corporate finance mib 2008

8/7/2019 corporate finance MIB 2008

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Corporate Finance

MIB Program Franois Desmoulins-LebeaultChristophe BonnetSimon BrillouetEmmanuelle Saint-Supryand the finance teachers of the Accounting, Law , and Financedepartment.

Grenoble Ecole de Management


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MIB Corporate Finance- Grenoble Ecole de Management 2

What is finance for you ?

Who wants to work in finance in the future ?

Who thinks she/he will work with finance ?

What differentiates your studies & aninvestment decision ?


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Session 1 : The financing cycle1-Introduction to finance2-The financial cycle and value creation3-Compounding and discounting

Session 2 Investment decisions - The DCF method1-Investment decisions : DCF method, calculation of the future cash-flowsSession 3 Investment decisions - Net present value and other criteria1-Investment decisions : net present value, IRR, other criteria2-Small casesSession 4 - Exercises and cases1-Investment decisions: additional exercises and cases

CORPORATE FINANCE 1

Reading

Brealey and Myers, Principles of Corporate Finance

Class notes


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Session 1 : The financing resources of corporations1-The financing resources of corporations : equity and debt2-The financial marketsSession 2 - Equity1-Equity : various types of equity, how to raise equity, estimationof the cost of equity (Gordon-Shapiro model, capital asset pricing model)Session 3 Debt financing and the WACC1-Debt financing : various types of debt, how to issue debt, the cost of debt2-The weighted average cost of capitalSession 4 - Exercises and cases1-Additional exercises and cases

CORPORATE FINANCE 2


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Session 1 : The financing cycle

Introduction to corporate finance The financial cycle and value creation Compounding and discounting

CORPORATE FINANCE 1


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1- Introduction to corporate finance



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Introduction to corporate finance

Finance relates to dealing with money and time

Concerns all economic agents:

Individuals, households

Companies

States

Finance for companies:

Cash management (treasury, banking relationships)

Control and accounting (accounts, tax,..)

Corporate Finance (financial policy, investments)


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Corporate finance

Investment policy

How the firm spends its money (real and financial assets)

Financing and payout policy

How the firm obtains funds (debt, equity, ) and disposes of excess cash

Valuing a firm



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What is corporate finance about ?

Cash

Corporations need cash in order to invest in real assets. Cash isobtained by issuing financial assets (securities).

Value creationCorporations create value if the return they produce exceeds theircost of financing



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Corporate finance is management, and involves

Taking decisions

Financing decisions (incl. dividends distribution)

Investment decisions

Managing information Internal information and decisions processes

External information to shareholders and other stakeholders

Competition

The companies are competing for finding financial resources



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Objectives of the course

Being able to identify the various sources of financing available forcompanies

Being able to calculate the cost of financing (i.e.: cost of capital)

Being able to take investment and financing decisions



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At the end of 2001, GM had $18.6 billion in cash. Should it invest in new projects orreturn the cash to shareholders? If it decides to return the cash, should it declare adividend or repurchase stock? If it decides to invest, what is the most valuableinvestment? What are the risks?


Financing decisions

In 1998, IBM announced that it would repurchase $2.5 billion in stock. Its pricejumped 7% after the announcement. Why? How would the market have reacted if IBMincreased dividends instead? Suppose Intel made the same announcement. Would weexpect the same price response?

Your firm needs to raise capital to finance growth. Should you issue debt or equity orobtain a bank loan? How will the stock market react to your decision? If you choosedebt, should the bonds be convertible? callable? Long or short maturity? If you chooseequity, what are the trade-offs between common and preferred stock?

Types of questions


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2- The financial cycle and value creation



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Finance is really about value Firms Projects and real investments SecuritiesCentral question

How can we create value through investment and financing decisions ?

The financial cycle and value creation

In finance, as well as in liberal economic theory, the main goal of a companyis to maximise shareholders wealth

But the objectives and interests of the other stakeholders have also to be

taken into account: employees, suppliers, customers, state and community


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Balance sheet view of the firm

A company is a bundle ofassets :

brands, patents, buildings and equipment, inventories,

but also reputation, know-how, market shares,

and, before all, teams of people

In order to build / purchase these assets, a company needs financial resources



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InvestmentsInvestments

- Customers- Raw materials

- Consumption

- Customers- Raw materials

- Consumption WealthWealth

StateState

EmployeesEmployees

CreditorsCreditors

ShareholdersShareholders

Decision

Equity

Debt

Dividends

& capital

gains

Dividends

& capital

gains

TaxesTaxes

Salary &

benefits

Salary &

benefits

InterestsInterests



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FirmsOperations

A bundle ofrealassets

Financial

Markets

investors providingfinancialresources

in exchange offinancialassets

Financial

Manager

(1)(2)

(3) (4a)

(4b)

(1) Cash raised by selling financial assets to investors

(2) Cash invested in the firms operations and used to purchase real assets

(3) Cash generated by the firms operations

(4a) Cash returned to investors

(4b) Cash reinvested

The financial managers role



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3- Compounding and discounting


Time is money


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Discounting :Taking time into account

Investing is a mechanism through which a company tends to increase itswealth, but cash flows will be generated along time, in the future

Because money has a cost and can be borrowed or lend, it is moreinteresting to get a cash flow now than tomorrow

Thus it we want to compare cash flows paid or received at a differentpoints of time, we need to convert all of them at their value of today (:present value)

This operation is called discounting

Compounding and discounting


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The cost of money takes the form of a rate, applied to the sums borrowedor lent. It is the interest rate

This rate can be decomposed into its components.

The first and more obvious component is the risk premium

The second and more complex component is called the risk free rate

This notion of interest rateis at the heart of finance



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There is a risk free rate because agents do massively preferimmediateconsumption to delayed consumption.

The contribution of this preference to the risk free rate is measuredthrough the inter-temporal rate of substitution.

The expected change in the value (or purchasing power) of money is theother component of the risk free rate. This is called anticipated inflation.

Each of these three elements is proportional to the length of time.

The sum of all these componentsis the interest rate andisspecificto each flow of money.



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t = 0, 1, . , n time

V0 = present value of a cash flow (at time 0)

Vt = future value of a cash flow (at time t)

r = interest rate = cost at which money can be borrowed or lent

Vt = future value

Vt = V0 (1+r) t

V0 = present value

V0 = Vt (1+r) -t

or V0 = Vt / (1+r)t


Time value of money


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A 1 received in the future is always worth less than 1 received today.

If the interest rate is r, then the present value of a riskless cashflow CFt received in t years is :

Time value of money

Present value =


You have 1 today and the interest rate on riskfree investments(Treasury bills) is 5%.How much will you have in

1 year 1

1.05 = 1.052 years 1 1.05 1.05 = 1.103t years 1 1.05 1.05 1.05 = 1.05t

These cashflows are equivalent to each other. They all have the

same value.

1 today is equivalent to (1+r)t in t years

1 in t years is equivalent to 1 / (1+r)t today


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PV of 1 received in year t

Year when 1 is received



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Discounting - Examples

Future value of a cash flow of 100 (Exercise 1)

Exercises 2 to 4

Case of successive cash flows over time :

Present valuePerpetuities

Growing perpetuities

Net Present Value

Exercises 5 to 9



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Discounting : Perpetuities and growing perpetuities (Shortcuts formula)

Present Value of subsequent cash flows :

Present value of a constant perpetual cash flow (Level cashflowstream forever) :

Present value of a growing perpetual cash flow (Cashflows growby a fixed percent forever) :

r

CFPV !

grCF

PV

!


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1tr)(1

CF

t

tV


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Firms in the S&P 500 are expected to pay, collectively, $20in dividends next year. If growth is constant, what shouldthe level of the index be if dividends are expected to grow5% annually? 6% annually? Assume r = 8%.

Growing perpetuity

Discounting : Growing perpetuities (example)



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Discounting : Net Present Value

The NPV of a cash flow stream is equal to the sum of the discounted cashflows, each cash flow having been discounted at the interest rate r


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Your firm spends $800,000 annually for electricity at its Boston headquarters.

A sales representative from Johnson Controls wants to sell you a new computer-controlled

lighting system that will reduce electrical bills by roughly $90,000 in each of the next three

years. If the system costs $230,000, fully installed, should you go ahead with the investment?

Net Present Value : example



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Session 2 : Investment decisions - the DCF Method

Investment decisions : DCF method, calculation of the future cash-flows

CORPORATE FINANCE 1


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Why would you want to invest ? to be richer

Investing is a mechanism through which an economic agent tends to increasehis wealth

The DCF method : investment decisions

As the company belongs to shareholders investing, for a company, is a wayto create wealth for shareholders

An investment decision aims at maximizing the firms value


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On which criteria are we going to take the decision to invest ?

The expected cash flows have to exceed the initial funds invested but this is not

enough, because moneyhas a cost

The expected return of the investmenthas to exceed the cost of the

financial resources


Example:

Suppose you can borrow money at a cost of 8%. You have an investment

opportunity offering a 6% return. Do you invest ?

Suppose you can borrow money at a cost of 4%. You have an investment

opportunity offering a 6% return. Do you invest ?

If the return on the investment is lower than the cost of your financial

resources, you will not create value but destroy value


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A company can increase its wealth through different kinds of investments:

Industrial investments: equipment, buildings, ... to increase production

to reduce operating costs

Commercial investments: marketing, development,

to increase sales to gain market shares, brand value,

Financial investments: acquisition of other companies to improve competitive position, enter new markets

R&D: patents, know-how To create new technologies, processes, products

Staff education

Assets:

- Fixed assets- tangible- intangible- financial

- Working

Capital



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Main steps in the investment process

Operational level (project planning) feasibility study

final studies

implementation: launch

follow-up: periodic controls After decision

Financial level (role of financial headquarters) set-up profitability goals, in view of the financial market

study profitability of projects submitted by other

headquarters, according to technical, commercial,

studies elaborate financing plan if a project is accepted

provide funds on time

check that goals have been reached After decision

Before decision

Before decision



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When do you take an investment decision ?

If you need it

If you create wealth, i.e.

if the return is higher

than the cost of financing

If you have the money

Operational matters -

assumed from now on

Financial matters:

our focus



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In order to take investment decisions, we need to:

Choose a blend of financial resources for the company and calculate

their cost (cost of capital) => WACC

Financing decisions

Check if the returns of the investment projects are higher than the

cost of capital




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The cost of the financial resources of the company can be calculated(WACC, or cost of capital)

The company creates value only if its investment projects deliver a returngreater than the WACC

Thus we have to compute the return of the project

And compute the consequences in terms of cash flows of the project



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1. Evaluate the costs of investment and/or disinvestment

2. Evaluate future cash flows

generated by invested funds in order to determine the economic wealthsurplus freed by the project

3. Check if this wealth is sufficient to remunerate investors: shareholders &creditors (wealth or return of the project > WACC)



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Forecasting cash flows


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Draw up a flow chart of the investment :

1. At the beginning of the project

2. During the project

3. At the end of the projects life

Money inflows

Money outflows

1

2

3




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Ignore sunk costsRemenberopportunity costsConsidermarginal costs not average costs


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Ignore sunk costs

Remenberopportunity costs

Considermarginal costs not average costs


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Investment flows:

1. At the beginning of the project:

Acquisition costs of assets

Installation / implementation costs

Marketing costs

Possible disposal of old equipment

Taxes, registration fees, tax credits,

2. During the project:

Depreciation tax shield

WCR (Working Capital Requirements), investments in operations

3. At the end of the project:

Possible disposal of used goods

Repairing and cleaning locations costs

Recovery of NWC

Cash flows



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Working capital Net working capital NWC


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Operating flows (evaluation of economic flows generated by theinvestment):

1. At the begining of the project:

No operating flow at the begining

2. During the project:

(Surplus of sales induced by the project) (incrementalexpenses to make the investment run)

including taxes on those elements

Gross operating margin of the project = EBITDA

3. At the end of the project:

Same as during the project

Cash flows


Total flows:

Sum of investment flows & operating flows from year 0 (date ofacquisition) to the end of the project


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You have the opportunity to invest in a wine distribution network. Forecasts aftermarket studies are the following :

Selling price 30

Unit cost 15

Volume: 12,000 / year

Truck purchase: 200,000 Duration: 5 years

Depreciation: 5 years, linear

Working capital requirements: 1 month of tunover

Tax rate: 30%

Fixed costs 60,000 / year

Evaluate the flows of such a project.

Example



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Investment flows :

The truck costs 200 K

On a straight line basis, the annual depreciation is 200 / 5 = 40 K peryear.

It provides a tax credit of 40 * 30% = 12 K a year.

The turnover has to be 30 * 12 K = 360 K / year

One month ofWC means that 360 / 12 = 30 K are required during thewhole project to finance inventories & customer credits. The firm willrecover those 30 K when liquidation occurs.

Example



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Investment flows:

Year 0 1 2 3 4 5

Acquisition,equipment

-200

Tax credit,depreciation

12 12 12 12 12

WCR -30 0 0 0 0 30

Investmentflow

-230 12 12 12 12 42

Example



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Operating flows:

In-flows

Sales: 30 * 12 K = 360 K / year

Out-flows:

Variable costs: 15 * 12 K = 180 K / year

Fixed costs: 60 K / year

Income tax is applied on gross operating margin, 120 * 30% = 36 K /year

The operating cash flow is then 360 180 60 36 = 84 K / year

Example



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Operating flows

Year 0 1 2 3 4 5

Turnover 360 360 360 360 360

- variablecosts

180 180 180 180 180

- fixedcosts

60 60 60 60 60

Grossoperating

profit

120 120 120 120 120

- Incometax

36 36 36 36 36

Operatingflow

84 84 84 84 84

Example



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Can I take a decision now ? No, I need to make these cash flows comparables NPV and otherdecision criteria

Year 0 1 2 3 4 5

Investment

flow -230 12 12 12 12 42

Operatingflow

0 84 84 84 84 84

Net flows -230 96 96 96 96 126

Example


Total flows


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Complication 1 : inflation



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Complication 2 : currencies



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Th DCF h d i d i i


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Th DCF th d i t t d i i


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Session 3 : Investment decisions - Net present value and other

decision criteria

Investment decisions : net present value, IRR, other criteria Small cases

CORPORATE FINANCE 1

I t t d i i NPV d th it i


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Decision criteria

Can we make a good investment decision with the project flow information ?

How are we going to compare different projects if we have several choices ?

We need decision criteria to check that the wealth due to the project exceeds

the required remuneration of shareholders & creditors

Investment decisions : NPV and other criteria

Decision criteria must take different deadlines into account: they must satisfythe debtors & the shareholders

Several criteria meet these requirements:

Net Present Value (NPV) Internal Rate of Return (IRR) & complementary approaches: payback

period, profitability rate,

In estment decisions NPV and other criteria


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NPV - Net Present Value

Principle

Compares the sum of the present values of a projects cash flows to

the one we would get by investing in the capital market

Process

Net present value = discounted sum of all cash flows generated bythe project

Discount rate = cost of capital

If initial investment expenses < future flows: PV is > 0, the

shareholders & creditors will get money

NPV rule: NPV > 0

NPV immediately measures the wealth surplus induced by theproject


! !

n

1tt

t0

r1INPV

! !

n

0tt

t

r1NPV



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IRR Internal Rate of Return

IRR is the rate of discount which equates the NPV of the cash flow to 0.

Shareholders required remuneration + creditors required remuneration = an overallconstraint on the firm: investment costs (= cost of capital)

The project is good only if

the wealth earned > cost of capital

The Internal Rate of Return measures the profitability of the project

How much do I get back if I invest 100 ?

Decision rule:

Project implemented if IRR > cost of capital (WACC)

0

IIPV

tt

t0

!

! !




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1. IRR = measurement of the profitability, so a standard (reference) isrequired : cost of capital

2. The implicit assumption of the reinvestment rate is strong

3. Possibility to have several rates when solving for IRR

4. Possible absence of IRR

5. Rate variations do not influence IRR





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! !

PBP

1tt

t0

r1

CFI

Period at which the sum ofdiscounted cash flows exceeds the amountinvested.

Cost of capital is the discount rate Use linear interpolation to find the payback period

PBP Payback Period : How long it takes to recover the firms original investment (or howlong the project takes to pay for itself). Break even point




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PI Profitability index


Measures the relation between future wealth & the amount invested Measures the wealth created by invested

IfPI > 1, the project is profitable Useful for the comparison of projected with different durations

0I

PVPI !



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Rules for decision


A project will be accepted when

NPV of economic flows > 0

Discounted with cost of capital

IRR > cost of capital

Profitability Index > 1 Pay Back < threshold set up by the firm

NPV is the most RELEVANT: other criteria are complementary


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Session 1 : The financing resources of corporations1-The financing resources of corporations : equity and debt2-The financial marketsSession 2 - Equity1-Equity : various types of equity, how to raise equity, estimation

of the cost of equity (Gordon-Shapiro model, capital asset pricing model)Session 3 Debt financing and the WACC1-Debt financing : various types of debt, how to issue debt, the cost of debt2-The weighted average cost of capitalSession 4 - Exercices and cases1-Additional exercises and cases

CORPORATE FINANCE 2 : FINANCING DECISIONS


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Session 1 : The financing ressources of corporation

1- The financing resources of corporations : equity and debt2- The financial markets

CORPORATE FINANCE 2


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1- The financing resources of corporations : equity and debt


The financing resources of corporations : financing decisions


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From the day of its creation, a company needs to find financial resourcesin order to be able to invest

Any kind of financial resource has a cost (similar to a renting price). Thiscost will depend on the global economic and financial conditions as well ason characteristics of the company (size, market, operating and financialrisk,)

We need to be able to select financial resources and to calculatetheir cost




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Invest in projects that yield a return greater than the minimum acceptable hurdlerate (cost of capital). (part 1)

The hurdle rate should be higher for riskier projects and reflect the financing mix used- owners funds (equity) or borrowed money (debt)

Returns on projects should be measured based on cash flows generated and the

timing of these cash flows; they should also consider both positive and negative side

effects of these projects.

Choose a financing mix that minimizes the hurdle rate and matches the assets

being financed. (part 2)

If there are not enough investments that earn the hurdle rate, return the cash to stockholders.

The form of returns - dividends and stock buybacks - will depend upon the stockholderscharacteristics.

Objective: Maximize the Value of the Firm


First principles



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There are only two ways in which a business can make money. The first is debt. The essence of debt is that you promise to make fixedpayments in the future (interest payments and repaying principal). If youfail to make those payments, you lose control of your business. The other is equity. With equity, you do get whatever cash flows are leftover after you have made debt payments.

The equity can take different forms: For very small businesses: it can be owners investing their savings For slightly larger businesses: it can be venture capital For publicly traded firms: it is common stock.

The debt can also take different forms For private businesses: it is usually bank loans For publicly traded firms: it can take the form of bonds

g p g



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In order to build / purchase assets, a company needs financial resources

Financing = finding a set of resources more or less expensive and risky for the firm

The financing decision is linked to the choice of the firms optimal financial / capital

structure

g p g

Cost of equity

Cost of debt :

InterestW

A

C

C

Return on > WACCinvestments

The financing resources of corporations : sources of funds


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Equity

Internal financing

Retained earnings

External financing

Private equity

Public equity

Debt

Bank debt

Leasing

Bonds: Publicdebt

g p

Management needs to find the appropriate financial structure for the company.

The cash flows from the projects will have to remunerate these resources.

The financing resources of corporations : sources of funds


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Sources of funds, International

g p

The financing resources of corporations : the financing mix question


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Capital structure, International

The financing resources of corporations : the financing mix question


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In deciding to raise financing for a business, is there an optimal mix of debt and equity? If yes, what is the trade off that lets us determine this optimal mix? If not, why not?

The simplest measure of how much debt and equity a firm is using currently is to look atthe proportion of debt in the total financing. This ratio is called the debt to capital ratio:Debt to Capital Ratio = Debt / (Debt + Equity)

Debt includes all interest bearing liabilities, short term as well as long term. Equity can be defined either in accounting terms (as book value of

equity) or in market value terms (based upon the current price). The resulting debt ratios can bevery different.


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2- The financial markets


The financing resources of corporations : financial markets


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Primary market :

As a primary market, its main function is to enable business to raise new capital byissuing shares to new shareholders or to existing shareholders or to the issue of loancapital or debentures.

Contract and cash flow between company and market

Direct impact on company cash

ie IPO, shares issue, bonds issue

Secondary market:

As a secondary market, the function of the financial market is to enable investors totransfer their securities (shares and loan capital) with ease.

Contract and cash flow between investors on the market

No direct impact on company cash

ie when an investor purchases shares or bonds on the market

A financial market is any mechanism for trading financial assets or securities. Frequently there is no

physical market-place. It provide mechanisms through with the corporate financial manager has access

to a wide range of sources of finance and indtruments. The financial markets acts in two importants ways :

The financing resources of corporations : financia l markets


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institutions financires

ETAT Administration mnages

Entreprises

8

7

6

5

4

3

21

March financierFinancial institutions

Companies

Financial markets

GovernmentHouseholds

The financing resources of corporations : financial markets


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Spot

Forward

option

Equities 1-

(st exch)

B s 1-

(st ck exch)

M et

M ket 1-

term

Interest rates

organized or OTCInterest rates

options

DOMESTIC

INTERNATIONAL

Exchange

(Forex)1

Forward

1-(2)

Currency

options1-(2)

Euro-equities

1-2

Euro- onds 1-2

Euro-facilities 1-2

Equities options

1-2

Eurocurrencies 1

shortterm


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Session 2 : Equity

1- Various types of equity, how to raise equity.2- Estimation of the cost of equity (Gordon-Shapiro model, capital asset

pricing model)

CORPORATE FINANCE 2


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1- Various types of equity, how to raise equity.

Session 2 : Equity

Equity : various types of equity


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Equity

Internal financing

Retained earnings

External financing

Private equity

Public equity

Debt

Bank debt

Leasing

Bonds: Publicdebt



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Internal financing (retained earnings)

Principle:

Retained earnings are earnings from past projects which have not beenreinvested nor distributed as dividends

Advantages

the firm is independent

less costly because no financing process outside the firm Limits

Taxation

Available liquidity = previous net incomes = gross income already taxed

Tends to delay the implementation of projects : firms rarely have the totalamount required by the investment



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External equity financing (increase in equity)

Principle

The company offers new shares in exchange of cash

Shareholders provide cash since they expect future profits

An increase in equity can be done with either existing or new shareholders

The process and costs differ whether the company is public or private

Advantages

Investors are ready to invest in attractive companies / projects

The firm is not obliged to distribute dividends in case of difficulties

Limits

Dilution of existing shareholders Possible loss of control (issue for family firms)

Take over risk for public companies

Cost, information, minimal size,...



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External equity financing (increase in equity)

Each equity investor (shareholder) is owner of the company and of itsinvestment projects, pro rata to its contribution

Shareholders have the right to participate to key decisions and to participate toprofits

Decisions are taken at majority during shareholders general meetings

Dividends may be distributed, but with no certainty

Shareholders expect a return, but this return is not fixed, nor guaranteed. Thereturn comes from dividends and/or capital gain.

Equity : how to raise equity ?


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Private companies are not listed on a stock market, which implies limitationson liquidity and on information

They are owned by:

Founders, managers, business angels, families

Private equity funds (venture capital, LBOs)

Why are they private?

Choice of he shareholders

Inability to be listed : small, young, risky,

Examples: Bertelsmann, Memscap, Legrand

Private equity

Equity : how to raise equity ?


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Public equity

Public companies are listed on a stock market. Their shares arenegotiable (liquid)

Evolutions since the 80s:

more funds

more markets (segmentation: size, technology)

more public companies

increased power of institutional investors (corporate governance)

International integration (ex: Euronext)


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2- Estimation of the cost of equity (Gordon-Shapiro model,capital asset pricing model)

Session 2 : Equity

Equity : the cost of equity


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For the shareholders of the firm :

An investment project aims at increasing their wealth: they expect areturn

For the managers of the firm:

An investment project should provide, at least, the return which investorsexpect

The return expected by shareholders is the cost of equity

Evaluating the cost of equity is not straightforward because the returnshareholders will finally get is uncertain and based on the future (which is notthe case for debt)

Investors being considered as rational, we can suppose they will base theirexpectations on:

Future growth in earnings

Risk

Equity : the cost of equity


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The cost of equity can only be estimated.

The basic methods are :

Dividend approach : future growth in dividends Based on future growth in dividends, i.e. future long term economic

growth of the company Cf. ch 4

Market approach : link between risk and return Link between the companys stock and markets fluctuation, i.e.

based on expected return and risk Cf. ch 7 & 8


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Cost of equity : dividend approach


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Expected rate of return

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Present value of expected

Cash flows (div. + capital gain)

E(Ri) = expected rate of return from

the shareholder

P0 = share price (present value)D1 = next expected dividend



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gP

DR

gRavecgR

DP

0

1i

i

i

10

!

"

!Present value of a growing perpetual

dividend(GORDON-SHAPIRO)

g

!

!

!

!

1tt

i

t

0

n

1tt

i

n

ti

t0

)(1

DP

)(1P

)(1DP

Present value of the share =

Discounted sum of dividends

forever

Present value of a constant perpetualdividend

0

1

i

i

1

0P

DR

R

DP !!



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Method for estimating the cost of equity (Gordon Shapiro, 1956):

Assumption: the dividend will grow at a constant rate g

In this case a share can be considered as an asset generating a perpetualcash flow growing annually at a rate g

grDPe

!1

0 gPDre !

0

1g

!

!1

0)1(

tt

t

r

DP

P0= present price of the share

D1= dividend expected in next year

g = future growth rate of dividends

re = cost of equity



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Advantages of the dividend approach model providing a simple way to estimate the cost of equity, based on

future growth

Limits of the dividend approach

Works only if g (growth rate) < r(cost of equity)

g assumed to be constant

infinite horizon some firms do not pay dividends (ex Microsoft until 2002)

P0 not available for private companies (need to find comparablecompanies)



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Practical application of the method:

Observe P0, price of a share, on the market during several sessions

Calculate the mean to reduce share price volatility (i.e. deviation fromaverage)

Observe the previous dividend policy and extrapolate it into the future

Evaluate the perspective of growth of the firm and of the related

industrial sector in order to estimate gCalculate the cost of equity

Cost of equity : market approach


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Approach based on the CAPM : Capital Asset Pricing Model

CAPM: best known model linking risk & return, built in the mid 60s bySharpe, Lintner & Treynor

Basic assumptions: investors are rational, the return they expect on afinancial asset is linked to its expected risk

This method requires to analyse the risks of a project

Risk: exists because future returns are uncertain

Each financial asset has a specific level of risk. Some are risk-free (Treasurybills).

Historical observations show a link between risk and return on the long term

(see Brealey & Myers, ch.7)



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The CAPM model says that the relationship between risk and return is linear:

Treasury bills are risk free (risk=0) and produce a return Rf (risk free rate)

A stock market portfolio bears a certain risk (average market risk), andproduces a return Rm (average return of the stock market)

Rm Rf = market risk premium

As Rf and Rm are observable, it is possible to draw a line linking risk and return. Thisline is called the security market line

iskTr r illr r t t k

Security

market

li e

:

r gr t r f t

t

k

rk t

f: ri k fr

r t f r t r

M rk t rtf li

pecte retur o

i estme t



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In a certain situation (no risk)

Cost of equity = risk free rate of the market

i.e. interest rate offered on Treasury bills

In an uncertain situation (reality)

Cost of equity = return demanded by investors =risk free rate + riskpremium

The risk premium of a specific share depends on:

the market risk premium

the specific (non-diversifiable) risk of the share ()



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and non diversifiable risk

In CAPM, the is used as a proxy for the non diversifiable risk of a share

measures the volativity of a specific share returns compared to the volatility ofthe market returns

measures the sensibility of a share returns to the market returns

2

m

imi

WW!



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The equation derived from the model is :

We are able to estimate the return expected by investors, ie the cost of equity,for any listed share.

E(return) = cost of equity(Rm - Rf) = market risk premium

F*

f

frrrre urnE !

Examples: calculations (Brealey & Myers, Ch. 9)

Isicomp

Isicomp Utilities F : 0,5

Isicomp Technologies F : 1,7

Calculate the cost of equity of each company assuming a risk free return of3,5% and a stock market return of 7,5%


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Cost of equity : conclusions


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Equity has a cost, equal to the return expected by shareholders

The cost of equity is not equal to the yield (dividend/price), because futurecapital gains have to be taken into account

The cost of equity is linked to future growth and to the level of risk of the

share

The cost of equity is based on future expectations and can only be estimated


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Session 3 : Debt financing and the WACC

1-Debt financing : various types of debt, how to issue debt, the cost ofdebt2-The weighted average cost of capital

CORPORATE FINANCE 2

Debt financing : various type of debt


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Principle

the firm borrows cash for a certain time, at a given interest rate the firm must pay the interest and reimburse the loan (principal),

according to the terms of the contract Debt can finance a part of the project

Advantages

No dilution of existing shareholders Interests paid are tax deductible for the company In general cost of debt < cost of equity

Disadvantage

Increased risk for the company

Drain on cash-flows (but good discipline for managers?) Risk of loss by shareholders and other stakeholders if company is unableto pay its debt (restructuring, bankruptcy)



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Debt can be classified according to 3 criteria

bank debt / bonds

fixed rate debt / floating rate debt

term: short, medium, long

The firm may choose between these categories according to its needs.


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Bonds

A bonds issue consists of debt split up in n parts (bonds), subscribed bynumerous investors and negotiable on a financial market

The term can be medium or long

The issue is generally advised by an investment bank which determinesthe conditions and markets the bonds to investors

Characteristics of a bond: Nominal value (the par)

Issue premium, redemption premium

Coupon (interest)

Redemption date(s)

Debt financing : Price of a bond


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Price of a bond =

discounted future cash flows present value of future coupons using the market rate r

price varies in the opposite way to r

P0 = price of the bond

Ck = coupon to be paid in year k

VRn = value on redemption

n

n

n

k

k

k

r

VR

r

C

)1()1(10

!

!

Debt financing : cost of debt


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Cost of debt

The cost of debt for the company is the IRR of all cash flows (positiveand negative) generated from the borrowers point of view. Corporate tax& expenses (fees, administrative costs) have to be included

Tax has to be taken into account because interest is tax deductible forthe company, and thus generates tax savings

If there are no expenses linked to the financing, the cost of debt is simplyequal to the interest rate of the debt, after tax

! !

n

1tt

t0

IRR1V

0

IRR1

CFVNPV

n

1tt

t0 !

!

!

Debt financing : cost of debt


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Examples

Vision Corp. is negotiating a 5 years bank loan, with the following conditions:

amount $6 m

interest rate 6% p.a., paid annually at year end

arrangement fee $120 000, paid to the bank in year 0

repayment : $2m end of years 3, 4, and 5

The corporate tax rate ofVision Corp. is 30%

Calculate the cost of this loan for Vision Corp. What would be the cost of the loan assuming no arrangement fee?

Cost and yield of a bond: exercise Bablock (ex 17)

Debt financing : Lease


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The lease is a contract by which the owner of a good agrees to let anotherhave the use of it for a specified period of time

During the contract: the user is not theowner of the good and pays a rent that istax deductible

At the end of the contract: theuser can use a purchase option &become the owner of the good



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Characteristics

the user is not the owner: shift of ownership risk

in case of bankruptcy, this debt cant be demanded (not payable). Theowner can recovers the asset

easy use for the company

the asset & the debt are not reported on the balance sheet (NB:theyare in consolidated statements)

in finance leasing is considered as bank debt (accounts are corrected toreport leasing if needed)



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The lease creates a flows (the rent), which is tax deductible, but the

depreciation tax savings are lost as the asset is not purchased

It is possible to forecast all the cash flows related to a leasingcontract (including the loss of depreciation tax savings). The IRR ofthe cash flows gives the cost of leasing

Leasing is an alternative to debt: need to compare the cost of debtwith the cost of leasing


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2-The weighted average cost of capital (WACC)

Session 3 : Debt financing

The weighted average cost of capital (WACC)


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A company is always financed by a combination of equity & debt

Their cost are different, so we need to calculate the WACC (WeightedAverage Cost of Capital)

The WACC is the cost of the financing resources of the company WACC = weighted costs of the means used to finance the project

The weighted average cost of capital (WACC)


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DE

DTrDE

ErWACC de

! )1(

re & rd = cost of equity and cost of debt (pre tax)

E = value of equityD = value of debt

T = marginal rate of corporate tax

Equity

E

re

Debt

D

rd

Pool of

ressources

Pool of

projects

corporate finance mib 2008

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