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Financial Forecasting Capital Structure Valuation

Financial Forecasting Capital Structure Valuation - BASIC...

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BASIC CORPORATE FINANCE THREE PARTS Financial forecasting o Short-run forecasting o General dynamics; sustainable growth Capital structure o MM o Static trade-off: Tax shield vs. Expected distress costs o Pecking order o An integrative approach Valuation o FCF o APV o WACC o Valuing companies CONCLUSIONS The bulk of the value is created on the LHS by making good investment decisions You can destroy a lot of value by mis-managing your RHS Financial policy should be supporting your business strategy You cannot make sound financial decisions without knowing the implications for the business Finance is too serious to leave it to finance people Making sound business decisions requires valuing them This involves knowing the business (to make appropriate cash flow forecasts and scenario analysis, etc.) Valuation exercises can indicate key value levers FINANCIAL FORECASTING Four Steps 1. Forecast Assets a. Assumptions 2. Forecast Liabilities and Net Worth, leaving out the liabilities you want to remain free (e.g. Bank Debt) a. Assumptions 3. Use the difference as the “Plug” for the funding need (e.g. Bank Debt) and compute the implied Net Income 4. Use the implied Net Income to compute the implied Net Worth and plug back into Step 2 until you converge. General Dynamics and Sustainable Growth The sustainable growth rate is g* = (1-d) x ROE o D = dividend o ROE = Return on Equity The sustainable growth rate g* = (1-d) x (NI/Sales) x (Sales/Assets) x (Assets/NW) Sustainable growth rate increases as o Dividends decrease (more reinvestment in the firm)
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o Profit margins increase (NI/Sales) o Asset turnover increases (Sales/Assets) o Leverage increases (Assets/NW) If a company grows faster than g* without issuing equity, its leverage will increase If a company grows slower than g* without buying back equity, its leverage will decrease The sustainable growth rate does not tell you whether growth is good or not; EVA or DCF is necessary for that Financial and business strategies cannot be set independently (too few degrees of freedom) – e.g. Citibank Sustainable growth is relevant only if you cannot will not raise equity, and you cannot let your D/E ratio increase Sustainable growth gives a quick idea of general dynamics o Cash cows (g<g*) o Finance junkies (g>g*) CAPITAL STRUCTURE Modigliani-Miller Theorem In frictionless markets, financial policy is irrelevant o Financial transactions are NPV = 0 (i.e. no arbitrage) QED o Corollary: Capital structure, long- vs. short-term debt, dividend policy, risk management are all irrelevant to firm value MM helps us avoid fallacies: o WACC fallacy It is true that since debt is safer than equity, investors demand a lower return for holding debt than for holding equity It is false that companies should always finance themselves with debt because they have to give away less return to investors False: WACC unchanged return on debt climbs with its risk o EPS fallacy
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