L2 flash cards corporate finance - SS 8

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  • Great article. Thanks for the info, very helpful. BTW, if anyone needs to fill out a “2014 IRS SS-8, [5-2014]”, I found a blank form here: "www.irs.gov" and also here "ss8 form"
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L2 flash cards corporate finance - SS 8

  1. 1. Expansion and Replacement Projects Expansion project - an independent project which does not affect the cash flows for the rest of the company. Replacement project - affects the cash flows of the rest of the company, therefore it is important to compare the cash flows from the new investment and the investment being replaced Formula for a new capital that needs to be invested in an expansion project where FCInv is the investment in new fixed capital and NWCInv is the investment in net working capital Study Session 8, Reading 25
  2. 2. Expansion and Replacement Projects (cont.) Formula for the initial capital that needs to be invested in a replacement project: Salo is the cash proceeds from the sale of old fixed capital, T is the tax rate and Bo is the book value of old fixed capital Formula for the after tax annual cash flows to be derived from an investment project: where S is sales, C is cash operating expenses and D is the depreciation charge Study Session 8, Reading 25
  3. 3. Expansion and Replacement Projects (cont.) Formula for the terminal year after tax non-operating cash flows: SalT is the terminal cash flows and BT is the book value of the fixed capita Replacement project cash flows include investment outlays, after tax operating cash flows over the life of the project and terminal cash flows. Study Session 8, Reading 25
  4. 4. Effects of Depreciation Method on Cash Flows The NPV of the capital project can be improved by the use of an accelerated depreciation method An accelerated depreciation method reduces the tax cash out flow in the early years and increases them in the later years Study Session 8, Reading 25
  5. 5. Effects of Inflation on Capital Budgeting Nominal cash flows include the effect of inflation Real cash flows are adjusted to eliminate the effect of inflation Nominal cash flows should be discounted at the nominal rate Real cash flows should be discounted at the real rate Formula for converting real discount rate to a nominal discount rate: Study Session 8, Reading 25
  6. 6. Capital Allocation in Mutually Exclusive Projects Replacement chain approach - used to evaluate capital allocation with mutually exclusive projects with different lives equivalent annual annuity - the NPV of both projects is converted into an equivalent annual annuity and the project with the greater annual positive payments is chosen. Capital rationing - the process of allocating capital to the best project when there is limited capital available. Study Session 8, Reading 25
  7. 7. Stand-Alone Risk of Capital Projects Standalone risk is usually assessed by calculating the dispersion of NPV or IRR. Sensitivity analysis - takes into account the change in NPV for a change in a unit of input. Scenario analysis - calculates NPV under different scenarios. Probability distribution - used for important variables in an NPV calculation. Study Session 8, Reading 25
  8. 8. Determining the Discount Rate The CAPM can be used to calculate the discount rate for capital projects. where: Rf - risk free rate β - risk of the project Rm - represents the return of the market (Rm-Rf)- represents the market premium Study Session 8, Reading 25
  9. 9. Determining the Discount Rate The CAPM can be used to calculate the discount rate for capital projects. where: Rf - risk free rate β - risk of the project Rm - represents the return of the market (Rm-Rf)- represents the market premium Study Session 8, Reading 25
  10. 10. Real Options in Evaluating a Capital Project Option - the right but not the obligation to make a decision in the future Real options - are options on real assets instead of financial assets Real options are a choice to make a decision about a capital project in the future which may impact the value of the project. Real options increase the value of a capital project Study Session 8, Reading 25
  11. 11. Real Options in Evaluating a Capital Project (cont.) Different Types of Real Options:  Timing options  Abandonment option  Growth option  Price setting option  Production flexibility option Study Session 8, Reading 25
  12. 12. Common Budgeting Pitfalls Managers may make errors when valuing capital projects. Some managers may choose the projects which give good short term benefits but do not generate value in the long run Some managers have the tendency to overspend or underspend the budget allocated. Sunk costs are often difficult to ignore Study Session 8, Reading 25
  13. 13. Accounting Income in Capital Budgeting Accounting income - the income reported on the income statement from the capital project. Accounting depreciation is based on the original cost of the investment. The after tax cost of debt is subtracted (ie considered) when calculating net income. Study Session 8, Reading 25
  14. 14. Economic Income in Capital Budgeting Economic income - the profit realized from an investment Interest is ignored in the economic income as it is included in the discount rate. Economic depreciation is based on the change in the market value of the investment. Study Session 8, Reading 25
  15. 15. Economic Profit Economic profit - reflects the income earned by all the capital holders, discounted to its present value at WACC. Formula: Where: NOPAT - net operating profit after tax or after tax EBIT $WACC - the dollar cost of capital which is equal to capital multiplied by the WACC Study Session 8, Reading 25
  16. 16. Residual Income The residual income method focuses on the return on equity Formula: Where: RIt - the residual income during time t NIt - the net income during time t rtBt-1 -the equity charge for period t Study Session 8, Reading 25
  17. 17. Claims Valuation Models In the claims model, the present value of each cash flow is added to get the value of the firm It values liabilities and equity which are the claims against the assets. The value of the assets should be equal to the value of the claims Study Session 8, Reading 25
  18. 18. Proposition I & II Without Taxes from Modigliani-Miller Modigliani and Miller assumed that the investors have homogenous expectations about returns and risks of stocks and bonds. Proposition I governs the basic capital structure decision VL=VU Study Session 8, Reading 25
  19. 19. Proposition I & II Without Taxes from Modigliani-Miller (cont.) Proposition 2 suggests that the cost of equity is the linear function of the firm’s debt to equity ratio. Study Session 8, Reading 25
  20. 20. Proposition I & II With Taxes from Modigliani-Miller Proposition I - the value of the firm is maximized when the capital structure contains 100% debt Study Session 8, Reading 25
  21. 21. Proposition I & II With Taxes from Modigliani-Miller (cont.) Proposition 2 argues that the 100% debt minimizes the WACC Study Session 8, Reading 25
  22. 22. Target Capital Structure vs Actual Capital Structure Target capital structure - the funding mix that a firm wants to achieve. Optimal capital structure - the point where the value of the company is maximized. Study Session 8, Reading 26
  23. 23. Debt Ratings in Capital Structure Policy Companies need to consider the impact of their capital structure decisions on credit ratings. Rising leverage may tempt the ratings agencies to lower the ratings. Rising leverage increases the risk is for both equity and debt providers. Study Session 8, Reading 26
  24. 24. Factors when assessing Firm’s Capital Structure Ability of the company to handle the financial obligations Business risk Agency costs Volatility of company’s cash flows and its need for financial flexibility Regulatory environment Study Session 8, Reading 26
  25. 25. International Differences in Financial Leverage Factors: Institutional legal and taxation differences Micro economic factors Macroeconomic factors Financial market factors Banking system factors General business environment of the country Differences exist between developed and developing countries Study Session 8, Reading 26
  26. 26. Theories of Dividend Policy 1. The first group believes that only the investment in fixed capital and working capital affects shareholder wealth. 2. Second group argues that the dividends are more important to the investors than the uncertain capital gains. Study Session 8, Reading 26
  27. 27. Dividend Signaling A company that announces an increase in dividend payouts may be indicating strong future prospects. Dividends can be used to signal to investors how the company is really doing. A company’s decision to initiate a dividend sends stronger signals than the words of the management. Study Session 8, Reading 27
  28. 28. Factors Affecting Dividend Policy Companies with many investment opportunities tend to pay lower dividends volatility of future earnings target payout ratios on future earnings Financial flexibility Tax consideration Shareholder’s preference Contractual and legal obligations Study Session 8, Reading 27
  29. 29. Dividend Tax Regimes Double Taxation system - earnings taxed at two levels (at the company level and at the investor level). Tax Imputation system - earnings are ultimately taxed at the shareholder’s specific rate. Split Rate system - earnings are taxed at two different rates. Study Session 8, Reading 27
  30. 30. Dividend Payout Policies Stable policy - dividends increase at a constant rate every year Target payout - the company sets aside a proportion of earnings which the company wants to disburse as dividends. Residual dividend policy - the cash flow remaining after capital budgeting is paid out as dividends. Study Session 8, Reading 27
  31. 31. Global Trends in Corporate Dividend Policies Companies adapt their dividend policies according to changes in investor preferences which differ globally. The portion of dividend paying companies have been on the decline in developed economies Fama and French stated the decline in dividend payout over time was due to the weaker related companies in the same industry. Study Session 8, Reading 27
  32. 32. Dividend Coverage Ratio Dividend coverage ratios - a way of assessing dividend safety Free cash flows - the earnings available for shareholders after working capital and fixed capital expenditures. Formula to Calculate Free Cash Flow coverage ratios : Study Session 8, Reading 27
  33. 33. Characteristics of Companies that Cannot Sustain Cash Dividends If the market is pessimistic about the dividends of the company Companies with extremely high dividend yields Past record of the company’s dividends Investors predicting a dividend cut Study Session 8, Reading 27
  34. 34. Major Business Forms and Associated Conflicts of Interest Sole Proprietorship A business run and owned by single person Have difficulty in raising capital Issues in the transferability of ownership Have unlimited liability No agency risk is present Creditors and suppliers are in a better position to ask for the quality information Study Session 8, Reading 28
  35. 35. Major Business Forms and Associated Conflicts of Interest (cont.) Partnership Similar to a Sole Proprietor, except that it has more than one owner The financial capital of the partners is pooled together. Partners share the business risk. Partnership contracts are devised Study Session 8, Reading 28
  36. 36. Major Business Forms and Associated Conflicts of Interest (cont.) Corporations A legal entity that has similar rights to a person Managers act as the agents of the firm Corporations can raise large capital Shareholders are the owners of the corporation and receive profits Owners do not need to be experts in the business Ownership is easily transferable Corporations have limited liability Study Session 8, Reading 28
  37. 37. Manager- Shareholder Conflicts agency relationship - relationship between managers and shareholders Management have control of undistributed income Managers may spend company money on lavish perquisites Managers may make risky investment decisions for their own benefits Study Session 8, Reading 28
  38. 38. Director-Shareholder Conflicts board of directors - act as an intermediary between the shareholders and managers Directors start to protect the interests of the managers The board is not independent The directors have personal relations with the managers or consulting agreements Generous payments to the directors Study Session 8, Reading 28
  39. 39. Board of Directors: Qualifications Expertise in the relevant field, operations and the technologies used by the company. Should have the knowledge of accounting and legal practices. Ethical soundness Experience in risk management and strategic planning. Board experience with other companies Commitment and dedication to serving the cause of the shareholders. There should be an absence of conflicts of interest. Study Session 8, Reading 28
  40. 40. Board of Directors: Competencies and Responsibilities Should establish corporate values and governance Should ensure that legal and regulatory requirements are met Should establish the long term strategic objectives for the company Should establish strong accountability measures and clear line of responsibilities. Determine the compensation package and hire the chief executive officer. Adequate training should be given to members. Board elections should be held annually. Directors should serve only on two or three boards Study Session 8, Reading 28
  41. 41. Effective Corporate Governance The CEO and chairman should be separate positions. Independent and outside counsel should be used by the board. Board members should be knowledgeable and experienced. Board should be annually evaluated and assessed. Board members should meet without the presence of the management. Study Session 8, Reading 28
  42. 42. Statement of Corporate Governance Policies Contain a clear code of ethics Define the measures for self assessment Contain measures for the monitoring and review responsibilities of the directors Contain a statement underlining the responsibilities of the management Contain reports of directors Study Session 8, Reading 28
  43. 43. Valuation Implications of Corporate Governance Accounting risk Asset risk Liability risk Risk taking Short term objectives Study Session 8, Reading 28
  44. 44. Classification Based on Integration and Mergers Acquisition - the purchase of some part of one company by another Merger - the adoption of one company by another where the target ceases to exist Statutory merger - when one company’s assets and liabilities are transferred to another company and the company ceases to exist Subsidiary merger - the company becomes the subsidiary of the buying company. Consolidation - both companies finish the legal structure and become a new company Target company or “target” - The company which is being acquired Acquirer - the acquiring company that acquires the target Takeovers - mergers Study Session 8, Reading 29
  45. 45. Classification Based on Integration and Mergers (cont.) Hostile takeover - when a company is being acquired against the wishes of the management and board of directors Friendly transaction - a potential business combination backed by management and the board Horizontal merger - when the merging companies operate in the same type of business Vertical merger - when the acquirer acquires a company in the same production chain Backward integration - a company acquires suppliers Forward integration - company acquires distributors Conglomerate merger - when a company in an unrelated business is acquired Study Session 8, Reading 29
  46. 46. Common Motivations Behind M&A Activity Economies of scale Increasing market share Cost saving through vertical integration Synergies Growth To acquire unique opportunities and resources Diversification For personal benefits Tax benefits Taking the business global Study Session 8, Reading 29
  47. 47. Bootstrapping and Post Merger EPS bootstrapping effect - Companies typically generate higher EPS following a merger Total earnings of the combined firms are unchanged. However, the number of total shares outstanding is decreased. There may be no economic gains of the process Study Session 8, Reading 29
  48. 48. Pioneer Stage and Merger Motivations pioneer stage – companies have low profit margins and large capital requirements. Newer companies may want to merge with the bigger and more experienced players in the industry to benefit from their expertise. Horizontal and conglomerate mergers occur at this stage Study Session 8, Reading 29
  49. 49. Rapid Growth and Merger Motivations rapid growth stage - firms have few participants in the market and high profit margins. Larger capital To meet sales demand and increase the production capacity Conglomerate and horizontal mergers are the choices Study Session 8, Reading 29
  50. 50. Mature Growth and Merger Motivations mature growth stage- firms still have growth present in the industry, but competition stops entering the market. Operational efficiency, savings and economies of scale Horizontal and vertical mergers are preferred Study Session 8, Reading 29
  51. 51. Stabilization and Merger Motivations stabilisation phase - firms suffer from increased competition and capacity constraints To improve management Economies of scale and reduce the costs Horizontal mergers are done at this stage Study Session 8, Reading 29
  52. 52. Decline and Merger Motivations decline phase – business is characterized by declining profit margins and over capacity. To acquire new growth opportunities, survival and operational efficiencies Horizontal vertical and conglomerate mergers occur Study Session 8, Reading 29
  53. 53. Merger Transactions: Acquisition Stock purchase - the most convenient form of acquisition the acquirer gives the shareholders of the target company some cash and securities. it must be approved by more than 50% of the shareholders asset purchase - the target company’s assets are purchased and payment is made to the target company Shareholder’s approval is needed if a substantial amount of assets are being sold Liabilities of the target company are assumed by the acquirer in stock purchase, but liabilities are avoided under the assets purchased. Study Session 8, Reading 29
  54. 54. Merger Transactions: Method of Payment cash offering method of payment - cash can come from the existing assets of the company or a debt issue. securities offering - the shareholders of the target company may receive the shares of the acquiring company Each shareholder gets the shares of the acquirer based on the number of shares of the target company held multiplied by the exchange ratio. Study Session 8, Reading 29
  55. 55. Merger Transactions: Target Management friendly merger - acquirer and target work together and sign the agreement before presenting it to the shareholders of the target company. If the bear hug fails, approval from the shareholders of the company can be received in two ways: 1. Tender offer is given to the shareholders of the target company, every shareholder decides to sell or not sell the shares. 2. In a proxy battle the acquirer tries to control the target by getting an acquirer approved board. Study Session 8, Reading 29
  56. 56. Pre-Offer Defense Mechanisms shark repellents - defence mechanisms poison pills - allow the company the option to offer shares of the target company at a discounted price flip-in pill - an option to buy the target company’s shares at discount flip-over pill - if the shareholders of the target company have the option to buy the shares of the acquiring company at a discount • Reincorporation can be undertaken to avoid hostile takeovers. • Staggered board elections can also be undertaken. • Supermajority of voting provisions • Golden parachutes Study Session 8, Reading 29
  57. 57. Post-Offer Defense Mechanisms the “just say no” defence file a law suit Greenmail option buy shares in the open leveraged recapitalization crown jewel defence Pac Man defence white knight defence white squire defence Study Session 8, Reading 29
  58. 58. The HHI and Likelihood of Antitrust Challenge Antitrust laws have been devised to stop takeovers which are not healthy for competition. The HHI is used to judge whether the antitrust challenge is qualified or not Study Session 8, Reading 29
  59. 59. Valuing a Target Company discounted cash flows approach - the company’s expected future cash flows are discounted to their present value. comparable company approach - the value of a comparable company plus a premium is used. A set of comparable companies is assessed transaction multiple approach - a set of relevant and recent sample transaction are evaluated. Study Session 8, Reading 29
  60. 60. Calculating Free Cash Flow Free cash flow - cash flows which are available for shareholders after capital expenditures.  Net income + Net interest after tax = Unlevered Net income + Change in deferred taxes = Net operating profit less adjusted taxes (NOPLAT) + Net noncash charges - Change in net working capital - Capital expenditures (Capex) = Free Cash Flow (FCF) Study Session 8, Reading 29
  61. 61. Evaluating Merger Bids pre-merger value of the target company - the absolute minimum bid that target shareholders should accept. The acquirer’s shareholders would not want to pay more than pre-merger value plus any value of the expected synergies. Study Session 8, Reading 29
  62. 62. Estimated Post-Merger Value Post merger value - a function of the pre merger value of both companies. Synergies - created as a result of merger and any cash paid to the target’s shareholders. Formula to Calculate Post Merger Value: VA*=VA+VT+S-C Where: VA* - the post merger value of the companies VA - the pre-merger value of the acquirer C - the cash paid to the target shareholders. Study Session 8, Reading 29
  63. 63. Gains of Target Definition: TP= PT-VT Where: PT - the price paid to the target VT - the pre-merger value of the target cash offer - the target’s shareholders will benefit by the amount paid above the market value. But the gain is capped at that amount. stock offer- the gain can be determined by the value of the post merger firm, because the shareholders do not receive cash they still have the ownership. Gains to the Target is defined as: PT=(N× PA×T) Study Session 8, Reading 29
  64. 64. Gains of Acquirer Shareholders To Calculate Synergies: S-TP=S-(PT-VT) Where: S -represents the synergies created Acquirer pays the premium in order to realise the synergies. The gains to the acquirer are derived from the synergies. The gains to the acquirer can include a combination of cost reductions and revenue enhancements. Study Session 8, Reading 29
  65. 65. Effects of Price and Payment Method in a Merger Transaction The acquirer wants to get the best deal by paying the lowest possible amount. The target wants to get the best deal by getting the highest amount. The acquirer receives the potential rewards of the merger. The gain to the target is the premium paid by the acquirer. The premium does not change for the target. Study Session 8, Reading 29
  66. 66. Empirical evidence in distribution of benefits Shareholders of the target gain in the short run. Target shareholders receive a 30% premium, on average. Acquirer’s stock price falls as a result. Acquirer and target see a higher stock return in cash offers than the stock offers. Hubris can also result in higher bids in excess of the real value. Study Session 8, Reading 29
  67. 67. Reasons for Divestiture divestiture - when a company decides to sell, spin-off or liquidate a division when a company decides to sell, spin-off or liquidate a division company decides that the division is a poor fit reverse synergies financial and cash flow needs Study Session 8, Reading 29
  68. 68. Equity Carve-Outs Create a new independent by giving a proportionate equity interest in a subsidiary A new legal entity is created Shares are sold to the outsiders Study Session 8, Reading 29
  69. 69. Spin-Offs Creates a new company by giving shares to the shareholders of the parent company. Proportional number of shares are offered. A spin-off gives the shareholders shares in the both companies. Split-Offs Parent company shares are exchanged by the existing shareholders to get a share in the new company. Study Session 8, Reading 29
  70. 70. Liquidation A firm is broken and sold piece by piece. Usually happens as a result of bankruptcy. A subsidiary of a division can also be liquidated. Study Session 8, Reading 29

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