L2 flash cards corporate finance - SS 8

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

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

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.

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


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:


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.


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.


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


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


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


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


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.


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.


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


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


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


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


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.


Proposition I & II With Taxes
from Modigliani-Miller
Proposition I - the value of the firm is maximized when the
capital structure contains 100% debt


Proposition I & II With Taxes
from Modigliani-Miller (cont.)
Proposition 2 argues that the 100% debt minimizes the WACC


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.


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.


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


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

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.


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.


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


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.


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.


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.


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 :


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


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


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


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


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


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


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.

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

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.


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


Valuation Implications of Corporate
Governance
Accounting risk
Asset risk
Liability risk
Risk taking
Short term objectives


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

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

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

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


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


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


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


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


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


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.

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.


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.

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

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

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


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.


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)

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.


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.

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)


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.


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.


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.


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


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


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.


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.


L2 flash cards corporate finance - SS 8

Recommended

Recommended

More Related Content

What's hot

What's hot (17)

Viewers also liked

Viewers also liked (8)

Similar to L2 flash cards corporate finance - SS 8

Similar to L2 flash cards corporate finance - SS 8 (20)

More from analystbuddy

More from analystbuddy (20)

Recently uploaded

Recently uploaded (20)

L2 flash cards corporate finance - SS 8