Summary of Corporate Finance

Finance

Lecture 1:

The performance of a corporation depends on how well managers succeed in creating
shareholder value. We show you how to use tools that are offered by financial theory and
help you just doing that: creating value.

In this course we discuss three main issues in finance:
1. Capital budgeting: capital budgeting decision involves how firms select projects that
create value. The theoretically optimal decision rule—the net present value method
—is discussed, also in relation to other selection criteria that are applied in practice.
2. Asset pricing: The asset pricing part concerns the way financial assets are priced by
the market. The focus is on the pricing of shares issued by firms and bonds issued by
firms and governments. Questions raised are: How are the term structure of interest
rates and promised coupon payments related to bond prices? What is the influence
of the expected stream of dividends and the level of market risk of firm’s projects on
the price of shares?
3. Financial investments: The financial investment decision is approached from a
portfolio perspective and ends with a discussion of the Capital Asset Pricing Model
(CAPM).

Financial Management:




How to create value? -> invest in projects (equity generated by issued shares)

Fundamental topics in FINANCE:
1. The Capital Budgeting decision
Example: The acquisition of a firm
2. The financing decision / The capital structure decision
3. The relation between the capital budgeting and the financing decision
Example: Net debt (total debt divided by Enterprise value aka how much debt in %)
4. The financial investment decision

, 5. Asset pricing
Example: PE ratio price: per share divided earnings per share

Hirshleifer Model:
Allocation decision: The financial economic decision for each
individual is how much to:
 consume
 invest in the financial markets
 invest in the real markets




4 Steps of explaining the Hirshleifer model:
1. Hirshleifer model without financial market and without real market
2. Hirshleifer model with financial market but without real market
3. Hirshleifer model with financial market and real market
4. Fisher separation theorem

Step 1 of Hirshleifer Model without financial market and without real market:
A1 A certain world is assumed: the individual knows all the decision alternatives and the
corresponding outcomes
A2 There is a one-period model where only two moments are important: the start of the period
(now, t=0) and the end of the period (later, t=1).
A3 The individual has a current income of CF 0 and a future income of CF 1

,At t=0 you receive CF0 and at t=1 CF1
(income at t=0 and t=1 respectively)

What do you do?
 At t=0 you can consume CF 0 completely, partly or nothing.
 If there is money left at t=0, you put this amount under your pillow and you consume
it including the CF 1 at t=1.




Step 2 of Hirshleifer model with financial market but without real market:
A14 Each participant can borrow or lend unlimitedly against the risk-free market interest
rate r f .

, Optimal Consumption Combination:
If we assume that the individual is able to rank his preferences consistently for the different
consumption combinations (C0,C1) and value these combinations by means of his utility
function, then we can derive indifference curves.

An indifference curve in this case contains the collection of consumption combinations to
which the individual assigns an equal utility value.




At point a 1, at t=0 a little is consumed. If you want to experience the same level of utility
with even less consumption at t=0, you want to be compensated with lots of extra
consumption at t=1.
(At points a 1, a 2 and a 3the same level of utility is experienced.)

The slope of an indifference curve therefore is called the marginal rate of substitution
between the present and future consumption.


Step 3 of the Hirshleifer model Hirshleifer model with financial market and real market: