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Corporate Financial Management 1

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  1. Corporate Financial Management 1 Jan Vlachý<vlachy@atlas.cz> Brigham, E.F., Ehrhardt, M.C. Financial Management: Theory and Practice, 13th Edition

  2. Basic Concepts Chapters1-3 • Corporate Financial Management • Isthe Art/Science of Creating and Maintaining the Value of a Company. • Gives a Firm its Common Language. • It Consists of • Investment Decisions • Financing Decisions • Managerial Decisions Corporate Financial Management 1

  3. Money × Real Assets Money × Financial Assets The World The Firm Financial Markets Investors Financial Intermed. Financ-ing Invest-ments Corporate Financial Management Financial Markets Investments F I N A N C E Investment Vehicle Model The Set of Contracts Model recognises imperfections and includes the assumption of both explicit and implicit contracts, incl. Corporate Organization. Corporate Financial Management 1

  4. The Financial Environment • Competitive Economic Environment • Two-Sided Transactions (Buyer×Seller Equil.) • Risk-Return Tradeoff • Signalling/ Behavioral Principle <= Market Efficiency (Information, Transactions) • Value (How can some people become rich?) • New Ideas, Expertise • Options • Time Value of Money Financial transactions create an equilibrium; Real investments create value Corporate Financial Management 1

  5. Accounting, Cash Flows & Taxes • Purposes of an Accounting System • Reporting the Firm’s Financial Activities to Stakeholders • Providing Information to Firm’s Decision Makers • Financial Management strives to use and interpret the information • Accounting - historical view • Finance - current and future Corporate Financial Management 1

  6. Limitations of Accounting • Why don’t shares trade at Book Val.? • Market×Book Value of Assets/Liabs • Historical Accounting (depreciation) • Inflation (value benchmarks have changed) • Liquidity (can it readily be sold?) • Time Value of Money (relates to Maturity and Terms) Note: Finance prefers to deal with cash flows in a time perspective. Corporate Financial Management 1

  7. Taxes • Income Tax • Make analyses on after-tax basis • For financial decisions, use marginal tax rate(relavant if tax is progressive or unsymmetrical on negative base) • Capital Gains Tax • Dividend/Interest Income Treatment • System Biases (Loss Carry-forwards, Exemptions, Deductions) Corporate Financial Management 1

  8. Time Value of Money Chapter 4 • Future goods are not valued so highly as the same goods available at an immediate moment of time, nor do they allow their owners to achieve the same utility. For this reason, it must be considered that they have a more reduced value in accordance with justice. (Giles Lessines, 1285) ... i.e. • People generally prefer having any amount of money at their disposal earlier rather than later. ... i.e. • Investors require positive returns as compensation for the inconvenience. Corporate Financial Management 1

  9. On Present and Future Values • You deposit $1,000 today with a bank that pays 5% interest per year. • FV1= PV+r×PV= PV(1+r)= $1,000×1,05= $1,050 (Simple Interest) • FV2= FV1(1+r)= PV(1+r)×(1+r)= PV(1+r)2= $1,102.50 (Compound Interest) Discounted Cash Flow Framework FVt= PV(1+r)tPV= FVt / (1+r)t Corporate Financial Management 1

  10. C0 C1 C2 C3 C4 t Return, Net Present Value • Return of an Investment (Rate of Return, Yield): • NPV= Present Value of expected cash flows (+positive-negative) Corporate Financial Management 1

  11. Practical Issues • Distinguish: • Realized Return • Expected Return (<= Risk) • Required Return (<= Unperfect Mkts) • Financial securities are usually priced “fairly” (Market Equilibrium). • Investment projects (and other entrepreneurial decisions) should bring value, i.e. have positive NPV. Corporate Financial Management 1

  12. Valuing Single Cash Flows (Ex.) • What is the Future Value of $2,000 invested at 3% per year for five years? • What is the Present Value of CZK 10m to be received two years from now if the required return is 4% per year? • What is the Expected Return for an investment costing €10,000 today and offering €12,000 in three years? Corporate Financial Management 1

  13. t Ct PV(Ct) 0 $ -10,000 -10,000.00 1 $ 2,000 1,818.18 2 $ 8,000 6,611.57 3 $ 5,000 3,756.57 Total PV: $ 2,186.33 Valuing Multiple Cash Flows • You can invest $10,000. As a result, you expect to get $2,000, $8,000, and $5,000 over the next three years, respectively. If the required return is 10%, what is the NPV of your investment? • What is the return if you know the NPV? Corporate Financial Management 1

  14. Annuities • Types of Annuity • Ordinary Annuity (Payments at end of period) • Annuity Due (Payments at beginning of period) • Deferred Annuity (First repayment more than one period after drawing) FVAn = PVAn(1+r)n; PVAn[due]= PVAn(1+r); PVAn[defd]= PVAn/(1+r)d Corporate Financial Management 1

  15. Amortization Schedules • A $1,000 loan yielding 8% requires equal payments at the end of the next three yrs. How much principal will be rpd. in Year 2? PMT = $1,000×[.08(1.08)3/(1.083-1)] = $388.03 P2 = V1 - V2 = |PMT2| - I2 = $332.67 Corporate Financial Management 1

  16. Perpetuities Problem 4-27 PV = $100 / 7% = $1,428.57 Growth Perpetuities: PMTt = PMT0(1+g)t PVgrowth = PMT1/(r-g) (... r > g) Corporate Financial Management 1

  17. Compounding Frequency (1) • Compare annual return on deposit with 6% interest paid annually and monthly. • FVA = PV×(1 + 6%) = PV×1.06 • rA = (FVA-PV) / PV = .06×PV/PV = 6% • FVM = PV×(1 + 6%/12)12 = PV×1.00512 = PV×1.0617 • rM = (FVM-PV) / PV = 6.17% Corporate Financial Management 1

  18. Compounding Frequency (2) • Compare the cost of a 6% (nominal rate) loan with monthly and quarterly interest. • Nominal Rate×Effective Annual Rate • NR = m×rm • EAR = (1 + rm)m - 1 • EARM = 1.00512 - 1 = 6.17% • EARQ = 1.0154 - 1 = 6.14% Corporate Financial Management 1

  19. Bond and Stock Valuation Chapters 5,7 • Main sources of capital for Company • Bond: Debt Capital • Stock: Equity Capital • Claim on fut. cash flows for Investor • Bond: Contractual interest and princi-pal payments (or proceeds of sale) • Stock: Dividends (theoretically forever) or proceeds of sale Corporate Financial Management 1

  20. Valuation Procedure • Based on discounted cash flow concept: • Estimate expected future cash flows • Determine required return (depending on the riskiness of the expected cash flows) • Compute the present value • Other possibilities: Market price of same or comparable asset Corporate Financial Management 1

  21. Features of Bonds/ Stocks • Par (Face, Princ.) Value • Coupon (Interest) Rate • Coupon Payment Frequency • Maturity: Original (Issue), Remaining(Residual) • Terms of Repayment: Bullet, Sinking Fund, Zero-Coupon (Pure Discount) • Call Provision (Option); other Rights; Junior/Senior • ??? • Dividends • Dividend Payment Frequency • N/A • N/A • Common/Preferred • Rights(Warrants, Convertibles)... See Chapt. 19, Hybrid Financing Corporate Financial Management 1

  22. Bond Valuation Problem 5-1 t 1 2 3 4 ... 8 9 10 11 12 Ct $ 80 $ 80 $ 80 $ 80 ... $ 80 $ 80 $ 80 $ 80 $1,080 r= 9% PV $ 73.39 $ 67.33 $ 61.77 $ 56.67 ... $ 40.15 $ 36.83 $ 33.79 $ 31.00 $ 383.98 $ 928.39 For bond w/semi-annual coupons n=24, Ct=$40. To put required return on same basis as annual bond, one should assume EAR= 9% = (1+rS)2 - 1, i.e. rS = \/1.09 - 1 = 4.4%. Corporate Financial Management 1

  23. Yield to Maturity/ Yield to Call (1) • Assume Johnson Co. has a bond with a face value of $1,000 that matures in 12 years, has a coupon rate of 8%, and is currently selling for $928.39. What is the required return to buy the bond (YTM = 9.00%)? • Assume it can be called in 10 years at a call price of $1,100. What would be therequired return to buy the bond if we knew the option would be excercised (YTC = 9.79%)? Corporate Financial Management 1

  24. Yield to Maturity/ Yield to Call (2) • Yield to Maturity= Promised Return • Yield to Call= Return if Called • N=12; PV=-928.39; PMT=80; FV=1,000 => I (YTM) = 9.00% • N=10; FV=1,100 => I (YTC) = 9.79% • Expected Return= YTM minus Risk • Credit (Default) Risk <= Rating • Interest Rate Risk/ Reinvestment Risk • FX Risk, Liquidity Risk... Corporate Financial Management 1

  25. Market Interest Rates/Yield Curve Corporate Financial Management 1

  26. Stock Valuation Problem • Value a share which is expected to pay dividends of $2.72 and $3.10, respectively, over the next two years, and sold thereafter for $48, if the required return is 10%? • V=$2.72/(1.1)+$3.10/(1.1)2+$48/(1.1)2= $44.70 • But... How did I estimate the market price in 2 years? • Let us assume constant dividends of $4.80 after Year 2. • Using perpetuity valuation: V2=$4.80/10%= $48 Corporate Financial Management 1

  27. Constant Growth Model • Dt = D0(1+g)t • V = D1/(r-g) (... r > g) • e.g.V = $36(1.05)/(13%-5%) = $472.5 • e.g.r = $1.30/$21.25 + 6% = 12.12% • CG formula can also be used for determining a horizon (terminal)value or for valuing declining growth stock. • For erratic or supernormal growth stock, split cash flows into two parts. Corporate Financial Management 1

  28. Risk and Return Chapters 6, 7 • Risk refers to the chance that some unexpected event would occur. • In business, that would mean the decrease of value of the firm, in financial markets any change in the value of financial instruments etc. • In other words, actual returns will differ from expected returns. • The expected return should therefore compensate an investor for the perceived risk. Corporate Financial Management 1

  29. Economy Prob. T-Bill Eq 1 Eq 2 Gold Bond Recession 0.10 5.0% -25.0% -15.0% 20.0% 10.0% Below avg. 0.20 5.0 -5.0 -5.0 7.0 7.0 Average 0.40 5.0 15.0 10.0 0.0 6.0 Above avg. 0.20 5.0 25.0 20.0 -2.0 5.0 Boom 0.10 5.0 50.0 30.0 -10.0 2.0 1.00 Investments with Risk Problem Corporate Financial Management 1

  30. Expected Return • E(r) = Σwiri • E(rEQ1) = .10(-25%) + .20(-5%) + .40(15%) + .20(25%) + .10(50%) = 12.5% • Eq 1 has the highest expected return. • Is it the best investment? Corporate Financial Management 1

  31. Stand-Alone Risk • σ = \/Σ(wi(ri-E(r))2 • σEQ1 = \/[.10(-25-12.5)2 + .20(-5-12.5)2 + .40(15-12.5)2 + .20(25-12.5)2 + .10(50-12.5)2] = 19.4% Volatility Corporate Financial Management 1

  32. Prob. T-bill Eq 2 Eq 1 HT 0 5 12.5 8.5 Actual Return (%) Probability Distributions Corporate Financial Management 1

  33. Economy Prob. Eq 1 Gold Port. Recession 0.10 -25.0% 20.0% -2.5% Below avg. 0.20 -5.0 7.0 1.0 Average 0.40 15.0 0.0 7.5 Above avg. 0.20 25.0 -2.0 11.5 Boom 0.10 50.0 -10.0 20.0 Portfolio Risk (1) • Assume portfolio with 50% invested in Eq 1, and 50% in Gold. • E(rP) = 7.25% • σP = 6.1% Corporate Financial Management 1

  34. Portfolio Risk (2) • p(=6.1%) is much lower than: • either Eq 1 (19.4%) or Gold (7.5%). • average of Eq 1 and Gold (13.5%). • The portfolio offers a decent return (average of Eq 1 and Gold returns) with low risk. • The key is low (actually negative) correlation between Eq 1 and Gold returns, facilitating diversification. Corporate Financial Management 1

  35. Managing Portfolio Risk • Systematic and Specific Risk [Law of Large Numbers] (Insurance, Consumer Credit) • Equilibrium Theories, e.g. Capital Asset Pricing Model [Sharpe, Lintner] (Equity Markets, Capital Investments) • Portfolio Theory [Markowitz] (Market Portfolios), based on function σP=ƒ(w1,w2,w3,..,σ1,σ2,σ3,..,ρ12, ρ13, ρ23,..) Corporate Financial Management 1

  36.  (%) Specific (Diversifiable) Risk 35 Total Risk 20 0 Systematic Risk 10 20 30 40 N Effect of Diversification Corporate Financial Management 1

  37. Capital Asset Pricing Model • In an efficient market, the required return will equal the expected return. • efficient market => equilibrium price • transactional, informational efficiency • efficient market  arbitrage • An asset’s required return is the sum of the riskless return and an asset-specific risk premium. • Beta (β) is a measure of the asset’s market (systematic, undiversifiable) risk. • SML: ri = rF + β(rM - rF) Corporate Financial Management 1

  38. β = 1 ri 0 < β < 1 β = 0 rF 45° rM Beta as a Sensitivity Measure ri = rF + β (rM - rF) Corporate Financial Management 1

  39. CAPM Utilization Problem • Two shares (in the same market) with known rF, βA, βB, rA, looking for rB. • rA = rF + βA (rM - rF) • rB = rF + βB (rM - rF) • 14% = 6% + 1.4(rM-6%) => rM= 11.7% • rB = 6% + 1.1(11.7%-6%) = 12.3% Note: The beta of a portfolio equals the weighted average of its component betas (VPbP = VAbA + VBbB + ...) Corporate Financial Management 1

  40. Options Chapter 8 • Option = Right (Financial and Embedded Options, i.e. Contracts) or Opportunity (Real Options) • Financial options are traded contracts, derivatives of Underlying Assets (Equities, FX, Bonds, Commodities, Indices...) • Financial Derivatives include Options, Warrants, Forwards, Futures, Swaps, Repos... • Financial Derivatives are used primarily for Risk Management (Hedging, Speculation) ... See Chapt. 23 Corporate Financial Management 1

  41. Applications • Financial Options • American vs. European Options • Call vs. Put Options • Exotic Options (various terms of exercise, caps, floors; exchange options, compound options,...) • Embedded Options... Constitute Contracts • Real Options... In Business Decisions ... See Chapts. 11,25 Corporate Financial Management 1

  42. Intrinsic Value (Call Option) Total Value (Call Option) V V out-of-the-money in-the-money p S p Time Value at-the-money The Value of Options • Intrinsic Value (would the option be executed if nothing changed till excercise date?) = ƒ(p; r; t) ...usually easy to assess; can be used for designing option strategies • Time Value = ƒ(t; s) ...calculated by means of models (using market equilibrium assumption and replication) Corporate Financial Management 1

  43. Using the Replication Principle Call Option: S = $40, p = $32, d = $16 or u = $64 at time t; rt = 2%. d: Option out of the money, i.e. Vd = 0 u: Uption in the money, i.e. Vu = 64 - 40 = $24 • Income structure can be replicated with N forward transactions. These must have zero value if underlying asset costs $16, and must therefored be issued with forward price F = $16. Their present value is VF = p - F/(1+rt) = $16.31. • Value of N forward transactions at settlement if underlying asset costs u is Vu = N(u - F). To replicate u = 64  Vu = 24, N = 24/(64-16) = 0.5. • The option value is thus VC = 0.5×16.31 = $8,16. Corporate Financial Management 1

  44. F = 1 100; N = 1 VF = 1157,63 - 1100e-0,25×5% = 71,29 VC = NVF = 71,29 F = 1 000 N = (u - S)/(u - d) = 2,50/102,5 = 0,0244 VF = 1050 - 1000e-0,25×5% = 62,42 VC = NVF = 1,52 N = 0 => VC =0 Numerical Model (Binomial, CRR) • Call Option S = 1 100; p = 1 000; r = 5%; 4 periods Corporate Financial Management 1

  45. Analytical Model (Black-Scholes) VC = p N(d1) - S e-rt N(d2) d1 = [ln(p/S) + (s2/2) t] / (st) d2 = d1 - st p= $500; S= $510; r= 3%; t= 3months (=0,25); s =20% d1 = [ln(500/510)+(0,04/2)×0,25]/(0,2×0,5) = -0,0730 d2 = -0,0730 - 0,2×0,5 = -0,1730 N(d1) = N(-0,0730) = 0,4709; N(d2) = N(-0,1730) = 0,4313 (cummulative distribution function for a standardised normal random variable) VC = 500×0,4709 - 510×e-20%×0,25×0,4313 = $17,12 VP = VC - p + Se-rt = 17,12-500+510×e-3%×0,25 = $23,31 (using put-call parity) Corporate Financial Management 1

  46. Cost of Capital Chapter 9 • Cost of Capital = Required Return for Capital Budgeting Project • 2 possible approaches • Use CAPM • Firm Value = Equity Value + Debt Value. • In a perfect market, a company cannot affect its value by changing the way it is financed - it just influences the distribution of risks and returns between different classes of investors. Corporate Financial Management 1

  47. Risk/Return of Real Assets • CAPM can be extended to include real assets (i.e. capital budgeting projects) • Pure Play Method (Finding single-product companies in the same line of business as project being evaluated) • Accounting Beta Method (Regression of return of assets against average return on assets in the whole market) Corporate Financial Management 1

  48. Weighted Average Cost of Capital • WACC = (1-L)re + L(1-T)rd • L = D/(D+E) ... Leverage • T... Marginal Income tax Rate • Always based on opportunity, not historical costs and values! • After-tax cost must be used for all components! • Correct risk assumptions have to be made for individual projects! Corporate Financial Management 1

  49. WACC Problems9-4, 9-7 • r = $3.6 / $70 = 5.14% • c = $3.6 / ($70×(1-5%)) = 5.41% • WACC = 30%×6%×(1-40%)+ 5%×5.8%+ 65%×12% = 9.17% Corporate Financial Management 1

  50. Component Cost of Equity • Ways to estimate required return: • DCF Method • CAPM Approach (b of equity, not project!) • Bond Yield + Risk Premium Method • Equity for new projects may come from retained earnings or new issue. • New issues incur flotation costs. In this case, the component cost of capital is higher than required return. Corporate Financial Management 1