1 cfa society phoenix wendell licon, cfa cfa level i exam tutorial 2014 corporate finance power...
TRANSCRIPT
1
CFA Society PhoenixWendell Licon, CFA
CFA Level I Exam Tutorial 2014
Corporate Finance
Power Point Slides
2
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
3
Financial Management
Agency Problems
• Mechanisms to align management with shareholders– Compensation– Threat of firing– Direct intervention by shareholders
(CalPERS) – Takeovers
6
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 =
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)
))1(
1(000,1)
)1(
111(40
202/
202/2/2/ dddd kkkk
7
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 =
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)
))1(
1(000,1)
)1(
111(44.36
202/
202/2/2/ dddd kkkk
8
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%
9
Cost of Capital (Common)
Discounted Cash Flow (DCF)
• 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)
gP
Dk
gk
DP cs
cs
0
110
12
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 non-alcoholic beverages
• Can Coke use 15% to discount the cash flows for an alcoholic beverage project?
13
WACC
Coke Example cont’d– Say alcoholic beverage projects require 22%
returns– Security market line
15
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
16
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
17
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
18
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%
19
Cost of Capital- MCC
How far can we go with Layer 2?1,000,000/.4 = 2,500,000 of new projects costs of
which2,500,000 * .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
21
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
22
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.
23
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 Flows1 5MM < 20MM2 5MM + 7 MM = 12MM <20MM3 12MM + 7MM = 19 MM <20MM4 19MM + 10MM = 29 MM >20MM
24
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.
25
Capital Budgeting
Discounted Payback Period
• Discount each year’s cash flow to a present day valuation and then proceed as with Payback Period.
26
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
27
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
28
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.
29
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)
30
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.
31
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.
32
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.
33
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%
34
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
35
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%.
36
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.
38
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.
40
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
41
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
42
Capital Budgeting - MIRR Ex: Initial outlay = 20,000, plus yr. 5 CF = -10,000. We’ll use k=12%Draw timeline1. PV of outflows = 20,000 + 10,000(1/1.12)5 = 25,6742. FV of inflows: yr. 1 CF = 5,000; yr. 2 and 3 CF = 7,000; yr. 4 CF =
10,000;YR FV1 5,000(1.12 ) 5-1 = 5,000(1.12 )4 = 7,8682 7,000 (1.12 ) 5-2 = 7,000(1.12 )3 = 9,8343 7,000 (1.12 ) 5-3 = 7,000(1.12 )2 = 8,7814 10,000(1.12 ) 5-4 = 10,000(1.12 )1 = 11,200
-------------Sum 37,683
43
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.
44
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?
45
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
46
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.
48
Cash Flows in Capital Budgeting
Cash flow is important, not Accounting Profits
• Net Cash Flow = NI + Depreciation
49
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)
50
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
51
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
52
Cash Flows in Capital Budgeting
What if projects have different lives?Machine #1: cost = 24,000, life 4 yrs, net benefits =
$8,000/yearMachine #2: cost = 12,000, life 2 yrs, net benefits =
$7,400/yeark = 10%
NPV1 = -24,000 + 8,000 PVIFA( 10%,4)= 1,359NPV2 = -12,000 + 7,400 PVIFA(10%,2)= 843
We cannot compare these like this, since have unequal lives.
53
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 4Inflows 7400 7400 7400 7400Outflows -12000 -12000
Net CF -12000 7400 -4600 7400 7400NPV2 = 1,540- so we choose machine #2, not #1
54
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
55
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
56
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
57
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
58
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)
60
Capital Structure and Leverage
Factors influencing a firm’s decision:
• Business risk - DOL
• Taxes
• Financial flexibility - DFL
• Managerial conservatism – risk aversion
61
Capital Structure and Leverage
Business Risk
• Break-even Operating Quantity
• Degree of Operating Leverage (DOLS)– A measure of the degree to which fixed costs
are used
• High Fixed Costs ===> High Operating Leverage
FVPQ
VPQ
FVCS
VCSor
Sales
EBITDOLs
)(
)(
%
%
VP
FQBE
62
Capital Structure and Leverage
Financial Risk
• Degree of Financial Leverage (DFLEBIT)
• A measure of the degree to which debt is used
• The higher the firm relies on debt, the greater the DFL will be
IEBIT
EBIT
IFVPQ
FVPQor
EBIT
EPSDFLEBIT
)(
)(
%
%
63
Capital Structure and Leverage
Combined Risk
• Degree of Total Leverage (DTLS)
– Measure of the combined leverage utilized by a firm
• DCLS = [DOLS] X [DFLEBIT]
IFVPQ
VPQor
Sales
EPSDCLS
)(
)(
%
%
64
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
65
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)
66
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
68
Capital Structure and Leverage
Signaling Theory• Signals must be costly
– New equity issue signal– New debt issue signal
69
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
70
Dividend Policy
• Residual Dividend Model– Dividend policy set to pay out cash that is not need
for investment or for reserve cash reasons
71
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
72
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?
73
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