Corporate Finance

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Corporate Finance

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Risk and Return/ Portfolio Analysis. 3. Cost of Capital. 4. Capital Structure and Firm Value. 5. Dividend Policy. 6. – PowerPoint PPT presentation

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Title: Corporate Finance


1
  • Corporate Finance
  • BBA 2- 2007/8 Term 2.
  • Investment Appraisal.
  • Risk and Return/ Portfolio Analysis.
  • 3. Cost of Capital.
  • 4. Capital Structure and Firm Value.
  • 5. Dividend Policy.
  • 6. Options.

2
Connections throughout the course. Investment
Appraisal Net Present Value with discount rate
(cost of capital) given. Positive NPV increases
value of the firm.
Cost of Capital (discount rate) How do companies
derive the cost of capital? CAPM, DVM.
Capital Structure and effect on Firm Value and
WACC.
3
  • Income Statement.
  • Revenue
  • Variable Costs
  • Fixed costs
  • Depreciation
  • EBIT
  • -rD
  • EBT
  • -tax
  • Net Income
  • -Dividends
  • Retained earnings

Finance Topics. Revenue Risk. Operating
Leverage. Business Risk. Financial
Gearing. Shareholder Risk and Return Dividend
Policy.
4
Income Statement measures the flows of revenues
and expenses during the year. Future Revenues are
uncertain Revenue risk. Production technology
reflected in costs Variable costs and Fixed
Costs. Fixed Costs (operating leverage) affect
EBIT risk gt business risk. Depn is not a cash
flow market Value of firm determined by
cashflow. Debt financing (fixed interest
payments) gt Financial Risk. Net Income is the
residual stream of earnings owned by shareholders
gt affected by business risk and financial
risk. Dividend Policy how much of NI should
board pay as dividend- how much should it retain
to reinvest?
5
Balance Sheet. Liabilities Share Capital
Retained Earnings Equity Debt (eg loans
etc) Total Liabilities
Assets Fixed Assets Current Assets Total Assets
Balance Sheet is a snapshot. Total Assets
Total Liabilities. Book Value of Equity. Topic
Capital Structure (market values).
6
Source and Application of Funds.Net Income
New Equity Dividends New Investment.gt Net
Income Dividends New Investment New Equity
Retained Earnings
7
Managements aim is maximisation of market
value. Market Value of Equity Price Per Share
Number of Shares. Two management decisions
Investment and financing decisions. Capital
Budgeting Decision Select Projects which
maximise Shareholders wealth. Net Present Value
Rule Positive NPV increases shareholder
wealth.
r discount Rate, cost of capital, or Investors
Required Return. X is net cashflow.
8
Section 1 Investment Appraisal. 1. Net Present
Value. Internal Rate of Return (IRR).
Payback. Accounting Rate of Return. 2. Correct
Method NPV! We should only include relevant
costs. We should consider economic not accounting
costs. Cashflows- take costs when they occur.
9
Calculation of Net Present Value. Special Case
Perpetuities.
Example A firm is considering a new project
needs to invest 900, project will provide net
cashflow of 100 forever, the cost of capital is
10. The NPV of this project is 100. Since NPV
is Positive, it should be accepted.
10
Example Consider the following new
project- Initial capital investment of 15m. It
will generate sales for 5 years. Variable Costs
equal 70 of sales. Fixed cost of project 200m
P.A. A feasibility study, cost 5000, has already
been carried out. Discount rate 12. Should we
take the project?
11
DO WE INVEST IN THIS NEW PROJECT?
NPV gt 0. COST OF CAPITAL (12) lt IRR (19.75).
12
Note that if the NPV is positive, then the IRR
exceeds the Cost of Capital.
NPV m
3.3m
Discount Rate
0
12
19.7
13
MUTUALLY EXCLUSIVE PROJECTS.
14
COMPARING NPV AND IRR
NPV
531
519
Discount Rate
10
22.8
25.4
PROJ D
PROJ C
Select Project with higher NPV Project C.
15
  • Mutually Exclusive Versus Independent Projects.
  • -Mutually exclusive we can only select one
    project- we choose the one with the highest NPV
    (project 1).
  • Independent Projects select all positive NPV
    projects (all projects).
  • Capital Rationing.

Project PV of Inflows Current Outflows PVI NPV
1 230,000 200,000 1.15 30,000
2 140,000 125,000 1.12 15,000
3 195,000 175,000 1.11 20,000
4 162,000 150,000 1.08 12,000
16
Capital Rationing And Independent Projects. The
firm is limited to a capital constraint of
300,000. Consider combinations of projects that
maximise weighted average PVI. Eg Projects 2 and
3
Project 1
Selecting Project 2 and 3 is superior to project
1.
17
Treatment of depreciation in NPV analysis. -We
only use cashflows in investment
appraisal. -Depreciation is not a
cashflow. -However, depreciation is allowable
against tax (see income statement), which affects
cashflow. For cashflow, add depreciation back-
18
Treatment of depreciation.
19
  • More Capital Budgeting Topics.
  • Projects with different lives.
  • We assume that projects are replicated at
    constant scale.

For Example Project A 2 years NPV (2)
10. Project B 3 years NPV(3) 14. K
10. Project A NPV(2, 10 ( 1.21/ .21)
57.6. Project B NPV (3, 14 (1.33 / .33)
56.4. Select Project A.
20
Capital Budgeting and Inflation.
K is the nominal cost of capital. We require real
cost of capital, where
Either add inflation to the cashflow estimates,
or remove inflation from the nominal cost of
capital.
21
Section 2 Risk and Return. An investors actual
return is the percentage change in price
Risk Variability or Volatility of Returns, Var
(R). We assume that Returns follow a Normal
Distribution.
Var(R).
E(R)
22
What do we mean by Risk? The risk reflects the
distribution (spread) of expected future
returns. Investors are assumed to be risk-averse
(dont like risk). The higher the spread (risk),
the higher the required return gt current price
adjusts to reflect this. Risk.
Returns
A
B
A
B
Time
B is riskier than A.
23
Risk Aversion. Investors prefer more certain
returns to less certain returns.
U
Wealth
150
100
200
Risk Averse Investor prefers 150 for sure than a
50/50 gamble giving 100 or 200.
24
Portfolio Analysis. Two Assets Investor has
proportion a of Asset X and (1-a) of Asset Y.
Combining the two assets in differing proportions.
E(R)
25
Portfolio of Many assets Risk Free Asset.
E(R)
Efficiency Frontier.
M

.


X



All rational investors have the same market
portfolio M of risky assets, and combine it with
the risk free asset. A portfolio like X is
inefficient, because diversification can give
higher expected return for the same risk, or the
same expected return for lower risk.
26
The Effect of Diversification on Portfolio
Variance.
Number of Assets.
An assets risk Undiversifiable Risk
Diversifiable Risk Market Risk Specific
Risk. Market portfolio consists of
Undiversifiable or Market Risk only.
27
Summary of Risk and Return Investors are assumed
to be risk averse. They combine assets to
diversify (reduce) risk. The more assets, the
lower the specific risk. The market portfolio
diversifies away all specific risk, and contains
all assets in the right proportions.
Implications for Investors. Current share prices
(which affect expected returns) are such that the
market only rewards investors for holding market
risk, not specific risk. Implications for
Individual Firms. Cost of Capital
(Investors required return) should only reflect
Market Risk (Beta CAPM).
28
  • Section 3 Cost of Capital.
  • Investors Required Return on their investment in
    a company.
  • Cost Of Debt Coupon Rate.
  • Cost of Equity.
  • 2 methods to estimate cost of equity- Capital
    Asset Pricing Model (CAPM), and Dividend
    Valuation Model (DVM).
  • CAPM.

(beta) is a measure of risk.
CAPM shows the higher the risk, the higher the
required return.
29
What do we mean by Risk? The risk reflects the
distribution (spread) of expected future
returns. Investors are assumed to be risk-averse
(dont like risk). The higher the spread (risk),
the higher the required return. Risk.
A
B
A
B
Time
B is riskier than A.
30
Risk Aversion. Investors prefer more certain
returns to less certain returns.
U
Wealth
150
100
200
Risk Averse Investor prefers 150 for sure than a
50/50 gamble giving 100 or 200. He will require
a higher return to take the gamble Hence CAPM.
31
CAPM.
E(r)
E(rm)
1
Beta is a measure of Undiversifiable
Risk. Investors can hold a portfolio of shares-
this diversifies away some of the risk. What
remains is undiversifiable. From Companys point
of view, cost of equity is the required return
for the shareholders, given the companys
undiversifiable risk.
32
Estimating Cost of Equity Using Regression
Analysis. We regress the firms past share price
against the market.
33
Dividend Valuation Model.
The Cost of Equity is the Investors required
return, and affects current market
price. Interchangeability- Given current market
price and expected cashflows, we can estimate
cost of equity, or, given cost of equity and
expected cashflows, we can calculate market value
of equity.
34
Section 4 Capital Structure and Firm
Value. Value of the firm Discounted Value of
future cashflows available to the providers of
capital. Value of the firm Value of Equity
Value of debt.
where
35
Miller- Modigliani Irrelevance Theorem.
Two firms, identical cashflows, same risk, but
one firm is unlevered, the other is levered.
Irrelevance Theorem Without Tax, Firm Value is
independent of the Capital Structure.
36
K
K
Without Taxes
With Taxes
D/E
D/E
V
V
D/E
D/E
37
Comparing MM and CAPM.
Type Of Capital CAPM Equation MM Equation
Debt
Unlevered Equity
Levered Equity
WACC
38
Capital Structure Irrelevance without
taxes. Example A firm has annual NCF 100K.
(cashflow is a perpetuity.) Risk free rate rf
7. E(rm) 17. Debt/TA 20. Cost of levered
equity (from CAPM) 12. WACC 11. V
100/0.11 909K. Now it changes its capital
structure to Debt/TA 35. Levered Beta will
change, to 0.61 gt cost of levered equity 13.2
gt WACC 11 gt V 909K.
39
Example Firm A current capital structure Debt/
TA 20. Risk free rate 7. Tax rate 50.
Systematic risk of firms equity,
A. Change Capital Structure, and take on new
project of same operating risk as current
risk. new project has 9.25 expected return. What
is firms current WACC, and new WACC? Should it
take new project?
40
  • Solution
  • Calculate current cost of equity, using CAPM.
  • Ke .07 0.17-.070.5 0.12.
  • 2. Therefore, current WACC 10.3.

3. Calculate unlevered cost of equity. From MM
4. Calculate new WACC using MM New WACC
9.44. Therefore, firm should not take new
project, even at 35 debt.
41
B. Comparing projects with different
risks. Project 1 required date 0 investment
100, Expected NCF at date 1 135, Systematic
risk, Project 2 required date 0 investment
100, Expected NCF at date 1 130, Systematic
risk, Solution Project 1 Cost of Unlevered
Equity for the new project, using CAPM
19. WACC for the new project, at 20 debt, using
MM 17.1 gt NPV 15.29. Project 2 Cost of
unlevered equity 13. WACC at 20 debt, 11.7
gt NPV 16.39. Select Project 2.
42
  • Although project 1 has a higher return than
    project 2, it is also riskier. Investors require
    a higher return for project 1.
  • So, project 2 is selected.
  • Capital Budgeting- each project must be evaluated
    at a cost of capital reflecting
  • Business Risk.
  • And Financial Leverage.

43
Separability of Financing and Investment
Decisions. Implication of MM Irrelevance Theorem
A firms financing decision is separate from
its investment decision. Pie Model of firm value.
D
Equity
DEBT
E
MM said it does not matter how you slice the pie
between debtholders and equity holders- total
size of pie is the same.
44
Combining Tax Relief and Debt Capacity
(Traditional View).
K
V
D/E
D/E
45
Trade-Off View of Optimal Capital Structure.
V
Eg Agency Costs/ signalling
D/E
K
D/E
46
Optimal Capital Structure. Under MM irrelevance,
value of firm is independent of capital
structure. Capital structure does not
matter. Reasons for Optimal Capital
Structure. Taxes. Bankruptcy Costs. Debt Capacity
(traditional view). Agency Costs (Selfish
Manager). Signalling. We provide an overview of
Agency Costs and signalling - will be covered in
depth in the 4th Year Course.
47
  • MM Irrelevance Theorem- Firm Value and WACC
    independent of Capital Structure- Capital
    Structure does not matter- Pie Model.
  • Problem No prescription to firms on how to
    finance projects.
  • Introduce tax relief on debt gt 100 debt!
  • Personal Taxes.
  • Bankruptcy Costs.
  • Traditional View.

48
  • MM Irrelevance Theorem- Firm Value and WACC
    independent of Capital Structure- Capital
    Structure does not matter- Pie Model.
  • Problem No prescription to firms on how to
    finance projects.
  • Introduce tax relief on debt gt 100 debt!
  • Personal Taxes.
  • Bankruptcy Costs.
  • Traditional View.

49
Agency Costs (Selfish Manager). Jensen and
Meckling (1976). If firm issues equity (reduced
managerial ownership of firm value), Manager
pursues private benefits (private jet, plush
offices, time off to play golf), reducing firm
value. -If firm issues debt, manager has
incentive to take risky projects
(risk-shifting). Trade-off Optimal Capital
Structure.
V
D/E
D/E
50
Agency Costs (continued). Hart (1984)- Effort
Level. Equity holders are soft- Manager can
reduce effort. Debt holders can liquidate the
firmgt Bankruptcy gt manager losing job. This
threat may lead to manager working harder gt
Increasing firm value. Therefore, increasing debt
increases firm value.
51
Agency Costs- Continued. Free cashflow (Jensen
1986). -Managers may have pet negative NPV
projects. Equity gt free cashflow gt managers
can take these bad projects gt firm value
falling. Debt gt reduces free cashflow. Managers
cannot take the bad projects gt Firm value
rises. - Important in Mergers- See 4th year
course.
52
Asymmetric Information. Manager has inside
information. Issuing debt or equity may reveal
this information to the market. Myers-Majluf. -Fir
m has 50/50 chance of good or bad news. Market
values this firm at an average. Then Manager
observes this news market does not. If bad news
arrives, firm is currently overvalued in the
market manager will issue shares This signals
bad news, and share price falls. If Good news
arrives, firm is undervalued in the market, and
manager will not issue shares. Therefore, Issuing
equity signals bad news, firm value falls.
53
Asymmetric Information (continued). Ross (1977)-
Debt has bankruptcy threat. Manager has
compensation based on firm value, but is
penalised financially if firm goes
bankrupt. Market cannot observe whether manager
is good or bad. Good manager issues debt- signals
that he is not too worried about bankruptcy
therefore, firm value rises. Bad Manager is
worried about bankruptcy- does not issue debt.
Firm Value falls. Empirical Evidence- Issuing
equity causes firm value to fall- Debt causes
firm value to rise- contrary to MM. Agency Costs
and Signalling are explored in more detail in 4th
YR.
54
Section 5 Dividend
Policy. Assume All equity firm. Value of Firm
Value of Equity discounted value of future
cashflows available to equity holders
discounted value of dividends (if all available
cashflow is paid out).
If everything not reinvested is paid out as
dividends, then
55
Miller Modiglianis Dividend Irrelevance.
MM used a source and application of funds
argument to show that Dividend Policy is
irrelevant
Source of Funds Application of Funds
56
-Dividends do not appear in the equation. -If the
firm pays out too much dividend, it issues new
equity to be able to reinvest. If it pays out too
little dividend, it can use the balance to
repurchase shares. -Hence, dividend policy
irrelevant. -Key is the availability of finance
in the capital market.
57
Example of Dividend Irrelevance using Source and
Application of Funds. Firm invests in project
giving it NCF 100 every year, and it needs to
re-invest, I 50 every year. Cashflow available
to shareholders NCF I 50. Now, NCF I
Div NS 50. If firm pays dividend of 50, NS
0 (ie it pays out exactly the cashflow available
no new shares bought or sold). If firm pays
dividend of 80, NS -30 (ie it sells new shares
of 30 to cover dividend). If firm pays dividend
of 20, NS 30 (ie it uses cashflow not paid out
as dividend to buy new shares). In each case, Div
NS 50.
58
Gordon Growth Model. Where does growth come
from?- retaining cashflow to re-invest.
Constant fraction, K, of earnings retained for
reinvestment. Rest paid out as dividend. Average
rate of return on equity r. Growth rate in
cashflows (and dividends) is g Kr.

59
Example of Gordon Growth Model.
How do we use this past data for valuation?
60
Gordon Growth Model
(Infinite Constant Growth Model). Let

61
  • Finite Supernormal Growth.
  • Rate of return on Investment gt market required
    return for T years.
  • After that, Rate of Return on Investment Market
    required return.

If T 0, V Value of assets in place
(re-investment at zero NPV). Same if r
62
Examples of Finite Supernormal Growth.
T 10 years. K 0.1.
  • Rate of return, r 12 for 10 years,then 10
    thereafter.

B. Rate of return, r 5 for 10 years,then 10
thereafter.
63
Comparison of Gordon Growth and MM
Irrelevance. A. In MM irrelevance, NCF I is
fixed each period. Dividends and NS balance out.
Capital freely available. B. In Gordon Growth,
NCF (1-K) NCF I Divs. No New
shares. Dividends affect reinvestment I, which
affects growth and value. Another School of
Thought considers the signalling properties of
dividends this will be covered in the 4th year
course.
64
Section 6 Options as Financial Building
Blocks. A call option gives the holder the right
(but not the obligation) to buy shares at some
time in the future at an exercise price agreed
now. A put option gives the holder the right (but
not the obligation) to sell shares at some time
in the future at an exercise price agreed
now. European Option Exercised only at maturity
date. American Option Can be exercised at any
time up to maturity. For simplicity, we focus on
European Options.
65
  • Factors Affecting Price of European Option (c).
  • -Underlying Stock Price S.
  • -Exercise Price X.
  • Variance of of the returns of the underlying
    asset ,
  • Time to maturity, T.

The riskier the underlying returns, the greater
the probability that the stock price will exceed
the exercise price. The longer to maturity, the
greater the probability that the stock price will
exceed the exercise price.
66
Combining options, graphic presentation. Buying a
Call Option.
Selling a put option.
Selling a Call Option.
Buying a Put Option.
67
Long in Stock
Buy a Bond
Sell a Bond
Short in Stock
S P B C. S P C B.
Other Combinations Spread, Straddle, Straps and
strips. See Exercise.
68
Equity as a Call Option. Black and Scholes
pointed out that equity is a call option on the
value of the levered firm. If Value of firm
exceeds face value of debt (exercise price of
call option), equityholders pay the exercise
price, and gain the increase in value. If value
of firm is less than face value of debt, option
is not exercised. Risky debt risk-free debt
put option (B P).
69
Building Blocks. S P B C for Option. V
P B S for levered firm. gt V (B P)
S. S Max 0, V D . Equity call
option. B P Min V, D . Risky debt risk
free debt put option. Therefore, V ( B P )
S.
S
B-P
V
V
D
D
70
Important Implications for Firm. Equity is a call
option Value of Equity in creases with
risk. Value of Put option increases with risk
Therefore value of debt decreases with
risk. After all, Equity holders have limited
liability, and S Max 0, V D . B P
Min V, D . With (B P) S V. Therefore,
if S increases, ( B P) decreases. Equity
holders will want to choose riskier projects.
71
Pricing Call Options Binomial Approach.
Cu 3
uS24.00
q
q
c
S20
1- q
1- q
dS13.40
Cd0
  • S 20. q0.5. u1.2. d.67. X 21.
  • 1 rf 1.1.
  • Risk free hedge Portfolio Buy One Share of Stock
    and write m call options.
  • uS - mCu dS mCd gt 24 3m 13.40.
  • M 3.53.
  • By holding one share of stock, and selling 3.53
    call options, your payoffs are the same in both
    states of nature (13.40) Risk free.

72
Since hedge portfolio is riskless
1.1 ( 20 3.53C) 13.40. Therefore, C
2.21. This is the current price per call option.
The total present value of investment 12 .19,
and the rate of return on investment is 13.40 /
12.19 1.1.
73
  • Application of Options- Convertible Debt.
  • Convertible Debt gives the holder the right (but
    not the obligation) to convert bonds into equity
    at a future date.
  • Convertible debt is a combination of straight
    debt plus a call option.
  • We saw that straight debt risky debt a put
    option.
  • CD D C B P C .
  • Implication Value of Convertible debt increases
    with risk of firms cashflows, and time to
    maturity.
  • -See CD exercise.
  • more detailed analysis of convertible debt in 4th
    year advanced finance course.