Summary Applied Corporate Finance
Topic 1 - KPMG
Difference between the price and the value of a corporation
Price: determined by demand and supply, market circumstances, irrational
behavior (emotional premium or discount). Methodology: trading & transaction
multiples
Value: buyer specific, depends on the expected CF generation including
synergies, risk perception and return requirements, based on LT horizon.
Methodology: discounted CF
DCF approach: forecast the FCF during the forecast period estimate the WACC
derive the terminal value after the forecast period select the right
discounting methodology adjust for non-operating assets / liabilities and net
debt
The operating enterprise value is the sum of discounted CFs
The operating EV is the starting point in the determination of the equity value
Key components of the DCF approach
To get the FCF, we need to consider non-cash posts like depreciation. Interest
payments / income will not be taken into account, this will be included via the
WACC (cost of debt = rf rate + credit spread; market, default and liquidity risk)
To develop a view on the companies’ strategy and construct a forecast, you need
to analyse the industry (understand trends and drivers) and the firm perspective
(competitive and strengths / weaknesses)
1
,Equity beta = leveraged beta, business risk * financial leverage (D/E)
Smaller firms have higher betas (SFP)
The continuing growth rate (G) should never exceed the nominal growth rate of
the economy or the industry and therefore should be lower than: real GDP growth
/ real industry growth + inflation
In competitive industries, the long run RONIC should not exceed WACC not
possible to make excess returns, will only have zero NPV projects and drives
RONIC towards some steady state level.
Mid-year discounting is more accurate, more realistic to assume CFs are
generated gradually during the year. Difference between mid-year and year-end:
(1+wacc)^0.5 -1 = wacc/2 do ^0.5, ^1.5 etc.
To get the equity value, corrections for (non) operating assets are made. All
assets and liabilities that are not included in free cash flow have to separately
valued and adjusted for in the present value of FCF and continuing value.
Operating EV + non-operating assets – non-operating liabilities = adjusted EV
For multiples, use the median because the average might be distorted by
outliners.
Topic 2 Managing Exposure: Transaction Exposure
We should hedge corporate risk because there are market imperfections: info
asymmetry, transaction costs, default costs & progressive taxes.
Example on progressive taxes: there is a 50/50 chance the dollar will depreciate
or appreciate. If it depreciates, the earnings are $5m, if appr: $15m. The 5m is
taxed for 20% and the 15m for 40% (because earnings > 10m will be taxed by
40%)
The expected earnings are thus $10m.
- The unhedged firm pays in taxes: (5m * 20%) * 50% + (15m * 40%) * 50%
= $2.5m
- The hedged firm knows the expected earnings of 10m will be true: 10m *
20% = $2m
Companies that hedge their FX exposure have a 5% higher value on average.
Most CFOs use forward contracts (98%), swaps are used by half and only 4%
future (standardized contracts)
2
, Cash flows, money amounts A&L, firm value
Financial statements
Hedge receivables by using financial contracts (forward, money market, options)
- Forward market hedge
If you are going to receive a currency, you agree to sell it in the future so you
enter a short position.
Today you fix your position at the forward exchange rate of $1.46/£, so if you
would receive £10,000 in one year – you are sure to receive $14,600 at that time.
If the spot rate turns out to be favorable, $1.50/£ for example, you could have
gotten $15,000 (£ appreciated) one could say the cost of the forward contract
is $400 (kind of insurance cost)
>Futures are not a good option, due to the market-to-market property, there are
interim CFs prior to the maturity date.
- Money market; lending & borrowing in the domestic and foreign
money market
5 step approach & self-financing strategy
Assume you receive £10,000 in one
year.
1. Borrow the PV of your receivable
2. Convert to home currency at current spot rate
3. Invest this amount at the rf rate in home country
4. After 1 year, collect your receivable and use it to repay the pound loan
5. Receive the maturity value of the dollar investment in the US.
£10,.09 = £9174.31 * $1.50 = 13,761.47
invest in US market * 1.061 = $14,600.92 use this amount to pay back the
£10,000
This yields the same outcome as the forward contract and that must be the case,
otherwise arbitrage opportunities could appear, interest parity would not hold.
- Options
Options control the downside risk potential (limited loss) while retaining the
upside potential (unlimited gain). Call = right to buy, put = right to sell
If you want to hedge your receivables, you are afraid the currency you will
receive one year from now will depreciate (pound) so you go short. Right now the
$/£ is $1.46/£ if the £ depreciates, you need to pay less dollars for one pound
and it might become $1.30/£ you have the right to sell the pounds at $1.46
because of the option. If the pound appreciates and it becomes $1.60/£, the put
option is useless because you will sell at the spot rate of 1.60, in this case the
spot > strike.
Strike = price of put spot = current price
- Swap agreements:
To hedge recurrent exposure: you will receive £100m p/y for the next 5 years. A
swap contract is a portfolio of forward contracts with different maturities:
currency swap agreement; an agreement to exchange one currency for another
at a predetermined exchange rate (swap rate)
Problem: long maturity contracts hard to find, you need to pay a premium.
3
Topic 1 - KPMG
Difference between the price and the value of a corporation
Price: determined by demand and supply, market circumstances, irrational
behavior (emotional premium or discount). Methodology: trading & transaction
multiples
Value: buyer specific, depends on the expected CF generation including
synergies, risk perception and return requirements, based on LT horizon.
Methodology: discounted CF
DCF approach: forecast the FCF during the forecast period estimate the WACC
derive the terminal value after the forecast period select the right
discounting methodology adjust for non-operating assets / liabilities and net
debt
The operating enterprise value is the sum of discounted CFs
The operating EV is the starting point in the determination of the equity value
Key components of the DCF approach
To get the FCF, we need to consider non-cash posts like depreciation. Interest
payments / income will not be taken into account, this will be included via the
WACC (cost of debt = rf rate + credit spread; market, default and liquidity risk)
To develop a view on the companies’ strategy and construct a forecast, you need
to analyse the industry (understand trends and drivers) and the firm perspective
(competitive and strengths / weaknesses)
1
,Equity beta = leveraged beta, business risk * financial leverage (D/E)
Smaller firms have higher betas (SFP)
The continuing growth rate (G) should never exceed the nominal growth rate of
the economy or the industry and therefore should be lower than: real GDP growth
/ real industry growth + inflation
In competitive industries, the long run RONIC should not exceed WACC not
possible to make excess returns, will only have zero NPV projects and drives
RONIC towards some steady state level.
Mid-year discounting is more accurate, more realistic to assume CFs are
generated gradually during the year. Difference between mid-year and year-end:
(1+wacc)^0.5 -1 = wacc/2 do ^0.5, ^1.5 etc.
To get the equity value, corrections for (non) operating assets are made. All
assets and liabilities that are not included in free cash flow have to separately
valued and adjusted for in the present value of FCF and continuing value.
Operating EV + non-operating assets – non-operating liabilities = adjusted EV
For multiples, use the median because the average might be distorted by
outliners.
Topic 2 Managing Exposure: Transaction Exposure
We should hedge corporate risk because there are market imperfections: info
asymmetry, transaction costs, default costs & progressive taxes.
Example on progressive taxes: there is a 50/50 chance the dollar will depreciate
or appreciate. If it depreciates, the earnings are $5m, if appr: $15m. The 5m is
taxed for 20% and the 15m for 40% (because earnings > 10m will be taxed by
40%)
The expected earnings are thus $10m.
- The unhedged firm pays in taxes: (5m * 20%) * 50% + (15m * 40%) * 50%
= $2.5m
- The hedged firm knows the expected earnings of 10m will be true: 10m *
20% = $2m
Companies that hedge their FX exposure have a 5% higher value on average.
Most CFOs use forward contracts (98%), swaps are used by half and only 4%
future (standardized contracts)
2
, Cash flows, money amounts A&L, firm value
Financial statements
Hedge receivables by using financial contracts (forward, money market, options)
- Forward market hedge
If you are going to receive a currency, you agree to sell it in the future so you
enter a short position.
Today you fix your position at the forward exchange rate of $1.46/£, so if you
would receive £10,000 in one year – you are sure to receive $14,600 at that time.
If the spot rate turns out to be favorable, $1.50/£ for example, you could have
gotten $15,000 (£ appreciated) one could say the cost of the forward contract
is $400 (kind of insurance cost)
>Futures are not a good option, due to the market-to-market property, there are
interim CFs prior to the maturity date.
- Money market; lending & borrowing in the domestic and foreign
money market
5 step approach & self-financing strategy
Assume you receive £10,000 in one
year.
1. Borrow the PV of your receivable
2. Convert to home currency at current spot rate
3. Invest this amount at the rf rate in home country
4. After 1 year, collect your receivable and use it to repay the pound loan
5. Receive the maturity value of the dollar investment in the US.
£10,.09 = £9174.31 * $1.50 = 13,761.47
invest in US market * 1.061 = $14,600.92 use this amount to pay back the
£10,000
This yields the same outcome as the forward contract and that must be the case,
otherwise arbitrage opportunities could appear, interest parity would not hold.
- Options
Options control the downside risk potential (limited loss) while retaining the
upside potential (unlimited gain). Call = right to buy, put = right to sell
If you want to hedge your receivables, you are afraid the currency you will
receive one year from now will depreciate (pound) so you go short. Right now the
$/£ is $1.46/£ if the £ depreciates, you need to pay less dollars for one pound
and it might become $1.30/£ you have the right to sell the pounds at $1.46
because of the option. If the pound appreciates and it becomes $1.60/£, the put
option is useless because you will sell at the spot rate of 1.60, in this case the
spot > strike.
Strike = price of put spot = current price
- Swap agreements:
To hedge recurrent exposure: you will receive £100m p/y for the next 5 years. A
swap contract is a portfolio of forward contracts with different maturities:
currency swap agreement; an agreement to exchange one currency for another
at a predetermined exchange rate (swap rate)
Problem: long maturity contracts hard to find, you need to pay a premium.
3
