GYAAN KOSH

TERM 3
Learning and
Development
Council, CAC

Corporate Finance
This document covers the basic concepts of Corporate
Finance covered in Term 3. The document only summarizes
the main concepts and is not intended to be an instructive
material on the subject.

Gyaan Kosh Term 3

CFIN

Learning & Development Council, CAC

Overview: The course deals with investment and financing decisions of a firm. The first half the course
is about the asset side of the firm and unde
understanding
rstanding the tools to make investment and capital
capita
budgeting decisions. The second half is about the liability and equity side of the firm and discusses
issues related to determination of optimal capital structure and method
methods used for raising capital to
finance investments.
Present Values:
Present value, also known as present discounted value, is the value on a given date of a future payment
or series of future payments, discounted to reflect the time value of money and other
othe factors such as
investment risk. Present value calculations are widely used in business and economics to provide a
means to compare cash flows at different times on a meaningful "like to like" basis.
The present value of stream of cash flows is given by

Ct is the expected cash flow in period t and rt is the discount rate

of the cash flow. The discount rate is determined by the riskiness
(non-diversifiable)
diversifiable) of the cash flow. Present values of cash flows C
with discount rate r for the various scenarios are:

Gyaan Kosh Term 3

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Learning & Development Council, CAC

Capital Budgeting:
A Capital Budget lists projects and investment that a company plans to undertake during coming years.
Firms analyze different projects and decide which one to accept through a process called Capital
Budgeting. Capital Budgeting process can be split into 2 steps as follows:
Step 1: Use incremental earnings to forecast projects future Cash Flows: Cash flow for a year is
calculated as:
al Expenditures
CF = EBIT (1 tax rate) + Depreciation & Amortization NWC Capital
Where, net working capital (NWC) is the difference between current assets and current liabilities.
When valuing a project free cash flows should be:
1. Incremental: Do not count sunk costs or cash flows that would occur even without the project
2. Operating:: Do not count financing cash flows such as interests or dividends
3. Firm-wide:
wide: Include all direct and indirect cash flows arising from the project
Key concepts to keep in mind while calculating the cash flows:
Do not include interest expenses in cash flows as they depend on leverage which is a company
decision and not specific to the project. Hence the net income calculated this way is called Unlevered
Net Income.
Net Working Capital is the difference between current assets and current liabilities.
liabiliti
We have to
include only the changes in the NWC and not the actual value while calculating the cash flows.
Always include the tax savings effects of expenses for e.g. due to depreciation. This is called the Tax
Shield.
Always include Opportunity Costt (cash flows from next best alternative) and refrain from Sunk Cost
Fallacy.
Step 2: Evaluate the Cash Flows and Project attractiveness based on some Investment criteria

Gyaan Kosh Term 3

CFIN

Learning & Development Council, CAC

CAPM:
Capital Asset Pricing Model prices systematic risks of securities. Future cash flows are uncertain; cash
flows represent the expected value and the opportunity cost of capital i.e. the discount rate must price
the risk involved. Market demands premium only for systematic or non
non-diversifiable
diversifiable part of the risk.
Idiosyncraticc or firm specific risk will even out by holding a large and well diversified portfolio.

Using historical average returns to estimate the expected returns of individual stocks gives estimation
error. Beta can be estimated from the regression of excess ret
return
urn of a stock on the return on a proxy for
the market portfolio using historical data. Estimating the market risk premium is difficult and historical
average excess return is often used. Asset beta of a levered firm with market values of debt D, and
equity E is given by the following:

Methodology using Comparables is particularly important and most widely used. Following are the
steps
Step 1: The Beta of company is a combination of Debt Beta and Equity Beta. The Beta discussed so far is
the Equity Beta. We can use equity beta of comparable companies to determine the required Equity
Beta.

Step 2: Equity beta of comparable companies need to be first Unlevered to remove effect of leverage
which is comparable company specific

Step 3: The Equity beta thus obtained needs to be Re-levered to capture the effect of leverage of the
company under consideration.

Gyaan Kosh Term 3

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Learning & Development Council, CAC

Note The above illustration establishes an important result that leverage magnifies the sensitivity to
market movements
Asset beta of a multi-division firm is the weighted average of asset beta of each division.
Capital Structure:
One of the fundamental questions of corporate finance is how a firm
should choose the proportion of debt, equity and other securities in
raising capital, thus determining the capital structure of the firm. The
owner(s) of the firm should ideally choose the capital structure that
maximizes the value of the firm.
Capital Structure in a perfect market:
Perfect markets satisfy the following 3 conditions:1. Investors and firms can trade the same set of securities at comparative
market prices equal to the present value of their future cash flow
2. There are no taxes, transaction costs, or issuance costs
3. A firms financing decisions do not alter cash flows generated by its
investments, nor do they reveal any new information about them.
In such perfect markets, Modigliani & Miller (MM) laid down the following 2 propositions:
1. The value of the firm is independent of its capital structure i.e. homemade leverage is a perfect
substitute for firm leverage and if identical firms with different capital structures have different values,
then the law of one price is violated and an arbitrage opportunity exists.
2. The cost of capital for levered equity of a firm is given by

The above assumptions of perfect markets and propositions of MM lead to the following implications:
1. Changing the capital structure of company only alters the risk of its equity and not its value.
2. The market value balance sheet of a firm shows that the market value of the assets equals the total
market value of the liabilities (i.e. debt, equity, and other securities)
3. A firm can change its capital structure at any point by issuing new securities and using the fund to
pay off its existing investors. This action would not change the value of the firm.
4. The benefit of debts lower cost of capital (as its less risky) is offset by levered equitys higher cost of
capital (since its riskier that unlevered equity), leaving the firms weighted average cost of capital
(WACC) unchanged in perfect markets:

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Learning & Development Council, CAC

5. Leverage increases the firms equity beta:

Capital Structure in an imperfect market:

So if capital structure does not affect the value of the firm, why is it that we see different amounts of
borrowings across firms with the same market value? This is because of market imperfections of taxes,
distress costs, agency costs, & asymmetric information.
Out of these imperfections, taxes are the most significant as interest payments are tax deductible,
increasing the earnings available to all investors. Thus gain available to investors is given by:
Interest tax shield = Corporate tax rate X Interest payments
Consequently, the levered value of the firm due to this tax shield is given by:

It also follows that WACC with corporate taxes is:

Given the benefit of the interest tax shield to the value of the company, it follows that every firm should
borrow as long as its EBIT is greater than the interest payments, but in reality this is not true. Why?
This is because of reasons such as financial distress costs, agency costs, agency benefits & asymmetric
information.
Bankruptcy (financial distress) is a costly process that imposes direct and indirect costs:
Direct Costs include costs of experts and advisors such as lawyers, accountants, appraisers, and
investment bankers employed during the bankruptcy process
Indirect Costs include the loss of customers, suppliers, employees or receivables during bankruptcy.
Indirect costs are usually much larger than direct costs.

Gyaan Kosh Term 3

CFIN

Learning & Development Council, CAC

Moreover, when the company faces bankruptcy agency costs may arise due to the conflict of interests
between the equity holders and the lenders. These costs could take the form of:
a) Shareholders taking on negative NPV projects with sufficient amounts of risks.
b) A firm failing to finance a positive NPV project by issuing debt.
c) Shareholders liquidating assets at a price below par to distribute proceeds as dividends.
However, leverage also has agency benefits that incentivize managers to run the firm more
efficaciously.
a) Leverage enables a company to concentrate ownership to limited number of managers, who in turn
are more likely work hard and consume less company perks.
b) Leverage reduces the likelihood of firm pursuing wasteful investments.
c) The threat of financial distress (due to debt) may commit managers to pursue strategies that improve
operations.
Given all these market imperfections, according to the tradeoff theory the value of the levered firm is

Finally, when managers have better information than investors (leading to a case of asymmetric
information), managers can use leverage to credibly signal the companys ability to generate more
future cash flows. On the other hand, as a result of information asymmetry investors would be inclined
to discount what they are willing to pay for an equity issuance, leading to adverse selection.
A note on payout policy:
When a firm wants to distribute cash to its shareholders, it can do so be either paying a dividend or
buying back shares. As per MM dividend irrelevance proposition, the firms choice of dividend
policy in a perfect market is irrelevant and does not affect its initial share price. In reality, market
imperfections such as personal dividend taxes, corporate taxes, managerial agency costs and future
growth signaling, affect the dividend policy of a firm.
1) Stock repurchases are preferred as they provide tax benefits if capital gains tax is lower than
dividends. Also firms with permanent increase in cash flow offer dividends whereas those with
temporary increases prefer repurchase as former is a commitment and the latter provides flexibility
2) Clientele affect: Based on the tax rate on Dividend and Capital gains and nature of clientele, one
policy is preferred over the other. The optimal dividend policy when the dividend tax rate exceeds
Capital gain tax rate is to pay no dividend at all.

Gyaan Kosh Term 3

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Learning & Development Council, CAC

3) Signaling Effects: Dividend and Repurchases offers different signaling to investors and based on
situations different approaches are adopted. E.g. repurchase signal management belief that stocks are
underpriced.
Takeaways on valuation from case studies
studies:
Some practical issues in determining the discount rate are:
Determining the market risk premium and risk free rate
Estimating beta and whether to use levered or unlevered beta
The premium for the size of the target company smaller the company greater the risk
The premium for the country in which the target firm operates
Accounting for other company specific risks.

A small note on IPO:

An initial public offering is when a company issues shares to
raise capital. Following are 3 IPO
O methods.
Tender offer method - results in winners curse due to
adverse selection
Book-building method - is now the norm for IPOs as it fixes
the problem of information asymmetry
IPO (Dutch) auction is vulnerable
lnerable to inaccurate pricing;
used by Google in its IPO.

POs when released are mostly underpriced. The theories explaining the rationale behind this observed
IPOs
under-pricing are:

Gyaan Kosh Term 3

The IPO process can be illustrated as

CFIN

Learning & Development Council, CAC

Gyaan Kosh Term 3

CFIN

Learning & Development Council, CAC

Appendix: Leveraged Recapitalization1

Leveraged Recapitalization is a strategy where a company takes on significant additional debt with
the purpose of either paying a large dividend or repurchasing shares. The result is a far more financially
leveraged company -- usually in excess of the "optimal" debt capacity. After the large dividend has been
paid, the market value of the shares will drop. A share is referred to as a "stub" when a financial recap
results in the decline if its price to 25% or less of its previous market value. In a successful recap the
value of the dividend plus the value of the stub exceeds the pre-recap share price.
The simplest measure of value added comes from the tax shield gained when a firm, which has debt
capacity resulting from free cash flows in excess of ongoing needs, increases its leverage. The classic
Modigliani-Miller calcuation of the present value of the tax shield is obtained by multiplying the
amount of debt by the tax rate of the firm. Other results of leverage include the disciplinary effects of
having to meet debt service payments, and the possible negative effects of the costs of financial distress.
The technique can be used, and has been used, as a "shark repellant" to ward off a hostile takeover,
actual or potential. This is done by adding debt, eliminating idle cash and debt capacity. Prospective
bidders would face the daunting task of returning the firm to leverage ratios closer to historical
industry levels. The recap may also give management a higher percentage of share ownership and
control. Although such recaps are designed as a takeover defense, a high percentage of firms that adopt
them are subsequently acquired. The technique can also be employed proactively, as a means of placing
free cash flows into shareholders' hands, and employing debt's disciplinary effect to improve
performance, thus increasing shareholder value. A related motivation is giving founder-owner liquidity.
The market response to announcements of leveraged recaps depends on whether they are defensive or
proactive. For defensive recaps, the effects are so varied -- negative as well as positive -- as to make
research results inconclusive. On average the effects seem to be positive (Gupta and Rosenthal, 1991).
Long run returns in excess of expected for proactive recaps seem to be of the order of 30%, similar to
the level in tender offers.
In the case of Sealed Air's leveraged recap, management purposefully and successfully used the
leveraged recapitalization as a watershed event, creating a crisis that disrupted the status quo and
promoted internal change, which included establishing a new objective, changing compensation
systems, and reorganizing manufacturing and capital budgeting processes. This case provides an
illustration of how financing decisions affect organizational structure, management decision making,
and firm value.
As Sealed Air suggests, the critical feature in both kinds of recaps is whether other operating
improvements are made. A key indicator of whether leverage is having the desired disciplinary effect is
the post-recap balance sheet progress. When successful, the large overhang of debt service obligations
galvanizes management to improve operational performance thus generating sufficient cash flows to
pay down the debt.

http://people.stern.nyu.edu/igiddy/levrecap.htm