Certificate Course on Introduction to Corporate Finance BY –LeDroit India ©2019 to 2020. All rights reserved.
LeDroit India Page |1 INTRODUCTION TO CORPORATE FINANCE For professionals who work in corporate finance, their ultimate goal is to maximize the value of a business through planning and implementing their resources while balancing risk and managing profitability for the company. Their activities can be divided into 3 categories: CAPITAL INVESTMENTS This is where managers have to decide which projects to invest in and which businesses to acquire or invest in. The goal is to earn the highest possible risk-adjusted return on those capital investments. CAPITAL FINANCING With Capital Financing, the objective is to optimize capital structure, which means the firm will have the lowest Weighted Average Cost of Capital. DIVIDENDS AND RETURN OF CAPITAL This is when managers have to decide how and when to return capital to the investors if they can’t find good enough use for it in the business. So in summary, Managers in corporate finance are concerned with making capital investments that have high risk-adjustment returns, funding those investments with the lowest possible costs and best capital structure and then finally returning capital to investors if they can’t earn a high enough risk-adjusted return on it. In the coming lessons, you’ll see how all these various components of Finance fit together as managers attempt to maximize the value of their businesses. There are two sides to the Capital Markets in Corporate Finance, on the one side are corporations and operating companies , they are businesses in all sorts of different industries and they need capital to grow in their various operations. And on the other side of the capital markets we have institutions that represent investors. These investors have money that they want to invest in companies. So, the capital flows from those investors into the Corporations and in exchange, the corporations issue back to the institutional investors, bonds or shares of their company. In the middle of all this, sits the investment bank which is also sometimes referred to as the sell side, uses its relationships and its contacts on both sides to facilitate these transactions. So, it speaks to the institutional investors and other corporations and brokers that deal to raise capital and issue shares back to investors. And finally in addition, we have the Public Accounting Firms which are involved in auditing and preparing financial statements for these corporations and are used by the Institutional Investors Copyright ©2019-2020.All rights reserved.
LeDroit India Page |2 So, to summarize, we have four key players in corporate finance that we are going to be concerned with in this course. The first is the Corporations, these are the companies that need capital. Secondly, there are the institutions that represent the investors that have money . Third are the investment banks, they broker the transactions between corporations and institutions. And then finally, we have the Public Accounting Firms which audit and oversee all of the financial information. So these are the key players in the Primary Market where new shares and bonds are issued by corporations. Now let’s look at the secondary market. In the secondary market, we have additional institutional investors or fund managers who want to buy securities of publically traded companies. And we have some other fund managers who may want to sell their positions in those companies. This is where Investors buy and sell on a stock exchange or Over-the- counter using Investment Banks. And the investment banks have sales and trading departments as well as equity research departments that help facilitate all of these transactions between investors. This is called the secondary market because the corporation or the company that issues the shares is not involved and does not appear anywhere throughout the transaction. These transactions are simply happening between investors. So, the investors are going to the investment banks to help them buy and sell shares in an already traded public company. Corporations are only involved in the primary market where they actually issuing new securities such as new bonds or new shares. Let’s take a closer look at the types of participants in the capital markets. There are two main categories involved in primary markets, investors and corporations. Within investors, we can further break them down into retail and institutional investors. Retail investor consist of individuals who have high net worth and Institutional Investors consist of mutual funds, pension funds, private equity firms, venture capital firms and angel investors. So there is a wide range of institutional investors and institutional investors may represent the retail or the individual investors as well. Within Corporations, there a broadly just 2 types: Public and Private. Public companies are traded on a stock exchange and private companies are privately held and traded by a few individual or institutional investors TYPES OF TRANSACTIONS 1. INITIAL PUBLIC OFFERING: This is the first time when a company issues securities to the public. Its IPO is its debut. 2. FOLLOW-ON EQUITY OFFERINGS: This is when the companies go back to the public markets to raise more money. 3. PRIVATE PLACEMENTS: This is the name given to companies that raise money privately. 4. MERGERS AND ACQUISITIONS: As the name describes, this is when the companies buy other businesses. Copyright ©2019-2020.All rights reserved.
LeDroit India Page |3 5. LEVERAGE BUY-OUT: This is a form of acquisition wherein the company uses a lot of leverage to use the minimum amount of equity possible to buy another business. 6. DIVESTITURE: When a company sells a business. As we continue through the course, it is important that you are aware of these different types of participants and different types of transactions that occur in the capital markets. CAPITAL INVESTMENT OVERVIEW A capital investment is any investment for which the economic benefit is greater than one year. For example, opening a new factory, entering a new market , acquiring another company, for researching and developing new products. These are examples of some investments done by companies that would provide more than one year of future revenue and economic value to the business . When this is the case, company will then record it on the balance sheet. Capital Investment increase the asset side the company’s balance sheet. As those assets go up, the company is expanding its balance sheet and if it does not have enough cash in hand to pay for those assets, with its cash, it will use debt or equity to fund the purchase of those assets. Managers in Corporate Finance seek to create value by investing in assets that have high risk-adjusted returns. Before accompany makes a capital investment it needs to assess whether or not it thinks that an investment will have an attractive pay-off. There are two main forms that we are going to use to evaluate the attractiveness of an investment., which are as follows: 1. NET PRESENT VALUE (NPV): It captures all the future cash flows of the business over the entire life of an investment discounted to the present. 2. INTERNAL RATE OF RETURN (IRR): It is measuring or estimating the internal rate of return that will be generated from purchasing the assets or making the investment at a specific price. NET PRESENT VALUE Copyright ©2019-2020.All rights reserved.
LeDroit India Page |4 This concept suggests that “Money now is more valuable than money later on, because you can use this money to make more money. You could run a business, or buy something now and sell it later for more, or simply put the money in the bank to earn interest. Let us say you can get 10% interest on your money. So $1,000 now can earn $1,000*10%= $100. Your $1,000 now becomes $1,100 next year. So, $1,000 now Is the same as $1,100 next year. Thus we say that $1,100 next year has a present value of $1,000, because $1,000 can become $1,100 next year at (10% interest). Now let us extend this idea further into the future. Suppose I tell you the future value of something and ask you to calculate the present value of it. Then, this present value is the Net present value. 100 90 80 2019 2020 2021 2022 2023 2024 In the above graph, consider the future value(cash flows) to be $100 each year, let us consider a period of 5 years. After 5 years, we consider the value of the business to be $1,200(terminal value). Terminal Value is the value of the business beyond the given time period (5 years in our case). And our discount rate is 10%. Discount rate refers to the rate of return on investment. Now let’s calculate the present value of this using the formula: PRESENT VALUE (PV) = FUTURE VALUE(FV)* 1/(1+i)^n I= Discount rate/ rate of return on investment; n= forecast period Thus, The present value of $100 in 2021 is , 100*1/(1+10/100)^1= $91 PV of $100 in 2022= 100*1/(1+10/100)^2= $83 PV OF $100 IN 2023= 100*1/(1+10/100)^3= $75 PV OF $100 IN 2024= 100*1/(1+10/100)^4= $68 Copyright ©2019-2020.All rights reserved.
LeDroit India Page |5 PV OF $100 IN 2025= 100*1/(1+10/100)^5= $62 The future cash flow beyond 5 years is $1,200 thus its PV= 1200*1/(1+10/100)^5= 745 Hence, the NPV= 91+83+75+68+62+745= $1,124. This means that the present value of $1,700 after 5 years is $1,124. Thus, when Managers in Corporate Finance make investment decisions, they’ll be looking at the net present value of all future cash flows to determine how much they should pay for that capital investment. TERMINAL VALUE is the value of the free cash flow beyond the forecast period. It is a very important concept as it makes up a large percentage of the total value of the business. There are generally 2 formulas to calculate terminal value: 1. Growing Perpetuity Formula: This formula assumes that the company operates indefinitely and that it grows at a constant rate forever. So we have to pick a very low growth rate though we believe a company can realistically grow out forever, typically this would be somewhere around the GDP growth rate or less than the GDP growth rate of the country. TERMINAL VALUE= FREE CASH FLOW*(1+GROWTH RATE) DISCOUNT RATE- GROWTH RATE (Discount rate is also called Cost of Capital.) 2. Exit Multiple Formula: This assumes that the business is sold at the end of the forecast period and if we want to know what the business could be sold for, we will look at comparable companies to see what multiples they are trading at in the market. We will look at multiples of Earnings, EBITDA or Revenue and multiply by the company’s terminal revenue, EBITDA or Earnings. A multiple is simply a ratio that is calculated by dividing the market or estimated value of an asset by a specific item on the financial statements, Earnings/EBITDA/Revenue in this case. TERMINAL VALUE= Financial Metric(Earnings, EBITDA, Revenue)*Multiple Lets look at an example to walk through these. Copyright ©2019-2020.All rights reserved.
LeDroit India Page |6 If we want to use Terminal Value Perpetuity Growth formula, we can take the $100 future cash flow that we had in our previous example, multiply it by 1 plus the GDP growth rate percent of the country, 1.54% in this case, and divide it by the company’s Cost of Capital minus the GDP growth rate. As such: Terminal Value= 100(1+1.54%)/10%-1.54% = $1,200 And with the Exit Multiple Formula, we get: Terminal Value= 100*12= $1,200 (Assume that this company has $100 earnings while the other companies of the same industry traded at 12 times the earnings of this company- hence the multiple here is 12) UNLOCKING THE DRIVERS OF VALUE Lets take a closer look at what drives value for business, more specifically, what can create a larger terminal value for a company. Let’s dissect each of the components of the perpetuity formula for terminal value. FREE CASH FLOW is essentially a function of a company’s overall business strategy and execution of that strategy which generates revenue and when taken into account with a cost structure and asset utilization rate, it finally derives cash flow. So, to the extent a company has a better strategy or revenue, lower costs and better use of assets, it creates more cash flow which creates more value. GROWTH, this means the Organic growth that the business can generate for itself and ultimately what’s sustainable over the long term. COST OF CAPITAL: Here we are essentially saying, what is the risk and how much has to be compensated to make this investment as well as looking at the current capital structure of the company and global macro economic factors as well. There are two parts of the formula that have been highlighted above, Risk and Growth, these are offsetting forces in the formula. To the extent a company has higher risk, it’s going to have a higher cost of capital and thus, a lower terminal value. But, to the extent a company is growing more, it’s going to have a smaller denominator and thus, a higher terminal value. So there’s a trade-off and a relationship between risk and growth. In brief, high growth companies are taking more risks so there is an inherent tension between risk and growth for the valuation of a business. Copyright ©2019-2020.All rights reserved.
LeDroit India Page |7 ENTERPRISE VALUE VS. EQUITY VALUE Enterprise value is the value of an entire business without giving consideration to it’s capital structure. Its important to differentiate between the Enterprise value of a business and the Equity Value of a business. The Equity Value of a business is the market capitalization or just the value that shareholders would receive if the company is sold. If the company has debt when its sold, the debt has to be repaid first and whatever is left, goes to the equity investors. This is why typically the equity value of a business is less than the enterprise value. When we calculate enterprise value, we are calculating the Net Present Value of all future cash flows of the business. Or we can take the Equity Value if its already known, add any debt that the company has and subtract any cash. Enterprise Value= Equity Value + Debt - Cash OR Net Present Value of the Business On the other side of this, we can calculate the equity value of the business by taking the share price and multiplying it by the shares outstanding, if the share price is known, otherwise we can calculate the net present value of the business which gives us the enterprise value when we subtract any debt and add any cash. Equity Value= Share price * Outstanding Shares OR NPV of the business- Debt + Cash It is important to differentiate between the Enterprise Value and the Equity alue when we are talking about the value of the business. INTERNAL RATE OF RETURN When assessing Capital Investments, Managers in Corporate Finance often use the Internal Rate of Return (IRR) as a way of evaluating how attractive an investment is. MERGERS AND ACQUISITIONS Mergers and Acquisitions is the process where companies buy, sell or combine with other businesses. There are many benefits and many reasons why companies want to make mergers and acquisitions. Some of the most common reasons include: Copyright ©2019-2020.All rights reserved.
LeDroit India Page |8 COST SAVINGS which are called Synergies by combining operations and becoming more efficient. REVENUE ENHANCEMENTS by being able to cross-sell or achieve more revenue. INCREASE MARKET SHARE ENHANCE FINANCIAL RESOURCES, thereby making the balance sheet more solid. But there are also some serious drawbacks and risks when it comes to M&A. The main drawbacks include: OVERPAYING for the company EXPENSES that go along with making an acquisition NEGATIVE REACTION TO THE MERGER OR ACQUISITION from the market In Corporate Finance, Mergers and Acquisitions are a major form of Capital investment that Managers and Investors have to look at very carefully and are often compared to projects and other types of Capital Investments that companies can make. Ultimately, companies should only acquire other businesses if they believe that it creates value for their shareholders and possesses an attractive risk-adjusted return, especially relative to other projects and internal investments that the company can make. TYPES OF MERGERS AND ACQUISITIONS 1. Horizontal Merger: Also known as a ‘Horizontal integration’ this type of mergers take place between, companies operating in the same industry, i.e., selling similar products and services. A horizontal merger takes a company a step closer towards monopoly by eliminating a competitor and establishing a stronger presence in the market. The other benefits of this form of merger are the advantages of economies of scale and economies of scope. These forms of merger are heavily scrutinized by the Competition Commission of India (“CCI”). merge together for the following reasons: Synergies: In business, it is often considered that 1+1=3, this means that if two companies merge together, they can be able to perform as good as 3 companies altogether. Copyright ©2019-2020.All rights reserved.
LeDroit India Page |9 Eliminate Market Competition/ Gain Market Share: Firm A and Firm B are the only competitors of each other, if they merge, they will thereby eliminate competition and hence, reduce the pressure on them and at the same time, be able to take benefit of each other’s market share. Thus, this could be a very good reason to get into a Horizontal Mergers deal. Technology/Management and Know-how Acquisition: Under this, a company not that good with its technical/management operations, but a huge market share, can merge with another company with all the advanced technologies/ good management to improve their performance. This way, the former can take benefits of the latter’s advancements while the latter can take benefits of the former’s market share. Examples of Horizontal Mergers : Lipton India & Brooke bond Bank of Mathura with ICICI Bank BSES Ltd. with Orissa Power Supply co. 2. Vertical Mergers: This type of merger takes place between companies which are in the same industry, but at different levels of the supply chain. For example, ABC is the supplier for raw materials to XYZ company, XYZ might merge with ABC to reduce its costs and to improve the efficiency of operations, thereby building synergies also. As a result, company XYZ, will become its own provider of raw materials (by merging with company ABC), instead of relying on a second party. This type of merger is further classified into: backward and forward Backward merger is when a business merges with another business which is above it In the supply chain. As in the above example where XYZ merges with ABC who is its supplier for raw materials. Forward Vertical merger is the one in which a business merges with another business which is below it in the supply chain. For example, a goods supplying company PQR, merges with STU who carries out the transportation of goods. Example of Vertical Merger: Reliance and FLAG Telecom group 3. Conglomerate Mergers: A deal between companies that are involved in totally unrelated business activities. For example, a company dealing in confectionary merges with another company dealing in Copyright ©2019-2020.All rights reserved.
LeDroit India P a g e | 10 Personal Care Goods. Here, the companies are not at all related to each other’s industries, but generally merge because both sense some benefits in getting into each other’s industries. A conglomerate Merger is further categorized as: Pure and Mixed. Pure Conglomerate Merger is when the companies are not at all related, while a Mixed Conglomerate merger is when the two companies are somewhat related. The possible motivation behind getting into a Conglomerate merger could be diversification or growth. A company at times might wish to explore and take benefits out of another fast growing industry and hence undergo a such type of merger. Example: L&T and Voltas Ltd. 4. Congeneric Mergers: A congeneric merger is a type of merger where two companies are in the same or related industries or markets but do not offer the same products. In a congeneric merger, the companies may share similar distribution channels, providing synergies for the merger. The acquiring company and the target company may have overlapping technology or production systems, making for easy integration of the two entities. This type of merger is often resorted to by entities who intend to increase their market shares or expand their product lines. 5. Reverse Merger: A private company which wants to go public, might merge with an already existing public company and hence get itself listed publicly. By doing so, the private company will be able to avoid the risks and costs involved in undergoing an IPO (Initial Public Offerings). Example: Godrej Soaps Ltd. with Gujrat Godrej Innovative Chemicals Ltd. Copyright ©2019-2020.All rights reserved.
LeDroit India P a g e | 11 TYPES OF ACQUISITIONS Types Of Acquisations Friendly Hostile Friendly Acquisitions: The target company’s Management or Board of Directors accept an offer to merge with or to be acquired by another company and encourage the shareholders to vote in the favor of the transaction. It is usually followed by the approval of transaction in a shareholders’ vote. Hostile Acquisitions: The target company’s Management or Board of Directors vote against the favor of the merger or acquisition. In that case, the acquirer passes on and makes a direct offer to the shareholders of the target company. If the shareholders vote in the favor of the transaction, the merger or the acquisition takes place and the current management or the Board of Directors is likely to be replaced by the acquirer. Another alternative for the acquirer is to start and win a Proxy fight. In a Proxy Fight, a group of shareholders, who are in the favor of the transaction, join forces to get enough shareholder votes to replace the current management, making the way for the merger or the acquisition. Copyright ©2019-2020.All rights reserved.
LeDroit India P a g e | 12 FRIENDLY VS. HOSTILE TAKEOVERS When an acquirer makes an offer to buy another company, the management or the Board of Directors of the target company may either accept or reject the offer. However, the ultimate decision of a company’s merger or acquisition depends on the shareholders of the company. If the majority of shareholders vote in the favor of the merger or acquisition, the deal takes place. This is one of the major fears among the publicly listed companies because, the greater is the number of public shareholders of a company, the more will the decision- making powers be outside the control of the actual management or Board of Directors of the company. HOW TO DEFEND AGAINST HOSTILE TAKEOVER Although the shareholders are the ultimate decision makers in an M&A, the management and the Board have their own tricks to block a deal. Following are the main strategies to defend against a hostile takeover: SHAREHOLDER RIGHT PLAN: Flip-in: In case of a hostile acquisition attempt, the target company issues additional shares to be sold to the current shareholders (except the acquirer if it owns the target’s stocks) at an attractively discounted price, thus diluting the shares of the acquirer and making the acquisition more expensive. Flip-out: The target enables its current shareholders to purchase the acquirer’s shares at an attractive discounted rate (after the hostile takeover). Voting Plan: The target company issues Preferred stocks (preference shares) which have superior voting rights over the common stock, making it harder to take control of the target. Greenmail: The target company acquires its shares owned by the acquirer with a premium over current price with a condition of no hostile takeover attempts. For example, Company A has been attempting to takeover company B, thus company B can make an offer to A stating that it will purchase all of A’s shares of B at a much higher price under the condition that A won’t make any attempts of a hostile takeover. Copyright ©2019-2020.All rights reserved.
LeDroit India P a g e | 13 The Golden Parachute: The target company entitles its CEO a guaranteed large compensation if he should be dismissed as a result of a takeover ,making an acquisition more expensive for the buyer. White Knight: A more preferable acquirer which would buy the target at a fair consideration with the support from the target’s Board and Management. Increasing Debt: Target can increase its Debt level significantly to discourage the acquirer, but this method may raise concerns among the shareholders. Making an Acquisition (Hunting While Getting Hunted): Target can buy another company that the acquirer is not interested in. Acquiring the Acquirer: The target, in case of a Hostile Takeover attempt, can solve this issue permanently by buying the potential buyer. Copyright ©2019-2020.All rights reserved.
LeDroit India P a g e | 14 HOW TO PROCESS M&A DEAL Step 1: Develop an acquisition strategy – Developing a good acquisition strategy revolves around the acquirer having a clear idea of what they expect to gain from making the acquisition – what their business purpose is for acquiring the target company (e.g., expand product lines or gain access to new markets) Step 2: Set the M&A search criteria – Determining the key criteria for identifying potential target companies (e.g., profit margins, geographic location, or customer base) Step 3: Search for potential acquisition targets – The acquirer uses their identified search criteria to look for and then evaluate potential target companies Step 4: Begin acquisition planning – The acquirer makes contact with one or more companies that meet its search criteria and appear to offer good value; the purpose of initial conversations is to get more information and to see how amenable to a merger or acquisition the target company is Step 5: Perform valuation analysis – Assuming initial contact and conversations go well, the acquirer asks the target company to provide substantial information (current financials, etc.) that will enable the acquirer to further evaluate the target, both as a business on its own and as a suitable acquisition target Step 6: Negotiations – After producing several valuation models of the target company, the acquirer should have sufficient information to enable it to construct a reasonable offer; Once the initial offer has been presented, the two companies can negotiate terms in more detail Step 7:M&A due diligence – Due diligence is an exhaustive process that begins when the offer has been accepted; due diligence aims to confirm or correct the acquirer’s assessment of the value of the target company by conducting a detailed examination and analysis of every aspect of the target company’s operations – its financial metrics, assets and liabilities, customers, human resources, etc. Step 8: Purchase and sale contract – Copyright ©2019-2020.All rights reserved.
LeDroit India P a g e | 15 Assuming due diligence is completed with no major problems or concerns arising, the next step forward is executing a final contract for sale; the parties make a final decision on the type of purchase agreement, whether it is to be an asset purchase or share purchase Step 9: Financing strategy for the acquisition – The acquirer will, of course, have explored financing options for the deal earlier, but the details of financing typically come together after the purchase and sale agreement has been signed Step 10: Closing and integration of the acquisition – The acquisition deal closes, and management teams of the target and acquirer work together on the process of merging the two firms Copyright ©2019-2020.All rights reserved.
LeDroit India P a g e | 16 TYPES OF BUYERS IN M&A DEAL Broadly, there are 2 types of buyers in an M&A deal: Types of Buyers in M&A deal Strategic Financial Buyers Buyers STRATEGIC BUYERS Strategic buyers are other operating businesses and are typically looking to expand either vertically,i.e., into a new area of the market or horizontally to get more market share in the same market. Or also looking to achieve operating synergies which can be in a form of cost- savings or revenue enhancements. Hence, there are 2 categories under strategic buyers, expansion and synergies. FINANCIAL BUYERS Financial Buyers are Private equity firms or Finance sponsors. These are professional investors and they do not invest to operate business .They will be using ‘Leverage’, that means to borrow money to get maximum equity returns and maximum returns on other investments. It is difficult to generalize as to which type of buyer is better in any transactions, sometimes a strategic buyer can pay more because of synergies and strategic value, while sometimes a private equity firm or a financial sponsor can pay more for higher ROI and equity returns. In either type of process, whether it is strategic buyer ,financial buyers or a combination of the two, there are very likely to be ‘Rival Bidders’. The vast majority of acquisitions are Copyright ©2019-2020.All rights reserved.
LeDroit India P a g e | 17 competitive or potentially competitive. Generally, companies have to offer more than Rival Bidders. If the buyers pay more than their competitors, the buyers may have the following reasons: They might be able to do more with the acquisition, meaning they could get more synergies, there is more strategic rationale, for instance. Another reason could be that they are simply willing to accept a lower expected rate of return. Or, they could just have a different view or forecast for the future, that is more optimistic and therefore it justifies paying more. And more often, the highest bidder wins the competition. For companies that are selling into an M&A transaction, it’s important to create a lot of tension between buyers to maximize the price at which the company is being sold. Therefore, the companies that are the buyers, that are making the acquisition, it is important not to overpay for the company and stick to a valuation that still provides an active-risk adjusted return. ACQUISITION VALUE AND ANALYSIS Strategic Buyer Scenario: The buyer would model the value of the target business as a stand-alone. STEP 1: Calculating the enterprise value of the business and keeping in mind, the factors like: Sales Growth EBIT Margins Operating Tax Rates Working Capital Requirements Capital Expendituress STEP 2: Value synergies that can be realized, hard synergies (cost savings) and soft synergies (revenue enhancements): Synergies can be created in the following ways- Sales (Volume and price)-Hard Synergy Working Capital- Vendor Relationships (Soft Synergies) EBIT Margin- (Hard Synergy) Product Mix Overhead reductions Operating Tax- (Hard Synergy) Copyright ©2019-2020.All rights reserved.
LeDroit India P a g e | 18 Tax Efficiency Tax Losses Capital Expenditures Efficiencies During an acquisition, the value of the target ,i.e, the enterprise value is calculated and the value of the synergies is added to it. To this sum, the costs of transaction must be deducted in order to find out whether the deal is profitable or not. This gives us a combination of Net Synergies and Stand-alone value, this combination should be compared to the combination of purchase price of the target and the value that the target is going to create for the purchasing party. ISSUES TO CONSIDER WHEN STRUCTURING A DEAL: There a lot of issues to consider when structuring an M&A deal. On both sides of the deal, there is the actual structuring environment that has many factors that can impact the deal. Outside this environment, there is a broader Macro-Economic environment , i.e., the Market Environment, that can also impact a lot of things in the deal. Factors affecting the Strategic Environment- Strategic Plan Competitive Bidding Hostile vs. Friendly Acquisition Capital Structure Public vs. Private Target Factors affecting the Market Environment- Contract Laws Accounting Rules Tax Market Conditions Corporate Law Available Financing Copyright ©2019-2020.All rights reserved.
LeDroit India P a g e | 19 Antitrust Laws CAPITAL FINANCING OVERVIEW: Capital Financing deals with how a company deals with any type of funding that is used to finance the purchase of an asset/project. This part of Corporate Finance, helps managers to take investment decisions, like whether to chose Equity as a source of raising funds or Undertake Debts. Thus, when a company makes a capital investment, its building the assets of the business, when a company uses capital financing, its going to increase either the debt or the equity of the business, thereby balancing out the balance sheet of the company. In he coming lessons we’ll be looking at the types of debts that the company can raise in order to fund its investments. THE BUSINESS LIFE-CYCLE: The business life-cycle is the progression of a business in phases over timeand is most commonly divided into five stages: Launch Growth Shake-out Maturity Decline PHASE 1: LAUNCH Each company begins its operations by launching a new product or service. During the launching phase, sales are low, but slowly (and hopefully steadily) increasing. Businesses focus on marketing to their target consumer segments by advertising their comparative advantages and value propositions. However, as revenue is low and initial start-up costs are high, businesses are prone to incur losses in this phase. PHASE 2: GROWTH Companies experience rapid sales growth in the growth phase. Businesses start seeing profit, as the sales increase in this phase and pass the break-even point. PHASE 3: SHAKE-OUT Copyright ©2019-2020.All rights reserved.
LeDroit India P a g e | 20 During the shake-out phase, sales continue to increase, but at a slower rate, usually due to either have reached market saturation or because of the entry of new competitors into the market. Sales peak during this phase. PHASE 4: MATURITY Sales begin to decrease slowly when the business has matured. The firm spends a lot on capital expenses and is able to make a higher inflow of cash, but the profits shown in the income statement during this phase is very low as the margins for profit become thinner. PHASE 5: DECLINE In the final stage of the business life cycle, sales, profit and cash-flow all decline. During this phase, companies accept their failure to extend their business lifecycle by adapting to the changing business environment. Firms lose their competitive advantage and exit the market. CORPORATE FUNDING LIFE-CYCLE: The 5 phases remain the same in this cycle, but this cycle moves in accordance with the level of risk involved in a business. PHASE 1: LAUNCH At launch, when sales are lowest, the level of risk is the highest. During this phase, it is impossible for the company to finance debt due to its unproven business model. And uncertain ability to repay the debt. As sales slowly begin to increase, the corporations’ ability to repay debt also increases. PHASE 2: GROWTH As companies experience booming sales growth, business risks decrease, while their ability to raise debt increases. During this phase, companies start seeing a profit and a positive cash flow, this evidences their ability to repay debt. The corporations’ products or services have been proven to provide value in the market place. Companies at the growth stage seek more and more capital as they wish to expand their market reach and diversify their businesses. PHASE 3: SHAKE-OUT The sales peak during the shake-out phase. The industry experiences step growth leading to fierce competition in the marketplace. However, as sales peak, the debt financing life-cycle increases exponentially. Companies prove their successful positioning in the market, exhibiting their ability to repay debt. Business risk continues to decline. PHASE 4: MATURITY As corporations mature, sales start to decline. However, unlike the earlier stage where the risk was higher with lower sales, at this phase, risk and sales are in correlation with one Copyright ©2019-2020.All rights reserved.
LeDroit India P a g e | 21 another to some extent and thus there is no business risk. Due to the elimination of the business risk, the most mature and stable businesses have the easiest access to debt capital. PHASE 5: DECLINE In this stage, the sales begin to decline at an accelerating rate. This decline in sales portrays the company’s inability to adapt to changing business environments and extend their life- cycle. CAPITAL STRUCTURE The Capital Structure of a firm is the proportion of debt and equity that is used to fund its operations and finance its assets. In order to optimize its structure, the firm decides whether it needs more of debt or equity and can issue whichever it requires. Generally, the optimal capital structure has a number of factors: The current economic climate The business’ existing capital structure The business’ life-cycle stage Having too much debt may increase the risk of default in repayments. Depending too much on equity may dilute earnings and value for original investors. Ideally, a company wants to lower its cost of capital so it uses a combination of both, debt and equity to hit the sweet spot where the cost of capital is the lowest. WEIGHTED AVERAGE COST OF CAPITAL: Weighted Average Cost of Capital (WACC) is simply the proportion of debt and equity a firm has, multiplied by their respective costs. The cost of equity is the required rate of return the shareholders expect for investing in a business, given its level of risk. The cost of debt is the rate of return that is required by the lenders, given the level of risk. Ultimately, the firms want to have the lowest possible cost of capital. The optimal capital structure of a firm is often defined as the proportion of debt and equity that result in the lowest Weighted Average Cost of Capital (WACC) for the firm. Copyright ©2019-2020.All rights reserved.
LeDroit India P a g e | 22 CAPITAL STACK The capital stack is a structure which includes the various types of ways in which the company raises capital, i.e., equity, debt, or a mix of both. TYPES OF EQUITY Broadly, there are 3 types of equity: Common shares- represent the last liquidity position and last dividend position Preference Shares- is given preference on liquidation and dividend payment as compared to common share holders. Shareholder loans- higher liquidity position than the other two types; no dividend is payable, rather an interest is paid. When a company is raising money, it needs to weigh the pros and cons of all these types of equities, to decide which equity suits well with the objectives of the company. SOURCES OF EQUITY: There are 2 main sources of raising equity capital: Private Markets Public Markets Private Markets: At the very beginning, companies are often funded by their founders or friends and family. This would be the very first capital that’s put into a new business. Some time later, if the company grows and may reach a stage where it can raise Venture Capital Money. Venture Capital is the very early stage for a high growth business. Moving on from Venture Capital, as the company matures a bit more, it may make sense to raise money from a Private Equity Firm. Private Equity Firms vary in terms of their strategies with some investing at a quite early stage with high risk and high growth, and other private equity firms investing in more mature businesses that are stable and product-able. So Private Equity is a very broad category. But generally, its more mature than venture capital. Public Markets: At some point after having utilized the private market capital, the companies decide to go public. They can either raise equity capital from Institutional investors which make up the bulk of the public markets and from retail investors which make up a smaller portion of public markets but are also important for raising money for the companies. Thus, the sources of equity that are available to a company also depends on the stage at which the company is operating, whether it is at the Launch stage, Growth stage and so on. Copyright ©2019-2020.All rights reserved.
LeDroit India P a g e | 23 PRIVATE EQUITY AND VENTURE CAPITAL FIRMS: Private Equity Firms manage funds or pools of capital that are invested in companies that represent an opportunity for a high rate of return. They take high risks while making such investments. They generally invest for limited time periods and once they have earned enough return on their investment, they take an exit from their existing investment in 5-10 years mostly, by the ways of IPO, selling to other Private Equity Firms, etc. Private Equity Funds are split into 2 categories: 1. Venture Capital firms typically invest in early stage or expanding businesses that have limited access to other forms of financing. 2. Buyout or Leverage Buyout Firms typically invest in more mature businesses, usually taking a controlling interest and leveraging the equity investments with external debts, i.e., they make a new investment with borrowed money. Buyout Funds tend to be significantly larger than Venture Capital Funds. PE firms tend to take and exit from an investment in 5-10 years. The typical exit routes for a Private Equity firm are: Total Exit Partial Exit TOTAL EXIT: A total exit would be selling the entire company to either a strategic buyer who wishes to conduct the company’s business operations, or to a sponsor which would be another type of private equity firm. PARTIAL EXIT: Under partial exit, the PE firms undergo Private Placement, wherein some of the shares of the company are sold either to a strategic buyer or to a sponsor. Another way of partial exit to restructure the company, where some new investors are brought in and some old investors are taken out. Copyright ©2019-2020.All rights reserved.
LeDroit India P a g e | 24 DEBT We can look at the use of Debt in 2 different ways: 1. Corporation’s point of view Corporations use debt for 2 reasons, to lower the cost of capital and avoid equity dilution. 2. Investor’s point of view: An investor may use debt to increase their equity return so that they have to put down as little equity as possible and fund the rest of it with debt. ASSESSING DEBT CAPACITY: Once we know why it makes sense for a company to take on some debt, we have to figure out how much debt will make sense for the company to be taken on. While giving Debt to a company, the lenders look at the following details : General Measures: Level of EBITDA ( Earnings before interest, taxes, depreciation and amortization) Volatility and hence how stable is the EBITDA Capital Expenditures of the company Risk and Competition in the industry Balance Sheet Measures: Borrowing Base Capacity Debt to Equity Ratio Debt to Capital Ratio Debt to Assets Ratio Copyright ©2019-2020.All rights reserved.
LeDroit India P a g e | 25 CREDIT RATINGS AND HIGH YEILD DEBT A company’s cost of debt is directly related to how risky it is and in order to assess how risky a company’s debt profile is, there are debt rating agencies that rate the companies. Moody’s, Standard and poor’s are a few examples of Credit Rating Agencies. EQUITY AND DEBT DIFFERENCES: EQUITY DEBT No interest payments or mandatory Has interest payments. fixed payments. Has a fixed repayment schedule No capital repayment. Prevents dilution of equity Lender has a ownership and a degree of control over the business. Requires covenants and financial performance metrics that must be met. Typically, has voting rights. Has a lower cost than equity. Has a high implied cost of capital. Expects a lower rate of return than Expects a high rate of return. equity. Has last claim on the firm’s assets in the Has first claims on the firm’s event of event of liquidation. liquidation. Provides maximum operational Contains restrictions on operational flexibility flexibility. Can push a company to default/bankruptcy. Copyright ©2019-2020.All rights reserved.
LeDroit India P a g e | 26 UNDERWRITING: When businesses decide that they need to raise money they go through an underwriting process. Underwriting is when a bank or another advisor helps a corporation raise money from investors in the form of debt or equity. The process itself actually involves conducting research on the business and the investment opportunity as well as building financial models, performing valuation and then marketing and selling the deal. Types of Underwriting: The types of underwriting commitments are: 1. Firm Commitment 2. Best Efforts Under Firm commitment, the underwriter agrees to buy the entire issue and assume full financial responsibility for any unsold shares. For example, a company wants to raise $100 million, the bank buys all $100 million and then turns around and sells that to investors. If it can sell the shares for more than it paid to the firm, it makes an extra profit. However, if it sells them for less, it loses money. Since most banks don’t want to take that level of risk, they typically do what’s called a Best Efforts type of underwriting, where they agree to sell and put as much efforts as possible into actually selling the entire deal but are not responsible at the end of the day for any unsold shares. The best efforts type of commitment is becoming increasingly more common. Underwriting Advisory Services: Underwriting advisory services can be broken down into 3 categories: 1. Planning In the planning phase, the investment bank or advisor on the transaction has to identify the key themes that investors would be looking for in the deal. 2. Timing and Demand: The timing and demand of an offering are crucial to a successful capital raising. Here are some factors that influence the assessment of the timing and demand of an offering: Current Market Condition: Is it a hot or a cold market issue? Copyright ©2019-2020.All rights reserved.
LeDroit India P a g e | 27 Current investor appetite: What is the current investor risk profile and appetite? Is it aggressive or conservative? Are investors risk preferring, neutral or averse? Investor Experience: What are the investors’ experiences? Are investors experienced in this field or market? Precedents and benchmark offerings: Has a similar company (based on size, industry and geographical location) issued an IPO in the past? What are some other companies that you can benchmark for an IPO? Current News Flow: What is the current news flow on the company? Is it a positive or a negative flow? 3. Issue Structure Deciding the structure of an offering is the final phase of an underwriting advisory service. Some factors that influence the issue structure are: Is it going to be a domestic or an international issue? Are the investor demands located domestically or overseas? Would investors from other countries be interested in this offering? Is the focus on institutional investors or retail investors? How will the sales occur? UNDERWRITING- THE BOOK-BUILDING PROCESS The book-building process starts with an indicative price range where the advisors and the underwriters feel the demand will be. They then go around and meet institutional investors to get commitment from them at specific prices and based on those prices they are actually able to build an order book or a book of demand where they can see where all the institutional investors are willing to invest, how many shares and at what price. And once they have that book of orders built, they are then able to go through it and set the price which is the clearing price, ensuring that all of the orders that are needed for the deal can actually be filled. Then they go to allocation, and with allocation, if the deal was over-subscribed, then investors would be cut down on a pro-rata basis. So the idea behind this process is to get as many orders as possible, for some investors, at the highest price as possible and then ensure that they are able to sell the whole deal at a certain price. Copyright ©2019-2020.All rights reserved.
LeDroit India P a g e | 28 UNDERWRITING- THE ROADSHOW One of the most important parts of the book-building process is the roadshow. The roadshow is an opportunity for the investors to meet directly with the management team. They will have discussions and presentations where they will talk about : Management structure, governance and quality Strategy, both tactical and long-term Funding requirements and purpose behind raising these funds A thorough analysis of the industry and sector, competitors, market demands, etc. Key risks; risks involved in business The idea behind this is to get the investors directly in front of the management team so that they can her from them first hand, the strands of their business and why they should invest. The Roadshow involves booking many meetings as possible. PRICING THE ISSUE: The issues to consider when pricing an offering. 1. Price Stability: It is really important to have stability in the secondary market. 2. Buoyant after-market: It should have enough market demand even after it has been traded off after the IPO. In this course we have learnt about Capital Investing, where companies decide where to invest their profits to generate more income and Capital Financing, where companies figure out the resources which they can use to raise capital for their operations. We also came across the various methods and processes that companies undergo while raising or investing capital. ******************** Copyright ©2019-2020.All rights reserved.
LeDroit India P a g e | 29 With this we have come to an end of the course. Kindly send us a mail on [email protected] whenever you are ready for the Test. In case of any doubts and queries send your question on [email protected] Copyright ©2019-2020.All rights reserved.
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Certificate Course on Introduction to Corporate Finance BY –LeDroit India ©2019 to 2020. All rights reserved.