corporate finance midterm #1 (FM review, ch 13, 15-16)

cash flow

the cash received from the firm’s assets must equal the cash flows to the firm’s creditors and stockholders

• sunk costs (not considered)

• opportunity costs

• change in NWC

• financing costs (not considered)

• taxes

cash flow from assets =

cash flow to creditors + cash flow to stockholders

operating cash flow - net capital spending - change in NWC

fed raises interest rates…

bond prices decrease

bonds with ______ maturity have greater interest rate risk

longer

non-cash assets increase…

cash outflow

liabilities or SE increase…

cash inflow

income statement

sales

(cogs)

(depreciation)

EBIT

(interest)

(tax)

net income

operating cash flow =

EBIT + depreciation - taxes

net capital spending =

(ending NFA - beginning NFA) + depreciation

change in NWC =

ending NWC - beg NWC

net working capital =

current assets - current liabilities

cash flow to creditors =

interest paid - net new borrowing

cash flow to stockholders =

dividends paid - net new equity raised

standalone principle

allows us to analyze each project in isolation from the firm simply by focusing on incremental cash flows

sunk costs

costs that have accrued in the past; don’t consider

opportunity costs

costs of lost options; consider MV

OCF = (EBIT - tax) + depreciation when…

interest expense = 0

liquidity ratios

• current ratio

• quick ratio

• cash ratio

current ratio =

current assets / current liabilities

quick ratio =

(CA - inventory) / CL

cash ratio =

cash / CL

long-term solvency ratios

• total debt ratio

• debt/equity ratio

• equity multiplier

total debt ratio =

(TA-TE)/TA

TD/TA

equity multiplier =

TA/TE

1 + D/E

• measure of the firm’s financial leverage

inventory ratio =

COGS/inventory

receivables turnover =

sales/AR

total asset turnover =

sales/TA

• measure of the firm’s asset use efficiency; how well does it manage it’s assets

profitability margins

• profit margin

• return on assets

• return on equity

profit margin =

net income / sales

• measure of how the firm’s operating efficiency; how well it controls costs

return on assets =

net income / TA

return on equity =

net income / TE

dupont identity

ROE = PM x TAT X EM

risk-return tradeoff

the greater the potential reward, the greater the risk

risk premium

extra return earned for taking a risk

variance

measures the volatility of asset returns

• greater volatility = greater uncertainty

• SD is the square root of the variance

historical variance =

sum of squared deviations from the mean / n-1

portfolio expected returns

the weighted average of the expected returns for each asset in the portfolio

• E(Rp) = weight of each stock x expected return

portfolio variance

σp = square root of sum of probability(Rp - E(Rp))²

• σp < sum of weighted σ

• the total risk of a combined portfolio is less than the weighted sum of individual asset risks

systematic risk

risk factors that affect a larger number of assets; measured by beta

• affects all companies

• includes changes in GDP, inflation, interest rates, etc.

• aka non-diversifiable risk/market risk

unsystematic risk

risk factors that affect a limited number of assets; diversifiable

• unique risk and asset specification

• includes labor strikes, part shortages

• no risk premium

diversification

not quantity in general but quantity over various industries

• can substantially reduce the variability of returns without an equivalent reduction in expected returns

• reduction in risk arises because worse than expected returns from one asset are offset by better than expected returns from another

total risk =

systematic risk + unsystematic risk

• measured by SD

• for a diversified portfolio = systematic risk

systematic risk principle

there is a reward for bearing risk but not a reward for bearing risk unnecessarily

• the expected return of a risky asset depends only on that asset’s systematic risk

CAPM/SML

E(R) = Rf + B[E(Rm) - Rf]

• representation of market equilibrium

• linear relationship between expected return and systematic risk

• market beta = 1

beta = 1

asset has the same systematic risk as overall market

• expected return of a stock = market return

beta < 1

asset has less systematic risk than overall market

beta > 1

asset has more systematic risk than overall market

reward-to-risk ratio =

E(R) -Rf / B

• slope of the SML

• above line = undervalued = buy

• below line = overvalued = sell

market equilibrium

all assets and portfolios must have the same reward-to-risk ratio and must equal that of the market

• same products have the same price

• 
  

factors affecting expected return

• pure time value of money: measured by Rf

• reward for bearing systematic risk: measured by MRP

• amount of systematic risk: measured by B

stock A is fairly priced →

stock B is a good buy (underpriced) because return is higher with same beta → everyone will buy B → price of B goes up → until E(R) for each is equal

cost of equity (dividend growth model)

Re = (D1/P0) + g

cost of debt

the return that lenders require on a firm’s debt; interest rate

• equal to YTM or current market rate

weighted average cost of capital (WACC)

the average rate a company expects to pay to finance operations and assets through a mix of debt and equity

• the overall return a firm must earn on its existing assets to maintain value of stock

• WACC = E/V(Re) + D/V(Rd)(1-Tc)

• weights are targets, not actual

• Tc = marginal

• firm value increases when WACC decreases

NPV for safe projects (i.e. no risk)

NPV = sum of discounted cash flows - initial cost

NPV for risky projects

NPV = sum of expected discounted cash flows - initial cost

all-equity firm

WACC = Re = R0

• accept projects whose IRRs exceed the cost of equity capital

net present value (NPV)

total value or absolute profit of an investment in today's dollars

• positive = accept project

estimation of beta

cov(Ri, Rm) / var (Rm)

covariance between stock & market / variance of market

• measures the responsiveness of a security to movements in the market

beta =

sum of (stock return - avg stock return)(market return - avg market return) / sum of (market return - avg market return)²

beta of company increases…

Re increases and value of company decreases

factors that can change beta

• changes in product line (systematic)

• changes in tech (systematic)

• deregulation (systematic)

• changes in financial statements

if you believe that the operations of the firm are similar to the operations of the industry…

use the industry beta

determinants of beta: cyclicality of revenues

highly cyclical firms = higher B

• retailers and car firms fluctuate with business cycle

• transportation firms and utilities are less dependent on the business cycle

determinants of beta: operating leverage

measures how sensitive a firm/project is to its FC

• increases as FC rises and VC falls

• magnifies the effect of cyclicality on B

degree of operating leverage =

(∆EBIT/EBIT) x (Sales/∆Sales)

(∆EBIT/EBIT) / (∆Sales/Sales)

1 + FC/OCF

degree of financial leverage =

(∆net income/net income) / (∆EBIT/EBIT)

if D/E increases…

Bequity increases

if D/E = 0…

all equity firm and Bequity = Basset (unlevered B)

financial leverage

the extent to which a firm relies on debt

Bequity =

B_UL (1+ D/E)

• increases with financial leverage

• reflects the systematic risk of a company’s existing assets and past financial choices

firm valuation

the value of the firm is the PV of expected future (distributable) cash flows discounted at the WACC

equity value =

firm value - debt

authorized shares

the number of authorized shares is stated in the articles of incorporation

• issued and outstanding

• issued and not outstanding: treasury shares (buy back shares)

amount paid when shares are sold =

capital surplus + par value

capital surplus

refers to amounts of directly contributed equity capital in excess of par value; increases BV of equity

par value

face value assigned to a single share by a company's founders when it is first created

book equity =

par value + capital surplus + RE - cost of treasury shares

where RE = beg RE + net income - dividends

book value

backward looking measure that tells us how much capital the firm has raised from shareholders in the past

• doesn’t measure the value that shareholders place on those shares today

market value

forward looking measure that depends on the future dividends that shareholders expect to receive

• MV of equity = shares outstanding X current market price

difference between BV and MV =

market value added

min votes to guarantee =

(total shares / directors + 1) +1

total votes =

shares owned X number of directors

straight voting

you get one vote per share for each individual seat up for election

• ex. 100 votes for seat A, 100 votes for seat B…

• majority = (shares/1) +1 = 51%

cumulative voting

your total votes are multiplied by the number of open seats and you can distribute them any way you want

• can assign all votes to one person (pool)

• allows minority shareholders to concentrate their votes on one person

straggered election

only a fraction of the directors are up for election in any given year

voting by proxy

legally assigning your voting rights to another party (often management)

dual class stocks

stocks with different voting right for management to security control

other shareholder rights

• right to share in assets in liquidation after all bills are paid

• right to vote in major corporate decisions (ex. M&A)

• rights to share proportionally in dividends (optional and paid at discretion of the board; NOT tax deductible)

debenture

unsecured corporate debt, typically of long maturity

bond

secured corporate debt (terms are often not used precisely)

note

unsecured debt with a maturity of under 10 years

senior debt

paid first in bankruptcy

junior/substantial debt

paid after senior debt in bankruptcy; higher return

secured debt

collateralized by an identifiable asset

callable debt

debt can be repurchased by the firm at a fixed price (the call price), if they so choose after a period of call protection

indenture agreement

legal agreement specifying the rules of the game between the firm and the lender, often includes covenants limiting actions that may harm debt holder

WACC with preferred stock

WACC = D/V(Rd)(1-Tc) + E/V(Re) + E/V(Rp)

where Rp = dividend/price of preferred stock

preferred stock

an equity claim that must be paid dividend before common shareholders

• dividend amount is fixed (just like bond) but paid at the discretion of the board

• typically no voting rights but awarded voting rights if dividend is not paid

• have equal claim to the stated value of the shares in bankruptcy

• not deductible against corporate income

• only have to pay tax on 30% of dividend

suggested pecking order for financing

1. internal funds (retained earnings)

2. issue new debt (less sensitive to info asymmetry)

3. issue equity as last resort