Corporate Finance Nothes, Appunti di Finanza Aziendale

Scarica Corporate Finance Nothes e più Appunti in PDF di Finanza Aziendale solo su Docsity! CORPORATE FINANCE CH 1 - INTRODUCTION TO CORPORATE FINANCE 1.1 What is Corporate Finance? Every decision that a business makes has financial implications and any decision which affects the finances of a business is a corporate finance decision. The purpose of the firm is to create value for the owner, who may or may not be the manager of the firm. The main goal of a firm in the: - Long run: maximise value; - Short run: create value (e.g. profit). This concept of value is reflected in the framework of the simple balance sheet model of the firm. Main goal of corporate finance is cash. What happens when you start a firm? • Hire staff: ↑ assets • Buy raw materials: ↑ assets • Buy machinery: ↑ assets • Invest your own money: ↑ equity • Borrow money: ↑ debt THE BALANCE SHEET MODEL OF THE FIRM These assets can be: • Current asset (or short term): those that have short lives, such as inventory, cash, receivables... • Non-current asset (or long term): those that will last a long-time, such as buildings, plant and equipment. • Current liabilities: liabilities that must be paid either with cash or with goods and services within one year or within the entity’s operating cycle (whichever is greater) (e.g. accounts payable, salaries payable...) • Non-current liabilities: liabilities that do not need to be paid within one year or within the operating cycle (e.g. loans) CORPORATE FINANCE HAS THREE MAIN AREAS OF CONCERN: 1. In what long lived asset should the firm invest? This question concerns the left side of the BS. We use the term capital budgeting to describe the process of making and managing expenditures on long-lived asset. 2. How can the firm raise cash for required capital expenditures? This question concerns the right side of the BS. We use the term capital structure to represent the proportions of the firm’s financing from debt and equity. 3.How should short term operating cash flows be managed? This question concerns the upper portion of the BS and in particular net working capital. 1. Capital Structure How can the firm raise cash for required capital expenditures? This question concerns the right side of the balance sheet. The answer: capital structure, which represents the proportions of the firm’s financing from current liabilities, long-term debt, and equity. The people or institutions that buy debt from (i.e., lend money to) the firm are called creditors, bondholders or debtholders. The holders of equity are called shareholders. CAPM is a model that describes the relationship between the expected return and risk of investing in a security Sometimes it is useful to think of the firm as a pie. Firm’s value = Debt + Equity Bank oriented country: more financial debt from banks Market oriented country: stock market The diversifiable risk is the risk that can be eliminated by diversification, can be “washed out” by diversification. Non-diversifiable risks are the risks that cannot be diversified away. 2. Capital Budgeting In what long-lived assets should the firm invest? This question concerns the left side of the balance sheet. We use the capital budgeting to describe the process of making and managing expenditures on long-lived assets. Used by companies to evaluate major projects and investments, such as new plants or equipment. The process involves analyzing a project's cash inflows and outflows to determine whether the expected return meets a set benchmark. Capital budgeting is the process by which investors determine the value of a potential investment project. 3. The Net Working Capital (NWC) Net working capital is NWC is the difference between a company’s current assets, such as cash, accounts receivable and inventories of raw materials and finished goods, and its current liabilities, such as accounts payable. An increase in NWC will generally lead to a decrease in the OCF (operating cash flow, the first section on the statement of cash flows that reports on regular activities that create revenue or expense in the entity’s business). This is because an increase in NWC means that current asset increase as well (or current liabilities decrease). To acquire these additional current asset, we typically spend cash and this is why we’ll see a negative effect on the OCF. NWC can be seen as a sponge that absorb cash. The larger the NWC the more cash/water it has absorbed. When we want get some extra cash out of the sponge, we simply comprise the sponge and the water (cash) flows out. ➝ Therefore, we have two ways current for seeing NWC: NWC = cA – cL (current assets, liabilities) NWC = (Raw materials + Receivables) – Account Payable Payout policy: refers to the ways in which firms return capital to their equity investors. Payouts to equity investors take the form of either dividends or share repurchases. ➝ Sole proprietorship is a business owned by one person. ➝ Any two or more people can get together and form a partnership. Partnerships fall into two categories: (1) general partnerships and (2) limited partnerships. ➝ Corporations: distinct legal entity. They can acquire and exchange properties. The Sole Proprietorship These types of firms are the easiest to understand since all the business activities are concentrated in one individual – the owner/manager. Decisions by the owner. Partnerships A partnership is very similar to that of a sole proprietorship. Generally, partners will have unlimited liability, which means that they are personally liable for all of their firm’s debts. Corporations Because a corporation is a separate legal entity, the informality that is common in sole proprietorships and partnerships is substituted by formal corporate governance structures that are commonly seen in large organizations. Common law countries: financial markets?? firm value is higher than in the civil; shareholders debts higher than in the civil Civil law countries: Agency cost is the cost of a conflict of interest between shareholders and management. These costs can be indirect or direct. Over-investment: NPV < 0 Under-investment: NPV > 0 (net present value) Critical elements: Cash holding, R&D, Dividends (R&D: research & develop.) Part 2: Value and Capital Budgeting CH 3 - Financial Statement Analysis 3.1 The Statement of Financial Position (Goal: calculate Equity) The statement of financial position (or balance sheet, BS) is an accountant’s snapshot of a firm’s accounting value on a particular date, as though the firm stood momentarily still. The statement of financial position states what the firm owns and how it is financed. Assets = Liabilities + Shareholder’s Equity When analysing a BS, the financial manager should be concerned about three points: Liquidity: liquidity refers to the ease and quickness with which assets can be converted to cash. - Current asset are the most liquid asset as they include cash and asset that will be converted into cash within a year from the date of the BS, such as trade receivable (amounts not yet collected from customer for goods/services sold to them) and inventories (raw material for production, work in progress and finished goods). - Non-current asset are the least liquid type of asset as they include PP&E or goodwill (an intangible non-current asset that reflects the premium paid by companies when they acquire other companies). The more liquid a firm’s assets are, the less likely the firm is to experience problems meeting short term obligation. However, having too much liquid may not be a good idea as liquid assets generally do have low rate of return than non-current asset. When the value of cash is correct? ➝ When we cover the short term debt, which is very important to individuate. For all indicators we have to do the comparison between the average of the sector. Ratio analysis We have seen that, to compare two firms, one may use common-size statements technique. Another way to compare different-size firms is to use financial ratios. One problem with ratios is that different people and different sources frequently do not compute them in exactly the same way, and this leads to much confusion. Financial ratios are traditionally grouped into the following categories: 1. Short-term solvency, or liquidity, ratios 2. Long-term solvency, or financial leverage, ratios 3. Asset management, or turnover, ratios 4. Profitability ratios 5. Market value ratios ►SHORT-TERM Solvency or Liquidity Measures Short-term solvency ratios as a group are intended to provide information about a firm’s liquidity, and these ratios are sometimes called liquidity measures. The primary concern is the firm’s ability to pay its bills over the short run without stress. Consequently, these ratios focus on current assets and current liabilities. For obvious reasons, liquidity ratios are particularly interesting to short-term creditors. 1. Current Ratio Because current assets and liabilities are, in principle, converted to cash over the following months, the current ratio is a measure of short-term liquidity. -To a creditor (particularly a short-term creditor such as a supplier) the higher the current ratio, the better. -To the firm, a high current ratio indicates liquidity, but it also may indicate an inefficient use of cash and other short-term assets. Absent some extraordinary circumstances, we would expect to see a current ratio of at least 1; a current ratio of less than 1 would mean that NWC is negative. This would be unusual in a healthy firm, at least for most types of businesses. 2. Quick or (Acid-Test) Ratio Inventory is often the least liquid current asset. It is also the one for which the book values are least reliable as measures of market value because the quality of the inventory is not considered. Some of the inventory may later turn out to be damaged, obsolete or lost. More to the point, relatively large inventories are often a sign of short-term trouble. To further evaluate liquidity, the quick, or acid-test, ratio is computed just like the current ratio, except inventory is omitted: 3. Cash Ratio A very short-term creditor might be interested in the cash ratio: ► LONG-TERM Solvency Measures Long-term solvency ratios are intended to address the firm’s long-run ability to meet its obligations or, more generally, its financial leverage. These ratios are sometimes called financial leverage ratios or just leverage ratios. We consider three commonly used measures and some variations. 1. Total Debt Ratio The total debt ratio takes into account all debts of all maturities to all creditors. It is computed as follows: 2. Times Interest Earned Another common measure of long-term solvency is the times interest earned (TIE) ratio: This ratio measures how well a company has its interest obligations covered, and it is often called the interest coverage ratio. 3. Cash Coverage A problem with the TIE ratio is that it is based on EBIT, which is not really a measure of cash available to pay interest. The reason is that depreciation, a non-cash expense, has been deducted out. Because interest is most definitely a cash outflow (to creditors), one way to define the cash coverage ratio is: EBITA, the numerator, is a basic measure of the firm’s ability to generate cash from operations, and it is frequently used as a measure of cash flow available to meet financial obligations. As long as your company is not running out of stock and thereby forgoing sales, the higher this ratio is, the more efficiently your company is at managing inventory. 2. Receivables Turnover and Days’ Sales in Receivables Our inventory measures give some indication of how fast we can sell products. We now look at how fast we collect on those sales. The receivables turnover ratio and days ‘sales in receivables figure implicitly assumes that all sales in a firm are credit sales. When this is not true, only credit sales figures should be used (not total sales). 3. Total Asset Turnover Moving away from specific accounts like inventory or receivables, we can consider an important ‘big picture’ ratio, the total asset turnover ratio: ► Profitability Measures Profitability measures are intended to measure how efficiently the firm uses its assets and how efficiently the firm manages its operations. They focus on net income. 1. Profit Margin Companies pay a great deal of attention to their profit margin: All other things being equal, a relatively high profit margin is obviously desirable. This situation corresponds to low expense ratios relative to sales. 2. Return on Assets Return on assets (ROA) is a measure of profit per asset value. It can be defined several ways, but the most common is: 3. Return on Equity Return on equity (ROE) is a measure of how the shareholders fared during the year. Because benefiting shareholders is our goal, ROE is, in an accounting sense, the true bottom-line measure of performance. ROE is usually measured as: This tells us, for every dollar of equity, a particular firm generated a particular % of profit, given by the ROE ratio. It is the return for shareholders. ► Market Value Measures Our final group of measures is based, in part, on information not necessarily contained in financial statements – the share price. Obviously, these measures can be calculated directly only for publicly traded companies. 1. Price-Earnings Ratio The first of our market value measures, the price–earnings (or PE) ratio (or multiple), is defined as: Mind that Earnings per Share (EPS) is calculated as: Because the PE ratio measures how much investors are willing to pay per unit of current earnings, higher PEs are often taken to mean that the firm has significant prospects for future growth. Of course, if a firm had no or almost no earnings, its PE would probably be quite large; so, as always, care is needed in interpreting this ratio. 2. Market-to-Book Ratio A second commonly quoted measure is the market-to-book ratio. 3.8 The Du Pont Identity As we mentioned in discussing ROA and ROE, the difference between these two profitability measures reflects the use of debt financing or financial leverage. A Closer Look at ROE To begin, let us recall the definition of ROE and make some modifications: What we have now done is to partition ROA into its two component parts, profit margin and total asset turnover. The last expression of the preceding equation is called the Du Pont identity after the Du Pont Corporation, which popularised its use. The Du Pont identity tells us that ROE is affected by three things: • Operating efficiency (as measured by profit margin) • Asset use efficiency (as measured by total asset turnover) • Financial leverage (as measured by the equity multiplier). Weakness in operating / asset use efficiency (or both) will show up in a diminished return on assets, which will translate into a lower ROE. e Goal of financial analysis: create the main indicators and measure the financial structure and economic performance. Time trend analysis involves examining financial data over a period of time to identify trends, patterns, and changes. CH 4 – DISCOUNTED CASH FLOW VALUTATION 4.1 VALUATION: THE ONE-PERIOD CASE Let’s begin with an example. Keith Vaughan is trying to sell a piece of undeveloped land in Wales. Yesterday he was offered £10,000 for the property. He was about ready to accept the offer when another individual offered him£11,424 to be paid a year from now. Keith has satisfied himself that both buyers are honest and financially solvent, so he has no fear that the offer he selects will fall through. Which offer should Keith choose? Mike Tuttle, Keith’s financial adviser, points out that if Keith takes the first offer, he could invest the £10,000 in the bank at an insured rate of 12 per cent. At the end of one year, he would have 11.200$ (10.000 * 1,12). Because this is less than the $11.424 Keith could receive from the second offer, Mike recommends that he take the latter. This analysis uses the concept of future value (FV) or compound value, which is the value of a sum after investing over one or more periods (this is what we have just seen, so multiply the sum times the interest rate). The compound or future value of $10,000 at 12 per cent is $11,200. An alternative method employs the concept of present value (PV). One can determine present value by asking the following question: how much money must Keith put in the bank today so that he will have $11,424 next year? We can write this algebraically as: PV = 10.200$. The formula for PV can be written as follows: FV / (1 + r)n FV: value of the money in the next years, value of money for tomorrow. Net present value (NPV) Is the present value of future cash flows minus the present value of the cost of the investment. If the NPV is negative, one should avoid that particular investment. Best method, because it considers the time value. We must increase value. So, NPV compares the value of future cash flows to the initial investment, accounting for the fact that a dollar received in the future is worth less than a dollar today. If NPV is positive, the investment is expected to be profitable, and if it’s negative, the investment is expected to result in a loss. ➡️ The formula for NPV can be written as follows: where C1 is the cash flow at date 1 and r is the rate of return that Keith Vaughan requires on his land sale. It is sometimes referred to as the discount rate. Present value analysis tells us that a payment of $11,424 to be received next year has a present value of $10,200 today. In other words, at a 12 per cent interest rate, Keith is indifferent between $10,200 today or $11,424 next year. If you gave him $10,200 today, he could put it in the bank and receive $11,424 next year. Because the second offer has a present value of $10,200, whereas the first offer is for only $10,000, present value analysis also indicates that Keith should take the second offer. Does a Potential Investment Add Value? A piece of land costs €85,000. Next year the land will be worth €91,000, a sure €6,000 gain. Given that the guaranteed interest rate in the bank is 10 per cent, should you undertake the investment? Cash flow: calculate with the balance sheet statement. ➡️ Tax-Shield approach: reduction in taxable income and tax liability that occurs as a result of specific tax deductions, credits, or allowances. It’s a method used to calculate the benefit a company or individual receives from tax-related financial decisions. We find it when we talk about debt, which can create it (tax shield). (Sales – Costs) x (1 - tc) + Depriciation x tc OCF = (Sales – costs)*(1-tc) + Depreciation*tc Where tc is again the corporate tax rate (28%) OCF = (1,500-700)*0,72 + 600*0,28 = 744 INCREMENTAL CASH FLOW (ICF) Represents the difference in cash flows between taking on a project or investment and not taking it on. All cash flow that are related to a single investment project, not to all. Important considerations: 1. Cash flows: movement of money into and out of a business, investment, or individual’s finances over a specific period of time. They are a critical aspect of financial analysis and are categorized into three main types: Operating, Investing and Financing CF. 2. Side effects: A side effect is classified as either erosion or synergy. • Erosion is when a new product reduces the cash flows of existing products. • Synergy occurs when a new project increases the cash flows of existing projects. - Rule: include side effects 3. Sunk Costs: Incremental cash flows exclude sunk costs, which are costs that have already been incurred and cannot be changed. Sunk costs are not relevant to decision-making because they are not affected by the investment decision. - Rule: ignore all sunk costs. 4. Opportunity Costs: Opportunity costs, or the foregone benefits of not pursuing an alternative investment, may be considered in the analysis of incremental cash flows. Rule: incorporate opportunity costs into your analysis 5. Allocated costs: An allocated cost is an accounting measure to reflect expenditure or an asset’s use across the whole company. - Rule: should be viewed as a cash outflow only if it is an incremental cost of the project. TIME VALUE OF MONEY Cash flows are discounted to take into account the fact that 1000€ to be received some time in the future is worth less today than 1000€ received immediately. 1000€ x 1+r Why? - Cash in hand is certain, therefore less risky - Opportunities to invest cash today to earn interest Business plan: analysis of the Financial statement, which is divided in 3 parts: Balance sheet Income statement CF statement Difference between PV and NPV: PV is the value of an amount of money today, discounted using an appropriate discount rate NPV is the present value of positive cash flows (inflows) and the present value of negative cash flows (outflows), taking into account the time value of money. Energy Renewables Ltd: An Example The Proposal The rare metals used to produce wind turbines are rapidly becoming more expensive. Owing to this, production cash outflows are expected to grow at 10 per cent per year. First-year production costs will be £100,000 per unit. Net working capital (that is, investment in raw materials and inventory) will immediately (year 0) grow to £100,000. This will remain level until year 2, when it will grow to £160,000, then increase again to £250,000 in year 3. By year 4 the project will be winding down and net working capital will be £210,000. At the end of the project, net working capital will return to zero as all inventory and raw materials are sold off. Based on Energy Renewables’ taxable income, the appropriate incremental corporate tax rate in the wind turbine project is 20 per cent. The appropriate discount rate for this type of investment is 12 per cent. Should Energy Renewables take the project? Step 1: Calculate Depreciation Step 2: Calculate Tax Payment Based on assumptions, we make it on the best hypotesis about the trend. Sales = Q x P Step 3: Generate Cash Flow Forecast Bottom-up approach = Net income + Dep NWC = Change in NWC + CF Investment CF = NWC + Opportunity cost + Manufacturing facilities Can we accept this project? Using the absolute value approach we can accept it, because the CF in iscreasing over the years. Step 4: Investment Appraisal Positive NPV, we can accept the project because it produces value, negative = reject. Discount factor is a measure of risk. It decides if NPV is positive or negative. CF and discount factor are the most important. DF includes the risk, so is the most important. EXAMPLE We suppose the following estimates: Cost on investment: 2million Time: 5y Sales: 300k costs: 200k Depreciation: 50k NWC = 50,000; -25,000; 35,000; -25,000; 50,000 Inputs: Growth rate: 10% for revenues and 5% for costs The debt ratio is 50% Interest rate is 5% Tax rate: 40% Cost of equity: 4% ➢ Your friend tells you that it does not matter when you receive cash, it is still worth the same. That is, NKr10,000 this year is the same as NKr10,000 next year. Is this correct? Explain. The concept that money received at different points in time has different values is known as the time value of money (TVM). TVM of money recognizes that money has different values at different points in time due to factors like inflation, opportunity cost, and risk. Therefore, receiving NKr10,000 this year is not the same as receiving NKr10,000 next year, as the latter is subject to these value-changing factors. ➢ As you increase the length of time involved, what happens to future values? What happens to present values? What happens to the future value of an annuity if you increase the rate r? What happens to the present value? As you increase the length of time involved: 1. Future Values (FV): Future values tend to increase. This is because over a longer time period, the effects of compounding become more significant. Compound interest or investment returns have more time to work, resulting in a higher future value. 2. Present Values (PV): Present values tend to decrease. This is because a future sum of money is worth less today due to the time value of money. The longer you have to wait to receive a certain amount, the less it's worth in today's terms. As you increase the rate 'r' (interest rate or discount rate) for both a single amount and an annuity: 1. Future Value of a Single Amount (FV): The future value of a single amount increases. A higher interest rate leads to more significant growth of a sum of money over time. 2. Present Value of a Single Amount (PV): The present value of a single amount decreases. A higher discount rate reduces the value of a future sum in today's terms. 3. Future Value of an Annuity (FV): The future value of an annuity increases. A higher interest rate means that each annuity payment earns more interest or returns over time, leading to a higher future value. 4. Present Value of an Annuity (PV): The present value of an annuity decreases. A higher discount rate reduces the value of a series of future cash flows in today's terms. In summary, increasing the length of time generally results in higher future values and lower present values. Increasing the interest rate typically leads to higher future values and lower present values for both single amounts and annuities. CH 5 - BOND, EQUITY AND FIRM VALUATION A bond is a certificate showing that a borrower owes a specified sum. To repay the money, the borrower has agreed to make interest and principal payments on designated dates. There are many types of bonds that exist in the capital markets and issuers include corporations, private firms, banks and governments. Pure Discount Bonds The pure discount bond is perhaps the simplest kind of bond. It promises a single payment, say $1, at a fixed future date. If the payment is 1 year from now, it is called a 1-year discount bond; if it is 2 years from now, it is called a 2- year discount bond, and so on. The date when the issuer of the bond makes the last payment is called the maturity date of the bond, or just its maturity for short. PV = F / (1+r)t Level Coupon Bonds Typical bonds issued by either governments or corporations offer cash payments not just at maturity, but also at regular times in between. These intermediate payments are called coupons of the bond. These types of bonds are called level coupon bonds (or simply coupon bonds). The value of the coupon bond is simply the present value of its cash flows (i.e., its coupons). Consols Not all bonds have a final maturity date. As we mentioned in the previous chapter, consols are bonds that never stop paying a coupon, have no final maturity date, and therefore never mature. Consols can be valued using the perpetuity formula of the previous chapter (e.g., if the market interest rate is 10% and the consols with a yearly interest payment of 50$ is valued at 50$/0,10 = 500$). PV = C/ r Bond prices fall with a rise in interest rates and rise with a fall in interest rates. Furthermore, the general principle is that a level coupon bond sells in the following ways: 1. At the face value if Coupon rate = Market-wide interest rate 2. At a discount if Coupon rate < Market-wide interest rate 3. At a premium if Coupon rate > Market-wide interest rate Yield to Maturity The yield to maturity (YTM) is the overall interest rate earned by an investor who buys a bond at the market price and holds it until maturity. Dividends vs Capital Gains Our goal in this section is to value ordinary shares. We learned in the previous chapter that an asset’s value is determined by the present value of its future cash flows. Equities provide two kinds of cash flows. First, they often pay dividends on a regular basis. Second, the shareholder receives the sale price when they are sold. Dividends are periodic payments made by a corporation to its shareholders out of its profits. They provide a steady stream of income to shareholders. Capital gains are profits realized from the sale of an asset, such as stocks or real estate. They result from the increase in the value of the asset over time. In short, dividends are regular income payments, while capital gains are profits made from selling assets at a higher price than their purchase cost. Thus, to value equity, we need to answer an interesting question. Is its value equal to the discounted PV of the sum of next period’s dividends plus next period’s share price? Or is its value equal to the discounted present value of all future dividends? Both answers are right. The value of an equity is £100. The company earns £100 extra in cash. What is the investor’s portfolio at t=1? Valuation of Different Types of Equities The preceding discussion shows that the value of the firm is the PV of its future dividends. How do we apply this idea in practice? The general model can be simplified if the firm’s dividends are expected to follow some basic patterns: (1) zero growth, (2) constant growth, and (3) differential growth. Zero growth: Income remains constant over time, no growth. Constant growth: Income grows at fixed rate, indefinitely. Differential growth: Income growth varies over time due to changing factors. Note that Div1 is the dividend on the equity at the end of the first period. The zero-growth formula is typical of mature industries, where companies are not expected to grow for a while. In the scenario of constant growth equities, typical of the insurance business, we have that no great investments are involved: hence, both the interest rate and the growth rate are very sharp, and small changes the final result will change drastically. The previous discussion has assumed that dividends usually growth at a rate g. Where does g come from? g = Retention ratio × Return on retained earnings Previously, g referred to growth in dividends. However, in this case the growth in earnings is equal to the growth rate in dividends, because the ratio to dividends to earnings is held constant. Where does R come from? Total return (R) has then two components. The first of these, is called the dividend yield. Since we calculate it as the expected cash dividend divided by the current price, it is conceptually similar to the current yield on a bond (annual coupon over bond’s price). The second part of the total return is the growth rate g. The dividend growth rate is also the rate at which the share price grows. We can thus interpret this growth rate as the capital gains yield, the rate at which the value of the investment grows. P0 = Div1/ (R – g) R – g = Div1 / P0 R = Div1 / P0 + g R = Dividend yield + Capital gains yield → R = Div1 / P0 + g Exercise earnings are an artificial construct. Although earnings are useful to accountants, they should not be used in capital budgeting because they do not represent cash 2. NPV uses all the cash flows of the project: other approaches ignore cash flows beyond a particular date; beware of these approaches. 3. NPV discounts the cash flows properly: other approaches may ignore the time value of money when handling cash flows. Beware of these approaches as well. 6.2 The Payback Period Method One of the most popular alternatives to NPV is payback. Here is how payback works: consider a project with an initial (in years 0) investment of –€50,000. Cash flows are €30,000, €20,000 and €10,000 in the first 3 years (from year 1 to year 3), respectively. A useful way of writing down investments like the preceding is with the notation: (–€50.000, €30.000, €20.000, €10.000) The firm receives cash flows of €30,000 and €20,000 in the first 2 years, which add up to the €50,000 original investment. This means that the firm has recovered its investment within 2 years. In this case 2 years is the payback period of the investment. The payback period rule for making investment decisions is simple. A particular cut-off date, say 2 years, is selected. All investment projects that have payback periods of 2 years or less are accepted, and all of those that pay off in more than 2 years (if at all) are rejected. There are at least three problems with payback: 1. Timing of cash flows within the payback period: let’s compare project A with project B. In years 1 through 3, the cash flows from A rise from €20 to €50, while the cash flows of B fall from €50 to €20. Because the cash flow of €50 comes earlier with project B, its net present value must be higher. Nevertheless, we just saw that the payback periods of those two projects are the same. Thus, a problem with this method is that it does not consider the timing of the cash flows within the payback period. This shows how the payback period is inferior to the NPV because such second method discounts the cash flows properly 2. 2. Payments after the payback period: now consider projects B and C, which have identical cash flows within the payback period. However, project C is preferred because it has a cash flow of €60,000 in the fourth year. Thus, another problem with the payback period method is that it ignores all cash flows occurring after the payback period itself. Because of the short-term orientation of the method, some valuable long-term projects are likely to be rejected. The NPV method does not have this flaw because it uses all the cash flows of the project 3. 3. Arbitrary standard for payback period: capital markets help us estimate the discount rate for the NPV method. The riskless rate, perhaps proxied by the yield on a Treasury investment, would be the appropriate rate for the aforementioned riskless investment. However, there is no comparable guide for choosing the payback cut-off date, so the choice is somewhat arbitrary. → The payback method differs from NPV and is therefore conceptually wrong. With its arbitrary cut- off date and its blindness to cash flows after that date, it can lead to some flagrantly foolish decisions if it is used too literally. Nevertheless, because of its simplicity, he payback method is often used by large, sophisticated companies when making relatively small decisions. EXAMPLE: Whait is the payback period if you invest 100€ now and receive 40€ every year starting one year from now and ending 5 years from now? 0 1 2 3 4 5 Cash flow -100 40 40 40 40 40 Cumulative CF -100 -60 -20 20 Fraction = 20 / 40 = 0.5 Payback period: 2.5 y 6.3 The Discounted Payback Period Method Aware of the pitfalls of payback, some decision-makers use a variant called the discounted payback period method. Under this approach, we first discount the cash flows. Then we ask how long it takes for the discounted cash flows to equal the initial investment. EXAMPLE What is the discounted payback period if you invest £100 now and receive £40 every year starting one year from now and ending five years from now? The discount rate is 8%. 0 1 2 3 4 5 Cash flow -100 40 40 40 40 40 PV CF rate 8% -100 37.04 34.29 31.75 29.40 27.22 Cumulative CF -100 -62.96 -28.67 3.08 Fraction: 28.67 / 31.75 = 0.9 Discounted Payback period: 2.90 years Although discounted payback looks a bit like NPV, it is just a poor compromise between the payback method and NPV. 6.4 The Average Accounting Return Method (AAR) Another attractive, but fatally flawed, approach to financial decision-making is the average accounting return. The average accounting return is the average project earnings after taxes and depreciation, divided by the average book value of the investment during its life. In spite of its flaws, the average accounting return method is worth examining because it is used frequently in the real world. The AAR is calculated as follows: AAR = Average Net Income / Average Investment • Net income in any year is: Net CF - Depreciation + Taxes. Depreciation is not a cash outflow. Rather, it is a charge reflecting the fact that the investment in the store becomes less valuable every year. • Due to depreciation, the investment reduces its value over time. As previously seen, the decision rule is very simple. A project should be accepted when the AAR is greater than the target return, while a project should be rejected when the AAR is lower than the target return. The AAR method is easy to use and it provides a sort of “backup” to discounted cash flow methods. However, two flaws are present in this method: first, it does not work with the right raw materials. It uses net income and book value of the investment, both of which come from the accounting figures while the NPV method uses cash flows, with are much less arbitrary than accounting numbers. Secondly, AAR takes no account of timing, while the NPV approach discounts properly. Example You are deciding whether to buy a store in a new shopping centre. The purchase price is £500,000. The store has an estimated life of five years and will need to be completely scrapped or rebuilt at the end of that time. The asset will depreciate using straight line depreciation. The target return on new investments is 15 per cent. 6.5 The Internal Rate of Return (IRR) Now we come to the most important alternative to the NPV method: the internal rate of return, universally known as the IRR. The IRR is about as close as you can get to the NPV without actually being the NPV. The basic rationale behind the IRR method is that it provides a single number summarizing the merits of a project. That number does not depend on the interest rate prevailing in the capital market. That is why it is called the internal rate of return; the number is internal or intrinsic to the project and does not depend on anything except the cash flows of the project. But how is the IRR calculated? The IRR is simply the rate that causes the NPV of the project to be zero (to do this with the computer, use the Excel formula TIR.COST in Italian or IRR in English): Accept a project if: IRR > Discount rate (r). Reject a project if: IRR < Discount rate (r). Considering the strengths of the IRR method, it is a simple return-based method, and it does not require an estimated discount rate like the NPV method does. On the contrary, when it comes to its weaknesses, we recognize the presence of an arbitrary rate in the process of decision, and we recognize the absence of scale-related considerations. Being it expressed as a percentage, small projects may have large IRRs and large projects small IRRs: comparison is then more complex. EXAMPLE Using trial and error, the IRR is between 23% / 24%. The exact value is 23.37%. 7.3 Inflation and Capital Budgeting Inflation is an important fact of economic life, and it must be considered in capital budgeting. We begin our examination of inflation by considering the relationship between interest rates and inflation. 7.4 Interest Rate and Inflation (Fisher equation) How does inflation affect interest rates? Consider the following example. Suppose a bank offers a one-year interest rate of 10%. This means that an individual who deposits $1,000 will receive $1,100 in one year. Although 10% may seem like a handsome return, one can put it in perspective only after examining the rate of inflation. Imagine that the rate of inflation is 6% over the year and it affects all goods equally. In this case, 3.8% is what you are really earning after adjusting for inflation (compared to the previous 10% nominal interest rate). We can refer to the 3.8% return as the real interest rate. In general, the relationship between real and nominal interest rates is depicted by the Fisher equation and yields the following formula: 7.5 Cash Flow and Inflation A nominal cash flow: actual money in cash to be received (or paid out). A real cash flow: cash flow’s purchasing power. It is important to stress that we need to maintain consistency between cash flows and discount rates. That is: - Nominal cash flows must be discounted at the nominal rate. - Real cash flows must be discounted at the real rate. As long as one is consistent, either approach is correct. To minimize computational error, it is generally advisable in practice to choose the approach that is easiest. This idea is illustrated in the following example: Example Shield Electric forecasts the following nominal cash flows on a particular project: The nominal discount rate is 14%, and the inflation rate is forecast to be 5%. What is the value of the project? Nominal CF: The project should be then accepted. Real CF: In order to resort then to real quantities, we have that the nominal CF need to be divided by the sum of 1 and the inflation rate. This is the proper process of deflation of nominal CF through the application of the inflation rate to get to real CF: Nominal CF have been divided by 1.05. We can then calculate the NPV of the project using real CF: the result is the same of one obtained through the previous method. NPVs are the same under both real and nominal calculation methods, provided that the proper discount rates are involved. 7.6 The Equivalent Annual Cost Method As we will see, the different approaches to operating cash flow all measure the same thing. If they are used correctly, they all produce the same answer, and one is not necessarily any better or more useful than another. In the discussion that follows, keep in mind that when we speak of cash flow, we mean cash flow in less cash flow out. The rule is again to resort to the easiest method to be applied, How to Compare the Present Value of Projects of Different Lives? Don’t do the following! Compare like with like: calculate the equivalent annual cost: EAC = (Asset price x Discount rate)/1- (1 + Discount rate)^-n EAC = (798,42 x 0,10) / 1 - (1+0,10)^-3 = 321,05 QUIZ ➢ Why is it important for the financial analyst to focus on incremental cash flows? Financial analysts focus on incremental cash flows because they represent the true financial impact of an investment, enabling better decision-making by isolating the project's specific cash flows and avoiding irrelevant costs. ➢ In a hyperinflationary environment, how would you incorporate inflation into a capital budgeting analysis? In a hyperinflationary environment, you would adjust all cash flows for inflation and use a discount rate that accounts for the expected inflation rate to determine the real value of the investment. Continuous monitoring and adjustments are crucial due to rapidly changing inflation rates. ➢ Explain what is meant by the equivalent annual cost method. When is EAC analysis appropriate for comparing two or more projects? Why is this method used? Are there any implicit assumptions required by this method that you find troubling? Explain. The Equivalent Annual Cost (EAC) method converts the costs of projects into equal annual amounts, making them easier to compare. It's appropriate when comparing projects with varying lifespans, initial costs, and cash flow patterns. EAC simplifies decision-making by providing an annual cost basis. Implicit assumptions in EAC include constant cash flows, fixed discount rates, reinvestment at the project's rate of return, and the neglect of uncertainty and risk. These assumptions can be problematic when real-world conditions deviate from these assumptions, potentially leading to inaccurate decisions. CH 9 – RISK AND RETURN: Lessons from market history When you invest some money in any asset, we can calculate the return in monetary terms or in %. We distinguish between the dividend and capital gain. In the case of a bond we consider the coupon instead of the dividend. If: Current price > Initial amount capital gain. Transform this monetary return into %: Calculate difference between Price1 and Price0 and get capital gain, you add dividend/coupon and you compare this monetary amount with initial investment. Expected return is what investors want to receive when they start investment. Standard deviation is the volatility of a security’s returns. Correlation is the relationship between returns of two securities. We always have to compare movements of two stocks at a time. The idea is to create portfolios of stocks, so the correlation coefficient between these stocks is also important. During boom the slowburn expects only 9% compared to 50% of the supertech. We can calculate expected return. But we also have to consider the riskiness of the stocks, so the variance. La barra sopra i numeri di solito si usa per L’average, per l’expected return meglio L’ondina. To calculate the variance, we sum the differences between the expected return and the various returns. We know that the expected return for A is higher than B but stock A presents 2.2 times the standard deviation (volatility) of stock B. So A has a higher expected return but a higher volatility, too. So it makes sense that B has lower return because of its lower volatility. Calculate correlation coefficient using covariance. Covariance is negative so we prefer to use correlation coefficient. Formula nell’esercizio. The covariance gives us an idea of the type of relationship between stocks, but not the strength of it. So we use the correlation: this coefficient can only go from -1 to +1. - +1 means that the stocks move exactly in the same direction, same strength, so there’s no point in building a portfolio. - If it’s -1 you get the same return but with opposite sign, so you reduce the riskiness in a portfolio. For most stocks the correlation coefficient is between 0.2/0.3 and 0.8/0.9. The -0.1639 means you reduce the risk. When you have a correlation coefficient +1 it means that you can’t take any benefit in diversifying because stocks move in same direction with same strength. When correlation coefficient is -1, you get same rate of return with opposite sign, so you can reduce riskiness. In this case they’re negative but they’re not -1 so risk is still there (but low). For most stocks the coefficient is between 0.1 and 0.9. Having a coefficient lower than 0 is rare. When it’s 0 there is no correlation between the stocks. With this portfolio we partially reduce the return of firm A, but we also greatly reduce the riskiness, volatility. If we consider only the weighted average, the standard deviation is greater than what we got. This is because it doesn’t consider the correlation, the diversification. Here we have the returns on portfolios made of the 2 securities in different percentages. The straight line is the one that doesn’t consider the correlation, diversification. Thanks to diversification the portfolio obtains better results in terms of risks and results. EFFICIENT FRONTIER: the line that considers diversification. This point MV is called minimum variance portfolio, so you get minimum level of risk. We said that with a correlation coefficient of -1 we can reduce the risk. In fact you can reach a point in which you have 0 risk and a positive return. If you calculate the correlation between a company close to bankruptcy and another you’ll find a negative coefficient. So you won’t reduce the risk if you invest in these two assets. A negative coefficient is not always good. But normally we don’t consider just 2 stocks. 9.2 Systematic and unsystematic risk A well diversified portfolio can reduce unsystematic risk but not systematic risk. If you invest in a single company you’ll face both risks. The total risk is the standard deviation for a stock. At least theoretically, you cannot ask a reward for the total risk, but just for the unsystematic risk component. Systematic + Unsystematic = Total risk An example of a risk free asset is a government bond. When combining it with a risky one, we do as before for the expected return, but with the variance the last term is 0, because in a risk free asset the volatility is 0. The same goes for the second term, so the only one we consider is the first term. 9.3 A linear relationship Rate of return of risk free asset: risk free rate. Along the line we combine the risk free and the risky assets. At a certain level, with the max amount of risk and max amount of return, theoretically we invest all our money in the risky asset, but if we borrow money we can increase our investment opportunities. Here we borrow 20% of our wealth and we use it in the risky asset. So the investment % is 120%. Because the CAPM supposes there’s only one rate of return for risk free assets we have to pay this to our lender. The idea of CAPM is that you first find the optimal portfolio (A in prev example) and you move on the line depending on the max risk one is willing to accept, which leads to different percentages of risk free assets. Homogeneous expectations: everybody has the same ideas regarding the future and market movements, riskiness etc, so everybody considers the market portfolio the most desirable one with the assets at their disposal. Heterogeneous expectations: each investor has a different portfolio of risk assets. The slope is the beta coefficient, normally calculated with historical data. It’s calculated comparing market risk and specific company risk. For the market it’s always 1. For other stocks it can be >1, called aggressive stocks, and <1, defensive stocks: investing here you can reduce the market movement, these stocks are less affected by market movement. With the others you have better results when the market goes well, worse when it goes badly. beta but lower expected return. If we want to gain more, we have to accept risk. But if we get same Beta with lower return, it’s not attractive enough. This is called overvalued. Slope depends on expected rate of return on market. CAPM is a theoretical model and there is just one factor. The APT (arbitrary pricing theory?) is a statistical model. We can use as many factors as required. We make statistical regression with data. Not able to forecast future because sensitivity (beta) is not stable. APT was better, but CAPM is preferred to understand rate of return from shareholder perspective. ➢ What is the difference between an expected return and an observed return? Is it possible to predict the surprise component of an observed return? The expected return is the anticipated return on an investment based on various factors such as historical data, market conditions, and risk assessments. It represents the average or mean return an investor can reasonably anticipate. On the other hand, the observed return is the actual return realized from an investment over a specific period. It is what actually happens and is based on historical performance. The surprise component of an observed return is the difference between the observed return and the expected return. If the observed return is higher than expected, there is a positive surprise, and if it’s lower, there’s a negative surprise. While it’s possible to calculate this surprise component, accurately predicting it in advance is challenging due to the uncertainty inherent in financial markets and the multitude of unpredictable factors influencing returns. ➢ Why does the market portfolio lie on the security market line? What does it mean if a security lies below the security market line? What would happen to the returns of the security if traders exploit any possible arbitrage opportunities? The market portfolio lies on the Security Market Line (SML) because it represents the optimal combination of risk and return in the market. According to the (CAPM), the SML depicts the relationship between expected return and systematic risk (beta). The market portfolio, being a diversified portfolio containing all assets in the market, theoretically provides the maximum expected return for a given level of systematic risk. If a security lies below the Security Market Line, it implies that its expected return is less than what would be predicted by the CAPM given its level of systematic risk. This situation suggests that the security is either undervalued or overperforming in terms of risk. Traders would likely exploit any arbitrage opportunities in this scenario. If a security is undervalued, traders might buy it to take advantage of potential future price increases. Conversely, if a security is overperforming in terms of risk, traders might sell it to capitalize on potential price corrections. These actions, driven by arbitrage, would tend to adjust the security’s price and returns back towards the Security Market Line. ➢ What is the relationship between the one-factor model and the CAPM? The one-factor model is often synonymous with the Capital Asset Pricing Model (CAPM) because both concepts essentially revolve around a single systematic risk factor: market risk. In the CAPM, the only factor considered is the market return, and it assumes that the expected return of an asset is determined by its beta, representing its sensitivity to market movements. The one-factor model, therefore, is a simplification of the CAPM, capturing the idea that the primary source of risk is the overall market. It states that the expected return of an asset is a function of its beta with respect to the market. In summary, the relationship between the one-factor model and the CAPM lies in their common focus on a single systematic risk factor, which is the market factor. The CAPM is a broader framework that incorporates this one-factor model as a foundational element. CH 12 – RISK AND COST OF EQUITY The reasoning for beta will be useful for investments and for evaluating investment projects inside the company. If company has high enough riskiness for satisfaction, I can decide to reinvest in the company. If return is not fully satisfying it’s more convenient to put money in different project. The manager must apply rate of return which is the same Beta as the reasoning of the shareholder. If company pays dividend, shareholders can decide to spend it usually on financial assets, but not necessary. So, return on project is not always equal to investor return (SLIDE) An investor can receive money as dividends or as new debt creation in form of new project. 12.1 How to estimate the discount rate of a project: If company decides not to give dividends, it doesn’t mean shareholders can accept to renounce on rewards on the company, but have to accept an alternative investment project, similar in terms of risks. You can use CAPM or Factor model. The discount rate of a project should be the expected return on a financial asset of comparable risk. 12.2 Estimation of Beta Beta can be estimated as the slope coefficient in a regression of Ri on Rm. Problems and solutions: - Betas may vary over time because company can change the business. Use more specific statistics to be coherent with new business. - Sample size may be inadequate. If you can’t calculate Beta for company, you can start from sample of comparable companies but you might not find an adequate number of similar betas. - Betas are influenced by changing leverage and business risk. You can adjust to changes or you can use average beta of comparable firms. 12.3 Determinants of Beta - Cyclicity of revenues: performance is tied to economic cycles. Food sector is less affected by cycles. Tourism industry is more affected. - Operating leverage: fixed costs high in relation to total costs. If you’re able to create the capacity to produce and sell products using third-part resources, you need less fixed investments. If you have short-term contracts, you don’t lose money. Comparing two companies producing WIP inside, and the other outside. The first invests a lot in machinary ecc, the second has less fixed costs. For example: Apple, most products are not produced by company itself but by third parties and company receives products, so they have more variable costs. - Financial leverage: high levels of debt in capital structure. higher risk, higher rate of return. Remember the balance sheet equation A = L + E Beta Asset is the weighted average of Beta Equity and Beta Debt. There is interest risk and companies can see money value of their debt change a lot. They have to refund debt in nominal value. If you can refund debt in lower value, the risk is transferred to bond holder, but in reality it doesn’t happen. Suppose company is riskier and they issue new debt at higher rate of return. This difference between original rate of return and new one is the cost for the higher risk that is transferred from shareholder to bond holder. For these reasons we put the beta debt equal to 0. 12.4 Extensions of the basic model Projects can have same risk as firm so we use firm discount rate. We have to use a different discount rate. Use firm discount rate when project has same risk profile as existing project, otherwise use different discount rates like project discount rate. If you undertake project in existing company you consider risk of the project but also the one of the company. A new project affects risk of the whole firm. The best approach to calculate cost of capital of new project is to consider the beta coefficient, consider weight of project in the company and calculate new beta of portfolio of projects. There is a risk contribution of project to company’s riskiness. Best approach is to consider cost of capital after project introduction. Apply first formula if you have to pay taxes on EBIT and there is no tax benefit on debt, but use second formula when company can deduct interest costs for tax purposes. First formula used if you think company won’t obtain tax benefit in current year or following years. If you’re not sure company can get tax benefit every year, better to change perspective. Beta = (Covariance between stock and market returns) / (Variance of market returns), pitfalls include sensitivity to time period and assuming a linear relationship. Using historical beta for future capital budgeting may be problematic due to changes in business operations, economic shifts, and evolving market conditions, making it less reliable for predicting future performance. ➢ How would you estimate the cost of capital for a project if its risk is different from that of the rest of the company? Similarly, how would you estimate the cost of capital for a project when the company has debt in its capital structure? For a project with different risk, use a risk-adjusted discount rate, applying a higher rate for higher risk. When a company has debt, estimate the cost of capital using the weighted average cost of capital (WACC), which considers both the cost of equity and the after-tax cost of debt in proportion to their contributions to the company's overall capital structure. CH 13 – EFFICIENT CAPITAL MARKETS AND BEHAVIOUR FINANCE How capital structure can create value? There are 3 ways to create value: - Asymmetric information: managers know more than investors. There is a potential for mispricing. You can use information to take advantage. People outside company don’t have right information to assess right prices. - Subsidies: some specific government subsidies, money that company can receive for specific reasons. Not all securities are tax efficient, the tax rate could be different for different assets. In US you sell stock and get a gain, you don’t pay taxes, but if you receive same amount of money as dividend you have to pay taxes. The tax system can affect decisions. Some tax elements can affect choice of places for headquarters. - Financial engineering: create new securities to take advantage of excess market demand. 13.1 A description of efficient capital markets When market is efficient, the price of stock fully reflects all available information. Impossible for anybody to have personal information. Inefficient market when price reflects only some information but not all. Returns can be different. If markets are inefficient, information is not public and it’s possible to take extra gainings. 13.2 Share price reactions: Efficiency vs Inefficiency - In theory, when a piece of new information is released to market, share price could react and must reach new equilibrium thanks to new positive information. Price is stable, suddenly management publishes new information, this can improve perspective of company and price reaches new point. - In reality, the response of stock price could be not so fast. Investors might not believe in it, or there is overreaction. In not so inefficient market equilibrium is reached but after a certain period of time. 13.3 The different types of efficiency - Weak form: current price incorporates all information that can come from past prices. - Semi Strong: current price includes all public information. - Strong form: all information both available and not available are included in prices. You have to spend money to get all information, so you have transaction costs. Strong efficiency is almost impossible to find in reality. COMMON MISCONCEPTIONS You can invest in a very complex model, and you can get extra profits, but all these investments require to invest money. Once you consider results net of costs, you’re not able to obtain a certain profit in a systematic way. 3 conditions for market efficiency: - Rationality - Independent deviations from rationality - Arbitrage We are rational, there could be some deviations but they are independent. Not possible to always take advantage arbitrage because behavior might not be in line with what is expected from the model. Any company announces quarterly earnings, but financial analysts use past periods to make predictions. When announcement is in line with what was expected, there is no earnings surprise. If you invest in stocks with most negative earnings surprises, you receive -0,11% after 6 months. An increase in earnings is less trustable than a decrease. You might not react quickly to positive surprise. 13.4 Book to price analysis Formulas: P/E P/BV P/CF Besides Italy and Finland, almost everywhere high book to value stocks outperform growth stocks, so people rely more on value stocks. Probably it is because people prefer the security of a larger firm rather than a smaller, newer one. Some implications for corporate finance: • Accounting and financial choices: in the long term the market is able to understand if the financials are fair or smartly arranged. There are several companies which falsified financial statements that were ruined. • Timing of debt and equity issues: As in efficient markets securities are always correctly priced, timing decisions become unimportant • Speculation: If markets are efficient, managers should not waste their time trying to forecast the movements of interest rates and foreign currencies • Using information in market prices: managers should use the information available on the market (acquisitions, announcements, competitors’ prices) as much as possible in corporate decisions. for example when a takeover is announced. QUIZ ➢ What rule should a firm follow when making financing decisions? How can firms create valuable financing opportunities? When making financing decisions, firms should consider the Modigliani-Miller Theorem as a rule, suggesting that the value of a firm is independent of its capital structure under certain conditions. To create valuable financing opportunities, firms should focus on optimizing their capital structure by evaluating the cost of capital, risk tolerance, cash flow, market conditions, flexibility, tax implications, and aligning financing decisions with long-term strategic goals. Diversifying financing sources and maintaining transparent communication with stakeholders also contribute to creating valuable opportunities. ➢ Explain what is meant by the efficient market hypothesis. Define the three forms of market efficiency and explain why a characteristic of an efficient market is that investments in that market have zero NPVs. The Efficient Market Hypothesis (EMH) states that financial markets efficiently incorporate all available information, making it difficult to consistently achieve abnormal returns. There are three forms of market efficiency: 1. Weak Form Efficiency: past trading information is already reflected in stock prices. 2. Semi-Strong Form Efficiency: all publicly available information, including announcements, is incorporated into stock prices. 3. Strong Form Efficiency: all information, including insider information, is fully reflected in stock prices. A characteristic of an efficient market is that investments have zero NPV because prices already reflect all available information, leaving no room for consistently profitable strategies based on historical or public information. ➢ Compare and contrast both theories. In your opinion, which is the most reflective of market behaviour? Explain. . Efficient Market Hypothesis (EMH) assumes markets are highly efficient, with prices instantly reflecting all available information. Behavioral Finance recognizes that investors can be irrational due In case of bankruptcy or liquidation, bondholders have a higher claim on the company’s assets over shareholders. They’re entitled to be repaid before shareholders receive anything, ensuring a more secure position for bondholders in the event of financial distress. Shares, or equities, represent ownership in the company. Shareholders are residual claimants, meaning they have rights to the company’s assets after all other obligations, including bonds and other debts, are settled. As a result, shareholders bear more risk compared to bondholders and have a lower priority in the hierarchy of repayment in case of financial trouble or liquidation. CH 15 – EQUITY FINANCING The Process of Raising Capital Other Approaches to Issuing New Equity IPO: initial public offering Investment banking function: - Formulate the method used to issue new securities - Price & sell the new securities 15.1 The Offer Price Too high = not successful issue Too low = not maximized return There must be some level of underpricing to encourage invest. Private equity refers to investments made in private companies or assets that are not publicly traded on stock exchanges. Private equity firms raise capital from investors to acquire or invest in companies with the aim of achieving high returns. These investments often involve a hands-on approach to improve the performance of the acquired businesses, and the ultimate goal is to sell or exit these investments for a profit, typically after a few years. Private equity can be a key player in the financial markets, influencing corporate strategies and contributing to economic development. The Subscription Price: Babcock International CH 18 – CAPITAL STRUCTURE The pie theory The position of the line between NWC (net working capital) and FA (fixed assets) depends on the characteristics of the business. The line dividing D and E is a decision of the management of the company. What is the right D/E ratio? That is the main question. Which is more important: to enlarge equity value or firm value? Is it best to increase equity or enterprise value? Theoretically, we should maximize the equity value, which leads to maximizing the enterprise value too. A well managed company should maximize the latter. Also because if you only maximize the equity value you don’t necessarily increase value for all stakeholders. The goal of a company should be the one of maximizing the enterprise value because when you do and bondholders have fixed prices, you maximize equity value. On the other side, when you maximize equity value not necessarily you share the value creation among the different categories of shareholders. Apparently, hypothesis one is gain and hypothesis three is loss but is just a supposition because nothing was really created in terms of wealth for the shareholders. Initial capital structure: no debt. The firm borrows 500 and with these pays dividends. After this distribution the manager thinks about the firm value. It could be the same as before, more or less. What changes is the possible equity value. The one in the middle is the most probable. But equity can change more based on market perceptions. Managers did nothing to increase the firm value in terms of facilities etc, its just a financial move. The capital structure of the shareholders didn’t change. The increase or decrease are effects of the market, not the result of an enlargement or reduction of the firm. As in the example of the pizza, the most important thing is the size of the pie, it is not important how it is sliced (in 8 or 12 slices). Everything starts from enterprise value, after you will decide how to reallocate between E and D. First you have to enlarge the pie. After, you reallocate assets so to maximize value for the shareholders. MODIGLIANI AND MILLER THEORY 18.1 Modigliani and Miller Proposition I (No taxes) The first assumption is that individuals can borrow at the same rate as companies. The relationship between the rate of return of equity in a levered and unlevered firm is given by an item proportional to the equity. The rate of return is positively related to the ratio of equity. RWACC = D/ (D+E) x RE + D/(D +E) x RD The cost of debt can be considered as fixed, so it’s a straight line. Re is directly linked to the ratio of equity. This is a visual representation of the second proposition. The cost of equity rises with leverage, because the risk associated with equity rises with leverage. 18.2 Modigliani and Miller Proposition II (No taxes) The cost of equity raises with leverage because the risk to equity rises with leverage. RE = RA + D/E (RA – RD) - Business Risk vs. Financial Risk Business risk and financial risk are two different types of risk that companies face. Business risk is the risk that a company will not be able to generate sufficient profits to cover its operating costs. This can be due to a variety of factors, such as changes in consumer demand, economic downturns, or increased competition. Financial risk, on the other hand, is the risk that a company will not be able to meet its financial obligations, such as debt payments. This can be due to factors such as high debt levels, interest rate fluctuations, or changes in the creditworthiness of customers or suppliers. - Business Risk and Cost of Equity Capital In general, firms with higher business risk will have a higher cost of equity capital. This is because investors will demand a higher return on their investment to compensate them for the increased risk of the firm not being able to generate sufficient profits. The cost of equity capital is a major component of a firm's weighted average cost of capital (WACC), which is the overall cost of capital for a firm. A higher WACC can make it more expensive for a firm to raise capital, which can limit its growth potential. - Firm A vs. Firm B If Firm A has greater business risk than Firm B, it will also have a higher cost of equity capital. This is because investors will perceive Firm A as being riskier and will demand a higher return on their investment. The higher cost of equity capital will make it more expensive for Firm A to raise capital, which can limit its growth potential. In conclusion, maximizing firm value is the same as maximizing share value in a world without taxes, transaction costs, or financial distress costs. In general, firms with higher business risk will have a higher cost of equity capital. ➢ In a world with no taxes, no transaction costs and no costs of financial distress, is the following statement true, false or uncertain? ‘If a firm issues equity to repurchase some of its debt, the share price of the firm’s equity will rise because the shares are less risky.’ Explain. Is true. When a firm repurchases its debt with equity, it is essentially exchanging a riskier form of financing (debt) for a less risky form of financing (equity). This reduces the firm's overall financial risk, which makes the firm's equity more attractive to investors. As a result, investors will be willing to pay a higher price for the firm's equity, causing the share price to rise. FINANCIAL STRUCTURE THEORY To operate, the firms need financial resources: debts and equity Two alternatives choices (but also complementary): - Acquisition of full risk capital (equity); - Acquisition of limited risk capital (financial debts, bonds, etc) Objective: Optimal financial structure (mix of funding sources that minimize the cost of capital and maximize the economic value of the enterprise) Measuring the cost of capital is one of the most important and controversial aspects of the Theory of Finance. First answer: To simplify the analysis, the following hypotheses must be formulated: 1. There are no personal taxes, corporate taxes, and even failures; 2. The leverage ratio of the company is changed instantly by making debts to pay the equity, and issuing shares to pay debts: there are no transaction costs; 3. All profits are distributed as dividends; 4. Expected operating profits of each company have the same probability of distribution in the opinion of investors; 5. Future operating earnings are supposed to be constant: their expected value is characterized by the same probability distribution of operating profits present. Defined the value of the firm, as: W = E + D E = market value of shares; D = market value of debts; Based on the assumptions we examine three separate capitalization rates: 1. Kd or Ki = FE/D = financial expenses (interest) /market value of debts; (Cost of debt) 2. Ke = NI/E = Net Income /market value of equity; (Return on market value equity) 3. Ko = Kd * (D/D + E) + Ke * (E/D + E) (WWCC) DURAND’s ANALYSIS What happens to the three rates (Ki, Ke, Ko) when the degree of leverage D/E increases? NI – NET INCOME METHODS Ki and Ke remaining constant and by varying the leverage the company continually decreases the cost of capital and increases its overall value. The enterprise, increasing debt and buying shares on the market at the same time, reduces the number of outstanding shares by increasing the price for shares. NOI (Net operating income) approach The global capitalization rate Ko remains constant at any level of debt. The rates Ko and Ki are constant at any level of debt and the quantity of the debt is entirely used by the company to acquire its own shares: Ke increases when the leverage ratio increases. According to the method NOI - Net operating income – NO optimal financial structure EXISTS. The increase in Ke (the return required by holders of equity securities) is exactly COMPENSATED from buying debts at a low price on the market. Conclusions at first answer 1. There is an optimal financial structure 2. The company's value increases if the leverage is used properly 3. To a certain point, the demands of the market compensate and outweigh the benefit from the debt and this causes an increase of Ke 4. Beyond a certain limit also Ki begins to grow and thus the availability of resources to "cheap" short supply 5. This causes an increase in Ko, the weighted average cost of capital 6. The optimal financial structure is when Ko is minimum Second answer M&M introduce three propositions through which the irrelevance of financial structure is demonstrated: 1. It is possible to divide the companies into classes of equivalent yield: the price of the securities in each class is proportional to their expected return. Any difference is linked to a "scale factor" since the companies belonging to a certain class have the same risk 2. Markets are perfectly competitive, no information asymmetries and transaction costs: companies and individuals can borrow at the same interest rates 3. Both corporate and personal taxes are not considered MODIGLIANI AND MILLER 1st proposition Perfect market/in equilibrium → the market value of any firm is independent of its capital structure and is obtained by capitalizing the expected return rate pk appropriate for its class of risk Vi = (Ei + Di) = Xi/pk Xi = expected return on assets of the company (Operating income); Vi = market value of firm; pk = capitalization rate of expected return for the firm i of class k The relationship between leverage and cost of capital is explained by the Method NOI. 2nd proposition The expected rate of return for an equity stake is equal to the rate of capitalization pk appropriate for a pure stream of equity returns in the same class, plus a premium related to financial risk and equal to the ratio Di/Ei multiplied by the difference between pk and cost of debt. Ke = pk + (pk – Kd)Di/Ei 3rd proposition If a company is acting in the interests of the shareholders (?) it will use an investment opportunity if and only if the rate of return of the project p * is equal to or higher than pk, that is, "the minimum rate of return for the investment firm will be in any case pk and it will not at all be influenced by the type of structure used to finance. 4. Mature Growth: As growth starts leveling off, firms will generally find two phenomena occurring. The earnings and cash flows will continue to increase rapidly, reflecting past investments, and the need to invest in new projects will decline. The net effect will be an increase in the proportion of funding needs covered by internal financing and a change in the type of external financing used. These firms will be more likely to use debt in the form of bank debt or corporate bonds to finance their investment needs. 5. Decline: The last stage in this corporate life cycle is decline. Firms in this stage will find both revenues and earnings starting to decline as their businesses mature and new competitors overtake them. Existing investments are likely to continue to produce cash flows, albeit at a declining pace, and the firm has little need for new investments. TRADE-OFF THEORY The Benefits of Debt (tax advantage) The primary benefit of debt relative to equity is the tax advantage it confers on the borrower. The primary benefit of debt relative to equity is the tax advantage it confers on the borrower. In the broadest terms, debt provides two differential benefits over equity. The first is the tax benefit: Interest payments on debt are tax-deductible, whereas 64789cash flows on equity are not. The Benefits of Debt (agency theory approach) The second is the added discipline imposed on management by having to make payments on debt. Both benefits can and should be quantified if firms want to make reasonable judgments on debt capacity. People that operate for shareholders, the managers. They must follow interests of shareholders but in many cases managers pursuit their own interests. Some of these personal objectives can differ from goals of owners. For this reason many times the owners try to involve the managers in ownership of the company. Managers can assume a certain ownership and they must operate following a pattern which is closer to interests of shareholders. Free cash flow hypothesis: firms with high free cash flow are more likely to make bad acquisitions than firms with low free cash flow An increase in dividends should benefit shareholders by reducing the ability of managers to pursue wasteful activities. In summary: free cash flow hypothesis provides another reason for firms to issue debt: - New equity dilutes the holdings of managers with equity interests, increasing their motive to waste resources -debt reduces free cash flow as the firm must make interest/principal payments reducing the opportunity for managers to waste resources. When company faces financial distress, we can account for direct costs connected to costs of consultant and legal procedure and other elements. The higher probability of bankruptcy, higher bankruptcy costs. But lower direct costs of bankruptcy, the lower the expected costs of bankruptcy. More important than direct costs are indirect costs. An example of indirect cost is the impaired ability to conduct business because suppliers and clients refuse to have contact with a company in financial distress because of loss of trust and reliability. Connected with cost to receive money from bank system and connected to the limits that the management of company with high default risk can face in day to day operations. Costs connected to agency: when a firm has debt, conflicts of interest arise between shareholders and bondholders, the former tempted to pursue selfish strategies. 19.6 Predicting financial distress The value of firm from assets’ side is a sort of pie that must be divided among 4 categories of stakeholders: - Government through taxes. - Through bankruptcy claims sometimes. - Bondholders claims Shareholders claims Bigger pie, bigger amount for each stakeholders. Before managers know inside information they can decide which kind of source of capital to employ considering information they know but market doesn’t know. Before managers know inside information they can decide which kind of source of capital to employ considering information they know but market doesn’t know. The D/E ratio is connected to past decision and comparable companies, so a company cannot choose a structure too different from those elements, but not necessary the ratio was chosen by company in a random way. The capital structure is affected by industry, market conditions etc and managers can decide based on the idea they have on over and under evaluations of company. The ratio could be different period by period. 19.7 Implications for Managers Take advantage of tax benefits by issuing debt, especially if the firm has: – High tax rate – Stable sales – Less operating leverage Avoid financial distress costs by maintaining excess borrowing capacity. QUIZ ➢ What are the direct and indirect and direct costs of bankruptcy? Explain and provide a practical example of those costs. The direct costs of bankruptcy involve legal and administrative fees, court expenses, and professional fees paid to lawyers or financial advisors. Indirect costs include damage to creditworthiness, loss of future borrowing opportunities, and decreased trust from stakeholders. Example: a small business filing for bankruptcy due to overwhelming debt. The direct costs would include legal fees paid to bankruptcy lawyers and court filing fees. Indirect costs could involve the business owner's inability to secure credit in the future, the loss of suppliers or vendors who no longer want to work with the company, and the decreased confidence from customers leading to reduced sales post-bankruptcy. These combined costs can significantly impact the business's ability to recover and thrive post-bankruptcy. ➢ What is trade-off theory of capital structure choice. Describe the main costs and benefits of debt within this model and its empirical limitations. The trade-off theory of capital structure explores how companies balance the advantages and drawbacks of using debt in their finances. Debt offers benefits like tax advantages from interest deductions and leveraging returns for shareholders. However, it comes with costs such as interest payments, financial distress risks, and potential bankruptcy expenses. Empirical challenges include Many financial institutions invest only in companies with regular dividend payments. Perhaps leads to higher stock prices: (Lower risk - lower ke - higher P0) As a result, dividends tend to be a function of the “sustainable growth” in earnings. • Ownership Control: Smaller firms may be averse to issuing new stock due to dilution of corporate control. Therefore, retain earnings and pay few dividends. • Inflation: Since replacement costs of assets are higher in inflationary periods, more retention of earnings may be required. • Dividend Reinvestment Plans: Investors can automatically reinvest dividends often at a discount with no transaction costs. Frequently a good investment tool. Companies may use these plans to raise additional equity capital. 21.2. Dividend Irrelevance Theory Modigliani-Miller support irrelevance. Investors are indifferent between dividends and retention-generated capital gains. If the firm’s cash dividend is too big, you can just take the excess cash received and use it to buy more of the firm’s stock. If the cash dividend is too small, you can just sell a little bit of your stock in the firm to get the cash flow you want. Theory is based on unrealistic assumptions (no taxes or brokerage costs), hence may not be true. Need empirical test. 21.3. What’s the “clientele effect”? Different groups of investors, or clienteles, prefer different dividend policies. The dividend clientele effect states that high-tax bracket investors (like individuals) prefer low dividend payouts and low tax bracket investors (like corporations and pension funds) prefer high dividend payouts. So different groups desire different levels of dividends. Clientele effects impede changing dividend policy. Taxes & brokerage costs hurt investors who have to switch companies. 21.4. Bird-in-the-Hand Theory Investors think dividends are less risky than potential future capital gains, hence they like dividends. If so, investors would value high payout firms more highly, i.e., a high payout would result in a high P0. 21.5. Tax Preference Theory Retained earnings lead to long-term capital gains, which are taxed at lower rates than dividends: 20% vs. up to 39.6%. Capital gains taxes are also deferred. This could cause investors to prefer firms with low payouts, i.e., a high payout result in a low P0. Which theory is most correct? • Empirical testing has not been able to determine which theory, if any, is correct. • Thus, managers use judgment when setting policy. • Analysis is used, but it must be applied with judgment. 21.6. Standard Method of Cash Dividend Payment - The process