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FINANCE 351: ADVANCED FINANCIAL MANAGEMENT

TOPIC 1: FINANCIAL MANAGERS & EFFICIENT MARKETS


Readings: Ch 1, 13 Berk & DeMarzo
Corporate Finance: coherent finance decisions, interacting w/investment
decisions
-

marketing (estimate additional revenue from launching new product)


strategy (predicting competitor response to price cut: price war or
differentiation)
operations (forecasting cost-saving after acquisition or merger)

Valuation & Capital Budgeting


Traditional valuation methods:
-

DCF & comparable company multiples


discount rates

Cross-border valuation
-

exchange rates & basic parity relations

Valuation using real options


Financing Decisions
-

capital structure policy


payout policy
raising equity capital
mergers & acquisitions

COMPANIES
3 basic legal forms of Business Organisation
1. sole proprietorship (sole trader):
easy setup (no legal paperwork)
profits taxed at personal marginal rate (single IRD number)
disadvantage: owner unlimited liability for debt & obligations (personal
assets risked)
2. partnership: 2+ owners
3. corporation (company):
shareholders limited liability
easy raise capital
Easy ownership transfer
US: disadvantage: double taxation (classical tax system)
profits before taxes
corporation tax 35%

100
(35)

net profits (100% paid as dividends)


income tax paid by investor 15%

65
(9.75)

first tax paid by


corporation
second tax paid by
investor

available to shareholder
$55.25
a) company profits taxed twice; at corporation level then investor level
b) loss of company cannot be used to offset individual tax liabilities

NZ: simple & tax-efficient


- imputation tax system only taxes dividend at SHolder level (example 3.2)
- companies <5 shareholders can gain additional tax benefits by electing
to be a lookthrough company (tax credit from company loss can be used to offset
ind. tax liab.)
- registration fast & easy: $160.22 to register online
Dividend Imputation
Australia, NZ, Norway offer complete relief from double taxation dividend income
-

as if company has paid tax on SHolders behalf


SHolders NOT taxed twice

Dividend imputation: corporate tax system, where some/all tax paid by company
may be attributed (imputed) to SHolders by tax credit, to reduce income tax
payable on distribution.
Other things equal, Sholders with LOWER marginal tax rates benefit more from
dividend imputation (as corporate tax rate is higher)
Public Companies
Separation of Ownership & Control
-

if many SHolders, not feasible for owners to have direct control of firm
Board of Directors: appoint CEO (Chief Executive), set important policies
(the stick) & remuneration (carrot) for executives
SHolders elect directors; directors represent & accountable to SHolders
- theoretically, SH can pressure board to change poor-performing CEO
- realistically, vote with feet, ie. sell shares
CEO: runs company

Agency Problem between Shareholders & Managers


SHolders (principal) hire managers (agent) to run company. Goals not always
same.
-

owners: maximise wealth (share value)


managers: theoretically, maximise companys equity value. Realistically,
when conflict of interest, managers may put self-interest first (agency
problem)

no agency problem if sole owner & manager/employee of company

Agency problems mitigated at cost through:


-

hiring auditor & forming various board committees to monitor CEO (not
effective; Enron, companies w/entrenched CEOsgain so much power that
CEO able to use firm to further own interests than SHs; make managerspecific valuable investments to reduce probability of replacement)
provide incentive packages tied to performance (but potentially excessive
risk-taking)

FINANCIAL MANAGERS
Specialised financial managers = CFO, Treasurer, Controller
-

other chief executives, engineers & marketing managers all involved


investment decisions

Considers:
i)
ii)

what assets to invest in (capital budgeting decisions)


how cash for investment raised (financing)

Fundamental objective: maximise SH (equity) value


-

value = market value, not accounting value


ideally managers focus long-term value instead of myopically on SPrices
(evidence show CEOs manipulate earnings to influence SPrice):
i) inflate earnings to beat analyst forecasts
ii) give earnings bath before options granted, or after new CEOs just take
over
(manipulating SOCI to make poor results appear even worse, to
enhance next years
earnings for bigger bonuses)
market value incorporates all future cash flows, adjusted for timing & risk
financial managers create value primarily by choosing NPV-positive
investment projects. Sources of (+)NPV = things firm can do better than
others:
i) economies of scale/scope in production, marketing (Amazon)
ii) unique products (Apple)
iii) absolute cost advantages (attractive mining project)
iv) Govt policy/regulatory protection (China automotive manufacturers)

EFFICIENT MARKETS
-

all securities fairly priced, no (+)NPV trading opportunity


implies securities w/equivalent risk = identical expected return

Financial managers care about market efficiency:


-

opportunities (+)NPV investment projects come by often


opportunities (+)NPV financing decisions rare:
i) NPV borrowing = net amount borrowed PV (future interest payments)
PV (future loan
repayment)
ii) NPV issuing shares = net proceeds (amount raise net fees) PV (future
dividends)
IF capital markets fully efficient, financial managers cannot create value
by financing decisions

Competition makes capital market more efficient:


If market efficient, impossible consistently make positive abnormal returns
(above reward for bearing risk)
i)
ii)
iii)

abnormal return = actual normal return


normal return = reward for bearing risk
CAPM = capital asset pricing model, defining what normal return
should be
rs = rf + s * (E[RMkt] rf)

Competition to beat market eliminates (+)NPV trading opportunities & makes


market efficient
i)
ii)
iii)

investors try earning (+) alphas, beat market, identify (+) NPV trading
opp.
(+) alpha investment opp. expected to generate return above normal
s = E(Rs) - rs
profiting from non-zero alpha stocks makes market more efficient
- long stocks to profit from (+) alpha trading opp.
- short stocks to profit from (-) alpha, in anticipation future SPrice
decrease

eg 1. Profit from non-zero alpha trading opp.


Assume CAPM is correct asset-pricing model. Market expected return 7% with
10% volatility & risk-free rate 3%. News arrives, changes only expected return of
following stocks:

Green leaf
Nat Sam

E(R)

Volatility

12%
10%

20%
40%

Beta (in relation to market


return)
1.5
1.8

Consider:
a) at current market prices, which stock represents buying opp.?
b) on which stock should you put sell order?
c) how will transactions affect price, expected return & alpha of stocks?
Green leaf: CAPM normal return = 3 + 1.5 (7 3) = 9%; 12 9 = = 3%. Buy.
Price would increase, E(R) decreases, decreases to zero.
Nat Sam: CAPM normal return = 3 + 1.8 (7 3) = 10.2%; 10 10.2 = = -0.2%.
Sell. P drops, E(R) increases, increases to zero.
Factors making market Less efficient
1. limits to arbitrage: constraints increasing cost for investors to profit from
non-zero investment opp.
i) transaction costs
ii) short-sale constraints
iii) P can deviate from fundamental value for prolonged period of time
2. informed investors profit from uninformed (but uninformed could simply
hold market portfolio)
3. sufficiently large group of investors to hold portfolios w/negative so
some investors can earn (+)
-

overconfidence & excessive trading of ind. investors (Barber & Odean)


buy stocks that neighbours bought (under-diversification & herding)
care more about extreme outcomes; prospect utility, behavioural
economic theory where value function steeper for losses than gains
(Tversky & Kahneman)
bounded rationality; rational decision-making limited by (time for) info
processing, affects all investors equally (Sims)
mood (Winter blues, sunny vs. cloudy days)

Capital Market Efficiency


Trading on takeover (merger) news & beat market:
-

If know info from work, buy stock of target company before news
announced to public. Trade profitable, but illegal
If buy stock of target after news announced, legal but not as profitable

Cannot really trade on stock recommendation and beat market


Fund managers generally cannot consistently beat market.
Event studies used to examine CARs around important news release:
-

Cumulative abnormal returns = abnormal returns cumulated over period


of time
using 3-day CAR = CAR (-1, 1)
CARi (t-1, t+1) = ARit-1 + ARit + ARit+1
ARit = abnormal return = alpha = actual normal
event day 0 = news release day
upward-trending CAR suggest investment opp. from buying
down-ward trending CAR, shorting

After paying fund manager salaries, bonus, expenses to buy computers & data,
average alpha = negative across all investment styles; more luck than skills.
Style-based Investing & Market Efficiency
Assume CAPM correct model to measure risk. If can use past returns to construct
trading strategy making money consistently (positive alpha), is it evidence
market not efficient?
Various (+) alpha trading strategies identified have persisted:
-

on average, small companies earned abnormal monthly return >1%


value companies (high book-to-market ratios) earned AMR >1%
if these abnormal profits risk-free, mkt competition has not driven P back
to normal; perhaps strategies entail systematic risks not identified by
CAPM (eg. HML factor in Fama & French); assuming CAPM is correct model
to measure risk may be incorrect

Implications of Market Efficiency for Financial Managers


Trust market prices & be aware of info contained in MP
-

recall investors tend to vote w/feet: under-performance of stock against


industry peers can signal CEO doing poorly
drastic P drops at announcement future acquisition can signal deal is
value destroying
should only make acquisitions if can add value (through synergies)

Treat MP as values, unless have info not reflected in price


-

debt: can you predict interest rate movements?


foreign debt: predicting exchange rates?
equity (of firm): managers tend to know info market does not (long-term
under-performance of IPOs & SEOs)

Not easy to trick market by manipulating acctg numbers which do not affect
future cash flows
SUMMARY
-

solving practical corporate finance problems req. business common sense,


in addition to basic finance theory
double taxation on dividends = main disadvantage of corporation in US
(absent in NZ)
in practice, CEOs do not always act in best interest of SH; bad CEOs stay
longer than desired by SH
fundamental job of financial manager = create value for SH. Primarily
achieved through choosing (+) NPV investment projects. (+) NPV financing
opp. rare.

TOPIC 2: VALUATION FOUNDATION


Readings: Ch 2 (Intro to F/S analysis)
Valuation using historical acctg info & assumptions
Finance & Accounting
Cash flow cycle of business
-

invest money to buy assets


assets bring profits
profits into cash again
cash given back to investors (dividend distribution) or re-invested

Acctg measures how many assets, amount profit generated, when cash coming
in & how used
PURCHASING & USING FIXED-ASSETS

Long term assets:


-

fixed assets (PPE) = depreciated


intangible: software amortised, goodwill impaired
D & A (depreciation & amortisation)
book value of asset = purchase price accumulated
depreciation/amortisation
investments in fixed assets need to be sufficient to support revenue
use revenue forecast to drive CAPEX forecast
forecasting revenue: sanity check, top-down & bottom-up
Top-down: consider overall market & use info to identify company
demographics (assumes that given existing market & potential market
growth, company can expect to capture a certain % share of market &
greater % in later years)
Bottom-up: detailed budget w/spending plans by department, projections
based on sales forecast; operating expense depreciation + capex.

eg. forecasting revenue, CAPEX, D&A & fixed assets using BASE method
000s

2012

2013

2014F

Revenue

17321
68

2239532

2239532 * 1.15
= 2575462

Revenue
growth

(22395321732168)/17321

steps &
assumptions
assume growth
rate 15%

68 = 29.3%
PPE
Beginning

356676

Addition

2239532*0.03 =
67186

Subtraction
(D&A)
Ending

capex =
2575462*0.03 =
77264
31391

310803

beginning = last
periods ending
assume CAPEX
3% of revenue
depreciation =
10.1% of
beginning PPE
E = B+A-S

INVESTING IN WORKING CAPITAL


Operating working capital (OWC) = amount capital required to run day-to-day
operations
-

OWC = OCA OCL


= operating current assets operating current liabilities
driven by operational decisions
OCA = CA cash & cash equivalents
OCA includes AReceivables & inventories
OCL = CL short-term borrowing
OCL includes APayables & accurals
OWC NOT balance OWC is a CASH FLOW
increase OWC = cash investment in business
decrease OWC = business requires less cash to run

Should we have highest OCL or smallest OCA (for a decreased OWC)?


-

too little inventory = lose customers


too little receivables = lose clients (credit sales)
too much payables = supplier may stop supplying
working capital management = working capital tightrope

eg. projecting OWC: forecasting revenue, OWC & increase in OWC


000s

2012

2013

2014F

Revenue
Revenue
growth

1732168

2239532
29.3%

2575462

OCA
OCL
OWC
OWC as %
Revenue

336988
170765
166223
166223/1732
168
= 9.6%

increase in
OWC

527109
308398
218711
9.77%

218711166223 =
52488

steps &
assumptions
assume 15%
revenue
growth in
2014

251623

32912

assum OWC
as % revenue
in 2014 =
2013
this year
last

Obtain OCA & OCL from Fig. 1 & 2


Increase in OWC = cash outflow (for investment)
GENERATING CASH PROFITS

CFO (cash flow from operations) measures amount cash profit operations
generate
1. project revenue
2. project EBITDA (earnings before interest, tax, depreciation, amortisation)
EBITDA = revenue * EBITDA%
EBITDA% = EBITDA margin assumption
EBITDA% = EBITDA/revenue
3. project EBIT
EBIT = EBITDA D&A
D&A from BASE method
4. directly tax EBIT = unlevered net income = EBIT * (1-t) = (revenue
costs D&A) * (1-t)
Unlevered: as if company 100% equity-financed & ignore financing effect
when projecting free cash flows
5. add back D&A = CFO
CFO = unlevered net income + D&A
eg. Forecasting EBIT, unlevered net income & CFO

000s
Revenue

2012
1732168

2013
2239532

2014F
2575462

Assumptions
assume 2014
revenue
growth 15%

EBITDA

138092

155255

178480

Assume 2014
EBITDA% =
2013

EBITDA%

7.97%

6.93%

D&A

41630

44017

31391

S in BASE
(assume
amort. = 0)

EBIT

96462

111238

147089

Unlevered net
income
CFO

105904

assume tax
rate 28%

137295

Free cash flow = CFO CAPEX OWC


2014 = 137295 77264 32912 = $27110
VALUATION BALANCE SHEET
Acctg balance sheet:
-

A = L + shareholder E
uses of funds = sources of funds

Valuation balance sheet:


-

enterprise value (EV) = market value equity + net debt


EV estimated as present value all future free cash flows (2.1)
EV = market value business assets (belongs to both debt holders &
shareholders)
net debt = debt cash

EV used to:
-

value project
value business (amount to pay to purch. all shares & retire all debts)

Why use Net Debt


Cash
PV of free cash flows
(EV)

Debt
market value of equity
(tends to be higher than
book value)

Referring to Fig. 1 & 2, net debt at 28th July, 2013 for Warehouse = $217mil
Enterprise Value
EV

net debt
equity
DCF (discounted CF) of all future cash flows renders EV

market capitalisation (market value of equity) = share price * # shares


outstanding
from EV to per share value to find intrinsic value of share (Assign. 1,
corporate finance analysts, research analysts, fund managers)
from share price to EV to compute valuation multiples (test, corporate
finance analysts, research analysts, fund managers)

Enterprise Value (if firm has investment in associates & minority interests)
INVESTMENT IN
ASSOCIATES
EV

Net debt
equity
MINORITY INTEREST

eg. From EV to per share value (w/investment in associates & MInterest)


If your DCFlow analysis suggests EV of Warehouse = $1bil, what is value per
share?
-

shares outstanding: 309.32mil


net debt: 217miln
value of investment in associate: 50mil
value of MInterests: 10mil

a) market cap. = 823k


b) per share value = $2.66
eg. From equity value to EV
Need EV to calculate valuation multiples; EV of Warehouse on 24 Feb 2014 given:
-

closing price on 24 Feb 2014: $3.39


shares outstanding: 309.32mil
net debt: $217mil
value of investment in assoc.: $50mil
value of MInterests: $10mil

EV = $1226mil
CORRECT & INCORRECT VALUATION MULTIPLES
EV must be divided by items ABOVE the interest lines
-

some EV multiples: EV/revenue, /EBITDA, /EBIT, /Subscriber, /User


EV/EBIT & EV/EBITDA multiple commonly used valuation multiples
EV multiples less affected by financing effects
removes differences (between companies) relating to D & A

Equity value (or share price) must be divided by items BELOW interest lines
-

equity multiples: P/E (Price/EPS, or market cap/net income); P/B (/book


value per share, or market cap/book value of equity)

WRONG MULTIPLES: EV/net income, market cap/User (unless net debt = 0, thus
EV = market capitalisation)
SUMMARY
-

corporate finance: pull out relevant info from F/S accurately

acctg ratios used to make CF projections

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