2021. 02. 08.

Information
• Materials: edu.gtk.bme.hu (Moodle)

CORPORATE FINANCE • Requirements:

(BMEGT35M105) – Condition of the signature is active participation in the group work

– Exam in the exam period ~ max. 100 points (to pass min. 50%)
LECTURE 1. INTRODUCTION – Kahoot ~ max. 10 points (if at least pass)
• Scale of grades: above 85 (5); 84,9-70 (4); 69,9-60 (3); 59,9-50 (2); below 49,9 (1)
Nikolett Szallerné Sereg
• Important dates:
sereg.nikolett@gtk.bme.hu
– Breaks on the 15th of March and the 5th of April
Department of Finance, QA332
– Presentation of the group works on the 3rd of May, 12:00-16:00 (replacement
lecture due to spring break)
2020/2021/2

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About the group work Corporate finance as Final exam topic

• 5 students/group – Who is in a group? • Corporate finance is marked with FC in your Programme plan  Part of the final
examination at the end of your studies
– Ifyou have preferences, then the following Google form must be • 3 topics out of 21 comes from the field of Corporate finance
Corporations
filled out by one of the members until the 19th of February:
- Aims of corporations
https://forms.gle/pDReM7PpKWxQj6Cj8 - Corporate governance
- Stakeholder groups and stakeholder management
the 19th of February groups are finalized (students without a
– After
Time value of money
group will be automatically arranged) - The concept of the interest rate and the risk premium
- Present and future value of cash flows (lump sum, annuity, perpetuity)
• Topic: a juicy story/news related to corporate finance
- The effect of compounding on the present and future value of cash flows
– Examples: Diesel emission scandal, WorldCom scandal, etc. Capital budgeting
- Process, basic principles, and useful concepts (e.g., sunk cost)
– Acceptable sources: relevant news sites, scientific articles
- Project categories and interactions
• 10 minutes presentation of the group works on the 3rd of May - Investment decision criteria (NPV, IRR, PI, EAA)

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Facebook page of our Department AGENDA • Introduction

• Present and future value of money
• Capital budgeting
• Analysis of risk factors
• Cost of Capital
• Long-term policies, capital structure
• Short-term policies, working capital
• Dividend policy

https://www.facebook.com/BMEPenzugyekTanszek
• Taxation
• Liquidity management, corporate default

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TODAY • Potato story

• Fundamentals of economics
• Risk aversion, utility maximization
• Rational calculation
INTRODUCTION
• Corporate governance
• Stakeholders

• Stakeholder management
• ESG

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Farm, potatoes, inhabitants…
„Let us imagine a farm that grows potatoes that are sold to and bought by
the inhabitants of a small village. … fertile land is limited, which implies …
a certain amount of potatoes. Let us further assume that the population of
the village grows, and consequently more potatoes are needed …
inhabitants of the village will bid against each other to buy them and the
farmer will be able to raise the price of the potatoes … the farmer may find
it profitable to increase production. The farmer may try to find additional
land (serious investment) or may also try to produce more potatoes on the
land she/he already has, by employing more labor and/or by utilizing more
equipment and manure. In either case, producing more potatoes will drive
up the cost of growing each potato for the farmer. The production will be
increased if the additional income generated by selling more potatoes
exceeds the additional expense required to produce them.”
Source: Marginalism by Bert Mosselmans
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Fundamentals of economics
• Marginalism: examining the effects of consuming/producing
an additional unit of a good or service
– Marginal analysis: comparison of the additional benefits and
additional costs incurred by the same activity
• Gossen’s first law - Law of diminishing marginal utility:
as the consumption of a good/services increases without interruption,
the utility derived from each additional unit is less and less
– Diminishing price: consumers are willing to pay less and less for an
additional unit due to the diminishing marginal utility
• Gossen’s second law - Law of equi-marginal utility:
in order to attain maximum utility, an individual is choosing/buying
products and services in such a way that the marginal utility divided by
the price is equal for every last unit
• Demand – Supply – Marshallian cross
– In the equilibrium: P=MR=MC
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2021. 02. 08.
Marginalism by Bert Mosselmans
• Conditions under which the last potato is produced considered as the "margin"
of the economic activity
– an additional potato will generate additional income (marginal revenue), but it
takes additional expenses (marginal costs)
– the farmer will produce more potatoes as long as the marginal revenue from a
potato exceeds the marginal cost of that potato
– even though more potatoes are available, the inhabitants’ willingness to pay
for an additional potato will decrease, which affects the marginal revenue of
the farmer
– willingness to pay is determined by the satisfaction (i.e., utility) that the
consumers expect to derive from consuming an additional potato
– the market price of a potato will be determined by the conditions at the margin
– in equilibrium marginal cost will be equal to marginal revenue
Utility
• The capacity of a commodity or service to satisfy human needs and wants
– Subjective: it depends upon the individual; measures psychological
(internal) satisfaction
– Relative:
varies from person to person and from time to time or place to
place even for the same individual, e.g., water at home or in the desert
– Abstract:cannot be seen or touched, e.g., advice of a lawyer
– Hardly measurable: mostly ranked or ordered in terms of preference
pattern (except in terms of money)
– Differentfrom usefulness and morality: e.g., smoking is harmful, but it
grants utility for smokers
– Different form joy: can be painful, e.g., injection
http://www.economicsdiscussion.net/articles/utility- features-creation-and-concepts-on- utility/2024
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Risk aversion and utility maximization Utility level

• Risk: the possibility that the actual amounts received later may differ from the • Approximate formula of the utility
expected, this includes not only negative but also positive deviation level of a risk-averse individual:
• Risk aversion leads to rejection of the mathematically „fair” options
• Expected utility ≠ expected value („mathematical expectation”)
– The level of utility (U) increases when
• Rational decision-makers aim to maximize the expected utility of wealth and not
its expected value expected return [E(r)] increases or
standard deviation of the return [σ(r)]
decreases
E.g.: The probability of winning or losing 1 million HUF is 50%
– Greater risk aversion coefficient (A)
– This
game is mathematically „fair”, because our wealth is not expected to
means stronger risk aversion (utility
change: E(W) = 0,5*(W0+1) + 0,5*(W0-1) = W0
function is more and more curved with
– BUTour utility would be reduced, thus we do not participate:
increasing A)
E(U(W)) = 0,5*U(W0+1) + 0,5*U(W0-1) < U(W0)

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Creation of my utility function Rational calculation

Gamble: Probability of winning 1000 EUR is p, probability of losing 1000 EUR is (1-p). • Gamble: we can win or lose $5 with 50%-50% probability
• Assume that our utility function is known:
• Assume I have 0 EUR right now and for me the utility of -1000 EUR is -100 and the
U(W)=ln(W)
utility of 0 EUR is 0.
• Our initial wealth is 10$
• Let's use von Neumann-Morgenstern expected utility model – What is the initial level of utility?
– Generally: E[U(A(X1,X2:p)]=pU(X1)+(1-p)U(X2) U(W0)=U(10)=ln(10)=2.30
– In the case of this gamble: (0~A(1000,-1000,p))  U(0)=p*U(1000) + (1-p)*U(-1000) • Would we participate in this gamble?
• Assume that I would choose to participate in the gamble – What is the expected payout of the gamble?
if the probability of winning is 0.6, then E(X)=p*X1+(1-p)*X2=
=0.5*5+0.5*(-5)=0
– What is the expected utility of our wealth?
– With this method I can create my utility function E[U(W)]=p*U(W0+X1)+(1-p)*U(W0-X2)=
• IMPORTANT: this is only true for me and not directly =0.5*ln(15)+0.5*ln(5)=0.5*2.71+0.5*1.61=2.16
comparable to others, the function values do not have • 2.16 < 2.30, i.e., the expected utility level is lower than the initial, thus we
individual meaning
would not participate…

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Certainty equivalent Rational calculation

• How much wealth would certainly result the previous expected utility level, 2.16? • What would be the expected payout of the gamble if the probability of winning
ln = 2.16 is 80%?
= .
= 8.67 E(X) = 0.8*5+0.2*(-5) = 3
• How much is it less than the initial 10? • What would be the certainty equivalent in this case?
8.67 − 10 = −1.33 – First, what is the expected utility of wealth?
• Participating in the gamble can also be interpreted as certainly losing 1.33 E[U(W)] = 0.8*ln(15)+0.2*ln(5) = 0.8*2.71+0.2*1.61 = 2.49 >2.30 ✓
– This -1.33 is the certainty equivalent of the gamble CE = eE[U(W)] - W0= e2.49 - 10 = 2.06
• Certainty equivalent (CE): the amount of money that certainly result the same • In terms of expected utility, the certain 2.06 and the risky 3 is equivalent
change in the level of utility that we would expect from the gamble • The difference between the two is called risk premium (RP) what is expected as
compensation for taking the risk (the expected value above CE):
RP = E(X) - CE
• What is the risk premium of this gamble?
– Applies to a specific person, who invests if CE > 0
RP = 3 - 2.06 = 0.94

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Rational calculation Kahoot

• Given an investment opportunity: investor is 15% likely to win 4 500$, 25% likely •6 Questions, 30-30 seconds
to lose 1 500$, and 60% likely to win 2 000$.
• Assume our utility function is U(W) = ln(W) and the initial wealth is 5 000$. https://play.kahoot.it/v2/?quizId=1b623831-31fb-47f1-b0c6-
• Is it worth investing in this opportunity? 343472320dad
– What is the initial level of utility?
ln(5 000) = 8.52
– What is the expected utility of wealth?
E(U(W)) = 0.15*ln(9 500) + 0.25*ln(3 500) + 0.6*ln(7 000) = 8.72
8.72 > 8.52  Yes.
• What is the risk premium of this opportunity? RP = E(X) – CE
E(X) = 0.15*4 500 + 0.25*(-1 500) + 0.6*2 000 = 1 500
CE = e8.72 – 5 000 = 1 124
RP = E(X) – CE = 376

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Corporation, LLC Corporate governance

• Business organization, legal entity • Definitions:
• Separate and distinct from its owners – “the system by which companies are directed and controlled” (Cadbury report, 1991)
• It has rights and responsibilities, e.g., – “Corporate governance includes a set of relationships between a company’s
can enter contracts, loan and borrow management, its board, its shareholders, and other stakeholders” (OECD, 1999, 2015)
money, sue and be sued, hire or fire – „ the system of internal controls and procedures by which individual companies are

employees, own assets, and pay managed. It provides a framework that defines the rights, roles and responsibilities of
various groups . . . within an organization” (CFA Institute, 2009)
taxes
• Poor corporate governance is a significant risk:
• Limited liability: shareholders may
– Weak control systems: e.g., bankruptcy
take part in the profits through shares
– Inefficient decisions: e.g., managers are taking excessive risks due to a bad
and dividends, but they are not
compensation scheme
personally liable for the company's
– Legal and reputational risks: e.g., Volkswagen’s emission scandal („dieselgate”)
https://www.youtube.com/watch?v=T1-dd60WU8U
debts resulting in fines and loss in reputation

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Stakeholders Stakeholder groups

1. Investors/Shareholders 1. Shareholders
– Own shares: voting rights and right to receive dividends
2. Creditors – Interested in corporate profitability: increased company value translates into higher share price
– Represented by board of directors: little direct involvement in corporate activities
3. Managers – Controlling vs minority shareholders: difference in power to influence company elections and
resolutions
4. Other employees 2. Creditors:
– Bondholders or banks: lenders and providers of debt financing, in exchange receive interest
5. Board of directors payments
– No voting power: as opposed to shareholders
6. Customers – Payments pre-determined: contractual agreement
– Interested in company’s stability: conflict of interest with shareholders who might have a
7. Suppliers higher risk tolerance
3. Managers and 4. other employees:
8. Government/Regulators – Managers: compensated through salary, bonuses, equity-based compensation
– Lower-level employees: ‘fair’ salary, working conditions, access to promotions, trainings, safe
9. Society and healthy work environment
– Interested in company’s viability: benefit from good performance, suffer from poor
performance (lay-offs)

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Stakeholder groups Stakeholder groups

5. Board of directors: 6. Customers:
– Elected by shareholders to protect their interests, provide strategic direction, monitor
– Satisfy their needs
company performance
– One-tier structure: single board of directors with executive (internal) and non-executive – Meet safety standards
(external) directors – Typically, less interested in company’s performance: except for long-term
– Two-tier structure: supervisory board (with executive directs) + management board (with
customers (e.g., MS PowerPoint and switching cost of learning another software)
non-executive directors). The former could challenge the latter
– No single optimal structure: number of directors should vary with company size, experience
7. Suppliers:
and qualifications of members, it can evolve in time – Interested in getting paid, on time
– CEO duality: when CEO is also chairman of the board. Less and less common in one-tier – Long-term relationship: benefitting both parties
systems, not permitted in two-tier systems
– Interested in company’s stability: like creditors
– Committees: BoD can establish them to focus on specific functions, e.g. audit committee,
compensation committee, nomination committee etc. 8. Government and regulators:
– Responsibilities: duty of care (act on a fully informed basis) + duty of loyalty (act in the – Protect the interest of the general public: safety standards, competition
interest of the company and its shareholders) authorities etc.
– Focus on strategic direction: delegate daily activities to management
– Protect country’s economic interests: collect taxes, impose import duties
– Oversees audit reports: from internal audits, the audit committee, external audits, proposes
follow-up action 9. Society (ESG)

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Stakeholder management Stakeholder management

• Conflict of interest between stakeholders (e.g., information • General meetings:
asymmetry, risk appetite, price, safety standards, stability, – Shareholders exercise their right to vote on major corporate matters (e.g., board of

taxes, etc.) directors' election)

– Annual general meeting following the end of the fiscal year, overview of internal
– Important to balance interests of different stakeholders and audit and company performance, addressing shareholder questions
limit conflicts – Extraordinary general meetings called to vote on significant resolutions, such as
modification of bylaws, mergers and acquisitions, sale of large assets, etc.
• Mechanisms (differ by country and jurisdiction)
• Audit function:
– common elements, such as the existence of – The set of systems, controls and policies in place to examine the firm’s operation and
• general meetings, financial records, in order to mitigate fraud
• auditing, – Internal audits: conducted by independent internal department

• policies on manager compensation, – External audits: conducted typically annually by an external audit firm, usually
recommended by the audit committee
• policies on related-party transactions, etc.
– Board of directors: review audits before they are presented to shareholders at the
annual general meeting

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Stakeholder management Environmetal and social governance (ESG)

• Compensation policies: – Lack of definitive terminology: several
– Aligning the interest of managers and shareholders: incentive plan including a commonly used terms co-exist: ‘sustainable
variable component based on stock price investing’ and ‘responsible investing’ and ‘ESG
• Risk of ‘short-termism’: managers maximize short-run stock price instead of company investing’ and ‘socially responsible investing’
performance leading to long-run stock price – Environmental and social factors evolved more
– Long-term incentive plans: e.g., restricting sale of stocks until retirement or delay slowly than other corporate governance factors
compensation partially until some performance targets are met – Recent environmental disasters and social
– Say on pay: shareholders vote on executive compensation plans controversies speeded up the use of ESG: e.g.,
• Policies on related-party transactions: BP oil spill in the Gulf of Mexico in 2010;
Walmart’s 2011 loss of a class action suit due to
– Increasingly common practice
wage discrimination and Volkswagen’s 2015
– Conducted by independent internal department to avoid conflicts of interest ‘dieselgate’ scandal
– Directors and managers are required to disclose any direct or indirect, actual or
– Good ESG can reduce a firm’s cost and/or
potential conflict of interest when dealing with a related-party (voting excluding mitigate the risk of litigation and improve its
those holding the conflicting interest) reputation https://www.economist.com/briefing/2019/08/22/big-business-is-
beginning-to-accept-broader-social-responsibilities

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ESG factors ESG implementation

– Environmental factors: natural Plenty of ways to choose ESG oriented company for investment:
resource management, pollution
prevention, water conservation, • Negative screening: most widespread approach, excludes certain
energy efficiency etc.
sectors from investment (e.g., fossil fuel extraction or weapons’ trade)
– Social factors: management of
human capital, human rights and • Positive screening (best-in-class): finding the best companies in each
welfare concerns, worker training, sector through some ESG scoring method
employee diversity etc.
• Thematic investing: investment in a specific sector e.g., startups
Minimizing social risks can reduce
operating costs as well (e.g., less dealing with climate change
waste, reduced reputational risks) • Impact investing: targets specific environmental or social goal, e.g.,
– Industry factors: e.g., emissions,
water usage and pollution crucial for a
buying green bonds to advance low-carbon initiatives
mining company, less important for a
bank
https://www.bbc.com/news/business-48999338

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Summary NEXT TIME • Present and future value of money

• Companies should consider all of their stakeholders, not just their shareholders, when You will need a CALCULATOR!
planning and implementing their strategy
• Conflicts of interests between different stakeholder groups arise naturally
• Adopting good corporate governance practices is important to mitigate these conflicts
• Environmental and social considerations play an increasingly important role in investments

https://www.youtube.com/watch?time_continue=1&v Thank you for your attention!

=VHGTsEwbOJY&feature=emb_title

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Group work
• 10 minutes presentations on the 3rd of May
CORPORATE FINANCE • About a juicy story/news related to corporate finance
(BMEGT35M105) – Examples: Diesel emission scandal, WorldCom scandal, etc.
– Acceptable sources: relevant news sites, scientific articles
LECTURE 2. TIME VALUE OF MONEY
• If
you have preferences, please fill out the following form until
Nikolett Szallerné Sereg the 19th of February: https://forms.gle/pDReM7PpKWxQj6Cj8
sereg.nikolett@gtk.bme.hu
the 19th of February groups will be finalized (students
• After
Department of Finance, QA332
without a group will be automatically arranged)

2020/2021/2

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Last time
• Utility is measuring the psychological (internal) satisfaction of the individual and
varies from person to person and from time to time or place to place even for the
same individual
• Certainty equivalent (CE): the amount of money that certainly result the same change
in the level of utility that we would expect from a given gamble
• Risk premium (RP): expected as compensation for taking risks TODAY:
• Corporation is a legal entity, it has limited liability
• Poor corporate governance is a significant risk (bankruptcy, inefficient decision
TIME VALUE OF MONEY
making, fines and loss in reputation)
• Conflict of interest between stakeholders (e.g., information asymmetry, risk appetite,
price, safety standards, stability, taxes, etc.)
– Important to balance them (general meetings, auditing, policies on manager
compensation, on related-party transactions, etc.)
• Environmental and social considerations play important role in corporate finance

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Would you accept an exchange where..
• You give 100$ now and certainly receive 100$ one year later…
– Positive time preference, opportunity cost, inflation (reduces the purchasing
power of a unit of currency)
https://www.youtube.com/watch?v=PCzi8k84X4g&feature=emb_title
Would you accept an exchange where..
• You give 100$ now and certainly receive 105$ one year later…
– Could I find better opportunity, which will make more than 5$ a year?
• What would be the interest rate? (105-100)/100=0.05 or 5%
• Interest rate can be thought of in three different ways:
– Required rate of return: the minimum rate of return an investor must
receive in order to accept the investment
– Discount rate: the rate at which we discounted the future amount to find
its value today
– Opportunity cost: the value that investors forgo by choosing a particular
course of action. E.g., if you would choose to spend the money today
instead the exchange, you would have forgone earning 5% on the money.
So we can view 5% as the opportunity cost of current consumption

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Risk premiums Timing of cash flows

• Interest rates (r) are set in the market by the forces of supply and demand • We will think of cash flows for now as simple payments (lump sum or annuity)
• Taking the perspective of investors in analyzing market-determined interest rates: • Timeline:
r is being composed of a real risk-free interest rate plus a set of premiums
(required returns or compensations for bearing different types of risk): 0 1 … N-1 N
r = real risk-free interest rate + inflation premium + default risk premium +
+ liquidity premium + maturity premium + … • E.g., 100
• inflation premium: for the expected inflation – Lump sum due in the 3rd year
– nominal risk-free interest rate: real risk-free interest rate + inflation premium 0 1 2 3

• default risk premium: for the possibility that the borrower will fail to pay back
• liquidity premium: for the risk of loss relative to an investment’s fair value if the 10 10 10
investment needs to be converted to cash quickly – Ordinary annuity for 3 years
• maturity premium: for the sensitivity to a change in market interest rates at 0 1 2 3
different maturities
CFA I. Time value of money

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Future value of a single cash flow (lump sum) Future value of a single cash flow (lump sum)
• You deposited $100 today in a saving account that pays you 3% interest per year. • Multiple periods: How much money will you get at the end of the third year if
How much money will you get at the end of the first year? the interest is automatically reinvested?
Period (N) Calculation Amount
= 100 =?
r =3% 1. 100*(1+0.03) $103

0 1 2. 100*(1+0.03)*(1+0.03) $106.09
3. 100*(1+0.03)*(1+0.03)*(1+0.03) $109.2727
−
• The interest rate can be calculated as: = = −1
• You will get $109.2727
• Then…
=1+r = 1+ = (1 + ) • The interest of the interest is $0.09 in the second period and $0.2727 in the third
• The future value is very sensitive to the interest rate (specially for longer
• If r = 3%, the future value of the $100 is: periods), e.g., if it would be 13% then
100 ∗ 1 + 0.03 = 103 = 100 ∗ 1 + 0.13 = 144,2897

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General formula of compounding The effect of compounding frequency on FV

• This method is called calculation based on compound interest or compounding r =3% Single
N FV/PV
• is the stated annual interest rate, m is the number of compounding periods per year
1 1.030 • /m (periodic rate) and mN (number of compounding periods) must be compatible
2 1.061
PV = (1 + ) 3 1.093 • Periodic and continuous compounding (e ≈ 2.7182818)
4 1.126
5 1.159 = (1 + ) =
6 1.194
0 1 … N 7 1.230
8 1.267
• r and N must be compatible: both variables must be defined in the same time unit 9 1.305
E.g., if N is stated in years, then r should be annual as well 10 1.344
11 1.384
12 1.426
= (1 + ) = ( / , %, ) = ( / , %, ) 13 1.469
14 1.513
15 1.558
• (1 + ) is called the future value factor, can also be donated as ( / , %, ) 16 1.605
17 1.653
• E.g., let's look at the previous example: PV=100$, r=3%, N=3 years 18 1.702
19 1.754
= 100 ∗ , 3%, 3 = 100 ∗ 1.093 = 109.3 20 1.806
CFA I. Time value of money

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Compounding frequency example Future value of an annuity

• Suppose your bank offers you an investment with a two-year maturity, a stated • An annuity is a series of equal payments at fixed intervals for a specified number
annual interest rate of 8 percent compounded quarterly, and a feature allowing of periods.
reinvestment of the interest at the same interest rate. You decide to invest $10,000.
• In the case of ordinary annuity, payments occur at the end of each period
What will the investment be worth at maturity?
• Suppose that you can save up $100 at the end of each year and you deposit it in
your saving account that pays you 3% interest per year. How much money will
you get at the end of the third year?
100 1 + 0.03
100 1 + 0.03 Sum =
100 100 100 100 1 + 0.03
• What if the interest is compounded continuously?
0 1 2 3

= 100 ∗ [(1 + 0.03) + 1 + 0.03 + 1 + 0.03 ] = 100 ∗ 3.0909 = 309.09

CFA I. Time value of money

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General formula for FV of an annuity Present value of a single cash flow (lump sum)
r =3% Annuity r =3% Single
• In general: = [ 1+ + 1+ + ⋯+ 1+ ] N FV/A
• You will need $10,000 for your tuition expenses 3 years from now. N PV/FV
– Formula for the sum of a geometric series is needed 1 1,000 How much should you deposit today in a saving account if the interest is 1 0,971
2 2,030 3% per year? 2 0,943
3 3,091 3 0,915
4 4,184 4 0,888
5 5,309 = (1 + ) 5 0,863
(1 + ) −1 6 6,468 = 6 0,837
= 7 7,662 (1 + ) = /(1 + ) 7 0,813
A A
8 8,892 8 0,789
9 10,159 = 1+ 9 0,766
10 11,464 10 0,744
0 1 … N 0 1 … N
11 12,808 11 0,722
12 14,192 12 0,701
PV = 10000 ∗ 1 + 0.03 = 9151.4166
13 15,618 13 0,681
( ) 14 17,086 14 0,661
• Future value annuity factor: =( , %, ) 15 18,599
• Present value factor: 1 + =( , r%, N) 15 0,642
16 20,157 16 0,623
– the reciprocal of the future value factor, e.g., FV=10000$, r = 3%, N = 3
• Let's look at the previous example: A=100$, r =3%, N=3 years 17 21,762 17 0,605
18 23,414 18 0,587
19 25,117 PV 19 0,570
= 100 ∗ ( , 3%, 3) = 100 ∗ 3.091 = 309.1 20 26,870 = 10000 ∗ , 3%, 3 = 10000 ∗ 0.915 = 9150 20 0,554

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Present value formula for freq. compounding Present value of an ordinary annuity
• A pension fund manager knows that the fund must make a lump sum payment of • Suppose you are considering purchasing a financial asset that promises to pay €100
$5million 10 years from now. She/he wants to invest an amount today which will grow per year for 3 years, with the first payment one year from now. The required rate of
to the required amount by then. The current interest rate of the chosen opportunity is 6 return is 3% per year. How much should you pay for this asset?
percent a year, compounded monthly. How much should she/he invest today to get the
$5 million 10 years from now?
100 1 + 0.03
Sum = 100 1 + 0.03
100 1 + 0.03 100 100 100

0 1 2 3

= 100[ 1 + 0.03 + 1 + 0.03 + 1 + 0.03 ] = 282.861

• With continuous compounding?
. ∗
PV= = 5,000,000 ∗ = 2,744,058.18047

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General formula for PV of an annuity Present value of perpetuity

r =3% Annuity
• In general: = + + ⋯+ N PV/A • Perpetuity (perpetual annuity): infinite series of equal cash flows, the first cash
1 0,971
2 1,913
flow occurring one period from now
3 2,829
4 3,717
5 4,580
1
(1 + ) − 1 =
=
(1 + )
6
7
5,417
6,230
(1 + )
A A A
8 7,020
9 7,786 • As long as interest rates are positive, the sum of present value factors converges:
10 8,530
0 1 … N 11 9,253

( )
12
13
9,954
10,635
=
• Present value annuity factor: = , %, 14 11,296
( ) E.g., a stock paying constant dividends is can be interpreted as a perpetuity
15 11,938
16 12,561
• Let’s look at the previous example: A=100$, r = 3%, N = 3 years 17 13,166 • With the first payment a year from now, a perpetuity of $10 per year with a 20%
18 13,754
PV= 100 ∗ ( , 3%, 3) = 100 ∗ 2.829 = 282.9 19 14,324 required rate of return has a present value of …
20 14,877
$10/0.2 = $50

19 20
 2021. 02. 15.

Finding the annuity for a given FV or PV Future and present value of unequal cash flows
r =3% Annuity
• The reciprocal of the present value annuity factor: A/FV • Gradient (1 + ) − −1
N A/PV = ( − 1) , N≥1 =
(1 + ) − 1 (1 + ) 1 1,030 1,000 (1 + )
= = 2 0,523 0,493
(1 + ) (1 + ) − 1 3 0,354 0,324
0G 1G … (N-1)G
4 0,269 0,239
5 0,218 0,188
• Or the reciprocal of the future value annuity factor: 6 0,185 0,155
7 0,161 0,131 0 1 2 … N
(1 + ) −1 8 0,142 0,112
= =
(1 + ) −1 9 0,128 0,098 • Exponential (just for fun) 1 − (1 − ) (1 + )
10 0,117 0,087 ≠
11 0,108 0,078 −
• You are planning to purchase a $120,000 house by making a 12 0,100 0,070
= (1 + ) =
down payment of $20,000 and borrowing the remainder with 13 0,094 0,064 =
a 20-year fixed-rate mortgage. The first payment is due at t = 14 0,089 0,059 1+
1. Current annual mortgage interest rates are 3%. What will 15 0,084 0,054
16 0,080 0,050
your yearly mortgage payments be? 17 0,076 0,046 (1 + ) (1 + ) … (1 + )
18 0,073 0,043
• = 100,000 ∗ , 3%, 20 = 100,000 ∗ 0.067 = 6700 19 0,070 0,040
20 0,067 0,037 1 2 N
0 …

21 22

Example for a gradient Solving for the interest rate (r)

• Suppose that an investment opportunity generates the following payouts in r =3% Gradient
• By rearranging the basic equation, = (1 + )
N PV/G
the future: CF2=100, CF3=200, CF4=300. What is the present value of this 1 0,000
opportunity if the annual discount rate is 3%? 2 0,943
3 2,773
4 5,438
5 8,889 = −1
300 1 + 0.03
6 13,076
Sum = 200 1 + 0.03 7 17,955
100 1 + 0.03 100 200 300 8 23,481
9 29,612
10 36,309 • You can buy a security now for $1000 and it will pay you $1,191 three years
0 1 2 3 4 11 43,533
12 51,248 from now. What annual rate of return are you earning?
13 59,420
= 300 1 + 0.03 + 200 1 + 0.03 + 100 1 + 0.03 =543.834 14 68,014

( )
15 77,000 1191
• Or with the Present value gradient factor: =( , %, ) 16 86,348 = − 1 = 0.06
( ) 17 96,028 1000
18 106,014
= 100 ∗ , 3%, 4 = 100 ∗ 5.438 = 543.8 19 116,279
20 126,799

23 24
 2021. 02. 15.

Solving for the time period (N) Kahoot

• You are interested in determining how long it will take an investment of €100 to •6 Questions, 30-30 seconds
double in value. The current interest rate is 7 percent compounded annually.
• By using the rule, ln = ( ) https://play.kahoot.it/v2/?quizId=f4be3782-9058-4fcd-bad7-
15fa7aa8ad93
(1 + ) = (1 + ) = ln 1+ = ln −

ln − 200 − 100
= = = 10.245
ln 1 + 1.07

• It will take approximately 10 years for the initial investment to grow double
SUMMARY
Assessing the amounts, timing and uncertainty of cash flows is one of the most
basic objective of corporate finance

25 26

NEXT TIME Decision criteria (NPV, IRR, PI, AE)

BRING A CALCULATOR!

Thank you for your attention!

27
 2021. 02. 22.

Group members
Group 1 Csongor Lili Gutierrez Murray Monica Lengyel Dorottya Sabayeva Fariza Sari Intan Permata

Group 2 Erőss Kinga Elvira Gyakovácz Dóra Kovács Henriett Kovács Kristóf Somogyi Kata

Group 3 Dangmany Thiphasone Dib Yazan Atif Fetiulina Nina Vannalath Parinya Wara Noor Ul

CORPORATE FINANCE Group 4 Balgabay Nazerke Hernandez Rojas Carlos Eduardo Levine Salazar Damian Antonio Prokopovich Iuliia Sanchez Guizar Juan Daniel

(BMEGT35M105) Group 5

Group 6
Aliyeva Ayshan

Besani Nour Jamal

Gurbanova Khayala

Gobechia Ana
Rahimov Elgiz

Kazimov Zeynal
Rzayeva Madina

Sainov Alikhan
Shirvanli Shirvan

Vardanidze Tamar

Group 7 Boulila Oussama Jumshudova Gunel Ronoh Chebet Carolyne Sisodia Ishita

LECTURE 3. DECISION CRITERIA Group 8

Group 9
Akparalieva Aziza

Akdag Ebrar Samed

Asanbekova Aizada

Hasanov Samir
Gaál Csaba Péter

Mamishov Shahin
Körtvélyessy Máté András

Mammadov Avaz
Tithi Tazrian Azad

Taghiyeva Maryam

Group 10 Arora Namrata Anil Huseynov Aghvan Mammadov Bahadur Mustafayev Turan Suleymanov Elvin Sahin
Nikolett Szallerné Sereg Group 11 Hamidov Ashraf Javadzade Vadim Latifov Khudayar Mammadov Farid Nguyen Vu Trinh

Group 12 De La Rosa Duarte Salomon Isaac Nassyrova Inara Song Wenting Tan Hongling ZHENG ZHIFANG
sereg.nikolett@gtk.bme.hu
Group 13 Ahmadova Irada AlFayyad Hasan Aslanov Ismayil Madaen Basel Nader Suleiman Mustafa Ahmed Amin

Department of Finance, QA332 Group 14 Bendraoui Oumaima Fiddah Alaa Matiea Atlehang Princes Mokakale Tumisang Pricelda Sassi Kawtar

Group 15 Akbarov Kazim Krémer Eszter Valéria Maczák Edit Éva Sztaraszta Vivien Wieder-Flautner Noémi Hedvig

Group 16 Asiri Ali Yasin Ali Cabrera Uscanga Claudia Lizbeth Mrad Mohamad Hussein Naveed Saqib Undrakh Oyunbat

Group 17 Gurbanli Matlab Huseynzade Rashad Jafarli Nihad Qiu Man Yahyayev Farid
2020/2021/2

1 2

Last time
• People has positive time preference; we care about the cost of the forgone
opportunities; we are „afraid” of the inflation
• Interest rate can be thought of in three different ways (required rate of return
or the minimum rate of return an investor must receive in order to accept the
investment; discount rate in present value calculation; opportunity cost that
investors forgo by choosing a particular course of action) TODAY:
• Interest rates (r) are set in the market by the forces of supply and demand DECISION CRITERIA
• Real risk-free rate + set of premiums (inflation, default, liquidity, maturity)
• Nominal risk-free interest rate = real risk-free interest rate + inflation premium
• Present and future value calculation formulas
• Assessing the amounts, timing and uncertainty of cash flows is one of the
most basic objective of corporate finance

3 4
 2021. 02. 22.

Amis of corporations - Value maximization Profit

• Different value categories
– Book value is the asset’s historical value and is represented on the balance sheet as
the actual cost minus depreciation
– Liquidation value is the amount that could be realized if the asset were sold
individually and not as part of going concern
– Market value is the observed value for an asset in the marketplace where buyers
and sellers negotiate a mutually acceptable price
– Fair value is the potential price or assigned value of a good or service which is
taking account its utility, supply, demand and competition for it
– Intrinsic value is a present value, the expected future cash flows discounted at an
appropriate discount rate, which reflects risks
• The objective is to maximize the intrinsic value of the firm
• The value of a firm represents owner’s (shareholder’s) wealth, which is given by the
present value of all expected future profits
• Total revenue reduced by total cost including the cost of capital
• Measure of success in a business, indicator of the comparative performance
• Typical source of profit:
– Arbitrage: detecting good business opportunities; something, somewhere,
somehow cheaper to obtain than it can be sold elsewhere or in a different way
– Innovation: developing a new way of meeting consumer needs in a more efficient
way than ever before
– Imitation, duplication: copying other’s arbitrages, innovations, preferably faster
than others
• Taking advantage of these will trigger a price correction and blow the opportunity
• The entrepreneurial activity basically means the search for arbitrage, innovation and
imitation opportunities
• The reward of the good entrepreneurial activity is the profit

5 6

Concept of corporate finance Capital budgeting

Investment decisions Financing decisions Dividend decisions • Process of decision making on long term (more than a year) capital projects
• It affects the future of the corporation, capital decisions cannot be easily
Finding right kind of Finding the right kind Finding the right
reversed, mistakes are very costly
investment of source and the right amount and timing to
opportunities: kind of mix of dept and return the „borrowed” • It makes up the long-term asset portion of the balance sheet:
Which investment? equity: money to its „owners”:
Current liabilities
What is the riskiness, What kind of source? How much money?
Current assets
mixture, magnitude and What is the optimal In which way (e.g.,
timing of cash flows? mix? dividends, buybacks)? Long term dept
What is the cost of
Fixed assets
capital?
(tangible and Shareholders’
intangible) equity

7 8
 2021. 02. 22.

Process of capital budgeting Typical project categories

1. Generating ideas • Replacement: a piece of equipment breaks down / wears out, or choosing
– From inside (from the top to the bottom of any functional area) or another type of equipment (no need to overanalyzing the decision)
outside of the company • Expansion: increase the size of the business (more careful consideration)
2. Analyzing individual proposals
• New products and services: more complex than the expansion (more
– Gathering the information to forecast cash flows and analyze the
uncertainty, could require involving more people into the decision)
profitability of the (alternative) projects
3. Planning the capital budget • Regulatory, safety and environmental: required by a governmental agency,
– Scheduling and prioritizing projects
an insurance company, or some other external party, revenue may not
occur, high costs could result the shut down of the project related part of
– Analyze the fit of the proposed projects with the company’s strategy
the business (could be a „painful” decison)
4. Monitoring and post-auditing
– Compare estimated and realized results and explain the differences • Others: pet projects of someone in the company (such as the CEO buying a
The benefits from the capital budgeting process should exceed the costs of new aircraft) or research and development decisions (involves very high
the efforts uncertainty)
CFA I. Corporate finance modul

9 10

Basic principales of capital budgeting Useful concepts in capital budgeting

• Decisions are based on expected cash flows
– A family farm can sell their grain for 20 MHUF if the weather is
favorable. There is a 10% chance that the weather will be very
drought, so only 10 MHUF worth of grain can be harvested. What is
their expected cash flow? The expected cash flow should reflect all
known risks E(CF)=0.9*20+0.1*10=19 MHUF
• Timing of cash flows is considered
• Sunk cost: current and future cash flows should not be affected by previously
incurred, irretrievable costs (time, money, effort)
• Opportunity cost: what a resource is worth in its next-best use
• Incremental cash flows: the additional cash flow that is realized because of the
decision, the cash flow with a decision minus the cash flow without that decision
• Externality: a cost or benefit inflicted or received by an unrelated third party, from
inside and outside of the company (e.g., a bar opens next to a restaurant)
• Cannibalization: it occurs when an investment takes customers and sales away

• Opportunity costs are taken under consideration

from another segment of the company. (e.g., Coca zero vs Coca light)
• Conventional cash flow: initial cash outflow(s) followed by a series of cash inflows
• Cash flows are analyzed on an after-tax basis
• Non-conventional cash flow: there is more than one change in direction of cash
• Financing costs are ignored in cash flow estimation, they are accounted inflows and outflows
in the cost of capital (aka discount rate) • (Note that a project can generate only cash outflows throughout its whole duration,
e.g., a heating system)

11 12
 2021. 02. 22.

Sunk cost Project interations

• Independent projects: their cash flows are independent of each other (e.g.,
new product line, improving IT infrastructure of workers)
• Mutually exclusive projects: they compete directly with each other, the
company can/should choose one of them (e.g., whether a manufacturer
expand its existing plant or build a new one)
• Project sequencing: investing in a project creates the option to invest in
other projects in the future (e.g., buying a land, then choosing equipment to
work on that land, etc.)
• Unlimited funds: the company can raise the funds it wants for all
profitable projects simply by paying the required rate of return
• Capital rationing: the company has a fixed amount of capital to invest. If
the company has more profitable projects than it has funds for, it must
allocate the funds to achieve the maximum shareholder value subject to the
https://www.youtube.com/watch?v=AFPgxIJHxsE funding constraints

13 14

Investment decision criteria Example

• Analysts use several criteria to evaluate capital investments • A fellow student tries to convince you to start operating a food truck
selling craft beer in front of BME’s main building.
• Mostly used measures:
– Net present value (NPV)
– Internal rate of return (IRR)
– Profitability index (PI)
– Equivalent Annual Annuity (EAA)

– Discounted payback period (DPP) • Your estimate of initial investment is 5500 EUR, then for 3 years
• An analyst must fully understand the economic logic behind each of these every year you can sell 10000 EUR worth of beer and you have
investment decision criteria as well as its strengths and limitations in practice 8000 EUR of expenses (tax included). The interest rate is 5%.
Is it profitable?

15 16
 2021. 02. 22.

Example Net Present Value Rule

-5500 2000 2000 2000 r =5% Annuity • Net present value is equal to the present value of all future cash flows, minus the
• Timeline: N PV/A
1 0,952 initial investment (outlay)
2 1,859
0 1 2 3 3 2,723
• Rule: if NPV ≥ 0, you should invest
4 3,546 – It means that the investment will provide at least the required rate of return
−5500 ∗ 1 + 0.05 + 2000 ∗ 1 + 0.05 + 2000 ∗ 1 + 0.05 + 5 4,329
+2000 ∗ 1 + 0.05 = −53.5 6 5,076 – In the case of competing alternatives or projects, higher NPV is better
7 5,786
• Or with the present value annuity factor: 8 6,463 • Advantages:
9 7,108 – Based on expected cash flows and considers the time value of money
10 7,722
= 2000 ∗ , 5%, 3 = 2000 ∗ 2.723 = 5446 → 5446−5500 = −53 11 8,306 (without time value consideration selling craft beer would seem a good investment:
This is called Net Present Value calculation, general formula:
12 8,863 -5.5 + 3*2 = 0.5)
13 9,394
14 9,899 – Simple decision rule: NPV < 0  do not invest
( ) ( ) 15 10,380
• Disadvantages:
= + = 16 10,838
(1 + ) (1 + ) 17 11,274 – Uncertainty about the interest rate, future cash flows and the duration of the project
18 11,690
is usually negative (initial investment) and ( ) means the expected 19 12,085 – Dependent on the size of the project: many smaller NPV projects could be completed
value of the risk-involved cash flows 20 12,462 with the same investment resulting in higher aggregate NPV (capital rationing)

17 18

Internal rate of return (IRR) Decision by IRR

• The interest rate which makes the NPV equal to 0: 2000 • Rule: IRR ≥ r  you should invest
( ) ( ) ( ) 1500
= + + ⋯+ = =0 – IRR (internal rate of return), r (minimum required rate of return)
(1 + ) (1 + ) (1 + ) 1000
NPV

• Advantages
• Example: 500

0
– Independent from the size of the project
-2000 1000 2000 500
0% 20% 40% 60% 80% 100% 120%
-500 • Disadvantages
• We need to find the IRR (trial and error): IRR

– A: If rA= 36% then NPVA= 11 30 – Analytical calculation is hard or impossible

– B: If rB= 37% then NPVB= -7 20 – It works well only with conventional cash flows (multiple IRR problem)
10
• Interpolation (linear estimation of a non-linear problem): – A multi-relative indicator: cannot be used for comparison of different
NPV

0
= + ∗ − = 35% 36% 37% 38% projects, only if they are doing the same business activity, with similar
( − ) -10
11 -20
cash flow timing and structure
= 0.36 + ∗ 0.37 − 0.36 = 0.3661
11 + 7 -30
IRR
• rA (where NPVA>0) and rB (where NPVB<0) better to be close CFA I. Corporate Finance

19 20
 2021. 02. 22.

NPV vs. IRR Profitability Index (PI)

• Both profitable, but you must choose (mutually exclusive projects): • The present value of a project’s future cash flows divided by the initial investment
• PI indicates the value you are receiving in exchange for one unit of invested capital
• Method is used when limited capital is available and projects are mutually exclusive
– Projects are ranked by their PI (indicator of the most productive use of limited capital)
• Profitability index is also called the benefit-cost ratio:
( ) ( )
∑ ∑
(1 + ) (1 + )
= =1+ =1+
– A (higher IRR) or B (higher NPV)? | | | | | |
• In the case of competing alternatives or projects: do not use IRR • Rule: PI ≥ 1, worth investing
– NPV is better
• Example: The Gerhardt Corporation investment (discussed earlier) had an outlay of
– Mathematically, whenever you discount a cash flow at a particular discount rate, you €50 million, a present value of future cash flows of €63.136 million, and an NPV
are implicitly assuming that you can reinvest a cash flow at that same discount rate. of €13.136 million. The profitability index is
– In the NPV calculation, you use a discount rate of 10 percent for both projects. In the
63.136 13.136
IRR calculation, you use a discount rate equal to the IRR of 21.86 percent for Project = =1+ = 1.26 >1 Profitable investment
50 50
A and 18.92 percent for Project B.

21 22

Equivalent Annual Annuity (EAA) Discounted Payback Period (DPP)

• The approach calculates the constant annual cash flow generated (1 + ) • The number of years it takes for the cumulative discounted cash flows from a
by a project over its lifespan as it would be an annuity =
(1 + ) − 1 project to equal the initial investment
• Good for different problems: • Example (r =10%)
– Determining the optimal time to replace an asset (the optimal replacement cycle)
– Evaluating projects with different life durations
– Projects that repeated in perpetuity

• Equivalent Annual Cost (EAC) to compare the cost-effectiveness and Equivalent Annual
Benefits (EAB) to compare the profitability of various assets that have unequal lifespans
• Example to EAC (r = 6%): 6% = −15 + −5 ∗ 2.673 = −28.37$
6% = −10 + −6 ∗ 1.833 = −21.00$
• The payback period (which ignores the time value of money) is between three and
Options CF0 CF1 CF2 CF3 four years: 3 years + 500/1,500 = 3.33 years
0.06(1 + 0.06)
A -15 -5 -5 -5 6% = −28.37 = −10.61$/
(1 + 0.06) − 1 • The discounted payback period is between four and five years:
B -10 -6 -6
0.06(1 + 0.06) 4 years + 245.20/931.38 = 0.26 = 4.26 years
6% = −21.00 = −11.45$/
(1 + 0.06) − 1
• A is better, it should be chosen • Drawback: CFs beyond the payback are ignored, no concrete decision criteria
CFA I. Corporate Finance

23 24
 2021. 02. 22.

Skiing Cannery
• Assume we are regular skiers – we go skiing 5 days per year (7 days with the travel) for the next • A canning company wants to install a new filling line:
five years; the opportunity cost of skiing is 8% – They have at their disposal a property with a book value of 100 MHUF (irretrievable)
• Options for getting the necessary equipment:
– A. We buy our own equipment and transport it on a roof box to the venue: 75 000 HUF for the – The price of the line is 50 MHUF, which will be completely outdated after 3 years
new equipment + 20 000 HUF for the roof box – Costs, taxes, etc. are expected to be 20 MHUF in each year, revenues are 45 MHUF
• We would probably replace it with a new one after 5 years, but we would sell the old one for
– There is an alternative option: the property would be leased by a paint factory (assumed to be
15 000 HUF
– B. We are renting the equipment at home and transport it to the venue: 2300 HUF/day for 7 days
equally risky) in the next 3 years for 10 MHUF per year
+ 20 000 HUF for the roof box • Is the investment worth making if the required rate of return is 5%? r =5% Annuity
– C. We are renting the equipment at the venue: 3300 HUF/ day for 5 days N PV/A
– The book value of 100 MHUF is the result of an earlier decision, 1 0,952
15000
= −75000 − 20000 + ≈ −84800 independent from the recent one: sunk cost 2 1,859
(1 + 0.08) 3 2,723
– CF0 = -50 MHUF and there is no residual value 4 3,546
(2300 ∗ 7) 16100 16100 16100 16100 – CF1 = CF2 = CF3 = (45-20) = 25 (in real sense)
= −20000 − − − − − ≈ −84300
1 + 0.08 (1 + 0.08) (1 + 0.08) (1 + 0.08) (1 + 0.08) – NPV of the new filling line without the paint factory option: -50+25*2.723=18.075 MHUF
(3300 ∗ 5) 16500 16500 16500 16500 – NPV of the paint factory option: 10 MHUF*2.723=27.23 MHUF
=− − − − − ≈ −65900
1 + 0.08 (1 + 0.08) (1 + 0.08) (1 + 0.08) (1 + 0.08) – NPV of the new filling line with the paint factory option: -50-27.23+25*2.723= -9.155
 No new filling line

25 26

What is the NPV of this cash flow series? What is the IRR?
200 r=8% Single Annuity 200 r=15% Single Annuity
N PV/FV PV/A N PV/FV PV/A
1 0,926 0,926 1 0,870 0,870
100 r = 8%
2 0,857 1,783 100 r = 8%
2 0,756 1,626
3 0,794 2,577 3 0,658 2,283
4 0,735 3,312 4 0,572 2,855
5 0,681 3,993 5 0,497 3,352
6 0,630 4,623 6 0,432 3,784
1 6 13 7
8
0,583
0,540
5,206
5,747
1 6 13 7
8
0,376
0,327
4,160
4,487
9 0,500 6,247 (8%) = 281.5 9 0,284 4,772
10 0,463 6,710 10 0,247 5,019
11 0,429 7,139 15% = ? 11 0,215 5,234
12 0,397 7,536 12 0,187 5,421
13 0,368 7,904 13 0,163 5,583
= (−1000 + 100) + 100( , 8%, 13) + 100( , 8%, 8)( , 8%, 5) =
-1000 -1000 15% = −900 + 200 , 15%, 13 − 100 , 15%, 5 =
= −900 + 100 ∗ 7.904 + 100 ∗ 5.747 ∗ 0.681 = −900 + 790.4 + 391.37 = 281.77
or = −900 + 200 ∗ 5.583 − 100 ∗ 3.352 = −900 + 1116.6 − 335.2 = −118.6
= (−1000 + 100) + 200( , 8%, 13) − 100( , 8%, 5) = 281.5
= + ∗ − = 0.08 + ∗ 0.15 − 0.08 = 0.12925
= −900 + 200 ∗ 7.904 − 100 ∗ 3.993 = −900 + 1580.8 − 399.3 = 281.5 ( − ) 281.5 + 118.6

27 28
 2021. 02. 22.

What is the EAA and the PI? Initial investment

200 r =8% Annuity • What is the initial investment of the project when NPV is 300 EUR? r=8% Single Annuity
N A/PV N PV/FV PV/A
1 1,080 200 1 0,926 0,926
100 r = 8%
2 0,561 2 0,857 1,783
3 0,388 100 3 0,794 2,577
4 0,302 4 0,735 3,312
5 0,250 10 r = 8% 5 0,681 3,993
6 0,216 6 0,630 4,623
1 6 13
1 6 13 7 0,192 7 0,583 5,206
8 0,540 5,747
8 0,174
9 0,500 6,247
9 0,160
10 0,463 6,710
(8%) = 281.5 10 0,149 ? -200 11 0,429 7,139
11 0,140 12 0,397 7,536
12 0,133 = 300 = − + 100 , 8%, 13 + 100 , 8%, 5 − 300 , 8%, 10 13 0,368 7,904
-1000 8% = 281.5 , 8%, 13 = 281.5 ∗ 0.127 = 35.75 13 0,127

= −300 + 100 ∗ 7.904 + 100 ∗ 3.993 − 300 ∗ 0.463 = 750.74

281.5
=1+ = 1+ = 1.31 300
| | 900 • What is the PI? =1+ = 1+ = 1.4
| | 750.74

29 30

Renting Frequency of Use of Capital Budgeting Techniques

• On the real estate market an apartment worth 200 THUF/m2 can be rented for
approximately 18 THUF/m2/year. What is the IRR assuming a renovation of 15
THUF/m2 in every 10th year?
• Trial and error method – Let’s try r = 6% and r =10%:
18 15 , 6%, 10 18 − 15 ∗ 0.076
6% = −200 + − = −200 + = 81 A/FV
0.06 0.06 0.06
N r=6% r=10%
1 1,000 1.000
2 0,485 0.476
18 15 , 10%, 10
10% = −200 + − = 18 − 15 ∗ 0.063 3 0,314 0.302
0.1 0.1 −200 + = −29.45 4 0,229 0.215
0.1
5 0,177 0.164
6 0,143 0.130
• Interpolation: 7 0,119 0.105
8 0,101 0.087
81
= 0.06 + ∗ 0.1 − 0.06 = 0.0893 9 0,087 0.074
81 + 29.45 10 0,076 0.063

2015 - CFA I. Corporate Finance

31 32
 2021. 02. 22.

Kahoot NEXT TIME • Risk analysis

•6 Questions, 30-30 seconds
https://play.kahoot.it/v2/?quizId=b94d634a-eb38-4138-8122-
4838bbfdd0fb

Thank you for your attention!

33 34
 2021. 03. 01.

CORPORATE FINANCE
(BMEGT35M105)
LECTURE 4. RISK ANALYSIS
Nikolett Szallerné Sereg
sereg.nikolett@gtk.bme.hu
Department of Finance, QA332
2020/2021/2
Last time
• Aim of corporation is to maximize the intrinsic value of the firm (it represents owner’s
wealth, which is given by the present value of all expected future profits of the firm)
• Profit: total revenue reduced by total cost including the cost of capital
– Typical sources: arbitrage, innovation, imitation
– Taking advantage of these will trigger a price correction and blow the opportunity
• Concept of corporate finance (investment, financing and dividend decisions)
• Capital budgeting: process (generating, analyzing, planning, monitoring) of decision making
on long term capital investment (makes up the long-term asset portion of the balance sheet)
• Typical projects (replacement, expansion, new product or services, regulatory, safety,
environmental, others)
• Basic principals: expected cash flows, timing, op. cost., after tax-bases, no financing cost
• Sunk cost, Incremental cash flow, Conventional vs. Non-conventional cash flows
• Independent vs. Mutually exclusive projects
• Investment decision criteria calculations (NVP, IRR, PI, DPP, EAA)

1 2

Estimation of cash flows

• An integral part of the capital budgeting process
• Future cash flows cannot be predicted with certainty
• External data and lot of assumption is needed
• Reality often tend to be far from the expectation
TODAY: – Alterations
can influence the outcome: economic and market factors,
RISK ANALYSIS vendor negotiations, overestimation of demand, abnormal breakdowns, etc.
• Danger in accepting an unviable investment or rejecting a good one
• Pursuit of accuracy is important (inaccurate data should be avoided)
• Risk analysis is essential
( ) ( )
= + =
(1 + ) (1 + )

3 4
 2021. 03. 01.

Risk analyis Qualitative methods – Risk matrix

• Process of analyzing expected and unexpected changes that may Risk • The level of risk is given by the
affect the outcome identification likelihood of occurrence and the
• Risk: a situation arises that affects the business (cash flows will Moderate High Critical
severity of impact
be different than expected)
• Visualization of the level of risks

Likelihood of Risk
– Operational risk: frequent breakdowns, increased storage and Risk analysis
maintenance costs, less output rate, etc. • Useful when the likelihood and
Low Moderate High
– Market risk: outdated technology, reduced demand, price cut by the impact cannot be quantified
competitors, increase in taxes, etc. precisely (or as preliminary step)
Risk or for categorization of risks
– Financial risk: changes in the cost of capital (later)
evaluation
– Imperfections of the future cash flow estimates • Disadvantages: subjective, Negligible Low Moderate

• Application of an appropriate risk premium: applicable rate of inconsistent interpretation

return for embracing the extra risks Risk • Resolutions: 3x3, 4x4, 5x5, etc. Impact of Risk
• Qualitative and quantitative methods management

5 6

How to use a risk matrix? Quanitative methods

• Sensitivity analysis, break-even point
• Grid analysis
• Scenario analysis
• Monte Carlo Simulation

https://www.youtube.com/watch?v=-E-jfcoR2W0

7 8
 2021. 03. 01.

Sensitivity analysis Example

• Also known as a What-If analysis
• Ananalysis of how sensitive the NPV is to a variable (e.g., material,
marketing costs, wage costs, sales price or volume), while keeping
other variables unchanged
• To measure the impacts of fluctuations (ceteris paribus) in parameters
(inputs) of the valuation model on the NPV (output)
• Gives a good overview of the most sensitive components of the model
• Helping us to understand the effect of changes in key variables, but
this one-variable-at-a-time change is rare in the real world
• Sensitivity analysis is performed using the following formula:
S = (dNPV/NPV)/(dx/x)
• where x is a parameter, d means the change in the NPV and in the parameter
• E.g., Our profit on selling beer is 5 EUR on each portion. We expect to sell 100
portion in the second year.
• What is the NPV of the given example?
NPV=(5*100)/(1.05)^2= 453.5
• What if we could sell 110 portion instead of the 100?
NPV=(5*110)/(1.05)^2= 498.87
• What is the sensitivity of the NPV to the change in the portion?
S=((498.87-453.5)/453.5)/((110-100)/100)= 1.00

9 10

Break-even point Grid analysis

• NPV=0 means zero
economic profit
• The maximum allowable
change (which will not
yet influence the
decision) can be
calculated individually
(where NPV is still
accaptable, not yet
negative)
• The amount of sales
volume which makes the
NPV equal to zero is
called break-even point
• Between the sensitivity and the scenario analysis
• Two key risk parameters are chosen (variables with the steepest lines in the
sensitivity analysis)
• NPVs are calculated by the combinations of their variants
• There is a line between positive and negative NPVs, this shows the limits
of the combined parameters
Marketing
Break-even point
Zero economic
profit

11 12
 2021. 03. 01.

Scenario analysis Example

• A firm wants to launch a new product and operate a new factory to produce it
• Considering various feasible outcomes based on potentially favorable and
• Surveys show three typical scenarios for product success:
unfavorable events that could take place in the future
– S1: Product will be unsuccessful, and the factory will have to be closed. Probability is 30%.
• Typical scenarios:
– S2: Product has the expected success for the planned 5 years. Probability is 50%.
– Base-case: based on original assumptions (expectations)
– S3: Product will be an explosive success and factory will be operating for an additional five
– Worst-case: the most severe outcome that could possibly happen years. Probability is 20%.
– Best-case: the finest outcome that could possibly happen • There are four versions to get the new factory:
• Simplifying the infinite number of outcomes for some typical scenarios, then – A. Building a new factory, which can be
recalculating the outcomes according to these alternative assumptions (allows sold at any time
several key variables to change simultaneously) – B. Renting with a contract for fix 5 years
(free option to expand the contract)
• The net present value of each scenario is weighted by the probability of their
– C. Renting without a fix-term contract for
occurrence
a higher price
• BUT: difficult to foreseen all possible scenarios and assign the correct – D. Renting with a contract for fix 10 years
probabilities to them for a lower price

13 14

Monte Carlo simulation Popular density functions

• Allows us to view the effects of an unlimited number of changes in our model
• The static NPV calculation provides the base for the simulation
• After determining which variables are subject to uncertainty, we define an appropriate
distribution for each variable (based on the opinion and estimation of experts)
• The number of simulation trials need to be declared and then the running simulation
will generate that much random values for each variable within their given distribution
• Since NPV depends on these “distributed” variables, at the end of the simulation we
will get the distribution of the NPV which is showing us the probability to getting a
positive NPV
• Correlations between variables and between the values of a given variable in different
periods can be declared as well (with the help of conditional probabilities, e.g., what
would be the value of Y if the value of X is …)
– usually, they are assumed to be constant in time
• Hard to find the appropriate estimates, subjective elements

15 16
 2021. 03. 01.

Process of the simulation Kahoot

•6 Questions, 30-30 seconds
https://play.kahoot.it/v2/?quizId=71e91311-559f-4319-b4c1-
ebed45f65d51

17 18

Additional homework for 2 extra points NEXT TIME • COST OF CAPITAL

• Choose a similar business opportunity as in the case study

– Should be as simple as the pizza place, but a different opportunity with only
one kind of product or service
• Define the NPV model of the business opportunity and calculate the NPV
• Choose one quantitative risk analysis method and implement it in the case
of the business opportunity
• Sendyour results in an xls file to sereg.nikolett@gtk.bme.hu until the
beginning of the next lecture on the 8th of March

Thank you for your attention!

19 20
 2021. 03. 08.

CORPORATE FINANCE
(BMEGT35M105)
LECTURE 5. COST OF CAPITAL
Nikolett Szallerné Sereg
sereg.nikolett@gtk.bme.hu
Department of Finance, QA332
2020/2021/2
Last time
• Cash flow estimation is an important part of capital budgeting
– Future cash flows cannot be predicted with certainty
• Risk analysis is essential
• Risk: cash flows will be different than expected (operational, market
risk, financial risks, imperfections of the future cash flow estimates)
• Application of an appropriate risk premium: applicable rate of return
for embracing the extra risks
• Qualitative (e.g., Risk matrix) and quantitative (e.g., Sensitivity
analysis, Break-even point, Grid analysis, Scenario analysis, Monte
Carlo Simulation) methods

1 2

The discount rate

• The discount rate is often called the “cost of capital”
– r which is earned by the company if its capital would be invested elsewhere, or
r which is saved by the company if its borrowed capital would be repaid (the
loss or the benefit given by the best alternative)
– the company should not carry out an investment which cannot earn more than
TODAY: its cost of capital

COST OF CAPITAL = +
(
(1 + )
)
=
(
(1 + )
)

• An appropriate discount rate is essential for making sound capital budgeting

decisions
– discount rate that investors should require given the riskiness of the investment
– r is being composed of a real risk-free interest rate plus a set of premiums
(required returns for bearing different types of risk)

3 4
 2021. 03. 08.

Risk and return CAPM in corporate finance

CAPM (Capital Asset Pricing Model) translates the measure of risk into a required rate of • Limitations of CAPM
return for bearing the risk – The only variable that should explain returns is beta
• It is assumed that an investor will hold the combination of a risk-free investment and the
– Empirical tests show that other variables (size, price/book value, macro
market portfolio (totally diversified as it is containing all the risky investments in the economic factors) help to explain differences in returns as well
securities world weighted according to their total market capitalization)
• BUT! CAPM is still the basic model in corporate finance for cost of capital
– Market indexes are used to represent the „theoretical” market portfolio
estimation (alternative models are more complicated and need more information
– Total risk of an investment = diversifiable + non-diversifiable risk  only the non-
than CAPM)
diversifiable risk is rewarded
• Three inputs of the CAPM
– the non-diversifiable (relevant) risk for any investment can be measured by the covariance
of its returns with returns on a market index, the slope of the characteristic line is called – The current risk-free rate
beta which shows the sensitivity of an investment to the movement of the market index – The expected market risk premium which is the expected return of the market
– The required return on an investment will be a linear function of its beta index over the risk-free rate
– The beta of the investment
Expected Return = Risk-free Rate + Beta * (Expected Return on the Market Portfolio - Risk-free Rate)

5 6

The risk-free rate The market risk premium

• Interest rate of a zero-coupon default-free bond that maturity matching the time horizon • Three main approaches
of the cash flows – Estimation based on historical data  historical average premium
– zero-coupon means that there is no uncertainty about reinvestment rates – Estimation based on current prices  implied premium
– no default risk generally means that the security is issued by the government – Estimationbased on survey data of different investors (e.g., analysts, researchers,
– E.g., the rate on 10-year US treasury bond institutions etc.)  average desired risk premium
• The risk-free rate and the estimated cash flows must be nominated in the same currency • Historical average premium approach
• Not every government happens to be default-free – Choosing a matching market index and risk-free investment (in the same currency
– Adjustment must be made to get a risk-free rate in the local currency, e.g., a non- as the estimated cash flows)
default-free government bond rate is 9.65%, the local currency rating from Moody’s is – Calculation of the geometric average returns on the chosen market index for a
Ba2 and the default spread for a Ba2 rated country bond is 2.65%. longer time period
Risk-free rate in the local currency = 9.65% - 2.65% = 7% – Calculation of the geometric average returns on the chosen risk-free investment
• If cash flows are estimated in real sense, then you must use real risk-free interest rate to (over the same time period as the market index)
harmonize the cost of capital, e.g., inflation-indexed treasury rate
– Using the difference between them as a forward-looking market risk premium

7 8
 2021. 03. 08.

The beta Determinants of beta

• Top-down beta: the result of a regression (return of a market index as R Square 0.574 • Industry effect
explanatory variable) 0.1 – Firms of a cyclical industry (revenues are higher in periods of economic prosperity and lower
in periods of economic downturn) have higher betas
– Slope of the characteristic line is the beta 0.08
– Firms with more nonessential products or services have higher betas
– Intercept of the regression shows the Jensen’s alfa, which is a measure 0.06

of performance, positive alfa means that the performance during the 0.04
• Operational leverage
period of the regression was better than it was expected by CAPM – Firms with higher fixed costs/variable costs ratio have higher betas
0.02

– R Square shows the portion of the non-diversifiable risk, (1-R square) • Financial leverage

Y
0
shows the portion of diversifiable (firm-specific) risk (not rewarded) -0.04 -0.02 0 0.02 0.04
– Firms with higher dept/equity ratio have higher betas
-0.02
– There are services (e.g., Bloomberg) providing beta estimation – regression beta for a traded firm is a levered beta, because the base of the calculation is the
• Bottom-up beta: average beta of firms with similar business characteristic -0.04 stock price, which reflects the leverage
100
– a weighted (by sales or operating income) average of unlevered betas of -0.06 y = 1.3042x + 0.0006 – = 1+ 1− . ., = 1.25 1 + 1 − 9% = 1.48
500
other firms operating in similar businesses -0.08
• Beta for a non-diversified investor must be adjusted
– If there is leverage, then levered beta must be calculated by the -0.1
– = .
debt/equity ratio (betas by industry on Damodaran’s website) X: Returns of a market index
E.g., Total beta = = 1.716
.
• Beta estimation can be based on accounting earnings for non-traded firms

9 10

Interest Coverage Ratios and Ratings: For

Cost of dept large non-financial service firms
(Damodaran, 08.03.2021)
Weighted Average Cost of Capital
more than lower than Rating DM
• A few possibility: = ∗ + ∗ ∗ (1 − )
-100000 0.199999 D2/D 17.44%
+ +
– Firm with traded bond: yield to maturity 0.20 0.649999 C2/C 13.09%
• The interest payments of the dept are tax deductible, thus we are considering the after-
– Rated firm: default spread on bonds 0.65 0.799999 Ca2/CC 9.97%
tax cost of dept
– Not rated firm: the interest rate on the recently borrowed long- 0.80 1.249999 Caa/CCC 9.46%
• E and D is the market value of equity and dept
term bank loan or with default spread based on a synthetic rating 1.25 1.499999 B3/B- 5.94%
– E.g., What is the market value of $1000 in dept? The interest expense is $20, the
1.50 1.749999 B2/B 4.86%
– Synthetic rating can be based on the firm’s interest coverage ratio maturity is 7 years and the pre-tax cost of dept is 4%.
1.75 1.999999 B1/B+ 4.05%
1
Interest Coverage Ratio = EBIT / Interest Expenses 1−
1 + 0.04 1000
2.00 2.2499999 Ba2/BB 2.77%
20 ∗ + = 879.96
• The cost of debt must be in the same currency as the cost of equity 2.25 2.49999 Ba1/BB+ 2.31%
0.04 1 + 0.04
and the estimated cash flows Baa2/BBB 1.71%
– Book value is less volatile than the market value and yield a lower cost of capital, but
2.50 2.999999
• We can convert the cost of dept (or the cost of capital) into another 3.00 4.249999 A3/A- 1.33%
using book value is conservative and do not have much economic sense
currency with the help of inflation rates: = 1 + ∗ −1 4.25 5.499999 A2/A 1.18% • Preferred stock and convertible debt should be considered
5.50 6.499999 A1/A+ 1.07% – Preferred stock has some of the characteristics of debt and equity as well: dividend is
1 + 2% paid out before the common dividend (not tax deductible)
. . , 1 + 10% ∗ − 1 = 8.93% 6.5 8.499999 Aa2/AA 0.85%
1 + 3%
8.5 100000 Aaa/AAA 0.69% – Convertible debt is part debt (as bond) and part equity (as conversion option)

11 12
 2021. 03. 08.

Example Kahoot
• Risk-free rate (rf) is 2%, the Market risk premium (MRP) is 5.5%, the Unlevered beta (βU) is •6 Questions, 30-30 seconds
1.25, the Default spread (Ds) of the firm is 1.2%, the Corporate Tax rate (TC) is 9%, the Market
value of the equity (E) is $120,000 and the Market value of the dept (D) is $40,000. https://play.kahoot.it/v2/?quizId=7db6dbe6-bbca-4f63-b892-
• What is the Cost of equity (rE) of the firm? d9004017e1a8
BL=BU*(1+D/E*(1-TC))=1.25*(1+1/3*(1-0.09)=1.629
rE=rf+ BL * MRP=0.02+ 1.629 *0.055=0.1096
• What is the After-tax Cost of dept (rD)?
rD=(rf + Ds)(1-TC)=(0.02+0.012)*(1-0.09)=0.029
• What is the Cost of capital (WACC)?
E/(E+D)= $120,000/$160,000=0.75
D/(E+D)=0.25
WACC = rE*E/(E+D)+rD*D/(E+D)=0.1096*0.75+0.029*0.25=0.08945

13 14

Additional homework for 2 extra points NEXT TIME • There will be no lecture on the 15th of March.
• Eszter Solt
• Choose another company to estemate its weighted average cost of
capital.
• Fill out the uploaded excel sheet with the data of the chosen
company.
• Send it to me via sereg.nikolett@gtk.bme.hu until the 15th of March
at Noon.

Thank you for your attention!

15 16
Corporate Finance
lecture 6
D R . SO LT ESZ T ER
BM E
2021
The value of the company
The Balance Sheet Modell
ASSETS LIABILITIES
Fixed Assets Owner’s equity
Property, plant and equipment
Long-term liabilities
Long term investments
long term debt
Intangible assets
Current assets deferred income tax
Inventory Short term liabilities
Accounts receivable accounts payable
Short term investments Short term loans
Cash
Decisions
STRATEGIC DECISIONS
What specific assets should the firm invest in?
How should the cash required for an investment be raised? capital structure
What is the cost of capital? capital budgeting
Dividend policy

Goal: maximizing owner’s value

Decisions
OPERATIONAL DECISIONS

How to manage cash inflows/outflows in the short run?

Current asset management

Goal: to ensure liquidity

The investment decision
Capital budgeting

Discounting future cash payments to find their present value

Applying these ideas to evaluate a simple investment proposal
Suppose that you are in the real estate business. You are considering
construction of an office block. The land would cost $50,000 and
construction would cost a further $300,000
You foresee a shortage of office space and predict that a year from now
you will be able to sell the building for $400,000
Net present value
You would be investing $350,000 now in the expectation of realizing
$400,000 at the end of the year
You should go ahead if the present value of the $400,000 payoff is
greater than the investment of $350,000
Assume for the moment that the $400,000 payoff is a sure thing
The office building is not the only way to obtain $400,000 a year from
now.
You could invest in a 1-year U.S. Treasury bill. Suppose the T-bill offers
interest of 7 percent
Net present value
How much would you have to invest in it in order to receive $400,000 at the end of
the year?
You would have to invest:
$400,000×1/1.07 = $400,000 ×.935 = $373,832
Therefore, at an interest rate of 7 percent, the present value of the $400,000 payoff
from the office building is $373,832
Selling price of the project
Let’s assume that as soon as you have purchased the land and laid out
the money for construction, you decide to cash in on your project.
How much could you sell it for?
Since the property will be worth $400,000 in a year, investors would be
willing to pay at most $373,832 for it now. That’s all it would cost them to
get the same $400,000 payoff by investing in a government security.
NPV as the market value
The $373,832 present value is the only price that satisfies both buyer
and seller
In general, the present value is the only feasible price, and the present
value of the property is also its market price or market value
To calculate present value, we discounted the expected future payoff
by the rate of return offered by comparable investment alternatives
The discount rate ,7 percent in our example, is called the opportunity
cost because it is the return that is being given up by investing in this
project
NPV
Net present value is found by subtracting the required initial investment from the present
value of the project cash flows:
NPV = PV – required investment = $373,832 – $350,000 = $23,832
The net present value rule states that managers increase shareholders’ wealth by
accepting all projects that are worth more than they cost.
Therefore, they should accept all projects with a positive net present value
Opportunity cost of capital
Net present value
OPPORTUNITY COST OF CAPITAL: Expected rate of return given up by investing
in a project
NET PRESENT VALUE (NPV): Present value of cash flows minus initial investment
Risk and present value
You will never be certain about the future values of office buildings. The
$400,000 represents the best forecast
Our initial conclusion about how much investors would pay for the
building is wrong
Since they could achieve $400,000 risklessly by investing in $373,832
worth of U.S. Treasury bills
You would have to cut your asking price to attract investors’ interest
Risk and opportunity cost
Suppose you believe the office development is as risky as an
investment in the stock market and that you forecast a 12 percent
rate of return for stock market investments
Then 12 percent would be the appropriate opportunity cost of capital.
That is what you are giving up by not investing in comparable securities.
Other Investment Criteria
Use of the net present value rule as a criterion for accepting or rejecting
investment projects will maximize the value of the firm’s shares.

Other criteria are sometimes also considered by firms when evaluating

investment opportunities.

Some of these rules are liable to give wrong answers; others simply need
to be used with care
Other investment criteria
alternative investment criteria e.g.:
internal rate of return,
payback period,
book rate of return,
profitability index
Internal rate of return (IRR)
Instead of calculating a project’s net present value, companies often prefer to ask
whether the project’s return is higher or lower than the opportunity cost of capital.
For example, when building the office block. You planned to invest $350,000 to get back
a cash flow of C1= $400,000 in 1 year
Therefore, you forecasted a profit on the venture of $400,000 – $350,000 = $50,000, and
a rate of return of:
Rate of return = profit/investment = C1 – investment =
= $400,000 – $350,000/ $350,000 = .1429, or about 14.3%
Internal rate of return (IRR)
The alternative of investing in a U.S. Treasury bill would provide a return of only 7
percent
Thus the return on your office building is higher than the opportunity cost of capital
This suggests two rules for deciding whether to go ahead with an investment project
Two rules for decision making
1. The NPV rule: Invest in any project that has a positive NPV when its cash flows are
discounted at the opportunity cost of capital
2. The rate of return rule: Invest in any project offering a rate of return that is higher than
the opportunity cost of capital
An investment that is with an NPV of zero will also have a rate of return that is just
equal to the cost of capital
The NPV rule
Suppose that the rate of interest on Treasury bills is not 7 percent but 14.3 percent
Since your office project also offers a return of 14.3 percent, the rate of return rule
suggests that there is now nothing to choose between taking the project and leaving
your money in Treasury bills
The NPV rule also tells you that if the interest rate is 14.3 percent, the project is evenly
balanced with an NPV of zero, it is worth what it costs
NPV = C0 + C1/1+r = –$350,000 + $400,000/1.143 = 0
The internal rate of return (IRR)
The internal rate of return (IRR) is the discount rate at which NPV equals zero. It is
also known as the discounted cash flow (DCF) rate of return
Remember if the office project’s cash flows are discounted at a rate of 7 percent, the
project has a net present value of $23,832
If they are discounted at a rate of 14.3 percent, it has an NPV of zero.
1. The project rate of return (in our example, 14.3 percent) is also the discount rate
which would give the project a zero NPV
The rate of return rule and the NPV
rule
1. The project rate of return (in our example, 14.3 percent) is also the discount rate
which would give the project a zero NPV
2. If the opportunity cost of capital is less than the project rate of return, then the NPV of
your project is positive.
If the cost of capital is greater than the project rate of return, then NPV is negative
Thus the rate of return rule and the NPV rule are equivalent
The payback period
Time until cash flows recover the initial investment of the project
The payback rule states that a project should be accepted if its payback period is less
than a specified cutoff period
Payback does not consider any cash flows that arrive after the payback period
Book rate of return
Accounting income divided by bookvalue.
Also called accounting rate of return.
Book rate of return = book income/ book assets
 Profitability index (PI)
The profitability index is an index that attempts to identify the relationship between the costs
and benefits of a proposed project through the use of a ratio calculated as

PV of future cashflows/Initial investment

A ratio of 1.0 is logically the lowest acceptable measure on the index, as any value lower
than 1.0 would indicate that the project's PV is less than the initial investment
As values on the profitability index increase, so does the financial attractiveness
of the proposed project
Investment Criteria

The NPV rule is the most reliable criterion for project evaluation.
NPV is reliable because it measures the difference between the cost of a project and the
value of the project
That difference—the net present value—is the amount by which the project would
increase the value of the firm
Assessment of the alternatives to the
NPV
Other rules such as payback period or book return may be viewed at best
as rough proxies for the attractiveness of a proposed project
they are not based on value, they can easily lead to incorrect investment decisions
Out of the alternatives to the NPV rule, IRR is clearly the best choice
It usually results in the same accept-or-reject decision as the NPV rule, but like the
alternatives, it does not quantify the contribution to firm value
Mutually exclusive projects
When two or more projects that cannot be pursued simultaneously

When you need to choose between mutually exclusive projects, the decision rule is
simple:

Calculate the NPV of each project and from the options that have a
positive NPV, choose the one with the highest NPV
Példa1

Example1
The table displays the cashflows of two mutually exclusive projects:

A investment B investment
year Estimated cashflows Estimated cashflows
0 -10.000 -6.000
1 4.000 4.000
2 4.000 4.000
3 4.000
4 4.000

The opportunity cost of capital is: 12%. Use the NPV and the PI
to choose between them.
 Solution
AF(4,12%)= 3. 037 (see annuity factor table)
4 000 x 3. 037 = 12 148
-10 000+12 148 = 2 148
NPVA = -10 000+4 000 x AF(4,12%)=2 148;
AF(2, 12%)= 1. 690
4.000 x 1. 690 = 6 760
-6 000+6 760 = 760
NPVB = -6 000+4 000 x AF(2,12%) = 760
PIA = 12.148/10.000 = 1,2148
PIB = 6.760/ 6.000 = 1,1266 A project is better
Annuity factor table
Solution
Annuity factor:
AF(r,n) = (1+r)n-1/r*(1+r)n (see annuity table)

When the two projects have different lifetimes

NPV equivalents should be calculated to make
them comparable: NPV/AF(r,n)
NPVA equivalent = 2 148/AF(4,12%) = 707/year
NPVB equivalent = 760/AF(2,12%) = 449/year
A project is better
 Example2
The estimated IRR for the project is 25%, its useful lifetime is 10
years with equal cashflows of HUF15 000 000 annually.
Calculate the initial outlay, the NPV and the discounted payback
period* for the project if the opportunity cost of capital is 17%
*Time until discounted cash flows recover the initial investment of
the project
 Solution
The project rate of return (in our example, 25 percent) is the discount rate
which would give the project a zero NPV
NPV = 0= -C0+15 000*AF(10,25%) C0=15 000x3.5705=53 557.5
NPV=-53 557.5+15 000*AF(10,17%)=-53 557.5+15 000x4.6586 =
=16 321.5>0 IRR>r
Discounted payback period: DT= -53 557.5+15 000*AF(t?,17%)
-53 557.5/15 000 = AF(t?,17%)
3.5705=AF(t?,17%) t=6 years (see annuity factor table)
Example3

The table displays the cashflows of two mutually exclusive projects: (in HUF 000)

machine C0 C1 C2 C3
A -100 110 121
B -180 110 121 133
The opportunity cost of capital is: 10%. calculate the NPV
and use NPV equivalents to choose between them
Solution
NPVA = -100 + 110/1,1 + 121/1,12 = -100+ 100+ 100 = 100> 0
NPVB= -180 + 110/1,1 +121/1,12+ 133/1,13 = 120> 0
for NPV B machine is better
NPVe equivalent (N* = NPV/annuity factor)
For "A" machine: AF(2,10 %) = 1.736 (see annuity factor table)
NPVe equivalent = 100 / 1.736 = 57.607
For "B" machine: AF(3, 10 %) = 2.487
NPVe equivalent = 120 /2.487 = 48.25
For NPVe equivalent A machine is better
Corporate Finance
Lecture 7
Working Capital

DR. SOLT ESZTER ÉVA

BME
2021
Working Capital
The Components of Working Capital
Short-term or current assets
Accounts receivable: unpaid bills that companies expect to be able to turn into cash in the near
future( trade credit)
Inventory: raw materials, work in process, or finished goods awaiting sale and shipment
Cash and marketable securities: dollar bills, bank deposits (demand deposits = money in
checking accounts that the firm can pay out immediately) and time deposits (money in savings
accounts that can be paid out only with a delay).
Marketable security: commercial paper (short-term unsecured debt sold by other firms),
Treasury bills (short-term debts sold by the United States government) and state and local
government securities.
Working Capital
The Components of Working Capital
The optimal cash balance is important!

Current Liabilities
accounts payable: outstanding payments due to other companies
short-term borrowing
Current assets and liabilities (example; USD; figures in
billions)
Current Assets Current liabilities

Cash 114 Short term loans 203

Marketable securities 89 Accounts payable 303

Accounts receivable 481 Accrued income taxes 46

Inventories 468 Current payments due on long-term debt 68

Other current assets 201 Other current liabilities 427

Total 1,353 Total 1,047

Working Capital and the Cash Conversion
Cycle
Net working capital: the difference between current assets and current
liabilities (often referred to as working capital)
Net working capital (current assets – current liabilities) =
= $1,353 – $1,047 = $306 billion
Current assets usually exceed current liabilities: firms have positive net working
capital
Working Capital and the Cash Conversion
Cycle
The components of working capital constantly change with the cycle of operations, but the
amount of working capital is fixed
This is one reason why net working capital is a useful summary measure of current assets or
liabilities
The cycle:purchasing raw materials, but it does not pay for them immediately. This delay is the
accounts payable period
The firm processes the raw material and then sells the finished goods. The delay between the
initial investment in inventories and the sale date is the inventory period
Some time after the firm has sold the goods its customers pay their bills. The delay between the
date of sale and the date at which the firm is paid is the accounts receivable period
 The Cash Conversion Cycle

The net time that the company is out of cash is reduced by the time it takes to pay
its own bills
The length of time between the firm’s payment for its raw materials and the
collection of payment from the customer is known as the firm’s cash conversion
cycle
Cash conversion cycle = (inventory period + receivables period) – accounts payable
period
The Cash Conversion Cycle
The longer the production process, the more cash the firm must
keep tied up in inventories
The longer it takes customers to pay their bills, the higher the value
of accounts receivable
If a firm can delay paying for its own materials, it may reduce the
amount of cash it needs. In other words, accounts payable reduce
net working capital
Inventory period

average inventory
Inventory period =
annual costs of goods sold/365

The ratio of inventory to daily output measures the average number of days
from the purchase of the inventories to the final sale
Accounts receivable period and Accounts
payable period
average accounts receivable
Accounts receivable period =
average annual sales/365

average accounts payable

Accounts payable period =
average annual cost of goods/365
Just in Time inventory management methodology
If you’re considering adopting a Just in Time inventory
management strategy, first ask yourself these questions:

Can my product/s be manufactured or supplied in a very short period of time?

Are my suppliers reliable and efficient enough to get products to me on time every time?
Do I have a thorough understanding of customer demand, sales cycles, and seasonal
fluctuations?
Is my order fulfillment system efficient enough to get orders to customers on time?
Does my inventory management system offer the flexibility needed to update and manage
stock levels on the fly?
When you can confidently say yes to all of the above, you’re in a good position to
start reaping the benefits of a Just in Time business model.
Corporate Finance
Practice 7
Working capital
DR. SOLT ESZTER ÉVA
BME
2021
Data from the Income Statement and the Balance Sheet These
data can be used to calculate the cash conversion cycle for U.S.
manufacturing firms (figures in billions)

Income Statement data Balance Sheet data

First Q of 2019 End of First Quarter 2018 End of First Quarter 2019

Sales $3,968 Inventory $470 $468

Cost of goods sold 3,518 Accounts receivable 471 481

Accounts payable 304 303
Calculating the Periods
(470 + 468)/2
Inventory period = = 48.7 days
3,518/365

(471 + 481)/2
Receivables period = = 43.8 days
3,968/365

(304 + 303)/2
Payables period = = 31.5 days
3,518/365
The cash conversion cycle
The cash conversion cycle =
= Inventory period + receivables period – accounts
payable period = 48.7 + 43.8 – 31.5 = 61.0 days

It takes the United States manufacturers 2 months

from the time they lay out money on inventories to
collect payment from their customers.
TEST 1,2
1 Suppose United States manufacturers are able to reduce inventory
levels to a year average value of $250 billion and average accounts
receivable to $300 billion. By how many days will this reduce the cash
conversion cycle?
2 Suppose that with the same level of inventories, accounts
receivable, and accounts payable, United States manufacturers can
increase production and sales by 10 percent. What will be the effect
on the cash conversion cycle?
Solution 1
The new values for the accounts receivable period and inventory
period are:

250
Days in inventory = = 25.9 days
3,518/365

This is a reduction of 22.8 days from the original value of 48.7 days.
Solution 1
300
Days in receivables = = 27.6 days
3,968/365

This is a reduction of 16.2 days from the original value of 43.8 days
The cash conversion cycle falls by a total of 22.8 + 16.2 = 39.0 days.
Solution 2
The inventory period, accounts receivable period, and
accounts payable period will all fall by a factor of 1.10. (The
numerators are unchanged, but the denominators are
higher by 10 percent)
Conversion cycle will fall from 61 days to 61/1.10 = 55.5
days
Homework for extra marks

How will the following affect the size of the firm’s optimal
investment in current assets?
a. The interest rate rises from 6 percent to 8 percent.
b. A just-in-time inventory system is introduced that reduces
the risk of inventory shortages.
c. Customers pressure the firm for a more lenient credit sales
policy.
◦ Please, send the answers to: sereg.nikolett@gtk.bme.hu
Corporate Finance
Lecture 8
Dividend policy

DR. SOLT ESZTER ÉVA

BME
2021
Dividends

Shareholders hope to receive a series of dividends on their

investment.

The company is not obliged to pay any dividend and the decision is
up to the board of directors.
Dividends-Business Expense?

As dividends are discretionary, they are not considered to be a business

expense.

Therefore, companies are not allowed to deduct dividend payments

when they calculate their taxable income.
The Board
The board usually consists of the company’s top management as well as outside directors, who are
not employed by the firm.

In principle, the board is elected as an agent of the shareholders.

It appoints and oversees the management of the firm and meets to vote on such matters as new
share issues.

Most of the time the board will go along with the management, but in crisis situations it can be very
independent.

For example, when the management of RJR Nabisco announced that it wanted to take over the
company, the outside directors stepped in to make sure that the company was sold to the highest
bidder.*

*https://homepage.univie.ac.at/youchang.wu/RJB.pdf
Stockholders’ rights

Stockholders have the ultimate control of the company’s affairs.

Occasionally companies need shareholder approval before they can

take certain actions.
For example, they need approval to increase the authorized capital or
to merge with another company.
What is a Dividend Policy?

Some researchers suggest the dividend policy is irrelevant,

in theory, because investors can sell a portion of their shares
or portfolio if they need funds.
A dividend policy is the policy a company uses to structure
its dividend payout to shareholders.
This is the dividend irrelevance theory, which infers that
dividend payouts minimally affect a stock's price.
What is a Dividend Policy?

A dividend policy is the strategy that businesses use to structure

these types of payments.
It determines the frequency with which dividends are paid out, as
well as the amount of the payment.
There are several different factors that may determine the dividend
policy type favored by a business, including debt obligations,
earnings stability, shareholder expectations, the company’s financial
policy, and the impact of the trade cycle.
Dividends and the Company's Strategy
Dividends are often part of a company's strategy.
However, they are under no obligation to repay shareholders using
dividends.
The three types of dividend policy: stable, constant, and residual
Even though investors know companies are not required to pay
dividends, many consider it a sign of that specific company's
financial health.
How a Dividend Policy Works

Despite the suggestion that the dividend policy is irrelevant, it is

income for shareholders.
Company leaders are often the largest shareholders and have the
most to gain from a generous dividend policy.
Most companies view a dividend policy as an integral part of their
corporate strategy.
Management must decide on the dividend amount, timing, and
various other factors that influence dividend payments.
Types of Dividend Policies

1. Stable Dividend Policy

A stable dividend policy is the easiest and most commonly used.
The goal of the policy is a steady and predictable dividend payout each year, which is what most
investors seek.
Whether earnings are up or down, investors receive a dividend.
The goal is to align the dividend policy with the long-term growth of the company rather than with
quarterly earnings volatility.
This approach gives the shareholder more certainty concerning the amount and timing of the
dividend.
The primary drawback of the stable dividend policy is that investors may not see a dividend increase
in boom years.
Types of Dividend Policies

2. Constant Dividend Policy

Under the constant dividend policy, a company pays a percentage of its earnings as
dividends every year.
In this way, investors experience the full volatility of company earnings.
If earnings are up, investors get a larger dividend; if earnings are down, investors
may not receive a dividend.
The primary drawback to the method is the volatility of earnings and dividends.
It is difficult to plan financially when dividend income is highly volatile.
Types of Dividend Policies

3. Residual Dividend Policy

Residual dividend policy is also highly volatile, but some investors see it as the
only acceptable dividend policy.
With a residual dividend policy, the company pays out what dividends
remain after the company has paid for capital expenditures(CAPEX) and working
capital.
This approach is volatile, but it makes the most sense in terms of business
operations.
Investors do not want to invest in a company that justifies its increased debt with
the need to pay dividends.
No Dividend Policy

Finally, there’s the option of not distributing dividends at all.

Within this dividend policy model, all profit is retained and reinvested
into the business to fund growth opportunities.
Generally, companies without a dividend policy tend to grow and
expand at a rapid rate, and the value of their company stock is likely to
appreciate significantly.
This can be especially attractive to investors, as the value of shares is
more important than the value of any potential dividends that they
may be missing out on.
Choosing the Right Dividend Policy for your Business
When you’re making our dividend policy decision, you should pay attention to some issues like:
What are your business’s future investment needs?
How significant are your company’s debt obligations?
Can you issue dividends while retaining an adequate level of working capital?
All these questions need to be answered before making a dividend policy decision.
Another important element to focus on is your business’s cash flow.
A strong, steady cash flow may be well suited to a regular dividend policy.
If your business has a more irregular cash flow then committing to regular dividend payments may
not be the best idea.
In this case, an irregular dividend policy or no dividend policy at all may be the right option for
your company.
Choosing the Right Dividend Policy for your Business

Another important element to focus on is your business’s cash flow.

A strong, steady cash flow may be well suited to a regular dividend
policy.
If your business has a more irregular cash flow then committing to
regular dividend payments may not be the best idea.
In this case, an irregular dividend policy or no dividend policy at all may
be the right option for your company.
Example of a Dividend Policy

Kinder Morgan (KMI) shocked the investment world when in 2015 they cut their
dividend payout by 75%, a move that saw their share price fall.*
However, many investors found the company on solid footing and making sound
financial decisions for their future.
In this case, a company cutting their dividend actually worked in their favor, and six
months after the cut, Kinder Morgan saw its share price rise almost 25%.
In early 2019, the company again raised its dividend payout by 25%, a move that
helped to reinforce investor confidence in the energy company.
*Kinder Morgan, Inc. operates as an energy infrastructure company in North
America.
Kinder Morgan, Inc. (NYSE:KMI) from a Dividend
Investor's Perspective
Owning a strong business and reinvesting the dividends is widely
seen as an attractive way of growing your wealth.
Yet sometimes, investors buy a stock for its dividend and lose money
because the share price falls by more than they earned in dividend
payments.
In this case, Kinder Morgan likely looks attractive to investors, given
its 8.1% dividend yield and a payment history of over ten years.
You'd guess that plenty of investors have purchased it for the
income.
Warren Buffett's Two Rules
Before you buy any stock for its dividend however, you should always
remember :
1) Don't lose money, and
2) Remember rule #1.
Kinder Morgan, Inc. (NYSE:KMI) from a Dividend
Investor's Perspective
Pay out Ratios

Dividends are typically paid from company earnings.

If a company pays more in dividends than it earned, then the dividend
might become unsustainable – far from an ideal situation.
So you need to form a view on if a company's dividend is sustainable,
relative to its net profit after tax.
In the last year (2019), Kinder Morgan paid out 2,135% of its profit as
dividends.
Unless there are mitigating circumstances, from the perspective of an
investor who hopes to own the company for many years, a payout ratio
of above 100% is definitely a concern.
 Dividends and Cashflow
You can also measure dividends paid against a company's levered free cash flow, to
see if enough cash was generated to cover the dividend.
Kinder Morgan paid out 82% of its cash flow last year.
This may be sustainable but it does not leave much of a buffer for unexpected
circumstances.
It's good to see that while Kinder Morgan's dividends were not covered by profits, at
least they are affordable from a cash perspective.
Still, if the company repeatedly paid a dividend greater than its profits, you'd be
concerned.
Extraordinarily few companies are capable of persistently paying a dividend that is
greater than their profits.
Dividend Volatility
One of the major risks of relying on dividend income is the potential for a company to struggle
financially and cut its dividend.
Not only is your income cut, but the value of your investment declines as well.
The last decade of Kinder Morgan's dividend payments:
This dividend has been unstable, which you can define as having been cut one or more times
over this time.
During the past 10-year period, the first annual payment was:
$1.2 in 2010, compared to $1.1 last year.
Dividend payments have shrunk at a rate of less than 1% per annum over this time frame.
You had better not buy Kinder Morgan for its dividend, given that payments have shrunk over the
past 10 years.
 Dividend Growth Potential

Kinder Morgan's EPS have fallen by approximately 44% per year during
the past five years.
A sharp decline in earnings per share is not great from a dividend
perspective, as even conservative payout ratios can come under
pressure if earnings fall far enough.
With a relatively unstable dividend, it's even more important to
evaluate if earnings per share (EPS) are growing, as it's not worth
taking the risk on a dividend getting cut, unless you might be rewarded
with larger dividends in future.
Conclusion
When we look at a dividend stock, we need to form a judgement
• on whether the dividend will grow,
•if the company is able to maintain it in a wide range of economic circumstances, and
if the dividend payout is sustainable.
Kinder Morgan paid out a high percentage of its income, although its cashflow is in
better shape.
Earnings per share have been in decline, and its dividend has been cut at least once
in the past.
From a dividend perspective: businesses can change, but it is hard to identify why
an investor should rely on this stock for their income.
Conclusion
First, Kinder Morgan paid out a high percentage of its income, although its
cashflow is in better shape.
Second, earnings per share have been in decline, and its dividend has been
cut at least once in the past.
There are a few too many issues for us to get comfortable with Kinder
Morgan from a dividend perspective.
Businesses can change, but we would struggle to identify why an investor
should rely on this stock for their income.
Investors’ Preferences
Warning Signs
Investors generally tend to favour companies with a consistent, stable dividend
policy as opposed to those operating an irregular one.
Still, investors need to consider a host of other factors, apart from dividend
payments, when analyzing a company.
You should consider if there are warning signs:
E.g. if interest payments are well covered by earnings so as dividend payments
of 6.35%?
Are profit margins higher/lower than last year?
Another Case: Boeing:
https://www.cnbc.com/video/2020/03/19/boeing-bailout-sticking-point-
in-coronavirus-aid-package-haley-leaves-board.html
Suspending Dividends

Boeing will cancel CEO pay, suspend its dividend and extend a pause on share
buybacks, as companies eager for government aid to curb fallout from the
coronavirus face pressure to cut payouts to investors.
Boeing’s decision echoes similar measures taken by the largest U.S. airlines in an
effort to win over taxpayer support for their requests for stimulus packages, as the
fast-spreading virus virtually erases air travel demand and hits the global economy.
Boeing is pursuing $60 billion in U.S. government aid to help prop up a U.S.
aerospace manufacturing supply chain already reeling from the year-old grounding
of its previously fast-selling 737 Max jetliner after fatal crashes.
Corporate Finance
Stock Valuation
Dr. Solt Eszter Éva
BME
Why is it important how stocks are valued?
• You may wish to check that any shares that you own are fairly priced
and to gauge your beliefs against the rest of the market
• Corporations need to have some understanding of how the market
values firms in order to make good capital budgeting decisions
• A project is attractive if it increases shareholder wealth
• You can judge it if you know how shares are valued
Shares/common stocks
• Firms issue shares of common stock to the public when they need to
raise money
• They typically engage investment banking firms such as Merrill Lynch
or Goldman Sachs to help them market these shares
• A shareholder is a part-owner of the firm
• A shareholder is entitled to a certain percent of the profit of the
company in dividend payments and to a certain percent of the votes
at the company’s annual meeting
• Equity” is still another word for stock. Stockholders are often referred
to as “equity investors.”
Primary market issues
• Sales of new stock by the firm occur in the primary market
• The two types of primary market issues:
i. In an initial public offering, or IPO, a company sells stock to the
public for the first time
ii. Seasoned offerings by established firms that already have issued
stock to the public and decide to raise money by issuing additional
shares
Secondary markets
• Exchanges are secondary markets for secondhand stocks
• Stocks of large firms are listed on a stock exchange, which allows investors
to trade existing stocks among themselves
• The New York Stock Exchange (NYSE) is an example of an auction market :
stocks are handled by a specialist, who acts as an auctioneer
• The specialist ensures that stocks are sold to those investors who are
prepared to pay the most and that they are bought from investors who are
willing to accept the lowest price
• By contrast, Nasdaq operates a dealer market, in which each dealer uses
computer links to quote prices at which he or she is willing to buy or sell
shares
• A broker must survey the prices quoted by different dealers to get a sense
of where the best price can be had
Book values
• The balance sheet shows the value of the firm’s assets and liabilities
• The simplified balance sheet in slide 8 shows that the book value of
all PepsiCo’s assets (plant and machinery, inventories of materials,
cash in the bank etc.) was $22,660 million at the end of 1998.
• PepsiCo’s liabilities (money that it owes the banks, taxes that are due
to be paid, etc.) amounted to $16,259 million.
Book values
• The difference between the value of the assets and the liabilities was
$6,401 million, (about $6.4 billion)
• This was the book value of the firm’s equity.
• Book value records all the money that PepsiCo has raised from its
shareholders plus all the earnings that have been plowed back on
their behalf.
BALANCE SHEET FOR PEPSICO, INC.
DECEMBER 26, 1998 (figures in millions
BALANCE SHEET FOR PEPSICO, INC., of dollars)

Assets Liabilities and Shareholders’Equity

Plant, equipment, and other assets Liabilities 16,259
22,660 Equity 6,401
Liquidation value per share
• The amount of cash per share a company could raise if it sold off all
its assets in secondhand markets and paid off all its debts
• The difference between a company’s actual value and its book or
liquidation value is often attributed to going-concern value
Market versus book values
August 1999

Firm Stock Price Book Value per Share Ratio:

Price/Book Value
Amgen 77.31 5.41 14.3
Consolidated Edison 42.88 26.80 1.6
Ford 51.44 23.38 2.2

McDonald’s 42.00 6.77 6.2

Microsoft 85.00 4.91 17.3

Pfizer 34.75 2.20 15.8
Walt Disney 29.19 10.06 2.9
Where did all that extra value come from for
Pfizer?
Largely from the cash flow generated by the drugs it has developed,
patented, and marketed.
These drugs are the results of a research and development (R&D)
program that since 1985 has averaged about $500 million annually.
But United States accountants don’t recognize R&D as an investment
and don’t put it on the company’s balance sheet.
Successful R&D does show up in stock prices, however.
The factors of going-concern value
It refers to three factors:
• Extra earning power
A company may have the ability to earn more than an adequate rate of return on
assets.
• Intangible assets
There are many assets that accountants don’t put on the balance sheet.
Some of these assets are extremely valuable to the companies owning or using
them but would be difficult to sell intact to other firms.
(take Pfizer, a pharmaceutical company, which sells at 15.8 times book value per
share)
The factors of going-concern value
• Value of future investments
If investors believe a company will have the opportunity to make
exceedingly profitable investments in the future, they will pay more for
the company’s stock today.
When Netscape, the Internet software company, first sold its stock to
investors on August 8, 1995, the book value of shareholders’ equity was
about $146 million. Yet the prices investors paid for the stock resulted in a
market value of over $1 billion. By the close of trading on that day, the price
of Netscape stock more than doubled, resulting in a stock market value of
over $2 billion, nearly 15 times book value.
In part, this reflected an intangible asset, the Internet browsing system.
In addition, Netscape was a growth company.
Investors believed in successful follow-on products.
 Market price
Going concern
• Market price need not, and generally does not, equal either book
value or liquidation value.
• Market value treats the firm as a going concern.
• Neither book value nor liquidation value treats the firm as a going
concern.
Valuing common stocks
Today’s price and tomorrow’s price
The cash payoff to owners of common stocks comes in two forms:
• (1) cash dividends and
• (2) capital gains or losses
Usually investors expect to get some of each
• Suppose that the current price of a share is P0 (time zero, which is today),
that the expected price a year from now is P1, and that the expected
dividend per share is DIV1
• We simplify by assuming that dividends are paid only once a year and that
the next dividend will come in 1 year
• The rate of return that investors expect from this share over the next year
is the expected dividend per share DIV1 plus the expected increase in price
P1 – P0, all divided by the price at the start of the year P0
Actual return
Expected return

• The actual return for a company may turn out to be more or less than
investors expect.
• At each point in time all securities of the same risk are priced to offer
the same expected rate of return.
• This is a fundamental characteristic of prices in well-functioning
markets. It is also common sense.
The dividend discount model
• Future stock prices are not easy to forecast, so a formula that requires
tomorrow’s stock price to explain today’s stock price is not generally
helpful !
• We use the discounted cashflow model of today’s stock price
• It states that share value equals the present value of all expected
future dividends
The dividend discount model
P0 = present value of (DIV1, DIV2, DIV3, . . ., DIVt = DIV1/(1 +r) + DIV2/(1 +r)2
DIV3/(1 +r)3 + …..DIV/(1 +r)t
How far out in the future could we look? In principle, 40, 60, or 100 years
or more (!)
Corporations are potentially immortal.
However, far-distant dividends will not have significant present values.
For example, the present value of $1 received in 30 years using a 10
percent discount rate is only $.057. Most of the value of established
companies comes from dividends to be paid within a person’s working
lifetime.
Simplifying the Dividend Discount Model
• Consider a company that pays out all its earnings to its common
shareholders.
• Such a company could not grow because it could not reinvest. *
• Stockholders might enjoy a generous immediate dividend, but they
could forecast no increase in future dividends. The company’s stock
would offer a perpetual stream of equal cash payments, DIV1 = DIV2 =
. . . = DIVt = . . . .
• *We assume it does not raise money by issuing new shares !!
Simplifying the Dividend Discount Model
• The dividend discount model says that these no-growth shares should
sell for the present value of a constant, perpetual stream of
dividends.
• Just divide the annual cash payment by the discount rate. The
discount rate is the rate of return demanded by investors in other
stocks of the same risk:
DIV1
P0 =
r
The dividend discount model for no growth
• Since our company pays out all its earnings as dividends, dividends
and earnings are the same:
EPS1
Value of a no-growth stock = P0 =
r

• where EPS1 represents next year’s earnings per share of stock

The constant-growth model
• Many companies grow at rapid or irregular rates for several years
before finally settling down.
• Obviously we can’t use the constant growth dividend discount model
in such cases.
• In some mature industries growth is reasonably stable and the
constant-growth model is approximately valid.
• In such cases the model can be turned around to infer the rate of
return expected by investors.
The constant-growth model
• The higher the fraction of earnings plowed back into the company,
the higher the growth rate.

• So assets, earnings, and dividends all grow by

g = return on equity x plowback ratio
DIV1
P0 =
(r−g)
Growth stocks and income stocks
• Investors buy growth stocks primarily in the expectation of
capital gains, and they are interested in the future growth of
earnings rather than in next year’s dividends.

• They buy income stocks principally for the cash dividends.

Share value with steady growth
• Suppose that Red Rose’s existing assets generate earnings per share
of $5.00.
• It pays out 60 percent of these earnings as a dividend. This payout
ratio results in a dividend of .60 × $5.00 = $3.00.
• The remaining 40 percent of earnings, the plowback ratio, is retained
by the firm and plowed back into new plant and equipment. (The
plowback ratio is also called the earnings retention ratio: RR)
• On this new equity investment Red Rose earns a return of 20
percent (ROE = .20)
Share value with steady growth
• If all of these earnings were plowed back into the firm, Red Rose
would grow at 20 percent per year.
• Because a portion of earnings is not reinvested in the firm, the
growth rate will be less than 20 percent.
• The higher the fraction of earnings plowed back into the company,
the higher the growth rate.
• So assets, earnings, and dividends all grow by g
• g = return on equity x plowback ratio = 20% × .40 = 8%
The present value of growth opportunities
PVGO
• Thus if Red Rose did not reinvest any of its earnings, its stock price
would not be $75 but $41.67
• The $41.67 represents the value of earnings from the assets that are
already in place
• The rest of the stock price ($75 – $41.67 = $33.33) is the net present
value of the future investments that Red Rose is expected to make:
• the present value of the superior returns on assets to be acquired in
the future. It is called the present value of growth opportunities, or
PVGO.
Definitions
• Sustainable growth rate (g): Steady rate at which firm can grow;
return on equity × plowback ratio
• Present value of growth opportunities(PVGO): Net present value of a
firm’s future investments
• Payout ratio: Fraction of earnings paid out as dividends
• Plowback ratio: Fraction of earnings retained by the firm
What is a „Corporate Raider”?
• A corporate raider is an investor who buys a large number of shares in a
corporation whose assets appear to be undervalued.
• The large share purchase would give the corporate raider significant voting rights,
which could then be used to push changes in the company's leadership and
management.
• This would increase share value and thus generate a massive return for the raider.
• Famous corporate raider Carl Ichan used tactics such as taking a company private,
compelling a spin-off, calling for an entirely new board of directors or calling for
a divestiture of assets to make a fortune with his hostile takeovers.
Solution
c. Sure. A raider could take over the company and generate a profit of
$4.17 per share just by halting all investments offering less than the 12
percent rate of return demanded by investors.
This assumes the raider could buy the shares for $37.50.
Reinvesting earnings and the rate of return
• Plowing earnings back into new investments may result in growth in
earnings and dividends but it does not add to the current stock price
if that money is expected to earn only the return that investors
require.
• Plowing earnings back does add to value if investors believe that the
reinvested earnings will earn a higher rate of return.
Present value of growth opportunities(PVGO), the return on
equity (ROE) and the rate of return(r)

If:
• ROE>r PVGO>0
• ROE=r PVGO=0
• ROE<r PVGO<0
Explanatory notes
• Treasury bills: A portfolio of 3-month loans issued each week by the
U.S. government.
• Treasury bonds: A portfolio of long-term issued by the U.S.
government and maturing in about 20 years.
• S & P 500: A portfolio of stocks of the 500 large firms that make up
the Standard & Poor’s Composite Index.
• Common stocks are the riskiest of the three groups of securities. When you
invest in common stocks, there is no promise that you will get your money
back. As a part-owner of the corporation, you receive whatever is left over
after the bonds and any other debts have been repaid.
Corporate Finance
Stock valuation
Practice

Dr. Solt Eszter Éva

BME
 Example
• Suppose Red Rose stock is selling for $75 a share (P0 = $75).
Investors expect a $3 cash dividend over the next year (DIV1 =
$3). They also expect the stock to sell for $81 in a year (P1 =
$81). Then the expected return to stockholders is :
r = ($3 + $81 – $75)/$75 = .12 = 12%
Expected rate of return = expected dividend
yield + expected capital gain: .04 + .08 = .12
 The market value of the stock
• You can also explain the market value of the stock in terms of
investors’ forecasts of dividends and price and the expected
return offered by other equally risky stocks
• This is just the present value of the cash flows the stock will
provide to its owner:
(DIV1 + P1)
Price today = P0 =
(1 + r)
 The market value of the stock
For Red Rose DIV1 = $3 and P1 = $81
If stocks of similar risk offer an expected return
of r = 12%, then today’s price for Red
Rose should be $75:
P0 = ($3 + $81)/1.12 = $75

How do we know that $75 is the right price?

Because no other price could survive in
competitive markets
 Actual return
Expected return

• The actual return for a company may turn out to be more or

less than investors expect.
• At each point in time all securities of the same risk are priced
to offer the same expected rate of return.
• This is a fundamental characteristic of prices in well-
functioning markets. It is also common sense.
 Example/Solution
Moonshine Industries has produced a barrel per week for the
past twenty years but cannot grow because of certain legal
hazards. It earns $25 per share per year and pays it all out to
stockholders. The stockholders have alternative, equivalent-
risk ventures yielding 20 percent per year on average. How
much is one share of Moonshine worth? (Assume the company
can keep going indefinitely)
Solution: P0 = DIV1/r = $25/$.20 = $125
 The Example of Red Rose
For Red Rose DIV1 = $3 and P1 = $81
If stocks of similar risk offer an expected return of r = 12%, then
today’s price for Red Rose should be $75:
($3 + $81)
P0 = = $75
1.12
 The Example of Red Rose
• Suppose that Red Rose’s existing assets generate earnings per
share of $5.00. It pays out 60 percent of these earnings as a
dividend. This payout ratio results in a dividend of .60 × $5.00
= $3.00. The remaining 40 percent of earnings, the plowback
ratio, is retained by the firm and plowed back into new plant
and equipment. (The plowback ratio is also called the earnings
retention ratio: RR) On this new equity investment the firm
earns a return of 20 percent. (ROE)
 The Example of Red Rose
• If all of these earnings were plowed back into the firm, Red Rose
would grow at 20 percent per year.
• Because a portion of earnings is not reinvested in the firm, the
growth rate will be less than 20 percent.
• The higher the fraction of earnings plowed back into the company,
the higher the growth rate. So assets, earnings, and dividends all
grow by:
• g = return on equity x plowback ratio =
• = 20% × .40 = 8%
 The Example of Red Rose

What if Red Rose kept to its policy of reinvesting 40 percent

of its profits but the forecast return on this new investment
was only 12 percent? In that case the expected growth in
dividends would also be lower:
g = return on equity (ROE) × plowback ratio =
12% × .40 = 4.8%
DIV1 $3.00
P0 = = = $41.67
( r – g) (.12 – .048)
 The Example of Red Rose
• To repeat, if Red Rose did not plow back earnings or if it earned
only the return that investors required on the new investment, its
stock price would be $41.67.
• The total value of Re Rose stock is $75. Of this figure, $41.67 is the
value of the assets already in place, and the remaining $33.33 is
the present value of the superior returns on assets to be acquired
in the future.
• The latter is called the present value of growth opportunities, or
PVGO. (Remember that investors expected Red Rose to earn 20
percent on its new investments, well above the 12 percent
expected return necessary to attract investors).
 Share value with steady growth
• Take the example of Red Rose again. The firm is expected to
pay a dividend next year of $3 (DIV1 = 3), and this dividend is
expected to grow at a steady rate of 8 percent a year
(g = .08)
• If investors require a return of 12 percent
(r = .12), then the price of Red Rose should be :
DIV1/(r – g) = $3/(.12 – .08) = $75
 Share value with steady growth
• Suppose that Red Rose’s existing assets generate earnings per
share of $5.00.
• It pays out 60 percent of these earnings as a dividend. This payout
ratio results in a dividend of .60 × $5.00 = $3.00.
• The remaining 40 percent of earnings, the plowback ratio, is
retained by the firm and plowed back into new plant and
equipment. (The plowback ratio is also called the earnings
retention ratio: RR)
• On this new equity investment Red Rose earns a return of 20
percent (ROE = .20)
 Share value with steady growth
• If all of these earnings were plowed back into the firm, Red
Rose would grow at 20 percent per year.
• Because a portion of earnings is not reinvested in the firm, the
growth rate will be less than 20 percent.
• The higher the fraction of earnings plowed back into the
company, the higher the growth rate.
• So assets, earnings, and dividends all grow by g
• g = return on equity x plowback ratio = 20% × .40 = 8%
 Share value without steady growth
• What if Red Rose did not plow back any of its earnings into
new plant and equipment?
• In that case it would pay out all its earnings as dividends but
would forgo any growth in dividends.
• So we could recalculate value with DIV1 = $5.00 and g = 0:
• P0 = $5.00 / .12 – 0 = $41.67
 The present value of growth opportunities
PVGO
• Thus if Red Rose did not reinvest any of its earnings, its stock price
would not be $75 but $41.67
• The $41.67 represents the value of earnings from the assets that
are already in place
• The rest of the stock price ($75 – $41.67 = $33.33) is the net
present value of the future investments that Red Rose is expected
to make:
• the present value of the superior returns on assets to be acquired
in the future. It is called the present value of growth
opportunities, or PVGO.
 Example1
• Suppose that instead of plowing money back into lucrative ventures, Red
Rose’s management is investing at an expected return on equity (ROE) of
10 percent, which is below the return of 12 percent that investors could
expect to get from comparable securities.
• a. Find the sustainable growth rate of dividends and earnings in these
circumstances. Assume a 60 percent payout ratio.
• b. Find the new value of its investment opportunities (PVGO). Explain why
this value is negative despite the positive growth rate of earnings and
dividends.
• c. If you were a corporate raider, would Red Rose be a good candidate for
an attempted takeover?
 Solution
a. The sustainable growth rate is:
g = return on equity (ROE) × plowback ratio
= 10% × .40 = 4%
b. First value the company. At a 60 percent payout ratio, DIV1 = $3.00
as before. Using the constant-growth model: P0 = $3.00/(.12 – .04)
= $37.50
which is $4.17 per share less than the company’s no-growth value of
$41.67. In this example Red Rose is throwing away $4.17 of potential
value by investing in projects with unattractive rates of return.
 What do earnings mean?
Some accounting problems
• We should be careful when we look at price-earnings ratios.
• “Expected future earnings” refers to expected cash flow less the
true depreciation in the value of the assets.
• “True” depreciation is the amount that the firm must reinvest
simply to offset any deterioration in its assets.
• In practice, however, when accountants calculate the earnings that
are reported in the company’s income statement, they do not
attempt to measure true depreciation.
• Instead, reported earnings are based on generally accepted
accounting principles, which use rough-and-ready rules of thumb
to calculate the depreciation of the company’ assets.
 What do earnings mean?
Some accounting problems
• A switch in the depreciation method can dramatically change
reported earnings without affecting the true profitability of the
firm
• Other accounting choices that can affect reported earnings are:
• the method for valuing inventories
• the decision to treat research and development as a current
expense rather than as an investment
• the way that tax liabilities are reported
Corporate finance
Lecture 10
Taxation
DR. SOLT ESZTER ÉVA
BME
2021
Definition
Tax is a compulsory financial charge or some other type of levy imposed on a
taxpayer (an individual or legal entity by a governmental organization in order to
fund government spending and various public expenditures.
A failure to pay, along with evasion of or resistance to taxation, is punishable
by law.
Taxes consist of direct or indirect taxes and may be paid in money.
The first known taxation took place in Ancient Egypt around 3000–2800 BC.
Definition
Most countries have a tax system in place to pay for public, common, or agreed
national needs and government functions.
Some levy a flat percentage rate of taxation on personal annual income, but
most scale taxes based on annual income amounts.
Most countries charge a tax on an individual's income as well as on corporate
income.
Types of taxes
Countries or subunits often also impose wealth taxes, inheritance taxes, estate
taxes, gift taxes, property taxes, sales taxes, payroll taxes or tariffs.
In economic terms, taxation transfers wealth from households or businesses to
the government.
This has effects that can both increase and reduce economic growth and
economic welfare.
Consequently, taxation is a highly debated topic.
Taxes on income and consumption
Most countries impose taxes on both income and consumption.
While income taxes are levied on net income (i.e. from labour and
capital) over an annual tax period, consumption taxes operate as a levy on
expenditure relating to the consumption of goods and services, imposed at the
time of the transaction.
Taxes on income and consumption
There are a variety of forms of income and consumption taxes.
Income tax is generally due on the net income realized by the taxpayer over an
income period.
In contrast, consumption taxes find their taxable event in a transaction, the
exchange of goods and services for consideration either at the last point of sale
to the final end user (retail sales tax and VAT), or on intermediate transactions
between businesses.
Direct tax
„A direct tax is one that cannot be shifted by the taxpayer to someone else,
whereas an indirect tax can be.„
In general, a direct tax is one imposed as distinct from a tax imposed upon a
transaction.
In this sense, indirect taxes such as a sales tax or a value added tax (VAT) are
imposed only if and when a taxable transaction occurs.
People have the freedom to engage in or refrain from such transactions.
Indirect tax
An indirect tax (such as sales tax, per unit tax, value added tax (VAT), or goods and
services tax (GST ), excise, consumption tax, tariff) is a tax collected by an
intermediary (such as a retail store) from the person who bears the ultimate
economic burden of the tax (such as the consumer).
The intermediary later files a tax return and forwards the tax proceeds
to government with the return.
In this sense, the term indirect tax is contrasted with a direct tax, which is collected
directly by government from the persons (legal or natural) on whom it is imposed.
Tax policy in the European Union

It consists of two components: direct taxation, which remains the sole

responsibility of member states, and indirect taxation, which affects free
movement of goods and the freedom to provide services.

With regard to European Union direct taxes, Member States have taken
measures to prevent tax avoidance and double taxation.
Tax policy in the European Union
EU direct taxation covers, regarding companies, the following policies:
 the common consolidated corporate tax base,
 the common system of taxation applicable in the case of parent companies and
subsidiaries of different member states,
 the financial transaction tax,
 interest and royalty payments made between associated companies,
 elimination of double taxation if the payment qualifies for application of the EC
Interest and Royalties Directive.
.
Tax policy in the European Union
Regarding direct taxation for individuals, the policies cover
 taxation of savings income,
 dividend taxation of individuals
 tackling tax obstacles to the cross border provision of occupational pensions.
Corporate tax
A corporate tax, also called corporation tax or company tax, is a direct tax
imposed on the income or capital of corporation or other legal entities.
Many countries impose such taxes at the national level, and a similar tax may be
imposed at state or local levels.
The taxes may also be referred to as income tax or capital tax.
Corporate tax

Partnerships are generally not taxed at the entity level.

A country's corporate tax may apply to:
 corporations incorporated in the country,
 corporations doing business in the country on income from that country,
 foreign corporations who have a permanent establishment in the country,
 or corporations deemed to be resident for tax purposes in the country.
Corporate tax
Company income subject to tax is often determined much like taxable income
for individual taxpayers.
Generally, the tax is imposed on net profits.
In some jurisdictions, rules for taxing companies may differ significantly from
rules for taxing individuals.
Certain corporate acts, like reorganizations, may not be taxed.
Some types of entities may be exempt from tax.
Corporate tax

Countries may tax corporations on its net profit and may also tax shareholders
when the corporation pays a dividend.

Where dividends are taxed, a corporation may be required to withhold

tax before the dividend is distributed.
Types of businesses

Sole proprietor:
 No partners, no stockholders, unlimited liability
 Well-suited for a small company with an informal business structure
Types of businesses

Partnership : to pool money and expertise

 Each partner has unlimited liability for all the business’ debt e.g. consulting
firms, investment banks
 until their financial requirements have grown too large to continue as
partnerships
Types of businesses
Corporations:
 Business is owned by stockholders who are not personally liable for the
business’s liabilities
 Limited liability: the most a stockholder can lose is the amount invested in the
stock
 Separation of ownership and management
 Elected board of directors
Advantages and drawbacks of different forms of
business
Partners and sole proprietors:
 Advantage: taxed only once as personal income, smaller costs
 Drawback: smaller profit potential with unlimited liabilities
Corporations:
 Advantage: larger profit potential with limited liabilities
 Drawback: as separate legal entities taxed on profits and dividends
Hybrid forms of businesses
Limited partnerships:
 General partner manages the business and has unlimited personal liability for
the business’s debts.
 Limited partner has a restricted role in the management and has the liability
only for the money they contribute to the business.
Hybrid forms of businesses

LLC or LLP ( limited liability partnerships):

All partners have limited liability AND the tax advantage of partnerships: taxed
as personal income

These forms suit rather for small and medium-sized companies.

INCOME STATEMENT FOR PEPSICO, INC., 1998 (in millions of dollars)

Net sales $22,348

Cost of goods sold 9,330

Other expenses 291

Selling, general, and administrative expenses 8,912

Depreciation 1,234

Earnings before interest and taxes (EBIT) 2,581

Net interest expense 321

Taxable income 2,260

Taxes 270

Net income 1,990

Allocation of net income

Addition to retained earnings 1,233

Dividends 757
Principles of tax policy
Many governments have to cope with less revenue, increasing expenditures and
resulting fiscal constraints.
Raising revenue remains the most important function of taxes, which serve as
the primary means for financing public goods such as maintenance of law and
order and public infrastructure.
Neutrality: Taxation should seek to be neutral and equitable between forms of
business activities.
Neutrality also entails that the tax system raises revenue while minimizing
discrimination in favour of, or against, any particular economic choice.
Principles of tax policy
Efficiency: Compliance costs to business and administration costs for
governments should be minimised as far as possible
Certainty and simplicity: Tax rules should be clear and simple to understand, so
that taxpayers know where they stand.
A simple tax system makes it easier for individuals and businesses to understand
their obligations and entitlements.
As a result, businesses are more likely to make optimal decisions and respond to
intended policy choices.
Principles of tax policy
Effectiveness and fairness: Taxation should produce the right amount of tax at
the right time, while avoiding both double taxation and unintentional non
taxation.
In addition, the potential for evasion and avoidance should be minimized.
Principles of tax policy

Flexibility: Taxation systems should be flexible and dynamic enough to ensure

they keep pace with technological and commercial developments.
It is important that a tax system is dynamic and flexible enough to meet the
current revenue needs of governments while adapting to changing needs on an
ongoing basis.
The issue of equity
Equity has two main elements; horizontal equity and vertical equity.
Horizontal equity suggests that taxpayers in similar circumstances should bear a
similar tax burden.
Vertical equity is a normative concept, whose definition can differ from one user
to another.
It suggests that taxpayers in better circumstances should bear a larger part of
the tax burden as a proportion of their income.
The issue of equity
In practice, the interpretation of vertical equity depends on
 the extent to which countries want to diminish income variation and
 whether it should be applied to income earned in a specific period or to
lifetime income.
Equity is traditionally delivered through the design of the personal tax and
transfer systems.
Taxation in Hungary
Taxation in Hungary is levied by both national and local governments.
Tax revenue in Hungary stood at about 40% of GDP.
The most important revenue sources include the income tax, social
security, corporate tax and the value added tax, which are all applied at the
national level.
Among the total tax income the ratio of local taxes is solely 5% while the EU
average is 30%.
Income tax in Hungary is levied at a flat rate of 15%.
A tax allowance is given through a family allowance.
Taxation in Hungary

The standard rate of value added tax is 27% — the highest in the European
Union.
There is a reduced rate of 5% for most medicines and some food products, and a
reduced rate of 18% for internet connections, restaurants and catering, dairy
and bakery products, hotel services and admission to short-term open-air
events.
Taxation in Hungary
In January 2017, corporate tax was unified at a rate of 9% — the lowest in the
European Union.
Dividends received are not subject to taxation, provided that are not received
from a Controlled Foreign Company (CFC).
Capital gains are included in corporate tax, with certain exemptions.
Employment income is subject to social security contributions for the employer
at a flat rate of 17,5%.
Capital gains are taxed at a flat rate of 15%.
Corporate tax rate in the USA

The United States imposes a tax on the profits of US resident corporations at a

rate of 21 percent (reduced from 35 percent by the 2017 Tax Cuts and Jobs Act).

The corporate income tax raised $230.2 billion in fiscal 2019, accounting for 6.6
percent of total federal revenue, down from 9 percent in 2017.
EU VAT rates

The EU sets the broad VAT rules through European VAT Directives, and has set
the minimum standard VAT rate at 15%.
The 27 member states (plus UK) are otherwise free to set their standard VAT
rates.
The EU also permits a maximum of two reduced rates, the lowest of which must
be 5% or above.
EU VAT rates

Some countries have variations on this, including a third, reduced VAT rate,
which they had in place prior to their accession to the EU.

Member states have now agreed that they will be free to set the reduced rates
on most goods and services, including e-books; domestic fuel, clothing etc.
Corporate income tax rates in Europe

Taking into account central and subcentral taxes, Portugal has the highest
statutory corporate income tax rate among European OECD countries, at
31.5 percent.
Germany and France follow, at 29.9 percent and 28.4 percent, respectively.
Hungary (9 percent), Ireland (12.5 percent), and Lithuania (15 percent) have the
lowest corporate income tax rates.
Corporate income tax rates in Europe
On average, European OECD countries currently levy a corporate income tax rate
of 21.7 percent.
This is below the worldwide average which, measured across 177 jurisdictions,
was 23.9 percent in 2020.
European OECD countries—like most regions around the world—have
experienced a decline in corporate income tax rates over the last decades.
In 2000, the average corporate tax rate was 31.6 percent and has decreased
consistently to its current level of 21.7 percent.
Topic to be discussed on the lecture
Corporate tax rates in developed economies are subject to intense public
debate.
Competition for mobile capital, including in particular foreign direct investment
(FDI), has prompted a number of countries to envisage lowering their corporate
tax rates in order to attract foreign investors after a period of relatively stable
tax rates after of the global financial crisis.
Are these policy changes likely to be effective in attracting FDI and to impact
significantly on tax revenues and GDP?
To answer the question consider:
 Corporate taxes are not the only determinant of FDI
 The impact of tax competition and tax policy changes depends on many other
features e.g.:
the degree of asymmetry of countries in terms of size and factor endowment,
the existence of agglomeration economies,
the existence of other tax categories,
the degree of factor mobility
the complementarity between mobile and immobile factors.
To answer the question consider:
 Despite the fall in corporate tax rates observed in developed economies, tax
bases have been generally broadened to compensate tax revenues losses.

 Countries are unlikely to face the same incentives in determining their

preferred corporate rates or in favouring corporate tax rate harmonisation
which could eventually lead to more efficient corporate tax setting at EU level.
To answer the question consider:
 One specific aspect influencing corporate tax policy preferences of a given
country is the size of its economy.
 Small countries are generally better off by setting low corporate tax rates in
order to attract foreign capital,
 while large economies can fix higher tax rates given that the home bias and
local agglomeration economies act as a break on investment outflows.
Corporate finance
Lecture 10
Liquidity management
Corporate default
DR. SOLT ESZTER ÉVA
BME
2021
Definition of liquidity management

 Liquidity management is a concept broadly describing a company’s ability to

meet financial obligations through cash flow, funding activities, and capital
management.
 Liquidity management can be challenging as it is impacted by revenue and cost
generating activities, capital and dividend plans, and tax strategies.
 It is closely linked to broader market, credit and general business
risks.
Why liquidity management matters…
 Many businesses have much of their value tied up in investments and assets
such as real estate, inventory and equipment.
 But to succeed, every business must have some liquidity that is ready access to
cash to cover expenses and make short-term investments.
 Liquidity management is a set of ongoing strategies and processes that ensure
that the business is able to access cash as needed to pay for goods and
services, make payroll and invest in new opportunities that arise.
Why liquidity management matters…
 Even profitable companies can fail if they don't have the cash available to pay
bills.
 It happens frequently as many businesses purchase inventory or incur
production costs long before their customers pay for those goods, and they must have
cash on hand to continue operating in the interim.
 As companies grow, they usually spend even more on new employees, new
facilities, new inventory and new equipment.
 If they have to wait too long to get paid by their customers and don't have extra cash
on hand, they could get behind on their obligations and end up with extra debt or even
in bankruptcy.
Liquidity management strategy
 A liquidity management strategy means that the business has a plan for
meeting its short-term and immediate cash obligations without experiencing
significant losses.
 It means your company is managing its assets, including cash to meet all
liabilities, cover all expenses and maintain financial stability.
 For companies that are over-leveraged, a liquidity management strategy
includes developing steps to reduce the gap between the cash available on
hand and their debt obligations.
What are the objectives of liquidity
management?

 Liquidity management is a cornerstone of every treasury and finance

department.
 Those who overlook a firm’s access to cash do so at their peril, as has been
witnessed so many times in the past.
What are the objectives of liquidity
management?

 In essence, liquidity management is the basic concept of the access to readily

available cash in order to fund short-term investments, cover debts, and pay for
goods and services.
 Liquidity planning is crucial, and involves finance and treasury managers’ ability
to look to the company’s balance sheet and convert funds that are tied up in
longer-term projects into cash for the firm to use in its day to day operations.
Liquidity risk
 In order to keep a regular grasp of the firm’s liquidity risk, managers will monitor the liquidity
ratio, in which firms will compare their most liquid assets (those that can be converted into cash
easily and quickly), with short term liabilities, or near-term debt obligations.
 If the firm finds itself unable to meet short term cash obligations, or cash equivalent
obligations, it may find itself in a position in which it must sell illiquid assets quickly.
 It can lead to a situation in which it may be forced to accept less than it’s assets’ fair value.
 Avoiding such as situation is key to successful liquidity risk management.
Techniques that help mitigate liquidity risks
There are a variety of different techniques applied by firms across the globe that help mitigate
liquidity risks and assist with liquidity planning:
 Receivables management: the strict approach to ensuring that clients and customers maintain
payments in a timely and orderly fashion.
o Clients will pay in such a way that the firm will be able to use the funds to meet short term
obligations.
o With many contracts, deals and invoices stipulating a required time period within which the
client must meet their payment obligations.
o Monitoring each client’s outstanding payments and ability to pay
Cash forecasting
 Cash forecasting: A key concept in good liquidity management.
o A good cash flow forecast accurately predicts the cash inflows and outflows expected over a pre
defined period in the future, normally twelve months.
o It includes projected income and expenses, and is informed by the previous period’s accounts.
o Being able to accurately assess when a company will have access.
 Payables management is another cornerstone of good liquidity management.
oThis is the maintenance of the firm’s outstanding liabilities and debts to third parties, which is any
goods or services supplied to the firm made on credit.
What Are Liquidity Ratios?
Liquidity ratios are an important class of financial metrics used to determine a
debtor's ability to pay off current debt obligations without raising external
capital.
Liquidity ratios measure a company's ability to pay debt obligations and its
margin of safety.
The most commonly used ratios are:
 Current ratio,
 Quick ratio,
 Operating cash flow ratio.
Liquidity and liquidity ratios

Liquidity is the ability to convert assets into cash quickly and cheaply.
Liquidity ratios are most useful when they are used in comparative form.
This analysis may be internal or external.
Liquidity ratios determine a company's ability to cover short-term obligations
and cash flows,
Solvency ratios are concerned with a longer-term ability to pay ongoing debts.
Internal analysis

Internal analysis regarding liquidity ratios involves using multiple accounting

periods that are reported using the same accounting methods.
Comparing previous periods to current operations allows analysts to track
changes in the business.
In general, a higher liquidity ratio shows a company is more liquid and has better
coverage of outstanding debts.
External analysis
External analysis involves comparing the liquidity ratios of one company to
another or an entire industry.
This information is useful to compare the company's strategic positioning in
relation to its competitors when establishing benchmark goals.
Liquidity ratio analysis may not be as effective when looking across industries as
various businesses require different financing structures.
Liquidity ratio analysis is less effective for comparing businesses of different sizes
in different geographical locations.
The Current Ratio

The current ratio measures a company's ability to pay off its current liabilities (payable within
one year) with its total current assets such as cash, accounts receivable, and inventories.
The higher the ratio, the better the company's liquidity position:

Current Ratio = Current Assets/​Current Liabilities

The Quick Ratio
The quick ratio measures a company's ability to meet its short-term obligations with its most
liquid assets and therefore excludes inventories from its current assets.
It is also known as the "acid-test ratio":
Quick ratio = (C+MS+AR)/CL
where: C= cash & cash equivalents
MS=marketable securities
AR=accounts receivable
CL=current liabilities​
Quick ratio

Another way to express this is:

Quick ratio = (Current assets - inventory - prepaid expenses)/Current liabilities
Days Sales Outstanding (DSO)

Days sales outstanding, or DSO, refers to the average number of days it takes a
company to collect payment after it makes a sale.
A high DSO means that a company is taking unduly long to collect payment and
is tying up capital in receivables.
DSOs are generally calculated on a quarterly or annual basis:
DSO = Average accounts receivable/​Revenue per day
Liquidity Crises

A liquidity crisis can arise even at healthy companies if circumstances arise that make it difficult
for them to meet short-term obligations such as repaying their loans and paying their
employees.
The best example of such a far-reaching liquidity catastrophe in recent memory is the global
credit crunch of 2007-09.
Commercial paper—short-term debt that is issued by large companies to finance current assets
and pay off current liabilities—played a central role in this financial crisis.
Default
In finance, default is failure to meet the legal obligations (or conditions) of a loan, for example
when a home buyer fails to make a mortgage payment, or when a corporation or government
fails to pay a bond which has reached maturity.
A national or sovereign default is the failure or refusal of a government to repay its national
debt.
The biggest private default in history is Lehman Brothers, with over $600 billion when it filed for
bankruptcy in 2008.
The biggest sovereign default is Greece, with $138 billion in March 2012.
Signs that might indicate default

Missed payments for supplies, raw materials, royalties, and similar unsecured operating liabilities.
In some cases, these defaults may be the result of contract disputes or other commercial issues, and
they often remain on the books only until the underlying issue is resolved or adjudicated.
Such disputes may involve immaterial amounts of money and may be cured with an eventual
settlement or renegotiation of the obligation.
Sometimes, however, late or missed payments might be early signs of deepening financial stress.
When material sums are involved and repayment can seem uncertain, creditors can initiate legal
action that could force the company into a bankruptcy proceeding.
A company subject to involuntary bankruptcy cedes control of its finances to an independent trustee
who has the general authority to redeploy or liquidate assets and to distribute cash in order to
satisfy verified creditors.
Signs
Failure to make timely principal or interest payments on secured debt.
Companies may be responsible for mortgages on company property and installment debt on
company vehicles and equipment.
When a company defaults on this kind of debt, the lender can take possession of the property or
equipment offered as security for the debt.
In some cases, the lender is limited to the secured assets, and if the obligation is greater than the
secured value, the lender must take the loss.
But in some lending deals, the lender was also given some kind of recourse to seek additional cash if
the secured property’s value were to be insufficient.
Secured creditors with recourse loans can pursue their claims in bankruptcy court, like unsecured
creditors.
Signs
Failure to make timely payments on unsecured bonds and notes.
An explicit failure to make timely payments on general obligation debt securities may have the
most immediately dire consequences of any default.
Aggrieved holders of securities on which the borrower defaults may seek immediate bankruptcy
court intervention, or they may use the threat of filing to force the company to renegotiate the
terms of the debt.
In the wake of a default and liquidation, different categories of debt will have different priorities
for repayment and thus different potential recovery values.
Signs
Generally, secured debt holders would be repaid first, receiving their collateral or its current
cash equivalent and any potential recourse payments.
Senior unsecured debt holders would then normally receive their shares from whatever assets
might remain after secured debt holders were repaid.
When those commitments are satisfied, subordinated (or junior) debt holders typically would
come next, then preferred shareholders, and then common shareholders.