Corporate Finance: Imperial College Business School

Corporate Finance
Jamie Coen
Imperial College Business School
Autumn 2022
Jamie Coen Review 1 / 42

Corporate finance in this course
Maximise the Value of the Firm
The Investment Decision The Financing Decision The Dividend Decision

Which assets should a How should a firm How and when should a firm
firm invest in? finance itself? return cash to shareholders?

This week
Today
• Review the concepts.
• Not exhaustive, but hopefully useful!
Tomorrow
• Exam practice.
• Solving the mock.

The Investment Decision

Investment (i)
Theory
• Assumptions → CAPM equation.
• What is the CAPM telling us about the pricing of assets?
• How betas vary with:
• Sector.
• Operating leverage.
• Financial leverage (and how to unlever a beta).

CAPM theory questions
1 Why don’t investors care about diversifiable risk? Would this

be true if:
1 Investments weren’t perfectly divisible?
2 Investors didn’t have access to all investments?
3 Some investors had private information about certain
securities?


be true if:
securities?
2 Why do investors in the CAPM all hold the same portfolio of
risky assets, even if they have different risk tolerance?


be true if:
securities?
3 Suppose the idiosyncratic risk of an asset doubles. What
happens to its stock price in equilibrium?


be true if:
securities?
3 Suppose the idiosyncratic risk of an asset doubles. What
happens to its stock price in equilibrium?
4 Explain precisely how higher operating leverage affects a
firm’s beta.

Investment (ii)
Application
1 Risk-free rate:
• Which instrument to choose.
• How to adjust for default risk.
2 Market risk premium.
• How to estimate it (survey, historical, implied) and the pros &
cons of each method.
3 Market beta.
• Top down approach, and interpreting regressions.
• Bottom up approach, and aggregating betas.

CAPM application questions
1 You estimate the ERP twice: via the historical method and
via the implied ERP method. The implied estimate is higher
than the historical estimate. Why might this be?

2 Suppose you are estimating betas for two stocks, using the
same market portfolio over the same period. You notice the
intercepts from the two regressions are the same. What, if
anything, does this tell us about the performance of these two
companies vs their expected performance?

2 Suppose you are estimating betas for two stocks, using the
same market portfolio over the same period. You notice the
intercepts from the two regressions are the same. What, if
anything, does this tell us about the performance of these two
companies vs their expected performance?
3 Suppose you are considering investments over 5 years, and

want an estimate of the risk-free rate. Is it a good idea to use
the return on a bond of maturity:
1 1 year?
2 10 years?

Investment (iii)
Evaluation
• The two types of empirical shortcomings for the CAPM.
• Logic, pros & cons of alternative approaches.

CAPM evaluation questions
1 Describe the empirical shortcomings of the CAPM, and how

researchers have discovered these shortcomings.
2 What is the logic of the intertemporal CAPM? Why has it not

replaced the CAPM as the dominant way of estimating the
cost of equity?
3 Describe the 3-factor model. What are its advantages and

disadvantages?

Investment (iv)
Cost of equity to WACC

• How to estimate the cost of debt.
• How to estimate weights to place on cost of debt and equity
in WACC.

Cost of capital questions
1 What is a synthetic rating, and how can it be used to

estimate a cost of debt?

Cost of capital questions
1 What is a synthetic rating, and how can it be used to

estimate a cost of debt?
2 Why shouldn’t you use the book value of equity in estimating

the weights for the WACC calculation?

Investment (v)
Cost of capital to hurdle rates

• Why costs of equity and capital are useful objects for
investment decision.
• Accounting-based approach.
• Cash flow-based approach.
• NPV as the ‘correct’ approach, and shortcomings of other
approaches relative to this.
• Hurdle rates for firms & projects.

Hurdle rates questions
1 If a project’s return on equity is equal to the firm’s cost of

equity, and has the same risk as the firm’s other projects,
should the firm proceed with the project?


2 Do the following take risk into account?

• A project’s internal rate of return.
• Comparing a project’s rate of return to its cost of equity or
WACC.


2 Do the following take risk into account?

• A project’s internal rate of return.
• Comparing a project’s rate of return to its cost of equity or
WACC.
3 If you mix hurdle rates and cash flows, and discount cash
flows to the firm using the cost of equity, how will your
investment decisions go wrong?

The Financing Decision

Financing (i)
Perfect capital markets

1 Modigliani & Miller’s assumptions, logic and result.
1 Cash flows on investments determine firm value.
2 Financing decision just slices pizza up differently.
3 CoE and CoD adjust with leverage such that WACC is
constant.
2 Homemade leverage.
3 Usefulness and insight of the model.

Capital structure in perfect capital markets: questions
1 What do Modigliani & Miller assume about bankruptcy?
2 Draw the cost of equity, cost of debt, and WACC as a

function of a firm’s leverage with perfect capital markets.
3 To what extent do you agree with this statement:

‘Modigliani & Miller’s result is not useful as its assumptions
do not hold.’
4 To what extent do you agree with this statement:

‘Modigliani & Miller tell us we don’t need to worry about the
financing decision.’

Financing (ii)
Imperfect capital markets

1 Market frictions: their sources and their implications for
financing decisions.
2 How these frictions will vary across firms.
3 Market frictions as the logic of the financing decision.

Capital structure in imperfect capital markets: questions
1 With perfect capital markets, the relationship between WACC

and leverage is flat. If markets are imperfect except
bankruptcy is costly, what would this relationship look like?
2 What is debt overhang?
3 How should a firm’s financing decision affect its investment
decisions?
→ If a firm chooses to be more leveraged than it should, what
will this do to its investment decisions?

Financing (iii)
Finding an optimal mix

1 Cost of capital approach:
1 Logic.
2 Step-by-step approach.
3 Evaluation.
2 Enhanced cost of capital approach and adjusted present value
approach.
1 Logic.
2 Evaluation.
3 Strengths and weaknesses of each approach.

Finding an optimal capital structure: questions
1 Summarise:
• The cost of capital approach.
• The enhanced cost of capital approach.
• The adjusted present value approach.

Finding an optimal capital structure: questions
1 Summarise:
• The cost of capital approach.
• The enhanced cost of capital approach.
• The adjusted present value approach.
2 What are the key weaknesses of each approach?

The Dividend Decision

Dividends (i)
Stylised facts and practicalities

1 Understand what dividends and buybacks are.
2 Be comfortable with terminology.
3 Know stylised facts.

Terminology & facts
1 What is the cum-dividend date, and what is the ex-dividend

date?

Terminology & facts

date?
2 What is the relative popularity of dividends and buybacks now

vs in the past?

Terminology & facts

date?
2 What is the relative popularity of dividends and buybacks now

vs in the past?
3 What do buybacks do to the balance sheet of a firm?

Dividends (ii)
How much cash to return?

1 Perfect capital markets.
1 Modigliani-Miller again.
2 Logic.
3 Homemade dividends.
4 Interpretation and contribution of result.
2 Imperfect capital markets.
• Role of taxes.
• Other frictions.

Modigliani & Miller on dividends: questions
1 Would Modigliani & Miller’s result still hold if it was costly to

issue stock? Why/why not?
2 Homemade dividends.
1 Suppose investors wish a firm hadn’t paid a dividend, but it
did. What can they do?
2 Suppose investors wish a firm had paid a dividend, but it
didn’t. What can they do?
3 Would homemade dividends still work in the same way if

dividends were taxed and capital gains were not?

4 Would Modigliani & Miller’s result still hold if bankruptcy was

costly? Why/why not?

4 Would Modigliani & Miller’s result still hold if bankruptcy was

costly? Why/why not?
5 Would Modigliani & Miller’s result still hold if a firm’s

managers and stockholders had information that debtholders
did not? Why/why not?

Dividends in imperfect capital markets: questions
1 How did we derive the following relationship?
PCUM − PEX = DIV (1 − τd∗ )

where
τd − τg
τd∗ =
1 − τg
2 Suppose this relationship holds on average, that the tax rate
on dividends is positive and that the tax rate on capital gains
is zero. Suppose I am exempt from all taxes. How can I trade
around the dividend date in order to make a profit?
3 What are tax clienteles? How can they rationalise what we
observe about payout policy in the real world?

4 Why might dividends be seen as a positive signal?

4 Why might dividends be seen as a positive signal?
5 Why might dividends sometimes be seen as a negative signal?

Dividends (iii)
How to return cash?

1 Modigliani-Miller once more.
2 Reasons to prefer buybacks.

Dividends & buybacks: questions
1 Why is the choice of dividends vs buybacks irrelevant in a

world with perfect capital markets?

Dividends & buybacks: questions
1 Why is the choice of dividends vs buybacks irrelevant in a

world with perfect capital markets?
2 Why might buybacks be preferred by:

1 Firms?
2 Investors?
3 Managers?

Dividends (iv)
Analysing dividend policy

1 Computing FCFE.
2 Logic of analysing payout policy: am I happy for this firm to
keep hold of cash it could pay to me?
3 Evaluate real firms’ payout policies.

Analysing dividend policy: questions
1 Why can’t we measure cash flows using net income directly?

Analysing dividend policy: questions
1 Why can’t we measure cash flows using net income directly?
2 What factors should I consider when evaluating a firm’s

payout policy?

Valuation

Valuation (i)
Intrinsic valuation.
1 DCF models in theory.
2 Determinants of intrinsic value.
3 Choice between DDM/FCFE/FCFF.
4 The practicalities of intrinsic valuation.
5 Topics:
• Enhancing value.
• Private firms.
• Implied equity risk premium.

Intrinsic valuation questions
1 When would you use a DDM rather than a FCFE-based

model?


model?
2 When would you use a FCFF-based model?


model?
3 Why don’t debt payments appear in FCFF?


model?
3 Why don’t debt payments appear in FCFF?
4 To what extent do you agree with the following statement:

‘One can estimate a firm’s implied cost of equity using its
share price and earnings forecasts. This might not be the
most reliable way of doing this, but it could give a useful
cross-check of other estimates.’

Valuation (ii)
Relative valuation.
1 How to define and work with multiples.
2 Multiples cannot be studied in isolation.
→ Need to understand fundamental drivers.
3 Regression as a means of controlling for fundamentals.
4 Relative vs intrinsic valuation.
• Information.
• Explicit and implicit assumptions.
• Role of intrinsic valuation in informing relative valuation.

Relative valuation questions
To what extent do you agree with the following statements?

1 ‘Relative valuation is simpler than intrinsic valuation’.
2 ‘Relative valuation is no better than intrinsic valuation, as to

understand it you have to effectively do a full DCF valuation.’
3 ‘Using regressions to control for fundamental factors is hardly

any better than simply comparing firms’ multiples if the
R-squared of the regression is close to zero.’

Valuation (iii)
Contingent claims valuation.

1 Nature and features of option contracts.
2 (Real) options are more common than you think.
3 Equity can be viewed as an option.
• Equity valuable even when debts exceed assets.
• Risk can enhance value of equity.
4 Concepts, not details!

Financial Institutions

Financial institutions
Logic, not institutional detail.
1 Might ask: how does fact some banks are too-big-to-fail
impact their WACC and their leverage choice?
2 Might ask: how does limiting leverage impact WACC?
3 Won’t ask: what was the policy response to the crisis?
Distinction between:
1 Firms’ private costs and benefits, which we need to
understand in order to know how they will act.
2 Social costs and benefits, which are what we ultimately care
about.
Power of tools in corporate finance to understand financial system

and the macroeconomy.

Financial institutions: questions
1 Suppose an important financial institution was in trouble. As

a policymaker, what types of considerations would you take
into account when deciding whether to rescue the firm?
2 Why might a banker argue against higher capital

requirements, and an academic argue in favour?
3 To what extent do you agree with the following statement:

‘If policymakers fix banks’ financing decisions, they don’t need
to regulate banks’ investment decisions.’
→ What about if capital markets were perfect?

Corporate Finance: Imperial College Business School

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Corporate Finance

Imperial College Business School

Jamie Coen Review 1 / 42

Maximise the Value of the Firm

The Investment Decision The Financing Decision The Dividend Decision

Jamie Coen Review 2 / 42

Jamie Coen Review 3 / 42

Jamie Coen Review 4 / 42

Jamie Coen Review 5 / 42

1 Why don’t investors care about diversifiable risk? Would this

Jamie Coen Review 6 / 42

1 Why don’t investors care about diversifiable risk? Would this

Jamie Coen Review 6 / 42

1 Why don’t investors care about diversifiable risk? Would this

Jamie Coen Review 6 / 42

1 Why don’t investors care about diversifiable risk? Would this

Jamie Coen Review 6 / 42

Jamie Coen Review 7 / 42

Jamie Coen Review 8 / 42

Jamie Coen Review 8 / 42

3 Suppose you are considering investments over 5 years, and

Jamie Coen Review 8 / 42

Jamie Coen Review 9 / 42

1 Describe the empirical shortcomings of the CAPM, and how

2 What is the logic of the intertemporal CAPM? Why has it not

3 Describe the 3-factor model. What are its advantages and

Jamie Coen Review 10 / 42

Cost of equity to WACC

Jamie Coen Review 11 / 42

1 What is a synthetic rating, and how can it be used to

Jamie Coen Review 12 / 42

1 What is a synthetic rating, and how can it be used to

2 Why shouldn’t you use the book value of equity in estimating

Jamie Coen Review 12 / 42

Cost of capital to hurdle rates

Jamie Coen Review 13 / 42

1 If a project’s return on equity is equal to the firm’s cost of

Jamie Coen Review 14 / 42

1 If a project’s return on equity is equal to the firm’s cost of

2 Do the following take risk into account?

Jamie Coen Review 14 / 42

1 If a project’s return on equity is equal to the firm’s cost of

2 Do the following take risk into account?

Jamie Coen Review 14 / 42

Jamie Coen Review 15 / 42

Perfect capital markets

Jamie Coen Review 16 / 42

1 What do Modigliani & Miller assume about bankruptcy?

2 Draw the cost of equity, cost of debt, and WACC as a

3 To what extent do you agree with this statement:

4 To what extent do you agree with this statement:

Jamie Coen Review 17 / 42

Imperfect capital markets

Jamie Coen Review 18 / 42

1 With perfect capital markets, the relationship between WACC

Jamie Coen Review 19 / 42

Finding an optimal mix

Jamie Coen Review 20 / 42

Jamie Coen Review 21 / 42

2 What are the key weaknesses of each approach?

Jamie Coen Review 21 / 42

Jamie Coen Review 22 / 42