Final Exam Topics | Corporate Finance II | FIN 3503, Study notes of Finance

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Final Exam Financial Statements • Income statement • Balance sheet • Statement of cash flows • Ratio analysis Cash from operating activities Net income $10.2 Sources and Uses Depreciation and amortization 8.0 Accounts receivable (8.0) Inventories (15.0) Prepaid expenses 1.0 Accounts payable 8.0 Accrued expenses 0.0 Net cash provided (used) by operations $4.2 Cash from investing Capital expenditures (10) ($10) Cash from financing activities Increase in short-term borrowings 1.0 Additions to long-term borrowings 4.0 Dividends paid (3.2) Net cash provided (used) by financing activities $1.8 Increase (decrease) in cash and marketable securities ($4.0) Beginning cash $12 Ending cash $8.0 Capital Budgeting • Net present value • Internal rate of return • Project cash flows What is NPV?   NPV I CF r t t t n    0 1 1 • NPV is a measure of whether the cash flows from a project are sufficient to: – recover the initial investment, – provide an adequate return for investors, – and generate cash for growth. Potential Conflict • NPV and IRR MAY yield conflicting decisions » If r < r*, NPVA > NPVB and IRRB > IRRA » If r = r*, NPVA = NPVB and IRRB > IRRA » If r > r*, NPVA < NPVB and IRRB > IRRA r* r NPV A B Multiple IRRs • Do these represent rates of return? r IRR NPV 18% 50% $0 Project Free Cash Flow 0 1 2 3 Sales $100.00 $100.00 $100.00 Expenses 85.00 85.00 85.00 Depreciation (25.00) (25.00) (25.00) EBT 160.00 160.00 160.00 Tax (60.80) (60.80) (60.80) Depreciation 25.00 25.00 25.00 Unlevered CF 124.20 124.20 124.20 Fixed assets ($100) D in NWC ($10) 10.00 SV, after-tax 25.00 Free cash flow ($110.00) $124.20 $124.20 $159.20 Valuation Formulas • Valuation formula: present value of the expected future free cash flows: • Free cash flow (FCF) is cash available to investors or for reinvestment, after all investments in plant and equipment and working capital needs have been met:         nc cn n t t t h WACCgWACC gFCF WACC gFCF V        1 1 1 1 0 FCFn+1     NOWCNFATEBIT NOWCgrossFADepTEBITFCF DD DD 1 )(1 Forecast Growth rate 4% 4% 4% 4% 4% 2% % of Sales 2009A 2010 2011 2012 2013 2014 2015 2016 Net Sales $480.00 $499.20 $519.17 $539.93 $561.53 $583.99 $595.67 $595.67 Cost of sales 83.33% 400.00 416.00 432.64 449.95 467.94 486.66 496.39 Gross profit $80.00 $83.20 $86.53 $89.99 $93.59 $97.33 $99.28 Depreciation 1.67% 8.00 8.32 8.65 9.00 9.36 9.73 9.93 SG&A expense 10.00% 48.00 49.92 51.92 53.99 56.15 58.40 59.57 EBIT $24.00 $24.96 $25.96 $27.00 $28.08 $29.20 $29.78 Taxes on EBIT 40.00% 9.60 9.98 10.38 10.80 11.23 11.68 11.91 Depreciation $8.00 $8.32 $8.65 $9.00 $9.36 $9.73 $9.93 DNWC 10.00% $1.80 $1.92 $2.00 $2.08 $2.16 $2.25 $1.17 Net fixed assets 2.00% 9.60 9.98 10.38 10.80 11.23 11.68 11.91 FCF 11.00 11.39 11.85 12.32 12.81 13.33 14.72 Cost of capital 10.50% Value 1-5 $45.83 Perpetuity value $105.09 $173.14 Enterprise value $150.92 P/E Multiple • Price/Earnings: If two firms have the same payout and EPS growth rates, and equivalent risk (i.e. same cost of equity), they should have the same P/E ratio.   gr EPS Div EPS P EPForward E   1 1 1 0/ Suppose that the interest rate the firm will pay on debt is 8%, the amount of interest bearing debt on the balance sheet is $1.5M and the corporate tax rate is 40%. The firm’s stock price is $10 and there are 500,000 outstanding shares. The firms' beta is 1.2, the current yield on the 10-year note is 5% and the market risk premium is 6%. What is the WACC? Suppose that the interest rate the firm will pay on debt is 8%, the amount of interest bearing debt on the balance sheet is $1.5M and the corporate tax rate is 40%. The firm’s stock price is $10 and there are 500,000 outstanding shares. The firms' beta is 1.2, the current yield on the 10-year note is 5% and the market risk premium is 6%. What is the WACC? • What is the effective interest cost to the firm?     %8.44.108.1  Trd Suppose that the interest rate the firm will pay on debt is 8%, the amount of interest bearing debt on the balance sheet is $1.5M and the corporate tax rate is 40%. The firm’s stock price is $10 and there are 500,000 outstanding shares. The firms' beta is 1.2, the current yield on the 10-year note is 5% and the market risk premium is 6%. What is the WACC? • What is the percentage or weight of debt in the firm’s capital structure? %23 0.5$5.1$ 5.1$   Raising Equity • Different kinds of investors • IPO pricing and comparables • Financing/ownership tradeoff Equity Financing For Private Companies • Angel investors • Venture capital • Institutional investors • Corporate investors Funding and Ownership • Financing and ownership tradeoff • Pre- and post-money value Number Percent Round Price of Shares Ownership Yours $0.067 1,500,000 30.00% Angel $0.067 500,000 10.00% Venture $2.00 3,000,000 60.00% 5,000,000 Pre-money $4,000,000.00 Post-money $10,000,000.00 )000,500000,500,1(*2$  )000,000,5(*2$ Example • Suppose that a bond has a face value of $10,000 and a conversion ratio of 450. What is the conversion price? Face value Conversion ratio $10,000 450 $22.22 P P    Capital Structure • Leverage and risk • MM Proposition I • MM Proposition II • Value of the leveraged firm and the tax shield • Tradeoff theory • Asymmetric information Financial Leverage and Risk • EPS rises more rapidly for the levered firm. • Why does stock price not increase? ($1.50) ($1.00) ($0.50) $0.00 $0.50 $1.00 $1.50 $2.00 $2.50 $3.00 $3.50 $0 $500 $1,000 $1,500 $2,000 $2,500 Debt and equity All equity Example 15.1a The Risk and Return of Levered Equity Execute: • The firm will owe debt holders $25,000  1.04 = $26,000 in one year. • Thus, the expected payoff to equity holders is $84,000 – $26,000 = $58,000, • for a return of $58,000 / $50,000 – 1 = 16%. Example 15.1a The Risk and Return of Levered Equity Evaluate: • While the total value of the firm is unchanged, the firm’s equity in this case is more risky than it would be without debt, but less risky than if the firm borrowed $50,000. • To illustrate, if demand is weak, the equity holders will receive $75,000 – $26,000 = $49,000, for a return of $49,000/$50,000 – 1 = – 2%. • If demand is strong, the equity holders will receive $91,000 – $26,000 = $65,000, for a return of $65,000/$50,000 – 1 = 30%. MM Proposition I: the value of the firm remains unchanged no matter what the capital structure; the value of the firm is the market value of the cash flows generated by its assets and is not affected by its choice of capital structure. D/TA Value EDU rED E r ED D r                Example 15.2 Computing the Equity Cost of Capital Solution: Plan: • Because your firm’s assets have a market value of $30,000, by MM Proposition I the equity will have a market value of $24,000 = $30,000 – $6,000. We can use Eq. 15.3 to compute the cost of equity. We know the unlevered cost of equity is ru = 15%. We also know that rD is 5%. Example 15.2 Computing the Equity Cost of Capital Execute: 6000 15% (15% 5%) 17.5% 24,000E r     Example 15.2 Computing the Equity Cost of Capital Evaluate: • This result matches the expected return calculated in Example 15.1 where we also assumed debt of $6,000. The equity cost of capital should be the expected return of the equity holders. MM: Cost of Capital D/TA Cost of Capital • Taxes but no risk r(1-T) WACC re   ECDWACC rED E Tr ED D r                1 Example 15.3 Computing the Interest Tax Shield Problem: • Shown on the next slide is the income statement for D.F. Builders (DFB). Given its marginal corporate tax rate of 35%, what is the amount of the interest tax shield for DFB in years 2005 through 2008? Example 15.3 Computing the Interest Tax Shield 1 DFB Income Statement (§ million) 2005 2006 2007 2008 2) Total sales $3,369 $3,706 $4,077 $4,432 3 Cost of sales —2,359 -—2,584 | —2,867 —3,116 4) Selling, general, and administrative expense —226 —248 -276 —299 5 Depreciation —22 —25 —27 —29 6 Operating income 762 849 907 988 7 Other income 7 8 10 12 9 EBIT 769 857 917 1,000 10) Interest expense —50 —80 —100 —100 11, Income before tax 719 777 817 900 12, Taxes (35%) —252 —272 —286 —315 13 Net income $467 $505 $531 $585 Example 15.4 Valuing the Interest Tax Shield Problem: • Suppose DFB from Example 15.3 borrows $2 billion by issuing 10-year bonds. DFB’s cost of debt is 6%, so it will need to pay $120 million in interest each year for the next 10 years, and then repay the principal of $2 billion in year 10. DFB’s marginal tax rate will remain 35% throughout this period. By how much does the interest tax shield increase the value of DFB? Example 15.4 Valuing the Interest Tax Shield Solution: Plan: • In this case, the interest tax shield lasts for 10 years, so we can value it as a 10-year annuity. Because the tax savings are as risky as the debt that creates them, we can discount them at DFB’s cost of debt: 6%. Example 15.4 Valuing the Interest Tax Shield Execute: • The interest tax shield each year is 35%  $120 million = $42 million. Valued as a 10-year annuity at 6%, we have: • The final repayment of principal in year 10 is not deductible, so it does not contribute to the tax shield. 10 1 1 (Interest Tax Shield) $42 million 1 6% 1.06 $309 million PV          Asymmetric Information • Asymmetric information means that managers, stockholders and debtholders are not privy to the same set of information concerning the firm. • Given this situation, incentives of these parties are not necessarily aligned. • Mangers may not act in the best interest of stockholders, but may maximize their own utility. • Under some circumstances, stockholders may be in conflict with debtholders. Asymmetric Information and Signaling • Pecking order of finance – internally generated funds – debt and possibly hybrids – new issues of common • Why? – Avoid discipline of market – lower issue costs – adverse signal sent to investors Asymmetric Information and Signaling • If a firm sells stock, investors interpret that the firm’s future prospects are not bright. • Why? – If a firm sells stock, it is because the shares are overvalued. – The firm does not have sufficient cash. • Thus, a firm should maintain excess borrowing capacity in order to avoid missing investment opportunities. Basic issue: if investment and capital structure remain constant, then where does payment of dividends come from? • From sale of new shares – new shares will be worth less since pie is sliced into more pieces – original stockholders have shares with lower value – but they have received an offsetting dividend. • The firm has done nothing for investors that investors could not do for themselves. Three Alternatives • Pay dividends with cash • Repurchase shares • High dividends with sale of shares Pay Dividends with Cash • Suppose the firm is going to pay a $2 dividend immediately and will use cash to do so. The firm expects to generate $48M in free cash flows and to pay a $4.80 dividend each year thereafter. 40$ 12. 80.4$ exP 42$ 12. 80.4$ 2$ cumP Before After Cash $20.00 $0.00 Other assets 400.00 400.00 Total market value $420 $400 Shares (millions) 10 10 Share price $42.00 $40.00 Gordon and Litner: Bird-in-Hand Theory • M&M ignore risk: since capital gains are riskier than dividends, the firm should pay more in dividends. • Suggests an inverse relationship between required returns and dividends. • That is, investors’ required returns will increase as dividends are decreased. • Evidence: stock prices go up with announcements of dividend increases. g P D r  0 1 Tax Theory • Both ignore taxes: dividends impose a tax burden on investors. • This implies a direct relationship between dividends and required returns. • They suggest that the firm should not pay dividends. g P D r  0 1 M&M response to Gordon and Litner: • Signaling –M&M agree that stock prices go up when firms announce dividend increases. – However, this is due to signaling effect. – That is, stockholders read the announcement to mean that the future of the company is bright. – The company predicts sufficient cash flows into the future so that they can afford the dividend. Solution Repurchase $20 Before Cash $50.00 Debt $200.00 Other assets 450.00 Stock 300.00 $500.00 $500.00 After Cash $30.00 Debt $200.00 Other assets 450.00 Stock 280.00 $480.00 $480.00 D/E 71.43%   MMDividend M Dividend 2$20$10.0 20$ %10   • A company has a market capitalization of $300,000 with 10,000 shares outstanding. The company is going to distribute $50,000 in an open market repurchase. –What is the price per share before the repurchase? – How many shares will be repurchased? –What is the price after the repurchase? Solution Market Capitalization $300,000 Repurchase $50,000 Shares 10,000 30$ 333,8 000,250$  Price before $30 Shares repurchased 1,667 Shares remaining 8,333 New market cap $250,000 Price after $30 667,1 30$ 000,50$  000,250$000,50$000,300$  • Suppose that a company pays a constant dividend of $2 and the cost of equity is 12%. Assume that investors pay a 20% tax on dividends and there is no capital gains tax. –What is the price per share? – If they do a repurchase, what is the price per share? Solution Dividend $2 Tax 20.00% Re 12.0% Price taxed dividend $13.33 Price repurchase $16.67   33.13$ 12. )2.12$   67.16$ 12. 2$  Example 16.2 Payout Decisions in a Perfect Capital Market Problem: • Barston Mining has $100,000 in excess cash. Barston is considering investing the cash in one-year Treasury bills paying 6% interest, and then using the cash to pay a dividend next year. Alternatively, the firm can pay a dividend immediately and shareholders can invest the cash on their own. In a perfect capital market, which option will shareholders prefer? Example 16.2 Payout Decisions in a Perfect Capital Market Evaluate: • Because Barston is not doing anything that the investors could not have done on their own, it does not create any value by retaining the cash and investing it for the shareholders versus simply paying it to them immediately. As we showed in Example 16.1, if Barston retains the cash, but investors prefer to have the income today, they can sell $100,000 worth of shares. Modigliani and Miller • MM Payout Irrelevance: In perfect capital markets, if a firm invests excess cash flows in financial securities, the firm’s choice of payout versus retention is irrelevant and does not affect the initial value of the firm. Payout Versus Retention of Cash • Retaining Cash with Imperfect Capital Markets – Based on MM’s payout irrelevance, the decision of whether to retain cash depends on market imperfections