Study session eight in the Level II CFA Program curriculum includes three readings (25-27) on Corporate Finance.
Capital Budgeting is the process by which companies make go/no-go decisions on projects. The approved financial calculators make most of the capital budgeting formulas pretty simple. Net present value and IRR, introduced in the Level I CFA Program curriculum, are core to finance and you need to understand the concept and the calculation.
A project NPV is found by putting in the initial cost as CF0 then each successive cash inflow in CF1 through CF… Do not forget to add the last year’s cash flow with the sales price. Then input the cost of capital as an interest rate and compute NPV.
Learn the two different ways to compare mutually exclusive projects with different lives: least common multiple and equivalent annual annuity. The least common multiple approach is just like the fractions work you (hopefully) remember from school. You must calculate each project’s NPV as if it was implemented multiple times to compare the two projects over the same total years. Example, a two-year and three-year project means you will calculate the NPV of the first project over three implementations (6 years) and the second project over two implementations (6 years).
For the annuity approach, you calculate the NPV for each then use the time value of money function on your calculator to find the EAA. The project NPV is input as your present value, required rate is the interest rate, future value is 0 and the appropriate number of periods. The calculated payment is the EAA.
The material on real options can be a little confusing but you really only need to understand the basic concept behind each type. Understand that, like financial options, the option on a project has value and so can change the go/no-go decision.
Remember the common pitfalls in capital budgeting: pet projects, sunk costs, misusing templates, bad accounting for cash flows, using IRR for a project with unconventional cash flows, and not using a discount rate commensurate with the project’s risk.
Understand the difference between economic and accounting income and how to calculate both.
The difference between the propositions of Modigliani and Miller is of secondary importance to the rest of the reading. The MM (without taxes) suggests that capital structure doesn’t matter while with taxes suggests that a firm would use 100% debt financing because of the interest tax shield.
Understand the difference between business risk (volatility of sales and operating leverage) and financial risk which is the amount of leverage in the capital structure. Operating leverage is just the contribution margin (quantity times difference in price and value) divided by EBIT. Financial leverage is the EBIT divided by earnings before taxes. The degree of total leverage is the product (multiplication) of the two.
Do not neglect UNDERSTANDING this material, instead opting just memorizing key concepts and formulas. Learning and understanding how a company uses operating and financial risk to increase profits is a very important step in analyzing where the company may be going or comparing it against competitors. Memorizing the material might get you the charter but understanding it will make you a smarter analyst.
Understand that a company with a high amount of financial leverage (as opposed to high operating leverage) is more likely to emerge from bankruptcy because debts and risk can be restructured.
Understand the risks in high financial leverage and the agency costs of equity (monitoring, bonding and residual loss).
A table with country-specific factors and the effect on the capital structure and maturity of debt will make the international section more easily digestible. Country-specific factors are: Macroeconomic (inflation and growth), institutional framework (legal system efficiency and origin, information intermediaries, and taxation), banking/financial markets (equity & bond markets, depth of investor base, and bank-based/market-based), information asymmetry, financial flexibility, tax deductibility, and industry. Think about it intuitively from the standpoint of an investor. If the institutional framework is weaker then investors will demand prohibitively higher rates of return and prohibitively higher rates for longer maturity debt. This will lead to higher short-term debt relative to equity and shorter maturities. If
Dividends and Share Repurchases
The dividend material starts with conceptual ideas about whether dividend payouts matter or not. The issue really isn’t definitively resolved so just worry about getting the basic idea behind the arguments.
More important is the rest of the material covering factors affecting policy, payout policy and the three measures of dividend safety. The five factors that affect the policy decision are: taxation of dividends, restrictions/covenants on payments, clientele effect, signaling effect, and float costs on equity.
Understand the chronology behind dividend payments (declaration date, ex-dividend date, holder of record, and payment date).
The dividend payout ratio is just dividends divided by net income. The higher the payout ratio, the more likely the dividend is unstable (especially if net income might fall).
The dividend coverage ratio is just the inverse of the payout ration (NI / Dividends) and is a lot like the interest coverage ratios you will need to learn.
The free cash flow to equity (FCFE) coverage ratio is the most practical. Remember FCFE equals cash flow from operations (CFO) minus fixed capital investment (FCinv) plus net borrowing. Your core cash flows from business minus the cash needed to invest in business continuation plus cash received from borrowing should be enough to cover dividends and share repos. (FCFE coverage = FCFE/ (dividends + share repos)
Understand how to calculate the target payout ratio and new dividend. The target payout ratio is a strategic goal that intends to payout a proportion of earnings over the long-term. The expected increase in dividends is the increase in earnings multiplied by the target ratio and an adjustment factor. (remember, this is the expected increase in the dividend not the new dividend).
Study session nine in the Level II CFA Program curriculum concludes the topic area with two readings on financing and control issues in Corporate Finance.
‘til next time, happy studyin’
Joseph Hogue, CFA