INTERMEDIATE CORPORATE
FINANCE
Pre-Master Finance
2021-2022
,Table of Contents
Week 1 ........................................................................................................................................ 2
Chapter 7) Investment Decision Rules ................................................................................................ 2
Chapter 8) Fundamentals of Capital Budgeting .................................................................................. 4
Week 2 ........................................................................................................................................ 9
Chapter 14) Capital Structure in a Perfect Market ............................................................................. 9
Chapter 15) Debt and Taxes.............................................................................................................. 14
Week 3 ...................................................................................................................................... 21
Chapter 16) Financial Distress, Managerial Incentives, and Information ......................................... 21
Chapter 17) Payout Policy ................................................................................................................. 28
Week 4 ...................................................................................................................................... 35
Chapter 23) Raising Equity Capital .................................................................................................... 35
Chapter 24) Debt Financing .............................................................................................................. 39
Chapter 25) Leasing .......................................................................................................................... 43
Week 5 ...................................................................................................................................... 49
Chapter 8) Fundamentals of Capital Budgeting ................................................................................ 49
Chapter 18) Capital Budgeting and Valuation with Leverage ........................................................... 49
Chapter 19) Valuation and Financial Modelling: A Case Study ......................................................... 56
Chapter 22) Real Options .................................................................................................................. 61
Week 6 ...................................................................................................................................... 69
Chapter 28) Mergers and Acquisitions ............................................................................................. 69
Chapter 29) Corporate Governance.................................................................................................. 76
Week 7 ...................................................................................................................................... 82
Chapter 30) Risk Management ......................................................................................................... 82
Chapter 31) International Corporate Finance................................................................................... 91
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,Week 1
Chapter 7) Investment Decision Rules
7.1. NPV and Stand-Alone Projects
• NPV Investment Rule: When making an investment decision, take the alternative with the highest
NPV. Choosing this alternative is equivalent to receiving its NPV in cash today.
• The NPV rule says that we should compare a project’s NPV to zero (the NPV of doing nothing) and
accept the project if its NPV is positive.
• The NPV of the project depends on the appropriate cost of capital. Often, there may be some
uncertainty regarding the project’s cost of capital. In that case, it is helpful to compute an NPV
profile: a graph of the project’s NPV over a range of discount rates.
o The internal rate of return (IRR) of an investment is the discount rate that sets the NPV
of the project’s cash flows equal to zero. The IRR of a project provides useful information
regarding the sensitivity of the project’s NPV to errors in the estimate of its cost of capital.
o The difference between the cost of capital and the IRR is the maximum estimation error in
the cost of capital that can exist without altering the original decision.
7.2. The Internal Rate of Return Rule
• One interpretation of the internal rate of return is the average return earned by taking on the
investment opportunity.
• The internal rate of return (IRR) investment rule is based on this idea: if the average return on
the investment opportunity (i.e., the IRR) is greater than the return on other alternatives in the
market with equivalent risk and maturity (i.e., the project’s cost of capital), you should undertake
the investment opportunity.
• IRR Investment Rule: Take any investment opportunity where the IRR exceeds the opportunity cost
of capital. Turn down any opportunity whose IRR is less than the opportunity cost of capital.
• The IRR rule is only guaranteed to work for a stand-alone project if all of the project’s negative
cash flows precede its positive cash flows. If this is not the case, the IRR rule can lead to incorrect
decisions.
• By setting the NPV equal to zero and solving for 𝑟, we find the IRR.
• There is no easy fix for the IRR rule when there are multiple IRRs. When multiple IRRs exist, our
only choice is to rely on the NPV rule.
• We can only rely on the IRR rule if all of the negative cash flows of the project precede the positive
cash flows. However, the IRR itself (so not the rule) remains a very useful tool. The IRR measures
the average return over the life of an investment and indicates the sensitivity of the NPV to
estimation error in the cost of capital.
7.3. The Payback Rule
• The payback investment rule states that you should only accept a project if its cash flows pay back
its initial investment within a prespecified period.
• To apply the payback rule, you first calculate the amount of time it takes to pay back the initial
investment, called the payback period. Then you accept the project if the payback period is less
than a prespecified length of time (usually a few years). Otherwise, you reject the project.
• The payback rule is not as reliable as the NPV rule because it:
o ignores the project’s cost of capital and the time value of money
o ignores cash flows after the payback period
o relies on an ad hoc decision criterion (what is the right number of years to require for the
payback period?).
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,• If the required payback period is short (one or two years), then most projects that satisfy the
payback rule will have a positive NPV. So firms might save effort by first applying the payback rule,
and only if it fails take the time to compute NPV.
7.4. Choosing between Projects
• When choosing any one project excludes us from taking the others, we are facing mutually
exclusive investments.
• When projects are mutually exclusive, we need to determine which projects have a positive NPV
and then rank the projects to identify the best one. In this situation, the NPV rule provides a
straightforward answer: Pick the project with the highest NPV.
o Because the NPV expresses the value of the project in terms of cash today, picking the
project with the highest NPV leads to the greatest increase in wealth.
• When projects differ in their scale of investment, the timing of their cash flows, or their riskiness,
then their IRRs cannot be meaningfully compared.
o The shortcoming of IRR: because it is a return, you cannot tell how much value will actually
be created without knowing the scale of the investment.
• Differences in Scaling → If a project has a positive NPV, then if we can double its size, its NPV will
double: By the Law of One Price, doubling the cash flows of an investment opportunity must make
it worth twice as much. However, the IRR rule does not have this property – it is unaffected by the
scale of the investment opportunity because the IRR measures the average return of the
investment. Hence, we cannot use the IRR rule to compare projects of different scales.
• Differences in Timing → Even when projects have the same scale, the IRR may lead you to rank
them incorrectly due to differences in the timing of the cash flows. The IRR is expressed as a
return, but the dollar value of earning a given return – and therefore its NPV – depends on how
long the return is earned. Earning a very high annual return is much more valuable if you earn it
for several years than if you earn it for only a few days.
• Differences in Risk → To know whether the IRR of a project is attractive, we must compare it to
the project’s cost of capital, which is determined by the project’s risk. Thus, an IRR that is attractive
for a safe project need not be attractive for a risky project. Ranking projects by their IRRs ignores
risk differences.
• When choosing between two projects, an alternative to comparing their IRRs is to compute the
incremental IRR, which is the IRR of the incremental cash flows that would result from replacing
one project with the other. The incremental IRR tells us the discount rate at which it becomes
profitable to switch from one project to the other. Then, rather than compare the projects directly,
we can evaluate the decision to switch from one to the other using the IRR rule.
• However, when using the incremental IRR to choose between projects, we encounter all of the
same problems that arose with the IRR rule:
o Even if the negative cash flows precede the positive ones for the individual projects, it
need not to be true for the incremental cash flows. If not, the incremental IRR is difficult
to interpret, and may not exist or may not be unique.
o The incremental IRR can indicate whether it is profitable to switch from one project to
another, but it does not indicate whether either project has a positive NPV on its own.
o When the individual projects have different costs of capital, it is not obvious what cost of
capital the incremental IRR should be compared to. In this case only the NPV rule, which
allows each project to be discounted at its own cost of capital will give a reliable answer.
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,7.5. Project Selection with Resource Constraints
• In principle, the firm should take on all positive-NPV investments it can identify. In practice, there
are often limitations on the number of projects the firm can undertake. Often this limitation is due
to resource constraints.
• In some situations, different projects will demand different amounts of a particular scarce
resource.
• If a firm has a fixed supply of resource so that it cannot undertake all possible opportunities, then
the firm must choose the best set of investments it can make given the resources it has available.
• Often, individual managers work within a budget constraint that limits the amount of capital they
may invest in a given period. In this case, the manager’s goal is to chose the projects that maximize
the total NPV while staying within her budget.
• The profitability index is the ratio of the project’s NPV to its initial investment. This ratio tells us
that for every dollar invested in a project, we will generate ..$ in value (so aim is to have more
than the initial investment of one dollar). Projects with a higher profitability index generate higher
NPVs per dollar invested, which indicates that they will use the available budget more efficiently.
Practitioners often use the profitability index to identify the optimal combination of projects
Value Created 𝑁𝑃𝑉
o Profitability Index = Resource Consumed = Resource Consumed
• Although the profitability index is simple to compute and use, for it to be completely reliable, two
conditions must be satisfied:
1. The set of projects taken following the profitability index ranking completely exhausts the
available resource.
2. There is only a single relevant resource constraint.
Chapter 8) Fundamentals of Capital Budgeting
8.1. Forecasting Earnings
• A capital budget lists the projects and investments that a company plans to undertake during the
coming year. To determine this list, firms analyse alternative projects and decide which ones to
accept through a process called capital budgeting. This process begins with forecasts of the
project’s future consequences for the firm. Some of these consequences will affect the firm’s
revenues; others will affect its costs.
• Our ultimate goal is to determine the effect of the decision on the firm’s cash flows, and evaluate
the NPV of these cash flows to assess the consequences of the decision for the firm’s value.
• To derive the forecasted cash flows of a project, financial managers often begin by forecasting
earnings. Thus, we begin by determining the incremental earnings of a project – that is, the
amount by which the firm’s earnings are expected to change as a result of the investment decision.
After this, we can use the incremental earnings to forecast the cash flows of the project.
• We begin by reviewing the revenue and cost estimates for the firm. After this we can forecast the
incremental earnings.
• While investments in plant, property, and equipment are a cash expense, they are not directly
listed as expenses when calculating earnings. Instead, the firm deducts a fraction of the cost of
these items each year as depreciation. Several different methods are used to compute
depreciation. The simplest method is straight-line depreciation, in which the asset’s cost (less any
expected salvage value) is divided equally over its estimated useful life.
• To compute a firm’s net income, we must first deduct interest expenses from EBIT. When
evaluating a capital budget decision, however, we do not include interest expenses. Any
incremental interest expenses will be related to the firm’s decision regarding how to finance the
project.
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,• Unlevered net income of a project indicates that it does not include any interest expenses
associated with debt.
• The correct tax rate to use is the firm’s marginal corporate tax rate, which is the tax rate it will
pay on an incremental dollar of pre-tax income.
o The incremental income tax expense is calculated as Income Tax = 𝐸𝐵𝐼𝑇 × 𝜏𝐶 , where 𝜏𝐶
is the firm’s marginal corporate tax rate.
• A project’s unlevered net income is equal to its incremental revenues less costs and depreciation,
evaluated on an after-tax basis:
o Unlevered Net Income = 𝐸𝐵𝐼𝑇 × (1 − 𝜏𝐶 ) = (Revenues − Costs − Depreciation) ×
(1 − 𝜏𝐶 )
• When computing the incremental earnings of an investment decision, we should include all
changes between the firm’s earnings with the project versus without the project.
• The opportunity cost of using a resource is the value it could have provided in its best alternative
use. Because this value is lost when the resource is used by another project, we should include
the opportunity cost as an incremental cost of the project.
• Project externalities are indirect effects of the project that may increase or decrease the profits
of other business activities of the firm.
o When sales of a new product displace sales of an existing product, the situation is often
referred to as cannibalization.
• A sunk cost is any unrecoverable cost for which the firm is already liable. Sunk costs have been or
will be paid regardless of the decision about whether or not to proceed with the project.
Therefore, they are not incremental with respect to the current decision and should not be
included in its analysis. A good rule to remember is that if our decision does not affect the cash
flow, then the cash flow should not affect our decision.
o Overhead expenses are associated with activities that are not directly attributable to a
single business activity but instead affect many different areas of the corporation. → To
the extent that these overhead costs are fixed and will be incurred in any case, they are
not incremental to the project and should not be included. Only include as incremental
expenses the additional overhead expenses that arise because of the decision to take on
the project.
o Any money that has already been spent on past research and development is a sunk cost
and therefore irrelevant. The decision to continue or abandon should be based only on
the incremental costs and benefits of the product going forward.
o When developing a new product, firms often worry about the cannibalization of their
existing products. But if sales are likely to decline in any case as a result of new products
introduced by competitors, then these lost sales are a sunk cost and we should not include
them in our projections.
• The sunk cost fallacy is a term used to describe the tendency of people to be influenced by sunk
costs and to “throw good money after bad.” That is, people sometimes continue to incest in a
project that has a negative NPV because they have already invested a large amount in the project
and feel that by not continuing it, the prior investment will be wasted.
8.2. Determining Free Cash Flow and NPV
• Earnings are an accounting measure of the firm’s performance. They do not represent real profits:
The firm cannot use its earnings to buy goods, pay employees, fund new investments, or pay
dividends to shareholders. To do those things, a firm needs cash. Thus, to evaluate a capital
budgeting decision, we must determine its consequences for the firm’s available cash.
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,• The incremental effect of a project on the firm’s available cash, separate from any financing
decisions, is the project’s free cash flow.
• There are important differences between earnings and cash flow: Earnings include non-cash
charges, such as depreciation, but do not include the cost of capital investment. To determine the
free cash flow from incremental earnings, we must adjust for these differences.
o Depreciation is not a cash expense that is paid by the firm. Rather, it is a method used for
accounting and tax purposes to allocate the original purchase cost of the asset over its
life. Because depreciation is not a cash flow, we do not include it in the cash flow forecast.
Instead, we include the actual cash cost of the asset when it is purchased.
o Net working capital (NWC) is the difference between current assets and current liabilities.
The main components of NWC are cash, inventory, receivables, and payables:
▪ NWC = Current Assets − Current Liabilities = Cash + Inventory +
Receivables − Payables
▪ The difference between receivables and payables is the net amount of the firm’s
capital that is consumed as a result of these credit transactions, known as trade
credit.
• We can also calculate free cash flows directly, instead of by first forecasting earnings, by using the
following shorthand formula:
Unlevered Net Income
o Free Cash Flow = ⏞ (Revenues − Costs − Depreciation) × (1 − 𝜏𝐶 ) + Depreciation −
CapEx − ∆𝑁𝑊𝐶
▪ Note that we first deduct depreciation when computing the project’s incremental
earnings, and then add it back (because it is a non-cash expense) when computing
free cash flow. Thus, the only effect of depreciation is to reduce the firm’s taxable
income.
o Free Cash Flow = (Revenues − Costs) × (1 − 𝜏𝐶 ) − CapEx − ∆𝑁𝑊𝐶 + 𝜏𝐶 ×
Depreciation
▪ 𝜏𝐶 × Depreciation, is called the depreciation tax shield. It is the tax savings that
results from the ability to deduct depreciation. As a consequence, depreciation
expenses have a positive impact on free cash flow.
• To compute NPV, we must discount free cash flow at the appropriate cost of capital. The cost of
capital for a project is the expected return that investors could earn on their best alternative
investment with similar risk and maturity.
o Given this cost of capital, we compute the present value of each free cash flow in the
𝐹𝐶𝐹 1
future: 𝑃𝑉(𝐹𝐶𝐹𝑡 ) = (1+𝑟)𝑡 𝑡 = 𝐹𝐶𝐹𝑡 ×
⏟ 𝑡
(1+𝑟)
𝑡−year discount factor
8.3. Choosing among Alternatives
• In many situations, however, we must compare mutually exclusive alternatives, each of which has
consequences for the firm’s cash flows. In such cases we can make the best decision by first
computing the free cash flow associated with each alternative and then choosing the alternative
with the highest NPV.
• To choose between two alternatives, we compute the free cash flow associated with each choice
and compare their NPVs to see which is most advantageous for the firm. When comparing
alternatives, we need to compare only those cash flows that differ between them.
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,8.4. Further Adjustments to Free Cash Flow
• When estimating a project’s free cash flow a number of complications can arise, such as non-cash
charges, alternative depreciation methods, liquidation or continuation values, and tax loss
carryforwards.
o Other non-cash items. In general, other non-cash items that appear as part of incremental
earnings should not be included in the project’s free cash flow. The firm should include
only actual cash revenues or expenses.
o Timing of Cash Flows. For simplicity, we treat cash flows as if they occur at the end of
each year. In reality, cash flows will be spread throughout the year.
o Accelerated Depreciation. Because depreciation contributes positively to the firm’s cash
flow through the depreciation tax shield, it is in the firm’s best interest to use the most
accelerated method of depreciation that is allowable for tax purposes. By doing so, the
firm will accelerate its tax savings and increase their present value.
▪ The Modified Accelerated Cost Recovery System or MACRS depreciation
categorizes assets according to their recovery period and specifies a fraction of
the purchase price the firm can depreciate each year.
▪ In addition, the tax code sometimes provides for bonus depreciation which allows
firms to deduct an additional portion of the purchase price when the asset is first
placed into service.
o Liquidation or Salvage Value. Assets that are no longer needed often have a resale value,
or some salvage value if the parts are sold for scrap. Some assets may have a negative
liquidation value. In the calculation of free cash flow, we include the liquidation value of
any assets that are no longer needed and may be disposed of. When an asset is liquidated,
any gain on sale is taxed.
▪ We calculate the gain on sale as the difference between the sale price and the
book value of the asset: Gain on Sale = Sale Price − Book Value
▪ The book value is equal to the asset’s original cost less the amount it has already
been depreciated for tax purposes: Book Value = Purchase Price −
Accumulated Depreciation
▪ We must adjust the project’s free cash flow to account for the after-tax cash flow
that would result from an asset sale: After-Tax Cash Flow from Asset Sale =
Sale Price − (𝜏𝐶 × Gain on Sale)
o Terminal or Continuation Value. Sometimes the firm explicitly forecasts free cash flow
over a shorter horizon than the full horizon of the project or investment. This is necessarily
true for investments with an indefinite life, such as an expansion of the firm.
▪ The terminal or continuation value of a project represents the market value (as
of the last forecast period) of the free cash flow from the project at all future
dates.
o Tax Carryforwards. A firm generally identifies its marginal tax rate by determining the tax
bracket that it falls into based on its overall level of pretax income. If pretax income is
negative, the firm is said to have a net operating loss (NOL). In that case, no tax is due,
and a feature of the tax code, called a tax loss carryforward, allows corporations to use
past NOLs as a deduction to reduce their taxable income in future years.
▪ Past NOLs that are carried forward thus provide future tax credits for the firm,
and the anticipated value of these credits is listed as a deferred tax asset on the
balance sheet.
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,8.5. Analysing the Project
• When evaluating a capital budgeting project, financial managers should make the decision that
maximizes NPV. As we have discussed, to compute the NPV for a project, you need to estimate
the incremental cash flows and choose a discount rate. The most difficult part of capital budgeting
is deciding how to estimate the cash flows and cost of capital.
• When we are uncertain regarding the input to a capital budgeting decision, it is often useful to
determine the break-even level of that input, which is the level for which the investment has an
NPV of zero.
• There is no reason to limit our attention to the uncertainty in the cost of capital estimate. In a
break-even analysis, for each parameter, we calculate the value at which the NPV of the project
is zero.
o The EBIT break-even for sales, is the level of sales for which the project’s EBIT is zero.
• Another important capital budgeting tool is sensitivity analysis, which breaks the NPV calculation
into its component assumptions and shows how the NPV varies as the underlying assumptions
change. In this way, sensitivity analysis allows us to explore the effects of errors in our NPV
estimates for the project.
o By conducting a sensitivity analysis, we learn which assumptions are the most important;
we can then invest further resources and effort to refine these assumptions.
• Scenario analysis considers the effect on the NPV of changing multiple project parameters.
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, Week 2
Chapter 14) Capital Structure in a Perfect Market
• A firm’s capital structure is the total amount of debt, equity, and other securities that a firm has
outstanding. If capital structure has a role in determining the firm’s value, it must come from
changes to the firm’s cash flows that result from market imperfections.
• In a perfect capital market, all securities are fairly priced, there are no taxes or transaction costs,
and the total cash flows of the firm’s projects are not affected by how the firm finances them. This
is an important benchmark, although capital markets are not perfect in reality.
14.1. Equity Versus Debt Financing
• The relative proportions of debt, equity, and other securities that a firm has outstanding
constitute its capital structure. When corporations raise funds from outside investors, they must
choose which type of security to issue. The most common choices are financing through equity
alone and financing through a combination of debt and equity.
• Equity in a firm with no debt is called unlevered equity. Because there is no debt, the date 1 cash
flows of the unlevered equity are equal to those of the project (no arbitrage).
o When the risk of unlevered equity equals the risk of the project, shareholders are earning
an appropriate return for the risk they are taking.
• Equity in a firm that also has debt outstanding is called levered equity. Promised payments to
debt holders must be made before any payments to equity holders are distributed.
o When the project’s cash flow will always be enough to repay the debt, the debt is risk
free.
o Because the cash flows of the debt and equity sum to the cash flows of the project, by the
Law of One Price the combined values of debt and equity must be equal to the firm’s total
cash flows.
• Leverage increases the risk of the equity of a firm. Therefore, it is inappropriate to discount the
cash flows of leverage equity at the same discount rate that is used for unlevered equity. Investors
in levered equity require a higher expected return to compensate for its increased risk.
o We can evaluate the relationship between risk and return more formally by computing
the sensitivity of each security’s return to the systematic risk of the economy.
• Leverage increases the risk of equity even when there is no risk that the firm will default. Thus,
while debt may be cheaper when considered on its own, it raises the cost of capital for equity.
14.2. Modigliani-Miller I: Leverage, Arbitrage, and Firm Value
• Using the Law of One Price, we argued that leverage would not affect the total value of the firm
(the amount of money the entrepreneur can raise). Instead, it merely changes the allocation of
cash flows between debt and equity, without altering the total cash flows of the firm.
• Modigliani and Miller showed that this result holds more generally under a set of conditions
referred to as perfect capital markets:
o Investors and firms can trade the same set of securities at competitive market prices equal
to the present value of their future cash flows.
o There are no taxes, transaction costs, or issuance costs associated with security trading.
o A firm’s financing decisions do not change the cash flows generated by its investments,
nor do they reveal new information about them.
• MM Proposition I: In a perfect capital market, the total value of a firm’s securities is equal to the
market value of the total cash flows generated by its assets and is not affected by its choice of
capital structure.
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