CFA

CFACorporate FinanceIntroduction

Resham Jain12010Corporate Finance - Resham JainKnowledge Academy - CFA - USAFinanceFinance: Money Management

Finance includes:-Personal Finance (Individual Planning)Public Finance (Monetary and Fiscal Planning)Corporate Finance (Company Planning)

Knowledge Academy - CFA - USA2010Corporate Finance - Resham Jain2Corporate FinanceCorporate Finance: Any financial or monetary activity that deals with a company and its money

It deals with:Financing DecisionsInvestment Decisions

Knowledge Academy - CFA - USA2010Corporate Finance - Resham Jain3Corporate FinanceIncludesCapital budgeting concepts Cost of Capital analysisCapital Structure issuesDividend policy considerationsWorking Capital ManagementCorporate Governance Issues etc.Knowledge Academy - CFA - USA2010Corporate Finance - Resham Jain4Corporate FinanceThe primary goal for any finance manager is to Maximize shareholders valueFor Valuation of firm, we need: Cash flow Liquidity Leverage Cost of Capital DividendsKnowledge Academy - CFA - USA2010Corporate Finance - Resham Jain5Reading assignmentsCapital BudgetingCost of CapitalWorking Capital ManagementFinancial Statement AnalysisThe Corporate Governance of Listed Companies62010Corporate Finance - Resham JainKnowledge Academy - CFA - USACFACorporate FinanceCost of Capital

Resham Jain72010Corporate Finance - Resham JainKnowledge Academy - CFA - USACapitalGrowth and investments goes togetherThese investments comes by using own funds or borrowed fundsWhich funds to use?Neither borrowing nor owners fund is costlessGetting the right mix of capital is essential to maximize firms value82010Corporate Finance - Resham JainKnowledge Academy - CFA - USAVarious long term capital which firm uses:Long-term debtPreferred stockCommon equity

Cost of Capital is not observable but rather must be estimated, which requires a host of assumptions and estimates. Again risk and return plays an important role in determining the same

92010Corporate Finance - Resham JainKnowledge Academy - CFA - USAWeighted Average Cost of CapitalThe cost of capital of a company is the required rate of return that investors demand for the average-risk investment of a companyTo estimate the required rate of return is to calculate the marginal cost of each of the various sources of capital and then calculate the weighted average of these costsWeights are the proportion of the various sources of capital102010Corporate Finance - Resham JainKnowledge Academy - CFA - USAWACCSolution:-WACC= wdkd(1 - T) + wpskps + wceks= 0.3(10%)(1-0.4) + 0.1(9%) + 0.6(14%)= 1.8% + 0.9% + 8.4% = 11.1%

SourcesDebtPreference SharesEquityAmountRs.30,000Rs.10,000Rs.60,000Cost10%9%14%Tax rate = 40%112010Corporate Finance - Resham JainKnowledge Academy - CFA - USAWACCMajor assumptions underlying WACCSame risk as the average-risk project of the companyConstant target capital structure throughout its useful lifeFactors influencing firms WACC:Market conditions, especially interest rates and tax ratesThe firms capital structure and dividend policyThe firms investment policy. Firms with riskier projects generally have a higher WACC

122010Corporate Finance - Resham JainKnowledge Academy - CFA - USACost of CapitalThe mix that produces the minimum cost of capital will maximize the value of the firm (or share price)So the question is how to arrive at this cost of capitalBasically, for analysis cost can be defined in two ways: Embedded cost (Historical) and Marginal cost (New)The cost of capital is used primarily to make decisions which involve raising and investing new capital. So, we should focus on marginal costs. (Compensation required) (Opportunity cost)Now, an overall or weighted average cost of capital must be used to know an appropriate discount rateCost of capital for all the above three sources of finance are determined and based on that cash flows are discounted132010Corporate Finance - Resham JainKnowledge Academy - CFA - USACost of DebtYield to maturity approach:eg: A 10-year, 12% semiannual bond sells for $1,023.22. T = 40%Kd = 11.60% (N=20, PV=-1023.22, PMT=60, FV = 1000, CPT=I/Y)Interest paid on debt is tax deductible so, after tax cost of debt must be used for determining WACC.After-tax cost of debt = Kd(1 - t) = 11.6 (1 - 0.6) = 6.96%Debt rating approach:Cost of debt determined based on rating, which is done based on maturity, security and seniority, industry, company profile, debt covenants, option-linked, fixed-floating, etc,.142010Corporate Finance - Resham JainKnowledge Academy - CFA - USAAfter-tax Cost of DebtInterest on debt is a tax deductibleTaking the tax-deductibility of interest as the base case, we adjust the pre-tax cost of debtMultiplying Kd by (1 - t) results in after-tax cost of capital152010Corporate Finance - Resham JainKnowledge Academy - CFA - USAIssues in estimating Cost of DebtFixed-rated Debt v/s Floating-rated DebtDebt with option-like featuresNonrated DebtLeases162010Corporate Finance - Resham JainKnowledge Academy - CFA - USACost of Preferred EquityCost of preferred stock is the commitment to pay dividends to the holder.Cost of preferred stock = rp = CMP of Preferred stock = $72 and dividend =$3.75 Kp = 3.75/72 = 5.21%

172010Corporate Finance - Resham JainKnowledge Academy - CFA - USACost of Common EquityCost of common equity is referred to as the rate of return required by a companys shareholders.Increase in equity can be made in two ways,: 1) Retained earnings and 2) New equity.Cost of equity is different from the above two with regard to the certainty of receiving the cash flows.

182010Corporate Finance - Resham JainKnowledge Academy - CFA - USAMethods for estimating cost of equity:Capital Asset Pricing Model Approach (CAPM)E(Ri) = RF + [E(RM) RF] [Use of Multi-factor CAPM]Dividend Discount Model Approach (DDM)KE = (where g = ROE*(1 Pay-out ratio)Bond Yield Plus Risk Premium MethodKE = rd + Risk PremiumFloatation cost for preferred and common stock are significant, so net price should be taken for estimating cost.Preferred and common dividends are not tax deductible so no adjustments.

192010Corporate Finance - Resham JainKnowledge Academy - CFA - USACapital Asset Pricing Model Approach (CAPM)E(Ri) = RF + [E(RM) RF]E(Ri) = Risk-free + Risk - PremiumIt shows linear relationship between risk and returnThe risk is classified into two parts: Systematic risk and unsystematic risk

Knowledge Academy - CFA - USA2010Corporate Finance - Resham Jain20Classification of Risk

Knowledge Academy - CFA - USA2010Corporate Finance - Resham Jain21BetaBeta is a measure of systematic riskBeta explains the sensitivity of security return with respect to market returnMarket return is an independent variable and stock return dependent variable.There can be ex-post (Historical) and ex-ante (Estimated) beta Knowledge Academy - CFA - USA2010Corporate Finance - Resham Jain22BetaMathematically it is derived from the relationship between market return and stock returnBased on this a regression line is formulatedRegression line is also known as characteristic line [Y = a + X]The slope of this line is beta, which shows the changes in stock return given the change in the market return

Knowledge Academy - CFA - USA2010Corporate Finance - Resham Jain23Characteristic line or Regression Line

Knowledge Academy - CFA - USA2010Corporate Finance - Resham Jain24Interpretation of BetaRs=2 + 1.2Rm (Characteristic Line)With Rm = 10%, Rs = 14%With Rm = 11%, Rs = 15.2%

Therefore, 1% change in market return will have 1.2% change in security return

Knowledge Academy - CFA - USA2010Corporate Finance - Resham Jain25Interpretation of Beta >1 : aggressive security ( =1.2, 10% change in market will have 12% change in stock)