Corporate Finance 2 — Debt & Equity
A Corporation in business has…:
- Legal personality: can be sued as itself, separate from its managers and employees,
and has responsibilities towards other legal persons (individuals, companies)
- Limited liability: CEO is not responsible for the company’s default > their personal
assets cannot be seized, though their stock/shares can down to $0 in value in the
worst cases, but that’s as bad as it will ever get
- Transferable shares: shares of the company can be sold/donated/exchanged
between different owners or on a market (Stock Exchange)
- Centralised management with fiduciary duty towards shareholders, with the Board
of Directors technically able to fire/hire the CEO and management (Executive
Committee)
- Shareholders can be seen as the owners of the company > they have various rights
such as voting rights, which we will explore throughout the course.
Debt & Equity (D&E) can both be seen as promises of cashflow in the future. Cashflow
promises that are tradable (for example on the London/NY Stock Exchange) are called
securities. From the perspective of their active holders, Equity & Debt are assets.
Main differences between D&E:
- Payoff structure: debt promises fixed payments (bond contracts) whereas equity
does not (there CAN be dividends given to shareholders, but that’s at the company’s
discretion and never mandated by the mere ownership of shares
- Maturity date: debt ends, not equity
- Seniority: you pay your creditors before you pay your shareholders (e.g. when the
company is liquidated, all debt obligations are paid before shareholders get the
remainder of the value to be extracted)
- Voice: equity holders have voting rights at annual meetings (proposals, resolutions,
etc) whereas creditors don’t have such rights (only contractual rights)
Cost of Equity
Assuming XYZ is a company fully funded by equity, with 10 million shares you all own.
- You wanna sell 1 million shares for £5 each
- Getting £5M costs me 1M shares, aka 10% of my shares
Cost of Equity = minimum rate of return prospective shareholders expect to get if they buy
shares of company ownership
, In this example shareholders are willing to pay £50M for ALL shares of XYZ (100% are
not for sale though, only 10%) but you would express the value of a portion of the
shares by computing the price/value of the entire enterprise
o /!\ We’re assuming no price impact here, a.k.a. same price per share applies
for any quantity of shares sold
What is the implied expected return by shareholders?
o We know that if the investors buy my entire Co for £50M, they expected the
present value of the expected cash-flows to be superior to that because
they wanna make a return!
o P = Price ; N = Number of shares bought
o Formula = what I get from investing in the company must NOT be lower than
the price I buy it for (PxN = 50)
The value of all cashflows expected from the company is the part on
the right-hand side of the formula
o Price I pay must be lower or equal to the present value of future cash-flows
o Founders will jack the price up as much as possible so that investors make as
little money as possible, and they get as much $ as possible to fund the daily
activities and production of the company
Solve the equation above to find re assuming investors get just their money back and no
supplementary return > use equality between the two branches of the equation to find the
rate (the IRR = internal rate of return) at which you’re discounting your cashflows
The IRR makes the equation equal exactly zero: the amount of money I put in today is
EXACTLY equal to the PV of future cash-flows discounted
If the return is any lower than the IRR/Discount rate, investors are losing money
To determine the IRR, I need to know the cash-flows and how much investors are
willing to pay for their shares in the company!
IRR = COST OF EQUITY (CoE)
Assumptions needed to compute CoE:
- No price impacts or transaction costs for simplicity
- re is XYZ’s cost of equity as perceived by the forecaster of cash-flows
- If no disagreement on the cashflow forecast, re is the same for all investors
- We’ll keep the assumption of symmetric information (everyone agreeing on
projected cashflows) for the sake of simplicity
A Corporation in business has…:
- Legal personality: can be sued as itself, separate from its managers and employees,
and has responsibilities towards other legal persons (individuals, companies)
- Limited liability: CEO is not responsible for the company’s default > their personal
assets cannot be seized, though their stock/shares can down to $0 in value in the
worst cases, but that’s as bad as it will ever get
- Transferable shares: shares of the company can be sold/donated/exchanged
between different owners or on a market (Stock Exchange)
- Centralised management with fiduciary duty towards shareholders, with the Board
of Directors technically able to fire/hire the CEO and management (Executive
Committee)
- Shareholders can be seen as the owners of the company > they have various rights
such as voting rights, which we will explore throughout the course.
Debt & Equity (D&E) can both be seen as promises of cashflow in the future. Cashflow
promises that are tradable (for example on the London/NY Stock Exchange) are called
securities. From the perspective of their active holders, Equity & Debt are assets.
Main differences between D&E:
- Payoff structure: debt promises fixed payments (bond contracts) whereas equity
does not (there CAN be dividends given to shareholders, but that’s at the company’s
discretion and never mandated by the mere ownership of shares
- Maturity date: debt ends, not equity
- Seniority: you pay your creditors before you pay your shareholders (e.g. when the
company is liquidated, all debt obligations are paid before shareholders get the
remainder of the value to be extracted)
- Voice: equity holders have voting rights at annual meetings (proposals, resolutions,
etc) whereas creditors don’t have such rights (only contractual rights)
Cost of Equity
Assuming XYZ is a company fully funded by equity, with 10 million shares you all own.
- You wanna sell 1 million shares for £5 each
- Getting £5M costs me 1M shares, aka 10% of my shares
Cost of Equity = minimum rate of return prospective shareholders expect to get if they buy
shares of company ownership
, In this example shareholders are willing to pay £50M for ALL shares of XYZ (100% are
not for sale though, only 10%) but you would express the value of a portion of the
shares by computing the price/value of the entire enterprise
o /!\ We’re assuming no price impact here, a.k.a. same price per share applies
for any quantity of shares sold
What is the implied expected return by shareholders?
o We know that if the investors buy my entire Co for £50M, they expected the
present value of the expected cash-flows to be superior to that because
they wanna make a return!
o P = Price ; N = Number of shares bought
o Formula = what I get from investing in the company must NOT be lower than
the price I buy it for (PxN = 50)
The value of all cashflows expected from the company is the part on
the right-hand side of the formula
o Price I pay must be lower or equal to the present value of future cash-flows
o Founders will jack the price up as much as possible so that investors make as
little money as possible, and they get as much $ as possible to fund the daily
activities and production of the company
Solve the equation above to find re assuming investors get just their money back and no
supplementary return > use equality between the two branches of the equation to find the
rate (the IRR = internal rate of return) at which you’re discounting your cashflows
The IRR makes the equation equal exactly zero: the amount of money I put in today is
EXACTLY equal to the PV of future cash-flows discounted
If the return is any lower than the IRR/Discount rate, investors are losing money
To determine the IRR, I need to know the cash-flows and how much investors are
willing to pay for their shares in the company!
IRR = COST OF EQUITY (CoE)
Assumptions needed to compute CoE:
- No price impacts or transaction costs for simplicity
- re is XYZ’s cost of equity as perceived by the forecaster of cash-flows
- If no disagreement on the cashflow forecast, re is the same for all investors
- We’ll keep the assumption of symmetric information (everyone agreeing on
projected cashflows) for the sake of simplicity
