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Lahore School of Economics. MBA II. Advance Corporate Finance. Winter 2018. Dr. Sohail Zafar. TA: Ms.

Farheen Hassan

Advance Corporate Finance

Lectures 1 to 4
Overview
These sessions are devoted to refreshing some of the basic concepts already covered in FM I, FM II, and
Corporate Finance courses. Corporate sector in Pakistan is rather small; there are about 88,000
companies of various types registered with SECP (Securities and Exchange Commission of Pakistan) and
only slightly less than 600 corporations are listed on the Pakistan Stock Exchange (PSX). Total market
capitalization (share price multiplied by number of shares outstanding) of listed corporations is about 87
billion US dollars, which is far lower than the market capitalization of a single well known MNC such as
Micro Soft, IBM, Exxon Mobil, Apple, etc. Therefore it is justified to start with the understanding that
corporate sector of Pakistan is relatively small.

Finance, as an area of study, can be divided into two major categories: a) Public Finance which deals with
the finances of a government; b) Business Finance. Business finance has three sub areas, namely,
financial institutions and markets, investment analysis and portfolio management including derivatives,
and business financial management. This course on advance corporate finance is about the business
financial management with focus on those businesses that are organized as corporate entities and their
shares are traded on a stock exchange; in other words, this course focuses on the corporate decision
making of those corporations that are public limited (instead of private limited) and have chosen to raise
equity capital from general public by issuing shares of ownership to general public. In this category fall
both private sector corporation whose shares are owned by private citizens and other corporations, and
public sector corporations whose majority shares (50% plus) are owned by the government of Pakistan
but also some portion of shares is owned by private citizens and other corporations. It is noteworthy that
some of the largest corporations in Pakistan in terms of their market capitalization (that is, no of shares *
share price) are public sector entities (that is, government owned) such as PSO, OGDC, NBP, PIA, Sui
Northern, Sui Southern, PPL, POL, National Refinery, etc, while some private sector corporations such as
Engro, Nestle, MCB, ABL, etc, also have large market capitalization, and both of these types are public
limited companies. Some private sector corporations that are private limited companies are also well
known, such as TCS and Daewoo as their shares are held by a small group of shareholders and these are
not listed and traded on the stock exchange. Financial information such as income statement, balance
sheet, earnings per share, etc of private limited companies are not available to general public as by law
private limited companies are not required to disclose such information to the general public.

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Lahore School of Economics. MBA II. Advance Corporate Finance. Winter 2018. Dr. Sohail Zafar. TA: Ms. Farheen Hassan

Overview of three major decision areas in corporate finance


All corporate decisions, and more so the decisions made by finance managers, must be guided by the
concern for value creation for the shareholders because ordinary shareholders (common shareholders)
are the legal owners of a corporation; and they have invested in a corporation to become wealthier.
Therefore ultimately all managerial decisions made by the professional managers should be guided, at
least in theory, by the consideration of making the owners of corporation wealthier, and that happens
only when share price goes up in the stock market. But in reality corporate managers are hired hands;
and do not always keep shareholders’ value creation as the prime concern in their decision making. This
situation is termed in finance literature as the Agency Problem. Managers, as agent of shareholders, are
expected to keep the well being (wealth creation) of the principals (that is the shareholders) in mind but
actually managers may pursue other objectives such as maximizing the size of assets under their control,
or maximizing the perks and benefits they get as part of their compensation package, or ensuring
continuity of their job, etc.

Broadly speaking, there are three areas of corporate decision making that are relevant to finance
managers. These are termed: investing decisions, financing decisions, and liquidity management
decisions.

Investing Decisions
Investing decisions are made by corporate managers to invest corporate funds to expand, or replace, or
modernize the assets of a corporation; and as a result of these decisions expansion in existing assets or
replacement of old assets with new and technologically advanced assets takes place. In Pakistani banking
circles the term BMR ( balancing, modernization, and replacement ) is used while referring to loans given
to corporations for these purposes. For the loan receiving corporate managers they are raising funds to
make investing decisions in their respective corporations to balance, modernize, and replace the assets of
their respective corporation, and taking loan is financing decision.

So you should be careful in which context you are using the word Investment. On the one hand investors
invest in a business as owner (shareholder) or as a lender (creditor / banks), and in that sense they act as
financiers of a corporation; and from the perspective of corporate managers involved in raising funds
from these 2 groups, such decisions are called financing decisions; on the other hand the funds received
from owners and creditors are invested by corporate managers in the assets of the corporation, and such
decisions made by the corporate managers are called investing decisions.

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Lahore School of Economics. MBA II. Advance Corporate Finance. Winter 2018. Dr. Sohail Zafar. TA: Ms. Farheen Hassan

It is customary to divide assets of industrial corporations into 2 categories namely FA (fixed assets) and
CA (current assets). CA and current liabilities (CL) are viewed as interrelated as mostly (but not always)
the funds raised as CL are invested in CA, therefore for decision making purposes sometimes it is relevant
to analyze what proportion of CA are not financed by CL; and such CA are called NWC (net working
capital); and NWC = CA – CL. This expression of NWC suggests that NWC is that portion of CA that are
financed by long term sources of funds, namely, debt capital and equity capital.

Debt capital of a corporation is in the form of its long term liabilities such as long term bank loan or lease
contracts or bonds payable. Equity capital of corporation is composed of owners funds received by a
corporation when it issues shares and investors buy these shares, also when a portion of profits are not
given out by the corporation as cash dividends to the shareholders but reinvested in the assets of the
corporation those funds are also owners provided funds and are called retained earnings or Reserves ).

To have clarity about investing decisions, financing decisions, and liquidity management decisions, the
following balance sheet model of the firm is analytically useful frame work.

Refreshing the balance sheet equation:

CA + FA = CL + LTL + OE (please note that LTL stands for long term liabilities, OE for owners’ equity)

CA – CL + FA = LTL + OE

But: CA - CL = NWC (net working capital), therefore

NWC + FA = LTL + OE

For example

CA + FA = CL + LTL + OE

100 + 400 = 50 + 250 + 200

100 – 50 + 400 = 250 + 200

50 + 400 = 250 + 200


NWC + FA = LTL + OE
450 = 450

Real Capital = Financial Capital

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Lahore School of Economics. MBA II. Advance Corporate Finance. Winter 2018. Dr. Sohail Zafar. TA: Ms. Farheen Hassan

Based on this logic when managers consider long term capital invested in a business they take NWC as
one category and FA as the other category of assets. Therefore total capital invested in a corporation is
viewed as:

Total Capital Invested in a corporation = NWC + FA. You can calculate it from LHS (Left Hand side) of
balance sheet, and it is real capital because it is in the form of real things such as cash, inventory,
machines, land, buildings, etc

Total Capital Invested in a corporation = LTL + OE. You can calculate it from RHS (Right Hand Side) of
balance sheet, and that is financial capital because it is in the form of pieces of papers. This is so because
both LTL and OE of a corporation are evidenced by pieces of papers .

When managers invest in FA and NWC of their co, such investments, naturally, result in expansion of the
asset base of a co and therefore expansion of production, storage, and selling capacity takes place.
Usually increase in assets is termed growth of a business, therefore investing decision are crucial for
corporate growth. In the long term, only growing companies can hope to survive because if a company is
not growing while its competitors are growing, then it becomes smaller in relative terms; and will soon
find itself a relatively insignificant player as compared to its competitors; and such a company is likely to
become target of takeover by the bigger and growing companies; or pushed out of the product or service
markets by the larger players. In the modern day competitive corporate world, survival in the long term
depends on growth; and growth requires replacement, modernization, and expansion in FA and NWC.
Therefore good investing decisions by management of a corporation are crucial for the company’s
future survival and growth prospects; whereas bad investing decisions about the choice, composition,
and size of FA and NWC are likely to hamper growth in future, and may jeopardize the very survival of a
co; because having inappropriate assets in place results in producing out of date, low quality products;
which in turn results in loss of market share and financial losses instead of profits.

Therefore it is correct to view investing decisions as the most important decisions that corporate
managers make; and that is why the top most level of corporate management is likely to be involved in
such decision making. In previous courses (FM I and FM II) you have been introduced with the basics of
making corporate investing decisions under the topic “Capital Budgeting”, and you are familiar with
various techniques used by managers to choose good investment projects, namely, NPV, IRR, Profitability
Index (also called benefit to cost ratio), Payback Period , Discounted Payback Period, and Accounting Rate
of Return

It must be emphasized that wealth of the owners (shareholders) of a corporation is in the form of market
value (MV) of the shares of that corporation. But market value of shares is a derivative because shares by

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Lahore School of Economics. MBA II. Advance Corporate Finance. Winter 2018. Dr. Sohail Zafar. TA: Ms. Farheen Hassan

themselves have no innate value as these are only pieces of papers; these shares derive their value from
the value of the assets of a corporation. In other words it is the market value of TA (total assets) which is
the basis of market value (MV) of shares.

MV of TA = MV of TL + MV of OE

You can juggle a bit this MV based balance sheet equality and have:

MV of TA - MV of TL = MV of OE

In this sense MV of equity is a residual amount , and in the literature some authors refer to it as net
assets. This expression emphasizes the fact that MV of OE (that is wealth of owners of a co) is a residual
or left over amount. In simple words, after selling all assets at their market value, and using that amount
first to pay all liabilities the left over amount belongs to owners of that corporation. It is possible that
assets are sold at such low amount that all the liabilities are not fully paid, and therefore the left over is
negative amount. In such case the shareholders have lost all their wealth invested in that corporation. For
example if MV of TA is 100 and MV of TL is 120, then MV of OE is 100 - 120 = - 20. If assets of such a co
are liquidated , its creditors won’t get their 120, rather they will get 100, and its owners would go home
empty handed having lost all their wealth invested in such a company.

It is also important to understand that:

Market value of OE of a public limited corporation listed on a stock exchange is also represented by

MV of Equity = number of shares outstanding * share price

and it is also called market capitalization of a corporation. Please note here that book value (BV) of TA as
reported in the balance sheet is a past oriented number because accountants record assets’ value using
historical cost principle; whereas in reality value of the same assets may be very different in the market
now.

Market value of TA of a corporation is affected significantly by the quality of investing decisions made by
its managers. If managers have put in place good quality assets in sufficient quantity, and then have used
these assets efficiently to produce and sell high quality goods and services, then these assets generate
high EBIT (earnings before interest and taxes, also called operating profits) per year and are considered
valuable. As a reminder, analytically income statement of industrial corporations can be written as:

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Lahore School of Economics. MBA II. Advance Corporate Finance. Winter 2018. Dr. Sohail Zafar. TA: Ms. Farheen Hassan

Financial Accounting Cost Accounting Income Statement


S 1000 S 1000
-CGS 400 - TVC (total variable cost) 500
---------- ------ ----------- --------
GP (gross profits) 600 TCM 500
-operating expenses 200 -TFC 100
----------- ------- ------------ ------
EBIT 400 EBIT 400
-interest expense 100 - interest expense 100
----------- ------ -------------------------- ------
EBT 300 EBT 300
-Corporate income tax 100 Corporate income tax 100
------------- ------- -------------------------------- ------
NI 200 NI 200
======= ===== ================== =====
S - CGS = GP.
GP – Operating Expenses = EBIT (earnings before interest and taxes also called operating Profits).
EBIT – Interest expense = EBT (earnings before tax).
EBT – Corporate Income tax = NI (net income or profit after tax, PAT).

As you know there is no distinction between CGS and operating expenses in a service businesses such as
restaurants, railways, airlines, hotels, etc; therefore income statement of a service company is modeled
as:

S 1,000
- Operating Costs 600
---------- -----------
EBIT 400
- Interest expense 100
----------- -----------
EBT 300
- Corporate income tax 100
------------- -----------
NI 200
======= =======

CGS + Operating Expenses put together are called Operating Costs per year.

Quality of Investing Decisions

For the analytical refinement and for the sake of comparability with other cos and with previous years
,usually EBIT alone is not used to judge the success of investing decisions and operating performance,

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Lahore School of Economics. MBA II. Advance Corporate Finance. Winter 2018. Dr. Sohail Zafar. TA: Ms. Farheen Hassan

rather a ratio called Return on Invested Capital (ROIC) is used to judge operating performance of a
corporation, and operating performance is viewed as indication of the quality of investing decisions made
by managers. Higher the ROIC, better is the operating performance, and that indicates that better
investing decisions were made by the corporate managers. ROIC is calculated as shown below:

ROIC = EBIT (1 - T) / total capital invested

For example: EBIT was last year 200 million , Tax rate on EBT is 30%, and total capital invested in a co was
FA + NWC = 1,200 million, then its last year’s ROIC

ROIC = 200(1 - 0.3) / 1,200

ROIC = 0.1167 = 11.67%

If in another co in the same industry ROIC was 8% then you can say operating performance was better in
the co that earned higher ROIC; and it means its managers had made better investing decision about
choice, size, composition, etc of their FA and NWC. Similarly if in a co over the years ROIC is improving,
you would conclude that its managers’ investing decisions are becoming better over the years.

Relationship of Break-even Sales quantity with Investing Decisions

Please be clear in your understanding that economists divide the same operating costs into TVC (total
variable cost) + TFC (total fixed cost) per year; and TVC = unit variable cost * units produced. Unit
variable cost is composed of raw material cost per unit, direct labor cost per unit , and variable FOH cost
per unit. TVC is called a product cost because it increases and decreases with the number of units
produced. Total fixed cost per year is a lump-sum amount for a period and therefore is treated as a
period cost by the cost accountants. Fixed operating costs are not directly traceable to units produced
but are incurred any way every period such as fixed factory overhead costs such as depreciation expense
of factory machines and buildings, security expense, insurance expense, salary expense of administration
staff, some portion of electricity expense, top management salaries and benefits, cost related to IT
systems staff, accounting & finance staff, etc. All of these are operating fixed costs, and are accounted on
a time period basis, such as one year; and remain fixed regardless of the number of unit produced in a
year; zero units or 1 million units , or 5 million units.

About the variable costs, it must be clearly understood that a factory can operate as long as variable costs
are being covered by the revenues generated from sales; but if sales fall so low that selling price per unit

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Lahore School of Economics. MBA II. Advance Corporate Finance. Winter 2018. Dr. Sohail Zafar. TA: Ms. Farheen Hassan

is lower than the variable cost per unit then there is no point in continuing to produce such products and
it is sensible to shut down the factory. This line of logic is based on the clear understanding of the nature
of fixed cost being a period cost, and no matter that sales revenue is low or high , these period costs in
any case are incurred. Therefore the decision to shut down production depends on variable cost being
met by sales revenues. After variable costs have been met by sales revenues and still there is some
amount left, that is called TCM (total contribution margin), this an amount available to cover fixed cost
and after doing so to give operating profits (EBIT). If selling price per unit is , say Rs 100, and variable cost
per unit is 80, then 20 is available per unit to contribute towards meeting the TFC and contribute,
thereafter toward EBIT. Suppose TFC per year is 5 million Rs.

You can analytically say:

S=P*Q ( Q = number of units, P = selling price per unit)

TVC = VC per unit * Q

Then

S – TVC – TFC per year = EBIT

(P * Q) - (VC per unit * Q) - TFC per year = EBIT

That level of Q at which EBIT is zero, that is no operating profit and no operating loss, is called break-even
quantity of sales; and it can be worked out as shown below by inserting zero in place of EBIT in the
equation given above:

(P * Q) - (VC per unit * Q) - TFC per year = 0

(P * Q) - (VC per unit * Q) = TFC per year + 0

Q (P - VC per unit) = TFC per year

Q Break Even = TFC per year / (P - VC per unit)

Using the data given above

Q Break Even = 5, 000, 000 / ( 100 – 80)

Q Break Even = 5,000, 000 / 20

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Lahore School of Economics. MBA II. Advance Corporate Finance. Winter 2018. Dr. Sohail Zafar. TA: Ms. Farheen Hassan

Q Break Even Sales Quantity = 250,000 units

Break Even Sales Revenues = Q Break Even * P

Break Even Sales Revenues = 250,000 * 100 Rs

Break Even Sales Revenues = 25,000, 000 Rs , that is 25 million Rs

So, this co needs to produce and sell 250,000 units at 100 Rs selling price per unit just to have zero EBIT,
that is to do break-even, having no operating profit and no operating loss; in this case profit or loss refers
to operating profit or loss, that is EBIT. But such a co may have net los , NI is negative, if it has interest
expense because from zero EBIT when interest expense is deducted then EBT is negative, and though
there would be no income tax on negative EBT, still NI would be negative.

The term (P – VC per unit) is called CM per unit (contribution margin per unit). In some businesses where
number of units produced and sold is not clearly accountable, such as in services businesses, you can use
CM percentage to estimate directly the break even sales revenue is rupees because break-even sales
quantity is not workable in such businesses.

CM % age = (S - TVC)/S; Or (P - VC per unit ) / P. Using this concept you can estimate Break-even Sales
revenues directly in Rupees. This is shown below for the data you are using in this example:

CM %age = (P - VC per unit) / P = (100 - 80) / 100 = 20 / 100 = 0.2 or 20 %. It means CM per unit is
20% of selling price, that is, 80% of selling price goes to cover variable cost per unit, and the remaining
20% of selling price is available to contribute toward paying the TFC per year and also to contribute
toward EBIT.

Break Even Sales Revenues = TFC per year / CM %age

Break Even Sale Revenue = 5,000,000 / 0. 2

Break Even sales revenue = 25,000,000 Rs that is 25 million rupees as you got above.

You can double check by using the income statement format:

S = (P * Q) = (100 * 250,000) =25, 000, 000

-TVC= (VC per unit * Q) = (80 * 250,000) =- 20,000,000

TCM = ( CM per unit * Q) = (20 * 250,000) = 5,000, 000

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Lahore School of Economics. MBA II. Advance Corporate Finance. Winter 2018. Dr. Sohail Zafar. TA: Ms. Farheen Hassan

-TFC per year =- 5,000,000

EBIT = 0

If a co manages to produce and sell more units than required to do break even, then its EBIT is positive.
For example if this co plans to produce and sells 300,000 units next year than its income statement would
be:

S = (P * Q) = (100 * 300,000) =30, 000, 000 Rs

-TVC= (VC per unit * Q) = (80 * 300,000) =- 24,000,000

TCM = ( CM per unit * Q) = (20 * 300,000) = 6,000, 000

-TFC per year =- 5,000,000

EBIT = 1,000,000

This one million positive EBIT is the result of TCM being greater than the TFC per year by one million
rupees.

You can change the formula for break even sales revenues to a formula for the Sales revenues needed to
have a target amount of EBIT, as shown below:

Sales for the Target EBIT = (TFC per year + Target EBIT) / CM %age

Suppose in this co you set next year’s target for EBIT at 1 million Rs, then what sales revenues should you
plan for the next year and what quantity you should sell next year?

Sales for the Target EBIT = (TFC per year + Target EBIT) / CM %age

Sales for the Target EBIT = (5,000,000 + 1,000,000) / 0.2

Sales for the Target EBIT = 30,000,000 or 30 million Rs

Number of unit to be sold for target EBIT = Sales for the Target EBIT / P

= 30,000,000 / 100

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Lahore School of Economics. MBA II. Advance Corporate Finance. Winter 2018. Dr. Sohail Zafar. TA: Ms. Farheen Hassan

= 300,000 unit of out put

In short, EBIT is the outcome of the investing decisions.

Relationship of Investing Decisions with Business Risk

Multiple factors such as nature of a business, industry norms, production technology, management
philosophy, and competitive environment have impact on the composition and amount of FA and NWC a
co’s managers choose to use. Generally high-tech companies rely on more sophisticated machines
embodying automation and robotics; and as a result of this choice of high-tech production methods their
investment in FA is high; such high investment in FA makes their production methods capital intensive.
On the other hand the use of labor intensive production technologies by a corporation requires relatively
lower investment in FA.

Usually those companies that use capital intensive production methods have relatively higher level of FA;
and therefore higher annual fixed operating costs related to these assets such as large depreciation
expense and large insurance expense, and also due to hiring highly qualified professionals to operate and
manage these assets such companies experience high fixed salaries related costs. The presence of above
mentioned high fixed operating costs per year result in higher break-even quantity for a business: such
business organizations have to produce and sell a huge quantity of output to meet not only variable costs
of material and labor but also their relatively high fixed operating costs per year, and therefore their
break-even quantity of sales to avoid losses is high, and that is termed as high business risk.

So , those corporations that use capital intensive production methods experience relatively high fixed
annual operating costs and to meet those high level of expenses these companies need to have high sales
just to avoid losses and to make break-even. Since uncertainty about sales is called business risk,
therefore such companies that have high break-even sales requirements face high business risk. In other
words you can say business risk is the result of employing such production methods that results in higher
breakeven sales level, which is a consequence of using high-tech, capital intensive, production methods.

On the other hand companies using less capital intensive methods of production, or in other words, more
labor intensive production methods, have relatively lower investment in FA and therefore lower annual
depreciation and insurance expense; and also fixed salaries expense of professionals is lower as these
companies do not need to hire many such professionals : thus their annual fixed operating costs are
lower. Therefore such companies can make break even by producing and selling a relatively smaller
quantity of output units; and consequently these businesses can do break-even at low quantity sold, and
their business risk is lower.

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Lahore School of Economics. MBA II. Advance Corporate Finance. Winter 2018. Dr. Sohail Zafar. TA: Ms. Farheen Hassan

As a result of bad investing decisions, a co produces products that do not sell at a profitable price. This
in-ability to sell at a profitable price is called business risk. Please note that at very low price almost
anything can be sold, the issue is to produce goods and services at a low enough cost and sell at high
enough price to be profitable; and in this context profits mean operating profits, that is , EBIT. Just to re-

emphasize, good investing decisions result in higher EBIT and higher ROIC. Business Risk is result of
Investing decisions.

How better quality of investing decisions impacts value creation

Coming back to the relevance of this type of analysis with the investing decision and value creation, you
should remember that conceptually there is no other reason for assets to have any market value except
the free cash flows expected to be generated by theses assets; either due to their productive use in the
business or by selling those assets. If managers have put in place up-to-date assets in sufficient amount,
and then used these assets productively, the result is high EBIT; and Free cash flows per year are = EBIT (1
–T) – increase in total capital invested. Therefore generating high EBIT is likely to result in high annual
free cash flows, and that translates ultimately in higher MV of TA as you would see in the following pages.

Please note that EBIT (operating profit) is result of pure business operations, and is not colored by the
mode of financing used by managers to raise funds to acquire FA and NWC of a corporation. In other
word EBIT is not influenced by the use of high or low amount of debt financing; rather EBIT it is influenced
by the type of assets (FA and NWC), their amount, their quality, and their productive use by the
management in business operations such as purchasing, storing, producing, packaging, transporting, and
selling the goods and services at a profitable price.

If managers have invested in the right kind of assets (that is NWC + FA), and then those assets are used
productively, the result is high free cash flows (FCF) per year generated by utilizing and managing the
assets of a co in a productive manner. Please note:

FCF per year = EBIT (1 – T) - increase in total capital

For example: Last year EBIT was 200 , tax rate is 30%, and total capital last year was 1,200 and in the
previous year was 1,100; then you would conclude that last year increase in total capital invested in this
co was 1,200 – 1,100 = 100; and last year’s FCF were:
FCF = 200 (1 - 0.3) - 100
FCF = 140 - 100
FCF = 40

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Lahore School of Economics. MBA II. Advance Corporate Finance. Winter 2018. Dr. Sohail Zafar. TA: Ms. Farheen Hassan

One commonly used method of estimating the Market Value of TA is by discounting expected FCF s of
future years till infinity; and WACC (weighted average cost of capital) of today is used as the discount rate.

As a reminder WACC = WcKc + WdKd (1 - T)

𝐹𝐶𝐹1 𝐹𝐶𝐹2 𝐹𝐶𝐹𝑛


𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑇𝐴 = + + ….+
(1 + 𝑊𝐴𝐶𝐶)1 (1 + 𝑊𝐴𝐶𝐶)2 (1 + 𝑊𝐴𝐶𝐶)𝑛

‘n’ is approaching infinity years. In this form this equation is not easy to solve as it requires estimating FCF
for each year till infinity. Later on you would learn that you need to estimate FCFs only for 4 or 5 years
and still can solve this equation.

Therefore if investing decision were good, then high EBIT would be the result in future years; and
expected free cash flows (FCFs) from assets are likely to be positive and big number in each future year
and sum of their PV will also be a big number, resulting in a high estimated market value of TA of co
today. After subtracting TL from this estimated MV of TA, you get an estimate of the MV of equity; and
dividing that by number of shares gives you estimated fair price of the share of that corporation. This line
of reasoning is going to be discussed in more detail during the lectures on valuation models. In the
present context of discussion about investing decisions suffice it to say that if managers make good
investment decisions about the choice, combination, and size of NWC and FA, and then manage these
assets well to generate high sales, and at the same time keep a lid on operating costs, then it is likely to
result in higher operating profits (EBIT) and higher free cash flows (FCF), which initially translates into high
market value of TA today and that ultimately translates into high shareholders’ wealth today, that is
shareholders’ wealth maximization takes place: that is value creation

Long term financing decisions.

Please look at the balance sheet model of the firm once again:

CA + FA = CL + LTL + OE

CA - CL + FA = LTL + OE

NWC + FA = LTL + OE

Total Capital Invested in a corporation = Total Capital Invested in a corporation

Real capital = Financial capital

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Lahore School of Economics. MBA II. Advance Corporate Finance. Winter 2018. Dr. Sohail Zafar. TA: Ms. Farheen Hassan

You can measure book value (accounting value) of total capital invested in a business both from LHS (left
hand side) and RHS (right hand side) of balance sheet; though both sides are measuring total capital
invested in a corporation yet LHS is a measure of real capital while RHS is a measure of financial capital
invested in a corporation. At any given point in time the two sides must be exactly same; and accounting
procedures are designed to record business transactions in a manner that the total of the 2 sides always
comes out equal: it is called balance sheet because 2 sides are in balance. LTL (long term liabilities) are
termed Debt Capital; while OE ( owner’s equity ) is termed Equity Capital; this allows you to say that
from the view point of financing a business:

Total Capital Invested in a corporation = debt capital + equity capital

The above stated model shows clearly that corporate financiers are only 2 groups of people: providers of
debt capital and providers of equity capital; and they provide 2 types of capital to the corporation: debt
capital is provided by creditors (lenders) such as bondholders and banks; while equity capital is provided
by owners who are called shareholders in a corporation. It is also clear from the model shown above that
financial capital provided by the financiers of a corporation can be viewed as invested into 2 broad
categories of assets, namely FA (fixed assets) and NWC (net working capital). Assets, by definition , are
the productive resources of a business that are expected to be used by the business to produce output
and sell it in future.

The results of corporate financing decisions are WACC of corporation and the capital structure of
corporation. Capital structure of a corporation refers to the mix of Long Term Liabilities + OE used by
corporate managers to finance FA & NWC of the co. Such mix is usually mentioned as percentage of debt
capital in total capital (Wd, also called weight of debt capital in total capital), and percentage of equity
capital in total capital (Wc , also called weight of equity capital in total capital). For example in a
corporation:

NWC + FA = LTL + OE = total capital


200 + 800 = 600 + 400 = 1,000
weight of debt in total capital (Wd) = debt capital / total capital
= 600 / 1,000
=0.6 or 60%
weight of equity in total capital (Wc) = equity capital / total capital
= 400 / 1,000
= 0.4 or 40%

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So you would say that the capital structure of this corporation is 60 and 40, referring to 60% debt capital
and 40% equity capital. Capital structure of a corporation has impact on its WACC (weighted average
cost of capital) and on its financial risk. WACC is measured as :

WACC = WcKc + WdKd (1 - T)


How Financing Decision impact value creation
One outcome of financing decisions is WACC of a co, and as you saw earlier WACC is part of the equation
to estimate MV of TA using FCFs , therefore if a co ‘s WACC is too high, then PV of its FCFs would be
smaller amount and therefore MV of its TA would be smaller, and after subtracting TL from it, the left
over called MV of equity would also be smaller amount. Thus too high a cost of capital has negative
impact on value creation for owners. Usually if a co takes heavy debt then not only its cost of debt (Kd)
goes up but also its cost of equity (Kc ) goes up because shareholders perceive more financial risk due to
presence of high level of debt as depicted by high Wd.
How to calculate weights of debt and equity capital for WACC calculations
It is better to use Market Values for the LTL and OE while calculating weight of debt capital (Wd) and
weight of equity capital ( Wc) for estimating the WACC of a corporation. But if a co has not issued Bonds
and its LTL are in the form of long term leases and loans from banks then Book Value of LTL in balance
sheet can be used as a proxy for the Market Value of LT Debt. If a business is organized as a private
limited company, then its shares are not traded; and market value of shares cannot be calculated easily.
Then either book value of equity as given in balance sheet is used for Wc calculation; or some efforts are
made to estimate MV of its equity indirectly by using proxies such as average PE ratio of comparable
companies is multiplied by EPS of this co; or average price to book value per share ratio of comparable
companies is multiplied by book value per share of this co to arrive at an estimate of its share price. But,
if a co is public limited co , and has its shares listed on a stock exchange, then it Market Value of Equity is
calculated as: Number of shares outstanding * Share price ; and this MV of equity is used to calculate
Wc, and that is more accurate number to calculate Wc for the WACC purposes instead of the book value
of OE given in the balance sheet.

How to estimate percentage costs of debt capital (Kd) and equity capital (Kc)
Percentage cost of debt capital is simply interest amount paid on LTL divided by the amount of LTL; it is
shown with symbol Kd. If a company uses loans from multiple banks then weighted average of interest
rates on those loans should be calculated to estimate Kd of that co. For example if a co has taken long
term loan 800 from MCB at 16% interest rate and another 500 from ABL at 18% then it cost of debt capital
is , Kd is = (800/1,300)*16% + (500/1,300) * 18% = 9.846 + 6.923 = 16.769%

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Estimating percentage cost of equity capital is an enigma in finance. It is shown with symbol Kc or Ks in
different text books. As a concept it is the percentage rate of return (ROR) expected by the owners who
have invested in this corporation. But how do we know what is that expected ROR? Is it same for the
owners of cement co, sugar co, steel co; or is it different? Within cement industry, should shareholders of
D.G. khan Cement and Maple Leaf cement expect the same ROR ? Does it make logical sense that
shareholders of a corporation expect to earn a lower ROR than the interest rate earned by the banks that
have given loan to this co? And many more relevant, and as yet unanswered, issues related to Kc make a
satisfactory and undisputed estimate of Kc an unresolved issue in finance literature, though Nobel prizes
have been given for proposing models of estimating Kc. There have been theoretical developments that
propose that percentage rate of return required by shareholders of a corporation should be based on the
risk of that share. One such theory is Capital Assets Pricing Model (CAPM). It proposes that expected
percentage rate of return from a share is dependent on the relevant risk of that share. Quantitatively this
model is written as:

Kc = Rf + (Rm - Rf ) Beta (Levered)


Here beta (levered) is the relevant risk of that share, Rf is rate of return any one can earn by investing in a
risk-free security such as one-year maturity government t-bills; and (RM – Rf) is called equity market risk
premium, that is, additional rate of return an investor would expect over and above risk free rate of
return for investing in corporate equities because corporate equity shares are riskier than a risk free
government bond. Multiplying equity market risk premium with beta (levered) of a specific co’s share
give the so called “ risk premium for that share”. Higher the beta, higher would be risk premium of that
share because the term (Rm - Rf) is same for all corporations as it is a macro-economic variable. When
higher risk premium of a share is added to risk free rate of return, higher would be the Kc (risk adjusted
required ROR) of that share. So shareholders of highly risk shares should expect to earn a higher
percentage rate of return.
Another measure of Kc is = { DPS1/P0 } + { (P1 – P0)/P0 }
This method does not include risk in estimating the rate of return expected by owners of a business; it
also require estimating next year’s cash dividends per share ( DPS1)and share price at the end of the next
year (P1).
Yet another crude rule of thumb for estimating Kc for the owners of a corporation is = Kd + a few
percentage points added as equity risk premium. For example if Kd of a Co is 13% and owners want
another 9%age pints as compensation for their risk being higher than the risk of banks that are lending to
this corporation because banks have legal claim if co fails to pay interest in time but owners of the same
co have no legal claim if co makes losses and fails to pay cash dividends to owners (shareholders).
Therefore owners justifiably view themselves as taking more risk than the risk taken by the banks, and

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therefore owners are justified in expecting to earn a higher Kc on the equity capital they have given to this
co than the Kd banks are earning by giving debt capital to this co. So Kd + 9 = 13 + 9 = 22% can be used
in this example as estimate of Kc. This line of logic rightly implies that Kc MUST ALWAYS BE HIGHER
THAN Kd

Financial risk
Financial risk of a co is result of its financing decisions, and this risk is usually quantified by debt to equity
ratio ( LT L / OE). This ratio is used both as a quantification of capital structure as well as quantification
of financial risk of a co. Debt to equity ratio can also be calculated as Wd / Wc because:
Wd = LT L / Total Capital, and Wc is OE / Total Capital , therefore:
Wd / Wc = (L T L / Total Capital) / (OE / Total Capital) , this simplifies as:
(LT L / Total Capital) * (Total Capital / OE) , and by cancelling out Total Capital you are left with
LT L / OE ratio.
Example above has the following debt to equity ratio:
LTL / OE = 600 / 400 = 1.5 / 1
Or:
Wd / Wc = 0.6 / 0.4 = 1.5 / 1
This debt to equity ratio is usually written as 1.5 times and it means that for every rupee invested by
owners in the corporation, 1.5 rupees were borrowed as long term liabilities. It means there is a relatively
heavy reliance on debt capital (that is borrowed funds or loans) in this business; and most of the capital to
finance FA and NWC was provided by the creditors (lenders / banks) and not by the owners
(shareholders). This manner of financing a business by using debt along with equity gives rise to financial
risk which is also called insolvency risk or bankruptcy risk because inability to service the debt (that is
making timely payment of loan installments) results in financial distress which can ultimately result in
bankruptcy of a corporation. Please note that more the reliance on debt capital, higher is the financial
risk as quantified by a higher debt to equity ratio.
Generally a business is insolvent when its TL exceed its TA as shown below
TA = TL + OE
100 = 130 + -30 (it is an in-solvent business)
100 = 90 + 10 ( it is a solvent business)
If a co has very heavy reliance on debt financing then its financial position is considered weak. Here it
must be noted that financial position is judged from the balance sheet as both LTL and OE are
components of balance sheet. If a co has balance sheet looks like the one shown below:
TA = TL + OE
100 = 30 + 70

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its financial position would be considered strong; and its financial risk is considered low because most of
the financing is provided by the owners and only a small percentage is provided by creditors (bank).
And if a co’s balance sheet has:
TA = TL + OE
100 = 0 + 100
then it has zero debt, zero financial leverage, and zero bankruptcy risk or financial risk. Its financial
position is very strong.
When creditors (lenders / banks) of an insolvent business realize that available corporate assets are
insufficient to pay the liabilities then they tend to be nervous and may demand their money back from
such a corporation, and if this corporation sells all its assets it still may not raise sufficient cash to pay all
its liabilities.

Why such a situation arises that a corporation’s TA are less than TL and its
OE is negative?

Usually it would happen due to persistent losses in a business year after year, because losses eat up OE.
Losses would first eat up the RE (retained earnings are also called reserves) and then the share capital
within OE is eaten up by the negative NI, thus if a business shows losses year after year, slowly first its RE
is wiped out by the losses, then its Paid-up share capital is wiped out, and then further incurrence of
losses would turn its OE into a negative number. As losses are born by the owners of the business
corporation; therefore their investment in such a loss making corporation keeps shrinking, which in other
words means OE shrinks due to losses, and ultimately turns into a negative number: now the corporation
is insolvent.
Equation for the statement of changes in RE

End RE = Beg RE + NI – cash dividends – stock dividends


The above stated equation shows that if in a year NI (net income) is negative, then retained earnings at
the end of the year would be smaller than the retained earnings at the beginning of the years. If year after
year a business corporation experiences losses (that is negative NI), then its RE keeps shrinking and
ultimately turns negative; in that case it is termed “accumulated losses”. In some cases, it is possible that
the amount of negative RE is so big that it exceeds the amount of paid-up share capital, the result is
negative OE:

End RE = Beg RE + NI – cash dividends – stock dividends


Year 1 = 100 + - 70 – 0 - 0
= 30

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Lahore School of Economics. MBA II. Advance Corporate Finance. Winter 2018. Dr. Sohail Zafar. TA: Ms. Farheen Hassan

Year 2 = 30 + - 50 - 0 - 0
= -20
So in just 2 years RE of positive 100 million turned into accumulated losses of 20 million, that is negative
RE of 20 million due to negative NI (loss) of 70 and 50 million in these 2 years. Now let us look at the OE

OE = Paid - up share capital + RE


Beginning of Year 1 OE = 10 +100 = 110 million
End of year 1 OE = 10 +30 = 40
End of year 2 OE = 10 - 20 = -10

For the sake of clarity and simplicity, let us assume TL did not change during these 2 years, then with this
shrinkage in OE on the right hand side of balance sheet, a commensurate shrinkage will take place on the
left hand side of balance sheet in TA of this corporation. Therefore both sides of balance sheets would
shrink due to losses; and soon TA of such a co would have shrunk so much that TA are a smaller amount
than TL; and therefore OE is negative because TA – TL = OE: now it is an insolvent business.
Statement of changes in OE:
Using the data shown above, you can see analytically how OE of such Co in its balance sheet would shrink
due to losses in the last 2 years.,

End OE = Beg OE + NI + shares issued – cash dividends – shares repurchased


Yr 1 = 110 + - 70 + 0 - 0 - 0 = 40
Yr 2 = 40 + - 50 + 0 - 0 - 0 = -10

The above equation also shows that OE increases when NI is positive, and decreases if NI is negative.

If the state of insolvency persists in a corporation, sooner or later such a business goes bankrupt. On the
plea of its creditors, judge in a bankruptcy court may declare such a business bankrupt. In such situations,
judge usually orders liquidation of corporate assets through a court appointed person, and cash thus
generated by liquidating (selling) the assets is distributed by the court among the liability holders
(creditors / banks) of such a business according to the seniority of their legal claim on the assets of this
business. These liability holders include banks, bondholders, employees whose salaries are unpaid, utility
companies whose bills are unpaid, accounts payable (suppliers) who are as yet unpaid, and government
bodies to whom this co owes taxes.

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Please understand clearly that in such a situation, owners (shareholders) have the last claim on the assets
of business, and it is not unusual that incase of liquidation of an insolvent business through the court
orders, the owners end up receiving nothing. Some of the creditors may also not receive their full claims
if the liquidation of assets does not generate sufficient cash.

Financing decisions by managers that place more reliance on debt capital in the capital structure of a
corporation result in higher fixed financing costs per year in the form of higher interest expense. Inability
to meet these interest liabilities can push a company into bankruptcy. Therefore the presence of higher
fixed financial costs result in higher financial risk for a company. At this stage it is important to be clear
about the difference between business risk and financial risk. Please remember that business risk was
the result of the presence of fixed operating costs and was there because of the investing decisions of
managers to use high-tech , capital intensive production methods. Now you have also learned that
financial risk was the result of the presence of fixed financial costs and was there because of the financing
decisions of managers to use debt financing.

Also understand clearly that financial costs (such as interest expense) are present in a business only if it
has taken loans. Therefore financing decisions by managers can result in a debt heavy capital structure,
that entails presence of high financial risk; and higher financial risk means a higher probability of default
on the debt servicing obligations in a year when sales are low and business is not good. Debt servicing
has 2 components: interest payment on debt , and repayment of the portion of debt that is falling due.

Liquidity management decisions


These are the decisions about managing CA and CL of a corporation; and are also termed as management
of working capital or short term financial management. CA are called working capital. Too much
investment by managers in CA such as cash is a drag on the profitability because cash is a non earning
asset. Too much investment in accounts receivables may result in higher bad debt expense in the future
and also higher collection costs. Too much investment in inventory may result in obsolescence, damage,
and theft of inventory, plus inventory has insurance and storage costs. Therefore generally over
investment in CA is likely to depress the profitability. But underinvestment in CA also causes many
problems. Shortages of cash at the time of bills payment or salary payments is embarrassing, shortages of
raw material inventory may result in factory shut down, and shortages of finished goods inventory results
in lost sales, lost customers, and lost market share.

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If a co does all its sales on cash basis to avoid investment in account receivables then it may have low bad
debt expenses and less need to take short term bank loan to finance account receivables; but this selling
policy may result in loss of some customers and such a co may face a competitive disadvantage in its
marketing efforts. Short term bank loan (called running finance in Pakistan) is usually taken by a co to
finance the receivables and inventory until receivables are collected and inventory is sold; but some
companies take short term bank loan purportedly to finance receivables and inventory while actually use
these funds to finance their FA. As a financial analyst, if you figure it out that some of the short term
bank loans are being used to finance FA then that portion of short term loan is technically debt capital and
should be shown as such. Balance sheet of such a company usually has negative NWC, for example:
CA + FA = CL + LTL + OE
100 + 500 = 200 + 200 + 200
In this case long term capital ( LTL + OE) is 400, but long term assets (FA) are 500, that means 100 worth of
FA were financed by using funds raised as CL.
CA - CL = NWC
100 - 200 = -100
And its NWC is negative.
You can do the following analysis for more clarity in the financing affairs of this co:
NWC + FA = LTL + OE
-100 + 500 = 200 + 200
400 = 400
It is clear that 400 million financial capital (LTL + OE) is not sufficient to finance FA of 500 million,
therefore the shortage of 100 million was met by investing the funds raised as CL into FA; and that
resulted in negative NWC. This financing arrangement also means questionable, and risky liquidity
management: an obvious shortage of liquidity is visible in this co as its NWC is negative. Managers doing
this type of working capital management are in fact taking high liquidity risk. Commercial banks do not
like giving short term loans (which are CL of the borrowing Co) for financing long term assets such as FA.
Companies operating with negative NWC should be a rarity; but that is not the case in Pakistan. Probably
because of peculiar belief of bankers that giving further short term loans (CL) to a co that already has
negative NWC is not too risky. The reason for such belief is past experience of bankers that when short
term bank loan is due owners do inject their personal funds in the business temporarily (called loans from
directors), to meet the loan repayment obligation and thus manage to avoid default on loans; and
therefore qualify for another short term loan from the same bank. By doing this trick such a co manages
to operate year after year with negative NWC.

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Accounts payable liability is generated when a co buys its raw materials on credit. Growing companies
experience an automatic increase in their accounts payable because they do heavy credit purchases of
raw material inventory to support higher level of production and sales. The same happens in growing
companies with accrued operating expenses payable liability such as utility bills payable and salaries
payable and advertising expense payable: all these current liabilities automatically increase with the
increase in production and sales of a company; and are termed spontaneous liabilities; and if sufficient
capital in the form of LTL + OE is not injected in the business, these increasing levels of CL soon surpass
the level of CA resulting in a situation where co is operating with negative NWC.

Profitability and Its relationship with liquidity and solvency of a corporation


If a corporation has less CA than CL, then its NWC is negative ( because NWC = CA - CL). This is a
situation where liquidity is low, and business has high liquidity risk. Liquidity risk refers to a state were a
corporation may find itself unable to pay its bills in time due to shortage of available cash or cash like
resources. Usually a misconception is widely prevalent that a company making losses would have liquidity
problems; and a co making profits would have no liquidity problem: that is not necessarily true. Even a
company making very high profits can face liquidity shortages because of reinvestment of its profits in
expansion of FA and/or CA such as inventory thereby leaving little or no cash for payment of its bills. In
fact new and fast growing companies often find themselves in such a situation where their product line is
successful in the market and demand is so high that they have to expand their production facilities quickly
and they end up investing all the cash in expansion of FA and inventories and account receivables, and
thereby leaving little cash for day to day operations.

You should be clear that Instead of liquidity, it is solvency of a corporation that is more directly linked with
its profitability. Due to high profits in a corporation its retained earnings and therefore OE increases
which results in improvement in solvency of business; while the opposite is true in case of a company
making losses: its OE shrinks and therefore OE as proportion of total capital keeps going down, and its
debt to equity ratio keeps increasing just by virtue of OE becoming a smaller and smaller number though
LTL may stay constant. Such a state of affairs in a corporation makes financial position of a corporation
weaker, and insolvency risk, or bankruptcy risk, or financial risk is high; such companies are termed as
having high financial leverage.

RISK and RETURN


Generally the framework of management decision making in corporate finance is driven by the twin
considerations of risk and return. In finance literature talking about returns without talking about risk is

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considered incomplete sentence. In all three decision areas in corporate finance briefly discussed above
the guiding considerations are risk and return. Just as a reminder we discussed in the previous pages how
investing decisions are the cause of business risk, and financing decisions are the cause of financial risk,
and working capital management decisions are the cause of liquidity risk in a corporation.

Risk
In different situations risk is measured and quantified in different ways; but generally the idea of risk is
related to the uncertainty of outcomes. If actual outcome may differ from the expected outcome then
there is risk in the given decision situation. The following paragraphs give brief description of certain
risks faced by the corporate finance mangers while making decisions; and show how these risks are
measured.
Relevant risk of a share is sensitivity of stock’s percentage rate of return to changes in market returns
and it is quantified as beta of a stock. As most of the companies have liabilities present in their balance
sheets therefore these cos are levered cos and have financial leverage, so it is more accurate to call their
stock beta as levered equity beta denoted as” beta L “ . Statistically beta of a stock is a ratio as given
below:
beta( Levered) = COV i,m / VAR m. ( ‘ i ’ is ROR of a stock ; and ‘m’ is ROR of stock market).
according to professor Hamada,
Beta L = Beta UL [ 1 + (1 – T) * Debt / OE ratio]
this equation allows you to bifurcate relevant risk of shares of a levered co into 2 parts ; namely, business
risk from the shareholder’s perspective as quantified by Beta (UL) (beta unlevered); and financial risk from
shareholder’s perspective as quantified by Debt / OE ratio. Please note that in real life you can calculate
only beta levered of a corporation’s share from past data of percentage rate of returns of that stock and
overall stock market as COV i,m / VAR m ; and its debt to equity ratio can be calculated from balance sheet.
Only then, beta unlevered (business risk for shareholder) is calculated indirectly by inserting the values of
beta levered, T (the tax rate), and debt to equity ratio in Professor Hamda’s equation.
For example : For PTCL share COV PTCL, M / VAR M = 200/150 = 1.33. This is Beta levered of PTCL share
because PTCL balance sheet has debt capital. If debt to equity ratio of PTCL is 1.5 and it falls in 30%
income tax rate then you can estimate its beta UL as shown below:
Beta L = Beta UL [ 1 + (1 – T) * Debt / OE ratio]
1.33 = Beta UL [1 + (1 - 0.3) *1.5]
1.33 = Beta UL [1 + 1.05]
1.33 / 2.05 = Beta UL
0.648 = Beta UL

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if 2 companies have same beta levered, same debt to equity ratio, and same corporate income tax rate
then their business risk as measured by beta unlevered would also be same. On the other hand if 2
companies have the same debt to equity ratio and same income tax rate; but if one of these co has higher
beta levered than it would also have higher beta unlevered, that is higher business risk in that company
would be causing its relevant risk for shareholders to be higher though both companies have same
financial risk as measured by their debt to equity ratio.
Business risk From managers’ perspective, it is uncertainty about sales; and therefore uncertainty about
NI, EPS, ROA, ROIC, and ROE, etc. generally uncertainty in these variables is quantified by standard
deviation (SD) of these variables using past dat.
Essential source of business risk is the uncertainty about selling the output at a profitably high enough
price. In different contexts and situations, different measures of business risk are used. In the context of
decomposing the relevant risk of a share, Beta (UL) is the measure of business risk. DOL (degree of
operating leverage) is another measure of corporation’s business risk, and it is quantified as % change in
EBIT / % change in Sales. For example if %age change compared to last year in EBIT is 5% and %age
change in sales is 2% then DOL = 5%/2% = 2.5 times. It means 1%age point change in sales results in 2.5%
age point change in EBIT. It is a sort of magnified impact of changes in sales revenues on EBIT. Higher the
DOL, higher is business risk of that co. Standard Deviation (SD) of sales, SD of EBIT, SD of NI, SD of
EPS, and SD of ROE, are also used as measure of business risk depending upon the decision making
context.

The cause of business risk is the presence of high fixed annual operating costs, such businesses need to
produce and sell large quantity of output just to cover their fixed operating costs, so their break-even
sales level is higher, and their business risk is higher. Therefore break-even sales can also be used in
certain situations as a measure of business risk. You can say that business risk is result of the investing
decisions.
Financial risk of a business is due to the financing decisions, that is, the manner its assets are financed; if
assets are financed by equity capital alone then such a business is called all equity financed, and has no
financial risk. Its stock’s beta levered and beta unlevered are same as its debt to equity ratio is zero. But
if assets are financed by using both equity capital and debt capital then such a business has financial risk
because if the debt providers are not serviced as per the contract, they can go to court and have the
business declared bankrupt. This financial risk can be quantified in different ways, for example: as
Debt/OE ratio , TA / OE ratio which is also called financial leverage ratio or equity multiplier, Total
Debt / TA ratio which is also called Debt ratio; DFL (degree of financial leverage) which is measured as
% change in NI / % change in EBIT. The presence of fixed financial costs such as fixed annual interest

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expense, or fixed annual lease payments, causes higher DFL, which means financial risk is higher, and
such a co has to earn sufficiently high EBIT to be able to pay fixed annual interest expenses related to its
use of debt capital. For example %age change in NI is 10% and %age change in EBIT is 5%, then DFL =
10%/5% = 2 times. It means one percentage point change in EBIT causes 2%age point change in NI. Higher
the DFL, higher is the financial risk of the corporation.
Total Risk of a Business is quantified as DTL ( degree of total leverage) and is measured as ;
DTL = DOL * DFL or as : %age change in NI / %age change in sales. For example if DOL is 2 and DFL is
3 then DTL = 2 * 3 = 6; which says 1%age point change in sales causes 6 %age point change in NI.
Total Risk of a portfolio of securities In the portfolio context total risk is SD or VAR of ROR of a portfolio
of securities and its formula is discussed in investment courses. In the context of portfolio theory total
risk is bifurcated into 2 types: diversifiable risk and non diversifiable risk.
Non Diversifiable Risk = (Beta i)2 * VARm

Risk of stock market = VARm

Diversifiable Risk = VAR (ei) ; where i could be single stock or portfolio

Liquidity Risk is high in a corporation if its NWC is negative; which also means its current ratio is less than
one.

Returns
Percentage Rate of Return on any asset (shares, bonds, real estate plots, paintings, jewelry, etc) , as a
generic concept , has 2 components namely a periodic income yield plus a capital gains yield. For the
shareholders of a corporation periodic income is in the form of cash dividends so it is called dividend
yield, for bondholders periodic income is in the form of interest so it is called interest yield. But for
investors in paintings or jewelry or plot of land there is no periodic income. The second portion of the
rate of return is simply a percentage increase (or decrease) in the price of the asset over the period, which
is usually one year. It is termed capital gains yield. Thus expected (ex ante) rate of return (ROR)
Expected Kc = expected dividend yield + expected capital gains yield
= (DPS 1 / Po) + (P1 - Po) / Po
=(10/100) + (120 – 100)/100
= 0.1 + 0.2
= 0.3 or 30%
Note: Po refers to current price of share, P1 refers to expected price after one year, and DPS 1 refers to
expected cash dividends per share during the next year. Expected ROR is an estimated number, actual

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ROR at the end of the year may turn out different than the expected ROR estimated at the beginning of
the year. Therefore expected ROR is risky, or uncertain. The uncertainty is due to the use of 2 estimated
data items, namely P1 and DPS1. Each analyst might have a different estimate of these 2 items for the
next year and therefore may end up estimating a very different expected ROR for that share.

Realized , ex-post, actual ROR: It’s the rate of return about which there is no ambiguity and no
disagreement among the analysts as it is actual historic rate of return. For a share it is equal to realized
dividend yield plus realized capital gains yield. For example If share of MCB was bought at Rs 250 a year
ago and it gave Rs 5 DPS during the year , and now after one year it is trading in the stock market at Rs
300 then Its realized dividend yield was:
DPS / Po = 5 /250 = 2%;
and its realized capital gains yield as:
(P1 – Po) / Po = (300 - 250) / 250 = 20%;
and realized annual rate of return (ROR) for the investor was:
dividend yield + capital gains yield = 2% + 20% = 22%.
This was realized or ex-post facto, or historical or actual ROR, and there is no ambiguity or dispute about
it.
The more relevant and contentious issue is to estimate expected or ex-ante ROR . There is an
equilibrium theory of risk and return called CAPM (Capital assets Pricing Model) and it is represented by
an equation : Kc = Rf + (Rm – Rf) Beta L ; according to this theory ROR depends on risk. Here Kc refers to
risk adjusted ROR required by shareholders of a corporation and beta levered is the relevant risk of that
share; so this model brings together risk and return in one equation and it says that higher risk leads to
higher returns and vice e versa. The rate of return for shares estimated by using CAPM is termed
required rate of return or risk adjusted rate of return. On the other hand the expected dividend yield
plus expected capital gains yield give expected rate return. Interestingly the required ROR and expected
ROR from a share are same only when its current price is at equilibrium (which is also called fair value or
justified value) otherwise if the 2 returns are not same then the stock is either underpriced or over priced
at its current Po.

It is a fundamental principle of finance that ex-ante ( i.e. before the fact) relationship between expected
ROR and risk of any asset is positive. Positive relation between risk and return means higher risk taking is
expected to give higher percentage rate of return, conversely, you can say there is no way to earn higher
return without taking higher risk. Financial frauds occur because people tend to focus on expected or
promised rate of return and tend to ignore the risk inherent in such very high promised returns.

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Lahore School of Economics. MBA II. Advance Corporate Finance. Winter 2018. Dr. Sohail Zafar. TA: Ms. Farheen Hassan

BASICS OF VALUE CREATION IN A CORPORATION

As discussed above under the investing decisions, how well the managers have managed a corporation’s
FA + NWC ( real capital) is quantified by return on the invested capital (ROIC), this rate of return is
based on operating performance and is not colored by the financing decisions about use of debt or equity
capital in financing the assets of a business because ROIC uses EBIT and EBIT is result of Sales minus
operating costs, therefore EBIT is not influenced by financing decisions, and is the result of business
operations of buying, storing, manufacturing, and selling. In that sense EBIT represents pure business
profits. ROIC is measured as: ROIC = EBIT (1 - T) / Total Capital invested . On the other hand two groups
who have provided financial capital to a corporation are the creditors and owners, and they have invested
capital in a corporation with the hope of earning a rate of return. The expected rate of return by owners
on their investment in a business is called cost of equity capital for a business (it is denoted by Kc), and
expected rate of return by creditors such as banks is called cost of debt capital for that business; and it is
denoted by Kd: it is the interest rate paid on loans.

Since the amount of debt and equity capital invested in a corporation is not same therefore simple
average of Kc and Kd cannot be taken as cost of total capital invested in a business; rather a weighted
average must be calculated as
WACC = WcKc + WdKd (1 - T)
= (0.4* 30%) + (0.6 * 12% (1 – 0.3))
= 12% + 5.04%
= 17.04%
In most countries interest paid on loans is a tax deductible expense for the borrowing co. Presence of
operating expenses such as salaries expense decreases the EBT (taxable income) , and therefore income
tax is lower. Similarly interest expense is also treated as tax deductible expense; and EBT is lower because
of the presence of interest expense. This practice results in something called interest tax shield, or income
tax savings due to the presence of interest expense. And presence of this tax saving due to the presence
of interest expense is blamed by some analysts as a reason for corporate managers to opt for higher and
higher debt in financing the business, and ignoring the resulting increase in financial and bankruptcy risk.
This Interest Tax Shield in Rupees can be calculated in rupees as Interest expense * T.
For example:
Interest expense of a co is 100 million and it is in 30% tax rate, then it pays on the one hand 100 million
interest expense but on the other hand it pays 100 * 0.3 = 30 million less in income tax because due to

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Lahore School of Economics. MBA II. Advance Corporate Finance. Winter 2018. Dr. Sohail Zafar. TA: Ms. Farheen Hassan

presence of interest expense in its income statement its EBT (taxable income) was less by 100 million.
This 30 million Tax saving is called Interest Tax Shield in Rupees.
Interest tax shield can be calculated as a percentage also.
Interest Tax Shield in percentage = Kd * T .
For example percentage interest rate on loans is 10% in a co, and it is in 30% tax bracket for income tax.
Then on the one hand it pays 10% interest on its loans but on the other hand it saves in income tax 10%
*0.3 = 3%. So , for such a corporation before tax percentage cost of debt capital, Kd, is 10%; but its after
tax percentage cost of debt capital, Ki, is Kd (1 - T) = 10% (1 - 0.3) = 7%. That is 3%age point tax saving
on its cost of debt. Its after tax percentage cost of debt capital is 3%age point lower than its before tax
percentage cost of debt, and that 3%age point is tax saving due to presence of debt capital and payment
of interest rate on this debt capital. This line of thinking sometimes lead corporate managers to have
higher and higher debt levels to enjoy bigger and bigger tax saving in their corporate income tax liability
In levered corporations actual interest cost is less than what is paid to the banks as interest; and that fact
is captured by the term (1 - T) in the WACC formula, whereas T refers to corporate income tax rate
applicable to that corporation. The weighted average of the two rate of returns expected by two groups
of investors or financiers is called WACC (Weighted Average Cost of Capital).
As long as a corporation earns ROIC higher than WACC, the value is created for shareholders, otherwise
value is destroyed for the owners.
The difference between ROIC and WACC is called EVA (economic value added). Positive EVA is a pleasant
surprise for owners in the form of extra rate of return for them over and above what they expected as Kc;
and therefore they would demand more shares of such a co and its share price would increase; that is
called value creation or increase in the wealth of share holders.

For example Total Capital Invested in a business corporation as Long Term Liabilities + OE is 1,000 million
Rs out of which long term liabilities are 600 million and OE is 400 million Rs ( Please note total capital is
also equal to NWC + FA of this corporation) and its EBIT last year was 200 million Rs and it pays 30%
corporate income tax (T). Its shareholders demand (expect) a rate of return (Kc) = 25% and it has
borrowed from banks at interest rate (Kd) of 16%.

Find ROIC:
ROIC = EBIT ( 1 – T) / Total Capital
ROIC = 200( 1 – 0.3) /1,000
ROIC =0.14 or 14%.
Find WACC:
Its Wc = 400/1000 = 40%; and Wd = 600 / 1000 = 60%. Its WACC comes out

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Lahore School of Economics. MBA II. Advance Corporate Finance. Winter 2018. Dr. Sohail Zafar. TA: Ms. Farheen Hassan

WACC = WcKc + WdKd(1 - T)


WACC= 0.4*25% + 0.6*16% (1 - 0.3)
WACC = 10% + 6.7%
WACC = 16.7%
Cost of capital invested in this business is 16.7% but ROIC earned on the same capital is only 14% , you
can conclude that since invested capital is earning a lower ROR than the percentage cost of the same
capital, therefore the corporate management is not managing the co in a manner that would create value
for its owners. Such a situation is a negative surprise for owners of the co therefore demand for shares of
such a co would decrease and its share price would fall, thus destroying value for its owners. Please note
that out of ROIC 14%, debt providers would get their proportionate share, that is Wd* Kd (1 - T) any way
as it is a legal liability on this corporation. Therefore after paying return to debt providers out the ROIC,
the left over returns belong to the owners of the corporation. In this case it is:
ROIC – Wd*Kd(1 - T) = 14 – [0 .6 * 16(1 - 0.3)] = 14 - 6.7 = 7.3
So after paying from ROIC proportionate share to the debt providers, the left over returns are only 7.3% ,
that is the realized WcKc for owners has turned out to be only 7.3% out of ROIC while they expected it to
be: Wc*Kc = 0.4* 25% = 10%. So 10 - 7.3 = 2.7% age points less than what the owners expected out of
the ROIC as their share. And that would be disappointing for the owners and they would off-load that
share which would cause share price to fall; resulting in value destruction for the shareholders.
In terms of expected rate of return for shareholders, that is Kc, you know that owners expected 25% Kc
but given the ROIC of 14% they actually realized a Kc that can be worked out as shown below:
WcKc = 7.3
0.4Kc = 7.3
Kc = 7.3 / 0.4 = 18.25%. And this is much lower than expected 25% Kc by owners.
Naturally owners (shareholders) would be disappointed, and they would be likely to get rid of shares of
such a co. Such an action by owners would push the share price lower thus making all the shareholders of
this co worse off, or poorer: value has been destroyed for the shareholders by virtue of this co earning an
ROIC that is lower than its WACC. This reality of value creation or value destruction is captured by EVA.
Find EVA:
EVA = ROIC – WACC
In this case
EVA = 14 – 16.7 = -2.7%
Negative EVA %age in this case is equal to the short fall in proportionate share of owners in ROIC, and this
negative EVA means value destruction for owners. By the same logic positive EVA in a year means value
creation for the owners as their share in ROIC turns out to be more than the proportionate share they
expected.

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Lahore School of Economics. MBA II. Advance Corporate Finance. Winter 2018. Dr. Sohail Zafar. TA: Ms. Farheen Hassan

In this example you saw with the help of data that if management uses the corporate assets not so
productively and profitably, and earns rate of return lower than what is demanded by the providers of
funds, then providers of funds won’t be happy because though banks would get their Kd (Interest rate on
loans) but owners may not get their expected Kc. So demand for such shares would fall, share price would
fall. Value destruction would result for owners. This is captured by the concept of economic value added
(EVA). If in a year EVA is positive, value is created for owners, and if EVA is negative, value is destroyed
for owners.
Managerial decisions that result in higher WACC (Financing decisions) or lower ROIC (investing decisions)
are value destroying; on the other hand managerial decisions that reduce WACC and enhance RIOC are
value creating. Financing decisions of managers have impact on WACC and investing decisions made by
the managers have impact on ROIC. Therefore both investing and financing decision impact
shareholders’ wealth.

Please note that in previous courses you have learnt that:


ROE= NI/OE
Three policies , namely net profit margin (NI/S), total asset turnover (S/TA), and equity multiplier (TA/OE,
also called financial leverage) effect ROE because:
NI / OE = NI/S * S/TA * TA/OE
it is called DuPont formula because it was first introduced by the DuPont co of USA. Extending the logic
of DuPont formula, you can analyze earnings per share (EPS) as:
EPS = NI/shares = NI/S * S/TA * TA/OE * OE/Shares.
Note: OE / shares ratio is called book value per share, or simply BV, and therefore:
EPS = ROE * BV
Logic of this line of analysis can be further extended to analyze cash dividends per share (DPS) as:
DPS = EPS * d . Whereas: d = total cash dividends / NI or , on a per share basis, DPS / EPS, depicting what
percentage of net income (NI) is distributed as cash dividends by a company in the given year. This ‘d’ is
called dividend payout ratio and reflects dividend policy of a company.
Or a more elaborate analytical break-up of DPS is:
DPS = NI / S * S / TA * TA/ OE * OE / BV * d
Since NI / S * S / TA = ROA, therefore
DPS = ROA * TA/OE * BV/Share * d
DPS = ROE * BV /share * d
DPS = EPS * d

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Lahore School of Economics. MBA II. Advance Corporate Finance. Winter 2018. Dr. Sohail Zafar. TA: Ms. Farheen Hassan

Generally ROA captures the impact of operating policies or investing decisions (that is NI/S and S/ TA),
and on the other hand TA /OE, OE / Shares, and ‘d’ capture impact of financing policies of a co. Therefore
DPS is affected both by operating policies (investing decisions) and financing policies (financing decision)
of a corporation.

As it would be discussed in detail in the next lecture, a constant growth rate (g) is attained by a
corporation if policies in 5 areas (namely profit margin (NI/Sales), asset turnover (Sales/TA), financial
leverage (TA/OE), number of shares outstanding, and dividend payout ratio (d) are kept constant. Note
all these 5 policy variables are part of DPS decomposition given above. Therefore under the assumption
of policy constancy, next year’s DPS, that is DPS1, can be estimated as: DPS1 = DPSo (1 + g).

Similarly the following year’s DPS (that is DPS2) can be estimated as :


DPS 2 = DPS 1 (1 + g) or as
DPS2 = DPS0(1 + g)2.

and similarly DPS 3 (cash dividend per share at the end of year 3) can be estimated under constant
policies assumption by
DPS 3 = DPS 0 (1 + g)3

Under the constant growth assumption share price in any year is estimated as present value of future
dividends and according to Gordon Model that is:
P0 = DPS1/ (Kc – g), intrinsic or fair value of share now
P1=DPS2/ (Kc – g), estimate of fair value after one year, that is, the next year
P2= DPS3/( Kc – g), estimate of fair value after 2 years
P3=DPS4/( Kc – g), estimate of fair value after 3 years
To extend the logic blindly
P20 = DPS21/ (Kc – g), estimate of share price after 20 years from now.
This formula also implies that P1 = Po(1 + g)
P2 = P1 (1 + g). Share price grows at constant growth rate ‘g’ if above stated 5 corporate policies are kept
constant.

Relationship of constant growth share valuation Model Called Gordon’s Model and
expected ROR of share
you can rearrange the terms of the Gordon’s pricing model:

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Lahore School of Economics. MBA II. Advance Corporate Finance. Winter 2018. Dr. Sohail Zafar. TA: Ms. Farheen Hassan

P0 = DPS1/ (Kc – g)
Po (Kc – g) = DPS1
Kc - g = DPS1/Po
Kc = (DPS 1 / Po) + g
since you know by now that ‘g’ can refer to growth in share price when above stated 5 corporate policies
are kept constant, therefore
g = (P1 - Po) / Po, and thus
Kc = (DPS 1 / Po) + (P1 - Po) / Po can be written as:
Kc = (DPS 1 / Po) + g and verbally it can be stated as
Kc = expected dividend yield + expected capital gains yield
and this is your familiar expected ROR formula for shareholders.

Fair Price ,or , Theoretical Price of a Share


You also know that for the current price of share to be the equilibrium price (also called the right price , or
the fair price, or justified price) the expected ROR and risk adjusted ROR of the share must be the same ,
only then the share is rightly priced. It means you can solve for the fair value of share by doing the
following
Expected Kc = Required Kc
Expected ROR = Required ROR
(DPS 1 / Po) + (P1 - Po) / Po = Rf + (Rm - Rf) beta L
Inserting all other values except Po, you can solve for Po, and then compare the solved Po with the
prevailing Po of that share in the market to make a judgment whether at prevailing Po in the market this

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Lahore School of Economics. MBA II. Advance Corporate Finance. Winter 2018. Dr. Sohail Zafar. TA: Ms. Farheen Hassan

share is overvalued or undervalued; and accordingly can make buy or sell recommendations for that
share.

Ultimately it is the owners of the corporation, called shareholders, who should become wealthier when a
business is managed by the professionals such as MBAs. In simple terms: job of MBAs managing a
corporation is to make the owners of corporation wealthier. Such increase in wealth of owners is called
value creation. Ideally top management decision making in all functional areas should be driven and
dictated by the concern for creation of value for the shareholders. Value creation is measured by the
increased share price in the stock market. EVA provides conceptual framework of value creation, and
helps you understand that value creation would take place only when operating performance as
measured by ROIC is good enough to cover cost of capital measured as WACC: only then EVA would be
positive. Gordon Model of constant growth shows that Share value depends on PV of all future dividends
while dividends are assumed to grow every year at a constant growth rate. Because shareholders
measure their wealth by the value of their shares in the market therefore success or failure of managers
in managing a corporation is determined by their ability to achieve growth in share price of their
respective corporation.

Impact of Financing decisions on valuation :


Let us see how financing decisions have impact on valuation of a co’s shares. Financing decisions result in
using low or high level of debt capital by a Co to finance its assets. The use of debt capital has impact on
WACC because too much debt would result in a high debt to equity ratio, and that higher debt to equity
ratio through Hamada’s equation translates into higher relevant risk for the share of that co as measured
by beta levered of the share. It is shown below;
[Beta ( levered) = Beta (UL) { 1 + (1 – T) * Debt / OE}]
For example 2 cement companies using exactly the same technology and located in the same location
would have same business risk, that is, their beta unlevered is same , say 0.8. But co A has debt to equity
ratio 2 and Co B has debt to equity ratio 1.5, then their financial risk is different ; and relevant risk of their
shares, beta levered, is also different
Co A
Beta ( levered) = Beta (UL) { 1 + (1 – T) * Debt / OE}
= 0.8 {1 + (1 - 0.3) 2
= 1.92
Co B
= 0.8 {1 + (1 - 0.3) 1.5
= 1.64

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Lahore School of Economics. MBA II. Advance Corporate Finance. Winter 2018. Dr. Sohail Zafar. TA: Ms. Farheen Hassan

higher beta levered resultantly goes into CAPM equation for Kc (the risk adjusted required rate of return
of shareholders), resulting in higher Kc.

Kc = Rf + (Rm – Rf) Beta (Levered)


For the 2 cement companies the respective risk adjusted required rate of return for shareholders works
out as follows if Rf is 10% and Rm is 20%:

Co A
Kc = 10 + (20 -10)1.92 = 29.2%
Co B
Kc = 10 + (20 - 10) 1.64 = 26.4%
And therefore cost of equity capital (Kc) of company A is higher whose beta levered is higher.

Since Kc is a component of WACC, therefore the WACC of Co A would be higher. Assume both
corporations are equally good in purchasing raw materials, producing and selling cement and therefore
have exactly same ROIC; yet Economic Value Added (EVA) would be lower in Co A because of its higher
WACC, which itself was due to it using higher debt capital.
EVA per year = ROIC - WACC
lower EVA means value creation is hurt. Please note that too high a debt to equity ratio can also result in
higher cost of debt capital (Kd) as well because further and further borrowing would ultimately result in
banks charging higher interest rate (Kd) from that company. Increase in Kd would further increase the
WACC.

There is another mechanism whereby you can understand negative impact of high WACC on valuation of
shares of a corporation: it is through the free cash flow model of share valuation. If 2 components of costs
of capital ( that is if kc and Kd ) are higher, then resulting WACC is also higher. Higher WACC results in
lower market value of TA because WACC is used as discount rate for estimating the market value of TA
according to the free cash flows model of valuation
Value of TA = FCF1/(1 + WACC)1 + FCF2 / (1 + WACC)2 + FCF3 / (1 + WACC)3 +……………………………………..+
FCF n / (1 + WACC)n .

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Lahore School of Economics. MBA II. Advance Corporate Finance. Winter 2018. Dr. Sohail Zafar. TA: Ms. Farheen Hassan

and if MV of TA is lower than after subtracting MV of TL the resulting estimated MV of OE would also be
lower resulting in lower share price: that is value destruction for owners of a business. So valuation is
impacted by financing decisions; and too much reliance on debt capital such as bank loans in a business
can negatively impact value of shares in the market.

Impact of Investing Decisions on valuation :


On the other hand valuation of shares of a co is also impacted by investing decisions made by its
management

Production methods and technology is embedded in the assets of a corporation; and poor management
of assets (NWC and FA) results in low free cash flows generated per year by the use of such assets. Note
that:
Free cash flows (FCF) per year = EBIT (I - T) – increase in total capital.
Increase in total capital = increase in NWC + increase in FA
These free cash flows are in the numerator and WACC is in the denominator of the FCF valuation model
given below, therefore poor investing decisions have negative impact on the valuation of a Co. The free
cash flows (FCF) valuation model in its generic form is written as:
Value of TA (Value of a Firm) = PV of future free cash flows generated by its assets
Value of TA = FCF1/(1 + WACC)1 + FCF2 / (1 + WACC)2 + FCF3 / (1 + WACC)3 +……………………………………..+
FCF n / (1 + WACC)n .
As FCF per year are = EBIT (1 – T) – increase in total capital , therefore better the quality of investing
decisions, higher is the EBIT and higher is, consequently, FCF per year; which ultimately translates into
higher value of TA, and after subtracting TL, the result is higher value of OE, which when divided by
number of shares gives higher share value: the value creation is thus impacted by the quality of investing
decisions.

In this valuation model, FCF1 refers to free cash flows in year one (next year), FCF2 refers to free cash
flows in year 2 in future , and so on until “n” years. Also note that there are superscript 1, 2,3, n, on the
term (1 + WACC) but they refer to discounting periods, and not to the WACCs of different years. Only
today’s WACC when project investment is being contemplated is relevant, not the WACCs of future years
because you are estimating PVs today; also the aim is to estimate today’s value of future free cash flows (
that is present value) so the relevant discount rate is today’s cost of capital. WACC is the appropriate
discount rate for free cash flows because total capital invested in a business is represented by NWC + FA;

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Lahore School of Economics. MBA II. Advance Corporate Finance. Winter 2018. Dr. Sohail Zafar. TA: Ms. Farheen Hassan

and financing for these assets is provided by LTL + OE, and providers of the 2 types of capital hope to earn
a percentage rate of return Kd and Kc, therefore weighted average of percentage cost of LTL and OE ( that
is Kd and Kc) is the theoretically correct discount rate to be used to find present value of cash flows
generated from the use of these assets.

Though an elaborate treatment of free cash flows (FCF) method of valuing assets of a co would be taken
up in the forth coming sessions, it suffices here to note that free cash flows for the next few years can be
estimated only if financial statements for the next few years have been estimated. Therefore our next
topic has to be financial planning where we shall learn various techniques of preparing projected financial
statements.
From another angle, good investing decisions result in managers choosing appropriate size, technology,
and combination of FA and NWC; and then managing these assets well. The result is low operating costs,
high revenues and consequently high EBIT and ultimately high ROIC; and when WACC is deducted from
ROIC, you get EVA. In a company higher ROIC leads to higher EVA, and that is an indicator of value
creation.

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