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Corporate Financial Policy 2004-2005 Introduction

Corporate Financial Policy 2004-2005 Introduction. Professor André Farber Solvay Business School Université Libre de Bruxelles. How to finance a company?. Should a firm pay its earnings as a dividends? When should it repurchase some of its shares?

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Corporate Financial Policy 2004-2005 Introduction

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  1. Corporate Financial Policy2004-2005Introduction Professor André Farber Solvay Business School Université Libre de Bruxelles

  2. How to finance a company? • Should a firm pay its earnings as a dividends? • When should it repurchase some of its shares? • If money is needed, should a firm issue stock or borrow? • Should it borrow short-term or long-term? • When should it issue convertible bonds? Cofipo 2005 01 Introduction

  3. Some data – Benelux 2004 Cofipo 2005 01 Introduction

  4. Divide and conquer: the separation principle • Assumes that capital budgeting and financing decision are independent. • Calculate present values assuming all-equity financing • Rational: in perfect capital markets, NPV(Financing) = 0 • 2 key irrelevance results: • Modigliani-Miller 1958 (MM 58) on capital structure The value of a firm is independent of its financing The cost of capital of a firm is independent of its financing • Miller-Modigliani 1961 (MM 61) on dividend policy The value of a firm is determined by its free cash flows Dividend policy doesn’t matter. Cofipo 2005 01 Introduction

  5. Market imperfections • Issuing securities is costly • Taxes might have an impact on the financial policy of a company • Tax rates on dividends are higher than on capital gains • Interest expenses are tax deductible • Agency problems • Conflicts of interest between • Managers and stockholders • Stockholders and bondholders • Information asymmetries Cofipo 2005 01 Introduction

  6. Course outline 09/02/2005 1. Introduction – MM 1958, 1961 16/02/2005 2. Debt and taxes 23/02/2005 3. Adjusted present value 02/03/2005 4. WACC 09/03/2005 5. Case study 16/03/2005 6. Option valuation: Black-Scholes 23/03/2005 7. Capital structure and options: Merton’s model 13/04/2005 8. Optimal Capital Structure Calculation: Leland 20/04/2005 9. Convertible bonds and warrants 27/04/2005 10. IPO/Seasoned Equity Issue 04/05/2005 11. Dividend policy 11/05/2005 12. Unfinished business/Review Cofipo 2005 01 Introduction

  7. Practice of corporate finance: evidence from the field • Graham & Harvey (2001) : survey of 392 CFOs about cost of capital, capital budgeting, capital structure. • « ..executives use the mainline techniques that business schools have taught for years, NPV and CAPM to value projects and to estimate the cost of equity. Interestingly, financial executives are much less likely to follows the academically proscribed factor and theories when determining capital structure » • Are theories valid? Are CFOs ignorant? • Are business schools better at teaching capital budgeting and the cost of capital than at teaching capital structure? • Graham and Harvey Journal of Financial Economics 60 (2001) 187-243 Cofipo 2005 01 Introduction

  8. Finance 101 – A review • Objective: Value creation – increase market value of company • Net Present Value (NPV): a measure of the change in the market value of the company NPV = V • Market Value of Company = present value of future free cash flows • Free Cash Flow = CF from operation + CF from investment • CFop = Net Income + Depreciation - Working Capital Requirement Cofipo 2005 01 Introduction

  9. The message from CFOs: Capital budgeting Cofipo 2005 01 Introduction

  10. From Markowitz to CAPM Expected Return Expected Return Security Market Line P 20% P M rM 14% 14% M rf8% 8% 2 Sigma 1 Beta Cofipo 2005 01 Introduction

  11. The message from CFOs : cost of equity Cofipo 2005 01 Introduction

  12. CAPM – an other formulation Consider a future uncertain cash flow C to be received in 1 year. PV calculation based on CAPM: with: See Brealey and Myers Chap 9 Cofipo 2005 01 Introduction

  13. Binomial option pricing model • Used to value derivative securities: PV=f(S) • Evolution of underlying asset: binomial model • u and d capture the volatility of the underlying asset • Replicating portfolio: Delta × S + M • Law of one price: f = Delta × S + M uS fu S fd dS Δt M is the cash positionM>0 for investmentM<0 for borrowing r is the risk-free interest rate with continuous compounding Cofipo 2005 01 Introduction

  14. Risk neutral pricing • The value of a derivative security is equal to risk-neutral expected value discounted at the risk-free interest rate • p is the risk-neutral probability of an up movement Cofipo 2005 01 Introduction

  15. State prices – Digital options • Consider digital options with the following payoffs: • Using the binomial option pricing equation: Calculation of present values using state prices: Cofipo 2005 01 Introduction

  16. Using state prices Calculation of present values using state prices: Cofipo 2005 01 Introduction

  17. Cost of capital with debt • CAPM holds – Risk-free rate = 5%, Market risk premium = 6% • Consider an all-equity firm: • Market value V 100 • Beta 1 • Cost of capital 11% (=5% + 6% * 1) • Now consider borrowing 20 to buy back shares. • Why such a move? • Debt is cheaper than equity • Replacing equity with debt should reduce the average cost of financing • What will be the final impact • On the value of the company? (Equity + Debt)? • On the weighted average cost of capital (WACC)? Cofipo 2005 01 Introduction

  18. Modigliani Miller (1958) • Assume perfect capital markets: not taxes, no transaction costs • Proposition I: • The market value of any firm is independent of its capital structure: V = E+D = VU • Proposition II: • The weighted average cost of capital is independent of its capital structure WACC = rAsset • rAsset is the cost of capital of an all equity firm Cofipo 2005 01 Introduction

  19. MM 58: Proof by arbitrage • Consider two firms (U and L) with identical operating cash flows X VU = EUVL = EL + DL Current costFuture payoff • Buy α% shares of U αEU = αVUαX ______________________________ • Buy α% bonds of L αDLαrDL • Buy α% shares of L αELα(X – rDL) ______________________________ • Total αDL+ αEL = αVL αX • As the future payoffs are identical, the initial cost should be the same. Otherwise, there would exist an arbitrage opportunity Cofipo 2005 01 Introduction

  20. MM 58: Proof using CAPM • 1-period company • C = future cash flow, a random variable • Unlevered company: • Levered (assume riskless debt): • So: E + D = VU =VU Cofipo 2005 01 Introduction

  21. MM 58: Proof using state prices • 1-period company, risky debt: Vu>F but Vd<F • If Vd < F, the company goes bankrupt Cofipo 2005 01 Introduction

  22. Weighted average cost of capital V (=VU ) = E + D Value of equity rEquity Value of all-equity firm rAsset rDebt Value of debt WACC Cofipo 2005 01 Introduction

  23. Using MM 58 • Value of company: V = 100 • Initial Final • Equity 100 80 • Debt 0 20 • Total 100 100 MM I • WACC = rA 11% 11% MM II • Cost of debt - 5% (assuming risk-free debt) • D/V 0 0.20 • Cost of equity 11% 12.50% (to obtain WACC = 11%) • E/V 100% 80% Cofipo 2005 01 Introduction

  24. Why are MM I and MM II related? • Assumption: perpetuities (to simplify the presentation) • For a levered companies, earnings before interest and taxes will be split between interest payments and dividends payments EBIT = Int + Div • Market value of equity: present value of future dividends discounted at the cost of equity E = Div / rEquity • Market value of debt: present value of future interest discounted at the cost of debt D = Int / rDebt Cofipo 2005 01 Introduction

  25. Relationship between the value of company and the WACC • From the definition of the WACC: WACC* V = rEquity * E + rDebt * D • As rEquity * E = Div and rDebt * D = Int WACC* V = EBIT V = EBIT / WACC Market value of levered firm If value of company varies with leverage, so does WACC in opposite direction EBIT is independent of leverage Cofipo 2005 01 Introduction

  26. MM II: another presentation • The equality WACC = rAsset can be written as: • Expected return on equity is an increasing function of leverage: rEquity 12.5% Additional cost due to leverage 11% WACC rA 5% rDebt D/E 0.25 Cofipo 2005 01 Introduction

  27. Why does rEquity increases with leverage? • Because leverage increases the risk of equity. • To see this, back to the portfolio with both debt and equity. • Beta of portfolio: Portfolio = Equity * XEquity + Debt * XDebt • But also: Portfolio = Asset • So: • or Cofipo 2005 01 Introduction

  28. Back to example • Assume debt is riskless: • Beta asset = 1 • Beta equity = 1(1+20/80) = 1.25 • Cost of equity = 5% + 6%  1.25 = 12.50 Cofipo 2005 01 Introduction

  29. Summary: the Beta-CAPM diagram   Beta L βEquity U βAsset r rAsset rDebt=rf rEquity 0 D/E   rEquity D/E rDebt WACC Cofipo 2005 01 Introduction

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