INTERNATIONAL FINANCE ENRICO COTTA RAMUSINO. Full Professor University of Pavia GIANLUIGI ZUFFI Independent Finacial Advisor, London, Singapore, Lugano MATTIA BAROSI Santander Private Banking Italy - Head of Investments LUCA LUPONE — PAOLO PAJARDI PWC Corporate Financealana E. Cotta Ramusino Firm Valuation 41) Portfolio Theory _ 2) caPM 3) DCF valuation — 2 4)Multiples = 5) Cases aoe G. Zuffi Financial Markets. 1) Financial System and Financial Markets 2) Financial Instruments: money market instruments, bonds, equities, derivatives, currencies 3) Risk and return profile of asset classes 4) Money management institutions M.Barosi Portfolio Management _{5) Case study 41) Investment process | 2) Forecasting returns 3) Quantitative Tools. 4) Fund selePortfolio Theory Assets are valued on the basis of their Risk/Return features e Return — Expected Return n R= Y Rit pi i=1 R, : Expected Return 71 11 = 1.....n Possible “states of the world” (scenarios) R,: Return generated by the asset in the “i” state of the world p;: Probability of occurrence of the “i” state of the worldRisk — Variability of returns, measured by: - Variance: VAR= ¥%.,(R)-R)°. p; - STD: VVAR Once R; and STD; are given, two simple selection rules apply: e Given R;— Minimize Risk e Given STD;—> Maximize ReturnThe portfolio approach - Given a portfolio P, made of assets A and B, in the quantities Xa and Xb; - Givent two possible states of the world: - State of the world 1 with probabillity p1 - State of the world 2 with probability p2; we find that: - The return on the portfolio is the weighted average of the return on A and B respectively (weighted for the quantities Xa and Xb) - While the risk of the portfolio is not.......Portfolio Return Ry = Xa" Ria + %p* Rig) Pi + Gat Roa t+ xp * Rap) Pa = xX4(Ria* Pit Roa Pa) + Xe (Rigs Pi + Rap’ D2) = xX,°Ry+ xp- Rp Xa= % of A Xp = % of B More generally n Rp = Ye Ri ist ...) ———> Assets included in the portfolioRisk of the portfolio VARy = (Rp ~ Ry)? Pi + (Ryo — Rp)? + 2 = [GaRia + XeRip) — (XaRa + xpRp)]?* Pr + [@aRoa + XpRop) — @aRa + XeRp)]? + po = [xa(Ria— Ra) + xe(Rip — Re))? + P1 + [xa(Roa — Ra) + xp (Roe — Rey]? * Bo= [x9(Ria — Ry)? + xB(Rip — Rp)? + 2xqxp(Ria — Ra)(Rip — Re)]? + Ps + [xi(Roa — Ra)? + x§(Rop — Rg)? + 2x4xp (Roa — Ra)(Rop — Re)? * Do = x2+ VAR, + x$- VAR + 2x4xpCOVap 2x4xXpCOVagp ————~> = 2X4Xp 04° Op * Pap AS COVap 04° Op PaB =INVESTMENT A STDa INVESTMENT B SCENARIO PROBABILITY EXPECTED RETURN - Rb STDb 0,3 0,4 0,3 ISCENARIO. PROBABILITY __ RETURNS 1 0,3 8,00 2 04 10,0000, 3 0,3 2,000 EXPECTED RETURN - Ra 7,000 RETURNSPORTFOLIO: Xa 50%; Xb 50% SCENARIO —- PROBABILITY Ra Rb Rp | 1 0,3 8,00] 21,0000| 14,500 2 04 10,00, 3,000 6,500 3 0,3 2,00) 26,0000, 14,0001 EXPECTED RETURN - Rp 14,1800] STDp 3, 8018) The expected return of the portfolio made of A and B is the weighted average of (expected) returns of the two assets included in the portfolio. The risk of the portfolio is not the weighted average of risk of the two assets but a smaller quantity. Why ?Covariance and correlation of assets’ returns peenanio PROBABILITY Ra-E(Ra) Rb-E(Rb) a b c a*b*c 1 0,3 1,0000 5,7000 1,7100 2 04 3,0000 -12,3000 -14,7600 | 3 0,3 -5,0000 10,7000 -16,0500| covariance correlation coefficient -29,1000) -0,8427STDy = [xf + oR +x + Og + 2x4xpCOVan Given: xX, = 0,5 Xp = 0,5 STD, = 3,38 STDg = 10,23 COVag = —29,1 > STDp = 3,80Given STDp = [x4 Of + XR + 0% + 2x4Xp + O4* Op * Paw We have some relevant cases 1) pag = 1 Then: STD, = |x + oR + xR Og + 2xgXp + O4' Op = V (xsd + Xpop)? STDp = XaGa + XpOpTHE CORRELATION COEFFICIENT: 1) CORRab =1. oeRp 18,00 16,00 14,00 12,00 10,00 8,00 6,00 4,00 2,00 0,00 3,38 4,75 612 7,49 STDp 8.86 10,232) Pag = —1 Then: STDpy = |x§* Of +xf OF — 2XAXp' O4* Op = Vv (X40 — Xpop)? STDy = X40, — XpOpTHE CORRELATION COEFFICIENT: 2) CORRab =- 12,00 0,00 2,00 4,00 6,00 STDp 8,00 10,00 12,003) paz = 0 Then: STDp = [xq og +x} 0gTHE CORRELATION COEFFICIENT : 3) CORRab = 00,00 2,00 4,00 6,00 8,00 10,00 STDp 12,00Portfolios with N Assets non VAR, = YYixeg Cony i=1 j=1 i=j n times => x? +o? i4j n?—n times => x;x;- COV;COV; 3 COV>Portfolio risk Non systematic risk, diversifiable Systematic risknon | diversifiable Number of assetsRi Efficient frontier STDiEfficient frontier Ri RE STDRE sTDm CML STDIRi Rm RF (Rm-Rf) sTDm sTDm Efficient frontier the CML equation is: Ri= RF + (Rm-Rf) * stom" STO STDITHE CAPITAL MARKET LINE Ri | Rm-Rf | STDm | STDi Ri 4 15 gore — 15 1602 4 6 8 10 12 STDi 14 16 18 20 22 2% 26 2B 30Return M RF Risk Let now consider investment A: why should we consider such an investment? Let now consider a portfolio made of A and M (the market portfolio) made of Xa and Xm = (1-Xa)The return is: Ry = XaRq t+ (1 — xa) Ru The risk is: STD, = |xz- of + (1 —x4)?.0%4 + 2x1 — X4)COVam Let's now assume to change the amount invested in A (let’s change x4) and see what happens to portfolio return and risk ORp oe = RA eae n aa Ra- Ru ReturnRisk ————> a STD, OX, 1 = Sho + (xa)? 0h -1 + 2x4(1 —X%4)COVaum) 2 * + [2xq +02 — 20% + 2x4 + 0% — ~ Ax4COVay + 2COVam Let’s now assume to put x, = 0 and see what happens to our findingsOSTD, at -1 7 3M)? (20% + 2 COVsm) Ox, _ COVam — on TUleHEEl The slope of CML is Ry — Rr om The slope of the AM line is aRy R,-R ASTD, COVam — o% ouIn M the slopes are equal. So: Ru ~ Re _ (Ram~ Ru): ou ou COVay — o% Ry- Rr Ra Ru oy © COVam — oF Ry — Rp)(COVam — O74 py = RH RNC ~ 28) 5p, ou . Re(C — OM py = Ru lOVam _ Re(COVam ~ OM a 4 Re + Ru 2 2. On onRy — Rp) COV, Ry = Rp + ou FP) AM That is: Ry — Rr Ra = Rp +———" 04" Pam om « COV am a: PAM Putting —— = -———— = ook em We have the traditional capital asset pricing model phormula Ry = Re t+ (Ru — Re) BiIn the CML world we entirely compensate assets’ risk Ru — Rr Ry= Re + oO In the CAPM world we compensate only the systematic part of risk Ry — R Ry = Rp + —" 4 im ou WHY??Capital structure and value creation The key question: What is the best mix of Debt (D) and Equity (E) in the financing of the firm, given that debt brings about tax benefits but even more financial risk? debt 0 Ebit 200 Interest costs 0 50 Pre tax profit 200 150 Taxes (40%) 80 60. Net profit 120 90 Difference in 420 : taxes ce Difference in +30 net profit | Effective cost of | _ | 30- (50-20) debt _Thatis 3% |THE TWO FACES OF DEBT: RISK AND TAX SHIELD MM (58) — 1) NO TAXES ll) NO TRANSACTION COSTS Il) SAME Rd FOR FIRM AND INDIVIDUALS THEN: (PP1): V = OCF /Ra where: * V=Value of the firm * OCF = operating cash flow + Ra= operating cost of capital (business risk only)MM 58 (continues) From the previous, we can have the following: (PP2): Re = Ra + (Ra-Rd)*D/E where: * Re =cost of equity capital * Rd =cost of debt * D/E = debt to equity ratio (leverage ratio)MM 63 (WITH TAXES) Vi= Vu +Tc*D where: * VI=Value of levered firm + Vu = Value of unlevered firm * Tc = corporate tax rate * D=debtMM ‘63 with taxes Unlevered firm Levered firm Debt 4000 (5%) Pre tax profit 800. Net profit Delta pay off = delta taxes = 80Let’s examine pay offs Unlevered Firm EBIT(1 — Te) EBIT(1—Te) re eee Ta Ta = \ =VWy+D-Te Levered Firm (EBIT — 7) +D)-(1—-Te) +1) D = EBITA—Tc)—1p-D+1p-D- To +1p*D = EBIT(1—Te) +17) *D° Te fs EBIT(1—Te) i T° D-Te Ta(MM 63) the previous relation is obtained as follows: unlevered levered Pay off Discount | Ra Ra for EBIT*(1-Tc) factor _Rd for Rd*D*Tc Value Vu | Vu+Te*DWhat about the cost of equity? In MM 58: Ry = Re + (Re — Ra) > Now: Vy tTe*-D=Dt+E Vy Ra tTe Drag = rg°D +E Ui 2 Rallies Re E E EV, D eB ta A-Te)az BUT Wy=D+E-T.-D =E+D(1-C) _ E+DA-Te) D Te E *Ra~ A Te) tae D D Te = Tq + Ral — Te) ea tah - Toe D Te = 1a + a — Ta) (1 — Tee (MM 63) D te =%q+(%—- we (MM 58)An example 1) Unlevered firm, no taxes Ra 0100 Rf=5%; ERP=5%; Bu=Bl=1; Ra=Re=10% EBIT(1-Te) | 600 2) Introducing taxation Ra 0,10 (Te=40%) Vu 6.0003) Introducing debt: we assume to reimburse 3000 of equity and to replace it with debt (Rd=5%) Tt'D | VievurTesD4) conseuqnces: a)Re raises to 12,14% (implying a Bl of 1,43). This value of Re verifies the value of equity (4200) b) WACC decreases from 10% (Ra) to 8,33%. This WACC value verifies the value of the levered firm (VI=7200) Re=Rat (Ra-Rd)"D/EMLTC) | 0,10+(0,10- 0,121429 |___0,05)*3000/4200*(0,6) (1000 - 150)*(0.6) E ~ Un/Re 4.200 WACC= Rd*(1- | 0,05"0,6"3000/7200+0,121429 | — 0,083333 Te)*D/V+Re*E/V | *4,200/7.200 Vie Vu#Te*D = EBIT*(1- 1000°(0,6)/0,083333 7.200 Tey/Ra |D Te= Tat (a -Ta) G A-Te) D = 0,10 + (0,05) F (1-Te) =0,15 (15%) In fact = 450 pak = /o,15 = 3000 [Why firms do not maximize the debt?]Beta Levered and Beta Unlevered We know that: D Re = Ra + (Ra — Ra) pA ~ Te) And, from CAPM: R, = Re + (Ru — Re) Bi Then: Re = Rp + (Ru ~ Rr) Be Ra = Rp + (Ru — Rr) Ba Ra = Rp + (Ru — Re) Ba So: D Ra + (Ra Rae T) = Re + (Ru — Rr) Be Putting Ry — Rp = ERP ERP: Equity Risk PremiumWe have Rp + ERPg, + [Rp + ERP: By — Rp + ERP - Bp]: (A —Te) D “B= Rr + ERP Be D Rp + ERPp, + ERP - Bal Te) - D —BpERP(1 ~ Tc) 7% = Rr + ERP Be Divide both members by ERP. D D Bat Ball — Te) p-A— Te) E* Bo = Be And D D Ba: [1+ Teg] = Bet Bo gl —Te)_ Bet Be RL~Te) “ a+2a-1) D=0 ———>Ba= Be Be D=0 ———s,=—2— Ba a+2a-1)) Ba =By (Beta “Unlevered”) | - It measures only the “business” (operating) risk - It is useful in practice...B of debt (Bp) Rp = Rp + ERP Bp Rp — Rr Bo =~ ERp ES: ERP = 6% Rr =4% Rp = 5% 5-4 = ——=0,166 By = z= 0,The weighted average cost of capital (WACC) Rp = Rp + ERP - Bp Re = Rp + ERP + By D Br = By + Bu ~ Bo) FG -Tc) D Re = Rp + ERP | By + (Bu ~ Bo) BG —T) Given this, the traditional WACC phormula D E WACC = RpG-Te) + ReZ Can be explained as follows:D WACC = (Ry + ERP: Bp)(A Te) + lr + ERP (0 + (Bu - Bo) a- ra))F D D E WACC = Re(1— Te) + ERP Bp 1 —Te) + Re 5 + ERP By + ERP Pa toe By V Bu E Cc. Vv erp rye Bo ERP = (1~To) WACC = Rr° D Teo E iat (F “7 ty) E D + ERP| fo(1— Te) + Bu + Bu A Ted D - Poe -T.)|WACC = R; (1 To) + ERP [Fra Tez] at ( cy Bu Vv C. V D D = Rp (1 Te 7) + ERPBy [1 2 Teo} D WACC = (a -T, 7) (Rp + ERPBy) D WACC = (1 a Te) “Ra