8.
9.
ROIC =
EBIT (1T )
Investor Supplied Capital
ROIC measures the after tax return that the firm provides for all of its investors. Since ROIC
does not vary the changes in the capital structure, the standard deviation of ROIC measures the
underlying risk of the firm considering the effects of debt financing, thereby providing a good
measure of business risk.
10.
Factors that Affect Business Risk
1. Variability of demand for the firms product
5. Variability of production cost
2. Competition
6. Foreign risk exposure
3. Variability of sales price
7. Legal exposure and regulatory risk
4. Product Obsolescence
8. Degree of Operating Leverage
2.
Financial Risk, which is the additional risk, placed on the ordinary equity shareholders as a result
of using debt.
11.
Capital structure policy involves a choice between risk and expected returns associated with
the firms financing mix.
12.
13.
Sources of Long-Term Financing
14.
Sources of Capital for Business Firms
a. Suppliers of debt financing which include capital funds borrowed from personal savings of friends or
relatives, financial institutions such as commercial bank loans or venture capitalists.
b. Suppliers of equity financing, which include capital funds invested by venture capitalists.
15.
16.
Advantages and Disadvantages of Debt Financing
17.
Advantages:
1.
Interest payments are tax deductible.
2.
The financial obligation is clearly specified and of fixed nature (with the exception of floating rate
bonds)
3.
In an inflationary economy, debt may be paid back with cheaper pesos.
4.
The use of debt, up to a prudent point, may lower the cost of capital to the firm. To the extent that
debt does not strain the risk position of the firm, its low after-tax cost may aid in reducing the
weighted overall cost of financing to the firms.
18.
Disadvantages:
1.
Interest and principal payment obligations are set by contact and must be met, regardless of the
economic position of the firm.
2.
Indenture agreements may place burdensome restrictions on the firm, such as maintenance of
working capital at a given level, limits on future debt offerings and guidelines for dividend policy.
Although bondholders generally do not have the right to vote, they may take virtual control of the
firm if important indenture provisions are not met.
3.
Utilized beyond a given point, debt may depress outstanding common stock values.
19.
20.
Classification of Debt Financing
1.
Term loans are always backed by some form of collateral. It should be noted that restricted
covenants are subject to negotiation. Term bonds are generally repaid with periodic instalments
which include both an interest and a principal component.
21.
Example: A firm borrows P1,500,000 which is to be repaid in five equal annual instalments. The loan
will carry an 8% rate of interest and payments will be made at the end of each of the next five
years.
a. Determine the annual amortization.
b. Prepare an amortization schedule that will show that the loan will be fully paid at the end of
five years?
2.
Bonds is any long-term promissory note issued by the firm. A bond certificate is the tangible
evidence of debt issued by a corporation or a governmental body and represents a loan made by
investors to the issuer
22.
Advantages:
1. The long-term debt is generally less expensive than other forms of financing because (a)
investors view debt as a relatively safe investment alternative and demand a lower rate of
return and (b) interest expenses are tax deductible.
2. Bondholders do not participate in extraordinary profits; the payments are limited to interest.
3. Bondholders do not have voting rights.
4. Floatation costs of bonds are generally lower than those of ordinary equity shares.
23.
Disadvantages:
1. Debt (other than income bonds) results in interest payments that, if not met, can force the
firm into bankruptcy.
2. Debt (other than income bonds) produces fixed charges, increasing the firms financial
leverage. Although this may not be a disadvantage to all firms, it certainly is for some firms
with unstable earnings streams.
3. Debt must be repaid at maturity and thus at some point involves a major cash outflow.
4. The typically restrictive in nature of indenture covenants may limit the firms future financial
flexibility
24.
Credit Quality Risk is the chance that the bond issuer will not be able to make timely
payments.
25.
Bond Ratings involve a judgment about a future risk potential of the bond provided by
rating agencies such as Moodys Standard and Poors and Fitch IBCA, Inc. Dominion Bond Rating
Services. Bond ratings are favourably affected by:
1. A low utilization of financial leverage
2. Profitable operations;
3. A low variability of past earnings;
4. Large firm size
5. Little use of subordinated debt
26.
Methods of Retiring Debt
1. Serial Payments
3. Call provision
2. Conversion
4. Bond Refunding
27.
28.
Preferred Shares is a class of equity shares which has preference over ordinary equity shares in
the payment of dividends and in the distribution of corporation assets in the event of liquidation
29.
Advantages:
1. Financing Flexibility
4. No maturity
2. Favorable financial leverage
5. Asset preservation
3. No dilution of control
6. No equal participation in earnings
30.
Disadvantages:
1. High Cost
2. Seniority of the holders claim
31.
32.
Ordinary Equity Share is a form of long-term equity that represents ownership interest of the
firm. Ordinary equity shareholders are called residual owners because their claims to earnings and
assets is what remains after satisfying the prior claims of various creditors and preferred
stockholders.
33.
Advantages:
1. No mandatory fixed charges
4. Increase creditworthiness
2. No definite maturity date
5. Avoidance of restrictive provisions
3. Potentially greater ease of sale
6. From a social viewpoint
34.
Disadvantages:
1. Dilution of control and earnings
2. Higher issue cost
3. Causes increase in component cost of capital
35.
36.
Leasing as a Form of Debt
37.
Advantages:
1. The lease may lack sufficient funds or the credit capability to purchase the asset from the
manufacturer, who is willing, however to accept a lease agreement or to arrange a lease obligation
with a third party.
2. The provisions of the lease obligation may be substantially less restrictive than those of a bond
indenture.
3. There may be no down payment requirement, as would generally be the case in the purchase of an
asset.
4. The lessor may possess particular expertise in a given industry allowing for expert product
selection, maintenance and eventual resale. Through this process, the negative effects of
obsolescence may be reduced.
5. Creditor claims on a certain types of leases, such as real estate are restricted in bankruptcy and
reorganization proceedings. Leases on chattels have no such limitation.
6. It is an easy method of financing capital asset having a heavy cost involved.
7. It permits the lessee for alternative use of funds without incurring huge capital investment on an
asset.
8. It spreads the capital cost over a period of the lease, so that sufficient flexibility is available by just
making payment of periodical lease rentals.
9. The lease rentals can be structured according to the needs of the lessee.
10. It helps to conserve the funds which can be used to improve the liquidity and can be used for some
other urgent purposes.
11. The lessee can avoid the risk of obsolescence by taking the asset on lease basis.
12. Leasing is free from restrictive covenants such as debt equity ratio, dividend declaration, etc.
13. Generally, lease or rent payments under operating lease are tax deductible.
14. Finally, a firm may wish to engaged in a sale-leaseback arrangement, in which assets already
owned by the lessee are sold to the lessor and then leased back.
38.
39.
Disadvantage:
1. The main criticism of leased method of financing is that the accounting procedure adopted for
recording lease method of financing is quite complicated.
2. Lease financing compared to other methods is generally more costly for the lease.
3. The financial lease has all the rigidities of other methods of financing
4. As the lease is not the owner of the asset, technically he cannot enforce the warranties or
guarantees enforceable against the vendor.
40.
41.
42.
43.
44.
45.
46.
59.
60.
4
3
6
5
A
C
Information
Requireme
nts
61.
62.
63.
64.
65.
66.
67.
68.
113.
114.
115.
116.
117.
118.
119.
120.
121.
122.
123.
124.
125.
126.
127.
128.
129.
130.
131.
132.
133.
161.
162.
Total
Less: Present Value of Investment
P755,400
750,000
163.
Net Present Value
P
5,400
164.
2. Internal Rate of Return
165.
IRR is also known as a discount rate of return and time adjusted rate of return is the
rate which equates the present value of the future cash inflows with the cost of investment
which produces them.
166.
Decision Rule:
167.
Accept Project if IRR > Cost of Capital
168.
Reject Project if IRR < Cost of Capital
169.
3. Profitability Index
170.
The profitability index is the ratio of the total present value of the future cash flows
divided by its investment.
171.
Formula:
172.
PV Index
PV of Cash Inflows
PV OF Net Investment
173.
Decision Rule: The higher the PV Index the more desirable the project. Projects with
index of 1 or greater than one should be accepted; otherwise the project is rejected.
174.
Advantages:
a. It considers the magnitude and timing of cash flows;
b. It provides an objective criterion for decision making which maximizes shareholders
wealth;
c. It provides a relative measure of return per peso of net investment
175.
The disadvantage of using PV Index is that conflict may arise with the NPV when
dealing with mutually exclusive investment.
176.
Illustrative Example:
177.
XYZ Company has a P200,000 funds available for investment. It is considering the
following projects:
178.
A
B
C
179.
180.
181.
182.
183.
a.
b.
c.
184.
a.
185.
P30,000
P 244,000
P 200,000
= 1.22
Project B
P 130,000
P 100,000
= 1.30
Project C
P 130,000
P 100,000
= 1.30
188.
189.
100,000
Project A
186.
187.
P130,000
b. Ranking of Projects
190.
Rank
Project
191.
1
B and C
192.
2
A
c. The company should invest in Projects B and C for the following reasons:
a) The PV indexes of Projects B and C are higher than A
b) The combined Net Present Value of the Projects B and C is higher than that of
Project A.
c) The company can afford to invest in both A and B.
4. Discounted Payback Period
193.
Discounted Payback Period is a capital budgeting method that determines the length
of time required for the investment cash flows, discounted at the investments cost of capital,
to cover its cost.
194.
Decision Rule:
195.
Accept Project if Calculated DBP Maximum Allowable Discounted Payback
196.
Reject Project if Calculated DBP > Maximum Allowable Discounted Payback
B. Non-Discounted Cash Flow Approach
1. Payback Period
197.
Payback Period is the length of time required for projects cumulative net cash inflows to
equal its net investment. It measures the time required for a project to break-even.
198.
Formula:
199.
Net Investment
Annual Net Cash Inflows
200.
201.
Payback Period
202.
Decision Rule: The desirability of the project is determined by comparing the projects
payback period against the maximum acceptable payback period as predetermined by
management. The project with shorter payback period than the maximum will be accepted.
In short:
203.
If: PB period Maximum allowed PB period; Accept
204.
If: PB period > Maximum allowed PB period; Reject
205.
Advantages:
a. It is easy to compute and understand.
b. It is used to measure the degree of risk associated with a project.
c. Generally, the longer the payback period, the higher the risk.
d. It is used to select projects which provide a quick return of invested funds.
206.
Disadvantages:
a. It does not recognize the time value of money.
b. It ignores the impact of cash inflows after payback period.
c. It does not distinguish between alternatives having different economic lives.
d. The conventional payback computation fails to consider salvage value, if any.
e. It does not measure profitability only the relative liquidity of the investment.
f. There is no necessary relationship between a given payback and investor wealth
maximization so an investor would not know what an acceptable payback is.
2. Bail-out Period
207.
In conventional payback computations, investment salvage value is usually ignored. An
approach which incorporates the salvage value in payback computations is the Bail-out
Period. This is reached when the cumulative cash earnings plus the salvage value at the end of
particular year equals the original investment.
208.
3. Payback Reciprocal
209.
Payback reciprocal measures the rate of recovery of investment during the payback period.
For projects with even cash flows, the payback reciprocal is computed as follows:
210.
Payback Reciprocal
1
Payback Period
211.
For projects with uneven cash flows, the payback reciprocal can be computed on an annual
basis by dividing the Cash Inflows for the year by the net investment.
212.
Alternative Way:
213.
214.
215.
216.
1
100
Payback Period
Thus, if a project has a payback period of 2.5 years, then the payback period reciprocal
would be:
1
100
2.5
40%
The higher the payback period reciprocal, (and hence the lower the payback period) the
more worthwhile the project becomes. The only relevance of this calculation is that laymen may
be more at ease in discussing percentage measures.
4. Accounting Rate of Return
217.
Accounting rate of return (ARR) or simple rate of return is a measure of a projects
profitability from a conventional accounting standpoint by relating the required investment to
the future annual net income.
218.
There are numerous ways to compute the ARR, but the most use way is to divide the
projects average annual net income by its initial investment or average net investments.
Average annual net income is determined by summing the expected net incomes over the
projects life and dividing by the total number of periods in the life of the project. Average net
investment is assumed to be one-half of the net investment.
219.
Formula:
220.
ARR
221.
222.
ARR
224.
225.
if
229.
230.
231.
232.
233.
234.
235.
236.
237.
223.
226.
227.
228.
Decision Rule:
Under the ARR method, choose the project with the highest rate of return. Accept the project
the ARR is greater than the cost of capital, Thus:
If: ARR Required rate of return; Accept
If: ARR < Required rate of return; Reject
Advantages:
a. It is easily understood by investors acquainted with financial statements.
b. It is used as a rough preliminary screening device of investment proposals.
Disadvantages:
a. It ignores the time value of money by failing to discount the future cash inflows and
outflows.
b. It does not consider the timing component of cash inflows.
c. Different averaging techniques may yield inaccurate answers.
d. It utilizes the concepts of capital and income primarily designed for the purposes of
financial statements preparation and which may not be relevant to the evaluation of
investment proposals.
Classification of Merger:
1. Horizontal merger is one that combines two companies in the same industry.
2. Vertical merger combines a firm with a supplier or distributor.
3. Conglomerate merger combines two companies that have no related products or market.
238.
Product Extension Merger is a combination of firms that sell different, but somewhat related
products.
239.
240.
Motives for Business Combinations
241.
Financial Motives
1. Maintenance of the firms rate of return
5. Lowering Cost of Capital
2. Revenue enhancement
6. Exhaust unused debt potential
3. Cost reduction
7. Reduction in bankruptcy costs
4. Tax considerations
242.
243.
Non-Financial Motives
1. Managers personal incentives
2. Possible synergistic effect
244.
245.
Valuing a Merger
246.
The Net Present Value (NPV) or the discounted cash flow (DCF) method is the most practical and
reliable tool used to evaluate whether a merger will be a profitable one. The NPV method allows the
bidder and target firm managers to predict pro forma cash flows of the merged firm.
247.
248.
Methods of Payment in Merger Transactions
1. Cash Purchase
249.
The purchase of another company can be viewed within the context of a capital budgeting decision.
Instead of purchasing new plant or machinery, the purchaser has opted to acquire a going concern.
2. Stock-for-Stock Exchange
250.
The shareholders of the acquired firm are concerned mainly about the initial price they are paid for
their shares and about the outlook for the requiring firm.
3. Debt and Preferred Stock Financing
251.
Since some investors prefer growth stocks, while others seek substantial dividend or interest
income, an acquiring company must at times offer a combination of securities in settlement with
the new stockholders. In an attempt to tailor a security for such investors, convertible debentures
and convertible preferred stock have frequently been used.
252.
Advantages:
a. Potential earnings dilution may be partially minimized by issuing a convertible security.
b. A convertible issue may allow the acquiring company to comply with the sellers income
objectives without changing its own dividend policy.
c. Convertible preferred stock also represents a possible way of lowering the voting power of
the acquired company.
4. Deferred Payment Plan
253.
The deferred payment plan, which has come to be called an earn-out, represents a relatively recent
approach to merger financing. The acquiring firm agrees to make a specified initial payment of cash
or stock and, if it can maintained or increase earnings, to pay additional compensation.
254.
Tender Offer
255.
A tender offer involves a bid by an interested party for controlling interest in another corporation.
The prospective purchaser approaches the stockholders of the firm, rather than the management,
to encourage them to sell their shares, typically at a premium over current market price.
256.
Tactics to Resist Unfriendly Mergers (Defense Tactics)
1.
White Knight
257.
A white knight is a company that comes to the rescue of a corporation that is being targeted for a
takeover.
2.
PacMan
258.
Pacman, the name taken from the video game, is another defensive tactic to tender offers, where
the firm under attack becomes the attacker.
3.
Shark Repellents
259.
Shark repellents are often used to discouraged unfriendly takeovers. As an example, a firm may
revise its by-laws to stagger the terms of directors so that only a few come up for election in any
one year.
4.
Poison Pill
260.
Another tactic is the poison pill, an action initiated automatically, if an unfriendly party tries to
acquire the firm. For instance, management might devise a plan whereby all the firms debt
becomes due, if the management is removed.
5.
Golden Parachute
261.
Still another tactic is the golden parachute, which stipulates that the acquiring company must pay
the executives of the acquired firm a substantial sum of money to let them down easy as new
management is brought into the company.
6.
Greenmail
262.
Greenmail or targeted repurchase is a defensive tactic used to protect against takeover after a
bidder buys a large number of shares on the open market and makes a tender offer.
7.
Staggered election of directors
263.
Staggered election of directors requires new shareholders to wait several years before being able to
place their own people on the board.
8.
Fair price provisions
264.
Warrants issued to shareholders that permit purchase of equity share at a small percentage (often
half) of market price in the event of a takeover attempt.
9.
Flip-over rights
265.
The charter of a target corporation may provide for its shareholders to acquire in exchange for their
equity share (in the target) a relatively greater interest in an acquiring entity.
10.
Flip-in rights
266.
Acquisition of more than a specified ownership interest in the target corporation by a raider is a
contingency, the occurrence of which triggers additional rights in the equity share other than the
equity shares acquired by the raider.
11.
Issuing Equity share
267.
The target corporation significantly increases the amount of outstanding equity share.
12.
Reverse Tender
268.
The target corporation may respond with a tender offer to acquire control of the tender offeror.
13.
Crown jewel transfer
269.
The target corporation sells or otherwise disposes of one or more assets that made it a desirable
target.
270.
14.
Legal action
271.
The target corporation may challenge one or more aspects of a tender offer. Delays increase costs
to the raider and enable defensive action.
272.
Divestitures
273.
A divestiture represents a variety of ways to divest a portion of the firms assets. It has become an
important vehicle in restructuring the corporation into a more efficient operation.
274.
Types:
1.
Sell-off - is the sale of a subsidiary, division or product line by one company to another.
2.
Spin-off Involves the separation of a subsidiary from its parent, with no change in the equity
ownership.
3.
Liquidation the asset sold to another company and the proceeds are distributed to the
stockholders.
4.
Going Private results when a company whose stock is traded publicly is purchased by a small
group of investors and the stock is no longer bought and sold on a public exchange.
5.
Leverage buyout is a special case of going private. The existing shareholders sell their shares to
a small group of investors.
275.
276.
International Aspects of Corporate Finance
277.
Why do companies, foreign and domestic go international?
1.
2.
3.
4.
5.
6.
7.
278.
1.
2.
3.
4.
5.
6.
7.
279.
280.
281.
282.
283.
284.
285.
286.
287.
288.
289.