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KEY CONCEPTS FOR CORPORATE FINANCE
August 2002
This text is designed primarily to show incoming MBA students what they should
already know in corporate finance, although it may also serve as a refresher.
Generally, if a student is not familiar with the principles here, he or she is
encouraged to pursue private study. To attempt the MBA course on Corporate
Finance or Entrepreneurship without this knowledge will lead to frustration for
everyone on the course, and lower the standards we are striving for at Robert
Kennedy College.
Risk and Reward............................................................................................................................. Balance Sheet Structure.................................................................................................................. Returns and Impact of Tax.............................................................................................................. Yield Curves................................................................................................................................... 2 Contribution Analysis..................................................................................................................... Key ratios........................................................................................................................................ Cash Flow Analysis........................................................................................................................ 2 Discounting..................................................................................................................................... Pro Forma Balance sheet and Income Statements.......................................................................... Weighted Average Cost of Capital (Corporate Model)................................................................... Finance for Entrepreneurs.............................................................................................................. 2 Dilution........................................................................................................................................... Investment Analysis within an ongoing Operation......................................................................... Tax Loss Effects.............................................................................................................................. Cost of Equity................................................................................................................................. Share Issuing and Trading.............................................................................................................. 2 Hedging........................................................................................................................................... Options Trading.............................................................................................................................. 2 EXHIBIT I: RESTATED BALANCE SHEET............................................................................... EXHIBIT II: THE INCOME STATEMENT LINKED TO BALANCE SHEET........................... EXHIBIT III: THE THREE PILLARS OF CASH FLOW............................................................ 2
PRINCIPLES OF CORPORATE FINANCE
Risk and Reward
If an investor is seeking a high return, the associated higher risk cannot be avoided. If all goes well, they will obtain their return, but the possibility of failure and loss remains significant. If they seeks to reduce or eliminate the "downside risk", then their reward if all goes well will be smaller.
This principle applies first and foremost to investment in debt vs. investment in equity. Debt is rewarded with a fixed rate of return. The creditor receives his interest as long as the borrower remains solvent:
- his prime risk is therefore the continued existence of the borrower:
- even that can be mitigated against by collateral, assets pledged by the borrower to the lender in the event of default (prime example: a mortgage)
- nevertheless there is a secondary risk in debt investments, notable in (tradable) long-term bonds. These can undergo market value changes as interest rates go up and down:
- can also fall in capital value should the bond issuer's credit rating decline
- note the concept of "yield", both "current" and "to maturity".
Equity investment has a double reward:
- the earnings associated with share ownership
- dividends
- the increase in retained earnings and, therefore, of the future earnings capability and asset value of the company
- the capital gain of an increasing share value.
Yet neither of these rewards is guaranteed. In a recession or in a poor year for the company, earnings may fall well short of expectations or even turn into losses. Capital gain (for publicly traded shares) will reflect actual performance, expected performance and the overall mood the stock market. Equity owners receive the "leftovers", but when success is achieved, these "leftovers" can be very attractive.
Creditors always stand before equity investors for their interest and principal. Even when a company is liquidated, the creditors' call on principal and accrued interest always comes before anything that the equity holders may receive. Bankruptcy is actually forced on companies in default over debt, but by the time that happens, they usually have a negative net worth anyway. Then creditors receive a "liquidation dividend" of so many cents in the dollar and shareholders receive nothing.
Preference shares lie in between. Dividend is set in advance and must be paid if the cash situation allows it. Dividends are usually "cumulative", i.e. they must be caught up with if ever they are skipped and common stock dividend may not be paid until all back dividends or preference shares have been settled.
Again, in liquidation, preference shareholders stand "in the queue" behind creditors but in front of common stockholders.
Balance Sheet Structure
To facilitate financial analysis, balance sheets should be simplified. Assets and liabilities should be grouped according to their behaviour. Moreover, the concept of "working capital" is recognition to a net asset consisting of current assets minus current liabilities.
- (^) creditors
- fiscal authorities
- preference share holders
- common stockholder as cash reward
- the company itself, or common stockholders, as reward via returned earnings.
Yield Curves
The yield of a bond is the average interest received over its life. It reflects both interest received and any change of value between purchase price and maturity value.
In terms of the US dollar, the only strictly risk-free bond is that issued by the U.S. government: "Uncle Sam" can always print more dollars. T-Bond yields vary according to the state of the economy. At a given point in time, yield also varies with the maturity of the T-Bond.
The usual variation is for longer-term yields to be higher than shorter ones (or upward slope). Downwards slopes can occur if a decrease in inflation is expected.
A simplistic approach to T-Bond yields is to add three components:
- the risk-free rate
- an addition for inflation
- an addition for "maturity risk".
The inflation addition has to be averaged out for the life of the bond. Arithmetic average is usually taken, but geometric average should, strictly speaking, be used.
Contribution Analysis
Be able to define:
- unit variable cost
- unit contribution
- contribution margin
- total contribution.
Understand why:
- profit = contribution - fixed costs
- breakeven revenue =
- revenue at a given profit =
Key ratios
Inventory turnover = CGS/inventory
PE ratio = share price/EPS
Cost of debt = interest x (1 - r)
Debt ratio = debt to total capital
Debt/equity ratio = another way of expressing same data.
Market capitalisation = number of shares x share price
= PE x PAT available to common stockholders
(For PAT in finance calculations, "PAT available to common stockholders" is nearly always the relevant figure.)
Cash Flow Analysis
The assessment of financial reward deals with cash or cash- equivalents. Somehow the amount of cash put into an investment has to be compared with the cash returned from it. That is the only way a proper comparison can be made between rates of return expressed as an equivalent yearly interest rate on capital invested.
There are three ways of determining cash flow:
- the "direct method" whereby cash is assessed as it enters and leaves the company by consideration of cash sales, accounts receivable, accounts payable, etc...
- this is of little use in financial analysis, but is quite helpful in short-term cash flow forecasting
- the "indirect method" whereby cash flow is deduced from the income statement and changes in the balance sheet
- this is traditionally used for the cash flow statement or published reports
- the "balance sheet method" whereby cash is used as a "plug figure" in a pro forma balance sheet and income statement development
- this is described more in paragraph 10.
Accountants use many different presentations for their cash flow statements derived by the "indirect method". They even move quite easily into a concept of "funds", whereby funds can be either cash or working capital. For financial purposes, the working capital approach is quite useless, and all emphasis should be on real cash, i.e. the amount by which the bank balance goes up or down!
The preferred method for financial analysis is to consider cash flow to be made up of three distinct pillars:
- operating cash
- investment cash
- financial cash.
These three pillars are shown in Exhibit III.
EBIT = Interest, I = debt x interest rate
tax = (EBIT - I) x r (the tax rate) = PBT x r
preference share dividends = preference share capital x dividend rate
common stock dividends = PAT available to common stockholders x dividend ratio
= {PBT(1-r) - preference share dividends} x dividend ratio
- amount carried forward to retained earnings = PAT avail. to common stockholders x (1 - dividend ratio)
These equations are expressed in other forms in Exhibit II.
Discounting
Know how to derive discount factors with formula:
WACC applies only to the "corporate model" of discounted cash flow analysis. It is not applicable, for example, to a self-standing company where the investors found the company and hope to sell their shares in it many years later.
In the corporate model, there is supposed to be corporate headquarters with responsibility of raising capital, investing it wisely and keeping existing capital suppliers (in three groups) happy. It is further assumed in the corporate model that all cash throughout the corporation, especially the cash of the individual divisional or project level, is the "property" of corporate headquarters. In this way, the cash flow of a project consists of its investment and then all positive cash generated over the life of the project.
In a given year, it is hoped that the amount of investments made into projects is balanced by cash flow back from more mature projects. Note that the word "project" here has a broad meaning: it can cover anything from investing in a new machine to saving operating costs, to launching a new product line, to opening a new division, investing in a subsidiary or even acquiring another company.
Individual investment projects need analysing over several years to see whether it is worthwhile making the investment in the first place. This is where discounted cash flow techniques are used, and the issue at stake is what cost of capital or "discount factor" to use. The answer is the WACC.
Cash really only exists on an "after-tax" basis. All costs of capital must therefore be expressed in after-tax terms, and that means you must always multiply the cost of interest by (1 - the tax rate), provided the corporation is profitable as a whole.
It also means that you can forecast an "after-tax cash flow" for the individual projects. Even though tax is paid by corporate rather than by projects, the total amount of tax paid and the results in cash flow can be worked out perfectly accurately by pretending that the project pays tax upon its operating profit, i.e. upon its EBIT.
Thus in working out the cash flow of a project, begin with an "equivalent PAT", derived by taking the project EBIT and multiplying it by (1 - r).
The interest phenomenon is left to corporate headquarters. If you wish to follow right through to the eventual PAT, you would sum all the EBIT x (1 - r) and then subtract I x (1 - r). But normally, you do not do this since you are interested in the discount factor as WACC, and you are focusing on the attractiveness of a project, rather than trying to sum the total profit of the company.
In the above logic, there is an easy slippage from accounting profits to cash flow in determining the cost of capital, but there seems to be no alternative means of thinking.
Finance for Entrepreneurs
When companies are started by their founders investing directly in the new share capital, there is no corporate reservoir of cash with its three components of the cost of capital. In fact, the whole concept of the WACC has very little applicability in entrepreneurial finance. Instead, it is of interest to work out how much cash is needed as a company grows and what reward the entrepreneurs receive as their company grows and achieves value. Again cash flow techniques have to be used, but in contrast to corporate finance in which residual values of investments are considered to be very minor, the residual value of a company that has been created and nurtured over several years is the most important asset in the hands of the original investors! The main reward in monetary terms for an entrepreneur is the increase, possibly huge increase, in the value of his company as an entity that can be sold in its own right.
Thus to determine his return on investment, both the expected and value of the company must be estimated as well as any intermediate dividends and all these amounts expressed in cash terms and discounted to determine the internal rate of return.
Note that in the above, the term "return on investment" is equivalent to an IRR and reflects return over several years.
The valuation of a company cannot simply be calculated, since its value depends on what people are prepared to pay for it. Nevertheless, there are at least three relevant methods of valuation which can be used to provide at least starting points for negotiations over sales price, or to indicate what sales value would be if the entrepreneurs were to choose to sell it (they may not). The three methods of valuation are:
- book value, preferably adjusted for any changes in the marketable value of assets
- it is this adjusted book value which has to be used in the calculation of goodwill
- a simple "times earnings" whereby the PAT available to common stockholders is multiplied by a number, typically in the order of six, to obtain total company value
- a more sophisticated "times deleveraged earnings", where a higher factor is taken (e.g. eight rather than six) and used to multiply the earnings that a company would achieve if there were no financial leverage effects:
- deleveraged earnings = EBIT x (1 - r) = PAT + (1 - r) x I
To see what the sellers would receive net, the amount of debt and preference shares should be subtracted from the above valuation.
Dilution
When a company raises new funds for a specific project, it may be legitimate to work out the WACC for the new funds. However, normally you should look upon WACC as an overall figure for the entire corporation with new projects sharing in a common pool and not having money from particular sources attached to them.
Nevertheless, as in many aspects of business, there are exceptions. It may be possible to raise some additional funds by two or three different means and use those funds to generate additional profits. Then the question is: what effect does this have on earnings per share? The approach for raising funds through interest or preference shares is to take the additional profit and subtract from that the after-tax cost of the interest or dividend respectively (multiply the interest by (1 r)!). You then divide the net income by the number of shares outstanding and you will have the change in EPS.
When new common stock is issued, however, working directly to the change in this way is not possible. You have to see the number of shares that have to be issued to raise the capital needed: take the market price of the shares and assume that you have to issue new shares at, for example, 10% less than market price. In the calculation for EPS (PAT available to common stockholders divided by number of shares outstanding), it is now the denominator which changes rather than the numerator. Thus you have to calculate the new EPS, and can derive the change in EPS only by comparison with the EPS before the new shares were issued and the investment made.
Investment Analysis within an ongoing Operation
When funds are invested in a new operation or project, cash flow analysis can follow the "corporate" or the "entrepreneurial" model. If the investment is in the context of an ongoing, profit and cash generating operation, a rather different cash flow model has to be used. It may be called the "incremental model", for it focuses on the changes in after-tax cash flow associated with a proposed investment compared with the cash flow that would have been realised without the investment.
He will want to move in the future, so "jack up" the percentage by 20, 30 or 40%. This gives you an "expected" or "target" rate of return for new shareholders based on market value of their stock. To re-express this in book value terms, just multiply by the market/book ratio.
Share Issuing and Trading
When a company first issues shares to the public, it is said to "go public" or "be floated". Unless the company is an exceptionally large, privately-held one, it is likely that the first publicly-traded shares will be issued through small local stock exchange or through the unlisted securities market (USM) or over the counter (OTC) -- the U.S. expression. The USM/OTC are not stock exchanges as such, but systems of trading electronically. They nevertheless have market-makers just as do shares on the major stock exchanges. The market-maker's role is to hold sufficient shares in a given stock for the market to operate smoothly and for him always to be able to give a current quote.
When shares are traded publicly, there is no direct impact on a company's accounts. It is vital for a publicly-traded company to follow the development of its share price as the quoted price is a measure of the success of the company and of the reward to shareholders, and therefore of their satisfaction. Moreover, decisions on raising new capital, particularly as concerns the mix of debt and equity, will greatly depend on the current price of the share. Finally, an excessively low share price makes a publicly-quoted company vulnerable to hostile take-over bids.
When a company issues shares, be it for the first time or a further issue, the usual procedure is to use an underwriter, i.e. a bank with the know-how and the resources to guarantee the success of a share issue. In some countries, any large bank will be capable of underwriting, but in the UK, there is a special class of banks called "merchant banks", and in the US called "investment banks". The underwriter first gives advice on the structure of a company and the presentation of its accounts and outlook. There usually has to be at least three years of successful operation before a new issue can be made. The underwriter will determine the likely issue price and the amount of capital that can be raised. He then underwrites the issue, i.e. he takes upon himself the responsibility of selling all the shares and is therefore responsible for any shares left unsold. In return for this, he receives a handsome underwriting fee, but seeks his profit from the fee rather than from a capital gain on shares he may have on his own account.
In the first instance, the underwriter places the shares with "institutional investors" made up of pension funds, life insurance companies, mutual funds (also known as "unit trusts") with the occasional rich personal investor (often found via private banking services). The price to the institutional investors has to be judged so that when the share is eventually (some days later) put onto the public market, the institutional investors may expect to receive a modest capital gain, in the order of a few percentage points.
It is part of the institutional investors' responsibility to give up some of the first shares they purchase in order ensure a satisfactory start to public trading.
There are alternative methods of going public, notably a system of bidding where potential investors state how many shares they would be prepared to buy at a given price. The lowest prices is then accepted which will float all the shares. This has the disadvantage for the issuer of his not knowing what price he will get before the flotation actually takes place.
Corporate bonds are issued in a very similar way, but the role of bidding is more important, since today most government bond issues are actually issued via a bidding process and corporate bond issuing is at least partly affected by this procedure.
Hedging
Any company involved in international trade is likely to face a difference of currency between expected revenues and expected costs. It is therefore more than likely to need a hedging tool so
as to know in advance what its revenues will be against its home currency costs. Two tools are available for this:
- an option to sell the incoming currency (called a "put" -- an option to buy is called a "call"). This is essentially an insurance policy with a fairly heavy premium against the risk of the revenue currency falling below a given level. In this hedge, the hedging company still has benefit from any unexpected increase in the revenue of the sale
- a forward purchase whereby a fixed amount of money is exchanged on a fixed date at a rate determined today. The future rate is the spot rate adjusted by the impact of the relative interest rate for each currency over the period. It is fairly easy to remember that currencies with a higher interest rate than the home currency are always cheaper for a forward purchase, by the ratio (1 + the interest rate of the home currency to 1 + interest rate of the purchased currency).
The disadvantage of forward purchasing is that the money has to arrive on time for the contract date, least additional exchange charges be incurred. Moreover, there is no possibility of benefiting from an upside change in the value of the incoming currency. But that is the point about hedging, the company that hedges is to be satisfied with the rate thus obtained and not worry about whether the final rate goes up or goes down. The major advantage of the forward market compared with the option market is that the forward market is very much less expensive.
Options Trading
This is a whole topic worthy of a book in its own right, and will be mentioned here only most briefly.
Options trading in shares is a relatively new tool which has proven very attractive as it enables relatively small investment amounts to be tallied into quite large gains (with a corollary of quite large possible losses!). A put option allows the sale of a share at a given price and is therefore of interest if the share value is expected to fall, while a call option is of interest if a share value is expected to rise. Options are issued above respectively below the strike price and initially have a value reflecting only the potential of gain vs. (for the option writer) the risk he has to carry. Once the strike price has been passed, however, an option has an intrinsic value equal to the difference between the strike price and the share price. In fact, options are always traded at above the intrinsic value, not just because of the chance of the gain, but because less capital is involved for a given absolute gain with the share price movements.
Options always have an expiry date and their value drops exactly to the intrinsic value (which may be zero) on the expiry date.
When options have a positive intrinsic value, they are said to be "in the money"; otherwise, they are "out of the money".
Options trading has significantly higher risk reward profile than trading in shares as such. It is not for amateurs!
EXHIBIT II: THE INCOME STATEMENT LINKED TO BALANCE SHEET
EBIT (Earnings Before Interests and Tax) less INTEREST = PBT (Profit Before Tax) less TAX = PAT (Profit After Tax) less DIVIDEND or DRAWINGS = carried forward (c/f) to retained earnings.
ASSETS
= current assets + fixed assets = current liabilities + long term debt + owners' equity
ASSET BASE
= working capital + fixed assets Therefore, asset base = assets - current liabilities
NET WORTH = asset base - debt
BEP (Basic Earning Power) = expressed as a percentage RoA (Return on Assets) = RoE (Return on Equity) = also expressed as percentages
If the tax rate = r (usually expressed as a percentage, but to be used as a decimal)
PAT = (1 - r) x PBT
PBT =
If preference shares received dividend, then it may be necessary to consider "profit after tax available to common stockholders":
PAT - preference share dividends
This is the relevant figure for EPS calculations.
EXHIBIT III: THE THREE PILLARS OF CASH FLOW
CASH FROM OPERATIONS
= PAT
+ DEPRECIATION
- INCREASE IN NCWC
- GAIN ON ASSET SALES
CASH USED FOR INVESTMENTS
= NEW FIXED ASSETS ACQUIRED
- NET RECEIPTS FROM ASSETS
DISPOSED OF
CASH FROM FINANCE
= NEW DEBT OR EQUITY ISSUED
- OLD DEBT OR EQUITY RETIRED
- DIVIDENDS
DIFFERENCE BETWEEN THESE THREE = CHANGE IN CASH BALANCE
