Capital budgeting/Investment decisions: non-current asset (tangible/non-tangible) – what LT investment ( WC, marketable securities) Capital structure/Financing decisions – how to raise fund for the selected investment (CL, LT-debt, Shareholder equity) Portfolio Variance Method 1: Step 1: Find the portfolio expected return of debt NOT zero of debt zero: all equity, zero debt, remain in same industry = (unlevered firm) = 0 Create value financial manager: smart 1. Investment 2. financing and 3. capital repayment decisions. •Sole Proprietorship: business owned and run by one person. There is no separation between the business & owner. The owner is personally liable for all the debts - unlimited liability. (Income tax once) •Partnership: General – all partners are liable for firms’ debt. Limited – general partner & limited partner (do not participate in management of biz, liability limited to the capital provided. (Limited life) •Corporation: separated from owners who are liable for obligation of biz, liability limited to the capital invested. Ownership & control are separated. Firm managed by BOD and CEO. (perpetual life) Capital Liquidity Tax Voting Standard method of raising Share can exchange easily Tax code 1 share 1 vote Risk and Return: this project [1] Opportunity cost – loss of salvage value if replace equipment. Deduct the opportunity cost from the cash flow. (Affect the initial cash outlay [2] Side effect/externalities: [+] complement: add the increase in sales revenue of the complement product [-] substitute/erosion: deduct from cash flow(sales) (affect the sales in OCF) IGNORE: [1]Sunk cost [2] Financing effect: interest expense → lesser tax → increase CF, interest & dividend expenses not included in calculation of debt zero & no tax of debt not zero & no tax of asset = of unlevered firm of common stock (equity) of levered (with debt) is > common stock Stability of Beta: ß is generally stable for firms remaining in the same industry → use industry ß. [1] Change in production line, technology [2] Deregulation [3] change in financial leverage. Restricted to few individual Restriction Tax on distributions General partners in charge. Agency problem: Principal (SH) – Agent problem (Manager – BOD): Exist between (SH & Manager) (SH & Creditors) instead of max SH wealth, “reasonable” return, max firm size & growth: 1. Increase job security as firm grows, 2. Increase power & salaries, 3. Create opp. for lower manager. [1] Interest Alignment: “Perk Consumption” – more outside ownership → less frugal as cost borne by outside shareholders. [2] Internal monitoring: Org. Structure: SH → elect BOD → select, monitor CEO, declare dividends, issue securities, make large investment outlays → CEO should run biz interest of SH, if not replace him . [3] External Monitoring – Threat of takeover: captured by entrenched CEO he performs poorly => share price falls => Low price leads to hostile takeover (ie 3d party replace BOD & CEO - Market Discipline) [4] Incentive, constraints and punishment. Compensation plans align interest. Tie salary to stock price, option, earnings, ROA. [5] Threat of Firing: SH elect new BOD & fire senior manager. [6] SH activism: large SH heavier influence on firms operations. Direct: [1] Exp to monitor mgmt actions (audit) [2] Exp to structure the org in a way that will limit undesirable mgmt behaviour by appoint outside investors to the BOD) Indirect: [3] Lost opp which increase firm value [3] Financial Leverage → Sensitivity of firms fixed cost of financing take on debt → higher FC (operate leverage) → higher Portfolio variance Method 2: Cash flow for final Year = OCF + 6000(1-0.34) after tax salvage value + recovery NOWC Main sources of Capital: Equity: Retained earning & new equity Debt: Bank borrowing & Issuing of bonds → Cost of debt: 1. Affected by: Interest rate level, default risk of firm, tax rates. 2. Interest company pay for secured/unsecured LT,ST debt. Perfectly negatively correlated: p = -1 Variance = 0 (riskless portfolio) Given progressive tax : 1. Increase tax rate and increase taxable income → increase tax shield Cost of Equity (CAPM): Return required for SH (risker, higher cost) Perfectly positively correlated, variance = 1 Unequal life: find EAA/EAC: Find the NPV of each project → solve for PMT → choose the highest EAA (Return) vs lowest EAC (cost) Sensitivity Analysis: Give better feel of project risk Total = diversifiable (unsystematic) + non-diversifiable systematic risk In large portfolio, the variance term (risk of each firm) is diversified but covariance (how each stock move together) is not. Relevant risk = security contribution to well-diversified portfolio risk. measure the responsiveness of a portfolio to the market. = 1 market return, = 0 (risk-free) >1 = more systematic < 1= less systematic risk To measure total risk → use SD To measure systematic risk → use beta To measure higher expected returns → the one with the higher beta (higher risk, higher returns) Diversified Portfolio → weighted average of unsystematic risk goes to zero Determinants of beta: [1] Business Risk → Cyclicity of revenue dependent on economic situation/market responses: Procyclical – High beta. Utilities – low beta. Volatile != high beta. High SD != High Beta.[2] [2] Operating Leverage → Sensitivity of firm’s fixed cost of production. Magnify the effect of cyclicity of beta. Degree of operating leverage (DOL) measure sensitivity to fixed cost. OL as FC & VC . Profit of firm with high fixed cost → more sensitive to change in volume → firm is risker → higher Step 1: Initial upfront cost + ∆ in NWC Step 2: OCF Step 3: Salvage value, tax on SV, recovery of NWC OCF = (Sales – Cost) (1-taxes) + taxes (depreciation) Break-even analysis: Give minimum target required Incremental after -tax cash flow = FCF = EBIT – Taxes on EBIT + Depreciation – Change in NOWC – CAPEX IR = 4, N=10 , PV = 1600, PMT NWC > 0 = negative cash impact CA → increase Cash/ AR (less cash inflow)/Inventory(increase cash outflow) -> less cash in the firm CL – Increase Account payable / accruals → more cash in the firm. (Change in NOWC = Y1-Y2) if sales increase, then the change is negative. Final year NWC = Y0 NWC – (Y1 to Y3) NPV understated if CF discounted with nominal GDP when inflation is positive (real = nominal – inflation) CONSIDER: Incremental cash flow: will CF occur ONLY if I take OCF = NI + D → EBIT =NI / (1+t) → EBIT + D + F = total revenue Financial break-even point = 𝑬𝑨𝑪+𝑭𝑪 (𝟏−𝒕)−𝑫(𝒕) (𝑷−𝑽)(𝟏−𝒕) Decision Tree: Relative, Comparable Valuation, Market Multiple, peer comparison. 𝑝 𝑠ℎ𝑎𝑟𝑒 𝑝𝑟𝑖𝑐𝑒 1. 𝑃𝑟𝑖𝑐𝑒 𝑡𝑜 𝑒𝑎𝑟𝑛𝑖𝑛𝑔 = 𝑒 = 𝑒𝑎𝑟𝑛𝑖𝑛𝑔 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 High P/E. means market expect firm to do well and its more profitable in the future. Limitations [-] hard to compare across different country due to different accounting rules [-] multiple cannot be used when earning are negative [-] P/E can be large for firms with small earning per share. 2. 𝑃𝑟𝑖𝑐𝑒 𝑡𝑜 𝑏𝑜𝑜𝑘 = 𝑝 𝑏 = 𝑚𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 𝑏𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 High P/B means market value share highly = growth stock. Low P/B = value stock 𝑝 𝑚𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 3. 𝑃𝑟𝑖𝑐𝑒 𝑡𝑜 𝑠𝑎𝑙𝑒 = 𝑠 = [+] since denominator not 𝑠𝑎𝑙𝑒𝑠 dependent on accounting choices, easier for comparison. [+] revenue is non-negative, it is useful for young companies. Value of Expand: Value to Delay: 𝐸𝑛𝑡𝑒𝑟𝑝𝑟𝑖𝑠𝑒 𝑣𝑎𝑙𝑢𝑒 𝑡𝑜 𝐸𝐵𝐼𝑇𝐴 = 𝐴’𝑠 𝑠ℎ𝑎𝑟𝑒 𝑝𝑟𝑖𝑐𝑒 = 𝐸𝑉 𝐸𝐵𝐼𝑇𝐴 𝑀𝑉 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦+𝑀𝑉 𝑜𝑓 𝑑𝑒𝑏𝑡−𝑒𝑥𝑐𝑒𝑠𝑠 𝑐𝑎𝑠ℎ # 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 𝐸𝑉 𝑀𝑉 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦+𝑀𝑉 𝑜𝑓 𝑑𝑒𝑏𝑡−𝑒𝑥𝑐𝑒𝑠𝑠 𝑐𝑎𝑠ℎ 𝐵𝑉 = 𝐵𝑉 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦+ 𝐵𝑉 𝑜𝑓 𝑑𝑒𝑏𝑡−𝑒𝑥𝑐𝑒𝑠𝑠 𝑐𝑎𝑠ℎ Limitations Relative valuation: [1] Peer Firms are not identical: expected growth rate, profitability, risk, accounting conventions, management & tech. Value to abandon: Value of option: (with option)(75) – project value (without)(-34.4) FCF = cash that firm is free to distribute to creditors and stockholders because it is not needed for working capital or fixed asset. Enterprise value = PV of future cash flow (underlying asset – nonoperating asset) Cost of operating asset 𝑬𝑽 = 𝑴𝒂𝒓𝒌𝒆𝒕 𝑽𝒂𝒍𝒖𝒆 𝒐𝒇 𝒆𝒒𝒖𝒊𝒕𝒚 + 𝑫𝒆𝒃𝒕 – 𝑬𝒙𝒄𝒆𝒔𝒔 𝑪𝒂𝒔𝒉 𝑭𝑪𝑭 ∗ (𝟏+𝒈) 𝑹 𝒘𝒂𝒄𝒄−𝒈 + 𝑬𝒙𝒄𝒆𝒔𝒔 𝑪𝒂𝒔𝒉 − 𝑽𝒂𝒍𝒖𝒆 𝒐𝒇 𝑫𝒆𝒃𝒕 * DCF is preferred over dividend growth model because firm may not pay dividends and it is hard to forecast. Sources of equity: [1] Angel investors – individual buy up equity in small private firm, may exert control, bring in expertise, difficult [2] Crowdfunding – startup raise small amount from large # of investors [3] Venture capital firm – Limited partnership that specialize in raising money to invest in PE of young firms. General partnership – run the firm, provide expertise, monitor the invested company, charge high fees. Limited Partners- pension funds, insurance companies, endowment, foundation may invest directly or indirectly. VC : financial intermediaries which raise fund from outside investor. Plays an active role in overseeing, advising and monitoring. Do not owe the co. forever → sell to another company, IPO IPO BENEFITS: [1] Greater Liquidity PE investor get the ability to diversify [2] Access to Capital through capital market. IPO DISADVANTAGES: [1] Equity holder are dispersed, hard to monitor management, agency problem [2] Too many requirement, high compliance cost. = 𝑴𝒂𝒓𝒌𝒆𝒕 𝒗𝒂𝒍𝒖𝒆 𝒐𝒇 𝒆𝒒𝒖𝒊𝒕𝒚 𝒏𝒖𝒎𝒃𝒆𝒓 𝒐𝒇 𝒔𝒉𝒂𝒓𝒆𝒔 Forecasting financial statement: [1] historical statements 3-5 years [2] company projections. [3] Equity research analyst [4] industry data benchmark growth and margin development against comparable companies. Seasoned Equity Offering: Public co. offer new shares to raise extra equity. Key difference: There is already market price for the stock. Cash Offering: offer new share to investor at large. Underwriter is needed. Dilute EPS. Rights Offering: offer new share to existing SH. Protect from underpricing and dilution of cash offer. Do not need underwriter. Specific time, price, quantity Exercise price: price that existing SH pay for new share. Number of rights: # of existing share needed to buy 1 new share 𝑡𝑜𝑡𝑎𝑙 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠 𝑛𝑒𝑤 𝑠ℎ𝑎𝑟𝑒𝑠 𝑖𝑠𝑠𝑢𝑒𝑑 Ex-rights: price needed to buy 1 new share in the market 𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠 𝑡𝑜𝑡𝑎𝑙 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 𝑠ℎ𝑎𝑟𝑒𝑠 𝑖𝑠𝑠𝑢𝑒𝑑 * right offering always lead to lower price. 𝑜𝑟𝑖𝑔𝑖𝑛𝑎𝑙 ℎ𝑜𝑙𝑑𝑖𝑛𝑔+ 𝑝𝑟𝑖𝑐𝑒 𝑝𝑎𝑖𝑑 𝑓𝑜𝑟 𝑎𝑑𝑑𝑖𝑡𝑜𝑛𝑎𝑙 𝑠ℎ𝑎𝑟𝑒 Cum rights (original price) : 𝑡𝑜𝑡𝑎𝑙 𝑠ℎ𝑎𝑟𝑒𝑠 Cum rights (original price) : value of the right + ex-right 𝑒𝑥−𝑟𝑖𝑔ℎ𝑡−𝑠𝑢𝑏𝑠𝑐𝑟𝑖𝑝𝑡𝑖𝑜𝑛 𝑝𝑟𝑖𝑐𝑒 Value of the right = #𝑜𝑓 𝑟𝑖𝑔ℎ𝑡𝑠 𝑡𝑜 𝑏𝑢𝑦 𝑜𝑛𝑒 𝑠ℎ𝑎𝑟𝑒 Value of the right : 𝑁𝑒𝑤 𝑝𝑟𝑖𝑐𝑒−𝑜𝑙𝑑 𝑝𝑟𝑖𝑐𝑒 #𝑜𝑓 𝑟𝑖𝑔ℎ𝑡𝑠 𝑡𝑜 𝑏𝑢𝑦 𝑜𝑛𝑒 𝑠ℎ𝑎𝑟𝑒 IPO Underwriter: Traditional IPO: [1] Firm commitment → sell all stock at offer price. Greenshoe Provision- issue more share @ offer price, 15% of offer size [2] Best Effort → IB firm manages a security issuance & design structure (buy cheap, resell them). Invites applicated for share @ offer price. IPO underpricing: underwriter set issue price. First day return = end of first trading day – offer price. Winner’s curse: underpricing counteract. Terminal value calculation assumes that business generate FCF that grows on constant rate in perpetuity. Normalize FCF of terminal value for highly cyclical business [6] Term loans → bank loan that lasts for a specific term [7] Syndicated Bank Loan → single loan funded by group of banks [8] revolving line of credit →credit commitment given to company 𝐸𝐵𝐼𝑇𝐴 (𝐴’𝑠 𝐸𝑉+ 𝐸𝑥𝑐𝑒𝑠𝑠 𝑐𝑎𝑠ℎ – 𝑑𝑒𝑏𝑡) 𝑒𝑛𝑡𝑒𝑟𝑝𝑟𝑖𝑠𝑒 𝑣𝑎𝑙𝑢𝑒 𝑡𝑜 𝐵𝑉 = 𝑽𝒂𝒍𝒖𝒆 𝒐𝒇 𝒆𝒒𝒖𝒊𝒕𝒚 = = Other IPO: Auction, Direct Listing (no underwriting fee, lock-up period cheap, depend on demand & supply, employee sell stock to public), Initial coin offering (sell token for future promise). SPAC → A company goes public, sponsor raised money in IPO → trust → buy securities → DESPAC (exchange cash for equity stake) take target firm public via reverse merger. → trade like stocks [+] fast, less disclosure, cheap [-] agency problem, low disclosure. IPO cyclicality (good times, more issue) Reaction: stock issue → decrease stock price while Debt → no change 1. Managerial information. Managers know that firm is overvalued, therefore they issue new share. But investor will discount it during issue 2. Debt capacity (financial distress as they have too much debt, little liquidity) (debt cheaper than equity, do not make sense to let new shareholder in), EPS diluted 3. Issue cost, secondary offering is expensive Underwriter increase stock price, provides insurance, certify the price, Issuing corporate debt [1] Prospectus → Public bond issue similar to stock, with indentures [2] Unsecured Debt → no collateral backing, in the case of bankruptcy, bondholders claim only unpledged asset. Notes/Debentures [3] Secured debt → specific asset (inventory) pledges as collateral [4] Mortgage bonds → Real property is pledge as collateral that Bondholder have direct claim during bankruptcy [5]Asset-backed bonds → specific asset (loans, leases) pledges as collateral that Bondholder have direct claim during bankruptcy Private debt: Cash flow from asset sales = 𝑺𝑽 − 𝒕(𝑺𝑽 − 𝑩𝑽) = add to terminal value if SV> BV: need to pay back excess tax shield.
