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Corporate Finance Bonds, Stocks, and Capital Allocation.

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Presentation on theme: "Corporate Finance Bonds, Stocks, and Capital Allocation."— Presentation transcript:

1 Corporate Finance Bonds, Stocks, and Capital Allocation

2 Overview The corporation –Ownership and Control –Limited Liability How does a corporation raise money? –Venture Capital –Stocks –Bonds Textbook topics –Weighted Average Cost of Capital, MARR and wealth of the firm –Other capital allocation issues (linear programming)

3 So you have this great idea… Computer matching service for ships and cargo Rocket Sled New gambling device (soon to be) Famous web site ?

4 Forms of Business Sole proprietor 1 person business; assets and debts of the business are the debts of the owner (proprietor). No protection from losses/liabilities. Partnership Several partners own the business and its cash flows. No protection from losses/liabilities. Limited Partnership Several partners own a business and its cash flows. Losses are limited to the initial investment. Limited Company (or Corporation) Shareholders own the business in proportion to their shares. The shareholders elect a board of directors to manage the business. Losses are limited to the price of shares. The board of directors choose how much of the company profits to redistribute to shareholders, and how much to keep for future investment.

5 Example Corporation Shareholders Trade shares Stock market Vote to Appoint Board of Directors Officers CEO (President), VP, Treasurer, Secretary Appoint Hire Employees Dividends ($$$) Annual report Issue more shares

6 Advantages of Corporations Independent existence –The corporation has an existence independent of its founder, shareholders, managers, or employees. –It is treated like a person under the law, and can hold bank accounts, owe taxes, or be penalized for wrong doing. Tradable shares Infinite life Separation of ownership (shareholders) from control (directors, officers, and employees) Limited liability for owners (shareholders), directors, and employees. –Can not lose more than they have invested.

7 Disadvantages of Corporations Paperwork and Regulatory costs In some countries, the need to have annual board of directors meetings in the country of registration Double taxation when profits are distributed as dividends to the share holders (in some countries) Added Bureaucracy in decision making

8 Profit of a Corporation Taxable Profit = Revenues – Tax Deductible Costs (Deductible Costs include labor, rent, lease of equipment, O&M for equipment, depreciation of purchased equipment, and interest on loans & bonds) Net Profit = Taxable Profit * (1-t) t = tax rate (e.g. 15%; 40%)

9 Venture Capital 101 1.Initial investors, called Angels are usually the friends/family/associates of the entrepreneur. 2.In high tech startups, the company may participate in a business incubator. The entrepreneurs share facilities and advice with other startup companies. 3.Initial employees may work for stock options instead of cash. Stock options gives the right to buy the stock later at a low price. The employee takes a gamble to make a lot of money, or nothing. This practice saves the startup some costs when money is scarce. It can also allow them to lure top talent that they can not afford.

10 Venture Capital 101 4. After proving the idea a bit, VC firms may be interested in investing. This takes much begging and rejection. The VC firms will want to buy stock very cheap (a few cents/share), hoping to sell out at the IPO (Initial Public Offering of Shares) 5. After a few rounds of VC funding, and continued success, the startup may be famous and ready for an IPO. 6. At the IPO, the VCs often cash out first, while others (e.g., employees) may have to wait a while before being allowed to sell their options or shares. 7. After the IPO, success is still not assured. Over 80% of IPOs are bad investments and decline in value.

11 Venture Capital 101 7. After the IPO, success is still not assured. Over 80% of IPOs are bad investments and decline in value.

12 Equity (stock) Stock in a corporation is often called equity The term equity comes from the equation Stockholders equity = Corp. Assets – Corp. Debts The book value of a share of stock =(stockholders equity / number of shares)

13 Valuing stock – PV of Dividends The stock price is usually determined in a market of voluntary buyers and sellers One early theory of stock valuation is that the price should equal the Present Worth (PW) of future dividends However, many famous companies (e.g. Microsoft) do not pay dividends.

14 Valuing stock – PW of future expected earnings Later theory assumed that except for tax issues, it should not affect stock price if a company distributes earnings as dividends or retains them for future investment. This theory would suggest that stock price is related to the PW of future expected earnings

15 Valuing stock – PW of future expected earnings EPS = corporate profit / number of shares P/E ratio = Stock price / EPS Example via Yahoo FinanceYahoo Finance P/E ratio is higher for high-tech growth companies than for established industrial companies. Why is this?

16 Valuing Stock – PW of future expected earnings Exponential growth formula Growth Rate=g = (A k - A k-1 )/ A k-1 Convenience rate i cr =[(1+i)/(1+g)]-1= (1+i-1-g)/(1+g)=(i-g)/(1+g) Special formula PV = A 1 (P/A, i cr %,N)/(1+g) Earnings/Share 2002 2003 2004 2005 Price of Stock = PRESENT VALUE For an infinite time horizon, well need (P/A, i cr %, )=1/ i cr % PV=A1* (P/A, i cr %, )/(1+f) PV of earnings = EPS*( (1+g)/(i-g) )/(1+g) = EPS/(i-g)

17 Valuing Stock – PW of future expected earnings If price of stock is related to present value of future expected earnings and we see that PV = EPS/(i-g) Then the P/E ratio should be P/E = PV/EPS = 1/(i-g) Where i = industry MARR g = earnings growth rate THIS EXPLAINS WHY COMPANYS with an EXPECTATION of GROWING EARNINGS have a HIGHER P/E ratio

18 Valuing Stock – Risk, Diversification, and Industry MARR Risk – individual stocks may go up or down due to individual company results. Price = Expected PV no reward or penalty for gambling Diversification – Do not put all your eggs in one basket. Imagine holding small shares of many different companies: some of the individual risks will cancel each other. Systematic risk – Risks that do not cancel. National and global risks (unemployment, inflation). Disaster. War. Capital Asset Pricing Model (CAPM) => Rates of return seems to be correlated with Systematic risk – NOT risk that can be diversified.

19 Bonds Are a way for companies to borrow large amounts of money – more than they could borrow from a single source Allow the company to borrow at a fixed interest rate Are traded in a market, called the bond market. Can vary in value with the markets attitude about the companys credit rating or ability to repay the debt. Usually give the bondholders rights to control the company if the debts are not repaid Do not otherwise give the bondholder any rights to manage the company or any additional profit beyond the terms of the bond (In the USA) interest is a tax deductible cost for the company. In contrast, dividends paid on stock do not generate any tax deductions.

20 Coupon rate vs. Yield The coupon rate is the interest rate payment set by the company. It is fixed. Usually the interest payment consists of 2 payments per year. The yield of a bond is the IRR of buying the bond at a price P determined by willing traders on the bond market. The price P varies with market forces.

21 Bond pricing formula Relationship between bond market prices (P), Face value (F), coupon rate per period (r%), number of periods until repayment (N), and bond yield per period (y%). Bond market price P is the PW of future bond payments P = F * (P/F,y%,N) + (r% * F) * (P/A,y%,N)

22 Example: Kmart, Inc. Bond This is the cash flow from buying a $1000 KMART 7.75% bond that matures in 12 years. Repayment of Face amount us$1000 The bond entitles the owner to payments of 7.75%*$1000/2 = $38.75 every 6 months The 7.75% is known as the coupon rate. 23 interest payments of us$38.75

23 Bond Pricing: Kmart Example We know that the bond market price for buying or selling this bond today can be obtained from a Present Worth analysis. P = F * (P/F,y%,N) + (r% * F) * (P/A,y%,N) In the case of the KMART bond, P= $1000 *(P/F,y%(/6mo),23)+ $38.75 * (P/A,y%(/6mo),23) Note: the yield is not the same as the coupon rate. The yield and market price are linked by the formula above.

24 Kmart Bond Price as function of yield

25 Weighted Average Capital Cost What? A Measure of overall capital costs. Includes effect of taxation. Why? WACC can be a guide for setting MARR. When a firm chooses a project with IRR>WACC, the project will earn a profit after paying the interest and returns expected by shareholders. The firm will become wealthier. If a firm sets MARR=WACC, then it will tend to choose profitable projects that reflect the firms access to capital. How? See next slides for an example.

26 WACC Example: Part 1 Lucky Holdings Limited, Hong Kong CapitalRate of return Bank Loans $5 000 0006% (interest) Bonds$10 000 0008% (interest) Stock$30 000 00012% (historical returns on stock) Retained Earnings$ 5 000 000Same as stock 12% TOTAL CAPITAL$50 000 000 What is the WACC? It is the average cost of capital, weighted by the amounts of capital, and adjusted for taxes.

27 WACC Example: Part 2 Lucky Holdings Limited, Hong Kong Interest is a tax deduction, the HK tax rate is 15% => HK government pays 15% of our interest! CapitalRate of returnAfter-tax Adjusted Cost Bank Loans $5 000 0006% (interest)6%*0.85 = 5.1% Bonds$10 000 0008% (interest)8%*0.85= 6.8% Stock$30 000 00012% (historical returns on stock) 12% Retained Earnings$ 5 000 000Same as stock 12%12% TOTAL CAPITAL$50 000 000WACC (next slide)

28 WACC Example: Part 3 Lucky Holdings Limited, Hong Kong WACC is the weighted average of the after-tax adjusted cost of capital. The weights are the capital amounts. CapitalAfter-tax Adjusted Cost Bank Loans $5 000 0006%*0.85 = 5.1% Bonds$10 000 0008%*0.85= 6.8% Stock$30 000 00012% Retained Earnings$ 5 000 00012% TOTAL CAPITAL$50 000 000 10.27% WACC= {(5.1%)(5)+ (6.8%)(10)+ (12%)(30)+ (12%)(5) }/50 =513.5%/50= 10.27%

29 Linear Programming and Capital Allocation Let x[j]=1 if project j is selected, 0 if project j is not selected PW of project j is PW[j] Initial capital requirements for project j are K[j] Max PW = j PW[j]*x[j] With respect to constraints j K[j]*x[j] <= Starting Capital (and other constraints, which can be added here) Example of additional constraint: projects 3 and 4 need the same land, can not choose both…. => This constraint can be written as x[3]+x[4]<=1

30 Review The corporation –Separation of Ownership and Control and Limited Liability are needed to help convince others to invest How does a corporation raise money? –Venture Capital –Stocks –Bonds Textbook topics –Weighted Average Cost of Capital, MARR and wealth of the firm –Other capital allocation issues (linear programming)

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