Hello everyone, welcome to Seminar Week seven of AFI 23.
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OK, so.
So this week we discuss.
Practice question week six Ann. I will give you some general feedback of assignment number 2 and some answer to one of the questions raised by one of the students in the previous.
Seminar, so let me share my screen on the.
Explanation of the practice test.
Practice questions all Week 6.
So this practical explanation file will be uploaded tomorrow, Friday night.
So we discuss.
The almost the same question that we discussed in the last week, so I assume that now everyone is familiar with the framework that we are discussing the valuation of the financial securities issued by a firm.
And that that could be affected by the important decision made by the shelter.
To remind you of what we discussed in the last week, we are considered one company. This company would have cash flow in the name of the Abbott, either 32,000 pounds or 18,000 pounds with equal probability and therefore the company has a risk. But in this question we simplified such that this risk is is a idiosyncratic risk. It is unsystematic risk therefore.
By using the our previous discussion of the.
As a pricing, we know that only the systematic risk requires compensation in the form of the higher expected return, but in this case we have just assumed that the firms risk is idiosyncratic. There is no systematic risk. Therefore, we know that investors would require zero risk premium. Therefore the required return in calculating present value of the future cash flows received by either DEP folder or by shareholders we have to.
Risk free rate as the required return becausw depth holders and shareholders. They're taking zero systematic risk. The firm has zero systematic risk.
OK, and then we discuss that given a bid we cannot use simply added as the free cash flow. There are two adjustments that we need to make. First of course we have to calculate how much tax the company should pay.
And then we know that we need to also make an adjustment as much as the investment expenditure.
The reason is that for the company to keep the future profit equal to the optimal planned level, then company should make a certain amount of investment.
Therefore, are in the general framework we take away.
In investment expenditure from Abbott and also of course we have to take away taxes and then we will calculate the free cash flow and the free cash flow. Is the concept of the profit from running the main business after paying the expenses related to the current sales and paying investment expenditure needed to keep the maintain the future profit equal to the planned optimal level? So free cash flow is the profit.
Available to be paid to the capital providers either debt holders or shareholders in the sense that a company typically raise raise raises capital by issuing either adapt or shares.
So we discussed that given everything you are supposed to calculate the taxable income to calculate taxes, but we discussed it by the law. The firm can treat interest payment as an interest expense, which means that the company can reduce the taxable income. Therefore the company would pay smaller taxes.
And then we also discussed that when we calculate after tax cash flow from operation, we have to add back non cash items such as depreciation. The reason is that when accountants they calculate a bit the earnings before interest and taxes added. They already took away non cash items such as depreciation. Becausw the law allows to treat such non cash items as an expense therefore.
Accountants can. They can reduce habit. Therefore the firm can reduce taxable income, but as a financial analyst you want to separate the concept of the expenses related to the current sales versus investment expenditure related to the future profit therefore.
Eventually we will take away depreciation, but we will take it away in the name of the investment expenditure. Therefore, when we calculate after tax cash flow from operation, we have to add back non cash items such as depreciation.
And then when we take away investment Spanish at that stop at that step. Of course, we considered appreciation.
So that is the primary discussing the last week. And also we discussed that given the free cash flow that orders, they should be paid 1st and then the remaining cash will be paid to the shareholders. That is the protection provided by the law that that order they should be paid first.
And then, given that this is the two possible future cashflows paid in at the end of the next period, appeared one. Therefore we can consider what is the present value of these future cash flows so that we can calculate the current market price of the existing debt or the current value of the shares outstanding.
So we discussed that given these two possible cash future cash flows received by existing app folders, then we can calculate present value by using the risk free rate. Is the required return and then we can consider present value of the cash flow received by shareholders again by using the risk free rate as the required return.
And then we say that when we consider the current value of the shares, we have to also consider current dividend payment that will be paid one millisecond later. But in this case, without changing capital structure, we understand that there is no source of any additional income. Additional cash flow for the firm. Therefore, we know that without capital changing the capital structure, we know that simply the first component, the present value of the cash flow received by shareholders.
Would be simply the value of the current value of the shares outstanding.
And then.
We discussed the what happens if the management team announces a.
Announces the policy capital structure policy that the company will issue additional debt in the name of the new bond one millisecond later in the previous week. We consider the case in which.
Both the existing depth and new that have the same priority, by which we mean that when the company pays to the depth orders, the company should pay at the same time to the existing debtholders ANAN new debit orders.
But in this query in this in this question, now we consider there is, uh, actually difference in the priority between existing debt and new debt in question number one through three. We consider the case in which the new bond Holder has a lower priority compared to the existing debt orders, which means that when the company pays to the debt orders first existing debtholders, they should be served first. OK, so the company, if possible should pay.
First, fully pay to the existing debt orders and then.
The remaining cash will be paid to the newborn Holder. The reason is that new bondholder is assumed to have a lower priority than the existing debt order, so that is the case we consider.
So.
Please start by considering there is no default in that case. Important really interest expense will be 1800 pounds because there are now 2 deaths existing that the new debt so interests of the existing depth of 1000 plus.
Entries of the new bond of 800 pounds so 1800 pounds is the interest expense.
And then we update the taxes paid and free cash flow and then cash received by each capital provider. But in this case, as we discussed in the last week, we know that in the better outcome the company does not have enough money. This free cash flow is actually smaller than to pay fully to the existing debt orders and new debit orders. Therefore we consider that the company would go to bankruptcy in the sense that shareholders they would they have a limited liability.
Option therefore, we know that in this case shareholders would want to declare bankruptcy. Therefore the shepherds would want to receive 0 cash flow rather than to receive negative cash.
So we have to update this table by taking into consideration that in the better outcome the company goes to bankruptcy differently from what we discussed in the last week in we know that in this week we have to consider the company actually pay first to the existing debt orders before paying any money to the new debt orders. Therefore we consider case in which the existing debt order would be paid fully even in the bad outcome.
And then the remaining cash will be paid to the new debt orders, that's why.
If you look at the interest expense in the bad outcome, now we write down interest payment to the existing debt orders of 1000 pound. Remember in the last week when we consider the case in which both the existing debt orders and new debt orders they have the same priority, we we consider that in the better outcome interest expense will be 0, because in that case we assume that either both 2 depths are fully served or both 2 deaths are devoted.
Therefore, in that case we consider 0 interest expense in the last week. But in this week now we consider that 2 deaths have different priorities. Therefore one debt would be served fully and then the the the other debt will be defaulted. OK, that's possible, and that is we call partial default.
Therefore, we consider that the existing debt holders are paid fully and then therefore interest payment to the existing debit orders. 1000 pound is written as an interest expense. Therefore, still the company reduced taxable income to certain amount. Therefore save taxes.
So given the free cash flow there for one 12,900 pounds, then we really see that yes, the company has.
Large enough to pay at least the existing debt orders, so the assumption we are using is correct so we can keep going on. Of course, you made assumption that partial default is possible, therefore at least existing debtholders would be paid fully, but after under the assumption you calculate free cash flow and if you see that the free cash flow is actually smaller than 9000 pounds, of course, then we have to update our assumption that that even the existing debt.
Is also defaulted in that case, of course, interest expense would be settled and which means that therefore in that case free cash flow will be smaller than £9000. Therefore, existing debt orders will receive the all the available cash smaller than £9000 and then do their total receiving set of cash flow, but in this in this example it is not. The company has cash flow large enough to pay at least fully to the existing debt order, so this assumption or partial difficulties.
A valid we keep it there for existing that orders. They should be paid fully 1st and then the remaining cash 3900 pounds will be paid to the new debt orders. Of course show those who do receive a set of cash flow because the firm goes to bankruptcy.
Therefore we can calculate the market price of the existing debt, so either 9000 pounds or 9000 pounds. Therefore, you can calculate the present value by.
By considering the risk free rate as the required return, again, the reason is that the firm has only the idiosyncratic risk or no systematic risk. So 8571.4 pounds is the market price of the existing debt after the announcement of this change in the capital structure. So we see that in this case actually the market price of the existing debt is not affected by the announcement of this change in the capital structure.
The reason is that even though the firm issues more debt, but effectively the existing debt order is protected to the degree very high becausw existing, that tool has a higher priority compared to the newly issued debt, so that is important condition here.
And then of course you can also calculate the market price of the new debt. I mean, the present value of these two posts were cashflows again by using the risk free rate as the required return. So 5095.2 is the price of the new debt.
And then we can consider the current value of the shares outstanding, such as present value of the cash flow that will be received by shareholders, plus current dividend as much as the price of the new debt.
So.
Regarding the first component, the present value of the future cash flows received by the shareholders, you can calculate the expected value considering the probability, and then you can calculate the present value by using the risk free rate as the required return. So that is the one component of the current value of the outstanding shares and the other component is the current dividend that will be paid one millisecond later as large as the.
Price of the new new debt.
Therefore you divide the current value of outstanding shares by the number of outstanding shares of 100. That will give you per share stock price of 84.95.
Before the announcement of the change in the capital structure, we know that.
Before the.
We know that the publisher stock price.
Was.
The purchase stock price before the announcement was 83.8. After the announcement, the purchase stock prices.
84 point.
95 So we see that in this case the purchase stock price increases, but very small magnitude, and most importantly, the reason is that exists as you see here, existing, that price is not affected by this.
You announcement of the change in the capital structure so effectively the existing debt orders are protected by this hyper higher priority rule. Therefore, even though the management team issues more adept, the management team cannot effectively shift the value from the existing debt orders to the shareholders. That's why the share if you look at the purchase price, it doesn't increase so much it does increase by small margin.
And the reason is that.
In the good outcome in the good outcome, which happens with the probability of a .5, the company can use a larger interest expense. Therefore the company can save US taxes too small magnitude. That's why the purchase stock price increases by small margin.
Yep.
So now we consider a another case. Now we consider.
Do we consider another case?
Question number four such that the new bondholders they have actually higher priority than the existing point holders do so in this case, actually, the existing vectors are protected by very magnetic, very small, so effectively existing data that they do not have any protection from the issuing more debt. So that is the case we consider.
Therefore, we already know what happens to good outcome, but consider bad outcome. Therefore, we know that the company would have cash large enough to pay at least to the new debit orders. Therefore we consider the partial default. Therefore, in this case, we consider the interest paid to the new bond orders of 800 pounds as interest expense.
Therefore, you calculate the free cash flow and then therefore the new debt orders. They should be paid first fully, and so that's why in this case new debit orders they. This new death is never defaulted, and then the remaining cash will be paid to the existing doctors.
So we can update the market price of the existing data by considering the present value of these two cashflows.
So as you see here when I wrote.
Now the.
Price of the existing debt declines greatly to 7161.
And so, but you see that the new bond price is quite high becauses it is never defaulted.
Therefore, as a result, can remember existing bond price declines a lot. I mean that is reflected in the large increase in the new bond price that would eventually increase the current value of outstanding shares. Therefore as a result.
The equilibrium are.
Porshe stock price increases greatly to 98.76. Remember before the announcement of such a change in the capital structure, the special stock price was.
80 three point. 883.8 is the purchase stock price before any change in the capital structure, an just after the announcement of the capital structure such that do bondholder would have actually higher priority than the existing bondholder. Now we see that purchase stock price increases greatly to 90.
Greatly to 98.76, so there is a large increase in the Perseus stock price. Intuitively, the reason is that by changing the capital structure in this particular way, I mean higher priority given to the new bond Holder and issuing this new bond, the management team effectively shifts the value large amount of the value from the existing bondholder to the shareholders. OK, there is a intuitive reason.
Why the purchase stock price increases so much?
So just one minute.
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Using the personal account, therefore I had to remove so now share again.
So.
So, so let me summarize what we have discussed. So in this practice test questions, practice questions. The question itself is very simplified example, there is no technical difficulty, but there are a few theoretical key points that you may better pay attention to. So when we say capital structure, typically we consider the leverage ratio or the gearing level. I mean when we say that we.
Typically focus on the amount of the depth relative to the total capital, such as depth plus.
Shares and we say that importantly, therefore we have to actually use the market values of depth and shares in calculating leverage ratio or appearing level. There is important point, but also is very convenient. That's why we many times we focus on only the amount of debt by discussing when we discuss capital structure. But this example shows that not only the capital structure is OK, the leverage ratio is very important aspect of the capitals.
Structure, but it is not all over the capital structure. So even if the amount of debt is the same by as illustrated by these two example questions, I mean, we just discuss this week by considering simply different priority. We see that there is a large change. There are large differences in the market price of the existing debt and purchase stock price. So so capital structure includes not only amount of debt.
But also so many detailed structure how the chapter are designed. I mean the quality difference in the priority between two depths, existing data, new depth that is one of the such possible design. Therefore in reality when you work as a financial analyst after graduating.
From ULMS
so you are supposed to pay attention, not only the amount of debt, but also as in detailed contractual clauses.
So, for instance, consider this existing debt. I mean this existing debt holders. They're not there, smart, therefore, when they?
And when they purchase existing that like I suppose, we can go back to like suppose 10 periods ago when existing debt was issued the first time.
It at that time existing debt orders. They may expect this kind of manipulation could occur in the future.
Therefore, if really concerned about such a possibility of manipulation, then then existing debt to the state would require certain protection mechanism put into the existing debt itself. Therefore, in practice, as you may have written, I mean you you have. If you have done already the reading assignment you have already known.
That there are actually many contractuel clothes clothes. I mean there is. It is a contract and in the depth existing data, Thursday, right explicitly certain kind of protection measures such as the company cannot issue more debt, or the company can issue. But the priority of the newly should adapt should be lower than the priority of the this existing depth. Something like that. This kind of.
Contract is written in The Intercept, and so that is.
So therefore, as a financial analyst, when you propose, you are recommending to purchase stocks company Ables as Company B. Then you are supposed to understand for instance you have to do take into consideration the capital structure. Suppose the company is A&B. They have the same amount of debt so leverage ratio gearing level is the same. But suppose but there is there could be some critical difference in this kind of protection measures mechanisms.
Of the particular debt and company versus company, then you have to. If there are such a particular conditions then you have to also pay attention and analyze. Of course then you have to determine whether such conditions are important or not. You cannot always pay attention so.
But if it is, if it is important, you have to read it carefully and then maybe you have to use some services provided by some.
Some some specialist is like lawyers and they could provide you with some insights about how interpret such legal.
Legal writings into the in terms of the financial cash flow. OK, so this is all about equilibrium. OK so and also we discussed that in this case we discussed that the.
The shareholders, given the limited liability option the shareholders can choose.
Either a declared bankruptcy or not OK, so this decision bankruptcy decision is made by shareholders and that could greatly affect the cash flows received by each capital provider and therefore the market prices of the financial securities issued by the firm therefore.
You are supposed to understand that when you consider the market value of the financial securities, you have to consider how the future cash flows received by each financial security Holder would be affected by the decisions made by the management team. So that's why I think in week eight we will discuss real options on our system, which we discuss how.
Flex abilities of the managers would affect the probability distribution of the cash flows, so so this in this example questions we discuss 1. One of the searcher flexibility which is called.
Limited liability because of limited liability, the management team effectively controlled by the shareholder can make a decision about this bankruptcy. So there is one example of the real options, but there could be other flexibility, such as the company if the business is good, could determine to expand.
Or business better than shooting or even completely closed and then simply choose not to running, but sell the businesses to other firms. There are many flexibility.
Those are flexibility's could greatly affect the cash flows received by capital providers. This holders of the different financial securities issued by the firm then you are supposed to take into your consideration for that purpose we will discuss what you have to do in I think in lecture week eight next week and.
Another point is that in this question I simplified the many things such as.
There is a issue how to calculate how? How to calculate interest expense or investment expenditure. There could be many items in reality even though I simplify them. Therefore you are you may learn you may learn financial accounting after this module. Maybe you learn and then you learn how to actually you can calculate each component correctly given so many different items in reality.
There yeah so, but this is not the financial accounting model, so I propose fully simplified so that you focus more on the whole picture. The big framework, but detailed component of the accounting procedure you are supposed to learn in other modules. And then another point is that in this questions I simplify that the there is no systematic risk, but there could be systematic risk involved in this.
Co spaces. In that case you should really seriously consider the required return in calculating present value of the future cashflows.
So for that proposing lecture week eight, I think So what I'm saying is that the management teams flexibility could greatly affect the probability distribution of the cash flows. In that case, you need to know how to calculate present value of the future cash flows for their proposed, you need to know the required return, but some cases, maybe it is very difficult to calculate the required return. For instance, suppose you can you are using campaign but you cannot calculate better.
In a correct way, suppose there is no information, suppose.
In such a case, then, you are supposed to use the replicating portfolio method. That's another quantitative framework that I discussed in lecture with a think so. In that case you are supposed to understand how to incorporate the required return implicitly by using the replicating portfolio methodology. So in went as I discuss in next week, you are not using expressive required return, but the framework this methodology.
Getting fully methodology allows you to implicitly and correctly incorporate the required return.
So that are the few points that you are supposed to pay attention.
Cool.
OK.
So this is a simple simple by the framer, but eventually you are supposed to understand how how individual economic agents they make equilibrium decisions and then how these decisions would affect equilibrium cash flow and then how. And then you are supposed to correctly calculate the present value.
That is the that are the key points that I wanted to discuss. So if you have questions, please let me know.
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Yeah, so I'm sharing my screen on.
Lighter.
So first.
In the previous seminar there was a question by one student, so question assignment #3 ask you to discuss the.
The capital structure. How capital structure would affect the cost of capital, especially the two opposing forces that are relevant to a firm's optimal choice about capital structure. Thereby, capital mean the declaratio, including key assumptions using your analysis and once again ask me the question about the English expression, what is the two opposing forces?
By two opposing forces, I mean the two factors that affect the optimal level of firms that degree ratio in the different ways in the sense that one factor would increase the firm's optimal declaration while the other factor would decrease the optimal depth declaration.
Yeah, that was my answer, so this is the.
There are a few important points you have to pay attention such that Now I XI give you one more day like the.
Due date and time is Monday, not Sunday. Monday there is a reason I I do that. There have been a few students who thought they submitted their essays, but it turns out that in the system they couldn't find the essay. So I mean not not many, but there were some small number of incidents.
So please make sure that after you so I I that's why I made the announcement. After you submit you will receive the confirmation message on Vitor. Maybe you have you better save this confirmation message. You can capture the screen.
Copy.
Screen capture you can screen capture the confirmation message, but also importantly, even after you receiving the confirmation message, you better double track Weather USA is really successfully unloaded to the Attorney Inbox on Vitor so that if something some some there were some technical issues in the system such that you cannot find your essay in this in the turning inbox even though you receive the confirmation message.
Then you either you have to unload it again or you have to contact me immediately so that the necessary actions can be taken.
So what I'm saying is that for there are many students in this module. For most students this doesn't happen, but I found that there were one or two students who reported this happened, but then it is better for us to act.
Quickly rather than rather than, you just submit and you assume it was unloaded and then after two or three days and you find that USA was not uploaded then it is complicated to handle this case. Therefore after you submit USA please or maybe suppose 10 minutes later for instance and then please check whether USA was actually successfully unloaded.
That's why I gave you one more day. So for instance, if you unloaded on on on Sunday for instance, please check it again on Monday or on Monday, for instance, because you have more time, maybe 1, one at least one hour before the deadline. You may unload the USA and then 10 minutes later you may check it whether USA was really unloaded well and there is another important condition there.
If the similarity check rate is higher than 50%, than USA will be considered as a fail for most of students this doesn't matter because I find that for most of students simulator radius quite Lowe's that'll percent 10%. I mean most of them lower than 50%, but there were small number of students whose as they show their similar radius too high, even 70%. It is not allowable. Therefore for assignment number three and four.
I I give you an option of the resubmission so you after submit your first draft. Suppose you find that similar similarity rate is too high. Then you have a second chance. Then you can revise your essay. I mean so that you really make sure that you write your essay in your own words and then you can resubmit. That is allowed so.
But by the school's policy standard, as the school policy, you understand that after three submissions, my understanding is that after three submissions, you need to wait for 24 hours to re submit it again, so.
Which means that if it is very close to the deadline deadline time, then you better try to resubmit no more than three times. OK, so which means that it will be better from the beginning. You better write it in your own words, but it turns out that similar rate is higher than 50%. Then you have to rewrite and resubmit, but don't assume that you can infinitely resubmit with the common sense.
That's what I wanted to discuss. Yeah, and.
The results, the marking of the assignment number two will be finished will be finished and then the results will be can be checked. I think. 12:00 PM today about one hour. 50 minutes later you can check if you want.
Most of the students they did very well in in doing Simon number two. They discuss very well in a balanced way all the important key points about of this campaign results and assumptions the motivation.
But some students I found it, they did not discuss well the important key points. In particular, the key points given in the instruction. Then in that case, those essays are considered as fail.
And some students also. I as I mentioned earlier, some students showed too high similarity rate. So in that case those students should do should try really try right there. All essays in their own words, most of students, they they have similar rate lower than 50%. So those cases will be OK. But if it happens that your previous essay had similarity rate much higher than 50%.
Please try to.
Write in your own words, so there similarly rate in the assignment number three and four are should be lower than.
Or equal to 50%.
OK, so yeah, so that is the yeah yeah, but most of students I found that yeah for assignment #2 most students the essay was good so you're doing well you can keep doing it, yeah?
So please let me know if any questions.
Have no questions. Then let me finish our discussion now and thank you for your attention and have a great weekend and see you.
Next week, bye.