Corporate Finance PDF

Corporate Finance Time Value Individuals prefer present consumptions for future consumption Monetary inflation Risk associated with the cash flow Discount rate: Present Value (PV) - Barwert Future Value – zukünftiger Wert EU inflation rate = 2,4% (current status 3rd October 20...

Corporate Finance Time Value Individuals prefer present consumptions for future consumption Monetary inflation Risk associated with the cash flow Discount rate: Present Value (PV) - Barwert Future Value – zukünftiger Wert EU inflation rate = 2,4% (current status 3rd October 2024) Which countries have the highest inflation rate summer 2024 (July-August)? Turkey, Venezuela, Argentina, Syria, South Sudan, Zimbabwe etc. How can inflation be good for the company? Definition “Inflation” = rise in the general level of prices of goods and services in an economy over a period of time Which countries have the deflation (negative inflation) in summer 2024? Sri Lanka, Senegal, Afghanistan etc. What is the difference among negative inflation, deflation and disinflation? Negative inflation/deflation = decrease in the general price level of goods and services Disinflation= a slowdown in the inflation rate Is deflation bad for the economy? As a customer perspective it is cheaper but the time period of getting the product/services are longer because of the (lower) production of the companies – deflation usually means falling wages First test: 7th of November Financial statements Types of financial statements: Balance sheet Income (profit and loss) statement Statement of cashflows Statement of stockholders equity Balance sheet A snapshot in time of the firms financial position: Assets = Liabilities + Stockholders Equity Assets: what the company owns (short-term assets, long-term assets) Liabilities: what the company owes Stockholders Equity: the difference between the value of the firms assets and liabilities Current assets: cash or expected to be turned into cash in the next year Cash Marketable securities Accounts receivable Inventories Other currents assets: pre-paid expenses (future expenses that are paid in advance eg. Insurance) Liabilities: Current Liabilities: due to be paid within the next year Accounts payable Short term debt/notes payable Current maturities of long-term debt Other current liabilities: taxes payable, wages payable Long term Liabilities: financial obligations of a company that are due more than one year in the future Long-term debt Capital leases Deferred taxes Stockholders Equity Book Value of Equity = Book value of assets – book value of liabilities Retained Earnings (Gewinnrücklagen) Net Income (Nettoeinkommen – keine Dividende) Exercise: Current assets: Cash raw material accounts receivable marketable securities inventories Statement of cashflows Financial statement that summarizes th amount of cash and cash equivalent entering and leaving a company. Operating activities Investing activities Financing activities Statement of cash flows – methods Direct method: every spending is mentioned Indirect method: no clue of transaction, but we know how the balance sheets will look like (from the knowledge of the balance sheet) Assignment 3 Horizontal analysis: summing up the groups Vertical analysis: total assets are 100% Big chances, comments Exam Calculator mitnehmen Formel werden hergegeben, aber man muss wissen welche Formel zu welcher Formel gehört Assignment 4: Income statement Income statement Notes of assignment 4: Revenues = total revenues Cost of sales = cost of revenues EBITDA = difference between EBITDA and gross profit = other operating expenses EBIT = difference EBIT and EBITDA = depreciation EBT = difference EBIT and interest expense Tax Expenses = difference Net income and EBT Comments: f.e. where is the income coming from FINANCIAL ANALYSIS Definition It is used to: compare the firm with itself over time as well as compare the firm to other similar firms. The financial analysis aims to analyze whether an entity is stable, liquid, solvent, or profitable enough to warrant a monetary investment. It is used to evaluate economic trends, set financial policies, build long-term plans for business activity, and identify projects or companies for investment. Who analyzes financial statement? Internal users (management) External users (investors, creditors, regulatory agencies, stock markets analysts and auditors) For example: bank = loan > they need the financial data (purpose of the bank is analyzing if the companies are paying the debt or not) Methods Ratio Analysis: Ratio analysis compares line-item data from a company's financial statements to evaluate it profitability, liquidity, efficiency, and solvency. Ratio analysis can track how a company is performing over time or how it compares to another business in the same industry or sector. Profitability: explore how much profit in general, for stakeholder, for sales can the company make –higher the profitability, then better 05 I Short Term Assets Management DEFINITION Short-term assets or securities in investments refer to assets that are held for less than one year. In accounting, the term "current" refers to a short-term asset, which means, expected to be converted into cash in less than one year or a liability, coming due in less than one year. Short-Term Assets - Examples Cash Marketable Securities (liquid fin. instruments that can be liquidated to cash quickly, e.g. common stock, treasury bills, money market instruments) Accounts Receivable (balance of money due to a firm for goods or services delivered or used but not yet paid for by customers) Inventories (raw material, work-in-progress, finished goods) Other Current Assets o Example: Pre-paid expenses (future expenses that are paid in advance, e.g. insurance) NET WORKING CAPITAL NWC is a measure of a company‘s liquidity, operational efficiency, and short-term financial health Net Working Capital or Working Capital = Current Assets – Current Liabilities 1. If a company has substantial positive NWC, then it should have the potential to invest and grow. 2. If a company‘s current assets do not exceed its current liabilities (negative NWC), then it may have trouble growing or paying back creditors. It might even go bankrupt. Significance of Net Working Capital In a typical manufacturing firm, current assets exceed one-half of total assets. Excessive levels can result in a substandard Return on Investment (ROI). Current liabilities are the principal source of external financing for small firms. Requires continuous, day-to-day managerial supervision. Working capital management affects the company‘s risk, return, and share price. Cash Management OPERATING CYCLE An operating cycle refers to the time it takes a company to buy goods, sell them and receive cash from the sale of said goods. In other words, it's how long it takes a company to turn its inventories into cash. The average length of time between when a firm originally purchases its inventory and when it receives the cash back from selling its product. Most firms buy their inventory on credit, which reduces the amount of time between the cash investment and the receipt of cash from that investment. The operating cycle is important because it can tell a business owner how quickly the company is able to sell inventory. Simply put, it determines the company's efficiency. A shorter operating cycle is more favorable as it means the company has enough cash to maintain operations, recover investments and meet various obligations. In contrast, if a business has a longer operating cycle, it means the company requires more cash to maintain operations. Formula: 𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝑪𝒚𝒄𝒍𝒆 = 𝑰𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒚 𝑻𝒖𝒓𝒏𝒐𝒗𝒆𝒓 𝑹𝒂𝒕𝒊𝒐 (𝑻𝒊𝒎𝒆𝒔) 𝑨𝒄𝒄𝒐𝒖𝒏𝒕𝒔 𝑹𝒆𝒄𝒆𝒊𝒗𝒂𝒃𝒍𝒆 𝑻𝒖𝒓𝒏𝒐𝒗𝒆𝒓 𝑹𝒂𝒕𝒊𝒐 (𝑻𝒊𝒎𝒆𝒔) 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 𝑅𝑎𝑡𝑖𝑜 (𝑇𝑖𝑚𝑒𝑠) = ∗ 360 𝑇𝑜𝑡𝑎𝑙 𝑆𝑎𝑙𝑒𝑠 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 𝑅𝑎𝑡𝑖𝑜 (𝑇𝑖𝑚𝑒𝑠) = ∗ 360 𝑇𝑜𝑡𝑎𝑙 𝑆𝑎𝑙𝑒𝑠 CASH CYCLE The cash conversion cycle (CCC), also called the net operating cycle or cash cycle, considers how much time the company needs to sell its inventory, collect receivables, and pay its bills. This metric expresses how many days the company takes to convert the cash spent on inventory back into cash from selling its product or service. The shorter the cash conversion cycle, the better, and the less time cash is in accounts receivable or inventory. Formula: 𝑪𝑪𝑪 = 𝑰𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒚 𝑻𝒖𝒓𝒏𝒐𝒗𝒆𝒓 𝑹𝒂𝒕𝒊𝒐 (𝑻𝒊𝒎𝒆𝒔) + 𝑨𝒄𝒄𝒐𝒖𝒏𝒕𝒔 𝑹𝒆𝒄𝒆𝒊𝒗𝒂𝒃𝒍𝒆 𝑻𝒖𝒓𝒏𝒐𝒗𝒆𝒓 𝑹𝒂𝒕𝒊𝒐 (𝑻𝒊𝒎𝒆𝒔) − 𝑨𝒄𝒄𝒐𝒖𝒏𝒕𝒔 𝑷𝒂𝒚𝒂𝒃𝒍𝒆 𝑻𝒖𝒓𝒏𝒐𝒗𝒆𝒓 (𝑻𝒊𝒎𝒆𝒔) 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 𝑅𝑎𝑡𝑖𝑜 (𝑇𝑖𝑚𝑒𝑠) = ∗ 360 𝑇𝑜𝑡𝑎𝑙 𝑆𝑎𝑙𝑒𝑠 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 𝑅𝑎𝑡𝑖𝑜 (𝑇𝑖𝑚𝑒𝑠) = ∗ 360 𝑇𝑜𝑡𝑎𝑙 𝑆𝑎𝑙𝑒𝑠 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑃𝑎𝑦𝑎𝑏𝑙𝑒 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑃𝑎𝑦𝑎𝑏𝑙𝑒 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 𝑅𝑎𝑡𝑖𝑜 (𝑇𝑖𝑚𝑒𝑠) = ∗ 360 𝑇𝑜𝑡𝑎𝑙 𝑆𝑎𝑙𝑒𝑠 CASH AND OPERATING CYCLES Operating Cycle: The length of time between the purchase of inventory and the cash collected from the sale of inventory. Net Operating Cycle: The length of time between paying for inventory and the cash collected from the sale of inventory. INVENTORY MANAGEMENT Inventory management refers to the process of ordering, storing, using, and selling a company's inventory. This includes raw materials, components, and finished products, as well as the warehousing and processing of these items. Inventory is the least liquid of current assets. Companies will often hold more stock than they need and this can be costly in terms of: Capital tied up Costs of holding stock Why to hold inventory? Transactions Motive: To meet anticipated production/sales and service delivery requirements Precautionary Motive: To maintain a cushion or buffer so that they can cope with any underestimates of demand that may have been made Speculative Motive: To take advantage of temporary opportunities to buy items of stock at less expensive purchase prices The two elements of inventory: The more inventory held, the greater the holding (storage) costs BUT the less the order costs (and vice versa). The art is to balance the two for optimal cost effectiveness. Economic Order Quantity (EOQ) Economic order quantity (EOQ) is the ideal quantity of units a company should purchase to meet demand while minimizing inventory costs such as holding costs, shortage costs, and order costs. EOQ represents the minimum point in total stock costs. O = Cost of placing an order S = Annual demand C = Holding cost of one unit Just in Time Inventory Control A just-in-time (JIT) inventory system is a management strategy that has a company receive goods as close as possible to when they are actually needed. So, if a car assembly plant needs to install airbags, it does not keep a stock of airbags on its shelves but receives them as those cars come onto the assembly line. Instead of holding inventory at the factory, only order inventory on a Just in Time basis (raw materials are ordered only as they are needed). Advantages: There is less stock in the factory, so costs are lower. This results in a lower unit cost. Disadvantages: If supplies are disrupted for some reason, the business will have no stock to fall back on. This will affect their production rates very quickly. ACCOUNT RECEIVABLES MANAGEMENT Accounts receivable management is the process of monitoring and controlling money customers owe to a business for goods or services purchased on credit. AR management ensures a company receives timely payment. Determining the Credit Policy Establishing Credit Standards: determine who will qualify for credit Establishing Credit Terms: determine the “net” period and if a discount will be offered Establishing a Collection Policy: determine course of action to take if a customer does not pay as agreed Monitoring accounts receivables Accounts Receivable Days: The accounts receivable days is the average number of days that it takes a firm to collect on its sales. A firm can compare the accounts receivable days to the credit terms. For example, if the credit terms specify “net 30” and the accounts receivable days outstanding is 45 days, the firm can conclude that its customers are paying 15 days late, on average. A firm can look at the trend in accounts receivable days. Payment Pattern: Provides information on the percentage of monthly sales that the firm collects in each month after the sale For example, a firm may observe that 10% of its sales are usually collected in the month of the sale, 40% in the month following the sale, 25% two months after the sale, 20% three months after the sale, and 5% four months after the sale. Management can then watch for deviations from this pattern. 06 I Short Term Financing - System of Payment Short-term financing is usually used for one specific purchase or for one single sum of money which is then expected to be paid off over a fairly short period of time. As a borrower, you probably would not be using the same source of short-term financing more than once or twice. If you do, this should be a red flag for how you are managing your finances. Short term financing means the financing of business from short term sources which are for a period of less than one year – sources: trade credit, bank finance, accrued expenses, deferred revenues, commercial papers, letter of credit Trade Credit (also known as accounts payable): This is the floating time allowed the business to pay for the goods or services which they have purchased or received. The general floating time allowed to pay is 28 days. This helps the businesses in managing their cash flows more efficiently and help in dealing with their finances. Trade credit is a good way of financing the inventories which means how many numbers of days the vendor will be allowed before its payment is due. The trade-credit is offered by the vendor as an inducement in continuing business and that is why it costs nothing. Bank Finance Corporate sector is very much dependent on the commercial bank for fulfilling their short- term financial needs, a limited portion of this need gets fulfilled by the trade credit, and the excess requirement over it gets fulfilled by a commercial bank. Bank credit has two forms, i.e., unsecured and secured credit. Unsecured credits are those that are not covered by collateral securities, and collateral securities cover secured credits. The ways of borrowing a sum from the bank are as follows: Working capital loan Discounting of bill (invoice discounting) Overdraft Letter of credit Cash credit Accrued Expenses The expenses which have already been acknowledged in the books before it has been paid are known as accrued expenses. Deferred Revenues Deferred revenue refers to a part of the firm’s income that has not been acquired, but pre- payment has already received by the customers. Commercial Papers Issuing of commercial papers is also one of the most used sources of financing now-a- days. These are the short-term notes describing that if a company needs money, they can issue commercial papers. It is used for financing of Trade credits, payroll and meeting additional short-term liabilities and commercial paper ranges from 15 days to 1 year. Letter of Credit The Letter of Credit shows the pledge of the buyer to the seller for making the payment. This document is issued by the bank, safeguarding the prompt and full payment to the seller. If the buyer fails to do so, the bank becomes liable to pay the amount to the seller, for issuing a letter of credit bank charges a percentage of the amount from the buyer and is delivered against the pledge of securities. ADVANTAGES OF SHORT-TERM FINANCING Easy to Obtain: Creditors make short-term funds easier to obtain as the risk involved in delivering loan varies according to payment time, and they think long- term credits or loans contains high-risk factor than short-term loans. Less Risky: In comparison with long-term financing, short-term financing is less risky, as creditors grant credit for a short period of time. Resilience: Short-term financing provides resilience as the borrower may adopt alternative sources of credit after negotiating the short-term credit account by debtors. DISADVANTAGES OF SHORT-TERM FINANCING Mature More Frequently: Firm’s producing capital goods worries more often about short-term creditors as they produce slow-moving inventories, and short- term financing creates a tight position for a firm more often. If short-term liabilities do not get settled timely, the creditors may demand closure of the firm. Costly: When general economic outlooks and collateral elements are considered, short-term finances at times looks costlier than long-term finances. 07 I Investment Decision-Making DEFINITION INVESTMENT the act of putting money, effort, time, etc. into something to make a profit or get an advantage or the money, effort, time, etc. used to do this f.e. bitcoins, stocks, bonds, real estates, starting your own business, mutual funds etc. What is an investment? An asset or item that is purchased with the hope that it will generate income or appreciate in the future. In an economic sense, an investment is the purchase of goods that are not consumed today but are used in the future to create wealth. INVESTMENT ANALYSIS Invest in projects that yield a return greater than the minimum acceptable hurdle rate: The hurdle rate should be higher for riskier projects and reflect the financing – mix used - owners’ funds (equity) or borrowed money (debt). Returns on projects should be measured based on cash flows generated and the timing of these cash flows; they should also consider both positive and negative side effects of these projects. Choose a financing mix that minimizes the hurdle rate and matches the assets being financed. If there are not enough investments that earn the hurdle rate, return the cash to stockholders. > The form of returns - dividends and stock buybacks - will depend upon the stockholders’ characteristics. INVESTMENT DECISION-MAKING Investment Decision Making (“Capital Budgeting”) deals with: Physical assets (such as buildings or machinery) Intangible assets (such as patents, software, goodwill) Financial assets (marketable securities or passive investment, controlling or influencing the operation of the second company - long-term and strategic investments, owning over 50% ownership – majority) Identification: Capital Expenditures and Cash Flows from Investments = CAPEX (=Investitionsausgaben) CAPITAL EXPENDITURES Capital Expenditures include costs incurred on the acquisition of a fixed asset and any subsequent expenditure that increases the earning capacity of an existing fixed asset. The cost of acquisition not only includes the cost of purchases but also any additional costs incurred in bringing the fixed assets into its present location and condition (e.g. delivery costs). Capital expenditures may include the following: Purchase costs (less any discount received) Delivery costs Legal charges Installation costs Up gradation costs Replacement costs CASHFLOW FROM INVESTMENTS An item on the cash flow statement that reports the aggregate change in a company‘s cash position resulting from any gains (or losses) from investments in the financial markets and operating subsidiaries, and changes resulting from amounts spent on investments in capital assets such as plant and equipment. Following are cash flows that are typically reported as cash flows from investing activities: Cash payments to acquire or construct long-term fixed assets such as plant and machinery, vehicles, equipment, etc. Cash receipts from sale property, plant and equipment and intangible assets such as buildings, copyrights, etc. Cash payments to purchase bonds or shares of other companies (subsidiaries, associates and joint ventures) Cash receipts from sale of bonds and shares of other companies Cash payments in the form of loans and advances and receipt related to payback of such loans and receivables, etc. EVALUATION OF INVESTMENT PROJECTS EFFECTIVENESS Capital Budgeting Models include: Accounting Rate of Return Payback Period Net Present Value Internal Rate of Return Each model has its benefits and drawbacks. Financial managers prefer the Net Present Value and the Internal Rate of Return methods. 2 reasons why these models are favoured: All of the cash flows over the entire length of the project are considered. The future cash flows are discounted to reflect the time value of money. Net Present Value Net present value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows over a period of time. NPV is used in capital budgeting and investment planning to analyze a project's projected profitability. Internal Rate of Return Internal Rate of Return (IRR) is the interest rate that makes the Net Present Value (NPV) zero. 08 I Long-Term Financing of Fiscal Assets FINANCING What is financing? Financing is the process of providing funds for business activities, making purchases, or investing. Financial institutions, such as banks, are in the business of providing capital to businesses, consumers, and investors to help them achieve their goals. The use of financing is vital in any economic system, as it allows companies to purchase products out of their immediate reach. There are two types of financing: Equity financing Debt financing Debt is a loan that must be paid back often with interest, but it is typically cheaper than raising capital because of tax deduction considerations. Equity does not need to be paid back, but it relinquishes (waives) ownership stakes to the shareholder. Both debt and equity have their advantages and disadvantages. Most companies use a combination of both to finance operations. EQUITY FINANCING "Equity" is another word for ownership in a company. For example, the owner of a grocery store chain needs to grow operations. Instead of debt, the owner would like to sell a 10% stake in the company for $100,000, valuing the firm at $1 million. Companies like to sell equity because the investor bears all the risk; if the business fails, the investor gets nothing. Equity financing refers to the sale of company shares in order to raise capital. Investors who purchase the shares are also purchasing ownership rights to the company. Equity financing can refer to the sale of all equity instruments, such as common stock, preferred stock, etc. Equity financing is especially important during a company’s startup stage to finance plant assets and initial operating expenses. Investors make gains by receiving dividends or when their shares increase in price. Stock A stock (also known as equity) is a security that represents the ownership of a fraction of a corporation. This entitles the owner of the stock to a proportion of the corporation's assets and profits equal to how much stock they own. Units of stock are called "shares." There are two main types of stock: Common and Preferred Common stock: Common stock usually entitles the owner to vote at shareholders' meetings and to receive any dividends paid out by the corporation. Preffered stock: Preferred stockholders generally do not have voting rights, though they have a higher claim on assets and earnings than the common stockholders. For example, owners of preferred stock receive dividends before common shareholders and have priority in the event that a company goes bankrupt and is liquidated. Equity Financing – Advantages Funding a business through investors has several advantages, including the following: The biggest advantage is that you do not have to pay back the money. If your business enters bankruptcy, your investor or investors are not creditors. They are part-owners in your company, and because of that, their money is lost along with your company. You do not have to make monthly payments, so there is often more cash on hand for operating expenses. Investors understand that it takes time to build a business. You will get the money you need without the pressure of having to see your product or business thriving within a short amount of time. Equity Financing – Disadvantages Similarly, there are a number of disadvantages that come with equity financing, including the following: How do you feel about having a new partner? When you raise equity financing, it involves giving up ownership of a portion of your company. The riskier the investment, the more of a stake the investor will want. You might have to give up 50% or more of your company, and unless you later construct a deal to buy the investor's stake, that partner will take 50% of your profits indefinitely. You will also have to consult with your investors before making decisions. Your company is no longer solely yours, and if the investor has more than 50% of your company, you have a boss to whom you have to answer. Equity Financing – Major sources Angel investors: Angel investors are wealthy individuals who purchase stakes in businesses that they believe possess the potential to generate higher returns in the future. The individuals usually bring their business skills, experience, and connections to the table, which helps the company in the long term. Crowdfunding platforms: Crowdfunding platforms allow for a number of people in the public to invest in the company in small amounts. Members of the public decide to invest in the companies because they believe in their ideas and hope to earn their money back with returns in the future. The contributions from the public are summed up to reach a target total. Venture capital firms: Venture capital firms are a group of investors who invest in businesses they think will grow at a rapid pace and will appear on stock exchanges in the future. They invest a larger sum of money into businesses and receive a larger stake in the company compared to angel investors. The method is also referred to as private equity financing. Corporate investors: Corporate investors are large companies that invest in private companies to provide them with the necessary funding. The investment is usually created to establish a strategic partnership between the two businesses. Initial public offerings (IPOs): Companies that are more well-established can raise funding with an initial public offering (IPO). The IPO allows companies to raise funds by offering its shares to the public for trading in the capital markets. DEBT FINANCING Most people are familiar with debt as a form of financing because they have car loans or mortgages. Debt is also a common form of financing for new businesses. Debt financing must be repaid, and lenders want to be paid a rate of interest in exchange for the use of their money. Some lenders require collateral. For example, assume the owner of the grocery store also decides that they need a new truck and must take out a loan for $40,000. The truck can serve as collateral against the loan, and the grocery store owner agrees to pay 8% interest to the lender until the loan is paid off in five years. Debt is easier to obtain for small amounts of cash needed for specific assets, especially if the asset can be used as collateral. While debt must be paid back even in difficult times, the company retains ownership and control over business operations. Debt financing occurs when a company raises money by selling debt instruments, most commonly in the form of bank loans or bonds. Such a type of financing is often referred to as financial leverage. Debt Financing – Advantages There are several advantages to financing your business through debt: The lending institution has no control over how you run your company, and it has no ownership. Once you pay back the loan, your relationship with the lender ends. That is especially important as your business becomes more valuable. The interest you pay on debt financing is tax deductible as a business expense. The monthly payment, as well as the breakdown of the payments, is a known expense that can be accurately included in your forecasting models. Debt Financing – Disadvantages Debt financing for your business does come with some downsides: Adding a debt payment to your monthly expenses assumes that you will always have the capital inflow to meet all business expenses, including the debt payment. For small or early-stage companies, that is often far from certain. Small business lending can be slowed substantially during recessions. In tougher times for the economy, it's more difficult to receive debt financing unless you are overwhelmingly qualified. Debt Financing – Options Bank loan: A common form of debt financing is a bank loan. Banks will often assess the individual financial situation of each company and offer loan sizes and interest rates accordingly. Bond issues: Another form of debt financing is bond issues. A traditional bond certificate includes a principal value, a term by which repayment must be completed, and an interest rate. Individuals or entities that purchase the bond then become creditors by loaning money to the business. Family and credit card loans: Other means of debt financing include taking loans from family and friends and borrowing through a credit card. They are common with start-ups and small businesses. SPECIAL CONSIDERATIONS The weighted average cost of capital (WACC) is the average of the costs of all types of financing, each of which is weighted by its proportionate use in a given situation. By taking a weighted average in this way, one can determine how much interest a company owes for each dollar it finances. Firms will decide the appropriate mix of debt and equity financing by optimizing the WACC of each type of capital while taking into account the risk of default or bankruptcy on one side and the amount of ownership owners are willing to give up on the other. Because interest on the debt is typically tax deductible, and because the interest rates associated with debt is typically cheaper than the rate of return expected for equity, debt is usually preferred. However, as more debt is accumulated, the credit risk associated with that debt also increases and so equity must be added to the mix. Investors also often demand equity stakes in order to capture future profitability and growth that debt instruments do not provide. Assignment: Spider Analysis in all year (3 analysis per company) 100% = competitor DuPont Analysis (chooses one analysis) + final conclusion Presentation: 5 mins, 5th December 8 a 09 I Cost of Capital, Optimal Capital Structure CAPITAL STRUCTURE Capital structure is the particular combination of debt and equity used by a company to finance its overall operations and growth. Equity capital arises from ownership shares in a company and claims to its future cash flows and profits. Debt comes in the form of bond issues or loans, while equity may come in the form of common stock, preferred stock, or retained earnings. Short-term debt is also considered to be part of the capital structure. Debt is one of the two main ways a company can raise money in the capital markets. Companies benefit from debt because of its tax advantages; interest payments made as a result of borrowing funds may be tax-deductible. Debt also allows a company or business to retain ownership, unlike equity. Additionally, in times of low-interest rates, debt is abundant and easy to access. Equity allows outside investors to take partial ownership of the company. Equity is more expensive than debt, especially when interest rates are low. However, unlike debt, equity does not need to be paid back. This is a benefit to the company in the case of declining earnings. On the other hand, equity represents a claim by the owner on the future earnings of the company. Types of capitalization structures Firms can either issue either more debt or equity to fund its operations. By issuing equity, firms give up some ownership in the company without the need to pay back investors; by issuing debt, companies increase their leverage by needing to pay back investors. A company's debt-to-equity ratio is a measure of risk for investors. Companies that use more debt than equity to finance their assets and fund operating activities have a high leverage ratio and an aggressive capital structure. A company that pays for assets with more equity than debt has a low leverage ratio and a conservative capital structure. That said, a high leverage ratio and an aggressive capital structure can also lead to higher growth rates, whereas a conservative capital structure can lead to lower growth rates. Firms in different industries will use capital structures better suited to their type of business. Capital-intensive industries like auto manufacturing may utilize more debt, while labor-intensive or service-oriented firms like software companies may prioritize equity. A company with too much debt can be seen as a credit risk: Too much equity, however, could mean the company is underutilizing its growth opportunities or paying too much for its cost of capital (as equity tends to be more costly than debt). Unfortunately, there is no magic ratio of debt to equity to use as guidance to achieve real- world optimal capital structure. What defines a healthy blend of debt and equity varies depending on the industry the company operates in, its stage of development, and can vary over time due to external changes in interest rates and regulatory environment. CAPITAL STRUCTURE AND RISK What is the optimal debt to equity ratio? Business risk Financial risk Business risk: Standard measure is beta (controlling for financial risk) Factors: Demand variability Sales price variability Input cost variability Ability to develop new products Foreign exchange exposure Operating leverage (fixed vs variable costs) Example of Business Risk: Suppose 10 people decide to form a corporation to manufacture disk drives. If the firm is capitalized only with common stock – and if each person buys 10%, each investor shares equally in business risk. Financial risk The additional risk placed on the common stockholders as a result of the decision to finance with debt. Leverage increases shareholder risk.  Leverage also increases the return on equity (to compensate for the higher risk). Example of Relationship between Business and Financial Risk: If the same firm is now capitalized with 50% debt and 50% equity – with five people investing in debt and five investing in equity. The 5 who put up the equity will have to bear all the business risk, so the common stock will be twice as risky as it would have been had the firm been all-equity (unlevered). Business and Financial Risk: Financial leverage concentrates the firm’s business risk on the shareholders because debt-holders, who receive fixed interest payments, bear none of the business risk. COST OF CAPITAL Cost of capital represents the return a company needs to achieve in order to justify the cost of a capital project, such as purchasing new equipment or constructing a new building. Cost of capital encompasses the cost of both equity and debt, weighted according to the company's preferred or existing capital structure. This is known as the weighted average cost of capital (WACC). A company's investment decisions for new projects should always generate a return that exceeds the firm's cost of the capital used to finance the project. Otherwise, the project will not generate a return for investors. COST OF DEBT The cost of debt is the effective interest rate that a company pays on its debts, such as bonds and loans. The cost of debt can refer to the before-tax cost of debt, which is the company’s cost of debt before taking taxes into account, or the after-tax cost of debt. The key difference in the cost of debt before and after taxes lies in the fact that interest expenses are tax-deductible. The cost of debt is generally easier to calculate. Equals the current interest cost to borrow new funds. Current interest rates are determined from the rate in the financial markets. COST OF EQUITY The cost of equity is the return that a company requires to decide if an investment meets capital return requirements. Firms often use it as a capital budgeting threshold for the required rate of return. A firm’s cost of equity represents the compensation that the market demands in exchange for owning the asset and bearing the risk of ownership. The traditional formula for the cost of equity is: the dividend capitalization model and the capital asset pricing model (CAPM). Beta is a measure of the volatility – or systematic risk – a a security or portfolio compared to the market as a whole. Beta Value Equal to 1.0 If a stock has a beta of 1.0, it indicates that its price activity is strongly correlated with the market. A stock with a beta of 1.0 has systematic risk. However, the beta calculation can’t detect any unsystematic risk. Adding a stock to a portfolio with a beta of 1.0 doesn’t add any risk to the portfolio, but it also doesn’t increase the likelihood that the portfolio will provide an excess return. Beta Value Less Than One A beta value that is less than 1.0 means that the security is theoretically less volatile than the market. Including this stock in a portfolio makes it less risky than the same portfolio without the stock. For example, utility stocks often have low betas because they tend to move more slowly than market averages. Beta Value Greater Than One A beta that is greater than 1.0 indicates that the security's price is theoretically more volatile than the market. For example, if a stock's beta is 1.2, it is assumed to be 20% more volatile than the market. Technology stocks and small cap stocks tend to have higher betas than the market benchmark. This indicates that adding the stock to a portfolio will increase the portfolio’s risk, but may also increase its expected return. Negative Beta Value Some stocks have negative betas. A beta of -1.0 means that the stock is inversely correlated to the market benchmark. This stock could be thought of as an opposite, mirror image of the benchmark’s trends. Put options and inverse ETFs are designed to have negative betas. There are also a few industry groups, like gold miners, where a negative beta is also common. WEIGHTED AVERAGE COST OF CAPITAL The weighted average cost of capital (WACC) represents a firm's average cost of capital from all sources, including common stock, preferred stock, bonds, and other forms of debt. The weighted average cost of capital is a common way to determine required rate of return because it expresses, in a single number, the return that both bondholders and shareholders demand in order to provide the company with capital. A firm’s WACC is likely to be higher if its stock is relatively volatile or if its debt is seen as risky because investors will demand greater returns. In most cases, a lower WACC indicates a healthy business that’s able to attract investors at a lower cost. By contrast, a higher WACC usually coincides with businesses that are seen as riskier and need to compensate investors with higher returns. OPTIMAL CAPITAL STRUCTURE The optimal capital structure of a firm is the best mix of debt and equity financing that maximizes a company’s market value while minimizing its cost of capital. In theory, debt financing offers the lowest cost of capital due to its tax deductibility. However, too much debt increases the financial risk to shareholders and the return on equity that they require. Thus, companies have to find the optimal point at which the marginal benefit of debt equals the marginal cost. Optimal capital structure = minimum WACC 10 I Company‘s Profit and Dividend Policy REVENUES – SALES Revenue is the money generated from normal business operations, calculated as the average sales price times the number of units sold. It is the top line (or gross income) figure from which costs are subtracted to determine net income. Revenue is also known as sales on the income statement. COSTS – EXPENSES An expense is the cost of operations that a company incurs to generate revenue. Common expenses include payments to suppliers, employee wages, factory leases, and equipment depreciation. There are two main categories of business expenses in accounting: Operating expenses: Expenses related to the company’s main activities, such as the cost of goods sold, administrative fees, and rent. Non-operating expenses: Expenses not directly related to the business' core operations. Common examples include interest charges and other costs associated with borrowing money. Costing methods: ABC (Activity-Based Costing) ABM (Activity-Based Management) ABC/M (Activity-Based Cost/Management) ABC (Activity-Based Costing): Activity-based costing (ABC) is a costing method that assigns overhead and indirect costs to related products and services. This accounting method of costing recognizes the relationship between costs, overhead activities, and manufactured products, assigning indirect costs to products less arbitrarily than traditional costing methods. However, some indirect costs, such as management and office staff salaries, are difficult to assign to a product. ABM (Activity-Based Management): Activity-Based Management (ABM) is a way of analyzing and evaluating a company’s business activities through activity-based costing and value-chain analysis. In other words, the ABM method is used to analyze the cost of an activity in relation to the value added by the activity, with the goal of operational and/or strategic improvement. PROFIT Formula: Revenues – Costs How to increase profit of the company? Increase Revenues: raise prices – expenses will remain constant, resulting in an increase in profit - sell more units – the contribution margin will rise higher than variable expenses, resulting in an increase in profit Decrease Costs: reduce fixed costs, reduce unit variable costs, reduce sales=reduced costs BREAK-EVEN POINT The breakeven point (break-even price) for a trade or investment is determined by comparing the market price of an asset to the original cost; the breakeven point is reached when the two prices are equal. In corporate accounting, the breakeven point formula is determined by dividing the total fixed costs associated with production by the revenue per individual unit minus the variable costs per unit. In this case, fixed costs refer to those which do not change depending upon the number of units sold. Put differently, the breakeven point is the production level at which total revenues for a product equal total expenses. Fixed costs – remain the same regardless of production output (lease and rental payments, insurance, interest payments) Variable costs – vary based on the amount of output produced (labour, commissions, raw materials) In the linear Cost-Volume-Profit Analysis model (where marginal costs and marginal revenues are constant, among other assumptions), the break-even point (BEP) (in terms of Unit Sales (X)) can be directly computed in terms of Total Revenue (TR) and Total Costs (TC) as: TR = Total Revenues, TC = Total Costs, FC = Fixed Costs, VC = Variable Costs, AVC = Average Variable Costs P = Price, Q = Quantity DIVIDEND POLICY A dividend policy is the policy a company uses to structure its dividend payout to shareholders. Some researchers suggest the dividend policy is irrelevant, in theory, because investors can sell a portion of their shares or portfolio if they need funds. This is the dividend irrelevance theory, which infers that dividend payouts minimally affect a stock's price. Despite the suggestion that the dividend policy is irrelevant, it is income for shareholders. Company leaders are often the largest shareholders and have the most to gain from a generous dividend policy. TYPES: Most companies view a dividend policy as an integral part of their corporate strategy. Management must decide on the dividend amount, timing, and various other factors that influence dividend payments. There are three types of dividend policies a stable dividend policy, a constant dividend policy, and, a residual dividend policy Stable Dividend Policy A stable dividend policy is the easiest and most commonly used. The goal of the policy is a steady and predictable dividend payout each year, which is what most investors seek. Whether earnings are up or down, investors receive a dividend. The goal is to align the dividend policy with the long-term growth of the company rather than with quarterly earnings volatility. This approach gives the shareholder more certainty concerning the amount and timing of the dividend. Constant Dividend Policy The primary drawback of the stable dividend policy is that investors may not see a dividend increase in boom years. Under the constant dividend policy, a company pays a percentage of its earnings as dividends every year. In this way, investors experience the full volatility of company earnings. If earnings are up, investors get a larger dividend; if earnings are down, investors may not receive a dividend. The primary drawback to the method is the volatility of earnings and dividends. It is difficult to plan financially when dividend income is highly volatile. Residual Dividend Policy Residual dividend policy is also highly volatile, but some investors see it as the only acceptable dividend policy. With a residual dividend policy, the company pays out what dividends remain after the company has paid for capital expenditures (CAPEX) and working capital. This approach is volatile, but it makes the most sense in terms of business operations. Investors do not want to invest in a company that justifies its increased debt with the need to pay dividends. 12 I Company Valuation BUSINESS VALUE AND VALUATION Business valuation: is a process of determining the economic value of a whole business or company unit. is used to determine the fair value of a business for a variety of reasons (sale value, establishing partner ownership, taxation,…). is typically conducted when a company is looking to sell all or a portion of its operations or looking to merge with or acquire another company. A business valuation might include an analysis of the company's management, its capital structure, its future earnings prospects or the market value of its assets. The tools used for valuation can vary among evaluators, businesses, and industries. Common approaches to business valuation include a review of financial statements, discounting cash flow models and similar company comparisons. Valuation is also important for tax reporting. The Internal Revenue Service (IRS) requires that a business is valued based on its fair market value. Some tax-related events such as sale, purchase or gifting of shares of a company will be taxed depending on valuation. Methods of valuation 1. Market Approach Market Capitalization Times Revenue Method Earnings Multiplier 2. Yield Method - Discounted Cash Flow (DCF) Method and EVA Method 3. Book Value MARKET APPROACH Market Capitalization: Market capitalization is the simplest method of business valuation. It is calculated by multiplying the company’s share price by its total number of shares outstanding. For example, as of January 3, 2018, Microsoft Inc. traded at $86.35. With a total number of shares outstanding of 7.715 billion, the company could then be valued at $86.35 x 7.715 billion = $666.19 billion. Times Revenue Method: Under the times revenue business valuation method, a stream of revenues generated over a certain period of time is applied to a multiplier which depends on the industry and economic environment. For example, a tech company may be valued at 3x revenue, while a service firm may be valued at 0.5x revenue. Earnings Multiplier: Instead of the times revenue method, the earnings multiplier may be used to get a more accurate picture of the real value of a company, since a company’s profits are a more reliable indicator of its financial success than sales revenue is. The earnings multiplier adjusts future profits against cash flow that could be invested at the current interest rate over the same period of time. In other words, it adjusts the current P/E ratio to account for current interest rates. YIELD METHOD - Discounted Cash Flow (DCF) Method and EVA Method The DCF method of business valuation is similar to the earnings multiplier. This method is based on projections of future cash flows, which are adjusted to get the current market value of the company. The main difference between the discounted cash flow method and the profit multiplier method is that it takes inflation into consideration to calculate the present value. BOOK VALUE This is the value of shareholders’ equity of a business as shown on the balance sheet statement. The book value is derived by subtracting the total liabilities of a company from its total assets. Other methods include: liquidation value, replacement value, breakup value, asset-based valuation and still many more.