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Review. FINA 7330 Advanced Corporate Finance Lecture 13 Ronald F. Singer Fall, 2009. Making Investment Decisions . NPV Rule Incremental Cash Flow After Tax basis when paid Opportunity Costs Changes in Working Capital Depreciation Not a Cash Flow Treat Inflation Consistently

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Review

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  1. Review FINA 7330 Advanced Corporate Finance Lecture 13 Ronald F. Singer Fall, 2009

  2. Making Investment Decisions • NPV Rule • Incremental Cash Flow • After Tax basis when paid • Opportunity Costs • Changes in Working Capital • Depreciation Not a Cash Flow • Treat Inflation Consistently • MAXIMIZE NPV

  3. Practical Problems in Capital Budgeting • Basically: What happens when you cannot take all positive NPV projects. • Must Consider the package of projects which maximizes the NPV of all possible alternatives • Classes: • Two possibilities • Once and for all deals • Repetitive deals

  4. Once and for all deals Mutually Exclusive Projects: Basically dealing with mutually exclusive decisions • Mutually Exclusive Projects • Beware of the conflicts between IRR and NPV • Investment Timing: When is the optimal time to take on a project: (Want to max the Present value of the NPV) • Budget Constraints: What subset of all possible combinations give you the highest NPV

  5. Repetitive Deals • Mutually Exclusive projects with different starting times, economic lives • Replacement Decision In general, you “smooth” the cash flows by finding Equivalent Annual Cash Flow, so that projects can be compared.

  6. Repetitive Deals • Mutually Exclusive projects with different starting times, economic lives • Equivalent Annual Cash Flow • Replacement Decision • Replace when • EACF replacement > EACF existing

  7. Analysis of Projects • Sensitivity Analysis • Scenario Analysis • Break Even Analysis • Monte Carlo Simulations • Real Options and Decision Trees • React to ongoing information as it is revealed

  8. Strategic Investment Decisions • Trust Market Values • Look for comparative advantage • Consider opportunity costs • How will introducing this project effect other products you produce • When will introduction of this project induce competition • What will happen to the price over time

  9. Payout Policy • Critical Dates • Announcement Date • Record Date • Payment Date • Ex-dividend Date

  10. Payout Policy • Dividends versus repurchase of shares • Signaling implications of announcements • Agency Costs • Free Cash Flow • Tax implications • Liquidity

  11. Lintner’s Model • DDiv(t) = a(Div(t)*-Div(t-1)) Where the dividend target (Div(t)*) is determined as a proportion of long run earnings

  12. Payout Policy • What investors do • What firms do • What effect does dividend policy have on price

  13. Empirical Payout Policy • Repurchases versus Dividends • Signals • Fixed price tenders versus open market purchases • High market/book versus low market/book • What does market/book tell you • What do you expect the reaction in these 2 cases to be • Repurchase versus Dividends

  14. Long-Run Policy • Tax Effects • Free Cash Flow

  15. Dividend Policy • What should corp. do? • What should individual do? • What is the impact on the total value of the firm

  16. Agency Problems • How do you induce managers to act in stockholders’ interest

  17. Message of EVA + Managers are motivated to only invest in projects that earn more than they cost. + EVA makes cost of capital visible to managers. + Leads to a reduction in assets employed. - EVA does not measure present value • Rewards quick paybacks and ignores time value of money + Present Value of EVA does measure NPV and thus consistent rewarding via EVA leads to good decisions

  18. Capital Structure • Capital Structure Defined • The Modigliani Miller Theory • Static Tradeoff Theory • Taxes • Bankruptcy costs and costs of financial distress • Information costs • Pecking Order Theory

  19. Capital Structure • Agency Problems • Underinvestment • Overinvestment (risk shifting)

  20. Raising Capital • Information and how capital is raised • Debt versus equity • Cash flow in versus cash flow out • Organizational changes • Transactions that increase ownership concentration increase stock prices • Underwritten versus Rights offering • Greater Commitment by underwriter has positive impact on stock price

  21. Summary • Leverage Increasing (+Price Reaction) • Cash Flow In (+Price Reaction) • Underwritten versus Rights Offering (less underpricing) • Firm Commitment versus Best Efforts • Negotiated versus Competitive Bid for underwriter • Traditional Registration versus Shelf Registration • Organizational Structure (Price reaction) • Increasing concentration of ownership • Voluntary Reorganization

  22. Advent of “innovative securities” • Inefficient markets • Incomplete markets • Resolves conflicts of interest • Tax or regulatory arbitrage • Encourage efficient production

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