CORPORATE FINANCIAL THEORY Lecture 4. Factors In Capital Budgeting & Capital Structure Decisions Market Values vs. all others Cost of Capital Competition

CORPORATE FINANCIALTHEORY

Lecture 4

Factors In Capital Budgeting & Capital Structure Decisions

Market Values vs. all others Cost of Capital Competition Bankruptcy Signaling Hypothesis Bondholder Wealth Expropriation Theory Agency costs

Topic Evolution

How To Measure Value (NPV, etc.)

Risk Return Trade Off (CAPM, etc.)

Modify Cash Flows

Scenario Analysis

Decision Tree

etc.

Modify Interest RatesWACC

APM

etc.

How To Create Positive NPVs

Past Finance Math = Easy

Today Creating Value = Hard

Smart investment decisions make MORE money than smart financing decisions

Smart investments are worth more than they cost:

= Positive NPVs

Firms calculate project NPVs by discounting forecast cash flows, but . . .

IMPORTANT CONSIDERATIONS&

QUESTIONS TO ASK

Source of Positive NPVs

Projects may appear to have positive NPVs because of forecasting errorse.g. some acquisitions result from errors in a DCF analysis

Don’t make investment decisions on the basis of errors in your DCF analysis.

Start with the market price of the asset and ask whether it is worth more to you than to others.


QUESTIONS TO ASK


Trust Market Values

Positive NPVs stem from a comparative advantage Look for comparative advantages

Strategic decision-making identifies this comparative advantage; it does not identify growth areas


QUESTIONS TO ASK


Don’t assume that other firms will watch passively.Ask --How long a lead do I have over my rivals? What will happen to prices when that lead disappears

In the meantime how will rivals react to my move? Will they cut prices or imitate my product?

Adjust your NPV calculations accordingly


QUESTIONS TO ASK

Do Projects Have Positive NPVs? Rents = profits that more than cover

the cost of capital NPV = PV (rents) Rents come only when you have a better

product, lower costs, some other competitive edge…or lower cost of capital

Sooner or later competition is likely to eliminate rents

Value Path


Comparative advantage Higher cash flows Lower COC Innovation Risk taking Good corporate governance

Other Factors in CS & CB

Signaling Hypothesis

Bondholder Wealth Expropriation Theory

Agency Theory and

Corporate Governance

Public Company Shareholders

Holdings of Corporate Equities as of 3rd quarter 2010© McGraw Hill Corp.2011

Asset Category 2005 2012 2005 2012

US Equity 40% 24% 61% 50%

Global Equity 20% 26%

Marketable Alternatives 0% 2% 11% 26%

Real Assets 6% 10%

Private Equity/ VC 5% 14%

Fixed Income 26% 20% 28% 24%

Cash 2% 4%

CalPERS Asset Allocation

Asset Category 2005 2012 2005 2012

US Equity 40% 24% 61% 50%



Real Assets 6% 10%


Fixed Income 26% 20% 28% 24%

Cash 2% 4%

Source: CalPERS 2005 Annual Investment Report, http://www.calpers.ca.gov/index.jsp?bc=/investments/assets/assetallocation.xml

Asset Category 2005 2012 2005 2012

US Equity 45% 18% 67% 36%



Real Assets 3% 14%


Fixed Income 16% 13% 24% 18%

Cash 8% 5%

CICF Asset Allocation

Asset Category 2005 2012 2005 2012

US Equity 45% 18% 67% 36%



Real Assets 3% 14%


Fixed Income 16% 13% 24% 18%

Cash 8% 5%

Source: CICF 2006 Audit Report, CICF Portfolio Review, June 30, 2012

1997 Textbook Asset Allocation Recommendation

Stocks 75%

Bonds 15%

Treasury bills 10%

http://www.cicf.org/

Role of The Financial Manager

Financial

managerFirm's

operations

Financial

markets

(1) Cash raised from investors

(1)

(2) Cash invested in firm

(2)

(3) Cash generated by operations

(3)

(4a) Cash reinvested

(4a)

(4b) Cash returned to investors

(4b)

The Principal Agent Problem

Shareholders = Owners

Managers = Employees

Question: Who has the power?

Answer: Managers

Corporate Governance

OwnerManagerSole Proprietor

Owner / ManagerPartnership

ManagerOwnerPublic Corporation

Corporate Governance (Public Cos.)

OWNERS

Fractured Limited resources Low incentive

MANAGERS

Organized Significant

resources Motivated Lobby state

legislatures

Governance Measures

Governance Measures

Corporate Governance: History

Results:1. “Anti-Investor Laws”

• Began in 1968 (Williams Act)• Peaked in1987 (CTS Corp. v. Dynamics)

2. Shareholder rights groups• Institutional Shareholder Services (1985)• Council of Institutional Investors (1985)• Activist institutional investors (CalPERS)

3. Legislative Reactions• Sarbanes-Oxley• Dodd-Frank

4. others…

Corporate Governance Research

QuestionDoes the level of shareholder rights correspond

with public company equity prices?

Corporate Governance And Equity PricesGompers, Ishii, Metrick, Quarterly Journal of Economics, Feb 2003, Vol. 118, Issue 1

Corporate Governance ResearchCorporate Governance And Equity PricesGompers, Ishii, Metrick, Quarterly Journal of Economics, Feb 2003, Vol. 118, Issue 1

Study• 1,500 publically traded

firms• 1990-1999• Governance Rating

(G-Index)• 10 Categories• “Dictatorship” to

“Democracy”

ResultsPositive G-Index

• Higher firm value• Higher profits• Higher sales growth• Efficient CAPEX• Higher Tobins’s Q

+ 11.4% per G category (up from 2.2%)

• Fewer Takeovers

Corporate Governance ResearchCorporate Governance And Equity PricesGompers, Ishii, Metrick, Quarterly Journal of Economics, Feb 2003, Vol. 118, Issue 1

• Seminal work in governance & equity prices• 517 citations in Business Source Premier

Does Delaware Law Improve Firm Value? Daines, Robert, Journal of Financial Economics, LXII (2001), 525–558.

Investor Protection and Corporate Valuation La Porta, Florencio Lopez-de-Silanes, and Vishny, Journal of Finance. June 2002, Vol. 57 Issue 3, p1147-1170.

Corporate Governance, Product Market Competition, and Equity PricesGiroud and Mueller, The Journal Of Finance, vol. LXVI, no. 2, April 2011, 563-600

Indiana & Investors

POSITIVES

LP, LLC, etc. laws Secretary of State

Online filings Investor protection

Property tax cap Lower corp. tax rates Right-to-work State fiscal health,

IEDC, etc. Higher education

NEGATIVES

Public company laws Takeover target Reduced capital

formationGovernance SuccessOld National Bank (ONB)• 99.1 Governance Score• Best governance in peer

group• Ethisphere Award• Largest Indiana public bank• Profit Margin = 17.94%• Earn. Gr. (yoy) = 59.90%• Major acquisition firm

Financial Market Functions

Source of funding Investor liquidity Risk management Source of information

Market Information Problems1. Consistent Forecasts2. Reducing Forecast Bias3. Getting Senior Management Needed

Information4. Eliminating Conflicts of InterestThe correct

information is …

Corporate Governance Problems

1. Ballot issues2. Maximizing value (whose?)3. Shareholder illusion of control and

shareholder rights4. Corporate law5. Institutional Shareholder Services

Incentives

Reduced effort Perks Empire building Entrenching investment Avoiding risk

Agency Problems in Capital Budgeting

Incentive Issues

Monitoring - Reviewing the actions of managers and providing incentives to maximize shareholder value.

Free Rider Problem - When owners rely on the efforts of others to monitor the company.

Management Compensation - How to pay managers so as to reduce the cost and need for monitoring and to maximize shareholder value.

CEO Compensation (2010)

CEO Compensation

Measuring performance

MVA EVA & Residual income Economic Income CFROI

MVA

Market Value Added

MVA = Market Cap year 2 – Market cap year 1

or

MVA = Market Cap – Book Value

Residual Income & EVA

• Techniques for overcoming errors in accounting measurements of performance.

• Emphasizes NPV concepts in performance evaluation over accounting standards.

• Looks more to long term than short term decisions.

• More closely tracks shareholder value than accounting measurements.

• EVA by Stern and Stewart out of Boston


Income

Sales 550

COGS 275

Selling, G&A 75

200

taxes @ 35% 70

Net Income $130

Assets

Net W.C. 80

Property, plant and equipment 1170

less depr. 360

Net Invest.. 810

Other assets 110

Total Assets $1,000

Quayle City Subduction Plant ($mil)



13.000,1

130ROI

Given COC = 10%

%3%10%13 NetROI


Investment Capital ofCost - Earned Income

required income-Earned Income

Income Residual

EVA

Residual Income or EVA = Net Dollar return after deducting the cost of capital

© EVA is copyrighted by Stern-Stewart Consulting Firm and used with permission.


million

EVA

10$

)000,112(.130

Income Residual


Given COC = 12%

Economic Profit

Invested Capital)(

Profit Economic

rROI

EP

Economic Profit = capital invested multiplied by the spread between return on investment and the cost of capital.

Economic Profit

$10million

1,000.12)-.13(

Invested Capital)(

rROIEP


Example at 12% COC continued.

Message of EVA

• Pros and Cons of EVA• Pros

• Managers motivated to invest in projects that earn more than they cost

• Makes cost of capital visible to managers

• Leads to reduction in assets employed

• Cons

• Does not measure present value

• Rewards quick paybacks

• Ignores time value of money

EVA of US firms - 2005

Econimic Value Added (EVA)

Capital Invested

Return on Capital

Cost of Capital

Microsoft 8,247 28,159 40.9 11.7 Johnson & Johnson 6,601 60,857 19.0 7.8 Wal-Mart Stores 5,199 109,393 10.8 5.8 Merck 3,765 32,400 18.4 7.6 Coca-Cola 3,637 18,353 25.3 5.9 Intel Corp 3,264 34,513 23.2 13.2 Dow Chemical 1,749 44,281 10.2 6.3 Boeing (67) 41,813 5.6 5.8 IBM (196) 71,196 10.5 10.8 Delta Airlines (1,413) 25,639 1.0 6.3 Pfizer (3,838) 209,293 5.8 7.6 Time Warner (5,153) 132,985 3.8 7.8 Lucent Technologies (6,279) 61,987 (0.7) 9.6

($ in millions)

Accounting Measurements

0

011 )(

price beginning

price in changereceipts cashreturn of Rate

P

PPC

Economic income = cash flow + change in present value

0

011 )(return of Rate

PV

PVPVC

CFROI(Building a better mouse trap)

• Developed by Holt Value Associates, Inc. in Chicago

• Modified NPV approach

• Basically a “decomposed” DCF model

• Utilizes objective data inputs


NCRs = Net Cash Receipts (from operations)

• are derived from sources and uses of funds statements

• Are calculated in 2 parts (existing operations & future investments) Discount Rates

Implied from market, using valuation models

Adjusted for Capital structure Non-operating Assets = Land & others

Assets operating-Non

of Value Realizable

RateDiscount 1 Value Warranted

Firm Total

NCRs


Share /Equity Common

Value Equity Common

Value Equity Total

Value Firm Total

Shares Adjusted

Interest Minority -

Stock Preferred &Debt -

Assets operating-Non

sInvestment Future

Assets Existing

Problem 1

Our company has the opportunity to invest in a project. Our initial outlay is $500. The project will yield $1200 at the end of the fourth year. Given a company cost of capital of 14%, what is the NPV of the project?

50.210500 4)14.1(1200

0

NPV

Problem 2

You are going to retire next month. An insurance agent offers to sell you an annuity which pays $20,000 per year (at the start of each year) for 15 years. Assuming a yield of 8% on the annuity, how much should you pay for the annuity?

884,184

08.108.

1

08.

12020annuity of PV 14

kk

Problem 3

If you sign an agreement today (t=0) to borrow $400 at the end of year 1, $400 at the end of year two, and repay $1000 at the end of year three, what is the interest rate you are paying? (hint: calculate the IRR)

Problem 3

If you sign an agreement today (t=0) to borrow $400 at the end of year 1, $400 at the end of year two, and repay $1000 at the end of year three, what is the interest rate you are paying? (hint: calculate the IRR)

Answer

T0 T1 T2 T3

0 + 400 + 400 - 1000

calculator return 15.83%

Problem 4

If you attempt to diversify your portfolio using BGE & Disney stock, which Portfolio, A, B, C is possible?

Risk

Return

DIS

BGE

A

B

C

Problem 4

If you attempt to diversify your portfolio using BGE & Disney stock, which Portfolio, A, B, C is possible?

Risk

Return

DIS

BGE

A

B

C

Problem 5

Based on the success of EuroDisney, Disney wishes to build two additional theme parks (SlavicDisney in Moscow, Russia and AfricaDisney in Lagos, Nigeria). Disney has a cost of capital of 14%. The company is in three industries; Movies,Theme Parks, & Consumer Products, with betas of 1.56, 1.7, and 1.2, respectively. Tbills are yielding 7% and the market return is at 15%.

What discount rate SHOULD the company use when evaluating these projects?

r = .07 + 1.7 ( .15 - .07 ) = 20.60%

Problem 6

Based on the success of EuroDisney, Disney wishes to build two additional theme parks (SlavicDisney in Moscow, Russia and AfricaDisney in Lagos, Nigeria). Disney has a cost of capital of 14%. The company is in three industries; Movies,Theme Parks, & Consumer Products, with betas of 1.56, 1.7, and 1.2, respectively. Tbills are yielding 7% and the market return is at 15%.

What discount rate should Disney use if it wishes to modernize its consumer products production facility & why?

14% because that is its borrowing rate.

Problem 7

DogDays Toy Co common stock is providing a 16% return. The company has no debt, but has a bond rating of AA (ytm=9%). Analysts feel that DogDays could add up to 30% debt without altering the required return on debt or equity. The company would like to build a plant to produce doggy basketball equipment, but the IRR is only 14% (where NPV = 0). What action can DogDays take to make the basketball project feasible?

Answer

Take on 30% debt and decrease the company’s COC.

r = 9 (30/100) + 16 (70/100) = 13.90%

Documents

CORPORATE FINANCIAL THEORY Lecture 4. Factors In Capital Budgeting & Capital Structure Decisions Market Values vs. all others Cost of Capital Competition