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Teoría Financial Management II

Financial Management II (Universidad Pompeu Fabra)

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Chapter 1: Investment decisions

PART A – Proje t’s Cash Flo s

Forecasting earnings

A capital budget lists the projects and investments that a company plans to undertake during
the o i g ea . Fi s fo e ast the p oje t’s futu e o se ue es fo the fi determining the
i e e tal ea i gs of a p oje t. That is, the a ou t hi h the fi ’s ea i gs a e
expected to change.

Earnings and cash flows are not the same. To pass from earnings to cash flows we should add
depreciation and amortization, subtract capital expenditures, and subtract the increase in
NWC. (CashFlow= Earnings + Depreciation + Amortization – Capital Expeditures – Increase in
NWC)

Feasibility Study

Revenue and Cost Estimates

 Estimated life of the project: four years


 Revenue estimates:
-Sales = 100,000 units/year.
-Per Unit Price = $235.
 Cost Estimates:
-Up-Front R&D = $15,000,000.
-Up-Front New Equipment = $7,500,000 (Expected life of the new equipment is
5 years (housed in existing lab)).
-Annual Overhead = $3,000,000.
-Per Unit Cost = $95.
 Cost of the feasibility study: $300,000

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Are taxes relevant even if we make losses? Yes, for example, in year 0 the company will owe
$ illio less. The fi should edit this ta sa i gs to the p oje t’s i e e tal ea i gs
forecast.

Capital Expenditures and Depreciation

Investments in plant, property and equipment are a cash expense not directly listed as
expense but a fraction of cost deducted each year as depreciation. Some methods are:

 St aight Li e Dep e iatio : Asset’s ost is divided equally over its life ($7.5 million ÷ 5
years = $1.5 million/year).
 Modified Accelerated Cost Recovery System (MACRS).

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Net Working Capital (NWC)

The cash included in NWC is cash that is not invested to earn a market rate of return (non-
invested ash held i the fi ’s he ki g a ou t, i a o pa safe o ash o . Fi s a
need to maintain a minimum cash balance to meet unexpected expenditures, and inventories
of raw materials and finished products to accommodate production uncertainties and demand
fluctuations. Also customers may not pay for the goods they purchase immediately
(receivables). While sales are immediately counted as part of earnings, the firm does not
receive any cash until the customers actually pay. In the same way, payables measure the
credit the firm has received from its suppliers.

Most projects require investment in NWC:

1. Cash held at registers, safe box or checking account.


2. Inventories of raw materials or finished product.
3. Receivables: earned but not charged (credit offered to customers)
4. Payables: spent but not paid (credit received by suppliers)

Trade credit: difference between receivables & payables.

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 Recall sales were 23.500, so if receivables are the 15% of sales, receivables are: 3.525.
 Recall COGS were 9500, so if payables are the 15% of COGS, payables are: 1.425.

Indirect effects

1. Project Externalities: There are indirect effects of the project that may increase or
decrease the profits of other business activities of the firm. Cannibalization is an
example, is when sales of a new product displaces sales of existing product. Would
customers of HomeNet have purchased existing Linksys wireless routers?
2. Opportunity costs: The value a resource could have provided in its best alternative
use. Ho e et’s e uipment will be housed in an existing lab, but what is the
opportunity cost of using the space for its best alternative? Renting it out?. Because
this value is lost when the resource is used by the project, we should include the
opportunity cost as an incremental cost of the project.
3. Further... sales, the average selling price, the average cost per unit will vary over time.

Where should we allocate the $300,000 of the feasibility study? This cost is not part of the cost
of the project, we should not include this 300.000$ as part of the cost because is money we
spend to know if the project is good or not, so it’s a sunk cost. If we do the feasibility study we
spe d this ua tit a d it does ’t atte if e do the p oje t o o.

PART B – Evaluating Risk-Free Projects

Assume that we have projects with known and certain future cash flows.

 The methods and rules to decide whether to invest are:


1)Net present value rule.
2)Internal rate of return rule.
3)Payback period and payback rule.
4)Profitability index.
 Project selection:
1)Mutually exclusive projects.
2)Scalable projects with limited resources.

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How to compare present and future? A euro today is worth more than one tomorrow. There is
the possibility to earn interest. For example, if interest is 10% a year, investing 10 million today
gives 11 million in a year:

 10.000.000 x (1 + 0.1) = 11.000.000

The future value in a year of 10 million is 11 million and the present value of 11 million in a
year is 10 million.

Future and Present Values

The future value is the amount to which an investment will grow after earning interest:

The present value is the value today of a future expected cash flow:

Net Present Value: an example

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Cash flows: i ediate $ . illio outflo a da i flo of $ illion per year for 4
years. Therefore, if discount rate is r = 0.10, the NPV is 7.2. Discount rate depends on the
riskiness of the cash flows:

 Equal to risk-free rate (government bond) if cash flows are certain.


 Higher risk implies greater discount and lower present value. So the value today of a
risky asset is lower than if the same asset was not risky.

The NPV Rule:

1. Forecast future cash flows.


2. Estimate a discount rate.
3. Discount future cash flows.
4. Go ahead if the present value of the payoff exceeds investment. If NPV > 0

NPV investment rule: when making an investment decision, take the alternative with the
highest NPV. Choosing this alternative is equivalent to receiving its NPV in cash today. In the
case of a stand-alone project, we must accept the project if it’s NPV is positi e.

But there are other criteria to decide whether is a good idea to take a project or not. Although
the NPV rule is the most used method there are: the IRR rule, the payback rule, the book rate
of return rule and the profitability index rule.

The IRR: an example

Asset value in two subsequent periods:

 AV0: 80m and AV1: 96.8m


 Return: ry = (96.8 – 80)/80 = 0.21 or 21%

Value in two non-subsequent periods:

 AV0: 80m and AV2: 96.8m


 Return --> Numerical method: find r such that Net Present Value (NPV) = 0

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The IRR Rule

The internal rate of return of a cash flow stream is the interest rate ry that makes the NPV of a
project equal to 0.

IRR and NPV

The IRR rule take (r>i) any investment opportunity where the IRR exceeds the opportunity cost
of capital. And turn down (r<i) any opportunity whose IRR is less than the opportunity cost of
capital.

The IRR rule is only guaranteed to work for independent projects if all of the p oje t’s egati e
cash flows precede its positive cash flows. If it is not the case, the IRR rule can lead to incorrect
decisions.

The IRR has some pitfalls:

 There might be several IRRs or none.


 Ignores magnitude and cannot select among different projects.
 Even more problematic if our discount rates are not stable over time (with which one
do we compare the cost of capital?)

Payback period and the payback rule

 The payback period is the number of periods (years) it takes before cumulative
forecasted cash flow equals initial outlay.
 The payback rule says only to accept p oje ts that pa a k i the desi ed ti e
frame.
 This method is deficient, primarily because it ignores cash flows after payback period
and the present value of future cash flows. Relies on an ad hoc decision: Which is the
appropriate payback time?.

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 This rule is typically used for small investment decisions. In such cases, the cost of
making an incorrect decision might not be large enough to justify the time required to
calculate de NPV.

Project Selection

If only one from a set of positive NPV projects can be selected, we should select that with the
largest NPV. When resources are limited, the profitability index (PI) helps selecting among
various project combinations and alternatives:

 PI = (NPV - C0 ) / ( -C0 ) = PV / ( -C0 )


 If resources are unlimited, we should select projects with PI>1.

When projects are mutually exclusive, the firm can only take on one of the projects even if
many of them are attractive. Often this limitation is due to resource constraints. Then the firm
must choose the best set of investments it can make given the resources it has available.
Managers often work within a budget constraint that limits the amount of capital they may
i est i a gi e pe iod. The a age ’s goal is to hoose the p oje ts that a i ize the total
NPV while staying within the budget.

Profitability Index

The profitability index measures the value created in terms of NPV per unit of resource
consumed. After computing the profitability index, we can rank projects based on it. For it to
be completely reliable, two conditions must be satisfied:

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1. The set of projects taken following the profitability index ranking completely exhausts
the available resource.
2. There is only a single relevant resource constraint.

PART C – Adjusting for Risk

Risky Cash Flows

Future cash flows should be f o o o e pe ted ash flo s . Example: Expected cash flow
of a project: CF=$100 per year for three years.

Discount rate needs to reflect risk of cash flows and therefore may need to be higher than the
isk-f ee rate:

 Risk-free rate, rf = 6%,


 But discount rate might need to be r = 12%
 Risk premium here is rp = 6%, and more generally

Discount Rate (r) = Risk Free Rate (rf) + Risk Premium (rp)

How to compute the expected cash flows?

Expected cash flows may come from scenario analysis. For example, CF = $100 if:

 200 in good scenario, 100 in medium one, and 0 in bad one.


 And all of these scenarios are equally likely (probability: 1/3 each).

 Finding the discount rate

In theory, what should the discount rate be?

 The return one can receive on similar investments, i.e. bearing same risks!
 Ofte alled cost of capital as it easu es oppo tu it ost of fu ds.

Ho to o pute the ost of apital of a p oje t of a fi ? Often start computing cost of


capital for the firm as a whole (many projects have similar risk as the firm as a whole). If not, it
is a good starting point that can be adjusted.

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 Esti ati g the fir ’s ost of apital

First, suppose that firm is financed with equity only:

 Fi ’s ost of apital = e pected equity return (see next chapter).


 Estimated using Capital Asset Pricing model (CAPM) (see next chapter).

Second, incorporate the possibility that it has debt, so there is the need to take into account
cost of debt as well as the cost of equity: We use weighted average cost of capital (WACC) (see
next chapter) .

CAPITAL ASSET PRICING MODEL (CAMP)

The expected return of any asset is equal to:

Risk-free rate and market risk premium

 Risk-free rate: Use some government bond interest rate as a proxy.


 Equity risk-premium: Use ou t i de po tfolio e.g. FTSE , IBEX ,…

Beta for a listed company

If a company is listed, use its past returns to estimate beta:

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CHAPTER 2: FIRM’S CAPITAL STRUCTURE


2.1. FINANCING DECISON
How are we going to pay for any investment?

- Internal capital: Retai ea i gs ge e ated i te al e uit .


- External capital: Debt or equity?
Which one of these 2 securities is chosen (debt or equity)? How we finance the
project?
Advantages of debt: Debtholders have to be paid before equityholders.
Advantage of equity: Equityhoders receive cash in form of dividends, which are not
tax-deductible, while interest payments of debt are tax-deductible expense.

Security: the way the firm is financed, it can be debt and/or equity.

The su of all se u ities issued to aise apital f o i esto s fi a i g i is alled fi ’s


capital structure.

This picture shows an overview of how firms are financed. Firms in the top use very little debt
(leverage). The proportional debt in average is low (see the red line).

The objective of this chapter is trying to understand why this differences (why one firm
chooses more debt than another one).

We can see in the graph that, in general, technological firms tend to have less debt. Why? They
have fewer tangible assets and so they need fewer loans. The value of these firms is given by

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intangible assets. Another reason could be that firms in this sector can have very uncertain
cash flows. Firms below the graph (with higher debt) have more certain or stable cash flows.
Firms with more certain cash flows are more likely to be financed.

Mo eo e , fi s that do i ate the a ket do ’t eed as u h de t, e ause the do ’t eed


to finance as much. They are able to ge e ate as u h o e that the do ’t eed it.

This pi tu e sho s that a oss se to s the e’ e ig diffe e es.

2.2. LINK TO CAPITAL BUDGETING (CHAPTER 1)


Capital budgeting is the investment decision. Capital structure is how we finance it.

How I finance my project to maximize the value of the firm? And how I finance my project to
minimize the cost of capital?

Firms are getting money from investors and they have to pay an interest (cost of capital for the
firm and a return for the bank).

Projects should be discounted at their appropriate risk.

If a project is financed with (internal or external) equity and has similar risk as the firm overall
and the firm is unlevered (no debt) use the expected return that equityholders can take
(equity cost of capital) as the cost of capital for the project. That is, use the estimates derived
from the CAPM model.

In many cases firm has both debt and equity. How do we adjust discount rate if the firm is
levered (it has both debt and equity)?

Should we use debt to finance the project? How much?

2.3. FINANCING A PROJECT-COMPANY (EXAMPLE)


Suppose Albert is an entrepreneur and you are an investor. The bright idea of Albert is a flying
bicycle.

Motivating Case: (1) Investment decision


Project description:

- Initial investment today: $800M


- Cash flows: $1400M (success) or $900M (failure) end of the year
- Each scenario (success, failure) is equally likely
- Due to project risk, investors ask for an additional 10% over the 5% risk-free rate
interest rate.

We can calculate the NPV (Net Present Value) of the project:

/ + /
NPV = - 800 +
,
= 200M > 0

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That’s a good p oje t e ause it’s positi e. We should go ahead.

Motivating Case: (2) Equity financing


Albert sells shares to you (he do equity financing). We a e t i g to fi d hat’s the alue of the
shares, i.e. how much you are willing to pay for the shares.

Assume the project is financed with equity.

The maximum you will be willing to pay is 1000. You can get 1400 or 900 if you buy all the
shares, so in expected terms buying shares can give you 𝑥 + 𝑥9 =$ , but
/ + /
you have to discount it: = $1000. This is the value of the equity.
,

You give Albert $1000M, he uses $800M to invest and 200 is the amount of money he pocket.
That’s h people ha e to i est in positive NPV.

 What is the a ket alue of the fi ’s u le e ed e uit today?

The valueof the firm is different. Here is:

Value of the firm = Equity + Debt = 1000 + 0 = $1000 We do ’t ha e ash

That’s hat sha eholde s a e illi g to pa toda .

 What’s i e to s’ equity expected returns in each scenario?

Returns in the good scenario: He pays 1000 and in the good scenario gets 1400, so

= 40%

Returns in the bad scenario: He pays 1000 and gets 900, so the return is -10%.

General return: = %. It’s ou etu , ut Al e t’s ost of e uit .

If we increase the value invested to 1500, then the expected return decreases and so the cost
of capital decreases too.

Conclusion: if the value the cost of capital

Motivating Case: (3) Debt and Equity financing


 DEBT: Suppose firm (Albert) also borrows $500M initially. What interest rate will the
bank has to charge Albert?

I te est ate ill depe d o the alue of the fi . Be ause it’s a isk f ee p oje t, the i te est
rate will be the riskfree interest rate of 5%.

The value of the debt is 500  the face value of the debt is 525 (500x1,05)

At the end of the year, Albert will have to pay $525M for the loan of $500M. We can see that
this is a riskfree investment, because I can pay it for sure getting 1400 or 900.

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So, the cost of capital of the firm will be 5%.

 EQUITY: What should now be the market value of equity today if you buy 100% of
shares?

Return of the good scenario: 1400 – 525 = 875


625 (expected cash flow)
Return of the bad scenario: 900 – 525 = 375

Now we have to discount the expected cash flow. How can we find the discount rate?

We ould o side that it’s %, ut it ill e wrong. The real cost of equity is higher, because
whenever you invest in a leverage firm you get more risk. On average you get more dispersion,
so you need to discount more.

The isk of the p oje t is ot the sa e as the isk of e uit e ause it’s a De t + Equity). Here
the discount we should use is 25%.

If you pay 500 for the equity, you get 25% return:
− Value of equity: 25%
Good scenario: 1400 – 525 = 875  Return: = 75%

− = 25%
Bad scenario: 900 – 525 = 375  Return: = -25%

Now we can calculate what you are willing to pay for the 100% shares.

Return of the good scenario: 1400 – 525 = 875


,
= 500 (the value of equity)
Return of the bad scenario: 900 – 525 = 375

The value of the firm is:

Value of the firm = Equity + Debt = 500 + 500 = $1000

We can get 2 conclusions:

1. The value of the firm in Case 1 (only equity) or in Case 2 (both equity and debt) is the
same (1000). And the amount pocket will be the same (200).
In Case 2 it does ’t atte ho the fi is fi a ed that the total alue of the fi has
to be the same. This is true under certain conditions. For example, if debt is 300 and
we know the value is 1000, then using the formula (Value of the firm = Equity + Debt)
we get that the equity value is 700.
What is goi g to e a p o le is a k upt . The , this o lusio o ’t e t ue.
The assumptions here were:
- The value is the maximum investors are willing to pay.
- The e’ e s e a ios e uall likel .
- The e’ e ot ta es. Whe the e’ e ta es it does ’t hold.

2. The cost of capital in both Cases is the same. And the NPV will also be the same.

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What’s the a e age etu i esto s a e getti g i Al e t’s fi ost of apital i Case
? The e’ e t pes of i esto s: a k and shareholders.

Bank  5% cost of debt O a e age the e’s a % ost of apital


Shareholders  25% +
of the firm. = 15%

It’s the sa e ost of apital as i Case .

PART (A): Debt, Equity and Modigliani and Miller


Proposition 1: Capital structure of the firm is irrelevant (total value of the firm is
independent of the capital structure). This preposition is true with absence of:

- Arbitrage opportunities
- Taxes
- Costs of bankruptcy
- Information problems
- Transaction costs

Then, with absence of this factors, the sum of cash flows to debt and equity holders is constant
(as we have seen in the example above). This is the same as saying that the formula V = E + D
holds (the value is constant).

 Proof: Take two identical firms, Unilevcom and Levcom, except for their capital
structure. They exist for a year and produce identical pre-tax profits X at the end of the
year (unknown at the beginning). Unilevcom is unleveraged (no debt) and Levcom has
any given level of leverage (has some debt). Assume that its debt is riskless, at interest
rate rD.Both will generate some cashflows with same probability.
Total and split cash flows are:

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The value of both firms is the same  same present value.

The same cash flows are X. In the case of Unilevcom all cash flows go to equityholders. The
present value will be U (or 1000 in the example seen before).

Lunievcom first pay debtholders, so if debt is D  the face value is (1 + rD)D. In this case the
future value of the cashflows paid to equityholders is (X – (1 + rD)D ), and its present value is E.

The result is that it has to be true that U = D + E. That’s hat proposition 1 says.

What if D+E < U?

To see that D+E has to e e ual to U, e a e goi g to see hat ill happe if this does ’t hold.

What if Unilevcom has $100M worth of equity (U) and Lunilevcom has $60M of equity (E) and
$30M of debt (D)?E + D = 90 < 100 = U.
- Buy 10% of equity ($6M) and 10% of debt ($3M) of Lunilevcom
- Sell short10% of equity of Unilevcom ($10M)
- Cash inflow of $1M at the beginning of the year
 Receive (buy):0.1[X-(1+rD)D]+0.1(1+rD)D
1rst part of the equation: amount paid to equity holders
2nd part of the equation: amount paid to debt holders. I get 10% of each one.
 Pay (sell short):0.1X
In total: 0.1[X-(1+rD)D]+0.1(1+rD)D - 0.1X= 0!!
At time 1 I have 0 risk.  Arbitrage opportunity!
Similarly, arbitrage opportunity if D+E > U.
IMP: I do ’t a e a out X, if it’s high I e ei e a lot of o e a d I also pa a lot. If it’s lo I
receive less money but also pay less; the terms cancel each other and whatever the X is, the
result is finally 0.

Proposition 2: Fi ’s ost of apital is i depe de t of its apital st u tu e. In other words,


all the return the investors made is the same no matter the debt issued.

The WACC (weighted average cost of capital) is always equal to rU (the return equity holders
would make if there was no debt).

r(Pre-tax) WACC = rE + rD = rU
+ +

Rearranging, rE = rU + (rU – rD)

If the firm has no debt  Equity (E) = Assets (A) rE = rA WACC = rA(because if D=0 we
can see in the formula above that rE = rU rE= WACC rA=WACC). So, WACC is equal to the
return of the project.

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We can see that the debt cost of capital is cheaper than the equity cost of capital.

As the fraction of the firm financed with debt increases, both the equity and the debt become
riskier and their cost of capital rises.Because more weighted is put on the lower-cost debt, the
weighted average cost of capital (WACC) remains constant.

 Proof:

Proposition 1 states that:

E+D=U (or E + D = A or market value of assets) if the e’s o de t,


the value of assets=value of equity)

By holding all debt and equity, we can replicate cash flows from unlevered equity, and as
in portfolio theory:

RE + RD = RU
+ +

(where R denotes realised returns).

Therefore, in expected terms:

r(Pre-tax) WACC = rE + rD = r U
+ +

What is D i p a tise? Net De t

Net Debt = Gross Debt – Cash

(You pay an interest on debt and you get an interest on cash)

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Example:

Net debt = 320M – 20M = 300M

WACC:

r(Pre-tax) WACC = rE + rD = rU
+ +

r(Pre-tax) WACC = (10%)+ (6%) = 8%


+ +

Capital budgeting

 If the p oje t has a e age isk sa e isk as the fi , a d the fi is unlevered:


- Risk of assets = risk of equity
- CAPM can be used to estimate risk of equity

 If the firm is, instead, levered:


- Risk of assets = Risk of the portfolio of its debt and equity
- Cost of capital for assets = cost of capital of this portfolio

r(Pre-tax) WACC = rA= rE + rD


+ +

- CAPM can be used to estimate the risk of equity (rE).

What is the asset beta?

Remember that beta measures risk:

ov r,rM
β=
𝑉𝑎 𝑀

As for the returns,

βA= βE + βD= βU
+ +

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where eta of the fi ’s assets easu es the isk of the fi ’s usi ess a ti ities.

Therefore, the equity beta is given by:

βE = βU + (βU –βD)

And if the firm has no risk of bankruptcy (βD=0):

βE = (1+ )βU

This equation shows how the risk of equity changes with the amount of debt. As debt
increases, it also increases βE.

In many cases βis zero (no risk of repaying the debt).

Levering and relevering betas


If the firm is not publicly trading, how can we estimate beta? Use the idea ofarbitrage or
comparing firms. Use a similar firm that is publicly trading and compare. We call it
o pa a les i usi ess te s. But, the e’s a p o le : de t le els a diffe .

An example: Ideko is private firm (no publicly trading). Equity betas of comparables of Ideko (3
firms similar to Ideko but publicly trading):

U le e i g the etas

In the picture above, β is aptu i g the isk of the e uit . The capital structure may be
completely different.

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1) We have to u le e o pa a le fi s’ eta with their capital structure to find asset


beta (or business risk).

(Table 2)

Rele e i g the etas

2) Estimate the average unlevered beta. (We can take an average of the 3 unlevered
betas obtained).

In our example, since Ideko products are:

- Not as lu u ious as Oakle ’s  beta is lower.


Not p es iptio p odu ts as Lu otti a’s  beta is higher.

Therefore, unlevered beta should be: βU,I= 1,2 (a number between 1,5 and 0,62).

3) Relever the beta with the capital structure of the firm of interest, to find its equity
beta.

In our example, assuming βD,I = 0,

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PART (B): Taxes, Bankruptcy Costs and the Trade-off Theory


Departures from M&M

In part (a), we showed that, in the M&M world:

- Capital st u tu e does ’t affe t fi ’s alue o WACC.


- Thus, investment and financing decisions are independent of capital structure.

In this part (b), we add reality to our assumptions. In the real world, people have to pay taxes.
The two results no longer hold. But we can see how the results change in terms of taxes.

We should consider:

- Corporate taxes: entities have to pay taxes, then a part of the after tax income is paid
to investors.
- Personal taxes: For example: investors also have to pay taxes on the dividends
received.
- Cost of bankruptcy

CORPORATE AND PERSONAL TAXES:

 Corporate Taxes:
Without taxes (and without bankruptcy costs, etc.) companies should be indifferent between
debt and equity.

If taxes exist, the objective should be to minimize them.

Suppose for the moment that companies are taxed but investors are not (e.g. pension funds).

I o de to i i ize o po ate ta es…

- Interest payments are tax-deductible while dividends are not. (Interest is considered
as an expense you pay before taxes). Therefore, firms prefer debt to equity.

Example: D.F. Builders (DFB)

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- What was the amount available to investors in 2005?

As investor is considered anyone who has bought a security in the firm. So, are both
equityholders and debtholders.

To debtholders you are paying 50 and to equityholders 467.

- Would it have been higher or lower without leverage?

If it as a fi ithout le e age, the e did ’t ha e i te est e pe ses  our taxable income


would be higher  more taxes  less net income.

One advantage of having debt is that ou’ e a le to give money to your investors
(debtholders) before paying taxes. The o e de t ou ha e, the lo e ou’ll pa ta es.

Another example:

Again we compare two identical firms, except for capital structure.

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By increasing the cash flows paid to debt holders through interest payments, a firm reduces
the amount paid in taxes. The increase in total cash flows paid to investors is the interest tax
shield. (The figure assumes a 40% marginal corporate tax rate).

 Personal Taxes:
Most investors are taxed when they receive cash.

Equity holders pay taxes (TE)on:

- Dividends: they pay an income tax (like IRPF) on the dividends. Depending on the
amount they receive they will pay more or less taxes.
- Capital gain: they pay a tax on the benefit they get from selling at a higher price.Ex.
You buy your shares at 5 and sell them at 10  capital gain of 5.You need to pay taxes
o apital gai s. It has a ad a tage: ou do ’t ha e to pay them immediately (they
might be deferred).

Debt holders pay taxes on (TD):

- Interest income from debt: they pay an income tax (like IRPF) on the interest payments
they receive.

Typically, capital gains are taxed at lower rates than dividends or interests. For example, the
taxes that equity holders and debt holders have to pay are:

Capital gains Dividends Interest income Mean


Equity holders 20% 45% 32,5%
Debt holders 45% 45%

We can see that equity holders compensate their tax payments, so finally:

As a result: TE < TD

Therefore, in the case of personal taxes equity has an advantage over debt.

 WACC with corporate taxes


We have analysed the taxes in terms of cash flows. Now, we are going to analyse it in terms of
returns.

Suppose here that:

- The project has similar risk as company overall


- The project is financed with same proportion of debt as the company overall
- Corporate taxes is the only imperfection

One can show that cost of capital of the project is then equal to:

r(Post-tax) WACC = rE + rD(1-TC)< rU


+ +

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After-tax borrowing is lower because interest is tax-deductible.

Hence, cost of capital decreases with debt.

It can then be shown that the levered value of an investment then is:

In this case the discount rate will e lo e . You’ e value of the project (present value) will be
higher, because it will be discounted at a lower rate (now, WACC < rU).

This is the same picture as before, but now with the presence of taxes. We can see that now
WACC is not constant, it’s lo e tha ithout ta es.

That’s e ause: as o e de t ou ha e  decrease the cost of capital (you can finance


yourself with a lower rate).

To sum up, the effect of taxes is simple:

- No taxes  the value and the returns are the same no matter the debt it has.
- Taxes  you can distribute each year more money to your investors and increase
value.

In general, if you have debt you benefit on taxes.

Another conclusion is:

High debt  low interest rate high value

A o’s e li e of pa kagi g, RFX


- Technology expected obsolete after four years.
- Expected sales of $60M per year over the next four years.
- Manufacturing costs and operating expenses expected to be $25M and $9M,
respectively, per year.
- Upfront R&D and marketing expenses of $6,67M.
- $24M investment in equipment (depreciated via the straight line method over four
years).
- Avco pays a corporate tax rate of 40%.

Expected cash flows from the project:

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A o’s Ma ket Value Bala e Sheet $M a d ost of apital ithout the RFX p oje t:

Net debt = Debt – Cash = 320M – 20M = 300M

Assume that the project has the same risk as the company overall and that the project is
financed with the same proportion of debt as the company overall (eg. If the company is
financed 30% debt and 70% equity the project will have the same percentages).

Is RFX a good idea?

We al ulate A o’s WACC:

< 8% calculated without taxes

No e a al ulate the p oje t’s alue:

NPV = -28M + 61,25 = 33,25M > 0

R/ We should go ahead and do this project.

COSTS OF BANKRUPTCY

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If debt is so good (decrease a di ease alue h do ’t e ha e so u h de t? Be ause


we will make bankruptcy.

Ba k upt is he a fi a ’t pa . A fi de la e that is i a k upt a d do ’t pa


shareholders, then they decide if the firm can change something and restructu e it o if it’s
better to sell what it has and close the company.

I sol e t o pa is a k upt o i a k upt , allo i g it to:

- obtain relief from debt payment


- make a fresh start, subject to conditions,
- and share assets fairly.

Liquidation is when the company ceases to exist.

The e’ e two types of bankruptcy:

- Compulsory: started by court order, from petition by debtholders.


- Voluntary: shareholders file a voluntary petition to start case.

Main bankruptcy chapters in the US (similar in other countries).

- Chapter 11 to restructure your debts.


- Chapter 7 for liquidation.

It’s i po ta t o l if a k upt affe ts e e ues o osts.

There are 2 types of bankruptcy costs:

 Direct costs: Legal process of restructuring (court costs, advisory fees, consulta ts… .
On average 2-3% of the assets (firm). Examples: United Airlines had $8,6M per month
for legal and professional services related to chapter 11 reorganisation.
 Indirect costs: they may come from different sources:
- Loss of customers: Bankruptcy may enable firms to walk away from future
commitments (support, future upgrades, etc.). When people think a company
is in trouble they stop buying.
- Loss of suppliers: Bankruptcy may enable firms not to pay for inventory. Eg.
Swissaair forced to shut because supplie s efuse to fuel pla es. That’s
because in the moment it has to declare bankruptcy no one wanted to sell to
them.
- Loss of employees: fear of job security. Eg. Pacific Gas and Electric Co paid to
retain 17 key employees.
- Loss of receivables: Debtors might have an opportunity to avoid obligations.
- Fire sales of assets: Companies need to sell assets quickly to raise cash. Firms
end up selling at a lower price, because they are forced to sell.

All this costs mean that the company will have less value, because of the bankruptcy  it will
try to have less debt (in order to avoid this costs).

Cost of debt in the presence of bankruptcy (Example)

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Westlake wants to borrow $1M for one year from a bank. It has 10% probability of going
bankrupt, in which case assets can be sold for $600.000. Legal costs would be $100.000.

Then, how much interest will the bank charge if it wants an average return of 10%?

On average, the bank want to get 1,1M in expected terms (1M+0,1x1M)

If it charge 10%, then it get 10% in 90% of the time but lose in 10% of the time (because of 10%
probability of bankruptcy). What can the bank do?

We ha e to fi d the that the a k ill ha ge i % of the ti e:

0,9(1+r)1.000.000 + 0,1(600.000-100.000)=1.100.000

r= 0,166 = 16,6%

The face value of the debt is: (1+0,166)1.000.000 = 1.166.666

I % of the ti e the a k ill e ei e . . if fi does ’t ust , a d i % of the ti e


it will receive 500.000 (600.000-100.000).

Because of bankruptcy, the cost of capital increases. If the firm takes too much debt, the cost
of de t i eases e ause the e’s o e p o a ilit to a k upt.

How much of this is due to the costs of bankruptcy?

If bankruptcy is possible ut it does ’t ha e a k upt osts, then the cost of capital would
be lower:

0,9(1xr)1.000.000 + 0,1(600.000)=1.100.000

r= 0,158 = 15,8%

If there was no possible bankruptcy, then: (1+r)1.000.000 = 1.100.000  r=10%

So, depending on the situation the interest will be different:

- If no bankruptcy  10%
- If possible bankruptcy (but no costs of bankruptcy)  15,8%
- If bankruptcy costs  16%

The higher the bankruptcy costs, the higher the interest rate the bank will charge to the firm.

SUMMING UP:

- Tax benefits vs. costs of financial distress (bankruptcy) costs: if you have debt you benefit on
taxes but if you have debt, it increases the possibility of going to bankruptcy. Trade-off
theory.

VL = VU + PV(Interest tax shield) – PV(Financial Distress Costs)

- To determine the PV(Financial Distress Costs), we need to compute:

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1. The probability to enter in bankruptcy, which:


- Increases with the a ou t of a fi ’s lia ilities, relative to assets.
- Increases with the olatilit of a fi ’s ash flo s and asset values.
2. The magnitude of costs once in distress (bankruptcy), which depends on industry:
- Technology: the magnitude of loss is high (loss of customers, key personnel,
lack of tangible assets being liquidated).
- Real estate: the magnitude of loss is low (assets can be sold relatively easy).
Eg. Airlines can sell the planes, so the loss will be less.

Optimal leverage:

This g aph sho s the alue of the fi depe di g o the de t it has. The e’ e effe ts:

- If the firm has more debt, it benefit from taxes  increase value.
- If it has more debt, increase the probability to bankrupt  decrease value.
(increase bankruptcy costs)

The optimal level of debt (that will maximize the value of the firm) depends on the firm itself
(as we have seen before).

The firm with the green line, with high distress costs, has it optimal level in D*high this is the
point that maximizes its value.

PART (C): Agency costs and asymmetric information

AGENCY COSTS
What are agency costs?

I a age elatio ship a p i ipal e gages a age t to pe fo a task o his o he ehalf


and it involves delegating authority by the principal.

Example: The CEO can be seen as an agent of the board of directors, and the board of directors
is the agent of shareholders, etc.

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Here we will talk about shareholder being principal of CEO, they are in an agency relation. And
also, debtholders (banks, people who buy bonds) are principal of CEO and shareholders
(debtholders trust that they will run the company well, hoping that at the end they pay them).

Moral hazard: te de of the age t to eha e i app op iatel .

Agency costs: costs associated to these conflicts.

Conflicts of interest between debtholders and shareholders

Managers often own shares and are elected by shareholders (insiders). And managers
a i ize sha eholde ’s ealth, so eti es at the e pe se of de tholde s a d e en at expense
of fi ’s alue.

Some examples:

- Over-investment (risk-shifting): Shareholders can gain by taking a negative-


NPV p oje t, if it’s suffi ie tl isk .
- Under-investment (debt overhang): Shareholders might not invest in positive
NPV projects because value of taking it goes to bondholders.

Example: Over-investment at Baxter, Inc.

The firm asks for a loan of $1M due at the end of the year. Without any change, market value
of its assets will be $900,000 at that time. Therefore, the firm will default on its loan and go
bankrupt.

A new strategy is possible:

- No upfront investment and 50% chance of success.


- If st ateg is su essful, the alue of the fi ’s assets ill e $ , M.
- If ot, the alue of the fi ’s assets ill e $ , .

Should Baxter change the strategy?

The e’ e optio s:

- Do nothing  Firm value = 900,000


. . + .
- Change strategy  Firm value = = 800,000

In terms of the NPV is better to do nothing  the firm should not change the strategy.

Problem: The shareholders might not have the right incentives.

If we think in terms of shareholders, they get:

- If do nothing: 0 (the firm is in bankruptcy)


. +
- If change the strategy: = 150,000

We can see that shareholders benefit changing strategy.

What will debtholders receive?

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- If do nothing: 900,000
, , + ,
- If change the strategy: = 650,000

Value  Firm Shareholders Debtholders


Change the strategy 800,000 150,000 650,000
Do nothing 900,000 0 900,000
Loss o gai if the de ide to ha ge the -100,000 150,000 -250,000
strateg

Shareholders care about themselves and have incentives to change strategy and gamble. In
this case, we can see that if shareholders decide to change the strategy they gain, but the firm
and debtholders lose. In this case, sha eholde s take a p oje t that is good fo the ut it’s
bad for the firm and debtholders.

Solution to this problem:

1. The company has to take less debt.


2. Covenant (legal contract). Debt holders have the right to avoid this things to happen if
they forecast it.

Example: Under-investment at Baxter, Inc.

The firm ask for a loan of $1M due at the end of the year. Without any change, market value of
its assets will be $900,000 at that time. Therefore, the firm will default on its loan and go
bankrupt.

A new strategy is possible:

- Initial investment of $100,000 and 50% chance of success.


- Risk-free interest rate of 5%.

Should Baxter change the strategy?

Cash flow (firm) Cash flow (debtholders)


t=0 t=1 t=0 t=1
No change - 900,000 - 900,000
Change -100,000 1,050,000
M , that’s hat the fi
has to pay to debt holders in t=1
Loss/gain -100,000 150,000
if change

We a see that it’s a good p oje t to ha ge the st ateg . The fi i ests , toda a d
gets 150,000 next year.

If so, how to pay fo it e ause assu e that the e’s o ash a aila le ? Ho to fi a e it?

The firm could sell shares and so obtain external capital:

Cash flow (new investor) if it has 10% shares Cash flow (new investor) if it has 100%
shares

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t=0 t=1 t=0 t=1


-100,000 (the money 5,000 -100,000 (the money 50,000
he invest) (1Mx1,05)=1,05M – he invest) (1Mx1,05)=1,05M –
1M= 0,05Mx10%= 1M= 0,05Mx100%=
A
5,000 50,000

Any rational shareholder will not invest in that firm, so no one will accept to become a
shareholder.

What a out old sha eholde s? Would the e illi g to i est , e t a? No, it’s the sa e
case.

In this problem, if investors put money they lose money. The ones beneficing for this
investment are debtholders. All the money investors put will go to pay the debtholders. This is
a problem called debt overhand problem.

*Debt overhang is the condition of an organization that has existing debt so great that it
cannot easily borrow more money, even when that new borrowing is actually a good
investment.

Therefore, although it’s a good p oje t to ha ge the st ateg , sha eholde s a e ot goi g to
do it, because the value of taking it goes to debtholders.

Solution to this problem:

Renegotiate part of the debt. The firm has to reduce debt claims of debtholders from
1,000,000 to a number that permits that shareholders obtain a return of 105,000. So, the firm
has to reduce the debt in order to induce new investors.

Cash flow (new investor) if it has 100% shares Cash flow (debtholders)
t=0 t=1 t=0 t=1
-100,000 (the money 105,000 - 945,000
he invest) (1Mx1,05)=1,05M –
0,945M = 105,000

The table shows that the firm has to renegotiate the debt in order to reduce the amount to
pay to 945,000. Then, new investors will be willing to invest in the project.  Doing this we
solve the problem.

We can see that the sum of what the firm pays to shareholders and what it pays to
debtholders is equal to the value of the firm making the project:

Value of the firm = 1,050,000 = 105,000 + 945,000

Conclusion: if the firm is in trouble may find it difficult to finance itself, although the NPV is
positive.  Solutio : Do ’t ha e so u h de t.

Sum up of the problem


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Other agency conflicts:

- Cashing out: Incentives to withdraw money just before default (Eg. Sell assets
below market value and use funds to pay immediate dividend).
- Short-sighted investment problem: Tendency to take up projects that pay up
early. You take projects that pay early (and you can pay them as a dividend),
instead of paying them in the future (that maybe will give the firm more
profitability).

In sum, agency costs of leverage:

Ex-post, le e age a e ou age i side s to take a tio s that i ease sha eholde ’s alue ut
edu e de t a d fi ’s alue Over-investment). As debt holders are the once bearing the
costs, ex-ante, the o ’t be willing to pay in debt issuance (cost of debt higher). Therefore, it
would be less money to distribute to shareholders.

This represents another cost of increasing leverage.

Solutio s: debt covenants : est i tio s o a tio s. We ill see i Chapte 3)

Conflicts of interest between ownership and control

Separation of ownership and control: Managers own small fractions (median: 0,25%), they are
rarely dismissed, but control the corporation. Why do we use them, then?

Managers care about investors (equity and debt holders), customers and suppliers, employees
and themselves!

Can debt help with this potential interest conflict? Yes. Increasing the level of debt will solve
these problems. Debt is going to put some pressure to the manager to behave well (he will
ake the possi le to i ease assets a d so, i ease ash flo s to pa de t a d do ’t
undertake negative NPV projects). If not, the CEO will try to decrease debt to have less
pressure.

Another advantage: if you increase debt, then it also increases the monitoring (undertaken by
a ks, i esto s… .

Too little leverage?

Investment in negative NPV projects produces:

- Excessive perks (benefits)


- Empire building: increase size of the firm. (This is bad for shareholders).
- Low-risk projects because of fear of job security.

Leverage:

- Obliges firm to make interest payments


- Redu es a age ’s a ilit to is eha e

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- Forces debtholders to monitor more


- As a result, it i eases the fi ’s alue

The free cash flow hypothesis: wasteful spending especially if large FCF available.

Leverage with Taxes, Financial Distress and Agency Costs

Reasons that push firms to increase debt (situations in which is considered that the firm has
too little leverage):

- Lost tax benefits


- Excessive perks
- Wasteful investments
- Empire building

Reasons that push firms to decrease debt (situations in which is considered that the firm has
too much leverage):

- Excess interest rates


- Financial distress costs
- Excessive risk taking
- Under-investment

The optimal debt level

- Firms with intense R&D have high R&D costs and future growth opportunities.
Current free cash flows may be low, because they have to do a lot of capital
investments. They have risky business strategies. Low debt levels.
- Low-growth/mature firms have stable cash flows and tangible assets. Here
managers may misbehave the cash flows and engage to negative NPV. High
debt levels.

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ASYMMETRIC INFORMATION

Asymmetric information: parties have different information. For example, managers have
superior information than investors rega di g fi ’s futu e ash flo s.

Transmitting positive information to investors:

- Signing a contract with large penalties might be too costly or impossible.


- Launch an investor relations campaign might be useless (not credible).
- The level of debt will be a signal confidence about the firm future prospects:
managers would avoid increasing leverage if the firm were in bad shape. (High
debt maybe means that the firm can pay it in the future).

Credibility Principal: O e’s self-interested seems credible only if they are supported by actions
that would be too costly if the claims were untrue.

Signaling (señalización) theory of debt

In order to signal quality, managers have an additional incentive to increase their debt ratio. If
firm has good quality, it will have no trouble to paythe debt interests. If not, the financial
distress and costs will be higher for the firm.

For the signal to be credible is important that firms in bad shape cannot mimic behaviour of
good firms, but indeed high debt ratio is costly for bad firms.

Adverse selection and the lemons

- Adverse selection: buyers and sellers have different information. The average
quality of the assets in the market differ from the average quality overall.
- Lemons principle: seller has private information about the good’s alue.
Buyers are willing to pay less due to adverse selection.

Selling Equity

Firms that sell new equity have private information about the quality of the future projects 
the e’ e i e ti es to issue e uit he sto k is o e alued. The efo e, buyers might only be
willing to buy the new equity at heavily discounted prices.

I side s’ jo is to o i e i esto s that the e’ e othe easo s to sell e uit , as illi g ess to
diversify or need of cash to fund new positive NPV investments.

Overall, stock price declines on the announcement of an equity issue.

Pecking Order Hypothesis

Managers prefer to fund investments by:

- First, using retained earnings


- As a second option, debt
- And equity only as a last resort.

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Firms with more retained earnings use less debt not because of lower optimal debt ratios but
because of asymmetric information external financing is more costly.

The bottom line of this chapter

1. With perfect capital markets fi ’s apital st u tu e alte s the isk of the e uit , ut
not its value or the amount raised from outsiders.
2. Optimal capital structure depends on imperfections:
- Taxes: Interest tax shield allows repayment without paying corporate tax. Each
dolla of pe a e t de t gi es pa e t o th .
- Bankruptcy: Too much leverage might lead to bankruptcy and its associated
costs.
- Agency costs: Too much debt can induce excessive risk-taking or
underinvestment, but with high free-cash flows too little might lead to
wasteful spending.
- Asymmetric information: Increasing leverage can be used to signal confidence
in the firm. Leverage is better than equity to deal with adverse selection.

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Chapter 3: Debt financing


a) Public debt (bonds): The contractual content of a bond issue.
- Bond types and characteristics
- Provisions and covenants
b) Private debt: Term loans.
- Revolving credit
- Private placements
c) Valuing risk-free corporate (and government) bonds
Relationship between yield and price of zero and non-zero coupon bonds
Price dynamics, sensitivity to changes in interest rates and the duration
d) Valuing risky bonds
e) Repayment Provisions

Debt issuing as part of a leveraged buyout (LBO)


What is an LBO? It’s a Leverage BuyOut. It occurs when someone does an acquisition with a lot
of debt. The objective of this is usually a privatization (move a company from public to
private).

We can see that Hertz made a lot of money trough debt securities ($11.123,9). They used both
public and private debt.
A term loan is a loan that the bank gives to the company and lasts for a specific term.
A revolving line of credit is a particular type of loan; a company asks for a line of $200, but if
they only spend $130, they only have to pay interest on that $130. By contrast, if you ask for a
term loan of $200 you will have to pay interest on the whole amount of money even if you
had ’t used all.
An asset- a ked fleet de t is a loa i hi h if the o pa does ’t epa a k the o e ,
they have the right to charge the money by acquiring assets of the company (in the case of
Hertz, with cars). Those assets are called collaterals (avals).

Part (a): Public Debt


The prospectus of a bond issue
Main elements: Principal or face value and coupon rates (interests), and their dates.
- Principal: nominal amount for calculating interest, typically repaid on due date.
(Face value).
- Coupon: for a given coupon rate (0 for zero-coupon or pure discount bonds):

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Example: A $1000 bond with a 10% coupon rate with semi-annual payments, pay coupons:
$1000 x 0.10 / 2 = $50 every 6 months.
Types of bonds
 Registered bond: a bond in which the Company's records denote ownership, and in
which interest and principal are paid directly to each owner.
 Bearer bonds: the bond holder must send in coupons to claim interest and must send a
certificate to claim the final payment of principal. Example: years ago the bond holder
had a paper with the coupons printed and he had to cut and send it in order to receive
the payment.

Types of corporate debt


Secured debt: Specific assets are pledged as collateral (aval) that bondholders have a direct
claim to in the event of bankruptcy.
Example1: mortgage bonds (property as collateral)
Example 2: Asset-backed bonds (any kind of asset as collateral)
Unsecured debt: In the event of bankruptcy, bondholders have a claim to only the assets that
are not already pledged as collateral on other debt.
Examples: Notes (government bonds) with maturities<10 years, and debentures
(longer).

Tranches: Different classes of securities that comprise a single bond issue. All classes of
securities are paid from the same cash flow source. (See Hertz example below)

Seniority: Indicated the order of priority when debt has to be paid: A senior bondholder is paid
first, in contrast, a junior debt holder has a lot more risk.
Most debenture issues contain clauses restricting the company from issuing new debt with
equal or higher priority than existing debt.

Hertz Junk Bond Issues: Here we can see 3 tranches with different conditions. For instance, the
subordinated Dollar-Denominate Note is a Junior Note, and by this they demand higher
interest due to the risk they carry (10,5%).

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Covenants and provisions


Restrictive covenants: Limitations set by bondholders on the actions of the Corporation. For
example, covenants may restrict the ability of management to pay dividends, the level of
further indebtedness or specify that the issuer must maintain a minimum amount of working
capital.

Repayment provisions: The issuer can repurchase a fraction of the outstanding bonds in the
market or make a tender offer for the entire issue. For callable bonds, exercise the call
provision.

Callable bonds: Issuers have the right (but not the obligation) to retire all outstanding bonds
on (or after) a specific date (the call date), for the call price (a certain price specified on the
bond contract). This property affects the price of the bond.

International bonds
Domestic Bonds: Issued by local entity and traded in local market, but purchased by foreigners
(in the currency of the country).

Foreign Bonds: Issued by a foreign company in a local market and intended for local investors.
Example: an American company issuing a bond in Europe.
They are denominated in the local currency.
- Yankee bond: a bond sold publicly by a foreign company in the US. Example:
Telefonica selling a bond in the US market.
- Samurai: a bond sold by a foreign firm in Japan.
- Bulldogs: foreign bonds in the United Kingdom.

Eurobonds: Not denominated in the local currency of the country in which they are issued.

Global Bonds: Bonds that are offered for sale in several different markets simultaneously.

Part (b): Private Debt - not publicly traded


 Term Loans
Syndicated: a group of banks rather than just one. Sometimes, when talking about huge
quantities of money, many banks associate in a syndicate and give a loan to a certain company.
In these cases possibly the company is asking for millions of dollars and so it would be too risky
for a solely bank to lend the money.

 Revolving Line of Credit: credit commitment for specific period (2, 3 years) that can be
used as needed. Gives a lot of flexibility.

 Private Placements: Bond issue sold to small group of investors rather than the general
public.

Private as compared to public debt:


Private debt is less costly to issue (lower registration costs: the fees are lower) but also less
liquid (you cannot sell the bond to somebody else; however, they might be traded within
financial institutions).

Other types of debt:


Sovereign Debt: Debt issued by national governments. The U.S. treasury issues:

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- Treasury bills: zero-coupon bonds with maturities up to 26 weeks (less than one
year).
- Treasury Notes: semi-annual coupon bonds with maturities 2 to 10 years
- Treasure bonds: semi-annual coupon bonds with maturities > 10 years
- Long Bonds: those with longest outstanding maturities (now 30 years)
- TIPS (Treasury-Inflation-Protected Securities): inflation-indexed bond (the
outstanding principal is adjusted for inflation)
Part (c): Risk-free Bond Valuation
Yield to maturity = cost of debt = expected return debt holders will make on the debt
If the bond becomes less attractive, the price will be lower and so the YTM higher: negative
relation between the price of the bond and the YTM. It applies both on the private and
secondary market.

YTM: unique implicit discount rate r that makes the bond cash flows has the value at its
current price.
For a risk-free (safe) bond: YTM = r = IRR (The Internal Rate of Return) of investing in the bond,
given its current price.

Zero-coupon bonds
The do ’t pa oupo s oupo ate = , ou o l get the fa e value at the maturity date) and
therefore are always sold at a discount (lower price than the principal), and are also called
pure discount bond. Example: Treasury Bills of the U.S. government.
Example: A safe bond without coupon with $ 100,000 of principal has a price of $ 96,618.36.
The cash flows and the YTM is:
FV
P=
+ YTM ^n

YTM of a zero-coupon bond maturing in n years:


The YTM that solves the equation is 3.5%

Since it is a safe zero-coupon bond that gives an interest without risk in that period, YTM must
be equal to the risk-free interest rate  IRR = YTM if safe, and YTM = irisk-free if safe and zero –
coupon.
What if not? Arbitrage opportunity.

Coupon bonds
These bonds pay, in addition to the principal, coupons. Examples of these are the treasury
notes and bonds.
Price of a bond with CPN annual coupons maturing in n years is:

The advantage of using YTM is that it does not depend on the principal (to solve this prices are
often given in percentage of the principal (face value)).

EXAMPLE: What is the YTM of the following bond?


A treasury bond of $ 1,000 due in 5 years paying a nominal coupon of 10.5%. The market price
is $1.078,8.

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 IRR (YTM) of these Cash flows is 8.5%.


We do ’t ha e to k o the fo ula to al ulate the YTM of oupon bonds, only for zero-
coupon bonds.

What is the difference between yield to maturity and the coupon rate?
- A bond's coupon rate is the actual amount of interest earned on the bond each year
based on its face value. The coupons are fixed; no matter what price the bond trades
for, the interest payments always equal $X per year.
- A bond's yield to maturity is the average rate of return based on the assumption it is
held until maturity date and not called. YTM is a complex but accurate calculation of a
o d’s etu i ludes the oupo ate that helps i esto s o pa e o ds ith
different maturities and coupons. There is a different YTM for every year to maturity.

Relationship between Price and YTM

Why bonds traded at a discount have CPN < YTM? Because at a discount means that the face
value is greater that the price of the bond (as 90 --- 100) and so, the YTM is higher than the
coupon rate.
Can zero-coupon bonds trade at a premium? No, without coupons this cannot happen (100 ---
90).

Coupon rates are often chosen so that bond trades initially at par.

Price of a bond may change over time as:


- Time to maturity shortens: If the rest does not change, as time passes the price
(discount or premium) approaches the par: the price of the bond converges to the
face value.
- Interest rates change: if YTM increases (decreases), the price needs to go down
(up); now this bond is less (more) attractive.
If the est does ’t ha ge the o d is e uall attractive), as time passes the YTM
o ’t ha ge.

Example
Zero coupon bond with YTM of 5% and FV of $100:
Value (price):

5 years after, the value is:


If ou u the o d the se o d ago the atu it date, the p i e ould e , … ea l
(face value).

Notice that buying for $ 23.14 and selling to 29.53 after five years, IRR is:
The return still 5%, so the YTM is also the return you get from buying and selling the bond.

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Bond prices for a constant YTM

Why the changes of non-zero coupon bonds are not smooth? Be ause the do ’t ha e
coupons.

What happens if the YTM changes? If interest rates change in the economy:
- Rates that investors demand for investing in bonds also change.
- The price of the asset in the market also changes.

Example
Zero coupon bond with YTM of 5% and FV 100.

Value:

If, suddenly, investors demand a 6%: the price is affected.

Sensitivity to changes in interest rates


A higher YTM reduces the present value of remaining cash flows.
If rates rise, the YTM rise and bond prices fall.
What types of bonds are more subject to fluctuations in the price?
 Long-term bonds are more sensitive to changes in interest rates than short-term
bonds.

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 Similarly, bonds with higher coupon rates are less sensitive to changes in interest
rates because they pay more upfront, and so, lower coupon bonds are more
sensitive.

Duration of a bond: It is a measure of the price sensitivity to changes in interest rates (YTM).
And measures how long, in years, it takes for the price of a bond to be repaid by its internal
cash flows = average number of years of the discounted cash flows.
- Zero-Coupon Bond - Duration is equal to its time to maturity.
- Coupon Bond - Duration will always be less than its time to maturity.

Co puti g the du atio of a o d

Duration of a perpetuity is +i /i, he e i is the discount rate. (1+9%) / 9% = 12,1 years.


(Price for Perpetuity Fa e alue/i = €/ . = . , €

Part (d): Risky Bond Valuation


In risky bonds, like corporate bonds, the issuer can default (credit risk):
- The risk of insolvency changes the price of a bond and the YTM.
o Investors pay less for bonds with credit risk than they would for an
identical default-free bond.
o The yield of bonds with credit risk will be higher than that of identical
default-free bonds, and there might be differences between YTM and the
expected return.

Example: two extreme cases and one more realistic.

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1) No Default: 1-year, zero-coupon with a YTM of 4%:

With a zero-coupon bond and no probability to default, the YTM = risk free rate
(expected return).
2) Certain Default (default for sure): the issuer will pay 90% of obligation. Here we know
for sure that the face value is going to be 900, so we calculate the price using 900

instead of 1000: If the price is lower, the YTM is


higher.

The yield to maturity in the second case is


(By convention, here we use promised rather the actual cash flow; we use the real face value
€ .

YTM higher than the expected return: . We see that here the YTM is different
from the expected return (15% vs. 4%).

In reality: There is some risk of default.

One-year, $1000, zero-coupon bond:


3) There is a 50% probability of full repayment of the face value and a 50% possibility of
default and then we will receive only $900  [50% * 1000 + 50% * 900 = 950].
Because of uncertainty, the discount rate is 5.1% (1.1% premium because default more likely if
economy is weak).

 Higher rate due to


risk (5.1%).
Investors receive 10.63% at most. In the bad scenario:
The average return is:

With the possibility of default (for sure or not), the YTM is difference expected return.
However, notice that lower YTM do not imply lower expected return! Compare this example to
the previous example where the return was 4%.
Bond ratings

Rating Agency Description


Investment Grade
Debt
AAA Best quality bonds. They carry the smallest degree of investment risk.
AA High quality by all standards, however margins of protection may not
be as large as in AAA securities.
A Possess many favorable investment attributes and are considered as
upper-medium-grade obligations. There may be some elements that
suggest a susceptibility to impairment some time in the future.
BBB Medium-grade obligations (neither highly protected nor poorly
secured).
BB and so on.

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Part (e): Repayment Provisions


To most important repayment options provisions: callable and convertible bonds.

CALLABLE BONDS: the company may call the bond back giving you a certain payment.
Issuers (for instance, firms) have the right (but not the obligation) to retire all outstanding
bonds on (or after) a specific date (the call date), for the call price.

If interest rates in the market have gone down by the time of the call date, the issuer will be
able to refinance its debt at a cheaper level and so will be incentivized to call the bonds it
originally issued in order to resell it at a higher price. Another way to see this is that, as
interest rates go down, the price of the bonds goes up; therefore, it is advantageous to buy the
bonds back at par value.
This is comparable to selling an option: the option writer gets a premium up front, but has a
downside if the option is exercised.

Prices of callable (at par) and non-callable bonds on call date


- If a bond is callable and the yield is under <5%, the issuer should call the bond and
refinance at lower rate, which means resell the bond at a higher price.
- A callable bond is less interesting for the investors but gives a lot of flexibility to
the firms.

Prices of callable (at par) and non-callable bonds prior to call date

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Suppose that this is a 20-year 5 coupon bond and the call time (when the bond can be called)
at par is in year 5:

We are interested in the yellow line (because it is the one that shows the payoffs of our 20-
year callable bond) and we will compare it with a 20 year non-callable bond and 5 year non-
alla le o d oth ha e the sa e % oupo . If it has a highe du atio it’ll e o e
sensitive (the line is stepper).
- If the yields are very high (9% a 10%) this bond is not going to be called (right side
of the g aph , that’s h the p i e ill e si ila to the -years non-callable
bond.
- The firm will call the bond if the yields are lower than 5%.

CONVERTIBLE PROVISIONS Convertible Bonds

Convertible bonds are corporate bonds with a provision that gives the bondholder an option to
convert the bond into a fixed number of shares of common stock. The number of shares you
would get in exchange is previously stipulated.
 Conversion Ratio: The number of shares received upon conversion of a convertible
bond, usually stated per $1000 of face value.
 Conversion Price: The face value of a convertible bond divided by the number of
shares received if the bond is converted.

Example
You have a convertible bond with a $1000 face value and a conversion ratio of 15: If you
convert bond into stock, you will receive 15 shares.
If you do not convert, you will receive $1000
- B o e ti g ou esse tiall pa $ fo sha es, i pl i g a o e sio
price per share of $66.67  1000/15 = 66,67

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- If the price of the stock exceeds $66.67, you will choose to convert; otherwise, you
will take the cash.
Convertible Bond Value

The higher the stock price, the higher the value for the share and also the higher the value of
the bond, because this bond in convertible in shares.
By holding this type of bond you will always get the best of the two, and whether you convert
or not will depend on the shares price.
These bonds are more attractive and so more expensive to buy. It is also similar to a call option
for the buyer of the bond.

We assume that we are 1 minute before maturity and we can exert this convertible option 
the payment of our bond in the maximum of the blue and the red lines.
- If e do ’t e e t the optio e ill e ei e the red payment which is the FV =
1000. Otherwise, the payoff of the blue line depends on the share price.
- Whether we convert or not will depend on the share price of that moment.

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Chapter 4: Equity Financing

Sources of equity financing:

 Personal funds: when somebody starts a company it usually begins with personal
fu ds. It’s diffi ult to o tai a loa f o the a k he the e t ep e eu has o l a
project.
 Equity capital
 Debt financing
 Other creative sources

Sources of personal financing for new ventures

PERSONAL FUNDS: the ajo it of fou de s o t i ute pe so al fu ds alo g ith s eat


e uit that is the alue of ti e a d effo t.

FRIENDS AND FAMILY: friends and family are the second source of funds. They often give
loans or do investments with mild conditions but they also make gifts. Sometimes there is no
compensation for this loans or the compensation is delayed. And in case of a rent, it is usually
free or reduced.

BOOTSTRAPPING METHODS: these methods consist of finding ways to avoid the need for
external financing or funding through creativity, ingenuity, thriftiness (ahorro), cost-cutting or
any means necessary. For example, some of these methods could be: buy used instead of new
equipment, coordinate purchases with other businesses, lease equipment instead of buying,
obtain payments in advance from customers, avoid unnecessary expenses, minimize personal
expenses, share office space with other businesses and apply for obtaining grants
(subvenciones).

BUSINESS ANGELS

Business angels are individuals who invest their personal capital directly in small start-ups with
positive perspectives. They are typically about 50 years old, with high income and wealth, well
educated and they usually have succeeded as entrepreneur. The number of business angels
has increased over the past decade.

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VENTURE CAPITAL

Venture capital firms invest in start-ups and small businesses with exceptional growth
potential. There are much fewer entrepreneurial firms in comparison to business angels. These
types of firms look for big successes so they reject the majority of the proposals they consider.
If a venture capital invests in a company which later goes public, it will earn lots of money.

Venture capital firms are limited partnerships that raise money in funds to invest in start-ups
and growing firms. The funds are raised from wealthy individuals, for instance. In the US there
are lots of venture capital firms, but there is much less activity in Europe. The few activity of
venture capital firms in Europe is mostly in the UK and Holland, whereas in Spain the activity is
very little.

INITIAL PUBLIC OFFERING (IPO)

The IPO is the o pa ’s fi st sale of sto k to the pu li . Whe a o pa goes pu li its sto k
is traded on one of the stock exchanges (bolsa de valores). This usually happens when a firm
has demonstrated it is viable and has a bright future, then the market values the firm for the
first time.

This is a complicated and expensive process usually done by successful firms and it is usually
necessary to hire and investment bank that acts as an advocate and adviser and walks a firm
through the process. This investment bank is the one who establishes an initial valuation of the
sto k ased o the fi ’s p i ate i fo atio a d it also fi ds out the investors willingness to
pa . T pi all the e is a oad sho that is a tou of eeti gs of the fi ’s top a age e t
with investors where the firm presents its business plan and tries to know the willingness to
pay of these potential investors.

The higher the stock price the better to the firm because they raise more money. But the price
should ’t e too high e ause if it is the ase i esto s ould ’t u these sto ks.

REASONS TO GO PUBLIC

 Reason 1: is a way to raise equity capital to fund current and future operations (cash
needs).
 Reason 2: a IPO aises a fi ’s pu li p ofile aki g it easie to att a t high-quality
customers, alliance partners and employees (marketing).

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 Reason 3: an IPO is a liquidity event that provides a means for a company shareholders
to cash out their investments (hacer líquidas sus inversiones).
 Reason 4: by going public a firm creates another form of currency that can be used to
grow the company.
 Shareholders prefer a public firm because of flexibility, if a company is public it’s easie
to buy and sell stocks.

SHARES
New shares: the money goes to the Old shares: the money goes to old
company. shareholders and they cash their
investments.

SEASONED EQUITY OFFERING (SEO) ISSUES (ampliación de capital)

SEO issuances (issuances = emisiones)

This consists of and already traded firm that issues new shares. Market values are already
established so placing these securities is generally less difficult than an IPO since there is less
asymmetric information (investors already know the company).

Types of SEOs

1. Follow-on offering: new shares are issued to the public.


2. Secondary offering: existing shares held by current owners are sold to the market

Both types of shares can be offered simultaneously.

PAYOUT POLICY: dividend vs. stock repurchases

Payout policy

Free cash flows can be retained or handed back to shareholders by paying dividends in cash or
buying back shares. Dividends can be regular cash dividends or special cash dividends. And the
buying back of shares can be a purchase directly from the market, a purchase at a fixed price
offered to shareholders (tender offer) or through private negotiations (greenmail).

Tender offer (oferta pública de adquisición: OPA): is a market operation by which a person or
entity offers to the shareholders of a company to buy their shares at a price higher than the
market price to achieve a majority stake in the company. This transaction can be done with the

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approval of the management (friendly takeover) or without their acceptance (hostile


takeover).

Example: Microsoft Payout Policy

The first time Microsoft returned money to its shareholders the company did a repurchasing of
shares, later on, it started to pay dividends. Share repurchases: 5.4bilions per year on average
from 1999 until 2004.
Dividends:
- Sta te di ide d of $ . pe sha e i .
- One-time dividend of $3 per share (total $32b) in 2004 (extraordinary dividend).
Four year plans from 2004:
- Repurchase $30b of its stock
- Pay regular annual dividends of $0.32 per share (not compulsory but shareholders
expect them).

When a firm issues shares it is important to decide how much money is it going to return to
shareholders. For debt the returning was compulsory but regarding shares the firm can decide
how much it wants to retain and how much it wants to pay out.

 DIVIDENDS: the firm pays a certain amount per share.

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 REPURCHASING OF SHARES: o sists of u i g sha es a d dest o the → edu e the


number of shares to increase the value of a single share.

Example: Genron

 No debt.
 Expected cash flows: 48 million per year indefinitely.
 The cost of capital (unlevered) is 12%.
 10 million shares outstanding.
 20 million i e ess ash i the ea futu e.
 Market value of equity: E = (48m/0,12) + 20m = 400 + 20 = 420 million (This is the
value of the equity and in this example it is also the value of the firm because there is
no debt).

How to pay back the 20 million? And the rest of cash flows?

OPTION 1

Consists of pa i g € th ough a spe ial di ide d pe sha e i ediatel illio €/ illio


of sha es outsta di g = € a d the pa out ash ge e ated th ough egula di ide ds €
million per year).

Value of a share: P =
420m/10million of shares = €
(price per share).

 The value of a share could


also be calculated doing the PV of all the
cash flows the shareholder is going to
receive:
 P = 2 + 4,8/0,12 = € (price per share).
 The sha eholde is goi g to e ei e , € e e ea a d doi g 4,8/0,12 is how the
value of a perpetuity has to be calculated (where the 0,12 is the cost of capital). Then
e ha e to su the e t ao di a di ide d of €.

¿What is the price of the share once the dividend of 2 Euros has been paid?

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 P = 4,8/0,12 = € (price per share). The share price will go down by the exact value of
the dividend.

The price before the dividend should be higher and at the moment this dividend is paid the
share price will go down by the exact value of the dividend.

¿What is the price of the share a minute efore re ei i g the regular di ide d of 4,8€?

 P = 4,8 + 4,8/0,12 = , € (price per share).

In the previous
graph we can
observe the oscillation
of the share price due
to dividends,
as we can see the
variations are very
similar to the ones
of the bonds
with the coupons.

MARKET VALUE BALANCE SHEET

Cum-dividend Ex-dividend
Cash 20 0
Other assets 400 400
Total market value of assets 420 400
Millions of shares 10 10
Share price € €

, , ,
𝐏 𝐢 𝐢 𝐬= + + ,
+ +⋯ = + = 𝟒𝟐€
+ , ^ ,

,
𝐏 𝐱 𝒊𝒗𝒊 = ,
= 𝟒𝟎€

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OPTION 2

The firm has 20 million that are going to be used to repurchase shares in the open market and
then burn them. In the future, there will be pay out cash generated through regular dividends.
The only difference is that at time 0 the firm is going to repurchase shares instead of paying a
dividend. How many shares the firm will be able to buy?

 N= illio / € sha e p i e = 476.190,47 shares (number of shares that the firm


will be able to buy).
 How many shares remain? 10.000.000 – 476.190,47 = 9.523.809,53 shares
 Value of equity?

 The sha e p i e sta s the sa e →

Now there are less shareholders, reducing the number of shares they push up the dividend per
share:

Now the price will shift between 42 and 47,04.

 P = 5,04/0,12 = € (price per share). The share price will go up and down by the exact
value of the dividend: 42 + 5.04 = 47.04€

If you were a shareholder, what would you prefer? Option 1 or Option 2?

Suppose your name is Stanley and you own 2.000 shares of the company. What would you
prefer? Option 1 or Option 2? (The first option is more liquid).

Stanley: 2.000 shares SHARES CASH TOTAL


Option 1 * . = . € * . = . € 84.000€
Option 2 * . = . € € 84.000€

 From option 2 to option 1: Stanley prefers option 1:

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From option 2 Stanley can create homemade dividends and get exactly the same profile as in
optio → C eatio of the ho e ade di ide ds: sell sha es a d get € * €/sha e) in
cash. The the ould ha e €i ash a d . i sha es * €/sha e).

 From option 1 to option 2: Stanley prefers 2 for whatever reason:


Fo optio , he a use the €i ash to u sha es / = sha es a d get the
same payoffs that in optio : €i ash a d . € i sha es + * €/sha e).

Conclusion: if some assumptions are hold, Stanley is indifferent, he would be indifferent


between option 1 and option 2 because he will receive the same amount of money after-all.
From the point of view of a shareholder it is the same a dividend policy or a stock repurchase.
Stanley could create the same pattern of cash flows. Despite this, the transaction costs are
higher in the repurchasing of shares and taxes are higher when dividends are paid.

OPTION 3

Suppose the firm wants to pay more than 2$ per share, for instance, suppose it wants to pay
48$ million in dividends in year 0. So the firm needs 28$ million extra to achieve its purpose.
How can the firm raise this extra money? They can issue new stock or borrow money.

How many shares does it need to issue?

 . . $= €*X
 X = 666.666,66 shares.

How many shares will there be outstanding?

 Now the firm will have 10.000.000 + 666.666,66 = 10.666.666,67 shares outstanding.

What will the dividend per share be?

 . . €/ . . , = . €

What will be the share price? Cum and ex-dividend?

Cum-dividend Ex-dividend
Share price P= , €+ , / . = € P= , / . = , €

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Modigliani-Miller theorem

The choice of paying dividends or repurchasing of stock is irrelevant for shareholders in the
absence of (perfect capital market):

 Arbitrage opportunities.
 Taxes.
 Transaction costs.
 Agency costs.
 Information problems.
 And if the investment, financing and operating policies are held fixed: the firm knows
how much to redistribute.

Effects of Taxes

 Remember that companies pay corporate taxes on earnings, that dividends are taxed
as ordinary income and that capital gains are usually taxed at a lower rate. We
understand capital gains as the taxes paid when repurchases are made.
 Still, tax rates differ according to income level, income horizon, tax jurisdiction and
type of investor account.
 Investors have different preferences.

How taxes affect dividend policy?

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There is no difference between pre-tax distribution through stock repurchase or dividends. But
dividends pay more immediate taxes (higher rate and all gains are immediately taxed). Future
tax liabilities are lower for dividends because capital gains will be lower. However, the total
amount paid in taxes (and its present value) will be higher for dividends.

Why firms pay dividends?

Usually repurchases have more advantages than dividends. But paying dividends has also some
advantages, for example, dividends have lower transaction costs. Tax-exempt shareholders
may prefer dividends because of the transaction costs of repurchases (brokerage fees →
charged for services such as negotiations, sales, purchases, delivery or advice on the
transaction , registration costs...).

There might be clientele effects: investors have some preference over company's policies, such
as payout policies. For instance, some investors may prefer the firm to pay dividends, so they
will invest in the firms that take this policy. While some other investors may prefer the firm to
epu hase. A o pa ust hoose poli ies to satisf i esto ’s eeds, othe ise i esto s
may sell their shares. In other words, investor's preference is an important factor in
determining firm's payout policy, which in some sense is a deviation for the MM theorem.

A company's stock price will move according to the demands and goals of investors in reaction
to a tax, dividend or other policy change affecting the company. The clientele effect assumes
that investors are attracted to different company policies, and that when a company's policy

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changes, investors will adjust their stock holdings accordingly. As a result of this adjustment,
the stock price will move. It can be that investors choose which company to invest depending
on their dividend policies.

Shareholders can be individuals or corporations (for instance, La Caixa and BBVA are investors
of Telefónica). Individual shareholders pay less taxes if there are stock repurchases than if
there are dividends. But for firms this is the opposite: corporations that hold shares of other
corporations may prefer dividends because they are taxed at a lower rate. This is why
companies like Telefónica do stock repurchases and also dividend policies. So as we can see,
the type of shareholders a company has, affects their decisions. In theory, the company looks
for what is better for its shareholders, but actually, managers change very little the dividend
policy to please the shareholders of the company.

In principle, firms that pay a lot of dividends is because they have investors unaffected by taxes
or that the majority of their shareholders are firms. But in reality, the company does not adapt
much, is the shareholder (individual or firm) who chooses the company to invest in.

Retaining versus paying out

What do a firm does with the cash available? 1. If the firm has cash available an there are
projects with positive NPV the firm must invest in them (and we should ask for money to invest
i those p oje ts if e ha e ’t got e ough!! . 2. If there are not projects available or after
investing in some projects there is still excess cash, the firm must pay out, hold the cash or buy
fi a ial assets → What should the firm do? → i pe fe t apital a kets this should ot
matter (MM). In theory, it is the same, the value for the shareholders should be the same.

But maybe the conditions of this theorem (MM) do not apply. For instance, there could be
bankruptcy costs. If this is the case, the firm should accumulate some cash to avoid problems.
Specially if the cash flows of this company are very volatile. One reason in favour of paying out
the excess cash is that, maybe, if the company keeps this cash there is a temptation to waste
this money.

ADVANTAGES & DISADVANTAGES OF RETAINING

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Retain
Advantages Disadvantages
Cash available to Agency costs:
cover future management may
investments (R&D use fund inefficiently.
projects,
acquisitions..).
Avoids direct and
indirect costs of
raising external
capital.
If earnings are
volatile this can help
to avoid bankruptcy
and its costs.

Which companies will keep more cash? You will have to decide depending on the type of
firm:
- Startups will tend to retain the earnings as they are growing.
- Stable and mature firms will tend to payout.

Payout Policy and Asymmetric Information

→ Earnings and dividends per share: their relation depends on information.

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It may be that earnings are very volatile, but dividends are quite stable. When a company has
to lower dividends, the decrease is stronger that the increase (which is more gradual).
Companies know that any change of the dividends will affect the price of the share a lot.

Reactions of the stock market

How does the market react to payout policy announcements? When a firm announces some
change in the payout policy the price of the share changes when the announcement is made
(not when the real change is made).

SOME EXAMPLES:

 Initiation of quarterly dividends: Starting paying dividends push the share price up.
 An increase in dividends: Increase of the share price (on average 2%).
 Omission of a dividend: Share price goes down on average by -9.5%.
 A repurchase of share with tender offer (a lot of shares): Share price goes up a lot
(+16%).
 A repurchase of share at the open market (less amount of shares repurchased):
Share price goes up but only 3% on average.

What do managers maximize? There are two type of values: intrinsic value and perceived
value. If you are a short-term shareholder, for you, the market value (perceived) is important.
If you are a long-term investor, you care about the intrinsic value (the real value). There are
decisions that increase or decrease both values, and these decisions will be easier to take. But
there are some decisions that increase a value and decrease the other one...

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Implicit assumption:

 Managers have more information than investors.


 They are not always able or willing to disclose this information.
 Their actions may indirectly reveal part of this info.

Simple numerical example

A CEO owns 20.000 shares and he plans to sell 10.000 in the near future and hold 10.000
indefinitely. He has a fixed salary and he does not have any previous concerns. He will weight
u e t a d i t i si alue e uall , a d a edu tio of € i i t i si alue eeds to e
compensated with an increase 1$ in current value.

A simple model (Miller and Rock, 1985)

This model tries to capture the idea of asymmetric information and the idea that managers
manipulate dividends to pretend to be of high quality.

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Usually operating cash flows cannot be fully observed, if investment expenditures and
di ide ds a e o se a le, these ope ati g ash flo s a e dedu ted.

If dividends are higher than expected it could be because operating cash flows are higher (this
would be a good new about the company). But it could be that dividends are higher because
i est e t e pe ditu es a e lo e ed → this ould e a ad e . Doi g this, the o pa
pretends to have higher operating cash flows to simulate being better.

If a manager has incentives to maximise the intrinsic value then he will pick up the optimal
investment level. If this manager wants to maximise the perceived value he will invest less and
increase the dividends.

EXAMPLE: operating cash flows: $25m

Suppose that management gives same weight to intrinsic and perceived value

OPTION 1 OPTION 2 OPTION 3


$10m dividend $15m dividend $20m dividend
$15m invested $10m invested $5m invested
Intrinsic value $220m $210m $200m
Current value $190m $210m $215m

If the company chooses option 3 instead of option 2 investors would not know if operating
cash has increased (good) or investment has decreased (bad because long term value will be
lower).

 Option 2 is what the market expects.


 A short-term shareholder would prefer option 3.
 A long-term shareholder would prefer option 1.
 An investors that is indifferent would prefer option 2.
 If there is another company that is a potential buyer of our company, our company will
choose option 3. In the long-term this decision would be negative but now the
potential buyers see better dividends so they assume that the company is performing
ell. The i esto s do ot see the e pe ditu es o the ash flo s → the o l see
dividends and share price.

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SUMMARY

 A manager with equal weight for short and long term value will choose option 2.
 Market correctly inferred that the firm would choose this option.
 If they had unexpectedly paid more dividends investors would have incorrectly
believed that the firm had better than expected cash flows.

CHAPTER 5: VALUATION METHODS


METHODS DISCOUNTING CASH FLOWS

We are going to study 4 methods used by a firm when it has to decide to take a project or not:

1) Weighted average cost of capital (WACC)


2) Adjusted present value: value of tax shields.
3) Flow to equity
4) Capital cash flows

Essentially, all methods compute cash flows and discount these cash flows, but in different
ways.

Method 1 and 2 discount free cash flows (FCF), and give you the value; method 3 discounts the
free cash flow equity (FCFE), and give you the NPV; and method 4 discount the capital cash
flows, and give you the value.

Other methods:

- Based on comparables or multiples


- Real Options

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(no els farem)

REMEMBER THE NEW PROJECT OF AVCO: RFX

- Technology expected obsolete after four years.


- Expected sales of $60 million per year over the next four years.
- Manufacturing costs and operating expenses expected to be $25 million and $9
million, respectively, per year.
- Upfront R&D and marketing expenses of $6.67 million.
- $24 million in equipment (straight line depreciation over 4 years).
- A o pa s a o po ate ta ate of % that’s the only imperfection included).

To review the investment decision:

- Make p e ise defi itio of f ee ash flo


- Calculate the value and net present value

Financing decision: sources and uses of funds.

First, we will see free cash flows.

Free cash flows, a precise definition:

The Unlevered Net Income, also alled Nopat, it’s diffe e t f o the et i o e u le e ed
et i o e does ’t ha e i te est . U le e ed et i o e is the i o e that the fi ould
ha e if it did ’t ha e de t.

The free cash flow (FCF) is after-tax flows generated from operations, without taking into
a ou t the de t st u tu e. I othe o ds, it’s the h potheti al ash flo s that ill go to
shareholders if there was no debt.

Unlevered net income can also be computed by adding back the afte -ta i te est to the Net
income.

ASSUMPTIONS:

1) Project has average risk. This means that the project itself has the same risk as the
company as a whole  P oje t’s ost of apital is ased o the isk of the fi .
2) D/E and D/V (where D is net debt) is constant: that means that the ratio debt to
equity or debt to value of the firm is constant.
o The isk of e uit a d de t a d WACC does ’t ha ge.
o The firm will need to adjust continuously its leverage.
o The percentage is a choice of the firm.

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3) The corporate tax is the only imperfection. E.g. We assu e that the e’ e eithe
financial distress (bankruptcy) nor agency costs.

Valuation using the weighted average cost of capital (WACC)

Remember that the (after-tax) cost of capital is:

As we saw earlier,

- Taking into account taxes, cost of capital is lower.


- The interest tax deductible and cost of capital decrease with debt.
- It can be shown that the (levered) value of the project is:

A o’s Bala e Sheet (at market values)

Net debt:

D = Debt – Cash = 320 – 20 = 300M

Enterprise value:

Enterprise Value = Equity + Net Debt = Equity + Gross Debt – Cash, or market value of non-cash
assets.

Enterprise Value = Equity + Net Debt = 300 + 300 = 600M

METHOD 1: VALUATION USING THE WEIGHTED AVERAGE COST OF CAPITAL


(WACC)

He e e al ulate A o’s WACC taking into account the advantage of taxes:

The present value (incorporating the tax advantage):

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Now, we can calculate the NPV, which is what you get from the project minus what you have
to pay.

NPV = 61.25M – 28M = 33.25M > 0

SUMMARY: WACC METHOD FOR INVESTMENT DECISIONS

Steps:

- Determine the free cash flows of the investment.


- Compute (after-tax) WACC.
- Compute the value of the investment, including the tax benefit of the leverage, by
discounting the free cash flow of the investment using the WACC.
- Compute the NPV (=added shareholder value) by subtracting the initial investment to
the investment value.
- If positi e, go ahead! If egati e, do ’t!

CONSTANT D/V RATIOS

Balance sheet without the project:

 What’s the effe t of the p oje t i the asset alue?

The value of the firm (assets) will increase by 61,25 (the present value).

 What do we have to do to keep a D/V constant?


,
We need to issue extra debt, so ask for a loan of = , (Because we have to keep D/V
𝑉 ,
= 1/2  D = = )

The new project will generate more assets in the future  increase the value of equity.

So, de t a d e uit ill i ease , . If the fi did ’t ha e to ask fo a e t a a ou t


of debt, then equity would have increased by 61,25).

Therefore, once the firm implements the project, the value of the assets will increase.

OPTION 1: The new balance sheet would be:

Cash: 20 Debt: 320 + 30,625 = 350,625

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Existing assets: 600 + 61,25 = 661,25 Equity: 300 + 30,625 = 330,625


_____________________ __________________

Total assets: 620 + 61,25 = 681,25 Total liabilities 620 + 61,25 = 681,25
+ equity

Now, Net Debt = Debt – Cash = 350,625 – 20 = 330,625

Which amount of money we got? Have we got additional amount of cash?

The loan gives as money (it goes in debt because we have to pay it). The loan is of 30,625 but
the firm has to pay the initial investment of the project, then:

30,625 – 28 = 2,625  The firm can keep this money as cash. However, with this option the
proportion would ’t e the a o ded o e / . So, the fi ould pa it as a dividend.

What’s the gain to shareholders? (Their additional profit?)

It’s the i ease i e uit : , + , = , NPV).

It’s i po ta t to k o that hat sha eholde s get f o a p oje t is the NPV. That’s h fi s
may choose positive NPV, and the higher the value more benefits to shareholders.

OPTION 2: An alternative to increase debt by 30,625 could have been reducing cash to 0 and,
instead of asking for a loan of 30,625 now we ask for a loan of 10,625 (because we have
reduced 20 cash and so, we need to cover the 10,625 left with debt).

Balance sheet once the project is made:

Remember: Target D/E = 1 or D/V = 1/2

We have to continue financing new investment with net debt = 50% of their market value (D/V
= ½)

The market value have increased by 61,25, hence we need to increase net debt by 30,625.
That’s e ause e ha e to keep the p opo tio : D/V = ½

D/ 61,25 = ½  D= 30,625

In this case, we eliminate cash holdings by 20 and borrow 10,625.

It’s the sa e de t o ash . (20 + 10,625)

Uses of funds: we pay the initial investment of 28 and pay the rest to shareholders (30,625-
28=2,625) together with the increased equity value of 30,625. In total:

30,625 + 2,625 = 33,25 (NPV).

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DEBT CAPACITY

Defi itio : It’s the a ou t of et de t Dt to have constant so that target ratio is constant. In
othe o ds, it’s the e t a a ou t of de t that ou eed to take fo the p oje t.

t
Dt = d x VLt or d =
𝑉𝐿

Where d is ta get atio a d VLt is leveraged value at time t (remember that VL0 is
o ti uatio alue, ot NPV . I optio e a ple d as ½, a d Dt was 30,625.

Notice that leverage value will change over time, therefore the amount of debt would also
change.

An alternative could be to maintain a non-constant target debt level.

IMPLEMENTING A CONSTANT D/V RATIO OVER TIME

Value of the project as time goes by:

To obtain the levered value in each year: In year 0 we have to discount the free cash flows of
the 4 following years. In year 1, we have to discount the free cash flows of the 3 following
years (2, 3, 4). In year 2, we have to discount the FCF of the following 2 years (3, 4). At year 3
we have to discount the FCF of year 4. Finally, in year 4 V4L is e ause the e’s o futu e fo
the project.

Leveraged value at any t can also be computed backwards, recursively:

We calculate debt capacity with the formula: D/V = ½  D = V/2. As we can see in the table,
debt capacity is half of the levered value.

We need to reduce debt outstanding every year: negative net borrowing.

As the alue ill go do , de t should go also do to ai tai the ta get atio . That
ea s that e ha e to pa pa t of the p i ipal. The efo e, the fi do ’t pa the principal
o e o ti e, as it’s likel ith o ds. He e it keeps pa i g it as ti e goes . A d, the fi
needs cash to cancelling debt (this additional debt because of the project). This has an impact

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on the amount of interest that you need to pay. It will change over time, because it depends
o the a ou t of de t. That’s ho o tgages o ks  you keep paying part of the principal
over time and then your interest also goes down.

METHOD 2: ADJUSTED PRESENT VALUE METHOD


We need to find the unlevered value (Vu) by discount free cash flows at ru:

It can be shown that it is valid to use this equation even if there are taxes as long as company
adjusts to a target debt level.

Adjust for imperfections (in this example, only taxes):

VU is the value the firm would have if it was unlevered.

VL is the value the firm would have if it was levered.

In this case, we take into account the advantage of taxes separately e do ’t i lude it i the
formula of ru).

Computing the tax shields

The formulas that we use:

If we keep a constant leverage ratio, the tax shield has a similar risk as the project as a whole
 discount with the unleveraged WACC.

EXAMPLE RFX:

Unlevered weighted average cost of capital (WACC):

rU = 𝑥 %+ 𝑥 % = 8%
+ +

Unlevered value and tax shields:

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Value added
of tax shield

We assu e that the e a e ’t age osts o a k upt osts. The ,

SUMMARY: APV METHOD FOR INVESTMENT DECISIONS

Steps:

- Determine the free cash flows of the investment.


- Compute (pre-tax) WACC.
- Compute the value of the investment, adding the unlevered value and value of
imperfections (e.g. tax shield), both of them computed using the pre-tax WACC.
- Compute the NPV by subtracting the initial investment to the present value.
- If positi e, go ahead! If egati e, do ’t!

METHOD 3: FLOW TO EQUITY METHOD


No , e do ’t use f ee ash flo s, e use f ee ash flo s to e uit , that is the f ee ash flo s
that goes to shareholders.

Compute the cash flow available for equity holders (FCFE), taking into account:

- The interest paid on debt


- Net borrowing: Changes in net debt amounts: Dt – Dt-1
(FCFE must match the sum of dividends and repurchases)

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Here we find the actual net income, not the unlevered. So, we need to add Interest Expense
and Net Borrowing.

Net Borrowing = Dt – Dt-1

We calculate the net borrowing with the calculation we have obtained before of Dt:

ALTERNATIVE WAY TO FIND FCFE

From FCF to FCFE:

Once we have the FCFE, we can discount using the cost of equity capital to find the added
value to shareholders (=NPV):

Dividend at time 0 Equity value at time 0  increase in value of shareholders in time 0.


We can see that equity holders expect 4Itdividends
comes fromin the
the future.
increaseAnd discount FCFE at the cost
in dividends.
of equity.

This method gets us directl the NPV ho u h sha eholde s e efit of the p oje t . It did ’t
give us the value.

The NPV it’s , M. If the fi a ts to see the alue of the p oje t e ha e to add the i itial
investment of 28.

METHOD 4: CAPITAL CASH FLOW METHOD


We need to find the capital cash flows , defi ed as ash flo s a aila le fo all the se u it
holders (debt and equity), which are equal to the sum of the cash flows to equity holders and
the cash flows to debt holders.

CAPITAL CASH FLOWS (CCF)

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Cash flows to debt holders (FCFD):

Cash flows to equity holders (FCFE):

Capital cash flows (CCF) = FCFD + FCFE

Now, we have to discount them at the pre-tax WACC (8%):

Then, find the NPV, subtracting the initial investment.

NPV = 61,25 – 28 = 33,25M

AN ALTERNATIVE: INCREMENTAL EQUITY AND DEBT VALUES

From discounting FCFD with cost of debt capital, we can compute the debt value:

From discounting FCFE with cost of equity capital, we can compute the equity value:

And therefore, the enterprise value:

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Then, find the NPV, subtracting the initial investment.

NPV = 61,25 – 28 = 33,25M

CHAPTER 6. COMPANY VALUATION


Instead of valuing a project, now we are going to do the valuation of a firm that is not trading
in the market. To do it, we are going to use two valuation methods: (1) Comparables or
multiples and (2) Discounting cash flows (from the last chapter).

Valuation based on comparables

The ethod of o pa a les does ’t dis ou t ash flo s of the o pa ut o pa es ith


similar companies. For instance, they rely in the idea that firms with same sales or profits in
sa e se to should ha e the sa e alue . I pli itl uses the idea of a se e of a it age.
But, unfortunately, there are not two identical firms, so we have to figure out how to adjust
fo diffe e es i , fo e a ple, s ale. To do this, e use the " ultiples atios o a easu e of
scale) of similar firms (as when we use price/meter of similar flats to find the price of a flat).

Some examples of multiples commonly used are:


 Enterprise alue e uit + et de t o p ofits, sales,... EV/p ofits, EV/sales,…
 Price to Earnings-per-share Ratio (PER) (next slide)

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 Price to book value.


Once I have the values I will be able to use them to calculate the value of a similar firm, using
the characteristics of the firm and these multiples.

Price to Earnings Ratio (PER or P/E)

𝐸 𝑖 𝑦
𝑆ℎ𝑎 𝑒 𝑃 𝑖𝑐𝑒 𝑃 º ℎ𝑎 𝑎 𝑖 𝑔 𝑒 𝑖
𝑃𝐸𝑅 = = = 𝑖 =
𝑎 𝑖 𝑔 𝑒 ℎ𝑎 𝑒 𝑃𝑆 𝑒 𝑖 𝑐 𝑒
º ℎ𝑎 𝑎 𝑖 𝑔

The , fi ’s sha e p i e P fi = EPS of the fi PER of si ila o pa ies

Cal ulati g the PER, e a use ea i gs…


 Historical; from in the last 12 months (trailing P/E)
 Expected; for the next 12 months (forward P/E)  Best option

Assuming constant
growth of dividends:

 Industries with high


growth rates and high
payout ratios (pay lots
of dividends) have higher PER.

Multiples to calculate the enterprise value:


The value of a firm is X times the EBIDTA, and to know the appropriate X value, we calculate
the one of similar firms in order to use it for our firm.
Firm enterprise value
𝑰𝑻 𝑰 𝑻
This multiple is good for comparison because it takes into account the value of debt.

Then, to calculate the firm value: (EBIT of the firm) x (V/EBIT of similar companies).
Assuming constant growth of free cash flows:

 This will be a high multiple for companies with high


growth.

Stock prices and multiples for the footwear industry

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Limitations: People do ’t use u h this ethod fo se e al easo s:


 To hi h e te d o pa ies a e si ila ? Ma diffe e es et ee the i -max
values.
 How to adjust for differences in ,for example, expected growth? And for accounting
differences in different countries?
 Using comparables we only know the relative value to a group of companies, but we
do ’t k o hethe i dust is o e /u de alued  If comparables are overvaluated,
the values for our firm will be overvaluated too. This is a problem because, for
i sta e, high te h o e aluatio u le ould ’t ha e ee dete ted.

Helping PKK valuing Ideko


Ideko is a firm that designs and produces sports eyewear. Its founder and owner wants to sell
the company, which is unlisted (not trading on the market).
He would implement operational and financial improvements and the firm would sold five
years later.
The company has a book value of $ 87m, and the founder would sell all the equity for $150m
(market capitalization or value of equity).
What value do we assign to Ideko? After the changes, is the acquisition of Ideko a good idea for
PKK?

Income statement and balance sheet

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*Firms want to have the lowest possible working capital to be able to use the cash for other
things that give them some benefit.

Steps:

(a) Qui k look at the esulti g o pa a les :


Assuming a value of equity of $150.

Enterprise Value = Equity + Net Debt = Equity + Debt (gross debt) – Cash (excess cash) = 150m
+ 4.5m – 6.5m = 148m  value of the firm (148) < value of equity (150), due to the negative
net debt.

Conclusion: still paying 148 (a lot more than the book value of Ideko), the multiples look similar
to the
closest competitors, and this is an indication that buying Ideko would probably be a good
investment for PKK.

(b) Business plan:


- Improvement in operations
Sales forecast:
The market, as a whole, will grow at 5% annually (current size: 10m  10% market share)
Reducing administrative costs and redirecting resources to sales and marketing, Ideko market
share grows from 10 to 15% in five years.
If the olu e e eeds % e’ ll e ui e e pa sio of p odu tio apa it .
Price forecast:
The average selling price to grow by 2% per year
The cost of raw materials to increase 1% per year

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Labour costs to grow by 4% per year

- Improvement in working capital management

Reduction of the credit to customers (and inventory):

The previous table shows that Ideko owner wanted to reduce the amount of receivables and
raw material (inventory), and keep more or less the same amount of cash and finished goods.

In the following table we can see that net working capital decreases in 2006 in respect to 2005,
and this is due to these changes, but notice also that, on the following years, net working
capital will constantly increase.

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- Leveraging up: repay existing debt and issue new debt

We plan to increase leverage by borrowing a 100M loan in 2005, and this debt will have an
interest rate of 6.8%.
In addition the company will need more funds in 2008 and 2009 because of the expansion (the
big investments previously seen): in those years we ask for 20 million more.

(c) Sources and uses of funds at time 0.


With new debt issued, how much do we need to pay?

Uses of funds to purchase:


Equity price ($150m) & payment of existing debt ($ 4.5m)
In addition there will be $ 5m in transaction costs. Then the total usage of funs is 159.500
Sources of Funds:
New debt ($100m) and excess cash of Ideko ($6.5m)
The contribution required is then $ 53m  159.500 – 100.000 – 6.500 = 53.000  This is what
e PKK eed to pa as the i itial i est e t . At the e d e ill see if the a uisitio is
going to be a good investment (NPV).

(d) Find the value of the equity:


1) Use comparables to find discount rate that will allow computing the resale value in 2010.
2) Use adjusted present value method to find value in 2005
3) Find the equity value, subtracting the debt value, and compare it with price that we need
to pay for that equity (in (c)).

At time 0 PKK needs to pay 53M. We need to go from earnings to cash flows and then discount
it.

Forecasting earnings: Finding the net income (earnings).

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Calculations needed for the following table:

- Sales  Sales = Market Size x Market Share x Average Sales Price

- Raw materials calculation (same for labour costs):


Raw Materials - Market Size x Market Share x Raw Materials per Unit

- Sales & marketing costs (same for administrative):


Sales and Marketing = Sales x (Sales and Marketing % of Sales)

- Income tax  Income Tax = Pretax Income x Tax Rate

Debt allows Ideko benefit from


the tax shields.
Tax shield = difference in the
income tax due to the reduction
in the EBIT made by the interest
expenses on the debt. The higher
the debt, the higher the interest
paid on the debt, the lower the
EBIT, and so the lower the income
tax paid by the firm.
Forecasting free cash flows: From the net income we are going to calculate cash flows.

We need to add back the interest tax but discount the tax shield: to do it simple we add the
after tax interest expense.

We can observe a negative FCF in 2009 (the year of the biggest investment). Also in 2008 we
have an increase in the net borrowing of 15.000 (we have increased the debt by 15 M and 5
o ei . I o pa iso to hapte , he e e do ’t a el the de t, a tuall e i ease
it.

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Estimating the cost of capital: Based on the CAPM of comparable firms, because Ideko is
unlisted.

We want to know at which rate I need to discount the cash flows.

Remember: B expresses the correlation between earnings and changes in the economy.

U le e i g the e uit etas BE)

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BU is the risk of the risk itself without the risk coming from the debt.
BD = 0 means 0 probability of bankruptcy: how risky the debt payments are.
If we wanted, from BU we could relever and get BE for Ideko.

Ideko’s u le e ed ost of apital


Since Ideko products ...
 Are not as luxurious as those of Oakley, its sales should vary less with the economic
cycle
 The a e ot p es iptio p odu ts as Lu otti a’s
 They are fashion rather than sporty
Ideko’s eta should e a ou d . ost of apital lose to Oakle ’s tha Nike’s o Lu otti a’s
Then:

Now I can discount the cash flows. It’s i po ta t to k o that this fo ula o ks also fo BE,
and then gives us the rE.

Multiple method to estimate continuation value  What happens to the value of the firm in
2010?

Method 1: Using multiples


For example using the EBITDA we can calculate the:
Continuation Enterprise Value at Forecast Horizon = EBITDA at Horizon x EBITDA Multiple at
Horizon

Recall that we could use different multiples and get different values in consequence.

Method 2: Discounting cash flows (Adjusted present value method)

Here we assume some growth (g): If sales grow at a nominal rate g and if the proportion of
operating expenditures is constant, income will also grow at a rate g.

Continuation value in year T:

Now we have the final value in 2010 and free cash flows 2005-2010, and the discount rate. All
we needed. Now compute recursively:

Calculate the unlevered value:

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* We only discount this once because this formula is an abbreviation of the longer one (as
done in previous chapters). It is the same as discounting every year each cash flow.

Calculate the value of the tax shields:


 Discount with rD because debt is predetermined! We use the cost of debt (rD) instead of the
rU.
Why? Different debt policies (in comparison to chapter 5) lead to different tax shield risk and
consequently different discounted taxes for the tax shields.
In chapter 5 the tax shields had more risk, because as we wanted to maintain the rate fixed,
we had less control over debt. In this case (chapter 6), the debt is fixed most of the time, and
thus it’s less isk , a d thus as I ha e o e o t ol o e de t, I ha e to use a diffe e t dis ou t
rate (rD instead of rU as in chapter 5).

Estimating the equity value

Given that the initial equity cost of the purchase is $53m, the purchase is attractive:
$ −$ =$  PKK should buy Ideko!

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