206 Flashcards
Corp finance 3 key words
what to invest in
how to fund it
how to manage it
investing is all about
budgeting what to invest it
how to fund it is about
raising cap with d/e
how to manage it is about
managing CA/CL
agency issues is when
principles (stockholders) and agents (managers) interests not aligned
what causes agency issues
sep of control and ownership
agency costs are
losses to shareholders wealth
mitigate agency issues by
external audits, pay reviews
TVM is not
linear
CAGR
compound annual growth rate
What is CAGR?
investments annual growth rate over a given period
For NPV what is the minimum price sell
NPV not including initial cost
for NPV, a higher r means
lower NPV and higher risk
What does a flat term structure mean?
r constant
advantages of NPV (2)
- includes TVM
- looks at all cash flows
IRR assumes
all future CFs are reinvested at IRR
how to work out the inflection point of 2 projects
A-B for each CF (or B-A)
IRR advantages
easy
IRR disadvantages (5)
doesn’t account for TVM
doesn’t distinguish financing vs investment
might not exist/ might have multiple
assumes term structure is flat
size/scale/timing of mutually exclusive
IRR rules for investing
if -CFS front loaded invest if IRR>r
if -CFS back loaded invest if IRR<r
investment vs financing projects
investment
- more conventional/traditional
- buy now, generate CFS
financing
- less conventional
-receive loan today, pay later
-already set up
investment vs financing projects
investment
- more conventional/traditional
- buy now, generate CFS
financing
- less conventional
-receive loan today, pay later
-already set up
A higher IRR means
more return, more efficient
What’s scaling?
scaling up the more efficient project
Modified IRR 3)
Discounting
Reinvestment
Combination
Discounting MIRR
discount -Cfs back to 0 and = to Initial cost
Reinvestment MIRR
put all cfs (not CF0) to end of project
Combination MIRR
discount -Cfs back to 0 and = to ICost and pt all cfs not CF0 forward to end
Independent projects
Choose any
Mutually exclusive
rank/choose 1
When does NPV and IRR not give the same decision?
non-conventional CF
mutually exclusive where IC and timing of CFs are VERY different
Payback period advantages
easy
favors liquidity
disadvantages of the payback period
subjective
bias towards higher CFs early on
ignores some CFs and TVM
NPV could be -
Profitability index
ratio between generation of Cfs vs generation of cost
Advantages of PIndex
when initial investment is limited
easy
correct if independent
accounts TVM
Disadv of PIndex
problems with mutually exclusive
ignores higher NPV
Capital budgeting decision is the
investment in NCA
3 key parameters of FCFs
size, timing, risk
finance vs accounting cfs
Finance
- valuing a CFs
- what is it, timing, risk
-where are we going?
Act
- what happened, where are we now?
- place to start
Revenues, Costs and Depreciation contribute (+/-) to CFs
+-+
$1 increase in x (inc/decr) CF
inc r, inc cf
inc c, decr cf
incr dep, incr cf
Depreciation is not
a real CF
Depreciation is a ___ because
tax shelter because it reduces taxable income
EBT
Earning before tax
R-FC-FC-Dep
Tax
EBT x TR
EAT
EBT- Tax
OCF
EAT + dip
NWC
cash to run day-to-day
not consumed but employed
increase in WC is an
outflow because it is tied up and cannot be used anywhere else and does not make any returns
NWC is in
inventory on books
Income tax is a
cash outflow
Book value
is how much you can sell for from IRR
a positive externality is a
synergy and increases CF of the project
a negative externality is a
erosion and decreases CF of the project
change in NWC
NWC yesterday - NWX today
nominal
actually generated without impact of inflation
real
Cfs with adjustment for inflation
inflation
increasing prices in economy, when basket of goods (CPI) increases
What’s wrong with mutually exclusive projects with different lives?
NPV may not be accurate as to where the big CFs fall
Ways to even out project lives
Lowest common multiple life
NPV perpetuity
Equivalent Annual Annuity
LCM life
extend/replicate out to lowest common life
NPV perpetuity assumes
assumes both chains of replacement continues forever
EAA, EAC, EAV
Equivalent annual annuity, equivalent annual costs, equivalent annual value
PVIFA
PV interest factor annuity just short version of the annuits of CFS
Do you want higher/lower EAV, or EAC?
high EAV, low EAC
LCM, Perp, EAA rules have identical returns and diff
identical, all 3 give the same
diff, NPV perp is best
NPV perp and LCM give diff and EAA not appropriate
2 types of uncertainty
Direct
- binary
- diffuse
Indirect
Direct uncertainty-binary, diffuse
binary is competition investment
diffuse, consumer demand or cost of inflation
indirect
financial markets/access to cap
Sensitivity analysis
effect on NPV while changing one variable and holding the others constant
Sensitivity analysis
effect on NPV while changing one variable and holding the others constant
a changing variable for sensitivity analysis could be
market size
Scenario analysis
effect on NPV of a particular combination of assumptions
Accounting break even
sales which net profit=0
Finc break even
sales when NPV=0
Accounting vs finc break-even point for NPV
accounting NPV=(-)
finance NPV=0
finc break-even IRR
= r required
marginal cost
cost to produce 1 more unit
marginal cost is the same as
variable cost
what does the monte carlo simulation do?
models real-world uncertainty
steps of monte carlo simulation
-est cf that could occur (from given distrib and og CF) then use that to calc NPV and it does this 100 times then models them to see the sitribution of what the NPV could look like
financial option
owner has the right but not the obligation to buy something in the future for the price set today
e.g having the option to wait and invest when CFs get bigger
Real options
opportunities to vary the nature or longevity of the project
expand, abandon, delay
real options analysis disadvantages
complicated and complex to communicate with managers/shareholders
lots of theories/assumptions
could increase agency problems
decision trees are good because
they are graphical, so easy to understand
Total value of assets is
current assets + fixed assets (tang and intangible)
Total value of firm to investors
current liabilities, long-term debt, shareholders equity
Capital structure is made up of?
debt, equity
Goal of capital structure mix is to find the mixture that
minimizes WACC, maximizes firm value
A=
E+L
Value of a firm
D+E
Accounting vs finc approach for valuing a firm
acct:
on a ledge D+E=Value
finc:
V=PV of all CFs
Business risk
possibility profits could be lower
equity risk arising from firms operating activities
business risk does not inc
financing effect
business risk is influenced by
numerous factors (competition, demand, govt policy)
financial risk
equity risk from financial policy (cap structure)
financial risk means and a
additional risk on shareholders as a result of financial leverage
financial risk depends only on
type of securities issued
financial leverage
use of debt
Advantages of leverage
- higher return on equity
-higher variability in return equity
-increases opportunities
Net income
EBIT-Interest
EPS
NI/Shares number
ROE
NI/E
ROAss
EBIT/Assets
equity is the
claim on future earnings of a company
equity is the
claim on future earnings of a company
With debt if earnings are good…
we perform better than without
if EBIT<BE pt
lev not helpful
what must happen for leverage to increase ROEq? why?
ROA>Rb
the company needs to earn more from its assets (ROA) than it pays in interest on its deb
homemade leverage is the
use of personal borrowing/lending to alter leverage
homemade leverage means s..
shareholders can adjust the amount of financial leverage by borrowing/lending on their own
2 portfolios can have
un lev firm, lev ourselves
lev firm, risk free rate
capital structure assumptions
perfect markets
homogenous expectations, business risk classes
perpetual CFs
MM proposition 1 is all about
valuation
MM Prop 1
cap structure is independent in determining value of firm
MM Prop 1 equation
Vu=Vl
MM1 Prop is saying
in an efficient market, investors can just replicate perfectly the CFs between 2 different assets, if they do that the prices must be consistent with the price to replicate
MM1 Prop means firm A
can just borrow to match the cap structure of firm B
MM1 Law of one price
investor pays the same price for identical CFs
MM1 means for WACC
that it is constant across all levels of lev
MM Prop 2 is all about
cost of capital
MM2 is that
required Re arises from sources of firm risk
debt increases what type of risk? u/s?
systematic which is market risk
What happens to ROEq when lev increases?
increases as shareholders need more compensation
why are interest payments lit comp to divs?
they are tax deductible where as divs are not
more interest means,
less taxable income
with taxes taken into account what is the value of a levered firm
Vl=Vu+tB
in a no tax world and markets are efficient what does this mean for us?
investors can arbitrage and prices sort themselves out, Vu=Vl, which means WACC is constant, this means cost of eq increases and then financial risk increases, business risk increases
in the tax world due to the tax shield what happens to cost of debt
cost of debt decreases, WACC decreases and hence, firm value increases
WACC is the
cost of capital and it reflects how the firm is funded
Critique for MM
personal tax disadvantages of debt makes corporate tax advantages ineffective
borrowers incur costs (bankruptcy and agency costs) which offset value on interest tax shield
Bankruptcy is when __ much of the firm is in debt
nearly 100%
Direct and indirect costs of bankruptcy
direct: lawyer’s fees
indirect: loss of opportunities from business
costs associated with bankruptcy affect firm value how?
lower
agency costs of debt
conflict that arises between shareholders and debtholders
3 selfish strategies of a stockholder within agency costs of debt
1) take larger risks
- Shareholders invest in NPV (-) that destroys the value of bondholders and boosts eq
2) underinvestment
- don’t want to invest their own money to boost debtholders
3) milking out
- takes eq money out in the form of more dividends leaving less for debt holders
2 ways to decrease costs of financial distress
protective convenants
debt consolidation
Protective convenants
+
keep biz running at min level
-
agreement for d/e holders to limit actions a firm can take (mergers)
debt consolidation
taking out a loan to pay off debt
static trade-off theory of capital structure
there is a trade-off between the tax advantage of debt and the costs of financial distress, only to a pt
is there an optimal pt where cap structure max value, min WACC?
yes
in a static world this an optimal __
B*
optimal capital structure is __ and firm is __
static but dynamic
taxes and bankruptcy costs are just
other claims on CFs of a firm, more pieces of pie
Agency costs of d/e ratio
work harder with debt, less FCF (paid out as divs) for managers to waste
Tax benefit and decreased agency costs of eq advantage of debt
- int payments are tax deducible meaning less taxable income
- Increased divs means less FCF for managers to waste
bankruptcy costs and agency costs of debt disadvantage of debt
- if firm cannot meet obligations then more financial distress
- managers hurt bondholders and boost eq holders (selfish strategies)
personal taxes mean eq income faces but int payments are
2x taxation (firms and shareholders)
only taxed individually
MM and personal taxes mean that corporate tax benefits of
lev are partially offset by personal taxes
2 special cases of personal tax
MM w/corp taxes Tps=Tpb so the gain from lev=Tcb
MM w/out corp taxes, gain lev=0
classical tax system favors
corporate tax
imputation tax system means
tc=0
in terms of div payments imputation tax system means
you get tax credited with div payments as corp taxes already paid on income
dividend imputation means what for debt?
debt becomes less attractivwe
agency costs and information asymmetries and at announcement
if Veq<MVe then the market has overvalued so sell as earn more than what they are worth
then at announcement Ve<MVe so stock price decreases
pecking order theory
retained earnings (internal)
debt
equity
if internal CFs> capital investment
use surplus to pay debt
debt ratio in pecking order theory
reflects the requirement for external financing
pecking order theory is at odds with
trade-off theory
EBIT does what when D increases
decreases
3 ways to value a project with leverage
1) adjusted present value
2) flow to equity
3) wacc method
APV incorporates
financing aspects
3 main side effects of financing APV
tax subsidy of debt
costs of issuing new securities
subsidy to debt financing
tax subsidy to debt APV means timeline-wise
borrow (+CF) year 0
pay int (-CF) years
costs of issuing new securities APV means timeline-wise
pay floatation cost (-CF) year 0
receive tax shield (+CF) years
costs of subsidy to debt financing APV means timeline-wise
borrow (+CF) year 0
pay int (-CF) years
flow to equity is where you discount
CF from projects to eq holders of lev firm at cost of levered equity capital
Discount LCFs at Rs
WACC method
discount UCF at WACC
pure play firm ___ can be used for__
Similar firm B can be used as a proxy but needs to be adjusted for the leverage amount
can be used for non-scale enhancing project
difference between long-term financing
ownership vs debt
financing order
equity
debt
ret earnings
financial deficit
difference between use of cash flow and internal financing
debt financing summary
not owners
no voting rights
int payments tax deductible
legal abilities
Excess debt= financial distress
int payments inc in cost of doing business
equity financing summary
ownership
voting rights
divs not tax deductible
divs not part of doing business costs
no legal claims
cannot go bankrupt
indenture
contract
collateral
financial securities or any asset pledged to the debt
mortgage
secured by real property
seniority
debt holders paid first
covenants
restrictive clauses in a bond contract to limit issuer taking actions that could hurt bondholders
bond covenant examples
issuing new debt, div/share repurchases, m and acq, asset disposition
debenture
unsecured bond
note
unsecured bond t<10
registered
keeps initial record of who purchased bond and change of owners
bearer bond
holder of bond=owner
3 forms of debt financing
0 coupon, non-0 coupon
fixed rate, floating rate
unsecured, secured
syndicated
an intermediate
larger bond offering
involved group of finc institutions to issue on behalf
corp debt
tenders
gov=tenderts
issue directly
smaller more customisable
call provision
issuer can opt to repurchase all or part of debt at or after specific date
valuable to issuer
can choose to call a bond when IR drops to save money by paying off bond and issuing another at lower IR
put provision
debt holders can resell bond back to issuer at par or face value after specified period but before bonds maturity
convertibility provision
debt convert to equity at given ratio
revolving line of credit
max amount bank willing to lend, if guaranteed referred to as revolving
syndicated bank loan
larger bank arranged loan with firm and sells portions to a syndicate pf other banks to help diversifty credit
angel investor
individual investor who buys eq in small, priv firms (fam friendd)
venture capital firm
intermediaries set up as limited partnerships
play active role but don’t want investment forever
institutional investors
pension funds, insurance
invest directly or indirectly by becoming limited partners in a venture capital firm
corporate investors
established corporations purchase equity in younger, priv companies
desire for investment returns
IPO vs SEO
IPO is initial, SEO is randomly
IPO
the initial offering of shares and usually where most eq is raised
underwriter
a financial expert, sells, prices and has networks
transfers risk of under subscriptions and involves an outside party
issuer sells issue to uw syndicate and they resell issues to public
types of underwriter
firm commitment for best effort
risk with uw
that under subscribe
dutch auction uw
accepts series of bids that inc price of shares and number of shares and add number of shares up until reach required to find price
underpricing
tend to under price to make sure all subscribes
price IPO at value less than real value
means issuer leaves money on table
costs of a public issue
5-10% usually
SEO
new share issuances by a public firm after IPO
3 diff SEO
rights issue, public issue and prov placement
rights issue
issue of ordinary shares to existing shareholders but allowing them to maintain current state
allows shareholders to avoid dilution effect
subscription price
price paid to obtain new shares issued under rights issue
ex rights date
first date when new buyers will not receive right to stock
priv placement
issue of large parcel of shares to institutional investors or clients of stockholders
issues at discount to encourage purchase
low cost and quick
existing shareholders don’t like as diluted their ownership
issuing long term debt 3 ways
public offer (like IPO)
family issue (like rights issue)
private issue (like priv placement(
do firms always raise funds in hope for projects
no
2 implications of financing choice
asymmetric information
signalling effect
Leasing definition
lessor remains legal owner, lessee obtains rights to use in exchange for money
Lease
contractual agreement between lessee and lessor
operating lease vs finc/capital lease
operating is a rental agreeement and can’t buy at end
finc is fully amortized and ownership may transfer
operating lease
not fully amortised (term<useful life)
permits the use of an asset and transfers ownership after the lease period is complete
requires lessor to maintain and uphold asset
cancellation opt for lessee
flexibility for lessee
not in balance sheet
can’t buy at end
financial lease
fully amortised (payments fully reco0ver cost of asset)
no maintenance or service from lessor
lessor lots of flexibility
appears on BS
Sale and lease back agreement
type of finc lease
company sells to another company then leases back
lessee receives CF then pays
frees up finc resources and means don’t have any risk associated with holding
leveraged lease
form of finc lease
borrows money in order to buy leased asset
3 sided agreement (lender, lessor, lessee)
lessee payments pay lessors int payments
lenders use a nonrecourse loan ( lessor not obligated to lender if lessee defaults)
conditions to meet if a capital/financial lease
PV payments of lease are greater than 90% of market value of asset at start
lease transfers owners by end of term
term is greater than 75% of useful life
bargain purchase option available
5 reasons to lease
flexibile financing
annual payments not lump
payments tax deductible
no risk attached to ownership of asset
deferral/smoothing of upfront purchase cost
main difference between buying and leasing
tax treatment of assets and expenses is different
CFs for buying
manufacturer sells asset to firm U
firm U uses and owns
firm U finances using d/e
CFs for leasing
manufacturer sells asset to firm U
firm U owns but doesn’t use
firm U lessens to firm L who uses and pays lessoor
firm U finances using d/e
main reason to borrow and then purchase
interest/depreciation tax shield
why are there no Cfs with interest tax shields for NAL?
inc in discount rate
NAL formula
L-B
think about in perspective (if you leased the cost of buying is + as you don’t have to pay)
NPV of CFs
NAL>0
lease
NAL<0
purchase
NAB
just opposite
B-L
NAB>0 buy
NAB<0 lease
straight down calculation of NAL 5 parts
cost, after tax leasing cost (Lease (1-Tc)), depreciation tax shield (Cost/LifeTc), after tax maintenance (Maintenance(1-Tc)), After tax salvage value (Sv(1-Tc))
other way of calculating NAL
OC= PV lease payments and residual value- purchase price asset
NAL= (tax savings from lease- tax savings from buy)-OC
3 steps for lessor payment calculations
1) amount to be amortized= PV AT lease income
= AT lease income * PVIFA
2) after tax lease income
3) lease payment= AT lease income / 1-lessor Tc
lessor amortized amount
initial- PV AT Sv- PV Deep tax shield
after tax lease income
amount to be amortized= PV after tax lease income
lease payment
AT lease income/ 1-lessor marginal tax rate
debt displacement
reducing debt with alternative forms of financing
secures funds through leasing,
goal of debt displacement is to manage a company’s debt load, often by finding more cost-effective or flexible sources of capital
lease payments create future financial obligations that are similar to debt so increase liabilities so increases D/E eq so makes levers look higher so riskier
leased assets cannot be collateral
if lease not use as much debt as if borrowed to buy
if identical firms banks should be prepared to lend more to purchasing firms as they are using more debt capacity s can cover from int side of things
what condition must be met to carry more debt under purchase option?
AT CFs from buying > At Cos from leasing
PV of differential CFs is
the purchasing firms additional debt capacity
banks should be prepared to loan more to
purchasing firms as they are using more of their debt capacity so they can cover more payments from int side of things
NAL in terms on debt capacity
NAL= purchase price- reduction in debt capacity if leasing
smallest lease payment accept
make Lmin *(1-Tr) at end payment and equate to 0then solves
after tax lease income is also the BE
BE NPv for income for leasing
highest least payment pay
make Lmax*(1-Tc) at end then solve for 0
tax arbitrage
cannot have lease if payment max pay < min payment accept
term loan
borrowers with a lump sum upfront in exchange for specific borrowing terms
amortised loan
annual p are same
balloon loan
low during, big at end
bullet loan
principal paid in full at end
with loans to finance equipment the equipment can be used as
collateral
2 types of equipment loans
conditional sales contract
chattel mortgage
3 loan formulas for PV, Int and principal
PV loan= Annual x PVIFA
Int payment= each year BB x IR
Principal= annual p-int p
why do you want a lower WACC
means less risk associated
