Corporate Finance Essentials: Capital, Risk, and Valuation
Capital Structure
Capital Structure refers to the way a firm finances its assets and operations through a combination of debt, equity, and securities such as preferred stock. It can influence a firm’s beta, market risk, and stock price.
Business Risk
Business Risk is the uncertainty in a firm’s operating income (EBIT) that arises from the nature of the firm’s operations.
Business Risk Factors
- Variability in demand
- Variability in sales price
- Variability in input costs
- Operating leverage
Financial Risk
Financial Risk results from using debt and magnifies returns to shareholders.
Leverage
Leverage occurs when a firm uses borrowed funds (debt), which magnifies potential returns. Its impact is seen on Earnings Per Share (EPS) and Return On Equity (ROE).
Modigliani and Miller
Modigliani and Miller showed no effect of capital structure on value without taxes or costs. However, with taxes, debt can add value up to a point.
Trade-Off Theory
Trade-Off Theory indicates an optimal debt level where incremental tax benefits equal incremental distress costs.
Optimal Capital Structure
Optimal Capital Structure maximizes the firm’s value (stock price) and minimizes WACC, not necessarily maximizing EPS.
WACC and Firm Value
The Weighted Average Cost of Capital (WACC) reflects the required returns of all security holders. Minimizing WACC maximizes the firm’s value. As WACC decreases, the value of the firm increases, and vice versa.
EPS vs. Value
High leverage may increase expected EPS, but maximizing EPS does not necessarily maximize stock price.
Factors Influencing Debt-Equity Mix
Firms consider signaling, taxes, bankruptcy risks, and industry factors when choosing their debt-equity mix.
Cash Cycle
Cash cycle = Receivables period – Payables period + Inventory period
Sales Forecast
The most important step when constructing forecasted financial statements is the sales forecast. As a firm’s sales grow, its current assets also tend to increase.
Additional Funds Needed (AFN)
AFN are funds that a firm must raise externally from non-spontaneous sources, i.e., by borrowing or by selling new stock to support operations. AFN is typically raised by a combination of notes payable, long-term debt, and common stock.
Negative AFN
A negative AFN means the firm doesn’t need to increase its borrowing as there is a surplus of funds. It indicates that retained earnings and spontaneous capital are more than sufficient to finance the additional assets needed. Too many funds can help pay off debt.
Sustainable Growth Rate
Sustainable Growth Rate is the maximum achievable growth without the firm having to raise external funds. Basically, it’s the growth rate at which the firm’s AFN = 0.
AFN and Capacity
Two firms with identical capacity ratios are earning the same amount of sales. Company A is operating at full capacity, while B is operating at 80%. If the two firms believe they will have the same growth in sales next year, which firm will need more external financing (AFN)? Firm A is likely to need more additional funds, other things held constant, because A is already running at full capacity.
Internal Rate of Return (IRR) and Net Present Value (NPV)
- If a project with normal cash flows has an IRR greater than the WACC, then the NPV is positive, which means the project should be accepted.
- A project should be accepted if IRR > WACC.
- Positive NPV Project: IRR > MIRR > WACC
- Negative NPV Project: IRR < MIRR < WACC
- Sunk Costs are ignored because they are irrelevant to the capital budgeting process.
- A project’s MIRR can never be greater than its IRR: False
- If the NPV is negative, then the IRR is also negative: False
Cash Conversion Cycle (CCC)
The Cash Conversion Cycle (CCC) measures how long a firm’s cash is tied up in its operations. It combines:
- Inventory Conversion Period (ICP): How long inventory sits before sale
- Receivables Collection Period or Days Sales Outstanding (DSO): How long customers take to pay
- Payables Deferral Period (PDP): How long the firm takes to pay its suppliers
CCC = ICP + DSO – PDP
A shorter CCC indicates more efficient working capital management since the firm’s cash is freed up sooner.
Cash Budget
Cash Budgets reflect cash inflows and outflows, including collections from sales and payments to suppliers, as well as interest and dividends. They must also consider timing.
- Short-term (daily/weekly) Cash Budget: For actual cash control and ensuring the firm doesn’t run out of cash.
- Long-term (monthly for a year) Cash Budget: For planning long-term needs.
Depreciation
Depreciation is a non-cash charge that doesn’t directly appear as a cash outflow, but changes in depreciation can affect tax payments and thus indirectly affect cash flow.
Trade Credit
Trade Credit is “free” only during the discount period if discounts are offered. It can be very costly to a firm if they do not take discounts.
- It is false to pay as early as possible in the discount period to lower the cost. You should actually wait until the last day of the discount period.
- Free credit ends when the discount period ends.
- A firm should always use free trade credit and use costly trade credit only if it’s cheaper than alternative financing.
Elements of Strategic Planning
- Mission statement
- Cooperative objective
- Operating plan
- Statement of corporate scope
Stakeholder Claims
An employee might have a claim on the cash flows, making them a stakeholder.
Bond Valuation
- Premium Bond: A bond that sells for more than face value. The coupon rate is greater than the market interest rate, or the market rate is below the coupon rate.
- Par Value Bond: A bond that sells exactly at its face value. The coupon rate is equal to the market interest rate.
- Discount Bond: A bond that sells for less than face value. The coupon rate is less than the market interest rate.
- Zero-Coupon Bond: Pays no interest but is initially sold at a discount to par. The investor earns a return by collecting the face value at maturity.
A bond has a $1000 par and makes annual payments of $100 with 5 years remaining until maturity. If the market interest rates are below 10%, then the bond should sell at a premium: TRUE
Timelines
Timelines can be over any compounding frequency: annual, quarterly, monthly, etc. You can use a timeline for any kind of Time Value of Money (TVM) problem.
Mortgage Payments
With a loan like a mortgage on a house, the longer you make your payments, the larger the percentage of the payment will be that reduces your principal.
Constant Growth Dividend Model
Constant Growth Dividend Model: Suppose dividends grow by 5%, then the stock price will also grow by 5%. So, the stock price one year from now will be 5% above the current price.
Primary Goal of the Firm
The primary goal of the firm is to maximize the long-run stock price, which is the intrinsic value per share of stock.
Target Capital Structure
Target Capital Structure aims to maximize the stock price, which maximizes the firm value and minimizes WACC.
Market Types
- Spot Market: Markets in which assets are bought or sold for “on-the-spot” delivery (literally, within a few days).
- Future Markets: Markets in which participants agree today to buy or sell an asset at some future date.
- Money Markets: Financial markets in which funds are borrowed or loaned for short periods (less than one year).
- Capital Markets: Financial markets for stocks and for intermediate- or long-term debt (one year or longer).
- Primary Markets: Markets in which corporations raise capital by issuing new securities.
- Secondary Markets: Markets in which securities and other financial assets are traded among investors after they have been issued by corporations.
Retained Earnings
Retained Earnings are the cumulative total of all earnings kept by the company during its life.
Working Capital
- Working Capital = Current Assets
- Net Working Capital (NWC): Current Assets – Current Liabilities
- Net Operating Working Capital (NOWC): Operating Current Assets (Current Assets – Excess Cash) – Operating Current Liabilities (Current Liabilities – Notes Payable)
Amortization
Amortization is a non-cash charge similar to depreciation, except that it represents a decline in the value of intangible assets.
Operating Income
Operating Income is earnings from operations before interest and taxes (EBIT).
Free Cash Flow
Free Cash Flow is the amount of cash that could be withdrawn without harming a firm’s ability to operate and produce future cash flows.
Tax Rates
- Marginal Tax Rate: The tax rate applicable to the last unit of a person’s income.
- Average Tax Rate: Taxes paid divided by taxable income.
Time Value of Money
- Compounding: Finding the future value.
- Discounting: Finding the present value.
- Ordinary Annuity: An annuity whose payments occur at the end of each period.
- Annuity Due: An annuity whose payments occur at the beginning of each period.
- Perpetuity: A stream of equal payments at fixed intervals expected to continue forever.
- Nominal Interest Rate or APR: The contracted interest rate.
- Effective Annual Rate (EFF%): The annual rate of interest actually being earned, as opposed to the quoted rate.
- Amortized Loan: A loan that is repaid in equal payments over its life.
- Maturity Date: A specified date on which the par value of a bond must be repaid.
- Original Maturity: The number of years to maturity at the time a bond is issued.
- Coupon Payment: The specified number of dollars of interest paid each year.
- Coupon Interest Rate: The stated annual interest rate on a bond.
- Yield to Maturity (YTM): The rate of return earned on a bond if it is held to maturity.
- Yield to Call (YTC): The rate of return earned on a bond when it is called before its maturity date.
Risk
Stand-alone Risk is the risk an investor would face if he or she held only one asset.
Assets
- Patent: Intangible Fixed Asset
- Trademark: Intangible Fixed Asset
- Pet Food Sold: Tangible Current Asset
- Production Equipment: Fixed Tangible Asset
- Liquid Asset: Something that could be sold for cash quickly without loss of value at a fair price.
Balance Sheets
Balance Sheets are used to compare big companies to smaller companies.
Cash Cycle
A negative cash cycle is good.
Periodic and Nominal Rates
- When given a periodic rate, the effective rate is found by multiplying the periodic rate by the number of periods in the year: False
- When given a periodic rate, the nominal rate is found by multiplying the periodic rate by the number of periods per year: True
Income Statement and Balance Sheet Formulas
- Total Assets = Total Debt + Total Equity
- Current Assets = Cash + Accounts Receivable + Inventory
- Current Liabilities = All Payables + All Accruals
- Total Debt = Short Term Debt (Notes Payable) + Long Term Debt (Bonds)
- Total Equity = Common Stock + Retained Earnings
- Net Income = EBIT – Interest – Taxes
- Net Income = (EBIT – Interest) x (1 – Tax Rate)
- EBIT = Net Income + Interest + Taxes
- EBIT = (Net Income / (1 – Tax Rate)) + Interest Expense
- EPS = Net Income / Shares
- Interest Expense = EBIT – (Net Income / (1 – Tax Rate))