Corporate Finance

classes for doctoral studies

Part 1.

Jacek Mizerka
Department of Corporate Finance
 What is Corporate Finance?
Corporate finance means financing of a firm—not simply an asset, not
simply an individual, but that unique combination of assets and
individuals that constitutes a firm. (L. Zingales, In Search of New Foundations,
Journal of Finance, The Journal of Finance, no. 4, August 2000)

Can such a defintion accurately determine a field of interest of a

scientific (?) discipline called Corporate Finance ?

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 What is Corporate Finance about?

1. In a narrow sense, Corporate Finance means a discipline

which deals with a way the activity of a firm (corporation)
is financed

2. In a broad sense, Corporate Finance is a discipline which

covers at least three areas:
A. Capital structure,
B. Corporate governance,
C. Valuation.

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 Two approaches to Corporate Finance

1) Normative approach – affirms how things should be and

which actions are good and which are wrong from the
point of view of the decision criterion.

2) Descriptive, "disinterested" approach – approach which

aims primarily at gathering knowledge (i.e. descriptions
and explanations) about financial phenomena but does
not wish to improve decision making.

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 Neoclassical Finance
1) Predecessor – old finance theory before 1958 – in this theory capital
market does not exist; focus on accounting – decisions made on the
basis of accounting statements.

2) Main paradigm: capital market is working smoothly.

3) Decision criterion: value of a firm; thanks to the good functioning of

the capital market, the value of a company can be derived directly
from the cash surplus

4) Importance of the firm’s value criterion – Fisher’s separation

theorem

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 Neoclassical Finance cont.
Fisher’s separation theorem
C1
W1 K1’
W1’ K1
D
B
C1B U1 U2

C1F A F
C1A
l1 K2’
K2
C0B C0A C0F E W0’ W0 C0
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 Neoclassical Finance cont.

.
5) What is of particular importance in Fisher’s separation
theorem:

The wishes or preferences of owners can be separated
from investment decisions and delegated to managers.

When making a decision concerning a project which
generates a positive net present value (NPV), the manager
maximizes the owners’ utility independently of their own
preferences.

An increase in the firm’s value (determined by cashflows) =
an increase in owners’ wealth

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 Neoclassical Finance cont.

 Main concepts

• Net Present Value

Free Cash Flow (FCF) = After-tax operating income [EBIT(1-T)] +
Depreciation – Capital expenditures (I) ± Change in net operating working Capital

n
FCFt
NPV = - I 0 + ∑
t=1 (1 + k)
t

n
FCFt
NPV = - I 0 + ∑ t
t=1
∏ (1+ k
i=1
i )

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 Neoclassical Finance cont.

 Main concepts, cont.

• Capital Asset Pricing Model

cov( r i ,r m )
E(rj) = rf + βj[E(rm)- rf ]; β i
= 2
σ (r m
)
where:
E(rj) – expected rate of return on security j,
rf – rate of return on risk free security,
E(rm) – expected rate of return on securities listed on a capital market
cov (rj, rm) – covariance rj and rm,
σ2(rm) – variance rm

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 Neoclassical Finance cont.
 Main concepts, cont.

• Fama French 3 Factor Model – supplement to CAPM

rFPL = rf + β FPL,m (RPM ) + β FPL,sml (SML) + β FPL,hml (HML)

RPM: difference between returns on a diversified market portfolio and a risk-free return

SMB (small minus big): difference between returns on diversified portfolios of small and
large capitalization stocks

HML (high minus low): difference between returns on diversified portfolios of high and
low B/M stocks

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 Neoclassical Finance cont.

 Main concepts, cont.

Modigliani&Miller Theory (MM Theory)
Basic assumptions: no taxes, all investors have the same information
as management

Proposition 1 (economy without taxes)

The market value of a firm is unaffected by its capital structure.

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Neoclassical Finance cont.

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 Neoclassical Finance cont.

Main concepts, cont.

Valuation methods - remarks

The value of a company is driven by its ability to produce economic benefits for owners and
creditors

The income approach, generally speaking, is based on future expected benefits discounted at
the current moment

A neccesary condition for applying the income approach - the company should be able to
generate benefits to creditors and owners

The benefits are measured by cash flows

Additional remarks- see P. Fernandez, Valuing Companies by Cash Flow Discounting:

10 Methods and 9 Theories

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 Neoclassical Finance cont.
 Main concepts, cont.
Option valuation – Black-Scholes Model
Call = Buying ∆ of the Underlying Asset + Borrowing
Put = Selling Short ∆ on Underlying Asset + Lending
The initial version of Black-Scholes model for call option valuation, ct
− rf T
ct = ∆t * Vt − e * Bt
present value of borrowing
The basic version of Black-Scholes model for call (c) and put (p) option
−rf T
ct = N (d1 ) *Vt − X * e * N (d 2 ); pt = X * e
rf T
* N ( − d 2 ) − Vt * N ( − d1 )
where: X - strike price
e – base for natural logarithm
rf – risk free rate
T – time to the expiration date of the option

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 Neoclassical Finance cont.
 Main concepts, cont.
Option valuation – Black-Scholes Model, cont.
N(d1), N(d2) – cumulative distribution function in points d1 i d2 respectively.

Vt σ2 Vt σ2
ln( ) + T * ( rf + ) ln( ) + T * ( rf − )
X 2 d2 = X 2 = d −σ t
d1 =
σ T
1

where: σ T

σ– standard deviation of an underlying asset.

Put- call parity:

−rf T
pt + Vt = ct + X * e

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 Call Option (right to buy)

Option’s value

Total value of an option

Intrinsic value of an
option
0 Strike price Value of an underlying asset

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 Put option (option to sell)

Option’s value

Intrinsic value of an option

Total value of an option

0 Strike price Value of an underlying

asset
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 Neoclassical Finance cont.
 Main concepts, cont.
Determinants of an option value

Value of an underlying asset: if , the right to buy at a fixed price (calls) will become
more valuable, and the right to sell at a fixed price (puts) will become less valuable.

Variance in that value: if , both calls and puts will become more valuable because all
options have a limited downside and depend upon price volatility for upside.

Expected dividends on the asset, which are likely to reduce the price appreciation
component of the asset, reduce the value of calls and increase the value of puts.

Strike Price of Options: if , the right to buy (sell) at a fixed price becomes less (more)
valuable.

Life of the Option; both calls and puts benefit from a longer life.

Interest Rates; if rates , the right to buy (sell) at a fixed price in the future becomes
more (less) valuable.

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 Neoclassical Finance cont.
 Main concepts, cont.
Main differences between DCF methods and option valuation models
1. DCF methods which are based on the expected values ​of cash flows in some
cases do not adequately capture uncertainty. The increase in risk (volatility) is
regarded as a threat

risk (σ) ↑ => discount rate ↑ => V (on the basis of DCF) ↓

As part of the option approach, the increase in risk is treated as an opportunity

(chance)

risk (σ) ↑ => value of an option ↑

2. The essence of options is that they include flexibility in decision making while the
DCF methods do not take flexibility into account

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 Neoclassical Finance cont.
 Main concepts, cont.
Cox-Ross-Rubinstein (binomial) model

Calculation of arbitrage probabilities

e f − V decrease
r

=V * q +V * ( 1 − q ) ⇒ q = increase
rf increase decrease
V0 * e
V − V decrease
where:
V0 - present value of an underlying asset;
Vincrease, Vdecrease – value of underlying asset in the next period assuming increase (decrease) in
the asset’s value,
rf- - risk free rate

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 Neoclassical Finance cont.
 Main concepts, cont.
Cox-Ross-Rubinstein (binomial) model, cont.

Calculation of the intrinsic value of an option

c(V)i,T = c(V)intrinsic,i,T=max(Vi,T -X;0);

i=1…nT (No. of nodes in binomial lattice in period T),

T- no. of years to the expiration date,
X – strike price

Calculation of the total value of an option

−r
max{[c( V )i ,T −t +1,increaseq + c(V )i ,T −t +1,decrease( 1 − q )]e f ; c(V )intrinsic,i ,T −t }

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 Neoclassical Finance cont.
 Main concepts, cont.
Real options approach
Disadvantages of NPV

NPV is based on the values ​of expected cash flows. NPV does not sufficiently take
uncertainty into account.

NPV does not allow us to operate with time; the set of possible alternatives is limited to: yes
or no.

NPV does not sufficiently take into account the fact that investments are at least partially
irreversible.

There is an analogy between investment projects and financial options

Investment projects can be identified and valued as options

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 Neoclassical Finance cont.

Main concepts, cont.

Real options approach
Investment treated as a call option

Investment Call option

Cash flow generated by a project Value of an underlying asset

Cash flow’s variability (volatilty) Volatilty of an underlying asset

Investment (capital) expenditure Strike price

Expiration time of an investment Expiration time of an option

Risk free rate Risk free rate

Net Present Value - NPV Intrinsic value of an option

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 Neoclassical Finance cont.

Main concepts, cont.

Real options approach
Expanded NPV (ENPV) = NPV + options values + (-) value of interdependencies between
particular options

Main difference between NPV and real option

In the discounted expected cash flow approach, an inrcrease in volatility of cash flows means
a higher risk, which causes a decrease in NPV
In the option approach, an increase in volatility causes an increase in the option’s value.
According to the option approach, a higher volatility is treated as a higher chance.

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 Neoclassical Finance cont.

Main concepts, cont.

Real options approach
Problems with the application of real options:
 Many sources of risk,
 The assumptions concerning market completeness are not fulfilled,
 Lack of twin security,
 Advanced mathematical methods used for valuation.

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 Moving away from complete market assumptions
Theory of the Firm: Managerial Behavior, Agency Costs and Ownership
Structure, Jensen and Meckling, JFE, 1976 (About 3400 citations)
Agency Theory!!! (on the basis of: free e-book download from spears.okstate.edu)

• Agent = Manager
• Principal = stock and debt holders
• Agency problem applied to the firm.
– Monitoring expenses by principal
– Bonding expenditures by agent (such as insurance or financial statements).
– Residual loss (imperfect contracts)
• Firms are legal fictions which serve as a nexus for a series of contracts

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 Moving away from a complete market assumptions, cont.
Agency Theory cont.
• Main idea
– Suppose Mike, a manager, owns 50% of a firm. Suppose Pete, the principal,
owns the other 50%.
– Mike has a friend. Mike hires the friend to do a disservice to the firm. It costs
$100. The firm gains nothing. Their agreement was for the friend to give $60
back to Mike personally.
– Mike gains $10 ($60 – ($100x0.5)). The friend gains $40. Pete loses $50.
– Mike will do this over and over, to the point where marginal utility from one
dollar’s expenditure of the firm’s resources equals the marginal utility of an
additional 50 cents (corresponding to 50% of ownership) in general purchasing
power.

Agency costs of debt and agency costs of equity play a very important role
in determining the structure of capital

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 Moving away from a complete market assumptions, cont.
Agency Theory cont.

• Conclusions:
– Agency costs should affect capital structure.
– Agency costs exist between managers and shareholders, and between
bondholders and shareholders.
– Agency costs of equity decrease with managerial ownership.
– Agency costs of debt increase as investment opportunities increase.

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 Moving away from complete market assumptions, cont.
Equity as a call option
Stockholders and bondholders have different objective functions, which can lead to
agency problems, where stockholders can expropriate wealth from bondholders.

The conflict can manifest itself in a number of ways - for instance, stockholders have
an incentive to take riskier projects than bondholders do, and to pay more out in
dividends than bondholders would like them to.

This conflict between bondholders and stockholders can be illustrated

dramatically using the option pricing model. Since equity is a call option on the value
of the firm, an increase in the variance in the firm’s value, other things remaining
equal, will lead to an increase in the value of equity.

It is therefore conceivable that stockholders can take risky projects with negative net
present values, which, while making them better off, may make the bondholders and
the firm less valuable.

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 Moving away from a complete market assumptions, cont.

Equity=option’s value

Total value of firm’s equity = option’s total value

Intrinsic value of firm’s equity =

intrinsic option’s value
0 Value of debt = strike price
Value of firm as a whole =
value of an underlying asset
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 Moving away from a complete market assumptions, cont.
An example
Underlying asset: Present value of Company X as a whole: 10 000 thous. PLN
Strike price: Present value of debt: 11 000 thous. PLN
Option’s value: Value of equity of Company X: ?
Assumptions:
σ(yearly volatility) = 20%,
No. of years to the expiration date (final date of debt repayment) – T = 2,
Risk free rate (yearly)- rf = 5%

c0(V)= Present value of equity of Company X (on the basis of the Black-Scholes model) =
ca PLN1.146 million

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Thank you for your attention!

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