Corporate Finance

1. The idea of the Corporation Benefits of modern corporation are;

• ownership transferable by trading shares

• corporation has unlimited life

• Shareholders’ liability limited to investment but at cost of agency risk

Objective of Corporations “Maximise the Value added to the financial resources (debt and equity) provided to the corporation” Agency Cost Defn: “When self-interested decisions by management cause a reduction in shareholder wealth” Can be reduced or limited by:

1. Legal Obligations 2. Monitoring 3. Bonding Costs

(Incentives)

Residual loss after 1-3 4. Managerial Reputation 5. Market for Corporate

Control

Income Statement Statement of Cashflows Revenues Net Income (Cost of Goods Sold) Depreciation (Selling Gen Admin Exp) (∆ Working Capital)

Operating Income Net Operating Cashflow Other Income

EBIT (∆ Fixed Assets)

(Interest Expense) Net Investing Cashflow

Pretax Income (Current Taxes) ∆ Notes Payable Deferred Taxes (Dividends Paid)

Net Income (∆ Marketable Securities)

Added to Retained Earnings Net Financing Cashflow (Dividends Paid) Balance Sheet Current Assets Current Liabilities

Cash Accts Payable Marketable Securities Notes Payable Accts Receivables Accrued Expenses Inventories Taxes Payable Fixed Assets Long Term Liabilities

Property Plant Equipment Long Term Debt (Accumulated Depreciation) Deferred Taxes Intangible Assets Stockholders’ Equity

Preferred Stock Common Stock Capital Surplus Accum. Retained Earnings (Treasury Stock) Net Working Capital = Accts Receivables – Accts Payable W/Cap acts as a buffer reconciling differences between Revenue and Expense recognitions to actual cash payments OCF = EBIT + Dep – Tax Expense CF (Assets) = OCF – Capex – ∆ W/Cap Capex = ∆ Fixed Assets + Depreciation Cash Gen (or Reqd) = NPAT + Dep – ∆ W/Cap – Capex – Div Operating Cycle – period from deliver from supplier to cash received from customer Cash Cycle – period from cash payment to supplier to cash received from customer

2. Valuation Cash flows for Valuation Valuation CF’s must be Incremental i.e.

• incl. side effects (erosion of core business profits)

• incl. opportunity costs (alt. use of resources)

• excl. sunk costs (e.g. market research) Financing cash flows (Int Exp & Div) are excluded from Valuation as financing is included in the discount rate

( )��������������

ENSESNONCASHEXPNOPAT

CAmortDepEBITOCFAT &1 +−= τ

alternatively OCFAT= (R-C)(1-τC) + Dep• τC

Year 0 1 2 3 ...10

Op CF AT 0 40 85 220 220 PPE (1,000) Tax on PPE Sale (150) Land (500) CGT on Land (30) Change in W/Cap (40) (40) (120) 0 0

Net CF (1,585) 0 (35) 220 1,370 Effect of Taxes on Valuation Cash flows

• Care required if R and C differ for tax purposes from CF’s used in project cash flows

• Tax on PPE sale if Dep adjustment: τC • (Book – Mkt Value) Note also that increasing depreciation increases NPV as get tax effect earlier with less discounting Effect of Inflation Nominal Rate (1+rNOM ) = (1+rREAL ) (1+E(I))

Match discount rates with Cash flows Depreciation tax shield remains same in nominal terms, hence inflation discounts tax shield: NPVNOM ≤ NPVREAL

Terminal Value Decision Liquidate Business? Use Salvage Value

• Dispose Fixed Assets (price?)

• Look for Tax Effects to land and machinery

• Recover Outstanding Working Capital Going Concern? Use Residual Value • Value using multiple or perpetuity P0=CF1 / (r-g)

• Check g is reasonable (GDP is 2 to 3 %)

• No recovery of Working Capital Other Valuation Techniques Residual Income: measure of adequate return on capital RI = NOPAT – Capital x WACC Note: NPV = PV(RI) if overheads excl. & no asset revaluations Valuation by Multiples: using Avg of Peer’s ratios

• Price multiples of peers: P/E or P/Bk but this assumes similar values for B/S, τC, W/Cap and Funding

• Better to use Enterprise Value multiples: EV / EBITDA or EV / EBIT to remove tax and capital structure effects

Other Project Selection Methods Payback Period: Simple but no discounting, CFs after payback ignored, no standard PB measure exists Profitability Index: PI = PV / I0 Useful for capital rationing as it provides “Bang for the Buck” Avg. Accounting Return: AAR = NIAVG / Avg Book Value IRR: hurdle rate which sets NPV to 0, suffers from scale and timing problems, assumes CFs reinvested at IRR Capital Rationing Pick all positive NPV projects, or use combination with PI, however this breaks down in multi-period capital rationing

3. Risk and the Required Rate of Return Weighted Avg. Cost of Capital WACC (aka rW):

( )

+−+

+=

SB

Br

SB

SrWACC

CBSτ1

where Cost of equity rS and Cost of debt rB are

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MRP

FMEFS rrrr −+= β

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MRP

FMDFB rrrr −+= β

Note S/V and B/V are target proportions for projects Determinants of Beta Operating risk: determined by cyclicality of revenues and operating leverage i.e. fixed / variable costs Financial risk: (leverage) increase variability of ROE, ↑risk carried by equity and ↑required return on equity

( )( )

( )

+−

−+

+−=

SB

B

SB

S

C

CD

C

EASSETτ

τβ

τββ

1

1

1

which rearranges to

( ) ( )

−−

−+=

S

B

S

B CD

CASSETE

τβ

τββ

111

Changes to capital structure affects Debt and Equity betas, but not Asset betas as βA = Cov(ROI, RM ) / σ

2(RM ) Company vs Project Cost of Capital

• Use company β if project is “scale enhancing” (more of same)

• Otherwise, the discount rate and β must reflect the risk of the project. Using company β will accept high risk projects and reject low risk projects – use Avg β and B/V of similar businesses

Effect of Imputation

Imputation pays equity CF from pre-tax income, lowering the tax

shield effect.

( )[ ]

+−−+

+=

SB

Br

SB

SrWACC

CBSγτ 11

where γ is the realised value of the imputation credit. γ is ≤ 1 due to foreign shareholders and earnings Imputation Effect on Value of Firm: VL = CF/ WACC where CF = X [1-τC (1-γ)]

4. Leverage and the Cost of Capital Effect of Changes to Capital Structure If ↑B then ↓S but ↑rS to reflect increased financial risk If ROA > rB then ↑B/V results in ↑EPS & ↑ROE Modigliani & Miller Propositions

No tax With Tax Value of the firm

Leverage makes no difference to firm value:

VL = VU

Leverage raises firm value at all levels: VL = VU + τC B

Cost of equity

Leverage raises the cost of equity:

rS = ρ +(ρ - rB )•B/S

Leverage raises the cost of equity (but by less)

rS = ρ +(ρ - rB )(1-τC )•B/S

WACC Leverage makes no difference to the WACC:

WACC = ρ

Cost of capital declines with higher leverage:

WACC = ρ [1 – (τC•B/V)]

Unlvrgd Firm U Leveraged Firm L

Net Op Income EBIT X X

- Int. Expense - (rB • B)

Pretax Income EBT X X - rB • B

- Tax (τc • EBT) (τc • EBT)

Profit Ungeared CF Levered CF

Cost of equity ρ ρ + (ρ - rB )(1-τC )•B/S

WACC ρ ρ [1 – (τC•B/V)]

Equity S X( 1- τC )/ ρ VL - B

Perpetual Debt B - B

Enterprise value VU = S VL = VU + τC B

Arbitrage to recreate Leverage effect Action Effect on Capital Effect on Income

Sell α of L + α SL - α (X – rB B) Buy α of U - α VU α X Borrow (recreate L) + α B - α ( rB B)

Net Effects α (VL – VU) 0

Trade off model – Benefits vs Costs of Debt M&M model says WACC falls continuously due to tax shelter effect so B/V should be 100%, however a number of factors may limit the use of debt to trade off this benefit:

• Company cannot access tax deductions on debt e.g tax losses carried forward

• Cost of debt is pushed up by the personal tax system – effect of τpS could outweigh tax shelter on debt Gain from Leverage with Personal Taxes

( )( )( )

BGpB

pSC•

−

−−−=

τ

ττ

1

111

• Bankruptcy and financial distress costs due to illiquidity, loss credit facilities, sales, staff i.e VL becomes VU + τC B-PV[E(BC)] otherwise you would receive B soon as VL=B

• Agency risks to debt holders: mgmt may undertake risky projects to get back to equity as only debt holders lose if fail; reject projects with +ve NPV as CF’s flow to debt holders; or milk assets and send revenue to dividends and bonuses

• Behavioural – ‘pecking-order’ theory – first internal cash for financing, then debt if possible, equity last due to dilution – mgmt may be signalling overvalued stock by raising equity – alternatively, may under gear to retain flexibility

Target debt weighting should be applied to the value of the project V, not to the initial investment as that is what determines the risk profile to equity

• If V > I0, i.e. if the project NPV > 0, then the project can carry more debt than (target B/V • I0 )

• Take Care! if NPV is large enough, B could be > I0 ! The same caution applies to a target market weight gearing ratio for a company, if market value is significantly > book value

5. APV and Valuation of Debt Comparison NPV with WACC or APV WACC Method: NPV=VL - I0 where VL = X( 1- τC )/WACC WACC captures value of tax shield τC •B

• WACC best if the project target debt ratio B/V constant - UCF can be discounted at the WACC

• otherwise WACC has be recalculated for each B/V

APV Method: VL = VU +PV(ITS) = X( 1- τC )/ρ +PV(ITS) where ITS is the Interest Tax Shield APV splits ungeared CF’s and tax shield. • APV better if the B/V changes. Note B/V can change if ↕V

• APV useful for unusual financing e.g. subsidised debt Non-Perpetual Debt : cannot use τC B for ITS PV of Non-Standard Debt To value a loan relative to equity, discount after tax loan cashflows at the pre-tax standard cost of debt, To value a subsidised loan relative to standard loan, discount the after tax loan cash flows at the post-tax standard cost of debt to isolate the financing cost and not the tax shield e.g: Loan: B0=$500 @ i=10%,τC=30%, 4yrs

0 1 2 3 4

Loan Cashflows 500 (35) (35) (35) (535) Note:

• If target B/V reached: may be no principle repayments

• include fees in subsidised loans

ΔNPV Comparison After Tax Loan Payments Discount Rate

PV(Loan vs Equity) -i•(1- τC )•P0 rB

PV(Loan vs Loan) -i•(1- τC )•P0 rB•(1- τC )

Displaced Debt PV (Displaced Debt) = PV(ITS) for debt above target B/V NPV= VU + PV(loan vs ---) + PV(Displ. Debt) + PV (WHT) Leases Financing Leases: Effectively Ownership Operating Leases: Operating Expense Good Reasons for Leasing:

• Taxation benefits

• Residual risk avoided

• Speed/Cost Bad Reasons for Leasing:

• lower gearing ratio (analysts see leases as debt anyway)

• lower Capex (lease pmts an Operational Expense) e.g: PPE=$100, Lease PMT=$23/yr, rB=10%,τC=30%, 4yrs

0 1 2 3 4

Principal Saved 100 - lost PPE sale less any tax Depr Adjustment (60)

- Lease Pmts (23) (23) (23) (23) - Tax Shield 7 7 7 7 - lost Dep• τC (6) (6) (6) (6)

Lease CFs 77 (22) (22) (22) (59) Note:

• lease payments usually in advance

• tax payments (and therefore ITS) usually in arrears

• Dep. Tax Shield opportunity cost in ∆NPV(lease vs loan)

ΔNPV Comparison Cashflows Discount Rate

Lease vs Equity Lease CFs rB

Lease vs Loan Lease CFs rB•(1- τC )

Other Methods for Debt & Firm Valuation

Method Cashflow Discount Rate

Equity CF OCF – int – tax rS Pre-tax CF OCF rS /(1-tc)•S/V + rB•B/V CF to Investors Equity CF + int rS•S/V + rB •B/V

6. Real Options Real options are options to 1)Start a project, 2) Expand a project later in its life, 3) Delay the start of a project to acquire more information or 4) Abandon the project if circumstances change. Equity as Call Option Firm can be valued as options.

• Equity owners own a call over the assets with a strike price

equal to the firm’s debt, B (get the upside above B) - Also own a put (If firm value ↓ below B they can ‘put’ the firm to its lenders who take the downside below B

• Debtholders have the put value captured by rB - rf Binomial Method

Solve for O0:

−+

−+

−

−=

VV

OOh so that ( )( )

−

−=+−

−−

++

OhV

OhVrOhV

f1

00

Put-call parity says

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PUTPV(E)CALLS

Debtofrisk for Discount DebtRisk FreeEquityValue Firm −+=

CALLS PUTS

Shareholder S Equity = C0 = Firm + Put - RFDebt = V0 + P0 - D/(1+rf)

Bondholder B Firm Value – Call = V0 - C0

=RFDebt + Put = D/(1+rf) - P0

Value of Firm V0 = C0 (S) + P0 (B) = P0 (S) + C0 (B)

NPV Approach Find PV of each node and discount to present t=0

( ) ( )( )

...1

0+

+

−+−=

−−++

r

VpVpINPV

Option Value is ∆NPV created by option Expansion Option: value expansion branches ∆NPV Abandonment Option: replace node values if shutdown and selling up more profitable (like early exercise of American put) Option to Delay: shift decision tree and compare ∆NPV Options applied to Natural Resource Firms The NPV of an investment in a resources project e.g. a gold mine - would be calculated by forecasting revenue, costs, Capex etc. Within the forecast would be an expected price path for gold This arguably underestimates the value of the project because the mining company acquires an option over the gold price by owning the mine. Since the gold price is volatile this option has value not captured in the NPV

7. Mergers and Acquisitions Bad Reasons for M&A: (1)Diversification (2) Earnings growth (P/E ratio not corrected) (3) Agency Costs (mgmt size incentives) Good Reasons : Capture Synergy

Value of Synergy Synergy: value created by combining Syn = VAT – (VA + VT) Synergies can come from

• Revenue: market power, access to markets, cross-sell

• Cost Savings: shared resources, purchasing power.

• Taxation: debt capacity (?), access to tax losses (?)

• Lower Capex & W/Cap required Synergies ↑CFs ( not diversification, size etc.) Acquisitions can be ‘horizontal’, vertical’ or ‘conglomerate’

Vertical Horizontal Conglomerate

Revenue ↑ ↑ Stable

Cost Savings x Supplier ↑ Customer

↑ Unrelated

Cash or Share Offer

• For T: scrip offers ‘roll-over’ relief from CGT in Aus

• For A: cash/share mix is a capital management decision driven by optimal gearing – incl gearing effect of T’s debt

• Bidders often try to show EPS accretion which can shift the mix more to cash than might be optimal

•

Buyer A Target T Combined

Share Price SA ST SAT No. Shares NA NT NAT Value VA VT VA + VT + Syn

Cash Offer Gain to T = (SOFFER – ST )• NT

Equiv. Cash Offer: gives same Gain to T as Share offer

Share Offer NAT = NA +(NT • Offer Ratio ) SAT =VAT / NAT

Gain to A = (SAT – SA )• NA Gain to T = Synergy – Gain to A

8. Equity Capital & Dividend Policy Capital Raising Issuing Equity is NPV neutral – its how use the cash that affects NPV (but Equity issue can affect the share price because it changes no. of shares in issue) Placements for Institutional Investors: Pros: speed, low level of documentation, control of the share register Cons: dilution of retail shareholders (value transferred not destroyed) who cannot take up their pro-rata share of the placement (but ASX limitations and some retail placements) Placement Subscription Price S at discount to P0

Dilution % = 1 – ( PEx / P0 ) where PEX price after placement Rights Issues: Pros: lower costs, no dilution effects. Cons: slow to execute

R = PEX – S where( ) ( )

( )nN

nSNPP

EX+

⋅−⋅= 0

Takeover consideration: Pros: Consideration is valued at market price; avoids limits on placements; avoids use of debt; may have tax advantages Cons: Dilution of existing shareholders if bidder overpaid; agency risk greater than if company had to come to market Other Methods Secondary Issues: • Demerger of a business for consideration • Dividend reinvestment plans • Staff remuneration • Issue of convertibles or other instruments with a call Initial Public Offers Valuation of IPO is based on forecasts and peer group and often established through a book-build Pros: liquidity, access to funds, profile Cons: higher compliance threshold for listed companies, possible ‘short-termism’ of market

Dividend Policy Can be Cash or stock (or DRP - optional), ordinary or special Other methods of returning cash to shareholders are buy-backs and capital returns. Theory: ‘dividend irrelevance’, ignoring tax effects, no difference to shareholders → implies dividends fluctuate with cash flow and investment needs Div Policy in Practice: much more stable as influenced by (1) signalling effects, (2) Clientele effects – high payout attracts income-sensitive investors who react badly to a cut in dividend (3) Capital mgmnt: maintaining a cash buffer & (4) Taxation... Taxes and Dividends:

• ‘Classical’ tax system: Divs double-taxed → low payout ratios and/or share buy-backs to distribute spare cash

• Imputation: encourage payouts vs. retention even if need to issue capital (e.g.DRP)

Capital Management Tools

• Dividends are part of an overall capital management strategy which is aimed at keeping an optimum level of gearing in the firm

• Active capital mgmt helps to reduce agency risk of a ‘lazy’ balance sheet which may lead to poor-quality investment decisions (and > optimum WACC)

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Dividends √ √ √ √ x x ↓ Special Dividend √ √ √ √ √ √ ↓ Pro-Rata Capital Return x √ x √ √ √ ↓ On-Market Buy back x √ x x √ x ↑ Off-Market Buy Back ≈ x √ √ √ √ ↑

9. International Corporate Finance Risks in Intl Business Political: currency controls, foreign ownership, tariffs & quotas, blocking funds & assets, war & civil unrest FX Risk: transaction at different rates than contract, translation of assets/liabilities, economic op risk with FX changes Valuing Cashflows for Foreign Investments: Availability: estimate ∆CFs from currency controls, DW taxes and ∆ tax credit recognition, dividend restrictions Currency: Match discount rates to cashflow currency

Discount Rate for Valuation:

( ) 11

11 −

+

++=

AUD

USD

AUDUSDIB

IBWACCWACC

• Use rf of cash flow currency. If markets integrated → Global CAPM to get Beta in cash flow currency

• No FX risk premium: forwards rates already reflect this

• No premium for political risk: risk declines in emerging markets as they mature, better to factor in risk in scenario analysis

e.g: Witholding Tax (WHT) 15%

0 1 2 3 4

Project CFs (5000) 125 125 125 125 Loan CFS 2000 (25) (25) (25) (25)

Net Local CFs (3000) 100 100 100 100 WHT x 15% none (15) (15) (15) (15) NPV= VU + PV(loan vs ---) + PV(Displ. Debt) + PV (WHT) Note: Displaced debt for foreign project may be debt in local currency so ITS will be at local tax rate for displaced debt AUD/USD = Spot → NPVAUD = NPVUSD /Spot