Summary: Corporate Finance
By: Thomas Konings
Contents
Week 1 – Topic 1 – Corporate Claims ..................................................................................................... 3
Basic Building Blocks ........................................................................................................................... 3
Liabilities ............................................................................................................................................. 3
Equity .................................................................................................................................................. 4
Week 1 – Topic 2 – Perfect Market......................................................................................................... 5
Maximization of Equity or Firm Value?............................................................................................... 5
Modigliani and Miller (MM) ................................................................................................................ 5
Weighted Average Cost of Capital (WACC) ......................................................................................... 6
WACC Formula (without taxes)........................................................................................................... 7
Leverage, EPS and P/E ratios............................................................................................................... 7
State Prices and Credit Derivatives ..................................................................................................... 7
Cost of Capital Nuances and Non-Financial Liabilities ........................................................................ 7
Week 1 – Topic 3 – Taxes ........................................................................................................................ 8
Relative Taxation of Debt and Equity.................................................................................................. 8
Firm value under different capital structures ..................................................................................... 8
Formulaic Valuation Methods: APV and WACC .................................................................................. 8
Sample application of Tax-adjusted valuation .................................................................................... 9
Contemplating Corporate Taxes and Leverage................................................................................... 9
Personal Income Taxes and Clientele Effects ................................................................................... 10
Workshop 2 ........................................................................................................................................... 10
Week 2 – Topic 4 – Imperfect Capital Markets..................................................................................... 11
Financial distress ............................................................................................................................... 11
What are direct costs/indirect costs? ........................................................................................... 11
Size of financial distress, expected costs of financial distress ...................................................... 11
Underinvestment .............................................................................................................................. 12
Risk-shifting ....................................................................................................................................... 13
How to address conflict between investors in practice? .................................................................. 13
Private information (overvaluation) ................................................................................................. 13
Implications for valuation ................................................................................................................. 13
Lecture Q&A:..................................................................................................................................... 13
Summary - Week 3 Topic 6 ................................................................................................................... 14
, Additional slides ................................................................................................................................ 15
Workshop 3: Risk Management ............................................................................................................ 16
Summary – Week 4 Topic 7 .................................................................................................................. 19
Dividend mechanics .......................................................................................................................... 19
Share repurchase mechanics ............................................................................................................ 19
Perfect market irrelevance ............................................................................................................... 19
Dividends and Share Repurchases .................................................................................................... 20
Personal Income Tax Differences and Investor Clienteles ............................................................ 20
Non-tax related differences .......................................................................................................... 20
Empirical evidence ............................................................................................................................ 20
Market reactions (event studies) .................................................................................................. 21
Survey evidence ................................................................................................................................ 21
Workshop 4: Payouts ............................................................................................................................ 22
, Week 1 – Topic 1 – Corporate Claims
Capital structure: sum total of all claims on the assets of the firms, “right to ownership”
Cashflow rights: how much money claim holders should receive, i.e. allocation of generated cash
Control rights: what remedies claim holders have, especially when they do not receive promised CFs
→ Example: bankruptcy for debtholders and appointment of corporate board for shareholders
Basic Building Blocks
Corporate Charter: basics of the firm, who holds decision power,
how to amend the charter, etc.
Basic building blocks: liabilities & equity (or leverage & stock)
Basic types of claims: (1) Financial claims [debt & equity, i.e.
securities] (2) Nonfinancial [corporate income taxes due, pension
obligations, accounts payable]
→ To truly have ownership you have to own all claims
Payoff diagram (right) → value of equity & debt depend on firm
value ➔ they are state-contingent claims
Note: only reflect value-varying aspects, not time-varying aspects
Liabilities
Cashflow rights: returned cash = interest payment (usually tax deductible for issuer), in event of
liquidation: absolute priority rule (APR) → Bond = senior security, paid before more-junior
Control rights: unless covenant violated or near financial distress, bondholders do not participate in
firm decisions (typically). If firm misses a payment or violates covenant: right to force bankruptcy
Note: covenants can contain more provisions, such as liquidity level requirements, breaking it can
cause bankruptcy.
Over time: hybrids → covenants that allow a bond to be converted into something else
→ Not always valuable (e.g. CEO example) but valuable ones have survived and are included here
Convertible bonds: bondholders right to convert debt to equity for predetermined price at
predetermined dates. On conversion: shareholders dilute but do not have to pay the debt anymore
→ Not always beneficial to convert: if debt would mean higher % of firm value, then keep debt
BEP @ firm value = value of bond / % of firm that bondholder controls by converting, i.e. 20/0.6=33
Note: convertible bonds have purpose, they align shareholder &
bondholder interest to a degree, if shareholders undertake project that
hurts plain bondholders they can profit if convertible.
Payoff (right): note equity slope is resulting share (40%)
Other corporate bond features:
→ More rights = lower interest rate
- Covenant: promises firm must keep or forced to redeem
→ D/E ratios, cannot sell asset, how much dividend, auditor,
what happens when it defaults on other bonds, repurchases, etc.
- Bond seniority: senior first dibs, satisfied in full before a subordinate (junior) bond
By: Thomas Konings
Contents
Week 1 – Topic 1 – Corporate Claims ..................................................................................................... 3
Basic Building Blocks ........................................................................................................................... 3
Liabilities ............................................................................................................................................. 3
Equity .................................................................................................................................................. 4
Week 1 – Topic 2 – Perfect Market......................................................................................................... 5
Maximization of Equity or Firm Value?............................................................................................... 5
Modigliani and Miller (MM) ................................................................................................................ 5
Weighted Average Cost of Capital (WACC) ......................................................................................... 6
WACC Formula (without taxes)........................................................................................................... 7
Leverage, EPS and P/E ratios............................................................................................................... 7
State Prices and Credit Derivatives ..................................................................................................... 7
Cost of Capital Nuances and Non-Financial Liabilities ........................................................................ 7
Week 1 – Topic 3 – Taxes ........................................................................................................................ 8
Relative Taxation of Debt and Equity.................................................................................................. 8
Firm value under different capital structures ..................................................................................... 8
Formulaic Valuation Methods: APV and WACC .................................................................................. 8
Sample application of Tax-adjusted valuation .................................................................................... 9
Contemplating Corporate Taxes and Leverage................................................................................... 9
Personal Income Taxes and Clientele Effects ................................................................................... 10
Workshop 2 ........................................................................................................................................... 10
Week 2 – Topic 4 – Imperfect Capital Markets..................................................................................... 11
Financial distress ............................................................................................................................... 11
What are direct costs/indirect costs? ........................................................................................... 11
Size of financial distress, expected costs of financial distress ...................................................... 11
Underinvestment .............................................................................................................................. 12
Risk-shifting ....................................................................................................................................... 13
How to address conflict between investors in practice? .................................................................. 13
Private information (overvaluation) ................................................................................................. 13
Implications for valuation ................................................................................................................. 13
Lecture Q&A:..................................................................................................................................... 13
Summary - Week 3 Topic 6 ................................................................................................................... 14
, Additional slides ................................................................................................................................ 15
Workshop 3: Risk Management ............................................................................................................ 16
Summary – Week 4 Topic 7 .................................................................................................................. 19
Dividend mechanics .......................................................................................................................... 19
Share repurchase mechanics ............................................................................................................ 19
Perfect market irrelevance ............................................................................................................... 19
Dividends and Share Repurchases .................................................................................................... 20
Personal Income Tax Differences and Investor Clienteles ............................................................ 20
Non-tax related differences .......................................................................................................... 20
Empirical evidence ............................................................................................................................ 20
Market reactions (event studies) .................................................................................................. 21
Survey evidence ................................................................................................................................ 21
Workshop 4: Payouts ............................................................................................................................ 22
, Week 1 – Topic 1 – Corporate Claims
Capital structure: sum total of all claims on the assets of the firms, “right to ownership”
Cashflow rights: how much money claim holders should receive, i.e. allocation of generated cash
Control rights: what remedies claim holders have, especially when they do not receive promised CFs
→ Example: bankruptcy for debtholders and appointment of corporate board for shareholders
Basic Building Blocks
Corporate Charter: basics of the firm, who holds decision power,
how to amend the charter, etc.
Basic building blocks: liabilities & equity (or leverage & stock)
Basic types of claims: (1) Financial claims [debt & equity, i.e.
securities] (2) Nonfinancial [corporate income taxes due, pension
obligations, accounts payable]
→ To truly have ownership you have to own all claims
Payoff diagram (right) → value of equity & debt depend on firm
value ➔ they are state-contingent claims
Note: only reflect value-varying aspects, not time-varying aspects
Liabilities
Cashflow rights: returned cash = interest payment (usually tax deductible for issuer), in event of
liquidation: absolute priority rule (APR) → Bond = senior security, paid before more-junior
Control rights: unless covenant violated or near financial distress, bondholders do not participate in
firm decisions (typically). If firm misses a payment or violates covenant: right to force bankruptcy
Note: covenants can contain more provisions, such as liquidity level requirements, breaking it can
cause bankruptcy.
Over time: hybrids → covenants that allow a bond to be converted into something else
→ Not always valuable (e.g. CEO example) but valuable ones have survived and are included here
Convertible bonds: bondholders right to convert debt to equity for predetermined price at
predetermined dates. On conversion: shareholders dilute but do not have to pay the debt anymore
→ Not always beneficial to convert: if debt would mean higher % of firm value, then keep debt
BEP @ firm value = value of bond / % of firm that bondholder controls by converting, i.e. 20/0.6=33
Note: convertible bonds have purpose, they align shareholder &
bondholder interest to a degree, if shareholders undertake project that
hurts plain bondholders they can profit if convertible.
Payoff (right): note equity slope is resulting share (40%)
Other corporate bond features:
→ More rights = lower interest rate
- Covenant: promises firm must keep or forced to redeem
→ D/E ratios, cannot sell asset, how much dividend, auditor,
what happens when it defaults on other bonds, repurchases, etc.
- Bond seniority: senior first dibs, satisfied in full before a subordinate (junior) bond
