Table of Contents
Chapter 1 Goals and Governance of the Corporation..........................................................5
1.1 Investment and financing decisions........................................................................................5
1.2 What is a corporation?...........................................................................................................5
1.3 Who is the financial manager?................................................................................................5
1.4 Goals of the corporation.........................................................................................................6
1.5 agency problems, executive compensation, and corporate governance.................................6
1.6 The ethics of maximizing value...............................................................................................7
Chapter 2 Financial Markets and Institutions......................................................................7
2.1 The importance of financial markets and institutions.............................................................7
2.2 The flow of savings to corporations........................................................................................7
2.3 Functions of financial markets and intermediaries.................................................................9
2.4 The crisis of 2007-2009...........................................................................................................9
Chapter 3 Accounting and Finance......................................................................................9
3.1 The balance sheet...................................................................................................................9
3.2 The income statement..........................................................................................................10
3.3 The statement of cash flows.................................................................................................11
3.4 Accounting practice and malpractice....................................................................................13
3.5 Taxes.....................................................................................................................................13
Chapter 4 Measuring Corporate Performance...................................................................13
4.1 How financial ratios relate to shareholder value..................................................................13
4.2 Measuring market value and market value added................................................................14
4.3 Economic value added and accounting rates of return.........................................................14
4.4 Measuring efficiency.............................................................................................................16
4.5 Analyzing the return on assets: The Du Pont system.............................................................16
4.6 Measuring financial leverage................................................................................................17
4.7 Measuring liquidity...............................................................................................................18
4.8 Interpreting financial ratios..................................................................................................19
Chapter 5 The time value of money..................................................................................20
5.1 Future values and compound interest..................................................................................20
5.2 Present values......................................................................................................................20
5.3 Multiple cash flows...............................................................................................................21
5.5 level cash flows: perpetuities and annuities.........................................................................22
5.7 Effective annual interest rates..............................................................................................24
5.8 Inflation and the time value of money..................................................................................25
1
, Listing of equations....................................................................................................................26
Chapter 6 Valuing bonds...................................................................................................26
6.1 The bond market..................................................................................................................26
6.2 Interest rates and bond prices..............................................................................................26
6.3 Yield to maturity...................................................................................................................28
6.4 Bond rates of return.............................................................................................................28
6.5 The yield curve......................................................................................................................29
6.6 Corporate bonds and the risk of default...............................................................................29
Chapter 7 Valuing stocks..................................................................................................30
7.1 Stocks and the stock market.................................................................................................30
7.2 Market values, book values and liquidation values...............................................................30
7.3 Valuing common stocks........................................................................................................31
7.4 Simplifying the dividend discount model..............................................................................32
7.5 Valuing a business by discounted cash flow..........................................................................33
7.6 There are no free lunches on wall street...............................................................................33
7.7 Market anomalies and behavioral finance............................................................................34
Chapter 8 Net present value and other investment criteria...............................................34
8.1 Net present value.................................................................................................................34
8.2 The internal rate of return....................................................................................................35
8.3 The profitability index...........................................................................................................37
8.4 The payback rule...................................................................................................................37
8.5 More mutually exclusive projects.........................................................................................37
8.6 A last look.............................................................................................................................39
Chapter 9 Using discounted cash-flow analysis to make investment decisions..................39
9.1 Identifying cash flows.................................................................................................39
9.2 Corporate income taxes........................................................................................................41
9.3 An example – Blooper industries..........................................................................................41
Chapter 11 Introduction to Risk, Return, and the Opportunity Cost of Capital...................43
11.1 Rates of return: a review....................................................................................................43
11.2 A century of capital market history.....................................................................................44
11.3 Measuring risk....................................................................................................................44
11.4 Risk and diversification.......................................................................................................45
11.5 Thinking about risk.............................................................................................................47
Chapter 12 Risk, return and capital budgeting..................................................................47
12.1 Measuring market risk........................................................................................................47
2
, 12.2 What can you learn from beta?...........................................................................................47
12.3 Risk and return...................................................................................................................48
12.4 The CAPM and the opportunity cost of capital....................................................................50
Chapter 13 The weighted-average cost of capital and company valuation........................52
13.1 Geothermal’s cost of capital...............................................................................................52
13.2 The weighted-average cost of capital..................................................................................52
13.3 Interpreting the weighted-average cost of capital..............................................................53
13.4 Practicing problems: measuring capital structure...............................................................53
13.5 More practical problems: estimating expected returns.......................................................54
13.6 Valuing entire businesses....................................................................................................55
Chapter 14 Introduction to corporate financing................................................................56
14.1 Creating value with financing decisions..............................................................................56
14.2 Patterns of corporate financing...........................................................................................56
14.3 Common stock....................................................................................................................57
14.4 Preferred stock...................................................................................................................57
14.5 Corporate debt...................................................................................................................57
14.6 Convertible securities.........................................................................................................58
Chapter 15 How corporations raise venture capital and issue securities............................58
15.1 Venture capital...................................................................................................................58
15.2 The initial public offering....................................................................................................59
15.3 General cash offers by public companies............................................................................59
15.4 The private placement........................................................................................................60
Chapter 16 Debt policy.....................................................................................................60
16.1 How borrowing affects value in a tax-free economy...........................................................60
16.2 Debt and the cost of equity.................................................................................................63
16.3 Debt, taxes, and the weighted-average cost of capital........................................................64
16.4 Cost of financial distress.....................................................................................................65
16.5 Explaining financing choices................................................................................................67
Chapter 17 Payout policy..................................................................................................67
17.1 How corporations pay out cash to shareholders.................................................................67
17.2 The information content of dividends and repurchases......................................................68
17.3 Dividends or repurchases? The payout controversy............................................................68
17.4 Why dividends may increase value.....................................................................................69
17.5 Why dividends may reduce value.......................................................................................69
17.6 Payout policy and the life cycle of the firm.........................................................................70
3
,Chapter 25 What we do and do not know about finance...................................................70
25.1 What we do know: the six most important ideas in finance................................................70
Summary PCF
4
,Chapter 1 Goals and Governance of the Corporation
1.1 Investment and financing decisions
Investment decisions are also called capital budgeting or capital expenditure (CAPEX) decisions.
They can both involve tangible assets and intangible. Financing decision = decision on the sources
and amounts of financing. Promise investors either:
- Put up cash in exchange for a share of future profits equity investors who contribute equity
financing
- Promise to pay back the investors’ cash plus a fixed rate of interest debt investors
The choice between debt and equity financing = capital structure decision.
When the firm invests, it requires real assets = assets used to produce goods and services. The firm
finances this by issuing financial assets to investors = financial claims to the income generated by the
firm’s real assets.
Financing decisions are thought to be less important than investment decisions.
1.2 What is a corporation?
Corporation = a business organized as a separate legal entity owned by stockholders. A corporation
is legally distinct from the shareholders, they therefore have limited liability. When shares are not
publicly traded the company is said to be closely held. Public shareholders elect a board of directors
separation of ownership and control gives corporations permanence. Downside is that it can cause
the managers and directors to act in their own best interest, rather than the stockholders’.
There is also an important tax drawback to corporations in the US because it is a separate legal
entity, it is taxed separately. It is also costly to manage the corporation’s legal machinery.
Partnerships have a tax advantage, do not have to pay income taxes. A hybrid is the limited liability
partnership (LLPs) or limited liability companies (LLCs) partnerships in which all the partners
have limited liability.
1.3 Who is the financial manager?
Chief financial officer (CFO) = supervises all financial functions and sets overall financial strategy.
Financial manager = anyone responsible for an investment or financing decision. What is their role?
The financial manager stands between the firm and outside investors. On the one hand, the financial
manager is involved in the firm’s operations, particularly by helping to make good investment
5
, decisions. On the other hand, he or she, deals with financial institutions and other investors and with
financial markets such as the New York Stock Exchange.
1.4 Goals of the corporation
The goal is to maximize the current market value of shareholders’ investment in the firm. Profit
maximization is not a well-defined corporate objective because:
- Which year’s profits? Shareholders will not welcome higher short-term profits if long-term
profits are damaged.
- A company may be able to increase future profits by cutting this year’s dividend and
investing the freed-up cash in the firm.
Why do some investments increase market value, while others reduce it?
As long as a corporation’s proposed investments offer higher rates of return than its shareholders can
earn for themselves in the stock market, its shareholders will applaud the investment and the market
value of the firm will increase. The minimum rate of return is called the hurdle rate or opportunity
cost of capital.
1.5 agency problems, executive compensation, and corporate governance
Agency problems = managers are agents for stockholders and are tempted to act in their own interest
rather than maximizing value. loss from value from agency problems = agency costs. Agency
problems arise whenever the stakeholders’ interests do not coincide. They are controlled in three
ways:
1. Corporations set up internal controls and decision-making procedures to prevent wasteful
spending and discourage careless investment.
2. Corporations try to design compensation schemes that align managers’ and shareholders’
interests.
3. The corporations are constrained by systems of corporate governance.
Well-designed compensation schemes alleviate agency problems by encouraging managers to
maximize shareholder wealth. Financing only moves from investors to firms if investors are protected
and if agency problems within firms are absent or at least tolerable. Therefore, there is a need for
corporate governance = laws, regulations, institutions and corporate practises that protect
shareholders and other investors. Good corporate governance relies in part on well-designed
management compensation packages. Other elements include:
- Legal requirements that protect investors from self-dealing by insiders.
- Board of directors
- Activist shareholders have become more active in monitoring management and pushing
for changes
- Takeovers
- Information for investors
6
Chapter 1 Goals and Governance of the Corporation..........................................................5
1.1 Investment and financing decisions........................................................................................5
1.2 What is a corporation?...........................................................................................................5
1.3 Who is the financial manager?................................................................................................5
1.4 Goals of the corporation.........................................................................................................6
1.5 agency problems, executive compensation, and corporate governance.................................6
1.6 The ethics of maximizing value...............................................................................................7
Chapter 2 Financial Markets and Institutions......................................................................7
2.1 The importance of financial markets and institutions.............................................................7
2.2 The flow of savings to corporations........................................................................................7
2.3 Functions of financial markets and intermediaries.................................................................9
2.4 The crisis of 2007-2009...........................................................................................................9
Chapter 3 Accounting and Finance......................................................................................9
3.1 The balance sheet...................................................................................................................9
3.2 The income statement..........................................................................................................10
3.3 The statement of cash flows.................................................................................................11
3.4 Accounting practice and malpractice....................................................................................13
3.5 Taxes.....................................................................................................................................13
Chapter 4 Measuring Corporate Performance...................................................................13
4.1 How financial ratios relate to shareholder value..................................................................13
4.2 Measuring market value and market value added................................................................14
4.3 Economic value added and accounting rates of return.........................................................14
4.4 Measuring efficiency.............................................................................................................16
4.5 Analyzing the return on assets: The Du Pont system.............................................................16
4.6 Measuring financial leverage................................................................................................17
4.7 Measuring liquidity...............................................................................................................18
4.8 Interpreting financial ratios..................................................................................................19
Chapter 5 The time value of money..................................................................................20
5.1 Future values and compound interest..................................................................................20
5.2 Present values......................................................................................................................20
5.3 Multiple cash flows...............................................................................................................21
5.5 level cash flows: perpetuities and annuities.........................................................................22
5.7 Effective annual interest rates..............................................................................................24
5.8 Inflation and the time value of money..................................................................................25
1
, Listing of equations....................................................................................................................26
Chapter 6 Valuing bonds...................................................................................................26
6.1 The bond market..................................................................................................................26
6.2 Interest rates and bond prices..............................................................................................26
6.3 Yield to maturity...................................................................................................................28
6.4 Bond rates of return.............................................................................................................28
6.5 The yield curve......................................................................................................................29
6.6 Corporate bonds and the risk of default...............................................................................29
Chapter 7 Valuing stocks..................................................................................................30
7.1 Stocks and the stock market.................................................................................................30
7.2 Market values, book values and liquidation values...............................................................30
7.3 Valuing common stocks........................................................................................................31
7.4 Simplifying the dividend discount model..............................................................................32
7.5 Valuing a business by discounted cash flow..........................................................................33
7.6 There are no free lunches on wall street...............................................................................33
7.7 Market anomalies and behavioral finance............................................................................34
Chapter 8 Net present value and other investment criteria...............................................34
8.1 Net present value.................................................................................................................34
8.2 The internal rate of return....................................................................................................35
8.3 The profitability index...........................................................................................................37
8.4 The payback rule...................................................................................................................37
8.5 More mutually exclusive projects.........................................................................................37
8.6 A last look.............................................................................................................................39
Chapter 9 Using discounted cash-flow analysis to make investment decisions..................39
9.1 Identifying cash flows.................................................................................................39
9.2 Corporate income taxes........................................................................................................41
9.3 An example – Blooper industries..........................................................................................41
Chapter 11 Introduction to Risk, Return, and the Opportunity Cost of Capital...................43
11.1 Rates of return: a review....................................................................................................43
11.2 A century of capital market history.....................................................................................44
11.3 Measuring risk....................................................................................................................44
11.4 Risk and diversification.......................................................................................................45
11.5 Thinking about risk.............................................................................................................47
Chapter 12 Risk, return and capital budgeting..................................................................47
12.1 Measuring market risk........................................................................................................47
2
, 12.2 What can you learn from beta?...........................................................................................47
12.3 Risk and return...................................................................................................................48
12.4 The CAPM and the opportunity cost of capital....................................................................50
Chapter 13 The weighted-average cost of capital and company valuation........................52
13.1 Geothermal’s cost of capital...............................................................................................52
13.2 The weighted-average cost of capital..................................................................................52
13.3 Interpreting the weighted-average cost of capital..............................................................53
13.4 Practicing problems: measuring capital structure...............................................................53
13.5 More practical problems: estimating expected returns.......................................................54
13.6 Valuing entire businesses....................................................................................................55
Chapter 14 Introduction to corporate financing................................................................56
14.1 Creating value with financing decisions..............................................................................56
14.2 Patterns of corporate financing...........................................................................................56
14.3 Common stock....................................................................................................................57
14.4 Preferred stock...................................................................................................................57
14.5 Corporate debt...................................................................................................................57
14.6 Convertible securities.........................................................................................................58
Chapter 15 How corporations raise venture capital and issue securities............................58
15.1 Venture capital...................................................................................................................58
15.2 The initial public offering....................................................................................................59
15.3 General cash offers by public companies............................................................................59
15.4 The private placement........................................................................................................60
Chapter 16 Debt policy.....................................................................................................60
16.1 How borrowing affects value in a tax-free economy...........................................................60
16.2 Debt and the cost of equity.................................................................................................63
16.3 Debt, taxes, and the weighted-average cost of capital........................................................64
16.4 Cost of financial distress.....................................................................................................65
16.5 Explaining financing choices................................................................................................67
Chapter 17 Payout policy..................................................................................................67
17.1 How corporations pay out cash to shareholders.................................................................67
17.2 The information content of dividends and repurchases......................................................68
17.3 Dividends or repurchases? The payout controversy............................................................68
17.4 Why dividends may increase value.....................................................................................69
17.5 Why dividends may reduce value.......................................................................................69
17.6 Payout policy and the life cycle of the firm.........................................................................70
3
,Chapter 25 What we do and do not know about finance...................................................70
25.1 What we do know: the six most important ideas in finance................................................70
Summary PCF
4
,Chapter 1 Goals and Governance of the Corporation
1.1 Investment and financing decisions
Investment decisions are also called capital budgeting or capital expenditure (CAPEX) decisions.
They can both involve tangible assets and intangible. Financing decision = decision on the sources
and amounts of financing. Promise investors either:
- Put up cash in exchange for a share of future profits equity investors who contribute equity
financing
- Promise to pay back the investors’ cash plus a fixed rate of interest debt investors
The choice between debt and equity financing = capital structure decision.
When the firm invests, it requires real assets = assets used to produce goods and services. The firm
finances this by issuing financial assets to investors = financial claims to the income generated by the
firm’s real assets.
Financing decisions are thought to be less important than investment decisions.
1.2 What is a corporation?
Corporation = a business organized as a separate legal entity owned by stockholders. A corporation
is legally distinct from the shareholders, they therefore have limited liability. When shares are not
publicly traded the company is said to be closely held. Public shareholders elect a board of directors
separation of ownership and control gives corporations permanence. Downside is that it can cause
the managers and directors to act in their own best interest, rather than the stockholders’.
There is also an important tax drawback to corporations in the US because it is a separate legal
entity, it is taxed separately. It is also costly to manage the corporation’s legal machinery.
Partnerships have a tax advantage, do not have to pay income taxes. A hybrid is the limited liability
partnership (LLPs) or limited liability companies (LLCs) partnerships in which all the partners
have limited liability.
1.3 Who is the financial manager?
Chief financial officer (CFO) = supervises all financial functions and sets overall financial strategy.
Financial manager = anyone responsible for an investment or financing decision. What is their role?
The financial manager stands between the firm and outside investors. On the one hand, the financial
manager is involved in the firm’s operations, particularly by helping to make good investment
5
, decisions. On the other hand, he or she, deals with financial institutions and other investors and with
financial markets such as the New York Stock Exchange.
1.4 Goals of the corporation
The goal is to maximize the current market value of shareholders’ investment in the firm. Profit
maximization is not a well-defined corporate objective because:
- Which year’s profits? Shareholders will not welcome higher short-term profits if long-term
profits are damaged.
- A company may be able to increase future profits by cutting this year’s dividend and
investing the freed-up cash in the firm.
Why do some investments increase market value, while others reduce it?
As long as a corporation’s proposed investments offer higher rates of return than its shareholders can
earn for themselves in the stock market, its shareholders will applaud the investment and the market
value of the firm will increase. The minimum rate of return is called the hurdle rate or opportunity
cost of capital.
1.5 agency problems, executive compensation, and corporate governance
Agency problems = managers are agents for stockholders and are tempted to act in their own interest
rather than maximizing value. loss from value from agency problems = agency costs. Agency
problems arise whenever the stakeholders’ interests do not coincide. They are controlled in three
ways:
1. Corporations set up internal controls and decision-making procedures to prevent wasteful
spending and discourage careless investment.
2. Corporations try to design compensation schemes that align managers’ and shareholders’
interests.
3. The corporations are constrained by systems of corporate governance.
Well-designed compensation schemes alleviate agency problems by encouraging managers to
maximize shareholder wealth. Financing only moves from investors to firms if investors are protected
and if agency problems within firms are absent or at least tolerable. Therefore, there is a need for
corporate governance = laws, regulations, institutions and corporate practises that protect
shareholders and other investors. Good corporate governance relies in part on well-designed
management compensation packages. Other elements include:
- Legal requirements that protect investors from self-dealing by insiders.
- Board of directors
- Activist shareholders have become more active in monitoring management and pushing
for changes
- Takeovers
- Information for investors
6
