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Corporate Finance
Corporate Finance
Corporate Finance
- By FinTree
eBook 5
Corporate Finance
Shareholder Stakeholder
theory theory
Principal-agent ª It arises because an agent is hired to act in the interest of the principal but
the agent’s interest may not coincide exactly with those of the principal.
Shareholders ª Shareholders are principals and board members are their agents
and managers ª Managers and directors are dependent on firm for employment
ª They may choose lower level of business risk than the shareholders would
or BOD
since their employment is dependant on firm’s performance.
ª There is an information asymmetry between shareholders and managers
because managers have more and better understanding of the functioning
of the firm. This decreases the ability of the shareholders or non-executive
directors to monitor and evaluate whether managers are acting in the best
interest of the shareholders.
LOS d
e
Stakeholder management - Management of company relations with stakeholders
re
Infrastructures
One-tier Two-tier
board board
2 Board responsibilitiese
Staggered board - Elections for some board positions are held each year
re
ç Selecting senior management, setting their compensation, evaluating their performance
and replacing them as needed.
ç Setting strategic direction.
ç Approving capital structure changes, acquisitions and large investment expenditures.
ç Reviewing company performance and taking necessary corrective steps.
nT
3 Board committees
Fi
2 Legal
environment
Dual class One class of shares may be entitled to several votes per share, while another
2
structure - class of shares is entitled to one vote per share
On average, companies with a dual class share structure have traded at a
discount to comparable companies with a single class of shares
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LOS j Environmental and social considerations in investment analysis
Negative Certain companies and certain sectors are excluded from portfolios.
screening - Eg. mining and oil production sector.
Positive No specific sectors are excluded from portfolios but investors identify
screening - best practices across environmental sustainability.
2
Impact Investing in order to promote specific social or environmental goals.
investing
Investors seek to make profit while at the same time having a
positive impact on the environment
Thematic
investing e
Refers to investing based on a single goal. Eg.
development of clean water resources
re
nT
Fi
Capital Budgeting
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LOS a
1 Capital budgeting process 2 Categories of capital
budgeting projects
Idea generation
Replacement Replacement
projects to maintain projects for cost
the business reduction
Analyzing project Without detailed Fairly detailed
proposals analysis analysis
New product or
Expansion Projects market
development
Create the firm- wide
Very detailed Detailed analysis
capital budget
analysis
Other projects
Mandatory Projects such as R&D
Monitoring decisions and
conducting a post-audit Without detailed
analysis
LOS b
1 Basic principles of capital
budgeting
e 2 Externalities
re
4 Decisions are based on cash flows, not Positive Negative
accounting income.
3 Conventional Unconventional
cash flow cash flow
pattern pattern
0 1 2 3 0 1 2 3
Unlimited Capital
funds rationing
Independent Mutually exclusive
´ Unlimited ´ Constraints on
select all select only one access to raising capital
projects, if NPV project (with the capital ´ Undertake
>0 highest NPV) ´ Firm can projects with
undertake all highest NPV
profitable
projects
Project sequencing - Investment in a project today creates opportunity to invest in projects in future
LOS d
Discounted Profitability
Payback
NPV IRR payback
period index
period
Time taken to
PV of inflows − PV
of outflows
Rate at which NPV
=0
PV of inflows = PV
of outflows
e
recover initial
investment
LOS e Total of
NPV
undiscounted
cash flows
1 (Y-axis intercept)
Crossover rate
Fi
IRR
(X-axis intercept)
WACC
NPV profile
The rate at which NPVs are equal is called as Crossover rate
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3 NPV IRR
ª
of firm
Theoretically the
best method
e
ª Provides information
on margin of safety
that NPV does not
ª
ª
Multiple IRR / No
IRR
Assumes
reinvestment at IRR
re
LOS f Relation between NPV and stock price
nT
Eg. Investment in new project = $300 mln, PV of future CFs = $400 mln
No. of shares outstanding = 50 mln, Market price of share = $25
Preferred
Equity stock Debt
Capital appreciation
Fixed dividend Fixed interest
Variable dividend
Dividend is a function Interest is to be paid
Dividend is a function of profitability irrespective of
of profitability profitability
nd
2 preference in case
Last preference in of liquidity and 1st preference in case
case of liquidity and dividend payment of liquidity and
dividend payment interest payment
LOS a
Capital
component
1
e
Calculation and interpretation of WACC
2 Costs
stock
Amount of
capital invested
Optimal
Capital
Budget
Kd = YTM x (1 - t)
nT
discount model
1
Y = a + bx
Covariance (s,m)
Beta =
Dependant variable Variance (m)
Independent variable
Intercept Slope/beta
2 Pure-play method
Ê
of time used and frequency.
Ê Beta may need to be adjusted upward for small firms to reflect inherent risk in them.
nT
Developing Eg.
country
RFR = 4% Rm = 9%
Sovereign SD of market CRP = 5% Beta = 1.5
CRP = X
yield spread SD of debt
Kce = RFR + (MRP + CRP) x β
Developed Kce = 4 + [(9 − 4) + 5) x 1.5
country
Kce = 19%
Kce = RFR + (MRP + CRP) x β
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LOS k Marginal cost of capital schedule
The correct method to account for floatation costs is to calculate the dollar amount of cost
and increase the initial cash outflow by this amount.
It should not be incorporated directly into the cost of equity because it is not an ongoing
expense and it would lead to increase in WACC which in turn will reduce the NPV
e
re
nT
Fi
Measures of Leverage
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LOS a
1
Variable Fixed
cost cost
Fixed Variable
cost cost
Degree of
Operating
Leverage
Degree of
Financial
Leverage e Uncertainty about
firm’s sales
Additional
uncertainty
about operating
re
earning
LOS b
1 Degree of operating Degree of financial Degree of combined
leverage (DOL) leverage (DFL) leverage (DCL)
Fi
% ∆ EBIT
% ∆ sales
% ∆ EPS
DOL × DFL
% ∆ EBIT
Sales − VC
EBIT % ∆ EPS
EBIT
% ∆ sales
EBT
Highest at low level of
sales Sales − VC
If there’s no FFC,
EBT
DFL=1
If there’s no OFC,
DOL=1
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+10% +10%
2 Sales 1000
Variable 400
cost
Contribution 600 Contribution % ∆ EBIT
1.5 DOL = Or
EBIT % ∆ Sales
Operating
200
fixed cost
DTL = DOL × DFL 3
+15%
EBIT 400
+15%
Interest 200
EBIT % ∆ EAT
EBT 200 2 DFL = Or
% ∆ EBIT
EBT
Taxes 100
EAT 100
+30% +30%
% ∆ Sales = % ∆ Contribution
% ∆ EBT = % ∆ EAT
% ∆ Net income = % ∆ PAT = % ∆ EPS
LOS c
LOS d LOS e
Fixed cost
Breakeven point (in amount) =
Contribution ratio
Contribution
Contribution ratio =
Sales
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Eg. Operating fixed cost = 10,000 Financing fixed cost = 20,000
Selling price = 100 Variable cost = 60 Desired profit = 30,000
OFC
Operating breakeven =
Contribution per unit
10,000
=
40
= 250
OFC + FFC
Total breakeven =
Contribution per unit
10,000 + 20,000
=
40
OFC + FFC
re
Contribution ratio
10,000 + 20,000
=
40%
= 75,000
nT
Fi
Dividends and Share Repurchases
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1 Cash dividends 2
Equity share
capital increases
No. of shares
increase
Price of shares
decrease
Shareholder’s
wealth is
unchanged
A company whose
e
Decrease in retained earnings, increases debt-to-
equity ratio
re
Value of
Total equity stock has fallen
shareholder’s
remains dramatically may
total shares is
unchanged declare Reverse
unchanged
stock split
Settlement cycle in US = T + 3
If a person buys shares on or after ex-dividend date, he will not receive the dividend
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LOS c Share repurchase methods
EPS
Earning yield =
MPS If borrowing cost > earning yield - EPS
Cost of borrowing = YTM × (1 − t)
LOS e
BV of Assets − BV of Liabilities
e
Impact of share repurchase on BVPS
Eg. (LOS d)
nT
Share price before buyback = $40 Shares outstanding before buyback = 120,000
EPS before buyback = $3 Cost of debt = 9% Tax rate = 30% Planned buyback = 20,000
EPS will increase after buyback, because earning yield > after tax cost of debt
360,000 − 50,400
=
100,000
= $3.096
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Eg. (LOS e)
Share price before buyback = $40 Shares outstanding before buyback = 120,000
Book value = $2.4 mln Planned buyback = $800,000
2,400,000
Current BVPS =
120,000
= 20
2,400,000 − 800,000
120,000 − 20,000
= 16
e
equivalent in terms of effect on shareholders’ wealth
Factory
(700)
Capital
(1000)
Working Capital
Cash
(300)
Accounts
Inventory
Receivable
Factory
2 (700)
Capital
(1000)
Working capital
is still 300
Current liabilities
Accounts Payable
e Amt.
100
Current assets
Inventory
Amt.
100+100
re
Accounts Receivable 100
100 worth of
current assets Cash 100
are funded by
Current
Liabilities
Total 100 Total 400
nT
LOS a
1 Sources of liquidity 2 Factors that influence a
company’s liquidity position
Primary Secondary
Fi
sources sources
DI PO
Used in normal day to Used in deteriorating
Drag on Inflows Pull on Outflows
day operations financial conditions
Eg. Uncollected Eg. Paying vendors
è Selling good è Selling assets receivables, sooner than is
è Collecting from AR è Negotiating debts obsolete inventory optimal
è Short-term funding (restructuring)
è Trade credit
è Line of credit
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Accounts payable - 50
LOS c
0 30 50 70
Inventory AR Cash
30 40
Operating cycle (70) = No. of days in Inventory (30) + No. of days in AR (40)
LOS d
purchases and pay expenses as they come due.
e
Daily cash position refers to uninvested cash balances a firm has available to make routine
Purpose of managing daily cash position - To have sufficient cash on hand (make sure net daily
cash position never becomes negative) but to avoid keeping excess cash because of interest income
re
forgone by not investing
3.09
90 days
1 + 3.09% 30
= 3.09%
970
j No Compounding j No Compounding
90 30/1000 =3% k 360 days 90 3.09% k 360 days
12%
l Face value as 360 12.36% l Investment value
360
base 3 as base
1 − 3%
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g Types of securities
allowed
Interest Interest
Investment value Face value g Persons responsible
for complying with
the guidelines
e
Cost of borrowing < Cost of annual trade credit = Take the discount
re
If inventory levels are too low, it will result in loss of sales due to stock-outs.
If inventory levels are too high, it will result in more carrying costs.
If credit terms are lenient, it will lead to increase in sales but at the cost of longer
average days of receivables. It may also increase bad debts.
Committed
Fi
Uncommitted Revolving
(regular)
Bank may refuse to lend if Bank charges a fee for Typically for longer terms.
circumstances change. making the commitment.