Course cover
Corporate finan
,Table of contents
Part 1: Value
Table of contents ............................................................................................................................................................ 1
Chapter zero: concept of valuation ................................................................................................................................ 5
0.1. The concept of financial value ............................................................................................................................. 5
0.2. trick-questions to approach any valuation exercise ............................................................................................. 5
Chapter one : introduction to corporate finance ............................................................................................................ 5
1.1. Corporate finance decisions............................................................................................................................ 5
1.2. Role of the financial manager .............................................................................................................................. 6
1.3. Which decisions matter most?............................................................................................................................. 6
M&M1: Capital structure-irrelevance proposition (add full name) ........................................................................ 6
1.4. Agency theory in corporate finance ..................................................................................................................... 7
Agency conflict........................................................................................................................................................ 8
Corporate governance solutions ............................................................................................................................. 8
Chapter two: How to calculate present values ............................................................................................................... 8
2.1. Time value of money............................................................................................................................................ 8
2.2. Compound interest .............................................................................................................................................. 8
2.3. Multiple discount periods .................................................................................................................................... 9
2.4. Formulae for future values and present values ................................................................................................... 9
Compound interest ................................................................................................................................................. 9
Multiple discount periods ....................................................................................................................................... 9
Present value of a stream of cash flows.................................................................................................................. 9
2.5. Accommodation for changing interest rates ........................................................................................................ 9
2.6. Special cash flow streams annuities and perpetuities ....................................................................................... 10
Annuity ................................................................................................................................................................. 10
Perpetuity ............................................................................................................................................................. 10
Relation annuity-perpetuity .................................................................................................................................. 11
Chapter three : Valuing bonds ...................................................................................................................................... 11
3.1 Global bond markets (background) .................................................................................................................... 11
3.2 Terminology ........................................................................................................................................................ 11
YTM reflects opportunity cost of bondholders ..................................................................................................... 12
Issuers ................................................................................................................................................................... 12
Modalities ............................................................................................................................................................. 12
3.3 Bond risks and ratings ......................................................................................................................................... 13
Bond risks ............................................................................................................................................................. 13
Bond ratings .......................................................................................................................................................... 13
3.4 Valuing a bond .................................................................................................................................................... 13
Duration or ‘Macaulay duration’ .......................................................................................................................... 13
Volatility % or ‘modified duration’........................................................................................................................ 14
, Drivers of volatility ................................................................................................................................................ 14
3.5 Interest rates and inflation ................................................................................................................................. 15
Chapter four : Valuing stocks ........................................................................................................................................ 15
4.1 Terminology ........................................................................................................................................................ 15
4.2 Stock market volatility ........................................................................................................................................ 16
4.3 DDM-model for valuing stocks ............................................................................................................................ 16
DDM: one-period setting ...................................................................................................................................... 16
DDM: multi-period setting .................................................................................................................................... 17
Special DDM cases ................................................................................................................................................ 17
4.4 Business valuation in practice ............................................................................................................................. 18
4.5 DCF-models (as an illustration, just theory no exs) ............................................................................................. 19
Chapter five : Investment decision tools ...................................................................................................................... 19
5.1 Investment decision tools ................................................................................................................................... 20
5.2 Rules of thumb .................................................................................................................................................... 20
1: Book rate of return ........................................................................................................................................... 20
2: Break-even analysis .......................................................................................................................................... 21
3 & 4: payback and discounted payback period.................................................................................................... 21
5.3 Value creating rule: NPV of a company project .................................................................................................. 21
5.4 A note on IRR/ROR .............................................................................................................................................. 21
5.5 Analyses based on NPV ....................................................................................................................................... 22
Rationed capital analysis....................................................................................................................................... 22
Equivalent annual cash flow analysis (EAC) .......................................................................................................... 22
Chapter six : Investments in practice ............................................................................................................................ 23
6.1 How to obtain the project’s free cash flows? ..................................................................................................... 23
6.2 Real world examples ........................................................................................................................................... 23
IM&C’s fertilizer project ........................................................................................................................................ 23
Investment project by United Pigpen (UPP) ......................................................................................................... 25
Make of buy decision ............................................................................................................................................ 25
Part 2: risk
Chapter seven : Measuring risk and return................................................................................................................... 26
7.1. Value and risk..................................................................................................................................................... 26
7.2. Return of a single security.................................................................................................................................. 26
7.3. Risk of a single security ...................................................................................................................................... 26
7.4. Return of a portfolio of securities ...................................................................................................................... 26
7.5. Risk of a portfolio of securities ........................................................................................................................... 27
Diversification ....................................................................................................................................................... 27
Types of risk .......................................................................................................................................................... 27
7.6. Beta of a single security ..................................................................................................................................... 27
Estimation in practice ........................................................................................................................................... 28
, 7.7. Beta of a portfolio .............................................................................................................................................. 28
7.8. Risk-adjusted returns: SHARPE-ratio .................................................................................................................. 28
Chapter eight : Portfolio theory and the CAPM ............................................................................................................ 29
8.1. Markowitz portfolio theory ................................................................................................................................ 29
8.2. Efficient frontier ................................................................................................................................................. 30
8.3. Equations ........................................................................................................................................................... 31
Equation 1: Capital market line ............................................................................................................................. 31
Equation 2: Securities market line ........................................................................................................................ 32
8.4. CML and SML summary ..................................................................................................................................... 32
8.5. Testing the CAPM............................................................................................................................................... 32
8.6. Arbitrage Pricing Theory (Ross) .......................................................................................................................... 33
8.7. Fama-French three factor model ....................................................................................................................... 33
Chapter nine : Risk and the cost of capital .................................................................................................................... 33
9.1. Cost equity: Opp. cost estimate individual shareholder .................................................................................... 33
9.2. WACC: Opp. cost estimate company as a whole ................................................................................................ 33
Managing your WACC ........................................................................................................................................... 34
Estimating and improving the WACC .................................................................................................................... 34
Capita Selecta
Chapter ten : Options ................................................................................................................................................... 35
10.1. Financial options .............................................................................................................................................. 35
Call options: the right to buy ................................................................................................................................ 35
Put options: the right to sell ................................................................................................................................. 36
10.2. Valuing financial options .................................................................................................................................. 36
10.3. ‘Real options’ ................................................................................................................................................... 36
10.4. Analytical tool: decision tree analysis .............................................................................................................. 37
Example ................................................................................................................................................................ 37
Corporate investment context example ............................................................................................................... 38
10.5. Tips and tricks for managers ............................................................................................................................ 39
Chapter eleven : Market efficiency ............................................................................................................................... 39
11.1. Efficient market hypothesis (EMH) .................................................................................................................. 39
Simple logic, huge discussions .............................................................................................................................. 40
Consensus? ........................................................................................................................................................... 40
11.2. Upcoming interesting alternatives ................................................................................................................... 41
Chapter twelve : Debt policy ........................................................................................................................................ 41
12.1. Which decision matters most? Inv. vs. fin. decisions ....................................................................................... 41
12.2. Leverage (M&M2) ............................................................................................................................................ 41
Example ................................................................................................................................................................ 41
12.3. Two competing capital structure theories ....................................................................................................... 42
Trade-off theory.................................................................................................................................................... 42
Corporate finan
,Table of contents
Part 1: Value
Table of contents ............................................................................................................................................................ 1
Chapter zero: concept of valuation ................................................................................................................................ 5
0.1. The concept of financial value ............................................................................................................................. 5
0.2. trick-questions to approach any valuation exercise ............................................................................................. 5
Chapter one : introduction to corporate finance ............................................................................................................ 5
1.1. Corporate finance decisions............................................................................................................................ 5
1.2. Role of the financial manager .............................................................................................................................. 6
1.3. Which decisions matter most?............................................................................................................................. 6
M&M1: Capital structure-irrelevance proposition (add full name) ........................................................................ 6
1.4. Agency theory in corporate finance ..................................................................................................................... 7
Agency conflict........................................................................................................................................................ 8
Corporate governance solutions ............................................................................................................................. 8
Chapter two: How to calculate present values ............................................................................................................... 8
2.1. Time value of money............................................................................................................................................ 8
2.2. Compound interest .............................................................................................................................................. 8
2.3. Multiple discount periods .................................................................................................................................... 9
2.4. Formulae for future values and present values ................................................................................................... 9
Compound interest ................................................................................................................................................. 9
Multiple discount periods ....................................................................................................................................... 9
Present value of a stream of cash flows.................................................................................................................. 9
2.5. Accommodation for changing interest rates ........................................................................................................ 9
2.6. Special cash flow streams annuities and perpetuities ....................................................................................... 10
Annuity ................................................................................................................................................................. 10
Perpetuity ............................................................................................................................................................. 10
Relation annuity-perpetuity .................................................................................................................................. 11
Chapter three : Valuing bonds ...................................................................................................................................... 11
3.1 Global bond markets (background) .................................................................................................................... 11
3.2 Terminology ........................................................................................................................................................ 11
YTM reflects opportunity cost of bondholders ..................................................................................................... 12
Issuers ................................................................................................................................................................... 12
Modalities ............................................................................................................................................................. 12
3.3 Bond risks and ratings ......................................................................................................................................... 13
Bond risks ............................................................................................................................................................. 13
Bond ratings .......................................................................................................................................................... 13
3.4 Valuing a bond .................................................................................................................................................... 13
Duration or ‘Macaulay duration’ .......................................................................................................................... 13
Volatility % or ‘modified duration’........................................................................................................................ 14
, Drivers of volatility ................................................................................................................................................ 14
3.5 Interest rates and inflation ................................................................................................................................. 15
Chapter four : Valuing stocks ........................................................................................................................................ 15
4.1 Terminology ........................................................................................................................................................ 15
4.2 Stock market volatility ........................................................................................................................................ 16
4.3 DDM-model for valuing stocks ............................................................................................................................ 16
DDM: one-period setting ...................................................................................................................................... 16
DDM: multi-period setting .................................................................................................................................... 17
Special DDM cases ................................................................................................................................................ 17
4.4 Business valuation in practice ............................................................................................................................. 18
4.5 DCF-models (as an illustration, just theory no exs) ............................................................................................. 19
Chapter five : Investment decision tools ...................................................................................................................... 19
5.1 Investment decision tools ................................................................................................................................... 20
5.2 Rules of thumb .................................................................................................................................................... 20
1: Book rate of return ........................................................................................................................................... 20
2: Break-even analysis .......................................................................................................................................... 21
3 & 4: payback and discounted payback period.................................................................................................... 21
5.3 Value creating rule: NPV of a company project .................................................................................................. 21
5.4 A note on IRR/ROR .............................................................................................................................................. 21
5.5 Analyses based on NPV ....................................................................................................................................... 22
Rationed capital analysis....................................................................................................................................... 22
Equivalent annual cash flow analysis (EAC) .......................................................................................................... 22
Chapter six : Investments in practice ............................................................................................................................ 23
6.1 How to obtain the project’s free cash flows? ..................................................................................................... 23
6.2 Real world examples ........................................................................................................................................... 23
IM&C’s fertilizer project ........................................................................................................................................ 23
Investment project by United Pigpen (UPP) ......................................................................................................... 25
Make of buy decision ............................................................................................................................................ 25
Part 2: risk
Chapter seven : Measuring risk and return................................................................................................................... 26
7.1. Value and risk..................................................................................................................................................... 26
7.2. Return of a single security.................................................................................................................................. 26
7.3. Risk of a single security ...................................................................................................................................... 26
7.4. Return of a portfolio of securities ...................................................................................................................... 26
7.5. Risk of a portfolio of securities ........................................................................................................................... 27
Diversification ....................................................................................................................................................... 27
Types of risk .......................................................................................................................................................... 27
7.6. Beta of a single security ..................................................................................................................................... 27
Estimation in practice ........................................................................................................................................... 28
, 7.7. Beta of a portfolio .............................................................................................................................................. 28
7.8. Risk-adjusted returns: SHARPE-ratio .................................................................................................................. 28
Chapter eight : Portfolio theory and the CAPM ............................................................................................................ 29
8.1. Markowitz portfolio theory ................................................................................................................................ 29
8.2. Efficient frontier ................................................................................................................................................. 30
8.3. Equations ........................................................................................................................................................... 31
Equation 1: Capital market line ............................................................................................................................. 31
Equation 2: Securities market line ........................................................................................................................ 32
8.4. CML and SML summary ..................................................................................................................................... 32
8.5. Testing the CAPM............................................................................................................................................... 32
8.6. Arbitrage Pricing Theory (Ross) .......................................................................................................................... 33
8.7. Fama-French three factor model ....................................................................................................................... 33
Chapter nine : Risk and the cost of capital .................................................................................................................... 33
9.1. Cost equity: Opp. cost estimate individual shareholder .................................................................................... 33
9.2. WACC: Opp. cost estimate company as a whole ................................................................................................ 33
Managing your WACC ........................................................................................................................................... 34
Estimating and improving the WACC .................................................................................................................... 34
Capita Selecta
Chapter ten : Options ................................................................................................................................................... 35
10.1. Financial options .............................................................................................................................................. 35
Call options: the right to buy ................................................................................................................................ 35
Put options: the right to sell ................................................................................................................................. 36
10.2. Valuing financial options .................................................................................................................................. 36
10.3. ‘Real options’ ................................................................................................................................................... 36
10.4. Analytical tool: decision tree analysis .............................................................................................................. 37
Example ................................................................................................................................................................ 37
Corporate investment context example ............................................................................................................... 38
10.5. Tips and tricks for managers ............................................................................................................................ 39
Chapter eleven : Market efficiency ............................................................................................................................... 39
11.1. Efficient market hypothesis (EMH) .................................................................................................................. 39
Simple logic, huge discussions .............................................................................................................................. 40
Consensus? ........................................................................................................................................................... 40
11.2. Upcoming interesting alternatives ................................................................................................................... 41
Chapter twelve : Debt policy ........................................................................................................................................ 41
12.1. Which decision matters most? Inv. vs. fin. decisions ....................................................................................... 41
12.2. Leverage (M&M2) ............................................................................................................................................ 41
Example ................................................................................................................................................................ 41
12.3. Two competing capital structure theories ....................................................................................................... 42
Trade-off theory.................................................................................................................................................... 42
