Corp finance topics

Corporate Finance Topics

2

Topics

¨  Capital Budge1ng & Project Evalua1on ¨  Taxes ¨  Dividends ¨  Short selling ¨  Dividend Irrelevance Proposi1on (M&M) ¨  Informa1on and agency issues

Capital Budge1ng Preliminary 3

PV=CFi

(1+k)ii=1

M

∑

NPV=CFi

(1+k)ii=0

M

∑

0 1 2 3 4 5

sunk costs

How do you decide whether to do a particular project or make a particular investment? How do you rank projects within your capital budget?

Capital Budge1ng Methods

¨  Net present value ¤  NPV should be posi1ve ¤  is hurdle rate or project cost

of capital

¨  Internal rate of return ¤  IRR should exceed hurdle rate

¨  Payback period ¤  Time periods to breakeven

Cash flows and +ming are always given

∑= +

+=N

1ii

i0 )k(1

CFCFNPV

∑= +

+==N

1ii

i0 IRR)(1

CFCF0NPV

∑= +

+==N

1ii

i0 )k(1

CFCF0NPV

0 1 2 3 4 5

sunk costs

N

k

k

Net Present Value Method

¨  Expected project cash flows are projected for periods 1 to N ¨  A discount rate for the project is determined

¤  The rate includes an adjustment for risks to the project cash flows rela1ve the firm’s total cash flow and cost of capital, kU

¨  The method determines if the NPV is posi1ve and thus a value crea1ng investment

¨  Alterna1ve projects can be ranked in descending NPV order

projectU

N

1ii

i0

kkk

)k(1CFCFNPV

Δ+=

++= ∑

=

Internal Rate of Return Method

¨  Find the discount rate, IRR, that equates NPV to zero ¨  The IRR should exceed a hurdle rate and thus creates

value ¨  Rank alterna1ve projects in descending order by IRR

k IRR

IRR)(1CFCF0NPV

N

1ii

i0

≥

++== ∑

=

Payback Period Method

¨  How many periods, , are required to recover (on an NPV basis) the ini1al investment?

¨  How many periods needed to achieve a posi1ve NPV ¨  Use the risk adjusted discount rate, ¨  Rank alterna1ve projects in ascending payback period

basis

∑= +

+=≡N

1ii

i0 )k(1

CFCF0NPV

k

N

0 1 2 3

Internal Rate of Return 8

10 10 110

100

100= CF(1+y)ii=1

3

∑ = 101+y( )

+ 10

1+y( )2+ 110

1+y( )3

P ⋅y3+ 3P.10( ) ⋅y2+(3P.10)⋅y.120=0

Income Tax Rates

Marginal Tax Rate

Single

10% $0 – $8,025 15% $8,026 – $32,550 25% $32,551 – $78,850 28% $78,851 – $164,550 33% $164,551 – $357,700 35% $357,701+

Marginal Tax Rate

Single

2.56% $0 -‐ $2,4003.57% $2,401 -‐ $17,5005.12% $17,501 -‐ $27,0006.84% $27,001 +

Nebraska

Currently, the average combined federal and state corporate tax rate in the U.S. is 40.0%, second among OECD countries to Japan's combined rate of 40.69%.

Ordinary Income Rate

Long-‐term Cap Gain & Dividend* Rate

Short-‐term Capital

Gain Rate

Long-‐term Gain on Real Estate**

Long-‐term Gain on Collectibles

10% 0% 10% 10% 10%15% 0% 15% 15% 15%25% 15% 25% 25% 25%28% 15% 28% 25% 28%33% 15% 33% 25% 28%35% 15% 35% 25% 28%

* Qualified dividends ** $250,000 exemption on primary residence

Short Selling

Long Investment (but short term holding period)Buy 100 shares of FMN in Oct-‐07 for 65.00$ per share for a total of 6,500$ "Buy at market"Sell 100 shares of FMN in Jul-‐08 for 15.00$ per share for a total of 1,500$ "Sell at Market"Net (5,000)$

Short Trade Borrow 100 shares of FMN in Oct-‐07 from your brokerSell 100 shares of FMN in Oct-‐07 from your brokerage account at for 65.00$ per share for a total of 6,500$ "Sell short"Buy 100 shares of FMN in Jul-‐08 into your brokerage account for 15.00$ per share for a cost of 1,500$ "Buy to Cover"Return 100 shares of FMN in Aug-‐08 to your brokerNet 5,000$

Project Expected Cash Flows

¨  Assume there are three future cash flow scenarios, A, B, and C during some future year. The expected cash flow is during that year is

¨  The scenarios are mutually exclusive – independent ¨  Example

¤  CFA = $1,000,000 with probability 50% ¤  CFB = $500,000 with probability 30% ¤  CFC = $150,000 with probability 20%

¨ 

¨  The risk (variance) in the expected cash flow is included in the discount rate

[ ]1p p p

pCFpCFpCFCFE

CBA

CCBBAA

=++

⋅+⋅+⋅=

[ ]000,680$

%20000,150$%30000,500$%50000,000,1$ CFE=

⋅+⋅+⋅=

Project Valua1on

¨  Present value of free cash flow – opera1ng and financing split using APV method

¨  Define project cash flow, CF, similar to free cash flow, FCF ¨  Include a cash flow at 1me 0 (likely an investment – a

nega1ve cash flow)

12

∑=

⎥⎦

⎤⎢⎣

⎡

++

+=

N

1ii

TS

ii

U

i0 )k1(

TS)k1(

FCFV

∑= +

+=N

1ii

i0 )k1(

CFCFNPV projectU kkk Δ+=

Project Valua1on

¨  Note ‘direct method’ for free cash flow ¤  Cash, not accrual, basis

¨  Ignore non-‐opera1ng assets, dividends, interest expense and income

13

RC: cash revenue (excluding IDI) COGSC: cash cost of goods sold or cost of revenue OXC: cash opera1ng expenses (SG&A, R&D) ITC: cash taxes paid CX: capital expenses CS: cash from sale of assets ΔCE: addi1onal opera1ng cash required

ITCCECSCXOXCCOGSCRCCF −Δ−+−−−=

τ⋅−τ⋅+−Δ−+−−−= IXIDIITCOCECSCXOXCCOGSCRCFCF

Dividend Payments 14

S M T W Th F S Jun-‐081 2 3 4 5 6 7

8 9 1011

Announcement Date

12 13 14

15 16 17 18 19 20 2122 23 21 22 23 24 2529 27 28 29 30

S M T W Th F S Aug-‐081 2

3 4 5 6 7 8 910 11 12 13 14 15 16

17 18

19 Ex-‐

Dividend Date

2021

Record Date

22 23

24 25 26 27 28 29 30

S M T W Th F S Sep-‐081 2 3 4 5 6

7 8 9 10

11 Payable Date 12 13

14 15 16 17 18 19 2021 22 23 24 25 26 2726 29 30

Microso0 Declares Quarterly Dividend REDMOND, Wash. — June 11, 2008 — Microsok Corp. today announced that its board of directors declared a quarterly dividend of $0.11 per share. The dividend is payable Sept. 11, 2008, to shareholders of record on Aug. 21, 2008. The ex-‐dividend date will be Aug. 19, 2008.

Opening stock price on 19 Aug =

Closing price on 18 Aug

– dividend per share ($0.11)

+ price gain (loss) due to over night changes in supply and demand for MSFT shares


Date Open High Low Close Volume Adj Close

30-‐Nov-‐04 26.75 27.01 26.7 26.81 75,960,400 25.5729-‐Nov-‐04 26.64 26.95 26.61 26.77 67,079,900 25.5326-‐Nov-‐04 26.56 26.82 26.55 26.6 24,398,700 25.3624-‐Nov-‐04 26.62 26.73 26.4 26.64 60,069,200 25.423-‐Nov-‐04 26.52 26.7 26.4 26.53 70,459,700 25.322-‐Nov-‐04 26.75 26.82 26.1 26.65 92,410,800 25.4119-‐Nov-‐04 27.03 27.07 26.84 26.86 85,808,600 25.6118-‐Nov-‐04 27.13 27.17 27 27.07 63,249,900 25.8117-‐Nov-‐04 27.25 27.35 27.06 27.17 58,830,700 25.9116-‐Nov-‐04 27.33 27.34 27.05 27.12 64,522,600 25.8615-‐Nov-‐04 27.34 27.5 27.2 27.39 104,468,000 26.1215-‐Nov-‐04 $ 3.08 Dividend12-‐Nov-‐04 30.16 30.2 29.8 29.97 162,269,000 25.6411-‐Nov-‐04 29.89 30.08 29.82 29.98 87,358,900 25.6510-‐Nov-‐04 29.92 30 29.69 29.73 84,097,700 25.449-‐Nov-‐04 29.43 29.89 29.35 29.77 100,401,000 25.478-‐Nov-‐04 29.18 29.48 29.13 29.28 112,802,100 25.055-‐Nov-‐04 29.21 29.36 29.03 29.31 95,337,700 25.084-‐Nov-‐04 28.38 29 28.38 29 87,867,700 24.813-‐Nov-‐04 28.65 28.65 28.31 28.47 79,666,700 24.362-‐Nov-‐04 28.26 28.47 28.03 28.24 89,417,100 24.161-‐Nov-‐04 28.16 28.28 27.96 28.08 72,930,900 24.00

Yahoo finance ‘historical prices’ for MSFT during Nov 2004

REDMOND, Wash. July 20, 2004 Microsok Corp. today announced that its board of directors approved an $0.08 per share quarterly dividend, plans to buy back up to $30 billion of the company's stock over the next four years, and a special one-‐1me dividend of $3 per share. hnp://www.microsok.com/presspass/press/2004/jul04/07-‐20boardPR.mspx

The 3rd quarter dividend ex-‐dividend date was August 23

The 4th quarter and special dividends ($3.08) were paid on Dec 2 to shareholders of record on Nov 17. The ex-‐dividend date was Nov 15.


Date Open Close Opening Gap

30-‐Nov-‐04 26.75 26.81 -‐0.0229-‐Nov-‐04 26.64 26.77 0.0426-‐Nov-‐04 26.56 26.6 -‐0.0824-‐Nov-‐04 26.62 26.64 0.0923-‐Nov-‐04 26.52 26.53 -‐0.1322-‐Nov-‐04 26.75 26.65 -‐0.1119-‐Nov-‐04 27.03 26.86 -‐0.0418-‐Nov-‐04 27.13 27.07 -‐0.0417-‐Nov-‐04 27.25 27.17 0.1316-‐Nov-‐04 27.33 27.12 -‐0.0615-‐Nov-‐04 27.34 27.39 -‐2.6312-‐Nov-‐04 30.16 29.97 0.1811-‐Nov-‐04 29.89 29.98 0.1610-‐Nov-‐04 29.92 29.73 0.159-‐Nov-‐04 29.43 29.77 0.158-‐Nov-‐04 29.18 29.28 -‐0.135-‐Nov-‐04 29.21 29.31 0.214-‐Nov-‐04 28.38 29 -‐0.093-‐Nov-‐04 28.65 28.47 0.412-‐Nov-‐04 28.26 28.24 0.181-‐Nov-‐04 28.16 28.08 0.19

November 2004 S M T W Th F S

1 2 3 4 5 67 8 9 10 11 12 13

14

15 Ex-‐

Dividend Date

1617

Record Date

18 19 20

21 22 23 24 25 26 2728 29 30

Opening price on 15 Nov = Closing price on 12 Nov -‐ $3.08 + price gain due to changes over the week end for MSFT stock

$27.34 = $29.97 -‐ $3.08 + $0.45

17

M&M Proposi1on 3

¨  “Dividend Irrelevance Proposi1on”

¨  Dividend payout policy is irrelevant to total shareholder value under certain condi1ons

¨  Illustra1on via an all-‐equity, constant growth firm with no debt and no non-‐opera1ng assets ¤  D = 0, NOA = 0, C = IC, T = 0

NOAL

OA PARAPCTSRE

EC

EC: Total common equity TS: Treasury stock (common)

18

Example

NOPAT0 DIV0

FCF0

IC0 IC1 IC2

FCF1 FCF2

ΔIC is the reinvestment needed to maintain gFCF at 5% and expected return on opera1ng assets at 10%

In this example FCF and ΔIC are defined to be the op1mal values for an all equity firm For an all equity firm, all of the FCF should be paid out as a dividend, if

•  dividend and capital gain taxes are equal

• A change in dividend payout does not signal financial distress

k 10%gFCF 5%EBIT 12,500,000$ τ 20%ns 8,000,000 ΔIC 6,000,000$ DB -‐$ NOA -‐$

Pay all FCF as dividend

Operating Assets Current Liabilitites ∆OA 6$ ∆CL -‐$

Nonoperating Assets Noncurrent Liabilities∆NOA -‐$ ∆NCL -‐$

Shareholders' Equity ∆PAR -‐$ ∆APC -‐$ ∆TS -‐$ ∆EC -$

∆RE 6$ ∆EB 6$

∆TA 6$ ∆LE 6$ ΔTS: change in treasury stock

ΔEC: change in common equity

ΔNOA: change in non-‐opera1ng assets (e.g., cash)

EBIT 12.50$ EBIT(1-‐τ) 10.00$

IX(1-‐τ) -‐$ NP 10.00$

IX(1-‐τ) -‐$ ΔT -‐$

NOPAT 10.00$ Δ IC 6.00$

FCF 4.00$ DIV 4.00$ ΔRE 6.00$

ΔOA=ΔRE 6.00$

20

Pay all FCF as dividend: Shareholder Value

m88$ 0$m4$0$m84$

ECDIVNOA%5%10)05.1(m4$

ECDIVNOAgk

)g1(FCFS

FCF

FCF

=

−++=

Δ−+Δ+−

⋅=

Δ−+Δ+−

+⋅=

Total shareholder value Total shareholder value per share

Fair value stock price

p

Cash flow to and from the

shareholder per share

( ) nsEC

nsDIV

nsNOA

nsgk)g1(FCFs

FCF

FCF Δ−+

Δ+

⋅−

+⋅=

$11.00 $0.50$10.50

m80$

m8m4$

m80$

m8m84$ s

=

+=

−++=

21

Pay No Dividend

¨  $6m investment needed to anain FCF growth of 5% ¤  Op1mal dividend payout and

reinvestment

OAΔICΔm4$DIVm4$FCFm6$ICΔ

m10$NOPAT

=

=

=

=

=

00.11$50.0$50.10$

0$m8m4$0$50.10$

nsEC

nsDIV

nsNOA50.10$s

=+=

−++=

Δ−+

Δ+=




∆RE 6$ ∆EB 6$

∆TA 6$ ∆LE 6$

22

Pay No Dividend

¨  Pay no dividend, yet FCF = $10m ¨  $6m investment needed to maintain FCF growth of 5%

¨  Excess reten1on of $4m

00.11$50.0$50.10$

0$0$m8m4$50.10$

nsEC

nsDIV

nsNOA50.10$s

=+=

−++=

Δ−+

Δ+=


Nonoperating Assets Noncurrent Liabilities∆NOA 4$ ∆NCL -‐$


∆RE 10$ ∆EB 10$

∆TA 10$ ∆LE 10$

EBIT 12.50$ DIV -‐$ EBIT(1-‐τ) 10.00$ ΔRE 10.00$ NP 10.00$ ΔOA 6.00$ NOPAT 10.00$ ΔNOA 4.00$

ΔIC 6.00$ FCF 4.00$

23

Pay Excess Dividend

¨  Pay excess dividend, DIV = NOPAT = $10m ¨  $6m investment needed to maintain FCF growth of 5%

¨  Raise $6m in common equity

00.11$75.0$25.1$50.10$ m8m6$

m8m10$0$50.10$

nsEC

nsDIV

nsNOA50.10$s

=−+=

−++=

Δ−+

Δ+=



Shareholders' Equity ∆PAR 1$ ∆APC 5$ ∆TS -‐$ ∆EC 6$

∆RE -‐$ ∆EB 6$

∆TA 6$ ∆LE 6$

EBIT -‐$ DIV 10.00$ EBIT(1-‐τ) 10.00$ ΔRE -‐$ NP 10.00$ ΔOA 6.00$ NOPAT 4.00$ ΔEC 6.00$

ΔIC 6.00$ FCF 4.00$

24

Example: Summary

Case 2

ΔNOA=change in excess cash Paid out too much dividend, so raise necessary

equity capital in market

DIV ΔNOA ΔEC pv(fcf) Δnoa p div Δec s-‐$ 4,000,000$ -‐$ 10.50$ 0.50$ 11.00$ -‐$ -‐$ 11.00$

1,000,000$ 3,000,000$ -‐$ 10.50$ 0.38$ 10.88$ 0.13$ -‐$ 11.00$ 2,000,000$ 2,000,000$ -‐$ 10.50$ 0.25$ 10.75$ 0.25$ -‐$ 11.00$ 3,000,000$ 1,000,000$ -‐$ 10.50$ 0.13$ 10.63$ 0.38$ -‐$ 11.00$ 4,000,000$ -‐$ -‐$ 10.50$ -‐$ 10.50$ 0.50$ -‐$ 11.00$ 5,000,000$ -‐$ 1,000,000$ 10.50$ -‐$ 10.50$ 0.63$ (0.13)$ 11.00$ 6,000,000$ -‐$ 2,000,000$ 10.50$ -‐$ 10.50$ 0.75$ (0.25)$ 11.00$ 7,000,000$ -‐$ 3,000,000$ 10.50$ -‐$ 10.50$ 0.88$ (0.38)$ 11.00$ 8,000,000$ -‐$ 4,000,000$ 10.50$ -‐$ 10.50$ 1.00$ (0.50)$ 11.00$ 9,000,000$ -‐$ 5,000,000$ 10.50$ -‐$ 10.50$ 1.13$ (0.63)$ 11.00$ 10,000,000$ -‐$ 6,000,000$ 10.50$ -‐$ 10.50$ 1.25$ (0.75)$ 11.00$

Case 1

Case 3

Share Buyback

¨  Use FCF to buy back shares ¨  $6m investment needed to maintain FCF growth of 5%

¨  Raise $6m in common equity ¤  Assume buy back has no transac1on cost

m0$DIVm4$FCF

m10$NOPAT

=

=

=

00.11$50.0$50.10$ m8m4$0$0$50.10$

nsEC

nsDIV

nsNOA50.10$s

=+=

−−++=

Δ−+

Δ+=



Shareholders' Equity ∆PAR -‐$ ∆APC -‐$ ∆TS (4)$ ∆EC (4)$

∆RE 10$ ∆EB 6$

∆TA 6$ ∆LE 6$

Alterna1ve Views of Case 2

¨  Alterna1ve B: Shareholder creates her own dividend ¤  She has 1000 shares with total value of $11,000 ¤  Seeks a dividend yield of 4.545% = $0.50/$11.00 ¤  So she sells 45.45 shares worth $500 = $11,000·∙ 0.04545 ¤  So she has 954.5454 shares remaining ¤ With total value of $10,500 ¤  Addi1onal assump1ons in this alterna1ve case

n  No transac1on cost for shareholder n  Dividend and capital gain tax equivalence for shareholder n  Frac1onal share transac1on possible

Essen1al Points

¨  Proposi1on 3 ¤  The dividend policy is relevant to total shareholder value in the

case where n  The firm has a transac1on fee for buying back or selling equity n  The changing of dividend does signal a change in firm value n  Shareholder dividend and capital gain tax rates are different n  The shareholder has a transac1on fee for buying and selling equity n  Frac1onal shares can be bought and sold

Informa1on and Agency Issues

¨  Informa1on asymmetry ¤  Adverse selec1on ¤  Moral hazard

¨  Incomplete informa1on

¨  Principal Agent Problem ¤  Alignment of interests

¤  Agency Cost

Corp finance topics

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