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Title: CORPORATE FINANCE MANAGEMENT 2


1
CORPORATE FINANCE MANAGEMENT 2
Master Course VŠFS Fall 2012 Irena
Jindrichovská irena.jindrichovska_at_mail.vsfs.cz
2
Literature
  • Brigham, E and Ehrhardt, M (2004) Financial
    management theory and practice, 13th ed.,
    Thomson Learning ISBN-10 0324259689 ISBN-13
    9780324259681
  • Other recommended sources
  • Brealey, R., Myers, S. and Allen, F. (2006)
    Corporate Finance, 8th international ed.,
    McGraw-Hill ISBN 0-07-111795-4
  • Ross, Westerfield Jaffe Fundamentals of
    Corporate Finance, 4th edition
  • Bender and Ward Corporate Financial Strategy,
    3rd ed. Butteworth-Heinemann, 2009
  • More sources may be recommended in lectures

3
Teaching plan
  • Regular studies
  • 12 hours lectures 6 hours excercises
    presentation of own work
  • Assignment conditions - essay on topic given
    active participation in seminars
  • Exam Written exam consisting of short essays and
    calculations

4
Outline of the course
  1. Introduction to Corporate finance management
  2. Mergers and acquisitions
  3. Cost of capital and capital structure
  4. Strategy and tactics of financing decisions -
    investment decision making
  5. Capital Restructuring and Multinational Fin.
    Management
  6. Lease Financing and Working Capital Management
  7. Risk Management and Real Options

5
INTRODUCTION TO CORPORATE FINANCE MANAGEMENT
6
Outline Lecture 1
  • Introduction
  • Capital structure
  • Company lifecycle
  • Role of financial manager
  • Financial markets
  • Agency theory
  • Stakeholders theory
  • Summary, exercises, references

7
Introduction to Corporate Finance
  • Basic questions not only from corporate finance
  • What long-term investment strategy should a
    company take on?
  • How can cash be raised for the required
    investments?
  • How much short-term cash flow does a company need
    to pay its bills?

8
The Balance-Sheet Model of the Firm
  • Current assets
  • Net working capital
  • Fixed assets
  • Tangible fixed assets
  • Intangible fixed assets
  • Current liabilities
  • Long term debt
  • Shareholders equity

9
Capital Structure
  • Financing arrangements determine how the value of
    the firm is sliced up.
  • The firm can then determine its capital
    structure.
  • Capital structure changes in the lifetime of the
    firm

10
Capital Structure
  • The firm might initially have raised the cash to
    invest in its assets by issuing more debt than
    equity
  • Later again it can consider changing that mix by
    issuing more equity and using the proceeds to buy
    back some of its debt

11
Life Cycle of the company and its funding
  • Boston Consulting Group Matrix
  • Axes
  • horizontal speed of growth of the market share
  • vertical market share
  • Start-up
  • Growth
  • Maturity
  • Decline
  • Each phase requires different approach to
    financial management according to generated
    Cash Flow

12
Life Cycle of the company II
Maturity Low investment need High CF generated Growth High investment need High CF generated
Decline Low investment need Low CF generated Start up High investment need Low CF generated
13
Role of the Financial Manager
  • 1. The firm should try to buy assets that
    generate more cash than they cost.
  • 2. The firm should sell bonds and stocks and
    other financial instruments that raise more cash
    than they cost.

14
Role of the Financial Manager
  • The firm must create more cash flow than it uses.
  • The cash flows paid to bondholders and
    stockholders of the firm should be higher than
    the cash flows put into the firm by the
    bondholders and stockholders.

15
Financial Markets
  • Primary and secondary markets
  • Spot and forward markets
  • Money markets
  • Equity markets
  • Organized and over-the-counter markets
  • LSE, AMEX, NYSE NASDAQ
  • Derivative markets
  • LIFFE, CBOT

16
Primary and secondary markets1
  • Help to get financing for companies
  • Investment companies
  • Pool together and manage the money of many
    investors
  • Arrange corporate borrowings and security issues
  • Issuing process

17
Primary and secondary markets2
  • Establish the price of securities through supply
    and demand
  • Execute and settle the transaction
  • Guarantee the settlement through the Clearing
    house- a special institution connected with each
    Stock Exchange
  • There is also a securities exchange commission
    (SEC ) setting the standards and rules of listing

18
Agency Theory
  • There are two groups with different interest in
    each corporation Shareholders and Managers
  • Goals of shareholders and managers are not the
    same
  • Jensen and Meckling (1976) Theory of the Firm
    Managerial Behavior,Agency Costs and Ownership
    Structure, JFE 1976
  • Defined Principal Agent relation

19
Principal - Agent
  • Owners i.e. Shareholders are Principals
  • Managers are Agents
  • Shareholders want value of their firm to be
    maximized
  • Managers should act on principals behalf but
    have different goals

20
Management Goals
  • Survival - avoid risky business decisions
  • Selfsufficiency prefer internal financing to
    issuance of new stock
  • Shareholders need to control management Agency
    Costs
  • Monitoring costs
  • Incentive fees to convince management to act in
    shareholders interest

21
Control methods
  • Directors are voted by Shareholders and
    management is selected by directors
  • Management compensation methods
  • Stock option plan
  • Bonuses
  • Performance shares
  • Threat of takeovers
  • Competition on management labor market

22
Stakeholders theory
  • All interested parties that have some relation to
    the company
  • Shareholders
  • Employees
  • Creditors
  • Banks
  • Suppliers
  • Clients
  • Environment
  • Municipalities

23
Summary
  • 1. The goal of financial management in a
    for-profit business is to make decisions that
    increase the value of the stock, or, more
    generally, increase the market value of the
    equity.
  • 2. Business finance has three main areas of
    concern
  • a. Capital budgeting. What long-term investments
    should the firm take?
  • b. Capital structure. Where will the firm get the
    long-term financing to pay for its investments?
    In other words, what mixture of debt and equity
    should we use to fund our operations?
  • c. Working capital management. How should the
    firm manage its everyday financial activities?

24
Summary 2
  • 3. The corporate form of organization is superior
    to other forms when it comes to raising money and
    transferring ownership interests, but it has the
    significant disadvantage of double taxation.
  • 4. There is the possibility of conflicts between
    stockholders and management in a large
    corporation. We call these conflicts agency
    problems and discussed how they might be
    controlled and reduced.

25
Exercise problems
  • Define and compare the three forms of
    organisation a proprietorship, a partnership and
    a corporation.
  • Explain the agency problem and discuss the
    relationship between managers and shareholders
  • What are the two types of agency costs?
  • How are managers bonded to shareholders?
  • Can you recall some managerial goals?
  • What is the set-of-contracts perspective?

26
Useful web source
  • On Agency theory A review paper
  • http//classwebs.spea.indiana.edu/kenricha/Oxford/
    Archives/Oxford202006/Courses/Governance/Articles
    /Eisenhardt20-20Agency20Theory.pdf

27
RECOMENDED READINGS
  • Brigham and Houston Fundamentals of Financial
    Management, 12th ed, Ch 1
  • Ross, Westerfield Jaffe Fundamentals of
    Corporate Finance, 4th edition Ch 1 and 2
  • Bender and Ward Corporate Financial Strategy,
    3rd ed. Butteworth-Heinemann, 2009, Ch 2

28
COST OF CAPITAL AND CAPITAL STRUCTURE
29
Outline
  • Introduction
  • Sources of long term financing
  • Debt versus equity
  • Long term debt
  • Preferred shares
  • Retained earnings
  • Newly issued shares,
  • Gordon model, debt plus risk premium, CAPM
    approach
  • WACC
  • Value of a company
  • Summary, exercises, references

30
Equity versus debt
Feature Equity Debt
Income Dividends Interest
Tax status Taxed as personal income. Are not business expense Taxed as personal income. Are business expense
Control Common stocks (sometimes preferred) usually have voting right Control is exercised with loan agreement
Default Firms cannot become bankrupt for nonpayment of dividends Unpaid debt is a liability. Nonpayment results in bankruptcy
Bottom line Tax status favours debt, but default favours equity. Control features of debt and equity are different but one is not better than other Tax status favours debt, but default favours equity. Control features of debt and equity are different but one is not better than other
31
Long term debt
  • Loans and bonds
  • Loans (interest is paid before taxes creation
    of tax shield, that lowers the cost of L/T debt)
    T tax rate
  • Bonds (yield to maturity)

32
Preferred shares
  • Perpetuity P C/r i.e.
  • kp C / P
  • May need to take in consideration issuance cost
    (flotation cost F)
  • kp C / (P-F)

33
Cost of retained equity
  • Using Gordon model of growing perpetuity
  • PD1/ (r-g) i.e.
  • ks (D1 / P) g

34
Cost of new equity
  • Using Gordon model of growing perpetuity taking
    in consideration flotation cost
  • ke (D1 / (P-F)) g

35
The CAPM approach
  • Estimate using the CAPM
  • Estimate of risk free rate rRF
  • Estimate the market premium RPM
  • Estimate the stocks beta coefficient bs
  • Substitute in the CAPM equation

36
Bond yield plus risk premium approach
  • Some analysts us an ad hoc procedure to estimate
    the firms cost of common equity
  • Adding a judgmental risk premium (3-5)
  • rs bond yield bond risk premium
  • It is logical to think that firms with risky, low
    rated high-interest-rate debt will also have
    risky high-cost equity

37
WACC
  • Weighted average cost of capital one way of
    measuring cost of capital of a company
  • WACCwdkd wpkp ws(e) ks(e)
  • Another way may be estimating through market
    model (SML) ex-post valuation

38
Factors that affect the weighted average cost of
capital
  • Factors that firm cannot control
  • The level of interest rates
  • Market risk premium
  • Tax rates
  • Factors the firm can control
  • Capital structure policy
  • Dividend policy
  • Investment policy

39
Summary
  1. Earlier chapters on capital budgeting assumed
    that projects generate riskless cash flows. The
    appropriate discount rate in that case is the
    riskless interest rate. Of course, most cash
    flows from real-world capital-budgeting projects
    are risky. This chapter discusses the discount
    rate when cash flows are risky.
  2. A firm with excess cash can either pay a dividend
    or make a capital expenditure. Because
    stockholders can reinvest the dividend in risky
    financial assets, the expected return on a
    capital-budgeting project should be at least as
    great as the expected return on a financial asset
    of comparable risk.

40
Summary 2
  • 3. The expected return on any asset is
    dependent upon its beta. Thus, we showed how to
    estimate the beta of a stock. The appropriate
    procedure employs regression analysis on
    historical returns.
  • We considered the case of a project whose beta
    risk was equal to that of the firm.
  • If the firm is unlevered, the discount rate on
    the project is equal to RF( M - RF)ß
  • where M is the expected return on the market
    portfolio and RF is the risk-free rate. In words,
    the discount rate on the project is equal to the
    CAPMs estimate of the expected return on the

41
Exercise questions
  1. Describe the various sources of capital.
  2. Describe the optimal capital structure.
  3. Explain the concept weighted average cost of
    capital (WACC).
  4. Explain how to calculate a value of a firm using
    WACC.

42
Exercise problem 1
  • 12.13 RWJ
  • Calculate the weighted average cost of capital
    for the Luxury Porcelain Company.
  • The book value of Luxurys outstanding debt is
    60 million. Currently, the debt is trading at
    120 percent of book value and is priced to yield
    12 percent. The 5 million outstanding shares of
    Luxury stock are selling for 20 per share. The
    required return on Luxury stock is 18 percent.
    The tax rate is 25 percent.

43
Exercise problem 2
  • 12.14 RWJ
  • First Data Co. has 20 million shares of common
    stock outstanding that are currently being sold
    for 25 per share. The firms debt is publicly
    traded at 95 percent of its face value of 180
    million. The cost of debt is 10 percent and the
    cost of equity is 20 percent. What is the
    weighted average cost of capital for the firm?
    Assume the corporate tax rate is 40 percent.

44
Useful web sources
  • Online Tutorial 8 How Do You Calculate A
    Company's Cost of Capital?
  • http//www.expectationsinvesting.com/tutorial8.sht
    ml
  • And a video lecture (rather easy)
  • http//www.youtube.com/watch?vJKJglPkAJ5o

45
RECOMENDED READINGS
  • Fundamentals of Corporate Finance, Ross,
    Westerfield and Jaffe, 6 th edition. Ch 12
  • Brigham and Houston Fundamentals of Financial
    Management, 12th ed, Ch 10

46
MERGERS AND TAKEOVERS
47
Outline
  • Introduction
  • Mergers ad acquisition rationale
  • Underling principles
  • Business motives for acquisitions
  • Financial strategy
  • Price reaction n acquisition announcement
  • Takeover defense
  • Summary, exercises, references

48
Mergers and Acquisitions
  • Mature companies try to reverse or accelerate the
    life cycle through dynamic changes in the
    structure of the business by mergers or
    acquisitions
  • Two businesses combine into one
  • Mergers are rare ? Acquisitions
  • Larger and smaller company ? acquirer and target
    company

49
Underlying principles
  • Combined future CFs are bigger than sum of CFs
    of two individual companies
  • Not in case of large premium paid to shareholders
    of the target
  • (90-125 of exp. value of the synergy has been
    paid to the sellers) - better to be seller then
    buyer

50
MAs market imperfections
  • Asymmetric price reaction on acquisition
    announcement
  • Target company is undervalued in the market
    (inefficient market)
  • Participants do not agree on the price of the
    target company stock
  • ? Synergy effect (225)

51
Source of synergy from acquisitions
  • Revenue Enhancement
  • Marketing Gains
  • Strategic Benefits
  • Market or Monopoly Power
  • Cost Reduction
  • Economies of Scale
  • Economies of Vertical Integration
  • Complementary Resources
  • Elimination of Inefficient Management

52
Source of synergy from acquisitions 2
  • Tax Gains
  • Net Operating Losses
  • Unused Debt Capacity
  • Surplus Funds
  • The Cost of Capital

53
Two bad reasons for mergers
  • Earnings Growth
  • EPS Game
  • Diversification
  • Systematic variability cannot be eliminated by
    diversification, so mergers will not eliminate
    this risk at all. By contrast, unsystematic risk
    can be diversified away through mergers.

54
Influence of innovative products
  • Management may forget the underlying principles
    justifying MA
  • Target company must be worth more than it will
    cost the acquirer

55
Cash versus Common Stock
  • Whether to finance an acquisition by cash or by
    shares of stock is an important decision.
  • The choice depends on several factors, as
    follows
  • 1. Overvaluation. If in the opinion of management
    the acquiring firms stock is overvalued, using
    shares of stock can be less costly than using
    cash.
  • 2. Taxes. Acquisition by cash usually results in
    a taxable transaction. Acquisition by exchanging
    stock is tax free.

56
Cash versus Common Stock 2
  • 3. Sharing Gains. If cash is used to finance an
    acquisition, the selling firms shareholders
    receive a fixed price. In the event of a hugely
    successful merger, they will not participate in
    any additional gains. Of course, if the
    acquisition is not a success, the losses will not
    be shared and shareholders of the acquiring firm
    will be worse off than if stock were used.

57
Financial strategy in acquisitions
  • Financial role - to evaluate the synergy effect
  • Strategy - change the financial structure of
    target company ? leverage the company
  • Target company with cash surpluses (mature group)
    ? Corporate raider acquires the company, strips
    it off the cash and leverages the company

58
Diversified companies
  • Diversified group should be valued at minimum
    weighted average P/E applicable to its component
    businesses
  • If the company does not perform well after
    acquisition ? sell parts of the group for higher
    P/E divestiture, spin-offs,

59
Greenmailing
  • Significant minority impacts on the corporate
    strategy
  • Raider buys a significant part of the co. which
    he considers undervalued and greenmails the
    management, asserting that the company is badly
    managed
  • Management buys him out ? cash drain

60
EPS game
  • Growth in P/E is automatically created by an
    equity funded acquisition if P/E of bidder gt P/E
    of target
  • If companies have the same P/E multiple
  • And financial structure of target company is
    changed ? debt instead of equity
  • EPS of the group ?
  • However, increased growth prospects are offset by
    ? financial risk due to ? debt

61
EPS game
  • Company A is considering acquiring companies B,
    C, and D but it wishes to ensure that each deal
    increases EPS. Finance can be raised through
    equity or debt or through any other financial
    mechanism. After-tax cost of debt 5.

62
Acquirer A no of shares 10 000 000 A no of shares 10 000 000 A no of shares 10 000 000 A no of shares 10 000 000
  share price () 1   share price () 1   share price () 1   share price () 1
  PAT () 1 000 000   PAT () 1 000 000   PAT () 1 000 000   PAT () 1 000 000
  EPS () 0,1   EPS () 0,1   EPS () 0,1   EPS () 0,1
  P/E 10   P/E 10   P/E 10   P/E 10
               
Target B no of shares 5 000 000 C no of shares 10 000 000 D no of shares 1 000 000 D no of shares 1 000 000
  share price () 1   share price () 0,5   share price () 5,0   share price () 5,0
  PAT () 1 000 000   PAT () 500 000   PAT () 250 000   PAT () 250 000
  EPS () 0,2   EPS () 0,05   EPS () 0,25   EPS () 0,25
  P/E 5   P/E 10   P/E 20   P/E 20
  P/EA gt P/EB     P/EA P/EC     P/EA lt P/ED     Invert the transaction ! Invert the transaction !
                       
Deal   A issues 5 mil shares at 1 A issues 5 mil shares at 1   A issues 5 mil debt for (5) A issues 5 mil debt for (5)   A issues 5 mil shares at 1 A issues 5 mil shares at 1   D issues 2 mil shares at 5 D issues 2 mil shares at 5
structure   and buys B     and buys B     and buys D     and buys A  
  New shares 5 000 000   New shares 0   New shares 5 000 000   New shares 2 000 000
               
      New debt 5 000 000        
      cost of debt 250 000        
               
Result AB no of shares 15 000 000 AC no of shares 10 000 000 AD no of shares 15 000 000 DA no of shares 3 000 000
  PAT () 2 000 000   PAT () 1 250 000   PAT () 1 250 000   PAT () 1 250 000
  EPS () 0,133   EPS () 0,125   EPS () 0,083   EPS () 0,417
  P/E 7,5   P/E 10   P/E 12   P/E 12
  share price () 1,00   share price () 1,25   share price () 1,00   share price () 5,00
63
Higher growth companies
  • EPS bidding lt EPS target
  • P/E bidding lt P/E target
  • Post-acquisition P/E ? to appropriate weighted
    average of the original businesses
  • EPS ? because bidding company is larger than
    target company

64
Takeover defense
  • Pre-offer defense
  • Shark repellent
  • Staggered board
  • Quorum
  • Poison pills
  • Re-capitalization with special right shares
  • Post offer defense
  • Pacman defense
  • Violation of antitrust law
  • Change of asset structure
  • Change of liabilities structure

65
Summary
  • The synergy from an acquisition is defined as the
    value of the combined firm (VAB) less the value
    of the two firms as separate entities (VA and
    VB), or Synergy VAB - (VA VB)
  • The shareholders of the acquiring firm will gain
    if the synergy from the merger is greater than
    the premium.
  • The three legal forms of acquisition are merger
    and consolidation, acquisition of stock, and
    acquisition of assets.
  • Mergers and acquisitions require an understanding
    of complicated tax and accounting rules

66
Summary 2
  • 4. The possible benefits of an acquisition come
    from
  • a. Revenue enhancement, b. Cost reduction, c.
    Lower taxes, d. Lower cost of capital
  • The reduction in risk from a merger may help
    bondholders and hurt stockholders.
  • 5. The empirical research on mergers and
    acquisitions is extensive. Its basic conclusions
    are that, on average, the shareholders of
    acquired firms fare very well, while the
    shareholders of acquiring firms do not gain much.

67
Exercise problems
  1. Do MAs create value at all?
  2. Who are the main beneficiaries of MA in the
    short term / long term?
  3. In an efficient market with no tax effects,
    should an acquiring firm use cash or stock?
  4. Explain the Japanese Keiretsu, how does it
    function?
  5. MA valuation problem on separate sheet

68
Useful web sources
  • A book on Mergers and acquisitions by Weston and
    Weaver (2001) - book preview
  • http//www.google.com/books?hlcslridY2Mz7tOuJ
    BgCoifndpgPP9dqmergersandacquisitionsots
    85kGKKGutcsigiY_Ztx8tQY42Kzmw2-UrVp25rTMvonepa
    geqmergers20and20acquisitionsftrue

69
Useful web source 2
  • Characteristics of takeover defense strategies
  • http//www.investopedia.com/articles/stocks/08/cor
    porate-takeover-defense.aspaxzz29MjA54dw

70
RECOMENDED READINGS
  • Fundamentals of Corporate Finance, Ross,
    Westerfield and Jaffe, 4th edition. Ch 29
  • Brigham and Houston Fundamentals of Financial
    Management, 12th ed, Ch 15

71
CAPITAL STRUCTURE
72
Outline
  • Capital structure concept maximizing value
  • Optimal capital structure
  • MM Theory of Independence
  • MM Theory of Dependence
  • Taxes and financial leverage
  • Cost of financial distress and agency costs
  • EBIT-EPS analysis
  • Summary, exercises, references

73
Goal of capital structure management
  • Maximize the share price
  • Minimize the weighted average cost of capital
  • Too big financial leverage can bring firm to
    bankruptcy
  • Too small financial leverage leads to
    undervaluing of share price

74
Miller Modigliani (1958)
  • The Cost of Capital, Corporation Finance and the
    Theory of Investment, American Economic Review
    48 261-297

75
Importance of capital structure
  • Cost of capital is one of the cost and therefore
    influence dividends
  • If the cost of capital are minimized, the
    payments to shareholders is maximized
  • If the cost of capital can be determined by
    corporate capital structure then the capital
    structure management is an important part of firm
    management

76
Assumptions
  • The share price is a perpetuity P0 Dt/Kc
  • The firm pays constant dividends
  • Dividend-Pay-Out 100, i.e. no retained
    earnings
  • There are no taxes
  • Capital structure consists of Debt Equity only

77
Further assumptions
  • Financial structure is modified by issuing new
    shares to buy out debt or the other way around
  • EBIT is assumed to remain constant
  • Shares and other securities are traded on
    efficient market

78
Proposition I. Independence Hypothesis
  • The cost of capital of the firm (K0) and share
    price P0 are both independent on capital
    structure (financial leverage)
  • Total market value of the firm securities stays
    unchanged disregarding the degree of leverage
    (picture)
  • The basic relation of Independence Hypothesis
    Percentage change of cost of equity Kc
    Percentage change in dividends Dt

79
Proposition II. Dependence Hypothesis
  • Both the cost of capital (K0) and share price
    (P0) are influenced by firms capital structure
  • Weighted average cost of capital (K0) will
    decrease as the D/E increases, and the share
    price (P0) increases with growing leverage,
    therefore companies should use as high leverage
    as possible (picture)

80
Dependence Hypothesis
  • According to Dependence Hypothesis Percentage
    change of cost of equity Kc 0, however,
    percentage change in dividends Dt gt 0
  • Percentage change of price percentage change of
    dividends

81
Taxes and financial leverage
  • The interest is deductible from the tax base
  • Use of debt in capital structure should lead to
    increased market value of firm securities
  • The middle view assumes that interest tax shied
    has its market value which increases total market
    value of the firm

82
Cost of financial distress
  • The probability of bankruptcy increases with
    increasing leverage.
  • The firm has the highest costs if it gets
    bankrupt
  • Assets are liquidated for lower than market
    price
  • Banks refuse to lend
  • Suppliers refuse to grant commercial credit
  • Dividend payments are stopped
  • At certain point the expected bankruptcy costs
    outweigh the tax shield and the firm has to
    change the capital structure (Pictures)

83
Further topics
  • Optimal financial structure
  • EBIT-EPS analysis
  • Point of financial indifference
  • Implicit cost cost of debt increased risk
  • Practical measures of capital structure management

84
Capital structure theories
  • The trade-off theory
  • The trade-off between benefits and costs of debt
  • Small debt small tax shield but more financial
    flexibility
  • Pecking order theory
  • Different types of capital have different costs
    -the least expensive source is used first

85
Summary 1
  • In general, a firm can choose among many
    alternative capital structures.
  • It can issue a large amount of debt or it can
    issue very little debt.
  • It can issue floating-rate preferred stock,
    warrants, convertible bonds, caps, and callers.
  • It can arrange lease financing, bond swaps, and
    forward contracts.

86
Summary 2
  • Because the number of instruments is so large,
    the variations in capital structures are endless.
  • We simplify the analysis by considering only
    common stock and straight debt in this chapter.
  • We examine the factors that are important in the
    choice of a firms debt-to-equity ratio.

87
Exercise questions
  1. Explain the concept of capital structure
  2. Define the optimal capital structure
  3. Explain the logic of MM Theory of independence
  4. Explain MM Theory of dependence
  5. Explain the role of taxes in financial structure
  6. Explain the cost of financial distress and agency
    costs

88
Exercise problem 1
  • Gearing Manufacturing, Inc is planning a 1 000
    000 expansion of its production facilities. The
    expansion could be financed by the sale of 1 250
    000 in 8 notes or by the sale of 1 250 000 in
    capital stock. Which would raise the number of
    shares outstanding from 50 000 to 75 000. Gearing
    pays income taxes at a rate of 30.
  • Suppose that income from operations is expected
    to be 550 000 per year for the duration of the
    proposed debt issue, Should Gearing be financed
    with debt or stock? Explain your answer.

89
Useful web sources
  • Financing decisions Capital Structure and cost
    of capital
  • http//www.slideshare.net/meowbilla/4a304-capital-
    structure
  • CFA 1 Materials
  • http//www.investopedia.com/exam-guide/cfa-level-1
    /corporate-finance/mm-capital-structure-versus-tra
    deoff-leverage.aspaxzz1sgRpYOfd

90
RECOMENDED READINGS
  • Fundamentals of Corporate Finance, Ross,
    Westerfield and Jaffe, 6 th edition. Ch 12
  • Brigham and Houston Fundamentals of Financial
    Management, 12th ed, Ch 10

91
STRATEGY AND TACTICS OF FINANCING DECISIONS -
INVESTMENT DECISION MAKING
92
Outline
  • Introduction
  • Investment decision making
  • Nature of projects and incremental cash flows
  • Project phases and relevant cash flows
  • Decision making methods incl. pros and cons
  • Comparing different projects
  • Summary, exercises, references

93
Investment Projects
  • Nature of project
  • Profit generating projects
  • Increasing capacity, new equipment
  • Replacement projects
  • Ecological projects minimizing loss

94
Long-term nature of projects
  • Analyzing - incremental cash flows
  • Changes of the firms cash flow that occur as a
    direct consequence of accepting the project
  • Costs vs. Cash flows
  • Sunk costs
  • Opportunity costs (potential revenues form
    alternative uses are lost)
  • Side effects - transfers

95
Project Phases
  • 1. Investment phase
  • 2. Operating phase (income and taxes)
  • 3. Liquidating phase (sometimes included in
    operating phase)

96
Investment decision making methods
Net Present Value - NPV Internal Rate of Return -
IRR Payback Period - PP Profitability Index -
PI Modified Internal Rate of Return - IRR
97
Net Present Value
  • The most frequently used decision making method
  • Discounts individual positive and negative cash
    flows to the present finding their present
    value
  • Projects with positive net present value are
    accepted
  • This method is sensitive to the discount rate
    used in the process of calculation

98
Internal Rate of Return
  • The discount rate of the project that forces its
    net present value to equal zero
  • NPV 0
  • Positive and negative cash flows are
    discounted at rate IRR. APPROXINMATION of this
    rate can be found using iterations or linear
    interpolation
  • Advantage - comparison with cost of capital
  • STRONG ASSUMPTION - cash inflows are
    reinvested at a rate IRR

99
Payback Period
  • Non-discounted method
  • Discounted method
  • Cumulated cash flows
  • ASSUMPTION- evenly distributed cash flows during
    the course of each period

100
Profitability index
  • Present value of cash inflows to present value of
    cash outflows
  • Decision rule PI gt 1
  • The same decisions as NPV
  • Profitability indexes of two projects can not be
    added, whereas the NPVs can

101
Modified Internal Rate of Return
  • Removes the strong assumption about reinvesting
    cash inflows for the high IRR
  • Maintains the advantage - easy comparison with
    cost of capital the appropriate discount rate

102
Modified IRR - formula
103
Comparing projects
Conflict between NPV and IRR Projects with
irregular cash flows Projects with several
negative cash flows Comparing projects with
different time horizon Crossover rate Capital
Asset Pricing Model - CAPM application in
capital budgeting
104
Summary
  1. Investment decision making must be placed on an
    incremental basis - sunk costs must be ignored,
    while both opportunity costs and side effects
    must be considered.
  2. Inflation must be handled consistently. One
    approach is to express both cash flows and the
    discount rate in nominal terms.
  3. When a firm must choose between two machines of
    unequal lives, the firm can apply either the
    matching cycle approach or the equivalent annual
    cost approach. Both approaches are different ways
    of presenting the same information.

105
Summary 2
  1. In this chapter we cover different investment
    decision rules. We evaluate the most popular
    alternatives to the NPV the payback period, the
    accounting rate of return, the internal rate of
    return, and the profitability index. In doing so,
    we learn more about the NPV.
  2. The specific problems with the NPV for mutually
    exclusive projects was discussed. We showed that,
    either due to differences in size or in timing,
    the project with the highest IRR need not have
    the highest NPV. Hence, the IRR rule should not
    be applied. (Of course, NPV can still be applied.)

106
Exercise questions
  1. What are the difficulties in determining
    incremental cash flows?
  2. Define sunk costs, opportunity costs, and side
    effects.
  3. What are the items leading to cash flow in any
    year?
  4. Why is working capital viewed as a cash outflow?
  5. Discuss the pros and cons of investment decision
    making methods
  6. What is the difference between the nominal and
    the real interest rate and nominal and real cash
    flow?
  7. Discuss the problems of IRR method

107
Useful web sources
  • http//www.studyfinance.com/lessons/capbudget/
  • http//www.capitalbudgetingtechniques.com/
  • What is capital budgeting - text
  • http//www.exinfm.com/training/capitalbudgeting.do
    c
  • Impact of inflation on investment decision making
  • http//www.studyfinance.com/jfsd/pdffiles/v9n1/mil
    ls.pdf

108
RECOMENDED READINGS
  • Fundamentals of Corporate Finance, Ross,
    Westerfield and Jaffe, 4th edition. Ch 7
  • Brigham and Houston Fundamentals of Financial
    Management, 12th ed, Ch 9, 10
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