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Universidad Complutense de Madrid
Facultad de CC EE y Empresariales
Grado en Economía
FINANCE
SALVADOR ROJÍ FERRARI
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• CONTENTS
• 1. Overview of Corporate Finance
• 1.1 What is Corporate Finance?
• 1.2 Forms of Business Organization
• 1.3 The Agency Problem
• 2. Financial Statements & Long-Term Financial Planning
• 2.1 Review of Financial Statements & taxes
• 2.2 Cash Flow
• 2.3 Financial Planning Models
• 2.4 External Financing and Growth
• 3. Introduction to Valuation:
• 3.1 Future & Present Value
• 3.2 Discounted Cash Flow Valuation
• 3.3 Effective Annual Rate
• 4. Interest Rates and Bond Valuation
• 4.1 Bond valuation, Features, types, and markets
• 4.2 Inflation and Interest Rates
• 4.3 Determinants of Bond Yields
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• 5. Stock Valuation• 5.1 Common Stock Valuation• 5.2 Some Features of Common and Preferred Stock• 5.3 The Stock Market
• 6. Net Present Value and other Investment Criteria• 6.1 Net Present Value & Profitability Index• 6.2 The (Discounted) Payback Rule• 6.3 The Internal Rate of Return
• 7. Making Capital Investment Decisions• 7.1 Project Cash Flow (CF): A First Look• 7.2 Pro Forma Financial Statements and Project Cash Flows• 7.3 Alternative Definitions of Operating CFs• 7.4 Special Cases of Discounted CF Analysis
• 8. Project Analysis and Evaluation• 8.1 Evaluating NPV Estimates• 8.2 Scenario and Other What-if Analysis• 8.3 Break-Even Analysis• 8.4 Operating Leverage• 9. Some Lessons from Capital Market History• 9.1 Returns• 9.2 The Variability of Returns• 9.3 Capital Market Efficiency
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• 10. Return, Risk, and the Security Market Line• 10.1 Expected Returns and Variances• 10.2 Announcements, Surprices, & Expected Returns• 10.3 Diversification & Portfolio Risk• 10.4 Systematic Risk and Beta• 10.5 The Security Market Line
• 11. Cost of Capital • 11.1 Cost of Equity• 11.2 Cost of Debt & Prefered Stock• 11.3 The Weighted Average Cost of Capital
• 12. Raising Capital• 12.1 The Financing Life Cycle• 12.2 Underwriters, IPOs & New Equity Sales• 12.3 Rights & Dilution• 12.4 Debt & Shelf Registration
• 13. Capital Structure• 13.1 Capital Structure & the Cost of Equity Capital• 13.2 M&M Propositions• 13.3 Optimal Capital Structure • 13.4 Other Models
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• 14. Dividend Policy
• 14.1 Cash Dividend
• 14.2 Does Dividend Policy Matter?
• 14.3 Establishing a Dividend Policy
• 14.4 Stock Repurchase & Stock Dividends, & Stock Splits
• 15. Other Topics
• 15.1 Short-Term Finance
• 15.2 Cash Management
• 15.3 Credit & Inventory Management
• Ross, Westerfield, Jordan
• McGraw Hill
• Corporate Finance Fundamentals, 8th edition
• Fundamentals of Corporate Finance, 9th edition
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• “In a few months, I expect to see the stock market much higher than today”
Irving Fisher
• (14 days before Wall Street crashed on Black Tuesday, october 29, 1929)
• “A severe depression such as 1920-21 is outside the range of probability. We are not facing a protracted
liquidation”
The Harvard Economic Society
(analysis offered days after the crash)
• What do the companies in these three groups have in common?
• Group A. American Motors, Studebaker, Detroit Steel, Maytag and National Sugar Refining.
• Group B. Boeing, Campbell Soup, Deere, IBM and Whirlpool.
• Group C. Cisco, eBay, McDonald's, Microsoft and Yahoo.
• All the companies in Group A were in the Fortune 500 in 1955, but not in 2011.
• All the companies in Group B were in the Fortune 500 in both 1955 and 2011.
• All the companies in Group C were in the Fortune 500 in 2011, but not 1955.
• Only 13.4% of the Fortune 500 companies in 1955 were still on the list 56 years later in 2011….
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Comparing the Fortune 500 companies in 1955 and 2011, there are only 67 companies that appear in both lists.
In other words, only 13.4% of the Fortune 500 companies in 1955 were still on the list 56 years later in 2011, and almost 87% of the companies have either gone bankrupt, merged, gone private, or still exist but have fallen from the top Fortune 500 companies (ranked by gross revenue).
Most of the companies on the list in 1955 are unrecognizable, forgotten companies today.
That's a lot of churning and creative destruction, and it's probably safe to say that many of today's Fortune 500 companies will be replaced by new companies in new industries over the next 56 years.
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1. Overview of Corporate Finance
1.1 What is corporate finance?
• It is the study of ways to answer by the Chief Financial Officer the 3 questions:
1) What long term investments should the firm take on? What (and where) real assets should the firm invest in?
It is an investment or capital budget decision. The CFO tries to:
• identify business opportunities
• Evaluate size, timing & risk of future CFs
2) Where will you take the long term financing? How should the cash for the investment be raised?
It is a financial or capital structure decision. The CFO tries to:
• Find the right mix Debt & Equity
• Find the least expensive sources of funds
• How & Where to raise the money
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3) How will you manage the everyday financial activities?
It is a working capital decision that ensures that the firm has sufficient resources to continue its operations
- How much cash & inventory to keep on hand?
- Should we sell on credit?
- What should be our short-term financing?
• Treasurer (obtain & manage the firm´s capital)
– cash management, raising capital, financial planning
• Controller (ensures that the money is used efficiently).
– Preparation of financial statements, accounting, tax obligations
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• 1.2 Forms of Business Organization
• Sole Propietorship: Own by one person.
– Unlimited liability.
– No distinction between personal & business income (for taxation)
– Limited equity to raise difficulty in raising cash
– Its life span = owner´s difficulty in transfering ownership
• Partnership. Two or more owners-partners
– General Partnership: all share gains & losses (partnership agreement)
– Unlimited liability
– Limited Partnership:
• One or more general partners run the business & unlimited liability.
• The limited partners dont run the business & limited liability: Common in real estate
– Both types have similar limitations than Sole Propietorship
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• Corporation (Co)
• It is a legal entity separate & distinct from its owners
• Can borrow money, own property, sue and be sued, enter into contracts, be a general or limited partner, own stock in another Co.
– Articles of incorporation (name, purpose, # shares...)
– Bylaws or rules describing how the Co regulates its existence
Stockholders elect the board of directors who then select the managers
The separation of ownership and management has clear advantages.
It allows share ownwership to change without interfering with operations
It allows the firm to hire professional managers
Its life is unlimited
The Co borrows money in its own name stockholders with limited liability
Due to these factors, it easier to raise cash
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• Some disadvantages of the C corporation:
• Double taxation: corporate and personal level
– an S Co: 100 or less shareholders is taxed as a partnership
– Limited Liability Company LLC:
• a hybrid of partnership and Co.
• The IRS considers it a Co unless it meets certain specific criteria
• Large accounting & law firms
• objectives might differ agency costs• ------------------------------------------------------------------------• www.business-ethics.com
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• 1.3. The Agency Problem.The Goal of Financial Management is...
• Profit maximization? Risk v profit? Short v long term? Accounting profit? Value creation?
• To maximize the current value per share of the existing stock or to maximize the market value of the existing owners´equity (not traded)
• Shareholder returns can’t give purpose to corporate life in the lengh of time a stock is held
• GE 3.5 years; Microsoft 3.5 months; Yahoo! 3.5 days!
• Sarbanes-Oxley or Sarbox Act (2002) (for listed firms)
• To protect investors from corporate abuses
• makes Co´s management responsible for the accuracy of the Co´s financial statements better internal controls
• Some Co delist or go dark higher cost of capital or join the AIM
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• The Agency Problem
• Exists whenever someone (the principal) hires another (the agent) to represent his or her interests
possibility of conflict of interest between the stockholder & management
• The cost of conflict:
– Indirect or lost opportunities (risky investments aren´t favor by agents)– Direct: 1) Unneeded expenditures & 2) monitor management actions
How closely are management goals aligned with stockholder goals?
- Related to the way managers are compensated (Stock options / markets for managers)
Can managers be replaced if they do not pursue stockholder goals?
- Related to the control of the firm (proxy fights & takeovers)
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• Chapter 2. A review. Financial Statements, taxes, and cash flow
• Balance Sheet BS
• Assets: current / fixed - tangible / intangible• Liabilities: current / long term
– Three things to keep in mind when examining a BS:
• liquidity / debt v equity / Market value versus book value
• Financial statements in the USA generally shows assets at historical cost
• For current assets, small difference, for fixed, sometimes, huge
• Some changes in accounting rules affect the book value of assets...but not its market value
• Many valuable assets (reputation, talent...) don´t appear on the BS
• The equity figure and the true value of the stock need not be related
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• The income statement IS
• Revenue when it accrues (GAAP rules) recognized at the time of sale (not collection)
• Expenses are based on the matching principle (match revenues with the costs associated with producing them)
• the cash outflow may have occured at some different time the IS figures are not representatives of the actual cash in-out flows
• A primary reason the IS contains noncash items, ie, depreciation
• Firms can vary output level by varying exp(fixed and variable), but accountants classify costs as product (COGS) & period (SG&AE), both fixed & variable
• The tax code is the result of political, not economic, forces
• There are six corporate tax brackets or marginal rates
• Average (tax bill / taxable income) versus marginal tax rate (of the extra tax if you earn an extra $)
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• 2.2. Cash Flow CF
• CF identity:CF from assets (Free CF) = CF to creditors + CF to stockholders
• It is the cash that the firm is FREE to distribute to creditors & stockholders because is not needed for WC or CAPEX
• FCF : OCF – net CAPEX – change in NWC
Operating CF = EBIT + Depreciation D – Taxes T
Accounting OCF = NI – D (avoid confusion¡¡¡¡ it considers interest)
we need to know how much of the OCF was reinvested:
Capital spending CAPEX : ending net fixed assets NFA – beguining NFA + depreciation
Change in net working capital NWC = ending - beginning NWC
• CF to creditors (bondholders) = interest paid less net new borrowing
• CF to stockholders = dividends paid less net new equity raised
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• Ratio Analysis
• Different people compute these ratios differently. Avoid confusion
• Mostly accounting figures.
• Grouped into
• 1.- S-T solvency, or liquidity measures:
– The ability to pay its bills over the short run. – Focus on current assets & liabilities– Book values & market values are likely to be similar
• Current ratio: current assets / current liabilities (in $ or times)
• It can be affected by some transactions:
• ∆ L-T borrowing ∆ current assets ∆ ratio
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• The quick or acid test ratio
• Current assets CA – Inventory) / Current liabilities CL
– Inventory is the least liquid current asset
– Book and market values are not always similar
– Large inventories are a sign of overproduction tied up in slow-moving
• Cash ratio = Cash / Current liabilities
• NWC to Total Assets
• Interval measure = CA / average daily operating costs
• Or how long the Co can operate withour another round of financing
• For newly founded firms
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• 2.- L-T solvency measures or leverage ratios
– The ability to pay its bills over the long run.
Total Debt Ratio = (Total assets (TA) – total equity (TE)) / TA
Debt – equity Ratio = Total debt (TD) / Total equity
(sometimes only L-T D / Total equity )
Equity multiplier = Total Assets / total equity
Perhaps accounts payable reflects trade practice more than debt policy
L-T debt Ratio = L-T D / (L-T D + Total equity) (aka total capitalization)
Times interest Earned or interest coverage ratio = EBIT / interest
Cash coverage ratio = (EBIT + depreciation = EBITDA) / interest
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• 3.- Asset Management, or turnover measures
• Measures how efficiently a firm uses its assets to generate sales
• We could use average or ending figures
– Inventory turnover IT = Cost of goods sold / inventory
(how fast we can sell products)
– Day´s sales in inventory = 365 / IT
– Receivables turnover = Sales / Accounts receivable
(how fast we collect on those sales)
– Average collection period = 365 / receivables turnover
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• 4.- Profitability measures (remember there are accounting figures¡¡¡)• How efficiently a firm uses its assets & manages its operations
– Profit margin = Net income (NI) / sales
– ROA= NI / TA or EBIT / TA
– ROE= Net income / Total equity
• 5.- Market value measures
– EPS = Net income / shares outstanding
– PEratio = price per share / earnings per share
– PEG = PE / expected future growth rate
(if too high –> PE is too high
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- Price / sales Ratio (for star ups)
- Market to book Ratio (focus on historical cost)
- Tobin´s Q Ratio = Market value of firm´s assets / replacement cost
The Du Pont Identity
1.- Multiply by TA
ROE = NI / TE = NI / TE x TA / TA = NI / TA x TA / TE
ROE = ROA x Equity multiplier (EM) o ROA x (1+D/E ratio)ROA = profit margen x total asset turnover
2.- Multiply by TA & sales
ROE = Sales / sales x NI / TA x TA /TE =
ROE = NI / sales x sales / TA x TA / TE
ROE = profit margin x Total asset turnover x EM = ROA x EM(EM could be considered financial leverage)
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• ROE is affected by
– Operating efficiency, measured by profit margin
– Asset efficiency, measured by total asset turnover
– Financial leverage, measured by equity multiplier
Financial statement information is used for
. Perfomance evaluation benchmark:Time trend & peer group analysis . Planning for the future (projections)
. S-T & L-T analysis by creditors & potencial investors
. The firm to evaluate suppliers and these to evaluate us to extend credit
. The custormer to evaluate if the firm will be around in the future
. Credit-rating agencies to evaluate creditworthiness
. Competitors
. M & A
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• 2.3 Long-term financial planning process (FPP)
• The six Ps= Proper Prior Planning Prevents Poor Performance
• FP formulates the way in which financial GOALS are achieved:
• Is Growth the ultimate goal?
• Dimensions of financial planning:
– Planning horizon: 2-5 years
– Aggregation: all projects are combined to determine needed investment
The FPP might require each division to prepare 3 alternative plans:
a worse case cost cutting, divestiture, liquidation
a normal case
a best case new products & expansion (detail the financing needed)
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The FPP should accomplish
- make explicit the linkages between investments & financing choices
- exploring investment & financing options for different scenarios
- develop contingency plans to avoid surprises
- ensure feasibility and consistency (coherence plans, goals & objectives)
- make managers to think about goals & priorities
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• FP model: the ingredients
• 1.- Sales Forecast is the driver factor projections
• The goal: to examine the interplay between investment & financing at different • possible sales levels
• 2.- Pro Forma Statements : Forecast BS, IS, statement of CFs
• 3.- Asset Requirements: changes in fixed assets & NWC
• 4.- Financial Requirements: dividend & stock & debt policies
• 5.- The Plug to bring the BS into balance external financing is needed
• Some Caveats:
– Rely on accounting relationships and not financial the 3 basics ingredients of firm value get left out: CF size, risk, timing
– It is an iterative process
– It is negociated between all the different parties, not the assessment of the future
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• Computerfield Co. Financial Statement
• (to see the interactions between sales growth & financial policy)
• IS BSSales $1000 Assets $500 Debt $250Costs 800 Equity 250• -------------------------------------------------------------• NI 200 Total A 500 Total 500
• Assuming all items grow at the same rate as sales by 20%
• Then, NI = $240; TA & TL+Equity = $600
• We must reconcile these two pro formas....• If NI = $240, and Equity ∆ 50 190 goes as
– Cash dividends (plug) or...– Retained earnings 250 + 240 = 490 debt must be retired to keep
TA=$600debt must be 600-490= 110 250-110= $ 140 retired (plug)
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2.4 External financing & growth (book 4.4 both editions).
Both are related
the higher the rate of growth in sales or assets, the greater the need for external financing
whether a firm runs a cash surplus or deficit depends on growth
Determinants of growth:
profit margin, dividend policy, financial policy, total asset turnover
The internal growth rate:
ROA * b / (1-ROA*b), b= plowback or retention rate
the maximun growth rate achieved without any external financing
The sustainable growth rate:
the maximun growth rate achieved without external equity financing & keeping D/E constant
ROE * b / (1-ROE*b) If total equity is taken from an ending balance If from the beginning, the g= ROE * b, if the average, another formula
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3. Introduction to valuation
3.1 Future & Present Value (chapter 5 RWJ, 9th edition)
3. 2 Discounted CF Valuation
Annuity present value = C * [1-PV factor] / r; PV factor = 1/(1+r)^t Annuity future value = C * [FVfactor-1] / r
Perpetuities PV = C/r
3.3 Effective Annual Rate EAR (annual percentage yield)
The interest rate expressed as if it were compounded once per year
v. Quoted (q) or Stated interest rate
The interest rate expressed in terms of the interest payment made each period
Ie, a rate compounded 10% semiannually it pays 5% every 6 months
$1 * 1.05^2= $1.1025 1.1025 -1= or 10.25% EAR
The quote rate is also called the Annual percentage Rate APR (q)
Ie,1.2% monthly the APR is 1.2 * 12 = 14.4%; EAR = 15.39%
Continuous compounding EAR= e^q -1 if APR (q) = 5.25% EAR= 5.39%
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loan types & amortization
Pure discount loan (T-bills)Interest-only loans (T-bonds)Amortized loans: (see chapter 6)
The borrower repays parts of the loan amount over time
- pay the interest each period + some fixed amount (principal)
- make a fixed payment each period the interest decline every period the most common way of amortizing loans & mortages
1) find out the payment C by using the annuity present value
2) Calculate the interest
3) Subtract it from the total payment C to calculate the principal portion
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• 4. Interest rates & Bond Valuation. 4.1 Bonds and Bond Valuation
• Coupon. The stated interest payment made on a bond
• Face (Par) Value. The principal amount that is repaid at the end
• Coupon Rate. The annual coupon / face value
• Maturity. The specified date on which the principal amount is paid
• Yield to Maturity YTM. The rate required in the market. Quoted as APRs• Ie, if YTM= 12%, then 6% twice a year EAR= (1+.06)^2-1= 12.36%
• Current Yield. A bond´s annual coupon divided by its price
• Discount (premium) bond sold for less (more) than face value
• Interest rate risk IRR. The risk depends on the price sensitivity to IR changes:
– The longer the time to maturity, the greater the IR risk– The lower the coupon rate, the greater the IR risk– The IRR increases at a decreasing rate– Asymmetry
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• Creditor or lender v, Debtor or borrower
Debt: Promises made by the issuing firm to pay principal when due and to make timely interest payments on the unpaid balance
(Interest is payable semiannually)
Hybrid securities:
– bond + option
– preferred= perpetual bond that pays only if money is earned tax benefit of bonds + bankrupcy benefits of stock
• S-T: < 18 months; notes < 5 / 10 years; L-T Debt > 5 / 10 (Bonds)
indenture or deed of trust:
• The written legal agreement between the corporation and its creditors
• A trustee is appointed by the Co to represent the bondholders
• Manage the sinking fund, represents the bondholders in default, and make sure the terms are obeyed
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Provisions of the bond indenture or deed of trust:
1. Terms of a bond.
Co Bonds usually have a face value of $1000
The par value (initial accounting value) is almost always = face value
In registered or bearer form (ownership is not recorded, less common)
2. Security. Classified according to
- Collateral. Any asset (usually bonds / stocks) pledged on a debt
- mortgage securities. Secured by a mortgage on the real property of the borrower (real estate), blanket (all the real property) or specific
A debenture is an unsecured bond (no pledged) in the UK, they are secured
In the UK, bonds are called treasure stock or gilds
Secured utility & railroad bonds, debenturesindustrial & financial
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• 3. Seniority
preference in position over other lenders
• Some debt is subordinated
In the event of default, they are paid off only after the specified creditors have been compensated senior / junior
4. Repayment
At maturity or before through a sinking fund (early redemption)
The Co makes annual payments to the trustee who retire a portion of the debt after a specified period of time (10 or more years)
Two ways:
buying in the market
calling in a fraction of the outstanding bond
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• 5. Call provision
Allows the Co to repurchase or call part or all of the bond issue at stated prices over a specific period
The stated call price is above the par value call premium (becames smaller over time).
For some period deferred call provision (protected)
• Make-whole call bondholders receive what the bond is worth: Yield to maturity of a T-bond + premium
6. Protective covenants
– Part of the indenture to limit actions a Co might wish to take
• limitations to dividends• limits pledging any assets to other lenders• Limits M&A• Limits sales or leases of any asset• maintain WC & collateral• furnish periodically audited financial statements
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6. Bond ratings
An assessment of the creditworthiness of the corporate issuer or....
- how likely the firm is to default and...
- the protection creditors have
Bond-rating firms:
Standard & Poor´s (S&P), Moody´s, and Fitch
Best quality: S&P AAA, Moody´s AaaSpeculative: S&P BB, B, Moody´s Ba, B
They don´t always agree. A bond´s credit rating can change
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• Types of bonds
• Government Bonds
– Most are ordinary, noncallable– No default risk– Exempt from state income taxes, but not federal¡¡¡
• Municipal notes & bonds
– Have vaying degrees of default risk– “Munis” are callable– Exempt from federal income taxes, not necessarily state taxes¡¡¡– The yield is lower, because of the tax break
• Zero coupon bonds
– For tax purposes, the issuer deducts (implicit) interest & the owner pays taxes on interest accrued (even though no interest is received)
– Some are a mix of ordinary and zero
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• Floating-rate bonds (floaters)
– Adjustments tied to an IR index with a lag to some base rate
– Its value depends on how the coupon adjustments are defined
– Some have provisions:
• a floor & ceiling or collar• redeemable at par after some specified amount of time (put provision)• Inflation-linked bonds TIPS / Treasure Inflation Protecion Securities or
linkers (principal / coupons)
Other bonds:
Catastrophe or cat bonds
Warrants: The buyer receives the right to purchase stock at a fixed price
Convertible bonds: swapped for a fixed number of shares
Income bonds: coupons are paid only if the fim´s income is sufficient
Put bonds: force the issuer to buy back the bond at a stated price if an specific event happens (the reverse of the call provision)
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• Bond Markets
• Most are traded OTC through networks of dealers
• No transparency privately negociated, but improving: corporate bond dealers are now required to report trade info through TRACE
• Small liquidity
• Bid-ask spread the price a dealer is willing to pay & take
• Quoted in 32nds 1/32 or tick. • If quoted 136:29 136 29/32136.906% face value or $1,369.06• If changed(previous day):+ 5 5/32 of 1%or 0.15625% face
value
• The convention is to quote prices net of accrued interest (clean price) but the price actually paid includes it (dirty or invoice price)
you pay more than the quoted price
• Inflation nominal v real rates
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• 4.2 Inflation & interest rates
• Nominal rate on an investment: % ∆ in the # $
• Real rate: % ∆ in the buying power
• Fisher effect:
• 1+nominal rate = (1+real rate) * (1+Inflation)
• Financial rates are almost always quoted in nominal terms
• To calculate PV:
• either discount nominal CFs at a nominal rate or discount real CFs at a real rate be consistent
• Read the articule by Altman about Junk bonds
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• 4.3 Determinants of Bond Yields
– The Term Structure of Interest Rates (TSIR)
• Shows the relationship ST – LT
• It tells us what nominal IR are on default-free, pure discount bonds (single lump sum) of all maturities or the time value of money
• Basic components:
1) Real rate or compensation for forgoing the use of money
2) the inflation premium or compensation for expected inflation
3) The IR-risk premium due to the potencial risk of loss resulting from changes in IR (IRP ∆ at a decreasing rate)
The three interact producing upward / downward sloping
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– Bond Yields & Yield Curve or the Treasure YC
• The Yield curve or plot of the yields on T-notes & bonds relative to maturity (based on coupon bond yields)
• (the TSIR are based on pure discount bonds)
• Components real rate + IR & inflation premiums
The non-Treasury bonds represent the combined effect of 3
components (real rate, inflation, IR risk) and 3 premiums for 3
extra features:
– default
– taxability
– liquidity
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• 5.1 Common Stock Valuation the Gordon model
• The required return= dividend yield + capital gains yieldk= D/P + g
• 5.2 Features of Common & Preferred Stock
• Shareholders elect directors who hire managers who hire workers….
• Shareholder rights
– Cumulative voting.
• The directors are elected all at once
• If there are N directors for election, then 1/(N+1)% of the stock + one share garantees a seat. It permits minority participation
• Some states have mandatory cummulative voting
• Its impact is minimized by staggered elections
– Straight voting.
• The directors are elected one at a time. • The shareholder may cast all votes for each member of the board
– Proxy voting: grant of authority to someone else to vote his shares
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Classes of stock
– Dual or multiple classes for control: A, B…
– Rights: to vote for directors, mergers, etc., dividends, liquidation, preemptive right (to maintain proportion in any new stock sold)
Preferred stock features
holders receive dividends & assets (liquidation) before ordinary stockholders
non voting privileges
for tax and legal purposes, it is a form of equity, but NOT for CFs debt
have a stated liquidating value, usually, $100
dividends payable are cumulative (if not paid, they are carried forward, without interest & be granted voting rights) or noncumulative (not very common)
The board can defer dividends indefinitely (common also forgo…) not debt
they have many debt features: sinking funds, credit ratings, convertible, callable
Some firms issue securities that look like preferred but treated as debt for taxes
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• 5.3 The Stock Markets consists of the
– primary market, in which new securities are originally sold to investors
• Traditional stock exchanges:NYSE-Euronext, NASDAQ, LSE, BME (Spain)
• Alternative markets: MAB, AIM, Alternext, Entry Standard
– Secondary market, in which previously issued securities are traded
• The traditional & alternative markets
• Other platforms: ECNs, Chi-X, Turquoise, Bats, internet...
– Dealer / market maker / specialist
maintains an inventory, and buys & sells at any time.
It pays the bid price and sells the ask price spread
– Broker:
– brings buyers & sellers together
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Organization of the NYSE or the Big Board
. merged with Euronext (Amsterdam, Brussels, Paris, Lisbon, LIFFE) & Arca (Archipelago Xch)
. The largest in the world: It has 1,366 members who own trading licenses
. Its 200 years old & It became a publicly owned corporation in 2006,
The NYSE Co. is listed in the NYSE¡¡¡
1) Commission brokers (members of brokerage houses)
. Execute customer orders & find the best price for the orders
2) Specialists (or market makers)
. are dealers in charge of a small set of securities
. maintain a fair market (inventoryliquidity) for their securities
. buy/sell when there are quantity disparities
3) Floor brokers help commission brokers to execute orders
. Less important because of the electronic order system SuperDOT
4) Floor traders independently trade for their own accounts on trading
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Sometimes well over a billion shares change hands in a day• The process of order flow
• NASDAQ
– Is a computer network– Has a multiple market maker system rather than a specialist system– It is almost an OTC market– Made up of the
• Global Select Market (1200) for larger and more actively traded• Global Market (1450) for large firms • Capital Market (550) for small firms
• ECN
– A website that allows investors to trade directly with each other
– Orders are transmitted to the NASDAQ: dealers & individual investors enter orders increase liquidity & competition
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6. NPV & Investment criteria
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• 6 NPV & Investment criteria
• An investment is worth undertaking if it creates value for its owners
• Capital budgeting or capital asset allocation (see slide 6)
– It is a search for investments for positive NPVs
– It becomes easier when we can compare the market price with roughly comparable investments
• 6.1 NPV or DCF
• The Profitability Index= PV CFs / Initial investment
– It may lead to incorrect decisions in comparisons of mutually exclusive investments
• 6.2 The payback rule (to break even in an accounting sense)
– Shortcomings: ignores time value & CFs beyond the cutoff, shortermism
– Advantages: many small decisions do not need detailed scrutiny bias toward liquidity free up cash for other uses quickly
• The discounted payback (to break even in an economic sense)
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• 6.3 The IRR (it doesn´t need a discount rate)
• Flaws: multiples rates of return
• Mutually exclusive investments (NPV profile)•
Investing or financing?
assumes a reinvestment rate similar to the IRR (optimistic)
CFs -100, 230, -132 TIR: 10% & 20%, mutually exclusive investments
1) You give me 1 € and I give you 1.5 € tomorrow
2) You give me 10 € and I give you 11 € tomorrow
2 generates a superior NPV; 1 generates a superior IRR it ignores scaling
Solution: to calculate the incremental IRR:
10-1= 9, 11-1.5= 9,5 Compare this IRR to the discount rate. If it is superior, then, the largest project should be carry out.
A solution: the Modified IRR (MIRR): many approaches
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• The Modified IRR (MIRR): The discounting approach
• 1. Discount all negative CFs back to the present at the required return RR
• 2. Add them to the initial cost• 3. Calculate de IRR
• CFs= -60, 155, -100 two IRRs: 25% & 33.3%
• If RR= 20% then,
• -60 – 100/1,2^2 = -129.44
• -129.44 + 155/(1+r) = 0 r= 284.49/129.44 = 19.74%
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• 7. Making Capital Investement Decisions
• .1 Which CFs are relevant?
• The incremental CFs take the project as a kind of “minifirm”» we, then, can compare it to the cost of acquiring it
Some pitfalls:
– Sunk costs: already been incurred and can not be removed
– Opportunity cost: the most valuable alternative that is given up
– Side effects. Negative: Erosion or canibalism
• The CFs of a new project that come at the expense of a firm´s existing project
• ( A positive spillover effect: An ∆ in consumables due to a reduction in prices)
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• Net Working Capital NWC: The firm supplies it at the beguinning & recovers it toward the end Current Assets – Current Liabilities
• Financing costs
– we do not include financing costs (interests, dividends, principal) - we are interested only in the CFs generated by the assets
• Other issues. We are interested in
– CFs that actually occurs, not accrued
– After-tax
We start a project evaluation with a Pro Forma or projected financial statements
Afterwords, we use the techniques described in chapter 9
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7.2. Pro Forma financial statement or projected CFs
Financial statements projecting future years´ operations
We need (quality) estimates of many quantities (see book case & 2.2)
Depreciation has CF consequences because it influences the tax bill
– Follows the modified accelerated cost recovery system or MARCS
• Every asset is assigned to a particular class with a specific tax life
• The annual depreciation: cost of the asset times a fixed %
• The market value can differ substantially from the book value
– if the market value is $3000, and the book value is 690, then we must pay taxes on the difference
– If the book value exceeds market value, then, the difference is treated as a loss, and we get a tax saving
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• 7,3 Alternative definitions of Operating CFs No covered
• 7.4 Special cases of DCF analysis
– Evaluating cost-cutting proposals buy new piece of machinery?
– Machinery cost: 80,000, 5 year-live straight-line depreciation, market value= 20,000, savings: 22,000 / year, tax =34%, discount rate= 10%
– The operating income increases by 22,000, and a depreciation of 80,000 / 5 = 16,000 / year EBIT= 22,000 – 16,000 = 6,000
– Operating CF:
– EBIT– taxes + depreciation = 6,000 – 2040 + 16,000 = 19,960
– capital spending (year 0) = - 80,000– (year 5) = 20000 *(1-0,34)= + 13,200
– CFs= -80,000 19,969 19,969 19,969 19,969 9,969 33160
– NPV= 3,860
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• mutually exclusive projects with different lives & similar benefits
• A firm must choose between two machines. The CFs are (real costs) are:
Machine A costs 500 € and 120 / year to operate. Replaced every 2 yearsMachine B: costs 600 € and 100 / year to operate. Replaced every 3 years
• WE must evaluate them with similar lives
The discount rate= 10%VA(A): 798, VA(B): 917 ¿is A better?
Equivalent Annual Cost (EAC) or annuity
We work out a cost per year for these two alternatives:
What annual amount has the same PV of costs?
PV= EAC * present value interest value factor or [1-(1/(1+R)^t)] / R we get EAC
PV annuity= VA (A)=798= annual payment x1.7355 798/1.7355 = annual payment = 459.81 €
PV annuity= VA (B)=917= annual payment x (annuity factor (3 years): 2.4869) 917/2.4869 = annual payment = 368.73 €
We should purchase B because is cheaper
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• 8.1 Project Analysis and Evaluation
• A positive NPV just means we must take a closer look...
• Projected future CFs forecasting or estimation risk assess economic “reasonableness” of the estimates. Avoid GIGO
• Potencial sources of value
– A basic principle of economics+ NPV investments are rare in highly competitive environments….
• Is our product better than that of our competition?
• Can we manufacture at lower cost?
• Can we distribute it more effectively?
• Can we identify underdeveloped market niches?
• Can we gain control of the market?
• What about potential competition?
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• 8.2 What-if Analysis
• 1st, a initial set of projections or base case
• 2nd, investigate the impact of assumptions about the future
• Put upper and lower bounds on the components of the project
• No simple decision rules. Stick to reasonable cases
Scenario
- all variables change a few values
- Worst / best cases will tell us the min / max NPV of the project by assigning the most / least favorable value to each item
Sensitivity
- one variable takes many values: To freeze all the variables except one to pinpoint which ones deserve the most attention
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Simulation
– A combination of scenario & sensitivity
– Repeat the sequence many times computer assistance
– many NPVs average value & spread
– All values are equaly likely to occur no realistic: values closer to the base scenario are more likely. New software has solved this problem
8.3 Break-even Analysis
Studies the relationship between the most important variable, sales, and profitability
Methods: 1) accounting net income is zero
2) cash operating CF is zero
3) financial NPV is zero
4) general EBIT is zero
8.4 Operating leverage / DOL
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9. Some Lessons from Capital Market History about risk & return
9.1 The historical record of returns. 2 components:
1) Income or cash received while you own the investment2) Capital gain / lost
Finance is the most readily quantifiable branch of economics
• Year-to-year historical rates of return after inflation (before taxes¡¡¡) in the USA mid 20s-90s
•T-Bills 0,6% RP: 0 SD: 3,3 T-Bonds 2,1% RP: 1,5 SD: 8,7Corporate Bonds: 2,7% RP: 2,1 SD: 8,3 Stocks SP 500 8,9% RP: 8,3 SD: 20,2Small Cap 13,9% RP:13,3 SD: 34,3
$ returns: dividend income + capital gains% returns: dividend yield D1/ Po + capital gains yield= (P1-Po)/ Po
Risk premiums RP: The excess return from an investment in a risky asset over a risk-free investment, or T-Bill
What determines the relative sizes of the RPs for the different assets...?
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• $1 invested in the USA in 1926 + investing dividends & interests it would have accumulated in year 2000 (before taxesbefore taxes):
• $6,402 (nominal) y $ 659.6 (real) Small cap• 2,586 266.5 S&P 500• 64 6.6 corporate bonds • 49 5 T-bonds• 16,6 1.7 T-bills
• BUT, if you could each month know in advance which of the two options,T-bills or S&P 500 Index between 1926 y 1996, offer a higher return, and act accordingly, then, the final nominal return before taxes would be.....
• A) $ 9,349 • B) $ 18,710• C) $ 2,300 mill• D) $ 58,098
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9.2 The variability of returns
1) We draw a frequency distribution for the returns= to count up the # of times the annual return on the portfolio falls within a each range, lets say, 10% each
2) Measure the spread of returns how volatile the return is
Variance how much the actual return deviates from the average in a typical year (standard deviation SD is the square root of the variance)
Lesson 1: Risky assets, on average, earn a RPLesson 2: Bearing risk, on average, is rewarded
Buy a stock for $100, after a year, it falls to $50, next year rises back to $100 Average return on investment?
Arithmetic average return: (-50% + 100%) /2 = 25% ¿?Geometric average return: [(1+R1)*(1+R2).....(1+Rt)]^(1/t) -1= (50%*200%) -1= 0 It is compounded over a multiyear period, It is smaller than the arithmetic
Geometric: what you actually earned per year on average compounded annuallyArithmetic: what you earned in a typical year
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• Returns are at least roughly normally distributed described by the average and the standard deviation (sd)
• Ie, if historically, the sd of returns on the large-company stocks is 20%, and the average return is 12.3%, then:
• For one sd:
• The probability that the return in a given year is in the range of -7.7 to 32.2% (12.3 +/- 20%) is 68%, or roughly, you should be outside this range in one year out of every three
• For two sd:
• There is a 5% chance that you should be outside the range -27.7 to 52.3% (12.3 +/- 2*20%)
• The historical average stock RP over a 106-year period is 7.1%.
• Nowdays is much smaller....
• There is a stability of long-run real equity returns the compound annual geometric real return on US stocks averaged 6.8% (1802-2007)
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• Coefficient of Variation:
• to standardize the sd or risk per unit of return: sd / expected value
• The probability distributions of returns pd are based on
• ex ante or ex post data
• For ex ante probabilidades, ie, variance * Prob• For ex post, historical / (n-1)
• In financial analysis, we face two sources of risk:
– 1) the risk associated with uncertain outcomes
– 2) the additional risk that results from using an incorrect pd
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• 9.3 Capital Market Efficiency
• In an efficient capital market, current market prices fully reflect available information. Three possibilities:
– Overreaction & correction– Delayed reaction– Efficient market reaction
Well-organized capital markets are efficient very small & uncommon Inefficiencies
Other markets are less efficient real estate / real asset markets
Due to competition among investors, the market becomes increasingly efficient
The investors study expectations about the firm (debt, clients, managers…) + the environment (industry, macro, international)
They are zero NPV investmentsNo arbitrage opportunities In the Long run intrinsic value = market value
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• Efficiency = a “fair” price it reflects the value of that stock given
• the information available
• Forms of market efficiency
• Strong form.
– All information, private and public, is reflected in stock prices
• Semistrong
- All public information is reflected in the stock price
• Weak form
– The price reflects the stock´s own past prices
History tells us that
prices respond rapidly to new information
the future of prices & mispricing are difficult to predict
EMH or “no free lunch” costless trading policies do not generate excess returns
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• 10 Return, risk, and the security market line
• 10.1 Expected return & variance (versus historical...)
– Select between the returns a or b:
- a) 10 m. euros
- b) 10 m euros expected according to the following conditions:
Economic state probability return
boom 1/3 20 m stagnant 1/3 10 m recession 1/3 0 m
20*1/3 + 10*1/3 + 0*1/3 = 10 m
¿which of the two options would you pick up?
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• St. Petersburg Paradox / Nicolas y Daniel Bernoulli
• Consider the following game of chance: you pay a fixed fee to enter and then a fair
• coin is tossed repeatedly until a tail appears, ending the game. The pot starts at 1$
• and is doubled every time a head appears. In short, you win 2k−1 dollars if
• the coin is tossed k times until the first tail appears.
• What would be a fair price to pay for entering the game?
• Consider what would be the average payout: With probability 1/2, you win 1 dollar;
• with probability 1/4 you win 2 dollars; with probability 1/8 you win 4 dollars etc. The
• expected value is thus
–
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An optimal portfolio: the Markowitz model
- The expected rate of return on a portfolio is simply a weighted average of the expected returns of the individual securities in the portfolio
- However the sd of a portfolio is not a weighted average of the sd of the individual securities, and each stock´s contribution to the portfolio sd is not xσ
- Portfolio risk is measured by the weighted sum of all covariances between all the assets in the portfolio
- To do so, a variance & covariance matrix is developed
73
we present data on realized rates of return for stocks W & M for a portfolio invested 50% in each
Year Stock W stock M portfolio WM ----------------------------------------------------------------------------1 10% 2% 6%2 2 10 63 9 3 64 3 9 6---------------------------------------------------------------------return 6% 6% 6%sd 4,08% 4,08% 0%
Given the same return....the risk has been eliminated¡
The returns have a correlation coefficient of -1
If the returns were similar, the coefficient woulb be +1The actual average correlation is between +0,5 and 0,7
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year stock W stock M portfolio WM---------------------------------------------------------------------1 8% 2% 5%2 4 10 73 10 -4 34 2 16 9---------------------------------------------------------------------return 6% 6% 6%sd 3,65% 8,79% 2,58%
If the returns tend to move together, then, the covariance is positive, if they move in opposite directions, then, it will be negative
If they move independently from each other, then, the covariance is zero.
Our portfolio has a covariance of -24
To compare cov, we standarize them by dividing them by the product of their sd: correlation coefficient, in our case, -0,6
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• State of Economy Probability Return A Return B Return C• ---------------------------------------------------------------------------------------• Boom 40% 10% 15% 20%• Bust 60% 8% 4% 0%
• Weights: A= 50%, B&C= 25%
• Boom/ E(R) = .5*10% + .25*15% + .25*20% = 13.75%• bust/E(R) = 5%• E(Rp)= 8,5%
• σ²(p)= .4*(.1375-.085)² + .6*(.05-.085)² = 0,0018375
• σ(p) = 5,4%
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100% A 100% B 100% A 100% B
10%
15%
8
16%
returns risks risk-return trade-offs
A
B
8 16
Expected portfolioreturn
Portfolio risk
Feasible or attainable set
Efficient frontier
M
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• 10.2 Announcements, Surprises & Expected Returns
• Lets look at why there is a difference between the actual return on an asset or portfolio and the expected return
• The return on a stock in the coming year is composed of:
– Expected return. It depends on the information shareholders have that bears on the stock
– Unexpected return. Based on the uncertainty & unexpected information
actual return= expected + unexpected return (+ or -, on average= zero) actual return= expected
An announcement = expected part + surprise
The relevant inf is already reflected or discounted in the expected return
markets are reasonably efficient in the semistrong form
News represent the surprise part of an announcement, not discounted by the market
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• 10.3 Diversification & Portfolio Risk (return & variance)
• The return on any stock traded in a financial market is composed of
– The normal or expected return by the sockholders based on information
– The uncertainty or risk due to unexpected information
Inditex increased in earnings= 19% …whereas H&M´s just 14%, Inditex stock fell 4% ¿why?
The unanticipated part of the return is the true risk. Two types:
systematic or market risk: influences a large number of assetsunsystematic or specific risk: affects a small number of assets
Total return R = E(R) + (unexpected return= market m + specific ε)
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• Diversification and Portfolio risk
• As the number of securities is increased, the portfolio´s standard deviation declines (from an average 49% to about 20%)
• Some of the stocks will go up in value because of positive company-specific events and some will go down because of negative events
• The net effect on the overall value is small cancel each other out
• The unsystematic risk is eliminated by diversification
• σ
30 # stocks
Nondiversifiable risk
Diversifiable risk
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As the unsystematic risk is eliminated by diversification,
the market will compensate investors,
not for bearing the total risk of a stock,
but
for bearing the nondiversifiable risk or portfolio risk
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To determine the optimal portfolio for a particular investor, we must know the investor´s attitude toward risk as reflected in his risk/return trade-off function or indifference curve
Expected return
Risk
A
B
Risk premium
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• A requires a higher expected return to compensate for a given amount of risk
• A higher risk aversion causes A to require a higher risk premium
• The higher curves denote a greater level of satisfaction or utility
• For any level of risk, there is a higher expected return
The optimal portfolio for each investor is found at the tangency point between the efficient set of portfolios and one of the investor´s indifference curves.
• This tangency point marks the highest level of satisfaction the investor can attain
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Expected portfolioreturn
Portfolio risk
AOptimal portfolio
∆ utility
Krf
p
Km
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If we assume that the return distribution of individual stocks follows a normal distribution, then,
the portfolio risk could be derived based on the portfolio covariances
we build a covariance matrix whose diagonal is made out of the portfolio´s variances.
To estimate all the parameters = N*(N+3) /2
or 8000 for the 125 stocks in the IGBM.
To calculate the weights of each stock requires a procedure cuadratic programming to maximize the
return, given a specific risk, or minimize the risk, given a specific return
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• 10.4 Systematic risk and beta
• There is a reward for bearing risk called risk premium• It is based on the systematic or market risk
• The expected return on an asset depends only on that asset´s systematic risk
• It is measured by Beta or β coefficient (how much systematic risk relative to an average asset)
• The average asset has a beta of 1
• Coca cola = 0.52; Yahoo! = 2.30; ·3M = .64; Google = 2.60
• Security A SD= 40%, beta= 0.50• Security B SD= 20%, beta= 1.50
• Which has greater total risk?• Systematic? Unsystematic?• Higher risk premium?• The beta of the portfolio? A weight= 40%0.4*0.5+0.6*1.5= 1.1
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• 10.5 The security market line (how risk is rewarded)
• Applied to active, competitive, well-functioning (financial) markets...
• Consider a portfolio made up of an asset A and the risk-free asset (by definition, it has no systematic or unsystematic risks = beta 0)
• We can vary the proportions between both securities, and the risk-free can be borrowed or lent
• Plot portfolio expected returns against the portfolios betas
• The slope of the line is just the risk premium RP on asset / beta
• The slope: a reward-to-risk ratio or RP per unit of systematic risk
• If we consider a second asset B, we can compare slopes
87
• The higher slope, A, will attract investors away from the lower B A´s price would rise A´s expected return would decline, and vice versa
• The buying and selling would continue until the two assets plotted on the same line same reward per unit of risk
• All assets must plot on the same line¡
• It must have average systematic risk Beta of 1
• The slope = (E(Rm) – Rf) / 1 or market risk premium
• E(Rp)
Bp
Asset A, slope= 7,5%
Asset B, slope= 6,67%
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• The Capital Asset Pricing Model CAPM
• If we let E(Ri) and βi stand for the expected return and beta on any asset, then, we know that asset must plot on the SML...
• Also, a market portfolio made up of all the assets with systematic risk or Bm= 1 slope = E(Rm) -Rf / 1 or market risk primium
• Therefore (E(Ri) –Rf) / Bi = E(Rm) – Rf, rearrange this...
• E(Ri) = Rf + [E(Rm) – Rf] βi
E(Rm)
Bm = 1
E(Rm) -Rf
The slope = market risk premium
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• The SML and the cost of capital
• Any new investment must offer an expected return that is no worse than what the financial markets offer for the same risk
• It must have a + NPV
• What is the appropiate discount rate?
• The expected return offered in financial markets on investments with the same systematic risk
• We compare expected return on investment to what the financial markets offer on an investment with the same beta
• This return is the minimum an investment must offer to be attractive
• It is called the cost of capital associated with the investment
• It is an opportunity cost
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• Chapter 11, cost of capital
• The return an investor receives is the cost of that security to the company that issued it
• Required rate of return = appropiate discount rate = cost of capital
• The cost of capital of an investment depends on its risk
• It depends on the use of the funds, not the source (how & where)
• The cost of equity (Re) o return equity investors require • two approaches (based on the past):
– The dividend growth model approach. It is simple...but
it needs dividends Re is too sensitive to the growth rate g
no explicit risk is considered
– The SML approach: it uses implicit risk, & no dividends needed– But...it needs the market RP and Beta
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• 11.2 The costs of debt (Rd)....
• Is the return the firm´s creditors demand & firm must pay on new borrowing
• If the firm already has bonds outstanding, then
– the yield to maturity is the market-required rate on the firm´s debt
– If we know the rating, we can find the IR on newly issued bonds,
• Cost of preferred stock (Rp) It is a perpetuity Rp = Div / price
• 11.3 The Weight Average Cost of Capital WACC
• The overall return the firm must earn on its existing assets to maintain the value of its stock
• E= market value of Equity, # shares outstanding x price per share
• D= market value of Debt, Tc = corporate tax rate
WACC = (E/V) Re + (D/V) Rd(1-Tc),
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• The interest paid by a corporation is deductible for tax purposes • • we could add (P/V)Rp or cost of preferred stock...and flotation costs...
• Do not use WACC as a cutoff for investments
• sometimes different projects / divisions have different betas.
– Use a WACC based on companies in similar lines of business
– Use a subjective adjustment
Flotation costs.
If we assume the firm uses a target capital structure, we have to
- factor in the flotation costs for each of the amounts of D & E raised
- the NPV is compared with this amount to see if the project is feasible
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• Chapter 12 Raising Capital
• A basic reason shareholder returns can´t give purpose to corporate life is the length of time a stock is held...
• GE= 3.5 years
• Microsoft= 3.5 months
• Yahoo!= 3.5 days¡
• Can such “customer” serve as the proper focus for the • corporate strategy?
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• 12.1 The Financing Life Cycle: Early-Stage Financing & Venture Capital VC
The term Private Equity labels equity financing for nonpublic firms
VC firms specialize in pooling funds from various sources
provide financing in stages contingent on specified goals being met:
- ground floor or seed money (step 1: to get a prototype)
- mezzanine-level (step 2: manufacturing, marketing, distribution)
They participate in running the start-up firm due to their general business expertise:
- financial strength & resources - involved in operations & decision making, - good referrences & contacts with suppliers, customers, etc., - specialization,
Exit strategy is key, also VC is very expensive
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• 12.2 IPOs - Selling securities to the Public
• Steps:
– Approval from the board of directors
– Registration statement about financial information and file it with the SEC except
• loans that mature within 9 months• less than $ 5 million (regulation A, with less requirements)• A private issue (fewer than 35 investors)
– Preliminary Prospectus (red herring) given to potential investors
– The Registration is effective on the 20th day after its filing
– That day a price is determined & selling effort gets under way, along with a final prospectus
– Tombstone ads are used by underwriters (investment banks) during & after the waiting period
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• Two types of public issues:
• Rights Offer: securities are initially offered only to existing owners.
(uncommon in the US)
General Cash Offer: offered to the general public
Inicial public offering IPO The first public equity issue
Seasoned equity offering SEO a new issue for a company with securities that have been previously issued
Underwriters (investment firms) buy the securities for less that the offering price (the gross spread). They form a Syndicate. They performe the following services:
- formulating the method used to issue the securities - pricing the new securities- selling
97
• Types of Underwriting
• Firm Commitment. The issuer sells the entire issue to the underwriters, who then attempt to resell it. The most common.
• Best Efforts. Beyond this, the underwriter does not guarantee any particular amount. Uncommon.
• Dutch (or Uniform Price) Auction Underwriting. The underwriter conducts an auction in which investors bid for shares. Very common in bond markets
• The Aftermarket: the period after a new issue is initially sold
• Green Shoe Options. Gives the underwriters the rights to buy additional shares at the offering price to cover overallotments (15% of the new shares)
• Lockup Agreements: How long insiders must wait after an IPO before they can sell their stock, usually, 180 days.
• The Quiet Period. The SEC requires a quiet period (40 days) = all communications are limited to ordinary announcements (no extra infor) logic: all relevant information is contained in the prospectus
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IPOs and Underpricing
If the price is too high unsuccessful & withdrawn
If the price is too low the existing shareholders experience an opportunity loss
& the new ones earn a higher return
The 1999-2000 experience a lot of underpricing The 1975-2007 average 17.2%
the degree of underpricing & # IPOs is highly variable through time cycles
Atributable to small, highly speculative issues
Why does it exist?
The average investor don´t get shares in a successful offering…..
To attract the average investor & avoid to be sued underprice new issues
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• New Equity Sales
Abnormal returns. On announcement of a seasoned issues, the existing stock drops on average 3%
Why?
1. Managerial information: to issue stock when overvalued
2. Debt usage: it may reveal too much debt or too little liquidity
3. Bad signal: if the project is good…. why should the firm let new
shareholders in on it?.... better issue debt
4. Issue cost
100
• The cost of issuing securities
• Gross spread. Direct fees paid to the underwriter or spread (7% average) between the price the issuer receives and the offer price
• Other direct expenses. Filing & legal fees, taxes
• Indirect expenses. Management time
• Abnormal returns. Existing stock drops on average 3%
• Underpricing. IPO´s lower price
• Green Shoe Options. Gives the underwriters the rights to buy additional shares at the offering price to cover overallotments
• There are economies of scale & Debt issues are less expensive
101
• 12.3 Rights
• If a preemptive right is in the corporation the firm must offer any new issue to existing shareholders
• Each shareholder is issued rights to by a specified number of new shares at a specified price & time
• The rights are traded in securities exchanges or OTC. Rare in the USA
• Cheaper than cash offers
• No underwriter needed
• If the stock is sold before the ex-rights date – the rights on-, the new owner will receive the rights
• It goes ex-rights two trading days before the record date or last day
• Shareholders can exercise their rights or sell them: he will not lose or win because of the rights offering
• The new market price of the stock will be lower than before the offeringit is like a stock split & the subscription price is arbitrary
102
• Dilution
• Loss in existing shareholders´value in terms of dilution of:
– Ownership. Avoided by using a Rights Offering
– Market value MV & book value BV
• If MV< BV and ∆ # shares EPS go down
• Three dilutions: Accounting, market, ownership
• Market dilution ONLY occurs if the project´s NPV is negative (and MV>AV)
12.4 Debt Issuing Public L-T Debt. Similar procedures:
Direct Private L-T Debt Financing (term loans & private placements)
- dont require SEC registration
- more restrictive covenants
- life insurance companies & pension funds dominate the segment
103
• Direct Private L-T Debt Financing. Two types:
Term loans. Direct business loans: 1-5 years
Private placements. The maturity is longer
• Shelf Registration (for Equity & Debt)
– A relaxed registration process that applies to well-known, seasoned issuers
– The firm can fulfill all registration-related procedures beforehand and go to market quickly when conditions become favorable.
– Allows a Co to register all issues it expects to sell within two years
– It uses a dribs & drabs or step by step method
– Rated investment grade & MV > $150 m
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• 13. 1 CAPITAL STRUCTURE POLICY (no taxes¡)
• Capital restructuring decisions in isolation from its investment decisions
• Management should try to find the capital structure (the target) that maximizes the firm or minimizes WACC
• The effect of Financial leverage depends on the company´s EBIT
• Under leverage, the higher the EBIT, the higher ROE & EPS (p. 511)
• Under leverage, shareholders are more exposed to risk because ROE & EPS are more sensitive to changes in EBIT
• Because of those factors, is capital structure a key consideration?
• It depends on homemade leverage:
• the use of personal borrowing or lending to change the overall amount of leverage so, the answer is NOT....see page 514 & table 16.5
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• If Kd < ke it does NOT mean it is always attractive va• €1 mill; Ke= 12%, Kd= 8% • Investment Equity 100% 50%• EBIT 150,000 150,000• Interest 0 40,000• Net Income 150,000 110,000• ROE 15% 22% = 15 + (15-8)• ROI 15% 15%
• ROE = ROI + (ROI-Kd) D/E If the net income is different & % D changes ROE is also different: (try D=75%36%)
• If EBIT= 0 & 100% Equity ROE= 0; 50% Equity; ROE -8%
• If EBIT= 200,000 & 100% Equity ROE=20%; 50% Equity 32%• (see financial leverage, next slide)
• You can observe a greater variability with ROE than with ROI (no leverage) ∆ Debt
• Explicit cost in terms of a larger Kd (not under MM)
• Implicit cost in terms of a larger Ke
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• Total assets: $ 200,000 • Stock price: $ 6,25
• Plan A high levered Plan B low levered
• Debt (8% ) 150,000 50,000• Equity 50,000 150,000• Total assets 200,000 200,000
• Two settings EBIT: 12,000 & 36,000
• Degree of financial leverage or DFL?
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• 13.2 M&M Proposition I: The Pie Model
• If the assets and operations are the same: 40% E – 60% D or 60% E – 40% D
• The size of the pie (the value of the firm) doesn´t depend on how it is sliced
• M&M Proposition II
• WACC= Ra= E/V * Re + D/V * Rd Rel= Reu + (Reu-Rd) * D/E
Cost of capital Re
Ra
Rd
D/E
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• Proposition II: Ra is the required return on the firm´s assets & it depends on the operating activities.
• Its risk is the business risk
• (Ra-Rd) *D/E is determined by the financial structure.
• Its risk is the financial risk debt financing ∆ the risks borne by the stockholders the required rate of return rises
• Both risks together the systematic risk
• M&M I & II with taxes & bankruptcy
• Interest paid is tax deductible
• Failure to meet debt obligations can result in bankruptcy
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• Interest tax shield. The tax saving from interest expense
• PV = Tc (tipo impositivo) * D * Rd /Rd (assuming a perpetual debt)
• Proposition I: Vl = Vu + Tc * D (l= levered, u= unlevered)
• WACC: Proposition II: Rel = Reu + (Reu- Rd)* (D/E) * (1-Tc)
Vl= Vu + Tc*D
Vu
D
Value of the firm
Re
Ru
WACCRd(1-Tc)
Cost of capital
D/E
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• MM with corporate taxes
• Ebit: $ 4 mill (no-growth situation), T: 40%, the firm pays out all its income as dividends, Kd= 8%, constant; Ku= 12%
• Vu= ebit (1-T) / ku = 4 mill / 0,12 = $20 mill
• With $10m debt Vl = Vu + Tc *D= 24m
• Equity E = V –D = 14m
• kl= ku + (ku-kd) * (D/E) * (1-Tc)• kl= 12% + (12% - 8%)*10m/14m*0.6= 13,71%
• WACC ka = (D/V)*kd(1-T) + (E/V)Kl• WACC ka = (10m/24m)*8%*0.6 + (14m/24m)* 13.71%= 10%,
• alsoKa= ebit(1-T) / V = 4 mill * 0.6 / 24 = 10 mill
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• Bankruptcy & Financial Distress Costs
• In principle, a firm becomes bankrupt when the value of its assets equals the value of its debt
• the value of equity is zero D = Assets economically bankrupt, but......
• ....Turning over the assets to the bondholders is a legal process, not an economic one.
– direct bankrupcy costs: legal & administrative
– indirect bankrupcy costs: cost of avoiding a bankruptcy filing normal operations are disrupted
– The possibility of loss that limits the amount of debt used
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• 13.3 Optimal Capital Structure CS
• The static trade off theory of capital structure no changes
– Firms borrow up to the point where the tax benefit from an extra $ = the cost in terms of probability of financial distress
– But...firms with losses, or with other tax shield sources, ie, depreciation, get none or little shield
– Also, firms with greater volatility in EBIT or intangible assets get debt at higher cost
V
D
Vu
Vl= Vu+Tc*DFinancial distress
cost of capital
D/E
Re
RuWACC
Rd
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• What is irrelevant, M&M or the capital structure?
• 13.4 Other models (besides MM, trade-off)
• (1) The Extended Pie Model
– Taxes & bankruptcy costs represent claims on the CFs
– The value of the government claims (taxes) decreases with leverage
– The value of bankruptcy claims rises with leverage
We can add slices to the pie, also, their sizes change
The essence of the MM intuition
the value of the firm depends on the total CF
But, the capital structure just cuts the CF up into slices without altering the total
The claims by share & bondholders are marketed claims
The ones by the government and litigants are nonmarketed
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The total value = marketed + nonmarketed claims (unaltered by capital structure)
The value of the marketed claims may be affected by changes in the structure
∆ in marketed claims implies an identical - ∆ in the nonmarketed
The optimal structure:
the one that max the value of marketed claims & min the nonmaketed
• Financial institutions are strongly levered due to:
– Benefits are less volatile– Watched by the central bank– No fiscal shields – Deposit insurance that reduces risks
Many CFOs select:
– First, a specific credit rating. – Second, the structure that better fits that rate
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• (2) The Pecking-Order Theory
• Firms prefer to use internal financing first
– If the stock is undervalued (a new project) dont sell it too cheaply
– If the stock is overvalued send a signal to investors the price falls
– There are extra expenses to raise capital externally
– No target capital structure
– Profitable firms (generally) use less debt
– Firms want financial slack or cash reserve
– It is applied to short-run, tactical issue of raising funds
(versus the trading off model, applied to long-run target capital goals)
Wide variation across industries: drugs & computers v. airlines & cable TV
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• A Quick Look at the Bankrupty Process
• Financial distress can be defined as:
– Business failure a terminated firm with a loss to creditors
– Legal bankruptcy a legal proceeding for liquidating (chapter 7) or reorganizing (chapter 11)
– Technical insolvency unable to meet its financial obligations
– Accounting insolvency negative net worth book liabilities > book assets
The absolute priority rule for the proceeds of the liquidation:
1. Administrative & legal expenses associated with the bankrupty2. Wages, salaries3. Contributions to employee benefit plans4. Consumer claims5. Governments tax claims6. Payment to unsecured creditors7. Payment to preferred stockholders8. Payment to stockholders
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• 14.1 Dividends & dividend policy
• Should the firm pay out money to its shareholders, or should the firm invest it for its shareholders?
• It is a payment made out of a firm´s earnings to its owners• It can be regular, extra, special, & liquidating• Expressed in terms of 1) $, 2) % of market price, 3) % of net income
• A chronology:
– Declaration date: the board of directors passes a resolution– Ex-dividend date: two business days before the date of record– Date of record: date of recorded shareholders (designated to receive it)– Date of payment
If you buy the stock two days before date of record, then you´ll get the Dividend
When the stock goes ex-dividend, then, we expect the value of the stockwill go down by about (because of taxes) the dividend amount
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• 14. 2 Does dividend policy matter?
• Dividend policy is the pattern of dividend payout
• 1) The irrelevance of dividend policy
– Any increase in dividend is offset by a decrease somewhere else (CFs, sell new stock, debt...). The PV of the dividend stream is unchanged (in theory)
– Homemade dividend policy. Some corporations offer automatic dividend reinvestment plans (ADRs or DRIPs)
2) Factors favoring a low payout
Taxes (see article # 1). Since 2002, 5%, (from january 1st, 2011, 39.6%¡¡¡)
Capital gains are deferred until the stock is sold
Flotation costs (equity & debt)
Bond indentures with covenants prohibiting ∆ dividends
The reinvestment by the firm increases the value of the equity
If the firm has excess cash The correct dividend policy will depend on the individual & corporate tax rates
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• 3) Factors favoring a high payout
• The desire for current income through the homemade dividend argument
– if low payout, sell stock, but there are brokeage fees and transaction costs
• Investors with substancial current consumption needs will prefer high current dividends
• A high payout resolves uncertainty Gordon´s bird-in-hand
• Many investors don´t receive an unfavorable tax treatment:
– Corporate investors are granted a 70% dividend exclusion, but not capital gains or interest on bonds
– Pension, endowment, & trust funds are in the zero tax brackets
BUT, stock prices react to unanticipated changes in dividends
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Information content effect
Based on expectations.
An ∆ signals to the market that the firm is expected to do well (not because of a ∆ payout policy) & vice versa
The clientele effect
Different investors desire different levels of dividends
It is a supply / demand argument until a dividend market is in equilibrium
If many investors like high dividends.....
can a firm boost its share price by rising the dividend payout ratio?
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14.3 Establishing a dividend policy
The residual dividend approach:
After meeting its investment needs while maintaining a desired D/E ratio
it can become an unstable`policy
A compromise dividend stability:
Avoid cutting +NPV projects, dividend cuts, sell equity
Maintain a target D/E & dividend payout ratios
To avoid instability, create two types of dividends: regular & extra....
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• 14.4 Stock Repurchase
• 3 ways: open market, tender offer (existing stockholders), targeted purchase (specific stockholders)
• It is an alternative to cash dividends both are essentially the same thing. But if there are taxes & other imperfections...
• If dividends paid: stock price & PE fall, EPS doesn´t change• If repurchase: EPS goes up, PE is similar to dividend´s
• Net equity sales in the US have been negative in some years
• Under current tax law, a repurchase has a significant tax advantage:
– A dividend is fully taxed as ordinary income
– In a repurchase, the investor pays taxes only if sells & on the capital gain on the sale, whereas a dividend pays as ordinary income
• The IRS does not allow a repurchase to avoid paying taxes
• Corporations smooth dividends avoid uncertainty
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• Stock dividend & stock split
– They ∆ # shares outstanding....diluting its value accordingly
– The stock dividend is expressed as a percentage
– The stock split is expressed as a ratio: three for two one extra for two
– The accounting treatment is different:
• a stock split affects the par value & # shares outstanding
• A stock dividend affects # shares outstanding & retain earnings
• for small dividends (less than 25%), it affects capital in excess of par value
In theory, stock dividends & splits should leave the value of the firm unaffected
liquidity? Trading range (to buy a round lot)?
For every share of Microsoft in 1986 you would own 288 shares today
Reverse splits: one for four four old shares for one new respectability?
Some exchanges delist companies under $1 price share
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• 15.1 Short-term Finance STF
• Net working capital NWC = CA – CL
• The primary concern in STF is the firm´s short-run operations and financing activities that create patterns of cash inflows & outflows
• The typical operating cycle.
– The period it takes to acquire inventory, sell it (inventory period), and collect for it (accounts receivable period)
– It describes how a product moves through the current asset accounts
The account payable period:
The time between receipt of inventory and payment
The cash cycle:
The time between cash disbursement and collection it depends on the inventory, receivables, and payables periods
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Calculating the operating & cash cycles already studied in accounting?
Inventory purchased
Inventory sold
Inventory period Accounts receivable period
Accounts payable period
Cash cycle
Cash paid for inventory
Cash received
Operating cycle
Cash flow time line
Some firms have negative cash cycles.(Amazon, 50 days, Boeing, 77 )....
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• The longer the cash cycle, the more financing is required
• The gap between S-T inflows & outflows can be filled either by borrowing or by holding a liquidity reserve (marketable securities)
• The S-T financial policy that a firm adopts will be reflected in at least two ways:
• A flexible policy would maintain:
– a high ratio of current assets to sales – less S-T debt and more L-T debt– a higher level of liquidity / NWC
It is costly, but future CFs are expected to be higher ie, liberal financing
• A restrictive policy would maintain
– a low ratio of current assets to sales – more S-T debt and less L-T debt
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• Managing current assets
• Involves a trade-off between costs that increases or decreases with ∆ current assets
– carrying –opportunity- costs
– shortage costs
• cashout, stockout, lost customer goodwill• brokerage costs
Current assets
$
Shortage costs
Carrying costs
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• A compromise financing policy
• The firm borrows in the short term to cover peak financing needs, but maintains a cash reserve during slow periods....
$
time
Flexible policy
Compromise policy
Restrictive policy
Marketable securities Short-term financing (borrowing)
Growth in fixed Assets & permanent Current assets
seasonal variation
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• The Cash Budget
• A forecast of cash receipts and disbursements for the next planning period (see exercise)
• Short-term borrowing
– Unsecured loans
• A line of credit. The firm is authorized to borrow up to a specific amount
• A revolver. Similar for lower periods
• Committed lines of credit are more formal legal arrangements
• Compensating balances. Money kept by the fitrm with a bank in low-interest bearing accounts as part of a loan agreement (2-5% of the amount borrowed
• Letters of credit. The bank issuing the letter promises to make a loan if certain conditions are met (the international goods arrive as promised)
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• Secured loans
• Accounts receivable financing involves
– Assigment: the lender has the receivables as security, but the borrower is still responsable
– Factoring. The receivable is discounted and sold to the lender
– Credit card receivable funding: A portion of each credit card sale is routed to the factor until the loan is paid off
• Inventory loans (to purchase inventory)
• Commercial paper. Issued by large, highly rated firms. Backed by a special line of credit
• Trade credit. To increase the account payable period. Expensive
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• 15.2 Cash Management
• A cash balance must be maintained to provide the liquidity necessary for transaction needs: paying bills
• Holding cash + marketable securities (cash equivalents) has an opportunity cost
• Cash managementoptimizing mechanisms for collecting and disbursing cash
• Float:• The difference between book cash and bank cash, representing the
net effect of checks in the process of clearing
• Two types: A firm´s payment generate a disbursement float, and its collection activities generate collection float
• The net effect or the sum of both is the net float
• Electronic data interchange has reduced float to the limit
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• 15.3 Credit and Inventory Management
• Credit
• Offering credit is a way of stimulating sales, but there are costs:
• Carrying the receivables (trade & consumer) & not been paid
• Components: terms of sale, credit analysis, collecting policy
• The optimal amount of credit is determined by the point the ∆ CFs form ∆ sales are equal to the ∆ costs of carrying the ∆ in investment in accounts receivables
• Firms with excess capacity, low variable operating costs, repeat customers extend credit more liberally
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• Inventory Management
• It has become an increasingly important specialty in its own right
• A firm´s operating cycle is made up of its inventory period and receivables period
• Inventory costs:
– Carrying costs: storage & tracking costs, obsolescence, theft, opportunity cost of capital
– Shortage costs: restocking costs & costs related to safety reserves
There is a trade-off between both
Inventory Management Techniques:
ABC, Economic Order Quantity Model, Derived-Demand Inventories
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• Economic Order Quantity Model EOQM
• To determine what order size the firm should use when it restocks
• Assume that the inventory is sold off at a steady rate until it hits zero & restock back to some optimal level
• Total carrying costs= average inventory * carrying costs / unit• • (Q/2) * CC
• Total restocking costs= fixed costs per order * nº orders• • F * (T/Q),
• T= total unit sales
time
Q
Average inventory
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• The cost-mnimizing quantity occurs where carrying & restocking costs are the same or the two lines cross
• (Q/2) * CC = F * (T/Q),
• Solving for Q*= [(2T * F) / CC]½
• But, the firm orders in advance of anticipated needs and keeps a safety stock of inventory
Restocking costs
Carrying costs
Q* Optimal size
Costs of holdinginventory
Reorderpoint
Safety stock
Delivery time
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• Derived-Demand Inventories
• Materials Requirements Planning MRP
– A computer-based system for ordering /scheduling production
– The ability to schedule backwards from finished goods to work-in-process to raw materials inventories
• Just-inTime Inventory JIT
– It minimizes inventory holdings
– It maximizes turnover
– It requires a lot of cooperation between suppliers
– Also called kanban (signal) systems
