Advanced Corporate FinanceRonald F. Singer

FINA 7330

Review of Financial Management

Lecture 1

Fall 2010

Administration

• Instructor: Ronald F. Singer

• Phone: 713-743-4771

• Office Hours: Tuesday 4:45 to 6:00, Thursday 4:00 to 4:45 or by appointment

• Room 210F Melcher Hall

• Webpage: www.bauer.uh.edu/singer

Class Administration

• Exams• Late Entrants• Reading, Eating, etc.• Attendance• Texts:

– Brealey, Myers and Allen, Principles of Corporate Finance, 10th ed.

– Wall Street Journal

• Valuation Problem – Groups, presentation, study

Outline

• Capital Budgeting Decision– Financial Statement Analysis – NPV Rule– Arbitrage and Risk – Time Value of Money– Complicated Decisions

• Investments– Risk versus Return– Optimal Portfolio Selection (CML)– Equilibrium Prices (SML and CAPM)

Review of Corporate Finance

• Three areas of inquiry–Capital Budgeting

–Capital Structure

–Payout policy

Capital Budgeting

• What is to be discounted?

• How do we discount?

• What is the decision rule and why?

Macintosh EnterprisesPro-Forma Income Statement

(Year ending December 31, 2008)($ thousand)

Sales $5,000 Less: Operating Expenses (COGS) 2,000 Depreciation & Amortization 500 Allocated G & A Costs 300 Operating Income (EBIT) $2,200 Less: Interest Expense 800 Earnings Before Tax (taxable income) 1,400 Less Tax (@ 35%) 490 Net Income (Earnings after Tax) $910

Earnings per Share (EPS) = Net Income/Shares = $0.91Assuming 1 million shares outstanding

8

Macintosh EnterprisesPro-Forma Cash Flow Statement(Year ending December 31, 2008)

($ thousand)Earnings Before Interest and Taxes $2,200 Less: Tax on Operations (@ 35%) (Note: not $490) 770Operating Income after Tax (EBIT(1-t) ) 1,430 Plus: Non-Cash Expenses (Depreciation & Amortization) 500Less: Change in Working Capital - 300

{Increase a/c receivable 200 increase in Inventory 100 Increase other ST Assets 100

Less: increase in a/c payable 150 Decrease ST Liabil. (50))} Change in Working Capital +300Cash Flow from Operations $1,630 Plus Interest Tax Shield (800 times 0.35) 280CASH FLOW $1,910 Less: Net New Investment (net of capital gains tax) 200

Less: Cash Flow to Bondholders (Interest, principal, Bond Repurchase, Call) 1, 270 Less: Cash Flow to Preferred stockholders 100Free Cash Flow to Common Stockholders 340EBITDA $2,700

Firm Valuation

• What determines the value of the Firm?– In a perfect capital market setting– In an efficient market setting– In the “Real World”

What determines the value of securities

• Security Pricing Models– Capital Asset Pricing Model (CAPM)– Arbitrage Pricing Model (APT)– Multifactor Model– Option Pricing or Contingent Claims Pricing

Capital Budgeting

• The Net Present Value Rule – What is it?– Why does it work?– Why would all investors regardless of their

personal preferences for current versus future consumption agree on the NPV Rule?

– Present Value and the No-Arbitrage Price • Why securities should sell at a price that is equal

to the PV of the Cash Flow to the holders.

First Separation Principle

• The firm can make a capital budgeting decision independently of how the project will be financed.

• Eventually, the firm will have to worry about how to finance the project, but the simple question right now is:– Are the benefits from investing greater than

the cost? • i.e. is the NPV of the project positive?

Risk

• Securities are priced as if the market in general is “risk averse”. That is, the typical investor appears to prefer a less risky alternative to a more risky alternative.

• So in order to induce investors to hold risky investments, the investment must be priced so as to reward the investor for the risk he takes on.

• This reward is called the risk premium associated with the expected return of risky securities, and projects.

Risk versus Return

• That is:

• E(Return of a risky venture)

= The reward for waiting plus compensation for taking on risk.

= Risk free return plus a risk premium.

Present value of what?

• We talk about the “Value” of something being equal to the “present value” of something.

What is this “something”?

CASH!!!

So, when we consider the value of a security or of a project, or of a firm, or any investment activity, we want to know what the Cash Flow will be and how to discount it.

Central Role of Cash Flow

• Capital Budgeting: Must consider Incremental Cash Flow

• Bonds and Stock (Dividends, interest, repurchases, principle)

• Investments (Free Cash Flow)

• Firm Valuation (Free Cash Flow)

Bond valuation

• What is the cash flow expected from a typical bond?

– You must be careful here to distinguish between the Coupon Rate and the Required Return.

• The coupon rate describes how the bond gets some of its cash flow out to the holders. It reflects the risk and interest rate of the Bond at the time the bond was originally issued, and may or may not be representative of the risk and level of interest rates today.

Stock

• Again, we need to find the Present Value of the Dividend stream. – Predicting the dividend stream is not easy. – We generally rely on fundamental analysis of

the value of the issuer.– Then value the firm and subtract the non-

equity securities issued by the firm to get the value of the Equity.

Investments

• Here the real question is how does a rational investor choose a portfolio of securities?

• There are three things that needs to be considered:– The Efficient set of Risky Assets

• Diversification

– The Efficient Risky Portfolio (CML)– the Relationship Between Risk and Expected Return

for:• Portfolios• Individual Securities

Efficient Set of Risky Assets

retu

rn

P

minimum variance portfolio

Individual Assets

Efficient Risky Portfolio

retu

rn

P

efficient frontier

rf

M

CML

Relationship between Risk and Return

• Efficient Portfolios (Capital Market Line)

Rp = Rf + Risk Premium

= Rf + (Rm - Rf) pp

MM

Relationship between Risk and Return

• Individual Securities (Capital Asset Pricing Model)

Ri = Rf + Risk Premium

= Rf + (Rm - Rf) ii

Capital Structure

• What is the Capital Structure Decision?

• What are the determinants of a firms’ capital structure

• What do we have to consider?

Payout Policy

• What is payout policy?

• What are the Issues?

• What factors are important?

Generally

• We look to violations of Perfect Capital markets: In particular:– Costly Information– Taxes– Agency Problems

• Failure to align

managements’ with stockholders’ interest

• Market for corporate control