays taxes and insurance)

Double-net lease (triple-net in real estate)

ASC Codificaiton Topic 840-10-15: restate company’s balance sheet (leased asset as fixed asset, lease payments as liability

Leases meeting any one of the following four conditions must be classified as a capital lease:

· The length of the lease is at least 75% of the estimated useful life of the asset.

· There is a transfer of ownership to the lessee at the end of the lease.

· The lease agreement contains a provision that allows the lessee to purchase the asset per a bargain purchase option during or at the end of the lease’s life.

· The present value of the discounted lease payments at the beginning of the lease term exceeds 90% of the asset’s fair market value.



Estimated Residual Value Sale and leaseback Lessor has primary claim on an asset’s residual value. Residual value is built in to most lease arrangements, and

potentially high residual value can lower lease payments. Residual value may impact a lease’s tax status and requirements

for listing as an Off-Balance Sheet Arrangement (OBSA) Assumed residual value is important because the lease may

require payment of the difference between this amount and actual residual value (e.g., tied to mileage or general condition of a vehicle)

Tax Considerations for U.S. CorporationsLease vs. Borrow-and-Buy

Based on comparing the costs of leasing with the costs of borrowing to buy the asset

Net present value of cash flows for each alternative


Equity Financing and Management

IPO Advantages

Diversification and increased liquidity Establishing the value of a closely held company Spin off a subsidiary

Disadvantages SEC disclosure Loss of managerial flexibility Surrender of some control Other factors:

· Smaller company stocks may not be especially liquid.· Small market/infrequent trading leads to undervalued stock.· Increased reporting and disclosure (debt rating).



The Decision to List StockAdvantages

Primary advantage: increased marketability of stock. Increased public exposure causes higher sales. Increased level of disclosure may lower WACC on a company’s

common stock and bonds, increasing the firm’s market value.Disadvantages

Additional requirements keep some companies in OTC market. OTC liquidity has increased since 1990s (e.g., NASDAQ). Some smaller companies voluntarily delist rather than comply

with disclosure requirements of SOX.Delisting – may still be traded on the OTC marketExchanges – requirements for various exchanges



Shareholder Rights

Control of Company

Cumulative Voting - # of votes per share as open posts on board

Proxy

Assigning another individual, trough a proxy, the right to vote at the annual meeting

Staggered Election of Directors

Makes it difficult to take over the entire board

Preemptive Right

Existing shareholders have first right to purchase shares of any new stock issue on a pro-rata basis based on the number of shares owned



Financing Mergers and Acquisitions

Merger

Two companies combine and one ceases to exist

Consensual

Acquisition

One company buys majority voting shares of another

Friendly – stock transfer or asset purchase· Bidding company informs board of intent· If rejected, bidder may take case directly to shareholders

Hostile – lack of due diligence· Direct tender to shareholders (usually a premium)· Proxy fight· Creeping tender offer



Stock Transfer Exchange of stock of companies May pay cash to shareholders of acquired firm Acquiring firm owns other’s assets and assumes liabilities

Asset Purchase Acquiring firm may buy some or all of the assets May selectively assume liabilities

Cash Payment Cash from either company Sale of assets Issuance of bonds – investment or junk

LBO – Leveraged Buy Out Small group of investors purchases a firm using large amounts of

debt; results in a high debt (i.e., leverage) ratio.


Other Topics in Financial Decisions

Tax StrategiesInternational businesses need global tax strategy to avoid unfavorable

tax consequences, such as: Double taxes Balancing home country and foreign tax considerations Working in countries without an international tax treaty network

Widespread and complex international transfer pricing rules: Strict arm’s length Understand both home country and foreign transfer rules

Deemed dividends

Solid tax strategy requires understanding firm’s: Business and financial position International operating strategy Intended areas of operation outside the U.S.


Other Topics in Financial Decisions

Impact of a Financial and Credit Crisis Impact on Financial Institutions

Crisis creates liquidity problems due to asset/ liability mismatch (long-term assets financed with short-term funds).

Governments provide liquidity infusion.

Systemic risks.

Tightening of Credit Markets FIs revalue portfolios → FIs reinforce capital base, tighten

lending standards, reduce lending → corporate ratings decline → non-bank, short-term lending markets reduced.

Increased Awareness of Financial Risk FIs revalue portfolios → FIs reinforce capital base, tighten

lending standards, reduce lending → corporate ratings decline → non-bank, short-term lending markets reduced.

Market Analysis and Research Tools

presented by: the northern trust company elizabeth v. hasten,ctp

Documents

equity capital

capital structure decisionshow

debt integrityexpertiseservice

longterm debt

public issuance

types of riskimportance

lowest cost

strategic assets