Finance Test 2

chapters 5-8

capital

money, or the equivalent of money, that is loaned to, or invested in, a business

debt

fixed obligation or liability of the business that must be paid back, with interest, over a specific amount of time

Equity

ownership in the business that does not require immediate repayment, but requires a return on the capital invested

Cost of debt

interest expense the borrower pays the lender

cost of equity

portion of cash flow the sponsor of a deal allocates to the investor

weighted average cost of capital

amount of interest expense and cash flow allotted to equity investors divided by the amount of capital. takes capital mix and tax effect into consideration

financial leverage

increasing debt to lower the cost of capital. the cost of debt is always cheaper than the cost of equity. So, equity investors have a greater risk. businesses should maximize the amount of debt they barrow. REMEBER, bank gets paid 1st

advantages of debt

cheaper, tax effect, more sources, easier to obtain, does not dilute ownership

advantages of equity

less demanding than creditors (will wait if you don’t have the money), do not require a set payment timeline, owners cannot close down a business (banks close businesses), partners can add experience, knowledge. and expertise

principle

the amount of money borrowed

term

number of months or years given to repay the loan

interest

amount paid to the lender for lending the funds

principal repayment

portion of debt service that reduces the amount of money owed to the lender

amortization rate

number of years debt service calculated is based upon

collateral

asset offered to lender as loan insurance

personal guarantee

signature agrees to use personal funds to make a debt service payment

pre-payment penalty

borrower pays the total amount of interest had the loan not been paid off early

bullet loan

short-term loan with a long-term amortization rate. (creates balloon payment)

balloon payment

payment due at the end of the loan term

business loans

used to start or expand a company. based on the merits of the owner, business plan, and financial strength of the borrower

construction loan

1 to 2 year term, interest only, used to build, expand, acquire, or renovate, asset being constructed is provided as collateral, 60% of total project cost

permanent loan

typically a 10 year term,

mini-perm loan

hybrid of a permanent loan, 5 year term

non-recourse loan

lender cannot seek payment from borrower’s personal assets

mezzanine loan

fills the gap between the total project costs, first mortgage, and equity capital invested. interest rate is higher than a permanent loan. term runs concurrently with permanent and mini-perm loan. (take a second loan because the project costed more than you thought)

convertible loan

hybrid of debt and equity. can be converted into equity. (if i don’t get all my money, i will take more ownership - mr.wonderful)

small business administration loan (SBA 7(a))

maximum amount is $2 million, below-market interest rate

CDC (504) or federal (504)

loan program for small businesses, used to purchase fixed assets, borrower required to provide 10% of project cost, interest rate is below market, borrower must have net worth under $7 million, and average annual earnings for two years under $3 million

leasing

form of debt financing, requires fixed or variable monthly lease payments

types of equity

cash, land, building leases (popular for restaurants), existing buildings, government subsidies (does not require any repayment) tax abatement (certain number of years they don’t have to pay tax on the land, training grant, infrastructure (highway exits, new curb, sidewalks)

sources of equity

individuals, insurance companies, venture capital funds, state and local governments, owners of assets, construction and management companies, and investment banks

hotel financing in the 1970s and 1980s

boom time for hotel and real estate developers. loans based on percentage of value, not costs. developers secured debt financing in excess of the projects costs. tax shelters were created. (goal was to super charge development).

savings and loan industry was able to make commercial real estate loans, residential loans, and own commercial real estate

government offered investment tax credits to developers, accelerated depreciation to developers

Tax Reformed Act of 1986

eliminated tax shelters, prohibited savings & loans from owning real estate, real estate projects went bankrupt, lenders began foreclosing on loans, began a monumental financial crisis in the U.S.

Resolution Trust Corporation (RTC)

created by the federal government to bail out loan industry. Tasks of RTC: assume ownership of failed savings and loans, sell loans, sell foreclosed assets, recoup cash for US citizens lost in the savings and loans.

RTC sold most of the loans and foreclosed assets for a small percentage of their actual value

real estate investment trusts (REIT)

tax exempt corporation that own real estate. three categories, equity REIT - invests and owns properties, mortgage REIT - invests in mortgages and mortgage related securities, hybrit REIT

(how marriot and hilton can be asset light)

timeshare

rights to a room are sold on a weekly basis

condominium hotels

each room is sold as an investment

mixed-use development

focuses on offering a range of products, may include a hotel, restaurant, retail space, etc

Time Value of Money (TVM)

based on face value and interest that can be earned

Present Value

current value of an asset based on the amount and timing of projected cash flows. (can calculate how much a business is worth, gives you the current value of an asset)

future value

value of an asset sometime in the future assuming a compounded rate of interest

present value of an asset is based on

projected future cash flows, factoring in the timing of the cash flow, risk of the cash flow being generated, mixed of capital used to finance the deal

hurdle rate

cost of equity to the investor or the required return of investment. (at what point do you want to take your money out of a safe investment and put it into an investment where you might lose your money) also defined as the minimum required rate of return an investment or project must earn to be considered acceptable

PMT business calculator

annuity payment

I/Y

interest or discount rate

N

number of years

single sum

only a single sum of money is involved in the calculation

Annuity

amount of money received or paid during each compounding period for a set time (think lottery)

regular annuity

money is receive or paid at the end of each compounding period

annuity due

money is received or paid at the beginning of each compounding period (more valuable than regular annuity

perpetuity

special type of annuity that pays or receives cash with no time limit (like social security, you don’t know the timeline, don’t know when its going to end)

uneven stream of cash flows

where payments are not the same in all compounding periods

compounding period

monthly compounding favors the lender, interest expense is being accrued or paid monthly

components of investment analysis

WACC, discount rate, capitalization method of valuation

WACC

used to calculate present value of an investment. rate used to discount future cash flows. mix and debt and equity depends on how much the company can borrow and pay debt service. (WACC = cost of equity + cost of debt (after tax))

discount rate

used to calculate present value of an asset by discounting each years cash flow. (as discounting rate increases, the present value of the investment decreases)

capitalization method of valuation

values the asset’s prior twelve months cash flow. Provides the asset’s approximate market value.

payback period

amount of time a project requires to pay back the initial equity investment. advantage - easy to calculate. disadvantage - doesn’t include the time value of money, ignores cash flow after the required payback period

payback period

cost / incremental cash flow

net present value

calculates the difference between an asset’s present value and purchase price. advantages - takes into account all cash flow, and TVM. disadvantages - difficult to compare multiple investment opportunities with different costs

internal rate of return (IRR)

discount rate that makes the NVP of an investment equal to zero. advantage - compare multiple deals with varying sales prices and costs. Disadvantages - assumes cash flows generated by the project are reinvested at the IRR calculated, multiple IRRs when cash flows go from negative to positive

modified internal rate of return

more conservative than IRR

factors impacting investment analysis

cost of capital (WACC), cap rates used to calculate the assumed sales price at the end of the analysis period, amount and timing of annual cash flows projected, acquisition price or development cost of the asset

cost of capital

the more financial leverage used, the lower the cost of capital, the lower the cost of capital the lower the discount rate, the lower the discount rate, the higher the present value and NVP

cap rate

the lower the cap rate, the higher the sales price and PV, NVP, and IRR. the highter the cap rate, the lower the sales price and PV, NVP, and IRR

amount and timing of projected cash flows

the more cash flow projected in the early years, the higher the PV, NVP, and IRR

acquisition price

the lower the price of the asset or total project cost, the higher the NVP and IRR (the less money we pay for it, the better the return)

need for growth

essential to a companies success. growth company’s earnings increase at least 15% each year.

private company owners expect profits - cash flow, and ROI to increase. stockholders expect the price of their stock to rise

shareholder value

shareholder value = market value

market value

public company - current market price of common stock multiplied by number of shares outstanding.

private company - sales price of the company

public company goals

increase earnings per share (EPS), increase the company’s stock multiple, increase the market price of common stock

investors are risk averse

the greater the risk, the higher the ROI demanded by investors (they don’t want to take a huge risk)

beta

market-related risk measurement. market beta = 1 (higher beta means it’s a riskier investment) (as an investor you can see how risky it is)

private company goals

increase cash flow, and generate a favorable return for owners

benefits of growth

clear career paths for employees, attract qualified employees, increase market share, limit new competition, diversify risk

growth strategies

increase sales and productivity of existing properties, expansion of physical facilities, franchising, management contracts, mergers and acquisitions, initial public offering

increase sales and productivity of existing properties - growth strategies

increase profit margin, increase sales, reduce expenses, increase labor productivity, reduce credit card commissions

expansion of physical facilities - growth strategies

focus on current or new markets, requires large quantities of new capital, earnings of additional assets must be greater than the company’s cost of capital

franchising - growth strategy

sell the rights to a brand in a specific location/market for a stated number of years.

Franchisees pay - franchise fee, franchise royalty fee, ancillary services (marketing, training, purchasing fees, etc.)

benefits - greater distribution system, rapid growth without large amounts of capital, higher profit margins.

Disadvantages - risk of not being able to control brand standards, and unable to control quality and consistency of the products and services

management contracts - growth strategy

operate properties for owners without management capabilities, available primarily to lodging companies, fees - 3%-5% of total sales & incentive fee based on a percentage of operating profit.

Disadvantage - risk of contract being terminated

mergers and acquisitions

available to large public companies, must have substantial amount of capital, funded by - debt, existing equity, selling new shares of stock, bartering

(highlight financial strengths, upside potential, and future value)

initial public offering (IPO)

utilized when: a company is ready for rapid growth, and when a company’s potential future value is much greater then its current value

IPO process - initial public offering

1. investment banker manages process (company)

2. law firm writes prospectus

3. accounting firm prepares certified audits for prior three years

4. road show (talk to investors, come up with a price point, set the price based on that)

5. stock offering is priced

6. management meets with stock exchange (start selling your company publicly)

Investment banker

plays important role in the IPO process.

before stock is sold - it helps you value the company, establish a price for the stock, manages the selling process.

after stock is on the market - maintains a market for the stock

managing a public company

management at public companies have many responsibilities. Like, they are required to file reports with the SEC, deal with Wall Street research analysts, must report to: board of directors, and stockholders