Corporate Financial

Click Management
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Jan Vlach <vlachy@atlas.cz>

Brigham, E.F., Ehrhardt, M.C. Financial Management:
Theory and Practice, 13th Edition
Basic Concepts
Chapters 1-3

Corporate Financial Management

Is the Art/Science of Creating and
Maintaining the Value of a Company.
Gives a Firm its Common Language.
It Consists of
Investment Decisions
Financing Decisions
Managerial Decisions
Corporate Financial Management 1 2
Investment Vehicle Model
Money Real Assets Money Financial Assets

Financial
Markets
The World The Firm Investors
Invest- Financ- Financial
ments ing
Intermed.

Corporate Financial Financial Investments

Management Markets
F I N A N C E
The Set of Contracts Model recognises imperfections
and includes the assumption of both explicit and implicit
contracts, incl. Corporate Organization.
Corporate Financial Management 1 3
The Financial Environment
Competitive Economic Environment
Two-Sided Transactions (BuyerSeller Equil.)
Risk-Return Tradeoff
Signalling/ Behavioral Principle
<= Market Efficiency (Information, Transactions)
Value (How can some people become rich?)
New Ideas, Expertise
Options Financial transactions
create an equilibrium; Real
Time Value of Money
investments create value
Corporate Financial Management 1 4
Accounting, Cash Flows & Taxes
Purposes of an Accounting System
Reporting the Firms Financial
Activities to Stakeholders
Providing Information to Firms
Decision Makers
Financial Management strives to use
and interpret the information
Accounting - historical view
Finance - current and future
Corporate Financial Management 1 5
Limitations of Accounting
Why dont shares trade at Book Val.?
MarketBook Value of Assets/Liabs
Historical Accounting (depreciation)
Inflation (value benchmarks have changed)
Liquidity (can it readily be sold?)
Time Value of Money (relates to Maturity
and Terms)
Note: Finance prefers to deal with cash flows
in a time perspective.
Corporate Financial Management 1 6
Taxes
Income Tax
Make analyses on after-tax basis
For financial decisions, use marginal
tax rate (relavant if tax is progressive
or unsymmetrical on negative base)
Capital Gains Tax
Dividend/Interest Income Treatment
System Biases (Loss Carry-forwards,
Exemptions, Deductions)
Corporate Financial Management 1 7
Time Value of Money
Chapter 4

Any Present Value has a greater

Future Value.
... i.e.
People generally prefer having any
amount of money at their disposal
earlier rather than later.
... i.e.
Investors require positive returns as
compensation for the inconvenience.
Corporate Financial Management 1 8
On Present and Future Values
You deposit $1,000 today with a bank
that pays 5% interest per year.
FV1= PV+rPV= PV(1+r)=
$1,0001,05= $1,050 (Simple Interest)
FV2= FV1(1+r)= PV(1+r)(1+r)=
PV(1+r)2= $1,102.50 (Compound Interest)
Discounted Cash Flow Framework

FVt= PV(1+r)t PV= FVt / (1+r)t

Corporate Financial Management 1 9
Return, Net Present Value
Return of an Investment (Rate of
Return, Yield):
CashFlow (EndValue BegValue )
Return
BegValue
NPV = Present Value of expected
cash flows (+positive-negative)
C0

C1 C2 C3 C4 t

Corporate Financial Management 1 10

Practical Issues
Distinguish:
Realized Return
Expected Return (<= Risk)
Required Return (<= Unperfect Mkts)
Financial securities are usually
priced fairly (Market Equilibrium).
Investment projects (and other
entrepreneurial decisions) should
bring value, i.e. have positive NPV.
Corporate Financial Management 1 11
Valuing Single Cash Flows (Ex.)
What is the Future Value of $2,000
invested at 3% per year for five years?
What is the Present Value of CZK 10m
to be received two years from now if
the required return is 4% per year?
What is the Expected Return for an
investment costing 10,000 today and
offering 12,000 in three years?

Corporate Financial Management 1 12

Valuing Multiple Cash Flows
You can invest $10,000. As a result, you
expect to get $2,000, $8,000, and $5,000
over the next three years, respectively. If
the required return is 10%, what is the
NPV of your investment?
t Ct PV(Ct)
0 $ -10,000 -10,000.00
1 $ 2,000 1,818.18
2 $ 8,000 6,611.57
3 $ 5,000 3,756.57
Total PV: $ 2,186.33
What is the return if you know the NPV?
Corporate Financial Management 1 13
Annuities
Types of Annuity
Ordinary Annuity (Payments at end of period)
Annuity Due (Payments at beginning of period)
Deferred Annuity (First repayment more than
one period after drawing)
n
1 1 r n 1
PVAn PMT PMT
1 r r 1 r
t n
t 1

FVAn = PVAn(1+r)n; PVAn[due] = PVAn(1+r);

PVAn[defd] = PVAn/(1+r)d
Corporate Financial Management 1 14
Amortization Schedules
A $1,000 loan yielding 8% requires equal
payments at the end of the next three yrs.
How much principal will be rpd. in Year 2?
PMT = $1,000[.08(1.08)3/(1.083-1)] = $388.03
t 1 2 3
Vt-1 $1,000.00 $691.97 $359.30
It 80.00 55.36 28.74
Vt-1 + It 1,080.00 747.33 388.04
PMTt -388.03 -388.03 -388.03
Vt 691.97 359.30 0.01
P2 = V1 - V2 = |PMT2| - I2 = $332.67
Corporate Financial Management 1 15
Perpetuities Problem 4-27

1 r n 1
PVperp lim PVAn lim PMT
r 1 r
n n n

PMT PMT PMT

lim
r r 1 r
n n
r

PV = $100 / 7% = $1,428.57
Growth Perpetuities:
PMTt = PMT0(1+g)t
PVgrowth = PMT1/(r-g) (... r > g)
Corporate Financial Management 1 16
Compounding Frequency (1)
Compare annual return on deposit
with 6% interest paid annually and
monthly.
FVA = PV(1 + 6%) = PV1.06
rA = (FVA-PV) / PV = .06PV/PV = 6%
FVM = PV(1 + 6%/12)12 = PV1.00512
= PV1.0617
rM = (FVM-PV) / PV = 6.17%

Corporate Financial Management 1 17

Compounding Frequency (2)
Compare the cost of a 6% (nominal
rate) loan with monthly and quarterly
interest.
Nominal RateEffective Annual Rate
NR = mrm
EAR = (1 + rm)m - 1
EAR M = 1.00512 - 1 = 6.17%
EAR Q = 1.0154 - 1 = 6.14%
Corporate Financial Management 1 18
Bond and Stock Valuation
Chapters 5,7

Main sources of capital for Company

Bond: Debt Capital
Stock: Equity Capital
Claim on fut. cash flows for Investor
Bond: Contractual interest and princi-
pal payments (or proceeds of sale)
Stock: Dividends (theoretically forever)
or proceeds of sale
Corporate Financial Management 1 19
Valuation Procedure
Based on discounted cash flow
concept:
Estimate expected future cash flows
Determine required return (depending
on the riskiness of the expected cash
flows)
Compute the present value
Other possibilities: Market price of
same or comparable asset
Corporate Financial Management 1 20
Features of Bonds/ Stocks
Par (Face, Princ.) Value ???
Coupon (Interest) Rate Dividends
Coupon Payment Dividend Payment
Frequency Frequency
Maturity: Original (Issue), N/A
Remaining (Residual)
Terms of Repayment: N/A
Bullet, Sinking Fund,
Zero-Coupon (Pure
Discount) Common/Preferred
Call Provision (Option); Rights (Warrants,
other Rights; Convertibles)... See
Junior/Senior Chapt. 19, Hybrid
Financing
Corporate Financial Management 1 21
Bond Valuation Problem 5-1

t Ct PV n
Ct
1 $ 80 $ 73.39 V
1 r
t
2 $ 80 $ 67.33 t 0
3 $ 80 $ 61.77
4 $ 80 $ 56.67 For bond w/semi-annual
... ... ... coupons n=24, Ct=$40.
8 $ 80 $ 40.15 To put required return on
9 $ 80 $ 36.83 same basis as annual
10 $ 80 $ 33.79 bond, one should
11 $ 80 $ 31.00 assume EAR = 9% =
12 $1,080 $ 383.98 (1+rS)2 - 1, i.e. rS = \/1.09 -
r= 9% $ 928.39 1 = 4.4%.

Corporate Financial Management 1 22

Yield to Maturity/ Yield to Call (1)
Assume Johnson Co. has a bond with a
face value of $1,000 that matures in
12 years, has a coupon rate of 8%, and is
currently selling for $928.39. What is the
required return to buy the bond (YTM =
9.00%)?
Assume it can be called in 10 years at a
call price of $1,100. What would be the
required return to buy the bond if we knew
the option would be excercised (YTC =
9.79%)?

Corporate Financial Management 1 23

Yield to Maturity/ Yield to Call (2)
Yield to Maturity= Promised Return
Yield to Call= Return if Called
N=12; PV=-928.39; PMT=80; FV=1,000 => I
(YTM) = 9.00%
N=10; FV=1,100 => I (YTC) = 9.79%
Expected Return= YTM minus Risk
Credit (Default) Risk <= Rating
Interest Rate Risk/ Reinvestment Risk
FX Risk, Liquidity Risk...

Corporate Financial Management 1 24

Market Interest Rates/Yield Curve
4

3,5

2,5

r 2

1,5

0,5

0
0 2 4 6 8 10 12
t

Corporate Financial Management 1 25

Stock Valuation Problem

Value a share which is expected to pay dividends

of $2.72 and $3.10, respectively, over the next two
years, and sold thereafter for $48, if the required
return is 10%?
V=$2.72/(1.1)+$3.10/(1.1)2+$48/(1.1)2= $44.70
But... How did I estimate the market price in 2
years?
Let us assume constant dividends of $4.80 after
Year 2.
Using perpetuity valuation: V2=$4.80/10%= $48

Corporate Financial Management 1 26

Constant Growth Model
Dt = D0(1+g)t
V = D1/(r-g) (... r > g)
e.g. V = $36(1.05)/(13%-5%) = $31.5
e.g. r = $1.30/$21.25 + 6% = 12.12%
CG formula can also be used for
determining a horizon (terminal) value or
for valuing declining growth stock.
For erratic or supernormal growth stock,
split cash flows into two parts.
Corporate Financial Management 1 27
Risk and Return Chapters 6, 7

Risk refers to the chance that some

unexpected event would occur.
In business, that would mean the decrease
of value of the firm, in financial markets
any change in the value of financial
instruments etc.
In other words, actual returns will differ
from expected returns.
The expected return should therefore
compensate an investor for the perceived
risk.
Corporate Financial Management 1 28
 Investments with Risk Problem

Economy Prob. T-Bill Eq 1 Eq 2 Gold Bond

Recession 0.10 5.0% -25.0% -15.0% 20.0% 10.0%

Below avg. 0.20 5.0 -5.0 -5.0 7.0 7.0

Average 0.40 5.0 15.0 10.0 0.0 6.0

Above avg. 0.20 5.0 25.0 20.0 -2.0 5.0

Boom 0.10 5.0 50.0 30.0 -10.0 2.0

1.00

Corporate Financial Management 1 29

Expected Return
E(r) = wiri
E(rEQ1) = .10(-25%) + .20(-5%) +
.40(15%) + .20(25%) + .10(50%) =
12.5%

Eq 1 Eq 2 Bond T-bill Gold

E(r) 12.5% 8.5% 6% 5% 2%

Eq 1 has the highest expected return.

Is it the best investment?
Corporate Financial Management 1 30
Stand-Alone Risk
= \/(wi(ri-E(r))2
EQ1 = \/[.10(-25-12.5)2 + .20(-5-12.5)2 +
.40(15-12.5)2 + .20(25-12.5)2 + .10(50-
12.5)2] = 19.4%
Volatility

T-bill Bond Gold Eq 2 Eq 1

0% 1.9% 7.5% 12.9% 19.4%
E(r) 5% 6% 2% 8.5% 12.5%

Corporate Financial Management 1 31

Probability Distributions
Prob. T-bill

Eq
2
Eq
HT1

0 5 8.5 12.5
Actual Return (%)

Corporate Financial Management 1 32

Portfolio Risk (1)
Assume portfolio with 50% invested in
Eq 1, and 50% in Gold.
Economy Prob. Eq 1 Gold Port.
Recession 0.10 -25.0% 20.0% -2.5%
Below avg. 0.20 -5.0 7.0 1.0
Average 0.40 15.0 0.0 7.5
Above avg. 0.20 25.0 -2.0 11.5
Boom 0.10 50.0 -10.0 20.0

E(rP) = 7.25%
P = 6.1%
Corporate Financial Management 1 33
Portfolio Risk (2)
p (=6.1%) is much lower than:
either Eq 1 (19.4%) or Gold (7.5%).
average of Eq 1 and Gold (13.5%).
The portfolio offers a decent return
(average of Eq 1 and Gold returns) with
low risk.
The key is low (actually negative)
correlation between Eq 1 and Gold
returns, facilitating diversification.
Corporate Financial Management 1 34
Managing Portfolio Risk
Systematic and Specific Risk [Law of
Large Numbers] (Insurance,
Consumer Credit)
Equilibrium Theories, e.g. Capital
Asset Pricing Model [Sharpe, Lintner]
(Equity Markets, Capital Investments)
Portfolio Theory [Markowitz] (Market
Portfolios), based on function
P=(w1,w2,w3,..,1,2,3,..,12, 13,
23,..)
Corporate Financial Management 1 35
Effect of Diversification
(%)
Specific (Diversifiable)
35 Risk

Total Risk

20

Systematic Risk

0
10 20 30 40 N
Corporate Financial Management 1 36
Capital Asset Pricing Model
In an efficient market, the required return
will equal the expected return.
efficient market => equilibrium price
transactional, informational efficiency
efficient market arbitrage
An assets required return is the sum of
the riskless return and an asset-specific
risk premium.
Beta () is a measure of the assets market
(systematic, undiversifiable) risk.
SML: ri = rF + (rM - rF)
Corporate Financial Management 1 37
Beta as a Sensitivity Measure
ri = rF + (rM - rF)

ri
=1

0<<1
rF
=0
45

rM
Corporate Financial Management 1 38
CAPM Utilization Problem

Two shares (in the same market) with

known rF, A, B, rA, looking for rB.
rA = rF + A (rM - rF)
rB = rF + B (rM - rF)
14% = 6% + 1.4(rM-6%) => rM = 11.7%
rB = 6% + 1.1(11.7%-6%) = 12.3%
Note: The beta of a portfolio equals the
weighted average of its component
betas (VP bP = VA bA + VB bB + ...)
Corporate Financial Management 1 39
Options Chapter 8

Option = Right (Financial and Embedded

Options, i.e. Contracts) or Opportunity
(Real Options)
Financial options are traded contracts,
derivatives of Underlying Assets (Equities,
FX, Bonds, Commodities, Indices...)
Financial Derivatives include Options,
Warrants, Forwards, Futures, Swaps,
Repos...
Financial Derivatives are used primarily
for Risk Management (Hedging,
Speculation) ... See Chapt. 23
Corporate Financial Management 1 40
Applications
Financial Options
American vs. European Options
Call vs. Put Options
Exotic Options (various terms of exercise,
caps, floors; exchange options, compound
options,...)
Embedded Options... Constitute Contracts
Real Options... In Business Decisions ...
See Chapts. 11,25

Corporate Financial Management 1 41

 The Value of Options
Intrinsic Value (would the option be executed if
nothing changed till excercise date?) = (p; r; t)
...usually easy to assess; can be used for designing
option strategies
Time Value = (t; ) ...calculated by means of models
(using market equilibrium assumption and replication)
Intrinsic Value (Call Option) Total Value (Call Option)
V V

out-of-the-money in-the-money

S p p
at-the-money Time Value

Corporate Financial Management 1 42

Using the Replication Principle
Call Option: S = $40, p = $32, d = $16 or u = $64 at
time t; rt = 2%.
d: Option out of the money, i.e. Vd = 0
u: Uption in the money, i.e. Vu = 64 - 40 = $24
Income structure can be replicated with N forward
transactions. These must have zero value if
underlying asset costs $16, and must therefored
be issued with forward price F = $16. Their
present value is VF = p - F/(1+rt) = $16.31.
Value of N forward transactions at settlement if
underlying asset costs u is Vu = N(u - F). To
replicate u = 64 Vu = 24, N = 24/(64-16) = 0.5.
The option value is thus VC = 0.516.31 = $8,16.
Corporate Financial Management 1 43
 Numerical Model (Binomial, CRR)
Call Option S = 1 100; p = 1 000; r = 5%; 4 periods
1 215,51 F = 1 100; N = 1
115,51 VF = 1157,63 - 1100e-0,255%
1 157,63 = 71,29
71,29 VC = N VF = 71,29
1 102,50 1 102,50
43,99 F = 1 000
2,50
1 050,00 1 050,00 N = (u - S)/(u - d) =
27,14 1,52 2,50/102,5 = 0,0244
1 000,00 1 000,00 1 000,00 V = 1050 - 1000e-0,255% =
F
16,74 0,93 0,00 62,42
952,38 952,38
VC = N VF = 1,52
0,56 0,00
907,03 907,03
0,00 0,00
863,84
0,00
N = 0 => VC = 0
Corporate Financial Management 1 822,70 44
0,00
Analytical Model (Black-Scholes)
VC = p N(d1) - S e-rt N(d2)
d1 = [ln(p/S) + (2/2) t] / ( t)
d2 = d1 - t
p= $500; S= $510; r= 3%; t= 3months (=0,25); =20%
d1 = [ln(500/510)+(0,04/2)0,25]/(0,20,5) = -0,0730
d2 = -0,0730 - 0,20,5 = -0,1730
N(d1) = N(-0,0730) = 0,4709; N(d2) = N(-0,1730) = 0,4313
(cummulative distribution function for a standardised
normal random variable)
VC = 5000,4709 - 510e-20%0,250,4313 = $17,12
VP = VC - p + Se-rt = 17,12-500+510e-3%0,25 = $23,31 (using put-
call parity)

Corporate Financial Management 1 45

Cost of Capital
Chapter 9

Cost of Capital = Required Return for

Capital Budgeting Project
2 possible approaches
Use CAPM
Firm Value = Equity Value + Debt
Value.
In a perfect market, a company cannot affect
its value by changing the way it is financed - it
just influences the distribution of risks and
returns between different classes of investors.
Corporate Financial Management 1 46
Risk/Return of Real Assets
CAPM can be extended to include
real assets (i.e. capital budgeting
projects)
Pure Play Method (Finding single-
product companies in the same line of
business as project being evaluated)
Accounting Beta Method (Regression
of return of assets against average
return on assets in the whole market)
Corporate Financial Management 1 47
Weighted Average Cost of Capital
WACC = (1-L)re + L(1-T)rd
L = D/(D+E) ... Leverage
T ... Marginal Income tax Rate
Always based on opportunity, not
historical costs and values!
After-tax cost must be used for all
components!
Correct risk assumptions have to be
made for individual projects!
Corporate Financial Management 1 48
WACC Problems 9-4, 9-7

r = $3.6 / $70 = 5.14%

c = $3.6 / ($70(1-5%)) = 5.41%

WACC = 30%6%(1-40%)+
5%5.8%+ 65%12% = 9.17%

Corporate Financial Management 1 49

Component Cost of Equity
Ways to estimate required return:
DCF Method
CAPM Approach (b of equity, not project!)
Bond Yield + Risk Premium Method
Equity for new projects may come from
retained earnings or new issue.
New issues incur flotation costs. In this
case, the component cost of capital is
higher than required return.

Corporate Financial Management 1 50

Application of DCF Method
QST stock is trading at $30 a share. QST
will pay a $3 dividend at the end of the
year and expects 5% annual growth. Costs
of flotation amount to 10%. What is the
required return and cost for new equity?
r = D1/V + g = $3/$30 + 5% = 15%
Vnet = V(1-F) = $30(1-10%) = $3090% = $27
re = D1/[V(1-F)] + g = $3/[$30(1-10%)] + 5%
= 16.1%

Corporate Financial Management 1 51

Risk, Leverage, Beta and WACC
Operating Leverage: influences rA, i.e. both
rE and rD <=> an increase in operating risk
increases bA and WACC.
Financial Leverage: in efficient markets, an
increase should increase bd, but leave bA and
WACC unchanged.
(1-TL)bA = L(1-T)bD + (1-L)bE (= portfolio)
Assuming low risk of debt, it is possible to
approximate bA = bE (1-L)/(1-TL)
... on Leverage more in Chapt. 15

Corporate Financial Management 1 52

Distinguish Risks
Operating (Business) Risk (depends on
structure of firms assets, not structure of
financing) <= Operating Leverage
Financial Risk (based on firms capital
structure) <= Fin. Leverage
Profit Shldr.
L=0
Return

Units Sold Co.

L = 50%
Return

Corporate Financial Management 1 53

Basics of Capital Budgeting Chapter 10

Generate ideas
Estimate the expected future cash flows
from the project.
Assess the risk and determine a required
return (cost of capital, hurdle rate, discount
rate).
Compute present value of cash flows; if
project has a positive NPV, it creates value
=> should be accepted.
Alt.: Find market price or compare with similar asset
Corporate Financial Management 1 54
Types of Projects
Capital budgeting projects include:
New products and new businesses
Maintenance projects
Cost saving/ revenue enhancement
Capacity expansion
Projects required by regulation/ policy
Independent/Exclusive Projects
Conventional/Nonnormal Cash Flows
Corporate Financial Management 1 55
Alternative Budgeting Measures
Net Present Value
Internal Rate of Return (=Expected Rtrn)
Profitability Index
Modified IRR (includes cost of capital)
Payback ... ignores time value of
money and cash flows beyond payback
Discounted Payback

Corporate Financial Management 1 56

Investment Criteria Problem

Year 0 1 2 3 4
CF -70,000 30,000 30,000 30,000 20,000
DCF -70,000 27,273 24,793 22,539 13,660
PB = 2 + (10,000/30,000) = 2.3 years
DPB = 2 + (17,934/22,539) = 2.8 years
NPV = DCF = $18.266
PI = DCF[1-4] / |CF0| = 1.26
IRR = 22.24%
MIRR = (129,230/70,000)1/4 - 1 = 16.56%

Corporate Financial Management 1 57

Issues
IRR brings same results as NPV with
independent and conventional projects
only
Unequal lives of exclusive projects, e.g.
replacement projects ... use common
horizon calculation or Equivalent Annual
Annuities (EAA = NPV[r(1+r)n/(1+r)n-1])
It is realistic to assume some kind of
capital budget constraint ... use artificially
high discount rate or capital rationing (e.g.
ranking by Profitability Index)

Corporate Financial Management 1 58

Estimating Cash Flows
Chapter 11

Cash flow income (includes e.g.

depreciation, ignores time value)
Measure on incremental (marginal)
basis
Only future expenditures/revenues
are relevant (avoid sunk costs)
Include taxes; not financing costs
(they are reflected in cost of capital)

Corporate Financial Management 1 59

Types of Budgeting Cash Flows
Net Initial Investment Outlay
new assets purchase, old assets
sale, increase in net working capital
Net Operating Cash Flow
Nonoperating Cash Flows
overhauls, changes in working capital
Net Salvage (Termination) Value
Tax Adjustment (CapitalizingExpensing)
Corporate Financial Management 1 60
Est. Cash Flows Problems 11-1,2,3

Corporate Financial Management 1 61

Budgeting Cash Flows Problem 11-9

NPV= - 7,160 + 2,000/1.15 + 2,384/1.152 + 1,968/1.13 +

1,744/1.154 + 1,712/1.155 + 3,232/1.156 = $921.36
Note: Different remaining lives, working capital investment
Corporate Financial Management 1 62
Analyzing Risk
Market Risk
Measured by b (see CAPM) impacts
discount rate
Stand-Alone Risk
Break-even Analysis
Sensitivity Analysis
Scenario Analysis
Monte Carlo Simulation
Corporate Financial Management 1 63
Simple Example
Project costs $100,000, expected sales 1,000
units, price $80/unit, cash op. exp.
$40/unit, 5-year life, fully amortized,
terminal value $10,000. Cap. cost 12%, tax
rate 25%. What is its NPV?
V = -I + [N(P-U)(1-T)+DT][((1+r)n-1)
/r(1+r)n] + [F(1-T)]/(1+r)5 = -100,000 +
[30,000+5,000]3.60 + 7,500/1.76 = $ 30,423

Corporate Financial Management 1 64

Break-even Analysis (Sales)
V = -I + [N(P-U)(1-T)+DT]3.60 + [F(1-
T)]/(1+r)5
What N* would result in V = 0?
-I + [N*(P-U)(1-T)+DT]3.60 + [F(1-
T)]/(1+r)5 = 0
N* = [(100,000-7,500/1,76)/3.60-5,000]/30 =
720 pcs.
i.e. the project breaks even at 720 units sold.
Usually easier to use numerical iteration.

Corporate Financial Management 1 65

Sensitivity Analysis (Price)
V = -I + [N(P-U)(1-T)+DT]3.60 +
[F(1-T)]/(1+r)5
V/P = [N(1-T)]3.60 = 7503.60 =
$ 2,700

i.e. a price cut of $1 will result in a project

value decrease by $ 2,700.
Almost always easier to use numerical
simulation.

Corporate Financial Management 1 66

Scenario Analysis (Sales, U.Cost)
Scenario Worst Most Best
Case Likely Case
Unit 850 1,000 1,100
Sales
Unit 45 40 38
Cost
NPV 2,711 30,423 47,185

Corporate Financial Management 1 67

Real Options
Flexibility to adjust plans based on newly
acquired information may increase NPV.
Growth/development options
Contraction/abandonment options
Investment timing options
Exchange options
Valuation methods:
Closed-form (analogy w/B-S)... rare
Decision trees
Monte Carlo
... further reading in Chapt. 25
Corporate Financial Management 1 68
Financial Planning
Chapter 12

Pro-Forma Financial Statements

Forecast the amount of external
financing that will be required
Evaluate the impact that changes in
the operating plan have on the value
of the firm
Set appropriate targets for
compensation plans

Corporate Financial Management 1 69

Steps in Financial Forecasting
Forecast sales
Project the assets needed to support
sales
Project internally generated funds
Project outside funds needed
Decide how to raise funds
See effects of plan on ratios and
stock price
Corporate Financial Management 1 70
Additional Funds Needed Problem

Cash $360 Accts. pay. $1,200

Accruals 600
Accounts rec. 2,400 S.-Term Loan 800
Inventory 1,800 Total CL $2,600
Total CA $4,560 L-T debt 1,000
Net FA 3,000 Equity 3,960
Total assets $7,560 Tot. liab.&eq. $7,560

Sales = $12,000; M = NI/Sales = 6%; P = D/NI =

25%.
Corporate Financial Management 1 71
Key Assumptions
Operating at full capacity last year.
Each type of asset grows proportionally
with sales.
Payables and accruals (i.e. current
liabilities) grow proportionally with
sales.
Existing profit margin (6%) and payout
(25%) will be maintained.
Sales are expected to increase by $3
million. (%S = 25%)
Corporate Financial Management 1 72
Graphical Illustration
Assets
Assets = 0.63 Sales

9,450 Assets =
7,560 (A/S)Sales
= 0.63($3,000)
= $1,890

Sales
0 12,000 15,000
A/S = $7,560/$12,000 = 0.63 = $9,450/$15,000
(i.e. Capital Intensity Ratio remains unchanged)
Corporate Financial Management 1 73
Calculating AFN
AFN = Required Increase in Assets -
Spontaneous Increase in Liabilities -
Increase in Retained Earnings
AFN= A(S/S0)- L*(S/S0)- MS1(1-P)
= $7,56025% - $1,80025% -
6%$15,00075% = $1,890-$450-$675
= $765,000

Corporate Financial Management 1 74

Projected Balance Sheet
Cash $450 Accts. pay. $1,500
Accruals 750
Accounts rec. 3,000 S.-Term Loan 1,565
Inventory 2,250 Total CL $3,815
Total CA $5,700 L-T debt 1,000
Net FA 3,750 Equity 4,635
Total assets $9,450 Tot. liab.&eq. $9,450

DR0=3,600/7,560=48%; DR1=4,815/9,450=51%
CR0=4,560/2,600=1.75; CR1=5,700/3,815=1.49
Corporate Financial Management 1 75
Corp. Valuation & Governance
Chapter 13

Corporate Valuation Model (Dividend

Growth Model)
Based on Free Cash Flow Estimation
(instead of dividends)
Can be used when dividends are not paid
(e.g. startups, subunits of firm)
1. Estimate the Value of Operations
(discount FCF = NOPAT Required Net
Operating Working Capital)
2. Add Value of Nonoperating Assets and
Growth Options
Corporate Financial Management 1 76
Value Based Management
Value-based Management involves the
systematic use of the corporate valuation
model to evaluate a companys decisions.
Value drivers:
Growth rate of sales
Operating profitability (NOPAT/Sales)
Capital requirements (Operating
Capital/Sales)
WACC
Company creates value when EROIC (i.e.
NOPAT/Capital) > WACC
Corporate Financial Management 1 77
Corporate Governance
Shareholder wealth may be adversely influenced
by management behavior (agency problem)
Corporate governance is a set of laws, rules and
procedures influencing managers in a way that
maximizes the firms intrinsic value.
Monitoring
Litigation
Threat of removal
Compensation plans
Hostile takeovers (avoid managerial
entrenchment)

Corporate Financial Management 1 78