1. 1 The Phoenix CFA Society Wendell Licon, CFA CFA Level I Exam Tutorial Corporate Finance May 9, 2012

2. 2 Financial Management Agency Problems Bondholders vs. stockholders (managers) –Occur when debt is risky –Managerial incentives to transfer wealth Management vs. stockholders –Occur when corporate governance system does not work perfectly –Managerial incentives to extract private benefits

3. 3 Financial Management Agency Problems Mechanisms to align management with shareholders –Compensation –Threat of firing –Direct intervention by shareholders (CalPERS) –Takeovers

4. 4 Cost of Capital WACC =

5. 5 Cost of Capital k d (1-T c ) –Where do we get k d from?

6. 6 Cost of Capital (debt) Example: First find the market determined cost of issued debt: 10-yr, 8% coupon bond, trades at $1,050, T C =.4 1,050 = k d/2 = 3.644%, so k d = 7.288% k d/2 (1-T c )= 3.644%(1-.4) = 2.1864% (semi-annual rate) k d (1-T c )=2.1864% * 2 = 4.3728% (annualized)

7. 7 Cost of Capital (debt with flotation costs) Flotation Costs Example: 2% of issue amount, coupon = 7.288% if issued at par (which is usually safe to assume), then coupon rate = investor’s YTM 980 = k d/2 = 3.7885% k d/2 (1-T c )= 3.7885%(1-.4) = 2.2731% (semi-annual rate) k d (1-T c )=2.2731% * 2 = 4.5462% (annualized)

8. 8 Cost of Capital (Preferred Shares) Already in after-tax form Flotation Costs (F): k ps = Div ps /{P(1-F)} Example: P= 100, Div ps = 10, F= 5% k ps = 10/{100(1-.05)}= 10.526%

9. 9 Cost of Capital (Common) Discounted Cash Flow (DCF) Simple g assumption? Cost of CS = Dividend Yield + Growth Example:D 1 = 3/yr, P 0 = 100, g= 12% k cs = 15% What about flotation costs? Multiply P 0 by (1 – F)

10. 10 Cost of Capital (Common) What about g? g = ROE x (plowback ratio) or g = ROE x (1 – payout rate)

11. 11 Cost of Capital (Common) Capital Asset Pricing Model (CAPM) k cs = k rf +  cs (k m – k rf )

12. 12 WACC The market is impounding the current risks of the firm’s projects into the components of WACC Say Coca Cola’s WACC is 15%, which would be the rate associated with non- alcoholic beverages Can Coke use 15% to discount the cash flows for an alcoholic beverage project?

13. 13 WACC Coke Example cont’d –Say alcoholic beverage projects require 22% returns –Security market line

14. 14 WACC Can be used for new projects if: –New project is a carbon copy of the firm’s average project –Capital structure doesn’t materially change – look at the WACC formula

15. 15 WACC Don’t think of WACC as a static hurdle rate of return which, if cleared, then the project decision is a “go” If the firm changes its project mix, the WACC will change but the risk level of the projects already in progress will not & neither do the required rates of return for those projects

16. 16 Cost of Capital- MCC Step 1: Calculate how far the firms retained earnings will go before having to issue new common stock (layer 1) Example: Simple capital structure LT Debt = 60% (yielding 8%) CS = 40% (Kcs = 15%) New Retained earnings (RE) = 1,000,000 (over and above the 40%) Marginal Tax Rate = 40% Debt Flotation Costs = 1% per year CS Flotation Costs = 1% per year

17. 17 Cost of Capital- MCC Concept: Keep our capital structure of 60%/40% in balance while utilizing our retained earnings slack matched with new debt, which is not in a slack condition Current WACC:.6*(.08)*(1-.4) +.4*(.15) = 8.8%

18. 18 Cost of Capital- MCC How far can we go with Layer 2? 1,000,000/.4 = 2,500,000 of new projects costs of which 2,500,000 *.6 = 1,500,000 in new issue debt and 1,000,000 = use of retained earnings Layer 2 WACC:.6*(.09)*(1-.4) +.4(.15) = 9.24% Layer 3 would include new projects over 2,500,000 with flotation costs for equity and flotation costs for debt

19. 19 Cost of Capital- MCC Layer 3 WACC:.6*(.09)*(1-.4) +.4(.16) = 9.64%

20. 20 Cost of Capital Factors Not in the firm’s control –Interest rates –Tax rates Within the firm’s control –Capital structure policy –Dividend policy –Investment policy

21. 21 Capital Budgeting Payback Period –The amount of time it takes for us to recover our initial outlay without taking into account the time value of money. – The decision rule is to accept any project that has a payback period <= critical payback period (maximum allowable payback period), set by firm policy.

22. 22 Capital Budgeting Payback Period –Assume our maximum allowable payback period is 4 years (nothing magical about 4 years as it is set by management): YearAccum. Cash Flows 15MM< 20MM 25MM + 7 MM = 12MM<20MM 312MM + 7MM = 19 MM<20MM 419MM + 10MM = 29 MM>20MM

23. 23 Capital Budgeting Payback Period Get paid back during the 4th year. We need $1MM entering yr 4, and get $10MM for the whole year. If we assume $10MM comes evenly throughout the year, then we reach $20MM in {1MM/10MM} or.1 yrs. So, payback = 3.1 years. Do we accept or reject the project? Accept, since 3.1 < 4.

24. 24 Capital Budgeting Discounted Payback Period Discount each year’s cash flow to a present day valuation and then proceed as with Payback Period.

25. 25 Capital Budgeting – Net Present Value NPV = PV (inflows) - PV(outflows) NPV =  ACF t / (1 + k) t - IO, where, IO = initial outlay ACF t = after-tax CF at t k = cost of capital (cost of capital for the firm) n = project’s life Decision rule: Accept all projects with NPV >= 0

26. 26 Capital Budgeting - NPV Accepting + NPV projects increases the value of the firm (higher stock value/equity), kind of like you are outrunning the cost of capital

27. 27 Capital Budgeting - NPV Invest $100 in your 1-yr business. My required rate of return is 10%. What would be the CF be at the end of year 1 such that the NPV = 0? ACF 1 = 100(1.1) = 110 (just the FV!) If NPV > 0, it is the same as ACF t > 110.

28. 28 Capital Budgeting - NPV Ex: 120. Now, what’s the investment worth? Just PV of $120 = 120/1.1 = 109.09. My stock is now worth 109.09, a capital gain of 9.09 due to you accepting the project. (the 9.09 is the NPV = 120/1.1 - 100 = 9.09)

29. 29 Capital Budgeting - IRR IRR is our estimate of the return on the project. The definition of IRR is the discount rate that equates the present value of the project’s after-tax cash flows with the initial cash outlay. In other words, it’s the discount rate that sets the NPV equal to zero. NPV =  ACF t / (1 + IRR) t - IO = 0, or  ACF t / (1 + IRR) t = IO The decision criterion is to accept if IRR >= discount rate on the project.

30. 30 Capital Budgeting - IRR Are the decision rules the same for IRR & NPV? Think about a project that has an IRR of 15% and a required rate of return (cost of capital) of 10%. So, we should accept the project.

31. 31 Capital Budgeting - IRR What is the NPV of the project if we discount the CF at 15%? –Zero - by definition of IRR. Is the PV of the CF’s going to be higher or lower if the rate is 10%? Higher - lower rate means higher PV. So, the sum term is bigger at 10%, so the NPV is positive ===> accept. NPV and IRR will accept and reject the same projects – the only difference is when ranking projects.

32. 32 Capital Budgeting - IRR Computing IRR: Case 1 - even cash flows Ex. IO = 5,000, Cf t = 2,000/yr for 3 years IO = CF(PVIFA IRR,3 ) ===> 5,000 = 2,000(PVIFA IRR,3 ) Just find the factor for n=3 that = 5,000/2,000 = 2.5 For i=9, PVIFA = 2.5313 For i=10, PVIFA = 2.4869 It’s between 9 & 10: additional work gives 9.7%

33. 33 Capital Budgeting - IRR Case 2 Uneven CF’s - even worse Trial and Error! Ex above: IO = 20,000, CF 1 = 5,000, CF 2 = 7,000, CF 3 = 7,000, CF 4 = 10,000, CF 5 = 10,000 We have to find IRR such that 0 = 5,000 (PVIF IRR,1 ) + 7,000 (PVIF IRR,2 ) + 7,000 (PVIF IRR,3 ) + 10,000 (PVIF IRR,4 ) + 10,000 (PVIF IRR,5 ) – 20,000

34. 34 Capital Budgeting - IRR NPV at 25% is -563. So, should we try a higher or lower rate? Lower (==> higher NPV) If we try 24%, we get NPV = -102.97, at 23%, we get NPV = 375 ==> it’s between 23 & 24%. A final answer gives 23.8%.

35. 35 Capital Budgeting - IRR IRR has same advantages as NPV and the same disadvantages, plus 1.Multiple IRRs: IRR involves solving a polynomial. There are as many solutions as there are sign changes in the cash flows. In our previous example, one sign change. If you had a negative flow at t 6 ==> 2 changes ==> 2 IRRs. Neither one is necessarily any good. 2. Reinvestment assumption: IRR assumes that intermediate cash flows are reinvested at the IRR. NPV assumes that they are reinvested at k (Required Rate of Return). Which is better? Generally k. Can get around the IRR problem by using the Modified IRR, MIRR.

36. 36 Capital Budgeting - MIRR Used when reinvestment rate especially critical Idea: instead of assuming a reinvestment rate = IRR, use reinvestment rate = k (kind of do this manually), then solve for rate of return. 1st: separate outflows and inflows –Take outflows back to present at a k discount rate –Roll inflows forward - “reinvest” them - at the cost of capital, until the end of the project (n) - now just have one big terminal payoff at n. The MIRR is the rate that equates the PV of the outflows with the PV of these terminal payoffs.

37. 37 Capital Budgeting - MIRR  ACOF t /(1 + k) t = (  ACIF t * (1 + k) n-t ) / (1 + MIRR) n where ACOF = after-tax cash outflows, ACIF = after-tax cash inflows. Solve for MIRR. MIRR >= k (cost of capital) ==> accept

38. 38 Capital Budgeting - MIRR Notice, now just one sign change with no multiple rate problems – one positive MIRR Plus, no reinvestment problem Still expressed as a % which people like Also, much easier to solve

39. 39 Capital Budgeting - MIRR Ex: Initial outlay = 20,000, plus yr. 5 CF = -10,000. We’ll use k=12% Draw timeline 1. PV of outflows = 20,000 + 10,000(1/1.12) 5 = 25,674 2. FV of inflows: yr. 1 CF = 5,000; yr. 2 and 3 CF = 7,000; yr. 4 CF = 10,000; YRFV 15,000(1.12 ) 5-1 = 5,000(1.12 ) 4 = 7,868 27,000 (1.12 ) 5-2 = 7,000(1.12 ) 3 =9,834 37,000 (1.12 ) 5-3 = 7,000(1.12 ) 2 =8,781 410,000(1.12 ) 5-4 = 10,000(1.12 ) 1 = 11,200 ------------- Sum37,683

40. 40 Capital Budgeting Decision Criteria So, NPV and IRR all give same accept/reject decisions. But, they will rank projects differently When is ranking important? Capital rationing - firm has fixed investment budget, no matter how many + NPV projects there are out there.

41. 41 Capital Budgeting Decision Criteria Ex. firm has $5MM –If firm used IRR to rank, would pick highest IRR projects, next highest, etc., until spent $5MM. With NPV, pick projects to maximize total NPV subject to not spending more than $5MM. Mutually exclusive projects - just means can’t do both. Which do we pick - highest NPV or IRR?

42. 42 Capital Budgeting Decision Criteria It’s easiest to see ranking problems through NPV profile - just a graph of NPV vs. discount rates: By NPV: for k 10% pick B

43. 43 Capital Budgeting Decision Criteria IRR: always pick B NPV better: it incorporates our k, it’s how much we’re adding to shareholder value. If k < 10%, IRR gives wrong decision.

44. 44 Capital Budgeting Post-Audit Compare actual results to forecast Explain variances

45. 45 Cash Flows in Capital Budgeting Cash flow is important, not Accounting Profits Net Cash Flow = NI + Depreciation

46. 46 Cash Flows in Capital Budgeting Incremental Cash Flows are what is important –Ignore sunk costs –Don’t ignore opportunity costs (think of next best alternative) –What about externalities (the effect of this project on other parts of the firm), and cannibalization –Don’t forget shipping and installation (capitalized for depreciation)

47. 47 Cash Flows in Capital Budgeting Changes in Net Working Capital –Remember to reverse this out at the end of the project –Example: think of petty cash

48. 48 Cash Flows in Capital Budgeting Projects with Unequal lives – 2 solutions Replacement Chain – like finding lowest common denominator Equivalent annual annuity – like finding how fast the cash is flowing in to the firm

49. 49 Cash Flows in Capital Budgeting What if projects have different lives? Machine #1: cost = 24,000, life 4 yrs, net benefits = $8,000/year Machine #2: cost = 12,000, life 2 yrs, net benefits = $7,400/year k = 10% NPV 1 = -24,000 + 8,000 PVIFA( 10%,4 )= 1,359 NPV 2 = -12,000 + 7,400 PVIFA( 10%,2 )= 843 We cannot compare these like this, since have unequal lives.

50. 50 Cash Flows in Capital Budgeting 1. Replacement chain approach. Construct a chain of #2’s to get the same number of years of benefits (like finding least common denominator): Year0 1 2 3 4 Inflows7400740074007400 Outflows-12000-12000 Net CF-12000 7400 -4600 7400 7400 NPV 2 = 1,540 - so we choose machine #2, not #1

51. 51 Cash Flows in Capital Budgeting 2. Equivalent annual annuity. Find the annual payment of an annuity that lasts as long as the project & whose PV equals the NPV of the project Project 1: NPV = EAA (PVIFA 10%,4 ) ==> EAA = 1,359/(PVIFA 10%,4 ) = 1359/3.1699 = 428.72 Project 2: NPV = EAA (PVIFA 10%,2 ) ==> EAA = 843/1.7355 =485.74

52. 52 Cash Flows in Capital Budgeting Dealing with Inflation As long as inflation is built into your cash flow forecast, you are OK because your discount rates should already take expected inflation into account

53. 53 Risk Analysis Types of Risk Stand-alone risk – think total risk or variance (or standard deviation) Corporate (within firm) risk – think of the firm as a portfolio of projects but not a completely diversified portfolio Market risk – think systematic or beta

54. 54 Risk Analysis Modeling Methods Sensitivity Analysis –Find the effect of a change due to a single variable change at a time Scenario Analysis –Find the effect of many simultaneous changes (brought on by different scenarios) Monte Carlo Simulation –Find the distributional effect of a number of random changes on repeated attempts

55. 55 Risk Analysis Market Risk Security Market Line –k cs = k rf +  cs (k m – k rf ) Measuring Beta –The pure play method Find a market traded firm whose only business is what you are interested in – Accounting beta method Accounting ROA of firm versus Average Accounting ROA for market construct (Text says S&P 400)

56. 56 Risk Analysis Investment Opportunity Schedule vs Marginal Cost of Capital

57. 57 Capital Structure and Leverage Factors influencing a firm’s decision: Business risk - DOL Taxes Financial flexibility - DFL Managerial conservatism – risk aversion

58. 58 Capital Structure and Leverage Business Risk Break-even Operating Quantity Degree of Operating Leverage (DOLS) –A measure of the degree to which fixed costs are used High Fixed Costs ===> High Operating Leverage

59. 59 Capital Structure and Leverage Financial Risk Degree of Financial Leverage (DFL EBIT ) A measure of the degree to which debt is used The higher the firm relies on debt, the greater the DFL will be

60. 60 Capital Structure and Leverage Combined Risk Degree of Total Leverage (DTL S ) –Measure of the combined leverage utilized by a firm DCL S = [DOL S ] X [DFL EBIT ]

61. 61 Capital Structure and Leverage Miller and Modigliani 1958 The value of the firm is independent of its capital structure, i.e., the financing mix is irrelevant (Miller and Modigliani 1958) Proposition: V U = V L

62. 62 Capital Structure and Leverage Assumptions Perfect capital markets –No taxes –No transaction costs –Borrow and lend at the same rate No bankruptcy costs Homogenous preferences and beliefs Firm issued debt is risk-free (no chance of bankruptcy)

63. 63 Capital Structure and Leverage Relax the Assumptions Introduce Taxes – more debt is better Relax no bankruptcy assumption – at some point, more debt reduces the value of the firm The above is really trade-off theory

64. 64 Capital Structure and Leverage Effect of WACC

65. 65 Capital Structure and Leverage Signaling Theory Signals must be costly –New equity issue signal –New debt issue signal

66. 66 Dividend Policy Dividend policy must strike a balance between future growth and the need to pay investors cash M&M irrelevance (homemade dividends) g = ROE x (1 – payout ratio) Signaling through dividends

67. 67 Dividend Policy Residual Dividend Model –Dividend policy set to pay out cash that is not need for investment or for reserve cash reasons

68. 68 Dividend Policy Timing Declaration date – declared by the board Holder-of-record-date – the last date that a person can hold the stock and still receive the dividend Ex-dividend date – the first date that a stock trades without rights to the dividend Payment date

69. 69 Dividend Policy Stock Dividends and Splits Splits: increasing the number of shares by a multiple Dividends: the dividend is paid in stock instead of cash Price effects of stock dividends and splits –Prices generally rise after the announcement –Signal? Higher cash dividends in the future?

70. 70 Dividend Policy Repurchases Advantages: –Positive signal to repurchases shares –Targeted dividends –Remove a large block –Get cash in investors hands without future expectations –Capital structure changes Disadvantages –Investor indifference, informational asymmetry among investors, paying to high a price for shares