Corporate Finance

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Introduction of the course

Study Session 1-2 Ethics & Professional Standards 10 -15%
Study Session 3 Quantitative Analysis 5 -10%
Corporate Finance Study Session 4

Study Session 5-6
Economics
Financial Reporting and Analysis
5 -10%
15 -20%
Study Session 7-8 Corporate Finance 5 -15%
Weight: 5%~15% Study Session 9-11 Equity Investment 15 -25%

Study Session 12-13 Fixed Income 10 -20%
Study Session 14 Derivatives 5 -15%
Study Session 15 Alternative Investments 5 -10%
SS7: Corporate Finance
Study Session 16-17 Portfolio Management and Wealth Plan 5 -10%
SS8: Financing and Control Issues
Weights: 100%
Summary
Ø Exam tips:
• 17年公司金融的考纲相较16年没有发生任何变化，仍然可 Evaluate Expansion & Replacement Projects
以沿用之前的准备思路。
• 根据统计，二级的公司金融科目是考生得分率最低的科目
Tasks:
之一，条件繁多，计算繁琐且环环相扣是二级公司金融考 Ø Calculate the yearly cash flows of expansion and replacement
题的特点。因此，在学习和复习时需要一定要结合大量的 capital projects and evaluate how the choice of depreciation

操练来熟悉计算的流程。 method affects those cash flows.
• 从考试内容来看，Session 7中包含大量公司金融的核心知
识点以及计算考点，是考试主要涉及的部分。需要大家重
点关注。
咨询电话：400-600-8011 邮箱：cfa@gaodun.cn 网站：http://finance.gaodun.cn

Preface Evaluate Capital Projects

Capital budgeting decisions Basic Capital Budgeting Approach
Ø Often use NPV or IRR n
C Ft C FT N O
NPV  
n
C Ft

n
C Ft
 0
N P V   C F0   
1  r  1  r 
t n
1  r  1  
t t t 1
t0 t0 IR R
CF: based on incremental, after-tax cash flows Ø |CF0| is Initial outlay

r: discounted at the opportunity cost of funds Ø CFt is annual after-tax operating cash flow
• Financing costs are ignored because both the cost of debt Ø CFTNO is terminal year after-tax non-operating cash flow
and the cost of other capital are captured in the discount
rate.
Evaluate Capital Projects Evaluate Capital Projects
Initial Outlay in Detail Annual After-tax Operating Cash Flow in Detail

Ø Outlay = FCINv + NWCInv – Sal0 + T(Sal0 – B0) Ø CF = (S− C − D)( 1−T ) + D, or CF = ( S−C )( 1−T ) + TD
• FCInv: investment in new fixed capital • S: sales
• NWCInv: investment in net working capital • C: cash operating expenses
• Sal0: salvage value from sale of old fixed capital • D: depreciation
• T: marginal tax rate • T: marginal tax rate
• B0: book value of old fixed capital

Evaluate Capital Projects Example 1: Evaluate Expansion Project

Terminal Year After-tax Non-operating Cash Flow in Detail Ø Equipment to expand production will cost $450 million,
Ø TNOCF = SalT + NWCInv − T(SalT − BT) depreciated straight-line to zero over three years for tax
• SalT: sal. value from sale of fixed capital on termination date purposes.
• NWCInv: recovery of investment in net working capital
Ø Salvage value for financial statement purposes is $30
• T: marginal tax rate
million.
• BT: book value of fixed capital on termination date
Ø Paid outside consultant $2 million for detailed market
share and cost analysis.
Ø Expected to generate incremental revenue of $350
million in each year for three years.
Example 1: Evaluate Expansion Project Example 1: Evaluate Expansion Project

Ø Additional annual cash operating expenses associated Solution Step 1: Calculate Incremental Cash Flows
with project are $150 million Ø Outlay = FCINv + NWCInv – Sal0 + T(Sal0 – B0)
Ø Investment in net working capital of $25 million will be =$450 + $25 – 0 + 0 = $475
recovered in three years Ø Depreciation: depends on method for tax purpose
Ø Expect to sell equipment in three years for $50 million =$450 / 3 = $150
Ø Project cost of capital is 20% and marginal tax rate is Ø CF = ( S−C )( 1−T ) + TD
40% =($350 – $150)(1 – 0.4) + (0.4)($150) = $180
Calculate NPV&IRR, determine appropriate investment Ø TNOCF = SalT + NWCInv − T(SalT − BT)
decision. =$50 + $25 – 0.4($50 – $0) = $55

Example 1: Evaluate Expansion Project Example 2: Evaluate Replacement Project

Solution Step 2: Calculate NPV and IRR
0 1 2 3
Incremental CF(step 1) – $475 $180 $180 $180+$55
PV of CF at 20% – $475 $150 $125 $136

n
C Ft C FT N O
NPV – $64 N P V   C F0   
Ø If the new equipment replaces the old equipment, an
1  r  1  r 
t n
t 1
IRR 11.6% IRR: computed r when NPV = 0 additional investment of $80,000 in net working capital will be
required. The tax rate is 30 percent, and the required rate of
Decision: Reject Reason: NPV < 0 and IRR < 20% return is 8 percent. Whether to replace or not?
Example 2: Evaluate Replacement Project Example 2: Evaluate Replacement Project

Solution Step 1: Calculate Incremental Cash Flows Solution Step 2: Calculate NPV and IRR
Ø Outlay = FCInv + NWCInv – Sal0 + T(Sal0 – B0) 10
102, 000 150, 000
Ø N P V  540, 000   1 .0 8 t

1 .0 8 1 0
 $ 2 1 3, 9 0 7
= 1,000,000 + 80,000 – 600,000 + 0.3(600,000 – 400,000) t 1
= $540,000
Ø IR R  1 5 .4 0 %
Ø CF = (S – C – D)(1 – T) + D Ø Decision: Accept the replacement project

=[(450,000 – 300,000) – (150,000 – 120,000) – (100,000 – Ø Reason: NPV>0, IRR>8%
40,000)](1 – 0.30) + (100,000 – 40,000) = $102,000
Ø TNOCF = SalT + NWCInv – T(SalT – BT)
= (200,000 – 100,000) + 80,000 – 0.30[(200,000 –
100,000) – (0 – 0)] = $150,000

Summary
Ø Importance: ☆ ☆ ☆
Ø Content: Evaluate Capital Projects
• 主要掌握扩张项目和替代项目NPV以及IRR的计算
ü 正确理解增量现金流的概念 Tasks:
ü 能计算不同Stages的增量现金流 Ø Evaluate capital projects and determine the optimal capital project in
Ø Exam tips: situations of 1) mutually exclusive projects with unequal lives, using
either the least common multiple of lives approach or the equivalent
• 这部分知识是考查重点，且多考计算题，需要通过大量
annual annuity approach, and2) capital rationing .
操练提高正确率。
Ø Calculate and interpret accounting income and economic income in
the context of capital budgeting
Evaluate Capital Projects Evaluate Capital Projects

Evaluate Mutually Exclusive Projects with Unequal Lives Evaluate Projects Under Capital Rationing
Ø Least Common Multiple of Lives Approach ( 最小公倍数法)
Ø Capital rationing is the case in which the company’s
• e.g. For 2-year project S and 3-year project L, replicate
capital budget has a size constraint, i.e. fixed money
their CFs in a 6-year horizon.
amount.
Ø Use profitability index (PI) since it shows the profitability
of each investment per currency unit invested:
Ø Equivalent Annual Annuity Approach (等效年金法) NPV

PI  1 
In itia l In v e s tm e n t
• A simple two-step procedure: 1) find NPV; 2) find PMT

Example 3: Evaluate Projects Under Capital Rationing Evaluate Capital Projects

Ø Omni Corporation has a $3,000 capital budget Evaluate Projects with Real Options
Investment Profitability Ø Types of real options
NPV
Outlay Index
• Timing Options
Project A 1,650 $700 1.42
Project B 1,400 $670 1.48 • Sizing Options
Project C 1,100 $400 1.36 • Flexibility Options
Project D 600 $200 1.33 • Fundamental Options
Project E 300 $60 1.20 Ø Evaluate approaches
Highest Total NPV(B+C+E)= $670 + $400 + $60 = $1,130 • Simple add: NPV(no option) + Net value of options
• More complicated: decision trees or option pricing models
Total Outlay = 1,400 + 1,100 + 300 = $2,800 < $3,000 budget
Risk Analysis of Capital Investments Risk Analysis of Capital Investments

Stand-Alone Methods (Assume Total Risk) Market Risk Methods (Assume Only Systematic Risk)
Ø Sensitivity Analysis Ø Consider only market risk for a diversified investor: β (“beta”)
• change one input variable at a time in base case Ø Discount rate = required rate of return
• more resultant change in NPV -> more sensitive -> riskier Ø Use CAPM and SML to find required rate of return:
Ø Scenario Analysis ri  R F   i [ E ( R M )  R F ]
• change several input variables for each scenario -- • Notice: we use PROJECT beta here to get the PROJECT
“pessimistic”, “most likely”(base), and “optimistic” discount rate (NOT company WACC)
Ø Monte Carlo Simulation Analysis • employ "pure-play" method to get beta: identify other
• stochastic variables -> probability distribution of NPV publicly traded stocks in the same business as the project

Factors That Affect Evaluation Factors That Affect Evaluation

Effects of Depreciation Method on Analysis : Effects of Inflation on Analysis
Ø NPV with Accelerated depreciation is larger than calculated
Ø The cash flows and discount rate used should both be
with Straight-line depreciation.
nominal or both be real.
• CF = ( S−C )( 1−T ) + TD
Ø Higher than expected inflation:
• Why? Larger depreciation in early years are assigned with
• Reduces value of depreciation tax shelter if tax
bigger weight, and so does the tax shield TD, and
therefore CF&NPV. system doesn’t adjust
Ø As a result, many countries specify the depreciation methods • Decreases value of fixed payments to bondholders
that are acceptable for tax purposes in their jurisdictions. • Revenues and costs not affected uniformly
Factors That Affect Evaluation Factors That Affect Evaluation

Common Capital Budgeting Pitfalls Common Capital Budgeting Pitfalls
Ø Not incorporating economic responses into the investment analysis Ø Overhead costs
Ø Misusing capital budgeting templates Ø Not using the appropriate risk-adjusted discount rate
Ø Pet projects Ø Spending all of the investment budget just because it is available
Ø Basing investment decisions on EPS, net income, or return on equity Ø Failure to consider investment alternatives
Ø Using IRR to make investment decisions Ø Handling sunk costs and opportunity costs incorrectly
Ø Bad accounting for cash flows

Other Income Measures Example 4 : Compute Economic Income

Economic Income V.S. Accounting Income Ø Omni Corporation project costs $25,000
Ø Accounting income: net income on financial statements Ø Cost of capital = 12%
Ø Economic Income = Cash flow + Change in market value
Ø After-Tax Cash flows:
or Economic income = Cash flow – Economic depreciation
• Year 1: $10,000 NPV = $4,172
Difference Economic Income Accounting Income
• Year 2: $12,000
Depreciation Beginning Market Value Beginning Book Value
- Ending Market Value - Ending Book Value • Year 3: $15,000
Interest already deducted
ignored
Expense interest expense to B e g in n in g M V =
1 0 ,0 0 0

1 2 ,0 0 0

1 5 ,0 0 0
 $ 2 9 ,1 7 2
debt holders 1 .1 2  1 .1 2  2 1 .1 2 3
Example 4 : Compute Economic Income Other Valuation Models

PV of remaining CFs Economic Profit
Year 1 Year 2 Year 3 Ø Used in asset valuation, performance measurement and
Beginning MV $29,172 $22,672 $13,393 management compensation. Focus on return to all investors.
Ending MV 22,672 13,393 0 Ø EP = NOPAT – $WACC
Change in MV – 6,500 – 9,279 – 13,393
• NOPAT = net operating profit after tax = EBIT(1 – tax rate)
After-tax CF 10,000 12,000 15,000
• $WACC = WACC × Capital
Economic Income $3,500 $2,721 $1,607
Ø Market value added (MVA) is NPV based on economic profit
Economic ROR = 12% 12% 12%
Econ Inc./Beg MV

E Pt
MVA  
1  W ACC 
t
t 1
Not accounting income Must equal to project cost of capital

Other Valuation Models Other Valuation Models

Residual income Claims Valuation
Ø Focus on return to debt holders and equity holders separately
Ø Focus on return to equity holders
Ø RIt = NIt – reBt–1 Balance Sheet
Assets Liabilities
• NIt = net income during period t
Equity
• reBt–1 = equity charge for period t
• CFs to debt holders = interest and principal, discounted at
= required return on equity × beginning book value of equity
cost of debt

R It
NPV   • CFs to equity holders = dividends and share repurchases,
 1  re 
t
t1
discounted at cost of equity
Summary of Capital Budgeting Summary

Who Likes to Use Which Model Ø Importance: ☆ ☆
Ø Corporate managers often focus on total after-tax cash flows Ø Content:
• e.g. Basic capital budgeting approach • Mutually exclusive projects with unequal lives
ü 最小公倍数法
Ø Security analysts use cash flows to stockholders
ü 等效年金法
• e.g. Free cash flow to equity
• Factors affect evaluation
Ø Real estate investors use cash flows to the equity investor after • Other valuation models
payments to creditors, which is like the claims valuation Ø Exam tips:
approach. • 这部分知识仍然是考查重点，概念和计算都有可能会考
到，需要考生定量和定性的去理解相关知识点。

Preface
Capital Structure Decision Objective
Capital Structure Ø Optimal capital structure maximizes the firm’s value by
minimizing the weighted average cost of capital:
Tasks: rw a c c
 D
 

 rd (1  t )  (
E
) re
 V  V
Ø Explain the Modigliani–Miller propositions regarding capital
• D = market value of debt, E = market value of equity
structure.
• V = D + E = market value of the firm
Ø Explain factors an analyst should consider in evaluating the
• rd = before-tax marginal cost of debt, t = marginal tax rate
effect of capital structure policy on valuation.
• re = marginal cost of equity
Ø Describe the role of debt ratings in capital structure policy.
marginal cost current cost
(raise additional capital) (the past is irrelevant)
Theory Theory
Modigliani and Miller Assumption Modigliani and Miller Theory

Ø Homogeneous expected cash flows Ø MM Proposition I (without taxes):
Ø Perfect capital markets • VLevered = VUnlevered
(no transactions costs, no taxes, no bankruptcy costs, and The market value of a company is not affected by the
symmetric information) capital structure of the company.
Ø Investors can borrow and lend at the risk-free rate Ø MM Proposition II (without taxes):
D
Ø No agency costs • re  r0  ( r0  rd ) ( )
E
Ø Independent financing decision & investment decision The cost of equity is a linear function of the company’s
debt/equity ratio.

Theory Theory
Modigliani and Miller Theory Impact from Various Costs

Ø Costs of Financial Distress
Ø MM Proposition I (with taxes):
• Direct & indirect costs
• VLevered = VUnlevered + tD
• Leverage increases -> Probability of bankruptcy increases
t = marginal tax rate, D = debt value Ø Agency costs
Ø MM Proposition II (with taxes): • Monitoring costs, bonding costs, and residual loss
D • Michael Jensen: higher debt level gives less free cash flow to
• re  r0  ( r0  rd ) (1  t ) ( )
E
managers to misuse -> lower agency costs
• rwacc < r0
Ø Costs of Asymmetric Information
WACC for the company with debt must be lower than
• Pecking order theory: internal capital > debt > external equity
that for the all-equity company
Theory Theory
Optimal Capital Structure Optimal Capital Structure
Ø Static trade-off theory of capital structure Ø Static trade-off theory of capital structure
• VL = VU + tD – PV(Costs of financial distress) • rWACC = (D/V)rd(1-t)+(E/V)r e
dynamic target
dynamic target

Practical Issues Practical Issues

Debt Ratings Evaluating Capital Structure Policy
Ø leverage rises->rating lowered->higher demanded costs
Ø Changes in its own capital structure over time
Ø with status as “Nationally Recognized Statistical Rating Organizations”
from (SEC), the 3 largest are Moody’s, Standard & Poor’s, and Fitch
Ø Capital structure of competitors with similar business risk
Ø Industry-specific factors
• volatility of opearating cash flows
• need for financial flexibility
• regulatory aspects
Ø Company-specific factors
• quality of corporate governance (affects agency costs)
Practical Issues – international differences Summary of Capital Structure
Theory V.S. Practice

Ø MM theory and various costs
Ø Static trade-off theory
• Pursue optimal (target) capital structure
Ø Practical issues: influences from external environment

Summary
Ø Importance: ☆ ☆ ☆
Ø Content: Dividend and Share Repurchases
• Modigliani and Miller Theory (Proposition 1 & 2)
ü Without tax Tasks:
ü With tax Ø Compare theories of dividend policy and explain implications
• Optimal capital structure
of each for share value given a description of a corporate
• Debt ratings
dividend action.
Ø Exam tips:
Ø Explain factors that affect dividend policy.
• MM理论以及相关推论是二级公司金融常考的知识点，结
合图像来记忆相关要点会起到事半功倍的效果。
Preface Effects of Dividend Policy

Why do we study this? Theories
Ø Capital budgeting: how to spend money efficiently Ø Dividend policy does not matter (MM)
Ø Capital structure: how to get money effectively Ø It does matter: bird-in-hand argument & tax argument
Ø Dividends&share repurchases: how to distribute money Ø Other theoretical issues
wisely • information signaling
• clientele effect
• agency costs

Effects of Dividend Policy Effects of Dividend Policy

Information Signaling Clientele Effect
Ø Dividend declaration resolves information asymmetry Ø Defined as "the existence of groups of investors (clienteles)
attracted by companies with specific dividend policies"
• initiations or increases convey positive information
• institutional investors
• omissions or reductions convey negative information
• individual investors
Ø Companies that consistently increase their dividends have:
Ø Not contradict the hypothesis of dividend policy irrelevance
• dominant or niche positions in their industry
Ø Consider tax: Pw – (Pw – Pb)(TCG) = Px – (Px – Pb)(TCG) + D(1 – TD)
• global operations Pw  Px  D
1  TD
1  TCG
• relatively high returns on assets • $1 dividend is worth $(1 – T D)/(1 – TCG) in capital gains
• relatively low debt ratios
Effects of Dividend Policy Factors Affecting Dividend Policy

Agency Costs Six Factors that Affect a Company’s Dividend Policy
Ø Between shareholders and managers Ø Investment opportunities
• Dividends payout reduces free cash flow for Ø Expected volatility of future earnings
managers to overinvest and run out of control Ø Financial flexibility
Ø Between shareholders and bondholders Ø Tax considerations
• Dividends transfer wealth from bondholders to Ø Flotation costs
shareholders Ø Contractual and legal restrictions

Factors Affecting Dividend Policy Dividend Policy

Tax Considerations Types of Dividend Policies
Ø Double taxation system Ø Stable Dividend Policy
• Dividend = NIpretaxpayout% (1-tcorporate)(1-tindividual on dividend) • most common, based on long-term forecast of earnings
• Effective tax rate = tcorporate + (1-tcorporate) tindividual on dividend • Expected dividend = Last dividend + (Expected increase in
Ø Dividend imputation tax system earnings × Target payout ratio × Adjustment factor)
• Dividend = NIpretaxpayout% (1-tindividual on dividend) Ø Constant Dividend Payout Ratio Policy
Ø Split-rate tax system • infrequently used, fluctuate with short-term earnings
• Dividend = NIpretaxpayout% Ø Residual Dividend Policy
*(1-tcorporate on dividend )(1-tindividual on dividend) • rarely used, highly volatile dividend payments
• Dividend = Earnings – (Capital budget × Equity%)
Dividend Policy Dividend Policy

Dividend V.S. Share Repurchase Global Trends in Payout Policy
Ø Share repurchase wins in aspects of Ø 1978 to 2000 U.S. first tier 100 large companies have a fairly
• potential tax advantages stable payout ratio of around 42%, second tier use share
• share price support/signaling that the company considers repurchase as a substitute
its shares a good investment Ø The fraction of companies paying cash dividends has been in
• added managerial flexibility long-term decline in most developed markets (e.g. US, Canada,
• offsetting dilution from employee stock options EU,UK, JP).
• increasing financial leverage Ø Since early 1980s in US and early 1990s in UK and Europe, the
fraction of companies engaging in share repurchases has
trended upward.

Dividend Policy Summary of Dividend Policy

Analysis of Dividend Safety One of the Longest Running Debates
Ø Payout decisions, along with financing (capital structure)
decisions, generally involve the board of directors and most
senior level of management and are closely watched by
investors and analysts
Ø High coverage ratio may indicate safety but not always • theories of the effects of dividend policy
Ø Warning signals for dividend cut: • factors that affect dividend policy
• negative external stock market indicators • types of dividend policies, the dividend-share repurchase
• extremely high dividend yields decision, global trends and analysis of dividend safety
Summary
Ø Importance: ☆ ☆
Ø Content: Corporate Performance,
• Effects of dividend policy Governance, and Business Ethics
• Factors affecting dividend policy (重点掌握税收) Tasks:
• Analysis of dividend policy Ø Compare theories of dividend policy and explain implications
Ø Exam tips: of each for share value given a description of a corporate
• 这部分的知识点比较零散，可以拆解成一个一个小的考 dividend action.
点，在考试时主要以定性判断为主，考查考生快速甄别
Ø Explain factors that affect dividend policy.
知识点的能力。

Preface Governance Mechanisms

Specific Financing and Control Issues Compare Interests of Key Stakeholder Groups
Ø Session 8 introduced main theories and practical issues related
to capital budgeting, capital structure, dividends and share
repurchase
Ø Session 9 focuses on specific financing and control issues
stemmed from the corporate finance study.
Ø In this reading, we take a close look at the governance
mechanisms that shareholders put in place to make sure that
managers are acting in their interests and pursuing strategies
that maximize shareholder value.
Governance Mechanisms Governance Mechanisms

Stakeholder Impact Analysis Principal–Agent Relationships Problems
Ø Identify stakeholders Ø The agency problem
Ø Identify stakeholders’ interests and concerns. • Unscrupulous agents (managers) can take
Ø As a result, identify what claims stakeholders are likely to advantage of any information asymmetry to mislead
make on the organization. principals (shareholders) and maximize their own
Ø Identify the stakeholders who are most important from interests at the expense of principals.
the organization’s perspective.
Ø Identify the resulting strategic challenges.

Ethics and Strategy Ethics and Strategy

Roots of Unethical Behavior Philosophical Approaches to Ethics
Ø Flawed personal ethics Ø Friedman Doctrine
• only one social responsibility of business: increase profits
Ø Fail to realize
Ø Utilitarian
Ø Culture that de-emphasizes business ethics
• greatest good for the greatest number of people
Ø Focus on unrealistic performance goals
Ø Kantian Ethics
Ø Unethical leadership
• people have dignity and need to be respected as such
Ø Rights Theories
• human beings have fundamental rights and privileges
Ø Justice Theories (justice decided under a "veil of ignorance")
Summary
Ø Importance: ☆
Ø Content: Corporate Governance
• Compare Interests of Key Stakeholder Groups
• Business ethics Tasks:
Ø Exam tips: Ø Compare major business forms and describe the conflicts of
• 这部分内容主要是介绍利益相关者理论，作为对于传统 interest associated with each.
公司金融理论的扩充，并不是考试主要考查方向，掌握 Ø Explain effective corporate governance practice as it relates to
到了解的程度即可。 the board of directors and evaluate strengths and weaknesses
of a company’s corporate governance practice.

Preface Corporate Governance

Corporate Governance Major Objectives
Ø Defined as "the system of principles, policies, Ø To eliminate or mitigate conflicts of interest
Ø To ensure that the assets of the company are used efficiently
procedures, and clearly defined responsibilities and
accountabilities used by stakeholders to overcome the Core Attributes of Effective Corporate Governance System
conflicts of interest inherent in the corporate form" Ø Delineation of the rights of stakeholders
Ø Clearly defined manager responsibilities
Ø Identifiable and measurable accountabilities
Ø Fairness and equitable treatment
Ø Complete transparency and accuracy in disclosures
Corporate Governance Corporate Governance

Major Business Forms Agency Relationships
Ø Areas of primary concern:
• Managers vs. shareholders
• Directors vs. shareholders


Board of Directors Have the Responsibility to: Assess Attributes of Board
Ø Establish ethical, competent, fair, and professional values Ø Composition of board; at least 75% of directors independent
Ø Ensure legal and regulatory requirements are met Ø Independent chairman on board (not CEO)
Ø Ensuring that the best interests of shareholders come first
Ø Qualifications of directors
Ø Establish clear lines of responsibility and a strong system
Ø Annual election of directors
Ø Hire the chief executive officer
Ø Annual board self-assessment
Ø Ensure sufficient information symmetry
Ø Meet frequently enough Ø Separate sessions of independent directors
Ø Acquire adequate training Ø Audit committee and audit oversight (only independent
directors)

Assess Attributes of Board Assess Attributes of Board
Ø Nominating committee (only independent directors) Ø Statement of governance policies
• codes of ethics
Ø Compensation committee and management compensation
(mostly performance-based) • statements of the oversight, monitoring, and review
responsibilities of directors
Ø Use of independent and expert legal counsel
• statements of management’s responsibilities
Ø Disclosure and transparency
• reports of directors’ examinations
Ø Insider or related-party transactions
• board and committee performance self-assessments
Ø Responsiveness of board of directors to shareholder proxy votes
• management performance assessments
• training provided to directors periodically


Environmental, Social, and Governance Risk Exposure Valuation Implications Posed by Weak Systems
Ø Legislative and regulatory risk Ø Accounting risk
Ø Legal risk Ø Asset risk
Ø Reputational risk Ø Liability risk
Ø Operating risk Ø Strategic policy risk
Ø Financial risk
Summary of Corporate Governance Summary

Keys of corporate governance Ø Importance: ☆
Ø Purpose is to minimize conflicts of interest Ø Content:

• Major business forms
Ø Major business forms differ in several aspects
• Agency relationships
Ø Attributes of effective governance • Assess attributes of board
Ø How to establish effective governance Ø Exam tips:

Ø Possible risks • 这部分内容主要延续了一级公司金融之中公司治理的理
论介绍，重点仍然是代理人理论中关于如何解决委托代
理问题的方法，主要以定性的概念辨析为主。

Preface
M&A
Introduction of Mergers & Acquisitions
Ø Companies enter into merger and acquisition activities
Tasks: for a variety of reasons:
Ø Classify merger and acquisition (M&A) activities based on • to achieve growth
forms of integration. • to diversify their businesses, etc.

Ø Explain common motivations behind M&A activity. Ø It involves a variety of complexities and risks
Ø Explain bootstrapping of earnings per share (EPS) and
calculate a company’s post-merger EPS.
Mergers and Acquisitions Mergers and Acquisitions

Classification
Ø Statutory Merger: Acquiring company obtains all of the target’s
assets and liabilities. The target company ceases to exist.


Classification Classification
Ø Subsidiary Merger: The target company becomes a subsidiary Ø Consolidation: Acquirer and target cease to exist in their prior
of the acquirer. Often used when target has strong brand identity form but come together to form a completely new company.
Company A Company B Company A

(Bidder) + (Target) (Acquirer) Company C
Company A
+ Company B
(Newly Formed)
Company B
(Subsidiary)

Classification Classification
Ø Horizontal merger: Two firms operate in the same business, Ø Vertical merger: Target company is along the production chain
usually as competitors. (in the pursuit of economies of scale) of the acquiring company. (backward/forward integration)
Electronics
Retailer
Small
Medium- Large Electronics
Clothing + sized
Clothing
Clothing Retailer/
Computer
Retailer
Retailer Retailer Manufacturer
Computer
Manufacturer


Classification Motivations
Ø Conglomerate merger: acquirer purchases another company Ø Synergy
that is unrelated to its core business.
Ø Internally (organic growth) or external growth
Ø Increasing market power
Shoe Manufacturer Shoe Ø Acquiring unique capabilities and resources
Manufacturer
& Organic
Food
Ø Diversification
Organic Restaurant
Food Ø Bootstrapping earnings
Restaurant
Ø Managers’ personal incentives

Motivations Bootstrapping Earnings
Ø Tax considerations Ø When a company’s earnings increase as a consequence
Ø Unlocking hidden value
of the merger transaction itself (rather than real
Ø Cross-border motivations
benefits), as an illusion of synergies or growth.
• Exploiting market imperfections
Ø New EPSA = Total earning / Total number of shares
• Overcoming adverse government policy
= (EarningA+EarningT) / (#ShareA+MVT/SA)
• Technology transfer
• Product differentiation
• Following clients

Example of Bootstrapping Earnings Summary

Ø Content:
• Classification of mergers and acquisitions
• Motivations of mergers and acquisitions
ü Bootstrapping earnings
Ø Exam tips:
• 这部分内容主要会考查各种并购的类型以及为什么企业
会从事并购业务，Bootstrapping earnings这个知识点有可
能会考计算题。
Mergers and Acquisitions

Industry Life Cycles’ Impact
Forms of Acquisitions & Takeover Defense Industry Life Types of
Industry Description Motives for Merger
Cycle Stage Mergers
Sell themselves to
Tasks: larger companies in
Substantial
Ø Contrast merger transaction characteristics by form of acquisition, mature or declining
Pioneering development costs and üConglomerate
industries allowing
development has low, but slowly üHorizontal
method of payment, and attitude of target management . them to pool
increasing, sales growth
management and
Ø Distinguish among pre-offer and post-offer takeover defense capital resources
mechanisms. Explosive growth in
High profit margins sales may require
Ø Calculate and interpret the Herfindahl–Hirschman Index . Rapid üConglomerate
caused by few large capital
accelerating üHorizontal
participants in requirements to
growth
the market expand existing
capacity


Industry Life Cycles’ Impact Industry Life Cycles’ Impact
Industry Life Types of Industry Life Industry Types of
Industry Description Motives for Merger Motives for Merger
Cycle Stage Mergers Cycle Stage Description Mergers
Mergers may be
Experiences a Horizontal mergers may be
undertaken to
drop in the entry üVertical undertaken to ensure survival;
Mature achieve economies
of new competitors, but üHorizontal Vertical mergers may be carried
growth of scale, savings,
growth potential Faces out to increase efficiency and
and operational Deceleration üHorizontal
remains overcapacity profit margins;
efficiencies of growth üVertical
and eroding Companies in related industries
Achieve economies and decline üConglomerate
profit margins may merge to exploit synergy;
of scale;
Companies in this industry may
Large companies
Stabilization Faces increasing acquire companies in young
may acquire smaller üHorizontal
and market competition and industries
companies to improve
maturity capacity constraints
management and
provide a broader
financial base

Forms of Acquisition Method of Payment
Ø Cash offering
Stock Purchase Asset Purchase
• pay for the merger with cash
Payment To shareholder To target
Ø Securities offering
Approval Shareholders None for “small”
• exchange ratio
Corporate taxes None Target pays CG
• target shareholders receive shares of the acquirer’s
S/H taxes S/H pay CG None common stock as compensation, might offer other
securities, such as preferred shares or even debt
Liabilities Acquirer assumes Usually avoids
assuming securities.
Ø Mixed offering


Mind-Set of Target Management Mind-Set of Target Management
Ø Friendly mergers Ø Hostile Mergers
• Bear hug: approach target board of directors (bypass CEO)
• approach target management directly (secrectly)
• Turn to friendly merger
• merger discussions and due diligence (secrectly)
• Or approach shareholders of target company
• definitive merger agreement (public announcement)
ü Tender offer (often use cash to quickly finish deal)
• proxy statement given to shareholders to vote
ü Proxy fight (vote for acquirer’s slate to replace
• attorneys file the required documentation with manager).
securities regulators

Pre-Offer Takeover Defense Mechanisms Post-Offer Takeover Defense Mechanisms
Ø Poison pill (flip-in pill & flip-over pill, “dead-hand” provision) Ø “Just Say No” defense
Ø Poison puts Ø Litigation
Ø In a state with restrictive takeover laws (U.S.) Ø Greenmail
Ø Staggered board of directors Ø Share repurchase
Ø Restricted voting rights Ø Leveraged recapitalization
Ø Supermajority voting provisions Ø “Crown Jewel” defense
Ø Fair price amendments Ø Pac-Man defense
Ø Golden parachutes Ø White knight defense
Ø White squire defense

Mergers and Acquisitions Summary

Antitrust Ø Importance: ☆ ☆ ☆
Ø Herfindahl–Hirschman Index: model market concentration Ø Content:

• Forms of acquisition
n
S a le s o r o u tp u t o f f ir m i
HHI   i
(
T o ta l s a le s o r o u tp u t o f m a r k e t
 100)2 • Takeover defense
• Herfindahl – Hirschman index
Government Ø Exam tips:
Post-Merger HHI Concentration Change in HHI
Action
• 这部分内容涉及到各种并购的支付形式以及防止恶意收
Less than 1,000 Not concentrated Any amount No action
Between 1,000 Moderately Possible 购的各种策略，是考试时常常考到的知识点。
100 or more
and 1,800 concentrated challenge
Highly
More than 1,800 50 or more Challenge
concentrated
Merger Analysis
Target Company Valuation-DCF
Valuation of Mergers & Acquisitions Ø E n te rp rise V a lu e 
n
F C Ft
 1  W A C C  
F C FT (1  g )
t 1
t
W A C C  g
Net income
Tasks:
+ Net interest after tax
Ø Compare the discounted cash flow, comparable company, and Unlevered net income
comparable transaction analyses for valuing a target company . + Change in deferred taxes
Ø Explain how price and payment method affect the distribution of risks Net operating profit less
adjusted taxes (NOPLAT)
and benefits in M&A transactions.
+ Net noncash charges
Ø Describe characteristics of M&A transactions that create value.
– Change in net working capital
– Capital expenditures (capex)
Free cash flow (FCF)

Example of DCF Example of DCF

Ø Seuss Publishing is considering acquiring Boynton Books. Seuss’
Income Statement 2007 2008 2009 2010
analysts have determined that a two-stage FCFF model is
Revenues $9,600 $10,368 $11,301 $12,318
appropriate for their analysis and have developed pro forma COGS 5,760 6,221 6,781 7,391
financials for Boynton. Gross profit 3,840 4,147 4,520 4,927
SGA expenses 1,075 1,161 1,265 1,379
Ø Calculate Boynton’s free cash flows and estimate Boynton’s
Depreciation 336 363 396 431
value. Pro forma financials are shown on following slides. EBIT 2,429 2,623 2,859 3,117
Net interest exp. 445 422 401 380
EBT 1,984 2,201 2,458 2,737
Taxes (35%) 694 770 860 958
Net income 1,290 1,431 1,598 1,779
Example of DCF Example of DCF
Other Data 2007 2008 2009 2010 2007 2008 2009 2010
Net Income 1,290 1,431 1,598 1,779
Change in NWC 307 332 362 394
+ Net interest exp.
Change in deferred 13 14 16 18
× (1 – T) 289 274 261 247
taxes
Unlevered NI 1,579 1,705 1,859 2,026
Capital expenditures 960 1,037 1,130 1,232
+ Δ Deferred tax 13 14 16 18
Tax rate 35.0% NOPLAT 1,592 1,719 1,875 2,044
WACC 10.0% + Depreciation 336 363 396 431
WACCadjusted 9.0% – Δ NWC 307 332 362 394
Terminal growth rate 5.5% – CAPEX 960 1,037 1,130 1,232
Free cash flows 661 713 779 849

Example of DCF Merger Analysis

Target Company Valuation-DCF
Ø Advantages of Discounted Cash Flow Analysis
• Expected changes in cash flows readily modeled
• Estimate of intrinsic value based on forecast fundamentals
• Changes in assumptions can be modified
Ø Disadvantages of Discounted Cash Flow Analysis
• Free cash flows is not profitability (heavy capex to expand)
• Estimate cash flow too far into future
• WACC is volatile
• Terminal value estimates too sensitive to WACC and g
Merger Analysis Example of Comparable Company Method

An analyst has identified three companies that they believe are
Target Company Valuation-Comparable Company
comparable to a firm under evaluation as a takeover candidate. The
Ø Collect a sample of comparable companies (similar size and relative value measures that they have selected are price-to-earnings
capital structure, as many as possible ) (P/E) and price-to-sales (P/S), and the average values of these ratios are
13.2 and 1.3. The target firm has earnings per share of $3.75, and sales
Ø Determine enterprise multiples or equity multiples
per share of $36.08. If the estimated takeover premium is 25%, what is
• EV/FCF, EV/EBITDA, EV/EBIT, EV/sales the estimated takeover price per share?
• P/CF, P/S, P/E, P/BV
Solution:
Ø Produce an estimate for the target’s value (use sample mean)
( D e a lP r ic e  S to c k P r ic e ) The estimated value based upon P/E is $49.50 = (3.75 × 13.2).
Ø T a k e o v e r P re m iu m 
S to c k P ric e The estimated value based upon P/S is $46.90 = (36.08 × 1.3).
Ø takeover price = estimated value x (1+takeover premium) The average of these two values is $48.20.
The estimated takeover price is $48.20 × 1.25 = $60.25.

Merger Analysis Merger Analysis

Target Company Valuation-Comparable Company Target Company Valuation-Comparable Transaction
Ø Advantages of Comparable Company Analysis Ø Collect a relevant sample of recent takeover transactions
• a reasonable approximation of a target’s relative value
Ø Calculate relative value multiples (already contain
• most of the required data are readily available
premium)
• estimates of value are derived directly from the market
Ø Derive an estimate for the target’s value (use sample mean)
Ø Disadvantages of Comparable Company Analysis
• Don’t double add takeover premium!
• sensitive to market mispricing
• must additionally estimate a fair takeover premium
• difficult for the analyst to incorporate any specific plans
• past premiums may not be timely or accurate

Target Company Valuation-Comparable Transaction Bid Evaluation
Ø Advantages of Comparable Transaction Approach Ø Target shareholders’ gain = Premium = P T – VT
• Not necessary to separately estimate a takeover premium. • PT = price paid for the target company
• Takeover value estimates recently established in the market • VT = pre-merger value of the target company
• Reduces litigation risk. Ø Acquirer’s gain = Synergies – Premium = S – (P T – VT)
Ø Disadvantages of Comparable Transaction Approach • S = synergies created by the business combination
• Real takeover values in past transactions were not accurate. Ø VA* = V A + V T + S – C
• Not adequate number of comparable transactions to use. • VA* = post-merger value of the combined companies
• Difficult for the analyst to incorporate any specific plans. • VA = pre-merger value of the acquirer
• C = cash paid to target shareholders

Example of Bid Evaluation Method Example 4: Bid Evaluation

Big Steel is considering making a bid for Small Steel. The following Solution:
data applies to the analysis: Value after takeover = $37,500 + $4,000 + $600 = $42,100m.
Big Steel Small Steel Shares exchanged for Small Steel = 1.45 x 40m = 58m.
Pre-merger stock price $75 $100 Post-takeover share price = value after takeover / shares
Number of shares outstanding 500m 40m
outstanding = 42,100m / 558m = $75.45.
Pre-merger market value $37,500m $4,000m
Takeover price = number of shares to small steel x post-takeover
Estimated synergies $600m
share price = 58m x $75.45 = $4,376.1m.
Gains to Small Steel = takeover premium = $4,376.1 - $4,000 =
If Big Steel buys Small Steel by exchanging 1.45 shares of its stock
$376.1m.
for each share of Small Steel, what are the gains to Big Steel and
Small Steel, respectively? Gains to Big Steel = synergies - takeover premium = $600 - $376.1 =
$223.9m.

Risk Shifting of Synergy Misestimating Characteristics of M&A Deals that Create Value
Ø Cash offering: acquirer enjoys or suffers more exposure Ø Buyer is strong
Ø Transaction premiums are relatively low
to synergy volatility.
Ø Number of bidders is low
Ø Stock offering: more risks and benefits of realizing
Ø Initial market reaction is favorable
synergies will be passed on to the target shareholders.
The empirical evidence suggests that
Ø Merger transactions create value for target company.
Ø Acquirers, in contrast, tend to accrue value in the years
following a merger.
Ø Synergies are often overestimated or difficult to achieve.

Merger Analysis Summary of M&A

Common Reasons for Restructuring Keys of Mergers and Acquisitions
Ø Change in strategic focus Ø Target company valuation
Ø Poor fit • Discounted cash flow
Ø Reverse synergy • Comparable company
Ø Financial or cash flow needs • Comparable transaction
Three Basic Ways that a Company Divests Assets Ø Bid evaluation
Ø Sell the assets of a division or offer an “equity carve-out” • Post-merger value
Ø “Spin-off” (similar “split-off”) • Gains of each party
Ø Liquidation Ø Empirical evidence suggests that synergies are often

overestimated or difficult to achieve.
Summary
Ø Content:
• Valuation of mergers and acquisitions
ü Discounted cash flow method
ü Comparable company method
ü Comparable transaction method
• Evaluation and analysis of mergers & acquisitions
Ø Exam tips:
• 这部分内容涉及到各种并购估值的策略，需要考生理解
You’re a Champion!
其中的估值理念以及局限性。
Thanks for staying with us. You have finished this chapter.

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全球财经证书培训领导品牌

Introduction of the course

Corporate Finance Study Session 4

Weight: 5%~15% Study Session 9-11 Equity Investment 15 -25%

题的特点。因此，在学习和复习时需要一定要结合大量的 capital projects and evaluate how the choice of depreciation

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Preface Evaluate Capital Projects

CF: based on incremental, after-tax cash flows Ø |CF0| is Initial outlay

Evaluate Capital Projects Evaluate Capital Projects

Initial Outlay in Detail Annual After-tax Operating Cash Flow in Detail

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Evaluate Capital Projects Example 1: Evaluate Expansion Project

Example 1: Evaluate Expansion Project Example 1: Evaluate Expansion Project

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Example 1: Evaluate Expansion Project Example 2: Evaluate Replacement Project

Incremental CF(step 1) – $475 $180 $180 $180+$55

PV of CF at 20% – $475 $150 $125 $136

Example 2: Evaluate Replacement Project Example 2: Evaluate Replacement Project

Ø CF = (S – C – D)(1 – T) + D Ø Decision: Accept the replacement project

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Evaluate Capital Projects Evaluate Capital Projects

Ø Equivalent Annual Annuity Approach (等效年金法) NPV

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Example 3: Evaluate Projects Under Capital Rationing Evaluate Capital Projects

Risk Analysis of Capital Investments Risk Analysis of Capital Investments

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Factors That Affect Evaluation Factors That Affect Evaluation

Factors That Affect Evaluation Factors That Affect Evaluation

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Other Income Measures Example 4 : Compute Economic Income

Example 4 : Compute Economic Income Other Valuation Models

Not accounting income Must equal to project cost of capital

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Other Valuation Models Other Valuation Models

discounted at cost of equity

Summary of Capital Budgeting Summary

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Modigliani and Miller Assumption Modigliani and Miller Theory

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Modigliani and Miller Theory Impact from Various Costs

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Practical Issues Practical Issues

Practical Issues – international differences Summary of Capital Structure

Theory V.S. Practice

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Preface Effects of Dividend Policy

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Effects of Dividend Policy Effects of Dividend Policy

Effects of Dividend Policy Factors Affecting Dividend Policy

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Factors Affecting Dividend Policy Dividend Policy

Dividend Policy Dividend Policy

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Dividend Policy Summary of Dividend Policy

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Preface Governance Mechanisms

Governance Mechanisms Governance Mechanisms

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Ethics and Strategy Ethics and Strategy

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Preface Corporate Governance

Corporate Governance Corporate Governance

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Corporate Governance Corporate Governance