doc. irena jindrichovskacorporate finance management 21 corporate finance management 2 master course...

Doc. Irena Jindrichovska

Corporate Finance Management 2 1

CORPORATE FINANCE MANAGEMENT 2

Master Course VŠFSFall 2013

Doc. Ing. Irena Jindřichovská, [email protected]



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

• Jindrichovská I. (2013) Finanční management. 1. ed.C.H.Beck Praha, 320 s., ISBN 978-80-7400-052-2 (in Czech)

• More sources may be recommended in lectures. Presentation will be updated during the course



Teaching plan• Regular studies:

12 hours lectures6 hours excercises+ presentation of own work

• Assignment conditions - essay on topic given – M&A case study + active participation in seminars – more details - Ing. Kateřina Kalinová

• Exam: Written exam consisting of short essays and calculations



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



INTRODUCTION TO CORPORATE FINANCE

MANAGEMENT



Outline Lecture 1

• Introduction• Capital structure• Company lifecycle• Role of financial manager• Financial markets• Agency theory• Stakeholders’ theory• Summary, exercises, references



Introduction toCorporate Finance

• Basic questions not only from corporate finance:

1. What long-term investment strategy should a company take on?

2. How can cash be raised for the required investments?

3. How much short-term cash flow does a company need to pay its bills?



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



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



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



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



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



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.



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.



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



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



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



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



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



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



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



Stakeholders’ theory

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



Summary1. 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?



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.



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?



Useful web source

• On Agency theory – A review paper

• http://classwebs.spea.indiana.edu/kenricha/Oxford/Archives/Oxford%202006/Courses/Governance/Articles/Eisenhardt%20-%20Agency%20Theory.pdf



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



COST OF CAPITAL AND CAPITAL STRUCTURE



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



Equity versus debtFeature: 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



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)

)1( Tkk nomd

t

t

r

M

r

rCB

)1(

)1(1



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)



Cost of retained equity

• Using Gordon model of growing perpetuity:

• P=D1/ (r-g); i.e.

ks = (D1 / P) + g



Cost of new equity

• Using Gordon model of growing perpetuity taking in consideration flotation cost:

ke = (D1 / (P-F)) + g



The CAPM approach

• Estimate using the CAPM– Estimate of risk free rate rRF

– Estimate the market premium RPM

– Estimate the stock’s beta coefficient s

– Substitute in the CAPM equation:

sMRFs RPrr )(



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



WACC

• Weighted average cost of capital – one way of measuring cost of capital of a company

WACC=wd*kd + wp*kp + ws(e)* ks(e)

• Another way may be estimating through market model (SML) – ex-post valuation



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



Summary1. 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.



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.

4. We considered the case of a project whose beta risk was equal to that of the firm.

5. If the firm is unlevered, the discount rate on the project is equal to RF+( M - RF)*ßwhere 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 CAPM’s estimate of the expected return on the



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.



Exercise problem 1

• 12.13 RWJ • Calculate the weighted average cost of capital

for the Luxury Porcelain Company. • The book value of Luxury’s 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.



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 firm’s 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.



Useful web sources

• Online Tutorial #8: How Do You Calculate A Company's Cost of Capital?

• http://www.expectationsinvesting.com/tutorial8.shtml

• And a video lecture (rather easy)

• http://www.youtube.com/watch?v=JKJglPkAJ5o



RECOMENDED READINGS

• Fundamentals of Corporate Finance, Ross, Westerfield and Jaffe, 6 th edition. Ch 12




MERGERS AND TAKEOVERS



Outline

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



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



Underlying principles

• Combined future CF’s are bigger than sum of CF’s 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



M&A’s = “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 (2+2=5)



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



Source of synergy from acquisitions 2

• Tax Gains– Net Operating Losses– Unused Debt Capacity– Surplus Funds

• The Cost of Capital



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.



Influence of innovative products

• Management may forget the underlying principles justifying M&A

• Target company must be worth more than it will cost the acquirer



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 firm’s 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.



Cash versus Common Stock 2

• 3. Sharing Gains. If cash is used to finance an acquisition, the selling firm’s 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.



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



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,…



“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



EPS game

• Growth in P/E is automatically created by an equity funded acquisition if P/E of bidder > 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



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%.

P EP A T P E P A T P E

P A T P A TG ro u p

A cq A cq Tg Tg

A cq Tg

* *

S h are p r ice P E E P S*



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 > P/EB P/EA = P/EC P/EA < P/ED Invert the transaction !

Deal A issues 5 mil shares at 1£ A issues 5 mil debt for (5%) A issues 5 mil shares at 1£ 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



Higher growth companies

• EPS bidding < EPS target

• P/E bidding < P/E target

• Post-acquisition P/E to appropriate weighted average of the original businesses

• EPS because bidding company is larger than target company



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



Summary1. 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.

2. The three legal forms of acquisition are merger and consolidation, acquisition of stock, and acquisition of assets.

3. Mergers and acquisitions require an understanding of complicated tax and accounting rules



Summary 2

4. The possible benefits of an acquisition come from: a. Revenue enhancement, b. Cost reduction, c. Lower taxes, d. Lower cost of capitalThe 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.



Exercise problems

1. Do M&As create value at all?

2. Who are the main beneficiaries of M&A 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. M&A valuation problem – on separate sheet



Useful web sources

• A book on Mergers and acquisitions by Weston and Weaver (2001) - book preview

• http://www.google.com/books?hl=cs&lr=&id=Y2Mz7tOuJBgC&oi=fnd&pg=PP9&dq=mergers+and+acquisitions&ots=85kGKKGutc&sig=iY_Ztx8tQY42Kzmw2-UrVp25rTM#v=onepage&q=mergers%20and%20acquisitions&f=true



Useful web source 2

• Characteristics of takeover defense strategies

• http://www.investopedia.com/articles/stocks/08/corporate-takeover-defense.asp#axzz29MjA54dw



RECOMENDED READINGS

• Fundamentals of Corporate Finance, Ross, Westerfield and Jaffe, 4th edition. Ch 29




CAPITAL STRUCTURE



Outline

• Capital structure concept – maximizing value• Optimal capital structure• M&M Theory of Independence• M&M Theory of Dependence• Taxes and financial leverage• Cost of financial distress and agency costs• EBIT-EPS analysis• Summary, exercises, references



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



Miller & Modigliani (1958)

• The Cost of Capital, Corporation Finance and the Theory of Investment, American Economic Review 48: 261-297



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



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



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



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



Proposition II.Dependence Hypothesis

• Both the cost of capital (K0) and share price (P0) are influenced by firm’s 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)



Dependence Hypothesis

• According to Dependence Hypothesis: Percentage change of cost of equity Kc= 0,

however, percentage change in dividends Dt > 0

• Percentage change of price = percentage change of dividends



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



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)



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



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



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.



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 firm’s debt-to-equity ratio.



Exercise questions

1. Explain the concept of capital structure

2. Define the optimal capital structure

3. Explain the logic of M&M Theory of independence

4. Explain M&M Theory of dependence

5. Explain the role of taxes in financial structure

6. Explain the cost of financial distress and agency costs



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.



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-tradeoff-leverage.asp#axzz1sgRpYOfd



RECOMENDED READINGS

• Fundamentals of Corporate Finance, Ross, Westerfield and Jaffe, 6 th edition. Ch 12




STRATEGY AND TACTICS OF FINANCING DECISIONS

- INVESTMENT DECISION MAKING



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



Investment Projects

• Nature of project

• Profit generating projects– Increasing capacity, new equipment– Replacement projects

• Ecological projects – minimizing loss



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



Project Phases

1. Investment phase

2. Operating phase (income and taxes)

3. Liquidating phase (sometimes included in operating phase)



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*



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



Internal Rate of ReturnThe 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



Payback Period

• Non-discounted method

• Discounted method

• Cumulated cash flows

• ASSUMPTION- evenly distributed cash flows during the course of each period



Profitability index

• Present value of cash inflows to present value of cash outflows

• Decision rule: PI > 1

• The same decisions as NPV

• Profitability indexes of two projects can not be added, whereas the NPVs can



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



Modified IRR* - formula

C O F

r

C IF r

IR Rt

tt

T tT t

t

T

T1

1

10

0

( )

( * )

IR R *C IF (1 r)

C O F

(1 r)

tT t

t 0

T

tt

t 0

TT

1



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



Summary1. 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.



Summary 2

4. 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.

5. 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.)



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 methods6. 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



Useful web sources

• http://www.studyfinance.com/lessons/capbudget/• http://www.capitalbudgetingtechniques.com/• What is capital budgeting - text• http://www.exinfm.com/training/

capitalbudgeting.doc• Impact of inflation on investment decision making• http://www.studyfinance.com/jfsd/pdffiles/v9n1/

mills.pdf



RECOMENDED READINGS


• Brigham and Houston: Fundamentals of Financial Management, 12th ed, Ch 9, 10



RISK AND RETURN RELATIONSHIP



PORTFOLIO RISK AND RETURN

• Risk and risk aversion• Investors’ attitudes• Diversification• Capital asset pricing model and SML• Beta coefficient• Arbitrage pricing theory• Exercises, web-sources and recommended

readings



INVESTMENTS AND RISK VS RETURN

• The investment process consists of two broad tasks. • One task is to find security and market analysis, by

which we assess the risk and expected-return attributes of the entire set of possible investment vehicles.

• The second task is the formation of an optimal portfolio of assets, which involve the determination of the best risk-return opportunities available from feasible investment portfolios and the choice of the best portfolio from the feasible set

111



RISK AND RISK AVERSION

• The presence of risk means that more than one outcome is possible.

• A simple prospect is an investment opportunity in which a certain initial wealth is placed at risk, and there are only two possible outcomes.

112



PORTFOLIO MANAGEMENT

• Risk and return relation (figures)

• Diversification– not perfect correlation of assets– investor is able to obtain higher return whilst

maintaining the same risk

( )



PORTFOLIO RETURN

E R x E Rp i ii

n

( ) ( )

1

Return on n-asset portfolio

E(Rp) Expected return of the portfolioE(Ri) Expected return of the i-th assetxi Weight (proportion) of i-th asset

within a portfolio

n Number of assets in the portfolio

x ii

n

1

1



PORTFOLIO RISK

Risk of the n-asset portfolio

p i j ijj

n

i

n

x x

11

p Standard deviation of a portfolioij Covariance of i-th and j-th assetsxi and xj Weight (proportion) of i-th and j-th assets

within a portfolio n Number of assets in a portfolio



CAPITAL MARKET LINE (CML)

• Market portfolio• Market return (RM)• Risk-free return (Rf)• Risk of the market (M)

R RR R

p f p

M f

M

All efficient portfolios will lie on the new efficient frontier

• Return of the portfolio (Rp)• Risk of the portfolio (p)



BETA COEFFICIENT

A measure of volatilityStandardized measure of risk, - relative risk compared to the market portfolio

i

i M

M

,2

i … risk of the i-th asseti,M … covariance of the i-th asset with the market portfolioM

2 … variance of the market portfolio



SECURITY MARKET LINE (SML)

• Return on the i-th security • Market return (RM )• Risk-free return (Rf )• Security beta (i )• Market premium (RM - Rf )

R R R Ri f M f i ( )

The expected return on any security can be estimated using theCapital Asset Pricing Model



CAPITAL ASSET PRICING MODEL (CAPM)

All assets can be organized on the Security market line (SML)in the Risk - Return space

Expected return of i-th asset can be calculated as:

R R R Ri f M f i ( )



ASSUMPTIONS OF CAPM (1)

• No transaction costs• All assets are infinitely divisible • No taxation• No single investor can affect the price

(perfect market)• Investors make decisions solely in terms of

expected returns and standard deviations• Unlimited short sales are allowed



ASSUMPTIONS OF CAPM (2)

• Unlimited lending and borrowing of funds at the (the same) riskless rate

• Homogeneous expectations concerning the mean and variance of assets

• All investors have identical expectations with respect to the portfolio decision inputs (1.exp. returns, 2.variances, 3.correlations)

• All assets (eg, including human capital) are marketable



CHARACTERISTIC LINE

R R R Ri f M f i

SML can be rewritten as:

(Ri - Rf ) … Excess return of the security(RM - Rf ) … Excess return of the market



BETA ESTIMATES

R R R Ri f M f i i

Estimating beta from historical returns using regression

Beta is a slope of a characteristic line of i-th security



Beta koeficient

Standardized measure of risk- Relative risk compared to Market portfolio

i

i M

M

,2

i … risk of i-th asseti,M … covariance of i-th asset with market portfolioM

2 … variance of market portfolio



ALPHA

An investor can be convinced, that the security is wrongly pricedaccording to CAPM.His estimate will differ by I

i iinvestor

f M f iR R R R

i iinvestor

iC A P MR R

If i > 0 the investor believes that the security is undervaluedIf i < 0 the investor believes that the security is overvalued



IMPACT ON THE CHARACTERISTIC LINE

R R R Ri

investorf i M f i i

Excess return of the security (Riinvestor - Rf ) is composed from:

1) difference between investor’s estimate and CAPM estimate (i)

2) excess return of the market times beta (RM - Rf ) *i

3) an error (i)



ARBITRAGE PRICING THEORY (APT)

• New and different approach to determining the asset prices

• More general then CAPM which takes into account means and variances of security returns

• Law of one price: two assets that are the same can not sell at different prices



FACTOR (INDEX) MODELS

• Return on any security is related to a set of factors, eg:– growth of real GDP – real interest rates– unexpected inflation– commodities prices– growth of population

• Not only to the market excess return



SINGLE FACTOR MODEL - RETURN

R a b F ei i i i *Uncertain return on an i-th security is determined by:

F uncertain value of a factorai expected value of i-th security in case

the value of factor F = 0bi sensitivity of i-th security to factor Fei uncertain error term



FACTOR MODEL - ASSUMPTIONS

• error term and factor are not correlated

• error terms of any two assets are not correlated

• returns of assets are correlated since they depend on the same factor



Summary

• Speculation is the undertaking of a risky investment for its risk premium.

• The risk premium has to be large enough to compensate a risk-averse investor for the risk of the investment.

• Hedging is the purchase of a risky asset to reduce the risk of a portfolio.

131



Summary 2

• The negative correlation between the hedge asset and the initial portfolio turns the volatility of the hedge asset into a risk-reducing feature..

• When a hedge asset is perfectly negatively correlated with the initial portfolio, it serves as a perfect hedge and works like an insurance contract on the portfolio.

132



Exercise problem• Riskless rate is 8 per cent and market rate is 12 per cent. • You investigate the following three investment opportunities:

• Portfolio Beta• A 0,6• B 1• C 1,4

a) Calculate for each of the three portfolios the expected return consistent with CAPM

b) Show graphically the expected portfolio returns c) Indicate on the graph what would happen to the capital market line in

(a) if the expected return on the market portfolio were 10 percent. d) Explain various implications of such movement.



Useful web source

• The website listed below has an online journal entitled Efficient Frontier: An OnlineJournal of Practical Asset Allocation. The journal contains short articles about various investment strategies that are downloadable in Adobe format.

• http://www.efficientfrontier.com

134



RECOMENDED READINGS

• Fundamentals of Corporate Finance, Ross, Westerfield and Jaffe, 4th edition. Ch 9 and 10

• Bodie, Z., Kane, A and Marcus, A. Investments 5th Ed., Mc Graw Hill. 2001 ch 6 and 7

• Sharpe, W., Alexander, G., Bailey, J.: Investments, 6th ed Ch. 6-9

135



BONDS AND SHARES



OUTLINE

• Introduction

• Debt securities, characteristics and risk

• Different types of bonds

• Bond rating

• Equity valuation

• Debt vs. equity

• Summary, exercises, references



DEBT SECURITIES - BONDS

BC

y

M

yt

tt

n

n

1 11

B…bond priceCt…fixed coupon, c…coupon rateM…principal (nominal value)y….yield, or discount rate ( r )



RISK CHARACTERISTICS OF BONDS

• Bonds are perceived as a safer investment alternative than stocks

• Long term bonds are more sensitive to the changes in interest rates than short term bonds

• Types of risk– default risk & time risk – interest rate risk & reinvestment risk



MATURITY AND VOLATILITY

• Prices and returns for long-term bonds are more volatile than those for shorter term bonds

• Interest rate risk



DIFFERENT TYPES OF BONDS

• ‘Plain vanilla’ bonds

• Floating rate bonds

• Deep discount bonds

• Income bonds (dependent on income)

• Convertible bonds

• Bonds with warrants



BOND RATING

• Moody’s Investor Service• Standard and Poor’s

– Rating default risk– Investment Grade, Non-investment grade – lower grade bonds below BBB for S&P and below Ba

for Mody’s

• Junk Bonds – in 1970s Michael Milkin in Drexel Burnham Lambert developed the high yield junk bond market



YIELD TO MATURITY

– Coupon bond: B=C/(1+r)+C/(1+r)2+…+C/(1+r)n+M/(1+r)n,

– Consol (perpetuity) r=C/Pc ) – Discount bond (1 year) r= (M-Pd)/Pd)

• Current bond prices and interest rates are negatively related: When interest rate rises, the bond price rise falls and vice versa



EQUITY - VALUATION

• Present value of future cash flows (dividends)

• Preference shares• Common shares

– Zero growth– Constant growth (Gordon Model)– Supernormal growth



NEW ISSUE

• Approval from BOD• File the Registration statement with SEC

– details of financial information (50 pages)

• Preliminary prospectus distributed to potential investors

• After approval by SEC the price of new issue is added and selling begins

• Compare with rights offer



EQUITY VERSUS DEBTFeature: 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



Summary1. Pure discount bonds and perpetuities

can be viewed as the polar cases of bonds. The value of a pure discount bond (also called a zero-coupon bond, or simply a zero) is

PV =F/(1+r)T

2. The value of a perpetuity (also called a consol) is PV = C/r



Summary 2

3.Ordinary bonds can be viewed as an intermediate case. The coupon payments form an annuity and the principal repayment is a lump sum. The value of this type of bond is simply the sum of the values of its two parts.

4. The yield to maturity on a bond is that single rate that discounts the payments on the bond to its purchase price.



Summary 3

5.A stock can be valued by discounting its dividends. We mention three types of situations:

a. The case of zero growth of dividends.b. The case of constant growth of dividends.c. The case of differential growth.6.An estimate of the growth rate of a stock is

needed for formulas (b) or (c) above. A useful estimate of the growth rate is

G = Retention ratio * Return on retained earnings



Exercise (1)• Consider two bonds, bond A and bond B, with

equal rates of 10 percent and the same face values of $1,000. The coupons are paid annually for both bonds. Bond A has 20 years to maturity while bond B has 10 years to maturity.a. What are the prices of the two bonds if the relevant market interest rate is 10 percent?b. If the market interest rate increases to 12 percent, what will be the prices of the two bonds?c. If the market interest rate decreases to 8 percent, what will be the prices of the two bonds?



Exercise (2)

• Consider a bond that pays an $80 coupon annually and has a face value of $1,000.Using excel calculate the yield to maturity if the bond hasa. 20 years remaining to maturity and it is sold at $1,200.b. 10 years remaining to maturity and it is sold at $950.



USEFUL WEB SOURCES

• On financial instruments http://www.investopedia.com/terms/f/financialinstrument.asp#axzz1e50d197V

• Corporate finance a practical approach - Clayman, Fridson, Troughton - CFA institute (incl. examples and calculations) Ch 4?

• http://www.google.com/books?hl=cs&lr=&id=PwyqVX3H1YkC&oi=fnd&pg=PT10&dq=corporate+finance+a+practical+approach&ots=r4Lk6fqqou&sig=zrTrbFmB1KiNKIun2Jxgey24XGU#v=onepage&q=bond&f=false



RECOMENDED READINGS



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