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Corporate Finance
MIB Program Franois Desmoulins-LebeaultChristophe BonnetSimon BrillouetEmmanuelle Saint-Supryand the finance teachers of the Accounting, Law , and Financedepartment.
Grenoble Ecole de Management
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MIB Corporate Finance- Grenoble Ecole de Management 2
What is finance for you ?
Who wants to work in finance in the future ?
Who thinks she/he will work with finance ?
What differentiates your studies & aninvestment decision ?
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MIB Corporate Finance- Grenoble Ecole de Management 3
Session 1 : The financing cycle1-Introduction to finance2-The financial cycle and value creation3-Compounding and discounting
Session 2 Investment decisions - The DCF method1-Investment decisions : DCF method, calculation of the future cash-flowsSession 3 Investment decisions - Net present value and other criteria1-Investment decisions : net present value, IRR, other criteria2-Small casesSession 4 - Exercises and cases1-Investment decisions: additional exercises and cases
CORPORATE FINANCE 1
Reading
Brealey and Myers, Principles of Corporate Finance
Class notes
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MIB Corporate Finance- Grenoble Ecole de Management 4
Session 1 : The financing resources of corporations1-The financing resources of corporations : equity and debt2-The financial marketsSession 2 - Equity1-Equity : various types of equity, how to raise equity, estimationof the cost of equity (Gordon-Shapiro model, capital asset pricing model)Session 3 Debt financing and the WACC1-Debt financing : various types of debt, how to issue debt, the cost of debt2-The weighted average cost of capitalSession 4 - Exercises and cases1-Additional exercises and cases
CORPORATE FINANCE 2
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MIB Corporate Finance- Grenoble Ecole de Management 5
Session 1 : The financing cycle
Introduction to corporate finance The financial cycle and value creation Compounding and discounting
CORPORATE FINANCE 1
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1- Introduction to corporate finance
Session 1 : The financing cycle
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MIB Corporate Finance- Grenoble Ecole de Management 7
Introduction to corporate finance
Finance relates to dealing with money and time
Concerns all economic agents:
Individuals, households
Companies
States
Finance for companies:
Cash management (treasury, banking relationships)
Control and accounting (accounts, tax,..)
Corporate Finance (financial policy, investments)
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MIB Corporate Finance- Grenoble Ecole de Management 8
Corporate finance
Investment policy
How the firm spends its money (real and financial assets)
Financing and payout policy
How the firm obtains funds (debt, equity, ) and disposes of excess cash
Valuing a firm
Introduction to corporate finance
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MIB Corporate Finance- Grenoble Ecole de Management 9
What is corporate finance about ?
Cash
Corporations need cash in order to invest in real assets. Cash isobtained by issuing financial assets (securities).
Value creationCorporations create value if the return they produce exceeds theircost of financing
Introduction to corporate finance
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Corporate finance is management, and involves
Taking decisions
Financing decisions (incl. dividends distribution)
Investment decisions
Managing information Internal information and decisions processes
External information to shareholders and other stakeholders
Competition
The companies are competing for finding financial resources
Introduction to corporate finance
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MIB Corporate Finance- Grenoble Ecole de Management 11
Objectives of the course
Being able to identify the various sources of financing available forcompanies
Being able to calculate the cost of financing (i.e.: cost of capital)
Being able to take investment and financing decisions
Introduction to corporate finance
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MIB Corporate Finance- Grenoble Ecole de Management 12
Investment decisions
At the end of 2001, GM had $18.6 billion in cash. Should it invest in new projects orreturn the cash to shareholders? If it decides to return the cash, should it declare adividend or repurchase stock? If it decides to invest, what is the most valuableinvestment? What are the risks?
Introduction to corporate finance
Financing decisions
In 1998, IBM announced that it would repurchase $2.5 billion in stock. Its pricejumped 7% after the announcement. Why? How would the market have reacted if IBMincreased dividends instead? Suppose Intel made the same announcement. Would weexpect the same price response?
Your firm needs to raise capital to finance growth. Should you issue debt or equity orobtain a bank loan? How will the stock market react to your decision? If you choosedebt, should the bonds be convertible? callable? Long or short maturity? If you chooseequity, what are the trade-offs between common and preferred stock?
Types of questions
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MIB Corporate Finance- Grenoble Ecole de Management 13
2- The financial cycle and value creation
Session 1 : The financing cycle
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MIB Corporate Finance- Grenoble Ecole de Management 14
Finance is really about value Firms Projects and real investments SecuritiesCentral question
How can we create value through investment and financing decisions ?
The financial cycle and value creation
In finance, as well as in liberal economic theory, the main goal of a companyis to maximise shareholders wealth
But the objectives and interests of the other stakeholders have also to be
taken into account: employees, suppliers, customers, state and community
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MIB Corporate Finance- Grenoble Ecole de Management 15
Balance sheet view of the firm
A company is a bundle ofassets :
brands, patents, buildings and equipment, inventories,
but also reputation, know-how, market shares,
and, before all, teams of people
In order to build / purchase these assets, a company needs financial resources
The financial cycle and value creation
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MIB Corporate Finance- Grenoble Ecole de Management 16
InvestmentsInvestments
- Customers- Raw materials
- Consumption
- Customers- Raw materials
- Consumption WealthWealth
StateState
EmployeesEmployees
CreditorsCreditors
ShareholdersShareholders
Decision
Equity
Debt
Dividends
& capital
gains
Dividends
& capital
gains
TaxesTaxes
Salary &
benefits
Salary &
benefits
InterestsInterests
The financial cycle and value creation
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FirmsOperations
A bundle ofrealassets
Financial
Markets
investors providingfinancialresources
in exchange offinancialassets
Financial
Manager
(1)(2)
(3) (4a)
(4b)
(1) Cash raised by selling financial assets to investors
(2) Cash invested in the firms operations and used to purchase real assets
(3) Cash generated by the firms operations
(4a) Cash returned to investors
(4b) Cash reinvested
The financial managers role
The financial cycle and value creation
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3- Compounding and discounting
Session 1 : The financing cycle
Time is money
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Discounting :Taking time into account
Investing is a mechanism through which a company tends to increase itswealth, but cash flows will be generated along time, in the future
Because money has a cost and can be borrowed or lend, it is moreinteresting to get a cash flow now than tomorrow
Thus it we want to compare cash flows paid or received at a differentpoints of time, we need to convert all of them at their value of today (:present value)
This operation is called discounting
Compounding and discounting
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Discounting :Taking time into account
The cost of money takes the form of a rate, applied to the sums borrowedor lent. It is the interest rate
This rate can be decomposed into its components.
The first and more obvious component is the risk premium
The second and more complex component is called the risk free rate
This notion of interest rateis at the heart of finance
Compounding and discounting
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MIB Corporate Finance- Grenoble Ecole de Management 21
Discounting :Taking time into account
There is a risk free rate because agents do massively preferimmediateconsumption to delayed consumption.
The contribution of this preference to the risk free rate is measuredthrough the inter-temporal rate of substitution.
The expected change in the value (or purchasing power) of money is theother component of the risk free rate. This is called anticipated inflation.
Each of these three elements is proportional to the length of time.
The sum of all these componentsis the interest rate andisspecificto each flow of money.
Compounding and discounting
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t = 0, 1, . , n time
V0 = present value of a cash flow (at time 0)
Vt = future value of a cash flow (at time t)
r = interest rate = cost at which money can be borrowed or lent
Vt = future value
Vt = V0 (1+r) t
V0 = present value
V0 = Vt (1+r) -t
or V0 = Vt / (1+r)t
Compounding and discounting
Time value of money
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A 1 received in the future is always worth less than 1 received today.
If the interest rate is r, then the present value of a riskless cashflow CFt received in t years is :
Time value of money
Present value =
Compounding and discounting
You have 1 today and the interest rate on riskfree investments(Treasury bills) is 5%.How much will you have in
1 year 1
1.05 = 1.052 years 1 1.05 1.05 = 1.103t years 1 1.05 1.05 1.05 = 1.05t
These cashflows are equivalent to each other. They all have the
same value.
1 today is equivalent to (1+r)t in t years
1 in t years is equivalent to 1 / (1+r)t today
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PV of 1 received in year t
Year when 1 is received
Compounding and discounting
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MIB Corporate Finance- Grenoble Ecole de Management 25
Discounting - Examples
Future value of a cash flow of 100 (Exercise 1)
Exercises 2 to 4
Case of successive cash flows over time :
Present valuePerpetuities
Growing perpetuities
Net Present Value
Exercises 5 to 9
Compounding and discounting
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Discounting : Perpetuities and growing perpetuities (Shortcuts formula)
Present Value of subsequent cash flows :
Present value of a constant perpetual cash flow (Level cashflowstream forever) :
Present value of a growing perpetual cash flow (Cashflows growby a fixed percent forever) :
r
CFPV !
grCF
PV
!
Compounding and discounting
!
!
n
1tr)(1
CF
t
tV
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MIB Corporate Finance- Grenoble Ecole de Management 27
Firms in the S&P 500 are expected to pay, collectively, $20in dividends next year. If growth is constant, what shouldthe level of the index be if dividends are expected to grow5% annually? 6% annually? Assume r = 8%.
Growing perpetuity
Discounting : Growing perpetuities (example)
Compounding and discounting
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Discounting : Net Present Value
The NPV of a cash flow stream is equal to the sum of the discounted cashflows, each cash flow having been discounted at the interest rate r
Compounding and discounting
! !
n
0tt
t
r1NPV
nt
tt 1
NPV1 r
1 1n
id
rid
r
!
!
! v
nt
t
t 0
1
NPV 1 r
1 1n
id
rid
r
!
! v
! v
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MIB Corporate Finance- Grenoble Ecole de Management 29
Your firm spends $800,000 annually for electricity at its Boston headquarters.
A sales representative from Johnson Controls wants to sell you a new computer-controlled
lighting system that will reduce electrical bills by roughly $90,000 in each of the next three
years. If the system costs $230,000, fully installed, should you go ahead with the investment?
Net Present Value : example
Compounding and discounting
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Compounding and discounting
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Compounding and discounting
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Compounding and discounting
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Compounding and discounting
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MIB Corporate Finance- Grenoble Ecole de Management 34
Session 2 : Investment decisions - the DCF Method
Investment decisions : DCF method, calculation of the future cash-flows
CORPORATE FINANCE 1
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Why would you want to invest ? to be richer
Investing is a mechanism through which an economic agent tends to increasehis wealth
The DCF method : investment decisions
As the company belongs to shareholders investing, for a company, is a wayto create wealth for shareholders
An investment decision aims at maximizing the firms value
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On which criteria are we going to take the decision to invest ?
The expected cash flows have to exceed the initial funds invested but this is not
enough, because moneyhas a cost
The expected return of the investmenthas to exceed the cost of the
financial resources
The DCF method : investment decisions
Example:
Suppose you can borrow money at a cost of 8%. You have an investment
opportunity offering a 6% return. Do you invest ?
Suppose you can borrow money at a cost of 4%. You have an investment
opportunity offering a 6% return. Do you invest ?
If the return on the investment is lower than the cost of your financial
resources, you will not create value but destroy value
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The DCF method : investment decisions
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MIB Corporate Finance- Grenoble Ecole de Management 38
A company can increase its wealth through different kinds of investments:
Industrial investments: equipment, buildings, ... to increase production
to reduce operating costs
Commercial investments: marketing, development,
to increase sales to gain market shares, brand value,
Financial investments: acquisition of other companies to improve competitive position, enter new markets
R&D: patents, know-how To create new technologies, processes, products
Staff education
Assets:
- Fixed assets- tangible- intangible- financial
- Working
Capital
The DCF method : investment decisions
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Main steps in the investment process
Operational level (project planning) feasibility study
final studies
implementation: launch
follow-up: periodic controls After decision
Financial level (role of financial headquarters) set-up profitability goals, in view of the financial market
study profitability of projects submitted by other
headquarters, according to technical, commercial,
studies elaborate financing plan if a project is accepted
provide funds on time
check that goals have been reached After decision
Before decision
Before decision
The DCF method : investment decisions
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When do you take an investment decision ?
If you need it
If you create wealth, i.e.
if the return is higher
than the cost of financing
If you have the money
Operational matters -
assumed from now on
Financial matters:
our focus
The DCF method : investment decisions
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In order to take investment decisions, we need to:
Choose a blend of financial resources for the company and calculate
their cost (cost of capital) => WACC
Financing decisions
Check if the returns of the investment projects are higher than the
cost of capital
Investment decisions
The DCF method : investment decisions
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The cost of the financial resources of the company can be calculated(WACC, or cost of capital)
The company creates value only if its investment projects deliver a returngreater than the WACC
Thus we have to compute the return of the project
And compute the consequences in terms of cash flows of the project
The DCF method : investment decisions
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1. Evaluate the costs of investment and/or disinvestment
2. Evaluate future cash flows
generated by invested funds in order to determine the economic wealthsurplus freed by the project
3. Check if this wealth is sufficient to remunerate investors: shareholders &creditors (wealth or return of the project > WACC)
The DCF method : investment decisions
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The DCF method : investment decisions
Forecasting cash flows
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Draw up a flow chart of the investment :
1. At the beginning of the project
2. During the project
3. At the end of the projects life
Money inflows
Money outflows
1
2
3
The DCF method : investment decisions
Forecasting cash flows
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The DCF method : investment decisions
Forecasting cash flows
Ignore sunk costsRemenberopportunity costsConsidermarginal costs not average costs
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The DCF method : investment decisions
Ignore sunk costs
Remenberopportunity costs
Considermarginal costs not average costs
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Investment flows:
1. At the beginning of the project:
Acquisition costs of assets
Installation / implementation costs
Marketing costs
Possible disposal of old equipment
Taxes, registration fees, tax credits,
2. During the project:
Depreciation tax shield
WCR (Working Capital Requirements), investments in operations
3. At the end of the project:
Possible disposal of used goods
Repairing and cleaning locations costs
Recovery of NWC
Cash flows
The DCF method : investment decisions
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The DCF method : investment decisions
Working capital Net working capital NWC
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Operating flows (evaluation of economic flows generated by theinvestment):
1. At the begining of the project:
No operating flow at the begining
2. During the project:
(Surplus of sales induced by the project) (incrementalexpenses to make the investment run)
including taxes on those elements
Gross operating margin of the project = EBITDA
3. At the end of the project:
Same as during the project
Cash flows
The DCF method : investment decisions
Total flows:
Sum of investment flows & operating flows from year 0 (date ofacquisition) to the end of the project
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You have the opportunity to invest in a wine distribution network. Forecasts aftermarket studies are the following :
Selling price 30
Unit cost 15
Volume: 12,000 / year
Truck purchase: 200,000 Duration: 5 years
Depreciation: 5 years, linear
Working capital requirements: 1 month of tunover
Tax rate: 30%
Fixed costs 60,000 / year
Evaluate the flows of such a project.
Example
The DCF method : investment decisions
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Investment flows :
The truck costs 200 K
On a straight line basis, the annual depreciation is 200 / 5 = 40 K peryear.
It provides a tax credit of 40 * 30% = 12 K a year.
The turnover has to be 30 * 12 K = 360 K / year
One month ofWC means that 360 / 12 = 30 K are required during thewhole project to finance inventories & customer credits. The firm willrecover those 30 K when liquidation occurs.
Example
The DCF method : investment decisions
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Investment flows:
Year 0 1 2 3 4 5
Acquisition,equipment
-200
Tax credit,depreciation
12 12 12 12 12
WCR -30 0 0 0 0 30
Investmentflow
-230 12 12 12 12 42
Example
The DCF method : investment decisions
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Operating flows:
In-flows
Sales: 30 * 12 K = 360 K / year
Out-flows:
Variable costs: 15 * 12 K = 180 K / year
Fixed costs: 60 K / year
Income tax is applied on gross operating margin, 120 * 30% = 36 K /year
The operating cash flow is then 360 180 60 36 = 84 K / year
Example
The DCF method : investment decisions
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Operating flows
Year 0 1 2 3 4 5
Turnover 360 360 360 360 360
- variablecosts
180 180 180 180 180
- fixedcosts
60 60 60 60 60
Grossoperating
profit
120 120 120 120 120
- Incometax
36 36 36 36 36
Operatingflow
84 84 84 84 84
Example
The DCF method : investment decisions
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Can I take a decision now ? No, I need to make these cash flows comparables NPV and otherdecision criteria
Year 0 1 2 3 4 5
Investment
flow -230 12 12 12 12 42
Operatingflow
0 84 84 84 84 84
Net flows -230 96 96 96 96 126
Example
The DCF method : investment decisions
Total flows
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Complication 1 : inflation
The DCF method : investment decisions
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Complication 1 : inflation
The DCF method : investment decisions
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Complication 1 : inflation
The DCF method : investment decisions
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Complication 2 : currencies
The DCF method : investment decisions
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Complication 2 : currencies
The DCF method : investment decisions
Th DCF h d i d i i
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Complication 2 : currencies
The DCF method : investment decisions
Th DCF th d i t t d i i
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Complication 2 : currencies
The DCF method : investment decisions
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Session 3 : Investment decisions - Net present value and other
decision criteria
Investment decisions : net present value, IRR, other criteria Small cases
CORPORATE FINANCE 1
I t t d i i NPV d th it i
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Decision criteria
Can we make a good investment decision with the project flow information ?
How are we going to compare different projects if we have several choices ?
We need decision criteria to check that the wealth due to the project exceeds
the required remuneration of shareholders & creditors
Investment decisions : NPV and other criteria
Decision criteria must take different deadlines into account: they must satisfythe debtors & the shareholders
Several criteria meet these requirements:
Net Present Value (NPV) Internal Rate of Return (IRR) & complementary approaches: payback
period, profitability rate,
In estment decisions NPV and other criteria
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NPV - Net Present Value
Principle
Compares the sum of the present values of a projects cash flows to
the one we would get by investing in the capital market
Process
Net present value = discounted sum of all cash flows generated bythe project
Discount rate = cost of capital
If initial investment expenses < future flows: PV is > 0, the
shareholders & creditors will get money
NPV rule: NPV > 0
NPV immediately measures the wealth surplus induced by theproject
Investment decisions : NPV and other criteria
! !
n
1tt
t0
r1INPV
! !
n
0tt
t
r1NPV
Investment decisions : NPV and other criteria
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IRR Internal Rate of Return
IRR is the rate of discount which equates the NPV of the cash flow to 0.
Shareholders required remuneration + creditors required remuneration = an overallconstraint on the firm: investment costs (= cost of capital)
The project is good only if
the wealth earned > cost of capital
The Internal Rate of Return measures the profitability of the project
How much do I get back if I invest 100 ?
Decision rule:
Project implemented if IRR > cost of capital (WACC)
0
IIPV
tt
t0
!
! !
Investment decisions : NPV and other criteria
Investment decisions : NPV and other criteria
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IRR Internal Rate of Return
Investment decisions : NPV and other criteria
Investment decisions : NPV and other criteria
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1. IRR = measurement of the profitability, so a standard (reference) isrequired : cost of capital
2. The implicit assumption of the reinvestment rate is strong
3. Possibility to have several rates when solving for IRR
4. Possible absence of IRR
5. Rate variations do not influence IRR
IRR Internal Rate of Return
Investment decisions : NPV and other criteria
Investment decisions : NPV and other criteria
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! !
PBP
1tt
t0
r1
CFI
Period at which the sum ofdiscounted cash flows exceeds the amountinvested.
Cost of capital is the discount rate Use linear interpolation to find the payback period
PBP Payback Period : How long it takes to recover the firms original investment (or howlong the project takes to pay for itself). Break even point
Investment decisions : NPV and other criteria
Investment decisions : NPV and other criteria
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PI Profitability index
Investment decisions : NPV and other criteria
Measures the relation between future wealth & the amount invested Measures the wealth created by invested
IfPI > 1, the project is profitable Useful for the comparison of projected with different durations
0I
PVPI !
Investment decisions : NPV and other criteria
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Rules for decision
Investment decisions : NPV and other criteria
A project will be accepted when
NPV of economic flows > 0
Discounted with cost of capital
IRR > cost of capital
Profitability Index > 1 Pay Back < threshold set up by the firm
NPV is the most RELEVANT: other criteria are complementary
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Session 1 : The financing resources of corporations1-The financing resources of corporations : equity and debt2-The financial marketsSession 2 - Equity1-Equity : various types of equity, how to raise equity, estimation
of the cost of equity (Gordon-Shapiro model, capital asset pricing model)Session 3 Debt financing and the WACC1-Debt financing : various types of debt, how to issue debt, the cost of debt2-The weighted average cost of capitalSession 4 - Exercices and cases1-Additional exercises and cases
CORPORATE FINANCE 2 : FINANCING DECISIONS
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Session 1 : The financing ressources of corporation
1- The financing resources of corporations : equity and debt2- The financial markets
CORPORATE FINANCE 2
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1- The financing resources of corporations : equity and debt
Session 1 : The financing ressources of corporation
The financing resources of corporations : financing decisions
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From the day of its creation, a company needs to find financial resourcesin order to be able to invest
Any kind of financial resource has a cost (similar to a renting price). Thiscost will depend on the global economic and financial conditions as well ason characteristics of the company (size, market, operating and financialrisk,)
We need to be able to select financial resources and to calculatetheir cost
The financing resources of corporations : financing decisions
The financing resources of corporations : financing decisions
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Invest in projects that yield a return greater than the minimum acceptable hurdlerate (cost of capital). (part 1)
The hurdle rate should be higher for riskier projects and reflect the financing mix used- owners funds (equity) or borrowed money (debt)
Returns on projects should be measured based on cash flows generated and the
timing of these cash flows; they should also consider both positive and negative side
effects of these projects.
Choose a financing mix that minimizes the hurdle rate and matches the assets
being financed. (part 2)
If there are not enough investments that earn the hurdle rate, return the cash to stockholders.
The form of returns - dividends and stock buybacks - will depend upon the stockholderscharacteristics.
Objective: Maximize the Value of the Firm
The financing resources of corporations : financing decisions
First principles
The financing resources of corporations : financing decisions
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There are only two ways in which a business can make money. The first is debt. The essence of debt is that you promise to make fixedpayments in the future (interest payments and repaying principal). If youfail to make those payments, you lose control of your business. The other is equity. With equity, you do get whatever cash flows are leftover after you have made debt payments.
The equity can take different forms: For very small businesses: it can be owners investing their savings For slightly larger businesses: it can be venture capital For publicly traded firms: it is common stock.
The debt can also take different forms For private businesses: it is usually bank loans For publicly traded firms: it can take the form of bonds
g p g
The financing resources of corporations : financing decisions
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In order to build / purchase assets, a company needs financial resources
Financing = finding a set of resources more or less expensive and risky for the firm
The financing decision is linked to the choice of the firms optimal financial / capital
structure
g p g
Cost of equity
Cost of debt :
InterestW
A
C
C
Return on > WACCinvestments
The financing resources of corporations : sources of funds
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Equity
Internal financing
Retained earnings
External financing
Private equity
Public equity
Debt
Bank debt
Leasing
Bonds: Publicdebt
g p
Management needs to find the appropriate financial structure for the company.
The cash flows from the projects will have to remunerate these resources.
The financing resources of corporations : sources of funds
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Sources of funds, International
g p
The financing resources of corporations : the financing mix question
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Capital structure, International
The financing resources of corporations : the financing mix question
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In deciding to raise financing for a business, is there an optimal mix of debt and equity? If yes, what is the trade off that lets us determine this optimal mix? If not, why not?
The simplest measure of how much debt and equity a firm is using currently is to look atthe proportion of debt in the total financing. This ratio is called the debt to capital ratio:Debt to Capital Ratio = Debt / (Debt + Equity)
Debt includes all interest bearing liabilities, short term as well as long term. Equity can be defined either in accounting terms (as book value of
equity) or in market value terms (based upon the current price). The resulting debt ratios can bevery different.
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2- The financial markets
Session 1 : The financing ressources of corporation
The financing resources of corporations : financial markets
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Primary market :
As a primary market, its main function is to enable business to raise new capital byissuing shares to new shareholders or to existing shareholders or to the issue of loancapital or debentures.
Contract and cash flow between company and market
Direct impact on company cash
ie IPO, shares issue, bonds issue
Secondary market:
As a secondary market, the function of the financial market is to enable investors totransfer their securities (shares and loan capital) with ease.
Contract and cash flow between investors on the market
No direct impact on company cash
ie when an investor purchases shares or bonds on the market
A financial market is any mechanism for trading financial assets or securities. Frequently there is no
physical market-place. It provide mechanisms through with the corporate financial manager has access
to a wide range of sources of finance and indtruments. The financial markets acts in two importants ways :
The financing resources of corporations : financia l markets
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institutions financires
ETAT Administration mnages
Entreprises
8
7
6
5
4
3
21
March financierFinancial institutions
Companies
Financial markets
GovernmentHouseholds
The financing resources of corporations : financial markets
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Spot
Forward
option
Equities 1-
(st exch)
B s 1-
(st ck exch)
M et
M ket 1-
term
Interest rates
organized or OTCInterest rates
options
DOMESTIC
INTERNATIONAL
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Forward
1-(2)
Currency
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Euro-equities
1-2
Euro- onds 1-2
Euro-facilities 1-2
Equities options
1-2
Eurocurrencies 1
shortterm
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Session 2 : Equity
1- Various types of equity, how to raise equity.2- Estimation of the cost of equity (Gordon-Shapiro model, capital asset
pricing model)
CORPORATE FINANCE 2
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1- Various types of equity, how to raise equity.
Session 2 : Equity
Equity : various types of equity
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Equity
Internal financing
Retained earnings
External financing
Private equity
Public equity
Debt
Bank debt
Leasing
Bonds: Publicdebt
Equity : various types of equity
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Internal financing (retained earnings)
Principle:
Retained earnings are earnings from past projects which have not beenreinvested nor distributed as dividends
Advantages
the firm is independent
less costly because no financing process outside the firm Limits
Taxation
Available liquidity = previous net incomes = gross income already taxed
Tends to delay the implementation of projects : firms rarely have the totalamount required by the investment
Equity : various types of equity
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External equity financing (increase in equity)
Principle
The company offers new shares in exchange of cash
Shareholders provide cash since they expect future profits
An increase in equity can be done with either existing or new shareholders
The process and costs differ whether the company is public or private
Advantages
Investors are ready to invest in attractive companies / projects
The firm is not obliged to distribute dividends in case of difficulties
Limits
Dilution of existing shareholders Possible loss of control (issue for family firms)
Take over risk for public companies
Cost, information, minimal size,...
Equity : various types of equity
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External equity financing (increase in equity)
Each equity investor (shareholder) is owner of the company and of itsinvestment projects, pro rata to its contribution
Shareholders have the right to participate to key decisions and to participate toprofits
Decisions are taken at majority during shareholders general meetings
Dividends may be distributed, but with no certainty
Shareholders expect a return, but this return is not fixed, nor guaranteed. Thereturn comes from dividends and/or capital gain.
Equity : how to raise equity ?
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Private companies are not listed on a stock market, which implies limitationson liquidity and on information
They are owned by:
Founders, managers, business angels, families
Private equity funds (venture capital, LBOs)
Why are they private?
Choice of he shareholders
Inability to be listed : small, young, risky,
Examples: Bertelsmann, Memscap, Legrand
Private equity
Equity : how to raise equity ?
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Public equity
Public companies are listed on a stock market. Their shares arenegotiable (liquid)
Evolutions since the 80s:
more funds
more markets (segmentation: size, technology)
more public companies
increased power of institutional investors (corporate governance)
International integration (ex: Euronext)
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2- Estimation of the cost of equity (Gordon-Shapiro model,capital asset pricing model)
Session 2 : Equity
Equity : the cost of equity
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For the shareholders of the firm :
An investment project aims at increasing their wealth: they expect areturn
For the managers of the firm:
An investment project should provide, at least, the return which investorsexpect
The return expected by shareholders is the cost of equity
Evaluating the cost of equity is not straightforward because the returnshareholders will finally get is uncertain and based on the future (which is notthe case for debt)
Investors being considered as rational, we can suppose they will base theirexpectations on:
Future growth in earnings
Risk
Equity : the cost of equity
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The cost of equity can only be estimated.
The basic methods are :
Dividend approach : future growth in dividends Based on future growth in dividends, i.e. future long term economic
growth of the company Cf. ch 4
Market approach : link between risk and return Link between the companys stock and markets fluctuation, i.e.
based on expected return and risk Cf. ch 7 & 8
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Cost of equity : dividend approach
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Expected rate of return
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E(Ri) = expected rate of return from
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Cost of equity : dividend approach
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Cost of equity : dividend approach
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Method for estimating the cost of equity (Gordon Shapiro, 1956):
Assumption: the dividend will grow at a constant rate g
In this case a share can be considered as an asset generating a perpetualcash flow growing annually at a rate g
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Cost of equity : dividend approach
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Advantages of the dividend approach model providing a simple way to estimate the cost of equity, based on
future growth
Limits of the dividend approach
Works only if g (growth rate) < r(cost of equity)
g assumed to be constant
infinite horizon some firms do not pay dividends (ex Microsoft until 2002)
P0 not available for private companies (need to find comparablecompanies)
Cost of equity : dividend approach
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Practical application of the method:
Observe P0, price of a share, on the market during several sessions
Calculate the mean to reduce share price volatility (i.e. deviation fromaverage)
Observe the previous dividend policy and extrapolate it into the future
Evaluate the perspective of growth of the firm and of the related
industrial sector in order to estimate gCalculate the cost of equity
Cost of equity : market approach
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Approach based on the CAPM : Capital Asset Pricing Model
CAPM: best known model linking risk & return, built in the mid 60s bySharpe, Lintner & Treynor
Basic assumptions: investors are rational, the return they expect on afinancial asset is linked to its expected risk
This method requires to analyse the risks of a project
Risk: exists because future returns are uncertain
Each financial asset has a specific level of risk. Some are risk-free (Treasurybills).
Historical observations show a link between risk and return on the long term
(see Brealey & Myers, ch.7)
Cost of equity : market approach
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The CAPM model says that the relationship between risk and return is linear:
Treasury bills are risk free (risk=0) and produce a return Rf (risk free rate)
A stock market portfolio bears a certain risk (average market risk), andproduces a return Rm (average return of the stock market)
Rm Rf = market risk premium
As Rf and Rm are observable, it is possible to draw a line linking risk and return. Thisline is called the security market line
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Cost of equity : market approach
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Cost of equity : market approach
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In a certain situation (no risk)
Cost of equity = risk free rate of the market
i.e. interest rate offered on Treasury bills
In an uncertain situation (reality)
Cost of equity = return demanded by investors =risk free rate + riskpremium
The risk premium of a specific share depends on:
the market risk premium
the specific (non-diversifiable) risk of the share ()
Cost of equity : market approach
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and non diversifiable risk
In CAPM, the is used as a proxy for the non diversifiable risk of a share
measures the volativity of a specific share returns compared to the volatility ofthe market returns
measures the sensibility of a share returns to the market returns
2
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WW!
Cost of equity : market approach
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Cost of equity : market approach
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The equation derived from the model is :
We are able to estimate the return expected by investors, ie the cost of equity,for any listed share.
E(return) = cost of equity(Rm - Rf) = market risk premium
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Examples: calculations (Brealey & Myers, Ch. 9)
Isicomp
Isicomp Utilities F : 0,5
Isicomp Technologies F : 1,7
Calculate the cost of equity of each company assuming a risk free return of3,5% and a stock market return of 7,5%
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Cost of equity : conclusions
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Equity has a cost, equal to the return expected by shareholders
The cost of equity is not equal to the yield (dividend/price), because futurecapital gains have to be taken into account
The cost of equity is linked to future growth and to the level of risk of the
share
The cost of equity is based on future expectations and can only be estimated
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Session 3 : Debt financing and the WACC
1-Debt financing : various types of debt, how to issue debt, the cost ofdebt2-The weighted average cost of capital
CORPORATE FINANCE 2
Debt financing : various type of debt
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Principle
the firm borrows cash for a certain time, at a given interest rate the firm must pay the interest and reimburse the loan (principal),
according to the terms of the contract Debt can finance a part of the project
Advantages
No dilution of existing shareholders Interests paid are tax deductible for the company In general cost of debt < cost of equity
Disadvantage
Increased risk for the company
Drain on cash-flows (but good discipline for managers?) Risk of loss by shareholders and other stakeholders if company is unableto pay its debt (restructuring, bankruptcy)
Debt financing : various type of debt
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Debt can be classified according to 3 criteria
bank debt / bonds
fixed rate debt / floating rate debt
term: short, medium, long
The firm may choose between these categories according to its needs.
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Debt financing : various type of debt
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Bonds
A bonds issue consists of debt split up in n parts (bonds), subscribed bynumerous investors and negotiable on a financial market
The term can be medium or long
The issue is generally advised by an investment bank which determinesthe conditions and markets the bonds to investors
Characteristics of a bond: Nominal value (the par)
Issue premium, redemption premium
Coupon (interest)
Redemption date(s)
Debt financing : Price of a bond
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Price of a bond =
discounted future cash flows present value of future coupons using the market rate r
price varies in the opposite way to r
P0 = price of the bond
Ck = coupon to be paid in year k
VRn = value on redemption
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Debt financing : cost of debt
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Cost of debt
The cost of debt for the company is the IRR of all cash flows (positiveand negative) generated from the borrowers point of view. Corporate tax& expenses (fees, administrative costs) have to be included
Tax has to be taken into account because interest is tax deductible forthe company, and thus generates tax savings
If there are no expenses linked to the financing, the cost of debt is simplyequal to the interest rate of the debt, after tax
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Debt financing : cost of debt
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Examples
Vision Corp. is negotiating a 5 years bank loan, with the following conditions:
amount $6 m
interest rate 6% p.a., paid annually at year end
arrangement fee $120 000, paid to the bank in year 0
repayment : $2m end of years 3, 4, and 5
The corporate tax rate ofVision Corp. is 30%
Calculate the cost of this loan for Vision Corp. What would be the cost of the loan assuming no arrangement fee?
Cost and yield of a bond: exercise Bablock (ex 17)
Debt financing : Lease
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The lease is a contract by which the owner of a good agrees to let anotherhave the use of it for a specified period of time
During the contract: the user is not theowner of the good and pays a rent that istax deductible
At the end of the contract: theuser can use a purchase option &become the owner of the good
Debt financing : Lease
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Characteristics
the user is not the owner: shift of ownership risk
in case of bankruptcy, this debt cant be demanded (not payable). Theowner can recovers the asset
easy use for the company
the asset & the debt are not reported on the balance sheet (NB:theyare in consolidated statements)
in finance leasing is considered as bank debt (accounts are corrected toreport leasing if needed)
Debt financing : Lease
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The lease creates a flows (the rent), which is tax deductible, but the
depreciation tax savings are lost as the asset is not purchased
It is possible to forecast all the cash flows related to a leasingcontract (including the loss of depreciation tax savings). The IRR ofthe cash flows gives the cost of leasing
Leasing is an alternative to debt: need to compare the cost of debtwith the cost of leasing
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2-The weighted average cost of capital (WACC)
Session 3 : Debt financing
The weighted average cost of capital (WACC)
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A company is always financed by a combination of equity & debt
Their cost are different, so we need to calculate the WACC (WeightedAverage Cost of Capital)
The WACC is the cost of the financing resources of the company WACC = weighted costs of the means used to finance the project
The weighted average cost of capital (WACC)
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DE
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re & rd = cost of equity and cost of debt (pre tax)
E = value of equityD = value of debt
T = marginal rate of corporate tax
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