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

2. 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. 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

4. 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

5. 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

6. 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

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

8. 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

9. Sources of Capital 3-2 Bonds
5/26/2018
Sources of Capital 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

10. 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

11. 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

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

13. 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

14. 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:

15. 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.

16. 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.

17. 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

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

19. 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

20. 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

21. Sources of Capital 3-3 Stocks and Stock Valuation
Stock Quotes
On-line resource:

22. Sources of Capital 3-3 Stocks and Stock Valuation
Price Trend
On-line resource:

23. 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)

24. 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

25. 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”

26. 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

27. 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

28. 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

29. 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) ,000
Cash Flow Year ,000
Cash Flow Year ,000
Cash Flow Year ,000
Cash Flow Year ,000

30. 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.

31. 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

33. 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) ,000
Cash Flow Year ,000
Cash Flow Year ,000
Cash Flow Year ,000
Cash Flow Year ,000

34. 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

35. Capital Budgeting 4-2 Capital Budgeting Decision Tools
Internal Rate of Return (IRR)
Working with a calculator
Cash Flow $
CF ,000
CF ,000
CF ,000
CF ,000
CF ,000

36. 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.

37. 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

38. 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

39. 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

40. 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%

41. 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%

42. 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

43. 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

44. Capital Budgeting 4-5 Business Start-up Case
Evaluation of proposals to fund new businesses by venture capitalists (“sharks”) on ABC show “Shark Tank”.

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

46. Module Wrap Up: Corporate Finance
Resources
On-line
Yahoo Finance
MSN MoneyCentral
Wall Street Journal On-line