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Title: Corporate Finance
Description: The revision guide includes summary of lecture notes, tutorials, relevant readings, exam qns and proposed answers. Scored a high first in the mod so quality of notes is guaranteed.
Description: The revision guide includes summary of lecture notes, tutorials, relevant readings, exam qns and proposed answers. Scored a high first in the mod so quality of notes is guaranteed.
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Joven Liew Jia Wen
12001778
Guide to Finance Basics
Balance sheet, Income statement and Cash flow statement
Balance Sheet
-summarise company’s financial position at a given point of time
-what company owns (assets)
-what company owes (liabilities)
-net worth (shareholders’ equity)
Assets = Liabilities + Equity
Analysis of balance sheet shows how efficiently the company is utilising its assets and managing its
liabilities
Assets = current + fixed assets
Current assets = cash at hand, account receivables, marketable securities, inventory
Current assets can be converted to cash within a year
Fixed assets = property, plant and equipment
Company must charge a portion of the cost of fixed assets to revenue each year, leading to
accumulated depreciation
Current book value = historic cost of equipment – accumulated depreciation
Goodwill = brand name, reputation
Liabilities = current and long term liabilities
Current liabilities = account payables, accrued salaries, accrued tax, short term loans
Current liabilities are payable within a year
Long term liabilities = bank loans, mortgages, bonds
Owners’ equity includes retained earnings (net profit retained on the balance sheet after payment of
dividends to shareholders)
Traditional balance sheet cannot reflect the value and profit potential of human capital
Working capital = current assets – current liabilities
Too little working capital means company cannot pay its bills
Too much reduces profitability as working capital is financed by interest-bearing loans
Inventory is component of working capital that affects non-financial managers
Inventory provides a buffer against production stoppage or interruptions of raw materials flow
1
Value of inventory decline as it sits on the shelf
Depreciation of inventory can be damaging esp in IT industry as technological advancement is fast
and products become obsolete quickly
Financial leverage = use of borrowed money to acquire an asset
Highly leveraged = percentage of debt on balance sheet is high relative to capital invested by owners
Financial leverage can increase returns on investment or increase risk
High debt incurs high interest cost
Operating leverage = extent to which operating cost is fixed
Company that relies heavily on high investments in machinery have high operating leverage
Company needs a financial structure that strikes a balance between equity and debt on the balance
sheet
Debt to equity ratio is important
Income statement
-shows cumulative business results within a defined time frame, usually half or one year
-tells you whether company is making a profit or loss
-known as P&L (profit and loss statement) too
-tell the company’s revenue, expenses and profit margin
Net income/ Net profit = revenue – expenses
Income statement starts with sales (revenue)
Expenses include taxes, depreciation, admin costs, interest expense
Cost of goods sold (COGS) = direct cost of manufacturing products
Sales revenue – cost of goods sold = gross profit
Gross profit – operating expenses (which includes depreciation) = Operating profit
Operating expenses include salaries of admin employees, office rent, other costs not directly related
to making the product
Depreciation is a way of allocating the cost of an asset over an asset’s useful life
Operating profit = Earnings before interest and taxes (EBIT)
If the company gives too many discounts on products, gross profit will fall
If marketers spend too much money to attract new customers, operating profit will fall
Income statement can help a manager check on generating revenue, managing budgets
2
Cash Flow statement
-how a company acquire and spend its cash over a given period of time
-Cash flow from operating activities, cash flow from financing activities, cash flow from investing
activities
-Cash flow from operating activities is generated from the general operations of the company
Ex
...
MSV = maximising shareholder value
Maximising shareholder wealth means maximising the flow of dividends to shareholders through
time
Integration of Company Business Plan (how I make money) with Financing Plan
-No financial plan can save a fatally flawed business plan
-Continually changing Business plan means sub-optimal financial plan
-basic type of financing plan varies depending on type of business and its future prospects
Start-ups: emphasis on growth development financing to secure the future (Twitter)
Midlife: Incremental capital for investment to hold off competitors (Samsung)
Fully mature: Solvency (Nokia)
Luxury Goods such as Hermes: High margin management, Low unit growth
Apple: High margin management, High unit growth
Walmart: High unit growth, low margin management
7
Profit maximisation is not the same as shareholder wealth maximisation because profits can be
easily manipulated and does not reflect the prospects, risks, accounting differences of the firm
Corporate governance** read textbk
-separation of ownership and control (principal and agent moral hazard problem)
-worry that the management may pursue goals that are not necessarily beneficial to the
shareholders (managerialism)
-Need to try to link rewards to shareholders wealth improvement by granting share options to
directors and managers (permit managers to purchase shares at some date in the future at a price
that is fixed now: managers have incentive to increase share price)
-Sackings or Selling shares and takeover threat (Shareholders sell shares resulting in lower share
price and lower rewards for managers)
-board of directors has the responsibility of overseeing the company and prevent managerialism
-AGM at which shareholders can vote to change the board of directors
Combined Code in UK vs Sarbanes-Oxley Act in US
More accurate, timely and detailed information concerning operations can help to monitor firms and
identify wealth-destroying actions by wayward managers
When a company have rights offering, it is raising emergency capital to survive
...
Issue of new
shares can lead to dilution so existing shareholders are unhappy esp when the new shares are issued
at a discount of 30% than original share price
...
Company survives is better than shares
being worthless
Rational market: stock market exactly and precisely reflect the future cash flow, prospects of the
future of the economy
Lecture 2: Ensuring Liquidity, Working Capital (W/C) management
-After financial crisis, we study mid-sized firms immediate tactics to gain access to liquidity and fund
their operations
-midsize companies search for robust growth and prosperity in a challenging recovery
Core financial disciplines
1
...
3
...
Investing and spending wisely
Avoiding waste
Promoting financial self-reliance
Act as good stewards of value, control and compliance
Be financial disciplined
-slash cost and maintain lean cost structure
-have a strong balance sheet and pay down debts at a ferocious pace
8
-eliminate excess inventory
-improve collections in a competitive buyer’s market for goods and services
-have optimal levels of cash, liquidity and working capital
-work hard to extract payments from increasing distressed customers
-negotiate more favourable terms from suppliers
-reduce inventory levels while maintaining overall margins
-create cash conscious culture in the whole firm, measure progress and emphasize on accountability
Growth can also outstrip working capital as urgent spending and investment needs outstrip
company’s ability to convert inventories and receivables into cash
Financial discipline contributes to comparative advantage and increases financial flexibility and
control (companies with limited borrowing capacity can react to unexpected circumstances) but may
have risk of under-investment
Under fierce competition, price instability and uncertainty, it is necessary to have a stable financial
foundation
...
Manage to the bottom line or income statement – many important cost items don’t appear
in income statement
-Sometimes, there are good trade offs
...
Balance sheet is a snapshot of
the company at a point in time and the goods are recorded at historical cost
...
Reward sales force only for growth – When salespeople are rewarded only for booked sales,
they want to book sales at any cost
...
Overemphasize on production quality – rewarding production people primarily on quality
metrics will slow down production and may have non-value added quality
-lock up capital in work-in-progress WIP inventory
-customers often lack the engineering sophistication to appreciate the incremental quality built into
products and are unwilling to pay higher price
-Should reduce WIP inventory to keep costs down
-Sometimes, by sacrificing a small un-noticeable amount of quality to make a notable improvement
in efficiency, a firm can maintain its reputation while freeing up large amounts of cash **
We should meet the quality expectations of the customers
...
Ex
...
Do not emphasize on unnecessary quality such as luxurious HQ or corporate jets which customers do
not pay for
4
...
Manage to current and quick ratios
-current ratio: current assets/ current liabilities
-can be misleading
-current ratio can be achieved by higher level of receivables and inventory and lower level of
payables (quite odd for WC practice)
-Long term loans to increase cash does not appear in current ratios so current ratios can be
manipulated
6
...
A company that is insolvent loses its top talent, supplier and market
standing
...
Do you agree?
Yes: It means high working capital
...
No: High working capital can come from high receivables due to poor or excessive credit terms given
to customers
...
High
working capital can mean excessive cash or inventories that can lead to loss, damage or theft
...
Apple
pays
its
Chinese
manufacturer Foxtron
in advance
Cash is an underproductive asset so Cannot service debt, possibly lead
value is destroyed
to default or bankruptcy
Temptation for fraud or outright theft
Cannot pay top talent on time and
they go off to competitor
Company becomes an acquisition Pay suppliers late or not at all,
target
losing preferential credit terms
Uses of Working Capital
1
...
In support of the company’s business plan (Not viable business plan won’t work)
3
...
Reduce company’s reliance on expensive long term financing (WC is a reliable and cheap
source of semi-permanent capital)
5
...
Ex
...
DSO = (account receivable/sales) x 365 days
**EXAM QNS: What is DSO and why is it necessary to analyse it?
DSO analysis: Timing of debtors, Credit terms given to customers as compared to rivals, Bad debt
indicators
Zero stock-outs (always available goods) policy is BAD: high prohibitive costs to maintain inventory,
incredibly wasteful
CFO/FD has a value role = maximise shareholders’ value in the long term
12
CFO is the steward of maximum value and has to increase stock price by increasing cash flow (create
value)
...
Manage WC 2
...
Manage
capital structure, debt/equity ratio 4
...
94 between cash flow and share price
Ex
...
The trucks’ content belonged to the suppliers until they were needed by
Dell
...
-Larger inventory of raw materials make it easier to smooth out firm’s production process but
holding large inventory is costly and reduces firm’s rate of return on invested capital
Current ratio = current assets/ current liabilities is a popular measure of firm’s liquidity
Can minimise use of current assets by efficiently managing its inventories and account receivables
and seeking out most favourable account payables and monitor short term borrowings
Firm can enhance its profitability by reducing cash and marketable securities since those assets
typically earn very low rates of return but it is exposed to higher risk of not being able to pay its bills
Net working capital = current assets – current liabilities
Principle of self-liquidating debt: maturity of the source of financing should be matched with the
length of time that the financing is needed
Ex
...
13
Temporary assets = current assets that will be liquidated and not replaced within the current year
(inventories and account receivables)
Permanent investments are investment in asset that the firm expects to hold for a period longer
than a year (plant and equipment, fixed assets)
Spontaneous source of financing = trade credit and other forms of account payable that arise
naturally out of day to day operations of the business
Trade credit exists when one firm provides goods and services to a customer with an agreement to
bill them later
Temporary sources of financing = current liabilities such as unsecured bank loans, commercial paper,
bank drafts
Permanent sources of financing = long term debt, preferred stock, common equity
Firm’s temporary or short term debt rises and falls with the rise and fall of firm’s temporary
investments in current assets
Operating cycle and cash conversion cycle measure how effectively the firm has managed its
working capital
The shorter the cycle the more efficient
Operating cycle measures the time period that has elapses from the date that an inventory item is
purchased until the firm collects the cash from its sale
Operating cycle = Inventory conversion period (average number of days that an item is held in
inventory before being sold) + Average collection period (average number of days its takes to collect
account receivable)
Cash conversion cycle = Operating cycle – Accounts Payable Deferral Period
Account payable deferral period = days payables outstanding = account payables/cost of sales x 365
Inventory turnover ratio = cost of goods sold/inventory
Inventory conversion period = inventory/cost of goods sold x 365
Average collection period = account receivable/daily credit sales
When firm purchase inventory on credit, it does not have cash tied up for the full length of the
operating cycle therefore cash conversion cycle is shorter
Managing Current liabilities
Source of Short term credit
1
...
Bank transaction loan = unsecured short term bank credit (obtained with a promissory note
to repay loan under unconditional promise)
3
...
Pledging account receivables or inventories (borrower pledge these items as collateral to
obtain a loan that is a percentage of the face value of the inventory pledged)
14
5
...
Maintain sufficient cash balance
-requires accurate forecast of firm’s cash receipts and disbursements
-reduce need for cash by speeding up cash collections and slowing down cash disbursements
-paying firm would like to extend the float (time taken for check to be received and processed and
cleared through banking system) and retain use of payment funds as long as possible
-advent of electronic funds and check clearing practices typically eliminates float now
2
...
Weighted average cost of capital (WACC)
The stock market prices shares on the basis of the current riskiness of the firm
A company is seen as a bundle of projects
If the projects are on average high risk, then required return will be high
Weight of debt, WD = debt/ total amount of capital from equity and debt
17
Weight of equity, WE = equity/ total amount of capital from equity and debt
KD = cost of debt
KE = cost of equity = rf + RP = risk free rate + risk premium
WACC = kD * WD + kE * WE
If we want to reduce the required rate of return and thus raise the value of the project, we can
change the weights of the formula in favour of debt
...
Hence, the only factor that can add value is cash flow
We always calculate Post-tax WACC using cost of equity as a return required after tax deductions on
returns and cost of debt after the tax shield effect
Post-tax WACC = pre-tax WACC (1-T)
Benefit of tax
A benefit of financing through debt is that the annual interest can be used to reduce taxable profit
thus lowering the cash that flows out to the tax authorities
After tax cost of debt (AT/COD): is almost always cheaper than comparable equity
EXAM QNS: Besides the after tax effect, what are the other reasons debt is cheaper than equity?
Debt is usually cheaper than equity because
1
...
Priority in liquidation under bankruptcy status, debts always get paid but equity can be
wiped out
3
...
3) = 5
...
0 = have returns that broadly move in line with market index
Beta greater than 1
...
Early studies show that high beta shares show lower returns than the CAPM predicts
and low risk shares tend to show rates of return higher than theory suggests
Betas are a more valid determinant of return in extreme market circumstances such as stock market
crash
...
Some analysts calculate a fundamental beta based on the type of business the company is engaged
(sale of cars is more sensitive to market conditions), degree of operating gearing (firm with high
fixed costs have profits that are highly sensitive to output levels), degree of financial gearing (higher
leverage, profits are vulnerable to shocks so higher beta)
In CAPM, the relationship between risk measured by beta and expected return is shown on the
security market line (SML)
Expected return = risk free rate + beta * (average risk premium for shares) where average risk
premium for shares is the expected return on the market minus the risk free rate
KE = rf + beta (rm – rf)
Risk premium is the required extra return over the risk free rate as revealed by investors over many
years and not just the current market returns and risk free rate
KE = rf + beta (RP)
Position of security return line (SML) depends on the risk free rate of return
Risk premium for holding shares has generally been in the range of 2 to 5%
Extra return on shares is around 3
...
Characteristic line: rj = a + beta * rm where it shows a perfect statistical relationsip between rate of
return of jth share and the rate of return on the market index portfolio
High beta companies do very well in booms and very badly in recessions Ex
...
Company’s shares are priced at P with Earnings of E per share and Dividend of d per share and d1
is the dividend to be received next year
Company has a policy of retaining a fraction b of its earnings each year to use for internal
investments
Earnings, dividends and reinvestment will all grow continuously at a rate of g = br where r is the rate
of return of reinvestment of earnings
P = d1/ (kE – g)
KE = d1/P + g
20
Rate of return investors require on a share is equal to the prospective dividend yield plus the rate at
which the dividend stream is expected to grow g
Cost of equity capital under this model is very sensitive to the figure g and there is no reliable
method to estimate it for the future
Cost of retained earnings
Retained earnings is the most important source of long term finance for most corporations
-profits that the company had made but not paid out as dividends
However, retained earnings should be seen as belonging to shareholders
-part of equity
Cost of retained earnings = expected returns required by shareholders buying new shares in a firm
Cost of debt capital
Cost of debt capital is affected by
1
...
Risk of default (expected rate of recovery of lender’s funds in the event of a default)
3
...
With equity capital, it is correct to use
market capitalisation figure (current share price x no
...
Cannot demand all divisions to achieve the same rate of return
Firm should not use a single discount rate for all its activities: very difficult to quantify likely risk
Some venture capitalist use hurdle rates (minimum rate of return) such as WACC+ inflation or
WACC+ safety margin
Best way to measure a company’s performance (Hagel and Brown)
ROE = return on shareholder’s equity (good measure that is consistent with maximising
shareholder’s wealth but should not focus too much on it)
Companies can resort to financial strategies to artificially inflate ROE, ROE is subjected to
manipulation
If underlying profitability deteriorate, more debt leverage will be needed to maintain ROE and this
creates more risk
High leverage increase ROE but not ROA
When you increase leverage to increase ROE, more cash is needed for debt servicing and these cash
cannot be used for investment which can increase future profits
...
Better to use ROA (return on assets) to analyse long term profitability
ROA explicitly takes into account the assets used to support the business and shows asset utilisation
Managers have to focus on activities they are best qualified to manage and spin out other activities
or assets to more specialised companies
Focus on capability leverage: variable cost outsourcing arrangements support scaling back in a
downturn
BUT ROA is a broad measure and sometimes many companies of the same industry have the same
ROA
In conclusion, use both ROA and ROE and other indicators such as CFROI (Cash flow return on
investment) and productivity measures of the company and compare with industry standards and
past performances
Does Capital Asset Pricing Model work?
CAPM used to measure cost of equity capital to determine expected returns on capital invested
Market is populated by highly sophisticated well informed sellers and buyers and investors care
more about their wealth (assume no imperfections like transaction costs)
Portfolio diversification: Portfolio is less risky than any of its components – reduce unsystematic risk
Unsystematic risk is risk perculiar to the investment or company ex
...
0 rises and falls with the same percentage as the broad market index
In CAPM, Rs = Rf + beta (Rmarket – Rf)
Corporate Funding
Proportion of debt is called gearing or leverage and the optimal level depends on risk and return
More debt increases returns on equity (ROE) as cost of equity is offset by increased amount of
cheaper debt
Organisations with more stable flows and longer term assets borrow proportionately more
Ex
...
As a company’s cost of equity is usually 2
...
However, heightened risk of default and bankruptcy has to be taken into account
...
3
...
At mature stage, the company has to be selective of investment and reduce gearing to scale back
borrowing
At failing business model stage, there should be net disinvestment and gearing levels should be low
(rights offer is the only type of equity financing to save the company)
Uses of WACC
1
...
Helps in capital expenditure decision making (whether to make new investment)
The lower the WACC, the higher the value of the company with all things being equal
Minimise WACC throughout the corporate value lifespan of a company
24
Single tier WACC assumes unlimited funds
...
However, this can result in lower returns
...
Though it is difficult to
come up with the tiers, it prioritise certain projects and allow for higher returns
...
Cost of equity = risk free rate x Equity risk premium x beta
Equity risk premium: additional risk associated with a diversified portfolio of common stocks
Cost of debt = risk free rate x Debt provider’s minimum return requirements x perceived specific risk
factors of borrower, adjusted for class of debt
Ex
...
Equity shareholders may ask for higher risk premium
...
How much financing is ideal for a company in its present state and future projected
productivity
2
...
At what TOTAL capital cost
Implications of too high or too low WACC (EXAM QNS)
Too high WACC (excessive discounting rate due Too low WACC, too much borrowing (lead to
to high amount of equity and cost of equity)
dilution as debtors can come in and affect
decisions of company if there are covenants tied
to loans)
Some profit generating internal and external Some shareholder value-destroying investments
investments are missed
(CAPEX) are pursued
Management undercalculates its own firm’s Management over-estimates its own firm’s
worth
worth
Possible threats to management as there is Within the organisation, there is distortion of
general financial under performance
priorities: emphasis on financial cosmetics
instead of fundamental improvements in core
operations which is the ultimate source of
company value
25
Excessive overall financing costs: fuel (support Company makes fatally flawed mistake of
financing) required to support company’s value justifying new project on low interest rate of
engine is too expensive due to high WACC, dedicated financing
resulting in distortions
EXAM QNS: If some debt is good, then loading up the firm or deal with maximum debt is better?
There is no absolute consensus on how OCS is determined or financing or penalties caused by
exceeding the ideal
High leverage (disadvantages)
1
...
Increased risk of default and bankruptcy, cost of equity will increase too (Chicago Tribune)
3
...
Deplete reserves and safety margin
5
...
Lose top talent to pay oversized principal and interest of debt
7
...
Asset Liquidation (Sell all the bad assets and sell assets to pay off debts)
2
...
Asset Expansion (Issue more equity to buy more assets so ratio improved but the amount of
debt is still the same and ROE goes down)
Case study 1: Morgan Stanley is undergoing transition to have a business model that relies more on
brokerage and less on high risk trading
-isn’t leveraged enough to capitalise on the surge in equity and bond markets
-underperforming as compared to peers like Goldman Sachs
-transition needs time so benefits of transition not shown yet (lower risk model to prevent the nearbankruptcy in recent Global Financial Crisis from happening again)
Case study 2: Spanish banks have ultra-high leverage profit model (borrow more to lend more and
earn transaction costs) that is failing because of the defaults in mortgages, increased financing
expenses due to poor macroeconomic situation (Spain cannot reduce its large budget deficit and
26
avoid a EU bailout)
...
Too high interest can eat into working capital
...
2
...
4
...
Look at operational leverage and see how susceptible sales are to changes in macro
activities
Lecture 4: Capital Structure: Policy, Design and Application
Barclays: Capital structure puzzle
Rules of thumb can be effective in certain circumstances but tend to harden into dogma and lose
their relevance in changing circumstances
Ex
...
Ex
...
Empirical methods of corporate finance are less precise than asset pricing models since they
are more qualitative
27
Ex
...
Theories of optimal capital structure are not mutually exclusive
Taxes, bankruptcy costs, underinvestment costs, information costs ALL play a role in determining the
optimal capital structure
3
...
Difficult to identify when FD has proprietary information so hard to test whether manager’s
private information of the company affects his decision and how market responds to it
Tax theory: Basic corporate profit tax allows companies to deduct interest payments but not
dividends in their calculation of tax income so adding debt lowers expected tax liability and increases
its after tax cash flow
However, this overstates the tax advantage of debt by only considering corporate taxes
...
These higher yields effectively reduce tax advantage of debt over equity
Many companies do not have extremely high debt levels because profits not high enough to benefit
from tax shield
Contracting cost theory: Cost of financial distress can be the loss in value that results in cutbacks of
promising investment when firms get into financial trouble
...
Underinvestment problem: investors who are asked to provide equity knows that their investment is
used to restore creditors’ position so the cost of new equity is so high
Therefore, companies with intangible investment opportunities called growth options should avoid
debt to limit their greater potential loss in value from underinvestment
In addition, maintaining a strong balance sheet with less debt can reassure suppliers of the
company’s staying power and suppliers are more willing to provide goods and services in more
favourable terms
However, too little debt can lead to over-investment
...
Debt can help to control such overinvestment
...
FD time the stock offerings which explains the
market negative responses to such offerings
...
Signalling model assumes that FD
decisions are designed primarily to communicate managers’ confidence in firm’s prospects
...
Debt obligates the firm to make a fixed set of cash payments over the term of debt security hence
adding more debt can serve as a credible signal of higher expected future cash flows
Increased in gearing lead to rise in share price as managers are signalling their increased optimism
Pecking order: Companies maximise value by systematically choosing to finance new investments
with the cheapest available source of funds
...
This prediction is supported
...
Debt issued by growth firms are concentrated in high priority
classes as they want to avoid serious conflict among different debt holders
...
Pecking order predicts that high profit companies have low debt ratios as they pay
investments using retained earnings
...
Evidence supporting signalling and pecking
model is less persuasive
...
29
Evidence seems to suggest that taxes play the smallest role in affecting FD decisions
Large mature firms tend to have high leverage, more long term debt, more complicated debt
structures and higher dividends
...
Short term bank loans are the least costly
...
Capital Structure Policy
Risk-return tradeoff
Managers are tempted to take on more debt because it can increase rate of return earned on
stockholder’s investment in the firm
...
Issuing and transaction costs associated with raising and servicing debt are
generally less than ordinary shares
...
Higher debt lowers WACC hence value of company increases
...
Tradeoff between threat of default and tax deductibility
Cash flow is the source of value
...
Capital structure determines the rate of return earned from investing in firm’s shares of common
stock and riskiness of investment
...
In 2009, Apple had no bank debt or bonds outstanding
When firm uses more debt than it can afford to service it, it has higher default risk and may be
forced into bankruptcy
...
Capital structure = equity + interest bearing debt, including short term bank loans
Firm’s financial structure = combination of capital structure + non-interest bearing liabilities such as
account payables and accrued expenses
Debt ratio = Total liabilities/ Total asset
30
Debt to Value ratio = total book value of interest bearing debt/ (book value of interest bearing
debt + market value of equity)
Total book value of firm interest-bearing debt = short term notes payable, portion of long term debt
that has to be repaid within a year, long term debt
Times Interest Earned Ratio = EBIT/ Interest expense
Financial leverage: having debt provides firm to ‘leverage’ the rate of return it earns on its total
capital into an even higher rate of return on firm’s equity
Favourable financial leverage: return on equity is higher than what the firm earns from investment
Average debt to value ratio for US firms = 42%
Casinos, natural gas utilities = high debt to value ratio
Software programming = low debt to value ratio
Operating gearing refers to the extent to which firm’s total costs are fixed
...
Financial gearing = proportion of debt in capital structure (usually measured to book figures but best
is market value)
Capital gearing = extent to which a firm’s total capital is in the form of debt = Long term debt/ Total
market capitalisation
Income gearing = proportion of profits taken by interest charges
(M&M) Capital Structure Theory
Mordigliani and Miller theorem (M&M) showed that under some idealistic conditions, it doesn’t
matter whether a firm uses no debt, a little debt or a lot of debt in its capital structure
Assumptions
1
...
No taxes, no costs associated to bankruptcy, debt obligations do not affect its ability to
operate business
Firm pays no taxes, WACC is also unaffected by its capital structure
3
...
Securities can be traded without cost and individuals can
borrow and lend at the same rate as firm
4
...
Updated alterations: transfer costs in switching from one form of financing to another, tax
deductibility of interest on debt, threat of bankruptcy, risk gearing implications, high debt
deteriorates CF by undermining investment (If firm is highly leveraged, I cannot finance a new high
yield project)
Total amount of cash firm distributes to debt and equity holders is always equal to firm’s cash flow
regardless of how firm constructs its capital structure
31
Shareholders can repackage cash flows provided by the firm in a way that replicate the cash flow
they would receive under any possible capital structure (include more bonds in personal portfolio)
No investor would ever pay more or less for a firm’s shares simply because the firm either borrowed
money or not (since you can transform the returns from investing in levered firms into unlevered
firms)
If the assumptions hold, total market value of firm’s debt and equity is independent of its capital
structure decision and the particular mix of debt and equity financing does not matter
...
Value of firm remains constant regardless of debt level
...
Cost of equity will rise to exactly offset the effect of cheaper debt
...
Expected rate of return on equity increases proportionately with the gearing ratio
Shareholders will demand a higher level of return with increased risk in their investment
...
The cut-off rate of return for new projects is equal to the WACC – which is constant
regardless of gearing
Capital structure matters in reality because
-Transaction costs can be important = rate at which investors can borrow may differ from rate at
which firms can borrow, if firms can borrow more cheaply, it is better for firms to take on more
financial leverage
Transaction costs affect all firms equally
-Interest is a tax deductible expense while dividends are not
...
When debt
obligations exceed its ability to generate cash, firm is forced to bankruptcy
...
Financial troubles distract managers from developing new products and generate large legal bills
...
Firms lose talent too as
employees have increased job insecurity
...
Cash shortage means cut in advertising to win
customers
...
Companies are often forced to sell their most
profitable operations in an attempt to raise cash too
...
Sensitivity of company’s revenues to general level of economic activity
2
...
Liquidity and marketability of firm assets
4
...
It is possible to reduce agency costs through the use of debt financing
...
Debt can be a source of discipline
...
This keeps cash out of reach of empire-building, perk-promoting and lazy managers
...
Investors tend to be sceptical of motives of firms that issue new shares
...
When firms announce intentions to issue equity,
share price general falls
...
Higher levels of debt have two benefits
...
Two: Use of debt financing can be a form of discipline to align incentives of
managers to that of shareholders
...
However, higher levels of debt can increase probability that a firm is financially distressed or
bankrupt
...
Capital structure differs across industries
Electricity and gas utilities and casinos tend to generate a lot of taxable income so more likely to
reap the tax benefit of debt
...
For computer software industries, financial distress is devastating
...
Hard to find talent
...
Casinos and hotels can take on lots of debt without jeopardizing the viability of their business
...
Making Financial Decisions
Compare Capital structure with other firms, effect of financing alternatives on the level and volatility
of firm’s reported earnings per share (EPS) and firm’s risk of default
By benchmarking a firm’s capital structure, we compare the firm’s current and proposed capital
structure to a set of firms in similar lines of business and subjected to same types of risks
...
This is favourable financial leverage as it increases both rate of return on shareholder’s
equity and EPS
...
When EBIT is high, more levered firm will realise higher EPS
...
EBIT-EPS chart = range of earnings chart
EBIT-EPS indifference point = point of intersection where EPS is the same regardless of financing plan
chosen
...
Financial flexibility
Able to maintain the ability to issue either debt or equity by not pushing to the limits
2
...
Firm becomes a less attractive business partner
...
Cash Flow and earnings volatility
4
...
Debt levels of similar firms
CADS and TIE
CADS = Cash available for debt servicing (which includes interest + principal)
TIE = Times interest earned (EBIT/Interest)
EXAM: Is TIE the only sufficient indicator for holding too much debt?
No, you need CADS, source of debt and maturity schedule of debt
It is important to pay off the principal too
...
Ex
...
OCS = optimal capital structure (debt and equity mix) to maximise shareholder wealth
Equity is the cushion for any setbacks
Debt provider will hope for company with low debt and lots of cash to repay debt
34
Shareholders would like to see a lot of debt since EPS will be high but not too high debt to result in
default
3 reasons to add debt:
1
...
Increase value by reducing WACC, debt has tax shield effect
3
...
No bank wants to be the lender of last resort
...
Exploit target’s remaining marginal debt servicing capacity (CADS, TIE)
2
...
Adjusted for the lifespan of the company whether a start-up or a mature company
Always compare indicated project return amount with marginal WACC
...
Myers Capital structure approaches
1
...
Pecking order (pursuit of lowest cost sources only however this can cause company to
become highly geared leading to higher financial and operating risk)
Considerations in financing type decisions
1
...
Leverage standards of industry
3
...
Capital availability for company’s alternatives
5
...
Pricing aberrations
7
...
WACC is variable over firm’s lifespan
...
Cost of cash includes opportunity cost of not borrowing
...
Maximum financing account: grow big or die
Maximum security: ensure that we always cover interest and principal payments
Low cost: have the lowest monthly amortisations
There is no one single right OCS, OCS depends on the time and given the firm’s circumstances
1
...
Peloton and LTCM chose 30:1 debt to equity ratio but in the end both firms collapsed
...
George Eastman who believed in low gearing ratio
also ultimately destroyed value for shareholders in Kodak
...
Pecking Order (seek out the cheapest financing available)
Low cost
Relative cost of financing increases from retained earnings, secured bank loan to senior unsecured
debt to corporate paper to debt-and-equity mix to preferred stock to common equity to rights
offering
However, retained earnings are not free, cost of cash = WACC
This planning is too short term as the company may be accumulating too much debt, leading to high
gearing ratio and ultimately collapse of credit-worthiness
Should have strategic instead of impulsive approaches to OCS
3
...
If the company wants a loan as fast as possible, not caring about the cost
of loan, they are under extreme cash pressure and financial distress
...
Last option of a company (for
emergency use)
4
...
Value of Debt tax cover vs Cost of default, bankruptcy (low cost)
Take on debt until threat of bankruptcy is so high that company can no longer borrow
Static trade-off: Benefit vs cost approach
But quite myopic, looks at debt in isolation = If financial community senses an inadequate margin of
safety, the downgrade in debt rating can easily overcome any advantage from debt coverage
Danger of slippage from equilibrium point, Altman Z score may accelerate
Best application restricted to assessment of incremental debt additions and for firms with low Debt
to capital ratio
Realise expenses in high tax country to get tax deductability on interest
35% tax rate becomes 35% tax cover
6
...
Servicing of long term debt (maximum security)
TIE (Times Interest earned) and CADS (Cash available for debt servicing) to analyse OCS
Compare with same industry competitors or other reference points
However, need to include maturity schedule to prevent balloon payment that cannot be refinanced
TIE may not reveal a company’s full financial picture if significant portion of company’s debt is
interest only
37
Not too obsessed with credit ratings, A- rating is better than A if it always you to get more debt
8
...
GM takes out 3bn line of credit in early 2000s
9
...
Based on company’s present stage in its economic lifespan (maximum financing amount)
Start-up usually has 100% equity (in expansion mode)
Young company eg
...
Have
selective investment and building demand (Dell in 2000)
Mature company: start to reduce gearing ratio to 60 or 70% with declining investment (HP today)
Old company with falling profit margins = should you make a massive new investment to transform
the company? Ex
...
Reserve for contingencies (maximum safety)
Getting loan or equity as factoring in an extra cushion for errors
Prepared for a ‘rainy day’, deliberate safety margin
When you are doing well, set up financing for when things go wrong
When you don’t need money, banks try to lend but when you need money, banks don’t lend
38
12
...
Top Line growth = growth in sales revenue (double-edged sword)
Increase value when sales are profitable and decrease value when each unit sold is unprofitable
Sales growth does not include information on balance sheet or expectations
Ex
...
2
...
Combination of top and bottom line growth
Have to check whether return on invested capital is falling
However, if just focus on ROIC, it can lead to underinvestment and ageing of equipment
4
...
Expectations based management
Stock prices reflect investors’ expectations about the firm future cash flow
To earn high rate of return, companies have to perform better than expected
Good to have performance measure that focus on revisions of expectations
39
To come up with expectations of a company’s performance, you look at historical rate, potential of
the company and the rates of other companies in the field
Lecture 5: Capital Asset Pricing Model
Capital Asset Pricing Model (CAPM) is the systematic way of calculating company cost of equity
comprised of three components: risk free rate, equity risk premium and beta
KE = rf + beta (rm – rf) where beta measures systematic risk
Should have forward looking estimates but usually it is a one period model
Rf can be manipulated
...
(distortion)
Rf is financing cost without risk, usually 10year gilts for UK or 10 or 30 year US government bonds
Rf is about the same as rate of inflation but when CB lowers interest rate, rf is lowered and CoE is
lowered so WACC falls and stock price increase
...
Distortion of priorities
...
2
...
4
...
6
...
Have strategies and capital structure of company changed?
Appropriate time horizon
Is history a good indicator of future risk?
How reliable is the information and statistics
Any asymmetry in trading activity
Special events ex
...
82%
Returns on a financial asset increase with risk
40
The argument goes that it is illogical to be less than fully diversified so investors tend to create large
portfolios
...
Systematic risk is the element of risk common to all firms to a greater or lesser extent
...
When Apple was about to close down last time, it had lower beta than IBM though its prices
were soaring and extremely volatile
Start-ups usually have high volatility and high betas
Stock market efficiency = idea that stock market ‘correctly’ prices shares
BUT CAPM may artificially be restricting investment opportunities undertaken by firms in national
economies
...
2% on the basis for geometric means
Generally, the extra return on shares over government bonds is in the region of 4 to 6%
Risk
Treasury bills are regarded as the safest possible investment because it is highly unlikely that the UK
government will default and the fact they mature in a matter of days means that their prices do not
vary a great deal
Prices fluctuate inversely to interest rates – if interest rates rise due to perceived increase in inflation,
price of bonds fall, producing a capital loss
For practical purposes, bonds issued by a reputable government may be viewed at being risk free if a
long term perspective is taken
...
As a result, other investors have reaped high rewards
...
Misjudging risk: shares are almost as likely to fall as to rise so people who suffer more pain
from losses than they get pleasure from gains will avoid equities
2
...
Nervousness: averse to short term risk
4
...
-If investor is able to first identify and invest in a market portfolio
-Secondly, able to lend or borrow at risk-free rate of return
Then alternative risk-return combinations lie on a straight line (positive linear association between
expected return % and risk)
Two options for the investor: One is to place all funds into risk-free securities and get a return of 6%
per year or invest all the funds in the market portfolio and get an additional 5% more
Refer to beta, systematic and unsystematic risk notes previously
Security Market Line (SML) shows the relationship between risk measured as beta and expected
return
...
Investors are risk averse and evaluate their investment portfolio solely in terms of expected
return and standard deviation of return measured over the same single holding period
2
...
Investors all have access to the same investment opportunity
4
...
A stock expected return does not depend on the growth rate of its expected future cash flow
Applications of CAPM
1
...
Mispriced shares (share with unusually attractive expected return for its beta level would be
a ‘buy’ opportunity: use beta to identify shares with anomalous risk return characteristics)
3
...
Shareholders demand a higher return for riskier assets
2
...
Risk of securities have systematic (risk factors that are common to all firms) and
unsystematic (can be diversified away) risks
4
...
Different shares have different degrees of sensitivity to the systematic risk elements
EXAM QNS: Diversification is a sound strategy for individuals but not a good strategy for investors
42
Diversification makes a corporation complex
...
There is conglomerate discount
of 13% as individual investors want to diversify on their own
...
Not clear whether it is more appropriate to use weekly, monthly or yearly data
2
...
Beta is unstable over time
4
...
Measurement error – large random errors
6
...
Investors’ expectations drive share prices so when we obtain risk premium for the market
from historical data, we may be making an error in assuming this is the appropriate rate
today since there is a large difference between expectations and outcome
8
...
Investments usually involve a commitment for many years however CAPM is based on
parameters measured at one point in time, keys variables in reality may change
...
Unrealistic assumptions that investors are rational and risk averse and they are able to
assess returns and standard deviations
...
All investors can borrow and lend at risk free rate of
interest and all assets are traded and it is possible to buy a fraction of a unit of an asset
...
Suboptimal diversification by investors: since investors tend to hold predominantly home
country assets
...
Investors are subjected to behavioural bias and lack of sophistication
13
...
In the international version of CAPM, investors worry about real currency fluctuation
In reality, intercept value of SML is higher than rf since there are other risk factors in play
...
Beta has not been able to explain returns very well
...
Ratio of the firm’s book
(balance sheet) value to its market value (total value of all shares issued) has had some explanatory
power: If the book value is high compared to market value, returns tend to be higher
Real investment risk is measured by the danger of a loss of quality and earning power through
economic changes or deterioration in management
Factor Models
CAPM assumes there is a single factor influencing returns on securities
It is reasonable to see that returns on a share respond to industry or sector changes as well as to the
general market changes
Multi-factor models are based on this notion that a security’s return may be sensitive to a variety of
factors
-we need to identify the important influences within the business and financial environment and to
measure the degree of sensitivity of particular securities
43
One factor model
Expected return rj = a + bF1 + e
Where a = intercept when factor F1 is zero, F1 is the factor under consideration, b is the sensitivity of
the return to the factor, e is the error term caused by other influences on return
This permits F1 to be any explanatory influences so in an investment there are factor risk and nonfactor risk
...
Most factor model analysis
takes place under the assumption that all non-factor (unsystematic) risk can be ignored because the
investors are fully diversified and this type of risk will not be rewarded with higher return
...
Arbitrage Pricing Theory (APT) by Stephen Ross
Assumes investors are fully diversified and therefore factor risks or systematic risks are the only
influence on long term returns
Systematic factors permissible under the APT are many and various
Expected return = Risk free return + b1 (r1 – rf) … + bn (rn – rf) + e
Where b stands for the security’s beta with respect to the first factor and the risk premium are the
extra percentage annual returns on a share for bearing this type of risk
Arbitrage pricing theory does not specify what will be the systematic risk factors nor does it state the
size or sign of the beta
Changes in macroeconomic environment = inflation, interest rates, industrial production levels,
money supply, personal consumption
BUT Arbitrage Pricing Theory does not tell us in advance what risk factors are
...
APT is good where there is more than
one factor influencing returns
...
Historical information to predict future returns can be disappointing
...
In their model, returns are determined by
1
...
Excess return on a broad market portfolio (rm – rf)
44
3
...
Difference between return on a portfolio of high book-to-market shares and the return on a
portfolio of low book-to-market shares = HML high minus low
Expected return = rf + b1 (rm – rf) + b2 (SMB) + b3 (HML)
Average small share is taken to be more risky and offers an additional risk premium
Share with high balance sheet value per share relative to market value per share is assumed to be
more risky and so offers a premium
Alternative approach to risk-return relationship
Value Line Safety Rank
Ranking of 1: lowest risk, Ranking of 5: highest risk
Two major subcategories of risk are combined to give the final rankings:
1
...
Financial strength rating (amalgam of risk factors like debt-coverage ratios, proportion of
profit absorbed by interest, fixed charge coverage, accounting methods, quick ratio and
company size)
Results show that Safety rank is the most powerful explanatory risk measure, followed by standard
deviation, followed by beta
...
National confiscation risk (risk that investor loses value of his investment due to national
policy like taxes) = govt bond period for a given time
2
...
Equity returns risk (equity investor’s residual claim on company’s earnings is secondary to
debt holders’ claims in bankruptcy = calculate forward breakeven price, estimate stock’s
future volatility (prices for options) using Black Scholes pricing model
Discounted Cash Flow (DCF) Gordon Shapiro Model
Share price = xt infinity / (WACC – g)
45
Where x is the discounted free cash flow, WACC is the weighted average cost of capital, g is growth
rate
Hence, we can work backwards to calculate WACC or cost of equity
...
However, it depends on a single price and assumed constant and stable cash flow and growth rate of
the company
Project appraisal and systematic risk
What determines the systematic risk of a share is the underlying activities of the firm
Some firms engage in high risk ventures and to shareholders, in exchange of accepting the possibility
of a large loss, will expect a high return
...
Probability that investment you choose will preserve the capital over time you intend to
invest your funds
2
...
Whether the after tax receipts from the investment will give him at least as much purchasing
power as he had to begin with
4
...
Ability of management to realise the full potential of the business and wisely employ cash
flow
6
...
Certainty that management will channel rewards of business to shareholders
8
...
Companies with such global power, might of brand names, attributes of projects, strengths
of distribution system Ex
...
Distinction between systematic and unsystematic risk is important
11
...
Portfolio theory: There is an efficient frontier that contains all the optimal bundles
...
However, this assumes that all assets are risky
...
13
...
1
...
3
...
Share prices will increase by 10%
Individual shareholder will be delighted as share prices increase
Buyback of shares at the beginning of the cycle
Too much cash is not good and Apple should not keep the cash since cash cost WACC
46
5
...
It is a wash, no effect on total shareholders so institutional investors are not happy
7
...
Bad proposition
Amazon has very high P/E ratio but low profits for share price because it has very high cash flow
which it invests in Kindle, makes acquisitions and pays warehouse in advance
-P/E valuation is always on future cash flow
-invest a lot so it seems that it has no profit
Activists
Activists like Icahn usually seek short term gains (short term bump in stock price and book up quick
profits) and not long term value (they bail out leaving the corporate management to clean the mess)
Activist investors like Carl C
...
Ackman and Nelson Peltz want to restructure many of
the world’s best-managed and profitable companies like Dell, Pepsi Co, Apple and Kraft
...
CEO of Pepsi uses cash flow from traditional beverages to finance investments and growth in
emerging markets, innovation and healthy brands which now account for 20% of Pepsi Co revenue
...
This shows performance with
purpose strategy which is very different from the financial engineering (Pepsi Co to buy a food
company he owns) proposed by Nelson Peltz
...
C
...
Whole Foods leadership ignored activist Mr
...
When economic changes put pressure on quarterly results, it takes wise leadership to avoid
pitfalls of cutting investment to achieve quarterly targets
...
Only way to sustain growth in shareholder value is by creating competitive advantage to provide
superior value for customers
**Icahn (activist) asked Apple to give extraordinary dividend of 75billion and encouraged Apple to
improve itself by buying back ‘a significant percentage’ of firm’s shares though it is difficult for Apple
since most of Apple’s cash is overseas and repatriation taxes are high
...
1
...
Increase in shareprice that benefit
individual shareholders
Negatives
Short term surges have no market effect at all,
buyback possible signalling effect only takes
place after multiple buy backs
...
Buy-back is accompanied by major equity
stack of a famous speculative investor –
apparent vote of confidence of his share
price expectations
Buy-backs in tech areas are consistently
disappointing according to FT (investors
presume that available cash should be spent on
high return investments so buyback can be seen
as a failure of management to develop enough
expansion investment opportunities)
3
...
No
inherent
improvement
in
market
capitalisation (any increase reflects a short term
psychological signalling effect only)
5
...
Equity provides a foundation for forward capital
investment so a fall in equity can have adverse
effect on company’s investment results
7
...
Management may be too involved in short term
window dressing instead of serious operations
based work
**Long hold institutional investors such as Hermes say they do not want the dividends! They prefer
the company to use the money to invest in Capital expenditure (CAPEX)
...
If the company gives dividend, it can be due to the fact that they cannot come up with new
investments that generate profit
...
Lecture 6: CFO and Investment Evaluation, including CAPEX
There are expectations built in by shareholders (expectations on the growth of the firm compared to
its peers)
...
Investments have to reach
expectations-based threshold rate
...
Investment Decision Criteria
1
...
There is a risk return tradeoff = different investment opportunities have different levels of
risk
3
...
Capital-budgeting decisions are critical in defining a company’s business
2
...
Successful investment choices lead to development of managerial expertise and capabilities
that influence the firm’s choice of future investments
Ex
...
5
million to build Disneyland Park in California
Typical capital budgeting process
1
...
Select those that offer an opportunity to create value, the opportunity’s value proposition is
thoroughly evaluated
Good investments are most likely to be found in markets that are less competitive
-barriers to new entrants are sufficiently high to keep out would-be competitors
Two types of investment
1
...
Ex
...
External (Merger/Alliance) – consolidation type, prospective improvement in CF, increase in
market power, creation of second major core opportunity but lower familiarity, greater
financial risk, traditional business may be neglected
Ex
...
Sometimes, external investment is a desperate move by CEO running out of time
...
Both types of investment are necessary because sometimes, it is better to go for merger instead of a
large scale investment to turn the company around from decline
...
2
...
4
...
6
...
8
...
Revenue enhancement investments = expansion of existing business
Ex
...
KMB, manufacturer of Huggies, made its disposable diapers more waterproof and began
marketing them as disposable swim pants called Little Swimmers
2
...
Wal-Mart located a regional distribution center in Texas while provided lower costs of supporting
stores within the region (does not expand firm’s revenues)
Other types of costs reducing investments arise when equipment either wears out or becomes
obsolete due to development of new and improved equipment
Ex
...
Mandatory or non-discretionary investments as a result of government mandates
Companies need to make capital investments to meet health, safety and environmental regulations
These are required for the company to continue to do business
Ex
...
If NPV = 0, project neither create nor destroy value
Since NPV is an estimate of the impact of investment opportunity on value of the firm, NPV is gold
standard of criteria for evaluating new investment opportunities
50
NPV uses a discount rate to discount cash flows back to present reflects risk in future cash flows (use
the company’s overall WACC rate instead of a rate targeted to use of specific financing of the
project)
...
When this happens, firm
must choose the best project
1
...
Firm’s constraints = limited managerial time to implement the project, limited financial
capital so firm engages in capital rationing to choose between alternative investments with
positive NPVs
Choose project with highest NPV BUT sometimes better to choose project with lower NPV if life of
project is shorter (firm ties up its capital for less time, less managerial time and less capital)
NPV created per year as a metric
Equivalent Annual Cost (EAC)
Mutually exclusive investments that have the same revenues but different useful lives (costs may
differ)
If we expect this piece of equipment to be replaced over and over again, we need to calculate
equivalent annual cost which is the cost per year of owning and operating the machine over its
lifetime
EAC = Present value of costs/ annuity present value interest factor
Choose investment with lower EAC as it is the less expensive alternative even though it may costs
the most to purchase originally
Profitability Index (PI)
PI is a cost benefit ratio equal to the present value of an investment’s future cash flows divided by its
initial cost
PI = Present value of future cash flow/ Initial cash outlay
If PI is greater than 1, NPV is positive, present value of investment’s future cash flow is larger than
initial cash outlay therefore the investment should be accepted
...
However, if firm has credit rationing then PI is better as it measures the
amount of wealth created per dollar invested
...
**IRR’s assumption about reinvestment of interim cash flows can lead to major budget distortions
(A company’s cost of capital is a clearer and more logical rate to assume reinvestments of interim
project cash flows)
Interim project cash flows may not be invested and give the same rate of return as calculated for the
project
Complications with IRR = Unconventional cash flow (change of polarity or sign)
If the investment involves initial cash outlay followed by a period of cash inflows, NPV is positive if
IRR is greater than required rate of return
BUT if the investment is receive cash inflow followed by future cash expenditure, an NPV greater
than zero signifies that IRR is less than the discount rate used to calculate NPV (for such investment,
it is better to have a IRR less than required rate of return)
Complications with IRR = multiple rates of return
Although any project can only have one NPV, a single project can have multiple IRR when some of
the later cash flows are negative
*When there is more than one sign reversal in the cash flow stream, multiple IRR exists = cannot use
IRR to evaluate
Ex
...
BBR system earns a very high return but over a
shorter period of time
However, if firm has access to external capital markets, the project with higher NPV instead of higher
IRR should be chosen
Modified Internal Rate of Return (MIRR)
To eliminate the problem of multiple IRR, we rearrange the project cash flows such that there is only
one change in the sign of cash flows over the life of the project
52
Discount all the negative cash flows after the initial cash outflow back to year 0 and add them to
initial cash outflow then calculate MIRR as IRR of modified cash flow stream
MIRR at least allows users to set more realistic interim reinvestment rates and therefore calculate a
true annual equivalent yield
BUT MIRR is not the true IRR as IRR depends only on the project’s actual cash flows as they are
realised
...
To calculate MIRR, we alter the amount and timing of project cash flows
...
Payback Period
Payback period for an investment opportunity is the number of years needed to recover the initial
cash outlay required to make the investment
Accept the project if the payback period is less than a pre-specified maximum number of years
The longer the firm has to wait to recover its investment, the more things can happen that might
reduce or eliminate the benefits of making the investment
Limitation: Payback period ignores time value of money and ignores cash flows that are generated
by the project after the payback period
No clear cut way to define cutoff criterion
Myopic: Payback period leads to short term investments but sometimes it is the long term
investment that generate the most profits
Discounted Payback Period
Number of years needed to recover the initial cash outlay from discounted cash flows
Accept the project if its discounted payback period is less than the pre-specified number of years
1
...
This is a crude indicator of project risk since payback favours projects that produce
significant cash flows in the early years of the project’s life which are in general less risky
3
...
(provide insight whether we
will get our money back in today’s dollars before the market disappears or the product
becomes obsolete)
4
...
2
...
4
...
6
...
Relevance
Completeness
Consistency
Accuracy
Reliability
Timeliness
Low cost of collection
Profit is an accounting concept and may not be the same as achieving shareholder wealth
maximisation
Shareholders are interested in future cash flow and precise timing of these cash flow so profit is a
poor approach due to depreciation and working capital
...
Depreciation is allocated by the accountant and these figures are not true cash flows
...
We need to consider cash floats to lubricate day to day business
...
3
...
This is not recognised by profit statement but it is recognised in NPV calculation
...
4
...
Make adjustment for the full amount of expense paid to creditors that have not flowed out
as cash
Net operating cash flow = profit + depreciation +/- changes in working capital
Incremental cash flow
A fundamental principle in project appraisal is to include only incremental cash flow
Cash flow dependent on project’s implementation = cash flow for firm with project – cash flow for
firm without project
1
...
Include all incidental costs (new project can increase or reduce sales of other products of the
company ex
...
Ignore sunk costs (only incremental costs and inflows should be considered)
Ex
...
Be careful with overheads (overheads are costs not directly associated with any one part of
the firm like managerial salaries, rent, light, heat)
**Interest should not be deducted from the net cash flow as opportunity cost of capital used to
discount the cash flows already incorporates a cost of these funds
Average return of investment (ROI) = Average profit/ investment
54
Replacement Decision
Existing machine may have years of useful life left in it but if your firm does not product at lowest
cost, another will
...
AB-BA fallacy (Existing PE of buyer and seller determine the decision so that synergism may
be excluded from consideration)
2
...
Market will not ignore that increase in debt forces a common shareholder to assume more
financial risk as a result of higher interest costs so unless this is offset, PE will decline
4
...
Key determinant of market price is the expected rate of return on incremental capital
invested not just the profits
6
...
Share prices are affected by fads that have nothing to do with efficiency
8
...
2
...
4
...
6
...
94 between cash flow and share price
...
AT & T is actually raising capital
expenditure but it is only making replacement costs and giving dividends
...
BUT US wireless market can turn nasty as competitors such as Sprint, T-Mobile and MetroPCS will
compete more aggressively in price and snag customers
Main competitor Verizon may match the increased capital expenditure (Vodafone owns 45% of
Verizon wireless business so Verizon is constrained to use cash to expand outside of wireless
business)
AT & T takes advantage of that and invest more than Verizon
...
57
Wedge Valuation Ideal
Returns decrease as people figure out how to undercut the firm and there is infinite entrance of new
entrants
...
A firm wants to increase its dominance value period (fully exploiting its comparative
advantage) and reduce its terminal value period
...
2
...
4
...
6
...
8
...
When a private company decides to raise outside equity capital, it can seek funding from
several potential sources
1
...
Their capital investment is often large relative to capital already in place in firm so they
typically receive a sizeable equity share in the business
...
Finding angels is difficult as it depends on how well
connected the entrepreneur is
...
Venture capital firms: A venture capital firm is a limited partnership that specialises in raising
money to invest in private equity of young firms
...
The general partners run the venture capital firm and
they are called venture capitalists
...
Venture firms invest in many
start-ups and limited partners benefit from the diversification
...
General partners charge an annual management fee of 1
...
5% of the fund’s committed capital and they also take a share of any positive return
generated by the fun in a fee called carried interest
...
However,
venture capitalist control about one-third of the seats on a start-up board of directors
...
3
...
Private
equity firms initiate their investment by finding a publicly traded firm and purchasing the
outstanding equity thereby taking the company private in a transaction called leverage
buyout (LBO)
...
Magnitude invested is bigger for private equity firms, up to $400bn invested in
2007
...
Institutional investors such as pension funds, insurance companies, endowments and
foundations manage large quantities of money
...
They may invest directly in
private firms or indirectly by becoming limited partners in venture capital or private equity
firms
...
Corporate investors: Many established corporations purchase equity in younger, private
companies and they may invest for corporate strategic objectives in addition to the desire
for investment returns
...
Automaker Daimler invested in 1-% equity stake of electric car
maker Tesla as part of a strategic collaboration on development of lithium ion battery
system
...
Outside investors: When a company founder decides to sell equity to outside investors for
the first time, common practise to issue preferred stock rather than common stock to raise
capital
...
Preferred stock issued
by young companies does not pay regular cash dividends
...
It will have all the future rights and benefits of common stock if
the company goes well and if the company runs into financial difficulties, the preferred
stockholders have a senior claim on assets of the firm
...
As a private company, investors cannot liquidate their investment by selling stock in the
public stock markets so they need an exit strategy
...
Alternative way to provide liquidity to investors is for the company
to become public traded company
...
This lack of ownership concentration undermines the investors’ ability to
monitor the company’s management and investors may discount the price they are willing to pay to
reflect the loss of control
...
Choices include the type of shares
sold and the mechanism the financial advisor will use to sell the stock
...
Primary and Secondary Offerings: at an IPO, a firm offers a large block of shares for sale to
the public for the first time
...
2
...
It does not guarantee that the stock
will be sold but instead tries to sell the stock for the best possible price
...
Firm commitment IPO is in which the underwriter
guarantees that it will sell all of the stock at the offer price
...
If entire issue doesn’t sell out, remaining shares must
be sold at lower price and underwriter takes the loss
...
British Petroleum
3
...
Investors place bids over a set period of time and an auction IPO is set the
highest price such that the number of bids at or above that price equals to the number of
offered shares
...
Ex
...
It wanted to provide employees and private equity investors with liquidity and
allocate shares to more individual investors and discourage short term speculation by letting
market bidders set the IPO price
...
Mechanics of an IPO
1
...
The lead underwriter is the primary banking firm responsible for
managing the deal
...
Major US
investment and commercial banks dominate the underwriting business
...
In many cases, the underwriter will also commit to
making a market in the stock after the issue, thereby guaranteeing that the stock will be
liquid
...
SEC Filings: SEC requires that companies prepare a registration statement, a legal document
that provides the financial and other information about the company to investors prior to
IPO
...
Once SEC reviews the registration
statement to ensure that the company has disclosed all the information necessary to the
investors to decide whether to purchase the stock, SEC will approve the stock for sale to the
general public
...
3
...
Although these commitments are nonbinding, they value their long
term relationships with the underwriters so they rarely go back on their word
...
This process of
coming up with offer price based on customers’ expressions of interest is called book building
...
Auctions have failed to become a popular IPO method and is
plagued by inaccurate pricing and poor after market performance because auctions do not use this
book building process that aids in price discovery
...
Pricing the deal and managing risk: Underwriters fee is called underwriting spread
...
Underwriters appear
to use information they acquire from book building stage to intentionally underpriced the
IPO to reduce exposure to losses
...
The lead underwriter usually makes a market in the stock and assigns an
analyst to cover it
...
Issuer will have
continued access to equity markets in event they want to issue more shares
...
Underpricing
Generally, underwriters set the issue price so that average first day return is postivie
...
Investors who are able to buy stock from underwriters at IPO price
also gain from first day underpricing
...
When an IPO goes well, allocation of shares for each investor is rationed
...
Strategy of investing in every IPO does not yield above
market returns
...
Magnitude of swings is huge
...
Sometimes, firms and investors seem to favour IPOs and at other times firms rely on
alternative sources of capital
...
In just a few months, the market has
gone from raising record amounts of money to reaching a 10 year high in the number of proposed
offerings being withdrawn because there is no market
...
However, unlike the collapse of market in 2000, the latest decline did not follow a widespread
collapse in prices of previous IPO
...
Ex
...
com
Cost of an IPO
A typical spread is 7% of issue price
...
There is a lack of sensitivity of fees to issue size
...
In support that the quality of the underwriter is important, underwriters charge very high fees gain
market shares
...
This can be attributed to
1
...
People who had already invested in Facebook wanted a quick return and hoped Facebook
have a high initial IPO price
3
...
Using DCF, Facebook is only worth 53bn (this is verified by the fund managers who aren’t in
Facebook yet)
5
...
Foundations are fake and FB made the mistake of listening to zealots that represent a small
share of the market
Currently, the IPO market is hot
...
Candycrush is going IPO
...
AliBaba will be the biggest IPO coming
...
***EXAM QNS: The phrase IPO means that a company of that name has never, ever traded shares
before
...
Usually, companies are semi-public
and not just owned by a handful of angel investors before they enter IPO
...
If the founders of the company are going to continue their position in
the company, they will then be concerned with dilution
...
Ex
...
How to do IPO pricing
1
...
Book building to ask institutional investors how much they are willing to pay
3
...
BEST: DCF + Market Froth
Seasoned Equity Offering (SEO)
Profitable growth opportunities occur throughout the life of the firm so firms return to equity
markets and offer new shares for sale and this is called seasoned equity offering
When a firm issues stock using a SEO, it follows many of the same steps as IPO but main difference is
that the market price for the stock already exists so price setting process is not necessary
...
Through these ads, investors would know who to call to buy stock
...
If a firm’s management
is concerned that its equity may be underpriced in the market, by using a rights offering the firm can
continue to issue equity without imposing a loss on current shareholders
...
Decision to raise financing externally usually implies that firm is pursuing an investment opportunity
and it is exercising its growth options
...
This explains post SEO lower returns
...
CDR, a private equity firm, purchased Hertz’s outstanding equity for 5
...
In addition, Hertz had 9
...
This is
a public company becoming private through a leveraged buyout (LBO)
...
The Hertz LBO
is the second largest transaction of its kind and it requires issuing large amounts of corporate debt
...
A public bond issue is similar to a stock issue
...
In addition, for public offerings, the prospectus
must include an indenture, a formal contract between the bond issuer and a trust company
...
While corporate bonds almost always pay coupons semiannually, a few corporations ex
...
Face value of bond does not always correspond to the actual money raised because of underwriting
fees and possibility that the bond might not actually sell at face value when it is offered for sale
initially
...
Bearer Bonds and Registered Bonds
Bearer bonds are like currency: Whoever physically holds the bond certificate owns the bond and to
receive coupon payment, the holder of the bearer bond must provide explicit proof of the ownership
...
Anyone producing the coupon is entitled to the payment but there are obvious hassles and serious
security concerns
...
Registered bonds: Issuer maintains a list of all holders of its bonds and brokers keep issuers informed
of any changes in ownership
...
This facilitates tax collection too
...
Debentures and Notes = unsecured debt, which means that in the event of a bankruptcy,
bondholders have a claim to only assets of the firm that are not already pledged as collateral
on other debt (Notes have shorter maturities [less than 10 years] than debentures)
2
...
Asset-backed bonds = secured debt where any kind of assets have been pledged as collateral
that bondholders have a direct claim to in event of bankruptcy
Junk bonds are bonds rated below investment grade
The bondholder’s priority in claiming assets in the event of default, known as bond’s seniority, is
important
...
Subsequent debenture issue that has lower priority than its outstanding debt, the new debt is called
subordinated debenture
Holders of this subordinated debt or tranche are likely to receive less in the event of a default as
compared to senior debt holders therefore the yield on subordinated debt is higher
...
Domestic bonds = bonds issued by local entity and traded in a local market but purchased by
foreigners
2
...
3
...
Global bonds combine features of all and offered for sale in several different markets
simultaneously
A bond that makes its payments in a foreign currency has different yield as it has exchange rate risk
...
The private debt market
is larger than the public debt market
...
Private
debt has the advantage that it avoids cost of registration but has the disadvantage of being illiquid
...
7bn term loan, a bank loan that lasts for a specific term
...
In Hertz case, the lead bank Deutsche Bank negotiates the terms of bank loan with CDR and sold
portions of it off to other banks
...
Line of credit is backed by specific assets so it is more secure than term
loan
...
Need not be registered and is less costly to issue
-often a simple promissory note is sufficient and can be tailored to particular situation
Private debt under Rule 144A can be traded by large financial institutions among themselves
...
65
Sovereign debt
Sovereign debt is debt issued by national governments (bonds issued by US government are called
Treasury securities)
These bonds enable the US government to borrow money so that it can engage in deficit spending
...
Treasury notes are semiannual coupon bonds with original maturities of between 1 and 10 years
...
TIPS: Treasury Inflation Protected Securities that are standard coupon bonds with outstanding
principal adjusted for inflation
In addition, the final repayment of principal at maturity is protected against deflation
...
Noncompetitive bidders just submit amount of bonds they wish to purchase and are guaranteed to
have orders filled at the auction
...
The highest yield accepted is termed the stop out yield
...
Zero coupon Treasury securities with maturities longer than one year also trade in bond market
...
The income on municipal bonds is not
taxable at the federal level
...
Serial bonds are bonds scheduled to mature serially over a number of years
...
Municipal bonds are not nearly as secure as bonds backed by the federal government
...
A mortgage backed security (MBS) is an asset-backed security backed by home mortgages
There are also asset-backed securities backed by student loans
...
Investors in junior tranche of an asset-backed security do not receive cash flows until investors in
the senior tranche of an asset-backed security received their promised cash flows
...
Some actions benefit equity holders at the expense of bond holders
Ex
...
In this case, equity holders receive the
value of firm’s assets + proceeds from the bond while bondholders are left with nothing
...
Other covenants restrict the level of further indebtedness and specify that the issuer must maintain
a minimum amount of working capital
...
The stronger the covenants, the less likely the issuer will default on the bond so the lower the
interest rate required by investors who buy the bond
...
Reduction in firm’s borrowing cost can more than outweigh the cost of the loss of flexibility
associated with covenants
...
The issuer can also repurchase a fraction of the outstanding bonds in the market or make a
tender offer for the entire issue
...
Bonds that contain such provision are known as callable bonds
...
The call price is generally set at or
above and expressed as a percentage of the bond’s face value
...
If
the call provision offers a cheaper way to retire bonds, the issuer will then call the bonds instead
...
Issuer will exercise call option only when
the coupon rate of the bond exceeds the prevailing market rate
...
I
market yields are low relative to bond coupon, it is likely that the bond will be called and its price
will be close to the price of a noncallable bond that matures on the call date
...
67
Yield to maturity of a callable bond is calculated as the discount rate that sets the present value of
the promised payments equal to current price, ignoring the call feature
...
Sinking Funds
Instead of repaying the entire principal balance on maturity date, the company makes regular
payments into a sinking fund administered by a trustee over the life of the bond
...
This way, the company can reduce the amount of outstanding
debt without affecting cash flows of remaining bonds
...
If the bond is trading at above face value, then the bonds are repurchased at par the decision is
made by lottery
...
In some cases, issuer has the option to accelerate payments
...
Some issues specify equal payments over life of the bond so ultimately retiring the issue on the
maturity date of the bond
...
Convertible bonds = some corporate bonds have a provision that gives bondholder an option to
convert each bond owned into a fixed number of shares of common stock at a ratio of conversion
ratio
...
Banks prefer to lend to large multinationals = companies’ safety + prospect of further banking work
derived from lending relationship such as advisory services, underwriting, cash management
Nonetheless, banks still require higher returns on credit lines as a result of their increased funding
costs Ex
...
High yield bond markets that
companies relied on tumbled during Global Financial Crisis
...
5p after Morgan Stanley analysts say that it has to raise
at least 20bn in a rights offer and halve its dividend
...
It does not expect HSBC to recover earnings until 2011
Some talk that HSBC believes Morgan Stanley note is based on accounting measures that are not in
force and there is no need for a rights issue
69
Some believe it will raise a smaller amount in order to finance acquisitions
Growing worries about write-offs from further loans turning sour
Mills – Assessing Growth Estimations in IPO valuations
Difficult to gauge market sentiment and set a price that does not go against the objectives
Key Components of a DCF valuation
1
...
3
...
Discount rate or cost of capital
Generation of future cash flows
Method for valuating cash flows over the time period beyond explicit forecast
Time horizon of explicit forecast
Error in decision making
1
...
First stage: finite period in which growth is assumed to be explicitly captured in the
projected cash flows over that period
2
...
Choose businesses comparable to the IPO company and obtain their relevant share price,
WACC, estimates for cash flow growth
2
...
A sentiment changing event like Linkenln IPO (2011) and Facebook IPO (2012) help to spur merger
activities by communicating to the world that the financial markets have moved forward from last
recession
Dotcom wave I created major corporations like Amazon, Google, eBay, Yahoo
Dotcom wave II will create major corporations like Twitter, Linkenln, Facebook
Dotcom wave II may start with Facebook acquisition of Instagram with 1bn dollars
There is significant correlation between increase in stock price and increase in merger activity
Wait for the shakeout period to be completed and for the market sense of true valuation to appear
The initial IPO price is based upon thin markets and abysmally incomplete information about the
company’s true future prospects and fundamentals
...
Only after a few quarters of the IPO, sufficient information emerges to
evaluate the company on true fundamentals
...
k
...
Vast number of market participants attempt to understand valuation and stock market
prices with accounting based methods thus CAP is seldom addressed
2
...
2
...
4
...
Company’s current return on invested capital (higher ROIC business are positioned best)
6
...
High barriers of entry help to sustain high ROIC
Market Implied CAP (MICAP) = get the company’s internal cash flow from the share price since it is
easy to calculate from the 0
...
It is wise to diversify the investment
portfolio so as to eliminate non-systematic risk
...
If overall portfolio of emerging markets is going down and whole class of
market securities goes bad, diversification only in that class of securities will not help
...
For instance, in the Global Financial Crisis case, it is still a bad loan
even after you repackage it into a CDO because the mortgage loan is inherently bad by giving it to a
poor borrower
...
However, it is bad for companies to diversify business units
...
This can become hard to manage
...
Advantages and Disadvantages of Single Rate and Multiple Hurdle Rates
Single Hurdle rate for ex
...
Any project with a rate of
return higher than the single hurdle rate will be approved and any project with a rate of return lower
than that will be rejected
...
There is no differentiation
between high and low desired projects
...
Multiple hurdle rates (8%, 15%, 20%)
allow us to approve projects of different size and risks
...
However, it is difficult to come up with the specific hurdle rates itself and it is
difficult to adjust for risk and size of projects
...
External investment is
usually more expensive as you need to pay acquisition purchase premium costs of about 20% higher
than the actual cost
...
Extraordinary Dividend
Extraordinary dividend (one off) does not create any corporate value!
Corporate value depends on free cash flow but dividends come from retained earnings that costs the
price of CoE or WACC
...
This
does not affect cash flow at all
...
One-off dividend is like buyback
...
Dividends are good only when they are given on a long term basis (recurring)
...
For instance, Utilities always give back dividends as it is part of their
operations and it is a good signalling effect
...
BUT Warren Buffet is notorious not to give a dividend
...
Ex
...
However, this can mean missing growth support and assume that FD can get
the financing they want all the time instead of planning the financing ahead
...
Firm is usually out of debt at least once a year
...
Term loans have maturities greater than a year
...
Twitter blew it
Twitter issued 70bn shares for an IPO price of $26 per share but the share quickly rose to $45 per
share, leading to the question whether Twitter left money on the table
Twitter could have gotten more capital by issuing a higher IPO price
...
Facebook issued a high IPO price but the price plunged since the IPO market was not hot at that time
and many angel investors took the opportunity to cash out
...
Twitter has a huge subscriber base which they have to grow it since there are low barriers to entry
...
Twitter only gave one class of ordinary shares and it is listed in the US to protect the interest of
initial shareholders
...
This helps to increase Twitter’s future prospects and value as it invests in the future
...
Newscorp bought MySpace and made the mistake of inserting too many ads and destroying
subscriber base
...
1
...
Twitter is satisfied with the amount it raised and is in good access to more capital as equity
is the safety cushion used to borrow more capital from banks
3
...
If the IPO price is priced too aggressively, people may
question the value of the company and stock price may plunge
...
4
...
Twitter did leave money on the table but it may not be too bad after all since they gained
good relations with the financial community
74
Lecture 8: Financial Window Dressing
Dividend Policy
Dividend policy is the determination of the proportion of profits paid out to shareholders usually
periodically
Issue to be addressed is whether shareholder wealth can be enhanced by altering the pattern of
dividends not the size of dividends overall
Assume the underlying investment opportunities and returns on business investment are constant
and the extra value that may be created by changing the capital structure (debt to equity ratio) is
constant
Therefore, only the pattern of dividend payments may add or subtract value
Whether a steady, stable dividend growth rate is better than a volatile one which varies from year to
year depending on the firm’s internal need for funds
UK quoted companies usually pay dividends every 6 months
...
Dividends may only be paid out of accumulated distributable profits (retained earnings) and not out
of capital
...
The determinant of value is the availability of projects with
positive NPVs and the pattern of dividends make no difference to the acceptance of these
...
Conditions under which this was held true include:
1
...
No transaction costs (investors face no brokerage costs when buying or selling shares and
companies can issue shares with no transaction costs)
3
...
All investors have free access to all relevant information
5
...
A firm can pay all the profits each
year as dividends would not necessarily be destroying shareholder wealth because in this ideal world,
any money paid out would quickly be replaced by having a new issue of shares
...
If a company choose not to
pay any dividends, shareholders can get an income by selling a portion of their shares to other
investors (homemade dividends)
...
75
Dividends as a residual
Once the firm has provided funds for all the projects which more than cover the minimum required
return, investors should be given the residual
If the firm kept all the cash flows and continue adding to its range of projects, the marginal returns
would likely to decrease
...
If cash flow is retained and invested within the firm at less than kE, shareholder wealth is
destroyed therefore it is better to raise dividend payout rate
2
...
In the real world, there are legal and administrative cost of organising a rights issue and it may be
necessary to prepare a prospectus and incur advertising costs and underwriting costs
...
Clientele effects
Some shareholders prefer a dividend pattern which matches their desired consumption pattern
There may be natural clienteles for shares which pay out high proportion of earnings and another
clientele for shares with low payout rate
Retired people, living off their private investments, may prefer a high and steady income so they will
be attracted to firms with high and stable dividend yield (Pension funds need regular cash receipts to
meet payments to pensioners)
Selling a proportion of shares on a regular basis would result in transaction costs and it is time
consuming and inconvenient to regularly sell off blocks of shares so it is much easier to receive a
series of dividend cheques
Some people acknowledge self-control problems and they want to live off the income but never
touch the capital hence shares with high dividends are attractive because they give income without
the need to dig into capital
Another type of clientele is people who are not interested in receiving high dividends in the near
term
...
This may
place pressure on management to produce a stable and consistent dividend policy because investors
need to know that a particular investment is going to continue to suit their preferences
...
Management therefore, to some extent, target a particular clientele
...
There is information asymmetry where managers know far more about the firm’s prospects than
finance providers (investors) hence dividends are one source investor use to put together
information about the firm
...
It is
risky for managers’ career prospects for them to increase the dividend above the regular growth
pattern if they are not expecting improved business prospects
Increase or decrease over the expected level of dividends lead to a rise or fall in share price
Generally company earnings fluctuate to a far greater extent than dividends
...
Markets react badly to dividend downturns and directors make strenuous efforts to avoid a decline
...
To double or treble dividends in good years increases the risk of having to reduce dividends should
profit growth tail off and losing the virtue of predictability and stability cherished by shareholders
...
Resolution of uncertainty
Myron Gordon argued that investors perceive that the company is replacing a certain dividend flow
to shareholders now with a more uncertain distant flow in the future hence they are subjected to
more risk and investors apply a higher discount rate
-market places a greater value on shares offering higher near term dividends
-Investors are showing a preference for the early resolution of uncertainty
Crucial factor here is the perceived risk (investors may overestimate the risk of distant dividends and
thus undervalue them) = investors prefer a higher dividend in the near term
This is also known as ‘bird in the hand fallacy’
The riskiness of a firm’s dividend is derived from the risk associated with the underlying business and
this risk is already allowed for through the risk adjusted discount rate kE hence to discount future
income even further is excessive
To discount at a higher rate would be to undervalue the shares and pass up an opportunity of a good
investment
Ownership control (agency theory)
UK firms pay out an excessive proportion of their earnings as dividends and this stifles investment
because of the lower retention rate
Concern should be many firms have policy of paying high dividends and issuing new shares to raise
cash for investment since cost of issuing shares can be burdersome and shareholders generally pay
tax on receipts of dividends = agency cost
Managers may not always act in the best interests of the owners and one way for owners to regain
some control over the use of their money is to insist on relatively high payout ratios then if
managers need funds for investment they have to ask
A firm who wishes to raise external capital for investment have to be scrutinised by a number of
experts such as investment bankers, underwriters, analysts at credit rating agencies, analysts at
stockbroking houses and shareholders
...
OR managers are merely over-confident and optimistic about their ability to invest the money wisely
...
Managers pay out excessive
dividends to keep money out of reach of the lenders – particularly in the case when the company is
about to fail thus lenders’ agreements often restrict dividend payments
78
Scrip dividends
A scrip dividend gives shareholders an opportunity to receive additional shares in proportion to their
existing holders instead of a normal cash dividend
...
Scrip dividends have the advantage that the cash does not leave the company
...
Shareholders may welcome scrip dividend as they can increase their holdings without brokerage
costs
...
Such an offer is designed to encourage the takeup of shares and is like a
mini-rights issue
...
This can be done to raise the level of borrowing on its balance sheet
1
...
3
...
5
...
7
...
9
...
Share-buybacks enhance earnings per share EPS
Individual investors will see the value of their stake rise
Conflict between the interests of different types of shareholders
Buybacks is a useful alternative when the company is unsure about the sustainability of a
possible increase in the normal cash dividend
Buybacks are not good as they absorb cash that could be spent on higher capital expenditure
If a company’s stock is overvalued, the company wastes money buying it
One off share-buyback has no signalling effect
Share buybacks reduce loose shares in the market and prevent an acquisition of the
company
At the same time, share buybacks reduce the proportion of equity in the company so WACC
falls
Share buybacks should only be done when at the trough of the economic cycle
A stable policy may be pursued on dividends and when surplus cash arises, shares are repurchased
...
Hence, a consistent
dividend can help to increase credit ratings and lowers interest rates payable
...
Dividend decision
Forces promoting high Forces promoting low
payout
payout
-Some clienteles
-Owner
control
(agency theory)
-uncertainty (bird in
the hand)
-signalling
-tax system
-some clienteles
-high growth potential
of firm
-instability
of
underlying earnings
-management desire to
avoid a future dividend
cut
-lender
agreement
restrictions
-low liquidity of firm
assets
Forces promoting a Forces promoting
fluctuating dividend
stable dividend
-dividends as a residual
-available only after
positive NPV projects
are financed
a
-some
clienteles
preferences
-signalling
-owner control (agency
theory)
-management desire to
avoid a future dividend
cut
-stability raises credit
standing for
debt
issues
Firms usually have a maintainable regular dividend that provides some certainty to a particular
clientele group and provides a stable background
...
Companies in cyclical industries are likely to be tempted
to set a relatively low maintainable regular dividend so as to avoid the dreaded consequences of a
reduced dividend in a particularly bad year
...
Best is to forecast surplus cash flow resulting from the subtraction of cash needed for investment
from that generated by firm’s operations over the medium and long term and pay a maintainable
regular dividend from that forecast
Dorsey – keeping tabs on earning quality
Business increase their economic value by selling more stuff, increasing prices on stuff they already
sell, sell new stuff or buying other business
Have to take note of
1
...
Cost-cutting – All things equal, you want to own a more efficient firm but cost cutting has its
limits
3
...
Colgate-Palmodive reduced cost of goods sold as a percentage of revenue dramatically and
consistently for several years so operating income outpaced sales by such a large margin
...
Ensure that earnings are not over-reliant on pricing as an increase in price can be offset by a loss in
market share
Cutting expenses can be useful when the company always over-invests Ex
...
Firms repurchase stock to distribute excess cash flow
2
...
Firms may repurchase stock to increase leverage ratio to reach target ratio
4
...
And to counter the dilution effects of employee and manager stock options (distribute cash
without diluting per share value of stock)
Results show that
1
...
Repurchases are not a replacement of dividends as repurchasing firms do not pay lower
dividends
3
...
In an active takeover market, firms repurchase stock to fend off unwanted takeover
attempts
5
...
Open market repurchase is a more flexible means of distributing capital with no obligations
7
...
Firms repurchase stocks due to distribution, investment, capital structure, corporate control,
or compensation policies
What sharebuybacks did for Office Depot
Office Depot used its once-flush balance sheets to buyback its own shares at nearly 6 times of its
current price = clear case share buybacks didn’t work
Buybacks are often ill-timed exercises rather than signals of insider excitement about a low valued
stock
81
Easyjet announced special dividend
Easyjet posted a sharp rise in profit and the budget airline will pay an extraordinary dividend of
$175m to shareholders amid signs it is solidifying its position in Europe’s short haul market
...
1p per share on top of its existing 33
...
They also highlighted the
decision to buy 135 new Airbus A320 jets to help control future costs
...
The bigger carriers cannot get the cost base or efficiency they have
...
It is Europe’s second largest low cost airline
...
Punctuality improved as it left
more time in schedule to turn flights around
...
Allocated seating makes boarding less stressful and increased customer
satisfaction
...
Easyjet Irish rival is still earning 25% higher net profit margin
Further earnings growth will lead to further share growth but having climbed rapidly, EasyJet may
have reached cruising altitude
It was a bad decision for Easyjet to give out an extraordinary dividend
1
...
Easyjet should have set the extra cash aside for contingency reserves
3
...
Rivals are copying Easyjet’s service standards: Ryanair will offer allocated seating in early
2014
5
...
Easyjet has been helped by capacity cuts in legacy
carriers
...
Many competitors coming up: Lufthansa’s revamped low cost subsidiary Germanwings is
shaken to be a force to be reckoned with and Spanish rival Vueling is expanding fast
7
...
Whisper numbers – unattributed references to knowledgeable sources, usually due to
borderline investor speculation and manipulation
2
...
Secondary valuation argument – no basis for higher price valuation ex
...
Reverse IPO = acquisition of an already public company by a private company and rename
itself
2
...
If PayPal
breaks out from Ebay, there can be revenue synergies obtained
...
However, it is important to add the costs of being a standalone company
...
Large scale private placement of the company by venture capitalists
It is important to buy or sell stocks at the right time
...
You can only make money with share buybacks if you did it at the
front 1/3 of an economic cycle
...
Office Depot had share buybacks in 2010 which proved to be a huge mistake
To evaluate a company, use the Gordon’s formula
...
Important to know the company’s value lifespan (CVL) and competitive advantage period (CAP)
A start up company like Spotify depends on equity only and needs an IPO
Facebook is in Contention or dominant period where it can get as much debt as it wants
Groupon which is in participative stage has thinner margins and CoE and CoD become more
expensive and has to start to reduce debt
To develop a financing plan, you will need
1
...
How much capital is needed
3
...
Amount of reserves put aside
5
...
Expected economic return (EER) of different scenarios whether the company do well, get
along or go bust
7
...
Heng Seng operates with one stock one vote, too democratic
83
How to lose the Financial Community
1
...
When numbers are released, it is difficult for analysts to calculate the basic performance
metrics like CFROI, NOPAT, CF, FCF
3
...
Dismiss calls for buybacks and extraordinary dividends without convincing proofs of
alternative profitable internal investment opportunities
5
...
Introduce company bespoke metrics which defy comparison with other firms, this raises
suspicion that the company is hiding important performance indicators from the community
7
...
Ocado is an online grocery shopping company founded in 2000
2
...
However, their business model is easily replicated and difficult to defend their business
model
4
...
Business model may be flawed inherently as seen in the US counterpart Webvan going bust
6
...
In 2012, there is a hint of bad news that Ocado is about to break its loan covenants
(covenants are a set of conditions set up by lenders to prohibit certain actions to ensure that
they get their money back ex
...
Ocado had to issue more shares in order for the lending facility to be extended and gained
more breathing space
9
...
There was also mention of selling Ocado’s
software of distribution and mapping services
...
Hence, surprisingly, Ocado share performance is doing well and had increased
dramatically from 75p to 557
...
84
BP had black marks on its operational history and is eager to show the world that they still know
what they are doing by having a new strategy and partnership in a new area (collaborate with
Ambani’s Reliance Industries in India to make a $7
...
BP has a 30% stake
...
However, it seems like BP is facing some problems such as
1
...
Total reserves may be lower than
predicted
...
2
...
3
...
At $4
...
BP only said that it
expects the price to increase but did not provide concrete evidence and basis for a future
market-based pricing mechanism
...
CFO of BP had communication problems with the financial community as not enough information is
given for the community to make proper analysis of BP
...
BP
did not provide more reports to prove that there are sufficient resources available in the main field
...
Analysts predict a
worse-case scenario in the absence of information and this leads to depressed valuation and BP
share price falls, causing market capitalisation to fall and this reduces shareholder value
...
Analysts only have incentives to care
about what is happening now
...
There are many negative comments from analysts
and BP is only blaming the analysts for not considering the other 22 oil and gas blocks it has picked
up
...
It seems as though BP had not found a solution or is
living in denial
...
At the same time, though the government
decided to double the gas price, there is still a lot of political delays and it is still under review
...
Financial Distress, Managerial Incentives and Information
In a perfect market, if a firm has access to capital markets and can issue securities at a fair price,
then it need not default as long as the market value of its assets exceeds its liabilities
...
Bankruptcy alone does not lead to greater reduction in total value of investors
...
85
In real life: There are both direct and indirect costs to bankruptcy
...
Investment
bankers may also assist in a potential financing restructuring in a Chapter 11 reorganisation
...
Lehman Brothers bankruptcy is expected to entail fees of over 900 million
...
Average direct costs of bankruptcy is approximately 3 to 4% of prebankruptcy market value of total
assets
...
Alternatives: Negotiate directly with creditors or have a prepackaged bankruptcy in which a firm will
first develop a reorganisation plan with the agreement of its main creditors and file for Chapter 11 to
implement the plan
...
Loss of customers = customers may be unwilling to purchase products whose value depend
on future support or service from the firm since firm may fail to honor the warranties or
provide replacement parts
...
Loss of suppliers = suppliers are unwilling to provide a firm with inventory as they fear they
will not be paid
3
...
This is especially costly for firms that depend on
human resource
4
...
Fire sale of assets = Sell assets quickly to raise cash so firms may accept a lower price than
would be optimal
6
...
Cost to creditors = if the loan to the firm was a significant asset for the creditor, default of
the firm can lead to financial distress of the creditor
When securities are fairly priced, the original shareholders of the firm pay the present value of the
costs associated with bankruptcy and financial distress
...
According to this, total value of a levered firm is equal to the value of the firm without leverage +
present value of the tax savings on debt – present value of financial distress costs
Present value of financial distress costs is affected by
86
1
...
Magnitude of the costs if the firm is in distress for Ex
...
Usually,
technology firms have less than 10% leverage
...
3
...
The higher the firm’s beta, the more likely the firm will be in distress in an economic
downturn
Optimal leverage is when the firm increases its leverage until the tax savings of debt is just offset by
the increased probability of incurring costs of financial distress
...
Agency costs of leverage
Agency costs are costs that arise due to conflicts of interest between stakeholders
Top managers usually hold shares in the firm and therefore they take actions that benefit the
shareholders but harm the firm’s creditors and lower the value of the firm
...
Leverage gives shareholders an incentive to replace low-risk assets with high-risk assets = asset
substitution problem
When a firm faces financial distress, it may choose not to finance new positive NPV projects = debt
overhang or underinvestment problem
Hence, debt holders may impose debt covenants which are rules or restrictions on the actions firms
can take
...
Covenants are designed to prevent management from exploiting debt holders
...
With
equity financing, there is dilution of ownership
...
It also helps to reduce wasteful investment
...
Hence, when the firm has low
levels of cash flow in excess of what is needed to make all the positive NPV investments and
payments to debt holders, the manager is motivated to run the firm as efficiently as possible
...
Furthermore,
creditors themselves will monitor the actions of the managers
...
87
Leverage as a credible signal
To convince the financial community that the company has a promising future, the company can
take on more debt and investors will interpret the additional leverage as a credible signal of the
CEO’s confidence
...
Hence, firms tend to issue equity when share price is high (equity is the cheapest) and
immediately after earnings announcement
...
Hence, firms tend to be
issuers of debt
...
IPO pricing
2
...
CAPM
4
...
Financing plan and Business plan
6
...
How you manage risk
8
...
Company corporate lifespan
10
...
What is the right time to issue equity and debt
New York stock exchange vs Heng Seng
-original founders can retain control with B class shares and issue A class shares to the public unlike
in Heng Seng, one share one vote
-access to US capital markets (US investors are more likely to invest in US than in Heng Seng)
-Heng Seng has a bad record where IPO stock shoots down a lot in the next day (it is more volatile)
Financial community
Least important in the financial community = CNBC TV and easily impressed members of the
financial press
Important members of financial community include
1
...
Independent investigatory oriented members of the financial press such as FT lex,
BreakingViews, NYT who are often right and not easily swayed
3
...
Analyse the intermediate financial plan and ask bankers for it
2
...
Understand the power of being the lead lender as the lead lender gets to enjoy the
marketing benefits and prestige so CFO should make use of this
4
...
Active cultivation of noncancellable facility when the company is doing well
Reactive approach
1
...
3
...
5
...
Be on time to provide company’s forward performance guidance
2
...
Do not rely on EPS guidance and financial window dressing tricks
4
...
Do not use baffle prose that defy comparison with other firms
6
...
Do not dismiss pressure of buybacks or extraordinary dividends without explaining or
proving that there are positive NPV investments to be made
8
...
Get clean accounting letter and get good tough auditors to identify fraud
10
...
Clear financial statement presentation
Predict a company’s termination using accounting, credit rating, Altman Z score, debt levels, liquidity
ratios
Company’s life cycle
Rating agencies help investors to decide which companies live the longest
Big industrial companies tend to start strong and deteriorate at a gradual and consistent pace
Financials tend to maintain a high credit rating before falling apart abruptly
Airlines have a nasty credit scare, a long struggling passage and a final dive to bankruptcy
High leverage firms are more subjected to bankruptcy risks
...
Hedge net economic exposure = check if the whole industry is exposed to the same risk and
pass the cost of the risk to customers
2
...
Indirect costs of hedging = opportunity costs of holding margin capital and lost upside
4
...
Should come up with a profile of probable cash flows that reflects company-wide calculation
of risk exposures and sources of cash
6
...
Companies should then take aggressive steps to mitigate risk
...
If company can finance strategic plans with high degree of certainty even without hedging, it
should avoid an expensive hedging plan
...
Explore alternatives to hedging that reduce risk inexpensively: contracting decisions that
pass risk to counterparty, strategic moves like vertical integration and operational changes
such as revising product specifications, shutting down manufacturing facilities when input
costs peak or holding additional cash reserves
90
Title: Corporate Finance
Description: The revision guide includes summary of lecture notes, tutorials, relevant readings, exam qns and proposed answers. Scored a high first in the mod so quality of notes is guaranteed.
Description: The revision guide includes summary of lecture notes, tutorials, relevant readings, exam qns and proposed answers. Scored a high first in the mod so quality of notes is guaranteed.