Slide Corporate Finance

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CHAPTER
Introduction to Corporate Finance

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Chapter Outline
1.1 What is Corporate Finance? 1.2 Corporate Securities as Contingent Claims on Total Firm Value 1.3 The Corporate Firm 1.4 Goals of the Corporate Firm 1.5 Financial Markets 1.6 Outline of the Text
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What is Corporate Finance?

Corporate Finance addresses the following three questions:
1. What long-term investments should the firm engage
in?
2. How can the firm raise the money for the required
investments?
3. How much short-term cash flow does a company
need to pay its bills?

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The Balance-Sheet Model of the Firm

Total Value of Assets: Current Assets Total Firm Value to Investors: Current Liabilities Long-Term Debt
Fixed Assets 1 Tangible 2 Intangible

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Shareholders Equity
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The Capital Budgeting Decision
Current Assets Current Liabilities Long-Term Debt

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What longterm investments should the firm engage in?
Shareholders Equity
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The Capital Structure Decision
Current Assets Current Liabilities Long-Term Debt
How can the firm raise the money for the required Fixed Assets investments? 1 Tangible
2 Intangible
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Shareholders Equity
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The Net Working Capital Investment Decision
Current Assets Current Liabilities
Net Working Capital
Long-Term Debt

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How much shortterm cash flow does a company need to pay its bills?
Shareholders Equity
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Capital Structure
The value of the firm can be thought of as a pie. The goal of the manager is to increase the size of the pie. 70% 30% 25%50% DebtDebt Equity
75% 50% The Capital Structure Equity decision can be viewed as how best to slice up a the pie. If how you slice the pie affects the size of the pie, then the capital structure decision matters.
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Hypothetical Organization Chart

Board of Directors Chairman of the Board and Chief Executive Officer (CEO) President and Chief Operating Officer (COO) Vice President and Chief Financial Officer (CFO)
Treasurer
Controller
Cash Manager
Capital Expenditures
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Credit Manager Financial Planning
Tax Manager
Financial Accounting
Cost Accounting Data Processing
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The Financial Manager

To create value, the financial manager should: 1. Try to make smart investment decisions. 2. Try to make smart financing decisions.
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The Firm and the Financial Markets

Firm
Invests in assets (B) Current assets Fixed assets Firm issues securities (A)
Financial markets
Retained cash flows (F) Short-term debt Cash flow from firm (C) Dividends and debt payments (E) Taxes (D) Long-term debt Equity shares
Ultimately, the firm must be a cash generating activity.

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Government
The cash flows from the firm must exceed the cash flows from the financial markets.
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1.2 Corporate Securities as Contingent Claims on Total Firm Value

The basic feature of a debt is that it is a promise by the borrowing firm to repay a fixed dollar amount of by a certain date. The shareholders claim on firm value is the residual amount that remains after the debtholders are paid. If the value of the firm is less than the amount promised to the debtholders, the shareholders get nothing.
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Debt and Equity as Contingent Claims

Payoff to debt holders If the value of the firm is more than $F, debt holders get a maximum of $F. $F Payoff to shareholders If the value of the firm is less than $F, share holders get nothing.
$F Value of the firm (X) Debt holders are promised $F. If the value of the firm is less than $F, they get the whatever the firm if worth. Algebraically, the bondholders claim is: Min[$F,$X]
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$F Value of the firm (X) If the value of the firm is more than $F, share holders get everything above $F.
Algebraically, the shareholders claim is: Max[0,$X $F]
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Combined Payoffs to Debt and Equity

Combined Payoffs to debt holders and shareholders If the value of the firm is less than $F, the shareholders claim is: Max[0,$X $F] = $0 and the debt holders claim is Min[$F,$X] = $X.
The sum of these is = $X Payoff to shareholders $F If the value of the firm is more than Payoff to debt holders $F, the shareholders claim is: Max[0,$X $F] = $X $F and the $F debt holders claim is: Value of the firm (X) Min[$F,$X] = $F. The sum of these is = $X
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Debt holders are promised $F.
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1.3 The Corporate Firm

The corporate form of business is the standard method for solving the problems encountered in raising large amounts of cash. However, businesses can take other forms.
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Forms of Business Organization

The Sole Proprietorship The Partnership
General Partnership Limited Partnership
The Corporation Advantages and Disadvantages

Liquidity and Marketability of Ownership Control Liability Continuity of Existence Tax Considerations
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A Comparison of Partnership and Corporations

Corporation Liquidity Shares can easily be exchanged. Usually each share gets one vote Double Broad latitude Partnership Subject to substantial restrictions. General Partner is in charge; limited partners may have some voting rights. Partners pay taxes on distributions. All net cash flow is distributed to partners. General partners may have unlimited liability. Limited partners enjoy limited liability. Limited life
Voting Rights
Taxation Reinvestment and dividend payout Liability
Limited liability
Continuity
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Perpetual life
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1.4 Goals of the Corporate Firm

The traditional answer is that the managers of the corporation are obliged to make efforts to maximize shareholder wealth.
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The Set-of-Contracts Perspective

The firm can be viewed as a set of contracts. One of these contracts is between shareholders and managers. The managers will usually act in the shareholders interests.
The shareholders can devise contracts that align the incentives of the managers with the goals of the shareholders. The shareholders can monitor the managers behavior.
This contracting and monitoring is costly.

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Managerial Goals
Managerial goals may be different from shareholder goals
Expensive perquisites Survival Independence
Increased growth and size are not necessarily the same thing as increased shareholder wealth.
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Separation of Ownership and Control

Board of Directors Debtholders Shareholders Management Debt Assets Equity
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Do Shareholders Control Managerial Behavior?

Shareholders vote for the board of directors, who in turn hire the management team. Contracts can be carefully constructed to be incentive compatible. There is a market for managerial talentthis may provide market discipline to the managersthey can be replaced. If the managers fail to maximize share price, they may be replaced in a hostile takeover.
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1.5 Financial Markets

Primary Market
When a corporation issues securities, cash flows from investors to the firm. Usually an underwriter is involved
Secondary Markets
Involve the sale of used securities from one investor to another. Securities may be exchange traded or trade over-thecounter in a dealer market.
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Financial Markets
Firms
Stocks and Bonds Money Bob
Investors securities Sue money
Primary Market Secondary Market

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Exchange Trading of Listed Stocks

Auction markets are different from dealer markets in two ways:
Trading in a given auction exchange takes place at a single site on the floor of the exchange. Transaction prices of shares are communicated almost immediately to the public.
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Efficient Capital Market

An efficient capital market is one in which the current price of a security fully reflects all the information currently available about that security.
Stock Valuation
Nguyen Viet Dung, PhD.
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Forms of the Efficient Market Hypothesis

Week-form efficient markets: current stock prices fully reflect all curently available security market information. Semistrong-form efficient markets: security prices adjust rapidly to the release of all new public information. Current security prices fully reflect all publicly available information. Strong-form efficient markets: stock prices fully reflect all information from public and private sources (inside information).
Stock Valuation Nguyen Viet Dung, PhD.
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Forms of the Efficient Market Hypothesis
Stock Valuation
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Implications of stock market efficiency

Week-form market efficiency: technical analysis has no value. Semistrong-form market efficiency: neither technical nor fundamental analysis has any value. Strong-form market efficiency: even insider trading creates no abnormal returns.
Stock Valuation
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Limitations to fully efficient markets

Information costs Information dissemination Transaction costs and taxes Liquidity Irrational investors
Stock Valuation Nguyen Viet Dung, PhD.
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Price reaction to the release of new public information

Stock price
Overreaction
Correct reaction (Semistrong-form market efficiency)
Underreaction
Release of new public information
Time
Stock Valuation
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Price reaction on the emerging Vietnamese stock market
Stock Valuation
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CHAPTER
Accounting Statements and Cash Flow

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Chapter Outline
2.1 The Balance Sheet 2.2 The Income Statement 2.3 Net Working Capital 2.4 Financial Cash Flow 2.5 The Statement of Cash Flows 2.6 Summary and Conclusions
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Sources of Information
Annual reports Wall Street Journal Internet
NYSE (www.nyse.com) Nasdaq (www.nasdaq.com) Text (www.mhhe.com)
SEC
EDGAR 10K & 10Q reports
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2.1 The Balance Sheet

An accountants snapshot of the firms accounting value as of a particular date. The Balance Sheet Identity is: Assets Liabilities + Stockholders Equity When analyzing a balance sheet, the financial manager should be aware of three concerns: accounting liquidity, debt versus equity, and value versus cost.
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The Balance Sheet of the U.S. Composite Corporation

U.S. COMPOSITE CORPORATION Balance Sheet 20X2 and 20X1 (in $ millions) Assets Current assets: Cash and equivalents Accounts receivable Inventories Other Total current assets 20X2 $140 294 269 58 $761 20X1 $107 270 280 50 $707
Fixed assets: Property, plant, and equipment $1,423 $1,274 Less accumulated depreciation -550 -460 Net property, plant, and equipment 873 814 Intangible assets and other 245 221 Total fixed assets $1,118 $1,035
The assets are listed in order 20X1 and Stockholder's Equity 20X2 Current Liabilities: by the length of time it $213 $197 Accounts payable Notes payable 50 53 normally would take a firm 205 Accrued expenses 223 Total current liabilities with ongoing operations$486 $455 to Long-term liabilities: converttaxes Deferred them into cash. $117 $104
Long-term debt Total long-term liabilities 471 $588 458 $562 Stockholder's equity: Preferred stock $39 $39 Common stock ($1 per value) 55 32 Capital surplus 347 327 Accumulated retained earnings 390 347 Less treasury stock -26 -20 Total equity $805 $725 Total liabilities and stockholder's equity $1,879 $1,742
Liabilities (Debt)
Clearly, cash is much more liquid than property, plant and equipment.
Total assets
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$1,879
$1,742
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Balance Sheet Analysis

When analyzing a balance sheet, the financial manager should be aware of three concerns: 1. Accounting liquidity 2. Debt versus equity 3. Value versus cost
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Accounting Liquidity
Refers to the ease and quickness with which assets can be converted to cash. Current assets are the most liquid. Some fixed assets are intangible. The more liquid a firms assets, the less likely the firm is to experience problems meeting short-term obligations. Liquid assets frequently have lower rates of return than fixed assets.
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Debt versus Equity

Generally, when a firm borrows it gives the bondholders first claim on the firms cash flow. Thus shareholders equity is the residual difference between assets and liabilities.
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Value versus Cost

Under GAAP audited financial statements of firms in the U.S. carry assets at cost. Market value is a completely different concept.
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2.2 The Income Statement

The income statement measures performance over a specific period of time. The accounting definition of income is Revenue Expenses Income
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U.S.C.C. Income Statement

U.S. COMPOSITE CORPORATION Income Statement 20X2 (in $ millions)
The operations section of the income statement reports the firms revenues and expenses from principal operations
Total operating revenues Cost of goods sold Selling, general, and administrative expenses Depreciation Operating income Other income Earnings before interest and taxes Interest expense Pretax income Taxes Current: $71 Deferred: $13 Net income Retained earnings: Dividends:
$2,262 - 1,655 - 327 - 90 $190 29 $219 - 49 $170 - 84
$86 $43 $43
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The nonoperating section of the income statement includes all financing costs, such as interest expense.
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$2,262 - 1,655 - 327 - 90 $190 29 $219 - 49 $170 - 84
$86 $43 $43
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Usually a separate section reports as a separate item the amount of taxes levied on income.
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$2,262 - 1,655 - 327 - 90 $190 29 $219 - 49 $170 - 84
$86 $43 $43
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U.S. COMPOSITE CORPORATION Income Statement 20x2 (in $ millions)
Net income is the bottom line.
$2,262 - 1,655 - 327 - 90 $190 29 $219 - 49 $170 - 84
$86 $43 $43
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Income Statement Analysis

There are three things to keep in mind when analyzing an income statement:
1. GAAP 2. Non Cash Items 3. Time and Costs
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Generally Accepted Accounting Principles

1. GAAP
The matching principal of GAAP dictates that revenues be matched with expenses. Thus, income is reported when it is earned, even though no cash flow may have occurred
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2. Non Cash Items
Depreciation is the most apparent. No firm ever writes a check for depreciation. Another noncash item is deferred taxes, which does not represent a cash flow.
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3. Time and Costs In the short run, certain equipment, resources, and commitments of the firm are fixed, but the firm can vary such inputs as labor and raw materials. In the long run, all inputs of production (and hence costs) are variable. Financial accountants do not distinguish between variable costs and fixed costs. Instead, accounting costs usually fit into a classification that distinguishes product costs from period costs.
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2.3 Net Working Capital

Net Working Capital Current Assets Current Liabilities NWC is usually growing with the firm.
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The Balance Sheet of the U.S.C.C.

$252m = $707- $455
Assets Current assets: Cash and equivalents Accounts receivable Inventories Other Total current assets 20X2 $140 294 269 58 $761 U.S. COMPOSITE CORPORATION Balance Sheet 20X2 and 20X1 (in $ millions) 20X1 $107 270 280 50 $707 Liabilities (Debt) and Stockholder's Equity Current Liabilities: Accounts payable Notes payable Accrued expenses Total current liabilities Long-term liabilities: Deferred taxes Long-term debt Total long-term liabilities 20X2 $213 50 223 $486 20X1 $197 53 205 $455
Fixed assets: Property, plant, and equipment $1,423 $1,274 Less accumulated depreciation -550 -460 Net property, plant, and equipment 873 814 Intangible assets and other 245 221 Total fixed assets $1,118 $1,035
Here we see NWC grow to $104 $117 471 458 $275 million in 20X2 from $562 $588 $252 million in 20X1. Stockholder's equity: Preferred stock $39 $39 $23 million value) Common stock ($1 par 55 32
Capital surplus 347 327 Accumulated Thistreasuryretained earnings million is increase of $23 390 347 Less stock -26 -20 $805 anTotal equity investment of the firm. $725
$275m = $761m- $486m

Total assets
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$1,879
$1,742
Total liabilities and stockholder's equity $1,879
$1,742
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2.4 Financial Cash Flow

In finance, the most important item that can be extracted from financial statements is the actual cash flow of the firm. Since there is no magic in finance, it must be the case that the cash from received from the firms assets must equal the cash flows to the firms creditors and stockholders. CF(A) CF(B) + CF(S)
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Financial Cash Flow of the U.S.C.C.

U.S. COMPOSITE CORPORATION Financial Cash Flow 20X2 (in $ millions)
Cash Flow of the Firm Operating cash flow (Earnings before interest and taxes plus depreciation minus taxes) Capital spending (Acquisitions of fixed assets minus sales of fixed assets) Additions to net working capital Total Cash Flow of Investors in the Firm Debt (Interest plus retirement of debt minus long-term debt financing) Equity (Dividends plus repurchase of equity minus new equity financing) Total
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$238
Operating Cash Flow: EBIT $219 $90 ($71) $238
(173)
Depreciation Current Taxes OCF
(23) $42 $36
$42
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$238
Capital Spending
(173)
Purchase of fixed assets $198 Sales of fixed assets (25) Capital Spending $173
(23) $42 $36
$42
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$238
(173)
(23) $42 $36
NWC grew from $275 million in 20X2 from $252 million in 20X1. This increase of $23 million is the addition to NWC.
$42
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$238
(173)
(23) $42 $36
$42
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$238
Cash Flow to Creditors Interest Retirement of debt $49 73
(173)
(23) $42 $36
Debt service 122 Proceeds from new debt sales (86) Total 36
$42
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$238
Cash Flow to Stockholders Dividends Repurchase of stock $43 6
(173)
(23) $42 $36
Cash to Stockholders 49 Proceeds from new stock issue (43) Total $6
$42
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$238
(173)
(23) $42 $36
The cash from received from the firms assets must equal the cash flows to the firms creditors and stockholders:
CF ( A ) CF ( B ) + CF ( S )
$42
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2.5 The Statement of Cash Flows

There is an official accounting statement called the statement of cash flows. This helps explain the change in accounting cash, which for U.S. Composite is $33 million in 20X2. The three components of the statement of cash flows are
Cash flow from operating activities Cash flow from investing activities Cash flow from financing activities
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U.S.C.C. Cash Flow from Operating Activities

U.S. COMPOSITE CORPORATION
Cash Flow from Operating Activities

20X2 (in $ millions)
To calculate cash flow from operations, start with net income, add back noncash items like depreciation and adjust for changes in current assets and liabilities (other than cash).
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Operations Net Income Depreciation Deferred Taxes Changes in Assets and Liabilities Accounts Receivable Inventories Accounts Payable Accrued Expenses Notes Payable Other Total Cash Flow from Operations
$86 90 13 (24) 11 16 18 (3) (8) $199
10
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U.S.C.C. Cash Flow from Investing Activities

Cash Flow from Investing Activities

Cash flow from Acquisition of fixed assets investing activities Sales of fixed assets involves changes Total Cash Flow from Investing Activities in capital assets: acquisition of fixed assets and sales of fixed assets (i.e. net capital expenditures).
$(198) 25 $(173)
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U.S.C.C. Cash Flow from Financing Activities

Cash Flow from Financing Activities

Cash flows to and from creditors and owners include changes in equity and debt.
Retirement of debt (includes notes) Proceeds from long-term debt sales Dividends Repurchase of stock Proceeds from new stock issue Total Cash Flow from Financing
$(73) 86 (43) (6) 43 $7
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U.S.C.C. Statement of Cash Flows

The statement of cash flows is the addition of cash flows from operations, cash flows from investing activities, and cash flows from financing activities.
Operations Net Income Depreciation Deferred Taxes Changes in Assets and Liabilities Accounts Receivable Inventories Accounts Payable Accrued Expenses Notes Payable Other Total Cash Flow from Operations Investing Activities Acquisition of fixed assets Sales of fixed assets Total Cash Flow from Investing Activities Financing Activities Retirement of debt (includes notes) Proceeds from long-term debt sales Dividends Repurchase of stock Proceeds from new stock issue Total Cash Flow from Financing Change in Cash (on the balance sheet) $86 90 13 (24) 11 16 18 (3) (8) $199 $(198) 25 $(173) $(73) 86 (43) (6) 43 $7 $33
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Statement of Cash Flows versus Cash Flow from the Firm

Since interest paid is deducted as an expense when net income is calculated (and not deducted under financing activities) there is a difference between cash flow from operations and total cash flow to the firmthe difference is interest expense.
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2.5 Summary and Conclusions

Financial statements provide important information regarding the value of the firm. You should keep in mind:
Measures of profitability do not take risk or timing of cash flows into account. Financial ratios are linked to one another.
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Chapter 3 Capital Budgeting Some Alternative Investment Rules

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Why Use Net Present Value?

Accepting positive NPV projects benefits shareholders. Example
Riskless project:
Initial cost: 100; unique cash flow in one year: 107; discount rate: 6 % NPV = 0.94 If the project is forgone: bank deposit 100 106 in one year the project benefits shareholders (absolute opportunity cost: 6) Firm value without project: V + 100; with project: V + 107/1.06
Risky project:
About as risky as the stock market: expected return (=required return) = 10 % NPV < 0 Opportunity cost = expected return on stock market = 10 %
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The Net Present Value (NPV) Rule

Net Present Value (NPV) = Total PV of future CFs - Initial Investment Estimating NPV:
1. Estimate future cash flows: how much? and when? 2. Estimate discount rate 3. Estimate initial costs
Minimum Acceptance Criteria: Accept if NPV > 0 Ranking Criteria: Choose the highest NPV
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Good Attributes of the NPV Rule

1. Uses cash flows 2. Uses ALL cash flows of the project 3. Discounts ALL cash flows properly Reinvestment assumption: the NPV rule assumes that all cash flows can be reinvested at the discount rate.
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The Payback Period Rule

How long does it take the project to pay back its initial investment? Payback Period = number of years to recover initial costs Minimum Acceptance Criteria:
set by management
Ranking Criteria:
set by management
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The Payback Period Rule (continued)

Disadvantages:
Ignores the time value of money Ignores cash flows after the payback period Biased against long-term projects Requires an arbitrary acceptance criteria A project accepted based on the payback criteria may not have a positive NPV
Advantages:
Easy to understand Biased toward liquidity
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Year 0 1 2 3 4 Payback period (years)
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A -100 20 30 50 60 3
B -100 50 30 20 60 3
C -100 50 30 20 60,000 3
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Managerial perspective
Used by large, sophisticated companies when making relatively small decisions Desirable features for managerial control: shorter time to evaluate the managers decision-making ability Also used by firms with good investment opportunities but no or little cash available Practitioners: academic criticisms of payback overstate realworld problems (e.g., project C) Bigger projects: NPV becomes the order of the day
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The Discounted Payback Period Rule

How long does it take the project to pay back its initial investment taking the time value of money into account? By the time you have discounted the cash flows, you might as well calculate the NPV.
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The Average Accounting Return Rule

AAR = Average Net Income Average Book Value of Investment
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The Average Accounting Return Rule

Another attractive but fatally flawed approach. Ranking Criteria and Minimum Acceptance Criteria set by management Disadvantages:
Ignores the time value of money Uses an arbitrary benchmark cutoff rate Based on book values, not cash flows and market values
Advantages:
The accounting information is usually available Easy to calculate
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The Internal Rate of Return (IRR) Rule

IRR: the discount that sets NPV to zero Minimum Acceptance Criteria:
Accept if the IRR exceeds the required return.
Ranking Criteria:
Select alternative with the highest IRR
Reinvestment assumption:
All future cash flows assumed reinvested at the IRR.
Disadvantages:
Does not distinguish between investing and borrowing. IRR may not exist or there may be multiple IRR Problems with mutually exclusive investments
Advantages:
Easy to understand and communicate
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The Internal Rate of Return: Example

Consider the following project:
$50 $100 $150
0 -$200
The internal rate of return for this project is 19.44%
NPV = 0 =
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$50 $100 $150 + + (1 + IRR) (1 + IRR) 2 (1 + IRR)3
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The NPV Payoff Profile for This Example

If we graph NPV versus discount rate, we can see the IRR as the x-axis intercept.
Discount Rate 0% 4% 8% 12% 16% 20% 24% 28% 32% 36% 40% NPV $100.00 $71.04 $47.32 $27.79 $11.65 ($1.74) ($12.88) ($22.17) ($29.93) ($36.43) ($41.86)
NPV
$120.00 $100.00 $80.00 $60.00 $40.00 $20.00 $0.00 ($20.00) -1% ($40.00) ($60.00)
IRR = 19.44%
9% 19% 29% 39%
Discount rate
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Problems with the IRR Approach

Multiple IRRs. Are We Borrowing or Lending? The Scale Problem The Timing Problem
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Problems with the IRR Approach
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Multiple IRRs
There are two IRRs for this project:
$200 0 -$200
NPV $100.00 $50.00 $0.00 -50% 0% ($50.00) ($100.00) ($150.00)
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$800 2 3 - $800 Which one should we use?
100% = IRR2
50%
100%
150%
200%
0% = IRR1
Discount rate
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Summarizing rules
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The Scale Problem

Would you rather make 100% or 50% on your investments? What if the 100% return is on a $1 investment while the 50% return is on a $1,000 investment?
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The Timing Problem

$10,000 Project A 0 -$10,000 Project B 0 1 2 3 -$10,000 The preferred project in this case depends on the discount rate, not the IRR.
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$1,000
$1,000
2 $1,000
3 $1,000 $12,000
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The Timing Problem

$5,000.00 $4,000.00 $3,000.00 $2,000.00
Project A Project B 10.55% = crossover rate
NPV
$1,000.00 $0.00 ($1,000.00) 0% ($2,000.00) ($3,000.00) ($4,000.00) 10% 20% 30% 40%
12.94% = IRRB
16.04% = IRRA
Discount rate
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Calculating the Crossover Rate

Compute the IRR for either project A-B or B-A
Year Project A Project B Project A-B Project B-A 0 ($10,000) ($10,000) $0 $0 1 $10,000 $1,000 $9,000 ($9,000) 2 $1,000 $1,000 $0 $0 3 $1,000 $12,000 ($11,000) $11,000
$3,000.00 $2,000.00 NPV $1,000.00 $0.00 ($1,000.00) 0% ($2,000.00) ($3,000.00) Discount rate
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10.55% = IRR
5% 10% 15% 20% A-B B-A
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Mutually Exclusive vs. Independent Project

Mutually Exclusive Projects: only ONE of several potential projects can be chosen, e.g. acquiring an accounting system.
RANK all alternatives and select the best one.
Independent Projects: accepting or rejecting one project does not affect the decision of the other projects.
Must exceed a MINIMUM acceptance criteria.
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The Profitability Index (PI) Rule

PI = Total PV of Future Cash Flows Initial Investment
Minimum Acceptance Criteria:

Accept if PI > 1
Ranking Criteria:
Select alternative with highest PI
Disadvantages:
Problems with mutually exclusive investments
Advantages:
May be useful when available investment funds are limited Easy to understand and communicate Correct decision when evaluating independent projects
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Independent projects
Accept if PI > 1 Reject if PI < 1
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Mutually exclusive projects
PI may lead to wrong selection This flaw can be corrected using incremental analysis
In case of capital rationing: PI may be useful

3 independent projects, limited funds: $20 million Project 3:
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6.8 The Practice of Capital Budgeting

Varies by industry:
Some firms use payback, others use accounting rate of return.
The most frequently used technique for large corporations is IRR or NPV.
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Example of Investment Rules

Compute the IRR, NPV, PI, and payback period for the following two projects. Assume the required return is 10%. Year 0 1 2 3
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Project A -$200 $200 $800 -$800
Project B -$150 $50 $100 $150
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CF0 PV0 of CF1-3 NPV = IRR = PI =
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Project A -$200.00 $241.92 $41.92 0%, 100% 1.2096
Project B -$150.00 $240.80 $90.80 36.19% 1.6053
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Payback Period: Project A Project B Time CF Cum. CF CF Cum. CF 0 -200 -200 -150 -150 1 200 0 50 -100 2 800 800 100 0 3 -800 0 150 150 Payback period for project B = 2 years. Payback period for project A = 1 or 3 years?
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6-30
Relationship Between NPV and IRR

Discount rate -10% 0% 20% 40% 60% 80% 100% 120%
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NPV for A -87.52 0.00 59.26 59.48 42.19 20.85 0.00 -18.93
NPV for B 234.77 150.00 47.92 -8.60 -43.07 -65.64 -81.25 -92.52
6-31
NPV Profiles
NPV
$400 $300 $200 $100 $0
-15% 0% 15% 30% 45% 70% 100% 130% 160% 190%
IRR 1(A)
IRR (B)
IRR 2(A)
($100) ($200)
Cross-over Rate
Corporate Finance
Discount rates
Project A Project B
6-32

This chapter evaluates the most popular alternatives to NPV:
Payback period Accounting rate of return Internal rate of return Profitability index
When it is all said and done, they are not the NPV rule; for those of us in finance, it makes them decidedly second-rate.
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Net Present Value and Capital Budgeting
Corporate Finance
7-1
Chapter Outline
7.1 Incremental Cash Flows 7.2 The Baldwin Company: An Example 7.3 The Boeing 777: A Real-World Example 7.4 Inflation and Capital Budgeting 7.5 Investments of Unequal Lives: The Equivalent Annual Cost Method 7.6 Summary and Conclusions
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7-2
Incremental Cash Flows

Cash flows matternot accounting earnings. Incremental cash flows matter.
Cash flows with project cash flows without project
Sunk costs dont matter.

Sunk costs: cost already occurred, cannot be changed by the decision to accept or reject the project.
Opportunity costs matter.

e.g., by taking a project, a firm forgoes other opportunities for using an asset.
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7-3
Incremental Cash Flows (cont.)

Side effects
Erosion: e.g., a new product reduces the cash flows of existing products Synergy: e.g., a new product increases the cash flows of existing products
Allocated costs
An expenditure may benefit a number of projects Viewed as cash outflow only if it is an incremental cost of the project
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7-4
Cash FlowsNot Accounting Earnings

Consider depreciation expense. You never write a check made out to depreciation. Much of the work in evaluating a project lies in taking accounting numbers and generating cash flows.
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7-5

Sunk costs are not relevant
Just because we have come this far does not mean that we should continue to throw good money after bad.
Opportunity costs do matter. Just because a project has a positive NPV that does not mean that it should also have automatic acceptance. Specifically if another project with a higher NPV would have to be passed up we should not proceed.
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7-6

Side effects matter.
Erosion and cannibalism are both bad things. If our new product causes existing customers to demand less of current products, we need to recognize that.
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7-7
Estimating Cash Flows

Cash Flows from Operations
Recall that: Operating Cash Flow = EBIT Taxes + Depreciation
Net Capital Spending

Dont forget salvage value (after tax, of course).
Changes in Net Working Capital

Recall that when the project winds down, we enjoy a return of net working capital.
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7-8
Interest Expense
Later chapters will deal with the impact that the amount of debt that a firm has in its capital structure has on firm value. For now, its enough to assume that the firms level of debt (hence interest expense) is independent of the project at hand.
Corporate Finance
7-9
7.2 The Baldwin Company: An Example

Costs of test marketing (already spent): $250,000. Current market value of proposed factory site (which we own): $150,000. Cost of bowling ball machine: $100,000 (depreciated according to ACRS 5-year life). Increase in net working capital: $10,000. Production (in units) by year during 5-year life of the machine: 5,000, 8,000, 12,000, 10,000, 6,000. Price during first year is $20; price increases 2% per year thereafter. Production costs during first year are $10 per unit and increase 10% per year thereafter. Annual inflation rate: 5% Working Capital: initially $10,000 changes with sales.
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7-10
The Worksheet for Cash Flows of the Baldwin Company

($ thousands) (All cash flows occur at the end of the year.)
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Investments: (1) Bowling ball machine 100.00 21.76* (2) Accumulated 20.00 52.00 71.20 82.72 94.24 depreciation (3) Adjusted basis of 80.00 48.00 28.80 17.28 5.76 machine after depreciation (end of year) (4) Opportunity cost 150.00 150.00 (warehouse) (5) Net working capital 10.00 10.00 16.32 24.97 21.22 0 (end of year) (6) Change in net 10.00 6.32 8.65 3.75 21.22 working capital (7) Total cash flow of 260.00 6.32 8.65 3.75 192.98 investment * We assume that the ending market value of the capital investment at year 5 is $30,000. Capital gain is the difference between adjusted basis is purchase price of the [(1) + (4) + (6)] machine ending market value and adjusted basis of the machine. The$5,760). We will the original incremental corporate tax less depreciation. The capital gain is $24,240 (= $30,000 assume the
for Baldwin on this project is 34 percent. Capital gains are now taxed at the ordinary income rate, so the capital gains tax due is $8,240 [0.34 ($30,000 $5,760)]. The after-tax salvage value is $30,000 [0.34 ($30,000 $5,760)] = 21,760.
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7-11
The Worksheet for Cash Flows of the Baldwin Company

Year 0 Investments: (1) Bowling ball machine 100.00 (2) Accumulated depreciation (3) Adjusted basis of machine after depreciation (end of year) (4) Opportunity cost 150.00 (warehouse) (5) Net working capital 10.00 (end of year) (6) Change in net 10.00 working capital (7) Total cash flow of 260.00 investment [(1) + (4) + (6)]
Year 1
Year 2
Year 3
Year 4
Year 5 21.76* 94.24 5.76 150
20.00 80.00 150.00 10.00
52.00 48.00
71.20 28.80
82.72 17.28
16.32 6.32 6.32
24.97 8.65 8.65
21.22 3.75 3.75
0 21.22 192.98
At the end of the project, the warehouse is unencumbered, so we can sell it if we want to.
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7-12
The Worksheet for Cash Flows of the Baldwin Company (continued)

Year 0 Year 1 Year 2 Year 3 Year 4 Income: (8) Sales Revenues
Year 5
100.00 163.00 249.72 212.20 129.90
Recall that production (in units) by year during 5-year life of the machine is given by: (5,000, 8,000, 12,000, 10,000, 6,000). Price during first year is $20 and increases 2% per year thereafter. Sales revenue in year 3 = 12,000[$20(1.02)2] = 12,000$20.81 = $249,720.
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7-13

Year 0 Year 1 Year 2 Year 3 Year 4 Income: (8) Sales Revenues (9) Operating costs 100.00 163.00 249.72 212.20 50.00 88.00 145.20 133.10
Year 5 129.90 87.84
Again, production (in units) by year during 5-year life of the machine is given by: (5,000, 8,000, 12,000, 10,000, 6,000). Production costs during first year (per unit) are $10 and (increase 10% per year thereafter). Production costs in year 2 = 8,000[$10(1.10)1] = $88,000
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7-14

Year 0 Year 1 Year 2 Year 3 Year 4 Income: (8) Sales Revenues (9) Operating costs (10) Depreciation
Year 5
50.00 20.00
100.00 163.00 249.72 212.20 129.90 88.00 145.20 133.10 87.84 32.00 19.20 11.52 11.52
Year 1 2 3 4 5 6 Total ACRS % 20.00% 32.00% 19.20% 11.52% 11.52% 5.76% 100.00%
Depreciation is calculated using the Accelerated Cost Recovery System (shown at right) Our cost basis is $100,000 Depreciation charge in year 4 = $100,000(.1152) = $11,520.
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7-15

Year 5 Income: (8) Sales Revenues 100.00 163.00 249.72 212.20 129.90 (9) Operating costs 50.00 88.00 145.20 133.10 87.84 (10) Depreciation 20.00 32.00 19.20 11.52 11.52 (11) Income before taxes 30.00 43.20 85.32 67.58 30.54 [(8) (9) - (10)] (12) Tax at 34 percent 10.20 14.69 29.01 22.98 10.38 (13) Net Income 19.80 28.51 56.31 44.60 20.16
Year 0 Year 1 Year 2 Year 3 Year 4
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7-16
Incremental After Tax Cash Flows of the Baldwin Company

Year 0 (1) Sales Revenues (2) Operating costs (3) Taxes (4) OCF (1) (2) (3) (5) Total CF of Investment (6) IATCF [(4) + (5)] Year 1 $100.00 -50.00 -10.20 39.80 260. 260. 39.80 Year 2 $163.00 -88.00 -14.69 60.51 6.32 54.19 Year 3 $249.72 -145.20 -29.01 75.51 8.65 66.86 Year 4 $212.20 133.10 -22.98 56.12 3.75 59.87 Year 5 $129.90 -87.84 -10.38 31.68 192.98 224.66
$39.80 $54.19 $66.86 $59.87 $224.66 + + + + NPV = $260 + (1.10) (1.10)2 (1.10)3 (1.10)4 (1.10)5 NPV = $51,588.05
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7-17
NPV Baldwin Company

CF0 CF1 F1 CF2 F2 CF3 F3
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260 39.80 1
CF4 F4 CF5
59.87 1 224.66 1 10 51,588.05
54.19 F5 1 66.86 1 I NPV
7-18
7.3 Inflation and Capital Budgeting

Inflation is an important fact of economic life and must be considered in capital budgeting. Consider the relationship between interest rates and inflation, often referred to as the Fisher relationship: (1 + Nominal Rate) = (1 + Real Rate) (1 + Inflation Rate) For low rates of inflation, this is often approximated as Real Rate Nominal Rate Inflation Rate While the nominal rate in the U.S. has fluctuated with inflation, most of the time the real rate has exhibited far less variance than the nominal rate. When accounting for inflation in capital budgeting, one must compare real cash flows discounted at real rates or nominal cash flows discounted at nominal rates.
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7-19
Example of Capital Budgeting under Inflation

Sony International has an investment opportunity to produce a new stereo color TV. The required investment on January 1 of this year is $32 million. The firm will depreciate the investment to zero using the straight-line method. The firm is in the 34% tax bracket. The price of the product on January 1 will be $400 per unit. The price will stay constant in real terms. Labor costs will be $15 per hour on January 1. The will increase at 2% per year in real terms. Energy costs will be $5 per TV; they will increase 3% per year in real terms. The inflation rate is 5% Revenues are received and costs are paid at year-end.
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7-20

Year 1 Physical Production (units) Labor Input (hours) Energy input, physical units 100,000 Year 2 200,000 Year 3 200,000 Year 4 150,000
2,000,000 200,000
2,000,000 200,000
2,000,000 200,000
2,000,000 200,000
The riskless nominal discount rate is 4%. The real discount rate for costs and revenues is 8%. Calculate the NPV.
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7-21

The depreciation tax shield is a risk-free nominal cash flow, and is therefore discounted at the nominal riskless rate. Cost of investment today = $32,000,000 Project life = 4 years Annual depreciation expense: $8,000,000 = $32,000,000 4 years
Depreciation tax shield = $8,000,000 .34 = $2,720,000

CF0 CF1 F1
Corporate Finance
0 2,720,000 4 I NPV 4 9,873,315
7-22
Year 1 After-tax Real Risky Cash Flows

Risky Real Cash Flows Price: $400 per unit with zero real price increase Labor: $15 per hour with 2% real wage increase Energy: $5 per unit with 3% real energy cost increase Year 1 After-tax Real Risky Cash Flows:
After-tax revenues = $400 100,000 (1 .34) = $26,400,000 After-tax labor costs = $15 2,000,000 1.02 (1 .34) = $20,196,000 After-tax energy costs = $5 2,00,000 1.03 (1 .34) = $679,800 After-tax net operating CF = $26,400,000 $20,196,000 $679,800 = $5,524,200
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7-23

After-tax revenues = $400 100,000 (1 .34) = $26,400,000 After-tax labor costs = $15 2,000,000 (1.02)2 (1 .34) = $20,599,920 After-tax energy costs = $5 2,00,000 (1.03)2 (1 .34) = $700,194 After-tax net operating CF = $26,400,000 $ 20,599,920 $ 700,194 = $ 31,499,886
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7-24

After-tax revenues = $400 100,000 (1 .34) = $26,400,000 After-tax labor costs = $15 2,000,000 (1.02)3 (1 .34) = $21,011.92 After-tax energy costs = $5 2,00,000 (1.03)3 (1 .34) = $721,199.82 After-tax net operating CF = $26,400,000 $ 21,011.92 $ 721,199.82 = $31,066,882
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7-25

After-tax revenues = $400 100,000 (1 .34) = $26,400,000 After-tax labor costs = $15 2,000,000 (1.02)4 (1 .34) = $21,432.16 After-tax energy costs = $5 2,00,000 (1.03)4 (1 .34) = $742,835.82 After-tax net operating CF = $26,400,000 $21,432.16 $742,835.82 = $17,425,007
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7-26

$5,524,200 $31,499,886 $31,066,882 $17,425,007
0
-$32,000,000
1 CF0 CF1 F1 CF2 F2 32 m 5,524,000 1 31,499,886 1
2 CF3 F3 CF4 F4 I
3 31,066,882 1 17,425,007 1 8 NPV
69,590,868
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7-27

The project NPV can now be computed as the sum of the PV of the cost, the PV of the risky cash flows discounted at the risky rate and the PV of the risk-free cash flows discounted at the riskfree discount rate.
NPV = $32,000,000 + $69,590,868 + $9,873,315 = $47,464,183
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7-28
7.3 The Boeing 777:

A Real-World Example
In late 1990, the Boeing Company announced its intention to build the Boeing 777, a commercial airplane that could carry up to 390 passengers and fly 7,600 miles. Analysts expected the up-front investment and R&D costs would be as much as $8 billion. Delivery of the planes was expected to begin in 1995 and continue for at least 35 years.
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7-29
Table 7.5 Incremental Cash Flows: Boeing 777

Sales Operating Year Units Revenue Costs Dep.
1991 1992 1993 1994 1995 14 $1,847.55 1,340.00 96.00 1,240.00 116.40 840.00 124.76 1,976.69 112.28 17,865.45 101.06 16,550.04 90.95
Taxes
(488.24) (461.18) (328.02) (82.08) 493.83 885.10
Capital Invest- Net Cash Flow NWC Spending ment

$400.00 $400.00 $(957.30) 600.00 300.00 181.06 1,722.00 (17.12) 200.00 1.85 600.00 (1,451.76) 300.00 (1,078.82) 200.00 182.91 (711.98) (229.97)
$865.00 $40.00 $(307.70)
1996 145 19,418.96 1997 140 19,244.23
19.42 1,741.42 681.74 19.42 2.30 1,806.79
Net Cash Flow can be determined in three steps: Taxes ($19,244.23 $16,550.04 $90.95)0.34 = $885.10 Investment $17.12 + $19.42 = $2.30 NCF $19,244.23 $16,550.04 $885.10 $2.30 = $1,806.79
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7-30
Year
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000
NCF
$ (957.30) $ (1,451.76) $ (1,078.82) $ (711.98) $ (229.97) $ 681.74 $ 1,806.79 $ 1,914.06 $ 1,676.05 $ 1,640.25
Year
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
NCF
$ 1,717.26 $ 1,590.01 $ 1,798.97 $ 616.79 $ 1,484.73 $ 2,173.59 $ 1,641.97 $ 677.92 $ 1,886.96 $ 2,331.33
Year
2013 2014 2015 2016 2017 2018 2019 2020 2021 2022
NCF
$ 2,213.18 $ 2,104.73 $ 2,285.77 $ 2,353.81 $ 2,423.89 $ 2,496.05 $ 2,568.60 $ 2,641.01 $ 2,717.53 $ 2,798.77
2001 $ 1,716.80
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2012 $ 2,576.47
2023 $ 2,882.44 2024 $ 2,964.45
7-31
7.3 The Boeing 777: A Real-World

Example
Prior to 1990, Boeing had invested several hundred million dollars in research and development. Since these cash outflows were incurred prior to the decision to build the plane, they are sunk costs. The relevant costs were the at the time the decision was made were the forecasted Net Cash Flows
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NPV Profile of the Boeing 777 Project

$60,000 $50,000 $40,000 $30,000 $20,000 $10,000 $0 ($10,000)0%
NPV
IRR = 21.12%
10%
20%
30%
40%
50%
Discount Rate
This graph shows NPV as a function of the discount rate. Boeing should accept this project at discount rates less than 21 percent and reject the project at higher discount rates.
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7-33
Boeing 777
As it turned out, sales failed to meet expectations. In fairness to the financial analysts at Boeing, there is an important distinction between a good decision and a good outcome.
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7.4 Investments of Unequal Lives: The Equivalent Annual Cost Method

There are times when application of the NPV rule can lead to the wrong decision. Consider a factory which must have an air cleaner. The equipment is mandated by law, so there is no doing without. There are two choices:
The Cadillac cleaner costs $4,000 today, has annual operating costs of $100 and lasts for 10 years. The Cheapskate cleaner costs $1,000 today, has annual operating costs of $500 and lasts for 5 years.
Which one should we choose?

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7-35
EAC with a Calculator

At first glance, the Cheapskate cleaner has a lower NPV Cadillac Air Cleaner
CF0 CF1 F1 I NPV
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Cheapskate Air Cleaner

CF0 CF1 F1 I NPV
4,000
100
1,000
500
10 10
4,614.46
5 10
2,895.39
7-36

This overlooks the fact that the Cadillac cleaner lasts twice as long. When we incorporate that, the Cadillac cleaner is actually cheaper.
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7-37

The Cadillac cleaner time line of cash flows:
-$4,000 100 -100 -100 -100 -100 -100 -100 -100 -100 -100
10
The Cheapskate cleaner time line of cash flows over ten years:
-$1,000 500 -500 -500 -500 -1,500 -500 -500 -500 -500 -500
10
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7-38
The Equivalent Annual Cost Method

When we make a fair comparison, the Cadillac is cheaper: Cadillac Air Cleaner
CF0 CF1 F1 I NPV
Corporate Finance
Cheapskate Air Cleaner

CF0 CF1 1,000 500 4 1,500 1 500 5 I NPV 10 4,693
4,000
100
F1 CF2 F1 CF3
10 10
4,614.46
F1
7-39
Investments of Unequal Lives

Replacement Chain
Repeat the projects forever, find the PV of that perpetuity. Assumption: Both projects can and will be repeated.
Matching Cycle
Repeat projects until they begin and end at the same timelike we just did with the air cleaners. Compute NPV for the repeated projects.
The Equivalent Annual Cost Method

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7-40
Investments of Unequal Lives: EAC

The Equivalent Annual Cost Method Applicable to a much more robust set of circumstances than replacement chain or matching cycle. The Equivalent Annual Cost is the value of the level payment annuity that has the same PV as our original set of cash flows. NPV = EAC ArT Where ArT is the present value of $1 per period for T periods when the discount rate is r.
For example, the EAC for the Cadillac air cleaner is $750.98 The EAC for the cheaper air cleaner is $763.80 which confirms our earlier decision to reject it.
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7-41
Cadillac EAC with a Calculator

Use the cash flow menu to find the PV of the lumpy cash flows. Then use the time value of money keys to find a payment with that present value. CF0 CF1 F1 I NPV
Corporate Finance
4,000
100
N I/Y PV PMT FV
10 10 4,614.46 750.98
10 10
4,614.46
7-42
Cheapskate EAC with a Calculator

Use the cash flow menu to find the PV of the cash flows. Then use the time value of money keys to find a payment with that present value. CF0 CF1 F1 I NPV
Corporate Finance
1,000
500
N I/Y PV PMT FV
10 10 4,693.21 763.80
5 10
4,693.21
7-43
Example of Replacement Projects

Consider a Belgian Dentists office; he needs an autoclave to sterilize his instruments. He has an old one that is in use, but the maintenance costs are rising and so is considering replacing this indispensable piece of equipment.
New Autoclave Cost = $3,000 today, Maintenance cost = $20 per year Resale value after 6 years = $1,200 NPV of new autoclave (at r = 10%) is $2,409.74 6 $20 $1,200 $2,409.74 = $3,000 + t (1.10) 6 t =1 (1.10)
EAC of new autoclave = -$553.29

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6 t =1
$2,409.74 =
$553.29 (1.10)t
7-44

Existing Autoclave
Year 0 Maintenance 0 Resale 900 Total Annual Cost 1 200 850 340 2 275 775 435 3 325 700 478 4 450 600 620 5 500 500 660
Total Cost for year 1 = (900 1.10 850) + 200 = $340 Total Cost for year 2 = (850 1.10 775) + 275 = $435 Total Cost for year 3 = (775 1.10 700) + 325 = $478 Total Cost for year 4 = (700 1.10 600) + 450 = $620 Total Cost for year 5 = (600 1.10 500) + 500 = $660
Note that the total cost of keeping an autoclave for the first year includes the $200 maintenance cost as well as the opportunity cost of the foregone future value of the $900 we didnt get from selling it in year 0 less the $850 we have if we still own it at year 1.
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7-45

New Autoclave
EAC of new autoclave = -$553.29 1 200 850 340 2 275 775 435 3 325 700 478 4 450 600 620 5 500 500 660
Existing Autoclave
Year 0 Maintenance 0 Resale 900 Total Annual Cost
We should keep the old autoclave until its cheaper to buy a new one. Replace the autoclave after year 3: at that point the new one will cost $553.29 for the next years autoclaving and the old one will cost $620 for one more year.
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7-46

Capital budgeting must be placed on an incremental basis.
Sunk costs are ignored Opportunity costs and side effects matter
Inflation must be handled consistently

Discount real flows at real rates Discount nominal flows at nominal rates.
When a firm must choose between two machines of unequal lives:

the firm can apply either the matching cycle approach or the equivalent annual cost approach.
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7-47
Dorm Beds Example

Consider a project to supply the University of Missouri with 10,000 dormitory beds annually for each of the next 3 years. Your firm has half of the woodworking equipment to get the project started; it was bought years ago for $200,000: is fully depreciated and has a market value of $60,000. The remaining $60,000 worth of equipment will have to be purchased. The engineering department estimates you will need an initial net working capital investment of $10,000.
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Dorm Beds Example

The project will last for 3 years. Annual fixed costs will be $25,000 and variable costs should be $90 per bed. The initial fixed investment will be depreciated straight line to zero over 3 years. It also estimates a (pre-tax) salvage value of $10,000 (for all of the equipment). The marketing department estimates that the selling price will be $200 per bed. You require an 8% return and face a marginal tax rate of 34%.
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7-49
Dorm Beds Example OCF0

What is the OCF in year zero for this project? Cost of New Equipment $60,000 Net Working Capital Investment $10,000 Opportunity Cost of Old Equipment $39,600 = $60,000 (1-.34) $109,600
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7-50
Dorm Beds Example OCF1,2

What is the OCF in years 1 and 2 for this project?
Revenue Variable cost Fixed cost Depreciation EBIT Tax (34%) Net Income 10,000 $200 = 10,000 $90 = $60,000 3 = $2,000,000 $900,000 $25,000 $20,000 $1,055,000
$358,700 $696,300 OCF =$696,300 + $20,000 $716,300 OCF = $2,000,000 925,000 358,700 = $716,300 ($2,000,000 925,000)(1 .34)+20,000.34 = $716,300
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Dorm Beds Example OCF3

Revenue Variable cost Fixed cost Depreciation EBIT Tax 10,000 $200 = 10,000 $90 = $60,000 3 = 10,000 $200 = $2,000,000 $900,000 $25,000 $20,000 $1,055,000
$358,700 NI $696,300 OCF = NI + D $716,300 We get our $10,000 NWC back and sell the equipment. The after-tax salvage value is $6,600 = $10,000 (1-.34) Thus, OCF3 = $716,300 + $10,000 + $6,600 = $732,900
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Dorm Beds Example NPV

First, set your calculator to 1 payment per year. Then, use the cash flow menu:
CF0 CF1 F1 CF2 F2
Corporate Finance
$109,600 $716,300
I NPV
8
$1,749,552.19
2
$732,900
29-0
CHAPTER
Mergers and Acquisitions

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29-1
Chapter Outline
29.1 The Basic Forms of Acquisitions 29.2 The Tax Forms of Acquisitions 29.3 Accounting for Acquisitions 29.4 Determining the Synergy from an Acquisition 29.5 Source of Synergy from Acquisitions 29.6 Calculating the Value of the Firm after an Acquisition 29.7 A Cost to Stockholders from Reduction in Risk 29.8 Two "Bad" Reasons for Mergers 29.9 The NPV of a Merger 29.10 Defensive Tactics 29.11 Some Evidence on Acquisitions 29.12 The Japanese Keiretsu 29.13 Summary and Conclusions
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29-2
29.1 The Basic Forms of Acquisitions

There are three basic legal procedures that one firm can use to acquire another firm:
Merger or Consolidation Acquisition of Stock Acquisition of Assets
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29-3
Varieties of Takeovers
Merger Acquisition Takeovers Proxy Contest Going Private (LBO)
Corporate Finance
Acquisition of Stock Acquisition of Assets
29-4
29.2 The Tax Forms of Acquisitions

If it is a taxable acquisition, selling shareholders need to figure their cost basis and pay taxes on any capital gains. If it is not a taxable event, shareholders are deemed to have exchanged their old shares for new ones of equivalent value.
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29-5
29.3 Accounting for Acquisitions

The Purchase Method
The source of much goodwill
Pooling of Interests
Pooling of interest is generally used when the acquiring firm issues voting stock in exchange for at least 90 percent of the outstanding voting stock of the acquired firm.
Purchase accounting is generally used under other financing arrangements.

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29-6
29.4 Determining the Synergy from an Acquisition

Most acquisitions fail to create value for the acquirer. The main reason why they do not lies in failures to integrate two companies after a merger.
Intellectual capital often walks out the door when acquisitions aren't handled carefully. Traditionally, acquisitions deliver value when they allow for scale economies or market power, better products and services in the market, or learning from the new firms.
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29-7
Synergy
Suppose firm A is contemplating acquiring firm B. The synergy from the acquisition is Synergy = VAB (VA + VB) The synergy of an acquisition can be determined from the usual discounted cash flow model:
T
Synergy = where
t=1
CFt (1 + r)t
CFt = Revt Costst Taxest Capital Requirementst

Corporate Finance
29-8
29.5 Source of Synergy from Acquisitions

CFt = Revt Costst Taxest Capital Requirementst
Revenue Enhancement Cost Reduction

Including replacement of ineffective managers.
Tax Gains
Net Operating Losses Unused Debt Capacity
Incremental new investment required in working capital and fixed assets

Corporate Finance
29-9
29.6 Calculating the Value of the Firm after an Acquisition

Avoiding Mistakes
Do not Ignore Market Values Estimate only Incremental Cash Flows Use the Correct Discount Rate Dont Forget Transactions Costs
Corporate Finance
29-10
29.7 A Cost to Stockholders from Reduction in Risk

The Base Case
If two all-equity firms merge, there is no transfer of synergies to bondholders, but if
One Firm has Debt

The value of the levered shareholders call option falls.
How Can Shareholders Reduce their Losses from the Coinsurance Effect?
Retire debt pre-merger.
Corporate Finance
29-11
29.8 Two "Bad" Reasons for Mergers

Earnings Growth
Only an accounting illusion.
Diversification
Shareholders who wish to diversify can accomplish this at much lower cost with one phone call to their broker than can management with a takeover.
Corporate Finance
29-12
29.9 The NPV of a Merger

Typically, a firm would use NPV analysis when making acquisitions. The analysis is straightforward with a cash offer, but gets complicated when the consideration is stock.
Corporate Finance
29-13
The NPV of a Merger: Cash

NPV of merger to acquirer =
Synergy Premium Synergy = VAB (VA + VB) Premium = Price paid for B VB NPV of merger to acquirer = Synergy Premium = [VAB (VA + VB)] [Price paid for B VB] = VAB (VA + VB) Price paid for B + VB = VAB VA Price paid for B
Corporate Finance
29-14
The NPV of a Merger: Common Stock

The analysis gets muddied up because we need to consider the post-merger value of those shares were giving away.
Target firm payout New firm value
New shares issued Old shares + New shares issued
Corporate Finance
29-15
Cash versus Common Stock

Overvaluation
If the target firm shares are too pricey to buy with cash, then go with stock.
Taxes
Cash acquisitions usually trigger taxes. Stock acquisitions are usually tax-free.
Sharing Gains from the Merger

With a cash transaction, the target firm shareholders are not entitled to any downstream synergies.
Corporate Finance
29-16
29.10 Defensive Tactics

Target-firm managers frequently resist takeover attempts. It can start with press releases and mailings to shareholders that present managements viewpoint and escalate to legal action. Management resistance may represent the pursuit of self interest at the expense of shareholders. Resistance may benefit shareholders in the end if it results in a higher offer premium from the bidding firm or another bidder.
Corporate Finance
29-17
Divestitures
The basic idea is to reduce the potential diversification discount associated with commingled operations and to increase corporate focus, Divestiture can take three forms:
Sale of assets: usually for cash Spinoff: parent company distributes shares of a subsidiary to shareholders. Shareholders wind up owning shares in two firms. Sometimes this is done with a public IPO. Issuance if tracking stock: a class of common stock whose value is connected to the performance of a particular segment of the parent company.
Corporate Finance
29-18
The Corporate Charter

The corporate charter establishes the conditions that allow a takeover. Target firms frequently amend corporate charters to make acquisitions more difficult. Examples
Staggering the terms of the board of directors. Requiring a supermajority shareholder approval of an acquisition
Corporate Finance
29-19
Repurchase Standstill Agreements

In a targeted repurchase the firm buys back its own stock from a potential acquirer, often at a premium. Critics of such payments label them greenmail. Standstill agreements are contracts where the bidding firm agrees to limit its holdings of another firm.
These usually leads to cessation of takeover attempts. When the market decides that the target is out of play, the stock price falls.
Corporate Finance
29-20
Exclusionary Self-Tenders
The opposite of a targeted repurchase. The target firm makes a tender offer for its own stock while excluding targeted shareholders.
Corporate Finance
29-21
Going Private and LBOs

If the existing management buys the firm from the shareholders and takes it private. If it is financed with a lot of debt, it is a leveraged buyout (LBO). The extra debt provides a tax deduction for the new owners, while at the same time turning the pervious managers into owners. This reduces the agency costs of equity
Corporate Finance
29-22
Other Devices and the Jargon of Corporate Takeovers

Golden parachutes are compensation to outgoing target firm management. Crown jewels are the major assets of the target. If the target firm management is desperate enough, they will sell off the crown jewels. Poison pills are measures of true desperation to make the firm unattractive to bidders. They reduce shareholder wealth.
One example of a poison pill is giving the shareholders in a target firm the right to buy shares in the merged firm at a bargain price, contingent on another firm acquiring control.
Corporate Finance
29-23
29.11 Some Evidence on Acquisitions: The Short Run

Takeover Successful Unsuccessful Technique Targets Bidders Targets Bidders
Tender offer 30% Merger 20% Proxy contest 8% 4% 0% NA 3% 3% 8% 1% 5% NA
Corporate Finance
29-24
29.11 Some Evidence on Acquisitions: The Long Run

In the long run, the shareholders of acquiring firms experience below average returns. Cash-financed mergers are different than stock-financed mergers. Acquirers can be friendly or hostile. The shares of hostile cash acquirers outperformed those of friendly cash acquirers. One explanation is that unfriendly cash bidders are more likely to replace poor management.
Corporate Finance
29-25
29.12 The Japanese Keiretsu

Keiretsu are reciprocal shareholding and trading agreements between firms. Usually a group of firms affiliated around a large bank, industrial firm, or trading firm. Nobody knows for sure if forming a keiretsu pays off or not.
Corporate Finance
29-26

The three legal forms of acquisition are
1. Merger and consolidation 2. Acquisition of stock 3. Acquisition of assets
M&A requires an understanding of complicated tax and accounting rules. The synergy from a merger is the value of the combined firm less the value of the two firms as separate entities. Synergy = VAB (VA + VB)
Corporate Finance
29-27

The possible synergies of an acquisition come from the following:
Revenue enhancement Cost reduction Lower taxes Lower cost of capital
The reduction in risk may actually help existing bondholders at the expense of shareholders.
Corporate Finance
10

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1-0

Introduction to Corporate Finance

What is Corporate Finance?

need to pay its bills?

The Balance-Sheet Model of the Firm

Fixed Assets 1 Tangible 2 Intangible

The Balance-Sheet Model of the Firm

Fixed Assets 1 Tangible 2 Intangible

What longterm investments should the firm engage in?

The Balance-Sheet Model of the Firm

The Balance-Sheet Model of the Firm

Fixed Assets 1 Tangible 2 Intangible

Hypothetical Organization Chart

Credit Manager Financial Planning

Cost Accounting Data Processing

The Financial Manager

The Firm and the Financial Markets

Ultimately, the firm must be a cash generating activity.

1.2 Corporate Securities as Contingent Claims on Total Firm Value

Debt and Equity as Contingent Claims

Algebraically, the shareholders claim is: Max[0,$X $F]

Combined Payoffs to Debt and Equity

Debt holders are promised $F.

1.3 The Corporate Firm

Forms of Business Organization

The Corporation Advantages and Disadvantages

A Comparison of Partnership and Corporations

Taxation Reinvestment and dividend payout Liability

1.4 Goals of the Corporate Firm

The Set-of-Contracts Perspective

This contracting and monitoring is costly.

Separation of Ownership and Control

Do Shareholders Control Managerial Behavior?

1.5 Financial Markets

Stocks and Bonds Money Bob

Investors securities Sue money

Primary Market Secondary Market

Exchange Trading of Listed Stocks

Efficient Capital Market

Nguyen Viet Dung, PhD.

Forms of the Efficient Market Hypothesis

Forms of the Efficient Market Hypothesis

Nguyen Viet Dung, PhD.

Implications of stock market efficiency

Nguyen Viet Dung, PhD.

Limitations to fully efficient markets

Price reaction to the release of new public information

Correct reaction (Semistrong-form market efficiency)

Release of new public information

Nguyen Viet Dung, PhD.

Price reaction on the emerging Vietnamese stock market

Nguyen Viet Dung, PhD.

Accounting Statements and Cash Flow

2.1 The Balance Sheet

The Balance Sheet of the U.S. Composite Corporation

Balance Sheet Analysis

Debt versus Equity

Value versus Cost

2.2 The Income Statement

U.S.C.C. Income Statement

$2,262 - 1,655 - 327 - 90 $190 29 $219 - 49 $170 - 84

$86 $43 $43

U.S.C.C. Income Statement