L2 flash cards corporate finance - SS 8

Study Session 8, Reading 25

Expansion and Replacement ProjectsExpansion project - an independent project which does not affect the cash flows for the rest of the company. Replacement project - affects the cash flows of the rest of the company, therefore it is important to compare the cash flows from the new investment and the investment being replaced

Formula for a new capital that needs to be invested in an expansion project

where FCInv is the investment in new fixed capital and NWCInv is the investment in net working capital


Expansion and Replacement Projects (cont.)

Formula for the initial capital that needs to be invested in a replacement project:

Salo is the cash proceeds from the sale of old fixed capital, T is the tax rate and Bo is the book value of old fixed capital

Formula for the after tax annual cash flows to be derived from an investment project:

where S is sales, C is cash operating expenses and D is the depreciation charge


Expansion and Replacement Projects (cont.)

Formula for the terminal year after tax non-operating cash flows:

SalT is the terminal cash flows and BT is the book value of the fixed capita

Replacement project cash flows include investment outlays, after tax operating cash flows over the life of the project and terminal cash flows.


Effects of Depreciation Method on Cash Flows

The NPV of the capital project can be improved by the use of an accelerated depreciation method

An accelerated depreciation method reduces the tax cash out flow in the early years and increases them in the later years


Effects of Inflation on Capital Budgeting

Nominal cash flows include the effect of inflationReal cash flows are adjusted to eliminate the effect of inflationNominal cash flows should be discounted at the nominal rateReal cash flows should be discounted at the real rate

Formula for converting real discount rate to a nominal discount rate:


Capital Allocation in Mutually Exclusive Projects

Replacement chain approach - used to evaluate capital allocation with mutually exclusive projects with different lives

equivalent annual annuity - the NPV of both projects is converted into an equivalent annual annuity and the project with the greater annual positive payments is chosen.

Capital rationing - the process of allocating capital to the best project when there is limited capital available.


Stand-Alone Risk of Capital Projects

Standalone risk is usually assessed by calculating the dispersion of NPV or IRR.

Sensitivity analysis - takes into account the change in NPV for a change in a unit of input.

Scenario analysis - calculates NPV under different scenarios.

Probability distribution - used for important variables in an NPV calculation.


Determining the Discount Rate

The CAPM can be used to calculate the discount rate for capital projects.

where: Rf - risk free rate β - risk of the project Rm - represents the return of the market (Rm-Rf)- represents the market premium


Real Options in Evaluating a Capital Project

Option - the right but not the obligation to make a decision in the futureReal options - are options on real assets instead of financial assets

Real options are a choice to make a decision about a capital project in the future which may impact the value of the project.

Real options increase the value of a capital project


Real Options in Evaluating a Capital Project (cont.)

Different Types of Real Options: Timing options Abandonment option Growth option Price setting option Production flexibility option


Common Budgeting Pitfalls

Managers may make errors when valuing capital projects. Some managers may choose the projects which give good

short term benefits but do not generate value in the long runSome managers have the tendency to overspend or

underspend the budget allocated. Sunk costs are often difficult to ignore


Accounting Income in Capital Budgeting

Accounting income - the income reported on the income statement from the capital project.

Accounting depreciation is based on the original cost of the investment.

The after tax cost of debt is subtracted (ie considered) when calculating net income.


Economic Income in Capital Budgeting

Economic income - the profit realized from an investment

Interest is ignored in the economic income as it is included in the discount rate.

Economic depreciation is based on the change in the market value of the investment.


Economic Profit

Economic profit - reflects the income earned by all the capital holders, discounted to its present value at WACC.

Formula:

Where: NOPAT - net operating profit after tax or after tax EBIT $WACC - the dollar cost of capital which is equal to capital multiplied by the

WACC


Residual Income

The residual income method focuses on the return on equity

Formula:

Where: RIt - the residual income during time t

NIt - the net income during time t

rtBt-1 -the equity charge for period t


Claims Valuation Models

In the claims model, the present value of each cash flow is added to get the value of the firm

It values liabilities and equity which are the claims against the assets. The value of the assets should be equal to the value of the claims


Proposition I & II Without Taxes from Modigliani-Miller

Modigliani and Miller assumed that the investors have homogenous expectations about returns and risks of stocks and bonds.

Proposition I governs the basic capital structure decisionVL=VU


Proposition I & II Without Taxes from Modigliani-Miller (cont.)

Proposition 2 suggests that the cost of equity is the linear function of the firm’s debt to equity ratio.


Proposition I & II With Taxes from Modigliani-Miller

Proposition I - the value of the firm is maximized when the capital structure contains 100% debt


Proposition I & II With Taxes from Modigliani-Miller (cont.)

Proposition 2 argues that the 100% debt minimizes the WACC


Target Capital Structure vs Actual Capital Structure

Target capital structure - the funding mix that a firm wants to achieve.Optimal capital structure - the point where the value of the company is

maximized.


Debt Ratings in Capital Structure Policy

Companies need to consider the impact of their capital structure decisions on credit ratings.

Rising leverage may tempt the ratings agencies to lower the ratings. Rising leverage increases the risk is for both equity and debt providers.


Factors when assessing Firm’s Capital Structure

Ability of the company to handle the financial obligationsBusiness riskAgency costs Volatility of company’s cash flows and its need for financial flexibility Regulatory environment


International Differences in Financial Leverage

Factors:Institutional legal and taxation differencesMicro economic factors Macroeconomic factors Financial market factorsBanking system factorsGeneral business environment of the countryDifferences exist between developed and developing

countries


Theories of Dividend Policy

1. The first group believes that only the investment in fixed capital and working capital affects shareholder wealth.

2. Second group argues that the dividends are more important to the investors than the uncertain capital gains.


Dividend Signaling

A company that announces an increase in dividend payouts may be indicating strong future prospects.

Dividends can be used to signal to investors how the company is really doing.

A company’s decision to initiate a dividend sends stronger signals than the words of the management.


Factors Affecting Dividend Policy

Companies with many investment opportunities tend to pay lower dividends volatility of future earnings target payout ratios on future earnings Financial flexibility Tax consideration Shareholder’s preference Contractual and legal obligations


Dividend Tax Regimes

Double Taxation system - earnings taxed at two levels (at the company level and at the investor level).

Tax Imputation system - earnings are ultimately taxed at the shareholder’s specific rate.

Split Rate system - earnings are taxed at two different rates.


Dividend Payout Policies

Stable policy - dividends increase at a constant rate every year

Target payout - the company sets aside a proportion of earnings which the company wants to disburse as dividends.

Residual dividend policy - the cash flow remaining after capital budgeting is paid out as dividends.


Global Trends in Corporate Dividend Policies

Companies adapt their dividend policies according to changes in investor preferences which differ globally.

The portion of dividend paying companies have been on the decline in developed economies

Fama and French stated the decline in dividend payout over time was due to the weaker related companies in the same industry.


Dividend Coverage Ratio

Dividend coverage ratios - a way of assessing dividend safety Free cash flows - the earnings available for shareholders after working capital

and fixed capital expenditures.

Formula to Calculate Free Cash Flow coverage ratios :


Characteristics of Companies that Cannot Sustain Cash Dividends

If the market is pessimistic about the dividends of the company Companies with extremely high dividend yields Past record of the company’s dividends Investors predicting a dividend cut


Major Business Forms and Associated Conflicts of Interest

Sole ProprietorshipA business run and owned by single person Have difficulty in raising capital Issues in the transferability of ownership Have unlimited liability No agency risk is present Creditors and suppliers are in a better position to ask for the quality information


Major Business Forms and Associated Conflicts of Interest (cont.)

PartnershipSimilar to a Sole Proprietor, except that it has more than one owner The financial capital of the partners is pooled together. Partners share the business risk. Partnership contracts are devised


Major Business Forms and Associated Conflicts of Interest (cont.)

CorporationsA legal entity that has similar rights to a personManagers act as the agents of the firm Corporations can raise large capital Shareholders are the owners of the corporation and receive profits Owners do not need to be experts in the business Ownership is easily transferable Corporations have limited liability


Manager- Shareholder Conflicts

agency relationship - relationship between managers and shareholders

Management have control of undistributed income Managers may spend company money on lavish perquisites Managers may make risky investment decisions for their own benefits


Director-Shareholder Conflicts

board of directors - act as an intermediary between the shareholders and managers

Directors start to protect the interests of the managersThe board is not independentThe directors have personal relations with the managers or consulting agreements Generous payments to the directors


Board of Directors: Qualifications

Expertise in the relevant field, operations and the technologies used by the company.Should have the knowledge of accounting and legal practices.Ethical soundness Experience in risk management and strategic planning. Board experience with other companies Commitment and dedication to serving the cause of the shareholders.There should be an absence of conflicts of interest.


Board of Directors: Competencies and Responsibilities

Should establish corporate values and governance Should ensure that legal and regulatory requirements are metShould establish the long term strategic objectives for the companyShould establish strong accountability measures and clear line of responsibilities. Determine the compensation package and hire the chief executive officer. Adequate training should be given to members. Board elections should be held annually.

Directors should serve only on two or three boards


Effective Corporate Governance

The CEO and chairman should be separate positions. Independent and outside counsel should be used by the board. Board members should be knowledgeable and experienced. Board should be annually evaluated and assessed. Board members should meet without the presence of the management.


Statement of Corporate Governance Policies

Contain a clear code of ethics Define the measures for self assessment Contain measures for the monitoring and review responsibilities of the

directors Contain a statement underlining the responsibilities of the management Contain reports of directors


Valuation Implications of Corporate Governance

Accounting risk Asset risk Liability risk Risk taking Short term objectives


Classification Based on Integration and Mergers

Acquisition - the purchase of some part of one company by another Merger - the adoption of one company by another where the target ceases to exist Statutory merger - when one company’s assets and liabilities are transferred to another company and the company ceases

to exist Subsidiary merger - the company becomes the subsidiary of the buying company. Consolidation - both companies finish the legal structure and become a new company Target company or “target” - The company which is being acquiredAcquirer - the acquiring company that acquires the target Takeovers - mergers


Classification Based on Integration and Mergers (cont.)

Hostile takeover - when a company is being acquired against the wishes of the management and board of directors

Friendly transaction - a potential business combination backed by management and the board Horizontal merger - when the merging companies operate in the same type of business Vertical merger - when the acquirer acquires a company in the same production chain Backward integration - a company acquires suppliers Forward integration - company acquires distributors Conglomerate merger - when a company in an unrelated business is acquired


Common Motivations Behind M&A Activity

Economies of scale Increasing market share Cost saving through vertical integrationSynergies Growth To acquire unique opportunities and resourcesDiversification For personal benefitsTax benefitsTaking the business global


Bootstrapping and Post Merger EPS

bootstrapping effect - Companies typically generate higher EPS following a merger

Total earnings of the combined firms are unchanged. However, the number of total shares outstanding is decreased.

There may be no economic gains of the process


Pioneer Stage and Merger Motivations

pioneer stage – companies have low profit margins and large capital requirements.

Newer companies may want to merge with the bigger and more experienced players in the industry to benefit from their expertise.

Horizontal and conglomerate mergers occur at this stage


Rapid Growth and Merger Motivations

rapid growth stage - firms have few participants in the market and high profit margins.

Larger capital To meet sales demand and increase the production capacityConglomerate and horizontal mergers are the choices


Mature Growth and Merger Motivations

mature growth stage- firms still have growth present in the industry, but competition stops entering the market.

Operational efficiency, savings and economies of scale Horizontal and vertical mergers are preferred


Stabilization and Merger Motivations

stabilisation phase - firms suffer from increased competition and capacity constraints

To improve managementEconomies of scale and reduce the costsHorizontal mergers are done at this stage


Decline and Merger Motivations

decline phase – business is characterized by declining profit margins and over capacity.

To acquire new growth opportunities, survival and operational efficienciesHorizontal vertical and conglomerate mergers occur


Merger Transactions: Acquisition

Stock purchase - the most convenient form of acquisitionthe acquirer gives the shareholders of the target company some cash and securities. it must be approved by more than 50% of the shareholders

asset purchase - the target company’s assets are purchased and payment is made to the target companyShareholder’s approval is needed if a substantial amount of assets are being sold

Liabilities of the target company are assumed by the acquirer in stock purchase, but liabilities are avoided under the assets purchased.


Merger Transactions: Method of Payment

cash offering method of payment - cash can come from the existing assets of the company or a debt issue.

securities offering - the shareholders of the target company may receive the shares of the acquiring company

Each shareholder gets the shares of the acquirer based on the number of shares of the target company held multiplied by the exchange ratio.


Merger Transactions: Target Management

friendly merger - acquirer and target work together and sign the agreement before presenting it to the shareholders of the target company.

If the bear hug fails, approval from the shareholders of the company can be received in two ways: 1. Tender offer is given to the shareholders of the target company, every shareholder decides to sell or not sell the shares. 2. In a proxy battle the acquirer tries to control the target by getting an acquirer approved board.


Pre-Offer Defense Mechanisms

shark repellents - defence mechanisms poison pills - allow the company the option to offer shares of the target company at a discounted priceflip-in pill - an option to buy the target company’s shares at discount flip-over pill - if the shareholders of the target company have the option to buy the shares of the acquiring company at a

discount

• Reincorporation can be undertaken to avoid hostile takeovers. • Staggered board elections can also be undertaken. • Supermajority of voting provisions • Golden parachutes


Post-Offer Defense Mechanisms

the “just say no” defencefile a law suit Greenmail option buy shares in the open leveraged recapitalizationcrown jewel defencePac Man defencewhite knight defencewhite squire defence


The HHI and Likelihood of Antitrust Challenge

Antitrust laws have been devised to stop takeovers which are not healthy for competition.

The HHI is used to judge whether the antitrust challenge is qualified or not


Valuing a Target Company

discounted cash flows approach - the company’s expected future cash flows are discounted to their present value.

comparable company approach - the value of a comparable company plus a premium is used. A set of comparable companies is assessed

transaction multiple approach - a set of relevant and recent sample transaction are evaluated.


Calculating Free Cash Flow

Free cash flow - cash flows which are available for shareholders after capital expenditures.

Net income+ Net interest after tax= Unlevered Net income+ Change in deferred taxes= Net operating profit less adjusted taxes (NOPLAT)+ Net noncash charges- Change in net working capital- Capital expenditures (Capex)= Free Cash Flow (FCF)


Evaluating Merger Bids

pre-merger value of the target company - the absolute minimum bid that target shareholders should accept.

The acquirer’s shareholders would not want to pay more than pre-merger value plus any value of the expected synergies.


Estimated Post-Merger Value

Post merger value - a function of the pre merger value of both companies.Synergies - created as a result of merger and any cash paid to the target’s shareholders.

Formula to Calculate Post Merger Value:

VA*=VA+VT+S-C

Where: VA* - the post merger value of the companies

VA - the pre-merger value of the acquirer

C - the cash paid to the target shareholders.


Gains of Target

Definition: TP= PT-VT

Where: PT - the price paid to the target

VT - the pre-merger value of the target

cash offer - the target’s shareholders will benefit by the amount paid above the market value. But the gain is capped at that amount. stock offer- the gain can be determined by the value of the post merger firm, because the shareholders do not receive cash they still have the

ownership.

Gains to the Target is defined as: PT=(N× PA×T)


Gains of Acquirer Shareholders

To Calculate Synergies:S-TP=S-(PT-VT)

Where: S -represents the synergies created

Acquirer pays the premium in order to realise the synergies. The gains to the acquirer are derived from the synergies. The gains to the acquirer can include a combination of cost reductions and revenue enhancements.


Effects of Price and Payment Method in a Merger Transaction

The acquirer wants to get the best deal by paying the lowest possible amount. The target wants to get the best deal by getting the highest amount. The acquirer receives the potential rewards of the merger. The gain to the target is the premium paid by the acquirer. The premium does not change for the target.


Empirical evidence in distribution of benefits

Shareholders of the target gain in the short run. Target shareholders receive a 30% premium, on average. Acquirer’s stock price falls as a result. Acquirer and target see a higher stock return in cash offers than the stock offers. Hubris can also result in higher bids in excess of the real value.


Reasons for Divestiture

divestiture - when a company decides to sell, spin-off or liquidate a division

when a company decides to sell, spin-off or liquidate a division company decides that the division is a poor fit reverse synergies financial and cash flow needs


Equity Carve-Outs

Create a new independent by giving a proportionate equity interest in a subsidiary

A new legal entity is createdShares are sold to the outsiders


Spin-Offs

Creates a new company by giving shares to the shareholders of the parent company.

Proportional number of shares are offered. A spin-off gives the shareholders shares in the both companies.

Split-OffsParent company shares are exchanged by the existing

shareholders to get a share in the new company.


Liquidation

A firm is broken and sold piece by piece. Usually happens as a result of bankruptcy. A subsidiary of a division can also be liquidated.

L2 flash cards corporate finance - SS 8

Economy & Finance

Transcript of L2 flash cards corporate finance - SS 8