Corporate Financing Decision (MFIN 641)

MBA Vth Term

Kathmandu University School of Management

Rajesh Sharma, PhD

Investment Decision
 Investment Decision: Apart from what you
have already covered

• Risk and Return Model: CAPM v/s Multi factor Model

• Inputs for CAPM:

– Risk Free Rate, Market Return, Beta
– Beta: Regression Beta v/s Bottom up Beta

• Estimating Betas for Non-Traded Firms: Levered and Unlevered

Beta

• Note on Cost of Debt

• Investment Decision: Sensitivity and Scenario Analysis

First Principles
Corporate Finance Decision
• Value Maximization: Gives corporate finance its
focus. As a result of this singular objective, we
can
– Choose the “right” investment decision rule to use,
given a menu of such rules.
– Determine the “right” mix of debt and equity for a
specific business
– Examine the “right” amount of cash that should be
returned to the owners of a business and the “right”
amount to hold back as a cash balance.
Corporate Finance Decision: Overall Flow
 Investment Decision
• Risk and Return

• Mean Variance Analysis

• Diversification: Diversifiable v/s Non-

Diversifiable

• Market Efficiency
Investment Analysis
• Invest in projects that yield a return greater than the
minimum acceptable hurdle rate.
– The hurdle rate should be higher for riskier projects and
reflect the financing mix used - owners’ funds (equity) or
borrowed money (debt)

• Returns on projects should be measured based on

cash flows generated and the timing of these cash
flows; they should also consider both positive and
negative side effects of these projects.
Investment Analysis: Hurdle Rate
Investment Analysis: Hurdle Rate
• Since financial resources are finite, there is a hurdle that projects
have to cross before being deemed acceptable.

• This hurdle will be higher for riskier projects than for safer projects.

• A simple representation of the hurdle rate is as follows:

Hurdle rate = Riskless Rate + Risk Premium

• The two basic questions that every risk and return model in finance
tries to answer are:
– How do you measure risk?
– How do you translate this risk measure into a risk premium?
Risk Return Model: Feature
• It should come up with a measure of risk that applies to all assets and not be
asset-specific.

• It should clearly delineate what types of risk are rewarded and what are not, and
provide a rationale for the delineation.

• It should come up with standardized risk measures, i.e., an investor presented

with a risk measure for an individual asset should be able to draw conclusions
about whether the asset is above-average or below-average risk.

• It should translate the measure of risk into a rate of return that the investor
should demand as compensation for bearing the risk.

• It should work well not only at explaining past returns, but also in predicting
future expected returns.
Risk Return Model: CAPM
• Uses variance of actual returns around an expected return as a measure
of risk.

• Specifies that a portion of variance can be diversified away, and that is

only the non-diversifiable portion that is rewarded.

• Measures the non-diversifiable risk with beta, which is standardized

around one.

• Translates beta into expected return -

Expected Return = Risk-free rate + Beta * Risk Premium

• Works as well as the next best alternative in most cases.

CAPM: Limitations
1. The model makes unrealistic assumptions
– Reliance on risk- return, Similar expectation of risk-return, Free access to
information, Borrow/ Lend at risk-free rate

2. The parameters of the model cannot be estimated precisely

– The market index used can be wrong.
– The firm may have changed during the ‘estimation period’

3. The model does not work well

– If the model is right, there should be:
• A linear relationship between returns and betas
• The only variable that should explain returns is betas
– The reality is that:
• The relationship between betas and returns is weak
• Other variables (size, price/book value) seem to explain differences in returns better.
Alternatives to CAPM
CAPM: Why persists ?
• The CAPM, notwithstanding its many critics and limitations, has survived as
the default model for risk in equity valuation and corporate finance. The
alternative models that have been presented as better models (APM,
Multifactor model) have made inroads in performance evaluation but not in
prospective analysis because:

– The alternative models (which are richer) do a much better job than the CAPM in
explaining past return, but their effectiveness drops off when it comes to estimating
expected future returns (because the models tend to shift and change).

– The alternative models are more complicated and require more information than the
CAPM.

– For most companies, the expected returns you get with the the alternative models is
not different enough to be worth the extra trouble of estimating four additional betas.
CAPM: Inputs
• The capital asset pricing model yields the following expected
return:
Expected Return =
Risk-free Rate+ Beta * (Expected Return on the Market Portfolio –
Risk-free Rate)

• To use the model we need three inputs:

a. The current risk-free rate
b. The expected market risk premium, the premium expected for
investing in risky assets, i.e. the market portfolio, over the riskless
asset.
c. The beta of the asset being analyzed.
Beta: Exploring Fundamentals

Determinants: Things to consider

• Product Type: Business Risk

• Leverage: Financial Risk
 Product Type: Business Risk

• Industry Effects: The beta value for a firm

depends upon the sensitivity of the demand for its
products and services and of its costs to
macroeconomic factors that affect the overall
market.
– Cyclical companies have higher betas than non-
cyclical firms
– Firms which sell more discretionary products will
have higher betas than firms that sell less discretionary
products
Leverage: Financial Risk
• Financial Leverage: As firms borrow, they create fixed costs (interest payments)
that make their earnings to equity investors more volatile. This increased earnings
volatility which increases the equity beta.

• The beta of equity alone can be written as a function of the unlevered beta and the
debt-equity ratio
L = u (1+ ((1-t)D/E))

Where,
L = Levered or Equity Beta
u = Unlevered Beta
t = Corporate marginal tax rate
D = Market Value of Debt
E = Market Value of Equity
Important Note: Estimating Betas for Non-Traded Firms

• The conventional approaches of estimating betas from regressions do not work for assets
that are not traded (not listed).

• One of the ways in which betas can be estimated for non-traded firms
– using comparable firms

• The beta of equity alone can be written as a function of the unlevered beta and the debt-
equity ratio
L = u (1+ ((1-t)D/E))

Where,
L = Levered or Equity Beta
u = Unlevered Beta
t = Corporate marginal tax rate
D = Market Value of Debt
E = Market Value of Equity
Important Note: Estimating Betas for Non-Traded Firms

Assume that you are trying to estimate the beta for a independent “Bookstore”.

Firm Beta Debt Equity R2

Books-A-Million 0.532 $45 $45

Borders Group 0.844 $182 $1,430
Barnes & Noble 0.885 $300 $1,606
Courier Corp0.815 $1 $285
Info Holdings 0.883 $2 $371
John Wiley &Son 0.636 $235 $1,662
Scholastic Corp0.744 $549 $1,063

Sector 0.7627 $1,314 $6,462 16%

- Unlevered Beta = 0.7627/(1+(1-.35)(1314/6462)) = 0.6737

- Industry average debt to equity ratio of 20.33%

 Important Note: Estimating Betas for Non-Traded Firms

• Since the debt/equity ratios used are market debt equity ratios, and the
only debt equity ratio we can compute for “Bookstore” is a book value
debt equity ratio, we have assumed that “Bookstore” is close to the
industry average debt to equity ratio of 20.33 %.

• Using a marginal tax rate of 40% (based upon personal income tax
rates) for “Bookstore”, we get a levered beta of 0.76.

Levered beta for “Bookstore” = 0.6737 (1 +(1-0.40) (0.2033)) = 0.76

• Using a risk-free rate of 4% (US treasury bond rate) and a historical risk
premium of 4.82%:

Cost of Equity = 4% + 0.76 (4.82%) = 7.66%

 Important Note: Estimating Betas for Non-Traded Firms

•• The
  owners of most private firms are not diversified. Beta measures
the risk added on to a diversified portfolio.

• Therefore, adjust the beta to reflect total risk rather than market risk.
This adjustment is a relatively simple one, since the R squared of the
regression measures the proportion of the risk that is market risk.
Total Beta = Market Beta / Correlation of the sector with the market

• For “Bookstore”:

– Total Beta = 0.6737/ = 1.68

– Cost of Equity = 4% + 1.68 (4.82%) = 12.09%

Hurdle Rate: Sum up
• Cost of Equity: From CAPM

• Cost of Debt: Special Consideration

• WACC: Based on Weightage

• Either the cost of equity OR the cost of capital can be

used as a hurdle rate: Depending upon whether the
returns measured are to equity investors or to all
claimholders on the firm (capital)
Special Consideration for Bond
• If the firm has bonds outstanding, and the bonds are traded, the yield to
maturity on a long-term, straight (no special features) bond can be used
as the interest rate.

• If the firm is rated, use the rating and a typical default spread on bonds
with that rating.

• If the firm is not rated

– and it has recently borrowed long term from a bank, use the interest rate on the
borrowing or
– estimate a synthetic rating for the company, and use the synthetic rating to
arrive at a default spread and a cost of debt
• Rating based on Interest Coverage Ratio = EBIT / Interest Expenses
• Default spread based on rating i.e. BBB = 1.5%
• Pre-tax rate of debt = Risk free rate + Default Spread= 4% +1.5%
• After –tax rate of debt = 5.5% (1-0.4) = 3.30%
Investment Analysis: Investment
Returns
Investment Returns
• Returns on projects should be measured based
on cash flows generated and the timing of
these cash flows; they should also consider
both positive and negative side effects of these
projects.
Measures of return: earnings versus cash
flows
• Principles Governing Accounting Earnings Measurement
– Accrual Accounting: Show revenues when products and services are sold or provided, not
when they are paid for. Show expenses associated with these revenues rather than cash
expenses.
– Operating versus Capital Expenditures: Only expenses associated with creating revenues in
the current period should be treated as operating expenses. Expenses that create benefits
over several periods are written off over multiple periods (as depreciation or amortization)

• To get from accounting earnings to cash flows:

– you have to add back non-cash expenses (like depreciation)
– you have to subtract out cash outflows which are not expensed (such as capital
expenditures)
– you have to make accrual revenues and expenses into cash revenues and expenses (by
considering changes in working capital).

• Understand cases: Profit with Negative CF & Loss with Positive CF

Measuring Returns Right: The Basic Principles

• Use cash flows rather than earnings.

“You cannot spend earnings”

• Use “incremental” cash flows relating to the investment decision, i.e.,

cashflows that occur as a consequence of the decision, rather than total
cash flows.

• Use “time weighted” returns, i.e., value cash flows that occur earlier
more than cash flows that occur later.

The Return Mantra: “Time-weighted, Incremental Cash Flow

Return”
Investment: Cash Flow and Discounting (Decision
Layout)

Discount cash flow using appropriate discount rate

Investment: Estimating Accounting Earnings (Example)
Background: Disney has already spent $0.5 Billion researching the proposal and getting the necessary licenses for
the park; none of this investment can be recovered if the park is not built. This expenditure has been capitalized and
will be depreciated straight line over ten years to a salvage value of zero.

Disney will face substantial construction costs (Capital Investment), if it chooses to build the theme parks.
– The cost of constructing Magic Kingdom will be $3 billion, with $2 billion to be spent right now, and $1
Billion to be spent one year from now.
– The cost of constructing Epcot II will be $1.5billion,with $1 billion to be spent at the end of the second
year and $0.5 billion at the end of the third year.
–  These investments will be depreciated based upon a depreciation schedule in the tax code, where
depreciation will be different each year.
– The capital maintenance expenditures are low in the early years, when the parks are still new but increase
as the parks age.
Investment: Depreciation and CAPEX schedule

How is Revenue and other expenses calculated? : Past Record or Comparable for NOPAT
Investment: Accounting View of Return

a) Book Capital at the start of each year

b) Avarage Book Capital over the year (Moving Average- 2 years)
What should this return be compared to?

The computed return on capital on this investment is about 4.18%. To

make a judgment on whether this is a sufficient return, we need to
compare this return to a “hurdle rate”.

Which of the following is the right hurdle rate? Why or why not?

a.  The risk-free rate of 2.75% (T. Bond rate)

b.  The cost of equity for Disney as a company (8.52%)
c.  The cost of equity for Disney theme parks (7.09%)
d.  The cost of capital for Disney as a company (7.81%)
e.  The cost of capital for Disney theme parks (6.61%)
f.  None of the above
Investment: Cash Flow and Discounting - NPV

1) Incremental Cash Flow: Sunk Cost (-) and tax saving (+).

2) Time weighted: Discount cash flow using appropriate discount rate that is calculated
earlier e.g. US 6.61% or calculate one using WACC method.

Note about the Importance of Business Model: Theme Parks are profitbale after 10 years
Investment: Key Assumptions and Measurement

• Revenue Assumption
• Expenses Assumption
• Depreciation and Capital Expenditure
• Working Capital

• Cash Flow, Terminal Value, Cost of Capital and Time Value of

Money: NPV and IRR
– Decision: Accept Project if NPV > 0 or IRR > hurdle rate
Side Costs and Benefits
• Most projects considered by any business create side costs and benefits for that business.
(i.e. Disney Movie acquiring Star Wars Franchise OR new park within vicinity)

• The side costs include the costs created by the use of resources that the business already
owns (opportunity costs) and lost revenues (Cannibalizing) for other projects that the
firm may have. (i.e. effect on League of Justice Franchise OR effect on old park within
vicinity)

• The benefits that may not be captured in the traditional capital budgeting analysis include
project synergies (where cash flow benefits may accrue to other projects) and options
embedded in projects (including the options to delay, expand or abandon a project).
(i.e. Establishing on Star Wars Theme Parks)

• The returns on a project should incorporate these costs and benefits.

Uncertainty in Project Analysis: What can we
do?
• The conclusions on a project are clearly conditioned on a large number of
assumptions about revenues, costs and other variables over very long time
periods.

• To the degree that these assumptions are wrong, the conclusions can also be
wrong.

• One way to gain confidence in the conclusions is to check to see how sensitive
the decision measure (NPV, IRR) is to changes in key assumptions.
– While this has become easier and easier to do over time, there are caveats that are
offered.
• Caveat 1: When analyzing the effects of changing a variable, hold all else constant. In the real
world, variables move together.
• Caveat 2: The objective in sensitivity analysis is to make better decisions, not churn out more
tables and numbers. (Simple is Better)
 Example

Sensitivity (e.g. in excel)

• What factors?
• What Range?

Considerations in selecting example:

• New Firms
• Unlevered Beta

Hence,
• WACC (Beta)- CAPM v/s Comparable
• Relative Multiples