Finance 1.1 The Corporation and Financial Markets PDF

Finance 1.1 The Corporation and Financial Markets Cash cycle Fund raising: deposit...

Finance 1.1 The Corporation and Financial Markets Cash cycle Fund raising: deposit External financing Product markets Capital markets disburse Use of Funds: ment Investment Cash inflow: deposit Internal financing disburse Cash outflow: Interest and ment repayments, dividends © FH AACHEN UNIVERSITY OF APPLIED SCIENCES | FACHBEREICH WIRTSCHAFTSWISSENSCHAFTEN | WWW.FH-AACHEN.DE | 8  Finance 1.1 The Corporation and Financial Markets Interest groups (so-called stakeholders): Owners, creditors, management, employees, customers, suppliers, society Langfristige Existenz- Securing long-term und Erfolgssicherung existence and success Intrinsic Financial Social Sachziele targets Finanzziele targets Sozialziele targets - Manufacturing high - Increase company - Compliance with quality products value environmental - Provision of - Making profit protection standards exclusive services - Securing solvency - Employee participation in corporate decisions © FH AACHEN UNIVERSITY OF APPLIED SCIENCES | FACHBEREICH WIRTSCHAFTSWISSENSCHAFTEN | WWW.FH-AACHEN.DE | 9  Finance 1.1 The Corporation and Financial Markets Further potential financial targets Profitability return on assets return on equity Return on invested capital Liquidity Solvency at any time Security Management of performance and financial risks Growth Ensuring that growth can be financed Independence Maintain entrepreneurial freedom © FH AACHEN UNIVERSITY OF APPLIED SCIENCES | FACHBEREICH WIRTSCHAFTSWISSENSCHAFTEN | WWW.FH-AACHEN.DE | 10  Finance 1.3 The Time Value of Money The Three Rules of Time Travel Rule 1: Comparing and Combining Values Our first rule is that it is only possible to compare or combine values at the same point in time. Rule 2: Moving Cash Flows Forward in Time Our second rule stipulates that to move a cash flow forward in time, we must compound it. Compounding means multiplying by the interest rate factor, (1+r) (for each period). Rule 3: Moving Cash Flows Back in Time Our third rule stipulates that to move a cash flow back in time, we must discount it. Discounting means dividing by the interest rate factor, (1+r) (for each period). Berk/DeMarzo, pp. 134-138. © FH AACHEN UNIVERSITY OF APPLIED SCIENCES | FACHBEREICH WIRTSCHAFTSWISSENSCHAFTEN | WWW.FH-AACHEN.DE | 30  Finance 1.3 The Time Value of Money The Internal Rate of Return In some situations, you know the present value and cash flows of an investment opportunity but you do not know the interest rate that equates them. This interest rate is called the internal rate of return (IRR), defined as the interest rate that sets the net present value of the cash flows equal to zero. Berk/DeMarzo, pp. 162-165. © FH AACHEN UNIVERSITY OF APPLIED SCIENCES | FACHBEREICH WIRTSCHAFTSWISSENSCHAFTEN | WWW.FH-AACHEN.DE | 50  Finance 1.4 Interest Rates The Effective Annual Rate (EAR) EAR indicates the actual amount of interest in percent that will be earned at the end of one year, i.e. reference always per annum (p.a.) Discount Rate for n periods = (1 + r)n – 1, where r: discount rate for one period n larger than 1 to compute a rate over more than one period n can be smaller than 1 to compute a rate over a fraction of a period Adjust discount rate to match the time period of the cash flows. Adjustment is necessary to apply present and future value formulas incl. perpetuity or annuity formulas. Berk/DeMarzo, pp. 178-179. © FH AACHEN UNIVERSITY OF APPLIED SCIENCES | FACHBEREICH WIRTSCHAFTSWISSENSCHAFTEN | WWW.FH-AACHEN.DE | 55  Finance 1.4 Interest Rates Annual Percentage Rate (APR) APR: Simple interest earned in one year, i.e. amount of interest earned without the effect of compounding. Interest Rate per Compounding Period = / 𝐴𝑃𝑅 Converting an APR to an EAR: 1 𝐸𝐴𝑅 1 𝑘 When working with APRs we must 1. Divide the APR by the number of compounding periods per year to determine the actual interest rate per compounding period. Then, if the cash flows occur at a different interval than the compounding period, 2. Compute the appropriate discount rate by compounding. Berk/DeMarzo, pp. 180-181. © FH AACHEN UNIVERSITY OF APPLIED SCIENCES | FACHBEREICH WIRTSCHAFTSWISSENSCHAFTEN | WWW.FH-AACHEN.DE | 57  Finance 1.5 Financial Decision Making and the Law of One Price Using Market Prices to Determine Cash Values Competitive market: Market in which goods can be bought and sold at the same price. Price then determines the cash value of the good. In competitive markets, value of a good will not depend on the views or preferences of the decision maker. Berk/DeMarzo, pp. 97-98. © FH AACHEN UNIVERSITY OF APPLIED SCIENCES | FACHBEREICH WIRTSCHAFTSWISSENSCHAFTEN | WWW.FH-AACHEN.DE | 70  Finance 1.5 Financial Decision Making and the Law of One Price Valuation Principle Value of an asset to a firm or its investors is determined by its competitive market price. The benefits and costs of a decision should be evaluated using these market prices (Benefits cash inflows and costs cash outflows) When the present value of the benefits exceeds the present value of the costs, the decision will increase the market value of the firm. Berk/DeMarzo, p. 98. © FH AACHEN UNIVERSITY OF APPLIED SCIENCES | FACHBEREICH WIRTSCHAFTSWISSENSCHAFTEN | WWW.FH-AACHEN.DE | 72  Finance 1.5 Financial Decision Making and the Law of One Price Arbitrage and the Law of One Price Arbitrage = the practice of buying and selling equivalent goods in different markets to take advantage of a price difference without taking any risk. Normal Market = is a competitive market in which there are no arbitrage opportunities Law of One Price = If equivalent investment opportunities trade simultaneously in different competitive markets, then they must trade for the same price in both markets. Berk/DeMarzo, pp. 106-107. © FH AACHEN UNIVERSITY OF APPLIED SCIENCES | FACHBEREICH WIRTSCHAFTSWISSENSCHAFTEN | WWW.FH-AACHEN.DE | 74  Finance 1.5 Financial Decision Making and the Law of One Price Separation Principle (of investment and financing decision) Due to no arbitrage, security transactions in a normal market neither create nor destroy value on their own, i.e. NPV Buy security PV All cash flows paid by the security Price Security 0 NPV Sell security Price Security PV All cash flows paid by the security 0 Therefore in normal markets: Evaluate NPV of an investment decision separately from the decision the firm makes regarding how to finance the investment Specific investment decision is independent from which other security transactions the firm is considering. Berk/DeMarzo, pp. 111-112. © FH AACHEN UNIVERSITY OF APPLIED SCIENCES | FACHBEREICH WIRTSCHAFTSWISSENSCHAFTEN | WWW.FH-AACHEN.DE | 76  Finance 2.1 Overview Pape, p. 35. © FH AACHEN UNIVERSITY OF APPLIED SCIENCES | FACHBEREICH WIRTSCHAFTSWISSENSCHAFTEN | WWW.FH-AACHEN.DE | 82  Finance 2.1 Overview Systematization financial instruments Finanzierungsinstrumente Financial instruments Außenfinanzierung External financing Innenfinanzierung Internal financing Eigenkapital Equity capital Hybridkapital Hybrid capital Fremdkapital Borrowed capital Finanzierung Financing from aus sales Financing from asset Finanzierung aus (Beteiligungsfinanzierung) (Equity financing) (Mezzaninefinanzierung) (Mezzanine financing) (Kreditfinanzierung) (Loan financing) dem Umsatzprozess revenues restructuring Vermögensumschichtung - Shareholder - Subordinated loans - Bank loans - Retention of profits - Working capital contributions - Convertible bonds - Bonds - Financing via management (partnerships) - Profit participation - Leasing depreciation - Divestments - New share issue rights - Supplier credits - Financing via - Sale-and-Lease- (corporations) - Factoring provisioning Back Pape, p. 37. © FH AACHEN UNIVERSITY OF APPLIED SCIENCES | FACHBEREICH WIRTSCHAFTSWISSENSCHAFTEN | WWW.FH-AACHEN.DE | 83  Finance 2.1 Overview Differentiation between equity and debt capital Criterion Equity Debt Legal status owner creditor liability liable either unlimited or No liability; priority claim limited to the amount of the vis-à-vis owners in the capital contribution; event of insolvency subordinated claim in the event of insolvency company management management right no right to manage time availability Indefinite term Limited term profit-sharing and Participation in profit or loss Fixed interest claim, no financing costs profit participation Tax implications profit to be taxed before Tax relief through interest distributed to equity investors payments strain on liquidity distribution only if profit is non-profit (fixed) interest generated payments Pape, p. 40. © FH AACHEN UNIVERSITY OF APPLIED SCIENCES | FACHBEREICH WIRTSCHAFTSWISSENSCHAFTEN | WWW.FH-AACHEN.DE  Finance 2.1 Overview Debt versus liabilities Liabilities A firm’s obligations to its creditors Part of the right-hand side of the balance sheet Debt Type of liability Borrowed money often for the purpose of financing large purchases E.g. bank loans, bonds © FH AACHEN UNIVERSITY OF APPLIED SCIENCES | FACHBEREICH WIRTSCHAFTSWISSENSCHAFTEN | WWW.FH-AACHEN.DE | 85  Finance 2.2.1.1 Short-term debt and liabilities Trade Credit / Supplier credit in practice, very important form of financing granting payment period within the terms of payment, e.g. payable 30 days net in balance sheet of the receiving company: trade payables Rationale: sales promotion by supplier Terms of payment are a component of price calculation, possibly "hidden discount" by granting cash discount (or implicit financing cost) Cash discount = possibility of deduction from the invoice amount granted in the terms of payment if payment is made within a certain period of time. Choice between two mutually exclusive alternatives Use of the cash discount or Use of supplier credit Berck/DeMarzo p. 960. © FH AACHEN UNIVERSITY OF APPLIED SCIENCES | FACHBEREICH WIRTSCHAFTSWISSENSCHAFTEN | WWW.FH-AACHEN.DE | 88  Finance 2.2.1.1 Short-term debt and liabilities Short-term financing with bank loans Bilateral bank loan (bullet): Firm pays interest on the principal loan amount and pays back the principal at maturity Line of credit: Bank agrees to lend a firm any amount up to a maximum available credit volume. Firm can pay back (parts of) utilized credit amount and can draw undrawn portion of credit line multiple times during tenor. This agreement offer high degree of flexibility to debtor. Bridge loan: “bridge the gap” until a firm can arrange for long-term financing, e.g. in M&A transactions. Berk/DeMarzo, pp. 987-988. © FH AACHEN UNIVERSITY OF APPLIED SCIENCES | FACHBEREICH WIRTSCHAFTSWISSENSCHAFTEN | WWW.FH-AACHEN.DE | 92  Finance 2.2.1.1 Short-term debt and liabilities Short-term financing with commercial papers Commercial papers: Short-term, unsecured debt used by large corporations that is usually a cheaper source of funds than a short-term bank loan. Average maturity between 30 days and maximum maturity of 365 days. Usually issuance under framework agreement between issuing company and dealing banks to handle the issuance process. Berk/DeMarzo, pp. 990-991. © FH AACHEN UNIVERSITY OF APPLIED SCIENCES | FACHBEREICH WIRTSCHAFTSWISSENSCHAFTEN | WWW.FH-AACHEN.DE | 93  Finance 2.2.1.2 Long-Term Debt and Liabilities Private Debt Private debt is debt that is not publicly traded, often a bank loan. A term loan is a loan that lasts for a specific term. A syndicated bank loan is a single loan that is funded by a group of banks rather than just a single bank. Usually, one member of the syndicate (the lead bank) negotiates the terms of the bank loan. A revolving line of credit is a credit commitment for a specific time period up to some limit, which a company can use as needed. A private placement is a bond issue that does not trade on a public market but rather is sold to a small group of investors. Because a private placement does not need to be registered, it is less costly to issue. Berk/DeMarzo, pp. 908-909. © FH AACHEN UNIVERSITY OF APPLIED SCIENCES | FACHBEREICH WIRTSCHAFTSWISSENSCHAFTEN | WWW.FH-AACHEN.DE | 95  Finance 2.2.1.2 Long-Term Debt and Liabilities Bond Covenants Covenants are restrictive clauses in a bond contract that limit the issuer from taking actions that may undercut its abilities to repay the bonds. Bond agreements often contain covenants that restrict the ability of management to pay dividends. Other covenants may restrict the level of further indebtedness and specify that the issuer must maintain a minimum amount of working capital. If the issuer fails to live up to any covenant, the bond goes into default. Berk/DeMarzo, pp. 914-915. © FH AACHEN UNIVERSITY OF APPLIED SCIENCES | FACHBEREICH WIRTSCHAFTSWISSENSCHAFTEN | WWW.FH-AACHEN.DE | 98  Finance 2.2.1.2 Long-Term Debt and Liabilities Examples of Bond Covenants Information Covenants  Providing Quarterly and Annual reports within certain period  Providing budget data Financial Covenants  Leverage  Equity ratio  Interest cover  Minimum Liquidity General Covenants  Restrictions on dividends to shareholders  Restrictions on disposition of assets or shareholdings © FH AACHEN UNIVERSITY OF APPLIED SCIENCES | FACHBEREICH WIRTSCHAFTSWISSENSCHAFTEN | WWW.FH-AACHEN.DE | 99  Finance 2.2.1.2 Long-Term Debt and Liabilities Sovereign Debt Sovereign debt is debt issued by national governments. The U.S. Treasury issues four kinds of securities: Treasury Security Type Original Maturity Bills Discount 4, 13, 25, and 52 weeks Notes Coupon 2, 3, 5, 7, and 10 years Bonds Coupon 30 years Inflation indexed Coupon 5, 10, and 30 years The last type of security is called TIPS (Treasury Inflation-Protected Securities). The coupon rate is fixed, but the outstanding principal is adjusted for inflation. Thus, although the coupon rate is fixed, the dollar coupon varies because the semiannual coupon payments are a fixed rate of the inflation-adjusted principal. Berk/DeMarzo, pp. 909-911. © FH AACHEN UNIVERSITY OF APPLIED SCIENCES | FACHBEREICH WIRTSCHAFTSWISSENSCHAFTEN | WWW.FH-AACHEN.DE | 100  Finance 2.2.1.2 Long-Term Debt and Liabilities Call Provisions A call feature allows the issuer of the bond the right (but not the obligation) to retire all outstanding bonds on (or after) a specific date (the call date), for the call price. A callable bond has a lower price than an otherwise equal non-callable bond. The yield to maturity of a callable bond is calculated as if the bond were not callable. This assumption – that the bond will not be called – is not always realistic, so bond traders often quote the yield to call. The yield to call (YTC) is the annual yield of a callable bond assuming that the bond is called at the earliest opportunity. Berk/DeMarzo, pp. 915-919. © FH AACHEN UNIVERSITY OF APPLIED SCIENCES | FACHBEREICH WIRTSCHAFTSWISSENSCHAFTEN | WWW.FH-AACHEN.DE | 101  Finance 2.2.1.2 Long-Term Debt and Liabilities Convertible Provisions Another way bonds are retired is by converting them into equity. Some corporate bonds have a provision that gives the bondholder an option to convert each bond owned into a fixed number of shares of common stock at a ratio called the conversion ratio. Such bonds are called convertible bonds. Often companies issue convertible bonds that are callable. By calling the bonds, a company can force bondholders to make their decision to exercise the conversion option earlier than they would otherwise like to. A convertible bond is worth more than an otherwise identical straight bond. Consequently, if both bonds are issued at par, the non-convertible bond must offer a higher interest rate. Many people point to the lower interest rates of convertible bonds and argue that therefore convertible debt is cheaper than straight debt – which is a misunderstanding. Berk/DeMarzo, pp. 919-921. © FH AACHEN UNIVERSITY OF APPLIED SCIENCES | FACHBEREICH WIRTSCHAFTSWISSENSCHAFTEN | WWW.FH-AACHEN.DE | 102  Finance 2.2.1.2 Long-Term Debt and Liabilities Leasing Contract between two parties: the lessee and the lessor. The lessee is liable for periodic payments in exchange for the right to use the asset. The lessor is the owner of the asset, who is entitled to the lease payments in exchange for lending the asset. Benefits for lessee: Most leases involve little or no upfront payment. Lease payments operational costs and thus immediately tax deductible for lessee. Legally, leasing is not debt financing, but economically it has very similar effects. This is why leasing is also referred to as a credit substitute. Berk/DeMarzo, p. 928. © FH AACHEN UNIVERSITY OF APPLIED SCIENCES | FACHBEREICH WIRTSCHAFTSWISSENSCHAFTEN | WWW.FH-AACHEN.DE | 103  Finance 2.2.1.3. Valuing Bonds Discounts and Premiums As already mentioned, zero-coupon bonds trade at a discount, that is, prior to maturity, their price is less than their face value. Coupon bonds may trade at a discount, at a premium (a price greater than their face value), or at par (price equal to their face value). When the bond price is We say the bond trades This occurs when Greater that the face value „above par“ or „at a premium“ Coupon Rate > YTM Equal to the face value „at par“ Coupon Rate = YTM Less than the face value „below par“ or „at a discount“ Coupon Rate < YTM Most issuers of bonds choose a coupon rate so that the bonds will initially trade at, or very close to, par. Berk/DeMarzo, pp. 213-214. © FH AACHEN UNIVERSITY OF APPLIED SCIENCES | FACHBEREICH WIRTSCHAFTSWISSENSCHAFTEN | WWW.FH-AACHEN.DE | 112  Finance 2.2.1.3. Valuing Bonds Corporate Bonds Corporate bonds = bonds issues by corporations The issuer may default, that is, might not pay back the full amount promised in the bond prospectus. This risk of default is known as the credit risk of the bond. The yield to maturity of a defaultable bond exceeds the expected return of investing in the bond. The bond‘s expected return, which is equal to the firm‘s debt cost of capital, is less than the yield to maturity if there is a risk of default. Moreover, a higher yield to maturity does not necessarily imply that a bond‘s expected return is higher. Berk/DeMarzo, pp. 222-226. © FH AACHEN UNIVERSITY OF APPLIED SCIENCES | FACHBEREICH WIRTSCHAFTSWISSENSCHAFTEN | WWW.FH-AACHEN.DE | 116  Finance 2.2.1.3. Valuing Bonds Bonds in the top four categories (i. e. down to Baa3/BBB-) are often referred to as investment-grade bonds because of their low default risk. Bonds in the bottom five categories are often called speculative bonds, junk bonds, or high-yield bonds because of their likelihood of default is high. The rating depends on the risk of bankruptcy as well as the bondholders‘ ability to lay claim to the firm’s assets in the event of such a bankruptcy. Thus, debt issues with a low-priority claim in bankruptcy will have a lower rating than issues from the same company that have a high-priority claim in bankruptcy of that are backed by specific asset such as a building or a plant. Often institutional investors are only allowed to buy investment-grade bond. This usually leads to a sharp increase in financing costs as soon as a company no longer qualifies as ‚investment-grade‘. Berk/DeMarzo, pp. 225-226. © FH AACHEN UNIVERSITY OF APPLIED SCIENCES | FACHBEREICH WIRTSCHAFTSWISSENSCHAFTEN | WWW.FH-AACHEN.DE | 118  Finance 2.2.2.1 Raising Equity Capital Sources of Funding Objective Angel Investors Individual investors who buy equity in tiny private firms (start-up’s); bring expertise Venture Capitalists Limited partnership that specializes in raising money to invest in the private equity of young firms Private Equity Organized very much like a venture capital firm, but it invests in the equity of existing privately held firms rather than start-up companies Institutional Investors Manage large quantities of money. Not surprisingly, they are also active investors in private companies Established Might invest for corporate strategic objectives in Corporations addition to the desire for investment returns Outside Investors Providing equity through (convertible) preferred stocks, issued by younger companies or common stock for established companies Berk/DeMarzo, pp. 867-872. © FH AACHEN UNIVERSITY OF APPLIED SCIENCES | FACHBEREICH WIRTSCHAFTSWISSENSCHAFTEN | WWW.FH-AACHEN.DE | 126  Finance 2.2.2.1 Raising Equity Capital Pre-money vs. Post-money Valuation The value of the prior shares outstanding at the price in the funding round is called the pre-money valuation. The value of the whole firm (old plus new shares) at the funding round price is known as the post-money valuation. The difference between the pre- and post-money valuation is the amount invested. In other words, Post-money valuation = Pre-money Valuation + Amount Invested Berk/DeMarzo, pp. 872-874. © FH AACHEN UNIVERSITY OF APPLIED SCIENCES | FACHBEREICH WIRTSCHAFTSWISSENSCHAFTEN | WWW.FH-AACHEN.DE | 127  Finance 2.2.2.1 Raising Equity Capital Initial Public Offering Process of selling stock to the public for the first time Before going public, check that the company is ready for the stock exchange! Financing goals Improvement of equity ratio Basis for future share and bond issues Share as acquisition currency for corporate takeovers Ownership goals Regulation of company succession Exit of venture capitalists (e.g. venture capital companies) Going public of subsidiaries Privatization of state-owned companies Corporate goals Realization of growth targets Increase in brand awareness Attractiveness for employees (e.g. by issuing employee shares) Berk/DeMarzo, pp. 878-879; Pape, p. 113-114. © FH AACHEN UNIVERSITY OF APPLIED SCIENCES | FACHBEREICH WIRTSCHAFTSWISSENSCHAFTEN | WWW.FH-AACHEN.DE | 129  Finance 2.2.2.1 Raising Equity Capital Types of Offerings (1/3) Primary and Secondary Offerings At an IPO, a firm offers a large block of shares for sale to the public. The shares that are sold in the IPO may either be new shares that raise new capital, known as a primary offering, or existing shares that are sold by current shareholders (as part of their exit strategy), known as a secondary offering. Berk/DeMarzo, pp. 879-881. © FH AACHEN UNIVERSITY OF APPLIED SCIENCES | FACHBEREICH WIRTSCHAFTSWISSENSCHAFTEN | WWW.FH-AACHEN.DE | 130  Finance 2.2.2.1 Raising Equity Capital Types of Offerings (2/3) Best-Effort and Firm Commitment IPOs For smaller IPOs, the underwriter commonly accepts the deal on a best-efforts IPO basis. In this case, the underwriter does not guarantee that the stock will be sold, but instead tries to sell the stock for the best possible price. Often, such deals have an all-or-non-clause. More commonly, an underwriter and an issuing firm agree to a firm commitment IPO, in which the underwriter guarantees that it will sell all of the stock at the offer price. The underwriter purchases the entire issue (at a slightly lower price than the offer price) and then resells it at the offer price. If the entire issue does not sell out, the underwriter must take the loss. Berk/DeMarzo, pp. 879-881. © FH AACHEN UNIVERSITY OF APPLIED SCIENCES | FACHBEREICH WIRTSCHAFTSWISSENSCHAFTEN | WWW.FH-AACHEN.DE | 131  Finance 2.2.2.1 Raising Equity Capital Types of Offerings (3/3) Auction IPO and Bookbuilding Process for IPOs In an auction IPO (OpenIPO) market determine the price of the stock by auctioning off the company. Investors place bids over a set period of time. An auction IPO then sets the highest price such that the number of bids at or above that price equals the number of offered shares. All winning bidders pay this price, even if their bid was higher. Mechanism, however, has not been widely adopted. When a bookbuilding process is used for the IPO, the underwriter – usually an investment bank – invites institutional investors to submit bids for number of shares and price they are willing to pay per share into an order book. The bank will determine a price range for the bookbuilding. Underwriter aggregates all submitted bids and determines final cutoff price by using a weighted average price. Range for price per share might be adjusted while book is open (usually 3 week period) and deal volume can be adjusted by underwriter via greenshoe option to secure flexibility and raise execution probability. Bookbuilding process is currently the dominating IPO mechanism in the market. Berk/DeMarzo, pp. 879-881. © FH AACHEN UNIVERSITY OF APPLIED SCIENCES | FACHBEREICH WIRTSCHAFTSWISSENSCHAFTEN | WWW.FH-AACHEN.DE | 132  Finance 2.2.2.1 Raising Equity Capital The Mechanics of an IPO Underwriters and the Syndicate lead underwriter responsible for managing the deal syndicate arranged by underwriter help to market and sell the issue SEC Filing Process (regulator) 1. Registration statement incl. preliminary prospectus (red herring) 2. SEC review of registration statement 3. Final Prospectus Valuation process including road show Pricing the deal and managing risk (e.g. greenshoe provision for over- allotment) Lockup Period (180 days) Berk/DeMarzo, pp. 881-886. © FH AACHEN UNIVERSITY OF APPLIED SCIENCES | FACHBEREICH WIRTSCHAFTSWISSENSCHAFTEN | WWW.FH-AACHEN.DE | 134  Finance 2.2.2.1 Raising Equity Capital The Mechanics of an SEO Firm‘s need for outside capital rarely ends at IPO Often firms return to equity markets and offer new shares for sale, called a seasoned equity offering (SEO) Primary and secondary shares Primary shares: New shares issued by company Secondary shares: Sold by existing shareholders in equity offering Two kinds of seasoned equity offerings Cash offer: Firm offers new shares to investors at large Rights offer: Firm offers new shares only to existing shareholders Berk/DeMarzo, pp. 892-894. © FH AACHEN UNIVERSITY OF APPLIED SCIENCES | FACHBEREICH WIRTSCHAFTSWISSENSCHAFTEN | WWW.FH-AACHEN.DE | 136  Finance 2.2.2.1 Raising Equity Capital Calculating the new shares price after SEO ∗ ∗ 𝑝 , where 𝑝 ≔ share price after SEO, 𝑝 ≔ share price of old shares, 𝑝 ≔ price of new shares 𝑜 ≔ number of old shares, 𝑛 ≔ number of new shares Computing the value of one right (𝑽𝑹 ) Upon request, each shareholder must be allocated a portion of the new shares corresponding to his or her portion in the previous share capital Intention of rights: Protection against dilution / changes in voting rights 𝑝 𝑝 𝑉 𝑜 1 Berk/DeMarzo, pp. 892-894. 𝑛 © FH AACHEN UNIVERSITY OF APPLIED SCIENCES | FACHBEREICH WIRTSCHAFTSWISSENSCHAFTEN | WWW.FH-AACHEN.DE | 137  Finance 2.3. Internal Financing Selected internal financing Financing from operating Financing from asset activities reallocation Financing via depreciation Divestment Financing via provisioning Working capital management Sale-and-Lease-Back see Pape, p. 238. © FH AACHEN UNIVERSITY OF APPLIED SCIENCES | FACHBEREICH WIRTSCHAFTSWISSENSCHAFTEN | WWW.FH-AACHEN.DE | 147  Finance 2.3. Internal financing – Working Capital Management Working Capital Management Reduction in inventory Reduction of the receivables portfolio Increase in trade payables © FH AACHEN UNIVERSITY OF APPLIED SCIENCES | FACHBEREICH WIRTSCHAFTSWISSENSCHAFTEN | WWW.FH-AACHEN.DE | 148  Finance 2.3. Internal financing – Working Capital Management Firm Value and Working Capital Any reduction in working capital requirements generates a positive free cash flow that the firm can distribute immediately to shareholders. Similarly, when evaluating a project, reducing the project‘s net working capital needs over the project‘s life reduces the opportunity cost associated with this use of capital. Managing working capital efficiently will maximize firm value. In the following some specific working capital accounts will be addressed. Berk/DeMarzo, p. 959. © FH AACHEN UNIVERSITY OF APPLIED SCIENCES | FACHBEREICH WIRTSCHAFTSWISSENSCHAFTEN | WWW.FH-AACHEN.DE | 149  Finance 2.3. Internal financing – Working Capital Management Receivables Management Establishing a credit policy involves three steps: 1. Establishing credit standards 2. Establishing credit terms 3. Establishing a collection policy An aging schedule categorizes accounts by the number of days they have been on the firm‘s books. It can be prepared using either the number of accounts or the dollar amount of the accounts receivable outstanding. If the aging schedule gets „bottom-heavy“ – that is, if the percentages in the lower half of the schedule begin to increase – the firm will likely need to revisit its credit policy. Berk/DeMarzo, pp. 962-965. © FH AACHEN UNIVERSITY OF APPLIED SCIENCES | FACHBEREICH WIRTSCHAFTSWISSENSCHAFTEN | WWW.FH-AACHEN.DE | 151  Finance 2.3. Internal financing – Working Capital Management Payables Management Similar to the situation with its accounts receivable, a firm should monitor its accounts payable to ensure that it is making its payments at an optimal time. One method is to calculate the accounts payable days outstanding and compare it to the credit terms. Some firms ignore the payment due period and pay later, in a practice referred to as stretching the accounts payable. Doing so reduces the direct cost of trade credit because it lengthens the time that a form has use to the funds. Suppliers may react to a firm whose payments are always late by imposing terms of cash on delivery (COD) or cash before delivery (CBD). Berk/DeMarzo, pp. 965-966. © FH AACHEN UNIVERSITY OF APPLIED SCIENCES | FACHBEREICH WIRTSCHAFTSWISSENSCHAFTEN | WWW.FH-AACHEN.DE | 153  Finance 2.3. Internal financing – Working Capital Management Inventory Management A firm needs its inventory to operate for several reasons. First, inventory helps minimize the risk that the firm will not be able to obtain an input it needs for production. If a firm holds too little inventory, stock-outs, the situation when a firm runs out of goods, may occur, leading to lost sales. Second, firms may hold inventory because factors such as seasonality in demand mean that customers purchases do not perfectly match the most efficient production cycle. Three categories of direct costs associated with inventory: Acquisition costs are the costs of the inventory itself over the period being analyzed (usually a year). Order costs are the total costs of placing an order over the period being analyzed. Carrying costs include storage costs, insurance, taxes, spoilage, obsolescence, and the opportunity cost of the funds tied up in the inventory. Berk/DeMarzo, pp. 966-968. © FH AACHEN UNIVERSITY OF APPLIED SCIENCES | FACHBEREICH WIRTSCHAFTSWISSENSCHAFTEN | WWW.FH-AACHEN.DE | 156  Finance 2.3. Internal financing – Working Capital Management Minimizing these total costs involves come trade-offs. For example, if we assume no quantity discounts are available, the lower the level of inventory a firm carries, the lower its carrying cost, but the higher its annual order costs, because it needs to place more orders during the year. Some firms seek to reduce their carrying costs as much as possible. With „just-in-time“ (JIT) inventory management, a firm acquires inventory precisely when needed so that its inventory balance is always zero, or very close to it. Berk/DeMarzo, pp. 967-968. © FH AACHEN UNIVERSITY OF APPLIED SCIENCES | FACHBEREICH WIRTSCHAFTSWISSENSCHAFTEN | WWW.FH-AACHEN.DE | 157  Finance 3.1. Investment Decision Rules NPV and Stand-Alone Projects NPV Investment Rule: When making an investment decision, take the alternative with positive NPV. Choosing this alternative is equivalent to receiving its NPV in cash today. Example: Researchers at Fredrick‘s Feed and Farm have made a breakthrough. They believe that they can produce a new, environmentally friendly fertilizer at a substantial cost savings over the company‘s existing line of fertilizer. The fertilizer will require a new plant that can be built immediately at a cost of $250 million. Financial managers estimate that the benefits of the new fertilizer will be $35 million per year, starting at the end of the first year and lasting forever. The financial managers responsible for this project estimate a cost of capital of 10% per year. Berk/DeMarzo, p. 247. © FH AACHEN UNIVERSITY OF APPLIED SCIENCES | FACHBEREICH WIRTSCHAFTSWISSENSCHAFTEN | WWW.FH-AACHEN.DE | 161  Finance 3.1. Investment Decision Rules The IRR Rule IRR Investment Rule: Take any investment opportunity where the IRR exceeds the opportunity cost of capital. Turn down any opportunity where IRR is less than the opportunity cost of capital. Remark: The IRR rule is only guaranteed to work for a stand-alone project if all of the project‘s negative cash flows precede its positive cash flows. The IRR rule will fail in the following situations: Pitfall #1: Delayed Investments Pitfall #2: Multiple IRRs Pitfall #3: Nonexistent IRR Berk/DeMarzo, pp. 250-254. © FH AACHEN UNIVERSITY OF APPLIED SCIENCES | FACHBEREICH WIRTSCHAFTSWISSENSCHAFTEN | WWW.FH-AACHEN.DE | 163  Finance 3.1. Investment Decision Rules The Payback Rule We will take the payback rule as an alternative decision rule for single, stand- alone projects. The payback investment rule states that you should only accept a project if its cash flows pay back its initial investment within a prespecified period. The payback rule is not as reliable as NPV because it ignores the project‘s cost of capital and the time value of money, ignores cash flows after the payback period, relies on an ad hoc decision criterion (what is the right number of years to require for the payback period?). However, the payback period may give you an impression of the risk of the project (the longer it takes to get the money back the longer the invested capital is at risk). Berk/DeMarzo, pp. 254-255. © FH AACHEN UNIVERSITY OF APPLIED SCIENCES | FACHBEREICH WIRTSCHAFTSWISSENSCHAFTEN | WWW.FH-AACHEN.DE | 166  Finance 3.1. Investment Decision Rules NPV Rule and Mutually Exclusive Projects Pick the project with the highest NPV. The NPV expresses the value of the project in terms of cash today, picking the project with the highest NPV leads to the greatest increase in wealth. Berk/DeMarzo, pp. 256-257. © FH AACHEN UNIVERSITY OF APPLIED SCIENCES | FACHBEREICH WIRTSCHAFTSWISSENSCHAFTEN | WWW.FH-AACHEN.DE | 168  Finance 3.1. Investment Decision Rules IRR Rule and Mutually Exclusive Projects The IRR rule is difficult to apply in case of mutually exclusive projects. Picking one project over another simply because it has a larger IRR can lead to mistakes. In particular, when projects differ in their scale of investment, the timing of their cash flows, or their riskiness, then their IRRs cannot be meaningfully compared. Berk/DeMarzo, pp. 257-258. © FH AACHEN UNIVERSITY OF APPLIED SCIENCES | FACHBEREICH WIRTSCHAFTSWISSENSCHAFTEN | WWW.FH-AACHEN.DE | 170  Finance 3.1. Investment Decision Rules Profitability Index Practitioners often use the profitability index to identify the optimal combination of projects to undertake in such situations: Profitability Index = Value Created / Resource Consumed NPV / Resource Consumed The profitability index measures the „bang for the buck“. After computing the profitability index, projects are ranked based on it. The profitability index will only be reliable if the following two conditions hold: 1. The set of projects taken following the profitability index ranking completely exhausts the available resource. 2. There is only a single relevant resource constraint. Berk/DeMarzo, pp. 262-264. © FH AACHEN UNIVERSITY OF APPLIED SCIENCES | FACHBEREICH WIRTSCHAFTSWISSENSCHAFTEN | WWW.FH-AACHEN.DE | 174  Finance 3.2. Fundamentals of Capital Budgeting Forecasting Earnings A capital budget lists the projects and investments that a company plans to undertake during the coming year. To determine this list, firms analyze alternative projects and decide which one to accept through a process called capital budgeting. Our ultimate goal is to determine the effect of the decision on the firm‘s cash flows, and evaluate the NPV of these cash flows to assess the consequences of the decision for the firm‘s value. Earnings are not actual cash flows. However, as a practical matter, to derive the forecasted cash flows of a project, financial managers often begin by forecasting earnings. Thus, we begin by determining the incremental earnings of a project, that is, the amount by which the firm‘s earnings are expected to change as a result of the investment decision. Berk/DeMarzo, p. 274. © FH AACHEN UNIVERSITY OF APPLIED SCIENCES | FACHBEREICH WIRTSCHAFTSWISSENSCHAFTEN | WWW.FH-AACHEN.DE | 180  Finance 3.2. Fundamentals of Capital Budgeting Capital Expenditures and Depreciation Several methods are used to compute depreciation. The simplest method is straight-line depreciation, in which the asset‘s cost (less any expected salvage value) is divided equally over its estimated useful life. If we assume the equipment is purchased at the end of year 0, and the use straight-line depreciation over a five-year life for the new equipment, HomeNet‘s depreciation expense is $1.5 million per year in years 1 to 5. This treatment of capital expenditures is one of the key reasons why earnings are not an accurate representation of cash flows. Berk/DeMarzo, pp. 275-276. © FH AACHEN UNIVERSITY OF APPLIED SCIENCES | FACHBEREICH WIRTSCHAFTSWISSENSCHAFTEN | WWW.FH-AACHEN.DE | 183  Finance 3.2. Fundamentals of Capital Budgeting Interest Expenses When evaluating a capital budgeting decision, we generally do not include interest expenses. Any incremental interest expenses will be related to the firm‘s decision regarding how to finance the project. Here we wish to evaluate the project on its own, separate from the financing decision. We refer to the net income we compute as the unlevered net income of the project, to indicate that it does not include any interest expenses associated with debt. Berk/DeMarzo, p. 276. © FH AACHEN UNIVERSITY OF APPLIED SCIENCES | FACHBEREICH WIRTSCHAFTSWISSENSCHAFTEN | WWW.FH-AACHEN.DE | 184  Finance 3.2. Fundamentals of Capital Budgeting Taxes The correct tax rate to use is the firm‘s marginal corporate tax rate, which is the tax rate it will pay on an incremental dollar of pre-tax income. We assume the marginal corporate tax rate for the HomeNet Project is 20% each year. Income Tax = EBIT * C C is the firm‘s marginal tax rate. There are no negative tax payments. Nevertheless, in the event of a loss in the project, the tax can be (fictitiously) positively attributed, since the loss reduces the tax burden from other activities of the company. If a company has no other taxable profit, the project loss can be carried forward to the next year and offset against future profits (balance sheet: deferred tax asset). Berk/DeMarzo, p. 276 and p. 291. © FH AACHEN UNIVERSITY OF APPLIED SCIENCES | FACHBEREICH WIRTSCHAFTSWISSENSCHAFTEN | WWW.FH-AACHEN.DE | 185  Finance 3.2. Fundamentals of Capital Budgeting Opportunity Costs Many projects use a resource that the company already owns. However, in many cases the resource could provide value for the firm in another opportunity or project. The opportunity cost of using a resource is the value it could have provided in its best alternative use. Because this value is lost when the resource is used by another project, we should include the opportunity cost as an incremental cost of the project. In the case of the HomeNet project, suppose the project will require space for a new lab. Even though the lab will be housed in an existing facility, we must include the opportunity cost of not using the space in an alternative way. Berk/DeMarzo, p. 277. © FH AACHEN UNIVERSITY OF APPLIED SCIENCES | FACHBEREICH WIRTSCHAFTSWISSENSCHAFTEN | WWW.FH-AACHEN.DE | 187  Finance 3.2. Fundamentals of Capital Budgeting Project Externalities Project externalities are indirect effects of the project that may increase or decrease the profits of other business activities of the firm. When sales of a new product displace sales of an existing product, the situation is often referred to as cannibalization. Suppose that approximately 25% of HomeNet’s sales come from customers who would have purchased an existing Cisco device if HomeNet were not available. If this reduction in sales of the existing product is a consequence of the decision to develop HomeNet, then we must include it when calculating HomeNet’s incremental earnings. Suppose that the existing device wholesales for $100 and that the cost of the existing device is $60 per unit. Berk/DeMarzo, p. 278. © FH AACHEN UNIVERSITY OF APPLIED SCIENCES | FACHBEREICH WIRTSCHAFTSWISSENSCHAFTEN | WWW.FH-AACHEN.DE | 189  Finance 3.2. Fundamentals of Capital Budgeting Sunk Costs and Incremental Earnings A sunk cost is any unrecoverable cost for which the firm is already liable. Sunk costs have been paid or will be paid regardless of the decision about whether or not to proceed with the project. A good rule to remember is that if our decision does not affect the cash flow, then the cash flow should not affect our decision. Common examples include fixed overhead expenses, past research and development expenditures, and unavoidable competitive effects. Berk/DeMarzo, p. 279. © FH AACHEN UNIVERSITY OF APPLIED SCIENCES | FACHBEREICH WIRTSCHAFTSWISSENSCHAFTEN | WWW.FH-AACHEN.DE | 191  Finance 3.2. Fundamentals of Capital Budgeting Net Working Capital NWC = Current Assets – Current Liabilities Most projects will require the firm to invest in net working capital. Suppose that HomeNet will have no incremental cash or inventory requirement (products will be shipped directly from the contract manufacturer to customers). However, receivables related to HomeNet are expected to account for 15% of annual sales, and payables are expected to be 15% of the annual cost of goods sold. Berk/DeMarzo, pp. 282-283. © FH AACHEN UNIVERSITY OF APPLIED SCIENCES | FACHBEREICH WIRTSCHAFTSWISSENSCHAFTEN | WWW.FH-AACHEN.DE | 198  Finance 3.2. Fundamentals of Capital Budgeting Calculating Free Cash Flow Directly The HomeNet‘s free cash flow can be calculated directly using the following shorthand formula: FCF = Unlevered Net Income + Depreciation – CapEx – NWC = (Revenues – Costs – Depreciation) * (1 – C) + Depreciation – CapEx – NWC or FCF = (Revenues – Costs) * (1 – C) – CapEx – NWC + C * Depreciation Berk/DeMarzo, pp. 283-284 © FH AACHEN UNIVERSITY OF APPLIED SCIENCES | FACHBEREICH WIRTSCHAFTSWISSENSCHAFTEN | WWW.FH-AACHEN.DE | 199  Finance 3.2. Fundamentals of Capital Budgeting Liquidation or Salvage Value Assets that are no longer needed often have a resale value, or some salvage value if the parts are sold for scrap. Some assets may have a negative liquidation value. In the calculation of the free cash flow, we include the liquidation value of any assets that are no longer needed and may be disposed of. When an asset is liquidated, any gain on sale is taxed. Gain on Sale = Sale Price – Book Value Book Value = Purchase Price – Accumulated Depreciation We must adjust the project‘s free cash flow to account for the after-tax cash flow that would result from an asset sale: After-Tax Cash Flow from Asset Sale = Sale Price – (C * Gain on Sale) Berk/DeMarzo, pp. 288-289. © FH AACHEN UNIVERSITY OF APPLIED SCIENCES | FACHBEREICH WIRTSCHAFTSWISSENSCHAFTEN | WWW.FH-AACHEN.DE | 200  Finance 3.2. Fundamentals of Capital Budgeting Terminal or Continuation Value Sometimes the firm explicitly forecasts free cash flow over a shorter horizon than the full horizon of the project or investment. In this case, we estimate the value of the remaining free cash flow beyond the forecast horizon by including an additional, one-time cash flow at the end of the forecast horizon called the terminal or continuation value of the project. This amount represents the market value (as of the last forecast period!) of the free cash flow from the project at all future dates. Berk/DeMarzo, p. 290. © FH AACHEN UNIVERSITY OF APPLIED SCIENCES | FACHBEREICH WIRTSCHAFTSWISSENSCHAFTEN | WWW.FH-AACHEN.DE | 203  Finance 3.2. Fundamentals of Capital Budgeting Analyzing the Project When we are uncertain regarding the input to a capital budgeting decision, it is often useful to determine the break-even level of that input, which is the level for which the investment has an NPV of zero. There is no reason to limit our attention to the uncertainty in the cost of capital estimate. In a break even-analysis, for each parameter, we calculate the value at which the NPV of the project is zero. Other accounting notions of break-even are sometimes considered. For example, we could compute the EBIT break-even for sales, which is the level of sales for which the project‘s EBIT is zero. Sensitivity analysis breaks the NPV calculation into its component assumptions and shows how the NPV varies as the underlying assumptions change. In this way, sensitivity analysis allows us to explore the effects of errors in our NPV estimates for the project. Berk/DeMarzo, pp. 293-296. © FH AACHEN UNIVERSITY OF APPLIED SCIENCES | FACHBEREICH WIRTSCHAFTSWISSENSCHAFTEN | WWW.FH-AACHEN.DE | 205  Finance 3.3. Cost of Capital Cost of Capital as a Discount Rate Cost of Equity: The Capital Asset Pricing Model (CAPM) There is a linear relationship between the company-specific risk and the return investors require for the provision of equity (= cost of equity of the company) Market risk premium 𝑟 , 𝑟 𝛽 · 𝐸𝑅 𝑟 Risk premium of security 𝑖 𝑟, required return of security 𝑖 𝑟 risk-free interest rate 𝛽 beta of investment 𝑖 with respect to the market portfolio 𝐸𝑅 expected return of the market portfolio Berk/DeMarzo, pp. 444-453. © FH AACHEN UNIVERSITY OF APPLIED SCIENCES | FACHBEREICH WIRTSCHAFTSWISSENSCHAFTEN | WWW.FH-AACHEN.DE | 210  Finance 3.3. Cost of Capital Cost of Capital as a Discount Rate Cost of Debt: Common Assumption in practice: Market value of debt = Balance sheet value of debt i. e. the current interest rate paid on debt also corresponds to future cost of debt. Plausible assumption (which is used here) if the company's credit risk has not changed much. Note: The cost of debt capital for companies does not correspond to the expected return of investors, since the latter must take into account the probability of default (see Berk/DeMarzo pp. 453-454), while companies (as long as they exist) must pay the agreed interest rate. Berk/DeMarzo, pp. 453-454. © FH AACHEN UNIVERSITY OF APPLIED SCIENCES | FACHBEREICH WIRTSCHAFTSWISSENSCHAFTEN | WWW.FH-AACHEN.DE | 211  Finance 3.3. Cost of Capital Cost of Capital as a Discount Rate Weighted Average Cost of Capital (WACC) Market values (not balance sheet values !!!) are taken into account for the calculation of the cost of capital. This also applies to the calculation of equity and debt ratios. 𝐸 𝐷 𝑟 ·𝑟 ·𝑟 · 1 𝜏 𝐸 𝐷 𝐸 𝐷 𝑟 Weighted Average Cost of Capital (in %) 𝑟 Cost of Equity (in %) 𝑟 Cost of Debt (in %) 𝜏 Corporate Tax Rate (in %) 𝐸 Market Value of Equity 𝐷 Market Value of Debt (Assumption here: = Balance Sheet Values) Berk/DeMarzo, pp. 463-466. © FH AACHEN UNIVERSITY OF APPLIED SCIENCES | FACHBEREICH WIRTSCHAFTSWISSENSCHAFTEN | WWW.FH-AACHEN.DE | 212