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OU BB831 - Corporate Finance (Return on Investment (Market & Investor…
OU BB831 - Corporate Finance
Return on Investment
Time preference rate
Opportunity cost:
The inducement required to persuade investors to give up being able to spend money during the investment period
UK Treasury (1981) = 3.5%
Risk premium
Factors
Maturity
Date Investor is entitled to demand payment
Variability of
income
Return is defined in generic terms but actual amount may fluctuate
Liquidity
Measure of ease of investment redemption
Event risk
Radical change to the company nature or capital structure
Credit Risk
Risk returns will not be paid out due to borrowers financial deterioration
Interest
rate risk
Price which investment can be sold will depend on market conditions at the time of sale
Real Rate
Accounts for inflation
Nominal rate
Does not take into account inflation. Headline rate on mortgage and binds
Quantify
Expected Return = Weighted Average
Standard Deviation
Process:
Return | Dispersion from Weighted Average | Square of Dispersion | Probability | Variance (Probability x Dispersion2)
Normal Distribution
1 SD from mean = 68.3%
2 SD from mean = 95.4%
3 SD from mean = 99.9%
Correlation Coefficient
Infaltion
Fischer equation
1 + Nominal Interest rate = (1 + Real Interest rate) x
(1 + Expected Inflation)
The Nominal rate is the Real rate + the inflation added back in.
Example: If £100k investment for 1 year. Nominal rate = 10.24% and inflation = 4%
(1.1/1.04)-1 = 6%
Future value of investment = £110,240
But purchasing power of interest at year end = 6k
Nominal rate can be used in the gordon's growth model.
Problems =
uses expected inflation
Inflation rate embedded in the equation may not be appropriate for the investor
Consumer Prices Index (CPI) < Retail Prices Index (RPI)
Brazil example (2014)
Monetary policy
Although the influence of government over monetary policy increased somewhat in the past years. The central bank in
practice no longer aims for 4.5% inflation, but instead wants inflation to be between 4.5% and 6.5%
Exchange rate policy
Fiscal policy
Market &
Investor context
Perfect Markets
Require
No one participant can manipulate market price
Perfect Information
No barriers to entry
No transaction costs
Efficient Market Hypothesis
Major stock markets are not perfect but are efficient according to studies
At any point in time, actual price of individual securities reflect the effects of information ased on event sthat have occurred on that the market expect
Insider trading regulation
Important in protecting the efficency of market
Fama (1965)
Strong form EMH
All information relevant to the value of a share whether public or privately known is quickly reflecting the market price
2008 Financial crisis
Belief - No need to verify prices of securities as reflects all infomation.
Ball (2009) If markets are competitve, high returns must be a result of high risk, high leverage, inside info or dishonest accounting
Semi-Strong
form EMH
Market is efficient if all relevant publicly available information is quickly reflected in the market price
Mrs O. effect
Weak EMH
Future price can not be predicted from historic prices
but weak-form limits investor knowledge to this only
#
Investors logically want more return for more risk, Most people will want to understand the risk. As new information enters the market they should be assessing that information to see if they are still getting a fair return.
Assumption that all investors are rational
#
all available information about a company’s prospects is reflected in its current share price
imply that current prices are the best forecast of discounted future cash flows (i.e. net present value)
imply that past prices do not contain information about future price changes
Random walk share prices
price series where all subsequent prices are not related to previous prices in any specific pattern
Test for using:
‘serial correlations between successive stock price changes’.
correlation of stock price with itself - past predicting future.
L & MacKinlay (1999) - short run correlations showresults above 0 due to 'too many moves in teh same direction.
Behavioural
Finance
Arbitrage:
risk free way of making money out of mis-priced securities, for examplebeing able to buy a share cheaply in out market and sell for a higher price in another
People don't always make logical decisions
Types of irrational behaviour
Overconfidence
Optimism
Representiveness
Same confidence in small samples as large samples
Conservatism
sticking close to the 'base case'
Belief perserverance
Arbitary starting point
Anchoring
Sticking to beliefs
Availability biases
Past experience
Prospect Theory
Investors do not behave as their wealth utility would suggest
Kahneman & Tversky (1979)
Loss Aversion:
Investors seem to be risk averse to gains and risk seeking to losses
Agency Theory
Shareholders = owners or 'Principle'
Directors = Agents
Should be aiming to manage shareholder wealth
Are they operating in share holder or self interests?
Corporate Governance
Corporate Responsibility
Managing a business to meet broader objectives such as human rights and environmental obligations.
Assumes that both the principle and agent are rational seeking to maximise their own percieved self-interest
However...
Information asymmetry
Problems
Adverse selction
Moral hazard
Addressed by
Asymmetry addressed by imposing disclosure requirements
Conflicts f interest addressed by attemnpts at linking director renumeration and performance
Corproate Governance
Uncertainty
Bubbles
Belief bubble (fad)
Bandwagon - people buy as they believe others will continue to = over valuation above the true price
Intrinsic bubble
Information bubble
Rational bubble
Time value of money
Multiple
Cashflows
Irregular cashflows
Calculate Sum:
PV of Yr1 cash flow = X1 / (1+IR)^1
PV of Yr2 cash flow = X2 / (1+IR)^2
PV of Yr3 cash flow = X3 / (1+IR)^3
...
Annuities
(regular payments)
#
Perpetuities PV = C/R
Annual effective rate = (1+R/N)n-1
Allows for comparison of products that pay multiple returns through the year. e.g. 10.1% semi annually vs 10% 12 times a year
Net Present Value
Future Value
Compounding
Interest
What will my investment be worth in n years
FV = PV x (1+R)^n
Geometric compounding
When being paid semi annually - take the route of (1+R)
When being paid quarterly - take the fourth route of (1+R)
Arithmetic compounding
TECHNICALLY INCORRECT
When being paid semi annually divide (1+R) by 2
Present Value
Discounting effect
PV = FV / (1+R)^n
What will I need to invest now to have an amount in n years
What is a FAIR return for the risk we are taking?
Investment Appraisal
Techniques
Capital budgeting
Questions:
Will aparticular investment meet the requirements of investors
Will the effect of an investment be an increase share price
Hurdle Rate
Discount rate (e.g. WACC) used in a project evaluation to reflect how much it will cost to fund the project based on a specific risk profile
Net Present Value (NPV)
PV of cashflows - PV of Costs
Either set out as table or use annuity calculation for continuous costs or savings
Can use discount factor tables
Invest relationship with Discount rate
+ve NPV = growth of company
-ve = destruction of company
value
Options to get round -ve NPV:
Generate income over longer period
Generate funds more cheapily - so lower discount rate
Conspiracy of optimisum!!
Internal Rate of Return (IRR)
The discount rate that gives an NPV of Zero
Use linear interpolation
Finad a +ve and -ve NPV for different discount rates
+ve Discount rate + ( ( +ve NPV / +ve NPV - -ve NPV ) x ( -Discount Rate - +ve Discount Rate ) )
Also use IRR function or goal seek in Excel
If IRR > hurdle rate then project = good
Disadvantages:
The scale of the project not considered
Competing projects - The slope of the NPV curve yields different NPVs @ different discount rates
Varying cashflows = double dip curve
assumes all money generated will be reinvested at same IRR
Accounting Rate of Return (ARR) (or ROCE)
Profit from project compared to sums invested in project
Earnings before interest & tax (EBIT) / average capital employed over year
harder:
Payback Period
Period before the net cashflow results inthe entire project outlay to be repaid
Payback Year + (-ve outstanding at beginning of year / cashflow in payback year ) x12
Addressing issues
Cashflows
Cash flow time periods - restrict to 5 - 10 years, Roll back any cashflows rolling over
Relevant Cashflows - should not be depreciation, in the future & must affect decision to go ahead.
Use Cash flows, not Accounting flows (e.g. profit)
Consider reversing depreciation, good weill write downs, amoritisation & employee pension adjustments
Consider adjustments sign
Relevant costs
Variable costs as result of making a unit
Finance and Management costs are not variable
Contribution = Sales - Variable (relevant) costs
Opertunity costs should be added into releavnt costs
Capital allowances
Tax liability reduced - consider depreciation method.
International projects
Inflation
Fischer equation - For working out discount rate
Look closer at these examples:
https://learn2.open.ac.uk/mod/oucontent/view.php?id=1244009§ion=4.2
https://learn2.open.ac.uk/mod/oucontent/view.php?id=1244009§ion=4.3
Exchange Rates
Purchasing Power Parity
Inflation
#
Adjust both costs and sales
Issues with real over nominal
Cashflows will inflate at different rate
Some cash flows are lagged
Tax is paid in nominal terms
Taxation
Resulting from profit
Resulting from Capital Allowances
International factors
Local vs domicile currency
Purchasing Power Parity theory
arbitrage ensures that commodity prices are the same everywhere
Project options
Th NPV of expected cashflows must exceed the cost of the project by an amount equal to the value of keeping the investment option alive
Investment Process
Project discount rate
Hurdle rate vs WACC
WACC is good as long as projects have similar non-diversfiable risks.
Common practise to adjust the hurdle rate upwards before using as hurdle rate.
Counters over-optimism of manager
Some projects such as health and safety have -ve NPV so other projetcs are charged for the loss
DCF fails to take into account options - e.g. delaying
Cost of debt/equity will change overtime :
Allows for adjustment for relative project risk
Adjusting for risk
Operating risk
Betas for each operating activity. Find by:
Review sector in th which the project is to be implemented
e.g. Various company Betas averaged by market capitalisation
Spread comparison more widely/globally
Harder for emerging markets
Asset Beta =
( E / D+E ) * EBeta
For specific questions. When the gearing is changed for a company the Asset beta does. Meaning you can calc the change in Equity beta as gearing changes.
Financial risk
Equity beta will change with debt ratio. Higher debt = higher equity beta (assuming equal operating risk for two companies)
Methods
Sensitivity analysis
- e.g. Inputs adjusted one at a time by 1% to see impact on NPV
Scenario analysis
- Consider different economic scenarios (change multiple inputs) and and see effect on NPV
Expected NPV
- estimated NPV for different scenarios and average based on liklihood.
Can use probability of different cashflow options and combine NPV's to get the ENPV.
Monte Carlo
- Alternative outcomes estimated for inputs and simulations run. Provides a distribution of possible results that gives a mean NPV + Spread of outcomes
Project Financing - Issues
Competing projects - with different fife spans
Equivalent cost
Use Annuity calculation to spread NPV over project duration.
*Find C
Funding linked to specific project
Project Finance - Large stand alone projects
Non-Recourse Financing = Sponsors can walk away from project without liability
Limited Recourse Financing = sponsors have some liability to repay debt
Public projects
Constructed on a 'Design, Build, Finance Operate' (DBFO agreement
Leasing (Secured borrowing)
Finance leases
Same as borrowing funds
Operating leases
Period = less than economic life of asset
Lessor retains risk and reward of ownership
Reasons to lease
Funds not available to purchase
-Tax advantages - lessor can make better use of capital tax allowances
Charities - less access to debt finance and no option for equity finance
May not wish to own asset - e.g. IT
Traditionally off-balace sheet financing
Higher ROCE and Asset Utilisation Ratio (AUR) (Revenue / Capital Employed)
Capital rationing
- Insufficient funds for all beneficial projects
Profitability (Cost-benefit) Index
NPV / Initial investment
For public sector, consider measures other than economic. e.g. ability to educate or keep people/products on move
subjective - agree via political/competitve means
Financing the Organisation
Estimating Risk and Return of an individual share
Total required premium
Risk-free rate
Includes:Time preference rate
#
Includes: Expected inflation
#
Consider the location of the risk to obtain inflation expectations
Closest to risk free = Treastur Bills & Long term bonds
Yield curves
Expectation hypothesis
Yield curve will follow the market expectation of interest rates
Can use Gilt market to provide a risk free rate and discount rate
Risk Premium
Equity risk
Estimating
Historical Data
Calculated as:
Difference between Total required Premium - Risk free rate implied by historical data (using Bonds or Treastury Bills as a bsis - e.g. 6.1 or 5.1% respectvely in the UK)
Assumes Past = Future
Need to consider high volume data samples
Advantage: Both Bond yields and Equity returns account for inflation, so in the Risk Premium difference inflation is neutralised.
Expert Opinion
Dividend Valuation Model (DVM)
Use the implied equity rate of return embedded in the current market price given dividend forecasts
Gordon Growth Model
(simplified version)
Assumes (unrealistically) dividends will grow at constant rate.
g
can be average historical growth rate of company share
or
Nominal growth rate (Fischer equation)
1 more item...
Example
Can be applied to market as whole
Dividend yield
= D1/Pi
1 more item...
Example
1 more item...
The excess return that investing in the stock market provides over a risk-free rate. This excess return compensates investors for taking on the relatively higher risk of equity investing.
CAPM
Relative valuation compared to market
Beta = volatility
Volatility reward relative to market
(A shares Beta)
Equity Beta
how an individualsharemoves relativetothe stock market as awhole
The risk of a portfolio is lower as more diverse shares are included in the portfolio. declining towards a core market risk level
Asset Beta
Compare to industry (then adjust for financial risk of company)
WACC
Cost of debt capital
Risk free rate + Credit Risk Premium
Credit rating = Credit worthiness - denotes the cost of debt. e.g. AA
Use government bonds of same maturity
Annual Interest / Annual average debt
Interest taken from balance sheet
debt = short + long term
Debt capital Ratio (Also known as Gearing)
How much debt is used to finance the org?
short + long term debt / Short + long term debt + Shareholder equity
Why important?
Need to make a return for investors!!??
Taxation
Value of company not impacted by the Cap structure whentax ignored
Debt interest = Tax deductible so increase amount for shareholdrers (Tax shield)
Higher gearing off set tax genefit by higher interest rates as worse risk
Rd = Cost of debt
Re = Cost of equity
Process
Re = using CAPM and DVM
Rd = using Credit Risk Premium and Actual Cost of borrowing
Calc Market Gearing
This is a nominal not real rate caolcualtion
overall required return on a company - compare to economic feasibility of expansionary oppertunities and mergers
Dividend Policy
Bird in the hand
Assumptions
Dividend policy has no effect on project choice - Not plausable
Perfect markets exist
High dividends sought by shareholders so command a higher price
Shares = PV of future dividend stream
Paying dividends reduces price
Does not create value - only NPV projects grow business
Taxation
UK dividend histiory
Early 1900: Dividends used as income
1920's: Roaring - Expected to remain stable
1929: Black Thursday
1930's: Shareholders unwelcome to dividend cuts
1945 - 73: UK government tries to control dividends to encourage re-investment
1950: Dividends are politically unacceptable - alligned with governement view of imposed wage freezes
1960: Reduction in private investors
1970: Tax relief on dividends --> ends 1997
Latter 20th century - No dividend = acceptable as signals more re-investment oppertunity
Signalling Theory
Paying dividens can be...
+ve signal = confidence in future performance
-ve signal = few investment opertunities
Dividends = management forecast of future earnins substaiated by cash
If managers aim for stability then changes are indicator of company health
Game Theory
Management take into account the existance of signalling causing self fullfilling effect
Agency
theory
Life cycle theory
Early years = more investment so less cash for dividencds
Later years - more cash
Managers dont always act in shareholders intesrests
Managers might pay dividends to show working in sharehodlers best interests. Instead of spending free cash
Market mechanisms to counter
Voted out by shareholders
Competitive markets for managers
Catering Theory
Clienteles with differing motives
eg. tax motives
Differing views on Capital gains and dividend results in management catering for these needs
Company Valuation
Book Value
A Comapnay is worth to its ordinary shareholders the value of its assets less the value of any liabilities to third parties.
Includes:
Some Assets at historic costs
Some assets written down to liquidation value
Some based on forecasted cashflows
Some written down over estimated useful lives
Will be somewhere between historic cost and current market value
Won't be economic value as not all assets are valued using PV of future cash flows
Adjusting book value
Tagible assets
IFRS - value at either historic or fair value (large company preference)
Fair value = value of asset or liability in an "arms-length transaction between unrelated willing and knowledgable parties.
Where properties are valued by surveyorsusing rental estimates the are considered to be at econmoic value.
If market value or reasonable asset value < depreciated book value, tangible assets are typically included in the balance sheet at lower market value.
Intangible assets
IFRS
Development
activities can be capitalised if future economic benefits can be linked to them,
Brands
can be capitalised if they have been acquired through the purchase of a company but not if built from scratch
Goodwill is capitalised
Substantial acquisition = will acquire goodwill which if capitalised will increase book value considerabley.
Other = R&D & IP
Off-balance sheet items
Finance realted (e.g. leases)
IFRS requires leases on the balance sheet.
Off-balance sheet financing (e.g pension assets, health and share option liabilities)
Can be substantial difference for pension asstes vs liabilities - Important for book value.
Make adjustments at bottom of balance sheet
Market Value
Market Multiples
Dividend Yield
Dividend per share / market price of the share
Price-book ratio
Market Price of the share /
book value per share
or
Market capitalisation /
book value of shareholders funds
Price-earnings ratio
Share price / earnigns per share
or
Market capitalisation / earnings for shareholders
Price-cashflow ratio
Definition 1
Definition 2
EBITDA
Specific valuation ratios
Company value = share price x # shares
vs Stock exchange - Quotations do not represent a valuation of a company by reference to its assets and earning potential
A fair market price would imply semi-strong market
Balance sheet may hide undervalued or overvalued asstes or liabilities
Some have insider information
Implies someone can be found to purchase at market price
Looking to purchase a controlling stake may rewquire a premium or sell a large chunk at a discount
Time element of share price - can vary 5% daily but can move 20-30%.
Other factors: Shareholder loyalty, Additional benefits (e.g. vouchers), employee loaylty, premium for control, fashion.
Recap
Income statement
Finicial position/balance sheet
Cashflow
