lOMoARcPSD|11911780
Corporate finance and behaviour
Chapter 1.1
Financial assets / securities: claims on the real assets or on the cash flow that they will
generate in order to pay for a real asset.
Investment decision: purchase of real assets (managing decisions important)
-> capital budgeting or capital expenditure decisions.
Financing decision: Sale of real assets (raising cash and meet obligations to banks)
Intangible assets: assets you can not touch (R&D, advertising, marketing etc.)
Capital structure decision: the choice between debt and equity financing.
Shareholders are equity investors, they contribute to equity financing. In return for their
cash they don’t get back a fixed (interest) return but they hold shares and therefore get a
fraction of future profits and cash flows.
Capital refers to a firms sources of long-term financing.
Corporations can raise equity financing in two ways:
1. Issue new shares of stock.
2. The corporation can take the cash flow generated by its existing assets and
reinvest the cash in new assets -> the corporation is then reinvesting on behalf of
existing stockholders (no new shares are issued).
If a corporation does not reinvest the generated cash flow it can build a reserve. Or
pay the cash to its shareholders or buy back shares (payout decision).
Market capitalization/ market cap: overall market value (market price of share X shares
outstanding).
Corporation: legal entity, a legal person that is owned by its shareholders. It can make
contracts, carry on business borrow or lend money, and can sue or be sued.
A corporation is owned by its shareholders but the shareholders have limited liability (they
cannot be held personally responsible-> cannot lose more than they have invested).
A company is closely held when shares are not publicly traded. Public companies when
shares are traded in public markets.
Corporations can in principle live forever due to Separation of ownership and
control managers can be replaced shares can be sold to new investors.
However, managers can act in their own self-interest. Other disadvantages of being a
corporation are the cost of managing the corporation’s legal machinery. And tax drawbacks
because a corporation is a separate legal entity it is taxed separately.
In partnerships sole proprietors face unlimited liability they can be held responsible for all
the business’s debts. But they do have a tax advantage (only income taxes).
General partners: manage business and have unlimited personal responsibility.
Limited partners: liable only for the money they invested and do not participate in
management.
Professional corporation: the business has limited lability, but the professionals can still be
sued personally for, for example malpractice.
, lOMoARcPSD|11911780
The choice between 4a and 4b depends on the promises made when cash was raised at
arrow 1.
1.2 The financial goal of the corporation
Financial objective: maximize the current market value of shareholders’ investment in the
firm. Risk averse persons will adjust their investment portfolio when the corporation
invests in too risky projects in order to try to increase their market value (they will switch
for example to government bonds).
Why maximizing shareholder value:
1. Each stockholder wants three things
a. To be as rich as possible (maximize his current wealth)
b. Transform that wealth into the most desirable time pattern of consumption
c. Manage the risk characteristics of that consumption plan.
2. Stockholders can achieve the best time pattern of consumption themselves
because of free access to competitive financial markets. They can choose the risk
characteristics of their consumption plan by investing in more or less risky
securities.
3. Financial managers can help stockholders by increasing their wealth = increasing
the market value of the firm and the current price of its shares.
Profit maximizing is not a well-defined financial objective because:
1. A corporation can increase current profits by cutting back on outlays while
those outlays may have added long-term value. Shareholders will not welcome
higher short-term profits if long-term profits are damaged.
2. A company can increase future profits by ting this years’ dividend and investing the
freed-up cash in the firm-> not in interest of stockholders if the company earns only
a modest return on the money.
The firm can either keep
and reinvest the cash or
return it to investors. If
the corporations proposed
investments offer higher
rates of return than its
shareholders can earn for
themselves in the financial
market, shareholders will
applaud the investment
and its stock price will increase. If the company earns a inferior return, shareholders boo,
stock price falls and stockholders demand their money back so they can invest on their own.
Opportunity cost of capital: if a corporation invests cash in a new project its shareholders
, lOMoARcPSD|11911780
lose the opportunity to invest the cash on their own. -> opportunity costs depend on risk and
return.
Agency problem: conflict between shareholders’ and managers’ objectives.
Agency costs: incurred when 1. managers do not attempt to maximize firm value.
2. Shareholders incur costs to monitor the managers and
constrain their actions.
Primary markets- securities are sold to investors, moneyt hat is raised goes to issuing firm
Secondary markets: investors trade with ach other, money that is raised goes to seller of
securities.
1.3 Preview of coming attractions
Chapter 2
2.1 Future values and present values
A dollar today is more than a dollar tomorrow. By investing you give up the opportunity to
spend X euro’s today but you gain the chance to spend X + interest euro’s next year.
Compound interest: interest on interest. It is the result of reinvesting interest, rather than
paying it out, so that interest in the next period is then earned on the principal sum plus
previously accumulated interest.
Present value: PV = Ct / (1+r)t
r= discount rate
Ct= cash flow
1/(1+r)t= discount factor= the present value of one dollar received in year t.
Net present value = PV – investment = NPV = C0 + C1/(1+r)
C0 = cash flow at time/ investment.
A save dollar is worth more than a risky dollar.
You take the discount rate with the same level of risk.
Rate of return: profit / investment
We can justify an investment by either one of the following rules:
1. Net present value rule: accept investments that have positive net present values.
2. Rate of return rule: Accept investments that offer rates of return in excess of
their opportunity costs of capital.
Discounted cash flow DCF: PV = ΣTt=1Ct/(1+r)t
NPV= C0 + PV = C0 + ΣTt=1 Ct /(1+r)t
2.2 looking for shortcuts – perpetuities and annuities
perpetuities: A perpetuity is an annuity that has no end, or a stream of cash payments that
continues forever.
Return = cash flow / present
value r = C /PV
PV = C/ r
2 warnings about the formula:
1. you can easily confuse the formula with the present value of a single payment (c/1+r)
, lOMoARcPSD|11911780
2. the formula tells us the value of a regular stream of payments starting on
eperiod from now.
Annuity: an asset that pays a fixed sum each year for a specified number of years.
Present value of t-year annuity= C[1/r-1/(r(1+r)t)]
Annuity factor: shows the present value of 1 euro a year for each of t years. 1/r-1/(r(1+r)t
Annuity due: a level stream of payments starting immediately. An annuity due is worth (!+r)
times the value of an ordinary annuity.
Future value of annuity= present value of annuity of $1 a year x (1+r)t
=[1/r-1/(r(1+r)t)] X (1+r)t = ((1+r)t – 1) / r
Future value at the end of year t = present value x (1+r)t
2.3 more shortcuts – growing perpetuities and annuities.
Present value of a growing perpetuity: C1/(r-g) (we assume r is greater than g)
PV of a growing annuity = C x 1/(r-g) [1-(1+g)t/(1+r)t]
2.4 How interest is paid and quoted
Effective annual interest rate (compounded interest): The interest rate that is actually
earned or paid on an investment, loan or other financial product due to the result of
compounding over a given time period.
Is higher than the annual percentage rate. Assume annual percentage rate is 12% to be paid
monthly. This means each month 12/12=1%. The effective annual interest rate is than
1.0112=0.1268 = 12.68%
If you invest $1 your investment at the end of the year will be
worth:(1+(r/m))m r= interest rate
m= compounded times (m is infinite)
and the effective interest rate is :(1+(r/m))m – 1
if m approaches infinity (1+(r/m))m approaches (2.718)r which is ert (natural logarithm)
annual percentage rate = uses simple interest
Week 2
Perpetuity: a level stream of cash flows forever.
Annuity: a level stream of cash flows for a fixed period of time.
Chapter 3
3. 4 explaining the term structure
Reasons you decide to hold on to bonds with low rate of return:
1. You believe that short-term interest rates will be higher in the future.
2. You worry about the greater exposure of long-term bonds to changes in interest rates
3. You worry about the risk of higher future inflation.
Bond: a mostly tradable certificate showing that a borrower owes a specified sum. To repay
the money the borrower has agreed to make interest and principal payments on designated
dates. (three types of bonds are pure discount bond (zero bond) level coupon bond (floaters)
and consol (perpetual bond).
Treasury bill: promise by the government to repay a fixed amount at some time in the future
= a pure discount bond (zero bond).
Corporate finance and behaviour
Chapter 1.1
Financial assets / securities: claims on the real assets or on the cash flow that they will
generate in order to pay for a real asset.
Investment decision: purchase of real assets (managing decisions important)
-> capital budgeting or capital expenditure decisions.
Financing decision: Sale of real assets (raising cash and meet obligations to banks)
Intangible assets: assets you can not touch (R&D, advertising, marketing etc.)
Capital structure decision: the choice between debt and equity financing.
Shareholders are equity investors, they contribute to equity financing. In return for their
cash they don’t get back a fixed (interest) return but they hold shares and therefore get a
fraction of future profits and cash flows.
Capital refers to a firms sources of long-term financing.
Corporations can raise equity financing in two ways:
1. Issue new shares of stock.
2. The corporation can take the cash flow generated by its existing assets and
reinvest the cash in new assets -> the corporation is then reinvesting on behalf of
existing stockholders (no new shares are issued).
If a corporation does not reinvest the generated cash flow it can build a reserve. Or
pay the cash to its shareholders or buy back shares (payout decision).
Market capitalization/ market cap: overall market value (market price of share X shares
outstanding).
Corporation: legal entity, a legal person that is owned by its shareholders. It can make
contracts, carry on business borrow or lend money, and can sue or be sued.
A corporation is owned by its shareholders but the shareholders have limited liability (they
cannot be held personally responsible-> cannot lose more than they have invested).
A company is closely held when shares are not publicly traded. Public companies when
shares are traded in public markets.
Corporations can in principle live forever due to Separation of ownership and
control managers can be replaced shares can be sold to new investors.
However, managers can act in their own self-interest. Other disadvantages of being a
corporation are the cost of managing the corporation’s legal machinery. And tax drawbacks
because a corporation is a separate legal entity it is taxed separately.
In partnerships sole proprietors face unlimited liability they can be held responsible for all
the business’s debts. But they do have a tax advantage (only income taxes).
General partners: manage business and have unlimited personal responsibility.
Limited partners: liable only for the money they invested and do not participate in
management.
Professional corporation: the business has limited lability, but the professionals can still be
sued personally for, for example malpractice.
, lOMoARcPSD|11911780
The choice between 4a and 4b depends on the promises made when cash was raised at
arrow 1.
1.2 The financial goal of the corporation
Financial objective: maximize the current market value of shareholders’ investment in the
firm. Risk averse persons will adjust their investment portfolio when the corporation
invests in too risky projects in order to try to increase their market value (they will switch
for example to government bonds).
Why maximizing shareholder value:
1. Each stockholder wants three things
a. To be as rich as possible (maximize his current wealth)
b. Transform that wealth into the most desirable time pattern of consumption
c. Manage the risk characteristics of that consumption plan.
2. Stockholders can achieve the best time pattern of consumption themselves
because of free access to competitive financial markets. They can choose the risk
characteristics of their consumption plan by investing in more or less risky
securities.
3. Financial managers can help stockholders by increasing their wealth = increasing
the market value of the firm and the current price of its shares.
Profit maximizing is not a well-defined financial objective because:
1. A corporation can increase current profits by cutting back on outlays while
those outlays may have added long-term value. Shareholders will not welcome
higher short-term profits if long-term profits are damaged.
2. A company can increase future profits by ting this years’ dividend and investing the
freed-up cash in the firm-> not in interest of stockholders if the company earns only
a modest return on the money.
The firm can either keep
and reinvest the cash or
return it to investors. If
the corporations proposed
investments offer higher
rates of return than its
shareholders can earn for
themselves in the financial
market, shareholders will
applaud the investment
and its stock price will increase. If the company earns a inferior return, shareholders boo,
stock price falls and stockholders demand their money back so they can invest on their own.
Opportunity cost of capital: if a corporation invests cash in a new project its shareholders
, lOMoARcPSD|11911780
lose the opportunity to invest the cash on their own. -> opportunity costs depend on risk and
return.
Agency problem: conflict between shareholders’ and managers’ objectives.
Agency costs: incurred when 1. managers do not attempt to maximize firm value.
2. Shareholders incur costs to monitor the managers and
constrain their actions.
Primary markets- securities are sold to investors, moneyt hat is raised goes to issuing firm
Secondary markets: investors trade with ach other, money that is raised goes to seller of
securities.
1.3 Preview of coming attractions
Chapter 2
2.1 Future values and present values
A dollar today is more than a dollar tomorrow. By investing you give up the opportunity to
spend X euro’s today but you gain the chance to spend X + interest euro’s next year.
Compound interest: interest on interest. It is the result of reinvesting interest, rather than
paying it out, so that interest in the next period is then earned on the principal sum plus
previously accumulated interest.
Present value: PV = Ct / (1+r)t
r= discount rate
Ct= cash flow
1/(1+r)t= discount factor= the present value of one dollar received in year t.
Net present value = PV – investment = NPV = C0 + C1/(1+r)
C0 = cash flow at time/ investment.
A save dollar is worth more than a risky dollar.
You take the discount rate with the same level of risk.
Rate of return: profit / investment
We can justify an investment by either one of the following rules:
1. Net present value rule: accept investments that have positive net present values.
2. Rate of return rule: Accept investments that offer rates of return in excess of
their opportunity costs of capital.
Discounted cash flow DCF: PV = ΣTt=1Ct/(1+r)t
NPV= C0 + PV = C0 + ΣTt=1 Ct /(1+r)t
2.2 looking for shortcuts – perpetuities and annuities
perpetuities: A perpetuity is an annuity that has no end, or a stream of cash payments that
continues forever.
Return = cash flow / present
value r = C /PV
PV = C/ r
2 warnings about the formula:
1. you can easily confuse the formula with the present value of a single payment (c/1+r)
, lOMoARcPSD|11911780
2. the formula tells us the value of a regular stream of payments starting on
eperiod from now.
Annuity: an asset that pays a fixed sum each year for a specified number of years.
Present value of t-year annuity= C[1/r-1/(r(1+r)t)]
Annuity factor: shows the present value of 1 euro a year for each of t years. 1/r-1/(r(1+r)t
Annuity due: a level stream of payments starting immediately. An annuity due is worth (!+r)
times the value of an ordinary annuity.
Future value of annuity= present value of annuity of $1 a year x (1+r)t
=[1/r-1/(r(1+r)t)] X (1+r)t = ((1+r)t – 1) / r
Future value at the end of year t = present value x (1+r)t
2.3 more shortcuts – growing perpetuities and annuities.
Present value of a growing perpetuity: C1/(r-g) (we assume r is greater than g)
PV of a growing annuity = C x 1/(r-g) [1-(1+g)t/(1+r)t]
2.4 How interest is paid and quoted
Effective annual interest rate (compounded interest): The interest rate that is actually
earned or paid on an investment, loan or other financial product due to the result of
compounding over a given time period.
Is higher than the annual percentage rate. Assume annual percentage rate is 12% to be paid
monthly. This means each month 12/12=1%. The effective annual interest rate is than
1.0112=0.1268 = 12.68%
If you invest $1 your investment at the end of the year will be
worth:(1+(r/m))m r= interest rate
m= compounded times (m is infinite)
and the effective interest rate is :(1+(r/m))m – 1
if m approaches infinity (1+(r/m))m approaches (2.718)r which is ert (natural logarithm)
annual percentage rate = uses simple interest
Week 2
Perpetuity: a level stream of cash flows forever.
Annuity: a level stream of cash flows for a fixed period of time.
Chapter 3
3. 4 explaining the term structure
Reasons you decide to hold on to bonds with low rate of return:
1. You believe that short-term interest rates will be higher in the future.
2. You worry about the greater exposure of long-term bonds to changes in interest rates
3. You worry about the risk of higher future inflation.
Bond: a mostly tradable certificate showing that a borrower owes a specified sum. To repay
the money the borrower has agreed to make interest and principal payments on designated
dates. (three types of bonds are pure discount bond (zero bond) level coupon bond (floaters)
and consol (perpetual bond).
Treasury bill: promise by the government to repay a fixed amount at some time in the future
= a pure discount bond (zero bond).
