English for Financial Markets JM Singer

PRESENT VALUES, CAPITAL BUDGETING AND THE COST OF

CAPITAL

CHAPTER OUTLINE

1) Introduction

2) Present Values, Useful Formulas, Net Present Value

3) Alternative methods to NPV

4) Making Decisions with the NPV rule

5) Risk Return and the Cost of Capital

6) The Weighted Average Cost of Capital

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GOALS OF COURSE, WHAT IS A CORPORATION, OBJECTIVES
OF CFO.

1. INTRODUCTION
A financial manager is key to a company's success. Here are some of keys
responsibilities:

1) Coordination and control. The financial manager must interact closely with the other
departments of the organization such as marketing, operations, and is associated to the
company's overall strategy.

2) Financial management is concerned with value creation that is the acquisition and the
allocation of funds among a company’s present and potential activities and projects.

The first function, the financing decision, involves generating funds either internally or
externally at the lowest cost possible.

The second function, the investment decision, is concerned with allocating funds over
time in such a way that shareholders` wealth is increased.
This latter task is accomplished by undertaking activities and purchasing or creating
assets that are worth more than they cost.

The Investment Decision The Financing Decision

Current Assets Current Liabilities
Cash Accounts Payable
Marketable Securities Short-Term Debt
Accounts Receivable Product Warranties
Inventory
Long-Term Liabilities
Long-Term Debt
Fixed Assets Pensions Obligations
Buildings Deferred Taxes
Equipment Leases
Land
Intangible Liabilities
No- Layoff Policy
Commitment to Quality
products and Services
Need to Advertise and Promote

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Intangible Assets
Brand Names
Trademarks and Patents Equity
Distribution Network Proceeds from Stock Sales
Customer Loyalty Retained Earnings
Loyal and Skilled Work Force Value Created by Investments

A balance sheet shows some of the assets a company invests in and how they are
financed.
Some assets are tangible (PP&E), some are intangible (Brand Name) but very valuable.
In fact, the intangible assets of some firms may be more critical to survival and
prosperity than their tangible assets.
The value of intangible assets such as brand names and customer loyalty, depends on
the extent to which a firm has met its customers` needs. The acquisition costs of these
assets come in the form of intangible liabilities (e.g. a stream of advertising and
promotion expenses and quality-assurances programs).

The objective of the financial function is to maximize the shareholders` wealth.

3) Interaction with capital markets. Each firm is affected by financial markets where
funds are raised.

The importance of finance is reflected in the evolution of the Chief Financial Officer’s
role (CFO) in the modern corporation. The CFO has become a key player who designs
corporate strategy and serves as the architect for acquisitions, takeover defenses,
overseas expansion, and corporate restructuring.

2. THE CORPORATE ENTITY

a. What is a corporation?
Businesses are organized as sole proprietorships, partnerships, or corporations.
However, most well-known corporations both in the US and in the EU are public
companies. This means that their shares are widely traded.

- Sole proprietorship
Owned by a single individual. Since there is no legal distinction between the
business and the owner, the business pays no taxes, all the profit accrues to the
proprietor and are taxed as individual income. The owner has unlimited personal
liability for the business debt. A serious drawback is the inability to raise large
amounts of capital

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 - Partnership
Two or more people can get together to form a partnership to conduct their
business. Partners also have unlimited liability for all of the
business` debt. The primary merit of partnership is ease to get started. However,
its shortcomings are (1) unlimited liability of the owner, (2) the difficulty in
transferring ownership, and (3) the limited life of this organization, makes it
difficult for it to raise large amounts of capital.

- Corporation
It is the most important form of business enterprise. It is a legal entity separate
and apart from its managers or owners. It enjoys (1) the ability to buy and sell
assets, (2) the ability to enter into contracts, and (3) the right to initiate and be
subject of legal action. The corporate form offers 3 distinct advantages over the
incorporated business:
i. Limited liability: Shareholders` liability is limited to the amount invested
in the business
ii. Easy transfer of ownership: Shares of stock can be transferred to new
owners far more readily than the equity interest in either the partnership
or the sole proprietorship
iii) Unlimited life: because it has a distinct legal entity, it can exist after its
owners and managers have withdrawn from the business

The combination of these three advantages enhances the ability of the

corporation to raise large amounts of money.
However, setting up a corporation is far more complex and costlier than starting
up an incorporated business. In addition, corporate earnings are subject to
double taxation.

b. If shareholders own the corporation, the elected Board of Directors manages the
company

c. Corporations have limited liability

d. Corporations pay taxes on their profits, shareholders pay taxes on the dividends
they receive from the company (no tax credit in the US)

e. In large corporations, separation between owners and managers is a necessity. If

objectives differ, conflict creates principal agent problem

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3. CHIEF FINANCIAL OFFICER
a. Role of the CFO

i) Stands between the firm’s operations and the financial markets

ii) Cash from investors is used to purchase real assets. Cash inflows from
real assets are used to repay the initial investments

iii) Capital Budgeting decision: What real assets should the company
invest in? Where these assets should be located? CFO evaluates the
project to determine if it is worth more than the capital required to
undertake it

iv) Financing decision: How should the funds be raised?

b. Goals of the CFO

i) Maximize value of the company
ii) Maximize own wealth
iii) Shareholders must be sure that these goals match

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 REVIEW OF PRESENT VALUE
The object of investment or capital budgeting decision is to find assets that are worth
more than they cost. Problem: how is assets value determined? Finance theory states that
an investment should be endorsed if its NPV is positive that is if today’s value of the
asset exceeds the required investment.

I. Present values and future values.

A dollar today is worth more than a dollar tomorrow because it can be

invested and earn an interest (r).
$1 will be worth $1 x (1 + r) in one year therefore:
PV = FV*discount factor Discount factor = 1/(1+r) PV= FV/(1+r)
r = the discount rate

How much should we invest today in a risk-free project that will pay-off $100,000
in one year? One-year T-bill interest rate is 4%
Answer: $100,000/(1+ 0.04) = $96,153.84.

The discount factor is also called the hurdle rate or the opportunity cost of capital
(the return that was foregone by investing in the project rather than investing in a
security of similar risk).

II. Net Present Value (NPV)

a) NPV recipe:

1. Identify size and timing of cash flows on a time line

2. Determine riskiness (discount rate)

3. Find NPV by discounting cash flows at appropriate discount rate

NPV = -Co + PV (with Co = initial investment)

b) Example:

If we pay $95,000 for the project (cash outflow), NPV= -$95,000 +

$96,153.84 = $1,153.84.

Do not forget the link between risk and discount rate. The riskier the
project, the higher the discount rate. If the project is riskier that initially
thought and the rate of return asked by investors on a risk-equivalent
security is 7%, the NPV will be negative at -$95,000 + $93,458 = -$1,542.
In that case it is not worth investing in the project.

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 Rule #1: Accept investments that have positive net present values.

c) Present values and Rates of return

Return on the project = profit/investment
= ($100,000-$95,000)/$95,000 = 5.26%. This is higher than the 4%
opportunity cost of capital.

Rule #2: Accept investments that offer rates of return in excess of their
opportunity cost of capital.

d) The opportunity cost of Capital for an investment project.

It is the expected rate of return demanded by investors in common stocks
or other securities of similar risks as the project. In other words, to
discount a project at its opportunity cost of capital (to obtain its present
value) is to determine the amount investors would be willing to pay for the
project. If NPV > 0, shareholders are better off.

USEFUL FORMULAS

I. How to calculate the rate of return of an investment?

Measures of historical rate of return

The Holding Period Return:
HPR = Ending Value of Investment/Beginning value of investment
An investor invests $200 today and will receive $220 back in year 1.
HPR = ($220/$200)1/n = 1.10 (with n = # of years. In this example n=1)

Holding Period Yield:

HPR = 1.10 -1 = 0.10 or 10% per annum

Example: Consider an investment that cost $250 and is worth $350 after being held for 2
years.
Annual HPR = ($350/$250)1/n = 1.401/n = 1.401/2 (n = number of years = 2) = 1.1832
Annual HPY = 18.32%

If the investment is held for 6-month the HPR would be ($350/$250) 1/0.5 = 1.96
Annual HPY = 96%

Note that we made implicit assumptions when converting the HPY to an annual basis.
This annualized holding period yield computation assumes a constant annual yield for
each year. For the 6-month investment, because of the uncertainty of being able to earn

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the same return in the future 6 months, institutions will typically not compound partial
year results.

Computing Mean Historical Returns

Used to indicate an investment’s rate of return expected to be received over an extended
period of time.
Year Beginning Value Ending Value HPR HPY
1 100 115 1.15 0.15
2 115 138 1.20 0.20
3 138 110.4 0.80 - 0.20

Arithmetic mean: ((0.15) + (0.20) + (-0.20))/3 = 0.05 = 5%

Geometric mean: ((1.15) x (1.20) x (0.80)) 1/3 - 1 = 0.05 = 3.35%
The GM is considered a superior measure of the long term mean rate of return because
it indicates the compound annual rate of return based on the ending value of the
investment versus its beginning value.
The AM is biased upward if you are attempting to measure an asset’s long-term
performance especially if it is a volatile security.

A portfolio of investment
Invest Number Beg Beg End Ending HPR HPY Mark Weighted
of shares price Market price market et HPY
Value ($) value Weig
ht
A 100,000 $10 1,000,000 $12 1,200,000 1.20 20% .05 0.01
B 200,000 $20 4,000,000 $21 4,200,000 1.05 5% .20 0.01
C 500,000 $30 15,000,000 $33 16,500,000 1.10 10% .75 0.075
Total 20,000,000 21,900,000 0.095

HPR = 21,900,000/20,000,000 = 1.095

HPY = 9.5%

II. Present value of a stream of extended cash flows

PV = C1/(1 + r1) + C2/(1 + r2)² + C3/(1 + r3)³ + ………+Cn/(1 + rn)n

Assuming flat rate structure:

PV = C1/(1 + r) + C2/(1 + r)² + C3/(1 + r)³ + ………+Cn/(1 + r)n

Example: You invest into a $1,000 bond maturing in 5 years and paying 7%
annually. Risk similar bonds offer a return of 4.8% (the opportunity cost for an
investor that invests in a 7% bond). How much should you pay for it?

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 PV = 70/1.048 + 70/(1.048)² + 70/(1.048)³ + 70/(1.048)4 + 1,070/(1.048)5
PV = $1,095.7

II. Perpetuities:

a) Perpetuity: asset that pays $C forever

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

2) Short formula: PV = C/r

b) Growing perpetuity

1) PV = C/(1 + r) + C(1 +g)/(1 + r)² + …..+C(1 + g)n-1/(1 + r)n

2) Short formula: PV = C/(r – g) with g = expected growth rate

III. Annuities: assets that pay a fixed sum each year for a specified amount of
years.

a) PV of perpetuity starting in year t + 1 C/[r (1 + r)t]

b) PV of annuity from year 1 to t C/r - C/[r (1 + r)t ] or

C[1/r – 1/r(1 + r)t ]

Also: PV = C x 1- (1 + r)-t
r
PV of an annuity refers to sum of money needed today to fund a series of
future annuity payments.

Example: Our 7% bond cash flow stream can be split in a 5-year annuity
of $70 and a final payment of $1,000.
PV bond = PV (coupon payments) + PV (final payment)
= 70[1/0.048 – 1/(0.048)(1.048) 5]+ 1,000/(1.048)5
= 304.75 + 791.03 = $1095.78
Value of the $70 5-year annuity = $304.75

Or PV = 70 x 1 – (1 + 0.048)-5 + 1,000
0.048 (1.048)5
PV = $304.75 + $791.03 = $1,095.78

IV. Compound interest

a) FV in year t of $100: $100(1 + r)t

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 b) PV of $100 to be received in year t: $100/(1 + r)t

c) APR issue: If a bank makes a loan at 6% APR but with monthly payments
the bank charges 6%/12 = 0.5% each month. For a $1,000 loan the bank
actually receives $1,000 x (1.005)12 = $1,061.67 after 12 months and
actually earns 6.1678%.

If the bond pays semi-annual payments, its price will be:

PV = 35/1.024 + 35/(1.024)² + 35/(1.024)³ +….. + 1,035/(1.024) 10
= $1,096.77
d) Continuous Compounding
FV of $100 invested for t years at a continuous compounded rate is worth
ert or 2.718rt

V. Nominal and Real interest rates

The real interest rate is the nominal interest rate adjusted for inflation. It defines
what will the purchasing power of your investment be at the end of the
investment period.

Using the Fisher formula: (1 + r Nom) = (1+ r Real) x (1 + inflation rate)

Therefore: (1 + r Real) = (1+ r Nom)/(1 + inflation rate)

A 9% nominal rate, with expected inflation of 6% translates into an expected real

rate of interest before tax of 2.83%. Real interest rates after tax can therefore be
negative!

Bond prices are affected by changes in interest rates. If interest rates fall to 2%,
the price of the bond will increase to $1235.69, if they increase to 12% the bond
price decreases to $819.76

A FIRST LOOK AT STOCK VALUATION

I. Expected return (capitalization rate) on a stock (r)

r = Div1 + (P1 – P0)

P0
Payoffs to owners: dividends and capital gains or losses

II. Today’s Price

Remember: All securities in an equivalent risk-class are priced to offer the same
expected return.

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 One-year model
Price = P0 = DIV1 + P1 (with r = expected return on stocks of similar risk)
1+r
If P0 market > P0, r on the stock is higher than r on stocks of similar risk therefore
investors will buy the stock until P0 market = P0.

If P0 market < P0, r on the stock is lower than return on stocks of similar risk
therefore investors will sell the stock until Po market = Po.

H years model
a) P0 = DIV1/(1 + r) + DIV2/(1 + r)² + DIV3/(1 + r)³ + ….
…..+ (DIVH + PH)/(1 + r)H

b) r already takes into account capital gains

c) PV of PH is often 0 since many firms are not expected to die soon

d) PV of a stock is thus the discounted stream of expected dividends

e) For firms that pay no dividend PH must be high

III. A simple way to estimate capitalization rate

DCF valuation with constant-growth rate of dividends
If dividends grow at a constant rate r then Po = DIV1/(r-g)
r = (DIV1/P0) + g with DIV1/P0 = dividend yield

g can be estimated by market analysts or using the payout ratio

g = dividend growth rate = plow back ratio x ROE

with i) ROE = EPS/book equity per share

ii) plow back ratio = 1 – payout ratio = 1 – DIV/EPS
Warning: Constant-growth DCF formula is a useful rule of thumb but should be
used with care. Always make sure that conclusions make sense.
DCF valuation with varying growth-rates of dividends can be used.

ALTERNATIVES TO NPV RULE

I. Payback Rule

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 A. Definition: accept investment projects that completely recover the
original investment within a specific period of time.

Consider 2 projects:
Co C1 C2 C3 Payback Period NPV (8%)
A -1,000 300 800 400 2 281
B -1,000 300 300 1,200 3 488
C -1,000 400 800 300 2 294

B. Limitations
1. Ignores cash flows after the payback period
If the cut-off date is 2 years, B may be rejected.

2. Does not consider timing of cash flows

Cannot discriminate between A and C.

3. Arbitrary standard for payback period

A Company may accept poor short-lived projects and reject good long-
lived ones.

4. Discounted payback rule can be used and will never accept a negative
NPV project. On the other hand, it still takes no account of cash flows
after the cut-off date.

II. Book Rate of Return

A. Definition: average project earnings after taxes and depreciation, divided

by the average book value of the investment during its life.

Book rate of return = book income/book assets

B. Accept projects for which the projected accounting rate of return

exceeds the targeted rate of return.

C. Limitations
1.Does not use cash flows
2.Takes no account of timing
3.Arbitrary choice of targeted rate of return
4.May not be a good measure of true profitability
5. Average return across the company's activities
III. Internal Rate of Return (IRR)

A. Definition: discount rate that makes NPV = 0

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 Rate of return = Profit/Investment

NPV = - Co + C1/(1 + discount rate) = 0

Thus, the discount rate = C1/C0 – 1
Therefore, IRR is the discount rate that makes NPV = 0

NPV = - Co + C1/(1+IRR)1 + C2 /(1+IRR)2 + C3(1+IRR)3 = 0

B. Accept projects for which the IRR exceeds the discount rate provided by
the capital markets.

C. Normally provides the same conclusion as NPV rule

D. Limitations

1. Multiple IRRs if signs of cash flows switch more than once

Descartes' « rule of signs »: There can be as many different solutions to a
polynomial as there are changes of signs.

2. Mutually Exclusive Projects

Example of 2 mutually exclusive projects.
A is a manually controlled machine and B is the same tool with the
addition of computer control.

Example:
Opportunity cost of capital (Rd) = 10%
Project C0 C1 IRR NPV
Manually controlled machine E -10,000 +20,000 100% +8,181
Same tool + Computer control F -20,000 +35,000 75% +11,218

NPV rule: F should be chosen

IRR rule: E should be chosen

To correct the problem, one must look at the IRR on the incremental
flows. In other words, is it worth putting the 10,000 additional
investment for F?
If project E has the highest return, calculate the IRR on the addition of
the computer control. If it is higher than the discount rate then F should
be accepted

Project C0 C1 IRR NPV

F-E -10,000 +15,000 50% +3,636
IRR = 50% on the incremental investment > 10% discount rate
So, take F, the IRR is unreliable.
3. Timing problem

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 Different timing of cash flows across two projects may lead to
accepting projects with higher IRR but lower NPV than an alternative
project.

Example:
Discount rate = 10%
Project 1 2 3 4 5 IRR NPV
A -10,000 10,000 2,000 1,000 1,000 26.87% 2,178
B -10,000 1,000 2,000 1,000 14,000 18.39% 2,875

For low discount rate IRRA > IRRB but NPVB > NPVA
For high discount rate IRRA > IRRB and NPVA > NPVB

In summary, when the discount rate is low, projects with larger cash
inflows that tend to occur late have lower IRR and higher NPV whereas
projects with smaller cash inflows that tend to occur early have larger
IRR but lower NPV.

4. Scale problem
IRR rule may lead to the acceptance of projects with higher IRR but
lower NPV than alternative projects.
Example:
Discount rate = 25%

Years 1 2 IRR NPV

Small project -10 30 200% 14
Large project -25 55 120% 19

In summary, when the discount rate is low, projects with larger cash
inflows that tend to occur late have lower IRR and higher NPV whereas
projects with smaller cash inflows that tend to occur early have larger
IRR but lower NPV.

Conclusion: It is easier and safer to use the NPV.

IV. Profitability Index

With budget constraints a firm may not be able to take on all the projects that
have a positive net present value. It must therefore pick the projects that offer the
highest NPV per dollar invested.

A. Definition: ratio of the present value divided by the initial investment

It can be written IP = NPV/C0 + 1

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B. Accept project (s) for which profitability index is the greatest

Example:
Rd = 10%
Year 1 2 3 PV NPV PI
A -20 20 40 51 31 2.55
B -50 50 60 95 45 1.9

Both projects are profitable because the PI > 1. A, however, is more profitable
then B.

C. May give different answer to NPV for mutually exclusive projects

(correctable with incremental analysis) or when one project is dependent on
another.

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MAKING INVESTMENT DECISION WITH THE NPV RULE

I. Using NPV

A. Important point to remember

1. Only cash flows are relevant, not earnings

euros received – euros paid out
2. Sunk (irrecoverable) costs don't matter.
3. Average/historical cost may not be a good predictor of incremental
payoffs
4. Opportunity costs matter
5. Account for changes in working capital
6. Consider impact of project on other projects

B. Simply ask the question: what impact will the project have on the cash
flows of the firm?

II. Be consistent in treatment of inflation

A. In principle, inflation is neutral: all prices, wages, incomes, etc. go up the

same amount
B. Discount nominal cash flows with a nominal discount rate and real cash
flows with a real discount rate
C. In practice inflation has real effects

1. Labor costs may go up faster than inflation because of improving

productivities
2. Depreciation deductions are based on purchase prices and are not
indexed to inflation. While your taxes increase under inflation,
your nominal tax shields do not increase, so the value of the firm
falls.

III. Depreciation: non-cash expense matters only because it reduces taxable

income

A. Value of annual tax shield is depreciation expense multiplied by the tax

rate
B. Present value of these tax shields is the sum of the discounted stream of
expected tax shields

1. Use riskless discount rate for estimating present value of tax

shields generally because we know what the depreciation expenses
will be.
2. Two exceptions to using the riskless discount rate
Tax rates change from time to time

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 Losses in future years may place firm in non-taxpaying position

IV. Effects of accounting changes on value

A. Cosmetic changes in accounting procedures alter reported earnings, but

have no impact on the value of the firm

B. Changes in cash flows are important

Investment project example:

$20M 5-year investment project. Straight line depreciation. A $1M initial inventory is
necessary to start the business. Tax rate is 35%.
Salvage value of assets = 0
Material is sold for $1.5M at the end of year 5.
NWC (10% of sales) recaptured at the end of year 5.
COGS = 70% of sales
Other expenses = 20% of sales.
Discount rate = 10%

Years 0 1 2 3 4 5
NWC 1 10 10.5 11 11 10
Change in NWC -1 -9 -0.5 -0.5 0 +1

Years 0 1 2 3 4 5
Revenues 100 105 110 110 100
-COGS 70 73.5 77 77 70
-Other expenses 20 21 22 22 20
Pre-tax profit 10 10.5 11 11 10
-Taxes 3.5 3.675 3.85 3.85 3.5
= Profit after tax 6.5 6.825 7.15 7.15 6.5
+ Depreciation 4 4 4 4 4
= CF from operations 10.5 10.825 11.15 11.15 11.5
+/- Change in NWC -1 -9 -0.5 -0.5 0 +1
+ CAPEX -20
+ NWC recapture 10
+ Gain on sale of asset 0.975 (1.5 x 1-35%).
= Net Cash Flow -21 1.5 10.32 10.65 11.15 23.47

PVCF -21 1.36 8.53 8 7.61 14.57

NPV = + 10.07M

The project should be undertaken

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V. NPV and probabilities

A. Expected NPV
E(NPV) = - C0 + E(C1) / (1+r)1 + E(C2) / (1+r)2 + …+ E(Cn) / (1+r)n

n
With E(Ct) =  Proba. x Ct,i
t=1

B. Variance of the NPV

n
Var (NPV) =  Prob.i x (NPVi – E(NPV))2
t=1

C. Example
Assume a 3-year project that costs 200. Cost of capital is 10%. Generated
cash flows depend on the economic situation. Two scenarios are expected.

Expected (NPV) calculation

Probability Year 1 Year 2 Year 3

Optimistic scenario 60% 100 120 130
Pessimistic scenario 40% 60 70 80
Expected CF 84 100 110

E(NPV) = - 200 + 84 (1.1)-1 + 100 (1.1)-2 + 110 (1.1) -3

E(NPV) = 41.65

Or Optimistic NPV = - 200 + 100/(1.1) + 120/(1.1)2 + 130/(1.1)3 = + 87.754

Pessimistic NPV = - 200 + 60/(1.1) + 70/1.1)2 + 110(1.1)3 = - 27.498
Expected NPV = + 87.75 x 60% + (- 27.5 x 40%) = + 41.65

Variance (NPV) calculation

NPV Probability E(NPV)

Optimistic scenario 87.754 60% 52.652
Pessimistic scenario -27.498 40% -10.999
100% 41.653

Var (NPV) = (87.754 – 41.653)2 x 60% + (-27.498 – 41.653)2 x 40% = 3,188

Standard deviation = 56.46

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Coefficient of variation = 56.46/41.653 = 1.36
VI. Equivalent Annual Cost

With NPV, future year by year cash flows are transformed into a lump-sum
expressed in today’s money. Equivalent annual cost does the reverse that is
transforming a lump-sum of investment today into an equivalent stream of future
cash-flows.

Example: Refinery example:

Investment: $400 million to upgrade refinery.
Material lasts 25 years and production will be $900 million gallons per year.
Cost of capital is 7%.
How much additional revenue should the company receive each year to cover the
$400 million investment?

Annuity calculation:
C = $400/[1/r – 1/r(1+r)25]
C = $34.3 million or $34.3 million/900 million gallons = $0.038 per gallon

Choosing between Long- and Short-Lived Equipment

Two machines A and B have identical capacity and do exactly the same job. A is
an economy model but will last only 3 years and is more expensive to run.

Co C1 C2 C3 C4 PV at 10%

A 500 120 120 120 $798.42

B 600 100 100 100 100 $916.99

A has the lowest PV costs but will last only 3 years and will need to be replaced a
year earlier than B. To compare, we have to convert PV cost to a cost per year, the
equivalent annual cost.

For A, 3-year annuity with a PV of $798.42 is:

$798.42 = Annuity payment x 3-year annuity factor
Annuity payment = 798.42/3-year annuity factor = $798.42/2.487 = $321.05

Or using the annuity formula

PV = C x 1 - (1 + r)-n thus, C = PV x r
r 1 - (1 + r) -n
C = $321.05

For B, $917/3.170 = $289.27

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 Conclusion: Machine B is a better deal because $289.27 < $32

Risk, Return and the Cost of Capital

There are two sources of funds that are used to finance an investment. Debt brought by
the debtholders and Equity brought by the shareholders.

Debt is a contractual agreement between a company (the borrower) and the

debtholders (the lenders) that gives them a privileged claim on the company’s income
and assets. To the contrary, equity holders have a random remuneration since they only
have residual claim on the income and the assets of the company. In the case of a
bankruptcy, they will always be paid after the debtholders.
Therefore, the financial risk facing the shareholders is greater than the one supported
by the debtholders and they will require a higher compensation for this incremental
risk.
That is why the return required by the shareholders is always greater than the return
asked by the holders of debt.

Rd > RE

The mix of these two fundamental financing costs is called the average cost of capital of
a company.

Therefore, in order to make sound investment decisions, the cost of capital of a project
or a company is required. It will be the return necessary to make a capital
budgeting project, such as buying or building a new plant, worthwhile. When analysts
and investors discuss the cost of capital, they typically mean the weighted average of a
firm's cost of debt and cost of equity blended together (WACC).
Practically, the cost of capital is used to discount the expected cash flows in order to find
the NPV of a project.

Conclusion: The higher the risk of an investment in a project the higher the required
return asked by investors.

I. Required Return for projects with the same market risk as the market
The expected return is current-risk free rate plus the expected risk premium
Example: If the risk-free rate Rf = 2% and the market risk premium is 8%, then the
expected return is 10%.

II. Measuring Portfolio Risk

1. Fluctuations in year-to-year returns are wide
2. The standard deviation measures the variability of return and the level of
risk of stocks

20
 3. The higher the standard deviation of expected returns, the higher the risk

III. Portfolio selection

1. The expected return on a stock portfolio is the weighted average of the
expected returns of the portfolio
2. In contrast, the standard deviation of a stock portfolio is less than the
weighted average of standard deviations of the stocks in the portfolio
a. Exception: The stocks exhibit perfect correlation
b. Diversification reduces risk

3. There are two types of risk

a. Unique risk: The risk can be eliminated by diversification. The
unique risk is peculiar to a particular firm.
b. Market risk also called systematic risk, the risk that cannot be
diversified away. For a well-diversified portfolio, it is the only risk
that matters. In other words, the predominant source of
uncertainty for a diversified investor is that the market will rise or
plummet, carrying the investor’s portfolio with it.
c. The investors are rewarder only for bearing market risk
d. Limits to diversification: The covariance measures the degree to
which two stocks covary. Since stocks tend to move together, not
independently, the covariance is usually positive. Positive
covariances between stocks limit the benefit of diversification.
The greatest payoff to diversification would happen if the stocks
were negatively correlated.

IV. Capital Budgeting and the Capital Asset Pricing Model (CAPM)

1. Beta is the standard CAPM measure of systematic risk

a. Treasury-Bills have a  = 0
b. The market has a  = 1

2. In general, CAPM tells us what the equity investor requires as a return on

the project. It is only an estimation.
a. Investors demand high returns for high beta stocks
b. CAPM predicts that beta is the only reason why the expected
returns differ.

3. CAPM has held fairly well over time. However, it appears that some risks
have not been captured by the model in particular for smaller stocks and
companies with book values higher than market values.

21
V. Using the Capital Asset Pricing Model (CAPM) to measure the cost of capital of
a project

1. The company’s cost of capital is defined as the expected return on a

portfolio of all the company’s existing securities
2. The company cost of capital is not the correct discount rate if the new
project is more or less risky than the firm’s existing business. Each project
should in principle be evaluated at its own opportunity cost of capital:
Rproject = Rf + Project Beta (Rmarket - Rf)
3. To estimate the project Beta, it is necessary to gather s of traded stocks
for a benchmark or twin firm that looks like the project. Industry betas
are useful as they tend to cancel out estimations errors on individual
betas.
4. Use Asset Betas (A), not equity Betas (E)

VI. Capital Structure and the Company Cost of Capital

1. Company cost of capital = Expected return on assets

Assets (RA) Debt  Rd Return on debt required by

debtholders (lenders)

Equity  Re Return on equity required by

equity holders

As said earlier, debtors have a contractual agreement in hand, that is

they have a first claim on the assets and the income of the
project/company. On the other hand, shareholders have no agreement
but have only a residual claim on the assets and income of a
project/company.

For that matter, it is riskier to be a shareholder than a debtor. Therefore,

re > rd

Company Cost of Capital (RA) = Debt Rd + Equity Re

Debt + Equity Debt + Equity

22
 In this formula, the weights are determined using market values and not
book values.

Assets value Liabilities and equity values

Company Value Debt Value (Vd)  rd
(VF)
Equity Value (VE)  re

The Value of the company = Market value of the assets = Market value of
Debt + Market Value of Equity

VF = V D + V E

Thus:

Debt = Debt Value = D/V

Debt + Equity Company Value

Equity = Equity value = E/V

Debt + Equity Company value

Re can be estimated by using the CAPM or the formula Re = D1 + g

P0
Rd can be estimated by looking at the yield to maturity on the company
bonds, or using the spread associated to the rating of the company, or by
looking at similar companies having issued bonds.

Example:
Company A has the following data:
Debt value = 30 M R debt = 7.5%
Equity value = 70 M R equity = 15%
Asset value = 100 M

R assets = (30% x 7.5%) + (70% x 15%) = 12.75%

2. A change in the capital structure affects the rate of return on a stock

Example:
Assume the company issues debt of 10M to repurchase 10M of equity.
Now we have:
Debt value = 40 M R debt = 7.875%
Equity value = 60 M R equity =? %

23
 Asset value = 100 M

Since the return on the assets (Rassets) is 12.75% we can recalculate Re

12.75% = (40% x 7.875%) + (60% x Re)

Re = 16%

More debt (higher leverage) means that the Equity holders are more at
risk since they have only a residual claim on the income and assets of the
company. They will therefore, ask for a higher return in order to finance
the company.

3. A change in the capital structure affects the Beta

Assets =  Equity E/V +  Debt D/V

Example:
If before refinancing:
 Debt = 0.1 and  Equity = 1.10

Then Assets = 30% x 0.10 + 70% x 1.10 = 0.80

And if after refinancing:

 Debt = 0.20 and  Equity =?

Then: 0.80 = 40% x 0.20 + 60% x e

Then e = 1.20

It is also possible to use the following formula:

e = Assets + (Assets -  Debt) x Vd

VE

e = 0.80 + (0.80 – 0.20) 40/60 = 1.20

In a tax-free environment, if the capital structure changes, the beta (the

risk) on the assets remains the same. However, both the Debt and the
equity do change.

24
Note: If  Debt is unknown it is possible to estimate the risk of the debt by
using the CAPM. In that case, Rd = Rf +  Debt (Rdebt market - Rf)
 Debt = Rd - Rf
Rdebt market - Rf
Rd – Rf is the spread, that is the incremental return asked by the
potential lenders to lend to a particular company.

Conclusion: In a tax-free environment, financial leverage or gearing

leaves the expected return on the firm’s assets unchanged but increases
the risk on the common stock and therefore, the expected rate of
return on the stock. In other words, the cost of capital does not depend
on financing.

25
The Weighted Average Cost of Capital (WAAC)

1. In a tax environment the adequate discount rate to use is the Weighted

Average Cost of Capital (WACC). The WAAC takes into account the tax
shield (tax savings) generated by the deductibility of interest expenses.
This is so, because the interest payments paid by the company on its
financial debt come in deduction of the EBIT to determine the taxable
income EBT, lowering the tax bill. The company will in effect only pay the
after-tax cost of debt and the return required by the debtholders will be
Rd (1-Tc).

2. WACC = Rd (1 – Tc) Debt + Re Equity

Debt + Equity Debt + Equity

WACC = Rd (1 – Tc) D + Re E
V V

Interest paid Tax shield

 
WACC = (D x Rd) – (D x Rd x Tc) + Re E/V
V

3. Example:
Consider company G market values.
E = 75M D = 50M V = D + E = 125M
Re = 14.6% Rd = 8%
E/V = 60% D/V = 40%

Tc = marginal corporate tax rate = 35%

Number of shares = 10 million

Current share price = 7.5

Look out: To estimate the WACC, only market values should be used and
not book values.

Under these conditions we can compute the WAAC

WACC = 0.08 (1 – 0.35) 40% + 0.146 (0.6)
WACC = 10.84%

Cost of Capital RA = 0.08 (40%) + 0.146 (0.6) = 11.96%

26
 Because of the tax shield on interest payments (8% x 35% = 2.8%,
weighted at 40% = 1.12%), the WACC is lower than the cost of capital.
The amount of the tax shield is D x Rd x Tc = 50M x 8% x 35% = 1.4M

Now assume that G wants to invest 12.5M in a project This project is

expected to generate 2.085M of pretax cash flow in perpetuity.

In order to use the firm’s WAAC for the project there are 3 conditions to
be respected:
1. The project’s business look like the firm’s one
2. The project capital structure is the same as the company’s
3. The tax rate is not supposed to change

If these conditions are met the after-tax cash flow will be:
After-tax cash flow = Pre-tax cash flow - interest paid
= 2.085M - (2.085M x 35%) = 1.355M

NPV = -12.5M + 1.355M = 0

0.1084

Since the NPV = 0, the investment is not worth being undertaken.

4. Using the WAAC for valuation

a. When sources of financing are different, use each cost and weight
for each element. WACC = Rd (1 – Tc) D/V + Rp P/V + Re E/V +
etc…

b. Short-term debt should be included when calculating the WAAC

except if it is temporary debt

c. Current liabilities.

i. Netted out in the Net Working Capital (NWC).

NWC = Current assets - Current liabilities

ii. Any increase (or decrease) in NWC is a cash outflow (or

inflow) and must be included in the expected cash flow
calculation
iii. If the short-term debt is important as it is the case for small
firms, it should not be netted out but should be included
when calculating the WACC.

27
 d. How to get the cost of financing?
i. Use stock market data for Re
ii. For healthy firms, use book value for traded debt because
the market value of their debt is not too far from book
value.
iii. For non-traded debt, look for an equivalent security that is
traded and bears the same default risk and maturity.

e. Industry cost of capital

For projects that are different from the firm’s main business, it is
better to use a WACC available for firms with operations and
markets similar to that of the project

f. Valuing companies using the WACC

The WACC is usually used to value projects. However, it can be
used as a discount rate to estimate the value of a whole company.
The target company is treated as if it were a project.
i. Forecast the company’s Free Cash Flows (FCF) and
discount them back to the present
ii. Capital structure must be stable
iii. Do not deduct interest. Calculate taxes as if the company
was all equity financed. The tax shield is picked up in the
WACC formula.
iv. A medium-term horizon (about 10 years) is set and a
terminal value (PV at the horizons of the post horizon
FCFs) is added
v. Discounting the FCF at WACC gives the value of the assets
of the company. To obtain the company’s equity value,
subtract the market value of debt (VE = VF – VD)
vi. The flow to equity method directly estimates the value of
equity. Discount the company’s FCF at the cost of equity.

5. Adjusting the WACC when the debt ratio changes

a. Higher leverage increases the financial risk thus the expected
return on equity Re. It reduced the WACC at first because of the
greater tax shield on debt interest payments.
b. The three-step WACC recalculation:
Company G example: Let’s consider that G wants to invest in a
project that supports 20% for debt financing versus 40% for the
firm as a whole. Since we are using the company’s WACC to
discount the cash flows of the project and since the project’s
capital structure is different from the company’s WACC, the

28
 company’s WACC must be adjusted to reflect the project’s capital
structure.

Step 1: Unlevering the WACC

Calculate the opportunity cost (R A) capital as if there were no
taxes:
RA = Rd D/V + RE E/V
RA = 12% x 40% + 14.6% x 60%
RA = 12%

Step 2: Estimate the cost of debt at new D/E ratio and recalculate
the new RE.
For the purpose of this example we assume that Rd remains
unchanged at 8%.

RE new = RA + (RA – Rd) D/E

RE new = 12% + (12% - 8%) 20%/80%
RE new = 13%

We see that the return asked by equity holders to invest in this

project decreases because of its lower financial risk.

Step 3: Recalculate the WACC reflecting the new capital structure

WACC new = Rd (1 – Tc) D/V + Re new E/V
WACC new = 8% (1- 35%) 20% + 13% x 80%
WACC new = 11.4%

The effect of lower leverage is an increase of the WACC (11.4% at

D/E = 20% vs 10.84% at D/E = 40%).

This may sound counterintuitive since the return asked by

investors is now higher even though the financial risk has
decreased. This however can be explained by the loss of part of
the benefit of tax shield at a lower debt level.

c. Unlevering and Relevering the Betas

Assets =  Debt (D/V) + equity (E/V)

equity = Assets + ( Assets -  Debt) D/E
New Re = Rf + new equity (Rmarket – Rf)

d. Rebalancing the WACC

29
 i. Since calculating the WACC assumes a stable capital
structure the company must rebalance its capital structure
to maintain overtime the same market value debt ratio
during time over the relevant future. If the value of the
company VF increases, the debt ratio D/V and E/V will
decrease and therefore, in theory, the company will have
to increase debt and equity to maintain a stable capital
structure.
ii. In reality companies do not rebalance in such a mechanical
way. They adjust their capital structure linearly over the
long run.
iii. However, if the capital structure changes dramatically as it
is the case in a financial restructuring when debt is
borrowed to repurchase equity or if the company payoff
its debt, the WACC cannot be used.

6. The Adjusted Present Value Method (APV)

APV = NPV + Sum of the PV of the side effect of accepting the project.
The NPV is calculated assuming all-equity financing (using the R A)
a. Base case example:
Assume a project needs a 10M investment
Cash Flows after tax = 1.8M for 10 years
RA = 12% (the project’s business risk)

NPV = -10M + 1.8M x annuity factor (12%, 10 years)

NPV = -10M + 1.8M x 5.65
NPV = -10M + 10.17M = 170,000

b. Increasing debt example:

Assume 5M is borrowed over 10 years to fund the project
Principal reimbursement = 0.5M per year
Rd = 8% p.a.
Tc = 35%
Repayment schedule over 10 years (in thousands):
Debt outstanding Interest Interest Tax shield PVTS
5,000 400 140 129.64
4,500 360 126 108

4,000 320 112 88.9

3,500 280 98 72
3,000 240 84 57.2
2,500 200 70 44.1
2,000 160 56 32.6

30
 1,500 120 42 22.7
1,000 80 28 14
500 40 14 6.5
Total PVTS: 576

APV = Base case + PV of the tax shields:

APV = 170,000 + 576,000
APV = 746,000

This project looks fine as the APV adds the PVTS to the base case.

APV is used when the capital structure varies like in the case of an
Leverage Buy out (LBO) where debt is tied to a project’s book
value and has to be repaid on a fixed schedule.

c. APV versus WACC

Example: Company G (please refer to paragraph VII, 3)
Initial investment = 12.5M
Cash flow after tax = 1.355M
RA = 12%
Tc = 35%
Rd = 8%
WACC = 10.84% (with D/V = 40%)

i. Using the APV

If the project is all equity financed
APV = Base case + PVTS

APV = -12.5M + 1.355 + 0

12%
APV = -1 .21M
Value of the project = 12.5M – 1.21M = +11.29M

If the project is financed with 5M debt (40% of the

investment). The debt is fixed once and for all and does
not vary.
APV = -12.5M + 5M x 8% x 35% = 0.54M
35%

APV = 540,000
Value of the project = 12.5 + 0.54M = +13.04M
Note that in this particular case the tax shield is a
perpetuity

31
 If the debt is rebalanced to 40% of actual project value, we
discount the Tax shield at the opportunity cost of capital
12%.

APV = -1.21M + 140,000/12%

APV = -1.21M + 1.17M
APV = -0.04M
APV = - 40,000

ii. Using the WACC (refers to paragraph VII,3)

NPV = -12.5M + 1.355M = 0
0.1084

iii. The highest value for the project is when a fixed debt is
assumed (not rebalanced) as it carries more tax shields.

32
EXERCISES

Present Values
1
If the PV of 150 paid at the end of one year is 130, what is the discount factor? What is
the discount rate?
2
A merchant pays 100,000 for a load of grain and is certain to resell in exactly one year
for 132,000.

3
A parcel of land costs 500,000. For an additional 800,000 you can build a hotel on the
property. The land and the motel should be worth 1,500,000 next year. Common stocks
with the same risk as this investment offer a 10% expected return. Would you build the
motel?
Why or why not?
4
An investment costs 1,548 and pays 138 in perpetuity. If the interest rate is 9% what is
the NPV?
5
A TV reality show game pledges to pay €2,000 per month for 20 years to the winner of a
lottery. Therefore, it advertises that the winner will pocket €480,000 over 20 years. Is
that correct? Assume 20-year OAT yield is 0.422%.
6
A couple is saving to buy a boat at the end of 5 years. If the boat costs 20,000 and they
can earn 10% a year on their savings, how much to they need to put aside at the end of
years 1 through 5.
7
You have the opportunity to invest in the Pragawan Kingdom at a 25% interest rate. The
inflation rate is 21%. What is the real rate of interest?

Stock Valuation
1
Company A is considering paying a €10 dividend at the end of the year. After the
dividend the stock is expected to sell at €110. If the market rate is 10%, what is the
current stock price?

33
Company B does not plow back any earnings and is expected to produce a stable
dividend stream of €5 a share. If the current stock price is €40, what is the market
capitalization rate (expected return on the stock)?

3
Company C’s earnings and dividends per share are expected to grow indefinitely by 5% a
year. If next year dividend is $10 and the expected return on the stock is 8%, what is the
current stock price?

4
Company C prime is like company C except that its growth will stop after year 4.
Afterwards, starting in year 5, it will pay all earnings as dividends. What is company C
prime’s current stock price? Assume next year’s EPS is $15.

5
Company D is expected to pay a dividend of €2 on its stock. For the following years, you
believe that the stock will keep growing at a rate of 8% a year in perpetuity. If your
required rate of return is 12%, how much would you pay for this stock?

6
Consider the following stocks:
a. Stock A is expected to provide a dividend of $10 a share forever.
b. Stock B is expected to pay a dividend of $5 next year. Thereafter, dividend growth is
expected to be 4% a year forever.
c. Stock C is expected to pay a dividend of $5 next year. Thereafter, dividend growth is
expected to be 20% a year for 5 years (until year 6) and zero thereafter.

If the market capitalization rate for each stock is 10%, which stock is the most valuable?
What if the capitalization rate is 7%?

Risk of the debt ( Debt)

A company can borrow with a spread of 1.5%. The market risk premium is 3.55%.
Estimate  Debt

Cost of Equity
In November N, BNP’s stock price is 85 €. Its expected dividend is 3 € and its expected
long-term expected growth rate is 4%.
What its expected cost of equity?

Capital structure and the cost of capital

1

34
The common stock of company Y is valued €50M while its debt value is €30M. Investors
require a 16% return on the stock and 8% on the debt. IF Y issues another $10M of
common stock and uses this money to retire debt, what happens to the expected return
on the stock? Assume that the change in capital structure does not affect the risk on the
debt and there are no taxes.

2
Company Z Is all equity financed and has a  of 1.0. The stock has a PER of 10 and is
priced to offer a 10% expected return. The company repurchases half the stocks by
issuing debt.
The debt yields a risk-free 5%.

Calculate the beta of the common stock after the refinancing.

What is the beta of the debt?

Calculate the asset beta

Give the investor’s required return on the common stock before the refinancing

Calculate the Re and RA after the refinancing

After-tax cost of capital (WACC) and APV

1
Calculate the WACC for company X, using the following information:
Debt: £75M book value outstanding. The debt is trading at 90% of par. Yield to maturity
is 9%.
Equity: 2.5M shares selling at £42 per share. Expected return on company X’s share is
18%.
Marginal tax rate is 30%.

What are the key assumptions underlying the calculation?

For what kind of projects would the company X’s WACC be the right discount rate?

2
Company X’s decides to move to a more conservative debt policy. A year later its debt
ratio (D/V) falls to 15%. The interest rate has dropped to 8.6%. Recalculate company X’s
WACC under these new assumptions. The company’s, business risk, opportunity cost of
capital, and tax rate have not changed.

35
 3

APV example:
A 1-year project’s initial investment is $1,000 and its expected cash inflow is $1,200. The
opportunity cost of capital (RA) is 20%. The borrowing rate Rd = 10% and the net tax
shield per dollar of interest is 0.35.

What is the project’s base case NPV?

What is the APV if the firm borrows 30% of the project’s initial investment?

4
SEB example:
In January N, Market risk premium is 7.33%,
10 year-TBond = 3.14%,
SEB = 0.9, and the company can raise debt at 4.2%.
E/V = 85%
Tc = 331/3 %
Calculate the company’s WACC

5
Changing the capital structure and Beta
LOL Inc. is an all-equity financed company. Its e is 1.1. It wants to borrow debt up to
20% of the company’s value. Bonds are issued at a rate of 3.8%. The risk-free rate is 3%
and the market risk premium 4%. The marginal tax rate is 33 1/3%.
Calculate the company’s new equity beta.

36
English for Financial Markets JM Singer

FINANCIAL ANALYSIS OF THE CONSOLIDATED

FINANCIAL STATEMENTS AND FORECASTS

OUTLINE OF THE CHAPTER:

- INTRODUCTION TO FINANCIAL ANALYSIS

- THE BASIC ACCOUNTING STATEMENTS

- FINANCIAL RATIOS ANALYSIS

- FINANCIAL FORECASTING

I. INTRODUCTION TO FINANCIAL ANALYSIS

To assess a company's financial strength a long list of ratios is used. A financial analyst
must preview what the ratios measure and how they connect to the ultimate
objective of value added to the shareholders.

Shareholder value
Market value added
Market book ratio

Investment Financing
How profitable? How fast can the company
grow by plowing back earnings?
Economic value added

37
Returns on capital, assets, and equity Sustainable growth rate

Efficient use of assets Profit from sales Prudent Sufficient liquidity for
leverage the coming year
Turnover ratios for Operating profit Debt ratios Liquidity ratios
assets, inventory, and margin Interest coverage Current, quick, and
receivables ratio cash ratios
IFRS (International Financial Reporting Standards) has become the basis for reporting in
the European Union and some 100 other countries have adopted them. The principal
exception remains the United States. Any move to bring the US companies to adopt IFRS
seems a long way off even though US GAAP and IFRS have substantially narrowed their
differences. Financial statements provide information to the firm's various stakeholders,
such as shareholders, bondholders, bankers, suppliers, employees and management,
who all want to be sure that their interests are being served.
U.S. public companies report to their shareholders quarterly and annually. They file their
annual statements with the SEC on form "10-K" and the quarterly statements are filed
on form "10-Q".

On line documents:
Form 10-K from 2020. Apple Inc. (US GAAP)
Document de référence 2018 – L’Oréal Finance (IFRS)

Norme IAS 1
This norm requires:
- A Balance Sheet (also called a Statement of Financial Situation) at the end of
the period (Bilan);
Statement that presents the relation between Assets, Liabilities and
Shareholders’ equity at a certain time. IFRS does not require any formal
presentation for the Balance Sheet. However, a list of information must be
presented. IAS1 requires only the distinction between current and non-
current elements.

- An Income Statement and a Statement of Compréhensive Income (Un état

du résultat net et des autres éléments du résultat global.
An income statement is a financial statement that shows the company's
income and expenditures. The statement of comprehensive income refers to
all other revenues and expenditures accounted directly in equity.
- A Statement of Equity (Un état de variation des capitaux propres pour la
période)
- A Statement of Cash-Flow (Un tableau des flux de trésorerie pour la période)
- Supplementary information summarizing the main accounting methods used
and other explanatory notes.

38
 II. THE BASIC ACCOUNTING STATEMENTS

The most important clues to a company’s health are usually contained in the three basic
financial statements: the balance sheet, the income statement, and the cash flow
statement.

1. The Balance Sheet

The balance sheet is a snapshot of a firm’s financial position at a given point in time.
It is a tabulation of what a firm owns (its assets), and what it owes (its liabilities). The
Net Assets (Total Assets – Total Liabilities) accrues to the shareholders.
In US GAAP, assets are listed in order of decreasing liquidity. Liabilities and equities
are listed in terms of increasing order of when they come due.

a. Assets
Current assets are likely to be converted into cash in a year; fixed assets include
land, plant, and equipment investments; other assets normally represent ownership
in other companies and goodwill. Goodwill arises when a company pays more than
the “fair market value” for an asset.

b. Liabilities and Shareholder’s equity

Current liabilities are debts that are payable within one year. Long-term liabilities
include not only financial debt like bonds and mortgages but also items like
employee post-retirement benefits (in the US) and deferred taxes.
Shareholder’s equity is the difference between total assets and all the liabilities. This
“book value” may be different from what we would have after liquidating all of the
assets and paid off the creditors.

c. Net working capital

Net Working Capital is current assets minus current liabilities, it is rarely highlighted
on the balance sheet of an American firm, but is an important measure of liquidity.

d. Difference between accounting and economic value

In an ideal world, there should be no differences between accounting and economic
values. There are 3 main problem areas.

- Asset and liability accounts do not represent current values.

39
 Accountants have adopted historical cost as the basis for valuation. The virtue of
historical cost is objectivity since accountants can agree on the same cost of a
piece of equipment. (Note: Under IFRS, Assets and Liabilities must be evaluated
at Fair Value)
- Some Intangible assets are excluded from the balance sheet.
Management skills, reputation, and strategic positioning never appear on the
balance sheet.
- Important liabilities may be understated or omitted
Divergence between book and market values of a firm’s liabilities has been
minimized. However, some companies may have contingent liabilities that are
seriously understated.

2. The Income Statement

The firm’s income statement summarizes revenues, expenses, and profits over some
time period. Net income is just the difference between sales and the various costs
and taxes.

3. The Statement of Cash Flows

Statements of cash flows reconcile differences between accounting revenues and
costs, and between cash receipts and disbursements. It explains the difference in the
cash account recorded on a company’s balance sheet between two periods.

Structurally, the statement of cash flows is divided into three sections: operating,
investing, and financing activities
a. Cash-flow from operating activities
Cash flow from operations is OCF = NI + (DEP + AMOR) – ΔWC
The section on cash flow from operating activities is essentially an effort to
recognize that net income calculated on an accrual basis may be quite different
than a firm’s cash flow.

b. Cash flow from investing activities

Free cash flow represents the cash flows generated by the company after it takes
on all profitable investment projects.
FCF = OCF – INVEST

c. Cash flow from financing activities

Includes those cash flows associated with the sale (or retirement) of long-term-
debt, the sale (or repurchase) of common stock, and the payment of dividends.

III. FINANCIAL RATIO ANALYSIS

Ratio analysis is a tool for organizing information in order to allow an analyst to

diagnose a firm’s financial condition and assess performance. Ratio analysis is useful as a

40
comparative tool. Two types of comparison can be made: (1) trend analysis (2) cross-
sectional analysis to compare a firm with others in the industry.
To conduct a thorough financial analysis and assess the financial health of a company 4
categories of ratios are usually used:

1. Operating Profitability ratios

These ratios measure the management’s effectiveness at generating net
income in relation to sales, total assets, and shareholder equity.
Profit margins attempt to measure the firm’s ability to control expenses in
relation to sales.

i. Sales. Even though this not a ratio, a proper financial analysis must start
with a thorough analysis of the company’s revenues. It is important to
understand the sales trend overtime. Also, a breakdown of the company’s
sales by products leads to a better understanding of the overall
profitability.
ii. Gross Profit Margin = Gross Profits/Net Sales
Gross profit = Net sales minus the cost of goods sold
Measures the relative profitability of sales in relation with cost of goods
sold. It says something about the firm’s pricing policy. Decreasing prices
may lead to lower margins and higher volume; conversely, higher prices
may generate higher margins but lower volume.
Note #1: If a company extends credit terms to attract customers instead of competing on
price, profitability should increase. However, any increase in gross profit may be illusory
if the company is taking on marginal customers to boost sales. Financing accounts
receivable has a cost and bad-debt losses may wipe out increased profits.

Note #2 : (France) Taux de Marge Brute (TMB) = Excédent Brut d’Exploitation

Net Sales
The French EBE also called Gross Operating Profit is close to the US EBITDA
EBE = Chiffre d’affaires – Achats consommés – Consommations en provenance de tiers
+ Subventions d’exploitation – Charges de personnel – Impôts et Taxes.
It is also equal to : Valeur Ajoutée - Charges de personnel - Impôts et taxes -
with Valeur Ajoutée = Net Sales – Achats et autres charges externes

EBITDA = EBIT + Depreciation and Amortization

iii. Operating Profit Margin = EBIT/Sales

This ratio takes into account depreciation and general and administrative
costs.
Operating profit (Earnings Before Interest and Taxes) = Gross profit -
SG&A
The volatility of EBIT is a prime indicator of the business risk

41
 EBT = EBIT - Interest expense - Net Foreign Exchange loss
EBITDA = EBIT + Depreciation and Amortization (Non-US GAAP)
(proxy for pre-tax cash flow often used by bankers. Not to be used
because it is a cash flow biased estimate.

iv. Net Profit Margin = Net Income/ Net Sales

The Net Profit accrues to the shareholders who, in turn, have to decide the
percentage to be distributed as dividends the rest being reinvested in the
company.
If Net Profit (loss) shows how much money the company actually makes
(or loses) from its revenues after having paid all its expenditures, the Net
Profit Margin shows how many dollars are actually made from $1 of sales.
A decrease may reflect the difficulties any growing firm experiences when
sales fail to meet expectations (added PP&E increases depreciation; higher
G&A staff - fixed in the short term). It may also reflect poor
product quality or a competitor who supplies customers with a superior
product at a lower price.

v. Other profitability ratios

If the preceding ratios measure the company’s ability to generate a profit
from its sales base, the following ratios assess the profit generated in
relation to the asset base and to the capital invested by the shareholders.
- The Return on Equity (ROE)
ROE = Net Income/Shareholders’ Equity
The ROE represents the amount of net income a company earns per one investment
dollar. It reveals how much profit a company makes with the money shareholders
have invested.

The ROE provides useful insights into linkage between corporate

strategy and finance. It can be rewritten

ROE = ROA x CSL = Net Profit Margin x Total Asset Turnover x CSL

with CSL = Capital Structure Leverage or equity multiplier

Profitability Efficiency Leverage

ROE = Net Income x Sales x Total Assets
Sales Total Assets Shareholders’
Equity

- The Return On Capital Employed (ROCE)

ROCE = EBIT/Shareholders’ Equity + Long Term Debt

The return on capital employed shows how much operating income is

generated for each dollar of capital invested.

42
 - The Return on Assets (ROA)
ROA = Net Income/Total Assets
This ratio shows how efficient a company's management is at using its
assets to generate earnings. It measures how much net earnings is
generated by one unit of asset.

In summary, ROE can be improved by:

i. Increasing net profitability (higher sales with controlled costs)
ii. increasing leverage (the equity multiplier). But that will
increase financial risk, interest expense and lower the profit
margin.
iii. increasing Total Asset Turnover that is by improving operating
efficiency ratios
Illustration: For a distribution company that might mean: (1) dealing on a
cash basis and avoid credit cards (no receivables), (2) maintaining
an inventory control system to produce high turnover, (3)
allocating shelf space to items that are selling rapidly, (4) leasing,
rather than owning, its facilities. This company must have a “real
time” information system that tells the company what’s selling
where.

2. Operating efficiency ratios

i. The Total Asset Turnover: Net Sales/Average Total Assets

This ratio shows how efficient a company’s assets are at generating sales.
The main elements of total assets should therefore be analyzed and
compared to sales.

ii. Cash turnover ratio: Net Sales/Average Cash and Marketable securities
This ratio shows how much cash by units of sale is left idle on the balance
sheet. This cash does not generate sales and may have a negative effect
on the TAT.
The cash turnover ratio (Sales/ Cash+MS) indicates how many times a
company went through its cash balance over an accounting period and
the efficiency of a company's cash in the generation of revenue.

Lots of cash left idle on the balance sheet lowers the cash turnover ratio
and is not desirable. To the contrary, moderate cash and marketable
securities on the balance sheet increases the cash turnover ratio and is

43
 desirable as it indicates a greater frequency of cash replenishment
through revenue.

iii. Account receivable turnover ratio: Net sales/Average Accounts

receivable
This ratio is used to quantify a company's effectiveness in collecting
its accounts receivable that is the money owed by customers.

A firm that is efficient at collecting on its payments due will have a higher
accounts receivable turnover ratio.
A low receivables turnover ratio could be the result of inefficient
collection, inadequate credit policies, or customers who are not
financially viable or creditworthy.

Receivable turnover in days = 365/Receivable Turnover ratio

The receivable turnover in days indicates how many days on average it
takes a company to collect its receivables.
A high receivable turnover in days is not desirable as it indicates that the
company is slow to collect its receivable from its clients.
A low receivable turnover in days is desirable as it indicates that the
company is quick and efficient at collecting the cash from its clients.

These ratios must be compared to those of the company’s main

competitors.

iv. Inventory Turnover ratio: Cost of Goods Sold/Average Inventory

Inventory turnover measures how fast a company sells its Inventory. A
low turnover implies weak sales and possibly excess inventory, also
known as overstocking. A high ratio, on the other hand, implies either
strong sales or insufficient inventory. The former is desirable while the
latter could lead to lost business.

Average Inventory Processing Period = 365/ Inventory Turnover

This ratio measures the number of days on average the company’s
inventory remains unsold. A high number of days is not desirable as it
shows that the company’s cash is trapped into inventories that are slow
at being sold. Conversely, a low number of days is desirable as the
company proved able to find quickly clients to whom it can sell its
existing inventory.

These ratios must be compared to those of the company’s main

competitors.

44
 v. Fixed assets turnover ratio: Net Sales/Average Net Fixed Assets
This ratio reflects the firm’s utilization of fixed assets.
An abnormally low turnover implies capital tied up in excessive fixed
assets. An abnormally high turnover ratio indicates a lack of productive
capacity to meet sales demand, or might imply the use of old, fully
depreciated fixed assets that may be obsolete and need replacement.

It can also be also useful to look at the company’s other important assets
such as Goodwill and other intangibles to complete the analysis of the
TAT and to better assess the management’s effectiveness at managing
them.

3. Internal Liquidity ratios

These ratios measure the quality and adequacy of current assets to meet current
liabilities as they come due. It is related to the size and composition of the firm’s
working capital position. Therefore, an evaluation of the quality of a firm’s
receivable and inventory accounts is critical to any assessment of liquidity.

i. Current ratio = Current Assets/Current Liabilities

This ratio shows if current liabilities are effectively covered by current
assets. In other words that the cash on hand and expected to be received
by the company over the accounting period will be enough to cover the
cash needed to pay off the current liabilities.

High current ratios may not be accurate indicators of a firm’s ability to

pay its bills on time (e.g. slowing receivables, obsolete inventories that
should be written off). Therefore, analysts use more conservative ratios.

ii. Quick ratio = (Cash + Marketable Securities + Receivables)/Current

liabilities
A more conservative measure of liquidity would exclude inventories, the
least liquid of a company’s current assets.
Even more conservative is the Cash Ratio

iii. Cash ratio = Cash and Marketable Securities/Current Liabilities

The cash ratio calculates a company's ability to repay its short-term debt
with cash or near-cash resources, such as easily marketable securities.
This information is useful to creditors when they decide how much
money, if any, they would be willing to loan a company.

45
iv. Accounts Receivable Turnover, Inventory Turnover and Payables
Turnover Ratios

If a company sees its cash tied up in receivables and inventories, at the

same time it receives an offset in terms of payment delays from its
suppliers who provide interest-free loans to the firm by carrying the
firm’s payable.

Payables Turnover Ratio = CGS/Average Trade Payables

The accounts payable turnover ratio is a short-term liquidity measure
used to quantify the rate at which a company pays off its suppliers.
Accounts payable turnover shows how many times a company pays off its
accounts payable during a period.

Accounts payable turnover in days = 365/ Payables Turnover

The accounts payable turnover in days shows the average number of
days that a payable remains unpaid. The higher the ratio the better.
A high ratio does not mean that the company cannot pay its bills, it only
says that the company was able to extract better term payments from its
suppliers.

v. Cash Conversion Cycle = Receivable Turnover in days + Inventory

Turnover in days - Payables Turnover in days

As seen earlier, effectiveness at collecting cash from customers and at

selling inventories is important for assessing management’s ability to
generate sales with the existing assets. But it is also key to determine a
company’s ability to pay debt obligations and its margin of safety. This
aspect is also captured in the Cash Conversion Cycle.

The cash conversion cycle (CCC) expresses the time (measured in days) it takes for a
company to convert its investments in inventory and other resources into cash flows from
sales.
A trend of decreasing or steady CCC values over multiple periods is a good sign while
rising ones should lead to more investigation and analysis based on other factors. 

4. Leverage Ratios

These ratios measure a company’s ability to handle its debt. They indicate the
proportion of debt on the balance sheet. Thus, the higher the figures, the
lower equity contributes to the financing of the assets and the higher
debtholders’ exposure to financial risk.
i. Debt Ratio 1 = Total Liabilities/Total Assets

46
 ii. Debt Ratio 2 = Total Liabilities/Total Equity

iii. Debt ratio 3 = Total Long-term debt/Total Equity

iv. Debt Ratio 4 = Total Assets/Total Equity

An increase in these ratios indicates that creditors are exposed to more

risk. In addition, increases in these ratios will impair a company’s ability
to borrow in the future, thereby reducing the firm’s flexibility in meeting
competitive and other threats.

v. Interest Coverage Ratio 1 = EBIT/Interest Expense

vi. Cash Flow Coverage Ratio 2 =

- EBIT + Depreciation + Lease/Rental Payments + Depreciation

Interest + Lease/Rental Payments
These 2 ratios measure the firm’s ability to meet its interest payments out of
annual earnings before interest and taxes (EBIT). They Indicate how far
earnings could decline before it would impossible to pay the interest charges
from current earnings.
However, what really matters is a company’s ability to generate cash in order
to service its contractual obligations, not accounting earnings.

- Cash Flow from operating activities + Interest expenses + Implied lease interest
Interest Expense + Implied Lease Interest

- Cash Flow from operating activities/Book Value of long-term debt

(Used to predict bankruptcy)

IV. Financial Forecasting

In order to issue a buy or sell recommendation on a company’s stock a whether
it is for portfolio investment purposes, mergers or any other financial transaction
such as Leverage-Buy-out, a financial analyst will try to assess its future cash flow
generation ability. In order to do this, a financial plan is needed. It will attempt to
set up one or several business scenarios that will show how the company’s
financial results could look like in the future.

Making the assumptions of a strategic plan visible (subject to scrutiny) increases

the likelihood of the plan’s feasibility and that corporate goals will be achieved.

The heart of the financial plan is contained in the pro forma (forecasted) balance
sheet and income statements.
1. Overview of corporate strategies
a. Lines of business

47
 b. Foreign vs. domestic operations
c. Product strategies
d. CEO’s letter to stockholders and employees

2. Structure of the industry

a. Checklist for evaluating an industry
- Competitive conditions
- Growth profile
- Regulatory environment
- Sensitivity to demographic changes
- Sensitivity to macroeconomic conditions
- Importance and rate of technological change
- Sensitivity to exchange rate changes
- Production profile
- Other important industry characteristics

b. Sources of information
- Standards and Poors Industry Survey
- Dun & Bradstreet Industry Norms and Key Business Ratios
- Moody’s Industrial Manuals

3. Current economic position of the firm

a. Profitability
b. Efficiency
c. liquidity
d. solvency and capital structure

4. Sales forecasting
The sales forecast is the heart of the financial planning process.
The annual forecasts are usually broken into quarterly and
monthly forecasts and are stated in monetary units and/or
physical units.

5. Financial forecasting using Pro-Forma financial statements

Pro forma income statement and balance sheet are needed if
expense, assets, and liability categories are not linearly related to
sale.

Example of Free Cash Flow forecasts for valuation purposes:

Proforma business plan of company Sigma established in 2007

(in millions of euros) 2008 2009 2010 2011 2012 2013 2014 2015

48
Sales 1,951 2,058 2,161 2,258 2,349 2,431 2,504 2,579
Growth rate 5.5% 5% 4.5% 4% 3.3% 3% 3%
EBIT Margin 19.0% 22.0 % 21 % 20 % 19.0% 19.0% 19.0% 19.0%

EBIT Margin 370.7 452.8 453.9 451.7 446.3 461.9 475.8 490.0

Income taxes (33%) -123.6 -150.9 -151.3 -150.6 -148.8 -154.0 -158.6 -163.3
Depreciation (2.8% of sales) 54.6 57.6 60.5 63.2 65.8 68.1 70.1 72.2
Change in Net Working Capital -13.0 -16.0 -12.0 -10.0 -10.0 -10.0 -10.0 -10.0
Capital Expenditures (3% of sales) - 54.6 -57.6 - 60.5 - 63.2 -65.8 - 68.1 - 70.1 - 72.2

Free Cash Flows 234.1 285.9 290.6 291.1 287.5 297.9 306.2 315.7

In order to calculate the present value of these cash flows, we need to estimate Sigma’s
WACC.

Assumptions:
10-year T-Bonds: 4%
Market Risk premium: 5%
Rd = 6.6%
D/V = 80%
Beta = 1.0
Corporate marginal tax rate: 33%
Growth rate beyond 2015: 3%

First, we estimate the return on equity using the CAPM

Re = 4% + 1 x 5% = 9%

Then, we estimate the WACC:

WACC = 9% x 80% + 6.6% (1 – Tc) x 20%

WACC = 8.8%

We can now discount the forecasted FCFs and find the value of Sigma’s equity

2008 2009 2010 2011 2012 2013 2014 2015

Discounted Free Cash Flows 215.2 241.5 225.6 207.8 188.6 179.6 169.7 160.8
Terminal Value 5,606

PV of Terminal Value 2,855

 of Discounted FCFs (2008-2015) 1,589
Firm Value 4,444
Debt Value -380
Equity Value 4,064

49
 Terminal Value computation: 315.7 x 1.03 = 5,606
8.8% - 3%

The equity value needs to be divided by the estimated number of outstanding

shares in 2008 to determine the intrinsic value of the stock.

English for Financial Markets JM Singer

MERGERS

Chapter Outline

1) Introduction

2) The nature of mergers and tender offers

3) Deal Structuring

4) Other corporate restructuring transactions

5) Valuation Methods

5) Estimating merger gains and costs

6) Takeover Defenses

50
1) INTRODUCTION: GENERALITIES ABOUT MERGERS

A) Definition
Mergers refer to the friendly combination of two or several separate businesses
into a new single legal entity. Therefore, mergers refer to negotiated deals that
meet certain technical and legal requirements where friendly parties arrive at a
mutually agreeable decision to combine their companies.

Acquisitions refer to the takeover of one entity by another. Tender offer usually
means that one firm or person is making an offer directly to the shareholders to
sell (tender) their shares at specified prices. Tender offer can be friendly or
hostile.

Mergers and acquisitions (M&A) is a general term that describes the

consolidation of companies or assets through various types of financial
transactions. M&A include mergers, acquisitions, divestures, alliances, joint
ventures, restructuring, minority
investments, licensing, franchising, as well as international activities.

B) Mergers drivers: Change Forces

- Technological change

- Efficiency of operation: Economies of scale which spread the large fixed cost of
investing in machinery or computer systems over a large number of units 

- Changes in industry organization. An example is the shift of the computer

industry from vertically integrated firms to a horizontal chain of independent
activities

- Favorable economic and financial conditions. Optimism about the future

encourage firms to made large-scale investments, often via M&As

51
- Deregulation and regulations (power industry, financial institutions)

- Globalization and freer trade

- New industries (e business)

- Negative trends in certain economies and industries

C) TYPES OF MERGERS FROM AN ECONOMIC STANDPOINT

- Horizontal mergers

A horizontal merger involves two firms that operate and compete in the same
kind of business activity. Although the main benefit is economies of scale not all
firms merge to achieve economies of scale.

Horizontal mergers are regulated by the government for possible negative

effects on competition. They make it easier for large companies to collude for
monopoly profits.

A roll up is a special kind of horizontal merger where a consolidator, led by a

strong and experienced management team and using debt as a financing tool
acquires a large number of small mature companies in a fragmented industry.
The goal of the roll up is to achieve economies of scale in purchasing, marketing,
information systems, distribution, and senior management. Initial Public
Offerings (IPO) have in recent years provided the consolidator with cash and
liquid shares by which to carry out the acquisitions.

- Vertical mergers

Vertical mergers occur between firms in different stage of production operation.

(Oil industry: exploration and production)

They may be technological reason for a firm to be vertically integrated

(integrated iron and steel producer: consolidation of reheating and
transportation cost).

May eliminate costs such as contracting, payment collecting, advertising.

Inventory planning may also be improved within a single firm.

- Conglomerate mergers
a. Involve firms engaged in unrelated types of business activity.

52
b. Production extension mergers broaden the product line of firms (concentric
mergers).
c. Geographic market extension merger
d. Pure conglomerate mergers

Conglomerates firms differ from investments companies such as mutual funds

that try to reduce risk by portfolio diversification in that they control the entities
to which they make major financial contributions. These entities require specific
skills in management, engineering, production, marketing etc…

D) Issues with mergers

Some argue that mergers increase value and efficiency and move their resources
to their optimal uses, thereby increasing shareholder value.

Others are sceptical arguing that acquired companies are efficient and that their
takeover does not improve their performance. Could M&A activity be a mere
redistribution of wealth from labour to shareholders, lawyers and accountants?

1. Sensible reasons for mergers

- Synergies (economies of scale: Horizontal and vertical mergers).
Fiscal synergies may also be a factor but may be blocked by fiscal
authorities. Ex: Pfizer (US) and Allergan (Irl) blocked in 2017.

- Complementary resources: It may be quicker and safer to merge with a

company that already have the resource, technology and human
talents necessary for success.

- Surplus funds: In mature industries, some cash-rich firms, to avoid

being targeted for takeover, may decide to invest their capital in other
firms rather than paying fat dividends or buying back their shares.

- Eliminating inefficiencies: Poorly managed companies that do not cut

costs or fail to expand their business becomes good candidates for
takeover by other firms with better management.

2. Dubious reasons for mergers

- Diversification: Cash-rich firms in stagnant industries often merge to
venture into new industries that they have little acquaintances with
(Example: General Food and Philipp Morris in 1987).

- Increasing earnings per share

53
 This is called the bootstrap game when there is no real gain created by
the merger and no increase in the two-firms’ combined value. In the
short term the addition of earnings from the two firms increase EPS,
but as time goes by and no value is created, the EPS falls back to its
previous level.

- Lower financing costs

When 2 firms merge the combined company can borrow at lower
interest rate than either firm could separately. In addition, the bonds
that were guaranteed by one of the two firms end up being guaranteed
by both. However, the stock holders lose because they have given
bondholders better protection but have received nothing in exchange.

Only if the merger decreases the risk of financial distress allowing for
higher borrowing levels and therefore higher interest tax shields would
the merger create value for the shareholders.

In the end Mergers often fail because:

- Managers cannot handle the difficult task of integrating the two firms.
This involves the production processes, the accounting methods, the
corporate culture.

- Managers tend to forget that the value of most businesses depends on

human assets. Among unhappy workers, the best of them may leave to
go work for competition or to create their own firm.

- The bidder overpaid the business it purchased.

2) THE NATURE OF MERGERS and TENDER OFFERS (French:

Offre publique d’Achat)
A) Nature of Merger transactions

There 2 ways to conduct a merger:

1. A new entity is created to which one or several companies bring their assets
“Merger – Creation”;
2. An existing entity absorbs the assets and liabilities of one or several separate
companies “Merger – Absorption”. The shareholders of the absorbed
companies become shareholders of the absorbing entity.

For accounting sake in the PCG (Plan Comptable Général) there 2 types of
mergers:

54
3. Fusion à l’endroit: The bidder takes over the target. The bidder’s
shareholders gain control over the target and the target’s shareholders lose
their control over the target company.
4. Fusion à l’envers: The bidder is the absorbed entity which takes over the
absorbing company. The target is the absorbing entity which loses its control
over the absorbed company.

Example:
Company A (the bidder) wants to absorb company B (the target):
A has 50,000 common shares ($ 100 par value). 95% of its shares is owned by its main
shareholder.
B has 30,000 common shares ($100 par value). 95% of its shares is owned by its main
shareholder.

Case #1: 1 share of A is exchanged against 1 share of B. Therefore, A must create 30,000 A shares
to replace the 30,000 B shares. After the merger there will be 80,000 A shares. A’s main
shareholder who prior to merger detained 47,500 A shares (50,000 A x 95%) will keep the
majority of the shares after the merger since B shareholder will have only 28,500 A shares (30,000
A x 95%). This is a straight merger.

Case#2: 2 shares of A are exchanged against 1 share of B. A must create 60,000 A shares to
replace the 30,000 B shares. After the merger there will be 110,000 A shares. A’s main
shareholder who detained 47,500 A shares prior to the merger (and still have 47,500 A shares after
the merger) is no longer the main shareholder after the merger.
To the contrary, B’s main shareholder who had 28,500 B shares prior to the merger, owns after the
merger 57,000 A shares (28,500 x 2) and takes control over company A. This is a reverse merger.

Finally, 2 methods for recording the assets and liabilities are used:

Entities under common control

- Fusion à l’endroit Book Value
- Fusion à l’envers Book Value

Entities not under common control

- Fusion à l’endroit Market value
- Fusion à l’envers Book value

5. Soulte: Amount of cash paid to reestablish equality between 2 parties in a

merger transaction.

In class example:

B) Timing of Merger Transactions

55
 In a tender offer, the bidder’s obtaining 50% or more of the shares of the target
firm is equivalent to having received shareholder approval. The offer is extended
to the individual shareholders so that management and the board of directors
can be bypassed. The tender offer can be friendly or unfriendly.

The minority shareholders must agree to the terms negotiated. The minority
always has the right to bring legal action if it feels that it has been treated
inequitably. Many minority “squeeze outs” in recent time were successful maybe
because the parent seeks to avoid costly litigation instituted by target
stakeholders.

A tender offer can be conditional or unconditional and restricted (to a certain

number of shares) or unrestricted. An “any-or-all” tender offer is unconditional
and unrestricted.

The US law requires a 20-day waiting period during which the target company
shareholders may make their decision to offer their shares for sale. The bidder
may extend the offer; the proration period is also extended automatically. If a
counter offer is made, the shareholders have 10 additional days to examine the
initial offer.

There can be “two-tier tender offer” in which the first-tier is paid in cash or
equity to obtain control. The second-tier, a smaller value, is often paid in
securities such as debt.

In France, the AMF requires a 25-day waiting period if the bidder holds less that
50% of the outstanding shares. It can be limited to 10 days if it holds more than
50% of the shares.

3) Deal Structuring
A) Taxable Versus Non-taxable Acquisitions
Rule of thumb in the US (but with many exceptions): exchange of stock is
nontaxable, exchange of stock for cash or debt is taxable.

B) Implications of nontaxable versus taxable

a. Non-taxable reorganizations
- Acquiring firm: Net Operating Losses (NOL) carryover, No write up
of assets or step up of depreciable assets can be made

- Target firm: Deferred tax gains for shareholders.

“Tax-free” reorganizations are actually only tax deferral for target firm
shareholders. Capital gains are payable upon sale of acquiring firm’s stock
Basis is original basis of the target stock.

56
 b. Taxable acquisitions
i. Acquiring firm: Stepped-up asset basis but no NOL
ii. Target firm: Capital gain recognition for target shareholders

C) Form of payment
a. Method of payment is usually cash, stock, debt, or some other
combination

b. Cash versus stock

i. Cash is used in cash tender offers and cash mergers. At closing target
shareholders exchange their shares for an agreed upon amount of
cash.
ii. Stock mergers
- Merging parties negotiate a ratio of acquirer shares that will be
exchanged for target shares

- When merger is completed, target shares are converted to

acquirer shares at upon agreed ratio

- Target shares will decline (or increase) in proportion to acquirer’s

stock price between merger announcement and completion

- Stock mergers bear considerable risk.

Example: Determination of an exchange ratio and the nature of the

transaction

Company A announces that it wishes to takeover company B.

A has 10,000 shares outstanding priced at €300 (€100 par value)

B has 6,000 shares outstanding priced at €200 (€100 par value)
Both companies are distinct.

The exchange rate will be €200/€300 = 200 x 1A = 2A

1B 1A 1B x 300 3B

2 shares of A for 3 shares of B

Or XA x €200 = 6,000 B shares x 300€

XA = 4,000

57
 with XA the number of A shares created to be exchanged for 6,000
B shares

ER = 4,000 A shares = 2A
6,000 B shares 3B

A will have to increase its capital by 4,000A x €100 = €400,000

This is a straight merger (fusion à l’endroit) because A shareholders keep the

majority control over the merged entity. In addition, before the transaction,
both companies were not under common control (Controle distinct).
Therefore, market values will be used for accounting.

c. A premium is usually paid to the Target shareholders

The gain of the merger is therefore split between the bidder’s
shareholders and the Target’s shareholders.

d. Stock mergers with collars

i. Many stock mergers use a collar, leaving the exchange ratio
uncertain until near closing of the deal

ii. Most common collar sets a maximum and a minimum

Between certain share prices of the acquirer, target will receive a
set dollar value of acquirer shares. But when acquirer stock rises
or falls out of price range, target will receive an agreed upon fixed
ratio of share.

iii. Another collar could specify a fixed exchange ratio unless the
acquirer stock traded above or below certain triggering levels

iv. An unrestrictive collar would specify that regardless of the stock

price movement of the acquirer, the target would receive a fixed
dollar amount worth of the acquirer stock based on a price near
the closing date

4) Other corporate restructuring transactions

A) Asset sale, Equity carve-out, Spin off)

1. Asset sale: Sale of a division, subsidiary, product line or other asset
directly to another firm. Transferred subsidiary or division is absorbed
within organizational structure of buying firm. Payment is usually cash.

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 In France: Partial asset contribution (Contribution partielle d’actifs): A
company A brings some of its assets to a company B and receives B
stocks in exchange. Close to the US Asset sale.

2. Equity carve-out (Détourage): Offering of a full or partial interest in a

subsidiary to the investment public. It is an IPO of a corporate subsidiary
or a split-off IPO. Creates new, publicly traded company with partial or
complete autonomy from parent firm.

3. Spin-off: Pro rata distribution of shares in a subsidiary to the existing

shareholders of the parent firm. It is a stock dividend in a subsidiary.
Creates a new, publicly traded company that is completely separate from
the former parent firm. No cash is generated by the parent.
Debt allocation between parent and subsidiary has capital structure
implications.

4. Similarities and differences:

All three partially or fully remove assets from - former parent firm’s
control.
Equity carve-outs and spinoffs create new corporate entities.
Asset sales transfer assets to another entity.
Sometimes used in tandem or employed sequentially.
Equity carve-outs can be first stage of a broader divestiture and are often
followed by either the sale of the remaining interest of subsidiary to
another firm or the Spinoff of remaining ownership to shareholders.

B) Split-ups, tracking stock, and exchange offers

1. Split-up (Cission): Separation of a company into two or more parts. Like in
mergers a split-up leads to the disappearance of the initial entity and the
creation of 2 or more newly created companies.
The term applies to a restructuring where firm is not merely divesting a
piece of the firm but is strategically breaking up the entire corporate
body. It is Usually accomplished with one or more equity carve-outs
and/or spinoffs.

2. Tracking stock (Action reflet): Separate class of common stock of parent

corporation. The value of stock based on cash flows of a specific division.
First issued in 1984 as part of EDS acquisition by General Motors. More
recently employed as part of public offering of a corporate subsidiary.

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 3. Exchange offer  (Offre publique d’échange). : Distribution of a subsidiary
where shareholders have a choice to retain parent shares or instead
exchange existing shares for new shares in subsidiary. (

4. Exchange offers versus spinoffs: Resembles spinoff in that shares are

issued in a separate, publicly traded company. Different in that shares in
new firm are received by holders that opt to trade in shares of parent
Example: Limited’s divestiture of Abercrombie and Fitch in 1998

5) Valuation Methods
A. Valuation is critical in M&A. Valuation failures can result from bidder paying too
much Valuation critical in M&As
1. Acquisition failures can result from bidder paying too much
2. Value of bidder tender offer may stimulate competing bidders
3. In bidder contest, winner is firm with highest estimates of value of target

B. Alternative Valuation Methods :

There are many valuation methods.
1. Net Book Value (Total Assets – Total debt). Actif Net Comptable or ANC in
French. Often used in the case of a liquidation
2. Net Book Value Value Adjusted (Market value of assets – Debt)
(Actif Net Comptable Corrigé or ANCC in French)
A static evaluation of the company. Does not consider its future
profitability and does not take into account certain key intangibles such as
employees’ technical ability and commitment, its reputation or its
economic prospects.

Reminder : ANCC = Actif net comptable (ANC) + plus-values (ou - moins-

values) sur éléments d'actif + réserves occultes (provisions non justifiées) +
fiscalité différée actif - fiscalité différée passif.

L’actif net comptable consiste à estimer la valeur d’une entreprise sur la

base de sa situation nette comptable. Il correspond à la valeur des capitaux
propres minorée des non valeurs, autrement dit à la somme des actifs
hormis les non valeurs, minorés de l’ensemble des engagements au passif.

3. Equity value: Share price x number of outstanding shares.

4. Return value: EPS/discount rate
5. Comparable Approaches

- Comparable Companies Analysis

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Choose a group of companies comparable with respect to:
(1) Size
(2) Similarity of products or production methods
(3) Age of company
(4) Recent trends and future pro, ;spects

Key ratios are calculated for each company. For example:

(1) Market value of shareholders' equity to sales
(5) Market value of equity in relation to book value of equity
(market/book)
(6) Market value of equity to earnings (price-to-earnings ratio)
(7) Sales or revenue per employee
(8) Net income per employee
(9) Assets needed to produce $1 of sales or revenue

Key ratios are averaged for group.

Average ratios are applied to absolute data for company of interest to
obtain its values. For example:
Equity value of Company W = Average market-to-sales ratio of
comparables × Company W’s Sales

Advantages
(1) Common sense approach: similar companies should sell for similar
prices
(2) Marketplace transactions are used
(3) Widely used in legal cases
(4) Used by investment bankers in fairness evaluation and opinions
(5) Can be used to establish valuation relationship for a company not
publicly traded

Example:

See example made in class

The PER method

The Price Earnings Ratio (PER) is frequently used as comparative ratio.
In that case, Price per share = EPS x PER

PER = VE/# of shares = Price = DIV = EPS (1 – b) = 1 - b

NI/# of shares EPS (r – g) EPS EPS (r-g) r–g

1-b
r – (b x roe)

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 We can see that the PER depends on the plow back ratio, required
return on equity, and the expected growth rate.

Price Earnings to Growth (PEG) is used when the companies in the

sample have different growth prospects. We can adjust each
company’s PER in the sample by dividing it by their respective growth
prospect
PEG = PER/g
Share price estimated = PEG (sample) x EPS (company) x g (company)

EBITDA multiple
EBITDA = EBIT + Depreciation and Amortization (Corresponds to the
EBE in the PCG). It is useful when different companies in the sample use
different depreciation accounting practices.
Equity value estimated = Multiple EBITDA (sample) x EBITDA (company)
– Debt.

Limitations:
(1) May be difficult to find companies that are actually comparable by
key criteria
(2) Ratios may differ widely for comparable companies
(3) Different ratios may give widely different valuations
(4) Companies in similar businesses and comparable in size may differ
in track records and opportunities: Growth rates in revenues, growth
rates in cash flows riskiness (beta) of companies, stages in life cycle of
industry and company, competitive pressures, opportunities for
expansion.

- Comparable Transactions Analysis

Valuation based on companies involved in the same kind of merger
transactions

Key ratios are calculated for each comparable deal based on actual
transaction prices. For example:
(1) Total paid to target’s sales
(2) Total paid to target’s book value
(3) Total paid to target’s net income
(4) Premium to target’s pre-merger market value
(5) Premium to combined firm pre-merger market value

- Key ratios are averaged for group and applied to merger transaction of
interest to obtain its value.

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 For example:
Value Paid to Target W = Average total paid-to-target’s sales ratio
× Target W’s sales
Value Paid to Target W = Market value of Target W
× (1 + Average premium to targets)
Value Paid to Target W = Market value of combined company
× (1 + average premium to
combined firms) – Market value of
buyer

- More directly applicable than company comparisons

(1) Companies may combine diverse activities
(2) M&A transactions involve premiums so results from comparable
companies need to be adjusted upward

- Limitations
(1) May be difficult to find transactions within a relevant time frame
(2) Transactions may not be truly similar
(3) Resulting ratios may vary widely
(4) Considerable judgment may be required
(5) Does not consider the estimated synergies that may vary between
different transactions

6. Discounted cash flow (DCF) spreadsheet approach

a. Procedure
- Historical data for each element of balance sheet, income statement,
and cash flow statement are presented — 5 to 10 years
- Detailed financial ratio analysis is performed to discover financial
patterns
- Additional critical analysis
(1) Business economics of industry in which company operates
(2) Company's competitive position
(3) Assessments of financial patterns, strategies, and actions of
competitors
- Based on analysis, relevant cash flows are projected
- Procedures similar to capital budgeting analysis

b. Spreadsheet Projections
Sales forecast is key to the projection process:
It is Important to understand the underlying growth patterns
The Growth rate must be consistent with forecast for economy
The Growth rate must be consistent with industry growth rate

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 The Growth rate must be consistent with market share in relation to
competitors.
Margins must also be carefully chosen and correspond to the market
position of the company.

c. Calculate Free Cash Flows (FCF)

Net Revenues
– Operating Expenses
Net Operating Income (NOI)
– Income Taxes
Net Operating Profits after Taxes (NOPAT or NOI(1-T))
+ Depreciation
Gross Cash Flows
– Change in working capital
– Capital expenditures Investments
– Change in other assets net
Free Cash Flows

Look out:
- Do not deduct interest.
- Calculate taxes as if the company was all equity financed. Tax shield is
picked up in the WACC formula.
- Managers usually set up a medium-term horizon (5 to 10 years) and
add a terminal value (PV at the horizons of the post horizons cash flow)

The value of the firm, in other words, the value of the assets is the sum of
the discounted FCF over for projected period plus the discounted value of
the Terminal Value.

The WACC is used as a discount rate (r) if the capital structure remains
stable.

n
Value of the firm (VF) =  FCFt + FCF t+1/ r-g
t = 1 (1+ r)
t
(1+ r) t
medium term horizon Terminal Value

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Value of the Equity (VE) = Value of the firm – Debt

Reminder :
WACC = rd (1 – T) D/V + re E/V
The required return on equity can be estimated using the CAPM
re = rf + Beta Firm (return on market – rf)
If the company is all-equity financed the return on equity is used instead.

Common misuses of the WACC:

- Can be used for projects (firms) that are similar to the bidder,
- Leveraging increases the financial risk for stockholders and therefore
the return on Equity. In this case the WAAC must be recalculated to
reflect the new capital structure.

If the capital structure of the firm changes there are 2 possibilities:

- Recapitalizations are cases in which the D/E is changed and maintained
at a new level in the future. A new WAAC must used to discount the
FCF.

- Leverage Buy Out (LBO) are cases where the firm’s D/E ratio falls
overtime and the debt outstanding, as a result of repayment of
principal, can be projected for each future time period.
The Adjusted Present Value (APV) method is therefore used.
The APV approach calculates the worth of a firm as an all equity entity
plus any additional cash flow from leverage.
n n
Value of the firm (VF) =  FCFt +  PVTS
t=1 (1+ rc) t
t=1

with:
rc = cost of capital (without debt)
PVTS = Present Value of Tax Shields

n
 Dt x rd x tc
t=1 (1 + rd)t
d. Evaluation of Spreadsheet Approach

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 - Advantages
a. Expressed in financial statements familiar to business community
b. Data are year by year with any desired detail of individual balance
sheet or income statement accounts
c. Flexibility and judgment in formulating projections

- Disadvantages
a. Numbers used in projections may create illusion that they are actual or
correct numbers. Numbers can’t replace good judgment about the
business.
b. Link between projected numbers and economic or business logic may
not be clear
c. May become highly complex
d. Details may obscure driving factors important in making projections

It is also possible to discount the expected dividends:

n

Share price =  Dt
t=1 (1 + r) t

If the dividends are expected to grow at a stable rate (g) we can use the
growing perpetuity formula (Gordon and Shapiro model):
n

Share price =  Dt
t=1 (r - g)

For a growing company we can use a formula that takes into account an
above average growth rate (first stage) and a growth rate more in line with
a mature business as competition heats up (second stage).

n
Share price =  Dt + D t+1/ r-g
t=1 (1 + r) t
(1 + r) t

6) Estimating merger gains and costs

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1. Question: Why two firms should be worth more together than apart? The NPV of
the merger must be calculated.
2. The NPV of the merger is the gain minus the cost

a. Gain = PVAB – (PVA – PVB)

b. Cost (Premium paid) = Purchase price - PVB
c. NPV = Gain – Cost = PVAB – (PVA – PVB) – (Purchase price – PVB)
d. NPV = PVAB – PVA – Purchase price
Example:
Firm A value = $200M
Firm B value = $50M
Gain =  PVAB = $25M
Suppose B is bought for $65M in cash

Therefore, the cost of the merger is $65M - $50M = $15M.

NPV = Gain – Cost = $25M - $15M = $10M

We see that the gain of the merger is split between A and B shareholders.

B shareholders: $15M (60%) = Premium

Gain $25M
A shareholders: $10M (40%) = NPV

NPV = Gain – Cost = $10M

3. The target’s stock price may have anticipated the merger.

In that case the value of the target is overestimated and the target’s shareholders
get the lion share of the gain.

Example: See in-class example

4. Estimating the cost when the merger is financed by stocks

Example: See in-class example

5. Asymmetric information: If the bidder has access to information that are not
available to the outsiders, it may value its own stock higher. In that case the target
shareholders would receive stocks value at an even higher price increasing the cost
of the transaction. They would receive a “free gift”. If A’s managers were that
optimistic about the future of the combines entities they would pay in cash.

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6. Illustration EXXON – Mobil (1998)

7) Takeover Defenses

A) Introduction
1. Not all mergers are welcome
2. Motivations for takeover defenses:
i. Target is resisting to get a higher price
ii. Management entrenchment
iii. Target management believes that it will do a better job on its
own.

B) Financial Defensive Measures

1. Efficiency
One view is that highly efficient firms with favorable sales growth and
high profitability margins provide defense against takeovers

Another view is that highly efficient firms become good takeover target
as bidder firm seeks to learn from efficiencies of target. At the same time
target firm may be viewed as undervalued if firm has long-range
investment plans whose payoffs are not reflected in current stock price

2. Financial characteristics of a vulnerable firm

i. Low stock price compared to good cash flows; low P/EPS ratio
ii. Highly liquid balance sheet with lots of cash and marketable
securities
iii. Small stockholdings
iv. Subsidiaries or properties that could be sold off without
significantly impairing cash flows

3. Financial defenses
i. Increase debt to repurchase equity and concentrate
management’s percentage holdings
ii. Increase dividends
iii. Loan covenants to accelerate repayment in case of a takeover
iv. Decrease excess cash and liquidate securities
v. Divest from low-profit operations, sell undervalued assets
vi. Buy other firms

C) Corporate Restructuring

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 1. Increase debt to repurchase equity and concentrate management’s
percentage holdings
2. Dilute the ownership position by using equity in acquisitions
3. Sell the assets in which bidder is most interested “Selling the crown
jewels”
4. Reorganization of Financial Claims
a. Debt for equity exchanges used to increase leverage
b. Dual class recapitalization used to increase voting power of
insider group enabling them to block a tender offer
c. Leverage recapitalization: Borrow lots of cash to pay a large
dividend and increase ownership position of insiders
“Scorched earth” policy.

D) Resistance strategies
1. PacMan defense
Target Counteroffers for bidder firm. Effective if target is much
larger than bidder (ELF/Total). Extremely costly since huge
amount of debt is raised to purchase shares.
2. White Knight: Target company combines with another “friendlier”
firm.
3. White Squire: Here the White Squire does not acquire control of
the target. Target sell large blocks of its stocks for a limited
amount of time to the white squire which may be required to vote
with target management. White Squire receive a seat on target’s
board and/or a generous dividend. Preferred stocks are used.

E) Resistance strategies
Antitakeover Amendments: Amendments to firm’s corporate charter that
impose new conditions on transfer of managerial control of firm (Shark
repellents)
1. Supermajority Amendments
Require shareholders’ approval by at least two-thirds vote for all
transactions involving change in control.
2. Supermajority Amendments
Staggered or classified boards: One-third of board stand for
election to 3-year term each year.

F) Poison Pills
Creation of securities carrying special rights exercisable by a triggering
event such as an accumulation of specified percentage of target shares or
the announcement of tender offer.

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G) Poison Puts
Poison puts or event risk covenants give bondholders the right to put
(sell) target bonds in the event of a change in control at an exercise price
usually set at 100-101% of the bond's face amount.

H) Golden Parachutes
Separation provisions of an employment contract that compensate
managers for loss of their jobs under change-of-control clause.
The Provision usually calls for lump-sum payment or payment over
specified period at full or partial rates of normal compensation.
Extreme cases of GPs are viewed as "rewards for failure"

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