Nanyang Business School. Financial Management. Nilanjan Sen, Ph.D., CFA

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1 Nanyang Business School Financial Management Nilanjan Sen, Ph.D., CFA Associate Dean, Nanyang Executive Education Director, English Executive MBA Program Director, Nanyang Fellows Program Nanyang Business School

2 Corporation Modern Corporations are often viewed as a nexus of contracts between shareholders, bondholders, other stakeholders and the broader community.

3 Corporation Advantages Limited Liability Unlimited Life Transfer of Ownership Capital Raising Disadvantages Double Taxation Costs Agency costs

4 Agency Relationship An Agency relationship arises when one or more individuals,called principals, hire another individual(s) or organization(s) called agents, to perform some service and delegates the decision making authority to that agent. Shareholders vs. Managers Shareholders vs. Bondholders

5 Agency Relationship Goal of the Management: Maximize the Shareholders Wealth i.e. Maximize Stock Price

6 Sources of Conflict Excessive perquisite consumption Differential information Mismatched horizons Investment in human capital Managerial risk-aversion Excessive retention of earnings

7 Norms Societal Environment Regulations Lobbying, Culture Equity mkt. Markets Takeovers Auditor Institutions Debt mkt. Share holder Debt holder Firm Manager Managerial mkt. Auditor mkt. Buying mkt. Supplier Regulator. Regulatory mkt. Other stakeholders Selling mkt. Managers Capital Budget Capital Raising Distribution of Returns Customer Arrows represent contracts

8 Agency Costs Agency Costs represent the difference between value of an actual firm and the value of an hypothetical firm which would exist in a perfect world where all the incentives of different agents are perfectly aligned.

9 Controlling Agency Costs Internal: Board of Directors: Composition, Leadership Structure Performance Sensitive Compensation Firm s Charter Ownership Structure External: Market for Corporate Control Managerial Labor Market Shareholder Activism Regulation

10 Corporate Governance Market Corporate Governance is, to a large extent, a set of mechanism through which outside investors protect themselves against expropriation by the insiders. Higher investor protection leads to higher valuations. Higher Investor Protection is associated with increased depth of the capital market. Higher Investor protection is associated with higher dividend payout.

11 Markets Physical Versus Financial Markets Primary versus Secondary Markets Money versus Capital Markets Spot versus Future Markets

12 Markets NYSE NASDAQ Electronic Communication Network (ECN)

13 Rates Real Return Risk Free Return = Real Return+ IP Nominal Return = Risk Free Return + Risk Premium

14 Time Value of Money Future value Present value Rates of return Amortization

15 Time Lines of Cash Flows i% CF 0 CF 1 CF 2 CF 3 Tick marks at ends of periods, so Time 0 is today; Time 1 is the end of Period 1; or the beginning of Period 2.

16 Time line for a $100 lump sum due at the end of Year Year i% 100

17 Time line for an ordinary annuity of $100 for 3 years i%

18 Time line for uneven CFs: -$50 at t = 0 and $100, $75, and $50 at the end of Years 1 through i%

19 What s the FV of an initial $100 after 3 years if i = 10%? 10% FV =? Finding FVs (moving to the right on a time line) is called compounding.

20 FV 1 After 2 years: After 1 year: = PV + INT 1 = PV + PV (i) = PV(1 + i) = $100(1.10) = $ FV 2 = FV 1 (1+i) = PV(1 + i)(1+i) = PV(1+i) 2 = $100(1.10) 2 = $

21 FV 3 In general, After 3 years: = FV2(1+i)=PV(1 + i) 2 (1+i) = PV(1+i) 3 = $100(1.10) 3 = $ FV n = PV(1 + i) n.

22 What s the PV of $100 due in 3 years if i = 10%? Finding PVs is discounting, and it s the reverse of compounding % PV =? 100

23 Solve FV n = PV(1 + i ) n for PV: PV = FV n 1+i n = FV n 1 1+i n 1 PV = $ = $ = $

24 Financial Calculator Solution INPUTS OUTPUT N I/YR PV PMT FV Either PV or FV must be negative. Here PV = Put in $75.13 today, take out $100 after 3 years.

25 Finding the Time to Double 0 1 2? 20% -1 FV = PV(1 + i) n $2 = $1( ) n (1.2) n = $2/$1 = 2 nln(1.2) = LN(2) n = LN(2)/LN(1.2) n = 0.693/0.182 =

26 What s the difference between an ordinary annuity and an annuity due? Ordinary Annuity i% Annuity Due PMT PMT PMT i% PMT PV PMT PMT FV

27 What s the FV of a 3- year ordinary annuity of $100 at 10%? % FV = 331

28 Financial Calculator Solution INPUTS OUTPUT N I/YR PV PMT FV Have payments but no lump sum PV, so enter 0 for present value.

29 PV of this ordinary annuity % = PV

30 Financial Calculator Solution INPUTS OUTPUT N I/YR PV PMT FV Have payments but no lump sum FV, so enter 0 for future value.

31 PV of uneven cash flow stream 0 10% = PV

32 Input in CFLO register: CF 0 = 0 CF 1 = 100 CF 2 = 300 CF 3 = 300 CF 4 = -50 Enter I = 10%, then press NPV button to get NPV = (Here NPV = PV.)

33 Mortgage Payments Car Selection Finding Rates Required Savings Retirement Planning Project Selection Security Valuation Applications

34 Financial Statements Major Financial Statements Balance Sheet Income Statements Statement of Cash Flows Formulated by the Financial Accounting Standards Board (FASB) Provides some choices of accounting principles Financial statements footnotes must disclose which accounting principles are used by the firm a

35 Financial Statements Assets Cash ST Invest. 71,632 0 Receivables 878, Inventories 1,716,480 1,287,360 Total C.A. 2,680,112 1,926,802 Plant&Equip 1,197,160 1,202,950 Depreciation 380, ,160 Net Properties 817, ,790 Total Asset 3,497,152 2,866,592

36 Financial Statements Liabilities and Equities Accounts Payable 436, ,160 Notes Payable 600, ,000 Accruals 408, ,000 Total CL 1,444,800 1,733,760 Long-Term Debt 500,000 1,000,000 Common Stock 1,680, ,000 Retained Earnings (128,584) (327,168) Total Equity 1,552, ,832 Total Liab and Equity 3,497,152 2,866,592

37 Financial Statements Income Statements Sales 7,035,600 5,834,400 COGS 5,728,000 5,728,000 Other Expenses 680, ,000 Depreciation 116, ,960 Total Oper.Costs 6,524,960 6,524,960 EBIT 510,640 (690,560) Interest Expenses 88, ,000 EBT (866,560) Taxes 169,056 (346,624) Net Income 253,584 (519,936)

38 Financial Statements Statement of Cash Flows Integrates the information on the balance sheet and income statement Shows the effects on the firm s cash flow of income flows and changes in various items on the balance sheet Three sections show cash flows from Operating activities Investing activities Financing activities

39 Financial Statements (A) Operating Activities: Use(-) or Source(+) Net Income + +Depreciation + +Increase in A/C Receivables _ +Increase in Inventories _ +Increase in A/C Payables + +Increase in Accruals + =Cash flow from Operations (B) Investing Activities Increase in Net Fixed Asses Buy or Sale of Business Interests

40 Financial Statements (C) Financing Activities: Use(-) or Source(+) Increase in Notes Payable + +Increase in Bond Outstanding + +Increase in common stock + +Payment of Dividend _ Net Change in Cash = A+B+C

41 Financial Statements Compare to other entities Examine a firm s performance relative to: The aggregate economy Its industry or industries Its major competitors within the industry Its past performance (time-series analysis)

42 Financial Statements Liquidity:Can we make required payments as they fall due? Asset management: Do we have the right amount of assets for the level of sales? Debt management: Do we have the right mix of debt and equity? Profitability: Do sales prices exceed unit costs, and are Sales high enough as reflected in PM, ROE, and ROA? Market value: Do investors like what they see as reflected in P/E and M/B ratios?

43 Financial Statements CR 99 = CA = $2,680 = 1.85x. CL $1,445 QR 99 = CA - Inv. CL $2,680 - $1,716 = $1,445 = 0.67x.

44 Financial Statements Net Sales Fixed Asset Turnover Average Net Fixed Assets Net Sales Total Asset Turnover Average Total Net Assets

45 Financial Statements Receivables turnover examines the quality of accounts receivable Receivables Turnover Net Annual Sales Average Receivables Receivables turnover can be converted into an average collection period Average Receivables Collection Period 365 Annual Turnover

46 Financial Statements Debt ratio= TIE= Total debt Total assets $1,445 = + $500 = 55.6%. $3,497 EBIT Int. expense = $510.6 = 5.8x. $88

47 Financial Statements Gross profit margin measures the rate of profit on sales (gross profit equals net sales minus the cost of goods sold) Gross Profit Margin Gross Profit Net Sales

48 Financial Statements Operating profit margin measures the rate of profit on sales after operating expenses (operating profit is gross profit minus sales, general and administrative (SG + A) expenses Operating Profit Margin Operating Profit Net Sales

49 Financial Statements Net profit margin relates net income to sales Net Profit Margin Net Income Net Sales

50 Financial Statements The Dupont System divides the ratio into several components that provide insights into the causes of a firm s ROE and any changes in it: ROE Net Income Common Equity Net Income Sales Sales Common Equity Sales Equity Sales Total Assets Total Assets Equity

51 Financial Statements Net Income Common Equity Net Income Sales Sales Total Assets Total Assets Common Equity Profit Total Asset Financial = x x Margin Turnover Leverage =3.6%x 2.0x 2.3 =16.3%

52 Financial Statements Comparison with industry averages is difficult if the firm operates many different divisions. Average performance is not necessarily good. Seasonal factors can distort ratios. Window dressing techniques can make statements and ratios look better. Different accounting and operating practices can distort comparisons. Sometimes it is difficult to tell if a ratio value is good or bad. Often, different ratios give different signals, so it is difficult to tell, on balance, whether a company is in a strong or weak financial condition.

53 Risk & Return Different concepts of Return Historical Expected Required Definition of Risk : Individual versus portfolio Trade off between Risk and Return

54 Risk & Return Economy Prob. T-Bill A B Recession % -22.0% 28.0% Below avg Average Above avg Boom

55 Expected Return k ^ = Expected rate of return. n i=1 k = k P. i k ^ A = 0.10(-22%) (-2%) (20%) (35%) (50%) = 17.4%. i

56 Standard deviation Standard deviation Variance 2 n i1 2 k kˆ P. i i

57 Stand Alone Risk n i1 2 k kˆ P. i i A: = (( ) ( ) ( ) ( ) ( ) ) 1/2 = 20.0%. T-bills = 0.0%. A = 20.0%. B = 13.4%.

58 Portfolio Risk and Return Assume a two-stock portfolio with $50,000 in and $50,000 in B. Calculate ^ r p and p.

59 Portfolio Risk Economy Prob. A B Port. Recession % 28.0% 3.0% Below avg Average Above avg Boom

60 Risk rp = (3.0%) (6.4%) (10.0%) (12.5%) (15.0%)0.10 = 9.6% p = (( ) ( ) ( ) ( ) ( ) ) 1/2 = 3.3%. p is much lower than: either stock (20% and 13.4%). average of A and B (16.7%). The portfolio provides average return but much lower risk. The key here is negative correlation.

61 p (%) 35 Risk Company Specific (Diversifiable) Risk Stand-Alone Risk, s p 20 0 Market Risk/Systematic ,000+ # Stocks in Portfolio

62 Measuring Systematic Risk Market risk, which is relevant for stocks held in well-diversified portfolios, is defined as the contribution of a security to the overall riskiness of the portfolio. It is measured by a stock s beta coefficient. For stock i, its beta is: b i = ( im i ) / M

63 Estimating Beta Run a regression with returns on the stock in question plotted on the Y axis and returns on the market portfolio plotted on the X axis. The slope of the regression line, which measures relative volatility, is defined as the stock s beta coefficient, or b.

64 Security Required Return Expected return Risk, b A 17.4% 1.29 Market T-bills B

65 Required return The Security Market Line (SML) is part of the Capital Asset Pricing Model (CAPM). SML: k i = k RF + (k M - k RF )b i. Assume k RF = 8%; k M ^ = k M = 15%. RP M = k M - k RF = 15% - 8% = 7%.

66 Expected versus Required Returns ^ k k A 17.4% 17.0% Undervalued Market Fairly valued T-bills Fairly valued B Overvalued

67 Financial Asset Valuation n k... Value CF 1 CF 2 CF n PV = CF 1+ k CF k 1 2 n CF 1+k n.

68 Bond Valuation Par Coupon Maturity Call Feature Convertible Put Bond Sinking Fund

69 What s the value of a 10-year, 10% coupon bond if k d = 10%? 10% V =? ,000 V B $100 $1, $ k d k d 1+ kd = $ $ $ = $1,000.

70 Bond Price if Required Return k = 13%? INPUTS OUTPUT N I/YR PV PMT FV When k d rises, above the coupon rate, the bond s value falls below par, so it sells at a discount.

71 What s yield to maturity? YTM is the rate of return earned on a bond held to maturity. Also called promised yield.

72 YTM on a 10-year, 9% annual coupon bond, that sells for $887? k d =? ,000 PV 1... PV 10 PV M 887 Find k d that works!

73 V B Find YTM INT... INT N + 1 k d 1+ k d M k d N k , + 1+k d 1 k d d INPUTS OUTPUT N I/YR PV PMT FV 10.91

74 Bond Ratings Investment Grade Junk Bonds Moody s Aaa Aa A Baa Ba B Caa C S&P AAA AA A BBB BB B CCC D

75 P D k D k D k D k s s s s Stock Value = PV of Dividends

76 Constant growth stock D D g D D g D D g t t t P D g k g D k g s s

77 Using the Stock Price Multiples to Estimate Stock Price Analysts often use the P/E multiple (the price per share divided by the earnings per share) or the P/CF multiple (price per share divided by cash flow per share, which is the earnings per share plus the dividends per share) to value stocks. Example: Estimate the average P/E ratio of comparable firms. This is the P/E multiple. Multiply this average P/E ratio by the expected earnings of the company to estimate its stock price.

78 Using Entity Multiples The entity value (V) is: the market value of equity (# shares of stock multiplied by the price per share) plus the value of debt. Pick a measure, such as EBITDA, Sales, Customers, Eyeballs, etc. Calculate the average entity ratio for a sample of comparable firms. For example, V/EBITDA V/Customers

79 Problems with Multiples It is often hard to find comparable firms. The average ratio for the sample of comparable firms often has a wide range. For example, the average P/E ratio might be 20, but the range could be from 10 to 50. How do you know whether your firm should be compared to the low, average, or high performers?

80 Efficient Market Securities are normally in equilibrium and are fairly priced. One cannot beat the market except through good luck or inside information. (More )

81 1. Weak-form EMH: Can t profit by looking at past trends. A recent decline is no reason to think stocks will go up (or down) in the future. Evidence supports weak-form EMH, but technical analysis is still used.

82 2. Semistrong-form EMH: All publicly available information is reflected in stock prices, so it doesn t pay to pore over annual reports looking for undervalued stocks. Largely true.

83 3. Strong-form EMH: All information, even inside information, is embedded in stock prices. Not true--insiders can gain by trading on the basis of insider information, but that s illegal.

84 Preferred Stock The dividend stream would be a perpetuity k s =13% PMT $2.00 P 0 = = = $ k 0.13 ^

85 Valuation:Equity &Firm Free Cash Flow to Equity (FCFE) = Net Income- Reinvestment Needs (Debt Repaid-New Debt Issued) The above needs to be discounted at Cost of Equity

86 Valuation:Equity &Firm Free Cash Flow to Firm (FCFF) = Net Income- Reinvestment Needs =EBIT(1-Tax Rate)-(Capital Expenditure-Depreciation) -Change in Non Cash Working Capital The above needs to be discounted at Cost of Capital (WACC)

87 Valuation:Equity &Firm Terminal Value Growing Perpetuity TV=CF(1+g)/k-g 2. Stable Perpetuity TV=CF/K 3.Multiple of Book Value 4.Multiple of Earnings 5.Liquidation

88 Cost of Capital Capital Components Debt Preferred Common Equity WACC= w d k d (1 - T) + w ps k ps + w ce k s.

89 Cost of Capital Firm s capital structure has 50% debt and 50% Equity Firm s Cost of debt = 6% and cost of equity = 14% Firms finds an investment opportunity with a rate of return = 9% and required investment of $1m. Firms decides to finance with debt - ACCEPT Firm subsequently finds another opportunity with return =12% and required investment = $1m To maintain the capital structure, firm considers equity for financing the project REJECT End Result Rejecting a higher return project Can Avoid this if use WACC=10%

90 Cost of Capital: Notes 1. After Tax Costs 2. Marginal Cost 3. Project Beta 4. Market based Ratio 5. Target Ratio

91 , i =? ,000 INPUTS OUTPUT N I/YR PV PMT FV 5.0% x 2 = r d = 10%

92 Component Cost of Debt Interest is tax deductible, so the after tax (AT) cost of debt is: r d AT = r d BT (1 - T) Use nominal rate. = 10%(1-0.40) = 6%. Flotation costs small, so ignore.

93 What s the cost of preferred stock? P P = $113.10; 10%Q; Par = $100; Use this formula: r ps D P ps n F = $ $100 $ $2.00 $10 $ %.

94 Picture of Preferred r ps =? $ D r Q Per $2.50 r Per. $2.50 r Per 2.25%; r ps ( Nom) 2.25%(4) $ %.

95 Note: Flotation costs for preferred are significant, so are reflected. Use net price. Preferred dividends are not deductible, so no tax adjustment. Just r ps. Nominal r ps is used.

96 What are the two ways that companies can raise common equity? Directly, by issuing new shares of common stock. Indirectly, by reinvesting earnings that are not paid out as dividends (i.e., retaining earnings).

97 Cost of Retained Earnings Earnings can be reinvested or paid out as dividends. Investors could buy other securities, earn a return. Thus, there is an opportunity cost if earnings are reinvested.

98 Cost of Retained Earnings 1. CAPM: r s = r RF + (r M - r RF )b = r RF + (RP M )b. 2. DCF: r s = D 1 /P 0 + g. 3. Own-Bond-Yield-Plus-Risk Premium: r s = r d + Bond RP.

99 Cost of Retained Earnings r s = r RF + (r M - r RF )b. = 7.0% + (6.0%)1.2 = 14.2%.

100 Cost of Retained Earnings r s D1 D0 1 g g P0 P0 $ $ g %.

101 Weights If you don t know the targets, it is better to estimate the weights using current market values than current book values. If you don t know the market value of debt, then it is usually reasonable to use the book values of debt, especially if the debt is short-term. (More...)

102 Weights Suppose the stock price is $50, there are 3 million shares of stock, the firm has $25 million of preferred stock, and $75 million of debt. (More...)

103 V ce = $50 (3 million) = $150 million. V ps = $25 million. V d = $75 million. Total value = $150 + $25 + $75 = $250 million. w ce = $150/$250 = 0.6 w ps = $25/$250 = 0.1 w d = $75/$250 = 0.3

104 WACC WACC = w d r d (1 - T) + w ps r ps + w ce r s = 0.3(10%)(0.6) + 0.1(9%) + 0.6(14%) = 1.8% + 0.9% + 8.4% = 11.1%.

105 WACC of Large Corporations Company WACC w d Intel (INTC) % Dell Computer (DELL % BellSouth (BLS) % Wal-Mart (WMT) % Walt Disney (DIS) % Coca-Cola (KO) % H.J. Heinz (HNZ) % Georgia-Pacific (GP) %

106 Factors affecting WACC Market conditions, especially interest rates and tax rates. The firm s capital structure and dividend policy. The firm s investment policy. Firms with riskier projects generally have a higher WACC.

107 Hurdle Rate The composite WACC reflects the risk of an average project undertaken by the firm. Different divisions may have different risks. The division s WACC should be adjusted to reflect the division s risk and capital structure.

108 Capital Budgeting:IRR Capital Budgeting: IRR Incremental After tax Cash Flows Normal versus Non Normal Independent versus mutually exclusive projects

109 Capital Budgeting:IRR Capital Budgeting CF 0 CF 1 CF 2 CF 3 Cost Inflows Payback Period Discounted Payback

110 Capital Budgeting:IRR Capital Budgeting: IRR CF 0 CF 1 CF 2 CF 3 Cost Inflows IRR is the discount rate that forces PV inflows = cost. This is the same as forcing NPV = 0.

111 Capital Budgeting 1. Estimate CFs (inflows & outflows). 2. Assess Riskiness of CFs. 3. Determine k = WACC for project. 4. Find NPV=PV of all cash flows

112 Capital Budgeting Year Project S Project L 0 (100) (100)

113 Project L: What s Project L s NPV? % = NPV L NPV S = $19.98.

114 What s Project L s IRR? IRR =? PV PV 2 PV 3 0 = NPV Enter CFs in CFLO, then press IRR: IRR L = 18.13%. IRR S = 23.56%.

115 Construct NPV Profiles Enter CFs in CFLO and find NPV L and NPV S at different discount rates: k NPV L (4) NPV S

116 NPV ($) 60 k 0 NPV L 50 NPV S Crossover Point = 8.7% (4) S 10 L IRR S = 23.6% IRR L = 18.1% Discount Rate (%)

117 NPV versus IRR NPV assumes reinvestment rate of WACC IRR assumes reinvestment at IRR. Reinvestment at opportunity cost, WACC, is more realistic, so NPV method is best. NPV should be used to choose between mutually exclusive projects.

118 MIRR Yes, MIRR is the discount rate which causes the PV of a project s terminal value (TV) to equal the PV of costs. TV is found by compounding inflows at WACC. Thus, MIRR assumes cash inflows are reinvested at WACC

119 MIRR for Project L (k = 10%) % PV outflows MIRR = 16.5% $100 = 10% $158.1 (1+MIRR L ) 3 MIRR L = 16.5% 10% TV inflows

120 Real Option DCF approach fails to capture all the options or managerial Flexibilities that has considerable impact on valuations. Examples: Waiting to Invest Option Growth Options Flexibility Options Exit Options Learning options Staged Investment

CHAPTER 9 The Cost of Capital

9-1 9-2 CHAPTER 9 The Cost of Capital Cost of Capital Components Debt Preferred Common Equity WACC What types of long-term capital do firms use? Long-term debt Preferred stock Common equity Capital components