corp finance topics
DESCRIPTION
This slide set is a work in progress and is embedded in my Principles of Finance course, which is also a work in progress, that I teach to computer scientists and engineers http://awesomefinance.weebly.com/TRANSCRIPT
Corporate Finance Topics
2
Topics
¨ Capital Budge1ng & Project Evalua1on ¨ Taxes ¨ Dividends ¨ Short selling ¨ Dividend Irrelevance Proposi1on (M&M) ¨ Informa1on and agency issues
Capital Budge1ng Preliminary 3
PV=CFi
(1+k)ii=1
M
∑
NPV=CFi
(1+k)ii=0
M
∑
0 1 2 3 4 5
sunk costs
How do you decide whether to do a particular project or make a particular investment? How do you rank projects within your capital budget?
Capital Budge1ng Methods
¨ Net present value ¤ NPV should be posi1ve ¤ is hurdle rate or project cost
of capital
¨ Internal rate of return ¤ IRR should exceed hurdle rate
¨ Payback period ¤ Time periods to breakeven
Cash flows and +ming are always given
∑= +
+=N
1ii
i0 )k(1
CFCFNPV
∑= +
+==N
1ii
i0 IRR)(1
CFCF0NPV
∑= +
+==N
1ii
i0 )k(1
CFCF0NPV
0 1 2 3 4 5
sunk costs
N
k
k
Net Present Value Method
¨ Expected project cash flows are projected for periods 1 to N ¨ A discount rate for the project is determined
¤ The rate includes an adjustment for risks to the project cash flows rela1ve the firm’s total cash flow and cost of capital, kU
¨ The method determines if the NPV is posi1ve and thus a value crea1ng investment
¨ Alterna1ve projects can be ranked in descending NPV order
projectU
N
1ii
i0
kkk
)k(1CFCFNPV
Δ+=
++= ∑
=
Internal Rate of Return Method
¨ Find the discount rate, IRR, that equates NPV to zero ¨ The IRR should exceed a hurdle rate and thus creates
value ¨ Rank alterna1ve projects in descending order by IRR
k IRR
IRR)(1CFCF0NPV
N
1ii
i0
≥
++== ∑
=
Payback Period Method
¨ How many periods, , are required to recover (on an NPV basis) the ini1al investment?
¨ How many periods needed to achieve a posi1ve NPV ¨ Use the risk adjusted discount rate, ¨ Rank alterna1ve projects in ascending payback period
basis
∑= +
+=≡N
1ii
i0 )k(1
CFCF0NPV
k
N
0 1 2 3
Internal Rate of Return 8
10 10 110
100
100= CF(1+y)ii=1
3
∑ = 101+y( )
+ 10
1+y( )2+ 110
1+y( )3
P ⋅y3+ 3P.10( ) ⋅y2+(3P.10)⋅y.120=0
Income Tax Rates
Marginal Tax Rate
Single
10% $0 – $8,025 15% $8,026 – $32,550 25% $32,551 – $78,850 28% $78,851 – $164,550 33% $164,551 – $357,700 35% $357,701+
Marginal Tax Rate
Single
2.56% $0 -‐ $2,4003.57% $2,401 -‐ $17,5005.12% $17,501 -‐ $27,0006.84% $27,001 +
Nebraska
Currently, the average combined federal and state corporate tax rate in the U.S. is 40.0%, second among OECD countries to Japan's combined rate of 40.69%.
Ordinary Income Rate
Long-‐term Cap Gain & Dividend* Rate
Short-‐term Capital
Gain Rate
Long-‐term Gain on Real Estate**
Long-‐term Gain on Collectibles
10% 0% 10% 10% 10%15% 0% 15% 15% 15%25% 15% 25% 25% 25%28% 15% 28% 25% 28%33% 15% 33% 25% 28%35% 15% 35% 25% 28%
* Qualified dividends ** $250,000 exemption on primary residence
Short Selling
Long Investment (but short term holding period)Buy 100 shares of FMN in Oct-‐07 for 65.00$ per share for a total of 6,500$ "Buy at market"Sell 100 shares of FMN in Jul-‐08 for 15.00$ per share for a total of 1,500$ "Sell at Market"Net (5,000)$
Short Trade Borrow 100 shares of FMN in Oct-‐07 from your brokerSell 100 shares of FMN in Oct-‐07 from your brokerage account at for 65.00$ per share for a total of 6,500$ "Sell short"Buy 100 shares of FMN in Jul-‐08 into your brokerage account for 15.00$ per share for a cost of 1,500$ "Buy to Cover"Return 100 shares of FMN in Aug-‐08 to your brokerNet 5,000$
Project Expected Cash Flows
¨ Assume there are three future cash flow scenarios, A, B, and C during some future year. The expected cash flow is during that year is
¨ The scenarios are mutually exclusive – independent ¨ Example
¤ CFA = $1,000,000 with probability 50% ¤ CFB = $500,000 with probability 30% ¤ CFC = $150,000 with probability 20%
¨
¨ The risk (variance) in the expected cash flow is included in the discount rate
[ ]1p p p
pCFpCFpCFCFE
CBA
CCBBAA
=++
⋅+⋅+⋅=
[ ]000,680$
%20000,150$%30000,500$%50000,000,1$ CFE=
⋅+⋅+⋅=
Project Valua1on
¨ Present value of free cash flow – opera1ng and financing split using APV method
¨ Define project cash flow, CF, similar to free cash flow, FCF ¨ Include a cash flow at 1me 0 (likely an investment – a
nega1ve cash flow)
12
∑=
⎥⎦
⎤⎢⎣
⎡
++
+=
N
1ii
TS
ii
U
i0 )k1(
TS)k1(
FCFV
∑= +
+=N
1ii
i0 )k1(
CFCFNPV projectU kkk Δ+=
Project Valua1on
¨ Note ‘direct method’ for free cash flow ¤ Cash, not accrual, basis
¨ Ignore non-‐opera1ng assets, dividends, interest expense and income
13
RC: cash revenue (excluding IDI) COGSC: cash cost of goods sold or cost of revenue OXC: cash opera1ng expenses (SG&A, R&D) ITC: cash taxes paid CX: capital expenses CS: cash from sale of assets ΔCE: addi1onal opera1ng cash required
ITCCECSCXOXCCOGSCRCCF −Δ−+−−−=
τ⋅−τ⋅+−Δ−+−−−= IXIDIITCOCECSCXOXCCOGSCRCFCF
Dividend Payments 14
S M T W Th F S Jun-‐081 2 3 4 5 6 7
8 9 1011
Announcement Date
12 13 14
15 16 17 18 19 20 2122 23 21 22 23 24 2529 27 28 29 30
S M T W Th F S Aug-‐081 2
3 4 5 6 7 8 910 11 12 13 14 15 16
17 18
19 Ex-‐
Dividend Date
2021
Record Date
22 23
24 25 26 27 28 29 30
S M T W Th F S Sep-‐081 2 3 4 5 6
7 8 9 10
11 Payable Date 12 13
14 15 16 17 18 19 2021 22 23 24 25 26 2726 29 30
Microso0 Declares Quarterly Dividend REDMOND, Wash. — June 11, 2008 — Microsok Corp. today announced that its board of directors declared a quarterly dividend of $0.11 per share. The dividend is payable Sept. 11, 2008, to shareholders of record on Aug. 21, 2008. The ex-‐dividend date will be Aug. 19, 2008.
Opening stock price on 19 Aug =
Closing price on 18 Aug
– dividend per share ($0.11)
+ price gain (loss) due to over night changes in supply and demand for MSFT shares
Dividend Payments 15
Date Open High Low Close Volume Adj Close
30-‐Nov-‐04 26.75 27.01 26.7 26.81 75,960,400 25.5729-‐Nov-‐04 26.64 26.95 26.61 26.77 67,079,900 25.5326-‐Nov-‐04 26.56 26.82 26.55 26.6 24,398,700 25.3624-‐Nov-‐04 26.62 26.73 26.4 26.64 60,069,200 25.423-‐Nov-‐04 26.52 26.7 26.4 26.53 70,459,700 25.322-‐Nov-‐04 26.75 26.82 26.1 26.65 92,410,800 25.4119-‐Nov-‐04 27.03 27.07 26.84 26.86 85,808,600 25.6118-‐Nov-‐04 27.13 27.17 27 27.07 63,249,900 25.8117-‐Nov-‐04 27.25 27.35 27.06 27.17 58,830,700 25.9116-‐Nov-‐04 27.33 27.34 27.05 27.12 64,522,600 25.8615-‐Nov-‐04 27.34 27.5 27.2 27.39 104,468,000 26.1215-‐Nov-‐04 $ 3.08 Dividend12-‐Nov-‐04 30.16 30.2 29.8 29.97 162,269,000 25.6411-‐Nov-‐04 29.89 30.08 29.82 29.98 87,358,900 25.6510-‐Nov-‐04 29.92 30 29.69 29.73 84,097,700 25.449-‐Nov-‐04 29.43 29.89 29.35 29.77 100,401,000 25.478-‐Nov-‐04 29.18 29.48 29.13 29.28 112,802,100 25.055-‐Nov-‐04 29.21 29.36 29.03 29.31 95,337,700 25.084-‐Nov-‐04 28.38 29 28.38 29 87,867,700 24.813-‐Nov-‐04 28.65 28.65 28.31 28.47 79,666,700 24.362-‐Nov-‐04 28.26 28.47 28.03 28.24 89,417,100 24.161-‐Nov-‐04 28.16 28.28 27.96 28.08 72,930,900 24.00
Yahoo finance ‘historical prices’ for MSFT during Nov 2004
REDMOND, Wash. July 20, 2004 Microsok Corp. today announced that its board of directors approved an $0.08 per share quarterly dividend, plans to buy back up to $30 billion of the company's stock over the next four years, and a special one-‐1me dividend of $3 per share. hnp://www.microsok.com/presspass/press/2004/jul04/07-‐20boardPR.mspx
The 3rd quarter dividend ex-‐dividend date was August 23
The 4th quarter and special dividends ($3.08) were paid on Dec 2 to shareholders of record on Nov 17. The ex-‐dividend date was Nov 15.
Dividend Payments 16
Date Open Close Opening Gap
30-‐Nov-‐04 26.75 26.81 -‐0.0229-‐Nov-‐04 26.64 26.77 0.0426-‐Nov-‐04 26.56 26.6 -‐0.0824-‐Nov-‐04 26.62 26.64 0.0923-‐Nov-‐04 26.52 26.53 -‐0.1322-‐Nov-‐04 26.75 26.65 -‐0.1119-‐Nov-‐04 27.03 26.86 -‐0.0418-‐Nov-‐04 27.13 27.07 -‐0.0417-‐Nov-‐04 27.25 27.17 0.1316-‐Nov-‐04 27.33 27.12 -‐0.0615-‐Nov-‐04 27.34 27.39 -‐2.6312-‐Nov-‐04 30.16 29.97 0.1811-‐Nov-‐04 29.89 29.98 0.1610-‐Nov-‐04 29.92 29.73 0.159-‐Nov-‐04 29.43 29.77 0.158-‐Nov-‐04 29.18 29.28 -‐0.135-‐Nov-‐04 29.21 29.31 0.214-‐Nov-‐04 28.38 29 -‐0.093-‐Nov-‐04 28.65 28.47 0.412-‐Nov-‐04 28.26 28.24 0.181-‐Nov-‐04 28.16 28.08 0.19
November 2004 S M T W Th F S
1 2 3 4 5 67 8 9 10 11 12 13
14
15 Ex-‐
Dividend Date
1617
Record Date
18 19 20
21 22 23 24 25 26 2728 29 30
Opening price on 15 Nov = Closing price on 12 Nov -‐ $3.08 + price gain due to changes over the week end for MSFT stock
$27.34 = $29.97 -‐ $3.08 + $0.45
17
M&M Proposi1on 3
¨ “Dividend Irrelevance Proposi1on”
¨ Dividend payout policy is irrelevant to total shareholder value under certain condi1ons
¨ Illustra1on via an all-‐equity, constant growth firm with no debt and no non-‐opera1ng assets ¤ D = 0, NOA = 0, C = IC, T = 0
NOAL
OA PARAPCTSRE
EC
EC: Total common equity TS: Treasury stock (common)
18
Example
NOPAT0 DIV0
FCF0
IC0 IC1 IC2
FCF1 FCF2
ΔIC is the reinvestment needed to maintain gFCF at 5% and expected return on opera1ng assets at 10%
In this example FCF and ΔIC are defined to be the op1mal values for an all equity firm For an all equity firm, all of the FCF should be paid out as a dividend, if
• dividend and capital gain taxes are equal
• A change in dividend payout does not signal financial distress
k 10%gFCF 5%EBIT 12,500,000$ τ 20%ns 8,000,000 ΔIC 6,000,000$ DB -‐$ NOA -‐$
Pay all FCF as dividend
Operating Assets Current Liabilitites ∆OA 6$ ∆CL -‐$
Nonoperating Assets Noncurrent Liabilities∆NOA -‐$ ∆NCL -‐$
Shareholders' Equity ∆PAR -‐$ ∆APC -‐$ ∆TS -‐$ ∆EC -$
∆RE 6$ ∆EB 6$
∆TA 6$ ∆LE 6$ ΔTS: change in treasury stock
ΔEC: change in common equity
ΔNOA: change in non-‐opera1ng assets (e.g., cash)
EBIT 12.50$ EBIT(1-‐τ) 10.00$
IX(1-‐τ) -‐$ NP 10.00$
IX(1-‐τ) -‐$ ΔT -‐$
NOPAT 10.00$ Δ IC 6.00$
FCF 4.00$ DIV 4.00$ ΔRE 6.00$
ΔOA=ΔRE 6.00$
20
Pay all FCF as dividend: Shareholder Value
m88$ 0$m4$0$m84$
ECDIVNOA%5%10)05.1(m4$
ECDIVNOAgk
)g1(FCFS
FCF
FCF
=
−++=
Δ−+Δ+−
⋅=
Δ−+Δ+−
+⋅=
Total shareholder value Total shareholder value per share
Fair value stock price
p
Cash flow to and from the
shareholder per share
( ) nsEC
nsDIV
nsNOA
nsgk)g1(FCFs
FCF
FCF Δ−+
Δ+
⋅−
+⋅=
$11.00 $0.50$10.50
m80$
m8m4$
m80$
m8m84$ s
=
+=
−++=
21
Pay No Dividend
¨ $6m investment needed to anain FCF growth of 5% ¤ Op1mal dividend payout and
reinvestment
OAΔICΔm4$DIVm4$FCFm6$ICΔ
m10$NOPAT
=
=
=
=
=
00.11$50.0$50.10$
0$m8m4$0$50.10$
nsEC
nsDIV
nsNOA50.10$s
=+=
−++=
Δ−+
Δ+=
Operating Assets Current Liabilitites ∆OA 6$ ∆CL -‐$
Nonoperating Assets Noncurrent Liabilities∆NOA -‐$ ∆NCL -‐$
Shareholders' Equity ∆PAR -‐$ ∆APC -‐$ ∆TS -‐$ ∆EC -$
∆RE 6$ ∆EB 6$
∆TA 6$ ∆LE 6$
22
Pay No Dividend
¨ Pay no dividend, yet FCF = $10m ¨ $6m investment needed to maintain FCF growth of 5%
¨ Excess reten1on of $4m
00.11$50.0$50.10$
0$0$m8m4$50.10$
nsEC
nsDIV
nsNOA50.10$s
=+=
−++=
Δ−+
Δ+=
Operating Assets Current Liabilitites ∆OA 6$ ∆CL -‐$
Nonoperating Assets Noncurrent Liabilities∆NOA 4$ ∆NCL -‐$
Shareholders' Equity ∆PAR -‐$ ∆APC -‐$ ∆TS -‐$ ∆EC -$
∆RE 10$ ∆EB 10$
∆TA 10$ ∆LE 10$
EBIT 12.50$ DIV -‐$ EBIT(1-‐τ) 10.00$ ΔRE 10.00$ NP 10.00$ ΔOA 6.00$ NOPAT 10.00$ ΔNOA 4.00$
ΔIC 6.00$ FCF 4.00$
23
Pay Excess Dividend
¨ Pay excess dividend, DIV = NOPAT = $10m ¨ $6m investment needed to maintain FCF growth of 5%
¨ Raise $6m in common equity
00.11$75.0$25.1$50.10$ m8m6$
m8m10$0$50.10$
nsEC
nsDIV
nsNOA50.10$s
=−+=
−++=
Δ−+
Δ+=
Operating Assets Current Liabilitites ∆OA 6$ ∆CL -‐$
Nonoperating Assets Noncurrent Liabilities∆NOA -‐$ ∆NCL -‐$
Shareholders' Equity ∆PAR 1$ ∆APC 5$ ∆TS -‐$ ∆EC 6$
∆RE -‐$ ∆EB 6$
∆TA 6$ ∆LE 6$
EBIT -‐$ DIV 10.00$ EBIT(1-‐τ) 10.00$ ΔRE -‐$ NP 10.00$ ΔOA 6.00$ NOPAT 4.00$ ΔEC 6.00$
ΔIC 6.00$ FCF 4.00$
24
Example: Summary
Case 2
ΔNOA=change in excess cash Paid out too much dividend, so raise necessary
equity capital in market
DIV ΔNOA ΔEC pv(fcf) Δnoa p div Δec s-‐$ 4,000,000$ -‐$ 10.50$ 0.50$ 11.00$ -‐$ -‐$ 11.00$
1,000,000$ 3,000,000$ -‐$ 10.50$ 0.38$ 10.88$ 0.13$ -‐$ 11.00$ 2,000,000$ 2,000,000$ -‐$ 10.50$ 0.25$ 10.75$ 0.25$ -‐$ 11.00$ 3,000,000$ 1,000,000$ -‐$ 10.50$ 0.13$ 10.63$ 0.38$ -‐$ 11.00$ 4,000,000$ -‐$ -‐$ 10.50$ -‐$ 10.50$ 0.50$ -‐$ 11.00$ 5,000,000$ -‐$ 1,000,000$ 10.50$ -‐$ 10.50$ 0.63$ (0.13)$ 11.00$ 6,000,000$ -‐$ 2,000,000$ 10.50$ -‐$ 10.50$ 0.75$ (0.25)$ 11.00$ 7,000,000$ -‐$ 3,000,000$ 10.50$ -‐$ 10.50$ 0.88$ (0.38)$ 11.00$ 8,000,000$ -‐$ 4,000,000$ 10.50$ -‐$ 10.50$ 1.00$ (0.50)$ 11.00$ 9,000,000$ -‐$ 5,000,000$ 10.50$ -‐$ 10.50$ 1.13$ (0.63)$ 11.00$ 10,000,000$ -‐$ 6,000,000$ 10.50$ -‐$ 10.50$ 1.25$ (0.75)$ 11.00$
Case 1
Case 3
Share Buyback
¨ Use FCF to buy back shares ¨ $6m investment needed to maintain FCF growth of 5%
¨ Raise $6m in common equity ¤ Assume buy back has no transac1on cost
m0$DIVm4$FCF
m10$NOPAT
=
=
=
00.11$50.0$50.10$ m8m4$0$0$50.10$
nsEC
nsDIV
nsNOA50.10$s
=+=
−−++=
Δ−+
Δ+=
Operating Assets Current Liabilitites ∆OA 6$ ∆CL -‐$
Nonoperating Assets Noncurrent Liabilities∆NOA -‐$ ∆NCL -‐$
Shareholders' Equity ∆PAR -‐$ ∆APC -‐$ ∆TS (4)$ ∆EC (4)$
∆RE 10$ ∆EB 6$
∆TA 6$ ∆LE 6$
Alterna1ve Views of Case 2
¨ Alterna1ve B: Shareholder creates her own dividend ¤ She has 1000 shares with total value of $11,000 ¤ Seeks a dividend yield of 4.545% = $0.50/$11.00 ¤ So she sells 45.45 shares worth $500 = $11,000·∙ 0.04545 ¤ So she has 954.5454 shares remaining ¤ With total value of $10,500 ¤ Addi1onal assump1ons in this alterna1ve case
n No transac1on cost for shareholder n Dividend and capital gain tax equivalence for shareholder n Frac1onal share transac1on possible
Essen1al Points
¨ Proposi1on 3 ¤ The dividend policy is relevant to total shareholder value in the
case where n The firm has a transac1on fee for buying back or selling equity n The changing of dividend does signal a change in firm value n Shareholder dividend and capital gain tax rates are different n The shareholder has a transac1on fee for buying and selling equity n Frac1onal shares can be bought and sold
Informa1on and Agency Issues
¨ Informa1on asymmetry ¤ Adverse selec1on ¤ Moral hazard
¨ Incomplete informa1on
¨ Principal Agent Problem ¤ Alignment of interests
¤ Agency Cost