Foundations of Financial Management PDF

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IBFoundations of Financial Management2015 – 16Table of ContentsFinancial Arithmetic ....................................................................................................... Error! Bookmark not defined. Compound Growth ......................................................................

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IB1250 Foundations of Financial Management 2015 – 16

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Table of Contents Financial Arithmetic ....................................................................................................... Error! Bookmark not defined.! •!

Compound Growth ............................................................................................ Error! Bookmark not defined.!

•!

Discount Factors & Net Present Value ...............................................................................................................3!

•!

Annuity & Perpetuity ..........................................................................................................................................4!

•!

Internal Rate of Return ...................................................................................... Error! Bookmark not defined.!

Company Financing ......................................................................................................................................................7! •!

Company Finance ...............................................................................................................................................7!

•!

Rights Issue .........................................................................................................................................................9

Cost of Capital ................................................................................................................. Error! Bookmark not defined.! •!

Risk Analysis .................................................................................................... Error! Bookmark not defined.!

•!

Capital Asset Pricing Model .............................................................................................................................12!

Working Capital Management ...................................................................................... Error! Bookmark not defined. •!

Working Capital ................................................................................................................................................13!

Project Appraisal ........................................................................................................................................................18! •!

Relevant Cash Flow ..........................................................................................................................................18!

•!

Inflation .............................................................................................................................................................21!

•!

Internal Rate of Return ......................................................................................................................................22

Capital Structure ........................................................................................................................................................24! •!

Introduction .......................................................................................................................................................24!

•!

Traditional View ...............................................................................................................................................25!

•!

Modigliani & Miller (1958) ..............................................................................................................................26!

•!

Modigliani & Miller (1963) ..............................................................................................................................27

•!

Trade-off Theory ...............................................................................................................................................28

•!

Pecking Order Hypothesis ................................................................................................................................29

Dividend Policy ...........................................................................................................................................................30! Shareholder Value ......................................................................................................................................................33 Market Efficiency........................................................................................................................................................36 Exchange Rate & Risk Management .......................................................................................................................39

2

Financial Arithmetic Ø Compound(Growth( §

Invest £1 today at the risk-free interest rate of 4% per annum, compounded annually:

§

A principal amount P invested for a period of T year at interest rate R, compounded annually, will grow to -

P * (1+R) T §

If compounded M times per year at regular intervals 𝑹

P * (1 + 𝑴#) §

M*T

If compounded continuously -

P * 𝒆𝑹∗𝑻

Ø Discount(Factors(&(Net(Present(Value( §

In order to end up with £1 at the end of T years, today we need to invest only:

£1 * ( §

𝟏 𝟏)𝑹#

)𝑻

This is the Present Value of £1 that we expect to receive T years from now

3

§

In return for some initial investment I a typical capital project is expected to generate a stream of future cash flows Ct , t = 1,2…T:

§

Net Present Value of project equals:

NPV = -I +

§

𝑪𝟏 𝟏)𝑹

+

𝑪𝟐 (𝟏)𝑹)𝟐

+

𝑪

𝑪𝟑 (𝟏)𝑹)𝟑

𝑻 + ……. + (𝟏)𝑹) 𝑻

If!NPV> 0,!then!the!project!adds!value!for!the!company’s!shareholders.!Provided! capital!is!not!rationed,!company!should!undertake!the!project.!

!!!!!!!!!!!!!!#

Ø Annuity(&(Perpetuity( §

An annuity is a stream of N equal cash flows C:

§

The annuity factor AN,R is the sum of the corresponding N present value factors, calculated using R as the discount rate:

AN,R =

𝟏 𝑹

𝟏

* 𝟏 − # (𝟏)𝑹)𝑵

4

§

The present value of an annuity is the product of annual cash flow C and the annuity factor AN,R :

PV = C * AN,R §

A perpetuity is an infinite stream of equal future cash flows C:

§

The present value of a perpetuity is obtained by letting 𝑵# →#∞ in the annuity formula: 𝑪

PV = 𝑹 §

Present Value of stream of expected future cash flows is given by Gordon growth model (Growing Perpetuities):

𝑪

PV = 𝑹1𝑮 , §

R>G

Gordon growth model can be rewritten as: 𝑪

R = 𝑷𝑽 + 𝑮 Total Return = Dividend Yield + Growth 5

§

Growing Annuities:

PV = C * 𝟏 − (

𝟏)𝑮

)𝑵

𝑹1𝑮

Ø Internal(Rate(of(Return( §

Internal rate of return, IRR, is the value of the discount rate R that makes NPV = 0

§

The NPV > 0 rule for accepting capital projects is equivalent to the rule: IRR > Hurdle rate

§

The hurdle rate / opportunity cost of capital for a project is the minimum rate of return that providers of firm’s capital require from the investment

6

Company Financing Ø Sources(of(funds( Sources of Funds v Operating cash flow v Equity v Debt v Other securities

Uses of Funds v Capital Expenditure v Investment in Working Capital v Dividends v Interests v Payments to Other Securities v Δ in Cash Position (+/-)

Providers of Funds v v v v v v

Firm itself Banks Venture Capital Private Equity Crowdfunding Financial Markets Primary (IPO, Rights, Private Placements) Secondary (Stock Exchanges)

è Debt § § § § §

Promises pre-determined rate of return on regular basis (=coupon interest) and/or one final payment (=return of principal) Secured (collateral, for e.g. hose mortgage) v/s unsecured debt Senior (literally means paid first) v/s junior Fixed Rate v/s Floating (for e.g. LIBOR – 3%) Callable, Convertible, Eurobonds… è As debt is always paid first, it bears the least amount of risk è More over the interest paid on debt is tax deductible

è Equity § § §

It constitutes part of ownership of the public company, i.e. shareholders are the owners They possess limited-liability and voting rights. Bears the highest risk as equity shareholders have rights on residual claim on the cash flows of the company

7

è Preference Shares § § § § §

Hybrid between debt and equity. Preference shareholders don’t have voting rights Preference dividend paid after all the lenders but before equity dividend Not corporate-tax deductible Preference dividends can be deferred

è Warrants § §

Confer rights to buy new shares for pre-determined price for fixed period Often attached to debt as “sweetener”

è Convertibles § §

Debt with an option to convert for a fixed number of new shares in the issuing firm for a fixed period of time It is valuable, so companies can issue debt with lower coupon rate

è Rights Issues § §

Offer existing shareholders to buy M new shares for N old shares (𝑴 𝑵) Shareholders can sell their rights to avoid being worse off

8

Ø Rights(Issue(

è Assume terms of rights issue are M-for-N at I: • You can buy M new shares • at an issue price I • for every N shares you already own è N shares priced at Scum plus cash M * I are exchanged for (N+M) new shares at Sex

N * Scum + M * I = (N+M) * Sex

9

Cost of Capital Ø Risk(Analysis( §

Expected return on a safe project

E[R] =

𝑬𝑪𝑭 1𝑰𝟎 𝑰𝟎

;

E[R] = Expected return ECF = Expected Cash Flow I0 = Investment in Year 0 §

Expected return of an unsafe project

E[R] = RF + MRP ; E[R] = Expected return RF = Risk-Free Rate MRP = Market Risk Premium

10

§

Sensitivity of a Project to Market Risk

è Beta!(β)!measures!degree!to!which!returns!on!asset!‘i"’!on!an!average!move!in!step!with! returns!on!the!market!portfolio.!It!is!a!measure!of!systematic"risk:"risk!that!cannot!be! diversified!away.!

! 𝑪𝒐𝒗#(𝑹𝒊 ,𝑹𝒎 )

βi!=!

𝝈𝟐 (𝑹𝒎)

!;!

Ri = Return on the asset ‘i’ Rm = Return on Market è When the stock market rises (or falls) on average § § §

the prices of high- β securities rise (or fall) faster than the market the prices of low- β securities rise (or fall) more slowly For most UK equities, the value of β lies within 0.7 and 1.3

è If an asset is not traded on exchanges, it is rational to compare it to the similar assets (usually the same industry), having similar systematic risks. §

Securities Market Line è Graph of expected return E[R] vs. beta ( β ) is a straight line called Securities Market Line (SML):

! !

11

Ø Capital(Asset(Pricing(Model( 1. CAPM (or SML) quantifies the relationship between expected return and systematic risk for any asset (or portfolio of assets):

E[Ri]=RF +βi·(E[RM]−RF) where exposure to systematic risk is measured by asset’s βi

2. Cost of capital is rate of return required by providers of firm’s finance: • shareholders expect to earn cost of equity (rE) on their shareholdings • lenders expect to earn cost of debt (rD) on their loans

12

3. WACC equals weighted average of cost of debt and cost of equity: • weights equal to the proportions (by market value) of equity and debt financing in the company’s capital structure §

WACC is a key input to corporate financial decision-making:  • equals return on a firm’s assets required on average by providers of firm’s capital • reflects overall risk level of firm’s operations 

§

Cost of debt is reduced by corporate tax shield: interest payments on debt are tax deductible. 

13

14

Working Capital Management Ø Working(Capital( §

Working Capital consists of o Current assets: cash, highly liquid securities, stock, debtors o Current liabilities: short-term loans, trade creditors, tax liabilities, interest on medium-term and long-term debt

Net Working Capital = Current Assets - Current Liabilities §

Working Capital Management is essential because firms need liquidity to meet its shortterm obligations.

§

Working Capital Cycle -

§

As stock earns no interest unlike cash, the opportunity cost associated of holding stock has to be weighted against not having money in an interest-bearing account

§

Therefore, companies aim at holding optimal stock. Alternatively, ‘just-in-time’ management keeps no stock of inventory, but sources it as and when required

15

§

In this case the Storage costs per year: (Average Level of Stock) * (Storage Cost per Unit)

𝑸

= 𝟐 # ∗ #𝑺 §

Order costs per year: (No. of Orders per Year) * (Fixed Cost per Order)

𝑵

= 𝑸#∗ 𝑹 §

Total costs per year = Storage costs + Order Costs

𝑸

𝑵

T(Q) = 𝟐 # ∗ #𝑺 + 𝑸 # ∗ 𝑹 §

As a firm, you would want to minimise the total cost. We simply minimise T(Q) by differentiating it with respect to the quantity and equating it to zero (first order derivative, remember calculus?)

16

§

The level of quantity that minimises the total costs is called Economic Order Quantity. It is the optimal level of quantity to re-order every time

17

Project Appraisal Ø Relevant(Cash(Flows( §

Only after-tax incremental cash flows are relevant

18

§

If future cash flows are uncertain, use expected cash flows

19

v Consider this Example (taken from Lecture Slides)

20

Ø Inflation( § § §

Nominal Cash Flows C1, C2, …., CT are measured in future dates. Real Cash Flows, c1, c2, …., cT. are measured in money of today and reflect purchasing power of the future If expected annual inflation rate over next T years’ equals i, then:

cT =

𝑪𝑻 𝟏)𝒊

𝑻

21

§

Note: è Cost of labour typically inflates faster than cost of materials è Capital Allowances on new buildings and equipment are not adjusted for inflation è Can work in nominal or real terms, provided we are consistent

§ § §

If NPV>0, project is said to earn an economic rent In a perfectly competitive market, all assets are priced such that NPV = 0 Markets for real assets (e.g. product markets or labour markets) less than perfectly competitive. Economic rents occur if firm enjoys competitive advantage: è Barriers to entry (monopolies, quotas) è Special resources, special knowledge

§



Ø Internal(Rate(of(Return( §

It is the discount rate that makes NPV = 0

§

IRR rule for investment projects è Accept project if IRR > R è Reject project if IRR < R And exactly the opposite for financing project

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Why? Here’s why:

§

§

Problems with IRR – •

Borrowing or Lending: As you saw above, IRR works in different directions for investing and financing projects.

•

Mutually exclusive projects: You cannot compare two IRRs for mutually exclusive projects

•

Different horizons: IRR, if you notice is bias towards early cash inflows, i.e. it gives more weightage to earlier cash inflows (discounting factor is smaller in the first few years).

•

Multiple IRR: There could be multiple IRRs if there are both cash ‘inflows’ and ‘outflows’ in the project.

What discounted cash flows leave out? • They treat initial investment as now or never • In real life, there are subsequent opportunities to expand, contract, postpone or abandon the projects

23

Capital Structure Ø Introduction( §

The!capital!structure!of!the!firm!is!the!mix!of!different!securities!issued!by!the!firm!to! finance!its!operations:!!

! 1. 2. 3. 4. 5. 6.

Debt:!corporate!bonds,!bank!loans!! Equity:!common!stock,!private!equity!! Preference"shares" " Warrants!! Convertible"bonds"" Other"hybrid"securities""

§

Market Value vs. Cost of Capital

𝐶 𝑃𝑉 = 𝑅 • • •

R of the firm is the opportunity cost We can influence R by changing the capital structure The value of the firm depends on R/WACC

§

Leverage 𝐴𝑠𝑠𝑒𝑡𝑠 = 𝐷𝑒𝑏𝑡 + 𝐸𝑞𝑢𝑖𝑡𝑦 𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒 =

𝐷𝑒𝑏𝑡 𝐷𝑒𝑏𝑡 + 𝐸𝑞𝑢𝑖𝑡𝑦

24

Ø Traditional(View( Optimal leverage ratio: • •

Maximizes market value Minimizes WACC

Leverage increases financial risk for a firm • •

Having moderate amount debt in the capital structure is optimal as interests are tax deductible, but; The risk for shareholders is higher when debt is issued, as they have claims on residual cash flows (after lenders are paid) therefore the cost of equity (return on equity) is high with higher levels of debt.

25

Ø Modigliani(&(Miller((1958)( MM Proposition 1: VALUE OF FIRM IS INDEPENDENT OF ITS CAPITAL STRUCTURE Assumptions •

•

Financial markets are frictionless and efficient - No transaction costs - No taxes - No information asymmetry - Individuals and firms can borrow and lend at the same rate Cash flows are given - Fixed investment and operating policies of the firm - No impact of leverage on managers’ incentives

Importance of Modigliani & Miller • •

Acts as a benchmark case Can see which assumption is violated and what it implies for capital structure policy

Investors • • •

It doesn’t matter which company an investor decides to invest in (unlevered or levered), as the value is exactly the same (VU= VL) Investors can replicate firm leverage – buy unlevered firm, and borrow to replicate the effects of leverage of the firm WACC is the same for both types of firms

𝑟W =

𝐷X + # 𝐼𝑛𝑡X − 𝐷[ 𝐷[

𝑟\ =

𝐸X + # 𝐷𝑖𝑣X − 𝐸[ 𝐸[

𝑟] =

𝑉X + # 𝐹𝐶𝐹X − 𝑉[ 𝑉[

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MM Proposition 2: COST OF CAPITAL DOES NOT DEPEND ON FIRM’S CAPITAL STRUCTURE •

Expected return on equity increases with leverage – the risk to the equity holders’ increases 𝑊𝐴𝐶𝐶 = #

𝐷 𝐸 ∗ 𝑟W + ∗ 𝑟 ≡ 𝑟] 𝐷+𝐸 𝐸+𝐷 \

( Ø Modigliani(&(Miller((1963)( Now we lift some assumptions of M&M (1958) (no taxes, etc.) è Interest paid on debt is corporate-tax deductible è Annual tax subsidy = I * Tc è Assuming interest payments are the same size each year

𝑃𝑉 𝑡𝑎𝑥#𝑠ℎ𝑖𝑒𝑙𝑑 − 𝑎𝑚𝑜𝑢𝑛𝑡#𝑜𝑓#𝑡𝑎𝑥𝑒𝑠#𝑠𝑎𝑣𝑒𝑑 = 𝐷 ∗ 𝑇 𝑉 i = 𝑉 j + 𝑃𝑉(𝑇𝑆)

• • •

With tax deductibility – capital structure influences how corporate income is split ...