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Corporate Finance Notes  Summative assessment – examination 2 hours 30 minutes  Formative assignment – written assignment 1500 (date to be confirmed) J. Berk and P. DeMarzo (2013), Corporate Finance, 3rd Ed, Pearson Higher Education 1.

An Introduction to Corporate Finance and Financial Markets

  

An introduction to finance and organisational goals (Berk and DeMarzo, Chp. 1 and 29) The financial objectives of the corporation, maximising shareholder wealth and share value (Berk and DeMarzo, Chapters 1 & 3) The principal-agent relationship and the separation of ownership from control

Financial decision making involves financial managers assessing alternatives  Objective is said to be shareholder wealth maximization  But has been debated (see articles by Montier 2014, Assness 2015, Jensen 2001)  HIERACHY of OBJECTIVES

 Financial decisions relating to access to funds and financial planning are central to the success of any business organisation.  Operational planning and financial planning are clearly interlinked.  The nature of the business will determine the need for short-term and longterm funds  Long-term funds are raised on the capital markets and there are essentially two main sources

1. Equity capital 2. Debt capital – borrowed funds There are three key issues in corporate finance • The investment decision • The decision on how to finance any investment • The dividend decision. Related to the above are the following • How to deal with issues raised by risk and uncertainty that pervade financial decision-making. • The extent to which markets price assets ‘correctly’. • The subject matter of corporate finance is concerned with how financial decisions within companies are taken and how the characteristics of financial markets affect that decision making process • Corporate Finance is primarily normative in that we are concerned with how decisions should be taken. The Separation of ownership from control: • A Corporation is a legal entity separate and distinct from its owners. • Management is given responsibility for running the corporation’s affairs in the shareholders’ interests. • Conflicts of interest between owners and managers. The Principle- Agent Problem: • [See Jensen and Meckling (1976)] • The principal - agent problem arises when one person (the principal) delegates responsibility to another person (the agent) • The agent is compensated by the principal • The interests of the principal and agent are not necessarily in harmony • The principal must therefore try to compensate the agent in such a way that the interests of the agent and the principal coincide. Jensen and Meckling identify the agency costs of the separation of ownership and control as the sum of: • The monitoring expenditures by the principal • The bonding expenditures by the agent • The residual loss. In essence: The assumed objective in corporate finance is to maximise shareholder wealth. But the separation of ownership from control gives rise to potential agency issues and strategies must be implemented to mitigate them

2.

The valuation of securities

Discounted cash flow approaches; bond valuation; stock valuation (Berk and DeMarzo, Chapters. 6 & 9. Pike, Neale and Linsley, Chapter 3.) The time value of money: • To meet the objective of shareholder value maximisation must take account of time value of money • Money received earlier is worth more than the same amount of money to be received at a later date because it can be profitably employed in the intervening period • The future value of a sum is;

FV V(1 i) n where V = sum invested n = number of periods invested i = period rate of interest e.g. If V = £100; n = 10; i = 10% what is the future value of £100? What happens if i = 11%? • The present value of a sum is;

Present value 

Future Val ue ( 1  i) n

What is the present value of a £1000 paid in 5 years time if i = 9%?

FV 1000  £649.93 to 2 d.p. 5 (1  i ) 1.09 5 Find the PV of £100 paid in 2 years time if i=10% PV 

Stock prices and returns • We can consider how to value a share by considering the economic or financial benefits that come from share ownership.

Example question: 3M (MMM) is expected to pay paid dividends of $1.92 per share in the coming year. You expect the stock price to be $85 per share at the end of the year. Investments with equivalent risk have an expected return of 11%. (a) What is the most you would pay today for 3M stock? (b) What dividend yield and capital gain rate would you expect at this price? P0 

Div1  P1 $1.92  $85   $78.31 (1  rE ) (1 .11) Dividend Yield 

Capital Gains Yield 

$1.92 Div1   2.45% $78.31 P0

$85.00  $78.31 P1  P0   8.54% $78.31 P0

Total Return = 2.45% + 8.54% = 10.99% ≈ 11% (c) Consider a second individual who holds the share in the company for a further year and then sells the share. What are the financial returns from holding the share are? We can consider the value of the share in year one, P 1, to be the discounted value of the dividend to be received after two years, D2, plus the discounted value of the share price to be received after two years, P2 :

Substituting into equation (1) gives: D D2 P2  P0  1  2 1  ke (1  k e ) (1  k e ) 2 What determines P2? We can use the same reasoning and continually substitute in for a future value of P. to obtain:  Dt P0  t t1 (1  k e ) The basic dividend valuation model tells us that the current share price is simply the discounted future dividend flow When D is constant: D P0  ke And the cost of equity capital is thus: That is the rate of return to shareholders is simply the ratio of the annual dividends to the share price when dividends are constant.

Constant Dividend Growth Model:

Equation (7) established the price of a security when dividend growth is constant but we can rearrange the formula to obtain ke as follows,

•

The rate of return is referred to as the cost of equity capital.

Example Question: AT&T plans to pay $1.44 per share in dividends in the coming year. Its equity cost of capital is 8%. Dividends are expected to grow by 4% per year in the future. Estimate the value of AT&T’s stock. $1.44 D $36 P0  1  ke  g 0.08  0.04

•

• •

There are alternative ways of calculating the growth rate (estimation or using the payout ratio - that do not necessarily yield the same rate of return). What are the limitations of using the constant growth formula? Possible to estimate expected returns for the entire stock market e.g. Harris and Marston, 2001, Journal of Applied Finance.

Non-Constant Growth in Dividends: • If dividends are not constant the formula has to be revised:

P • •

 D (k  g )  D1 D2 D3    4 e 3  2 3 1  ke (1  ke ) (1  ke )  (1 ke ) 

In this example it is assumed that the rate of growth of dividends is constant after three years Can calculate the rate of growth by trial and error or using historical data.

‘Home Made Dividends’: • When earnings are retained to finance growth, shareholders are foregoing dividends in the expectation of higher dividends later. • Some shareholders may rely on dividend income and may object to dividends being withheld. To overcome this problem they can sell some shares to create ‘home-made dividends’. Valuing Debt (Debenture Stock): • Debt holders have a prior claim on the assets of the company and therefore debt capital is typically lower risk and cheaper than equity capital in the same company. • The nominal yield or coupon rate is the rate of interest on the FACE value of the unit of the bond. • It is not necessarily the same as the market rate of interest. • The current yield is the nominal interest payment, expressed in pounds, divided by the current market price • The most important rate of interest from the point of view of the investor and the firm is the yield to maturity. • The yield to maturity takes account not only of the annual interest payments, but also capital repayments at maturity. • It is a measure of TOTAL return from holding the stock until maturity. The value of a bond can be calculated as:

Where: Pt is the market price of the security at time t R is the redeemable value (Face) C is the annual interest payment (coupon) i is the yield to maturity or redemption yield n is the number of periods to maturity

Bond Valuation Formula: [Berk and DeMazo Chapters 6 and 9 provide a detailed treatment of stock and bond valuation. In particular you should familiarise yourself with the use of Present Value Tables – they can cut down on the work required to calculate stock and bond prices.]

3.

Investment Decision Making Under Conditions of Certainty The Fisher (or Hirshleifer) Separation Theorem, its assumptions, relevance and validity Copeland, Weston & Shastri, Chapters 1 & 2. Lumby and Jones Ch 4 Hirshleifer, J. (1958), 'On the Theory of Optimal Investment Decision', Journal of Political Economy, August. • A main subject area of corporate finance is the study of the ways individuals and firms allocate resources through time, i.e. intertemporal choice. • Capital markets and firms have crucial roles in this process. • The individual faces the decision of how much to consume now (C0) and how much to consume in the future (C1) • The decision not to consume now is equivalent to the decision to invest • To analyse how the individual solves this problem we make a number of simplifying assumptions:  outcomes of investment are known with certainty  no transactions costs  no taxes  decision relates to one period only - i.e. beginning of period and end of period  y0 income is received at the beginning of the period and y1 income is received at the end of the period  marginal utility (MU) of consumption is positive  MU of consumption decreases as consumption increases

The Indifference Curve and its Slope: • An indifference map can be derived which has the usual properties. • The slope of the indifference curve at any point measures the individual’s rate of trade-off between C0 and C1 at that point

MRS C0 , C1 

 C1  C0

 (1  ri ) u=constant

• This can also be thought of as the individual’s subjective rate of time preference. • We can now consider the investment opportunities which the individual faces.

C1  y1  I 0 (1  rI ) • Let C0 be consumption at the beginning of the period, C1 be consumption at the end of the period, I0 be investment at the beginning of the period and r I be the rate of return on investment, which varies with the amount invested.

Production Opportunity Set:

Consumption- Investment Decision:

The Multi-Person Economy: • With many individuals there are opportunities for the exchange of intertemporal consumption between individuals • Let us assume that perfect capital markets exist: • all traders have equal and costless access to information • buyers and sellers take prices as given • no brokerage fees, transfer taxes or transactions costs • This allows individuals to borrow or lend at the market rate of interest, r • We can then show that the individual’s wealth, W0, represents the present value of current plus future income:

W0  y 0 

y1 (1 r )

• Similarly, the end of period wealth, W1, is given by:

W 1  W0 (1  r )  y 0 (1  r )  y1 Financial market line:

Bringing together the three components: the indifference curves; the production opportunity set; and the financial market line.

This shows there are two separate steps in the individual’s decision making process: 1. the optimal level of production is chosen by undertaking those investment opportunities which have a rate of return higher than the market rate of interest - the investment decision 2. the individual chooses the optimal consumption pattern by borrowing or lending up to the point where the subjective rate of time preference is equal to the market rate of interest - the consumption decision Fisher (Hershleifer) Separation Theorem • The splitting of the decision making process in this way is known as the Fisher (or Hirshleifer) Separation Theorem • The FST has the important implication that since the investment decision can be taken without information concerning investor preferences, this decision can be delegated to managers • In equilibrium:

MRS i  MRS j  - (1  r )  MRT Consumption-investment decision with multiple owners

Market imperfections and the breakdown of the separation theorem • Consider the case where the rate of interest for borrowing is greater than the rate of interest for lending • This leads to there being two financial market lines and the breakdown of the FST

Summary: • In the presence of capital markets: • Investors can reach a higher level of utility than if they are absent • The FST shows that the investment decision can be left to financial managers • The model is based on a number of simplifying assumptions and complications arise when there are, for example, multiple interest rates

4.

Investment Decisions in Practice Payback, average rate of return, net present value, internal rate of return. The implications of tax, inflation and information costs. Patterns of use of investment appraisal techniques (Berk and DeMarzo, Chapters 7 and 8)

Aims: • Understand the importance and nature of the investment decision • Appreciate the rules to be used in estimating cash flows from a project • Be able to utilise traditional and discounting techniques of investment appraisal • Be able to compare the strengths and weaknesses of the various techniques • Understand how to deal with some key practical problems which arise when appraising investment opportunities

Intro: • The investment decision is one of the key questions in corporate finance. • Derive rule(s) that enable the proper choice of investment project – increase shareholder value). • Traditional and discounting methods of appraisal – former flawed. Classification of capital expenditure: • Different forms of capital expenditure • The process of capital budgeting • Planning, Estimating, Evaluating, Selecting, Implementing, Postauditing. • Estimating the cash flows from a project •

•

Independent projects: if the cash flows of a project do not impact on whether other projects are accepted or rejected it is referred to as an independent project. Mutually exclusive projects: if a single project is to be accepted from a set of possibilities then these projects are referred to as mutually exclusive.

Techniques of capital budgeting (investment appraisal) 1. Traditional:

a. Payback. b. Accounting Rate of Return

[B&deM 7.3]

a. NPV b. IRR c. Profitability Index

[B&deM 7.1] [B&deM 7.2] [B&deM 7.5]

2. Discounting:

1. Payback – time required to recoup the initial investment. 2. Accounting rate of profit – Average accounting profit/average investment (or initial investment) 3. Net Present Value n

CFt I t (1 )  r  1 t

NPV = 

4. Internal Rate of Return n

CFt

 (1  i) t 1

t

 I 0

[Excel spreadsheet that appears on DUO provides a number of illustrations of the application of capital investment appraisal techniques and some of the issues that arise.]

Issues in investment appraisal 1. Investment Appraisal and inflation • Inflation impacts on both the cash flows of the project and the interest rates • Need to distinguish between the real interest rate and the nominal interest rate (1+RIR) x (1+INFLR) = (1+NIR) • Where RIR = real interest rate INFLR = inflation rate NIR = Nominal(market)interest rate • Thus:

1 nominal interest rate Real interest rate  1 1 inflation rate

2. Capital Rationing • Capital rationing refers to the situation where the implicit assumption within the NPV decision rule, that capital will always be available to finance acceptable projects, does not hold. • Types of capital rationing: • Hard capital rationing • Soft capital rationing • Assume: • Capital is rationed at present but will be freely available in the future. • Projects are infinitely divisible and exhibit constant returns to scale. Single period capital rationing • Investment decision: 1. Find NPV of future cash flows. 2. Express the NPV as a ratio to capital outlay. (This ratio is often called the 'benefit-cost' B-C ratio). 3. Rank projects in terms of B-C ratio. 4. Accept projects with highest B-C ratio until all capital is allocated. [See spreadsheet example] Multi-period capital rationing • Linear programming Investment Appraisal in Practice • Once the assumption of certainty/full knowledge is dropped, NPV does not provide definite decision advice. Nonetheless, use of NPV is still good managerial practice Handling risk and uncertainty in Investment Appraisal [See Handout] • Both risk and uncertainty refer to a situation where there are more possible outcomes than will actually occur • If we can identify the probability of each possible outcome we are dealing with a situation of risk. If we are unable to identify the probability of each possible outcome we are dealing with a situation of uncertainty

Methods for dealing with risk and uncertainty • Traditional methods: • Risk adjusted discount rate • Expected NPV • Sensitivity Analysis • Modern approaches: • Maximin • Maximax • Bayes-Laplace criterion • Hurwicz criterion • Minimax regret Summary • Importance of choosing the correct: • Method of investment appraisal (NPV) • Cash flows (incremental) • Discount rate • Data used in NPV calculations must be relevant and reliable • Issues arising in relation to: • Capital rationing • Risk and uncertainty [This slideshow provides an introduction to the material on capital investment appraisal. You should now read Berk and DeMarzo Chapter 7.]

5. (a) Expected Return and Risk The difference between risk and uncertainty, portfolio theory, the role of diversification in reducing risk, systematic and unsystematic risk [Berk and DeMarzo, Chapter 10] Aims:  Be aware of the importance of the risk return trade-off in asset holding  Appreciate that returns vary between and within different asset classes  Be able to calculate the expected return and risk associated with a single asset Historical rate of return  Dimson, Marsh and Staunton (2002) presents year-to-year historical rates of return for the following THREE types of financial instruments in the U.S. that offer different degrees of risk. • Treasury bills • Government bonds • Common stocks

• Where ln represents the natural logarithm of price in period t and t-1 respectively • A detailed discussion of return calculations can be found at: • http://faculty.washington.edu/ezivot/econ424/returnCalculations.pdf

What does the distribution of returns look like? 

A large enough sample drawn from a normal distribution looks like a ‘bellshaped’ curve.

Risk and return • The mean and standard deviation completely describe the normal distribution • The mean and the standard deviation provide measure of the return and risk associated with any investment • A crucial question is ‘how do investors make a choice between different investments which offer different combinations of risk and return?’

Expected Return • The mean or expected value provides a good measure of expected return N

E ( X )   pi X i   X i1

• The expected value of a variable is given by the sum of the observations weighted by their probability of occurrence. • The average return on a stock can be calculated using historical data as follows:

Risk • But what do we mean by the term risk? • Risk refers to a situation wh...