Master in Business Administration (M.B.A.

REVISION SESSION 1 Corporate Finance

Textbook References
Berk, J. & DeMarzo, P., Corporate Finance: The Core, 2nd Edition, Pearson Global Edition, 2011 Chapter 3. Chapter 4 Chapter 5 Chapter 8. Chapter 15.

MBA Corporate Finance

April 27, 2011

1. ARBITRAGE & LAW OF ONE PRICE

Arbitrage
MBA Corporate Finance

The practice of buying and selling equivalent goods in different markets to take advantage of a price difference. An arbitrage opportunity occurs when it is possible to make a profit without taking any risk or making any investment. Normal Market A competitive market in which there are no arbitrage opportunities.
April 27, 2011 3

Law of One Price If equivalent investment opportunities trade simultaneously in different competitive markets, then they must trade for the same price in both markets. Unless the price of the security equals the present value of the securitys cash flows, an arbitrage opportunity will appear. No-Arbitrage Price of a Security:

MBA Corporate Finance

Price(Security) = PV (All cash flows paid by the security)

April 27, 2011

2. RISK AND RETURN

The higher the risk of an investment, the higher will be the return required by the providers of the capital: Impacts on the cost of capital Put simply, if a company only invests in safe projects or offers the providers of capital a guaranteed return on their capital, then the cost of such capital to the company would be low. Conversely, for higher risk investments the cost of capital to the company will be high to compensate the investors for the additional risk.

MBA Corporate Finance

April 27, 2011

Elements Of Return
Return Required is a combination of two elements for a given financial instrument: 1. Risk-free return: level of return expected of an investment with zero risk to the investor. 2. Risk premium: return required above and beyond the risk-free rate for an investor to be willing to invest in the company. Risk Free Return Risk-free rate is normally equated to the return offered by short-dated government bonds or treasury bills (gilts).
April 27, 2011 6

MBA Corporate Finance

The Determinants of Interest Rates

Inflation and Real Versus Nominal Rates
MBA Corporate Finance

Nominal Interest Rate: The rates quoted by financial institutions and used for discounting or compounding cash flows. Real Interest Rate: The rate of growth of your purchasing power, after adjusting for inflation:
Growth in Purchasing Power = 1 + rr = 1 + r Growth of Money = 1 + i Growth of Prices

The Real Interest Rate

MBA Corporate Finance

r i rr = r i 1 + i
Where, rr = real interest rate, r = nominal interest rate, i = rate of inflation.

April 27, 2011

4. TIME VALUE OF MONEY

The Three Rules of Time Travel:
MBA Corporate Finance
April 27, 2011

Annuities
When a constant cash flow will occur at regular intervals for a FINITE NUMBER of N periods, it is called an annuity.

MBA Corporate Finance

Present Value of an Annuity

N C C C C C PV = + + + ...+ = 2 3 N n (1+ r) (1+ r) (1+ r) (1+ r) n=1 (1+ r)

April 27, 2011

10

Perpetuities
When a constant cash flow will occur at regular intervals FOREVER it is called a perpetuity: Investment = $100 reinvested every year. Interest per year = 5%.

MBA Corporate Finance

April 27, 2011

11

The value of a perpetuity is simply the Cash Flow (CF) divided by the interest rate (r).

MBA Corporate Finance

CF PV (CF in perpetuity ) = r
Using the terminology of shares in the above formula we get: Dividend Share Price (P0 ) = KE
Where KE = Cost of Equity d = Constant Dividend per annum P0 = Market Price of the share at year 0 (excl. dividend that has just been paid)

April 27, 2011

12

Growing Perpetuities
Assume you expect the amount of your perpetual payment to increase at a constant rate g.

MBA Corporate Finance

Present Value of a Growing Perpetuity

C PV (growing perpetuity) = r-g

April 27, 2011

13

5. COST OF EQUITY
Definition:
MBA Corporate Finance

The rate of return required by a shareholder. This may be calculated in one of two ways: 1. Dividend-Discount Model (DDM). 2. Capital Asset Pricing Model (CAPM).

April 27, 2011

14

DIVIDEND DISCOUNT MODEL

Definition:
MBA Corporate Finance

To understand how to calculate the cost of equity, we start with the closely related calculation of the companys share price: Share price = PV of the expected future dividends received by the shareholders. Cash-Inflow from the dividends perpetuity. a

April 27, 2011

15

Applying the Dividend Discount Model

What is the price if we plan on holding the stock for N years?
MBA Corporate Finance

Div3 Div1 Div2 P0 = + + + L = 2 3 1 + rE (1 + rE ) (1 + rE )

n =1

Divn (1 + rE ) n

This is known as the Dividend Discount Model. rE : Equity cost of capital.

April 27, 2011

16

Constant-Dividend Growth Model (

MBA Corporate Finance

The simplest forecast for the firms future dividends states that they will grow at a constant rate g, forever.

April 27, 2011

17

Constant-Dividend Growth (Gordons Growth Model)

MBA Corporate Finance

Div1 P0 = rE g
Then,

rE

Div1 = + g P0

is the Cost of Equity.

The value of the firm today depends on the expected dividend level in Year 1, the cost of equity, and the growth rate.

April 27, 2011

18

Estimating Growth Of Dividends

The first method of determining growth g is:
MBA Corporate Finance

g=

D0 -1 Dn

Where D0 = current dividend. Dn = dividend n-years ago.

April 27, 2011

19

The is another way of estimating the growth of dividends:

g = r b
MBA Corporate Finance

g = rE b

Where r = Return on Reinvested Funds or on Equity. b = Proportion of Funds Retained. The rationale of the model = growth of dividends only occurs if a company retains some of its earnings to reinvest in the business.

April 27, 2011

20

CAPITAL ASSET PRICING MODEL

Definition:
MBA Corporate Finance

The Capital Asset Pricing Model (CAPM) = values shares by measuring the risk of a particular share against the risk of the overall market in all shares. The rationale = There is a relationship between risk and return.

April 27, 2011

21

Systematic & Unsystematic Risk

Definition of Systematic Risk: Risk affecting all the company shares in the market (the stock market). Caused by economy-wide considerations. Definition of Unsystematic Risk: Risk associated with intrinsic and specific parameters associated with individual companies.

MBA Corporate Finance

April 27, 2011

22

 (Beta) Factors
The factor was devised as a means to measure the systematic risk of a single company share or a portfolio. The market portfolio is taken to be the benchmark and is given a factor of 1. All other shares or portfolios will have a factor greater or smaller than 1 depending on their systematic risk and considering their required returns.

MBA Corporate Finance

April 27, 2011

23

Return Calculations and CAPM

From CAPM, we can derive the following mathematical formula for the required return for a particular share:
MBA Corporate Finance

(K E - RF ) = .(RM - RF )
Where KE = Required (Expected) Return from Individual Share. = Beta Factor of Individual Share. RF = Risk-free Rate of Interest. RM = Return on Market Portfolio

This means that the expected excess return of the particular share over the risk free rate equals the shares times the expected excess return of the market over the risk free rate.
April 27, 2011 24

MBA Corporate Finance

(RM RF) is referred to as the market risk premium or the equity risk premium (ERP). The risk free rate RF is the rate on short term gilts which are effectively risk free. The above equation can be re-written as:

K E = RF + .(RM - RF )

This is the Cost of Equity

April 27, 2011

25

Criticisms of CAPM
1. CAPM = single period model the values calculated are only valid for a finite period of time and will need to be recalculated or updated at regular intervals. 2. CAPM assumes no transaction costs associated with trading securities. 3. Any beta value calculated will be based on historic data and may not be appropriate currently particularly so if the company has changed the capital structure or their type of business. 4. Market return may change considerably over short periods of time. 5. CAPM assumes an efficient investment market where it is possible to diversify away risk Not necessarily the case as some unsystematic risk may remain. 6. Additionally the idea that all unsystematic risk is diversified away will not hold true if stocks change in terms of volatility.
April 27, 2011 26

MBA Corporate Finance

6. VALUING BONDS
Bond Terminology
MBA Corporate Finance

Bond Certificate: States the terms of the bond. Maturity Date: Final repayment date. Term: The time remaining until the repayment date. Face Value: Notional amount used to compute the interest payments.

April 27, 2011

27

 Coupon: Promised interest payments. Coupon Rate: Determines the amount of each coupon payment:
MBA Corporate Finance

Coupon Rate Face Value CPN = Number of Coupon Payments per Year

Coupon Bonds
Yield to Maturity = single discount rate that equates the PV of bonds remaining cash flows AND current price.

MBA Corporate Finance

1 1 FV P = CPN + 1 N y (1 + y ) (1 + y ) N

Discounts & Premiums

MBA Corporate Finance

Bond Prices Immediately After a Coupon Payment

Terminology
1. Loan notes, bonds and debentures are issued by a company Gilts and treasury bills are issues by a government.
MBA Corporate Finance

2. Traded debt is always quoted in $100, 1,000, 10,000 nominal units or blocks. 3. Interest paid on the debt is stated as a percentage of nominal value ($100 as stated) = Coupon payment or coupon rate. 4. Debt can be: a) Irredeemable never paid back b) redeemable at par (nominal value) c) or redeemable at a premium or discount (for more or less). 5. Interest can be either fixed or floating (variable).
April 27, 2011

31

Cost of Irredeemable Debt With Tax

calculation based on the PV of a perpetuity formula, but we calculate the return on the debt for a given market price.

MBA Corporate Finance

i.(1- T) KD = P0
Where i = Interest Paid T = Marginal Tax Rate P0 = Market Price excl. interest on the loan stock (similar to excl. dividend for shares).

April 27, 2011

32

Cost Of Redeemable Debt with Tax

The KD for a redeemable debt is given by the IRR of the relevant cash flows: The relevant cash flows would be: The market value of the debt/bond. The interest payment per period. The redemption value of the debt/bond. Annual interest payments for year 1 to year n = i(1 - T). Discount each cash-flow (@ a rate above or below the coupon rate).

MBA Corporate Finance

April 27, 2011

33

Interpolate the IRR using the following formula:

MBA Corporate Finance

NPVRLow IRRInterpolation = RLow + NPVR - NPVR Low High

x RHigh - RLow

If the current market value = redemption value, use the same formula as for the irredeemable debt formula.

April 27, 2011

34

Bank Debt (Non Tradeable Debt)

A substantial proportion of the debt of companies is not traded. Bank loans and other non-traded loans have a cost of debt equal to the coupon rate adjusted for tax:

MBA Corporate Finance

K Loan =Interest (Coupon) Rate (1-T)

April 27, 2011

35

8. WEIGHTED AVERAGE COST OF CAPITAL (WACC)

WACC is the average of cost of the companys financing (equity, loan notes, bank loans, preference shares) weighted according to the proportion each element bears to the total pool of funds.

MBA Corporate Finance

April 27, 2011

36

Example
General information: Taxation Rate = 30% Equity information: Ordinary Shares issued = 140,000,000 Ordinary Share price = 8.50 Equity Beta = 1.3 Market Return (Expected by Equity Investors) = 14%

MBA Corporate Finance

April 27, 2011

37

Convertible Debt Information: Interest Rate on Debt = 8%

MBA Corporate Finance

Debt Book Value = 110,000,000 Debt Market Price = 110 Treasury Bond (Risk-Free) Rate = 3.5% Redemption at Par (100) = 8 years Bank Loan information: Loan Interest Rate = 10% Loan Book Value = 10,000,000

April 27, 2011

38

WACC Calculations
Cost of Equity Rf Beta () RM RM- Rf Ke = RF+ (Rm-Rf)

MBA Corporate Finance

3.5% 1.3 14% 10.5% 17.15%

Cost of Bank Loan Interest on Loan

kL (After-Tax) = 10% * (1-0.30)

10.0% 7.0%

April 27, 2011

39

MBA Corporate Finance

Cost of Convertible Debt Year 0 1 2 3 4 5 6 7 8

Description Market Value Interest Interest Interest Interest Interest Interest Interest Interest + Par NPV IRR Kd = IRR

Cash flow *(1-t) DCF 1 - 8% -110 1.000 5.6 0.926 5.6 0.857 5.6 0.794 5.6 0.735 5.6 0.681 5.6 0.630 5.6 0.583 105.6 0.540 4.45% 4.11%

PV1 DCF 2 - 2% -110.000 1.000 5.185 0.980 4.801 0.961 4.445 0.942 4.116 0.924 3.811 0.906 3.529 0.888 3.268 0.871 57.052 0.853 -23.792

PV2 -110.000 5.490 5.383 5.277 5.174 5.072 4.973 4.875 90.129 16.372

IRR = LR + [NPV LR / (NPV LR NPV HR)] * (HR - LR)

-23,792 = Sum (Market Value & InterestPV1) 16,372 = Sum (Market Value & InterestPV2)

4.11% = IRR ( CF0 : CF8 ; 8%)

April 27, 2011

40

Nb Shares * Share Price = 140,000,000 * 8.50 = 1,190,000,000

MBA Corporate Finance

Workings for WACC Number of Shares Value of Equity Value of Debt Bank Loan Equity Covertible Debt Bank Loan WACC

140 121,000,000 = (110,000,000 / 100) * 110 1190 121 10 Value of Capital Cost of Capital VC * CC 1190 17.15% 204.09 121 4.11% 4.97 10 7.00% 0.70 1321 209.76 15.88%

WACC = 15.88% = 209.76 / 1,321

209.76 = 204.09 + 4.97 + 0.70

April 27, 2011

41

Use Of WACC
1. WACC appropriate if company adopts a pooled funds approach to financing its projects and: The company will maintain its existing capital structure in the long run (i.e. same financial risk); The project has the same degree of systematic (business) risk as the company has now. 2. WACC appropriate if the project is insignificant relative to the size of the company. 3. If funds raised specifically for a project, different methods more appropriate (e.g. marginal cost of capital)

MBA Corporate Finance

April 27, 2011

42

9. DEBT & TAXES

The Law of One Price implies equivalent financial transactions neither create nor destroy value. However, if capital structure does matter, then it must stem from a market imperfection: Tax is one of these imperfections. Corporations pay taxes on their profits AFTER INTEREST PAYMENTS ARE DEDUCTED: Thus, interest expense reduces the amount of corporate taxes This creates an INCENTIVE TO USE DEBT.
April 27, 2011 43

MBA Corporate Finance

Example
Consider Safeway, Inc. which had earnings before interest and taxes of approximately $1.85 billion in 2008, and interest expenses of about $350 million. Safeways marginal corporate tax rate was 35%.

MBA Corporate Finance

April 27, 2011

44

Interest Tax Deduction

Safeways debt obligations reduced the value of its equity. But the total amount available to all investors was higher with leverage:

MBA Corporate Finance

In Safeways case, the gain is equal to the reduction in taxes with leverage: $648 million $525 million = $123 million. The interest payments provided a tax savings of 35% $350 million = $123 million.

Interest Tax Shield Reduction in taxes paid due to the tax deductibility of interest (i.e. interest is deductible from taxable income):
Interest Tax Shield = Corporate Tax Rate Interest Payments

MBA Corporate Finance

The WACC with and without Corporate Taxes

MBA Corporate Finance

6. Questions & Answers

MBA Corporate Finance

Q&A

April 27, 2011

48

DOMINUS ILLUMINATIO MEA

MBA Corporate Finance

Thank You !

April 27, 2011

49