Financial management
3e bachelor Handelsingenieur (SEM 2)
kQNd,
Examen:
- Closed book, on computer (formularium is available on the exam)
- Multiple choice questions and open questions
- ‘trail’ exam in early may
,Inhoudsopgave
CHAPTER 1 – OBJECTIVES AND FUNCTIONS OF FINANCIAL MANAGEMENT ....................................................... 4
1. WHAT IS THE OBJECTIVE OF FINANCIAL MANAGEMENT?............................................................................................................... 4
1.1 Which objective? .................................................................................................................................................................. 4
2. CORPORATE GOVERNANCE .......................................................................................................................................................... 6
CHAPTER 2 – BASIC VALUATION CONCEPTS .......................................................................................................... 7
1. PRESENT VALUE AND FUTURE VALUE ............................................................................................................................................ 7
2. INTEREST PERIODICITY SMALLER THAN ONE YEAR ........................................................................................................................ 8
3. FUTURE AND PRESENT VALUE OF A SERIES OF DIFFERENT CASH FLOWS ........................................................................................ 9
3.1 Present value of an infinite series of equal cash flows (perpetuity) ................................................................................. 9
3.2 Present value of an infinite series of constantly growing cash flows ............................................................................... 9
3.3 Present value of a finite series of equal cash flows (annuities) ....................................................................................... 10
4. THE VALUATION OF ANNUITIES AND PERPETUITIES .............................................................. ERROR! BOOKMARK NOT DEFINED.
5. REAL AND NOMINAL INTEREST RATES ON LOANS WITH A PERIODICITY LESS THAN ONE YEAR ...................................................... 10
CHAPTER 3 – VALUATION OF (BOND)LOANS AND SHARES .................................................................................12
1. VALUATION OF SIMPLE (BOND) LOANS ........................................................................................................................................ 12
1.1 Definition ............................................................................................................................................................................. 12
1.2 Duration of a loan .............................................................................................................................................................. 13
1.4 Time to maturity and interest rate .................................................................................................................................... 16
1.5 Zero-coupons bonds ........................................................................................................................................................... 16
2. VALUING SHARES BASED ON DIVIDENDS ..................................................................................................................................... 16
2.1 The dividend discount model (DDM) ................................................................................................................................ 16
2.2 Growth models ................................................................................................................................................................... 17
2.2.1 Case 1 – constant dividend growth g ............................................................................................................................... 17
2.2.2 Case 2 – No growth.......................................................................................................................................................... 17
2.2.3 Case 3 – Decreasing dividend growth............................................................................................................................. 18
3. MARKET EFFICIENCY – EXAMEN!!!! ........................................................................................................................................... 19
3.1 Three forms of market efficiency ...................................................................................................................................... 20
3.1.1 Weak – the worst performing Belgian stocks in 2004 ................................................................................................... 20
3.1.2 Semi-strong ..................................................................................................................................................................... 20
3.1.3 Strong .............................................................................................................................................................................. 20
3.2 Misunderstandings about efficient markets ................................................................................................................... 20
3.3 But are capital markets efficient? ..................................................................................................................................... 21
3.3.1 The weak form of market efficiency ................................................................................................................................ 21
3.3.2 Semi-strong market efficiency ........................................................................................................................................ 21
3.3.3 Strong market efficiency ................................................................................................................................................. 23
3.4 Conditions for market efficiency ....................................................................................................................................... 23
CHAPTER 4 – THE RELATIONSHIP BETWEEN THE REQUIRED RETURN AND RISK ........................................... 25
1. REQUIRED RATE OF RETURN AND RISK: PORTFOLIO WITH TWO SHARES ..................................................................................... 25
1.1 Expected rate of return, variance and covariance .............................................................................................................25
1.2 The effect of diversification ............................................................................................................................................... 26
2. REQUIRED RATE OF RETURN AND RISK: PORTFOLIO WITH MORE THAN TWO SHARES ................................................................. 27
2.1 The risk of a portfolio with multiple shares ......................................................................................................................27
2.2 Risk-free borrowing and investing ....................................................................................................................................27
2.3 Combinations of risky and risk-free investments ........................................................................................................... 28
2.4 Market equilibrium ........................................................................................................................................................... 29
3. BETA COEFFICIENT ..................................................................................................................................................................... 29
3.1 Beta and risk premium ...................................................................................................................................................... 29
3.2 The ‘security market line’ ................................................................................................................................................. 29
4. CAPITAL ASSET PRICING MODEL ............................................................................................................................................... 30
5. ALTERNATIVE MODELS................................................................................................................................................................ 31
5.1 The arbitrage pricing model (APM) .................................................................................................................................. 31
PAGINA 1
, 5.2 Fama-French-Carhart model (CAPM) .............................................................................................................................. 31
5.3 Fama-french five-factor model (2015) ............................................................................................................................... 32
5.4 Multi-factor models ........................................................................................................................................................... 32
CHAPTER 5 – VALUING OPTIONS .......................................................................................................................... 33
1. WHAT IS AN OPTION? ................................................................................................................................................................. 33
1.1 Value of a call option on the exercise date (buyers perspective)...................................................................................... 33
1.2 Value of a put option on the exercise date (buyers perspective) ..................................................................................... 33
1.3 The buyer’s right is the seller’s obligation ........................................................................................................................ 34
2. END VALUE ................................................................................................................................................................................ 34
3. TIME VALUE ................................................................................................................................................................................35
3.1 Difference between share price and exercise price ...........................................................................................................35
3.2 Remaining life of the option ............................................................................................................................................. 36
3.3 The volatility of the underlying asset ............................................................................................................................... 36
3.4 Interest rate ....................................................................................................................................................................... 36
3.5 Dividend (only for share options) .....................................................................................................................................37
4. VALUATION OF OPTIONS ............................................................................................................................................................37
4.1 Binomial method ................................................................................................................................................................37
4.2 The black & Scholes formula ............................................................................................................................................ 38
4.3 Valuing a put option ......................................................................................................................................................... 39
5. PUT-CALL PARITY....................................................................................................................................................................... 40
CHAPTER 6 – ASSESSING INVESTMENT PROJECTS ............................................................................................... 41
1. DETERMINING CASH FLOWS ........................................................................................................................................................ 41
2. EVALUATION METHODS ............................................................................................................................................................. 42
2.1 Net Present Value (NPV) .................................................................................................................................................. 42
2.2 Payback period .................................................................................................................................................................. 43
2.3 Average book profitability ................................................................................................................................................ 43
2.4 Internal Rate of Return (IRR) – Problems with IRR ....................................................................................................... 43
2.4.1 The problems ................................................................................................................................................................... 44
2.4.2 Mutually exclusive projects ........................................................................................................................................... 44
CHAPTER 7 – FURTHER REFINEMENTS IN ASSESSING THE INVESTMENT .......................................................... 46
1. THE IMPACT OF INFLATION ........................................................................................................................................................ 46
2. CAPITAL RATIONING .................................................................................................................................................................. 46
3. PROJECTS WITH DIFFERENT LIFETIMES ....................................................................................................................................... 47
4. REPLACEMENT OF A MACHINE ................................................................................................................................................... 48
5. REAL OPTIONS IN INVESTMENT PROJECTS .................................................................................................................................. 48
CHAPTER 8 – COST OF CAPITAL ............................................................................................................................. 51
1. THE WEIGHTED AVERAGE COST OF CAPITAL ................................................................................................................................ 51
1.1 The cost of ordinary share capital, with debt financing ................................................................................................... 51
1.2 The cost of preference shares .............................................................................................................................................53
1.3 The cost of debt financing ..................................................................................................................................................53
2. INVESTMENT AND FINANCING DECISION .....................................................................................................................................53
3. REQUIRED RATE OF RETURN FOR AN INDIVIDUAL INVESTMENT PROJECT.................................................................................... 54
CHAPTER 9 - CAPITAL STRUCTURE ....................................................................................................................... 55
1.THEORY OF MODIGLIANI & MILLER .............................................................................................................................................55
1.1 EBIT-EPS analysis ...............................................................................................................................................................55
1.2 Modigliani and miller (M&M) ...........................................................................................................................................55
1.3 The impact of capital structure on the value of a company ........................................................................................... 56
2. DEVIATIONS FROM THE ASSUMPTIONS OF MODIGLIANI & MILLER ............................................................................................ 59
2.2 Corporate taxes ................................................................................................................................................................. 59
2.2.1 Corporate taxes and value .............................................................................................................................................. 59
2.2.2 Corporate taxes and WACC .......................................................................................................................................... 60
2.3 Bankruptcy costs ................................................................................................................................................................ 61
PAGINA 2
, 3. EQUITY AND DEBT AS OPTIONS .................................................................................................................................................. 62
3.1 Equity as a Call Option ..................................................................................................................................................... 62
3.2 Debt as an option .............................................................................................................................................................. 63
CHAPTER 12 – ISSUING SHARES ............................................................................................................................. 65
1. ORDINARY SHARES ..................................................................................................................................................................... 65
2. WHO INVESTS IN SHARES? ......................................................................................................................................................... 65
2.1 Who invests in shares ........................................................................................................................................................ 65
2.2 Who invests in shares of young companies? ................................................................................................................... 66
2.2.1 the “3 F’S”: Friends, Family and Fools ............................................................................................................................ 66
2.2.2 Crowdfunding ................................................................................................................................................................. 66
2.2.3 Business angels ............................................................................................................................................................... 68
2.2.4 Venture capital funds (→ private equity funds) .......................................................................................................... 68
2.2.5 Strategic partners ........................................................................................................................................................... 69
2.2.6 Institutional investors ................................................................................................................................................... 69
2.2.7 The stock exchange ........................................................................................................................................................ 69
3. PUBLIC ISSUE OF SHARES ............................................................................................................................................................ 69
4. ORGANISED SHARE MARKETS ..................................................................................................................................................... 70
5. EURONEXT BRUSSELS................................................................................................................................................................. 72
6. INITIAL PUBLIC OFFERINGS: TWITTER & SPOTIFY ...................................................................................................................... 72
6.1 Twitter - 7 November 2013 .................................................................................................................................................72
6.2 The direct listing of Spotify on the New York Stock Exchange .......................................................................................73
6.3 Special purpose acquisition company (SPAC) ................................................................................................................ 74
7. RIGHT OFFERINGS: LSG AND SOLVAY ........................................................................................................................................ 74
7.1 Rights offering of Laundry Systems Group ...................................................................................................................... 74
7.2 Rights offering of Solvay ....................................................................................................................................................75
CHAPTER 13 – FINANCIAL DEBT............................................................................................................................. 76
1. PROTECTIVE CLAUSES AND GUARANTEES .................................................................................................................................... 76
2. COLLATERAL.............................................................................................................................................................................. 76
3. BOND LOANS ............................................................................................................................................................................. 76
3.1 Some concepts.................................................................................................................................................................... 76
3.2 Types of bonds ................................................................................................................................................................... 77
3.3 Bonds with call option ...................................................................................................................................................... 77
3.4 Bonds with warrants ......................................................................................................................................................... 78
3.5 Convertible bonds.............................................................................................................................................................. 78
4.COMMERCIAL PAPER .................................................................................................................................................................. 80
CHAPTER 15 – WORKING CAPITAL MANAGEMENT .............................................................................................. 82
1. THE HEDGING APPROACH TO FINANCING MATURITY .................................................................................................................. 82
2.WORKING CAPITAL MANAGEMENT ............................................................................................................................................. 82
3. TRADE CREDIT ........................................................................................................................................................................... 84
CHAPTER 16 – CASH MANAGEMENT AND FINANCIAL PLANNING ...................................................................... 86
PAGINA 3
3e bachelor Handelsingenieur (SEM 2)
kQNd,
Examen:
- Closed book, on computer (formularium is available on the exam)
- Multiple choice questions and open questions
- ‘trail’ exam in early may
,Inhoudsopgave
CHAPTER 1 – OBJECTIVES AND FUNCTIONS OF FINANCIAL MANAGEMENT ....................................................... 4
1. WHAT IS THE OBJECTIVE OF FINANCIAL MANAGEMENT?............................................................................................................... 4
1.1 Which objective? .................................................................................................................................................................. 4
2. CORPORATE GOVERNANCE .......................................................................................................................................................... 6
CHAPTER 2 – BASIC VALUATION CONCEPTS .......................................................................................................... 7
1. PRESENT VALUE AND FUTURE VALUE ............................................................................................................................................ 7
2. INTEREST PERIODICITY SMALLER THAN ONE YEAR ........................................................................................................................ 8
3. FUTURE AND PRESENT VALUE OF A SERIES OF DIFFERENT CASH FLOWS ........................................................................................ 9
3.1 Present value of an infinite series of equal cash flows (perpetuity) ................................................................................. 9
3.2 Present value of an infinite series of constantly growing cash flows ............................................................................... 9
3.3 Present value of a finite series of equal cash flows (annuities) ....................................................................................... 10
4. THE VALUATION OF ANNUITIES AND PERPETUITIES .............................................................. ERROR! BOOKMARK NOT DEFINED.
5. REAL AND NOMINAL INTEREST RATES ON LOANS WITH A PERIODICITY LESS THAN ONE YEAR ...................................................... 10
CHAPTER 3 – VALUATION OF (BOND)LOANS AND SHARES .................................................................................12
1. VALUATION OF SIMPLE (BOND) LOANS ........................................................................................................................................ 12
1.1 Definition ............................................................................................................................................................................. 12
1.2 Duration of a loan .............................................................................................................................................................. 13
1.4 Time to maturity and interest rate .................................................................................................................................... 16
1.5 Zero-coupons bonds ........................................................................................................................................................... 16
2. VALUING SHARES BASED ON DIVIDENDS ..................................................................................................................................... 16
2.1 The dividend discount model (DDM) ................................................................................................................................ 16
2.2 Growth models ................................................................................................................................................................... 17
2.2.1 Case 1 – constant dividend growth g ............................................................................................................................... 17
2.2.2 Case 2 – No growth.......................................................................................................................................................... 17
2.2.3 Case 3 – Decreasing dividend growth............................................................................................................................. 18
3. MARKET EFFICIENCY – EXAMEN!!!! ........................................................................................................................................... 19
3.1 Three forms of market efficiency ...................................................................................................................................... 20
3.1.1 Weak – the worst performing Belgian stocks in 2004 ................................................................................................... 20
3.1.2 Semi-strong ..................................................................................................................................................................... 20
3.1.3 Strong .............................................................................................................................................................................. 20
3.2 Misunderstandings about efficient markets ................................................................................................................... 20
3.3 But are capital markets efficient? ..................................................................................................................................... 21
3.3.1 The weak form of market efficiency ................................................................................................................................ 21
3.3.2 Semi-strong market efficiency ........................................................................................................................................ 21
3.3.3 Strong market efficiency ................................................................................................................................................. 23
3.4 Conditions for market efficiency ....................................................................................................................................... 23
CHAPTER 4 – THE RELATIONSHIP BETWEEN THE REQUIRED RETURN AND RISK ........................................... 25
1. REQUIRED RATE OF RETURN AND RISK: PORTFOLIO WITH TWO SHARES ..................................................................................... 25
1.1 Expected rate of return, variance and covariance .............................................................................................................25
1.2 The effect of diversification ............................................................................................................................................... 26
2. REQUIRED RATE OF RETURN AND RISK: PORTFOLIO WITH MORE THAN TWO SHARES ................................................................. 27
2.1 The risk of a portfolio with multiple shares ......................................................................................................................27
2.2 Risk-free borrowing and investing ....................................................................................................................................27
2.3 Combinations of risky and risk-free investments ........................................................................................................... 28
2.4 Market equilibrium ........................................................................................................................................................... 29
3. BETA COEFFICIENT ..................................................................................................................................................................... 29
3.1 Beta and risk premium ...................................................................................................................................................... 29
3.2 The ‘security market line’ ................................................................................................................................................. 29
4. CAPITAL ASSET PRICING MODEL ............................................................................................................................................... 30
5. ALTERNATIVE MODELS................................................................................................................................................................ 31
5.1 The arbitrage pricing model (APM) .................................................................................................................................. 31
PAGINA 1
, 5.2 Fama-French-Carhart model (CAPM) .............................................................................................................................. 31
5.3 Fama-french five-factor model (2015) ............................................................................................................................... 32
5.4 Multi-factor models ........................................................................................................................................................... 32
CHAPTER 5 – VALUING OPTIONS .......................................................................................................................... 33
1. WHAT IS AN OPTION? ................................................................................................................................................................. 33
1.1 Value of a call option on the exercise date (buyers perspective)...................................................................................... 33
1.2 Value of a put option on the exercise date (buyers perspective) ..................................................................................... 33
1.3 The buyer’s right is the seller’s obligation ........................................................................................................................ 34
2. END VALUE ................................................................................................................................................................................ 34
3. TIME VALUE ................................................................................................................................................................................35
3.1 Difference between share price and exercise price ...........................................................................................................35
3.2 Remaining life of the option ............................................................................................................................................. 36
3.3 The volatility of the underlying asset ............................................................................................................................... 36
3.4 Interest rate ....................................................................................................................................................................... 36
3.5 Dividend (only for share options) .....................................................................................................................................37
4. VALUATION OF OPTIONS ............................................................................................................................................................37
4.1 Binomial method ................................................................................................................................................................37
4.2 The black & Scholes formula ............................................................................................................................................ 38
4.3 Valuing a put option ......................................................................................................................................................... 39
5. PUT-CALL PARITY....................................................................................................................................................................... 40
CHAPTER 6 – ASSESSING INVESTMENT PROJECTS ............................................................................................... 41
1. DETERMINING CASH FLOWS ........................................................................................................................................................ 41
2. EVALUATION METHODS ............................................................................................................................................................. 42
2.1 Net Present Value (NPV) .................................................................................................................................................. 42
2.2 Payback period .................................................................................................................................................................. 43
2.3 Average book profitability ................................................................................................................................................ 43
2.4 Internal Rate of Return (IRR) – Problems with IRR ....................................................................................................... 43
2.4.1 The problems ................................................................................................................................................................... 44
2.4.2 Mutually exclusive projects ........................................................................................................................................... 44
CHAPTER 7 – FURTHER REFINEMENTS IN ASSESSING THE INVESTMENT .......................................................... 46
1. THE IMPACT OF INFLATION ........................................................................................................................................................ 46
2. CAPITAL RATIONING .................................................................................................................................................................. 46
3. PROJECTS WITH DIFFERENT LIFETIMES ....................................................................................................................................... 47
4. REPLACEMENT OF A MACHINE ................................................................................................................................................... 48
5. REAL OPTIONS IN INVESTMENT PROJECTS .................................................................................................................................. 48
CHAPTER 8 – COST OF CAPITAL ............................................................................................................................. 51
1. THE WEIGHTED AVERAGE COST OF CAPITAL ................................................................................................................................ 51
1.1 The cost of ordinary share capital, with debt financing ................................................................................................... 51
1.2 The cost of preference shares .............................................................................................................................................53
1.3 The cost of debt financing ..................................................................................................................................................53
2. INVESTMENT AND FINANCING DECISION .....................................................................................................................................53
3. REQUIRED RATE OF RETURN FOR AN INDIVIDUAL INVESTMENT PROJECT.................................................................................... 54
CHAPTER 9 - CAPITAL STRUCTURE ....................................................................................................................... 55
1.THEORY OF MODIGLIANI & MILLER .............................................................................................................................................55
1.1 EBIT-EPS analysis ...............................................................................................................................................................55
1.2 Modigliani and miller (M&M) ...........................................................................................................................................55
1.3 The impact of capital structure on the value of a company ........................................................................................... 56
2. DEVIATIONS FROM THE ASSUMPTIONS OF MODIGLIANI & MILLER ............................................................................................ 59
2.2 Corporate taxes ................................................................................................................................................................. 59
2.2.1 Corporate taxes and value .............................................................................................................................................. 59
2.2.2 Corporate taxes and WACC .......................................................................................................................................... 60
2.3 Bankruptcy costs ................................................................................................................................................................ 61
PAGINA 2
, 3. EQUITY AND DEBT AS OPTIONS .................................................................................................................................................. 62
3.1 Equity as a Call Option ..................................................................................................................................................... 62
3.2 Debt as an option .............................................................................................................................................................. 63
CHAPTER 12 – ISSUING SHARES ............................................................................................................................. 65
1. ORDINARY SHARES ..................................................................................................................................................................... 65
2. WHO INVESTS IN SHARES? ......................................................................................................................................................... 65
2.1 Who invests in shares ........................................................................................................................................................ 65
2.2 Who invests in shares of young companies? ................................................................................................................... 66
2.2.1 the “3 F’S”: Friends, Family and Fools ............................................................................................................................ 66
2.2.2 Crowdfunding ................................................................................................................................................................. 66
2.2.3 Business angels ............................................................................................................................................................... 68
2.2.4 Venture capital funds (→ private equity funds) .......................................................................................................... 68
2.2.5 Strategic partners ........................................................................................................................................................... 69
2.2.6 Institutional investors ................................................................................................................................................... 69
2.2.7 The stock exchange ........................................................................................................................................................ 69
3. PUBLIC ISSUE OF SHARES ............................................................................................................................................................ 69
4. ORGANISED SHARE MARKETS ..................................................................................................................................................... 70
5. EURONEXT BRUSSELS................................................................................................................................................................. 72
6. INITIAL PUBLIC OFFERINGS: TWITTER & SPOTIFY ...................................................................................................................... 72
6.1 Twitter - 7 November 2013 .................................................................................................................................................72
6.2 The direct listing of Spotify on the New York Stock Exchange .......................................................................................73
6.3 Special purpose acquisition company (SPAC) ................................................................................................................ 74
7. RIGHT OFFERINGS: LSG AND SOLVAY ........................................................................................................................................ 74
7.1 Rights offering of Laundry Systems Group ...................................................................................................................... 74
7.2 Rights offering of Solvay ....................................................................................................................................................75
CHAPTER 13 – FINANCIAL DEBT............................................................................................................................. 76
1. PROTECTIVE CLAUSES AND GUARANTEES .................................................................................................................................... 76
2. COLLATERAL.............................................................................................................................................................................. 76
3. BOND LOANS ............................................................................................................................................................................. 76
3.1 Some concepts.................................................................................................................................................................... 76
3.2 Types of bonds ................................................................................................................................................................... 77
3.3 Bonds with call option ...................................................................................................................................................... 77
3.4 Bonds with warrants ......................................................................................................................................................... 78
3.5 Convertible bonds.............................................................................................................................................................. 78
4.COMMERCIAL PAPER .................................................................................................................................................................. 80
CHAPTER 15 – WORKING CAPITAL MANAGEMENT .............................................................................................. 82
1. THE HEDGING APPROACH TO FINANCING MATURITY .................................................................................................................. 82
2.WORKING CAPITAL MANAGEMENT ............................................................................................................................................. 82
3. TRADE CREDIT ........................................................................................................................................................................... 84
CHAPTER 16 – CASH MANAGEMENT AND FINANCIAL PLANNING ...................................................................... 86
PAGINA 3
