Corporate Finance:

Capital Budgeting: - Decisions based on CF

Sunk Costs excluded from NPV analysis; Externalities included; CFs based on Opportunity Costs; Timing
of CFs important; CFs based on after tax!
MACRS -> Modified Accelerated Cost Recovery System (like CCA Rates)
Half year convention -> assumes asset placed in service in the middle of the first year; not adjusted for
salvage value;
Incremental CFs: 1 Initial Outlay, 2 operating CF; 3 Terminal Year CF
1 - Initial Investment Outlay : FCinv + NWC Inv
NWC Inv = non-cash current assets - non-debt CLs = NWC
* If NWC Inv is +ive, represents cash needed (outflow) and Need addl cash to fund inc
@ termination, firm should expect inflow equal to initial NWC outflow for example.
2 - Incremental After-tax Operating CFs = Sales Cash expenses Depreciation x (1-t) + D
= (S C D) (1 T) + D

OR

= (S C) (1 T) + TD

*NI Impact: (1-T) + (TD)

3 - Terminal Year After-tax non-operating CFs : (TNOCF) * At end of assets life, cash inflows -> after-tax
salvage value & return of net working capital.
TNOCF = Sal T + NWC Inv T (Sal T B T)
Sal T = pretax cash proceeds of sale of Fixed Assets;

B T = book value of fixed capital sold.

Replacement Project Analysis:

Reflect the sale of the old asset in the calculation of the initial outlay:
1 - Outlay = FCInv + NWC Inv Sal0 + T (Sal0 B0)
Incremental operating cash flows -> CFs from new asset minus CFs from old asset:
2 - CF = (S - C) (1-T) + DT
3 TNOCF = (Sal T new Sal T old) + NWC inv T(SalT new BVT new) (SalT Old BVT Old)
* Inflation Effects!!-> if inflation is higher than expected, reduce FVs;

opposite for lower

Mutually Exclusive Projects with Different Lives:

Least common multiple of lives approach: Least Common Lives & Chain NPV
Equivalent Annual Annuity Approach (EAA): Use TVM function on calc, solve for PMT, Highest EAA wins!
Seems like the LCM approach takes IRR priority over NPV, but just do the calcs anyways to be safe
EAA method inputs the NPV calcs into the TVM buttons on calculator -> solve for PMT -> choose highest!
Capital Rationing -> Maximize firm NPV among potential projects within budget
Finite capital for projects: Which one to choose from? Choose combination that yields highest NPV.
Sensitivity analysis -> start w base case, then input (indep variable) to see how sensitive dependent
variable (result)is one at a time;
Scenario analysis -> multiple varaibles at a time (worst case scenario and best case scenarios)
Simulation Analysis (monte carlo):
CAPM:

probability distribution

RF + (Rmk RF)

Real Options -> Timing, Abandonment [put], Expansion [call], Flexibility, Etc.
Overall NPV = Project NPV Option Cost + Option Value;

Calc NPV w/o; option must have value

Accounting Income Vs Economic Income:

Economic Profit -> Measure of profit in excess of dollar cost of capital invested in a project.
EP = NOPAT - $WACC
NOPAT = Net Operating Profit After Tax = EBIT (1 Tax Rate)
$WACC = Dollar cost of capital = WACC x Capital
Capital = dollar amount of investment
Economic Income

= Cash Flow + (end mkt value beginning market value)

= CF Economic Depreciation; ED = (beg mkt end mkt)

NPV = MVA (Mkt Value Added)

EPt / (1+WACC)T
*same as NPV!

Residual Income = Net Income Equity Charge;

Re: reqd return on Equity;
Bt-1: beg period BV of Equity
Claims Valuation Approach -> divides operating cash flows based on Debt & Equity. Values company, not
project
Capital Stucture:
Mogdalini and Miller.
MM1 (no Tax) : Capital Structure not relevant (no Tax, trans costs, bankruptcy costs)(borrow/lend @
RFR);
VL = VU;
MM2 (no Tax): Cost of Equity increases as proportion of debt financing increases; Debt has priority claim
on assets and income. risk to equity holders inc as use of debt inc .
re = ro + D/E (ro rd);

e-> equity; d-> debt; o -> unlevered cost of capital

MM1 (with Tax): optimal capital structure is 100% debt:

MM2 (with Tax): WACC minimized @ 100% Debt;

VL = VU + (T x D);
rc = ro + D/E (ro-rd) (1-TC)

Cost of Financial Distress: (Bankruptcy, etc) discourages use of debt; Direct -> Legal Fees, admin fees,
bankruptcy fees; In Direct: forgone investment opportunities, losing trust, etc
Agency Costs: Cost associated with Conflicts of interest between Managers and Owners (Compensation,
Monitoring Costs, bonding costs)
Costs of Asymmetric Information: taking on debt signals confidence. Issuing equity signals that mgmt.
considers stock to be overvalued.
Pecking Order Theory: Internally Generated Equity (Retained Earnings), Debt, External Equity
Static Trade-off Theory: There is an Optimal Capital Structure; VL = VU + (T x D) (cost of fin. Distress)
Target Capital Structure Vs Optimal: Target changes depending on economic conditions; Equity value
fluctuates, debt ratings (S&P, Moodys).

International Differences:
Japan, Italy France
More debt use
Shorter Debt Maturity (Japan)
Emerging -> shorter and less debt

Legal Factors:

US, UK
Less Debt Use
Longer Debt Maturity
Developed -> Longer and more debt

weak legal system -> use more debt and shorter debt

Information Asymmetry: high level >use more debt

(managers & investors big gap -> high);

auditors & clarity -> low

Taxes:

lower dividend tax inc use of Equity

Banking System:
debt

Liquid Capital Markets -> use longer debt; More Reliance on banks -> higher

Macro Economics:
Inflation higher -> less debt & shorter term; GDP: higher GDP growth -> longer
maturity debt
Dividend and Share Repurchase
Dividend Irrelevance: Too high? Use $ to buy back same stock; Too low? Sell some stock & keep $
Bird in Hand: Certain Dividends now better than future expected gains;
Signals: Dividend initiation could mean company is optimistic about sharing wealth with investors;
However, could signal a lack of profitable reinvestment opportunities;
Clientele Effect -> varying dividend preferences of different groups; Eg. High tax bracket investors (low
div) vs Low bracket (high div)
P = $ D (1-TD) / (1 TCG);

If TD > TCG, Price shall decrease less than D

P = change in price when stock goes from Div to ex-div

Agency Costs: Managers Vs shareholders
Factors Affecting Dividend Policy:
-

Investment Opportunities; Expected Volatility of Earnings (long-run); Financial Flexibility )(repurchases less sticky than div policy); Tax Considerations; Floatation Costs (issue new stock);
Contractual/Legal Obligations (Covenants, etc).

Double Taxation ->

EFT = corp tax rate + (1 corp tax rate) (Indiv tax rate)

Split Rate -> two rates, one for retained and one for div
Imputation Tax System ->

eft = shareholder marginal rate

Target Payout Ratio Adjusted Model

Expected div = (previous div) +[ (expected inc EPS) x (target payout ratio) x (adjustment factor)]
Adj factor = 1/# years over which the adj in dividend takes place

*actual payout ratio could

inc/dec counter intuitively
from year to year

Constant Dividend Payout Ratio Policy (seldomly used!)

Residual Dividend Model:
Dividends paid are earnings less funds retained to maintain capital budget

Share Repurchases -> Company buys back shares of own common stock (Price signaling, offset dilution,
inc leverage, tax advantages, etc)
$ repurchases vs $ dividend -> same thing.

EPS = (earnings after tax cost borrowing) / # shares

If EY > cost of debt, then new EPS will be higher ; EY < cost of debt -> New EPS lower
Less US companies pay Div than European; Develped ->trend is less; Share repurchases trend (US&EU)
Dividend Safety ->

*less than 1 unsustainable

Dividend payout ratio = Div / NI -> Inverse of Div coverage ratio

FCFE Coverage =

FCFE

(CF Available after WC & FC are accounted for)

Dividends + share repurchases

Corporate Performance: Governance & Ethics
Internal Stakeholders: stockholders; employees, managers, board members
External Stakeholders: customers, suppliers, creditors, unions, govts, local communities, general public.
Utilitarianism: Greatest good for largest number of people
Corporate Governance: System of principals, policies, procedures & clearly defined responsibilities &
accountabilities used by stakeholders to overcome conflicts of interest inherent in corporate form.
2 Objectives: 1- Eliminate /Reduce conflicts of interest; 2 Use Company assets in measure w best
interest of owners;
Board of Directors: Institute corporate values; create long term objectives; Determine mgmt.
responsibilities / evaluate performance/compensation; meet regularly

At least should be independent; chairman should be independent; Qualifications; Election process:

Staggered ensures continuity, although prevents turnover; Self-assessment annually, Meet w/o mgmt.
regularly; Audit committee.
Mergers and Acquisitions:
Acquisition -> one company buys only part of another (purchase of assets, distinct segment (subsidiary),
etc.)
Merger -> Acquirer absorbs entire target company -> only one remains (like Jet Li)
Statutory Merger -> Acquiring company acquires all of Targets As & Ls
Subsidiary Merger -> Target becomes subsidiary of purchaser
Consolidation -> both cease to exist in prior form; Form completely new company
Merger Types
Horizontal: often competitors; same or similar industry
Vertical: forward integration -> towards customer;

backward integration -> buy supplier

Conglomerate -> Separate Industries

Synergies: combined Company worth more than 2 separate entities;
Bootstrapping EPS:
acquirer.

External vs Organic Growth

Packaging combined earnings for 2 companies after merger to increase EPS of

High P/E (growth firm) acquires low P/E (Mature) to create apparent synergies
= Improve EPS; Numerator = Sum [tot. earnings]; Denominator = less than sum [tot. shares outstanding]
Industry Life Cycle: Pioneer/Development (large capital needs, no profit); Rapid Growth (high profit
margins, little competition); Mature Growth (reduced margins); Stabilization Phase (growth matches
overall economy); Decline Phase;
Acquisition Types: Stock Purchase and Asset Purchase
Stock Purchase: acquirer gives target cash and or securities in exchange for shares of targets stock;
Needs majority consent, shareholders bear tax benefits/consequences; Must be entire A&L of company
Asset Purchase: Buys Targets Assets, payment made to FIRM not shareholders. Majority not reqd
Payment Method: Stock -> Target shareholders share in risk; valuation overpriced stock signals;
Bear Hug -> in hostile bid -> approaches targets board of directors directly with merger offer.

Tender offer -> acquirer offers to buy shares directly from shareholders (each accept/reject)
Proxy Battle -> seeks to control board by having shareholders approve new board
Defense Mechanisms:
Pre-Offer
Poison Pill -> gives current shareholders the right to purchase additional shares of stock @ extremely
attractive prices (e.g. Discount to market value); usually triggered when equity stake exceeds some
threshold level.
Flip-in Pill -> targets shareholders can buy target shares @ discount
Flip-Over Pill -> targets shareholders can by acquirer shares @ discount
Dead-hand -> in friendly merger = board has right to redeem pill prior to triggering event
Poison put (Bondholders) -> gives bondholders option to demand immediate repayment of bond.
Staggered Board, Restricting Voting Rights; Supermajority Voting; Golden Parachutes (lucrative $
payouts for Mgmt if they leave); etc
Post-Offer
Just-Say-No; Litigation; Greenmail (allows Target to buy back shares @ premium); Share-Repurchase;
Leveraged Re-Cap; Crown Jewel (target sells major asset to neutral 3rd party); Pac-Man Defense; White
Knight (Friendly 3rd Party bid-up price); White Squire(Friendly 3rd party buy portion of target)
Herfindahl-Hirschman Index
MSi = Mkt Share ; N = # firms
Calculate HHI before and After Merger
Sum of Squared Mkt. Shares of firms in industry

HHI < 1000 is okay

Between 1000 and 1800 moderate
> 100 Might be challenged
Post-Merger HHI > 1800 Highly concentrated
> 50 challenged

Valuing Target Company: Discounted CFs; Comparable Company; Comparable Transaction ->
Discounted CFs:

6 Steps

#1) ,2 or 3 stage Model;

#2) Pro-forma statements;

#3) FCFF using Pro-forma:

NI
+Net Interest After Tax

= [int expense int income] x (1 marg tax rate)

= Unleveraged Net Income

= EBIT x (1-tax)

+/- deferred taxes

= Net Operating Profit less adjusted taxes (NOPLAT)
+ Net Non-cash Charges
+/- WC

= [Net WC = CA-CL]

- Capital Expenditures
= FCF (Free Cash Flow)
#4) Discount the FCF to present value @ appropriate discount rate [WACC} -> adj WACC
FCFF = NI + NCC (non-cash charges) [Int X (1-Tax)] FCInv WC Inv
#5) Determine Terminal Value & Discount back to present -> 2 Ways:
Constant Growth:

Terminal Value T = FCFT (1+g)

(WACCadj g)

Market Multiple:

Terminal ValueT = FCFT x ( P/FCF)

-> P=Projected Price

#6) Add Discounted FCF for 1st Stage & Terminal Value to determine value of the Target
Using Comparables:
#1) Identify a set of Comparable Firms (same industry, size, capital structure)
#2) Calculate Various relative value measures: EV (Enterprise Value); EV to EBITDA; EV to sales; P/E; P/S;
P/B; etc.
#3) Calculate Descriptive statistics for relative value metrics and apply those measures to the target
firm: mean, median, range:
eg. Value = EPS x (P/E)
#4) Estimate Take Over Premium ->
DP = Deal Price per share;

TP = (DP-SP)/SP

SP = Target Company Stock Price

#5) Calculate estimate stock value based on comparable + Take-over premium

Using Comparable Transaction Analysis: No need to apply TP. (1,2,3 of above but with transactions)
Compare Methods:
DCF: +ives: easy, customizable, fundamentals; -ives: difficult when CFs are ive, estimates subject to
error, discount rates ; etc
Comp. Company:
data easy to access; estimates directly from mkt; However: assumes mkt is
accurate (may not be), difficult to incorporate synergies;
Comp transaction:

No TP needed; BUT hard to find suitable comparables that are recent enough

Post-Merger Value of Acquirer: Combined Firm should be worth more than the sum of the 2 separate
parts: 1 + 1 = 3!
VAT = VA + VT + (S-C);
VA & VT are pre-merger values of target and acquirer; S= Synergies created; C =
cash paid to target shareholders
Gains to Target:

Gain T = TP = PT VT

Gain to Acquirer:

Gain A = S TP = S (PT VT)

* if paid by new stock -> PT = (n x PAT)

Non-cash PT = (N x PAT) N = # shares target receives

Acquirer wants lowest price; Target wants highest; Payment Method, Acquirer assumes risk, receives
reward (cash payment);
Historical -> target gains 30%; Acquirer loses 1-3%; Winners curse; overestimate synergies (managerial
hubris)
Divestiture: Company sells, liquidates, spins-off a division or subsidiary
Carve-Out: new independent company
Spin-Off: Carve-out, but shares are not IPO, they are distributed proportionally to shareholders of
parent;
Split-Off: Share can be exchanged between parent and new company (choice of ownership)
Liquidation: break up firm; sell piece by piece.