CFA 2 Corporate Finance
Terms in this set (47)
EP = NOPAT - $WACC
NOPAT = EBIT (1-tax rage)
$WACC = WACC * Capital (debt + equity)
RI = Net income - equity charge
Equity charge = r(t)
B(t-1) -> required rate of return
the beginning-of-period book value of equity (B(t-1))
HHI Index concentration level:
Amount of change that would trigger challenge
1. <1000 - any change won't trigger action
2. 1,000 - 1,800 - 100 or more - possible challenge
3. > 1,800 - 50 or more - challenge
Give managers choices regarding the operational aspects.
1. price-setting: increase price to take advantage of excess demand.
2. production flexibility: increase production
oil drill: invest or not depends on oil price
Alternate forms of determining income for a project
1. Economic profit
2. Residual Income
3. Claims valuation
Calculate: Increase in dividends based on a target payout ratio
= increase in earnings x target payout ratio x adjustment factor
Adjustment factor = 1/Number of year
Dividend payout ratio
Dividend / Earnings
EI = Cash flow - Economic depreciation
= CF - (V(t-1) - V(t))
After tax operating CF = (S - C - D)*(1-T) + D + After tax salvage
V(t) = PV(CF(t+1) + CF(t+2) + ...)
Economic rate of return
The year's economic income divided by the beginning market value
Types of merger in :
consolidation vs. acquisition
acquisition: result in acquired comp
cons: result in a different comp
Pooling of interests accounting method
Pool assets at book value -> higher reported income (lower depreciation expenses) compared to acquisition (purchase) method
Interest used in calculating PBO
Current service cost
Increase in the PV of defined benefit obligation as a result of employee services in the current period
actuarial loss vs gain (pension)
Change in assumptions increases obligation -> actuarial loss
Double taxation: effective rate
corporate tax rate + (1 - corp tax) x indi tax rate...
expected dividends in stable dividend policy
previous dividend + expected increase in EPS x target payout ratio x adjustment factor
The profitability of the project after considering the real option = NPV (based on project alone) - cost of option + value of option
Define real options:
1. timing option
2. abandonment option
3. expansion option
4. flexibility option
5. fundamental option
1. delay making investment
2. abandon: PVs from existing > PV future CF
3. expansion: only if creates positive value
4. flexibility: price-setting (increase price to benefit from excess demand) or production flexibility (increase shifts, work overtime)
5. fundamental option: projects that are options themselves because the payoffs depend on the price of an underlying asset.(e.g. payoffs of gold mines depend on gold prices)
static-trade off theory
seeks to balance the costs of financial distress with the tax shield benefits from using debt and states that there is an optimal capital structure that has an optimal proportion of debt. Removing both MM's assumptions of no taxes and no costs of financial distress, there comes a point where the incremental value added by the tax shield is exceeded by the additional expected costs of financial distress, and this point represents the optimal capital structure.
Which of the following is least likely to be categorized as a cost of financial distress?
A) Premiums paid for bonding insurance to guarantee management performance.
B) Legal fees paid to bankruptcy lawyers.
C) Having a potential merger partner pull out of a proposed deal.
Premiums paid for bonding insurance to guarantee management performance is an example of an agency cost. Agency costs are costs associated with the fact that all public companies are not managed by owners and the conflict of interest created by that fact. Costs of financial distress can be direct or indirect. Direct costs would include cash expenses associated with bankruptcy, such as legal and administrative fees, while indirect costs would include foregone business opportunities, inability to access capital markets, or loss of trust from customers, suppliers, or employees.
target vs.optimal capital structure
target: more like a floating range
Which of the following is least likely to be a reason why a firm's actual capital structure may vary from the target capital structure?
A) The firm decides to finance a low risk project with 100% debt to improve the project's profitability.
B) The firm decides to issue additional equity because management believes the firm's stock is overpriced.
C) The firm decides to issue additional debt due to a temporary discount in underwriting fees for corporate debt.
A firm should always finance a project based on the firm's weighted average cost of capital, although when evaluating a project, the firm may apply a risk factor to adjust the risk of the project. A corporate manager generally cannot deem some projects as being financed by debt and some by equity as all projects are effectively financed proportionately based on the firm's capital structure. In practice, a firm's actual capital structure will float around its target. For a firm that does have a target capital structure, the actual structure may vary from the target due to market value fluctuations, or management's desire to exploit an opportunity in a particular financing source.
a firm's capital structure impacts: default risk? return on equity?
Impact of debt rating on debt and equity cost
Lower debt ratings signifies higher risk to both debt and equity capital providers and will cause both to demand higher returns on their investment.
Spread in cost of debt between AAA and BBB
the average spread between AAA rated bonds and BBB rated bonds has been 100 basis points, so 100 basis points is the most likely answer. Note however that the actual spread may fluctuate due to market conditions, and may be wider in recessions
Factors an analyst should consider when evaluating a firm's capital structure
1. Changes in the firm's capital structure over time: essential for evaluating whether or not management's decisions have worked to improve the firm's value.
2.Capital structure of competitors with similar business risk.
3.Factors affecting agency costs such as the quality of corporate governance
At the optimal capital structure the firm will minimize the WACC, maximize the share price of the stock and maximize the value of the firm.
Major factors that influence international differences in financial leverage
Institutional, legal, and taxation factors.
Financial market and banking system factors.
Japan tends to use more short-term debt compared to US
conditions that usually relate to more use of long-term debt
1. countries with higher GDP growth
2. highly liquid stock and bond market
3. low inflation
4. developed countries
5. legal system and institutional investor presence tends to be greater in the U.S
Accounting for stock repurchase
reduce book value of equity by the amount ($) of stock repurchase
Impact of increased earnings payout ratios for firms following a long-term residual dividend payment policy
note: long term residual dividend is different from constant dividend
1. stable dividend
2. constant dividentd
3. residual dividend
4. long term residual dividend
1. stable dividend: use a target dividend payout ratio
2. constant dividend:use a constant payout ratio -> dividends vary with earnings -> rarely use
3. residual dividend: dividends are based on earnings less funds the firm retains to finance the equity portion of its capital budget - based on the firm's (1) investment opportunity schedule (lOS), (2) target capital structure, and (3)access to and cost of external capital.
-> usually not stable, depending on each yr's invtmt opp
4. long-term resid dividend: forecasting their capital budget over a longer time frame ->The leftover earnings are dividends, relatively const amt. rest of cash is distributed as share repurchase.
global trends in corporate dividends policies
1. US vs. European
2. trend globally
3. stock repurchase
1. A lower proportion of U.S. companies pay dividends as compared to their European counterparts.
2. Globally, the proportion of companies paying cash dividends has trended downwards.
3. Stock repurchases have been trending upwards in the United States since the 1980s and in the United Kingdom and continental Europe since the 1990s.
NI / dividend
FCFE coverage ratio
FCFE / (dividend + stock repurchase)
common types of diversitures;
1. carve-out: the intent is to establish a new, independent firm (sub). Therefore, the parent company usually does not maintain a controlling interest in the new firm. separate management, new public stock issued
2. spin-off: similar to carve out, but shares offered to parent's existing shareholders in pro-rata basis
3. split-off: the parent's existing shareholders must surrender their shares in the parent to obtain shares in the new firm. [split]
4. liquidation: break the comp apart and sell
Note: no acquisition premium needed to be added when value comps using comparable transactions
diversiture vs. spin-off
Both actions involve the sale of a subsidiary or some coherent subset of the firm's assets. In the case of a divestiture, the sale is usually for cash. In the case of a spin-off it involves the distribution of the new firm's shares to the parent's existing shareholders.
Change in price when stock goes ex-dividend
P(div) - P(no div) = D x (1 - tax div) / (1 - tax capital gain)
Benefits of staggered board
allow for continuity of knowledge and experience in the company, which is essential for good corp governance
Calculate cost of equity from:
- cost with no debt
r(e) = r(0) + (r(0) - r(d))(1-t)*D/E
economic rate of return = WACC
beg market value - end market val
= after tax operating cash flow - econ depreciation
target buys its shares from acquirer at a premium, used to be popular until taxed highly
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