CLOSING  THOUGHTS  

Alas,  it  is  3me  to  leave.  

The Investment DecisionInvest in assets that earn a return

greater than the minimum acceptable hurdle rate

The Financing DecisionFind the right kind of debt for your firm and the right mix of debt and

equity to fund your operations

The Dividend DecisionIf you cannot find investments that make your minimum acceptable rate, return the

cash to owners of your business

Hurdle Rate4. Define & Measure Risk5. The Risk free Rate6. Equity Risk Premiums7. Country Risk Premiums8. Regression Betas9. Beta Fundamentals10. Bottom-up Betas11. The "Right" Beta12. Debt: Measure & Cost13. Financing Weights

Investment Return14. Earnings and Cash flows15. Time Weighting Cash flows16. Loose Ends

Financing Mix17. The Trade off18. Cost of Capital Approach19. Cost of Capital: Follow up20. Cost of Capital: Wrap up21. Alternative Approaches22. Moving to the optimal

Financing Type23. The Right Financing

Dividend Policy24. Trends & Measures25. The trade off26. Assessment27. Action & Follow up28. The End Game

Valuation29. First steps30. Cash flows31. Growth32. Terminal Value33. To value per share34. The value of control35. Relative Valuation

Set Up and Objective1: What is corporate finance2: The Objective: Utopia and Let Down3: The Objective: Reality and Reaction

36. Closing Thoughts

3

Ponderous  Thoughts,  or  maybe  not  

1.  There  are  few  facts  and  lots  of  opinions.  a.  Even  the  givens  (cash  &  risk  free  rate)  are  not  b.  With  accoun3ng  and  market  numbers,  all  bets  are  off.  

2.  The  real  world  is  a  messy  place.  a.  Money  making  firms  can  become  money  losers  b.  Companies  can  be  restructured/  given  faceliRs  

3.  Models  don’t  compute  values  and  op3mal  paths.  You  do.  

4.  Change  is  the  only  constant.  

4

I.  What  are  the  conflicts  of  interest?  

Inside stockholders Want to maximize value while

retaining control

Outside stockholders Want to maximize their returns

(stock price plus dividends).

Board of DirectorsWant to preserve personal connections with the managers and personal perks.

ManagersWant to maximize their compensation and increase personal marketability.

EmployeesWant to minimize job risk

and maximize wages/benefits.

Lenders Bankers/Bondholders

want to minimize credit risk and ensure that interest/principal

get paid.

Society Wants companies

to add to economic pie

without creating social costs.

CustomersWant the best possible product/service at the

lowest price

RegulatorsWant to ensure that you follow the rules

and do not create problems for them.

Government

Consultants Auditors

5

II.  Risk  and  the  Marginal  Investor  

Actions/Risk that affect only one firm

Actions/Risk that affect all investments

Firm-specific Market

Projects maydo better orworse thanexpected

Competitionmay be strongeror weaker thananticipated

Entire Sectormay be affectedby action

Exchange rateand Politicalrisk

Interest rate,Inflation & news about economy

Figure 3.5: A Break Down of Risk

Affects fewfirms

Affects manyfirms

Firm can reduce by

Investing in lots of projects

Acquiring competitors

Diversifying across sectors

Diversifying across countries

Cannot affect

Investors can mitigate by

Diversifying across domestic stocks Diversifying across asset classes

Diversifying globally

6

III.  Risk  Profiles  and  Costs  of  Equity  

Risk free RateRisk Premium

for average risk investment+ X

Relative Risk MeasureRisk in investment, relative to the

average risk investment

Macro Economic Uncertainty

Investor risk aversion

How discretionary is your product/

service to your customers?

Expected Inflation

Expected real interest

rate

What proportion of

your costs are fixed costs?

How much have you

borrowed?

The Fundamentals

Earnings Variability

Stock price Volatility

Balance Sheet Ratios

The Observables

7

Cost  of  Capital  

Cost of Equity Cost of Debt= Riskfree Rate + DefaultSpread

Market-value Weights of Debt & Equity

Cost of Capital = Cost of Equiity (E/(D+E)) + After-tax cost of debt (D/(D+E))

Equity includesOptions

Debt includes all fixed commitments

Rating

ActualRating

SyntheticRating

8

IV.  The  Quality  of  Investments:  The  Firm  View  

Cost of Capital = Cost of Equiity (E/(D+E)) + After-tax cost of debt (D/(D+E))

After-tax Operating Income Capital Invested in Assets in Place

Return on Capital = After-tax Operating Income/ Capital Invested in Assets in Place

Return Spread =ROC - WACC

EVA = (ROC - WACC) (CapitalInvested)

Cost of Equiity

Net Income Equity Invested in Assets in Place

Return on Equity= Net Income/ Equity Invested in Assets in Place

Return Spread =ROE - COE

Equity EVA = (ROE - COE) (Equity Invested)

9

V.  The  Trade  Off  on  Debt  

10

VI.  The  Op3mal  Mix  of  Debt  and  Equity  

Cost of capital = Cost of Equity (Equity/ (Debt + Equity)) + Pre-tax cost of debt (1- tax rate) (Debt/ (Debt + Equity)

Tax benefit ishere

Bankruptcy costs are built into both the cost of equity the pre-taxcost of debt

As you borrow more, he equity in the firm will become more risky as financial leverage magnifies business risk. The cost of equity will increase

As you borrow more, your default risk as a firm will increase pushing up your cost of debt.

At some level of borrowing, your tax benefits may be put at risk, leading to a lower tax rate.

11

VII.  Geang  to  the  Op3mal  Mix  

¨  How  quickly?  ¤  If  under  levered,  are  you  the  poten3al  target  of  a  hos3le  acquisi3on?  

¤  If  over  levered,  are  you  under  threat  of  bankruptcy?  ¨  How?  

¤  Recapitaliza3ons:  Borrow  money  &  buy  back  stock,  if  under  levered,  or  Issue  equity  and  re3re  debt,  if  over  levered.  

¤  Investments:  Take  investments  primarily  with  debt,  if  under  levered,  or  take  investments  primarily  with  equity,  if  over  levered.  

12

VIII.  The  Right  Kind  of  Financing  

Firm Value

Value of Debt

The perfect financing: Provides you with the tax benefits of debt, while also giving you the flexibility of equity.

13

IX.  Measuring  Poten3al  Dividends  

Begin with the net income (which is after interest expenses and taxes)

Add back the non-cash charges such as depreciation & amortization

Subtract out reinvestment needs- Capital expenditures- Investments in Non-cash Working Capital (Change)

Subtract out payments to non-equity investors- Principal Repayments- Preferred Stock Dividends

Add any cash inflows from new debt - New Debt Issues

To get to the Cash that is available for return to Owners

14

IX.  Measuring  Poten3al  Dividends  

Begin with the net income (which is after interest expenses and taxes)

Add back the non-cash charges such as depreciation & amortization

Subtract out reinvestment needs- Capital expenditures- Investments in Non-cash Working Capital (Change)

Subtract out payments to non-equity investors- Principal Repayments- Preferred Stock Dividends

Add any cash inflows from new debt - New Debt Issues

To get to the Cash that is available for return to Owners

15

X.  Valua3on:    Match  up  cashflows  and  discount  rates…    

Cashflow to EquityNet Income- (Cap Ex - Depr) (1- DR)- Change in WC (!-DR)= FCFE

Expected GrowthRetention Ratio *Return on Equity

FCFE1 FCFE2 FCFE3 FCFE4 FCFE5

Forever

Firm is in stable growth:Grows at constant rateforever

Terminal Value= FCFE n+1/(ke-gn)

FCFEn.........

Financing WeightsDebt Ratio = DR

Discount at Cost of Equity

Value of Equity

EQUITY VALUATION WITH FCFE

Cashflow to FirmEBIT (1-t)- (Cap Ex - Depr)- Change in WC= FCFF

Expected GrowthReinvestment Rate* Return on Capital

FCFF1 FCFF2 FCFF3 FCFF4 FCFF5

Forever

Firm is in stable growth:Grows at constant rateforever

Terminal Value= FCFF n+1/(r-gn)

FCFFn.........

Discount at Cost of Capital (WACC) = Cost of Equity (Equity/(Debt + Equity)) + Cost of Debt (Debt/(Debt+ Equity))

Firm Value- Value of Debt= Value of Equity

DISCOUNTED CASHFLOW VALUATION

16

Back  to  First  Principles  

The Investment DecisionInvest in assets that earn a

return greater than the minimum acceptable hurdle

rate

The Financing DecisionFind the right kind of debt for your firm and the right mix of debt and equity to

fund your operations

The Dividend DecisionIf you cannot find investments

that make your minimum acceptable rate, return the cash

to owners of your business

The hurdle rate should reflect the riskiness of the investment and the mix of debt and equity used

to fund it.

The return should relfect the magnitude and the timing of the

cashflows as welll as all side effects.

The optimal mix of debt and equity

maximizes firm value

The right kind of debt

matches the tenor of your

assets

How much cash you can

return depends upon

current & potential

investment opportunities

How you choose to return cash to the owners will

depend whether they prefer

dividends or buybacks

Maximize the value of the business (firm)

17

Read  Chapter  12  

Task  From  a  first  principles  standpoint,  

judge  your  firm.