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Corporate finance: capital budgeting (LT investment?

)
capital structure (debt vs. equity), working capital
management decision (CA, CL; capital structure can affect
the value of the assets, e.g. tax deductibility of interest)
Risk: To determine whether return is adequate, compare to
benchmark

r tr avg

r D ( 1T c )
rD

D
E
+r
V EV

(cost of debt) using YTM, then interest

deductibility of tax, estimate r E


equity beta (using CAPM formula)

t=1

D1
>r
P0 E
D
r^ e = 1 <r E
P0
r^ e =

Impact of inflation: shifts up the SML


Impact of risk aversion: pivotal shift of the SML upwards
Capital Structure: Equity (RE, new equity) vs. Debt (Bank
borrowing, bonds)

Estimate

Overpriced: below SML, for stock:

WACC=

S.D. (total risk) =

Underpriced: above SML, for stock:

(cost of equity) using

Markowitz portfolio theory: combining stocks into portfolios


can reduce standard deviation below the level obtained from a
i=1
simple weighted average calculation due to correlation
C.V. is standardized measure of dispersion about the expected
coefficient
value (relative variability), that shows the risk per unit of
Efficient portfolio: portfolio that provides the greatest

expected return for a given level of standard deviation (risk),


return =
the lowest risk for a given expected return all efficient
r^
portfolios are represented on an efficient frontier (MVP:
2 2
2 2
p = w1 1 +(1w1 ) 2+ 2 w1 (1w1)Corr ( R1, R2 ) 1 2
minimum variance portfolio)

Covariance
S

r ir ) 2Pi=

( XY )= XY X Y

Pr ( s )( R i ,sE ( R i ) )( R j ,s E ( R j ) )
s=1

Correlation coefficient =

XY
X Y
=1.0

(standardizes

the units); [-1,1]; riskless portfolio:


Market risk (responsiveness of security to a change in market
position)

cov (r i , r m)

2
M

i M

2
M

M = market value weighted portfolio of all existing risky


securities; investors are able to allocate their money across
the risk-free asset and market portfolio with optimal result
CML is composed of various combination of the market
portfolio. As you move along the CML, you are investing in the
market portfolio and/or investing/borrowing at risk free rate.
industry, with no significant change in capital structure): Thus, although your overall portfolio S.D. changes along the
- Business Risk
various points of the CML, all points along the line move in
o Cyclicality: highly cyclical firms have higher perfect sync with each other. And each S.D. is a weighted
average of the S.D. of the risk free asset and the S.D. of the

o Operational leverage: higher proportion of market portfolio. You cannot combine points on the CML to get
anything lower than a weighted average S.D. their
fixed costs of production and lower variable
correlations are +1.
costs = higher operational leverage =
Market portfolio: portfolio at the tangent line of the risk free
change operating profit
asset with the efficient frontier of all risky assets available
(included in proportion to their market value, and because all
change sales
risky assets are included, it is a completely diversified
Financial Risk (bankruptcy risk): higher cost of
portfolio)
financing, higher financial leverage; In absence of tax,
For market portfolio, M =1
<1: less systematic risk than market
>1: more systematic risk than market
Determinants of (stable if stays in the same

A=

D
D
D
E
D +
E =
E , E= A (1+ )
D+ E
D+ E
D+ E
D
Goal:
shareholder wealth maximization maximize by 1.)

If the operations of the firm are similar to the rest of the


industry, should use industry .

Value of firm 2.) Wealth of owners 3.) Price of stock 4.)


Contribution to economy
3 aspects of cash flows that affect stock prices, i.e.
intrinsic/market value (stocks true value based on accurate
risk and return, estimated by PV of future CFs discounted by
rate of return from CAPM, vs. market price based on perceived
information as seen by the marginal investor) 1.) Amount of
cash flows expected by shareholders 2.) Timing 3.) Riskiness of
the cash flow stream (individuals required rate of return)
Annual report (F.S. used for credit decisions, risk analysis,
financial distress prediction, management evaluations,
investment selection); valuing of items at historical cost except
marketable securities and inventories 1.) Balance sheet one
point; A = L + E 2.) Income statement over period of time 3.)
Statement of retained earnings one point; RE (beginning of
year) + net income dividends = RE (end of year) 4.)

Statement of cash flows one point (sources of cash:


decrease in assets except cash, increase in equity and
liabilities); 1. Operating activities (NI, changes in most CA, e.g.
A/P, A/R, Inv) 2. Investment activities (changes in FA) 3.
Financing activities (changes in N/P, LT debt and equity
accounts, dividends)
Profit is not good enough: it subtracts depreciation, ignores
cash expenditures on new FA (capitalized), record income and
expenses at the time of sales, does not consider changes in
working capital
Cash flow from assets (net cash flow from operations, FCF)=
OCF (= EBIT + depreciation taxes from EBIT= if no interest
expense, OCF = NI + depreciation = Sales Costs Taxes
(*dont deduct non-cash deductions or interest expense) =
(Sales Costs including depreciation)(1 T) + Depreciation *
T) NCS (= ending net FA beginning net FA + depreciation)
Changes in NOWC
CFFA* + Interest Tax Shield (separate operations from
financing, so affects CF available to creditors and
shareholders) = CF to creditors (interest paid net new
borrowing, e.g. LT debt and N/P) + CF to stockholders
(dividends paid net new equity raised)
Assets = Liabilities + Income
CA + net FA= CL + LT debt + common stock + retained
earnings
Net working capital (cash + other CA CL)+ net fixed assets =
LT debt + common stock + retained earnings
NI = Addition to RE + Dividends
Liabilities = interest-bearing liabilities (short term loans +
N/P, a result of financing activities) + non-interest bearing
liabilities (A/P, extended from our suppliers, result of
operating activities)

Asset management (turnover/efficiency) ratios: how


productively the firm is using its assets
a. Inventory turnover = COGS / Inventory
Days sales in inventory = 365 / Inventory turnover
b. Rec. turnover = Sales / Receivables
Days sales outstanding or ave. collection period
= Accounts receivables / Average Daily Sales
= 365 / Receivables Turnover
c. FA turnover = Sales / net FA
TA turnover = Sales / TA
4. Profitability ratios: return on its investments
Profit margin = Net income / sales, Basic earning
power (removes effects of taxes and financial
leverage) = EBIT / total assets, ROA = net income /
total assets, ROE = net income* (deduct preferred
dividend) / total common equity
Effect of debt on ROE and ROA interest expense lowers
net income, lowering ROA, but for ROE, it also lowers equity
so depends
ROE can be a problem bc it does not consider risk, the
amount of capital invested, might encourage managers to
make investment decisions that do not benefit shareholders;
only focus on return
5. Market value ratios: firms prospects and how the
market values the firm; relates the firms stock price to its
earnings, cash flows and book value per share
a. Price / Earnings per share: how much investors are
willing to pay for $1 of earnings
b. Market price per share / Book value per share: how
much investors are willing to pay for $1 of book value
equity
Du Pont system: ROE = Profit margin (operating efficiency) *
Total asset
turnover
use efficiency)
* Equity multiplier
cash= retained earnings(increased by Dividends)+
common
stock (asset
+ CL
CA other thancash
net asse
(financial leverage) = (NI/Sales)* (Sales/TA) * (TA/TE)
Gross working capital: total current assets
Annuity: series of cash flows in which the same cash flow CF
Net working capital: CA CL
takes place each period for a set number of periods, e.g.
Interested in Net Operating Working Capital working
ordinary annuity (1st CF occurs one period from now, at the end
capital stemming from our operating policies (cash, A/R,
st
Inventory, A/P, etc.) and removed from our financing decisions of period 1) vs. annuity due (1 CF occurs immediately, at the
beginning
of
period
1)
(exclude non-operating working capital such as N/P, short-term
loans) = Operating CA Operating CL = (Cash + Inv. + A/R)
(Accruals + A/P)
Book values (historical costs accumulated depreciation)
determined by GAAP; Market values determined by
current trading values in the market, e.g. MV of shareholders
equity = market capitalization = share price x # of
outstanding shares
Enterprise value of a firm (value of underlying business
assets and separate from the value of any non-operating cash
and marketable securities that the firm may have; usually seen
as more accurate than market capitalization) = market value
of equity + debt excess cash
Authorized capital stock (# shares can issue legally)
a.) Issued capital stock: issued to outsiders
Outstanding capital stock held by outsiders
Treasury stock bought back and held by company
b.) Unissued capital stock: not issued to outsiders
Market-to-book ratio = market value of equity / book value
of equity
Common-size B/S percentage of total assets
Common-size I/S percentage of sales
1. Liquidity ratios: ability to convert assets to cash quickly
without a significant loss in value, ability to meet its
maturing ST obligations
Current ratio = CA/CL, Quick ratio = (CA Inv)/CL,
Cash ratio = Cash/CL creditors who loan ST, NWC to
Total Asset ratio = NWC/TA, Interval measure =
CA/Avg. daily operating costs startups, how many
days it can survive
2. Long-term solvency (financial leverage: extent that a
firm relies on debt financing rather than equity) ratios: how
heavily the company is in debt
Total-debt ratio = total debt / total assets, Debt/equity
ratio = (TA TE) / total equity, Equity multiplier =
TA/TE = 1 + debt/equity ratio, LT Debt ratio = LT Debt /
(LT debt + TE)
Times interest earned ratio = EBIT / interest
Cash coverage ratio=(EBIT + depreciation)/ interest

3.

PMT1
Annuity PV =

1
( 1+r )t

r
PV Annuity due= Annuity PV( 1+r )
n
PMT(1+ r) 1
Annuity FV =
r
FV Annuity due= Annuity FV(1+r )
Growing annuity

payment1(
PV =first

1+ g n
)
1+r

rg

Perpetuity: set of equal payments that are paid forever

PV =

C ( period payment )
r

Growing perpetuity

PV =

C1
rg

Effective annual rate of interest rate actual rate paid after


taking into consideration any compounding that may occur
during the year. If interest is compounded more than once a
year, then the stated rate will be different than the effective
rate.
Annual percentage rate (quoted rate/ stated rate/nominal
annual rate, i.e. quoted by law) = period rate * the number of
periods per year (never divide the effective rate by # of
periods)

EAR=[1+

APR m
] 1
m

, m = compounding frequency per

year
Different types of loans
1.) Pure discount loans: interest and principal payment made
at the end

2.) Interest only loans: interest paid throughout + principal at


the end,
3.) Loans with fixed principal payments: interest and fixed
amount of principal paid throughout the loan period
4.) Amortized loans: interest and a portion of the principal
paid throughout the loan period (equal payment covers
the interest expense and reduces principal)

In equilibrium, expected returns


and expected capital gains=

, r^ e

D1
+g
p0

(estimate dividends
) = required returns

(from CAPM) r E ,
Required return = Dividend yield + Capital yield
Stock prices (decided by expected future CFs) change
because:
Bond: long-term debt instrument sold to raise money
(creditor); coupon: periodic interest payment, par-value: face 1. r E could change: R E=R f + i ( RmR f ) , and
value of a bond, maturity: specified date on which the bonds
Rf =r (real risk free interest rate)+inflation premium
par amount is paid, term: time remaining until the principal
2. g could change due to macroeconomic or firm-specific
repayment made
situation
Callability: issuer can redeem the bond before it matures
Corporate value model: value of the entire firm = PV of the
Sinking fund: pool of money set aside to help repay a bond
firms free cash flows, i.e. use DCF to find value today; MV of
issue, allow repurchasing its bonds periodically and at a
firm = PV of the firms future CFFA; MV of common stock =
specified sinking fund price pay off loan over life; Bond
MV of firm MV of firms debt preferred stock; Intrinsic
indenture: contract between company and bondholders
stock price = MV of common stock / # of shares [method is
1
Coupon1
preferred to dividend growth model, esp for firms that dont
N
(1+r d )
pay dividends assumes that free cash flow will grow at
Bond-value (PV) =
Face Value
+
N
constant rate]; TV n represents value of firm at the
rd
(1+r d )
point that growth becomes constant: for corporate project
Overall rate of return =
and corporate valuation model, dividends and interest
Annual Coupon+(Current pricebeginning price)
expenses should NOT be included in the estimate of relevant
CFs (financing effects are accounted for by the discount rate
Beginning bond price
using WACC)
Yield to maturity (bonds yield): rate earned if a bond is
All CFs must be on an after-tax & incremental basis.
held to maturity, interest rate required in the market on the
Whether to undertake a project (TVM? Risk-adjusted? +
bond, rate implied by current bond price; yield which equates
value?):
the PV of all cash flows from a bond to the price of a bond;
1. NPV decision making: a. Estimate the expected cash
increases with inflation useful for comparison with other
potential investments with the same risk level: Bond pricing flows, b. Estimate the required return for projects of this risk
theorem: bonds of similar risk (and maturity) will be priced to
yield about the same return (the same YTM), regardless of the
coupon rate
-Price of bond (premium) > face value if coupon rate >
discount rate
-YTM < Current yield < Coupon rate: bond sell at premium
-Price of bond (discount) < face value if coupon rate <
discount rate
-Coupon rate < Current yield < YTM: bond selling at discount
Current yield: annual interest paid a by a bond, expressed as
a % of its current market price doesnt care about capital
gain/loss
Bond rating affected by financial performance, bond contract
provision
Floating rate bonds coupon rate depends on some index
value less price risk, coupon less likely to differ from the
YTM
Term structure: relationship between time to maturity and
yields, for bonds of the same risk and holding all else equal
(default risk)
**when solving questions, I/Y = (YTM + i/r change) / number of
periods
Longer maturity + lower coupon rate bond more i/r sensitive
Factors that affect bond yields: real interest rate, expected
future inflation, interest rate risk, default risk, taxability, lack of
liquidity
Value of bond = PV of expected CFs =

D t +1
D t +2
^
Pt =
+
+
(1+ r E ) (1+r E)2

But how to estimate these dividends?


1. Constant Dividend:

P 0=

D
rE

, cost of equity: required

rate using CAPM


2. Constant dividend growth (firms with long-term stable
growth: same as nominal growth):

D1
; limitation: r E > g
r E g

P0=

D 0 (1+ g)
=
r Eg

3. Supernormal Growth (non-constant growth)

level (use CAPM), c.

NPV =
t=1

CF t

(1+r )t

CF 0

(difference

between the intrinsic value of a project and its cost) accept if


NPV>0 (add value to the firm, increase owners wealth): If
comparing unequal life projects, cannot use NPV, use
Equivalent Annual Cost/Annuities: take the NPV as the PV,
and find the PMT (annuity received per year), then choose
highest EEA
2. Payback period: Accept if the payback period is less than
some present limit (easy, adjust for uncertainty of later CF,
biased towards liquidity) / Discounted payback rule:
3. Average accounting return (average net income/average
book value) decision rule: Accept if the AAR is greater than a
preset rate
4. Internal rate of return (return that makes the NPV=0)
rule: accept if IRR > required rate of return
NPV and IRR will give the same answer except: mutually
exclusive (if the CF of 1 can be adversely impacted by the
acceptance of the other) independent projects: choose
higher NPV/IRR but may have NPV profile cross due to
size differences and timing differences, thus depends on your
discount rate, r, and those with non-conventional CF (CF
signs change >1): if sign changes >1, there can be more
than 1 IRR, thus must look at the NPV profile (>1 IRR,
and cross-point)
NPV assumption: CFs are reinvested at companys WACC,
the opportunity cost of capital or the firms overall interest
rate; IRR assumption: CFs are reinvested at IRR assuming
the former is more realistic, so NPV is the best
5. Modified internal rate of return rule: use WACC to
compound and discount the CFs correctly assumes
reinvestment at opportunity cost and avoids the problem of
multiple IRR; thus use when there are non-normal CFs and
more than one IRR, i.e. PV outflows = TV inflows/
(1+MIRR)^n
6. Profitability index (benefit/cost ratio) =

Total PV of futureCFs
Initial Investment

>1, then accept (useful when we

have limited capital)


Capital budgeting: relies heavily on pro forma
statements, esp. I/S.
Depreciation expense: same as depreciation schedule for tax
purpose (straight-line, accelerated) non-cash expense, but
lowers taxes payable via depreciation tax shield = D*T

Replacement Projects*** Steps:


1. Do the Pro Formal Income Statement (Cost savings,
incremental depreciation EBIT, tax, NI)
2. Figure out CFFA (Overall incremental project cash
flow): 1. Net initial investment outlay, i.e. CF at time 0 [ - New
machine cost + net salvage value increase in NWC], 2.
Future OCF (after-tax basis) [reduction in production costs on
after-tax basis + annual depreciation tax shield (=incremental
depreciation * tax rate), must take note that new depreciation
= new machine cost / # of years], 3. CO later to support the
initial investment outlay, 4. Terminal year CF (include the
return of NWC + net salvage value after-tax after-tax
opportunity cost after-tax for old machines salvage) and
impact of inflation on CF (nominal vs. real discount rate; if
nominal, downward bias on PV): affect revenues, but not
depreciation, but not sunk costs. Then calculate NPV, IRR
3. Find NPV, if the life span is not the same, find EAA
instead (convert NPV to an annuity PMT) choose highest
EAA
Net salvage value: if salvage value BV, there is a tax
effect
S>B: gain on sale (tax on salvage value received = (SB)*T, after-tax salvage value = S (S-B)*T)
B>S: loss on sale (tax-saving = -(S-B)*T, after-tax salvage
values = S + T* |SB|
Financial planning:
1. Sales Forecast 2. Pro Forma statements (% of sales
approach: all assets, A/P vary directly with sales profit
margin is constant, N/P, LT debt, and equity (dividends) are
management decision, do not vary with sales Find the new
NI then NI dividends = Addition to RE, then add to equity
with debt as the plug variable. Got extra, then can borrow
more ST/LT, sell more common stock, or decrease dividend
payout, which increases RE, increase cash account.

L
SM ( S1 )(RR)
S0
A
S
S0

IF not operating at full capacity: then find capacity sales


(= actual sales/% of capacity), then see if need to adjust Fixed
Asset (figure out Target ratio = FA / Capacity sales, then figure
out how much more FA you need for the excess sales FA
= target ratio x excess sales)
Excess capacity: lower asset: turnover is better, less new
debt, hence lower interest rate: higher profits, EPS, ROE; debt
ratio, TIE improve
Working capital management: choosing and controlling the
levels and mix of cash, marketable securities, receivables and
inventories, as well as the different types of short-term
financing
Working capital policy: deciding the level of each type of CA
to hold, and how to finance CA (cash + inventory + receivables
management); reflected in (i) current ratio (ii) turnover of cash
& securities (iii) inventory turnover (iv) accounts receivable
turnover (DSO) conservative (ok if lead to greater
profitability) or inefficient

*Ta
ke the average for A/P, inventory, A/R
Minimizing cash cycle = minimizing external financing
A/P period = Payables deferrable period = 365 / Payables
turnover
Payables turnover =

Total purchase ( COGS+ End InvBeginning Inv)


Average payable

Managing short-term assets tradeoff between:


Carrying costs with CA, cost to store and finance
AFN =
; Retention ratio = 1
the assets vs. Shortage costs with CA, costs to
replenish assets (order costs, safety reserves, i.e. lost sales)
Why hold cash and goal of cash management: minimize
Payout ratio
cash for 1. Transaction balances, 2. Precautionary, 3.
External financing needed if the LT debt remains the same =
Compensating balances (for loans/services), 4. Speculation.
(A-(L+E))
How? (lockbox: time of processing check, wire transfer,
A*: Assets whose value and growth are directly tied to sales
remote disbursement account, forecast accuracy, hold
L*: liabilities that spontaneously change with sales
Assumption for AFN: firm operating at full capacity, constant marketable securities, negotiate a line of credit: how much you
profit margin, dividend payout ratio/retention ratio is constant can borrow up to)
Float: difference between cash as shown on the firms books
If operating at less than full capacity: no additional fixed
asset required A<L+E (balance by repaying debt, buy back and on its banks books; Net float = disbursement float
(when a firm writes cheques: Bank book >0) + collection
stock, etc.)
float (when cheque is received increases book balance before
Internal financing (retained earnings) and growth may
bank credits the account: bank book <0): cost = opportunity
not be enough, then resort to external financing
Assumption for below: liabilities are non-spontaneous (do not cost of not being able to use the $
vary with sales), thus AFN = spontaneous increase in assets Size of float depends on: dollar amount and time delay(=
mailing time + processing delay + availability delay)
increase in RE
Cash budget is a cash management tool (purpose: forecast
Net IncomeDividends
cash inflows, outflows, and ending cash balances, used to plan
b = retention ratio (RR) =
loans needed or funds available to invest). Structure: Cash at
Net Income
start if not borrowing + Net CF (inflow, e.g. collection +
Internal growth rate (how much the firm can grow asset
interest earned + proceeds from sale of FA and stock and
ROA b
using RE as the only source of financing) =
bonds bad debts outflows, e.g. wages, rent) target cash =
1ROA b
surplus/deficit: invest in assets or return to stockholders for
Sustainable growth rate (how much firm can grow by using surplus
internally generated funds and issuing debt to maintain a
Receivables management: via credit management (increase
ROE b
sales vs. bad debt with aging schedule and cost of financing
constant debt ratio) =

receivables) with its own credit policy (4 variables: i. credit


1ROE b
period, ii. Discounts for early payments, iii. Credit standards,
Determinants of growth: ROE (Du Pont Identity: profit margin,
iv. Collection policy)
TA turnover, financial leverage) + Dividend policy
A/R = Credit sales per day x Length of collection period
Ignore financing feedback (adding interest expense, lowering
Implied interest rate for credit term of 2/10 net 45
NI, RE)
EAR = (1/0.98)^(365/35) 1
1. Financial statement method more flexible
Whether to change credit policy: Find the incremental CF,
2. Equation method (assumes constant profit margin may
then find the PV of incremental CF using PV of perpetuity
not be the case because of interest expense), constant
(because its forever). Deduct cost of switching (original
dividend payout and a constant capital structure (no new stock
revenue + increase in cost) = NPV>0
issued)

Derivatives: ultimate payoff to the investor depends directly


on the value of another security or commodity, e.g. options
(leveraged investment), forwards & futures, extended
derivatives (for risk management and speculation via large
leverage ratio potential)
Call option: gives the owner the right to purchase a given
asset on a given date (or anytime before that date, i.e.
American option) for a predetermined price (exercise/strike
price) Put option: sell an asset
Call option: X< S T , can buy below market price, in the

money Value of option = CT =ST X ; if X> S T , out


of the money let it expire and value of option = 0; at the
money S=X; always expire on 3rd Friday
Payoff of call at maturity: CT =max ( ST X , 0)
Profit to call holder = Payoff Premium (cost of option at
purchase)
Put-Call Parity:

C+

X
=S0 +P
T
(1+ r f )

Price of stock + Price of put = Price of call + PV of exercise


price

P=C +

X
S 0
(1+r f )T

Intrinsic value payoff that could be made if the option was


immediately exercised: For CALL: Stock price Exercise price
For PUT: Exercise price Stock price

max ( S0 X , 0 ) C 0 S0
Time value of an option (speculative premium)= difference
between the option price and the intrinsic value; most of time
value is volatility value
In the money: option with positive intrinsic value
Call
Put
Stock Price
+
Exercise
+
Price
Interest rate
+
-

Zenith is considering the purchase of a lockbox service from


the local bank. Currently, it takes 5 days to collect funds from
customers; this would be reduced by 2 days with the lockbox
system. The average number of payments received per day is
400 and the average check size is $120. The bank will charge
4 per check in return for operating the lockbox system.
Assume one-year T-bills yield 6% and assume that a year has
360 days. Should Zenith purchase the system?
Benefit: An immediate inflow of 2 days of cash: 2 X 400 X
$120 = $96,000
Cost: Daily cash outflow 400 X 0.04 = $16;
Daily interest rate = (1.06)^1/360 1 = 0.0162%
the PV of the perpetuity = $16/0.000162 = $98,844.03
Since Cost > Benefit, the company should not use the lockbox
service.
Dija bought its existing mass baking equipment 2 years ago for
$100M. At the time of purchase, $10M salvage value was
anticipated and the equipment was expected to be used for 12
years. The new baking equipment will cost $300M and will
have a useful life of 10 years, with a $20M salvage value
anticipated at the end of the equipments useful life. Notably,
the new production process will require an initial investment in
NOWC of $30M, although this is expected to be recovered at
the end of the first year of operations under the new
production method. As well, the replacement production
method is expected to result in $50M more in revenues each
year and as well result in a decrease in operating costs of
$10M. Today, Dija can sell the old baking equipment for $80M.