Summary Sheet of entire course, used for exam PDF

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Download Summary Sheet of entire course, used for exam PDF

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General Consider all Stakeholders  Shareholders (max. Stockholder Wealth) -> Agency Problem o Self-correcting: Activist investors, responsive boards, fire managers  Bondholders/Lenders (Safety vs. risk-taking) o Conflict: Dividend/Buybacks, Risk shifting, additional borrowing o Self-correcting: Covenants, Hybrid providing alignment  Society (social costs and benefits hard to estimate; asbestos) o Self-correcting: More laws, investor/customer backlash  Financial Markets (self-correction mechanism; shareholder activism) o Self-correcting: more scepticism, punishment for misleading market Bord of Directors issues  Usually not a full time job  May lack expertise and info  Might not be independent from management  Interest may be insufficiently aligned w/ shareholders  CEO might be chairman of BoD

Risk and Return Expected rate of return = possible outcome x probability of outcome occurring Measuring Risk (Stand-alone Risk: SD and exp. return, CV) Standard Deviation = Using historic data (Sample) = = risk per unit of return  CV used to compare situation where SD1>SD2 but E(k)2>E(k)1 Portfolio of inversely correlated stock -> variance cancels out r = Correlation Coefficient -> use regression to figure out correlation r = -1.0 means perfectly negatively correlated (riskless portfolio) risk is reduced, as long as r contributes more risk o b>1.0 -> greater swings v. market b smaller swings o b>0 moves with market b shift in SML) How to use: Compare E(RoR) with SML req. RoR (↑Risk aversion -> steeper SML)

Determining WACC WACC = wdkd(1-T)+weke+wpfkpf Cost of Debt (YTM (1-T)) Usually cheaper, but increases risk of financial distress and bankruptcy Components of required rate Real risk-free rate, k* function of production opps. + time preference for consumption IP Inflation Premium for exp. inflation (k*+IP = krf) DRP Default Risk Premium LP Liquidity Risk Premium (depends on size of company) MR Maturity Risk Premium (incl. Reinvestment Risk and IR/Price Risk P Sinking fund; call % of issue if IRcoupon rate -> reduces risk to bond holders (almost like amortizing loan) Secured creditors are junior only to past due property tax Yields Current Yield = Annual Coupon/Current Price Capital gains yield = Change in Price/Beginning Price Exp. Total Return = YTM = Exp(Current Yield + Capital Gains Yield) To compare Bonds: Effective annual rate = EFF% = Expect YTC on premium bonds, YTM on discount and par bonds USE FORWARD LOOKING COST OF DEBT (and nominal annual IR)

We evaluate exp. future returns vs. cost of new capital to finance project In reality: Marginal YTM, Current YTM, YTM or marginal cost of new debt is fine  For Corporate bonds, use YTM (not coupon rate) on existing bonds  Use YTC if bond is likely to be called (trades at premium) o But better to not use current or historical cost of debt  If looking to finance with new issue, use coupon rate of new issue  For bank loans, use IR on new loans (not existing ones)  Short-Term debt is usually not permanent source of financing o not incl. when estimating CoC (but part of Cap Structure) o If permanent, incl. as separate capital component USE MARGINAL TAX RATE TO CALCULATE AFTER-TAX COST OF DEBT USE MARKET VALUE OF DEBT and MARKET VALUE OF EQUITY  For bank loans, can assume Book Value = Market Value Solving for rd(1-T), with Flotation Cost using financial calc.: N= # of periods, PV=Par x (1-% Float. Cost), PMT = Coupon x (1-T), FV = Par Solve for I/YR to get rd(1-T)

Cost of Common Equity Common Equity includes New Shares and Retained Earnings  Cost of issuing new equity = req. RoR on equity + flotation cost = o KNew Stock = Dividend Growth Model (aka Dividend-Yield-Plus-Growth-Rate of DCF)

derived from (if k given, change P, -> g unch.)  Requires ks>g and g is constant. g is long-term growth rate, cannot stay high  Widely used in Asia, given immature public markets Dividend Yield = Total Rate of Return = Dividend Yield + Div. Growth Rate = Div. Yield + CG Yield Capital Gains Yield = for constant growth, CG Yield = g = Div. Growth Required Return (if Market effic.) = Total Return = Dividend Yield + CG Yield  When calculating Div. Yield and CG Yield, project CFs, discount to get P0 Then calculate Div. Yield and get CG Yield = k – Div. Yield  Higher growth: higher value, higher CG Yield  Issues o Stock must pay dividend (assumes mature stock) o g assumed to be constant, is difficult to forecast, cannot g>k  Estimating g: o Dividend growth rate = DividendT+1/DividendT – 1 o Fair, since companies do not change policy unless no choice o Else, use arithmetic/simple or geometric avg. (CAGR) (DLast/DFirst)1/N -1 o If company just started paying dividends, use industry avg. g o Use sustainable growth rate:  g = ROE x (1-Dividend pay-out Ratio) = ROE x Retention Ratio CAPM (kM used is index that matches stock characteristics)  Requires mature public market and stock price history Choosing Risk-free Rate  Risk-free rate should be in same currency as cashflows  KRF is approximated by safest debt amongst borrowers in a country  Government is usually safest borrower in a country (but can still default) o If substantial, use Govt Bond Yield – Sovereign Default (CDS) Spread  Choose current, not average rate  In theory T-Bill (more volatile) should be used, as CAPM is one-period model  In practice, T-bond (10yr) is used regardless of project life Choosing MRP  Consider Relevance: more current better, but might be more volatile o Historical data: Assume same risk-reward relationship tdy as in past  Consider Consistency: Consistent with KRF methodology and asset class, e.g. use MRP of large cap stocks when looking at large company  Caution: In practice KRF and KM does not move in tandem (investor behaviour)  Might use DDM to get required risk premium (use index div. yield and est. g); o Historical Beta  Best representation of current relationship between stock vs market returns  Requires judgement; more data pts = accurate, but market conditions change Adjusting Beta (If company matures and Beta narrows in on market avg.)  .67 x Historical Beta + .33 x (1.0) Modifying Beta through Fundamentals (Bottom-up)  Weighted avg. (Div Mkt Value/Total Mkt Value) of individual division’s Beta  Company Beta = Div1 Weight x Div1 Beta + Div2 Weight x Div2 Beta BetaLevered = BetaUnlevered x (1 + (1-T)x(D/S)) = BetaUnlevered x (1 + (1-T)x(wD/wS))

Own-Bond-Yield-Plus-Equity Risk Premium

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use avg. of CAPM and DCF ks - Bond Yield as company specific RP

Cost of Preferred Equity F= Flotation Cost as % of P, if not for WACC -> remove F  Hybrid security with par and fixed payments  No voting rights, no maturity date, right to dividends before CE  If PS got maturity, treat as bond (kPS = I/YR, VPS = PV)

WACC Only use LT Capital Components, disregard WC. Use TARGET capital structure Use MVs, especially for equity, for debt BV may be used as approx.  ↑leverage -> ↑ tax shield and ↓FCF (customers scared) -> Company Value  ↑leverage -> ↑cost of debt and equity -> MV of D, S and V V of Firm = V of unlevered firm + V of tax-shield – V of bankruptcy cost  Highest V of firm is when WACC minimized Value of firm = Only one EBIT, Perpetuity: Steps to calculate additional debt needed and equity buyback 1. Calculate new WACC, given target capital structure 2. Calculate new EV, discounting FCF with new WACC 3. Amt of debt to be issued = New EV x % of Debt – existing debt 4. New Equity Value = New EV x % of Equity 5.

 Solve for Price (Share Price at repurchase) if shares issued, change signs To analyse effect, list (before/after); comp. Value of Firm, Stock Price and WACC Other considerations  Sets managerial constraint; commits “free” cash flow -> forces discipline o If company held by large shareholders on BoD, might not be necessary  Business risk (higher if ↑Operating Lev. Or Fixed Cost) = SD of RoE(unlev.) o More volatile earnings -> higher chance of bankruptcy, shld use ↓debt o Financial leverage will add financial risk = SD of RoE – SD of RoE(unlev.) o Stand-alone risk = Business Risk + Financial Risk = SD of RoE  Consider how Ratios change (Effect on credit rating) (check at end)  Other Factors: Debt Capacity (leave slack), Desired bond rating, Biz Risk&Cycles Qualitative: Financial flex., Sales stability, managerial conservatism, control, asset structure, growth rate, profitability, taxes, market conditions, cost struc.  May use WACC of “Surrogate” if info not available. Should have: o Similar biz risk: industry, size, ops structure o Similar financial risk: leverage ratio, debt servicing ability ALL ABOVE is for COMPOSITE WACC, reflecting risk of typical, avg. project For each project and division, use unique risk-adjusted WACC WACC Factors: Markets, MRP, Tax Rates | Cap Structure, Dividend & Investment Policy

Investment Decision Tool (Capital Budgeting) Capital Budgeting: What Fixed Assets should we add? 1. Estimate Net CFs 2. Assess riskiness of CFs 3. Determine risk-adjusted WACC 4. Find NPV and/or IRR (or other criteria) and accept/reject RoR compared to Hurdle Rate (CoC)  ROI = (Current Value of Investment - Cost of Investment)/Cost of Investment o Simple and intuitive, but neglects time, risk, TVM, size  Accounting RoR = avg. annual NI/avg. Investment or Initial Investment o No TVM, arbitrary (is ARR good or not?) Payback

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Compare and choose shortest period o Info on liquidity, but no TVM, risk, Size, CF after recovery, short-sighted Discounted Payback  Same as above, but uses PV of all CF – similar issues NPV (Sum of PV of net CFs) = PV of Inflows – PV of Outflows  For independent projects: accept if NPV>0, mutually excl. -> compare NPVs o Gives bottom line of investment, Incorporates risk Calc: NPV(Discount Rate, CF0, {CF1, CF2, CF3, CF4}, {optional frequencies of CFs}) ISSUE: cannot compare projects with different lifespan Either: Choose project with higher IRR or replicate project to same life

IRR (Discount Rate that NPV=0) Break-even discount rate IRR(CF0, {CF1, CF2, CF3, CF4}, {optional CF frequencies}) Cannot be used if CFs non-normal (more than 1 sign change)  Difference between WACC and IRR is safety margin Calc: IRR(CF0, {CF1, CF2, CF3, CF4}, {optional CF frequencies})  If IRR>Discount Rate -> return is greater than cost, accept  If mutually exclusive, choose higher IRR  Does not account for size, change in WACC can create conflict with NPV  Cannot distinguish between borrowing and investment project NPV and IRR Independent projects: same decision IRR>k, means NPV>0 Mutually excl. projects: may cause conflict depending on Discount Rate Due to project size and timing of CFs, IRR favours small projects, since required investments smaller, also favours shorter payback periods MIRR (= Discount Rate which makes PV of TV of Inflows = PV of outflows) Step 1: Find PV of outflows Step 2: Find PV of inflows and compound to FV using same discount rate NPV(WACC, CF0, {CF1,…, CFN) x (1+WACC)N Step 3: Discount Sum of TV at MIRR, so that = PV of outflows TV of inflows/(1+MIRR)N = PV of outflows MIRR vs IRR  MIRR assumes reinvestment at WACC (good)  There is only one MIRR, takes care of CF timing  Both don’t account for size of project; If MIRR and NPV have conflict, use NPV Sensitivity Analysis Go through scenarios, e.g. 10% drop in sales -> how does NPV change? Capital Rationing Companies may have CapEx limit, cannot take on all NPV positive projects May use Profitability Index Independent: Accept if PI>1 Mutually Excl.: Highest PI and PI>1  Tells Profit/Dollar of investment, but cannot compare different size Project’s Cost of Capital Considerations: Stand-alone risk (var. of returns), Corporate risk (var. contributed to firm’s return, determines bankruptcy prob.), Market/Beta Risk (Effect of project on firm’s Beta) Increasing marginal Cost of Capital: As capital budget ↑, cost of capital↑, e.g. company reaches point where Debt cannot ↑, issuing equity is expensive

Returns/Net incremental CFs Only consider relevant/incremental CFs = CF w/ Project – CF wo/ Project  Include positive/negative externalities: project causes higher CF or lower CF  Do not include sunk cost  Include incremental: e.g. opportunity costs  ONLY CARE ABOUT CFs (but also opportunity costs) Consider Inflation:  Nominal CF discounted at nominal r, real CF discounted at real r  Nominal r > real r, includes inflation component  Usually: discount nominal CF at nominal r Project’s Value V = FCF discounted at WACC FCF = CF from operations - CF from Δ in WC - CF from Δ in fixed assets CF from Operations Sales Costs Incl. COGS, SG&A, etc. Depreciation Depreciation for period = = EBIT Taxes = = NOPAT = EBIT (1-T) = unlevered NI + Depreciation Add back non-cash expense = = OPERATING CF = EBIT x (1-T) + D/A = NI + D/A + Interest Exp after Tax DO NOT SUBSTRACT INTEREST EXPENSES AND DIVIDENDS for CF projection Terminal ValueT = Salvage Value: incorporate if finite project Salvage Value – Net Book Value (after depr.) = Taxable Profit Salvage Value – (Taxable Profit x T) = Net Terminal Cash Flow If Salvage Value how does NPV change? Scenario analysis: Best case, base case, worst case -> prob. Distribution Adjust WACC to reflect project risk, else will pursue mostly risky projects

Manage Current Assets

Importance: Reduction in CF from Δ in WC leads to higher FCF -> higher Value ↑ Working Capital = Use of Cash, less FCF, ↑ funding needs, ↑ funding costs NWC = CA – CL NOWC = Cash + Receivables + Inventories – Payables – Accruals (excl. ST investment and ST loans) Permanent NOWC -> NOWC at low point of cycle Temporary NOWC -> Additional NOWC as result of biz fluctuations Measuring WC Efficiency Ratio Analysis:  NWC Management -> NWC Ratio = NWC/Total Assets Overall Asset Utilization:  Asset Turnover Ratio = Sales/Avg. Total Assets  ROA = NI/Avg. Total Assets  ROE = NI/Avg. Stockholder’s Equity Compare ratios with peers or study the trend Return on Total Assets = Net Income / Avg. Total Assets (Net Profit / Net Sales) x (Net Sales / Avg. total Assets) ROA Model Net Profit Margin x Total Assets Turnover Return on Equity = Dupont ROE Model

Net Income / Avg. Owners’ Equity (Net Profit / Net Sales) x (Net Sales / Avg. Total Assets) x (Avg. Total Assets / Avg. Equity) Net Profit Margin x Total Asset Turnover x Equity Multiplier

Cash Conversion Cycle + Inventory (to Sale) Conversion = Inventories / (COGS/365) Or Days’ Inventory = 365/Inventory Turnover + Receivables Collection Period = Receivables / (Net Sales/365) Or Days’ Receivables Payables Deferral Period = (Payables + Accrued Liabilities) / Or Days’ Payables (COGS/365) RECOGNIZE Δ in Inv, AR, AP, as periods change -> Changes TOTAL ASSETS Inventory Turnover = COGS/Inv. or NS/Inv. Asset Turnover = NS/TA Days of Working Capital = (Receivables+Inventory-Payables)/Avg. Daily Sales Cash and Cash Equivalents Tool: Cash Budget (Forecast Sales, then derive each element below) 1. For Period -> Net CF = Collections – Purchases – Cash Expenses 2. Initial Cash + Net CF, compare to target cash balance of period; 3. CashStart + Net CF – Target Cash = Surplus Cash AFN = Financing Capital Needed Increase in Spontaneously Generated Funds RE of next period

Net Float = Difference in Cash on firm’s book and bank’s book 1 day deposit + 1 day for bank to clear check->2 Days Collections Float(bad) 6 days to clear written checks -> 6 Days Disbursement Float (good) Net Float = Disbursement Float – Collections Float (Ideal Float is long) Effect on WC -> Net Float x Daily Checks written = Amount of less WC needed Lengthen Float by  Ask customer to pay upfront, insist on quick payment methods for customers and use lockboxes (quicker than receiving checks at HQ)  Mail checks for payment Ratios: Current Ratio = CA/CL Quick Ratio = (CA-Inventory)/CL Accounts Receivable Optimize through credit policy; Terms of Sales (2/10, net 30 = 2% Discount if paid within 10 days, must pay in 30) Credit Standards (Character, Capital, Capacity, Conditions, Collateral) Collection Policy (Prob. Of default incr. with age of account) Ratios: DSO = Receivables/avg. Daily Sales Bad Debt/Sales AR turnover Ratio = Sales/avg. AR Aging Schedule: Breakdown of receivables by age of accounts Inventories Need to ensure sufficient to meet demand, no excess or shortage Type of costs to keep in mind Ordering Costs: Transaction costs of ordering and shipping inventory Holding Costs: Rent & Maintenance of warehouses, etc. Stock-out Costs: Opportunity cost of lost sales when low inventory Ratios: Inventory Turnover ratio= COGS/Avg. Inventory (↑ more efficient) Some companies use Sales instead of COGS Inventory Conversion Period = Avg. Inventory/COGS per day (↓ faster)

WC Policies and Managing Current Liabilities WC Policies Moderate: Match maturity of asset with maturity of financing Aggressive: Use of ST financing to finance permanent assets Conservative: Use permanent capital only (for perm. and temp. assets)

WC Policies

Factors to consider  Slope of Yield Curve: Steeper -> LT capital more expensive  Ease of raising LT capital: Easier for public companies  Financing Flexibility: ST debt fast to get, easier to repay, but needs refinancing Current Liabilities Accruals (e.g. wage accruals, tax accruals)  Cannot be controlled, interest-free loans from employees and tax authorities Unearned Revenue  Beneficial to the firm -> interest-free loan, opposite of AR Commercial Paper  Issued by large companies, slightly above T-bill rate. Cheap source of shortterm funding -> bought and held as marketable security Accounts payables (Trade Credit)  Spontaneous and easy to get, but cost might be high  Think of “discount” given as financing fee charged after discount period o 1/10, net 30 -> merchandise 99%, financing charge 1% if buyer pays till 30 Avg. AP = Total annual purchases / 365 x credit period (take net or gross dep. on period) Annualized Opportunity Cost of forgoing the discount (Nominal Cost) = Or =  Does not take into account compounding of interest -> need EAR Total Trade Credit = (Yearly purchase net of discount/365) x Credit Period Free Trade Credit = (Yearly purchase net of discount/365) x Discount Period Costly Trade Credit = Total Trade Credit – Free Trade Credit Effective Annual Rate = (1+Periodic Rate)n – 1 Periodic Rate = n= Comparing Short-term debt Types: Revolver (flexible draw down and payback) Use EAR to compare  Simple interest means annual compounding (kNOM=EAR=Interest/Par)  Interest Discount Loan (bullet payment, no interest payment): o Receive Par-Interest at T0, pay back Par at Maturity o Face Amount of loan = o Use financial calculator to solve for I/YR = EAR (if 1yr loan)  Add-on loan, means interest added to Par, then all divided by # of periods o Interest Payments = (Par + Par x nominal IR)/(# of payments)  Loan Amount = (Par + Par x nominal IR), BUT only Par is paid out T 0  Use calculator to get I/YR = periodic rate (PV=Par, FV=0)

 APR = Periodic Rate x pmts per year

->use formula above for EAR

IPO Incorporates asymmetric information as opposed to usual “efficient market” Benefit of IPO  Raise equity capital, incr. liquidity, founders diversify, VC gets exit, incr. brand and status of firm, easier to raise capital in the future, establish firm’s MV Disadvantages  Expensive admin cost (reporting & disclosure), share dilution (lower EPS), Owner’s control ↓ (new BoD members, proxy fight, hostile takeover, shareholder’s expectation, PR), ↓freedom (SEC), flotation cost, under-pricing IPO Process BoD approves -> Choose underwriter (IB), lawyer, auditor -> agree on terms with IB (firm commitment or best effort) -> register with SEC and get approval -> DD and prospectus -> Roadshow & Bookbuilding -> final prospectus -> launch IPO Note: Red herring = Prelim prospectus that does not constitute offer Factors affecting IPO  Valuation method (different prices), Market conditions, Asymmetric info, interest (demand v. supply), Winner’s curse  Info asymmetry reduced by Roadshow/Marketing, DD, Firm Commitment, IB’s relationship with investors (IB is middle man btw. Company and market) Pricing an IPO  Book-building: S...