Review
FINA 7330
Advanced Corporate Finance
Lecture 13
Ronald F. Singer
Fall, 2009
Making Investment Decisions
• NPV Rule
– Incremental Cash Flow
– After Tax basis when paid
– Opportunity Costs
– Changes in Working Capital
– Depreciation Not a Cash Flow
– Treat Inflation Consistently
• MAXIMIZE NPV
Practical Problems in Capital
Budgeting
• Basically: What happens when you
cannot take all positive NPV projects.
– Must Consider the package of projects which
maximizes the NPV of all possible alternatives
• Classes:
– Two possibilities
• Once and for all deals
• Repetitive deals
Once and for all deals
Mutually Exclusive Projects: Basically
dealing with mutually exclusive decisions
– Mutually Exclusive Projects
• Beware of the conflicts between IRR and NPV
– Investment Timing: When is the optimal time
to take on a project: (Want to max the
Present value of the NPV)
– Budget Constraints: What subset of all
possible combinations give you the highest
NPV
Repetitive Deals
• Mutually Exclusive projects with different
starting times, economic lives
• Replacement Decision
In general, you “smooth” the cash flows by
finding Equivalent Annual Cash Flow, so
that projects can be compared.
Repetitive Deals
• Mutually Exclusive projects with different
starting times, economic lives
– Equivalent Annual Cash Flow
• Replacement Decision
– Replace when
• EACF replacement > EACF existing
Analysis of Projects
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Sensitivity Analysis
Scenario Analysis
Break Even Analysis
Monte Carlo Simulations
Real Options and Decision Trees
– React to ongoing information as it is revealed
Strategic Investment Decisions
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Trust Market Values
Look for comparative advantage
Consider opportunity costs
How will introducing this project effect
other products you produce
• When will introduction of this project
induce competition
• What will happen to the price over time
Payout Policy
• Critical Dates
– Announcement Date
– Record Date
– Payment Date
– Ex-dividend Date
Payout Policy
• Dividends versus repurchase of shares
– Signaling implications of announcements
– Agency Costs
• Free Cash Flow
– Tax implications
– Liquidity
Lintner’s Model
 DDiv(t) = a(Div(t)*-Div(t-1))
Where the dividend target (Div(t)*) is
determined as a proportion of long run
earnings
Payout Policy
• What investors do
• What firms do
• What effect does dividend policy have on
price
Empirical Payout Policy
• Repurchases versus Dividends
• Signals
– Fixed price tenders versus open market
purchases
– High market/book versus low market/book
• What does market/book tell you
• What do you expect the reaction in these 2 cases
to be
– Repurchase versus Dividends
Long-Run Policy
• Tax Effects
• Free Cash Flow
Dividend Policy
• What should corp. do?
• What should individual do?
• What is the impact on the total value of the
firm
Agency Problems
• How do you induce managers to act in
stockholders’ interest
Message of EVA
+ Managers are motivated to only invest in
projects that earn more than they cost.
+ EVA makes cost of capital visible to managers.
+ Leads to a reduction in assets employed.
- EVA does not measure present value
- Rewards quick paybacks and ignores time value
of money
+ Present Value of EVA does measure NPV and
thus consistent rewarding via EVA leads to good
decisions
Capital Structure
• Capital Structure Defined
• The Modigliani Miller Theory
• Static Tradeoff Theory
– Taxes
– Bankruptcy costs and costs of financial
distress
– Information costs
• Pecking Order Theory
Capital Structure
• Agency Problems
– Underinvestment
– Overinvestment (risk shifting)
Raising Capital
• Information and how capital is raised
– Debt versus equity
– Cash flow in versus cash flow out
• Organizational changes
– Transactions that increase ownership
concentration increase stock prices
• Underwritten versus Rights offering
– Greater Commitment by underwriter has
positive impact on stock price
Summary
– Leverage Increasing (+Price Reaction)
– Cash Flow In (+Price Reaction)
– Underwritten versus Rights Offering (less
underpricing)
• Firm Commitment versus Best Efforts
• Negotiated versus Competitive Bid for underwriter
• Traditional Registration versus Shelf Registration
– Organizational Structure (Price reaction)
• Increasing concentration of ownership
• Voluntary Reorganization
Advent of “innovative securities”
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Inefficient markets
Incomplete markets
Resolves conflicts of interest
Tax or regulatory arbitrage
Encourage efficient production