1. Dr Irena JindrichovskaCorporate Finance Management 21 CORPORATE FINANCE MANAGEMENT 2 Master Course VŠFS Fall 2012 Irena Jindřichovská irena.jindrichovska@mail.vsfs.cz

2. Dr Irena JindrichovskaCorporate Finance Management 22 Literature Brigham, E and Ehrhardt, M (2004) Financial management: theory and practice, 13th ed., Thomson Learning ISBN-10: 0324259689; ISBN-13: 9780324259681 Other recommended sources: Brealey, R., Myers, S. and Allen, F. (2006) Corporate Finance, 8th international ed., McGraw-Hill ISBN: 0-07-111795-4 Ross, Westerfield & Jaffe; Fundamentals of Corporate Finance, 4th edition Bender and Ward: Corporate Financial Strategy, 3rd ed. Butteworth-Heinemann, 2009 More sources may be recommended in lectures

3. Dr Irena JindrichovskaCorporate Finance Management 23 Teaching plan Regular studies: 12 hours lectures 6 hours excercises+ presentation of own work Assignment conditions- essay on topic given + active participation in seminars Exam: Written exam consisting of short essays and calculations

4. Dr Irena JindrichovskaCorporate Finance Management 24 Outline of the course 1.Introduction to Corporate finance management 2.Mergers and acquisitions 3.Cost of capital and capital structure 4.Strategy and tactics of financing decisions - investment decision making 5.Capital Restructuring and Multinational Fin. Management 6.Lease Financing and Working Capital Management 7.Risk Management and Real Options

5. Dr Irena JindrichovskaCorporate Finance Management 25 INTRODUCTION TO CORPORATE FINANCE MANAGEMENT

6. Dr Irena JindrichovskaCorporate Finance Management 26 Outline Lecture 1 Introduction Capital structure Company lifecycle Role of financial manager Financial markets Agency theory Stakeholders’ theory Summary, exercises, references

7. Dr Irena JindrichovskaCorporate Finance Management 27 Introduction to Corporate Finance Basic questions not only from corporate finance: 1.What long-term investment strategy should a company take on? 2.How can cash be raised for the required investments? 3.How much short-term cash flow does a company need to pay its bills?

8. Dr Irena JindrichovskaCorporate Finance Management 28 The Balance-Sheet Model of the Firm Current assets –Net working capital Fixed assets –Tangible fixed assets –Intangible fixed assets Current liabilities Long term debt Shareholders’ equity

9. Dr Irena JindrichovskaCorporate Finance Management 29 Capital Structure Financing arrangements determine how the value of the firm is sliced up. The firm can then determine its capital structure. Capital structure changes in the lifetime of the firm

10. Dr Irena JindrichovskaCorporate Finance Management 210 Capital Structure The firm might initially have raised the cash to invest in its assets by issuing more debt than equity; Later again it can consider changing that mix by issuing more equity and using the proceeds to buy back some of its debt

11. Dr Irena JindrichovskaCorporate Finance Management 211 Life Cycle of the company and its funding Boston Consulting Group Matrix Axes –horizontal: speed of growth of the market share –vertical: market share Start-up Growth Maturity Decline Each phase requires different approach to financial management – according to generated Cash Flow

12. Dr Irena JindrichovskaCorporate Finance Management 212 Life Cycle of the company II Maturity Low investment need High CF generated Growth High investment need High CF generated Decline Low investment need Low CF generated Start up High investment need Low CF generated

13. Dr Irena JindrichovskaCorporate Finance Management 213 Role of the Financial Manager 1. The firm should try to buy assets that generate more cash than they cost. 2. The firm should sell bonds and stocks and other financial instruments that raise more cash than they cost.

14. Dr Irena JindrichovskaCorporate Finance Management 214 Role of the Financial Manager The firm must create more cash flow than it uses. The cash flows paid to bondholders and stockholders of the firm should be higher than the cash flows put into the firm by the bondholders and stockholders.

15. Dr Irena JindrichovskaCorporate Finance Management 215 Financial Markets Primary and secondary markets Spot and forward markets Money markets Equity markets Organized and over-the-counter markets –LSE, AMEX, NYSE; NASDAQ Derivative markets –LIFFE, CBOT

16. Dr Irena JindrichovskaCorporate Finance Management 216 Primary and secondary markets1 Help to get financing for companies Investment companies Pool together and manage the money of many investors Arrange corporate borrowings and security issues –Issuing process

17. Dr Irena JindrichovskaCorporate Finance Management 217 Primary and secondary markets2 Establish the price of securities through supply and demand Execute and settle the transaction Guarantee the settlement through the ‘Clearing house’- a special institution connected with each Stock Exchange –There is also a securities exchange commission (SEC ) setting the standards and rules of listing

18. Dr Irena JindrichovskaCorporate Finance Management 218 Agency Theory There are two groups with different interest in each corporation – Shareholders and Managers Goals of shareholders and managers are not the same Jensen and Meckling (1976): Theory of the Firm: Managerial Behavior,Agency Costs and Ownership Structure, JFE 1976 Defined Principal – Agent relation

19. Dr Irena JindrichovskaCorporate Finance Management 219 Principal - Agent Owners i.e. Shareholders are Principals Managers are Agents Shareholders want value of their firm to be maximized Managers should act on principals’ behalf but have different goals

20. Dr Irena JindrichovskaCorporate Finance Management 220 Management Goals Survival - avoid risky business decisions Selfsufficiency – prefer internal financing to issuance of new stock Shareholders need to control management – Agency Costs – –Monitoring costs –Incentive fees to convince management to act in shareholders’ interest

21. Dr Irena JindrichovskaCorporate Finance Management 221 Control methods Directors are voted by Shareholders and management is selected by directors Management compensation methods –Stock option plan –Bonuses –Performance shares Threat of takeovers Competition on management labor market

22. Dr Irena JindrichovskaCorporate Finance Management 222 Stakeholders’ theory All interested parties that have some relation to the company –Shareholders –Employees –Creditors –Banks –Suppliers –Clients –Environment –Municipalities

23. Dr Irena JindrichovskaCorporate Finance Management 223 Summary 1.The goal of financial management in a for-profit business is to make decisions that increase the value of the stock, or, more generally, increase the market value of the equity. 2.Business finance has three main areas of concern: a. Capital budgeting. What long-term investments should the firm take? b. Capital structure. Where will the firm get the long-term financing to pay for its investments? In other words, what mixture of debt and equity should we use to fund our operations? c. Working capital management. How should the firm manage its everyday financial activities?

24. Dr Irena JindrichovskaCorporate Finance Management 224 Summary 2 3.The corporate form of organization is superior to other forms when it comes to raising money and transferring ownership interests, but it has the significant disadvantage of double taxation. 4.There is the possibility of conflicts between stockholders and management in a large corporation. We call these conflicts “agency problems” and discussed how they might be controlled and reduced.

25. Dr Irena JindrichovskaCorporate Finance Management 225 Exercise problems Define and compare the three forms of organisation a proprietorship, a partnership and a corporation. Explain the agency problem and discuss the relationship between managers and shareholders –What are the two types of agency costs? –How are managers bonded to shareholders? –Can you recall some managerial goals? –What is the set-of-contracts perspective?

26. Dr Irena JindrichovskaCorporate Finance Management 226 Useful web source On Agency theory – A review paper http://classwebs.spea.indiana.edu/kenrich a/Oxford/Archives/Oxford%202006/Course s/Governance/Articles/Eisenhardt%20- %20Agency%20Theory.pdfhttp://classwebs.spea.indiana.edu/kenrich a/Oxford/Archives/Oxford%202006/Course s/Governance/Articles/Eisenhardt%20- %20Agency%20Theory.pdf

27. Dr Irena JindrichovskaCorporate Finance Management 227 RECOMENDED READINGS Brigham and Houston: Fundamentals of Financial Management, 12th ed, Ch 1 Ross, Westerfield & Jaffe; Fundamentals of Corporate Finance, 4th edition Ch 1 and 2 Bender and Ward: Corporate Financial Strategy, 3 rd ed. Butteworth-Heinemann, 2009, Ch 2

28. Dr Irena JindrichovskaCorporate Finance Management 228 COST OF CAPITAL AND CAPITAL STRUCTURE

29. Dr Irena JindrichovskaCorporate Finance Management 229 Outline Introduction Sources of long term financing Debt versus equity Long term debt Preferred shares Retained earnings Newly issued shares, –Gordon model, debt plus risk premium, CAPM approach WACC Value of a company Summary, exercises, references

30. Dr Irena JindrichovskaCorporate Finance Management 230 Equity versus debt Feature:EquityDebt Income:DividendsInterest Tax status: Taxed as personal income. Are not business expense Taxed as personal income. Are business expense Control:Common stocks (sometimes preferred) usually have voting right Control is exercised with loan agreement Default:Firms cannot become bankrupt for nonpayment of dividends Unpaid debt is a liability. Nonpayment results in bankruptcy Bottom line: Tax status favours debt, but default favours equity. Control features of debt and equity are different but one is not better than other

31. Dr Irena JindrichovskaCorporate Finance Management 231 Long term debt Loans and bonds –Loans (interest is paid before taxes – creation of tax shield, that lowers the cost of L/T debt); T = tax rate –Bonds (yield to maturity)

32. Dr Irena JindrichovskaCorporate Finance Management 232 Preferred shares Perpetuity P = C/r; i.e. k p = C / P May need to take in consideration issuance cost (flotation cost F) k p = C / (P-F)

33. Dr Irena JindrichovskaCorporate Finance Management 233 Cost of retained equity Using Gordon model of growing perpetuity: P=D 1 / (r-g); i.e. k s = (D 1 / P) + g

34. Dr Irena JindrichovskaCorporate Finance Management 234 Cost of new equity Using Gordon model of growing perpetuity taking in consideration flotation cost: k e = (D 1 / (P-F)) + g

35. Dr Irena JindrichovskaCorporate Finance Management 235 The CAPM approach Estimate using the CAPM –Estimate of risk free rate r RF –Estimate the market premium RP M –Estimate the stock’s beta coefficient  s –Substitute in the CAPM equation:

36. Dr Irena JindrichovskaCorporate Finance Management 236 Bond yield plus risk premium approach Some analysts us an ad hoc procedure to estimate the firms cost of common equity Adding a judgmental risk premium (3-5%) r s = bond yield + bond risk premium It is logical to think that firms with risky, low rated high-interest-rate debt will also have risky high-cost equity

37. Dr Irena JindrichovskaCorporate Finance Management 237 WACC Weighted average cost of capital – one way of measuring cost of capital of a company WACC=w d *k d + w p *k p + w s(e)* k s(e) Another way may be estimating through market model (SML) – ex-post valuation

38. Dr Irena JindrichovskaCorporate Finance Management 238 Factors that affect the weighted average cost of capital Factors that firm cannot control –The level of interest rates –Market risk premium –Tax rates Factors the firm can control –Capital structure policy –Dividend policy –Investment policy

39. Dr Irena JindrichovskaCorporate Finance Management 239 Summary 1.Earlier chapters on capital budgeting assumed that projects generate riskless cash flows. The appropriate discount rate in that case is the riskless interest rate. Of course, most cash flows from real-world capital- budgeting projects are risky. This chapter discusses the discount rate when cash flows are risky. 2.A firm with excess cash can either pay a dividend or make a capital expenditure. Because stockholders can reinvest the dividend in risky financial assets, the expected return on a capital-budgeting project should be at least as great as the expected return on a financial asset of comparable risk.

40. Dr Irena JindrichovskaCorporate Finance Management 240 Summary 2 3. The expected return on any asset is dependent upon its beta. Thus, we showed how to estimate the beta of a stock. The appropriate procedure employs regression analysis on historical returns. 4.We considered the case of a project whose beta risk was equal to that of the firm. 5.If the firm is unlevered, the discount rate on the project is equal to RF+( M - RF)*ß where M is the expected return on the market portfolio and RF is the risk-free rate. In words, the discount rate on the project is equal to the CAPM’s estimate of the expected return on the

41. Dr Irena JindrichovskaCorporate Finance Management 241 Exercise questions 1.Describe the various sources of capital. 2.Describe the ”optimal” capital structure. 3.Explain the concept: weighted average cost of capital (WACC). 4.Explain how to calculate a value of a firm using WACC.

42. Dr Irena JindrichovskaCorporate Finance Management 242 Exercise problem 1 12.13 RWJ Calculate the weighted average cost of capital for the Luxury Porcelain Company. The book value of Luxury’s outstanding debt is $60 million. Currently, the debt is trading at 120 percent of book value and is priced to yield 12 percent. The 5 million outstanding shares of Luxury stock are selling for $20 per share. The required return on Luxury stock is 18 percent. The tax rate is 25 percent.

43. Dr Irena JindrichovskaCorporate Finance Management 243 Exercise problem 2 12.14 RWJ First Data Co. has 20 million shares of common stock outstanding that are currently being sold for $25 per share. The firm’s debt is publicly traded at 95 percent of its face value of $180 million. The cost of debt is 10 percent and the cost of equity is 20 percent. What is the weighted average cost of capital for the firm? Assume the corporate tax rate is 40 percent.

44. Dr Irena JindrichovskaCorporate Finance Management 244 Useful web sources Online Tutorial #8: How Do You Calculate A Company's Cost of Capital? http://www.expectationsinvesting.com/tu torial8.shtmlhttp://www.expectationsinvesting.com/tu torial8.shtml And a video lecture (rather easy) http://www.youtube.com/watch?v=JKJgl PkAJ5ohttp://www.youtube.com/watch?v=JKJgl PkAJ5o

45. Dr Irena JindrichovskaCorporate Finance Management 245 RECOMENDED READINGS Fundamentals of Corporate Finance, Ross, Westerfield and Jaffe, 6 th edition. Ch 12 Brigham and Houston: Fundamentals of Financial Management, 12th ed, Ch 10

46. Dr Irena JindrichovskaCorporate Finance Management 246 MERGERS AND TAKEOVERS

47. Dr Irena JindrichovskaCorporate Finance Management 247 Outline Introduction Mergers ad acquisition rationale Underling principles Business motives for acquisitions Financial strategy Price reaction n acquisition announcement Takeover defense Summary, exercises, references

48. Dr Irena JindrichovskaCorporate Finance Management 248 Mergers and Acquisitions Mature companies try to reverse or accelerate the life cycle through dynamic changes in the structure of the business by mergers or acquisitions Two businesses combine into one Mergers are rare  Acquisitions Larger and smaller company  acquirer and target company

49. Dr Irena JindrichovskaCorporate Finance Management 249 Underlying principles Combined future CF’s are bigger than sum of CF’s of two individual companies Not in case of large premium paid to shareholders of the target –(90%-125% of exp. value of the synergy has been paid to the sellers) - better to be seller then buyer

50. Dr Irena JindrichovskaCorporate Finance Management 250 M&A’s = “market imperfections” Asymmetric price reaction on acquisition announcement: Target company is undervalued in the market (inefficient market) Participants do not agree on the price of the target company stock ? Synergy effect (2+2=5)

51. Dr Irena JindrichovskaCorporate Finance Management 251 Source of synergy from acquisitions Revenue Enhancement –Marketing Gains –Strategic Benefits –Market or Monopoly Power Cost Reduction –Economies of Scale –Economies of Vertical Integration –Complementary Resources –Elimination of Inefficient Management

52. Dr Irena JindrichovskaCorporate Finance Management 252 Source of synergy from acquisitions 2 Tax Gains –Net Operating Losses –Unused Debt Capacity –Surplus Funds The Cost of Capital

53. Dr Irena JindrichovskaCorporate Finance Management 253 Two “bad” reasons for mergers Earnings Growth –EPS Game Diversification –Systematic variability cannot be eliminated by diversification, so mergers will not eliminate this risk at all. By contrast, unsystematic risk can be diversified away through mergers.

54. Dr Irena JindrichovskaCorporate Finance Management 254 Influence of innovative products Management may forget the underlying principles justifying M&A Target company must be worth more than it will cost the acquirer

55. Dr Irena JindrichovskaCorporate Finance Management 255 Cash versus Common Stock Whether to finance an acquisition by cash or by shares of stock is an important decision. The choice depends on several factors, as follows: 1. Overvaluation. If in the opinion of management the acquiring firm’s stock is overvalued, using shares of stock can be less costly than using cash. 2. Taxes. Acquisition by cash usually results in a taxable transaction. Acquisition by exchanging stock is tax free.

56. Dr Irena JindrichovskaCorporate Finance Management 256 Cash versus Common Stock 2 3. Sharing Gains. If cash is used to finance an acquisition, the selling firm’s shareholders receive a fixed price. In the event of a hugely successful merger, they will not participate in any additional gains. Of course, if the acquisition is not a success, the losses will not be shared and shareholders of the acquiring firm will be worse off than if stock were used.

57. Dr Irena JindrichovskaCorporate Finance Management 257 Financial strategy in acquisitions Financial role - to evaluate the synergy effect Strategy - change the financial structure of target company  leverage the company Target company with cash surpluses (mature group)  Corporate raider acquires the company, strips it off the cash and leverages the company

58. Dr Irena JindrichovskaCorporate Finance Management 258 Diversified companies Diversified group should be valued at minimum weighted average P/E applicable to its component businesses If the company does not perform well after acquisition  sell parts of the group for higher P/E – divestiture, spin-offs,…

59. Dr Irena JindrichovskaCorporate Finance Management 259 “Greenmailing” Significant minority impacts on the corporate strategy Raider buys a significant part of the co. which he considers undervalued and “greenmails” the management, asserting that the company is badly managed Management buys him out  cash drain

60. Dr Irena JindrichovskaCorporate Finance Management 260 EPS game Growth in P/E is automatically created by an equity funded acquisition if P/E of bidder > P/E of target If companies have the same P/E multiple And financial structure of target company is changed  debt instead of equity EPS of the group  However, increased growth prospects are offset by  financial risk due to  debt

61. Dr Irena JindrichovskaCorporate Finance Management 261 EPS game Company A is considering acquiring companies B, C, and D but it wishes to ensure that each deal increases EPS. Finance can be raised through equity or debt or through any other financial mechanism. After-tax cost of debt = 5%.

62. Dr Irena JindrichovskaCorporate Finance Management 262 AcquirerAno of shares10 000 000Ano of shares10 000 000Ano of shares10 000 000Ano of shares10 000 000 share price (£)1 1 1 1 PAT (£)1 000 000 PAT (£)1 000 000 PAT (£)1 000 000 PAT (£)1 000 000 EPS (£)0,1 EPS (£)0,1 EPS (£)0,1 EPS (£)0,1 P/E10 P/E10 P/E10 P/E10 TargetBno of shares5 000 000Cno of shares10 000 000Dno of shares1 000 000Dno of shares1 000 000 share price (£)1 0,5 share price (£)5,0 share price (£)5,0 PAT (£)1 000 000 PAT (£)500 000 PAT (£)250 000 PAT (£)250 000 EPS (£)0,2 EPS (£)0,05 EPS (£)0,25 EPS (£)0,25 P/E5 10 P/E20 P/E20 P/E A > P/E B P/E A = P/E C P/E A < P/E D Invert the transaction ! Deal A issues 5 mil shares at 1£ A issues 5 mil debt for (5%) A issues 5 mil shares at 1£ D issues 2 mil shares at 5 £ structure and buys B and buys D and buys A New shares5 000 000 New shares0 5 000 000 New shares2 000 000 New debt5 000 000 cost of debt250 000 ResultABno of shares15 000 000ACno of shares10 000 000ADno of shares15 000 000DAno of shares3 000 000 PAT (£)2 000 000 PAT (£)1 250 000 PAT (£)1 250 000 PAT (£)1 250 000 EPS (£)0,133 EPS (£)0,125 EPS (£)0,083 EPS (£)0,417 P/E7,5 P/E10 P/E12 P/E12 share price (£)1,00 share price (£)1,25 share price (£)1,00 share price (£)5,00

63. Dr Irena JindrichovskaCorporate Finance Management 263 Higher growth companies EPS bidding < EPS target P/E bidding < P/E target Post-acquisition P/E  to appropriate weighted average of the original businesses EPS  because bidding company is larger than target company

64. Dr Irena JindrichovskaCorporate Finance Management 264 Takeover defense Pre-offer defense –Shark repellent –Staggered board –Quorum –Poison pills –Re-capitalization with special right shares Post offer defense –Pacman defense –Violation of antitrust law –Change of asset structure –Change of liabilities structure

65. Dr Irena JindrichovskaCorporate Finance Management 265 Summary 1.The synergy from an acquisition is defined as the value of the combined firm (V AB ) less the value of the two firms as separate entities (V A and V B ), or Synergy V AB - (V A + V B ) The shareholders of the acquiring firm will gain if the synergy from the merger is greater than the premium. 2.The three legal forms of acquisition are merger and consolidation, acquisition of stock, and acquisition of assets. 3.Mergers and acquisitions require an understanding of complicated tax and accounting rules

66. Dr Irena JindrichovskaCorporate Finance Management 266 Summary 2 4.The possible benefits of an acquisition come from: a. Revenue enhancement, b. Cost reduction, c. Lower taxes, d. Lower cost of capital The reduction in risk from a merger may help bondholders and hurt stockholders. 5.The empirical research on mergers and acquisitions is extensive. Its basic conclusions are that, on average, the shareholders of acquired firms fare very well, while the shareholders of acquiring firms do not gain much.

67. Dr Irena JindrichovskaCorporate Finance Management 267 Exercise problems 1.Do M&As create value at all? 2.Who are the main beneficiaries of M&A in the short term / long term? 3.In an efficient market with no tax effects, should an acquiring firm use cash or stock? 4.Explain the Japanese Keiretsu, how does it function? 5.M&A valuation problem – on separate sheet

68. Dr Irena JindrichovskaCorporate Finance Management 268 Useful web sources A book on Mergers and acquisitions by Weston and Weaver (2001) - book preview http://www.google.com/books?hl=cs&lr= &id=Y2Mz7tOuJBgC&oi=fnd&pg=PP9& dq=mergers+and+acquisitions&ots=85k GKKGutc&sig=iY_Ztx8tQY42Kzmw2- UrVp25rTM#v=onepage&q=mergers%2 0and%20acquisitions&f=truehttp://www.google.com/books?hl=cs&lr= &id=Y2Mz7tOuJBgC&oi=fnd&pg=PP9& dq=mergers+and+acquisitions&ots=85k GKKGutc&sig=iY_Ztx8tQY42Kzmw2- UrVp25rTM#v=onepage&q=mergers%2 0and%20acquisitions&f=true

69. Dr Irena JindrichovskaCorporate Finance Management 269 Useful web source 2 Characteristics of takeover defense strategies http://www.investopedia.com/articles/stock s/08/corporate-takeover- defense.asp#axzz29MjA54dwhttp://www.investopedia.com/articles/stock s/08/corporate-takeover- defense.asp#axzz29MjA54dw

70. Dr Irena JindrichovskaCorporate Finance Management 270 RECOMENDED READINGS Fundamentals of Corporate Finance, Ross, Westerfield and Jaffe, 4th edition. Ch 29 Brigham and Houston: Fundamentals of Financial Management, 12th ed, Ch 15

71. Dr Irena JindrichovskaCorporate Finance Management 271 CAPITAL STRUCTURE

72. Dr Irena JindrichovskaCorporate Finance Management 272 Outline Capital structure concept – maximizing value Optimal capital structure M&M Theory of Independence M&M Theory of Dependence Taxes and financial leverage Cost of financial distress and agency costs EBIT-EPS analysis Summary, exercises, references

73. Dr Irena JindrichovskaCorporate Finance Management 273 Goal of capital structure management Maximize the share price Minimize the weighted average cost of capital Too big financial leverage can bring firm to bankruptcy Too small financial leverage leads to undervaluing of share price

74. Dr Irena JindrichovskaCorporate Finance Management 274 Miller & Modigliani (1958) The Cost of Capital, Corporation Finance and the Theory of Investment, American Economic Review 48: 261-297

75. Dr Irena JindrichovskaCorporate Finance Management 275 Importance of capital structure Cost of capital is one of the cost and therefore influence dividends If the cost of capital are minimized, the payments to shareholders is maximized If the cost of capital can be determined by corporate capital structure then the capital structure management is an important part of firm management

76. Dr Irena JindrichovskaCorporate Finance Management 276 Assumptions The share price is a perpetuity: P 0 = D t /K c The firm pays constant dividends Dividend-Pay-Out = 100%, i.e. no retained earnings There are no taxes Capital structure consists of Debt & Equity only

77. Dr Irena JindrichovskaCorporate Finance Management 277 Further assumptions Financial structure is modified by issuing new shares to buy out debt or the other way around EBIT is assumed to remain constant Shares and other securities are traded on efficient market

78. Dr Irena JindrichovskaCorporate Finance Management 278 Proposition I. Independence Hypothesis The cost of capital of the firm (K 0 ) and share price P 0 are both independent on capital structure (financial leverage) Total market value of the firm securities stays unchanged disregarding the degree of leverage (picture) The basic relation of Independence Hypothesis: Percentage change of cost of equity K c = Percentage change in dividends D t

79. Dr Irena JindrichovskaCorporate Finance Management 279 Proposition II. Dependence Hypothesis Both the cost of capital (K 0 ) and share price (P 0 ) are influenced by firm’s capital structure Weighted average cost of capital (K 0 ) will decrease as the D/E increases, and the share price (P 0 ) increases with growing leverage, therefore companies should use as high leverage as possible (picture)

80. Dr Irena JindrichovskaCorporate Finance Management 280 Dependence Hypothesis According to Dependence Hypothesis: Percentage change of cost of equity K c = 0, however, percentage change in dividends D t > 0 Percentage change of price = percentage change of dividends

81. Dr Irena JindrichovskaCorporate Finance Management 281 Taxes and financial leverage The interest is deductible from the tax base Use of debt in capital structure should lead to increased market value of firm securities The middle view assumes that interest tax shied has its market value which increases total market value of the firm

82. Dr Irena JindrichovskaCorporate Finance Management 282 Cost of financial distress The probability of bankruptcy increases with increasing leverage. The firm has the highest costs if it gets bankrupt – –Assets are liquidated for lower than market price –Banks refuse to lend –Suppliers refuse to grant commercial credit –Dividend payments are stopped At certain point the expected bankruptcy costs outweigh the tax shield and the firm has to change the capital structure (Pictures)

83. Dr Irena JindrichovskaCorporate Finance Management 283 Further topics Optimal financial structure EBIT-EPS analysis Point of financial indifference Implicit cost cost of debt – increased risk Practical measures of capital structure management

84. Dr Irena JindrichovskaCorporate Finance Management 284 Capital structure theories The trade-off theory –The trade-off between benefits and costs of debt –Small debt – small tax shield but more financial flexibility Pecking order theory –Different types of capital have different costs - the least expensive source is used first

85. Dr Irena JindrichovskaCorporate Finance Management 285 Summary 1 In general, a firm can choose among many alternative capital structures. It can issue a large amount of debt or it can issue very little debt. It can issue floating-rate preferred stock, warrants, convertible bonds, caps, and callers. It can arrange lease financing, bond swaps, and forward contracts.

86. Dr Irena JindrichovskaCorporate Finance Management 286 Summary 2 Because the number of instruments is so large, the variations in capital structures are endless. We simplify the analysis by considering only common stock and straight debt in this chapter. We examine the factors that are important in the choice of a firm’s debt-to-equity ratio.

87. Dr Irena JindrichovskaCorporate Finance Management 287 Exercise questions 1.Explain the concept of capital structure 2.Define the optimal capital structure 3.Explain the logic of M&M Theory of independence 4.Explain M&M Theory of dependence 5.Explain the role of taxes in financial structure 6.Explain the cost of financial distress and agency costs

88. Dr Irena JindrichovskaCorporate Finance Management 288 Exercise problem 1 Gearing Manufacturing, Inc is planning a $ 1 000 000 expansion of its production facilities. The expansion could be financed by the sale of $1 250 000 in 8% notes or by the sale of $ 1 250 000 in capital stock. Which would raise the number of shares outstanding from 50 000 to 75 000. Gearing pays income taxes at a rate of 30%. Suppose that income from operations is expected to be $ 550 000 per year for the duration of the proposed debt issue, Should Gearing be financed with debt or stock? Explain your answer.

89. Dr Irena JindrichovskaCorporate Finance Management 289 Useful web sources Financing decisions: Capital Structure and cost of capital http://www.slideshare.net/meowbilla/4a304- capital-structurehttp://www.slideshare.net/meowbilla/4a304- capital-structure CFA 1 Materials http://www.investopedia.com/exam-guide/cfa- level-1/corporate-finance/mm-capital- structure-versus-tradeoff- leverage.asp#axzz1sgRpYOfdhttp://www.investopedia.com/exam-guide/cfa- level-1/corporate-finance/mm-capital- structure-versus-tradeoff- leverage.asp#axzz1sgRpYOfd

90. Dr Irena JindrichovskaCorporate Finance Management 290 RECOMENDED READINGS Fundamentals of Corporate Finance, Ross, Westerfield and Jaffe, 6 th edition. Ch 12 Brigham and Houston: Fundamentals of Financial Management, 12th ed, Ch 10

91. Dr Irena JindrichovskaCorporate Finance Management 291 STRATEGY AND TACTICS OF FINANCING DECISIONS - INVESTMENT DECISION MAKING

92. Dr Irena JindrichovskaCorporate Finance Management 292 Outline Introduction Investment decision making Nature of projects and incremental cash flows Project phases and relevant cash flows Decision making methods incl. pros and cons Comparing different projects Summary, exercises, references

93. Dr Irena JindrichovskaCorporate Finance Management 293 Investment Projects Nature of project Profit generating projects –Increasing capacity, new equipment –Replacement projects Ecological projects – minimizing loss

94. Dr Irena JindrichovskaCorporate Finance Management 294 Long-term nature of projects Analyzing - incremental cash flows –Changes of the firms cash flow that occur as a direct consequence of accepting the project Costs vs. Cash flows Sunk costs Opportunity costs (potential revenues form alternative uses are lost) Side effects - transfers

95. Dr Irena JindrichovskaCorporate Finance Management 295 Project Phases 1. Investment phase 2. Operating phase (income and taxes) 3. Liquidating phase (sometimes included in operating phase)

96. Dr Irena JindrichovskaCorporate Finance Management 296 Investment decision making methods Net Present Value - NPV Internal Rate of Return - IRR Payback Period - PP Profitability Index - PI Modified Internal Rate of Return - IRR*

97. Dr Irena JindrichovskaCorporate Finance Management 297 Net Present Value The most frequently used decision making method Discounts individual positive and negative cash flows to the present – finding their present value Projects with positive net present value are accepted This method is sensitive to the discount rate used in the process of calculation

98. Dr Irena JindrichovskaCorporate Finance Management 298 Internal Rate of Return The discount rate of the project that forces its net present value to equal zero NPV = 0 Positive and negative cash flows are discounted at rate IRR. APPROXINMATION of this rate can be found using iterations or linear interpolation Advantage - comparison with cost of capital STRONG ASSUMPTION - cash inflows are reinvested at a rate IRR

99. Dr Irena JindrichovskaCorporate Finance Management 299 Payback Period Non-discounted method Discounted method Cumulated cash flows ASSUMPTION- evenly distributed cash flows during the course of each period

100. Dr Irena JindrichovskaCorporate Finance Management 2100 Profitability index Present value of cash inflows to present value of cash outflows Decision rule: PI > 1 The same decisions as NPV Profitability indexes of two projects can not be added, whereas the NPVs can

101. Dr Irena JindrichovskaCorporate Finance Management 2101 Modified Internal Rate of Return Removes the strong assumption about reinvesting cash inflows for the high IRR Maintains the advantage - easy comparison with cost of capital – the appropriate discount rate

102. Dr Irena JindrichovskaCorporate Finance Management 2102 Modified IRR* - formula

103. Dr Irena JindrichovskaCorporate Finance Management 2103 Comparing projects Conflict between NPV and IRR Projects with irregular cash flows Projects with several negative cash flows Comparing projects with different time horizon Crossover rate Capital Asset Pricing Model - CAPM application in capital budgeting

104. Dr Irena JindrichovskaCorporate Finance Management 2104 Summary 1.Investment decision making must be placed on an incremental basis - sunk costs must be ignored, while both opportunity costs and side effects must be considered. 2.Inflation must be handled consistently. One approach is to express both cash flows and the discount rate in nominal terms. 3.When a firm must choose between two machines of unequal lives, the firm can apply either the matching cycle approach or the equivalent annual cost approach. Both approaches are different ways of presenting the same information.

105. Dr Irena JindrichovskaCorporate Finance Management 2105 Summary 2 4.In this chapter we cover different investment decision rules. We evaluate the most popular alternatives to the NPV: the payback period, the accounting rate of return, the internal rate of return, and the profitability index. In doing so, we learn more about the NPV. 5.The specific problems with the NPV for mutually exclusive projects was discussed. We showed that, either due to differences in size or in timing, the project with the highest IRR need not have the highest NPV. Hence, the IRR rule should not be applied. (Of course, NPV can still be applied.)

106. Dr Irena JindrichovskaCorporate Finance Management 2106 Exercise questions 1.What are the difficulties in determining incremental cash flows? 2.Define sunk costs, opportunity costs, and side effects. 3.What are the items leading to cash flow in any year? 4.Why is working capital viewed as a cash outflow? 5.Discuss the pros and cons of investment decision making methods 6.What is the difference between the nominal and the real interest rate and nominal and real cash flow? 7.Discuss the problems of IRR method

107. Dr Irena JindrichovskaCorporate Finance Management 2107 Useful web sources http://www.studyfinance.com/lessons/capbud get/http://www.studyfinance.com/lessons/capbud get/ http://www.capitalbudgetingtechniques.com/ What is capital budgeting - text http://www.exinfm.com/training/capitalbudgeti ng.dochttp://www.exinfm.com/training/capitalbudgeti ng.doc Impact of inflation on investment decision making http://www.studyfinance.com/jfsd/pdffiles/v9n 1/mills.pdfhttp://www.studyfinance.com/jfsd/pdffiles/v9n 1/mills.pdf

108. Dr Irena JindrichovskaCorporate Finance Management 2108 RECOMENDED READINGS Fundamentals of Corporate Finance, Ross, Westerfield and Jaffe, 4th edition. Ch 7 Brigham and Houston: Fundamentals of Financial Management, 12th ed, Ch 9, 10