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67 Cards in this Set
- Front
- Back
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What is capital budgeting? |
The total value of assets. |
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What is capital structure? |
The total firm value to investors (made up of liabilities and shareholder equity) |
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How do you maximize the value of a business? |
1. Investment Decision 2. Financing Decision 3. Dividend Decision |
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What is the principle of Corporate Finance? |
Invest in projects that yield a return greater than the minimum acceptable hurdle rate (diskless rate + risk premium) |
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What is the objective of corporate finance? |
To maximize the value of the firm (shareholder equity) |
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What is a discount factor? |
Present value of a future payment |
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What is the basic principle? |
A dollar today is worth more than a dollar tomorrow. |
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What is the rate of return rule? |
Accept investments that offer rates of return in excess of their opportunity costs of capital. |
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What is the weighted average cost of capital? |
weights cost of debt and equity by proportion of each type of capital employed (used as discount rate) |
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What is cost of debt? |
Interest rate at which the company could raise its new long-term debt corresponding t its targeted structure |
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What is CAPM? |
Securities Market Line, where SML describes expected return for all assets and portfolios in economy |
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What are the characteristics of debt? |
-fixed claim -tax deductible -high priority -fixed maturity -no management control |
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What are examples of debt? |
-bank debt -commercial paper -corporate bonds |
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What are characteristics of equity? |
-residual claim -not tax-deductible -lowest priority -infinite management control |
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What are examples of equity? |
-owner's equity -venture capital -common stock -warrants |
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What is the cost of capital? |
Expected return on a portfolio of all the company's existing securities. Opportunity cost of capital for investment in firm's assets. |
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What is the hurdle rate? |
If returns are measured to equity investors, use cost of equity. If returns are measured to capital/firm, use cost of capital. |
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What is operating leverage? |
Percentage of fixed costs in a company's cost structure. Higher degree of operating leverage means more risk. Operating leverage measures sensitivity of EBIT in comparison to output volume. |
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What is financial leverage? |
Degree at which investor's borrow money. It can increase shareholder return on investment and there are tax advantages. The capital structure (leverage) affects beta estimate. As beta increases, the firm is burdened with more debt. |
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What are debt covenants? |
A bond covenant that limits or restricts any additional debt that may be incurred by issues. Debt limitations look to protect the current lenders by maintaining the firm's degree of leverage. |
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What is short-term financial? |
Networking capital=assets-libabilities
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How do you measure a firm's financing mix? |
Debt to capital ratio=debt/(debt+equity) |
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What is a credit rating? |
An assessment of credit worthiness of individuals and corporations. Based on history of boring and repayment. Based on likelihood that bond issue will make interest payments, investment grade and non-government grade. |
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What is the conflict of interest in regards to credit rating? |
Issuers select and pay the rating agencies for their bonds. |
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What are valuation approaches? |
1. Intrinsic Valuation: value of an asset is a function of its fundamentals. Essentially discounted cash flow to estimate. 2. Relative Valuation: based on what investors are paying for similar assets. This takes advantage of price multiples. 3. Contingent Claim Valuation: contingent on an external event. |
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What are valuation methods? |
-Market based (comparable transactions and companies) -Cash-flow Based (discounted cash flow (either WACC, dividend), economic value added, or real options valuation) -Other (asset valuation or payback method) |
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What are the pros of discounted cash flow? |
-analytically correct based on CAPM -includes systematic and specific risk -requires no comparison -generates intrinsic value |
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What are the cons of discounted cash flow? |
-projections are subject to individual assessment -calculating terminal value requires assumption |
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What are the strengths of discounted cash flow? |
-closest to intrinsic stock value -helps investors steer clear of inexpensive companies -relies on FCF -can also apply sanity check -identifies where companies coming from |
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What are weaknesses of discounted cash flow? |
-ony as good as input assumptions -works best when high degree of confidence about future cash flows -susceptible to error -asumes management doesn't play active role -constant WACC does not reflect reality |
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What is the structure of discounted cash flows? |
It is the gross value of the company. -Terminal value (projects expected cash flows) -present value of cash flow during planning period -non-operating assets |
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What are the steps to calculate shareholder value? |
1. Determine planning horizon 2. Project cash flows for planning horizon 3. Determine corporate cost of capital (WACC) 4. Discount future cash flows with WACC toobtain firm value net of non-operating assets 5. Determine residual value 6. Determine value of non-operating assetsto obtain firm value 7. Determine market value of debt 8. Subtract market value of debt from firmvalue to obtain shareholder value |
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What are free cash flows? |
All cash flows available for satisfying claims of investors |
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How do you calculate residual value? |
-Exit Multiple Method: based on transaction comparables and historical premiums paid for control -Growing Perpetuity Method: company continues operating in perpetuity an generates FCFs |
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How do you arrive at the market value of debt |
-use market prices (if not available use equivalents)
1. Identify contractual payments 2. Identify credit rating of instrument 3. Estimate market prices through comparable instruments with equal coupon duration, rating, etc 4. Calculating present value of debt payments using effective interest on equivalent instruments (if no equivalents exist, discounted book values have to be used) |
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What is hybrid debt? |
Complex instruments. You would need to separate into individual components and value using specific monitors. |
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What are multiples for valuation? |
- Quickest way to value a company, anduseful in comparing similar companies or similar transactions -Based on ‘law of one price’ (i.e.similar assets have similar prices) -Market-based valuation compared tocash-flow based valuation -Attempt to capture firm’s operating andfinancial to yield and entity or enterprise value |
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What are valuation methods? |
-Equity Value -Enterprise Value |
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What is comparable companies analysis? |
It compares public market valuation levels, stock trading patterns, and basic operating and financial ratios of companies in the same industry in order to derive benchmarks. Benchmark multiples combined with company data yields valuation ranges. |
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What are the pros of comparable companies analysis? |
-flexible valuation tool -place company in industry context -represents view of financial market -can be used to analyze breakdown |
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What are the cons of comparable companies analysis? |
-every company is different -thinly traded stocks, small capitalization, and poorly covered stock do not fully reflect financial value -figures fail to capture intangible values -valuation is mainly influenced by external market conditions -growth only valued simplicity by level of multiple |
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What are types of Comparable Companies Multiples? |
-EV/Sales (for fast growing companies and industries far away from maturity) -EV/EBITDA (high depreciation levels can distort valuation, comparison of asset-intensive companies with companies that have different investment patterns) -EB/EBIT (most common for describing operational power of company) -P/E (used in public capital markets, doesn't take differences in taxation and financial structure of companies into account) |
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How do you calculate multiples? |
1. Comparable Companies Multiple (share price x outstanding shares) 2. Comparable Transaction Multiple (Purchase Price x outstanding debt) |
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What is the After-tax WACC? |
The tax benefit from interest expense deductibility must be included in the cost of funds. This tax benefit reduces the cost of debt by a factor of the marginal tax rate. |
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What are the assumptions of MM? |
-homogeneous, costless, complete information -constant investment policy -unlimited access to capital markets -no costs of financial distress -no transaction costs -no or lump-sum taxes |
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What are the real world implications of MM? |
-agency problems due to asymmetric information -agency problems, managerial incentive problem -limits to external financing, pecking order -direct and indirect costs of financial distress -transaction costs associated with the issuance of financing instruments -convexity in tax systems |
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What is Financial Distress? |
-represents a state in which severe financial limitations impose binding constraints on management -an insolvent firm is under financial distress but a distressed firm is not always insolvent -exposer to financial distress risk rises with D/E and leads to higher cost of debt -costs arising from bankruptcy or distorted business decisions before bankruptcy are direct and indirect costs |
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What is the principal agent theory? |
It arises within the firm when managers act other than in the interest of the shareholders. The problem is to design monitoring or incentive systems that make managers act in the best interest of the shareholders. This deals with problems that arise under asymmetric information when principal hires agent and the two don't have identical interests? |
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What are solutions to the principal agent theory? |
Introduce incentives to align with the gals of the agents and principals. This ensures managers have interest in value of the shares. It fives managers shared interest in profit by tying some part of their remuneration directly to the firm's profits. It makes promotion subject to the profits of the company as a whole or to the section in which the person is employed. |
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What is the agency cost? |
It arises whenever you hire someone else to do worthing for you because your interest (as a principal) may deviate from those of the person you hired (as agent) |
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What can a clash of interest lead to? |
Stockholders investing in riskier projects, and paying themselves large dividends when you would rather have them keep the cash in the business. |
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What are the characteristics of corporations? |
Firm as a 'nexus of contracts'. There are three distinct interests: separation of ownership and control. Shareholders (ownership, principal), BOD (control), and top management (Implementation, agent). It has a limited liability, unlimited life, transferable ownership and is a taxable entity. |
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What are examples of agency/problem costs? |
-Direct expropriation:take cash out, looting assets, low transfer pricing -Wide scale looting during Russian privatization -Indirect expropriation by non-optimal invest (empire building: excess firm expansion, hubris: incorrectly assessing an investments worth, underinvestment/ over-investment, not maximizing shareholder wealth) -indirect actions: shrinking, excess consumption of perks -illegal actions: insider trading, misleading statements |
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What are ways to manage agency problems? |
-Board of Directors – outsiders vs.insiders, CEO, size (bigger boards are more dysfunctional), composition ofaudit, nominating and compensation committees -Firm’s voting structure – dual classstocks, concentrated vs. disperse ownership -Inventives -takeover market - antitakeover provisions, regulations, ownership structure -managerial labour market -judicial review -Government -monitoring function |
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What is the agency view of Financial Contracting? |
covenants help resolve agency problems of financial contracting, as it prohibits certain actions and specifies certain actions. |
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What are instruments to resolve agency conflicts of equity financing? |
-Ex-ante preventative control (capital structure policy, supervisory board, supervisory investors,management compensation schemes) -Ex-post corrective control (managerial labour market, market for corporate control, ownership structure, company charter/board by-laws) |
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What are instruments to resolve agency conflicts of debt financing? |
-ex-ante preventative control: behavioural constraints for shareholders, assignment of control rights to creditors, third-party monitoring -ex-post corrective control: co-decision making/veto rights potable debt (exit option), convertible debt )switch options) |
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What is the Pecking Order Theory? |
It states that firms prefer to issue debt rather than equity if internal finances are insufficient 1. Firms use internal funds 2. Issue Debt 3. Raise equity |
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What is Pecking Order Theory motivated by? |
Asymmetric information: as managers know more about their company's prospective risks and value than outside investors, this affects the choice between internal and external financing and between the issue of debt or equity. |
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What is shareholder value? |
Management should first condor the interest of shareholders in its business decisions. |
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What is stakeholder value? |
Management should serve the interests of all stake holders |
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What are the types of dividends |
-cash dividend -special dividend -liquidation dividend -stock dividends/stock split -share repurchases |
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What are the steps for how dividends are determined? |
1. Firms have longer term target dividend payout ratios 2.Managers focus more on dividend changesthan on absolute levels 3.Dividends changes follow shifts inlong-run, sustainable levels of earnings rather than short-run changes inearnings 4. Managers are reluctant to make dividendchanges that might have to be reversed 5. Firms repurchase stock when they haveaccumulated a large amount of unwanted cash or wish to change their capitalstructure by replacing equity with debt |
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What is the method of dividend payments? |
1. Declaration date 2. Ex-dividend date: determines whether a shareholder is entitled to payment 3. Record date 4. Payment date |
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What are share repurchases? |
A company is buying back its shares from the marketplace, reducing the number of outstanding shares on the market. When this happens, the relative ownership stake of each investor increases because there are fewer shares of the company. |
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What are reasons for repurchasing? |
-one-time return of cash to investors -may provide a way to increase insider control -way to support a company's stock price -method of paying out earnings that is tax-advantaged |
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What are methods of repurchasing stock? |
-repurchase tender offer -open market repurchase -privately negotiated repurchase |
