Financial Management and corporate Banking, Appunti di Finanza Aziendale

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FINANCIAL MANAGEMENT AND CORPORATE BANKING FIRST MAIN CONCEPT - BALANCE SHEET Accounting perspective Assets liabilities Assets Debt Equity Financial perspective assets liabilities Current assets, inventories Fixed assets Cash & CE Current liabilities Financial debt Equity Net working capital= current assets – current liabilities = a/r + inventory – a/p NFP= Financial debt – cash Assets (uses of funds) Liabilities (sources of funds) Net working capital Fixed assets NFP Equity SECOND MAIN CONCEPT – VALUE MANAGEMENT PERSPECTIVE/ VALUE OF THE COMPANY  Cash flows coming from Net invested capital (NIC) should be aligned with risks in liabilities (cost of financing)  We discount the future cash flows of the company at the cost of capital (k)  we get a value of the company’s assets (Wa)  K is a risk measure  Once we’ve obtained the value of the assets, we can deduct the NFP to obtain the value of Equity (Wa – NFP = We). This is the value of the company from the perspective of shareholders. The work of the manager to increase We is to improve the assets’ capacity to generate future income or reduce the cost of capital. Value here is an intrinsic perspective  Investment’s decision and capital risk will impact the We THIRD MAIN CONCEPT - MARKET PRICE & RETURN PERSPECTIVE We must consider the market’s view and the expectations of the market about the value we create. Financial market checks for the value creation of firms and recognizes if managers are able to create value in the long run. How does the market express its judgment? Through an expected rate of return, that could be different from the one we can compute because of the future expectations.  K* is the equilibrium cost of capital, given by the most efficient financial structure  K is given by the expected returns of the market Maybe the market demands for higher or lower return:  If the market demands for higher returns (K>K*), we have to discount for something more, and the price is lower than the value of the company (P<W)  If the market demands for lower returns (K<K*), the price is higher than the value of the company (P>W) Price to book value ratio= market value of equity/ book value of equity OR share price/equity per share  this is a ratio from the equity side  If price to book value > 1  it’s positive because the market appreciates what the company does. The market recognizes a goodwill. The management is creating value from the market’s perspective. There are a lot of opportunities in term of future cash flows  If price to book value = 1  If price to book value < 1  there is a bad will. The management is destroying value from the market’s perspective. I need to improve operations, strategy, decisions. There is a complementary ratio calculated from the assets side: the enterprise value= market capitalization (number of shares * price) + NFP  value of the assets in the perspective of the market  If the enterprise value > NIC  the market thinks the company is doing well, is adding additional wealth  If enterprise value < NIC  we have a bad will  If enterprise value = NIC  no value creation and no value disruption TOBIN’SQ = market value of the firm/ invested capital at replacement costs The value of the assets should be computed considering the replacement costs, and that is the difference with the previous ratio. You need to update the data in the balance sheet to their current value  If TOBIN’SQ <1  bad will  If TOBIN’SQ >1  goodwill FOURTH MAIN CONCEPT – RISK &UNCERTAINTY We will introduce a probabilistic viewpoint compared to a deterministic perspective  Deterministic view: simplified view of uncertainty. When we have to forecast the cash flow, we forecast the expected cash flow that on average ethe company can produce. We are partially capturing the uncertainty  Probabilistic view: for each year of cash flow, we will treat risk through discounting and the standard deviation as a measure of risk FIFTH MAIN CONCEPT – MANAGEMENT OBJECTIVE Management objective – maximize value – shareholders perspective Managers can engage in opportunistic behaviors, and they pursue private benefits at the expenses of other financial stakeholders (debtholders) FREE CASH FLOW TO EQUITY DELTA CASH & EQUIVALENTS Dividend policy/retained earnings It is forward looking It is historical Value of assets (Wa)= sum of F.C.F.O discounted at a certain rate k We (value of the Equity) = Wa – Debt We = sum of F.C.F.E discounted at a certain rate  F.C.F.E. is the free cash flow to equity DIFFERENCE BETWEEN EQUITY AND DEBT Dividends are variable according to the quantity of NET INCOME generated by the company  it’s not a fixed remuneration for shareholders, but it’s variable. In contrast, the debtholders are entitled to receive interests, which are a fixed payment that follows a contract  interests have the priority over dividends Shareholders are exposed to more risk rather than the debtholders. The debtholders have also a priority over the shareholders (they are paid first). The equity value is a residual value obtained after subtracting the Debt value  shareholders are also called residual claimants. Debtholders are repaid with the liquidation value of the assets, excluding the hypothesis of bankruptcy In case of bankruptcies, the residual assets must be liquidated, and the firm is over. In this case, the debtholders won’t probably receive the entire capital, as the value of the assets is lower and there is not enough residual value to be distributed. The liquidation process isn’t often enough to recover the original amount of debt (only 20%); in these cases, for the equity-holders there is nothing left. The priority are the workers, the banks, other debtholders, and eventually the shareholders  Shareholders are naturally exposed to this kind of situations THE DISTRIBUTION PROCESS OF VALUE, REMUNERATION, RISK To understand the degree of risk of the different components of the company's capital and the remuneration that market must requires (the cost of capital) for each component, it is necessary to analyze how the different components of the value (operating flows, operational risk) and the enterprise value is distributed among shareholders and lenders. There is variability of future cash flow  the payoff to debtholders and shareholder can modify. If EV (enterprise value) decreases, we’ll be able to distribute less When the EV > D  there is no default  if we liquidate the assets of the firm, we’ll have a residual value sufficient to repay the debt When EV < D  we don’t have enough value to repay fully the debtholders  nothing goes to the shareholders BUT THE FUTURE CASHFLOWS ARE NOT CERTAIN  VOLATILITY AND VARIABILITY We need to consider the cost of failure/default  bankruptcy costs If the enterprise value is lower than the debt value, that is - the firms fail, we move from a “going concern” view, to a bankruptcy and liquidation view CASE OF LIMITED LIABILITY WITH BANKRUPTCY COSTS Bankruptcy costs are reducing the residual value that could be given to debtholders. CF= cost of failure/default What happens to the shareholders?  nothing different from the previous case because they just lose the invested capital if EV < D The only variation is for the debtholders THE CONCEPT OF RISK IN FINANCE Cost of capital= it’s a cost of financing NOMINAL FREE RISK INTEREST RATE: Government bonds are risk free  probability of default is small  remuneration is low in terms of percentage  but you’re sure you’ll get your capital back 1. INFLATION RATE: Inflation reduced our purchasing power  you want to protect capital against inflation 2. REAL FREE RISK INTEREST RATE: It motivates one economic actor to lend his money to another without any risk Every cost of capital is composed by a component of credit risk and equity risk DISTRIBUTION OF FUTURE CASH FLOWS Because the value of the firm is represented by the sum of discounted cash flows that it will generate. Since these values are future and uncertain, they cannot be forecasted accurately but only in terms of a probabilistic distribution: this is the essence of financial risk. Since the value of future cash flows is uncertain, the process of value discounting, necessary to determine the enterprise value, involves the use of a cost of capital represented by a free risk interest rate, to which a risk premium is added. The distribution of all the possible sum of discounted cash flows provides the distribution of E in time 0. The higher the variability, the higher the risk, the higher the remuneration Standard deviation: it measures the dispersion around the mean. The higher, the higher the risk. It is the variability  Financial risk: related to the concept of variability of the future results. It is a symmetrical risk. It is a speculative risk  Risk of bankruptcy: it is a pure risk because it produces consequences due to a certain event. We don’t have symmetrical returns. It’s just for the debtholders FINANCIAL RISK: We have to transform a financial risk into a premium (something that provides an incentive)  how to assess a company risk premium? Model to price risk: CAPITAL ASSET PRICING MODEL (CAPM) It’s based on a simple relationship between risk and return. The higher the risk, the higher the return  Sharpe ratio  I obtain the current value of debt Case – risky debt There is probability of default, that the EV < D. the debt is no more free of risk, and we must introduce a premium The equilibrium interest rate contains the premium embedded The principal repayment  we may have a loss and we have to subtract it We should be able to extract the premium: – the higher the expected loss over the debt, the higher the risk for the debt holders – the longer the period to repay the debt, the higher the risk exposure, the higher the volatility What are the determinants of the expected loss?  probability of a default (+)  the expected value of debt in case of default (exposure at default) in practice, the higher the rating the higher the credit worthiness of the firm  the rating provides the credit risk premium (credit spread). For high ratings, the credit spread is low AAA  higher level of credit worthiness  low credit spread C  lowest level of credit  the level of risk is very high  high credit spread Interest coverage ratio: EBITDA/Interest expenses  the higher the ratio, the higher the sustainability of debt EXERCISE: - Nominal value of debt= 180 - Maturity=5 years - EV at time 0= 200 - Free risk interest rate= 2% - EV at the maturity = 200 - Cost of debt? To compute the premium, we need the expected loss (weight the expected losses for the probabilities)  expected loss= 20.5 Risk premium= 20.5/180 * 2%/ (1+2%) ^5 -1 = 2.19% Cost of debt= 2% + 2.19% = 4.19% The price of a bond, which is the market price of debt, is given by a series of coupon (regular payments) discounted + the nominal value of the bond discounted: For a bond traded on a market, with a price, it is possible to calculate the Internal Rate of Return (IRR) of the bond. This the discount rate at which the sum of the discounted cash flows and the discounted nominal value are equal to the market price. This internal rate of return is the yield to maturity How to transform an annual rate into a semiannual rate: If we expect the inflation to increase more, we expect prices of bonds (debt) will go down (already issued) the level of interest rate moves up and I need more protection. My request for remuneration is higher COST OF CAPITAL OF THE FIRM (K) = Kd + Ke made up by 2 components (cost of debt and cost of equity) WHY DO WE NEED IT?  Evaluation purpose  Managerial relevance  To get the EV, we have to discount the FCOC at a certain rate (which is the cost of capital of the firm)  Assess certain capital structure choices  determine the right mix of financing (Debt/equity) that minimizes the cost of capital  Managing the performance of the managerial action (performance management)  if the return of assets > cost of capital of the firm  there is value creation Cost of capital has several managerial applications Kd = nominal risk-free rate (Ifr) + risk premium (π) - RISK PREMIUM: Credit risk premium or equity risk premium - NOMINAL RISK-FREE RATE: Real free-risk interest rate + inflation rate INFLATION RATE At the same time, inflation has an impact both on the cost of capital (K) and on the FCFO (companies can adjust the FCFO to inflation)  we can have different scenarios. This depends on the way companies treat inflation Today, we’re experiencing inflation due to the increase in the price of raw materials (energy) – Some companies cannot immediately adjust their prices to inflation (ex: car manufacturers. They already declared the price of the car to the market)  low flexibility to adapt price to inflation – Some companies can adjust their prices according to the costs of raw materials  neutral to inflation p= inflation rate specific firm premium risk HOW INFLATION IMPACT ON THE VALUE OF THE COMPANY? In this analysis, we’re not adding any risk premium, assuming that the company is risk free (to simplify) - Inflation has the same impact on the cost of financing and on FCCO  it’s neutral because we can simplify it - We’re not sure if inflation has the same impact on numerator and on the denominator  not neutral ASSUMPTION: In the long run, we may have stability in corporate results (same cashflows). If cash flows are always the same (perpetuity): Today we’re assisting to lots of events that change the expectations of inflation (like war). The objective of corporate managers is to be neutral to inflation EXAMPLE FOR THE TERMINAL VALUE ASSESSMENT: Nominal interest rate= 5.1% Assumption: The company is updating cash flows to the current inflation rate Terminal Value? TERMINAL VALUE= 3200 * (1 + 2%)/ 5.1% - 2% OR 3200/3% I will obtain the same value = 106.667 Present value = 106667/ (1 + 5.1%) ^5 = 83.338 DIFFERENT TYPOLOGIES OF DEBT IN THE FIRMS The typologies of debt more commonly used in firms can be categorized according to these variables:  Duration: revolving debt, debt at sight, short-term debt, medium-long term debt. The higher the tenor, the higher the risk  Seniority: secured debt, unsecured debt, subordinate debt, mezzanine debt. The lower the seniority, the higher the risk  Guarantees: unsecured debt versus mortgaged debt with assets of the firm or guaranties or mortgaged debt with external real guarantees (e.g.: from shareholders). They can be both internal (real estate facilities, cash/securities) or external (home assets, personal savings) DURATION If we shift from short-term (tenor < 12-18 months) to long-term debt (>18 months), we expose ourselves to higher volatility (uncertainty) of future cashflows SENIORITY  If I’m fully protected (with guarantees), debt is free of risk. Even if the firm defaults, debtholders will be reimbursed  Debt junior has lower priority  the exposure to risk is higher INTERNAL GUARANTEES  If the debt is not guaranteed, it embeds more risk EXTERNAL GUARANTEES COST OF CAPITAL= COST OF DEBT + COST OF EQUITY COST OF EQUITY: fair return for equity holders Kd = i (fr) + credit risk premium Ke = i (fr) + equity risk premium In the case of EQUITY RISK PREMIUM, the specific component of risk is not rewarded, while the systemic risk is (related to industrial dynamic, to the business). We will measure risk in terms of CORRELATED VOLATILITY (it’s a relative risk) and not in terms of absolute volatility. EQUITY RISK PREMIUM: β * market risk premium When investing, we need to compose a diversified portfolio. We must eliminate the specific risk. The investor diversifies and consider the systematic risk of the stock  A non-diversified investor is more exposed to risk compared to a diversified investor (investments in multiple businesses). An entrepreneur that invests al his capital is just one single company is exposed to the higher risks, but he’s also the one who can earn more (compared to other classes of shareholders or investors, like a pension fund). An entrepreneur is, by definition, non-diversified Adjusted Beta, industry beta, levered and unlevered beta ADJUSTED BETA Raw BETA can be affected by certain events happening in the time period I’m considering computing the variance and covariance (almost 2 years). For example, in the last two years (2021-2022) there has been more volatility, and maybe the level of Beta is higher than normal, because of the extraordinary events. But if we are investors, we should consider a long period of time and use the Beta ADJUSTED Assumption of the BETA ADJUSTED: in the long term the BETAs of different companies in a certain industry will catch up with the average of the market BETA (1) β MARKET = 1 If β raw < 1  β adjusted > β raw If β raw > 1  β adjusted < β raw According to the characteristics of debt (duration, guarantees, seniority), you can have certain probability of default, and a certain exposure of default  expected loss WHAT DETERMINES THE BETA OF A FIRM?  Cyclicity of revenues: it offers a measure of how much the firm is correlated to the economic cycle with regard to the dynamic of revenues. As the cyclicity increases, the beta increases as well.  Operating leverage: ratio between fixed costs and variable costs/total costs. If a company has high fixed operating costs as a portion of its total operating costs, it has a high operating leverage, and it is riskier. Nonetheless, if the demand goes up, the margins will be higher. It indicates how the risk arising from real markets is transmitted to real risk in the company through its operating cash flows. In particular, the operating leverage – measured by the ratio between the percentage variation of EBIT and percentage variation of revenues (or as the ratio between contribution margin and EBIT) – indicates the sensitivity of the earnings when revenues change. If a firm has a high operating leverage, the beta will tend to be high.  Financial leverage: is the ratio between financial debt and equity. Since the interests associated to debt are a fixed cost, when the leverage increases, the variability of equity increase, and the beta increases as well. If the financial leverage is high, the company is riskier because it has to pay the interests on debt BETA LEVERED & BETA UNLEVERED BETA UNLEVERED: BETA of the assets of the company, not affected by the debt of the company BETA LEVERED: BETA affected by the debt When we have debt, we should always consider the taxes effect If we increase debt, we increase also the βd EXERCISE SESSION – Levering & un-levering the β First tutorship: pricing the debt and the market value of debt  There is a relationship between the risk of the company and the return  Β – WACC  Β – Enterprise Value  we are going to assume that there is a steady growth CASE – GOLDEN EAGLE (electronic industry) MRP: return observed on the market – return free rate 1. WACC? 2. EV? WACC (weighted average cost of capital) = Ke*E/D+E + Kd*(1-t) *D/D+E For (D+E) we have to look at the average of the competitors Kd*(1-t) is an information provided by the text Ke (L) = nominal rf + β(L) *MRP ACTIONS TO CALCULATE Ke: 1. Calculate the βa and D/E of the comparable companies, then we calculate the average to find the βa and D/E of the sector. We have to look at the comparables because our main company isn’t listed 2. Calculate the βL of GOLDEN EAGLE 3. Calculate the Ke (L) of GOLDEN EAGLE βa= βe* E/E+D(1-t) + βd * D(1-t)/E+D(1-t) The tax rate I should use for this calculation is 25%, which is the tax rate conventional for de-levering D/E = 0.94  That means that D= 0.94 while E = 1. We can also us ethe absolute terms of equity and debt β (L) = βa + (βa - Βd) * D/E * (1-t) = 0.82 + (0.82- 0.2) * 0.73* (25%) = 1.16 Ke (L) = nominal rf + β(L) *MRP = 2.72% + 1.16 * 6% = 9.68% Nominal rf = (1 + real rf) * (1 + expected inflation) – 1 = (1.2% +1) *(1+1.5%)-1= 2.72% WACC= Ke*E/D+E + Kd*(1-t) *D/D+E = 9.68%*1/0.73+1 + 5%*0.73/0.73+1 = 7.71% EV= it assumes that the future cash flows will growth at a constant rate of 2% = FCFO 1 / (WACC -g) FCFO 1= FCFO 0 * (1 + g) = 32 * (1 + 2%) = 32.64 million EV = 32.64/ 7.71 – 2 = 572 million SUMMARY COMPARABLES β (L) E D βa D/E 1 1.3 3200 3000 0.85 0.94 2 1.4 600 1100 0.71 1.83 3 1 Text Text 0.80 0.44 4 0.8 Text Text 0.80 0 5 1.2 text text 0.95 0.44 Average 0.82 0.73 FCFO 1 = FCFO 0 * (1+g) = 28 * (1 + 3%) = 28.84 ASSESSING THE Ke There are some difficulties in assessing the Ke using the market data (maybe affected by extraordinary events, international crisis impacting the stock dynamics)  today the βe is affected by short-term dynamics (war in Ukraine, international crisis) In conducting our analysis, we should use stable measures Which are the problems?  LISTED  Short term dynamics of the market  UNLISTED  lack of the β Ke= i rf+ β * MRK  result of the CAPM application (β*MRP = equity risk premium) Alternatives: 1. Assess the Ke according to the historical stock prices and returns 2. Assess the Ke according to historical accounting returns 3. Assess the Ke by looking at the implicit Ke in stock prices 4. Derive the Ke embedded in the enterprise value unlevered FIRST ALTERNATIVE: HISTORICAL STOCK EXCHANGE RETURNS Remuneration - Re (ex post return on the equity invested into the company) = capital gain + dividend yield  this is the historical shareholder remuneration (total shareholder return) The assumption is that history will be repeated  Re = Ke = capital gain + dividend yield SECOND ALTERNATIVE: HISTORICAL ACCOUNTING RETURNS We are no more using market data, but accounting data/ values  NOPAT = EBIT – taxes We look at the average ROI net of taxes of the sector  Ke unlevered = Ko= NOPAT/NIC * Net Worth indicates that the Equity of the firm is computed through its book value  book value of equity Ke levered = average ROE = Net Income/book value of equity THIRD ALTERNATIVE: IMPLICIT RETURNS IN STOCK EXCHANGE PRICES We use the dividend discount model (DDM) The general formula is: P0 = DIV 1/Ke – g  We are assuming the perpetuity Ke = dividend yield + growth rate FOURTH ALTERNATIVE According to the APV model  EV levered = EV unlevered + tax shield – expected loss Assuming perpetuity  EV unlevered= FCFO 1/ Ke unlevered  FCFO 1 = EV unlevered * Ke unlevered  Ke unlevered = FCFO 1/ EV unlevered EV levered = FCFO 1/WACC  FCFO 1 = EV levered * WACC  WACC= FCFO 1/ EV levered DESIGN THE CAPITAL STRUCTURE OF THE COMPANY Capital structure  D/E. There are 4 approaches that guide us in designing the capital structure 1. Trade-off theory  minimize the cost of capital (WACC)  based on a pure economic perspective, targeting factors we can quantify 2. Pecking order theory  Prefer equity than debt to maintain control 3. Agency theory  Favors the use of debt instead of equity 4. Market timing theory  the firm should choose according to the contingent market conditions that could make equity or debt more convenient BENEFITS  Assuming perpetuity: value of tax shield= t * D  If there is debt, we have a contractual obligation to pay the debtholders  management is more disciplined in its actions and doesn’t use the cash for individual purposes (agency theory)  When we have debt, we have contractual obligations to be respected  this requires a higher transparency from the company (you must produce additional information). Debt forces the company to produce information and that reduces the costs related to information asymmetry (pecking order theory)  common for small-medium enterprises DISADVANTAGES  Possibility of default  potential value reduction due to an excessive level of debt  Agency costs  ex: when the company is using a lot of debt, the management tends to be very risk adverse (under-investing) even if the investments are profitable because they are scared things would go badly; ex: the management may decide to abuse the company liquidity  Loss of business flexibility  you’re forced to use the cashflow to repay the debt before doing other activities From a pure economic perspective (things we can measure), we have a simple economic model for the design of the capital structure: V lev = V unl + tax shield – bankruptcy costs Using this model, that captures the first benefit and cost of having debt, we can obtain this guideline for managers in using the capital structure: There is an optimal D/E that maximizes the value of the company. It corresponds to the minimum cost of capital. The first evidence of costs of default materializes in the cost of debt  when debt is too high, credit risk will increase too, and the cost of debt increases Debt can be associated to the strike price of a call option, while EV can be associated to the underlying assets. A call option gives the holder the right to buy the underlying assets according to the convenience related to the strike price.  If the EV is > than the strike price (D), the option is exercised, and the payoff is the difference between EV – D;  if EV is < than the strike price (D), the call option is not exercised, and the holder lose an amount equal to the book value of equity “A call option on financial assets gives the holder the right, but not the obligation, to buy a certain amount of an underlying asset [S] (e.g., shares) at a fixed price [K] (called the strike price or exercise price) before (American option) or at the expiry date of the option (European option)”  If the value of the underlying asset (S)> Strike price (K): the buyer earns the difference: S – K;  If the value of the underlying (S) < Exercise price (K): the buyer does not exercise the option. We can apply the same method to evaluate the equity capital VALUE OF A CALL OPTION ON THE COMPANY We’re assuming the equity capital is a call option The determinants of the value of a call option are: 1) The Underlying Asset (S) [+] When the option is exercised, the call holder can opt to pay the strike price (K) and receive a share with value S: his gain is (S-K), so his interest is to maximize S  the higher the value of the underlying assets, the higher the value of the call option; in the same way, the higher the EV, the higher the value of Equity 2) The Strike Price (K) [-] When the holder exercises the call option, he earns (S-K). Hence, his interest is to reduce the strike price  The higher the strike price, the lower the probability to exercise the option 3) The Volatility [+] The value of the option will increase the higher the expected volatility of the underlying asset value. The option holder benefits from the upward swings, while he is protected against negative movements (he can choose not to exercise the option)The higher the volatility, the higher the possibility to have a huge gain 4) The risk-free rate [+] The call value increases, the higher the interest rates. The present value of the strike price is lower with higher discount rate (the risk-free interest rate)  The higher the risk-free rate, the higher the value of the option, because it makes the present value of the strike price lower (and makes the option more convenient) 5) The time to maturity [+] (duration of the option). The time to maturity affects the value of the option through two variables: a) volatility: the longer the time to the exercise date, the more likely the price of the underlying asset to rise or fall. b) strike price: the longer the time to the exercise date, the lower the NPV of the strike price  the longer the maturity of the option, the more likely the price of the underlying assets moves up and makes the option more convenient. The longer the time where we can exercise the option, the higher the value of the option 6) The dividends [-] Dividends affect the option because when the stock pays dividends, the market price of the stock is adjusted to reflect the dividend paid (decreases). If I consider Equity as an option: Everything that relates to net financial position (strike price(D) and dividends (cash outflows)) is in a negative relationship with the value of the call option  these two values have a negative impact on the value of equity DETERMINISTIC VIEW (discounting future cash flows) vs OPTION VIEW  The higher the debt, the lower the value of equity  E = EV – D  Dividends (-) These are the only things equal in the two approaches, BUT  Volatility (-)  Rik-free rate (-) The difference is the way we treat risk!!! What is the most correct view?  the option view offers a more realistic view of the external environment. In an uncertain environment, we prefer to trat equity as a call option (probabilistic view that incorporate uncertainty) The value of a call option is given by: the difference between value of underlying assets (EV) and the strike price (D)  E = EV - D But these values are uncertain and therefore follow a normal distribution (in the deterministic view, we have assumed these values were certain)  now we’re introducing volatility EXAMPLE - A company has a current EV of 100 million - standard deviation of the EV is 20% - nominal value of Debt = 80 million - Risk free rate = 5% Current equity value of the company  E= EV – D  100 – 80 = 20 million But the EV is uncertain, and it probably varies according to a normal distribution  there is UNCERTAINTY Formula to price a call option: By considering uncertainty, the equity value moves from 20 to 40.284 million If I increase volatility,  I’ll obtain a higher value of equity (because I’m using the option view THE VALUE OF EQUITY IN DISTRESS COMPANIES The first implication is that equity will have value, even if the value of the firm falls well below the face value of the outstanding debt  Such a firm will be viewed as troubled by investors, accountants, and analysts, but that does not mean that its equity is worthless  example of Moncler There is the possibility of relaunching the company and generate value The implication of valuing the equity using the option model is that the value of the equity diverges substantially from the value obtained based on the formula NEW LESSON - We’ve analyzes the financing policy (capital structure policies – D/E)  D - Now we’re going to analyze the dividend policy (decisions to retain earnings or distribute them through dividends) E - Create value in the asset side through investment policy (value added investments)  A DIVIDEND POLICY If the management decides to distribute dividends  cash out  NFP increases  reduction of the equity value EV – NFP = EQUITY VALUE Financing policy  trade-off theory (minimize the cost of capital WACC)  optimal capital structure  maximize the equity value Dividend policy  ???  equity value maximization Main choices that could be undertaken to maximize the equity value: Retention (plowback) vs distribution (payout ratio) • payout ratio = 1 – plowback ratio = dividends (time 1) / net income (time 0) Plowback = 0  We don’t have a projected ROE  we are not investing anything Plowback = 1  shareholders don’t receive anything  there is no value for them  For ROE < Ke  favor distributions of dividends  you don’t have good projects  return money to shareholders  For ROE > Ke  favor retention of earnings Steady state: P0 = NI (0)/Ke = 100/10% =1000 Financing policy  using as a reference the trade-off theory (minimum WACC)  the objective is to maximize the equity value  The condition limit here is related to the presence of bankruptcy costs (if we extend too much the debt, the company may enter a state of financial distress)  we cannot extend the debt at maximum (100%) Dividend policy  using as a reference the dividend discount model (growth)  the objective is to maximize the equity value  If we retain more  ROE is satisfactory  we enhance the value of the company  The condition limit is that g < Ke  Ke is the minimum required return from equity holders  we cannot retain all the earnings or distribute all the dividends. Investors (institutional ones) expect to receive a dividend, especially from listed companies DIVIDEND POLICY  GROWTH  What’s the net present value of net opportunities? The complete formula assuming perpetuity is the following: P0 = value of a share = NI (0)/Ke  simplified model assuming perpetuity and assuming the company is in a condition of steady state (ROE = Ke) N.P.V.G.O. (net present value of growth opportunities) = Equity value with growth - Equity value without growth N.P.V.G.O. = NI (0) * payout/ Ke – (plowback * ROE) – NI (0)/Ke Relative N.P.V.G.O. = N.P.V.G.O./ equity value with growth = % If the % is positive, we are creating value. But is it worth it? How do assess which is the optimal %? Everything depends on the type of investments the company has. The value is created on the asset side, while on the liability side it is preserved Numerical example:  NI (2015) = 2.5  Dividends (2016) = 1.5  Payout= 0.6  Plowback= 0.4  ROE expected= 11.5%  Ke= 9.5%  P0?  NPVGO?  Relative NPVGO? We should consider an equity value with growth because earnings are reinvested and there’s the possibility to create value (ROE > Ke). We are not in a condition of steady state P0 = NI * payout/ Ke – (plowback * ROE) = 2.5* 0.6/9.5-(0.4*11.5) = 1.5/9.5-4.6 = 30.61 million NPVGO = 30.61 – 2.5/9.5 = 4.28 million (contribution to the value given by the dividend policy adopted) Relative NPVGO = 4.28/30.61= 14% By retaining 40% of the earning, we’re able to generate an additional value of 4.28 million. Is this worth?  I’m retaining 1 million and I’m generating value for 4.28 million  it’s worth it  the retention policy makes sense because the % is quite relevant If ROE expected = 10.5% We expect a lower equity value  P0 = 2.5*0.6/9.5-(0.4* 10.5) = 1.5/ 9.5 -4.2 = 28.3 million < 30.61 NPVGO = 28.3 – 26.31 = 1.99  the value created demonstrated it’s still worth to retain the earnings, because I’m retaining 1 million and generating 2 million What is the optimal level of reinvested income? Optimal plowback? Investments are the driving force of value creation. We start from the choice of new investments  we select investments that produce a return higher than the WACC, and we skip the others (ROI < WACC) ROI > WACC  value creation  I have incentives to increase the plowback and maximize it The overall amount of invested capital = 150 (50 + 50 + 50) The ratio between D/E = 1  we have to maintain this ratio  we use 75 additional equity and 75 additional debts so that not to alter the capital structure NET INCOME REINVESTED optimal = 75 EXERCISE SESSION: Theoretical concepts: DDM focus on the equity side  cash flows, capital (k), and growth rate (g)  dividends, Ke, g (ROE* plowback) starting point: P0= DIV (1)/ (1+Ke) ^t Assuming perpetuity: P0= DIV (1)/ (Ke -g) Optimal payout ratio (dividends distributed): 1. CASH FLOWS: cash flow generated by the core business of the company on a daily basis EBIT * (1-t) (+) depreciation & amortization (D&A) (-) CAPEX (-) Delta working capital = FCFO EBIT*(1-t) = NOPAT D&A – CAPEX = NET CAPEX 2. WACC: ke* E/D+E + kd*(1-t) * D/D+E For E and D, we need to use the market value. Valuation looks into the future; we need to use inputs that as much as possible resembles the future. Book values don’t grasp the real value of debt and equity. Market values are updated more frequently, and they better represent the prospects of the company when building the WACC formula 3. Growth rate (g): return * reinvestment rate (RR) Return = ROCE Reinvestment rate = (CAPEX – D&A + Delta WC) / NOPAT - ROCE= NOPAT/CE  EBIT*(1-t)/ net fixed assets + working capital - ROIC= NOPAT/ (E + NFP) Example: TeleSpace |Company based in Brasil - EBIT 0= 3544 - Tax rate= 30% - CAPEX 0= 1659 - D&A= 1914 - Delta WC (y0 - y1) = 1119  from y0 to y1 the capital has increased - Book value of Equity= 20057 - Book value of Debt= 8042 - Cash 0= 12277 - Market value of Equity= 21982 - Market value of Debt= 5519 - Risk free rate= 7% - MRP= 8% - βL=0.8 - Kd= 9.5% EV 0? (Use the FCFO approach) 1. Step 1: FCFO1  FCFO 0* (1+g) 2. Step 2: WACC 3. Step 3: determine g and EV FCFO 0 = EBIT (0) * (1-t) = NOPAT 0= 3544* 0.7 = 2480.8 (+) D&A = 1914 (-) CAPEX= 1659 (-) Delta WC= 1119 = FCFO 0= 1616.8 WACC= 13.4* 21982/27501 + 9.5*0.7* 5519/27501 = 12.05% Ke= rf + βL*MRP= 7% + 0.8*8% = 13.4% Kd= 9.5% Growth rate= return * reinvestment rate = 15.7% * 34.8% = 5.46%  This is too high for a stable steady state growth. We’ll not see numbers higher than 2/3% Return= we’ll use the ROIC= NOPAT/ (E + NFP)  we have to use book values = 2480.8 / (20057+ 8042- 12277) = 15.7% RR= (CAPEX – D&A + Delta WC) / NOPAT = (1659 -1914 + 1119) /2480.8 = 34.8% FCFO 1 = 1616.8 * (1+ 5.46%) = 1705.1 Are we assuming steady state or not? EV 0= 1705.1/ (12.05 – 5.46) % = 25.9 M HOW TO DERIVE THE IMPLICIT WACC EV 0 = FCFO 1/ (WACC – g)  WACC can be derived as an inverse formula We can calculate it only if we have EV as an input, so if the company is listed WACC= FCFO 1 /EV + g For the assignment, go into Borsa Italiana and look at the values  EV 2021 = FCFO 2022/ (WACC – g) Corporate governance and corporate financial choices: opportunistic behavior and possible solutions (the covenants) Value management The goal is to maximize the enterprise value (EV):  Maximize the equity value for shareholders  Minimize the bankruptcy/default risk for bondholders The opportunistic behavior of firms when there is a high default probability If equity holders don’t see the possibility for a value recovery, they may act opportunistically, grabbing more of the value for themselves and leaving less value for debtholders Necessary condition for opportunistic behaviors The debt can not be pre-negotiated by debt-holders  in case debtholders understand the equity holders are putting in place an opportunistic behavior, they would immediately react updating the interest rates (considering debt more risky), or putting more restricting conditions on the use of debt  they would protect themselves from predatory behaviors  they will reduce the possibility of incurring in an opportunistic behavior The expected value of the firm without bankruptcy costs If EV< D  probability of default  area comprehended between nominal debt and D How to reduce the probability of default? ACCOUNTING TRICKS Manipulate the accounts to show the company is profitable and have huge liquidity (Pharmalat) BAIT AND SWITCH First, the firm issues little amount of debt at a reduced interest rate. When this debt cannot be re- negotiated any more, then the shareholders issue a new tranche of debt that increases the overall risk of the debt of the firm, at higher and higher interest rate. Instead of working on the value creation, you re- finance the debt (increase the debt) with a higher interest rate Sometimes, we see some of these opportunistic behaviors all together (combined together)  Moby  Bait and switch and shortsighted investments Necessary conditions for opportunistic behaviors 1) In general: the conditions on interest rate cannot be renegotiated, if not, as in the case of bank debt, interest rates adjust, and the value of debt does not change, and the policy becomes ineffective. The debtholders cannot review the conditions of debt 2) In case of risky investments: the present value of new investments is sufficient in order not to penalize shareholders too 3) In case of refusal to provide equity: the new investments are not sufficiently favorable to increase both the debt value and the equity value How debtholders answer to opportunistic behaviors: Protective covenants Since the opportunistic strategies from shareholders tend to expropriate part of the debtholders’ value, these tend to defend themselves by using protection schemes named as «covenants», that is - agreements able to limit the opportunistic behaviors of managers and shareholders:  Obligation to reimburse the debt if the covenant is “broken” (e.g.. If liquidity drops below a certain level, if interest coverage rate does not fall within minimum values, etc.)  limits to issuance of additional debt (to avoid the Bait and Switch)  Changes in control of the corporation (to avoid the take the money and run)  Limitation of dividends and share repurchases  limit to pay dividend up to a certain point granting the company has some available cash to repay the debt  Sale of assets/ approval of debtholders to sell certain assets  Maintenance of properties  collaterals to debtholders should be maintained  Provision for insurance These are all instruments to avoid/limit opportunistic behaviors by managers and shareholders. In case they (covenants) are broken, debtholders can receive their capital amount back CREDIT RISK RATING Value Based Management and Credit Risk Management in Corporate Banking Value creation mechanism (for banks) If a non-financial company fails, there are some negative consequences (social issues), but the business is replaced by competitors; while, if a bank defaults, the consequences that may happen are more severe for the whole financial system. For example, a bank failure triggers a bank-run  risk of contagion  reduction pf lending activity  real economy is affected NET INCOME/PROFIT= Revenues – operating costs ECONOMIC PROFIT= it’s a risk adjusted version of the NET PROFIT. Banks need to include risk considerations - Typical source of revenues of a bank as a financial company: interest expenses paid by the borrowers + commission fees or services - Typical operating costs of a bank: interests paid on the sources of financing Sources of financing/liability side: 1. Funds provided by central bank 2. Deposits 3. Bonds issued by bank to finance its operations 4. Equity capital Asset side: 1. Credits The debt is huge, higher than a typical non-financial company, because banks have more alternatives to finance their operations. By nature, they are physiologically more leveraged  risk plays an important role ECONOMIC PROFIT: Revenues – operating costs - expected loss in case of default – unexpected events Banks have to set aside a fraction of their capital against expected loss and unexpected events that may produce credit losses (ex: the pandemic) RAROC  Risk adjusted return on capital = (revenues – operating costs – expected losses)/EC Economic capital: market value of the equity capital of the bank (the EC is risk adjusted) When RAROC > Ke  value creation In a non-financial company, we were used to compare the ROI with the WACC In a financial company (bank) we now consider the RAROC compared with the Ke How are banks measuring this risk? BASEL 1 (1974)  common framework relevant for the entire economic system Minimum regulatory capital that could protect banks against possible unexpected events: 8% of the total assets of the banks weighted for their related risk Example: Let’s assume that the risk weight of credits is 10%, while the one of market securities is 5% Total assets of the banks weighted for their related risk: 60*0.1 + 40*0.05= 6+2= 8 I have to put aside 8% of 8 = 0.64 Actually, in the initial agreement, there were fixed weights for certain assets: The limit of this table is that there was no distinction between companies according to their different size or their different level of risk, or their performance  the level of risk wasn’t properly assessed Later on, banks agreed on reviewing this agreement, and the innovation they brought in the second version of the agreement (BASEL 2) was: Introduction of a system to measure risk that could better assess the relative, specific credit risk of the borrowers  CREDIT RATING SYSTEM  the risk weights vary according to the level of risk of the single borrowers CREDIT PRICING How to price the credit risk? We need to generate returns through the credit lending activity that could cover two types of losses, the expected and unexpected ones Expected loss= probability of default * loss given default * exposure at the date of default Assets Liabilities CREDITS (60) Credit lending activity MARKET SECURITIES (40) REGULATORY CAPITAL?