Corporate Financial Management 1

1
Corporate Financial Management 1

• Jan Vlachý ltvlachy_at_atlas.czgt
• Brigham, E.F., Ehrhardt, M.C. Financial
  Management Theory and Practice, 13th Edition

2
Basic Concepts
Chapters 1-3

• Corporate Financial Management
• Is the Art/Science of Creating and Maintaining
  the Value of a Company.
• Gives a Firm its Common Language.
• It Consists of
• Investment Decisions
• Financing Decisions
• Managerial Decisions

3
Investment Vehicle Model
The Set of Contracts Model recognises
imperfections and includes the assumption of both
explicit and implicit contracts, incl. Corporate
Organization.
4
The Financial Environment

• Competitive Economic Environment
• Two-Sided Transactions (BuyerSeller Equil.)
• Risk-Return Tradeoff
• Signalling/ Behavioral Principle
• lt Market Efficiency (Information, Transactions)
• Value (How can some people become rich?)
• New Ideas, Expertise
• Options
• Time Value of Money

Financial transactions create an equilibrium
Real investments create value
5
Accounting, Cash Flows Taxes

• Purposes of an Accounting System
• Reporting the Firms Financial Activities to
  Stakeholders
• Providing Information to Firms Decision Makers
• Financial Management strives to use and interpret
  the information
• Accounting - historical view
• Finance - current and future

6
Limitations of Accounting

• Why dont shares trade at Book Val.?
• MarketBook Value of Assets/Liabs
• Historical Accounting (depreciation)
• Inflation (value benchmarks have changed)
• Liquidity (can it readily be sold?)
• Time Value of Money (relates to Maturity and
  Terms)
• Note Finance prefers to deal with cash flows in
  a time perspective.

7
Taxes

• Income Tax
• Make analyses on after-tax basis
• For financial decisions, use marginal tax rate
  (relavant if tax is progressive or unsymmetrical
  on negative base)
• Capital Gains Tax
• Dividend/Interest Income Treatment
• System Biases (Loss Carry-forwards, Exemptions,
  Deductions)

8
Time Value of Money
Chapter 4

• Any Present Value has a greater Future Value.
• ... i.e.
• People generally prefer having any amount of
  money at their disposal earlier rather than
  later.
• ... i.e.
• Investors require positive returns as
  compensation for the inconvenience.

9
On Present and Future Values

• You deposit 1,000 today with a bank that pays 5
  interest per year.
• FV1 PVrPV PV(1r) 1,0001,05 1,050
  (Simple Interest)
• FV2 FV1(1r) PV(1r)(1r) PV(1r)2 1,102.50
  (Compound Interest)

Discounted Cash Flow Framework
FVt PV(1r)t PV FVt / (1r)t
10
Return, Net Present Value

• Return of an Investment (Rate of Return, Yield)

• NPV Present Value of expected cash flows
  (positive-negative)

11
Practical Issues

• Distinguish
• Realized Return
• Expected Return (lt Risk)
• Required Return (lt Unperfect Mkts)
• Financial securities are usually priced fairly
  (Market Equilibrium).
• Investment projects (and other entrepreneurial
  decisions) should bring value, i.e. have positive
  NPV.

12
Valuing Single Cash Flows (Ex.)

• What is the Future Value of 2,000 invested at 3
  per year for five years?
• What is the Present Value of CZK 10m to be
  received two years from now if the required
  return is 4 per year?
• What is the Expected Return for an investment
  costing 10,000 today and offering 12,000 in
  three years?

13
Valuing Multiple Cash Flows

• You can invest 10,000. As a result, you expect
  to get 2,000, 8,000, and 5,000 over the next
  three years, respectively. If the required return
  is 10, what is the NPV of your investment?

• What is the return if you know the NPV?

14
Annuities

• Types of Annuity
• Ordinary Annuity (Payments at end of period)
• Annuity Due (Payments at beginning of period)
• Deferred Annuity (First repayment more than one
  period after drawing)

FVAn PVAn(1r)n PVAndue PVAn(1r) PVAndef
d PVAn/(1r)d
15
Amortization Schedules

• A 1,000 loan yielding 8 requires equal payments
  at the end of the next three yrs. How much
  principal will be rpd. in Year 2?
• PMT 1,000.08(1.08)3/(1.083-1) 388.03

P2 V1 - V2 PMT2 - I2 332.67
16
Perpetuities
Problem 4-27

• PV 100 / 7 1,428.57
• Growth Perpetuities
• PMTt PMT0(1g)t
• PVgrowth PMT1/(r-g) (... r gt g)

17
Compounding Frequency (1)

• Compare annual return on deposit with 6 interest
  paid annually and monthly.
• FVA PV(1 6) PV1.06
• rA (FVA-PV) / PV .06PV/PV 6
• FVM PV(1 6/12)12 PV1.00512 PV1.0617
• rM (FVM-PV) / PV 6.17

18
Compounding Frequency (2)

• Compare the cost of a 6 (nominal rate) loan with
  monthly and quarterly interest.
• Nominal RateEffective Annual Rate
• NR mrm
• EAR (1 rm)m - 1
• EAR M 1.00512 - 1 6.17
• EAR Q 1.0154 - 1 6.14

19
Bond and Stock Valuation
Chapters 5,7

• Main sources of capital for Company
• Bond Debt Capital
• Stock Equity Capital
• Claim on fut. cash flows for Investor
• Bond Contractual interest and princi-pal
  payments (or proceeds of sale)
• Stock Dividends (theoretically forever) or
  proceeds of sale

20
Valuation Procedure

• Based on discounted cash flow concept
• Estimate expected future cash flows
• Determine required return (depending on the
  riskiness of the expected cash flows)
• Compute the present value
• Other possibilities Market price of same or
  comparable asset

21
Features of Bonds/ Stocks

• Par (Face, Princ.) Value
• Coupon (Interest) Rate
• Coupon Payment Frequency
• Maturity Original (Issue), Remaining (Residual)
• Terms of Repayment Bullet, Sinking Fund,
  Zero-Coupon (Pure Discount)
• Call Provision (Option) other Rights
  Junior/Senior

• ???
• Dividends
• Dividend Payment Frequency
• N/A
• N/A
• Common/Preferred
• Rights (Warrants, Convertibles)... See Chapt. 19,
  Hybrid Financing

22
Bond Valuation
Problem 5-1
t 1 2 3 4 ... 8 9 10 11 12
Ct 80 80 80 80 ...
80 80 80 80 1,080 r 9
PV 73.39 67.33 61.77
56.67 ... 40.15 36.83 33.79
31.00 383.98 928.39
For bond w/semi-annual coupons n24, Ct40. To
put required return on same basis as annual bond,
one should assume EAR 9 (1rS)2 - 1, i.e. rS
\/1.09 - 1 4.4.
23
Yield to Maturity/ Yield to Call (1)

• Assume Johnson Co. has a bond with a face value
  of 1,000 that matures in 12 years, has a coupon
  rate of 8, and is currently selling for 928.39.
  What is the required return to buy the bond (YTM
  9.00)?
• Assume it can be called in 10 years at a call
  price of 1,100. What would be the required
  return to buy the bond if we knew the option
  would be excercised (YTC 9.79)?

24
Yield to Maturity/ Yield to Call (2)

• Yield to Maturity Promised Return
• Yield to Call Return if Called
• N12 PV-928.39 PMT80 FV1,000 gt I (YTM)
  9.00
• N10 FV1,100 gt I (YTC) 9.79
• Expected Return YTM minus Risk
• Credit (Default) Risk lt Rating
• Interest Rate Risk/ Reinvestment Risk
• FX Risk, Liquidity Risk...

25
Market Interest Rates/Yield Curve
26
Stock Valuation
Problem

• Value a share which is expected to pay dividends
  of 2.72 and 3.10, respectively, over the next
  two years, and sold thereafter for 48, if the
  required return is 10?
• V2.72/(1.1)3.10/(1.1)248/(1.1)2 44.70
• But... How did I estimate the market price in 2
  years?
• Let us assume constant dividends of 4.80 after
  Year 2.
• Using perpetuity valuation V24.80/10 48

27
Constant Growth Model

• Dt D0(1g)t
• V D1/(r-g) (... r gt g)
• e.g. V 36(1.05)/(13-5) 31.5
• e.g. r 1.30/21.25 6 12.12
• CG formula can also be used for determining a
  horizon (terminal) value or for valuing declining
  growth stock.
• For erratic or supernormal growth stock, split
  cash flows into two parts.

28
Risk and Return
Chapters 6, 7

• Risk refers to the chance that some unexpected
  event would occur.
• In business, that would mean the decrease of
  value of the firm, in financial markets any
  change in the value of financial instruments etc.
• In other words, actual returns will differ from
  expected returns.
• The expected return should therefore compensate
  an investor for the perceived risk.

29
Investments with Risk
Problem
30
Expected Return

• E(r) Swiri
• E(rEQ1) .10(-25) .20(-5) .40(15)
  .20(25) .10(50) 12.5

• Eq 1 has the highest expected return.
• Is it the best investment?

31
Stand-Alone Risk

• s \/S(wi(ri-E(r))2
• sEQ1 \/.10(-25-12.5)2 .20(-5-12.5)2
  .40(15-12.5)2 .20(25-12.5)2 .10(50-12.5)2
  19.4

Volatility
32
Probability Distributions
33
Portfolio Risk (1)

• Assume portfolio with 50 invested in Eq 1, and
  50 in Gold.

• E(rP) 7.25
• sP 6.1

34
Portfolio Risk (2)

• ?p (6.1) is much lower than
• either Eq 1 (19.4) or Gold (7.5).
• average of Eq 1 and Gold (13.5).
• The portfolio offers a decent return (average of
  Eq 1 and Gold returns) with low risk.
• The key is low (actually negative) correlation
  between Eq 1 and Gold returns, facilitating
  diversification.

35
Managing Portfolio Risk

• Systematic and Specific Risk Law of Large
  Numbers (Insurance, Consumer Credit)
• Equilibrium Theories, e.g. Capital Asset Pricing
  Model Sharpe, Lintner (Equity Markets, Capital
  Investments)
• Portfolio Theory Markowitz (Market Portfolios),
  based on function sPƒ(w1,w2,w3,..,s1,s2,s3,..,?12
  , ?13, ?23,..)

36
Effect of Diversification
37
Capital Asset Pricing Model

• In an efficient market, the required return will
  equal the expected return.
• efficient market gt equilibrium price
• transactional, informational efficiency
• efficient market ? arbitrage
• An assets required return is the sum of the
  riskless return and an asset-specific risk
  premium.
• Beta (ß) is a measure of the assets market
  (systematic, undiversifiable) risk.
• SML ri rF ß(rM - rF)

38
Beta as a Sensitivity Measure
ri rF ß (rM - rF)
39
CAPM Utilization
Problem

• Two shares (in the same market) with known rF,
  ßA, ßB, rA, looking for rB.
• rA rF ßA (rM - rF)
• rB rF ßB (rM - rF)
• 14 6 1.4(rM-6) gt rM 11.7
• rB 6 1.1(11.7-6) 12.3
• Note The beta of a portfolio equals the weighted
  average of its component betas (VP bP VA bA
  VB bB ...)

40
Options
Chapter 8

• Option Right (Financial and Embedded Options,
  i.e. Contracts) or Opportunity (Real Options)
• Financial options are traded contracts,
  derivatives of Underlying Assets (Equities, FX,
  Bonds, Commodities, Indices...)
• Financial Derivatives include Options, Warrants,
  Forwards, Futures, Swaps, Repos...
• Financial Derivatives are used primarily for Risk
  Management (Hedging, Speculation) ... See Chapt.
  23

41
Applications

• Financial Options
• American vs. European Options
• Call vs. Put Options
• Exotic Options (various terms of exercise, caps,
  floors exchange options, compound options,...)
• Embedded Options... Constitute Contracts
• Real Options... In Business Decisions ... See
  Chapts. 11,25

42
The Value of Options

• Intrinsic Value (would the option be executed if
  nothing changed till excercise date?) ƒ(p r
  t) ...usually easy to assess can be used for
  designing option strategies
• Time Value ƒ(t s) ...calculated by means of
  models (using market equilibrium assumption and
  replication)

43
Using the Replication Principle

• Call Option S 40, p 32, d 16 or u 64
  at time t rt 2.
• d Option out of the money, i.e. Vd 0
• u Uption in the money, i.e. Vu 64 - 40 24
• Income structure can be replicated with N forward
  transactions. These must have zero value if
  underlying asset costs 16, and must therefored
  be issued with forward price F 16. Their
  present value is VF p - F/(1rt) 16.31.
• Value of N forward transactions at settlement if
  underlying asset costs u is Vu  N(u - F). To
  replicate u 64 ? Vu 24, N 24/(64-16) 0.5.
• The option value is thus VC 0.516.31 8,16.

44
Numerical Model (Binomial, CRR)

• Call Option S 1 100 p 1 000 r 5 4
  periods

45
Analytical Model (Black-Scholes)

• VC p N(d1) - S e-rt N(d2)
• d1 ln(p/S) (s2/2) t / (s ?t)
• d2 d1 - s ?t
• p 500 S 510 r 3 t 3months (0,25) s
  20
• d1 ln(500/510)(0,04/2)0,25/(0,20,5)
  -0,0730
• d2 -0,0730 - 0,20,5 -0,1730
• N(d1) N(-0,0730) 0,4709 N(d2) N(-0,1730)
  0,4313 (cummulative distribution function for a
  standardised normal random variable)
• VC 5000,4709 - 510e-200,250,4313 17,12
• VP VC - p Se-rt 17,12-500510e-30,25
  23,31 (using put-call parity)

46
Cost of Capital
Chapter 9

• Cost of Capital Required Return for Capital
  Budgeting Project
• 2 possible approaches
• Use CAPM
• Firm Value Equity Value Debt Value.
• In a perfect market, a company cannot affect its
  value by changing the way it is financed - it
  just influences the distribution of risks and
  returns between different classes of investors.

47
Risk/Return of Real Assets

• CAPM can be extended to include real assets (i.e.
  capital budgeting projects)
• Pure Play Method (Finding single-product
  companies in the same line of business as project
  being evaluated)
• Accounting Beta Method (Regression of return of
  assets against average return on assets in the
  whole market)

48
Weighted Average Cost of Capital

• WACC (1-L)re L(1-T)rd
• L D/(DE) ... Leverage
• T ... Marginal Income tax Rate
• Always based on opportunity, not historical costs
  and values!
• After-tax cost must be used for all components!
• Correct risk assumptions have to be made for
  individual projects!

49
WACC
Problems 9-4, 9-7

• r 3.6 / 70 5.14
• c 3.6 / (70(1-5)) 5.41
• WACC 306(1-40) 55.8 6512 9.17

50
Component Cost of Equity

• Ways to estimate required return
• DCF Method
• CAPM Approach (b of equity, not project!)
• Bond Yield Risk Premium Method
• Equity for new projects may come from retained
  earnings or new issue.
• New issues incur flotation costs. In this case,
  the component cost of capital is higher than
  required return.

51
Application of DCF Method

• QST stock is trading at 30 a share. QST will pay
  a 3 dividend at the end of the year and expects
  5 annual growth. Costs of flotation amount to
  10. What is the required return and cost for new
  equity?
• r D1/V g 3/30 5 15
• Vnet V(1-F) 30(1-10) 3090 27
• re D1/V(1-F) g 3/30(1-10) 5
  16.1

52
Risk, Leverage, Beta and WACC

• Operating Leverage influences rA, i.e. both rE
  and rD ltgt an increase in operating risk
  increases bA and WACC.
• Financial Leverage in efficient markets, an
  increase should increase bd, but leave bA and
  WACC unchanged.
• (1-TL)bA L(1-T)bD (1-L)bE ( portfolio)
• Assuming low risk of debt, it is possible to
  approximate bA bE (1-L)/(1-TL)
• ... on Leverage more in Chapt. 15

53
Distinguish Risks

• Operating (Business) Risk (depends on structure
  of firms assets, not structure of financing) lt
  Operating Leverage
• Financial Risk (based on firms capital
  structure) lt Fin. Leverage

54
Basics of Capital Budgeting
Chapter 10

• Generate ideas
• Estimate the expected future cash flows from the
  project.
• Assess the risk and determine a required return
  (cost of capital, hurdle rate, discount rate).
• Compute present value of cash flows if project
  has a positive NPV, it creates value gt should be
  accepted.
• Alt. Find market price or compare with similar
  asset

55
Types of Projects

• Capital budgeting projects include
• New products and new businesses
• Maintenance projects
• Cost saving/ revenue enhancement
• Capacity expansion
• Projects required by regulation/ policy
• Independent/Exclusive Projects
• Conventional/Nonnormal Cash Flows

56
Alternative Budgeting Measures

• Net Present Value
• Internal Rate of Return (Expected Rtrn)
• Profitability Index
• Modified IRR (includes cost of capital)
• Payback ... ignores time value of money and cash
  flows beyond payback
• Discounted Payback

57
Investment Criteria
Problem

• PB 2 (10,000/30,000) 2.3 years
• DPB 2 (17,934/22,539) 2.8 years
• NPV SDCF 18.266
• PI SDCF1-4 / CF0 1.26
• IRR 22.24
• MIRR (129,230/70,000)1/4 - 1 16.56

58
Issues

• IRR brings same results as NPV with independent
  and conventional projects only
• Unequal lives of exclusive projects, e.g.
  replacement projects ... use common horizon
  calculation or Equivalent Annual Annuities (EAA
  NPVr(1r)n/(1r)n-1)
• It is realistic to assume some kind of capital
  budget constraint ... use artificially high
  discount rate or capital rationing (e.g. ranking
  by Profitability Index)

59
Estimating Cash Flows
Chapter 11

• Cash flow ? income (includes e.g. depreciation,
  ignores time value)
• Measure on incremental (marginal) basis
• Only future expenditures/revenues are relevant
  (avoid sunk costs)
• Include taxes not financing costs (they are
  reflected in cost of capital)

60
Types of Budgeting Cash Flows

• Net Initial Investment Outlay
• new assets purchase, old assets sale, increase in
  net working capital
• Net Operating Cash Flow
• Nonoperating Cash Flows
• overhauls, changes in working capital
• Net Salvage (Termination) Value
• Tax Adjustment (CapitalizingExpensing)

61
Est. Cash Flows
Problems 11-1,2,3
62
Budgeting Cash Flows
Problem 11-9
NPV - 7,160 2,000/1.15 2,384/1.152
1,968/1.13 1,744/1.154 1,712/1.155
3,232/1.156 921.36 Note Different remaining
lives, working capital investment
63
Analyzing Risk

• Market Risk
• Measured by b (see CAPM) impacts discount rate
• Stand-Alone Risk
• Break-even Analysis
• Sensitivity Analysis
• Scenario Analysis
• Monte Carlo Simulation

64
Simple Example

• Project costs 100,000, expected sales 1,000
  units, price 80/unit, cash op. exp. 40/unit,
  5-year life, fully amortized, terminal value
  10,000. Cap. cost 12, tax rate 25. What is its
  NPV?
• V -I N(P-U)(1-T)DT((1r)n-1) /r(1r)n
  F(1-T)/(1r)5 -100,000
  30,0005,0003.60 7,500/1.76  30,423

65
Break-even Analysis (Sales)

• V -I N(P-U)(1-T)DT3.60
  F(1-T)/(1r)5
• What N would result in V 0?
• -I N(P-U)(1-T)DT3.60 F(1-T)/(1r)5
  0
• N (100,000-7,500/1,76)/3.60-5,000/30 720
  pcs.
• i.e. the project breaks even at 720 units sold.
• Usually easier to use numerical iteration.

66
Sensitivity Analysis (Price)

• V -I N(P-U)(1-T)DT3.60
  F(1-T)/(1r)5
• ?V/?P N(1-T)3.60 7503.60  2,700
• i.e. a price cut of 1 will result in a project
  value decrease by 2,700.
• Almost always easier to use numerical simulation.

67
Scenario Analysis (Sales, U.Cost)
68
Real Options

• Flexibility to adjust plans based on newly
  acquired information may increase NPV.
• Growth/development options
• Contraction/abandonment options
• Investment timing options
• Exchange options
• Valuation methods
• Closed-form (analogy w/B-S)... rare
• Decision trees
• Monte Carlo
• ... further reading in Chapt. 25

69
Financial Planning
Chapter 12

• Pro-Forma Financial Statements
• Forecast the amount of external financing that
  will be required
• Evaluate the impact that changes in the operating
  plan have on the value of the firm
• Set appropriate targets for compensation plans

70
Steps in Financial Forecasting

• Forecast sales
• Project the assets needed to support sales
• Project internally generated funds
• Project outside funds needed
• Decide how to raise funds
• See effects of plan on ratios and stock price

71
Additional Funds Needed
Problem
Sales 12,000 M NI/Sales 6 P D/NI
25.
72
Key Assumptions

• Operating at full capacity last year.
• Each type of asset grows proportionally with
  sales.
• Payables and accruals (i.e. current liabilities)
  grow proportionally with sales.
• Existing profit margin (6) and payout (25) will
  be maintained.
• Sales are expected to increase by 3 million.
  (?S 25)

73
Graphical Illustration
A/S 7,560/12,000 0.63 9,450/15,000 (i.e.
Capital Intensity Ratio remains unchanged)
74
Calculating AFN

• AFN Required Increase in Assets - Spontaneous
  Increase in Liabilities - Increase in Retained
  Earnings
• AFN A(?S/S0)- L(?S/S0)- MS1(1-P)
  7,56025 - 1,80025 - 615,00075
  1,890-450-675 765,000

75
Projected Balance Sheet
DR03,600/7,56048 DR14,815/9,45051 CR04,560
/2,6001.75 CR15,700/3,8151.49
76
Corp. Valuation Governance
Chapter 13

• Corporate Valuation Model (Dividend Growth
  Model)
• Based on Free Cash Flow Estimation (instead of
  dividends)
• Can be used when dividends are not paid (e.g.
  startups, subunits of firm)
• Estimate the Value of Operations (discount FCF
  NOPAT Required Net Operating Working Capital)
• Add Value of Nonoperating Assets and Growth
  Options

77
Value Based Management

• Value-based Management involves the systematic
  use of the corporate valuation model to evaluate
  a companys decisions.
• Value drivers
• Growth rate of sales
• Operating profitability (NOPAT/Sales)
• Capital requirements (Operating Capital/Sales)
• WACC
• Company creates value when EROIC (i.e.
  NOPAT/Capital) gt WACC

78
Corporate Governance

• Shareholder wealth may be adversely influenced by
  management behavior (agency problem)
• Corporate governance is a set of laws, rules and
  procedures influencing managers in a way that
  maximizes the firms intrinsic value.
• Monitoring
• Litigation
• Threat of removal
• Compensation plans
• Hostile takeovers (avoid managerial entrenchment)