Transcript E - MBA

Summary of Courses
in Finance
(Revision for the State Exam)
Mihály Ormos
Summary in finance, MBA2001
1
Business Economics & Corporate Finance
9. Financing corporations
–Pure equity financed mini-firm approach
–Effects of capital structure in a perfect market
–Effects of capital structure in a slightly imperfect market
10. Dividend policy
–Significance of indifference of dividend policy in financial
analyses
–Explaining the indifference of dividend policy in a perfect
market
–Explaining the indifference of dividend policy in a slightly
imperfect market
Summary in finance, MBA2001
2
Business Economics & Corporate Finance
11. Determination of cash flow streams
– Relevant cash flows
– Consideration of inflation
– Consideration of taxation
12. Determination of opportunity cost
–Determination of opportunity cost by the CAPM
–Country risk approach
–Opportunity cost by WACC
13. Business economic analyses
–Net present value
–Internal rate of return
–Profit index and annual equivalent
Summary in finance, MBA2001
3
Business Economics & Corporate Finance
14. Options
–Properties of options
–Factors influence put and call option prices
–Real-options
15. Companies in the modern market economies
–Main types of modern market economies
–Shareholder’s value – stake holder’s approach
–Mechanism of shareholder’s value
Summary in finance, MBA2001
4
Financing
Pure equity financed mini-firm approach
Firm
Project
E(F1)
E(Fn)
E(F2)
0
1
2
E(FN)
…
n
…
N
F0
Shareholder
Investment
decision
βproject
IRR

E ( Fn )
0
n
n 0 (1  ralt )
NPV  
IRR  ralt
Dividend
E(r) értékpapír-piaci egyenes
Capital
Tőkepiaci
m.
alternative
alternatíva
piaci portfolió
ralt
E(rM)
rf
1
Summary in finance, MBA2001
β
5
Financing
Pure equity financed mini-firm approach
If perfect capital market is assumed, the influence of
debt policy on the value (Net Present Value) is
negligible, therefore in economic analyses of projects
pure equity financed mini-firm will be assumed.
Summary in finance, MBA2001
6
Financing
Effects of capital structure in perfect market
Nine different
factors should be investigated:
Projects
Firm
r1 E(F )
– Value, Expected
return and
Risk
of
the
Value
of
the
firm
E
(
r
)

a
E
(
r
)
E(F )

V
i
i
E(F )
E(F
)
E(r1), β1Equity, Debt
i
–a1,Firm,
rM
n
n+1
20
21
Value of
Equity
Equity
2
1
rE
 a1 E3 (r1 )  a2 E5 (r2 )  ...  a5 E (r5 )
PV
The
Firm
1
VVaiPV
 i i   NPVi
r
E(F23)
E(F3) E(Fn)
rM
E(Fof
) equityE(F
i 1 the sum
i 4
E(F
) the firm is equal i to
The value
of
of
the
value
and
) the value
E(F )
a2,of
E(rdebt
2), β2 V=E+D (the
can be characterised
as the financial
 astructure
PrM capital
1 1  a2  2  ...  a5  5
E(F )
PV2
E(F ) by the D/E ratio)
leverage of the firm which
is
shown
E, E(rE), βE
i ai  1
r
E(F )
E(F ) E(F ) 3
rV V)] and the risk of the firm [βV] are
The expected return
of the firm
V
E(F ) [E(r
E V  D
a3,given
E(r3), βby
the projects
of the firm
PV
3
rM
3
E(F )
E(F )
Debts
E(F
) E(F ) the expected return and
ThereforeE(Fthe
value,
the
risk
of
the firm is
r
M
) r
E
rD
4
independent
from
the
capital
structure
of
the
company,
from the D/E
Value of so
Debts
NPV4
a4,ratio
E(r4), β4
rE(F
)
E
D
M
2
2
1
n+1
1
3
1
n
2
2
1
3
n
2
n+1
E(F1)
E(F4)
r E(F3)
5
NPV5
a5, E(r5), β5
rM
E(F2)
n+1
0
E (rV ) V EE(rE )D rD
V
V
DE   D 
V 
E
D
V
V
1
V ED
E(F1) E(F2) E(F3)
rM
rD,βDE
DD, V
D/E
Andor György, Vállalati
Vállalati pénzügyek
pénzügyek
Summary in finance, MBA2001
7
Financing
Effects of capital structure in perfect market
Debts
The risk of the debts (βD) in a low leveraged situation is 0,
because the equity covers the debts, therefore
the required return of the debts (rD) is equal to the risk free
return.
After a certain leverage the risk and therefore the required
return of the debts begin to increase,
because the probability of debt trapping is increased.
Summary in finance, MBA2001
8
Financing
E(r)
in perfect market
E(rV)
rD
rD
rf
0
Risk-free
Debt
1
Risky
Debt
D/E
rM
β
βV
βD
0
Risk-free
Debt
Summary in finance, MBA2001
1
Risky
Debt
D/E
9
Financing
Effects of capital structure in perfect market
Equity
Rearranging the previous two equations (Firm) to the expected
return and to the risk of the equity the next relations can be
found:
Summary in finance, MBA2001
10
E(r)
E(rE)
E(rV)
Financing
in perfect market
rD
rf
0
Risk-free
debt
1
Risky
debt
β
D/E
βE
βV
βD
0
Risk-free
debt
1
Risky debt
Summary in finance, MBA2001
D/E
11
Financing
Effects of capital structure in perfect market
Equity (Stocks)
The leverage increases the risk (βE) and the expected return
(E(rE)) of the stocks,
however, the value of the stocks is not affected (the risk and the
expected return is increasing together in the function of D/E,
so it is just sliding up on the security market line of the CAPM),
therefore the capital structure is indifferent for the shareholders.
Summary in finance, MBA2001
12
Financing
E(r)
in perfect market
E(rE)
E(rV)
rD
E(r)
rf
0
Risk-free
debt
1
Risky
debt
D/E
β
βE
βV
βD
0
Risk-free
debt
1
Risky
debt
Summary in finance, MBA2001
V
E(rV)
E
rf
D
βV
β
D/E
13
Financing
Effects of capital structure in perfect market
Conclusion
The changing D/E ratio has no effect on the value of the firm, the
equity and the debt (MM. I.)
The expected return of the equity is proportionally increasing
with the D/E ratio.
The rate of increase in the beginning is linear, then due to the
increasing required rate of debt return (rD) the increase slows
down. (MM. II.)
This is why the pure equity financed “mini-firm” approach is
adequate in corporate financial analyses.
Summary in finance, MBA2001
14
Financing
Effects of capital structure in a slightly imperfect market
I. Corporate tax (*)
Financing the corporation by debts is advantageous, because
interest connected to the debts can be cleared in the books as
financial expenditure so the tax base is reduced and with this
the tax liability is decreased.
(annual tax saving= tc•D•rD)
The tax saving means cost reduction, so raises the expected cash
flow and return of the firm.
It can be derived that the present value of a leveraged firm is
increased by ~tcD.
This increase is due to the shareholders.
Summary in finance, MBA2001
15
E(r)
E(rE)*
E(rE)
E(rV)*
rD
rD(1-tc)
E(rV)
E(r)
V*
V
E(rV)
E
E*
rf
rf
0
Risk-free
debt
1
Risky
debt
D
D
D/E
P
β
βE
β
βV
V*
V
βV
E
E*
βD
0
Risk-free
debt
1
Risky
debt
Summary in finance, MBA2001
D
D/E
0
1
D/E
16
Financing
Effects of capital structure in a slightly imperfect market
I. Corporate tax (*)
II. Personal income tax as well (**)
All elements of the capital structure are taxed with almost the
same rate, therefore it is indifferent in capital structure
decisions.
III. Financial distresses (***)
Financial distress occurs when the company is not able to cover
its liabilities due to the high financial leverage and in this case
the legal regulation over-defenses the state and the debtors and
over-weakens the position of the shareholders.
The probability of this kind of situation is increased by the D/E
ratio, so decreasing the value of the stocks.
Summary in finance, MBA2001
17
Financing
Effects of capital structure in a slightly imperfect market
P
V**
V
V***
Value losses due to
Financial distresses
E***
0
D/Eopt
D/E
Even in case of slight market imperfection, the value changing
effect of the financial leverage is negligible, so the pure
equity financed mini-firm approach is appropriate.
Summary in finance, MBA2001
18
Dividend policy
Significance of indifference of dividend policy in financial analyses
If the indifference of dividend policy is assumed, then
Firm
the project analyses
canProject
be derived through the cash
flow steams of a pure equity financed mini-firm, so the
shareholder’s cash flows resulted from dividend pay
Investment
β
IRR
Shareholder
offs can be neglected.
decision
E(F )
If above hypothesis can be proved, the
IRR  r
NPVcorporate

0
(1  r )
financial analyses are highly
simplified, because the
Dividend
mini-firm approach can be used.
E(r) értékpapír-piaci egyenes
E(F1)
E(Fn)
E(F2)
E(FN)
…
0
1
2
n
…
N
F0
project

n
n 0
Capital
Tőkepiaci
m.
alternative
alternatíva
alt
n
alt
piaci portfolió
ralt
E(rM)
rf
1
Summary in finance, MBA2001
β
19
Dividend policy
Explaining the indifference of dividend policy in a perfect market
The suppositions (circumstances)
the firm has settled on its investment program (i.e. it is already worked out
that how much of this program can be financed by borrowing, and the plan
meets other funds requirements)
perfect market (fair issuing price, zero transaction cost, equal tax rates –
dividend and price earnings)
What happens if the dividend wanted to be increased without
changing the investment and borrowing policy?
The only solution is to print some new shares and sell them.
Miller and Modigliani states that the dividend policy has no affect
to the value of the firm in the above circumstances.
Investment and borrowing policy is determined so to increase the value of
dividend new shares have to be offered so one part of the company become
the property of the new owners.
Summary in finance, MBA2001
20
Dividend policy
Explaining the indifference of dividend policy in a perfect market
Before dividend
After dividend
Total value of firm
New stocks
money
price
decrease
It is indifferent for the old owners how they get money
by dividend or by selling some of their stocks.
Summary in finance, MBA2001
21
Dividend policy
Explaining the indifference of dividend policy in a perfect market
Shares
Dividend financed by
stock issue
No dividend no stock
issue
New stockholders
New stockholders
Cash
Cash
Firm
Shares
Cash
Old stockholders
Summary in finance, MBA2001
Old stockholders
22
Dividend policy
Explaining the indifference of dividend policy in a slightly imperfect market
Arguments usually presents some kind of market
imperfection (tax differences, transaction cost)
Reasons to pay higher dividend
– There is a conservative group which believes that an increase
in dividend payout increases firm value
– In lack of information the high dividend is a good sign
– The paid dividend is certain while the price increase is
uncertain
Reasons to pay lower dividend
– High transaction cost of issuing
– Higher taxation of divined incomes
Summary in finance, MBA2001
23
Dividend policy
Explaining the indifference of dividend policy in a slightly imperfect market
Even in case of slight market imperfections the
indifference can be defended.
Empirically it can be proven that a supply-demand
equilibrium is created between investors’ preferences
to dividend and corporations’ dividend policies.
If there existed better dividend policy, all company
would use this,
however many kind of policies can be found in the
market.
Summary in finance, MBA2001
24
Determination of cash flow streams
Introduction
What is the aim of determination of cash flows?
– Corporate financial analyses are based on the future cash
flows created by the project.
– These cash flows will be examined through the analyses
Summary in finance, MBA2001
25
Determination of cash flow streams
•
•
•
•
•
•
•
•
Relevant cash flows
Cash flows should be estimated on change base
All derivative effects have to be considered (with or
without)
Opportunity cost has to be taken into consideration
Sunk Cost
Careful separation of overheads
Working capital needs
Sub-versions should be separated
Financing effects should be considered separately
Summary in finance, MBA2001
26
Determination of cash flow streams
Consideration of inflation
Using nominal values.
All cash flows are considered on current price, so the estimated
price changes tendencies – of e.g. material costs, payments to
personnel, selling price – are calculated. Of course the
opportunity cost should be considered in the same way.
Using real values.
Unchanging, today prices are considered, but in this case the
opportunity cost should be estimated on the same way.
Summary in finance, MBA2001
27
Determination of cash flow streams
Consideration of taxation
Most taxes are taken into account as costs, i.e. they are
considered as indirect or general expenditures for
which the base is the net profit.
General rule that is in the estimation of cash flows and
in the estimation of opportunity cost the same
calculation procedure should be used.
Summary in finance, MBA2001
28
Determination of opportunity cost
Determination of opportunity cost by the CAPM
The opportunity cost gives the reference return in
economic analyses.
The project’s expected return have to exceed this to be
worthy for the owner to accomplish the investment.
In the determination of the opportunity cost we have to
start from the CAPM.
–There exists risk-free asset
–There is a premium accompanied to risk taking
–The required, expected and average returns are equal
F1
Fn Fn+1
ralt  E (r )  rtime  rrisk
 rf  E (rrisk premium)
 rf  β ( E (rM )  rf )
F2
F0
 rf  βhistoricalaverage  (rM  rf )historicalaverage
Summary in finance, MBA2001

Fn
0
n
n  0 (1  ralt )
NPV  
29
rf
Determination of opportunity cost
Determination of opportunity cost by the CAPM
By definition the return of the risk free asset (time premium)
is the return of any real asset with zero standard
ralt
 rf (There
historical
rf )historical average
deviation.
is no
asset(r
like
this…)
average
M 
In the estimation the return of that financial asset should be
considered, which certainly pays back the claim with its
interest. There is only one issuer which can guarantee that
this will happen and this is the government.
Therefore some kind of government security should be
considered.
The risk of inflation can be eliminated in two ways:
–inflation indexed government security
– modifying with the estimated inflation rate
If the return of government security is changing in time, the
return of zero-coupon bonds, or the return of security
with similar maturity to the project life time.
Summary in finance, MBA2001
30
rM
Determination of opportunity cost
Determination of opportunity cost by the CAPM
By definition the return of the market portfolio can be
given by the expected return of that portfolio which
ralt
 rf  the
 rf )historical
historical
average (rMweighted
average
represents
capitalization
average
return
of all securities traded in the world.
This can be approximated with the global portfolios e.g.
MSCI world index
However it would be rational to hold the global portfolio
(MSCI), however there are many factors against the
rational behaviour. Therefore a segmentation of the
global market can be discovered.
In this case separate CAPM worlds can be found.
and the return of the market portfolios of these worlds
depends on the expectations of the investors in the
given world.
Summary in finance, MBA2001
31

Determination of opportunity cost
Determination of opportunity cost by the CAPM
We are always interested in the opportunity cost of projects,
(but the risk of a specific project and the risk of a specific
ralt
 (company)
rf  historical
(rM  equal)
rf )historical
stock
is not
necessarily
nevertheless
average
average
capital market information is available only on stocks.
Two step procedure
– Estimation of unlevered betas
– From unlevered calculation of project betas
Main factors cause the differences:
– Sales revenues sensitivity to fluctuation of the whole economy
– Effect of operating leverage Fix Cost / Total Cost
– Financial leverage MM II.
For starting point we can choose the beta of the given
company if the function of the project is similar to the
function of the firm, otherwise industrial averages can be
used.
Summary in finance, MBA2001
32
Determination of opportunity cost
Country risk approach
This approach can be used in those countries which has a fairly
young capital market.
In this case developed capital market data can be used as the
basis of the estimation.
The above data should be modified by the country risk factors
which can be defined by the characteristics of the capital
markets and other factors.
This modification is a three step procedure:
1. Determination of the country risk factor which can be found by the creditratings of financial consulting companies like the moody’s or blomberg.
2. From this rating the extra return connected to government securities can
be found so this has to be converted to the extra premium of stocks i.e.
companies.
3. Determination of the relationship between the firm and the country
concerning the risk.
Summary in finance, MBA2001
33
Determination of opportunity cost
Opportunity cost by WACC
The expected return of the firm can be expressed as the weighted
average of the expected return on equity and debt, this is called
the Weighted Average Cost of Capital:
E
D
ralt  WACC  E (rV )  E (rE )  rD
V
V
WACC is used in opportunity cost estimation in case of the
investigated project’s business activity (risk) is close to the
business activity (risk) of the firm.
The idea behind the calculation shows that the project should
create a profit at least which covers above the interest on debt
the required return of equity.
If the corporate income tax is considered as well then the above
expression is modified to
ralt *  WACC*  E (rV )* 
Summary in finance, MBA2001
E*
D
E (rE ) * 
(1  t c )rD
V*
V*
34
Business economic analyses
Introduction
The main steps of a corporate financial analyses are
–Determination of opportunity costs (identification of the return
of alternative capital market investment possibility with
similar risk) 
–Determination of future cash-flows (this is the sum of economic
effects of the project) 
–Economic analyses (comparison between the profitability of the
project and the alternative investment possibility)
• NPV, IRR, PI, AE
Summary in finance, MBA2001
35
Business economic analyses
Net present value

E(Fn )
NPV  
0
n
n 0 (1  ralt )
Net Present Value is the sum of discounted cash-flows of
a given project by the opportunity cost.
So in this way the economic value of a project can be
compared to other investment possibility with the
same risk. The result of NPV calculation shows the
value increase above the alternative investment
possibility.
Therefore, the project will be implemented if the
NPV>0.
Summary in finance, MBA2001
36
Business economic analyses
Internal rate of return
Internal Rate of Return is defined as the rate of discount
which makes the NPV=0.
In this case the average return of the project is
determined and this is compared to the opportunity
cost.
So the IRR rule is to accept an investment project if the
opportunity cost of capital is less then the IRR.
Pitfalls of IRR:
–It shows the average return of the project i.e. the increase of
unit equity in unit time
–Lending or borrowing
–Multiple rates of return
–Mutually exclusive projects
–Short- and long term interest rates may differ
Summary in finance, MBA2001
37
Business economic analyses
Profit Index and Annual Equivalent
Profit index is the quotient of the Net Present Value and
the investment cost of the project:
NPV
PI 
F0
It is used in case of limited capital, for mutually
exclusive projects.
Summary in finance, MBA2001
38
Business economic analyses
Profit Index and Annual Equivalent
Annual equivalent can be used to compare mutually
exclusive and repeating projects with different life
time.
In this case the future cash-flows of the project
converted to annuity and these annuities will be
compared (NPV of the normal cash flows has to give
the same result as the NPV of the annuity)
Summary in finance, MBA2001
39
Companies in the modern market economy
Introduction
Development of public limited corporations
Early capitalism
•
•
•
•
individuals and families
unlimited liability
the owner and the manager is the same
Development of technology and mass production required
the concentration of capital
Limited liability
• legal entity
• shares are tradable
More owner one company
• management and ownership are separated, but
• the goals are different
• agency problem
Summary in finance, MBA2001
40
Companies in the modern market economies
Main types of modern market economies
The types are connected to the degree, the manner, and
the function of intervention of the state into the
economic processes.
The three form of modern market economy:
–Corporate (market) controlled (Anglo-Saxon)
–State controlled (Asian capitalism)
–Negotiation based market economy (Rhenish)
Summary in finance, MBA2001
41
Companies in the modern market economies
Main types of modern market economies
Corporate (market) controlled (Anglo-Saxon)
The role of the state is narrow
USA, Great-Britain
–Weak feudalism
–Parliamentary political system
–Smooth and continuous industrialisation
Summary in finance, MBA2001
42
Companies in the modern market economies
Main types of modern market economies
State controlled
Relatively the highest state coordination
–intervenes the microeconomic processes
–selectively influences the operations of companies
–plays a significant role in the allocation of recourses like
• state owned firms
• financing R&D
• reduced rate credits
Japan and France
–Strong feudalism and aristocracy
–Late but rapid industrialisation, therefore
–High industrial concentration
–The bank system has a significant role
–The state in sight of the international competition strengthened
its position.
Summary in finance, MBA2001
43
Companies in the modern market economies
Main types of modern market economies
Negotiation based market economy
The economic processes are based on the negotiations of
the leading economic roles.
The main idea is “social partnership” i.e. political
consensus between the employers, the employees, and
the bureaucracy.
The negotiations include:
–wages
–prices
–taxes
–employment
–economic stability and growth
Summary in finance, MBA2001
44
Companies in the modern market economies
Main types of modern market economies
by the financing system of the economy
By the role of the bank system three types can be
distinguished:
Capital market based financing system
–New recourses can be obtained by issuing stocks or bonds,
bank loans are used mainly for temporary financing
Credit based financing system with administrative
dominance
–Small and moderate exchanges so the firms have to use the
banks for financing.
–Subsidies through the banking system
Credit based financing system with institutional
dominance
–Some large banks, and they have shares in the firms,
investment funds are owned
Summary in finance, MBA2001
45
Companies in the modern market economies
Shareholder’s value – stake holder’s approach
Share holder’s value approach:
–Only the growth of the company’s value counts
–The firm works as a “revenue producing machine”
–From the 90’s this form became the major approach
–Capital market based financing system
Stake holder’s value
–They are the buyers, the suppliers, the investors, the creditors,
the employees, the government
–Their interests should be considered
–More comfortable, and humane
–Credit based financing system
Summary in finance, MBA2001
46
Companies in the modern market economies
Mechanism of shareholder’s value
If there are dominant shareholders’ of the company, the
board of directors and carrier competition work well.
If the ownership is crumbled (because of the demand of
capital new issues happened, diversification of owners,
etc.) then the intervention of owners to the business
activity of the firm is decreased even the members of
the board could be delegated by the management.
However, if the shareholders’ is pushed into the
background, then the firm is usually pushed to the
edge, so the owners are gladly sell their stocks and by
this the buyout of the company can happen, and the
new owners are easily fire the management.
Summary in finance, MBA2001
47
Derivatives
Properties of options
Derivative instruments are financial assets with returns
depend on value of other factors.
Two basic types:
– Termins (forwards and futures)
Termin transactions are basically sales contracts for a
predefined future date, however the seller does not have to
own the asset of the contract.
– Options
Options give the opportunity to buy or sell an asset on a
specified price.
Summary in finance, MBA2001
48
Derivatives
Properties of options
Types of option:
– Call is the opportunity or obligation to buy
– Put is the opportunity or obligation to sell
– Short positions are obligations to sell or buy (writer)
– Long positions are rights to sell or buy
Option price or premium
Buyer is the value which
Sellerhave to be
paid by the buyer for the opportunity.
Call option
Rightprice
to buy
Obligation(contracted)
to sell asset
Exercise
of Strike
is asset
the predefined
price
of the asset
Put option
Right(K).
to sell asset Obligation to buy asset
X0 is the actual price of the asset
The owner of an option can
– sell the option on actual price
– at expiration draw the option
– wait until expiration and do nothing
American vs. European option
Summary in finance, MBA2001
49
Value of Call and Put options at expiration
LC
LP
K
K
K
X
SC
K
X
SP
K
K
X
K
Summary in finance, MBA2001
X
K
50
Profit on Call and Put options
Profit on LP
Profit on LC
K
K
K
FV(c)
K
X
Profit on SC
X
FV(p)
Profit on SP
FV(c)
FV(p)
K
X
K
X
K
K
Summary in finance, MBA2001
51
Derivatives
Factors influence option prices
• Actual stock price
• Strike or Exercise price
• Intrinsic value (relation of X0 and K)
– Call ITM situation the intrinsic value = X0-K
– Call ATM and OTM situation this value is 0
• Volatility of the stock returns (standard deviation of
annual returns)
• Time to option expiration
• Mature dividend until expiration
• Risk free return (i.e. the present value of exercise price)
• Time value of option
The difference between the value of the option (c) and its
intrinsic value
Summary in finance, MBA2001
52
Derivatives
Factors influence option prices
Value of LC
Actual price: X0
Modified intrinsic value: X0-PV(K)
Value of option: c
K-PV(K)
PV(D)
Intrinsic value: X0-K
PV(K) PV(K)+PV(D) X0
K
X0-PV(K)-PV(D)
PV(K)+PV(D)
Summary in finance, MBA2001
53
Derivatives
Real-options
Real options are option analogies fitted to corporate
investments by which those parameters can be
evaluated that cannot be included in NPV calculations.
Like
derivative investment possibilities (Call option)
possibility of leaving a business (Put option)
Summary in finance, MBA2001
54