Corporate Finance

What is a firm according to corporate finance?

• collection of investment projects → use of the company’s capital with the expectation of generating future returns

  • business unit

  • product line

  • new factory

  • research & development initiative

How should capital be allocated?

flow to uses where it generates the highest return relative to the level of risk involved

Why does capital allocation reflect an imperfect reality?

• irrational decision-making → emotions, incomplete analysis, cognitive bias

• uncertainty about the future

• market frictions

  • information asymmetries → overstating potential returns

  • limited investor capabilities → lack of expertise, time, or resources

  • transaction costs → cost of gathering information, due diligence & executing investments

  • agency problems → intermediaries may not act in the investor’s best interest

What is financial analysis?

• systematic process of examining a company's financial statements to evaluate its financial health, performance, and potential for creating shareholder value

• profitability of the company

• risk of investment

• efficiency of using resources

• meeting financial obligations

• worth of investing

What is a financial statement?

• comprehensive reports about a company’s past financial performance

• serve as source for shareholders, creditors, employees, customers, suppliers, regulatory authorities

What are the four main types of financial statements?

• balance sheet

• income statement

• statement of cash flows

• statement of changes in shareholders’ equity

What are the steps of an investment cycle?

What is the balance sheet (statement of financial position)?

• snapshot of the firm’s financial position (assets, liabilities, and shareholders’ equity) at a given point in time

• assets = liabilities + shareholders’ equity

• shareholders’ equity = difference between the value of the firm’s assets & liabilities

What are non-current assets?

• assets for long-term use (operational)

• net property, plant & equipment (PPE)

• goodwill & intangible assets

• other non-current assets

What are current assets?

• cash or expected to be turned into cash within the next year

• cash

• marketable securities (short-term investments, e.x. in other companies’ stocks)

• accounts receivable (money customers owe)

• inventories

• other current assets (e.x. pre-paid expenses)

What are current liabilities?

• due to be paid within one year

• accounts payable

• short-term debt/notes payable

• current maturities of non-current debt

• other current liabilities

What are non-current liabilities?

• to be paid beyond one year

• long-term debt

• capital leases

• deferred taxes

How is net working capital calculated?

net working capital = current assets - current liabilities

How is the book value of equity calculated?

• book value of equity = book value of assets - book value of liabilities

• could be negative

• many of the firms valuable assets may not be captured on the balance sheet (e.x. brand reputation, innovative culture, customer relationships)

How is the market value of equity calculated?

• market value of equity = market price per share * no. of shares outstanding

• cannot be negative

• often differs from book value

How is the market-to-book ratio (price-to-book ratio) calculated?

• market-to-book ratio = market value of equity / book value of equity

• success → ratio >1

• mature companies with stable earnings → low M/B ratio

• growth stocks → high M/B ratio

• shows how the market perceives a company’s future prospects

What is enterprise value?

• total value of a company’s assets, regardless of how it is financed

• value of a firm’s underlying business operations/assets

• debt: sum of interest-bearing liabilities

  • net debt = total debt - cash & short-term investments

• enterprise value = market value of equity + debt - cash = market value of equity + net debt

What is net income?

• total earnings of the firm’s equity holders

• profit belonging to the shareholders after everyone else has been paid

How is earnings per share calculated?

earnings per share = net income / shares outstanding

What is the diluted earnings per share?

• future EPS could be diluted by in-the-money share (stock) options, convertible bonds, or warrants → diluted EPS takes these into account

• how much profit each share would earn if all possible shares that could exist in the future were actually issue

• assumes warrants & convertible bonds have been used → lowers EPS

What does the statement of cash flows show?

• record of the sources and uses of the firm’s cash over a given period of time

• derived from income statement & changes in the balance sheet

• 3 sections

  • cash flow from operating activities

  • cash flow from investing activities (e.x. buying machines)

  • cash flow from financing activities

What is free cash flow?

cash generated by a firm from its operational & investment activities → used to meet its obligations to its capital providers

What are profitability ratios?

Measures of a firm’s ability to generate profits as a percentage of the sales generated (margin ratios; margin = portion of sales that is a profit)

How is gross margin calculated?

How is operating margin calculated?

How is EBIT margin calculated?

How is net profit margin calculated?

What are liquidity ratios?

• Measures of a firm’s ability to meet short-term debt obligations

• Help to assess a firm’s liquidity / financial solvency from information of the balance sheet / statement of financial position

How is the current ratio calculated?

How is quick ratio calculated?

How is cash ratio calculated?

What do interest coverage ratios show?

• Measures of a firm’s ability to meet its interest payments by comparing its earnings with its interest expenses

• A higher ratio means a firm is earning much more than necessary to meet its obligations (High-quality borrowers > 5x EBIT / Interest coverage; Low-quality borrowers < 1.5 EBIT / Interest coverage)

How is EBIT/interest coverage calculated?

How is EBITDA/interest coverage calculated?

What do leverage ratios show?

• Measures of a firm’s reliance on debt as a source of financing

• Can be measured using book or market values

How is debt-equity ratio calculated?

How is debt-to-capital ratio calculated?

How is debt-to-EV ratio calculated?

How is equity multiplier calculated?

What do valuation ratios show?

• Measures to help investors assess the market value of a firm

• Make intra-industry comparisons of firm valuations

How is price-to-earning (P/E) ratio calculated?

How is EV to EBIT calculated?

How is EV to sales calculated?

What do operating/investment returns show?

• Measures of a firm’s returns on investment

• Compare its income to its investment using financial information from the balance sheet / statement of financial position

How is return on equity calculated?

How is return on assets calculated?

How is return on investment capital calculated?

How is asset turnover calculated?

What is expected return?

• probability weighted average of all potential outcomes

• sum of outcomes x probability

What is risk?

dispersion / variation of possible outcomes around the expected return

What is risk tolerance?

willingness to accept potential losses in exchange for higher potential gains

What is net present value?

• over time net cash inflows & outflows accounting for the time value of money → discounting

• current value of a future stream of cash flows minus the initial investment

What is the internal rate of return?

• discount rate that makes NPV = 0

What is the terminal value?

• present value of all future cash flows → contribution of future cash flows approaches 0

• the estimated value of a business or asset at a specific point in the future

When should an investment be delayed?

when expected rate of return > required rate of return (r>R)

What happens when there are multiple IRRs?

• happens due to non-conventional cash flows → when cash flow switches from positive to negative

• NPV is positive at very low & very high discount rates, but negative in between

• present due to multiple positive cash flows separated by negative cash flows

• there can be as many IRRs as prefix changes

• e.x. projects with repeated investments & withdrawals, building a factory that later requires large demolition costs

When is there no existent IRR?

• benefits are so significant that there is no discount rate that makes the NPV negative

• at low discount rates later positive cash flows offset the costs, at high discount rates the early cash flow offsets the later occurring costs

What is risk?

• measurable uncertainty

• probabilities & possible outcomes can be calculated

• can calculate expected values

What is uncertainty?

• unmeasurable → probabilities & outcomes cannot be known

• most of future in reality is mostly uncertain

What is the difference between expected values and actual outcomes?

• expected values: theoretical averages

• in reality only one scenario will actually occur → may not be a match to the calculated expected value

What is the capital budget?

List of investments a company plans to undertake

What is capital budgeting?

Process used to analyze alternate investments & decide which ones to accept

What are incremental earnings?

Amount by which the firm's earnings are expected to change as a result of the investment decision

What is free cash flow?

• actual cash a company generates after covering its operating expenses and capital expenditures (such as equipment or property maintenance)

• represents the remaining money a business can use to pay dividends, reduce debt, or reinvest into growth

How is free cash flow calculated?

FCF = EBIT × (1-t) + depreciation - capital expenditures - increase in net working capital = EBIT × (1-t) - increase in net fixed assets - increase in net working capital = (revenue-cost-depreciation) × (1-t) + depreciation - capital expenditure - change in net working capital

capital expenditures: funds invested long-term

net working capital: additional cash tied up in operations; non-cash current assets - non-interest-bearing current liabilities

net fixed assets: gross financial assets - accumulated depreciation

unlevered net income: after-tax earnings without considering financing effects; revenue-cost-depreciation

depreciation: reduces corporate tax that has to be paid

How does free cash flow to the firm and flow to equity differ?

• FCF: cash available to all providers of capital

• FCFE: cash available only to common stakeholders after debt holders have been paid

  • debt holders paid first → affects risk of shareholders (residual claim)

  • lending money to firms is less risky than investing

What is business/asset risk?

• risk that a company will not be successful with its products/services

• asset side of the balance sheet is determined by what the business needs

• determines the total economic value the firm generates before any distribution to claimholders

What is financial risk?

• possibility that, if a company uses a lot of debt, there might not be anything left for shareholders after servicing the debt

• arises from the capital structure decisions made by management

• exists solely because of the presence of debt in the capital structure

What is the difference between retained earnings and dividends?

• retained earnings: reinvested in the company

• dividends: free to spend anywhere

What is net working capital?

• current assets - current liabilities

• measure of liquidity

What is the cost of capital?

• minimum rate of return a company must earn on its existing assets to satisfy its creditors, owners and other providers of capital

• interest expense already included

• used as a discounting rate for FCF

What is break-even analysis?

Computes the level of a parameter that makes the project’s NPV equal to zero

What is sensitivity analysis?

• Shows how the NPV varies with a change in one of the assumptions, holding the other assumptions constant

• Helps rank the most impactful parameters of the investment project based on their effect on NPV

What is scenario analysis?

Considers the effect on the NPV of simultaneously changing multiple

assumptions → more realistic

Why is debt called leverage?

debt amplifies the variability of equity returns in both directions

What does the capital asset pricing model show?

• What return should investors expect for taking on risk

• How much compensation is fair

What is systematic (market risk)?

• affects the entire market (e.x. economic recession, inflation, political instability)

• can’t eliminate this risk through diversification

What is unsystematic (specific) risk?

• specific to individual companies or industries (e.x. CEO scandal, product recall, new competition)

• can be eliminated through diversification

What does beta show?

• measure of systematic risk

• to what extent does a security’s return move together with the overall market return

  • β = 1: The security moves exactly with the market.

  • β > 1: The security is more volatile than the market.

  • β < 1: The security is less volatile than the market.

What does the efficient frontier diagram show?

• best possible risk-return combinations available to investors

• efficient frontier: all possible combination of risky assets that offer the highest expected return for each level of risk

• capital market line (CML): for risk-free investments, tangent to efficient frontier line, and touches it at one point → market portfolio

Why in the market portfolio universal regardless of risk preference?

every rational investor should hold the same mix of risky assets, and only vary the overall risk by adjusting how much risk-free asset they own

How is expected return calculated?

r_i = r_f + β_i × (E[r_Mkt] - r_f)

What are real-world applications of CAPM?

• Corporate Finance: Calculating the cost of equity capital

• Investment Analysis: Determining if stocks are fairly priced

• Portfolio Management: Constructing efficient portfolios

How is total risk measured?

by volatility

What is a market portfolio? What is the market index?

• market portfolio: value-weighted portfolio of all securities traded in the market → proxy for market index

• market index: report the value of a particular portfolio of securities

How can the expected market return be calculated?

How can you estimate a stock’s beta?

• select a comparable stock

• estimate the beta for the comparable stock from historical returns

• unlever the beta → what would the company’s beta be if it was financed entirely through equity

  • β_Asset= β_Equity x (1 / [1 + (1-t) × D/E])

• lever the beta for the project’s financial risk (use own debt/equity ratio)

  • β_Equity= β_Asset x (1 + [(1-t) × D/E])

How can the debt cost of capital be calculated?

• yield-to-maturity

  • debt cost of capital = yield to maturity on a firm’s outstanding debt

• debt-rating

  • debt cost of capital = yield based on similarly rated debt (bonds) with similar maturity

  • for when the firm’s bonds aren’t frequently traded

• beta-CAPM

  • debt cost of capital = expected return for debt based on its beta using CAPM

  • difficult to estimate beta for debt as corporate bonds are traded infrequently → use indices by rating category

  • for calculations: market risk premium = expected rate of market return

  • cost of capital → choose an alternative if you can guarantee higher returns → NPV with a discounting rate of the cost of capital

What are bonds?

• tradable debt securities

• at issuance the issuer determines the terms

  • principal (face/par value)

  • coupon rate (periodic interest payments)

  • maturity date

  • other features (callability, convertibility, covenants)

• the terms of the bond don’t change, only market price, reflecting changing risk perceptions

  • if yield increases, price must fall since payout is the same → capital loss if selling

What is yield-to-maturity?

• IRR an investor will earn from holding the bond to maturity and receiving its promised payments

  • expected rate of return only if risk is very low or 0

• accuracy depends on the risk of firm default

  • low risk: YTM is a reasonable estimate

  • high risk: YTM will overstate investors’ expected return

    • e.x. return is 8%, but average loss is 60%, and probability of default is 5.5% → expected annual loss: 0.055 × 0.60 = 0.033 → expected return: 8% - 3.3% = 4.7%

How is the weighted average cost of capital calculated?

How is asset (unlevered) beta calculated?

How is the effective after-tax interest rate calculated?

How does taking tax into account influence WACC and the target leverage ratio?

• WACC with taxes decreases as debt increases

• benefit of cheap debt is amplified by the tax shield, while cost of equity is not → bet benefit to leverage → favor debt

• include tax benefit to the discount rate to avoid double counting

What is the use of the unlevered cost of capital and WACC?

• unlevered cost of capital (pre-tax WACC)

  • expected return investors will earn by holding the firm’s assets

  • can be used to evaluate an all-equity project with the same risk as the firm

• WACC

  • evaluate a project with the same risk and the same financing as the firm

What are the assumptions of the Modigliani-Miller model?

• homogeneous expectations → all investors have identical beliefs about future cash flows & returns

• homogeneous business risk classes (same class → same asset risk)

• perpetual cash flows

• perfect capital markets

  • price of securities at a competitive market = present value of their future cash flows → efficient markets → prices immediately reflect all available price-relevant information

  • no taxes, transaction costs, issuance costs, or agency costs associated with security trading → no friction

  • a firm’s financing decisions do not change the cash flows generated by its investments, nor do they reveal new information about them → investment & financing decisions are independent of each other → financing method doesn’t affect the revenue generated

What is the argument made by Modigliani and Miller (proposition I)?

In a perfect capital market, the total value of a firm is equal to the market value of the total cash flows generated by its assets and is not affected by its choice of capital structure.

What is the law of one price?

• a firm’s securities and assets need to have the same total market value → otherwise arbitrage opportunity would exist

• if one would be worth then the other, investors could make riskless profits by buying the cheap & selling the expensive one

What is homemade leverage?

• investors in the capital market can take out loans themselves → use leverage in their own portfolios to adjust the leverage choice made by the firm

• perfect substitute for corporate leverage

• to increase payoff, take personal debt & buy shares of an unlevered firm → get charged the same cost of capital as the firm would

  • the MM model does not consider interest paid on debt!

What is the MM proposition II about?

The cost of capital of levered equity is equal to the cost of capital of unlevered equity plus a premium that is proportional to the market value of the debt-to-equity ratio.

• the more debt you add, the more amplified the risk premium, the higher the cost of equity → adding cheap debt is offset by the increasing cost of equity