Corporate issuers, Equity and Fixed
income
Corporate issuers
Introduction (brief notes of section)
Corporate governance is the system of internal control and procedures by which individual
companies are managed. Provides a framework that defines rights, roles and responsibilities of
various groups within an org Minimise conflicting interests
Typically reflects either shareholder theory or stakeholder theory
Two tier board of director includes: a supervisory board (non-execs) and management (execs)
Principal agent relationship
Proxy voting- Authorise someone else to vote on their behalf
A amendment to corporate bylaws take place in EGM- significant changes to a company
Cumulative voting- accumulate their shares for a single candidate in an election involving more
than one director. Raises the likelihood that the minority shareholders will be represented by at
least one director on the board. Not permitted in some countries
Agreed elements of board of directors are- duty of care and duty of loyalty
Board of directors’ committees: usually ensure enterprise risk management
o Audit committee
o Governance
o Remuneration
o Nomination
o Risk
o Investment
A proxy contest- persuade to vote activists (group) onto the board
Tender offer- Sell to individuals (managerial) who want to control
Uses of capital
Steps in capital allocation process
1. Idea generation
2. Investment analysis
3. Capital allocation planning
4. Monitoring and post audit
Types of capital projects
1. Replacement projects- maintain existing size of business
2. Expansions projects- expand business
3. New products and services-New stakeholder involvement
4. Regulatory, safety and environment projects-Might not generate revenue
Capital allocation assumptions
Decisions based on cash flows- done on accrual basis and subtract non-cash expenses such as
depreciation
Cash flows are not accounting net income or operating income. Econ income includes cash flows
plus change in company’s market value
, Cash flows are based on opportunity costs
Cash flows are analysed on an after-tax basis
Timing of cash flows is crucial
Financing costs are ignored- this is reflected in the required rate of returns
Key concepts of capital allocation
NPV IS CF BY OPPORTUNTIY COSTS
IF NPV VS IRR go with NPV
Sunk costs- have already been incurred. Decisions should only reflect current and future cash
flows
Opportunity costs- Next best use
Incremental cash flow- cash flow with a decision minus cash flow without the decision.
Basically, cash flow realised because of the decision to do X
Conventional cash flows vs non-conventional cash flows:
o Conventional- starts with initial outflow followed by a series of inflows c
o Non-conventional- Starts with initial outflow not followed by inflows only can be a
combination of both. More than once changing form positive to negative
unconventional
Types of projects
Independent projects vs mutually exclusive projects- cash flows are independent of each other.
Can invest in A and B but not both
Project sequencing- Might invest today and if results are good invest in the next stage
Unlimited funds vs capital rationing- Unlimited funds environment assumes the company can
raise the funds it wants for all profitable projects by paying required rate of return. Rationing-
have a fixed amount of funds- must choose what is going to max returns to shareholders
If have to choose between NPV and IRR- NPV wins
Sources of finance
Internal financing
1. Operating cash flows
2. Accounts payable- 2/10, net 30 mean 2% discount if pay in ten days or all due on the 30 th
3. Accounts receivable- quicker receivable
4. Inventory- JIT
5. Marketable security
Financial intermediaries
1. Uncommitted lines of credit- not reliable and unofficial. Require no compensation other than IR
2. Committed lines of credit- Less than a full year known as regular lines. SR liabilities
3. Revolving credit agreement- Formal agreement that are over many years. Payback periodically
4. Secured asset loan- Lien against an asset as part of the loan
5. Factoring- Sell its AR
6. Web-based and non-banking
Capital markets
1. Commercial paper- SR and unsecured. Used by well-known companies. Few days’-270 days.
2. Debt and equity
3. Leasing obligations
, A drag on liquidity is when receipts lag creating pressure from lack of funds
Pull on liquidity is when disbursements are paid to quickly
Intro-Cost of capital
Cost of capital
The rate of return that the supplier of capital requires as compensation for the capital
Have debt, equity and hybrid which each make up a component of cost of capital
Must calculate the marginal cost of debt and weighted avg it
WACC- Weighted average cost of capital referred to as marginal cost of capital because it is the
cost that a company incurs for additional capital
Cost of debt
Cost of debt is equal to risk free plus premium for risk. Two methods:
o Yield to maturity- what the rate is if buy bond and hold to maturity
o Debt-rating-use yield on comparable bond. Rate of similar bond(1-Tax)= After tax COD.
Known as matrix pricing
Usually less costly than equity and pref
Cost of equity
Estimation difficult due to the uncertainty of future cash flows in the amounts and timing
Two methods:
o CAPM
o Bond yield plus risk premium (BYPRP)- RD+ risk premium
Estimating Beta
For public companies use least squared regression- known as unadjusted or raw historic beta
Found that beta usually regresses towards 1.
Adjusted beta= (2/3) (1.3) + (1/3) (1.0)
When D-E raises asset beta remains the same and equity beta increases
Capital structure
Modigliani-Miller assumptions
Theory that a firm can’t change firm value by simply changing the capital structure
Assumptions:
o Homogeneous expectations on returns- agree on given investments expected CF
o Perfect capital markets- No transaction costs, taxes, bankruptcy costs and everyone has
the same info
o Risk free rate- borrow and lend at rf
o No agency cost- Managers always act to shareholder maximisation
o Independent decisions- Financing+ investment decisions are independent of each other
MM Proposition I without taxes: Capital structure irrelevant:
o Uses the concept of arbitrage. If the value of unleveraged company is not equal to that
of a levered company- investors can make a risk-free profit by selling overvalued to buy
undervalued- forcing things to be even
o Value of levered VL= VU Value of unlevered
o Absence of taxes
MM Proposition II without taxes: Higher leverage raises the COE:
income
Corporate issuers
Introduction (brief notes of section)
Corporate governance is the system of internal control and procedures by which individual
companies are managed. Provides a framework that defines rights, roles and responsibilities of
various groups within an org Minimise conflicting interests
Typically reflects either shareholder theory or stakeholder theory
Two tier board of director includes: a supervisory board (non-execs) and management (execs)
Principal agent relationship
Proxy voting- Authorise someone else to vote on their behalf
A amendment to corporate bylaws take place in EGM- significant changes to a company
Cumulative voting- accumulate their shares for a single candidate in an election involving more
than one director. Raises the likelihood that the minority shareholders will be represented by at
least one director on the board. Not permitted in some countries
Agreed elements of board of directors are- duty of care and duty of loyalty
Board of directors’ committees: usually ensure enterprise risk management
o Audit committee
o Governance
o Remuneration
o Nomination
o Risk
o Investment
A proxy contest- persuade to vote activists (group) onto the board
Tender offer- Sell to individuals (managerial) who want to control
Uses of capital
Steps in capital allocation process
1. Idea generation
2. Investment analysis
3. Capital allocation planning
4. Monitoring and post audit
Types of capital projects
1. Replacement projects- maintain existing size of business
2. Expansions projects- expand business
3. New products and services-New stakeholder involvement
4. Regulatory, safety and environment projects-Might not generate revenue
Capital allocation assumptions
Decisions based on cash flows- done on accrual basis and subtract non-cash expenses such as
depreciation
Cash flows are not accounting net income or operating income. Econ income includes cash flows
plus change in company’s market value
, Cash flows are based on opportunity costs
Cash flows are analysed on an after-tax basis
Timing of cash flows is crucial
Financing costs are ignored- this is reflected in the required rate of returns
Key concepts of capital allocation
NPV IS CF BY OPPORTUNTIY COSTS
IF NPV VS IRR go with NPV
Sunk costs- have already been incurred. Decisions should only reflect current and future cash
flows
Opportunity costs- Next best use
Incremental cash flow- cash flow with a decision minus cash flow without the decision.
Basically, cash flow realised because of the decision to do X
Conventional cash flows vs non-conventional cash flows:
o Conventional- starts with initial outflow followed by a series of inflows c
o Non-conventional- Starts with initial outflow not followed by inflows only can be a
combination of both. More than once changing form positive to negative
unconventional
Types of projects
Independent projects vs mutually exclusive projects- cash flows are independent of each other.
Can invest in A and B but not both
Project sequencing- Might invest today and if results are good invest in the next stage
Unlimited funds vs capital rationing- Unlimited funds environment assumes the company can
raise the funds it wants for all profitable projects by paying required rate of return. Rationing-
have a fixed amount of funds- must choose what is going to max returns to shareholders
If have to choose between NPV and IRR- NPV wins
Sources of finance
Internal financing
1. Operating cash flows
2. Accounts payable- 2/10, net 30 mean 2% discount if pay in ten days or all due on the 30 th
3. Accounts receivable- quicker receivable
4. Inventory- JIT
5. Marketable security
Financial intermediaries
1. Uncommitted lines of credit- not reliable and unofficial. Require no compensation other than IR
2. Committed lines of credit- Less than a full year known as regular lines. SR liabilities
3. Revolving credit agreement- Formal agreement that are over many years. Payback periodically
4. Secured asset loan- Lien against an asset as part of the loan
5. Factoring- Sell its AR
6. Web-based and non-banking
Capital markets
1. Commercial paper- SR and unsecured. Used by well-known companies. Few days’-270 days.
2. Debt and equity
3. Leasing obligations
, A drag on liquidity is when receipts lag creating pressure from lack of funds
Pull on liquidity is when disbursements are paid to quickly
Intro-Cost of capital
Cost of capital
The rate of return that the supplier of capital requires as compensation for the capital
Have debt, equity and hybrid which each make up a component of cost of capital
Must calculate the marginal cost of debt and weighted avg it
WACC- Weighted average cost of capital referred to as marginal cost of capital because it is the
cost that a company incurs for additional capital
Cost of debt
Cost of debt is equal to risk free plus premium for risk. Two methods:
o Yield to maturity- what the rate is if buy bond and hold to maturity
o Debt-rating-use yield on comparable bond. Rate of similar bond(1-Tax)= After tax COD.
Known as matrix pricing
Usually less costly than equity and pref
Cost of equity
Estimation difficult due to the uncertainty of future cash flows in the amounts and timing
Two methods:
o CAPM
o Bond yield plus risk premium (BYPRP)- RD+ risk premium
Estimating Beta
For public companies use least squared regression- known as unadjusted or raw historic beta
Found that beta usually regresses towards 1.
Adjusted beta= (2/3) (1.3) + (1/3) (1.0)
When D-E raises asset beta remains the same and equity beta increases
Capital structure
Modigliani-Miller assumptions
Theory that a firm can’t change firm value by simply changing the capital structure
Assumptions:
o Homogeneous expectations on returns- agree on given investments expected CF
o Perfect capital markets- No transaction costs, taxes, bankruptcy costs and everyone has
the same info
o Risk free rate- borrow and lend at rf
o No agency cost- Managers always act to shareholder maximisation
o Independent decisions- Financing+ investment decisions are independent of each other
MM Proposition I without taxes: Capital structure irrelevant:
o Uses the concept of arbitrage. If the value of unleveraged company is not equal to that
of a levered company- investors can make a risk-free profit by selling overvalued to buy
undervalued- forcing things to be even
o Value of levered VL= VU Value of unlevered
o Absence of taxes
MM Proposition II without taxes: Higher leverage raises the COE:
