closing(thoughts(people.stern.nyu.edu/adamodar/pdfiles/acf4e/webcastslides/session36.pdf · if you...
TRANSCRIPT
CLOSING THOUGHTS
Alas, it is 3me to leave.
The Investment DecisionInvest in assets that earn a return
greater than the minimum acceptable hurdle rate
The Financing DecisionFind the right kind of debt for your firm and the right mix of debt and
equity to fund your operations
The Dividend DecisionIf you cannot find investments that make your minimum acceptable rate, return the
cash to owners of your business
Hurdle Rate4. Define & Measure Risk5. The Risk free Rate6. Equity Risk Premiums7. Country Risk Premiums8. Regression Betas9. Beta Fundamentals10. Bottom-up Betas11. The "Right" Beta12. Debt: Measure & Cost13. Financing Weights
Investment Return14. Earnings and Cash flows15. Time Weighting Cash flows16. Loose Ends
Financing Mix17. The Trade off18. Cost of Capital Approach19. Cost of Capital: Follow up20. Cost of Capital: Wrap up21. Alternative Approaches22. Moving to the optimal
Financing Type23. The Right Financing
Dividend Policy24. Trends & Measures25. The trade off26. Assessment27. Action & Follow up28. The End Game
Valuation29. First steps30. Cash flows31. Growth32. Terminal Value33. To value per share34. The value of control35. Relative Valuation
Set Up and Objective1: What is corporate finance2: The Objective: Utopia and Let Down3: The Objective: Reality and Reaction
36. Closing Thoughts
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Ponderous Thoughts, or maybe not
1. There are few facts and lots of opinions. a. Even the givens (cash & risk free rate) are not b. With accoun3ng and market numbers, all bets are off.
2. The real world is a messy place. a. Money making firms can become money losers b. Companies can be restructured/ given faceliRs
3. Models don’t compute values and op3mal paths. You do.
4. Change is the only constant.
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I. What are the conflicts of interest?
Inside stockholders Want to maximize value while
retaining control
Outside stockholders Want to maximize their returns
(stock price plus dividends).
Board of DirectorsWant to preserve personal connections with the managers and personal perks.
ManagersWant to maximize their compensation and increase personal marketability.
EmployeesWant to minimize job risk
and maximize wages/benefits.
Lenders Bankers/Bondholders
want to minimize credit risk and ensure that interest/principal
get paid.
Society Wants companies
to add to economic pie
without creating social costs.
CustomersWant the best possible product/service at the
lowest price
RegulatorsWant to ensure that you follow the rules
and do not create problems for them.
Government
Consultants Auditors
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II. Risk and the Marginal Investor
Actions/Risk that affect only one firm
Actions/Risk that affect all investments
Firm-specific Market
Projects maydo better orworse thanexpected
Competitionmay be strongeror weaker thananticipated
Entire Sectormay be affectedby action
Exchange rateand Politicalrisk
Interest rate,Inflation & news about economy
Figure 3.5: A Break Down of Risk
Affects fewfirms
Affects manyfirms
Firm can reduce by
Investing in lots of projects
Acquiring competitors
Diversifying across sectors
Diversifying across countries
Cannot affect
Investors can mitigate by
Diversifying across domestic stocks Diversifying across asset classes
Diversifying globally
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III. Risk Profiles and Costs of Equity
Risk free RateRisk Premium
for average risk investment+ X
Relative Risk MeasureRisk in investment, relative to the
average risk investment
Macro Economic Uncertainty
Investor risk aversion
How discretionary is your product/
service to your customers?
Expected Inflation
Expected real interest
rate
What proportion of
your costs are fixed costs?
How much have you
borrowed?
The Fundamentals
Earnings Variability
Stock price Volatility
Balance Sheet Ratios
The Observables
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Cost of Capital
Cost of Equity Cost of Debt= Riskfree Rate + DefaultSpread
Market-value Weights of Debt & Equity
Cost of Capital = Cost of Equiity (E/(D+E)) + After-tax cost of debt (D/(D+E))
Equity includesOptions
Debt includes all fixed commitments
Rating
ActualRating
SyntheticRating
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IV. The Quality of Investments: The Firm View
Cost of Capital = Cost of Equiity (E/(D+E)) + After-tax cost of debt (D/(D+E))
After-tax Operating Income Capital Invested in Assets in Place
Return on Capital = After-tax Operating Income/ Capital Invested in Assets in Place
Return Spread =ROC - WACC
EVA = (ROC - WACC) (CapitalInvested)
Cost of Equiity
Net Income Equity Invested in Assets in Place
Return on Equity= Net Income/ Equity Invested in Assets in Place
Return Spread =ROE - COE
Equity EVA = (ROE - COE) (Equity Invested)
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V. The Trade Off on Debt
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VI. The Op3mal Mix of Debt and Equity
Cost of capital = Cost of Equity (Equity/ (Debt + Equity)) + Pre-tax cost of debt (1- tax rate) (Debt/ (Debt + Equity)
Tax benefit ishere
Bankruptcy costs are built into both the cost of equity the pre-taxcost of debt
As you borrow more, he equity in the firm will become more risky as financial leverage magnifies business risk. The cost of equity will increase
As you borrow more, your default risk as a firm will increase pushing up your cost of debt.
At some level of borrowing, your tax benefits may be put at risk, leading to a lower tax rate.
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VII. Geang to the Op3mal Mix
¨ How quickly? ¤ If under levered, are you the poten3al target of a hos3le acquisi3on?
¤ If over levered, are you under threat of bankruptcy? ¨ How?
¤ Recapitaliza3ons: Borrow money & buy back stock, if under levered, or Issue equity and re3re debt, if over levered.
¤ Investments: Take investments primarily with debt, if under levered, or take investments primarily with equity, if over levered.
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VIII. The Right Kind of Financing
Firm Value
Value of Debt
The perfect financing: Provides you with the tax benefits of debt, while also giving you the flexibility of equity.
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IX. Measuring Poten3al Dividends
Begin with the net income (which is after interest expenses and taxes)
Add back the non-cash charges such as depreciation & amortization
Subtract out reinvestment needs- Capital expenditures- Investments in Non-cash Working Capital (Change)
Subtract out payments to non-equity investors- Principal Repayments- Preferred Stock Dividends
Add any cash inflows from new debt - New Debt Issues
To get to the Cash that is available for return to Owners
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IX. Measuring Poten3al Dividends
Begin with the net income (which is after interest expenses and taxes)
Add back the non-cash charges such as depreciation & amortization
Subtract out reinvestment needs- Capital expenditures- Investments in Non-cash Working Capital (Change)
Subtract out payments to non-equity investors- Principal Repayments- Preferred Stock Dividends
Add any cash inflows from new debt - New Debt Issues
To get to the Cash that is available for return to Owners
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X. Valua3on: Match up cashflows and discount rates…
Cashflow to EquityNet Income- (Cap Ex - Depr) (1- DR)- Change in WC (!-DR)= FCFE
Expected GrowthRetention Ratio *Return on Equity
FCFE1 FCFE2 FCFE3 FCFE4 FCFE5
Forever
Firm is in stable growth:Grows at constant rateforever
Terminal Value= FCFE n+1/(ke-gn)
FCFEn.........
Financing WeightsDebt Ratio = DR
Discount at Cost of Equity
Value of Equity
EQUITY VALUATION WITH FCFE
Cashflow to FirmEBIT (1-t)- (Cap Ex - Depr)- Change in WC= FCFF
Expected GrowthReinvestment Rate* Return on Capital
FCFF1 FCFF2 FCFF3 FCFF4 FCFF5
Forever
Firm is in stable growth:Grows at constant rateforever
Terminal Value= FCFF n+1/(r-gn)
FCFFn.........
Discount at Cost of Capital (WACC) = Cost of Equity (Equity/(Debt + Equity)) + Cost of Debt (Debt/(Debt+ Equity))
Firm Value- Value of Debt= Value of Equity
DISCOUNTED CASHFLOW VALUATION
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Back to First Principles
The Investment DecisionInvest in assets that earn a
return greater than the minimum acceptable hurdle
rate
The Financing DecisionFind the right kind of debt for your firm and the right mix of debt and equity to
fund your operations
The Dividend DecisionIf you cannot find investments
that make your minimum acceptable rate, return the cash
to owners of your business
The hurdle rate should reflect the riskiness of the investment and the mix of debt and equity used
to fund it.
The return should relfect the magnitude and the timing of the
cashflows as welll as all side effects.
The optimal mix of debt and equity
maximizes firm value
The right kind of debt
matches the tenor of your
assets
How much cash you can
return depends upon
current & potential
investment opportunities
How you choose to return cash to the owners will
depend whether they prefer
dividends or buybacks
Maximize the value of the business (firm)
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Read Chapter 12
Task From a first principles standpoint,
judge your firm.