UCP-CF 09,11-03
Transcript of UCP-CF 09,11-03
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CorporateFinance
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IDENTIFYING & ESTIMATING PROJECT CASHFLOW
Chapter 8 (Finance for Executives-Hawawini,viallet-3e)
The Cash Flow PrincipleThe with/without Principle
Estimating Relevant Cash FlowsVarious types of CostsSensitivity/Scenario Analysis
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Fundamental principles guiding thedetermination of a projects cash flows and howthey should be appliedActual Cash-Flow Principle- Cash flows must be measured at the time theyactually occur
With/without Principle- Cash flows relevant to an investment decisionare only those that change the firms overall cash
position- Sunlight Manufacturing Companys (SMC)designer desk lamp project used to illustrateapproach
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After reading this chapter, students shouldunderstand:
The actual cash-flow principle and thewith/without principle and how to apply themwhen making capital expenditure decisions.
How to identify a projects relevant andirrelevant cash flows
Sunk costs and opportunity costs
How to estimate a projects relevant cash flows4Corporate Finance
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The Actual Cash-flow Principle
Cash flows must be measured at the time they
actually occurIf inflation is expected to affect future prices andcosts, nominal cash flows should be estimated
Cost of capital must also incorporate theanticipated rate of inflation
If the impact of inflation is difficult to determine,
real cash flows can be employedInflation should also be excluded from thecost of capital
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A projects expected cash flows must bemeasured in the same currency
Nominal Cash Flow: The Cash Flow thatincorporate anticipated / expected inflation shouldbe estimated.
Real Cash Flow: The values of cash flowscalculated with the assumption that prices and
costs will not be effected by anticipated inflation.
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The With/Without Principle
The relevant cash flows are only those thatchangethe firms overall future cashposition, asa result of the decisionto invest
AKA: incremental, or differential, cash flows Equal to differencebetween firms expected
cash flows if the investment is made (the
firm with the project) and its expected cashflows if the investment is not made(the firmwithout the project)
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To illustrate the definitions of incremental,differential cash flows and those ofrelevant/irrelevant costs, unavoidable costs,
sunk costs and opportunity costs consider thefollowing example
Example: A person must decide whether to driveto work or take public transportation
If he drives his monthly costs are:
Insurance costs $120Rent on garage near apartment $150Parking fees $ 90Gas and car service $110
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If he takes the train his monthly ticket costs are$140
The cash flows with the project are (assuminghe doesnt drive his car)CF(train): = -120 150 140 = -$410
The cash flows without the project are(assuming he drive his car)CF(car): = -120 150 90 110 = -470The incremental cash flows areCF(train) CF(car)= -$410 - -$470 = +$60
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The Designer Desk Lamp Project
Sunlight Manufacturing Company (SMC) is
considering a possible entrance in the designerdesk lamp market
The projects characteristics are reported in
Exhibit 8.1
SMCs financial manager must
Estimate the projects expected cash flows
Determine whether the investment is a value-creatingproposal
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EXHIBIT 8.1a:Data Summary of the Designer Desk Lamp Project.
ITEM CORRESPONDING UNITS OR VALUE TYPE TIMING
1. Expected annual 45,000; 40,000; 30,000; 20,000; 10,000 Revenue End of year 1 to 5unit sales
2. Price per unit $40 first year, then rising annually at 3% Revenue End of year 1 to 5
3. Consulting $30,000 Expense Already incurredcompanys fee
4. Losses on $100,000 Net cash loss End of year 1 to 5standard lamps
5. Rental of building $10,000 Revenue End of year 1 to 5to outsiders
6. Cost of the equipment $2,000,000 Asset Now
7. Straight-line $400,000 ($2,000,000 divided by 5 years) Expense End of year 1 to 5depreciation expenses
8. Resale value of $100,000 Revenue End of year 5equipment
9. Raw material cost/unit $10 the first year, then rising annually at 3% Expense End of year 1 to 5
10. Raw material inventory 7 days of sales Asset Now
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EXHIBIT 8.1b:Data Summary of the Designer Desk Lamp Project.
ITEM CORRESPONDING UNIT OR VALUE TYPE TIMING
11. Accounts payable 4 weeks (or 28 days) of purchases Liability Now
12. Accounts receivable 8 weeks (or 56 days) of sales Asset Now
13. Work in process and 16 days of sales Asset Nowfinished goods inv
14. Direct labor cost $5 the first year, then rising annually at 3% Expense End of year 1 to 5per unit
15. Energy cost $1 the first year, then rising annually at 3% Expense End of year 1 to 5
per unit
16. Overhead charge 1% of sales Expense End of year 1 to 5
17. Financing charge 12% of the net book value of assets Expense End of year 1 to 5
18. Tax expenses on 40% of pretax profits Expense End of year 1 to 5income
19. Tax expenses on 40% of pretax capital gains Expense End of year 5capital gains
20. After tax cost of 9% (see Chapter 10) Not in thecapital cash flow
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Identifying A Projects Relevant Cash FlowsSunk CostCost that has already been paidand for which
there is no alternative use at the time when theaccept/reject decision is being made
With/without principle excludes sunk costs
from the analysis of an investment
Opportunity Costs
Associated with resources that the firm coulduse to generate cash, if it does not undertake theproject
Costs do not involve any movement of cashin or outof the firm
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Costs Implied by Potential Sales ErosionAnother example of an opportunity costSales erosion can be caused by the project, or
by a competing firmRelevant only if they are directly related tothe project
If sales erosion is expected to occuranyway, then it should be ignored
Allocated CostsIrrelevant as long as the firm will have to paythem anyway
Only consider increases in overhead cashex enses resultin from the ro ect
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Depreciation ExpensesDo not involve any cash outflows
Irrelevant to an investment decision
However provides for tax savings by reducingthe firms taxable profit
These tax savings are added to the projects
relevant cash flows
Tax Expenses
If an investment is profitable, the additionaltaxthe firm will have to pay is a relevant cash outflowComputed using the firms marginal corporatetax rate
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Tax savings from the deductibility of interestexpenses are taken into account in a projectsestimated after-tax cost of capital
Financing CostsCash flows to the investors, not cash flows
fromthe projectAre captured in the projects cost of capitalShould not be deducted from the projects
cash flow streamInvestment- and financing-related cash flowsfrom the designer desk lamp project are shownin Exhibit 8.2
EXHIBIT
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INITIALCASH FLOW
Investment-related cash flows $1,000 +$1,200 +$91
Financing-related cash flows +$1,000 $1,100 Zero
Total Cash Flows Zero +$100 +$91
TERMINALCASH FLOW
NPV at10%
TYPE OF CASH-FLOW STREAM
EXHIBIT 8.2:Investment- and Financing-Related Cash-Flow Streams
InflationIf inflation is incorporated in the cost of capital,then it should also be incorporated in the
calculation of cash flows
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Estimating A Projects Relevant Cash FlowsThe expected cash flows must be estimatedover the economic life of the project
Not necessarily the same as its accountinglifethe period over which the projects fixedassets are depreciated for reporting purposes
Measuring The Cash Flows Generated By A
ProjectClassic formula relating the projects expectedcash flows in period tto its expected contributionto the firms operating margin in period t:CF = EBIT 1-Tax + De - WCR - Ca ex
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Where:CFt =relevant cash flowEBITt = contribution of the project to the Firms
Earnings Before Interest and TaxTaxt = marginal corporate tax rate applicable tothe incremental EBITt
Dept = contribution of the project to the firmsdepreciation expensesWCRt = contribution of the project to the firms
working capital requirementCapext = capital expenditures related to theproject
E i i Th I i i l C h O fl
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Estimating The Projects Initial Cash OutflowProjects initial cash outflow includes the followingitems:
Cost of the assets acquired to launch the projectSet up costs, including shipping and installationcosts
Additional working capital required over the firstyearTax credits provided by the government to
induce firms to investCash inflows resulting from the sale of existingassets, when the project involves a decision toreplace assets, including any taxes related to thatsale
E i i Th P j t I di C h
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Estimating The Projects Intermediate CashFlowsThe projects intermediate cash flows are
calculated using the cash flow formulaEstimating The Projects Terminal Cash FlowThe incremental cash flow for the last year of
any project should include the following items:The last incremental net cash flow the project isexpected to generateRecovery of the projects incremental working capital
requirement, if anyAfter-tax resale value of any physical assets acquired inrelation to the projectCapital expenditure and other costs associated with thetermination of the ro ect
EXHIBIT 8 3a:
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EXHIBIT 8.3a:Estimation of the Cash Flows Generated by the Designer Desk LampProject.Figures in thousandsof dollars; data from Exhibit 8.1
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EXHIBIT 8 3b:
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EXHIBIT 8.3b:
Estimation of the Cash Flows Generated by the DesignerDesk Lamp Project.Figures in thousands of dollars; data from Exhibit 8.1
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EXHIBIT 8 4:
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EXHIBIT 8.4:Calculation of Net Present Value for SMCs Designer Desk Lamp Project.Figures from Exhibit 8.3
Sh ld SMC L h th N P d t?
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Should SMC Launch the New Product?
The project has a positive NPV
Before making the final decision, the firmshould perform a sensitivity analysis on theprojects NPV to account for two importantelements:SMC may notbe able to raise the price of itsnew lamp in steps with the inflationSMC may incur net cash lossesas a result ofa potential reduction in the sales of its
standard desk lamps
S iti it f th P j t NPV t Ch i
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Sensitivity of the Projects NPV to Changes inthe Lamp Price
Even if SMC is unable to raise the price of itslamps by the three percent expected rate ofinflation, the project is still worth undertaking
Because its NPV remains positive
Sensitivity of NPV to Sales Erosion
Before deciding whether to launch the designerdesk lamp project, SMCs managers mustdetermine
The size of the possible annual reduction in
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The size of the possible annual reduction insales and net cash flows through sales erosionWith an estimated $100,000 yearly sales
erosion, the project is no longer a value-creatingproposalHowever, it can withstand some sales erosionand still have a positive NPV
Sensitivity analysis is a useful tool whendealing with project uncertaintyHelps identify those variables that have thegreatest effect on the value of the proposalShows where more information is neededbefore a decision can be made
LONG TERM FINANCIAL PLANNING &
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LONG-TERM FINANCIAL PLANNING &GROWTH
Chapter 4 (Corporate Finance Fundamentals -RWJ-8e)
Financial Planning ModelsExternal Financing and GrowthInternal Growth and Sustainable GrowthOperating leverage/Break-even AnalysisChapter ObjectivesUnderstand how to apply the percentage of salesmethod.
Understand how to compute the external financingneeded to fund a firms growth.Understand the determinants of a firms growth.Understand some of the problems in planning for
growth.
What is Financial Planning?
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What is Financial Planning?
Formulates the way financial goals are to be
achieved.
Requires that decisions be made about an
uncertain future.
Recall that the goal of the firm is to maximize the
market value of the owners equity
The basic policy elements of financial planning
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The basic policy elements of financial planningare:
The firms needed investment in new assets.
The degree of financial leverage the firm
chooses to employ.
The amount of cash the firm thinks it is
necessary and appropriate to pay shareholders.
The amount of liquidity and working capital thefirm needs on an ongoing basis.
Important Questions
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Important QuestionsIt is important to remember that we are workingwith accounting numbers, and we should ask
ourselves some important questions as we gothrough the planning process. For example:
How does our plan affect the timing and risk ofour cash flows?
Does the plan point out inconsistencies in ourgoals?
If we follow this plan, will we maximise ownerswealth?
Dimensions of Financial Planning
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Dimensions of Financial Planning
The planning horizon is the long-range period
that the process focuses on (usually two to fiveyears).
Aggregation is the process by which thesmaller investment proposals of each of a firmsoperational units are added up and treated as
one big project.
Financial planning usually requires threealternative plans: a worst case, a normal case,
and a best case.
Accomplishments of Planning
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Accomplishments of Planning
Optionsfirm can develop, analyse and
compare different scenarios.
Avoiding surprises development of
contingency plans.
Feasibility and internal consistency
develops a structure for reconciling differentobjectives.
Elements of a Financial Plan
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Elements of a Financial Plan
An externally supplied sales forecast (either an
explicit sales figure or growth rate in sales).
Projected financial statements (pro-formas).
Projected capital spending.
Necessary financing arrangements.
Amount of new financing required (plug figure).
Assum tions about the economic environment.
Example A Simple Financial Planning Model
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ExampleA Simple Financial Planning Model
Recent Financial Statements
Income Statement Balance SheetSales $100 Assets $50 Debt $20Costs 90 Equity 30Net Income $ 10Total $50 Total $50
Assume that:
1. Sales are projected to rise by 25 per cent2. The debt/equity ratio stays at 2/33. Costs and assets grow at the same rate as
sales
Pro-Forma Financial Statements
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Pro-FormaFinancial Statements
Income StatementBalance Sheet
Sales $125.00 Assets $ 62.50 Debt $25.00Costs 112.50 Equity 37.50Net $12.50 Total $62.50 Total $62.50
What is the plug?
Notice that projected net income is $12.50, but
equity only increases by $7.50. The difference,$5.00 paid out in cash dividends, is the plug.
Percentage of Sales Approach
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Percentage of Sales ApproachSome items vary directly with sales, while othersdo not:
Income Statement
Costs may vary directly with sales - if this isthe case, then the profit margin is constant.Depreciation and interest expense may not
vary directlywith sales if this is the case, thenthe profit margin is not constant.Dividends are a management decision andgenerally do not vary directly with sales this
influences additions to retained earnin s.
Balance Sheet
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Balance SheetInitially assume all assets, including fixed,vary directlywith sales
Accounts payable will also normally varydirectlywith sales.
Notes payable, long-term debt and equitygenerally do not vary directly with sales
because they depend on management decisionsabout capital structureThe change in the retained earnings portion ofequity will come from the dividend decision.
ExampleIncome Statement
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Example Income StatementSales $1 000Costs 800
Taxable Income 200Tax (30%) 60Net profit $140Retained earnings $112
Dividends $28ExamplePro-Forma Income Statement
Sales (projected) $1 250
Costs (80% of sales) 1 000Taxable Income 250
Tax (30%) 75
Net profit $175
ExampleSteps
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Example StepsUse the original Income Statement to create a pro-forma; some itemswill vary directlywith sales.Calculate the projected addition to retained earnings
and the projected dividends paid to shareholders.Calculate the capital intensity ratio.ExampleBalance SheetAssets
Current assets ($) (% of sales)Cash 160 16Accounts receivable 440 44
Inventory 600 60Total 1 200 120
Non-current assetsNet plant and equipment 1 800 180Total assets 3 000 300
Liabilities and owners equity
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Liabilities and owners equity
Current liabilities ($) (% of sales)Accounts payable 300 30
Notes payable 100 n/aTotal 400 n/aLong-term debt 800 n/aShareholders equity
Issued capital 800 n/aRetained earnings 1 000 n/aTotal 1 800 n/aTotal liabilities & owners equity 3 000 n/a
ExamplePartial Pro-Forma Balance Sheet
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AssetsCurrent assets ($) ChangeCash 200 $40Accounts receivable 550 110
Inventory 750 150Total 1 500 $300Non-current assetsNet plant and equipment 2 250 $450Total assets 3 750 $750
Liabilities and owners equityCurrent liabilities ($) ChangeAccounts payable 375 $ 75Notes payable 100 0Total 475 $ 75Long-term debt 800 0
Shareholders equityIssued capital 800 0Retained earnings 1 140 $140Total 1 940 $140Total liabilities & owners equity 3 215 $215
External financing needed 535 $535
ExampleResults of Model
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Example Results of ModelThe good newsis that sales are projected to increaseby 25 per cent.
The bad news is that $535 of new financing isrequired.
This can be achieved via short-term borrowing, long-term borrowing, and new equity issues.
The planning process points out problems and potentialconflicts.
Assume that $225 is borrowed via notes payable, and
$310 is borrowed via long-term debt.
Plug figure now distributed and recorded within
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Plug figure now distributed and recorded withinthe Balance Sheet.
A new (complete) pro-forma Balance Sheet cannow be derived.
ExamplePro-Forma Balance SheetA
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Assets
Current assets ($) ChangeCash 200 $ 40
Accounts receivable 550 110Inventory 750 150Total 1 500 $300
Non-current assetsNet plant and equipment 2 250 $450
Total assets 3 750 $750Liabilities and owners equity
Current liabilities ($) ChangeAccounts payable 375 $ 75Notes payable 325 $225
Total 700 $300Long-term debt 1 110 $310
Shareholders equityIssued capital 800 0Retained earnings 1 140 $140
Total 1 940 $140Total liabilities & owners equity 3 750 $750
External Financing and Growth
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External Financing and Growth
The higher the rate of growth in sales or assets,
the greater the external financing needed (EFN).Growth is simply a convenient means ofexamining the interactions between investmentand financing decisions. In effect, the use ofgrowth as a basis for planning is just a reflectionof the high level of aggregation used in theplanning process.
Need to establish a relationship between EFNand growth (g).
ExampleIncome Statement
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Example Income Statement
Sales $500
Costs 400Taxable Income $100Tax (30%) 30
Net profit $70Retained earnings $25Dividends $45
ExampleBalance Sheet
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($) (% ofsales)
($) (% ofsales)
Assets Liabilities
Current assets 400 80 Total debt 450 n/a
Non-currentassets
600 120 Owners equity 550 n/a
Total assets 1000 200 Total 1000 n/a
Ratios Calculatedp(profit margin) = 14%
R(retention ratio) = 36%ROA (return on assets) = 7%ROE (return on equity) = 12.7%
D/E(debt/equity ratio) = 0.818
Growth
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GrowthNext years sales forecast to be $600.Percentage increase in sales:
Percentage increase in assets also 20 per cent.
Increase in AssetsWhat level of asset investment is needed to
support a given level of sales growth?For simplicity, assume that the firm is at fullcapacity. in assets be financed?
20%$500$100
The indicated increase in assets required equals:A
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q qAg
where A = ending total assets from the previous period and g =the growth rate in sales
How will the increase
Internal Financing
Given a sales forecast and an estimated profitmargin, what addition to retained earnings can beexpected?
This addition to retained earnings represents thelevel of internal financingthe firm is expected togenerate over the coming period.
The expected addition to retained earnings is:
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The expected addition to retained earnings is:where: S= previous periods sales
g= projected increase in sales
p= profit marginR= retention ratio
External Financing Needed
If the required increase in assets exceeds theinternal funding available (that is, the increase in
retained earnings), then the difference is theexternal financing needed (EFN).
EFN = Increase in Total Assets
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Addition to Retained Earnings
= A(g)p(S)R (1 + g)
Increase in total assets = $1000 20%= $200
Addition to retained earnings= 0.14($500)(36%) 1.20= $30
The firm needs an additional $200 in new financing. $30 can be raised internally. The remainder must be raised externally (external
financing needed).
REoAddition tassetsin totalIncreaseEFN
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170$
201%36500$140)200(1000$
)1()()(
...
gRSpgA
)(
RelationshipTo highlight the relationship between EFN and g:
Setting EFN to zero, gcan be calculated to be2.56 per cent.This means that the firm can grow at 2.56 per
cent with no external financing (debt or equity).
g
g.%.
gRSpARSp
97525
%)36(500$1401000$36500$140EFN
Financial Policy and Growth
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y
So far sees equity increase (via retained
earnings), debt remain constant and D/Edecline.
If D/E declines, the firm has excess debtcapacity.
If the firm borrows up to its debt capacity, whatgrowth can be achieved?
Sustainable Growth Rate (SGR)
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( )
The sustainable growth rateis the growth rate a
firm can maintain given its debt capacity, ROEand retention ratio.
R
R
ROE1
ROE
SGR
ExampleSustainable Growth Rate
Continuing from the previous example:
4.82%
0.360.1271
0.36).1270(SGR
The firm can increase sales and assets at a rate
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of 4.82 percent per year without selling anyadditional equity, and without changing its debt
ratio or payout ratio.
Determinants of Growth
Growth rate depends on four factors:profitability (profit margin)dividend policy (dividend payout)
financial policy (D/Eratio)asset utilisation (total asset turnover).
If a firm does not wish to sell new equity, and its
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q y,profit margin, dividend policy, financial policy andtotal asset turnover (or capital intensity) are all
fixed, then there is only one possible growth rate.Do you see any relationship between the SGRand the Du Pont identity?
ESTIMATING THE COST OF CAPITAL (WACC)
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( )Chapter 10 (Finance for executives-Hawawini,viallet-3e)
Estimating the cost of equityThe dividend discount modelThe CAPM approach
Estimating the cost of capital of a project
Cash is not freeit comes at a priceThe price is the cost to the firm of usinginvestors moneyCost of CapitalReturn expected by the investors for the capital
the su l
Background
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gObjective of ChapterShows how to estimate the cost of capital to be used in
discounted cash flows modelsInvestors do not normally invest directly in projectsThey invest in the firms that undertake projectsChallenge is to identify firms, called proxies or pureplaysExhibit the same risk characteristics as the projectunder consideration.After a proxy has been identified need to estimate thereturn expected by the investors who hold the securities
the proxy has issuedAssume that there are only two types of securitiesStraight bondsCommon shares
Return expected from the assets managed by a firmt b th t t l f th t t d b b dh ld
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must be the total of the returns expected by bondholdersand shareholders, weighted by their respectivecontribution to the financing of these assets
Weighted average cost of capitalor WACCSunlight Manufacturing Companys (SMC) desk lampprojectUsed to illustrate the case when a projects cost of
capital is the same as the firms cost of capitalBuddy's Restaurant ProjectIllustrates how to estimate the projects cost of capitalwhen the project has a risk that differs from the risk of
the firmAfter reading this chapter, students should understand:How to estimate the cost of equity capitalHow to combine the cost of different sources of
financing to obtain a projects weighted average cost of
How to estimate the cost of debtTh diff b t th t f it l f fi
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The difference between the cost of capital for a firmand the cost of capital for a project
Identifying Proxy Or Pure-Play FirmsWhen the projects risk profile is similar to thefirms risk profile, the proxy is the firm itself
Classification systems used to select pure-playsare far from perfect
Often trade-offs need to be made between
possible large measurement errors of a smallsample of closely comparable companies anda larger sample of firms that are only loosely
comparable to the project
Estimating The Cost Of Debt
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gIf a firm takes out a loan, the firms cost of debtis the rate charged by the bank
If we know a sufficient amount of informationthe valuation formula can be solved for theinvestors required rate of return
If the firm has no bonds outstanding, its cost of
debt can be estimated by adding a credit riskspread to the yield on government securities ofthe same maturity
t t+1 t+2 T
t t
D D D
+ +2
D
1 t Tk k
Coupon PMT Coupon PMT Coupon PMT Coupon PMTBond Price = + + + +1+ 1+ 1+ 1+k k
Since interest expenses are tax deductible, thef f d b i h l f
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after tax cost of debt is the relevant cost ofdebt
After-tax cost of debt= Pre-tax cost of debt (1 - marginal corporatetax rate)
However, the after tax cost of debt is a valid
estimator only ifThe firm is profitable enough, orA carry back or carry forward rule applies to
interest expenses
Estimating The Cost Of Equity:
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The Dividend Discount ModelAccording to the dividend discount model, the
price of a share should be equal toPresent value of the stream of future cashdividends discounted at the firms cost of equity
The dividend discount model cannot be use to
solve for the cost of equityUnless simplifying assumptions regarding thedividend growth rate are made
Estimating The Cost Of Equity: DividendsGrow At A Constant RateFirms cost of equity is the sum of its expecteddividend yield and the expected dividend growth
If we assume the dividend that a firm is expected
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to pay next year will grow at a constant rateforever
D0 = 2.00, kE = 13%, g = 6%.
Constant growth model:
P0 = D0 (1 + g)/P0 + g= 2(1 + 0.06)/ (0.13 0.06)
= $2.12/ 0.07 =$30.29
What is the stocks market value one year from now,P1?
D1 will have been paid, so expected dividends are D2,
D3, D4 and so on. Thus,
1
E0
DIV
k = +gP
P1 = D2 / (kE g)D (1 + g)^2/ (kE g)
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= D0 (1 + g)^2/ (kE g)
= $2.247/ 0.07= $32.10
Find the expected dividend yield and capital gains yield during the first
year.Dividend yield = D1 / P0 = $2.12/ $30.29 = 7%
CG Yield = (^P1 - P0 )/ P0 = ($32.10 $30.29) / $30.29 =6%
Estimating The Cost Of Equity: How Reliable
Is The Dividend Discount Model?For the vast majority of companies, the simplisticassumptions underlying the reduced version of
the dividend discount model are unacceptableThus, an alternative valuation approach isneededThe capital asset pricing modelor CAPM
Estimating The Cost Of Equity:
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The Capital Asset Pricing ModelThe greater the risk, the higher the expected
returnWhat is the nature of the risk?How is it measured?
How does it determine the return expected byshareholders from their investment?
Diversification Reduces RiskA major implication of holding a diversifiedportfolio of securities is that the risk of a singlestock can be divided into two components
Unsystematicordiversifiable riskC b li i t d th h tf li
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Can be eliminated through portfoliodiversificationIncludes company-specific events such asthe discovery of a new product (positive effect)
or a labor strike (negative effect)Systematic ornondiversifiable risk
Cannot be eliminated through portfoliodiversificationEvents that affect the entire economy insteadof only one firm, such asChanges in the economys growth rate,inflation rate and interest rates
Diversification Reduces Risk
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Financial markets will not reward unsystematicrisk
Because it can be eliminated throughdiversification at practically no cost
Thus, the only risk that matters in determining therequired return on a financial asset is the assetssystematic risk
In other words, the required rate of return on afinancial asset depends only on its systematicrisk
Measuring Systematic Risk With the Beta
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CoefficientA firms systematic risk is usually measured
relativeto the market portfolioPortfolio that contains all the assets in theworld
Systematic risk of a stock is estimated byMeasuring the sensitivity of its returns tochanges in a broad stock market index
Such as the S&P 500 indexThis sensitivity is called the stocks betacoefficient
The Impact Of Financial Leverage On A
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Stocks BetaA firms risk depends on
Risk of the cash flows generated by the firms assets(business risk)Firms asset (or unlevered) beta captures its businessrisk
The risk resulting from the use of debt (financial risk)Thus, firms beta coefficient is affected by both
Firms equity beta (or levered beta) captures bothbusiness and financial risk
equity
asset
Debt1+ 1 - tax rateEquity
equity assetDebt
1+ 1 - tax rateEquity
EXHIBIT 10.4:
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Average Annual Rate of Return on CommonStocks, Corporate Bonds, U.S. Government
Bonds, and U.S. Treasury Bills, 1926 to 1995.AverageRiskPremium
AverageAnnualReturn
Type ofInvestment
The Capital Asset Pricing Model (CAPM)
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Treasury bills are the safest investment available
Usually used as a proxy for the risk-free rateRisk premium of a security
Difference between the expected return on asecurity and the risk-free rate
Market risk premiumRisk premium of the market portfolio
Since beta measures a securitys risk relative to
the market portfolioA securitys risk premium equals the marketrisk premium the securitys beta.
The CAPM states that the expected return on anyi i h i k f l h k i k
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security is the risk-free rate, plus the market riskpremium multiplied by the securitys beta
Using The CAPM To Estimate SMCs Cost Of
EquityTreasury bill rate is replaced by the rate ongovernment bonds
Since it is difficult to estimate future Treasurybill rates
SMCs cost of equity of12.37% is estimatedfrom the market risk premium of 6.2 percent and
SMCs beta of 1.06
i F M F iR = R + R - R
KE, SMC = 5.8% + (6.2%) x 1.06 = 12.37%E i i Th C Of C i l Of A Fi
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Estimating The Cost Of Capital Of A FirmWhat is the firms cost of capital?
Minimum rate of return the project mustgenerateIn order to meet the return expectations of its
suppliers of capitalAssuming that a project has the same riskas thefirm that would undertake itA firms cost of capital is its weighted averagecost of capital, or WACCAssuming that the firm is financed by debt andequity, its WACC is equal to
Weighted average of the cost of these twof fi i
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means of financingWeights equal to the relative proportions of debt
and equity used in financing the firms assetsWACC= kD (1 TC) E/(E+D) + kE E/(E+D)