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# CorporateFinanceII FIN3503

Temple

GPA 3.97

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This 83 page Class Notes was uploaded by Simone Beer on Monday September 28, 2015. The Class Notes belongs to FIN3503 at Temple University taught by EdwardBoyer in Fall. Since its upload, it has received 89 views. For similar materials see /class/215461/fin3503-temple-university in Finance at Temple University.

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Date Created: 09/28/15

Final Exam Financial Statements Income statement Balance sheet Statement of cash ows Ratio analysis Assets Current assets Cash Accounts receivable Inventories Prepaid expenses Total current assets Fixed assets and intangibles Property plant and equipment Accumulated depreciation Total noncurrent assets Total assets Liabilities and Stockholders Equity Current liabilities Notes payable Current maturities of longterm debt Accounts payable Accrued expenses Total current liabilities Longterm debt Total stockholders39 equity Total liabilities and stockholders39 equity 12 48 57 119 90 39 51 170 14 40 66 34 70 170 Net sales Cost of goods sold Gross pro t EBITDA Selling and administrative expenses Depreciation Operating pro t EBIT Net interest eXpense Earnings before income taxes EBT Income taxes Net income NI Dividends Retained earnings 4800 4000 800 480 80 240 70 170 68 102 32 70 Cash from operating activities Net income Sources and Uses Depreciation and amortization Accounts receivable Inventories Prepaid expenses Accounts payable Accrued expenses Net cash provided used by operations Cash from investing Capital expenditures Cash from nancing activities Increase in shortterm borrowings Additions to longterm borrowings Dividends paid Net cash provided used by nancing activities Increase decrease in cash and marketable securities Beginning cash Ending cash 102 80 80 150 10 80 00 42 10 10 10 40 32 18 40 12 80 Capital Budgeting Net present value Internal rate of return Project cash ows What is NPV CF NPVz I t O 1rt NPV is a measure of Whether the cash ows from a project are suf cient to recover the initial investment provide an adequate return for investors and generate cash for growth What is the IRR i cot 2102 CIt t0 1 R t1 1 R The IR is a discount rate that equates the PV of the cash out ows to the PV of the cash in ows IR is not a rate of return except in one case How IR and NPV evaluate independent projects Caution this relates to standard cash ows NPV or IR IfIRR gt r NPV gt O IfIRR r NPV O IfIRR lt r NPV lt 0 IR r Potential Con ict NPV and IR MAY yield con icting decisions If r lt r NPVA gt NPVB and IRRB gt IRRA If r r NPVA NPVB and IRRB gt IRRA I r gt NPVA lt NPVB and IRRB gt IRRA A Multiple IRRs Do these represent rates of return IRR 18 50 r 0 Project Free Cash Flow 0 1 2 3 Sales 10000 10000 10000 Expenses 8500 8500 8500 Depreciation 2500 25 00 2500 BET 16000 16000 16000 Tax 6080 6080 6080 Depreciation 2500 2500 2500 Unlevered CF 12420 12420 12420 Fixed assets 100 A inNWC 10 1000 SV aftertax 2500 Freecash ow 11000 12420 12420 15920 Free Cash Flow Stock Valuation Valuation formula Free cash ow statement Comparables Enterprise Value Enterprise value EquityMV Debt Cash FCF EBIT1T Depreeiati0n CapX ANWC Valuation Formulas Valuation formula present value of the expected future free cash ows szanCFlghr FCFn1gc 0 1 WA CC WA CC ch WA CC Free cash ow FCF is cash available to investors or for reinvestment after all investments in plant and equipment and working capital needs have been met FCF EBIT1 T Dep AFAgross ANO WC EBIT1 T ANFA ANOWC Net Sales Cost of sales Gross pro t Depreciation SGampA expense EBIT Taxes on EBIT Depreciation ANWC Net xed assets FCF Cost of capital Value 1 5 Perpetuity value Enterprise value Forecast Growth rate 4 4 4 4 4 2 of Sales 2009A 2010 2011 2012 2013 2014 2015 2016 48000 49920 51917 53993 56153 58399 59567 59567 8333 40000 41600 43264 44995 46794 48666 49639 8000 8320 8653 8999 9359 9733 9928 167 800 832 865 900 936 973 993 1000 4800 4992 5192 5399 5615 5840 5957 2400 2496 2596 2700 2808 2920 2978 4000 960 998 1038 1080 1123 1168 1191 800 832 865 900 936 973 993 1000 180 192 200 208 216 225 117 200 960 998 1038 1080 1123 1168 1191 1100 1139 1185 1232 1281 1333 1472 1050 4583 10509 17314 15092 PE Multiple PriceEarnings If two rms have the same payout and EPS growth rates and equivalent risk ie same cost of equity they should have the same PE ratio DiV P EP F0rwardPE 0 Sl EPS1 rE g Enterprise Value Multiples FCF FCF V0 rWACC gFCF EBITDAl EB T DA1 EB T DA1 FWACC g FC F WeightedAverage Cost of Capital WACC 2rdl T re 57 p V V V D market value of debt used to nance investments E market value of equity used to nance investments P market value of preferred stock used to nance investments V D E P market value of the rm s securities rd interest paid on debt r6 required return to equity rp required return on preferred Suppose that the interest rate the rm will pay on debt is 8 the amount of interest bearing debt on the balance sheet is 15M and the corporate tax rate is 40 The rm s stock price is 10 and there are 500000 outstanding shares The rms39 beta is 12 the current yield on the 10year note is 5 and the market risk premium is 6 What is the WACC Suppose that the interest rate the rm will pay on debt is 8 the amount of interest bearing debt on the balance sheet is 15M and the corporate taX rate is 40 The rm s stock price is 10 and there are 500000 outstanding shares The rms39 beta is 12 the current yield on the 10year note is 5 and the market risk premium is 6 What is the WACC What is the effective interest cost to the rm rd1 T 08 4 48 Suppose that the interest rate the rm will pay on debt is 8 the amount of interest bearing debt on the balance sheet is 15M and the corporate taX rate is 40 The rm s stock price is 10 and there are 500000 outstanding shares The rms39 beta is 12 the current yield on the 10year note is 5 and the market risk premium is 6 What is the WACC What is the percentage or weight of debt in the rm s capital structure 15 23 1550 Suppose that the interest rate the rm will pay on debt is 8 the amount of interest bearing debt on the balance sheet is 15M and the corporate taX rate is 40 The rm s stock price is 10 and there are 500000 outstanding shares The rms39 beta is 12 the current yield on the 10year note is 5 and the market risk premium is 6 What is the WACC What is the cost of equity re r0 360m rrf 05 1206 122 Suppose that the interest rate the rm will pay on debt is 8 the amount of interest bearing debt on the balance sheet is 15M and the corporate taX rate is 40 The rm s stock price is 10 and there are 500000 outstanding shares The rms39 beta is 12 the current yield on the 10year note is 5 and the market risk premium is 6 What is the WACC What is the WACC WACCDDEjrd1 T E j DE WACC 23O48 77122 1049 Raising Equity Different kinds of investors IPO pricing and comparables Financingownership tradeoff Equity Financing For Private Companies Angel investors Venture capital Institutional investors Corporate investors Funding and Ownership Financing and ownership tradeoff Pre and postmoney value Number Percent Round Price of Shares Ownership Yours 0067 1500000 3000 Angel 0067 500000 1000 Venture 200 3000000 6000 5000000 Premoney 400000000 2 1500 Postmoney 1000000000 2 500 000 500000 0000 Comparables Valuation Uses multiples like PE or P Sales Company PE P Sales Ray Products 188 12 ByceFrasier 195 09 Fashion Ind 241 08 Recrecation Int 224 07 Average 212 09 EarningsRevenue 15 325 PE 212 09 Shares 20 20 Price estimate 1590 1463 215212 325 20 Debt Financing YTM YTC Convertible bonds Example Suppose that a bond has a face value of 10000 and a conversion ratio of 450 What is the conversion price P 2 Face value Conversion ratio 10 000 450 P 2222 Capital Structure Leverage and risk MM Proposition I MM Proposition 11 Value of the leveraged rm and the taX shield Tradeoff theory 39 Asymmetric information Financial Leverage and Risk EPS rises more rapidly for the levered rm Why does stock price not increase 350 39 300 7 Debt and equlty 250 7 200 7 150 7 100 7 050 7 000 i OI5OJ500 1000 1500 2000 2 00 100 150 Example 151a The Risk and Return of Levered Equity Problem Suppose you borrow 25000 when nancing a coffee shop which is valued at 75000 You expect to generate a cash ow of 75000 at the end of the year if demand is weak 84000 if demand is as expected and 91000 if demand is strong The current riskfree interest rate is 4 and there s a 8 risk premium for the risk of the assets According to Modigliani and Miller what should the value of the equity be What is the expected return Example l5la The Risk and Return of Levered Equity Solution Plan The value of the rm s total cash ows does not change it is still 75000 Thus if you borrow 25000 your rm s equity will be worth 50000 To determine its expected return we will compute the cash ows to equity under the two scenarios The cash ows to equity are the cash ows of the rm net of the cash ows to debt repayment of principal plus interest Example 15121 The Risk and Return of Levered Equity Execute The rm will owe debt holders 25000 X 104 26000 in one year Thus the expected payoff to equity holders is 84000 26000 58000 for a return of 58000 50000 l 16 Example 15la The Risk and Return of Levered Equity Evaluate While the total value of the rm is unchanged the rm s equity in this case is more risky than it would be without debt but less risky than if the rm borrowed 50000 To illustrate if demand is weak the equity holders will receive 75000 26000 49000 for a return of 4900050000 l 2 If demand is strong the equity holders will receive 91000 26000 65000 for a return of 6500050000 l 30 MM Proposition 1 the value of the rm remains unchanged no matter what the capital structure the value of the rm is the market value of the cash ows generated by its assets and is not affected by its choice of capital structure Value D E 1quot Z 1quot 1quot U D E D D E E D TA Proposition 11 Riskfree Debt The expected rate of return on equity of a levered rm increases in proportion to the debtequity ratio expressed in market values and the rate of increase depends on the spread between r A and rD Value rE rU rD DE Example 152 Computing the Equity Cost of Capital Problem Suppose you borrow only 6000 when nancing your coffee shop According to MM Proposition 11 What will your rm s equity cost of capital be Example 152 Computing the Equity Cost of Capital Solution Plan Because your rm s assets have a market value of 30000 by MM Proposition I the equity Will have a market value of 24000 30000 6000 We can use Eq 153 to compute the cost of equity We know the unlevered cost of equity is ru 15 We also know that rD is 5 Example 152 Computing the Equity Cost of Capital Execute 6000 24 000 rE 15 15 5175 Example 152 Computing the Equity Cost of Capital Evaluate This result matches the expected return calculated in Example 151 Where we also assumed debt of 6000 The equity cost of capital should be the expected return of the equity holders HOW d0 taxes impact optimal capital structure The value of the rm is now the value of the unlevered rm plus the taX shield on debt VL VU PVTaxShieZd VL VU TCD MM Value of the rm with tax Implication rm should be almost 100 debt nanced Value D TA MM Cost of Capital Taxes but no risk Cost of Capital D E r r l T r My C WACC r1T D TA Example 153 Computing the Interest Tax Shield Problem Shown on the next slide is the income statement for DF Builders DF B Given its marginal corporate taX rate of 35 What is the amount of the interest taX shield for DFB in years 2005 through 2008 Example 153 Computing the Interest Tax Shield Example 153 Computing the Interest Tax Shield Solution Plan From Eq 154 the interest tax shield is the taX rate of 35 multiplied by the interest payments in each year Example 153 Computing the Interest Tax Shield Execute 1 million 2005 2006 l 2007 2008 2 Interest expense 50 80 too 100 3 Interest tax shield 35 x interest expense 175 28 l 35 35 Example 154 Valuing the Interest Tax Shield Problem Suppose DF B from Example 153 borrows 2 billion by issuing 10year bonds DFB s cost of debt is 6 so it will need to pay 120 million in interest each year for the next 10 years and then repay the principal of 2 billion in year 10 DFB s marginal tax rate will remain 35 throughout this period By how much does the interest tax shield increase the value of DF B Example 154 Valuing the Interest Tax Shield Solution Plan In this case the interest tax shield lasts for 10 years so we can value it as a 10year annuity Because the tax savings are as risky as the debt that creates them we can discount them at DFB s cost of debt 6 Example 154 Valuing the Interest Tax Shield Execute The interest taX shield each year is 35 x 120 million 42 million Valued as a 10year annuity at 6 we have PVInterest TaX Shield 42 million gtlt LKI 1 j 6 10610 309 million The nal repayment of principal in year 10 is not deductible so it does not contribute to the taX shield Tradeoff Theory Optimal capital structure is determined by nancial distress costs MlVl tax Value F1nanc1al d1stress costs PV tax shield MM no tax D TA What is the implication for managers as a result of the tradeoff theory The value of the rm is maximized Where the marginal taX shield equals the marginal nancial distress costs Managers should increase debt until for the last dollar of debt raised the additional taX shield just equals the additional nancial distress costs VL VU T CD PVFinanciaZDistreSS Asymmetric Information Asymmetric information means that managers stockholders and debtholders are not privy to the same set of information concerning the rm Given this situation incentives of these parties are not necessarily aligned Mangers may not act in the best interest of stockholders but may maximize their own utility Under some circumstances stockholders may be in con ict With debtholders Asymmetric Information and Signaling Pecking order of nance internally generated funds debt and possibly hybrids new issues of common Why Avoid discipline of market lower issue costs adverse signal sent to investors Asymmetric Information and Signaling If a rm sells stock investors interpret that the rm s future prospects are not bright Why If a rm sells stock it is because the shares are overvalued The rm does not have suf cient cash Thus a rm should maintain excess borrowing capacity in order to avoid missing investment opportunities Payout Policy Modigliani and Miller Dividend Irrelevance The value of the rm is determined by the earning power of the rm s assets and not by how those earnings are distributed Stockholders returns are unaffected by whether the rm pays dividends or they receive capital gains when they sell shares of stock Suggests a onetoone tradeoff between capital gains and dividends D1 r g Po Basic issue if investment and capital structure remain constant then where does payment of dividends come from From sale of new shares new shares will be worth less since pie is sliced into more pieces original stockholders have shares with lower value but they have received an offsetting dividend The rm has done nothing for investors that investors could not do for themselves Three Alternatives Pay dividends with cash Repurchase shares High dividends With sale of shares Pay Dividends With Cash Suppose the firm is going to pay a 2 dividend immediately and Will use cash to do so The rm expects to generate 48M in free cash ows and to pay a 480 dividend each year thereafter Before After P 2 480 2 42 Cash 2000 000 m 12 Other assets 40000 40000 480 Total market value 420 400 Pex T 40 Shares millions 10 10 Share price 4200 4000 Share Repurchase Suppose the stock price is 42 the rm has 20M in cash and the rm has 10M shares outstanding Shares repurchased Remaining shares Shares 2 20M 2 047619M Shares 10M 047619M 9524M rep 504 9524 Cash 2 w 2 42 12 Other assets Total market value Shares millions Share price Before After 20 00 0 00 40000 40000 420 400 10 9 524 42 00 42 00 High Dividend Equity Issue Suppose the rm wants to pay the 48M in FCF in dividends now by selling shares of stock since it only has 20M in cash It must raise 28M by selling Sharesnew W 067M 42 The required dividend is W 48M 450 1067M Pm 450 430 450 3750 42 Gordon and Litner BirdinHand Theory MampM ignore risk since capital gains are riskier than dividends the rm should pay more in dividends Suggests an inverse relationship between required returns and dividends That is investors required returns will increase as dividends are decreased 1 2 g g Evidence stock prices go up with P0 announcements of dividend increases Tax Theory Both ignore taxes dividends impose a tax burden on investors This implies a direct relationship between dividends and required returns r 1 P g 0 They suggest that the rm should not pay dividends MampM response to Gordon and Litner Signaling MampM agree that stock prices go up when rms announce dividend increases However this is due to signaling effect That is stockholders read the announcement to mean that the future of the company is bright The company predicts sufficient cash flows into the future so that they can afford the dividend MampM response to taX theory Clientele effect Different investors fall into different taX brackets Sorne prefer dividends and others do not By changing dividend policy the rm only changes its clientele and not its value A company has 50M in cash total assets of 500M and 200M in debt The company wants to repurchase 20M in stock What changes will occur on the balance sheet and what will its new leverage ratio be Suppose that the company wanted to issue a dividend instead If the cost of equity is 10 what is the amount of the dividend if paid in perpetuity Solution Repurchase 20 Before Cash 5000 Debt 20000 Other assets 45000 Stock 30000 50000 50000 After Cash 3000 Debt 20000 Other assets 45000 Stock 28000 48000 48000 DE 7143 Dzvzdend 2 0 M 10 Dividend O1020M 2M A company has a market capitalization of 300000 with 10000 shares outstanding The company is going to distribute 50000 in an open market repurchase What is the price per share before the repurchase How many shares will be repurchased What is the price after the repurchase Solution Market Capitalization 300000 Repurchase 50000 Shares 10000 Price before 30 Shares repurchased 1667 Shares remaining 8333 New market cap 250000 Price after 30 50000 1667 30 300000 50000 250000 250000 8333 30 The rm has excess cash of 150 no debt and 400 shares outstanding at 10 per share If the company decides to pay out this cash as a one time dividend What is the eXdiVidend share price in a perfect capital market If they do a repurchase instead What is the share price Solution Cash 15000 Shares 400 Stock price 10 150 0375 Dividend per share 0375 400 P6X 9625 150 Shares repurchased 15 W 15 New shares 385 New market cap 3850 New price 10 40010 150 3850 Suppose that a company pays a constant dividend of 2 and the cost of equity is 12 Assume that investors pay a 20 taX on dividends and there is no capital gains taX What is the price per share If they do a repurchase what is the price per share Solution Dividend 2 TaX 2000 Re 120 Price taxed dividend 1333 Price repurchase 1667 21 2 12 1333 21667 12 Example 162 Payout Decisions in a Perfect Capital Market Problem Barston Mining has 100000 in excess cash Barston is considering investing the cash in oneyear Treasury bills paying 6 interest and then using the cash to pay a dividend next year Alternatively the rm can pay a dividend immediately and shareholders can invest the cash on their own In a perfect capital market which option will shareholders prefer Example 162 Payout Decisions in a Perfect Capital Market Solution Plan We need to compare what shareholders would receive from an immediate dividend 100000 to the present value of what they would receive in one year if Barston invested the cash Example 162 Payout Decisions in a Perfect Capital Market Execute If Barston retains the cash at the end of one year the company will be able to pay a dividend of 100000 x 106 106000 Note that this payoff is the same as if shareholders had invested the 100000 in Treasury bills themselves In other words the present value of this future dividend is exactly 106000 106 100000 which is the same as the 100000 shareholders would receive from an immediate dividend Thus shareholders are indifferent about Whether the rm pays the dividend immediately or retains the cash Example 162 Payout Decisions in a Perfect Capital Market Evaluate Because Barston is not doing anything that the investors could not have done on their own it does not create any value by retaining the cash and investing it for the shareholders versus simply paying it to them immediately As we showed in Example 161 if Barston retains the cash but investors prefer to have the income today they can sell 100000 worth of shares Modigliani and Miller MM Payout Irrelevance In perfect capital markets if a rm invests excess cash ows in nancial securities the rm s choice of payout versus retention is irrelevant and does not affect the initial value of the rm Payout Versus Retention of Cash Retaining Cash With Imperfect Capital Markets Based on MM s payout irrelevance the decision of whether to retain cash depends on market imperfections Forecasting Financial Statements Percent of sales

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