Corporate Finance

Concepts and tools

2013

Capital structure - Risk, return & value

Perfect markets:
Risk & cost of capital constant
RA= RE x E/V + RD x D/V RE= RA + (RA - RD) x D/E

Cash flows constant Hence, value constant

VL=VU = D + E

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Capital structure Risk, return & value

With taxes:
Cost of capital - declines linearly with leverage
WACC = RE x E/V + RD (1-Tax) x D/V

Alternatively - Cash flows greater by the ITS Hence, value greater by PV(ITS)
VL = VU + PV(ITS)

PV of ITS?
When perpetual fixed debt:
PV(ITS) = T x D (discount rate is RD)

When D/V constant:

ITS = VL x (target D/V) x RD x T (implied discount rate = RA) No separate valuation of ITS attempted, rather WACC approach
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Capital structure Risk, return & value

With bankruptcy costs:
VL = VU + PV (ITS) PV( Bankruptcy costs/Financial distress)
Financial flexibility - the concern from increased leverage for relatively low levered firms

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Cost of capital
Capital allocation:

Divisional WACCs for multi-division firms Divisional WACC assumes:

Independent debt & equity financing by divisions

Divisional betas from a set of peers

Asset beta from peer group equity betas through unlevering Equity beta of divisions from the asset beta (say, average) through re-levering (at target D/V)

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Cost of capital

For un-levering and re-levering

When investment grade debt (moderate D/V ratio)

Beta of debt close to zero

Un-levering -- A = E x E/V Re-levering E (target) = A x target V/E

When D/V high - beta debt not zero

Debt holders share the risk of the asset with equity holders

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Combined valuation firm/equity levered firm

Free cash flow to firm (FCFF):
PV of FCFF at WACC = Firm value FCFF = PBIT (1-Tax) + Depn. NWC Capex

Equity value = Firm value - Debt

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Combined valuation firm / equity levered firm

Free cash flow to equity (FCFE):
PV of FCFE at RE = Equity value
FCFE= PAT + Depn. NWC Capex Debt cash flows

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Combined valuation firm / equity levered firm

Capital cash flow (CCF)
CCF discounted at RA = Value of Firm
CCF = PAT + Interest + Depn. NWC Capex Equity value = Firm value Debt

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Disaggregated valuation - levered firm

Adjusted Present Value (APV)
APV = VU + PV(ITS) + PV(subsidy)
VU = FCFF discounted at RA PV(ITS) at the market rate of debt (RD) PV(subsidy) = NPV of subsidized debt at RD x (1-Tax)

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Valuation Which method?

Advisable to use:
APV or CCF when the debt-equity ratios are changing APV has the added advantage of:
Offers break-up of value => All equity value & financing side effects separately Also discounts the cash flows at different rates reflective of their risk

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Mergers and acquisitions

Cash acquisition:
Gain to target = Acquisition Premium Gain to acquirer (NPV) = Synergy Acquisition Premium

Stock acquisition:
Gain to target = (VA x t VT x a) + S x t Gain to acquirer = (VT x a VA x t) + S x a

On merger announcement:
PT = PA x Exchange Ratio
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Target valuation
Strategic acquisition:
WACC for discounting targets cash flows = Targets WACC (no financing impact)

LBO:
Financing impact (high PV (ITS)) possible through greater leverage
Greater D/V ratio on acquisition

Either CCF method or APV advised due to changing D/V ratios

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Financing equity/convertibles
Large equity issues require price discovery bookbuilding & stabilization very common Convertibles address some of the market frictions

Information asymmetry

Agency cost

Mandatory convertibles = Deferred equity (dividend enhanced)

Optional convertibles = Contingent equity = Bond + option

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Risk Management
Concern about risk from non-core elements of business
Horizon for hedging through derivatives usually 1-2 years Approach to risk measurement, and management:
Net exposure to cash flows/profit (natural hedges accounted) Risk = Exposure x Volatility for the horizon
Large risk => risk management policy Small risk => view

Risks over longer horizons managed with operational or strategic decisions Risk management directly relevant for non-equity claimants (creditors, employees)

Core-risk managed through equity capital

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International capital budgeting

If parities hold:
Local and foreign currency valuations lead to the same project NPV estimate

Distortions of parity frequent due to:

Segmented markets

Cost of capital could vary across investors

Beta lower if investors portfolio less than perfectly correlated with the proposed asset Other sources risk country specific risks -- sovereign risk

These suggest that real cost of capital could vary across investors
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International capital budgeting

Parity distortions could lead to:
Mis-valuation of currencies
Firms independent exchange rate estimates could be used (may lead reluctance to use the current spot rate)

Interaction between exchange rate and cash flows

Economic exposure of cash flows due to exchange rate fluctuations Interactions must be built into the local currency cash flow estimates
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