Download The Phoenix CFA Society Wendell Licon, CFA

CFA Society Phoenix
Wendell Licon, CFA
CFA Level I Exam Tutorial 2015
Corporate Finance
Power Point Slides
1
Financial Management
Agency Problems
• Bondholders vs. stockholders (managers)
– Occur when debt is risky
– Managerial incentives to transfer wealth
• Management vs. stockholders
– Occur when corporate governance system
does not work perfectly
– Managerial incentives to extract private
benefits
2
Financial Management
Agency Problems
• Mechanisms to align management with
shareholders
– Compensation
– Threat of firing
– Direct intervention by shareholders
(CalPERS)
– Takeovers
3
Cost of Capital
WACC =
wcs kcs  w ps k ps  wd k d (1  Tc ) 
cs
ps
d
k cs 
k ps 
k d (1  Tc )
cs  ps  d
cs  ps  d
cs  ps  d
4
Cost of Capital
kd(1-Tc)
– Where do we get kd from?
5
Cost of Capital (debt)
Example: First find the market determined cost of
issued debt:
10-yr, 8% coupon bond, trades at $1,050, TC = .4
1,050 =
40(
1
kd / 2

1
kd / 2
1
1
)

1
,
000
(
)
20
20
(1  kd / 2 )
(1  kd / 2 )
kd/2 = 3.644%, so kd = 7.288%
kd/2(1-Tc)= 3.644%(1-.4) = 2.1864% (semi-annual
rate)
kd(1-Tc)=2.1864% * 2 = 4.3728% (annualized)
6
Cost of Capital (debt with flotation
costs)
Flotation Costs
Example: 2% of issue amount, coupon = 7.288% if issued
at par (which is usually safe to assume), then
coupon rate = investor’s YTM
980 =
36.44(
1
kd / 2

1
kd / 2
1
1
)  1,000(
)
20
20
(1  kd / 2 )
(1  kd / 2 )
kd/2= 3.7885%
kd/2(1-Tc)= 3.7885%(1-.4) = 2.2731% (semi-annual rate)
kd(1-Tc)=2.2731% * 2 = 4.5462% (annualized)
7
Cost of Capital (Preferred Shares)
Already in after-tax form
• Flotation Costs (F): kps= Divps/{P(1-F)}
• Example: P= 100, Divps= 10, F= 5%
• kps= 10/{100(1-.05)}= 10.526%
8
Cost of Capital (Common)
Discounted Cash Flow (DCF)
P0 
D1
D
 kcs  1  g
kcs  g
P0
• Simple g assumption?
• Cost of CS = Dividend Yield + Growth
• Example:
D1= 3/yr, P0 = 100, g= 12%
kcs = 15%
• What about flotation costs? Multiply P0 by
(1 – F)
9
Cost of Capital (Common)
What about g?
g = ROE x (plowback ratio) or
g = ROE x (1 – payout rate)
10
Cost of Capital (Common)
Capital Asset Pricing Model (CAPM)
• kcs = krf + cs(km – krf)
11
WACC
• The market is impounding the current risks
of the firm’s projects into the components
of WACC
• Say Coca Cola’s WACC is 15%, which
would be the rate associated with nonalcoholic beverages
• Can Coke use 15% to discount the cash
flows for an alcoholic beverage project?
12
WACC
Coke Example cont’d
– Say alcoholic beverage projects require 22%
returns
– Security market line
13
WACC
14
WACC
Can be used for new projects if:
– New project is a carbon copy of the firm’s
average project
– Capital structure doesn’t materially change –
look at the WACC formula
15
WACC
• Don’t think of WACC as a static hurdle
rate of return which, if cleared, then the
project decision is a “go”
• If the firm changes its project mix, the
WACC will change but the risk level of the
projects already in progress will not &
neither do the required rates of return for
those projects
16
Cost of Capital- MCC
Step 1: Calculate how far the firms retained
earnings will go before having to issue new
common stock (layer 1)
• Example: Simple capital structure
• LT Debt = 60% (yielding 8%)
• CS = 40% (Kcs = 15%)
• New Retained earnings (RE) = 1,000,000 (over
and above the 40%)
• Marginal Tax Rate = 40%
• Debt Flotation Costs = 1% per year
• CS Flotation Costs = 1% per year
17
Cost of Capital- MCC
Concept: Keep our capital structure of
60%/40% in balance while utilizing our
retained earnings slack matched with new
debt, which is not in a slack condition
• Current WACC:
.6*(.08)*(1-.4) + .4*(.15) = 8.8%
18
Cost of Capital- MCC
How far can we go with Layer 2?
1,000,000/.4 = 2,500,000 of new projects costs of
which
2,500,000 * .6 = 1,500,000 in new issue debt
and 1,000,000 = use of retained earnings
• Layer 2 WACC:
.6*(.09)*(1-.4) + .4(.15) = 9.24%
• Layer 3 would include new projects over 2,500,000 with
flotation costs for equity and flotation costs for debt
19
Cost of Capital- MCC
Layer 3 WACC:
.6*(.09)*(1-.4) + .4(.16) = 9.64%
20
Cost of Capital Factors
Not in the firm’s control
– Interest rates
– Tax rates
Within the firm’s control
– Capital structure policy
– Dividend policy
– Investment policy
21
Capital Budgeting
Payback Period
– The amount of time it takes for us to recover
our initial outlay without taking into account
the time value of money.
– The decision rule is to accept any project that
has a payback period <= critical payback
period (maximum allowable payback period),
set by firm policy.
22
Capital Budgeting
Payback Period
– Assume our maximum allowable payback
period is 4 years (nothing magical about 4
years as it is set by management):
Year
Accum. Cash Flows
1 5MM
< 20MM
2 5MM + 7 MM = 12MM <20MM
3 12MM + 7MM = 19 MM <20MM
4 19MM + 10MM = 29 MM >20MM
23
Capital Budgeting
Payback Period
• Get paid back during the 4th year. We need
$1MM entering yr 4, and get $10MM for the
whole year. If we assume $10MM comes evenly
throughout the year, then we reach $20MM in
{1MM/10MM} or .1 yrs.
• So, payback = 3.1 years.
• Do we accept or reject the project?
Accept, since 3.1 < 4.
24
Capital Budgeting
Discounted Payback Period
• Discount each year’s cash flow to a
present day valuation and then proceed as
with Payback Period.
25
Capital Budgeting – Net Present
Value
NPV = PV (inflows) - PV(outflows)
NPV =

ACFt / (1 + k)t
- IO ,
where,
• IO = initial outlay
• ACFt = after-tax CF at t
• k = cost of capital (cost of capital for the firm)
• n = project’s life
Decision rule: Accept all projects with NPV >= 0
26
Capital Budgeting - NPV
Accepting + NPV projects increases the
value of the firm (higher stock
value/equity), kind of like you are
outrunning the cost of capital
27
Capital Budgeting - NPV
Invest $100 in your 1-yr business. My
required rate of return is 10%. What
would be the CF be at the end of year 1
such that the NPV = 0?
• ACF1 = 100(1.1) = 110 (just the FV!)
• If NPV > 0, it is the same as ACFt > 110.
28
Capital Budgeting - NPV
Ex: 120. Now, what’s the investment worth?
• Just PV of $120 = 120/1.1 = 109.09.
• My stock is now worth 109.09, a capital
gain of 9.09 due to you accepting the
project. (the 9.09 is the NPV = 120/1.1 100 = 9.09)
29
Capital Budgeting - IRR
IRR is our estimate of the return on the project. The
definition of IRR is the discount rate that equates the
present value of the project’s after-tax cash flows with
the initial cash outlay.
• In other words, it’s the discount rate that sets the NPV
equal to zero.
NPV =


ACFt / (1 + IRR)t
- IO = 0, or
ACFt / (1 + IRR)t = IO
• The decision criterion is to accept if IRR >= discount rate
on the project.
30
Capital Budgeting - IRR
Are the decision rules the same for IRR &
NPV? Think about a project that has an
IRR of 15% and a required rate of return
(cost of capital) of 10%. So, we should
accept the project.
31
Capital Budgeting - IRR
What is the NPV of the project if we discount
the CF at 15%?
– Zero - by definition of IRR. Is the PV of the
CF’s going to be higher or lower if the rate is
10%? Higher - lower rate means higher PV.
So, the sum term is bigger at 10%, so the
NPV is positive ===> accept.
NPV and IRR will accept and reject the
same projects – the only difference is
when ranking projects.
32
Capital Budgeting - IRR
Computing IRR: Case 1 - even cash flows
• Ex. IO = 5,000, Cft = 2,000/yr for 3 years
IO = CF(PVIFA IRR,3) ===> 5,000 = 2,000(PVIFA IRR,3)
Just find the factor for n=3 that = 5,000/2,000 = 2.5
• For i=9, PVIFA = 2.5313
• For i=10, PVIFA = 2.4869
• It’s between 9 & 10: additional work gives 9.7%
33
Capital Budgeting - IRR
Case 2 Uneven CF’s - even worse
• Trial and Error!
• Ex: IO = 20,000, CF1 = 5,000, CF2 = 7,000,
CF3 = 7,000, CF4 = 10,000, CF5 = 10,000
• We have to find IRR such that
• 0 = 5,000 (PVIF IRR,1) + 7,000 (PVIF IRR,2) +
7,000 (PVIF IRR,3) + 10,000 (PVIF IRR,4) +
10,000 (PVIF IRR,5) – 20,000
34
Capital Budgeting - IRR
• NPV at 25% is -563. So, should we try a
higher or lower rate?
Lower (==> higher NPV)
If we try 24%, we get NPV = -102.97, at 23%,
we get NPV = 375
==> it’s between 23 & 24%. A final answer
gives 23.8%.
35
Capital Budgeting - IRR
IRR has same advantages as NPV and the same
disadvantages, plus
1. Multiple IRRs: IRR involves solving a polynomial.
There are as many solutions as there are sign
changes in the cash flows. In our previous example,
one sign change. If you had a negative flow at t6 ==>
2 changes ==> 2 IRRs. Neither one is necessarily
any good.
2. Reinvestment assumption: IRR assumes that
intermediate cash flows are reinvested at the IRR.
NPV assumes that they are reinvested at k (Required
Rate of Return). Which is better? Generally k. Can
get around the IRR problem by using the Modified IRR,
MIRR.
36
Capital Budgeting - IRR
1.
Multiple IRRs:
2. Reinvestment assumption:
37
Capital Budgeting - MIRR
• Used when reinvestment rate especially critical
• Idea: instead of assuming a reinvestment rate =
IRR, use reinvestment rate = k (kind of do this
manually), then solve for rate of return.
• 1st: separate outflows and inflows
– Take outflows back to present at a k discount rate
– Roll inflows forward - “reinvest” them - at the cost of
capital, until the end of the project (n) - now just have
one big terminal payoff at n.
• The MIRR is the rate that equates the PV of the
outflows with the PV of these terminal payoffs.
38
Capital Budgeting - MIRR
39
Capital Budgeting - MIRR
 ACOFt/(1 + k)t = ( ACIFt* (1 + k) n-t) / (1
+ MIRR) n
where ACOF = after-tax cash outflows,
ACIF = after-tax cash inflows.
Solve for MIRR.
MIRR >= k (cost of capital) ==> accept
40
Capital Budgeting - MIRR
• Notice, now just one sign change with no
multiple rate problems –
one positive MIRR
• Plus, no reinvestment problem
• Still expressed as a % which people like
• Also, much easier to solve
41
Capital Budgeting - MIRR
Ex: Initial outlay = 20,000, plus yr. 5 CF = -10,000. We’ll use k=12%
Draw timeline
1. PV of outflows = 20,000 + 10,000(1/1.12)5 = 25,674
2. FV of inflows: yr. 1 CF = 5,000; yr. 2 and 3 CF = 7,000; yr. 4 CF =
10,000;
YR
FV
1
5,000(1.12 ) 5-1 = 5,000(1.12 )4 =
7,868
2
7,000 (1.12 ) 5-2 = 7,000(1.12 )3 =
9,834
3
7,000 (1.12 ) 5-3 = 7,000(1.12 )2 =
8,781
4
10,000(1.12 ) 5-4 = 10,000(1.12 )1 =
11,200
Sum
------------37,683
42
Capital Budgeting Decision Criteria
• So, NPV and IRR all give same accept/reject
decisions. But, they will rank projects differently
• When is ranking important?
• Capital rationing - firm has fixed investment
budget, no matter how many + NPV projects
there are out there.
43
Capital Budgeting Decision Criteria
Ex. firm has $5MM
– If firm used IRR to rank, would pick highest
IRR projects, next highest, etc., until spent
$5MM. With NPV, pick projects to maximize
total NPV subject to not spending more than
$5MM.
Mutually exclusive projects - just means
can’t do both. Which do we pick - highest
NPV or IRR?
44
Capital Budgeting Decision Criteria
• It’s easiest to see ranking problems through NPV profile
- just a graph of NPV vs. discount rates:
• By NPV: for k < 10%, pick A. For k > 10% pick B
45
Capital Budgeting Decision Criteria
• IRR: always pick B
• NPV better: it incorporates our k, it’s how
much we’re adding to shareholder value.
If k < 10%, IRR gives wrong decision.
46
Capital Budgeting Post-Audit
• Compare actual results to forecast
• Explain variances
47
Cash Flows in Capital Budgeting
Cash flow is important, not Accounting
Profits
• Net Cash Flow = NI + Depreciation
48
Cash Flows in Capital Budgeting
• Incremental Cash Flows are what is
important
– Ignore sunk costs
– Don’t ignore opportunity costs (think of next
best alternative)
– What about externalities (the effect of this
project on other parts of the firm), and
cannibalization
– Don’t forget shipping and installation
(capitalized for depreciation)
49
Cash Flows in Capital Budgeting
Changes in Net Working Capital
– Remember to reverse this out at the end of
the project
– Example: think of petty cash
50
Cash Flows in Capital Budgeting
Projects with Unequal lives – 2 solutions
• Replacement Chain – like finding lowest
common denominator
• Equivalent annual annuity – like finding
how fast the cash is flowing in to the firm
51
Cash Flows in Capital Budgeting
What if projects have different lives?
Machine #1: cost = 24,000, life 4 yrs, net benefits =
$8,000/year
Machine #2: cost = 12,000, life 2 yrs, net benefits =
$7,400/year
k = 10%
NPV1 = -24,000 + 8,000 PVIFA( 10%,4)= 1,359
NPV2 = -12,000 + 7,400 PVIFA(10%,2)= 843
We cannot compare these like this, since have unequal
lives.
52
Cash Flows in Capital Budgeting
1. Replacement chain approach. Construct a
chain of #2’s to get the same number of years of
benefits (like finding least common
denominator):
Year
0
1
2
3
4
Inflows
7400 7400 7400 7400
Outflows -12000
-12000
Net CF
-12000 7400 -4600 7400 7400
NPV2 = 1,540
- so we choose machine #2, not #1
53
Cash Flows in Capital Budgeting
2. Equivalent annual annuity. Find the annual
payment of an annuity that lasts as long as the
project & whose PV equals the NPV of the
project
Project 1: NPV = EAA (PVIFA 10%,4) ==>
EAA = 1,359/(PVIFA 10%,4) =
1359/3.1699 = 428.72
Project 2: NPV = EAA (PVIFA 10%,2) ==>
EAA = 843/1.7355 =485.74
54
Cash Flows in Capital
Budgeting
Dealing with Inflation
• As long as inflation is built into your cash
flow forecast, you are OK because your
discount rates should already take
expected inflation into account
55
Risk Analysis
Types of Risk
• Stand-alone risk – think total risk or
variance (or standard deviation)
• Corporate (within firm) risk – think of the
firm as a portfolio of projects but not a
completely diversified portfolio
• Market risk – think systematic or beta
56
Risk Analysis
Modeling Methods
• Sensitivity Analysis
– Find the effect of a change due to a single variable
change at a time
• Scenario Analysis
– Find the effect of many simultaneous changes
(brought on by different scenarios)
• Monte Carlo Simulation
– Find the distributional effect of a number of random
changes on repeated attempts
57
Risk Analysis
Market Risk
• Security Market Line
– kcs = krf + cs(km – krf)
• Measuring Beta
– The pure play method
• Find a market traded firm whose only business is what you
are interested in
–
Accounting beta method
• Accounting ROA of firm versus Average Accounting ROA for
market construct (Text says S&P 400)
58
Risk Analysis
Investment Opportunity Schedule vs
Marginal Cost of Capital
59
Capital Structure and Leverage
Factors influencing a firm’s decision:
• Business risk - DOL
• Taxes
• Financial flexibility - DFL
• Managerial conservatism – risk aversion
60
Capital Structure and Leverage
Business Risk
• Break-even Operating Quantity
Q BE
F

P V
• Degree of Operating Leverage (DOLS)
– A measure of the degree to which fixed costs
are used DOL  %EBIT or S  VC  Q( P  V )
s
%Sales
S  VC  F
Q( P  V )  F
• High Fixed Costs ===> High Operating Leverage
61
Capital Structure and Leverage
Financial Risk
• Degree of Financial Leverage (DFLEBIT)
• A measure of the degree to which debt is
used
%EPS
Q( P  V )  F
EBIT
DFLEBIT 
%EBIT
or
Q( P  V )  F  I

EBIT  I
• The higher the firm relies on debt, the greater the
DFL will be
62
Capital Structure and Leverage
Combined Risk
• Degree of Total Leverage (DTLS)
– Measure of the combined leverage utilized by
a firm
DCLS 
%EPS
Q( P  V )
or
%Sales Q( P  V )  F  I
• DCLS = [DOLS] X [DFLEBIT]
63
Capital Structure and Leverage
• Miller and Modigliani 1958
• The value of the firm is independent of
its capital structure, i.e., the financing
mix is irrelevant (Miller and Modigliani
1958)
• Proposition: VU = VL
64
Capital Structure and Leverage
Assumptions
• Perfect capital markets
– No taxes
– No transaction costs
– Borrow and lend at the same rate
• No bankruptcy costs
• Homogenous preferences and beliefs
• Firm issued debt is risk-free (no chance of
bankruptcy)
65
Capital Structure and Leverage
Relax the Assumptions
• Introduce Taxes – more debt is better
• Relax no bankruptcy assumption – at
some point, more debt reduces the value
of the firm
• The above is really trade-off theory
66
Capital Structure and Leverage
Effect of WACC
wcs kcs  w ps k ps  wd k d (1  Tc ) 
67
Capital Structure and Leverage
Signaling Theory
• Signals must be costly
– New equity issue signal
– New debt issue signal
68
Dividend Policy
• Dividend policy must strike a balance between
future growth and the need to pay investors
cash
• M&M irrelevance (homemade dividends)
• g = ROE x (1 – payout ratio)
• Signaling through dividends
69
Dividend Policy
• Residual Dividend Model
– Dividend policy set to pay out cash that is not need
for investment or for reserve cash reasons
70
Dividend Policy
Timing
• Declaration date – declared by the board
• Holder-of-record-date – the last date that a
person can hold the stock and still receive the
dividend
• Ex-dividend date – the first date that a stock
trades without rights to the dividend
• Payment date
71
Dividend Policy
Stock Dividends and Splits
• Splits: increasing the number of shares by a
multiple
• Dividends: the dividend is paid in stock
instead of cash
• Price effects of stock dividends and splits
– Prices generally rise after the announcement
– Signal? Higher cash dividends in the future?
72
Dividend Policy
Repurchases
• Advantages:
–
–
–
–
Positive signal to repurchases shares
Targeted dividends
Remove a large block
Get cash in investors hands without future
expectations
– Capital structure changes
• Disadvantages
– Investor indifference, informational asymmetry
among investors, paying to high a price for shares
73