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CTP Review
Chapter 13
Presented by: The Northern Trust Company
Elizabeth V. Hasten,CTP
© 2012 Northern Trust Corporation
Chapter 12
Financial Decisions and Management
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Importance of Finance and Treasury
 Objectives
for Treasury Professionals
Short-term
– to sustain organizations operations
– to sustain organizations overall financial
objectives and mission
Long-term
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Importance of Finance and Treasury
Financial Objectives for Different Types of Organizations:
For-profit
Not-for-profit
Government
• Managers work for
owners.
• Managers work
toward goals set by
charter.
• Managers work for
the public.
• Maximize firm’s
long term value =
value of common
stock
• Generate returns
greater than cost of
funds.
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• Using best
resources available
as efficiently as
possible, to provide
maximum benefits.
• Similar to Not-forProfit - provide
maximum benefit
as defined by legal
responsibilities.
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Importance of Finance and Treasury
The Finance Function
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Accounting
Responsible for accurately recording assets,
liabilities, revenues, expenses
Funding
Determines overall cost of capital and capital
structure
Capital Budgeting
Quantitatively evaluates projects and estimates
relative returns; then qualitatively evaluates projects
Financial Planning
Determines need for present and
future funding
Risk Management
Includes financial, credit, counter-party and other
types of risk
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Importance of Finance and Treasury
Key Capital Financial Decision
 Financing
Decisions
 How
much capital to raise outside the company? How fast will
organization grow?
 Capital
Structure Decisions
 How
much short-term and long-term debt is to be used vs. equity capital?
Determine mix with lowest cost with flexibility.
 Asset
Investment Decisions
 Which
projects or acquisitions to fund? How much to invest in strategic
assets (compete for funding)?
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Importance of Finance and Treasury
Key Capital Financial Decisions
 Dividend
Decisions
 How
much dividends should the company pay or not pay and
reinvest? Many factors:
 Board of directors, in its role as the “voice” of stockholders,
decides whether to pay a dividend
 Decision is guided by shareholder or, in some cases, analyst
expectations
 May also depend on a company’s industry, stage of development,
dividend payment history and/or covenants
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Raising and Managing Long-Term Capital
 Why
Private Placement is preferred over Public Issuance:
 Less
covenants
 Smaller
issue size
 Reduced
time
 Minimal
reporting requirements or disclosures
 IPOs require disclosure of ownership, financial statements, etc…
 Lower
costs
 Of reporting and disclosure
 Price can fluctuate due to economy, technology, government
regulations or public perception of company
 Control
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over who holds debt
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Raising and Managing Long-Term Capital
 Managing
Outstanding Capital
 Manage
Legal and Payment Requirements
 Manage Trustee Relationships
 Disbursing Agent
 Shareholders – dividends
 Bondholders – P&I payments
 Other obligations under covenants
 Investor
Relations
 Maintain shareholder lists
 Send financial statements, annual reports, other filings
 Communicate with share- and bond-holders
 Answer investors’ questions
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Cost of Capital and Firm Value
 Primary
sources of capital are L-T debt (bonds) and equity (stock and
retained earnings)
 Cost
of Debt:
 Relevant cost is After-Tax
 Pre-tax cost of bond is Yield to Maturity (YTM), or the rate of
return over the bond’s remaining life based on market price when
measured. TYM is converted to an after-tax rate using the
following equation:
After-Tax rD = rD (1-T)
After-Tax rD = After-tax cost of debt
rD = Yield to maturity on newly issued debt (before tax)
T = Company’s marginal income tax rate
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Cost of Capital and Firm Value
Cost of Debt example: Marginal tax rate = 30% and a YTM = 5% on a
newly issued debt.
After-Tax rD = rD (1-T)
After-Tax rD =.05 (1-0.30) = .035 = 3.5%
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Cost of Capital and Firm Value
 Primary
sources of capital are L-T debt (bonds) and equity (stock and
retained earnings)
 Cost
of Common Equity:
 CAPM – Capital Asset Pricing Model (Chapter 12)
 Cost that applies to equity funds that are obtained through
retained earnings.
r E= r RF = (rM – r RF) β
rE = Required rate of return on stockholder’s equity
rRF = Expected rate of return on the Risk-Free asset (T-Bill)
rM = Expected rate of return on the market portfolion (S&P 500)
β = Beta value for the company’s stock
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Cost of Capital and Firm Value
Cost of Equity Capital example: Risk Free Rate (T-bill) = 4.0%, return
on overall market is 10.0%, beta is 1.2.
r E= r RF = (rM – r RF) β
rE = .04 + (0.10 - 0.04)(1.2) = 0.112 or 11.2%
The cost of equity capital is 11.2%, which means that the equity raised
through retained earnings costs the company 11.2%, and the
stockholders require a rate of return of 11.2% from the company
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Cost of Capital and Firm Value
 Weighted
Average Cost of Capital (WACC)
 Calculates
weighted average of the costs of long-term debt and equity
where the weights represent the proportion of each in long-term
financing.
WACC = WDrD(1 – T) + WErE
WACC = Weighted Average Cost of Capital
W = % (weight) of each source of financing in relation to the sum of
debt and equity financing
D = Debit
E= Equity
(rD)(1 – T) = After-tax cost of debt
rE = Cost of equity (common stock and retained earnings)
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Cost of Capital and Firm Value
WACC example: 1/3 or 33.3% of financing provide by debit and 2/3 or
66.7% provided by equity.
WACC = WDrD(1 – T) + WErE
WACC = 0.333 x 0.05 x (1 – 0.3) + (0.667 x 0.112) = 8.64%
The WACC or overall cost of capital is 8.64%, which is an estimate of
the market’s expected return for this company.
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Cost of Capital and Firm Value
 Firm
Value
 Economic
value added (EVA) emphasizes a rate of return on assets
that exceeds the cost of capital to create shareholder value. Assume
that $50,000,000 of capital is employed, the company generated an
operating profit of $6,800,000, and WACC is 8.64%.
EVA = EBIT (1 – Tax Rate) – (WACC)(Long-Term Debt + Equity)
= $6,800,000(1 – 0.30) – (.0864)($50,000,000)
= $4,760,000 - $4,320,000 = $440,000
Positive EVA will cause share price to increase .
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Debt Financing and Management
 Costs
of Borrowing
 Interest
expense
 Credit
enhancements (guarantees or letters of credit)
 Rating
agency fees
 Legal
fees
 Commitment
and facility fees
 Broker/Dealer
 Monitoring,
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fees
negotiating (soft $ cost), and maintaining loan covenants
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Debt Financing and Management
Basic Components in Interest Rates
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r*RF
Real risk-free rate of
interest
Rate demanded by savers to compensate for
delaying use of money today, absent risk or
inflation, for 1-year maturity.
IP
Inflation premium
The real-risk free rate plus the inflation
premium matches the T-bill rate in the U.S.
DP
Default premium
For investments other than government
securities, a risk-return premium is added.
LP
Liquidity premium
While markets for most securities of large
governments are highly liquid, other
markets have lower liquidity.
MP
Maturity premium
Longer-term investments have more price
risk and thus a maturity premium.
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Debt Financing and Management
 Base
Rates
 Economic
conditions and yield curves (Ch 11) impact base rates
 LIBOR – London Interbank Offer Rate
 Fed Funds (Federal Reserve) Rate
 Prime Rate
 Short-
vs. Long-Term Borrowing
 Risks
of Short-Term Borrowing
 Fluctuation of rates – companies use derivatives to reduce risk
(Long-Term Borrowing uses fixed rates)
 Availability of funds – may not always be available from lenders
– mitigated by using multi-year lines of credit
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Debt Financing and Management
 Advantages
of Short-Term Borrowing:
 Ease of access:
 No Fed reserve requirements < 365 days
 Less-restrictive covenants
 Flexibility for future borrowing
 Ability to finance seasonal credit needs efficiently
 Can be obtained from spontaneous sources:
 A/P
 Accrued expenses
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Debt Financing and Management
 Disadvantages
of Short-Term Borrowing:
 Continuing need to roll over financing
 Lender may not renew:
 Changes in financial variables in the firm
 Changes in general economic conditions
 Clean-up periods on lines of credit
 Downsides to secured borrowing:
 Asset monitoring
 Asset key ratios
 Limited to percentage of asset value
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Debt Financing and Management
 Loan
Agreements and Covenants
 Impose
restrictions (covenants) or obligations on management, which
have an impact on decision making
 Restrictions
could include:
Ability to sell certain assets
Right of an organization to issue additional bonds
Use of second or junior mortgages
Key ratios that limit flexibility in financial decision making
Payment of dividends
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Debt Financing and Management
 Credit
Rating Agencies
 National
Recognized Statistical Rating Organizations (NRSRO)
ratings are not investment recommendations but an assessment of the
potential downside loss.
 Generally
have access to firm’s internal information (widely
accepted).
 Dodd-Frank
Act rating agency changes:
 Rating agencies must provide greater disclosure of rating models
and methodologies.
 Subject to greater liability.
 SEC given two years to eliminate conflicts of interest between
rating agencies and the organizations they regulate.
 Classes:
 Issuer – Issuer’s overall capacity to meet financial obligations
 Issue-Specific – Consider the specific terms of the issue
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Debt Financing and Management
 Ratings
Process – quantitative and qualitative analysis
 Reviews
 Credit
of Ratings – usually once per year
Rating Scales
 Scales used for bonds recognized by SEC
 Short-Term credit uses different system since Long-Term debt
has more variables that affect ratings
 Long-Term Bond Credit Ratings (page 491)
 Short-Term Credit Ratings (page 492)
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Lease Financing and Management
 Capital
Asset Acquisition process:
 Acquisition
- capital budget decision already made prior to leasing
decision
 Finance
 Why
- borrowing or leasing
Companies Lease -
 Lessor
receives lease payments from lessee; both get a tax benefit
 Direct
substitute for debt
 Good
for when there is a high uncertainty for future demand or for
items outside firm’s area of expertise
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Lease Financing and Management
 Types
 Sale
of Leases
and leaseback
 Give company cash infusion
 For companies that cannot take advantage of depreciation tax
benefits
 Operating
or service leases
 Lessor maintains, retains asset at end
 Often OBSA
 Shorter duration than life of asset
 Capital
Asset Acquisition process:
 Acquisition - capital budget decision already made prior to
leasing decision
 Finance - borrowing or leasing
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Lease Financing and Management
 Capital
or financial leases
 Alternative to borrowing funds and purchasing asset
 Residual value is estimated value at end of lease (lessee maintains asset
and pays taxes and insurance)
 Double-net lease (triple-net in real estate)
 ASC Codificaiton Topic 840-10-15: restate company’s balance sheet
(leased asset as fixed asset, lease payments as liability
 Leases meeting any one of the following four conditions must be
classified as a capital lease:
 The length of the lease is at least 75% of the estimated useful life
of the asset.
 There is a transfer of ownership to the lessee at the end of the lease.
 The lease agreement contains a provision that allows the lessee to
purchase the asset per a bargain purchase option during or at the
end of the lease’s life.
 The present value of the discounted lease payments at the
beginning of the lease term exceeds 90% of the asset’s fair market
value.
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Lease Financing and Management
 Estimated
Residual Value
 Sale and leaseback
 Lessor has primary claim on an asset’s residual value.
 Residual value is built in to most lease arrangements, and
potentially high residual value can lower lease payments.
 Residual value may impact a lease’s tax status and requirements
for listing as an Off-Balance Sheet Arrangement (OBSA)
 Assumed residual value is important because the lease may
require payment of the difference between this amount and actual
residual value (e.g., tied to mileage or general condition of a
vehicle)
 Tax
Considerations for U.S. Corporations
 Lease
vs. Borrow-and-Buy
 Based on comparing the costs of leasing with the costs of
borrowing to buy the asset
 Net present value of cash flows for each alternative
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Equity Financing and Management
 IPO
 Advantages
 Diversification and increased liquidity
 Establishing the value of a closely held company
 Spin off a subsidiary
 Disadvantages
 SEC disclosure
 Loss of managerial flexibility
 Surrender of some control
 Other factors:
 Smaller company stocks may not be especially liquid.
 Small market/infrequent trading leads to undervalued stock.
 Increased reporting and disclosure (debt rating).
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Equity Financing and Management
 The
Decision to List Stock
 Advantages
 Primary advantage: increased marketability of stock.
 Increased public exposure causes higher sales.
 Increased level of disclosure may lower WACC on a company’s
common stock and bonds, increasing the firm’s market value.
 Disadvantages
 Additional requirements keep some companies in OTC market.
 OTC liquidity has increased since 1990s (e.g., NASDAQ).
 Some smaller companies voluntarily delist rather than comply
with disclosure requirements of SOX.
 Delisting
– may still be traded on the OTC market
 Exchanges
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– requirements for various exchanges
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Equity Financing and Management
 Shareholder
 Control
Rights
of Company
 Cumulative
Voting - # of votes per share as open posts on board
 Proxy
 Assigning another individual, trough a proxy, the right to vote at
the annual meeting
 Staggered
Election of Directors
 Makes it difficult to take over the entire board
 Preemptive
Right
 Existing shareholders have first right to purchase shares of any
new stock issue on a pro-rata basis based on the number of shares
owned
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Equity Financing and Management
 Financing
Mergers and Acquisitions
 Merger
 Two companies combine and one ceases to exist
 Consensual
 Acquisition
 One company buys majority voting shares of another
 Friendly – stock transfer or asset purchase
 Bidding company informs board of intent
 If rejected, bidder may take case directly to shareholders
 Hostile – lack of due diligence
 Direct tender to shareholders (usually a premium)
 Proxy fight
 Creeping tender offer
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Equity Financing and Management
 Stock
Transfer
 Exchange of stock of companies
 May pay cash to shareholders of acquired firm
 Acquiring firm owns other’s assets and assumes liabilities
 Asset
Purchase
 Acquiring firm may buy some or all of the assets
 May selectively assume liabilities
 Cash
Payment
 Cash from either company
 Sale of assets
 Issuance of bonds – investment or junk
 LBO
– Leveraged Buy Out
 Small group of investors purchases a firm using large amounts of
debt; results in a high debt (i.e., leverage) ratio.
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Other Topics in Financial Decisions
 Tax
Strategies
 International
businesses need global tax strategy to avoid unfavorable
tax consequences, such as:
 Double taxes
 Balancing home country and foreign tax considerations
 Working in countries without an international tax treaty network
 Widespread
and complex international transfer pricing rules:
 Strict arm’s length
 Understand both home country and foreign transfer rules
 Deemed
 Solid
dividends
tax strategy requires understanding firm’s:
 Business and financial position
 International operating strategy
 Intended areas of operation outside the U.S.
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Other Topics in Financial Decisions
 Impact
of a Financial and Credit Crisis
 Impact
on Financial Institutions
 Crisis creates liquidity problems due to asset/ liability mismatch
(long-term assets financed with short-term funds).
 Governments provide liquidity infusion.
 Systemic risks.
 Tightening
of Credit Markets
 FIs revalue portfolios → FIs reinforce capital base, tighten
lending standards, reduce lending → corporate ratings decline →
non-bank, short-term lending markets reduced.
 Increased
Awareness of Financial Risk
 FIs revalue portfolios → FIs reinforce capital base, tighten
lending standards, reduce lending → corporate ratings decline →
non-bank, short-term lending markets reduced.
 Market
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Analysis and Research Tools
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