Wykład 1
What is Corporate Finance?
Corporate Finance addresses the following three questions:
What long-term investments should the firm choose?
How should the firm raise funds for the selected investments?
How should short-term assets be managed and financed?
The Financial Manager’s primary goal is to increase the value of the firm by:
Selecting value creating projects
Making smart financing decisions
Hypothetical Organization Chart
The finance activity whitin the firm
The treasure is responsible for handling cach flows, managing capital-expenditures decisions, and making financial plans.
The controller handles the accounting function, which includes taxes cost and financial accounting, and information system.
The Firm and the Financial Markets
The Corporate Firm
The corporate form of business is the standard method for solving the problems encountered in raising large amounts of cash.
However, businesses can take other forms.
Forms of Business Organization
The Sole Proprietorship
The Partnership
General Partnership
Limited Partnership
The Corporation
A Comparison
Goals of the Corporate Firm-set of contracts view point
The firm can be viewed as a set of contracts
The corporate firm will attempt to maximiye the shareholders wealth by taking actions that increase the current value per share of existing stock of the firm
The Goal of Financial Management
What is the correct goal?
Maximize profit?
Minimize costs?
Maximize market share?
Maximize shareholder wealth?
The goal of
The most important job of a financial manager is to create value from the firm’s capital budgeting, financing, and net working-capital activities
How to financial managers create value?
The firm should try to buy assets that generate more cash than they cost
The firm should sell bonds and stocks and other financial instruments that rise more cash than they cost
The firm must create more cash flow tham it uses
The Agency Problem
Agency relationship
Principal hires an agent to represent his/her interest
Stockholders (principals) hire managers (agents) to run the company
Agency problem
Conflict of interest between principal and agent
Managerial Goals
Managerial goals may be different from shareholder goals
Expensive perquisites
Survival
Independence
Increased growth and size are not necessarily equivalent to increased shareholder wealth
SURVIVAL- organizational survival means that management will always try to command sufficient reasources to avoid the firm going out of
INDEPENDENCE AND SELF-SUFFICIENCY – this is the freedom to make decisions without encountering external parties or depending on outside financial markets (Packing Order Theory)
Managing Managers
Managerial compensation
Incentives can be used to align management and stockholder interests
The incentives need to be structured carefully to make sure that they achieve their intended goal
Corporate control
The threat of a takeover may result in better management
Other stakeholders
Financial Markets
Primary Market
-Issuance of a security for the first time
Secondary Markets
-Buying and selling of previously issued securities
-Securities may be traded in either a dealer or auction market
-NYSE
-NASDAQ
Wykład 2
Financial Statements and Cash Flow
Key Concepts and Skills
Understand the information provided by financial statements
Differentiate between book and market values
Know the difference between average and marginal tax rates
Know the difference between accounting income and cash flow
Calculate a firm’s cash flow
Chapter Outline
2.1 The Balance Sheet
2.2 The Income Statement
2.3 Taxes
2.4 Net Working Capital
2.5 Financial Cash Flow
2.6 The Accounting Statement of Cash Flows
Sources of Information
Annual reports
Wall Street Journal
Internet
NYSE (www.nyse.com)
NASDAQ (www.nasdaq.com)
Textbook (www.mhhe.com)
SEC
EDGAR
10K & 10Q reports
2.1.The Balance Sheet
An accountant’s snapshot of the firm’s accounting value at a specific point in time
The Balance Sheet Identity is:
Assets ≡ Liabilities + Stockholder’s Equity
The assets are listed in order by the length of time it would normally take a firm
with ongoing operations to convert them into cash.
Clearly, cash is much more liquid than property, plant, and equipment.
Current assets: cash and equivalents, accounts receivable investments
Balance Sheet Analysis
When analyzing a balance sheet, the Finance Manager should be aware of three concerns:
Liquidity
Debt versus equity
Value versus cost
Liquidity
Refers to the ease and quickness with which assets can be converted to cash—without a significant loss in value
Current assets are the most liquid.
Some fixed assets are intangible.
The more liquid a firm’s assets, the less likely the firm is to experience problems meeting short-term obligations.
Liquid assets frequently have lower rates of return than fixed assets.
Debt versus Equity
Creditors generally receive the first claim on the firm’s cash flow.
Shareholder’s equity is the residual difference between assets and liabilities.
Value versus Cost
Under Generally Accepted Accounting Principles (GAAP), audited financial statements of firms in the U.S. carry assets at cost.
Market value is the price at which the assets, liabilities, and equity could actually be bought or sold, which is a completely different concept from historical cost.
2.2. The Income Statement
Measures financial performance over a specific period of time
The accounting definition of income is:
Revenue – Expenses ≡ Income
The operations section of the income statement reports
the firm’s revenues and expenses from principal operations.
The non-operating section of the income statement includes
all financing costs, such as interest expense.
Usually a separate section reports the amount of taxes levied
on income.
Net income is the “bottom line.”
Income Statement Analysis
There are three things to keep in mind when analyzing an income statement:
Generally Accepted Accounting Principles (GAAP)
Non-Cash Items
Time and Costs
GAAP
The matching principal of GAAP dictates that revenues be matched with expenses.
Thus, income is reported when it is earned, even though no cash flow may have occurred.
Non-Cash Items
Depreciation is the most apparent. No firm ever writes a check for “depreciation.”
Another non-cash item is deferred taxes, which does not represent a cash flow.
Thus, net income is not cash.
Time and Costs
In the short-run, certain equipment, resources, and commitments of the firm are fixed, but the firm can vary such inputs as labor and raw materials.
In the long-run, all inputs of production (and hence costs) are variable.
Financial accountants do not distinguish between variable costs and fixed costs. Instead, accounting costs usually fit into a classification that distinguishes product costs from period costs.
2.3.Taxes
The one thing we can rely on with taxes is that they are always changing
Marginal vs. average tax rates
Marginal – the percentage paid on the next dollar earned
Average – the tax bill / taxable income
Other taxes
Marginal versus Average Rates
Suppose your firm earns $4 million in taxable income.
What is the firm’s tax liability?
What is the average tax rate?
What is the marginal tax rate?
If you are considering a project that will increase the firm’s taxable income by $1 million, what tax rate should you use in your analysis?
2.4.Net Working Capital
Net Working Capital ≡ Current Assets – Current Liabilities
NWC usually grows with the firm
Here we see NWC grow to $275 million
in 2006 from $252 million in 2005.
$ 23 million.
This increase of $23 million is an investment of the firm.
2.5.Financial Cash Flow
In finance, the most important item that can be extracted from financial statements is the actual cash flow of the firm.
Since there is no magic in finance, it must be the case that the cash flow received from the firm’s assets must equal the cash flows to the firm’s creditors and stockholders.
CF(A)≡ CF(B) + CF(S)
The cash flow received from the firm’s assets must
equalizer the cash flows to the firm’s creditors and stockholders:
(Total 42, 42)
2.6.The Statement of Cash Flows
There is an official accounting statement called the statement of cash flows.
This helps explain the change in accounting cash, which for U.S. Composite is $33 million in 2007.
The three components of the statement of cash flows are:
Cash flow from operating activities
Cash flow from investing activities
Cash flow from financing activities
ad.1. To calculate cash flow from operations, start with net income,
add back non-cash items like depreciation and adjust
for changes in current assets and liabilities (other than cash).
ad.2.Cash flow from investing activities involves changes in capital assets:
acquisition of fixed assets and sales of fixed assets
(i.e., net capital expenditures).
Ad.3. Cash flows to and from creditors and owners include changes
in equity and debt.
The statement of cash flows is the addition of cash flows
from operations, investing, and financing.
What is the difference between book value and market value? Which should we use for decision making purposes?
What is the difference between accounting income and cash flow? Which do we need to use when making decisions?
What is the difference between average and marginal tax rates? Which should we use when making financial decisions?
How do we determine a firm’s cash flows? What are the equations, and where do we find the information?
Wykład 3
The Analysis of Financial Statements
THE USE OF FINANCIAL RATIOS
Financial Ratio - a relative measure that evaluation efficiency or condition of a particular aspect of a firm's operations and status
RATIO ANALYSIS
Ratio Analysis involves methods of calculating and interpreting financial ratios in order to access a firm’s performance and status
Ratio analysis is a diagnostic tool that helps to identify problem areas and opportunities within a company.
Interested parties
Three sets of parties are interested in ratio analysis:
Shareholders
Creditors
Management
Types of Ratio Comparisons
Ratios are not very helpful by themselves: they need to be compared to something
Combined Analysis – uses both types of analysis to assess a firm’s trends versus as competitors or the industry
There two types of ratio comparisons:
cross - sectional analysis (Comparisons are made to industry standards) - analiza struktury
time-series analysis (Comparisons to the firm itself over time are also made) – analiza dynamiki
Benchmarking Financial Ratios
Financial ratios are not very useful on a stand-alone Basic; they must be benchmarked against something. Analysts compare ratios against the following:
The Industry norm –most common type of comparison. Analysis will develop an industry average, which they will compare to the company they are evaluating.
It is better to use a cross- sectional analysis, ie. Individually select the companies that best fit the company being analyzed.
Aggregate economy - It is sometimes important to analyze a company's ratio over a full economic cycle. This will help the analyst understand and estimate a company's performance in changing economic conditions, such as a recession.
The company's past performance – This is a very common analysis. It is similar to a time-series analysis, which looks mostly for trends in ratios.
Words of Caution Regarding Ratio Analysis
A single ratio rarely tells enough to make a sound judgment.
Financial statements used in ratio analysis must be from similar points in time.
Audited financial statements are more reliable than unaudited statements.
The financial data used to compute ratios must be developed in the same manner.
Inflation can distort comparisons.
Grups of Financial Ratios
Liquidity
Activity
Debt
Profitability
Ratio analysis
Ratios allow comparison through time or between companies.
As we look at each ratio, ask yourself:
How is the ratio computed?
What is the ratio trying to measure and why?
What is the unit of measurement?
What does the value indicate?
How can we improve the company’s ratio?
Analyzing Liquidity:
Liquidity refers to the solvency of the firm
,,Liquid firm” is one that can easily meet its short-term obligations as they come due
A second meaning includes the concept of converting an asset into cash with little or no loss in value (cost, time).
Three Important Liquidity Measures
Net Working Capital (NWC)
NWC = Current Assets - Current Liabilities
Current Ratio (CR)
Current Assets
CR =
Current Liabilities
Quick (Acid-Test) Ratio (QR)
Current Assets - Inventory
QR =
Current Liabilities
Current Ratio (CA / CL)
is used to test a company's liquidity by dividing the proportion of current assets available to cover current liabilities.
to ascertain whether a company's short-term assets (cash, cash equivalents, marketable securities, receivables and inventory) are readily available to pay off its short-term liabilities (current portion of term debt, payables, accrued, expenses and taxes).
In theory, the higher CR, the better
Commentary:
The current ratio is used extensively in financial reporting.
However, it can be misleading in both a positive and negative sense - i.e., a high current ratio is not necessarily good, and a low current ratio is not necessarily bad.
Banchmarking: 2:1, 1,6-1,8, 1,5 – 2 (overliquidity)
Quick ratio (CA- I)/CL (acid test ratio)
Is a liquidity indicator that further refines, the current ratio by measuring the amount of the most liquid current assets there are to cover current liabilities.
It is more conservative than the current ratio because it excludes inventory and other current assets, which are more difficulted to turn into cash.
A higher ratio means a more liquid current position
Banchmarking: 1:1, 0,7 – 0,9.
Commentary:
beneficial is to compare the quick ratio with the current ratio. If the current ratio is significantly higher, it is a clear indication that the company's current assets are dependent on inventory.
Both the QR and the CR assume liquidation of accounts receivable and inventory as thae basis for measuring liquidity
as a going concern a company must focus on the time it takes to convert its working capital assets to cash - that is the true measure of liquidity.
Cash ratio - C / CL
is an indicator of a company's liquidity that further refines both the current ratio and the quick ratio by measuring the amount of cash, cash equivalents to cover current liabilities.
Commentary:
The cash ratio - is the most stringent and conservative of the three short-term liquidity ratios
It looks at the most liquid short-term assets of the company, which can be most easily used to pay off current obligations
It ignores inventory and receivables, as there are no assurances that these two accounts can be converted to cash in a timely matter to meet current liabilities
The cash ratio is seldom used in financial reporting or by analysts of a company
It is no realistic for a company to purposefully maintain high levels of cash assets to cover current liabilities, as it's seen as poor asset utilization to hold large amounts of cash on its balance sheet. This money could be returned to shareholders or used elsewhere to generate higher returns.
The usefulness of this ratio is limited.
Cash Conversion Cycle
Express the length of time (in days) that a company uses to sell inventory receivables and pay its accounts payable
The cash conversion cycle (CCC) measure the number of days a company’s cash is tied up in the production and sales process of its operations and the benefit it gets from payment terms from its creditors
The shorter this cycle, the more liquid the compay’s working capital position is.
The CCC is also known as the “cash” or “operating cycle”
CCC = DIO + DSO + DPO
DIO – days inventory outstanding
DSO – days sales outstanding
DPO – days payable outstanding
DIO is computed by:
Dividing the cost of sales (income statement) by 365 days to get the cost of sales per day figure
Calculating the average inventory figure by adding the year’s beginning and ending inventory figure and dividing by 2 to obtain an average amount of inventory for any given year
Dividing the average inventory figure by the cost of sales per day figure
DIO gives a measure of the number of days it takes for the company’s inventory to turnover, i.e. to be converted to sales, either as cash or accounts receivable
DSO:
Dividing net sales by 365 to get a net sales per day figure
Calculating the average accounts receivable
DSO gives a measure of the number of days it takes to a company to collect on sales that go into accounts receivables (credit purchases)
DPO gives a measure of how long it takes the company to pay its obligation to suppliers
WYKŁAD 4
Analyzing Activity
Activity is a more sophisticated analysis of a firm’s liquidity, evaluating the speed with which certain accounts are converted into sales or cash; also measures a firm’s efficiency
Activity ratios measure different segments of a company's overall operational performance and management during the period being measured.
Each of these ratios look at how well a company turns its assets into revenue as well as how efficiently a company converts its sales into cash.
Basically, these ratios look at how efficiently and effectively a company is using its resources to generate sales and increase shareholder value (manangement).
In general, the better these ratios are, the better it is for shareholders.
Five Important Activity Measures
Inventory Turnover (IT)
Average Collection Period (ACP)
Average Payment Period (APP)
Fixed Asset Turnover (FAT)
Total Asset Turnover (TAT)
Assets Turnover – variations
Instead of using fixed assets same asset – turnover ratios would use total assets
The former is preferred because, it represents a multiplicity of management decisions on capital expenditures
This capital investment is a better performance indicator than that evidenced in total asset turnover
Fixed-Asset Turnover
This ratio is a rough measure of the productivity of a company's fixed assets (property, plant and equipment) with respect to generating sales.
For most companies, their investment in fixed assets represents the single largest component of their total assets.
The annual turnover ratio is designed to reflect a company efficiency in managing these significant assets
The higher the yearly turnover rate, the better.
Commentary:
There is no exact number that determines whether a company is doing a good job of generating revenue from its investment in fixed assets. This makes it important to compare the most recent ratio to both the historical levels of the company along with peer company and/or industry averages.
A company's investment in fixed assets is very much linked to the requirements of the industry in which it conducts its business. Fixed assets vary greatly among companies.
Sales/Revenue for Employee
This indicator measure the amount of dollar sales or revenue, generated per employee. The higher the dollar figure the better
Labor – intensive business ( ex-mass market retailers will be less productive in this metric than a high – tech, high product – value manufacturer)
S/R = $\frac{\text{Revenue}}{Number\ of\ Employees/Average}$
The Operating Cycle
Expressed as an indicator (days) of management performance efficiency, the operating cycle is a "twin" of the cash conversion cycle. While the parts are the same - receivables, inventory and payables - in the operating cycle, they are analyzed from the perspective of how well the company is managing these critical operational capital assets, as opposed to their impact on cash.
Commentary:
The operating cycle has the same make up as the cash conversation cycle. Management efficiency is the focus of the operating cycle while cash flow is the focus of the cash conversation cycle
Analyzing Debt
Debt is a true "double-edged" sword as it allows for the generation of profits with the use of other people's (creditors) money, but creates claims on earnings with a higher priority than those of the firm's owners.
Financial Leverage is a term used to describe the magnification of risk and return resulting from the use of fixed-cost financing such as debt and preferred stock.
The use of leverage can be a double – edged sword for companies
If the company manages to generate returns above their cost of capital, investors will benefit
However with the added risk of the debt on its books, a company can be easily hurt by this leverage of it is unable to generate returns above the cost of capital
Basically , any gains or losses are magnified the use of leverage in the company’s capital structure
Measures of Debt
There are Two General Types of Debt Measures:
Degree of Indebtedness
Ability to Service Debts
Four Important Debt Measures
Debt Ratio (DR)
Debt-Equity Ratio (DER)
Times Interest Earned Ratio (TIE)
Fixed Payment Coverage Ratio (FPC)
The Debt Ratio - commentary:
The debt ratio gives users a quick measure of the amount of debt that the company has on its balance sheet compared to its assets.
The more debt compared to assets a company has the more leveraged it is and the risker it is considered to be
One thing to note with this ratio it isn’t a pure measure of a company’s debt or indebtedness, as it also includes operational liabilities, such as accounts payable and taxes payable. Companies use these operational liabilities as going concerns to fund the day – to – day operations of the business, so they aren’t really “debts” in the leverage sense of this ratio.
Debt-Equity Ratio
Compares a company's total liabilities to its total shareholders' equity.
This is a measurement of how much suppliers, lenders, creditors and obligors have committed to the company versus what the shareholders have committed.
To a large degree, the debt – equity ratio provides another vantage point of a company’s leverage position, in this case, comparing total liabilities to shareholders equity, as opposed to total assets in the debt ratio.
Similar to the debt ratio
A lower the percentage means that a company is using less leverage and has a stronger equity position.
Times Interest Earned or Interest Coverage Ratio
The interest coverage ratio (TIE) is calculated by dividing a company's EBIT (earnings before interest and taxes) by the company's interest expenses for the same period.
It is used to determine how easily a company can pay interest expenses on outstanding debt.
The lower the ratio, the more the company is burdened by debt expense.
When a company's interest coverage ratio is only 1.5 or lower, its ability to meet interest expenses may be questionable.
Commentary:
The ability to stay current with interest payment obligations is absolutely critical for company as a going concern. While the non-payment of debt principal is a seriously negative condition, a company finding itself in financial/operational difficulties can stay alive for quite some time as long as it is able to service its interest expanses
Prudent borrowing makes sense for most companies. Interest expanses affect a company’s profitability, so the cost – benefit analysis dictates that borrowing money to fund a company’s assets has to have a positive effect. An a simple interest coverage ratio would be an indicator of this circumstance, as well as indicating substantial additional debt capacity
Wykład 5 - 11.04.2012
Analyzing Profitability
Profitability measures assets the firm's ability to operate efficiently and are of concern to owners, creditor, and management
A Common-Size Income Statement, which expresses each income statement item as a percentage of sales, allows for easy evaluation of the firm’s profitability relative to sales.
Profitability Ratios
In the income statement, there are four levels of profit or profit margins:
gross profit,
operating profit,
pretax profit
net profit.
“Margin” is the amount of profit (at a gross, operating, pretax or net income level) generated by the company as a percent of the sales generated
Profit margin analysis uses the percentage calculation to provide a comprehensive measure of a company's profitability on a historical basis (3-5 years) and in comparison to peer companies and industry benchmarks.
The objective of margin analysis is to detect consistency or positive/negative trends in a company’s earnings.
Positive profit margin analysis translates into positive investment quality
To a large degree it is the quality and growth of a company’s earnings that drives its stock price
Six Basic Profitability Measures
Gross Profit Margin (GPM)
Operating Profit Margin (OPM)
Net Profit Margin (NPM)
Return on Total Assets (ROA)
Return On Equity (ROE)
Earnings Per Share (EPS)
Price Earnings (P/E) Ratio
Profitability Ratios
Often the terms: “income”, “profit” and “earnings” are used interchangeable in financial reporting
To obtain the gross profit amount, simply subtract the cost of sales (cost of goods sold) from net sales/revenue
The operating profit amount is obtain by subtracting the sum of the company’s operating expenses from the gross profit amount. Generally, operating expenses would include such account captions as selling, marketing and administrative, research and development, depreciation and amortization, rental properties, etc,.
Investors need to understand that the absolute number in the income statemet don’t tell us very much, which is why we must look to margin analysis to discern a company’s true profitability. These ratios help us to keep score, as measured over time of management’s ability to manage costs and expenses and generate profit. The success or determines a company’s profitability
A large growth in sales will do little for a company’s earnings if costs and expenses grow disproportionately
Lastly, the profit margin percentage for all the levels of income represents the number of pennies, there are in each dollar of sales.
Gross Profit Margin
A company’s cost of sales, or cost of goods sold, represents the expense related to labor, raw, materials and manufacturing overhead involved in its production process.
This expense is deducted from the company’s net sales/revenue, which results in a company’s first level of profit, or gross profit.
The gross profit margin is used to analyze how efficiently a company is using its raw materials, labor and manufacturing-related fixed assets to generate profits.
A higher margin percentage is a favorable profit indicator.
Operating Profit Margin
By subtracting selling, general and administrative (SG&A) or operating, expenses from a company's gross profit number, we get operating income.
Management has much more control over operating expenses than its costs of sales outlays. This, investors need to scrutinize the operating profit margin carefully.
Positive and negative trends in this ratio are, for the most part, directly attributable to management decisions.
A company's operating income figure is often the preferred metric of investment analysts, versus its net income figure, for making inter-company comparisons and financial projections.
Pretax Profit Margin
Again many investment analysts prefer to use a pretax income number for reasons similar to those mentioned for operating income. In this case a company has access to a variety of tax-management technique, which allow it to manipulate the timing and magnitude of its taxable income.
Net Profit Margin
Often referred to simply as a company’s profit margin the so-called bottom line is the most often mentioned when discussing a company’s profitability. While undeniably an important member, investors can easily see from a complete profit margin analysis that there are several income and expense operating element in an income statements that determine a net profit margin. It behooves investors to take a comprehensive look at a company’s profit margins on a systematic basis.
Return on Assets
Businesses require different-sized asset bases
The ROA measurement should be used historically for a company being analyzed. If peer company comparisons are made, it is imperative that the companies being reviewed are similar in product line and business type. Simply being categorized in the same industry will not automatically make a company comparable.
As a rule of thumb, investment professionals like to see a company’s ROA came in at no less than 5%.
Of course there are exceptions to this rule. An important one would apply to banks, which strive to record an ROA of 1,5% or above.
Return On Equity
This ratio indicates how profitable a company is by comparing its net income to its average shareholders' equity.
ROE measures how much the shareholders earned for their investment in the company.
The higher the ratio percentage, the more efficient management is in utilizing its equity base and the better return is to investors.
$$\text{ROE} = \frac{\text{Net\ profit}}{\text{Sales}} + \frac{\text{Sales}}{\text{Assets}} + \frac{\text{Assets}}{E\text{quity}}$$
Widely used by investors, the ROE ratio is an important measure of a company’s earnings performance. The ROE tells common shareholders how efficiently their money is being employed. Peer company, industry and overall market comparisons are appropriate. However, it should be recognized that there are variations in ROEs among same types of businesses. In general, financial analysts consider return on equity ratios in the 15-20% range as representing attractive levels of investment quality.
While highly regarded as a profitability indicator, the ROE metric does have a recognized weakness.
Investors need to be aware that a disproportionate amount of debt in a company’s capital structure would translate into a smaller equity base. Thus, a small amount of net income (the numerator) could still produce a high ROE off a modest equity base (the denominator).
The lesson here for investors is that they cannot look at a company's return on equity in isolation. A high, or low, ROE needs to be interpreted in the context of a company's debt-equity relationship. The answer to this analytical dilemma can be found by using the return on capital employed (ROCE) ratio.
Return On Capital Employed
The return on capital employed (ROCE) ratio, expressed as a percentage, complements the ROE ratio by adding a company's debt liabilities or funded debt to equity to reflect a company's total "capital employed".
By comparing net income to the sum of a company's debt and equity capital, investors can get a clear picture of how the use of leverage impacts a company's profitability.
Financial analysts consider the ROCE measurement to be a more comprehensive profitability indicator because it gauges management's ability to generate earnings from a company's total pool of capital.
DuPont System of Analysis
DuPont System of Analysis is an integrative approach used to dissect a firm's financial statements and assess its financial condition
It ties together the income statement and balance sheet to determine two summary measures of profitability, namely ROA and ROE.
The Du Pont Identity
ROE = NI / TE
Multiply by 1 and then rearrange:
ROE = (NI/TE)(TA/TA)
ROE = (NI / TA) (TA / TE) = ROA * EM
Multiply by 1 again and then rearrange:
ROE = (NI / TA) (TA / TE)(Sales/Sales)
ROE = (NI / Sales) (Sales / TA) (TA / TE)
ROE= PM x TAT x EN
The firm’s return is broken into three components:
a profitability measure (net profit margin)
an efficiency measure ( total asset turnover)
a leverage measure ( financial leverage multiplier)
Using the Du Pont Identity
ROE = PM * TAT * EM
Profit margin is a measure of the firm’s operating(financial) efficiency – how well it controls costs.
Total asset turnover is a measure of the firm’s asset use efficiency – how well it manages its assets.
Equity multiplier is a measure of the firm’s financial leverage.
Summarizing All Ratio
An approach that views all aspect of the firm’s activities to isolate key areas of concern
Comparisons are made to industry standards (cross sectional analysis)
Comparisons to the firm itself over time are also made (time-series analysis)
WYKŁAD 6
Cost of Capital
Cost of Capital - The return the firm’s investors could expect to earn if they invested in securities with comparable degrees of risk
Capital Structure - The firm’s mix of long term financing and equity financing
The cost of capital represents the overall cost of financing to the firm
The cost of capital is normally the relevant discount rate to use in analyzing an investment
The overall cost of capital is a weighted average of the various sources:
WACC = Weighted Average Cost of Capital
WACC = After-tax cost x weights
Cost of Debt
The cost of debt to the firm is the effective yield to maturity (or interest rate) paid to its bondholders
Since interest is tax deductible to the firm, the actual cost of debt is less than the yield to maturity:
After-tax cost of debt = yield x (1 - tax rate)
The cost of debt should also be adjusted for flotation costs (associated with issuing new bonds)
Example: Tax effects of financing with debt
with stock with debt
EBIT 400,000 400,000
- interest expense 0 (50,000)
EBT 400,000 350,000
- taxes (34%) (136,000) (119,000)
EAT 264,000 231,000
Now, suppose the firm pays $50,000 in dividends to the
shareholders
with stock with debt
EBIT 400,000 400,000
- interest expense 0 (50,000)
EBT 400,000 350,000
- taxes (34%) (136,000) (119,000)
EAT 264,000 231,000
- dividends (50,000) 0
Retained earnings 214,000 231,000
The monetary cost of debt is the return required by investors in the market place on recuntries of a similar risk, class, adjusted for the tax shield effect.
Kd= I(1-t)/VD
I – annual interest to be paid
t – company’s effective corporation tax rate
VD – current value of the bond
EXAMPLE: Cost of Debt
The company issues 1000 bonds each of 100£ nominal value. The bond has a 10% coupon rate. At the time the bond is issued the coupon rate equals the current interest rate in the market for bonds in a similar risk class. The coupon’s effective tax rate is 30%. What is the cost of the debt?
Kd = 10 000 (1- 0,30)/ 100 000 = 7%
(100 000 x 0,1)
Cost of New Preferred Stock
Preferred stock:
has a fixed dividend (similar to debt)
has no maturity date
dividends are not tax deductible and are expected to be perpetual or infinite
$$\text{Cost\ of\ preferred\ stock\ } = \frac{\text{dividend\ }}{\ price\ - \ flotation\ cost}$$
Cost of Preferred stock: Example
Cost of Equity: Retained Earnings
Why is there a cost for retained earnings?
Earnings can be reinvested or paid out as dividends.
Investors could buy other securities, and earn a return.
Thus, there is an opportunity cost if earnings are retained.
Common stock equity is available through retained earnings (R/E) or by issuing new common stock:
Common equity = R/E + New common stock
Cost of Equity: New Common Stock
The cost of new common stock is higher than the cost of retained earnings because of flotation costs
selling and distribution costs (such as sales commissions) for the new securities
Cost of Equity
There are a number of methods used to determine the cost of equity
We will focus on two:
Dividend growth Model
CAPM
The Dividend Growth Model Approach
Estimating the cost of equity: the dividend growth model approach
According to the constant growth (Gordon) model:
$Po = \frac{\text{Dt\ }}{\ RE\ \ - \ g}$
Rearranging $RE = \frac{\text{Dt\ }}{\text{Po}} + g$
Example: Estimating the Dividend Growth Rate
Dividend Growth Model
This model has drawbacks:
Some firms concentrate on growth and do not pay dividends at all, or only irregularly
Growth rates may also be hard to estimate
Also this model doesn’t adjust for market risk
Therefore many financial managers prefer the capital asset pricing model (CAPM) - or security market line (SML) - approach for estimating the cost of equity
Capital Asset Pricing Model (CAPM)
The Security Market Line (SML)
Finding the Required Return on Common Stock using the Capital Asset Pricing Model
The Capital Asset Pricing Model (CAPM) can be used to estimate the required return on individual stocks. The formula:
Then, using the CAPM we would get a required return of
CAPM/SML approach:
Advantage: Evaluates risk, applicable to firms that don’t pay dividends
Disadvantage: Need to estimate
Beta
the risk premium (usually based on past data, not future projections)
use an appropriate risk free rate of interest
Estimation of Beta: Measuring Market Risk
Market Portfolio - Portfolio of all assets in the economy
In practice a broad stock market index, such as the WIG, is used to represent the market
Beta - sensitivity of a stock’s return to the return on the market portfolio
Theoretically, the calculation of beta is straightforward:
Problems
Betas may vary over time.
The sample size may be inadequate.
Betas are influenced by changing financial leverage and business risk.
Solutions
Look at average beta estimates of comparable firms in the industry
Problems 1 and 2 (above) can be moderated by more sophisticated statistical techniques.
Problem 3 can be lessened by adjusting for changes in business and financial risk.
Stability of Beta
Most analysts argue that betas are generally stable for firms remaining in the same industry
That’s not to say that a firm’s beta can’t change
Changes in product line
Changes in technology
Deregulation
Changes in financial leverage
What is the appropriate risk-free rate?
Use the yield on a long-term bond if you are analyzing cash flows from a long-term investment
For short-term investments, it is entirely appropriate to use the yield on short-term government securities
Use the nominal risk-free rate if you discount nominal cash flows and real risk-free rate if you discount real cash flows
Weighted Average Cost of Capital (WACC)
WACC weights the cost of equity and the cost of debt by the percentage of each used in a firm’s capital structure
WACC= (E/V) x RE + (D/ V) x RD x (1-TC)
(E/V)= Equity % of total value
(D/V)=Debt % of total value
(1-Tc)=After-tax % or reciprocal of corp tax rate Tc. The after-tax rate must be considered because interest on corporate debt is deductible
WYKŁAD 7
Capital structure
Issues:
What is capital structure?
Why is it important?
What are the sources of capital available to a company?
What is business risk and financial risk?
What are the relative costs of debt and equity?
What are the main theories of capital structure?
Is there an optimal capital structure?
Capital Structure and the Pie
The value of a firm is defined to be the sum of the value of the firm’s debt and the firm’s equity
V = B + S
If the goal of the firm’s management is to make the firm as valuable as possible,
than the firm should pick the debt – equity ratio that makes the pie as big as possible.
What is “Capital Structure”?
Definition
The capital structure of a firm is the mix of different securities issued by the firm to finance its operations.
Securities
Bonds, bank loans
Ordinary shares (common stock), Preference shares (preferred stock)
Hybrids, eg warrants, convertible bonds
Ordinary shares (common stock)
Risk finance
Dividends are only paid if profits are made and only after other claimants have been paid e.g. lenders and preference shareholders
A high rate of return is required
Provide voting rights – the power to hire and fire directors
No tax benefit, unlike borrowing
Preference shares (preferred stock)
Lower risk than ordinary shares – and a lower dividend
Fixed dividend - payment before ordinary shareholders and in a liquidation situation
No voting rights - unless dividend payments are in arrears
Cumulative - dividends accrue in the event that the issuer does not make timely dividend payments
Participating - an extra dividend is possible
Redeemable - company may buy back at a fixed future date
Loan capital
Financial instruments that pay a certain rate of interest until the maturity date of the loan and then return the principal (capital sum borrowed)
Bank loans or corporate bonds
Interest on debt is allowed against tax
Seniority of debt
Seniority indicates preference in position over other lenders.
Some debt is subordinated.
In the event of default, holders of subordinated debt must give preference to other specified creditors who are paid first.
Security
Security is a form of attachment to the borrowing firm’s assets.
It provides that the assets can be sold in event of default to satisfy the debt for which the security is given.
Indenture
A written agreement between the corporate debt issuer and the lender.
Sets forth the terms of the loan:
Maturity
Interest rate
Protective covenants
e.g. financial reports, restriction on further loan issues, restriction on disposal of assets and level of dividends
Warrants
A warrant is a certificate entitling the holder to buy a specific amount of shares at a specific price (the exercise price) for a given period.
If the price of the share rises above the warrant's exercise price, then the investor can buy the security at the warrant's exercise price and resell it for a profit.
Otherwise, the warrant will simply expire or remain unused.
Convertible bonds
A convertible bond is a bond that gives the holder the right to "convert" or exchange the par amount of the bond for ordinary shares of the issuer at some fixed ratio during a particular period.
As bonds, they provide a coupon payment and are legally debt securities, which rank prior to equity securities in a default situation.
Their value, like all bonds, depends on the level of prevailing interest rates and the credit quality of the issuer.
Their conversion feature also gives them features of equity securities.
Measuring capital structure
Debt/(Debt + Market Value of Equity)
Debt/Total Book Value of Assets
Interest coverage: EBITDA/Interest
Debt capacity
Maximum proportion of debt the firm can include in its capital structure an still maintain its lowest composite cost of capital
Target debt ratios
An influence of the level of target debt ratio is the ability to meet financing charges, also
Maintain a desired bond rating
Providing an adequate borrowing reserve
Exploiting the advantages of financial leverage
Selected leverage data for US corporations
Interpreting capital structures
Capital structures can be changed
Leverage is reduced by
Cutting dividends or issuing stock
Reducing costs, especially fixed costs
Leverage increased by
Stock repurchases, special dividends, generous wages
Using debt rather than retained earnings
Business risk and Financial risk
Firms have business risk generated by what they do
But firms adopt additional financial risk when they finance with debt
Business Risk
The basic risk inherent in the operations of a firm is called business risk
Business risk can be viewed as the variability of a firm’s Earnings Before Interest and Taxes (EBIT)
Business risk is multidimensional and international and is affected by:
The sensitivity of the firm’s product demand to general economic conditions
The degree of competition to which the firm is exposed
Product diversification
Growth prospects
Global sales volumes and production output
Financial Risk
Debt causes financial risk because it imposes a fixed cost in the form of interest payments.
The use of debt financing is referred to as financial leverage.
Financial leverage increases risk by increasing the variability of a firm’s return on equity or the variability of its earnings per share.
Risk and the Income Statement
Financial Risk vs. Business Risk
There is a trade-off between financial risk and business risk.
A firm with high financial risk is using a fixed cost source of financing. This increases the level of EBIT a firm needs just to break even.
A firm will generally try to avoid financial risk - a high level of EBIT to break even - if its EBIT is very uncertain (due to high business risk).
Why should we care about capital structure?
By altering capital structure firms have the opportunity to change their cost of capital and – therefore – the market value of the firm
What is an optimal capital structure?
An optimal capital structure is one that minimizes the firm’s cost of capital and thus maximizes firm value
Cost of Capital:
Each source of financing has a different cost
The WACC is the “Weighted Average Cost of Capital”
Capital structure affects the WACC
Capital Structure Theory
Basic question
Is it possible for firms to create value by altering their capital structure?
Major theories
Modigliani and Miller theory
Trade-off Theory
Signaling Theory
Modigliani and Miller (MM)
Basic theory: Modigliani and Miller (MM) in 1958 and 1963
Old - so why do we still study them?
Before MM, no way to analyze debt financing
First to study capital structure and WACC together
Won the Nobel prize in 1990
Most influential papers ever published in finance
Very restrictive assumptions (perfect capital market)
First “no arbitrage” proof in finance
/first specification of factors influencing capital structure
Basis for other theories
A Basic Capital Structure Theory
Debt versus Equity
A firm’s cost of debt is always less than its cost of equity
debt has seniority over equity
debt has a fixed return
the interest paid on debt is tax-deductible.
It may appear a firm should use as much debt and as little equity as possible due to the cost difference, but this ignores the potential problems associated with debt.
There is a trade-off between the benefits of using debt and the costs of using debt.
The use of debt creates a tax shield benefit from the interest on debt.
The costs of using debt, besides the obvious interest cost, are the additional financial distress costs and agency costs arising from the use of debt financing.