Corporate Finance and Behaviour ECB2FIN
Manal Talhi
Summary Corporate Finance and
Behaviour
Week 1: Chapter 8 & 9 Chapter 8: Portfolio theory and the capital asset pricing model....................... 3
8-1 Harry Markowitz and the birth of portfolio theory....................................................................... 3
8-2 The relationship between risk and return..................................................................................... 3
8-3 Validity and role of the capital asset pricing model ...................................................................... 4
8-4 Some Alternative theories ............................................................................................................ 4
Chapter 9: Risk and cost of capital .......................................................................................................... 5
9-1 Company and project costs of capital ........................................................................................... 5
9-2 Measuring the cost of equity ........................................................................................................ 5
9-3 Analysing project risk .................................................................................................................... 5
9-4 Certainty equivalents – another way to adjust for risk ................................................................. 6
Week 2; Chapter 13: Efficient markets and behaviour finance .............................................................. 7
13-1 Differences between investment and financing decisions ......................................................... 7
13-2 The efficient market hypothesis ................................................................................................. 7
13-3 Bubbles and market efficiency .................................................................................................... 8
13-4 Behavioral finance ....................................................................................................................... 8
13-5 The Five lessons of Market efficiency ......................................................................................... 9
Chapter 17: Does debt policy matter? .................................................................................................... 9
17-2 financial risk and expected returns ........................................................................................... 10
17-4 (17-3 nothing that important) A final word on the after-tax weighted-average cost of capital
........................................................................................................................................................... 10
Week 3; Chapter 18: How much should a corporation borrow ............................................................ 11
18-1 Corporate Taxes ........................................................................................................................ 11
18-2: Corporate and personal taxes .................................................................................................. 11
18-3 Costs of financial distress .......................................................................................................... 12
18-4 The pecking order of financing choices..................................................................................... 13
Week 4: Chapter 20 & 21 Options, Futures, Swaps and other Derivatives Chapter 20 Understanding
options................................................................................................................................................... 15
20-1 Calls, puts and shares ................................................................................................................ 15
20-2 Financial alchemy with options ................................................................................................. 15
20-3 What determines option values ................................................................................................ 15
Chapter 21: Valuing options .................................................................................................................. 16
1
, Corporate Finance and Behaviour ECB2FIN
Manal Talhi
21-1 A simple option-valuation model .............................................................................................. 16
21-2 The Binomial method for valuing options ................................................................................. 17
21-3 The Black-Scholes formula ........................................................................................................ 18
21-4 Black-Scholes in action .............................................................................................................. 18
21-5 Option values at a glance .......................................................................................................... 19
Week 5: Chapter 28: Financial Analysis................................................................................................. 20
28-1 Financial ratios .......................................................................................................................... 20
28-2 Financial statements ................................................................................................................. 20
28-3 Home Depot’s financial statements .......................................................................................... 20
28-4 Measuring home depot’s performance .................................................................................... 21
28-5 Measuring efficiency ................................................................................................................. 22
28-6 Analyzing the return assets: the Du Pont system ..................................................................... 23
28-7 Measuring Leverage .................................................................................................................. 23
28-8 Measuring liquidity ................................................................................................................... 24
28-9 Interpreting financial ratios....................................................................................................... 24
Week 6: Chapter 30; Working Capital management............................................................................. 26
30-1 The composition of working capital .......................................................................................... 26
30-2 Inventories ................................................................................................................................ 26
30-3 Credit management .................................................................................................................. 27
30-4 Cash ........................................................................................................................................... 29
30-5 Marketable securities................................................................................................................ 30
Week 7: Chapter 27: Managing International risks............................................................................... 32
27-1 The foreign exchange market ................................................................................................... 32
27-2 Some basic relationships ........................................................................................................... 32
27-3 Hedging currency risk ................................................................................................................ 34
27-4 Exchange risk and international investment decisions ............................................................. 35
27-5 Political risk ............................................................................................................................... 36
2
, Corporate Finance and Behaviour ECB2FIN
Manal Talhi
Week 1: Chapter 8 & 9
Chapter 8: Portfolio theory and the capital asset pricing model
8-1 Harry Markowitz and the birth of portfolio theory
Efficient portfolios: this portfolios offer the highest expected return for any level of risk,
rf: risk free rate of interest → so standard deviation is zero
Sharpe ratio: risk premium/ standard deviation = r-rf/ → this offers the highest ratio of risk
premium to standard deviation.
8-2 The relationship between risk and return
Market risk premium: the difference between the return on the market and the interest rate.
➔ rm – rf
Capital asset pricing model (CAPM) : this model states that the expected risk premium on each
investment is proportional to its beta. This means that each investment should lie on the sloping
security market line connecting Treasury bills and the market portfolio.
The expected risk premium on an investment with a beta of 0.5 is half the expected risk premium on
the market.
Expected risk premium on stock = beta X expected risk premium on market
r – rf = (rm-rf)
The basic principles of portfolio selection:
1. Investors like high expected return and low standard deviation.
a. Efficient portfolios: Common stock portfolios that offer the highest return for a given
standard deviation
2. If the investor can lend or borrow at the risk-free rate of interest, one efficient portfolio Is
better than all the others: the portfolio that offers the highest ratio of risk premium to
standard deviation.
a. Risk averse person: will put part of his money in this efficient portfolio and part in a
risk free asset
b. Risk tolerant person: may put all the money in this portfolio or borrow money to put
more in it
3. The composition of this best efficient portfolio depends on investor’s assessments of the
expected returns, SD and correlations.
a. If no one has superior information, everyone should hold on to the same portfolio
a.k.a. the market portfolio
4. Do not look at the risk of a stock in isolation but at its contribution to portfolio risk
5. A stock’s sensitivity to changes in the value of the market portfolio is known as beta
a. Beta measures the marginal contribution of a stock to the risk of the market portfolio
The message of the CAPM: if everyone holds onto the market portfolio, and if beta measures each
security’s contribution to the risk of the market portfolio, then it is no surprise that the risk premium
demanded by investors is proportional to beta.
3
Manal Talhi
Summary Corporate Finance and
Behaviour
Week 1: Chapter 8 & 9 Chapter 8: Portfolio theory and the capital asset pricing model....................... 3
8-1 Harry Markowitz and the birth of portfolio theory....................................................................... 3
8-2 The relationship between risk and return..................................................................................... 3
8-3 Validity and role of the capital asset pricing model ...................................................................... 4
8-4 Some Alternative theories ............................................................................................................ 4
Chapter 9: Risk and cost of capital .......................................................................................................... 5
9-1 Company and project costs of capital ........................................................................................... 5
9-2 Measuring the cost of equity ........................................................................................................ 5
9-3 Analysing project risk .................................................................................................................... 5
9-4 Certainty equivalents – another way to adjust for risk ................................................................. 6
Week 2; Chapter 13: Efficient markets and behaviour finance .............................................................. 7
13-1 Differences between investment and financing decisions ......................................................... 7
13-2 The efficient market hypothesis ................................................................................................. 7
13-3 Bubbles and market efficiency .................................................................................................... 8
13-4 Behavioral finance ....................................................................................................................... 8
13-5 The Five lessons of Market efficiency ......................................................................................... 9
Chapter 17: Does debt policy matter? .................................................................................................... 9
17-2 financial risk and expected returns ........................................................................................... 10
17-4 (17-3 nothing that important) A final word on the after-tax weighted-average cost of capital
........................................................................................................................................................... 10
Week 3; Chapter 18: How much should a corporation borrow ............................................................ 11
18-1 Corporate Taxes ........................................................................................................................ 11
18-2: Corporate and personal taxes .................................................................................................. 11
18-3 Costs of financial distress .......................................................................................................... 12
18-4 The pecking order of financing choices..................................................................................... 13
Week 4: Chapter 20 & 21 Options, Futures, Swaps and other Derivatives Chapter 20 Understanding
options................................................................................................................................................... 15
20-1 Calls, puts and shares ................................................................................................................ 15
20-2 Financial alchemy with options ................................................................................................. 15
20-3 What determines option values ................................................................................................ 15
Chapter 21: Valuing options .................................................................................................................. 16
1
, Corporate Finance and Behaviour ECB2FIN
Manal Talhi
21-1 A simple option-valuation model .............................................................................................. 16
21-2 The Binomial method for valuing options ................................................................................. 17
21-3 The Black-Scholes formula ........................................................................................................ 18
21-4 Black-Scholes in action .............................................................................................................. 18
21-5 Option values at a glance .......................................................................................................... 19
Week 5: Chapter 28: Financial Analysis................................................................................................. 20
28-1 Financial ratios .......................................................................................................................... 20
28-2 Financial statements ................................................................................................................. 20
28-3 Home Depot’s financial statements .......................................................................................... 20
28-4 Measuring home depot’s performance .................................................................................... 21
28-5 Measuring efficiency ................................................................................................................. 22
28-6 Analyzing the return assets: the Du Pont system ..................................................................... 23
28-7 Measuring Leverage .................................................................................................................. 23
28-8 Measuring liquidity ................................................................................................................... 24
28-9 Interpreting financial ratios....................................................................................................... 24
Week 6: Chapter 30; Working Capital management............................................................................. 26
30-1 The composition of working capital .......................................................................................... 26
30-2 Inventories ................................................................................................................................ 26
30-3 Credit management .................................................................................................................. 27
30-4 Cash ........................................................................................................................................... 29
30-5 Marketable securities................................................................................................................ 30
Week 7: Chapter 27: Managing International risks............................................................................... 32
27-1 The foreign exchange market ................................................................................................... 32
27-2 Some basic relationships ........................................................................................................... 32
27-3 Hedging currency risk ................................................................................................................ 34
27-4 Exchange risk and international investment decisions ............................................................. 35
27-5 Political risk ............................................................................................................................... 36
2
, Corporate Finance and Behaviour ECB2FIN
Manal Talhi
Week 1: Chapter 8 & 9
Chapter 8: Portfolio theory and the capital asset pricing model
8-1 Harry Markowitz and the birth of portfolio theory
Efficient portfolios: this portfolios offer the highest expected return for any level of risk,
rf: risk free rate of interest → so standard deviation is zero
Sharpe ratio: risk premium/ standard deviation = r-rf/ → this offers the highest ratio of risk
premium to standard deviation.
8-2 The relationship between risk and return
Market risk premium: the difference between the return on the market and the interest rate.
➔ rm – rf
Capital asset pricing model (CAPM) : this model states that the expected risk premium on each
investment is proportional to its beta. This means that each investment should lie on the sloping
security market line connecting Treasury bills and the market portfolio.
The expected risk premium on an investment with a beta of 0.5 is half the expected risk premium on
the market.
Expected risk premium on stock = beta X expected risk premium on market
r – rf = (rm-rf)
The basic principles of portfolio selection:
1. Investors like high expected return and low standard deviation.
a. Efficient portfolios: Common stock portfolios that offer the highest return for a given
standard deviation
2. If the investor can lend or borrow at the risk-free rate of interest, one efficient portfolio Is
better than all the others: the portfolio that offers the highest ratio of risk premium to
standard deviation.
a. Risk averse person: will put part of his money in this efficient portfolio and part in a
risk free asset
b. Risk tolerant person: may put all the money in this portfolio or borrow money to put
more in it
3. The composition of this best efficient portfolio depends on investor’s assessments of the
expected returns, SD and correlations.
a. If no one has superior information, everyone should hold on to the same portfolio
a.k.a. the market portfolio
4. Do not look at the risk of a stock in isolation but at its contribution to portfolio risk
5. A stock’s sensitivity to changes in the value of the market portfolio is known as beta
a. Beta measures the marginal contribution of a stock to the risk of the market portfolio
The message of the CAPM: if everyone holds onto the market portfolio, and if beta measures each
security’s contribution to the risk of the market portfolio, then it is no surprise that the risk premium
demanded by investors is proportional to beta.
3
