1. Basics of Valuation Corporate Finance Peking University HSBC UK Campus 1 Outline • Intro to corporate finance. • Basics of valuation: – Review of financial tools. – Discounted cash flow analysis: • Perpetuities. • Annuities. 2 Corporate Finance • Every decision that a business makes has financial implications, and any decision which affects the finances of a business is a corporate finance decision. • Defined broadly, everything that a business does fits under the rubric of corporate finance. 3 Traditional Accounting Balance Sheet • The figure above shows a traditional accounting balance sheet. 4 Financial View of the Firm • The figure above shows the financial view. 5 Forms of Organization • • • Sole proprietorship: – A business owned by a single individual that keeps all the profits and has unlimited liability for business debts. Partnership: – Two or more owners (partners). – The advantages and disadvantages of a partnership are basically the same as those of a proprietorship, unless there are some limited partners. Corporations: – Ownership represented by shares of stock that can be readily transferred, and the life of the corporation is therefore not limited. – The corporation borrows money in its own name so that the stockholders have limited liability for corporate debts: • The most they can lose is what they have invested. – The corporate form has a significant disadvantage, i.e. double taxation: • Profits are taxed both at the corporate level when they are earned and at the personal level when they are paid out. 6 Financial Decisions • We focus on corporations and the three decisions: – Capital budgeting, i.e., the process of planning and managing a firm’s long-term investments. – Capital structure, i.e., the mixture of debt and equity maintained by a firm. – Dividend decision, i.e., the amount of cash should be returned to the owners. 7 Who Decides? • Agency theory: – One person or entity (the agent) is able to make decisions and/or take actions on behalf of, or that impact, another person or entity (the principal). • What about corporations? – Corporate management is the agent. – Shareholders are the principal. Managers decide 8 Goal of a Financial Manager • The primary goal of a financial manager of a corporation is to maximize the shareholder value, i.e., to maximize the price of the stock of the corporation (public companies) or the market value of the owners’ equity (private companies). 9 How to Maximize the Value? • How should the financial manager maximize shareholders’ value? – Choose projects with positive and greatest net present value (NPV) (investment decisions): • Which real assets should the firm acquire? – Choose capital structure that minimizes the cost of capital (financing decisions): • How should the firm finance the investments? Both decisions impact firm value 10 Agency Problems • Do financial managers always maximize shareholders’ value? – No, agency problems and information asymmetry. 11 Valuation • General Dynamics, a large defense contractor, took 43 years to obtain a stock value of $2.7π΅π. • Netscape took a few minutes to do the same, when it announced an IPO. • Netscape had no profits and paid no dividend. • How is it possible for these two very different firms to have the same value? 12 How to Value an Invesment? • Use of the discount cash flow approach (DCF). • Key factors in the DCF analysis: – Current and expected future cash flow (CF). – Discount rate, i.e., ππ‘ , of expected future cash flow. – Timing of cash flow, i.e., π‘. 13 Expected? • • • In finance, a key ingredient in each decision problem is choosing uncertainty about future conditions. Implications of uncertainty: – Outcomes (or states of the world). – Probabilities associated to the possible outcomes. Since it is impossible to know the exact event in the future, expectation could help one to make decisions. Expected value as decision criterion 14 Uncertainty in Corporate Finance • Estimate expected future cash flows: – Analyze historical accounting statement. – Predictions for the future. 15 Discount Rate in Corporate Finance • For capital budgeting decisions, the discount rate is the cost of capital, i.e., the firm’s expected required rate of return: – The cost of company’s fund, i.e., both debt and equity. – Other names include cost of capital, weighted average cost of capital (WACC), hurdle rate, etc. Analyze the capital structure and how it impacts the cost of capital 16 Discounting • Why discounting? – A dollar received in one year is less than a dollar today (time value of money). • If you have a dollar today, you can invest it in the bank and receive more than a dollar by some future date. – Thus, we discount future cash flows using the appropriate discount rate: π πΈ[πΆπΉ1 ] πΈ[πΆπΉ2] πΈ[πΆπΉπ ] 1 ππ = + + β― + = ΰ· πΈ[πΆπΉ ] . π‘ 1 + π1 1 1 + π2 2 1 + ππ π 1 + ππ‘ π‘ π‘=1 17 Simplifying the DCF Analysis • Let’s assume the following: – Cash flow and discount rates are given (no expected cash flows at the moment): • As starting point, we assume that πΈ[πΆπΉπ‘ ] = πΆπΉπ‘ . • As time goes on, we will learn how to compute these two key inputs when facing corporate finance decisions!!! – Cash flow occurs at the end of each period. – Discount rate is the same for all the future periods, i.e., ππ‘ = π. 18 Patterns • If future cash flows have certain patterns, then the DCF formula can be simplified into various forms. • Examples: – All future cash flows are constant. – Future cash flows are growing at a constant rate. – Future cash flows grow at different rate over different period. 19 Example • We just bought a vacation house. • The vacation house can be rented for $30,000 a year, and you expect the first payment to be made in a year. • The maintenance and upkeep will cost $5,000 a year. • You plan to rent out the house forever. • The appropriate discount rate is 20%. • What is the vacation house worth? 20 Perpetuity • If the cash flows are constant forever, they are called a perpetuity. • Compute the present value of a perpetuity: πΆπΉ1 πππ0 = . π • Note that the value is as of one period before the first payment. 21 Value of the House • • 30000 πππ0 πΆπΉ1 = 0.2 = $150,000. −5000 πππ0 πΆπΉ2 = 0.2 = −$25,000. • ππ π»ππ’π π = $150,000 − $25,000 = $125,000. 22 Preferred Stock • Preferred stock (or preference stock) is an important example of a perpetuity: – When a corporation sells preferred stock, the buyer is promised a fixed cash dividend every period (usually every quarter) forever. – This dividend must be paid before any dividend can be paid to regular stockholders–hence the term preferred. 23 Selling the House • Now we are not going to hold the house forever, but sell it some time in the future. • We plan to rent it out for $30,000 a year, and we expect the first payment to be made in one year. • On the other hand, the maintenance and upkeep will cost us $5,000 a year. • We will hold the property for 4 years, after which we will sell for $130,000. • The appropriate discount rate is 20%. 24 Annuity • If the cash flows are constant for a set number of years, i.e., π, then you have an annuity. • Compute the present value of an annuity: – DCF formula is simplified as: πΆπΉ1 1 1 1 πππ΄0 = β 1− = πΆπΉ1 β − . π π π 1+π π π 1+π • Note that the value is as of one period before the first payment. 25 The Value Becomes • πππ΄0 πΆπΉ1 = • πππ΄0 πΆπΉ2 = • ππ0 πΆπΉ3 = 30000 0.2 −5000 0.2 130,000 1+0.2 4 [1 − [1 − 1 1+0.2 4 1 ] = $77,662.04. 1+0.2 4 ] = −$12,943.63. = $62,692.90. • ππ π»ππ’π π = πππ΄0 πΆπΉπ1 + πππ΄0 πΆπΉπ2 + ππ0 πΆπΉ3 = $77,662.04 − 12,943,63 + 62,692.90 = $127,411.27. 26 Growth and Perpetual Cash Flows • Now instead of charging $30,000 each year, assume that you charge the first year’s rent $15,000 and will grow each year at the rate of 5%. • Again, the maintenance will cost you $5,000 a year. • Now you intend to hold the property indefinitely. The appropriate discount rate is 20%. • What about cash flows? 27 Growing Perpetuity • If perpetual cash flows are growing at a constant rate, then we call it a growing perpetuity. • Compute the present value of a growing perpetuity. • The π·πΆπΉ formula is simplified as: πΆπΉ1 πππ0 = . π−π 28 Growth • Now, instead of charging $30,000 each year, assume that you charge the first year’s rent $15,000, and will grow it at the rate of 10% for 3 years after that. • The maintenance will cost you $5,000 a year. • You will hold the property for 4 years, and sell it for $130,000. • The appropriate discount rate is 20%. • What about cash flows? 29 Growing Annuity • If the cash flows occur for a set of period and grow at a constant rate, then they are called a growing annuity. • Compute the present value of a growing annuity: – The π·πΆπΉ formula is simplified as: π πΆπΉ1 1+π πππ΄0 = β 1− π−π 1+π 1 1+π π = πΆπΉ1 β − . π π−π π−π 1+π 30 Adjusting the Discount Rate • The discount rate used to find the present value of cash flows is comprised of 3 things: – Time value of money. – Risk. – Inflation (if the rate is nominal). 31 Risk-Adjusted Discount Rates • Most real-world cash flows in the future are risky. • The discount rate should be adjusted to incorporate for risk: – Capital Asset Pricing Model (CAPM). – Arbitrage Pricing Theory (APT). • We will be more specific when studying the cost of capital (lecture VII). 32 Inflation • Inflation is a general increase in prices across the economy over a period of time. • Example: – In 1997, movie “Titanic’’ made $600.80ππ: • It is worth $639.83ππ in year 2000. – In 1939, movie “Gone with the wind’’ made $198.60ππ: • It is worth $1,001.69ππ in 2000. 33 Real Discount Rates • The nominal discount rate, π, is the actual rate of return without removing the impact of inflation. • The real discount rate, π, is the rate adjusted for inflation, i.e., with inflation removed from the rate. • Fisher equation: 1+π = 1+π 1+π , where π is inflation rate. 34 Be Consistent!!!! • Nominal cash flow (actual dollars): – Dollars as of the year in which they occur. • Real cash flow (constant dollars): – Dollars as of a particular base year. • Consistency treatment: – When discounting nominal dollars, use the nominal discount rate. – When discounting real dollars, use the real discount rate. 35 Example • If you earn 8% return on an investment (or your discount rate is 8%) and inflation over this period is 3%, then a portion of your return is due to inflation. • What is your real rate of return? 1 + 8% = 1 + π 1 + 3% . π = 4.854% 36 Inflation Rate • How do you calculate inflation rates? – Consumer price index πΆππΌ : πΆππΌ1990 1 + π1990 = . πΆππΌ1989 • If the CPI for 1990 is 104, and it is 100 for 1989, then over this period: πΆππΌ1990 104 π1990 = πΆππΌ − 1 = 100 − 1 = 4%. 1989 37 Constant Dollar Adjustment • To restate cash flows in constant dollars, you need to CPI-adjust the cash flows. • In-class exercise: – A firm’s sales were $100,000 in 1980, and $200,000 in 1990. – You want to compare the dollar amounts excluding the impact of inflation. – If the 1990 CPI is 104 and the 1980 CPI is 80, then: • What is the ππππ sales in terms of ππππ dollars? • What is the average annual inflation rate between ππππ and ππππ? 38 Then • The 1990 sales in terms of 1980 dollars are: ππ΄πΏπΈπ1980π $ 1 + π1980−1990 = ππ΄πΏπΈπ1990π $ , πΆππΌ1990 104 1 + π1980−1990 = = = 1.3. πΆππΌ1980 80 ππ΄πΏπΈπ1990π $ $200,000 ππ΄πΏπΈπ1980π $ = = = $153,846.15. 1 + π1980−1990 1.3 • The average annual inflation rate between 1980 and 1990 is: 1 + πππππ’ππ 10 = 1 + π1980−1990 = 1.3. πππππ’ππ = 2.658% 39 Main References • Ross, S.A., Westerfield, R. and B.D. Jaffe, “Corporate Finance”, McGraw-Hill, 2015, Chapter 1. • Ross, S.A., Westerfield, R. and B.D. Jaffe, “Corporate Finance”, McGraw-Hill, 2015, Chapter 2. • Ross, S.A., Westerfield, R. and B.D. Jaffe, “Corporate Finance”, McGraw-Hill, 2015, Chapter 4. 40