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Corporate Finance Made Simple

Simple financial theory shows that the total value of a company should not change if its capital structure does. This is known as capital structure irrelevance, or Modigliani-Miller (MM) theory. Total value is the value of all its sources of funding; this is similar to a simple (debt + equity) enterprise value. The MM argument is simple; the total cash flows a company makes for all investors (debt holders and shareholders) are the same regardless of capital structure. Changing the capital structure does not change the total cash flows. Therefore the total value of the assets that give ownership of these cash flows should not change. The cash flows will be divided up differently so the total value of each class of security (e.g. shares and bonds) will change, but not the total of both added together. Looking at this another way, if you wanted to buy a company free of its debt, you would have to buy the equity and buy, or pay off, the debt. Regardless of the capital structure you would end up owning the same streams of cash flows. Therefore the cost of acquiring the company free of debt should be the same regardless of capital structure. Furthermore, it is possible for investors to mimic the effect of the company having a different capital structure. For example, if an investor would prefer a company to be more highly geared this can be simulated by buying shares and borrowing against them. A who investor would prefer the company to be less highly geared can simulate this by buying a combination of its debt and equity. MM theory depends on simplifying assumptions such as ignoring the effects of taxes. However, it does provide a starting point that helps understand what is, and is not, relevant to why capital structure does seem to matter to an extent. The different tax treatments of debt and equity are part of the answer, as are agency problems (conflicts of interest between shareholders, debt holders and management). There are extensions to MM theory which suggest that the actions of market forces, together with the tax treatment of debt and equity income in the hands of investors, means that for most companies the gains that can be made by adjusting capital structure will be fairly small. Given that companies would not deliberately adopt inefficient capital structures, we can assume that all companies have roughly equivalently good capital structures so from a valuation point of view we can reasonably assume that capital structure is irrelevant.

Ramesh Arivalan, Bsc (Hons) Finance - NUI

Corporate Finance Made Simple

A mix of a company's long-term debt, specific short-term debt, common equity and preferred equity. The capital structure is how a firm finances its overall operations and growth by using different sources of funds. A company's proportion of short and long-term debt is considered when analysing capital structure. When people refer to capital structure they are most likely referring to a firm's debt-to-equity ratio, which provides insight into how risky a company is. Usually a company more heavily financed by debt poses greater risk, as this firm is relatively highly levered. Once the company begins to raise equity capital from outside investors, the founders begin to suffer dilution. This is the loss of a proportional percentage of the company's shares when shares are purchased by outside investors. If founders own 100% of the company before outside investment and 80% after, they are deemed to have suffered a 20% dilution in their interest in the company. The word suffered is interesting because dilution isn't necessarily negative. Founders may have a smaller piece of the pie but should be concentrating on the overall value of the pie and its potential to increase in value now that the company has raised capital to accelerate the growth of the business. Products now have a better chance to getting to market in time and potentially eclipsing competitive offerings. Talent needed for the business can be hired and key individuals to help growth or product development can be brought onboard. Money is now available for marketing, brand building and lead generation fundamental for growth. In addition, the bringing in of outside investors, if thought through, can bring new talent onto the board - people with particular skills such as industry experience, contacts and credibility that may reassure potential customers. Notwithstanding the value that outside investors can bring, the primary question in the mind of most entrepreneurs is the valuation they can obtain from investors. There will be a pre money valuation (before the investment comes in) and a post money valuation i.e. the pre money valuation plus the amount of capital invested in the company.

Ramesh Arivalan, Bsc (Hons) Finance - NUI

Corporate Finance Made Simple

There isn't a scientific formula that will be recognised by all parties to come to an agreed valuation. It will be down to negotiation and like all negotiations; entrepreneurs need to have the research done. By all means do the revenue models and prepare the spreadsheets, but also have examples of other investments that can act as a benchmark. However fundamentally it will come down to both parties wanting to do business together in the belief that there will be future shareholder vale from the partnership. Founders should never loose sight of the value of closing the funding round. Too much focus on pre-money valuations and possible dilution can alienate investors and lead to a failure to obtain the capital.

The difference between the present value of cash inflows and the present value of cash outflows. NPV is used in capital budgeting to analyse the profitability of an investment or project. NPV analysis is sensitive to the reliability of future cash inflows that an investment or project will yield. NPV compares the value of a dollar today to the value of that same dollar in the future, taking inflation and returns into account. If the NPV of a prospective project is positive, it should be accepted. However, if NPV is negative, the project should probably be rejected because cash flows will also be negative. For example, if a retail clothing business wants to purchase an existing store, it would first estimate the future cash flows that store would generate, and then discount those cash flows into one lump-sum present value amount, say $565,000. If the owner of the store was willing to sell his business for less than $565,000, the purchasing company would likely accept the offer as it presents a positive NPV investment. Conversely, if the owner would not sell for less than $565,000, the purchaser would not buy the store, as the investment would present a negative NPV at that time and would, therefore, reduce the overall value of the clothing company. Payback Period is the length of time required to recover the cost of an investment. The investment rules of the firms manger, is accepting project if payback period is less than some specific number of years. All other things being equal, the better investment is the one with the shorter payback period. For example, if a project costs $100,000 and is expected to return $20,000 annually, the payback period will be $100,000 / $20,000, or five years.
Ramesh Arivalan, Bsc (Hons) Finance - NUI

Corporate Finance Made Simple

There are two main problems with the payback period method: 1. It ignores any benefits that occur after the payback period and, therefore, does not measure profitability. 2. It ignores the time value of money. Because of these reasons, other methods of capital budgeting like net present value, internal rate of return or discounted cash flow are generally preferred. Internal rate of return (IRR) is defined as the discount rate often used in capital budgeting that makes the net present value of all cash flows from a particular project equal to zero. Generally speaking, the higher a project's internal rate of return, the more desirable it is to undertake the project. As such, IRR can be used to rank several prospective projects a firm is considering. Assuming all other factors are equal among the various projects, the project with the highest IRR would probably be considered the best and undertaken first. IRR is sometimes referred to as "economic rate of return (ERR)". You can think of IRR as the rate of growth a project is expected to generate. While the actual rate of return that a given project ends up generating will often differ from its estimated IRR rate, a project with a substantially higher IRR value than other available options would still provide a much better chance of strong growth. IRRs can also be compared against prevailing rates of return in the securities market. If a firm can't find any projects with IRRs greater than the returns that can be generated in the financial markets, it may simply choose to invest its retained earnings into the market. In some cases, payback period can be better. It is a quick calculation, and is intuitive and easily understandable. It could also be a good "tiebreaker" between two projects with similar IRR's and NPV's, or between two highly risky projects with hard-to-project cash flows. IRR and NPV are better because they simply take more factors into account, which you already described above. Besides, if your objective is to make a profit, why stop the analysis at the point of break-even? You get a more complete answer with IRR/NPV In conclusion, if conflicting investment decision methods occur, recommend to use the Net Present Value method because is the most academically acceptable.

Ramesh Arivalan, Bsc (Hons) Finance - NUI

Corporate Finance Made Simple

Bond is defined as a debt investment in which an investor loans money to an entity (corporate or governmental) that borrows the funds for a defined period of time at a fixed interest rate. Bonds are used by companies, municipalities, states and U.S. and foreign governments to finance a variety of projects and activities. Bonds are commonly referred to as fixed-income securities and are one of the three main asset classes, along with stocks and cash equivalents. There is an inverse relationship between price and yield: when interest rates are rising, bond prices are falling, and vice versa. For example if you buy a bond for $100 that pays a certain interest rate (coupon). Interest rates (coupons) go up. That same bond, to pay thencurrent rates, would have to cost less: maybe you would pay $90 the same bonds if rates go up. Ignoring discount factors, here is a simplified example, a 1-year bond. Let's say you bought a 1-year bond when the 1-year interest rate was 4.00%. The bond's principal (amount you pay, and will receive back at maturity) is $100. The coupon (interest) you will receive is 4.00% * $100 = $4.00. Today: You Pay $100.00 Year 1: You receive $4.00 Year 1 (Maturity): You Receive $100 Interest Rate = $4.00 / $100.00 = 4.00% Now, today, assume the 1-year interest rate is 4.25%. Would you still pay $100 for a bond that pays 4.00%? No. You could buy a new 1-year bond for $100 and get 4.25%. So, to pay 4.25% on a bond that was originally issued with a 4.00% coupon, you would need to pay less. How much less? Today: You Pay X Year 1: You Receive $4.00 Year 1 (Maturity): You Receive $100

Ramesh Arivalan, Bsc (Hons) Finance - NUI

Corporate Finance Made Simple

The interest you receive + the difference between the redemption price ($100) and the initial price paid (X) should give you 4.25%: [($100 - X) + $4.00] / X = 4.25% $104 - X = 4.25% * X $104 = 4.25% * X + X $104 = X (4.25% + 1) $104 / (1.0425) = X X = $99.76 So, to get a 4.25% yield, you would pay $99.75 for a bond with a 4.00% coupon. In addition to the fact that bond prices and yields are inversely related, there are also several other bond pricing relationships: An increase in bond's yield to maturity results in a smaller price decline than the price gain associated with a decrease of equal magnitude in yield. This phenomenon is called convexity. Prices of long term bonds tend to be more sensitive to interest rate changes than prices of short term bonds. For coupon bonds, as maturity increases, the sensitivity of bond prices to changes in yields increases at a decreasing rate. Interest rate risk is inversely related to the bond's coupon rate. (Prices of high coupon bonds are less sensitive to changes in interest rates than prices of low coupon bonds. Zero coupon bonds are the most sensitive.) The sensitivity of a bond's price to a change in yield is inversely related to the yield at maturity at which the bond is now selling.

Ramesh Arivalan, Bsc (Hons) Finance - NUI

Corporate Finance Made Simple

REFERENCES Richard A. Brealey, Stewart C, Myers and Alan J. Marcus (2010): Fundamentals of Corporate Finance, Sixth Edition, Irwin: Tata McGraw-Hill. Capital structure - http://www.smallbusinesscan.com/emerging/money/485-capital-structure-.html Theodore Grossman and John Leslie Livingstone (2009): The Portable MBA in Finance and Accounting, Fourth Edition, New Jersey: John Wiley & Sons Modigliani-Miller Theorem - http://www.investopedia.com/terms/m/modiglianimillertheorem.asp

Ramesh Arivalan, Bsc (Hons) Finance - NUI