Notes:
Free Cash Flow:
The amount of cash left over after paying expenses (cap ex and operational costs)
Unlevered Free Cash flow: Available to both debt and equity investors, it is used to calculate
enterprise value.
Free cash flow is calculated as EBIT (or operating income) * (1 - tax rate) + Depreciation + Amortization - change in net working capital - capital expenditures.
Levered Free Cash Flow: Only available to equity investors. Cash after it has made its debt and other financial obligations. Using this you will calculate equity value.
Levered free cash flow is calculated as Net Income (which already captures interest expense) + Depreciation + Amortization - change in net working capital - capital expenditures - mandatory debt payments.
Key Point: A company can appear to be profitable from a net income perspective and thus have a positive Unlevered Free Cash flow, but have a negative Levered Cash Flow. (Equity owners get paid the last in bankruptcy, thus levered FCF will be the least amount)
Chapter 13 - 16 Introduction to Business and Finance
The US government allowed GM to borrow at 2.2% and took an equity stake in the company - "The U.S. government invested about $65 billion of equity in GM and in 2009 owned 60% of the firm. The federal government’s bailout used equity financing, as GM’s precarious financial position could not be sustained with debt financing. By wiping debt off the balance sheet and injecting equity into the firm, the federal government made it easier for GM to become profitable, at least in the short-term, with taxpayers taking on the losses from the equity investment. In mid-2019, the market capitalization (value of all GM’s common shares) was about $57 billion. With $65 billion invested in GM, the taxpayers have a long way to go before their investment breaks even. On a time-value-of-money basis, it will take even longer.12"
Restricted stock vs. stock options "Use of restricted stock is gaining popularity as a way to align managers’ interests with those of shareholders without the bad consequences of stock options. Restricted stock is given to employees but they cannot sell it until it vests, which typically occurs after three to five years. Employees who leave the firm before the stock vests lose their restricted shares. Under some company plans, top managers forfeit restricted shares if the firm has poor financial performance or they miss financial targets. Restricted stock’s time to vest is typically longer than that of shorter-term stock options and it has less upside (large return) potential. But, whereas stock options can become worthless if the stock price does not rise sufficiently, restricted shares will retain some value as long as the firm doesn’t go bankrupt. In addition, holders receive dividends of restricted shares even before they vest."
Ratio Analysis - dividing various financial statement numbers as a comparison: "Three basic categories of ratio analysis are used. First, financial ratios can be used in trend analysis (also known as time series analysis) to evaluate a firm’s performance over time. Second, ratios are used in cross-sectional analysis, in which different firms are compared at the same point in time. Third, industry comparative analysis is used to compare a firm’s ratios against average ratios for other companies in the firm’s industry. This allows the analyst to evaluate the firm’s financial performance relative to industry norms."
"Many types of ratios can be calculated from financial statement data or stock market information. However, it is common practice to group ratios into five basic categories:
Liquidity ratios - one popular is the current ratio which is a company current assets divided by current liability and can be used to show liquidity issues if number is too low
Asset management ratios - how the company is using their assets to produce revenue, a total assets turnover ratio of .33 means that a company needs 3 dollars of assets to produce one dollar of revenue (rises when revenue outpaces assets)
Financial leverage ratios - total debt to total assets (total debt/total assets) - shows how much of the company is currently being financed to creditors (going up means debt is rising faster than assets)
Profitability ratios - net profit margin is the firm's net income after taxes divided by net sales and this shows the ability to earn a return after meeting interest and tax obligations
Market value ratios - price to book and price to earnings (P/E) - shows what the market and investors value the company at
Consulting
Sales revenues minus various costs gives us operating profit, or earnings before interest and taxes (EBIT). Sales can be expressed as unit price (P) multiplied by quantity sold (Q), or P × Q.
The costs can be expressed by variable cost per unit (vc) and fixed costs (FC). The variable cost per unit (vc) times the quantity sold (Q) gives us total variable cost:
vc × Q. Total fixed costs, FC, are constant; they are called “fixed” because they do not change with increases or decreases in output. Thus, we can find operating income as follows:
EBIT=Sales−Total variable costs−Fixed costs
In terms of our symbols, this becomes the following:
EBIT = P * Q (total sales) - (variable cost * quantity) - Fixed Costs = x
If X is positive, company should pursue product, and can plug in how many units they predict they can sell to get their projected EBIT
Equation to find Quantity needed to BE ->
P-VC in the equation is Contribution margin (basically the amount of profit added by each unit sold
Fixed Income and Cash Alternatives
US Treasury Bills - "Treasury bills are sold at a discount through competitive bidding in a weekly auction. These bills are offered in all parts of the country but sell mostly in New York City. Treasury bills are actively traded in secondary money markets, mostly those in New York City.
Figure 15.6 shows the levels and volatility, or tendency to change rapidly, of three-month. Treasury bill yields between 1997 and 2019. The yields were around 5% in 1997 and peaked during this time frame at about 6% in 2000. They declined with the beginning of the 2001 recession following attempts by the Federal Reserve System to stimulate the economy. Rates rose in 2004–2007 as the Fed increased its discount rate and federal funds rate as economic growth increased demand for loanable funds before easing in late 2007. With the Great Recession, interest rates declined sharply in late 2007 and T-bills stayed near 0% until the Fed started to raise interest rates again in December 2015."
(T-Bills considered risk free due to high likelihood of us government defaulting - slightly better than holding cash)
Commercial paper - IOU’s form companies very short term for companies that need quick money
CD’s - Interest rates are usually above t bills, are offered by banks in return for money deposited by the buyer
Municipal securities - given out by cities, towns, states, school districts, etc. (exempt form federal income tax)
Net working capital - "Working capital includes a firm’s current assets, which consist of cash, marketable securities, accounts receivable, and inventories. Current liabilities are short-term debt items that, generally, consist of accounts payable (trade credit), notes payable (short-term loans), and accrued liabilities. Net working capital is defined as current assets “net,” or less, current liabilities:"
Prime Rate (the baseline interest rate the bank will offer) - "the interest rate a bank charges its most creditworthy customers. Interest rates on loans are typically stated in terms of the prime rate plus a risk differential, such as prime + 2%. Loan papers will call this “prime plus 2” (or simply P + 2). Higher-risk borrowers will have higher differentials in order to compensate the bank for lending to riskier customers."
Chapter 17 - 18 Introduction to Business and Finance
Net Present Value and Internal Rate of Return
"We know that the market value of an investment is the present value of future cash flows to be received from the investment. The net benefit, or net present value (NPV), of an investment is the present value of a project’s cash flows minus its cost:"
SWOT Analysis: examines a firm’s strengths, weaknesses, opportunities, and threats. With it, managers can identify capital budgeting projects that allow the firm to exploit its competitive advantages or prevent others from exploiting its weaknesses."
NPV (Net present value) can tell you which projects will be over the hurdle rate or you cost of capital, IRR (Internal Rate of Return) will tell you your breakeven point on the cost of capital (interest rates)
At the point where NPV goes negative, that is the maximum discount rate the firm can afford to pay to breakeven on the project
If a project returns more than its cost of capital, the NPV is positive. If a project returns less than its cost of capital, the NPV is negative. An issue with the use of IRR is that it may rank projects differently than the NPV. The firm should do all projects with higher IRR than required rates and any project with positive NPV, or highest NPV
However a process called Cannibalization can occur when the project requires cash flows from another product line, meaning that just because a project has a NPV that is greater may not be bitter because it may cost more capital to start EX. Corporate strategists reportedly considered how the introduction of Pepsi One, a new low-calorie cola soft drink product, would affect sales of Diet Pepsi and Pepsi-Cola.16"
This comes back to the principle of Opportunity Cost
Cost of Equity and Debt:
Flotation costs: costs endured by the company that want to offer shares - these go to the bankers and accountants and lawyers who all have to be paid if a equity offering is to be made
Series of Equations: used to figure out cost of using equity offering of common stock to raise capital
WACC - required rate of return to be profitable on projects
How to use WACC - the company identifies what percentage it would like to use of debt and equity, then it found the cost of these two, multiples them and adds them together, this creates a “average” cost of capital that is “weighted” This number is a breakeven number for any projects needed to unfold
(these are subject to change with interest rates and stock prices and flotation costs by bankers)
Pecking order is a a theory that managers prefer to use additions to retained earnings to finance the firm, then debt, and as a final resort, new equity"
Under this pecking order hypothesis, financial theory implies that firms have no optimal debt/equity ratios.Instead, they follow the pecking order, exhausting internal equity (retained earnings) first and resorting to debt then, external equity (new issues of common stock) as a last resort
Summary: of the Cost of Equity and Debt OFferings Chapter 18 "We have covered a lot of ground and a lot of controversy. Let’s summarize the practical implications of these discussions and list the influences of theory and real-world evidence on a firm’s capital structure decisions.
18.8.8.1 Business Risk
Firms in the same industry will generally face the same business risks. Many financial managers confess they examine their competitors’ capital structures to determine if their own financial strategies are appropriate. A firm’s DOL affects the amount of debt it can issue. Firms with highly variable EBIT cannot afford to issue large amounts of debt, as the combined effects of high business and financial risk may imperil the firm’s future. In general, greater EBIT variability reduces the firm’s reliance on debt.26
18.8.8.2 Taxes and Non Debt Tax Shields
Under current tax regulations, the debt interest deduction is a strong influence in favor of debt. The tax incentive for debt financing can diminish as a firm accumulates non debt tax shields, such as depreciation expense, R&D, and large advertising outlays.
18.8.8.3 Mix of Tangible and Intangible Assets
Agency costs and bankruptcy costs can make debt less attractive as a financing alternative for firms with large amounts of intangible assets, such as goodwill, customer loyalty, R&D, and growth opportunities.
18.8.8.4 Financial Flexibility
Among the greatest concerns of financial managers is maintaining access to capital. Without the ability to raise financing, a firm may have to pass up attractive investment opportunities, or a temporary cash crunch may push it to the edge of default. Loss of financial flexibility can disrupt the firm more than the strictest bond covenants. Some firms seek financial flexibility by maintaining financial slack or unused debt capacity. One way to do this is to maintain an investment-grade bond rating or to maintain large lines of credit.
It may be good to have financing that can be eliminated if it is unnecessary. The firm can arrange for debt financing with a maturity matching the expected period of need. For maturity matching, debt holds an important advantage over preferred stock or common stock financing, because equity securities do not have a stated maturity, which makes it possible to retire them conveniently. A lease arrangement for fixed assets is advantageous, because the lease term may be set to coincide with the duration of the need for the assets.
18.8.8.5 Control of the Firm
Common shareholders receive dividends and have voting control of the firm. Additional equity issues will likely reduce per-share dividends and dilute control. If shareholders worry about control, they may force a firm to use more debt financing and less external equity financing.
18.8.8.6 Profitability
Firms with above-average profitability can reduce flotation costs and restrictive debt covenants by relying on internal equity to finance capital budgeting projects. More-profitable firms tend to use less debt financing. (Pecking order)
18.8.8.7 Financial Market Conditions
A firm can minimize its financing costs by issuing debt when interest rates are near cyclical lows, especially if economists forecast rising rates in the future. Likewise, it is advantageous to issue stock when stock prices are high rather than depressed.
18.8.8.8 Management’s Attitude Toward Debt and Risk
When push comes to shove, it is people, meaning the management team, who decide about financing policy. Some management teams may be more conservative and hesitant to issue debt; others may be more aggressive and willing to increase the firm’s financial leverage. Their judgment and expectations for the firm’s financial future will affect the firm’s capital structure."
In Class Notes:
Primary market - original issue market where a company sells stock to the public - first time is a IPO
Secondary market - overtake the shares are traded after the IPO
Third securities market : operate inn OTC - these stocks are not regulated like primary and secondary markets do
Ipo - first time a private company offers shares for the first time
Investment bankers - structures how a private companies is going to ipo (underwriters)
Public offering - company offers shares to the investing public
Private placement - sale of securities to a small group of private investors (is this private equity?)
Trust indenture - used when you have a bond financing, lending the company money with yield as returned, this is called the indenture