Professional Documents
Culture Documents
CFA CI Full Version Updated 0407
CFA CI Full Version Updated 0407
External
Connected
Shareholders Creditors
Loans Interest
Appoint
Internal
Committees Employees
Goods, Goods,
Cash services services Cash
Suppliers Customers
Taxes
Regulators
6
Stake Interest/Influence
Stake Interest/Influence
Stake Interest/Influence
Stake Interest/Influence
Delegates authority/Hire
(2) Internal
Board of director Senior managers
(3)
Committees Employees
(6)
Customers Suppliers
Regulators
Managers/
Shareholders Conflict of interest
Directors
• The interest of managers When the board is Managers and directors have
and directors is more influenced by more and better information
dependent on firm insiders about the functioning and
performance → managers favor strategic direction of the firm
→ prefer lower of business management than shareholders → manager
risk interests at the may make strategic decisions
• The interest of shareholders expense of that are not necessarily in the
holding diversified portfolios shareholders or best interest of shareholders
is less dependent on the favor one group of → weaken the ability of
firm shareholders at the shareholders to exercise
→ may choose higher expense of another control
business risk to get more
profits
13
Board of
Manager Conflict of interest
director
Controlling Minority
Conflict of interest
shareholders shareholders
Controlling Minority
Conflict of interest
shareholders shareholders
Conflicts between
Mechanism
a. General meetings
• Require board of director to address about the company’s performance and
other matters involved in.
• Enable shareholders to participate in discussions and to vote on major corporate
matters and transactions that are not delegated to the board of directors.
Managers/
Shareholders
Directors
(*)
Proxy voting Cumulative voting
Implications
Mechanism
Shareholders
Board of (1)
Manager
director
(1)
• Guide managers on the company’s strategic direction, oversee and monitor
management’s actions in implementing the strategy.
• Evaluate and rewards or disciplines management performance.
• Supervise the company’s audit, control, and risk management functions
Implications
• Ensure the proper governance of the company → act in the best value for the
shareholders.
• Mitigating agency problems and their associated risks.
22
Mechanism
Implications
Mechanism
Implications
Mechanism
Implications
Mechanism
Implications
(*)
• Nonmandatory and nonbinding say on pay systems (e.g., Canada):
the board is required to ask for feedback, rather than their imposition
on renumeration policies and is not required to act upon it.
• Mandatory and nonbinding system: the board is required to enable
shareholders to vote on remuneration plans, but the board does not
have to abide by the result of the vote.
• Mandatory and binding system: the board is required to enable
shareholders to vote on remuneration plans, but the board has to
abide by the result of the vote.
27
Mechanism
Implications
Mechanism
• Labor law: The framework that outlines employee rights such as working hours,
hiring and firing, pensions, and other employee benefits.
• Employment contracts: for the individual and outline the employee’s rights and
responsibilities; they are not all-encompassing, leaving some discretion within
the relationship.
• Other items such as the code of ethics and human resources documents are
intended to outline the relationship in order to manage and mitigate any legal
or reputational risks.
Implications
Employers and employees can determine clearly about their rights and
responsibilities:
• A company seeks to comply with employees’ rights and mitigate legal or
reputational risks in violation of these rights
• Ensure that employees are fulfilling their responsibilities toward the company
and are qualified and motivated to act in the company’s best interests
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Mechanism
Implications
Mechanism
Implications
(1) There is a single board of directors that includes both internal and
external directors.
• Internal (executive) directors: senior managers employed by the
firm.
• External (non-executive) directors: are not company managers,
provide objective decision making, monitoring, and performance
One-tier
assessment.
board
• Independent directors: are non-executive directors who have no
other relationship with the firm regard to employment, ownership
or remuneration.
(2) Lead independent director has the ability to call meetings of the
independent directors, separate from meetings of the full board.
(3) The general practice is for all board member elections to be held at
the same meeting and each election to be for multiple years
Two-tier board
One-tier board
Board of director
Report for
monitoring Supervision
purpose
Supervisory board/commitee
33
(1) Elections for some board positions are held each year
(2) Board of directors are typically divided into three classes
that are elected separately in consecutive years - one class
every year:
• Negative aspect: need several years to replace a full board
Staggered
→ limit the ability of shareholders to replace board
board
members in any one year → limits their ability to effect a
major change of control at the company.
• Positive aspect: provides continuous implementation of
strategy and oversight without constantly being reassessed
by new board members thereby bringing short-termism into
company strategy.
34
Duty of the board member is to act in the interest of the company and
shareholders → prevent individual board members from acting in their
own interest, or the interest of another individual or group, at the
expense of the company and all shareholders
• Regular receive reviews and reports from both management and the
company’s risk function
• Review any proposals for corporate transactions or changes, such as
major capital acquisitions, divestures, mergers, and acquisitions, before
they are referred to shareholders for approval, if applicable.
36
Strategy
Internal control
Board of director Management
Risk management
Support
Audit committee
Governance committee
Nominations committee
Remuneration committee
Risk committee
Investment committee
37
Audit committee
Governance committee
Nominations committee
Remuneration committee
Risk committee
• Informs the board about appropriate risk policy and risk tolerance of the
organization
• Oversees the enterprise-wide risk management processes of the
organization.
39
Investment committee
Shareholder engagement
Shareholder Activism
The legal environment varies around the world and offers different
protections to the shareholder or creditor:
• Common-law system: judges’ rulings become law in some instances
→ shareholders’ and creditors’ interests are considered to be better
protected
• Civil law system: judges are bound to rule based only on specifically
enacted laws → the rights of creditors are more clearly defined
→ creditors generally have a better protected position
43
Media
Operational efficiency
Improved control
Straight voting structure: one vote per share → any shareholder’s voting
power is equal to the percentage of the company’s outstanding shares
owned by that shareholder.
Dual class structure: common shares may be divided into two classes, one
of which has superior voting rights to the other.
There are two mechanism in dual class structure:
• A share class carries one vote per
Each share has equal voting rights, but:
share and is publicly traded
• One share class (held by insiders)
• Another share class (held exclusively
elects a majority of the board
by company insiders or family
• Another share class would be entitled
members) carries several votes per
to elect only a minority of the board
share
For example: Alibaba
For example: Facebook
The founders/insiders can still control The insiders retain substantial power
board elections and all other major over the affairs of the corporation
voting matters even when their because they control a majority of the
ownership level < 50%. board.
50
Sustainable investing
A term used in a similar context to responsible investing, but its key focus is on
factoring in sustainability issues while investing.
Responsible investing
The broadest term used to describe investment strategies that incorporate
environmental, social, and governance (ESG) factors into their approaches.
Socially responsible
ESG investing Impact investing
investing (SRI)
Excluded companies
x x x
59
Learning outcomes
28.b. Demonstrate the use of net present value (NPV) and internal rate
of return (IRR) in allocating capital and describe the advantages
and disadvantages of each method.
Definition
The capital allocation process is identifying and evaluating capital projects,
that is, projects where the cash flows to the firm will be received over a
period longer than a year.
The steps typically involved in the capital budgeting process are as follows:
The organization of the profitable proposals that together best fit the
company’s strategy. Financial and real resource constraints mean the
scheduling and prioritizing of capital investments are key considerations.
Project 1 18%
36% Project 3
18%
Project 2
28% Project 4
Post-audit
Conclusion
Investment projects
Investment projects may be sub-divided
into:
• Replacement projects to maintain the
business;
• Replacement projects for cost
reduction
Example:
• Replacing existing equipment with newer
c. New technology
Products • The decision whether to replace a piece
and Services
of equipment becomes obsolete
Expansion projects
Investment projects that expand
business size and often involve greater
uncertainty and management
consideration than replacement
projects.
c. New Example:
Products Vietcombank opens a representative office
and Services in New York (2019).
70
Example:
c. New TH true milk introduces “TH true juice”
Products and product line.
Services
71
c. New
Products and Occasionally, however, the cost of such
Services projects is sufficiently high that the
company would be better off to cease
operating altogether or to shut down
any part of the business that is related to
the project.
Others
Some projects are not easily analyzed
through the capital allocation process.
Example: A senior manager of a architecture firm wants the most qualified designers
to involve in a smart greenhouse project just because he is interested in gardening.
73
Sunk cost
A sunk cost is one that has already been incurred. One cannot change a sunk
cost. Decisions made today, however, should be based on current and future
cash flows and should not be affected by prior, or sunk, costs.
Opportunity cost
An opportunity cost is the value of the next best alternative that is foregone in
making the decision to pursue a particular Project.
For example, if we invest $1 million in a piece of equipment, the opportunity cost
of investing in that piece of equipment is the amount that $1 million would have
earned in its next-most-profitable use. Opportunity costs should be included in
project costs.
Externality
An externality is the effect of an investment on things other than the
investment itself.
An investment affects the cash flows of other parts of the company, and these
externalities can be positive or negative.
A project has a conventional cash flow pattern if the sign on the cash flows
changes only once, with one or more cash outflows followed by only cash
inflows.
Cash inflows
0 1 …
2 3 4 Cash outflows
An unconventional cash flow pattern has more than one sign change.
Cash inflows
0 1 3 …
2 4 Cash outflows
Opportunity costs are cash flows that a firm will lose by undertaking the
project under analysis. These are cash flows generated by an asset the firm
already owns that would be forgone if the project under consideration is
undertaken.
→ Opportunity costs should be included in project costs.
5. Project interactions
Independent projects are capital investments whose cash flows are independent
of each other.
Example:
If projects A and B are independent, and both projects are profitable, the firm
could accept both project.
Mutually exclusive projects compete directly with each other. Multiple projects
are mutually exclusive if only one of them can be accepted so that profitability
must be evaluated a among the projects.
Example:
If Projects A and B are mutually exclusive, either Project A or Project B can be
accepted, but not both. Making a capital allocation decision to select one of two
different stamping machines, each with different costs and outputs, is an example
of ranking two mutually exclusive projects.
80
5. Project interactions
Project sequencing
Many capital projects are sequenced over time, so that investing in a project
creates the option to invest in future projects
Example:
The company might invest in a project today and one year later invest in a second
project:
• If the financial results of the first project or new economic conditions are
favorable, the company would undertake the second project.
• If the results of the first project or new economic conditions are not favorable,
the company would not invest in the second project.
0 t=1
Yes
Invest in project 2
Favorable
Invest in Project 1
result?
Not invest in project 2
No
81
5. Project interactions
Explanation:
If a firm’s profitable project
opportunities exceed the amount of
funds available, the firm must ration,
or prioritize, its capital expenditures
with the goal of achieving the
maximum increase in value for
shareholders, given its available
capital.
82
Net present value (NPV) is the sum of the present values of all the expected
incremental cash flows if a project is undertaken.
n
CF1 CF2 CF3 CFn CFt
NPV = CF0 + + + +…+ =
(1+k)1 (1+k)2 (1+k)3 1+k n (1+k)t
t=0
Where:
▪ CF0 = initial investment outlay (a negative cash flow),
▪ CFt = after-tax cash flow at time t ( can be positive and negative),
▪ k = required rate of return for project.
83
Decision rule:
Because the NPV is the amount by which the company’s wealth increases as a
result of the investment, the decision rule for the NPV is as follows:
Note: In the rare case that NPV turns out to be zero, the project could be
accepted because it meets the required rate of return.
84
CF0 -500
C01 100
F01 1
C02 170
F02 1
C03 230
F03 1
C04 260
F04 1
87
Example: Back to the example calculating the present value of an uneven cashflow
Step 2: Enter the discount rate and calculate the cashflow
• Press
• The screen displays “ I=“
Internal rate of return (IRR) is the discount rate that makes the present
value of the expected incremental after-tax cash inflows just equal to the
present value of the project’s estimated cash outflows.
PV (inflows) = PV (outflows)
Alternatively, the IRR is also the discount rate for which the NPV of a project is
equal to zero: n
CF1 CF2 CF3 CFn CFt
NPV = 0 = CF0 + + + +…+ =
(1+k)1 (1+k)2 (1+k)3 1+k n (1+k)t
t=0
NPV
Discount rate
0
Decision rule:
*The required rate of return for a given project is usually the firm’s cost of capital.
→ The required rate of return is often called the hurdle rate, the rate that a
project’s IRR must exceed for the project to be accepted by the company.
Note: the required rate of return may be higher or lower than the firm’s cost of
capital to adjust for differences between the project’s risk and the average risk of
all of the firm’s projects (which is reflected in the firm’s current cost of capital).
Required rate
of return
Firm’s cost of capital
Projects with higher than avg. risk
Projects with lower than avg. risk
90
Example: Back to the example calculating the present value of an uneven cashflow
Step 1: Entering the cashflows
Action Display Input value
CF0 -500
C01 100
F01 1
C02 170
F02 1
C03 230
F03 1
C04 260
F04 1
93
Example: Back to the example calculating the present value of an uneven cashflow
Step 2: Enter the discount rate and calculate the cashflow
• Press
NPV and IRR criteria will usually indicate the same investment decision for a given
capital investment (Acceptance or rejection of the investment).
Example:
If Project A and Project B were independent projects and the cost of capital were
7%, the company would accept both projects, as they both have positive NPVs
and their IRRs exceed the cost of capital (7%).
95
▪ The NPV shows the amount of gain, or wealth increase in company value,
as a currency amount.
▪ The NPV assumes reinvestment of cash flows at the required rate of
return, while the IRR assumes reinvestment at the IRR. The reinvestment
assumption of the NPV is the more economically realistic measure.
▪ Another issue is that when the cash flows are nonconventional (i.e., they
change sign more than once), there are multiple IRRs.*
(*) This is one of IRR problems that will be mentioned in the next slide
If NPV is always preferred over IRR for selecting projects, why do companies
even bother with IRRs?
Answer: The reason is that many people find it easy to understand a rate of return.
96
NPV
Advantages Disadvantages
Advantages Disadvantages
One way to approach the question of whether a company is creating value for its
shareholders is to compare the return on the company’s investment in assets to
its cost of capital.
The ROIC measure is often compared with the associated cost of capital
(COC), the required return used in the NPV calculation and the company’s
associated cost of funds.
If a corporation invests in
positive-NPV projects
Example:
Freitag Corporation is investing €600 million in distribution facilities. The present
value of the future after-tax cash flows is estimated to be €850 million.
Freitag has 200 million outstanding shares with a current market price of €32.00
per share. This investment is new information, and it is independent of other
expectations about the company. What should be the investment’s effect on the
value of the company and the stock price?
Solution:
The NPV of the investment = PV of the future after-tax cash flows – Initial outlay
= €850 million − €600 million = €250 million.
The total market value of the company prior to the investment is
€32.00 × 200 million shares = €6,400 million.
→ The value of the company should increase by €250 million, to €6,650 million.
→ The price per share should increase by the NPV per share, or €250 million/200
million shares = €1.25 per share.
→ The share price should increase from €32.00 to €33.25.
103
Real options are options that allow companies to make decisions in the
future that alter the value of capital investment decisions made today.
0 t=1
Waiting for
a period of time
Yes
Invest now Take actions
Would the contingent on
Making all capital
future economic events or
investment
information be incurred?
decisions now Reject
No
104
Real options are options that allow companies to make decisions in the
future that alter the value of capital investment decisions made today.
0 t=1
a. Timing Options
b. Sizing Options
c. Flexibility Options
d. Fundamental Options
106
Abandonment options
0 1 2 … n n+1
… …
If the future financial results are strong , the company can make
additional investments.
Expansion options
110
They allow the company to change They offer the operational flexibility
the price of a product. to alter production when demand
varies from what is forecast.
111
Example:
The payoff for a copper mine is dependent on the market price for copper:
- If copper prices are low, it may not make sense to open a copper mine,
- If copper prices are high, opening the copper mine could be very profitable.
→ The operator has the option to close the mine when prices are low and
open it when prices are high.
112
(*) The reasons why should not use only IRR to make investment decisions
are mentioned above in LOS 28.b.
Learning outcomes
Types of financing
External
Internal
Financial Capital
Other
intermediaries markets
• Operating cash • Uncommitted • Commercial • Leasing
flows • Committed paper
• Accounts • Revolving • Debt
payable • Secured loans • Equity
• Accounts • Factoring • Hybrid
receivable
• Inventory
• Marketable
securities
1. Internal financing
Company
Internal financing
121
1. Internal financing
Dividend
Net income Depreciation
Payments
(*) Note that the term “operating cash flow” mentioned here is different from the
“operating cash flow” that appears on the Cash flow statement in the FRA topic.
122
1. Internal financing
The company
(Account payable)
The longer a company delays its payment, the more it can finance its
daily purchase
123
1. Internal financing
The company
(Account receivable )
The sooner a company can collect what it is owed, the less its need to
finance its operations in some other way
124
1. Internal financing
Shortening
Shortening inventory days
AR days
1. Internal financing
The sooner receivables are collected, the higher liquidity they have
1. Internal financing
Inventories are goods that are waiting to be sold and hold by the
company
1. Internal financing
2. External financing
2. External financing
Reliability
130
2. External financing
Committed or
Types Definition Period
not?
Uncommitted
2. External financing
Can be listed in
Types Cost
the footnotes?
Uncommitted
2. External financing
Secured loans are loans in which the lender requires the company to
provide collateral in the form of an asset.
Provide collateral
Company Bank
Lend money
(*) A lien is a claim or legal right against assets that are typically used as
collateral to satisfy a debt.
133
2. External financing
2.1.3. Factoring
Factoring refers to the actual sale of receivables at a discount from their face
value. Debt factoring involves three parties: a business, a client, and a debt
factoring company.
Factor
In a factoring arrangement, the company shifts the credit granting and collection
process to the factor. The cost of this credit (i.e., the amount of the discount)
depends on the credit quality of the accounts and the costs of collection.
134
2. External financing
2. External financing
The company can finance funds on capital markets by using three kinds
of financial instruments
Capital markets
Convertible debts
Long-term debts and convertible
preferred stocks
136
2. External financing
Issuing CP for
▪ Holding for
Issuer A Holder B maturity;
Lending money to ▪ Trading
2. External financing
2. External financing
b. Long-term debt
Note: Debt payments have priority over payments to equity holders and
the interest paid on debt is typically tax deductible
139
2. External financing
b. Long-term debt
2. External financing
Issue shares
Shareholders Company
• Receive dividends
• Elect board of directors
• Have control
• Entitled to residual value of
assets in case of bankruptcy
141
2. External financing
Access to
All material
information about Confidential
information
the company
2. External financing
Readily traded on
Illiquidity
public stock More difficult to sell
premium
exchanges
143
2. External financing
Preferred shares are hybrid securities that are issued by companies and
have characteristics of both bonds and common equity
Characteristics:
• Dividends on preferred shares are often fixed but can be variable
• No maturity date
• Not a tax-deductible expense for the company
• Can choose to defer or decline to pay dividends on preferred equity
• Priority of payments:
Debt → Preferred shares → Common equity
• In case of business failure, preferred shareholders have similar
seniority over common shareholders
144
2. External financing
Convertible instruments
2. External financing
Debt Equity
2. External financing
Debt Equity
2. External financing
Leasing Obligations
The lease is a debt instrument where the asset owner (the lessor) gives
another party (the lessee) the right to use the asset. In return, the lessee
makes make regular lease payments.
Leasing contract’s components:
• A set of contractually fixed payments
• Specifies the length of time the lessee can use the asset
• Specifies whether the lessee is responsible for maintenance of the
asset
• Specifies whether the lessee can buy the asset at the end of the
leasing period and if so, at what price
The leasing might offer lower joint costs for the company and for
suppliers of capital than buying and financing separately
148
Monetary policy
The company
3.2. Firm-specific
Inflation Taxation
considerations*
Government policy
(*) There are ten firm-specific considerations, that will be mentioned in section 3.2.
Firm-specific considerations
149
3.1.1. Taxation
3.1.2. Inflation
Borrower Lender
Fiscal policy refers to the use of government spending and tax policies to
influence economic conditions, especially macroeconomic conditions
Large companies with strong operating cash flows can rely more heavily
on internal financing
Small companies, especially those that are younger and faster growing,
or without cash flow, must rely more on external financing
155
• Real property and equipment are good collateral for mortgages and
asset-backed bonds
• Assets that are unique, highly specialized, and intangible might not be
valuable as collateral
A publicly traded company incurs flotation costs when it issues new debt
or equity securities. Flotation costs include various expenses that are
company specific:
• Legal fees
• Registration fees
• Audit fees
• Underwriting fees
Flotation costs increase the cost of financing and can affect a company’s
financing decisions
164
1. Managing liquidity
Cash balances
1. Managing liquidity
1. Managing liquidity
1. Managing liquidity
1. Managing liquidity
Short-term funds
Short-term funds include items such as:
• Trade credit
• Bank lines of credit
• Short-term investment portfolios.
1. Managing liquidity
Liquidating assets
This depends on how both short-term and long-term assets can be
liquidated and converted into cash without substantial loss in value
1. Managing liquidity
A drag on liquidity occurs when there is a delay in cash coming into the
company, creating pressure from the decreased available funds
Company
A pull on liquidity occurs when cash leaves the company too quickly,
requiring companies to expend funds before they receive funds from
sales that could cover the liability.
171
1. Managing liquidity
A drag on liquidity
Major drags on receipts involve pressures from credit management and
deterioration in other assets and include the following:
1. Managing liquidity
A pull on liquidity
Major pulls on payments include the following:
2. Liquidity ratios
Liquidity ratios
• Measure a company’s ability to meet short-term obligations to
creditors as they mature or come due,
• Analyze the relationship between:
o Current assets and current liabilities;
o The rapidity with which receivables and inventory can be
converted into cash
Liquidity ratios
2. Liquidity ratios
Current assets
Current ratio =
Current liabilities
Current Usage: Expresses current assets in relation to current liabilities.
ratio
Interpretation: A high current ratio is desirable as it indicates a
higher level of liquidity.
Cash+Short−term investment
Cash ratio =
Current liabilities
Usage: Represents a reliable measure of an entity’s liquidity in a
Cash ratio crisis situation. Only highly marketable short-term investments
and cash are included.
Interpretation: A high cash ratio is desirable as it indicates greater
liquidity.
176
2. Activity ratios
Activity ratios measure how well key current assets are managed over time
Purchases Sales
Days of inventory on hand Days of sales outstanding
2. Activity ratios
Activity ratios measure how well current assets are managed over time
• Usage: The number of DSO represents the elapsed time between a sale and cash
collection, reflecting how fast the company collects cash from customers.
• Interpretation:
o A high receivables turnover might indicate that the company’s credit
collection are highly efficient or result from overly stringent credit or
collection policies, which can hurt sales if competitors offer more lenient
credit terms to customers and vice versa
o A high DSO means that the company’s credit collection are highly inefficient.
178
2. Activity ratios
Activity ratios measure how well current assets are managed over time
Number of Days of
Payables
Purchases Pay cash Sales Receipt cash
2. Activity ratios
Activity ratios measure how well current assets are managed over time
2. Activity ratios
Activity ratios measure how well current assets are managed over time
• Usage: Indicates the amount of time that elapses from the point when a
company invests in working capital until the point at which the company collects
cash
• Interpretation: A short cycle is desirable, as it indicates greater liquidity
181
Cost of capital is the rate of return that the suppliers of capital (lenders
and owners) require as compensation for their contribution of capital.
Corporate capital
Hybrid instrument
Equity Debt
(Preferred stock,
(Common stock) (Bond, Loan)
Convertible debt)
The weights are the proportions of the various sources of capital that the
company uses to support its investment program.
Represent the company’s target capital structure, not the current capital
structure
Where:
• wd = the target proportion of debt in the capital structure when the
company raises new funds
• rd = the before-tax marginal cost of debt
• t = the company’s marginal tax rate
• wp = the target proportion of preferred stock in the capital structure
when the company raises new funds
• rp = the marginal cost of preferred stock
• we = the target proportion of common stock in the capital structure
when the company raises new funds
• re = the marginal cost of common stock
Answer:
WACC = wd × rd × 1−t + wp × rp + we × re
= (0.3)(0.08)(1 – 0.40) + (0.1)(0.1) + (0.6)(0.15) = 11.44%.
The cost for ABC Corporation to raise new funds while keeping its
current capital structure is 11.44%.
190
The tax deductibility of debt reduces the effective marginal cost of debt
to reflect the income shielded from taxation (tax shield)
There may be reasons why additional interest expense is not tax deductible
(e.g., not having sufficient income to offset with interest expense)
→ the effective cost of debt is rd without any adjustment for a tax shield.
191
Answer:
Marginal tax After-tax Cost of After-tax Cost of
rate debt equity
Corporate capital
affect affect
HOW to estimate?
YTM is the annual return that an investor earns on a bond if the investor
purchases the bond today and holds it until maturity.
In other words, it is the yield, rd , that equates the present value of the
bond’s promised payments to its market price:
PMT1 PMTn FV n PMTt FV
P0 = rd + … + r n+ r n = σt=1 r t + r n
1+ 1+ d 1+ d 1+ d 1+ d
2 2 2 2 2
where: Po = the current market price of the bond
PMTt = the interest payment in the period t
rd = the yield to maturity
n = the number of periods remaining to maturity
FV = the maturity value of the bond
Assumptions:
• Bond interest is paid semi-annually (not the case in all countries);
• Any intermidiate (i.e. payments prior to maturity) are reinvested at
r
the rate of d semi-annually.
2
195
We can use a financial calculator to solve for i - the six-month yield (see
next slide) → i = 2.342%
→ the before-tax cost of debt is: rd = 2.342% × 2 = 4.684%.
→ after-tax cost of debt is: rd (1 - t) = 0.04684(1 - 0.35)= 0.03045, or 3.045%
196
20 N = 20
-1,025 PV = -1,025
25 PMT = 25
1,000 FV = 1,000
Step 2: Calculate I/Y
Press and then .
rd
→ i = = 2,342 (%)
2
→ rd = 4,684 (%) 196
197
2. Debt-rating approach
When a reliable current market price for a company’s debt is not available
Debt-rating approach
2. Debt-rating approach
Considerations
• Debt ratings are ratings of the debt issue itself, with the issuer being
only one of the considerations.
• Debt seniority and security (*), also affect ratings and yields
(*)
• Debt security means that a debt (i.e. bond) is secured by a form of
collateral.
• Seniority ranking is the systematic way in which lenders are repaid in
case of bankruptcy or liquidation.
Reference: Please refer to Reading 39: Fixed-income Securities: Defining
elements
199
Floating-rate Debt
Nonrated Debt
Debt-rating approach (in case the yields on the company’s debts are not
available) can not be used to estimate the cost of nonrated debts
Impliation: Estimate a company’s “synthetic” debt rating based on financial
ratios to estimate cost of debt using debt-rating approach, however, this
may be imprecise.
Ratings: The grade assigned to a corporation or its debt instrument
showing rating agency's predictions of how well a firm can make as
promised to pay periodic interest and repay the principal.
200
Issuer buy back bonds at lower price and take advantage of this
situation by issuing new bonds at higher new price and lower
interest rates payable to bondholder
Implication
If the company already has debt
outstanding with optionlike If the company is believed to add
features that are believed are or remove option features in
representative of the future debt future debt issuance
issuance
Lease
Answer:
The current terms indicate the most current actual cost of the preferred
stock.
→ the cost of preferred stock for De Gouden Tulip is 6.5%. Because
preferred dividends offer no tax shield, there is no adjustment made on
the basis of the marginal tax rate.
208
HOW to estimate?
Estimate the cost of equity based on the capital asset pricing model
theory:
The expected return on a stock, E(Ri ), is the sum of the risk-free rate of
interest, RF , and a premium for bearing the stock’s market risk,
βi E RM −RF , which is called “Equity risk premium”.
E Ri = RF + βi E RM − RF
where: βi = the return sensitivity of stock i to changes in the market return
RF = the risk-free rate of interest
E(RM ) = the expected return on the market
E(RM ) - RF = the expected market risk premium
210
1. Overview on Beta
Beta estimation
Used as
A critical component of CAPM
A component of calculation of WACC
213
• In US: S&P 500 Index and The most common choice is five
NYSE Composite years of monthly data, yielding
• In Japan: Nikkei 225 Index 60 observations.
215
b. Adjusted beta
Adjusted “Raw”
2/3 1/3 1.0
beta beta
(*) Beta measures a security’s systematic risk relative to the movements in the
overall market → in the long term, the beta values fluctuate less due to more
diversification and growing in size → beta mean reversion
→ future beta move toward the mean value of 1.
216
Answer:
Adjusted beta = (2/3) (0.4) + (1/3) (1.0) = 0.6
217
Not reflect
Beta is
underlying changes
understated
in value
218
Step 1:
Choose Peer/Comparable company
peer
company Publicly traded Similar business risk
Answer: (continued)
Step 3: Unlevered peer company’s beta to estimate beta of asset
Since Merck is 40% funded by debt, it is 60% funded by equity
→ Merck’s D/E = 4/6
1 1
βAsset = βEquity (Merck Co.) x = 0.7 x 4 = 0.46
1+ 1−t D
E 1+ 1−0.21
6
2% - 7%
Flotation cost
224
a. Treatment 1 b. Treatment 2
a. Treatment 1
b. Treatment 2
Answer:
Flotation cost = $200,000 × 0.045 = $9,000
Treatment 1 Treatment 2
Answer: (continued)
Treatment 1 Treatment 2
Answer: (continued)
Discussion:
1. Using these 2 treatments results in different assessments of value:
Compare with treatment 2:
• The cost of equity in treatment 1 would have increased from 10.55%
(treatment 2) to 10.82% (treatment 1) → increase the WACC from
7.39% (treatment 2) to 7.53% (treatment 1)
• NPV of treatment 1 is higher than NPV in treatment 2
2. Adjusting the flotation cost from the initial cash outflow (treatment 2)
is the correct approach because it provides the most accurate
assessment of the project’s value once all cash costs, and their timing,
are considered.
230
Learning outcomes
31.a. Describe how a company’s capital structure may change over its
life cycle
Introduction
This reading reviews some of the key factors affecting capital structure,
including the following:
Company life Companies typically evolve over time from cash consumers to
cycle cash generators, with decreasing business risk and increasing
debt capacity. (Refer to los 31.a)
+ Revenue
Cashflow
0
Time
-
Stage in life cycle Start-up (a) Growth (b) Mature (c)
Financial management
Revenue growth Beginning Rising Slowing
Cash flow Negative Improving Positive/Predictable
Business risk High Medium Low
Debt capital/leverage
Availability Very limited Limited/improving High
Cost High Medium Low
Typical cases N/A Secured Unsecured
Typical % of capital Close to 0% 0%–20% 20% +
structure
234
a. Start-up stage
Business characteristics:
• Sales are just beginning and operating earnings and cash flows tend to be
low or negative.
• Business risk is relatively high.
• Assets, both accounts receivable and fixed assets, typically are low and
therefore not available as collateral for debt.
• Company debt is quite risky and require high interest rates.
b. Growth stage
Business characteristics:
• Revenue and cash flow are rising and business risk is reduced.
• Debt financing cost is reduced and investors may be willing to lend to the
company, often with the loans secured by fixed assets or accounts
receivable.
• There may be assets that can be used to secure debt, such as receivables,
inventory, or fixed assets.
c. Mature stage
Business characteristics:
• Revenue growth is slowing.
• Cash flow is significant and relatively stable, business risk is much lower.
• Debt financing is widely available at relatively low cost.
Cyclical Industries
“Capital-Light” Businesses
• Capital structure characteristics: They tend to have little debt in their capital
structures and in many cases have substantial net cash
239
1. Modigliani–Miller assumptions
In 1958, Nobel laureates Franco Modigliani and Merton Miller (we will refer
to them as MM) published their seminal work on capital structure theory.
Modigliani and Miller (MM) used simplifying assumptions to show the
irrelevance of capital structure to firm value.
3. Risk-free rate: Investors can borrow and lend at the risk-free rate.
40% 40%
60% 60%
Common equity
Debt
241
share share
Arbitrage profit
Conclusion, the value of the levered company (VL) is equal to the value of
the unlevered company (Vu ),
Vu = VL
Results of MM Proposition I :
• Managers cannot create firm value simply by changing the company’s
capital structure
• The value of a company is determined solely by its cash flows, not by its
relative reliance on debt and equity capital.
re
D
re = r0 + (r0 − rd )
E
r0
D/E
245
Demonstration:
(1) According to MM Proposition I, Weighted average cost of capital (WACC)
is unaffected by capital structure.
WACC = constant = r0
(2) M&M also give theory on the assumption that:
• There is no financial distress and agency costs
• Ability to borrow and lend at the risk-free rate
rd = constant
(3) To understand the M&M view, we go back with WACC formula:
E.re + D.rd (1 − t)
WACC =
E+D
In M&M view without tax, we ignore the impact of tax, so t = 0
246
Demonstration:
• Buiding cost of equity linear function:
From (3), we have:
E.re + D.rd
WACC = = r0 [from (1)]
E+D
D D
⇒ r0 = ( )r +( )r
E+D d E+D e
r (E + D) − D.rd
⇒ re = 0
E
D
Linear function: re = r0 + (r0 − rd )
E
The proportions of debt versus equity in the firm’s capital structure do not
affect the firm’s overall cost of capital or the value of the firm
Cost of D
re = r0 + (r0 − rd )
capital E
E.re + D.rd (1 − t)
r0 WACC =
E+D
rd rd =constant
Gearing D/E
249
Example:
Unlevered capital structure
Leverkin Company, which currently has an all-equity capital structure.
Leverkin has expected annual cash flows to equityholders (which we denote
as “CFe”) of $5,000 and a cost of equity, which is also its WACC, of 10%.
For simplicity, we assume that all cash flows are perpetual. Therefore,
Leverkin’s value is equal to
CFe $5,000
V= = = $50,000
WACC 10%
Levered capital structure
Now suppose that Leverkin plans to issue $15,000 in debt at a cost of 5%
and use the proceeds to buy back $15,000 worth of its equity.
Under MM Proposition I, VL = VU, so the value of Leverkin must remain the
same at $50,000. Under MM Proposition II, the cost of Leverkin’s equity
when it has $15,000 debt and $35,000 equity is
$15,000
re = 10% + 10% − 5% ≈ 12.143%
$35,000
250
Example:
Levered capital structure (cont.)
Furthermore, the value of Leverkin must equal the sum of the present value
of cash flows to debtholders and equityholders. With $15,000 debt at a cost
of 5%, Leverkin makes annual interest payments of $750 to debtholders,
leaving $5,000 − $750 = $4,250 for equityholders. Therefore, the total value
of the company is:
$750 $4,250
V=D+E= + = $15,000 + $34,999.59 ≈ $50,000
5% 12.143%
The more debt the company uses, the greater the cost of equity, but the
total value of the company does not change and neither does the weighted
average cost of capital.
With its new capital structure, the company’s WACC remains at 10%:
$15,000 $35,000
WACC = 5%+ 12.143%=10%
$50,000 $50,000
251
Example:
We can summarize the impact of change in capital structure as the
following graph:
Cost of capital D
re = 10% + 5%
E
12.143%
10% WACC
rd = 5%
Now let’s explore what happens when we take a more realistic assumption,
that of corporate taxes.
When t is not zero, the term (1 − t) is less than 1 and serves to reduce the
cost of levered equity (re )
The cost of equity rises as the company increases the amount of debt in its
capital structure, but it rises at a slower rate than in the no-tax case
The increase in re does not offset the benefit of the cheaper debt finance
and therefore the WACC falls.
257
r0 E.re + D.rd (1 − t)
WACC =
E+D
rd (1−t)
rd (1−t) = constant
Gearing D/E
Additional reading:
Debtholders receive: rd .D
Shareholders in a levered firm receive: (EBIT − rd D)(1-t)
The total cash flow to allstakeholders is: (EBIT − rd D)(1-t) + rd .D
The present value of this stream of cash flows is VL
VL = PV of ((EBIT − rd D)(1-t) + rd D) = PV of (EBIT 1 −t +rd .D.t)
Note that, PV of EBIT(1-t) is VU , PV of rd .D.t is tD VL = VU + tD
259
Additional reading:
Additional reading:
Additional reading:
Demonstration:
E + (1 − t)D0 D
⇒ (1 + re ) = (1 + r0 ) 0 − (1 + rd )(1 – t) 0
E0 E0
D0 D
⇒ (1 + re ) = (1 + r0 )+(1 + r0 )(1 − t) − (1 + rd )(1 – t) 0
E0 E0
D0
⇒ (1 + re ) = (1 + r0 )+(1 + r0 − 1 − rd )(1 − t)
E0
D0
⇒ re = r0 + (r0 − rd )(1 − t)
E0
262
Example:
Let us return to the example of the Leverkin Company. Recall that annual
cash flows to equityholders are $5,000 and the WACC is 10%. As before,
Leverkin is planning to issue $15,000 of 5% debt in order to buy back an
equivalent amount of equity. Now, however, assume that Leverkin pays
corporate taxes at a rate of 25%.
Since the company does not currently have debt, the after-tax cash flows
are $5,000(1 – 0.25) or $3,750.
Because the cash flows are assumed to be perpetual, the value of the
company at 10% is $37,500, considerably less than it was when there were
no taxes. Now suppose Leverkin issues $15,000 of debt and uses the
proceeds to repurchase common stock.
According to MM Proposition I with corporate taxes, the value of the
company is:
VL = VU + tD = $37,500 + 0.25($15,000) = $41,250
263
Example:
Since the value of the debt is $15,000, the value of the equity (after the
buyback) must be ($41,250 − $15,000) = $26,250. According to MM
Proposition II with corporate taxes, the cost of the levered equity is:
D $15,000
re = r0 + (r0 − rd )(1 − t) = 10% + (10% −5%)(1 − 25%) = 12.143%
E $26,250
Note that the value of the company must also equal the present value of
cash flows to debt and to equity:
re D (CFe − rd D)(1 − t) $750 ($5,000 − $750)(1 − 25%)
VL = D + E = + = +
rd re 0.05 12.143%
≈ $41,250
which is the same result that we got from MM Proposition I with corporate
taxes. As a further check, using Equation 5, the WACC for the levered
Leverkin is:
$15,000 $35,000
WACC = 5%(1 − 25%) + 12.143%
41,250 $41,250
= 9.091% < 10% (unlevered WACC )
The result confirms that the WACC would fall as we use leverage in our
capital structure.
264
One type of cost that can be expected to increase at higher levels of debt
financing is costs of financial distress.
Costs of financial distress are the increased costs a company faces when
earnings decline to the point where the firm has trouble paying its fixed
financing costs (interest on debt).
265
Expected cost = Cost of financial distress (a) x probability of financial distress (b)
We consider only the tax shield provided by debt and the costs of financial
distress. As a result, we can write the value of a leveraged company as
VL = VU + tD − PV of costs of financial distress
The static trade-off theory seeks to balance the costs of financial distress
with the tax shield benefits from using debt
This point represents the optimal capital structure for a firm, where the WACC
is minimized and the value of the firm is maximized.
Note: each firm’s optimal capital structure depends on its business risk
(operating risk and sales risk), tax rate, corporate governance, industry
influences, and other factors.
268
Value of
levered firm
Firm value Cost of financial
Maximum firm distress
value Value of Levered Firm
PV of tax shield with Financial Distress
Value of
Unlevered Firm
Company may adopt its optimal capital structure as Target capital structure
A company’s capital structure at any point in time may differ from the target
due to:
• Management may exploit short-term opportunities in one or another
financing source
• Market-value fluctuations continuously affect the company’s capital
structure
Ideally, we want to use the proportion of each source of capital that the
company would use in the project or company
Example: suppose a company has the following market values for its capital:
Weights
Bonds outstanding $5 million 25%
Preferred stock $1 million 5%
Common stock $20 million 70%
273
Capital structure
policies and
targets (1)
Market Capital
conditions (3) Capital structure investment
financing (2)
Asymmetric
information (4)
274
Company
a. Debt Ratings
Implication:
Debt ratings reflects a company’s level of leverage as well as financial risks
→ Debt ratings are an important consideration in the practical management
of leverage, and maintaining the company’s rating at a certain level may
also be an explicit policy target for management.
For example: A company might target an S&P debt rating of A or higher.
While optimal capital structure is calculated using the market value of equity
and debt, company capital structure targets often use book value instead for the
following reasons:
1. Market values can fluctuate substantially and seldom impact the appropriate
level of borrowing.
2. For management, the primary concern is the amount and types of capital
invested by the company.
Book value reflects the amount of Market value only reflects the price
capital that is actually used by the that shares of capital are traded on
≠
company to finance for its the market, thus are affected by
investments. invester’s expectation of return.
2. Match the cash flows and maturity structure of the assets and debt.
Asset liability misalignment increases the risk of default and cost
of capital for companies:
• A company financing long-term assets with short-term obligations faces
rollover risk, which may threaten profitability if short-term financing
costs go up over the financing period.
• A company financing short-term assets with long-term financing beyond
the term needed faces the risk that the company overpays in financing
cost.
278
3. Market conditions
Market conditions:
• Macro-economics
• Country’s specific factors
• Credit market conditions
Cost of debt
Asymmetric information
Asymmetric information
A hierarchy to managers’
selection of methods for
financing – pecking order
theory (next slide)
281
Level of potential
information content * Information content: It is the
amount of information conveyed
Internal financing through an action taken by the
managers.
Debt For example, financing by internal
funds hardly gives out any signal to
Equity the market, so the information
content of this action is low.
Prefencces of
managers
282
Prefencces of managers
283
Agency cost ↑
“Perquisite consumption” refers to items that executives may legally authorize for
themselves that have a cost to shareholders, such as subsidized dining, a corporate jet
fleet, and chauffeured limousines.
284
Freedom for managers to either take on more debt or unwisely spend cash ↓
Agency cost ↓
285
Debt vs equity
Customers [6]
holders [2]
3. Preferred Stockholders
The conflict of interest between common stock holders and preferred stock
holders is similar to the conflict of interest between common stock holders
and debt holder.
289
Minority
shareholder
Controlling
shareholder
The risk varies between Bank/private lenders and Public debt holder
291
Customers
Customers of specialized products have an interest in the financial health
and survival of firms that are their key suppliers, similar to the interest of
debt holder.
Suppliers
• Suppliers typically are short-term creditors of a firm and thus have an
interest in the firm’s continuing ability to meet its obligation.
• Some suppliers have invested time and capital in developing specialized
products for a firm and will lose significant revenue if that firm fails.
7. Employees
32.a. Define and explain leverage, business risk, sales risk, operating risk,
and financial risk and classify a risk
These companies have the same net income, but are they identical in
terms of operating and financial characteristics? Would we appraise these
two companies at the same value?
Continue in the next slide
299
Discussion:
Both companies earned a net income of $800,000 but have different cost
structure:
Company A has a higher proportion of fixed costs (56.25%) in its cost
structure → higher level of leverage.
→ resulting in differing volatility of net income.
300
Discussion:
The dominance of fixed costs (both operating and financial) in company
A’s cost structure (higher leverage) results in higher earnings volatility. A
25% fluctuation in sales results in an 81% fluctuation in company A’s net
income, but only a 38% fluctuation in company B’s net income.
(*) Revenue (prices and quantity of (**) The greater the fixed operating
sales) is affected by economic costs relative to variable operating
conditions, industry dynamics, costs → difficult to adjust its
government regulation, and operating costs to changes in sales
demographics. → the greater the operating risk.
Financial risk
(uncertainty in net income)
a. DOL formula
a. DOL formula
a. DOL formula
∆Q × (P −AVC) × Q
=
Q × P −AVC − F × ∆Q
Q × (P −AVC)
=
Q × P −AVC − F
Q × (P −AVC)
DOL =
Q × P −AVC − F
307
a. DOL formula
Answer
Answer:
A ($) B ($)
The higher the proportion of fixed operating costs in a company’s cost structure,
the more sensitive its operating income is (the higher DOL) to changes in units sold
→ the higher the company’s operating risk.
310
a. DFL formula
% change
→ DFL = 40%/20% = 2
311
a. DFL formula
%∆EPS
=
%∆EBIT
a. DFL formula
∆EPS EBIT
= ×
EPS ∆EBIT
Q × (P −AVC) − F
DFL =
Q × P −AVC − F − C
313
a. DFL formula
Answer
The higher the use of fixed financing sources by a company, the greater the
sensitivity of net income to changes in operating income (higher DFL)
→ the higher the financial risk of the company.
315
Q × (P −AVC) [Q × (P −AVC) − F]
= DOL × DFL = ×
Q × P −AVC − F [Q × P −AVC − F − C]
Q × (P −AVC)
=
[Q × P −AVC − F − C]
Conclusion:
Calculate Beta’s Net income and ROE if its EBIT changes by 10% in 2
cases?
319
Using financial leverage reduce net income due to increasing fixed costs,
but increase ROE as well as the variability of ROE compared to without
financial leverage.
321
Breakeven point
Units sold
QBE
F+C
QBE =
P − AVC
323
F
QOBE =
P − AVC
324
Atom Beta
Price 4 4
Revenue/ Revenue/
Revenue
Expense Expense
Net income
Revenue Total
Net income cost
Net loss
Total
Net loss cost Fixed costs
Fixed costs = 120,000
= 40,000
40,000 Units sold 60,000 Units sold
Atom Beta
326
Conclusion
• A firm that choose operating and financial structure that result in
greater total fixed cost (level of leverage) will have a higher
breakeven point.
• Leverage can magnify the effects of changes in sales on net income
(illustrated by charts in Example 10)
• The further the units of sold are from the breakeven point, the greater
the net income → the greater the magnifying effects of leverage on
net income.