2021
2022
Corporate Financial
Management
A SUMMARY OF THE LECTURES
LOUIST
A summary made by LouisT for the course: Corporate Financial Management given in 2021/2022
,Contents
Chapter 1. Introduction to the course ................................................................................................... 4
1.1 Why do we have Finance? ...................................................................................................... 4
1.1.1 Company Value & Shareholder Value ............................................................................ 4
1.2 Discounting ............................................................................................................................. 5
1.2.1 Present Value .................................................................................................................. 5
1.2.2 Net Present Value ........................................................................................................... 5
1.2.3 Discount Rate .................................................................................................................. 6
1.2.4 Cashflows ........................................................................................................................ 6
1.3 Market Value vs Book Values ................................................................................................. 7
1.3.1 Arbitrage ......................................................................................................................... 7
1.4 Alternative Decision Rules...................................................................................................... 7
1.5 Webcast 1: Discounting & Compounding .............................................................................. 7
1.5.1 Compounding .................................................................................................................. 8
1.6 Webcast 2: Ways of quoting an interest rate ........................................................................ 8
1.6.1 Conversion ...................................................................................................................... 8
1.7 Webcast 3: Annuities and perpetuities .................................................................................. 9
Chapter 2. Capital Budgeting identifying & Forecasting Cash Flows .................................................. 10
2.1 Fundamentals of Capital Budgeting ..................................................................................... 10
2.2 Elements of costs .................................................................................................................. 10
2.2.1 Sunk Costs ..................................................................................................................... 10
2.2.2 Opportunity Costs ......................................................................................................... 11
2.3 From Earnings to Cash Flows ................................................................................................ 11
2.4 Concept Check....................................................................................................................... 12
2.5 Webcast 4: Net Working Capital .......................................................................................... 12
2.5.1 Example / Mock Exam Question .................................................................................. 13
2.6 Webcast 5: Project Analysis ................................................................................................. 13
2.6.1 Break-Even Analysis ...................................................................................................... 14
2.6.2 Sensitivity Analysis ....................................................................................................... 14
2.6.3 Scenario Analysis .......................................................................................................... 14
Chapter 3. Valuing Stocks and bonds + Discount Rate ........................................................................ 15
3.1 Discounting Cash Flows ........................................................................................................ 15
3.1.1 Company-Wide Discount Rate ..................................................................................... 15
3.1.2 Weighted Average Cost of Capital (WACC) .................................................................. 15
3.2 Bonds ..................................................................................................................................... 15
3.2.1 How does a Bond work? ............................................................................................... 16
A summary made by LouisT for the course: Corporate Financial Management given in 2021/2022
, 3.2.2 Other issues................................................................................................................... 16
3.3 Stock ...................................................................................................................................... 17
3.3.1 Constant Dividend Growth Model ............................................................................... 17
3.3.1 Constant Dividend Growth Model ............................................................................... 18
3.3.2 Efficient Market Hypothesis ......................................................................................... 18
3.3.2 Conclusion ..................................................................................................................... 18
3.4 Webcast 6: Yield Curves/Spot and Forward Rates .............................................................. 18
3.4.1 Yield Curves ................................................................................................................... 18
3.4.2 Spot vs Forward Rates .................................................................................................. 19
3.5 Webcast 7: Relative Valuation ............................................................................................. 20
Chapter 4. Risk, Diversification, and CAPM ......................................................................................... 21
4.1 Risk ........................................................................................................................................ 21
4.2 Variance as a risk measure ................................................................................................... 21
4.2.1 Calculating Variance ..................................................................................................... 21
4.2.2 Variance of a portfolio .................................................................................................. 22
4.2.2 Calculating Portfolio Risk.............................................................................................. 23
4.2.3 Expected Return of Each Portfolio ............................................................................... 23
4.2.4 Diversification benefits ................................................................................................. 24
4.3 Capital Asset Pricing Model (CAPM) .................................................................................... 25
4.3.1 SML ................................................................................................................................ 26
4.4 Find Beta ............................................................................................................................... 27
4.5 Conclusion ............................................................................................................................. 27
Chapter 5. Taxes ................................................................................................................................... 28
5.1 Effect of Taxes ....................................................................................................................... 28
5.1.1 Decisions ....................................................................................................................... 29
5.1.2 Consequences for Capital Structure ............................................................................. 30
5.1.3 Consequences for Investors ......................................................................................... 30
5.2 Optimal Capital Structure ..................................................................................................... 31
5.2.1 Capital Structure: Results ............................................................................................. 32
5.3 Using the WACC with leverage ............................................................................................. 33
5.3.1 Leveraged Betas ............................................................................................................ 33
5.3.2 Adjusted Present Value ................................................................................................ 33
5.3.3 Problems ....................................................................................................................... 34
5.4 Different Risks in one company ........................................................................................... 34
Chapter 6. Corporate Finance Theory and its extensions ................................................................... 36
6.1 Mondigliani & Miller: Prop 1 ................................................................................................ 36
A summary made by LouisT for the course: Corporate Financial Management given in 2021/2022
, 6.1.1 A(n) (im)perfect Capital Market ................................................................................... 36
6.1.2 Recap ............................................................................................................................. 37
6.2 Mondigliani & Miller: Prop 2 ................................................................................................ 37
6.2.1 Consequences for Capital Structure ............................................................................. 37
6.3 Consequences of Default in Imperfect Markets .................................................................. 38
6.4 Agency Theory ...................................................................................................................... 38
6.4.1 Conflicts of interest: Leverage ...................................................................................... 39
6.4.2 Conflicts of interest: Asset Substitution ...................................................................... 39
6.4.3 Conflicts of interest: Debt Overhang............................................................................ 40
6.4.4 Remarks......................................................................................................................... 40
6.5 Intermezzo: Pecking Order Theory....................................................................................... 41
6.6 The Rich Field of Corporate Finance .................................................................................... 41
A summary made by LouisT for the course: Corporate Financial Management given in 2021/2022
,Chapter 1. Introduction to the course
Welcome to this summary. First, an introduction to this course. The objectives of this course are as
follows:
• You will be able to understand and work with the basic concepts of valuation
➔ Time value of money
➔ Discounting and compounding
➔ Valuation under uncertainty.
• Be able to apply these in realistic situations
• Understand the driving forces behind risk and the cost of capital.
• Relate the above to the valuation of projects, companies, and their equity.
• Navigate problems related to capital budgeting, leverage, and capital structure (including
in situations with taxes)
• Be aware (and critical) of the implicit assumptions in these methods.
You will learn these by:
➔ Maths (Cashflows, Discount Rates, discounting those cashflows)
➔ Comprehension: questioning the realism of the calculation: identify shortcuts theory might
make, consequences and decisions.
➔ Aim: You will perform the analysis, judge the quality of it and see the implication.
1.1 Why do we have Finance?
We have Finance because the link between Finance and decisions is strong. After all, any decision
has a financial component in some way. Whatever you seek to do will cost you money and then you
have to figure out, the money that we are going to commit and is it going to be used in a good way.
Will the return be good, will it be justified? What will we invest in or forego? We are going to try to
study how various alternatives, are going to increase the value of the company.
Additionally, it should look at how it should be financed, such as through equity or debt. We see that
there are two parties to the transactions and both will be looking at value. Such as a bank that can
give out a loan, shareholders that can invest. The decisions they take, what the effects are on the
company will be a topic of this course.
Finance is an aspect of every decision made in the corporate world, you could expand it beyond the
corporate world, if you want to remain active, it would go for NGOs and more.
1.1.1 Company Value & Shareholder Value
Company value is seen as shareholder value. It's purely the nature of the contract between the
company and shareholders. The shareholder is residual claimants as they have no guarantee of
getting any return on their investment but they are entitled to everything that remains after other
claims have been settled. The focus on shareholder value is logical as it is how the legal contract
works but in lecture 6 we will see more about this.
However, there is plenty of scope for conflicts between the shareholders and the management, as
the latter is in control. Corporate Governance studies these conflicts of interest. These conflicts could
exist between shareholders and bondholders, management and shareholders, and more. This field
also requires a thorough understanding of what drives value in a company.
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A summary made by LouisT for the course: Corporate Financial Management given in 2021/2022
,1.2 Discounting
How much value is there? What is something worth? I need to know what is it worth to me but also
what it is worth for others, which is the market value. What kind of monetary value would other
people assign to it, so I know for what I can sell it.
To do so, we need to understand that money going in and out is different. This means we have to
compare different cash flows, the value I’m getting out of something worth at least as much as I’m
paying for it? If I promise to give someone 1,000 dollars in 2 years from now, would it be worth the
same right now? Inflation might say not, so it might be 900 dollars right now. You might put it in the
stock market but then you have risk. This means it is your decision, to look at the alternatives and
the purchasing power.
The central difficulty is that these cash flows aren’t matched in time: expenditure and revenue come
at different moments. This affects the value of these cash flows. A cash flow payable or receivable
right now is, by its definition, certain. Cashflows that come later may not come at all, be
smaller/larger, or have a different value.
This means we want to correct the cashflows for the riskiness and the time value of money. Probably
also the convenience of having money. If you have perfect capital markets, then it doesn’t matter
because you can always go to the bank and get money. So we need to figure out the cashflows in the
future and the riskiness of this.
Example
Suppose, we’re an oil company and we’re planning to build a new oil platform. Suppose the initial
outlay is 2 billion, and we’ll produce oil for the next 25 years. Which factors are relevant here?
We have to look at the risks, such as compliance and environmental risks. It could also look at how
much oil we can pump and how much we can store it or sell it immediately. There are also other
concerns such as disasters and cleaning if required.
Additionally, we have to look at the cash flows that we can be getting in the next 25 years, which
means it would also depend on the market conditions. We could also look at how much markets are
willing to pay for the risks.
1.2.1 Present Value
So to compare a future cash flow with one today we need to discount the future cash flow, which
means we need to know the present value. The general formula for this is:
The discount rate r combines all elements that make a future cash flow have less value compared to
one today: riskiness (amount and value/purchasing power of that amount), and time preference. It’s
a positive number, often quoted as a percentage (4% means r= 0.04 in this formula)
1.2.2 Net Present Value
However, we can also look at net present value. This means we don’t have one cash flow but 25. If
we use this, we can compare (for example) expenditure today with revenue in the next period. The
result of adding all cashflows – positive and negative – after they have been discounted tells us how
much value we create/lose from a decision. This number is called the net present value, or NPV. This
combines cashflows from different periods, each discounted back to the current time.
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A summary made by LouisT for the course: Corporate Financial Management given in 2021/2022
, A set of cash flows that has a positive NPV adds value to your company, a negative value implies a
loss of value. Therefore, it becomes crucial to establish what determined the NPV. The answer is in
the formula: the discount rate and the CFs themselves.
1.2.3 Discount Rate
Discount rates are closely tied to risk. The riskier the cash flow, the more expected return is required
to make investors/companies take on the risk. This can be determined with the market as risk is a
tradeable good but it is a little more complex because there might be different risks per different
time period. The interest rate for a loan starting now and maturing in 30 days is different from that
for a loan maturing in 10 years. Again, this is due to differences in risk and time value of money.
Interest rates and discount rates are related, so factors driving interest rates are also relevant:
➔ Inflation: most of the time – but not always – markets set interest rates such that the reduction
of purchasing power caused by inflation is at least compensated. The interest rate you
pay/receive is the nominal interest rate, subtract the inflation rate and you have the real interest
rate.
➔ Expected future: Government policies, central bank actions, and simply supply and demand
(available savings and available investment projects, respectively)
The discount rate ® will be regarded as given for now but later we explore how to determine this
ourselves.
1.2.4 Cashflows
Cashflows aren’t always as neat and tidy as this will change. Realistically, we’ll rarely see cashflows
that remain the same or grow at a constant rate. In business, CFs are likely to be changing from
period to period, especially in the first years of a project. Moreover, discount rates may change over
time as well (see the influencing factor on the previous slide and the yield curve in lecture 3).
The only real solution is to use Excel – or similar software- and discount each CF separately with its
discount rate.
The crucial element of all of this is that there is an anchor, which is the market value. NPV only works
if you use market values because otherwise, we will get an inconsistent calculation. This means we
need to follow the law of one price, which means if we have the same thing and there is competition,
then the same thing should have one value. If I take 100 pounds and convert it to euros, it should be
one value of this.
This is a driving force behind many results in Finance, as it rules out arbitrage profits, meaning we can
depend on the price reflecting competitive market conditions.
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A summary made by LouisT for the course: Corporate Financial Management given in 2021/2022
