Advanced Company Finance. BBA4 Semester 1, 2003 Brief Revision of BBA2 Corporate Finance.

1. Advanced Company Finance. • BBA4 Semester 1, 2003 • Brief Revision of BBA2 Corporate Finance. • Investment Appraisal, decision trees, and real options. • 3. Cost of Capital, Capital Structure, Firm Value. • 4. Optimal Capital Structure - Agency Costs, Signalling. • 5. Dividend Policy. • 6. Risk management. • 7. Convertible Debt. • 8. Mergers and Takeovers.

2. Income Statement. • Revenue • Variable Costs • Fixed costs • Depreciation • EBIT • -rD • EBT • -tax • Net Income • -Dividends • Retained earnings Finance Topics. Revenue Risk. Operating Leverage. Business Risk. Financial Gearing. Shareholder Risk and Return Dividend Policy.

3. Balance Sheet. Liabilities Share Capital + Retained Earnings Equity Debt (eg loans etc) Total Liabilities Assets Fixed Assets Current Assets Total Assets Balance Sheet is a snapshot. Total Assets = Total Liabilities. Book Value of Equity. Topic: Capital Structure (market values).

4. Revision of BBA2 Course The firm has two decisions: investment decisions and financing decisions. New Investment Appraisal (Investment decision). We examined 4 possible methods: Accounting Rate of Return, Payback, NPV, IRR. POSITIVE NPV Increases Shareholder Wealth. Perpetuities.

5. Revision of BBA2 Course (Continued). Discount Rate in NPV = Investors’ required return = cost of capital. Estimating Cost of Capital: Cost of equity: CAPM: Investors with well-diversified portfolios only get rewarded for holding systematic or market risk. They are not rewarded for holding diversifiable or specific risk. Security Market Line. The higher the beta, the higher the cost of equity.

6. Revision of BBA2 Course (Continued). WACC = cost of equity (from CAPM) x % of equity in capital structure + after tax cost of debt x % of debt in capital structure. Values here are market values. Capital Structure- the firm’s financing decision. The amount of debt and the amount of equity. Miller-Modigliani Irrelevance.

7. Revision of BBA2 Course (Continued). Capital Structure and Firm Value. MM irrelevance: MM Diagrams. Without tax, firm value is independent of capital structure. With Tax: 100% debt maximises firm value!!! Debt capacity, fin distress, agency costs, signalling. New BBA4 capital structure topics: agency costs+signalling. Product market competition. Behavioural Finance. Finally, in BBA2, we looked at options. We will use in BBA4!

8. Options- Revision A call option gives the holder the right (but not the obligation) to buy shares at some time in the future at an exercise price agreed now. A put option gives the holder the right (but not the obligation) to sell shares at some time in the future at an exercise price agreed now. European Option – Exercised only at maturity date. American Option – Can be exercised at any time up to maturity. For simplicity, we focus on European Options.

9. Buying a Call Option. Selling a put option. Selling a Call Option. Buying a Put Option.

10. Options: Black Scholes Model. • -Binomial Approach: discrete time periods. Large number of inputs. • Black-Scholes approach: continuous price process. • only 5 inputs. • Value of call Option: d1

11. General explanation. • -Probability that call will generate positive cashflow at expiration. • Replicating portfolio: buy units of the underlying asset; • Borrow • Portfolio with same cashflows as call option • Therefore, same value. • Dividend Adjustment: (see real options: option to delay). = dividend yield = dividends/current asset value.

12. Section 1: Investment Appraisal and real Options Some of the NPV topics covered in BBA2:- -Conflicts between NPV and IRR. -Mutually exclusive V independent projects. -Capital Rationing. -Competitive Bidding (eg Space Structures Case Study). New BBA4 NPV Topics. Decision trees. Risk analysis. Real Options. How do we get positive NPV projects?

13. DO WE INVEST IN THIS NEW PROJECT? NPV > 0. COST OF CAPITAL (12%) < IRR (19.75%).

14. Treatment of depreciation.

15. Decision Trees and Sensitivity Analysis. Example: From RWJ. New Project: Test and Development Phase: Investment $100m. 0.75 chance of success. If successful, Company can invest in full scale production, Investment $1500m. Production will occur over next 5 years with the following cashflows.

16. Production Stage: Base Case Date 1 NPV = -1500 + = 1517

17. Decision Tree. Date 1: -1500 Date 0: -$100 NPV = 1517 Invest P=0.75 Success Do not Invest NPV = 0 Test Do not Invest Failure P=0.25 Do Not Test Invest NPV = -3611 Solve backwards: If the tests are successful, SEC should invest, since 1517 > 0. If tests are unsuccessful, SEC should not invest, since 0 > -3611.

18. Now move back to Stage 1. Invest $100m now to get 75% chance of $1517m one year later? Expected Payoff = 0.75 *1517 +0.25 *0 = 1138. NPV of testing at date 0 = -100 + = $890 Therefore, the firm should test the project. Sensitivity Analysis (What-if analysis or Bop analysis) Examines sensitivity of NPV to changes in underlying assumptions (on revenue, costs and cashflows).

19. Sensitivity Analysis. - NPV Calculation for all 3 possibilities of a single variable + expected forecast for all other variables. Limitation in just changing one variable at a time. Scenario Analysis- Change several variables together. Mosher Case study. Break - even analysis examines variability in forecasts. It determines the number of sales required to break even.

20. Break-even Analysis. Accounting Profit. Breakeven Point = 2091 Engines. NPV. Breakeven Point = 2315 Engines.

21. Investment Appraisal and Real Options (Damadoran 889 –905). • -Traditional investment analysis: Take a project if NPV > 0. • -Does not consider the options associated with investment projects. • Option to Delay. • Option to expand in future. • Option to Abandon a project.

22. Option to Delay. A project requires initial investment of X, PV of cash inflows is V. NPV = V- X. Firm invests in obtaining exclusive rights to the project. This gives it the ability to delay investment. Decision rule: If V > X, invest in the project (positive NPV). If V < X, do not invest in the project (negative NPV).

23. PV of cashflows. +ve NPV -ve NPV X V Cost of exclusive rights Just like a call option: The underlying asset is the project. The higher the variance in outcomes, the more valuable is the option to delay. Estimating the variance in the project: Similar past projects, Scenario and sensitivity analysis (probabilities) Similar businesses.

24. The option to delay is exercised when the firm decides to invest in the project. Exercise price is initial investment X. Option to delay expires when the exclusive rights lapse. After this time, competition drives NPV to zero. Cost of delaying after NPV turns +Ve- less time to have competitive advantage. Evenly distributed cashflows: Annual Cost of Delay (in %) =1/n. Valuation practice: Damadoran Pg 892.

25. Option to delay: Example (Damadoran Pg 892). • possibility to acquire exclusive rights to market new product. • If rights acquired: Initial investment $50 M. • Service only expected to generate $10 M per year. • No competition for next 5 years. • Static NPV (now or never):

26. Example (continued) • -but: high uncertainty over market interest in project. • mkt tests indicate current low demand, but possible large future demand. • S = $33M, • Using Black-Scholes formula:

27. Option to delay and Competition (Smit and Ankum). • -benefit: wait to observe market demand. • -cost: Lost cash flows. • -cost: lost monopoly advantage, increasing competition. • Net Operating Cashflow = opportunity cost plus economic rent; Economic Rent: Innovation, barriers to entry, product differentiation, patents. Long-run: ER = 0. Firm needs too identify extent of competitive advantage.

28. Option to delay and Competition (Smit and Ankum) – Cont’d. Cash inflow during deferment period = In monopoly model: constant economic rent. In competition, economic rent declines to zero. -trade-off between option value of waiting, and loss from competition.

29. Option to Expand. -initial project may allow further future investments or future entry into other markets. -initial project is an option- should be willing to pay for this. Ie: firm may take a negative NPV project due to high NPV on future projects (option can be evaluated today). Eg: Initial project => right to expand and invest in new future project. Future Project NPV: V-X (assessed today). -must take future project by certain date.

30. PV of cashflows -ve NPV From expansion X +ve NPV From expansion Initial Proj Investment -like a call option. A firm can use option analysis to rationalise investing in –ve NPV project which leads to future opportunities. Option analysis shows the value of this.

31. Option to Abandon a Project. The remaining value on a project is V. Liquidation value is L. Remaining life n years. Payoff from owning an abandonment option: = 0 if V > L. =L – V if L > V. -Put option. PV L

32. How do we get positive NPV projects (Shapiro)? • -Traditional investment appraisal assumes positive NPV projects exist. • Mechanical process: estimating cashflows; cost of capital. • Finding +ve NPV projects in competitive markets is difficult. • Need to identify projects that create competitive advantage. • Structure investments to exploit economies of scale and scope. • Cost advantages; learning curves. • Product differentiation. • This emphasises that search for +ve NPV projects begins with firm’s strategy.

33. The Investment Appraisal Debate. Richard Pike: Sample size: 100 Large UK based Firms.

34. Combination of Techniques: Pike 1992: ( ) = NPV

35. Some Reasons for usage of wrong techniques. • -Managers prefer % figures => IRR, ARR • Managers don’t understand NPV/ Complicated Calculations. • Payback simple to calculate. • Short-term compensation schemes => Payback (Levy 200 –203, Pike 1985 pg 49). • Increase in Usage of correct DCF techniques: • Computers. • Management Education.

36. Risk and Return -revision. An investor’s actual return is the percentage change in price: Risk = Variability or Volatility of Returns, Var (R). We assume that Returns follow a Normal Distribution. Var(R). E(R)

37. Portfolio Analysis. Two Assets: Investor has proportion a of Asset X and (1-a) of Asset Y. Combining the two assets in differing proportions. E(R)

38. Portfolio of Many assets + Risk Free Asset. E(R) Efficiency Frontier. M * . * * X * * * All rational investors have the same market portfolio M of risky assets, and combine it with the risk free asset. A portfolio like X is inefficient, because diversification can give higher expected return for the same risk, or the same expected return for lower risk.

39. The Effect of Diversification on Portfolio Variance. Number of Assets. An asset’s risk = Undiversifiable Risk + Diversifiable Risk = Market Risk + Specific Risk. Market portfolio consists of Undiversifiable or Market Risk only.

40. SECTION 2: Cost Of Capital (revision). The cost of capital = investors’ required return on their investment in a company. Investors are risk averse. The higher the risk, the higher the required return.

41. Cost of Capital: Revision (continued). Estimating the cost of equity. DVM: => CAPM: APT: Practice: rule of thumb: E(r ) = risk-free rate plus an element for risk.

42. Cost of Equity (continued) CAPM quantity of risk. Security Market Line.

43. Estimating Cost of Equity Using Regression Analysis. We regress the firm’s past share price returns against the market.

44. Using Probability assessment to estimate cost of capital. A new project has the following data, Total Risk = Systematic Risk + specific risk.

45. Cost of Capital: Revision (continued). Combining cost of equity with cost of debt to obtain WACC. • Ke only rewards investors for systematic risk. • Must use market values of debt and equity (not book values). • WACC is the marginal cost for new investments. Therefore, WACC may be different for different projects (why?).

46. Risk-adjusted required returns- The Pure-play technique. (Shapiro Pg 324) -technique for determining different WACC’s for different projects or divisions. Step 1: Identify pure-play firms: publicly traded firms similar to your firm’s project or business. Step 2: determine betas for pure-plays- from return data (see BBA2) or from already published data. -these are the equity betas (depends on business and financial risk).

47. Pure-Play (continued). Step 3: Adjust for leverage. The pure-play’s debt ratios may differ from your own capital structure. Convert the levered equity beta into unlevered beta (asset beta). Step 4: Relever the asset beta (to reflect your firm’s financing mix):

48. Pure-Play (continued). Step 5: Calculate the Project’s (or division’s) cost of equity- Use CAPM. Step 6: Calculate the project’s required rate of return (WACC). Limitations. Different divisions might have different debt capacities- may affect target capital structures. Pure Play assumes no interaction between divisions. Movement from single rate to multiple rates may face managerial resistance (why?)

49. Link to Section 3: Link between Value of the firm and NPV. Positive NPV project immediately increases current equity value (share price immediately goes up!) Pre-project announcement New capital (all equity) New project: Value of Debt Original equity holders New equity New Firm Value

50. Example: =500+500=1000. 200 60 -20 = 40. Value of Debt = 500. Original Equity = 500+40 = 540 New Equity = 20 =1000+60=1060. Total Firm Value