Corporate Finance Finals 2023 PDF

Corporate Finance Finals 2023 Summary Session 1 (i.e. Chapter 1, 2 & 3) – Financial management and control of a firm Session 2 ( i.e. Chapter 4) – The time value of money Session 3 (i.e. Chapter 6) – The internal rate of...

Corporate Finance Finals 2023 Summary Session 1 (i.e. Chapter 1, 2 & 3) – Financial management and control of a firm Session 2 ( i.e. Chapter 4) – The time value of money Session 3 (i.e. Chapter 6) – The internal rate of return and other investment rules Session 4 (i.e. Chapter 7) – Making capital investment decisions Session 5 (i.e. Chapter 5) – Stock Valuation Session 6 (i.e. Chapter 5 & 16) – How to value bonds Session 7 (i.e. Chapter 9) – Risk and Return – statistics Session 8 (i.e. Chapter 10) – The capital asset pricing model – CAPM and the cost of equity Session 9 (i.e. Chapter 12) – The weighted average cost of capital WACC 1 Session 1 (i.e. Chapter 1, 2 & 3) – Financial management and control of a firm There are 3 different types of organizations: o Sole proprietorship o Partnership o Corporation Sole proprietorship: Owned by 1 person, taxed as personal income and no distinction between business income and personal income. Advantage: easy to start and low cost Disadvantage: unlimited liability, limited transferability Corporation: It’s a legal person distinct from the owners. Stockholders elect the board of directors. The board of directors can: o Declare a dividend o Issue securities o Make large investments Directors elect the CEO and the president; their mission is to run the company in the interest of the stockholders. This point of view is criticized after the financial crisis and the environmental awareness. These points of views have created new corporations around the world known as: benefit corporation or enterprise à mission in French. There is also an aim to challenge the rule of “Shareholder primacy” which says that the corporation does everything to have its shareholders happy but for now most companies still follow this rule. The CFO (Chief Financial Officer) stands between o Cash flows invested in the real assets of the firm o Cash flows generated by the real assets of the firm o Cash flows invested in the firm by the investors o Cash flows generated by the firm and returned to the investors or retained into the firm He is Treasurer and Controller: o Treasurer: Capital budgeting, Financing, Cash management, recommending dividend policy, Insurance, Pension plans 2  o Controller: Accounting, Preparation of financial statements, Preparing budgets, Internal auditing THE ROLE OF THE FINANCIAL MANAGER The CFO tries to maximize the value of the firm through o Investment decision o Financing decision o Dividend decision AN OVERVIEW OF FINANCIAL STATEMENTS The Balance sheet: The balance sheet gives a picture of the firm at a particular time What are the assets available to run the business? How were these assets financed? The income statement: What do we record in the income statement? o Revenues o Expenses necessary to earn the revenues. When do we record in the income statement? o Revenues are recorded when earned, not when they are paid 3  o Expenses are recorded when incurred to produce the revenues, not when they are paid Periodicity: Quarterly, semi-annual, annual Depreciation o Depreciation is the process by which a company gradually records the loss in value of a fixed asset. o Depreciation is a cost (recorded in the income statement) and impact the net value of the assets (recorded in the balanced sheet) o Depreciation is a non-cash expense The cash flow statement: Three sections in the cash flow statement o Cash flow from the operations o Cash flow from investing o Cash flow from financing Two ways to prepare a cash flow statement o Direct method: Reports all cash receipts and cash disbursements from operating activities. Lengthy and tedious. o Indirect method: The indirect method adjusts net income for items that affected reported net income but didn't affect cash. Easier and faster. 4 5 Session 2 ( i.e. Chapter 4) – The time value of money Future Value / Compounding: We use compound interest to know the value of an investment in the future. Every interest earned is re-invested the next year with the initial principal. Formula: Future Value (FV): Vn= V0 (1+r)n with V0 being the principal, r the rate and n the duration(in years) over which the investment is made. Example: An individual wants to place his money in the bank at a rate of 9% for 8 years. Its initial capital is 1000$. With the Future Value formula, we know that at the end of year 8, our capital will have grown to 1000*(1+0,09)8 so 1992,56$ Present Value / Discounting: The opposite of compounding is discounting. With the present value, you know how much to invest if you want to earn a defined amount at year n with an interest rate r. Formula: Present Value (PV): V0 = Vn / (1+r)n Example: You want to know how much you must put in the bank now to get 1992,56$ at the end of year 8, with an interest rate of 9%. We then must use the PV Formula, 1992,56/(1+0,09)8=1000. So, 1000$ must be put in the bank today. Compounding Periods If you are compounding/discounting at an infra-annual rate, you must divide your rate by the number of periods per years (m) and multiply the time (n) by m. Example: Interest are compounded at a semiannual rate for n years, FV = Vn= V0 (1+r/2)^n*2 If you are supposing that you compound at an infinitely small period, you use the formula: C0*exp(r*n) The harmonized interest rate chosen by the European Union is called Annual percentage rate (APR), it considers interest but also management fees to give the total cost of borrowing. The annual rate of return which considers the compounding over the different periods is called Effective Annual Rate (EAR) or Effective Annual Yield (EAY). Net Present Value The present value of the security is the sum of the discounted cash flows generated by the security: 𝐹 Formula: N𝑃𝑉 = ∑𝑁 𝑛 𝑛=1 (1+𝑟)𝑛 The Net Present Value (NPV) is the difference between the PV of the security and its market value. In an efficient market, NPV =0. 6 NPV: o Value created by an investment o Maximum additional amount that the investor is willing to pay to make the investment o Difference between the PV and the market value Perpetuity: The PV for a perpetuity is given by PV=C/r with C being the coupon paid every year. If the value of the coupon is increasing every period at a rate g, PV= C/(r-g) Annuity: Annuities are payment made every year for a fixed number of periods (N). To know the PV of these annuities, we must discount them every year for the number of years remaining until the end of the payments. Formula for annuity: 𝐹 1 𝑃𝑉 = ⋅ [1 − ] 𝑟 (1 + 𝑟)𝑁 𝐹 𝐹𝑉 = ⋅ [(1 + 𝑟)𝑁 − 1] 𝑟 7 Session 3 (i.e. Chapter 6) – The internal rate of return and other investment rules The Net Present Value (NPV) from a project is the sum of the discounted cash flows. o NPV > 0: accept the project o NPV < 0: reject the project Example: o Initial investment: C0 = 1000 o Cash flows generated by the project: C1 = 200; C2 = 400; C3 = 600 o Interest rate of return: r = 5% 𝐶1 𝐶2 𝐶3 𝑁𝑃𝑉 = − 𝐶0 + + + 1 + 𝑟 (1 + 𝑟 )2 (1 + 𝑟 )3 200 400 600 𝑁𝑃𝑉 = − 1000 + + 2 + 1 + 0,05 (1 + 0,05) (1 + 0,05)3 𝑁𝑃𝑉 = 71,59 > 0 The NPV is positive, so we accept the project. The Internal Rate of Return (IRR) from a project is the discount rate that makes the NPV equal to 0. o IRR > discount rate: accept the project o IRR < discount rate: reject the project Example: o Initial investment: C0 = 1000 o Cash flows generated by the project: C1 = 200; C2 = 400; C3 = 600 o Discount rate: r = 5% 𝐶1 𝐶2 𝐶3 − 𝐶0 + + 2 + =0 1 + 𝐼𝑅𝑅 (1 + 𝐼𝑅𝑅) (1 + 𝐼𝑅𝑅)3 𝐼𝑅𝑅 = 8,2% > 5% The IRR is higher than the discount rate, so we accept the project. Problems with IRR: o Sometimes we can have multiple IRR when the cash is changing through time or no IRR when the NPV is always positive o IRR is constant so it’s not appropriate for long life projects o When we want to choose between two mutually exclusive projects, we can’t use IRR because of scale problem and/or timing problem 8 Session 4 (i.e. Chapter 7) – Making capital investment decisions There are some examples in the book, we don’t show it here, but it could help the understanding of the notions below. Key notations for this chapter NPV Net present value OCF Operation cash flows 𝑪𝒊 cash flow at time i EBIT Earnings before interest 𝒕𝒄 corporate tax rate PV Present value and taxes 7.1 – Incremental cash flows It is important to understand that we use cash flows rather than accounting income because it only takes into account the money you have or you spend, without receivables créances clients or account payable dettes fournisseurs. Thus, we always discount cash flows, not earnings, when performing a capital budgeting allocation. Earnings do not represent real money. However, it is not enough to use cash flows. In calculating NPV of a project, only cash flows that are incremental to the project should be used. Several definitions that are quite useful A sunk cost is a cost that has already occurred. Because sunk costs are in the past, they cannot be changed by the decision to accept or reject the project. We should ignore sunk cost. An opportunity cost is the fact that an asset has several uses, and potential revenues from alternative uses are lost. Side effects Another difficulty in determining incremental cash flows comes from the side effects of the proposed project on other parts of the firm. A side effect is classified as either erosion cannibalization or synergy. Erosion occurs when a new product reduces the sales, and hence the cash flows of existing products. Syngergy occurs when a new project increases the cash flows of existing projects. Allocated costs Frequently a particular expenditure benefits a number of projects. Accountants allocate this cost across the different projects when determining income. However, for capital budgeting purposes, this allocated cost should be viewed as a cash outflow of a project only if it is an incremental cost of the project. 7.2 – An example Cf. Book, it helps to understand sunk, opportunity and incremental costs and the uses of some formula such as OPC, NWC or computing depreciations. 9 7.3 – Inflation and capital budgeting Interest rates and inflation Nominal interest rates vs. real interest rates 1 + 𝑛𝑜𝑚𝑖𝑛𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒𝑠 𝑟𝑒𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒𝑠 = −1 1 + 𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒𝑠 𝑟𝑒𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒𝑠 ≅ 𝑛𝑜𝑚𝑖𝑛𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒𝑠 − 𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 The idea is really simple. For instance, you have €3,000 in your Livret A bank account, the nominal interest rates on the Livret A is 3%, so you earned at the end you the year 0.03 * 3,000 = €90. But the inflation is about 5% in France, so in fact you lose purchasing power because real 1.03 interest rates is − 1 = −0.019 ≅ 0.03 − 0.05 ≅ −0.02. 1.05 The question is now: should we discount cash flow with the nominal or real rate? The answer is simple. Nominal cash flow must be discounted at the nominal rate. Real cash flow must be discounted at the real rate. It is obviously the same for the NPV because it is nothing but sum of cash flows. 7.4 – Alternative definition of operating cash flow EBIT = Sales – Cost – Depreciation, this is the general formula. Taxes = EBIT * 𝑡𝑐 OCF = EBIT + Depreciation – Taxes Using maths, we can transform these formulas. The bottom-up approach Project income = EBIT – Taxes OCF = EBIT – Taxes + Depreciation = Project income + Depreciation The top-down approach OCF = Sales – Cost – Taxes The tax yield approach OCF = Sales – Cost – Taxes = EBIT + Depreciation – EBIT * 𝑡𝑐 = (Sales – Cost)(1 – 𝑡𝑐 ) + Depreciation * 𝑡𝑐 All of these approachs are equivalent, and have the same difficulties, but in some situation, it will be easier to use one of them. 10 7.5 – Investments of unequal lives: the equivalent annual cost method Again, nothing difficult. Example: Let’s set up a discounted rate at 20% Imagine that you are quite hesitating between buying a machine A at €500 which will be replaced in 3 years with an annual maintenance of €120 or machine B at €600 with a life of 4 years and an annual maintenance of €100? We cannot directly compare machine A and B, but at first sight, A is less expensive. Cash flow for machine A: 120 120 120 −500 − − − = −752,78 1,2 1,22 1,23 752,78 The cost per annum of machine A is = 250,93. 3 Cash flow for machine B: 100 100 100 100 −600 − − − − = −858,87 1,2 1,22 1,23 1,24 858,87 The cost per annum of machine B is = 214,72. 4 214,72 < 250,93, you should take machine B. Note that 3 & 4 are approximative, officially you have to use the formula of annuity. And with the same logic, machine A has to be replaced 1 year sooner than machine B. 11 Session 5 (i.e. Chapter 5) – Stock Valuation 3 approaches to determine the stock valuation: - Net Asset Value (NAV) - Liquidation Value - Market Value 2 methods to determine Market Value: - The absolute valuation approach (DCF, DDM) - The relative valuation approach (multiples) Absolute valuation – Discounting Cash Flows Div = dividends R = discount rate P1= future selling price If you hold the stock forever then the formula is: If the dividends are constant then P0= Div/r If the dividends are not constant but grow at a certain rate then: The "no growth, constant dividend" assumption is realistic for many utility stocks. This kind of company is called "income stock". 12 The "constant dividend growth rate" does not happen in reality but it is a pretty good approximation over the long run This kind of company is called "growth stock" The relative valuation approach: Multiples By using a multiple, you simply try to relate the stock price to a financial item. Many multiple ratios exist: PER (or PE): Price Earnings Ratio EBIT multiple PBV (or PBR): Price to Book Value (or Price to Book Ratio) And so on… PER = price per share / earnings per share Consequently, the PER depends on: - EPS growth g - Interest rates through k - Perceived risk through k It depends on: - The growth rate of operating profit - The risk of the capital employed - The level of interest rates 13 Book value versus Market value Book value: Accounting term, which usually refers to a business' historical cost of assets less liabilities. The book value of a firm is determined from a company's records by adding all assets (generally excluding such intangibles as goodwill), then deducting all debts and other liabilities. Market value: Value established by market transactions Book value of the assets of a company may have little or no significant relationship to market value. The difference is usually accounted for as the goodwill. Market value of the firm V = E + D V= value E = equity D = debt The PBR indicates investors’ expectations of the company’s management’s ability to create shareholder value from a given stock of assets and liabilities. The PBR should be larger than 1 if the firm return on equity (rE) is larger than the required rate of return (kE). A high PBR shows that the market believes in managers’ ability to create value from assets. A low PBR shows that the market thinks that the firm is unable to add value. Income stocks versus growth stocks Example from the slides: A firm has a capitalization rate r of 15%. It is expected to pay a dividend per share of €5 next year and then the dividend is expected to grow at 10% a year. Its EPS next year is expected at €8.33 and we know that its ROE is 25%. Each year the firm retains 40% of its earnings that invested into new assets on which it earns 25% of return the year after. What is its theoretical price per share today? => 5€ / (0,15-0,10) = 100 What is the payout ratio? => 5/8,33 = 0,6 How can we justify the 10% expected growth rate? (where does the growth rate come from?) => 40%*25% = 10% What would be its price if it had no growth? => 8,33 / 15% = 55.53 NPV1 = -3.33 +.83/.15 = 2.22 -3,33 = 5- 8,33 0.83 = 3.33* 25% 14 PVGO = NPV1 / (r – g) = 2.22 / (15% - 10%) = €44.44 100 = present value without growing cash flows (55.53) + present value of the future cash flows (44.44). 15 Session 6 (i.e. Chapter 5 & 16) – How to value bonds Unlike conventional bank loans, debt securities can be traded on secondary markets. Debt securities can be: - Bonds - Commercial paper - Treasury bill and notes - Certificates of deposit - Mortgage-backed bonds Basic concepts are included in the debt contract: The principal Nominal or Face value or Par value Issue price Redemption Maturity Guarantees Income Issue date Interest rate Periodic coupon payment Value of a bond is the sum of the present value of the future interest + present value of repayment The yield to maturity is the discount rate for which the bond’s net present value is 0. Cash Flows (Coupons + Principal) are fixed But the discount rate (YTM) may change over the life of the bond because of changes in Expected inflation Risk-free rate Risk Premium Rating agencies provide ratings for the debt of : companies, banks, sovereign states and municipalities Ratings agencies are Standard & Poor’s, Fitch and Moody’s. Debt securities rated between AAA and BBB are referred to as “Investment Grade”, and those rated between BB and D as “Speculative Grade” or junk bonds. The spread is the difference between the rate of return on a bond and that on a benchmark used by the market. 16 Session 7 (i.e. Chapter 9) – Risk and Return – statistics Risk always exists. Saying that risk can be eliminated is either to be excessively confident or be unable to think about the future – both very serious faults for an investor. Risk can be divided in two categories: - Economic risks (political, natural, inflation, operational and other risks) which affect cash flows. - Financial risks (liquidity, currency, interest rate and other risk) which do not affect directly cash flows The riskier a security is, the more volatile its price. The degree of risk depends on the investment timeframe and tends to diminish over the long term. Investors use the concept of expected return, which is the average of possible returns weighted by their likelihood of occuring. Ex-ante expected return is equal to: The risk of security can be seen as the dispersion of its possible returns around an average return. Standard deviation in returns is the most often used measure to evaluate the risk of an investment. Standard deviation is expressed as the square root of the variance. The standard deviation of single assets is higher than the standard deviation of the entire market. If investors buy portfolios of assets, instead of single assets, they can reduce the overall risk of their entire portfolio because asset prices move independently. 17 Session 8 (i.e. Chapter 10) – The capital asset pricing model – CAPM and the cost of equity The concept of risk premium only makes sense when risk is spread over many investment. Portfolio and diversification are Fundamentals concepts in finance. Return required by investors: the CAPM The capital asset pricing model (CAPM) was developed in the late 1950s and 1960s by H. Markowitz, W. Sharpe, J. Lintner and J. Treynor The CAPM says that if all investors hold the market portfolio, the risk premium they will demand is proportional to the beta coefficient: Covariance between security J return and the market return is: Required rate of return for firm J = risk-free rate + βJ x market risk premium The market risk premium (kM-RF) can be estimated with two approaches: - Expected or forward risk premium - Historical risk premium We should use expected risk premium for calculating a discount rate. But many times, the historical approach is used because it’s easier to implement. The security market line (SML) is instructive. It helps to determine the required rate of return on the basis of the market risk. A parallel shift in the SML reflects a change in the interest rate. A non-parallel shift of the SML implies a change in the remuneration of risk. The position of a firm regarding the SML serves as a decision making. A stock above the SML is undervalued, while a stock below the SML is overvalued. An important property of CAPM is that the beta for a portfolio is simply a weighted average of the betas for each security inside the portfolio. 18 Session 9 (i.e. Chapter 12) – The weighted average cost of capital WACC The balance sheet of a firm tells us what weighted average cost of capital (WACC) is. The cost of debt is tax deductible and you must use market value for equity and debt. To create value, the return on the assets (r) must be sufficient to cover the cost of financing (k) The WACC is the discount rate you must use to estimate the net present value of an investment or the value of a firm. Estimating the value of a firm 1. Consider operating cash flows: EBIT x (1 – Tc) = NOPAT Add back depreciation Deduct any net investment required, if any Do not forget the change in NWC Change in (account receivable + inventory – account payable) 2. Estimate the market value of debt and the cost of debt 3. Estimate the market value of equity and the cost of equity 4. Compute the WACC 5. Discount the operating cash flows at the WACC and you get the total value of the firm 6. In order to find the equity value, you can deduct the value of debt from the total value For a real example see the Microsoft case on K2 For the finals I highly recommend to every one of you to train on the three-case studies Ginza (CM4 on K2), Solaria (TD5) and Kanterbrew (TD9) and also to make the finals from last year on K2. 19