from nominal to real cashflows
CF_real = CF_nom / (1+p)^t
what is deflation? (in corporate finance)
deflation is a discounting based on the inflation rate rather than the cost of capital
in other words, we are defining the real value of a nominal flow with respect to a “deflated” time
the three macro components of cost of capital k
originating from the economic system
1. real risk free rate
2. inflation rate
originating from the firm/project
3. risk premium
what is the “condition of homogeneity”?
discounting nominal (real) cash flows with nominal (real) rates
!!! we can use real CFs and real rates if we ASSUME the company’s cashflows are NEUTRAL with respect to the INFLATION of the ECONOMIC system
!!! if we decide to use real flows produced by the company AND need to INCLUDE the RISK PREMIUM we must DEFLATE it
risk premium_real = risk premiun_non / (1+p)
!!! nominal risk premium is the one found in the CAPM
NOM CFs exercise
slide 14
neutral vs competitive inflation
If the company’s cash flows are expected to grow at a rate in line with inflation, then the inflation of flows is defined as “neutral”, meaning it neither adds nor subtracts value
if the expected growth of operating cashflows is =/ , the inflation is “non-neutral”
!!!!!!! in a non-neutral scenario we CANNOT discount REAL flows with REAL rates !!!!!!!
(since the inflation rate contained in the risk-free interest rate is not equal to the growth rate of operating free cash flows)
extra: formulas
why is inflation relevant in the valuation of companies?
because it appears in two different forms in the valuation formulas
- expected inflation in the economic system present in the discount rate
- “characteristic” inflation of the company: the GROWTH rate per UNIT OF PROFIT MARGIN (dynamics of prices-costs and prices-revenues)
every year the company’s flows GROW by SPECIFIC INFLATION and are DISCOUNTED based on SYSTEM INFLATION
define “company” inflation
variation in the company’s UNIT PROFIT MARGIN
what are examples of favorable / unfavorable inflation?
- unfavorable inflation: p* < p
EV will be less than in “neutral” inflation conditions. The firm is unable to “keep” inflation. - favourable inflation: p* > p
EV will be greater than in neutral inflation conditions
summary scheme of the effects of different combinations in the use of discount rates and flows
- REAL CF REAL RATES: ONLY CORRECT IN NEUTRAL INFLATION
! uses UNLIMITED capitalization of the flow at time 0 - REAL CF, NOMINAL RATES: WRONG UNDERESTIMATION
- NOM CF NOM RATE: ALWAYS CORRECT (uses gordon’s perpetual growth formula)
- NOM CF REAL RATE: WRONG OVERESTIMATION
in the gordon growth method, why is the growth rate associated with FUTURE (otherwise we underestimate values) cashflows both on numerator and denominator?
because the inflation of the economic system is already included in the cost of capital
3 possibilities when estimating TV
(useful when you have a formulated business plan in the 2 stage model)
TV =
inflation NEUTRALITY
1. [real cash flows / real rate] / discounted back to time 0 at NOMINAL rate
! no growth
- [growing (p) cashflows / (nominal rate - p) / discounted back to time 0 at NOMINAL rate
!!! p*=p
NON_NEUTRAL inflation
3. [growing (p) cashflows / (nominal rate - p) / discounted back to time 0 at NOMINAL rate
p = economic system
p* = company’s inflation
practical exercise
slide 26
real vs nominal cost of capital
K_real = i_rf + RP/(1+p)
K_nom = i_rf + RP
what does it mean to “maximize the EV”?
- max shareholder’s wealth
- minimize risk for debtholders
eventually, also max manager’s remuneration
in the presence of perfectly efficient markets, there is little room for opportunistic behaviours as favoring one of the actors will detriment another
what are opportunistic behaviours of firms with high probability of default?
shareholders trying to steal value from debtholders (going for “value creation” to “value distribution”)
basically, market value of debt is reduced and, according to the accounting equation, if EV remains the same the difference must flow into equity
necessary conditions for opportunistic behavior
- debt is not on demand
- interest rate conditions CANNOT be renegotiated by financiers
- risk of bankruptcy is REALLY high or the company is already going bankrupt
what is the characteristic of “debt at sight”?
If risk grows, interest rate adjusts and the market value of debt remains constant
conversely (like in bonds), if interest rate is fixed then the market value of debt will adjust
6 examples of opportunistic behaviours by shareholders/companies
- asset substitution (increasing risk)
shareholders change the profile of assets increasing the risk > if EV = (higher risk offset by higher risk) > STDV of future possible EV changes > probability of bankruptcy increases but ALSO opportunities for shareholders (which don’t have anything else to lose as of now)
- debt overhang or “underinvestment” (refusal to provide equity)
the company has the opportunity to make investments with a positive NPV and increase EV, but in case of bankruptcy then debtholders are the first to benefit. - SHORTsighted investment (investment in LONG term projects, even with negative NPV)
longer investments INCREASE the STD of EV and “lock in” debtholders
- distribution of dividends (take liquidity at the expense of creditors), repayment of capital, or repurchase of own shares (since all EV is owned by debtholders in bankruptcy conditions, company cannot distribute dividends but might repurchase shares)
- accounting tricksù
masking EV values
masking fin leverage to obtain capital
masking FS to obtain more favorable financing conditions - “bait and switch” (issuance of new debt)
not necessarily linked to bankruptcy, and NOT applicable to already virtually bankrupt companies
usually in the initial stages of a company, here is how it works: issue a limited qty of debt > if debt cannot be renegotiated > issue further debt
keep going and just fuck all prior creditors, acting on the market value of debt
what is debtholder’s response to opportunistic behaviours?
protective covenants
Obligation to repay the debt upon “breaking” of the covenants (for example, if liquidity falls below a certain conventional level, if interest coverage does not meet a minimum level, etc.)
Limits to issuance of additional debt
Limits to changes in control of the corporation
Limits to the distribution of dividends and share repurchases
Limits to the sale of specific operating assets (for example, licenses, trademarks or patents)
Maintenance of real estate properties (they act as a guarantee)
Provision for insurance (Request for insurance or guarantees, external or funds)
