This is my handwritten summary that made me pass this course with an 8 with ease. It contains:
- all the mandatory chapters from the book
- some self-written bonus explanations to clarify difficult matters.
- tips and tricks from the tutorial sessions
I also made sure that what was written in...
Principles of Corporate Finance
By Brealy, Myers and Allen – 12 th Editon
, DEAR PEOPLE THAT READ MY SUMMARY
In all honesty, I must admit that the book is not the best book in the world in my
opinion. You will fnd yoursell having to read the same paragraph in the book a
hundred tmes belore you even start to understand.
This has to do, in my opinion, with the lact that there is no clear logic between
all the diferent parts. I have put a lot ol efort in trying to get the logic into my
summary and make it stll as concise as possible.
That is also the reason why you will see some bonus stories in this summary,
next to a lot ol diferent ttles lor the same chapters (I thought they made more
sense) and you will fnd a lot ol helplul overviews in the summary.
I hope you fnd my summary stll enjoyable and clear enough. Merijn out+
,Contents
1 Introduction to corporate finance....................................................................................................... 6
1.1 Corporate investment and fnanninn denisions..............................................................................................6
1.1.1 Investment Decisions..........................................................................................................................................................................6
1.1.2 Financing Decisions.............................................................................................................................................................................7
1.1.3 What is a corporatonn.......................................................................................................................................................................7
1.1.4 The role ol the fnancial manager......................................................................................................................................................7
1.2 The fnannial noal of the norporaion.............................................................................................................7
1.2.1 Maximizing market value...................................................................................................................................................................7
1.2.2 The investment trade-of....................................................................................................................................................................8
1.2.3 Agency problems and the solutonn corporate governance...............................................................................................................8
2 How to calculate present values........................................................................................................... 8
2.1 Future values and present values...................................................................................................................8
2.1.1 Calculatng luture values....................................................................................................................................................................8
2.1.2 Calculatng present values..................................................................................................................................................................9
2.1.3 Valuing an investment opportunity....................................................................................................................................................9
2.1.4 Net present value.............................................................................................................................................................................10
2.1.5 Risk and present value......................................................................................................................................................................10
2.1.6 Present values and Rates ol Return.................................................................................................................................................11
1.1.1 NPV with multple cash ows...........................................................................................................................................................11
1.1.2 The opportunity cost ol capital........................................................................................................................................................11
2.2 How interest is paid and quoted...................................................................................................................13
2.2.1 Contnuous compounding................................................................................................................................................................13
2.2.2 Some fnishing examples..................................................................................................................................................................15
2 Valuing bonds.......................................................................................................................................... 15
What is a bond?..................................................................................................................................................15
2.1 Usinn present value formula to value bonds................................................................................................15
2.2 How bond prines vary with interest rates.....................................................................................................17
2.2.1 Rate ol return and interest...............................................................................................................................................................17
2.2.2 Duraton............................................................................................................................................................................................18
2.2.3 Volatlity............................................................................................................................................................................................18
2.3 The term strunture of interest rates.............................................................................................................18
2.3.1 Term structure and the present value.............................................................................................................................................19
2.3.2 The law ol one price.........................................................................................................................................................................19
2.3.3 Measuring the term structure..........................................................................................................................................................19
2.3.4 Why the discount lactor declines as luturity increases...................................................................................................................19
2.4 *Explaininn the term strunture.....................................................................................................................20
2.4.1 Expectatons theory ol the term structure.......................................................................................................................................20
2.4.2 Introducing risk.................................................................................................................................................................................20
2.4.3 In aton and term structure.............................................................................................................................................................20
2.5 *Real and nominal rates of interest.............................................................................................................20
2.6 *The risk of Default.......................................................................................................................................20
3 The value of common stock................................................................................................................. 20
3.1 How nommon stonks are traded...................................................................................................................20
3.2 How nommon stonks are valued...................................................................................................................21
3.2.1 Looking at the reports ol a company itsell.......................................................................................................................................21
3.2.2 Looking at comparable companies...................................................................................................................................................21
3.2.3 Looking at stock price.......................................................................................................................................................................21
, 3.3 Esimainn the nost of equity napital............................................................................................................22
4 Net present value and other investment criteria......................................................................... 22
4.1 A review of the basins...................................................................................................................................22
4.2 Paybank rule.................................................................................................................................................23
4.3 Internal (or disnounted-nash-fow) rate of return........................................................................................23
4.3.1 Pitall 1 – Lending or Borrowingn.....................................................................................................................................................25
4.3.2 Pitall 2 – Multple rates ol return....................................................................................................................................................25
4.3.3 Pitall 3 – Mutually exclusive projects..............................................................................................................................................25
4.3.4 Pitall 4 – What il there is more than one opportunity cost ol capital............................................................................................25
4.3.5 What does the book think ol the IRRn.............................................................................................................................................25
5.4 *Choosinn napital investments when resournes are limited........................................................................26
5 Making investment decisions with the Net Present Value Rule...............................................26
5.1 Applyinn the net present value rule..............................................................................................................26
5.1.1 Only cash ow is relevant.................................................................................................................................................................26
5.1.2 Always estmate cash ows on an incremental basis.......................................................................................................................27
5.1.3 Be consistent in your treatment ol in aton....................................................................................................................................28
5.1.4 Separate investment and fnancing decisions..................................................................................................................................28
6 Introduction to risk and return......................................................................................................... 28
6.1 Over a nentury of Capital Market History in one easy lesson.......................................................................28
6.1.1 Rate ol return...................................................................................................................................................................................28
6.1.2 Calculatng the rate ol return...........................................................................................................................................................28
6.1.3 Market return and how to calculate it.............................................................................................................................................28
6.2 Measurinn Portolio Risk...............................................................................................................................29
6.2.1 How to get to the standard deviaton..............................................................................................................................................29
6.2.2 How diversifcaton reduces risk.......................................................................................................................................................29
7.3 *Calnulainn portolio risk.............................................................................................................................30
6.3 How individual senuriies aaent portolio risk..............................................................................................31
6.4 Diversifnaion and value addiivity..............................................................................................................31
7 Portfolio theory and the capital asset pricing model.................................................................. 31
7.1 Harry Markowitz and the birth of portolio theory......................................................................................31
7.1.1 Efcient portolios............................................................................................................................................................................31
7.1.2 Borrowing and lending.....................................................................................................................................................................32
7.2 The relaionship between risk and return.....................................................................................................33
Roundinn oa the story of the CAPM...................................................................................................................33
7.3 *Validity and role of the napital asset prininn model...................................................................................34
8 Risk and the cost of capital.................................................................................................................. 34
8.1 Company and projent nosts of napital..........................................................................................................34
2.2.3 The company cost ol capital.............................................................................................................................................................34
2.2.4 Using the company cost ol capital to accept new projects..............................................................................................................34
2.2.5 Perlect pitchn Why the company cost ol capital is a good measure................................................................................................35
2.2.6 Debt and company cost ol capitaln introducing the Weighted Average Cost ol Capital..................................................................35
8.2 Measurinn the nost of equity........................................................................................................................36
2.2.7 From beta to expected return..........................................................................................................................................................36
2.2.8 The asset beta...................................................................................................................................................................................37
13 Efficient markets and behavioural finance.................................................................................. 37
8.3 We always nome bank to NPV......................................................................................................................38
8.4 What is an efnient market..........................................................................................................................38
2.2.9 Three types ol efcient markets and their evidence.......................................................................................................................38
8.5 The evidenne anainst market efnienny........................................................................................................39
2.2.10 The small-frm efect.......................................................................................................................................................................39
2.2.11 Investors respond slowly to new inlormaton................................................................................................................................39
2.2.12 Bubbles...........................................................................................................................................................................................39
, 8.6 Behavioural fnanne......................................................................................................................................39
2.2.13 Risk attudes and prospect theory................................................................................................................................................39
2.2.14 Beliels about possibilites...............................................................................................................................................................39
2.2.15 Limits to arbitragen why we cannot exploit inefciencies infnitely...............................................................................................40
2.2.16 Selling short....................................................................................................................................................................................40
2.2.17 Incentve problems.........................................................................................................................................................................40
2.3 The fve lessons of market efnienny............................................................................................................40
2.3.1 Markets have no memory................................................................................................................................................................40
2.3.2 Trust market prices...........................................................................................................................................................................40
2.3.3 Read the entrails...............................................................................................................................................................................40
2.3.4 Do-it-yoursell alternatve.................................................................................................................................................................40
2.3.5 Seen one stock, seen them all..........................................................................................................................................................41
2.3.6 The implicatons to the fnancial manager.......................................................................................................................................41
17 Does debt policy matter?................................................................................................................... 41
8.7 The eaent of fnannial leverane in a nompeiive tax-free enonomy............................................................41
2.3.7 Introducing fnancial leverage..........................................................................................................................................................41
2.3.8 Introducing Modigliani and Miller....................................................................................................................................................42
2.3.9 The law ol conservaton ol value......................................................................................................................................................42
8.8 Finannial risk and expented returns..............................................................................................................43
2.3.10 Propositon 2...................................................................................................................................................................................43
2.3.11 Introducing the beta.......................................................................................................................................................................44
8.9 The weinhted-averane nost of napital..........................................................................................................46
2.3.12 The traditonalist view on rates ol return on levered euuity.........................................................................................................46
2.3.13 Imperlectons and opportunites....................................................................................................................................................46
8.10 A fnal word on the afer-tax weinhted-averane nost of napital................................................................46
A bonus recap ol the theorems.................................................................................................................................................................46
9 How much should a corporation borrow?...................................................................................... 46
9.1 Corporaion taxes.........................................................................................................................................47
9.1.1 How does this contribute to the value ol stockholders’ euuityn.....................................................................................................47
9.1.2 MM and taxes...................................................................................................................................................................................48
18.3 Costs of Finannial Distress..........................................................................................................................48
9.1.3 Sources ol these costs......................................................................................................................................................................48
9.1.4 Debt and incentves..........................................................................................................................................................................49
9.1.5 And what do these games costn.......................................................................................................................................................50
9.1.6 Distress costs vary lor diferent assetsn the trade-of theory ol capital structure...........................................................................50
20 Understanding options...................................................................................................................... 51
A small bonus story about Utz and Mark...........................................................................................................51
9.2 Calls, Puts and shares...................................................................................................................................51
9.2.1 Call opton.........................................................................................................................................................................................51
9.2.2 Put opton.........................................................................................................................................................................................52
9.2.3 Calls and puts lrom the seller’s perspectve.....................................................................................................................................52
9.2.4 Proft diagrams.................................................................................................................................................................................52
9.3 Finannial alnhemy with opions....................................................................................................................52
9.3.1 Only losses, no gainsn “the masochists strategy”.............................................................................................................................53
9.3.2 Only gains, no losses.........................................................................................................................................................................53
2.3.14 The put-call parity...........................................................................................................................................................................53
9.4 What determines opion values...................................................................................................................54
POINT An When a stock is worthless, an opton is worthless....................................................................................................................54
POINT Bn When the stock price becomes large, the opton price approaches the stock price less the present value ol the exercise
price...........................................................................................................................................................................................................54
POINT Cn The opton price always exceeds its minimum value.................................................................................................................54
10 Valuing options..................................................................................................................................... 55
10.1 A simple opion-valuaion model................................................................................................................55
10.1.1 The replicatng portolio.................................................................................................................................................................55
10.1.2 Indiferent investors.......................................................................................................................................................................57
, 10.2 The binomial method for valuinn opions..................................................................................................57
2.3.15 Euuity as a call opton.....................................................................................................................................................................58
10.4 Insuranne....................................................................................................................................................60
28 Financial analysis................................................................................................................................ 61
10.5 Finannial raios...........................................................................................................................................61
10.6 Finannial statements..................................................................................................................................61
10.7 Home depot’s fnannial statements............................................................................................................62
10.7.1 The income statement....................................................................................................................................................................62
10.8 Measurinn home depot’s performanne......................................................................................................63
10.8.1 Market-to-book rato......................................................................................................................................................................63
10.8.2 Economic Value Added (EVA).........................................................................................................................................................63
10.8.3 Accountng rates.............................................................................................................................................................................64
10.9 Measurinn efnienny...................................................................................................................................65
10.10 Analysinn the return on assets: The Du Pont System...............................................................................65
3 Important terminology and formulas per concept of corporate finance..............................66
3.1 Returns..........................................................................................................................................................66
3.1.1 The corporaton................................................................................................................................................................................66
3.1.2 Discountng and Compounding........................................................................................................................................................66
3.1.3 Perpetuites.......................................................................................................................................................................................66
3.1.4 Annuites...........................................................................................................................................................................................66
3.1.5 Bonds................................................................................................................................................................................................67
4 The basic symbols which are everywhere...................................................................................... 67
4.1 Disnouninn...................................................................................................................................................67
4.2 The diaerent returns.....................................................................................................................................67
4.3 Risks..............................................................................................................................................................68
5 A timeline overview for cashflows.................................................................................................... 68
6 How to calculate present value: an overview................................................................................ 69
1 INTRODUCTION TO CORPORATE FINANCE
1.1 CORPORATE INVESTMENT AND FINANCING DECISIONS
Because corporatons need money to buy real assets, they need a way to retrieve that money.
Corporatons can do this by handing out ssecurites’ or sfnancial assets’. These assets give the buyer a
very small bit ol the companyn a share. The (inital) buyer lends money to the corporaton and
exchange is paid a percentage ol his investment over tme. So, this means that we have two types ol
investmentsn purchasing real assets and purchasing a fnancial asset. Let’s take a closer look.
1.1.1 Investment Decisions
Simply put, the investment decision involves the purchase ol a real asset. This real asset can be
tangible, such as a new PC, but also intangible, such as R&D. The book relers to the investment
decisions as Capital Expenditure (CAPEX), due to the lact that the purchase is done at the expense ol
the capital ol the corporaton. The basic rule is that today’s investment creates tomorrow’s return.
Such a return is ol course not always immediately afer the investment. Let’s lor example think ol an
,investment in a new main ofce building. Such an ofce takes years to build, so it also takes years to
see the frst returns. It might even be the case that there is no return at all, lor example when
nobody starts using the headuuarters because it was built wrong.
1.1.2 Financing Decisions
Financing Decisions involve decisions with the money needed to make investment decisions. This
money has to come lrom somewhere. A corporaton could lend money lrom a bank and be in dept
with the bank or could hand out new bonds selling parts ol the corporaton (dept vs. equity
fnanninn). Choosing between these two is called the scapital structure decision’. The book locusses
on euuity fnancing. Euuity fnancing can be done in two waysn by issuing new stocks or by reinvestng
existng cash ows in new assets. The extra cash ows which are not used as an investment, can be
held lor luture investments or can be paid out to the shareholders. Paying the shareholders or not is
commonly relerred to as the pay-out decision.
In the end however, are the assets the most important to the corporaton. They give the company its
value, not the way it spends its money.
1.1.3 What is a corporation?
Used a lot already but what are we relerring ton A corporaton is a legal entty, meaning that lor the
law it is a person that is owned by its shareholders. This person can make decisions, bonds, do bids
and sue or be sued. Even though the shareholders own the person/corporaton, they cannot be held
responsible lor the decisions made by the corporaton. They can lose their investment completely
but also no more than that.
A corporaton is thus owned by its shareholders. We can see two types ol corporaton in this sense.
Firstly, the closely held corporaton which does not issue his stocks to the public market. On the
other hand, the public the public held, public corporatons are tradeable on the public market. Such a
public held corporaton is held by its shareholders. Even though they own the corporaton to an
extent, they cannot control it. This creates a separaton ol ownership and control.
1.1.4 The role of the financial manager
The fnancial manager stands between the frm and outside investors. On the one hand, the fnancial
manager helps manage the frm’s operatons by making good investment decisions. On the other
hand, the fnancial manager deals with investors and fnancial insttutons such as banks and
exchanges.
1.2 THE FINANCIAL GOAL OF THE CORPORATION
In the end, the corporaton is owned by its shareholders and thus exists only because ol these
investors/shareholders. It is thus in the nature ol a corporaton to have the satslacton ol its
shareholders as goal.
1.2.1 Maximizing market value
All shareholders want to make the most ol their share, so increasing the market value ol their
investment is key to the manager. The extra value ol the shareholder’s investment is their proft
which they can spend in any way they like. But as we already discussed, the shareholders are owners
but not managers. The manager should thus make sure the market value keeps on increasing by
investng in the right projects. A sound balance between risk-tolerant (high risk, high revenue) and
risk-averse (low risk, low revenue) is needed to keep such an increase realistc.
, 1.2.2 The investment trade-off
The corporaton thus has two optons ol investng. On one hand, they can invest in projects (involving
real assets) but on the other hand, they can return on the investments ol shareholders (paying them
their dividend). You can make this approachable by understanding the opportunity costsn
Investment Opportunity Cost
Investment in projent Possibility lor shareholders to invest more cash
in bonds
Payinn dividend to shareholders New cash ows lrom new investments
Note the lollowingn It is in the end the capital that is the opportunity costs+ This is relerred to as the
opportunity cost ol capital.
It is thus the manager’s responsibility to make balance out the risk to maximize the proft but at the
same tme maximize the shareholders’ possibility to keep on investng. Yet, at the same tme the
manager should not take immense risks just to maximize cash ows. On the contrary, these choices
are limited by law, rules, unwriten rules and mutual trust.
1.2.3 Agency problems and the solution: corporate governance
The lact that ownership and control are separated, puts managers in a risky situaton. On one hand
they are in control (and have enormous power) ol the company but at the same tme they do not
own anything ol that company and can thus be fred a la minute. This creates the agency problem.
Managers might show signifcantly bad behavior by buying expensive cars, jets or diners on behall ol
the company. They might even shy away lrom relatvely risky projects with high revenues just to
reassure their job. This contradicts their primary job ol maximizing proft+ We are economics, so we
express such a problem in money. The money we miss by such bad behavior, is relerred to as sagency
costs’.
2 HOW TO CALCULATE PRESENT VALUES
It is tme to get into the mathematcs ol values. Economics use the sentence sa dollar today is worth
more than a dollar tomorrow’ to illustrate the phenomenon we are going to analyze this chapter. We
want to know what money we can earn with our investments.
2.1 FUTURE VALUES AND PRESENT VALUES
2.1.1 Calculating future values
Let’s act like you have invested 100€ in a bank account which pays you an interest rate ol 7%. You
want to know what you earn in the next year. You can get there by using the lollowing lormulan
V t =V o × ( 1+r )t
V t =Value (V) at a spenifn ime (t) ) V o =Base value (at year 0) ) r =interest rate
So suppose our investment is 100 and the interest is 7%, we can calculate our price lor diferent t’s
V 1=100 × (1+ 0,07 )1=€ 107
V 2=100 × (1+ 0,07 )2=€ 114,49
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