B40.2302 Course Review

1
B40.2302 Course Review

• Modified 12/5/2001 by Jeffrey Wurgler

2
Topics Covered

• Course overview
• Key slides from Classes 1-11

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Principles of Corporate Finance Brealey and Myers
Sixth Edition

• Finance and the Financial Manager

• Slides by
• Matthew Will, Jeffrey Wurgler

Chapter 1

• The McGraw-Hill Companies, Inc., 2000

Irwin/McGraw Hill
4
Role of The Financial Manager
(1)
(2)
Financial
Firm's
Financial
(4a)
manager
operations
markets
(4b)
(3)
(1) Cash raised from investors (external finance)
(2) Cash invested in firm
(3) Cash generated by operations
(4a) Cash reinvested (internal finance)
(4b) Cash returned to investors
5
Principles of Corporate Finance Brealey and Myers
Sixth Edition

• Present Value and The Opportunity Cost of
  Capital

• Slides by
• Matthew Will, Jeffrey Wurgler

Chapter 2

• The McGraw-Hill Companies, Inc., 2000

Irwin/McGraw Hill
6
Net Present Value
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Risk and Present Value

• Higher-risk projects require higher discount
  rates.
• Higher discount rates cause lower PVs.

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A Fundamental Result

• Investors with free and equal access to borrowing
  and lending markets will always invest in
  positive NPV projects, no matter what their
  preferred time pattern of consumption.
• Corollary Shareholders A and G both agree that
  firm should maximize its NPV.

9
Principles of Corporate Finance Brealey and Myers
Sixth Edition

• How to Calculate Present Values

• Slides by
• Matthew Will, Jeffrey Wurgler

Chapter 3

• The McGraw-Hill Companies, Inc., 2000

Irwin/McGraw Hill
10
Short Cuts

• Perpetuity - A constant cash flow is received
  forever, starting at the end of the first period.

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Short Cuts

• Growing perpetuity - A cash flow growing at rate
  g is received forever. The first cash flow,
  arriving at the end of the first period, is C1.

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Short Cuts

• Annuity A constant cash flow that arrives only
  for t periods. The first cash flow arrives at end
  of first period.

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Discount nominal cash with nominal rate, real
cash with real rate

• NPV rule gives same answer whether discounting
  nominal cash by nominal rate or real cash by real
  rate.
• Just dont mix them up!

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Principles of Corporate Finance Brealey and Myers
Sixth Edition

• The Value of Common Stocks

• Slides by
• Matthew Will, Jeffrey Wurgler

Chapter 4

• The McGraw-Hill Companies, Inc., 2000

Irwin/McGraw Hill
15
Valuing Common Stocks

• Dividend Discount Model - Model of todays stock
  price which states that share value equals the
  present value of all expected future dividends.
• H - Time horizon for your investment. Can be
  infinity.

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Valuing Common Stocks

• Constant Growth DDM - A version of the dividend
  growth model in which dividends grow at a
  constant rate g.
• When you use the growing perpetuity formula to
  value a stock, you are using the Gordon Growth
  Model.

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EPS, P/E, and share price

• Rearranging,
• Growth stocks sell at high P/E ratios because
  PVGO is high.
• But utilities sell at high P/E ratios because r
  is low

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FCF and PV

• Valuing a Business
• The value of a business is often computed as the
  present value of FCF out to a valuation horizon
  (H).
• The value at H is sometimes called the terminal
  value or horizon value

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Principles of Corporate Finance Brealey and Myers
Sixth Edition

• Why Net Present Value Leads to Better
  Investment Decisions than Other Criteria

• Slides by
• Matthew Will, Jeffrey Wurgler

Chapter 5

• The McGraw-Hill Companies, Inc., 2000

Irwin/McGraw Hill
20
Principles of Corporate Finance Brealey and Myers
Sixth Edition

• Making Investment Decisions with the Net
  Present Value Rule

• Slides by
• Matthew Will, Jeffrey Wurgler

Chapter 6

• The McGraw-Hill Companies, Inc., 2000

Irwin/McGraw Hill
21
Topics Covered

• What To Discount
• IMC Project
• Project Interaction
• Timing
• Equivalent Annual Cost
• Replacement
• Cost of Excess Capacity
• Fluctuating Load Factors

22
Principles of Corporate Finance Brealey and Myers
Sixth Edition

• Introduction to Risk, Return, and the
  Opportunity Cost of Capital

• Slides by
• Matthew Will, Jeffrey Wurgler

Chapter 7

• The McGraw-Hill Companies, Inc., 2000

Irwin/McGraw Hill
23
Measuring Risk
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Principles of Corporate Finance Brealey and Myers
Sixth Edition

• Risk and Return

• Slides by
• Matthew Will, Jeffrey Wurgler

Chapter 8

• The McGraw-Hill Companies, Inc., 2000

Irwin/McGraw Hill
25
Security Market Line / CAPM
Expected return
SML
rf
Beta
1.0
SML/CAPM Eri rf Bi (Erm - rf )
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Principles of Corporate Finance Brealey and Myers
Sixth Edition

• Capital Budgeting and Risk

• Slides by
• Matthew Will, Jeffrey Wurgler

Chapter 9

• The McGraw-Hill Companies, Inc., 2000

Irwin/McGraw Hill
27
Company Cost of Capitalsimple approach

• The overall company cost of capital is based on
  the weighted-average beta of the individual asset
  / project betas.
• The weights in the weighted average are
  determined by the of firm value attached to
  each asset / project.
• Example Say firm value is split as
• 1/3 New ventures investment (B2.0)
• 1/3 Expand existing business investment (B1.3)
• 1/3 Plant efficiency investment (B0.6)
• Average asset beta (1/3)2.0 (1/3)1.3
  (1/3)0.6 1.3
• This average beta determines the company cost of
  capital.

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Risk and DCFPutting it all together

• Example
• Project A is expected to produce CF 100 mil
  for each of three years. Given a risk free rate
  of 6, a market risk premium of 8, and an asset
  beta of .75, what is the PV of the project?

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Principles of Corporate Finance Brealey and Myers
Sixth Edition

• Spotting and Valuing Options

• Slides by
• Matthew Will, Jeffrey Wurgler

Chapter 20

• The McGraw-Hill Companies, Inc., 2000

Irwin/McGraw Hill
30
Option Value

• Determinants of Call Option Price
• 1 - Underlying stock price ()
• 2 - Exercise (strike) price (-)
• 3 - Standard deviation of stock returns ()
• 4 - Time to option expiration ()
• 5 - Interest rate ()

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Black-Scholes

• Our examples have just been simple up-or-down
  movements
• In these cases, the binomial method is perfect
• In reality, there may be a continuum of outcomes
• Black-Scholes formula uses a replicating
  portfolio
• argument to derive European call option value
  under these circumstances

VCall N(d1)P- N(d2)PV(S)
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Principles of Corporate Finance Brealey and Myers
Sixth Edition

• Real Options

• Slides by
• Matthew Will, Jeffrey Wurgler

Chapter 21

• The McGraw-Hill Companies, Inc., 2000

Irwin/McGraw Hill
33
Topics Covered

• Real Options
• Follow-on investments
• Abandon
• Wait (and learn)
• Vary output or production methods
• Valuation examples mixed in

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Principles of Corporate Finance Brealey and Myers
Sixth Edition

• An Overview of Corporate Financing

• Slides by
• Matthew Will, Jeffrey Wurgler

Chapter 14.1-14.3

• The McGraw-Hill Companies, Inc., 2000

Irwin/McGraw Hill
35
Patterns of Corporate Financing

• Two ways to finance investment
• Raise equity or debt (external finance)
• Plow back profits rather than distribute them to
  shareholders (internal finance)

36
Principles of Corporate Finance Brealey and Myers
Sixth Edition

• An Overview of Corporate Financing

• Slides by
• Matthew Will, Jeffrey Wurgler

Chapter 14.4

• The McGraw-Hill Companies, Inc., 2000

Irwin/McGraw Hill
37
Corporate Debt

• General features of debt
• Borrower (stockholder) promises a certain stream
  of interest and principal payments
• But borrower may choose to default
• Lender doesnt usually have voting rights, but in
  case of default lender gets assets
• Asset administration handled by bankruptcy court

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Principles of Corporate Finance Brealey and Myers
Sixth Edition

• The Many Different Kinds of Debt

• Slides by
• Matthew Will, Jeffrey Wurgler

Chapter 24

• The McGraw-Hill Companies, Inc., 2000

Irwin/McGraw Hill
39
Topics Covered

• Domestic Bonds and International Bonds
• The Bond Contract
• Interest, Security, Seniority
• Asset-Backed Securities
• Repayment/Retirement Provisions
• Covenants
• Private Placements and Project Finance

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Principles of Corporate Finance Brealey and Myers
Sixth Edition

• Warrants and Convertibles

• Slides by
• Matthew Will, Jeffrey Wurgler

Chapter 22.1-22.3

• The McGraw-Hill Companies, Inc., 2000

Irwin/McGraw Hill
41
Warrants

• Warrant - Right to buy a security (usually
  shares) from a company at a stipulated price, on
  or before a stipulated date.
• - A call option!

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Convertible Bonds

• Convertible Bond - Bond that the holder may
  exchange for a specified amount of another
  security (usually shares).
• Convertibles are thus a combined security,
  combining a straight bond and a call option
• Like bond-warrant combo, except in bond-warrant
  combo you dont have to surrender one to get the
  other you have both
• Example to understand terms ALZA
• 5 Convertible 2006, face value 1000
• Convertible into 26.2 shares
• Conversion ratio 26.2
• Conversion price 1000/26.2 38.17
• Market price of shares 28

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Principles of Corporate Finance Brealey and Myers
Sixth Edition

• Valuing Debt

• Slides by
• Matthew Will, Jeffrey Wurgler

Chapter 23

• The McGraw-Hill Companies, Inc., 2000

Irwin/McGraw Hill
44
Topics Covered

• The Term Structure
• Term Structure Theories
• Risk Duration and Volatility
• Risk Default

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Principles of Corporate Finance Brealey and Myers
Sixth Edition

• How Corporations Issue Securities

• Slides by
• Matthew Will, Jeffrey Wurgler

Chapter 15.2-15.6

• The McGraw-Hill Companies, Inc., 2000

Irwin/McGraw Hill
46
Topics Covered

• The Initial Public Offering
• The Underwriters
• Underpricing and The Winners Curse
• General Cash Offers

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Principles of Corporate Finance Brealey and Myers
Sixth Edition

• The Dividend Controversy

• Slides by
• Matthew Will, Jeffrey Wurgler

Chapter 16.1-16.4

• The McGraw-Hill Companies, Inc., 2000

Irwin/McGraw Hill
48
MM Dividend irrelevance

• Modigliani Miller dividend proposition
• Dividend policy is irrelevant in perfect capital
  markets

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MM Dividend irrelevance

• Some key assumptions
• Investment policy held constant
• No transaction costs (e.g. repurchasing premium
  for company, cost of mailing dividend checks)
• Dividends and capital gains taxed at same rate
• If you claim dividends do matter, one or more of
  these assumptions must be violated. That is the
  power of the theorem it clarifies how dividends
  could matter.

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Principles of Corporate Finance Brealey and Myers
Sixth Edition

• Does Debt Policy Matter?

• Slides by
• Matthew Will, Jeffrey Wurgler

Chapter 17

• The McGraw-Hill Companies, Inc., 2000

Irwin/McGraw Hill
51
MM Debt Policy Proposition I

• Modigliani Miller debt policy proposition
• The market value of a company is independent of
  its capital structure.

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MM Debt Policy Irrelevance
r
rE
rA
rD
D E
Risk free debt
Risky debt
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Corporate Taxes

• Taxes dont change the total size of the pretax
  pizza.
• But now the government gets a slice.
• Governments slice is smaller (and investors
  slices are bigger) when debt is used.
• MM proposition I with corporate taxes
• Firm Value Value of All Equity Firm
• PV(Tax Shield)
• and in special case where debt is permanent
• Firm Value Value of All Equity Firm TcD

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Costs of Financial Distress

• Costs of Financial Distress - Costs arising from
  bankruptcy or distorted business decisions on the
  brink of bankruptcy.
• Firm value Value of All Equity Firm
• PV(Tax Shield)
• - PV(Costs of Financial Distress)

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Trade-off Theory
Costs of financial distress
PV of interest tax shields
Market Value
Value of levered firm
Value if All Equity
Debt ratio
Optimal amount of debt
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Principles of Corporate Finance Brealey and Myers
Sixth Edition

• Financing and Valuation

• Slides by
• Matthew Will, Jeffrey Wurgler

Chapter 19

• The McGraw-Hill Companies, Inc., 2000

Irwin/McGraw Hill
57
After-Tax WACC vs. APV

• With consistent assumptions, get same answer.
• WACC assumes constant debt ratio ?, but then
  dont have to value tax shield explicitly ?
• APV lets tax shields vary over time ?, but have
  to calculate them yourself ?.
• APV more flexible can handle other financing
  effects besides interest tax shields ?

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Principles of Corporate Finance Brealey and Myers
Sixth Edition

• Leasing

• Slides by
• Matthew Will, Jeffrey Wurgler

Chapter 25.2-25.6

• The McGraw-Hill Companies, Inc., 2000

Irwin/McGraw Hill
59
Operating Leases

• Bottom line for lessee Operating lease or buy?
• Buy if the lessees equivalent annual cost of
  ownership and operation is less than the best
  available operating lease rate
• Otherwise lease
• Complication If operating lease includes option
  to cancel/abandon, need to factor that in

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Financial Leases

• Bottom line for lessee Financial lease or
  buy-and-borrow?
• Buy-and-borrow if can devise a borrowing plan
  that gives same cash flow as lease in every
  future period, but higher immediate cash flow
  (equivalently, buy-and-borrow if incremental
  lease cash flows are NPVlt0)
• Otherwise lease

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Principles of Corporate Finance Brealey and Myers
Sixth Edition

• Managing Risk

• Slides by
• Matthew Will, Jeffrey Wurgler

Chapter 26

• The McGraw-Hill Companies, Inc., 2000

Irwin/McGraw Hill
62
Topics Covered

• Insurance
• Futures contracts
• Forward contracts
• Swaps
• How to set up a hedge

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Hedging

• Hedging
• Taking on one risk to offset another
• Some basic tools for hedging
• Futures
• Forwards
• Swaps

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Principles of Corporate Finance Brealey and Myers
Sixth Edition

• Managing International Risk

• Slides by
• Matthew Will, Jeffrey Wurgler

Chapter 27

• The McGraw-Hill Companies, Inc., 2000

Irwin/McGraw Hill
65
Exchange Rate Relationships

• In simplest world (people are risk-neutral and
  face no transaction costs for international
  trade), they are all equal (!)

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International Capital Budgeting
Equivalent Intl. Capital Budgeting Techniques

• 1) (Easy) Discount foreign CFs at foreign cost of
  capital. (Can then convert this present value to
  using spot exchange rate.)
• 2) (Hard) Convert to assuming all currency risk
  was hedged (use forward exchange rates), and then
  discount with cost of capital.
• These techniques are equivalent (verify BM6 p.
  806-807)
• Thus, hedging allows you to separate the
  investment decision from decision to take on
  currency risk

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Principles of Corporate Finance Brealey and Myers
Sixth Edition

• Corporate Financing and the Six Lessons
  of Market Efficiency

• Slides by
• Matthew Will, Jeffrey Wurgler

Chapter 13

• The McGraw-Hill Companies, Inc., 2000

Irwin/McGraw Hill
68
Return to NPV

• How does market efficiency affect financing?
• But in inefficient markets, maybe NPV(financing)
  gt0
• Financing may be relevant if firm can find
  ways to finance at below-market costs, i.e.
  ways to finance below its rational cost of
  capital
• So market efficiency is central to MM conclusion
• Are markets efficient or not?
• A controversial issue in finance
• Evidence that markets are approximately efficient
• However, can find exceptions if one looks
  carefully at the data
• These may be important enough to affect financing
  decisions

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Market Efficiency 3 versions

• Weak Form Efficiency
• Market prices reflect past price information.
• Prices move as a random walk
• Semi-Strong Form Efficiency
• Market prices reflect all publicly available
  information, not just past prices
• Strong Form Efficiency
• Market prices reflect all information, both
  public and private.

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Pecking Order Theory

• Pecking Order Theory of Incremental Financing
  Decisions - Theory that uses asymmetric
  information to argue that firms prefer to fund
  their investments using internal finance, then
  (if internal finance is insufficient) by debt
  issues, then (as a last resort) by equity issues.
• Pecking Order Theory of Capital Structure
• Theory in which capital structure evolves as the
  cumulative outcome of past incremental financing
  decisions, each of which is taken using the above
  rule.

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Market Timing Theory

• Market timing theory of financing decisions
• Financing theory when markets are not semi-strong
  efficient, e.g. when investors underreact to the
  bad news in equity issue or the good news in a
  repurchase
• Says raise whatever form of finance is currently
  available at the lowest risk-adjusted cost. (In
  MM efficient markets, this makes no sense, since
  all forms of finance are efficiently priced at
  the same risk-adjusted cost.)
• For example, issue equity if it is relatively
  overpriced, or long-term debt if it is relatively
  overpriced, or short-term debt if it is
  relatively overpriced
• Consistent with empirical evidence that firms can
  time the market

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Principles of Corporate Finance Brealey and Myers
Sixth Edition

• Making Sure Managers Maximize NPV

• Slides by
• Matthew Will, Jeffrey Wurgler

Chapter 12.3

• The McGraw-Hill Companies, Inc., 2000

Irwin/McGraw Hill
73
The Principal-Agent Problem
The problem How do owners get managers to act
in their interests? (i.e. to maximize NPV)
Shareholders Owners Principals
Managers Control Shareholders agents
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The Principal-Agent Problem
How might managers interests differ from
shareholders interests?

• Low effort (slacking/shirking)
• Expensive perks (corporate jets)
• Empire building (overinvestment)
• Entrenching investment (to keep job)
• Avoiding risk (so as not to lose job)

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Potential solutions

• Incentives
• Monitoring
• Debt finance
• Takeover pressure
• Managerial outside labor market
• Proxy fights

76
Principles of Corporate Finance Brealey and Myers
Sixth Edition

• Mergers

• Slides by
• Matthew Will, Jeffrey Wurgler

Chapter 33

• The McGraw-Hill Companies, Inc., 2000

Irwin/McGraw Hill
77
Topics Covered

• Sensible Motives for Mergers
• Some Dubious Reasons for Mergers
• Estimating Merger Gains and Costs
• Takeovers Unsolicited/hostile mergers