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MN50324: MAF Corporate Finance: Semester 2, 2007/8

MN50324: MAF Corporate Finance: Semester 2, 2007/8 Investment Appraisal, decision trees, and real options. Risk and Return and Cost of Capital. Capital Structure and Value of the Firm. 4. Optimal Capital Structure - Agency Costs, Signalling. 5. Mergers and Acquisitions.

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MN50324: MAF Corporate Finance: Semester 2, 2007/8

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  1. MN50324: MAF Corporate Finance: Semester 2, 2007/8 • Investment Appraisal, decision trees, and real options. • Risk and Return and Cost of Capital. • Capital Structure and Value of the Firm. • 4. Optimal Capital Structure - Agency Costs, Signalling. • 5. Mergers and Acquisitions. • 6. Dividend Policy/Share Repurchases. • 7. Venture Capital. • 8. International differences in Corporate Finance Practices. • 9. Behavioral Finance.

  2. The Major Decisions of the Firm. • Investment Appraisal (Capital Budgeting) – Which New Projects to invest in? • Capital Structure (Financing Decision)- How to Finance the new projects – Debt or equity? • Payout Policy – Dividends, Share Repurchases, Re-investment. • => Objective: Maximisation of Shareholder Wealth.

  3. 1. Investment Appraisal. • Objective: Take projects that increase shareholder wealth (Value-adding projects). • Investment Appraisal Techniques: NPV, IRR, Payback, ARR, Real Options…. • Which one is the Best rule for shareholder wealth maximisation?

  4. Connections in Corporate Finance. Investment Appraisal: Net Present Value with discount rate (cost of capital) given. Positive NPV increases value of the firm. Cost of Capital (discount rate): How do companies derive the cost of capital? – CAPM/APT. Capital Structure and effect on Firm Value and WACC.

  5. SECTION 1: Investment Appraisal. Debate over Correct Method - Accounting Rate of Return. - Payback. - NPV. - IRR. - POSITIVE NPV Increases Shareholder Wealth. 2. Correct Method - NPV! -Time Value of Money - Discounts all future cashflows

  6. Net Present Value Perpetuities. IRR => Take Project if NPV > 0, or if IRR > r.

  7. Example. Consider the following new project: -initial capital investment of £15m. -it will generate sales for 5 years. - Variable Costs equal 70% of sales value. - fixed cost of project £200k PA. - A feasibility study, cost £5000, has already been carried out. Discount Rate equals 12%. Should we take the project?

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

  9. Note that if the NPV is positive, then the IRR exceeds the Cost of Capital. NPV £m 3.3m Discount Rate % 0 12 % 19.7%

  10. CONFLICT BETWEEN APPRAISAL TECHNIQUES.

  11. COMPARINGNPVANDIRR - 1 NPV 531 519 10% 22.8% 25.4% Discount Rate PROJ D PROJ C Select Project with higher NPV: Project C.

  12. COMPARINGNPVANDIRR -2 NPV Discount Rate Impossible to find IRR!!! NPV exists!

  13. COMPARINGNPVANDIRR –3 Size Effect Discount Rate: 10% Project A : Date 0 Investment -£1000. Date 1 Cashflow £1500. NPV = £364. IRR = 50% Project B:- Date 0 Investment -£10 Date 1 Cashflow £18. NPV = £6.36 IRR = 80%. Which Project do we take?

  14. Mutually Exclusive Versus Independent Projects. • Mutually Exclusive project: firm can only take one (take project with highest positive NPV). • Independent project: firm can take as many as it likes (take all positive NPV projects). • Consider slide 10: Which project(s) would you take, and what would be the value-added, if projects are a) mutually exclusive, and b) independent?

  15. Which Cash-flows to use? • Economic costs and revenues: ie take the cash when it occurs. (see depreciation treatment). • Relevant Cashflows. • Incremental cashflows. • => NPV is a measure of value-creation for shareholders from taking new project.

  16. Treatment of depreciation.

  17. 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.

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

  19. 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.

  20. 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).

  21. 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.

  22. EVA (Economic Value Added). • EVA developed, and trade-marked, by Stern and Stewart. • EVA closely related to NPV • But NPV = investment decision rule, forward-looking expected value-creation over life of a project. • EVA is an ongoing Annual Performance Evaluation Technique. • Rewards managers on annual value-creation.

  23. EVA with constant invested capital. • Project with Initial required Capital Investment • Capital Lasts forever (no depreciation). • Project generates cashflow in each future period n.

  24. EVA example. • Consider an investment opportunity requiring initial investment of 250 (no depreciation). • Project is expected to produce perpetuity of 35 (ie annually forever). • Discount rate

  25. EVA Example • EVA of investment opportunity in every year is • Present Value of these EVAs is

  26. Real Options. • Real Options recognise flexibility in investment appraisal decision. • Standard NPV: static; “now or never”. • Real Option Approach: “Now or Later”. • -Option to delay, option to expand, option to abandon. • Analogy with financial options (later in course).

  27. Types of Real Option • Option to Delay (Timing Option). • Option to Expand (eg R and D). • Option to Abandon.

  28. Valuation of Real Options • Binomial Pricing Model • Black-Scholes formula

  29. Value of a Real Option • A Project’s Value-added = Standard NPV plus the Real Option Value. • For given cashflows, standard NPV decreases with risk (why?). • But Real Option Value increases with risk. • R and D very risky: => Real Option element may be high.

  30. Simplified Examples • Option to Expand (page 241 of RWJ) If Successful Expand Build First Ice Hotel Do not Expand If unsuccessful

  31. Option to Expand (Continued) • NPV of single ice hotel • NPV = - 12,000,000 + 2,000,000/0.20 =-2m • Reject? • Optimistic forecast: NPV = - 12M + 3M/0.2 • = 3M. • Pessimistic: NPV = -12M + 1M/0.2 = - 7m • Still reject?

  32. Option to expand (continued) • Given success, the E will expand to 10 hotels • => • NPV = 50% x 10 x 3m + 50% x (-7m) = 11.5 m. • Therefore, invest.

  33. Option to abandon. • NPV(opt) = - 12m + 6m/0.2 = 18m. • NPV (pess) = -12m – 2m/0.2 = -22m. • => NPV = - 2m. Reject? • But abandon if failure => • NPV = 50% x 18m + 50% x -12m/1.20 • = 2.17m • Accept.

  34. Game-theoretic Approach to Real Options. • Option to Delay in the Face of Competition (Smit and Ankum).

  35. 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.

  36. 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.

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

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

  39. 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). • Behavioural Factors (see later section on Behavioural Finance!!) • Increase in Usage of correct DCF techniques: • Computers. • Management Education.

  40. SECTION 2: Risk and Return/Portfolio Decision/ Cost Of Capital. The cost of capital = investors’ required return on their investment in a company. It provides the appropriate discount rate in NPV. Investors are risk averse. Future share prices (and returns) are risky (volatile). The higher the risk, the higher the required return. p r A B t t

  41. 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)

  42. Risk Aversion. Investors prefer more certain returns to less certain returns. U Wealth 100 150 200 Risk Averse Investor prefers £150 for sure than a 50/50 gamble giving £100 or £200.

  43. 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)

  44. 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.

  45. 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.

  46. Relationship between Investor Portfolio Decision and Firm’s Cost of Capital • Investors can diversify away all specific risk; therefore, should only be rewarded for holding each firm’s market risk => CAPM. • CAPM provides the firm’s cost of equity.

  47. Derivation of CAPM from Portfolio Analysis • Sharp and Lintner (see Copeland and Weston).

  48. Capital Asset Pricing Model Security Market Line.

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

  50. Weighted Average Cost of Capital (WACC). When we have estimated Cost of Debt, and Cost of Equity- if we have market values of debt and equity, we can calculate WACC – discount rate in NPV of new investments.

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