The Phoenix CFA Society Wendell Licon CFA Level

The Phoenix CFA Society Wendell Licon, CFA Level I Exam Tutorial 2013 Corporate Finance Online Video Power Point Slides 1

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 2

Financial Management Agency Problems • Mechanisms to align management with shareholders – Compensation – Threat of firing – Direct intervention by shareholders (Cal. PERS) – Takeovers 3

Cost of Capital WACC = 4

Cost of Capital kd(1 -Tc) – Where do we get kd from? 5

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) 6

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) 7

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% 8

Cost of Capital (Common) Discounted Cash Flow (DCF) • Simple g assumption? • Cost of CS = Dividend Yield + Growth • Example: D 1= 3/yr, P 0 = 100, g= 12% kcs = 15% • What about flotation costs? Multiply P 0 by (1 – F) 9

Cost of Capital (Common) What about g? g = ROE x (plowback ratio) or g = ROE x (1 – payout rate) 10

Cost of Capital (Common) Capital Asset Pricing Model (CAPM) • kcs = krf + cs(km – krf) 11

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 nonalcoholic beverages • Can Coke use 15% to discount the cash flows for an alcoholic beverage project? 12

WACC Coke Example cont’d – Say alcoholic beverage projects require 22% returns – Security market line 13

WACC 14

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 15

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 16

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 (over and above the 40%) • Marginal Tax Rate = 40% • Debt Flotation Costs = 1% per year • CS Flotation Costs = 1% per year 17

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% 18

Cost of Capital- MCC How far can we go with Layer 2? 1, 000/. 4 = 2, 500, 000 of new projects costs of which 2, 500, 000 *. 6 = 1, 500, 000 in new issue debt and 1, 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 19

Cost of Capital- MCC Layer 3 WACC: . 6*(. 09)*(1 -. 4) +. 4(. 16) = 9. 64% 20

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 21

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. 22

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 Flows 1 5 MM < 20 MM 2 5 MM + 7 MM = 12 MM <20 MM 3 12 MM + 7 MM = 19 MM <20 MM 4 19 MM + 10 MM = 29 MM >20 MM 23

Capital Budgeting Payback Period • Get paid back during the 4 th year. We need $1 MM entering yr 4, and get $10 MM for the whole year. If we assume $10 MM comes evenly throughout the year, then we reach $20 MM in {1 MM/10 MM} or. 1 yrs. • So, payback = 3. 1 years. • Do we accept or reject the project? Accept, since 3. 1 < 4. 24

Capital Budgeting Discounted Payback Period • Discount each year’s cash flow to a present day valuation and then proceed as with Payback Period. 25

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 26

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 27

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? • ACF 1 = 100(1. 1) = 110 (just the FV!) • If NPV > 0, it is the same as ACFt > 110. 28

Capital Budgeting - NPV Ex: 120. Now, what’s the investment worth? • Just PV of $120 = 120/1. 1 = 109. • 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) 29

Capital Budgeting - 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. 30

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. 31

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. 32

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% 33

Capital Budgeting - IRR Case 2 Uneven CF’s - even worse • Trial and Error! • Ex above: IO = 20, 000, CF 1 = 5, 000, CF 2 = 7, 000, CF 3 = 7, 000, CF 4 = 10, 000, CF 5 = 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 34

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%. 35

Capital Budgeting - IRR has same advantages as NPV and the same disadvantages, plus 1. Multiple IRRs: IRR involves solving a polynomial. There 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 t 6 ==> 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. 36

Capital Budgeting - IRR 1. Multiple IRRs: 2. Reinvestment assumption: 37

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. • 1 st: 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. 38

Capital Budgeting - MIRR 39

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 >= k (cost of capital) ==> accept 40

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 41

Capital Budgeting - MIRR Ex: Initial outlay = 20, 000, plus yr. 5 CF = -10, 000. We’ll use k=12% Draw timeline 1. PV of outflows = 20, 000 + 10, 000(1/1. 12)5 = 25, 674 2. FV of inflows: yr. 1 CF = 5, 000; yr. 2 and 3 CF = 7, 000; yr. 4 CF = 10, 000; YR FV 1 5, 000(1. 12 ) 5 -1 = 5, 000(1. 12 )4 = 7, 868 2 7, 000 (1. 12 ) 5 -2 = 7, 000(1. 12 )3 = 9, 834 3 7, 000 (1. 12 ) 5 -3 = 7, 000(1. 12 )2 = 8, 781 4 10, 000(1. 12 ) 5 -4 = 10, 000(1. 12 )1 = 11, 200 Sum ------37, 683 42

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. 43

Capital Budgeting Decision Criteria Ex. firm has $5 MM – If firm used IRR to rank, would pick highest IRR projects, next highest, etc. , until spent $5 MM. With NPV, pick projects to maximize total NPV subject to not spending more than $5 MM. Mutually exclusive projects - just means can’t do both. Which do we pick - highest NPV or IRR? 44

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 45

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. 46

Capital Budgeting Post-Audit • Compare actual results to forecast • Explain variances 47

Cash Flows in Capital Budgeting Cash flow is important, not Accounting Profits • Net Cash Flow = NI + Depreciation 48

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) 49

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 50

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 51

Cash Flows in Capital Budgeting What if projects have different lives? Machine #1: cost = 24, 000, life 4 yrs, net benefits = $8, 000/year Machine #2: cost = 12, 000, life 2 yrs, net benefits = $7, 400/year k = 10% NPV 1 = -24, 000 + 8, 000 PVIFA( 10%, 4)= 1, 359 NPV 2 = -12, 000 + 7, 400 PVIFA(10%, 2)= 843 We cannot compare these like this, since have unequal lives. 52

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 4 Inflows 7400 Outflows -12000 Net CF -12000 7400 -4600 7400 NPV 2 = 1, 540 - so we choose machine #2, not #1 53

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 54

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 55

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 56

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 57

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) 58

Risk Analysis Investment Opportunity Schedule vs Marginal Cost of Capital 59

Capital Structure and Leverage Factors influencing a firm’s decision: • Business risk - DOL • Taxes • Financial flexibility - DFL • Managerial conservatism – risk aversion 60

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 61

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 62

Capital Structure and Leverage Combined Risk • Degree of Total Leverage (DTLS) – Measure of the combined leverage utilized by a firm • DCLS = [DOLS] X [DFLEBIT] 63

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 64

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) 65

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 66

Capital Structure and Leverage Effect of WACC 67

Capital Structure and Leverage Signaling Theory • Signals must be costly – New equity issue signal – New debt issue signal 68

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 69

Dividend Policy • Residual Dividend Model – Dividend policy set to pay out cash that is not need for investment or for reserve cash reasons 70

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 71

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? 72

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 73