Corporate Finance

Corporate Finance

Introduction

Firms are:

Financing cycle:

• Raise capital
• Manage the operations

Invest in valuable projects

Return the capital/reinvest

There are four pillars of corporate finance:

1. Governance
2. Real decisions
3. Financing
4. Valuation

Each of them are connected to each other.

Financial manager:

• Investment decisions: capital budgeting, what projects should be invested in?
• Raising capital: capital structure, determining the mix of debt and equity
• Dispersing excess capital: dividend policy, share repurchases, repaying debt

Raising capital

There are two different ways:

1. Debt
   • Banks
   • Bond market
   • Finance companies
   • Commercial paper market
2. Equity
   • Individuals
   • Investment banks
   • Market making
   • Institutional investors
   • Institutions

The debt has a specified interest payment, a fave value and a fixed maturity; in case of default it has a first priority. It has also bond covenants, interest is tax-deductible for the corporation.

Equity has dividends set by the board of directors but a minimal par value, moreover it has the last priority in case of default so who choose equity is a residual claimant. It has no maturity but voting rights in the board of directors and dividend payments are not tax deductible.

The source of equity are:

• Private equity

When the risk of a project is similar to the average risk of the firm’s assets the cost of capital for the project is its WACC.

If the firm maintains a constant debt to equity ratio we can get the levered NPV by discounting the FCF using the WACC.

WACC method:

• determine the free cash flow of the project
• Compute the weighted average cost of capital
• Compute the NPV of the project, including the tax benefit of leverage, by discounting the free cash flow on the project using the WACC

Project has comparable risk than the rest of the firm’s assets, taking the project will not alter the debt to equity ratio.

APV method:

• APV separates the effects of financial structure from other effects
• APV incorporates the value of the tax shield directly rather than adjusting the discount rate
• The valuation is done in two steps:
• Value the project as if no interest were paid and no tax shelter were available
• Add the value of the tax shield

unlevered cost of capital reflecting the risk of the assets, weighted average cost of capital without tax.

Pre tax WACC is: _{V^L APV = V^U + PV (interest tax shield)}

Value the FCF using r_u as if all equity financed

Value the tax shield using r_u the TS has the same risk as the project.

The firm’s unlevered cost of capital equals its pretax WACC because it represents investors required return for holding the entire firm, equity and debt. This argument relies on the assumption that the overall risk of the firm is independent of the choice of leverage.

The tax shield will have the same risk as the firm if the firm maintains a target leverage ratio; the firm adjusts its debt proportionally to a project value or its cash flows, where the proportion need not remain constant.

A constant market debt equity ratio is a special case.

WACC vs APV

• Both methods produce the same valuation if used consistently, generally:

• WACC is easiest to use when firm maintain a fixed debt ratio over the project lifetime

• APV is more appropriate for alternative leverage policies

• APV is more flexible to account for other frictions

Project based costs of capital

In the real world a specific project may have different market risk than the average project for the firm; in addition different projects will vary in the amount of leverage they will support.

To use WACC in a project we need to estimate the project equity cost of capital which depends on the incremental debt the company will take on as a result of the project.

A project equity cost of capital may differ from the firm’s equity cost of capital if the project uses a target leverage ratio that is different than the firm’s. the project equity cost of capital can be calculated as follows:

r_e = r_u + ^D/_E (r_u - r₀)

Example

Exchange rate:

• $1.80 per British Pound
• $1.20 per Euro
• €1.60 per British Pound

Step 1: Convert $ into British Pound

$ / $1.80 = £0.5556

Step 2: Convert Pound into Euro

£0.5556 * €1.60 = €0.8889

Step 3: Convert Euro to Dollar

€0.8889 * $1.20 = $1.0667

Example

Two bonds:

• One pays $5,000 in 2 years
• Second pay $7,000 in 5 years

Interest rate=12%

PV₁ = 5,000 / (1+12%)² = 3,985.97

PV₂ = 7,000 / (1+12%)⁵ = 3,977.99

SUM = 3,985.97 + 3,977.99 = 7,963.96

Present value:

PV = Σ (Amount_t / (1+r)^t)

We estimate that a new marketing strategy will generate:

• $300,000 next year
• $500,000 in 2 years
• $200,000 in 3 years

PV = 300,000 / (1+12%) + 500,000 / (1+12%)² + 200,000 / (1+12%)³ = 808,810.73

Cost of capital=12%

In a multiple periods the rate of return corresponds to the time interval that amounts are discounted, only amounts at the same point in time can be added or subtracted before they are discounted.

CHOOSING BETWEEN PROJECTS

Mutually exclusive projects:

• when you must choose only one project among several possible projects the choice is mutually exclusive
• NPV rule: selected the project with the highest NPV
• IRR rule: selecting the project with the highest IRR may lead to mistakes

Probability index: can be used to identify the optimal combination of projects to undertake.

Probability index = ^{Value created}/_{Resource consumed} = ^NPV/_{Resource consumed}

Private equity and IRR

Private equity funds invest in private companies, companies which are not listed in the stock market; this funds can invest directly in private companies or buy out listed companies and take them out of the stock market.

Exiting early wins boosts the IRR even when doing so destroys value.

The problem with the IRR is that it implicitly assumes that proceeds from exiting quickly a company can be reinvested at the rate of return generated by that company in the first year; but in reality when a private equity fund returns money to its investors, their default option is to reinvest this money in the stock market, which yields a lower return.

So using the IRR as a performance metric leads to inefficient decisions.

The same relationship holds for returns.

Debt betas are:

• Publicly traded firms, measuring equity betas are easy (run a regression)
• Public debt
• Private debt
• Benchmarks

WACC: Weighted Average Cost of Capital

We incorporate taxes into our cost of capital estimate; interest payments on debt are tax deductible at the corporate level but dividend payments not.

The true cost to the firm of having debt capital is the after tax cost of debt capital, incorporating this idea yields WACC.

Key assumptions:

• Capital structure is constant
• There are no other costs or benefits from debt

Key takeaways:

• Project and firm discount rates capture the systematic risk of the cash flows
• We cannot often directly measure these betas so we calculate them based upon what we can measure, the debt and equity returns.
• These measures have to be adjusted for the capital structure of the firm since leverage will increase debt and equity betas.
• When interest expense is tax deductible we use WACC to estimate the firm's cost of capital.

Cost of debt

What expected return is required by a firm's creditors, cost that firm must pay on its debt?

1. The yield of debt: give the expected returns
   • Valid if there is little risk of default
   • If there is significant risk of default, yield to maturity will overstate creditor's expected returns
2. Cost of bank debt from annual reports
   • More difficult to get
   • Annual reports or advanced databases, capital IQ
3. Debt beta
   • Using the CAPM
   • Much less historical data, private securities-infrequent trading
   • Most people would say beta of debt is simply zero