Business FinanceObjectives :To Develop an understanding ofvPrinciples of financing Decisions and appropriate Capital structuresvFinancial implications of a change in size or circumstancesvPrinciples of risk managementvEffective management of Foreign currency and related treasury transactionsvSource of Capital and Capital ManagementWhat is Business Finance ?Financial Planning & Control toAchieve the Financial Objectives of the FirmBusiness FinanceBusiness FinanceFinancial Management is therefore all aboutResidual Cash FlowsWhich accrue to Ordinary ShareholdersHence the importance of theTime Value of MoneyOrPresent Value Business FinancePresent ValueFuture cash flows discounted back to todaysValue1/(1+R)nR = The appropriate Discount Rate(Weighted Average Cost of Capital)Most Important DecisionvThe Investment Decision often viewed as the most important decision.vDecision made now affects future returns.vGenerally cant reverse decision without significant loss of initial investment.Financial Implications of a change in Firm SizevInternal Chapter 8 Capital BudgetingvExternalChapter 11 Valuation of CompaniesChapter 12 Mergers & Take-oversInternal GrowthWhat Constitutes Internal Growth ?ProductvMarket Volume vServiceInternal GrowthLarge Capital Expenditure DecisionInvestmenti.e.Major Outlay At Start of ProjectInvestment in WCProjected Stream of InflowsTerminal ValuesInternal GrowthThe key Question:Is this Project Worth the InvestmentBusiness Finance seeks to answer this throughvComparative CostsvAccounting Rate of Return (ARR)vPaybackvDiscounted Cash FlowsInternal GrowthAccounting Rate of ReturnPage 207Average Annual Profits* 100% Average InvestmentPluses:Easy to calculate & UnderstandMinus: Accounting Profit not Cash FlowExample Page 207Internal GrowthPaybackPage 209How Long to repayment of Initial InvestmentPluses: Easy/Liquidity Mgt/ Caution/Risk MgtMinuses:No Cash post PB/No TVOM/TimingPage 211Internal GrowthComparative CostPage 211vProject with lowest cost winsvIgnores Time Value of MoneyProject Cash FlowsInternal GrowthDiscounted Cash Flows (DCF)Page 212Internal Rate of ReturnDiscounts all CF at Rate for Zero NPVvPluses:Cashflow/TVOMvMinuses:Not unique/Magnitude of CF/Fails to select between Mutually ExclusiveInternal GrowthDiscounted Cash Flows (DCF)Page 217Net Present ValueDiscounts all CF at Cost of CapitalvPluses:Cashflow;TVOM;Magnitude of CFvMinuses: None!Page 218Internal GrowthExam TipBe able to perform these calculationsvOrganise your answer vState Assumptions ClearlyvBe PracticalInternal GrowthCapital RationingFunds not sufficient to accept all +NPV ProjectsNo Leverage availableIssue cost too highBorrowing LimitsRank Via Profitability IndexInternal GrowthvProfitability Index = NPV . Outlay in Year of Rationing NPV = Project NPVOutlay =Project Outlay Internal GrowthOther Issues / Factors to be ConsideredvCapital AllowancesvBusiness Risk (Operating Gearing)vTiming of Cash FlowsvRelevant Cash Flows (Ignore Sunk Costs)vRisk Adjusted Cost Of CapitalvSensitivity AnalysisvInflation (?)Internal GrowthRisk and UncertaintyvRisk Adjusted Cost of Capital = CAPMObjectivity an issuevTime limit on Cash FlowsWeights short projectsvSensitivity AnalysisInternal GrowthSensitivity AnalysisvAbsolute sumvA RatevCertainty Equivalent ApproachvProbability TheoryvSimulation ModelsInternal GrowthLease V BuyTraditional Method (Page 238)vAcquisition DecisionIs Asset worth havingNPV assuming outright purchaseIf NPV= + Go to Financing DecisionvFinancing DecisionLease or BuyUse cost of Borrowings as Discount RateInternal GrowthLease V BuyAlternative Method (Page 241)vFinancing DecisionLeasing V Outright purchase using after tax cost of borrowings as COCvInvestment DecisionOperating CF using WACC and incorporate PV of Best Financing DecisionInternal GrowthAsset Replacement DecisionsvIdentical NewReplacement cycle to min PV operating CostsUse Equivalent Annual Cost (No Inflation)i.e. PV Cost * Annuity Factor for life of asset(See page 242)vOtherwise Lowest Common Multiple or Finite method eg 15 yearsInternal GrowthAsset Replacement DecisionsDifferent AssetWhen to replace not how often to give the lowest total PV CostEquivalent Annual Cost of New Machine in perpetuity plus PV of Old MachineSee page 243Valuation of CompaniesvReasons for ValuationvQuoted and Unquoted companiesvValuation MethodsvShare Prices & Market EfficencyThe Valuation of Quoted & Unquoted Companies Valuation of Shares is necessary when Quoted CompanyvTake-over BidvStock Market price is not perceived as fair valuevPart Sale Management BuyoutUnquoted Company(Private Company)vTaxationvMerger vFlotationvSecurity for LoanvShare OptionUnquoted CompaniesvDiscount the P/EvLoss of Key EmployeesvPremium for controlling interestvGearingThe Valuation of Quoted & Unquoted CompaniesMethods of ValuationvP/E Earnings MethodvAccounting Rate of ReturnvNet assets methodvDividend yield methodvCAPM (plus Div yield method)vSuper Profits MethodvDiscounted Future ProfitsChoice of method depends on size of shareholding being valued i.e. reason for valuationThe Valuation of Quoted & Unquoted CompaniesMethod of Valuation is dependent on decision criteriaThe Valuation of Quoted & Unquoted CompaniesP/E Ratio Earnings Method of ValuationP/E relates earnings per share to Share ValueP/E = Market Value per share Earnings per ShareMarket Value per share = P/E * EPSMarket Value = Earnings * P/EThe Valuation of Quoted & Unquoted CompaniesP/E Ratio Earnings Method of ValuationEPS can be historical of prospective (Exam)Higher the P/E the higher the PriceHigh P/E may indicate:Expectation of EPS future growthSecurity of EarningsStatusQuoted Company (P/E of Unquoted Co 50% of Quoted company)The Valuation of Quoted & Unquoted CompaniesP/E Ratio Earnings Method of Valuation Guidelines:vUnquoted Co P/E is ultimately negotiation : Look atvGeneral economies and financial conditionsvType of industry and its prospectsvSize of Co within the industry & overall marketvMarketabilityvDiversity of ShareholdingsvSustainability and reliability of ProfitsvAsset Backing and LiquidityvNature of AssetsvGearingvKey Individual &/or Skill reliance The Valuation of Quoted & Unquoted CompaniesThe Accounting Rate of Return MethodValue = Estimated Future ProfitsReq. RoR on Cap EmpvAdjust Profits for changes post acquisition in:vDirectors RemunerationvInterest Charges (Debt Restructuring)vCharge for notional Rent where existing properties will be soldvProduct &/or management rationalisationThe Valuation of Quoted & Unquoted CompaniesThe Accounting Rate of Return MethodvUsed to determine the maximum Price as it represents desired return post acquisitionThe Valuation of Quoted & Unquoted CompaniesNet Assets MethodValue of Shares in a particular Net Tangible assets attributable to that class by the number of shares in that classExclude intangibles unless they have a market valueAsset values vary and this is the biggest difficulty with this methodThe Valuation of Quoted & Unquoted CompaniesNet Assets MethodvProfessional ValuationvAre all liabilities reflected in the Net AssetsvAre Current assets valued properlyvGoing concern V Break up valuevCost of Rationalisation post acquisitionvOff Balance Sheet issuesThe Valuation of Quoted & Unquoted CompaniesNet Assets Method use when:vSecurity factor i.e. min value of companyvMeasure of comparison in a mergervCo A low asset backingvCo B high asset backingvCo B would expect a premium for strong asset basePage 369The Valuation of Quoted & Unquoted CompaniesDividend Yield MethodValue = Dividend in PenceExpected Dividend Yield %Minority interest valuationOne can use the growth model to reflect future dividendvMV = Do(1+G)(R-G)Do = Current Div G = Growth R = Cost of CapitalThe Valuation of Quoted & Unquoted CompaniesCAPM MethodGood for pricing shares for Stock exchange listingUse it in conjunction with Div Yield method Ke = Rf + B(Rm-Rf)Ke = cost of equity = cost of capital for Div YieldRf = Risk Free Rate (Treasury Bills)B = Companys BetaRm = Market ReturnThe Valuation of Quoted & Unquoted CompaniesCombination of Earnings & Net Asset BasisAcquisition on going concern basis but some assets will be soldvUse Earnings methodvadjust for NRV of assets soldThe Valuation of Quoted & Unquoted CompaniesvSuper Profits (Out of Fashion)Excess of expected profits over fair return used to calculate goodwillGoodwill is then added to Net assetsvDiscounted Future ProfitsDiscount the future cash flows post acquisition investment at appropriate cost of CapitalThe Valuation of Quoted & Unquoted CompaniesShare Price & Market EfficiencyCharting & Technical Analysis to predict share priceEfficient Market Hypothesis The degree to which information is reflected in the share pricevWeak FormvSemi Strong FormvStrong FormMergers & Take-oversvProcessvDue diligencevMgt Buy-outsvListing RulesMergers and Take-oversTake-OvervPurchase of a controlling interestMergervAn amalgamation of two companies to form a single companyThis distinction is not always clearMergers and Take-oversReason for M&A is synergisticOperating EconomiesManagement AcquisitionDiversificationAsset Backing Quality of earnings (portfolio impact)Finance and liquidityGrowthMarket Share / removal of CompetitionIncreases EPSEntry into new marketTaxDefensiveMergers and Take-oversTypes of M&AHorizontalVerticalConglomerateMergers and Take-oversPurchase ConsiderationvCash = Buy out the other shareholdersvPaper = Issuing new shares (Paper) as considerationMergers and Take-oversFactors affecting the ChoicevAcquiring CompanyDilution of EPSCost to the CompanyGearingControlIncrease in Authorised share capitalIncrease in Borrowing LimitsMergers and Take-oversFactors affecting the ChoicevAcquired CompanyTaxation vCash immediate CGT/ Shares postponed CGTIncomevMaintenance V immediate capital GainFuture investmentsBe Aware of Mezzanine FinanceMergers and Take-oversDefence against a Take-OvervDefence tactics are governed by city code on M&AvDirectors must at all times act in best interest of shareholdersPrepare a defending circularvMk price of acquirer to high not sustainablevMk price of acquirer to low not fair valueProfit ForecastsRevalue assetsHigher DividendsMergers and Take-oversDefence against a Take-OverManagement ChangesWhite Knight (Same info to all parties)Sell crown jewels (Code doesnt allow this)Reverse take-over (Packman strategy)Golden Parachute (Code disclosure)Discredit offerRefer to monopolies & mergers commissionMergers and Take-oversDefence against a Take-OvervCity code does not allowSelling or acquiring material amount of assetsNon normal contractsIssuing more shares or securitiesMergers and Take-oversAdvising the bidding and target companyvRecommending a PriceVarious valuation techniquesvEvaluating an existing offerMax and min valuesvEvaluate the offerVarious valuation techniquesAn AcquisitionvIdentification of acquisition criteriavHeads of AgreementvDue DiligencevSale & Purchase agreementPost AcquisitionStrategicCulturalOperationalDue diligencevAccountingvLegalvcommercialvTechnicalPage 417Mergers and Take-oversManagement BuyoutsvPartiesManagement Team acquisitionDirectors DisinvestmentFinancial backers of buyout teamMergers and Take-oversManagement BuyoutsvReasonsSub peripheral to main activesLoss making SubParent Co needs cashNew owner of group rationalisingBetter corporation and price agreementRetiring management (private co)Mergers and Take-oversMotivations for MBOMore likely to succeedRisksvEquity InvestmentvPersonal wealth exposurevPersonal borrowing riskRewardsvLarge Long term pay offvFlotation if successfulvOwner managedvOnly option to redundancyMergers and Take-oversManagement Buyouts Institutional investorDoes Mgt Team have full range of skillsWhy is Co for saleBusiness Plan What is being boughtWhat is the price and is it reasonableMgt own investmentLong Term stake with exit mechanismMergers and Take-oversManagement Buyouts ProblemsFair priceTaxation & LegalChanging working practicesCash FlowsExisting pension rightsBoard formationLoss of key employees