Aalto University Mikkeli Week 3 Session 1 9

Aalto University - Mikkeli Week 3 (Session 1) : 9 -00 am – 10 -00 am Corporate governance and firm’s ability to obtain cost effective finance Lecture Slides

Benefits to investors – from firm raising capital

Diversification and Risk • Portfolio Risk reduction

The optimal domestic portfolio

Diversification and Risk • Calculation of portfolio risk and return – An example

Preliminary Note: The difference between stock price and total return

Market Segmentation • Capital market segmentation is a financial market imperfection caused mainly by government constraints, institutional practices, and investor perceptions • Other imperfections are – – – – Asymmetric information Lack of transparency High securities transaction costs Foreign exchange risks Political risks Corporate governance differences Regulatory barriers

Cost of Equity, Debt and Capital

International Diversification and Risk • Calculation of portfolio risk and return – An investor can reduce investment risk by • holding risky assets in a portfolio. • as long as the asset returns are not perfectly positively correlated, the investor can reduce risk, because some of the fluctuations of the asset returns will offset each other. • Calculation of portfolio risk and return – An example • Ausdrill’s Chief Financial Officer, Caitlin, is considering investing Ausdrill’s marketable securities in two different risky assets: an index of the Australian equity markets and an index of the German equity markets. The two equities are characterised by the following expected returns and expected risks.

International Diversification and Risk • Calculation of portfolio risk and return – An example • The expected return of the portfolio

International Diversification and Risk • Calculation of portfolio risk and return – An example • The standard deviation of the portfolio’s expected return

Estimating the Cost of Equity • Cost of equity is calculated using the Capital Asset Pricing Model (CAPM) Where ke krf km β = expected rate of return on equity = risk free rate on bonds = expected rate of return on the market = coefficient of firm’s systematic risk • The normal calculation for cost of debt is analyzing the various proportions of debt and their associated interest rates for the firm and calculating a before and after tax weighted average cost of debt

Estimating the Cost of Debt • For developed countries, the target’s local or the acquirer’s home country cost of debt. • For emerging countries, the cost of debt ( ) is as follows: where Rf = Local risk free rate or U. S. treasury bond rate converted to a local nominal rate if cash flows are in the local currency; if cash flows in dollars, the U. S. treasury rate CRP = Specific country risk premium expressed as difference between the local country’s (or a similar country’s) government bond rate and the U. S. treasury bond rate of the same maturity FRP = Firm’s default risk premium (i. e. , additional premium for similar firms rated by credit rating agencies or estimated by comparing interest coverage ratios used by rating agencies to the firm’s interest coverage ratios to determine how they would rate the firm. )

Standard & Poor's ratings

Sample mapping of default probabilities to ratings

Weighted Average Cost of Capital (WACC) Where k. WACC = weighted average cost of capital ke = risk adjusted cost of equity kd = before tax cost of debt t = tax rate E = market value of equity D = market value of debt V = market value of firm (D+E)

I. Introduction of net present value (NPV) techniques

Net Present Value (NPV) • Net Present Value (NPV): Net Present Value is found by subtracting the present value of the after-tax outflows from the present value of the after-tax inflows. 9 -18

NPV Solution Brighton Ventures has determined that the appropriate discount rate (k) for this project is 13%. NPV = $10, 000 (1. 13)1 $10, 000 (1. 13)4 NPV = + + $12, 000 (1. 13)2 $7, 000 (1. 13)5 + $15, 000 (1. 13)3 - $40, 000 $8, 850 + $9, 396 + $10, 395 + $6, 130 + $3, 801 - $40, 000 NPV = - $1, 428 +

NPV Acceptance Criterion The management of Brighton Ventures has determined that the required rate is 13% for projects of this type. Should this project be accepted? No! The NPV is negative. This means that the project is reducing shareholder wealth. [Reject as NPV < 0 ]

Net Present Value (NPV) • Net Present Value (NPV): Net Present Value is found by subtracting the present value of the after-tax outflows from the present value of the after-tax inflows. Decision Criteria If NPV > 0, accept the project If NPV < 0, reject the project If NPV = 0, technically indifferent Copyright © 2009 Pearson Prentice Hall. All rights reserved. 9 -21

II. Payback period

What is the Payback Period? The length of time before the original cost of an investment is recovered from the expected cash flows or. . . How long it takes to get our money back.

Proposed Project Data Brighton Ventures has determined that the after-tax cash flows for the project will be $10, 000; $12, 000; $15, 000; $10, 000; and $7, 000, respectively, for each of the Years 1 through 5. The initial cash outlay will be $40, 000.

Independent Project u For this project, assume that it is independent of any other potential projects that Brighton Ventures may undertake. • Independent -- A project whose acceptance (or rejection) does not prevent the acceptance of other projects under consideration.

Payback Period (PBP) 0 -40 K 1 2 3 4 5 10 K 12 K 15 K 10 K 7 K PBP is the period of time required for the cumulative expected cash flows from an investment project to equal the initial cash outflow.

Payback Solution (#1) 0 -40 K (-b) Cumulative Inflows 1 10 K 2 3 (a) 4 5 12 K 22 K 15 K 37 K(c) 10 K (d) 47 K 7 K 54 K PBP =a+(b-c)/d = 3 + (40 - 37) / 10 = 3 + (3) / 10 = 3. 3 Years

Payback Solution (#2) 0 1 2 -40 K 10 K -30 K PBP Cumulative Cash Flows 12 K -18 K 3 4 5 15 K -3 K 10 K 7 K 7 K 14 K = 3 + ( 3 K ) / 10 K = 3. 3 Years Note: Take absolute value of last negative cumulative cash flow value.

PBP Acceptance Criterion The management of Brighton Ventures has set a maximum PBP of 3. 5 years for projects of this type. Should this project be accepted? Yes! The firm will receive back the initial cash outlay in less than 3. 5 years. [3. 3 Years < 3. 5 Year Max. ]

Critical appraisal of techniques Payback period NPV Basis of measurement Cash flows profitability Measure expressed No. years Dollar amount Strengths Easy to understand Considers time value of money Allows comparison across projects Accommodates different risk levels over a projects lifecycle Doesn’t consider time value of money Difficult to compare dissimilar projects Limitations Doesn’t consider cash flows after payback period