Corporate Finance Notes 2
Corporate Finance Notes 2
Corporate Finance Notes 2
Corporate Finance
Chapter 29: Financial Planning
The amount of long-term financing raised, given the capital requirement, determines
whether the firm is a short-term borrower or lender:
➔ When long-term financing does not cover the cumulative capital requirement,
the firm must raise short-term capital to make up the difference
➔ When long-term financing more than covers the cumulative capital requirement,
the firm has surplus cash available.
What is the best level of long-term financing relative to the cumulative capital
requirement? There is no set answer, however these are given facts:
Current assets can be converted into cash more easily than long-term assets. So firms
with large holdings of current assets enjoy greater liquidity, although some of them are
more liquid than others. There are some advantages to holding a large reservoir of cash,
particularly for smaller firms that face relatively high costs to raising funds on short
notice. Some firms choose to hold more liquidity than others, because:
● Companies with rapidly growing profits may generate cash faster than they can
redeploy it in new positive-NPV investments. This produces a surplus of cash
that can be invested in short-term securities
● Financial managers of firms with a surplus of long-term financing and with cash
in the bank don’t have to worry about finding the money to pay next month’s bills.
The cash can help to protect the firm against a rainy day and give it the breathing
space to make changes to operations.
● However, there are also drawbacks to surplus cash. Holdings of marketable
securities are at best a zero-NPV investment for a taxpaying firm. Also, managers
of firms with large cash surpluses may be tempted to run a less tight ship and
may simply allow the cash to seep away in a succession of operating losses.
Cash Cycle
Notes to consider when calculating cash flows from operating activities: We start with
net income and then make 2 adjustments:
1. Since depreciation is not a cash outlay, we must add it back to net income.
2. We need to recognize the fact that the income statement shows sales and
expenditures when they are made, rather than when cash changes hands.
Net Working Capital → a useful summary measure of current assets and liabilities, since
it is unaffected by seasonal or other temporary movements between different current
assets or liabilities, although the assets may have different degrees of liquidity.
The cash cycle affects the amount of working capital that the firm needs.
𝐶𝑎𝑠ℎ 𝑐𝑦𝑐𝑙𝑒 = 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑑𝑎𝑦𝑠 𝑖𝑛 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 + 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑐𝑜𝑙𝑙𝑒𝑐𝑡𝑖𝑜𝑛 𝑝𝑒𝑟𝑖𝑜𝑑 + 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑝𝑎𝑦𝑚𝑒𝑛𝑡 𝑝𝑒𝑟𝑖𝑜𝑑
Cash Budgeting
Inflows:
● Sales become accounts receivable before they become cash. Cash flows comes
from collections on accounts receivable. This depends on the average number of
days those clients take to pay their purchase.
● Selling fixed assets
● Tax refund or insurance claim
Outflows:
● Accounts payable
● Increase in inventories
● Labor, administrative, and other expenses
● Capital expenditures
● Taxes, interest, and dividend payments
Short-Term Financing
Short-term financing plans are developed by trial and error. You lay out one plan, think
about it, and then try again with different assumptions on financing and investment
alternatives. You continue until you can think of no further improvements. There are
(optimization) models that make these assumptions.
Questions to ask:
Bank loan: The firm can borrow and repay whenever it wants to do so, as long as it does
not exceed its credit limit.
Long-Term Financing
Smart financial managers need to plan for the long term and to consider the financial
actions that will be needed to support the company’s long-term growth, which involves
capital budgeting on a large scale. Here is where finance and strategy come together.
𝐸𝑥𝑡𝑒𝑟𝑛𝑎𝑙 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑟𝑒𝑞𝑢𝑖𝑟𝑒𝑑 = 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑖𝑛 𝑁𝑊𝐶 + 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑓𝑖𝑥𝑒𝑑 𝑎𝑠𝑠𝑒𝑡𝑠 + 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 − 𝐶𝐹 𝑓𝑟𝑜𝑚 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑜𝑛𝑠
Steps to find out how much extra capital a company needs and the implications for its
debt ratio:
1. Project next year’s net income plus depreciation, assuming a planned increase in
revenues.
2. Project what additional investment in net working capital and fixed assets will be
needed to support this increased activity and how much of the net income will be
paid out as dividends. The sum of these expenditures gives you the total uses of
capital.
a. If the total uses of capital exceed the cash flow generated by operations,
the company will need to raise additional long-term capital.
3. Construct a forecast, or pro forma, balance sheet that incorporates the
additional assets and the new levels of debt and equity. There are many options:
– investigate whether the company could cut back on net working capital
Percentage of sales model: Almost all the forecasts for the company are proportional to
the forecasted level of sales. However, in reality many variables will not be proportional
to sales. For example, important components of working capital such as inventory and
cash balances will generally rise less rapidly than sales. In addition, fixed assets such as
plant and equipment are not usually added in small increments as sales increase.
There are general relationships between a firm’s growth objectives and its financing
needs.
Internal growth rate: maximum growth rate that a company can achieve without external
funds
If a company wishes to grow faster than this without raising equity capital, it would need
to:
Sustainable growth rate: highest growth rate the firm can maintain without increasing
its financial leverage (without any additional equity issues).
There are 3 levels of market efficiency depending on the degree of information reflected
in security prices:
1. Weak market efficiency: prices reflect the information contained in the record of
past prices and it is impossible to consistently make superior profits by studying
past returns because they follow a random walk.
2. Semi strong market efficiency: prices reflect not just past prices but all other
public information and prices will adjust immediately to it.
3. Strong market efficiency: prices reflect all the information that can be acquired
by painstaking analysis of the company and the economy, so there are no
superior investment managers who can consistently beat the market.
If all investors hold index funds then nobody will be collecting information and prices will
not respond to new information when it arrives. An efficient market needs some smart
investors who gather information and attempt to profit from it. To provide incentives to
gather costly information, prices cannot reflect all information. There must be some
profits available to allow the costs of information to be recouped. But if the costs are
small, relative to the total market value of traded securities, then the financial market
can still be close to perfectly efficient.
In an efficient market it is not possible to find expected returns greater (or less) than the
risk-adjusted opportunity cost of capital. This implies that every security trades at its
fundamental value, based on future cash flows (Ct) and the opportunity cost of capital
(r). If price differs from fundamental value, then investors can earn more than the cost of
capital, by selling if the price is too high and buying when it is too low.
∞
𝐶𝑡
𝑃= ∑ 𝑡
𝑡=1 (1+𝑟)
Small-firm effect
Why there are abnormally high returns on the stocks of small firms considering CAPM:
Returns appear to be higher in January than in other months, they seem to be lower on a
Monday than on other days of the week, and most of the daily return comes at the
beginning and end of the day.
Investors underreact to the earnings announcement and become aware of the full
significance only as further information arrives.
When firms issue stock to the public, investors typically rush to buy. On average those
lucky enough to receive stock receive an immediate capital gain. However, researchers
have found that these early gains often turn into losses.
Bubbles: speculative frenzy, and asset prices then reach levels that cannot easily be
justified by the outlook for profits and dividends. They can happen when prices rise
rapidly, and more and more investors join the game on the assumption that prices will
continue to rise. They can be self-sustaining for a while but will always end up bursting.
Corporations invest in long-term assets and in net working capital. Most of the cash to
pay for these investments is generated internally: it comes from cash flow allocated to
depreciation and from retained earnings. This investment into the firm is good since it
provides positive NPV, increasing shareholder value.
➔ Usually, internal funds (retained earnings plus depreciation) cover most of the
cash needed for investment. However, in case of deficit, companies must cut
back on dividends to increase retained earnings, or it must raise new debt or
equity capital from outside investors.
1. What fraction of profits should be put back into the business rather than paid out
to shareholders?
2. What fraction of the financial deficit should be met with debt rather than equity?
The amount of investments that are financed by internal funds rather than external
funds depend on the company and the behavior of its financial manager, having both
strategies and some pros and cons. This also happens when choosing the balance
between equity and debt ratio.
Common Stock
A corporation is owned by its common stockholders, which means that they are the ones
to make investment and operating decisions or have the right to vote in widely owned
corporations. Some of this common stock is held directly by individual investors, but the
● Majority voting: each director is voted upon separately and stockholders can cast
one vote for each share that they own.
● Cumulative voting: the directors are voted upon jointly and stockholders can, if
they wish, allot all their votes to just one candidate, giving more power to
minorities.
There might be two classes of common stocks that have the same cash-flow rights but
one of them has a higher control right with higher voting power. This may be used to
toss out bad management or to force management to adopt policies that enhance
shareholder value. The last ones also usually are sold at premium price since they may
come with extra benefits.
Common stocks are issued by corporations. But a few equity securities are issued not by
corporations but by partnerships or trusts.
The partnership units are just like the It is the possibility to be the passive
shares in an ordinary corporation, having owner of a single asset. They are not
dividends and contribution on losses. It taxed if they distribute at least 95% of
has the advantage that the profits avoid earnings to the REITs’ owners, who must
corporate income tax. However, it has a pay whatever taxes are due on the
limited life contrary to corporations that dividends.
can outlive their initial founders.
Preferred stock: it offers a series of fixed payments to the investor. The company can
choose not to pay a preferred dividend, but in that case, it may not pay a dividend to its
common stockholders. This means that the firm must pay all past preferred dividends
before common stockholders
Debt
When companies borrow money, they promise to make regular interest payments and to
repay the principal. However, this liability is limited. Stockholders have the right to
default on the debt if they are willing to hand over the corporation’s assets to the
lenders.
The company’s payments of interest are regarded as a cost and are deducted from
taxable income. Thus, interest is paid from before-tax income, whereas dividends on
common and preferred stock are paid from after-tax income. Therefore, the government
provides a tax subsidy for debt that it does not provide for equity.
There are many types of debts securities, and their mixture reflects the financial
manager’s response to several questions:
There are many promises that a company makes that look like debt but are presented in
other names. These include accounts payable, which are simply obligations to pay for
goods that have already been delivered and are therefore like short-term debt. Other
arrangements might be leasing equipment on a long-term basis instead of buying it: the
firm promises to make a series of lease payments to the owner of the equipment, which
is just like the obligation to make payments on an outstanding loan.
Given the enormous variety of corporate securities, it’s no surprise to find hybrids that
incorporate features of both debt and equity. The dividing line between debt and equity
is sometimes hard to locate, but these are some overall features of both:
● Equity is a residual claim that participates in the upsides and downsides of the
business after debt claims are satisfied. Equity has residual cash-flow rights and
residual control rights.
● Debt has first claim on cash flows, but its claim is limited. It does not participate
in the upsides of the business. Debt has no control rights unless the firm defaults
or violates debt covenants.
Sale of shares to raise new capital, which Sale of second-hand shares, transaction
are more infrequent. partial ownership of a firm from one
person to the other that has no influence
on the company’s assets
Individuals don’t sell their stocks on the secondary market alone, using the help of a
brokerage
Financial institutions act as financial intermediaries that gather the savings of many
individuals and reinvest them in loans or in the financial markets. These include banks,
savings and loan companies, insurance companies, mutual funds.
1. The financial intermediary may raise money in special ways, for example, by
taking deposits or by selling insurance policies.
2. The financial intermediary invests in financial assets, such as stocks, bonds, or
loans to businesses or individuals, while the manufacturing company’s main
investments are in real assets, such as plants and equipment.
● The payment mechanism: banks and others provide ways for individuals and
firms to send and receive payments quickly and safely over long distances via
checking accounts, credit cards, and electronic transfers.
● Borrowing and lending: Almost all financial institutions are involved in channeling
savings toward those who can best use them. It is cheaper and more convenient
to use a financial intermediary to link up the borrower and the lender.
● Pooling risk: Financial markets and institutions allow firms and individuals to
pool their risks, which means sharing the risk
Venture Capital
The success of a new business depends critically on the effort put in by the managers.
Therefore, venture capital firms try to structure a deal so that management has a strong
incentive to work hard. Venture capitalists rarely give a young company up front all the
money it will need. At each stage they give enough to reach the next major checkpoint.
When a new business raises venture capital, these cash-flow rights and control rights
are usually negotiated separately. The venture capital firm will want a say in how that
business is run and will demand representation on the board and a significant number of
votes. The venture capitalist may agree that it will relinquish some of these rights if the
business subsequently performs well. However, if performance turns out to be poor, the
venture capitalist may automatically get a greater say in how the business is run and
whether the existing management should be replaced.
Venture capital firms pool funds from a variety of investors, seek out fledgling
companies to invest in, and then work with these companies as they try to grow, called
private equity investing. Most venture capital funds are organized as limited private
partnerships with a fixed life of about 10 years. Pension funds and other investors are
the limited partners. The management company, which is the general partner, is
responsible for making and overseeing the investments, and in return receives a fixed
fee and a share of the profits, called the carried interest.
Venture capital investors tend to specialize in young high-tech firms that are difficult to
evaluate and they monitor these firms closely. They also provide ongoing advice to the
firms that they invest in and often play a major role in recruiting the senior management
team. Their judgment and contacts can be valuable to a business in its early years and
can help the firm to bring its products more quickly to market.
For every 10 first-stage venture capital investments, only two or three may survive as
successful, self-sufficient businesses. From these statistics come two rules for success
in venture capital investment:
1. Don’t shy away from uncertainty: accept a low probability of success, but don’t
buy into a business unless you can see the chance of a big, public company in a
profitable market.
2. Cut your losses: identify losers early, and if you can’t fix the problem throw no
good money after bad.
An initial public offering is usually made to raise new capital or to enable shareholders to
cash out. There are also other benefits to going public, including a readily available
yardstick of performance by the company’s stock prices; possibility to reward the
management team with stock options; the company can diversify its sources of finance
and reduce its borrowing cost since information about the company becomes more
widely available.
➔ Primary: new shares are sold to raise additional cash for the company.
➔ Secondary: the existing shareholders decide to cash in by selling part of their
holdings.
A new issue is costly since there are substantial administrative costs. Preparation of the
registration statement and prospectus involved management, legal counsel, and
accountants, as well as the underwriters and their advisers. In addition, the firm had to
pay fees for registering the new securities, printing and mailing costs, and so on.
Under-pricing: when the offering price is less than the true value of the issued
securities, investors who buy it get a bargain at the expense of the firm’s original
shareholders. Whenever a company goes public, it is very difficult to judge how much
investors will be prepared to pay for the stock and sometimes the underwriters misjudge
dramatically. For IPOs, under-pricing usually exceeds all other issue costs.
● a low offering price on an IPO raises the price when it is subsequently traded in
the market and enhances the firm’s ability to raise further capital.
● Buyers won’t feel like they overpaid (winner’s curse)
The degree of under-pricing fluctuates sharply from year to year. Hot new-issue periods
arise because investors are prone to periods of excessive optimism and would-be
issuers time their IPOs to coincide with these periods.
1. They can pay a dividend: it is set by the board of directors. Its announcement
states that the payment will be made to all stockholders and, around a week later,
dividend checks are mailed. They can also be issued in the form of stock
dividends instead of cash. In some countries there is a minimum proportion of
earnings that must be distributed as dividends, and other restrictions may be
imposed by lenders. Companies usually pay a regular cash dividend each quarter,
but occasionally this is supplemented by a one-off extra or special dividend.
2. Or they can buy back some of the outstanding shares: the reacquired shares are
kept in the company’s treasury and may be resold if the company needs money.
This can be done in 4 main ways:
- The company announces that it plans to buy its stock in the open
market, just like any other investor
- The company makes tender offer where they offer to buy back a
stated number of shares at a fixed price, which is typically set at
about 20% above the current market level. The stakeholder can
then accept or deny this offer
- Employ a dutch auction: the firm states a series of prices at which
it is prepared to repurchase stock. Shareholders submit offers
declaring how many shares they wish to sell at each price and the
company calculates the lowest price at which it can buy the
desired number of shares.
- repurchase sometimes takes place by direct negotiation with a
major shareholder.