Corporate Finance Flashcards
1
Q
Cash Flows Table Format (expansion project)
A
- Year 0: FC Inv + WC Inv
- Year 1-5: After tax operating cash flows
- Terminal year: after tax FA sales + Return of WC Inv (year 5 can be a terminal year. Step three is added to the total after tax cash flow)
2
Q
Compute after-tax operating cash flow
A
+ Sales
- Operating expenses
- Depreciation
= Operating income before taxes
- taxes on operating income
= Op income after taxes
+ Depreciation
= After-tax operating cash flow
3
Q
After-tax Salvage Value
A
= (Sale price of FA) - [(Gain on FA) X (Tax rate)]
4
Q
MACRS
A
Modified Accelerated Cost Recovery System
5
Q
When does MACRS switch to straight line method?
A
- when the straight line amount would be at least as much as under the double or 150%(15 yr - 30 yr MACRS) method.
6
Q
Calculate MACRS annual depreciation
A
- Determine double or 150% (over 15 yrs is 150%)
- Assume asset has been used for 6 months in first year
- Divide 1st year Dep % by 2 (5 years = 40%/2 = 20%)
- Multiply each year’s beg BV by double/150%
- Switch to straightline when optimal
7
Q
Depreciation Tax Savings
A
= Depreciation Exp. X Tax Rate
8
Q
Three steps of evaluating a replacement project
A
- Investment outlays
- Change in annual after-tax operating cash flows
- Terminal year after-tax non-operating cash flow
9
Q
Investment Outlay Calculation (Replacement Project)
A
+FC Investment
+NWCInvestment (
-Sale of old equipment
+Taxrate(gain on sale of old equipment)
Investment Outlay
- Remember to use book value (less accumulated depr)
10
Q
Annual After-tax Operating Cash Flow (Replacement Project)
A
= (ΔSales-ΔCosts)(1-t)+ΔtD
- ΔtD is the change in the depreciation tax shield*
- You are only concerned about the change in cash flows*
11
Q
Terminal year after-tax non-operating cash flow (Replacement Project)
A
TNOCF =
+ Difference on sale of new/old equip
+ Return of additional WC
- Incremental flow from taxes on disposal
= TNOCF
- incremental flow from taxes are calculated like this example… .4(600K - BV) - .4(125K - BV)
12
Q
Methods to compare projects with unequal lives
A
- Least common multiple of lives
* The cash flows (including the repeated investment needs to be broken out)* - Equivalent annual annuity approach
* - If this is a one-shot project vs. investment chain, the project with the greatest NPV should be chosen.*
13
Q
Equivalent Annual Annuity Approach (EAA)
A
Comput the payment as if the project was an annual annuity
- PV = negative NPV
- FV = 0
- N = Project life
- Cpt Payment
* - This may be superior to the common lifespan method*
14
Q
Profitability Index & Capital Rationing
A
- Hard or soft capital rationing means you can’t invest in everything and must prioritize
- PI = PV of Cash Flows / Initial investment
15
Q
3 Methods to Evalutate Standalone Risk
A
- Sensitivity analysis: How much does NPV change for a change in one variable.
- Scenario analysis: Each scenario tests the impact of probable scenarios across multiple variables.
- Simulation/Monte Carlo analysis: Define probability distributions for each variable
16
Q
SML for CAPM to determine appropriate discount rate.
A
SML or Ri = Rf + β(Rm-Rf)
17
Q
Types of Real Options
A
- Timing Options: Can the company delay?
- Sizing Options: Can company abandon or expand project?
- Flexibility Options: Can prices be changed and can output quantities be changed?
- Fundamental Options: Options intrinsic to the project
18
Q
Price a project option (sizing example)
A
- Weight the project according to probable outcomes and calculate NPV
- Calcuate the NPV and weight it based on the probable outcomes from the time the option is “exercisable”.
- Compare the difference between the value of 1 to the value of 2 to determine the value of the option.
19
Q
Economic income / ΔMarket Value / Economic Rate of Return
A
EI = After tax operating cash flow - change in Market Value
ΔMV = NPV of future cash flows at beginning of period - NPV of future cash flows at end of period. Each year’s ending MV = the nex year’s beginning MV
ERR = EI / Beginning MV
MAKE SURE YOU ONLY INCLUDE FUTURE CASH FLOWS (NOT CURRENT) CASH FLOWS FROM THE END OF THE YEAR TO CALCULATE THE NPV.
20
Q
Accounting Income
A
- Includes interest expense (rather than just assuming it is embedded in the discount rate)
- Is net income so depreciation is not added back
DO NOT FORGET TO SUBTRACT INTEREST BEFORE TAXES SINCE THIS WILL PROBABLY NOT BE ALREADY DONE.
21
Q
Economic Profit Definition
A
- What the company has after debt and equity holders are paid required rate of return.
- Economic Profit = NOPAT - $WACC
- NOPAT = Net operating profit after tax (does not include interest) EBIT(1-Tr)
- $WACC = invested capital each year (BV of assets) X Required rate of return or cost of capital
22
Q
NPV of Economic Profit
A
= NPV of each year’s EP + Initial Capital Investment
23
Q
Residual Income / Equity Charge for Period
A
RI = Net Income for Period - Equity Charge for Period
ECfP = (Required return on equity) X (Beginning BV of Equity)
24
Q
Required Return on Equity
A
Cost of Capital(WACC) = WoD(CoD)(1-Tr) + WoE(Re)
- -WoD: Weight of Debt*
- CoD: Cost of Debt (interest rate)*
- WoE: Weight of Equity*
- Remeber that WACC formula may also include preferred or other types of equity/debt*
25
Total project value based on Residual Income
= equity investment + debt investment + NPV of residual income
- The investment is equal to the initial capital (this may be split between debt and equity)
26
Claims Valuation
1. Discounted NPV of payments to debt and equity holders
2. Debt is discounted based on the cost of debt
3. Equity is discounted based on the Re of equity
27
Steps to calculate Claims Valuation
1. Calculate interest payments: Interest expense (accounting income)
2. Calculate principle repayment:
3. Calculated equity distributions:
4. Discount debt payments at cost of debt and equity payments at Re
## Footnote
*Payments to shareholders are the net excess of after tax cash flows after debt payments.*
28
Calculate Equity Payments for Claims Valuation
+ Net income
+Depreciation expense
_- Debt principle payments_
Equity Payments
29
Equity Distributions
+ Net Income
+ Depreciation
_- Principle payments to debt_
= Equity Distributions
30
WACC
= D/v(rD)(1-Tr) + E/v(rE)
* - r = marginal cost of equity or debt
- Marginal = What it will cost to raise _additional_ capital
- The weight is calculated from the "Value" of the firm. WACC goes down when debt is added even though debt increases the Re.*
31
MM Proposition I without Taxes
1. There are no costs, lending is at Rfr and markets are efficient
2. Therefore there are no difference in value based on capital structure
3. Leveraged and unleveraged firms are equal and differences are irrelevant
4. Investors can create their own capital structures by leveraging their investment
32
MM Proposition II (without taxes)
Include Regression Equation for Cost of Equity
1. The cost of equity is a **_positive_** linear function of the company's debt-equity ratio: Re = Ro + D/E(Ro-Rd)
* - Ro = cost of equity for unlevered firm*
2. Because debt has a priority over equity
3. WACC remains same regardless of adjustments in D/E
33
Total Value of Company under Proposition II without Taxes
V = Int/Rd + EBT/Re
## Footnote
* - This assumes that debt and earnings are perpetuities so the perpetuity formula shoudl be used.*
* - Remember to net out interest payments from EBT*
34
Cost of Equity MM II with Taxes
Re = Ro + [(Ro-Rd)(1-Tr)(D/E)]
35
Value of Vl and Vu firms
1. Vl = Vu without taxes
2. Vl = Vu + (Tr)(D)
3. Ve + Vd = Vl
4. Ve + Vd = Vu + (Tr)(D)
5. Vu = Ve + Vd(1-Tr)
36
Calculate Vu and Vl assuming taxes
EBIT = 10,000
TR = .4
Re = .1
Rd = .06
Vd = 25,000
```
Vu = EBIT(1-t) / RWacc
10,000(.06)/.1 = $60,000
```
Vl = Vu + (Tr X D)
$60,000 + 10,000 = $70,000
37
The costs of financial distress and bankruptcy
1. Direct costs (legal, admin etc.)
2. Indirect costs (lost opportunity, impaired brand etc.)
38
Agency Costs
1. Monitoring Costs (shareholders keeping an eye on management)
2. Bonding Costs (management's costs to reassure shareholders - insurance etc)
3. Residual Loss (costs that can't be eliminated through monitoring or bonding)
39
Jensen's Free Cash Flow Hypothesis
Higher levels of debt require managers to be more careful about cash flow and minimize potential to misuse funds.
40
The Optimal Capital Structure: Static Trade-off Theory
Vl = Vu + Tr(D) - PV(Costs of Financial Distress)
## Footnote
*- The value is maximized when the PV of financial distress is equal to the advantage of getting more debt. The WACC will start increasing at this point.*
41
Dividend Irrelevance Theory
- With no taxes and efficient market investors could create thier own dividends
1. Stock volatility cold make this difficult
2. Transaction costs are also an issue
3. If dividends are taxed at higher rate than cap gains then investors should favor low dividend stocks
42
Expected Decrease in Share Price after Ex-Dividend
Pw - Px = (1 - Td) / (1 - Tcg) X D
## Footnote
Pw - Px: Right to get the div vs. no div
Td, Tcg: Tax on dividends vs. tax on capital gains
D: Dividend
*- If D=$1 then formula tells you how much that $1 is worth in capital gains*
43
Implications of Expected Share Price Change after ex-Dividend
1. If Td = Tcg then the stock should drop by the amount of the dividend
2. If Td \> Tcg then the stock will drop by less than the dividend
3. If Td \< Tcg then the stock will fall by more than the dividend
44
Double Taxation regime formula for ETR
ETR = CTR + [(1-CTR) X MTRd]
* - ETR: Effective Tax Rate*
* - CTR: Corporate Tax Rate*
* - MTRd: Marginal Tax Rate on dividends*
45
Dividend Imputation System formula for ETR
ETR = Tliability of Investor / Pretax NI
(CTr \* Pretax NI) - (InvestorTr \* Pretax NI) = Net tax credit/liability
46
Split Rate Tax System Formula for ETR
ETR = CTrD + [(1-CTrD) X MTrD]
Corporate Tr on Divs: .20
Corporate Tr on RE: .35
Invstrs Marginal Tr on Divs: .15
.15 = .20 + [(.80) X .15]
47
Dividend Policy Types: Stable (formula for growth)
Stable dividend policy: Don't raise it until you are sure you can sustain it.
Expected Dividend increase = +ΔNI X Target P.O. X Adjustment Factor
Adjustment Factor = 1/N (n= number of years adjustment will take place)
48
Dividend Policy Types (Constant Dividend Payout) Formula
- A constant % of EPS
49
Dividend Policy Types (Residual) formula
1. NI - [(Project investments) X (% of equityrequired for project))] = Dividend
2. NI - [Capex Spending X % of equity in D/E ratio] = Dividend
50
Effect of Share Buybacks on BS and IS
1. If earnings yield is less than debt costs EPS falls
2. If BB is financed with assets, leverage increases EPS may also fall if those assets could have returned at least the company's WACC.
51
Dividend Payout Ratio vs. Dividend Coverage Ratio
DPO: Dividends / NI
DCR: NI / Dividends
52
Free Cash Flow to Equity Coverage Ratio
FCFE CR = FCFE / [Dividends + ShareBB]
FCFE = CFO - FCinv + NetBorrowing
1. If ratio is greater than 1 then company is retaining earnings
2. Less than 1 then company is borrowing cash to pay dividends+BB
53
Corporate Governance Definition
Policies, principles, and procedures that are clearly defined in order for stakeholders (equity and management) to resolve conflicts.
54
Objectives of Corporate Governance
1. Eliminate conflicts of interest between stakeholders2. Ensure that assets are used in best interest of investors and stakeholders2:15
55
Principle Agent Problem
Managers (agents) may pursue interests that differ from the stake holders. 14:30
56
Good Corporate Governance Describes the Rights and/or Responsibilities of Stakeholders?
#NAME?
57
Forms of M&A Integration
1. Statutory merger: Target ceases to exist
2. Subsidiary merger: Target remains (usually because of valuable brand)
3. Consolidations: Both acquireror and target cease and new entity emerges
58
Requirements for Bootstrapping Effect
Bootstrapping - The new entity has more EPS than the other two entities not because of an economic advantage but because of the merger.
1. Acquirer must have a P/E ratio that is greater than the target
2. Acquirer's P/E doesn't fall after the merger.
59
Poison Pills (3-types) + Puts
1. Flip in pill: Target shareholders can buy target shares at discount
2. Flip over pill: Target shareholders can buy acquirer shares at discount
3. Dead hand: Pill can only be cancelled by vote of continuing directors
4. Poison puts: Target's bond holders can sell thier bonds back to target at par or above. (acquirer will need to raise a lot more capital to pay off bond holders)
60
Herfindahl-HIrschman Index (HHI)
HHI = ∑(Sales of firm i / total sales of market x 100)^2
1. HHI of less than 1,000 indicates market is not concentrated
2. HHI between 1,000 and 1,800 moderately concentrated - Merger will be challenged if HHI increases by 100 points or more.
3. HHI above 1,800 is highly concentrated - Merger will be challenged if HHI increases by more than 50 points.
61
Target Company Valuation: DCF - Step One
Calculate PV of FCFF from NI from Proforma I.S. for the period analyst is confident about forecasts...
FCFF Calculation
1. Net operating profit after tax (NOPAT)
- Net income
_+ Interest after tax (int X (1-Tr))_
Unlevered income
_+ Change in deferred taxes (YoY Δ in taxes from I.S.)_
NOPLAT
+ Depreciation
- Δ Working Capital
_- Capex_
**Free Cash Flow**
*- Change in defferred taxes is just the difference between the current year's DT and the year before on the income statment.*
62
Target Company Valuation: DCF - Step Two
The PV of the terminal value of the target.
1. Contstant Growth Model
[FCFF last year in stage one X (1+G)] / (WACC - G)
2. Relative valuation model
FCFF last year in stage one X expected valuation multiple (estimate)
63
Target Company Valuation DCF: Discount Rate?
1. Non-control then use target's WACC
2. Potential merger then adjust the WACC to account for additional merger risk
64
Target Company Valuation: Comparable Company Analysis
1. Comparable companies are identified
2. Average valuation multiples are calculated (PE, P/BV etc.)
3. Multipes are then applied to target **plus a takeover premium** and the average estimated stock price is calculated.
4. Repeat that process for takeover premium + Step 3 value
65
Target Company Valuation: Comparable Transaction Analysis
No need to create separate multiples and acquisition premium since estimates are derived from comparable companies that are post merger.
1. Identify merged company comparisons
2. Caculate valuation multiples based on transaction valuation and calculate average
3. Apply average valuations to target company
66
Post Merger Value of A\*
Va\* = Va + Vt + S - C
Va: Value of A before merger
Vt: Value of t before merger
S: Synergies
C: Cash paid to target's shareholders
67
Takeover Premium, Synergies and Acquirer's gain
1. Target's gain (Takeover Premium) = (Cash + Stock Value) - Original MV
2. Acquirer's gain = Synergies - TP
3. TP + Acquirer's Gain = Synergies
68
Forms of Restructuring (4 types)
1. Equity Carve Out: New entity's shares offered to outsiders (cash inflow)
2. Spin off: New entity's shares are issued to existing P's shareholders
3. Split off: New entity's shares are offered to existing shareholders in exchange for P's shares.
4. Liquidation: Assets sold off piecemeal - usually a bankruptcy
69
Pooling of Interest vs. Acquisition Method
- Pooling assets are brought over at BV and no good will is recognized on BS
- Acquisition method assets are brought over at fair value adn GW is on BS
70
IFRS vs. GAAP recognition of Goodwill
GAAP calculates goodwill based on the fair value of the entity minus the fair value of the company's net assets (Full Goodwill)
IFRS calculates good will based on full goodwill or based on the fair value of the acquisition consideration minus the fair value of the acquirers percentage of the net assets.
* T has 900K in net assets but whole company is worth 1MM. A pays 800K for 80% interest in T. *
* GAAP & IFRS: 1MM - 900K = 100K goodwill (full goodwill)*
* IFRS: 800K - ( 900 X 80%) = 80K goodwill (partial goodwill)*
71
WACC when the inflation rate is given
Inflation WACC = (1+WACC) X (1+inflation)
