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The Phoenix CFA Society Wendell Licon, CFA. CFA Level I Exam Tutorial Corporate Finance May 9, 2012. Financial Management. Agency Problems Bondholders vs. stockholders (managers) Occur when debt is risky Managerial incentives to transfer wealth Management vs. stockholders

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## The Phoenix CFA Society Wendell Licon, CFA

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**The Phoenix CFA SocietyWendell Licon, CFA**CFA Level I Exam Tutorial Corporate Finance May 9, 2012**Financial Management**Agency Problems • Bondholders vs. stockholders (managers) • Occur when debt is risky • Managerial incentives to transfer wealth • Management vs. stockholders • Occur when corporate governance system does not work perfectly • Managerial incentives to extract private benefits**Financial Management**Agency Problems • Mechanisms to align management with shareholders • Compensation • Threat of firing • Direct intervention by shareholders (CalPERS) • Takeovers**Cost of Capital**WACC =**Cost of Capital**kd(1-Tc) • Where do we get kd from?**Cost of Capital (debt)**Example: First find the market determined cost of issued debt: 10-yr, 8% coupon bond, trades at $1,050, TC = .4 1,050 = kd/2 = 3.644%, so kd = 7.288% kd/2(1-Tc)= 3.644%(1-.4) = 2.1864% (semi-annual rate) kd(1-Tc)=2.1864% * 2 = 4.3728% (annualized)**Cost of Capital (debt with flotation costs)**Flotation Costs Example: 2% of issue amount, coupon = 7.288% if issued at par (which is usually safe to assume), then coupon rate = investor’s YTM 980 = kd/2= 3.7885% kd/2(1-Tc)= 3.7885%(1-.4) = 2.2731% (semi-annual rate) kd(1-Tc)=2.2731% * 2 = 4.5462% (annualized)**Cost of Capital (Preferred Shares)**Already in after-tax form • Flotation Costs (F): kps= Divps/{P(1-F)} • Example: P= 100, Divps= 10, F= 5% • kps= 10/{100(1-.05)}= 10.526%**Cost of Capital (Common)**Discounted Cash Flow (DCF) • Simple g assumption? • Cost of CS = Dividend Yield + Growth • Example: D1= 3/yr, P0 = 100, g= 12% kcs = 15% • What about flotation costs? Multiply P0 by (1 – F)**Cost of Capital (Common)**What about g? g = ROE x (plowback ratio) or g = ROE x (1 – payout rate)**Cost of Capital (Common)**Capital Asset Pricing Model (CAPM) • kcs = krf + cs(km – krf)**WACC**• The market is impounding the current risks of the firm’s projects into the components of WACC • Say Coca Cola’s WACC is 15%, which would be the rate associated with non-alcoholic beverages • Can Coke use 15% to discount the cash flows for an alcoholic beverage project?**WACC**Coke Example cont’d • Say alcoholic beverage projects require 22% returns • Security market line**WACC**Can be used for new projects if: • New project is a carbon copy of the firm’s average project • Capital structure doesn’t materially change – look at the WACC formula**WACC**• Don’t think of WACC as a static hurdle rate of return which, if cleared, then the project decision is a “go” • If the firm changes its project mix, the WACC will change but the risk level of the projects already in progress will not & neither do the required rates of return for those projects**Cost of Capital- MCC**Step 1: Calculate how far the firms retained earnings will go before having to issue new common stock (layer 1) • Example: Simple capital structure • LT Debt = 60% (yielding 8%) • CS = 40% (Kcs = 15%) • New Retained earnings (RE) = 1,000,000 (over and above the 40%) • Marginal Tax Rate = 40% • Debt Flotation Costs = 1% per year • CS Flotation Costs = 1% per year**Cost of Capital- MCC**Concept: Keep our capital structure of 60%/40% in balance while utilizing our retained earnings slack matched with new debt, which is not in a slack condition • Current WACC: .6*(.08)*(1-.4) + .4*(.15) = 8.8%**Cost of Capital- MCC**How far can we go with Layer 2? 1,000,000/.4 = 2,500,000 of new projects costs of which 2,500,000 * .6 = 1,500,000 in new issue debt and 1,000,000 = use of retained earnings • Layer 2 WACC: .6*(.09)*(1-.4) + .4(.15) = 9.24% • Layer 3 would include new projects over 2,500,000 with flotation costs for equity and flotation costs for debt**Cost of Capital- MCC**Layer 3 WACC: .6*(.09)*(1-.4) + .4(.16) = 9.64%**Cost of Capital Factors**Not in the firm’s control • Interest rates • Tax rates Within the firm’s control • Capital structure policy • Dividend policy • Investment policy**Capital Budgeting**Payback Period • The amount of time it takes for us to recover our initial outlay without taking into account the time value of money. • The decision rule is to accept any project that has a payback period <= critical payback period (maximum allowable payback period), set by firm policy.**Capital Budgeting**Payback Period • Assume our maximum allowable payback period is 4 years (nothing magical about 4 years as it is set by management): YearAccum. Cash Flows 1 5MM < 20MM 2 5MM + 7 MM = 12MM <20MM 3 12MM + 7MM = 19 MM <20MM 4 19MM + 10MM = 29 MM >20MM**Capital Budgeting**Payback Period • Get paid back during the 4th year. We need $1MM entering yr 4, and get $10MM for the whole year. If we assume $10MM comes evenly throughout the year, then we reach $20MM in {1MM/10MM} or .1 yrs. • So, payback = 3.1 years. • Do we accept or reject the project? Accept, since 3.1 < 4.**Capital Budgeting**Discounted Payback Period • Discount each year’s cash flow to a present day valuation and then proceed as with Payback Period.**Capital Budgeting – Net Present Value**NPV = PV (inflows) - PV(outflows) NPV = ACFt / (1 + k)t - IO , where, • IO = initial outlay • ACFt = after-tax CF at t • k = cost of capital (cost of capital for the firm) • n = project’s life Decision rule: Accept all projects with NPV >= 0**Capital Budgeting - NPV**Accepting + NPV projects increases the value of the firm (higher stock value/equity), kind of like you are outrunning the cost of capital**Capital Budgeting - NPV**Invest $100 in your 1-yr business. My required rate of return is 10%. What would be the CF be at the end of year 1 such that the NPV = 0? • ACF1 = 100(1.1) = 110 (just the FV!) • If NPV > 0, it is the same as ACFt > 110.**Capital Budgeting - NPV**Ex: 120. Now, what’s the investment worth? • Just PV of $120 = 120/1.1 = 109.09. • My stock is now worth 109.09, a capital gain of 9.09 due to you accepting the project. (the 9.09 is the NPV = 120/1.1 - 100 = 9.09)**Capital Budgeting - IRR**IRR is our estimate of the return on the project. The definition of IRR is the discount rate that equates the present value of the project’s after-tax cash flows with the initial cash outlay. • In other words, it’s the discount rate that sets the NPV equal to zero. NPV = ACFt / (1 + IRR)t - IO = 0, or ACFt / (1 + IRR)t = IO • The decision criterion is to accept if IRR >= discount rate on the project.**Capital Budgeting - IRR**Are the decision rules the same for IRR & NPV? Think about a project that has an IRR of 15% and a required rate of return (cost of capital) of 10%. So, we should accept the project.**Capital Budgeting - IRR**What is the NPV of the project if we discount the CF at 15%? • Zero - by definition of IRR. Is the PV of the CF’s going to be higher or lower if the rate is 10%? Higher - lower rate means higher PV. So, the sum term is bigger at 10%, so the NPV is positive ===> accept. NPV and IRR will accept and reject the same projects – the only difference is when ranking projects.**Capital Budgeting - IRR**Computing IRR: Case 1 - even cash flows • Ex. IO = 5,000, Cft = 2,000/yr for 3 years IO = CF(PVIFA IRR,3) ===> 5,000 = 2,000(PVIFA IRR,3) Just find the factor for n=3 that = 5,000/2,000 = 2.5 • For i=9, PVIFA = 2.5313 • For i=10, PVIFA = 2.4869 • It’s between 9 & 10: additional work gives 9.7%**Capital Budgeting - IRR**Case 2 Uneven CF’s - even worse • Trial and Error! • Ex above: IO = 20,000, CF1 = 5,000, CF2 = 7,000, CF3 = 7,000, CF4 = 10,000, CF5 = 10,000 • We have to find IRR such that • 0 = 5,000 (PVIF IRR,1) + 7,000 (PVIF IRR,2) + 7,000 (PVIF IRR,3) + 10,000 (PVIF IRR,4) + 10,000 (PVIF IRR,5) – 20,000**Capital Budgeting - IRR**• NPV at 25% is -563. So, should we try a higher or lower rate? Lower (==> higher NPV) If we try 24%, we get NPV = -102.97, at 23%, we get NPV = 375 ==> it’s between 23 & 24%. A final answer gives 23.8%.**Capital Budgeting - IRR**IRR has same advantages as NPV and the same disadvantages, plus • Multiple IRRs: IRR involves solving a polynomial. There are as many solutions as there are sign changes in the cash flows. In our previous example, one sign change. If you had a negative flow at t6 ==> 2 changes ==> 2 IRRs. Neither one is necessarily any good. 2. Reinvestment assumption: IRR assumes that intermediate cash flows are reinvested at the IRR. NPV assumes that they are reinvested at k (Required Rate of Return). Which is better? Generally k. Can get around the IRR problem by using the Modified IRR, MIRR.**Capital Budgeting - MIRR**• Used when reinvestment rate especially critical • Idea: instead of assuming a reinvestment rate = IRR, use reinvestment rate = k (kind of do this manually), then solve for rate of return. • 1st: separate outflows and inflows • Take outflows back to present at a k discount rate • Roll inflows forward - “reinvest” them - at the cost of capital, until the end of the project (n) - now just have one big terminal payoff at n. • The MIRR is the rate that equates the PV of the outflows with the PV of these terminal payoffs.**Capital Budgeting - MIRR** ACOFt/(1 + k)t = ( ACIFt* (1 + k) n-t) / (1 + MIRR) n where ACOF = after-tax cash outflows, ACIF = after-tax cash inflows. Solve for MIRR. MIRR >= k (cost of capital) ==> accept**Capital Budgeting - MIRR**• Notice, now just one sign change with no multiple rate problems – one positive MIRR • Plus, no reinvestment problem • Still expressed as a % which people like • Also, much easier to solve**Capital Budgeting - MIRR**Ex: Initial outlay = 20,000, plus yr. 5 CF = -10,000. We’ll use k=12% Draw timeline 1. PV of outflows = 20,000 + 10,000(1/1.12)5 = 25,674 2. FV of inflows: yr. 1 CF = 5,000; yr. 2 and 3 CF = 7,000; yr. 4 CF = 10,000; YR FV 1 5,000(1.12 ) 5-1 = 5,000(1.12 )4 = 7,868 2 7,000 (1.12 ) 5-2 = 7,000(1.12 )3 = 9,834 3 7,000 (1.12 ) 5-3 = 7,000(1.12 )2 = 8,781 4 10,000(1.12 ) 5-4 = 10,000(1.12 )1 = 11,200 ------------- Sum 37,683**Capital Budgeting Decision Criteria**• So, NPV and IRR all give same accept/reject decisions. But, they will rank projects differently • When is ranking important? • Capital rationing - firm has fixed investment budget, no matter how many + NPV projects there are out there.**Capital Budgeting Decision Criteria**Ex. firm has $5MM • If firm used IRR to rank, would pick highest IRR projects, next highest, etc., until spent $5MM. With NPV, pick projects to maximize total NPV subject to not spending more than $5MM. Mutually exclusive projects - just means can’t do both. Which do we pick - highest NPV or IRR?**Capital Budgeting Decision Criteria**• It’s easiest to see ranking problems through NPV profile - just a graph of NPV vs. discount rates: • By NPV: for k < 10%, pick A. For k > 10% pick B**Capital Budgeting Decision Criteria**• IRR: always pick B • NPV better: it incorporates our k, it’s how much we’re adding to shareholder value. If k < 10%, IRR gives wrong decision.**Capital Budgeting Post-Audit**• Compare actual results to forecast • Explain variances**Cash Flows in Capital Budgeting**Cash flow is important, not Accounting Profits • Net Cash Flow = NI + Depreciation**Cash Flows in Capital Budgeting**• Incremental Cash Flows are what is important • Ignore sunk costs • Don’t ignore opportunity costs (think of next best alternative) • What about externalities (the effect of this project on other parts of the firm), and cannibalization • Don’t forget shipping and installation (capitalized for depreciation)**Cash Flows in Capital Budgeting**Changes in Net Working Capital • Remember to reverse this out at the end of the project • Example: think of petty cash**Cash Flows in Capital Budgeting**Projects with Unequal lives – 2 solutions • Replacement Chain – like finding lowest common denominator • Equivalent annual annuity – like finding how fast the cash is flowing in to the firm**Cash Flows in Capital Budgeting**What if projects have different lives? Machine #1: cost = 24,000, life 4 yrs, net benefits = $8,000/year Machine #2: cost = 12,000, life 2 yrs, net benefits = $7,400/year k = 10% NPV1 = -24,000 + 8,000 PVIFA( 10%,4)= 1,359 NPV2 = -12,000 + 7,400 PVIFA(10%,2)= 843 We cannot compare these like this, since have unequal lives.**Cash Flows in Capital Budgeting**1. Replacement chain approach. Construct a chain of #2’s to get the same number of years of benefits (like finding least common denominator): Year 0 1 2 3 4 Inflows 7400 7400 7400 7400 Outflows -12000 -12000 Net CF -12000 7400 -4600 7400 7400 NPV2 = 1,540 - so we choose machine #2, not #1

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