Review of key concepts

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Review of key concepts

• C15.0008 Corporate Finance Topics
• Summer 2006

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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

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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 cant make money by investing nothing
• Assets that pay the same cash-flows have the same
  price (also called The law of one price)

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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 dont make
  higher returns from dumb gambles.

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What you should know

• Valuation equation
• Cash flows
• Discount rates (cost of capital)
• The WACC approach

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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

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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 (30.5)/2 1 75

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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

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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 investments 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.

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Estimating Cash Flows

• What are the relevant project cash flows?
• 1) Expected
• 2) Incremental
• 3) After-tax
• 4) Cash flows

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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 costsexcluded
• Opportunity costsincluded
• Side effectsincluded

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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.

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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 firms projects are of similar risk,
  then the risk of the firms cash flows will be
  the same as project risk ? the right project
  discount rate is the firms cost of capital (WACC)

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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 stocks beta

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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)

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Equity Betas

• Stock Volatility Beta
• SP 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
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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

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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
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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

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Financing Mix WMT

• Equity market cap as of 23rd June, 2006
• 199.8 billion
• Debt value (balance sheet) B 29 bill.
• Weights
• V BS 228
• wB B/V 13 wS S/V 87

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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 WMTs discount rate for average risk
  projects. These projects only create value (i.e.,
  NPV0) if they return more than 6.6

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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

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The WACC approach

• NPV ?tUCFt / (1rWACC)t
• UCF unlevered (total) cash flows
• UCF 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.

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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