CUBIC 2016 Corporate Finance Day 2 5/26/2018 CUBIC 2016 Corporate Finance Day 2 Bob Donchez CUBIC Fundamentals of Finance

Outline of Topics 1) Introduction to Financial Management    Financial Statements and Analysis Case #1: Financial Analysis: Vail Resorts, Inc Sources of Capital Capital Budgeting Case #2: Business Start-up Decision: Naturally Wrapped Food Stand  

3-0 Sources of capital funding by companies Topics 3-0 Private sources of funding 3-1 Retained profits 3-2 Bonds and bank loans 3-3 Stock

Sources of Capital 3-0 Private Sources of Funding Private start-ups initially get money from: Self Family and friends Angel capital Venture capital Most funds available as equity, hard for start-ups to borrow

Sources of Capital 3-1 Retained profits Company profits can be used for: Dividends Retained earnings Retained earnings are an important source of funds for new companies to grow

A. The faster a company can grow B. The slower a company can grow Question The more a company pays in dividends (all other aspects remaining the same) A. The faster a company can grow B. The slower a company can grow C. Dividends have no effect on growth

Sources of Capital 3-2 Bonds Section Topics: Bond Terminology Bond Ratings Types of Bonds Interest rates and their effect on bond values

Sources of Capital 3-2 Bonds Bond Terminology Par/Face Value: amount paid at maturity Coupon: interest payment (usually fixed) Maturity: date when bond face value paid Yield to maturity (YTM): % return of bond (if held to maturity) Bond covenants: loan agreement, terms

Sources of Capital 3-2 Bonds 5/26/2018 Sources of Capital 3-2 Bonds Rating agencies and sample rating chart QUALITY S&P Moody's Description High Grade AAA Aaa Bonds judged to be of the best quality. They carry the smallest degree of investment risk.    AA Aa Bonds that are judged to be of high quality by all standards. They are rated lower than the best bonds because margins of protection may not be as large.  Medium Grade A Upper-medium grade obligations. Factors giving security to principal and interest are considered adequate. Bottom of Inv. Grade BBB Baa Bonds that are considered as medium-grade obligations -- they are neither highly protected or poorly secured. Speculative Grade BB Ba Bonds that have speculative elements. Protection of principal and interest may be moderate. B Bonds that lack the characteristics of a desirable investment. There may be small assurance of principal and interest payments over any long period. Default CCC Caa Bonds of poor standing. These issues may be in default or there may be elements of danger present with respect to principal and interest. CC Ca Obligations speculative to a high degree. These issues are often in default. C Lowest rated class in Moody's list. Rating given to income bonds on which interest is not being paid. D Issues in arrears in interest and/or principal payments. CUBIC Fundamentals of Finance

Sources of Capital 3-2 Bonds Rating agencies and sample rating chart QUALITY S&P Moody's High Grade AAA Aaa   AA Aa Medium Grade A Bottom of Inv. Grade BBB Baa Speculative Grade BB Ba B Default CCC Caa CC Ca C D

Sources of Capital 3-2 Bonds Bond Ratings Estimates bond quality, probability of default Has major effect on yields and price As ratings fall: Quality of the bonds fall The probability of bond default rises The price of the bond falls The resulting yields rise to compensate for risk

Sources of Capital 3-2 Bonds Types of Bonds Secured versus unsecured bonds Callable bonds Convertible bonds Bond by issuer Corporation Government

Sources of Capital 3-2 Bonds Yield curves (term structure of interest rates) Provides the yields on the same type of bond over different maturity levels

Sources of Capital 3-2 Bonds Interest rates Changes in interest rate have a strong effect on bond prices: As interest rates rise, bond prices fall As interest rates fall, bond prices rise Long term bonds are affected much more than short term bonds On-line resources: http://finance.yahoo.com/bonds http://www.investinginbonds.com/

Sources of Capital 3-2 Bonds Advantages of debt Cheaper than equity Usually a fixed cost Usually a tax deductible interest expense After expenses, interest, and taxes are paid, shareholders keep all profits remaining—no “dilution” of equity. Debt can enhance profitability through financial leverage.

Sources of Capital 3-2 Bonds Disadvantages of debt Interest is a required expense and must be paid. If not, possible bankruptcy Debt usually entails many terms and conditions that can limit flexibility of the company. The more debt used, the higher the probability of financial distress.

C. The price will remain unchanged D. It really depends Question What will likely happen to the price of a bond issued by a company that may be approaching bankruptcy? A. Its price will rise B. Its price will fall C. The price will remain unchanged D. It really depends

Sources of Capital 3-3 Stocks and Stock Valuation Topics Features of equity Stock valuation Stock quotes

Typically, which security is riskier to an investor? Question Typically, which security is riskier to an investor? A. Bonds B. Common stock C. They have the same risk

Sources of Capital 3-3 Stocks and Stock Valuation Features of equity Common stock Shareholders “own” the company Proportional claim to company and dividends Returns come from dividends and price appreciation Shareholders elect Board of Directors who elect Officers Proxy voting allows shareholders to appoint a representative to vote Dividends paid at discretion of Board of Directors

Sources of Capital 3-3 Stocks and Stock Valuation Stock Quotes On-line resource: http://finance.yahoo.com/

Sources of Capital 3-3 Stocks and Stock Valuation Price Trend On-line resource: http://finance.yahoo.com/

Sources of Capital A comparison between stocks and bonds Item Bonds (debt) Stock (equity) Cost to Company Cheaper More Expensive Risk to company Higher (can cause bankruptcy) Lower (can’t cause bankruptcy) Return to Buyer Risk to Buyer (depends on rating) (price fluctuates more)

A comparison between stocks and bonds 10 year price performance 5/26/2018 A comparison between stocks and bonds 10 year price performance CUBIC Fundamentals of Finance

Question Consider two business ventures with the following cash flows. Which should you invest in? Guess.. Note: required return is 15% Cash Flows Venture “A” Venture “B” Cash Flow Now -10,000 -40,000 Cash Flow Year 1 6,000 10,000 Cash Flow Year 2 5,000 11,000 Cash Flow Year 3 4,000 12,000 Cash Flow Year 4 3,000 35,000 Venture “A” Venture “B”

4-0 Capital Budgeting Topics 4-1 Introduction to Capital Budgeting 4-2 Capital Budgeting Decision Tools 4-3 Determining Relevant Cash Flows 4-4 Developing Cash Flow Projections 4-5 Case #2: Business Start-up Decision: Naturally Wrapped Food Stand

Capital Budgeting 4-1 Introduction to Capital Budgeting Allocating scarce company resources to the highest use Types of projects Replacement projects Efficiency projects New business Expand existing business Go into a new business Research and development Independent versus mutually exclusive projects

Capital Budgeting 4-1 Introduction to Capital Budgeting Decision tools: Payback (breakeven) Internal Rate of Return (IRR) Comment on direction of cash flows: Positive (+) is a cash inflow Negative (-) is a cash outflow

Capital Budgeting 4-2 Capital Budgeting Decision Tools Payback Definition: period of time it takes to recover the initial cost of a project—then compare to company standard Example Cash Flow $ Cash Flow Year 0 (start) -10,000 Cash Flow Year 1 +6,000 Cash Flow Year 2 +5,000 Cash Flow Year 3 +4,000 Cash Flow Year 4 +3,000

Capital Budgeting 4-2 Capital Budgeting Decision Tools Payback Decision criteria Independent projects: Fund all projects with payback less than company standard. Mutually exclusive projects: Fund project with fastest payback less than company standard.

Capital Budgeting 4-2 Capital Budgeting Decision Tools Payback Advantages Simple Focus on liquidity (when initial investment is returned) Good for low cost, short term projects Disadvantages Ignores cash flows after payback period Company payback standard is arbitrary Ignores time value of money Poor for high cost, long term projects

Capital Budgeting 4-2 Capital Budgeting Decision Tools Internal Rate of Return Definition The average return associated with given cash flows; Example Cash Flow $ Cash Flow Year 0 (start) -10,000 Cash Flow Year 1 +6,000 Cash Flow Year 2 +5,000 Cash Flow Year 3 +4,000 Cash Flow Year 4 +3,000

Capital Budgeting 4-2 Capital Budgeting Internal Rate of Return (IRR) Working with a calculator Setting decimals Clearing memory Checking periods per year TVM buttons

Capital Budgeting 4-2 Capital Budgeting Decision Tools Internal Rate of Return (IRR) Working with a calculator Cash Flow $ CF 0 -10,000 CF 1 +6,000 CF 2 +5,000 CF 3 +4,000 CF 4 +3,000

Capital Budgeting 4-2 Capital Budgeting Decision Tools Internal Rate of Return Decision Criteria: Independent projects: Fund all projects with IRR greater than company hurdle rate. Mutually exclusive projects: Fund project with highest IRR greater than company hurdle rate.

Capital Budgeting 4-2 Capital Budgeting Decision Tools Internal Rate of Return Advantages Usually similar results to NPV Considers all cash flows IRR rate can be compared to risk, cost of capital (“hurdle rate”) Disadvantages Can give multiple solutions (rare) Can be unrealistic with reinvestment assumption

Capital Budgeting 4-2 Capital Budgeting Decision Tools Comparing 2 projects: Apply each decision tool and decide which project is best. Cash Flows Venture “A” Venture “B” Cash Flow Now -10,000 -40,000 Cash Flow Year 1 6,000 10,000 Cash Flow Year 2 5,000 11,000 Cash Flow Year 3 4,000 12,000 Cash Flow Year 4 3,000 35,000

3 years 3.2 years 4 years More than 4 years Question What is the payback period for the following cash flows? Cash Flows Venture “B” Cash Flow Now -40,000 Cash Flow Year 1 10,000 Cash Flow Year 2 11,000 Cash Flow Year 3 12,000 Cash Flow Year 4 35,000 3 years 3.2 years 4 years More than 4 years

What is the IRR for the following cash flows? Question What is the IRR for the following cash flows? Cash Flows Venture “B” Cash Flow Now -40,000 Cash Flow Year 1 10,000 Cash Flow Year 2 11,000 Cash Flow Year 3 12,000 Cash Flow Year 4 35,000 -14.1% +11.2% +19.8% +29.4%

Capital Budgeting 4-2 Capital Budgeting Decision Tools Comparing 2 projects: Apply each decision tool and decide which project is best. Criteria Venture “A” Venture “B” Decision? Best? Payback < 2 years A, B IRR 32.98%

Capital Budgeting 4-3 Determining Relevant Cash Flows Basic Principle: include all incremental (marginal) cash flows associated with the project The stand alone principle Sunk costs Opportunity costs Erosion, cannibalization Net working capital changes

Capital Budgeting 4-4 Developing Cash Flow Projections Cash flows measured over time and divided into 3 categories: Initial investment expenses Project cost Net working capital needed Annual operating cash flows OCF = EBIT + Dep – Tax Terminal year cash flows (if given a fixed project life) Salvage value recovery (after tax) Recovery of working capital

Capital Budgeting 4-5 Business Start-up Case Evaluation of proposals to fund new businesses by venture capitalists (“sharks”) on ABC show “Shark Tank”. http://www.youtube.com/watch?v=g31M8WmKeqg https://www.youtube.com/watch?v=no86yZVXMjA&nohtml5=False http://www.youtube.com/watch?v=3UuFR4Y4uw8

Module Wrap Up: Corporate Finance Resources Textbooks “Essentials of Corporate Finance”, 8th edition, by Ross, Westerfield, Jordan, McGraw Hill, 2014. (expensive text) “Finance for Non-Financial Managers”, by Siciliano, 2015, McGraw-Hill. (inexpensive paperback)

Module Wrap Up: Corporate Finance Resources On-line Yahoo Finance http://finance.yahoo.com/ MSN MoneyCentral http://www.msn.com/en-us/money Wall Street Journal On-line http://online.wsj.com/home-page