CORPORATE FINANCE NOTES CAPITAL BUDGETING 1.

Process of identifying and evaluating capital projects (cash flow to firm received over period > 1 year). 2. May be most important responsibility of finance manager: a. Involves purchase of costly LT assets with lives of many years determine firm future success b. Underlying principles applicable to other corporate decisions as working capital mgt and making strategic M&A. c. Consistent with mgts primary goal of max shareholder value. 3. Four administrative steps: a. Idea Generation Good project ideas from various sources (senior mgt, functional div, employees, sources outside company) b. Analysing Project Proposals Decision to accept/reject depends on projects expected future cash flow. Cash flow forecast must be made for each product to determine expected profitability. c. Create firm-wide capital budget Prioritize profitable projects according to cash flow timing, available coy resource, overall strategic plan. d. Monitoring decisions and conducting post-audit Compare actual to projected results. Project managers should explain if did/not match. Process only good as i/p estimates, so post-audit should identify systematic errors in forecasting process and improve coy operations. 4. Capital Budgeting Projects a. Replacement projects to maintain business Continue existing ops and if yes, whether maintain procedures/process. b. Replacement projects for cost reduction Obsolete but usable equipment should be replaced. Fairly detailed analysis needed. c. Expansion projects Grow business and involve complex decision-making process as require explicit forecast of future demand. Very detailed analysis needed. d. New product/mkt development Complex decision-making process with detailed analysis due to large amount of uncertainty. e. Mandatory projects Required by govt agency or insurance coy. Involve safety-related or environmental concerns. Generate little/no revenue but accompany new revenueproducing projects by the coy. f. Other projects Pet project of senior mgt (corporate perks) or high-risk endeavour difficult to analyse with typical methods (R&D) 5. Five key principles: a. Decisions based on cash flows i. Relevant are incremental cash flows (changes in cash flows that occur if project undertaken)

b.

c. d.

e.

ii. Sunk costs cannot be avoid even if project not undertaken. Should not be included in analysis. iii. Externalities effects of acceptance of project may have on other cash flows. Cannibalisation occurs when new project takes sale from existing project. Should subtract lost sales of existing project from expected new sales of new project. iv. Conventional cash flow pattern sign on cash flows change only once; Unconventional cash flow pattern more than on sign change. Cash flows based on opportunity costs i. Cash flows that firm will lose by undertaking project and should be considered. Eg. Firm use own land for project, should charge land cost as could be sold. Timing of cash flows i. Account for time value of money cash flows received earlier worth more. Cash flows analysed on after-tax basis i. Impact of taxes must be considered firm value based on cash flows firm can keep, not given to govt. Financing costs reflected in projects IRR i. Discount rate used in analysis is firms cost of capital (not projects). ii. Only projects with expected return more than cost of capital will increase firm value.

6. Interdependence: a. Independent Projects unrelated to each other and allow for each to be evaluated based on own profitability. b. Mutually Exclusive Only one project can be accepted. Projects compete with each other. 7. Sequencing Some projects must be undertaken in certain order so investing in one today creates opportunity to invest in others in future. 8. Funds a. Unlimited Funds Firm can undertake all projects with expected returns > cost of capital. b. Capital Rationing- Constraints on amount of capital can raise. Ration or prioritize capital expenditures with goal of achieving max increase in value for shareholders given capital. 9. NPV a. Sum of PV of all expected incremental cash flows if project undertaken. b. Discount rate used is firms cost of capital, adjusted for project risk level.

c. Positive NPV expected to increase shareholder wealth; Zero NPV has no expected effect on shareholder wealth. d. For independent projects, NPV decision rule is accept any project with +ve NPV and reject any project with ve NPV. 10. IRR a. IRR is discount rate that makes PV of expected incremental after-tax cash inflows equal to initial project cost. (PV of inflow = PV of outflow)

b. Use trial-and-error or financial calculator. c. IRR decision rule: determine required rate of return for given project (cost of capital). Note required rate may be higher/lower than cost of capital to adjust for difference in project risk and firm average project risk. If IRR > required rate, accept project. 11. Payback Period a. No. of years it takes to recover initial cost of investment. b. Measure of liquidity, so for firm with liquidity concerns, short payback period is better. c. Drawbacks: does not take into account TVM or cash flows beyond payback period (terminal/salvage value) useless as profitability measure. d. Benefit: good measure of project liquidity. Firms with limited liquidity access impose max payback period constraint then use NPV or IRR. 12. Discounted Payback Period a. No. of years to recover initial investment in present value must be greater than Payback period. b. Address drawback by discounting cash flows but does not address cash flows beyond payback period measure of liquidity not profitability. 13. Profitability Index a. PI is PV of projects future cash flows divided by initial cash outlay.

b. NPV is difference between PV of future and initial cash flows; PI is ratio of PV of future to initial cash flows. If NPV +ve, PI > 1; If NPV ve, PI < 1 c. Decision Rule: PI >1, accept project. PI < 1, reject. 14. NPV Profile a. Graph that shows projects NPV for different discount rates. b. IRR where NPV profiles intersect x-axis - where NPV = 0. c. Crossover rate Rate at which both projects NPVs are equal. d. If cash flows come later in projects life, NPV falls faster as discount rate up.

15. NPV advantage a. Direct measure of expected increase in firm value. Theoretically best method. b. Weakness: Does not consider project size. 16. IRR advantage a. Measures profitability as %, showing return on each dollar invested information on margin of safety that NPV does not. b. Weakness: (1) producing rankings of mutually exclusive projects different from NPV (2) multiple/no IRRs unconventional cash flow pattern 17. Conflicting Project Rankings a. NPV is the only acceptable criterion when ranking projects. b. Difference in Project Size. c. NPV assumes project cash flows can be reinvested at discount rate used. Realistic assumption as project cash flow used to reduce firms capital requirements IRR not realistic to assume reinvestment. 18. Method used depends on: a. Location European countries use payback as much/more than IRR and NPV. b. Coy size Larger coys use discounted cash flow techniques (NPV, IRR) c. Public vs Private Private use payback while Public use discounted cash flow. d. Mgt Education Higher education level use discounted cash flow. 19. NPV and Stock Price a. As NPV is direct measure of expected change in firm value from undertaking capital project, it is also criterion most related to stock prices. In theory, should cause proportionate increase in coys stock price. b. Change sin stock price result more from changes in expectations about firms positive NPV projects. May fall if analysts expect lower profitability.

COST OF CAPITAL 1. Weighted Average Cost of Capital (WACC)/ Marginal Cost of Capital (MCC)\ a. Cost of financing firms assets. b. Proper rate to discount CF associated with capital budgeting project. c. Based on long-run target weights. 2. Capital Components (Debt, Preferred Stock, Common Equity) a. Liabilities to finance Assets. b. Component Cost of Capital - Cost of each component i. Kd Cost of debt. Rate at which firm issue new debt. Yield to maturity on existing debt. ii. Kd (1-t) After-tax cost of debt. Interest paid on corporate debt tax deductible in many countries. iii. Kps Cost of preferred stock. iv. Kce Cost of common equity.

3. Financing departments aim to keep costs low and balance funding sources between three. Hence, investment decision based on WACC. a. Compare return on project that requires expenditure to WACC so as to decide whether undertaking project will increase firm value. b. However, since WACC reflect average risk of projects, not appropriate for all new projects. Adjust upward for greater-than-average risk. c. Also note implicit assumption that capital structure of firm remain at target structure over life of project. d. Calculate NPVs of projects using marginal cost of capital.

4. Weights calculation a. Base on firms target capital structure. ie. proportions based on market values that firm expects to achieve over time. b. Else, use current capital structure based on market values. May wish to incorporate trend if noticeable. c. Else, use industry average capital structure. 5. Marginal cost of capital (cost of raising additional capital) a. Can increase as larger amounts are invested in new projects. 6. Investment Opportunity 7. Firm take projects with IRR > cost of funds; Projects with IRR < marginal cost of additional capital should not be undertaken as will erode value to firm.

8. Cost of Debt

a. b. c. d. e.

I/R at which firms can issue new debt net of tax savings from tax deductibility of interest. Market Interest Rate (YTM) on new marginal debt, not coupon rate on existing debt. If debt not publicly trade (no YTM), use rating and maturity of existing debt to estimate. Make adjustments if debt characteristics will affect yield (eg. covenants, seniority). For firms using floating-rate, estimate long-term cost of debt using current yield curve (term structure).

9. Cost of preferred stock

10. Cost of equity capital a. Firm could avoid part of cost of common stock outstanding by using retained earnings to buy back shares of own stock. b. CAPM model: Risk-free rate is one closest to project useful life, beta is stocks risk measure. Note: does not capture country risk. c. Dividend Discount model: estimate growth rate from security analysts or sustainable growth rate. Note: Difficult to estimate future growth rate.

d. Bond Yield + Risk Premium model: Adding 3-5 % points risk premium to market yield on firms long-term debt. 11. Projects Beta is measure of its systematic/market risk. a. Used to adjust for differences between projects specific risk and firms average project risks. b. Pure-Play method: Based on equity beta of publicly traded firm engaged in similar business and risk as project. c. However, beta is function of business risks and financial structure. Greater reliance on debt financing greater equity beta. Hence, should adjust pure-play beta for leverage.

- for comparable firm

- for subject firm d. Challenges: i. Beta estimated using historical returns data. Sensitive to length of time and frequency of data. ii. Affected by index chosen to represent market return. iii. Revert toward 1 over time, so adjustment needed. iv. Upward adjustment for small-cap firms needed to reflect risk 12. Country risk premium a. Added to market risk premium in CAPM. b. Reflect increased risk associated with developing country.

13. Marginal Cost of Capital a. Cost of last new dollar of capital firm raises. b. Shows WACC for different amounts of financing. c. As firm raise additional debt, cost of debt will rise to account for additional financial risk. d. Issuing new equity is more expensive than using retained earnings due to flotation costs. 14. Break Points a. Occurs when cost of one WACC component changes.

15. Flotation costs a. Fees charged by investment bankers when company raises external equity capital. b. 2-7% of total equity capital raised, depending on offering type. c. Cannot add directly to cost of equity compute as will discount future cash flows at higher WACC to determine NPV. d. Cash outflow that occurs at initiation of project and affect project NPV by increasing initial cash outflow. correct way is adjust initial project cost.

MEASURES OF LEVERAGE 1. Leverage/Gearing amount of fixed costs a firm has. Could be operating or financing costs. a. Greater leverage greater variability of firms after-tax operating earnings and NI. b. Given change in sales greater change in operating earnings when employ operating leverage given change in operating earnings greater change in NI when employ financial leverage. 2. Business Risk risk associated with operating income. a. Combination of sales risk (uncertainty about sales) and operating (additional uncertainty about operating earnings caused by fixed operating costs) risk. 3. Financial Risk additional risk that common shareholders bear when firm use fixed cost (debt) financing interest payments. a. Greater proportion of debt in capital structure, greater the firms financial risk. 4. Degree of Operating Leverage - % change in operating income (EBIT) that results from given % change in sales.

a. For DOL at particular level of unit sales:

b. DOL is highest at low levels of sales and declines at higher levels of sales. 5. Degree of Financial Leverage Ratio of % change in NI (EPS) to % change in EBIT

a. For particular operating earnings level:

6. Degree of Total Leverage Measures sensitivity of EPS to change in sales.

7. Use of financial leverage significantly increase risk and potential reward to common stockholders. a. Interest expense rep fixed cost that reduce NI lower NI spread over smaller base of shareholder equity magnify ROE. b. Increase rate of change for ROE. c. Therefore, increase risk of default but also increase potential return for equity holder. 8. Breakeven Quantity of Sales Sale qty for which Rev equal Total Costs, NI is zero.

a. Contribution margin = Price per unit Variable Cost per unit

b. Operating BE quantity of Sales

c. Firm that choose operating and financial structures that result in greater TFC will have higher BE quantity of sales. d. Leverage magnifies effects of changes in sales on NI further sale are from BE level of sales, greater magnifying effects of leverage e. Degree of total leverage is different for every level of sales.

DIVIDENDS AND SHARE REPUCHASES 1. Cash Dividends Payments made to shareholders in cash. a. Regular Dividends Company pays portion of profits on consistent schedule. LT record of stable/increasing dividends is sign of financial stability. b. Special/Extra/Irregular Dividends Favourable circumstances allow firm to make onetime cash payment, in addition to regular dividends. Used by cyclical firms (automakers) to share profits when times are good but maintain flexibility to conserve cash when profits down. c. Liquidating Dividends Company goes out of business and distributes proceeds. Treated as return of capital and amounts over investors tax basis taxed as capital gains. 2. Dividends reduce assets and equity market value. a. Immediately after dividend paid, price of stock should drop by amount of dividend.

3. Stock Dividends & Splits increase total number of outstanding shares but value of shareholders total shares unchanged. a. Stock prices rise after split/dividend occur because split taken as +ve signal from mgt about future earnings if no good report earning follows, returns to original (splitadjusted) level b. Tend to reduce liquidity due to higher % brokerage fees on lower-priced stocks. 4. Stock Dividends Paid out in new shares of stock rather than cash. a. More shares outstanding but each worth less. b. Eg. 20% stock dividend means every shareholder gets 20% more stock. 5. Stock Splits divide each existing share into multiple shares. a. More share but price of each share drop correspondingly to number of shares created no change in owners wealth. b. Eg. 3-for-1 stock split: Each old share split into 3 new shares. c. More common than stock dividends. 6. Reverse Stock Splits a. After reverse split, fewer shares outstanding but a higher stock price offset and shareholder wealth unchanged. b. $20-$80 perceived optimal stock price per share. If less than $5 per share, view as below investment grade. Exchanges may impose minimum stock price and delist those below. Use reverse split to increase stock price. 7. Effect on Financial Ratios a. Paying cash dividend: i. decrease assets (cash) decrease liquidity ratios and increase debt-to-asset ratio. ii. Decrease shareholders equity (retained earnings) increase debt-to-equity ratio. b. Stock dividends/splits/reverse split no effect on leverage or liquidity ratios as do not change assets/shareholders equity. Only change no. of equity shares. 8. Dividend Payment Chronology a. Declaration Date Date BOD approve dividend payment. b. Ex-dividend Date First day share of stock trades without dividend. Cutoff date for receiving dividend (buy on/after, wont receive dividend). c. Holder-of-Record Date - 2 business days after (b). Date where shareholders of record to receive dividend. d. Payment Date Date dividend checks mailed out or payment electronically transferred to shareholder accounts. 9. Stocks should fall by dividend on ex-dividend date. However, due to tax, drop in price may be closer to after-tax value of dividends. 10. Share Repurchase Coy buys back shares of own common stock. a. Buy in open market Buy at prevailing market price. Authorised by BOD for certain no. of shares. Buying in open market gives flexibility to choose transaction timing.

b. Buy fixed number of shares at fixed price Make tender offer to repurchase specific no. of shares at price premium to current market. i. Shareholders may tender shares according to offer terms. If more than total, buy back pro rata amount from each shareholder. ii. Select tender offer price or use Dutch Auction to determine lowest price. c. Repurchase direct negotiation negotiate directly with largest shareholder to buy back block of shares, at premium to market price. i. Keep large block of shares from coming into market and reducing stock price / repurchase shares from potential acquirer after unsuccessful takeover attempt. ii. If pay more than market value increase in wealth for seller and decrease for remaining shareholders. 11. Share Repurchase reduce no. of outstanding shares increase EPS. a. Calculation of EPS determine on +ve/-ve effect of stock repurchase. b. Purchase with company funds reduce interest income and earnings c. Purchase with borrowed funds incur interest cost Reduce earnings directly by after-tax cost of borrowed funds. i. Increase EPS if after-tax cost of debt < earnings yield of shares before repurchase. If equal, EPS unchanged. 12. Share Repurchase also affects book value of share. a. BVPS will decrease if repurchase price > original BVPS 13. If Share Repurchase use coy own cash, can be considered alternative to cash dividend in distributing earnings. a. If tax treatment on both are same, share repurchase has same impact as cash dividend of equal amount.

WORKING CAPITAL MANAGEMENT 1. Primary sources of liquidity Sources of cash used in normal day-to-day operations. a. Cash balances Selling G&S, collect receivables, generating cash from other sources (ST investments) b. Short-Term Funding Trade credit from vendors, lines of credit from banks. c. Effective Cash flow management of collections and payments 2. Secondary sources of liquidity Liquidating ST or Long-lived assets, Negotiating debt agreements, Filing for bankruptcy and reorganising coy. a. Change coys financial structure and operations significantly. b. Indicate financial position deteriorating. 3. Drags on Liquidity a. Delay/Reduce cash inflows or Increase borrowing ones. b. Eg. Uncollected receivables and bad debts, obsolete inventory (longer to sell), tight short-term credit due to economic conditions. 4. Pulls on Liquidity a. Accelerate cash outflows.

b. Eg. Paying vendors sooner, change in credit terms that require repayment of outstanding balances. 5. Liquidity ratios used to determine firms ability to pay ST liabilities. a. Current ratio: if higher, more likely coy can pay short-term bills. If less than one, coy has negative working capital and is probably facing liquidity crisis.

b. Quick ratio/Acid-test ratio: more stringent as exclude inventories and less liquid asset.

c. Receivables Turnover: Desirable to have receivables turnover close to industry norm.

d. No. of days of receivables/ avg collection period/ avg days sales outstanding: Average no. of days it takes for customers to pay bills. Desirable to have collection period close to industry norm. i. Firms credit term important benchmark to interpret ratio. ii. Too high customers slow in paying too much capital tied up in assets. iii. Too low credit policy too rigorous hamper sales.

e. Inventory turnover: efficiency to processing and inventory management.

f.

Avg Inventory Processing Period/ No. of days of inventory: Desirable to have processing period close to industry norm. i. Too high too much capital tied up in inventory obsolete inventory ii. Too low inadequate stock on hand hurt sales.

g. Payables T/O ratio: measure of trade credit use.

h. Payables payment period/ No. of days of payables: Average amount of time it takes coy to pay bills

6. Operating Cycle Average no. of days it takes to turn raw materials into cash proceeds from sales.

7. Cash conversion/Net operating cycle length of time to turn cash investment in inventory back into cash. a. High cycles are undesirable Excessive amount of investment in working capital.

8. Aim: Ensure sufficient cash (target balance) but avoid keeping excess cash balances as interest foregone by not investing in ST securities:

9. Yield calculations for ST discount securities: a. % discount from face value

b. Discount-basis yield (Bank Discount Yield)

c. Money-market yield

10. Cash Management Objective is earn market return without taking on much risk (liquidity/default) invest in high credit and short maturity securities. a. Written investment policy statement is advised. i. Statement of purpose and objective of investment portfolio. ii. Guidelines on strategy and types of securities to use. iii. Who allowed to purchase securities, responsible for complying with coy guidelines, steps to take if guidelines not followed.

iv. Limitations on securities, credit ratings, proportions of portfolio. b. IPS evaluated on how well policy can be satisfied without taking on excessive credit/liquidity risk. 11. Managing A/R a. Aging Schedule (Can also show in % of month total)

b. Weighted Average Collection Period Avg days outstanding per dollar of receivable.

c. Evaluate trade-off between stricter credit terms (and borrower creditworthiness) and ability to make sales. 12. Inventory Management a. Trade-off: too low levels will result in lost sales due to stock-outs while too large have carrying costs. b. Comparing inventory ratios between industries or companies with different strategies can be misleading 13. A/P Management a. Payables represent source of working capital to firm. b. If pay earlier, cash used unnecessarily and interest on it sacrificed; if pay late, damage relationships with suppliers and lead to restrictive credit terms/cash purchase requirements/interest charges. c. Trade credit usually contain discount available to those who pay quickly and due date. i. Eg. 2/10 net 60 invoice paid in 20 days, 2% discount, else 60 days due. ii. Trade credit can be source of liquidity but if > cost of ST liquidity from other sources, better to pay within discount. d. Cost of not taking early payment discount (annual rate):

e. If short payables period taking advantage of discounts due to good low-cost funds available to finance working capital needs.

f.

If long payables period important buyer so can utilize A/P as source of ST funding with little cost.

14. Sources of Short-Term Funding from Banks a. Lines of credit used by large, financially sound companies. i. Uncommitted bank extends credit for certain amount but refuse to lend if circumstances change. ii. Committed/Regular/Overdraft bank extends credit that it commits to for some time (more reliable). Charge a fee, loans are less than a year, I/R stated in ST ref rate (LIBOR or US prime rate) + margin to compensate credit risk. iii. Revolving for longer term (> 1 year). Like (c), can be verified and listed in footnotes as source of liquidity. b. Bankers Acceptances guarantee from customer bank that payment will be made upon receipt of goods. i. Used by exporters who can sell this acceptance at discount to generate immediate funds. c. Factoring Actual sale of receivables at discount from face values i. Size of discount depend on how long till receivable due, creditworthiness of customer, collection history on receivable. ii. Factor buyer of receivables. Takes on responsibility to collect receivables and credit risk of portfolio. 15. Companies with weak credit may have to pledge assets as collateral for bank borrowings. a. Short-Term: Receivables (firm still services and responsible for unpaid ones), Inventory b. Long-Term: Fixed assets c. Blanket Lien gives claim to all current and future assets as collateral if primary collateral insufficient and borrowing firm defaults. 16. Sources of Short-Term Funding from Non-Banks a. May be used by small firms and those with poor credit. Cost is higher than other sources b. Commercial Paper = ST debt securities issued by large creditworthy coys. i. Sell directly to investors (direct placement) or through dealers (dealer-placed paper) for slightly lower I/R than bank.