Professional Documents
Culture Documents
Five pillars:
Corporate financial management
Capital markets and funding
Cash and liquidity management
Risk management
Treasury operations and controls
Treasurys linkage to managing enterprise risk:
Slide 28
Financial health of firm (balance sheet view)
Enough working capital? Funding decision? Short term long-term? Dividend ? What
assets to invest? Solvent?
Financial health of firm (cash flow view)
(1) Financing: Cash raised from investors
(2) Allocation: Cash invested in firm
(3) Return on investment: Cash generated by operations
(4a) Allocation: Cash reinvested
(4b) Distributing: Cash returned to investors (interest or dividends)
Advisory role:
Decisions, transactions made by divisions, subsidiaries
Agency role:
Week 2
Who Measures Performance?
Management (compare with targets, budgets, peers)
Business owners (e.g. institutional shareholders)
Investors (e.g. individual shareholders)
Financials institutions (e.g. lenders), other creditors
Analysts (e.g. stock brokers)
Regulators (e.g. ASIC, ASX) disclosure etc.
The Firms Cash Flows
Operating Cash Flows: cash flows directly related to the production and sale of a
firms products and services.
Investing Cash Flows: cash flows associated with the purchase and sale of non
current assets and business interests.
Financing Cash Flows: cash flows that result from debt and equity financing
transactions.
Horizontal analysis: Trend analysis
Vertical analysis: express a percentage of significance
Pro Forma Statements limitations
Historical data (not necessarily an indication of future)
Some variables may be forced to take a desired value
Sometimes it is difficult to break the fixed and variable costs
Need to make adjustments to account for changes in the firms strategy
Du Pont analysis
ROE=leveraged multiplier*ROA ROA=net utilization*net profit margin
Limitations of Ratios
Historical data (not necessarily an indication of future)
Poor or inadequate accounting methods
Inflation or changes to fair values
Changes in accounting methods
Existence of unusual items during a financial year e.g.. losses by fire
Year-end may not be typical of firms position during year
Different year ends may mean peer ratios not comparable
Management changes
Changes to economy, industry-wide recession, etc
OCF = (Revenue Costs Depreciation &/or Amortisation)x (1 T) + Depreciation
&/or Amortisation
Free Cash Flow (FCF) is the amount of cash flow available for distribution to debt
and equity holders after:
1.meeting all operating needs
The hurdle rate should be higher for riskier projects and reflect the financing mix
used -owners funds (equity) or borrowed money (debt)
2.
WACC = (E/(D+E)) x Re + (D /(D+E)) x Rd x (1-Tc)
The WACC can be used throughout the firm as the companywide cost of capital for
new investments that
1.are of comparable risk to the rest of the firm, and
2.that will not alter the firms debt-equity ratio.
Can the existing required rate of return be used to assess the required rate of return
on a firms new investment projects?
Use risk-adjusted discount rate (RADR) or adjust cash flow (certainty equivalent
method)
3.
Certainty-equivalent approach
1.Adjust all cash flows by certainty-equivalent coefficients to get certain cash flows
2.Discount the certain cash flows by the risk-free rate of interest
3.Apply normal capital-budgeting criteria
Scenario Analysis is a risk analysis technique which considers the effect on the NPV
of simultaneously changing multiple assumptions.
Definition of Stress Test analysis:
Stress testing is a form of deliberately extreme testing used to determine the stability
of the expected outcomes to a project or a company's valuation.
It involves testing beyond normal operational, economic or financial conditions to
identify results that may involve extreme outcomes.
Week 4
NPV shortcoming:
Standard NPV analysis fails to take into account the value of managerial flexibility
The real world is characterized by change, uncertainty and competitive interactions
=>
A real option is the right, but not the obligation, to take an action ( e.g., deferring,
expanding, contracting, or abandoning ) at a predetermined cost called the exercise
price, for a predetermined period of time the life of the option.
When there is high uncertainty and when managers have flexibility to respond to it,
real options are important. But the value of real options relative to NPV is large when
the NPV is close to zero.
the appropriate mind-set is to recognize that the net present value technique
systematically undervalues everything because it fails to capture the value of
flexibility
while the value of flexibility is always positive, the price that you have to pay for it
often exceeds its value
Option to expand operations
Buy a call option
Option to abandon
Buy a put option
Decision Tree Analysis: See questions
Advantages:
Successfully explains valuation of multiple companies believed to have substantial
real options
Explain some of the difference in markets not accounted for by traditional
techniques
Disadvantage:
Real Options can be miscalculated / mis-used and mis-value a company
Week 5
The cost of debt is the market interest rate that the firm has to pay on its borrowing.
It will depend upon three components:
The general level of interest rates
The default premium
Risk that firm will fail to make its obligated debt payments, including interest
expense or principal
The liquidity premium
To estimating bond ratings, use interest coverage ratio (EBIT/Interest expense)
Note: This is highly simplified !
If firm has bonds outstanding, and bonds are traded, yield to maturity on long-term,
straight (no special features) bond can be used as interest rate
If firm is rated, use rating and typical default spread on bonds with that rating to
estimate cost of debt
If firm is not rated, and has recently borrowed long term from bank, use interest rate
on borrowing
The cost of equity is
the required rate of return given the risk
inclusive of both dividend yield and price appreciation (capital growth)
1. CAPM
Estimate beta: regress stock return against market
Estimation period
Longer periods provide more data, but firms change
Shorter periods can be affected more easily by significant firm-specific events during
the period
Decide on return interval (daily, weekly etc.)
Shorter intervals yield more observations, but suffer from more noise
An alternative to cash dividend where the objective is to increase the price per share
rather than paying a dividend
Why Companies Repurchase Shares?
Dividend substitution (taxation driven)
If capital gains are taxed more favourablythan dividends
Improved performance measures
EPS may rise, but if cash is returned rather than used to retire debt, financial risk is
increased and P/E ratio along with share price may fall
Signaling and undervaluation
Managers buying back company stock indicates that they believe the stock is
undervalued by the market
Alternatively, a buy-back announcement could be accompanied by some new
information, e.g. sale of unprofitable asset/division
Resource allocation and agency costs
Share repurchase returns capital to shareholders, who can reallocate funds into
profitable activities through the capital market.
Reduces the potential for managers to inefficiently use free cash (i.e. reduces agency
costs).
Financial flexibility
Payment of dividends is a long-term commitment, and sudden major changes
(especially decreases) in dividend policy are unappreciated by market.
Buy-backs offer an alternative way to make distributions that may not be permanent.
Employee share options
Unlike paying dividends, share repurchases do not lead to the ex-dividend price
drop-off.
Option holders (typically management) prefer a share repurchase to a dividend
payout as a means of distributing profits to shareholders.
=DIV(1-Td*)
Td*=(Td-Tg)/(1-Tg)
This measures the additional tax paid by the investor per dollar of after-tax capital
gains income that is instead received as a dividend.
Dividend Capture and Tax Clienteles
The preference for share repurchases rather than dividends depends on the difference
between the dividend tax rate and the capital gains tax rate
Tax rates vary by income, by jurisdiction, and by whether the stock is held in a
retirement account
Given these differences, firms may attract different groups of investors depending on
their dividend policy
Resulting in clientele effects
Clientele Effect
When the dividend policy of a firm reflects the tax preference of its investor clientele
Individuals in the highest tax brackets have a preference for stocks that pay no or low
dividends, whereas tax-free investors and corporations have a preference for stocks
with high dividends.
Imputation Tax System
Slide 49 50
Week 7
Cash Conversion Cycle
A firm can minimize its working capital by
speeding up collection on sales
increasing inventory turns, and
slowing down the disbursement of cash.
Graph Slide 11
Operating Cycle: The time from the beginning of the production process to collection
of cash from the sale of the finished product
CCC = the amount of time the firms resources are tied up.
Calculated by:
CCC = OC APP OR
CCC = AAI + ACP APP
Where:
OC = Operating cycle
APP = Average payment period
AAI = Average age of inventory
ACP = Average collection period
Graph: slide 14
Requires management of:
Inventory (raw inventory and finished goods) (more turnover)
Credit terms of suppliers (accounts payable management)(pay payable slowly)
Week 8
What is Structured Finance ?
Financing techniques tailored to special needs or constraints of issuers or investors
Hybrid Instruments combines elements of traditional instruments into a single
complex instrument
Corporate Bonds
Long term debt instruments used by the corporate sector.
The longer the maturity, the higher the coupon rate.
The larger the issue, the lower the coupon rate.
The riskier the issuer, the higher the coupon rate.
Maturity
This is the number of years over which the issuer has promised to meet the
conditions of the obligation
Principal
The principal of a bond is the amount that the issuer agrees to repay the bondholder
at the maturity date
Coupon = Yield PV = FV Par
Coupon < Yield PV < FV Discount
Capital Notes
Capital Notes are debt securities that have equity like features attached
Convertible Bond
A corporate bond with a provision that gives the bondholder an option to convert each
bond owned into a fixed number of shares of common stock
Conversion Ratio --The number of shares of common stock into which a convertible
security can be
converted. It is equal to the face value of the convertible security divided by the
conversion price.
Conversion Price --The price per share at which common stock will be exchanged for
a convertible security. It is equal to the face value of the convertible security divided
by the conversion ratio.
If convert at a fixed dollar price
the number of shares you receive depends on the market price of the shares at
conversion
Securities are converted at a higher price than if they would have been directly
issued. This has the impact of reducing the dilution effect
Information signaling
Company with good future prospects can issue stock through the back door by
issuing convertible bonds
Avoids negative signal of issuing stock directly
Since prospects are good, bonds will likely be converted into equity, which is what
the company wants to issue
Asset substitution (or bait-and-switch). Firm issues low cost straight debt, then
invests in risky projects
Bondholders suspect this, so they charge high interest rates
Convertible debt allows bondholders to share in upside potential, so it has low rate.
Preference shares
A preference share is a 'hybrid' security, meaning it has features of both debt and
equity
Debt characteristics
pays a regular defined income stream, and
generally has a fixed maturity date
Equity characteristics
pays income in the form of dividends, and
generally converts into ordinary shares at some future point
Advantages
Dividend obligation not contractual Avoids dilution of common stock
Avoids large repayment of principal
Disadvantages
Preferred dividends not tax deductible, so typically costs more than debt
Increases financial leverage, and hence the firms cost of common equity
Week 9
The Basic Share Dividend Valuation Equation
Discount all dividends
If no growth rate, =Divt+1/Re or Divt+1+P1/1+Re
If constant growth rate, =Divt+1/Re-g
If differential growth rate, ````````
Free Cash Flow Valuation Model
To find the value of the ordinary shares :
Vs= VcVD-Vp
Inventory Storage
Long-term storage of inventory is another strategy for offsetting commodity price
risk.
Long-term storage of inventory also requires a substantial cash outlay upfront.
Hedging and Risk Reduction
Risks to a business which may be hedged?
Price fluctuations
Currency and interest rate fluctuations Political instability
Weather changes
Cash shortfalls & Financial distress
Credit risk
Natural hedges need to be identified and then if the resulting exposure is outside the
risk appetite of the company, then derivative contracts such as forwards and options,
can be used to reduce the exposure to the desired level
Example: pricing gold forward
Buy a replicating strategy:
Buy Commodity on the spot market for cash, and carry it into the future (store it);
Borrow the cash needed to fund the purchase, and repay the loan on date t = 1.
Note that the interest rate is your cost of carry:
Borrowing cash on date t = 0 allows you to carry the Commodity forward to date t =
1;
The interest rate is the cost that you pay for carrying the commodity forward.
Week 11
Types of Foreign Exchange Risk
Transaction
the effect of exchange rate moves on transactional account exposure related to
receivables (export contracts), payables
(import contracts) or repatriation of dividends.
Translation:
balance sheet exchange rate risk and relates exchange rate moves to the valuation of
a foreign subsidiary and, in turn, to the consolidation of a foreign subsidiary to the
parent companys balance sheet.
Economic:
the risk to the firms present value of future operating cash flows from exchange rate
movements
the effect of exchange rate changes on revenues (domestic sales and exports) and
operating expenses (cost of domestic inputs and imports).
Falling exchange rates: increase costs for importation
the cost of servicing foreign currency debt increases
for the business, the cost of investing overseas could increase
Rising exchange rate
it can decrease the value of investment in foreign subsidiaries and monetary assets
(when translating the value of such assets into the domestic currency)
Forward Exchange Rate
The exchange rate set in a currency forward contract: it applies to an exchange that
will occur in the future
Interest rate parity
Based on relative interest rates
Purchasing power parity
Based on relative inflation rates
Cash-and-Carry Strategy
A strategy used to lock in the future cost of an asset by buying the asset for cash
today and
carrying it until a future date
Impact of changes in domestic interest rates
As Australian interest rates increase relative to offshore rates, then the cost of hedging
imports will increase and the cost of hedging exports will
fall
Adverse movement in interest rates can:
increase borrowing costs for borrowers reduce returns for investors
reduce the net present value (NPV) of organisations due to the effect of changes in
the discount rate (interest rate) on the value of financial instruments, hedges and the
return on projects.
Dollar Gap
GAP = G = Rate sensitive assets rate sensitive liabilities
Positive RSA > RSL Increase Increase
Positive RSA > RSL Decrease Decrease
Negative RSA < RSL Increase Decrease
Negative RSA < RSL Decrease Increase
Interest Rate Risk Measurement: Duration
Duration
Duration of equity=DA*Asset/all+DL*Liability/All
Change in value=-D*Change in interest rate*value/1+interest rate
Duration Gap Change in interest rate change in equity
Positive Increase Decrease
Positive Decrease Increase
Negative Increase Increase
Negative Decrease Decrease
Example: Slide 51
Week 12
Treasury Management Systems
Key aspects
Dealing (segn of duties, security)
Cash management (balance and transaction management, forecasting,reconciliations)
Risk management
Reporting
Accounting
Market risk is the uncertainty resulting from changes in market prices.
Why is Market risk measurement important ?
management information
setting risk limits (risk appetite)
resource allocation
performance evaluation
Regulatory requirements (Responsible Officers)
Techniques used to measure and manage risk
Sensitivity test
Stress testing
Duration
Var
Credit risk:
The risk of loss through the default on financial obligations
Default risk:
The risk that the issuer will not fulfill its financial obligations to the investor/creditor
in accordance with the terms of the obligation
Five Cs of credit assessment
Character condition capacity capital collateral
Z-score