Review of key concepts

C15.0008 Corporate Finance Topics

Summer 2006

What is corporate finance?

• The study of how firms raise and use money– The objective is to increase corporate wealth– “Corporate wealth” means the wealth of

stakeholders who have a say in the control of the firm

• All corporate financing and investment decisions are wealth maximizing decisions

Basic principles of finance

• “Financial markets are smart”– Markets aggregate the information available

to the multitude of investor that participates in the market. Also called “Market Efficiency”

• “No Free lunch” – The concept of no-arbitrage– You can’t make money by investing nothing– Assets that pay the same cash-flows have the

same price (also called “The law of one price”)

Basic Principles of Finance

• “A dollar today is worth more than a dollar tomorrow” – Money has time value– Impatience and inflation– Consequently, if you have to wait, you can expect to

be paid more.• “The risk return tradeoff” – Riskier assets yield

higher expected returns. – Caveat: Only “smart” risk is rewarded. Specifically

speaking, “smart” risk is sensitivity to market conditions. You don’t make higher returns from dumb gambles.

What you should know:

• Valuation equation

• Cash flows

• Discount rates (cost of capital)

• The WACC approach

What is a return?

• A return on an asset is the percentage increase in its value over any given amount of time. It includes any payouts from the asset.

• The expected return is simply the average percentage expected increase in value over the future

• Example: A stock is valued at $ 2 today. After a year, you expect it to be valued at $ 3.

• Return = (Expected future value/ Present value) – 1 = 3/2 – 1 = 50%

Return with payout

• Go back to our simple example. Assume the dividend on the stock is USD 0.5 in addition to the future expected price.

• Then return = (Expected future value/Present value) – 1 = (3+0.5)/2 – 1 = 75%

Discounting

• Discounting is the process of estimating the current value of an asset given a future value and an expected return

• For 1 year, Present value = Future value/(1+ expected return)

• For n years, Present value = Future value/(1+ expected return)n

DCF Valuation Equation

The natural (and correct) tool for project/investment evaluation is “net present value” (NPV). NPV is defined as the present value of the investment’s cash flows, or alternatively as the sum of the present values of the individual cash flows:

NPV is the dollar value of the investment, e.g., a capital budgeting project or financial investment.

T

tt

tT

tt r

CCPVNPV

00 )1()(

Estimating Cash Flows

What are the relevant project cash flows?

1) Expected

2) Incremental

3) After-tax

4) Cash flows

Incremental Cash Flows

Establish the base case, i.e., what would the cash flows look like without the project. The incremental cash flows are the difference between the cash flows with the project and without the project. • Sunk costs—excluded• Opportunity costs—included• Side effects—included

Discount Rates

Capital is expensive because there are always other alternatives for the investment of that capital, e.g., instead of undertaking a project, a firm can always return the capital to investors.

The appropriate discount rate is the rate of return that could be earned by investors on an alternative investment of equal risk, i.e., the opportunity cost of capital.

Characteristics of Discount Rates

• The discount rate increases with the (market) risk of the cash flows

• Discount rates (opportunity costs of capital) are investment/project specific

• If all a firm’s projects are of similar risk, then the risk of the firm’s cash flows will be the same as project risk the right project discount rate is the firm’s cost of capital (WACC)

Cost of Equity: The CAPM

E(R) = RF + [E(RM) - RF] = sensitivity to the market

Remember: the “cost” of equity and the expected return on equity are the same. The “cost of equity” to the corporation is the same as the return that an investor requires on it.

RF -- the risk-free rate

[E(RM) - RF] -- the market risk premium -- the stock’s beta

Estimating the Parameters

• The risk-free rate – the current Treasury yield (matched horizon)

• The market risk premium – the historical premium (or current estimate)

• Stock beta – estimated from historical returns (industry beta if not available)

Equity Betas

Stock Volatility Beta

S&P 500 10% 1.00

Wal-Mart 17% 0.21

IBM 27% 1.18

Anheuser-Busch 12% 0.36

Boston Beer 33% -0.42

Source for betas: http://finance.yahoo.com

Cost of Equity: WMT

CAPM: E(r) = rF + [E(rM) - rF]

= 0.21 (Friday, June 24th)

rF = 5.23% (10-year Treasury yield)

E(rM) - rF = 6%

E(r) = 5.23% + 0.21(4%) = 6.49%

Cost of Debt: WMT

Maturity Yield

2/15/30 5.39%

Rating: AA/Aa2

rB = 5.39%

rB(1-Tc) = 5.39% (1-0.35) = 3.51%

Where Tc is the corporate tax rate

Source: NASD TRACE database

Weights

Assume: constant capital structure• Weights depend on market values of the various

sources of financing• Book value of debt is often used instead of

market value due to data availability• Target (average) weights, not the specific source

of funds used to finance the project

Financing Mix: WMT

• Equity market cap as of 23rd June, 2006:

= $199.8 billion

• Debt value (balance sheet): B = $29 bill.

• Weights:

V = B+S = 228

wB = B/V = 13% wS = S/V = 87%

After-Tax WACC: WMT

WACC = wB rB(1-T)+wS rS

WACC = 0.13(3.5%) + 0.87(6.5%) 6.11%

The WACC is WMT’s discount rate for average risk projects. These projects only create value (i.e., NPV>0) if they return more than 6.6%

Non-Average Risk Projects

WACC is fine for average risk projects, but what if a project is not of average risk, e.g., a multi-division firm?

Use project cost of capital (otherwise high risk projects look too good and low risk projects look too bad):

1) Make an ad hoc adjustment

2) Estimate risk from project returns

3) Estimate the WACC via the pure play method

The WACC approach

NPV = tUCFt / (1+rWACC)t

UCF – unlevered (total) cash flowsUCF = EBIT(1-T) + depreciation – capex – nwc

rWACC – weighted average cost of capital

The WACC approach works at the project level and at the firm level.

Assignments

• Reading– RWJ: Chapter 22.1-22.6, 22.8– Problems: 22.1, 22.2, 22.8

• Problem sets– Problem Set 1 due next Wednesday