Main summary Corporate finance
Week 1
0-1- Corporate Claims
Firms are usually financed by different financial claims. (Equity and Debt)
There are also more refined financial claims such as junior vs senior debt or convertible
bonds.
The capital structure of a firm is the total sum of all claims on the assets of the firms.
Together, all claims represent all the firm’s assets, they are the firm. Claims are not just debt
and equity :government claims, non-financial liabilities (e.g. A/P), pension liabilities, etc.
Equity (shareholders) “own” corporations only after other obligations are satisfied.
Shareholders are “residual claimants”.
Financial claims embed two types of rights:
1. Cash flow right contracts how firm generated cash will be allocated.
2. Control right allow the claim owner to enforce their cash flow rights.
Capital structure determines how rights are allocated, between different types of investors/
claimholders. This also implies that value of stakes of different claimholders such as debt and
equity is summing up to the total value of a firm.
Cashflow rights
Pay off diagram: plot the payoffs of different claims as a function of the underlying firm
value at fixed time.
The “firms terminates” aspects is usually unimportant. But payoff diagrams are not good at
illustrating the time-varying aspects of claims.
Payoff diagram example.
Keep in mind that bond holders have priority.
➢ Equity is like a call option on the company’s assets with a strike equal to the outstanding
debt. After all outstanding debt to bond holders has been paid, that when the strike
price is hit and equity holders get paid.
,Financial liabilities (debt)
➢ Cash flow rights: Bonds are like loans that promise specific payoffs at specific times in the
future.
➢ Control rights: No control rights, unless the firm fails to pay what is promised or unless a
bond covenant (agreement) is violated. Then they have the ability to force bankruptcy
Non-financial liabilities
➢ Often of similar magnitude as financial liabilities
➢ Typical: account payables, trade credit, leases, warranties and tax obligations.
➢ Control right can be weak or strong: Strong = tax obligations, weak = customer
warranties and/or leases.
Equity (stocks)
Stock = equity and ordinary = common
➢ Cashflow rights: usually last dibs (i.e. only after other obligations have been paid), but
unlimited upside
➢ Control rights: shareholders can elect the corporate board, which appoints and
supervises management.
➢ These stock holders only have the rights to the cashflows after all other obligations have
been paid back.
Other types of bonds and equity.
Bond features (seniority, covenants, coupons,…) (junior debt and senior debt).
Convertible bond.
➢ Share classes, can allow different voting vs cash flow rights.
➢ Preferred equity has some equity and some debt characteristics
➢ Warrants and options give their owner the right to purchase stock in the future at a
predetermined price.
0-2- No Arbitrage Pricing (basics) (the law of one price).
“Law of one price” or “No-arbitrage” pricing is probably the key concept in finance.
Arguments used for capital structure (Modigliani Miller) but also for valuation
Arbitrage = buying and selling “equivalent” goods to take advantage of price differences.
Equivalent = generating same payoffs
Arbitrage opportunity = A situation in which it is possible to make a profit without taking any
risk/making any investment (Free lunch)
➢ Sell more expensive securities and buy cheaper one -> profit today and no risk later
➢ Sell fraction of more expensive one (e.g. 90%) to buy cheaper one -> no cost today
and positive payoff later.
Assume that arbitrage opportunities don’t exist (cannot exist in the long-run). Why?
Somebody will take immediate advantage of it and trade accordingly -> push up price of
cheaper one, lower price of other one.
Basic assumption for valuation/pricing. Implication:
1. Modigliani-Miller
, 2. Multiples
3. DCF
4. Option pricing / put-call parity
Example: for no arbitrage strategy.
That security C is nothing else then a call option.
So we just priced a call option with the stock as an underlying and with strike price k = 10.
Payoff call = max(S – K,0)
, 0-3- Options
Option: A contract that gives its owner the right (but not the obligation) to purchase or sell
an asset (the “underlying”) at a fixed price at some future date.
➢ Call option: gives its owner the right to buy an asset
➢ Put option: gives its owner the right to sell an asset
Option writer: seller of an option contract.
Exercising an option: the holder of an option enforces the agreement and buys or sells the
asset at the agreed-upon price.
Strike price (exercise price): price at which an option holder buys or sells the underlying
when the option is exercised.
Expiration (maturity) date:
➢ The deadline for exercising the option (American option)
➢ The single date at which the option can be exercised (European option)
➢ American options are more common but are also a little harder to value: we will
focus on European options in this lecture.
Strike price = 20, price is 30 means 10 payoff ($) = Call option
Week 1
0-1- Corporate Claims
Firms are usually financed by different financial claims. (Equity and Debt)
There are also more refined financial claims such as junior vs senior debt or convertible
bonds.
The capital structure of a firm is the total sum of all claims on the assets of the firms.
Together, all claims represent all the firm’s assets, they are the firm. Claims are not just debt
and equity :government claims, non-financial liabilities (e.g. A/P), pension liabilities, etc.
Equity (shareholders) “own” corporations only after other obligations are satisfied.
Shareholders are “residual claimants”.
Financial claims embed two types of rights:
1. Cash flow right contracts how firm generated cash will be allocated.
2. Control right allow the claim owner to enforce their cash flow rights.
Capital structure determines how rights are allocated, between different types of investors/
claimholders. This also implies that value of stakes of different claimholders such as debt and
equity is summing up to the total value of a firm.
Cashflow rights
Pay off diagram: plot the payoffs of different claims as a function of the underlying firm
value at fixed time.
The “firms terminates” aspects is usually unimportant. But payoff diagrams are not good at
illustrating the time-varying aspects of claims.
Payoff diagram example.
Keep in mind that bond holders have priority.
➢ Equity is like a call option on the company’s assets with a strike equal to the outstanding
debt. After all outstanding debt to bond holders has been paid, that when the strike
price is hit and equity holders get paid.
,Financial liabilities (debt)
➢ Cash flow rights: Bonds are like loans that promise specific payoffs at specific times in the
future.
➢ Control rights: No control rights, unless the firm fails to pay what is promised or unless a
bond covenant (agreement) is violated. Then they have the ability to force bankruptcy
Non-financial liabilities
➢ Often of similar magnitude as financial liabilities
➢ Typical: account payables, trade credit, leases, warranties and tax obligations.
➢ Control right can be weak or strong: Strong = tax obligations, weak = customer
warranties and/or leases.
Equity (stocks)
Stock = equity and ordinary = common
➢ Cashflow rights: usually last dibs (i.e. only after other obligations have been paid), but
unlimited upside
➢ Control rights: shareholders can elect the corporate board, which appoints and
supervises management.
➢ These stock holders only have the rights to the cashflows after all other obligations have
been paid back.
Other types of bonds and equity.
Bond features (seniority, covenants, coupons,…) (junior debt and senior debt).
Convertible bond.
➢ Share classes, can allow different voting vs cash flow rights.
➢ Preferred equity has some equity and some debt characteristics
➢ Warrants and options give their owner the right to purchase stock in the future at a
predetermined price.
0-2- No Arbitrage Pricing (basics) (the law of one price).
“Law of one price” or “No-arbitrage” pricing is probably the key concept in finance.
Arguments used for capital structure (Modigliani Miller) but also for valuation
Arbitrage = buying and selling “equivalent” goods to take advantage of price differences.
Equivalent = generating same payoffs
Arbitrage opportunity = A situation in which it is possible to make a profit without taking any
risk/making any investment (Free lunch)
➢ Sell more expensive securities and buy cheaper one -> profit today and no risk later
➢ Sell fraction of more expensive one (e.g. 90%) to buy cheaper one -> no cost today
and positive payoff later.
Assume that arbitrage opportunities don’t exist (cannot exist in the long-run). Why?
Somebody will take immediate advantage of it and trade accordingly -> push up price of
cheaper one, lower price of other one.
Basic assumption for valuation/pricing. Implication:
1. Modigliani-Miller
, 2. Multiples
3. DCF
4. Option pricing / put-call parity
Example: for no arbitrage strategy.
That security C is nothing else then a call option.
So we just priced a call option with the stock as an underlying and with strike price k = 10.
Payoff call = max(S – K,0)
, 0-3- Options
Option: A contract that gives its owner the right (but not the obligation) to purchase or sell
an asset (the “underlying”) at a fixed price at some future date.
➢ Call option: gives its owner the right to buy an asset
➢ Put option: gives its owner the right to sell an asset
Option writer: seller of an option contract.
Exercising an option: the holder of an option enforces the agreement and buys or sells the
asset at the agreed-upon price.
Strike price (exercise price): price at which an option holder buys or sells the underlying
when the option is exercised.
Expiration (maturity) date:
➢ The deadline for exercising the option (American option)
➢ The single date at which the option can be exercised (European option)
➢ American options are more common but are also a little harder to value: we will
focus on European options in this lecture.
Strike price = 20, price is 30 means 10 payoff ($) = Call option
