ACFI3310 Advanced Corporate Finance Week 1 Slides PDF

ACFI3310 Advanced Corporate Finance Week 1: Module Introduction, and Net Present Value and Cost of Capital Wansu Hu Room HU 3.32 [email protected] 1  Introduction to Module Module Team and Approach Learning Outcomes Assessments Lecture...

ACFI3310 Advanced Corporate Finance Week 1: Module Introduction, and Net Present Value and Cost of Capital Wansu Hu Room HU 3.32 [email protected] 1  Introduction to Module Module Team and Approach Learning Outcomes Assessments Lecture Programme Recommended Reading 2  Module Team and Approach Module Leader: Wansu Hu ([email protected]) Module Team: Mathew Potter ([email protected]) Bola Babajide ([email protected]) Navpreet Cheema ([email protected]) Weekly activities: 50min lecture and 50min seminar each week In addition, pre-seminar questions should be completed BEFORE your allocated seminar Reading, consolidation and revision is recommended in addition to the lecture and seminar activities 3  Learning Outcomes Subject specific skills and knowledge 1. Critically evaluate the financing and investment policies of a corporation, including the use of gearing and advanced valuation techniques. 2. Assess the feasibility of mergers and acquisitions, and other forms of corporate expansion. 3. Evaluate the risk of bankruptcy using alternative models associated with its prediction, including solvency and profitability measures. 4. Critically evaluate advanced topics in corporate finance, including the role of options and dividend policy. Non-subject specific skills 5. Make appropriate use of learning resources including specialised finance- related electronic information databases. 6. Display advanced numeracy and quantitative skills including data analysis, interpretation and extrapolation. 7. Efficiently plan and manage independent study, including improved time- management and self-motivation skills. 8. Effectively communicate conceptually challenging concepts and ideas, orally or in writing. 4  Assessments Assessment 1 Assessment 2 (LO 3, 5-8) (LO 1-2, 4, 6-8) Individual Bankruptcy Type Examination Assignment Length 500 words 2 hours Weighting 30% 70% 12pm (Noon) Deadline Thursday, 13th Feb 2025 Timetabled centrally (Week 20) Please note: The bankruptcy assignment will be provided with the Week 8 learning materials. The revision materials for the exam, including past papers and solutions, will be provided with the Week 25 learning materials. The material for the bankruptcy assignment will be covered during Weeks 8-10. You will not be examined on the learning materials for Weeks 8-10 in your exam. All other learning materials are examinable. The word count for the bankruptcy assignment excludes analysis that will be 5 required in the appendices of your submission.  Lecture Programme Part Weeks Lecturer Wansu Hu 1. Capital structure 1-5, 7 [email protected] Matthew Potter 2. Bankruptcy 8-10 [email protected] c.uk Wansu Hu 3. Dividend policy 11, 15-16 [email protected] 4. Mergers and Wansu Hu 17-19 Acquisitions [email protected] Matthew Potter 5. Options 20-24 [email protected] c.uk Wansu Hu Revision 25-27 [email protected] 6  Recommended Reading Brealey, R.A., Myers, S.C. and Allen, F (2017) Principles of Coporate Finance, McGraw Hill (core text) Arnold, G. and Lewis, D.S. (2019) Corporate financial management, Pearson Education (recommended text) 7  Weeks 1-5, 7: CAPITAL STRUCTURE We Topic ek 1 NPV and Cost of Capital 2 Efficient Market Hypothesis 3 Capital Structure and Modigliani and Miller theory I 4 Capital Structure and Modigliani and Miller theory II 5 Risk-Adjusted WACC 6 Enhancement Week 7 Adjusted Present Value 8  NPV and Cost of Capital Briefly describe the goal of Shareholder’s Wealth Maximization Be able to calculate the net present value (NPV) of a project Be able to calculate the weighted-average cost of capital (WACC) 9  Shareholder’s Wealth Maximization A corporation is a legal entity separate to its owners (the shareholders). The primary objective of shareholder’s wealth maximization - to maximize the current market value of shareholder’s investment in the firm - is widely accepted in both theory and practice. E.g., If investors can access well-functioning financial markets, shareholders can manage their own savings and investment plans (e.g. timing of consumption, and risk), but managers can help by increasing the current market value of their investment in the firm.10  Shareholder’s Wealth Maximization (Continued) Corporations face two principle financial decisions: – What investments should the corporation make? (the investment decision) – How should it pay for the investments? (the financing decision) The separation of ownership and control in public corporations create agency problems. Any loss of value that results is called an agency cost. 11  The Investment Trade-Off A corporation can either reinvest cash or return it to investors. If cash is reinvested, the opportunity cost is the expected rate of return that could have 12 obtained by investing in financial assets.  Calculating Present Values How much must you invest today to receive a cash flow in n years time? The present value of the future cash flow is: The rate is called the discount rate. The expression is called the discount factor. 13  Valuing an Investment Opportunity The net present value (NPV) is the sum of the present values of the cash flows associated with the project: It represents the change in shareholder’s wealth for accepting a project: – If NPV is positive the project should be accepted (rate of return for the project exceeds the cost of capital ) – If the NPV is negative the project should be 14  Discount Factors for Perpetuities Year: 1 2 3 4 5 6 … Discount Factor Perpetuity X X X X X X … Delayed perpetuity X X X … (shown for k=3) k = length of delay = year of first cash flow - 1 15  Discount Factors for Annuities Year: 1 2 3 4 5 6 … Discount Factor Annuity X X X X … (shown for n=4) Delayed Annuity (shown for n=4, X X X X … k=1) n = length of annuity, k = length of delay = year of first cash flow - 1 16  Worked Example You are a financial analyst for Jeffrey Plc and are considering whether to invest surplus funds into the following project: Year After-tax Net Cash Flow (£’000) 0 -2,000 1 500 2 250 3 onwards 200 Calculate the NPV and decide whether to accept or reject the project. Assume that Jeffrey’s after-tax cost 17 Worked Example (Continued) After-tax Net Year Cash Flow (£’000) DF (10%) PV (£’000) 1.000 0 -2,000 -2000.0 (=1/1.100) 0.909 1 500 454.5 (=1/1.101) 0.826 2 250 206.5 (=1/1.102) 8.264 3 onwards 200 1652.8 (=1/1.102 x 1/0.10)* Total 313.8 *The delayed perpetuity formula has been used with a 2-year delay (k = year of first cash flow – 1) The project should be accepted according to the NPV criterion because 18 the NPV is positive.  Sources of Finance Equity Ordinary shares Preference shares Debt Bonds Bank loan(s) 19  Cost of Capital The company cost of capital is the expected rate of return a company must earn on its investments in order to satisfy the shareholders. The cost of equity is the expected rate of return required by the company’s shareholders. It can be determined by using the Capital Asset Pricing Model (CAPM). The cost of debt is the expected rate of return required by the company’s lenders. Interest is tax-deductible for corporations, so the after-tax cost of debt to the company is , where is the marginal corporation tax rate. 20  Cost of Capital (Continued) The cost of capital to the company is given by a weighted-average, known as the weighted-average cost of capital (WACC): 𝐸 𝐷 𝑊𝐴𝐶𝐶 =𝑟 𝑒 + 𝑟 𝑑 ( 1 − 𝑇 ) 𝑉 𝑉 = market value of equity = market value of debt = market value of company The weights are proportions based on the company’s capital structure. WACC is applicable to new projects that have the same 21 risks as the current projects.  Worked Example Firethorn Plc is financed as follows: Ordinary shares of 50p each with a nominal value of £2.5 million. Bank Loan of £1.0 million with an interest rate of 4%. The shareholders of Firethorn Plc expect a rate of return of 12% and the share price is currently £1.30. Assume that the corporation tax rate is 20%. Required: Calculate the cost of capital to the 22 firm WACC Worked Example (Continued) E= Number of shares x share price = £2.5m/£0.50 x £1. re = 12% D = £1.00m rd(1-T) = 4% x (1 – 0.2) = 3.2% V = E + D = £6.50m + £1.00m = £7.50m E/V = £6.50m/£7.50m = 0.867 D/V = £1.00m/£7.50m = 0.133 WACC = (0.867 x 12%) + (0.133 x 3.2%) = 10.8%  Worked Example A project requires an initial investment of £1,000,000. It has been estimated that the project will yield pre-tax cash flows of £600,000 for the next 2 years and a year 3 cash flow of £500,000. The company is financed in the following way: Ordinary shares: 1.5m shares of 50p nominal value. The shares have a current price of £0.75. Based on the Capital Asset Pricing Model, the expected rate of return is 11%. Bank Loan: £550,000 at 5.2% interest. Required: Calculate the NPV of the project and 24 Worked Example (Continued) E= Number of shares x share price = 1.5m x £0.75 = £1 re = 11% D = £550,000 rd(1-T) = 5.2% x (1 – 0.3) = 3.64% V = E + D = £1,125,000 + £550,000 = £1,675,000 E/V = £1,125,000/£1,675,000 = 0.672 D/V = £550,000/£1,675,000 = 0.328 WACC = (0.672 x 11%) + (0.328 x 3.64%) = 8.59% (roun  Worked Example (Continued) After-tax Net Year Cash PV Flow (£’000) DF (9%) (£’000) 1.000 0 -1,000 -1,000.0 (=1/1.090) 420 0.917 1 385.3 [=(1-0.3) x 600] (=1/1.091) 420 0.842 2 353.5 [=(1-0.3) x 600] (=1/1.092) 350 0.772 3 270.2 [=(1-0.3) x 500] (=1/0.093) Total 9.0 The project should be accepted according to the NPV criterion because the NP is positive. 26  Summary and Further Reading Further Reading: – Brealey, R. A., Myers, S. C. and Allen, F. (2017), Principles of Corporate Finance, McGraw Hill, Ch 5 & 9 – Arnold, G. (2013), Corporate Financial Management, FT Prentice Hall, Ch 2 & 19 Summary: – The primary objective of shareholder’s wealth maximization is widely accepted in both theory and practice. – Net present value (NPV) is the sum of the present values of the associated cash flows. It represents the change in shareholder’s wealth for accepting a project. – The cost of capital to the company is a blend of the cost of equity and the after-tax cost of debt, known as 27