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
Corporation Modern Corporations are often viewed as a nexus of contracts between shareholders, bondholders, other stakeholders and the broader community.
Corporation Advantages Limited Liability Unlimited Life Transfer of Ownership Capital Raising Disadvantages Double Taxation Costs Agency costs
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
Agency Relationship Goal of the Management: Maximize the Shareholders Wealth i.e. Maximize Stock Price
Sources of Conflict Excessive perquisite consumption Differential information Mismatched horizons Investment in human capital Managerial risk-aversion Excessive retention of earnings
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
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.
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
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.
Markets Physical Versus Financial Markets Primary versus Secondary Markets Money versus Capital Markets Spot versus Future Markets
Markets NYSE NASDAQ Electronic Communication Network (ECN)
Rates Real Return Risk Free Return = Real Return+ IP Nominal Return = Risk Free Return + Risk Premium
Time Value of Money Future value Present value Rates of return Amortization
Time Lines of Cash Flows 0 1 2 3 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.
Time line for a $100 lump sum due at the end of Year 2. 0 1 2 Year i% 100
Time line for an ordinary annuity of $100 for 3 years. 0 1 2 3 i% 100 100 100
Time line for uneven CFs: -$50 at t = 0 and $100, $75, and $50 at the end of Years 1 through 3. 0 1 2 3 i% -50 100 75 50
What s the FV of an initial $100 after 3 years if i = 10%? 10% 1 2 3 100 FV =? Finding FVs (moving to the right on a time line) is called compounding.
FV 1 After 2 years: After 1 year: = PV + INT 1 = PV + PV (i) = PV(1 + i) = $100(1.10) = $110.00. FV 2 = FV 1 (1+i) = PV(1 + i)(1+i) = PV(1+i) 2 = $100(1.10) 2 = $121.00.
FV 3 In general, After 3 years: = FV2(1+i)=PV(1 + i) 2 (1+i) = PV(1+i) 3 = $100(1.10) 3 = $133.10. FV n = PV(1 + i) n.
What s the PV of $100 due in 3 years if i = 10%? Finding PVs is discounting, and it s the reverse of compounding. 0 1 2 3 10% PV =? 100
Solve FV n = PV(1 + i ) n for PV: PV = FV n 1+i n = FV n 1 1+i n 1 PV = $100 1.10 = $100 0.7513 = $75.13. 3
Financial Calculator Solution INPUTS OUTPUT 3 10 0 100 N I/YR PV PMT FV -75.13 Either PV or FV must be negative. Here PV = -75.13. Put in $75.13 today, take out $100 after 3 years.
Finding the Time to Double 0 1 2? 20% -1 FV = PV(1 + i) n $2 = $1(1 + 0.20) n (1.2) n = $2/$1 = 2 nln(1.2) = LN(2) n = LN(2)/LN(1.2) n = 0.693/0.182 = 3.8. 2
What s the difference between an ordinary annuity and an annuity due? Ordinary Annuity 0 1 2 3 i% Annuity Due PMT PMT PMT 0 1 2 3 i% PMT PV PMT PMT FV
What s the FV of a 3- year ordinary annuity of $100 at 10%? 0 1 2 3 10% 100 100 100 110 121 FV = 331
Financial Calculator Solution INPUTS OUTPUT 3 10 0-100 N I/YR PV PMT FV 331.00 Have payments but no lump sum PV, so enter 0 for present value.
PV of this ordinary annuity 0 1 2 3 10% 90.91 82.64 75.13 248.69 = PV 100 100 100
Financial Calculator Solution INPUTS OUTPUT 3 10 100 0 N I/YR PV PMT FV -248.69 Have payments but no lump sum FV, so enter 0 for future value.
PV of uneven cash flow stream 0 10% 1 2 3 4 90.91 247.93 225.39-34.15 100 300 300-50 530.08 = PV
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 = 530.09. (Here NPV = PV.)
Mortgage Payments Car Selection Finding Rates Required Savings Retirement Planning Project Selection Security Valuation Applications
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
Financial Statements Assets 2001 2000 Cash 1400 7282 ST Invest. 71,632 0 Receivables 878,000 632160 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 380,120 263,160 Net Properties 817,040 939,790 Total Asset 3,497,152 2,866,592
Financial Statements Liabilities and Equities 2001 2000 Accounts Payable 436,800 524,160 Notes Payable 600,000 720,000 Accruals 408,000 489,000 Total CL 1,444,800 1,733,760 Long-Term Debt 500,000 1,000,000 Common Stock 1,680,936 460,000 Retained Earnings (128,584) (327,168) Total Equity 1,552,352 132,832 Total Liab and Equity 3,497,152 2,866,592
Financial Statements Income Statements 2001 2000 Sales 7,035,600 5,834,400 COGS 5,728,000 5,728,000 Other Expenses 680,000 680,000 Depreciation 116,960 116,960 Total Oper.Costs 6,524,960 6,524,960 EBIT 510,640 (690,560) Interest Expenses 88,000 176,000 EBT 422640 (866,560) Taxes 169,056 (346,624) Net Income 253,584 (519,936)
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
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
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
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)
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?
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.
Financial Statements Net Sales Fixed Asset Turnover Average Net Fixed Assets Net Sales Total Asset Turnover Average Total Net Assets
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
Financial Statements Debt ratio= TIE= Total debt Total assets $1,445 = + $500 = 55.6%. $3,497 EBIT Int. expense = $510.6 = 5.8x. $88
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
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
Financial Statements Net profit margin relates net income to sales Net Profit Margin Net Income Net Sales
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
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%
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.
Risk & Return Different concepts of Return Historical Expected Required Definition of Risk : Individual versus portfolio Trade off between Risk and Return
Risk & Return Economy Prob. T-Bill A B Recession 0.10 8.0% -22.0% 28.0% Below avg. 0.20 8.0-2.0 14.7 Average 0.40 8.0 20.0 0.0 Above avg. 0.20 8.0 35.0-10.0 Boom 0.10 8.0 50.0-20.0 1.00
Expected Return k ^ = Expected rate of return. n i=1 k = k P. i k ^ A = 0.10(-22%) + 0.20(-2%) + 0.40(20%) + 0.20(35%) + 0.10(50%) = 17.4%. i
Standard deviation Standard deviation Variance 2 n i1 2 k kˆ P. i i
Stand Alone Risk n i1 2 k kˆ P. i i A: = ((-22-17.4) 2 0.10 + (-2-17.4) 2 0.20 + (20-17.4) 2 0.40 + (35-17.4) 2 0.20 + (50-17.4) 2 0.10) 1/2 = 20.0%. T-bills = 0.0%. A = 20.0%. B = 13.4%.
Portfolio Risk and Return Assume a two-stock portfolio with $50,000 in and $50,000 in B. Calculate ^ r p and p.
Portfolio Risk Economy Prob. A B Port. Recession 0.10-22.0% 28.0% 3.0% Below avg. 0.20-2.0 14.7 6.4 Average 0.40 20.0 0.0 10.0 Above avg. 0.20 35.0-10.0 12.5 Boom 0.10 50.0-20.0 15.0
Risk rp = (3.0%)0.10 + (6.4%)0.20 + (10.0%)0.40 + (12.5%)0.20 + (15.0%)0.10 = 9.6% p = ((3.0-9.6) 2 0.10 + (6.4-9.6) 2 0.20 + (10.0-9.6) 2 0.40 + (12.5-9.6) 2 0.20 + (15.0-9.6) 2 0.10) 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.
p (%) 35 Risk Company Specific (Diversifiable) Risk Stand-Alone Risk, s p 20 0 Market Risk/Systematic 10 20 30 40 2,000+ # Stocks in Portfolio
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
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.
Security Required Return Expected return Risk, b A 17.4% 1.29 Market 15.0 1.00 T-bills 8.0 0.00 B 1.7-0.86
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%.
Expected versus Required Returns ^ k k A 17.4% 17.0% Undervalued Market 15.0 15.0 Fairly valued T-bills 8.0 8.0 Fairly valued B 1.7 2.0 Overvalued
Financial Asset Valuation 0 1 2 n k... Value CF 1 CF 2 CF n PV = CF 1+ k CF + + 1+ k 1 2 n 1 2... + CF 1+k n.
Bond Valuation Par Coupon Maturity Call Feature Convertible Put Bond Sinking Fund
What s the value of a 10-year, 10% coupon bond if k d = 10%? 10%... 0 1 2 10 V =? 100 100 100 + 1,000 V B $100 $1, 000 +... + $100 + 1 + k d 1 10 10 1+ k d 1+ kd = $90.91 +... + $38.55 + $385.54 = $1,000.
Bond Price if Required Return k = 13%? INPUTS OUTPUT 10 13 100 1000 N I/YR PV PMT FV -837.21 When k d rises, above the coupon rate, the bond s value falls below par, so it sells at a discount.
What s yield to maturity? YTM is the rate of return earned on a bond held to maturity. Also called promised yield.
YTM on a 10-year, 9% annual coupon bond, that sells for $887? 0 1 9 10 k d =?... 90 90 90 1,000 PV 1... PV 10 PV M 887 Find k d that works!
V B Find YTM INT... INT 1 + + N + 1 k d 1+ k d 1 + + M k d N 887 90 1+ k 90 1000, + 1+k d 1 k 1 10 10 + d +... + d INPUTS OUTPUT 10-887 90 1000 N I/YR PV PMT FV 10.91
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
P D k D k D k D k s s s s 0 1 1 2 2 3 3 1 1 1 1... Stock Value = PV of Dividends
Constant growth stock D D g D D g D D g t t t 1 0 1 2 0 2 1 1 1 P D g k g D k g s s 0 0 1 1
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.
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
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?
Efficient Market Securities are normally in equilibrium and are fairly priced. One cannot beat the market except through good luck or inside information. (More )
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.
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.
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.
Preferred Stock The dividend stream would be a perpetuity. 0 1 2 3 k s =13% 2.00 2.00 2.00 PMT $2.00 P 0 = = = $15.38. k 0.13 ^
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
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)
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
Cost of Capital Capital Components Debt Preferred Common Equity WACC= w d k d (1 - T) + w ps k ps + w ce k s.
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%
Cost of Capital: Notes 1. After Tax Costs 2. Marginal Cost 3. Project Beta 4. Market based Ratio 5. Target Ratio
0 1 2 30-1,153.72 i =?... 60 60 60 + 1,000 INPUTS OUTPUT 30-1153.72 60 1000 N I/YR PV PMT FV 5.0% x 2 = r d = 10%
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.
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 = $2. 0.1 $100 $113.10 $2.00 $10 $111.10 0.090 9.0%.
Picture of Preferred 0 1 2 r ps =? -111.1 2.50 2.50... 2.50 $111.10 D r Q Per $2.50 r Per. $2.50 r Per 2.25%; r ps ( Nom) 2.25%(4) $111.10 9%.
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.
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).
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.
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.
Cost of Retained Earnings r s = r RF + (r M - r RF )b. = 7.0% + (6.0%)1.2 = 14.2%.
Cost of Retained Earnings r s D1 D0 1 g g P0 P0 $4. 19105. $50 0. 05 g 0. 088 0. 05 13. 8%.
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...)
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...)
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
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%.
WACC of Large Corporations Company WACC w d Intel (INTC) 16.0 2.0% Dell Computer (DELL 12.5 9.1% BellSouth (BLS) 10.3 39.8% Wal-Mart (WMT) 8.8 33.3% Walt Disney (DIS) 8.7 35.5% Coca-Cola (KO) 6.9 33.8% H.J. Heinz (HNZ) 6.5 74.9% Georgia-Pacific (GP) 5.9 69.9%
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.
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.
Capital Budgeting:IRR Capital Budgeting: IRR Incremental After tax Cash Flows Normal versus Non Normal Independent versus mutually exclusive projects
Capital Budgeting:IRR Capital Budgeting 0 1 2 3 CF 0 CF 1 CF 2 CF 3 Cost Inflows Payback Period Discounted Payback
Capital Budgeting:IRR Capital Budgeting: IRR 0 1 2 3 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.
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
Capital Budgeting Year Project S Project L 0 (100) (100) 1 70 10 2 50 60 3 20 80
Project L: What s Project L s NPV? 0 1 2 3 10% -100.00 10 60 80 9.09 49.59 60.11 18.79 = NPV L NPV S = $19.98.
What s Project L s IRR? 0 1 2 3 IRR =? -100.00 PV 1 10 60 80 PV 2 PV 3 0 = NPV Enter CFs in CFLO, then press IRR: IRR L = 18.13%. IRR S = 23.56%.
Construct NPV Profiles Enter CFs in CFLO and find NPV L and NPV S at different discount rates: k 0 5 10 15 20 NPV L 50 33 19 7 (4) NPV S 40 29 20 12 5
NPV ($) 60 k 0 NPV L 50 NPV S 40 50 5 33 29 40 30 Crossover Point = 8.7% 10 15 20 19 7 (4) 20 12 5 20 S 10 L IRR S = 23.6% 0-10 0 5 10 15 20 23.6 IRR L = 18.1% Discount Rate (%)
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.
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
MIRR for Project L (k = 10%) 0 1 2 3 10% -100.0-100.0 PV outflows 10.0 60.0 80.0 MIRR = 16.5% $100 = 10% $158.1 (1+MIRR L ) 3 MIRR L = 16.5% 10% 66.0 12.1 158.1 TV inflows
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