Corporate Finance Notes

Mikkel Østergaard Schrøder Corporate Finance (notes) Last updated: 21/03/2019
Corporate Finance
-The tools and analysis used to make informed financial decisions
Section Page
Topic 1 – Introduction 1
Topic 2 – The time value of money 3
Topic 3 – Valuing bonds and stocks 6
Topic 4 – Investment criteria 9
Topic 5 – Risk and return 11
Topic 6 – CAPM and efficient markets 12
Topic 7 – WACC 14
Topic 8 – Debt policy 16
Topic 9 – Payout policy 19
Topic 10 – Mergers and acquisitions 20
Topic 11 – International financial management 23
Topic 12 – Options 26
Topic 13 – Risk Management 28
Topic 1 – Introduction
Overall structure of the content:

Purpose of decisions: Maximize corporate value (this entails not just maximizing profits in one
year, but maximizing the company’s value in the long run). This is done through two separate
decisions; investment and financing.
Investment decision: What the company should invest in. Which assets; tangible assets
(machines, plants) or intangible assets (patents, brands)? Also called capital budgeting. This is
important since resources are finite and not all investments give the same return (opportunity cost
of capital – should one invest in projects inside the company (and which?) or in financial markets
(and which stocks or bonds?)).
Financing decision: How the company should raise money for its investments and operations.
What should be the mix (capital structure) of debt and equity (shares/stock) financing?
Cash flows in organizations:
Some general terms:

Book value: The historical cost of assets and liabilities adjusted for depreciation (usually not the
value we look at in corporate finance).
Market Value: The current value of assets and liabilities (usually the value we look at in corporate
finance because it is the value shareholders care about).
Profits: In corporate finance we record income and expenses at the time of sales, not at the time
of cash exchange (e.g. accounts receivable is considered money we already have). This also means
that depreciation is only used for tax purposes and then added back afterwards to the net income.
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On the cost side, this means that if we purchase a machine the full cost of the machine is
registered at the time of the purchase.
Cash Flows (CF): Money we get or pay at some point in time, e.g. negative cash flow from buying a
machine or a positive cash flow from making a profit.
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Topic 2 – The time value of money
Note for you who are reading through this chronologically:

Corporate finance might seem to have a lot of different formulas and things to remember, but it is
actually really simple once you understand it. You will come to see that everything we do is really
just doing the same thing in different situations. We always seek to find out what things are worth
today. Whether it is finding the stock price, valuing projects or deciding what bonds to buy, we
always just look at the cash flows we expect in the future and find out what they are worth today.
To understand why this is the case, we first start out by looking at the time value of money.
Time value of money:

Future value (FV): Investing money changes the value of the money over time. Because this effect
is often positive, we always want to receive money as soon as possible. What the money is worth
in the future depends on the present value of what you invest, PV, the interest rate, r, and the
time period, t. We take into consideration compound interest (interest on interest) and get the
following formula:
𝐹𝑉 = 𝑃𝑉 ∗ (1 + 𝑟)𝑡
Present value (PV): To evaluate how attractive getting a certain amount of money in the future is,
we can calculate backwards (discount) to find out how much the money is worth in terms of
todays money (i.e. how much we would have to invest today to get a certain amount of money in
the future). From the formula for FV, we can isolate PV and get that:
𝐹𝑉
𝑃𝑉 = = 𝐹𝑉 ∗ (1 + 𝑟)−𝑡
(1 + 𝑟)𝑡
Cash flows:
Present value of cash flows: If we want to find out what a series of cash flows in different years
are worth today, we simply discount each cash flow back to today with respect to the right
number of years, and sum them up in the end:
𝐶𝐹1 𝐶𝐹2 𝐶𝐹𝑡
𝑃𝑉 = + + ⋯ +
(1 + 𝑟)1 (1 + 𝑟)2 (1 + 𝑟)𝑡
Note: This is the “Mother of all formulas” for corporate finance. Almost everything we do will be
about finding the right cash flows and discount rate to put into this formula.
Perpetuity: A stream of equal cash flows that never end. A trick to finding out what this stream of
cash flows is worth today (year 0) is to simply divide the constant payment, C, (first payment is
expected one year from now) with the interest rate:
𝐶
𝑃𝑉 =
𝑟
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ATTENTION: note here that we assume that the first payment is one year from now. So, if an
exercise tells you that the first payment will happen in year 3, you use the formula, and then
discount the value of the perpetuity back 2 years (not 3) to find the present value.
If the stream of cash flows is growing at a constant rate, g, we can very easily take this into
account as well by just subtracting the growth rate from the interest rate:
𝐶
𝑃𝑉 =
𝑟−𝑔
Annuity: A stream of equal cash flows for a limited period of time. We could use the formula for
present value of cash flows for this, but it is often quicker to use the following formula. If we have
a constant cash flow, C, an interest rate, r, over a period of time, t, the present value of these cash
flows is:
1 1
𝑃𝑉 = 𝐶 [ − ]
𝑟 𝑟(1 + 𝑟)𝑡
If you need to find the future value, you simply just multiply the PV with (1+r) t.
Interest and inflation:

Annual Percentage Rate (APR): simple method of going from interest rate payed several times a
year to the yearly interest rate. If you get 3% twice a year, you get 6% per year.
Note: Do not use this method, since it does not take into account compounded interest. Use EAR.
Effective ANNUAL Interest Rate (EAR): method of going from interest rate payed several times a
year to the yearly interest rate taking into account compounded interest.
Examples:
Interest payed monthly: (1 + monthly rate)12 = 1 + EAR
Interest payed quarterly: (1 + quarterly rate)4 = 1 + EAR
Interest payed semiannually: (1 + semiannual rate)2 = 1 + EAR
Inflation: Rate at which prices as a whole change, 𝜋.
Nominal interest rate: rate at which money invested grow.
Real interest rate: rate at which money invested grow taking inflation into account.
1 + 𝑛𝑜𝑚𝑖𝑛𝑎𝑙 𝑖𝑛𝑡. 𝑟𝑎𝑡𝑒
1 + 𝑟𝑒𝑎𝑙 𝑖𝑛𝑡. 𝑟𝑎𝑡𝑒 =
1 + 𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛
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Real cash flow: If we take inflation into account, any given cash flow will have a different ‘real’
value in each year. The real cash flow, ct, at time t after removing the effect of inflation, 𝜋,
depends on the actual amount of money, Ct, received at time t:
𝐶𝑡
𝑐𝑡 =
(1 + 𝜋)𝑡
Note: only use real interest and real cash flows if the exercise mentions it explicitly. Otherwise you can just
assume that this has already been taken into account/ not necessary to take into account.
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Topic 3 – Valuing bonds and stocks

Now we got the fundamentals in place. All we’ll do from here on out is to simply apply the time
value of money to different situation. Sure, there will be some new terminology, but the overall
goal and formulas do not change, we still find out what future cash flows are worth today.
Bonds:
Bond: Tradeable financial asset (security) that obligates the issuer to make specified payments to
the bondholder.
Issue bond = borrow money
Buy bond = lend money
Face value (par value, principal value): Payment at maturity of the bond. In exercises in the book
“Fundamentals of Corporate Finance“, by Brealey, Myers and Marcus, 9th edition, International
Student Edition, this can be assumed to be 1000 if nothing else is stated.
Maturity date: The date where the face value is paid out as well as the last interest payment.
Coupons: Annual interest payment, as a percentage of face value.
Coupon rate: The percentage of the face value payed out as interest annually.
Bullet bond: face value is repaid in full at maturity date (not distributed over the lifetime of the
bond). This type of bond is the only one we work with and the only you can expect at exam.
Bond valuation:
Bond price: The value of all future cash flows from a bond. The mother of all formulas can be
translated in terms of a bullet bond:
𝑃𝑉 = 1
+ 2
+ ⋯+ →
(1 + 𝑟) (1 + 𝑟) (1 + 𝑟)𝑡
𝑐𝑝𝑛1 𝑐𝑝𝑛2 (𝑐𝑝𝑛 + 𝑓𝑎𝑐𝑒 𝑣𝑎𝑙𝑢𝑒)𝑡
𝑃𝑉 = 1
+ 2
+ ⋯+
(1 + 𝑟) (1 + 𝑟) (1 + 𝑟)𝑡
If the bond’s lifetime is long, it might be easier to calculate it as an annuity + the face value
discounted:
1 1 𝑓𝑎𝑐𝑒 𝑣𝑎𝑙𝑢𝑒
𝑃𝑉 = 𝑐𝑝𝑛 [ − ] +
𝑟 𝑟(1 + 𝑟)𝑡 (1 + 𝑟)𝑡
Note here that all we did was replacing C with the yearly coupon (cpn) in the annuity formula and
adding the additional face value we are paid in the end.
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Premium, on par and discount: If the coupon rate is higher than the market interest rate (discount
rate), it means the annual interest payment is larger than one would otherwise get in the market.
To justify this higher interest payment, the bond price will be higher, so that the overall earnings
from the bond is the same as in the rest of the market. In general, we can have three different
situations:
Coupon rate > Discount rate => Bond price > Face value => Selling at a premium
Coupon rate = Discount rate => Bond price = Face value => Selling at on par
Coupon rate < Discount rate => Bond price < Face value => Selling at a discount
Yield to maturity (YTM): the one and only discount rate that makes the price of the bond equal to
the present value of the bond. Since the discount rate (or interest rate) in the market can change
over time, we want to know what discount rate was used to price the bond. So, if we know the
price, coupons, face value and maturity date of the bond, we can use our formula to isolate r:
𝑐𝑝𝑛1 𝑐𝑝𝑛2 (𝑐𝑝𝑛 + 𝑓𝑎𝑐𝑒 𝑣𝑎𝑙𝑢𝑒)𝑡
𝑃𝑉 = 𝑝𝑟𝑖𝑐𝑒 = 1
+ 2
+ ⋯+
(1 + 𝑟) (1 + 𝑟) (1 + 𝑟)𝑡
In this case where PV = price, then r = YTM.
ATTENTION: isolating r will require Excel or an advanced calculator. This is not required for the
exam. In the exam you simply set up the formula, state that r should be isolated and that r = YTM.
However, if asked if a certain discount rate is the YTM, you can simply test it by inserting it in the
formula and see if it is equal to the bond price.
Bonds and risk:

Bond risk: Since the one that issued the bonds can get into financial difficulties or go bankrupt, in
which case the coupons and face value is no longer payed, there is a certain amount of risk to
buying bonds. This risk is reflected in the interest rate/coupon rate that the bond pays. A riskier
bond will pay more.
Government bonds: We assume that government bonds are risk-free, since governments very
rarely go bankrupt. Yield on risk-free bonds is the yield on government bonds.
Corporate Bonds: Corporations can get into financial difficulties and thus the interest rate they
pay out on their bonds is usually higher than that of government bonds.
Risk premium: The difference between yield on risk-free bonds and a given corporate bond, i.e.
the difference in their YTM.
Stocks:
Common stock (shares, equity): Ownership shares in a publicly held corporation. Often with
voting rights. Dividend not guaranteed.
Preferred stock: No voting rights, but guaranteed dividends (payed before common stock).
Dividend: Periodic cash distributions from the firm to the shareholders (not guaranteed in
contrast to interest rate payments).
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Expected return: If we expect a dividend as well as a certain price of the stock in a year from now,
our expected rate of return is:
𝐷𝐼𝑉1 + 𝑃1 − 𝑃0
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑒𝑡𝑢𝑟𝑛 = 𝑟 =
𝑃0
Where P0 is the current price of the stock and P1 is the price we expect in one year from now.
Stock valuation:
Stock price (dividend discount model (DDM)): The value of all future cash flows from a stock. The
mother of all formulas can be translated in terms of a stock:
𝑃𝑉 = 1
+ 2
+ ⋯+
(1 + 𝑟) (1 + 𝑟) (1 + 𝑟)𝑡
𝐷𝐼𝑉1 𝐷𝐼𝑉2 𝐷𝐼𝑉𝐻 + 𝑃𝐻
𝑃0 = 1
+ 2
+⋯+
(1 + 𝑟) (1 + 𝑟) (1 + 𝑟)𝐻
Where H is the investment horizon (number of years investors are expected to hold the stock) and
thus PH is the expected price of the stock at time H.
Gordon growth model: If dividends are expected to grow at a constant rate, g, forever we can
calculate the stock price in the same way we calculated the present value of a perpetuity:
𝐷𝐼𝑉1
𝑃0 =
𝑟−𝑔
Growth rate:
Payout ratio: Fraction of earnings paid out as dividends.
Plowback ratio: Fraction of earnings retained by the firm.
Return on equity (ROE): Under the assumption that a firm pays out all earnings (does not retain
anything), the return on an investor’s ownership is:
𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
𝑅𝑂𝐸 =
𝑒𝑞𝑢𝑖𝑡𝑦 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
Growth rate: The rate at which the firm grows and thus also the rate at which the dividends grow:
𝑔 = 𝑝𝑙𝑜𝑤𝑏𝑎𝑐𝑘 𝑟𝑎𝑡𝑖𝑜 ∗ 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑒𝑞𝑢𝑖𝑡𝑦
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Topic 4 – Investment criteria

Now that we understand how to value bonds and stocks we turn to projects. Again, it will be the
same thing as always; finding the present value of all future cash flows. If you’ve understood things
so far, I’m sure this topic will be piece of cake!
Projects:
Net present value (NPV): To evaluate whether an investment is a good decision we calculate the
present value of all cash flows in the project (both positive and negative). If the NPV is positive,
the project should be carried out. If it is negative it should not. If you can choose one of two
projects, choose the one with the highest NPV.
𝑁𝑃𝑉 = 𝐶0 + + + ⋯ +
(1 + 𝑟)1 (1 + 𝑟)2 (1 + 𝑟)𝑡
Where C0 are the initial cash flows required to start the project (often negative (investments
needed)). For the discount rate, r, opportunity cost of capital should be used, i.e. what is the
expected rate of return given up by investing in this project. For now, we will take it as a given.
Payback period: Time until cash flows recover the initial investment in the project. To find this,
simply sum up cash flows each year until the initial investment has been covered. If you invest
based on payback period, any cashflow (no matter how large) beyond the payback period is
disregarded.
Internal rate of return (IRR): The one and only discount rate that makes the PV of all future cash
flows equal to the initial investment (and thus gives NPV = 0). This is much like YTM.
0 = 𝐶0 + + + ⋯ + →
(1 + 𝐼𝑅𝑅)1 (1 + 𝐼𝑅𝑅)2 (1 + 𝐼𝑅𝑅)𝑡
−𝐶0 = 1
+ 2
+ ⋯+
(1 + 𝐼𝑅𝑅) (1 + 𝐼𝑅𝑅) (1 + 𝐼𝑅𝑅)𝑡
Think of IRR as the return obtained on the initial investment C0. So, if IRR is higher than your
opportunity cost of capital, you should invest in the project.
ATTENTION: like with YTM, isolating IRR will require Excel or an advanced calculator. This is not
required for the exam. In the exam you simply set up the formula and state that IRR should be
isolated.
Profitability index: Relates the value of the project to its costs. This is useful when you can choose
different combinations of projects:
𝑁𝑒𝑡 𝑝𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒
𝑃𝑟𝑜𝑓𝑖𝑡𝑎𝑏𝑖𝑙𝑖𝑡𝑦 𝑖𝑛𝑑𝑒𝑥 =
𝑖𝑛𝑖𝑡𝑖𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
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Project cashflows:
Cash flows to consider: When evaluating a project all cash flows directly related to this project
should be included.
-Include startup costs
-Include indirect effects (if we sell a new product, we might sell less of our old product)
-Include investment in working capital (if nothing else stated, this is freed up at the end of project)
-Include shutdown costs (e.g. if we were drilling for oil, we have to remove the drilling platform)
-Forget sunk costs (these are there whether or not we do the project)
Calculating operational cash flows: We need to find the operating cash flow each year from doing
a certain project. This we do by setting up the income statement. As mentioned in the very
beginning, we only consider expenses/profits when the cash flows actually occur. This means that
depreciation should not be considered a cash flow. However, for tax purposes we still need to
include this when calculating operating cash flow.
Revenue R
Expenses E
Depreciation D .
Profit (EBIT) P (= R - E - D)
Tax (x%) T (= P · x) .
Net profit NP (= P - T)
Operating cash flow = NP + D
Because depreciation is not an actual cash flow, we add it back and the final operating cash flow is
thus NP + D. This is the annual cash flow from doing the project. Add other cash flows such as
startup costs, working capital, shutdown costs etc. to the appropriate years and insert it all into
the NPV formula to find the NPV for the project.
Note: it might be very useful to draw a timeline to better keep track of when cash flows occur.
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Topic 5 – Risk and return

So now we’ve learnt to value bonds, stocks and projects, however, before we move on with
mergers and acquisitions, we need to take a step back and have a better look at how we discount
the cash flows. You probably remember that we discount cash flows using the return we could
otherwise get in the market. But what is the return in the market? And how is this related to risk?
Risk and return:

Risk: The chance the bond- /stock issuer will default (go bankrupt) or in another way not be able
to pay out what is owed. A general rule of thumb is that the riskier the stock or bond, the higher
will also be the return. This is simply to compensate for the higher risk. The additional return is
known as the risk premium. Common stocks are in general riskier than bonds, which are in general
riskier than treasury bills (government bonds).
Measuring risk: Risk is determined by past events. We expect a stock that has proven risky in the
past to also be risky in the future. Thus, risk is measured through statistics.
Variance: A measure of volatility. To find this we find the average return (mean) and calculate the
average difference for days in the past (standard deviation). To make sure that negative deviations
from the mean does not decrease the risk we square the deviations.
2 2
∑𝑁𝑖=1(𝑟𝑖 − 𝑟̅ )
2
𝑉𝑎𝑟𝑖𝑎𝑛𝑐𝑒 = 𝜎 = 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 (𝑟 − 𝑟̅ ) =
𝑁
I.e. if you have a number of values, find the average value, find out the difference between each
value and the average, put each of the differences to the power of 2 (square them), sum them up
and finally divide them by the number of values.
Standard deviation: Average deviation from the mean return.
𝑆𝑡. 𝑑𝑒𝑣. = √𝑣𝑎𝑟𝑖𝑎𝑛𝑐𝑒
Risk and diversification:

Diversification: Increasing the number of different assets in your portfolio. This will reduce overall
risk, since it is less likely that the return will be worse than expected on all the assets, i.e. the
st.dev. is lower.
Portfolio rate of return: the average rate of return on everything in your portfolio:
𝑃𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝑟𝑎𝑡𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛
= 𝑓𝑟𝑎𝑐𝑡𝑖𝑜𝑛 𝑜𝑓 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝑖𝑛 𝑓𝑖𝑟𝑠𝑡 𝑎𝑠𝑠𝑒𝑡 ∗ 𝑟𝑎𝑡𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑓𝑖𝑟𝑠𝑡 𝑎𝑠𝑠𝑒𝑡
+ 𝑓𝑟𝑎𝑐𝑡𝑖𝑜𝑛 𝑜𝑓 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝑖𝑛 𝑠𝑒𝑐𝑜𝑛𝑑 𝑎𝑠𝑠𝑒𝑡 ∗ 𝑟𝑎𝑡𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑠𝑒𝑐𝑜𝑛𝑑 𝑎𝑠𝑠𝑒𝑡
Unique risk (specific risk): Risk factors affecting only one firm (can be diversified away).
Market risk (systematic risk): Risk factors affecting the overall stock market (cannot be diversified
away)
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Topic 6 – CAPM and efficient markets

Now that we have a slightly deeper understanding of risk and its connection to return, we can
focus on actually calculating the return. This will help getting us one step further towards the
opportunity cost of capital, i.e. the discount rate. Hang in there! I’m sure we can do this together!
Measuring market risk:

Market portfolio: Portfolio of all assets in the economy. In practice represented by a market
index.
Beta: A measure of how much a stock moves when the market moves. There are three possible
scenarios:
Stock with 𝛽 > 1 responds more to market changes
Stock with 𝛽 = 1 responds by moving like the market
Stock with 𝛽 < 1 responds less to market changes
To find the beta in practice one would plot (x, y) = (market return in %, portfolio return in %) and
do linear regression, where the slope would be the beta of the portfolio.
Beta of a portfolio: If we are given betas of all stocks in a portfolio, we can calculate the beta of
the collective portfolio in a similar way as we calculated portfolio rate of return:
𝐵𝑒𝑡𝑎 𝑜𝑓 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜
= 𝑓𝑟𝑎𝑐𝑡𝑖𝑜𝑛 𝑜𝑓 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝑖𝑛 𝑓𝑖𝑟𝑠𝑡 𝑠𝑡𝑜𝑐𝑘 ∗ 𝑏𝑒𝑡𝑎 𝑜𝑓 𝑓𝑖𝑟𝑠𝑡 𝑠𝑡𝑜𝑐𝑘
+ 𝑓𝑟𝑎𝑐𝑡𝑖𝑜𝑛 𝑜𝑓 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝑖𝑛 𝑠𝑒𝑐𝑜𝑛𝑑 𝑠𝑡𝑜𝑐𝑘 ∗ 𝑏𝑒𝑡𝑎 𝑜𝑓 𝑠𝑒𝑐𝑜𝑛𝑑 𝑠𝑡𝑜𝑐𝑘
CAPM:
Capital asset pricing model (CAPM): The relationship between risk and return. It explains the
expected rate of return on an investment with a given beta:
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑒𝑡𝑢𝑟𝑛 = 𝑟𝑓 + 𝛽(𝑚𝑎𝑟𝑘𝑒𝑡 𝑟𝑖𝑠𝑘 𝑝𝑟𝑒𝑚𝑖𝑢𝑚) →
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑒𝑡𝑢𝑟𝑛 = 𝑟𝑓 + 𝛽(𝑟𝑚 − 𝑟𝑓 )
where rf is the risk-free interest rate, rm is the return on the market portfolio and 𝛽 is the beta for
the firm or portfolio under consideration. Here we see that the higher beta (the more volatile) the
higher is the expected return.
12
Security market line (SML): If we illustrate CAPM graphically we get a line on which all fairly priced
stocks will be.
Stocks that are above the SML (e.g. k on the
graph) have a higher return than they should have
given their risk level. We say they are underpriced.
You pay too little for the return you get.
Stocks that are below the SML (e.g. h on the

graph) have a lower return than they should have
given their risk level. We say they are overpriced.
You pay too much for the return you get.
ATTENTION: it might seem counterintuitive that stocks above the SML are underpriced, while
stocks below are overpriced. However, read the descriptions carefully and look at the graph and it
should eventually make sense.
Opportunity cost of capital (= CAPM): The rate of return you could have gotten by investing in
something else. The best estimate of this is the return we expect to get given a certain amount of
risk. This is exactly what the CAPM reflects. rf and rm are always the same. The beta is what
determines the expected rate of return. So as long as we know a project’s beta, we can calculate
the opportunity cost of capital for the project through the CAPM.
Market efficiency:
Market efficiency: An efficient market is unpredictable and thus unexploitable. The day to day
movement in stock prices do not reflect any particular pattern. Some anomalies happen and stock
prices generally increase with good new and decrease with bad news, but the overall pattern is
random. Thus, the market is seemingly efficient.
13
Topic 7 – WACC

Now we know a way to discount a given project if we have a given beta for the project. However,
since companies often choose projects similar to their existing operations, we can find a more
generalized discount rate that we can use for any typical project carried out by the company
(WACC). If you understood the previous topic, I’m sure you’ll also be able to follow along in this
one. Let’s do it!
WACC:
Capital structure: the firm’s mix of long-term debt and equity (how it is financed). This mix is
important because companies have to pay interest on their debt and dividend on their equity to
shareholders. Thus, the capital structure determines the cost of the capital the firm has.
Cost of capital: The payback the firm’s investors demand for investing money in the firm. This
depends on the return these investors would expect to be able to get elsewhere.
Debt: Value of bonds issued. The advantage of debt is that interest payments are tax deductible,
so that more debt = less tax. If e.g. the tax rate is 35%, we only need to pay 65% of the debt costs.
The disadvantages of debt will be covered later.
Weighted average cost of capital (WACC): the weighted average of the returns demanded by
investors. Companies are typically financed through debt (bonds), equity (common stock) and
sometimes also preferred stock. The weighted average of the cost of these (taking tax shield
generated by debt into account) can be expressed as the following:
𝐷 𝐸 𝑃
𝑊𝐴𝐶𝐶 = ( ∗ (1 − 𝑇𝐶 ) ∗ 𝑟𝑑𝑒𝑏𝑡 ) + ( ∗ 𝑟𝑒𝑞𝑢𝑖𝑡𝑦 ) + ( ∗ 𝑟𝑝𝑟𝑒𝑓𝑒𝑟𝑟𝑒𝑑 )
𝑉 𝑉 𝑉
Where D is debt, E is equity (common stock), P is preferred stock, V is the value of the company
(V=D+E+P), Tc is corporate taxes and r is the return required by the different investors. How to get
to all these numbers is described in the two next sections.
Note: because the WACC is an average, it should only be used as a discount rate for projects that
are similar to the ones that the company is already doing.
Required rates of return:
Debt (bank): rdebt = interest rate on loans
Debt (bonds): rdebt = YTM
Equity (common): requity = CAPM
𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑
Equity (preferred): rpreffered = 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑝𝑟𝑒𝑓. (because 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑝𝑟𝑒𝑓𝑒𝑟𝑟𝑒𝑑 = )
𝑟𝑝𝑟𝑒𝑓𝑓𝑒𝑑
14
Book value vs. market value: Investors do not care about the historical value of assets and
liabilities, they care about the current market value. We are often given book values and to
convert we do the following for the different book values:
-Bonds: discount coupons and face value to present value as we did earlier, using the current
interest rate.
-Equity: market price per share multiplied by the number of outstanding shares.
-Bank debt (short-term): use book value (because interest rate on bank loans are aligned to the
general level of interest, and when they are short-term, they are usually considered risk-free by
the bank).
Valuing entire businesses:

Estimating PV of a business: To value an entire business, simply find all cash flows in all years and
discount them appropriately and add the “horizon value” (how we expect the company to develop
beyond the years we can predict accurately). This is much like the dividend discount model from
topic 3:
𝐶𝐹1 𝐶𝐹2 𝐶𝐹𝐻 + 𝑃𝑉𝐻
𝑃𝑉 = + + ⋯ +
(1 + 𝑟)1 (1 + 𝑟)2 (1 + 𝑟)𝐻
where (as previously) CF in a given year is the profit after tax + depreciation, and the present
𝐶𝐹
horizon value (PVH) is = 𝑟−𝑔𝐻 (the perpetuity formula taking a given growth rate into account).
15
Topic 8 – Debt policy

By now you must have gotten quite sick of discount rates, am I right? Don’t worry, me too. Let’s
move on to something else instead. Remember in the WACC how we had to consider the dept
ratio? Well I’m sure you’re just dying to find out a bit more about how to choose the right dept
level. Say no more! The next few pages are devoted to exploring just that. And do you know what
the best part is? You’re now more than halfway through your corporate finance journey!
Relevance of debt ratio:

Note: we look at the Modigliani & Miller propositions and see what happens when we relax some
assumptions. We will get to the most exact model in the end, but each step is important to
understand because certain elements and effects might be brought up in the exam.
𝐷
Debt ratio: 𝐷+𝐸
Modigliani & Miller proposition I: Debt is irrelevant. In perfect markets, the market value of a
company does not depend on its capital structure.
Perfect market assumptions:
-Debt is risk free (bondholders always get repaid)
-No taxes
-No bankruptcy costs or financial distress costs (comes with high debt/leverage)
-No investor constraints (e.g. borrowing constraints)
-No management incentive effects (e.g. inflating stock price)
“Debt is risk-free” assumption: Debt increases risk for stockholders. The more debt, the less is
financed by equity, and thus the stockholders have more equity per stock/share. Any change in
operating income will then have a larger effect on the return of stockholders. However, when risk
increases, so does expected return, and the two effects cancel each other out.
Modigliani & Miller proposition II: Taking the WACC under the assumption of no taxes (and not
looking at preferred stock), we get that the required return on all assets in the firm (or cost of
capital) is:
𝐷 𝐸
𝑟𝑎𝑠𝑠𝑒𝑡𝑠 = (𝑟𝑑𝑒𝑏𝑡 ∗ ) + (𝑟𝑒𝑞𝑢𝑖𝑡𝑦 ∗ ) ⇔
𝑉 𝑉
𝐷
𝑟𝑒𝑞𝑢𝑖𝑡𝑦 = 𝑟𝑎𝑠𝑠𝑒𝑡𝑠 + (𝑟 − 𝑟𝑑𝑒𝑏𝑡 )
𝐸 𝑎𝑠𝑠𝑒𝑡𝑠
From this we see that expected return on a common stock increases in proportion to the debt-
equity ratio (more debt -> higher expected return (like in the first proposition)).
16
MM II graphically:
We see from the graph on the left
that the return on assets do not
change no matter how much we
increase debt-equity ratio. Thus,
debt does not matter under the
assumptions of a perfect market.
Removing no taxes assumption: With taxes there will now be benefits to debt in terms of the tax
shield.
Annual tax shield = (corporate tax rate) x (interest payment)
This means that to maximize the market value of the firm, it should be fully debt financed (as seen
on the graph below to the left).
Taking taxes into account also means that MM II turns into the WACC. As seen on the graph below
to the right, the WACC decreases with more debt, i.e. the cost of capital decreases. This is because
the required return on debt is not efficiently lower due to the tax shield.
Removing no financial distress cost assumption:

Financial distress costs come from the fact that
with high level of debt, stakeholders will begin to
fear a bankruptcy. Thus, banks will demand higher
interest, some employees will leave and some
business opportunities will be lost due to the
inability to borrow more money.
Note: This means that there is now an optimal
level of debt as illustrated to the right.
17
Theories for choosing debt level:

Trade-off theory: The theory that capital structure is based on trade-off between tax savings and
distress costs of debt.
-Explains: Companies with safe, tangible assets and plenty of taxable income should make use of
the tax shield. They have much collateral in their assets to back up the debt. Meanwhile,
companies without many safe, tangible assets should be relatively more equity financed.
-Does not explain: In practice, most stable and profitable companies generally borrow the least.
Pecking order theory: Firms prefer to issue debt rather than equity if they lack finance. Order of
preference: Internal funds (no market signal) -> debt (unclear signal) -> equity (likely negative
signal). This is due to the fact that issuing more equity sends a signal that the company can benefit
from selling more stocks are the current market price, i.e. that the stock is overvalued. Reaction by
market: stock price drops.
-Explains: Successful companies do not borrow, because they do not need outside funding and
does not want to send the wrong signal, thereby leading to low D/E ratio.
-Does not explain: In practice, many fast-growing companies issue a lot of equity to finance
investments
Theory of financial slack: Companies should have ready access to cash or debt financing (avoid
having too much debt so it can be increased if needed). In this way the company retains flexibility
and can easily acquire funds for new attractive projects.
-Explains: Why successful companies issue a lot of equity.
-Disadvantage: “free-cash flow problem” which leads to the company accepting too many or not
thought-through projects.
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Topic 9 – Payout policy

So we found out that there are different arguments for what the optimal amount of debt is and no
clear answer to what is right – it depends on the individual situation. We’ll now move on to looking
at how firms pay back equity investors. Should they pay out dividends or buy back stocks? Spoiler
alert… it does not matter to the investors! Let’s see why!
Terminology:
Declaration date (announcement date): Date where the firm announces (or suggests) the next
dividend payment (amount, ex-dividend date or payment date).
Ex-dividend date: Date that determines whether a stock holder is entitled to a dividend payment.
Anyone holding stock before this date is entitled to a dividend.
Payment date: Date where the relevant owners (buying before ex-dividend date) receive
payment.
Investor wealth: the amount of cash the investor holds + the value of his/her shares.
Payout methods:
Stock dividend: Distribution of additional shares to a firm’s stockholders. Example: If an investor
holds 100 shares and there is a 10% stock dividend payout, the investor will then have 110 shares.
However, with more shares and the same company value, each share will be worth less, so
effectively the investor’s wealth is the same. In addition, the investor’s ownership in the company
is also the same.
Cash dividend: Payout of a given amount of cash per share to a firm’s stockholders. Because cash
is an asset in the company, the company’s value will decrease, thus making each share worth less.
In the end, investor wealth will be the same as before the payout. In addition, the investor’s
ownership in the company is also the same.
Stock repurchase: Firm buys back stock from its shareholders. If an investor chooses to sell shares,
his/her wealth will still be the same (just holds more cash). If shares are not sold back, the wealth
also remains unchanged. In addition, the investor’s ownership in the company is also the same if
he/she sells back shares.
Note: arguments can be made about indirect effects such as signals sent to the market by
choosing a specific payout method. Overall there are both arguments for and against which
payout policy to use. Conclusion: it depends on the individual situation just as with debt-ratio in
the previous topic.
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Topic 10 – Mergers and acquisitions

Can you feel it? You’re are beginning to master the art of corporate finance! There’s just a few
more topics to go. As with all business students you are probably very eager to learn more about
M&A. Besides some new concepts and terminology, it is actually the same as we’ve always done;
discounting future cash flows to find the present value.
Terminology:
Merger: Combination of two firms into one, with the acquirer assuming assets and liabilities of the
target firm.
Acquisition: Takeover of firm by purchase of that firm’s common stock or assets – and the target
may (or may not) continue as a separate firm.
Tender offer: Outsiders directly offer to buy the stock of the firm’s shareholders. Can either be
friendly or hostile.
-Friendly offer: management is informed about the bid before and the board gives their opinion to
shareholders. However, no approval of management is needed, it is just a nice thing to do.
-Hostile: offer to buy the stock of the firm’s shareholders without talks with management.
Valuating M&A:
Synergy: When two companies are worth more together than apart, i.e. when:
PV(AB) > PV(A) + PV(B)
M&A is sensible if there is synergy and the initiating company is also better off. I.e. enough of the
synergy effect has to go to the initiating company so that the project has a positive NPV value:
NPV = PV(economic gain) – PV(cost)
Sources of synergy/motives:
-Economics of scale (horizontal merger): Larger firm can spread fixed costs over a larger volume of
output (e.g. might only need one IT department for the combined firm).
-Economics of vertical integration: Control over suppliers may reduce costs and increase efficiency.
-Combining complementary resources: Each firm might have what the other needs.
-Mergers as a use for excess funds: If the firm does not have many positive NPV projects,
acquisition might be the best use of its funds.
Changing corporate control:

Mergers and acquisitions: Buying assets, liabilities or making an offer for common stock. New
owners can then replace management if they like.
20
Successful Proxy Contest: A group of (large) shareholders change the board of directors by
accumulating the right to vote on other shareholders behalf (accumulate proxies). This is often
more feasible that getting each small shareholder to vote.
Divestitures, spin-offs and carve-outs: Part of the firm becomes a new identity with new owners
(and management).
-Divestiture: When a firm sells some of the assets to another entity.
-Spin Off: The process where a business separates the ongoing operations of a specific unit into
two parts, and gives the shareholders of the original parent firm shares in the two parts. The new
unit and parent now function as separate entities.
-Carve Outs: Similar to a spin off, but the carve out issues shares of the new firm to the public
(instead of existing shareholders).
Leveraged buyout (LBO) of the firm: A group of shareholders (or management – MBO) buys the
firm and it is to a large extent financed with debt. Their shares become private equity in the
company, thus decreasing the number of shares. This turns public companies relatively more
private. Because it is debt financed it is more frequent in times with low interest rate and easy
access to debt.
Defense mechanisms:
Poison pill: Measure taken by a target firm to avoid acquisition (makes the firm unappetizing). E.g.
giving existing shareholders the right to buy additional shares at an attractive price if a bidder
acquires a large holding. Or issuing vast amounts of shares to friendly investors, which reduces
value of shares already bought by bidder and makes probability of getting more shares low.
Poisson puts: Bondholders can demand repayment if ownership is changing, which might be too
expensive for the acquirers.
White knights: Friendly potential acquirer sought by the company targeted by an unwelcome
acquirer.
Shark repellent: Amendment to a company charter made to forestall takeover attempts. E.g.
merger must be approved by a supermajority of 80% instead of 50%.
Limitations on ownership and voting rights: E.g. stating that no shareholder can have more than
30% of the voting rights.
Golden parachutes: The management can leave with big bonuses if there is a change in control.
Staggered board of directors: Only a fraction is elected each year (change of control takes a long
time).
Customer assurance program: Customers get money back if acquirer reduces customer support.
21
Mergers in practice, pros and cons:

Who benefits:
-Shareholders of the target.
-Lawyers and brokers.
-The executives of the acquiring firm.
Who loses:
-Shareholder of the acquirer due to overpayment.
-Executives of the target.
-All employees due to restructuring.
22
Topic 11 – International financial management

Now we’ve actually gone through all of the most essential stuff. All that is left for us to do is to look
at some tools for managing risk and how we take all we’ve learnt into an international perspective.
We’ll start with the latter and look at how we discount projects and cash flows in foreign
currencies taking into account inflation and exchange rates.
Terminology:
Exchange rates: Prices of currencies. There are two different ways to states these:
-Direct quote: Amount of domestic currency that you pay for one foreign currency
(7,46 DKK per 1 Euro)
-Indirect quote: Amount of foreign currency that you get for one domestic currency.
(0,13 Euro per 1 DKK)
Spot rate: The current exchange rate.
Forward rate: An agreed upon exchange rate in the future (typically different than the spot rate).
If goods are going to be sold in the future in some foreign currency, the seller of the goods might
want to avoid the uncertainty of exchange rate changes. Therefore, the seller can enter a contract
to be able to exchange money at a certain exchange rate in the future.
-If you get a lower amount of foreign currency per domestic currency at the forward rate than you
would at the spot rate, we say the foreign currency trades at a premium (i.e. you get less per
domestic currency, so the foreign currency is effectively more expensive).
-If you get a higher amount of foreign currency per domestic currency at the forward rate than you
would at the spot rate, we say the foreign currency trades at a discount (i.e. you get more per
domestic currency, so the foreign currency is effectively less expensive).
Depending on how the exchange rate is quoted, the two ways to calculate the percentage
premium/discount are as follows:
𝐹𝑜𝑟𝑤𝑎𝑟𝑑 𝑃𝑟𝑖𝑐𝑒 – 𝑆𝑝𝑜𝑡 𝑃𝑟𝑖𝑐𝑒
𝐷𝑖𝑟𝑒𝑐𝑡 𝑞𝑢𝑜𝑡𝑒: = 𝑝𝑟𝑒𝑚𝑖𝑢𝑚 𝑜𝑟 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡
𝑆𝑝𝑜𝑡 𝑃𝑟𝑖𝑐𝑒
𝑆𝑝𝑜𝑡 𝑃𝑟𝑖𝑐𝑒 – 𝐹𝑜𝑟𝑤𝑎𝑟𝑑 𝑃𝑟𝑖𝑐𝑒

𝐼𝑛𝑑𝑖𝑟𝑒𝑐𝑡 𝑞𝑢𝑜𝑡𝑒: = 𝑝𝑟𝑒𝑚𝑖𝑢𝑚 𝑜𝑟 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡
𝐹𝑜𝑟𝑤𝑎𝑟𝑑 𝑃𝑟𝑖𝑐𝑒
23
The 4 basic relationships in exchange rates:

Purchasing Power Parity (PPP): The general cost of living must be the same in every country
(otherwise people would just choose to live where it is cheapest). For this to be true over time, the
relation between inflation rates between two countries, must be the same as the relation
between the expected spot rate in the future and the spot rate today between the two countries.
I.e. two countries with large differences in inflation rates would also expect to have a large
difference between their exchange rate in the future compared to the one they have today.
1 + 𝑖𝑓𝑜𝑟𝑒𝑖𝑔𝑛 𝐸(𝑆𝑓𝑜𝑟𝑒𝑖𝑔𝑛 𝑝𝑒𝑟 𝑑𝑜𝑚𝑒𝑠𝑡𝑖𝑐 )
=
1 + 𝑖𝑑𝑜𝑚𝑒𝑠𝑡𝑖𝑐 𝑆𝑓𝑜𝑟𝑒𝑖𝑔𝑛 𝑝𝑒𝑟 𝑑𝑜𝑚𝑒𝑠𝑡𝑖𝑐
where i is the inflation rate, S is the spot rate, and E(S) is the expected spot rate in the future
(equal to the forward rate)
Note: if you are given exchange rate in ‘domestic per foreign’ (direct quote), you simply flip the
left side of the equation so (1 + idomestic)/(1 + iforeign) = (E(Sdomestic per foreign)/Sdomestic per foreign).
International Fisher Effect (IFE): Real interest rate must be equal among all countries. If it were
not, all people would invest where it was highest, move money to this country and interest rates
would adjust. Remember real interest rate from topic 2? Putting this equal between two countries
and rearranging, we get that:
1 + 𝑟𝑓𝑜𝑟𝑒𝑖𝑔𝑛 1 + 𝑖𝑓𝑜𝑟𝑒𝑖𝑔𝑛
=
1 + 𝑟𝑑𝑜𝑚𝑒𝑠𝑡𝑖𝑐 1 + 𝑖𝑑𝑜𝑚𝑒𝑠𝑡𝑖𝑐
where i is the inflation rate, and r is the interest rate.

Interest Rate Parity: The relationship between nominal interest rates among countries, must be
equal to the relationship between the forward rate and the spot rate. If this was not the case,
people would invest all their money in the country with the most favorable interest rate compared
to the forward rate.
1 + 𝑟𝑓𝑜𝑟𝑒𝑖𝑔𝑛 𝑓𝑓𝑜𝑟𝑒𝑖𝑔𝑛 𝑝𝑒𝑟 𝑑𝑜𝑚𝑒𝑠𝑡𝑖𝑐
=
1 + 𝑟𝑑𝑜𝑚𝑒𝑠𝑡𝑖𝑐 𝑆𝑓𝑜𝑟𝑒𝑖𝑔𝑛 𝑝𝑒𝑟 𝑑𝑜𝑚𝑒𝑠𝑡𝑖𝑐
where r is the interest rate, f is the forward rate, and S is the spot rate.
Expectations theory of exchange rates: The forward rate is equal to the expected spot rate in the
future. We divide both sides with the spot rate, because then it fits conveniently into the three
previous relationships.
𝑓𝑓𝑜𝑟𝑒𝑖𝑔𝑛 𝑝𝑒𝑟 𝑑𝑜𝑚𝑒𝑠𝑡𝑖𝑐 𝐸(𝑆𝑓𝑜𝑟𝑒𝑖𝑔𝑛 𝑝𝑒𝑟 𝑑𝑜𝑚𝑒𝑠𝑡𝑖𝑐 )
=
𝑆𝑓𝑜𝑟𝑒𝑖𝑔𝑛 𝑝𝑒𝑟 𝑑𝑜𝑚𝑒𝑠𝑡𝑖𝑐 𝑆𝑓𝑜𝑟𝑒𝑖𝑔𝑛 𝑝𝑒𝑟 𝑑𝑜𝑚𝑒𝑠𝑡𝑖𝑐
1+𝑟𝑓𝑜𝑟𝑒𝑖𝑔𝑛 1+𝑖𝑓𝑜𝑟𝑒𝑖𝑔𝑛 𝐸(𝑆𝑓𝑜𝑟𝑒𝑖𝑔𝑛 𝑝𝑒𝑟 𝑑𝑜𝑚𝑒𝑠𝑡𝑖𝑐 ) 𝑓𝑓𝑜𝑟𝑒𝑖𝑔𝑛 𝑝𝑒𝑟 𝑑𝑜𝑚𝑒𝑠𝑡𝑖𝑐

Note: You can combine all four = 1+𝑖 = =𝑆
1+𝑟𝑑𝑜𝑚𝑒𝑠𝑡𝑖𝑐 𝑑𝑜𝑚𝑒𝑠𝑡𝑖𝑐 𝑆𝑓𝑜𝑟𝑒𝑖𝑔𝑛 𝑝𝑒𝑟 𝑑𝑜𝑚𝑒𝑠𝑡𝑖𝑐 𝑓𝑜𝑟𝑒𝑖𝑔𝑛 𝑝𝑒𝑟 𝑑𝑜𝑚𝑒𝑠𝑡𝑖𝑐
24
Exchange rate risk and international capital budgeting

Exchange rate risk: There are two main sources of risk in relation to exchange rate:
-Transaction exposure: Fluctuating exchange rates makes it more uncertain what profits will be
made from investments in foreign countries (can be mitigated by entering a forward rate
contract).
-Economic exposure: Unexpected exchange rate fluctuations might change the market. Even if the
firm has no international activities, exchange rates changes can increase competition and affect
prices.
Note: mitigation strategies for this is further discussed in the next topic.
NPV in an international setting: calculate NPV as usual, but take into account the exchange rate
and how it changes throughout the years. A simple way to do this is to:
1. Calculate the expected cash flows in each year as usual, but in the foreign currency.
2. Exchange the foreign cash flows into the domestic currency. The exchange rate each year is
found using the interest rate parity. A trick to easily calculate the forward rate for any year, is to
simply put the relationship between the interest rates to the power of the year, t:
1 + 𝑟𝑓𝑜𝑟𝑒𝑖𝑔𝑛 𝑡
𝑓𝑓𝑜𝑟𝑒𝑖𝑔𝑛 𝑝𝑒𝑟 𝑑𝑜𝑚𝑒𝑠𝑡𝑖𝑐 = 𝑆𝑓𝑜𝑟𝑒𝑖𝑔𝑛 𝑝𝑒𝑟 𝑑𝑜𝑚𝑒𝑠𝑡𝑖𝑐 ( )
1 + 𝑟𝑑𝑜𝑚𝑒𝑠𝑡𝑖𝑐
where f is the forward rate, i.e. the exchange rate you use in the respective years, S is the spot
rate, r is the interest rate, and t is the year you want the exchange rate for.
3. Discount the cash flows back to year 0 as usual.
25
Topic 12 – Options

I bet the previous topic was a bit dull for a nearly-master-of-corporate-finance such as yourself.
Don’t worry, we’ll move on to something much harder. Actually, this will probably be the hardest
thing in the entire course. It’s not that there is a lot of stuff, it is more that it can be a bit difficult to
wrap your head around. But fear not! We’ll make it through together as always!
Options:
Derivative: Something that derives its value from something else. E.g. a share derives its value
from the value of its firm, interest rate derives its value from the economy, and a bond derive its
value from future expectations.
Option: A derivative that gives the right (not obligation) to either sell or buy an asset at a specified
exercise price. If you fear that prices will drop in the future, you might want the right to your
goods at a certain price in the future to mitigate (hedge) risk. There are two types of options:
-Call option: gives the right to buy an asset at a specified exercise price (strike price).
-Put option: gives the right to sell an asset at a specified exercise price (strike price).
The right is obtained for a given period (American) or at a given point in time (European). Due to
the flexibility of the American options, these are (all else equal) more expensive.
Note: although you have the right to sell/buy in the future, you are not obliged to do so. If you
have the right to buy an ice cream for 10, but the market price has dropped to 9, you would of
course just buy it for 9 and not exercise your option.
Option value: The value of an option is the amount of profit one could earn by exercising the
option today. This value can (not taking option price into account) never be negative, since if
profits were negative, one would simply just not exercise the option.
The value of a call option will increase when the market price of the
asset linked to the option gets above the value at which one has the
right to buy the asset for. I.e. if the market price is higher than the
call option exercise price, one has the right to buy the asset cheaper
than the market price.
The value of a put option will increase when the market price of the
asset linked to the option gets below the value at which one has the
right to sell the asset for. I.e. if the market price is lower than the put
option exercise price, one has the right to sell the asset for more
than the market price.
Note: if we add the realistic assumption that the option has a price,
we would have to subtract the price from the option value to find the
actual profits one makes from exercising the option.
26
Option properties: Options can reduce/hedge risk and gives the opportunity to gain from
favorable price movements, while not losing on unfavorable ones. However, since options have a
price (option premium (the additional cost one pays apart from the exercise price)), it is not free
to hedge the risks.
Option terminology: Some terminology directly related to options.
-Long position: When you are the buyer of the option.
-Short position: When you are the seller of the option.
Call Put
-In the money S>X S<X
-At the money S=X S=X
-Out of the money S<X S>X
where S is the market price of the asset the option is linked with and X is the exercise price of the
option.
Put-Call Parity: (Holds only for European options not paying dividend) The market does not allow
for risk-free earnings (arbitrage opportunities), so if one buys a stock and a put option for this
stock (the right to sell at a certain price), the value of this must be the same as buying a call option
for the stock (the right to buy at a certain price) and investing the present value of the exercise
price in a bank deposit, where one earns interest.
exercise price
Value of stock + value of put = value of call + (1+r)t
Option price determinants: A sum up of effects of different factors on option price.

Effect on option price if factor rises
Call Put
Stock price (S) ↑ ↓
Exercise price (X) ↓ ↑
Stock volatility (𝜎) ↑ ↑
Time to maturity (T) ↑ ↑
Interest rates (r) ↑ ↓
Real options: Options embedded in real (physical) assets (i.e. not financial assets such as bonds,
shares, etc.). Real options in a project are actual choices that the managers can make; can expand
and make follow up investments; can shrink or abandon project; can wait and invest later; can
vary the production methods and the output; etc.
The more real options a project has, the more valuable it is, since risk can be mitigated by
choosing differently.
27
Topic 13 – Risk Management

Amazing! You made it through options! Now there is just this small topic on how to manage risk
(hedging) left and you’ll be a master of corporate finance ready to tackle any financing or
investment decision. Thanks for coming along on this great journey. It has been a lot of fun and a
true honor! Good luck with everything going forward!
Managing risk:
Risk management (hedging): Risk management is the process by which various risks are identified,
measured and controlled – also called hedging.
Risks can (usually) not be eliminated, but they can be hedged. To hedge risks firms use derivatives
or insurance. This decreases the probability of financial distress. However, it is also costly, and one
could argue that if investors wanted less risk, they would simply invest in less risky shares in
another firm.
Common hedging tools: Three of the most common ways to manage risk:
-Option: The right (not obligation) to either sell or buy an asset at a specified exercise price.
-Forward/future contract: Contract (an obligation, not an option) between two parties for delivery
(buy or sell) of an asset at a negotiated price (forward price) on a set date in the future (if an
intermediary takes care of the contract it is called a future). Profit = market price at maturity date -
initial futures price.
-Swap: Arrangement where two counterparties exchange one stream of cash flows for another
stream.
Example: You have an apple tree and are getting apples every year. Your neighbor has a pear tree
and is getting pears every year. You really like pears and your neighbor really likes apples. It would
be costly for both of you to chop down your trees and plant the ones you want. Instead you enter
into a swap, i.e. you get your neighbor’s pears that you really like, while your neighbor gets your
apples which he/she really likes. You both get what you want and avoid the cost of planting new
trees.
28

Corporate Finance Notes

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Mikkel Østergaard Schrøder Corporate Finance (notes) Last updated: 21/03/2019

Overall structure of the content:

Cash flows in organizations:

Some general terms:

Topic 2 – The time value of money

Note for you who are reading through this chronologically:

Time value of money:

Interest and inflation:

Interest payed monthly: (1 + monthly rate)12 = 1 + EAR

Interest payed quarterly: (1 + quarterly rate)4 = 1 + EAR

Interest payed semiannually: (1 + semiannual rate)2 = 1 + EAR

Inflation: Rate at which prices as a whole change, 𝜋.

Nominal interest rate: rate at which money invested grow.

Topic 3 – Valuing bonds and stocks

Note for you who are reading through this chronologically:

Bonds and risk:

Topic 4 – Investment criteria

Note for you who are reading through this chronologically:

Topic 5 – Risk and return

Note for you who are reading through this chronologically:

Risk and return:

𝑆𝑡. 𝑑𝑒𝑣. = √𝑣𝑎𝑟𝑖𝑎𝑛𝑐𝑒

Risk and diversification:

Topic 6 – CAPM and efficient markets

Note for you who are reading through this chronologically:

Measuring market risk:

𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑒𝑡𝑢𝑟𝑛 = 𝑟𝑓 + 𝛽(𝑟𝑚 − 𝑟𝑓 )

Stocks that are below the SML (e.g. h on the

Note for you who are reading through this chronologically:

Valuing entire businesses:

Topic 8 – Debt policy

Note for you who are reading through this chronologically:

Relevance of debt ratio:

Annual tax shield = (corporate tax rate) x (interest payment)

Removing no financial distress cost assumption:

Theories for choosing debt level:

Topic 9 – Payout policy

Note for you who are reading through this chronologically:

Topic 10 – Mergers and acquisitions

Note for you who are reading through this chronologically:

Changing corporate control:

Mergers in practice, pros and cons:

Topic 11 – International financial management

Note for you who are reading through this chronologically:

𝑆𝑝𝑜𝑡 𝑃𝑟𝑖𝑐𝑒 – 𝐹𝑜𝑟𝑤𝑎𝑟𝑑 𝑃𝑟𝑖𝑐𝑒

The 4 basic relationships in exchange rates:

where i is the inflation rate, and r is the interest rate.

1+𝑟𝑓𝑜𝑟𝑒𝑖𝑔𝑛 1+𝑖𝑓𝑜𝑟𝑒𝑖𝑔𝑛 𝐸(𝑆𝑓𝑜𝑟𝑒𝑖𝑔𝑛 𝑝𝑒𝑟 𝑑𝑜𝑚𝑒𝑠𝑡𝑖𝑐 ) 𝑓𝑓𝑜𝑟𝑒𝑖𝑔𝑛 𝑝𝑒𝑟 𝑑𝑜𝑚𝑒𝑠𝑡𝑖𝑐

Exchange rate risk and international capital budgeting

Note for you who are reading through this chronologically:

Option price determinants: A sum up of effects of different factors on option price.

Topic 13 – Risk Management

Note for you who are reading through this chronologically:

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