CF 04 Lecture Notes
CF 04 Lecture Notes
CF 04 Lecture Notes
CORPORATE FINANCE
Lecture notes
Lecture 1. Introduction
The company can be restructured from private to a public one via IPO, and vice versa. Another type of
structural change comes from M&As. The companys goal is to acquire the companies bringing
synergy gains and those undervalued due to the inefficient management. The best defence from the
acquisition is to maximize its own value.
The goal of corporate governance is to internalize the external effects, balance the economic interests
of all stakeholders. In well-functioning financial markets, this maximizes shareholder value.
Typical CF questions:
How to measure the projects worth for the company?
Are companies' market prices justified? (e.g., dot-coms)
How to choose among the projects given the budget constraint and external effects?
How to account for risks associated with the project?
o Systematic vs company-specific risks
Are risks always bad?
Is it good to have volatile oil prices?
o Yes, if managers have flexibility in the future decisions.
Should we invest now in a project, which seems unprofitable (has negative NPV)?
o Probably, yes. It may yield high profit in certain future scenarios (oil pipeline)
Should we invest now in a project, which is profitable (has positive NPV)?
o Probably, not. It may be even more profitable next period (gold extraction)
Should we give managers higher salaries or higher bonuses?
o Bonuses encourage higher performance, but may also lead to the manipulations and excessive
risk-taking.
Does it matter how to finance the project: by debt or by equity?
Would you like the company to have much debt?
o Yes, to minimize taxes and to discipline the managers. Not too much, to avoid bankruptcy.
Should the company borrow money from banks or issue bonds?
o The company can renegotiate the terms of bank credit.
Would you like the company to pay high dividends? (e.g., Microsoft)
o Yes, if too much managerial discretion (Surgut). No, because of double taxation and signalling
that the company has no valuable inv projects.
How will the market react to the share buyback?
o The company signals that its shares are undervalued.
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How will the market react to the new equity issue?
o Usually negatively: either the companys shares are overvalued, or it needs to finance a new
inv project.
How should the company communicate with the market? Always provide precise info in time?
What drives the companys decision to go public? Why are there hardly any IPOs in Russia?
Would you like the company to grow via acquisitions?
o Yes, if the main motivation comes form synergy gains, and not empire-building.
Specifics of corporation
Do not take the current form of corporations and stock markets as given, it is an endogenous outcome!
Advantages of corporation in comparison with sole proprietorship and partnership:
Ltd liability: lesser risks for investors
o Crucial for development of stock markets and diversification
Easy transfer of ownership
o Promotes liquidity
Unlimited life
o Makes it easier to attract financing
Disadvantages:
Separation of ownership and control, the agency conflict
o Solved in two ways: US vs Germany
Double taxation
History: 1811, general act of incorporation in NY, specifying that all investors of NY corporations
have limited liability
Not so obvious that limiting the freedom of contracts is good
Hot discussion at the time: could spur excessive risk taking
California was the last to copy in 1931
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long term, instantaneously.
The objective of stock price performance provides some very elegant theory on:
o how to pick projects
o how to finance them
o how much to pay in dividends
Traditional corporate financial theory breaks down when the interests/objectives of the decision
makers in the firm conflict with the interests of stockholders.
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o Bondholders (Lenders) are not protected against expropriation by stockholders.
o Financial markets do not operate efficiently, and stock prices do not reflect the underlying
value of the firm.
o Significant social costs can be created as a by-product of stock price maximization.
Solutions:
Choose a different mechanism for corporate governance
Choose a different objective:
o Maximizing earnings / revenues / firm size / market share
o The key thing to remember is that these are intermediate objective functions. To the degree
that they are correlated with the long term health and value of the company, they work
well. To the degree that they do not, the firm can end up with a disaster
Maximize stock price, but reduce the potential for conflict and breakdown:
o Making managers (decision makers) and employees into stockholders
o Providing information honestly and promptly to financial markets
Counter reaction
The strength of the stock price maximization objective function is its internal self correction
mechanism. Excesses on any of the linkages lead, if unregulated, to counter actions which reduce or
eliminate these excesses
managers taking advantage of stockholders has lead to a much more active market for corporate
control.
stockholders taking advantage of bondholders has lead to bondholders protecting themselves at the
time of the issue.
firms revealing incorrect or delayed information to markets has lead to markets becoming more
skeptical and punitive
firms creating social costs has lead to more regulations, investor and customer backlashes.
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o Maximize Stock Price: This will also maximize firm value
For publicly traded firms in inefficient markets, where bondholders are protected:
o Maximize stockholder wealth: This will also maximize firm value, but might not maximize
the stock price
For publicly traded firms in inefficient markets, where bondholders are not fully protected
o Maximize firm value, though stockholder wealth and stock prices may not be maximized at
the same point.
For private firms, maximize stockholder wealth (if lenders are protected) or firm value (if they are
not)
Functions: providing
current status and past performance information to owners and creditors
a convenient way for owners and creditors to set performance targets & to impose restrictions
on the managers of the firm
a convenient template for financial planning
Balance Sheet
Assets Liabilities + Shareholders Equity
Tabulates a companys assets and liabilities at a specific point in time
o Info on value of the assets and the capital structure
Sorting of
o Assets by liquidity
o Liabilities by maturity
Assets and liabilities are represented by historical costs
o The original cost adjusted for improvements and aging = Book Value
o Avoid using market value, since is too volatile and easily manipulated
o Preference for underestimating value
Strict categorization into E or L: the liability must satisfy
o The obligation will lead to CF at some specified or determinable date
o The firm cannot avoid the obligation
o The transaction behind the obligation has already happened
However, important liabilities may be under-stated or omitted
Assets
Current Assets ( ): will convert into cash within a year
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o Cash
o Accounts Receivable ( )
Recognizing not collectible ones: reserves (danger of manipulation!)
o Inventory (): valued by FIFO, LIFO, wdt-avg
LIFO increases costs and reduces taxes
LIFO reserve: difference between LIFO and FIFO valuations
Investments and Marketable Securities ( )
o Minority passive / active investment (<20% / 20-50% of the ownership): BV or MV
o If majority active investment (>50%): include in the consolidated balance sheet
Intangible Assets ( ): amortized over expected life (say, 40 years)
o Patents and trademarks: valuation depends on whether generated internally or acquired
o Goodwill: the difference between BV and MV of the acquired firm (purchase accounting)
Fixed Assets ( ; Land, Plant and Equipment): BV with adjustment for aging
o Depreciation: straight line or accelerated (improves the earnings in the first years)
Income Statement
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Revenue Expenses Income
Summarizes the companys profitability during a time period
o Records sales, expenses, taxes, and net income
Matching principle of the accrual accounting:
o Revenues and expenses are recognized when the good is sold
Becomes complicated for long-term contracts and buyers with credit risk
o In contrast to the cash-based approach: recognizing revenues when received and expenses
when paid
A companys accounting income and cash flow are two different things
Categorization of expenses:
o Operating: provide benefits only for the current period (cost of labor and materials)
Also included: depreciation (based on historical cost) and R&D
o Financing: arising from non-equity financing (interest expenses)
o Capital: generate benefits over multiple periods (buying land and buildings), written off as
depreciation
To improve forecasting, separately: nonrecurring items
o Income from discontinued operations, extraordinary gains & losses, adjustments for
changes in accounting principles
Retained earnings are not added to the cash balance in the balance sheet, but are added to
shareholders equity
Inflation distorts the measuring of income and the valuation of assets
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Financial Ratio Analysis
Trend Analysis
Cross-Sectional Analysis
Profitability Ratios
Return on Assets (ROA) = EBIT(1-tax) / Total Assets
Return on Equity (ROE) = Net Income / BV(equity)
Gross Profit Margin = Gross Profit / TA
Operating Profit Margin = EBIT / Sales
Net Profit Margin = Net Income / Sales
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Reputation
Good Employee Relations
Pricing Applications
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Differences between real and financial options, which are crucial for the Black-Scholes approach:
1. The underlying asset is not traded
Option pricing theory is built on the premise that a replicating portfolio can be created using
the underlying asset and riskless lending and borrowing.
2. The price of the asset may not follow a continuous process
If there are no price jumps, as it is with most real options, the model will underestimate the
value of deep out-of-the-money options.
o One solution is to use a higher variance estimate to value deep out-of-the-money
options and lower variance estimates for at-the-money or in-the-money options.
o Another is to use an option pricing model that explicitly allows for price jumps, though
the inputs to these models are often difficult to estimate.
3. The variance may change over the life of the option
The assumption that option pricing models make, that the variance is known and does not
change over the option lifetime, is not unreasonable when applied to listed short-term options
on traded stocks.
When option pricing theory is applied to long-term real options, there are problems with this
assumption, since the variance is unlikely to remain constant over extended periods of time and
may in fact be difficult to estimate in the first place.
4. Exercise is not instantaneous
The option pricing models are based upon the premise that the exercise of an option is
instantaneous. This assumption may be difficult to justify with real options, where exercise
may require the building of a plant or the construction of an oil rig, actions which are unlikely
to happen in an instant.
The fact that exercise takes time also implies that the true life of a real option is often less than
the stated life.
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The standard deviation in gold prices is 20%, and the current price of gold is $350 per ounce. The
riskless rate is 9%, and the cost of capital for operating the mine is 10%. The inputs to the model are
as follows:
The value of the mine as an option is $ 9.75 million, in contrast to the static capital budgeting analysis
which would have yielded a net present value of $ 2.40 million ($42.40 million - $ 40 million). The
additional value accrues directly from the mine's option characteristics.
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Call Value= 544 .22 exp(-0.05)(20) (0.8498) -600 (exp(-0.08)(20) (0.6030)= $ 97.08 million
This oil reserve, though not viable at current prices, still is a valuable property because of its potential
to create value if oil prices go up.
A simple example
Assume that you have a firm whose assets are currently valued at $100 million and that the standard
deviation in this asset value is 40%.
Further, assume that the face value of debt is $80 million (It is zero coupon debt with 10 years left to
maturity).
If the ten-year treasury bond rate is 10%, how much is the equity worth? What should the interest rate
on debt be?
Model Parameters
Value of the underlying asset = S = Value of the firm = $ 100 million
Exercise price = K = Face Value of outstanding debt = $ 80 million
Life of the option = t = Life of zero-coupon debt = 10 years
Variance in the value of the underlying asset = 2 = Variance in firm value = 0.16
Riskless rate = r = Treasury bond rate corresponding to option life = 10%
Applicability in valuation
Input Estimation Process
Cumulate market values of equity and debt (or)
Value of the
Value the firm using FCFF and WACC (or)
Firm
Use cumulated market value of assets, if traded.
Variance in If stocks and bonds are traded,
Firm Value
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2firm = we2 e2 + wd2 d2 + 2 we wd ed ed
Where h is the reversion speed. The variable x(t) has normal distribution with mean and
variance given by:
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This is necessary due the log-normal properties
Using the previous equation relating P(t) with x(t), we get the risk-neutral mean-reversion sample
paths for the oil prices.
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The known formula for a commodity futures prices is F(t) = e(r ) t P. This equation is deduced by arbitrage and assumes
that is deterministic, so it looks contradictory with our assumption of systematic jump and with our model that implies
that is as uncertain as P. But we want an implicit value for and so for , to get a market reference for . It is only a
practical market evaluation for the discount rate that is assumed constant in our model.
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Lectures 7-9. Capital structure
Treatment of Warrants and Convertibles
Warrants and conversion options (in convertible bonds, for instance) are long term call options, but
standard option pricing models are based upon the assumption that exercising an option does not affect
the value of the underlying asset. This may be true for listed options on stocks, but it is not true for
warrants and convertibles, since their exercise increases the number of shares outstanding and brings
in fresh cash into the firm, both of which will affect the stock price. The expected negative impact
(dilution) of exercise will make warrants less valuable than otherwise similar call options. The
adjustment for dilution in the Black-Scholes to the stock price involves three steps:
Step 1: The stock price is adjusted for the expected dilution from warrant exercise.
Dilution-adjusted S = (S ns+W nw) / ns
where,
S = Current value of the stock
nw = Number of warrants outstanding
W = Market value of warrants outstanding
ns = Number of shares outstanding
When the warrants are exercised, the number of shares outstanding will increase, reducing the stock
price. The numerator reflects the market value of equity, including both stocks and warrants
outstanding.
Step 2: The variance used in the option pricing formula is the variance in the value of the equity in the
company (i.e., the value of stocks plus warrants, not just the stocks).
Step 3: The call is valued with these inputs.
Dilution-adjusted value = Call Value from model
2. Pooling of interest: A issues n new shares in exchange for 10 shares of B, such that n shares of the
combined firm are worth 150.
Solving the equation 150/700 = n/(25+n), we find n=6.818. Naturally, the share price is the same as in
the previous case: $22, as As shareholders must be indifferent between the two methods given a fixed
premium for Bs shareholders.
Given the probability of merger q, say, equal to 0.6, one can compute the pre-merger price of A:
Pre-merger P(A) = 0.6P*(A) + 0.4P0(A) = 0.6*20 + 0.4*22 = $20.8.
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Lecture 13. Corporate governance
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