Corporate finance and risk management

Question 1

What is Corporate Finance about?

Answer 1

Damodaran (1997): Corporate finance covers any decisions made by
firms which have financial implications. Thus, there is a corporate financial
aspect to almost every action taken by a firm, no matter which functional
area claims responsibility for it

Question 2

Owners =
“Shareholders”

Answer 2

• Shareholders don’t directly own the firm’s real assets (e.g. plants)
• They possess the firm’s real assets indirectly via financial assets
(i.e. shares of the company)

Question 3

Board of
Directors

Answer 3

• Board of directors is elected by the firm’s shareholders
• Board of directors appoints senior management of the firm

Question 4

Types of
Corporations

Answer 4

Public Company:
• Shares traded on public markets (e.g. SIX)
• Multiple market listings possible
• Example: CS Group listed on SIX and NYSE

Private Company:
• Shares not traded publicly
• Examples: IKEA, AMAG

Question 5

Advantages
of Corporations

Answer 5

• Liability of owners limited to invested funds
• Lifespan not tied to the owner (potentially infinite life)
• Ease of ownership transferal
• Ease of raising capital

Question 6

Disadvantages
of Corporations

Answer 6

• Corporations face the problem of double taxation
• Costs related to set-up and regulation (e.g. filing of reports)
• Issues associated with the separation of ownership and control
(agency problems)

Question 7

Corporations in
Switzerland

Answer 7

• Aktiengesellschaft (AG): Swiss equivalent to US corporations
(corp.) and public limited companies (plc) in the UK
• Swiss corporate law is primarily set out in the Swiss Code of
Obligations (CO) (Obligationenrecht/OR)

Question 8

Most large companies have 3 top-level financial managers:

Answer 8

Chief financial officer:
Responsible for financial policy and corporate planning.

Treasurer:
responsible for Cash management, raising capital and banking relationships.

controller:
responsible for preparation of financial statement, accounting and taxes.

Question 9

Investment Decisions
 How to spend money?

Answer 9

• Build a new plant
• Run a large-scale advertising campaign
• Carry out R&D for a new drug

Question 10

Financing Decisions
 How to raise money?

Answer 10

• Borrow from a bank
• Use retained cash flows
• Sell additional shares of stock or issue bonds

Question 11

Payout Decisions
 How much to transfer to
shareholders?

Answer 11

• Reinvestment versus payout to shareholders
• Different payout options

Question 12

Market Value

(MV)

Answer 12

• Market value measures what investors are willing to pay today in
order to receive a stream of risky cash flows in the future
• Forward looking: MV depends on expected future cash flows
• Stocks and bonds represent claims on the firm’s future cash flows
• In efficient markets the market price represents the best estimation
for the market value.

Question 13

Book Value

(BV)

Answer 13

• Book value is determined based on accounting rules
• Backward looking
• Difference of a firm’s MV over BV is called “Going Concern Value”

Question 14

Maximization of
firm value is NOT
profit maximization

Answer 14

• Market values are driven by expectations about future cash flows
• Profit ≠ cash flow! Possible to report profits without generating cash
• Example: If sales are on credit, a company may report (accounting)
profits without generating cash flows

Question 15

Present Value

(PV)

Answer 15

• Present value of cash flow CF received in one period from now
PV=CF/(1+r)
• The expression 1/(1+r) is called discount factor; r is the discount rate

Question 16

Opportunity Cost
of Capital

Answer 16

• r denotes the rate of return which investors demand for streams of
cash flows with similar risk characteristics
• r therefore is the return investors expect to earn when investing in
alternative investment opportunities with comparable risk
• r is called “opportunity cost of capital” or “hurdle rate” of a project

Question 17

Present Value: Generalization

Answer 17

Question 19

Present Value of a Cash Flow Stream

Answer 19

Question 20

Perpetuity

Answer 20

Question 21

Growing Perpetuity

Answer 21

Question 22

Annuity

Answer 22

Question 23

Growing Annuity

Answer 23

Question 24

The Key: Systematic and Unsystematic Risk

Answer 24

Different risk factors are relevant for a single share, but only systematic risk factors are relevant from a market perspective.

Only systematic risk factor are relevant for firm (and project) valuation. The unsystematic risk factors can be diversified and disappear in a portfolio context.

Question 25

What is this Beta about?

Answer 25

Definition: Beta (β) is a sensitivity measure which shows how the return of a single share develops in relation to the development of the market return. It quantifies the amount of systematic market risk which is taken by the investor when investing in that specific share.

Question 26

Cost of Debt

Answer 26

• Cost of debt = opportunity cost of capital reflecting the debt holders’ risk of investment in the firm (“debt holders’ required rate of return”) • A company’s investments usually are for medium- to longer-term projects and the cost of debt should reflect this.

Question 27

Cost of Debt: Estimation in Practice

Answer 27

• If the company’s debt is traded, then the cost of debt can be approximated by the yield-to-maturity of the firm’s traded long-term debt
• If the firm’s debt is not traded, then proceed as follows
• Debt-rating approach: Use yields on comparably rated bonds with maturities similar to the outstanding debt of the company
• Bank loan approach: Obtain the cost of debt as the average interest rate paid on the company’s medium- to longer-term bank loans

Question 28

Inconsistency of these Approaches

Answer 28

• Theoretically the cost of debt should reflect the expected return for debtholders. But the coupon or the yield to maturity is a promised return with only shortfall risk. Therefore the expected return is always lower than the promised return.

Question 29

Cost of Debt

Answer 29

• Interest on debt is tax deductible and, hence, the cost of debt should be adjusted to reflect this deductibility (“debt tax shield”) • Solution: Multiply the before-tax cost of debt (rd) by the factor (1 – tc), where tc denotes the marginal tax rate • We call rd×(1 − tc) the after-tax cost of debt

Question 30

Cost of Equity

Answer 30

• Dividends and other payments to shareholders are not tax deductible • Therefore, the cost of equity doesn’t have to be adjusted for taxes.

Question 31

When to use WACC

Answer 31

WACC can be used in these (restricted) circumstances

• Risk of project is similar to the risk of the company’s existing assets
• Existing capital structure doesn’t change when accepting the project
• The project doesn’t impact on the cost of capital of existing assets
• Application of the Discounted Cash Flow methodology

Question 32

Measuring Capital Structure

Answer 32

• WACC relies on market value based capital structure • MV of Equity: Share price times number of shares outstanding • MV of Debt • Ideally: PV of all coupons and principals, discounted with YTM • Problem: MV of debt can be hard to obtain as not all debt is traded • Solution in practice: Approximate MV of debt by the BV of debt

Question 33

Starting point

Answer 33

• The company belongs to the shareholders • Shareholders appoint managers to run the company in their interest

 Managers don’t own the company, they manage it

Question 34

Shareholders vs other stakeholders

Answer 34

• Shareholders want the firm value to be maximized • Other stakeholders (workforce, management, …) also have financial interests in the company

 Managers are often obliged to appease not only the shareholders but the other stakeholders as well

Question 35

Agency Dilemma

Answer 35

• People making the decisions are not the owners of the firm • Indirect monitoring of management through board of directors • Asymmetric information and divergence of interests between principals (shareholders) and agents (managers)

Question 36

Consequences

Answer 36

• Managers might do things that do not benefit shareholders - Investments in negative NPV-projects such as corporate jets - Shy away from risky projects due to fear of job loss

Question 37

Corporate Governance

Answer 37

• Mitigation of agency problems through legal requirements, compensation plans, board of directors, threat of takeovers, etc. • “Good corporate governance ensures that the shareholders’ pockets are close to the managers’ hearts.” (BMA, 2010)

Question 38

Investment Appraisal

Answer 38

• Evaluation of the attractiveness of an investment proposal based on the net present value (NPV), the internal rate of return (IRR), or some other investment criterion.

Question 39

Net Present Value (NPV)

Answer 39

• NPV = Difference between PV of future benefits and PV of capital invested, discounted at the company’s cost of capital • NPV decision rule = accept all projects with a positive NPV • Regarded as the best investment appraisal method by academics

Question 40

(NPV)
Time Value of Money

Answer 40

NPV accounts for a dollar today being worth more than a dollar tomorrow • A dollar today can be invested to start earning interest immediately • Rules ignoring the time value of money are not sensible

Question 41

(NPV)

Reliance on Cash Flows

Answer 41

NPV accounts for all relevant cash flows over life of project • Decision rules relying on accounting profits or being affected by managers’ choice are inferior

Question 42

(NPV)

Transparency and Flexibility

Answer 42

• NPVs are measured in today’s dollars and thus are additive • Method also works when the discount rate changes during project life

Question 43

Some important rules (BM: Chapter 6)

Answer 43

1. Only cash flow is relevant:
    No non-cash expenditure or income (e.g. depreciation)
    Account for cash flows at the collection time
2. Only incremental cash flows are relevant:
    Include taxes (from EBIT when applying a tax-adjusted WACC as cost of capital)
    include all incremental cash flows but no cash flows which would occur anyway
    Include opportunity costs (e.g. to let the office space in case the additonal project is not undertaken)
    Forget sunk costs (e.g. previous investments in the project)
    Remember salvage value (e.g. can the machine be sold after the project?)
3. Treat inflation consistently:
    Use the same inflation in your WACC and in your cash flow projections
4. Separate investment and financing decision:
    Use the WACC as discount rate and therefore do not account for financing cash flows
    But include changes in net working capital (investments in inventory, receivables and financing through payables)

Question 44

NPV Investment Criterion

Answer 44

• NPV decision rule = accept all projects with a positive NPV

Question 45

Complications in practice

Answer 45

• Projects might be mutually exclusive with a different time horizon
• Capital rationing

Question 46

Equivalent Annual Annuity (EAA)

(Exclusive projects)

Answer 46

• Definition: cash flow per period with the same (net) present value as the (net) present value of the projects

Question 47

Equivalent Annual Annuity: Appraisal:

Advantages

Answer 47

• Flexibility: Compare projects even when there are differences in cost and revenue streams or lifespans • Simple method for selecting among mutually exclusive projects: Choose project with highest EAA (or lowest when just looking at costs)

Question 48

Equivalent Annual Annuity: Appraisal:

Disadvantages

Answer 48

EAA method is based on very restrictive assumptions • No technological progress • Infinite replacement of the machines

Question 49

Capital rationing:

NPV Investment Criterion and Reality

Answer 49

• Ideal NPV decision rule: accept all projects with a positive NPV • However, in reality, firms face capital constraints  Firms are often unable to invest in high-NPV projects

Question 50

Capital rationing:

Reasons for capital rationing

Answer 50

• Management induced capital rationing if a project is considered to be too big of a burden for the firm  Soft rationing: helps to slow down unwanted growth • Capital rationing due to investors not willing (or being unable) to provide the capital required for a project  Hard Rationing: often observed when it is difficult to disentangle worthy projects from less valuable ones

Question 51

Internal Rate of Return (IRR):

Definition

Answer 51

The IRR is the discount rate at which the NPV is equal to 0.

Question 52

Internal Rate of Return (IRR):

Investment Criterion

Answer 52

Accept all projects with IRR greater than the opportunity cost of capital

Question 53

Internal Rate of Return (IRR):

Notes

Answer 53

• IRR is related to NPV and gives same results (if carefully applied) • In the one-period case with CF 0<0, the IRR is the return on investment • Don’t confuse the IRR with the opportunity cost of capital r • IRR is a project characteristic • Opportunity cost of capital is determined by the market

Question 54

Problems with IRR:

NPV decreases with discount rate

Answer 54

• When NPV is a downward sloping function of the discount rate r the IRR Rule leads to the same decision as the NPV rule • This was the case of the last example

Question 55

Problems with IRR:

Complications

Answer 55

There are some instances where a blind application of the IRR capital budgeting technique leads to an undesirable solution: • Borrowing vs Lending • Multiple IRRs • Mutually exclusive projects • Capital rationing

Question 56

Borrowing vs Lending: Discussion:

NPV increases with discount rate

Answer 56

• When NPV is an upward sloping function of the discount rate r the IRR Rule has to be reversed and projects with IRR smaller than the opportunity cost of capital should be accepted

Question 57

Borrowing vs Lending: Discussion:

Intuition

Answer 57

• Case of the previous example: An increase in the discount rate does not affect the positive cash flow in t=0 but reduces the PV of the negative cash flow in t=1 (borrowing project) • In a borrowing project, the IRR is the borrowing rate. Would you rather borrow at a high or low rate?

Question 58

Multiple IRRs:

Problem

Answer 58

• Projects whose cash flows switch sign (e.g. neg – pos – neg) • Example of negative Cash Flows late in a project’s life: Decommissioning and clean-up costs

Question 59

Multiple IRRs:

Numerical Example

• CF0 = -925, CF1 = 1000, CF2 = 1400, CF3 = -1500 (clean-up costs) • What is the NPV at r=0%, r=10%, and r=30%?

Answer 59

r=0; -25
r=10%; 14.14
r=30%; -10.11

Question 60

Multiple IRRs:

Discussion

Answer 60

• NPV in the example is a hump-shaped function of r. • If the NPV is a hump-shaped function of r, then one should accept the project if the opportunity cost of capital lies between the two IRRs. • If NPV = U-shaped function of r, accept the project if the opportunity cost of capital is either below the first or above the second IRR.

Question 61

IRR versus NPV: Discussion:

NPV Investment Criterion

Answer 61

1. Requirements • Computation of NPV at the prevailing opportunity cost of capital 2. Accept the project if the NPV at this single point is positive. Reject the project if the NPV at this point is negative.

Question 62

IRR versus NPV: Discussion:

IRR Decision Rule

Answer 62

1. Requirements • Computation of all IRRs of the NPV function • Shape of entire NPV function (e.g., increasing, hump-shaped, …) 2. Accept the project if the opportunity cost of capital satisfies certain requirements w.r.t. the various IRR(s) derived in step 1.  The only case where the IRR rule is easy to apply is when the initial cash flow in t=0 has the opposite sign of all subsequent cash flows.