finance quiz.

11810633

Ziyuan Zhou

Group 2

1. Project Financing

Presented

2. EVA

Economic Value Added (EVA) is a performance metric that evaluates the creation of shareholder value. It is the calculation of what the firm’s profits remain after deducting the costs of capital (WACC), which composed of both debt and equity.

The key difference between EVA and the older metrics, such as EPS, ROI, is that EVA actually indicates the economic value of the firm, whereas the older metrics only show the accounting profits. The implicit cost, which also known as opportunity cost, has been considered in EVA. Therefore, even though a company has a high EPS or ROI, doesn’t necessarily mean this company is generating positive economic value with investors’ money.

Shareholders now also use EVA to evaluate their managers’ performance. If the EVA is a positive figure, it is an indicator of good management because the manager is helping gaining value by using the investor’s money. Conversely, the negative EVA means the wealth of shareholders is being diminished due to the poor capital management. The board may need to replace their manager even when holding a beautiful EPS or ROI report.

The problems of EVA are mainly caused by its little relevance of a firm’s future performance. In certain industries with higher average P/E ratio, such as biotech or business software, companies will usually generate losses before the enormous return in some potential projects. EVA can hardly show the potential profitability of these investments. Similar problems occur in startup ventures, EVA would be negative even if the project were on track to a strong positive NPV in the next few years. On the other hand, based on GAAP, R&D program or advertisement will be recorded as expenses, this may cause a negative EVA as well. But from an economic perspective, these cash outlays are necessary investments, not just simply costs. Lastly, using EVA as a measure of managers’ performance would easily trigger a chasing of quick return instead of the future development of firms. It is especially unfavorable to those long-term investors.

3. Equity carve-outs, spin-offs.

These two are both the methods that being used to divest some amount of the assets, a division or a subsidiary by the parent company. When companies want to enhance the economies of scale or synergies, they usually merge or acquire some other firms. On the contrary, firms will also adopt carve-outs or spin-offs when synergies and economies of scale no longer exist, or for other compelling reasons.

In a spin-off, all or at least 80% of shares of the subsidiary would be distributed to its existing shareholders by the parent company, in the form of a special dividend. After the spin-off, there are two separate, publicly held independent firms. The spin-off is a distinct entity and has its own management. The parent company must relinquish control of the subsidiary by giving away at least 80% of its voting and non-voting shares and typically receives no cash consideration.

Example: In 2014, Healthcare company Baxter International, Inc.(BAX) spun-off its biopharmaceuticals business Baxalta Incorporated (BXLT). The separation was announced in March, and was completed on July 1. Baxter shareholders received one share of Baxalta for each share of Baxter common stock held. The spin-off was achieved through a special dividend of 80.5% of the outstanding shares of Baxalta, with Baxter retaining a 19.5% stake in Baxalta immediately after the distribution. Interestingly, Baxalta received a takeover offer from Shire Pharmaceuticals (SHPG) within weeks of its spin-off; Baxalta's management rebuffed the offer saying it undervalued the company.

In a carve-out, the parent company sells some amount or all of shares of the subsidiary to the public through an IPO. So the parent company will receive certain amount cash inflow, which is different from spin-offs. And also, in order to remain the control of the subsidiary and keep the possibility of spin-off in the future, no more than 20% of the subsidiary’s shares could be offered in an IPO.

Example: In February 2009, Bristol-Myers Squibb Company (BMY) sold 17% of the shares in its subsidiary Mead Johnson Nutrition Company (MJN). By December 23, 2009, the Mead Johnson IPO was the best performing one on the New York Stock Exchange, with the shares increasing nearly 80% from the IPO issue price.

4. Stock Repurchase

Stock repurchase is also called buyback, which means that one company buying their own stocks from either the market or some current stockholders. Repurchase from market are normally traded at current market price, repurchase from current stockholder, on the other hand, are traded at some fixed price.

There are several reasons that company repurchase.

Stock price. The stock price is calculated by dividing total stock value over stock outstanding. It is clear that the less stock outstanding there is, the bigger stock price will be. Compared to non-repurchase, company can hint the market their stock has been undervalued, and attract more investors.

With net income as a fixed number, lower stock outstanding, will give the company a higher earnings per share, a higher return on asset, return on equity and so on. Better financial ratio will also increase the company’s image. Next, each shareholder will receive a higher dividend if the total dividend amount is fixed, calculated by total dividend over stock outstanding.

If the company has its earnings and total dividends growing, less stock outstanding also means higher dividend growth. Either way, shareholders will be satisfied by the company’s managers. Last but not the least, stock repurchase limit the number of shares in the market, which is one of the effective way to avoid hostile takeover.

Generally, stock repurchase is conducted through one of two ways:

Tender Offer

In this way, company has to submit or tender some amount of their shares within certain rules or frame. Then the tender offer will stipulate the number of shares that the company is willing to repurchase and the price range they would pay. Investors can take the offer by stating the number of shares and the price they can accept. The company will find the right mix to buy the shares at their lowest cost when receive all of the offers.

2. Open Market

The company will be like other individual investors in the market, they buy shares on the open market at current market price.

5. Leverage

Leverage is when an investor or business uses borrowed money in an attempt to increase rate of return on an investment. Basically, it means that people borrow money to do some business. One of the important ratio for leverage is debt to equity ratio, which is calculated by dividing total debt over total equity. By looking at this ratio, investors and banks can analysis the leverage degree of the company. The higher ratio means company has more debt need to pay off.

Degree of operating leverage, a.k.a DOL, is a leverage ratio, which analysis specific operating leverages’ influence on company’s earning before interest and taxes for a certain period of time. It is clear measures impacts on EBIT, which represent earning before interest and taxes. It is calculated by dividing “Change in EBIT” over “Change in Earnings” for this certain period. The higher DOL is, the more volatile EBIT will be. It will be harder for executors to predict sales and make decisions when DOL relatively high.

Degree of financial leverage, a.k.a DFL, is a leverage ratio, which analysis how relatively EPS impact company’s operating income. It is calculated by dividing “Change in EPS” over “Change in EBIT”. The higher DFL is, the more impact on income, the more risk are. Vice versa. However, company have control by setting up proper WACC.

Degree of total leverage, a.k.a DTL, is the combination of degree of operating leverage and financial leverage. It is calculated with DOL times DFL,

which equals (“Change in EBIT” *”Change in EPS”) / (“Change in earnings” * “Change in EBIT”)

which equals “Changes in EPS”/ “Change in earnings”.

Company have high DOL and DFL will also means that EPS is higher volatile with a small change in sales.

6. Crowdfunding

Crowdfunding is a way to raise capital from public, its model combines group buying and paying in advance activity. Usually, crowdfunding is used by some small organizations or individuals, by displaying their innovative and distinguishing products or services on internet or some other modern medium, people who are interested in those products or services will be willing to pay for it in advance, once the company or individual has raised sufficient capital to start the program, the stage of crowdfunding will be completed and in the next step, the promised products or services will be given.

 

Pros:

1.    Easy to start, everyone can utilize it once they have basic internet knowledge.

2.    Low risk, money received first, and then products or services provided.

3.    A good way to promote your product to both the public and investors by displaying widely.

Cons:

1.    Must fulfill the promise on time. In order to be trusted, you must give promises to the public which will lead to the pressure of production, including the quality and quantity.

2.    Insufficient financing channels, unstable source of funds from the public, a growing number of crowdfunding activities will distract the business and the supporters which won’t give entrepreneurs stable funds in long period

3.    Unlike traditional VC, who can advise entrepreneurs with experiences, the public will only provide money to support the program, not ideas

 

Example:

 

The movie Wolf Totem

 

Wolf Totem is a 2015 Chinese-language film based on the novel. Directed by French director Jean-Jacques Annaud, it used crowdfunding on Alibaba’s crowdfunding platform Taobao to raise funds and it was one of the first crowdfunding movies, and it successfully raised 73 million Chinese Yuan from the public to fire the first shot. Eventually earn 697 million Chinese Yuan at box offices and won two important rewards from Beijing Movie Festival.