Corporate Financial Decision Making Table of Contents

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Corporate Financial Decision Making

FNCE20005 Semester 2, 2023

Lecture 1: Takeovers

• Classification of Takeovers How the businesses are related:

o Horizontal takeovers – Target and acquirer are in the same industry o Vertical takeovers – Target’s industry buys or sells to acquirers industry o Conglomerate takeovers – Target and acquirer operate in unrelated

industry

The reaction of the target company:

o Friendly takeovers – Typically approved by the target’s management o Hostile takeovers – Typically resisted/not approved by the target’s

management

How the acquisition will be paid (shareholders must be paid something):

o Cash takeovers – Give target firm shareholders cash in exchange for their shares

o Share takeovers – Give target firm shareholders the acquiring firm’s shares in exchange for their shares. Can be fixed or floating.

o And others such as collar deals

• Market Reaction to Takeovers

Most acquirers pay a substantial acquisition premium.

ð This is a result of holders pre-merge not wanting to sell their shares at the trading price prior to the acquisition announcement. Unless they pay such premiums to shareholders, they will not sell their shares.

Announcement Price Reaction Premium Paid over

Premerger Price

Target Acquirer

43% 15% 1%

Acquirer price can go up or down. Typically goes up if the merger ‘makes sense’, and goes down if there’s no good reason for it.

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Others way to calculate it:

o From PoF:(R–OC–D)(1–t)+D–I–∆NWC o Cf from operations – cf to investments o Free cash flow to equityholders

ð FCFE = Net Income + Depreciation – Capital Expenditures – Inc. in NWC + Net borrowing

• EBIT(1-t)

EBIT(1-t) is EBIT after taxes

EBIT = Earnings before interest and taxes

o By using EBIT(1-t), we are ignoring interest expense and are calculating an incorrect tax expense

o We ignore interest expenses because cash flows generated by the assets go to both debtholders and equity holders

o We are calculating the free cash flow (to the firm)

o Interest expense represents the cash flow that goes to debtholders o We end up paying a higher tax expense, however, we will adjust for the

interest tax shield when calculating the discount rate, not cash flows

• Depreciation

o Depreciation is an accounting expense, and not a cash outflow, so we add it back

o Depreciation is also an economic expense in the sense that it represents something real

o Depreciation is not a cash expense, but it is a tax-deductible expense o Tax-deductible → Depreciation expense is included when calculating EBIT o It is a part of CoGS and S&GA (Sales and General Administrative expenses) o Not cash expense → we add it back

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Terminal Value:

K.EL$%#G '#GH. = IM_&× (1 + O)

E − O =IM_&BC E − O o g must be lower than the growth of the economy

o The terminal value is accounts for a much larger part of firm value than the cash flows from the projection period

o Cash flow “growth” doesn’t need to be positive

Lecture 4: Valuation

• Relative Valuation

Also known as comparable companies analysis (“comps”)

o In relative valuation, you generally follow the steps below o Choose a target firm

o Come up with a list of firms that are comparable to the target firm ð Often firms in the same industry

o Calculate various measures and ratios to compare o Conclusion (is it over-valued or under-valued?) An application of the law of one price

o In efficient markets, two identical items should not be selling at different prices

Compared to the DCF

o The DCF can be considered an “absolute” valuation

o We can’t calculate a completely accurate discount rate, whereas with relative valuation we start off with market valuations, hence is a much better starting point

• P/E Ratio

A popular measure when using relative valuation the price to earnings ratio (PE ratio)

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Lecture 5: Advanced Capital Budgeting I

NPV are just estimates, hence we need to look at when things work out but also when they don’t work out

• Scenario Analysis

What happens to the NPV under different cash flow scenarios?

At the very least, look at:

o Best case - high revenues, low costs o Worst case - low revenues, high costs o Measures of the range of possible outcomes

Best case and worst case are not necessarily probable, but they can still be possible The takeaway through this analysis, is looking at the worst case and asking the question as a company, “can we handle the loss?,” if it occurs.

• Sensitivity Analysis

Analyse the effects of changing an input variable, holding all else constant (similar to

‘what if we changed...?’)

We want to determine what the NPV is most sensitive to (impacted by the most) e.g selling price, volume.

o Benefits of sensitivity analysis is that it highlights the areas where cash flow risk can materialize. Knowing this, managers can choose to collect more data and conduct further analysis before the project begins -> leading to a more accurate NPV calculation. After the project begins, the managers know where to focus their managerial attention so that they can try to prevent or mitigate the bad outcomes as it is possible to do so.

o Sensitivity analysis can also act as a checklist that forces managers to think about the downside. By human nature, we tend to believe what we want to believe. This type of analysis forces us to examine what we don’t want to see and often wilfully ignore.

o One downside of sensitivity analysis is that it does not consider how the variables are interrelated to each other – the analyst can still view the interrelation

through picking and choosing the variables that the analyst thinks will likely occur together. For example, in the example above, the analyst can assume that in scenarios where the pessimistic selling price is realized, that the sales volume

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• Key Question: Lease vs Borrow to Buy?

• Use the NPV method to value a finance lease

• Identify the incremental cash flows from leasing as opposed to borrowing to buy

• Discount these cash flows and sum them up to get NPV

Discount rate: opportunity cost of capital

o Our alternatives are: 1) lease or 2) borrow-to-buy

o The opportunity cost of capital for the lease is the after-tax cost of borrowing on an equivalent loan to buy the asset:

o After-tax cost of borrowing = interest rate x (1 – corporate tax rate)

o We implicitly assume that the cash flows from leasing are as safe as the interest and principal payments on a loan issued by the lessee

What are the tax-shields or tax payments related to a lease contract and who is affected?

o Tax-shields from lease payments (lessee)

o Tax-shields from asset depreciation (lessor-owner of the asset)

o Tax on gain from the sale of asset (lessor-owner of the asset)

Residual value in the context of leasing is the market value of the asset at the end of the lease.

For leasing to be advantageous for the lessee the finance provided by leasing must be greater than the liability incurred by leasing

Six steps required for lessee to evaluate a lease 1. Cost of asset (avoid paying this) ↑ 2. Lease payments (must pay these) ↓

3. Tax shield from lease payments (reduces tax payable) ↑ 4. Depreciation tax shield (miss out on this) ↓

5. Residual payment/value (must pay/miss out) ↓ 6. Tax on gain/loss on sale of asset (depends) ↑ or ↓

• Financing can complement investment strategy

• Lease or Buy using debt

• This is a financing decision, not an investment decision

Corporate Financial Decision Making Table of Contents