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--Managing Capital for Investment, Financing and Operation
Corporate Financial Management --Capital Budgeting, Cost of Capital & Firm Valuation --Managing Capital for Investment, Financing and Operation By Dr. Xueping Wu City University of Hong Kong April
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1. Capital Budgeting A firm has existing and future projects
Good managers maintain and launch good projects What are good projects? A project provides a stream of future cash flows We need the knowledge of finance to shift cash flows across time Discounted cash flows=Present value for today’s decision making “Good” projects = high present values
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Project Selection Rules
Net Present Value Payback Period Discounted Payback Period The Internal Rate of Return The Profitability Index
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The Net Present Value (NPV) Rule
=Total PV of future cash flows - Initial Investment Estimating NPV (three components): (1) Estimate future cash flows (2) Estimate discount rate (3) Estimate initial costs (investment) NPV>0 Minimum Acceptance Criteria: Accept if NPV > 0 Ranking Criteria: Choose the highest NPV
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Example Accept the project because NPV>0. 1 2 3 $50 $100 $150
1 2 3 $50 $100 $150 -$200 (Investment) Accept the project because NPV>0.
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The Payback Period Rule
How long does it take the project to “pay back” its initial investment? Payback Period = number of years to recover initial investment Minimum Acceptance Criteria is set by management Ranking Criteria is also set by management Example: Initial Investment=$200 Project A: Project B: CF(Year 1)=$50 CF(Year 1)=$50; CF(Year2)=$150 CF(Year2)=$100; CF(Year3)=$100 CF(Year 3)=$250 Payback Period (A) Payback Period (B) = 2 Years =2 + ( )/250 = 2.2 Years
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The Discounted Payback Period Rule
How long does it take the project to “pay back” its initial investment taking the time value of money into account? Example: Initial Investment=$200, cost of capital=15% Project A: Project B: PV(50)=50/1.15= PV(50)=50/1.15=43.48 PV(150)=150/1.152= PV(100)=100/1.152=75.61 PV(100)=100/1.153= PV(250)=250/1.153=164.38 Total PV(A)=$ Total PV(A)=$283.47 Discounted Payback Period (A) Discounted Payback Period (B) =2+( )/65.75 =2+ ( )/131.50 =2.66 years =2.49 years Time value of money matters!
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The Internal Rate of Return (IRR) Rule
IRR: the special discount rate that sets NPV to zero Minimum Acceptance Criteria: Accept if the IRR exceeds the required return. Ranking Criteria: Select alternative with the highest IRR Example: 1 2 3 $50 $100 $150 -$200 The IRR for this project is 19.44%
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The Profitability Index (PI) Rule
PI=PV(all future cash flows) divided by initial investment Minimum Acceptance Criteria: Accept if PI > 1 Ranking Criteria: Select alternative with highest PI Example: Initial Investment=$200 Project A: PV=$222.65, so PI=222.65/200=1.11 Project B: PV=$283.47, so PI=283.47/200=1.42
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Work Sheet for Cash Flows (CF)
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Sales (Revenues) $100.0 $163.00 $249.72 $212.20 $129.90 (2) Operating costs -50.00 -88.00 133.10 -87.84 (3) Taxes -10.20 -14.69 -29.01 -22.98 -10.38 (4) Operating CF (1) – (2) – (3) 39.80 60.51 75.51 56.12 31.68 (5) Investments –260. –6.32 –8.65 3.75 192.98 (6) CF [(4) + (5)] –260. 39.80 54.19 66.86 59.87 224.66 05 . 588 , 51 $ ) 10 1 ( 66 224 87 59 86 19 54 80 39 260 5 4 3 2 = + - NPV
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2. Cost of Capital Capital = Debt + Equity (or actually all financing means including convertible bonds and warrants) Cost of Debt=Interest Rate(s) Debt-rating (S&P: AAA, AA, …, BBB,… Junk..) Cost of Equity=Required rate of return Capital Structure (mix of financing means) WACC=Weighted Average of Cost of Capital
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Average Return and Risk
Average Returns and Standard Deviation for Equities, Bonds, and Bills in the US., 1900 – 2006 (over 106 yrs) Asset classes with greater volatility (std. Dev.) pay higher average returns. Average return on stocks is more than double the average return on bonds, but stocks are 2.5 times more volatile.
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Historical Returns, Average Standard Series Annual Return Deviation Distribution Large Company Stocks 12.3% 20.0% Small Company Stocks Long-Term Corporate Bonds Long-Term Government Bonds U.S. Treasury Bills Inflation 0% – 90% + 90% Source: © Stocks, Bonds, Bills, and Inflation 2008 Yearbook™, Ibbotson Associates, Inc., Chicago (annually updates work by Roger G. Ibbotson and Rex A. Sinquefield). All rights reserved.
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Cost of Equity Tradeoff between risk and return for stocks
Diversification through holding a portfolio Intuition: Don’t put all eggs in one basket! Total Risk vs. Priced Risk Expected return = required rate of return Capital Asset Pricing Model (CAPM) High risk, high (required) return
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Diversification and Beta Risk
Total risk = Systematic Risk + Unique Risk Unique risk can be diversified away in a portfolio Systematic risk arises from the whole economy. You should not pay any risk premium for unique risk because it will offset itself automatically in a group of different firms (portfolio) Systematic risk is priced but unique risk isn’t. Beta risk (b) measures systematic risk or a firm’s return sensitivity to the market return over time. bi=Cov (rm,ri)/Var(rm)
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Capital Asset Pricing Model
CAPM: E(ri)=rf+[E(rm)-rf] bi for firm i (any firm) Example: Firm A: 20%=2%+[15%-2%]x1.385 Firm B: 10%=2%+[15%-2%]x0.615
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Capital Budgeting & Project Risk
Project IRR Beta risk rf bFIRM Incorrectly rejected positive NPV projects Incorrectly accepted negative NPV projects Hurdle rate Various projects can have different levels of beta risk A firm that relies on one hurdle rate (discount rate) for all projects may risk over- and under-rejection of projects!
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Capital Structure The Miller-Modigliani (MM) Theorem
The value of a pizza remains the same no matter how you slice the pizza. In a frictionless market, firm value depends on the quality of projects but not on how to finance the projects (e.g., a specific mix of debt & equity). But in imperfect markets, how to finance matters in mitigating market imperfection Firm-specific, optimal capital structure Example: Hi-tech firms: a lot of equity financing Utility firms: a lot of debt financing
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Cost of Capital with Debt and Equity
The firm as a whole is called the firm’s assets. The value of the firm as a whole is the value of both stock (S) and debt or bonds (B). The Weighted Average Cost of Capital (WACC) is given by: Example: equity=$60, debt=$40 (So firm value=$100) Required stock return=20%, BBB-rating bond yield=10% WACC=0.6x20%+0.4x10%=16% Can you lower WACC? Leverage affects risk and return!
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Risk and the Income Statement
Sales Operating – Variable costs Leverage – Fixed costs EBIT – Interest expense Financial Earnings before taxes Leverage – Taxes Net Income
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Business Risk The basic risk inherent in the operations of a firm is called business risk Business risk can be viewed as the variability of a firm’s Earnings Before Interest and Taxes (EBIT)
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Financial Risk Debt causes financial risk because it imposes a fixed cost in the form of interest payments. The use of debt financing is referred to as financial leverage. Financial leverage increases risk by increasing the variability of a firm’s return on equity or the variability of its earnings per share.
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Business Risk and Financial Risk
β β= 1 βA = β 1 B/S E(r) E(rm) rf E(rS) E(rA) - rf E(rA) E(rS) - E(rA) Unlevered A risk profile of a company: Equity risk equity β – sensitivity to rm Financial risk related to leverage (B/S) Business risk economic activity, asset b Equity risk reflects the business risk as well as the financial risk Equity β ≠ Asset β when B/S > 0
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Market Imperfection (Frictions)
Tax Distortion Transaction costs Agency problems e.g., bond holders versus equity holders mangers versus equity holders Controlling versus small investors Asymmetric information problem e.g., adverse selection effect
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Optimal Capital Structure (a Tradeoff Model)
Present value of tax shield Value if 100% equity financed V (Market Value) Debt/Equity Ratio Optimal debt/equity ratio Value of company Present value of financial distress costs Value of the “Levered” company = Value of the company when completely equity financed + Present value of the tax advantage for debt - Present value of financial distress costs
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Minimal WACC Cost of Equity WACC Cost of debt Debt Ratio Cost of Capital ( % ) Optimal debt ratio Minimal WACC Cost of equity increases because of financial risk increase Cost of debt increases because of default risk increase Cost of capital (WACC) is the lowest at the optimal capital structure
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WACC Estimates for Some Large U. S. Corporations
Company WACC wd=B/(S+B) Intel (INTC) 16.0 2.0% Dell Computer (DELL) 12.5 9.1% BellSouth (BLS) 10.3 39.8% Wal-Mart (WMT) 8.8 33.3% Walt Disney (DIS) 8.7 35.5% Coca-Cola (KO) 6.9 33.8% H.J. Heinz (HNZ) 6.5 74.9% Georgia-Pacific (GP) 5.9 69.9%
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Adjusted Present Value Approach in Capital Budgeting
APV = NPV + NPVF The value of a project to the firm can be thought of as the value of the project to an unlevered firm (NPV) plus the present value of the financing side effects (NPVF). There are four side effects of financing: (1) The Tax Subsidy to Debt (2) The Costs (or Benefits) of Issuing New Securities (3) The Costs of Financial Distress (4) Government Subsidies to Bank Financing
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APV Example Consider a project of the Pearson Company. The timing and size of the incremental after-tax cash flows for an all-equity firm are: –$1,000 $ $ $ $500 The unlevered cost of equity is r0 = 10%: The project would be rejected by an all-equity firm: NPV < 0.
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APV = NPV + NPV debt tax shield
APV Example, cont’d Now, imagine that the firm finances the project with $600 (=B) of debt at rB = 8%. Pearson’s tax rate is 40% (=tc), so they have an interest tax shield worth tcBrB = .40×$600×.08 = $19.20 each year. The net present value of the project under leverage is: APV = NPV + NPV debt tax shield Note, the example in the text assumes a perpetual project, so the PV of the tax shield is calculated assuming a perpetuity. The approach in this slide is comparable, but for a finite life project. So, Pearson should accept the project with debt.
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3. Growth and Firm Valuation
Investments, growth and firm value Suppose X = EBIT of current activities (perpetuity) I(t) = Investment at time t r* = Return on investment (firm specific) r = Required Rate of Return (from capital market)
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Assets-in-Place (AIP) and Investment
(1) Present value of AIP: X/r NPV(t) of future investment: r*I(t)/r-I(t) (2) NPV(0) of future investment: Total Firm Value=(1)+(2)
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Growth Opportunities Assume a series of investment I(t) for t=1, 2,…, N, then Total Firm Value becomes: AIP Value + NPV of GO (very noisy!) If r*>r, V0>X/r Growth Firm r*=r, V0=X/r Expanding Firm r*<0, V0<X/r Shrinking Firm
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P/E Ratio and Growth If r*>r, P/E>1/r Growth Firm
r*=r, P/E=1/r Expanding Firm r*<0, P/E<1/r Shrinking Firm (Negative growth firm) Get high r*, then the firm can grow! P/E ratio in the market has the information!
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Investment Return (r*) and Growth Rate
FX swap contract contains multi-period forward transactions but with one forward price
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