Corporate Finance. EduPristine PGCFR. EduPristine

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1 Corporate Finance EduPristine

2 Agenda Reading 1: Capital Budgeting Reading 2: Cost of Capital Reading 3: Measures of Leverage Reading 4: Dividend and Share Repurchases Reading 5: Working Capital Management Reading 6: Corporate Governance 1

3 Capital Budgeting 2

4 Coverage of the topic Capital Budgeting 1. Meaning and process of capital budgeting 2. Types of Projects 3. Basic Principles 4. Techniques of capital budgeting 5. Other Concepts a) Projects with unequal life b) Capital Rationing c) NPV & stock price 3

5 Meaning of Capital Projects Capital project Project involving huge sum of money outflow to purchase a capital asset (Long-term asset for use) Typical cash flow pattern Outflow at To followed by a stream of Cash Inflows Different e.g. of Capital Projects 1. Replacementprojects: replacing old equipment with new one (cash flows can be predicted with more certainty) 2. Expansionprojects: expanding current production capacity (comparatively requires more analysis to determine the cash flows) 3. New Product or services: introducing new product or service (more rigorous analysis is required to find out cash flows, carries more risks) 4. Regulatory, safety and environmental: Required by government or some external party. May generate no revenue. 5. Other projects: Risky projects difficult to analyze by usual method (R&D) or pet projects of someone in the company (CEO buying a private jet) 4

6 Meaning and process of capital budgeting Capital Budgeting Refers to planning for proposed capital outlays and financing of these outlays Evaluating Projects for which cash flows will be received over a period longer than a year Decision should be consistent with the goal of maximizing shareholder value Has following 4 administrative stages: Idea generation: which all are the projects where a company can invest money (Most important) Analyzing project proposals: finding cash flows, risks etc. of the project (Most time consuming) Creating firm wide capital budgets: analyze whether to take the projects now or at later stage etc. Monitoring and Post-Audit: again reviewing the cash flows, risks etc. of the shortlisted projects 5

7 Basic principles of capital budgeting 1. Evaluation of decisions is based on cash flows, not accounting income 2. Cash flows are analyzed on an after-tax basis because shareholders get benefit from profit after tax only Cash flows After Tax is NOT EQUAL to Net Income. (PAT from Income Statement) 3. Evaluation is based on Incremental Cash Flows Difference between the cash flows with project & cash flows without the project under consideration. This cash flows should be taken for analysis & not the total cash flows 4. Timing of cash flows affects decisions because of time value of money Earlier cash flows are more valuable than future cash flows 5. A project must earn equal to or more than its opportunity Cost to be accepted (like a benchmark) Opportunity Costs is the profit that would have earned through the next best project) E.g. :Investment in Stocks Vs. Interest income in an FD 6

8 Basic principles of capital budgeting (Contd.) 6. Sunk Costs do not play any role in Capital Budgeting It is the cost which cannot be recovered (whether the project is selected or not) E.g.: money paid to market research firm for determining demand for a new product Purchase price of the old machinery which is now contemplated to be replaced. 7. Externalities MUST be considered while evaluating a project It is the effect of the investment on other aspects besides the investment itself: It can be a negative impact or a Positive Impact Cannibalization:One product of a company eating over the share of another product of the same company Maruti Suzuki s Alto model s sale being impacted due to the launch of A-Star model 8. Financing costs (like interest rate) are not considered as a part of the cash flows because they are already considered in project's hurdle rate (required rate of return) 9. Pattern of Cash Flows a) Conventional Cash flow One initial outflow followed by a series of inflows b) Nonconventional Cash Flows Cash flows can flip from positive to negative after the initial outflow 7

9 Basic principles of capital budgeting (Contd.) 10. Role of Depreciation Depreciation is a non-cash expense hence does not play any active role in determining CF However, since it s a tax deductible expense, it leads to tax saving Reduced tax outflow is deemed to a cash inflow Two approaches to calculate CFAT 1. CFAT = PBDT *(1-T) + Dep x T 2. CFAT = PAT + Dep 11. Gain or Loss on Capital Asset Whenever a capital asset is sold, gain / loss is calculated Gain (or Loss) = Scrap or Sale value -Book Value (on the date of Sale) This capital gain (or loss) is taxable thus results into additional taxes (or tax savings) Net Cash Flow in case of: 1. Gain = Sale Value additional taxes 2. Loss = Sale value + Tax Savings (deemed inflow) 8

10 Basic principles of capital budgeting (Contd.) 12. Working Capital Adjustment In case a new capital asset is purchased, there is a change warranted in the operational or working capital requirement also. E.g. A bigger machinery will Need more stock of Raw material Additional Raw Material Will have more WIP at any point in time -Additional WIP Will produce more finished output - Additional finished goods Overall, more investments will have to be made in the Working capital Adjustments required are: 1. Treat the ADDITIONAL working capital as cash out flow at To (as part of the initial cash flow) 2. Treat the same amount as cash inflow at the end of the project (as part of the terminal value) 9

11 Different Types of Project 1. Mutually Exclusive Projects Projects out of which only one can be selected Acceptance of one would imply rejection of the other Compete directly with each other a) Either old machinery can be repaired or can be replaced by a new machinery b) Purchase of a laptop Either Dell or HP 2. Independent Projects Projects which can be selected irrespective of the other project Acceptance of one DOES NOT mean rejection of the other DO NOT Compete directly with each other a) Entering a new market South Africa and Egypt BOTH can be done at the same time b) Purchase of CDs Moser Baer and Sony BOTH can be done at the same time 10

12 Techniques of Capital Budgeting The methods which are used to evaluate the project based on its cash flows are known as techniques of capital budgeting There are five main techniques of capital budgeting 1. Average Accounting Rate of Return (ARR) 2. Payback Period (PBP) 3. Net Present value (NPV) 4. Profitability Index (PI) 5. Internal Rate of Return (IRR) Each technique has a different mathematical construct to evaluate the project, each will have its own limitations and advantages vis-à-vis other techniques Due to difference in basic construct, the evaluation result may be DIFFERENT 11

13 Tech 1 -Average Accounting Rate of Return (ARR) ARR is average (accrual) return earned from the project during its life Return is expressed as % of the average investment during the project life AAR= Average Average net income book value Decision Criteria: Accept the project if the ARR is more than the benchmark rate Example ABC Limited Limitations Cash flows are not considered Time Value of money ignored Year Net Accounting Income 1 (49,000) 2 104, , ,000 Initial Investment 4,00,000 Salvage Value after 4 years is 20,000 12

14 Solution: Average NI =(-49, , , ,000) / 4 = 58,250 Average Book Value=(400, ,000) / 2 = 210,000 AAR =27.74% 13

15 Tech 2 Payback Period (PBP) It is the time period taken to recover the initial cost of an investment Decision Criteria: Shorter the PBP, better the project is It is more widely used in industries where the lifecycle of the project is very short Used when investor is more interested in capital preservation rather than earning interest Limitations Cash flows post the PBP are not considered Time Value of money ignored Example Project A Project B Year CFAT Year CFAT 1 1, , , ,500 Initial Investment - 3,000 PBP?? 14

16 Tech 2 improved Discounted PBP The discounted payback method uses the present value of the project's estimated cash flows It is the number of years it takes a project to recover its initial investment in present value terms It is always greater than the payback period without discounting Example Project A Project B Year CFAT Year CFAT 1 1, , , ,500 Initial Investment - 3,000 DPBP?? Cost of capital is 12% 15

17 Solution: Answer for example on Payback Period (PBP) and Discounted PBP 16

18 Tech 3 Net Present Value As the name suggest, it is the NET difference between the present value of Cash inflows and present value of cash outflows discounted at the required rate of return. NPV = PVCI PVCO As a conventional pattern of cash flow, PVCI can be expressed as: PVCI Where CF1 = (1+ k) CF2 + (1+ k) CF t = after tax cash flow at time t 1 k =required rate of return for project 2 CFn (1+ k) n = n t= 0 (1+ CFt k) t Decision criteria IF. NPV > 0 NPV < 0 NPV = 0 The project may be accepted. The project should be rejected. DECISION The Company is indifferent in accepting or rejecting the project. The project does not add any value to shareholder. 17

19 Example 1 Project A Project B Year CFAT Year CFAT 1 12, , , , , , , , , ,000 Cash Flows 84,000 84,000 Initial Investment 60,000 After tax Cost of Capital is 10% NPV?? 18

20 Example 2 Choosing the correct rate of discount is crucial for effective project evaluation process Project C Year CFAT 1 10, , , , ,500 Initial Investment 48,000 WACC is 6%, NPV WACC is 10%, NPV 19

21 Solution: Answer 1: NPV Project A Project B 1, , Answer 2: After Tax Cost of Capital NPV 6% % (4,605.67) 20

22 Tech 4 Profitability Index (PI) PI is the INDEXED return earned by the project over its Initial cash outflow PI is the present value of a project's future cash flows divided by the initial cash outlay. Decision criteria; If PI > 1.0, accept the project If PI < 1.0, reject the project PVof future cashflows PI = = 1+ CF 0 If NPV is >0, PI >1 If NPV is <0, PI <1 NPV CF 0 Example Project A Project B Year CFAT PV Year CFAT PV 1 1,500 1, ,200 1, ,200 1, ,500 1,188 Initial Investment - 3,000 PI 21

23 Solution: Project A Project B Year CFAT PV Year CFAT PV 1 1,500 1, ,200 1, ,200 1, ,500 1,188 Initial Investment - 3,000 PI =3714/ =3563/

24 Tech 5 Internal Rate of Return It is the annualized effective compounded rate or return that can be earned on the capital invested It is the MWR (Discounted Cash Flow Application) Mathematically, IRR is the discount rate that makes the present value of the expected incremental aftertax cash inflows just equal to the initial cost of the project In equation form, this is expressed as: PV (Cash Inflow) = PV (Cash Outflow) CF CF NPV = = ( CF0 ) (1+ IRR) (1+ IRR) 2 CFn (1+ IRR) n Decision Criteria: If IRR > the required rate of return, accept the project If IRR < the required rate of return, reject the project 23

25 Example 3 Project A Project B Year CFAT Year CFAT 1 12, , , , , , , , , ,000 Cash Flows 84,000 84,000 Initial Investment 60,000 NPV?? IRR?? 24

26 Solution: Project A Project B NPV 1, , IRR 11.06% 14.01% 25

27 NPV Profile NPV Profile is the graph that shows a project s NPV as a function of various discount rates. NPV on Y-axis and Discount Rate on X-axis. The discount rate where NPV is 0 is the IRR When discount rate = 0, NPV reflects the undiscounted difference between Inflows and outflows NPV A B A preferred over B Crossover Rate B preferred over A IRR of B A s cash inflows are farther from To compared to B s cash inflows. As a result, the impact of rate hike is more prominent in case of A s NPV compared to B s NPV IRR of A Rate A is preferable B is preferable 26

28 IRR vs NPV For conventional projects, the NPV and IRR will agree on whether to invest or not to invest. NPV and IRR may give conflicting results for different project sizes: Choose NPV Limitations of IRR Size effect ignored by IRR Multiple IRR or No IRR problem IRR assumes yearly returns are invested at the IRR which may not be possible most of the times 27

29 Preference of Capital Budgeting Methods 1. Financial textbooks preach the superiority of the NPV and IRR methods. 2. In Europe, Pay Back Period is used more often than IRR and NPV. 3. Larger companies prefer to use the NPV, IRR methods 4. Private corporations used the payback period more frequently than public corporations 5. Companies managed by MBA s had stronger preferences for discounted cash flow techniques (NPV and IRR methods) 28

30 Other Concepts - Projects with Unequal lives When the options that are being evaluated are of different tenure (project life), we need to make an adjustment The objective of this adjustment is to make like-to-like comparison between both the projects removing the impact of unequal lives. Methods that can be used: A. Least common multiple of lives approach Example: Project Eagle of 6 years and Project Bird of 3 years. Since LCM of both the projects complete duration is 6, calculate NPV/IRR from Project Eagle as usual and for Project Bird assume the project restarts at the end of 3rd year. So in effect Project Bird will have to be repeated twice for a like to like comparison with Project Eagle B. Equivalent Annual Annuity Approach Simpler approach Step 1: It basically calculates the sequence of annual payments (annuities) that is equal to the project s NPV. Step 2: The project which has higher annuity is selected 29

31 Other Concepts NPV and Share Price NPV is the addition to shareholders wealth (at To)by taking an action and discounting its CFs using WACC Wealth of the shareholders is measured by the share price Therefore by Fundamental Analysis, NPV is addition in the Market capitalization at To The value of the company is the value of existing investments plus the NPV of all future investments. If a project has an NPV of $250 Mn and the current value of the company is $5,000 Mn (100 Mn outstanding shares), the total market cap will increase by $250 Mn. Share price should increase by $2.5 ($250 Mn divided by 100Mn) New share price will be $50 + $2.5 = $52.5 Because of speculations and other forces prevailing in the capital market, the above relation might not hold true at all time 30 30

32 Other Concepts Capital rationing Firms/Companies have fixed amount of capital to allocate amongst capital projects Capital rationing is the allocation of this fixed amount of capital among the set of available projects such that the selection will maximize shareholder s wealth Project s with negative NPVs are to be discarded irrespective of availability of capital 1. Hard capital rationing funds allocated to the manager of capital project cannot be increased 2. Soft capital rationing manager of capital project is allowed to increase allocated capital budget provided they can justify to senior management of creating shareholder value on that additional capital Profitability Index is used to rank projects on the basis of their relative returns 31 31

33 Practice Question Venture Ltd. has Rs. 30 Lacs available for investment in capital projects. It has the option of making investment in projects 1, 2, 3 and 4. Each project is entirely independent and has a useful life of 5 years. The expected present value of cash flows from the projects is as follows: Projects Initial Outlay Present value of cash Inflows 1 8,00,000 10,00, , 00,000 19, 00, , 00,000 11, 40, , 00,000 20, 00,000 Which of the above investment should be undertaken? Assume that the cost of capital is 12% and risk free interest rate is 10% p.a. Given compounded sum of Re. 1 at 10% in 5 years is Rs and discount factor of Re. 1 at 12% rate for 5 years is o

34 Other Concepts Project Sequencing Project Sequencing Sequenced through time so that investing in a project creates the option to invest in future projects. Example: A chemical company can first select a project of establishing the chemical plant & then to use the excess heat of chemicals it can establish a chemical power plant 33

35 Question Set 1 1. Which of the following is least accurate about discounted payback period? A. It ignores terminal value B. It is shorter than regular payback period C. It is the time taken by the present value of cash flows to equal the initial investment 2. Which of the following statements is least accurate? A. If NPV for a project is negative then its IRR can be positive. B. Cash flows in capital budgeting should include opportunity costs. C. Discounted payback period is smaller than normal payback period. 3. A company X bought a machinery for $100 and expects to give the following cash inflow: Year 1: 50, Year 2: 40, Year 3: 10, Year 4: 15 The Required rate of return is 4%. Calculate the Payback Period and Discounted Payback Period. A. 3 and 3.47 B and 3 C. 3 and 4 34

36 Question Set 1 (Contd.) 4. If a four-year project having payback period of 2.5 years then A. IRR will be higher than the cost of capital B. NPV will be positive C. None of the above 5. Sigma Tech has a net worth of $4 million and Global Inc has a net worth of $500 million. Which of the following methods of capital budgeting is most likely to be used by these companies? A. Sigma should use the NPV method B. Global should use the discounted payback method C. Sigma should follow the discounted payback method 35

37 Solutions (Q.Set1) 1. Solution: B It is shorter than regular payback period 2. Solution: C If the cost of capital >IRR then NPV can be negative whatever is the value of IRR. Cash flows should include opportunity costs. Discounted payback period is larger than normal payback period because future cash flows are discounted and their PV is less than undiscounted value. 3. The correct answer is 3 and The correct answer is C. 5. Solution: C Sigma is a smaller company as compared to Global, hence is more likely to follow the discounted payback method. 36

38 Question Set 2 1. In the capital budgeting process, three of the major steps are: A. Analyze the project proposal, create firm wide capital budget and monitor decisions. B. Analyze the project proposal, raise capital and monitor project performance. C. Analyze the project proposal, create firm wide capital budget and raise capital 2. Which of the following costs is least likely to be used in capital budgeting analysis? A. Fees paid to a marketing research firm to estimate the demand for a new product prior to a decision on the project. B. Cannibalization of its existing product market due to the launch of another product by a firm. C. The tax saving affect of depreciation cost. 3. Which of the following is true about Cannibalization: A. It s a positive externality B. It s a negative externality C. It s not an externality 37

39 Question Set 2 (Contd.) 4. With regards to capital budgeting, an appropriate estimate of the incremental cash flows from a project is least likely to include: A. Interest Costs B. Externalities C. Opportunity Costs 5. The effects that the acceptance of a project may have on firm s other cash flows is known as: A. Opportunity Cost B. Externalities C. Sunk Cost 38

40 Solutions (Q.Set2) 1. Solution: A Capital budgeting has 4 steps. In none of the steps capital is raised in capital budgeting process. 2. Solution: A Fees paid to a marketing research firm to estimate the demand for a new product prior to a decision on the project is a sunk cost and should not be included in the capital budgeting analysis. 3. The correct answer is It s a negative externality. 4. The correct answer is Interest Costs. 5. Solution: B Opportunity Cost: Cash flows that a firm will lose by undertaking the project Sunk Cost: Costs that cannot be avoided, even if the project is not undertaken 39

41 Question Set 3 1. Calculate the NPV, IRR of the Hisar Project A. 5,882.79, 10.64% B , 20.64% C , 10.64% Zentec Limited - Hisar project (in Lacs) Year CFAT 1 3, , ,000 Initial Investment 5,000 After tax Cost of Capital is 10% 2. A company is considering two projects A and B which are mutually exclusive. The cross over rate in the NPV profile of both the projects is 8.5%. If internal rate of return (IRR) for project A and B is 13% and 15% respectively then which of the following statements is correct? A. At required rate of return of 10% only project A should be accepted. B. At required rate of return of 10% both projects should be accepted. C. At the required rate of return of 8% only project A should be accepted 40

42 Question Set 3 (Contd.) 3. During capital budgeting cannibalization effect of an existing product line due to the launch of a new product is an example of: A. Externalities B. Sunk Costs C. Opportunity Costs 4. Sigma Corporation is planning to launch a new product in the market for which it has paid Xylus Consultants a fee of $4000 to do a market survey to gauge the demand for the product. The new product is expected to cause a 5% decline in the market share of its existing brands. Also the facilities for the manufacturing of the project could earn a lease rent of $1500 per month, if the project were not to be undertaken. Which of the following regarding the project cash flow is least likely true? A. The cash flows should not take into account the consultants fee B. The loss in lease rent is relevant to the decision making C. The loss of sale of existing product is irrelevant to the decision making 41

43 Solutions (Q.Set3) 1. B , 20.64% 2. C. Since both the projects are mutually exclusive hence only one of them can be accepted. For required rate of return > 8.5 %( but less than 15%) project B should be accepted For required rate of return < 8.5% project A should be accepted. 3. A. Externalities are the effects the acceptance of a project may have on other cash flows of the firm. An example of negative externality is cannibalization effect of an existing product line due to the launch of a new product. 4. C. The cost of cannibalisation should be considered in the incremental cash flows 42

44 Cost of Capital 43

45 Coverage of the topic -Cost of Capital 1. Context for Cost of Capital 2. Different Components of Capital 3. Cost of individual Components of Capital 4. Weighted average cost of capital (WACC) 5. Marginal cost of capital (MCC) 6. Other Topics A. Calculating βeta for the project B. Country equity risk premium (CRP) C. Treatment of floatation costs 44

46 Context for cost of capital Three main decision to be taken by a Finance Manager Financing Decision: How to raise most optimum finance Investment Decision: How to make most optimum investments Dividend Decision: How to distribute profits in the most optimum manner Common Objective: To maximize Shareholders wealth Financing and Investing decisions are independent: there is no one to one relationship between every action of both decisions In evaluating investing decisions, there is need for an opportunity cost against which the returns from the project/ asset can be comparedwith This opportunity cost is genesis of Cost of Capital 45

47 Cost of Capital - Meaning Different ways to understand the meaning of cost of capital: 1. The rate of return that the suppliers of capital, bondholders and owners, require as a compensation for their contribution of capital 2. The cost to finance assets of the firm 3. The minimum rate which the assets of the firm must earn to add to shareholders wealth 4. The opportunity cost which is used as a benchmark to evaluate capital projects 5. WACC reflects the average risk of projects that make up the firm 46

48 Different Components of Capital Three main components of capital Equity share (Common equity) Preference Share (preferred Stock) Debt (Bank loan, Debenture or Bonds) Source of capital Amount of return Certainty of payment Equity Not certain Not certain Preference Certain Not certain Debt Certain Certain Investor s risk 47

49 Cost of debt capital (Kd) A. Company perspective Interest rate at which firms can issue new debt (Kd) (This is generally used for perpetual debt) Interest Expense K d = Market Price of Debt B. Investor s perspective: Investor s YTM on existing debt (Most preferred) The Yield to Maturity (YTM) is the annual return that an investor earns on a bond if the investor purchases the bond now and holds it until maturity. YTM is the IRR from point of view of the investor YTM is to be used for calculation purposes and not coupon rate C. Alternate perspective: Debt Rating Approach To be used only when current market price of debt is uncertain and can not be used to estimate YTM Compare the ratings and maturity of the debt to arrive at Kd (Matrix pricing) Impact of taxes Interest expense on debt capital is an allowable expenditure for tax purposes >> results into tax savings After-tax cost of debt = interest rate -tax savings = Kd -Kd(t) = Kd(1 -t) 48

50 Issues in Estimating the Cost of Debt 1. Fixed Rate Debt vs. Floating Rate Debt Estimating the cost of a floating rate security is difficult because the rate of interest is fluctuating over the life of the debt it depends not only on the current yields but also on future yields. The analyst may use the current term structure of interest rates and term structure theory to assign an average cost to such instruments 2. Debt with Embedded Options Problem in valuing bonds with call, conversion or put options. Options affect the value of debt a) Callable bonds have higher yields than similar non-callable bonds b) Putable bonds have lower yields than similar non-putable bonds. Analysts may use the YTM method if future bonds to be issued with embedded options are similar to bonds already traded in the market. Else, the YTM can be adjusted to reflect the embedded options. 49

51 Issues in Estimating the Cost of Debt (Contd.) 3. Non-rated Debt If the company does not have any outstanding debt or the company does not have rated bonds then yields on the existing debt is not available (YTM model fails) In such case: Researchers arrive at a synthetic debt rating based on financial ratios. Not accurate since information about the particular bond issue are not captured by the synthetic rating. 50

52 Cost of non-callable, nonconvertible preferred stock (Kps) A. Company perspective It is the cost that a company has committed to pay preferred stockholders as a preferred dividend when it issues preferred stock (Kp) Preferred Dividends K ps = Market Price of Preferred Stock B. Investor s perspective: Investor s YTM on existing Preferred Stock (Only for Comparison purpose) The Yield to Maturity (YTM) is the annual return that an investor earns on a Preference share if the investor purchases the share now and holds it until maturity. YTM is the IRR from point of view of the investor YTM is to be used for calculation purposes and not coupon rate of dividend Impact of taxes Preference Dividend is NOT an allowable expenditure for tax purposes >> DOES NOT result into tax savings 51

53 Cost of equity capital (Ke) Ke can be calculated by three Approaches: 1. Capital asset pricing model (CAPM) 2. Dividend discount model (DDM) 3. Bond yield plus risk premium Answer will be different by all three approaches Impact of taxes Common Dividend is NOT an allowable expenditure for tax purposes >> DOES NOT result into tax savings 52

54 1. Capital asset pricing model (CAPM) Where: R e f [ E( R R ] = R + β ) b is the returns sensitivity of stock returns to changes in the market return E(R m ) is the expected return on the market (index) E(R m ) R f is the expected market risk premium (compensation for extra risk taken) m f Beta: is the measure of systematic risk Beta = Covariance (Equity & Market) Variance (Market) = Coefficient of Correlation X Std deviation (Equity) Std deviation (Market) Important points 1. Historical Equity Risk Premium: Equity risk premium observed over a long period of time is a good indicator of the expected equity risk premium. 2. Limitations: The level of risk of the stock index may change over time The risk aversion of investors may change over time Estimates are sensitive to the method of estimation and the historical period covered. 53

55 2. Dividend discount model (DDM) Where: R e D 1 = P +G 0 D1 : is the dividend expected after one year Po is the market price of the common share today G = sustained (constant) growth expected in dividends G = (retention rate) x (return on equity) = (1-payout rate) x (RoE) 54

56 3. Bond yield plus risk premium R e Analysts often use an ad hoc approach to estimate the required rate of return on equity This is done by adding a risk premium (3-5% -for investing in equity compared to debt) to market yield on the same firm s long term-debt Example: Bond MF v/s Equity MF = bond yield+ Equity risk premium Note: Bond yield is before tax (if after tax cost of firm is given, convert it to before tax) 55

57 Calculating Weighted Average of Cost of Capital Cost Weight age Debt K d W d Preferred Stock K ps W ps Equity Stock K e W e WACC = Wd* Kd (1-t) + Wps* Kps + We* Ke 56

58 Methods of Calculating Weights used in WACC Preference of weights should be: 1. Market values of Target Capital Structure 2. Market Values of the Current Capital structure 3. Industry averages as the target capital structure 4. Book Values of the Current Capital structure The weights used in the WACC should be adjusted for 1. Historical trends 2. Any announcement by the company to alter its capital structure 57

59 Marginal Cost of Capital - Coverage 1. Basic Explanation 2. Optimal Capital Budget 3. Break points 4. MCC Schedule` 58

60 Marginal Cost of Capital - Basic Meaning MCC is the cost of incremental capital raised by the firm In other words, what it would cost to raise additional funds for the potential investment project. Let us identify the difference between WACC and MCC A company wants to raise capital for an expansion plan for setting up new factory. Although the existing debt is at 12%, any additional debt can be raised at 14%. New shares will involve an issue cost of Rs. 2.5 per share. Particulars S 1 S 2 S 3 S 4 S 5 Marks obtained Calculate Average and Marginal Marks of the studentss 59

61 Optimal Capital Budget The Optimal Capital Budgetis that amount of capital raised and invested at which the marginal cost of capital is equal to the marginal return of investing (Similar to MC = MR in Economics) 1. Investment Opportunity Schedule Returns to a company s investment opportunities are generally believed to decrease as the company makes additional investments as represented by the Investment Opportunity Schedule. 2. Marginal Cost of Capital: As the firm raises more capital - the cost of capital increases: A. Cost of debt rises to account for the additional financial risk and B. Cost of new equity is higher than retained earnings due to floatation costs. Project IRR Cost of Capital% Investment Opportunity Schedule Marginal Cost of Capital Optimal Capital Budget New Capital raised($) 60

62 Break Points Break points occur when the cost of any one of the components of a company's cost of capital changes. Break Point = Amount of capital Weight of at which the component' s cost of capital the newcompone nt in the capital structure changes Example: Amount of new Debt (Rs. Cr.) K d (1-t) Amount of new Equity (Rs. Cr.) K e % % % % % % Capital Structure of 60% Equity and 40% Debt 61

63 The Marginal Cost of Capital Schedule MCC schedule depicts the WACC at different levels of additional financing MCC schedule typically has an upward slope because financing cost increase as the requirement for additional financing increases: K d rises as the existing debt may have a covenant that restricts the company from issuing debt with similar seniority as existing debt K e rises as debt increases, there is increased risk for the equity shareholders (financial leverage) WACC Amount of New Capital 62

64 Using WACC (or MCC) in Capital Budgeting If we chose to use the company s WACC as discount rate in the calculation of the NPV of a project, we assume the following: a) The project has the same risk as the average-risk project of the company b) The project will have a constant target capital structure throughout its useful life. Companies may use an ad-hoc or a systematic approach for adjusting the WACC to evaluate new projects with risks different than risk of companies existing projects. 63

65 Other Topics 1. Beta and Cost of Capital for a Project Project: A new venture by an existing company which is in addition to its other businesses Beta(total systematic risk) is a combination of: 1. Operating risk AND 2. Financial risk Risk (and Beta) of a new project can be very different than overall Risk (and Beta) of the firm There is a need to evaluate risks (Beta) specific to the particular project in order to estimate the discount rate (WACC) to evaluate that particular project Since each project is not represented by a publicly traded security, it is difficult to calculate the Project Beta In order to estimate Beta for the Project -Pure Play Method is USED 64

66 Pure-Play Method 1. Identify company/group of companies comparable to the project i.e. engaged ONLY in business similar to that of the new project 2. Un-leverthe beta in step 1 since the benchmark company will have a different financial structure which also impacts Overall asset s Operational risk. (All figures on RHS are for the benchmark company) Beta (Asset) = Beta (Equity) Equity Equity + Debt (I T) 3. Re-Lever:Now once you have adjusted the beta, then again reload the beta with financial risk of company evaluating the project. (All figures on RHS are for the main subject company) Beta (Equity) = Beta (Asset or Project) Equity + Debt (1 T) Equity 65

67 Practice Question on Pure-Play method Acme Inc. is considering a project in the food distribution business. It has a D/E ratio of 2, a marginal tax rate of 40%, and its debt currently has a yield of 14%, Balfor, a publicly traded firm that operates only in the food distribution business, has a marginal tax rate of 30%, a D/E ratio of 1.5 and an equity beta of 0.9. The risk-free rate is 5% and the expected return on the market portfolio is 12%. Calculate Balfor s asset beta, the project s equity beta, and the appropriate WACC to use in evaluating the project. 66

68 Solution: Answer: B % Perez caterers ltd s asset beta = 1.2[1/{1+(1-0.4)(2.5)}] = 0.48 Equity beta for the project = 0.48[1+(1-0.3)(1.5)] = Project cost of equity = (5) = 10.92% Weight of Debt = 3/(3+2) = 3/5 Weight of equity = 2/(3+2) = 2/5 WACC for the project = 2/5(10.92) + 3/5(10)(1-0.3) = = % 67

69 Other important points on Project Beta Calculation of Beta 1. Arriving at a beta for a publically traded company (to be used under Pure Play Method) is easy 2. For companies which are not publically traded, estimating a beta requires making proxy by using the information on the project or company combined with a beta of a publically traded company. Challenges in estimating beta of comparable company s equity 1. Beta is estimated using historical returns. 2. Affected by which index is chosen to represent the market return 3. Adjustment needs to be made for the (believed) tendency of beta to revert towards 1 over time 4. Beta of small-capitalized firms may need to be adjusted upward to reflect risk inherent in small firms that is not captured by usual estimation methods 68

70 Other Topics 2. Country equity risk premium (CRP) Context: β does not adequately capture the country risk of an emerging / developing market We need to add a country risk premium (CRP) to the market risk premium Risk of investing in a developing country is measured by the sovereign yield spread i.e. the difference in yields between the developing country s government bonds (denominated in local currency) and Treasury bonds of similar maturity The above compensates only the bond risk. This is adjusted for the equity market risk by adjusting it for the relative risk of equity markets to the bond markets Ke = Rf + ß [E(Rm) Rf + CRP] CRP= Sovereign yield Annualized Standard Deviation of equity index of developing Country In Developing currency spread Annualized Standard Deviation of sovereign bond market In developed currency Consider Sovereign = Government What is developing is a relative term 69

71 Example Facts of the case: Pakistan s 10 year G Sec Bond Yield = 16% India s 10 year G Sec Bond yield = 10% Annualized SD of Pakistan stock market index = 40% Annualized SD of rupee denominated 10 year Pakistan s G Sec bond= 15% Project Beta = 1.25 E(Rm) = 15% and Rf = 8% Calculate Ke for investing in Pakistan. 70

72 Solution: Country Risk Premium: =(16% -10%)*(40%/15%) = 16% Cost of Equity: = 8% (15% -8% + 16%) = 36.75% 71

73 Other Topics 3. Floatation costs Charges / Fees paid for raising external equity capital This fees is paid to the investment bankers to the issue for their services to help in capital raising Amount of flotation costs Floatation costs for equity can range from 1.5% to 1.8% based on the country of the issue and other factors. For debt and preferred stock: usually below 1% -the floatation costs are not included in the costs since its very low Treatment of Floatation Costs Either Increase the initial cost of the project or (Better Method) Incorporate floatation costs into the cost of capital (Not Preferred) 72

74 Question Facts of the case: Cash Outlay: $4 Million Annual after tax cash flows : $1.5 Million for 4 years Tax rate : 40% Before tax cost of debt: 7.5% MV of Equity: $35 Expected Dividend next year ; $4 Growth rate : 6% Capital Structure is 40:60 (Debt: Equity) Flotation Cost of equity: 4.5% Calculate WACC and NPV. 73

75 Solution Preferable method Out of the $4 Million cash outlay, 60%, that is $2.4 Million is Equity and $1.6 is Debt Adjusting the 4.5% floatation costs to this cast outlay, we have $4M + $2.4*4.5% = $4.108M Using DDM, 35=4/(r e -0.06) => r e = 17.42% Given r d is 7.5% WACC = 0.6*17.42%+0.4*7.5%*(1-0.4) = 12.25% NPV = (1.1225) (1.1225) = Million 1.5 (1.1225) 4 74

76 Questions 1. If Debt Outstanding is 20 Crs Common Equity stock outstanding is 40 Crs Preferred Stock Outstanding is 30 Crs Calculate W d, W ps and W e A. 0.22, 0.33, 0.44 B. 0.33, 0.22, 0.44 C. 0.44, 0.22, K d = 8%, K ps = 9%, K ce = 10.5%, W d = 35%, W ps = 15%, W ce = 50%, Tax rate = 40% Calculate WACC: A. 9.40% B. 8.28% C. 7.74% 75

77 Question 3. A stock whose market price is $60 is expected to declare a dividend of 60%(Face value $10). What is the Cost of Equity if the dividends are projected to grow at a rate of 5%? A. 65% B. 15% C. 5% 4. If the difference between the yields of Govt. bonds in India (developing country) denominated in Rupee and the treasury bonds of USA having same maturity, increases. What will be the effect on the cost of equity of a firm in India. A. Increases B. Decreases C. No Impact 76

78 Solution 1. A. 0.22, 0.33, B. 8.28% Answer A takes before tax cost of debt Answer C takes after tax cost of debt and Preferred stock 3. B. 15% Answer A takes 60% dividend on market price instead of face value Answer C subtracts g instead of adding it to (D 1 /P 0 ) 4. A. Increases There is a positive relation between Sovereign yield risk and CRP 77

79 Measures of Leverage 78

80 Coverage of the topic Measures of Leverage 1. Key terms used in Leverage Analysis 2. Meaning and Need for Leverage 3. Types of Leverage A. Operating Leverage B. Financial Leverage C. Combined Leverage 4. Break even Analysis A. Break even points B. Operating Break even points 79

81 Key terms used in Leverage Analysis Cost Structure of a company is the mix of two types of cost: (in terms of variability) Variable Costs fluctuate in DIRECT PROPORTION with the level of production and sales. Example: Raw materials cost, delivery charges Fixed Costs are expenses which DO NOT FLUCTUATE at all regardless of level of production Example: Rent, wages for salaried employees, interest on debt Fixed costs may further be divided into: Operating Fixed Cost: Related to operational aspects / business model of the company. These are the cost related to the main / incidental activity of the business Financial Fixed Cost: Related to capital structure of the company Among Debt, Equity and Preference share, only DEBT has a fixed cost Interest that needs to be paid irrespective of the profits. 80

82 Key terms used in Leverage Analysis (contd.) Different types of risk (Variability in earnings) 1. Business Risk: risk associated with operating earnings a) Sales Risk a) uncertainty associated with respect to the price and quantity of goods and services b) Even if companies have the same cost structure, differing sales risk affects the potential variability of the company s profitability b) Operating Risk a) risk associated with the operating cost structure, in particular, the use of fixed costs in operations b) The greater the fixed operating costs relative to variable operating costs, the greater the operating risk 2. Financial Risk a) Risk on PAT due to debt on capital structure b) By taking on fixed obligations, such as debt and long term leases, the company increases its financial risk 81

83 Meaning and Need for Leverage A Leveris a simple machine which enhances the input efforts to produce greater output Leverage is the use of fixed costto maximize the impact for a given input 1. Operating Leverage: Use of Operating Fixed Cost to maximize the impact on Operating Profit (EBIT) for a given change in Sales 2. Financial Leverage: Use of Financial Fixed Cost to maximize the impact on PAT for a given change in Operating Profit (EBIT) 3. Combined Leverage: Use of total Fixed Cost to maximize the impact on PAT for a given change in Sales Relation with other variables:high leverage >> High risk >> High Beta >> High Ke >> Greater discount rate that should be used in its valuation. The amount of financial leverage is usually a deliberate choiceby the management of the company whereas amount of operating leverage is driven by prevalent business model in each industry. Businesses with plants, land, equipment that can be used to collateralize borrowings may be able to use more financial leverage than business that don t. 82

84 Effect of Operating Leverage on Operating Profits Facts of the case Company A operates only on variable Cost whereas Company B uses some Fixed Costs (Rs. 100) During 2011 (Base Case) both companies earned Rs. 1,000 as Operating profit which experienced 20% increase during Compare the change in EBIT for both the companies given this 20% increase in Sales. Company A No Fixed Cost Company B With Operational Fixed Cost Base Case 20% incr in Sales Base Case 20% incr in Sales Sales 1,000 1,200 1,000 1,200 Variable Cost 600 (60%) 720 (60%) 500 (50%) 600 (50%) Contribution Fixed Cost (Oper) Operating Income (EBIT)

85 Impact of Leverage Double Edged SWORD (Construct of the Income Statement is important) Operational Financial Combined Sales decrease 10% Base Case Sales increase 10% Sales 1,000 Variable Cost 600 Contribution 400 Fixed Cost (Oper) Operating Income (EBIT) 300 EBIT decrease 10% Base Case EBIT increase 10% Operating Income (EBIT) 300 Fixed Cost (Financial) PBT % 100 PAT 150 No. of Shares EPS

86 Degree of Operating Leverage - Formulae Formula 1 DOL = % change in Operating Income % change in Sales Operating Income = (No of Units Sold) X [(Price per Unit) (Variable Cost per Unit)] [Fixed Operating Costs] Formula 2 DOL = Q( P V ) Q( P V ) F Contribution EBIT Contribution Contribution - F Where Q: No. of units produced P: Price per unit V: Variable price per unit F: Fixed cost in production 85

87 Degree of Financial Leverage - Formulae Formula 1 DFL = % change in Net Income % change in Operating Income Formula 2 DFL = Q( P V ) F Q( P V ) F I EBIT EBT EBIT EBIT - Interest Where Q: No. of units produced P: Price per unit V: Variable price per unit F: Fixed cost in production 86

88 Degree of Combined Leverage - Formulae Formula 1 DCL = DOL * DFL= % changeinnetincome % changeinsales Formula 2 (N r of DOL) DTL = Q( P V ) Q( P V ) F I Contribution EBT Contribution Contribution F I (D r of DFL) Where Q: No. of units produced P: Price per unit V: Variable price per unit F: Fixed cost in production 87

89 Breakeven Points The breakeven points QBE is the number of units produced at which the company s net income is zero or the point at which revenues are equal to cost Q BE = OpFC + P V Int Total Fixed Costs Contribution per unit Firms with higher leverage have higher break even quantities, all else equal. Revenue and Costs (Rs.) Revenue Total Cost Variable Cost Total Fixed Cost Output (No. of units) 88

90 Operating Breakeven Points When the breakeven point is specified in terms of the operating profit then it is known as the operating breakeven point Revenues at the operating breakeven point are set equal to operating costs at the operating breakeven point to solve for the operating break even quantity. Q OBE = F P V Only Operational Fixed Costs Contribution per unit 89

91 Question: Degree of Total Leverage 1. A company XYZ Ltd sells 10,000 units of water bottles at a price of $4 per unit. ABC s fixed costs are $10,000 and it pays an annual interest of $ 3,000.The variable cost of production is $ 2 per unit and the operating profit (EBIT) is $ 14,000. Which of the following statements is true? A. Degree of Total Leverage = 2.54 B. Degree of Total Leverage = 1.91 C. Degree of Total Leverage = Ques 2: Given that a company XYZ manufactures 10,000 widgets each can be sold in the market for $24. The variable cost per widget is $12. While the fixed costs are $100,000. What is the operating leverage: A. 7.2 B. 6.0 C Ques 3: Assuming that the operating income for XYZ on sale of 10,000 widgets is $24,000 and interest cost is $15,000. Calculate the degree of financial leverage and the degree of total leverage DFL DTL A B C

92 Questions(cont..) 4. Company ipaxx is planning to launch a new personal communicator. The device is considered to be highly innovative and is eagerly anticipated by their customers. Total fixed cost in development has been $24mn with per unit contribution margin expected to be around $12,000. The company had borrowed from the market to fund its development. The interest costs are around $5mn. The operating breakeven point and the breakeven point are closest to Q OBE Q BE A 2,000 2,417 B 2,417 2,000 C 2,120 2, Ques 5: Business Risk is a combination of: D. Sales risk and financial risk E. Operating risk and financial risk F. Sales risk and operating risk 91

93 Solution: Degree of Total Leverage 1. Ans: Hence Degree of Operating Leverage = 10,000*($4-$2)/ (10,000*($4-$2) -$10,000) = 2.00 Degree of Financial leverage = EBIT/ (EBIT Interest) = $14,000/ ($14,000-$3,000) = 1.27 Degree of Total Leverage = 2.0*1.27 = Ans: B DOL 10,000 *(24 12) = 10,000 *(24 12) 100,000 = Ans: C 24,000 DFL= = 2.67 DTL= DOL * DFL= 6* 2.67= 16 24,000 15, Ans: A 24mn Q OBE = = 2, 000units 12,000 24mn+ 5mn Q OBE = = 2, ,000 units 5. Ans: C -Business Risk is a combination of sales risk and operating risk 92

94 Effect of Financial Leverage on Net Income and Return on Equity Facts of the case Consider a company, Great Everest Infrastructure, with net revenue as $20 Million. Its operating profit being $10 Million. Its tax rate is 40%. It has no debt and $20 Million in shares outstanding. (FV 100) If the company had issued $10 million at 8% per annum in debt to buyback $10 Million worth of shares from the market, compare Net Incomes and Returns on Equity. Scenario 1 Scenario 2 No Debt 50% Debt Operating Profit 10,000,000 10,000,000 Interest Expense 0 800,000 EBT 10,000,000 9,200,000 40% 4,000,000 3,680,000 Net Income 6,000,000 5,520,000 No. of Equity Share 200, ,000 EPS ROE 30% 55.2 % Net Income Decreases, ROE increases 93

95 Dividend and Share Repurchases 94

96 Coverage of the topic Capital Budgeting 1. Dividends a) Meaning b) Chronology c) Types d) Forms 2. Important terms in relation to Shares 3. Share Repurchase and its methods 4. Effect of Share Repurchase on a) Earning Per Share b) Book value Per share 5. Similarity between Cash Dividends and Share Repurchase 95

97 Meaning of Dividends Three main decision to be taken by a Finance Manager 1. Financing Decision : How to raise most optimum finance 2. Investment Decision: How to make most optimum investments 3. Dividend Decision: How to distribute profits in the most optimum manner Common Objective: To maximize Shareholders wealth Share OR stock is the risk capital that is invested in the business Bonds, Bank Loan and Debentures are the e.g. of Borrowed capital Dividends Every capital provider expects some return for contributing his capital in the business Return (in any form) paid by the company to its stockholders is called Dividend Source of capital Equity Preference Debt Type of Return Common Dividend Preference Dividend Interest 96

98 Order of distribution of returns to different capital providers Particulars Sales (Less) COGS (Less) Selling Exp (Less) Administrative Exp (Less) General Exp EBITDA Profit and Loss Account (Less) Depreciation EBIT 1 (Less) Interest on Debt EBT (Less) Income Tax Expense PAT 2 3 (Less) (Less) Preference Dividend Earning Attributable to Common stockholders Common Dividends Profit and Loss Appropriation Account Retained Earnings 97

99 Dividend Payment Chronology Declaration Date Ex-Dividend Date Holder of Record Date Payment Date 1. Declaration Date: date on which the corporation declares a specific dividend BOD approves in board meeting 2. Ex-Dividend Date: first day when the share trades without the dividend value (share price falls generally). Any investor who buys shares on or after this date does not get the dividend 3. Holder of Record Date: The date on which the shareholder listed on the corporation s records will deemed to have ownership. This is generally two business days after the ex-date Settlement date for stocks is three business days after the trade (T + 3) 4. Payment Date: date on which the dividends are actually paid out 98