MB101 International Corporate Finance

PART 2: CORPORATE FINANCE

What is corporate finance?

• ASSESSING INVESTMENT OPPORTUNITIES
• DECIDING HOW TO FINANCE INVESTMENTS

APPLY Theory to real world situations:

• Big picture of corporate financial decisions
• Understanding what happens in the real financial world

3 objectives of the course:

1. INVESTMENT (hurdle rate, return on investment)
2. FINANCING (mix of debt and equity, right type of debt)
3. DIVIDEND (how to give it back to owners)

Maximize the value of the enterprise MAX EV = Σ_t=1^∞ [CF_t / (1+r_a)^t]

5) Cash flows (not earnings) are king in finance

Reconciliating the parts of a balance sheet of a company according to liquidity (from current assets and liabilities are supposed to be converted into cash).

CURRENT < 1 year

LONG TERM > 1 year

It gives a perspective on the past performance of the firm.

A Financial Perspective on a BS

FINANCIAL BALANCE SHEET

ASSETS

• A. IN PLACE investments already made (that generate cash today)
• CURRENT ASSETS the value that will be created by future investments (EXPECTATIONS)

LIABILITIES

• DEBT fixed claim on cash flows (No role in management) TAX DEDUCTIBLE
• EQUITY the amount depends on corporate governance and the stage of the life cycle of the firm

The closer to maturity, the higher the amount of dividends paid (PAY-OUT RATIO)

NATURE OF THE BUSINESS (INDUSTRY)

FINANCING DECISIONS depend on

LIFE CYCLE (FIRM)

Banks do not tend to receive loans unless the firm should have operating profits

• Share capital
• Equity ➜ reserves ➜ retained earnings (self-financing)

BALANCE SHEET

A=L

CURRENT ASSETS

• CASH
• ACCOUNT RECEIVABLE
• INVENTORY
• MARKETABLE SECURITIES

NON CURRENT ASSETS

• FIXED ASSETS
  • TANGIBLE
  • INTANGIBLE (FINANCIAL)

ACCOUNTS PAYABLE

SHORT TERM DEBT

CURRENT LIABILITIES

LONG TERM DEBT

EQUITY

• CAPITAL
• RESERVES
• RETAINED EARNINGS

INCOME STATEMENT

REVENUES

• COST OF GOODS SOLD
• MARKETING & ADMINISTRATIVE EXPENSES

EBITDA

• DEPRECIATION
• AMORTIZATION

EBIT

OPERATING INCOME

• FIN INCOME
• FIN EXPENSES

PROFIT BEFORE TAX

• TAX

NET INCOME

• Earnings per share (EPS) = NET INCOME / No. of shares
• REINVESTED
• RETURNED TO OWNERS -> DIVIDENDS (PAYOUT) -> PAYOUT POLICY -> PAYOUT RATIO

What to look for

1. LIQUIDITY
• PROBABILITY OF DEFAULT
• OPPORTUNITY COST
2. DEBT vs. EQUITY
• DEBT SERVICE
• DIFFERENT PAYOUTS ON THE EQUITY OF ASSETS
3. ACCOUNTING VS MARKET VALUE (BOOK VALUE)
   • (PRICE . No OF SHARES)
   • STOCK PRICE VS BVPS
   • PRICE TO BOOK RATIO

PBP

the number of years you need to repay the investment

Σ CF_E=0

_t=0

DISADVANTAGES

• not information about profitability
• doesn't consider CF after the PBP
• not included the timing of the CF
• how much money the firm doesn't get after the PBP

ADVANTAGE

• easy and quick
• useful to make comparisons

DISCOUNTED PAYBACK PERIOD

Σ CF_t/(1+k)^t = 0

_t=0

• takes into account the timing of CF

NB: DPBP>PBP (CF are smaller because discounted)

NET PRESENT VALUE

Σ (CF_t/(1+k)^t)

• t=0

n = useful life of the project

DECISION RULE

NPV>0 investNPV<0 do not investNPN_A NPV_B>0 invest in project A rather than B

DCF

DCF=Σ(CF_t/(1+k)^t)

• t=0

f(k)

k_j is a FUNCTION of k.NPV is the value assumed by the DCF with a given k.

INTERNAL RATE OF RETURN

value of i that makes DCF=0

DECISION RULE

IF k<IRR investIF k>IRR not invest

DISADVANTAGE

• does not take into account the SIZE of the investment
• IF some CF are negative, IRR not reliable

CAPM - CAPITAL ASSET PRICING MODEL

Ke = Rf + (B)(RPM)

(1) Risk free

Same currency of the cash flows generated by the investment

DEFAULT FREE RATE

LONG TERM

• 10 years government bond

BIAS (?)

GOVMNT. BOND RATE

SPREAD (given according to risk) ⇒ 2%

RISK FREE RATE ⇒ 6,5% (?)

So, if the government were default free:

Rf = 10Y Gov Bond Rate - DEF.SPREAD

Default Spread

Measure of the risk that a government defaults

Sovereign Bond Spread

NB

Every country different operational ratio for bonds which is paper

1. Government bond issued in USD or Euros or Yen
2. Compare it to the corresponding risk free bond (T-bills Bond)
3. Compute the spread and subtract it to the interest rate of the bond issued in local currency

Credit Default Swap

Cost for protecting the investment from the currency risk

• pros ⇒ Updated continuously
• cons ⇒ Reaction to short-term expectations

Rating-Based Estimate

(2) Market Risk Premium

Measures with risk aversion of the investors

Average return of the stock market over the past vs Average return of government bonds ⇒ HISTORICAL AVERAGE (50 years)

SURVEY APPROACH (expected) → MARKET RISK PREMIUM

HISTORICAL APPROACH

• Choose the type of data set (e.g., errors)
• Frequency of observations
• Type of average (better geometric average)

PROS: Looks forward.

CONS: Extremely volatile short term based on individual expectations.

Do not use T-bills and T-bonds because they are short term.

BE CAREFUL IN DISTINGUISHING BETWEEN HISTORICAL VALUE OF MRP AND EXPECTATION

COST OF DEBT (K_d)

K_d depends on:

• RISK FREE RATE
• TAX BENEFITS
• CREDIT SPREAD

interest rates directly available

The firm is rated/NOT rated

recent borrowing history

INTEREST COVERAGE RATIO

The assumption is that K_d > R_f → K_d = (R_f + CREDIT SPREAD)

WEIGHTS D/E

A. Equity:

• better to use the market values of equity if available (although more stable, the book value gives just a past perspective)

B. DEBT:

• which debt? (financial debt no matter the time horizon)
• which value? (book value more stable, proxy if mkt value, use mkt value for quoted companies)

Calculating the WACC

WACC = K_e^E/_E+D + K_d(1 - t)^D/_E+D

use a target capital structure based on market values of D and E

WACC is an opportunity cost of the financial resources (D and E) employed

where c of firm on average and cost

(cost of capital) of each investment

MAXIMISING the ENTERPRISE value

EV = ∑_t=0^∞(CF_t/ (1 + WACC)^t)

CASH FLOWS

• timing
• size

ASSUMPTIONS

• GROWTH RATE
• working capital
• currency
• CAPEX
• cost structure