Welcome! 2023 Class Corporate Finance (RSM 333) Contact: otto.yung@alumni.utoronto.ca 1 RSM 333 – CORPORATE FINANCE Welcome to Session 1 Session 1 – Introduction and Capital Budgeting Methods Session 2 – Estimating Cash Flows and Capital Budgeting Decisions Session 3 – Capital Budgeting – Risk & Return Session 4 – Cost of Capital Session 5 – Capital Structure I – Debt/Equity Mix Session 6 – Capital Structure II – Limits to the Use of Debt Midterm Session 8 – Dividend Policy Session 9 – Valuation Session 10 – Mergers and Acquisitions Session 11 – Financial Analysis / Financial Planning & Growth / Working Capital Mgt Session 12 – Group Presentations Final Exam (during Exam Period) Contact: otto.yung@rotman.utoronto.ca 2 RSM 333 Introduction and Capital Budgeting Methods (Session 1) Introduction to Corporate Finance • Definition & Goal of a Corporation • Financial Management Decisions & Financial Statements Project Valuation (Net Present Value and Other Investment) • Introduction to Capital Budgeting Process • Average Accounting Return (AAR) • Payback Period & Discounted Payback Period • Net Present Value & Profitability Index (PI) • IRR (Internal Rate of Return) • IRR vs. NPV • How to Rank Projects? Types of Business Organizations • Sole Proprietorships • A business owned by one person • Personally responsible, can lose personal assets such as a house or bank account • Partnerships • A business owned and operated by two or more people • Partners are responsible for the actions of all partners, not just themselves • Corporations • A business organized as a separate legal entity under corporate law, with ownership divided into transferable shares 4 Corporations • Advantages • Limited liability • Unlimited life • Liquid transfer of ownership • Easier to raise capital vs. sole proprietorship or partnership • Professional management often distinct from owners • Disadvantages • Separation of ownership and control – incentive alignment • Double taxation (income is taxed at the corporate level and then dividends paid from income are taxed again at the personal level) 5 Corporations • What should be the goal of a corporation? • • • • Maximize profit? Minimize costs? Maximize market share? Maximize the current value of the company’s stock? 6 Corporations • What should be the goal of a corporation? • Maximize the Current Market Value of Shareholders’ Equity • Managers must select and fund investments that increase the wealth of shareholders • Does this mean we should do anything and everything to maximize owner wealth? 7 The Role of Management • Regardless of the goals of the corporation, it must be managed by someone (other than owners): we call this “separation of ownership and control” • The management team decides firm policies: • CEO (Chief Executive Officer) • CFO (Chief Financial Officer) • COO (Chief Operating Officer) • etc. • Would managers have the incentives to maximize the market value of shareholder equity? 8 Separation of Ownership and Control 9 Finance Function within the Corporation • • The Top Finance Executive is the CFO Two main financial positions report to the CFO • Controller • Compliance • Tax Management • Systems/MIS • Internal Audit • Accounting / Budgeting • Treasurer • Forecasting • Pension Management • Capital Budgeting • Cash & Credit Management • Financing / Risk Management 10 RSM 333 Introduction and Capital Budgeting Methods (Session 1) Introduction to Corporate Finance • Definition & Goal of a Corporation • Financial Management Decisions & Financial Statements Project Valuation (Net Present Value and Other Investment) • Introduction to Capital Budgeting Process • Average Accounting Return (AAR) • Payback Period & Discounted Payback Period • Net Present Value & Profitability Index (PI) • IRR (Internal Rate of Return) • IRR vs. NPV • How to Rank Projects? Finance Management Decisions • Capital Budgeting • What long-term investments or projects should the business take on? • When do we replace assets? • Capital Structure • How should we pay for our assets? • Should we use debt or equity? • “Financing” decision • Working Capital Management • Availability of cash and inventories when needed • Credit to customers and from suppliers/lenders • How do we manage the day-to-day finances of the firm? 12 Finance Management Decisions: Capital Budgeting • Capital Budgeting • What long-term investments or projects should the business take on? • When do we replace assets? • Left side of the balance sheet, long-term assets 13 Finance Management Decisions: Capital Structure • Capital Structure • How should we pay for our assets? Should we use debt or equity? • Right side of the balance sheet 14 Finance Management Decisions: Working Capital Mgt • Working Capital Management • How do we manage the day-to-day finances of the firm? • Both sides of the balance sheet, NWC = CA - CL 15 Main Financial Statements • Balance Sheet • Assets = Liabilities + Equity • Income Statement • Income = Revenue – Expenses • Cash Flow Statements • Explains how cash balance changed due to: • Operations • Investments • Financing • Link between B/S and I/S? • Income not paid out as dividends adds to retained earnings • Review textbook Chapter 2 if needed 16 RSM 333 Introduction and Capital Budgeting Methods (Session 1) Introduction to Corporate Finance • Definition & Goal of a Corporation • Financial Management Decisions & Financial Statements Project Valuation (Net Present Value and Other Investment) • Introduction to Capital Budgeting Process • Average Accounting Return (AAR) • Payback Period & Discounted Payback Period • Net Present Value & Profitability Index (PI) • IRR (Internal Rate of Return) • IRR vs. NPV • How to Rank Projects? Capital Expenditures (“CAPEX”) Decisions • A firm’s investments in long-lived assets • Tangible (property, plant and equipment) or • Intangible (e.g., research and development, patents) • Very important to the future direction of the company • Involves very significant outlay of money and managerial time • Takes many years to demonstrate their returns 18 Capital Budgeting: CAPEX Decision Process • The process includes: • Identifying investment alternatives (capex project) • Evaluating these alternatives • Implementing the chosen investment decisions • Objective: • Maximize the wealth of the shareholders of the firm • A good method of project evaluation will: • Take all incremental project cash flows into consideration • Discount these cash flows at an appropriate risk adjusted discount rate 19 What is a “Project”? • Typical cash flow pattern: • CF0 = initial after-tax incremental cash outlay or “investment” required • CFt = estimated after-tax future incremental cash flow at time t • Projects can be: • Equipment replacement/expansion of current business activities • New products or processes CF0 20 Different Types of Projects • Independent Projects • Can be analyzed individually and each is accepted/rejected • Mutually Exclusive Projects • Are those where just one will be selected • e.g., building a subway or light rail -> Choose maximum NPV • Contingent Projects • Must be done together • e.g., upgrading the software requires a hardware change • Calculate the NPV of the two in combination to see if they are acceptable • Synergistic Projects • Are worth more if done together • e.g., build a larger soccer stadium and at the same time invest in more 21 premium players RSM 333 Introduction and Capital Budgeting Methods (Session 1) Introduction to Corporate Finance • Definition & Goal of a Corporation • Financial Management Decisions & Financial Statements Project Valuation (Net Present Value and Other Investment) • Introduction to Capital Budgeting Process • Average Accounting Return (AAR) • Payback Period & Discounted Payback Period • Net Present Value & Profitability Index (PI) • IRR (Internal Rate of Return) • IRR vs. NPV • How to Rank Projects? Capital Budgeting Models 23 Average Accounting Return (AAR) 24 Average Accounting Return (AAR) - Example • • • You want to invest in a machine that produces squash balls The machine costs $90,000 and has a 3-year useful life Assume straight-line depreciation (so annual depreciation is $30,000) • Given a net income (cash flow) forecast for the life of the project See Excel Example 25 Average Accounting Return (AAR) – Things to Remember • The objective is to maximize the wealth of the shareholders of the firm • A good method of project evaluation: • Takes all incremental project cash flows into consideration • Discounts all these cash flows at an appropriate risk-adjusted discount rate • So, is the AAR method a “good” method of project evaluation? 26 Average Accounting Return (AAR) • Advantages • Accounting information is usually available • Easy to calculate • Disadvantages • Ignores the time value of money • Uses an arbitrary benchmark cutoff rate (how does management set this?) • Based on net income and book values, not cash flows and market values 27 Payback Period • Payback Period: • How many years it will take to recover the initial investment (CF0) from the cash inflows the project will generate? • Decision Rule: • Accept only projects that pay back initial investment faster than “cutoff” set by management. Shorter is better if ranking projects. • Two versions: • Basic (i.e., non-discounted) and discounted • The basic payback approach ignores the time value of money • Both versions do not consider all project cash flows • Why useful? • Simple • Addresses liquidity and control concerns not captured by more 28 sophisticated DCF techniques Payback Period - Example • • A project has an initial investment cost of $500,000 Annual cash flows are as follows: • Year 1: $125,000 • Year 2: $180,000 • Year 3: $220,000 • Year 4: $240,000 • What is the payback period? • It takes 2.89 years to recover the investment • $195,000 $220,000 • Year 1 + Year 2 + 0.89 of Year 3 (i.e., 0.89 = • • • $125,000 + $180,000 + $195,000 = $500,000 You can assume cash flows occur “during the year” then it’s 2.89 years You can assume cash flows occur “end of the year” then it’s 3 years ) If the company accepts only projects that pay off in 2 years, this project 29 would be rejected. Assessing the Payback Period Rule • Advantages: • Easy to understand • Biased toward liquidity • Disadvantages: • Basic -> Ignores the time value of money • Ignores cash flows after the payback period • Biased against long-term projects • Arbitrary acceptance criteria (how is the “cutoff” selected?) • A project accepted based on the payback criteria may not have a positive NPV 30 “Discounted” Payback Period - Example • We discount the cash flows before calculating the Payback Period • Assume you have the following information on Project X: • Initial outlay: -$1,000 • Required rate of return = 10% • Annual cash flows are as follows: • Year 1: $200 • Year 2: $400 • Year 3: $700 • Year 4: $300 • Discounted Payback Period: • $200 + 1+0.10 $400 1+0.10 2 • • Discounted payback period is just under 3 years This incorporates TVM, but still has all the other disadvantages + $700 1+0.10 3 = $182 + $331 + $526 = $1,039 > $1,000 31 Net Present Value (NPV) • NPV: Present value of benefits minus the present value of costs • πππ = πΆπΉ0 + • Decision Rule: Accept if NPV > 0 • If NPV > 0, then PV (Benefits) > PV (Costs), will create shareholder value • Ranking Decision: Choose the project with higher NPV • Project with higher NPV will create more shareholder value πΆπΉ1 1+π + πΆπΉ2 1+π 2 + πΆπΉ3 1+π 3 + … = σππ=0 πΆπΉπ 1+π π 32 Net Present Value (NPV) - Example • • • Initial outlay = $12,000 After-tax cash flows: • Year 1 = $5,000 • Year 2 = $5,000 • Year 3 = $8,000 Discount rate (k) = 15% • π΅π·π½ = −$ππ, πππ + • Conclusion: Proceed with the project because NPV is positive • In a perfectly efficient market, the total value of the firm should rise by the value of the NPV if the project is undertaken. • The project should increase the market capitalization of the firm by $1,389 (i.e., equity value) • If the firm is listed and if there are 10,000 shares outstanding, the share price should increase by $0.1389 $π,πππ $π,πππ + π.ππ π.πππ + $π,πππ π.πππ = $π, πππ 33 Why Net Present Value? • Includes and discounts all project cash flows at an appropriate discount rate and assumes that interim cash flows during the project’s life are “reinvested” at this rate (sensible) • Firm value will increase by the NPV of accepted projects • The total value of the firm is the sum of the values of the different projects, divisions, or other entities within the firm (value additive property) • Is the only method that always ranks mutually exclusive projects properly to maximize shareholder wealth 34 Profitability Index (PI) • PI measures the PV of benefits vs. the PV of the investment cost so it is a “relative” profitability measure • ππΌ = • Higher PI is better • We accept projects with a PI over 1 (i.e., positive NPVs) • Useful if investment funds are limited (NPV assumes all good projects can be funded) • Easy to understand as it is “benefit to cost” ratio ππ (πΆππ β πΌπππππ€π ) ππ (πΆππ β ππ’π‘ππππ€π ) 35 Profitability Index (PI) • • • • Again, back to our example Initial outlay = $12,000 After-tax cash flows: • Year 1 = $5,000 • Year 2 = $5,000 • Year 3 = $8,000 Discount rate (k) = 15% • At a 15% discount rate, π·π° = • For independent projects, PI is fine as it makes the same accept/reject decisions as NPV • But for mutually exclusive projects, NPV should be used to rank • Calculate the total NPV for all feasible project combinations and select the highest NPV 36 $ππ,πππ $ππ,πππ = π. πππ Internal Rate of Return (IRR) • It’s the discount rate that sets the NPV of the project to equal zero • 0 = πΆπΉ0 + • Or alternatively, 0 = σππ‘=0 • A higher IRR is better • Decision rule: if IRR > discount rate (k): Then the project is acceptable • IRR and NPV criteria make the same accept/reject decisions • How do you calculate IRR? • Trial and error, financial calculator, Excel πΆπΉ1 1+πΌπ π + πΆπΉ2 1+πΌπ π 2 + πΆπΉ3 1+πΌπ π 3 + …+ πΆπΉπ 1+πΌπ π π πΆπΉπ 1+πΌπ π π‘ See Excel for Example 37 A Mathematical Problem with the IRR Method • • • If the cash flows of a project change in sign more than once, there will be multiple IRRs (note: recall that a quadratic formula has 2 roots). There are more roots (or IRRs) when there are more sign changes Example: • Investment today = -$100 • Cash Flow 1 = $230 and Cash Flow 2 = -$132 $230 −$132 + 1+π 1+π 2 • Nππ = $100 + • Set NPV = $0 to find IRR: $0 = $100 + • Quadratic equation of this form: 0 = a + bx + cx2 • 0 = -100 + 230x + cx2 $230 1+πΌπ π • The roots of a quadratic equation is: π₯ = • Hence IRR = 10% and 20% + −$132 1+πΌπ π 2 −π ± Another Example – See Excel File π2 −4ππ 2π 38 “Modified” Internal Rate of Return (MIRR) • IRR calculation assumes that interim cash flows are reinvested at the IRR • Is this realistic? Will the firm be able to reinvest at the project IRR? • If the true reinvestment rate of interim cash flows is less than the calculated IRR, then IRR will overstate returns • McKinsey report “Internal Rate of Return: A Cautionary Tale” • Modifying reinvestment rate to firm’s cost of capital can change calculated IRR dramatically (e.g., from 130% to 22%) • If we use the firm’s cost of capital as the reinvestment rate, it will be the same assumption that NPV uses 39 MIRR - Example • Back to our example -> With a 15% discount rate (i.e., cost of capital) • πππ = −$12,000 + • IRR = 0.21 or 21% (assumes that you reinvest each cash flow at 21%) • MIRR assumes that you reinvest each cash flow at 15% • To solve for MIRR -> Find the future value of the cash inflows and find the future value of the cash outflow compounded by MIRR • πΉπ πΆππ β ππππππ€π = $5,000 1.15 2 + $5,000 1.15 + $8,000 = $20,326.50 • πΉπ πΆππ β ππ’π‘ππππ€π = $12,000 1 + ππΌπ π 3 • πΈππ’ππ‘π: $12,000 1 + ππΌπ π 3 = $20,326.50 • MIRR = 19.3% (i.e., > 15%) (confirms that this is a good project) $5,000 $5,000 $8,000 + + 1.15 1.152 1.153 = $1,389 40 IRR vs. NPV • When IRR > k, NPV > 0 • When the IRR exceeds the cost of capital (k), NPV is positive • Therefore, either method will identify projects that will add value to the firm • However, IRR cannot be used to rank projects • Main Assumptions • IRR: Cash flows are re-invested at IRR • NPV: Cash flows are re-invested at cost of capital (i.e., k) • Which approach is more realistic? • Why would there be another project with the same IRR? • Why would positive NPV projects be waiting to be undertaken? • In equilibrium they should all be taken • NPV is more realistic 41 IRR vs. NPV • Conflicted Project Ranking • (assume k = 0.15 or 15%) • According to NPV… • • Project 1: πππ = −100 + • Project 2: πππ = −500 + • NPV is higher for Project 2 200 1.15 750 1.15 = 73.91 > 0 → π΄πππππ‘ π‘βπ πππππππ‘ = 152.17 > 0 → π΄πππππ‘ π‘βπ πππππππ‘ According to IRR… • 100 = 200 1+πΌπ π 1 , πΌπ π 1 = 1 ππ 100% > 15% → π΄πππππ‘ π‘βπ πππππππ‘ • 500 = 750 1+ πΌπ π 2 , πΌπ π 2 = 0.50 ππ 50% > 15% → π΄πππππ‘ π‘βπ πππππππ‘ • IRR is higher for Project 1 See Excel for another example 42 NPV vs. IRR vs. PI • IRR: the discount rate that sets the NPV of a project to zero • NPV vs. IRR: make the same accept/reject decision because: • If NPV > 0 then IRR > appropriate discount rate for the project • Also, PI > 1 because PV of benefits exceed PV of costs • • • NPV is the “dollar value” of accepting a project IRR is the percentage rate of return on the NPV project PI is the PV of benefits per dollar of costs • IRR and PI are intuitively appealing but neither ranks projects properly. • NPV does! 43 When Would a Firm Have to Rank Projects? • If they are mutually exclusive so you must pick one of a set • If you have a limited capital budget and have to pick only the most desirable projects • Could be financial constraints (e.g., limit on available funds) • Could have limit on other resources (e.g., skilled workers) • Could be a managerial choice to limit growth to a certain level • Consider an example of a set of independent projects • No constraints • With constraint (e.g., spending limit) • NPV, IRR, and PI will rank the projects in a different manner 44 How to Rank Independent Projects? • Consider a firm that has six different capital investment proposals this year. Each project has its initial cost, after-tax cash flows, NPV, IRR, PI, and are shown in the table below. Each project has the same risk as the overall firm with a cost of capital of 10%. Project Initial Cost ($) Annual ATCF ($) Useful Life NPV ($) IRR (%) PI A 1,500,000 290,000 7 -88,159 8.19 0.94 B 3,000,000 700,000 6 48,682 10.55 1.02 C 4,000,000 1,040,000 6 529,471 14.40 1.13 D 70,000 20,000 7 27,368 21.08 1.39 E 1,000,000 290,000 5 99,328 13.82 1.10 F 960,000 200,000 8 106,985 12.99 1.11 Contact: otto.yung@alumni.utoronto.ca 45 How to Rank Independent Projects? • Different ranking -> If the decision rule was based on NPV, IRR, and PI • Total capital budget = $9,030,000 and total NPV = $811,835 Rank NPV IRR PI 1st C D D 2nd F C C 3rd E E F 4th B F E 5th D B B A A Rejected A Contact: otto.yung@alumni.utoronto.ca 46 What if the Capital Budget was $6M? • • • Rank NPV IRR PI 1st C D D 2nd F C C 3rd E E F Capital Budget $5,960,000 $5,070,000 $5,030,000 Total NPV $735,785 $656,168 $663,825 NPV ranking will ensure shareholder wealth maximization under the budget constraint The loss in NPV because of the $6M capital budget constraint is $76,050 (i.e., $811,835 - $735,785) General rule: select a combination of projects with the highest NPV, given the 47 constraint Which Capital Budgeting Techniques Are Used? • Survey of US CFOs by Graham and Harvey (Journal of Financial Economics, 2001) asked how often they relied on different capital budgeting techniques • https://people.duke.edu/~charvey/Research/Published_Papers/P67_The_theory_and.pdf 48 Which Capital Budgeting Techniques Are Used? • Survey of US CFOs by Graham and Harvey asked how often they relied on different capital budgeting techniques: • 75.7% uses IRR, 74.9% uses NPV, 56.7% uses payback and 12% uses profitability index • Larger firms are more likely to use NPV • Similar results in the survey of Canadian managers (Benouna, Meredith, and Marchant): • 94.2% uses NPV and 87.7% uses IRR • Sources: • Graham and Harvey, “The theory and practice of corporate finance: Evidence from the Journal of Financial Economics 60 (2001): 187-243 • Benouna, Meredith, and Marchant, “Improved capital budgeting decision making: Evidence from Canada” Management Decision 48 (2010): 225-247 https://people.duke.edu/~charvey/Research/Published_Papers/P67_The_theory_and.pdf http://www.dl.edi-info.ir/Improved%20capital%20budgeting%20decision%20making.pdf 49 RSM 333 – CORPORATE FINANCE Welcome to Session 1 Session 1 – Introduction and Capital Budgeting Methods Session 2 – Estimating Cash Flows and Capital Budgeting Decisions Session 3 – Capital Budgeting – Risk & Return Session 4 – Cost of Capital Session 5 – Capital Structure I – Debt/Equity Mix Session 6 – Capital Structure II – Limits to the Use of Debt Midterm Session 8 – Dividend Policy Session 9 – Valuation Session 10 – Mergers and Acquisitions Session 11 – Financial Analysis / Financial Planning & Growth / Working Capital Mgt Session 12 – Group Presentations Final Exam (during Exam Period) Contact: otto.yung@rotman.utoronto.ca 50
