Corporate Finance - Summary FK

Frédéric Kröger Corporate Finance – Summary
Corporate Finance – Summary
❖ Role and Objective of Financial Management (Chap 1)

o MANAGING IN A COMPETITIVE WORLD
o 3 Kind of questions faced by Financial Managers
▪ Investment decisions
E.g. Will a particular investment be successful ?
▪ Financing decisions
E.g. Where will the funds come from to finance the investment ?
▪ Dividend decisions
E.g. How should cash flows be used or distributed ? What’s the optimal dividend policy ?
o FIRM’S CASH FLOW GENERATION PROCESS (within a company)
▪ To start a company you need funds

→ External funds
▪ With loan money you can make investments
▪ Which is used to produce and sell GaS
▪ Then you distribute or reinvest (→ Internal funds)
GaS ➔ Goods and Services
Engine of the Company
o SHAREHOLDER WEALTH MAXIMIZING

▪ Main goal of Financial Managers is shareholder wealth maximizing
▪ Creating value is something with a view on the future (lies within the future)
o Maximizing PV (present value) of expected future cash flows
▪ Stock price depends on how the future of the company looks like
• What is the amount of expected cash flows ?
• What is the timing of expected cash flows ?
• What is the risk of expected cash flows ?
o Shareholder Wealth Maximization IS NOT Profit Maximization
▪ Profit Maximization is not good because
• It’s an accounting figure
• No timing
• No risk
o AGENCY RELATIONSHIP
o Different Roles
▪ Shareholders (owners) elect every year → Board of Directors
▪ Board of Directors evaluate and check if take good decisions → Management
(CEO, CFO, …)
▪ Management goal is to maximize wealth of shareholders
o Agency Problems
▪ Sometimes Management take decisions not in line with value maximization
Aim at maximizing own welfare instead of shareholders’ wealth
• E.g.: Consumption of on-the-job perquisites (company cars, airplanes, …)
• E.g.: Empire building
▪ There are solutions but they cost money → Agency Costs
o Agency Costs
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▪ Management incentives (stock options)

▪ Monitor performance (audits)
▪ Complex organization structures (multiple managers)
▪ Protective covenants (capital rationing)
o SAMPLE ORGANIZATION CHART
2
❖ Time Value of Money (Chap 5)

“A $ today is worth more than a $ tomorrow”
o FUTURE VALUE OF A CASH FLOW
o Simple Interest ➔ Interest paid on the principal sum only
𝑭𝑽𝒏 = 𝑷𝑽𝟎 . (𝟏 + 𝒏 . 𝒊)
o Compound Interest ➔ Interest paid on the principal and on prior interest

𝑭𝑽𝒏 = 𝑷𝑽𝟎 . (𝟏 + 𝒊)𝒏
▪ (1 + i)n is Future Value Interest Factor (FVIFi,n ) can be found in Table I

When using the table → 𝑭𝑽𝒏 = 𝑷𝑽𝟎 . (𝑭𝑽𝑰𝑭𝒊,𝒏 )
o PRESENT VALUE OF A CASH FLOW

o Present Value
𝟏
𝑷𝑽𝟎 = 𝑭𝑽𝒏 . [ ]
(𝟏 + 𝒊)𝒏
▪ Present Value Interest Factor (PVIFi,n ) can be found in Table II
When using the → 𝑷𝑽𝟎 = 𝑭𝑽𝒏 . (𝑷𝑽𝑰𝑭𝒊,𝒏 )
o INTEREST COMPOUNDED MORE THAN ONE PER YEAR

▪ Interest paid out more frequently than once per year
o Future Value
▪ m ➔ # of times interest is compounded
▪ n ➔ # of years
▪ 𝐢𝐧𝐨𝐦 ➔ Nominal interest rate
𝒊𝒏𝒐𝒎 𝒏𝒎
𝑭𝑽𝒏 = 𝑷𝑽𝟎 . [𝟏 + ]
𝒎
o Present Value
𝑭𝑽𝒏
𝑷𝑽𝟎 = 𝒏𝒎
𝒊
[𝟏 + 𝒏𝒐𝒎
𝒎 ]
o Effective annual rate of interest
• If I get 5% per year but it is paid twice a year, it means you get twice 2,5%
which is more valuable than getting once 5%
• 𝐢𝐞𝐟𝐟 ➔ Effective interest rate
𝒊𝒏𝒐𝒎 𝒎
𝟏 + 𝒊𝒆𝒇𝒇 = [𝟏 + 𝒎
]
o ANNUITY
▪ Annuity ➔ Series of equal cashflows (PMT (payment)) for a specified number
of periods
o Ordinary Annuity
▪ Ordinary Annuity ➔ PMT occurs at the end of each period
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▪ Future Value of an Ordinary Annuity

(1+i)n −1
• is Future Value Interest Factor of an Annuity (FVIFAi,n ) can be
i
found in Table III
When using the table → 𝑭𝑽𝑨𝑵𝒏 = 𝑷𝑴𝑻 . (𝑭𝑽𝑰𝑭𝑨𝒊,𝒏 )
▪ Present Value of an Ordinary Annuity

1
1−
i(1+i)n
• is Present Value Interest Factor of an Annuity (PVIFAi,n ) can
i
be found in Table IV
When using the table → 𝑷𝑽𝑨𝑵𝟎 = 𝑷𝑴𝑻 . (𝑷𝑽𝑰𝑭𝑨𝒊,𝒏 )
▪ Present Value of a Perpetuity

• Perpetuity is a special Annuity that goes on forever
𝑷𝑴𝑻
𝑷𝑽𝑷𝑬𝑹𝟎 =
𝒊
o Annuity Due
▪ Annuity Due ➔ PMT occurs at the beginning of each period
▪ Future Value of an Annuity Due

(1+i)n −1
• is Future Value Interest Factor of an Annuity (FVIFAi,n ) can be
i
found in Table III
When using the table → 𝑭𝑽𝑨𝑵𝑫𝒏 = 𝑷𝑴𝑻 . (𝑭𝑽𝑰𝑭𝑨𝒊,𝒏) . (𝟏 + 𝒊)
▪ Present Value of an Annuity Due

1
1−
i(1+i)n
• is Present Value Interest Factor of an Annuity (PVIFAi,n ) can
i
be found in Table IV
When using the table → 𝑷𝑽𝑨𝑵𝑫𝟎 = 𝑷𝑴𝑻 . (𝑷𝑽𝑰𝑭𝑨𝒊,𝒏 ) . (𝟏 + 𝒊)
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❖ Bonds – Characteristics (Chap 6)

o RETURN
o Bonds (interest)
▪ Fixed income (prespecified return)
• Company will be obliged to pay interest (coupon payments)
If not able to pay → bankruptcy
• Constant distributions
• Fixed intervals
▪ Tax deductible
o Common Stock (C/S) (dividend)
▪ Variable income
• Depending upon profit/loss
▪ Not tax deductible
o REFUNDING
o Bonds
▪ Invested capital (➔ Principal amount) is fully repaid
▪ Price you pay for a bond is not equal the amount you will get from
the company (Par Value or Face Value or Principal Amount)
• At maturity date / sinking fund
▪ Sinking fund ➔ Repays part of the bond also intermediately
• At par / discount / premium
▪ Priced at Par ➔ Price of bond equals Par Value
▪ Priced at a Discount ➔ Priced lower than Par Value
▪ Priced at a Premium ➔ Priced higher than Par Value
▪ Fixed due date (at maturity)
• Call feature
➔ Company that issues the bond, has the right to repay the bond earlier
o Common Stock (C/S)
▪ Gain or Loss
▪ No maturity date (➔ permanent form of LT financing)
o SENIORITY
o Bonds
▪ Higher priority (fixed) claim on assets
• Mortgage (secured bonds) / Debenture (unsecured bonds)
▪ Mortgages ➔ Priority claim on certain assets
▪ Debentures ➔ No specific claim on assets
• Subordinate (junior bonds) / Unsubordinated bonds (senior bonds)
▪ Senior bonds ➔ Priority over junior bonds
→ LOWER RISK
o Common Stock (C/S)
▪ Residual claim on assets (ownership)
→ HIGHER RISK
o PREFERRED STOCK (P/S)

▪ Intermediate position between C/S and Bonds
▪ Dividends are not tax deductible
▪ Preference over C/S with regard to earnings and assets
▪ Cumulative feature: Dividends cannot be paid on C/S unless all or a
prespecified amount of preferred dividends in arrears has been paid
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❖ Bonds – Valuation (Chap 6)

o FUNDAMENTAL VALUATION PRINCIPLE: Discounted Cash Flow Valuation (DCF)
▪ The value of something depends on
• Fundamental analysis
▪ Have to think about the market → expected cashflows and end-value
• Required expected return (CH 8)
𝒓 = 𝒓𝒇 + 𝒓𝒊𝒔𝒌 𝒑𝒓𝒆𝒎𝒊𝒖𝒎
▪ Risk premium ➔ How certain are you about cash flow
▪ More uncertain you are → Higher risk premium
→ Willing to invest if you compensate with higher expected return
o Simple one-period case
𝒑𝒓𝒐𝒇𝒊𝒕 • The Value is not more than what you are
𝒓𝒆𝒕𝒖𝒓𝒏 = willing to pay
𝒊𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕
𝑪𝑭𝟏 + 𝑷𝟏 − 𝑷𝟎 𝑪𝑭𝟏 + 𝑷𝟏
𝒓= 𝑷𝟎 =
𝑷𝟎 𝟏+𝒓
o Multi-period case
𝒕=𝑯
𝑪𝑭𝒕 𝑷𝑯
𝑷𝟎 = ∑ 𝒕
+
(𝟏 + 𝒓) (𝟏 + 𝒓)𝑯
𝒕=𝟏
o The formula can be used for Individual valuation and Market valuation
o With formula you can now understand
▪ Price Volatility (Why stock price of a company changes)
• Change in expectations about future cash flow
• Change in perception of the risk of the company
• E.g. New information coming to the market
▪ E.g. New contract → future cash flows go up → Stock price goes up
▪ E.g. Lawsuit → risk premium goes up → Stock price goes down
▪ Bubbles (Irrational high price for something)
• Irrationality can be in the numerator
▪ Irrational high expected cash flows
• Irrationality can be in the denominator
▪ Irrational low risk premium
o FORMULA
▪ 𝐤 𝐝 ➔ Required expected return = Discount rate = Yield to maturity (YTM)
▪ 𝐢 ➔ Coupon rate
▪ 𝐌 ➔ Face value = Par value = Principal value
▪ 𝐈=𝐢 ×𝐌
𝒏
𝑰 𝑴
𝑷𝟎 = ∑ 𝒕
+ 𝑷𝟎 = 𝑰 . (𝑷𝑽𝑰𝑭𝑨𝒌𝒅 ,𝒏 ) + 𝑴 . (𝑷𝑽𝑰𝑭𝒌𝒅 ,𝒏 )
(𝟏 + 𝒌𝒅 ) (𝟏 + 𝒌𝒅 )𝒏
𝒕=𝟏
o Coupon rate (𝐢) ≠ Discount rate (𝐤 𝐝 )

▪ If i < k d ➔ 𝐏𝟎 < 𝐌 (at discount)
▪ If i > k d ➔ 𝐏𝟎 > 𝐌 (at premium)
▪ If i = k d ➔ 𝐏𝟎 = 𝐌 (at par)
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o 4 CONCEPTS
o Sensitivity of the value of a bond with respect to changes in 𝐤 𝐝
▪ If k d rises → price of bond goes down
▪ LT bond is more sensitive to changes in the k d than ST bond
o Perpetual Bond
▪ Special bond that has no maturity date
▪ Formula: 𝑰
𝑷𝟎 =
𝒌𝒅
o Zero Coupon Bonds
▪ Special bond that doesn’t pay any interest payments
▪ Will always be priced at a discount
▪ Formula: 𝑴
𝑷𝟎 =
(𝟏 + 𝒌𝒅 )𝒏
▪ Table:
𝑷𝟎 = 𝑴 . (𝑷𝑽𝑰𝑭𝒌𝒅,𝒏 )
o Value of P/S
▪ Pays a fixed dividend payment
▪ Formula: 𝑫𝒑
𝑷𝟎 =
𝒌𝒑
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❖ Common Stock: Characteristics & Valuation (Chap 7)

o CHARACTERISTICS
o Balance Sheet Accounts for C/S
▪ Shareholders equity (= book value of the equity) consists of 3 items:
▪ When a company issues shares. Amount of cash injected into de company
is divided into Par value account and Additional paid-in capital account
• Par value of C/S (fixed until issues shares)
▪ Theoretical value that has been attributed to a share of the company
• Additional paid-in capital (fixed until issues shares)
▪ Contributed capital in excess of par value
• Retained earnings (R/E)
▪ Par of benefits left after distributing dividends
𝑺𝒕𝒐𝒄𝒌𝒉𝒐𝒍𝒅𝒆𝒓𝒔′ 𝑬𝒒𝒖𝒊𝒕𝒚
▪ 𝑩𝒐𝒐𝒌 𝒗𝒂𝒍𝒖𝒆 𝒑𝒆𝒓 𝒔𝒉𝒂𝒓𝒆 =
# 𝒔𝒉𝒂𝒓𝒆𝒔 𝒐𝒖𝒕𝒔𝒕𝒂𝒏𝒅𝒊𝒏𝒈
o Rights of Common Stockholders
▪ Dividend rights
• If company decided to pay dividends, you get a part of dividends
▪ Asset rights
• If company goes bankruptcy and everyone has been paid, have the right to
get some money
▪ Pre-emptive rights
• If company decides to issue new stocks, have the right to buy first
▪ Voting rights
• 1 vote per share
o Features of C/S
▪ C/S classes
• Voting and nonvoting
▪ Stock dividends
• If company wants to distribute dividends but not in cash, they can
distribute in form of stocks
• On the balance sheet, there is a transfer from R/E account to the C/S and
additional paid-in capital accounts
▪ Stock repurchases
• 4 reasons:
▪ Disposition of excess cash
▪ Financial restructuring
▪ Future corporate needs
▪ Reduction of takeover risk
▪ Stock splits
• Stock is split in multiple stocks when one share is to expensive
▪ Reverse stock splits
o VALUATION OF C/S
o Dividend Discount Model (Gordon-Shapiro Model)
𝒏
𝑫𝒕 𝑷𝒏
𝑷𝟎 = ∑ 𝒕
+
(𝟏 + 𝒌𝒆 ) (𝟏 + 𝒌𝒆 )𝒏
𝒕=𝟏
▪ Problem → future cashflows (dividends and selling price) are unknown
▪ Solution → Assume growth structure of infinite dividends
➔ General Dividend Valuation Models
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o General Dividend Valuation Model

▪ Zero growth
• Current dividend always stays the same
• 𝒈=𝟎
• Formula reduces to perpetuity
𝑫
𝑷𝟎 =
𝒌𝒆
▪ Constant growth dividend
• Company grows every year but by a small percentage, so the growth rate
(𝒈) is smaller than 𝐤 𝐞
• 𝐤𝐞 > 𝒈
• Formula This formula is only for
mature companies with
𝑫𝒕 = 𝑫𝟎 (𝟏 + 𝒈)𝒕 low constant growth
𝑫𝟏 𝑫𝟏
𝑷𝟎 = 𝒌𝒆 = +𝒈
𝒌𝒆 − 𝒈 𝑷𝟎
▪ Above-normal growth
• Young companies who grow rapidly in the beginning years and then enter
a maturity period with a constant growth rate
• Multiple growth rates
𝒏 𝑫𝒏+𝟏
𝑫𝟎 . (𝟏 + 𝒈𝟏 )𝒕 𝒌𝒆 − 𝒈𝟐
𝑷𝟎 = ∑ +
(𝟏 + 𝒌𝒆 )𝒕 (𝟏 + 𝒌𝒆 )𝒏
𝒕=𝟏
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❖ Analysis of Risk and Return: Conceptual relationships (Chap 8.1)

o EXPECTED RETURN
o Expected Return = “Risk-free” return + Risk premium
𝒓 = 𝒓𝒇 + 𝒓𝒊𝒔𝒌 𝒑𝒓𝒆𝒎𝒊𝒖𝒎
Typically yield on a T-Bill
is taken as a proxy
o Risk-free return
▪ Return you get on the financial market if you do not take any risk
▪ This is a theoretical concept
▪ We have proxies for that
o Proxy
▪ Exists in real world
▪ Comes as close as possible to theoretical concept
▪ Proxy for “risk-free” return
→ E.g. US T-Bill
• Called Treasury Bill not government bond
because it is a gov. bond that is short term bond (1 or 3 months)
o RISK FREE RETURN

o “risk-free” rate of return is the sum of 2 components
▪ Real “risk-free” rate of return + expected inflation premium
• Inflation premium compensates investors for the loss of purchasing power
due to inflation
E.g. if you want 3% more purchasing power in future and expected
inflation premium is 1%; you need a 4% “risk-free” rate of return
o SOURCES OF THE RISK PREMIUM

▪ The reason why different bonds have different yield to maturities comes
from different risk premium
(As “risk-free” return is the same)
o Maturity risk premium

▪ Yield to maturity of the risk premium between bonds can differ due to a
different maturity E.g. 1-year bond vs 10-year bond
▪ Different maturity comes with different risk premium
▪ Yield curve :
• LT bonds have higher maturity risk premium
▪ 3 complementary theories explaining this:

• Liquidity premium theory (interest rate risk)
▪ LT bond have higher interest rate risk
because they are more sensitive to changes in the interest rate (CHAP 6)
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• Expectations theory
▪ 2 options when investing in bond for LT
▪ Buy LT bond
▪ Buy ST bond and after getting face value buy another ST bond, etc
▪ LT interest rate is the average of future ST interest rates
(if LT i.r. higher than current ST i.r., market expects that the ST i.r. will rise)
▪ Rising ST i.r. mostly depends on our expectations about inflation
▪ Real i.r. doesn’t vary much, it’s more expectation about inflation that
triggers changes in i.r.
▪ So rising yield curve means we expect inflation in the future
▪ Sometimes we have a downward sloping yield curve
(LT i.r. lower than ST i.r.)
→ Market expects deflation (typical characteristic of crisis)
➔ Downward yield can be an expectation about future crisis
• Market segmentation theory
▪ See market of LT- and ST-bonds as different markets
▪ Demand from investors
▪ Supply from governments
• E.g. LT-bonds in 2012

Risk-taking investors went up again after the crisis
→ Demand for LT-bonds drops
But gov needed LT-financing to finance public deficit
→ Supply of LT-bonds rose
▪ Price of LT bond is opposite to the yield (as it is denominator)
o Default risk premium

▪ Risk of not getting the contractual payments (coupon payments/face value)
E.g. If the company from whom you bought the bonds goes bankrupt
▪ Business risk ➔ The variability of operating earnings over time
▪ Financial risk ➔ The additional variability in earnings per share resulting
from the use of debt financing. Financial obligations of the company
E.g. Amount of liabilities of the company
▪ Some companies are specialized in measuring the default risk with ratings
→ “AAA” higher quality (so less risky) than “BB”
→ “BB” and lower are called non-investment grade or junk bonds
or high-yield bonds
• Junk comes from “a higher default risk”
o Seniority risk premium (Chap 6)

▪ Bonds have different seniority
E.g. Mortgage and Debenture
→ Mortgage has higher seniority, so lower risk, so yield to maturity lower than debenture
E.g. Senior and Junior
→ Senior bond has higher seniority, so lower risk, so yield to maturity lower than junior
o Marketability risk premium

▪ Different between listed bonds and unlisted bonds
▪ Marketability ➔ How easy and how cheap can I sell the bond if I want to
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o RISK-EXPECTED RETURN RELATIONSHIP
o 4 REASONS WHY INVESTORS ARE READY TO BUY BONDS WITH EXPECTED LOSS
o Obligation
➔ Insurance companies, Banks, Pension funds are obliged to have a
portfolio that consists partly of gov bonds even with negative yields
o Currency Speculation
➔ Currency that rises in value, may more than offset a negative yield by a positive
currency effect
o Safe Haven
➔ Better take a small loss, than risk losing much more (averse investors)
o Rising Price
➔ If market interest rates continue to decrease, the value of the bonds will increase
(Interest rates and bonds are moving opposite)
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❖ Analysis of Risk and Return: Mathematics (Chap 8.2)

o EXPECTED RETURN
o Expected Return ➔ weighted average of all the individual possible returns
o Distribution of returns ➔ Set of all possible returns
o 𝒓̂ ➔ expected return (“r hat”)
𝒓̂ = Sum (all possible returns x their probability)
𝒏
𝒓̂ = ∑(𝒓𝒋 . 𝒑𝒋 )
𝒋=𝟏
o RISK
o Risk
▪ Risk ➔ Potential variability of returns
▪ Risk-free returns are known with certainty (risk = 0)
▪ Standard deviation (σ)➔ Measure of risk
𝒏
𝝈 = √∑ (𝒓𝒋 − 𝒓̂)𝟐 . 𝒑𝒋
𝒋=𝟏
o Probability distribution of returns

▪ The flatter the curve, the riskier it is
o Risk of Loss
▪ If you want to calculate the probability of loss on an investment, need
calculate the Z-score and look in Z-table (i.e. Standard normal distribution)
• It will calculate probability left to the target score
• Here target score = 0% (as want to know probability of loss)
𝑻𝒂𝒓𝒈𝒆𝒕 𝒔𝒄𝒐𝒓𝒆 − 𝑬𝒙𝒑𝒆𝒄𝒕𝒆𝒅 𝒗𝒂𝒍𝒖𝒆

Z-score =
𝑺𝒕𝒂𝒏𝒅𝒂𝒓𝒅 𝒅𝒆𝒗𝒊𝒂𝒕𝒊𝒐𝒏
• If you get in Table V → 0.0985 means 9.85% probability of loss

o Coefficient of Variation
▪ Coefficient of Variation (υ) ➔ Relative measure of risk, measuring the risk
per unit of expected return
▪ Appropriate measure of risk when comparing 2 investment projects with
different expected returns
▪ Best stock has lowest coefficient of variation because gives you lesser risk per
unit of expected value
𝝈
υ=
𝒓̂
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o EXPECTED RETURN AND RISK OF PORTFOLIO

▪ Portfolio is a combination of different stocks
o Expected Return of Portfolio
▪ Weighted average of the expected returns of the individual stocks
▪ Weights (w) ➔ amount of money you invest in a stock divided by total
amount of money you invest 𝒏
▪ Weights have to sum to 1 𝒓̂𝒑 = ∑ 𝒘𝒊 . 𝒓̂𝒊
𝒋=𝟏
o Risk of a Portfolio
▪ The risk of the portfolio will depend on the risks of the different stocks
▪ But more important factor in risk of a portfolio is the way in which the stocks
move together ➔ Correlation coefficient (ρ) (btwn -1 and 1)
• ρ = 1 → Perfectly positively correlated
▪ If return of stock A goes up, then return of stock B will go up on same ratio
• ρ = -1 → Perfectly negatively correlated
• ρ = 0 → Zero correlation
o Risk Diversification
▪ As soon as the correlation coefficient is <1
→ You will have Risk Diversification
→ The lower, the more Risk Diversification
o Standard Deviation of a Portfolio
𝝈𝒑 = √𝒘𝟐𝑨 𝝈𝟐𝑨 + 𝒘𝟐𝑩 𝝈𝟐𝑩 + 𝟐𝒘𝑨 𝒘𝑩 𝝆𝑨𝑩 𝝈𝑨 𝝈𝑩
o Efficient portfolio’s
• When combining more than 2 stocks, the choice of all portfolio’s will not
Expected Return (𝒓̂𝒑 )(%)
be a line but will be a surface

(The surface is all possible portfolios you can make with all sorts of stocks)
• Each stock is a dot in the surface
▪ You are only interest in the stocks that lie on the blue line
Those are → Efficient portfolio’s
• Because when you want to make a portfolio with a certain expected
return, the less risky one, is the one on the blue line
Standard Deviation (𝝈𝒑 )(%)
o How much risk can you reduce by combining stocks?

▪ Theoretically you could reach 0 but that’s not real
• At one point, by adding stocks to your portfolio, the standard deviation
doesn’t go down anymore
▪ Total Risk = Market Risk + Specific Risk
• Market risk (Systematic) ➔ Part of standard deviation that you can’t get
away. Risk that are worldwide, and too which all companies are to some
extend exposed to (measured by the beta)
Sensitivity to general economic events
• Specific risk (Unsystematic) ➔ Risk that can be diversified away
▪ Different ways of diversifying your risk

• Diversifying across sectors
• Diversifying across countries
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o Measuring Market Risk (β)

▪ Measure of the sensitivity of a security’s or portoflio’s return to the market
portfolio return
• Typically broad stock index is taken as a proxy
(E.g. MSCI World, Basket of stocks of all over the world and from different sectors)
𝐂𝐨𝐯𝐚𝐫𝐢𝐚𝐧𝐜𝐞𝒋,𝒎
𝜷𝒋 =
𝐕𝐚𝐫𝐢𝐚𝐧𝐜𝐞𝐦
▪ Equivalent way to calculate the Beta → Calculate the Regression

• Slope of the Regression line = Beta
▪ If Beta = 1.5
→ means that on average, return of market portfolio goes up by 1%
→ Return on average of your portfolio will go up by 1,5%
▪ Can find the Beta’s on “Yahoo Finance” for example
▪ If you expect the future economy will go down, you want to lower your β
• Called Portfolio strategy “Beta Timing”
o CAPITAL ASSET PRICING MODEL (CAPM)

o CAPM ➔ Model that links risk with expected return
▪ Risk premium is now quantified (𝜷𝒋 (𝒓̂𝒎 − 𝒓̂𝒇 ))
• 𝜷𝒋 → Measure for Market Risk
• 𝒓̂𝒎 − 𝒓̂𝒇 → Market Risk Premium ➔ Reward for taking a risk
➔ Expected return you get on financial market for taking a market risk
▪ On financial markets, you only get rewarded by expected reward by taking
up market risk. Not Specific risk
▪ Because you can easily get rid of specific risk with diversification
𝒌𝒋 = 𝒓̂𝒇 + 𝜷𝒋 (𝒓̂𝒎 − 𝒓̂𝒇 )
▪ Security Market Line (SML)

• Graphical representation of CAPM
▪ Can be used to estimate expected return on a stock of any company not just
on mature companies (as in Chap 7)
15
❖ Capital Budgeting and Cash Flow Analysis (Chap 9)

o A. CLASSIFYING INVESTMENT PROJECTS
o Reason why we invest (Investment projects can be generated by) :
1. Growth opportunities (asset expansion projects)
• Buying a new building, sell more goods, produce more, etc
2. Cost Reduction opportunities (asset replacement projects)
• Replace an old machine with a new more efficient one
3. To meet legal requirements and/or health and safety standards
• Investment in pollution control equipment
o Within each opportunity classification different types of projects exist :
1. Independent
• Acceptance or rejection has no effect on other projects
E.g. Replacement of computer system and building a new factory
2. Mutually exclusive
• Acceptance of one automatically rejects the others (you have to choose)
E.g. Implementation of ERP system by SAP or Oracle
3. Contingent
• Acceptance of one is dependent upon the selection of another
E.g. Building factory in a remote area, requires investments in roads and
facilities for employees
o B. BASIC FRAMEWORK FOR CAPITAL BUDGETING

o Simplified Capital Budgeting Model
▪ Y-axis
• IOC (Investment Opportunity Curve) ➔ Expected return
Projects are sorted by expected return
• MCC (Marginal Cost of Capital) ➔ Minimal required return by investors
▪ X-axis
• Amount of money needed for investment projects
• Can also be seen as how much money investors are ready to invest
• IOC > MCC ➔ Acceptable project (Value creating project)
• IOC < MCC ➔ Unacceptable project
o What if available investment funds are too low to invest in all acceptable projects ?
➔ Capital Rationing or Funds Constraint
▪ Search for another combination of projects (E.g. A+B+C+E if only 7M)
▪ Attempt to relax the funds constraint (Trying to get more money)
▪ Excess funds (Use the excess for something else)
• Invest in ST securities
• Reduce outstanding debt
• C/S dividends
o Capital Budgeting Problems/Difficulties
▪ All projects may not be known at one time
▪ Changing market/New technologies/Strategies, this graph can get obsolete
▪ Hard to determine behaviour of MCC
▪ Varying degrees of uncertainty of expected returns and CFs
16
o C. ESTIMATING CASH FLOWS FOR CAPITAL BUDGETING

▪ Typical CF stream for an investment project
o 2 Rules
▪ On an incremental basis (Δ)
• Include indirect effects
E.g. Launch of PS5 has impact on sales of PS4
• Exclude sunk costs
E.g. R&D
• Include opportunity costs of resources
E.g. Rent income or market value of owned building
▪ On an after-tax basis
o Estimating the Net Investment (NINV)

▪ STEP 1 → Cost plus installation and shipping
+
▪ STEP 2 → Increases in initial net working capital
(current assets – current liabilities)
-
▪ STEP 3 → Net proceeds from sale of existing assets (E.g. Selling old machine)
+/-
▪ STEP 4 → Taxes associated with the above sale
=
NINV
• 3 Possibilities for STEP 4
▪ NINV for a multiple-period investment

• You will have to calculate the Present Value of the series of outlays
discounted at the cost of capital (Chap 12)
o Computing Net Cash Flows (NCF)
𝑵𝑪𝑭 = (∆𝑹 − ∆𝑶 − ∆𝑫𝒆𝒑)(𝟏 − 𝑻) + ∆𝑫𝒆𝒑 − ∆𝑵𝑾𝑪
ΔOEAT (operating earnings after tax)

▪ ΔR ➔ Revenues : sales, …
▪ ΔO ➔ Operating costs : costs of goods sold, wages and salaries, …
• INCLUDE opportunity costs and indirect effects
• EXCLUDE sunk costs
• EXCLUDE interest expenses = financial cost (included in cost of capital Chap 12)
▪ ΔDep ➔ Depreciation : installed cost divided by # years of depreciation
▪ T ➔ Tax: marginal tax rate
▪ ΔNWC ➔ Net Working Capital : Cash, inventory,
Accounts Receivable (A/R) – Accounts Payable (A/P)
o End of project : have to also consider
▪ Proceeds from sale of asset (incl. tax)
▪ Recovery of net working capital
• Generally no tax consequences associated with recovery of NCW
• Resulting decrease in NWC represents increase in NCF
17
❖ Capital Budgeting: Decision Criteria and Real Option Considerations (Chap 10)
o CAPITAL BUDGETING CRITERIA
▪ 4 important capital budgeting criteria
▪ Used to evaluate quality of an investment project
o Payback Period (PB)
▪ How many years it takes before the cumulative net cash flows (NCF) “pays
back” the net investment (NINV)
• If annual NCF is constant
𝑵𝑰𝑵𝑽
𝑷𝑩 =
𝑨𝒏𝒏𝒖𝒂𝒍 𝑵𝑪𝑭
• If annual NCF is not constant
▪ Subtract 1st annual NCF to NINV and count 1 and then continue until
Annual NCF > Remaining NINV (you will then add to your count the
division of Annual NCF / Remaining NINV)
▪ Characteristics of PB
• Advantage
▪ Simple to calculate and to understand
• Disadvantages
▪ Ignores CFs after the Payback period
▪ Ignores the time value of money
→ May lead to decisions that do not maximize shareholder wealth
o Net Present Value (NPV)
▪ Criteria that leads to good decisions
▪ NPV is estimation of wealth that investment project creates for stockholders
▪ Present value of NCF minus NINV
𝒏
𝑵𝑪𝑭𝒕
𝑵𝑷𝑽 = 𝑷𝑽𝑵𝑪𝑭 − 𝑵𝑰𝑵𝑽 𝑵𝑷𝑽 = ∑ − 𝑵𝑰𝑵𝑽
(𝟏 + 𝒌)𝒕
𝒕=𝟏
• k ➔ Cost of capital (required return)
▪ NPV ≥ O → acceptable project
• Positive NPVs increase owner’s wealth
• Negative NPVs decrease owner’s wealth
o Internal Rate of Return (IRR)
▪ Expected return of the project (IOC in Chap 9)
▪ Discount rate that equates NINV to the PV of NCFs
𝒏
𝑵𝑪𝑭𝒕
𝑵𝑰𝑵𝑽 = ∑
(𝟏 + 𝑰𝑹𝑹)𝒕
𝒕=𝟏
▪ Discount rate for which the NPV is zero
𝒏
𝑵𝑪𝑭𝒕
𝑵𝑷𝑽 = ∑ − 𝑵𝑰𝑵𝑽 = 𝟎
(𝟏 + 𝑰𝑹𝑹)𝒕
𝒕=𝟏
▪ Characteristics of IRR
• IRR ≥ k → Acceptable project
IRR ≥ k ↔ NPV ≥ 0 (/!\ they never disagree if project is acceptable or not)
• 2 pitfalls with IRR
▪ NCF pattern with also negative NCFs can result in multiple IRRs
▪ NPV and IRR can disagree on which is best for mutually exclusive projects
➔ NPV is preferred
18
o Profitability Index (PI)

▪ PI is relative measure showing wealth creation per dollar investment
▪ Ratio of the PV of NCF divided by NINV
𝑵𝑪𝑭𝒕
∑𝒏𝒕=𝟏
𝑷𝑽𝑵𝑪𝑭 (𝟏 + 𝒌)𝒕
𝑷𝑰 = 𝑷𝑰 =
𝑵𝑰𝑵𝑽 𝑵𝑰𝑵𝑽
▪ Characteristics of PI
• PI ≥ 1 → Acceptable project
• IRR ≥ k ↔ NPV ≥ 0 ↔ PI ≥ 1
• Pitfall
▪ NPV and PI can disagree on which is best for mutually exclusive projects
➔ No capital rationing → NPV is preferred
➔ Capital rationing → PI is preferred
o Capital Budgeting Under Capital Rationing
1. Calculate PI for projects
2. Order projects from highest to lowest PI
3. Accept projects with highest PI until entire capital budget is spent
• If budget cannot be spent entirely bc next acceptable project is too large?
→ Chap 9
o REAL OPTIONS IN CAPITAL BUDGETING

▪ When calculating NPV, you also try to consider certain flexibilities of project
▪ The flexibilities also create value
o Investment timing option
➔ Delaying, to evaluate addition information
E.g. Investing now or next year
o Abandonment option
➔ Permanent ability to stop project, to avoid negative cash flows
E.g. When production costs rise due to rising oil price (→ SEE SLIDE 15)
o Shutdown options
➔ Temporarily ability to stop project, to avoid negative cash flows
o Growth options
➔ Second-stage investment, to generate large positive cash flows
E.g. First-stage R&D investment
o Design-in options
➔ Input/Output or expansion flexibility
E.g. NGCC power plant, multiple car manufacturing, overcapacity
o MUTUALLY EXCLUSIVE PROJECTS HAVING UNEQUAL LIVES

▪ If have to choose between mutually exclusive projects with unequal lives
▪ Example slide 16
• Project B may look more interesting, but have to consider the time taken
to create the value
→ can do twice project A so at the end it is preferred
o Methods to equate project lives
▪ Continue replacement chain of shorter life project till the life of longer
project is reached
▪ Transform NINV-NCF chain into equivalent (same NPV) annual annuity
𝑵𝑷𝑽 = 𝑨𝒏𝒏𝒖𝒊𝒕𝒚 × 𝑷𝑽𝑰𝑭𝑨𝒌, 𝒏
➔ Equivalent annual annuity can be viewed as equivalent annual cash flow

from investment project’s replacement chain
19
❖ The Cost of Capital (Chap 12)

o COST OF CAPITAL
▪ ➔ Minimum required return of the investors for an investment project
▪ Used for investment analysis or capital budgeting in:
• IRR analysis (Chap 9, slide 6 & Chap 10, slide 10)
• NPV analysis (Chap 10, slide 7)
▪ Consists out of different component costs (each type of investor has its own
cost of capital or required return)
• Equity investors → cost of equity capital, 𝐤 𝐞
• Preferred stock investors → cost of preferred stock capital, 𝐤 𝐩
• Debt investors → cost of debt capital, 𝐤 𝐢
o CALCULATING THE COMPONENT COSTS

▪ In general, they are calculated as the expected return of the component securities
o Cost of equity capital → Expected return of equity
▪ Cost of internal equity capital (internal financing with retained earnings (R/E))
𝑫𝟏
• 𝐤𝐞 = +𝒈 using constant dividend growth
𝑷𝟎
(next dividend / current stock price + growth rate)
• 𝐤 𝐞 = 𝒓𝒇 + 𝜷𝒋 (𝒓𝒎 − 𝒓𝒇 ) using CAPM
▪ Cost of external equity capital (external financing with issue of new shares)
𝑫𝟏
• 𝐤′𝐞 = +𝒈 where 𝑷𝒏𝒆𝒕 = 𝑷𝟎 − 𝑰𝒔𝒔𝒖𝒊𝒏𝒈 𝒄𝒐𝒔𝒕𝒔 𝒑𝒆𝒓 𝒔𝒉𝒂𝒓𝒆
𝑷𝒏𝒆𝒕
• Cost of external equity capital > Cost of internal equity capital
because you have more costs with external equity
o Cost of preferred stock capital → Expected return of preferred stock
𝑫𝒑
• 𝐤𝐩 = where 𝑷𝒏𝒆𝒕 = 𝑷𝟎 − 𝑰𝒔𝒔𝒖𝒊𝒏𝒈 𝒄𝒐𝒔𝒕𝒔 𝒑𝒆𝒓 𝒔𝒉𝒂𝒓𝒆
𝑷𝒏𝒆𝒕
o Cost of debt capital → Expected return of debt
• → Yield-to-maturity on bonds OR interest payment (%) on bank loan (𝒌𝒅 )
• But interest payments are tax deductible, so the cost of debt capital
should be calculated as an after-tax cost of debt
• 𝐤 𝐢 = 𝒌𝒅 (𝟏 − 𝑻) where 𝒌𝒅 = 𝑷𝒓𝒆𝒕𝒂𝒙 𝒄𝒐𝒔𝒕 𝒐𝒇 𝒅𝒆𝒃𝒕
And 𝑻 = 𝑻𝒂𝒙 𝒓𝒂𝒕𝒆
• When increasing the capital budget the firm goes from cheaper smaller
loans to more expensive bigger loans or bonds
o COST OF CAPITAL IS A “Weighted Average”

▪ Combine the 3 components by calculating a weighted average and get WACC
𝑬 𝑩 𝑷𝒇
𝒌𝒂 = (𝒌𝒆 ) + (𝒌𝒊 ) + (𝒌 )
𝑬 + 𝑩 + 𝑷𝒇 𝑬 + 𝑩 + 𝑷𝒇 𝑬 + 𝑩 + 𝑷𝒇 𝒑
▪ Weights should not reflect how the investment project is financed but, how
the company is financed → its capital structure
▪ Weights should reflect market values NOT book values
→ Nevertheless book values can be used if market values not available or too volatile
• 𝑬 = 𝑆𝑡𝑜𝑐𝑘 𝑝𝑟𝑖𝑐𝑒 × 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑠𝑡𝑜𝑐𝑘𝑠
• 𝑩 = 𝐵𝑜𝑛𝑑 𝑝𝑟𝑖𝑐𝑒 × 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑏𝑜𝑛𝑑𝑠 + 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 𝐿𝑇𝑏𝑎𝑛𝑘 𝑙𝑜𝑎𝑛𝑠
CHECK BEFORE STUDY
B only includes LT debt (bonds and LT-bank loans) NOT working capital
• 𝑷𝒇 = 𝑃𝑟𝑒𝑓𝑒𝑟𝑟𝑒𝑑 𝑠𝑡𝑜𝑐𝑘 𝑝𝑟𝑖𝑐𝑒 × 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑝𝑟𝑒𝑓𝑒𝑟𝑟𝑒𝑑 𝑠𝑡𝑜𝑐𝑘𝑠
20
o CALCULATING
▪ Calculating the MCC or WACC schedule example
o Step 1: Calculate the different component costs and their weights
o Step 2: Compute the MCC or WACC for each increase of the capital budget
1. Calculate the breaking points → Capital budget levels (combining all components)
where the low-cost component is exhauster and higher-cost component is required
𝑨𝒎𝒐𝒖𝒏𝒕 𝒐𝒇 𝒍𝒐𝒘𝒄𝒐𝒔𝒕 𝒄𝒐𝒎𝒑𝒐𝒏𝒆𝒏𝒕 𝒂𝒗𝒂𝒊𝒍𝒂𝒃𝒍𝒆
X=
𝑪𝒐𝒎𝒑𝒐𝒏𝒆𝒏𝒕 𝒇𝒓𝒂𝒄𝒕𝒊𝒐𝒏 𝒊𝒏 𝒄𝒂𝒑𝒊𝒕𝒂𝒍 𝒔𝒕𝒓𝒖𝒄𝒕𝒖𝒓𝒆
2. Calculate the MCC or WACC for each increment of the capital budget
21
❖ Capital Budgeting and Risk (Chap 11)

o RISK-ADJUSTED DISCOUNT RATE (RADR)
▪ Very similar to the WACC but based on the project not on the company
▪ IRR and NPV analysis of an investment project should reflect the riskiness of
the project
→ the 𝒌𝒂 = 𝑊𝐴𝐶𝐶 should be adjusted for project risk
→ 𝑹𝑨𝑫𝑹 = 𝒌∗𝒂 = 𝑾𝑨𝑪𝑪∗ (𝒌∗𝒂 = 𝒌𝒂 of the project not the company)
𝑬 𝑩 𝑷𝒇
𝒌∗𝒂 = 𝑾𝑨𝑪𝑪∗ = (𝒌∗𝒆 ) + (𝒌𝒊 ) + (𝒌 )
𝑬 + 𝑩 + 𝑷𝒇 𝑬 + 𝑩 + 𝑷𝒇 𝑬 + 𝑩 + 𝑷𝒇 𝒑
 𝒌𝒂 ➔ Company Cost of Capital • The only difference btw the WACC and the RADR ;
(= WACC) By applying the CAPM to calculate the cost of equity capital you need to
 𝒌∗𝒂 ➔ Project Cost of Capital use the Beta of the project instead of the Beta of the Company
(= RADR) 𝒌∗𝒆 = 𝒓𝒇 + 𝜷𝒑𝒓𝒐𝒋𝒆𝒄𝒕 (𝒓𝒎 − 𝒓𝒇 )
o Why it is important to use the RADR rather than the WACC ?

• In this example we will assume that we have a company that is financed
only by equity so 𝒌𝒂 = 𝒌𝒆
• Security Market Line is the graphical representation of CAPM (SML)
▪ Using 𝒌𝒂 for all investment projects will result in 2 types of errors

Because
• Error Type I → Rejecting low-risk projects that should be accepted
• Error Type II → Accepting high-risk projects that should be rejected
▪ So, you should use RADR

Type of project Project risk RADR vs WACC
Cost improvement LOW 𝒌∗𝒂 < 𝒌𝒂
projects project risk < company risk
Expansion of existing TYPICAL 𝒌∗𝒂 = 𝒌𝒂
business project risk = company risk
Speculative ventures HIGH 𝒌∗𝒂 > 𝒌𝒂
project risk > company risk
o CALCULATING APPROPRIATE PROJECT BETA

▪ Project beta can be observed as the company beta of a company for which the
existing business is similar the investment project
▪ BUT, observed company beta reflects both the operational risk (existing business and
to the investment project), but also the financial risk (capital structure of the
observed company)
→ Replace financial risk from observed company by the investing company’s own
22
1. Convert Leveraged Beta (𝜷𝒐𝒃𝒔

𝒍 ) → Unleveraged Beta (𝜷𝒖 )
▪ 𝑻𝒐𝒃𝒔 ➔ Tax Rate
 𝜷𝒍 ➔ With financial risk ▪ (𝑩⁄𝑬)𝒐𝒃𝒔 ➔ Debt Equity Ratio (market value of debt/equity)
 𝜷𝒖 ➔ No financial risk
𝜷𝒐𝒃𝒔
𝒍
𝜷𝒖 =
𝟏 + (𝟏 − 𝑻𝒐𝒃𝒔 )(𝑩⁄𝑬)𝒐𝒃𝒔
2. Calculate leveraged project beta (𝜷𝒍 ) to reflect financial risk of investing company
𝜷𝒍 = 𝜷𝒖 [𝟏 + (𝟏 − 𝑻𝒊𝒏𝒗 )(𝑩⁄𝑬)𝒊𝒏𝒗 ]
o WHEN AND HOW CONSIDER TOTAL RISK ?

• Total risk = Market risk (systematic risk) + Specific risk (unsystematic risk)
▪ IRR and NPV analysis only adjust for the market risk, via the beta
▪ But sometimes Specific risk matters
• For investors that do not or cannot diversify (owners of small firms or
employees)
• When firm failure (due to dramatic firm-specific event) results in negative
social effects (E.g. Bank failure, infrastructure failure, healthcare failure)
▪ Techniques that consider Total Risk (WPO)
• NPV-Payback approach
• Simulation approach
• Scenario analysis
• Sensitivity analysis
• Certainty equivalent
o NPV-Payback approach
▪ Accept project if NPV > 0 and payback period less than critical nbr of years
• The longer the payback period
→ The higher the probability of a firm-specific project failure
o Simulation approach
▪ Make simulation (Left)
▪ Then try to calculate what is the probability NPV is negative (Z-score) (Right)
o Scenario analysis
▪ Will consider impact of simultaneous changes in input variables on the
acceptability of an investment project
1. Define different scenarios based on simultaneous values of input variables
(optimistic, pessimistic and a most likely scenario)
2. Estimate the probability of each scenario
3. Compute NPV under each scenario
4. Compute expected NPV
5. Compute standard deviation of the NPV
6. Compute z-score and associated probability of failure
23
o Sensitivity analysis
▪ Identifying key variables by changing systematically each input variable
separately to identify which input has the most impact on NPV
▪ Putting additional efforts in the estimation and/or improvement of key
variables
24
❖ Capital Structure Management (Chap 14)

o INCOME STATEMENT
o Traditional income statement
▪ Operating costs ➔ Cost of sales (selling, general, administrative expenses)
▪ Sales – Operating costs = Operational result
→ Earnings Before Interest and Taxes (EBIT)
▪ Interest expenses ➔ Costs related to your debts

▪ EBIT – Interest – Taxes = Earnings After Taxes (EAT)
▪ If also financed with preferred stock
→ Also have to subtract the promised dividend to preferred stockholders
▪ Earnings available to common stockholders / Nbr of shares

→ Earnings per share (EPS)
o Revised income statement
▪ Divide operating leverage (costs) between:
• Variable operating costs
• Fixed operating costs
▪ Financial leverage
• Fixed capital costs
o OPERATING LEVERAGE
▪ Operating leverage ➔ Relative amount of fixed operating costs in your
production cost structure (%)
▪ With operating leverage you have higher fixed costs
• Capital-intensive VS Labour-intensive production
• Permanent VS Temporary labour contracts
• Fixed salary VS Sales commission
o Example
▪ Operating leverage is tied to the cost structure (use of fixed operating costs
such that a change in sales is magnified into a relatively larger change in EBIT)
▪ Operating leverage may increase the expected EBIT
BUT
Also increases the variability of the EBIT
25
o FINANCIAL LEVERAGE
▪ Financial leverage ➔ Relative amount of fixed financial costs in your
financial cost structure (%)
▪ With financial leverage you have more debt and preferred equity
• Debt and preferred equity VS Common equity financing
o Example
▪ Financial leverage is tied to the capital structure (use of fixed financial costs
such that a change in EBIT is magnified into a relatively larger change in EPS)
▪ Financial leverage may increase the expected EPS
BUT
Also increases the variability of the EPS
o WHY SHOULD WE CARE ABOUT OPERATING AND FINANCIAL LEVERAGE?

▪ Firm’s operating and financial leverage has an impact on, respectively, firm’s
business risk (variability of EBIT) and financial risk (variability of EPS +
probability of insolvency)
▪ So by managing firm’s operating and financial leverage, can influence
business and financial risk of the firm
▪ The greater is a firm’s business risk → The less the amount of financial
leverage that will be used in optimal capital structure
▪ Other examples
• During certain times (high business risk), your firm may prefer temporary
over permanent labor contracts (→ level down operating leverage)
• Mature, stable and diversified firms (low business risk), can take on more
debt (→ level up financial leverage) at a reasonable cost of debt
o HOW TO MEASURE OPERATING AND FINANCIAL LEVERAGE?

▪ Useful to compare with peers and over time (and if needed act)
% Δ Sales
DOL
DCL % Δ EBIT
DFL
% Δ EPS
o Degree of Operating Leverage (DOL)
▪ DOL = 2 → If sales go up or down by 1%, EBIT will go up or down by 2%
o Degree of Financial Leverage (DFL)

▪ DFL = 2 → If EBIT goes up or down by 1%, EPS will go up or down by 2%
o Degree of Combined Leverage (DCL)

▪ DCL = 4 → EPS will go up and down by 4% for each unit change in sales
26
o EBIT-EPS ANALYSIS
▪ Helps us to choose how to finance your company (choose financial structure)
▪ 2 important lines
• Blue line ➔ Company 100% financed by equity (common stock)
• Green line ➔ Company partly using debt financing
▪ Starts below 0, because whatever happens still have to pay your debts
▪ Steeper, because of the effect of financial leverage
▪ 2 important points
• Loss point ➔ Where there is no loss or gain
▪ Loss point = Required interest payment
• Indifference point ➔ Where equity capital structure equally as good as
financial leveraged structure
o How to calculate the indifference point?
▪ Determine level of EBIT where EPS would be identical under either structure
• 𝑰𝒅 ➔ Interest payment under debt financing alternative
• 𝑵𝒅 ➔ Number of shares under debt financing alternative
• 𝑰𝒆 ➔ Interest payment under equity financing alternative
• 𝑵𝒆 ➔ Number of shares under equity financing alternative
• 𝑫𝒑 ➔ Preferred dividend
𝑬𝑷𝑺 (𝒇𝒐𝒓 𝒅𝒆𝒃𝒕 𝒇𝒊𝒏𝒂𝒏𝒄𝒊𝒏𝒈) = 𝑬𝑷𝑺 (𝒇𝒐𝒓 𝒆𝒒𝒖𝒊𝒕𝒚 𝒇𝒊𝒏𝒂𝒏𝒄𝒊𝒏𝒈)
(𝑬𝑩𝑰𝑻 − 𝑰𝒅 )(𝟏 − 𝑻) − 𝑫𝒑 (𝑬𝑩𝑰𝑻 − 𝑰𝒆 )(𝟏 − 𝑻) − 𝑫𝒑

=
𝑵𝒅 𝑵𝒆
o Need to probability distribution of EBIT

→ Riskiness of debt- and equity financing alternatives or capital structure
1. Estimate the expected value and variability of EBIT (via simulation or scenario analysis)
2. Estimate the probability that EBIT will be below indifference point (z-score)
3. Estimate the probability that EBIT will be below the required interest payments 𝑰𝒅 or
𝑰𝒆 = loss point (z-score)
27
➔ EBIT-EPS Analysis is a technique to compare the riskiness of debt- and equity

financing alternatives or capital structure, and helps with the decision-making
with respect to the financing investments and optimal capital structure
28
❖ Real Estate Finance (Guest Lecture)

▪ Real Estate is one of the 3 main asset classes (+ Equities and Fixed income)
o REAL ESTATE VALUATION METHODS
o Discount Cash Flow method (DCF)
▪ Investors buy real estate because they expect that the property is going to
generate future cash flows
▪ In real estate, there are 2 types of cash flows
• Net Operating Income (NOI) ➔ cash flow from operations (rent paid by
tenants)
• Terminal Value (TV) ➔ Cash flow from sale of the asset at the end of
holding period
▪ DCF formula 𝒏
𝑵𝑶𝑰 𝑻𝑽
𝑷𝟎 = ∑ 𝒕
+
(𝟏 + 𝒌𝒓 ) (𝟏 + 𝒌𝒓 )𝒏
𝒕=𝟏
• 𝑷𝟎 ➔ Price/value of the property in year 0

• 𝑵𝑶𝑰 ➔ Net Operating Income
• 𝑻𝑽 ➔ Terminal Value
• 𝑲𝒓 ➔ Required rate of return (discount rate) (= average return that investors
earn on similar properties with same risk over full investment period)
▪ Example
• If cash flows are constant, can use PVIFA (annuity)

• Normally, before you can discount all cash flows to the present, you must:
▪ Forecast the expected future cash flows (NOI + TV)
▪ Determine the required rate of return (𝑲𝒓 )
▪ Calculating NOI
▪ Operating costs → property taxes, insurance, cleaning, advertising

But NEVER include capital expenses or depreciation
o Direct Capitalization method (Cap rate)

• Faster method than DCF
BUT
Less precise + doesn’t take time value of money into account
▪ Another way to calculate the price of a property is by using cap rate
▪ Cap rate indicates how long it will take to recover the amount invested in a
property. (E.g. Cap rate = 10%, will take around 10 years for recovering investment)
▪ 𝑪𝒂𝒑 𝒓𝒂𝒕𝒆 ≠ 𝑲𝒓 used in DCF
29
o REAL ESTATE MARKET

▪ Composed of 3 markets
▪ All markets are translated into the “4-Quadrant Model” which shows how they
interact
o Tenant Market (➔ Market for the use of space in properties)
o Investment Market (➔ Market for the exchange of ownership of properties)

▪ Translates market rent (𝑹𝟎 ) into a price (𝑷) investors are willing to pay for properties
• The higher the market rent → The more investors are willing to pay
▪ Slope depends on the attractiveness of RE relative to other asset classes
o Development Market (➔ Market where new properties are developed)

▪ P determines whether it is profitable to start new developments or not
▪ The higher the P → The higher chance that constructions are profitable
→ Higher number of new constructions
• If P > CC → Profitable AND If P < CC → Not profitable
30
o Real Estate Supply

▪ RE supply is influenced by 2 opposing forces
• New developments → Shifting supply to the right
• Outdated buildings → Shifting supply to the left
▪ Net effect determines the impact on RE supply
• Current stock = Stock last year + Nbr of new dvlpmts – Outdated stocks
• If Nbr of new dvlpmts = Nbr of outdated buildings → RE supply is constant
o EXTERNAL SHOCKS IN 4 QUADRANT MODEL

1. Economic growth
▪ Acceleration of economic growth
(companies search for additional office space, households search for bigger houses, etc)
➢ Demand curve shifts to the right
➢ Supply stays constant (inelastic)
➢ Increase in demand leads to substantial increase in the market Rent to R1
➢ Raises the price investors are willing to pay to P1
➢ More profitable for development industry to start new constructions
➢ Once complete, new developments are added to the RE stock (new level Q1)
➢ Process continues until all markets find a new equilibrium
▪ Equilibrium are at lower levels than immediately after the shock

➢ Market first overreacts and then falls
slightly back to new equilibrium levels
➢ Adjustment mechanism after a shock
shows a cyclical pattern
2. Shift in preferences (SR impact)

▪ QE program ECB (bond purchase program) to stimulate economy
→ Drop in bond yields
➢ Bond investors start looking for more attractive investments, such as RE
➢ Investment curve rotates downwards
➢ Demand for RE investments increased
➢ Investors are willing to pay more for same market rent/property
31
3. Increase in registration fees (SR impact)

▪ Makes it more expensive to build new properties for developers
➢ Curve shifts to the left (require a higher price for new constructions)
➢ Less development activity reduces RE supply after some time, leading to
higher rents and higher valuations
32

Corporate Finance - Summary FK

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Frédéric Kröger Corporate Finance – Summary

Corporate Finance – Summary

❖ Role and Objective of Financial Management (Chap 1)

o FIRM’S CASH FLOW GENERATION PROCESS (within a company)

▪ To start a company you need funds

GaS ➔ Goods and Services

Engine of the Company

o SHAREHOLDER WEALTH MAXIMIZING

▪ Management incentives (stock options)

o SAMPLE ORGANIZATION CHART

❖ Time Value of Money (Chap 5)

o Compound Interest ➔ Interest paid on the principal and on prior interest

▪ (1 + i)n is Future Value Interest Factor (FVIFi,n ) can be found in Table I

o PRESENT VALUE OF A CASH FLOW

o INTEREST COMPOUNDED MORE THAN ONE PER YEAR

▪ Future Value of an Ordinary Annuity

▪ Present Value of an Ordinary Annuity

▪ Present Value of a Perpetuity

▪ Future Value of an Annuity Due

▪ Present Value of an Annuity Due

❖ Bonds – Characteristics (Chap 6)

o PREFERRED STOCK (P/S)

❖ Bonds – Valuation (Chap 6)

o Coupon rate (𝐢) ≠ Discount rate (𝐤 𝐝 )

❖ Common Stock: Characteristics & Valuation (Chap 7)

o General Dividend Valuation Model

❖ Analysis of Risk and Return: Conceptual relationships (Chap 8.1)

o RISK FREE RETURN

o SOURCES OF THE RISK PREMIUM

o Maturity risk premium

• LT bonds have higher maturity risk premium

▪ 3 complementary theories explaining this:

• E.g. LT-bonds in 2012

o Default risk premium

o Seniority risk premium (Chap 6)

o Marketability risk premium

o RISK-EXPECTED RETURN RELATIONSHIP

❖ Analysis of Risk and Return: Mathematics (Chap 8.2)

o Probability distribution of returns

𝑻𝒂𝒓𝒈𝒆𝒕 𝒔𝒄𝒐𝒓𝒆 − 𝑬𝒙𝒑𝒆𝒄𝒕𝒆𝒅 𝒗𝒂𝒍𝒖𝒆

• If you get in Table V → 0.0985 means 9.85% probability of loss

o EXPECTED RETURN AND RISK OF PORTFOLIO

o Standard Deviation of a Portfolio

𝝈𝒑 = √𝒘𝟐𝑨 𝝈𝟐𝑨 + 𝒘𝟐𝑩 𝝈𝟐𝑩 + 𝟐𝒘𝑨 𝒘𝑩 𝝆𝑨𝑩 𝝈𝑨 𝝈𝑩

be a line but will be a surface

o How much risk can you reduce by combining stocks?

▪ Different ways of diversifying your risk

o Measuring Market Risk (β)

▪ Equivalent way to calculate the Beta → Calculate the Regression

o CAPITAL ASSET PRICING MODEL (CAPM)

𝒌𝒋 = 𝒓̂𝒇 + 𝜷𝒋 (𝒓̂𝒎 − 𝒓̂𝒇 )

▪ Security Market Line (SML)

❖ Capital Budgeting and Cash Flow Analysis (Chap 9)

o B. BASIC FRAMEWORK FOR CAPITAL BUDGETING

o C. ESTIMATING CASH FLOWS FOR CAPITAL BUDGETING

o Estimating the Net Investment (NINV)

▪ NINV for a multiple-period investment

ΔOEAT (operating earnings after tax)

o Profitability Index (PI)

o REAL OPTIONS IN CAPITAL BUDGETING

o MUTUALLY EXCLUSIVE PROJECTS HAVING UNEQUAL LIVES

𝑵𝑷𝑽 = 𝑨𝒏𝒏𝒖𝒊𝒕𝒚 × 𝑷𝑽𝑰𝑭𝑨𝒌, 𝒏

➔ Equivalent annual annuity can be viewed as equivalent annual cash flow