Final Lecture C L Mattoli C C L

Final Lecture C. L. Mattoli (C) C. L. Mattoli, 2008 1

Forward n n n In the course we have discussed many aspects of finance, focusing on financial management of corporations. Finance is very different from economics and accounting. The differences are embodied in the use of cash flows versus earnings, time values of cash flows, and the inclusion of risk. Like economics, finance, these days, also looks at psychological factor of human transactions This lecture reviews the course materials. (C) C. L. Mattoli, 2008 2

What is Finance (C) C. L. Mattoli, 2008 3

What is Finance? n n n The modern definition of finance is the allocation of financial resources over time under conditions of risk At the macro level, finance encompasses the study of the operations of financial institutions and markets within the economy in the allocation of funds (money) to various uses. At the micro level, finance essentially involves the processes of investment decision making and funding (financing) of investments, by firms, financial institutions and individuals. (C) C. L. Mattoli, 2008 4

The 4 Basic Branches of Finance Traditional finance is broken into 4 basic topics: 1. Corporate Finance, which is the main topic of this course. 2. Investments 3. The study of financial institutions. 4. International finance. (C) C. L. Mattoli, 2008 5

Corporate and Business Finance n n n Corporate (or business) finance studies all of the financial ideas, operations, jobs and decisions that go into running a business. Moreover, business finance includes topics from the other major areas because they cover topics that are relevant to business finance. On the other hand, the ideas contained in this topic apply also to the others. (C) C. L. Mattoli, 2008 6

Business Finance n n Starting a business cannot be done, thoughtlessly. Many people believe that starting a business is the key to getting rich, but they rarely understand what it takes to start and run a business, successfully. The first step in starting a business is investment. You decide what your business will be, e. g. , selling eggs or making candles. You will have to find a place to run the business. (C) C. L. Mattoli, 2008 7

Business Finance n n You might have to invest in equipment or just display counters. You will have to have extra money to pay expense, while you are in the start up phase. (Capital Budgeting) You will need money for all of this initial investment. Where will you get it? Thus, the second step is financing your business. Will you risk your own money? Will you borrow money? Or will you find others to invest in your business as partners or part owners. (Capital Structure) (C) C. L. Mattoli, 2008 8

Business Finance n n n Then, once you start the business, you will have to manage your day-to-day financial affairs, like collecting money from customers and paying suppliers, employees, and your landlord. This third step of business finance will be important for keeping you in business. (Working Capital Management) These are the 3 basic topics that we will study in business finance. (C) C. L. Mattoli, 2008 9

Accounting for decisions Current Assets Cash A/R Inventory Working Capital Current Liabilities Accrued Expenses A/P SR Debt Long term debt Equity Long term assets Capital Budgeting (C) C. L. Mattoli, 2008 Capital Structure 10

How businesses are organized n 1. 2. 3. 4. n Businesses can be set up in several different forms: Sole proprietor Partnership Corporation Trust We shall concentrate on the first three, in this course. (C) C. L. Mattoli, 2008 11

Financing business operations n n Sources of financing are direct or indirect In direct finance the supplier of funds (called surplus units) and the user of funds (called deficit units) deal with one another, directly. This happens when a company issues stock or debt securities directly to investors. It could be a private placement to a small group (even as small as 1) investors or a public offering to the general public. In Intermediated finance, a financial intermediary collect funds from suppliers and, then, dole them out to fund users. Banks, for example, take deposits and then make loans from the pooled deposits. (C) C. L. Mattoli, 2008 12

Debt and Equity Defined n n n Debt is a contractual arrangement to borrow money that will be repaid in the future. Equity represents an ownership interest, so there is no expectation that it will be ‘repaid’ in the future. Equity holders can get their money back by selling their ownership interest. For corporations, that ownership interest is represented by shares of stock. In accounting terms, A – L = E, Assets less liabilities = Book equity. (C) C. L. Mattoli, 2008 13

What you Get n n n Debt holders receive interest payments from the borrower (and eventually, at maturity, the principal amount of the loan) Interest payments provide a tax deduction for the borrower. Interest income is taxable income for the holders of bonds and other debt. Equity holders may receive dividends, periodically, or not. They own shares of stock. Dividends are not tax deductible, but give the shareholder imputation credits if they are franked (C) C. L. Mattoli, 2008 14

Features of companies n n The thing that distinguishes corporations, either private or public, is that they issue ownership certificates called shares of stock. In a private company, shares are held by a small number of people and cannot be readily sold. The term public company means that the stock is held by the general public and can be sold to anyone else. Stock shareholders (the owners of companies) have limited liability. They can only lose their investment in the stock. (C) C. L. Mattoli, 2008 15

How the Corporation is Run n The stockholder owners usually elect directors of the corporation. These are their direct agents. The election is by vote according to the number of shares each owner holds. Then, directors hire managers, who become secondary agents of the stockholders and who are paid to manage the company for the owners’ benefit. People, in general, are self-interested. There is potential for conflict of interest in all agency relationships. This is known as the agency problem. (C) C. L. Mattoli, 2008 16

Ownership Transfer n n n One of the downsides of buying any type of investment is that you might lose some or all of your money. Sole proprietorships, some partnership shares, and large business investment projects, like investment in PP&E, might be difficult to divest. Moreover, sole traders have no source of equity capital but their own money, and partnerships might have difficulty finding new partners to contribute equity. (C) C. L. Mattoli, 2008 17

Ownership Transfer n n If you can easily resell (transfer ownership of) an investment, you will feel better about making the investment, in the first place. Ease of transfer is one of the greatest benefits of the corporate organizational form of business. As a result of ease of transfer, corporations will have an easier time raising capital. As we will discover, shortly, it will be even easier to raise more equity capital, if the corporation is a public company. It will also help them raise debt. (C) C. L. Mattoli, 2008 18

Financial markets n n n The financial markets are not a specific place. Financial markets include all of the means of making financial contracts, which is what securities and other types of financial instruments are. The other important function is providing a means of buying and selling of those contracts, initially or in an after-market. (C) C. L. Mattoli, 2008 19

Corporate market value n n n The value of a publicly-traded corporation is the market capitalisation of the company Market capitalisation is the total value of a corporation as measured by the price of each issued share multiplied by the number of issued shares. For example, if XYZ Corp. has 1 million shares, which are priced at $50/share, in the stock market, the total market capitalization is $50/share x 1 million shares = $50 million. Market value of a debt or any security is calculated as the value of each security times the number outstanding. (C) C. L. Mattoli, 2008 20

Financial Statement Analysis (C) C. L. Mattoli, 2008 21

Intro n n To begin financial analysis, we need financial information. One of the most common forms of financial information is the financial statements of companies or other businesses. Remember, again, that finance is not accounting, so we will need to use financial information in the proper manner. In particular, you should understand the difference between income and cash flow and accounting value versus market value (C) C. L. Mattoli, 2008 22

Abstract Basic Balance Sheet Net WC = CA - CL Current Assets Cash A/R Inventory Current Liabilities Accrued Expenses A/P SR Debt Non-current liabilities, including Long term debt Long term assets Tang. fixed assets Intangibles E=A-L (C) C. L. Mattoli, 2008 Equity 23

Market value vs. book (acctg) value n n The true value of something is what you could sell it for (in, e. g. , a market): market value. The numbers shown in a BS are the book values of the firms assets and liabilities. Book value may not be representative of market value, which is what we want. In addition, many of the firms true assets are not even listed on the BS. These are things, like band name, management and employee skill, and reputation. (C) C. L. Mattoli, 2008 24

Textbook Table 2. 2 (C) C. L. Mattoli, 2008 25

Non-cash Items n n n A major reason that accounting income differs from actual cash flows is that accounting income statements include non-cash items. Depreciation is one of the most common. Financial managers is critically interested in the actual timing of cash flows (time value), in order to come up with proper values of things. (C) C. L. Mattoli, 2008 26

Corporate Taxes n n n The current corporate tax rate is a flat-rate of 30% on all income. In a flat-rate tax, there is only one tax rate, a percentage of income that is owed as taxes. Thus, if income before tax is $1 mil. , then, taxes =30%x$1 mil. =$300, 000, and net income AT=$700, 000=$1 mil. -$300, 000 = $1 mil. x(1– tax rate)=$1 mil. x 70%= $700, 000. (C) C. L. Mattoli, 2008 27

Personal Marginal Tax Rates Taxable income $ Marginal tax rate % 0 – 6 000 nil 6 001 – 25, 000 15 25, 001 – 75, 000 30 75, 001 – 150, 000 40 over 150, 000 45 (C) C. L. Mattoli, 2008 28

Dividend taxation in Australia n n In the so-called classical taxation system, corporate profits are taxed; some of the ATI is paid out to shareholders, who are taxed again on their dividend income. Thus, in a classical system, corporate profits are double taxed. In the imputation system, the company tells the shareholder how much tax it paid on the income that made the dividend. The shareholder, then, adds that tax imputation franking credit to his cash dividend income. (C) C. L. Mattoli, 2008 29

Effect of a $700 dividend fully franked at 30% tax rate Percentage 150/700 = -21. 4% 0/700 = 0% (C) C. L. Mattoli, 2008 100/700 = +14. 3% 150/700 = + 21. 4% 30

The flow of cash n n What we care about, in finance, is the actual cash that flows into and out of a business venture and when. The accounting statement of cash flows of a company is helpful, but it is not the exact information that we need, in finance. Since the BS is broken up into liabilities and equity equals assets, cash flows will, similarly, go from assets to pay creditors and owners. CF from assets = CF to creditors + CF to owners. (C) C. L. Mattoli, 2008 31

Table 2. 5 from text book: CF identity (C) C. L. Mattoli, 2008 32

Ratio Analysis – fundamental analysis n n n In module one, we first mentioned the usefulness of ratios, when we looked at income on investment, in a ratio with initial investment, rate return on investment. The percentages, in common-size balance sheets are ratios: item/total assets or item/revenues. We use many different ratios as a means of analyzing financial data to put things on an equal footing. See below. (C) C. L. Mattoli, 2008 33

Ratio classification n 1. 2. 3. 4. 5. 6. 7. We will cover ratios that can be put into the following general classifications: Growth rates Rates of return Profitability ratios Efficiency ratios - Turnovers ST solvency - liquidity ratios LT solvency Market value ratios (C) C. L. Mattoli, 2008 34

Textbook Table 3. 5 (C) C. L. Mattoli, 2008 35

Valuation (C) C. L. Mattoli, 2008 36

Time Value of Money n n n A dollar, now, is worth more than a dollar, later. Thus, money has a time value. If you have money, now, you invest it and earn more money (future value). If you get money, later, you lost the opportunity to invest (opportunity cost). In investment, we invest money, now, to get cash flows, in the future, whether we invest in equipment or we buy the securities of companies. Therefore, finance asks the question: what is money, received later, worth to us, right now (present value). (C) C. L. Mattoli, 2008 37

Future Value: Simple Interest n n In finance, we talk about (percentage) rates of return, and usually, annual percentage rates (APR) of return. Interest on savings in a bank is an example of a rate of return. In that regard, if I put $100 in a bank account that earns a 10%/year interest rate of return, then, I will earn 10% of that $100, in a year, or 10% $100 = $10. Therefore, at the end of a year, I will have $110, in bank = $100, original principal, plus $10, interest earned. (C) C. L. Mattoli, 2008 38

Future Value: Simple Interest n n We can put this into a simple equation form as FV 1 = P + r. P = P(1 + r), where r is the annual rate of return = interest rate, in this case. We have used the notation, FV 1, to indicate that this is the value of your savings account, in the future, and we call it the future value. If you earn interest on that principal for n years, where n can be > 1 or n < 1, then, the simple interest equation becomes FVn = P + nr. P = P(1 +nr). In n years, you will have P(1+nr) dollars in future value. (C) C. L. Mattoli, 2008 39

Future Value: Compounded n n More common than simple interest is compound interest. If I put $100 (P) in bank for a year, at the end of a year, I will have $110 [FV = P(1+nr)], in the bank. If I leave that money, in the bank, I will earn interest on the whole thing At the end of 2 years, I will have FV 2 = $110(1+10%) = $121 = $100(1+10%)*(1+10%) = $100(1+10%)2 = P(1+r)2. (C) C. L. Mattoli, 2008 40

Future Value: Compounded n n n What has happened is that we have earned interest on the interest that we earned in the previous year. This is referred to as compounding, and you earn compound interest on your principal. For any number of years, n, the future value equation with compounding of interest is given by FVn = P(1+r)n. (C) C. L. Mattoli, 2008 41

FV for multiple CF’s n n We can make a general formula for cash flows, CFm, invested in year m, and held in the account til year n as: The symbol, , is used to denote the sum of the objects to its right, indexed by m, over the specified range of m, in this case, m = 0, 1, 2, …, n. (C) C. L. Mattoli, 2008 42

PV of any future payment n n n Assuming that interest is compounded, the PV of an amount of money, FVn, that will be received n years into the future, is PV = FVn/(1+r)n. We usually refer to r as the discount rate or the required rate of return (RRR), and the PV is discounted future cash flow. It just tells us what a future cash flow is worth to us, today, given that we could invest (opportunity) it, if we had it now, and earn r rate of return compounded to that future time. (C) C. L. Mattoli, 2008 43

PV of MCF’s n n Since we can find PV for any future CF, and PV is right now, time = n = 0, then, if we have PV’s for a bunch of future CF’s, the PV of the sum of the CF’s is the sum of all of the PV’s of those CF’s. The general formula for a stream of CF’s, CFi, discounted at rate, k, is given by (C) C. L. Mattoli, 2008 44

Annual Effective Rate n n n When interest is compounded more than once a year the earning rate is larger than with annual compounding. Assume that k = APR and m = # of periods in a year. If we take PV and add compound interest for one year (m periods), we will have FV = PV(1+k/m)m at the end of a year. We can find the effective rate of return over the year from our basic equation for return: reff ann rate of return = [PV(1+k/m)m – PV]/PV = (1+k/m)m – 1 = reff. (C) C. L. Mattoli, 2008 45

The real point: one time We usually talk about PV, the value right now, or some FV. n The real point is that, in finance, we realize that money has a time value. n Because of that, if we are to value things and we want to compare their values, then, they all have to be valued at the same. n n We could value them, now, t=0 or 3 years from now. (C) C. L. Mattoli, 2008 46

Securities, Markets & Valuation (C) C. L. Mattoli, 2008 47

Intrinsic Value n The value of anything is its DFCF value. The value of future cash flows must be brought back to the present by discounting at some opportunity cost RRR. It is called the intrinsic value. n It is the price that we should pay, if we want to earn the RRR that we use to discount the cash flows. n (C) C. L. Mattoli, 2008 48

Bond definitions n n Years to maturity will decrease as time moves on. All bonds have a Face Value (par value) (FV), the amount paid at the end, usually multiples of $1, 000. Most bonds will also pay interest in the form of coupon interest payments, usually paid semi-annually. The coupon rate, %C is stated on the bond. (C) C. L. Mattoli, 2008 49

Zero-coupon bonds n n We should pay PV for the bond, based on our own RRR = k. Thus, PV = FV/(1 + k)n where FV is the face value of the bond and n is the number of years to maturity (assuming that you want to). earn a compound annual return on investment =k In that regard, if I invest PV, now, and I get FV, in n years, I will earn an annual compound rate of return on investment of k: k = [FV/PV]1/n -1. (C) C. L. Mattoli, 2008 50

Coupon Bonds n n n Coupon bonds have regular coupon interest payments, so they will pay multiple CF’s over their lives, but they are only slightly more complicated to value. Our general equation for CF valuation is: A coupon bond has coupon interest payments, C, every year through maturity, plus a final payment of FV at the maturity time. (C) C. L. Mattoli, 2008 51

Coupon Bonds n n n In fact, sometimes, securities dealers, clip off the strip of coupon payments, and sell the strip and the ZCB face value portion, separately. In that manner they create what is called a strip and a ZCB from a coupon bond. In any event we can value a coupon bond as: Coupons =annuity payments Face value =homemade ZCB = C[1 – (1+k)– M]/k + FV/(1+k)M (C) C. L. Mattoli, 2008 52

Bond Yields: Investors’ RRR’s n n You can find bond yields in the market place, these are market RRR’s. Government bonds, representing a zerodefault rate, provide a floor on interest rates on bonds. There will be a risk-structure of rates, based on a scale, like S&P’s, with riskier bonds demanding a higher RRR than the less risky. There are several other factors that go interest rates. (C) C. L. Mattoli, 2008 53

The Fisher Effect A person gives up current consumption to save money. n To lend his money he will want not to lose his purchasing power. n Thus, inflation should be a component of all interest rates. n The Fisher Effect says nominal rate = real rate + inflation: R ≈ r + h n (C) C. L. Mattoli, 2008 54

Term Structure n n n There will also be a component to rates that depends on the term to maturity. This is known as the term structure of rates. Usually, the term structure is an upward sloping line, a higher and higher rate as the term to maturity increases. The longer that you wait to get paid, the more chance there is for something bad to happen, including a change in inflation or interest rates. (C) C. L. Mattoli, 2008 55

Rates Summed Up n n All rate will include a real rate and inflation, as components. However, expected inflation is more important. Usually, because interest rate increases with increasing term to maturity, there is a larger and larger risk premium as term gets larger. On top of that structure is a default risk structure, and premiums may also vary with the term. Final considerations in interest rates are taxability (interest on some bonds or bonds might be totally or partial tax free, e. g. ) and liquidity of the market for the bond. (C) C. L. Mattoli, 2008 56

Equity n n Equity will, in general, be more difficult to value than debt, using DFCF methods. Equity has a potentially infinite life and it has no promised cash flows. Finally, there is no easy measure for RRR’s, like in the bond markets. For valuation using DFCF, we usually focus on dividends, and the constant dividend model is a compact equation (C) C. L. Mattoli, 2008 57

Cash Flows n n n If we buy a stock at P 0, get D 1 during the year and sell the stock at the end for P 1, the value is P 0 = (D 1 + P 1)/(1+k) Other future price will come from a similar equation: P 1 = (D 2+P 2)/(1+k); Pn = (Dn+1 + Pn+1)/(1+k). That leads to further equations: P 0 = D 1/(1+k) + D 2/(1+k)2 + … + P n/(1+k)n and, an infinite dividend discount model: (C) C. L. Mattoli, 2008 58

Special Cases n n A special case that results in a compact reduced equation is constant dividend growth. Constant dividend growth model (CDGM), the Gordon Model, dividends grow by g % per year, so Dn+1 = Dn(1+g). Then the value equation becomes P 0 = D 1/(k – g). Dividend growth is actually sometimes a corporate goal. (C) C. L. Mattoli, 2008 59

RRR for Equities n n n Take the CDGM and turn it inside out to get k = D 1/P 0 + g. That says that the RRR for a stock is composed of the dividend yield = D 1/P 0 plus the dividend growth rate. In general, rate of return = (income + cap. gain)/Init. Invest. = inc/II + %ΔP. Implicit CDGM is that share price will grow at the growth rate, g. Then, the first equation is k = dividend yield + cap gain yield. (C) C. L. Mattoli, 2008 60

Preference (Preferred) Shares n n n Preference shares (pfd) pay a fixed dividend, which must be paid before dividends can be paid on the common shares. In liquidation, the preferred shareholders must be paid before the common shareholders. Voting rights for preferred shares will be limited to votes involving the shares or there might be no voting rights (see example in table 7. 2 in the text). (C) C. L. Mattoli, 2008 61

Preference (Preferred) Shares n n n For example, a 10% $100 par value pfd would have an annual dividend of 10%x$100 = $10/year. Dividends might be cumulative or noncumulative. Cumulative, then, if payment cannot be made in any one year, it will cumulate to the next year. Non-cumulative, if it can’t be paid, tough luck. (C) C. L. Mattoli, 2008 62

Preference (Preferred) Shares n n Limited life: it is redeemable preferred. There might even be a sinking fund for retiring the issue. A non-redeemable preferred is valued as a perpetuity; redeemable preferred would be valued like a coupon bond. That is why many people say that preferred capital is like debt capital. It has fixed payments and can have a liquidating final payment. The real difference is for legal and tax purposes. Dividends non-payment does not lead to default, and pfd dividends are treated as dividend for tax purposes. (C) C. L. Mattoli, 2008 63

Common Ordinary Shares n n Common equity has the residual right to assets and income. Common shareholders have 1 vote per share. All companies hold an annual vote for directors. In Australia, there is straight voting whereby all directors are elected at one time. Another possibility is staggered voting wherein part, say 1/3 of the board, is elected each year. (C) C. L. Mattoli, 2008 64

Securities Markets. n n n Markets serve 2 important functions. Primary markets are for issuing securities. Secondary markets support the primary markets by providing a means to sell securities, rather than hold them til term or forever. Markets are especially important for equity, as there is really no alternative, except to walk the streets to find investors. At least, for debt, there also banks and other financial institutions as alternatives. (C) C. L. Mattoli, 2008 65

Brokers and Dealers n n n A broker just gets paid commissions to execute buy and sell orders. Dealers maintain inventory of securities and maintain a bid, the price they will buy at, and an ask (offer), the price they will sell at: they make money on the bid-ask spread. Markets comprised of dealer networks are called OTC (over the counter) markets. (C) C. L. Mattoli, 2008 66

The ASX n n As opposed to OTC, the ASX is an exchange market with 1 best bid and offer for each share, as opposed to multiple bids and asks in a dealer network. Members of the exchange are the only ones to execute orders for trading on the exchange. Orders are executed by the Stock Exchange Automated Trading System (SEATS), so there is no trading floor, like the NYSE. Shares of about 1700 companies are listed for trading on the ASX. (C) C. L. Mattoli, 2008 67

Capital Budgeting (C) C. L. Mattoli, 2008 68

Intro n n n In the beginning of the course, we looked at the 3 main decisions that financial managers of a company need to make. Capital budgeting (or allocation) is, probably, the most important of the 3 since it will determine the very character of the business. Also, since the capital budgeting decisions result in what the business invests its money in, we also call it the investment decision of the firm. (C) C. L. Mattoli, 2008 69

Value n n We have learned that the proper way to value things is using DFCF methods. In the present context, then, we should value potential projects for the firm by discounting the expected cash flows of the project. Projects will also have initial investment, startup costs. Thus, our method of valuing a project will be to value it on DFCF, then, compare that value to how much it will cost to do a project. (C) C. L. Mattoli, 2008 70

Value n n This is the essence of the Net present value (NPV) method of valuing business projects. The NPV of a project is the difference between the DFCF value and the initial investment outlay (IO = II) , i. e. , (C) C. L. Mattoli, 2008 71

Business investment value n n As we said, previously, business investment is: the output is worth more than the input. In the case of a business investment, there is a long time frame for the investment (project). Thus, we expect multiple future cash flows, and we must account for the time value The future cash flows are estimates. (C) C. L. Mattoli, 2008 72

Business investment value n n n Moreover, they are more complicated cash flows, involving estimates of future costs of inputs, like labor and materials, as well as estimated sales prices and volumes, in future years. The original investment outlay will involve purchase of PP&E as well as estimates of other startup requirements for WC. The final ingredient is a proper choice of the RRR that will give investors enough of a return. (C) C. L. Mattoli, 2008 73

A first example n n Assume Craig wants to add dress making to his businesses. He buys a sewing machine for $1, 000, and he assumes that it will last for 5 years. Craig estimates his inflows (dress sales) and outflows (costs) over the five years. At the end of the 5 year project, Craig believes that he can resell the used sewing machine for $100 as scrap (or as a used sewing machine). (C) C. L. Mattoli, 2008 74

The cash flows n Assuming that the proper RRR for Craig is 15%, then, we have the situation displayed in the table, below. Time line IIO Inflows Outflows Net inflow Salvage Net CF Discounted PV inflows 0 -1000 1055 2 3 4 5 500 200 300 -1000 1 500 200 300 261 300 300 227 197 172 NPV = 55 >0 500 200 300 100 400 199 (C) C. L. Mattoli, 2008 75

The outcome n n In the above table, we assume RRR =15%. The DFCF value of the net inflows is $1, 055: NPV = $1, 055 - $1, 000 = $55. That means that the project is estimated to add $55 in value to Craig’s business above his RRR over the period. If NPV had turned out to be a negative value, it would subtract from net worth (C) C. L. Mattoli, 2008 76

The NPV Decision Rule n n n From the above example and discussion, we can come up with a decision rule for using NPV: accept positive NPV, negative NPV Assume that the firm is in business, and they already have a RRR demanded by their investors. Given our discussion in Mod 4 (Securities valuation), shareholders will determine the value of the company’s stock based on DFCF valuation, using an appropriate RRR. (C) C. L. Mattoli, 2008 77

NPV & Risk n n n An implicit assumption in the NPV methodology is that the risk of a project must be the same as the average risk of the firm. We have chosen an “appropriate” discount rate to use in NPV that is somehow connected to the rate at which investors discount the company’s CF’s to value its shares. We have also learned, in the preceding module, that, in the marketplace for returns, there is a risk component to rates of return, in the market. (C) C. L. Mattoli, 2008 78

NPV & Risk n n Thus, the risk that investors perceive in the firm has been incorporated into their RRR. When we use RRR, determined by those factors, to calculate NPV, the project must have the same risk as the general risk of the firm, or it will demand a different RRR. A new product would be a riskier than average venture. A company that has a division that makes military tanks and one that makes chopsticks will have average risk, different from the risks of each of its divisions. (C) C. L. Mattoli, 2008 79

Payback Period: a non-DFCF rule n n There a number of other decision rules for investment. The first is the payback period, which does not account for time value: We pay out money to buy an investment: our initial investment outlay. PBP is the length of time it takes for CF’s to cover IO. In the next slide, we show PBP calculation. (C) C. L. Mattoli, 2008 80

Payback Period Example n The payback period is over 3 years but under 4. It is 100/300 = 1/3 year over 3 years. Time 0 line IIO 1000 Inflows Outflows Net inflow Salvage Net CF Payback paid to go payback period = 1 2 3 4 5 500 200 300 300 300 700 400 3 1/3 300 100 300 500 200 300 100 400 (C) C. L. Mattoli, 2008 100/300 = 1/3 81

Average Accounting Return n Another non-DFCF method is called the average accounting return (AAR) of a project or the accounting rate of return (ARR). There a number of different definitions of AAR of the general form: [average accounting profits from investment]/[average accounting value of investment]. We shall use the definition: average net income/average book value. (C) C. L. Mattoli, 2008 82

Internal Rate of Return n n A second DFCF method that we shall examine is internal rate of return (IRR). We encountered the concept of IRR when we looked at bonds: the IRR solves the coupon bond equation for YTM. The IRR method is also related to NPV. With NPV we begin with a given value for RRR, and we compare the DFCF from the investment with the price, IIO, that we pay for the investment. (C) C. L. Mattoli, 2008 83

Internal Rate of Return n IRR finds the RRR that makes DFCF exactly equal to IIO, i. e. , the rate of return that equates present value of the project’s cash flows to the initial outlay. Thus, we can write the equation form of IRR as: Then, the required rate of return that makes NPV=0 is the IRR. (C) C. L. Mattoli, 2008 84

RRR vs. NPV n In the chart below we show RRR vs. NPV for a project, known as an NPV profile 600 RRR vs. NPV 500 400 300 200 100 0 2% -100 4% 6% 8% 10% 12% 14% 16% 18% 20% Series 1 (C) C. L. Mattoli, 2008 85

Mutually Exclusive Projects n n Projects can be mutually exclusive (ME). That means choosing one but not both (or all). For example, you want to buy a new computer for your business. You evaluate the CF’s of using IBM, HP, or Lenovo. In the end, you need only one computer system, so, choosing one eliminates the others. (C) C. L. Mattoli, 2008 86

ME example n n n CF’s for two projects, B & C, are shown, below. The NPV of B is $147 and C is $106, using a 10% RRR. IRR’s for the projects are 17. 01% for B and 13. 06% for C. Time 0 1 Project B -1000 Project C -1000 2 450 100 3 380 125 (C) C. L. Mattoli, 2008 4 300 5 200 460 100 600 87

NPV Profiles for B & C NPV Profiles for ME Projects 600 500 B 400 C 300 200 100 0 -100 2% 4% 6% 8% 10% 12% 14% 16% 18% 20% -200 -300 (C) C. L. Mattoli, 2008 88

The lesson for ME, IRR, and NPV n n n It will always be more appropriate to use NPV over IRR. People care more about the money that they make, NPV, versus their returns on investment, especially when IRR might not be a good rate for reinvestment, anyway. Thus, if there are conflicting opinions from IRR and NPV for ME, go with the choice given by NPV. (C) C. L. Mattoli, 2008 89

The Profitability Index n n n The profitability index (PI), also known as the cost-benefit ratio, is similar to NPV, in that it compares the DFCF from the project to the cost, so it is. PI = DFCF/IO, the discounted cash flow value of the project divided by the initial investment cost (outlay). Thus, if PI > 1, accept; PI < 1, reject. PI just gives a ratio, so there might be cases for ME projects in which one has a higher PI but a lower actual NPV. In such cases, the choice lies in the decision given by NPV. (C) C. L. Mattoli, 2008 90

More on CF’s n n Since the focus, in finance is cash flows, we must be careful to include the proper cash flows and exclude improper ones in our evaluation. Two things should be noted, before hand. First, companies may spend some money, in the ordinary course of their business, looking at and for new business ideas (projects). What will be important is the net cash flows that a project adds to the firm. (C) C. L. Mattoli, 2008 91

Sunk Costs n n There are some unusual costs that are part of business project evaluation. Sunk costs are costs that a business incurs in looking at potential projects, in its regular course of business. They are liabilities that must be paid whether or not the project is actually undertaken. An example is a fee for a market analysis for a potential new product. (C) C. L. Mattoli, 2008 92

Opportunity Costs n n n The opportunity cost concept arises in business project evaluation. Basically, opportunity costs are in terms of what you give up. For example, suppose you own a building that you paid $500, 000 for, 10 years ago. Due to new zoning laws, you are now allowed to convert the building into apartments. The opportunity cost that should be included in evaluation of the apartment project is how much you could sell it for, today, in the market. (C) C. L. Mattoli, 2008 93

Incremental Cash Flow n n n To truly analyze the cost and benefits of adding a new business to an existing business, we consider all of the changes in cash flow of the whole business associated with the project. In other words, we consider the total net affect of the new business on cash flows. The relevant project CF’s are, therefore, incremental cash flows, the net additions or subtractions of cash flow of the whole firm. (C) C. L. Mattoli, 2008 94

Incremental Cash Flow n n n In that regard, we do not have to actually calculate the whole of cash flows of the firm with and without the project. We only have to figure out the incremental cash flows of the project. That is known as the stand alone principle. We evaluate the project incremental cash flows, considering it as a stand alone business. (C) C. L. Mattoli, 2008 95

Incremental Example Suppose we have the following comparison of cash flows for some year in the life of a project. Project Implemented – Project Not Implemented Increment = Sales 12000 9000 3000 Cash op. cost (5000) (4000) (1000) Depreciation (2000) (1000) 5000 4000 1000 (1500) (1200) (300) = Net oper. inc. 3500 2800 700 + depreciation 2000 1000 =Operating Cash flow 5500 3800 1700 Pre-tax income Taxes (30%) (C) C. L. Mattoli, 2008 96

NWC and Projects n n n Startup costs for a business involve more than just things like equipment purchase. It will also involve working capital. For example, if you start a clothing boutique, you will have to buy some inventory for startup. Suppose, also, that your monthly sales will be $100, 000, and about 25%, credit sales. Then, you will also need room, in the beginning, for A/R of $25, 000. (C) C. L. Mattoli, 2008 97

WC recovery n n n WC initial investment is normally recovered at the end of the project (unless otherwise specifically stated in a problem). For example, if we invest in inventory, in the beginning, it will have been sold and included in OCF’s, and there will be no inventory at the end of the project. Example, get $100, 000 of dresses to sell. Sell them for $100, 000. At the end there are none left. (C) C. L. Mattoli, 2008 98

Depreciation n The value of depreciation, in finance, is the tax savings, and we always use tax depreciation. For example, if an asset costs $100, 000, can be depreciated over 5 years, has a terminal value of $20, 000, and useful life of 8 years, D = $100, 000/5 = $20, 000, straight line (prime cost). Alternatively, depreciation might be given in %/year instead of years. The two ways are just inverses of each other: D in years = 1/[D in %/year]. (C) C. L. Mattoli, 2008 99

BV vs. MV: Taxes on Sale of P&E n n n Suppose that you sell the asset of the last example, in year 4, for $25, 000. The BV = $100, 000 – 4 x$20, 000 = $20, 000. Then, the tax law says that you must pay tax on the gain (or loss, which is a tax savings) on sale price over BV: Taxable Gain = 25, 000 – 20, 000 = $5, 000. (C) C. L. Mattoli, 2008 100

Multiple Futures: Scenarios n The next level of analysis involves creating multiple scenarios and cash flows for the future: average, good and bad. Cash Flows & NPV Year Bad -200000 1 59800 99730 24490 2 59800 99730 24490 3 59800 99730 24490 4 59800 99730 24490 5 IRR Good 0 NPV Average 59800 99730 24490 $15, 565. 62 $159, 504. 33 ($111, 719. 03) 15. 10% 40. 88% (C) C. L. Mattoli, 2008 -14. 40% 101

Sensitivity Analysis n n n In scenario analysis, we vary all of the variables. In sensitivity analysis, we vary one variable at a time to see what happens to the results. For example, we could vary unit sales, fixed costs, or prices. In the end we will be able to construct a graph of NPV vs. the variable. The higher the slope of the line, the more sensitive is the NPV to that variable. We show an example of unit variation, below. (C) C. L. Mattoli, 2008 102

Sensitivity Analysis n NPV vs. Units $50, 000. 00 $40, 000. 00 $30, 000. 00 $20, 000. 00 $10, 000. 00 $0. 00 5300 ($10, 000. 00) 5500 5700 5900 6100 6300 6500 6700 ($20, 000. 00) (C) C. L. Mattoli, 2008 103

Risk (C) C. L. Mattoli, 2008 104

Intro n n We have discussed the inputs of returns, including, maturity, inflation, and risks. We have been using RRR’s, but, so far, we have said little about how they are determined for a particular investment. In order to explore this question, more fully, we have to quantify risk. Then, we can take a closer look at returns and their relationship to risk. (C) C. L. Mattoli, 2008 105

Detailed Returns The authors of the textbook have compiled quarter-to-quarter returns for classes of Australian assets (over 20 years). n The portfolios are: 1. ASX All Ordinaries Index. 2. Government bonds with 10 years to maturity 3. Cash as investment in 30 -day BAB’s 4. The CPI, a broad measure of inflation. n (C) C. L. Mattoli, 2008 106

Real and Nominal Returns Over the 20 year period, the average return on cash was 8. 4%, for 10 -year T-bonds 10. 6%, for equities 14. 4%, and inflation averaged 3. 9%. We break these down, further. n Real average return on cash was 4. 5% (= 8. 4% – 3. 9%), on 10 -year Tbonds 6. 7%, on equities 10. 5%. n (C) C. L. Mattoli, 2008 107

Risk Premiums n n n BAB’s are bank-guaranteed debt of large corporations with good credit, and we have limited maturity to 30 days, and are highly liquid. Thus, our cash rate is virtually default-risk free, and we designate it as the riskless rate We find that equities had an excess return of 5%, the price for bearing the risk of owning equities, the risk premium, the reward for bearing the risk, for holding equities. (C) C. L. Mattoli, 2008 108

Summary of Returns Average Returns 1982 -2002 Category Average Return Risk Premium 14. 4% Real Return 10. 5% All Ordinaries 10 Year TBonds Cash 10. 6% 6. 7% 2. 2% 8. 4% 4. 5% 0. 0% Inflation 3. 9% -- -- (C) C. L. Mattoli, 2008 6. 0% 109

Variability & Risk n n The risk premium for T-bonds was 2%, equities, 6%. Logically, if the risk premium is higher, then, so must be the risk. Risk is, basically, the chance that the future will turn out differently than expected. We quantify it as the variability of return. The average return on equities was 14. 4%, the range was – 40% to + 30%, about 70%. The average for T-bonds was 10. 6% and the range was only – 4% to 12%, or a range of 16%. Thus, a correspondence between our conception of risk and the market’s assignment of a bigger premium for bearing the risk. (C) C. L. Mattoli, 2008 110

Histogram of Returns: fig. 10. 9 (C) C. L. Mattoli, 2008 111

Analysis of the Spread n n n The statistical/probability concept that captures the spirit of what we want is the variance of returns. The variance measures the spread of a distribution, while also accounting for the height, the frequency or probability, of the distribution, in the calculation. The spread is measured from the central (mean) return. (C) C. L. Mattoli, 2008 112

Ex post variance n The ex post variance is the weighted average of the deviations of observed returns from the mean return n Where T is the number of past observations and we use Mean(O) = Ō (C) C. L. Mattoli, 2008 113

Markets in Action n n A big topic in finance is market efficiency. The most important thing in investing is information. Market prices change all the time as new information arrives and is disseminated to market participants who reassess their views. The question of market efficiency becomes how fast and accurately do markets adjust. In an efficient market, prices should fully reflect all of the available information so that there is no reason to believe that prices are either too high or too low. (C) C. L. Mattoli, 2008 114

Possible Reactions & Adjustments n n Suppose that a company announces a new project that management has figured will greatly increase the PV of its shares. In a completely efficient market, the price will adjust quickly to the news. Other possibilities are delayed reaction, taking several days to assimilate the information, or overreaction and subsequent adjustment. We show the 3 possibilities in the next slide. (C) C. L. Mattoli, 2008 115

Figure 10. 12 (C) C. L. Mattoli, 2008 116

The Efficient Market Hypothesis n n n The gist of the EMH is that well-developed financial markets, like the ASX, are relatively efficient, although there are “anomalies”. In an efficient market, all investments are zero NPV investments because DFCF=P. In practice, competition among investors in information gathering and processing will move more and more prices to their proper levels. (C) C. L. Mattoli, 2008 117

The Efficient Market Hypothesis n n As investors analyze the information, they may conclude that a price is too high or too low. Their action, their vote, in the market, buying or selling shares will help to move the price towards its true level. The leftover, inefficient stocks will be just enough to keep those people in business whose specialty is finding, analyzing and investing in undervalued investments. (C) C. L. Mattoli, 2008 118

Forms of the EMH n n EMH has been presented in 3 forms Strong form = all information is reflected in price. No such thing as inside information. However, inside information does exist. Semi-strong = all publically-available information is reflected in prices, so, security analysis has no value. Weak efficiency =present price reflects the history of prices, so technical stock analysis has no value. (C) C. L. Mattoli, 2008 119

Expected & Unexpected Returns n n Share prices and returns depend on information. Thus, the expected return, over the next year, is based on known information. That is the normal return. However, unexpected things can happen during the year. That will mean that the total return for a stock will be its expected plus unexpected return, Total return = E(R) + U. Over time, the unexpected part will cancel itself out, having negative surprises, some years, and positive surprises, other years. (C) C. L. Mattoli, 2008 120

Announcements & News n n Since the market already has expectations for a company’s outlook, some news is already discounted by the market. Unforeseen events could lead to a surprise in an announcement. Thus news = expected + surprise = expected + unexpected. We relate the expected parts to market efficiency: current price represents all of the known information, including expectations. From here on, we will equate news with only the real news, the surprise. (C) C. L. Mattoli, 2008 121

Systematic & Unsystematic Risk n n n The real risk in owning an investment resides in the surprises. If we always got what was expected, there would be no risk. Part of the risk of surprise will affect the whole investment market. For example, if the economy has unexpected slow growth, that will affect the whole stock market. Thus, we call this risk, systematic risk: the risk to the whole system, in this case, the stock market. (C) C. L. Mattoli, 2008 122

Systematic & Unsystematic Risk n n n The other part of surprise will affect a company or industry. For example, if oil prices fall to $60/barrel when they had been expected to remain at $100. That risk is called unsystematic, unique or asset-specific risk. Then, also, we can rewrite return for an individual asset as R = E(R) + systematic part + unsystematic part = E(R)+m + . (C) C. L. Mattoli, 2008 123

Diversification & Risk n n As it turns out, if we diversify our investment, i. e. , spread it out over more and more stocks, we will get lower and lower portfolio risk, or variations of return. There will, however, be a limit to the amount of risk that we can eliminate: the unsystematic risk: it is diversifiable risk. What cannot be is the systematic risk. We show the situation, in the next slide. (C) C. L. Mattoli, 2008 124

Risk Diagram n Risk Diagram Diversifiable risk Risk associated with market portfolio (systematic risk) 2 Number of securities in portfolio (C) C. L. Mattoli, 2008 125

What type of risk matters? n n n A well diversified portfolio only contains systematic risk because we can, by intelligent diversification, get rid of unsystematic risk The unsystematic risk of each asset is offset by the unsystematic risks of the other assets in the portfolio, if constructed properly Theoretically, investors cannot expect to gain higher returns by increasing unsystematic risk. (C) C. L. Mattoli, 2008 126

Systematic Risk & Beta n n n The systematic risk principle says that reward for bearing risk resides in systematic risk. Then, expected return should also depend on systematic risk. In reality, one asset might react differently than another to the way things turn out for the whole system. is the systematic risk of an asset. For the entire market is 1; > 1 is riskier than the market; < 1 is less risky than the market; < 0 is anti-correlated with the market. (C) C. L. Mattoli, 2008 127

Portfolio Betas Unlike portfolio variance which was complicated to calculate, portfolio beta is simple. n The beta for a portfolio is calculated exactly like portfolio expected return. n We just do a weighted sum of betas for the individual investments, weighted by their portfolio weights, P = W 1 1 +W 2 2 + … n (C) C. L. Mattoli, 2008 128

Beta and the Risk Premium n Assume that you form portfolios from a risky asset with risk, , and a riskless asset. n Then, portfolio expected return and risk will be RP = W E(R) + (1 – W)RF and P = W + (1 – W) 0 = W . That equation describes a line, varying W, relating portfolio return to portfolio beta, and the slope of the line is slope = [E(R) - RF]/ , the reward-to-risk ratio, which must be the same for all assets. n (C) C. L. Mattoli, 2008 129

The SML & the CAPM n n n The line in risk-return space is commonly referred to as the security market lime (SML). To find the line, recall that beta for the market is 1, so slope = [E(RM) – RF]/1. Then for any asset in the market, slope = [E(R) RF]/ = E(RM) – RF, so, E(R) = RF + [E(RM) – RF] . This equation is the famous capital asset pricing model (CAPM). Since the model is usually applied to the stock market, the risk premium, E(RM) – RF is usually referred to as the equity risk premium, ERP. (C) C. L. Mattoli, 2008 130

Graphical Meaning of the CAPM n n CAPM-Security Market Line (SML) Risk of the market is beta = 1. E(R) E(R(M)) R(0) 1 n β (contd) (C) C. L. Mattoli, 2008 131

COC (C) C. L. Mattoli, 2008 132

From Market to Business n n n CAPM theory says markets determine a relationship between return and risk for securities: the SML with slope reward per unit risk. Considering more general investments, like business projects, the SML offers a benchmark for reward-risk relationships. Thus, any investment that a company makes must offer expected return at least as good as that offered, in the markets, for a particular level of (systematic) risk. (C) C. L. Mattoli, 2008 133

From Market to Business If it did not, the firm’s shareholders would be better off, investing on their own. n Our job becomes: find investments with returns superior to the markets. They will have NPV > 0. n We compare the expected return on the investment (IRR) to the return offered in the market for the same beta. n (C) C. L. Mattoli, 2008 134

The Nature of COC n n RRR for a business project means the project must earn a return equal to the RRR to have non-negative NPV. A firm must earn RRR = COC to pay its investors for the use of their capital in a project. To get the proper RRR/COC we turn to the capital markets and use the rate for level of risk to discount CF’s. Thus, COC should be a function of the investment, not the investors, i. e. , COC depends on the use, not the source of funds. (C) C. L. Mattoli, 2008 135

Financial Policy and COC n n The firm will fund itself with both debt and equity, so its COC will be a blended value. Thus, we look at its cost of debt capital and its cost of equity capital. Then, we can use the capital weightings to find WACC. Capital structure is a managerial variable. We assume, here, that cap structure is a given target capital structure with a fixed debt-equity ratio. (C) C. L. Mattoli, 2008 136

Prologue n n n By beginning with COC equity, we are doing the hard work, first. As we have seen in our discussion of applying DFCF methods to infinite-term equity can only be done in idealized circumstances. Alternatively, the RRR of a firm’s shareholders can not be computed directly but must be approximated, in one way or another. (C) C. L. Mattoli, 2008 137

Table 12. 1 (C) C. L. Mattoli, 2008 138

Capital Weightings n n There a number of ways that we could approach the weighting. For example, a firm with privately-placed equity and debt will have only accounting values for capital and weights. Better than BV’s are market values, but they fluctuate a lot. The preferred weights are so-called target capital weights: what the firm wants to be. (C) C. L. Mattoli, 2008 139

No Risk Adjustment Project COC’s SML Accept improperly WACC Reject improperly (C) C. L. Mattoli, 2008 140

Risk-adjusted Split RRR’s for Projects SML Reject WACC Accept High Risk Average Risk Low risk (C) C. L. Mattoli, 2008 141

Capital Structure (C) C. L. Mattoli, 2008 142

The Question n n Our job is to choose capital structure that will maximize firm value. Value is DFCF value, and, for a company, CF’s are discounted at the WACC, which contains capital structure weights. Value is inversely related to the RRR, so, alternatively, the question becomes: what capital structure will minimize WACC? We say one capital structure is preferable to another, if the WACC is smaller, and optimal capital structure is that which will absolutely minimize WACC, also called the target capital structure of the firm. (C) C. L. Mattoli, 2008 143

Consequences of Financial Leverage n n n Financial leverage refers to the use of debt. Lower COC debt can enhance ROE. However, debt has interest payments that must be paid: they are fixed costs. Thus, variability of income and ROE will also increase with increasing debt, but will shareholders reassess their risk in the firm? The answer is no. Shareholders can create their own, homemade leverage by splitting their money between shares and lending/borrowing, on their own. 144

Textbook Leverage Example n Figure 13. 1 Disadvantage Advantage (C) C. L. Mattoli, 2008 145

Cap Structure & COC Equity n n n Our preceding arguments about the stock price and leverage are just a special case of the Miller-Modigliani (MM) Proposition I: a firm’s capital structure is irrelevant. MM Prop 1, the Pie Model, says if the asset side of two companies’ balance sheets are the same, then, the right hand side, the capital does not matter. Capital structure is the way the pie (pie chart) is sliced, the size of the pie is the same. (C) C. L. Mattoli, 2008 146

Cap Structure & COC Equity n n According to MM I, cap structure has no affect on firm value, but it does change, so we should look at the WACC. We write WACC = RA = (D/V)RD + (E/V)Re, or RE = RA + (RA – RD)(D/E), which says RE is a straight line with slope (RA – RD) versus (D/E). This is MM Proposition II: COCE depends on: (1) ROA, (2) the cost of debt, and (3) the D/E. RE increases as D/E increases: the risk of equity returns increases with increasing leverage, which increases the RRR. (C) C. L. Mattoli, 2008 147

Cap Structure & COC Equity n n n Some simple calculations will show that RA = (D/V)RD + (E/V)RE = (D/V)RD + (E/V)[RA + (RA – RD)(D/E)] = (E/V)RA + (D/V)RA =RA. In other words, WACC is independent of capital structure (MM I, restated). The mechanism is that the increased benefit of more and more lower cost debt is exactly offset by the increasing COCE from the addition of leverage. (C) C. L. Mattoli, 2008 148

Figure 13. 3 (C) C. L. Mattoli, 2008 149

The CAPM, the SML & Proposition II n n How does financial leverage affect systematic risk? CAPM: RA = Rf + A(RM – Rf) q n Where A is the firm’s asset beta and measures the systematic risk of the firm’s assets Proposition II q q Replace RA with the CAPM and assume that the debt is riskless (RD = Rf) RE = Rf + A(1+D/E)(RM – Rf) (C) C. L. Mattoli, 2008 150

Business & Financial Risk n n MM II: firm has risk because of the business it is in and how it operates it: the business risk of the firm, represented by the first term in the MM II equation. Business risk depends on the systematic risk of the firm’s assets. The second term in the equation depends on cap structure and is dependent on the firm’s financial risk. The financial risk of equity is increased by addition of debt to the capital structure. Financial risk increases even though the business risk is constant, and that leads to increasing COCE. (C) C. L. Mattoli, 2008 151

The Affect of Taxes n n n The preceding analysis was assuming no corporate taxes. Taxes have a real affect since interest is a tax deductible expense and gets a tax shield, which is an added benefit of debt financing. On the negative side is the absolute obligation to meet promises of debt service payments. Not meeting them could result in bankruptcy. Value of a levered firm = value of an unlevered firm + PV of interest tax shield. Value of equity = Value of the firm – Value of debt. (C) C. L. Mattoli, 2008 152

Textbook Figure 13. 4 (C) C. L. Mattoli, 2008 153

MM II with taxes The WACC also decreases as D/E increases due to the effective government subsidy on interest payments n We have RA = (E/V)RE + (D/V)(RD)(1 T C) n So, RE = RU + (RU – RD)(D/E)(1 -TC) n (C) C. L. Mattoli, 2008 154

Graphical MM II + T (C) C. L. Mattoli, 2008 155

Default on Debt n n The unrealistic conclusion of MM with taxes is that we should lever the firm to almost 100% debt. Realistically, the more debt, the more obligated we are to make payments, and the risk that we cannot increases. When a debtor defaults on payments, the lenders can take him to court and lay claim to assets. A firm becomes bankrupt, in principle, when A = L, so E = 0, and transfer of control goes from owners to creditors. Bankruptcy has its costs. (C) C. L. Mattoli, 2008 156

Costs of Bankruptcy n n The precursor to bankruptcy is financial distress when the company is having difficulty meeting its debt obligations but has not yet tipped into default. At that point the company will spend time and energy in avoiding bankruptcy. Moreover, as the firm fights for its life, customers might beg off, good employees might quit, and potentially lucrative projects might be shelved. These indirect costs of bankruptcy are called financial distress costs. (C) C. L. Mattoli, 2008 157

Optimal Capital Structure. n n n Thus, the ever-increasing benefit of leverage a la MM + T is moderated by the ever-increasing probability of distress, default and bankruptcy. The result is that instead of the increasing line, in figure 13. 4, it will be humped with a peak at the optimal capital structure, thereafter decreasing with increasing leverage. We show this combined picture in the next slide. (C) C. L. Mattoli, 2008 158

Figure 13. 6 (C) C. L. Mattoli, 2008 159

Dividends & Such (C) C. L. Mattoli, 2008 160

Intro n n Then, the cash flow is rolling in. What should it do with that cash flow? We can retain some or all of these cash flows to invest in new projects or otherwise We can also distribute some cash to shareholders as cash dividends. However, should not the corporation be able to better invest the shareholder’s money than the shareholders themselves? (C) C. L. Mattoli, 2008 161

Intro n n n Cannot the shareholders create their own cash flows by selling some shares? The corporation can also do the same thing in a share repurchase, buying shares in the market, paying cash to those who want to sell shares, instead of paying dividends. Just like in the case of capital structure, there is no current comprehensive theory of dividend decisions. There are only simplified theories and some suggestions. (C) C. L. Mattoli, 2008 162

Steps in cash dividends 1. 2. 3. 4. First, a dividend must be declared by the board of directors and then. The announcement date is the date of directors’ meeting. The record date is used to identify all shareholders-of-record. The ex-dividend date is 4 days prior to the record date in a system where share transfer and settlement in the secondary market, is 5 days. Payment date is usually several weeks after the date of record. (C) C. L. Mattoli, 2008 163

Price on X n n The day before an ex-date, the stock trades with a right to receive a dividend. The next day it will no longer contain that right. Thus, the price should drop from one day to the next to reflect the loss of value of the dividend. So, if the stock was $50 on the day before ex. D, and D = $2, then, the price on the ex-date should be around $2 less, or $48. (C) C. L. Mattoli, 2008 164

Irrelevance MM showed that, under a number of specific assumptions, dividend policy affects neither the price of a firm’s shares nor a firm’s cost of capital, i. e. dividend policy is irrelevant. n It is based on the assumptions that, if there are no taxes, shareholders will be focused on total return: capital gains plus dividend yield n (C) C. L. Mattoli, 2008 165

Homemade dividends n Irrelevance relies on the basic premise that the market value of a firm q depends on the PV of future cash flows from its assets q which in turn depends on investment decisions not on dividend decisions. q Both investors and managers have the same information regarding future investment opportunities (C) C. L. Mattoli, 2008 166

Homemade dividends n n n Assume either no taxes or taxes that are the same for both capital gains and dividends, Then, SH can make their own ‘dividends’ by selling shares (alternative means of cash inflow for investors). They can neutralize dividends by purchasing more shares if dividends are paid by the company (C) C. L. Mattoli, 2008 167

In the Real World Reasons that dividends might be relevant are usually based on things like: 1. Tax differentials 2. Psychology 3. Agency costs 4. Information n (C) C. L. Mattoli, 2008 168

Residual Dividend n n Assume a company wants to maintain its capital structure but wants to minimize its need to sell new equity. Then, it will look to invest free cash flow in positive NPV projects and payout any leftovers. This is called residual dividend policy. We would expect, then, young fast-growing firms to have a low payout ratio and older mature firms with less opportunity to grow to have high payouts. (C) C. L. Mattoli, 2008 169

Stable Dividend n n As opportunities wax and wane, a residual dividend policy could have a very unpredictable pattern. The definition of a stable dividend policy is one in which the firm pays a fixed payout ratio. That will be effected either semi-annually, called cyclical policy or yearly. Most firms try to at least not cut dividends because it can send a negative signal to the markets. (C) C. L. Mattoli, 2008 170

Compromise Policy n 1. 2. 3. 4. 5. n 5 Goals dominate real world policy: Avoid cutting +NPV projects to pay D. Avoid cuts in dividends. Minimize need to sell equity. Maintain target capital structure. Maintain a target payout ratio. Companies can satisfy goals with regualr and extra dividends. (C) C. L. Mattoli, 2008 171

Additional Policy Considerations n n The clientele effect refers to that certain groups of investors will gravitate to high or low payout ratio stocks. Thus, companies might design dividend policy to attract certain investors, and it must keep that in mind when administering policy on an ongoing basis. Firm’s must also be aware of changes in the demand side of the market for dividends. Investors take signals, i. e. , infer information from dividend announcements. (C) C. L. Mattoli, 2008 172

Bonus Shares: Stock Dividends n n As an alternative to cash, dividends can also be paid out in shares, e. g. , stock dividend of 0. 1 shares per share of outstanding stock (called bonus shares in Australia). Even though there is no value paid for shares, and the value of the firm has not changed, investors can take a bonus share issue as a positive signal from management. Then, the market value will increase. (C) C. L. Mattoli, 2008 173

Share Repurchases n n A real alternative to cash dividends is for the company to repurchase some of its shares. That way, investors can get some cash. It should have no impact on value, if cash is paid to investors by dividend or by repurchasing shares. Tax-wise, though, tax must be paid on dividends, while tax is paid only by those who sell shares into the repurchase. In addition, signals can be inferred from repurchasing: if the company believes that its shares are a good buy, then, maybe they are undervalued. (C) C. L. Mattoli, 2008 174

DRIP’s n n n While some people like cash and, therefore, cash dividends, other don’t like dividends and would prefer gains in principal. Dividend reinvestment plans (DRIP’s) give shareholders a chance to not get dividends but to get growth in principal, instead. For those signed up for the plan, the company takes their dividends and exchanges the cash for new share at a discount to market value with no transactions fees. (C) C. L. Mattoli, 2008 175

Splits & Reverse Splits n n Beyond bonus shares, companies can also do share splits, e. g. , each old share becomes 2 new shares, or Reverse splits, whereby each old share might become ½ a new share. Companies do this, mainly to adjust the prices of their stocks for investors to purchase comfortably. The reason is that shares are normally sold in blocks of 100 shares; lower amounts are called odd-lots, and their purchase is more expensive in transaction costs. (C) C. L. Mattoli, 2008 176

Splits & Reverse Splits n n So, many companies try to adjust the price of their stocks, in the market, so many investors, or certain investors can purchase them. Thus, a price of $25/share means $2, 500/block. Warren Buffet of Berkshire Hathaway has taken the other tact and has a share price for his company’s stock in the range of several hundred thousand US$/share, so that only the wealthy can own his shares. Again, this is marketing and stock design. (C) C. L. Mattoli, 2008 177

Ending n n Practice exam today at 2 -4 Exam Friday, 20 th, 2: 30, rms 406/503 Help: email, text, set up office visit. Good luck. (C) C. L. Mattoli, 2008 178

END (C) C. L. Mattoli, 2008 179