Lecture 1: Value Creation
Main Finance concept: Maximize firm’s value (Lec 6)
1. Financing decision: find the right kind of debt for your firm and the right mix of debt and equity
to fund your operations. (Lec 2,4,9,11,10)
2. Investment decision: invest in assets that earn a return that is greater than the minimum
acceptable cost of capital. (Lec 1,3,5,8)
3. Dividend decision: if you can’t find investments that make your minimum acceptable cost of
capital, return the cash to the owners of your business. (Lec 7)
Value Creation
NPV < 0 → Do not invest (destroys value)
NPV > 0 → Invest (creates value)
Financial Statements
→ The balance sheet provides a snapshot of the company’s assets on the one hand and a
company’s equity and liabilities on the other. (PHOTO)
“The assets show how the firm uses its capital (its investments), and the other side summarizes the
sources of capital, or how a firm raises the money it needs.”
Examples of assets: cash, buildings, inventories, accounts receivable.
Examples of liabilities: loan from a bank, accounts payable
→ The Income Statement or P&L shows the revenues and costs over the past period. (FILM)
“The income statement shows the flow of revenues and expenses generated by the assets and
liabilities of a firm between two dates.
Examples of P&L items: Total sales, COGS, D&A
- Balance sheet note: Increase in equity is equal to the profit, e.g. if you sell something for 800 and the cogs is
250, the increase in equity is 550 -
- Increase in depreciation, means decrease in equity (BS) and profit (P&L) -
From Financial Statements to CFs
,Complications
- Inflation
Usually, we think in nominal terms, i.e., the amount of money we get. However, inflation means that,
in the future, the nominal amount will be worth less in real terms.
- Inflation is not too bad if you’re indebted because the debt amount also becomes
worth less.
- Choosing between projects when capital is limited
If available capital is infinite ➔ invest in all positive NPV projects. In reality, this is seldom the
case.
Solution:
1) Create all combinations;
2) Eliminate not realistic combinations;
3) Choose the combination with the highest NPV
Alternatives to the NPV
- Payback period
= the number of years it takes to recover the initial cash outlay on a project.
→ We can’t say which project is better as PP ignores the opportunity cost of capital AND it doesn’t
consider all CFs
,(The opportunity cost of capital definition is the return on investment a company or an individual loses because they choose to
invest their funds in another project rather than invest it in a security that provides a return.)
- Profitability Index (PI)
= PV(CFs generated by project) / PV(Investments needed for the project)
Rule: if PI > 1 then NPV > 0
Problem: Can’t tell which investment is better!
- Internal Rate of Return (IRR)
= rate which equates the present value of cash outflows and inflows. In other words, it is the rate that
makes the computed NPV exactly zero.
Problems with IRR, IRR is best only used in combination with NPV. Highest IRR is not necessarily the
best project (highest NPV is).
Market Value vs Book Value
Market Value: forward looking (growth opportunities; high quality management etc are included)
Book Value: historical value
Interest Coverage Ratios
→ EBIT / interest expense
→ EBITDA / interest expense
Even though you get more profit in year X, you might also have taken on more debt (higher interest
expense), which leads to lower interest coverage ratios,
Profitability and Valuation Ratios
Enterprise Value = Equity (mkt cap) + debt - cash
Operating Returns
Return on Assets (ROA) = (net income + interest expense) / total assets
Lecture 2: Capital Structure I
Betas as a proxy for Risk
→ Beta = how much the value of a firm is impacted by the overall market conditions, i.e., the degree
of correlation
- Higher beta ‐> more risky firm ; lower beta ‐> less risky firm
- Investors will expect to earn higher returns if the risk is higher
- Same holds for debtholders: Banks expects to earn relatively low interest on secured debt
(mortgages) and relatively high interest on unsecured debt (credit card loans)
, Debt VS Equity
Returns to debt and equity
- Debt is served first - Equity is ‘residual claimant’
- Concave (hol) return structure - Convex (bol, looking from 0-point) return structure
WACC (Weighted average cost of capital)
→ Costs of Capital are the weighted average of costs of equity and costs of debt (ignoring taxes).
Optimal Capital Structure
→ What is the optimal capital structure of a corporation? → That is, what is the D/E ratio that
maximized value of shareholders’ equity
→ Assume Modigliani-Miller: Capital structure is irrelevant
MM Assumptions:
Assume you live in a world where… (perfectly efficient market)
1. Investors and firms can trade the same set of securities at competitive market prices equal to
the PV of their future cash flows (investors and firms borrow and lend at same interest rate)
2. NO taxes, bankruptcy/transaction/issuance costs
3. A firm’s financing decisions do not change the cash flows generated by its investments, nor
do they reveal new information about them
4. There are no informational asymmetries or agency costs
MM Proposition I: In a perfect capital market, the total value of a firm’s securities (firm value) is equal
to the market value of the total cash flows generated by its assets and is NOT affected by its choice of
capital structure
→ If market is frictionless, capital structure is irrelevant for firm value (MM 1):
- When debt is included, lower cost of debt and higher cost of equity (than when 100% equity
financed). So equity holders get more in return because of their increased risk.
- Leverage increases the risk of equity even when there is no risk that the firm will default.
- Thus, while debt may be cheaper, its use raises the cost of capital for equity. Considering
both sources of capital together, the firm’s weighted average cost of capital (WACC) with
leverage is the same as for the unlevered firm.
Main Finance concept: Maximize firm’s value (Lec 6)
1. Financing decision: find the right kind of debt for your firm and the right mix of debt and equity
to fund your operations. (Lec 2,4,9,11,10)
2. Investment decision: invest in assets that earn a return that is greater than the minimum
acceptable cost of capital. (Lec 1,3,5,8)
3. Dividend decision: if you can’t find investments that make your minimum acceptable cost of
capital, return the cash to the owners of your business. (Lec 7)
Value Creation
NPV < 0 → Do not invest (destroys value)
NPV > 0 → Invest (creates value)
Financial Statements
→ The balance sheet provides a snapshot of the company’s assets on the one hand and a
company’s equity and liabilities on the other. (PHOTO)
“The assets show how the firm uses its capital (its investments), and the other side summarizes the
sources of capital, or how a firm raises the money it needs.”
Examples of assets: cash, buildings, inventories, accounts receivable.
Examples of liabilities: loan from a bank, accounts payable
→ The Income Statement or P&L shows the revenues and costs over the past period. (FILM)
“The income statement shows the flow of revenues and expenses generated by the assets and
liabilities of a firm between two dates.
Examples of P&L items: Total sales, COGS, D&A
- Balance sheet note: Increase in equity is equal to the profit, e.g. if you sell something for 800 and the cogs is
250, the increase in equity is 550 -
- Increase in depreciation, means decrease in equity (BS) and profit (P&L) -
From Financial Statements to CFs
,Complications
- Inflation
Usually, we think in nominal terms, i.e., the amount of money we get. However, inflation means that,
in the future, the nominal amount will be worth less in real terms.
- Inflation is not too bad if you’re indebted because the debt amount also becomes
worth less.
- Choosing between projects when capital is limited
If available capital is infinite ➔ invest in all positive NPV projects. In reality, this is seldom the
case.
Solution:
1) Create all combinations;
2) Eliminate not realistic combinations;
3) Choose the combination with the highest NPV
Alternatives to the NPV
- Payback period
= the number of years it takes to recover the initial cash outlay on a project.
→ We can’t say which project is better as PP ignores the opportunity cost of capital AND it doesn’t
consider all CFs
,(The opportunity cost of capital definition is the return on investment a company or an individual loses because they choose to
invest their funds in another project rather than invest it in a security that provides a return.)
- Profitability Index (PI)
= PV(CFs generated by project) / PV(Investments needed for the project)
Rule: if PI > 1 then NPV > 0
Problem: Can’t tell which investment is better!
- Internal Rate of Return (IRR)
= rate which equates the present value of cash outflows and inflows. In other words, it is the rate that
makes the computed NPV exactly zero.
Problems with IRR, IRR is best only used in combination with NPV. Highest IRR is not necessarily the
best project (highest NPV is).
Market Value vs Book Value
Market Value: forward looking (growth opportunities; high quality management etc are included)
Book Value: historical value
Interest Coverage Ratios
→ EBIT / interest expense
→ EBITDA / interest expense
Even though you get more profit in year X, you might also have taken on more debt (higher interest
expense), which leads to lower interest coverage ratios,
Profitability and Valuation Ratios
Enterprise Value = Equity (mkt cap) + debt - cash
Operating Returns
Return on Assets (ROA) = (net income + interest expense) / total assets
Lecture 2: Capital Structure I
Betas as a proxy for Risk
→ Beta = how much the value of a firm is impacted by the overall market conditions, i.e., the degree
of correlation
- Higher beta ‐> more risky firm ; lower beta ‐> less risky firm
- Investors will expect to earn higher returns if the risk is higher
- Same holds for debtholders: Banks expects to earn relatively low interest on secured debt
(mortgages) and relatively high interest on unsecured debt (credit card loans)
, Debt VS Equity
Returns to debt and equity
- Debt is served first - Equity is ‘residual claimant’
- Concave (hol) return structure - Convex (bol, looking from 0-point) return structure
WACC (Weighted average cost of capital)
→ Costs of Capital are the weighted average of costs of equity and costs of debt (ignoring taxes).
Optimal Capital Structure
→ What is the optimal capital structure of a corporation? → That is, what is the D/E ratio that
maximized value of shareholders’ equity
→ Assume Modigliani-Miller: Capital structure is irrelevant
MM Assumptions:
Assume you live in a world where… (perfectly efficient market)
1. Investors and firms can trade the same set of securities at competitive market prices equal to
the PV of their future cash flows (investors and firms borrow and lend at same interest rate)
2. NO taxes, bankruptcy/transaction/issuance costs
3. A firm’s financing decisions do not change the cash flows generated by its investments, nor
do they reveal new information about them
4. There are no informational asymmetries or agency costs
MM Proposition I: In a perfect capital market, the total value of a firm’s securities (firm value) is equal
to the market value of the total cash flows generated by its assets and is NOT affected by its choice of
capital structure
→ If market is frictionless, capital structure is irrelevant for firm value (MM 1):
- When debt is included, lower cost of debt and higher cost of equity (than when 100% equity
financed). So equity holders get more in return because of their increased risk.
- Leverage increases the risk of equity even when there is no risk that the firm will default.
- Thus, while debt may be cheaper, its use raises the cost of capital for equity. Considering
both sources of capital together, the firm’s weighted average cost of capital (WACC) with
leverage is the same as for the unlevered firm.
