Advanced Financial Management

only include future, incremental cash flows

(e.g. no interest, no sunk costs, non-cashflows, book values, unavoidable costs etc)

interest = cost of finance is measured in the cost of capital/discount rate

1. Allocative Efficiency
   1. does the market attract funds to the best companies
2. Operational Efficiency
   1. does the market have low transaction costs & a convenient tradingn platform
3. Informational Efficiency
   1. Is all info available to investors at all times
4. Pricing Efficiency
   1. do share prices quickly & accurately reflect all known info about the company

the value of share is based on expectations of future CF from owning the shares. The strength of the link between company performance & share price depends on pricing efficiency of markets.

1. weaj form efficiency
   1. current shareprices reflect all information in record of past prices
   2. price movements cant be forecasted based on past trends
2. semi strong form efficiency
   1. current shareprices reflect all publicly available information 
   2. price only alters with new info & share prices follow random wallk
   3. to beat: insider trading
3. strong form efficiency
   1. share price reflects all published & unpublished information
   2. predictio not possible & insider trading not possible

Market efficiency relies on investors researchiing public information to find under-over priced shares. However, if market is effiicient, there will be no mispriced shares.

= market becomes more efficient when investors believe it is inefficient and do research to discover information

P0 = D1/1+re + D2//1+re^2 etc

P0 = D/Re (constant dividend to infinity)

P0 = current ex-div market value

re = shareholders required rate of return = cost of equity ke

• theoretical FV of shares in unlisted companies where a quoted market price is unknown
• for listed companies w. known share price: required rate of return of shareholders / companies cost of equity finance ke

b = proportion of profits retained = retained profit / profit

re = actual return = RoE = Profit / Net assets

same as of shares with constant dividend to annuity

ke=re=D/P0

Po = I / kd

kd = bondholders required return

P0 = ex interest market price

MV of coupon interest + redemption price discounted at investors required rate of return (=kd = yield to maturity)

yield to maturity = 

100 treasury note, 4%, trading at 98

ytm = 104/98

PV of future interest payments

plus higher of

• redemption value
• forecast conversion value 

both discounted at bondholders required rate of return (kd)

kd = IRR of pre-tax cash flows
from the bond

(1+semi annual cost)^2-1

if market interest rates increase,market price of bonds will decrease.

Bond prices fall when market interest rates rise because existing bonds become less attractive compared to new bonds.

Bond prices fall when market interest rates rise because existing bonds with lower fixed coupons must drop in price to offer investors the new higher required return.

helps investors understand when they can expect to receive the bond's principal and interest payment

modified duration = approx. percentage price change in a bond for a 1% in yield

maculay duratin / (1+YTM)

• Expectations theory
  • if IR are expected to increase, the curve is normal (Yield increases with years to maturity). If IR are expected to decline, the curve may invert
• liquidity preference theory
  • by investing for a longer period, investor is deferring his consumption and requires a higher yield as compensation
• market segmentation theory
  • if few investors seek to invest long term but many borrowers wish to borrow long term,the price of long-term money will be high and the yield curve will be upward sloping
  • different types of market participants (e.g. individual investors, institutional investors) influence varying segments of the yield curve (e.g. pension funds typically invest long term)
• risk
  • risky debt will have a higher yield at all terms to maturity, than risk-free government debt. therefore there will be a different yield curve for each class of debt by risk
  • default risk may be more significant on corporate debt, the corporate yield curve may rise more steeply than the government yield curve

when a project does not change the companys:

• Gearing level (financial risk)
• Operational risk (business risk)

Ke= required rate of return

Methods = DVM & CAPM

Business Risk

• Volatility of operating profit/CF due to the nature of the industry, country and level of OPERATIONAL gearing (fixed vs. variable costs)

Financial Risk

• ADDITIONAL variability in the return to equity due to debt (financial gearing). Interest on debt is a fixed cost, which leads to more volatile profits for shareholders

Ke increases due to the increased financial risk: debt = fixed cost increases = profit for shareholders reduces.

debt is riskier when you're not profitable

-> pushes up WACC

proportion of debt relative to equity increases. since kd<ke this pushes WACC down

Without tax

• introduction of debt increases Ke due to gearing
• WACC remains same because Ke offsets cheaper cost of debt
• Kd remains constant because financial distress risk is ignored
• Conclusion: value of company with and without gearing is the same. only investment decisions affect value of company. NOT finance decisions
  • not true in practice
  • (indicates no optimal gearing level)

with tax

• ke increases
• WACC reduces because of the tax shield
• Kd remains stable, ignores financial distress risk
• Value of company geared is higher than ungeared

• Adjusted WACC

• CAPM for cost of capital

• Adjusted Present Value

suggests that a company aims to balance relative costs and benefits of debt to determine optimal strucuture

• relevant benefits: tax savings on interest payments which reduces overal cost of capital
• costs of debt:
  • agency costs: debt contracts might include restrictive covenants which can result in loss in potential shareholder wealth
  • financial distress cost: if stakeholder perceive level of gearing as dangerous, this can have impact on company
  • bankrupcy costs

1. Retained equity
   1. no issue cost
   2. otherwise distributable as dividends
2. Bond issue/bank loan
3. fresh equity issue

Companies should choose cheapest available source of new finance

• Unsystematic risk
  • diversifiable risk
  • risk unique to a company/industry
• systematic risk
  • market risk
  • impacts entire market and cannot be controlled or diversified away

total risk = systematic + unsystematic

- through more shares in portfolio, the unsystematic risk is diversified away & total risk reduces to approach systematic risks

investors should be rewarded only for risks they cannot avoid = systematic risk

general expectation is that most shares are held by institutional investors that hold a diversified portfolio. therefore CAPM states that companies should specialise and only need to compensate shareholders for the systematic risk they face

its also cheaper for shareholders to maintain a diversified portfolio of shares than for a company to hold a diversified portfolio of projects

Equity beta = when a company is geared. reflects systematic business risk & financial risk of a share

Asset beta = when a company is ungeared. reflects only systematic business risk

• calculate asset beta of a proxy with their equity beta
• solve for equity beta with financial structure of own company

1. Base case NPV
   1. operating CF
   2. take equity beta of benchmark company and calculate asset beta
   3. calculate Ke in CAPM with asset beta
2. PV of adjustments
   1. Issue costs of debt 
   2. Tax shields of interest payments - PV discounted at cost of debt
   3. Subsidies benefit - PV discounted at cost of debt

Hard = capital markets impose limits on amounts of finance available

soft = company sets internal limits on finance availability

IRR implies that CF from a project can be reinvested at IRR itself

MIRR assumes that CF are reinvested at companys required rate of return

PVr = present value of project returns

PVi = PV of investment outlay

re = reinvestment rate = required rate of return = cost of capital

Indicates the time it will approximately take to recover half of the present value of the project

(Earlier CF are discounted less, later CF are discounted more)

measures sensitivity of the value of a project to a change in IR

Maculay duration / 1+WACC

variance = σ²

^{standard deviation =} σ

an indication of the potential monetary loss likely to occur at a given level of confidence.

Confidence level = proability that a portfolios losses will not exceed a specific max. amount

Project VaR = N(conf. level) * s * T^1/2

Where:

• N (confidence level) is the number of standard deviations from the mean for the given confidence level
• s is the annual standard deviation of the project's returns
• T is the number of years of the project.

1. Asset valuation (Asset-Liabilities)
2. Relative valuation
3. Cash flow valuation
   1. DVM
   2. Free Cash Flow