L1 flash cards corporate finance (ss11)

Capital Budgeting Process:
Steps of the Capital Budgeting Process
 Brainstorming potential investment ideas
 Gathering and analysing information relating to potential future
cash-flows that different projects can generate.
 Capital Budget Planning involves integrating new profitable projects
into the firm’s overall investment strategy.
 Post auditing and monitoring helps determine why there is a gap
between the predicted and realized values of sales, net
profit, expenses and cash flows.
 Post-Auditing tracks systematic errors
 Business operations can be improved
 Post-auditing will help the company make better capital
budgeting decisions in the future.
Study Session 11, Reading 36

Categories of Capital Budgeting
Types of Projects
 Replacement Projects: When the company needs to
replace old equipment in order to continue operations.
 Expansion Projects: When the size of the business is
increased and therefore, more uncertainties arise.
 New Products and Services: Determining whether the
company should expand its product range into new
markets. The uncertainty (ie risk) is higher for new products
and services than expansion projects.
 Safety, Regulatory and Environment Projects: Are normally
forced by government agencies and are high in cost, and
may generate negative returns.

Basic Principle of Capital Budgeting
Capital budgeting considers after tax cash flows (not
earnings), the timing of cash flows, the opportunity cost of
capital, it ignores financing costs, and also sunk costs.

Cash Flow Estimation
 Cash flows are used rather than earnings.
 Only incremental cash flows are considered
 The timing of cash flows is crucial
 Opportunity cost of incremental cash flows is considered.
 Cash flows on an after tax basis are considered.
 Ignores financing cost as after tax cash flows are discounted
at the investor’s cost of capital to derive the ‘Net Present
Value’.
 Incremental cash flow –cash flow after decision minus cash
flow without decision
 Externalities are considered.

Selection of Capital Projects
 Mutually exclusive projects
 Project sequencing
 Capital rationing

Methods to Evaluate a Single Capital Project
Net Present Value (NPV)
 NPV can be calculated as:
 CF = Cash flow after tax
r = required rate of return
Outlay = cash flow investment in the beginning
 Net Present Value (NPV) is the present value of the after tax
net cash flows that the company will receive in the future from
a given project
 If the NPV is >0, the company should invest in the project.
 If the NPV is <0, the company should not invest in the project.

Internal Rate of Return (IRR)
 The IRR is the discount rate which makes the NPV of the
project = 0. That is, it is the discount rate required to make the
present value of all future cash flows = 0.
 IRR can be back solved, using the following formula:
 If the IRR of the project is > r (required rate of return), then
the company should invest.
 If the IRR of the project is < r (required rate of return), then
the company should not invest.

Payback Period
 The Payback Period is the number of years that a projects
takes to fully recover the invested capital in a given project.
 The drawbacks of the payback period method are that it does
not consider the riskiness of the expected future cash flows,
the time value of money is ignored, and this it ignores all cash
flows after the payback amount is achieved.
 An advantage of the payback period is that it provides an
indicator of the likely liquidity of the project.

Discounted Payback Period
 The Discounted Payback Period is the number of years a
project takes to generate its initial invested capital, while
considering the time value of money and the risk profile of the
future cash flows.
 However cash flows after the discounted payback period are
ignored.

Average Accounting Rate of Return (AARR)
 The Average Accounting Rate of Return is calculated as:
 Unlike the other capital budgeting tools, it uses Net Income
(earnings) rather than cash flows.
 Advantages of AAR are that it is easily understandable and
simple to calculable.
 Disadvantages are that it is not based on cash flows, no time
value of money is captured and AAR does not tell us if it is a
good or a bad investment

Profitability Index
 The Profitability Index (PI) is the ratio of the present value of
future cash flows to the investment made initially. It is
calculated as:
 For independent projects, a company should invest in a project
if PI > 1.0, and should not invest if PI is < 1.0.
 Although PI is not used as frequently as NPV and IRR, it is used
for guiding purposes under capital rationing constraints

NPV and IRR Conflict Due to Different
Cash Flow Patterns
 Supply Project A and B have similar initial investment, but
different cash flow:
 If the two projects are mutually exclusive and there is a
conflict between the decision suggested by NPV and IRR, an
investor should make the investment decision suggested by
the NPV method.
 The reinvestment assumption is basically assuming that the
cash flow will be reinvested at the same discount rate used in
the NPV calculation.

NPV and IRR Conflict Due to
Project Scale
 Another issue arises when the scale of the projects is different.
For example, should an investor invest in a smaller project
with a higher return, or a larger project with lower returns (but
still greater than its cost of capital).
 An example of conflict between NPV and IRR due to difference
in project scale is exemplified below.

NPV and IRR Conflict Due to Multiple
IRRs
 Multiple IRR problems ‘might’ arise when the sign of cash
flows change twice and the project is non-conventional.
 Multiple IRR - IRR satisfy these equations, when IRR was
between 100% and 200% the NPV was positive and at the
peak when IRR = 140%.

NPV and IRR Conflict Due to No IRR
 It is possible that a project has no IRR at all.
 Having no IRR does not mean the project is unacceptable.

Most Common Capital Budgeting
Methods
 NPV and IRR are the most taught capital budgeting techniques.
 Larger companies prefer NPV and IRR.
 Private corporations consider the payback period as access to
capital is more limited.

Relationship between NPV, Company
Value and Stock Prices
Stock Prices and NPV
 If listed corporations invest in a positive NPV project, it
increases the wealth of its shareholders.
 For example, assume XYZ Corporation invests in a $600m
project which has an after tax cash flow of $850m. XYZ has
200m shares outstanding with a market price of $32 per share.
 The value of any company is basically the sum of its current
investments, plus the NPV of its future investments.

Weighted Average Cost of Capital
 The cost of capital is directly proportionate to the riskiness of
the expected cash flows .
 The cost of capital is the amount of money (compensation)
paid for the supply capital. It compensates owners of the
capital.
 An investor will only invest, if the returns meet or exceed its
cost of capital.
 The Marginal Cost of Capital is the cost of additional capital
needed for a potential project investment

 The WACC can be calculated as:
t = marginal tax rate company
= proportion of debt taken by company
= before –tax marginal cost of debt
= marginal cost of preferred stock
= proportion of preferred stock the company uses
= marginal cost of equity
= proportion of equity the company uses.

Impact of Tax on the Cost of Debt
 If debt is included in the capital structure of the company, tax
reduces the cost of capital because interest on debt is typically
tax deductible.-
 The Cost of Debt finance is therefore typically expressed as
r-d(1-t)

Estimating the Cost of Equity
 Estimating the cost of common equity is more difficult than
estimating the cost of debt.
 That being said, several methods can be used to estimate the
cost of equity, based on equity market values
 In the case of preferred stock, calculating the cost of capital is
easier as the dividends are typically fixed.

 Analysts can use three approaches to estimate the capital
structure of a company for the purpose of calculating the
WACC:
 Assume the current capital structure is ongoing.
 Examine the past trend and management statements
regarding the capital structure
 Use industry average as the target capital structure

Marginal Cost of Capital
 An optimal capital budget occurs when capital is invested to
the point that the marginal cost of capital is equal to the
marginal return of the investment.
 If the systematic risk of a certain project is higher or lower
than the average of the current project portfolio, a respective
adjustment is made to the WACC of the company

Debt Rating Approach
 If the current market price of debt issued by a company is not
available, then the debt-rating approach is used to estimate
the before-tax cost of debt.
 The debt rating approach considers the cost of debt of other
observable companies, with a similar credit rating and other
characteristics.

Cost of Preferred Stock
 If the current market price of debt issued by a company is not
available, then the debt-rating approach is used to estimate
the before-tax cost of debt.
 The debt rating approach considers the cost of debt of other
observable companies, with a similar credit rating and other
characteristics.

Capital Asset Pricing Model
 Under the capital asset pricing model (CAPM) approach, we
use the basic CAPM theory to come to the conclusion
expected return on a stock, as highlighted in the following
formula:
 The equity risk premium (ERP) of the CAPM is

Capital Asset Pricing Model
 A multifactor model incorporates factors like priced
risk, macro-economic factor and factors specific to company
types. It is an alternative to the CAPM (which only considers
systematic risk as its sole factor). A typical factor risk premium
is:

The Historical Equity Risk Premium
Approach
 The historical equity risk premium approach assumes that the
equity risk premium calculated over a long period of time is a
good indicator of the expected equity risk premium.

The Survey Approach
 Under the survey approach, a panel of experts are asked to
estimate an equity risk premium. The average of those results
is taken.

Dividend Discount Model Approach
 The dividend discount model approach uses the following
formula:
 where the expected dividend is divided by current share price
plus the expected dividend growth rate.
 We use this formula to find out the required rate of
return, from which we subtract the risk free rate to arrive at an
estimate of the risk premium.

The Gordon Growth Model
 The Gordon Growth Model can be defined as:
 where:
V = the intrinsic value of a share
D = dividend per share
r= cost of equity

Bond-Yield-Plus Risk-Premium
 The bond yield plus risk premium (BYPRP) approach suggests
that the cost of capital for equity capital (the riskier cash flows)
is higher than the cost of debt (the less risky cash flows).
re=rd + Risk Premium
 Here, the risk premium is compensation for the additional risk
of equity capital relative to debt capital.

Estimating Beta
 Beta estimates are sensitive to estimation methods such as:
 Estimation period
 Periodicity of the return interval
 Selected of appropriate market index
 Smoothing technique
 Adjustment for small-cap stocks

Country Risk Premium for a
Developing Country
 Investors need to be compensated for bearing country risk.
 A country spread estimate is also the sovereign yield spread. It
is also the difference between the government bond yield of
the country and a similar Treasury Bond Yield with same
maturity in the home country. Equity premium of country can
be calculated as follows:

Marginal Cost of Capital Rises as
Additional Capital is Raised
 As companies raise more funds, the cost of capital changes for
two reasons:
 The company may be unable to issue additional debt at the
same seniority level as its existing debt. Hence has to offer
additional debt at higher rates.
 The deviation from the target capital structure due to
‘lumpiness’ of security issuance.

Breaking Points of Capital Structure
 A breaking point in capital structure occurs when the cost of
capital changes due to a change in source.
 Raising capital is not typically smooth. Therefore, raising new
capital may result in a step up in the capital cost schedule.

Flotation Costs
 Flotation Costs are a fee that investment banks charge
companies for assistance in raising capital. The size of the fee
depends on the size and type of capital that a company raises.
 There are two methods to treat flotation costs:
 Add flotation costs into the cost of capital.
 Flotation costs should be added into a project’s
evaluation, and not in the cost of capital.

Leverage
 A highly leveraged company has volatile earnings and cash
flows which in turn increases the risk of lending.
 Highly leveraged companies have a higher probability of
bankruptcy in downturns of the economic cycle.

Fixed Cost Leverage
 The cost structure of a company consists of two components:
variable costs and fixed costs.
 Variable costs fluctuate with the number of goods produced.
Fixed costs stay constant, regardless of output levels.
 A company with a greater portion of fixed costs vs. variable
costs has greater variation in net income, because small
changes in revenue can have a greater impact on earnings.

Business Risk
 Business risk is possibility that a company will achieve lower
than expected profits.
 Business risk is a combination of sales and operating risk.
 Sales Risk
 Operating risk
 Financial risk relates to how a company finances its operating
assets.

Degree of Operating Leverage
 The Degree of Operating Leverage is the ratio of fixed to
variable costs. The level of operating risk largely relates to the
industry that the business operates in.
 It calculates the operating income elasticity to a change in
revenue (ie how sensitive operating income is to changes in
revenue). .
 DOL = (% change in operating income)/(% change in units sold)
 Operating Income = (# of units sold) [(Price/ unit)-(Variable
cost / unit)] - [Fixed operating costs]

Degree of Financial Leverage
 The Degree of Financial Leverage (DFL) tells us how sensitive
net income is to a change in operating income.
 Degree of Financial Leverage = (% change in net income)/(%
change in operating income)
 The Degree of Total Leverage is the sum of the Degree of
Operating Leverage and the Degree of Financing Leverage.

Effect of Financial Leverage on A
Company’s Net Income
 Financial leverage can improve the ability of a company to
earn a greater return on shareholder capital.
 Financial leverage magnifies increases in earnings per share
during periods of rising operating income, but adds to the risks
for stockholders and creditors because of added interest
obligation.
 A firm that has a higher amount of debt also has additional
fixed financial costs in the form of interest payments.
 Financial leverage (or gearing) can be calculated as:
Financial Leverage (Debt on Equity Ratio) = Debt / Equity

Return on Equity
 Higher financial leverage is riskier than a firm with low
financial leverage, the return on equity (ROE) may be higher
since the highly leveraged firm is using borrowed money to
invest in profitable (positive NPV) projects.
 Return on Equity can be calculated as:
Return on Equity = Return on Assets Financial Leverage

The Break-Even Point
 Breakeven analysis indicates the relationship between cost,
production, volume and returns.
 The business owner or manager usually considers several
factors when studying break-even analysis:
 The capital structure of the company.
 Variable expenses.
 Fixed expenses such as rent, insurance, heat, and light.
 The inventory, personnel, and space required to operate
properly.
 Setup of the organization.

 The Breakeven Point can be calculated as:
 Breakeven Point =

Variable costs
Break Even Point
Profit
Output Volume
Sales
$
100
0
100
Fixed Costs
Total Costs
Revenue

Margin of Safety
 The Margin of Safety enables a business to know the amount it
has gained or lost for each quantity of sales. It helps a business
easily determine whether they are over or below the
breakeven point.
 It can be calculated as:
Margin of Safety = Total budgeted or actual sales − Break even sales

Dividends
 A payment made out of a firm’s earnings to its owners, in the
form of either cash or stock.
 If a payment is made from other sources than current or
accumulated retained earnings, the term distribution is used.
 A distribution from earnings is a dividend, while a distribution
from capital is a liquidating dividend.

Stock Splits
 A stock split is usually undertaken by companies that have
seen their share price increase to levels that are either too
high or are beyond the price levels of similar companies in
their sector.
 A Reverse stock split or reverse split occurs when a company
issues a smaller number of new shares to each shareholder, in
proportion to that shareholder's original shares.

Dividend Payment Chronology
 Dividend is the payment declared by a company’s board of
directors and given to its shareholders out of the company's
current or retained earnings.
 The key dates relating to the payment of a dividends are:
 Declaration Date
 Ex-dividend Date
 Record Date
 Payment Date

Methods of Share Repurchases
 On-market share repurchases occur when a company buys
back its own shares in the marketplace, reducing the number
of outstanding shares.
 Off-market share repurchase is any purchase of shares directly
from the shareholders.

Reasons for Share Repurchases
 Repurchase announcements are viewed as positive signals by
investors because the repurchase is often motivated by
management's belief that the firm's shares are undervalued.
 It can remove a large block of stock that is overhanging the
market and keeping the price of per share down.
 Companies can use the residual model to set a target cash
distribution level, then divide the distribution into a dividend
component and a repurchase component.

Earnings Per Share (EPS)
 Earnings Per Share (EPS) represents the portion of a
company's earnings, net of taxes and preferred stock
dividends, that is allocated to each share of common stock.
 EPS can be calculated by dividing net income earned in a given
reporting period by the total number of shares outstanding
during the same period.
 Earnings Per Share (EPS) =

Price Effect of a Stock Repurchase
 A stock repurchase typically has the effect of increasing the
price of a stock as it signals to the market that management
believe the stock is undervalued.

Book Per Value Share
 Book value per share indicates the book value of each share of
stock. Book value is a company's net asset value, which is
calculated by total assets minus total liabilities.
 Its formula is:
Book value per share =

Impact of Share Repurchases on
Book Value Per Share
 A share repurchase can be either positive or negative for book
value per share, depending on the share repurchase price
relative to book value.
 If the share repurchase is undertaken at a price less than book
value, then the repurchase will be BVPS accretive. If it is
undertaken at a price greater than book value, then it is BVPS
decretive.

Shareholder’s Wealth
 A share repurchase can be either positive or negative for book
value per share, depending on the share repurchase price
relative to book value.
 If the share repurchase is undertaken at a price less than book
value, then the repurchase will be BVPS accretive. If it is
undertaken at a price greater than book value, then it is BVPS
decretive.

Liquidity Position
Sources of Liquidity
 The liquidity of an asset is its ease of convertibility into cash or
a cash equivalent asset.
 The investment portfolio represents a smaller portion of
assets, and serves as the primary source of liquidity.
 Secondary sources include negotiating debt
contracts, liquidating assets, and filing for bankruptcy and
reorganization.

Factors Influencing Liquidity Position
 Liquidity risk can arise through the inability to access, at
economically viable conditions, the financial resources needed
to guarantee the firm’s ability to operate.
 The two main factors influencing the firm’s liquidity position
are the resources generated or used by operating and
investing activities, and the maturity and renewal profiles of
debt or liquidity profile of financial investments.

Working Capital
 Working Capital it the relationship between a firm's short-term
assets and its short-term liabilities.
 It indicates the ability to satisfy both maturing short-term debt
and upcoming operational expense.
 Formula of working capital:
Working Capital = Current Assets - Current Liabilities

Measuring Liquidity
 The Cash Ratio is a formula for measuring the liquidity of a
company by calculating the ratio between all cash and cash
equivalent assets and all current liabilities.
 The Cash Ratio is measured as:
 Cash ratio =
=

Operating Cycles
 An operating time cycle is the average time period between
the acquisition of inventory and the receipt of cash from the
inventory's sale.
 A short operating cycle means a more prompt return on
investment for the firm's inventory.
 Operating cycle calculations are completed with this formula:
 Operating cycle = DIO + DSO – DPO
DIO represents day’s inventory outstanding
DSO represents day sales outstanding
DPO represents day’s payable outstanding.

Cash Conversion Cycles
 The cash conversion cycle is the duration of time it takes a firm
to convert its activities requiring cash back into cash returns.
 The cycle is composed of the three main working capital
components:
 Accounts receivables outstanding in days (ARO)
 Accounts payable outstanding in days (APO)
 Inventory in days (IOD).

Cash Position Management
 Managing short-term cash flows may result in reducing costs.
 Carrying costs indicates the return forgone by investing too
heavily in short-term assets.
 Shortage cost is the cost of running out of short-term assets.

Forecasting
 Predict minimum cash balances during the specific period.
 Measuring the typical cash inflows and outflows of the
company in a period.
 Prepare cash forecasts for shorter periods of time if cash flows
are tight.
 Cash flow forecasting is extremely difficult in periods of rapid
growth.

Net Cash Position
 Net Cash Position can be calculated as:
NCP = WC –WCR
Where,
NCP = Net Cash Position
WC = Working Capital
WCR = Working Capital Requirement
 If WC > WCR : we have a positive net cash position
If WC < WCR : we have a negative net cash position

Daily Cash Flows Monitoring
 It is important to collect cash flow information on a timely
basis.
 Use short-term investments and borrowings to help with cash
position management.

What is Yield?
 Yield is one component of the total return of holding a
security.
 A high yield on one security may be offset by a decline in
market value of the capital over the period. Higher return
often means higher risk .
 Yield levels are impacted by inflation expectations.

Yield To Maturity
 Yield to Maturity (YTM) is the rate of return anticipated on a
bond if it is held until the maturity date.
 YTM is calculated as:

Short Term Investments
 Money market funds can be used as short-term investment
vehicles.
 They provide flexibility to a company’s liquidity position as
they can be sold at any time at the current share price.

Management of Inventory
 Inventory management is the process of efficiently overseeing
the constant flow of units into and out of an existing inventory.
 Inventory turnover can be used to measure how efficiently a
company is using its inventory. It can be calculated as:
revenue/average inventory
 Buffer stock is additional units above and beyond the
minimum number required to maintain production levels.

Accounts Receivable
 Accounts receivable represents money owed by entities to the
firm on the sale of products or services on credit.
 The process commences with a receipt of a customer order
and ends with the collection of the cash from the customer
 Receivables turnover is calculated as:

Accounts Payable
 Accounts payable are debts that must be paid off within a
given period of time in order to avoid default. They are usually
debts owed to suppliers of the business.
 The accounts payable turnover ratio indicates how many times
a company pays off its suppliers during an accounting period.

Short Term Funding
 Short-term financing programs are designed to be repaid
within a one-year period and are designed to meet the various
needs of companies.
 Short-term Financing Methods facilitate the smooth running of
business operations by meeting day to day financial
requirements.

Modes of Financing
 Unsecured Loans
 If the company`s credit rating is deficient, the bank may lend
money only on a secured basis
 Under a revolving line of credit, the bank agrees to lend
money up to a specified amount on a recurring basis.

Calculating the Cost of Finance
 In order to compare the costs of various sources of short term
finance, an analyst may use:
 Annual Rate of Interest=
 When credit is unavailable from a bank, the company may
have to go to a commercial finance company, which typically
charges a higher interest rate than the bank and requires
collateral.

Dupont Model
 Three-component Dupont Model

Dupont Model
 Five-component Dupont Model

Proforma Statements
 Performa statements are made on last year’s results with a
bold assumption that the company will grow similar to its last
year’s results.
 Proforma analysis incorporates:
 Relationship between revenues and sales are estimated
 Revenues forecasting
 Financial burdens estimation
 Income statement and balance sheet construction on the
basis of predictions

Corporate Governance
 Corporate governance can be defined as the system by which
companies are directed and controlled.
 Corporate governance structure specifies the distribution of
rights and responsibilities among different participants in the
corporation
 It also provides the structure through which the company
objectives are set, and the means of attaining those objectives
and monitoring performance.
 There are no formal penalties for non-compliance

The OECD and Corporate Governance
 The Organisation for Economic Co-operation and Development
(OECD) has set out principles of corporate governance that
countries may use to develop their own standards of corporate
governance. These principles are as follows.
 The corporate governance framework should promote
transparent and efficient markets
 The corporate governance framework should protect and
facilitate the exercise of shareholder’s rights.
 The corporate governance framework should ensure the
equitable treatment of all shareholders

Shareholder Protection
 When investors finance firms, they typically obtain certain
rights or powers that are generally protected through the
enforcement of regulations and laws.
 Rules protecting investors include
company, security, bankruptcy, takeover, and competition
laws, but also from stock exchange regulations and accounting
standards.

The Role of the Board of Directors
 The primary responsibility of the Board is to foster the long-
term success of the corporation, consistent with its fiduciary
responsibility to shareowners.
 To carry out this responsibility, the Board must ensure that it is
independent and accountable to shareowners and must exert
authority for the continuity of executive leadership with
proper vision and values.
 The Board is singularly responsible for the selection and
evaluation of the corporation's CEO and included in that
evaluation is assurance as to the quality of senior
management.

Benefits of Independent Board
Members
 Counterbalance management weaknesses.
 Ensure legal and ethical behaviour at the company, while
strengthening accounting controls.
 Extend the “reach” of a company through
contacts, expertise, and access to debt and equity capital.
 Help a company survive, grow and prosper over time
through improved succession planning

Qualifications of Board Members
 Leadership Experience
 Industry-specific experience
 Area of expertise
 Relationships
 Diversity
 Time

The Audit Committee
 An audit committee is an operating committee of the Board of
Directors that the responsibility of providing oversight of
financial reporting and disclosure.
 Committee members are drawn from members of the
company's board of directors.
 A qualifying audit committee is sometimes required for a
company to be listed on a stock exchange.

The Compensation Committee
 The Compensation Committee has primary responsibility for
reviewing and approving the compensation of the Company's
CEO and other executive officers; overseeing the Company's
benefit plans; and reviewing and making recommendations to
the full Board regarding Board compensation.

The Nomination Committee
 The Nomination Committee has role of evaluating the board of
directors and examining the skills and characteristics that are
needed in board candidates.

Corporate Code of Ethics
 A code of business ethics often focuses on social issues.
 A Corporate Code of Ethics may set out general principles
about an organization's beliefs on matters such as
mission, quality, privacy or the environment.
 It should dictate procedures to determine whether a violation
of the code of ethics has occurred and, if so, what remedies
should be imposed.

Areas of Shareholder Rights
 Voting Rules
 Shareholder Sponsored Proposals
 Common Stock Classes
 Takeover Defenses

L1 flash cards corporate finance (ss11)

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