By Joanne Gonzales,2014-08-07 11:32
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Financial forecasting

    o Short-run forecasting

    o General dynamics; sustainable growth

     Capital structure

    o MM

    o Static trade-off: Tax shield vs. Expected distress costs

    o Pecking order

    o An integrative approach


    o FCF

    o APV

    o WACC

    o Valuing companies


The bulk of the value is created on the LHS by making good investment decisions

     You can destroy a lot of value by mis-managing your RHS Financial policy should be supporting your business strategy You cannot make sound financial decisions without knowing the implications for the business

     Finance is too serious to leave it to finance people Making sound business decisions requires valuing them This involves knowing the business (to make appropriate cash flow forecasts and scenario

    analysis, etc.)

     Valuation exercises can indicate key value levers


Four Steps

1. Forecast Assets

    a. Assumptions

    2. Forecast Liabilities and Net Worth, leaving out the liabilities you want to remain free (e.g.

    Bank Debt)

    a. Assumptions

    3. Use the difference as the “Plug” for the funding need (e.g. Bank Debt) and compute the

    implied Net Income

    4. Use the implied Net Income to compute the implied Net Worth and plug back into Step 2 until

    you converge.

General Dynamics and Sustainable Growth

The sustainable growth rate is g* = (1-d) x ROE

    o D = dividend

    o ROE = Return on Equity

     The sustainable growth rate g* = (1-d) x (NI/Sales) x (Sales/Assets) x (Assets/NW)

     Sustainable growth rate increases as

    o Dividends decrease (more reinvestment in the firm)

    o Profit margins increase (NI/Sales)

    o Asset turnover increases (Sales/Assets)

    o Leverage increases (Assets/NW)

     If a company grows faster than g* without issuing equity, its leverage will increase If a company grows slower than g* without buying back equity, its leverage will decrease The sustainable growth rate does not tell you whether growth is good or not; EVA or DCF is

    necessary for that

     Financial and business strategies cannot be set independently (too few degrees of freedom)

     e.g. Citibank

     Sustainable growth is relevant only if you cannot will not raise equity, and you cannot let your

    D/E ratio increase

     Sustainable growth gives a quick idea of general dynamics

    o Cash cows (g<g*)

    o Finance junkies (g>g*)


Modigliani-Miller Theorem

In frictionless markets, financial policy is irrelevant

    o Financial transactions are NPV = 0 (i.e. no arbitrage) QED

    o Corollary: Capital structure, long- vs. short-term debt, dividend policy, risk

    management are all irrelevant to firm value

     MM helps us avoid fallacies:

    o WACC fallacy

    ; It is true that since debt is safer than equity, investors demand a lower return

    for holding debt than for holding equity

    ; It is false that companies should always finance themselves with debt

    because they have to give away less return to investors

     False: WACC unchanged return on debt climbs with its risk

    o EPS fallacy

    ; It is true that EPS can go up (or down) when a company increases its


    ; It is false that companies should choose their financial policy to maximize

    their EPS

     Stock price will be unchanged since we will discount higher EPS

    flows at a higher rate (due to the increased risk) of leverage

    o Win-Win fallacy

    ; It is true that investors differ in their preferences and needs, and thus want

    different cash flow streams

    ; It is false that the sum of what all investors will pay is greater if the firm

    issues different securities (e.g. debt and equity) tailored for different

    clienteles of investors

     Prices adjust so that the net value of these issues is unchanged Guidance for systematic exploration of “frictions”

    o Taxes

    o Costs of financial distress

    o Information asymmetry

    o Agency problems

Tax Shield of Debt

Debt increases firm value by reducing the corporate tax bill

    o If lots of cash, use (D-Cash), i.e. the Net Debt

    o Interest payments are tax deductible

    o Personal taxes tend to reduce but not offset this effect

    V(w/debt) = V(all equity) + PV(tax shield)

PV(tax shield)

    o If debt level constant at D tD

    o If leverage ratio D/V is constant tkD/k DA

     Other Motivations for Debt

Free Cash Flow problem:

    o Too much cash relative to good investment opportunities

    o Management might misallocate funds, e.g. expanding into unrelated businesses

    o Debt is a way to pump cash out of the firm

    o Imposes discipline

     Litigation risk:

    o Debt is a way to get funds out before the plaintiffs can get it

Costs of Financial Distress

     Direct and indirect costs reduces the size of the pie, i.e. the value of the firm Direct costs of bankruptcy:

    o Legal and administrative costs, fees, etc.

    o Usually too small, especially expected costs

     Indirect costs of financial distress:

    o Debt overhang inability to raise funds

    ; Benefits of raising equity if in distress go to the creditors first

    ; Pass up valuable projects

    ; Competitors become aggressive

    o Risk-taking behavior equity holders only benefit if the company continues

    o Scare off customers and suppliers (e.g. Boeing and subsequent market for specialized


Checklist for Target Capital Structure ***


    o How much does the company benefit from debt tax shield? Expected distress costs = Probability of Distress x Distress Costs:

    o Volatility of cash flow (industry or technological change, macroeconomic shocks, etc.)

    o Need for external funds for investment

    o Competitive threat if pinched for cash

    o Customers and suppliers care about distress (e.g. implicit warranty or specific investment)

    o Specific assets that are difficult to re-deploy or sell

    o Debt structure

    ; # of creditors

    ; Complexity of debt (e.g. Massey)

Pecking Order

     Applicable to companies that are mature and/or already public See Wilson Lumber case

     Firm’s general financing choices, in order of preference:

    o Retained earnings

    o Debt borrowing

    o Issue equity

     Theory: Information asymmetry between the firm and the market means that external finance

    is more costly than internal funds

    o Management and external capital providers have different information sets

    o Debt less sensitive to information since it has a priority in payment

    o Issuing equity may signal the market that management thinks the stock is overvalued Implications for investment:

    o Project value depends on financing

    o Some projects will be undertaken only if funded internally or with relatively safe debt but

    not with equity

    o Companies with less cash and more leverage will be more prone to under-invest

    o Rationale for hoarding cash

     Implications for capital structure:

    o If a firm follows the pecking order, its leverage ratio results from a series of incremental

    decisions, not an attempt to reach a target

    ; High cash-flow Leverage ratio decreases

    ; Low cash-flow Leverage ratio increases

    o There may be good and bad times to issue equity depending on the degree of

    information asymmetry

    o Rationale for hybrid instruments (e.g. convertible debt)

     Pecking order is a descriptive theory, not a prescriptive one

    o Financing choices by firms

    o Explains finance junkies’ high leverage (e.g. Massey)

    o Does not explain cash cows’ low leverage more likely “agency” (e.g. Intel)

     If firms use Pecking order blindly and ignore static trade-off (i.e. debt tax-shield vs. expected

    costs of financial distress), then:

    o Cash cows will end up with too little leverage (e.g. UST)

    ; Good news: It’s never too late to lever up

    o Finance junkies will end up with too much leverage (e.g. Massey)

    ; Bad news: It can be too late to unlever (debt overhand)

    ; Short-term debt is temporary relief but worsens things in time

An Integrative Approach

Establish long-run “target” capital structure