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FEC521
CORPORATE FINANCE
COURSE
LECTURER
Emre Akyol, Ph.D.
emre.akyol2@gmail.com
0 533 744 38 68
2
Course Description
p
Corporate Finance is a broad area interlinked with every
decision made within a company; as every decision made has
some financial implications, and any decision which affects the
financial shape of the firm is considered as a corporate finance
decision
3
Course Description
p
The course is developed and taught in a way that the relevant
topics are first discussed in general terms and then by way of
examples that illustrate in more concrete terms how a corporate
manager might proceed in a given situation
4
Learning
g Objectives
j
define and discuss the basic characteristics of a corporation and
the objectives of the firm
explain the principles of capital budgeting and discuss common
capital budgeting pitfalls
value debt securities and calculate duration
demonstrate the use of financial statements
define and discuss capital structure, and calculate and interpret
the degree of operating leverage, financial leverage, and total
leverage
5
Learning
g Objectives
j
explain cash dividends, stock dividends, stock splits, reverse
stock splits and discuss their impact on shareholder value
define and discuss the objectives and core attributes of an
effective corporate governance system
calculate and interpret the weighted average cost of capital
(WACC)
value equities
explain the common motivations behind M&A activity, and
compare and contrast the major methods for valuing a target
company
6
The Course is towards Current and Potential
Business Consultants
Financial Analysts
y
M&A Specialists
Corporate and Commercial Bankers
Treasury Analysts and Managers
Strategic Planning Executives
Corporate Directors
CEOs & CFOs
Portfolio Managers
7
Course Material
1. Lecture Notes (Power Point Slides). Available through the
course web-page
2. Questions & Answers (Power Point Slides). Available
through the course web-page
3. Textbook: Fundamentals of Corporate Finance, Brealey,
Myers, and Marcus (BMM), Irwin/McGraw-Hill, 6th
Edition, 2009
4. Equity Research Reports. Available through the course web-
page
5. Fixed Income Research Reports. Available through the
co rse web-page
course eb page
8
ASSESSMENT / EVALUATION METHODS
1. Midterm: (40%)
2. Comprehensive Final: (60%)
9
Characteristics of a Corporation
p
10
Characteristics of a Corporation
p
11
Characteristics of a Corporation
The financial management function is usually associated with a top
officer of the firm, such as a vice president of finance or some other
chief financial officer (CFO)
The CFO oversees both the treasurers and the controllers work.
He or she is deeply involved in the financial policy making and
corporate planning. Often will have general managerial
responsibilities
p beyond
y strictly
y financial issues and may
y also be a
member of the board of directors
The controllers office handles cost and financial accounting, tax
payments, and management information systems
The treasurers office is responsible for managing the firms cash
and credit, its financial planning, and its capital expenditures
12
Goals of the Corporation
p
Possible goals of for-profit businesses
13
Goals of the Corporation
p
From the stockholders point of view, the goal of financial
management and corporate management is to maximize the
current value per share of the existing stock
Therefore, good corporate decisions increase the market value
of the shareholders equity and poor decisions decrease it.
In fact, we could have defined corporate finance as the study of
the relationship between business decisions and the value of the
stock in business.
14
Future Value of a Single
g Sum
Future value is the amount to which a current deposit will grow
over time when it is placed in an account paying compound interest
FV = PV * (1 + I/Y)N
where,
15
Future Value of a Single
g Sum
Example: Calculate the FV of a US$300 investment at the end
of 10 years if it earns an annually compounded rate of return of
8%.
16
Present Value of a Single
g Sum
PV of a single sum is todays value of a cash flow that is to be
received at some point in the future. In other words, it is the amount
of money that must be invested today, at a given rate of return over a
given period of time, in order to end up with a specified FV.
The process for finding the PV of a cash flow is known as
discounting (such that future cash flows are discounted back to the
present)
The interest rate used in the discounting process is commonly
referred to as the discount rate but mayy also be referred to as the
opportunity cost, required rate of return, and the cost of capital.
PV = FV / (1 + I/Y) N
17
Present Value of a Single
g Sum
Example: Given a discount rate of 9%, calculate the PV of a
US$1,000 cash flow that will be received in five years.
19
Net Present Value
The Net Present Value of an investment project is the sum of
the present values of all the expected incremental cash flows, the
changes in cash flows that will occur if the project is undertaken
20
Net Present Value
The following four-step procedure may be used to compute NPV:
Identify all cash inflows and cash outflows associated with the
investment
Determine the appropriate discount rate or the opportunity cost
for the investment
Using the appropriate discount rate, find the PV of all cash flows
Compute the sum of the DCFs
21
Net Present Value
For a normal project, with an initial cash outflow followed by a
series of expected after-tax cash inflows, the NPV can be calculated
as:
NPV = CFO0 + [CF1 / (1 + k)1] + [CF2 / (1 + k)2] + ............ + [CFn /
(1 + k)n]
where
CF0 = the initial investment outflow
CFn = after-tax cash flow at time n
k = required rate of return for the project
22
Net Present Value
A positive NPV project is expected to increase shareholder
wealth, while a negative NPV project is expected to decrease
shareholder wealth
NPV decision rule is to accept any project with a positive NPV,
and reject any project with a negative NPV
23
Net Present Value
Example:
Calculate the NPV of the below investments, and determine for
each investment whether it should be accepted or rejected. Assume
that the discount rate is 10%.
1)Initial cost of US$2,000 and positive cash flows of US$1,000 at
the end of year 1, US$800 at the end of year 2, US$600 at the
end of year 3, and US$200 at the end of year 4.
25
Internal Rate of Return (IRR)
To calculate IRR, one may use 1) trial-and-error method,
which is guessing IRRs until you get the right one, or 2) a
financial calculator.
The IRR decision rule: 1) determine the required rate of return
for the investment, which is usually the firms cost of capital,
but the required rate of return may be higher or lower than the
firms cost of capital depending on the specific investments
risk and the firms average investment risk, 2) if IRR > the
required rate of return, accept the investment, 3) if IRR < the
req ired rate of return,
required ret rn reject the investment.
in estment
26
Internal Rate of Return (IRR)
( )
Example:
Calculate the IRR of the below investments, and determine for each
investment whether it should be accepted or rejected. Assume that
the discount rate is 10%.
1)Initial cost of US$2,000 and positive cash flows of US$1,000 at
the end of year 1, US$800 at the end of year 2, US$600 at the
end of year 3, and US$200 at the end of year 4.
30
Discounted Payback
y Period (DPBP)
( )
The DPBP solves one of the drawbacks of PBP by discounting
cash flows, but still does not consider any cash flows beyond the
payback period.
Therefore, investment decisions should not be based on DPBP
alone.
31
Profitability
y Index ((PI))
The PI is the present value of an investments future cash flows
divided by the initial cost.
PI = PV of future cash flows / CF0 = 1 + NPV / CF0
If the NPV of an investment is positive, then the PI will be greater
than one; if the NPV is negative, then the PI will be less than one.
Therefore,
if PI > 1.0, accept the investment
if PI < 1.0, reject the investment
32
Profitability
y Index ((PI))
Example:
Calculate the PI of the below investments.
1)Initial cost of US$2,000 and positive cash flows of US$1,000 at
the end of year 1, US$800 at the end of year 2, US$600 at the
end of year 3, and US$200 at the end of year 4.
2) Initial cost of US$2,000 and positive cash flows of US$200 at
the end of year 1, US$600 at the end of year 2, US$800 at the
end of year 3, and US$1,200 at the end of year 4.
33
The Relative Advantages and Disadvantages of NPV and IRR
NPV is theoretically and practically the best method, as it is a direct
measure of the expected increase in the value of the firm. Its major
weakness is that it does not take the size of the investment into
consideration. For example, an NPV of US$1,000 is great for an
investment costing US$2,000, but not so great for an investment costing
US$2,000,000.
The major advantage of IRR is that it measures profitability as a
percentage.
p g Therefore, it pprovides information on the margin
g of safetyy
that the NPV does not. Via the IRR, one can tell how much below the
IRR the actual investment return could fall, in percentage terms, before
the
h iinvestment becomes
b uneconomic
i (has
(h a negative
i NPV).
) The
h major
j
drawbacks of the IRR are 1) the possibility of producing rankings of
mutually exclusive projects different from those from NPV analysis, 2)
the possibility of multiple IRRs, or no IRR for an investment.
34
Conflicting
g Project
j Rankings
g
The NPV and IRR may give conflicting project rankings
depending on the project sizes. The smaller project may have
a higher IRR, but the increase in the firm value (NPV) may be
small compared to the increase in the firm value (NPV) of the
larger project, even though the IRR is lower.
35
Multiple
p IRR and No IRR Problems
If the project has non-normal cash-flow pattern, meaning that
there are cash-outflows during the life or at the end of the project,
mathematically speaking 1) there may be more than one IRR, that
is, there may be more than one discount rate that will produce an
NPV equal to zero, or 2) there may be no IRR, meaning that there
is no discount rate that results in a zero NPV, while the project
might be a profitable one.
Neither of these problems can arise with the NPV method, as it
produces the theoretically correct accept / reject decisions for
projects with non-normal cash-flow patterns.
36
Replacement
p Chain - Mutually
y Exclusive Projects
j with
Different Lives
When two projects are mutually exclusive, the firm may choose
one project or the other, but not both
If mutually exclusive projects have different lives, and the
projects are expected to be replaced indefinitely as they wear out,
an adjustment needs to be made in the decision-making process,
which is called the least common multiple of lives approach
37
Replacement Chain - Mutually Exclusive Projects with Different Lives
Example: Company XYZ is planning to modernize its production
facilities. It is considering either 1) Machine A with a useful life of six years,
or 2) Machine B, which has a useful life of three years. The time lines
presented
t d below
b l show h theth cashh flows
fl andd NPVs
NPV off these
th two
t mutually
t ll
exclusive projects
Expected
p Cash Flows For Machine A ((in dollars))
0 1 2 3 4 5 6
-20,000 4,000 7,000 6,500 6,000 5,500 5,000
NPV = US$3
US$3,245.47
245 47
NPV = US$2,577.44
38
Replacement
p Chain - Mutually
y Exclusive Projects
j with Different Lives
Answer:
The NPVs indicate that Machine A should be selected as
39
Replacement
p Chain - Mutually
y Exclusive Projects
j with Different Lives
Answer:
Assuming no changes in annual cash flows and a constant cost of capital of
12%, we can compute the NPV of the two back-to-back Machine Bs as follows:
40
The Relationship Between NPV and Stock Price
As the NPV is a direct measure of the expected change in firm value, it is
also the criterion most related to stock prices. A positive NPV project
should
h ld cause a proportionate
ti t increase
i in
i a firms
fi stock
t k price.
i
Example:
Company XYZ is investing US$500mn in a new equipment. The present
value of the future expected incremental after-tax cash flows resulting
from the equipment is US$750mn. The Company XYZ has 100m shares
outstanding,
t t di withith a currentt market
k t price
i off US$45 per share.
h Assuming
A i
that the investment is a new information, and is independent of other
expectations about the company, calculate the effect of the new
investment on the value of the Company XYZ, and its stock price.
41
Features of Fixed Income Securities
42
Features of Fixed Income Securities
44
Features of Fixed Income Securities
The promises of the issuer and the right of the bondholders are
set forth in great detail in a bond
bondss indenture.
indenture
The affirmative covenants set forth activities that the
borrower promises to do, such as paying interest and principal on
a timely basis.
Negative covenants set forth certain limitations and restrictions
on the borrowers activities, such as imposing limitations on the
borrowers ability to incur additional debt unless certain tests are
satisfied. Another example could be a limitation on the amount of
dividend to be paid to stockholders.
45
Features of Fixed Income Securities
46
Features of Fixed Income Securities
The par value (principal value, face value, redemption value, maturity
value) of a bond is the amount that the issuer agrees to repay the
bondholder at the maturity date
date.
As bonds have different par values, the practice is to quote the price of
a bond as a percentage of its par value. A value of 100 means, 100% of
par value. So, for example, if a bond has a par value of US$1,000 and
the issue is selling for US$900, this bond would be selling at 90. If a
bond with a par value of US$5,000
$ is selling for US$5,500,
$ the bond is
said to be selling for 110.
When a bond trades below its par value, it is said to be trading at a
discount.
When a bond trades above its par value, it is said to be trading at a
premium.
47
Features of Fixed Income Securities
The coupon rate (nominal rate), is the interest rate that the
issuer agrees to pay each year.
Th annuall amountt off the
The th interest
i t t paymentt made
d to
t
bondholders during the term of the bond is called the coupon,
which is determined by multiplying the coupon rate by the par
value of a bond, such as:
For example, a bond with a 12% coupon rate and a par value of
US$1,000 will pay annual interest (coupon) of US$120 ( =
US$1,000 x 0.12).
48
49
Features of Fixed Income Securities
50
Features of Fixed Income Securities
51
Risks Associated with Investing in Bonds
Interest Rate Risk
Yield Curve Risk
Prepayment Risk
Call Risk
C di Risk
Credit Ri k
Liquidity Risk
Currency Risk
Inflation Risk
Volatility Risk
Event Risk
Sovereign
g Risk
52
Risks Associated with Investing in Bonds
Interest rate risk, which is generally considered as the major
risk a fixed income security investor faces, refers to the effect of
changes in the prevailing market rate of interest on bond values,
such that bond values fall, when interest rates rise.
Thi is
This i the
h source off interest
i rate risk
i k which
hi h is
i approximated
i d by
b
a measure called duration.
For example,
example suppose investor X purchases a 12% coupon 10
10-
year bond at a price equal to par (100). If the market interest rate
rises to 13% when the investor X wants to sell this bond,
bond as the
coupon rate is fixed, he/she will have to sell the bond at a
discount,, meaning
g at a pprice below 100.
53
Risks Associated with Investing in Bonds
54
Risks Associated with Investing in Bonds
Call risk arises when a bond includes a provision that allows the
issuer to retire, or call, all or part of the issue before the maturity date;
and there are three major disadvantages of this feature from the
investors perspective:
1) The cash-flow pattern of a callable bond is not known with certainty
as it is not known when the bond will be called.
2) As the issuer is likely to call the bonds when the interest rates decline
below the bonds coupon rate, the investor is exposed to reinvestment
risk, such that the investor will have to reinvest the proceeds when the
bond is called, at interest rates lower than the bond
bondss coupon rate.
3) The price appreciation potential of a bond will be reduced relative to
an otherwise comparable option-free bond.
55
Risks Associated with Investing in Bonds
57
Risks Associated with Investing in Bonds
58
Risks Associated with Investing in Bonds
59
Valuation of Fixed Income Securities
Estimate the cash flows over the life of the security. For a bond, there
are two types of cash flows: 1) the coupon payments, and 2) the return
of principal.
The cash flows of a security are the collection of each periods cash flow.
In the case of a fixed income security, it does not make any difference
whether the cash flow is interest income or payment of principal.
We can identify three situations where estimating future cah flows poses
difficulties:
The principal repayment stream is not known with certainty. This category
includes bonds with embedded options. Callable bonds, mortgage-backed
securities, and asset-backed securities are examples of asset classes with
such an uncertainty.
The coupon payments are not known with certainty. With floating-rate
securities, the coupon payments may depend on the price of a commodity,
the rate of inflation over some future period,
period or market interest rates.
rates
61
Discounting the Expected Cash Flows
62
Discounting the Expected Cash Flows
Example:
Calculate
C l l t the
th value
l off a bond
b d that
th t matures
t in
i four
f years, has
h an
annual coupon rate of 10%, and has a maturity value (par value)
of US$100. The discount rate to be used is 8%.
63
Discounting the Expected Cash Flows
Example:
Calculate
C l l t the
th value
l off a bond
b d that
th t matures
t in
i four
f years, has
h an
annual coupon rate of 10%, and has a maturity value (par value)
of US$100. The discount rate to be used is 12%.
64
Present Value Properties
For a given discount rate, the further into the future a cash flow
is received, the lower its present value.
The higher the discount rate, the lower the present value.
65
Relationship between Coupon Rate, Discount Rate, and Price
Relative to Par
coupon rate < yield required by the market, therefore price <
par value (discount)
coupon rate > yield required by the market, therefore price >
ppar value (p
(premium))
66
Change in a Bonds Value as It Moves toward Maturity
At the
th maturity
t it date,
d t the
th bonds
b d value
l isi equall to
t its
it par value,
l
so over time as the bond moves toward its maturity date, its price
will move to its par value.
67
Change in a Bonds Value as It Moves toward Maturity
Example:
Now suppose th
N thatt the
th bbonds
d price
i iis iinitially
iti ll below
b l par value.
l If
the discount rate is 12%, the 4-year 10% coupon bonds value is
US$93.9253. Assuming the discount rate remains at 12%, one
year later the cash flows and the present value of cash flows
would be as below:
68
Change in a Bonds Value as It Moves toward Maturity
Example:
Consider
C id once again i the
th 4-year
4 10% coupon bbond. d Wh
When the
th
discount rate is 8%, the bonds price is US$106.6243. Suppose
that one year later, the discount rate is still 8%. There are only
three cash flows remaining since the bond is now a 3-year
security. The cash flows and the present value of the cash flows
are:
69
Change in a Bonds Value as Yields Change and It Moves
toward Maturity
Example:
Suppose that the discount rate for the 4-year 10% coupon is 8%,
so that the bond is selling for US$106.6243. One year later, the
discount rate appropriate for a 3-year 10% coupon increases from
8% to 9%. The cash flows and the present value of the cash
flows are:
70