CORPORATE
FINANCIAL
THEORY
Lecture 4
Factors In Capital Budgeting & Capital
Structure Decisions







Market Values vs. all others
Cost of Capital
Competition
Bankruptcy
Signaling Hypothesis
Bondholder Wealth Expropriation Theory
Agency costs
Topic Evolution
How To Measure Value (NPV, etc.)
Risk Return Trade Off (CAPM, etc.)
Modify Cash Flows
Modify Interest Rates
Scenario Analysis
WACC
Decision Tree
APM
etc.
etc.
How To Create Positive NPVs


Smart investment decisions make MORE money than
smart financing decisions
Smart investments are worth more than they cost:
= Positive NPVs

Firms calculate project NPVs by discounting forecast
cash flows, but . . .
Source of Positive NPVs

Projects may appear to have positive NPVs because
of forecasting errors
e.g. some acquisitions result from errors in a DCF analysis


Don’t make investment decisions on the basis of errors
in your DCF analysis.
Start with the market price of the asset and ask
whether it is worth more to you than to others.
Source of Positive NPVs

Trust Market Values

Positive NPVs stem from a comparative advantage


Look for comparative advantages
Strategic decision-making identifies this comparative
advantage; it does not identify growth areas
Source of Positive NPVs

Don’t assume that other firms will watch passively.
Ask -How long a lead do I have over my rivals? What will
happen to prices when that lead disappears
In the meantime how will rivals react to my move?
Will they cut prices or imitate my product?

Adjust your NPV calculations accordingly
Do Projects Have Positive NPVs?




Rents = profits that more than cover the cost of
capital
NPV = PV (rents)
Rents come only when you have a better product,
lower costs, some other competitive edge…or lower
cost of capital
Sooner or later competition is likely to eliminate
rents
Value Path
Source of Positive NPVs






Comparative advantage
Higher cash flows
Lower COC
Innovation
Risk taking
Good corporate governance
Other Factors in CS & CB

Signaling Hypothesis

Bondholder Wealth Expropriation Theory
Agency Theory
and
Corporate Governance
Public Company Shareholders
Holdings of Corporate Equities as of 3rd quarter 2010
© McGraw Hill Corp.2011
CalPERS Asset Allocation
Asset Category
2005
2012
2005
2012
US Equity
40%
24%
61%
50%
Global Equity
20%
26%
Marketable Alternatives
0%
2%
11%
26%
Real Assets
6%
10%
Private Equity/ VC
5%
14%
26%
20%
28%
24%
2%
4%
Fixed Income
Cash
Source: CalPERS 2005 Annual Investment Report,
http://www.calpers.ca.gov/index.jsp?bc=/investments/assets/assetallocation.xml
CICF Asset Allocation
Asset Category
2005
2012
2005
2012
US Equity
45%
18%
67%
36%
Global Equity
22%
19%
Marketable Alternatives
4%
21%
8%
46%
Real Assets
3%
14%
Private Equity/ VC
Fixed Income
Cash
Source: CICF 2006 Audit Report, CICF Portfolio Review, June 30, 2012
1997
Asset Allocation Recommendation
2%Textbook11%
Stocks
75%
Bonds
15%
5% bills
Treasury
10%
16%
13%
8%
24%
18%
Role of The Financial Manager
(2)
(1)
Financial
manager
Firm's
operations
(4a)
(4b)
(3)
(1) Cash raised from investors
(2) Cash invested in firm
(3) Cash generated by operations
(4a) Cash reinvested
(4b) Cash returned to investors
Financial
markets
The Principal Agent Problem
Shareholders = Owners
Question: Who has
the power?
Answer: Managers
Managers = Employees
Corporate Governance
Sole Proprietor
Owner
Manager
Partnership
Owner / Manager
Public Corporation
Owner
Manager
Corporate Governance (Public Cos.)
OWNERS



Fractured
Limited resources
Low incentive
MANAGERS




Organized
Significant resources
Motivated
Lobby state legislatures
Governance Measures
Governance Measures
Corporate Governance: History
Results:
1. “Anti-Investor Laws”
• Began in 1968 (Williams Act)
• Peaked in1987 (CTS Corp. v. Dynamics)
2. Shareholder rights groups
• Institutional Shareholder Services (1985)
• Council of Institutional Investors (1985)
• Activist institutional investors (CalPERS)
3. Legislative Reactions
• Sarbanes-Oxley
• Dodd-Frank
4. others…
Corporate Governance Research
Corporate Governance And Equity Prices
Gompers, Ishii, Metrick, Quarterly Journal of Economics, Feb 2003, Vol. 118, Issue 1
Question
Does the level of shareholder rights correspond
with public company equity prices?
Corporate Governance Research
Corporate Governance And Equity Prices
Gompers, Ishii, Metrick, Quarterly Journal of Economics, Feb 2003, Vol. 118, Issue 1
Study
• 1,500 publically traded
firms
• 1990-1999
• Governance Rating
(G-Index)
• 10 Categories
• “Dictatorship” to
“Democracy”
Results
Positive G-Index
• Higher firm value
• Higher profits
• Higher sales growth
• Efficient CAPEX
• Higher Tobins’s Q
+ 11.4% per G category
(up from 2.2%)
• Fewer Takeovers
Corporate Governance Research
Corporate Governance And Equity Prices
Gompers, Ishii, Metrick, Quarterly Journal of Economics, Feb 2003, Vol. 118, Issue 1
• Seminal work in governance & equity prices
• 517 citations in Business Source Premier
Does Delaware Law Improve Firm Value?
Daines, Robert, Journal of Financial Economics, LXII (2001), 525–558.
Investor Protection and Corporate Valuation
La Porta, Florencio Lopez-de-Silanes, and Vishny, Journal of Finance. June 2002, Vol.
57 Issue 3, p1147-1170.
Corporate Governance, Product Market Competition, and Equity Prices
Giroud and Mueller, The Journal Of Finance, vol. LXVI, no. 2, April 2011, 563-600
Indiana & Investors
NEGATIVES



Public company laws
Takeover target
Reduced capital formation
Governance Success
Old National Bank (ONB)
• 99.1 Governance Score
• Best governance in peer group
• Ethisphere Award
• Largest Indiana public bank
• Profit Margin = 17.94%
• Earn. Gr. (yoy) = 59.90%
• Major acquisition firm
POSITIVES


LP, LLC, etc. laws
Secretary of State
 Online filings
 Investor protection





Property tax cap
Lower corp. tax rates
Right-to-work
State fiscal health, IEDC, etc.
Higher education
Financial Market Functions




Source of funding
Investor liquidity
Risk management
Source of information
Market Information Problems
1.
2.
3.
4.
Consistent Forecasts
Reducing Forecast Bias
Getting Senior Management Needed Information
Eliminating Conflicts of Interest
The correct
information
is …
Corporate Governance Problems
1.
2.
3.
4.
5.
Ballot issues
Maximizing value (whose?)
Shareholder illusion of control and shareholder
rights
Corporate law
Institutional Shareholder Services
Incentives
Agency Problems in Capital Budgeting





Reduced effort
Perks
Empire building
Entrenching investment
Avoiding risk
Incentive Issues



Monitoring - Reviewing the actions of managers and providing
incentives to maximize shareholder value.
Free Rider Problem - When owners rely on the efforts of
others to monitor the company.
Management Compensation - How to pay managers so as to
reduce the cost and need for monitoring and to maximize
shareholder value.
CEO Compensation (2013)
Median Total Direct Compensation for
CEOs of Large Companies
6,000,000
Value in U.S. dollars
5,000,000
4,000,000
3,000,000
2,000,000
1,000,000
0
Salary
Source: Towers Watson’s proprietary data.
Target bonus
Long-term incentives
CEO Compensation
Growth in CEO compensation in the U.S.
1200
1100
1000
900
Compensation, $ millions
800
700
600
Total compensation
500
400
300
200
100
Salary + bonus
0
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
Source: Execucomp
Measuring performance
 MVA
 EVA
& Residual income
 Economic Income
 CFROI
MVA
Market Value Added

MVA = Market Cap year 2 – Market cap year 1
or

MVA = Market Cap – Book Value
Residual Income & EVA
•
•
•
•
•
Techniques for overcoming errors in accounting
measurements of performance.
Emphasizes NPV concepts in performance
evaluation over accounting standards.
Looks more to long term than short term decisions.
More closely tracks shareholder value than
accounting measurements.
EVA by Stern and Stewart out of Boston
Residual Income & EVA
Quayle City Subduction Plant ($mil)
Income
Assets
Sales
550
Net W.C.
COGS
275
Property, plant and
equipment
1170
Selling, G&A 75
200
taxes @ 35%
Net Income
70
$130
80
less depr.
360
Net Invest..
810
Other assets
110
Total Assets
$1,000
Residual Income & EVA
Quayle City Subduction Plant ($mil)
130
ROI 
 .13
1,000
Given COC = 10%
NetROI  13%  10%  3%
Residual Income & EVA
Residual Income or EVA = Net Dollar return
after deducting the cost of capital
EVA  Residual Income
 Income Earned - income required
 Income Earned - Cost of Capital  Investment

© EVA is copyrighted by Stern-Stewart Consulting Firm and used with permission.
Residual Income & EVA
Quayle City Subduction Plant ($mil)
Given COC = 12%
EVA  Residual Income
 130  (.12 1,000)
 $10million
Economic Profit
Economic Profit = capital invested
multiplied by the spread between return on
investment and the cost of capital.
EP  Economic Profit
 ( ROI  r )  Capital Invested
Economic Profit
Quayle City Subduction Plant ($mil)
Example at 12% COC continued.
EP  ( ROI  r )  Capital Invested
 (.13 - .12) 1,000
 $10million
Message of EVA
• Pros and Cons of EVA
• Pros
• Managers motivated to invest in projects that earn more
than they cost
• Makes cost of capital visible to managers
• Leads to reduction in assets employed
• Cons
• Does not measure present value
• Rewards quick paybacks
• Ignores time value of money
EVA of US firms - 2005
($ in millions)
Econimic Value Added
(EVA)
Microsoft
Johnson & Johnson
Wal-Mart Stores
Merck
Coca-Cola
Intel Corp
Dow Chemical
Boeing
IBM
Delta Airlines
Pfizer
Time Warner
Lucent Technologies
8,247
6,601
5,199
3,765
3,637
3,264
1,749
(67)
(196)
(1,413)
(3,838)
(5,153)
(6,279)
Capital
Invested
28,159
60,857
109,393
32,400
18,353
34,513
44,281
41,813
71,196
25,639
209,293
132,985
61,987
Return on
Capital
40.9
19.0
10.8
18.4
25.3
23.2
10.2
5.6
10.5
1.0
5.8
3.8
(0.7)
Cost of
Capital
11.7
7.8
5.8
7.6
5.9
13.2
6.3
5.8
10.8
6.3
7.6
7.8
9.6
Accounting Measurements
cash receipts  change in price
Rate of return 
beginning price
C1  ( P1  P0 )

P0
Economic income = cash flow + change in present value
C1  ( PV1  PV0 )
Rate of return 
PV0
CFROI
(Building a better mouse trap)
•
Developed by Holt Value Associates, Inc. in Chicago
•
Modified NPV approach
•
Basically a “decomposed” DCF model
•
Utilizes objective data inputs
CFROI
(Building a better mouse trap)
Total Firm
Warranted Value


Realizable Value of
NCRs


Non - operating Assets
1  Discount Rate
NCRs = Net Cash Receipts (from operations)
•
are derived from sources and uses of funds statements
•
Are calculated in 2 parts (existing operations & future investments)
Discount Rates
 Implied from market, using valuation models
 Adjusted for Capital structure

Non-operating Assets = Land & others
CFROI
(Building a better mouse trap)
Existing Assets
 Future Investment s
 Non - operating Assets
Total Firm Value
- Debt & Preferred Stock
Total Equity Value
- Minority Interest
Common Equity Value
 Adjusted Shares
Common Equity / Share
Problem 1
Our company has the opportunity to invest in a project. Our initial
outlay is $500. The project will yield $1200 at the end of the
fourth year. Given a company cost of capital of 14%, what is
the NPV of the project?
NPV0  500  (11200
4  210.50
.14 )
Problem 2
You are going to retire next month. An insurance agent offers to
sell you an annuity which pays $20,000 per year (at the start
of each year) for 15 years. Assuming a yield of 8% on the
annuity, how much should you pay for the annuity?
 1

1
PV of annuity  20k  20k  

14 
.
08


.
08
1

.
08


 184,884
Problem 3

If you sign an agreement today (t=0) to borrow
$400 at the end of year 1, $400 at the end of year
two, and repay $1000 at the end of year three,
what is the interest rate you are paying? (hint:
calculate the IRR)
Problem 3
If you sign an agreement today (t=0) to borrow $400 at the end of year 1,
$400 at the end of year two, and repay $1000 at the end of year three,
what is the interest rate you are paying? (hint: calculate the IRR)
Answer
T0
T1
T2
T3
0
+ 400
+ 400
- 1000
calculator return 15.83%
Problem 4
If you attempt to diversify your portfolio using BGE & Disney
stock, which Portfolio, A, B, C is possible?
Return
A
DIS
B
C
BGE
Risk
Problem 4
If you attempt to diversify your portfolio using BGE & Disney
stock, which Portfolio, A, B, C is possible?
Return
A
DIS
B
C
BGE
Risk
Problem 5
Based on the success of EuroDisney, Disney wishes to build two
additional theme parks (SlavicDisney in Moscow, Russia and
AfricaDisney in Lagos, Nigeria). Disney has a cost of capital
of 14%. The company is in three industries; Movies,Theme
Parks, & Consumer Products, with betas of 1.56, 1.7, and 1.2,
respectively. Tbills are yielding 7% and the market return is at
15%.
What discount rate SHOULD the company use when evaluating
these projects?
r = .07 + 1.7 ( .15 - .07 ) = 20.60%
Problem 6
Based on the success of EuroDisney, Disney wishes to build two
additional theme parks (SlavicDisney in Moscow, Russia and
AfricaDisney in Lagos, Nigeria). Disney has a cost of capital of
14%. The company is in three industries; Movies,Theme Parks, &
Consumer Products, with betas of 1.56, 1.7, and 1.2,
respectively. Tbills are yielding 7% and the market return is at
15%.
What discount rate should Disney use if it wishes to modernize its
consumer products production facility & why?
14% because that is its borrowing rate.
Problem 7
DogDays Toy Co common stock is providing a 16% return. The company has
no debt, but has a bond rating of AA (ytm=9%). Analysts feel that
DogDays could add up to 30% debt without altering the required return on
debt or equity. The company would like to build a plant to produce doggy
basketball equipment, but the IRR is only 14% (where NPV = 0). What
action can DogDays take to make the basketball project feasible?
Answer
Take on 30% debt and decrease the company’s COC.
r = 9 (30/100) + 16 (70/100) = 13.90%