principles of corporate finance - freetesta.roberta.free.fr/my books/business/mcgraw-hill...u...
TRANSCRIPT
![Page 1: Principles of Corporate Finance - Freetesta.roberta.free.fr/My Books/Business/Mcgraw-Hill...u Finance and the Financial Manager Principles of Corporate Finance Brealey and Myers Sixth](https://reader035.vdocuments.mx/reader035/viewer/2022062416/611e6bf15919943bc424f344/html5/thumbnails/1.jpg)
u Finance and the Financial Manager
Principles of Corporate FinanceBrealey and Myers Sixth Edition
Chapter 1
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2
Topics Covered
wWhat Is A Corporation?w The Role of The Financial Manager
wWho Is The Financial Manager?w Separation of Ownership and Managementw Financial Markets
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3
Corporate Structure
Sole Proprietorships
Corporations
Partnerships
Unlimited Liability
Personal tax on profits
Limited Liability
Corporate tax on profits +
Personal tax on dividends
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4
Role of The Financial Manager
Financial
managerFirm's
operations
Financial
markets
(1) Cash raised from investors
(2) Cash invested in firm
(3) Cash generated by operations
(4a) Cash reinvested(4b) Cash returned to investors
(1)(2)
(3)
(4a)
(4b)
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5
Who is The Financial Manager?
Chief Financial Officer
ComptrollerTreasurer
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6
Ownership vs. Management
Difference in Information
w Stock prices andreturnsw Issues of shares and
other securities
w Dividends
w Financing
Different Objectives
w Managers vs.stockholdersw Top mgmt vs.
operating mgmt
w Stockholders vs. banksand lenders
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7
Financial Markets
Primary
Markets
Secondary
Markets
OTC
Markets
Money
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8
Financial Institutions
Company
IntermediariesBanks
Insurance Cos.
Brokerage Firms
ObligationsFunds
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9
Financial Institutions
Intermediaries
InvestorsDepositors
Policyholders
Investors
ObligationsFunds
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u Present Value and The Opportunity Cost of Capital
Principles of Corporate FinanceBrealey and Myers Sixth Edition
Chapter 2
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11
Topics Covered
w Present Valuew Net Present Value
w NPV Rulew ROR Rulew Opportunity Cost of Capital
wManagers and the Interests of Shareholders
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Present Value
Present Value
Value today ofa future cash
flow.
Discount Rate
Interest rate usedto compute
present values offuture cash flows.
Discount Factor
Present value ofa $1 futurepayment.
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Present Value
1factordiscount =PV
PV=ValuePresent
C×
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14
Present Value
Discount Factor = DF = PV of $1
Discount Factors can be used to compute the present value ofany cash flow.
DFr t=
+1
1( )
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15
Valuing an Office Building
Step 1: Forecast cash flows
Cost of building = C0 = 350
Sale price in Year 1 = C1 = 400
Step 2: Estimate opportunity cost of capital
If equally risky investments in the capital market
offer a return of 7%, then
Cost of capital = r = 7%
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Valuing an Office Building
Step 3: Discount future cash flows
Step 4: Go ahead if PV of payoff exceeds investment
374)07.1(400
)1(1 === ++r
CPV
24374350 =+−=NPV
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Net Present Value
rC+
+1
C=NPV
investment required-PV=NPV
10
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18
Risk and Present Value
w Higher risk projects require a higher rate ofreturn.
w Higher required rates of return cause lowerPVs.
374.071
400PV
7%at $400 C of PV 1
=+
=
=
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19
Risk and Present Value
374.071
400PV
7%at $400 C of PV 1
=+
=
=
357.121
400PV
12%at $400 C of PV 1
=+
=
=
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20
Rate of Return Rule
w Accept investments that offer rates of returnin excess of their opportunity cost of capital.
Example
In the project listed below, the foregone investmentopportunity is 12%. Should we do the project?
14%or .14350,000
350,000400,000investment
profitReturn =
−==
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21
Net Present Value Rule
w Accept investments that have positive netpresent value.
Example
Suppose we can invest $50 today and receive $60in one year. Should we accept the project given a10% expected return?
55.4$1.1060
+-50=NPV =
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22
Opportunity Cost of Capital
Example
You may invest $100,000 today. Depending on thestate of the economy, you may get one of threepossible cash payoffs:
140,000110,000$80,000Payoff
BoomNormalSlumpEconomy
000,110$3
000,140000,100000,80C payoff Expected 1 =
++==
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23
Opportunity Cost of Capital
Example - continued
The stock is trading for $95.65. Depending on thestate of the economy, the value of the stock at theend of the year is one of three possibilities:
140110$80eStock Pric
BoomNormalSlumpEconomy
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24
Opportunity Cost of Capital
Example - continued
The stocks expected payoff leads to an expectedreturn.
15%or 15.65.95
65.95110profit expectedreturn Expected
110$3
14010080C payoff Expected 1
=−
==
=++
==
investment
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Opportunity Cost of Capital
Example - continued
Discounting the expected payoff at the expectedreturn leads to the PV of the project.
650,95$1.15
110,000PV ==
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26
Investment vs. Consumption
w Some people prefer to consume now. Someprefer to invest now and consume later.Borrowing and lending allows us to reconcilethese opposing desires which may existwithin the firm’s shareholders.
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Investment vs. Consumption
A n
B n
100
80
60
40
20
2020 40 60 80 100income in period 0
income in period 1
Some investors will prefer A
and others B
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28
Investment vs. Consumption
The grasshopper (G) wants toconsume now. The ant (A) wants towait. But each is happy to invest. Aprefers to invest 14%, moving up thered arrow, rather than at the 7%interest rate. G invests and thenborrows at 7%, thereby transforming$100 into $106.54 of immediateconsumption. Because of theinvestment, G has $114 next year topay off the loan. The investment’sNPV is $106.54-100 = +6.54
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Investment vs. Consumptionw The grasshopper (G) wants to consume now.
The ant (A) wants to wait. But each is happyto invest. A prefers to invest 14%, moving upthe red arrow, rather than at the 7% interestrate. G invests and then borrows at 7%,thereby transforming $100 into $106.54 ofimmediate consumption. Because of theinvestment, G has $114 next year to pay offthe loan. The investment’s NPV is $106.54-100 = +6.54
100 106.54DollarsNow
DollarsLater
114
107
A invests $100 nowand consumes $114next year
G invests $100 now,borrows $106.54 andconsumes now.
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Managers and Shareholder Interests
w Tools to Ensure Management Responsiveness
èSubject managers to oversight and review byspecialists.
è Internal competition for top level jobs that areappointed by the board of directors.
èFinancial incentives such as stock options.
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u How to Calculate Present Values
Principles of Corporate FinanceBrealey and Myers Sixth Edition
Chapter 3
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32
Topics Covered
w Valuing Long-Lived Assetsw PV Calculation Short Cuts
w Compound Interestw Interest Rates and Inflationw Example: Present Values and Bonds
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Present Values
Discount Factor = DF = PV of $1
w Discount Factors can be used to computethe present value of any cash flow.
DFr t=
+1
1( )
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Present Values
w Discount Factors can be used to computethe present value of any cash flow.
DFr t=
+1
1( )
1
11 1 r
CCDFPV
+=×=
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Present Values
w Replacing “1” with “t” allows the formulato be used for cash flows that exist at anypoint in time.
t
tt r
CCDFPV
+=×=
1
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Present Values
Example
You just bought a new computer for $3,000. The paymentterms are 2 years same as cash. If you can earn 8% onyour money, how much money should you set aside todayin order to make the payment when due in two years?
PV = =30001 08 2 572 02
( . )$2, .
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Present Values
w PVs can be added together to evaluatemultiple cash flows.
PV C
r
C
r= + +
+ +1
12
21 1( ) ( )....
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38
Present Values
w Given two dollars, one received a year fromnow and the other two years from now, thevalue of each is commonly called theDiscount Factor. Assume r1 = 20% and r2 =7%.
87.
83.
2
1
)07.1(00.1
2
)20.1(00.1
1
==
==
+
+
DF
DF
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39
Present Values
Example
Assume that the cash flowsfrom the construction and saleof an office building is asfollows. Given a 7% requiredrate of return, create a presentvalue worksheet and show thenet present value.
000,300000,100000,150
2Year 1Year 0Year
+−−
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Present Values
Example - continued
Assume that the cash flows from the construction and sale of an officebuilding is as follows. Given a 7% required rate of return, create apresent value worksheet and show the net present value.
( )400,18$
900,261000,300873.2
500,93000,100935.1
000,150000,1500.10Value
Present
Flow
Cash
Factor
DiscountPeriod
207.11
07.11
==++=−−=−−
TotalNPV
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Short Cuts
w Sometimes there are shortcuts that make itvery easy to calculate the present value of anasset that pays off in different periods. Thesetolls allow us to cut through the calculationsquickly.
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Short Cuts
Perpetuity - Financial concept in which a cashflow is theoretically received forever.
PVC
r =
=luepresent va
flow cashReturn
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Short Cuts
Perpetuity - Financial concept in which a cashflow is theoretically received forever.
rC
PV 1
ratediscount flow cash
FlowCash of PV
=
=
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Short Cuts
Annuity - An asset that pays a fixed sum eachyear for a specified number of years.
( )
+
−×= trrrC
1
11annuity of PV
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Annuity Short Cut
Example
You agree to lease a car for 4 years at $300 per month.You are not required to pay any money up front or at theend of your agreement. If your opportunity cost of capitalis 0.5% per month, what is the cost of the lease?
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Annuity Short Cut
Example - continuedYou agree to lease a car for 4 years at $300 permonth. You are not required to pay any money upfront or at the end of your agreement. If youropportunity cost of capital is 0.5% per month,what is the cost of the lease?
( )10.774,12$
005.1005.1
005.1
300Cost Lease 48
=
+
−×=
Cost
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Compound Interest
i ii iii iv vPeriods Interest Value Annuallyper per APR after compoundedyear period (i x ii) one year interest rate
1 6% 6% 1.06 6.000%
2 3 6 1.032 = 1.0609 6.090
4 1.5 6 1.0154 = 1.06136 6.136
12 .5 6 1.00512 = 1.06168 6.168
52 .1154 6 1.00115452 = 1.06180 6.180
365 .0164 6 1.000164365 = 1.06183 6.183
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Compound Interest
02468
1012141618
0 3 6 9 12 15 18 21 24 27 30
Number of Years
FV
of
$1
10% Simple
10% Compound
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Inflation
Inflation - Rate at which prices as a whole areincreasing.
Nominal Interest Rate - Rate at which moneyinvested grows.
Real Interest Rate - Rate at which thepurchasing power of an investment increases.
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Inflation
1 + real interest rate = 1+nominal interest rate1+inflation rate
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51
Inflation
1 + real interest rate = 1+nominal interest rate1+inflation rate
approximation formula
Real int. rate nominal int. rate - inflation rate≈
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52
InflationExample
If the interest rate on one year govt. bonds is 5.9%and the inflation rate is 3.3%, what is the realinterest rate?
Savings
Bond
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53
InflationExample
If the interest rate on one year govt. bonds is 5.9%and the inflation rate is 3.3%, what is the realinterest rate?
1
1
+
+
real interest rate =
real interest rate = 1.025
real interest rate = .025 or 2.5%
1+.0591+.033 Savings
Bond
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54
InflationExample
If the interest rate on one year govt. bonds is 5.9%and the inflation rate is 3.3%, what is the realinterest rate?
1
1
+
+
real interest rate =
real interest rate = 1.025
real interest rate = .025 or 2.5%
Approximation =.059-.033 =.026 or 2.6%
1+.0591+.033 Savings
Bond
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55
Valuing a Bond
Example
If today is October 2000, what is the value of the followingbond?
w An IBM Bond pays $115 every Sept for 5 years. In Sept2005 it pays an additional $1000 and retires the bond.
w The bond is rated AAA (WSJ AAA YTM is 7.5%).
Cash Flows
Sept 01 02 03 04 05115 115 115 115 1115
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56
Valuing a Bond
Example continuedIf today is October 2000, what is the value of the following bond?
w An IBM Bond pays $115 every Sept for 5 years. In Sept 2005 it pays anadditional $1000 and retires the bond.
w The bond is rated AAA (WSJ AAA YTM is 7.5%).
( ) ( ) ( ) ( )
84.161,1$
075.1115,1
075.1115
075.1115
075.1115
075.1115
5432
=
++++=PV
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57
Bond Prices and Yields
0
200
400
600
800
1000
1200
1400
1600
0 2 4 6 8 10 12 14
5 Year 9% Bond 1 Year 9% Bond
Yield
Pric
e
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u The Value of Common Stocks
Principles of Corporate FinanceBrealey and Myers Sixth Edition
Chapter 4
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59
Topics Covered
w How To Value Common Stockw Capitalization Rates
w Stock Prices and EPSw Cash Flows and the Value of a Business
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60
Stocks & Stock Market
Common Stock - Ownership shares in apublicly held corporation.
Secondary Market - market in which alreadyissued securities are traded by investors.
Dividend - Periodic cash distribution from thefirm to the shareholders.
P/E Ratio - Price per share divided by earningsper share.
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61
Stocks & Stock Market
Book Value - Net worth of the firm according tothe balance sheet.
Liquidation Value - Net proceeds that would berealized by selling the firm’s assets andpaying off its creditors.
Market Value Balance Sheet - Financialstatement that uses market value of assets andliabilities.
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62
Valuing Common Stocks
Expected Return - The percentage yield that aninvestor forecasts from a specific investment over aset period of time. Sometimes called the marketcapitalization rate.
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63
Valuing Common Stocks
Expected Return - The percentage yield that aninvestor forecasts from a specific investment over aset period of time. Sometimes called the marketcapitalization rate.
Expected Return = =+ −
rDiv P P
P1 1 0
0
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64
Valuing Common Stocks
The formula can be broken into two parts.
Dividend Yield + Capital Appreciation
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65
Valuing Common Stocks
The formula can be broken into two parts.
Dividend Yield + Capital Appreciation
Expected Return = = + −r
DivP
P PP
1
0
1 0
0
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66
Valuing Common Stocks
Capitalization Rate can be estimated using theperpetuity formula, given minor algebraicmanipulation.
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67
Valuing Common Stocks
Capitalization Rate can be estimated using theperpetuity formula, given minor algebraicmanipulation.
gP
Divr
grDiv
P
+==
−==
0
1
10 RatetionCapitaliza
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68
Valuing Common Stocks
Return Measurements
0
1
PDiv
YieldDividend =
Sharey Per Book EquitEPS
Equityon Return
=
=
ROE
ROE
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69
Valuing Common Stocks
Dividend Discount Model - Computation of today’sstock price which states that share value equals thepresent value of all expected future dividends.
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70
Valuing Common Stocks
Dividend Discount Model - Computation of today’sstock price which states that share value equals thepresent value of all expected future dividends.
H - Time horizon for your investment.
PDiv
r
Div
r
Div P
rH H
H01
12
21 1 1=
++
++ + +
+( ) ( )...
( )
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71
Valuing Common Stocks
Example
Current forecasts are for XYZ Company to paydividends of $3, $3.24, and $3.50 over the next threeyears, respectively. At the end of three years youanticipate selling your stock at a market price of$94.48. What is the price of the stock given a 12%expected return?
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72
Valuing Common Stocks
ExampleCurrent forecasts are for XYZ Company to pay dividends of $3, $3.24,and $3.50 over the next three years, respectively. At the end of threeyears you anticipate selling your stock at a market price of $94.48. Whatis the price of the stock given a 12% expected return?
PV
PV
=+
++
+ ++
=
3 001 12
3 241 12
350 94 481 12
00
1 2 3
.( . )
.( . )
. .( . )
$75.
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73
Valuing Common Stocks
If we forecast no growth, and plan to hold out stockindefinitely, we will then value the stock as aPERPETUITY.
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74
Valuing Common Stocks
If we forecast no growth, and plan to hold out stockindefinitely, we will then value the stock as aPERPETUITY.
Perpetuity PDiv
ror
EPS
r= =0
1 1
Assumes all earnings arepaid to shareholders.
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75
Valuing Common Stocks
Constant Growth DDM - A version of the dividendgrowth model in which dividends grow at a constantrate (Gordon Growth Model).
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76
Valuing Common Stocks
Example- continued
If the same stock is selling for $100 in the stockmarket, what might the market be assuming aboutthe growth in dividends?
$100$3.
.
.
=−
=
0012
09
g
g
Answer
The market isassuming the dividendwill grow at 9% peryear, indefinitely.
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77
Valuing Common Stocks
w If a firm elects to pay a lower dividend, and reinvestthe funds, the stock price may increase becausefuture dividends may be higher.
Payout Ratio - Fraction of earnings paid out asdividends
Plowback Ratio - Fraction of earnings retained by thefirm.
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78
Valuing Common Stocks
Growth can be derived from applying thereturn on equity to the percentage of earningsplowed back into operations.
g = return on equity X plowback ratio
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79
Valuing Common Stocks
Example
Our company forecasts to pay a $5.00dividend next year, which represents100% of its earnings. This will provideinvestors with a 12% expected return.Instead, we decide to plow back 40% ofthe earnings at the firm’s current returnon equity of 20%. What is the value ofthe stock before and after the plowbackdecision?
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80
Valuing Common Stocks
ExampleOur company forecasts to pay a $5.00 dividend next year, whichrepresents 100% of its earnings. This will provide investors with a 12%expected return. Instead, we decide to blow back 40% of the earnings atthe firm’s current return on equity of 20%. What is the value of the stockbefore and after the plowback decision?
P0
512
67= =.
$41.
No Growth With Growth
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81
Valuing Common Stocks
ExampleOur company forecasts to pay a $5.00 dividend next year, whichrepresents 100% of its earnings. This will provide investors with a 12%expected return. Instead, we decide to blow back 40% of the earnings atthe firm’s current return on equity of 20%. What is the value of the stockbefore and after the plowback decision?
P0
512
67= =.
$41.
No Growth With Growth
g
P
= × =
=−
=
. . .
. .$75.
20 40 08
312 08
000
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82
Valuing Common Stocks
Example - continued
If the company did not plowback some earnings, thestock price would remain at $41.67. With theplowback, the price rose to $75.00.
The difference between these two numbers (75.00-41.67=33.33) is called the Present Value of GrowthOpportunities (PVGO).
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83
Valuing Common Stocks
Present Value of Growth Opportunities (PVGO)- Net present value of a firm’s futureinvestments.
Sustainable Growth Rate - Steady rate at whicha firm can grow: plowback ratio X return onequity.
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84
FCF and PV
w Free Cash Flows (FCF) should be thetheoretical basis for all PV calculations.
w FCF is a more accurate measurement of PVthan either Div or EPS.w The market price does not always reflect the
PV of FCF.
wWhen valuing a business for purchase, alwaysuse FCF.
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85
FCF and PV
Valuing a BusinessThe value of a business is usually computed as thediscounted value of FCF out to a valuation horizon(H).
w The valuation horizon is sometimes called theterminal value and is calculated like PVGO.
HH
HH
rPV
rFCF
rFCF
rFCF
PV)1()1(
...)1()1( 22
11
++
+++
++
+=
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86
FCF and PV
Valuing a Business
HH
HH
rPV
rFCF
rFCF
rFCF
PV)1()1(
...)1()1( 22
11
++
+++
++
+=
PV (free cash flows) PV (horizon value)
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87
FCF and PV
Example
Given the cash flows for Concatenator ManufacturingDivision, calculate the PV of near term cash flows, PV(horizon value), and the total value of the firm. r=10% andg= 6%
66613132020202020(%) growth .EPS
1.891.791.681.59.23-.20-1.39-1.15-.96-.80- FlowCash Free
1.891.781.681.593.042.693.462.882.402.00Investment
3.783.573.363.182.812.492.071.731.441.20Earnings
51.3173.2905.2847.2643.2374.2028.1740.1400.1200.10ValueAsset
10987654321
Year
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88
FCF and PV
Example - continued
Given the cash flows for Concatenator Manufacturing Division, calculatethe PV of near term cash flows, PV (horizon value), and the total value ofthe firm. r=10% and g= 6%
.
( ) 4.2206.10.
59.1
1.1
1 value)PV(horizon 6 =
−=
( ) ( ) ( ) ( ) ( )6.3
1.123.
1.120.
1.139.1
1.115.1
1.196.
1.1.80
-PV(FCF) 65432
−=
−−−−−=
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89
FCF and PV
Example - continued
Given the cash flows for Concatenator Manufacturing Division, calculatethe PV of near term cash flows, PV (horizon value), and the total value ofthe firm. r=10% and g= 6%
.
$18.8
22.4-3.6
value)PV(horizonPV(FCF)s)PV(busines
=+=
+=
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u Why Net Present Value Leads to Better Investment Decisions than Other Criteria
Principles of Corporate FinanceBrealey and Myers Sixth Edition
Chapter 5
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91
Topics Covered
w NPV and its Competitorsw The Payback Period
w The Book Rate of Returnw Internal Rate of Returnw Capital Rationing
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92
NPV and Cash Transfers
w Every possible method for evaluating projectsimpacts the flow of cash about the companyas follows.
Cash
Investmentopportunity (real
asset)Firm Shareholder
Investmentopportunities
(financial assets)
Invest Alternative:pay dividendto shareholders
Shareholders investfor themselves
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93
Payback
w The payback period of a project is the numberof years it takes before the cumulativeforecasted cash flow equals the initial outlay.
w The payback rule says only accept projectsthat “payback” in the desired time frame.w This method is very flawed, primarily
because it ignores later year cash flows andthe the present value of future cash flows.
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94
Payback
Example
Examine the three projects and note the mistake wewould make if we insisted on only taking projectswith a payback period of 2 years or less.
050018002000-C
018005002000-B
50005005002000-A
10% @NPVPeriod
PaybackCCCCProject 3210
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95
Payback
Example
Examine the three projects and note the mistake wewould make if we insisted on only taking projectswith a payback period of 2 years or less.
502050018002000-C
58-2018005002000-B
2,624350005005002000-A
10% @NPVPeriod
PaybackCCCCProject 3210
+
+
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96
Book Rate of Return
Book Rate of Return - Average income divided byaverage book value over project life. Also calledaccounting rate of return.
Managers rarely use this measurement to makedecisions. The components reflect tax andaccounting figures, not market values or cash flows.
assetsbook incomebook
return of rateBook =
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97
Internal Rate of Return
Example
You can purchase a turbo powered machine toolgadget for $4,000. The investment will generate$2,000 and $4,000 in cash flows for two years,respectively. What is the IRR on this investment?
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98
Internal Rate of Return
Example
You can purchase a turbo powered machine tool gadget for $4,000. Theinvestment will generate $2,000 and $4,000 in cash flows for two years,respectively. What is the IRR on this investment?
0)1(
000,4)1(
000,2000,4 21 =
++
++−=
IRRIRRNPV
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99
Internal Rate of Return
Example
You can purchase a turbo powered machine tool gadget for $4,000. Theinvestment will generate $2,000 and $4,000 in cash flows for two years,respectively. What is the IRR on this investment?
0)1(
000,4)1(
000,2000,4 21 =
++
++−=
IRRIRRNPV
%08.28=IRR
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100
Internal Rate of Return
-2000
-1500
-1000
-500
0
500
1000
1500
2000
2500
10 20 30 40 50 60 70 80 90 100
Discount rate (%)
NP
V (
,000
s)
IRR=28%
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101
Internal Rate of Return
Pitfall 1 - Lending or Borrowing?w With some cash flows (as noted below) the NPV of
the project increases s the discount rate increases.
w This is contrary to the normal relationship betweenNPV and discount rates.
75.%20728,1320,4600,3000,1
%10@3210
−+−−−+NPVIRRCCCC
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102
Internal Rate of Return
Pitfall 1 - Lending or Borrowing?w With some cash flows (as noted below) the NPV of the project
increases s the discount rate increases.
w This is contrary to the normal relationship between NPV and discountrates.
DiscountRate
NPV
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Internal Rate of Return
Pitfall 2 - Multiple Rates of Returnw Certain cash flows can generate NPV=0 at two
different discount rates.
w The following cash flow generates NPV=0 at both(-50%) and 15.2%.
150150150150150800000,16543210
−+++++−CCCCCCC
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Internal Rate of Return
Pitfall 2 - Multiple Rates of Returnw Certain cash flows can generate NPV=0 at two different discount rates.
w The following cash flow generates NPV=0 at both (-50%) and 15.2%.
1000NPV
500
0
-500
-1000
DiscountRate
IRR=15.2%
IRR=-50%
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105
Internal Rate of Return
Pitfall 3 - Mutually Exclusive Projectsw IRR sometimes ignores the magnitude of the
project.w The following two projects illustrate that
problem.
818,1175000,35000,20
182.8100000,20000,10
%10@Project 0
++−++−
F
E
NPVIRRCC t
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106
Internal Rate of Return
Pitfall 4 - Term Structure AssumptionwWe assume that discount rates are stable
during the term of the project.w This assumption implies that all funds are
reinvested at the IRR.w This is a false assumption.
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Internal Rate of ReturnCalculating the IRR can be a laborious task. Fortunately,financial calculators can perform this function easily. Notethe previous example.
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Internal Rate of ReturnCalculating the IRR can be a laborious task. Fortunately,financial calculators can perform this function easily. Notethe previous example.
HP-10B EL-733A BAII Plus
-350,000 CFj -350,000 CFi CF
16,000 CFj 16,000 CFfi 2nd {CLR Work}
16,000 CFj 16,000 CFi -350,000 ENTER
466,000 CFj 466,000 CFi 16,000 ENTER
{IRR/YR} IRR 16,000 ENTER
466,000 ENTER
IRR CPTAll produce IRR=12.96
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Profitability Index
wWhen resources are limited, the profitabilityindex (PI) provides a tool for selecting amongvarious project combinations and alternatives.
w A set of limited resources and projects canyield various combinations.w The highest weighted average PI can indicate
which projects to select.
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110
Profitability Index
Example
We only have $300,000 to invest. Which do we select?
Proj NPV Investment PI
A 230,000 200,000 1.15
B 141,250 125,000 1.13
C 194,250 175,000 1.11
D 162,000 150,000 1.08
InvestmentNPV
Indexity Profitabil =
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Profitability Index
Example - continued
Proj NPV Investment PI
A 230,000 200,000 1.15
B 141,250 125,000 1.13
C 194,250 175,000 1.11
D 162,000 150,000 1.08
Select projects with highest Weighted Avg PIWAPI (BD) = 1.13(125) + 1.08(150) + 1.0 (25)
(300) (300) (300)
= 1.09
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Profitability Index
Example - continued
Proj NPV Investment PI
A 230,000 200,000 1.15
B 141,250 125,000 1.13
C 194,250 175,000 1.11
D 162,000 150,000 1.08
Select projects with highest Weighted Avg PIWAPI (BD) = 1.09
WAPI (A) = 1.10
WAPI (BC) = 1.12
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Linear Programming
w Maximize Cash flows or NPV
w Minimize costs
Example
Max NPV = 21Xn + 16 Xb + 12 Xc + 13 Xd
subject to
10Xa + 5Xb + 5Xc + 0Xd <= 10
-30Xa - 5Xb - 5Xc + 40Xd <= 12
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u Making Investment Decisions with the Net Present Value Rule
Principles of Corporate FinanceBrealey and Myers Sixth Edition
Chapter 6
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Topics Covered
wWhat To Discountw IM&C Project
w Project InteractionèTiming
èEquivalent Annual Cost
èReplacementèCost of Excess Capacity
èFluctuating Load Factors
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116
What To Discount
Only Cash Flow is Relevant
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117
What To Discount
Only Cash Flow is Relevant
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What To Discount
ÜDo not confuse average with incrementalpayoff.ÜInclude all incidental effects.ÜDo not forget working capital requirements.
ÜForget sunk costs.ÜInclude opportunity costs.ÜBeware of allocated overhead costs.
Points to “Watch Out For”
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119
w Be consistent in how you handle inflation!!
w Use nominal interest rates to discountnominal cash flows.w Use real interest rates to discount real cash
flows.
w You will get the same results, whether youuse nominal or real figures.
Inflation
INFLATION RULEINFLATION RULE
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120
Inflation
Example
You own a lease that will cost you $8,000 next year,increasing at 3% a year (the forecasted inflationrate) for 3 additional years (4 years total). Ifdiscount rates are 10% what is the present valuecost of the lease?
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121
Inflation
Example
You own a lease that will cost you $8,000 next year,increasing at 3% a year (the forecasted inflationrate) for 3 additional years (4 years total). Ifdiscount rates are 10% what is the present valuecost of the lease?
1 + real interest rate = 1+nominal interest rate1+inflation rate
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InflationExample - nominal figures
Year Cash Flow PV @ 10%
1 8000
2 8000x1.03 = 8240
8000x1.03 = 8240
8000x1.03 = 8487.20
80001.10
2
3
==
==
7272 73
6809 92
3 6376 56
4 5970 78
429 99
82401 108487 20
1 108741 821 10
2
3
4
.
.
.
.
$26, .
..
..
.
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123
InflationExample - real figures
Year Cash Flow [email protected]%
1 = 7766.99
2 = 7766.99
= 7766.99
= 7766.99
80001.03
7766.991.068
82401.03
8487.201.03
8741.821.03
2
3
4
====
7272 73
6809 92
3 6376 56
4 5970 78
26 429 99
7766 991 068
7766 991 068
7766 991 068
2
3
4
.
.
.
.
..
..
..
= $ , .
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124
IM&C’s Guano Project
Revised projections ($1000s) reflecting inflation
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IM&C’s Guano Project
w NPV using nominal cash flows
( ) ( ) ( ) ( )
( ) ( )$3,519,000or 519,3
20.1444,3
20.1110,6
20.1136,10
20.1685,10
20.1205,6
20.1381,2
20.1630,1
000,12
76
5432
=++
++++−−=NPV
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126
IM&C’s Guano Project
Cash flow analysis ($1000s)
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127
IM&C’s Guano Project
Details of cash flow forecast in year 3 ($1000s)
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IM&C’s Guano Project
Tax depreciation allowed under the modified accelerated costrecovery system (MACRS) - (Figures in percent ofdepreciable investment).
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129
IM&C’s Guano Project
Tax Payments ($1000s)
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130
IM&C’s Guano Project
Revised cash flow analysis ($1000s)
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131
Timing
w Even projects with positive NPV may bemore valuable if deferred.
w The actual NPV is then the current value ofsome future value of the deferred project.
tr
t
)1( date of as valuefutureNet
NPVCurrent +
=
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132
Timing
Example
You may harvest a set of trees at anytime over thenext 5 years. Given the FV of delaying the harvest,which harvest date maximizes current NPV?
9.411.915.420.328.8 valuein change %
109.410089.477.564.450($1000s) Net FV
543210
YearHarvest
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Timing
Example - continued
You may harvest a set of trees at anytime over the next 5 years. Giventhe FV of delaying the harvest, which harvest date maximizes currentNPV?
5.581.1064.4
1 year in harvested if ==NPV
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134
Timing
Example - continued
You may harvest a set of trees at anytime over the next 5 years. Giventhe FV of delaying the harvest, which harvest date maximizes currentNPV?
5.581.1064.4
1 year in harvested if ==NPV
67.968.367.264.058.550($1000s) NPV
543210
YearHarvest
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Equivalent Annual Cost
Equivalent Annual Cost - The cost per periodwith the same present value as the cost ofbuying and operating a machine.
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Equivalent Annual Cost
Equivalent Annual Cost - The cost per periodwith the same present value as the cost ofbuying and operating a machine.
Equivalent annual cost =present value of costs
annuity factor
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Equivalent Annual Cost
Example
Given the following costs of operating two machinesand a 6% cost of capital, select the lower costmachine using equivalent annual cost method.
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Equivalent Annual Cost
Example
Given the following costs of operating two machinesand a 6% cost of capital, select the lower cost machineusing equivalent annual cost method.
Year
Machine 1 2 3 4 PV@6% EAC
A 15 5 5 5 28.37
B 10 6 6 21.00
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139
Example
Given the following costs of operating two machinesand a 6% cost of capital, select the lower cost machineusing equivalent annual cost method.
Year
Machine 1 2 3 4 PV@6% EAC
A 15 5 5 5 28.37 10.61
B 10 6 6 21.00 11.45
Equivalent Annual Cost
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140
Machinery Replacement
Annual operating cost of old machine = 8
Cost of new machine
Year: 0 1 2 3 NPV @ 10% 15 5 5 5 27.4
Equivalent annual cost of new machine = 27.4/(3-year annuity factor) = 27.4/2.5 = 11
MORAL: Do not replace until operating cost
of old machine exceeds 11.
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Cost of Excess Capacity
A project uses existing warehouse and requires a new one to be built inYear 5 rather than Year 10. A warehouse costs 100 & lasts 20 years.
Equivalent annual cost @ 10% = 100/8.5 = 11.7
0 . . . 5 6 . . . 10 11 . . .
With project 0 0 11.7 11.7 11.7
Without project 0 0 0 0 11.7
Difference 0 0 11.7 11.7 0
PV extra cost = + + . . . + = 27.6 11.7 11.7 11.7(1.1)6 (1.1)7 (1.1)10
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Fluctuating Load Factors
$30,00015,0002machines twoofcost operating PV
$15,0001,500/.10pachineper cost operating PV
$1,5007502machineper cost Operating
units 750machineper output Annual
MachinesOld Two
=×=
=×
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143
Fluctuating Load Factors
$27,000500,132machines twoofcost operating PV
$13,500750/.106,000pachineper cost operating PV
$7507501machineper cost Operating
000,6$machine pecost Capital
units 750machineper output Annual
esNew Machin Two
=×=+
=×
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Fluctuating Load Factors
000,26..$..............................machines twoofcost operating PV
$16,000.10/000,16,000$10,000,000/.101pachineper cost operating PV
$1,000000,11$1,0005002machineper cost Operating
000,6$0machine pecost Capital
units 1,000units 500machineper output Annual
eNew Machin One MachineOld One
=+==×=×
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u Introduction to Risk, Return, and the Opportunity Cost of Capital
Principles of Corporate FinanceBrealey and Myers Sixth Edition
Chapter 7
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146
Topics Covered
w 72 Years of Capital Market HistorywMeasuring Risk
w Portfolio Riskw Beta and Unique Riskw Diversification
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147
The Value of an Investment of $1 in 1926
Source: Ibbotson Associates
0,1
10
1000
1925 1933 1941 1949 1957 1965 1973 1981 1989 1997
S&PSmall CapCorp BondsLong BondT Bill
Inde
x
Year End
1
5520
1828
55.38
39.07
14.25
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148
0,1
10
1000
1925 1933 1941 1949 1957 1965 1973 1981 1989 1997
S&PSmall CapCorp BondsLong BondT Bill
The Value of an Investment of $1 in 1926
Source: Ibbotson Associates
Inde
x
Year End
1
613
203
6.15
4.34
1.58
Real returns
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Rates of Return 1926-1997
Source: Ibbotson Associates
-60
-40
-20
0
20
40
60
26 30 35 40 45 50 55 60 65 70 75 80 85 90 95
Common Stocks
Long T-Bonds
T-Bills
Year
Perc
enta
ge R
etur
n
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150
Measuring Risk
Variance - Average value of squared deviations frommean. A measure of volatility.
Standard Deviation - Average value of squareddeviations from mean. A measure of volatility.
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151
Measuring RiskCoin Toss Game-calculating variance and standard deviation
(1) (2) (3)
Percent Rate of Return Deviation from Mean Squared Deviation
+ 40 + 30 900
+ 10 0 0
+ 10 0 0
- 20 - 30 900
Variance = average of squared deviations = 1800 / 4 = 450
Standard deviation = square of root variance = 450 = 21.2%
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Measuring Risk
1 1 24
12 1113
1013
3 20123456789
10111213
-50
to -
40
-40
to -
30
-30
to -
20
-20
to -
10
-10
to 0
0 to
10
10 t
o 20
20 t
o 30
30 t
o 40
40 t
o 50
50 t
o 60
Return %
# of Years
Histogram of Annual Stock Market ReturnsHistogram of Annual Stock Market Returns
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153
Measuring Risk
Diversification - Strategy designed to reduce risk byspreading the portfolio across many investments.
Unique Risk - Risk factors affecting only that firm.Also called “diversifiable risk.”
Market Risk - Economy-wide sources of risk thataffect the overall stock market. Also called“systematic risk.”
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154
Measuring Risk
Portfolio rate
of return=
fraction of portfolio
in first assetx
rate of return
on first asset
+fraction of portfolio
in second assetx
rate of return
on second asset
((
((
))
))
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155
Measuring Risk
05 10 15
Number of Securities
Po
rtfo
lio s
tan
dar
d d
evia
tio
n
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156
Measuring Risk
05 10 15
Number of Securities
Po
rtfo
lio s
tan
dar
d d
evia
tio
n
Market risk
Uniquerisk
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Portfolio Risk
22
22
211221
1221
211221
122121
21
óxóóñxx
óxx2Stock
óóñxx
óxxóx1Stock
2Stock 1Stock
=
=
The variance of a two stock portfolio is the sum of thesefour boxes:
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158
Portfolio Risk
Example
Suppose you invest $55 in Bristol-Myers and $45in McDonald’s. The expected dollar return onyour BM is .10 x 55 = 5.50 and on McDonald’s itis .20 x 45 = 9.90. The expected dollar return onyour portfolio is 5.50 + 9300 = 14.50. Theportfolio rate of return is 14.50/100 = .145 or14.5%. Assume a correlation coefficient of 1.
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Portfolio Risk
2222
22
211221
2112212221
21
)8.20()45(.óx8.201.171
45.55.óóñxxsMcDonald'
8.201.171
45.55.óóñxx)1.17()55(.óxMyers-Bristol
sMcDonald'Myers-Bristol
×=×××
×=×××
×=×=
Example
Suppose you invest $55 in Bristol-Myers and $45 in McDonald’s. Theexpected dollar return on your BM is .10 x 55 = 5.50 and onMcDonald’s it is .20 x 45 = 9.90. The expected dollar return on yourportfolio is 5.50 + 9300 = 14.50. The portfolio rate of return is14.50/100 = .145 or 14.5%. Assume a correlation coefficient of 1.
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160
Portfolio Risk
Example
Suppose you invest $55 in Bristol-Myers and $45 in McDonald’s. Theexpected dollar return on your BM is .10 x 55 = 5.50 and onMcDonald’s it is .20 x 45 = 9.90. The expected dollar return on yourportfolio is 5.50 + 9300 = 14.50. The portfolio rate of return is14.50/100 = .145 or 14.5%. Assume a correlation coefficient of 1.
% 18.7 352.1 DeviationStandard
352.108)1x17.1x20.2(.55x.45x
]x(20.8)[(.45)
]x(17.1)[(.55) Valriance Portfolio22
22
==
=++
=
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Portfolio Risk
)rx()r(x Return PortfolioExpected 2211 +=
)óóñxx(2óxóxVariance Portfolio 21122122
22
21
21 ++=
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162
Portfolio RiskThe shaded boxes contain variance terms; the remaindercontain covariance terms.
1
2
3
4
5
6
N
1 2 3 4 5 6 N
STOCK
STOCKTo calculateportfoliovariance addup the boxes
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163
Beta and Unique Risk
beta
Expected
return
Expectedmarketreturn
10%10%- +
-10%+10%
stock
Copyright 1996 by The McGraw-Hill Companies, Inc
-10%
1. Total risk =diversifiable risk +market risk2. Market risk ismeasured by beta,the sensitivity tomarket changes.
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Beta and Unique Risk
Market Portfolio - Portfolio of all assets in theeconomy. In practice a broad stock marketindex, such as the S&P Composite, is usedto represent the market.
Beta - Sensitivity of a stock’s return to thereturn on the market portfolio.
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Beta and Unique Risk
2m
imiB
σσ
=
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166
Beta and Unique Risk
2m
imiB
σσ
=Covariance with themarket
Variance of the market
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u Risk and Return
Principles of Corporate FinanceBrealey and Myers Sixth Edition
Chapter 8
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168
Topics Covered
wMarkowitz Portfolio Theoryw Risk and Return Relationship
w Testing the CAPMw CAPM Alternatives
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169
Markowitz Portfolio Theory
w Combining stocks into portfolios can reducestandard deviation below the level obtainedfrom a simple weighted average calculation.
w Correlation coefficients make this possible.w The various weighted combinations of stocks
that create this standard deviations constitutethe set of efficient portfoliosefficient portfolios.
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170
Markowitz Portfolio Theory
Price changes vs. Normal distributionMicrosoft - Daily % change 1986-1997
0
100
200
300
400
500
600
-10% -8% -6% -4% -2% 0% 2% 4% 6% 8% 10%
# of
Day
s(f
requ
ency
)
Daily % Change
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171
Markowitz Portfolio Theory
Price changes vs. Normal distributionMicrosoft - Daily % change 1986-1997
0
100
200
300
400
500
600
-10% -8% -6% -4% -2% 0% 2% 4% 6% 8% 10%
# of
Day
s(f
requ
ency
)
Daily % Change
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172
Markowitz Portfolio Theory
Standard Deviation VS. Expected ReturnInvestment C
0
2
4
6
8
10
12
14
16
18
20
-50 0 50
% p
roba
bilit
y
% return
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173
Markowitz Portfolio Theory
Standard Deviation VS. Expected ReturnInvestment D
0
2
4
6
8
10
12
14
16
18
20
-50 0 50
% p
roba
bilit
y
% return
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174
Markowitz Portfolio Theory
Bristol-Myers Squibb
McDonald’s
Standard Deviation
Expected Return (%)
45% McDonald’s
u Expected Returns and Standard Deviations vary givendifferent weighted combinations of the stocks.
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Efficient Frontier
Standard Deviation
Expected Return (%)
•Each half egg shell represents the possible weighted combinations for twostocks.
•The composite of all stock sets constitutes the efficient frontier.
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Efficient Frontier
Standard Deviation
Expected Return (%)
•Lending or Borrowing at the risk free rate (rf) allows us to exist outside theefficient frontier.
rf
Lending
Borro
wingT
S
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177
Efficient Frontier
Example Correlation Coefficient = .4
Stocks σ % of Portfolio Avg Return
ABC Corp 28 60% 15%
Big Corp 42 40% 21%
Standard Deviation = weighted avg = 33.6
Standard Deviation = Portfolio = 28.1
Return = weighted avg = Portfolio = 17.4%
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178
Efficient Frontier
Example Correlation Coefficient = .4
Stocks σ % of Portfolio Avg Return
ABC Corp 28 60% 15%
Big Corp 42 40% 21%
Standard Deviation = weighted avg = 33.6
Standard Deviation = Portfolio = 28.1
Return = weighted avg = Portfolio = 17.4%
Let’s Add stock New Corp to the portfolio
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179
Efficient Frontier
Example Correlation Coefficient = .3
Stocks σ % of Portfolio Avg Return
Portfolio 28.1 50% 17.4%
New CorpNew Corp 3030 50%50% 19% 19%
NEW Standard Deviation = weighted avg = 31.80
NEW Standard Deviation = Portfolio = 23.43
NEW Return = weighted avg = Portfolio = 18.20%
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180
Efficient Frontier
Example Correlation Coefficient = .3
Stocks σ % of Portfolio Avg Return
Portfolio 28.1 50% 17.4%
New Corp 30 50% 19%
NEW Standard Deviation = weighted avg = 31.80
NEW Standard Deviation = Portfolio = 23.43
NEW Return = weighted avg = Portfolio = 18.20%
NOTE: Higher return & Lower risk
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181
Efficient Frontier
Example Correlation Coefficient = .3
Stocks σ % of Portfolio Avg Return
Portfolio 28.1 50% 17.4%
New Corp 30 50% 19%
NEW Standard Deviation = weighted avg = 31.80
NEW Standard Deviation = Portfolio = 23.43
NEW Return = weighted avg = Portfolio = 18.20%
NOTE: Higher return & Lower risk
How did we do that?
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182
Efficient Frontier
Example Correlation Coefficient = .3
Stocks σ % of Portfolio Avg Return
Portfolio 28.1 50% 17.4%
New Corp 30 50% 19%
NEW Standard Deviation = weighted avg = 31.80
NEW Standard Deviation = Portfolio = 23.43
NEW Return = weighted avg = Portfolio = 18.20%
NOTE: Higher return & Lower risk
How did we do that? DIVERSIFICATION
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183
Efficient Frontier
A
B
Return
Risk(measuredas σσ)
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Efficient Frontier
A
B
Return
Risk
AB
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Efficient Frontier
A
BN
Return
Risk
AB
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Efficient Frontier
A
BN
Return
Risk
ABABN
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Efficient Frontier
A
BN
Return
Risk
AB
Goal is to moveup and left.
WHY?
ABN
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Efficient Frontier
Return
Risk
Low Risk
High Return
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189
Efficient Frontier
Return
Risk
Low Risk
High Return
High Risk
High Return
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Efficient Frontier
Return
Risk
Low Risk
High Return
High Risk
High Return
Low Risk
Low Return
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191
Efficient Frontier
Return
Risk
Low Risk
High Return
High Risk
High Return
Low Risk
Low Return
High Risk
Low Return
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192
Efficient Frontier
Return
Risk
Low Risk
High Return
High Risk
High Return
Low Risk
Low Return
High Risk
Low Return
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Efficient Frontier
Return
Risk
A
BNABABN
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194
Security Market Line
Return
Risk
.
rf
Efficient PortfolioRisk Free
Return =
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Security Market Line
Return
Risk
.
rf
Risk Free
Return =
Market Return = rm
Efficient Portfolio
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196
Security Market Line
Return
Risk
.
rf
Risk Free
Return =
Market Return = rm
Efficient Portfolio
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197
Security Market Line
Return
BETA
.
rf
Risk Free
Return =
Market Return = rm
Efficient Portfolio
1.0
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198
Security Market Line
Return
BETA
rf
Risk Free
Return =
Market Return = rm
1.0
Security MarketLine (SML)
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Security Market LineReturn
BETA
rf
1.0
SML
SML Equation = rf + B ( rm - rf )
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200
Capital Asset Pricing Model
R = rf + B ( rm - rf )
CAPM
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201
Testing the CAPM
Avg Risk Premium1931-65
Portfolio Beta1.0
SML
30
20
10
0
Investors
MarketPortfolio
Beta vs. Average Risk Premium
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202
Testing the CAPM
Avg Risk Premium1966-91
Portfolio Beta1.0
SML
30
20
10
0
Investors
MarketPortfolio
Beta vs. Average Risk Premium
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203
Testing the CAPM
0
5
10
15
20
25
Average Return (%)
Company size
Smallest Largest
Company Size vs. Average Return
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204
Testing the CAPM
0
5
10
15
20
25
Average Return (%)
Book-Market Ratio
Highest Lowest
Book-Market Book-Market vsvs. Average Return. Average Return
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205
Consumption Betas vs Market Betas
Stocks (and other risky assets)
Wealth = marketportfolio
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206
Consumption Betas vs Market Betas
Stocks (and other risky assets)
Wealth = marketportfolio
Market riskmakes wealth
uncertain.
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207
Consumption Betas vs Market Betas
Stocks (and other risky assets)
Wealth = marketportfolio
Market riskmakes wealth
uncertain.
Standard
CAPM
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208
Consumption Betas vs Market Betas
Stocks (and other risky assets)
Wealth = marketportfolio
Market riskmakes wealth
uncertain.
Stocks (and other risky assets)
Consumption
Standard
CAPM
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209
Consumption Betas vs Market Betas
Stocks (and other risky assets)
Wealth = marketportfolio
Market riskmakes wealth
uncertain.
Stocks (and other risky assets)
Consumption
Wealth
Wealth is uncertain
Consumption is uncertain
Standard
CAPM
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210
Consumption Betas vs Market Betas
Stocks (and other risky assets)
Wealth = marketportfolio
Market riskmakes wealth
uncertain.
Stocks (and other risky assets)
Consumption
Wealth
Wealth is uncertain
Consumption is uncertain
Standard
CAPM
Consumption
CAPM
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211
Arbitrage Pricing Theory
Alternative to CAPMAlternative to CAPM
Expected Risk
Premium = r - rf
= Bfactor1(rfactor1 - rf) + Bf2(rf2 - rf) + …
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212
Arbitrage Pricing Theory
Alternative to CAPMAlternative to CAPM
Expected Risk
Premium = r - rf
= Bfactor1(rfactor1 - rf) + Bf2(rf2 - rf) + …
Return = a + bfactor1(rfactor1) + bf2(rf2) + …
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213
Arbitrage Pricing TheoryEstimated risk premiums for taking on risk factors
(1978-1990)
6.36Mrket
.83-Inflation
.49GNP Real
.59-rate Exchange
.61-rateInterest
5.10%spread Yield)(r
ium Risk PremEstimatedFactor
factor fr−
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u Capital Budgeting and Risk
Principles of Corporate FinanceBrealey and Myers Sixth Edition
Chapter 9
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Topics Covered
wMeasuring Betasw Capital Structure and COC
w Discount Rates for Intl. Projectsw Estimating Discount Ratesw Risk and DCF
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216
Company Cost of Capital
w A firm’s value can be stated as the sum of thevalue of its various assets.
PV(B)PV(A)PV(AB) valueFirm +==
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217
Company Cost of Capital
w A company’s cost of capital can be comparedto the CAPM required return.
Required
return
Project Beta1.26
Company Costof Capital
13
5.5
0
SML
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218
Measuring Betas
w The SML shows the relationship betweenreturn and risk.
w CAPM uses Beta as a proxy for risk.w Beta is the slope of the SML, using CAPM
terminology.w Other methods can be employed to determine
the slope of the SML and thus Beta.w Regression analysis can be used to find Beta.
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219
Measuring Betas
Hewlett Packard Beta
Slope determined from 60 months ofprices and plotting the line of bestfit.
Price data - Jan 78 - Dec 82
Market return (%)
Hew
lett-Packard return (%)
R2 = .53
B = 1.35
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220
Measuring Betas
Hewlett Packard Beta
Slope determined from 60 months ofprices and plotting the line of bestfit.
Price data - Jan 83 - Dec 87
Market return (%)
Hew
lett-Packard return (%)
R2 = .49
B = 1.33
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221
Measuring Betas
Hewlett Packard Beta
Slope determined from 60 months ofprices and plotting the line of bestfit.
Price data - Jan 88 - Dec 92
Market return (%)
Hew
lett-Packard return (%)
R2 = .45
B = 1.70
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222
Measuring Betas
Hewlett Packard Beta
Slope determined from 60 months ofprices and plotting the line of bestfit.
Price data - Jan 93 - Dec 97
Market return (%)
Hew
lett-Packard return (%)
R2 = .35
B = 1.69
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223
Measuring Betas
A T & T Beta
Slope determined from 60 months ofprices and plotting the line of bestfit.
Price data - Jan 78 - Dec 82
Market return (%)
A T
& T
(%)
R2 = .28
B = 0.21
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224
Measuring Betas
A T & T Beta
Slope determined from 60 months ofprices and plotting the line of bestfit.
Price data - Jan 83 - Dec 87
Market return (%)
R2 = .23
B = 0.64
A T
& T
(%)
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225
Measuring Betas
A T & T Beta
Slope determined from 60 months ofprices and plotting the line of bestfit.
Price data - Jan 88 - Dec 92
Market return (%)
R2 = .28
B = 0.90
A T
& T
(%)
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226
Measuring Betas
A T & T Beta
Slope determined from 60 months ofprices and plotting the line of bestfit.
Price data - Jan 93 - Dec 97
Market return (%)
R2 = ..17
B = .90
A T
& T
(%)
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227
Beta Stability % IN SAME % WITHIN ONE RISK CLASS 5 CLASS 5 CLASS YEARS LATER YEARS LATER
10 (High betas) 35 69
9 18 54
8 16 45
7 13 41
6 14 39
5 14 42
4 13 40
3 16 45
2 21 61
1 (Low betas) 40 62
Source: Sharpe and Cooper (1972)
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228
Capital Budgeting & Risk
Modify CAPM (account for proper risk)
• Use COC unique to project, rather than Company COC
• Take into account Capital Structure
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229 Company Cost of Capitalsimple approach
w Company Cost of Capital (COC) is based onthe average beta of the assets.
w The average Beta of the assets is based on the% of funds in each asset.
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230 Company Cost of Capitalsimple approach
Company Cost of Capital (COC) is based on the average beta ofthe assets.
The average Beta of the assets is based on the % of funds ineach asset.
Example
1/3 New Ventures B=2.0
1/3 Expand existing business B=1.3
1/3 Plant efficiency B=0.6
AVG B of assets = 1.3
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231
Capital Structure - the mix of debt & equity within a company
Expand CAPM to include CS
R = rf + B ( rm - rf )becomes
Requity = rf + B ( rm - rf )
Capital Structure
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232
Capital Structure & COC
COC = rportfolio = rassets
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233
Capital Structure & COC
COC = rportfolio = rassets
rassets = WACC = rdebt (D) + requity (E)
(V) (V)
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234
Capital Structure & COC
COC = rportfolio = rassets
rassets = WACC = rdebt (D) + requity (E)
(V) (V)
Bassets = Bdebt (D) + Bequity (E)
(V) (V)
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235
Capital Structure & COC
COC = rportfolio = rassets
rassets = WACC = rdebt (D) + requity (E)
(V) (V)
Bassets = Bdebt (D) + Bequity (E)
(V) (V)
requity = rf + Bequity ( rm - rf )
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236
Capital Structure & COC
COC = rportfolio = rassets
rassets = WACC = rdebt (D) + requity (E)
(V) (V)
Bassets = Bdebt (D) + Bequity (E)
(V) (V)
requity = rf + Bequity ( rm - rf )
IMPORTANT
E, D, and V areall market values
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237
0
20
0 0,2 0,8 1,2
Capital Structure & COC
Expectedreturn (%)
Bdebt Bassets Bequity
Rrdebt=8
Rassets=12.2
Requity=15
Expected Returns and Betas prior to refinancing
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238
Pinnacle West Corp.
Requity = rf + B ( rm - rf )
= .045 + .51(.08) = .0858 or 8.6%
Rdebt = YTM on bonds
= 6.9 %
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239
Pinnacle West Corp.
.15.51Average Portfolio
21.37.ResourcesL&PP
21.43.CorpWest Pinnacle
23.70. EnergyPECO
15.39. EnergyOGE
19.35.System ElectricNE
18.65.Inc GPU
19.66.Assoc UtilitiesEastern
17.56. EnergyDTE
20.65. EdisonedConsolidat
18.30. HUdsonCentral
19.60. ElectricBoston
ErrorStandard.Beta
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240
Pinnacle West Corp.
9.3%or .093
)10(.65.)08(.35.
=
+=
+== equitydebtassets rV
Er
V
DrCOC
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241
International Risk
.47.1203.80Taiwan
.35.1472.36Kazakhstan
.62.1603.80Brazil
1.46.4163.52Argentina
Betatcoefficien
nCorrelatio Ratioσ
Source: The Brattle Group, Inc.
σ Ratio - Ratio of standard deviations, country index vs. S&P composite index
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242
Unbiased Forecast
w Given three outcomes and their relatedprobabilities and cash flows we can determinean unbiased forecast of cash flows.
.2.250.8
million $1.0.5.501.0
.3.251.2forecast
Unbiased
flow cash
weightedProbyProbabilit
flow cash
Possible
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243
Asset Betas
Cash flow = revenue - fixed cost - variable cost
PV(asset) = PV(revenue) - PV(fixed cost) - PV(variable cost)
or
PV(revenue) = PV(fixed cost) + PV(variable cost) + PV(asset)
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244
Asset Betas
)PV(revenuePV(asset)
B)PV(revenue
cost) ePV(variablB
)PV(revenuecost) PV(fixed
BB
assetcost variable
cost fixedrevenue
++
+=
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245
Asset Betas
−=
=
PV(asset)cost) PV(fixed
1B
PV(asset)cost) ePV(variabl-)PV(revenue
BB
revenue
revenueasset
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Risk,DCF and CEQ
Example
Project A is expected to produce CF = $100 mil foreach of three years. Given a risk free rate of 6%, amarket premium of 8%, and beta of .75, what is thePV of the project?
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247
Risk,DCF and CEQ
Example
Project A is expected to produce CF = $100 mil for each of three years.Given a risk free rate of 6%, a market premium of 8%, and beta of .75,what is the PV of the project?
%12
)8(75.6
)(
=+=
−+= fmf rrBrr
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248
Risk,DCF and CEQ
Example
Project A is expected to produce CF = $100 mil for each of three years.Given a risk free rate of 6%, a market premium of 8%, and beta of .75,what is the PV of the project?
%12
)8(75.6
)(
=+=
−+= fmf rrBrr
240.2 PVTotal
71.21003
79.71002
89.31001
12% @ PV FlowCashYear
AProject
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249
Risk,DCF and CEQ
Example
Project A is expected to produce CF = $100 mil for each of three years.Given a risk free rate of 6%, a market premium of 8%, and beta of .75,what is the PV of the project?
%12
)8(75.6
)(
=+=
−+= fmf rrBrr
240.2 PVTotal
71.21003
79.71002
89.31001
12% @ PV FlowCashYear
AProject
Now assume that the cashflows change, but areRISK FREE. What is thenew PV?
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250
Risk,DCF and CEQ
Example
Project A is expected to produce CF = $100 mil for each of three years.Given a risk free rate of 6%, a market premium of 8%, and beta of .75,what is the PV of the project?.. Now assume that the cash flows change,but are RISK FREE. What is the new PV?
240.2 PVTotal
71.284.83
79.789.62
89.394.61
6% @ PV FlowCashYear
Project B
240.2 PVTotal
71.21003
79.71002
89.31001
12% @ PV FlowCashYear
AProject
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251
Risk,DCF and CEQ
Example
Project A is expected to produce CF = $100 mil for each of three years.Given a risk free rate of 6%, a market premium of 8%, and beta of .75,what is the PV of the project?.. Now assume that the cash flows change,but are RISK FREE. What is the new PV?
240.2 PVTotal
71.284.83
79.789.62
89.394.61
6% @ PV FlowCashYear
Project B
240.2 PVTotal
71.21003
79.71002
89.31001
12% @ PV FlowCashYear
AProject
Since the 94.6 is risk free, we call it a Certainty Equivalentof the 100.
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252
Risk,DCF and CEQ
Example
Project A is expected to produce CF = $100 mil for each of three years.Given a risk free rate of 6%, a market premium of 8%, and beta of .75,what is the PV of the project?.. Now assume that the cash flows change,but are RISK FREE. What is the new PV?
The difference between the 100 and the certainty equivalent(94.6) is 5.4%…this % can be considered the annualpremium on a risky cash flow
flow cash equivalentcertainty 054.1
flow cashRisky =
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253
Risk,DCF and CEQ
Example
Project A is expected to produce CF = $100 mil for each of three years.Given a risk free rate of 6%, a market premium of 8%, and beta of .75,what is the PV of the project?.. Now assume that the cash flows change,but are RISK FREE. What is the new PV?
8.84054.1
100 3Year
6.89054.1100
2Year
6.94054.1
100 1Year
3
2
==
==
==
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Risk,DCF and CEQ
w The prior example leads to a generic certaintyequivalent formula.
tf
tt
t
r
CEQ
r
CPV
)1()1( +=
+=
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u A Project Is Not a Black Box
Principles of Corporate FinanceBrealey and Myers Sixth Edition
Chapter 10
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256
Topics Covered
w Sensitivity Analysisw Break Even Analysis
wMonte Carlo Simulationw Decision Trees
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How To Handle Uncertainty
Sensitivity Analysis - Analysis of the effects ofchanges in sales, costs, etc. on a project.
Scenario Analysis - Project analysis given aparticular combination of assumptions.
Simulation Analysis - Estimation of theprobabilities of different possible outcomes.
Break Even Analysis - Analysis of the level ofsales (or other variable) at which the companybreaks even.
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258
Sensitivity Analysis
Example
Given the expected cash flowforecasts for Otoban Company’sMotor Scooter project, listed onthe next slide, determine theNPV of the project givenchanges in the cash flowcomponents using a 10% cost ofcapital. Assume that allvariables remain constant, exceptthe one you are changing.
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259
Sensitivity Analysis
315- FlowCashNet
3.0flow cash Operating
1.5after taxProfit
1.550% @ .Taxes
3profitPretax
1.5onDepreciati
3Costs Fixed
30Costs Variable
37.5Sales
15-Investment
10-1 Years0Year
Example - continued
NPV= 3.43 billion Yen
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Sensitivity AnalysisExample - continued
Possible Outcomes
bil 2bil 3bil 4Cost Fixed
275,000300,000360,000CostVar Unit
380,000375,000350,000priceUnit
.16.1.04ShareMarket
mil 1.1mil 51mil .9SizeMarket
OptimisticExpectedcPessimistiVariable
Range
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261
Sensitivity AnalysisExample - continuedNPV Calculations for Pessimistic Market Size Scenario
NPV= +5.7 bil yen3.3815- FlowCashNet
3.38flow cash Operating
1.88after taxProfit
1.8850% @ .Taxes
3.75profitPretax
1.5onDepreciati
3Costs Fixed
33Costs Variable
41.25Sales
15-Investment
10-1 Years0Year
+
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Sensitivity AnalysisExample - continued
NPV Possibilities (Billions Yen)
6.53.40.4Cost Fixed
11.13.415.0-CostVar Unit
5.03.44.2-priceUnit
17.33.410.4-ShareMarket
5.73.41.1SizeMarket
OptimisticExpectedcPessimistiVariable
Range
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263
Break Even Analysis
w Point at which the NPV=0 is the break even point.
w Otoban Motors has a breakeven point of 8,000 unitssold.
Sales, 000’s
PV (Yen)
Billions
400
200
19.6
85 200
Break even
NPV=9
PV Inflows
PV Outflows
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Monte Carlo Simulation
w Step 1: Modeling the Projectw Step 2: Specifying Probabilities
w Step 3: Simulate the Cash Flows
Modeling Process
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Decision Trees
960 (.8)
220(.2)
930(.4)
140(.6)
800(.8)
100(.2)
410(.8)
180(.2)
220(.4)
100(.6)
+150(.6)
+30(.4)
+100(.6)
+50(.4)
-550
NPV= ?
-250
NPV= ?
-150
0
or
Turboprop
Piston
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Decision Trees
960 (.8)
220(.2)
930(.4)
140(.6)
800(.8)
100(.2)
410(.8)
180(.2)
220(.4)
100(.6)
+150(.6)
+30(.4)
+100(.6)
+50(.4)
-550
NPV= ?
-250
NPV= ?
-150
0
or
812
456
660
364
148
Turboprop
Piston
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Decision Trees
960 (.8)
220(.2)
930(.4)
140(.6)
800(.8)
100(.2)
410(.8)
180(.2)
220(.4)
100(.6)
+150(.6)
+30(.4)
+100(.6)
+50(.4)
-550
NPV= ?
-250
NPV= ?
-150
0
or
812
456
660
364
148( ) ( ) 81220.22080.960 =×+×
Turboprop
Piston
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Decision Trees
960 (.8)
220(.2)
930(.4)
140(.6)
800(.8)
100(.2)
410(.8)
180(.2)
220(.4)
100(.6)
-550
NPV= ?
-250
NPV= ?
-150
0
or
812
456
660
364
148
+150(.6)
+30(.4)
+100(.6)
+50(.4)
*450
331
45015010.1
660=−Turboprop
Piston
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269
Decision Trees
960 (.8)
220(.2)
930(.4)
140(.6)
800(.8)
100(.2)
410(.8)
180(.2)
220(.4)
100(.6)
-550
NPV= ?
-250
NPV= ?
-150
0
or
812
456
660
364
148
+150(.6)
+30(.4)
+100(.6)
+50(.4)
NPV=444.55
NPV=888.18
NPV=550.00
NPV=184.55
*450
331
18.88815010.1
812=+
Turboprop
Piston
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270
Decision Trees
960 (.8)
220(.2)
930(.4)
140(.6)
800(.8)
100(.2)
410(.8)
180(.2)
220(.4)
100(.6)
812
456
660
364
148
+150(.6)
710.73
+30(.4)
+100(.6)
403.82
+50(.4)
-150
0
*450
331
or
NPV=444.55
NPV=888.18
NPV=550.00
NPV=184.55
-550
NPV= ?
-250
NPV= ?
( ) ( )40.55.44460.18.888 ×+×=
Turboprop
Piston
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Decision Trees
960 (.8)
220(.2)
930(.4)
140(.6)
800(.8)
100(.2)
410(.8)
180(.2)
220(.4)
100(.6)
812
456
660
364
148
+150(.6)
710.73
+30(.4)
+100(.6)
403.82
+50(.4)
-550
NPV=96.12
-250
NPV=117.00
-150
0
*450
331
or
NPV=444.55
NPV=888.18
NPV=550.00
NPV=184.55
12.9655010.1
73.710=−
Turboprop
Piston
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Decision Trees
960 (.8)
220(.2)
930(.4)
140(.6)
800(.8)
100(.2)
410(.8)
180(.2)
220(.4)
100(.6)
812
456
660
364
148
+150(.6)
710.73
+30(.4)
+100(.6)
403.82
+50(.4)
-550
NPV=96.12
-250
NPV=117.00
-150
0
*450
331
or
NPV=444.55
NPV=888.18
NPV=550.00
NPV=184.55
Turboprop
Piston
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u Where Net Present Values Come From
Principles of Corporate FinanceBrealey and Myers Sixth Edition
Chapter 11
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274
Topics Covered
w Look First To Market Valuesw Forecasting Economic Rents
wMarvin Enterprises
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275
Market Values
wSmart investment decisions makeMORE money than smartfinancing decisions
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Market Values
w Smart investments are worth more thanthey cost: they have positive NPVs
w Firms calculate project NPVs bydiscounting forecast cash flows, but . . .
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Market Values
w Projects may appear to have positive NPVsbecause of forecasting errors.
e.g. some acquisitions result from errors ina DCF analysis.
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Market Values
w Positive NPVs stem from a comparativeadvantage.
w Strategic decision-making identifies thiscomparative advantage; it does notidentify growth areas.
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Market Values
w Don’t make investment decisions on thebasis of errors in your DCF analysis.
w Start with the market price of the asset andask whether it is worth more to you than toothers.
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Market Values
w Don’t assume that other firms will watchpassively.
Ask --How long a lead do I have over my rivals? Whatwill happen to prices when that lead disappears?
In the meantime how will rivals react to mymove? Will they cut prices or imitate myproduct?
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Department Store Rents
NPV = -100 + + . . . + = $ 1 million
[assumes price of property appreciates by 3% a year]
Rental yield = 10 - 3 = 7%
NPV + + . . . + + = $1 million
8 8 + 134
1.10 1.1010
8 - 7 8 - 7.21 8 - 8.87 8 - 9.13
1.10 1.102 1.109 1.1010
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EXAMPLE: KING SOLOMON’S MINE
Investment = $200 million
Life = 10 years
Production = .1 million oz. a year
Production cost = $200 per oz.
Current gold price = $400 per oz.
Discount rate = 10%
Using Market Values
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EXAMPLE: KING SOLOMON’S MINE - continued
If the gold price is forecasted to rise by 5% p.a.:
NPV = -200 + (.1(420 - 200))/1.10 + (.1(441 - 200))/1.102 + ... = - $10 m.
But if gold is fairly priced, you do not need to forecast future gold prices:
NPV = -investment + PV revenues - PV costs
= 200 + 400 - ΣΣ ((.1 x 200)/1.10t) = $77 million
Using Market Values
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Do Projects Have Positive NPVs?
w Rents = profits that more than cover thecost of capital.
w NPV = PV (rents)
w Rents come only when you have a betterproduct, lower costs or some othercompetitive edge.
w Sooner or later competition is likely toeliminate rents.
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Competitive Advantage
Proposal to manufacture specialty chemicals
w Raw materials were commodity chemicalsimported from Europe.
w Finished product was exported to Europe.
w High early profits, but . . .
w . . . what happens when competitorsenter?
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Marvin Enterprises
Capacity Unit cost
Technology Industry Marvin Capital Prodn. Salvagevalue
1. 2011 120 - 17.5 5 2.5
2. 2019 120 24 17.5 5 2.5
* Proposed
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Marvin Enterprises
Prices
Technology Productioncost
Interestoncapital
Interestonsalvage
Investabove
Scrapbelow
1. 2011 5.5 3.5 .5 9 6
2. 2019 3.5 3,5 .5 7 4
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Marvin Enterprises
5 6 7 10 Price
800
400320240
Demand
Demand = 80 (10 - Price)
Price = 10 x quantity/80
Demand for Garbage Blasters
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Marvin Enterprises
NPV new plant = 100 x [-10 + Σ ((6 - 3)/1.2t ) + 10/1.25
= $299 million
Change PV existing plant = 24 x Σ (1/1.2t ) = $72 million
Net benefit = 299 - 72 = $227 million
Value of Garbage Blaster Investment
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Marvin Enterprises
•VALUE OF CURRENT BUSINESS: VALUE
At price of $7 PV = 24 x 3.5/.20 420
•WINDFALL LOSS:
Since price falls to $5 after 5 years,
Loss = - 24 x (2 / .20) x (1 / 1.20)5 - 96
•VALUE OF NEW INVESTMENT:
Rent gained on new investment = 100 x 1 for 5 years = 299
Rent lost on old investment = - 24 x 1 for 5 years = - 72
227 227
TOTAL VALUE: 551
CURRENT MARKET PRICE: 460
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Marvin Enterprises
100 200 280
NPV new plant
Change in PV existing plant
Total NPV ofinvestment
400
600
200
-200
NPV $m.
Addition tocapacitymillions
Alternative Expansion Plans
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u Making Sure Managers Maximize NPV
Principles of Corporate FinanceBrealey and Myers Sixth Edition
Chapter 12
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Topics Covered
w The capital investment processw Decision Makers and Information
w Incentivesw Residual Income and EVAw Accounting Performance Measures
w Economic Profit
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The Principal Agent Problem
Shareholders = Owners
Managers = Employees
Question: Who hasthe power?
Answer: Managers
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Capital Investment Decision
Project Creation“Bottom Up”
Strategic Planning“Top Down”
Capital Investments
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Off Budget Expenditures
ÜInformation TechnologyÜResearch and Development
ÜMarketingÜTraining and Development
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Information Problems
1. Consistent Forecasts2. Reducing Forecast Bias
3. Getting Senior ManagementNeeded Information
4. Eliminating Conflicts ofInterest
The correctinformation
is …
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Growth and Returns
12
11
10
9
8
7
5 10 15 20 25
Rate of return, %
Rate ofgrowth,
%
Economic rate of return
Book rate of return
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Brealey & Myers Second Law
The proportion of proposedThe proportion of proposedprojects having a positive NPVprojects having a positive NPVat the official corporate hurdleat the official corporate hurdle
rate is independent of therate is independent of thehurdle rate.hurdle rate.
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Incentives
w Reduced effortw Perks
w Empire buildingw Entrenching investmentw Avoiding risk
Agency Problems in Capital Budgeting
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Incentive Issues
wMonitoring - Reviewing the actions ofmanagers and providing incentives tomaximize shareholder value.
w Free Rider Problem - When owners rely onthe efforts of others to monitor the company.w Compensation - How to pay managers so as
to reduce the cost and need for monitoringand to maximize shareholder value.
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Residual Income & EVA
w Techniques for overcoming errors inaccounting measurements of performance.
w Emphasizes NPV concepts in performanceevaluation over accounting standards.w Looks more to long term than short term
decisions.
wMore closely tracks shareholder value thanaccounting measurements.
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Residual Income & EVA
Income
Sales 550
COGS 275
Selling, G&A 75
200
taxes @ 35% 70
Net Income $130
Assets
Net W.C. 80
Property, plant andequipment 1170
less depr. 360
Net Invest.. 810
Other assets 110
Total Assets $1,000
Quayle Quayle City City Subduction Subduction Plant ($mil)Plant ($mil)
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Residual Income & EVA
Quayle Quayle City City Subduction Subduction Plant ($mil)Plant ($mil)
13.000,1
130==ROI
Given COC = 10%
%3%10%13 =−=NetROI
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Residual Income & EVA
Residual Income or EVA = Net Dollar returnafter deducting the cost of capital.
[ ]Investment Capital ofCost - EarnedIncome
required income- EarnedIncome
Income Residual
×===EVA
© EVA is copyrighted by Stern-Stewart Consulting Firm and used with permission.
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Residual Income & EVA
Quayle Quayle City City Subduction Subduction Plant ($mil)Plant ($mil)
Given COC = 12%
million
EVA
10$
)000,112(.130
Income Residual
+=×−=
=
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Economic Profit
Economic Profit = capital investedmultiplied by the spread between return oninvestment and the cost of capital.
Invested Capital)(
ProfitEconomic
×−==
rROI
EP
© EVA is copyrighted by Stern-Stewart Consulting Firm and used with permission.
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Economic Profit
$10million
1,000.12)-.13(
Invested Capital)(
=×=×−= rROIEP
© EVA is copyrighted by Stern-Stewart Consulting Firm and used with permission.
Quayle Quayle City City Subduction Subduction Plant ($mil)Plant ($mil)
Example at 12% COC continued.
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Message of EVA
+ Managers are motivated to only invest inprojects that earn more than they cost.
+ EVA makes cost of capital visible tomanagers.
+ Leads to a reduction in assets employed.- EVA does not measure present value.
- Rewards quick paybacks and ignores timevalue of money.
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EVA of US firms - 1997
6.120.11702,30347-yWalt Disne
2.78.9420,13298UAL
5.87.15963,4335Safeway
5.121.20885,423,119 MorrisPhilip
8.111.47680,51,727Microsoft
5.1423.0219,221,688Merck
3.1321.8138,181,327Johnson & Johnson
8.117.867,4312,743-IBM
7.1515.224,18599-Packard-Hewlett
7.95.982,8873,527- MotorsGeneral
7.1217.753,5672,515 ElectricGeneral
1.912.158,2721,719 MotorFord
0.912.223,0246,81ChemicalDow
9.7%36.0%$10,814$2,442ColaCoca Capital
ofCost
Capital
on Return
Invested
CapitalEVA$ in millions)
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Accounting Measurements
0
011 )(
price beginningprice in changereceipts cash
return of Rate
P
PPC −+=
+=
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312
Accounting Measurements
0
011 )(
price beginningprice in changereceipts cash
return of Rate
P
PPC −+=
+=
Economic income = cash flow + change in present value
0
011 )(return of Rate
PVPVPVC −+
=
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Accounting Measurements
ECONOMIC ACCOUNTING
Cash flow + Cash flow +
change in PV = change in book value =
Cash flow - Cash flow -
economic depreciation accounting depreciation
Economic income Accounting income
PV at start of year BV at start of year
INCOME
RETURN
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Nodhead Store Forecastes
YEAR1 2 3 4 5 6
Cash flow 100 200 250 298 298 298PV at start ofyear (r = 10%)
1000 1000 901 741 517 271
PV at end ofyear (r = 10%)
1000 901 741 517 271 0
Change invalue
0 -99 -160 -224 -246 -271
Economicincome
100 101 90 74 52 27
Rate of return%
10 10 10 10 10 10
Economicdepn.
0 99 160 224 246 271
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Nodhead Book Income & ROI
YEAR1 2 3 4 5 6
Cash flow 100 200 250 298 298 298BV at start ofyear, strt linedepn
1000 833 667 500 333 167
BV at end ofyear, strt linedepn
833 667 500 333 167 0
Change in BV -167 -167 -167 -167 -167 -167Book income -67 +33 +83 +131 +131 +131Book ROI % -6.7 4.0 12.4 26.2 39.3 78.4Book depn. 167 167 167 167 167 167
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u Corporate Financing and the Six Lessons of Market Efficiency
Principles of Corporate FinanceBrealey and Myers Sixth Edition
Chapter 13
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Topics Covered
wWe Always Come Back to NPVwWhat is an Efficient Market?
èRandom Walk
w Efficient Market Theoryw The Evidence on Market Efficiencyw Six Lessons of Market Efficiency
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Return to NPV
w NPV employs discount rates.w These discount rates are risk adjusted.
w The risk adjustment is a byproduct of marketestablished prices.w Adjustable discount rates change asset values.
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Return to NPV
Example
The government is lending you $100,000 for 10years at 3% and only requiring interest paymentsprior to maturity. Since 3% is obviously belowmarket, what is the value of the below market rateloan?
repayment loan of PV-
pmtsinterest of PV- borrowedamount NPV =
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Return to NPV
ExampleThe government is lending you $100,000 for 10 years at 3% and onlyrequiring interest payments prior to maturity. Since 3% is obviouslybelow market, what is the value of the below market rate loan?
Assume the market return on equivalent risk projects is 10%.
012,43$
988,56000,100
)10.1(
000,100
)10.1(
000,3000,001NPV 10
10
1
=−=
−
−= ∑
=tt
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Random Walk Theory
w The movement of stock prices from day today DO NOT reflect any pattern.
w Statistically speaking, the movement of stockprices is random (skewed positive over the long term).
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Random Walk Theory
$103.00
$100.00
$106.09
$100.43
$97.50
$100.43
$95.06
Coin Toss Game
Heads
Heads
Heads
Tails
Tails
Tails
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Random Walk Theory
S&P 500 Five Year Trend?or
5 yrs of the Coin Toss Game?
80
130
180
Month
Lev
el
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324
Random Walk Theory
S&P 500 Five Year Trend?or
5 yrs of the Coin Toss Game?
80
130
180
230
Month
Lev
el
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325
Random Walk Theory
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Random Walk Theory
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327
Random Walk Theory
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328
Random Walk Theory
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329
Random Walk Theory
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Efficient Market Theory
wWeak Form EfficiencyèMarket prices reflect all historical information.
w Semi-Strong Form EfficiencyèMarket prices reflect all publicly available
information.
w Strong Form EfficiencyèMarket prices reflect all information, both public
and private.
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Efficient Market Theory
w Fundamental AnalystsèResearch the value of stocks using NPV and other
measurements of cash flow.
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Efficient Market Theory
w Technical AnalystsèForecast stock prices based on the watching the
fluctuations in historical prices (thus “wigglewigglewatcherswatchers”).
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Efficient Market Theory
LastMonth
ThisMonth
NextMonth
$90
70
50
MicrosoftStock Price
Cyclesdisappear
onceidentified
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Efficient Market Theory
-16-11-6-149
141924293439
Days Relative to annoncement date
Cu
mu
lati
ve A
bn
orm
al R
etu
rn
(%)
Announcement Date
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Efficient Market Theory
-40
-30
-20
-10
0
10
20
30
40
1962
1977
1992
Ret
urn
(%)
FundsMarket
Average Annual Return on 1493 Mutual Funds and theMarket Index
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Efficient Market Theory
0
5
10
15
20
First Second Third Fourth Fifth
Ave
rage
Ret
urn
(%)
IPOMatched Stocks
IPO Non-Excess Returns
Year AfterOffering
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Efficient Market Theory
1987 Stock Market Crash
119310.114.
7.16)( crash pre =
−=
−=
gr
DivindexPV
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Efficient Market Theory
1987 Stock Market Crash
119310.114.
7.16)( crash pre =
−=
−=
gr
DivindexPV
928096.114.
7.16)( crashpost =
−=
−=
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indexPV
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Lessons of Market Efficiency
ÜMarkets have no memoryÜTrust market prices
ÜRead the entrailsÜThere are no financial illusionsÜThe do it yourself alternative
ÜSeen one stock, seen them all
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Example: How stock splits affect value
0
5
10
15
20
25
30
35
40
Month relative to split
Cumulative abnormal return %
-29 0 30
Source: Fama, Fisher, Jensen & Roll
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u An Overview of Corporate Financing
Principles of Corporate FinanceBrealey and Myers Sixth Edition
Chapter 14
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Topics Covered
w Patterns of Corporate Financingw Common Stock
w Preferred Stockw Debtw Derivatives
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w Firms may raise funds from external sourcesor plow back profits rather than distributethem to shareholders.
w Should a firm elect external financing, theymay choose between debt or equity sources.
Patterns of Corporate Financing
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Patterns of Corporate FinancingTABLE 14-1 Sources and uses of funds in nonfinancial corporations expressed as percentage of eachyear's total investment.
1988 1989 1990 1991 1992 1993 1994 1995 1996 1997Uses.'1. Capital expenditures 74 87 87 98 73 89 92 77 81 832. Investment in net 26 13 13 2 27 19 20 23 19 17working capital and otherusesa3. Total investment 100 100 100 100 100 100 100 100 100 100Sources:4. Internally generated 81 87 90 112 88 88 86 78 89 85cash b5. Financial deficit 19 13 10 -12 12 12 14 22 11 15(5 - 4); equals requiredexternal financingFinancial deficit coveredby:6. Net stock issues -26 -27 -14 3 6 4 -7 -8 -9 -147. Net increase in debt 45 40 24 -14 7 8 21 30 20 30
a Changes in short-term borrowing are shown under net increase in debt. "Other uses" are net of any increase inmiscellaneous liabilities and any statistical discrepancy.
b Net income plus depreciation less cash dividends paid to stockholders
Source: Board of Governors of the Federal Reserve System, Division of Research and Statistics, Flow of FundsAccounts, various issues.
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Aggregate balance sheet for manufacturing corporationsin the United States, 1997 (figures in Billions).
Current assets 1,320$ Current liabilities 997$ Fixed assets 2,181 Long term debt 815 Less 1,097 Other long term 576 deprecication liabilitiesNet fixed assets 1,085 Total long term liabilities 1,391
Other long term 1,491 Stockholders' equity 1,508
Total assets 3,896 Total liabilities and 3,896 stockholders' equity
Patterns of Corporate Financing
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61.3896
1391997assets Total
Debt=
+=
48.15081391
1391equitysliabilitie termLongsliabilitie termLong
=+
=+
? How do we define debt ?
Patterns of Corporate Financing
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DEBT TO TOTAL CAPITAL
Book Book, Market Market, Adjusted Adjusted
Canada 39% 37% 35% 32%France 48 34 41 28Germany 38 18 23 15Italy 47 39 46 36Japan 53 37 29 17United Kingdom 28 16 19 11United States 37 33 28 23
Patterns of Corporate Financing
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Common Stock
Book Value vs. Market ValueBook value is a backward looking measure. It tellsus how much capital the firm has raised fromshareholders in the past. It does not measure thevalue that shareholders place on those shares today.The market value of the firm is forward looking, itdepends on the future dividends that shareholdersexpect to receive.
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Common Stock
Example - Mobil Book Value vs. Market Value (12/97)
Total Shares outstanding = 783.4 million
19,125Value)(Book equity commonNet
3,158-costat sharesTreasury
821-adjustmentCurrency
20,661earnings Retained
1,549capital in paid Additional
894par) ($1 Shares Common
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Common Stock
Example - Mobil Book Value vs. Market Value (12/97)
Total Shares outstanding = 783.4 million
billion $56.4ValueMarket
783.4x shares of #
$72/sh= price Market 1997 Dec
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Preferred StockPreferred Stock - Stock that takes
priority over common stock inregards to dividends.
Net Worth - Book value of commonshareholder’s equity plus preferredstock.
Floating-Rate Preferred - Preferredstock paying dividends that vary withshort term interest rates.
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Corporate Debt
w Debt has the unique feature of allowing theborrowers to walk away from their obligation to pay,in exchange for the assets of the company.w “Default Risk” is the term used to describe the
likelihood that a firm will walk away from itsobligation, either voluntarily or involuntarily.
w “Bond Ratings”are issued on debt instruments tohelp investors assess the default risk of a firm.
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Corporate Debt
TABLE 14-5 Large firms typically issue many different securities. This table
shows some of the debt securities on Mobil Corporation's balance sheet at the end
of 1996 and 1997 (figures in millions).
Debt Security 1996 19976 1/2% notes 1997 $1486 3/8% notes 1998 200 $2007 1/4% notes 1999 162 1488 3/8% notes 2001 200 1808 5/8% notes 2006 250 2508 5/8% debentures 2021 250 2507 5/8% debentures 2033 240 2168% debentures 2032 250 1648 1/8% Canadian dollar eurobonds 1998 a 1109 % ECU eurobonds 1997 b 148
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Corporate Debt
continued
TABLE 14-5 Large firms typically issue many different securities. This table
shows some of the debt securities on Mobil Corporation's balance sheet at the end
of 1996 and 1997 (figures in millions).
Debt Security 1996 19979 5/8% sterling eurobonds 1999 187 182Variable rate notes 1999 110Japanese yen loans 2003-2005 388 347Variable rate project financing 1998 105 52Industrial revenue bonds 1998-2030 491 484Other foreign currencies due 1997-2030 1090 764Other long-term debt 660 716Capital leases 247 335Commercial paper 1634 1097Bank and other short 894 1168
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Corporate Debt
Prime Rate - Benchmark interest rate charged bybanks.
Funded Debt - Debt with more than 1 year remainingto maturity.
Sinking Fund - Fund established to retire debt beforematurity.
Callable Bond - Bond that may be repurchased byfirm before maturity at specified call price.
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Corporate Debt
Subordinate Debt - Debt that may be repaid inbankruptcy only after senior debt is repaid.
Secured Debt - Debt that has first claim on specifiedcollateral in the event of default.
Investment Grade - Bonds rated Baa or above byMoody’s or BBB or above by S&P.
Junk Bond - Bond with a rating below Baa or BBB.
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Corporate Debt
Eurodollars - Dollars held on deposit in a bankoutside the United States.
Eurobond - Bond that is marketed internationally.Private Placement - Sale of securities to a limited
number of investors without a public offering.
Protective Covenants - Restriction on a firm toprotect bondholders.
Lease - Long-term rental agreement.
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Corporate Debt
Warrant - Right to buy shares from a company at astipulated price before a set date.
Convertible Bond - Bond that the holder mayexchange for a specified amount of another security.
Convertibles are a combined security, consisting ofboth a bond and a call option.
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Derivatives
Traded Options - A derivative that gives the firm theright (but not the obligation) to buy or sell an assetin the future at a price that is agreed upon today.
Futures - A contractual obligation entered into inadvance to buy or sell an asset or commodity.
Forwards - A tailor made contract for the purchase ofan asset. Not traded on exchanges like futures.
Swaps - An agreement between two parties toexchange the interest rate characteristics of twoloans.
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u How Corporations Issue Securities
Principles of Corporate FinanceBrealey and Myers Sixth Edition
Chapter 15
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Topics Covered
w Venture Capitalw The Initial Public Offering
w The Underwritersw General Cash Offersw Rights Issue
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Venture Capital
Venture Capital
Money invested to finance a new firm
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Venture Capital
Since success of a new firm is highly dependent onthe effort of the managers, restrictions are placed onmanagement by the venture capital company andfunds are usually dispersed in stages, after a certainlevel of success is achieved.
Venture Capital
Money invested to finance a new firm
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Venture Capital
2.0Value2.0Value
1.0equity originalYour 1.0assetsOther
1.0capital venturefromequity New 1.0equitynew from Cash
Equityand sLiabilitieAssets
($mil)Sheet BalanceValue Market StageFirst
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Venture Capital
14.0Value14.0Value
5.0equity originalYour 9.0assetsOther
5.0stage1st fromEquity 1.0assets Fixed
4.0stage 2nd fromequity New 4.0equitynew from Cash
Equityand sLiabilitieAssets
($mil)Sheet BalanceValue Market Stage Second
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Initial Offering
Initial Public Offering (IPO) - First offering of stockto the general public.
Underwriter - Firm that buys an issue of securitiesfrom a company and resells it to the public.
Spread - Difference between public offer price andprice paid by underwriter.
Prospectus - Formal summary that providesinformation on an issue of securities.
Underpricing - Issuing securities at an offering priceset below the true value of the security.
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The Underwriters
1,293ers UnderwritAll
33Chase
46Jenrette LufkinDonaldson
58StearnsBear
68ton First BosSuisseCredit
104MorganJP
121 BrothersLehman
137Sachs Goldman
140Stanley Morgan
167 BarneySmith Saloman
$208 LynchMerrill
issues) total of ($bil
1997 in rsUnderwrite U.S. Top
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The Underwriters
496ers UnderwritAll
18Paribas
18 BrothersLehman
22 HoareAMROABN
23Stanley Morgan
24MorganJP
27ton First BosSuisseCredit
29 MorganDeutsche
29Warburg SBC
32Sachs Goldman
$37 LynchMerrill
issues) total of ($bil
1997 in rsUnderwrite Intl. Top
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Initial OfferingAverage Expenses on 1767 IPOs from 1990-1994
Value of Issues
($mil)
Direct
Costs (%)
Avg First Day
Return (%)
Total
Costs (%)
2 - 9.99 16.96 16.36
10 - 19.99 11.63 9.65
20 - 39.99 9.7 12.48
40 - 59.99 8.72 13.65
60 - 79.99 8.2 11.31
80 - 99.99 7.91 8.91
100 - 199.99 7.06 7.16
200 - 499.99 6.53 5.70
500 and up 5.72 7.53
All Issues 11.00 12.05
25 16
18 15
18 18
17 95
16 35
14 14
12 78
1110
10 36
18 69
.
.
.
.
.
.
.
.
.
.
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Tombstone
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General Cash Offers
Seasoned Offering - Sale of securities by a firm that isalready publicly traded.
General Cash Offer - Sale of securities open to allinvestors by an already public company.
Shelf Registration - A procedure that allows firms tofile one registration statement for several issues ofthe same security.
Private Placement - Sale of securities to a limitednumber of investors without a public offering.
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Underwriting SpreadsGross underwriter spreads of selected issues, 1998
Issue amount, Underwriter's
Type Company millions of dollars spread, percent
IPO Hypertension Diagnostics, Inc. 9.3 8.49IPO Actuate Software Corp. 33.0 7.00IPO Enterprise Product Partners 264.0 6.36IPO EquantNY 282.2 5.25IPO Conoco 4403.5 3.99
Seasoned Coulter Pharmaceuticals 60.0 5.48Seasoned Stillwater Mining 61.5 5.00Seasoned Metronet Commuications Corp. 232.6 5.00Seasoned Staples, Inc. 446.6 3.25Seasoned Safeway, Inc. 1125.0 2.75Seasoned Media One Group 1511.3 2.74
Debt:2-year notes General Motors Acceptance Corp. 100 0.1830-year debentures Bausch & Lornb, Inc. 200 0.886-year notes Ararnark Corp. 300 0.6315-year subordinated notes B anque Paribas 400 0.75Convertible zero-coupon Aspect Telecommunications 490 3.00bonds10-year notes Federal Home Loan Mortgage Corp. 1500 0.15
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Rights Issue
Rights Issue - Issue of securities offered only tocurrent stockholders.
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Rights IssueRights Issue - Issue of securities offered only to
current stockholders.
Example - AEP Corp currently has 11 million sharesoutstanding. The market price is $24/sh. AEPdecides to raise additional funds via a 1 for 11rights offer at $22 per share. If we assume 100%subscription, what is the value of each right?
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Rights Issue
⇒ Current Market Value = 2mil x $24 = $264 mil
⇒ Total Shares = 11 mil + 1 mil = 12 mil
⇒ Amount of new funds = 1 mil x $22 = $22 mil
⇒ New Share Price = (264 + 22) / 12 = $23.83/sh
⇒ Value of a Right = 24 - 23.83 = $0.17
Example - AEP Corp currently has 11 million shares outstanding. Themarket price is $24/sh. AEP decides to raise additional funds via a 1 for 11rights offer at $22 per share. If we assume 100% subscription, what is thevalue of each right?
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u The Dividend Controversy
Principles of Corporate FinanceBrealey and Myers Sixth Edition
Chapter 16
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Topics Covered
w How Dividends Are Paidw How Do Companies Decide on Dividend
Payments?w Information in Dividends and Stock
Repurchasesw Dividend Policy is Irrelevant
w The Rightistsw Taxes and the Radical Leftw The Middle of the Roaders
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Types of Dividends
¤Cash Div¤Regular Cash Div
¤Special Cash Div¤Stock Div¤Stock Repurchase (3 methods)
1. Buy shares on the market2. Tender Offer to Shareholders3. Private Negotiation (Green Mail)
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Dividend Payments
Cash Dividend - Payment of cash by the firmto its shareholders.
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Dividend Payments
Cash Dividend - Payment of cash by the firmto its shareholders.
Ex-Dividend Date - Date that determineswhether a stockholder is entitled to a dividendpayment; anyone holding stock before thisdate is entitled to a dividend.
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Dividend Payments
Cash Dividend - Payment of cash by the firmto its shareholders.
Ex-Dividend Date - Date that determineswhether a stockholder is entitled to a dividendpayment; anyone holding stock before thisdate is entitled to a dividend.
Record Date - Person who owns stock on thisdate received the dividend.
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Dividend Payments
Stock Dividend - Distribution of additionalshares to a firm’s stockholders.
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383
Dividend Payments
Stock Dividend - Distribution of additionalshares to a firm’s stockholders.
Stock Splits - Issue of additional shares tofirm’s stockholders.
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384
Dividend Payments
Stock Dividend - Distribution of additionalshares to a firm’s stockholders.
Stock Repurchase - Firm buys back stockfrom its shareholders.
Stock Splits - Issue of additional shares tofirm’s stockholders.
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Stock Repurchases
0
.
.
.
.
.
.
.
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
$ B
illio
ns
U.S. Stock Repurchases 1985-1997
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386
Dividend Payments
Aug 14 Aug 25 Aug26 Sept 1 Sept 15
Declaration With- Ex-dividend Record Paymentdate dividend date date date
date
Share price falls
Maytag’s Quarterly Dividend
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The Dividend Decision
1. Firms have longer term target dividend payoutratios.
2. Managers focus more on dividend changes than onabsolute levels.
3. Dividends changes follow shifts in long-run,sustainable levels of earnings rather than short-runchanges in earnings.
4. Managers are reluctant to make dividend changesthat might have to be reversed.
Lintner’s “Stylized Facts”
(How Dividends are Determined)
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The Dividend Decision
w Attitudes concerning dividend targets vary
w Dividend Change
1
1
EPS ratiotarget
dividendtarget DIV
×==
01
01
DIV-EPS ratiotarget
changetarget DIV-DIV
×==
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The Dividend Decision
w Dividend changes confirm the following:
( )01
01
DIV-EPS ratiotarget rate adjustment
changetarget rate adjustmentDIV-DIV
××=×=
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Dividend Policy
-15
-10
-5
0
5
10
15
Div RiseDiv Cut
Source: Healy & Palepu (1988)
Cha
nge
EP
S/P
rice
at
t =
0 a
s %
Year
Impact of Dividend Changes on EPS
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Dividend Policy is Irrelevant
w Since investors do not need dividends toconvert shares to cash they will not payhigher prices for firms with higher dividendpayouts. In other words, dividend policy willhave no impact on the value of the firm.
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392
Dividend Policy is IrrelevantExample - Assume Rational Demiconductor has no extra cash, but declares a
$1,000 dividend. They also require $1,000 for current investment needs.Using M&M Theory, and given the following balance sheet information,show how the value of the firm is not altered when new shares are issuedto pay for the dividend.
Record Date
Cash 1,000
Asset Value 9,000
Total Value 10,000 +
New Proj NPV 2,000
# of Shares 1,000
price/share $12
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393
Dividend Policy is IrrelevantExample - Assume Rational Demiconductor has no extra cash, but declares a
$1,000 dividend. They also require $1,000 for current investment needs.Using M&M Theory, and given the following balance sheet information,show how the value of the firm is not altered when new shares are issuedto pay for the dividend.
Record Date Pmt Date
Cash 1,000 0
Asset Value 9,000 9,000
Total Value 10,000 + 9,000
New Proj NPV 2,000 2,000
# of Shares 1,000 1,000
price/share $12 $11
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394
Dividend Policy is IrrelevantExample - Assume Rational Demiconductor has no extra cash, but declares a
$1,000 dividend. They also require $1,000 for current investment needs.Using M&M Theory, and given the following balance sheet information,show how the value of the firm is not altered when new shares are issued topay for the dividend.
Record Date Pmt Date Post Pmt
Cash 1,000 0 1,000 (910sh @ $11)
Asset Value 9,000 9,000 9,000
Total Value 10,000 + 9,000 10,000
New Proj NPV 2,000 2,000 2,000
# of Shares 1,000 1,000 1,091
price/share $12 $11 $11
NEW SHARES ARE ISSUED
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Dividend Policy is Irrelevant
Example - continued - Shareholder Value
Record
Stock 12,000
Cash 0
Total Value 12,000
Stock = 1,000 sh @ $12 = 12,000
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396
Dividend Policy is Irrelevant
Example - continued - Shareholder Value
Record Pmt
Stock 12,000 11,000
Cash 0 1,000
Total Value 12,000 12,000
Stock = 1,000sh @ $11 = 11,000
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397
Dividend Policy is Irrelevant
Example - continued - Shareholder Value
Record Pmt Post
Stock 12,000 11,000 12,000
Cash 0 1,000 0
Total Value 12,000 12,000 12,000
Stock = 1,091sh @ $115 = 12,000
w Assume stockholders purchase the new issue with the cashdividend proceeds.
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Dividends Increase Value
Market Imperfections and Clientele Effect
There are natural clients for high-payout stocks,but it does not follow that any particular firm canbenefit by increasing its dividends. The highdividend clientele already have plenty of highdividend stock to choose from.
These clients increase the price of the stockthrough their demand for a dividend paying stock.
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399
Dividends Increase Value
Dividends as Signals
Dividend increases send good news about cashflows and earnings. Dividend cuts send bad news.
Because a high dividend payout policy will becostly to firms that do not have the cash flow tosupport it, dividend increases signal a company’sgood fortune and its manager’s confidence infuture cash flows.
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Dividends Decrease Value
Tax Consequences
Companies can convert dividends into capitalgains by shifting their dividend policies. Ifdividends are taxed more heavily than capitalgains, taxpaying investors should welcome such amove and value the firm more favorably.
In such a tax environment, the total cash flowretained by the firm and/or held by shareholderswill be higher than if dividends are paid.
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Taxes and Dividend Policy
w Since capital gains are taxed at a lower ratethan dividend income, companies should paythe lowest dividend possible.
w Dividend policy should adjust to changes inthe tax code.
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Taxes and Dividend Policy
0.101000.10100(%) return of rateAfter tax
66.9)17.15()83.510(1050.2)50.120(taxes)-gain cap(div
incomeTax After Total17.183.5.202.5012.50.2020% @ Gain Cap onTax
00.510.50050% @ div onTax
4.161005.12100(%) return of ratePretax
5.8312.50gain Capital
96.67100pricestock sToday'
112.50112.50payoffpretax Total
100Dividend
102.50112.50price sNext year'dividend) (high
BFirm
dividend) (no
A Firm
96.679.66
10010
96.6715.83
10012.5
=×=×
=+−−=−++
=×=×=×
=×=×
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Taxes and Dividend Policy
1998 Marginal Income Tax Brackets
Income Bracket
Marginal Tax Rate Single Married (joint return)15% $0 - $25,350 $0 - $42,350
28 25,351 - 61,400 42,351 - 102,30031 61,401 - 128,100 102,301 - 155,95036 128,101 - 278,450 155,951 - 278,450
39.6 over 278,450 over 278,450
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Taxes and Dividend Policy
Rate of Income tax
0% 39.60%Operating Income 100 100Corporate tax (Tc=.35) 35 35After Tax income (paid as div) 65 65Income tax 0 25.7Cash to Shareholder 65 39.3
In U.S., shareholders are taxed twice (figures in dollars)
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Taxes and Dividend Policy
Rate of Income tax
15% 33% 47%Operating Income 100 100 100Corporate tax (Tc=.33) 35 33 33After Tax income 67 67 67
Grossed up Dividend 100 100 100Income tax 15 33 47Tax credit for Corp Pmt -33 -33 -33Tax due from shareholder -18 0 14Cash to Shareholder 85 67 53
Under imputed tax systems, such as that in Australia, shareholdersreceive a tax credit for the corporate tax the firm pays (figures inAustralian dollars)
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u Does Debt Policy Matter?
Principles of Corporate FinanceBrealey and Myers Sixth Edition
Chapter 17
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Topics Covered
w Leverage in a Tax Free Environmentw How Leverage Effects Returns
w The Traditional Position
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M&M (Debt Policy Doesn’t Matter)
wModigliani & MillerèWhen there are no taxes and capital markets
function well, it makes no difference whether thefirm borrows or individual shareholders borrow.Therefore, the market value of a company doesnot depend on its capital structure.
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M&M (Debt Policy Doesn’t Matter)
Assumptions
w By issuing 1 security rather than 2, companydiminishes investor choice. This does not reducevalue if:
è Investors do not need choice, OR
è There are sufficient alternative securitiesw Capital structure does not affect cash flows e.g...
èNo taxes
èNo bankruptcy costs
èNo effect on management incentives
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Example - Macbeth Spot Removers - All Equity Financed
201510% 5(%) shares on Return
2.001.501.00$.50shareper Earnings
2,0001,5001,000$500Income Operating
D C BA
Outcomes
10,000 $Shares of ValueMarket
$10shareper Price
1,000shares ofNumber
Data
M&M (Debt Policy Doesn’t Matter)
Expectedoutcome
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Example
cont.
50% debt
M&M (Debt Policy Doesn’t Matter)
3025150%(%) shares on Return
321$0shareper Earnings
500,11,000500$0earningsEquity
500500500$500Interest
000,21,5001,000$500Income Operating
CBA
Outcomes
5,000 $debt of ueMarket val
5,000 $Shares of ValueMarket
$10shareper Price
500shares ofNumber
Data
D
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Example - Macbeth’s - All Equity Financed
- Debt replicated by investors
3020100%(%) investment$10 on Return
3.002.001.000 $investment on earningsNet
1.001.001.00$1.0010% @Interest :LESS
4.003.002.00$1.00shares twoon Earnings
DCBA
Outcomes
M&M (Debt Policy Doesn’t Matter)
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MM'S PROPOSITION I
If capital markets are doing their job, firms cannot increase value by tinkering with capital structure.
V is independent of the debt ratio.
AN EVERYDAY ANALOGY
It should cost no more to assemble a chicken than to buy one whole.
No Magic in Financial Leverage
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Proposition I and Macbeth
2015(%) shareper return Expected
1010($) shareper Price
2.001.50($) shareper earnings Expected Equityand Debt Equal
:Structure Proposed
EquityAll
:StructureCuttent
Macbeth continued
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Leverage and Returns
securities all of uemarket valincome operating expected
r assets on return Expected a ==
×
++
×
+= EDA r
ED
Er
AD
Dr
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M&M Proposition II
15.000,10
1500securities all of uemarket valincome operating expected
r r AE
==
==
( )DAAE rrVD
rr −+=
Macbeth continued
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M&M Proposition II
15.000,10
1500securities all of uemarket valincome operating expected
r r AE
==
==
( )DAAE rrVD
rr −+=
( )
20%or 20.
10.15.50005000
15.
=
−+=Er
Macbeth continued
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r
DE
rD
rE
M&M Proposition II
rA
Risk free debt Risky debt
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419
Leverage and Risk
200shares on Return
20($) shareper Earnings:debt % 50
155shares on Return
1.50.50($) shareper Earningsequity All$1,500
Income
$500
Operating
Macbeth continued
Leverage increases the risk of Macbeth shares
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Leverage and Returns
×
++
×
+= EDA B
ED
EB
AD
DB
( )DAAE BBVD
BB −+=
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WACC
×+
×== EDA r
V
Er
V
DrWACC
Ü WACC is the traditional view of capital structure, risk and return.
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422
WACC
.10=rD
.20=rE
.15=rA
BEBABD
Risk
ExpectedReturn
Equity
Allassets
Debt
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WACC
Example - A firm has $2 mil of debt and100,000 of outstanding shares at $30 each. Ifthey can borrow at 8% and the stockholdersrequire 15% return what is the firm’s WACC?
D = $2 million
E = 100,000 shares X $30 per share = $3 million
V = D + E = 2 + 3 = $5 million
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WACCExample - A firm has $2 mil of debt and 100,000 of
outstanding shares at $30 each. If they can borrow at 8% andthe stockholders require 15% return what is the firm’sWACC? D = $2 million
E = 100,000 shares X $30 per share = $3 million
V = D + E = 2 + 3 = $5 million
12.2%or 122.
15.53
08.52
=
×+
×=
×+
×= ED r
VE
rVD
WACC
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425
r
DV
rD
rE
rE =WACC
WACC
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r
DV
rD
rE
WACC
WACC (traditional view)
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r
DV
rD
rE
WACC
WACC (M&M view)
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u How Much Should a Firm Borrow?
Principles of Corporate FinanceBrealey and Myers Sixth Edition
Chapter 18
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Topics Covered
w Corporate Taxes and Valuew Corporate and Personal Taxes
w Cost of Financial Distressw Pecking Order of Financial Choices
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Financial Risk - Risk to shareholders resulting fromthe use of debt.
Financial Leverage - Increase in the variability ofshareholder returns that comes from the use of debt.
Interest Tax Shield- Tax savings resulting fromdeductibility of interest payments.
C.S. & Corporate Taxes
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Example - You own all the equity of Space BabiesDiaper Co.. The company has no debt. Thecompany’s annual cash flow is $1,000, beforeinterest and taxes. The corporate tax rate is 40%.You have the option to exchange 1/2 of your equityposition for 10% bonds with a face value of $1,000.
Should you do this and why?
C.S. & Corporate Taxes
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Example - You own all the equity of Space Babies Diaper Co.. The companyhas no debt. The company’s annual cash flow is $1,000, before interestand taxes. The corporate tax rate is 40%. You have the option to exchange1/2 of your equity position for 10% bonds with a face value of $1,000.
Should you do this and why?
All Equity 1/2 Debt
EBIT 1,000
Interest Pmt 0
Pretax Income 1,000
Taxes @ 40% 400
Net Cash Flow $600
C.S. & Corporate Taxes
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All Equity 1/2 Debt
EBIT 1,000 1,000
Interest Pmt 0 100
Pretax Income 1,000 900
Taxes @ 40% 400 360
Net Cash Flow $600 $540
Example - You own all the equity of Space Babies Diaper Co.. The companyhas no debt. The company’s annual cash flow is $1,000, before interestand taxes. The corporate tax rate is 40%. You have the option to exchange1/2 of your equity position for 10% bonds with a face value of $1,000.
Should you do this and why?
C.S. & Corporate Taxes
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C.S. & Corporate Taxes
All Equity 1/2 Debt
EBIT 1,000 1,000
Interest Pmt 0 100
Pretax Income 1,000 900
Taxes @ 40% 400 360
Net Cash Flow $600 $540
Total Cash Flow
All Equity = 600
*1/2 Debt = 640*1/2 Debt = 640
(540 + 100)
Example - You own all the equity of Space Babies Diaper Co.. The companyhas no debt. The company’s annual cash flow is $1,000, before interestand taxes. The corporate tax rate is 40%. You have the option to exchange1/2 of your equity position for 10% bonds with a face value of $1,000.
Should you do this and why?
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Capital Structure
PV of Tax Shield = (assume perpetuity)
D x rD x Tc
rD
= D x Tc
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Capital Structure
PV of Tax Shield = (assume perpetuity)
D x rD x Tc
rD
= D x Tc
Example:
Tax benefit = 1000 x (.10) x (.40) = $40
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Capital Structure
PV of Tax Shield = (assume perpetuity)
D x rD x Tc
rD
= D x Tc
Example:
Tax benefit = 1000 x (.10) x (.40) = $40
PV of 40 perpetuity = 40 / .10 = $400
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Capital Structure
PV of Tax Shield = (assume perpetuity)
D x rD x Tc
rD
= D x Tc
Example:
Tax benefit = 1000 x (.10) x (.40) = $40
PV of 40 perpetuity = 40 / .10 = $400
PV Tax Shield = D x Tc = 1000 x .4 = $400
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Capital StructureFirm Value =
Value of All Equity Firm + PV Tax Shield
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Capital StructureFirm Value =
Value of All Equity Firm + PV Tax Shield
Example
All Equity Value = 600 / .10 = 6,000
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Capital StructureFirm Value =
Value of All Equity Firm + PV Tax Shield
Example
All Equity Value = 600 / .10 = 6,000
PV Tax Shield = 400
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Capital StructureFirm Value =
Value of All Equity Firm + PV Tax Shield
Example
All Equity Value = 600 / .10 = 6,000
PV Tax Shield = 400
Firm Value with 1/2 Debt = $6,400
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C.S. & Taxes (Personal & Corp)
Relative Advantage Formula
( Debt vs Equity )
1-TP
(1-TPE) (1-TC)
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C.S. & Taxes (Personal & Corp)
Relative Advantage Formula
( Debt vs Equity )
1-TP
(1-TPE) (1-TC)
RAF > 1 Debt
RAF < 1 Equity
Advantage
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Example 1All Debt All Equity
Income BTCP 1.00
less TC=.46 0.00
Income BTP 1.00
Taxes TP =.5 TPE=0 0.50
After Tax Income 0.50
C.S. & Taxes (Personal & Corp)
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Example 1All Debt All Equity
Income BTCP 1.00 1.00
less TC=.46 0.00 0.46
Income BTP 1.00 0.54
Taxes TP =.5 TPE=0 0.50 0.00
After Tax Income 0.50 0.54
C.S. & Taxes (Personal & Corp)
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Example 1All Debt All Equity
Income BTCP 1.00 1.00
less TC=.46 0.00 0.46
Income BTP 1.00 0.54
Taxes TP =.5 TPE=0 0.50 0.00
After Tax Income 0.50 0.54
RAF = .926 Advantage Equity
C.S. & Taxes (Personal & Corp)
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Example 2All Debt All Equity
Income BTCP 1.00
less TC=.34 0.00
Income BTP 1.00
Taxes TP =.28 TPE=.21 0.28
After Tax Income 0.72
C.S. & Taxes (Personal & Corp)
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Example 2All Debt All Equity
Income BTCP 1.00 1.00
less TC=.34 0.00 0.34
Income BTP 1.00 0.66
Taxes TP =.28 TPE=.21 0.28 0.139
After Tax Income 0.72 0.521
C.S. & Taxes (Personal & Corp)
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Example 2All Debt All Equity
Income BTCP 1.00 1.00
less TC=.34 0.00 0.34
Income BTP 1.00 0.66
Taxes TP =.28 TPE=.21 0.28 0.139
After Tax Income 0.72 0.521
RAF = 1.381 Advantage Debt
C.S. & Taxes (Personal & Corp)
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wToday’s RAF & Debt vs Equity preference.
wOld Tax Code
1-.28
(1-.28) (1-.34)= 1.52RAF =
C.S. & Taxes (Personal & Corp)
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wToday’s RAF & Debt vs Equity preference.
wNew Tax Code
1-.28
(1-.20) (1-.34)= 1.36RAF =
C.S. & Taxes (Personal & Corp)
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wToday’s RAF & Debt vs Equity preference.
1-.28
(1-.20) (1-.34)= 1.36RAF =
Why are companies not all debt?
C.S. & Taxes (Personal & Corp)
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Capital Structure
Structure of Bond Yield Rates
D
E
Bond
Yield
r
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455 Weighted Average Cost of Capitalwithout taxes (traditional view)
r
DV
rD
rE
Includes Bankruptcy Risk
WACC
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Financial Distress
Costs of Financial Distress - Costs arising frombankruptcy or distorted business decisions beforebankruptcy.
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Financial Distress
Costs of Financial Distress - Costs arising frombankruptcy or distorted business decisions beforebankruptcy.
Market Value = Value if all Equity Financed
+ PV Tax Shield
- PV Costs of Financial Distress
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Financial Distress
Debt
Mar
ket V
alue
of
The
Fir
m
Value ofunlevered
firm
PV of interesttax shields
Costs offinancial distress
Value of levered firm
Optimal amountof debt
Maximum value of firm
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Conflicts of Interest
Circular File Company has $50 of 1-year debt.
Circular File Company (Book Values)Net W.C. 20 50 Bonds outstandingFixed assets 80 50 Common stockTotal assets 100 100 Total liabilities
Circular File Company (Book Values)Net W.C. 20 50 Bonds outstandingFixed assets 80 50 Common stockTotal assets 100 100 Total liabilities
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Conflicts of Interest
Circular File Company has $50 of 1-year debt.
w Why does the equity have any value ?w Shareholders have an option -- they can obtain the
rights to the assets by paying off the $50 debt.
Circular File Company (Market Values)Net W.C. 20 25 Bonds outstandingFixed assets 10 5 Common stockTotal assets 30 30 Total liabilities
Circular File Company (Market Values)Net W.C. 20 25 Bonds outstandingFixed assets 10 5 Common stockTotal assets 30 30 Total liabilities
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Conflicts of Interest
Circular File Company has may invest $10 asfollows.
y)probabilit (90% $0
$10Invest
y)probabilit (10% $120
Next Year PayoffsPossibleNow
Ø Assume the NPV of the project is (-$2). What is the effect on the market values?
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Conflicts of Interest
Circular File Company value (post project)
w Firm value falls by $2, but equity holder gains $3
Circular File Company (Market Values)Net W.C. 10 20 Bonds outstandingFixed assets 18 8 Common stockTotal assets 28 28 Total liabilities
Circular File Company (Market Values)Net W.C. 10 20 Bonds outstandingFixed assets 18 8 Common stockTotal assets 28 28 Total liabilities
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Conflicts of Interest
Circular File Company value (assumes a safe projectwith NPV = $5)
w While firm value rises, the lack of a high potential payoff forshareholders causes a decrease in equity value.
Circular File Company (Market Values)Net W.C. 20 33 Bonds outstandingFixed assets 25 12 Common stockTotal assets 45 45 Total liabilities
Circular File Company (Market Values)Net W.C. 20 33 Bonds outstandingFixed assets 25 12 Common stockTotal assets 45 45 Total liabilities
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Financial Distress Games
ØCash In and Run
ØPlaying for Time
ØBait and Switch
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Financial Choices
Trade-off Theory - Theory that capital structure isbased on a trade-off between tax savings and distresscosts of debt.
Pecking Order Theory - Theory stating that firmsprefer to issue debt rather than equity if internalfinance is insufficient.
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Trade Off Theory & Prices
1. Stock-for-debt Stock price
exchange offers falls
Debt-for-stock Stock price
exchange offers rises
2. Issuing common stock drives down stock prices;repurchase increases stock prices.
3. Issuing straight debt has a small negativeimpact.
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Issues and Stock Prices
w Why do security issues affect stock price? Thedemand for a firm’s securities ought to be flat.
! Any firm is a drop in the bucket.
! Plenty of close substitutes.
! Large debt issues don’t significantly depressthe stock price.
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Pecking Order Theory
Consider the following story:
The announcement of a stock issue drives down the stock pricebecause investors believe managers are more likely to issue whenshares are overpriced.
Therefore firms prefer internal finance since funds can be raised without sending adverse signals.
If external finance is required, firms issue debt first and equity as a last resort.
The most profitable firms borrow less not because they have lowertarget debt ratios but because they don't need external finance.
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Pecking Order Theory
Some Implications:
ÜInternal equity may be better than externalequity.
ÜFinancial slack is valuable.
ÜIf external capital is required, debt is better.(There is less room for difference in opinionsabout what debt is worth).
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u Interactions of Investment and Financing Decisions
Principles of Corporate FinanceBrealey and Myers Sixth Edition
Chapter 19
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Topics Covered
w After Tax WACCw Tricks of the Trade
w Capital Structure and WACCw Adjusted Present Value
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After Tax WACC
w The tax benefit from interest expensedeductibility must be included in the cost offunds.
w This tax benefit reduces the effective cost ofdebt by a factor of the marginal tax rate.
×+
×= ED r
V
Er
V
DWACC
Old Formula
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After Tax WACC
×+
×−= ED r
VE
rVD
TcWACC )1(
Tax Adjusted Formula
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After Tax WACC
Example - Sangria Corporation
The firm has a marginal tax rate of 35%. The cost ofequity is 14.6% and the pretax cost of debt is 8%.Given the book and market value balance sheets,what is the tax adjusted WACC?
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After Tax WACCExample - Sangria Corporation - continued
Balance Sheet (Book Value, millions)Assets 100 50 Debt
50 EquityTotal assets 100 100 Total liabilities
Balance Sheet (Book Value, millions)Assets 100 50 Debt
50 EquityTotal assets 100 100 Total liabilities
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476
After Tax WACCExample - Sangria Corporation - continued
Balance Sheet (Market Value, millions)Assets 125 50 Debt
75 EquityTotal assets 125 125 Total liabilities
Balance Sheet (Market Value, millions)Assets 125 50 Debt
75 EquityTotal assets 125 125 Total liabilities
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477
After Tax WACCExample - Sangria Corporation - continued
Debt ratio = (D/V) = 50/125 = .4 or 40%
Equity ratio = (E/V) = 75/125 = .6 or 60%
×+
×−= ED r
VE
rVD
TcWACC )1(
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478
After Tax WACCExample - Sangria Corporation - continued
×+
×−= ED r
VE
rVD
TcWACC )1(
%84.10
1084.
146.12575
08.12550
)35.1(
==
×+
×−=WACC
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479
After Tax WACCExample - Sangria Corporation - continued
The company would like to invest in a perpetualcrushing machine with cash flows of $2.085million per year pre-tax.
Given an initial investment of $12.5 million,what is the value of the machine?
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480
After Tax WACCExample - Sangria Corporation - continued
The company would like to invest in a perpetual crushing machine withcash flows of $2.085 million per year pre-tax. Given an initial investmentof $12.5 million, what is the value of the machine?
Cash FlowsPretax cash flow 2.085Tax @ 35% 0.73After-tax cash flow $1.355 million
Cash FlowsPretax cash flow 2.085Tax @ 35% 0.73After-tax cash flow $1.355 million
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481
After Tax WACCExample - Sangria Corporation - continued
The company would like to invest in a perpetual crushing machine withcash flows of $2.085 million per year pre-tax. Given an initial investmentof $12.5 million, what is the value of the machine?
01084.355.1
5.12
10
=
+−=
−+=
gr
CCNPV
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482
After Tax WACC
w Preferred stock and other forms of financingmust be included in the formula.
×+
×+
×−= EPD r
V
Er
V
Pr
V
DTcWACC )1(
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483
After Tax WACC
Balance Sheet (Market Value, millions)Assets 125 50 Debt
25 Preferred Equity50 Common Equity
Total assets 125 125 Total liabilities
%04.11
1104.
146.12550
10.12525
08.12550
)35.1(
==
×+
×+
×−=WACC
Example - Sangria Corporation - continued
Calculate WACC given preferred stock is $25 mil of total equity andyields 10%.
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484
Tricks of the Trade
wWhat should be included with debt?
èLong-term debt?
èShort-term debt?
èCash (netted off?)
èReceivables?
èDeferred tax?
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485
Tricks of the Trade
w How are costs of financing determined?è Return on equity can be derived from market data.
è Cost of debt is set by the market given the specificrating of a firm’s debt.
è Preferred stock often has a preset dividend rate.
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486
Historical WACC
0
5
10
15
20
25
30
1965
1968
1971
1974
1977
1980
1983
1986
1989
1992
1995
1998
Cost of EquityWACCTreasury Rate
Perc
ent
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487
WACC vs. Flow to Equity
è If you discount at WACC, cash flows have to be
projected just as you would for a capital
investment project. Do not deduct interest.
Calculate taxes as if the company were 41-equity
financed. The value of interest tax shields is
picked up in the WACC formula.
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488
WACC vs. Flow to Equity
è The company's cash flows will probably not be forecasted
to infinity. Financial managers usually forecast to a
medium-term horizon -- ten years, say -- and add a
terminal value to the cash flows in the horizon year. The
terminal value is the present value at the horizon of post-
horizon flows. Estimating the terminal value requires
careful attention, because it often accounts for the
majority of the value of the company.
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489
WACC vs. Flow to Equity
èDiscounting at WACC values the assets and
operations of the company. If the object is to
value the company's equity, that is, its common
stock, don't forget to subtract the value of the
company's outstanding debt.
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Adjusted Present Value
APV = Base Case NPV + PV Impact
w Base Case = All equity finance firm NPV.
w PV Impact = all costs/benefits directlyresulting from project.
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491
example:Project A has an NPV of $150,000. In orderto finance the project we must issue stock,with a brokerage cost of $200,000.
Adjusted Present Value
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492
example:
Project A has an NPV of $150,000. In order tofinance the project we must issue stock, with abrokerage cost of $200,000.
Project NPV = 150,000
Stock issue cost = -200,000
Adjusted NPV - 50,000
don’t do the project
Adjusted Present Value
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493
example:Project B has a NPV of -$20,000. We canissue debt at 8% to finance the project. Thenew debt has a PV Tax Shield of $60,000.Assume that Project B is your only option.
Adjusted Present Value
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494
example:
Project B has a NPV of -$20,000. We can issuedebt at 8% to finance the project. The new debthas a PV Tax Shield of $60,000. Assume thatProject B is your only option.
Project NPV = - 20,000
Stock issue cost = 60,000
Adjusted NPV 40,000
do the project
Adjusted Present Value
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495
Miles and Ezzell
++−=
DcD r
rTLrrWACC
11
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u Spotting and Valuing Options
Principles of Corporate FinanceBrealey and Myers Sixth Edition
Chapter 20
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497
Topics Covered
w Calls, Puts and Sharesw Financial Alchemy with Options
wWhat Determines Option Valuew Option Valuation
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498
Option Terminology
Call Option
Right to buy an asset at a specified exerciseprice on or before the exercise date.
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499
Option Terminology
Put OptionRight to sell an asset at a specified exercise
price on or before the exercise date.
Call Option
Right to buy an asset at a specified exerciseprice on or before the exercise date.
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Option Obligations
Buyer Seller
Call option Right to buy asset Obligation to sell asset
Put option Right to sell asset Obligation to buy asset
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501
Option Value
w The value of an option at expiration is a function ofthe stock price and the exercise price.
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Option Value
w The value of an option at expiration is a function ofthe stock price and the exercise price.
Example - Option values given a exercise price of $85
00051525ValuePut
25155000Value Call
110100908070$60eStock Pric
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Option Value
Call option value (graphic) given a $85 exercise price.
Share Price
Cal
l opt
ion
valu
e
85 105
$20
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504
Option Value
Put option value (graphic) given a $85 exercise price.
Share Price
Put o
ptio
n va
lue
80 85
$5
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505
Option Value
Call option payoff (to seller) given a $85 exercise price.
Share Price
Cal
l opt
ion
$ pa
yoff
85
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506
Option Value
Put option payoff (to seller) given a $85 exercise price.
Share Price
Put o
ptio
n $
payo
ff
85
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Option Value
Protective Put - Long stock and long put
Share Price
Posi
tion
Val
ue
Long Stock
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Option Value
Protective Put - Long stock and long put
Share Price
Posi
tion
Val
ue
Long Put
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509
Option Value
Protective Put - Long stock and long put
Share Price
Posi
tion
Val
ue Protective Put
Long Put
Long Stock
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510
Option Value
Protective Put - Long stock and long put
Share Price
Posi
tion
Val
ue Protective Put
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Option ValueStraddle - Long call and long put
- Strategy for profiting from high volatility
Share Price
Posi
tion
Val
ue Long call
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Option ValueStraddle - Long call and long put
- Strategy for profiting from high volatility
Share Price
Posi
tion
Val
ue
Long put
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513
Option ValueStraddle - Long call and long put
- Strategy for profiting from high volatility
Share Price
Posi
tion
Val
ue
Straddle
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514
Option ValueStraddle - Long call and long put
- Strategy for profiting from high volatility
Share Price
Posi
tion
Val
ue
Straddle
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Option Value
Upper Limit
Stock Price
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Option Value
Upper Limit
Stock Price
Lower Limit
(Stock price - exercise price) or 0whichever is higher
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517
Option Value
Components of the Option Price1 - Underlying stock price
2 - Striking or Exercise price
3 - Volatility of the stock returns (standard deviation of annualreturns)
4 - Time to option expiration
5 - Time value of money (discount rate)
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Option Value
Black-Black-ScholesScholes Option Pricing Model Option Pricing Model
OC = Ps[N(d1)] - S[N(d2)]e-rt
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519
OC = Ps[N(d1)] - S[N(d2)]e-rt
OC- Call Option Price
Ps - Stock Price
N(d1) - Cumulative normal density function of (d1)
S - Strike or Exercise price
N(d2) - Cumulative normal density function of (d2)
r - discount rate (90 day comm paper rate or risk free rate)
t - time to maturity of option (as % of year)
v - volatility - annualized standard deviation of daily returns
Black-Scholes Option Pricing ModelBlack-Scholes Option Pricing Model
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520
(d1)=ln + ( r + ) t
Ps
S
v2
2
v t
32 34 36 38 40
N(d1)=
Black-Scholes Option Pricing ModelBlack-Scholes Option Pricing Model
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521
(d1)=ln + ( r + ) t
Ps
S
v2
2
v t
Cumulative Normal Density FunctionCumulative Normal Density Function
(d2) = d1 - v t
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522
Call Option
Example
What is the price of a call option given the following?
P = 36 r = 10% v = .40
S = 40 t = 90 days / 365
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523
Call Option
(d1) =ln + ( r + ) t
Ps
S
v2
2
v t
(d1) = - .3070 N(d1) = 1 - .6206 = .3794
Example
What is the price of a call option given the following?
P = 36 r = 10% v = .40
S = 40 t = 90 days / 365
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524
Call Option
(d2) = - .5056
N(d2) = 1 - .6935 = .3065
(d2) = d1 - v t
Example
What is the price of a call option given the following?
P = 36 r = 10% v = .40
S = 40 t = 90 days / 365
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525
Call Option
OC = Ps[N(d1)] - S[N(d2)]e-rt
OC = 36[.3794] - 40[.3065]e - (.10)(.2466)
OC = $ 1.70
Example
What is the price of a call option given the following?
P = 36 r = 10% v = .40
S = 40 t = 90 days / 365
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Put - Call Parity
Put Price = Oc + S - P - Carrying Cost + Div.
Carrying cost = r x S x t
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527
ExampleABC is selling at $41 a share. A sixmonth May 40 Call is selling for $4.00.If a May $ .50 dividend is expected andr=10%, what is the put price?
Put - Call Parity
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528
Example
ABC is selling at $41 a share. A six month May 40Call is selling for $4.00. If a May $ .50 dividend isexpected and r=10%, what is the put price?
Put - Call Parity
Op = Oc + S - P - Carrying Cost + Div.
Op = 4 + 40 - 41 - (.10x 40 x .50) + .50
Op = 3 - 2 + .5
Op = $1.50
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u Real Options
Principles of Corporate FinanceBrealey and Myers Sixth Edition
Chapter 21
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530
Topics Covered
w Real OptionsèFollow Up Investments
èAbandon
èWait
èVary Output or Production
w Binomial Model
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531
Corporate Options
4 types of “Real Options”1 - The opportunity to make follow-up investments.2 - The opportunity to abandon a project3 - The opportunity to “wait” and invest later.4 - The opportunity to vary the firm’s output or production methods.
Value “Real Option” = NPV with option - NPV w/o option
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532
Intrinsic Value
Option to Wait
OptionPrice
Stock Price
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533
Intrinsic Value + Time Premium = Option Value
Time Premium = Vale of being able to wait
Option to Wait
OptionPrice
Stock Price
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534
More time = More value
Option to Wait
OptionPrice
Stock Price
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535
Example - AbandonMrs. Mulla gives you a non-retractableoffer to buy your company for $150 mil atanytime within the next year. Given thefollowing decision tree of possibleoutcomes, what is the value of the offer (i.e.the put option) and what is the most Mrs.Mulla could charge for the option?
Use a discount rate of 10%
Option to Abandon
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536
Example - AbandonMrs. Mulla gives you a non-retractable offer to buy your company for $150 milat anytime within the next year. Given the following decision tree of possibleoutcomes, what is the value of the offer (i.e. the put option) and what is themost Mrs. Mulla could charge for the option?
Option to Abandon
Year 0 Year 1 Year 2
120 (.6)
100 (.6)
90 (.4)
NPV = 145
70 (.6)
50 (.4)
40 (.4)
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537
Option to Abandon
Year 0 Year 1 Year 2
120 (.6)
100 (.6)
90 (.4)
NPV = 162
150 (.4)
Option Value =
162 - 145 =
$17 mil
Example - AbandonMrs. Mulla gives you a non-retractable offer to buy your company for $150 milat anytime within the next year. Given the following decision tree of possibleoutcomes, what is the value of the offer (i.e. the put option) and what is themost Mrs. Mulla could charge for the option?
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538
Reality
w Decision trees for valuing “real options” in acorporate setting can not be practically doneby hand.w We must introduce binomial theory & B-S
models
Corporate Options
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539
Probability Up = p = (a - d) Prob Down = 1 - p
(u - d)
a = er∆∆ t d =e-σ σ [∆ ∆ t].5 u =eσσ [∆ ∆ t].5
∆∆t = time intervals as % of year
Binomial Pricing
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540
Example
Price = 36 σ = .40 t = 90/365 ∆ t = 30/365
Strike = 40 r = 10%
a = 1.0083
u = 1.1215
d = .8917
Pu = .5075
Pd = .4925
Binomial Pricing
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541
40.37
32.10
36
37.401215.13610
=×=× UPUP
Binomial Pricing
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542
40.37
32.10
36
37.401215.13610
=×=× UPUP
10.328917.3610
=×=× DPDP
Binomial Pricing
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543
50.78 = price
40.37
32.10
25.52
45.28
36
28.62
40.37
32.10
36
1+=× tt PUP
Binomial Pricing
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544
50.78 = price
10.78 = intrinsic value
40.37
.37
32.10
0
25.52
0
45.28
36
28.62
36
40.37
32.10
Binomial Pricing
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545
50.78 = price
10.78 = intrinsic value
40.37
.37
32.10
0
25.52
0
45.28
5.60
36
28.62
40.37
32.1036
( ) ( )[ ] ( )trdduu ePUPO ∆−××+×
The greater of
Binomial Pricing
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546
50.78 = price
10.78 = intrinsic value
40.37
.37
32.10
0
25.52
0
45.28
5.60
36
.19
28.62
0
40.37
2.91
32.10
.10
36
1.51
( ) ( )[ ] ( )trdduu ePUPO ∆−××+×
Binomial Pricing
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547
50.78 = price
10.78 = intrinsic value
40.37
.37
32.10
0
25.52
0
45.28
5.60
36
.19
28.62
0
40.37
2.91
32.10
.10
36
1.51
( ) ( )[ ] ( )trdduu ePUPO ∆−××+×
Binomial Pricing
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548
Expanding the binomial model to allow morepossible price changes
1 step 2 steps 4 steps
(2 outcomes) (3 outcomes) (5 outcomes)
etc. etc.
Binomial vs. Black Scholes
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549
How estimated call price changes as numberof binomial steps increases
No. of steps Estimated value
1 48.1
2 41.0
3 42.1
5 41.8
10 41.4
50 40.3
100 40.6
Black-Scholes 40.5
Binomial vs. Black Scholes
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u Warrants and Convertibles
Principles of Corporate FinanceBrealey and Myers Sixth Edition
Chapter 22
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551
Topics Covered
wWhat is a Warrant?wWhat is a Convertible Bond?
w The Difference Between Warrants andConvertibleswWhy do Companies Issue Warrants and
Convertibles?
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552
Warrant Value
Example: BJ Services warrants, January 1999
Exercise price $ 15 Warrant price $ 9 Share price $ 16
BJ Services share price
15
Warrant price at maturity
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553
Warrant Value vs. Stock Price
Value ofwarrant
Exercise price = $15
Actual warrant valueprior to expiration
Theoretical value(warrant lowerlimit)
Stockprice
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United Glue Warrants
Ü # shares outstanding = 1 mil
Ü Current stock price = $12
Ü Number of shares issued per share outstanding = .10
Ü Total number of warrants issued = 100,000
Ü Exercise price of warrants = $10
Ü Time to expiration of warrants = 4 years
Ü Annualized standard deviation of stock daily returns = .40
Ü Rate of return = 10 percent
w United glue has just issued $2 million package ofdebt and warrants. Using the following data,calculate the warrant value.
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555
United Glue Warrants
w United glue has just issued $2 million package of debt andwarrants. Using the following data, calculate the warrantvalue.
warranteach ofCost 100,000500,000
$5
1,500,000-2,000,000500,000
warrants w/oloans of value- financing total warrantsofCost
=
==
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556
United Glue Warrants
w United glue has just issued $2 million package of debt andwarrants. Using the following data, calculate the warrantvalue.
(d1) = 1.104
N(d1) = .865
(d2) = .304
N(d2) = .620
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557
United Glue Warrants
w United glue has just issued $2 million package of debt andwarrants. Using the following data, calculate the warrantvalue.
Warrant = 12[.865] - [.620]{10/1.14]
= $6.15
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558
United Glue Warrants
w United glue has just issued $2 million package of debt andwarrants. Using the following data, calculate the warrantvalue.
w Value of warrant with dilution
loans of value-assets total
s United'of Value
firm ealternativ
of ueequity valCurrent == V
millionV 5.12$5.518 =−=
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559
United Glue Warrants
w United glue has just issued $2 million package of debt andwarrants. Using the following data, calculate the warrantvalue.
w Value of warrant with dilution
$12.50 1
million 12.5firm ealternativ
of price shareCurrent ===
millionNV
64.6$ valuegivesformula ScholesBlack =
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560
United Glue Warrants
w United glue has just issued $2 million package of debt andwarrants. Using the following data, calculate the warrantvalue.
w Value of warrant with dilution
03.6$64.610.11
firm ealternativ on call of value1
1
=×
×+ q
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561
What is a Convertible Bond?
w ALZAè 5% Convertible 2006
è Convertible into 26.2 shares
è Conversion ratio 26.2
è Conversion price = 1000/26.2 = $38.17
è Market price of shares = $28
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562
What is a Convertible Bond?
w ALZAè 5% Convertible 2006
è Convertible into 26.2 shares
è Conversion ratio 26.2
è Conversion price = 1000/26.2 = $38.17
è Market price of shares = $28
w Lower bound of valueè Bond value
è Conversion value = 26.2 x 28 = 733.60
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563
What is a Convertible Bond?w How bond value varies with firm value at maturity.
0
1
2
3
0 1 2 3 4 5
Value of firm ($ million)
default
bond repaid in full
Bond value ($ thousands)
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564
What is a Convertible Bond?w How conversion value at maturity varies with firm value.
0
1
2
3
0 0.5 1 1.5 2 2.5 3 3.5 4
Value of firm ($ million)
Conversion value ($ thousands)
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565
What is a Convertible Bond?w How value of convertible at maturity varies with firm value.
0
1
2
3
0 1 2 3 4
Value of firm ($ million)
default
bond repaid in full
convert
Value of convertible ($ thousands)
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u Valuing Debt
Principles of Corporate FinanceBrealey and Myers Sixth Edition
Chapter 23
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567
Topics Covered
w The Classical Theory of Interestw The Term Structure and YTM
w Duration and Volatilityw Explaining the Term Structurew Allowing for the Risk of Default
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568
Debt & Interest Rates
Classical Theory of Interest Rates (Economics)wdeveloped by Irving Fisher
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569
Debt & Interest Rates
Classical Theory of Interest Rates (Economics)wdeveloped by Irving Fisher
Nominal Interest Rate = The rate you actuallypay when you borrow money.
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570
Debt & Interest Rates
Classical Theory of Interest Rates (Economics)
w developed by Irving Fisher
Nominal Interest Rate = The rate you actually pay when youborrow money.
Real Interest Rate = The theoretical rate you pay when youborrow money, as determined by supply and demand.
Supply
Demand
$ Qty
r
Real r
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571
Debt & Interest Rates
Nominal r = Real r + expected inflation
Real r is theoretically somewhat stable
Inflation is a large variable
Q: Why do we care?
A: This theory allows us to understand the Term Structure ofInterest Rates.
Q: So What?
A: The Term Structure tells us the cost of debt.
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572
Term Structure
Spot Rate - The actual interest rate today (t=0)
Forward Rate - The interest rate, fixed today, on a loan madein the future at a fixed time.
Future Rate - The spot rate that is expected in the future.
Yield To Maturity (YTM) - The IRR on an interest bearinginstrument.
YTM (r)
Year
1981
1987 & present
1976
1 5 10 20 30
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573
Debt & Risk
Example (Bond 1)
Calculate the duration of our 10.5% bond @ 8.5% YTM
Year CF PV@YTM % of Total PV % x Year
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574
Debt & Risk
Example (Bond 1)
Calculate the duration of our 10.5% bond @ 8.5% YTM
Year CF PV@YTM % of Total PV % x Year
1 105
2 105
3 105
4 105
5 1105
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575
Debt & Risk
Example (Bond 1)
Calculate the duration of our 10.5% bond @ 8.5% YTM
Year CF PV@YTM % of Total PV % x Year
1 105 96.77
2 105 89.19
3 105 82.21
4 105 75.77
5 1105 734.88
1078.82
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576
Debt & Risk
Year CF PV@YTM % of Total PV % x Year
1 105 96.77 .090
2 105 89.19 .083
3 105 82.21 .076
4 105 75.77 .070
5 1105 734.88 .681
1078.82 1.00
Example (Bond 1)
Calculate the duration of our 10.5% bond @ 8.5% YTM
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577
Debt & Risk
Year CF PV@YTM % of Total PV % x Year
1 105 96.77 .090 0.090
2 105 89.19 .083 0.164
3 105 82.21 .076 0.227
4 105 75.77 .070 0.279
5 1105 734.88 .681 3.406
1078.82 1.00 4.166 Duration
Example (Bond 1)
Calculate the duration of our 10.5% bond @ 8.5% YTM
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578
Debt & RiskExample (Bond 2)
Given a 5 year, 9.0%, $1000 bond, with a 8.5% YTM, what isthis bond’s duration?
Year CF PV@YTM % of Total PV % x Year
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579
Debt & Risk
Year CF PV@YTM % of Total PV % x Year
1 90
2 90
3 90
4 90
5 1090
Example (Bond 2)
Given a 5 year, 9.0%, $1000 bond, with a 8.5% YTM, what isthis bond’s duration?
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580
Debt & Risk
Year CF PV@YTM % of Total PV % x Year
1 90 82.95
2 90 76.45
3 90 70.46
4 90 64.94
5 1090 724.90
1019.70
Example (Bond 2)
Given a 5 year, 9.0%, $1000 bond, with a 8.5% YTM, what isthis bond’s duration?
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581
Debt & Risk
Year CF PV@YTM % of Total PV % x Year
1 90 82.95 .081
2 90 76.45 .075
3 90 70.46 .069
4 90 64.94 .064
5 1090 724.90 .711
1019.70 1.00
Example (Bond 2)
Given a 5 year, 9.0%, $1000 bond, with a 8.5% YTM, what isthis bond’s duration?
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582
Debt & Risk
Year CF PV@YTM % of Total PV % x Year
1 90 82.95 .081 0.081
2 90 76.45 .075 0.150
3 90 70.46 .069 0.207
4 90 64.94 .064 0.256
5 1090 724.90 .711 3.555
1019.70 1.00 4.249 Duration
Example (Bond 2)
Given a 5 year, 9.0%, $1000 bond, with a 8.5% YTM, what isthis bond’s duration?
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583
Term Structure
What Determines the Shape of the TS?
1 - Unbiased Expectations Theory
2 - Liquidity Premium Theory
3 - Market Segmentation Hypothesis
Term Structure & Capital Budgeting
w CF should be discounted using Term Structure info.
w Since the spot rate incorporates all forward rates, then youshould use the spot rate that equals the term of your project.
w If you believe inother theories take advantage of the arbitrage.
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584
Yield To Maturity
wAll interest bearing instruments are priced tofit the term structure.
wThis is accomplished by modifying the assetprice.wThe modified price creates a New Yield,
which fits the Term Structure.
wThe new yield is called the Yield To Maturity(YTM).
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585
Yield to Maturity
ExamplewA $1000 treasury bond expires in 5 years. It
pays a coupon rate of 10.5%. If the marketprice of this bond is 107-88, what is theYTM?
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586
Yield to Maturity
Example
w A $1000 treasury bond expires in 5 years. It pays acoupon rate of 10.5%. If the market price of thisbond is 107-88, what is the YTM?
C0 C1 C2 C3 C4 C5
-1078.80 105 105 105 105 1105
Calculate IRR = 8.5%
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587
Default, Premiums & Ratings
The risk of default changes the price of a bond andthe YTM.
Book Example
We have a 9% 1 year bond. The built in price is$1000. But, there is a 20% chance the company willgo into bankruptcy and not be able to pay. What isthe bond’s value?
A:
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588
Default, Premiums & RatingsBook Example
We have a 9% 1 year bond. The built in price is $1000. But,there is a 20% chance the company will go into bankruptcyand not be able to pay. What is the bond’s value?
A: Bond Value Prob
1090 .80 = 872.00
0 .20 = 0 .
872.00=expected CFValue
YTM
= =
= =
872
1091090800
36 3%
.$800
.
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589
Default, Premiums & Ratings
Conversely - If on top of default risk, investorsrequire an additional 2 percent market risk premium,the price and YTM is as follows:
Value
YTM
= =
= =
872111
59
1090785 59
38 8%
.$785.
..
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u The Many Different Kinds of Debt
Principles of Corporate FinanceBrealey and Myers Sixth Edition
Chapter 24
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591
Topics Covered
w Domestic Bonds and International Bondsw The Bond Contract
w Security and Seniority Asset-BackedSecuritiesw Repayment Provisions
w Restrictive Covenantsw Private Placements and Project Financew Innovation in the Bond Market
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592
Bond Terminology
w Foreign bonds - Bonds that are sold to local investors inanother country's bond market.
w Yankee bond- a bond sold publicly by a foreign company inthe United States.
w Sumari - a bond sold by a foreign firm in Japan.
w Eurobond market - wind European and Americanmultinationals were forced to tap into international marketsfor capital.
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593
Bond Terminology
w Indenture or trust deed - the bond agreementbetween the borrower and a trust company.
w Registered bond - a bond in which the Company'srecords show ownership and interest and principleare paid directly to each owner.
w Bearer bonds - the bond holder must send incoupons to claim interest and must send a certificateto claim the final payment of principle.
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594
Bond Terminology
w Accrued interest - the amount of accumulated interest sincethe last coupon payment
w Debentures - long-term unsecured issues on debt
w Mortgage bonds - long-term secured debt often containing aclaim against a specific building or property
w Asset-backed securities - the sale of cash flows deriveddirectly from a specific set of bundled assets
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595
Bond Terminology
w Sinking fund - a fund established to retired debtbefore maturity.
w Callable bond - a bond that may be repurchased by athe firm before maturity at a specified call price.
w Defeasance - a method of retiring corporate debtinvolving the creation of a trust funded with treasurybonds.
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596
Straight Bond vs. Callable Bond
Value ofstraight bond
25 50 75 100 125 150
25
50
75
100
bondValue of
Straight bond
bond callableat 100
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597
Bond Terminology
w Restrictive covenants - Limitations set by bondholderson the actions of the Corporation.
w Negative Pledge Clause - the processing of givingunsecured debentures equal protection and when assetsare mortgaged.
w Poison Put - a clause that obliges the borrower to repaythe bond if a large quantity of stock is bought by singleinvestor, which causes the firms bonds to beat downrated.
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598
Bond Terminology
w Pay in kind (PIK) - a bond that makes regular interestpayments, but in the early years of the bonds life the issuercan choose to pay interest in the form of either cash or morebonds with an equivalent face value.
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599
Covenants
w Debt ratios:èSenior debt limits senior borrowing
èJunior debt limits senior & junior borrowingw Security:
èNegative pledgew Dividendsw Event riskw Positive covenants:
èWorking capitalèNet worth
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600
Event Risk: An Example
October 1993 Marriott spun off its hotel management businessworth 80% of its value.
Before the spin-off, Marriott’s long-term book debt ratio was2891/3644 = 79%. Almost all the debt remained with the parent(renamed Host Marriott), whose debt ratio therefore rose to 93%.
Marriott’s stock price rose 13.8% and its bond prices declined byup to 30%.
Bondholders sued and Marriott modified its spinoff plan.
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601
Project Finance
1. Project is set up as a separate company.
2. A major proportion of equity is held byproject manager or contractor, so provision offinance and management are linked.
3. The company is highly levered.
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602
Parties In Project Finance
Contractor Supplier(s)
Equity investors
Government Projectcompany
Equity sponsor
Lenders
Purchaser(s)
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603
Risk AllocationRisk Shifted to: Contract
Completion/continuingmanagement
Sponsor Management contract/completion gtees / workingcapital maintenance
Construction cost Contractor Turnkey contract/ fixed price/delay penalties
Raw materials Supplier(s) Long-term contract/ indexedprices/ supply or pay
Revenues Purchaser(s) Long-term contract/ indexed tocosts/ take or pay/ throughputagreements/ tolling contract
Concession/regulation Government Concession agreement/provision of supportinginfrastructure
Currencyconvertibility
Government Gtees or comfort letters/ hardcurrency paid to offshoreescrow account
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u Leasing
Principles of Corporate FinanceBrealey and Myers Sixth Edition
Chapter 25
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605
Topics Covered
wWhat is a Lease?wWhy Lease?
w Operating Leasesw Valuing Financial LeaseswWhen Do Financial Leases Pay?
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606
Lease Terms
w Operating Leasesw Financial Leases
èRental LeaseèNet lease
èDirect lease
èLeveraged lease
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607
Why Lease?
w Sensible Reasons for LeasingèShort-term leases are convenient
èCancellation options are valuable
èMaintenance is provided
èStandardization leads to low costs
èTax shields can be usedèAvoiding the alternative minimum tax
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608
Why Lease?
w Dubious Reasons for LeasingèLeasing avoids capital expenditure controls
èLeasing preserves capital
èLeases may be off balance sheet financing
èLeasing effects book income
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609
Operating Lease
Example
Acme Limo has a client who will sign a lease for 7years, with lease payments due at the start of eachyear. The following table shows the NPV of thelimo if Acme purchases the new limo for $75,000and leases it our for 7 years.
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610
Operating LeaseExample - cont
Acme Limo has a client who will sign a lease for 7 years, with lease payments dueat the start of each year. The following table shows the NPV of the limo if Acmepurchases the new limo for $75,000 and leases it our for 7 years.
Year0 1 2 3 4 5 6
Initial cost -75Maintenance, insurance, selling, -12 -12 -12 -12 -12 -12 -12
and administrative costsTax shield on costs 4.2 4.2 4.2 4.2 4.2 4.2 4.2Depreciation tax shield 0 5.25 8.4 5.04 3.02 3.02 1.51Total -82.8 -2.55 0.6 -2.76 -4.78 -4.78 -6.29
NPV @ 7% = - $98.15
Break even rent(level) 26.18 26.18 26.18 26.18 26.18 26.18 26.18Tax -9.16 -9.16 -9.16 -9.16 -9.16 -9.16 -9.16Break even rent after-tax 17.02 17.02 17.02 17.02 17.02 17.02 17.02
NPV @ 7% = - $98.15
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611
Financial LeasesExample
Greymore Bus Lines is considering a lease. Youroperating manager wants to buy a new bus for$100,000. The bus has an 8 year life. The bussaleswoman says she will lease Greymore the busfor 8 years at $16,900 per year, but Greymoreassumes all operating and maintenance costs.
Should Greymore buy or lease the bus?
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612
Financial LeasesExample - cont
Greymore Bus Lines is considering a lease. Your operating managerwants to buy a new bus for $100,000. The bus has an 8 year life. The bussaleswoman says she will lease Greymore the bus for 8 years at $16,900per year, but Greymore assumes all operating and maintenance costs.
Should Greymore buy or lease the bus?
Year0 1 2 3 4 5 6 7
Cost of new bus 100.00 Lost Depr tax shield (7.00) (11.20) (6.72) (4.03) (4.03) (2.02) - Lease payment (16.90) (16.90) (16.90) (16.90) (16.90) (16.90) (16.90) (16.90) Tax shield of lease 5.92 5.92 5.92 5.92 5.92 5.92 5.92 5.92 Cash flow of lease 89.02 (17.98) (22.18) (17.70) (15.01) (15.01) (13.00) (10.98)
Cash flow consequences of the lease contract to Greymore
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613
Financial LeasesExample - cont
Greymore Bus Lines is considering a lease. Your operating managerwants to buy a new bus for $100,000. The bus has an 8 year life. The bussaleswoman says she will lease Greymore the bus for 8 years at $16,900per year, but Greymore assumes all operating and maintenance costs.
Should Greymore buy or lease the bus?
Cash flow consequences of the lease contract to Greymore:
•Greymore saves the $100,000 cost of the bus.
•Loss of depreciation benefit of owning the bus.
•$16,900 lease payment is due at the start of each year.
•Lease payments are tax deductible.
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614
Financial LeasesExample - cont
Greymore Bus Lines Balance Sheet without lease
Equivalent lease balance sheet
Greymore Bus Lines (figures in $1,000s)Bus 10 100 Loan secured by busAll other assets 1000 450 Other loans
550 EquityToital Assets 1100 1100 Total liabilities
Greymore Bus Lines (figures in $1,000s)Bus 10 100 Financial leaseAll other assets 1000 450 Other loans
550 EquityToital Assets 1100 1100 Total liabilities
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615
Financial Leases
Example - cont
Greymore Bus Lines can borrow at 10%, thus thevalue of the lease should be discounted at 6.5% or.10 x (1-.35). The result will tell us if Greymoreshould lease or buy the bus.
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616
Financial LeasesExample - cont
Greymore Bus Lines can borrow at 10%, thus the value of the leaseshould be discounted at 6.5% or .10 x (1-.35). The result will tell us ifGreymore should lease or buy the bus.
( ) ( ) ( )
( ) ( ) ( )$700-or 70.
1.065
10.98-
1.065
13.00-
1.065
15.02-
1.065
15.02-
1.065
17.71-
1.065
22.19-
1.06517.99
-89.02lease NPV
765
432
−=
=
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617
Financial Leases
Example - cont
Greymore Bus Lines lease cash flows can also bethought of as loan equivalent cash flows.
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618
Financial LeasesExample - cont
Greymore Bus Lines lease cash flows can also be thought of as loanequivalent cash flows.
Year0 1 2 3 4 5 6 7
Amount borrowed at year end 89.72 77.56 60.42 46.64 34.66 21.89 10.31 0.00Interest paid @ 10% -8.97 -7.76 -6.04 -4.66 -3.47 -2.19 -1.03Tax shield @ 35% 3.14 2.71 2.11 1.63 1.21 0.77 0.36Interest paid after tax -5.83 -5.04 -3.93 -3.03 -2.25 -1.42 -0.67Principal repaid -12.15 -17.14 -13.78 -11.99 -12.76 -11.58 -10.31Net cash flow of equivalent loan 89.72 -17.99 -22.19 -17.71 -15.02 -15.02 -13.00 -10.98
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619
Financial Leases
Example - cont
The Greymore Bus Lines lease cash flows can alsobe treated as a favorable financing alternative andvalued using APV.
$3,0008,000-5,000APV
lease of NPVproject of NPVAPV
=+==
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u Managing Risk
Principles of Corporate FinanceBrealey and Myers Sixth Edition
Chapter 26
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621
Topics Covered
w Insurancew Hedging With Futures
w Speculating and Marginw SWAPS
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622
Insurance
wMost businesses face the possibility of ahazard that can bankrupt the company in aninstant.
w These risks are neither financial or businessand can not be diversified.w The cost and risk of a loss due to a hazard,
however, can be shared by others who sharethe same risk.
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623
Insurance
ExampleAn offshore oil platform is valued at$1 billion. Expert meteorologistreports indicate that a 1 in 10,000chance exists that the platform maybe destroyed by a storm over thecourse of the next year.
How can the cost of this hazard beshared?
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624
Insurance
Example - cont.An offshore oil platform is valued at $1 billion. Expert meteorologistreports indicate that a 1 in 10,000 chance exists that the platform maybe destroyed by a storm over the course of the next year.
How can the cost of this hazard be shared?
Answer:
A large number of companies with similar risks can eachcontribute pay into a fund that is set aside to pay the costshould a member of this risk sharing group experience the1 in 10,000 loss. The other 9,999 firms may notexperience a loss, but also avoided the risk of not beingcompensated should a loss have occurred.
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625
Insurance
Example - cont.An offshore oil platform is valued at $1 billion. Expert meteorologistreports indicate that a 1 in 10,000 chance exists that the platform maybe destroyed by a storm over the course of the next year.
What would the cost to each group member be forthis protection?
Answer:
000,100$000,10
000,000,000,1=
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626
Insurance
wWhy would an insurance company not offer apolicy on this oil platform for $100,000?
èAdministrative costs
èAdverse selectionèMoral hazard
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627
Insurance
w The loss of an oil platform by a storm may be 1 in10,000. The risk, however, is larger for an insurancecompany since all the platforms in the same areamay be insured, thus if a storm damages one in maydamage all in the same area. The result is a muchlarger risk to the insurer.
w Catastrophe Bonds - (CAT Bonds) Allow insurersto transfer their risk to bond holders by selling bondswhose cash flow payments depend on the level ofinsurable losses NOT occurring.
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628
Hedging
Business has risk
Business Risk - variable costs
Financial Risk - Interest rate changes
Goal - Eliminate risk
HOW?Hedging & Futures Contracts
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629
Hedging
Ex - Kellogg produces cereal. A major component and costfactor is sugar.
w Forecasted income & sales volume is set by using a fixedselling price.
w Changes in cost can impact these forecasts.
w To fix your sugar costs, you would ideally like to purchase allyour sugar today, since you like today’s price, and made yourforecasts based on it. But, you can not.
w You can, however, sign a contract to purchase sugar atvarious points in the future for a price negotiated today.
w This contract is called a “Futures Contract.”
w This technique of managing your sugar costs is called“Hedging.”
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630
Hedging
1- Spot Contract - A contract for immediate sale & delivery ofan asset.
2- Forward Contract - A contract between two people for thedelivery of an asset at a negotiated price on a set date in thefuture.
3- Futures Contract - A contract similar to a forward contract,except there is an intermediary that creates a standardizedcontract. Thus, the two parties do not have to negotiate theterms of the contract.
The intermediary is the Commodity Clearing Corp (CCC). TheCCC guarantees all trades & “provides” a secondary marketfor the speculation of Futures.
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631
Types of Futures
Commodity Futures
-Sugar -Corn -OJ
-Wheat-Soy beans -Pork bellies
Financial Futures
-Tbills -Yen -GNMA
-Stocks -Eurodollars
Index Futures
-S&P 500 -Value Line Index
-Vanguard Index
SUGAR
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632
Futures Contract Concepts
Not an actual sale
Always a winner & a loser (unlike stocks)
K are “settled” every day. (Marked to Market)
Hedge - K used to eliminate risk by locking in prices
Speculation - K used to gamble
Margin - not a sale - post partial amount
Hog K = 30,000 lbs
Tbill K = $1.0 mil
Value line Index K = $index x 500
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633
Ex - Settlement & SpeculateExample - You are speculating in Hog Futures. You think that the
Spot Price of hogs will rise in the future. Thus, you go Long on10 Hog Futures. If the price drops .17 cents per pound ($.0017)what is total change in your position?
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634
Ex - Settlement & SpeculateExample - You are speculating in Hog Futures. You think that the
Spot Price of hogs will rise in the future. Thus, you go Long on10 Hog Futures. If the price drops .17 cents per pound ($.0017)what is total change in your position?
30,000 lbs x $.0017 loss x 10 Ks = $510.00 loss
Since you must settle your account every day, you must giveyour broker $510.00
50.63
50.80-$510
centsper lbs
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635
Commodity HedgeIn June, farmer John Smith expects to harvest 10,000
bushels of corn during the month of August. In June,the September corn futures are selling for $2.94 perbushel (1K = 5,000 bushels). Farmer Smith wishesto lock in this price.
Show the transactions if the Sept spot price drops to$2.80.
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636
Commodity HedgeIn June, farmer John Smith expects to harvest 10,000 bushels of
corn during the month of August. In June, the September cornfutures are selling for $2.94 per bushel (1K = 5,000 bushels).Farmer Smith wishes to lock in this price.
Show the transactions if the Sept spot price drops to $2.80.
Revenue from Crop: 10,000 x 2.80 28,000
June: Short 2K @ 2.94 = 29,400
Sept: Long 2K @ 2.80 = 28,000 .
Gain on Position------------------------------- 1,400
Total Revenue $ 29,400
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637
Commodity HedgeIn June, farmer John Smith expects to harvest 10,000
bushels of corn during the month of August. In June,the September corn futures are selling for $2.94 perbushel (1K = 5,000 bushels). Farmer Smith wishesto lock in this price.
Show the transactions if the Sept spot price rises to$3.05.
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638
Commodity HedgeIn June, farmer John Smith expects to harvest 10,000 bushels of
corn during the month of August. In June, the September cornfutures are selling for $2.94 per bushel (1K = 5,000 bushels).Farmer Smith wishes to lock in this price.
Show the transactions if the Sept spot price rises to $3.05.
Revenue from Crop: 10,000 x 3.05 30,500
June: Short 2K @ 2.94 = 29,400
Sept: Long 2K @ 3.05 = 30,500 .
Loss on Position------------------------------- ( 1,100 )
Total Revenue $ 29,400
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639
Commodity SpeculationYou have lived in NYC your whole life and areindependently wealthy. You think you knoweverything there is to know about pork bellies(uncurred bacon) because your butler fixes it for youevery morning. Because you have decided to go on adiet, you think the price will drop over the next fewmonths. On the CME, each PB K is 38,000 lbs. Today,you decide to short three May Ks @ 44.00 cents perlbs. In Feb, the price rises to 48.5 cents and youdecide to close your position. What is your gain/loss?
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640
Commodity Speculation
Nov: Short 3 May K (.4400 x 38,000 x 3 ) = + 50,160
Feb: Long 3 May K (.4850 x 38,000 x 3 ) = - 55,290
Loss of 10.23 % = - 5,130
You have lived in NYC your whole life and areindependently wealthy. You think you knoweverything there is to know about pork bellies(uncurred bacon) because your butler fixes it for youevery morning. Because you have decided to go on adiet, you think the price will drop over the next fewmonths. On the CME, each PB K is 38,000 lbs. Today,you decide to short three May Ks @ 44.00 cents perlbs. In Feb, the price rises to 48.5 cents and youdecide to close your position. What is your gain/loss?
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641
Margin
w The amount (percentage) of a FuturesContract Value that must be on deposit with abroker.
w Since a Futures Contract is not an actual sale,you need only pay a fraction of the assetvalue to open a position = margin.w CME margin requirements are 15%
w Thus, you can control $100,000 of assets withonly $15,000.
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642
Commodity Speculation with margin
You have lived in NYC your whole life and are independently wealthy.You think you know everything there is to know about pork bellies(uncurred bacon) because your butler fixes it for you every morning.Because you have decided to go on a diet, you think the price will dropover the next few months. On the CME, each PB K is 38,000 lbs.Today, you decide to short three May Ks @ 44.00 cents per lbs. InFeb, the price rises to 48.5 cents and you decide to close your position.What is your gain/loss?
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643
Nov: Short 3 May K (.4400 x 38,000 x 3 ) = + 50,160
Feb: Long 3 May K (.4850 x 38,000 x 3 ) = - 55,290
Loss = - 5,130
Loss 5130 5130
Margin 50160 x.15 7524 ------------ = -------------------- = ------------ = 68% loss
You have lived in NYC your whole life and are independently wealthy.You think you know everything there is to know about pork bellies(uncurred bacon) because your butler fixes it for you every morning.Because you have decided to go on a diet, you think the price will dropover the next few months. On the CME, each PB K is 38,000 lbs.Today, you decide to short three May Ks @ 44.00 cents per lbs. InFeb, the price rises to 48.5 cents and you decide to close your position.What is your gain/loss?
Commodity Speculation with margin
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644
SWAPS
Birth 1981
Definition - An agreement between two firms, in which eachfirm agrees to exchange the “interest rate characteristics” oftwo different financial instruments of identical principal
Key points
Spread inefficiencies
Same notation principle
Only interest exchanged
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645
SWAPS
w “Plain Vanilla Swap” - (generic swap)
w fixed rate payer
w floating rate payer
w counterparties
w settlement date
w trade date
w effective date
w terms
w Swap Gain = fixed spread - floating spread
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646
SWAPS
example (vanilla/annually settled)XYZ ABC
fixed rate 10% 11.5%
floating rate libor + .25 libor + .50
Q: if libor = 7%, what swap can be made 7 what is the profit (assume $1milface value loans)
A:XYZ borrows $1mil @ 10% fixed
ABC borrows $1mil @ 7.5% floatingXYZ pays floating @ 7.25%ABC pays fixed @ 10.50%
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647
SWAPS
example - cont.
Benefit to XYZ Net position
floating +7.25 -7.25 0
fixed +10.50 -10.00 +.50
Net gain +.50%
Benefit ABC Net Position
floating +7.25 - 7.50 -.25
fixed -10.50 + 11.50 +1.00
net gain +.75%
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648
SWAPS
example - cont.
Settlement date
ABC pmt 10.50 x 1mil = 105,000
XYZ pmt 7.25 x 1mil = 72,500
net cash pmt by ABC = 32,500
if libor rises to 9%
settlement date
ABC pmt 10.50 x 1mil = 105,000
XYZ pmt 9.25 x 1mil = 92,500
net cash pmt by ABC = 12,500
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649
SWAPS
w transactions
w rarely done direct
w banks = middleman
w bank profit = part of “swap gain”
example - same continued
XYZ & ABC go to bank separately
XYZ term = SWAP floating @ libor + .25 for fixed @ 10.50
ABC terms = swap floating libor + .25 for fixed 10.75
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650
SWAPS
example - example - contcont..
settlement date - XYZBank pmt 10.50 x 1mil = 105,000
XYZ pmt 7.25 x 1mil = 72,500net Bank pmt to XYZ = 32,500
settlement date - ABCBank pmt 7.25 x 1mil = 72,500ABC pmt 10.75 x 1mil = 107,500
net ABC pmt to bank = 35,000
bank “swap gain” = +35,000 - 32,500 = +2,500
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651
SWAPS
example - cont.benefit to XYZfloating 7.25 - 7.25 = 0
fixed 10.50 - 10.00 = +.50 net gain .50
benefit to ABC
floating 7.25 - 7.50 = - .25fixed -10.75 + 11.50 = + .75 net gain .50
benefit to bankfloating +7.25 - 7.25 = 0fixed 10.75 - 10.50 = +.25 net gain +.25
total benefit = 12,500 (same as w/o bank)
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u Managing International Risk
Principles of Corporate FinanceBrealey and Myers Sixth Edition
Chapter 27
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653
Topics Covered
w Foreign Exchange Marketsw Some Basic Relationships
w Hedging Currency Riskw Exchange Risk and International Investment
Decisions
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654
Foreign Exchange Markets
Exchange Rate - Amount of one currency neededto purchase one unit of another.
Spot Rate of Exchange - Exchange rate for animmediate transaction.
Forward Exchange Rate - Exchange rate for aforward transaction.
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655
Foreign Exchange Markets
Forward Premiums and Forward DiscountsExample - The yen spot price is 112.645 yen per
dollar and the 6 month forward rate is 111.300 yenper dollar, what is the premium and discountrelationship?
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656
Foreign Exchange Markets
Forward Premiums and Forward DiscountsExample - The yen spot price is 112.645 yen per dollar and the
6 month forward rate is 111.300 yen per dollar, what is thepremium and discount relationship?
4.8%=100x 111.300
111.300-112.6454
)(-Discountor Premium=Spot Price
Spot Price- PriceForward
×
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657
Foreign Exchange Markets
Forward Premiums and Forward DiscountsExample - The yen spot price is 112.645 yen per dollar and the
6 month forward rate is 111.300 yen per dollar, what is thepremium and discount relationship?
Answer - The dollar is selling at a 4.8% premium, relative to theyen. The yen is selling at a 4.8% discount, relative to thedollar.
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658
Exchange Rate Relationships
w Basic Relationships
1 + r
1 + rforeign
$
1 + i
1 + iforeign
$
f
Sforeign / $
foreign / $
E(s
Sforeign / $
foreign / $
)
equals
equals
equals equals
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659
Exchange Rate Relationships
1) Interest Rate Parity Theory
w The ratio between the risk free interest rates in twodifferent countries is equal to the ratio between theforward and spot exchange rates.
1 + r
1 + r=
foreign
$
f
Sforeign / $
foreign / $
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660
Exchange Rate Relationships
Example - You have the opportunity to invest$1,000,000 for one year. All other things beingequal, you have the opportunity to obtain a 1 yearJapanese bond (in yen) @ 0.25 % or a 1 year USbond (in dollars) @ 5%. The spot rate is 112.645yen:$1 The 1 year forward rate is 107.495 yen:$1
Which bond will you prefer and why?
Ignore transaction costs.
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661
Value of US bond = $100,000 x 1.05 = $105,000
Exchange Rate Relationships
Example - You have the opportunity to invest $1,000,000 for one year. Allother things being equal, you have the opportunity to obtain a 1 yearJapanese bond (in yen) @ 0.25 % or a 1 year US bond (in dollars) @ 5%.The spot rate is 112.645 yen:$1 The 1 year forward rate is 107.495 yen:$1
Which bond will you prefer and why? Ignore transaction costs.
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662
Value of US bond = $100,000 x 1.05 = $105,000
Value of Japan bond = $100,000 x 112.645 = 112,645,000 yen exchange
Exchange Rate Relationships
Example - You have the opportunity to invest $1,000,000 for one year. Allother things being equal, you have the opportunity to obtain a 1 yearJapanese bond (in yen) @ 0.25 % or a 1 year US bond (in dollars) @ 5%.The spot rate is 112.645 yen:$1 The 1 year forward rate is 107.495 yen:$1
Which bond will you prefer and why? Ignore transaction costs
![Page 663: Principles of Corporate Finance - Freetesta.roberta.free.fr/My Books/Business/Mcgraw-Hill...u Finance and the Financial Manager Principles of Corporate Finance Brealey and Myers Sixth](https://reader035.vdocuments.mx/reader035/viewer/2022062416/611e6bf15919943bc424f344/html5/thumbnails/663.jpg)
663
Value of US bond = $100,000 x 1.05 = $105,000
Value of Japan bond = $100,000 x 112.645 = 112,645,000 yen exchange
112,645,000 yen x 1.08 = 112,927,000 yen bond pmt
Exchange Rate Relationships
Example - You have the opportunity to invest $1,000,000 for one year. Allother things being equal, you have the opportunity to obtain a 1 yearJapanese bond (in yen) @ 0.25 % or a 1 year US bond (in dollars) @ 5%.The spot rate is 112.645 yen:$1 The 1 year forward rate is 107.495 yen:$1
Which bond will you prefer and why? Ignore transaction costs
![Page 664: Principles of Corporate Finance - Freetesta.roberta.free.fr/My Books/Business/Mcgraw-Hill...u Finance and the Financial Manager Principles of Corporate Finance Brealey and Myers Sixth](https://reader035.vdocuments.mx/reader035/viewer/2022062416/611e6bf15919943bc424f344/html5/thumbnails/664.jpg)
664
Value of US bond = $100,000 x 1.05 = $105,000
Value of Japan bond = $100,000 x 112.645 = 112,645,000 yen exchange
112,645,000 yen x 1.08 = 112,927,000 yen bond pmt
112,927,000 yen / 107.495 = $1,050,500 exchange
Exchange Rate Relationships
Example - You have the opportunity to invest $1,000,000 for one year. Allother things being equal, you have the opportunity to obtain a 1 yearJapanese bond (in yen) @ 0.25 % or a 1 year US bond (in dollars) @ 5%.The spot rate is 112.645 yen:$1 The 1 year forward rate is 107.495 yen:$1
Which bond will you prefer and why? Ignore transaction costs
![Page 665: Principles of Corporate Finance - Freetesta.roberta.free.fr/My Books/Business/Mcgraw-Hill...u Finance and the Financial Manager Principles of Corporate Finance Brealey and Myers Sixth](https://reader035.vdocuments.mx/reader035/viewer/2022062416/611e6bf15919943bc424f344/html5/thumbnails/665.jpg)
665
Exchange Rate Relationships
2) Expectations Theory of Exchange Rates
Theory that the expected spot exchange rateequals the forward rate.
f
Sforeign / $
foreign / $
=E(s
Sforeign / $
foreign / $
)
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666
Exchange Rate Relationships
3) Purchasing Power Parity
The expected change in the spot rate equalsthe expected difference in inflation betweenthe two countries.
1 + i
1 + i=
foreign
$
E(s
Sforeign / $
foreign / $
)
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667
Exchange Rate Relationships
ExampleIf inflation in the US is forecasted at 2.0%this year and Japan is forecasted to fall2.5%, what do we know about the expectedspot rate?
Given a spot rate of 112.645yen:$1
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668
Exchange Rate Relationships
foreign/$
foreign/$
$
foreign )=
i+1
i+1
S
E(s
Example - If inflation in the US is forecasted at2.0% this year and Japan is forecasted to fall2.5%, what do we know about the expected spotrate?
Given a spot rate of 112.645yen:$1
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669
Exchange Rate Relationships
foreign/$
foreign/$
$
foreign )=
i+1
i+1
S
E(s
Example - If inflation in the US is forecasted at2.0% this year and Japan is forecasted to fall2.5%, what do we know about the expected spotrate?
Given a spot rate of 112.645yen:$1
112.645
E(s )=
.02+1
.025-1 foreign/$
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670
Exchange Rate Relationships
solve for Es Es = 107.68
foreign/$
foreign/$
$
foreign )=
i+1
i+1
S
E(s
Example - If inflation in the US is forecasted at2.0% this year and Japan is forecasted to fall2.5%, what do we know about the expected spotrate?
Given a spot rate of 112.645yen:$1
112.645
E(s )=
.02+1
.025-1 foreign/$
![Page 671: Principles of Corporate Finance - Freetesta.roberta.free.fr/My Books/Business/Mcgraw-Hill...u Finance and the Financial Manager Principles of Corporate Finance Brealey and Myers Sixth](https://reader035.vdocuments.mx/reader035/viewer/2022062416/611e6bf15919943bc424f344/html5/thumbnails/671.jpg)
671
Exchange Rate Relationships
4) International Fisher effect
The expected difference in inflation ratesequals the difference in current interest rates.
Also called common real interest rates.
1 + r
1 + r=
foreign
$
1 + i
1 + iforeign
$
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672
Exchange Rate Relationships
Example - The real interest rate in each country isabout the same.
.028 =.975
1.0025=
i+1
r+1)(
foreign
foreign=realr
.029 =1.021.05
=i+1
r+1)(
$
$=realr
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673
Exchange Rate Risk
Example - Honda builds a new car in Japan for a cost +profit of 1,715,000 yen. At an exchange rate of 101.18:$1the car sells for $16,950 in Baltimore. If the dollar rises invalue, against the yen, to an exchange rate of 105:$1, whatwill be the price of the car?
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674
Exchange Rate Risk
Example - Honda builds a new car in Japan for a cost +profit of 1,715,000 yen. At an exchange rate of 101.18:$1the car sells for $16,950 in Baltimore. If the dollar rises invalue, against the yen, to an exchange rate of 105:$1, whatwill be the price of the car?
1,715,000 = $16,333
105
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675
Exchange Rate Risk
Example - Honda builds a new car in Japan for a cost +profit of 1,715,000 yen. At an exchange rate of 101.18:$1the car sells for $16,950 in Baltimore. If the dollar rises invalue, against the yen, to an exchange rate of 105:$1, whatwill be the price of the car?
1,715,000 = $16,333
105Conversely, if the yen is trading ata forward discount, Japan willexperience a decrease inpurchasing power.
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676
Exchange Rate RiskExample - Harley Davidson builds a motorcycle for acost plus profit of $12,000. At an exchange rate of101.18:$1, the motorcycle sells for 1,214,160 yen inJapan. If the dollar rises in value and the exchange rate is105:$1, what will the motorcycle cost in Japan?
![Page 677: Principles of Corporate Finance - Freetesta.roberta.free.fr/My Books/Business/Mcgraw-Hill...u Finance and the Financial Manager Principles of Corporate Finance Brealey and Myers Sixth](https://reader035.vdocuments.mx/reader035/viewer/2022062416/611e6bf15919943bc424f344/html5/thumbnails/677.jpg)
677
Exchange Rate RiskExample - Harley Davidson builds a motorcycle for acost plus profit of $12,000. At an exchange rate of101.18:$1, the motorcycle sells for 1,214,160 yen inJapan. If the dollar rises in value and the exchange rate is105:$1, what will the motorcycle cost in Japan?
$12,000 x 105 = 1,260,000 yen (3.78% rise)
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678
Exchange Rate Risk
w Currency Risk can be reduced by usingvarious financial instruments.
w Currency forward contracts, futures contracts,and even options on these contracts areavailable to control the risk.
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679
Capital Budgeting
Techniques
1) Exchange to $ and analyze.
2) Discount using foreign cash flows andinterest rates, then exchange to $.
3) Choose a currency standard ($) andhedge all non dollar CF.
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u Financial Analysis and Planning
Principles of Corporate FinanceBrealey and Myers Sixth Edition
Chapter 28
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681
Topics Covered
w Executive Paper Corporationw Financial Ratios
w The DuPont Systemw Financial Planningw Growth and External Financing
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682
Executive Paper
Executive Paper Balance Sheet
Dec Dec1998 1999 diff
Assets
Current AssetsCash & Securities 100.0 110.0 10.0Receivables 433.1 440.0 6.9Inventory 339.9 350.0 10.1
Total 873.0 900.0 27.0
Fixed AssetsP, P, E 929.8 100.0 -829.8accum Depr 396.7 450.0 53.3
Net Fixed Assets 533.1 550.0 16.9
Total Assets 1,406.1 1,450.0 43.9
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683
Executive Paper
Dec Dec1998 1999 diff
Liabilities and Equity
Current LiabilitiesDebt due in 1 year 96.6 100.0 3.4Payable 349.9 360.0 10.1
Total current liabilities 446.5 460.0 13.5
Long term debt 400.0 400.0 0.0
Shareholders equity 559.6 590.0 30.4
Total liabilities and equity 1,406.1 1,450.0 43.9
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684
Executive Paper
Executive Paper - Other Data 1998 1999
Estimated repalcement cost of assets 1110 1231
Market value of equity 598 708
Average number of shares, millions 14.16 14.16
Share price, dollars 42.25 50
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685
Executive Paper
Executive Paper Income Statement (1999)
$ millionsRevenues 2,200.00Costs 1,980.00Depreciation 53.30EBIT 166.70Interest 40.00Tax 50.70Net income 76.00
Dividend 45.60Retained earnings 30.40Earnings per share, dollars 5.37Dividend per share, dollars 3.22
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686
Executive Paper
Executive Paper Sources and Uses of Funds (1999)
Sources: $ millionsNet Income 76.00 Depreciation 53.30 Operating cash flow 129.30 Borrowing - Stock issues - Total sources 129.30
Uses:Increase in net working capital 13.50 Investment 70.20 Dividends 45.60 Total uses 129.30
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687
Leverage Ratios
Long term debt ratio =long term debt
long term debt + equity
Debt equity ratio =long term debt + value of leases
equity
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688
Leverage Ratios
Total debt ratio =total liabilities
total assets
Times interest earned =EBIT
interest payments
Cash cover age ratio =EBIT + depreciation
interest payments
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689
Liquidity Ratios
Net working capital
to total assets ratio=
Net working capitalTotal assets
Current ratio =current assets
current liabilities
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690
Liquidity Ratios
Cash ratio =cash + marketable securities
current liabilities
Quick ratio =cash + marketable securities + receivables
current liabilities
Interval measure =cash + marketable securities + receivablesaverage daily expenditures from operations
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691
Efficiency Ratios
Asset turnover ratio =Sales
Average total assets
NWCturnover =sales
average net working capital
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692
Efficiency Ratios
Days' sales in inventory =average inventory
cost of goods sold / 365
Inventory turnover ratio =cost of goods soldaverage inventory
Average collection period =average receivablesaverage daily sales
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693
Profitability Ratios
Return on assets =EBIT - tax
average total assets
Net profit margin =EBIT - tax
sales
Return on equity =earnings available for common stock
average equity
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694
Profitability Ratios
Plowback ratio =earnings - dividends
earnings
= 1 - payout ratio
Payout ratio =dividendsearnings
Growth in equity from plowback =earnings - dividends
earnings
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695
Market Value Ratios
Forecasted PE ratio =P
aveEPS1
r - g0
1
=Di v
EPSx1
1
PE Ratio =stock price
earnings per share
Dividend yield =dividend per share
stock price
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696
Market Value Ratios
Market to book ratio =stock price
book value per share
Price per share = P =Divr - g0
1
Tobins Q =market value of assets
estimated replcement cost
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697
The DuPont System
w A breakdown of ROE and ROA intocomponent ratios:
ROA =EBIT - taxes
assets
ROE =earnings available for common stock
equity
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698
The DuPont System
ROA =salesassets
xEBIT - taxes
sales
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699
The DuPont System
ROA =salesassets
xEBIT - taxes
sales
assetturnover
profitmargin
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700
The DuPont System
ROE =assetsequity
xsalesassets
xEBIT - taxes
salesx
EBIT - taxes - interestEBIT - taxes
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701
The DuPont System
ROE =assetsequity
xsalesassets
xEBIT - taxes
salesx
EBIT - taxes - interestEBIT - taxes
leverageratio
assetturnover
profitmargin
debtburden
![Page 702: Principles of Corporate Finance - Freetesta.roberta.free.fr/My Books/Business/Mcgraw-Hill...u Finance and the Financial Manager Principles of Corporate Finance Brealey and Myers Sixth](https://reader035.vdocuments.mx/reader035/viewer/2022062416/611e6bf15919943bc424f344/html5/thumbnails/702.jpg)
u Short Term Financial Planning
Principles of Corporate FinanceBrealey and Myers Sixth Edition
Chapter 29
![Page 703: Principles of Corporate Finance - Freetesta.roberta.free.fr/My Books/Business/Mcgraw-Hill...u Finance and the Financial Manager Principles of Corporate Finance Brealey and Myers Sixth](https://reader035.vdocuments.mx/reader035/viewer/2022062416/611e6bf15919943bc424f344/html5/thumbnails/703.jpg)
703
Topics Covered
w Working Capitalw Links Between Long-Term and Short-Term
Financing
w Tracing Changes in Cash and Working Capital
w Cash Budgetingw A Short-Term Financing Plan
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704
Working Capital
Net Working Capital - Current assets minus currentliabilities. Often called working capital.
Cash Conversion Cycle - Period between firm’spayment for materials and collection on its sales.
Carrying Costs - Costs of maintaining current assets,including opportunity cost of capital.
Shortage Costs - Costs incurred from shortages incurrent assets.
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705
Firm’s Cumulative Capital Requirement
Lines A, B, and C show alternative amounts of long-term finance.
Strategy A: A permanent cash surplus Strategy B: Short-term lender for part of year and borrower for
remainder Strategy C: A permanent short-term borrower
A
B
C
Year 2Year 1
Dollars
Cumulativecapital requirement
Time
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706
Working Capital
Simple Cycle of operations
Cash
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707
Working Capital
Simple Cycle of operations
Cash
Raw materialsinventory
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708
Working Capital
Simple Cycle of operations
Cash
Finished goodsinventory
Raw materialsinventory
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709
Working Capital
Simple Cycle of operations
Cash
Finished goodsinventory
ReceivablesRaw materials
inventory
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710
Working Capital
Simple Cycle of operations
Cash
Finished goodsinventory
ReceivablesRaw materials
inventory
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711
Changes in Cash & W.C.Example - Dynamic Mattress Company
11595equity sowner'11595Assets Total
and LiabTotal5040Assets Net Fixed
2016 Deprless
7056investment Gross
Assets Fixed
7665WorthNet 6555AssetsCurr Total
125 DebtTerm Long3025 RecvAccts
2725Curr Liab Total2526Inventory
2720 PayableAccts 50Securities Mark
05oans Bank L54Cash
abilitiesCurrent Li54AssetsCurrent
19991998 Equity& sLiabilitie19991998Assets
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712
Changes in Cash & W.C.Example - Dynamic Mattress Company
Income Statement
Sales $350
Operating Costs 321
Depreciation 4
EBIT 25
Interest 1
Pretax income 24
. Tax at 50% 12
Net Income $12
Assume
dividend = $1 mil
R.E.=$11 mil
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713
Changes in Cash & W.C.Example -
Dynamic
MattressCompany
1 $balancecash in Increase
$30 UsesTotal
1Dividend
5receivable accounts Increased
5securities marketable Purchased
14assets fixedin Invested
5loanbank short term Repaid
Uses
$31Sources Total
4onDepreciati
12incomeNet
operations fromCash
7payable accounts Increased
1sinventorie Reduced
7debt termlong Issued
Sources
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714
Changes in Cash & W.C.Example - Dynamic Mattress Company
Dynamic used cash as follows:w Paid $1 mil dividend.
w Repaid $5 mil short term bank loan.
w Invested $14 mil.
w Purchased $5 mil of marketable securities.
w Accounts receivable expanded by $5 mil.
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715
Cash Budgeting
Steps to preparing a cash budgetStep 1 - Forecast the sources of cash.
Step 2 - Forecast uses of cash.
Step 3 - Calculate whether the firm is facing a cashshortage or surplus.
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716
Cash BudgetingExample - Dynamic Mattress Company
Dynamic forecasted sources of cash
AR ending balance = AR beginning balance + sales - collections
Quarter 1st 2nd 3rd 4th
Sales, $mil 87.50 78.50 116.00 131.00
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717
Cash BudgetingExample - Dynamic Mattress Company
Dynamic collections on ARQtr
1st 2nd 3rd 4th
1. Beginning receivables 30.0 32.5 30.7 38.2
2. Sales 87.5 78.5 116.0 131.0
3. Collections
. Sales in current Qtr (80%) 70 62.8 92.8 104.8
. Sales in previous Qtr (20%) 15.0 17.5 15.7 23.2
Total collections 85.0 80.3 108.5 128.0
4. Receivables at end of period
. (4 = 1 + 2 - 3) $32.5 $30.7 $38.2 $41.2
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718
Cash BudgetingExample - Dynamic Mattress Company
Dynamic forecasted uses of cashw Payment of accounts payable
w Labor, administration, and other expenses
w Capital expenditures
w Taxes, interest, and dividend payments
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719
Cash BudgetingExample - Dynamic Mattress Company
Dynamic
cash budget
$35.0$26.0$15.0$46.5
uses) minus (sources
inflow cashNet
93.095.095.3131.5cash of uses Total
5.04.54.04.0dividends & interest, , taxes
8.05.51.332.5esexpenditur capital
30.030.030.030.0expenses admin andlabor
50.055.060.065.0AP ofpayment
cash of Uses
128.0121.080.385.0Sources Total
0.012.50.00.0other
128.0108.580.385.0AR on scollection
cash of Sources
4th3rd2nd1st
Qtr
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720
Cash BudgetingExample - Dynamic Mattress Company
Dynamic short term financing requirements
$.5-$35.5$61.5$46.5
period) of endat caash minus
balance cash (minimum required
financing short term Cumulative
5555balance cash operating Min
4.5+30.5-56.5-41.5-period of endat Cash=
35+26+15-46.5-flow cashNet +
30.5-56.5-41.5-5period ofstart at Cash
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721
A Short Term Financing PlanExample - Dynamic Mattress Company
Dynamic forecasted deferrable expenses
40444852$mil errable,Amount Def
4th3rd2nd1stQuarter
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722
A Short Term Financing Plan
Example -
Dynamic
Mattress
Company-
Financing PlanFinancing Plan
1st 2nd 3rd 4thNew borrowing
1. Line of credit 41.0 0.0 0.0 0.02. Stretching payables 3.6 20.0 0.0 0.03. Total 44.6 20.0 0.0 0.0
Repayments4. Line of credit 0.0 0.0 4.8 36.25. Stetched payables 0.0 3.6 20.0 0.06. Total 0.0 3.6 24.8 36.27. Net new borrowing 44.6 16.4 -24.8 -36.28. Plus securities sold 5.0 0.0 0.0 0.09. Less securities bought 0.0 0.0 0.0 0.010. Total cash raised 49.6 16.4 -24.8 -36.2
Interest payments:11. Line of credit 0.0 1.2 1.2 1.012. Stretching payables 0.0 0.2 1.0 0.013. Less interest on securities -0.1 0.0 0.0 0.014. Net interest paid -0.1 1.4 2.2 1.015. Funds for Compensating balances 3.2 0.0 -1.0 -2.216. Cash required for operations 46.5 15.0 0.3 -35.017. Total cash required 49.6 16.4 -24.8 -36.2
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u Credit Management
Principles of Corporate FinanceBrealey and Myers Sixth Edition
Chapter 30
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724
Topics Covered
w Terms of Salew Commercial Credit Instruments
w Credit Analysisw The Credit Decisionw Collection Policy
w Bankruptcy
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725
Terms of Sale
Terms of Sale - Credit, discount, and payment termsoffered on a sale.
Example - 5/10 net 30
5 - percent discount for early payment
10 - number of days that the discount is available
net 30 - number of days before payment is due
![Page 726: Principles of Corporate Finance - Freetesta.roberta.free.fr/My Books/Business/Mcgraw-Hill...u Finance and the Financial Manager Principles of Corporate Finance Brealey and Myers Sixth](https://reader035.vdocuments.mx/reader035/viewer/2022062416/611e6bf15919943bc424f344/html5/thumbnails/726.jpg)
726
Terms of Sale
w A firm that buys on credit is in effect borrowingfrom its supplier. It saves cash today but will haveto pay later. This, of course, is an implicit loan fromthe supplier.
w We can calculate the implicit cost of this loan.
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727
Terms of Sale
w A firm that buys on credit is in effect borrowingfrom its supplier. It saves cash today but will haveto pay later. This, of course, is an implicit loan fromthe supplier.
w We can calculate the implicit cost of this loan
( )Effective annual rate
1 + - 1discountdiscounted price
365 / extra days credit=
![Page 728: Principles of Corporate Finance - Freetesta.roberta.free.fr/My Books/Business/Mcgraw-Hill...u Finance and the Financial Manager Principles of Corporate Finance Brealey and Myers Sixth](https://reader035.vdocuments.mx/reader035/viewer/2022062416/611e6bf15919943bc424f344/html5/thumbnails/728.jpg)
728
Terms of Sale
Example - On a $100 sale, with terms 5/10 net 60,what is the implied interest rate on the credit given?
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729
Terms of Sale
Example - On a $100 sale, with terms 5/10 net 60,what is the implied interest rate on the credit given?
( )( ) 45.4%or .454,=1-+1
1-+1
rate annual Effective
365/50
955
credit days 365/extra
price discounteddiscount
=
=
![Page 730: Principles of Corporate Finance - Freetesta.roberta.free.fr/My Books/Business/Mcgraw-Hill...u Finance and the Financial Manager Principles of Corporate Finance Brealey and Myers Sixth](https://reader035.vdocuments.mx/reader035/viewer/2022062416/611e6bf15919943bc424f344/html5/thumbnails/730.jpg)
730
Credit Instruments
w Terminologyèopen account
èpromissory note
è commercial draft
è sight draftè time draft
è trade acceptance
èbanker’s acceptance
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731
Credit Analysis
Credit Analysis - Procedure to determine thelikelihood a customer will pay its bills.
w Credit agencies, such as Dun & Bradstreet providereports on the credit worthiness of a potentialcustomer.
w Financial ratios can be calculated to help determine acustomer’s ability to pay its bills.
![Page 732: Principles of Corporate Finance - Freetesta.roberta.free.fr/My Books/Business/Mcgraw-Hill...u Finance and the Financial Manager Principles of Corporate Finance Brealey and Myers Sixth](https://reader035.vdocuments.mx/reader035/viewer/2022062416/611e6bf15919943bc424f344/html5/thumbnails/732.jpg)
732
Credit Analysis
Numerical Credit Scoring categoriesèThe customer’s character
èThe customer’s capacity to pay
èThe customer’s capital
èThe collateral provided by the customerèThe condition of the customer’s business
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733
Credit Analysis
Multiple Discriminant Analysis - A technique usedto develop a measurement of solvency, sometimescalled a Z Score. Edward Altman developed a ZScore formula that was able to identify bankruptfirms approximately 95% of the time.
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734
Credit Analysis
Multiple Discriminant Analysis - A technique usedto develop a measurement of solvency, sometimescalled a Z Score. Edward Altman developed a ZScore formula that was able to identify bankruptfirms approximately 95% of the time.
Altman Z Score formula
Z = 3.3EBIT
total assets+ 1.0
sales
total assets+.6
market value of equity
total book debt
+ 1.4retained earnings
total assets+ 1.2
working capitaltotal assets
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735
Credit Analysis
Example - If the Altman Z score cut off for a creditworthy business is 2.7 or higher, would we acceptthe following client?
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736
Credit Analysis
Example - If the Altman Z score cut off for a creditworthy business is 2.7 or higher, would we acceptthe following client?
EBIT
total assets
sales
total assets
market equitybook debt
=
=
=
1 2
1 4
9
.
.
.
retained earningstotal assets
working capitaltotal assets
=
=
.
.
4
12
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737
Credit Analysis
Example - If the Altman Z score cut off for a creditworthy business is 2.7 or higher, would we acceptthe following client?
A score above 2.7 indicates good credit.
Firm' s Z Score
( . . ) ( . . ) ( . . ) ( . . ) ( . . ) .3 3 12 1 0 1 4 6 9 1 4 4 1 2 12 3 04x x x x x+ + + + =
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738
Credit Analysis
w Credit analysis is only worth while if theexpected savings exceed the cost.èDon’t undertake a full credit analysis unless the
order is big enough to justify it.
èUndertake a full credit analysis for the doubtfulorders only.
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739
The Credit Decision
Credit Policy - Standards set to determine the amountand nature of credit to extend to customers.
w Extending credit gives you the probability of makinga profit, not the guarantee. There is still a chance ofdefault.
w Denying credit guarantees neither profit or loss.
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740
The Credit Decision
The credit decision and its probable payoffs
Refuse credit
Offer credit
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741
The Credit Decision
The credit decision and its probable payoffs
Refuse credit
Offer credit
Customer pays = p
Customer defaults = 1-p
Payoff = 0
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742
The Credit Decision
The credit decision and its probable payoffs
Refuse credit
Offer credit
Customer pays = p
Customer defaults = 1-p
Payoff = Rev - Cost
Payoff = - Cost
Payoff = 0
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743
The Credit Decision
w Based on the probability of payoffs, the expectedprofit can be expressed as:
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744
The Credit Decision
w Based on the probability of payoffs, the expectedprofit can be expressed as:
p x PV(Rev - Cost) - (1 - p) x (PV(cost)
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745
The Credit Decision
w Based on the probability of payoffs, the expectedprofit can be expressed as:
w The break even probability of collection is:
p x PV(Rev - Cost) - (1 - p) x (PV(cost)
p =PV(Cost)PV(Rev)
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746
Collection Policy
Collection Policy - Procedures to collect and monitorreceivables.
Aging Schedule - Classification of accounts receivableby time outstanding.
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747
Collection Policy
Sample aging schedule for accounts receivable
$298,000$58,000$40,000$200,000Total
30,00021,0004,0005,000Omega
*****
*****
*****
5,0005,00000Beta
10,0000010,000AlphaOwed
Total
Overdue Month
1 thanMore
Overdue
Month1
Yet Due
NotAmount
Name
sCustomer'
![Page 748: Principles of Corporate Finance - Freetesta.roberta.free.fr/My Books/Business/Mcgraw-Hill...u Finance and the Financial Manager Principles of Corporate Finance Brealey and Myers Sixth](https://reader035.vdocuments.mx/reader035/viewer/2022062416/611e6bf15919943bc424f344/html5/thumbnails/748.jpg)
u Cash Management
Principles of Corporate FinanceBrealey and Myers Sixth Edition
Chapter 31
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749
Topics Covered
w Inventories and Cash Balancesw Cash Collection and Disbursement Systems
èFloat
w Bank Relations
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750
Inventories & Cash Balances
Economic Order Quantity - Order size thatminimizes total inventory costs.
Economic Order Quantity =2 x annual sales x cost per order
carrying cost
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751
Inventories & Cash Balances
Determination of optimal order size
Inve
ntor
y co
sts,
dol
lars
Order size
Total costs
Carrying costs
Total order costs
Optimalorder size
![Page 752: Principles of Corporate Finance - Freetesta.roberta.free.fr/My Books/Business/Mcgraw-Hill...u Finance and the Financial Manager Principles of Corporate Finance Brealey and Myers Sixth](https://reader035.vdocuments.mx/reader035/viewer/2022062416/611e6bf15919943bc424f344/html5/thumbnails/752.jpg)
752
Inventories & Cash Balances
w The optimal amount of short term securities sold toraise cash will be higher when annual cash outflowsare higher and when the cost per sale of securities ishigher. Conversely, the initial cash balance fallswhen the interest is higher.
Initial cash balance =2 x annual cash outflows x cost per sale of securities
interest rate
![Page 753: Principles of Corporate Finance - Freetesta.roberta.free.fr/My Books/Business/Mcgraw-Hill...u Finance and the Financial Manager Principles of Corporate Finance Brealey and Myers Sixth](https://reader035.vdocuments.mx/reader035/viewer/2022062416/611e6bf15919943bc424f344/html5/thumbnails/753.jpg)
753
Inventories & Cash Balances
wMoney Market - market for short termfinancial assets.è commercial paper
è certificates of deposit
è repurchase agreements
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754
Inventories & Cash Balances
Value of bills sold = Q =
2 x annual cash disbursement x cost per sale interest rate
2 x 1260 x 20 .08
Weeks0
25
12.5
balance ($000)
Cash
Average
inventory
=
= 25
1 2 3 4 5
(Everyman’s Bookstore)
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755
Float
w Time exists between the moment a check is writtenand the moment the funds are deposited in therecipient’s account.w This time spread is called Float.
Payment Float - Checks written by a company thathave not yet cleared.
Availability Float - Checks already deposited thathave not yet cleared.
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756
FloatPayment Float illustration - The company issues a
$200,000 check that has not yet cleared.
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757
FloatPayment Float illustration - The company issues a
$200,000 check that has not yet cleared.
Company’s ledger balance
$800,000+
Payment float
$200,000
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758
FloatPayment Float illustration - The company issues a
$200,000 check that has not yet cleared.
Company’s ledger balance
$800,000+
Payment float
$200,000
equals
Bank’s ledger balance
$1,000,000
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759
FloatAvailability Float illustration - The company
deposits a $100,000 check that has not yet cleared.
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760
FloatAvailability Float illustration - The company
deposits a $100,000 check that has not yet cleared.
Company’s ledger balance
$900,000+
Payment float
$200,000
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761
FloatAvailability Float illustration - The company
deposits a $100,000 check that has not yet cleared.
Company’s ledger balance
$900,000+
Payment float
$200,000
equals
Bank’s ledger balance
$1,100,000
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762
FloatNet Float illustration
Net float = payment float - availability float
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763
FloatNet Float illustration
Net float = payment float - availability float
Bank’s ledger balance
$1,100,000
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764
FloatNet Float illustration
Net float = payment float - availability float
Available balance
$1,000,000+
Availability float
$100,000
equals
Bank’s ledger balance
$1,100,000
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765
Managing Float
w Payers attempt to create delays in the checkclearing process.w Recipients attempt to remove delays in the
check clearing process.w Sources of delay
èTime it takes to mail check
èTime for recipient to process check
èTime for bank to clear check
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766
Managing Float
Check mailed
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767
Managing Float
Check mailed
Check received
Mail float
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768
Managing Float
Check mailed
Check received
Check deposited
Mail float
Processing float
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769
Managing Float
Check mailed
Check received
Check deposited
Cash availableto recipient
Check charged topayer’s account
Mail float
Processing float
Presentationfloat
Availabilityfloat
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770
Managing Float
Concentration Banking - system whereby customersmake payments to a regional collection center whichtransfers the funds to a principal bank.
Lock-Box System - System whereby customers sendpayments to a post office box and a local bankcollects and processes checks.
Zero-Balance Accounts - Regional bank accounts towhich just enough funds are transferred daily to payeach day’s bills.
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u Short Term Lending and Borrowing
Principles of Corporate FinanceBrealey and Myers Sixth Edition
Chapter 32
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772
Topics Covered
w Short-Term LendingwMoney Market Instruments
w Floating Rate Preferred Stockw Short Term Borrowing
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773
Sources of Short Term Financing
wMoney Marketsw Commercial paper
w Secured loansw Eurodollars
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774
Cost of Short-Term Loans
Simple Interest
Amount of loan X annual interest rate
number of periods in the year
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775
Cost of Short-Term Loans
Simple Interest
Effective annual rate
Amount of loan X annual interest rate
number of periods in the year
)(1 + quoted annual interest raten
n- 1
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776
Cost of Short-Term Loans
Discount Interest
)(Face value of loan X 1 - quoted annual interest ratenumber of periods in the year
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777
Calculating Yields
Example
In January of 1999, 91-day T-bills were issued at a discount of4.36%.
1. Price of bill = 100 - 91/360 x 4.36 = 98.898
2. 91-day return = (100 - 98.898) / 98.898 = 1.11%
3. Annual return = 1.11 x 365/91 = 4.47% simple interest
or
(1.0111)365 / 91 - 1 = 4.55% compound interest
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778
Money Market Investments
w US Treasury Billsw Federal Agency Securities
w Short-Term Tax-Exemptsw Bank Time Deposits and CDsw Commercial Paper
wMedium Term Notesw Bankers’ Acceptancesw Repos
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779
Credit Rationing
Investments Payoff Prob. of PayoffProject 1 -12 15 1Project 2 -12 24 or 0 .5 or .5
Example - Henrietta Ketchup
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780
Credit Rationing
Expected Payoff Expected Payoffto Bank to Ms. Ketchup
Project 1 110 15Project 2 (.5x10) + (.5x0) = +5 .5 x (24-10) = +7
Example - Henrietta Ketchup
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781
Credit Rationing
Expected Payoff Expected Payoffto Bank to Ms. Ketchup
Project 1 5 10Project 2 (.5x5) + (.5x0) = +2.5 .5 x (24-5) = +9.5
Example - Henrietta Ketchup
![Page 782: Principles of Corporate Finance - Freetesta.roberta.free.fr/My Books/Business/Mcgraw-Hill...u Finance and the Financial Manager Principles of Corporate Finance Brealey and Myers Sixth](https://reader035.vdocuments.mx/reader035/viewer/2022062416/611e6bf15919943bc424f344/html5/thumbnails/782.jpg)
u Mergers
Principles of Corporate FinanceBrealey and Myers Sixth Edition
Chapter 33
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783
Topics Covered
w Sensible Motives for Mergersw Some Dubious Reasons for Mergers
w Estimating Merger Gains and Costsw The Mechanics of a Mergerw Takeover Battles
wMergers and the Economy
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784
1997 and 1998 Mergers
Selling Company Acquiring Company Payment, billions of dollars
NYNEX Bell Atlantic 21.0McDonnell Douglas Boeing 13.4Digital Equipment Compaq Computer 9.1Schweizerischer Union Bank of Swiz. 23.0Energy Group PCC Texas Utilities 11.0Amoco Corp. British Petroleum 48.2Sun America American Intl. 18.0BankAmerica Corp. Nationsbank Corp. 61.6Chrysler Daimler-Benz 38.3Bankers Trust Corp. Deutsche Bank AG 9.7Netscape America Online 4.2Citicorp Travelers Group Inc. 83.0
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785
Sensible Reasons for Mergers
Economies of Scale
A larger firm may be able to reduce its per unit cost by usingexcess capacity or spreading fixed costs across more units.
$ $$Reduces costsReduces costs
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786
Sensible Reasons for Mergers
Economies of Vertical Integration
èControl over suppliers “may” reduce costs.
èOver integration can cause the opposite effect.
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787
Sensible Reasons for Mergers
Economies of Vertical Integration
èControl over suppliers “may” reduce costs.
èOver integration can cause the opposite effect.
Pre-integration(less efficient)
Company
S
S
S
S
S
S
S
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788
Sensible Reasons for Mergers
Economies of Vertical Integration
èControl over suppliers “may” reduce costs.
èOver integration can cause the opposite effect.
Pre-integration(less efficient)
Company
S
S
S
S
S
S
S
Post-integration(more efficient)
Company
S
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789
Sensible Reasons for Mergers
Combining Complementary Resources
Merging may result in each firm filling in the“missing pieces” of their firm with pieces from theother firm.
Firm A
Firm B
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790
Sensible Reasons for Mergers
Combining Complementary Resources
Merging may result in each firm filling in the“missing pieces” of their firm with pieces from theother firm.
Firm A
Firm B
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791
Sensible Reasons for Mergers
Mergers as a Use for Surplus Funds
If your firm is in a mature industry with few, if any,positive NPV projects available, acquisition may bethe best use of your funds.
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792
Dubious Reasons for Mergers
w Diversificationè Investors should not pay a premium for
diversification since they can do it themselves.
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793
Dubious Reasons for Mergers
The Bootstrap Game
Acquiring Firm has high P/E ratio
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794
Dubious Reasons for Mergers
The Bootstrap Game
Acquiring Firm has high P/E ratio
Selling firm has low P/E ratio (due to lownumber of shares)
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795
Dubious Reasons for Mergers
The Bootstrap Game
Acquiring Firm has high P/E ratio
Selling firm has low P/E ratio (due to lownumber of shares)
After merger, acquiring firm has short termEPS rise
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796
Dubious Reasons for Mergers
The Bootstrap Game
Acquiring Firm has high P/E ratio
Selling firm has low P/E ratio (due to lownumber of shares)
After merger, acquiring firm has short termEPS rise
Long term, acquirer will have slower thannormal EPS growth due to share dilution.
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797
Dubious Reasons for Mergers
Earnings perdollar invested
(log scale)
NowTime
.10
.067
.05
Muck & Slurry
World Enterprises (before merger)
World Enterprises (after merger)
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798
Estimating Merger Gains
w Questionsè Is there an overall economic gain to the merger?
èDo the terms of the merger make the companyand its shareholders better off?
????
PV(AB) > PV(A) + PV(B)
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799
Estimating Merger Gains
w Economic Gain
Economic Gain = PV(increased earnings)
= New cash flows from synergies
discount rate
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800
Takeover Defenses
White Knight - Friendly potential acquirer sought bya target company threatened by an unwelcomesuitor.
Shark Repellent - Amendments to a company chartermade to forestall takeover attempts.
Poison Pill - Measure taken by a target firm to avoidacquisition; for example, the right for existingshareholders to buy additional shares at an attractiveprice if a bidder acquires a large holding.
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u Control, Governance, and Financial Architecture
Principles of Corporate FinanceBrealey and Myers Sixth Edition
Chapter 34
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802
Topics Covered
w Leveraged Buyoutsw Spin-offs and Restructuring
w Conglomeratesw Private Equity Partnershipw Control and Governance
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803
Definitions
w Corporate control -- the power to makeinvestment and financing decisions.
w Corporate governance -- the role of theBoard of Directors, shareholder voting, proxyfights, etc. and the actions taken byshareholders to influence corporate decisions.w Financial architecture -- the financial
organization of the business.
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804
Leveraged Buyouts
w The difference between leveraged buyoutsand ordinary acquisitions:
1. A large fraction of the purchase price is debtfinanced.
2. The LBO goes private, and its share is nolonger trade on the open market.
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805
Leveraged Buyouts
w The three main characteristics of LBOs:
1. High debt2. Incentives3. Private ownership
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806
Leveraged Buyouts
Acquirer Target Year Price ($bil)
KKR RJR Nabisco 1989 24.72$ KKR Beatrice 1986 6.25$ KKR Safeway 1986 4.24$ Thompson Co. Southland 1987 4.00$ AV Holdings Borg-Warner 1987 3.76$ Wing Holdings NWA, Inc. 1989 3.69$ KKR Owens-Illinois 1987 3.69$ TF Investments Hospital Corp of America 1989 3.69$ FH Acquisitions For Howard Corp. 1988 3.59$ Macy Acquisition Corp. RH Macy & Co 1986 3.50$ Bain Capital Sealy Corp. 1997 811.20$ Citicorp Venture Capital Neenah Corp. 1997 250.00$ Cyprus Group (w/mgmt) WESCO Distribution Inc. 1998 1,100.00$ Clayton, Dublier & Rice North Maerican Van Lines 1998 200.00$ Clayton, Dublier & Rice (w/mgmt) Dynatech Corp. 1998 762.90$ Kohlberg & Co. (w.mgmt) Helley Performance Products 1998 100.00$
10 Largest LBOs in 1980s and 1997/98 examples
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Spin-offs, etc.
w Spin off -- debut independent companycreated by detaching part of a parentcompany's assets and operations.
w Carve-outs-- similar to spin offs, except thatshares in the new company are not given toexisting shareholders but sold in a publicoffering.
w Privatization -- the sale of a government-owned company to private investors.
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Privatization
wMotives for Privatization:
1. Increased efficiency2. Share ownership3. Revenue for the government
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Privatization
Amount Issued,Country Company and Date $ millions
France St. Gobain (1986) 2,091.40$ France Paribas (1987) 2,742.00$ Germany Volkswagon (1961) 315.00$ Jamaica Caribbean Cement (1987) 45.60$ Jpan Japan Airlines (1987) 2,600.00$ Mexico Telefonos de Mexico (1990) 3,760.00$ New Zealand Air New Zealand (1989) 99.10$ Singapore Neptune Orient Lines (1981-1988) 308.50$ United Kingdom British Gas (1986) 8,012.00$ United Kingdom BAA (Airports)(1987) 2,028.00$ United Kingdom British Steel (1988) 4,524.00$ United States Conrail (1987) 1,650.00$
Examples of Privatization
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Conglomerates
Sales Rank Company Numebr of Industries
8 ITT 3815 Tenneco 2842 Gulf & Western Industries 4151 Litton Industries 1966 LTV 1873 Illinois Central Industries 26
103 Textron 16104 Greyhound 19128 Marin Marietta 14131 Dart Industries 18132 U.S. Industries 24143 Northwest Industries 18173 Walter Kidde 22180 Ogden Industries 13188 Colt Industries 9
The largest US conglomerates in 1979
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Private Equity Partnership
Investment Phase Payout Phase
General Partner put up1% of capital
General Partner get carriedinterest in 20% of profits
Limitedpartners put in99% of capital
Limitedpartners getinvestment
back, then 80%of profits
Investment indiversifiedportfolio ofcompanies
Sale or IPO ofcompanies
Partnership Partnership
Company 1
Company 2
Company N
Mgmt fees
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u Conclusion: What We Do and Do Not Know about Finance
Principles of Corporate FinanceBrealey and Myers Sixth Edition
Chapter 35
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Topics Covered
wWhat We Do KnowwWhat We Do Not Know
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7 Most Important Ideas in Finance
w Net Present Valuew Capital Asset Pricing Model (CAPM)
w Efficient Capital Marketsw Value Additivity & Law Conservation of
Valuew Capital Structure Theory
w Option Theoryw Agency Theory
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10 Unsolved Problems In Finance
w How major decisions are made?wWhat determines project risk and PV ?
w Risk and return - What have we missed?w How important are the exceptions to the
Efficient Market Theory?w Is management an off-balance-sheet liability?
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10 Unsolved Problems In Finance
w How can we explain the success of newmarkets and new securities?w How can we resolve the dividend controversy?
wWhat risks should a firm take?wWhat is the value of liquidity?