MSC Semester 2, 2003: Company Finance Richard Fairchild: staff.bath.ac.uk/mnsrf .

1. MSC Semester 2, 2003: Company Finance • Richard Fairchild: http://staff.bath.ac.uk/mnsrf. • Room: WH9.21 Email: mnsrf@bath.ac.uk • Topics in Investment Appraisal. • Risk and Return/ Portfolio Analysis. • 3. Cost of Capital, Capital Structure, Firm Value. • 4. Optimal Capital Structure - Agency Costs, Signalling. • 5. Dividend Policy. • 6. Options/Risk Management. • 7. Convertible Debt. • 8. Mergers and Takeovers.

2. Connections throughout the course. Investment Appraisal: Net Present Value with discount rate (cost of capital) given. Positive NPV increases value of the firm. Cost of Capital (discount rate): How do companies derive the cost of capital? – CAPM, DVM. Capital Structure and effect on Firm Value and WACC.

3. Income Statement. • Revenue • Variable Costs • Fixed costs • EBIT • -rD • EBT • -tax • Net Income • -Dividends • Retained earnings Finance Topics. Revenue Risk. Operating Leverage. Business Risk. Financial Gearing. Shareholder Risk and Return Dividend Policy.

4. Balance Sheet. Liabilities Share Capital + Retained Earnings Equity Debt (eg loans etc) Total Liabilities Assets Fixed Assets Current Assets Total Assets Balance Sheet is a snapshot. Total Assets = Total Liabilities. Book Value of Equity. Topic: Capital Structure (market values).

5. SECTION 1: Investment Appraisal. • Debate over Correct Method • - Accounting Rate of Return. • - Payback. • - NPV. • - IRR. • - POSITIVE NPV Increases Shareholder Wealth. • 2. Correct Method - NPV! • -Time Value of Money • - Discounts all future cashflows

6. Calculation of NPV. Perpetuities: Value of the Firm = present value of future cashflows. or Positive NPV increases firm value.

7. Example. Consider the following new project: -initial capital investment of £15m. -it will generate sales for 5 years. - Variable Costs equal 70% of sales value. - fixed cost of project £200m PA. - A feasibility study, cost £5000, has already been carried out. Discount Rate equals 12%. Should we take the project?

8. DO WE INVEST IN THIS NEW PROJECT? NPV > 0. COST OF CAPITAL (12%) < IRR (19.75%).

9. Note that if the NPV is positive, then the IRR exceeds the Cost of Capital. NPV £m 3.3m Discount Rate % 0 12 % 19.7%

10. Conflict Between Appraisal Techniques.

11. COMPARINGNPVANDIRR - 1 NPV 531 519 10% 22.8% 25.4% Discount Rate PROJ D PROJ C Select Project with higher NPV: Project C.

12. COMPARINGNPVANDIRR -2 NPV Discount Rate Impossible to find IRR!!! NPV exists!

13. COMPARINGNPVANDIRR –3 Discount Rate: 10% Project A : Date 0 Investment -£1000. Date 1 Cashflow £1500. NPV = £364. IRR = 50% Project B:- Date 0 Investment -£10 Date 1 Cashflow £18. NPV = £6.36 IRR = 80%. Which Project do we take?

14. Mutually Exclusive Versus Independent Projects. • -Mutually exclusive – we can only select one project- we choose the one with the highest NPV (project 1). • Independent Projects – select all positive NPV projects (all projects). • Capital Rationing.

15. Capital Rationing And Independent Projects. The firm is limited to a capital constraint of £300,000. Consider combinations of projects that maximise weighted average PVI. Eg: Projects 2 and 3: Project 1: Selecting Project 2 and 3 is superior to project 1.

16. Treatment of depreciation in NPV analysis. -We only use cashflows in investment appraisal. -Depreciation is not a cashflow. -However, depreciation is allowable against tax (see income statement), which affects cashflow. For cashflow, add depreciation back:-

17. Treatment of depreciation.

18. Capital Budgeting and Inflation. K is the nominal cost of capital. We require real cost of capital, where Either add inflation to the cashflow estimates, or remove inflation from the nominal cost of capital.

19. NPV and Competitive Bidding. • Positive NPV => immediate increase in share price. • Negative NPV => decrease in share price. • Competitive bid for a supply contract, where lowest price wins (eg Space Structures exercise). • Find Lowest bid price without NPV going negative. • Find bid price such that NPV is zero. Eg: A company is bidding for a contract to supply Y units P.A. for 3 years. Optimal bid price P?

20. The optimal bid price solves; Or: if supply forever (perpetuities) Simple to rearrange these equations to find P!

21. Decision Trees and Sensitivity Analysis. Example: From RWJ. New Project: Test and Development Phase: Investment $100m. 0.75 chance of success. If successful, Company can invest in full scale production, Investment $1500m. Production will occur over next 5 years with the following cashflows.

22. Production Stage: Base Case Date 1 NPV = -1500 + = 1517

23. Decision Tree. Date 1: -1500 Date 0: -$100 NPV = 1517 Invest P=0.75 Success Do not Invest NPV = 0 Test Do not Invest Failure P=0.25 Do Not Test Invest NPV = -3611 Solve backwards: If the tests are successful, SEC should invest, since 1517 > 0. If tests are unsuccessful, SEC should not invest, since 0 > -3611.

24. Now move back to Stage 1. Invest $100m now to get 75% chance of $1517m one year later? Expected Payoff = 0.75 *1517 +0.25 *0 = 1138. NPV of testing at date 0 = -100 + = $890 Therefore, the firm should test the project. Sensitivity Analysis (What-if analysis or Bop analysis) Examines sensitivity of NPV to changes in underlying assumptions (on revenue, costs and cashflows).

25. Sensitivity Analysis. - NPV Calculation for all 3 possibilities of a single variable + expected forecast for all other variables. Limitation in just changing one variable at a time. Scenario Analysis- Change several variables together. Break - even analysis examines variability in forecasts. It determines the number of sales required to break even.

26. Break-even Analysis. Accounting Profit. Breakeven Point = 2091 Engines. NPV. Breakeven Point = 2315 Engines.

27. The Investment Appraisal Debate. Richard Pike: Sample size: 100 Large UK based Firms.

28. Combination of Techniques: Pike 1992: ( ) = NPV

29. Some Reasons for usage of wrong techniques. • -Managers prefer % figures => IRR, ARR • Managers don’t understand NPV/ Complicated Calculations. • Payback simple to calculate. • Short-term compensation schemes => Payback (Levy 200 –203, Pike 1985 pg 49). • Increase in Usage of correct DCF techniques: • Computers. • Management Education.

30. Berkovitch and Israel: Why the NPV Criterion does not Maximise NPV. -So far, NPV has been best technique, and managers use other techniques through ignorance. -In contrast, Berkovitch and Israel argue that NPV might sometimes be inefficient. -Model –Divisional Mgt identify investment opportunities. Submit capital budget requests to top mgt (HQ). -divisional mgr is an empire builder- submits bigger project with lower NPV – hides smaller project with higher NPV. -IRR or PI performs better.

31. SECTION 2: Cost Of Capital. The cost of capital = investors’ required return on their investment in a company. It provides the appropriate discount rate in NPV. Investors are risk averse. Future share prices (and returns) are risky (volatile). The higher the risk, the higher the required return. p r A B t t

32. Risk and Return. An investor’s actual return is the percentage change in price: Risk = Variability or Volatility of Returns, Var (R). We assume that Returns follow a Normal Distribution. Var(R). E(R)

33. What do we mean by Risk? The risk reflects the distribution (spread) of expected future returns. Investors are assumed to be risk-averse (don’t like risk). The higher the spread (risk), the higher the required return => current price adjusts to reflect this. Risk. Returns A B A B Time B is riskier than A.

34. Risk Aversion. Investors prefer more certain returns to less certain returns. U Wealth 100 150 200 Risk Averse Investor prefers £150 for sure than a 50/50 gamble giving £100 or £200.

35. Portfolio Analysis. Two Assets: Investor has proportion a of Asset X and (1-a) of Asset Y. Combining the two assets in differing proportions. E(R)

36. Portfolio of Many assets + Risk Free Asset. E(R) Efficiency Frontier. M * . * * X * * * All rational investors have the same market portfolio M of risky assets, and combine it with the risk free asset. A portfolio like X is inefficient, because diversification can give higher expected return for the same risk, or the same expected return for lower risk.

37. The Effect of Diversification on Portfolio Variance. Number of Assets. An asset’s risk = Undiversifiable Risk + Diversifiable Risk = Market Risk + Specific Risk. Market portfolio consists of Undiversifiable or Market Risk only.

38. Summary of Risk and Return: Investors are assumed to be risk averse. They combine assets to diversify (reduce) risk. The more assets, the lower the specific risk. The market portfolio diversifies away all specific risk, and contains all assets in the right proportions. Implications for Investors. Current share prices (which affect expected returns) are such that the market only rewards investors for holding market risk, not specific risk. *****Implications for Individual Firms. *********** Cost of Capital (Investor’s required return) should only reflect Market Risk – (Beta – CAPM).

39. Cost of Equity. Dividend Valuation Model. This assumes that all net cashflows are paid out as dividends. Interchangeability- if we know the dividends and the market value, we can calculate the cost of equity. If we know the cost of equity and the dividends, we can calculate the market value.

40. Cost of Equity (continued) CAPM quantity of risk. Security Market Line.

41. Estimating Cost of Equity Using Regression Analysis. We regress the firm’s past share price returns against the market. See the regression exercise on my home page.

42. Weighted Average Cost of Capital (WACC). When we have estimated Cost of Debt, and Cost of Equity- if we have market values of debt and equity, we can calculate WACC – discount rate for new investments. See Mobil Energy Exercise.

43. Link to Section 3: Link between Value of the firm and NPV. Positive NPV project immediately increases current equity value (share price immediately goes up!) Pre-project announcement New capital (all equity) New project: Value of Debt Original equity holders New equity New Firm Value

44. Example: =500+500=1000. 200 60 -20 = 40. Value of Debt = 500. Original Equity = 500+40 = 540 New Equity = 20 =1000+60=1060. Total Firm Value

45. Positive NPV: Effect on share price. Assume all equity.

46. SECTION 3: Value of the Firm and Capital Structure. Introduction:- Value of the Firm = Value of Debt + Value of Equity = discounted value of future cashflows available to the providers of capital. (where values refer to market values). Capital Structure is the amount of debt and equity: It is the way a firm finances its investments. Unlevered firm = all-equity. Levered firm = Debt plus equity. Miller-Modigliani said that it does not matter how you split the cake between debt and equity, the value of the firm is unchanged (Irrelevance Theorem).

47. Value of the Firm = discounted value of future cashflows available to the providers of capital. -Assume Incomes are perpetuities. Miller- Modigliani Theorem: Irrelevance Theorem: Without Tax, Firm Value is independent of the Capital Structure. Note that

48. K K D/E D/E V V D/E D/E

49. Which Cashflows do we use? Annual Income statement: Revenues 1000 Less Variable Costs 200 Less Fixed Costs 200 EBIT (=NCF) 600 Less Debt Interest (2000 @ 5%) 100 for debtholders EBT500 Less Tax (20%) 100 Net Income (NI)400 for equityholders

50. Calculating Levered Firm Value in our Numerical Example (see Income Statement). Let Cost of levered Equity: Market Value of Debt = 2000. Cost of risk free Debt = 5%. a) b) Now, => See Henderson Exercise.