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Corporate Finance and Controlling M4

Master of Business Administration & Engineering

Prof. Katarina Adam

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21/04/2013

Table of Contents – International Controlling
Course Overview and Topics
1. International Controlling - Context 1. Terminology
2. IFRS vs. HGB 3. Basel III and its effects

4. International Harmonization and Standardization 5. Organizational Design of International Corporations 6. Organizational Integration of the Finance Function 7. Corporate Governance and Ethics

2. Corporate Finance 1. Basic of Investment Criteria: Net present Value, IRR 2. Long-term Finance: equity finance, debt finance, leasing 3. Economic Value Add (EVA) 4. Weighted Average Cost of Capital (WACC) 5. Venture Capital, IPO, 6. Stocks and Stock Evaluation

3. Cash Planning & Liquidity Management 1. Cash Flow Management 2. Working Capital Management 3. Finance Analysis and Planning 4. Lifecycle Costing 4. Managerial Accounting (Controlling) 1. Overview 2. Product Costing Methods a. Process Costing b. Activity-based Costing c. Job-Order Costing 3. Project Controlling 4. Value Chain Controlling 5. Profit Center Reporting 6. Segment Reporting 7. Transfer Pricing 5. Risk Management 1. Defining Risk 2. Types of Risk 3. Portfolio Theory and the Capital Asset pricing Model (CAPM) 4. Risk Management

Prof. Katarina Adam

2

21.04.2013

What is corporate finance?
 Every decision that a business makes has

financial implications, and any decision which affects the finances of a business is a corporate finance decision.  Defined broadly, everything that a business does fits under the rubric of corporate finance.

4 . operating leverage.Business Risk versus Financial Risk  Business risk:  Uncertainty in future EBIT. etc. and ROIC.  Depends on business factors such as competition. NOPAT.  Financial risk:  Additional business risk concentrated on common stockholders when financial leverage is used.  Depends on the amount of debt and preferred stock financing.

The Traditional Accounting Balance Sheet The Balance Sheet Assets Long Lived Real Assets Fixed Assets Current Liabilties Liabilities Short-term liabilities of the firm Short-lived Assets Investments in securities & assets of other firms Current Assets Financial Investments Debt Other Liabilities Equity Debt obligations of firm Other long-term obligations Equity investment in firm Assets which are not physical. like patents & trademarks Intangible Assets .

The Financial View of the Firm Assets Existing Investments Generate cashflows today Includes long lived (fixed) and short-lived(working capital) assets Liabilities Debt Fixed Claim on cash flows Little or No role in management Fixed Maturity Tax Deductible Assets in Place Expected Value that will be created by future investments Growth Assets Equity Residual Claim on cash flows Significant Role in management Perpetual Lives .

preferences and equity shares on a firm‘s balance sheet. Optimum capital structure is the capital structure at which the market value per share is maximum and the cost of capital is minimum.Capital Structure The term capital structure is used to represent the proportionate relationship between debt. .

Capital Structure Why important? Enables one to optimize the value of a firm or its WACC By finding the “best mix” for the amounts of debt and equity on the balance sheet Provides a signal that the firm is following proper rules of corporate finance to improve its balance sheet. This signal is central to valuations provided by market investors and analysts .

Capital Structure Factors affecting capital structure External: • • • • • • • • • • • Size of company Nature of the industry Investors Cost of inflation Legal requirements Period of finance Level of interest rate Level of business activity Availability of Funds Taxation policy Level of stock prices Internal: • • • • • • • • • Financial leverage Risk Growth and stability Retaining control Cost of capital Cash flow Flexibility Purpose of finance Asset structure .

000 €. For the expansion the corporation needs borrowed money (debts). The interest rate is constantly 4 % Question: How will the return on equity develop? . the estimated return is about 10. The corporation plans to open four new subsidiaries and the estimated return for each subsidiaries is also about 10.Optimal Capital Structure A firm with one headquarter is looking for expansion. At this situation the firm is financed by 100% equity ownership.000 € p..a.

00 2 20 100 0 0.00 1 10 Subsidiary I 100 100 1.00 1 10 0 10 10 % 10 % interest Earnings after interests 0 10 4 16 ROE Return on assets 10 % 10 % 16% 10 % ROE= 10 % = .Optimal Capital Structure Headquarter Equity Liabilities / debts leverage subsidiary Earnings before interests interest Earnings after interests ROE Return on assets Headquarter Equity Liabilities / debts leverage subsidiary Earnings before interests 100 0 0.

00 3 30 8 22 22 % 10 % ROE= 10 % = .00 4 40 12 28 28 % 10 % Subsidiary IV 100 400 4.00 5 50 16 34 34 % 10 % Equity Liabilities / debts leverage subsidiary Earnings before interests interest Earnings after interests ROE Return on assets 100 0 0.Optimal Capital Structure Headquarter Subsidiary I Subsidiary II Subsidiary III 100 300 3.00 1 10 0 10 10 % 10 % 100 100 1.00 2 20 4 16 16% 10 % 100 200 2.

Cost of Financial Distress Value of Firm. V Tax Shield VL VU 0 Debt Distress Costs 13 .Tax Shield vs.

Short Term Trade Credits Accrued Expensives Deferred Incomes .Venture Capital .Long Term Reserves & Surplus Decrease in Assets .Grants / Subsidies .Lease Financing . . Debentures Secured Loans Unsecured Loans .Rights .Ways of Investment Financing Self Financing Stock Debt Financing Third Party .Preference .Long Term Bonds.Hire Purchase .Short Term Commercial Papers Factoring Recievables Public Deposit Ways of investment can be largely categorized into internal and external financing.Ordinay .ESCO Financing .

owners’ funds (equity) or borrowed money (debt) Returns on projects should be measured based on cash flows generated and the timing of these cash flows.  If there are not enough investments that earn the hurdle rate.  Choose a financing mix that minimizes the hurdle rate and matches the assets being financed. Objective: Maximize the Value of the Firm . return the cash to stockholders.  The form of returns . they should also consider both positive and negative side effects of these projects.will depend upon the stockholders’ characteristics.   The hurdle rate should be higher for riskier projects and reflect the financing mix used .dividends and stock buybacks .First Principles  Invest in projects that yield a return greater than the minimum acceptable hurdle rate.

.The Objective in Decision Making  In traditional corporate finance. When the stock is traded and markets are viewed to be efficient.  A narrower objective is to maximize stockholder wealth. or operate as constraints on firm value maximization. the objective in decision making is to maximize the value of the firm. the objective is to maximize the stock price.  All other goals of the firm are intermediate ones leading to firm value maximization.

Annual Meeting BONDHOLDERS Lend Money Maximize stockholder wealth No Social Costs SOCIETY Costs can be traced to firm Managers Protect bondholder Interests Reveal information honestly and on time Markets are efficient and assess effect on value FINANCIAL MARKETS .The Classical Objective Function STOCKHOLDERS Hire & fire managers .Board .

What can go wrong? STOCKHOLDERS Have little control over managers Managers put their interests above stockholders BONDHOLDERS Lend Money Managers Bondholders can get ripped off Delay bad news or provide misleading information Significant Social Costs SOCIETY Some costs cannot be traced to firm Markets make mistakes and can over react FINANCIAL MARKETS .

firms can raise capital from debt .  In addition to equity.From Cost of Equity to Cost of Capital  The cost of capital is a composite cost to the firm of raising financing to fund its projects.

whether operating or capital.  Any lease obligation. whether short term or long term.  As a consequence. debt should include  Any interest-bearing liability. .What is debt?  General Rule: Debt generally has the following characteristics:    Commitment to make fixed payments in the future The fixed payments are tax deductible ## Failure to make the payments can lead to either default or loss of control of the firm to the party to whom payments are due.

the yield to maturity on a long-term. use the rating and a typical default spread on bonds with that rating to estimate the cost of debt.  If the firm is not rated.Estimating the Cost of Debt  If the firm has bonds outstanding. use the interest rate on the borrowing or estimate a synthetic rating for the company. and the bonds are traded. and use the synthetic rating to arrive at a default spread and a cost of debt  The cost of debt has to be estimated in the same currency as the cost of equity and the cash flows in the valuation.  If the firm is rated. .   and it has recently borrowed long term from a bank. straight (no special features) bond can be used as the interest rate.

500/700= 5. the rating can be estimated from the interest coverage ratio Interest Coverage Ratio = EBIT / Interest Expenses  For a firm.Estimating Synthetic Ratings  The rating for a firm can be estimated using the financial characteristics of the firm. In its simplest form.500 million and interest expenses of $ 700 million Interest Coverage Ratio = 3. which has earnings before interest and taxes of $ 3.00 .

this is more a reflection of weakness than strength Using book value rather than market value is a more conservative approach to estimating debt ratios: For most companies. consistency requires the use of book value in computing cost of capital: While it may seem consistent to use book values for both accounting return and cost of capital calculations. . it does not make economic sense.  There are three specious arguments used against market value    Book value is more reliable than market value because it is not as volatile: While it is true that book value does not change as much as market value. using book values will yield a lower cost of capital than using market value weights. Since accounting returns are computed based upon book value.Weights for Cost of Capital Calculation  The weights used in the cost of capital computation should be market values.

0525)11. There are two solutions:    Assume book value of debt is equal to market value Estimate the market value of debt from the book value For example: Disney. a current cost of borrowing of 5.0525)11.100 million.53 $12. with book value of 13.100 (1.53 . (1 666 1 (1. 915 million Estimated MV of Disney Debt = .53 years.25% and an weighted average maturity of 11.0525 13. interest expenses of $666 million.Estimating Market Value Weights  Market Value of Equity should include the following    Market Value of Shares outstanding Market Value of Warrants outstanding Market Value of Conversion Option in Convertible Bonds  Market Value of Debt is more difficult to estimate because few firms have only publicly traded debt.

at a rate that reflects their risk. .Converting Operating Leases to Debt  The “debt value” of operating leases is the present value of the lease payments. this rate will be close to or equal to the rate at which the company can borrow.  In general.

the appropriate hurdle rate is the cost of equity. depending upon whether the returns measured are to equity investors or to all claimholders on the firm (capital)  If returns are measured to equity investors. the appropriate hurdle rate is the cost of capital.Choosing a Hurdle Rate  Either the cost of equity or the cost of capital can be used as a hurdle rate. .  If returns are measured to capital (or the firm).

  The hurdle rate should be higher for riskier projects and reflect the financing mix used .owners’ funds (equity) or borrowed money (debt) Returns on projects should be measured based on cash flows generated and the timing of these cash flows.dividends and stock buybacks .will depend upon the stockholders’ characteristics. they should also consider both positive and negative side effects of these projects.  The form of returns .  Choose a financing mix that minimizes the hurdle rate and matches the assets being financed. return the cash to stockholders.Back to First Principles  Invest in projects that yield a return greater than the minimum acceptable hurdle rate. .  If there are not enough investments that earn the hurdle rate.

files.png .wordpress.Measuring Investment Returns Jerry Maguire Source:http://howtoexperience.com/2012/09/showmethemoney.

 If there are not enough investments that earn the hurdle rate.  The form of returns . . they should also consider both positive and negative side effects of these projects.   The hurdle rate should be higher for riskier projects and reflect the financing mix used .  Choose a financing mix that minimizes the hurdle rate and matches the assets being financed.owners’ funds (equity) or borrowed money (debt) Returns on projects should be measured based on cash flows generated and the timing of these cash flows.dividends and stock buybacks . return the cash to stockholders.will depend upon the stockholders’ characteristics.First Principles  Invest in projects that yield a return greater than the minimum acceptable hurdle rate.

Operating versus Capital Expenditures: Only expenses associated with creating revenues in the current period should be treated as operating expenses.Measures of return: earnings versus cash flows  Principles Governing Accounting Earnings Measurement   Accrual Accounting: Show revenues when products and services are sold or provided.  To get from accounting earnings to cash flows:    . Expenses that create benefits over several periods are written off over multiple periods (as depreciation or amortization) you have to add back non-cash expenses (like depreciation) you have to subtract out cash outflows which are not expensed (such as capital expenditures) you have to make accrual revenues and expenses into cash revenues and expenses (by considering changes in working capital). Show expenses associated with these revenues rather than cash expenses. not when they are paid for.

The Return Mantra: “Time-weighted.. i. Incremental Cash Flow Return” . rather than total cash flows. You cannot spend earnings..  Use “incremental” cash flows relating to the investment decision.  Use “time weighted” returns. value cash flows that occur earlier more than cash flows that occur later. i.e. cashflows that occur as a consequence of the decision.Measuring Returns Right: The Basic Principles  Use cash flows rather than earnings.e.

Finding the Right Financing Mix: The Capital Structure Decision .

 The form of returns .   The hurdle rate should be higher for riskier projects and reflect the financing mix used . they should also consider both positive and negative side effects of these projects.dividends and stock buybacks . return the cash to stockholders.First Principles  Invest in projects that yield a return greater than the minimum acceptable hurdle rate.  Choose a financing mix that minimizes the hurdle rate and matches the assets being financed.  If there are not enough investments that earn the hurdle rate.will depend upon the stockholders’ characteristics. Objective: Maximize the Value of the Firm .owners’ funds (equity) or borrowed money (debt) Returns on projects should be measured based on cash flows generated and the timing of these cash flows.

relative to funding needs Common s tock Warrants Convertibles St age 3 High Growth High. Mo derate. b ut con st rained by in fras tructu re Hig h. as p ro jects dry up . as a percent of firm value Lo w.Financing Choices across the life cycle Revenues $ Rev en ues / Earn in gs Earnings Time External funding needs Hig h. relative to firm value. relative to funding needs Debt More than funding needs External Financing Growth s tage Financing Transit ions Vent ure Capital Common Stock St ag e 2 Rapid Exp an sion Retire debt Repurchas e st ock St age 5 Decline St age 4 Mature Growth Acces sing private equity Inital Public offering Seas oned equity is s ue Bond is s ues . Internal financi ng Negative or low Owner’s Equit y Bank Debt St ag e 1 St art -up Negative or low Low. Declining. relativ e to firm value.

.  Equity can be defined either in accounting terms (as book value of equity) or in market value terms (based upon the current price). short term as well as long term.Measuring a firm’s financing mix  The simplest measure of how much debt and equity a firm is using currently is to look at the proportion of debt in the total financing. The resulting debt ratios can be very different. This ratio is called the debt to capital ratio: Debt to Capital Ratio = Debt / (Debt + Equity)  Debt includes all interest bearing liabilities.

Added Discipline: Greater the separation between managers and stockholders --> Greater the benefit 2.Debt: Summarizing the Trade Off Advantages of Borrowing 1. Loss of Future Financing Flexibility: Greater the uncertainty about future financing needs --> Higher Cost . Agency Cost: Greater the separation between stockholders & lenders --> Higher Cost 3. Tax Benefit: Disadvantages of Borrowing 1. Bankruptcy Cost: Higher business risk --> Higher Cost Higher tax rates --> Higher tax benefit 2.

A Hypothetical Scenario
 Assume you operate in an environment, where (a) there are no taxes (b) there is no separation between stockholders and managers. (c) there is no default risk (d) there is no separation between stockholders and bondholders (e) firms know their future financing needs

The Miller-Modigliani Theorem
 In an environment, where there are no taxes,

default risk or agency costs, capital structure is irrelevant.  The value of a firm is independent of its debt ratio.

Implications of MM Theorem
 Leverage is irrelevant. A firm's value will be

determined by its project cash flows.  The cost of capital of the firm will not change with leverage. As a firm increases its leverage, the cost of equity will increase just enough to offset any gains to the leverage

.Pathways to the Optimal  The Cost of Capital Approach: The optimal debt ratio is the one that minimizes the cost of capital for a firm.  The Sector Approach: The optimal debt ratio is the one that brings the firm closes to its peer group in terms of financing mix.

I. .  If the cash flows to the firm are held constant. The Cost of Capital Approach  Value of a Firm = Present Value of Cash Flows to the Firm. the value of the firm will be maximized. and the cost of capital is minimized. discounted back at the cost of capital.

70% 6.00% 10.50% 17.80% 5.00% 9.40% 5.50% 10.30% 13.50% 10.64% 11.50% 12% After-tax Cost of Debt WACC 4.20% 18.40% 19.50% 9.00% 9.02% 11.60% 12.23% 10.41% 10.15% 10.14% 10.20% 8.50% 11% 11.70% 15% 17% 19% .40% 10.40% 5.10% 9.20% 11.10% 5.Applying Cost of Capital Approach: D/(D+E) 0 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% ke 10.40% 16.50% 10.10% 13.32% 10.30% 7.36% 10.10% 14% 15% kd 8% 8.

Katarina Adam 43 21/04/2013 .Prof.

00% 9.60% 10.80% 10.40% WACC 20% 80% Debt Ratio 100% 60% 40% 90% 30% 50% 70% 0 10% .WACC and Debt Ratios Weighted Average Cost of Capital and Debt Ratios 11.20% 10.40% 11.00% 10.40% 10.20% 11.80% 9.60% 9.

Calculate the effect on Firm Value and Stock Price.Mechanics of Cost of Capital Estimation 1. Estimate the Cost of Equity at different levels of debt: Equity will become riskier -> Beta will increase -> Cost of Equity will increase. Estimate the Cost of Capital at different levels of debt 4. Estimation will use levered beta calculation 2. Estimate the Cost of Debt at different levels of debt: Default risk will go up and bond ratings will go down as debt goes up -> Cost of Debt will increase. we will use the interest coverage ratio (EBIT/Interest expense) 3. To estimating bond ratings. .

101 + 14668 = $69.077 $2.805 $303 9.882 $1.Estimating Cost of Debt Start with the current market value of the firm = 55.24 AAA 4.882 $1.00% 11.11% D/E = 10/90 = .977 10% of $69. 769 mil D/(D+E) 0.00% Debt to capital D/E 0.805 $0 ∞ AAA 4.35% $3.00% 10.077 $2.769 EBITDA Depreciation EBIT Interest Pre-tax Int.1111 $ Debt $0 $6.35% Same as 0% debt Same as 0% debt Same as 0% debt Pre-tax cost of debt * $ Debt EBIT/ Interest Expenses From Ratings table Riskless Rate + Spread . cov Likely Rating Pre-tax cost of debt $3.

50 4.25 – 5.70% 0.35% 4.05 .50 – 3.50 3.6.50 5.00% 6.0 0 % 14.25% 4.50 .0 0 % Market inte rest rat e on d e bt 4.0 0% 6.90 – 2. 5 0 1.20 Rati n g AAA AA A+ A ABBB BB+ BB B+ B BCCC CC C D Typical de f ault spread 0.90 1.00 2.00 1.00% 1.50% 4.85% 5.00% 5.0 0 % .00% 8.0 0 % 24.The Ratings Table Interest Co v era ge Ratio > 8.70% 4.35% 0.50% 3.50 0.0 0 % 12.2.50% 2.25% 8.00% 10.50 – 6.50% 6.0 0 % 12.80 – 1.20 – 0.0 0 % 16.65 – 0.50% 7.25 2.65 < 0.50 .5 6.1.80 0.50% 0.25 0.75 1.00% 2.85% 1.75 – 1.00 – 4.00% 10.0 0 % 20.25 – 1.

24 AAA 4. 8 85 $41.23 BB+ 0. 9 08 $34.9 7 7 $13.0 2 A2.3 3 % De bt $0 $6.00% 6. 8 38 $55. 9 31 $27.8 6 % 11.76% 31.0 0 % 16.31 C 0. 7 92 .4 1 % 14.1 3 % 10.0 0 % 16.3 0 % 3.9 3 0 $10.36 C 0.3 4 9 $5.25% 18.5 0 % 13.14% 37. Cost of Debt and Debt Ratios De bt Ratio 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% Interest expense $0 $303 $698 $1. 8 15 $62.6 9 8 $7.00% 12.0 0 % 15.28 C Interest rate o n debt 4.0 0 % 16.8 1 4 $8.42 C 0.3 0 % 3.50 C 0.0 0 % 16 .0 0 % 16.6 2 % 13.73% 37.35% 5.73% 37.3 0 % 2.3 9 % 13.2 4 % 8. 9 54 $20. 0 47 Interest Cove rag e Bond Ratio Rating • AAA 9.84 CCC 0.0 0 % Cost of Tax De bt Rate (after -tax) 37.3 0 % 2.7 5 % 13. 8 61 $48.35% 4.Bond Ratings.7 2 % 14.2 5 6 $3.5 8 2 $6.

(How Much Did It Drop In % Terms?)  Reduce Current Operating Income By Same Magnitude  Constraint on Bond Ratings . Past Recession Approach  Look At What Happened To Operating Income During The Last Recession.The Downside Risk  Doing What-if analysis on Operating Income  A. Standard Deviation Approach Standard Deviation In Past Operating Income  Standard Deviation In Earnings (If Operating Income Is Unavailable)  Reduce Base Case By One Standard Deviation (Or More)   B.

 Will the optimal be different if you invested in projects instead of buying back stock?   No.What if you do not buy back stock.  The optimal debt ratio is ultimately a function of the underlying riskiness of the business in which you operate and your tax rate. As long as the projects financed are in the same business mix that the company has always been in and your tax rate does not change significantly.. if the projects are in entirely different types of businesses or if the tax rate is significantly different. . Yes.

using all debt for a financial service firm will lead to high debt ratios.  The definition of debt is messy for financial service firms.  The effect of ratings drops will be much more negative for financial service firms.  There are likely to regulatory constraints on capital .Analyzing Financial Service Firms  The interest coverage ratios/ratings relationship is likely to be different for financial service firms. In general. Use only interestbearing long term debt in calculating debt ratios.

50% -40.40 B6.05 – 0.00% -40.75% -20.00% 0.00% 0.00% 2.50 B 6.20 .50 A+ 1.25% -20.00% 0.00% 0.00% 0.00% 0.00% 0.30 CCC 10.75% -20.75 – 0.00% -20.60 B+ 5.00% 0.00 – 2.00% > 3.00 AAA 0.10 C 14.0.50% -17.40% -15.00% 0.00% .50% 1.50 – 2.90 BB+ 4.90% -5.20 – 1.30 – 0.Interest Coverage ratios.70% 0.50% -40.60 – 0.20 BBB 2.00% 1. ratings and Operating income Long Term Interest Coverage Ratio Rating is Spread is Operating Income Decline < 0.40 – 0.00% -50.50 – 3.00 AA 0.90 – 1.25% -25.50 – 0.50 A1.75 BB 4.20 CC 12.00% -20.00% 2.00 A 1.05 D 16.25% -10.10 – 0.

> Lower Optimal Debt Ratio 2. Tax Rate Higher tax rates .> Higher Optimal Debt Ratio Lower Pre-tax CF . Variance in Earnings [ Shows up when you do 'what if' analysis] Higher Variance .Determinants of Optimal Debt Ratios  Firm Specific Factors          1.. Default Spreads Higher .> Higher Optimal Debt Ratio Lower tax rates ....> Lower Optimal Debt Ratio Lower . Pre-Tax CF on Firm = EBITDA / MV of Firm Higher Pre-tax CF .> Higher Optimal Debt Ratio 1..> Lower Optimal Debt Ratio 3..> Lower Optimal Debt Ratio Lower Variance .> Higher Optimal Debt Ratio  Macro-Economic Factors  ...

Relative Analysis I.     Higher tax rates -> Higher debt ratios (Tax benefits) Lower insider ownership -> Higher debt ratios (Greater discipline) More stable income -> Higher debt ratios (Lower bankruptcy costs) More intangible assets -> Lower debt ratios (More agency problems) . Industry Average with Subjective Adjustments  The “safest” place for any firm to be is close to the industry average  Subjective adjustments can be made to these averages to arrive at the right debt ratio.II.

Pay off debt with retained new equity or with retained earnings. Borrow money& buy shares. No Does the firm have good projects? ROE > Cost of Equity ROC > Cost of Capital Yes No Take good projects with 1. Debt/Equity swaps 2. Issue new equity and pay off debt. 3. Yes Take good projects with debt. use cash to pay off debt 3. No Do your stockholders like dividends? Yes Pay Dividends No Buy back stock . 2. Equity for Debt swap 2. earnings. Reduce or eliminate dividends. Sell Assets. Renegotiate with lenders No Does the firm have good projects? ROE > Cost of Equity ROC > Cost of Capital Actual < Optimal Underlevered Is the firm a takeover target? Yes Increase leverage quickly 1.A Framework for Getting to the Optimal Is the actual debt ratio greater than or lesser than the optimal debt ratio? Actual > Optimal Overlevered Is the firm under bankruptcy threat? Yes Reduce Debt quickly 1.

we reduce our risk of default.Designing Debt: The Fundamental Principle  The objective in designing debt is to make the cash flows on debt match up as closely as possible with the cash flows that the firm makes on its assets. . increase debt capacity and increase firm value.  By doing so.

Convertible if cash flows low now but high exp. Floating Rate * More floating rate .Design the perfect financing instrument  The perfect financing instrument will  Have all of the tax advantages of debt  While preserving the flexibility offered by equity Start with the Cash Flows on Assets/ Projects Duration Currency Effect of Inflation Uncertainty about Future Growth Patterns Cyclicality & Other Effects Define Debt Characteristics Duration/ Maturity Currency Mix Fixed vs.if CF move with inflation .with greater uncertainty on future Straight versus Convertible .Options to make cash flows on debt match cash flows on assets Commodity Bonds Catastrophe Notes Design debt to have cash flows that match up to cash flows on the assets financed . growth Special Features on Debt .

if the security that you have designed does not deliver the tax benefits. there may be a trade off between mismatching debt and getting greater tax benefits. .  In addition. however.Ensuring that you have not crossed the line drawn by the tax code  All of this design work is lost.

since it makes them safer. Regulatory authorities want to ensure that you meet their requirements in terms of capital ratios (usually book value). Equity research analysts want them not to issue equity because it dilutes earnings per share. Financing that leaves all three groups happy is nirvana.Effect on Ratios .Value relative to comparables Ratings Agency .Effect on EPS .Ratios relative to comparables Regulatory Concerns .Measures used Operating Leases MIPs Surplus Notes Can securities be designed that can make these different entities happy? . ratings agencies and regulators applauding  Ratings agencies want companies to issue equity. Consider ratings agency & analyst concerns Analyst Concerns .While keeping equity research analysts.

specified at the time of the issue  That is tax deductible  And failing to make the payment can cause ? (Can it cause default?)  When trust preferred was first created.Debt or Equity: The Strange Case of Trust Preferred  Trust preferred stock has  A fixed dividend payment. ratings agencies have started giving firms only partial equity credit for trust preferred. . As they have become more savvy. ratings agencies treated it as equity.

Equity and Quasi Equity  Assuming that trust preferred stock gets treated as equity by ratings agencies.Debt. which of the following firms is the most appropriate firm to be issuing it? • A firm that is under levered. but has a rating constraint that would be violated if it moved to its optimal • A firm that is over levered that is unable to issue debt because of the rating agency concerns. .

Soothe bondholder fears  There are some firms that face skepticism from bondholders when they go out to raise debt. because   Of their past history of defaults or other actions They are small firms without any borrowing history  Bondholders tend to demand much higher interest rates from these firms to reflect these concerns.Tangible and liquid assets create less agency problems Existing Debt covenants .Less observable cash flows lead to more conflicts Type of Assets financed . consider issuing convertible bonds Convertibiles Puttable Bonds Rating Sensitive Notes LYONs . Factor in agency conflicts between stock and bond holders Observability of Cash Flows by Lenders .Restrictions on Financing If agency problems are substantial.

  Issuing equity or equity based products (including convertibles). firms should not lock in these mistakes by issuing securities for the long term. when equity is under priced transfers wealth from existing stockholders to the new stockholders Issuing long term debt when a firm is under rated locks in rates at levels that are far too high. given the firm’s default risk. In particular.  What is the solution   If you need to use equity? If you need to use debt? .And do not lock in market mistakes that work against you  Ratings agencies can sometimes under rate a firm. and markets can under price a firm’s stock or bonds. If this occurs.

Measures used .Less observable cash flows lead to more conflicts Existing Debt covenants Convertibiles .Effect on Ratios .When there is more uncertainty. it .Designing Debt: Bringing it all together Start with the Cash Flows on Assets/ Projects Duration Currency Growth Patterns Effect of Inflation Uncertainty about Future Cyclicality & Other Effects Define Debt Characteristics Duration/ Maturity Currency Mix Fixed vs.Restrictions on Financing Puttable Bonds Rating Sensitive Notes LYONs If agency problems are substantial.Effect on EPS .Convertible if inflation cash flows low . Floating Rate Straight versus * More floating rate Convertible .with greater uncertainty now but high on future exp. growth Special Features on Debt .if CF move with . you might override results of previous step Analyst Concerns .Value relative to comparables Ratings Agency Regulatory Concerns .Options to make cash flows on debt match cash flows on assets Commodity Bonds Catastrophe Notes Design debt to have cash flows that match up to cash flows on the assets financed Overlay tax preferences Consider ratings agency & analyst concerns Factor in agency conflicts between stock and bond holders Deductibility of cash flows for tax purposes Differences in tax rates across different locales Zero Coupons If tax advantages are large enough.Ratios relative to comparables Operating Leases MIPs Surplus Notes Can securities be designed that can make these different entities happy? Observability of Cash Flows by Lenders .Firms with credibility problems may be better to use short term debt will issue more short term debt .Tangible and liquid assets create less agency problems Consider Information Asymmetries Uncertainty about Future Cashflows Credibility & Quality of the Firm . consider issuing convertible bonds Type of Assets financed .

tied to the success of movies. thoug h foreign component is growing 3. M ost of Disney’s product offerings are derived from a. . Very long te rm 1. Short term 2. b. Short te rm 2. Primarily in dollars. Affected by success of movie and broadcasting di visions. Drive n by advertisin g revenues and show success Type of Financing Debt should be 1. Have cash outflows primaril y in dollars (since Disney makes most of its movies in the U.S. 3. but a significant proportion of revenues come 2. Medium term their movie productions. linked to network ratings. Projects are likel y to be 1. Have net cash flows that ar e heavily drive n by whether the movi e is a “hit”. (Lio n King or Nemo Bonds) Broadcasting Theme Parks Consumer Products Debt should be 1.) but cash inflows could have a substantial foreign cu rrency component (because o f overseas sales) 3. who are likely to stay away if the dolla r tourist make up. Projects are likely to be shor t to medium term and linked to the success of Debt should be the movie division. Short te rm 2. If possible.The Right Debt for Disney Business Movies Project Cash Flow Characteristics Projects are likel y to 1. Primaril y in dollars. If possible. Dollar debt. Projects are likel y to be Debt should be 1. Primaril y dolla r debt 3. Long term 2. Mix of cu rrencies. strengthens 3. based upon from foreign tourists. Be short term 2. which is often difficul t to predic t. Primaril y dolla r debt.

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67 .Basic Definitions  V = value of firm  FCF = free cash flow  WACC = weighted average cost of capital  rs and rd are costs of stock and debt  ws and wd are percentages of the firm that are financed with stock and debt.

How can capital structure affect value? V = ∑ ∞ FCFt (1 + WACC)t t=1 WACC= wd (1-T) rd + wsrs 68 .

A Preview of Capital Structure Effects  The impact of capital structure on value depends upon the effect of debt on:   WACC FCF (Continued…) 69 .

Debtholders’ “fixed” claim increases risk of stockholders’ “residual” claim.   Firm’s can deduct interest expenses.  Cost of stock.  Reduces the taxes paid  Frees up more cash for payments to investors  Reduces after-tax cost of debt (Continued…) 70 .The Effect of Additional Debt on WACC  Debtholders have a prior claim on cash flows relative to stockholders. rs. goes up.

71 . to increase  Adding debt increase percent of firm financed with low-cost debt (wd) and decreases percent financed with high-cost equity (ws)  Net effect on WACC = uncertain. rd.The Effect on WACC  Debt increases risk of bankruptcy  Causes pre-tax cost of debt.

“fire” sales. Indirect costs: Lost customers.e.   Direct costs: Legal fees. reduction in productivity of managers and line workers.The Effect of Additional Debt on FCF  Additional debt increases the probability of bankruptcy. etc.. reduction in credit (i. accounts payable) offered by suppliers (Continued…) 72 .

73 . Impact of indirect costs  NOPAT goes down due to lost customers and drop in productivity  Investment in capital goes up due to increase in net operating working capital (accounts payable goes down as suppliers tighten credit).

NOPAT.Business Risk: Uncertainty in EBIT.  Degree of operating leverage (DOL).  Uncertainty about input costs.  Uncertainty about output prices. and ROIC  Uncertainty about demand (unit sales). 74 .  Product and other types of liability.

 The higher the proportion of fixed costs relative to variable costs. 75 .What is operating leverage. the greater the operating leverage. and how does it affect a firm’s business risk?  Operating leverage is the change in EBIT caused by a change in quantity sold.

Katarina Adam 76 21/04/2013 .EVA => Economic Value Added To be continued… Prof.