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## Corporate Financial Management 1

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**Corporate Financial Management 1**Jan Vlachý<vlachy@atlas.cz> Brigham, E.F., Ehrhardt, M.C. Financial Management: Theory and Practice, 13th Edition**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**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**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**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**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**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**Time Value of Money**Chapter 4 • Any Present Value has a greater Future Value. ... 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**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**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**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**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**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**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**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**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**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**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**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**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**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**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**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**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**Market Interest Rates/Yield Curve**Corporate Financial Management 1**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**Constant Growth Model**• Dt = D0(1+g)t • V = D1/(r-g) (... r > g) • e.g.V = $36(1.05)/(13%-5%) = $31.5 • 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**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**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**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**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**Prob.**T-bill Eq 2 Eq 1 HT 0 5 12.5 8.5 Actual Return (%) Probability Distributions Corporate Financial Management 1**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**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**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** (%)**Specific (Diversifiable) Risk 35 Total Risk 20 0 Systematic Risk 10 20 30 40 N Effect of Diversification Corporate Financial Management 1**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**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**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**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**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**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**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**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**Analytical Model (Black-Scholes)**VC = p N(d1) - S e-rt N(d2) d1 = [ln(p/S) + (s2/2) t] / (st) d2 = d1 - st 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**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**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**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**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**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