Summary for Corporate Finance and Behaviour: Textbook / Lectures / Tutorials /
Connect Quizzes / Practice Exams UU Economics & Business Economics Year 2
Textbook Material: Principles of Corporate Finance (BMA)
Chapter 1 – 7 (recap IFA year 1)
Chapter 8 + 9 + 13 + 17 + 18 + 20 + 21 + 28 + 30 + 27
Recap: Chapter 1 – 7
Financing decisions (how to finance or raise investments in the present and meet obligations from the
past; borrowing and retaining cash flows; lenders and shareholders with the sale of securities and
other financial assets; financing decisions are easier to reverse than investment decisions and
markets for financial assets are often more competitive than real asset markets).
Investment decisions = Capital Budgeting CapEx (purchase of real assets to generate future cash
flows; managing assets already in place; the opportunity cost of capital sets standard for these; large
decisions are made by the board of directors; smart investment decisions create more value than
smart financing decisions).
Shareholders (owners) want financial managers to increase and maximise the corporation’s market
value and the current stock price; in other words, managers have to maximise value.
Real assets (tangible / intangible; value for a corporation; these assets have to be financed).
Financial assets (securities or claims; way of paying for real assets, e.g. bank loans, common stock,
preferred stock, corporate or government bonds, options, etc.).
Capital investments can generate future cash returns; costs and risks of investments can be huge, but
a huge success is also possible.
Equity financing (shareholders or equity investors purchase shares from a firm, which promise a
varying amount of money, namely a fraction of the firm’s profits, dividends; issuing new stock or
reinvesting on behalf of the existing shareholders).
Debt financing (borrowing money from a bank or another creditor).
Capital structure (choice between debt and equity financing; long-term; financial managers have to
maximise shareholder value; MM theory states that capital structure is irrelevant for market value).
Pay-out decision (firm’s decision to either reinvest cash flows for new investments, or pay out
dividends to shareholders, or repurchase a fraction of the outstanding shares to increase share price
or improve financial ratios).
Market capitalisation or cap (the market value of a firm; outstanding shares multiplied by the price of
a share; Shares Outstanding * Current Share Price).
Types of enterprises (sole proprietorship, controlled by one owner, and ‘infinitely’ liable; partnership,
shared control and ownership, more than one owner; corporation).
Corporation (legal entity or enterprise with limited liability; a legal person owned by shareholders but
legally distinct from them; board of directors of shareholders and managers are not the same, there is
separation of ownership and control; ownership can be transferred easily; double taxation, on profits
and dividends).
Closely held firm (private; no outstanding shares to public investors outside of the firm).
Public firm (outstanding shares for individuals, pension funds, insurance companies, etc., all with
diversified portfolios; most firms go public after some time with good growth and future opportunities).
Shareholders (dividends), bondholders (coupon payments), employees (wages), management
(wages) and the government (wages) are claimants to a corporation’s income stream.
Real assets, financed by liabilities, equity or retained earnings, can generate cash flows in the future;
the value of money is different over time, so discounting is used to calculate the present value of future
cash flows in order to add the cash flows up.
Present value PV for discounting future cash flows to a value which money has at this moment (in
the present); future value FV for calculating what money at this moment will be worth in the future
when investing or saving it to receive interest, hereby compounding interest when the ‘future’ is
further away than one period; discount factor DF to use when discounting to get the PV, using the
interest rate r and a duration t; Net Present Value NPV to calculate whether an investment decision is
profitable or not by summing up all cash flows in the present value and subtracting the investment
cost, hereby choosing to invest when the NPV exceeds zero; rate of return or cost of capital r;
, perpetuities (constant and growing; delayed) which give constant or growing ‘coupons’ of payments
forever without a repayment of the face value; annuities (constant and growing; delayed) which give
constant or growing ‘coupons’ of interest payments for a particular time period after which the face
value is also repaid; Annuity = Perpetuity – Delayed Perpetuity; Annual Percentage Rate APR for
simple discounting; Effective Annual Rate EAR for compound or even continuous discounting.
Financial markets provide financing, information and liquidity, and reduce risks.
Cash flows from Operating = Revenues – Expenses – Taxes.
Taxes = Tax Rate * (Sales – Cash Expenses – Depreciation).
Annual Tax Shield = Depreciation * Tax Rate (or PV of tax shield = T C * D).
Additional Investment in Working Capital = Inventory increase + Accounts Receivable increase –
Accounts Payable increase.
The beta is the standard risk measure for individual securities, comparing the securities to the market.
The availability of data about prices of (common) stocks, (government) bonds, (put and call) options,
and commodities makes it viable for investors to make decisions.
Treasury bills (T-bills) are the safest type of investment, with a standard deviation of zero; the only
possible risk comes from inflation volatility.
Chapter 8: Portfolio Theory and the Capital Asset Pricing Model
The stock market is risky due to a spread in possible outcomes (variance, standard deviation); risk can
be systematic (market risk) or unsystematic (specific or unique risk).
Unsystematic risk is asset-specific, meaning it does not account for the whole market; therefore, this
unsystematic risk is diversifiable by broadening the investment portfolio through investing in many
firms, and it can be eliminated or mitigated.
No matter to what extent investment portfolios are diversified, some level of risk will always exist and
investors seek compensation for this risk through a high rate of return r for high risk.
The return on an individual stock or portfolio of stocks should equal the cost of capital.
CAPM: Expected Return on Security = Risk-Free rate + Beta * (Market Return – Risk-Free rate).
R = Rf + β * (Rm – Rf), where Rm – Rf = Risk Premium or Equity Market Premium.
Beta β measures risk, or market volatility, meaning the change in price of a security compared to
changes in the market price (sensitivity to market changes); riskier investments should earn a higher
premium over the risk-free rate.
Portfolio Diversification (reducing the standard deviation in a portfolio by choosing stocks which do
not move together; if returns are normally distributed, expected return r and standard deviation σ are
the only two measures that an investor needs to consider; the gain from diversification depends on
how highly the stocks are correlated; unrealistic assumptions are perfect positive correlation, ρ = 1,
where diversification has no effect at all, and perfect negative correlation, ρ = -1, where there is no risk
when combining two stocks; the goal of an investor is a return as high as possible with risk as low as
possible).
Modern Portfolio Theory (MPT; assembling a portfolio of assets such that the return r is maximised for
a given risk measure / level; in other words, deploying funds to give the highest expected return for a
given standard deviation risk and return should not be assessed separately, but assessed by how it
contributes to the overall risk and return of a portfolio; analysis of portfolios of investments;
interrelationship between risk and return, measured by the correlation; the Efficient Portfolio Line
offers the highest expected return for all levels of risk).
Asset returns (distribution, variance, standard deviation; n number of assets, meaning 2n + (n(n + 1) /
2).
Lending or borrowing money at a risk-free rate (no standard deviation) and combining that with
placing a portion of money in risky common stock yields a certain expected return and standard
deviation.
Sharpe Ratio = (Required Return R – Risk-Free rate Rf) / Standard Deviation; this ratio is tracked to
measure the risk-adjusted performance of investment managers (internal decision-makers); it is also
the slope of the CML (Capital Market Line).
