Corporate Finance Cheat Sheet PDF

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Lecture 1: Corporate Governance Objective of Corp Fin 4 Issues with Stock Price Maximization as the sole objective 1) Conflict (Agency problem) Stockholders control management through AGM, and interests are represented BOD AGM Small stockholders go AGM because value of holdings is too small Unused v...

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Lecture 1: Corporate Governance & Objective of Corp Fin 4 Issues with Stock Price Maximization as the sole objective 1) Shareholder-Manager’s Conflict (Agency problem) Stockholders control management through AGM, and interests are represented by BOD AGM - Small stockholders don’t go AGM because value of holdings is too small - Unused votes are utilized by incumbent management in their favour - Large institutional investors go with incumbent (rather sell stock rather than create change) BOD - Often handpicked by management (and won’t go against mgmt decisions) - Directors hold token (very small) stakes in company – no vested interest - May be CEOs and sit on each other’s boards to rubber-stamp decisions How do Managers put their own interests over shareholders?  Greenmail: Managers, under threat of takeover, buy out acquirer’s existing stake at a much higher price to keep their jobs  firm’s cash is misused  Golden parachutes: Large unemployment benefits paid out to managers  Poison pills: Defensive tactic which floods market with new shares, and makes acquiring the firm much more expensive  individual stock’s value eroded  Overpaying on takeovers: ∆Firm value is distributed to stakeholders of acquired company 2) Shareholder-Bondholders Conflict Bondholders  Safe projects to ensure they get paid; minimize downside risk Stockholders  Risky projects to gain capital appreciation; focus on upside Actions which worsen bond-holders positions  Increasing dividends: Less cash on hand, lower liquidity  Higher default risk  Taking riskier projects than agreed: Higher risk profile, at unchanged coupon rate  Borrowing more on same assets: Divided salvage value  Make existing lenders worse of 3) Firms and Financial Markets Inefficiency  Stock price does not reflects value  Information can be suppressed or delayed; or released intentionally to mislead current/ future prospects to market. Manipulation of financial markets by insiders  Short-sightedness of investors  reward short term gimmicks, fail to see good long term projects; overreact to news. Irrational and prices can move for no reason  Conflict of interest btwn analyst’s coverage and brokerage services (more likely to say BUY) 4) Firms and Society  Social cost/benefit cannot be fully traced back to the firm.  Costs unknown at time of activity; costs weighed diferently by diferent people Shareholders’ REPONSE:  Vote against BOD selection/ Mgmt compensation contracts  Activist investors like Carl Icahn, take large positions to drive change  Nomination Committee to nominate suitable directors without COI  Institutional investors are more active in monitoring companies (Calpers and Lens Fund)

1. Identify Country Default Risk, using 1) Credit Default Swaps; 2) Moody’s Rating of Country; or 3) Diference in YTM of 10yr USD bond issued by SGD - 10yr USD bond issued by USD. 2. YTM of SG Govt-issued 10yr SGD bond - SG Default Spread = Risk-free rate in SG C) If country no rating, never issue bonds, then do the analysis in USD currency. Then, convert USD Cost of equity to Local currency, accounting for inflation:

1+COE∈SGD=( 1+COE ∈USD ) [ Determine Risk Premium = (Market Risk – Risk Free) A) Historical Premium Approach (Regression) - Mature, Developed Countries 1. Define time period for estimation (5yr, mthly) 2. Calculate returns on a stock index 3. Calculate returns on a riskless security 4. Calculate the diference.

¿

Std Dev of Stock Prices √ Number of years

B) Historical Premium Approach - Developing Countries 1. Obtain Indo Default Spread (shown earlier with 3 methods) 2. Adjust against Std Dev of Stock index and Std Dev of bond index Indo Country Risk Premium= Indo Default spread × (SD of stock index/SD of bond index) 3. COE in US terms = US Rf + [ BetaL ( US Equity RP + Indo RP ) ]

Societal REPONSE:  Laws and regulations against flouting societal norms and social costs  Consumers choose not to purchase from socially-irresponsible firms (Palm oil companies)

CAPM requires least inputs. Alternative Models measure past returns better, but not future. Marginal investor: owns a lot of stock and trades a lot; likely to make next trade. Capital Asset Pricing Model:

Expected Return= R f +β (R M − R f ) Assumptions: Perfect information; No transaction costs. Everyone holds a diversified portfolio. Only one source of risk: market risk, is rewarded. Uses the variance of actual returns around expected return as a measure of risk Expected R = what investors expect to make, if stock is correctly priced & CAPM is correct  Hurdle Rate for managers = Riskfree + Risk Premium on Investment Determine Riskfree Rate A) Developed, Mature Country 1. No default risk or uncertainty about reinvestment – US govt Zero-coupon bond, 10 years 2. Use same maturity as the CF being analyzed, generally longer maturity better 3. Issuer from same country as where CFs are derived, to prevent inflation risk B) Emerging Country  No default-free entity, Govt has default risk.

+

D1 D2 + 1+ IRR ¿

represents beta of stock

represents the proportion of market risk. 1-

R

2

is firm-specific risk.

*Int PMT= Pre-tax cost of debt

×

Debt value (which is PV of lease payments)

βL

βL

of each

βL βU

.

Bottom-up beta for non-traded assets:  Use public comparable firms to estimate of similar public firms + D/E ratios. Un-lever to get

U

D

U

L

D

Purpose: value of debt is proportional to unlevered firm value

.

βU

, then

lever using actual D/E Private Firms: Adjust beta to reflect total risk rather than just market risk:

Beta Levered √ R2

*Take R2 (correlation of sector with market) of comparable publicly traded firms. Going public & business diversification  lowers the cost of equity DEBT: Commitment for future fixed payments; include lease obligations. Tax deductible. Cost of Debt: 1) YTM on outstanding LT, straight bonds 2) If firm is rated AA, use typical default spread on that rating 3) Use I/R on recent LT borrowing from bank. 4) If not rated, use Synthetic Rating. Use Int Cov Ratio to find Default Spread on table

Interest coverageratio=

( DE ) (β −β ) E D β =( β +( β E+D ) E+D )

Proportional Debt Policy:

Bottom-up beta for financial institutions:  Difficult to diferentiate operating and financing assets: cannot get unlevered beta  Deutsche Bank – Split into commercial banking and investment banking, then use the average levered beta of comparable banks in both division

outperformed its CAPM projections *Regression should be done against an index based on investor’s portfolio

R

e. Use weighted average of Division EV + Cash to get Company

Totalbeta=

B) MV of Operating leases: PV of lease obligations and discounted at Pre-tax cost of debt. Adjusted EBIT = Reported EBIT + Int PMT. [Assume: prin. repayment = depre of leased asset]

β L =β U + ( 1−T )

- Assumption: D/E is evenly distributed across all divisions  Beta of a firm post-merger is Market-value Weighted Average of both companies, using unlevered betas. Then, lever up using post-transaction D/E.

Returns=a+ β R M

*r = pre-tax Cost of Debt; n = Weighted Average Maturity of debt

Add MV of Conversion Option to Equity, MV of straight debt to Debt, under Capital Structure. Non-investment grade Debt; below BBB considered Junk, considered risky debt. Has beta. Adjusted Hamada Equation:

EV Sales

d. Allocated debt / Estimated equity – D/E ratio for divisions. Lever to get

βL

n

1+r ¿ ¿ 1+r ¿n ¿ BV of debt ¿+ ¿ 1 1− ¿ ¿ Est . MV of debt=PMT ¿

MV of Conver . Option ( Eq ) =MV of Con

of

division.

1) Find

Weights for WACC calculation Weights used in WACC computation should be Market values. A) MV of interest-bearing debt:

C) MV of Convertible bonds

b. Division EV * Industry Average D/D+E = Proportion of debt for divisions. Express each division’s debt as % of total debt. Multiply with Total Actual debt = Allocated debt. c. Division EV – Allocated debt = Estimated Equity for each Division

Lever up using firm’s D/E ratio to get

Returns=R f (1−β )+ β R M R ¿ ]  +ve means stock ¿ Jensen' s Alpha=a−¿ β

βU Cash 1− Firm Value

3B) Use Net Assets of division as proxy for Weighted Average to get Company

CAPM:

2

. Adjust away cash, if it skews Enterprise Value.

β EV (Correct for cash)=

Division EV = Revenue of division *

Real Discount Rate = (1+ Nominal Discount Rate / 1+ Inflation) -1 Regression Beta:

*Gradient

βU

comparable firms.

D) Survey approach  reflects hopes; not accurate Evaluation: A) Statistically-accurate, requires long time period. C) IERP is based on projections of g and dividends. More forward-looking. Assumes market pricing efficient.

Regression equation:

of comparable firms and their mean D/E ratios

Mkt equity +Debt −Cash EV = Sales Revenues

R 1+IR ¿ ¿ ¿3 ¿ D3 ¿

Financial Markets REPONSE:  Payof to uncovering negative news is high, with Option trading & Short-selling  Greater access with technology – more difficult to control information  Punishment for misleading information through dumping of stock (Volkswagen emissions)

βL

3A) Find beta of individual division. a. Obtain industry averages of

C) Implied Risk Premium approach 1. Equate current index to PV of CFs (dividend yield). Estimate g using S&P500. 2. Calculate IRR which is = expected return on stocks. 3. Implied Equity Risk Premium = Rm –Rf

Bondholders’ DEFENSE:  Restrictive covenants on corporate decisions incorporated into lending agreement;  Feature Bonds: Puttable bonds - protect from downside and sell at PAR value, Ratings sensitive bonds - compensate higher coupon for higher company risk profile  Convertible bonds - Bondholders can convert to equity-holders to gain upside

Lecture 2: Risk and Return Models + Hurdle Rates

1) Find mean

2) De-lever to get industry

|

R 1+IR ¿ ¿ ¿

( DE ) ]

*Use Marginal TR, unless Tax Exp > EBIT. Effective TR = (EBIT/ Tax Exp * Marginal TR) Bottom-up beta:

+ Longer time horizon, minimizes Std Error in estimate + Use Geometric Average to derive LT cost of equity (like CAGR) - Assumes no change in Risk aversion of investors, nor Riskiness of index - Emerging markets may not have enough data; or too short time horizon  high std error

Index value P 0=

% Change∈ EBIT /% Change ∈revenues  high earnings variability  higher beta 3. Financial leverage: Higher interest payments  earnings volatility  higher beta

β L =β U [1+ (1−T )

| Price today = Price begin (1+GA)n | MRP = GAIndex – GAT-bill | Std Error

Test for Board Independence (Calpers Test) 1) Are majority of directors “outside directors”, not holding a position in company? 2) Is Board’s Chairman independent of company? (Benefits of CEO being chair  efficiency) 3) Are compensation and audit committees composed entirely of outsiders? (COI) Others: Qualifications/experience, Independence (no COI), Tenure Outcome: Boards are now smaller, ½ outsiders, with lead independent chairman; board compensated with stocks and options, not just cash.

Modified Objective Functions: Public traded + Efficient Mkts + Protected B/H – Maximize Share Price Public traded + Inefficient Mkts + Protected B/H – Maximize S/H wealth Public traded + Inefficient Mkts + Unprotected B/H – Maximize Firm value Private – Maximize S/H wealth if B/H are protected, maximize Firm value if not

1+ In 1+ In

Lecture 3: Hurdle Rates Part II Determinants of Beta: 1. Nature of Business (Consumer Discret. – above 1; Utility – Below 1, less volatile than market) 2. Operating leverage: Fixed costs/Variable costs  nature of industry

EBIT Interest expens

Diference between Synthetic and Actual ratings Actual: 1) considers more ratios and factors, like country risk; 2) Allow for sector-wide biases in ratings; 3) Reflect normalized earnings, not one-time high EBIT

Debt Cost of Capital: YTM is return an investor will earn from holding bond to maturity If Default Risk low, YTM = Investor Expected Return; If Default Risk high, YTM overstates Investor Expected Return. Expected return of bond: rd = (1-p) YTM + p (YTM-L) P: probability of default; YTM = yield to maturity; L = expected loss rate (60%) Lecture 4: Measuring Investment Returns - Use “incremental” cash flows, not total. – Use incremental, not allocated. - Use Relevant Depreciation (Not Sunk Costs + Fixed Costs) to adjust EBIT(1-T) - WC = Current Assets – Current Liabilities

FCFEquity =EBIT (1−T )+ Dep−Cape ¿ FCFFirm= EBIT ( 1−T ) +Dep−Capex ¿ FCFFirm= FCFE + Interest expense ( 1 Net Debt Issued = (D/ D+E) * (Capex – Dep + ∆Noncash WC) Ending BV of Assets = Beginning BV – Depre + Capex Maintenance BV of Equity = BV of Assets + BV of Working Capital – BV of Debt In determining WACC for FOREIGN PROJECTS, consider: 1) Exchange rate risk - Adjust cost of capital for company’s investments in other markets. However if company has projects in a large number of countries, OR its investors are globally diversified, it may be diversifiable – ignore. 2) Political risk, esp in emerging markets. When calculating COE, using additional CRP. Measuring ROC of existing investments

Aftertax ROC=

EBIT ( 1− ( BV of debt +BV of equ

Return Spread = Aftertax ROC −WACC

Economic Value Added=Return Spread

TotalCapital=Preproject Investments + If depreciation method is straight line, can just take the average of initial investment and the salvage value to compute average book value.

Initial investment+Endin Average BV = 2 Assuming purchasing power parity:

$ R inflation t ¿ dollar inf $R )=Exch Expected exchangerate t ( dollar Net Present Value (NPV): Sum of present values of all cash flows from the project (including initial investment). Accept if NPV>0. Company will increase in value = NPV. Internal Rate of Return (IRR): The discount rate that sets the NPV=0. Percentage rate of return based upon incremental time-weighted cash flows. Accept if IRR>hurdle rate. Salvage value: Expected proceeds from selling all the investment in the project at the end of project life. Usually = BV of fixed assets + Working Capital Initial Investments: at time=0, Investment costs + Working Capital Terminal value: PV of all cash flows that occur after estimation period ends

 Stable earnings, lower bankruptcy cost, can take on more debt  More accountability and transparency, can take on more debt  More uncertainty about future funding needs, should take on less debt  Firms with high info asymmetry issue more debt, avoid selling underpriced securities Calculate Debt Maturity

2. Unlevered FV = Current MV of firm – Tax benefits of Debt + Expected Bankruptcy cost B). Estimate tax benefits (PV of all future tax savings) at diferent levels of debt. 

PV of Tax benefits=Dollar debt ×tax ra C) Estimate a probability of bankruptcy at each debt level. Multiply by cost of bankruptcy

Average Debt Maturity=

[( Maturity A∗M(including both direct and indirect) to estimate expected bankruptcy cost.

Finding the right financing mix Optimal debt ration minimizes the WACC of firm, maximizing firm value (NPV). 1) Cost of Capital Approach: Estimating Optimal WACC A. Calculate Cost of Equity for each D/E  afects levered beta B. Calculate Pretax Cost of Debt. Step 1) Use D/(D+E) × Market value of firm = $ Debt value Step 2) $ Debt x Estimated Rating’s Cost of debt = Interest Exp Step 3) EBIT / Int Exp = Interest Coverage Ratio Step 4) If Int Cov Ratio out of Synthetic Cost of Debt, use high COD. Do Step 2 again C. Calculate Cost of Capital = WACC.

Firm value=

FCF (1+g ) ∨Firm Value= WACC −g

4) Relative analysis: Compare with industry average, based on determinants, like tax rates, stability of income and amt of intangible assets. Regress debt ratios on variables to determine debt ratios. Estimate variables under consideration. Plug into cross-sectional regression and estimate predicted debt ratio.

Debt ratio=a+ b ( Tax rate) +c ( Earnings 1. Higher tax rates  Tax benefits; 2. Stable income  Lower bankruptcy costs

3. Insider ownership  Greater discipline 4. Intangible assets  Agency problems

Evaluation: Best measure depends on objective of analysis –if want to issue lot of debt, choose highest optimal ratio. Method 1, 2 and 3 are absolute – solely determined by firm’s characteristics. Method 4 is RELATIVE – benchmarked to industry.

FCFEbank = NI – Increase in Regulatory Capital or Book Equity Dividend matrix Cash surplus + poor projects – pressure to pay more dividends/do buybacks Cash surplus + good projects – flexibility in dividend policy Cash deficit + poor projects – cut dividends but real problem is investment policy Cash deficit + good projects – reduce cash payout Lecture 6 Supplementary 5 Types of Share Repurchases in US 1. Open-Market buyback: Buy at prevailing price 2. Fixed Tender price: Buy at fixed price, prorate if oversubscribe 3. Dutch auction: Firm declares # to buyback. S/H submit bids. Clearing price at last tendered 4. Targeted share repurchase: Buyback from certain shareholders 5. Transferable put right: For 5 shares owned, get 1 free put, sell stock to firm at exercise price 2 Share Repurchases in SG 1. Of-market: Equal access buyback scheme. Up to 10% total; can hold as treasury stock. 2. On-market purchase: Cap on price ≤5% average for last 5 days – reduce index volatility Reasons for Share Repurchase (Reduce E) 1. Tax – good for shareholders if dividends tax higher than capital gain 2. Signaling - signal undervaluation. 5% rule limits efectiveness in SG 3. Takeover defense: Mops up shares from holders wanting to sell 4. Earning mgmt: manage EPS (Earnings Yield> After Tax Cost Of Debt). 5. Executive Stock Options. 6. Distribute one-time gains

Other measures to combat uncertainty in project analysis: - Payback period in years - Sensitivity analysis and what-if questions - Simulations – Incorporate probabilistic estimates Equity analysis 

ROE=

Net incomeafter debt payments BV equity

, has to be larger than COE

4. Find new Firm Value with new WACC, to find the increase in firm value.

NPV∗WACC −n

1− ( 1+WACC )

=EAA

Lecture 5: Capital Structure Advantages of debt 1) Tax Shield – Interest expenses are tax-deductible, dividends are not 2) Added discipline –Mitigate agency costs for managers to undertake negative NPV projects, exercise prudence in investment decisions Disadvantages: 1) Increase expected bankruptcy cost = Probability of going bankrupt × Cost of bankruptcy (Direct + Indirect); May trigger debt covenants, higher IR on notes. Value of firm afected. 2) Agency costs of asset substitution harming BH 3) Loss of future flexibility – When borrowing reaches capacity, unable to finance in the future.  Higher marginal tax rate, lower after-tax COD, should take on more debt

2,000,000

Earnings before Buyback After-tax cost of funds

EPS # shares repurchased After-tax Cost of Debt Earnings Yield (EPS/P0)

$1.00 200,000 4%

Earnings After Buyback # sh...