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- 2. 2 Topics ¨ Capital Budge1ng & Project Evalua1on ¨ Taxes ¨ Dividends ¨ Short selling ¨ Dividend Irrelevance Proposi1on (M&M) ¨ Informa1on and agency issues
- 3. Capital Budge1ng Preliminary 3 PV= CFi (1+k)i i=1 M ∑ NPV= CFi (1+k)i i=0 M ∑ 0 1 2 3 4 5 sunk costs How do you decide whether to do a particular project or make a particular investment? How do you rank projects within your capital budget?
- 4. Capital Budge1ng Methods ¨ Net present value ¤ NPV should be posi1ve ¤ is hurdle rate or project cost of capital ¨ Internal rate of return ¤ IRR should exceed hurdle rate ¨ Payback period ¤ Time periods to breakeven Cash flows and +ming are always given ∑= + += N 1i i i 0 )k(1 CF CFNPV ∑= + +== N 1i i i 0 IRR)(1 CF CF0NPV ∑= + +== N 1i i i 0 )k(1 CF CF0NPV 0 1 2 3 4 5 sunk costs N k k
- 5. Net Present Value Method ¨ Expected project cash flows are projected for periods 1 to N ¨ A discount rate for the project is determined ¤ The rate includes an adjustment for risks to the project cash flows rela1ve the firm’s total cash flow and cost of capital, kU ¨ The method determines if the NPV is posi1ve and thus a value crea1ng investment ¨ Alterna1ve projects can be ranked in descending NPV order projectU N 1i i i 0 kkk )k(1 CF CFNPV Δ+= + += ∑=
- 6. Internal Rate of Return Method ¨ Find the discount rate, IRR, that equates NPV to zero ¨ The IRR should exceed a hurdle rate and thus creates value ¨ Rank alterna1ve projects in descending order by IRR k IRR IRR)(1 CF CF0NPV N 1i i i 0 ≥ + +== ∑=
- 7. Payback Period Method ¨ How many periods, , are required to recover (on an NPV basis) the ini1al investment? ¨ How many periods needed to achieve a posi1ve NPV ¨ Use the risk adjusted discount rate, ¨ Rank alterna1ve projects in ascending payback period basis ∑= + +=≡ N 1i i i 0 )k(1 CF CF0NPV k N
- 8. 0 1 2 3 Internal Rate of Return 8 10 10 110 100 100= CF (1+y)i i=1 3 ∑ = 10 1+y( ) + 10 1+y( ) 2 + 110 1+y( ) 3 P⋅y3 + 3P.10( )⋅y2 +(3P.10)⋅y.120=0
- 9. Income Tax Rates Marginal Tax Rate Single 10% $0 – $8,025 15% $8,026 – $32,550 25% $32,551 – $78,850 28% $78,851 – $164,550 33% $164,551 – $357,700 35% $357,701+ Marginal Tax Rate Single 2.56% $0 -‐ $2,400 3.57% $2,401 -‐ $17,500 5.12% $17,501 -‐ $27,000 6.84% $27,001 + Nebraska Currently, the average combined federal and state corporate tax rate in the U.S. is 40.0%, second among OECD countries to Japan's combined rate of 40.69%. Ordinary Income Rate Long-‐term Cap Gain & Dividend* Rate Short-‐term Capital Gain Rate Long-‐term Gain on Real Estate ** Long-‐term Gain on Collectibles 10% 0% 10% 10% 10% 15% 0% 15% 15% 15% 25% 15% 25% 25% 25% 28% 15% 28% 25% 28% 33% 15% 33% 25% 28% 35% 15% 35% 25% 28% * Qualified dividends ** $250,000 exemption on primary residence
- 10. Short Selling Long Investment (but short term holding period) Buy 100 shares of FMN in Oct-‐07 for 65.00$ per share for a total of 6,500$ "Buy at market" Sell 100 shares of FMN in Jul-‐08 for 15.00$ per share for a total of 1,500$ "Sell at Market" Net (5,000)$ Short Trade Borrow 100 shares of FMN in Oct-‐07 from your broker Sell 100 shares of FMN in Oct-‐07 from your brokerage account at for 65.00$ per share for a total of 6,500$ "Sell short" Buy 100 shares of FMN in Jul-‐08 into your brokerage account for 15.00$ per share for a cost of 1,500$ "Buy to Cover" Return 100 shares of FMN in Aug-‐08 to your broker Net 5,000$
- 11. Project Expected Cash Flows ¨ Assume there are three future cash flow scenarios, A, B, and C during some future year. The expected cash flow is during that year is ¨ The scenarios are mutually exclusive – independent ¨ Example ¤ CFA = $1,000,000 with probability 50% ¤ CFB = $500,000 with probability 30% ¤ CFC = $150,000 with probability 20% ¨ ¨ The risk (variance) in the expected cash flow is included in the discount rate [ ] 1p p p pCFpCFpCFCFE CBA CCBBAA =++ ⋅+⋅+⋅= [ ] 000,680$ %20000,150$%30000,500$%50000,000,1$ CFE = ⋅+⋅+⋅=
- 12. Project Valua1on ¨ Present value of free cash flow – opera1ng and financing split using APV method ¨ Define project cash flow, CF, similar to free cash flow, FCF ¨ Include a cash flow at 1me 0 (likely an investment – a nega1ve cash flow) 12 ∑= ⎥ ⎦ ⎤ ⎢ ⎣ ⎡ + + + = N 1i i TS i i U i 0 )k1( TS )k1( FCF V ∑= + += N 1i i i 0 )k1( CF CFNPV projectU kkk Δ+=
- 13. Project Valua1on ¨ Note ‘direct method’ for free cash flow ¤ Cash, not accrual, basis ¨ Ignore non-‐opera1ng assets, dividends, interest expense and income 13 RC: cash revenue (excluding IDI) COGSC: cash cost of goods sold or cost of revenue OXC: cash opera1ng expenses (SG&A, R&D) ITC: cash taxes paid CX: capital expenses CS: cash from sale of assets ΔCE: addi1onal opera1ng cash required ITCCECSCXOXCCOGSCRCCF −Δ−+−−−= τ⋅−τ⋅+−Δ−+−−−= IXIDIITCOCECSCXOXCCOGSCRCFCF
- 14. Dividend Payments 14 S M T W Th F S Jun-‐08 1 2 3 4 5 6 7 8 9 10 11 Announcement Date 12 13 14 15 16 17 18 19 20 21 22 23 21 22 23 24 25 29 27 28 29 30 S M T W Th F S Aug-‐08 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 Ex-‐ Dividend Date 20 21 Record Date 22 23 24 25 26 27 28 29 30 S M T W Th F S Sep-‐08 1 2 3 4 5 6 7 8 9 10 11 Payable Date 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 26 29 30 Microso0 Declares Quarterly Dividend REDMOND, Wash. — June 11, 2008 — Microsok Corp. today announced that its board of directors declared a quarterly dividend of $0.11 per share. The dividend is payable Sept. 11, 2008, to shareholders of record on Aug. 21, 2008. The ex-‐dividend date will be Aug. 19, 2008. Opening stock price on 19 Aug = Closing price on 18 Aug – dividend per share ($0.11) + price gain (loss) due to over night changes in supply and demand for MSFT shares
- 15. Dividend Payments 15 Date Open High Low Close Volume Adj Close 30-‐Nov-‐04 26.75 27.01 26.7 26.81 75,960,400 25.57 29-‐Nov-‐04 26.64 26.95 26.61 26.77 67,079,900 25.53 26-‐Nov-‐04 26.56 26.82 26.55 26.6 24,398,700 25.36 24-‐Nov-‐04 26.62 26.73 26.4 26.64 60,069,200 25.4 23-‐Nov-‐04 26.52 26.7 26.4 26.53 70,459,700 25.3 22-‐Nov-‐04 26.75 26.82 26.1 26.65 92,410,800 25.41 19-‐Nov-‐04 27.03 27.07 26.84 26.86 85,808,600 25.61 18-‐Nov-‐04 27.13 27.17 27 27.07 63,249,900 25.81 17-‐Nov-‐04 27.25 27.35 27.06 27.17 58,830,700 25.91 16-‐Nov-‐04 27.33 27.34 27.05 27.12 64,522,600 25.86 15-‐Nov-‐04 27.34 27.5 27.2 27.39 104,468,000 26.12 15-‐Nov-‐04 $ 3.08 Dividend 12-‐Nov-‐04 30.16 30.2 29.8 29.97 162,269,000 25.64 11-‐Nov-‐04 29.89 30.08 29.82 29.98 87,358,900 25.65 10-‐Nov-‐04 29.92 30 29.69 29.73 84,097,700 25.44 9-‐Nov-‐04 29.43 29.89 29.35 29.77 100,401,000 25.47 8-‐Nov-‐04 29.18 29.48 29.13 29.28 112,802,100 25.05 5-‐Nov-‐04 29.21 29.36 29.03 29.31 95,337,700 25.08 4-‐Nov-‐04 28.38 29 28.38 29 87,867,700 24.81 3-‐Nov-‐04 28.65 28.65 28.31 28.47 79,666,700 24.36 2-‐Nov-‐04 28.26 28.47 28.03 28.24 89,417,100 24.16 1-‐Nov-‐04 28.16 28.28 27.96 28.08 72,930,900 24.00 Yahoo finance ‘historical prices’ for MSFT during Nov 2004 REDMOND, Wash. July 20, 2004 Microsok Corp. today announced that its board of directors approved an $0.08 per share quarterly dividend, plans to buy back up to $30 billion of the company's stock over the next four years, and a special one-‐1me dividend of $3 per share. hnp://www.microsok.com/presspass/ press/2004/jul04/07-‐20boardPR.mspx The 3rd quarter dividend ex-‐dividend date was August 23 The 4th quarter and special dividends ($3.08) were paid on Dec 2 to shareholders of record on Nov 17. The ex-‐dividend date was Nov 15.
- 16. Dividend Payments 16 Date Open Close Opening Gap 30-‐Nov-‐04 26.75 26.81 -‐0.02 29-‐Nov-‐04 26.64 26.77 0.04 26-‐Nov-‐04 26.56 26.6 -‐0.08 24-‐Nov-‐04 26.62 26.64 0.09 23-‐Nov-‐04 26.52 26.53 -‐0.13 22-‐Nov-‐04 26.75 26.65 -‐0.11 19-‐Nov-‐04 27.03 26.86 -‐0.04 18-‐Nov-‐04 27.13 27.07 -‐0.04 17-‐Nov-‐04 27.25 27.17 0.13 16-‐Nov-‐04 27.33 27.12 -‐0.06 15-‐Nov-‐04 27.34 27.39 -‐2.63 12-‐Nov-‐04 30.16 29.97 0.18 11-‐Nov-‐04 29.89 29.98 0.16 10-‐Nov-‐04 29.92 29.73 0.15 9-‐Nov-‐04 29.43 29.77 0.15 8-‐Nov-‐04 29.18 29.28 -‐0.13 5-‐Nov-‐04 29.21 29.31 0.21 4-‐Nov-‐04 28.38 29 -‐0.09 3-‐Nov-‐04 28.65 28.47 0.41 2-‐Nov-‐04 28.26 28.24 0.18 1-‐Nov-‐04 28.16 28.08 0.19 November 2004 S M T W Th F S 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 Ex-‐ Dividend Date 16 17 Record Date 18 19 20 21 22 23 24 25 26 27 28 29 30 Opening price on 15 Nov = Closing price on 12 Nov -‐ $3.08 + price gain due to changes over the week end for MSFT stock $27.34 = $29.97 -‐ $3.08 + $0.45
- 17. 17 M&M Proposi1on 3 ¨ “Dividend Irrelevance Proposi1on” ¨ Dividend payout policy is irrelevant to total shareholder value under certain condi1ons ¨ Illustra1on via an all-‐equity, constant growth firm with no debt and no non-‐opera1ng assets ¤ D = 0, NOA = 0, C = IC, T = 0 NOA L OA PAR APC TS RE EC EC: Total common equity TS: Treasury stock (common)
- 18. 18 Example NOPAT0 DIV0 FCF0 IC0 IC1 IC2 FCF1 FCF2 ΔIC is the reinvestment needed to maintain gFCF at 5% and expected return on opera1ng assets at 10% In this example FCF and ΔIC are defined to be the op1mal values for an all equity firm For an all equity firm, all of the FCF should be paid out as a dividend, if • dividend and capital gain taxes are equal • A change in dividend payout does not signal financial distress k 10% gFCF 5% EBIT 12,500,000$ τ 20% ns 8,000,000 ΔIC 6,000,000$ DB -‐$ NOA -‐$
- 19. Pay all FCF as dividend Operating Assets Current Liabilitites ∆OA 6$ ∆CL -‐$ Nonoperating Assets Noncurrent Liabilities ∆NOA -‐$ ∆NCL -‐$ Shareholders' Equity ∆PAR -‐$ ∆APC -‐$ ∆TS -‐$ ∆EC -$ ∆RE 6$ ∆EB 6$ ∆TA 6$ ∆LE 6$ ΔTS: change in treasury stock ΔEC: change in common equity ΔNOA: change in non-‐opera1ng assets (e.g., cash) EBIT 12.50$ EBIT(1-‐τ) 10.00$ IX(1-‐τ) -‐$ NP 10.00$ IX(1-‐τ) -‐$ ΔT -‐$ NOPAT 10.00$ ΔIC 6.00$ FCF 4.00$ DIV 4.00$ ΔRE 6.00$ ΔOA=ΔRE 6.00$
- 20. 20 Pay all FCF as dividend: Shareholder Value m88$ 0$m4$0$m84$ ECDIVNOA %5%10 )05.1(m4$ ECDIVNOA gk )g1(FCF S FCF FCF = −++= Δ−+Δ+ − ⋅ = Δ−+Δ+ − +⋅ = Total shareholder value Total shareholder value per share Fair value stock price p Cash flow to and from the shareholder per share ( ) ns EC ns DIV ns NOA nsgk )g1(FCF s FCF FCF Δ −+ Δ + ⋅− +⋅ = $11.00 $0.50$10.50 m8 0$ m8 m4$ m8 0$ m8 m84$ s = += −++=
- 21. 21 Pay No Dividend ¨ $6m investment needed to anain FCF growth of 5% ¤ Op1mal dividend payout and reinvestment OAΔICΔ m4$DIV m4$FCF m6$ICΔ m10$NOPAT = = = = = 00.11$50.0$50.10$ 0$ m8 m4$ 0$50.10$ ns EC ns DIV ns NOA 50.10$s =+= −++= Δ −+ Δ += Operating Assets Current Liabilitites ∆OA 6$ ∆CL -‐$ Nonoperating Assets Noncurrent Liabilities ∆NOA -‐$ ∆NCL -‐$ Shareholders' Equity ∆PAR -‐$ ∆APC -‐$ ∆TS -‐$ ∆EC -$ ∆RE 6$ ∆EB 6$ ∆TA 6$ ∆LE 6$
- 22. 22 Pay No Dividend ¨ Pay no dividend, yet FCF = $10m ¨ $6m investment needed to maintain FCF growth of 5% ¨ Excess reten1on of $4m 00.11$50.0$50.10$ 0$0$ m8 m4$ 50.10$ ns EC ns DIV ns NOA 50.10$s =+= −++= Δ −+ Δ += Operating Assets Current Liabilitites ∆OA 6$ ∆CL -‐$ Nonoperating Assets Noncurrent Liabilities ∆NOA 4$ ∆NCL -‐$ Shareholders' Equity ∆PAR -‐$ ∆APC -‐$ ∆TS -‐$ ∆EC -$ ∆RE 10$ ∆EB 10$ ∆TA 10$ ∆LE 10$ EBIT 12.50$ DIV -‐$ EBIT(1-‐τ) 10.00$ ΔRE 10.00$ NP 10.00$ ΔOA 6.00$ NOPAT 10.00$ ΔNOA 4.00$ ΔIC 6.00$ FCF 4.00$
- 23. 23 Pay Excess Dividend ¨ Pay excess dividend, DIV = NOPAT = $10m ¨ $6m investment needed to maintain FCF growth of 5% ¨ Raise $6m in common equity 00.11$75.0$25.1$50.10$ m8 m6$ m8 m10$ 0$50.10$ ns EC ns DIV ns NOA 50.10$s =−+= −++= Δ −+ Δ += Operating Assets Current Liabilitites ∆OA 6$ ∆CL -‐$ Nonoperating Assets Noncurrent Liabilities ∆NOA -‐$ ∆NCL -‐$ Shareholders' Equity ∆PAR 1$ ∆APC 5$ ∆TS -‐$ ∆EC 6$ ∆RE -‐$ ∆EB 6$ ∆TA 6$ ∆LE 6$ EBIT -‐$ DIV 10.00$ EBIT(1-‐τ) 10.00$ ΔRE -‐$ NP 10.00$ ΔOA 6.00$ NOPAT 4.00$ ΔEC 6.00$ ΔIC 6.00$ FCF 4.00$
- 24. 24 Example: Summary Case 2 ΔNOA=change in excess cash Paid out too much dividend, so raise necessary equity capital in market DIV ΔNOA ΔEC pv(fcf) Δnoa p div Δec s -‐$ 4,000,000$ -‐$ 10.50$ 0.50$ 11.00$ -‐$ -‐$ 11.00$ 1,000,000$ 3,000,000$ -‐$ 10.50$ 0.38$ 10.88$ 0.13$ -‐$ 11.00$ 2,000,000$ 2,000,000$ -‐$ 10.50$ 0.25$ 10.75$ 0.25$ -‐$ 11.00$ 3,000,000$ 1,000,000$ -‐$ 10.50$ 0.13$ 10.63$ 0.38$ -‐$ 11.00$ 4,000,000$ -‐$ -‐$ 10.50$ -‐$ 10.50$ 0.50$ -‐$ 11.00$ 5,000,000$ -‐$ 1,000,000$ 10.50$ -‐$ 10.50$ 0.63$ (0.13)$ 11.00$ 6,000,000$ -‐$ 2,000,000$ 10.50$ -‐$ 10.50$ 0.75$ (0.25)$ 11.00$ 7,000,000$ -‐$ 3,000,000$ 10.50$ -‐$ 10.50$ 0.88$ (0.38)$ 11.00$ 8,000,000$ -‐$ 4,000,000$ 10.50$ -‐$ 10.50$ 1.00$ (0.50)$ 11.00$ 9,000,000$ -‐$ 5,000,000$ 10.50$ -‐$ 10.50$ 1.13$ (0.63)$ 11.00$ 10,000,000$ -‐$ 6,000,000$ 10.50$ -‐$ 10.50$ 1.25$ (0.75)$ 11.00$ Case 1 Case 3
- 25. Share Buyback ¨ Use FCF to buy back shares ¨ $6m investment needed to maintain FCF growth of 5% ¨ Raise $6m in common equity ¤ Assume buy back has no transac1on cost m0$DIV m4$FCF m10$NOPAT = = = 00.11$50.0$50.10$ m8 m4$ 0$0$50.10$ ns EC ns DIV ns NOA 50.10$s =+= − −++= Δ −+ Δ += Operating Assets Current Liabilitites ∆OA 6$ ∆CL -‐$ Nonoperating Assets Noncurrent Liabilities ∆NOA -‐$ ∆NCL -‐$ Shareholders' Equity ∆PAR -‐$ ∆APC -‐$ ∆TS (4)$ ∆EC (4)$ ∆RE 10$ ∆EB 6$ ∆TA 6$ ∆LE 6$
- 26. Alterna1ve Views of Case 2 ¨ Alterna1ve B: Shareholder creates her own dividend ¤ She has 1000 shares with total value of $11,000 ¤ Seeks a dividend yield of 4.545% = $0.50/$11.00 ¤ So she sells 45.45 shares worth $500 = $11,000·∙ 0.04545 ¤ So she has 954.5454 shares remaining ¤ With total value of $10,500 ¤ Addi1onal assump1ons in this alterna1ve case n No transac1on cost for shareholder n Dividend and capital gain tax equivalence for shareholder n Frac1onal share transac1on possible
- 27. Essen1al Points ¨ Proposi1on 3 ¤ The dividend policy is relevant to total shareholder value in the case where n The firm has a transac1on fee for buying back or selling equity n The changing of dividend does signal a change in firm value n Shareholder dividend and capital gain tax rates are different n The shareholder has a transac1on fee for buying and selling equity n Frac1onal shares can be bought and sold
- 28. Informa1on and Agency Issues ¨ Informa1on asymmetry ¤ Adverse selec1on ¤ Moral hazard ¨ Incomplete informa1on ¨ Principal Agent Problem ¤ Alignment of interests ¤ Agency Cost