- Know the relationship between BDY, BEY, HPY and EAY well i.e. what the drawbacks are of each and which gives higher or lower results relative to the others.
- Know how to calculate BDY, BEY, HPY and EAY very well
- The money market yield (MMY) is the holding period yield (HPY) times 360/t and is always greater than the discount yield (BDY) which is the actual discount from face value times 360/t, since the holding period yield is always greater than the percentage discount from face value. A security’s BDY and MMY always <>, and its EAY always > BEY.
- So EAY > BEY > MMY > BDY
- For pricing debt or equity, use market price rather than face value or book value
- weak on finding the Beta for a project calculation - probably just a brute for memorization
LOS 44b - Discuss the basic principles of capital budgeting, including the choice of the proper cash flows
Capital budgeting includes 5 key principles:
- Decisions are based on cash flows, not accounting income; so take into account incremental cash flows; do not consider sunk costs such as market research into a potential new product; consider negative externalities such as cannibalisation and positive ones which may boost another product.
conventional cash flow pattern = negative first cash flow, positive cash flows from then on
unconventional cash flow pattern = sign on the cash flow changes more than once - Cash flows are based on opportunity costs e.g. account for the cost of the company-owned land that a proposed new building would occupy
- Timing of cash flows - earlier cash flows are more valuable than later ones
- cash flows are analysed on an after-tax basis - we want to know what we keep from the project
- financing costs are already reflected in the required rate of return i.e. the discount rate used in the capital budgeting analysis takes account of the firms cost of capital; only projects expected to return more than the cost of capital needed to fund them will increase the value of the firm
LOS 44c - Explain how the following project interactions affect the evaluation of a capital project:
- Independent versus Mutually Exclusive Projects Independent projects are unrelated to one another and can be evaluated based on their own profitability. Mutually exclusive projects = only one project in a set of projects can be accepted.
- Project Sequencing Just as it sounds. the order of projects is important. choosing a certain project now may provide opportunities for other projects if profitable. If unprofitable, it precludes the other project.
- Unlimited Funds versus Fund Rationing If you have unlimited money, choose the projects which will make more than the cost of capital. With constraints on money, you will have to prioritise projects and ration money to those projects that make the most monetary sense.
LOS 44d - Calculate and interpret the results using each of the following to evaluate a single capital project: NPV, IRR, payback period, discounted payback period, and profitability index (PI)
NPV is the sum of all the present values (including any initial negative outlay) of the expected incremental after-tax cash flows if a project is undertaken, discounted at the firm's cost of capital (adjusted for risk). A positive NPV is expected to increase shareholder wealth and vice versa. For independent projects, the NPV decision rule is to accept any project with a positive NPV
IRR is the discount rate that makes the after tax PV of all the cash flows (discounted at the firm's cost of capital) equal to the initial cost of the project i.e. makes PV(inflows)=PV(outflows) and therefore is the discount rate that makes the NPV = 0. IRR Decision Rule (1) determine required rate of return for a project (usually firm's cost of capital adjusted for risk) and (2) if IRR > cost of capital then accept.
Payback Period (PBP) is the number of years it takes to recover the initial cost. You may be given a Cumulative Net Cash Flows (NCF) table which is a running total of how much you have paid down on the initial cost or how much profit you have made. If the breakeven point is between two years, divide the NCF at the start of the year by the next cash inflow (the next year) e.g. -400/1200 will give you 0.333 of a year.
PBP Decision rule Payback period is about liquidity i.e. when will i have the money back so i can do something else with it. It is not for accept/reject because it does not take into account time value of money or cash flows beyond the payback period (so terminal/salvage value wouldn't be included).
Discounted Payback Period = # of years it takes to pay back intial outlay in PV terms and therefore is always greater than non-discounted PBP. Addresses TMV drawback of PBP but does not address the other concerns.
Profitability Index (PI) = the PV of a project's future cash flows divided by the initial cash outlay. i.e. PI = PV of future cash flows including intial cash flow/initial cash flow = CF0 + NPV/CFo
If NPV is positive then PI will be greater than one. Therefore, if PI > 1.0 accept the project.
- So if NPV is positive, IRR will be greater than cost of capital and PI will be > 1.0
LOS 44e: Explain the NPV profile, compare and contrast the NPV and the IRR methods when evaluating independent and mutually exclusive projects, and describe the problems associated with each of the evaluation methods
- NPV profile depicts the NPV of (multiple) projects at varying costs of capital. The cost of capital is along the x axis so the IRR will be where the NPV profile intersects the x axis i.e. where NPV = 0
- NPV profiles intersect where their NPV's are equal (the crossover rate); in the below profile, project 1 has a higher NPV at discount rates lower than 7.2% and project 2 has higher NPV at discount rates higher than 7.2% (so the discount rate determines which project has a higher NPV)
- The NPV profiles intersect because of the timing of their cash flows; the NPV of a project (e.g. project 1) will fall faster if it has later cash flows than another project (project 2)
key advantage of NPV = direct measure of the expected increase in shareholder value (therefore, preferred method). disadvantage = does not tell you the size of the project e.g. a project that cost a $1,000,000 but has a positive NPV of $10 is probably not a wise investment
key advantage of IRR is that it solves the latter problem; measures profitability as a percentage i.e. return on each dollar invested. We can tell how far the project has to fall before it becomes uneconomical/ distadvantage: (1) can produce different rankings than NPV approach for same projects (2) possibility that there are multiple IRR's or no IRR for a project (due to unconventional cash flows for projects with positive NPV)
when in doubt (for mutually exclusive projects) use NPV IRR can be huge for a very small project e.g. investing $10 and making $100 might give you an IRR of 85% but only increases shareholder value by $90 whereas a large investment of a smaller IRR (say 20% IRR on a million bucks) is obviously a better investment.
NPV implicitly assumes that the money made could be reinvested at the discount rate used which is realistic whereas IRR implies it could be reinvested at the IRR rate which is not realistic.
LOS 44f: Describe and account for the relative popularity of the various capital budgeting methods and explain the relation between NPV and company value and stock price
Capital budgeting method varies according to:
Location European countries tend to use PBP method as much as IRR/NPV
Sophistication - the more sophisticated the company (size/education/private) the more likely the IRR/NPV method is used
Relationship between NPV and Stock Price
in theory, a positive NPV should cause a proportionate increate in a company's stock price. e.g.
- if share price is $10 with 1000 shares outstanding then value = $10,000
- if NPV of new project is $2000 then new value of company = $12,000
- new share price = 12,000/1000 = $12
in reality, share price is more function of expectations about earnings so announcement of NPV positive project may cause share price to drop if NPV is less than expect or it might rise disportionately if the project signals other projects or expectations
LOS 45a: Calculate and interpret the weighted average cost of capital (WACC) of a company
Calculate WACC = (wd)[kd(1 - t)] + (wps)(kps) + (wce)(kce)
where:
- wd = weight of debt
- kd = cost of debt
- t = marginal tax rate
- wps = weight preferred stock
- kps = cost of preferred stock
- wce = weight common equity
- kce = cost of common equity
WACC gives you the opportunity cost of capital or the discount rate for discounting future cash flows when capital budgeting
- For any given project, your IRR should be higher than your WACC in order to approve the project
- If your project is riskier than the risk of the projects that make up the firm, the WACC may need to be revised upward or vice versa
LOS 45b: describe how taxes affect the cost of capital from different capital sources
Interest paid on debt is often tax deductible hence the debt is often discounted by 1-t (which decreases the cost of debt by the marginal tax rate). Other sources of capital (ps and ce) are not typically tax deductible so they are not discounted.
LOS 45c: Describe alternative methods of calculating the weights used in the WACC, including the use of the company's target capital structure
- WACC should be based on firm's target capital structure - the weights (based on market values) of debt, ps, and ce the firm expects to achieve over time
- if no info is available, use firms current structure
- if there is a trend (e.g. firm has been increasing debt) then follow that trend in your weighting system
- otherwise use industry average capital structure as target structure for firm
LOS 45d: Explain how the marginal cost of capital and the investment opportunity schedule are used to determine the optimal capital budget
- Company creates wealth for shareholders by earning more on its investment in its assets than is required by those who provide capital to the firm (the WACC)
- Marginal Cost of Capital (cost of raising capital) generally increases as larger amounts are invested - hence the upward sloping marginal cost of capital curve
- Expected returns (IRR's) of potential projects can be ordered from highest IRR to lowest IRR to create a downward sloping investment opportunity schedule
- where the MCC curve intersects the investment opp schedules is the optimal capital budget which makes sense because the firm should take on all projects with an IRR greater than the cost of capital
LOS 45e: Explain the marginal cost of capital's role in determining the NPV of a project
- WACC is the appropriate discount rate for projects with the same level of risk as the firm's existing projects; WACC's should be adjusted up/down for higher/lower risk projects
- implicit assumption that capital structure of a firm will remain the same over the span of the project
- NPV should be calculated using the WACC/Marginal Cost of Capital and those projects with a positive after tax NPV should be accepted
LOS 45f: Calculate and interpret the cost of fixed rate debt capital using the YTM approach and the debt rating approach
- After-tax cost of debt is the rate, kd(1 - t) is the interest rate at which firms can issue new debt net of the tax savings
- Cost of debt is the market interest rate (YTM) of new (marginal) debt, not coupon rate on firm's existing debt
- if YTM is not available (e.g. debt is not publicly traded), analyst may use the rating and maturity of the firm's existing debt e.g. if firm's debt is rated AA with maturity of 15 yrs, you can use yield curve for AA rates debt with maturity of 15 yrs
- if anything (e.g. covenants, seniority) affect the yeidl, adjust appropriately
- for firms with floating rate debt, estimate the longer-term cost of the firm's debt using the current yield curve (term structure for the appropriate rating category)
LOS 45g: Calculate and interpret the cost of non-callable, non-convertible preferred stock
- cost of preferred stock (kps) = Dps/P
- where Dps is preferred dividends and P is market price
LOS 45h: Calculate and interpret the cost of equity capital using the capital asset pricing model approach, the divident discount model approach, and the bond-yield-plus risk-premium approach
All of these approaches measure the required rate of return on the firm's common stock - the opportunity cost of capital i.e. the firm can lower some of this part of the WACC by using retained earnings to buy back shares (lowering cost of common stock outstanding)
Hence all of these approaches are ways of valuing the cost of common stock
1) CAPM = RFR + B[E(Rm) - RFR]
- RFR = Risk free rate
- E(Rm) = expected return on the market
- Beta is the stock's risk measure
- this is another formula that makes sense when you break it down. it is the risk free rate plus the risk premium multiplied by the market risk
2) Dividend discount model approach
- Po = D1/(kce - g)
where:
- D1 = next year's dividend
- kce = the required rate of return on common equity
- g = the firm's expected constant growth rate
Rearranging the terms you can solve for kce = (D1/P0) + g
Use the growth rate projected by security analysts or estimate growth using:
- g = (retention rate)(return on equity) = (1 - payout rate)(ROE)
this is also intuitive; the growth rate is the amout of ROE the firm will keep
3) Bond yield plus risk premium approach
ballpark figure constructed by adding a risk premium (3-5%) to the market yield on the firm's long term debt
- kce = bond yield + risk premium of 3-5%
LOS 45i: Calculate and interpret the beta and cost of capital for a project
Project's beta = systematic or market risk; use project's beta to adjust for differences between a specific project's risk adn the average risk fo a firm's projects
Pure-play method = find a publicly traded firm purely engaged in the same biz as the project and begin with that firm's beta and then unlever it (to adjust for the company's dependence on debt financing) and then relever it based on the financial structure of the company evaluating the project. Then use this equity beta to calculate the cost of equity to be used in evaluating the project.
To get asset beta for publicly traded firm, discount the equity beta for the form by the after tax debt-to-equity ratio
- ΒASSET = ΒEQUITY[1/1+(1(1-t)D/E)]
to get equity beta for the project, use the subject firm's tax rate and debt-to-equity ratio and re-lever the beta so...
- BPROJECT = BASSET[1+((1-t)D/E)]
issues for this method:
- beta is estimated using historical returns which may be sensitive to the length of time used
- estimate is affected by the index chosen to represent market return
- betas are believe the revert to 1 over time - need to account for this
- estimates of betas for small cap firms may include a risk premium for risk of smaller firm not captured by usual estimation methods
LOS 45j: Explain the country equity risk premium in the estimation of the cost of equity for a company located in a developing market
CAPM is problematic in developing countries because Beta does not capture country risk premium
general risk of developing country is reflected in its sovereign yield spread (the difference between yields of sovereign debt and similar maturity Treasuries)
we must also adjust the sovereign yield spread by the ratio of the volatility of equities in dev country/volatility of sovereign bonds for that country (for bonds denominated in developed market's currency)
so revised CAPM: kce = B[E(Rmkt)-RFR+CRP]
where CRP is:
country risk premium = sovereign yield spread * (volatility dev. equities/ volatility dev. bonds in US$)
LOS 45k: Describe the marginal cost of capital schedule, explain why it may be upward sloping with respect to additional capital, and calculate and interpret its break points
- marginal cost of capital schedule tends to be upward sloping because as a firm raises more and more capital , the costs of different sources of financing will increase
- e.g. cost of debt may rise due to increased risk, convenant protecting seniority of earlier debt issues, flotation costs of issuing new stock
- marginal cost of capital schedule shows the WACC for different amounts of financing
- break points occur any tiem the cost of one of the components of the company's WACC changes and is calculated thusly:
break point =
amt of capital at which a component's cost of capital changes
weight of the component in the capital structure
LOS 45l: Explain and demonstrate the correct treatment of flotation costs
- Flotation costs are a fixed one-off costs and should rightly be accounted for as part of the initial cost of the project and NOT as part of WACC in any way
Problem set issues:
- calculate Marginal Cost of Capital
- calculate ke using dividend discount approach
Reading 46: Working Capital Management
LOS 46a. describe primary and secondary sources of liquidity and factors that influence a company’s liquidity position;
- primary sources of liquidity are the sources of cash the company usese in its day-to-day operations e.g. cash balances from sales of goods and services, collecting receivables and investment income. Short term funding includes trade credit from vendors and lines of credit from banks
- secondary sources of liquidity indicates trouble e.g. liquidating short-term or long-lived assts, renegotiating debt agreements, filing for bankruptcy and restructured
- drags and pulls drags on liquidity are things that delay/reduce cash inflows (bad debts, incollected receivables, obsolete inventory, etc.) pulls are things that accelerate cash outflows e.g. paying vendors sooner than is optimal
LOS 46b. compare a company’s liquidity measures with those of peer companies;
most of the comparisons are performed comparing the following ratios to industry norms
- current ratio = current assets/current liabilities high ratio means better ability to pay short term bills; less than one means trouble
- quick ratio = (cash + marketable securities + receivables)/current liabilities i.e. same as current ratio but only using the most liquid assets
Measures of how well a company is managing its working capital include:
- receivables turnover = credit sales/average receivables
- number of days of receivables = 365/receivables turnover
- inventory turnover = COGS/average inventory
- number of days of inventory = 365/inventory turnover
- payables turnover = purchases/average trade payables
- number of days of payables = 365/payables turnover
- NB all of these are measures of turnover i.e. the item/average of the opposite measure e.g. COGS/avg inventory and the number of days is just 365/turnover
- NB you want these to mostly be close to industry norms
LOS 46c. evaluate overall working capital effectiveness of a company, using the operating and cash conversion cycles, and compare its effectiveness with other peer companies;
- operating cycle = number of days it takes to turn raw materials into cash proceeds from sales
- operating cycle = days of inventory + days of receivables
- cash conversion cycle or net operating cycle is the length of time it takes to turn the firm's cash investment in inventory back into cash, in teh form of collections from the sales of that inventory
- cash conversion cycle = (avg days of receivables) + (avg days of inventory) + (avg days of payables)
- NB high cash conversion cycles are undesirable - implies too much investment in working capital
- NB understand what the ratios are saying about the business
LOS 46d. identify and evaluate the necessary tools to use in managing a company’s net daily cash position;
Need to ensure there is sufficient cash without letting it sit idle; answer is to keep much of it highly liquid, low risk securities etc. such as:
- Treasuries
- Bank COD's
- Banker's Acceptances
- Repurchase Agreements
- Commercial Paper
- Money Market Mutual Funds
- Adjustable-rate preferred stock = stock which resets quarterly to current market yields and has tax advantage
LOS 46e. compute and interpret comparable yields on various securities, compare portfolio returns against a standard benchmark, and evaluate a company’s short-term investment policy guidelines;
- % discount from face value = (face value - price)/face value
- discount basis yield (or BDY) = % discount * (360/t)
- money market yield = ((face value - price)/price)* (360/t) = HPY * (360/t)
- bond equivalent yield = HPY * (365/t)
returns on firm's short term securities investments should be stated as BEY's. Return on portfolio should be expressed as weighted average of those yields
LOS 46f. assess the performance of a company’s accounts receivable, inventory management, and accounts payable functions against historical figures and comparable peer company values;
- A firm's inventory, receivables, and payables management can be evaluated by comparing days of inventory, days of receivables, and days of payables for the firm over time, and by comparing them to industry averages or averages for a group of peer companies.
- A receivables aging schedule and a schedule of weighted average days of receivables can each provide additional detail for evaluating receivables management.
LOS 46g. evaluate the choices of short-term funding available to a company and recommend a financing method.
Choices for short term borrowing depends on firm's size and credit-worthiness; options (in order of decreasing firm creditworthiness and increasing cost):
- commercial paper
- bank lines of credit
- collateralised borrowing
- nonbank financing
- factoring (of receivables)
FINANCIAL STATEMENT ANALYSIS
LOS 47: Demonstrate the use of pro forma income and balance sheet statements
- Pro forma income and balance sheet statements are forward-looking financial statements constructed based on specific assumptions about future business conditions and firm performance.
- process begins with making an assumption about which variable is the overall driver (e.g. sales) of income and balance sheet items
- e.g. if sales are forecast to increase by 10% then we could forecast that COGS, fixed assts, total assets, debt and interest expense etc. could increase by 10%
- i.e. that the percentage of each relative to sales will be maintained
Constructing a sales-driven pro forma financial statement:
- Estimate the relation between change in sales and the changes in sales-driven income statement and balance sheet items
- Estimate the future tax rate, interest rate on debt, lease payements, etc.
- Forecast sales for the period of interest
- Estimate fixed operating costs and fixed financial costs
- Integrate these estimates into pro forma financial statements for the period of interest
To calculate future sales, you can:
- calculate average compound growth rate of sales over 5 or 10 year period and use that rate to forecast future sales
- regression analysis to estimate relationship between GDP growth and growth in sales and use economists' estimates of future GDP growth to forecast (assumes correlation)
- economic cycles, seasonality of sales, specific events, changes in regulation/tax rate etc. can also be incorporated into model
We can move the financial statements through iterations based on "what if" scenarios such as what if the company decided not to pay dividends and yielded a surplus. Then what if this surplus was used to pay down debt? Interest payments would come down and more money would come in from the savings there... etc. etc.
The Corporate Governance of Listed Companies: A Manual For Investors
LOS 48a: Define and describe corporate governance
Corporate governance is the set of internal controls, processes, and procedures by which firms are managed. It defines the appropriate rights, roles, and responsibilities of the management, the board of directors, and shareholders within an organisation. It is the firm's checks and balances.
Good corporate governance seeks to ensure that:
- the board of directors protects shareholders interests
- the firm acts lawfully and ethically in dealings with shareholders
- the rights of shareholders are protected and shareholders have a voice in governance
- the board acts independently from management
- proper procedures and controls cover management's day-to-day operations
- the firm's financial, operating, and governance activities are reported to shareholders in a fair, accurate, and timely manner
LOS 48b: Discuss and critique characteristics and practices related to board and committee independence, experience, compensation, external consultants, and frequency of elections, and determine whether they are supportive of shareowner protection
Corporate governance is the set of internal controls, processes, and procedures by which firms are managed. Good corporate governance practices ensure that the board of directors is independent of management and that firm and its managers act lawfully.
LOS 48c: Describe board independence and explain the importance of independent board members in corporate governance
Majority of board should be independent but experienced enough to advise management and review its activities.
LOS 48d: Identify factors that indicate a board and its members possess the experience required to govern the company for the benefit of its shareholders
experience with:
- the products or services the firm produces
- financial operations, accounting, and auditing
- legal issues
- strategies and planning
- firm's business and financial risks
LOS 48e: Explain the provisions that should be included in a strong corproate code of ethics and the implications of a weak code of ethics with regard to related-party transactions and personal use of company assets
- code of ethics - practice what you preach;
- comply with corp gov standards in home country and stock exchange;
- no advantages to outsiders that are not available to shareholders;
- have someone responsible for corp governance
LOS 48f: State the key areas of responsibility for which board committees are typically created and explain the criteria for assessing whether each committee is able to adequately repesent shareholder interests
- Audit committee - proper account procedures, external independent auditor, free commuincations
- Compensation committee - ensure fair and appropriate (not excessive) compensation which is linked to long term profitability; shareholder approval for share based compensation (dilution issues); be transparent about compensation
- Nominations committee - recruitment of new, qualified board members; review existing board members; succession planning
LOS 48g: Evaluate, from a shareholder's perspective, company policies related to voting rules, sharehodler sponsored proposals, commons stock classes, and takeover defenses
- don't make it difficult to vote proxies
- confidence voting and remote proxy voting are good
- takeover defenses are generally not in the shareholders' best interest
rules of thumb:
- independence is good; promoting rights and interests of shareholders is good
- any conflict of interest e.g.tie to management, consulting fees, personal loans from company, long-serving board members, family ties, cross-directorships, unreasonable compensation packages, chairman is also CEO = bad
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