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CFA Level II 2020 > Corporate Finance > Flashcards

Corporate Finance Flashcards

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1
Q

Replacement Project

A
  1. Must reflect sale of old asset

outlay = FCInv + NWC - sale + T(proceedsO)

  1. Calculate ∆ in cash flows

∆CF = (∆S - ∆C)(1 - T) + ∆DT

  1. TV

(SaleN - SaleO) + NWC - T(proceedsN - proceedsO)

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2
Q

Expansion Project: TV Final Year

A

Sale + NWC - T(proceeds)

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3
Q

Expansion Project: After tax Operating Cash Flows

A

CF = [(∆S - ∆C)(1 - T) + ∆DT

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4
Q

Expansion Project: Initial Investment Outlay

A

Purpose: Upfront cost Includes: Price, s/h, installation, FCInv, NWC

NWC: ∆non-cash current assets - ∆non debt liabilities

If positive additional financing is required

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5
Q

Expansion/Replacement Project Segments

A
  1. Initial Investment Outlay
  2. After-tax Operating Cash Flow over life
  3. TV in final year
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6
Q

Modified Accelerated Cost Recovery System (MACRS)

A

Purpose: assets classified into categories; 3, 5, 7, 10 yrs

Each year’s depreciation is based on recovery %

Depreciable basis = purchase price + s/h and installation costs

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7
Q

Capital Budgeting Key Principles

A
  1. Decisions are based on cash flows

Sunk costs and externalities

  1. Cash flows are based on opportunity costs (e.g MUST include cost of land cuz land can be sold)
  2. Cash flows are worth more earlier
  3. Cash flows are analyzed on an after tax basis
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8
Q

Inflation Affects on Capital Projects

A
  1. Nominal cash flows reflect inflation.
  2. Real cash flows must be adjusted for inflation
  3. Changes in inflation affect project profitability
  4. Inflation reduces the tax savings
  5. Inflation decreases the value of payments to bondholders
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9
Q

Mutually Exclusive Projects with different lives

A

Step One: Find each projects NPV (using the calculator)

Step Two: Calculate the PMT for each project

Use calculator; PV = x; FV = x, N = x, I = x, COMPUTE PMT

Remember PV value is NEGATIVE

Step Three: Select the highest annuity payment

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10
Q

Capital Rationing

A

Purpose: the allocation of a fixed amount of capital among available projects to maximize shareholder wealth

This violates market efficiency

Types:

  1. Hard capital: budget cannot increase
  2. Soft capital; budget can increase if management approve
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11
Q

Types of Sensitivity analysis

A
  1. Sensitivity Analysis: changing one input at a time to see how sensitive the dependent variable is
  2. Scenario Analysis; best-case, worse-case with probabilities
    a. Allows for changes in multiple input variables all at once
  3. Simulations (Monte Carlo); forecast of probability distributions for key inputs
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12
Q

Capital Asset Pricing Model (CAPM)

A

Use: to determine the appropriate discount rate for the project

Formula: Required return = Rf + Bproject [(Rmkt) - Rf]

If Bproject is > Bcompany = more risky, more likely to accept

If Bproject is < Bcompany = less risky, more likely reject

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13
Q

What is the Hurdle Rate?

A

Definition: risk adjusted required rate of return for the project

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14
Q

Real Options: Timing Options

A

allow a company to delay making an investment while waiting for more info

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15
Q

Real Options: Abandonment

A

similar to put options; allow management to abandon a project

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16
Q

Real Options; Expansion

A

similar to call options; can make additional investments if it creates value

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17
Q

Real Options: Flexibility

A

gives mangers a choice of the operational aspects

i. Price-setting; can change the price of the product (based on demand)
ii. Production-flexibility; paying workers overtime, using different materials, etc.

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18
Q

Real Options; Fundamental

A

an example is a copper mine (value is based on copper price)

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19
Q

2 Ways to calculate Real Options

A
  1. Determine the NPV without the option
    a. options are always positive so if the NPV is positive without it, then can proceed
  2. Calculate NPV without option then estimate value of option
    a. Overall NPV = project NV - option cost + option value
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20
Q

Economic income

A

Economic income = cash flow + (ending market value - beginning market value)

  1. cash flow = operating income (1 - T) + dep
  2. BMV = PV of all the cash flows
  3. EMV = PV of first cash flow
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21
Q

Economic vs Accounting Income

A

Accounting income is the reported net income on the financial statements

  1. Differs because based on original cost, EI is based on MV
  2. interest expense is considered as a separate line item (EI has it included)
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22
Q

WACC

A

cost of equity * weight of equity + cost of debt * (1 - T) * weight of debt

If Needed:

Cost of preferred stock: D / V

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23
Q

Economic profit

A

Purpose: a measure of profit in excess of the dollar cost of capital invest

Formula: EP = net operating profit after tax - WACC * capital

a. NOPAT = EBIT (1 - tax rate)
b. Capital = dollar amount invested

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24
Q

Residual income

A

Purpose: focuses on returns on equity

Formula: RI = NI - Re * BVet-1

a. Re = required return on equity
b. BVet-1 = beginning of period BV of equity

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25
Q

MM Proposition 1

A

(No taxes): value of a firm is unaffected by it’s capital structure

  1. Capital markets are perfectly competitive (no taxes or transactions costs)
  2. Investors have the same cash flow expectations
  3. Riskless borrowing and lending
  4. VL = VU (value of levered firm = value of unlevered firm)
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26
Q

MM Proposition 2

A

(No taxes): cost of equity increases linearly as a company increases debt

  1. Still assumes a perfect market
  2. Debt cost is lower than equity cost but it increases equity cost

3. No change in the firms WACC

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27
Q

MM Proposition 3

A

(with taxes): value is maximized at 100% debt

  1. Get a tax shield provided by debt
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28
Q

MM Proposition 4

A

(With Taxes): WACC is minimize at 100% Debt

  1. WACC declines as leverage increases
29
Q

Asymmetric Information

A

Definition: managers know more about the company than the creditors

  1. Issuing bonds is a good sign
  2. Issuing equity is typically viewed as a negative signal that managers believe a firm’s stock is overvalued.
30
Q

Static Trade-Off Theory

A

Purpose: Balancing the equity and debt to obtain the optimal structure

Formula: VL = VU + (t x d) - PV

a. Optimal level is when the cost of financial distress = the benefits of the tax shield

31
Q

Country-Specific Factors on Capital Structure

A

Use of Total Debt Maturity of Debt

Strong legal system Lower Longer

Less asymmetry info Lower Longer

Low dividend taxes Lower N/A

More liquid stock mkt N/A Longer

Reliance on bank system Higher N/A

Higher inflation Lower Shorter

32
Q

Dividend Policy Theories

A
  1. MM Dividend Irrelevance; in a perfect world without taxes dividends don’t matter. You can take dividends and purchase more stock if you want.
  2. Bird-in-Hand (dividend preference theory): investors prefer the certainty of cash over capital gains
  3. Tax aversion: Investors prefer to not receive dividends because they are taxed at a higher rate
33
Q

Dividend Signals

A
  1. Increase = good
  2. Decrease = bad
  3. Initiation = could be negative/positive
34
Q

Dividend Clientele Effect

A

Definition: Different groups of investors desire different levels of dividends

  1. High-tax-bracket investors want low dividend payouts
  2. Institutional investors want high paying dividends (may be required)
35
Q

Change in stock price when dividend pays

A

∆P = D(1 - Td) / (1 - Tcg)

36
Q

Agency Issues

A

Managers may have an incentive to overinvest because increasing dividends would limit their free cash

37
Q

Dividend Policy Factors

A
  1. Investment Opportunities: many high NPV projects would keep dividends low
  2. Expected Volatility of future earnings: more volatile earnings less likely of an increase to dividends
  3. Financial flexibility: firm may purchase back stocks instead of dividends
  4. Tax considerations: capital gains (only taxed when sold) vs dividends (tax immediately)
  5. Flotation costs: new stock issues have 3-7% of fees (retained earnings have no fee)
38
Q

Calculate the effective tax rate

A

Effective tax rate = corporate tax rate + (1 - corporate tax rate)(individual tax rate)

Imputation tax system: all taxes are effectivey paid at the shareholder rate

39
Q

Dividend Payout Ratios

A
  1. Stable dividend:

expected dividend = prev D + (expected increase in EPS * payout ratio * adj factor)

a. Adj factor = 1 /# of years
2. Constant dividend payout ratio: a specific payout ratio is applied to all earnings (seldom used)
3. Residual Dividend Model

40
Q

Residual Dividend Model

A

Purpose: dividends are based on earnings minus the funds retained to finance equity

Step 1: identify the optimal capital budget

Step 2: Use earnings to fund the amount of equity needed to remain optimal

Step 3: Pay out dividends with the “residual” earnings (what is left)

Example: Debt-to-equity ratio of 0.5, $1,000 earnings, $900 of planned capital spending

  1. Debt-to-equity ratio of 0.5 implies 1/3 debt and 2/3 equity
  2. Need to spend 900: so 300 is debt and 600 is equity
  3. Then take earnings - equity (1000 - 600) so 400 could be paid out for dividends
41
Q

Reasons for Share repurchases

A

a. Potential tax advantages
b. Share price support/signaling
c. Added flexibility
d. Offset dilution from employee stock options
e. Increased financial leverage

42
Q

Dividend payout ratio

A

Dividend payout ratio = dividends / net income

Analysis: higher = bad, most likely will cut dividend

43
Q

Dividend coverage ratio

A

Dividend coverage ratio = net income / dividends

44
Q

FCFE coverage ratio

A

FCFE coverage ratio = FCFE / (dividends + share repurchases)

Analysis: Less than one is unsustainable

45
Q

Friedman Doctrine

A

only social responsibility of a business is to increase profits within the rules

46
Q

Factors in choosing a corporate strategy

A
  1. Predictability: how accurately a company can forecast industry factors
  2. Malleability - can the company and its competitors influence the industry
47
Q

Residual Income Strengths and Weaknesses

A

Strengths

  1. Not dependent on a TV
  2. It is a minority position
  3. Works for non-dividend payers and negative CF

Weakness

  1. Data can be manipulated
48
Q

Utilitarianism

A

business must weigh the consequences to society for their actions.

Seeks to produce the highest good for the largest number of people.

Think cost-benefit analysis (but some difficult to measure)

49
Q

Kantian ethics

A
  1. People deserve dignity and respect
  2. People are different from other factors of production
50
Q

Rights Theories

A
  1. Cannot violate the rights of others.
  2. People have fundamental rights and privileges.
51
Q

Justice Theories

A

focus on distribution of economic output. Justice is met if all participants would agree the rules are fair.

Under the “veil of ignorance”. A sweatshop may be illegal in the US but an improvement for those in a poor country

52
Q

Corporate Governance Objectives

A

Eliminate or reduce conflicts of interest use assets for the best interests of investors

53
Q

Corporate governance will:

A
  1. Define the rights
  2. Define the oversight responsibilities of managers and directors
  3. Provide fair treatment between managers, directors, and shareholders
  4. Transparency and accuracy
54
Q

Board of Directors Responsibilities

A
  1. Complies with all legal and regulatory requirements
  2. Create long-term strategic objectives
  3. Determine managements responsibilities
  4. Evaluate the CEO
  5. Ensure board members are adequately trained
55
Q

Analyzing Board of Directors

A
  1. 75% of board members should be independent
  2. CEO should not be chairman
  3. Directors are not on more than 2-3 boards
  4. Board elections are NOT staggered and done annually

5 Most senior manager pay is tied to performance

  1. Have an audit committee with only independent members and meets with auditors annually
  2. Should hire independent legal counsel
  3. Responding to shareholder proxy votes
56
Q

Types of Mergers

A

a. Horizontal: both in the same industry
b. Vertical Merger: moving up or down the supply gain (restaurant buying a farm)
c. Conglomerate Merger: both in different industries

57
Q

Bootstrapping

A

the combined firmed has less shares so it increases EPS even though nothing was added

58
Q

Industry Life Cycles

A
  1. Pioneer/development: early stages
    a. Horizontal and conglomerate mergers
  2. Rapid Growth: higher profit margins and rapid growth.
    a. Horizontal and conglomerate mergers
  3. Mature Growth: more competition, lower profit margins, above average growth a. Looking for synergies so vertical and horizontal mergers
  4. Stabilization: Growth is close to GDP
    a. seeking mergers to generate economies of scale and lower costs.
    b. Look to acquire small companies
  5. Decline phase
59
Q

Hostile Merger Steps

A
  1. Submit a proposal to the BOD - this is called a bear hug
  2. If doesn’t work go directly to the shareholders
    i. Tender offer: the acquirer offers to buy the shares
    ii. Proxy battle: try to vote in new board of directors
60
Q

Pre-Offer Defense Mechanisms

A

a. Poison Pill: gives shareholders the right to purchase shares at a discount.
b. Poison Put: gives the bondholders the option to demand immediate repayment
c. Restrictive takeover laws: some states are more strict than others
d. Staggered board
e. Restrictive voting rights
f. Supermajority voting
g. Fair price amendment: fair price based on a formula
h. Golden parachutes

61
Q

Post-Offer Defense Mechanisms

A

a. Greenmail: buying back the stock the acquirer has at a premium
b. Share repurchase: tendering an offer to purchase its own shares back
c. Leveraged recapitalization: leveraging to purchase shares back
d. Crown Jewel: selling a major asset to a third party
e. Pac-man: take over the acquirer instead
f. White Knight Defense: a friendly third party starts a bidding war
g. White squire defense: friendly third party buys a minority stake

62
Q

Herfindahl-Hirschman Index (HHI) Analysis

A

Analysis:

< 1000 means industry is competitive

1,000 - 1,800 = moderately concentrated, if the move was over 100 points it will be challenged

1,800 = 1,800 concentrated and it will be challenged, any move over 50 points wont be allowed

63
Q

Discount cash flow analysis Advantages/Disadvantages

A

Advantages

1) Easy to model cash flows
2) Model is easy to customize
3) Based on forecasts

Disadvantages

1) Hard when cash flow is negative
2) Estimating cash subject to error
3) Discount rate changes over time

64
Q

Comparable transaction analysis Disadvantages

A

1) Assumes other companies valuations were accurate
2) May not be enough transactions
3) Hard to account for synergies

65
Q

Post-Merger Value

A

Vat = Va + Vt + S - C

66
Q

Gains Accrued to the Target in a Merger

A

GAINt = TP = Pt - Vt

67
Q

Gains Accrued to the Acquirer in a Merger

A

GAINa = S - TP = S - (Pt - Vt)

68
Q

Ways a Firm can reduce size

A

a. Equity carve-outs: create a new, independent company by giving away equity interest and will do an IPO
b. Spin-offs: also create a new company but are distributed proportionately to the current shareholders
c. Split-offs: allows shareholders to receive new shares of a division in exchange for a portion of their shares in the main company

69
Q

Herfindahl-Hirschman Index (HHI) Formula

A

Formula: n(MS * 100)²

Example: supposed 20 firms, each have 5% market share. 19 and 20 decide to merge

Pre-Merger: 20 (.05 * 100)² = 500

Post-Merger: 18(.05 * 100)² + 1(.10 * 100)² = 550

CFA Level II 2020 (13 decks)

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