Strategic financial management
Les 1: 27/09
Practicalities
Lecture 8-10: financial modelling
- = the act of building financial models in excels
- Make a virtual version of a company and see what it will look like in the future
- Often used in fin decisionmaking
- You get grades in return for being there and participating actively in the lectures
Examination
- Everything on Toledo
- Study material
o Slides op Toledo, maar ingevulde slides pas achteraf na de les op Toledo
o Academic papers
o Book chapters -> kun je gaan kopiëren in de bib
- 15% of the grade, you get just by participating in the last three lectures
- 85% on written examination (14th of January)
o Mostly multiple choice -> verhoogde seizuur
o But at least one open question (zie voorbeeldvraag op Toledo)
No recordings of the lectures
LES 1: Capital Structure
What comes to mind when you hear the word capital structure
- Which type of funding we use to finance our company
- Distribution between debt and equity in a firm
How should we think about capital structure?
The intuition behind Modigliani & Miller (1958)
Suppose that you buy an asset (a house) today
- The price you pay today: 100.000
- You plan to sell it next year
- Mortgage rate, if you take a mortgage = 5%
o You can choose: not taking mortgage, taking 50% mortgage, taking 90% mortgage
- House price can: drop next year, increase next year, boom in the housing market next year
(alles 1/3 kans)
1
, = the realized returns
= the expected returns
Where does this 55% come from?
- If you sell the house after one year, you get 130.000
- You took a mortgage of 50% -> that means: we borrowed 50.000
o We have to repay the 50.000
o We have to repay the interest of 5% = 2500
- (Return – payback to the bank) / the investment, equity that we put in it
- (130.000 – (50.000 + 2500)) / 50.000 = 55%
Does the value of the house depend on the size of the mortgage?
- No
On what does it depend?
- On the state of the economy: house price drops, raises or booms
What does change with the size of the mortgage?
- Obviously
o The interest that you have to may, the more I borrow, the more interest I will have to
pay
o You become more leveraged
- The expected return on investment
o The more leverage you take, the higher ROI, but the more risk you get
- The risk of your investment
o You can see this in the standard deviation
o If the standard deviation goes op, the risk also goes up
o The more leverage you take, the more risk you get
M&M Proposition I
Proposition: In a perfect capital market, the total value of a firm is equal to the market value of its
current and future cash flows generated by its asset and is not affected by its choice of capital
structure.
- Perfect capital markets = strong assumption
- Value only depending on the present value of the current and future cashflows that the firm
will generate.
o Vb. investment in house: the value of the house depends only on if it is going to be
an expected bad market or good market (not on the mortgage that you take). The
potential market is influencing the value of the house, not whether I buy the house
with equity or debt
- The size of the pie is the same, it does not matter the way of financing
- Value of a firm V = value of its equity (E) + value of its debt (D)
Exercise 1
- Firm that is fully funded trough equity. Project: invest 800
- Tomorrow: 1400 in strong economy, 900 in a weak economy (probability both 50%)
- Risk free rate = 5% = Rrisk free
- Project risk premium = 10% = Rproject - Rrisk free
- 1. NPV of this project?
- 2. For how much can we sell this project, what is the value that we can raise?
2
, - 3. What are the returns that shareholders will get form this project? In the good state, in the
bad state, in expectation?
Solution 1
- 1. NPV = ((0,5*1400+0,5*900) / 1,15) – 800 = 200
- Where does the 1,15 come from? We need to discount the future cash flows with the total
risk of the project Rproject (10% = Rproject - 5%)
- 2. Equity that we can raise = ((0,5*1400 + 0,5*900) / 1,15 = 1000
- 3. Returns in the good state = 40% (1000 + 40% van 1000 = 1400
o They put in 1000 -> was het geen 800 -> neen je moet kijken naar de equity that we
can raise = 1000
- 3. Return in the bad state = -10% (1000 -10% van 1000 = 900)
- 3. Expected return = 0,5*40% + 0,5*-10% = 15%
o The shareholders get a reward that is equal to Rproject
o This is not a coincidence, see further
Exercise 2
- Now suppose the firm borrows $500, in addition to selling equity
o So first borrowing 500, raise the rest with equity
- Note: Project Cash Flows > Debt Owed in each state!
o Debt is risk-free ➔ Rdebt = Rrisk free = 5%
- Payoffs to Debt and Equity
o D -> in strong or weak economy, you have to pay the bank 500 + 5%
o E is different in strong and weak economy because debtors are paid out first
- 1. What is the value of equity now = how much are people going to be willing to pay to
purchase this equity?
- 2. Why is the value of debt not 457
Solution 2
- 1. Value of equity = (0,5*875 + 0,5*375)/1,15 = 543
o The expected payoff is higher
o ! if you don’t discount, you het the expected cash flow -> not the same as the value
of the equity
o ‘but you say that you are only willing to pay 500 for this. Why is that? Because you
believe in the M&Mt theorem, that tells you that it should only be worth 500, that
the value of the firm is unchanged.’ => the value of the equity in the M&M world has
to stay 500, people are only willing to pay 500 for the investment => SO second
question
- Why is the value of the equity 500 and not not 543?
o The risk increases, because the leverage (vreemd vermogen) brengt risk met zich
mee
o So in the formula, we have to use another discount rate because Rproject (the risk of
the project) is higher -> 25% in stead of 15%
- We are pre-promising a piece of the pie to the bank. And the investors in equity take the
residual claim so they increase their risk
3
, - 2. Why is the value of debt not 457
o If I would discount 525/1,15 = 457
o But the value of debt is not 457, but the value is 500 => reason: you have to discount
525/1,05
o 1,05 because that is the return that they will ask, because they are risk free (the bank
is fully risk free)
▪ How can you see that the bank is fully risk free in this model?
They always get the same price / amount, no matter what
Even if the economy goes bad, the opbrengst is still high enough to payback
the bank (900 is more than enough to pay back the bank)
Because of that, the shareholders can sell a piece of the pie to the bank, with
certainty that they can repay the bank.
- SO the ADH have a higher project risk (25%) and the bank had a risk free rate (5%)
Levered equity carries a higher risk premium than unlevered equity
- We therefore need to discount it with a larger discount rate
- In this particular case -> risk premium is no longer 15% but 25%
Exercise 3
Calculate the expected returns in the economy for each of the actors
Bank heeft volledige return 5% 5% 5%
Strong: 375 winst, weak 125 verlies 75% -25% 25%
In dit lijntje overall 0,5*return D + 0,5*return E -> 40% -10% 15%
Takeways from this box
- 1. Leved equity -> higher risk -> higher return (good state 75%, bad state – 25%; previously
good state +40%, bad state -10%) => in expectation, they earned 25% => this is equal to the
risk they take (Rproject = 0,25)
- 2. The reason why the shareholders need a higher discount rate, is not because the risk of
the business changed (the business is exactly the same as it was before). Where do we see
that?
o Good state, still 1400 (+40% return), bad state, still 900 (-10% return) -> in
expectation these two have a risk of 15% -> this is still unchanged (in het rijtje van de
firm is de expected return nog steeds 15%
o The reason that the equity now carries a higher risk premium is simply because the
fin ris, that is been introduced due to the leverage
- 3. The additional risk that the firm took, is not the same as default risk, the firm does not
default in any of these scenarios, because there is always money to fully repay the bank
o Zelfs in een weak economy is er genoeg geld verdiend om de bank helemaal terug te
betalen, de ADH hebben gewoon minder
4
Les 1: 27/09
Practicalities
Lecture 8-10: financial modelling
- = the act of building financial models in excels
- Make a virtual version of a company and see what it will look like in the future
- Often used in fin decisionmaking
- You get grades in return for being there and participating actively in the lectures
Examination
- Everything on Toledo
- Study material
o Slides op Toledo, maar ingevulde slides pas achteraf na de les op Toledo
o Academic papers
o Book chapters -> kun je gaan kopiëren in de bib
- 15% of the grade, you get just by participating in the last three lectures
- 85% on written examination (14th of January)
o Mostly multiple choice -> verhoogde seizuur
o But at least one open question (zie voorbeeldvraag op Toledo)
No recordings of the lectures
LES 1: Capital Structure
What comes to mind when you hear the word capital structure
- Which type of funding we use to finance our company
- Distribution between debt and equity in a firm
How should we think about capital structure?
The intuition behind Modigliani & Miller (1958)
Suppose that you buy an asset (a house) today
- The price you pay today: 100.000
- You plan to sell it next year
- Mortgage rate, if you take a mortgage = 5%
o You can choose: not taking mortgage, taking 50% mortgage, taking 90% mortgage
- House price can: drop next year, increase next year, boom in the housing market next year
(alles 1/3 kans)
1
, = the realized returns
= the expected returns
Where does this 55% come from?
- If you sell the house after one year, you get 130.000
- You took a mortgage of 50% -> that means: we borrowed 50.000
o We have to repay the 50.000
o We have to repay the interest of 5% = 2500
- (Return – payback to the bank) / the investment, equity that we put in it
- (130.000 – (50.000 + 2500)) / 50.000 = 55%
Does the value of the house depend on the size of the mortgage?
- No
On what does it depend?
- On the state of the economy: house price drops, raises or booms
What does change with the size of the mortgage?
- Obviously
o The interest that you have to may, the more I borrow, the more interest I will have to
pay
o You become more leveraged
- The expected return on investment
o The more leverage you take, the higher ROI, but the more risk you get
- The risk of your investment
o You can see this in the standard deviation
o If the standard deviation goes op, the risk also goes up
o The more leverage you take, the more risk you get
M&M Proposition I
Proposition: In a perfect capital market, the total value of a firm is equal to the market value of its
current and future cash flows generated by its asset and is not affected by its choice of capital
structure.
- Perfect capital markets = strong assumption
- Value only depending on the present value of the current and future cashflows that the firm
will generate.
o Vb. investment in house: the value of the house depends only on if it is going to be
an expected bad market or good market (not on the mortgage that you take). The
potential market is influencing the value of the house, not whether I buy the house
with equity or debt
- The size of the pie is the same, it does not matter the way of financing
- Value of a firm V = value of its equity (E) + value of its debt (D)
Exercise 1
- Firm that is fully funded trough equity. Project: invest 800
- Tomorrow: 1400 in strong economy, 900 in a weak economy (probability both 50%)
- Risk free rate = 5% = Rrisk free
- Project risk premium = 10% = Rproject - Rrisk free
- 1. NPV of this project?
- 2. For how much can we sell this project, what is the value that we can raise?
2
, - 3. What are the returns that shareholders will get form this project? In the good state, in the
bad state, in expectation?
Solution 1
- 1. NPV = ((0,5*1400+0,5*900) / 1,15) – 800 = 200
- Where does the 1,15 come from? We need to discount the future cash flows with the total
risk of the project Rproject (10% = Rproject - 5%)
- 2. Equity that we can raise = ((0,5*1400 + 0,5*900) / 1,15 = 1000
- 3. Returns in the good state = 40% (1000 + 40% van 1000 = 1400
o They put in 1000 -> was het geen 800 -> neen je moet kijken naar de equity that we
can raise = 1000
- 3. Return in the bad state = -10% (1000 -10% van 1000 = 900)
- 3. Expected return = 0,5*40% + 0,5*-10% = 15%
o The shareholders get a reward that is equal to Rproject
o This is not a coincidence, see further
Exercise 2
- Now suppose the firm borrows $500, in addition to selling equity
o So first borrowing 500, raise the rest with equity
- Note: Project Cash Flows > Debt Owed in each state!
o Debt is risk-free ➔ Rdebt = Rrisk free = 5%
- Payoffs to Debt and Equity
o D -> in strong or weak economy, you have to pay the bank 500 + 5%
o E is different in strong and weak economy because debtors are paid out first
- 1. What is the value of equity now = how much are people going to be willing to pay to
purchase this equity?
- 2. Why is the value of debt not 457
Solution 2
- 1. Value of equity = (0,5*875 + 0,5*375)/1,15 = 543
o The expected payoff is higher
o ! if you don’t discount, you het the expected cash flow -> not the same as the value
of the equity
o ‘but you say that you are only willing to pay 500 for this. Why is that? Because you
believe in the M&Mt theorem, that tells you that it should only be worth 500, that
the value of the firm is unchanged.’ => the value of the equity in the M&M world has
to stay 500, people are only willing to pay 500 for the investment => SO second
question
- Why is the value of the equity 500 and not not 543?
o The risk increases, because the leverage (vreemd vermogen) brengt risk met zich
mee
o So in the formula, we have to use another discount rate because Rproject (the risk of
the project) is higher -> 25% in stead of 15%
- We are pre-promising a piece of the pie to the bank. And the investors in equity take the
residual claim so they increase their risk
3
, - 2. Why is the value of debt not 457
o If I would discount 525/1,15 = 457
o But the value of debt is not 457, but the value is 500 => reason: you have to discount
525/1,05
o 1,05 because that is the return that they will ask, because they are risk free (the bank
is fully risk free)
▪ How can you see that the bank is fully risk free in this model?
They always get the same price / amount, no matter what
Even if the economy goes bad, the opbrengst is still high enough to payback
the bank (900 is more than enough to pay back the bank)
Because of that, the shareholders can sell a piece of the pie to the bank, with
certainty that they can repay the bank.
- SO the ADH have a higher project risk (25%) and the bank had a risk free rate (5%)
Levered equity carries a higher risk premium than unlevered equity
- We therefore need to discount it with a larger discount rate
- In this particular case -> risk premium is no longer 15% but 25%
Exercise 3
Calculate the expected returns in the economy for each of the actors
Bank heeft volledige return 5% 5% 5%
Strong: 375 winst, weak 125 verlies 75% -25% 25%
In dit lijntje overall 0,5*return D + 0,5*return E -> 40% -10% 15%
Takeways from this box
- 1. Leved equity -> higher risk -> higher return (good state 75%, bad state – 25%; previously
good state +40%, bad state -10%) => in expectation, they earned 25% => this is equal to the
risk they take (Rproject = 0,25)
- 2. The reason why the shareholders need a higher discount rate, is not because the risk of
the business changed (the business is exactly the same as it was before). Where do we see
that?
o Good state, still 1400 (+40% return), bad state, still 900 (-10% return) -> in
expectation these two have a risk of 15% -> this is still unchanged (in het rijtje van de
firm is de expected return nog steeds 15%
o The reason that the equity now carries a higher risk premium is simply because the
fin ris, that is been introduced due to the leverage
- 3. The additional risk that the firm took, is not the same as default risk, the firm does not
default in any of these scenarios, because there is always money to fully repay the bank
o Zelfs in een weak economy is er genoeg geld verdiend om de bank helemaal terug te
betalen, de ADH hebben gewoon minder
4
