Presented by: The Northern Trust Company Elizabeth V. Hasten,CTP
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Transcript of Presented by: The Northern Trust Company Elizabeth V. Hasten,CTP
© 2012 Northern Trust Corporation
Presented by: The Northern Trust CompanyElizabeth V. Hasten,CTP
Windy City Summit CTP Review
Chapter 13
Service Expertise Integrity
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Chapter 12
Financial Decisions and Management
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Importance of Finance and Treasury
Objectives for Treasury Professionals
Short-term – to sustain organizations operations
Long-term – to sustain organizations overall financial objectives and mission
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For-profit
• Managers work for owners.
• Maximize firm’s long term value = value of common stock
• Generate returns greater than cost of funds.
Not-for-profit
• Managers work toward goals set by charter.
• Using best resources available as efficiently as possible, to provide maximum benefits.
Government
• Managers work for the public.
• Similar to Not-for-Profit - provide maximum benefit as defined by legal responsibilities.
Financial Objectives for Different Types of Organizations:
Importance of Finance and Treasury
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The Finance Function
Accounting Responsible for accurately recording assets, liabilities, revenues, expenses
Funding Determines overall cost of capital and capital structure
Capital Budgeting Quantitatively evaluates projects and estimates relative returns; then qualitatively evaluates projects
Financial Planning Determines need for present and future funding
Risk Management Includes financial, credit, counter-party and other types of risk
Importance of Finance and Treasury
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Key Capital Financial Decision Financing Decisions
How much capital to raise outside the company? How fast will organization grow?
Capital Structure DecisionsHow much short-term and long-term debt is to be used vs. equity capital?
Determine mix with lowest cost with flexibility. Asset Investment Decisions
Which projects or acquisitions to fund? How much to invest in strategic assets (compete for funding)?
Importance of Finance and Treasury
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Key Capital Financial Decisions Dividend Decisions
How much dividends should the company pay or not pay and reinvest? Many factors:
Board of directors, in its role as the “voice” of stockholders, decides whether to pay a dividend
Decision is guided by shareholder or, in some cases, analyst expectations
May also depend on a company’s industry, stage of development, dividend payment history and/or covenants
Importance of Finance and Treasury
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Raising and Managing Long-Term Capital
Why Private Placement is preferred over Public Issuance:
Less covenants
Smaller issue size
Reduced time
Minimal reporting requirements or disclosures
IPOs require disclosure of ownership, financial statements, etc…
Lower costs
Of reporting and disclosure
Price can fluctuate due to economy, technology, government regulations or public perception of company
Control over who holds debt
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Managing Outstanding Capital
Manage Legal and Payment Requirements
Manage Trustee Relationships
Disbursing Agent· Shareholders – dividends· Bondholders – P&I payments· Other obligations under covenants
Investor Relations
Maintain shareholder lists
Send financial statements, annual reports, other filings
Communicate with share- and bond-holders
Answer investors’ questions
Raising and Managing Long-Term Capital
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Primary sources of capital are L-T debt (bonds) and equity (stock and retained earnings)
Cost of Debt:
Relevant cost is After-Tax
Pre-tax cost of bond is Yield to Maturity (YTM), or the rate of return over the bond’s remaining life based on market price when measured. TYM is converted to an after-tax rate using the following equation:
Cost of Capital and Firm Value
After-Tax rD = After-tax cost of debt
rD = Yield to maturity on newly issued debt (before tax)
T = Company’s marginal income tax rate
After-Tax rD = rD (1-T)
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Cost of Debt example: Marginal tax rate = 30% and a YTM = 5% on a newly issued debt.
Cost of Capital and Firm Value
After-Tax rD = rD (1-T)
After-Tax rD =.05 (1-0.30) = .035 = 3.5%
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Cost of Capital and Firm Value
Primary sources of capital are L-T debt (bonds) and equity (stock and retained earnings)
Cost of Common Equity:
CAPM – Capital Asset Pricing Model (Chapter 12)
Cost that applies to equity funds that are obtained through retained earnings.
r E= r RF = (rM – r RF) β
rE = Required rate of return on stockholder’s equity
rRF = Expected rate of return on the Risk-Free asset (T-Bill)
rM = Expected rate of return on the market portfolion (S&P 500)
β = Beta value for the company’s stock
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Cost of Equity Capital example: Risk Free Rate (T-bill) = 4.0%, return on overall market is 10.0%, beta is 1.2.
r E= r RF = (rM – r RF) β
Cost of Capital and Firm Value
rE = .04 + (0.10 - 0.04)(1.2) = 0.112 or 11.2%
The cost of equity capital is 11.2%, which means that the equity raised through retained earnings costs the company 11.2%, and the stockholders require a rate of return of 11.2% from the company
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Weighted Average Cost of Capital (WACC)
Calculates weighted average of the costs of long-term debt and equity where the weights represent the proportion of each in long-term financing.
Cost of Capital and Firm Value
WACC = WDrD(1 – T) + WErE
WACC = Weighted Average Cost of Capital
W = % (weight) of each source of financing in relation to the sum of debt and equity financing
D = Debit
E= Equity
(rD)(1 – T) = After-tax cost of debt
rE = Cost of equity (common stock and retained earnings)
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WACC example: 1/3 or 33.3% of financing provide by debit and 2/3 or 66.7% provided by equity.
WACC = WDrD(1 – T) + WErE
Cost of Capital and Firm Value
WACC = 0.333 x 0.05 x (1 – 0.3) + (0.667 x 0.112) = 8.64%
The WACC or overall cost of capital is 8.64%, which is an estimate of the market’s expected return for this company.
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Cost of Capital and Firm Value
Firm Value
Economic value added (EVA) emphasizes a rate of return on assets that exceeds the cost of capital to create shareholder value. Assume that $50,000,000 of capital is employed, the company generated an operating profit of $6,800,000, and WACC is 8.64%.
EVA = EBIT (1 – Tax Rate) – (WACC)(Long-Term Debt + Equity)
= $6,800,000(1 – 0.30) – (.0864)($50,000,000)
= $4,760,000 - $4,320,000 = $440,000
Positive EVA will cause share price to increase .
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Debt Financing and Management
Costs of BorrowingInterest expenseCredit enhancements (guarantees or letters of credit)Rating agency feesLegal feesCommitment and facility feesBroker/Dealer feesMonitoring, negotiating (soft $ cost), and maintaining loan covenants
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Basic Components in Interest Rates
r*RF Real risk-free rate of interest
Rate demanded by savers to compensate for delaying use of money today, absent risk or inflation, for 1-year maturity.
IP Inflation premium The real-risk free rate plus the inflation premium matches the T-bill rate in the U.S.
DP Default premium For investments other than government securities, a risk-return premium is added.
LP Liquidity premium While markets for most securities of large governments are highly liquid, other markets have lower liquidity.
MP Maturity premium Longer-term investments have more price risk and thus a maturity premium.
Debt Financing and Management
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Base Rates
Economic conditions and yield curves (Ch 11) impact base rates
LIBOR – London Interbank Offer Rate
Fed Funds (Federal Reserve) Rate
Prime Rate
Short- vs. Long-Term Borrowing
Risks of Short-Term Borrowing
Fluctuation of rates – companies use derivatives to reduce risk (Long-Term Borrowing uses fixed rates)
Availability of funds – may not always be available from lenders – mitigated by using multi-year lines of credit
Debt Financing and Management
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Debt Financing and Management
Advantages of Short-Term Borrowing: Ease of access:
· No Fed reserve requirements < 365 days· Less-restrictive covenants
Flexibility for future borrowing Ability to finance seasonal credit needs efficiently Can be obtained from spontaneous sources:
· A/P· Accrued expenses
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Disadvantages of Short-Term Borrowing: Continuing need to roll over financing Lender may not renew:
· Changes in financial variables in the firm· Changes in general economic conditions
Clean-up periods on lines of credit Downsides to secured borrowing:
· Asset monitoring· Asset key ratios· Limited to percentage of asset value
Debt Financing and Management
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Debt Financing and Management
Loan Agreements and Covenants Impose restrictions (covenants) or obligations on management, which
have an impact on decision makingRestrictions could include:
Ability to sell certain assetsRight of an organization to issue additional bondsUse of second or junior mortgagesKey ratios that limit flexibility in financial decision makingPayment of dividends
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Debt Financing and Management
Credit Rating Agencies
National Recognized Statistical Rating Organizations (NRSRO) ratings are not investment recommendations but an assessment of the potential downside loss.
Generally have access to firm’s internal information (widely accepted).
Dodd-Frank Act rating agency changes: Rating agencies must provide greater disclosure of rating models
and methodologies. Subject to greater liability. SEC given two years to eliminate conflicts of interest between
rating agencies and the organizations they regulate.Classes:
Issuer – Issuer’s overall capacity to meet financial obligations Issue-Specific – Consider the specific terms of the issue
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Ratings Process – quantitative and qualitative analysis
Reviews of Ratings – usually once per year
Credit Rating Scales
Scales used for bonds recognized by SEC
Short-Term credit uses different system since Long-Term debt has more variables that affect ratings
Long-Term Bond Credit Ratings (page 491)
Short-Term Credit Ratings (page 492)
Debt Financing and Management
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Lease Financing and Management
Capital Asset Acquisition process:
Acquisition - capital budget decision already made prior to leasing decision
Finance - borrowing or leasing Why Companies Lease -
Lessor receives lease payments from lessee; both get a tax benefit
Direct substitute for debtGood for when there is a high uncertainty for future demand or for
items outside firm’s area of expertise
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Lease Financing and Management
Types of Leases Sale and leaseback
Give company cash infusion For companies that cannot take advantage of depreciation tax
benefits
Operating or service leases Lessor maintains, retains asset at end Often OBSA Shorter duration than life of asset
Capital Asset Acquisition process:
Acquisition - capital budget decision already made prior to leasing decision
Finance - borrowing or leasing
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Lease Financing and Management
Capital or financial leases Alternative to borrowing funds and purchasing asset
Residual value is estimated value at end of lease (lessee maintains asset and pays taxes and insurance)
Double-net lease (triple-net in real estate)
ASC Codificaiton Topic 840-10-15: restate company’s balance sheet (leased asset as fixed asset, lease payments as liability
Leases meeting any one of the following four conditions must be classified as a capital lease:
· The length of the lease is at least 75% of the estimated useful life of the asset.
· There is a transfer of ownership to the lessee at the end of the lease.
· The lease agreement contains a provision that allows the lessee to purchase the asset per a bargain purchase option during or at the end of the lease’s life.
· The present value of the discounted lease payments at the beginning of the lease term exceeds 90% of the asset’s fair market value.
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Lease Financing and Management
Estimated Residual Value Sale and leaseback Lessor has primary claim on an asset’s residual value. Residual value is built in to most lease arrangements, and
potentially high residual value can lower lease payments. Residual value may impact a lease’s tax status and requirements
for listing as an Off-Balance Sheet Arrangement (OBSA) Assumed residual value is important because the lease may
require payment of the difference between this amount and actual residual value (e.g., tied to mileage or general condition of a vehicle)
Tax Considerations for U.S. CorporationsLease vs. Borrow-and-Buy
Based on comparing the costs of leasing with the costs of borrowing to buy the asset
Net present value of cash flows for each alternative
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Equity Financing and Management
IPO Advantages
Diversification and increased liquidity Establishing the value of a closely held company Spin off a subsidiary
Disadvantages SEC disclosure Loss of managerial flexibility Surrender of some control Other factors:
· Smaller company stocks may not be especially liquid.· Small market/infrequent trading leads to undervalued stock.· Increased reporting and disclosure (debt rating).
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Equity Financing and Management
The Decision to List StockAdvantages
Primary advantage: increased marketability of stock. Increased public exposure causes higher sales. Increased level of disclosure may lower WACC on a company’s
common stock and bonds, increasing the firm’s market value.Disadvantages
Additional requirements keep some companies in OTC market. OTC liquidity has increased since 1990s (e.g., NASDAQ). Some smaller companies voluntarily delist rather than comply
with disclosure requirements of SOX.Delisting – may still be traded on the OTC marketExchanges – requirements for various exchanges
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Equity Financing and Management
Shareholder Rights
Control of Company
Cumulative Voting - # of votes per share as open posts on board
Proxy
Assigning another individual, trough a proxy, the right to vote at the annual meeting
Staggered Election of Directors
Makes it difficult to take over the entire board
Preemptive Right
Existing shareholders have first right to purchase shares of any new stock issue on a pro-rata basis based on the number of shares owned
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Equity Financing and Management
Financing Mergers and Acquisitions
Merger
Two companies combine and one ceases to exist
Consensual
Acquisition
One company buys majority voting shares of another
Friendly – stock transfer or asset purchase· Bidding company informs board of intent· If rejected, bidder may take case directly to shareholders
Hostile – lack of due diligence· Direct tender to shareholders (usually a premium)· Proxy fight· Creeping tender offer
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Equity Financing and Management
Stock Transfer Exchange of stock of companies May pay cash to shareholders of acquired firm Acquiring firm owns other’s assets and assumes liabilities
Asset Purchase Acquiring firm may buy some or all of the assets May selectively assume liabilities
Cash Payment Cash from either company Sale of assets Issuance of bonds – investment or junk
LBO – Leveraged Buy Out Small group of investors purchases a firm using large amounts of
debt; results in a high debt (i.e., leverage) ratio.
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Other Topics in Financial Decisions
Tax StrategiesInternational businesses need global tax strategy to avoid unfavorable
tax consequences, such as: Double taxes Balancing home country and foreign tax considerations Working in countries without an international tax treaty network
Widespread and complex international transfer pricing rules: Strict arm’s length Understand both home country and foreign transfer rules
Deemed dividends
Solid tax strategy requires understanding firm’s: Business and financial position International operating strategy Intended areas of operation outside the U.S.
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Other Topics in Financial Decisions
Impact of a Financial and Credit Crisis Impact on Financial Institutions
Crisis creates liquidity problems due to asset/ liability mismatch (long-term assets financed with short-term funds).
Governments provide liquidity infusion.
Systemic risks.
Tightening of Credit Markets FIs revalue portfolios → FIs reinforce capital base, tighten
lending standards, reduce lending → corporate ratings decline → non-bank, short-term lending markets reduced.
Increased Awareness of Financial Risk FIs revalue portfolios → FIs reinforce capital base, tighten
lending standards, reduce lending → corporate ratings decline → non-bank, short-term lending markets reduced.
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