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  1. CFA Corporate Finance Introduction Resham Jain

  2. Finance Finance: Money Management Finance includes:- • Personal Finance (Individual Planning) • Public Finance (Monetary and Fiscal Planning) • Corporate Finance (Company Planning)

  3. Corporate Finance • Corporate Finance: “Any financial or monetary activity that deals with a company and its money” • It deals with: • Financing Decisions • Investment Decisions

  4. Corporate Finance Includes… • Capital budgeting concepts • Cost of Capital analysis • Capital Structure issues • Dividend policy considerations • Working Capital Management • Corporate Governance Issues etc.

  5. Corporate Finance • The primary goal for any finance manager is to “Maximize shareholder’s value” • For Valuation of firm, we need: • Cash flow • Liquidity • Leverage • Cost of Capital • Dividends

  6. Reading assignments • Capital Budgeting • Cost of Capital • Working Capital Management • Financial Statement Analysis • The Corporate Governance of Listed Companies

  7. CFA Corporate Finance Cost of Capital Resham Jain

  8. Capital • Growth and investments goes together • These investments comes by using own funds or borrowed funds • Which funds to use? • Neither borrowing nor owner’s fund is costless • Getting the right mix of capital is essential to maximize firm’s value

  9. Various long term capital which firm uses: • Long-term debt • Preferred stock • Common equity “Cost of Capital is not observable but rather must be estimated, which requires a host of assumptions and estimates. Again risk and return plays an important role in determining the same”

  10. Weighted Average Cost of Capital • The cost of capital of a company is the required rate of return that investors demand for the average-risk investment of a company • To estimate the required rate of return is to calculate the marginal cost of each of the various sources of capital and then calculate the weighted average of these costs • Weights are the proportion of the various sources of capital

  11. WACC Solution:- WACC = wdkd(1 - T) + wpskps + wceks = 0.3(10%)(1-0.4) + 0.1(9%) + 0.6(14%) = 1.8% + 0.9% + 8.4% = 11.1%

  12. WACC Major assumptions underlying WACC • Same risk as the average-risk project of the company • Constant target capital structure throughout its useful life Factor’s influencing firm’s WACC: • Market conditions, especially interest rates and tax rates • The firm’s capital structure and dividend policy • The firm’s investment policy. Firms with riskier projects generally have a higher WACC

  13. Cost of Capital • The mix that produces the minimum cost of capital will maximize the value of the firm (or share price) • So the question is how to arrive at this cost of capital • Basically, for analysis cost can be defined in two ways: Embedded cost (Historical) and Marginal cost (New) • The cost of capital is used primarily to make decisions which involve raising and investing new capital. So, we should focus on marginal costs. (Compensation required) (Opportunity cost) • Now, an overall or weighted average cost of capital must be used to know an appropriate discount rate • Cost of capital for all the above three sources of finance are determined and based on that cash flows are discounted

  14. Cost of Debt Yield to maturity approach: • eg: A 10-year, 12% semiannual bond sells for $1,023.22. T = 40% • Kd = 11.60% (N=20, PV=-1023.22, PMT=60, FV = 1000, CPT=I/Y) • Interest paid on debt is tax deductible so, after tax cost of debt must be used for determining WACC. • After-tax cost of debt = Kd(1 - t) = 11.6 (1 - 0.6) = 6.96% Debt rating approach: • Cost of debt determined based on rating, which is done based on maturity, security and seniority, industry, company profile, debt covenants, option-linked, fixed-floating, etc,.

  15. After-tax Cost of Debt • Interest on debt is a tax deductible • Taking the tax-deductibility of interest as the base case, we adjust the pre-tax cost of debt • Multiplying Kd by (1 - t) results in after-tax cost of capital

  16. Issues in estimating Cost of Debt • Fixed-rated Debt v/s Floating-rated Debt • Debt with option-like features • Nonrated Debt • Leases

  17. Cost of Preferred Equity • Cost of preferred stock is the commitment to pay dividends to the holder. • Cost of preferred stock = rp = • CMP of Preferred stock = $72 and dividend =$3.75 • Kp = 3.75/72 = 5.21%

  18. Cost of Common Equity • Cost of common equity is referred to as the rate of return required by a company’s shareholders. • Increase in equity can be made in two ways,: 1) Retained earnings and 2) New equity. • Cost of equity is different from the above two with regard to the certainty of receiving the cash flows.

  19. Methods for estimating cost of equity: • Capital Asset Pricing Model Approach (CAPM) • E(Ri) = RF + β[E(RM) – RF] [Use of Multi-factor CAPM] • Dividend Discount Model Approach (DDM) • KE = (where g = ROE*(1 – Pay-out ratio) • Bond Yield Plus Risk Premium Method • KE = rd + Risk Premium • Floatation cost for preferred and common stock are significant, so net price should be taken for estimating cost. • Preferred and common dividends are not tax deductible so no adjustments.

  20. Capital Asset Pricing Model Approach (CAPM) • E(Ri) = RF + β[E(RM) – RF] • E(Ri) = Risk-free + Risk - Premium • It shows linear relationship between risk and return • The risk is classified into two parts: Systematic risk and unsystematic risk

  21. Classification of Risk

  22. Beta • Beta is a measure of systematic risk • Beta explains the sensitivity of security return with respect to market return • Market returnis an independent variable and stock returndependent variable. • There can be ex-post (Historical) and ex-ante (Estimated) beta

  23. Beta • Mathematically it is derived from the relationship between market return and stock return • Based on this a regression line is formulated • Regression line is also known as characteristic line [Y = a + βX] • The slope of this line is beta, which shows the changes in stock return given the change in the market return

  24. Characteristic line or Regression Line

  25. Interpretation of Beta • Rs=2 + 1.2Rm (Characteristic Line) With Rm = 10%, Rs = 14% With Rm = 11%, Rs = 15.2% • Therefore, 1% change in market return will have 1.2% change in security return

  26. Interpretation of Beta • β >1 : aggressive security (β =1.2, 10% change in market will have 12% change in stock) • β <1 : defensive security (β =0.8, 10% change in market will have only 8% changes in stock) • β =0 : Risk-free security (No change) • β =1 : Market Portfolio (Portfolio replicating market index) (Same Change)

  27. Security Market Line E(Ri) SML E(RM) slope = [E(RM) - Rf] = Eqm. Price of risk RISK PREMIUM Rf bM= 1.0 Defensive security Aggressive security Rs = Rf + (Rm – Rf) β

  28. Illustration • Company X’s beta is equals to 1.75. Return on market portfolio equals to 12%. Risk-free rate equals to 8%. • E(Ri) = RF + β[E(RM) – RF] • E(Ri) = 8 + 1.75[12 – 8] = 15%

  29. Determining the WACC Schedule • The cost of each individual source of finance for various levels of usage has to be estimated. • Given the ratio of different sources of finance in the new capital structure, find out the levels of total new financing at which the cost of various sources would change. These levels, called breaking points, can be found out as: Breaking Point on Account of a Source = • Calculate the weighted average cost of capital for various ranges of total financing between the breaking points. • List out the weighted average cost of capital for each level of total new financing. This is the weighted marginal cost of capital schedule.

  30. Illustration – WACC Schedule • ABC Ltd. is planning to raise equity, preference and debt capital in the following proportions: Equity : 0.50 Preference : 0.20 Debt : 0.30 The cost of the three sources of finance for different levels of usage?

  31. Cost at different levels of usage

  32. Calculation of Breaking Point

  33. WACC for Various Ranges of Total New Financing

  34. THE MARGINAL COST OF CAPITAL (MCC) WACC WACC Total capital raised A Typical MCC Schedule • The MCC breaks upward when the cost of a capital component increases. • The first break usually occurs when retained earnings runs out and outside equity is raised at higher cost.

  35. Combining IOS and MCC Project IRRs WACC a b c 12.4% 10.24% d e $5m $10m • The MCC schedule represents the cost of capital faced by the firm (ranking from the cheapest to the most expensive). • The IOS represents the projects that are available to the firm (ranking from the most desirable to the least desirable).

  36. Investment Opportunity Schedule (IOS) • In order to construct the IOS, the firm needs to first estimate the IRR of each of the project it is considering. Once that is accomplished, the financial manager can plot the IOS, which is a chart of the IRRs of the firm’s projects arranged from the highest IRR to the lowest IRR

  37. Optimal Investment Decision

  38. Estimating Beta • Estimate Stock Beta • Through use of market model regression of the company’s stock returns against market returns Issues need to be considered while estimating beta: • Estimation Period • Periodicity of return interval • Selection of an appropriate market index • Use of smoothing technique • Adjustments for small-capitalization stocks

  39. BETA • Readymade beta are available for the traded company through various financial analysis vendors such as Barra, Bloomberg, Thompson Financial’sDatastream, Reuters, Valueline, etc. Beta of a company is affected by • Business risk (Uncertainty in revenue) • Operating risk (Uncertainty in operating costs) • Financial risk (uncertainty in finance cost)

  40. How to estimate beta of a non-publicly traded company? • Pure-Play Method • Process of ‘unlevering’ and ‘levering’ the beta • This requires using a comparable publicly traded company’s beta and adjusting it for financial leverage differences. Estimating a beta using the Pure-Play Method: • Select the comparable • Estimate comparable’s beta • Unlever the comparable’s beta • Lever the beta for the project’s financial risk • Calculate WACC

  41. Illustration • Orange Computers Ltd. Is planning to set up a software project. • Pre-tax cost of debt is 14 % • Tax rate is 40% • Proposed D/E ratio is 2:1 • Risk free rate of interest 8% • Return on market portfolio 12% • The company has obtained the financial information relating to similar companies:

  42. Solution • Step 1: The company has already done the first step of collecting beats of comparable companies. • Step 2: Calculation of asset betas From the given information and equation: Assets beats are: • Step 3: Calculation of equity beta The equity beta is

  43. Solution • Step 4: Calculation of expected return on equity by shareholders Ke = Rf+ β(Rm – Rf) = 0.08+1.19(0.12-0.08) = 12.76% • Step 5: Calculation of WACC.

  44. Country Risk • This is added over and above the equity risk premium

  45. Flotation Cost • Cost incurred while raising funds, so effective funds for utilization is less • Usually flotation cost is applicable for equity because of higher cost involved in raising money • In case of debt or preferred stock generally it is ignored because the cost is quite small Cost of External Equity • When flotation cost is in absolute form: • When flotation cost is in relative form: