IBM Applied Corporate Finance Prof Ian Giddy New

IBM Applied Corporate Finance Prof. Ian Giddy New York University

What the Course is About. . . q Corporate finance: shareholder value can be affected by financial decisions: investment, financing, payout & risk management. Restructuring may be needed to realize latent value. u. Corporate investment decisions u. Corporate financing choices u. Risk management u. M&A and restructuring Copyright © 2004 Ian H. Giddy Corporate Finance 4

The Decisions that Create Shareholder Value CORPORATE INVESTMENT DECISIONS Copyright © 2004 Ian H. Giddy CORPORATE FINANCING CHOICES CORPORATE PAYOUT POLICIES CORPORATE RISK MANAGEMENT CREATING CORPORATE ECONOMIC VALUE Corporate Finance 9

Finance in the Corporation

Finance in the Corporation Board of Directors Chairman of the Board and Chief Executive Officer (CEO) President and Chief Operations Officer (COO) Vice President Finance (CFO) Vice President Marketing Controller Treasurer Cash Manager Capital Expenditures Copyright © 2004 Ian H. Giddy Vice President Production Credit Manager Financial Planning Tax Manager Cost Accounting Manager Financial Accounting Manager Data Processing Manager Corporate Finance 16

Corporate Investment Decisions: Build or Buy? The Virtual Corporation Copyright © 2004 Ian H.

Capital Budgeting: Present Value of Cash Flow Streams Consider SBC Communications’ projections of an investment in South Africa’s Telkom. How much n What is the cost of is it worth investing? funding this investment? What is the required return on this $1, 000 investment? $900 n ? $400 $300 -$100 Time Copyright © 2004 Ian H. Giddy Corporate Finance 18

How Much Debt? What Kind? Copyright © 2004 Ian H. Giddy Assets Liabilities Value

When Debt and Equity are Not Enough Assets Liabilities Debt Value of future cash flows Contractual int. & principal No upside Senior claims Control via restrictions Equity Residual payments Upside and downside Residual claims Voting control rights Copyright © 2004 Ian H. Giddy Corporate Finance 21

Corporate Balance Sheet and Allocation of Cash Flows Total Value of the Firm to Investors in the Financial Markets Total Value of Firm’s Assets Copyright © 2004 Ian H. Giddy equal Liabilities Corporate Finance 22

Corporate Balance Sheet and Allocation of Cash Flows Total Value of the Firm to Investors in the Financial Markets Total Value of Firm’s Assets B. Firm invests in assets Current Assets Fixed Assets A. Firm issues securities, gets money F. Dividends, E. Retained cash flows buybacks and debt payments Financial Markets Short-term debt Long-term debt Equity shares C. Cash flow from firm’s assets D. Government (taxes) Copyright © 2004 Ian H. Giddy Corporate Finance 23

Sources of Corporate Financial Risk Uncertain Markets Uncertain Exposures Risk! Mistaken Views Wrong Risk

Corporate Finance: The Context

The Firm Must Attract Investors The Economy Investors Copyright © 2004 Ian H. Giddy

Investors Have Choices q Money market instruments - Short-term debt instruments, like deposits and bills q Bonds - used by businesses and governments to raise money q Common Stock - Units of ownership, interest, or equity q Preferred Stock, Convertibles, other hybrids - A form of ownership with features of both debt and common stock Copyright © 2004 Ian H. Giddy Corporate Finance 28

Investors Compare Possible Investments Against Market Benchmarks Source: Bloomberg. com Copyright © 2004 Ian

Total Yield is What Investors Seek q “Yield to maturity” combines coupons and capital gains - all cash flows. q The yield to maturity on any bond, is the rate that will make the present value of the cash flows from the investment equal to the price of the investment. q Also known as the internal rate of return or IRR. Copyright © 2004 Ian H. Giddy Corporate Finance 30

Longer-Term Investments Generally Offer Higher Interest Rates Term Structure of Interest Rates u More commonly known as a yield curve, it shows the relationship between the interest rate, or rate of return, and the time to maturity of securities with similar issuer characteristics u Yield curves can be downward-sloping, flat, or upward sloping u The three theories of term structure are the expectations hypothesis, liquidity preference theory, and market segmentation theory u A normal yield curve is upward-sloping Copyright © 2004 Ian H. Giddy Corporate Finance 31

The US Treasury Yield Curve January 2003 Source: bondsonline. com Copyright © 2004 Ian

Interest Rates and Required Rates of Return Interest Rate Fundamentals q The interest rate is the "price" of borrowed funds q The required return is the owner's expected return q The real rate of interest (k*) is the cost of money that balances the supply of and demand for funds q The risk-free rate of interest (RF) represents the real rate of interest plus inflationary expectations q The nominal rate of interest (k) is the actual rate of interest charged by the supplier of funds q Interest rates differ between currencies, based on exchange-rate expectations Copyright © 2004 Ian H. Giddy Corporate Finance 33

Risker Investments Have to Offer Higher Returns Risk and Return u. A positive relationship exists between risk and nominal or expected return u The actual return earned on a security will affect the subsequent actions of investors u Investors must be compensated for accepting greater risk with the expectation of greater return Risk Copyright © 2004 Ian H. Giddy Corporate Finance 34

Risker Investments Have to Offer Higher Returns: Example Source: bondsonline. com Copyright © 2004

The Value of Money

The Role of Time Value in Finance q Future Value versus Present Value q A dollar tomorrow is worth less than a dollar today q Compounding is used to find future value q Discounting is used to find present value Copyright © 2004 Ian H. Giddy Corporate Finance 37

The Concept of Future Values FVn = PV (1+r)n FVn = Future value at the end of the year n PV = Present value, or original principal amount r = Annual rate of interest paid n = Number of periods (usually years) separating the present value and the future value, or number of years the money is left on deposit n Time Note: The term (1+r) is the future value of interest factor, or FVIFr, n Copyright © 2004 Ian H. Giddy Corporate Finance 38

IBM’s Eurodollars If IBM deposits $8 million today in a Eurodollar account paying 9% annual interest, how much will IBM have at the end of three years? PV = $8 m 0 FV 3? 1 2 3 PV = $8, r = 9% , n = 3 FV 3 = $8 X (1 +. 09)3 = $8 X (1. 295) = $10. 36 m. Copyright © 2004 Ian H. Giddy Corporate Finance 39

Compounding More Frequently Than Annually New variable: m = number of compounding periods per year u. Divide r by m u. Multiply m times n Thus: FVn = PV x (1 + r/m)mxn Copyright © 2004 Ian H. Giddy Corporate Finance 40

The Effective Rate of Interest reff = (1 + m r/m) - 1 r is the nominal, or stated, rate Only $499 a month! reff is the effective rate Only 11. 99% APR! m is the number of times per year interest is paid Copyright © 2004 Ian H. Giddy Corporate Finance 41

Effective Rate of Interest Nominal Rate, r, = 12% Compounding Period m Annual 1 12. 00% Semiannual 2 = 12. 36% Quarterly 4 = 12. 55% Monthly 12 = 12. 68% Daily 360 = 12. 75% Copyright © 2004 Ian H. Giddy Effective Rate reff = (1+r/m)m 1 (1 +. 12/1) -1 = 1 +. 12 -1 =. 12 = (1 +. 12/2)2 -1 = 1. 1236 -1 =. 1236 (1 +. 12/4)4 -1 = 1. 1255 -1 =. 1255 (1 +. 12/12)12 -1 = 1. 1268 -1 =. 1268 (1 +. 12/360)360 -1 = 1. 1275 -1 =. 1275 Corporate Finance 42

Future Value of an Annuity An annuity is a series of equal payments over time FVAn = PMT x (FVIFAr, n) Where: PMT = payment, or the amount of one cash flow; n is the number of payments. FVIFA factors are found in table; or: Copyright © 2004 Ian H. Giddy Corporate Finance 43

Future Values: Summary Single amount: the amount times the future value of interest factor, or FVIFk, n : Annuity: the periodic payment times the future value of annuity factor, or FVIFAr, n : Copyright © 2004 Ian H. Giddy Corporate Finance 44

Present Value is the current dollar value (today's value) of a future amount of

Present Value of a Single Amount PVn = FV n /(1+r) = FVn x (PVIFr, n) PVIFr, n or (1+r)n is called the present value of interest factor. PVIF factors can be computed or found in tables. Copyright © 2004 Ian H. Giddy Corporate Finance 46

Present Value of Cash Flow Streams Present Value Of A Mixed Stream Mixed streams are non-annuity cash flows, i. e. they reflect no particular pattern. Consider projections of a new investment’s profits: $1, 000 ? $400 $100 $300 Time Copyright © 2004 Ian H. Giddy Corporate Finance 47

Present Value of an Equal Stream of Payments PVAn = PMT x (PVIFAk, n) Where: PVIFAk, n is the present-value interest factor for an annuity, found from tables, or: Copyright © 2004 Ian H. Giddy Corporate Finance 48

Brotherly Love You lend $300 to your brother; he says he can repay it in 3 installments of $100 on your birthday. The current Treasury note rate is 6%. What’s brotherly love worth? The PV of a three-year annuity of $100 discounted at 6% can be found by discounting each cash flow by the appropriate PVIF. Value: Yr 1: $100 x (. 943) = Yr 2: $100 x (. 890) = Yr 3: $100 x (. 840) = Total $ 94. 30 89. 00 84. 00 $267. 30 or can be simplified as $100 (. 943 +. 890 +. 840) = $100 x (2. 673). Copyright © 2004 Ian H. Giddy Corporate Finance 49

Present Values: Summary Single amount: the amount times the present value of interest factor, or PVIFr, n : Annuity: the periodic payment times the present value of annuity factor, or PVIFAr, n : Copyright © 2004 Ian H. Giddy Corporate Finance 50

Present Value Of A Perpetuity A perpetuity is an annuity that goes on forever.

Application: Basic Bond Pricing The formula for a bond’s price is $1, 000 PRINCIPAL

Contact Prof. Ian Giddy NYU Stern School of Business 44 West 4 th Street New York, NY 10012 Tel 212 -998 -0426; Fax 212 -995 -4233 ian. giddy@nyu. edu www. giddy. org Copyright © 2004 Ian H. Giddy Corporate Finance 115