09 Finance

CORPORATE FINANCEIndex1. Basic Principles of Corporate Finance to Maximize Firm’s Value (3)2. Sources of Capital (4)3. Long Term Sources of Funds (5)4. Capital Structure (7)Optimal Structure (7)Financial Leverage (7)Operating Leverage (7)Combined Leverage (7)5. Dividend Policy / Distribution of Earnings (8)6. Cost of Capital (9)7. Risk Management (11)8. Portfolio Diversification & Optimal Investment Decision Making (12)Capital Asset Pricing Model (12)9. Conflict wit Lenders (13)10. Firm & Society (13)11. Financial Planning (14)12. Capital Budgeting (15)13. Working Capital Management (18)14. Expansion & Divestment Types (20)15. Mergers & Acquisitions (20)16. Financial Analysis Techniques (21)17. Business Valuation (23)Asset Based Approach (23)Transaction Based Approach (23)Market Based Approach (24)18. Lease vs. Buy (25)Basic Principles of Corporate Finance to Maximize Firm’s Value•Investment Decisionso Invest in assets that earn a return greater than the minimum acceptable discount rateo The discount rate should reflect the riskiness of the investment and mix of debt and equity used to fund it.o The return should reflect the magnitude and timing of cash flows as well as all side effects•Financing Decisionso Find the right kind of debt for the firm and the right mix of debt and equity to fund your operationso The optimal mix of debt and equity maximizes firm valueo The right kind of debt matches the tenor of your assets•Dividend Decisiono If you cannot find investments that make you minimum acceptable rate, return the cash to owners of your businesso How much cash you can return depends on current and potential investment opportunitieso How you choose to return cash to the owners will depend whether they prefer dividends or buybacksSources of Capital•Criteria to choose source of moneyo Entity’s short term and long term needso Simplicityo Desire to keep controlo Personal guaranteeo Timely availabilityo Cost of borrowing•Private Placementso Sale of shares directly to a financial institution.o Saves cost of middleman.•Public Marketso Raising money in the primary marketo More avenues – more investors.o Easy to sell in open marketo Dilution of controlo High cost of going publico Additional reportingo Information available to competitorso Higher Taxes – Lose Small Business Deduction benefit. •Bankso Strict Criteria - Loan to Value Ratio, more down sometimes.o Personal guarantee of directorso Debt covenants - Maintain minimum ratios, etc.•Other Financial Institutions – GE Capital, etcLong Term Sources of Funds•Bank Financing – term loan.•Bondso Risk: Considered “risk free” to the extent that future cash flows are known for certain. Only risk is that of default on the interest payments or on the final redemption value, but bonds are usuallyissued by Government or well established corporations so risk is minimal.o Retractable Bond: holder has option to sell bond back to company at specified date before maturityo Extendible Bond: holder has option to extend bond beyond maturityo Callable Bond – issuer has option to buy bond back at specified date before maturityo Interest Payments = contractual so mandatory; or holders may obtain some control or put company into bankruptcy.o Maturity Value: lump sum paid at end of term including premium.o Value = PV of future interest payments.o Face/Par Value: Bond value at initial issue upon which interest payments are based. This only corresponds to “value” of the bond when the market interest rate for that type of bond is exactlythe same as the bond interest rate.•Preferred Shareso Fixed dividendo Cumulative Preferred Shares: Dividends in arrears must be paid before any dividends can be paid to common share holders; If not paid in one year will be paid in next year.o Risk: less risky; when cash flow are tight, don’t have to declare a dividend vs interest payment on debt must be made, but riskier to investor so requires greater yield because cash flows notguaranteed as to timing.o Participating Preferred Shares: In addition to regular dividend on preferred shares, entitled to receive more dividend if dividend to commons shareholders exceeds certain dollar amount. Onliquidation, entitled to receive share in residual assets with common shareholders.o Valuation: Expected dividend ($) each year / Expected rate of return (assumption dividend will be paid each year)o Convertible Preferred Shares: Converts to common shares under certain conditions.•Common Shareso No fixed dividends.o Depending on class of shares, can or cannot have voting rights.o Valuation:Same as for preferred shares = Expected dividend each year / Expected rate of returnGrowing Company – Company reinvests some earnings into operations so grows & increased dividends each year. Growth assumed to be constant in the futureso total yield = Starting yield plus Growth. Can use CAPM to value shares.o Price Earnings (P/E) RatioMarket Value Per Share / Earnings Per ShareEPS for last 4 quarters or 2 last quarters + 2 estimated quarters or all 4 estimated quarters.Shows how much investor is willing to pay per dollar of earnings.More useful to compare the P/E ratios of one company to other companies in the same industry, to the market in general or against the company's own historicalP/E.Not useful to compare the P/E of a technology company (high P/E) to a utility company (low P/E) as each industry has much different growth prospects.Capital StructureOptimal Structureo Weigh Debt and Equity to maximize shareholders wealtho Debt is cheaper as its tax deductibleo Calculate Weighted Average Costo LeverageFinancial Leverage•Measures amount of debt in capital structure•Calculation: (1) EBIT/EBIT-Interest (2) Debt Equity Ratio. Where EBIT is Earnings Before Interest and Tax.•Higher the Ratio higher the leverage•Higher leverage higher risk.•If high, hard to raise more money with lower cost.•With lower leverage, easier to get money which can be used to increase profits.Operating Leverage•Measures operating cost structure (Fixed vs. Variable Cost)•Calculation : % Change in Operating Income / % Change in Unit Volume•ExampleIncome Period 1: $20,000 at 50,000 UnitsIncome Period 2: $32,000 at 60,000 Units% Change in Income: $12,000/$20,000 = 60%% Change in Volume: 10,000/50,000 Units = 20%Operating Leverage: 60% / 20% = 3.0 : 1.0•At 1% change in volume, there is 3% change in income.•Higher Operating Leverage, Higher Risk, Higher Break Even Point, Small decrease in sales will result into higher decrease in income.•Automation increase profits in good times when sale is higher.Combined Leverage•Calculation: FL X OLDividend Policy / Distribution of Earnings•Stability of Dividendo Dollar Amount each yearo Dividend Payout Ratio: Dividend/Net Incomeo Dividend Yield: Dividend/Market Price•Stock Dividendso Non-Cash Dividend. Instead of paying cash, company issues more shares.o Total Market Value does not change as value of individual share adjustso Intention to keep funds in the company for investment.•Capital Dividendso Paid from paid up capitalo Paid when company has no earningso Generally not taxableo Shrinks capital base which is not good for expansion•Stock Splitso Increase in number of shares of a class, for example, 100 shares of $10 converted to 200 shares of $5; total value is still $1000.o Ratio set by BOD.o Total market value does not changeo Done to lower market price to increase trading, as higher price shares become affordable after split.•Share Repurchaseso Buy back of own shareso Done if shares are selling at lower price.•Dividend Reinvestmento Option to shareholder to purchase shares with cash dividend•Legal Ruleso Can be distributed from current/past earningso Cannot be declared if company is insolvent•Dividend Policy Considerationso Return on investment should exceed return that shareholders get by investing themselves.o Dividend Tax implications for shareholderso Cash need of shareholderso Restriction of dividend payment by debt covenantso Company’s cash position to make paymento Growth plans justifying retaining fundsCost of Capital•The cost of capital determines how a company can raise money (through a stock issue, borrowing, or a mix of the two). This is the rate of return that a firm would receive if it invested ina different vehicle with similar risk.•Calculating Component Costso Long Term Debt: (Interest Paid + Floating Cost) X (1-tax rate)o Preferred Shares: Dividend Paid + Floating Cost (1-tax rate)o Cost of EquityCost of Equity: Dividend Growth ModelDividend per Share (Next Year) / Current Market Value(+) Growth Rate of DividendRepresents the compensation that the market demands in exchange forowning the asset and bearing the risk of ownership.Example: Let’s say you require a rate of return of 10% on investmentin shares. The stock is currently trading at $10 and will pay a dividend of$0.30. Through a combination of dividends and share appreciation yourequire a $1.00 return on your $10.00 investment. Therefore the stock willhave to appreciate by $0.70, which, combined with the $0.30 fromdividends, gives you your 10% cost of equity.Cost of Equity: Capital Assets Pricing ModelCost of Equity: P/E RatioUse judgement to decide out of above three methods: Average or a close figure.o Cost of Retained EarningsRE are not free to the company. They represent reinvested earnings forshareholdersRE represent money shareholders could have spent if it had been distributed as dividends.Shareholders deserve return on REMarket Return on new shares is the starting point for estimating cost of RE.No need to adjust floating cost as there is no such costCost of RE part of calculation of WACC•Weighted Average Cost of Capitalo Companies use mix of sources of capital, not a particular source, so WACC is relevant.o Calculations based on market prices for both equity and debt.o WACC equation is the cost of each capital component multiplied by its proportional weight and then summing.o ExampleEquity: MV $600,000 Cost 7% Weight (60% - $600,000/$1000,000)Debt: MV $400,000 Cost 5% Weight (40% - $400,000/$1000,000)Solving (7% X 60%) + (5% X 40%) WACC is 6.20%Risk Management•Risk is an important factor to consider. Risk is directly related to expected rate of return. When assessing riskiness of projects, investors should consider risk tolerance and portfoliodiversification. If investment sole source of income, consider lower risk projects. Mix of different investments can be used to optimize overall return.•Types of Risko Business Risk/Non Systematic RiskRelates to variability of Sales and Operating resultsCan be reduced by Diversification.Affected by Operating Leverage, Financial Leverage & Industry conditions.o Market Risk/Portfolio Risk/Systematic RiskRelates to changes in economy and market conditionsCannot be reduced by DiversificationPortfolio Diversification & Optimal Investment Decision MakingCapital Asset Pricing Modelo The way CAPM helps investors calculate their return is by using a simple formula that explains the relationship between expected return and risk:o Expected Rate of Return r = rf + B (rm - rf)Where:rf = The risk-free interest rate is the interest rate the investor would expect to receive from a risk-free investment. For example, Return on Treasury BillsB = A stock beta is used to mathematically describe the relationship between themovements of an individual stock versus the entire stock market. Investors canthen use a stock's beta to measure the risk of a security versus the market.rm = The expected market return is the return the investor would expect toreceive from a broad stock market indicator such as the S&P 500 Index. Forexample, over the last 17 years or so, the S&P 500 has yielded investors anaverage annual return of around 8.10%.o So what exactly is this CAPM formula telling us?The formula states that the expected return of a stock is equal to the risk-free rate of interest, plus the risk associated with all common stocks (market premiumrisk), adjusted for the risk of the common stock we're examining.This means the investor can expect a rate of return on an asset thatcompensates them for both the risk-free rate of interest, the stock market's risk,and the stock's individual risk.Conflict with Lenderso Increasing dividends significantly: When firms pay cash out as dividends, lenders to the firm are hurt and stockholders may be helped. This is because the firm becomesriskier without the cash.o Taking riskier projects than those agreed to at the outset: Lenders base interest rates on their perceptions of how risky a firm’s investments are. If stockholders then take on riskier investments, lenders will be hurt.o Borrowing more on the same assets: If lenders do not protect themselves, a firm can borrow more money and make all existing lenders worse off.Firm & SocietyFinancial decisions can create social costs and benefits.o A social cost or benefit is a cost or benefit that accrues to society as a whole and not to the firm making the decisionEnvironmental costs (pollution, health costs, etc.)Quality of Life costs (traffic, housing, safety, etc.)o Examples of social benefits include:creating employment in areas with high unemploymentsupporting development in inner citiescreating access to goods in areas where such access does not existFinancial Planning•Pro Forma Financial Statementso A financial statement that a company prepares to consider the effects of a potential activity.For example, if a company is considering acquiring another, it may prepare a pro formafinancial statement to estimate what effect the acquisition would have on itsown financial circumstances. A pro forma financial statement can also be part of the riskanalysis of a situationo Forecast Sales, Operating Expenses.o Use Cash Budgeto Incorporate impact of financial decisions, e.g. Dividend, Future Investments, etc. •Short-term Planning•Long-term PlanningCapital Budgeting•Capital budgeting is the planning process used to determine whether an organization's long term investments such as new machinery, replacement machinery, new plants, new products, and research development projects are worth pursuing. It is budget for major capital, orinvestment, expenditures•It starts with identification of alternatives•Use Case facts to assess each alternative based on company’s objectives•Use appropriate Quantitative tool to make analysis.o Net Present Value (Primary and best quantitative criteria)o Internal Rate of Return (If company uses it or if cash flows are even)o Payback Period (Secondary criteria)o After making quantitative analysis, make qualitative analysis and consider other factors. •Qualitative Analysiso Sensitivity Analysis (Different scenarios)o Customer, Employee, Society Concernso Shareholder preferenceso Environmental Issues•Net Cash Flow/ Net Present ValueCash OutflowTime 0 : Investment $ Cash InflowTime 1: Operations $Time 2: Operations $Time 3: Operations $Time 4: Operations $Time 5: Operations $Time 5: Terminal Value $Total Cash Inflow $Net Cash Inflow$+ve Net Cash Inflow: Accept the Project•Points to consider for Cash Flowso Discount cash flows with cost of capital (Normal Risk). Use higher discount rate for high risk projectso Use incremental cash flows. Ignore Sunk Cost.o Use cash flows net of tax (tax shield)o Don’t include interest expense as it is already incorporated in the discount rate.o Accounting income is adjusted for non-cash items.o Consider opportunity cost.•Capital Budgeting and Income Taxo Tax impact can change your decision. Consider tax implication carefully.o Calculate income and expenses net of taxo CCA is non-cash item but it’s tax deductible. Add back tax saved on CCA to cash flows.o Only half of capital gains are taxable.o Consider impact of investment tax credits or other Government incentives. •Review Project Viabilityo Review project against plano Consider increment cash flows to make analysis. Sunk cost is irrelevant. If incremental cash inflows are more than increment cash outflows, project can be continued.•Internal Rate of Returno IRR is the rate at which Discounted Cash Inflow equal Discounted Cash Outflow. In other words, NPV is zero at IRR.o IRR is actual rate of return of a project.o Compare IRR to Cost of Capital; IRR > Cost of Capital = Accept the project.o Avoid IRR method in fluctuating cash flows.•Profitability Indexo Calculation: PV of Cash Inflows / Initial Investment.o If PI > 1, accept the project•Capital Rationingo Company has more projects with +ve NPV than it has available investment. It has to decide which project to keep.o Rank projects from highest to lowest NPV.o Alternatively, sell project ideas to another company or form a joint venture to raise capital.o Also Companies may want to implement capital rationing in situations where past returns of investment were lower than expected. For example, suppose ABC Corp. has a cost ofcapital of 10% but that the company has undertaken too many projects, many of whichare incomplete. This causes the company's actual return on investment to drop wellbelow the 10% level. As a result, management decides to place a cap on the number ofnew projects by raising the cost of capital for these new projects to 15%. Starting fewernew projects would give the company more time and resources to complete existingprojects.Working Capital Management•Working Capital FinancingIssue: Use ST or LT funds to financePermanent portion of Current Assets s/b funded by LT fundsCurrent portion can be funded with ST fundsCost Benefit Analysis required to decide optimal mix.•Optimal level of Cash & Cash equivalents: arrange for shortfall and invest excess cash. •Credit Policies & ARo Should be reasonable and competitiveo Should not be too tight which result in lost saleso Level of AR depends on Sales, Credit Terms, and Collection Management.o Watch for Aging of AR.o Compare Cash Discount to cost of capital to free AR. If interest rates are lower, don’t offer cash discount. If interest rates are higher, Cash Discount is good.o Factoring can be an option to free AR. But its expensive form of financing. Don’t go for factoring in case of tight margins.•Inventory Managemento Important factors to hold inventorycarrying costdemandavailabilityo The carrying cost of inventory is the cost of maintaining average inventory in warehouse.It includes:-Rent and utilitiesInsurance and taxes on inventoryPhysical inventory and cycle countingInventory shrinkageOpportunity cost of the money invested in inventoryo Just-in Time ApproachSaves carrying costGreat option if lead time shortestIf lead time more, can result in lost sales•Accounts Payable Managemento Negotiate favourable terms with vendors but don’t compromise price. Vendors may charge higher price for extending payment terms.o Take advantage of cash discounts. If cash not available, borrow short term if justified.o Don’t pay interest or penalties by delaying payments.•Cash Flow Planningo Consider all components of Working Capital.o Cash flow problem indicators – slow inventories, delay in collection of AR, past due AP, etco Use Cash BudgetRecord predicted receipts and payments.Find gap in cash and find sources to secure fundsConsider investing excess cash in short term securitiesConsider these items – cash sales, AR collections, AP payments, Wages, Dividend Payments, Tax Instalments, Loan repayments, Interest payments Minimum cash in handUpdate budget on monthly basisExpansion & Divestment Types•Mergers: the combination of two or more companies•Acquisitions: the purchase or acquisition of control by one business entity of another business entity•Joint Ventures: an economic activity resulting from a contractual agreement whereby two or more entities jointly control•Spin Offs: A new company is created from a part of an existing company, with shareholders receiving shares of the new companyMergers & Acquisitionso To achieve economies of scale and pool resourceso To diversify risko To consolidate market shareo Off-set losses by merging loss making company with income generating company for tax purposes.o To control sources of supply (take over)Financial Analysis Techniques•Free Cash Flow / Available Casho CalculationCash from Operations (Net Profit + Amortization/Non-Cash items + Interest-Tax)(-) Capital Expenditure Needs(+)/ (-) Net Working Capital Needs•Horizontal/Trend Analysiso Calculation Over yearso Index of base year set at 100o Useful for Sales and Income analysis•Vertical/Common Size Analysis:o Calculation As % of Totalo Useful for checking relative composition of B/S and I/S items.•Ratio Analysiso Select ratios which are relevanto Normalize data; adjust exceptional itemso Assess ratios collectivelyo Consider qualitative factors•Liquidity Radioso Current RatioAbility to meet short term obligationsCalculation: Current Assets / Current Liabilitieso Quick (Acid Test) RatioMore stringent testCalculation: (Current Assets-Inventory-Prepaid Expenses)/Current Liabilities o AR TurnoverHigher is better to free funds and avoid bad debts.Too low means tight credit policiesCalculation Turnover: Credit Sales/ARCalculation Collection Days:AR/Avg. Daily Credit Sales or 365 Days/AR Turnovero Inventory TurnoverHigher is betterCalculation Turnover: COGS/Avg. Inventory•Performanceo Profit MarginCalculation Gross Margin: Gross Profit / SalesCalculation Operating Margin: EBIT / Saleo Return on AssetsIndicates efficiency of assetsCalculation: Net Income / Total Assetso Return on EquityIndicates return to shareholdersCalculation: Net Income / Shareholders Equity•Leverageo Also known as financial capacity or debt utilization ratioo Debt to Total AssetsIndicates proportion by which assets are financed by debt.Very high not good.Calculation: Total Liabilities / Total Assetso Debt to EquityA measure of a company's financial leverage calculated by dividing its totalliabilities by stockholders' equity. It indicates what proportion of equity and debt thecompany is using to finance its assets.Calculation: Total Liabilities/ Equity or LT Debt/EquityA high debt/equity ratio generally means that a company has been aggressive infinancing its growth with debt. This can result in volatile earnings as a result of theadditional interest expense.o Times Interest EarnedIndicated number of times earnings are before interest and tax.Calculation: EBIT/Interest ExpenseBusiness Valuation•It is determination of value of net assets or ownership interest.Asset Based Approacho Adjusted Net Book Value (Market Values)Adjust assets (for example, provision for doubtful debts, write down obsolete inventory)Deducted Book Value of Intangibles (Exception – Copy rights, patents, franchise rights, etc, which has market value)o Liquidation ValueAssumed as orderly liquidation not forced.Net Realizable Value of Net Assets (-) Liquidation Cost.o Replacement CostUse same approach as Adjusted Net Book Value approach above.Instead of Market Values, use Replacement Cost.Replacement Cost is Cost to buy similar asset including installation cost.Transaction Based Approacho Discounted Cash FlowAnnual Future Cash flows (5-7 years, depending on case facts)- Annual Capital investment+/- Net Working Capital= Annual discretionary cash flowX PV Factor+ Present Value of Terminal/Salvage Value+ Net Realizable Value of Redundant Assets (Not generating operating Cash flows)= Value of Businesso Capitalization of Cash FlowCalculation Annual discretionary cash flow as above.Divide by capitalization rate which is Discount Rate Adjusted for Inflation and Growth.+ Present Value of Terminal Value+ Net Realizable Value of Redundant Assets (Not generating operating Cash flows)= Value of Businesso Capitalization of EarningsBased on Accounting Earnings.Not preferred method, use cash flows instead.o Discounted EarningsBased on Discounted Accounting Earnings.Not preferred method, use cash flows instead.Market Based ApproachValue for publicly traded companiesStock prices may not truly reflect real value of a business.Should be used with other methods.•Depending on case facts, choose appropriate approacho If no going concern – Liquidation Valueo Going concern but not actively operating (H.Co) – Asset Basedo Active Business: Transaction BasedLease vs. BuyAfter you have decided to go for a project based on positive NPV and other factors, now you have to decide whether you should lease or go for loan to have that asset.When you buyo Pay for the entire cost of an asset.o Monthly payments are higher than for leasing (Consider cash flow position)o Typically make a down payment, pay sales taxes in cash or roll them into loano Pay an interest rate determined by Loan Company.o Make first payment a month after you sign your contract.o Later, decide to sell or trade the asset for its depreciated resale or trade value.o Claim CCA on asset value.o Write off interest on loan.When you leaseo Pay only a portion of a asset's cost, which is the part that you "use up" during the time you're using it.o Leasing is a form of financing and is not the same as renting.o Have the option of not making a down payment; you pay sales tax only on your monthly payments.o Pay a financial rate that is similar to the interest on a loan.o May also be required to pay fees and possibly a security deposit that you don't pay when you buy.o Make your first payment at the time you sign your contract.o At lease-end, either return the asset, or purchase it for its depreciated resale value. You may be charged a lease-end disposition fee.o Lessee cannot claim CCA on asset, lessor will.o Entire lease payment can be written off for tax purposes.•Net Value to Leasing (NVL)o NVL represents savings that would result by choosing to lease an asset, as opposed to purchase it outright. The benefit of leasing is determined by comparing the net presentvalue of purchasing the asset outright to the net present value of leasing it.o NVL=Initial Investment Outlay (-) Equivalent Loano Where Initial Investment Outlay is Purchase Price + Delivery & Installation Cost – Any Investment Tax Credit.o Equivalent Loan is amount of cash flows which lessee can use to repay conventional loan. For example, if lessee does not lease but buy asset, he can use the leasepayments to pay the loan. And if he saves some money by leasing asset, it will reducethese payments.。