Corporate Finance and Financial Market

Corporate Finance and Financial Market

These notes were taken at Rice University in a Management program  held in May 2011, that was conducted by Dr.  James P. Weston.

Finance: two areas (Investing and financial decisions)

·      Corporate Finance: Inside the firm

How to structure (D+E) to maximize the value of the firm (A)

What make it valuable: The ability to produce income

·      Investment Finance: Risk Management

In what assets / companies we invest.

Stock market represent 8% of the US financing.

Investments are mostly made using cash-flow.

Paying dividends is a priority, as well as repaying the owners.

Decision making under uncertainty:

·      Economic Evaluation (Economic forecast)

·      Organizational behavior. Psychology based

Financial Valuation

What is the value of something?

1)   What people are willing to pay for…? Not clear!!

2)   The total amount of the DISCONTED CASHFLOWS

Water well that has run dry

Water well connected to an active aquifer.

Interest: Money today is better than money tomorrow!

Even with NO inflation, money today is better than money tomorrow.

Future Value:

FV= PV x (1+r)ⁿ  

Example: 1 $ + 10% Interest

Year 1: 1 x (10%) + 1 = 1,1

Year 2: 1,1 x 10% +1 = 1,21

Year 3: 1,21 x 10% +1= 1 x (1 + 10%) ³

PV = FV / (1+r) ⁿ

Discount rate! = (1+r) ⁿ

Capital Budgeting

Classifications of Decision:

A)   Accept or Reject

B)   Best of a set (mutually exclusive)

C)   Ranking (Independent and limited cash)

Value is created when benefits of decisions exceed costs (NPV > 0)

NPV = NCF0/(1+r)^0 + NCF1/(1+r)^1 + NC2/(1+r)^2….

Tools for making Capital Budgeting Decisions:

1)   NPV at the Discounted Rate

2)   Payback period to recover initial investment. The lowest the better. Its a little arbitrary. Difficult to compare different projects. NEVER LOOK AT PAYBACK ALONE!

3)   ROI = Expected Profit / Average Investment (Problems: No discounting, no clear discount rate). It’s a better measure than payback. You need NPV to make a good decision. This is based on accounting that has distortions (Depreciation is NOT a real expense and an Fix Asset does not loose value in the exact amount expressed in the devaluation. Devaluation is more Tax oriented)

4)   IRR: Is like NPV. It’s the Calculation of at what rate your NPV is CERO!

As long as the IRR is above the Cost of Capital, the project has a Positive NPV (Create Value). IRR is expressed in percentage. NPV is an amount. A larger IRR could also mean a much lower NPV! Do not compare different projects using just IRR!

FREE CASHFLOW:  Free Cashflow is MONEY THAT I CAN SPEND

EBIT – Taxes on EBIT = NOPAT (Net Operating Profit After Tax)

“Every choice has his opportunity cost”

Smith Inc

D=40 , E=60, Revenue= 100, Cost= 90, Deprec= 3, Tax 30%

100 (Rev) – 90 (Cost) – 3 (Deprec) – 2,4 (Interest) = 4,6 x 0,30 (Tax) = 3,22

We need to maximize Shareholder Value!

What are Firms: Contracts

a)    Investors looking for a return hire Managers

b)   Managers that have the objective to Maximize the value of the firm

c)    Employers & Assets that should produce results (Profitability compared to the risk of the business)

Working Capital

Retail:

Net working capital will increase

This creates a real cash drain on the firm

Computing Free Cash Flow:

·      Depreciation: NO actual cash Flow

·      Capital Expenditures: Building a new plan.  NOT reflected in the Balance Sheet. Not reflected until starts producing! Spreading the costs on the lifecycle of the asset, not considering when you really paid.

FCF = NOPAT + Depreciation – Increase/decrease in NON cash working Capital + After Tax salvage value – Capital Expenditure

If you DECREASE the NON CASH CURRENT ASSETS (Inventory, Accounts Receivables), you are INCREASING your cash position.

The firm’s cost of Capital

The money of a company belongs to the Stockholders. How much should we pay in dividends and how much should I invest.

Take into consideration the cost of opportunity, in the same way that we have the choice to invest in many companies or financial instruments.

What is the minimum required return that I should get to invest on a financial asset of similar risk?.

WACC = E/(E+D)x Re + D/(E+D) x Rd x (1-Tc)

Weighed average Cost of Capital

(1-Tc) = Interest payments provides a Tax Shield (The taxable Income is lower!)

·      Rev 100

·      Int       5

·      Tax 35% = 0,35 x (95)  = 34 (not 35!)

The Tax is LOWER interest is considered as an expense that lowers the NI.

Capital Aset Pricing Model:

 CAPM :  Rfree + Risk Premium = Rfree + BETA (Rm – Rfree)

Historical Info: 1926 – 2011:

Long Term Bonds 5%

Large Co: 11 %

Small Co: 12%

Today Rmarket = 4% + 7% = 11%

Rmarket: 500 diversified Companies

Should be lower risk than any single Co.

For example: Chevron has LOWER that one Beta (Beta Chevron= 0,7)

Beta: How a company “wegles” compared to the market.

Covariance: Statistical measurement of association.

Variance: How much you move over all

BETA: Cov (ri, Rm) / Var (Rm)

Beta: Correlation with the movement of my firm against the market.

If Beta = 1,5 : CAPM  4% + 1,5 x  (11% – 4%) = 4%+ 1,5 x 7% =  14,5%

ð Turkey example: R (What you need to eat the turkey) = The Turkey without flavor (Rfree) + The Gravy (Risk Premium)

Cost of Debt

How much should I pay to get an additional dollar of debt today.

Bond: The term comes as they are usually “bonded” to some assets or operations.

Cost of Debt = Risk Free rate + Quality Spread (Risk Premium)

Risk Premium (Debt) = depend on the Company Ratings

AAA: 1 year: add 0,11 //  5 year: add 0,31 : 4 + 0,11 = 4,11

Baa: 1 year: add 0,60 = 4,60   //  0,87  = 4,87

BB (High Yield / Junk) : 1 year: +3,5 = 7,5%  //  5 years: 3,8 = 7,8%

Mixing the Capital structure does not affect very much the WACC (Does not affects the nature of the risk). The risk is associated to the Assets, not on how you finance the business.

High BETA, in recessions people and company avoid buying products from these companies: Walmart LOW BETA: People continue buying on good/bad economies. On the other side, Caterpilar does not on bad economic conditions or recession.

The tax shield LOWERS the cost of the debt.

If Rd = 10% and Tc = 30% => The cost of debt will be 10% x (1- 0,3) = 7%

Remember to consider TERMINAL VALUE (How much are you able to sell an asset at Book Value).

Derivatives:

- Forwards and Futures

 - Swaps: Involves two different products (potato vs corn, Fixed vs Floting rates, exchange rates…)

- Options: Let you cover to downsize conditions. Caps (Call Options) Floors (Put Options).

o   Collars: Simultaneously buy a put option and sell a Call option. It’s the most common position held on a energy exchange floor… (Buying a Put option covers you in case prices drop to much. Its costly. This is compensated by selling a call Option if the price is really high, I sell you at a lower price). This lets you assure a predictable frame of the price you are selling your goods.

=> More than half Fortune 500 companies use derivatives.