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) How do Managers put their own interests over shareholders? Greenmail: Managers, under threat of takeover, buy out existing stake at a much higher price to k...

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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)' 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$jobs$à$firm’s$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$expensive$à$individual$stock’s$value$eroded$ • Overpaying$on$takeovers:$∆Firm$value$is$distributed$to$stakeholders$of$ acquired$company$ 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$ • Institutional$investors$are$more$active$in$monitoring$companies$$ Test$for$Board$Independence$(Calpers$Test)$ 1) Are$majority$of$directors$“outside$directors”,$not$holding$a$position$in$ company?$ 2) Is$Board’s$Chairman$independent$of$firm?$(Benefits$of$CEO$being$chair$à$ efficiency)$ 3) Are$compensation$and$audit$committees$composed$entirely$of$outsiders?$ Others:$Qualifications/experience,$Independence$(no$COI),$Tenure$ Outcome:$Boards$are$now$smaller,$10$is$optimum,$½$outsiders,$with$lead$ independent$chairman;$board$compensated$with$stocks$and$options,$not$just$ cash.$ Bondholders’'DEFENSE:' • Restrictive$covenants$on$corporate$decisions$incorporated$into$lending$ agreement;$ • Feature$Bonds:$Puttable'bonds$-$protect$from$downside$and$sell$at$PAR$value,$ put$the$bond$back$to$the$firm$at$face$value,$if$firm$take$actions$that$hurt$ bondholders.$ • Ratings$sensitive$Notes$-$compensate$higher$coupon$for$higher$company$risk$ profile$ • Convertible$bonds$-$Bondholders$can$convert$to$equity-holders$to$gain$upside$$$ Financial'Markets'REPONSE:'' • Payoff$to$uncovering$negative$news$is$high,$with$Option$trading$&$Short-selling$$ • Greater$access$with$technology$–$more$difficult$to$control$information$ • Punishment$for$misleading$information$through$dumping$of$stock$ Societal'REPONSE:'' • Laws$and$regulations$against$flouting$societal$norms$and$social$costs$$ • Consumers$choose$not$to$purchase$from$socially-irresponsible$firms$(Palm$oil$ firms)' 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$not$ ' Lecture'2:'Risk'and'Return'Models'+'Hurdle'Rates' CAPM$require$least$inputs.$Alternative$Models$measure$past$return$better,$but$ not$future$ Marginal'investor:'owns$a$lot$of$stock$and$trades$a$lot;$likely$to$make$next$trade.$ $ Capital'Asset'Pricing'Model:$𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑(𝑅𝑒𝑡𝑢𝑟𝑛 = 𝑅. + 𝛽(𝑅2 − 𝑅. )$ 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$correct$ à$Hurdle$Rate$for$managers$=$Riskfree$+$Risk$Premium$on$Investment$ $$ riskfree$rate$can$be$negative,$ex.$Japan$for$short$period$when$people$are$willing$ to$place$their$asset$in$bank$thinking$it$is$safer$ market$risk$premium$cannot$be$negative$ Beta$can$be$negative.$Ex:$gold$company$during$depression.$Market$is$bad$but$ people$rush$to$buy$gold$thinking$it$holds$value$ Determine'Riskfree'Rate' A)'Developed,'Mature'Country' 1.$No$default$risk$or$uncertainty$on$reinvestment$–$US$govt$Zero-coupon$bond$ 2.$Use$same$maturity$as$the$CF$being$analyzed,$generally$10$year$is$sufficient$ 3.$Issuer$from$same$country $as$where$CFs$are$derived,$to$prevent$inflation$risk $ $$$$$lower$interest$rate$=$safer,$why$Euro$choose$Germany’s$rate$as$risk$free$ B)'Emerging'Country' à'No'default-free'entity,'Govt'has'default'risk.$$$ YTM$of$SG$Govt-issued$10yr$SGD$bond$-$SG'Default'Spread$=$Risk-free$rate$in$SG$ Have$to$identify$country$default$spread$through:$1)$Moody’s$Rating’s$respective$ default$spread$2)$YTM$of$10yr$USD$bond$issued$by$SGD$-$10yr$USD$bond$issued$by$ USD$3)$Credit$Default$Swaps:$Use$the$CDS$adj$for$US$ The$above$are$nominal$rates.$Real$rates$need$to$use$inflation$adjusted$bonds,$or$ in$long$term,$approximate$to$real$GDP$growth$

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 + 𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛CDE 1 + (𝐶𝑂𝐸(𝑖𝑛(𝑆𝐺𝐷( = 1 + 𝐶𝑂𝐸(𝑖𝑛(𝑈𝑆𝐷 [( ]$ 1 + 𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛F.C. 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$the$difference.$ $ $ How$to$calculate$GA:$Price$today$=$Price$begin$(1+GA)n$$ $

MRP$=$GAIndex$–$GAT-bill$$$$$$$$$$$$$$estimated$Std$Error$= (

$ $ Division$EV$=$Revenue$division$*(

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1)Division$EV$*$ Industry$Average$D/D+E$=$ estimated$debt$for$divisions.$Express$ each$division’s$debt$as$%$of$total$debt.$Multiply$with$Total$Actual$debt$=$ Allocated$debt.$ 2)$Division$EV$–$Allocated$debt$=$Estimated$Equity$for$each$Division$ 3).$Allocated$debt$/$Estimated$equity$–$D/E$ratio$for$divisions.$Lever$to$get$𝛽v of$ each$division.$

$ Convert$to$a$nominal$foreign$Cost$of$Equity$=$(1+US$cost$of$equity)x(1+foreign$ inflation)/(1+US$inflation)-1;$ real$US$cost$of$equity=(1+US$cost$of$equity)x1/(1+US$inflation)-1$ inflation:$1+nominal$discount$rate=$(1+real$discount$rate)x(1+$inflation$rate)$ • Beta$of$a$firm$post-merger$is$Market-value$Weighted$Average$of$both$ companies,$using$unlevered$betas.$Then,$lever$up$using$post-transaction$D/E.$ $ Bottom-up$beta$for$financial$institutions:$

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3. Implied$Equity$Risk$Premium$=$Rm$–Rf$$$$$$$$$$$$$g$means$stable$growth$rate$future$ Implied'premium'usually'lower'than'historical' ' Corporate'Equity'Risk'Premium'in'one'country' (1)$all$company$face$same$country$risk:E(Return)*=Riskfree*Rate*+*β"(Mature* ERP)*+*CRP**(2) exposure is similar to other market risk: E(Return)*=Riskfree* Rate*+*β"(Mature*ERP*+*CRP);**CRP*in*1&*2,*based*either*on*locational*of* incorporation*or*weighted*average*of*CRP*it*does*business*in .*(3)*different* exposure*to*country*risk*E(Return)*=Riskfree*Rate*+*β"(Mature*ERP)*+*λCRP,* λ=*firm*%*of*revenues*domestically/*average*firm*%*of*revenue*domestically.** λ"can"also"be"achieve"through"graphs*

• Difficult$to$differentiate$operating$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$ $ Bottom-up$beta$for$non-traded$assets:$ • Use$public$comparable$firms$to$estimate$ 1)$Find$𝛽v $of$similar$public$firm$+$D/E$ratios.$Unlever$to$get$𝛽F $,$then$lever$use$ actual$D/E$ Private$Firms:$Adjust$beta$to$reflect$total$risk$rather$than$just$market$risk:$ 𝐵𝑒𝑡𝑎(𝐿𝑒𝑣𝑒𝑟𝑒𝑑( 𝑇𝑜𝑡𝑎𝑙(𝑏𝑒𝑡𝑎 = $ 𝑅d *Take$R2$(correlation$of$sector$with$market)$of$comparable$publicly$traded$firms.$$ Going$public$&$business$diversification$à$lowers$the$cost$of$equity $$ 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,$use$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$ 𝐸𝐵𝐼𝑇 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡(𝑐𝑜𝑣𝑒𝑟𝑎𝑔𝑒(𝑟𝑎𝑡𝑖𝑜 = $ 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡(𝑒𝑥𝑝𝑒𝑛𝑠𝑒 Difference$between$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$

Regression'Beta:' Regression$equation:$$ 𝑅𝑒𝑡𝑢𝑟𝑛𝑠 = 𝑎 + 𝛽 (𝑅2 $ CAPM:$$ $ 𝑅𝑒𝑡𝑢𝑟𝑛𝑠 = 𝑅. 1 − 𝛽 + 𝛽(𝑅2 $ Estimation$period$2-5$years,$return=(end$price-begin$price+dividend)/begin$price$ 𝐽𝑒𝑛𝑠𝑒𝑛′𝑠(𝐴𝑙𝑝ℎ𝑎 = 𝑎 − [𝑅. (1 − 𝛽)]$à$+ve$means$stock$outperformed$CAPM$ projection$ *Regression$should$be$done$against$an$index$based$on$investor’s$portfolio$$ *Gradient$𝛽$represents$beta$of$stock$ 𝟐

$of$comparable$firm.$

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+$Longer$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$data;$too$short$time$horizon$à$high$ std$error$ Equity$risk$premium$should$be$higher$than$Government$Bond,$cuz$riskier$ B)'Historical'Premium'Approach'-'Developing'Countries' 1.$Risk$Premium$of$country$market=$market$Risk$Premium$of$US$+$country$equity$ risk$premium(default$spread$on$country$bond$based$on$ratings)$ 2.$Risk$Premium$of$country$market$=$US$Risk$Premium$x$(SD$of$country/$SD$of$US)$ 3.$Risk$Premium$of$country$market$=$market$Risk$Premium$of$US$+$ Default$spread$ on$country$bond$x$(SD$country$equity/$SD$country$bond)$when$bond&equity$ highly$correlated$ $ C)'Implied'Risk'Premium'approach' 1. Equate$current$index$to$PV$of$CFs$(dividend$yield).$Estimate$g$using$S&P500.$$ 2. Calculate$IRR$which$is$=$expected$return$on$stocks.$$D2=D1*current$etc.$ 𝐼𝑛𝑑𝑒𝑥(𝑣𝑎𝑙𝑢𝑒(𝑃0 =

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4)$Use$weighted$average$of$Division$𝛽F $to$get$Company$𝛽F .$Lever$up$using$firm’s$ D/E$ratio$to$get$𝛽v .$Adjust$for$cash$ Divisional$Beta:$

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𝑹 $represents$the$proportion$of$market'risk.'1-𝑹 'is$firm-specific$risk.$ Diversified$investors$focus$on$market$risk,$undiversified$investor$focus$on$total$ risk.$ 1$Standard$error:68%,$2$standard$error:95%$ ' Lecture'3:'Hurdle'Rates'Part'II'

Determinants'of'Beta:' 1.$Nature$of$Business$(Consumer$Discret.$>1;$Utility$$EBIT.$Effective $TR$=$(EBIT/$Tax$Exp$*$Marginal$ TR)$ Bottom-up'beta:'' 1)$Find$mean$𝛽v $of$comparable$firms$and$their$mean$D/E$ratios$ 2)$De-lever$to$get$industry$𝛽F .$Adjust$away$cash,$if$it$skews$Enterprise$Value.$$ 𝛽F $ 𝛽wx(( 𝐶𝑜𝑟𝑟𝑒𝑐𝑡(𝑓𝑜𝑟( 𝑐𝑎𝑠ℎ) = 𝐶𝑎𝑠ℎ 1− 𝐹𝑖𝑟𝑚(𝑉𝑎𝑙𝑢𝑒

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Weights'for'WACC'calculation' Weights$used$in$WACC$computation$should$be$Market$values.$$ A)$MV$of$interest-bearing$debt:$ 1 1− 𝐵𝑉(𝑜𝑓 (𝑑𝑒𝑏𝑡 (1 + 𝑟)Š $ + 𝐸𝑠𝑡. 𝑀𝑉(𝑜𝑓(𝑑𝑒𝑏𝑡 = 𝑃𝑀𝑇 𝑟 (1 + 𝑟)Š *r$=$pre-tax$Cost$of$Debt;$n$=$Weighted$Average$Maturity$of$debt$ $ 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$asset]$(usually$off$books,$if$already$in$the$book,$no$need$to$add$back)$ *Int*PMT=*Pre-tax*cost*of*debt*×*Debt*value*(which*is*PV*of*lease*payments)* pv*of*lease*payment*=*PV*of*lease*obligation*x*cost*of*debt* Adjusted*BV*of*capital*=*original*+*PV*of*lease*obligation* Adjusted*return*of*capital*=*adjust*EBIT(1-t)/adjusted*bv*of*capital* $ MM$theorem:$relationship$between$cost$of$equity$and$debt$ $ra=$cost$of$asset,$independent$of$D/E$ratio$ C)$MV$of$Convertible$bonds$ Hybrids:$Cost$of$preferred$stock=$preferred$dividend$per$share/$market$price$per$ share,$convertible$debt$should$be$broken$up$to$different$components$ MV(of(𝐶𝑜𝑛𝑣𝑒𝑟. 𝑂𝑝𝑡𝑖𝑜𝑛( 𝐸𝑞 = (𝑀𝑉(𝑜𝑓(𝐶𝑜𝑛𝑣𝑒𝑟. 𝐵𝑜𝑛𝑑 − (𝑀𝑉(𝑜𝑓 (𝑆𝑡𝑟𝑎𝑖𝑔ℎ𝑡(𝐵𝑜𝑛𝑑$ Add$MV$of$Conversion$Option$to$Equity,$MV$of$straight$debt$to$Debt,$under$Cap$ Structure$ $ $ 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)$ ' Measuring'ROC'of'existing'investments' (𝐵𝑉)𝑇𝑜𝑡𝑎𝑙(𝐶𝑎𝑝𝑖𝑡𝑎𝑙 = 𝑃𝑟𝑒𝑝𝑟𝑜𝑗𝑒𝑐𝑡(𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡𝑠 + 𝐹𝑖𝑥𝑒𝑑(𝐴𝑠𝑠𝑒𝑡𝑠 + 𝑊𝑜𝑟𝑘𝑖𝑛𝑔(𝐶𝑎𝑝𝑖𝑡𝑎𝑙$ working$capital$can$be$not$included$ 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 + 𝐸𝑛𝑑𝑖𝑛𝑔 (𝑠𝑎𝑙𝑣𝑎𝑔𝑒(𝑣𝑎𝑙𝑢𝑒 𝐴𝑣𝑒𝑟𝑎𝑔𝑒(𝐵𝑉 = $ 2 $ 𝐸𝐵𝐼𝑇 1 − 𝑇 $ 𝐴𝑓𝑡𝑒𝑟𝑡𝑎𝑥(𝑅𝑂𝐶 = 𝐵𝑉(𝑜𝑓 (𝑑𝑒𝑏𝑡 + 𝐵𝑉(𝑜𝑓 (𝑒𝑞𝑢𝑖𝑡𝑦 − 𝐶𝑎𝑠ℎ ™š~‰„›ƒ•(…~|š $ 𝑅𝑒𝑡𝑢𝑟𝑛(𝑆𝑝𝑟𝑒𝑎𝑑 = 𝐴𝑓𝑡𝑒𝑟𝑡𝑎𝑥(𝑅𝑂𝐶 − 𝑊𝐴𝐶𝐶$ 𝐄𝐜𝐨𝐧𝐨𝐦𝐢𝐜(𝐕𝐚𝐥𝐮𝐞(𝐀𝐝𝐝𝐞𝐝 = 𝑅𝑒𝑡𝑢𝑟𝑛(𝑆𝑝𝑟𝑒𝑎𝑑 ∗ ( 𝐵𝑉(𝑜𝑓 (𝑑𝑒𝑏𝑡 + 𝑒𝑞𝑢𝑖𝑡𝑦 − 𝐶𝑎𝑠ℎ ªš~‰„›ƒ•(…~|š $ $

$ ∗ (𝑭𝑪𝑭𝑭𝒊𝒓𝒎 = 𝐸𝐵𝐼𝑇 1 − 𝑇 + 𝐷𝑒𝑝 − 𝐶𝑎𝑝𝑒𝑥 − ∆𝑁𝑜𝑛𝑐𝑎𝑠ℎ(𝑊𝐶 WC$=$Current$Assets$–$Current$Liabilities,$inventory$is$included$in$WC$ Net'Present'Value'(NPV):$Sum$of$present$values$of$all$cash$flows$from$the$ project$(including$initial$investment).$Accept$if$NPV>0$ Internal'Rate'of'Return'(IRR):'The$discount$rate$that$sets$the$NPV=0.$Percentage$ rate$of$return$based$upon$incremental$time-weighted$cash$flows.$$Accept$if$ IRR>hurdle$rate.$ Salvage'value:'Expected$proceeds$from$selling$all$the$investment$in$the$project$at$ the$end$of$project$life.$Usually$=$BV$of$fixed$assets$+$Working$Capital$ Initial'Investments:$at$time=0,$Investment$costs$+$Working$Capital$ Terminal'value:'PV$of$all$cash$flows$that$occur$after$estimation$period$ends$ $ CFA 𝐶𝐹𝐴 𝐶𝐹𝐵 𝐶𝐹𝐵 𝑁𝑃𝑉 = −8m + + ⋯+ + + ⋯ + ¹¹ 1.10 1.1 f 1.2¸ 1.2 𝐶𝐹𝐴 𝐶𝐹𝐴 𝐶𝐹𝐵 ($ = −8𝑚 + ( −( )+ 0.1( 0.1( 1.1 f 0.2((1.1f ) $ Possible'reasons'for'different'NPV'and'IRR'results:' -$Project$can$only$have$one$NPV,$but$more$than$one$IRR.$ -$NPV$likely$to$be$larger$for$“large-scale”$projects,$which$IRR%$is$higher$for$“small$ scale”$ -$NPV$assumes$intermediate$cash$flows$get$reinvested$at$the$“hurdle$rate”$$ -$IRR$assumes$intermediate$cash$flows$get$reinvested$at$IRR%$ $ $ Assuming$purchasing$power$parity:$ $𝑅 $𝑅(𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 • 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑(𝑒𝑥𝑐ℎ𝑎𝑛𝑔𝑒(𝑟𝑎𝑡𝑒•( ( ) = 𝐸𝑥𝑐ℎ𝑎𝑛𝑔𝑒(𝑟𝑎𝑡𝑒(𝑡𝑜𝑑𝑎𝑦×( ) $ 𝑑𝑜𝑙𝑙𝑎𝑟 𝑑𝑜𝑙𝑙𝑎𝑟(𝑖𝑛𝑓

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,$has$to$be$larger$than$COE$

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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.$Tax$rate$may$change$if$EBIT$cannot$absorb$ 𝐹𝐶𝐹( 1 + 𝑔 𝐹𝑖𝑟𝑚(𝑣𝑎𝑙𝑢𝑒 = (((( |(((((((( Firm(Value = (𝑀𝑉¾~†• + (𝑀𝑉~‚ƒ„•… ($ 𝑊𝐴𝐶𝐶 − 𝑔 Full'valuation'approach$$ 1.$Estimate$FCFF.$ 2.$Calculate$implied$g$in$current$market$value$(equity$value$+$debt$value).$$ 𝑔 = [ 𝐹𝑖𝑟𝑚(𝑣𝑎𝑙𝑢𝑒(×(𝑊𝐴𝐶𝐶›}¾ − F 𝐶𝐹𝐹]/((𝐹𝑖𝑟𝑚(𝑣𝑎𝑙𝑢𝑒 + F𝐶𝐹𝐹)$ 4. Find$new$Firm$Value$with$new$WACC,$to$find$the$increase$in$firm$value.$ OR'Incremental'approach' 𝐹𝑉›}¾ (𝑊𝐴𝐶𝐶›}¾ − 𝑊𝐴𝐶𝐶Š~Ò ) $ 𝐹𝑉Š~Ò − 𝐹𝑉›}¾ = (𝑊𝐴𝐶𝐶Š~Ò − 𝑔) Limitation:$1)$Static.$EBIT$is$critical$in$analysis$–$if$EBIT$change,$optimal$debt$ratio$ change$ 2)$As$debt$ratio$and$rating$changes,$indirect$bankruptcy$costs$cause$EBIT$to$be$ affected,$not$accounted$for' Repurchase'price' $ A)$Investors$are$rational$and$want$same$share$of$firm$value$as$those$who$sell,$ Increase$in$value$per$share$=$

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New$stock$price(=$repurchase$price)$=$Current$price$+$Increase$in$value$ $ B)$Investors$are$irrational$ 1.$Calculate$increase$in$Firm$Value$ 2.$#$of$shares$repurchased$=$Excess$debt$capacity$or$$$of$share$ buyback/Repurchase$price$ 3.$#$of$outstanding$shares$=$Total$-$#$of$shares$repurchased$ 4)$Increase$in$value$per$Remaining$share$=$$ ∆Firm$value$–$ [(Repurchase–$Original$Price)$x$#$shares$repurchased]/$#$remaining$ shares' Ending$BV$of$Assets$=$Beginning$BV$–$Depre$+$Capex$Maintenance$$ BV$of$Equity$=$BV$of$Assets$+$BV$of$Working$Capital$ –$BV$of$Debt$ Average$BV$of$equity$is$used$ $ 𝑭𝑪𝑭𝑬𝒒𝒖𝒊𝒕𝒚 = 𝑬𝑩𝑰𝑻(1 − 𝑇) + 𝐷𝑒𝑝 − 𝐶𝑎𝑝𝑒𝑥 − ∆𝑁𝑜𝑛𝑐𝑎𝑠ℎ(𝑊𝐶 − 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡(𝑒𝑥𝑝 ((1 − 𝑇) + D 𝑒𝑏𝑡(𝑖𝑠𝑠𝑢𝑒 − 𝐷𝑒𝑏𝑡(𝑟𝑒𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠$$ FCFF*=*EBIT*(1-t)*–*NCE,**FCFE*=*Net*Income* –*NCE*+*ΔD** Net*Income=*(EBIT-interest)(1-t) $ Net'Debt'Issued$=$(D/$D+E)$*$(Capex$–$Dep$+$∆Noncash$WC)$

2)'Enhanced'Cost'of'Capital'Approach:$Indirect$costs$of$bankruptcy$built$into$ Operating$Income$à$Estimate$drop$in$EBITDA$for$rating$$à$Adjust$interest$ coverage$ratio$à$Recalculate$cost$of$debt$ à$Recalculate$cost$of$capital.$ Seeks$ balance$between$low$COC$and$high$OI$$ Dynamic*analysis:*draw*from*a*distribution*of*operating*income*(thus* allowing*for*different*outcomes)** For$banks:$hard$to$estimate$Interest$Expenses.$Focus$on$long-term$debt$to$ calculate$interest$coverage$ratio$(for$banks$specifically),$and$use$book$value$of$ equity$capital.$Debt$capacity$pegged$to$equity$raised. Determinants'of'the'Optimal'Debt'Ratio:'' 1)$Marginal$tax$rate$–Higher$the$marginal$TR,$greater$benefit$of$borrowing$ 2)$Pre-tax$CF$return$–$Firms$that$have$more$Operating$Income$and$CFs,$relative$ to$firm$value,$should$have$higher$optimal$debt$ratios$(due$to$greater$ability$to$ take$on$debt)$ w¿bÊEÉ .$$ à$𝐶𝑎𝑠ℎ(𝑓𝑙𝑜𝑤(𝑝𝑜𝑡𝑒𝑛𝑡𝑖𝑎𝑙 = 2x (›.(~‚ƒ„•… a2x (›.(¾~†•

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Perpetuity=A/r,'Growing'Perpetuity='Expected'Cashflow'Next'year/(r-g)' 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$affected.$$$$$$$$ 2)$Agency$costs$of$asset$substitution$harming$Bold$ Holder$ 3)$Loss$of$future$flexibility$–$When$borrow$reaches$capacity,$unable$to$finance$in$ future.$$ $ à$Higher$marginal$tax$rate,$lower$after-tax$COD,$should$take$on$more$debt$ à$More$accountability$and$transparency,$can$take$on$more$debt$ à$Firms$with$high$info$asymmetry$issue$more$debt,$avoid$selling$underpriced$ securities$ Calculate'Debt'Maturity$ 𝑀𝑎𝑡𝑢𝑟𝑖𝑡𝑦É ∗ ( 𝑀𝑉É + ( 𝑀𝑎𝑡𝑢𝑟𝑖𝑡𝑦 ¿ ∗ ( 𝑀𝑉¿ 𝐴𝑣𝑒𝑟𝑎𝑔𝑒(𝐷𝑒𝑏𝑡(𝑀𝑎𝑡𝑢𝑟𝑖𝑡𝑦 = ($ 𝑀𝑉 Ê›•|}

' Finding'the'right'financing'mix' Optimal$debt$ration$minimizes$the$WACC$of$firm,$maximizing$firm$value$(NPV).$ 1)'Cost'of'Capital'Approach:$$ Estimating'Optimal'WACC' A.$Calculate$Cost$of$Equity$for$each$D/E$à$affects$levered$beta$ B.$Calculate$Pretax$Cost$of$Debt.$ Step$1)$Use$D/(D+E)$×$Market$value$of$firm$=$$$Debt$value$ Step$2)$$$Debt$x$Estimated$Rating’s$Cost$of$debt$=$Interest$Exp$ Step$3)$EBIT$/$Int$Exp$=$Interest$Coverage$Ratio$

Growth$firms$have$lower$CFs$as$%$of$firm$value$and$lower$optimal$debt$ratios.$ More$intangible$assets$à$more$agency$costs$à$lower$optimal$debt$ratio.$ 3)$Operating$risk$–Volatile$OI,$earnings$variability,$higher$unlevered$betas$à$ higher$COE.$Lower$bond$ratings,$higher$default$spread$&$COD$à$Lower$optimal$ debt$ratios$$$ 4）Risk$premium$increases,$both$COD$and$COE$increase$ 3)'Adjusted'Present'Value'Approach:$$ 𝐹𝑖𝑟𝑚(𝑣𝑎𝑙𝑢𝑒 = 𝑈𝑛𝑙𝑒𝑣𝑒𝑟𝑒𝑑(𝑓𝑖𝑟𝑚 (𝑣𝑎𝑙𝑢𝑒 + PV( 𝑇𝑎𝑥(𝑏𝑒𝑛𝑒𝑓𝑖𝑡𝑠(𝑜𝑓 (𝑑𝑒𝑏𝑡 − 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑(𝑏𝑎𝑛𝑘𝑟𝑢𝑝𝑡𝑐𝑦 (𝑐𝑜𝑠𝑡(𝑓𝑟𝑜𝑚 (𝑑𝑒𝑏𝑡 $$ A)$Estimate$unlevered$firm$value$(FV).$$ 1.$Estimate$unlevered$beta,$cost$of$equity$and$value$the$firm.$ 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$different$levels$of$debt.$ à$𝑃𝑉(𝑜𝑓 (𝑇𝑎𝑥(𝑏𝑒𝑛𝑒𝑓𝑖𝑡𝑠 = 𝐷𝑜𝑙𝑙𝑎𝑟(𝑑𝑒𝑏𝑡(×(𝑡𝑎𝑥 (𝑟𝑎𝑡𝑒($ C)$Estimate$a$probability$of$bankruptcy$at$each$debt$level.$Multiply$by$cost$of$ bankruptcy$(including$both$direct$and$indirect)$to$estimate$expected$bankruptcy$ cost.$ $$ 4)'Relative'analysis:$Compare$with$industry$average,$based$on$determinants,$like$ tax$rates,$stability$of$income$and$amt$of$intangible$assets.$$ Regress$debt$ratios$on$variables$that$you$believe$determine$debt$ratios.$Estimate$ the$firm’s$variables.$Plug$in$to$estimate$predicted$debt$ratio.$For$ex:$ 𝐸𝐵𝐼𝑇𝐷𝐴 )$ 𝐷𝑒𝑏𝑡(𝑟𝑎𝑡𝑖𝑜 = 𝑎 + 𝑏 𝑇𝑎𝑥(𝑟𝑎𝑡𝑒 + 𝑐 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠(𝑣𝑎𝑟. + 𝑑( 𝐹𝑖𝑟𝑚(𝑉𝑎𝑙𝑢𝑒 $ 1.$Higher$tax$rates$à$Tax$benefits;$$3.$Insider$ownership$à$Greater$discipline$ 2.$S table$income$à$Lower$bankruptcy$costs$$$4.$ Intangible$assets$à$Agency$ problems$ $ Evaluation:$Best$measure$depends$on$obj...