FIN 300 Lecture Notes - Lecture 3: Dividend Policy, Capital Budgeting, Capital Structure

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6 Dec 2017

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***we are going to finish up chapter 18 before we start on chapter 3. Roa & roe the less the net income we retain the lower our growth rates. Working capital policy - current assets and liabilities. Capital budgeting - cash flows of time value and money. Capital structure - how are we gonna structure it. 3. 4 valuing cash flows at different points in time. Identify the role of financial managers in decision making. Recognize the role competitive markets play in determining the value of a good. Understand the valuation principle and how it"s used to identify decisions that increase the value of firm. Assess the effect of interest rates on today"s value of future cash flows. Benefits should be higher payoff than the costs, stay profitable stay in business. You must have a pessimistic view of the market as things generally go worse than better more frequently. You must look at marketing, economics, org behaviour, strategy, and operations.

Related Questions

F1 Q19-Q20

Please show workings/give explanations

Note: Questions 11 â 20 are based on the same mega problem. For convenience we have included the entire set of information in every question. For purposes of the questions that follow, assume that changes in working capital are negligible and capex and depreciation are of the same magnitude and therefore cancel each other. This is the assumption we made in most of the videos to focus on valuation effects of borrowing and taxes and to figure out the key differences between alternative valuation methods.

Q19) You are planning on opening a consulting firm. You have projected an EBIT of $2 million starting next year (t = 1) with a growth rate of 3% over the foreseeable future thereafter. This endeavor will require a substantial investment and you will have to convince investors to provide you the capital to do so. You will invest some of your own money, convincing other investors will of course be useful for your valuing your own investment decision. A critical piece of your analysis is figuring out the present value of the cash flows of the business. Your research has revealed the following information: similar consulting businesses equity has an average beta of 2.40 and the average debt-to-equity ratio in this industry is close to zero. The risk-free rate is 3.20% and the expected market risk premium (the average difference between the market return and the risk-free rate) is 4.50%. The corporate tax rate is 35% and interest payments on debt are tax deductible. Soon thereafter your hearing about your new business, your bank is willing to extend you long-term loan/debt in perpetuity of $3.50M as long as you can pay an interest rate of 8%. Realizing that the chances of bankruptcy are negligible with this amount of ongoing debt on your balance sheet, and the riskiness of the tax shield of debt is the same as the riskiness of debt, you decide to take on $3.50M of debt in perpetuity. Given this decision, you want to consider the Multiples Approach to Valuation as a double-check for your detailed Discounted Cash Flow (DCF) based analyses. Fortunately, there have been several market transactions in this business environment, but you want to choose the most optimal multiple to use given your decision to use a capital structure that is different from the competition where virtually no debt is used. The best multiple to use will be:

a) Either P/E or EBITDA multiple is suitable for your situation.

b) Neither P/E nor EBITDA multiple is suitable for your situation.

c) EBITDA multiple.

d) P/E multiple.

Q20) You are planning on opening a consulting firm. You have projected an EBIT of $2 million starting next year (t = 1) with a growth rate of 3% over the foreseeable future thereafter. This endeavor will require a substantial investment and you will have to convince investors to provide you the capital to do so. You will invest some of your own money, convincing other investors will of course be useful for your valuing your own investment decision. A critical piece of your analysis is figuring out the present value of the cash flows of the business. Your research has revealed the following information: similar consulting businesses equity has an average beta of 2.40 and the average debt-to-equity ratio in this industry is close to zero. The risk-free rate is 3.20% and the expected market risk premium (the average difference between the market return and the risk-free rate) is 4.50%. The corporate tax rate is 35% and interest payments on debt are tax deductible. Soon thereafter your hearing about your new business, your bank is willing to extend you long-term loan/debt in perpetuity of $3.50M as long as you can pay an interest rate of 8%. Realizing that the chances of bankruptcy are negligible with this amount of ongoing debt on your balance sheet, and the riskiness of the tax shield of debt is the same as the riskiness of debt, you decide to take on $3.50M of debt in perpetuity.The government however is seriously contemplating removing the tax subsidy to debt, that is, the deductibility of interest but not dividends from earnings before taxes are calculated. Given this information, and assuming that costs of bankruptcy are likely to be negligible, you should:

a) Change your capital structure and lower your debt.

b) Not worry about your capital structure and focus on the value drivers of your business.

c) Keep your capital structure unchanged because all your previous analysis will remain valid.

F1 Q11-15

Please show all workings/give explanations

Q11. You are planning on opening a consulting firm. You have projected an EBIT of $2 million starting next year (t = 1) with a growth rate of 3% over the foreseeable future thereafter. This endeavor will require a substantial investment and you will have to convince investors to provide you the capital to do so. You will invest some of your own money, convincing other investors will of course be useful for your valuing your own investment decision. A critical piece of your analysis is figuring out the present value of the cash flows of the business. Your research has revealed the following information: similar consulting businesses equity has an average beta of 2.40 and the average debt-to-equity ratio in this industry is close to zero. The risk-free rate is 3.20% and the expected market risk premium (the average difference between the market return and the risk-free rate) is 4.50%. The corporate tax rate is 35% and interest payments on debt are tax deductible. What is the value of your company assuming that it will be all-equity financed? (Enter the nearest rounded dollar number without any $ or comma sign.)

Q12. You are planning on opening a consulting firm. You have projected an EBIT of $2 million starting next year (t = 1) with a growth rate of 3% over the foreseeable future thereafter. This endeavor will require a substantial investment and you will have to convince investors to provide you the capital to do so. You will invest some of your own money, convincing other investors will of course be useful for your valuing your own investment decision. A critical piece of your analysis is figuring out the present value of the cash flows of the business. Your research has revealed the following information: similar consulting businesses equity has an average beta of 2.40 and the average debt-to-equity ratio in this industry is close to zero. The risk-free rate is 3.20% and the expected market risk premium (the average difference between the market return and the risk-free rate) is 4.50%. The corporate tax rate is 35% and interest payments on debt are tax deductible. You decide to start the business and issue 500,000 shares to finance an all-equity firm, the price per share will be (Enter the number with up to two decimals but without any $ or comma sign):

Q13. You are planning on opening a consulting firm. You have projected an EBIT of $2 million starting next year (t = 1) with a growth rate of 3% over the foreseeable future thereafter. This endeavor will require a substantial investment and you will have to convince investors to provide you the capital to do so. You will invest some of your own money, convincing other investors will of course be useful for your valuing your own investment decision. A critical piece of your analysis is figuring out the present value of the cash flows of the business. Your research has revealed the following information: similar consulting businesses equity has an average beta of 2.40 and the average debt-to-equity ratio in this industry is close to zero. The risk-free rate is 3.20% and the expected market risk premium (the average difference between the market return and the risk-free rate) is 4.50%. The corporate tax rate is 35% and interest payments on debt are tax deductible. You decide to start the business and issue 500,000 shares to finance an all-equity firm. Soon thereafter your hearing about your new business, your bank is willing to extend you long-term loan/debt in perpetuity of $3.50M as long as you can pay an interest rate of 8%. Assuming that the chances of bankruptcy are negligible with this amount of ongoing debt on your balance sheet, if you take this debt and retire shares using the debt, the value of the firm will go:

a) Remain the same.

b) Down.

c) Cannot determine based on the available information.

d) Up.

Q14. You are planning on opening a consulting firm. You have projected an EBIT of $2 million starting next year (t = 1) with a growth rate of 3% over the foreseeable future thereafter. This endeavor will require a substantial investment and you will have to convince investors to provide you the capital to do so. You will invest some of your own money, convincing other investors will of course be useful for your valuing your own investment decision. A critical piece of your analysis is figuring out the present value of the cash flows of the business. Your research has revealed the following information: similar consulting businesses equity has an average beta of 2.40 and the average debt-to-equity ratio in this industry is close to zero. The risk-free rate is 3.20% and the expected market risk premium (the average difference between the market return and the risk-free rate) is 4.50%. The corporate tax rate is 35% and interest payments on debt are tax deductible. You decide to start the business and issue 500,000 shares to finance an all-equity firm. Soon thereafter your hearing about your new business, your bank is willing to extend you long-term loan/debt in perpetuity of $3.50M as long as you can pay an interest rate of 8%. Realizing that the chances of bankruptcy are negligible with this amount of ongoing debt on your balance sheet, and the riskiness of the tax shield of debt is the same as the riskiness of debt, you are seriously contemplating taking on the debt and using all of it to retire some shares. If you decide to enter this debt contract with the bank, the value of the firm will become (Enter the nearest rounded dollar number without any $ or comma sign):

Q15. You are planning on opening a consulting firm. You have projected an EBIT of $2 million starting next year (t = 1) with a growth rate of 3% over the foreseeable future thereafter. This endeavor will require a substantial investment and you will have to convince investors to provide you the capital to do so. You will invest some of your own money, convincing other investors will of course be useful for your valuing your own investment decision. A critical piece of your analysis is figuring out the present value of the cash flows of the business. Your research has revealed the following information: similar consulting businesses equity has an average beta of 2.40 and the average debt-to-equity ratio in this industry is close to zero. The risk-free rate is 3.20% and the expected market risk premium (the average difference between the market return and the risk-free rate) is 4.50%. The corporate tax rate is 35% and interest payments on debt are tax deductible. Soon thereafter hearing about your new business, your bank is willing to extend you long-term loan/debt in perpetuity of $3.50M as long as you can pay an interest rate of 8%. Realizing that the chances of bankruptcy are negligible with this amount of ongoing debt on your balance sheet, and the riskiness of the tax shield of debt is the same as the riskiness of debt, you are seriously contemplating taking on the debt and using all of it to retire some shares. If you decide to enter this debt contract with the bank, what will be the price per share of the remaining shares? (Enter the nearest rounded dollar number without any $ or comma sign):

BTR Warehousing, which is considering the acquiition of Galaxy Sun Corp., estimates that acquiring Galaxy Sun will result in an incremental value for the firm. The analysts involved in the deal have collected the following information from the projected financial statements of the target company:

Data collected (in millions of dollars)

	Year 1	Year 2	Year 3
EBIT	$14.0	$16.8	$21.0
Interest Expense	4.0	4.4	4.8
Debt	31.9	37.7	40.6
Total net operating capital	121.5	123.9	126.3

Galaxy Sun Corp. is a publicly traded company, and its market-determined pre-merger beta is 1.20. You also have the following information about the company and the projected statements:

a) Galaxy Sun currently has a $32.00 million market value of equity and $ 20.80 million in debt.

b) The risk-free rate is 4%, there is a 6.10% market risk premium, and the capital aset pricing model purchases a pre-merger required rate of return on equity of 11.32%.

c) Galaxy Sun's cost of debt is 6.00% at a tax rate of 35%.

d) The projections assume that the company will have a post-horizon growth rate of 5.00%.

e) Current total net operating capital is $118.0, and the sum of existing debt and debt required to maintain a constant capital structure at the time of acquisitionis $29 million.

f) The firm does not have any nonoperating assets such as marketable securities.

Given this information, use the adjusted present value (APV) approach to calculate the following values involved in merger analysis:

1. Unlevered cost of equity: 8.10%/ 6.82% / 9.22% / 10.50%

2. Horizontal value of unlevered cash flows: $211.99 million / $279.92 million / $266.59 million / $132.70 million

3. Horizontal value of tax shield: $41.80 million / $39.81 million / $66.35 million / $38.32 million

4. Unlevered value of operations: $64.28 million / $233.62 million / $235.75 million / $228.61 million

5. Value of tax shield: $35.94 million / $74.66 million / $62.57 million / $39.65 million

6. Value of operations: $138.94 million / $271.69 million / $268.26 million / $296.19 million

7. Thus, the total value of Galaxy Sun's equity is $250.89 million / $214.95 million / $43.48 million / $275.39 million

8. Supposse BTR Warehousing plans to use more debt in the first few years of theacquisition of Galaxy Sun Corp. Assuming that using more debt will not lead to an increse in bankruptcy costs for BTR Warehousing, the interest tax shields and tha value of the tax shield in the analyssis, will decrease / increase, leading to a higher / lower value of operations of the acquired firm.

9. The APV approach is considered useful for valuing acquisition targets, because the method involves finding the values of the unlevered firm and the interest tax shield separately and then summing those values. Why is it difficult to value certain types of acquisitions using the corporate valuation model?

- The acquiring firm immediately retires the target firm's old debt. Thus, the acquisition deal consists of only new debt in its capital structure.

- The acquiring firm usually assumes the debt of the target firm. Thus, old debt with different coupon rates usually becomes a part of the aquisition deal.

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FIN 300 Lecture Notes - Lecture 3: Dividend Policy, Capital Budgeting, Capital Structure

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