Advanced Corporate Finance

ADVANCED CORPORATE FINANCE Prof.
Michael Tröge
0. INTRODUCTION
Overview
 Advanced Corporate Finance
 Class Philosophy
 Curriculum
 Grading
 References
 What else for starting a successful career in Finance
 Before we start let’s collect some information about you with WOOCLAP
Do not confuse finance with words that has it in it like “financial modelling”.
Course Philosophy: Concepts not techniques
 Objective:
 Understand the “why” not the “how”
 Apply financial concepts creatively to understand motivation and effects of financial operations
 Understand the
 Economic mechanisms behind financial operations
 Motivations behind financial strategies
 Origin of value creation
 We will review but not focus on
 Basic tools and techniques

 Legal and accounting details
 Institutions and procedures
Examples: Recent Financial Transactions
 Exemple 1: Iliad going private
 Motivation?
 Why does equity value go up? (Equity value is the value of a company available to owners or shareholders. It is the
enterprise value plus all cash and cash equivalents, short and long-term investments, and less all short-term debt,
long-term debt and minority interests).
EQUITY VALUE = enterprise value + cash – net debt (ricordiamo che net debt is debt - cash)
 Why does the bond value decline?
Bond value is prezzo equo di un’obbligazione ovvero è il valore attuale del flusso di cassa che si prevede genererà.
 Exemple 2: 20 year old Jake Freedman makes 80 million in 3 months
 Activist investment strategy
 Realize that convertible bonds increase in value with risk
 https://www.ft.com/content/b83144bd-830e-4e1d-a9a1-a1ee1ba61dab
 https://www.sec.gov/Archives/edgar/data/886158/000193921022000002/ex.pdf
 https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3405367
Quale è la differenza tra azioni e obbligazioni?
Nel caso delle obbligazioni, gli investitori assumono lo status di creditori. Con le azioni, invece, si diventa soci. Si tratta, quindi, di due
posizioni ben diverse che hanno delle ripercussioni anche nel rapporto rischio/rendimento.
Stock is azioni in Italian
Is it good if a company goes private?
Share prices often rise when companies announce that they're going private since acquirers may have to offer a premium of up to 40%
over the current stock price to entice existing shareholders to sell. Also, investors may get excited about the turnaround prospects of a
business after it goes private.
Its bonds might continue to trade, but holders will not receive principal and interest payments. As a result, a default could occur, and
the value of the bonds might decline significantly.
Course Content
1. Preliminaires
 Financial Statements+ Ratios
 Creating Forecasts
2. Present Value and its pitfalls

 Taking into account risk
 Alternative ways to determine discount factors
3. Valuing Bonds, Stocks and Investment Projects
 Expected and promised yields
 The Gordon Growth Model and its implications
 Understanding FCTF
4. How not to create value (Modigliani Miller)
 Leverage and EPS games
 Basic Merger Economics
5. Risk and Capital Structure
 Valuing Tax shields
 Bankruptcy and its costs
6. Option Theory of Capital strucure
 Another way of valuing risk debt and equity
 Risk and Value
7. Applied Valuation and its Pitfalls
 Basic valuation methods
 Variants of DCF
8. Moral Hazard and Agency Costs
 Management Shareholder conflict
 Creditor Sharehodler conflict
9. Adverse Selection and Pecking Order
 Announcement effects of financing decisions
 Information sensitivity
10. Current Topics
 Capital strucutre and strategy
 Behavioural corprorate finance
What should you know?
 Prerequisites:
 Accounting and Financial Modelling
 Financial Mathematics and Basic Asset Pricing
 We will review most of this quickly
 You can find these topics in any Corporate Finance texbook (see references)
 Let’s check with a WOOCLAP
 Complement the Specialization with electives depending on your interests/ career goals
 Valuation
 Applied Investment Banking
 Financial Institutions Management…
The three Theoretical Frameworks used in Finance
1. Classic Finance with perfect markets
 Identically informed and rational decision makers
 Modigliani Miller Theorems, CAPM, Option Pricing
 Underlying Economic Theory: complete markets with perfect competition (Arrow/ Debrew markets, Coase Theorem)
2. Asymmetric information: Incentives and adverse selection
 Agency Theory, Signaling, Market Failures…..
 Underlying Economic Theory: Economics of asymmetric information (Akerlof/Stiglitz etc.), Game Theory (Nash,
Harsanyi etc.)
3. Behavioral Finance
 Irrational decision makers
Course Philosophy
 Rapid pace
 Active participation
 Close to research
Grading
 Final (online) exam of two hours at the end of the class 80%
 Class participation & Wooclap: 20% of the final grade
 Optional:
 Additional assignments: I will provide throughout the course additional assignments to help you remember basic
concepts and train the concepts discussed in class.
 If handed in, all additional assignments will constitute up to 30% of the grade, class participation & Wooclap 20%
and the final exam 50%.
 If you hand in part of the assignments they will contribute pro-rata.
Bibliography/ References
 The Basics
 Corporate Finance, Jonathan Berk Peter DeMarzo
 A First Course in Corporate Finance, Ivo Welch,
 Case Studies in Finance, Robert E. Bruner,
 More Advanced
 Financial Markets and Corporate Strategy, M. Grindblatt and S. Titman,
 Advanced Corporate Finance, Ogden, Jen, O’Connor
 Research Level
 Theory of Corporate Finace, Jean Tirole
Jobs in Finance
 Classic I Banking
 Asset Management
 Mutual Funds
 PE Funds
 Hedge Funds
 Private Debt
 Ratings, Financial Research
 Insurance
 Corporate Banking
 Finance Function in a Corporation
Out of class activities
 I-banking bootcamp, typically in October, Date?
 ESCP Finance Society
 Get your free FT subscription!
 Check out our Finance databases in the data room

 Refinitiv (formerly Reuters Eikon)
 Bloomberg
Things we can do if there is sufficient interest
 Alumni career talks
 30min cv + 30min Q&A, Thursdays between 12:15 and 13:5. Attendance compulsory
 CFA Research Challenge
 ESCP Finance Specialization achieved 3rd place last year
 ESCP Student Activist Hedge fund
 Exists at Harvard and LSE
 Check out Bill Ackman, Carson Block, David Einhorn, Daniel Loeb….
 Investment games/ Finance Competitions
 Stupid ….but why not
 https://www.finmarketguru.com/20-top-finance-based-competitions-across-world/
Professional Certifications in Finance
 Entry level
 BMC Bloomberg: « participation confirmation »
 The Gold Standard
 CFA level I
 We award 3 scholarships in January for June exam
 Required for investment management in France
 Certification AMF (answer 100 out of 600 questions)
 Less well known and more specialized
 CAIA – scholarships available
 FRM/ GARP
 PRM/ PRMIA
 Moody’s, Fitch…
For your « Finance Culture »
 Beadtime reading:
 20th century classics
• Barbarians at the Gate (LBO)
• Liar’s Poker (Bond Trading)
• Predator’s Ball (Junk Bonds)
• F.I.A.S.C.O.: Blood in the Water on Wall Street (Derivatives)

• Traders, Guns & Money (Derivatives)
 21st century and crisis
• Too big to fail (Bailouts)
• The big short (Mortgage Backed Securities)
• Black Edge (Hedge Funds)
• Flash Boys (High Frequency Trading)
 Essays:
 The New Financial Order (R.Shiller)
 Economics for the Common Good (J. Tirole)
 Saving Capitalism from the Capitalists (Rajan & Zingales)
 Treasure Island (Shaxon)
 The Banker’s New Clothes (Admati & Hellwig)
 Documentaries:
 Betting on Zero
 Inside Job
 The Smartest Guys in the Room
 Movies:
 Working Girl
 Other people’s money
 Trading places
 Wall Street
 Boiler room
 Margin call
 The big short
 Industry
Be beware of BS
 Books:
 Airport library investment books
• E.g. BS on Warren Buffet
 Hagiographies of corporate leaders
• The art of the deal ….
 Films
 Wall Street 2: Money Never Sleeps

 The Wolf of Wall Street
Internet Ressources:
 Serious ressources
 Dealbreaker
 Alphaville FT
 MarginalRevolution
 NakedCapitalism
 Matt Levine/Bloomberg
 To be avoided:
 Investopedia: Often misleading and frequently totally wrong (e.g. def. of EV)
 Zero Hege: Occasionally some good stuff but mostly crazy conspirationist
 Seekingalpha, marketwatch, stockstotrade, Timothy Sykes… and other bullshit-spreading day trader sites
« Practical » online training
 Mostly Excel skills + Interview knowledge
 breakingintowallstreet.com
 www.wallstreetmojo.com
 www.wallstreetprep.com/.....
 Great Financial Anlaysis:
 https://www.muddywatersresearch.com/research/
1. Financial Statements and Forecasting
We very briefly review the three basic financial statement, mostly to agree on terminology. We then go over the mechanics of
generating a 3 statement operating model of a firm.
Content:
1. Financial Statements
2. Some Ratios
3. Forecasting Financial Statements
4. Digisys Case
Financial statement in finance is different than in accounting, how you forecast financial statement.
1. Financial Statements
Accounting, Management Control, Finance: What’s the Difference?
 (Financial) Accounting:
 Provides aggregate information to shareholders and creditors

 Rule based system: (FASB->US GAAP, IASB->IFRS)
 Managerial Accounting/ Management Control (Cost accounting)
 Provides decision support to management
 Judgement based, detailed and disaggregated firm-internal information about products, individual activities,
divisions, plants, operations and tasks
 Finance
 Provides the tools to make investment decisions and raise capital (equity and debt)
Financial Statements
 Income Statement (= statement of earnings, profit and loss account)
 Estimate of profit “earned” in a period of time
 Always judgement based
 Always possibility of « Earnings Management »
 Balance Sheet: Two opposing views:
 Backwards looking: Where did the company’s money come from (Liabilities) and where did it go (Assets)?
 Forward looking: What does the company need to pay back (Liabilities) and what are the resources to do this
(Assets)?
 IFRS: mixture of both views
 Cash Flow Statement
 How much did the company’s bank account increase?
 The only « hard » non judgement-based information
 But often not very useful….
Income Statement Terminology
 Income statement (US English) or Profit and Loss account/P&L (UK English)
 The P&L lists revenues (= sales = turnover in UK English) and expenses during a particular period.
 The difference between revenues and expenses is the “net income” or “net profit”
 Revenues: recorded when “earned”
 (premature) revenue recognition?
 Expenses: recorded when corresponding revenues are earned (matching principle)
 (delayed/ omitted) expense recognition
Income Statement Terminology
 COGS vs. SG&A
 Cost of Goods Sold (COGS)
• The cost of producing or acquiring the goods or services to be sold : purchase price of the raw material,
expenses of turning it into a product, D&A of production equipment… mostly variable costs.
 Selling, general, and administrative expenses (SG&A):
• Combined payroll costs (salaries, commissions, and travel expenses) of executives, sales people and
administrative employees, and advertising expenses….rather fixed costs.
 Operating Expenses vs. Financing Costs
 Operating Expenses (Opex)
• Everything that is not financial expenses and capital expenditure i.e. COGS + SG&A
• Sometimes used equivalently to SG&A
 Financing Costs
• Interest paid to creditors and dividends paid to preferred stockholders
A strange thing accountants do: Depreciation and Amortization (D&A)
 Capital Expenditures (Capex) produce Fixed Assets with a lifetime of more than one year.
Capex indica in economia aziendale l'ammontare di flusso di cassa che un'impresa impiega per acquistare, mantenere o
implementare le proprie immobilizzazioni operative, come edifici, terreni, impianti o attrezzature.
 Example: We spend 100 in Capex to buy a machine that lasts 10 years. How to transform Capex into costs?
 Two different views:
 Matching principle: These costs should be distributed over the lifetime of the asset.
 Market value of asset: The loss in value due to the aging of the machine should be considered as the cost
 Depreciation: Tangible assets
 Amortization: Intangible assets (Brand, Goodwill)
 Capitalize or Expense?
 Often both choices possible

Depreciation in finance we get a volatily income the first year and then very high the others. From a finance persperctive we cut it in
pieces and we produce a much regular smooth income allocating costs during the years. But accountant say the decpreciation reprsents
the decline of the cost during years. But actually none knoes the value of the machine after years.
Income statement formats
 Grouping by nature
 Cash costs and D&A are given separately
 Grouping by function
 Allocations of expenses to functional classifications (Cogs, SG&A etc.) but no separation of cash costs and D&A
 Today mostly mixed format: Separates by function but also indicates D&A
 Exceptional items?
 Comprehensive Income?
CURRENT SHORT LESS THAN ONE YEAR
FFIXED THE OPPOSITE
The operating liabilities and the financial liabilities. We divide debt between financial activities and operating ones. The accounts
payables are debt we get basically for free. Unvoluntary investors.
Paid in capital and retained earnings is money invested in past.
Goodwill is an accounting backward looking.

Balance Sheet: Market vs. Book Values
 Traditional Accounting:
 Book value of asset = Historical cost – depreciation
 Problems:
 Historical cost ≠ current cost or value
 Depreciation ≠ value loss
 Consequence: book values are often meaningless
 New approach (IFRS)
 Book value = fair value
 Problems:
 Market, NPV or Cost-based
 Often impossible to define or arbitrary
 Frequent Fluctuations
 Fair value of liabilities?
What do the amounts in the right hand side of the balance sheet represent? The money investors should give back to investors if its
bond or loan but if its equity is the money invested by investors in the past. In accounting these 2 versions are mixed, here in finance we
see the second one.
What do the amounts on the left side of the balance sheet represent ? historically we could say the historical cost of the different assets
minus depreciation.
We say now also the market value of assets.
And the present value of future cash flows produced by the assets.
What is a goodwill? An accounting adjustment that is necessary if a company is acquired for a price that is higher than its book value.
Balance Sheet Terminology: Current vs. Fixed Assets
 Current assets or gross working capital comprise assets that are relatively liquid, or expected to be converted into cash within
12 months.
 Current assets typically include:
 Cash
 Accounts Receivable
 Inventory
 raw materials, work in process, and finished goods held for eventual sale
 Other expenses
 E.g. prepaid expenses
Balance Sheet Terminology: Tangible vs. Intangible Assets
 Tangible fixed assets (Property, plant, and equipment/ PP&E)
 Machinery and equipment
 Buildings
 Land
 Tangible current assets: Inventory
 Intangibles
 Software, trademarks, patents, copyrights, import quotas
 Goodwill
Balance Sheet Terminology: Current vs. Long Term Liabilities
 Current Liabilities:
 Short-term debt: payable within 12 months
 Accounts payable: Credit extended by suppliers to a firm
 Accrued expenses:
 Short term liabilities incurred in the firm’s operations but not yet paid for: rent, interest, wages etc.
 Long-Term Debt
 Loans from banks or other institutions for longer than 12 months
 Other long term liabilities: e.g. pension liabilities
 Capital Employed * = Non current Liabilities = Equity and long term (operating and financial) Debt
Balance Sheet Terminology: Financial vs. Operating Liabilities
 Financial Debt = debt provided by a financial investor
 Bank debt
 Bonds outstanding
 Operating Liabilities = financing generated by the firm’s operations
 Accounts payable
 Accrued expenses
 Long term operating liabilities (pensions, lease obligaitons)
 Invested Capital* = Financial Liabilities
 Almost all assets are « operating assets » except « cash and equivalent »
Balance Sheet Terminology: Net (Operating) Working Capital
Net Working Capital
Il capitale operativo è l'ammontare di risorse che compongono e finanziano l'attività operativa di un'azienda ed è un
indicatore utilizzato allo scopo di verificare l'equilibrio finanziario dell'impresa nel breve termine (current).
 Current assets – current liabilities =
 Cash + Receivables + Inventory – Payables – short term debt
 Problem: Mixture of Financial and Operating Items
Net Operating Working capital
La differenza tra questo e il primo net working capital. Quello operating non toglie il short term debt e non muoviamo
cash.
 Operating assets – operating liabilities = Receivables + Inventory – Payables
If you start a business you have to raise money to finance Fixed Assets + Net (Operating) Working Capital
Balance Sheet Terminology
 Equity= Money invested (or left in the company) by shareholders in the past.
 Common stock and Additional Paid in Capital
 Retained Earnings
 Money that could have been taken out but hasn’t = cumulative total of all the net income over the life of the firm,
less common stock dividends that have been paid out over the years
 Treasury Stock
 Stock that was once outstanding and has been re-purchased by the company
 Needs to be subtracted from equity

In IFRS you add back interest. Money going back to creditors. The financial cash doesn’t have interest
We don’t want to use taxes we use adjusted taxes on EBIT, so we replace the actual taxes with taxes on EBIT.
It is considered as financed totally with equity.
Noplat lat is less adjusted taxes.
Assume company with no debt we remember FCTF. Is the same of operating cash and investment cash in case of a company with no
debt. And you remove any effect of debt.
Operating Cash
Net Income
+ Depreciation
- Change in operating working capital
+ interest expense (sometimes omitted…)
= After-tax cash flows from operations
Reminder: Change in operating working capital = Change in current operating assets - Change in current operating liabilities =
= Change in receivables
+ Change in inventory
– Change in payables
Investing Cash Flows and Financing Cash Flows
 Investing Cash Flow:
 (Net) Capital expenditures = Change in Gross Fixed Assets (not net Fixed Assets) =
 Includes sale of fixed assets (positive cash flow)
 Sometimes includes financial investments
 Financing Cash Flow
 A firm can either receive money from or distribute money to its investors. The firm can:
 Pay interest to lenders (included if added back in operating cash)
 Pay dividends to stockholders
 Increase or decrease in financial-term debt
 Issue stock to new shareholders or repurchase stock from current shareholders
Notes to the Financial Statements
 The notes are a key part of analyzing a company’s financials
 Important reconciliations in the notes
 Can’t fully understand the numbers without them
 Explain accounting method decisions
 Parts to look at:
 MD&A (Management Discussion and Analysis)
 Debt reconciliations
 Acquisitions
 Segment data
Sources of Financial Statement Information
 Stock market listed US companies have to disclose detailed financial statements. USA ONLY.
 The quarterly statements are calles 10-Q and the annual statements 10 –K
 They can be downloaded at the US governments EDGAR website
 Other more convenient web sources of financial information are Reuters (for financial ratios) Bloomberg (for government
bond rates) , as well as Yahoo Finance (for stock prices and financial statements).
 At ESCP we have access to Bloomberg terminals (data room) and Refinitiv (Online through Library website)
2. Financial Ratios
Ratios and Benchmarking
 In order to obtain a first understanding of a company’s risk and return, financial analysts use different types of ratios.
 Ratios are not very helpful by themselves; they need to be compared to something
 Time-Trend Analysis
 Used to see how the firm’s performance is changing through time
 Peer Group Analysis
 Compare to similar companies or within industries
Categories of Financial Ratios
 Financial Ratios can be classified into 5 main categories:
1. Profitability Ratios
2. Liquidity or Short-Term Solvency ratios
3. Financial Structure/Capitalization/ Long Term Solvency Ratios
4. Asset Management or Activity Ratios
5. Market Value Ratios
 In general there are no rules, financial analysts make up their own ratios
Limitations of Ratio Analysis
 Accounting numbers always subject to window dressing.
 Accounting practices differ among firms
 Sometimes ratios cannot be caluclated (e.g. negative equity)
 Ratio magnitudes are largely irrelevant; a good ratio in one environment can be bad in another.
 Difficulty in finding peers
 Peer group averages affected by the presence of heterogeneity between firms in a given industry
 Peer group may not provide a desirable target ratio or norm
Profitability Ratios
 Profitability Measures assess the firm's ability to generate income (reddito)
 Two general forms:
 Margins = Measure of Profit/Sales
 Gross Profit Margin (GPM)
 Operating Profit Margin (OPM)
 Net Profit Margin (NPM)
 Returns = Measure of Profit/ Investment

 Return on Assets (ROA)
 Return on Equity (ROE)
Ratios are about comparing companies.
Profitability Ratios: Different types of Returns
 ROA = Net Income/ Total Assets
 Makes no sense!
 Several variants:
 EBIT Return On Assets = Return on Total Assets (ROTA) = EBIT/ Total Assets
 ROCE = EBIT (1-tax) / Capital Employed
 ROIC = EBIT (1-tax) / Invested Capital
• And more CROGI, ROGIC….
 Return on Equity = Net Profit / Total Equity
 Depends heavily on leverage (see later)
Liquidity or Short-Term Solvency ratios
 Just for completeness, not very relevant for us
 Liquidity ratios measure the company's ability to pay their bills in the short run:
Liquidity or Short-Term Solvency ratios
 Sometimes there exist guidelines such as
 “The ideal benchmark for the current ratio is $2:$1 where there are two dollars of current assets (CA) to cover $1 of
current liabilities (CL). The acceptable benchmark is $1: $1 but a ratio below $1CA:$1CL represents liquidity risk as
there is insufficient current assets to cover $1 of current liabilities.”
 In reality risk depends a lot the specific circumstances:
 Are there any credit lines that have not been draw?
 What is the quality of receivables
 Etc…
Activity / Asset utilization ratios
 Just for completeness, not very relevant for us
 Asset utilization ratios measure the efficiency of asset management: How are assets used to generate revenues?
 Asset Turnover = Sales/Total Assets
 Fixed Asset Turnover = Sales/Net Fixed Assets
 Inventory Turnover = Sales /Inventory
 Sometimes: Cost of Goods Sold /Inventory
 Receivables Turnover = Sales/ Receivables
 Payables Turnover = Annual Purchases/ Payables
Activity / Asset utilization ratios
 Asset utilization ratios are sometimes expressed in “days of sales”, or “days of cost” to calculate the average
collection/payment period
 Average Collection Period = Accounts Receivable /(Annual Sales/365)
 Average Payment Period = Accounts Payable/(Purchases from suppliers /365)
Financial Structure or Capitalisation Ratios
 Information about capital structure can be expressed in different ways:
 Debt Ratio = Debt/ Total Assets
 Equity ratio = Equity/Total Assets
 Debt-Equity Ratio = Leverage = Debt/ Equity
 All of these ratios can be calculated in Market Values or Book Values
 Debt/EBITDA Ratio : Commonly used in Buyouts
 Times Interest Earned Ratio = EBIT/ Interest
 Sometimes more complicated versions such as Fixed Payment Coverage Ratio = EBIT + Lease Payments/ (Interest +
Lease Payments +{(Principal Payments + Preferred Stock Dividends) X [1 / (1 -T)]})
Market Value Ratios
 Enterprise Value = Market Value of Assets = Market Value of Debt + Market Value of Equity - Cash
 D/EV = is the debt ratio at market values
 P/E = Price/Earnings ratio = Stock Price/ Earnings per Share = Market Capitalization/ Earnings
 EBIT Multiplier = Enterprise Value/ EBIT
 EBITDA Multiplier = Enterprise Value/ EBITDA
 Market to Book ratio = Market Value of Equity/ Book Value of Equity
 Tobin’s q = Enterprise Value/ Book Value of Assets
3. Forecasting Financial Statements
Operating / 3 Statements Model
 A operating model helps to
 Evaluate companies
 Anticipate Investment and Financing Policy

 Analyze risk by developing scenarios
The % of Sales Method
 The most basic method of forecasting financial statements
 This method assumes that most items maintain a constant relationship to the level of sales
 However some items always need to be separately estimated based on the previous year’s values:
• PP&E(t) = PP&E(t-1)- D&A(t)+ Capex(t)
• Debt(t)=Debt(t-1)+ New issues (t) - Reimbursements (t)
• Equity(t)= Equity(t-1) + Net income(t)- Dividends(t)
 This is best done on a separate “calculation” sheet.
Steps in building an operating model
1. Obtain historical financials
2. Calculate historical ratios and build assumptions for forecast on separate sheet
3. Project the Income Statement
4. Determine PPE/D&A/Capex, Equity and Debt on separate sheet
5. Project the Balance Sheet
6. Determine operating WC
7. Project the Cash Flow Statement
8. Balance the Balance Sheet
9. Add interest to the Income Statement
10. Check consistency
11. Check basic financial ratios
These are the 11 steps from historical to forecast and once you have foreast you can play with different scenarios.
Some rules for Excel models
 Use a consistent colour scheme
 Blue = inputs (historical, assumptions, drivers)
 Black = calculations
 Green = links to other worksheets
 Use the same columns for the same years across sheets
 Enable iterative calculation with maximum iterations = 100
Example Digisystem Case
 Digisystem SA is a producer of highly specialized cloud services for SMEs. The company has been founded in 2017 with an
equity investment of 200 000 Euros and after some experimentation is now realizing very high growth. The cloud business is
very capital intensive as it relies on powerful servers which age very quickly and have to be exchanged after approximately 4
years. Despite being highly profitable, the company needs more cash in the next years. As the company’s owner, you want to
know if you should continue to expand and how you should finance the future expansion. Draw on the last 4 years of financial
statement provided in the joined Excel file to answer these questions.
Project Income Statement
 Sales using the growth formula
 COGS projected as a % of sales (cost of goods sold)
 SG&A can be considered fixed, but here % of sales
 Link to D&A (and Capex) calculated later in the PP&E sheet
 Non-recurring items cannot be projected: 0
 Link to interest income and expense calculated later in the debt schedule.
 Dividend per share projected using a growth rate or a payout ratio
Project Balance Sheet 1/ Percentage of sales:
 Cash and cash equivalent
 Accounts Receivable
 Other items projected as a % of COGS or SG&A
 Inventories
 Accounts Payable
 Prepaid expenses
 Accrued liabilities
Project Balance Sheet 2/ Separate calculations
 Net PP&E
 here % of sales
 Other possibilities:
• Gross Values constant (no capex)
• Net values constant (only replacement Capex = D&A)

• Predetermined Capex/investment program
 Equity
 Determined in the calculation sheet using past equity and retained earnings
 Debt repayment or issuance
 From the separate debt schedule
 Likely needs to be adjusted to balance the balance sheet
Project Cash Flow Statement
 Operating cash flow =Net income + D&A – increase operating WC +interest
 Investing cash flow = Capex (including change in other LT assets and proceeds from sale of fixed assets)
 Financing cash flow = Dividends +interest+ Change in Debt + Change in Equity
Balance the Balance Sheet: Traditional Approach
 This approach does not need the cash flow statement
 Add a balance check line under the balance sheet before attempting to balance the model
 If Assets> Liabilities, the company will require additional funding
 If Assets<Liabilities, the company generates excess cash
 Include “Excess cash” and “Revolver (short term debt)” accounts in the BS
 Excess cash = MAX (Liabilities- Assets, 0)
 Revolver = MIN(Liabilities- Assets, 0)
 Add new long term financing or increase payout if these accounts become too large.
Traditional Approach: Interest income and interest expense
 Two methods of interest calculation
 Last year’s debt or cash balance * interest rate
 The average of last year’s and this year’s debt or cash balances * interest rate
 Calculated on the debt schedule including Revolver
 Interest income on cash can be included
 Using the average balance makes the model circular
 Does not create a problem if you “enable iterative calculations” in your excel sheet on File-> Options-> Formulas.
Traditional Approach: Consistency Check
 Calculate difference in cash (iucluding excess cash and revolver as negative cash)
 Verify that it is identical to cash flow from the cash flow statement
Balance the Balance Sheet: Modern Approach
 This approach relies on the cash flow statement to balance the balance sheet:
 Add (subtract) the change in cash obtained from the cash flow statement to the firm’s cash position
 If firm’s cash position becomes negative, add short term debt (revolver) to liabilities
 If the model contains no errors it should now verify Assets= Liabilities
Check Financial Ratios and develop Scenarios
 Ratios
 Is leverage reasonable?
 Is liquidity sustainable?
 Scenarios
 What happens if sales growth changes?
 What happens if COGS or SG&A change?
 Alternative financing structures?
2. Present Value
Present value (PV) underlies all value calculations in Finance, but there are many pitfalls. This chapter discusses how to
correctly determine PV with a special focus on different methods to determine discount rates.
 Expected Cash Flows
 Discount Factors
o CAPM
o Fama French
 Theoretical Foundations of NPV
 Exercises
It is used to valuate investments projects.

Risks are in both numerator and denominator. There are some failure risk to integrate in the PV. Changing the Expected Cash Flow.
Sometimes you look at the discount ovvero denominator. The discount rate in the required return cioe r al denominator.
Total risk is unsystematic risk plus systematic risk.
What Is Systematic Risk? Systematic risk refers to the risk inherent to the entire market or market segment. Systematic risk, also known
as undiversifiable risk, volatility risk, or market risk, affects the overall market, not just a particular stock or industry.
The difference between systematic and non systematic risk knows ad specific.
can be called non diversified and the second one diversifiable.
Market risk and idiosyncratic risk.
Requires risk premium no risk premium
Here I want high return cause ridk adverse investors I want to be paid more.
Non correlato con altri rischi
Caluclating Expectations of Cash Flows
 Outcomes:
 Cash Flows CF i , t realize in period t with probability pi ,t

 Option 1: Discount expected flows
 First calculate expected cash flows E(CF ¿¿ t)=∑ p i ,t CF i , t ¿

i
(CF ¿¿ t)
 Then discount expected cash flows PV =∑ E ¿
t ( 1+r )t
 Option 2: Calculate expectation of discounted flows
 Scenarios a), b)…with cash Flows CF a¿ ,t ¿ realize with probability pa ¿ ¿ ( e.g.: a) worst case b) base case c) best
case.
∑ CF a ¿ , t
 Calculate present value for each scenario PV a ¿ ¿= t
¿
t
( 1+r )
 Then calculate overall value as probability weighted average PV = pa ¿ PV ¿a ¿ ¿+ p b ¿ PV ¿b ¿ ¿+ … .
Simple example
 A Solar energy producer will generate free cash to the firm of 10million per year forever if its new plant is approved
 If the plan is not approved the old plant produces 5million per year.
 Statistics show that the probability of the new plan being approved is 70%.
 What is the value of the company? Cost of capital 5%
 Option 1:
Expected cash flow 0,7*10+ 0,3*5=8,5
Value = 8,5/0,05=170 this is the current value
 Option 2:
Success cash flow 10
Value in success scenario = 10/0,05 = 200
Failure cash flow 5
Value in failure scenario = 5/0,05 = 100
Total value= 0,7*200+0,3*100 = 17
Here first discounting then probability waging.
Application: Pricing Pharmaceutical Startups
 Drug Development Phases:
 Phase 1: These trials usually enroll 20 to 100 healthy volunteers or people with the condition being studied, and last
several months. This phase measures safety by testing for any adverse side effects of the treatment, but not
necessarily how effective the drug or device is.
 Phase 2: Around 70% of potential new drugs enter Phase 2, which continues to measure safety, while also looking at
how effective the treatment is. Phase 2 trials recruit up to several hundred patients with the condition to take part.
This phase typically lasts several months to two years.
 Phase 3: Just 33% of drugs make it to Phase 3, which tests the potential treatment in the largest number of people.
This phase measures both safety and effectiveness with many volunteers, sometimes thousands. Phase 3 trials last
from one to four years.
 FDA approval: After Phase 3, a pharmaceutical company may submit a New Drug Application (NDA) or a biologics
license application (BLA) for the treatment to the Food and Drug Administration (FDA). The FDA then reviews results
from all stages of the trial to determine whether it will approve the drug and allow the pharmaceutical company to
begin marketing it to the public.
 Estimated costs and duration
 Phase 1 study US$5 million, 1 year
 Phase 2 US$15 million, 2 years
 Phase 3 US$40.5 million, 4 years
 New Drug Application (NDA) US$3 million, 2 years

(Fictive) Example: Discounting Expected Cash Flows to evaluate Pharma startup
 Current status: Start of Phase 1
 Estimated Nr. pf potential patients: 100 000
 Adoption rate 20%
 Pricing 5k/patient/year
 Patent protection: during 20 years starting now
 Discount Factor 2%
−5 63∗−15 3∗−40 −2
 PV = +0 , +0 , 63∗0 , +0 , 63∗0 , 3*0,58* +0 , 63∗0 ,3 *0,58*0,85*
1 ,02 1, 02
3
1 , 02
7
1, 02
9
( 100
1 ,02
10
+
100
1 , 02
11
+…+
100
1 ,02 )
20 =55
 For a more realistic example check out
 https://www.edisongroup.com/publication/new-efficacy-and-new-indications-from-old-drugs/27844
Application: The Elon Musk/ Twitter takover bid / Merger Arbitrage
 Twitter’s share price was $35, until Musk made a takover offer at $54,20 on April 14th, 2022.
 April 25th: Merger agreement is signed
 Given the stock market decline this is now a very high price and Musk wants to renege.
 August 23th: Whistleblower raises concerns about security, giving Musk an excuse to back out
 What is the probability of the merger going through that is implied by the market price of the stock?
p∗54 , 2+ ( 1− p )∗35=41
p∗( 54 , 2−35 ) =41−35
p ≈ 30 %
41 is the stock price la linea abbastanza dritta dopo il picco verso il basso
Quindi the probability waited average of the 2 scenarios. Is the average of 35 and 54,2
Merged arbitrage is what this is called.
30% is the probability of him buying it.
Sarebbe stato folle comprare a 54, takeover price, una cosa che vale molto meno in quanto lo stock price va a 41 dopo il suo annuncio.
35 is the non-takeover price.
Decrease cashflow if you want to take risk, the numerator.
Is the opportunity cost of capital
100 is what you invest in different stocks in 1925 and 2005 is the return. Small stock are risky and more return.
The standard model to determine Risk Premia : CAPM
 The Capital Asset Pricing Model (CAPM) is the most frequently used model to determine the risk premium on a given
investment.
 Risk premia only depend on systematic risk measured with beta according to the following formula:
This is the formula how the market reacts to risk.
Required if cost, anticipated if market.
Risk free return plus risk premium which is usually SP 500 the blue line in the previous graph.
Beta dello stock i compared to the market è correlation coefficient market and i volatility.
Standard deviation of return, we never look at the price.
The stock can have higher or lower volatily than the market ovvero sigma. We multiplate it with correlation coefficient. If correlation is 1
when a goes up b goes up, but not the same amount per forza. They move in parallel but one can more higher than the other. Perfect
correlation
If is 0 means no connection. A goes up doesn’t tell me anything about b goes up or down. The size of the movement can be very
different.
Perfect co movement they move in parallel, so correlation is 1.
Volatility is average deviation from the average.
Da meta no relationship at all so it is 0

So the entire period we have correlation of 0.5
Beta is utile per capire the aggressive of an investment.
Beta > 1 aggressive investment
B <1 defensive
Can beta be negative? When correlation is negative.
Jhons and johns has low beta, the demand is not market related in Europe for example. No flatuaction of the market. Is very stable
investment. Beta 0.3
Ve = rf (4%) + B (0.3) * 4% (market risk premium)
We can calculate beta also with the regression.
High beta stock is GameStop, cause volatility is high of GameStop even if the correlation is not super high.
Banks as Goldman Sachs beta 1,4.
Un beta superiore a 1.0 indica che il prezzo del titolo è teoricamente più volatile del mercato. Per esempio, se il beta di un titolo è 1.2, si
suppone che sia il 20% più volatile del mercato.
Risk free rate is typically government bonds.
Value = div / 1+r + div/1+r^2 etc…
Dove r is implied market return
Determining beta with a linear regression
 A stock’s beta can be determined with a linear regression of its excess return Rit – RFt against the market’s excess return Rmt –
RFt :
(Rit – RFt) = αi + βi1(Rmt – RFt) + eit
 αi = Jensen’s alpha = Actual rate of return– Expected Rate of Return
 Often used as measure of portfolio manager’s ability
 Attention: Regressing returns Rit instead of excess returns Rit – RFt will yield the same beta but not alpha
 The R squared (R2) of the regression provides an estimate of the proportion of the risk (variance) of a firm that can be
attributed to market risk.
The beta is the slope of the regression. The higher the beta the higher the return.
Alpha is the excess return

The CAPM with Excel
 Using Regession in Data Analysis Tool and data from Yahoo Finance and Fama’s homepage*
 Dependent Variable Y= AMD return – risk free rate
 Independent Variable X= Market – risk free rate
Market Risk Premium/ Historical risk premiums
 The historical premium is the premium that stocks have earned over riskless securities.
 It depends on
 How far back you go in history…
 Whether you use T.bill rates or T.Bond rates
 Whether you use geometric or arithmetic averages.
 The country you look at
 For instance, looking at the US:

Negative beta means negative risk premium. So will move against other stocks in the market. Return lower than a risk free premium.
In general we look at portfolios and not individual stocks.
Here we have the alpha
There are other factors that influence return. Portfolio as functions of other parameters and not only beta. Here you look at market cap.
For the large companies work, they produce return what beta predicts, the others outperform the CAPM.
Smaller companies have higher return than the one justified by the beta.
In undervaluation we have anomalies came out.

High book to market ratio means book value / market value. Is past / future. Is is very high you have invested more than you think you
will have back.
Multifactor Models: Fama/French 3 Factor
Use multiple instead of simple regression:
(Rit – RFt) = αi + βi1(Rmt – RFt) + βi2SMBt + βi3HMLt + eit

where,
 Rmt is the return on a stock market portfolio
 SMB (i.e., “Small Minus Big”) is the return to a portfolio of small capitalization stocks less the return to a portfolio of
large capitalization stocks
 HML (i.e., “High Minus Low”) is the return to a portfolio of stocks with high ratios of book-to-market values (i.e.,
“value” stocks) less the return to a portfolio of low book-to-market value (i.e., “growth”) stocks
Multifactor Models: Fama/French 3 Factor
Long term risk premia associated with factors:
 Similar to the market risk premium in the CAPM these premia can be multiplied with the respective factor betas to generate
an Size and Market/Book adjusted expected return
 Task: Calculate factor loadings (=betas) and expected returns for AMD, Newmont Gold, Apple, TempletonGrowth and
Vanguard Income
More recent research: Skewness & Low risk anomaly
 Harvey and Siddique (2000) Smith (2007)
 Investors like Skewness and Co-skewness
 Small stocks and stocks with high market to book ratio have lower (co) skewness of returns, i.e. more downside risk
 Ang et al (2006, 2009 )
 Low risk anomaly
 ideosyncratic volatility is negatively related to expected returns
 Probably related to « gambling » investors
 Bali et al. (2011)
 Effect disappears if we control for stocks that have made very high returns in previous month
The stock with the highest volatility has the lower return
Summary: How well does the CAPM predict actual stock returns
 CAPM determines the risk premium rational investors should require
 In the long run this risk premiums should show up as an increase in expected returns
 Empirical evidence on this is mixed
 Stocks with high beta do generally have a higher return but the exact relationship depends a lot on the time and
methodology of the study
 There are other factors that do predict stock returns,
• Size
• Book to Market ratio
 Factor models such as the Fama French Models can be used to take these effects into account
 Low risk anomaly: There seems to be a negative risk premium for « gambling stocks »
Using the CAPM in Corporate Finance
 The CAPM is widely used in a corporate finance/M&A despite it’s poor empirical performance
 Simple, intuitive, consistent
 Normative rather than positive
 Gambling preferences not relevant
 Multifactor models are recommended (McKinsey valuation) but rarely used
 Low risk anomaly seems to have implications for capital strucutre theory (Leverge and the beta anomaly, Baker et al. 2019,
See later in class)
Exercise: Valuing Risky Stocks

 The Ectoplasto Drug Company's common stock is considered highly speculative. Security analysts believe that over the next
year four possible outcomes are possible for the company's research program. There is a 60% chance that their new drug will
be successful, in which case the stock will be worth $240 per share. There is a 5% chance that the drug will be a complete
failure, in which case the stock will be worthless. There are two mid-range outcomes: a 15% chance of a good but not
spectacular drug ($180 per share), and a 20% chance of an average selling drug ($75 per share). If the appropriate discount
rate is 25%, how much should you be willing to pay for the stock today? What will be your return if the research program
turns out to be very succesful?
Exercise: Discount Factors using CAPM and Fama French
CAPM
E(R abc) = -0,52% + 1.5 *4.7% = 7.57%
FAMA FRENCH
E(R abc) = -0.52% + 1.5 * 5.4% + 0.8 * 2.8% + - 0.2 *5% = 8,82%
3. Valuation of Financial Assets
In this chapter we quickly go over the basic applications of the present value principle and explain how to value bonds,
stocks, investment projects and companies.
 Bond Valuation
 Stock Valuation
 Valuation of Investment projects
 Fundamentals of Company valuation

U S corporate bonds have
8 5/8 = 8,625%
8,625 * 1000/ 2= 43,12 euro
Example: Three approaches to value a bond
 You want to buy bonds with a rating of BBB. The bonds have the following characteristics
o face value 1000 euros

o Annual coupons of 15%
o maturity 3 years
 What price are you willing to pay?
 Possible valuation approaches
1. Theoretically correct: Discount expected cash flows with CAPM generated discount factor
2. Different discount factor: Discount expected cash flows at average historic return on similar bonds
3. Used in practice for low risk bonds: Discount promised cash flows at yield of comparable bonds
1. Approach: Valuing a risky bond using expected flows and CAPM
 You think a rating of BBB implies
 a default probability of 1%.
 only the final payout is risky
 the loss given default is 100%
 the bond’s beta is β=0.1,
 the market risk premium is 5%

 the risk free rate is 5%
 The CAPM formula yields a required return of 5%+0,1*5% = 5,5%
 We get for the value of the bond

Problem with this approach:
 Bond risk is very asymmetric, but this asymmetry is not captured in the CAPM
 Future default probabilities are difficult to estimate
 In practice rarely used because risk premia for bonds are not well predicted by CAPM
Spread, risk premium and expected loss rate
 There are 3 diffferent “rate differences”:

 Spread: Promised – risk free
 Risk premium: Expected – risk free
 Expected loss rate: Promised - expected
2. Approach: Discounting expected flows at expected return of similar bonds
 Same assumptions as before
 Historically the risk premium, (i.e. the average outperformance compared to the risk free rate) on a portfolio of bonds with
BBB rating has been 1,5 %.
 Current risk free rates are 5%, hence we should earn 6.5% on average
 We get for the value of the bond
150 150 1150∗0 , 99

+ + =1215
1,065 ( 1,065 )2 ( 1,065 )3
 This approach still requires an estimate of expected cash flows.
 In practice only applied in high-risk companies
3. Approach: Standard bond valuation
 Normally bonds are approximately valued by discounting promised flows (not adjusted for default probabilities) at “promised
rates”.
 These promised rates are calculated as risk-free (or benchmark) rate + spread
 Example:
 Risk free rates are 5%
 Comparable BBB bonds have an average spread of 170 basis point i.e. a yield of 6,70%
 Discounting the promised flows at this rate we get

Price Quotes for Bonds
 The full price (dirty price, invoice price): The euro amount the buyer pays (seller receives) when he purchases (sells) a bond
 The quoted price (clean price): Normally bond prices are given as a percentage of face value and as “clean prices” excluding
accrued interest
WSJ on 09/04/2019: Credit Markets: Deere Bonds Sell At Record Low Yields
Deere & Co. sold 30-year bonds at a record low yield for U.S. corporate debt of that maturity on Tuesday, seizing on tumbling U.S.
Treasury yields to lock in favorable interest rates.
On a busy day for corporate bond issuance, Deere sold 30-year bonds at an initial yield of 2.877%. That broke the previous record of
3.197% that Walt Disney Co. had set when it sold 30-year bonds in July 2016, according to LCD, a unit of S&P Global Market
Intelligence. Deere's bond yield was also a shade lower than the yield on a new 30-year bond that Disney sold Tuesday -- although
Disney's bond distinguished itself with a slightly lower coupon rate, having priced at just under 97 cents on the dollar.
Overall, investors expected more than 20 companies to sell bonds Tuesday, as businesses rushed to lock in low rates following a
month long decline in government bond yields. Those continued to decline after weak manufacturing data added to concerns that a
slowdown in global growth is catching up to the U.S.
Helping drag down corporate bond yields, the yield on the benchmark 30-year Treasury settled Tuesday at 1.954%, compared with
1.968% on Friday. That was just above its record low of 1.941% set last week.
---- By Sam Goldfarb
Applying the present value principle to stock valuation

 Problem:
 Payoff from stock is highly uncertain

 Stocks do not have a predetermined lifetime
 Nevertheless a stock price should correspond to the present value of dividends received by investors
The dividend should be imagined as expected return. Constant dividend grows g% increase or decrease per year.
D1/ r-g
 How should we calculate this present value in concrete cases?
Gordon growth model
 Assumption
 Dividends evolve with a contant growth rate of g% per year.
 In this case we can apply the formula for growing perpetuities and obtain the Gordon Growth model:
Suppose we have different stock and dividends. I want to calculate the dividend yield for every stock the expected capital
gains.
FCTE
Examples: Valuing Simple Cash Flow Streams using the Gordon Model
 Income stock:
Div1 = 10, r=10%, g=0%
 Growth stock
Div1 = 10, r=10%, g=5%
 Declining stock
Div1 = 10, r=10%, g=-5%
 Extreme growth
No dividend for the next 20 years
Then constant dividend of 10
 Calculate for every stock 1) the price 2) the dividend yield 3) the expected capital gains
Free Cash to Equity (FTE) vs. Dividends
 Free Cash to Equity represents “potential payout to shareholders” i.e. cash that can be paid out as dividends/buybacks or kept
on the balance sheet as excess cash.
 The present value of FTE must be the same as the present value of dividends.
 Simplified Calculation:
EBIT
- Interest
= taxable income
- taxes paid
= Net Income
+ Depreciation and Amortization
- Increase in Working Capital
- Capital expenditures
+ Change in Debt
= FTE
The sustainable growth formula
 No company has permanent perpetual growth

 Estimating the permanent growth rate g is therefore always an approximation
 Practitioners sometimes use the « sustainable growth » formula
g=b × ROE
 Here b is the « reinvestment rate » or plowback, i.e. the fraction of profits reinvested in the company.
 The formula relies on very restrictive assumptions but can be used as a cross-check for growth rates
P/E Ratios: a common but very imprecise Valuation Tool
 The Price / Earning ratio tells us the value of one dollar in the company’s earnings
 The inverse of the P/E ratio is called the earnings yield
 P/E ratios can be calculated with trailing (last) twelve month (TTM or LTM) or forward earnings
 Unfortunately the P/E ratio varies widely over time and across companies and countries
 Increases with growth
 Decreases with risk
PE ratios and Gordon Growth model
 Using the Gordon Growth model and a earnings plowback of b:
 Hence the Price Earnings Ratio (PE) should depend on
 Dividend growth
 Discount rates ( and therefore risk)
 The payout ratio (attention: payout ratio will influence growth)

Valuing investment projects
 The last of our 3 applications of NPV
 Procedure:
 Establish accounting forecasts
 Transform these forecasts into Free Cash Flows to the Firm:
 Eliminate accrual accounting
 Identify project specific flows
 Calculate Net Present Value (NPV) of the Project
 Decide to invest or not!
Free Cash to the Firm (FCTF)
 Definition: Free Cash Flow to the Firm is the cash flow of the project/ firm, calculated as if it was financed entirely by equity.
 Simplified calculation:
EBIT
- taxes on EBIT
= NOPLAT
= FCTF
Example: Evaluate an investment project
A tannery wants to invest in a new machine which will tan leather hides during 3 years.
 Number of hides/year 10000
 Sales price/unit € 400
 Unit costs € 200.
 Fixed costs € 0,5M par an
 Investment € 1,5M
 The machine has no resale value
 Depreciation over 3 years.
 Working capital: 50 % of sales

 Corporate taxes: 50%
 Debt/(Debt+Equity): 20%
 Stock beta: 1,5
 Risk free return 3%
 Market risk premium 5%
 Interest rate 3%
D/D+E * rd (1-t)
20% x 3% x (1+0.5) + 0.8% x (1+0.5)
Wacc 8.7%
Fundamentals of Company Valuation
 In finance we value companies as investments
 Principle: Determine price which gives the investor an appropriate return by discounting future cash flows at this return
 Note:
 There are more traditional valuation approaches that do not use this principle (book value based, multiple
approach)
 Some buyers may derive non monetary benefits – impossible to value.
Value and Price of a Company’s Assets
 Companies can be valued by evaluating the assets:
 Buying a company’s assets is an investment project with NPV of
 The highest price the acquirer should pay (i.e. the value of the target’s assets) is therefore
Valuing a company by valuing its liabilities
 Companies can also be evaluated by valuing their liabilities:
 Value of Equity
 Discount future Free Cash to Equity (dividends and changes of equity level) at cost of equity
 Value of Debt
 Discount Cash to Debt (interest rates and changes of debt level) at cost of debt
 Enterprise value should be the sum of the two
Valuing a company by valuing its assets
 Combining the two valuation approaches we obtain
Free Cash to the Firm (FCTF)/ Cash to Debt/ Cash to Equity
 Cash to Equity: Cash that can be paid out to shareholders
 Cash to Debt: Cash that is paid out to creditors (Interest + Change in debt level)
 Without corporate taxes:
Free Cash to the Firm = Cash to Debt + Cash to Equity
 With corporate taxes:
Free Cash to the Firm + tax shields of debt = Cash to Debt + Cash to Equity
The Traditional Accounting Balance Sheet

 Backwards looking: Where did the cash come from (liabilities) and where did it go (assets)?
The Financial View of the Firm
 Forward looking: Where will the cash come from (assets) and where will it go (liabilities)?
 Note : Both views are present in modern accounting (IFRS)
Summary
 Value in Finance is Present Value
 Risky Cash Flows should be evaluated by
 Calcualting expectations
 Discounting with a discout rate including a risk premium
 The risk premium is normally determined with the CAPM
 The P/E ratio of a stock depends on growth(+) and risk (-)
 Bonds are usually discounted at promised rates determined as risk free rate + spread
 Companies can be valued by valuing their liabilities as well as by directly valuing their assets
Exercises
 Apparently Bond C has a higher yield than the other bonds. Does this mean that you should invest in C?
 What will be the (dirty) price of B six months later if the yield didn’t change? What will be the quoted (clean) price ?
Exercise: Valuing Risky Bonds
 The bonds of Astrafarb (8% coupon, remaining maturity 1 year) are currently available for The market value of Astrofarbs
bonds is 97% of face value,
 Determine the bond’s yield to maturity.
 The yield on 1 year treasury bonds is 5%, what is the bond’s spread?
 You believe that the probability of default is 5% and that in case of default creditors will receive nothing. What
return do you expect on your investment?
 Given your risk aversion, if you do not expect to earn a risk premium of at least 80pb you prefer to invest in treasury
bonds. Should you buy the bond?
 What is the highest return that you can make on this investment if you buy it at 97% of face value?
Exercise: Stock Valuation with Gordon Shapiro
 Convex, Inc., has announced that it will not pay dividends for another 10 years, but it is expected to pay a $2 annual dividend
on its common stock from year 11 on. The dividend is expected to increase at a constant 8% per year indefinitely.
 If the required rate of return on Convex's stock is 16%, what is its current value?
 What would you pay for the common stock if you expect the first dividend to be delayed for another 5 years?
 What would you pay for the common stock if you think that dividends will start in 11 years but not grow but
decrease at rate of 4% per year.
Exercise: Investment Projects
 Your company is thinking about the implementation of a new computer system which would substantially reduce working
capital by improving inventory turnover and receivables collection.
 The computer system costs $100k accounted for as operating costs and would immediately and perpetually reduce working
capital by $200k.
 What are the Free Cash Flows to the Firm of this investment project?
 Is the project profitable?
Exercise: Investment Projects
 United Pigpen is considering a proposal to manufacture high-protein hog-feed. The project would make use of an existing
warehouse, which is currently rented out at an annual rental charge of $100,000. In addition to using the warehouse the
proposal envisages an investment in plant and equipment of $1.2 million. This could be depreciated for tax purposes straight-
line over 10 years. However, Pigpen expects to terminate the project at the end of 8 years and to resell the plant and
equipment in year 8 for $400,000. Finally, the project requires an initial investment in working capital of $350,000. Year sales
of hog feed are expected to be a constant $4.2million per year. Manufacturing costs are expected to be 90% of sales, and
profits are subject to tax at 35%. The cost of capital is 12%. What is the NPV of Pigpen’s project?
Exercise: Valuing a company by valuing its assets and liabilities
 A company produces regular free cash flows to the firm (FCTF) of 10 without growth. The company’s stock has a beta of 1,5.
The risk free rate is 2.5% and the market risk premium is 5%. The company is financed with a constant debt level of 50 on
which it pays 2.5% interest. The company pays no taxes.
 Determine cash to equity and cash to debt
 What is the value of the company’s equity
 What is the company’s WACC
 Please value the company’s assets by discounting FCTF at WACC.
Exercise: Cash Flows and Company Valuation with risky debt
 A company produces regular free cash flows to the firm (FCTF) of 20 without growth. The company’s stock has a beta of 1,5.
The risk free rate is 3% and the market risk premium is 6%. The company is financed with a constant debt level of 100 on
which it pays 5% interest. The company pays no taxes.
 Determine cash to equity and cash to debt
Exercice: Cost of Capital with Risky Debt
 Depending on the signature of a contract, a company will produce perpetual free cash flows to the firm of 21.05 or 0 without
growth. The probability of the contract signature is 95%. Cost of equity is 12%. The company is financed with a constant debt
level of 100 on which it pays 5,26% interest. The company pays no taxes.
 Determine expected cash to equity and cash to debt
Exercise: Company Valuation and Equity Issues
 The startup company “fairtrade” has been founded with an initial equity investment of 100 000 Euros. Currently it produces a
perpetual constant free cash flow of 20 000 Euros per year. An additional investment of 100 000 Euros could generate
supplementary perpetual cash flow of 30 000 Euros. The cost of capital is 10%.
 What is the value of the company?
 Currently the company has 1000 shares outstanding. How many shares at which prices would the company have to
issue to finance the new investment?
 What is the NPV of buying a new share ? What is the annual return? Does this seem correct?
 Assume the company sells shares at book values to finance the new shareholders. How much did the old
shareholders lose?
Exercise: Company Valuation and Equity Issues

 Free Cash Flows include future Capex as well as the future benefits of future Capex.
 Hence in this case Capex of -100K and then perpetual cash flows of 50
 The present value of these cash flows is 400K
 This implies a value of shares of 400 Euros, hence 100K/400 =250 shares need to be issued to finance the 100K.
 This in turn means that the investor holds 25/125=20% of the shares after the capital increase, receiving the rights to 10K
annual profits (dividends).
 This provides him with excatly the return of 10% that is appropriate
Exercise: Diversified Companies
 Simeons AG has two divisions: One procudes medical technology, the other consumer electronics. The medical technology
produces a cash flow of $20m the consumer electronics pruduce annual Free cash of $40m. Both cash flows are supposed to
grow at 5%. The company is 100% equity fianced. Risk-free rates are at 3% and the market risk premium at 6%
 The economic beta of consumer electronics is 2, the beta of medical technology is 1
 What is the value of the two divisions?
 What is the beta of Simenon’s stock?
 What is the cost of capital of Simenon?
 A new investment in medical technology will provide a 12% IRR. Should it be accepted?
4. Modigliani-Miller
Before we can understand how Finance can create value we need to understand when Finance does not create value. This
is the objective of the M-M Theorems. We will use the M-M Theorems to illustrate how companies can use capital
structure and mergers to manipulate performance indicators.
 Enterprise Value and WACC
 MM Theorems without taxes
 MM on Dividends
Capital Structure, Cost of Capital and Firm Value
 The value of the Firm can be calculated by discounting FCTF at WACC
 By definition FCTF does not change with leverage
 Therefore maximizing firm value is equivalent to minimizing WACC
 What is the effect of leverage on the cost of capital?
 50 years after the seminal Modigliani Miller paper on capital structure and firm value there is still considerable
confusion among practitioners about the effect of leverage on firm value!
WACC and leverage
 The cost of debt is lower than the cost of equity (why?).
 However: Increasing the proportion of debt finance will not necessarily decrease the weighted average cost of capital
 Leverage will increase the risk for shareholders and therefore also their required return!
Illustration: Risk and Leverage
 Leverage increases stock volatility:
 Example: Identical companies with and without leverage
 Now an economic shock decreases asset value by 10%
 What percentage of their investment do shareholders lose
 if the company has no debt?
 If the company is levered?
 Note: This increase in risk has nothing to do with bankruptcy risk!
Leverage and beta
Leverage, Firm Value and Cost of Capital
 The discount rate for very risky earnings must be higher than the discount rate for less risky earnings!
 What does this imply for the cost of capital?
 It could decrease with leverage because this increase in risk is not very high
 It could increase because the increase in risk for shareholders outweighs the increased usage of debt.
 Answer: Modigliani Miller Theorems
The Modigliani-Miller Theorem: Assumptions
 Free Cash to the Firm is not affected by financial structure.

 Financial structure does not affect investment policy of the firm, managerial effort, corporate governance,
compensation of management, bargaining power of firm, competitive dynamics between firms.
 No transactions costs.
 No bankruptcy costs (The possibility of bankruptcy is not excluded)
 No costs of financial distress.
 No taxes.
 Symmetric information.
 Every agent has the same information. Nobody knows more than anybody else.
 No arbitrage.
Questions asked by MM
 Is the value of the levered firm EVL different from the value of the unlevered firm EVU ?
 How does the required rate of equity return rEL change as leverage D / EL changes?
 What happens to the firm’s WACC under a leverage change?
 How do the answers change under corporate taxation? (next session)
The Modigliani Miller Theorems (without corporate taxes)
 Modigliani-Miller Prop. I: The value of a firm does not change with its capital structure
 Modigliani-Miller Prop. II: Cost of Equity increases with leverage as

 Modigliani-Miller on Cost of Capital: “Cost of capital does not change with leverage”
Proof Nr. 1: Modigliani-Miller Proposition I
Underlying idea : Buying debt and equity of the leveraged company results in receiving the same cash flows as the unleveraged
company.
Hence, the value of both must be the same
In detail: Two investments with the same payoffs:
1. Buy a proportion k of equity in firm U
2. Buy a proportion k of equity and debt (perpetual) of firm L
As the payoffs are identical, the costs (i.e. the value) must be identical too:
Proof Nr. 2: Modigliani-Miller on Cost of Capital
 If the company’s value can be calculated as present value of the Free Cash flows to the firm discounted at WACC
 FCTF do not change with capital structure
 Firm value does not change with capital structure
 Therefore WACC must also remain constant
Proof Nr 3.: Proposition II

Modigliani-Miller Theorems: the “Pizza” Intuition
 Company value is determined by what the company owns not how it is financed.
 Fundamentally the cash flows produced by a company‘s assets determine its value
 Capital structure determines how these cash flows are shared among different types of investors but does not influence the
total value of these cash flows.
 Standard capital structure creates two types of flows:
 a risky, less valuable one: Dividends (or potential dividends i.e. Cash to Equity).
 a less risky, more valuable one: interest and principal reimbursement (Cash to Debt).
 However risk and cash are divided up, the value remains the same
Modigliani-Miller Theorems: “Home made leverage” Intuition
 Idea: In our idealized world leverage on the company’s balance sheet produces exactly the same effects than leverage on the
level of an investor’s portfolio:
 An investor can therefore lever the cash flows of an unlevered company himself, buy levering up his portfolio, or
 unlever the cash flows of a levered company, but investing part of his wealth in debt.
 Conclusion: If the investor can do it himself, why should levering or unlevering add value for him?
Consequences of the Modigliani-Miller (1958) Theorems on Financing Decisions
Only operational decisions create value.
Financing decision are irrelevant.
A company can chose any capital strucutre, it doesn ’t matter
- That would be a pity for corporate finance researchers
Problem:
- We know that companies in the same industries tend to have similar capital structures
- Therefore there seems to be something like a preferred capital structures
- We know also that sometimes capital structure change can create wealth (LBO)
Consequences of the Modigliani-Miller (1958) Theorems on Investment Decisions
 An investment project is profitable or not, independently of the way it has been financed.
 Investment decisions can therefore be separated from financing decisions.
 We have already used this result when discounting an investment project’s cash flows at the cost of capital.
So finally what determines capital structure?
We will reason backwards:
If capital structure is important in real life situation this is because some of the assumption necessary for the Modigliani Miller
Theorems do not hold true.
For example:
- We know that companies pay taxes

- That capital markets are imperfect
- That capital structure can influence operational decisions and therefore a company ’s assets.
Modigliani Miller and the CAPM
 Modigliani Miller is more general than the CAPM, it holds even if the CAPM doesn ’t hold.
 In the case the CAPM holds we can calculate the beta of a portfolio containing all of the firm’s equity and debt as:
 This must be equal to the beta of the unlevered company’s equity
 This equation allows us to adjust betas for leverage (see next handout for exercises)
 « unlevered beta » reflects the economic risk of the company’s free cash flows to the firm
 « levered beta » or stock beta reflects the economic as well as the financial risk affecting the cash flows to equity
Some Applications
 Dilutive and accretive effects of capital structure changes
 Valuing Companies using Multiples
 Modigliani Miller and CAPM
 The Economics of Mergers
Dilutive and accretive effects of capital structure changes
 Earnings by share (EPS) changes are a widely used performance metric
 Capital Structure changes will affect EPS.
 Increasing Leverage normally increases EPS
 Increasing Equity finance will normally decrease EPS
 Exception: High growth companies
 In a Modigliani Miller world these EPS changes will not affect the stockholders’ wealth.
 A PE change will compensate EPS changes.
 This principle can be used to easily anticipate the consequences of leverage changes on EPS and PE ratios.
Example: Capital structure and EPS changes
 Parapluie SA is fully equity financed with 100 shares outstanding. There are no taxes. EBIT=FCTF= € 10
 Market value of equity = € 100.
 Share price = € 1
 EPS = € 10/100= € 0,1

 PER= €100/ €10=10x
 Now the company issues € 40 in debt at an interest rate of 5%
 This money is used to buy back and cancel 40 shares
 What is the company’s EPS after the operation?
 What is the company’s stock price after the operation?
 Net income after operation: € 10-0,05* € 40= € 8
 Number of shares still outstanding: 60
 Hence new EPS: € 8/60= € 0,13
 The operation is accretive, EPS has increased by 33%!
 Did the operation increase the stock price?
 Wrong reasoning:
 Problem with this reasoning: Leverage increased risk and growth of earnings and therefore PER will change!
 Applying MM reasoning:
 EV is 100 before and after the operation
 Hence the value of the levered firm’s equity is €100- €40= €60
 This implies a PER of €60/ 8€= 7,5 instead of 10 as before!
 With this PER we obviosuly get
 The increase in leverage has not affected stock prices. Higher EPS (=dividends) have been exactly compensated by
higher risk.
Comment: EPS adjustments after dividend payouts
 If we replace the share buyback with a dividend payout, we will get EPS dilution. However normally EPS should be adjusted for
dividend payouts to reflect the earnings received by a shareholder who remains “fully invested”.
 After ajustement, we will get the same EPS increase
 In previous example:
 Dividend of € 40 or € 0,4/share
 New stock price = € 0,6
 Invest dividends back into shares: 0,4 € buys 2/3=0,666 of one share.
 Total shares owned by fully invested shareholder: 1,666
 Earnings on these shares: 1,666*0,08=0,13 as before!

Leverage can also be dilutive
 Normally higher leverage implies lower PERs.
 However in companies with high growth potential, higher leverage increases PERs.
 Precise condition:
PER > 1/after tax interest rate
⇔ after tax interest rate> earnings yield.
 Example: Umbrella Inc, is fully equity financed with 100 shares outstanding. There are no taxes. EBIT=FCTF= € 4
 Market value of equity = € 100.
 Share price = € 1
 EPS = € 4/100= € 0,04
 PER= €100/ €4=25x
 Now the company issues € 40 in debt at an interest rate of 5%
Example: Dilutive leverage
 Net income after operation: € 4-0,05* € 40= € 2
 Number of shares still outstanding: 60
 Hence new EPS: € 2/60= € 0,03
 The operation is dilutive, EPS has decreased by 66%!
 Again this does not imply a decrease in the stock price
Example: Dilutive leverage
 Applying MM reasoning:
 EV is 100 before and after the operation
 Hence the value of the levered firm’s equity is €100- €40= €60
 This implies a PER of €60/ 2€= 30 instead of 10 as before!
 With this PER we obviosuly get
 The increase in leverage has not affected stock prices. Lower EPS (=dividends) have been exactly compensated by higher
growth ( and higher risk).
Dilutive leverage: Intuition
 If “after tax interest rate> earnings yield”, company must be growing
 For growing companies, leverage can increase the growth rate of net (after interest) income.
 Example: Unlevered firm growth at 20%, i.e. EBIT = Net Income = 10, 12 ,14,4….
 If we subtract 2 in interest every year, we get Net Income = 8,10, 12,4. This is a growth rate of 10/8-1= 25% in the first year
and 12,4/10-1=24% > 20% in the second
 Intuition: Subtracting a fixed number from a growing series increases the growth rates
Summary: Leverage and EPS
 Leverage changes always impact EPS
 Low growth firm with PER < 1/after tax interest rate
 Leverage is accretive
 High growth firm with PER > 1/after tax interest rate
 Leverage is dilutive
 In the MM world these changes have no impact on the stock price as they are compensated by a change in risk and growth of
the levered cash flow
 Conclusion: EPS may be useful to assess the effect of operating reforms but not to assess financial transactions.
Supplement: Leverage and ROE
 ROE is a frequently used performance indicator but not the real return to shareholders.
 In basic Financial Analysis classes you learn about the « leverage effect », i.e. that an increase in leverage increases ROE if
 We now know that this increase is basically « window dressing » i.e., not related to shareholder value because it is
accompanied by an equivalent increase in risk/gowth of earnings.
Mergers/ Demergers and EPS: Terminology
 Merger: general term, two separate corporations combine to form a single corporation.
 Consolidation: Both firms cease to exist and a new corporation is established
 Example: Two utilities, Peco Energy Co. and Unicom combine to form Exelon (nation’s fourth largest power
generator). Each Peco share could be exchanged for one share of Exelon common stock or $45. Unicom share could
be exchanged for 0.95 share of Exelon or $42.75.
 Acquisition: Shareholders of the acquired firm receive cash or an equity stake in the new entity.
 Example: HP-Compaq merger - - Compaq shareholders received 0.6325 shares of HP common stock for each
Compaq share OR equal cash value.
Terminology for De-Mergers
 Divestments: General Term
 Sell-Offs:
 Direct sale of a subsidiary or part of the company to another company
 Spin - Offs
 A subsidiary is floated on the stock market and the subsidiary’s shares are distributed to the original shareholders
 Equity Carve-Outs
 Similar to Spin-Offs, but a majority of the shares will be kept by the parent company
 Bust -up
 Complete piecemeal sale of a conglomerate company
Basic economic effects of mergers:
 Risk of the merged entity?
 Growth of the merged entity?
 Cost of capital of the merged firm ?
 Value of the merged firm?
 Wealth generated during the merger?
 Distribution of the wealth generated?
 Evolution of accounting ratios such as: EPS, ROE, P/E
 Impact of payment methods:
 Shares
 Cash
Example: Merger without synergies
 We live in a Modigliani Miller World without taxes
 Company A has no debt, a perpetual stable cash flow of 10m and a cost of capital of 5%.
 Company B has no debt, perpetual cash flows of 7,5m and a cost of capital of 15%.
 Values of Company A and B?
 Cash flows, cost of capital and company value if A and B merge (no synergies)?
 Specific risk of A, B and merged company AB?
 P/E ratio of A, B and AB?
Exemple (continued)
 Assume that every company has 10m shares
 Share price and EPS of A and B
 A buys B for $50m with a share issue at market price
 How many shares issued at which price?
 EPS dilution or accretive?
 Stock Price reaction of A?
 Same question if A buys B at $60m
Solutions:
PVA=$200m, PVB=$50m, PVAB=$250m,
P/EA=20, P/EB=6.6, P/EAB=14.2,
CashAB=17.5m, WACCAB=7%,
Shareprice A=20, B=5. EPSA=1, EPSB=7.5,

Acquisition at 50:
A issues 50/200*10=2.5 shares, EPS AB=17.5/12.5=1.4, -> accretive but neutral
Acquisition at 60:
A issues 60/200*10=30 shares, EPS AB=17.5/13=1.35 accretive but stock price reaction: 5% decrease!
First conclusions: Mergers in the MM world
 We have demonstrated that in a perfect MM world:
 There are no « financial synergies »
 Cost of capital will be weighted average cost of previous costs of capital.
 EPS change has no close relationship with value change
 An equity financed acquisition of a company with expensive earnings (higher PE than the acquirer) will always mechanically
decrease EPS and vice versa.
 This EPS change is not related to shareholder value changes!
Risk Fallacy Nr. 1: Mergers diversify risk
 Management will often argue that a merger with a non-related business is necessary to diversify a company’s risk. This should
decrease the cmap,y’s cost if fiunance and create shareholder value
 Wrong:
 The merger only reduces divesifiable risk
 Diversifyable risk is not realted to the cost of finance
Risk Fallacy Nr. 2: Mergers reduce interest rates on loans
 Merged companies will often have a lower risk and therefore be able to obtain lower interest rates on debt
 Strictly speaking this should not influence the cost of debt of the company, i.e. the risk adjusted return the company pays on
its borrowings.
 Possible argument: Larger companies have a better bargaining power and can therefore get a better deal from the bank
Example: Mergers and Interest rates on loans
 Suppose companies A and B have asset value of 300 each and a 5% default risk with 100% loss given default
 This risk will never realize at the same time for both companies.
 Both companies have 100 in debt with 10% interest rate that needs to be paid back at the end of the year.
 Before merger:
 Value of debt =100
 Expected return (=cost of) on debt = 110*0.95/100-1=4.5%
 After merger debt is risk free, if interest rate remains
 Value of debt at least =110/1.045≈105
 Value of Equity for A+B after merger: 600-2x105=390
 Merger destroys 10 in shareholder value
Motivation for Mergers

 A Merger/ Company sale should create value for shareholders ( of the acquirer at least)
 Value creation with a Merger:
 and inversely for value generation with a De-Merger
 In general:
 Good Reasons for value creation:
 Increase in Cash Flows
 Bad arguments for value creation:
 Decrease in Discount Factors
Allocating the value created
 If there is value creation the value has to be divided between shareholders of target and the acquirer.
 Range of feasible prices for target B:
 Price at low range: Acquirer will receive the value
 Price at high range: Target shareholders will receive the value.
 Distribution of this surplus will be determined by the respective bargaining power of acquirer and target.
Example: Merger Decision with synergies
 Example
PVA=$200m, PVB=$50m
Merging A and B allows cost savings with a PV of $25m
So Gain = PVAB– (PVA+PVB) = ∆ PVAB = $25m
 Suppose B is bought for cash for $65m
 a $15m (30%) premium, not unusual
 NPV to A: Gain – Cost = $50m+$25m-$65m=$10m
 Prediction: Upon announcement of merger, B’s market capitalization will rise to $65m, A’s will rise by $10m
Estimating merger costs for stock deal
 When merger is financed by giving shares in the acquirer (normally issued after the merger announcement) to the target
shareholders, the cost calculation is different
 Cost depends on value of shares in new company received by shareholders of selling company
 If sellers receive N shares, each worth PAB , then:
 Cost = N * PAB
 … to illustrate, return to previous example …

Merger Decision
 Example (continued)
 Suppose A has 1m shares outstanding
 Suppose B is bought for .325m shares (not cash)
 Cost to A is not .325*200 = 65 since A’s share price will go up at the merger announcement
 Need to calculate post-deal share price of A
 New firm will have 1.325m shares outstdg., will be worth $275m
 So new share price is 275/1.325=207.55
 Cost = .325*207.55 = $67.45m
 NPV to A = $75 - $67.45 = $7.55m
 When will acquirers pay with shares and when in cash?
Further conclusions
 In a perfect world:
 Wealth creation has to be allocated to acquirer and target shareholders.
 Shares are in general considered less valuable but in fact more expensive if the deal is really value increasing!
 What about the real world?
Sensible Reasons for Mergers
 Economies of Scale
 A larger firm may be able to reduce its per-unit cost by using excess capacity or spreading fixed costs across more
units
 Economies of Scope
 Producing related products in one company may be cheaper than producing them separately
 Economies of Vertical Integration
 Merge with supplier (integrate “backward”) or customer (integrate “forward”)
 Control over suppliers may reduce costs
 Or control over marketing channel may reduce costs
Sensible Reasons for Mergers
 Eliminate Inefficiencies in the Target
 Target may have unexploited investment opportunities, or ways to cut costs or increase earnings
 Replace firm with “better management”
 Many “hostile” deals fall in this category
 Unused tax shields
 Firm may have potential tax shields but not have profits to take advantage of them
 After Penn Central bankruptcy/reorganization, it had $billions of unused tax-loss carryforwards

 It then bought several mature, taxpaying companies so these shields could be used
 Exit of initial owner
 Owner manager of family want to diversify their wealth because of personal risk aversion!
Dubious Arguments for Mergers
 To Use Surplus Cash
 If your firm is in a mature industry with no positive NPV projects left, cash should be handed back to shareholders.
 Diversification of acquirer
 Investors should not pay a premium for diversification if they can do it themselves!
 In fact normally diversified firms sell at a discount
 Makes sense only to the extent that reduces costs of financial distress
 Or if the target’ owner is undiversified
 Increasing EPS
 Some mergers undertaken simply to raise EPS
 This can be easily obtained by structuring the deal appropriately but does not mean that shareholder value is
increased
Dubious Arguments for Mergers
 Lower (promised) rates on debt
 Merged firm can borrow at lower interest rates
 This happens because when A and B are separate, they don’t guarantee each other’s debt
 After the merger, each one does guarantee the other’s debt; if one part of business fails, creditors can still get
money from the other part
 but this is not a net gain
 Now, A and B’s shareholders have to guarantee each other’s debt
 This loss to shareholders cancels the gain from the safer debt
 Possible argument: Bargaining power of merged company is larger and therefore bank margins lower!
Likely but bad motivations
 Managerial Self Interest
 Hubris /empire building of acquirer
 Risk diversification of management
 Wealth extraction through insider trading, success fees, golden parachutes, higher salaries
 Reduction of competition
 Good for shareholders but bad for the economy
Empirical evidence on value creation in mergers
 Accounting based performance evaluation:

 Only about 40% of the mergers seem to improve combined profits or cash flows
 Some evidence that persistent acquirers perform better
 Some evidence that acquirers are more dynamic
 Management’s evaluation
 Executives regard more than 50% of mergers as failure, mostly because of cultural differences and insufficient post
acquisition planning.
Empirical evidence on mergers and stock prices
 Wealth Creation for the shareholders:
 Target shareholders do very well
 Average return for target’s shareholders: between 20 and 30% around announcement date
 Acquiring shareholders slightly negative or zero over announcement period
 Average return for bidder’s shareholders: between -6 and 0%
 Combined effect is slightly positive
 Taking longer term view, acquiring shareholders do badly and overall mergers result in negative gains
Performance impact of announcements depends crucially on certain factors
 Method of payment
 cash has positive impact, equity has negative impact
 Horizontal or conglomerate
 Horizontal deals do better
 Time period
 Deals during boom periods underperform

 Organisational form of target
 Acquisitions of private targets do not underperform
 Hostile or friendly
 Hostile deals do better
Interpretation of impact evidence
 Consistent with managerial motives
 Only weakly consistent with efficiency motives
 Controversy:
 Initial share price reaction is accurate and low long run returns reflect other factors
 Initial share price reaction is wrong because stock market overvalues takeovers during the announcement period
and then reverts its value over the long run
Exercises
Exercice: Leverage and cost of capital
 We are in a perfect Modigliani Miller World without taxation. Company A has no debt, perpetual constant cash flows of $20m
and a cost of capital = cost of equity of 10%. Company A thinks that its capital structure is sub-optimal and wants to attain a
debt/equity ratio of 50% without changing the composition of its assets. The company can take on debt at 5%.
 What is the company’s value?
 How much debt does the company need?
 What should be the cost of equity of the levered company.
 Could you discount the levered company’s cash to equity at the cost of equity
 What is the levered company’s WACC?
Exercice: Leverage, cost of capital and beta
 We consider the same company A as in the previous exercice. Company A’s shares have a beta of 1. The risk free rate and the
market risk premium are both at 5%. The company’s debt is risk free debt and has an interest rate of 5%.
 What is the cost of equity of the unlevered company according to the CAPM?
 Could you calculate the levered company’s beta?
 What is the cost of equity of the levered company according to the CAPM?
 What is the cost of capital of the levered company?
Merger Economics: Exercise
 We live in a Modigliani Miller World without taxes. Company A has no debt, a perpetual cash flow of 20m and a cost of capital
of 10%. Company B has no debt, perpetual cash flows of 4m, a cost of capital of 10% and an expected growth of 2%.
 Company A wants to buy Company B for 60m financed with an equity issue.
 The CEO of A doesn’t understand finance and thinks that the deal should increase his company’s EPS
 Both companies have 10m shares. Determine EPS and EPS dilution for A if A acquires B with cash.
 If you are the Investment bank advising A, how would you structure the deal such that A’s CEO will accept it?
Solution
 Value A 10/0.1-0.5=200m, EPS A=$2
 Value B =50m EPS=$0.4
 60m/200m*10m=3m new shares have to be issued
 EPS of Merged entity= 24/13=1.8
 Finance with debt at 5%
 Earnings =24*0.05*60=21
 EPS =21/10=2.1!
Exercise
 Merger with synergies: Price range
 Merger with synergies and exchange of shares
 Takeover with toehold
Payout Policy according to Modigliani and Miller (1961)
 Different Types of Payouts
 Share buybacks
 Irrelevance of Payout Policy
Different Types of Payouts
 Dividends:
 Regular cash dividend.
• Public companies in the US often pay quarterly dividends
 Extra cash dividend/ Special Dividend.
• The extreme case would be a liquidating dividend.
 Stock repurchase
 Open market repurchase
 Tender Offer to all Shareholders
 Private negotiation (green mail)
 Attention : Stock dividends are not payouts
 No cash leaves the firm.
 The firm only increases the number of shares outstanding, equivalent to stock splits
Financial Ratios
 Dividends are reported in three ways:
 Dividend rate = annual dividend
 Dividend per share (DPS): dollar amount per share

 Dividend yield: DPS divided by share price
 Payout ratio: DPS divided by EPS
 Dividend cover = EPS /DPS = 1/Payout Ratio
 (Each measure can be calculated to include repurchases)

Modigliani-Miller Theorem for Payout Policy
 If there are :
 No taxes.
 No transaction costs.
 Investment and operating policies are held fixed.
 Symmetric information.
 Then shareholders are indifferent between paying the money out as a dividend, via repurchases or keeping it on the balance
sheet.
Irrelevance of Payout Policy: An Interpretation
 Payout policy normally involves 2 decisions:
 How much of the firm’s earnings should be distributed to shareholders as dividends, and
 How much should be retained for capital investment?
 Only the investment decision is important for share value. Payout policy is irrelevant if we keep the capital investment fixed.
 The investment policy determines the cash flow available for paying dividends
 Payout policy will only influence:
 the timing of the payout
 the form of the payout
 This will not affect the NPV of the cash received by the shareholders.
Taxes, Issuance Costs, and Dividends
 MM assumed no taxation
 In reality long-term capital gains had a big tax advantage over dividends for high-income individuals in the US, but this almost
disappeared in 2003 following the Bush tax reform.
 The same low tax rate (15% used to be 39.6% under Clinton) now applies to dividends and long-term capital gains.
 The effective tax rate on long-term capital gains is even lower than 15% if your holding period is longer than a year.
 Short-term capital gains are taxed as ordinary income (35%).

Summary: Payout Policy
 In a perfect Modigliani Miller world shareholders’ wealth is not affected by the company’s payout policy if it does not affect
the company’s FCTF.
 Dividends decrease the stock price by the amount paid out
 Share buybacks decrease the number of shares outstanding without affecting the share value
 In reality share buybacks have a tax advantage.
Exercises
Exercice : Payout Policy
 Company X is financed with 100 000 shares and produces a a constant annual cash flow of $10 per share. Cost of equity is
10%. The company is considering three ways of distributing the cash to shareholders:
 Policy 1 : Pay a regular annual $10 cash dividend, with the first dividend being paid out today.
 Policy 2 : Invest cash available at the beginning of the first year during 4 years at 10% annual return in the stock
market. From the end of the first year on, distribute all cash immediately as dividends. Pay out an exceptional
dividend at the end of year 5.
 Policy 3: Use cash available at the beginning of year 1 to buy back shares.
Exercise: The effect of leverage on shareholder’s wealth
 Umbrella Inc. is currently 100% equity-financed with 10000 shares outstanding. It produces a constant annual cash flow of 10
k Euros. Cost of capital is 10%. The company wants to replace 33% of this equity by debt at an interest rate of 3%.
 How many shares does the company have to buy back in order to change leverage without changing the
composition of assets.
 How does leverage affect earnings per share?
 Try to evaluate the levered company using the unlevered company's P//E ratio. Why is this wrong?
 Try to calculate the levered company’s cost of capital assuming that leverage does not affect the cost of equity. Use
the previously calculated equity value. Why is this wrong?
 Evaluate the levered company with the wrongly calculated WACC. Compare with the previous valuation using the
wrong P/E ratio.
Solution: The effect of leverage on shareholder’s wealth
 The company needs to buy back 1/3 of equity or 3333 shares
 Enterprise value =10K/0.1=100k. Hence, there will be 33k of debt with interest of 1k after levering up. After interest earnings
=10-1=9k therefore EPS =9k/6,6k shares = 1.35Euros up from 1Euro
 P/E of levered company= 10 hence share price 13.5? No, risk has gone up and PE has gone down! In fact share price should
remain the same and PE decrease to 10/1.35=7.4
 If we use the wrong PE we obtain for the market value of equity 6.66k*13.5= 90k, therefore WACC= 10%(9/(9+3.3))+
3%(3.33/(9+3.3))=8.1%
 EV= 10/0.081=123.3 hence Equity value =123.3-33=90k
 Same value as before, because we made the same mistake!
Exercise: Greenmail
 A corporate raider has acquired 20% of Globalcom’s shares. Shares are currently traded at $15, which according to analysts
correctly reflects the company’s value. Globalcom’s management is afraid of being fired and agrees to buy back the raider’s
stake at $20 per share. What should be the share price after the buyback? How much do the minority shareholders lose?
Quizz: Leverage
 In a perfect MM world, what happens to cost of equity, cost of capital, PE ratio, EPS and company value if a slowly growing
company replaces equity with debt.
 What happens if a strongly growing company does the same thing?
Quizz: Payout Policy
 Current stock prices are $10. In a perfect MM world, what happens to stock price, shareholders’ wealth and company value if
a company:
 pays out a dividend of $1/share
 gives an additional share to each shareholder owning 10 shares (stock dividend or stock split)
 Buys back 10% of the company’s shares at market prices
 Issues an additional 10% of shares at market prices
 Buys back 10% of the company’s shares at twice the market price?
 Issues an additional 10% of shares at twice the market price?
5.Risk and Capital Structure
In this chapter we discuss first the simple Tradeoff Theory which explains on how tax shields and bankruptcy costs can
determine an optimal capital structure. we then discuss how because of limited liability, upside and downside risk has
different effects on the value of debt and equity. Option theory can help us to understand the impact of risk changes on the
value of these securities.
 The Tradeoff Theory of Capital Structure
 Tax shields
 Modigliani Miller with taxes
 Personal income taxes
 Bankruptcy and Firm Value
 Limited Liability
 Historic Evolution
 Veil piercing
 Debt and Equity as options
 Applications
Taxes, Capital Structure and Firm Value
 If the company pays taxes, pre-tax cash flows are distributed to :
 Shareholders
 Creditors
 The state
 Company value = value of flows distributed to shareholders and creditors = after tax value
 Taxes depend on debt levels
 Therefore after tax value of the company depends on debt levels
Taxes and debt
Cash flows and tax shields
We must adapt WACC if we still want the present value of Free Cash to the Firm and Cash Flows to the different types of investors to be
equal
Modigliani Miller with taxes (1963)
 Proposition I (with taxes)
 Company Value increases with leverage
 Proposition II (with taxes)
 The cost of equity increases with leverage but at a slower rate than without taxes
 Weighted average cost of captial
 Wacc decreases with leverage
 Note: The detailed relationship between leverage and WACC depends on assumptions made about the future debt levels.
Several adjustment formulas are available.
Corporate Tax Effects: Formulas for constant debt levels (APV case)
Corporate Tax Effects
 Intuition: Government takes away a part of the pizza. The tax slice is smaller with more debt finance (higher leverage).
Conclusion
 “All else equal, considerations of the corporate income tax should make debt finance more attractive.”
 Unprofitable investment projects can become profitable for the levered firm.
 If the world worked as in the MM Theorem with taxes the optimal financial structure would entail 100% debt finance. Why do
firms not take 100% debt?
 Reason:
 Personal taxes
 Bankcruptcy costs
 Agency costs
Exercise: Taxes and debt
 Umbrella SA is equity financed and has a pre-tax income/Ebit of 10. The corporate tax rate is 50%, the company’s cost of
capital is 10%. The owner wants to exchange 67% of equity with a 3% loan.
 Determine the annual tax shields of the levered company.
 What is the present value of the tax shields discounted at cost of debt?
 Determine the value of the levered company as sum of the unlevered company’s value and the present value of tax
shields.
 Determine the levered company’s cost of equity and WACC using the formulas given in class.
 Verify that you do indeed find the same equity and firm value as before.
Solution
 Value unlevered firm =50

 Debt level= 0,67*50=33
 Annual tax shields = Interest* tax rate=1*0,5
 Present value of tax shield 3%*0,5=1/0,03*0,5=16,6
 Value of the unlevered company=50
 Value of the levered company= 50+16=66
 Value of the levered equity=66-33=33
 Cost of equity levered company= 10%+33/33(10%-3%)(1-0,5) =13,5%
 Wacc using formula=7,5%
 Wacc using weights =7,5%
 FCTF discounted at tax adjusted Wacc=5/0,075=66
Exercise: Buyout Finance
 Company A has a stable pre tax cash/ EBIT flow of 10m year without growth and no debt. It is privately owned, management
has 5% of equity. Corporate taxes are 50%, cost of captial is 10%. Now a Buyout Fund acquires the equity and asks the
company to take on 50m in Bank Debt at 8%. The excess cash of 50m is paid out as special dividend. Management re-invests
the cahs they gained form the sale in the company. The LBO fund sells the remaining shares are sold in an IPO
 What is the gain of the Buyout Fund?
 What is the percentage of shares held by management after the LBO?
Personal Income Taxes
Individual Income Tax
 While the corporate income tax encourages debt finance, the individual income tax serves to mitigate this preference.
 Interest income:
 taxed at the individual level in the year it is earned. This is known as taxing on an accrual basis. Further, interest
income is taxed at the individual’s full marginal tax rate.
 Equity income: dividends capital gains.
 Dividends are taxed when paid. In some countries the tax on dividends is lower than the tax on interest.
 Capital gains are taxed when realized. This creates a deferral advantage (since delaying reduces the PV of tax bill).
The Intuition
 Think about having $1 that you are free to label as “interest” or “equity return” for tax purposes. What label should you
apply?
Example
 In 1981, the maximum individual income tax rate in the US was 70% and the average effective tax rate on capital gains was
estimated to be 16%. The corporate income tax rate was 46%. Using these figures, total taxation of equity 1-(1-0.46)(1-
0.16)=0.55 and total taxation on debt 0.70
 Under this set of assumed rates, there would be a tax disadvantage to debt finance.
 In reality many investors in debt are also tax exempt.
Conclusion
 Various institutional features cause equity income to face a lower effective tax rate than debt income at the individual level.
 These differences mitigate the tax advantage to debt finance at the corporate level. In fact, it is possible for there to be a net
disadvantage to debt finance.
 Historically, and under current tax law, there is a net advantage to debt finance for a corporation in the top bracket.
Exercice: Taxes in France (2019)
 Is there a tax advantage for debt finance?
 Corporate tax 34,93%
 Tax in dividend income (High bracket) 35%
 Capital gains tax (impôt sur les plus values) 34.5%.= capital gains tax at the rate of 19% plus 15.5% social charges.
 Tax on interest income 27%
 Hence income from debt and equity is taxed at similar rates at the investor level but income from debt is untaxed at the
corporate level.
 Interest has a clear tax advantage !
Bankruptcy and Bankruptcy Costs
Bankruptcy in perfect markets
 In the Modigliani/Miller world
 bankruptcy simply means that there is not enough cash for shareholders
 I this case creditors receive all the FCTF
 In the real world
 bankruptcy is a complicated court administered procedure to resolve conflicts in case creditors cannot be paid in full
 In an efficient bankruptcy process the creditors become the company ’s new owners
 They will typically not liquidate the company, but continue to run the company.
 The company’s value should therefore be the same independently if it is run by the old shareholders or the creditors
-> smililar to MM world
Exemple: Bankruptcy and Enterprise Value
 Startup SA will produce perpetual cash flows of 15 or 5, with probabiltiy 50%, depending on the signature of an important
contract.
 Cost of Captial 10%:
 Without debt:
 Enterprise value is 100
 With debt of face value 75
 In the case of bankruptcy 20 go to judges lawyers etc.
 Without debt:
 Enterprise Value 100
 With debt with a face value of 75
 In the case of bankruptcy half of the existing clients will leave
 Without debt:
 Enterprise Value 100
 With debt with a face value of 75

Conclusion
 Contrary to the assumptions of Modigliani and Miller, in reality bankruptcy reduces the value of the firm
 direct transaction costs
 indirect costs: Lower expected future cash flows due to the bankruptcy
 These expected additional future costs will reduce the value of the levered company today
 Higher leverage makes bankruptcy more likely and increases therefore expected bankruptcy costs
 Risky companies have higher bankruptcy probabilities and therefore higher bankruptcy costs.
 Companies with a lot of intangibles will tend to lose more value during bankruptcy.
Tradeoff theory
 Can the optimal capital structure really be determined as a tradeoff between bankruptcy costs and tax shields?
 According to this theory which type of companies should have low or high leverage?
 What about the identity of the shareholders?
 What about the number and identity of creditors?
Applications
 Tax Driven Financial Innovation
 « junk bonds »
 Pay-in-Kind Securities (PIK's)

 ARCN: adjustable rate convertible notes
 Strip Financing
Tax Motivated Financial Innovation
 Idea: Accept high bankruptcy risk in order to be able to benefit from tax shields
 « junk bonds »
 LBO’s
 Idea: Allow tax deductibility of payments but reduce probability or cost of bankruptcy.
 Pay-in-Kind Securities (PIK's)
 ARCN: adjustable rate convertible notes
 Strip Financing
Tax Motivated Financial Innovation
 Junk Bonds: Have high interest rates and therefore high tax shields. Enable even risky companies to extract tax shields
 Pay-in-Kind Securities (PIK's): Give issuer option to pay interest in cash or in additional securities valued at par. Zero coupon
bonds give the corporation interest deductions without forcing it to part with internal cash-flow. There is no danger of
bankruptcy (but the danger of dilution of existing shareholders)
The Tale of the ARCN
 ARCN: adjustable rate convertible notes
 Designed by Goldman Sachs to meet the "letter of the law" as in regulations written by Treasury in 1982.
 Short-term convertible bond.
 Generally worth converting if value of stock did not fall by more than 40% prior to maturity.
 Interest payments on ARCN's mimicked the dividend for the corporation.
 Junior to any other class of debt.
 Treasury issued ruling in 1983 classifying ARCN's as equity.
Preferred Redeemable Increased Dividend Equity Security – PRIDES
 First introduced by Merrill Lynch, PRIDES are synthetic securities issued by special purpose vehicles (SPVs)
 The SPV is situated in an offshore jurisdiction and financed with equity.
 The SPV then lends money at a fixed, tax-deductible interest rate to the company.
 In addition the SPV enters in a forward contract to purchase at the maturity of the loan equity in the company for a price
equal to the loan’s face value.
 Similar to ARCNs, PRIDES allow for a series of tax deductible payments but generate little bankruptcy risk as there is no
reimbursement of the debt’s face value
Strip Financing
 Strip Financing: Debt securities are held in equal proportions by all outside equity holders. That is, debt strips are stapled to
equity.
 This aligns the interests of debt and equity.

 Allows firms to exploit tax advantage of debt at a lower cost in terms of agency conflicts.
Exercise: Firm Value and risky debt
 A joint venture is supposed to deliver a cash flow of either 60 or 160 with probability 50% at the end of the year. The company
will then be dissolved without bankruptcy costs. Cost of capital is 10%
 What is the value of the joint venture today?
 Suppose that the firm is financed with 60 in debt. What interest rate should the bank ask for to get on average the
risk free return of 5% on the risky loan?
 What should be the cost of equity of the levered company according to the MM theorems?
 Calculate the weighted average cost of capital for the levered company.
 Evaluate the company’s assets by discounting free cash flow at the weighted average cost of capital.
Solution
 Value: 110/1,1=100,
 In the case of bankruptcy the bank gets 60 otherwise it gets (1+interest)*60. The interest of 10% yields an average return of
5%
Exercise: Firm Value and risky debt (cont.)
 Suppose now that in the case of bankruptcy the bank has to pay 10 in order to liquidate the joint venture and get
some money back. What interest rate does the bank have to ask for to get on average the risk free return of 5%?
 What is the risk adjusted cost of debt for the company?
 Calculate the weighted average cost of capital for the levered company including bankruptcy costs.
 Suppose the company is paying taxes of 30%. Which capital structure is cheaper: 100% equity or 60% debt?
Exercise: Firm Value and risky debt (cont.)
 Surprisingly, the local savings bank has agreed to provide credit at a 7% interest rate.
 What is the risk adjusted cost of debt for the company?
 Calculate the weighted average cost of capital for the levered company and use it to evaluate the company
 What is the market value of debt assuming a 5% expected yield?
 What is the market value of equity?
Quizz: Leverage
 In a perfect MM world with taxes, what is the effect of an increase in leverage on
 cost of equity,
 cost of capital
 value of the company?
 In a perfect MM world with taxes and bankruptcy costs, what is the effect of an increase in leverage on
 cost of equity,
 cost of capital
 value of the company?

Appendix: Levering/Unlevering Betas with tax shields
 Value of Levered Firm = Value of Unlevered Firm + Tax Shields = Equity + Debt
 EVL = VU + D × TC = E + D
 Remember: portfolio beta is weighted average of the betas of the assets in the portfolio
 Beta of levered firm’s assets:
Appendix: Levering/Unlevering Betas (Continued)
Appendix: Levering/Unlevering Betas (Continued)
Limited Liability and the Option Theory of Capital Structure
 Limited Liability
 Historic Evolution
 Veil piercing
 Debt and Equity as options
 Applications
Limited Liability
 Limited Liability implies that an investor in equity cannot lose more than he has invested, even if he has wealth outside the
business.
 This is different from “de facto” limited liability which arises because the shareholder has no additional wealth
 Not a straightforward concept:

 Middle age in Europe: debtor’s prison
 Early limited liability concepts:
 Roman and early Islamic law: Have a slave running a business
 17th century, joint stock charters with limited liability were awarded as privilege to special companies such as the
East India Company.
Limited Liability
 General limited liability statues:
 French société commandite 1671
 Limited partnership statutes in different US states, first enacted by New York in 1822
 UK: Limited liability act in 1855
 Limitations to limited liability:
 Veil piercing
 Action en comblement du passif
Debt, Equity and Enterprise Value with Limited Liability
 The value of equity is max(Assets-FVD, 0)
 The value of debt is min(Assets, FVD)
 Equity can be understood as a Call option on the company’s assets with a strike price equal to the face value of debt FVD
 Risky debt can be understood as a risk free asset with a current value of PV(FVD) together with a short position in a put option
on the company’s assets with a strike price equal to the face value of debt FVD.
 This is useful to
 Understand qualitatively how risk affects debt and equity values
 Quantify the value of equity and debt in highly levered companies
Limited Liability, Risk and Value of Debt and Equity
 Limited liability and the option feature of capital structure has direct implications:
 Debt value = Value of risk free debt – put

 This decreases with an increase in risk
 Equity value = value of call
 This increases with risk
 Hence shareholders will generally have incentives to increase the risk of assets.
Simple Example: Risk and Shareholder Value
 Farine SA today has a value of 100
 With a more aggressive corporate strategy the company could achieve 50 or 150 (with prob. 50%) depending on whether an
important contract will be signed
 The company is financed with long term loans having a face value of 70
 Determine for both strategies:
 Today ’s company value
 The value of equity
 The value of debt
Risk and Shareholder Value
 Increasing the risk by keeping the expected company value constant will increase shareholder value
 They gain from the upside
 No increased losses on the downside.
 On average their payoff will increase
 This increase in shareholder value comes from a decrease in the value of debt due to the increase of default risk.
The Put-Call equality for the firm’s capital structure
 The following two strategies yield the same result:
 Owning the firm’s asset and a put with strike of FVD
 Owing a risk free bond and a call on the firm’s assets with strike D.
 Therefore these strategies must have the same price:

 Reminder:
 the Call is equivalent to the firm’s equity
 Debt is equivalent to the the risk free bond and a short position in the Put = PV(FVD) – Put = Assets - Call
The Black and Scholes formula
 The Black and Scholes model values European options on non dividend paying stock.
 The value of a call option in the Black-Scholes model can be written as a function of the following variables:
S = Current value of the underlying assets = EV
K = Strike price of the option = FVD
t = Life to expiration of the option
r = Riskless interest rate corresponding to the life of the option
(sigma) s2 = Volatility of the underlying asset
The Black Scholes Model
 Value of Call
C= S N(d1) – K e- r t N(d²)
where, N is the cumulative Normal Distribution and
Application to valuation: A simple example
 Assume that you have a firm whose assets are currently valued at $100 million and that the standard deviation in this asset
value is 40%.
 The face value of debt is $80 million (It is zero coupon debt with 10 years left to maturity).
 The ten-year treasury bond rate is 10%,
 Questions:
 What is the value of the equity?
 What should the interest rate on debt be?
Model Parameters
 Value of the underlying asset = S = Value of the firm = $ 100 million

 Exercise price = K = Face Value of outstanding debt = $ 80 million
 Life of the option = t = Life of zero-coupon debt = 10 years
 Volatility = Standard deviation in firm value = 0.4
 Riskless rate = r = Treasury bond rate corresponding to option life = 10%
Valuing Equity as a Call Option
 Based upon these inputs, the Black-Scholes model provides the following value for the call:
d1 = 1.5994 N(d1) = 0.9451
d2 = 0.3345 N(d2) = 0.6310
 Value of the equity= call = 100 (0.9451) - 80 exp(-0.10)(10) (0.6310) = $75.94 million
 Market value of the outstanding debt = $100 - $75.94 = $24.06 million
 Appropriate interest rate on debt = ($ 80 / $24.06)^1/10 -1 = 12.77%
The Effect of Catastrophic Drops in Value
 Assume now that a catastrophe wipes out half the value of this firm (the value drops to $ 50 million), while the face value of
the debt remains at $ 80 million. What will happen to the equity value of this firm?
 Possible answers:
 It will be worth nothing since the face value of debt outstanding > Firm Value
 It will drop in value to $ 25.94 million [ $ 50 million - market value of debt from previous page]
 It will be worth more than $ 25.94 million
Valuing Equity in the Troubled Firm
 Value of the underlying asset = S = Value of the firm = $ 50 million
 Exercise price = K = Face Value of outstanding debt = $ 80 million
 Life of the option = t = Life of zero-coupon debt = 10 years
 Volatility = 0.4
 Riskless rate = r = Treasury bond rate corresponding to option life = 10%
The Value of Equity as an Option
 Based upon these inputs, the Black-Scholes model provides the following value for the call:
d1 = 1.0515 N(d1) = 0.8534
d2 = -0.2135 N(d2) = 0.4155
 Value of the call = 50 (0.8534) - 80 exp(-0.10)(10) (0.4155) = $30.44 million
 Value of the bond= $50 - $30.44 = $19.56 million
 When the value of the Assets drops by 50m, the equity value only drops by $75.94 - $30.44 = $35,5m because of the option
characteristics of equity. The difference is absorbed by a decrease in the value of debt
 This explains why often stock in firms, which are essentially bankrupt, still have value.
Options and Capital Structure: Implications

 Equity can have positive value (option value) even if the current value of assets is lower than the value of debt
 The value of debt can be lower than face value even if today assets have a higher value than debt
 The sum of both must still be the value of the assets: value preservation!
 An increase in volatility of asset values will increase the value of equity!
 This can be seen from the Black Scholes formula but is also directly intuitive:
 Higher risk will increase upside for shareholders but not decrease downside which is capped by limited liability
 Higher risk will decrease debt values, therefore it must increase equity values (value preservation!)
Some words on real option valuation
 Option theory is also used in a different context, to evaluate strategic options and estimate the value of flexibility
 Example 1 (starting option): A company buys a copper mine with production costs of $3/lb. Current prices are at
$2.6/lb.
 Example 2 (waiting option): An investment is profitable at current product prices, but may become unprofitable if
future prices go down. Should the company invest or wait?
 Again the Black Scholes formula can be adapted to these situations. In practice these tools are mostly used for commodity
investments.
6.Summary of Valuation
We review the different types of DCF valuation procedures in light of the concepts acquired in the previous lectures.
Companies have to be evaluated in many different contexts:
- Stock market analysis

- Takeovers and Mergers
- Credit decisions
- Restructuring decisions
Reminder I: Fundamental concept of value in Finance = Present Value/ Discounted Cash Flow (DCF)
However: Sometimes other valuation methods are more practical.
Reminder II: There is a difference between price and value!
Basic valuation methods
 Book Value Based

- Reevaluated assets
- Liquidation value
 Multiples
- Equity Multiples
- Enterprise Multiples
 DCF
- WACC
- Adjusted Present Value (APV)
- Flow to Equity (FTE)
- Capital structure as option
- Real Options…
Methods based on book value
 Balance sheet based methods
 Book Value of Assets = Market Value of Assets?
- Historical Cost, Depreciation
 Market Value of Assets = Market Value of Company?
 Tangible assets
- Reevaluation possible, but conceptual problems: sales price; replacement value.
- The sum can be more valuable than the parts.
 Intangible assets: patents, trademarks
 Assets which cannot be listed on the balance sheet: market position, reputation.
Market value of an investment: This is the present value of the cash flows generated after making the initial investment.
Book value of the investment: Essentially initial investment outlay (minus depreciation). We have:
NPV can be understood as the difference between market and book value, the « value created ».
Re-evaluated assets
Book values can be made more realistic by replacing them with the current market values of assets. Several conceptual problems:
- Groups of assets may be more valuable than separate assets

- Sales value or Replacement value?
- Normally Re-evaluated sales value of assets is lower than company value
- Otherwise: Liquidate Company!
Re-evaluated assets = Liquidation Value = Lower boundary for firm value
Summary: Balance sheet-based methods
 No theoretical foundation: Balance sheet data are backwards looking; Market values depend on the future.
 Useful to determine the liquidation value: Therefore, used by banks; Used in the case of bankrupt companies.
 Can be used as complement to an evaluation: If asset value is higher than cash flow value –> liquidate.
 Less useful for modern companies: service sector; human capital.
Comparables | Multiples
Fundamental idea: Compare the companies you want to evaluate with similar companies for which you know the value and adjust
for different size:
Two types of values:
 Equity value
 Enterprise value (Equity + Debt – Cash)
Both types of values can come from stock markets (“compco”) or other transactions (“comptrans”).
Proxies for size:
- EBIT, EBITDA, Cash, Sales, number of clients

- total assets, retail surface, total reserves
Equity vs. Enterprise Value Multiples
Enterprise value multiples:
- use the total value (debt + equity – cash) of the comparable companies.
- theoretically sounder way.
- to get the equity value, subtract value of debt.
- Size proxy must be independent of leverage: EBIT, EBITDA, Cash to the Firm, Sales, Assets, Nr. Clients.
Equity value multiples:
- directly evaluate the company’s equity.

- often more practical.
- will lead to valuation errors if companies with different leverage are compared.
- Size proxy must be consistent with “money to equity”, i.e. net profits, EBITDA-interest, cash to equity, book value of equity
etc.
The most common multiples
Price/ Earnings ratio
 Equity and Enterprise version:

Equity Value/Net profits
Enterprise Value / EBITDA, Enterprise Value / EBIT, Enterprise Value/ Cash
 Inconsistent calculation: Enterprise Value / Net profits

Price/ capital ratio
 Equity and Enterprise version:

Market value of equity/Book value of equity
(Market value of equity+ value of debt)/Book value of total assets (Tobin’s q)
 Inconsistent calculation: Market value of equity/Book value of total assets
Reminder: Equity Multiples and Leverage
A change in debt level can have an impact on the price/earnings multiple if it is calculated as Equity Multiple
Reasons:
- Net earnings in a highly levered company are more risky and therefore less valuable than earnings in a similar company
with low debt.
- Net earnings in a high growth companies grow even faster if the company is levered. Earnings in a levered company can
therefore be more valuable than earnings in a similar company with low debt.
This error is extremely common for stock market investors. It can be avoided by using Enterprise Multiples.
Other problems with multiples
Multiples do not only depend on leverage but also on:
Growth, size, industry, country, time…..
Using the average multiple will we underestimate or overestimate the value of Hyperstore?
Adjusting multiples using regression analysis
The influence of different factor on Multiples can be taken into account with regression analysis:
Example: Valuing Hyperstore using regression
More precise solution:
- capture the effect of size with a linear regression of Multiples on growth factors
- The estimated coefficients of the regressions are:

- New estimate of the appropriate EBIT Multiplier
- The new estimation for the value of the company is:
Conclusion: Multiples and regression
Linear regression allows to take into account the growth of the company we want to evaluate. If the company grows faster than the
sample of comparable companies, we will obtain a higher value.
The regression method can be generalized to take into account other variables influencing the price: leverage, size, other financial
ratios.
Problems:
- you need a large number of comparable companies.

- Multiples are still a « Black Box approach » the statistical adjustment does not explain why the value is more important.
Comments: the PER/ Growth ratio makes no sense whatsoever and should not be used.
Problems with multiples
Fundamental Problems: A number of different factors influence multiples: earnings growth (Gordon/Shapiro), leverage (risk premia,
Modiglani/Miller).
Practical Problems: Often comparable companies (peer group) are difficult to find, especially for conglomerates, international
companies or new industries. Time frame for calculation of multiples: Multiples change in time.
Accounting Problems: Very similar companies can have very different multiples depending on their accounting policy: “Adjustments”
in order to obtain consistent information.
Evaluation with multiples means relying on the evaluation done by others on other companies if everybody else gets it wrong so will I
stock market bubbles (internent; japanese stockprices)
Summary: Valuing with Multiples
 Multiples valuation is valuation by comparison.

 (Almost) anything goes, except inconsistently calculated multiples.
 Enterprise value multiples are less dependent on leverage than equity multiples.
 Regression analysis can be used to refine multiple valuation.
 But fundamentally multiples are a simple but very imprecise method to value companies.
 Often multiples are used to summarize a valuation.
DCF Methods
Basic idea
Valuation Principle: A company is an investment and should therefore be valued with the same methods as other investments. The
price should be chosen such that the investor obtains at least the same return as on other investments with similar risk.
We know from financial mathematics: The PV of a series of cash flows corresponds to the price at which the investor gets a return
equal to the discount rate. The return on an investment with high systematic risk should be higher than the return on an investment
with low risk (CAPM).
Several variants of DCF Models
 Enterprise value (Entity) methods: give the enterprise value.

 Use Free Cash Flow to the Firm (FCTF)and cost of capital.
 Different ways to adjust for tax shields of debt (WACC, APV)
 Equity methods: directly give the value of equity.
 Dividend Discount Models: Directly evaluate the cash flow to investors by discounting dividend forecast at cost of equity.
 Free Cash to Equity: Use free cash to equity (i.e. potential dividends) instead of dividends
Modelling Risk in Discounted Cash Flows (DCF) Methods
 Usually a single stream of (expected) cash flow forecasts is discounted.

 It is often a good idea to forecast and evaluate different scenarios. The firm value is the probability weighted average of these
scenario values.
 Sensitivity analysis consists in identifying “value drivers” which have a high impact on the firm value (e.g. sales growth) and
therefore need to be forecasted with high precision.
Using Option Pricing Methods in Discounted Cash Flows (DCF) Methods
Capital structure options: This approach makes sense if:
- Firms are very highly levered/close to insolvent.

- Asset volatility can be easily quantified (e.g., commodity producers, real estate)
Real option analysis can be understood as a more detailed scenario analysis, where some choices precondition other choices.
Reminder: Free Cash to the Firm (FCTF), Cash Flow to Equity (FTE) and Dividends
Free Cash to the Firm is the cash produced or absorbed by the company’s assets.
- Can be accumulated or paid out to creditors or shareholders.

- Is affected by economic risk.
Free Cash to Equity is the cash produced or absorbed by the company’s assets and the company’s debt.
- Can be accumulated or paid out to shareholders.

- Is affected by economic and financial risk.
Dividends are the part of Cash to Equity that is paid out to shareholders; the remaining part is accumulated on the balance sheet.
- Eventually all Cash to Equity must be paid out as dividends.

l Free Cash to the Firm:
EBIT
- taxes on EBIT
= NOPLAT
= FCTF
l Free Cash to Equity

EBIT
- Interest
= taxable income
- taxes paid
= Net Income
+ Change in Debt
= FTE
Present Value of Dividends, Cash to Equity and Free Cash to the Firm (without taxes)
 According to Modigliani Miller (1958): The value of a company does not depend on its capital structure (except for tax
effects)!
Therefore, we can evaluate a company as if it was entirely equity financed:
- FCTF would be the firm’s Cash to Equity in case the firm had no debt!
- WACC would be the firm’s cost of equity in case it has no debt!
 According to Modigliani Miller (1961)
- The value of a company does not depend on its payout policy!
- CTE and Dividends differ in timing but should always have the same present value!
- Usually, CTE is easier to forecast because it does not depend on payout decisions.
Tax Treatment in Entity methods
Free Cash to the Firm assumes more taxes than the company has really paid. How can we adjust for this difference?
WACC approach: Adjust for tax shield of debt by adjusting discount factor by the (1-tc) tax factor (WACC)
APV approach: Calculate discount factor without tax correction, add NPV of debt tax shields to obtain enterprise value. More on this
later.
Overview: APV, FTE, and WACC
Reminder: Cost of Equity and Cost of Debt
Cost of Equity= required average return for shareholders:
- CAPM
- Fama-French
- Subjective
Cost of Debt= required average return for creditors
- Yield minus expected loss rate

- Risk free rate plus risk premium
- For investment grade companies no risk adjustment necessary: Interest rate on bank loans, Current yield on bonds,
Weighted average between long- and short-term rates.
Reminder: Weighted Average Cost of Capital (WACC)
Discount rate for a given company’s FCTF:

Tax Shields
How to take into account tax shields?
- Total Cash Flow goes to three parties: Debtholders, Equity holders and State.
- Free Cash Flow assumes that taxes are paid on EBIT.
- Real taxes are lower because they are calculated after interest payments.
- Firm value using discounted FCF would therefore be too low.
- Two methods for adjusting for tax shields of debt: Adding back net present value of tax shields: Adjusted present value
(APV); Adjusting discount rate downwards in order to increase NPV of the firm: Weighted Average Cost of Capital (WACC)
The Adjusted-Present-Value (APV) Approach
APV explicitly calculates the value of the tax shields.
Procedure:
- Calculate Cash Flows as if Firm was all equity financed.

- Calculate required return for unlevered firm without tax correction
- Discount the company’s Cash Flows

- Add NPV of debt tax shields to obtain enterprise value
Implicit Assumption: The amount of future debt is known and independent of the firm’s evolution. Advantage: Possible to handle
complex tax situations and capital structures.
Example: Pivatejet Inc.
Privatejet Inc. produces Free Cash Flows of €20million/ year without growth. The unlevered cost of capital is 10%. The company pays
40 % taxes but as a startup in France the first 3 years are exempt from taxation. The company has a debt level of €150million on which
it pays 3% interest and which it will maintain for 5 years. Then debt will be reduced to a permanent level of €50million from year 6 on.
Calculate the value of the firm without debt and tax exemption.
What is the value of the tax exemption?
What is the present value of the tax shield generated by debt?
Unlevered and fully taxed value €200million

PV of legal tax shields: EBIT = € 20m/ (1-0,4) =33m, Tax shield = € 13m/year, PV of tax shield = 13/1,1+13/1,1^2+13/1,1^3=32m
PV of interest tax shield:
150*3%*0,4= € 1,8m annual tax savings with PV of 1,8/1,03^4+1,8/1,03^5= € 3,2m in years 4 and 5
50*0,4/1,1^5= € 12,4m
Overall value of levered company: 200+32+3,2+12,4= € 247,6million
The Weighted-Average-Cost-of-Capital (WACC) Approach
WACC includes the tax shields in the discount factor. Procedure:
- Calculate Cash Flows as if Firm was all equity financed.

- Calculate average Weighted Average Cost of Capital with adjustment factor for tax deductibility of interest:
- Discount the company’s Cash Flows with the Industry WACC
Implicit Assumption: The capital structure at market values stays the same if the firm value changes, i.e., the amount of debt is
readjusted aftershocks to the company value.
Simple Example: Evaluating Companies using WACC
Privatejet Inc. wants to maintain the value of debt issued at about the same size than the value of equity. How would you estimate the
value of the company using the WACC Approach?
Solution
Cost of Equity for similar firms (CAPM): rE=17%
Unlevered cost of capital: r0 = 17%*1/2 + 3%*1/2=10%
Discount rate adjusted for tax shields
rWACC = 17%*1/2 + 3% (1-0,4) *1/2=9,4%
Discounting the Free Cash flow at WACC we obtain an enterprise value of € 20m/0,094= € 212
Lower than the APV value because tax shields are (implicitly) assumed to be risky.
Problem 1: Levered and unlevered WACC
I want to evaluate firm B, but I only know the cost of capital for a firm A in a similar industry but with a different capital structure. How
do I adjust WACC for the different capital structures?
Step 1: Calculate unlevered cost of capital for A
Step 2: Calculate levered cost of equity for B
Step 3: Calculate new weighted cost of capital for B
Problem 2: The circularity problem
Problem: If you want to calculate WACC you need to know the capital structure in market values. This implies that you know the value
of equity which is precisely what we were looking for!
Frequently used but wrong solution:
- Use book value of equity.

- the evaluation errors produced by this method can be important.
Correct solution:
- Find a solution to the following fixed-point problem.

- Start by assuming some value of Equity.
- Calculate WACC using this value.
- Calculate value of equity using this WACC
- Compare the obtained and the starting value of Equity.
- Adjust starting value until you find the same value as the input value.
The circularity problem: Example
The cost of capital for unlevered firms is 10%. Privatejet has €100m of riskless debt at 3% outstanding.
Problem: How to calculate cost of Equity? How to calculate WACC?
Solution: Assume E= €100m. Then calculate r E=r0+D/E(r0-rD) and rWACC=E/(D*E)rE+(1-r) D/(D*E)rD, evaluate the company using this r WACC
and recalculate E. Readjust your first estimate of E and repeat until you get the same values:
Comparing entity methods: APV versus WACC
APV:
 Theoretically the most appealing method.

 Clear distinction between value if equity financed a tax shield.
 Complicated tax situations are much easier to consider.
 Changing capital structure can be adjusted for.
 Appropriate method if future amount of debt is known.
 Financing subsidies, cost of issuing.
WACC
 Appropriate if capital structure is re-balanced to remain constant in market values.

 Only one discount factor, easier to calculate.
 Industry standard.
 Circularity problem.
The Flow-to-Equity (FTE) Approach
FTE directly discounts the cash flows received by shareholders. Procedure:
- Calculate Cash Flows to Equity after interest and taxes.

- Calculate required Return for Equity.
- Discount Cash Flow to Equity at rE.

- If you want to find the value of the entire company, add the market value of debt.
Difficult to calculate but appropriate for banks and insurance companies -value creation with liabilities. Very complex if future capital
structure changes.
Comments : FTE and the « PE method »
 Cash-Flow to Equity is normallly not used because it requires a detailed forecast of debt levels
 Exception : Banks and Insurance Companies
o These companies are not financed in perfect capital markets, therefore MM theorems do not apply
o They make money with their liabilties
o Focussing on FCTF would neglect value creation with liabilites (deposits, technical reserves)
o FTE includes cash generated by liabilities
 Private Equity funds often use a FTE approach but do not adjust the cost of equity for the change in leverage during the holding
period.
 This is conceptually wrong!
Continuing Values
Usually, it does not make much sense to try to project a company’s cash over more than 10 years. The firm’s value coming from cash
generated after 10 years can be taken into account in a continuing value that will be discounted as the last cash flow. Depending on
economic assumption about the company different continuing values can be chosen:
- Perpetual growth of cash flows

- Convergence and asset replacement scenarios
- Values form comparables (multiples)
Asset Replacement = Convergence Scenario
Asset replacement scenario: At time T we have no new net investment; therefore, the FCF is equal to NOPLAT:
Convergence scenario: From time T on, competitive forces (entry, imitation) will ensure that ROIC is equal to WACC.
Substitute INV in FCF definition:

FCT is proportional to NOPLAT and grows at rate g.
PV of a cash flow which grows at rate g:
If ROIC = WACC after period T, we get
Estimating Continuing Values
 Asset replacement scenario (constant NOPLAT = FCF forever after T) and convergence scenario (ROIC = WACC after T) imply the
same continuing value.
 The convergence scenario has growing NOPLAT and growing FCF, but also growing net investment; it is not more advantageous.
 Growing NOPLAT and growing FCF is in itself not a sign of success; important is how much capital is used up to reach this growth.
Model building: How to forecast Cash Flows?
This is the most important part of valuation. Think about Competitive position, new products, evolution of costs, evolution of prices,
market share, R&D.
Develop scenarios and calculate average values. Think about financial rations that should remain constant. Check consistency. Think
about strategic options and apply real option methods. Estimate continuing value / sustainable growth.
One way of proceeding:
- Forecast the size and growth of the target market.

• Are these forecasts reasonable?
- Forecast the market share.
• Competitive analysis (product positions, etc.)
• Market structure (entry and exit)
• Check against similar markets.
- Forecast profit margin.
• Explore the profit drivers of a firm.
• Evolution of comparative advantage .
What are typical profit margins in the industry?
Knowing the Company …
What are the profit determinants of a firm?

l Sales volume? In which division? Which product line?
l Number of clients? Service?
l Product positioning? Marketing?
l Production costs? Energy costs? Capital costs? Labour costs?
FCF analysis should be grounded in a knowledge of the profit drivers.
Getting the details right
 In real world evaluation problems, you will encounter a high number of practical problems.
 You will have to solve the most of these problems on a pragmatic case by case base, keeping in mind the fundamental principles
and methods of valuation.
 For a number of these problems there are standard solutions:
o Getting around accounting problems
o Finding the Value of Debt, Equity and other financial instruments
 Finding the Cost of different financial instruments
The risk of a project changes over time
If the projects non diversifiable risk changes over time the cost of capital can be adapted to take into account, the new risk.
l Attention: Initial risk of most projects is diversifiable

l Don’t use high interest rate instead of taking expectations!
Example: You want to buy an oil drilling right. In the first year you have a 50% risk that there will be no oil, afterwards cash flows will
be very stable.
Solution: Calculate beta of oil prices and corresponding discount factor. Discount Expected CF=1/2*Success CF at this rate.
Fundamental Problems with DCF Valuation
- Optional nature of equity neglected: Real Options, strategic default models.

- Debt is always good.
 more debt means more tax shields, means more value.
 A firm which is entirely financed by debt would be paying no corporate taxes.
 this only bothers academics (until recently?)
- What are the limits for the use of debt?
 Bankruptcy costs: Direct Costs (lawyers, fees) and Indirect Costs (interruption of supply and sales networks, loss of
personnel)
 Agency costs: Shirking, Risk Shifting.
Understanding value drivers
- To better understand the risks, it can be useful to

- Decompose the value of a company in : the liquidation value of existing assets, the value generated by the existing assets,
the value of investment opportunities
- Decompose the value of a company into the value of different business units.
- Analyse the value of the company under different scenarios and calcualte expected values.
Exercise
Machinetec is a medium sized machine tool company, specializing in the fabrication of clutches for industrial applications. The
company’s owner and CEO has now reached the age of 75 and decided that he will not be able to efficiently manage the business any
more. His unique son is not interested in replacing him as CEO, he follows its own carrier as a researcher in the US. You have recently
been hired as analyst by the boutique investment bank which has advised Machinetec for many years now on financial transactions.
Your boss, an old friend of Machinetec’s CEO, has asked you to closely analyze the following exit options for the company.
- Management buyout with the help of buyout firm
- Sale to a large and diversified German machine tool company
- Introduction to the stock market.
You start by trying to find out the approximate market value of Machinetec’s equity. Last year’s financial statements in simplified form
are given below:
Balance sheet in millions

Assets Liabilities
Current Assets 80 Current Liabilities 30
Property Plant and Equipment 100 Long Term Debt 120
Intagibles 20 Equity 50
Total Assets 200 Total Liabilities and Equity
P&L in Millions
Sales 500
EBITDA 50
EBIT 30
Net Interest 10
Pre-tax Profit 10
Tax@50% 10
Net Profit 10
l Calculate Machinetec’s Free Cash Flow to the Firm for the given year, assuming that working capital remained constant
compared to the year before and that last year the company has made gross investments of 10 million Euro.
l Calculate Machinetec’s Free Cash Flow to the Equity using the same assumptions as in a), assuming that last year the company
has paid back 10 million Euro of long-term debt.
l The company’s stock has a beta of 1.5. The current risk-free rate of return is 3%. Calculate the company’s cost of equity using a
market risk premium of 8%.
l Use the Flow to Equity method to give an approximation of the company’s value, assuming that in the following years the
company will not change its debt level but otherwise deliver perpetually the same Cash to Equity as last year.
l Machinetec’s pays an average interest rate of 8.3% on its long-term debt and pays corporate taxes of 50%. Assuming that the
market value of its equity is 130 million Euros, what would be its WACC?
l Can you evaluate again now the company’s equity using a Free Cash to the Firm/WACC approach?
l What would be the cost of capital value of the firm’s equity in case it had no debt and no tax shields?
l What would be the value of the firm’s equity in case it had no debt and no tax shields?
l What is the present value of the tax shields if the company permanently keeps the current debt level? Use the APV approach to
determine the value of tax shields.
l What is therefore the value of the firm’s equity determined with APV?
l What is the company’s Price/Earnings ratio? The average P/E ratio of the machinetool industry is 8. How could you explain the
difference?
7.Asymmetric Information I: Moral Hazard
 Moral Hazard
 Adverse Selection
Capital Structure and Enterprise Value
What we have done so far:

- MM without taxes:
 Capital Structure does not matter.
 Not consistent with evidence.
- MM with taxes and Bankruptcy costs (Tradeoff Theory):
 Seems to explain some observations.
 But there are many exceptions.
 Quantitative predictions are very far from reality.
- Next attempt:
 Remove the assumption that future Free Cash Flows are not affected by capital structure, i.e. capital structure affects
investment and management decisions.
Capital structure affects investment and management decisions
Assumptions so far :
- Management and Shareholders maximize enterprise value

- Make all investments with positive NPV, avoid investments with negative NPV.
- This will determine future Free Cash Flows
Why would they do something different, if capital structure changes?
Why does capital structure impact Free Cash Flows?
Answer Nr. 1 Conflicting Objectives
 Optimal decision for firm ≠ Optimal decision for management or shareholders.

 This creates Moral Hazard.
 Conflicts of interest are affected by capital structure.
 These conflicts are analysed by Agency Theory.
Answer Nr. 2 Information Content of Financing Actions
 Financing decisions can be understood as a signal.

 This will impact the firm value because of Adverse Selection.
 These situations are analysed by Signalling Theory.
Both of these theories build on the economics of asymmetric information.
The economics of asymmetric information vs. traditional economics
 The Modigliani/Miller framework is the corporate finance equivalent of the traditional Arrow/Debreu world in economics.
 In this world there are essentially no good reasons for why bad decisions are taken.
 A firm will always realize all positive NPV projects and maximize its value.
 Financing decisions will not affect this value.
 This “value preservation principle” allows us to obtain quick but often approximate solutions for many problems in finance.
 In the 1970s Joseph Stiglitz, Michael Spence and George Akerlof developed formal arguments for why rational decision makers
take suboptimal decisions.
 Their key insight was that in many situations we have “information asymmetry”, i.e., a situation where one decision maker has
better information than another. This information asymmetry cannot be easily overcome because credible communication is
not possible.
 Together with the evolution of game theory this led to the evolution of modern Microeconomics with many applications to
questions of optimal firm behaviour, market design, regulation etc.
 In finance these theories can help to explain why and how financing decisions affect firm value.
Moral Hazard and Adverse Selection
Asymmetric information appears in two forms:
 Asymmetric information about actions => Moral hazard => agency/incentive problems
 Asymmetric information about characteristics (quality) => Adverse selection => market failure
In both types of situations free markets will lead to a suboptimal outcome (so called « second best »). Different financial structures,
regulations and appropriate market design can then improve the functioning of the market (approach « first best »)
Agency Problem N1: Shareholder Creditor conflicts

We know that because of limited liability /option characteristics of debt and equity:
- Shareholders benefit from high profits.

- Creditors suffer from high risk.
Therefore, Shareholders and Creditors do not have the same objectives:
- Creditors want the company to be managed for low risk.

- Shareholders want the company to be managed for high profitability and high risk.
This conflict can lead to suboptimal decisions on the part of shareholders.
Example:
Farine SA has a low-risk strategy producing a stable enterprise value (EV) of 100. With a more aggressive corporate strategy the
company could achieve a future EV of 40 or 140 (with prob. 50%)
Case Nr. 1: What is the current EV if the firm is unlevered?
Case Nr. 2: What is the EV if the company is financed with long term loans having a face value of 70
To determine EV, determine for both strategies:
- Today ’s company value

- The value of equity
- The value of debt
- Repeat with a loan value of 40.
- Safe strategy: EV=100

- Risky strategy: EV= 90
 With 0 debt, EV=EU: Safe strategy will be implemented
 With 70 debt: Safe strategy: EL=100-70=30; Risky strategy: EL = (140-70) *0,5+ 0*0,5=35
⇒ Risky strategy will be implemented!
⇒ EVL= 90 ≠ EVU= 90, DL +EL =EVL ⇒ DL =EVL –EL =55
Leverage transfers 15 in value from creditors to shareholders but creates agency costs of 10. Overall shareholders are still benefitting,
despite a reduction in enterprise value of 10.
Conclusion 1: Leverage and Risk-Shifting
l The upside potential of high risk is captured by shareholders whereas the downside potential is absorbed by creditors.
l Therefore, shareholders can increase the current (= expected future) value of shares by choosing a risky strategy.
l This is more profitable if the company has higher leverage.
l This behaviour is referred to as “risk shifting” or “asset substitution”.
l It can lead to the choice of inferior but risky projects by the company’s management if the company is too highly levered.
Who bears the agency costs?
In the previous example the lender loses money: He provides a loan of 70 that after the increase in risk is valued at 55. A smart bank
will protect itself with a high interest rate. At what rate would the bank accept to finance the loan of 70?
(40+x)/2=70 ⇒ x= 100 (interest rate 100/70-1=42%)
The bank will only lend if in case of success if it receives 100.
In this case the value of equity will become EL = (140-100) *0,5+ 0*0,5=20. ⇒ The shareholders suffer from their own behaviour!
Conclusion 2: Risk shifting that is anticipated by creditors hurts shareholders
l If risk shifting is anticipated by the creditors, they will protect themselves with high interest rates.
l In this case the reduction in EV will translate into a reduction in the equity value.
l Can the shareholder avoid this? This depends on asymmetric information.
l Suppose the creditor does not observe the shareholders risk shifting? Does the shareholder have incentives to shift risk?
l Answer: Ex ante the shareholder has incentives to commit to not shift risk, ex post after the loan is awarded, he will always shift
risk.
l Commitment devices: Governance structure, loan covenants etc.
Leverage and Firm Value with risk shifting

Discussion: Which firms are likely to suffer most from risk shifting?
Firms with a potential for risk-shifting by management will lose value if financed with too much debt. These firms should be financed
by equity or more sophisticated financial contracts (convertibles, preferred stock etc.). Two conditions for risk shifting:
- There exist many strategic options with different risk.

- Creditors cannot distinguish between these different choices.
Applies to: Startups, high tech firms, firms that are in a reorientation phase etc. Does not apply to: Utilities, mines etc.
Credit Rationing
Companies often claim that banks don’t provide loans despite the fact that they have safe and profitable investment projects. This is
surprising: Why do banks not exploit this opportunity? Answer: asymmetric information:
Assume that the company in the previous example needs a loan of 92 to finance the project yielding a safe 100. Will the bank provide
the loan? No, because… the firm implements the risky project which yields 90<92. Hence: Some companies with valuable investment
projects cannot be financed by debt. If the bank awards a loan the firm, it will shift to a highly risky, but unprofitable strategy.
Summary: Risk and Shareholder Value
Increasing risk will often increase shareholder value. They gain from the upside. No increased losses on the downside. On average
their payoff will increase. Risk shifting can increase shareholder value even though Enterprise value will go down. With rational
lenders shareholders suffer from their own risk-shifting. Firms with high potential for risk shifting should not use too much debt.
In many cases the potential for risk-shifting will lead to credit rationing, where banks do not want to finance profitable projects even
at high interest rates.
Underinvestment/ Debt Overhang

The Underinvestment/ Debt Overhang problem is a specific variant of the general « risk shifting » problem. Making new equity
investments in a risky firm will decrease the risk for creditors. This benefits creditors and harms shareholders. Shareholders of highly
levered companies will therefore often not be able to capture the return on their new investment. In this case they will renounce to
make profitable investments.
Example:
A company has existing assets and a new investment project with the following anticipated cash flows:
Year 1 2
Existing Assets 100 50
Investment Project-75 100
If we set the discount rate to zero we find:
PV (Existing Assets) = 150
NPV (New Investment) = 25
The project is profitable and will be carried out if the company is equity financed. Lets assume that the company has debt promising
a flow of 100 in period 2 :
Period 1 2
Existing Assets 100 50
Investment Project -75 100
Debt -100
What is the value of the debt?
Conclusion: Shareholders are reluctant to invest money in a highly levered company because the wealth generated by this
investment mainly benefits the creditors. Essentially the equity injection would reduce risk and therefore have a negative effect on
shareholders. As before, if creditors anticipate this underinvestment behaviour, it is the shareholders who will suffer from their own
behaviour.
How can the problem be solved or at least reduced?
Possible Solutions:
l Avoid high leverage.

l Limit dividend payments.
l Renegotiate debt.
l Choose debt with short horizon.
Applications
 Gambling for Resurrection: The “risk shifting” problem is particularly important if the company is close to bankruptcy.
Profit for shareholders with a reasonable strategy: probably nothing because the company is already bankrupt.
Loss in case of failure of a risky project: nothing because everything is already lost.
Therefore, banks often prefer to liquidate companies which are close to bankruptcy.
 Take the Money and Run: Similar to explicit risk shifting, risk shifting through underinvestment becomes especially important
in companies that are close to bankruptcy. A company can then even make negative investments: Shareholder will liquidate
profitable projects to have the cash paid out as dividends. This is called the “Take the Money and Run” strategy.
 Structuring Venture Finance: Venture Capitalists almost never use debt to finance start-ups. Reason: Start-up companies have
many strategic options; it is therefore almost impossible to control the risk of a start-up company; pure debt finance would
provide high incentives for risk shifting.
Convertible debt in Venture => Finance Venture finance mostly uses “convertible preferred stock”. This is a security with debt
like features that can be exchanged into a certain number of shares. Conversion will take place is the company is very successful
and dilute the wealth of the Manager/Owner. This has two effects:
- By reducing the upside for the Manager/Owner it reduces incentives to increase

risk
- If the Manager/Owner nevertheless shifts risk the investor will participate
 Flight Security and Leverage: It has been shown that more highly levered airlines have more small technical problems. Reason
is Under Investment in maintenance. Example: Xavier Niel has recently taken the group private. The operator's shares were
finally delisted from Euronext Paris from October 14 following a squeeze-out offer. Since then, Iliad has entered the high-yield
debt market, placing a €3.7 billion ($4.2 billion) four-tranche bond issue with European and American investors.
Example: Financing Start-up Firms with many Strategic Options / Risk Shifting
Outside Investment of 5m needed to start a company. The owner-manager has two possible strategies.
- low risk/high expected return: Value of the company always 6m, expected return 20%
- high risk/low expected return
• Proba 50%, Strategy unsuccessful: Value 0
• Proba 50%, Strategy successful: Value 10
• Expected value 5m, expected return 0%
Excessive Risk Taking with Debt Finance
- Financing with debt:

o suppose owner chooses risk-free strategy. He will make a benefit of 6m-5m=1m
o suppose he chooses the risky strategy. He will make an expected benefit of 0.5*(10m-5m) = 2.5m. Hence, he will
always choose the risky strategy.
- Additional Problem: the bank will not provide debt of 5m because the interest rate would be prohibitive.
- Debt financing is not feasible!
- Financing with Equity: Sell 5/6 of the shares to outside investor:
o Payoff for entrepreneur: with safe strategy 1m and with risky strategy 1/6*10*0,5=0.83.
- He will choose safe and profitable strategy.
Example: Convertible debt can solve the problem!
- Financing with convertible debt: Bank has the right to convert debt into 82% of the firm’s capital.
o suppose owner chooses riskless strategy. Will the bank convert? No because 0,82*6m<5m.
o suppose he chooses the risky strategy.
 In case of the successful outcome the bank will convert because 10*0.82=8.2>5. Only 1.8 will remain for
the initial owner.
 In case of the unsuccessful outcome the bank will not convert and try to squeeze the max out of the
bankrupt firm.
 Expected profit for owner 0.9.
- The owner has no incentive to increase risk and debt financing becomes feasible.
- Value of convertible debt will be less information sensitive than equity value.
Example: Shareholder - Creditor Conflicts and Capital Structure Choices
- A company has 100 which it can invest in projects A or B with the following characteristics:
o Project A: 105 or 115 with 50% probability
o Project B: 160 or 50 with 50% probability
- We assume for simplification risk neutral investors and a zero-discount rate.
o What is the NPV of both projects?
o What is the company value with100% equity and with debt of face value of 70?
o If creditors anticipate the shareholder ’s behaviour how much will they ask to be reimbursed for investing 70?
o What will be the value of shares in this case?
o What will the shareholders do?
- Project C :180 or 0 with probability of 50%
Agency Problem N2: Management - Shareholder conflicts

External and Internal Equity
- The separation of ownership and control/management creates the second classic agency problem.
o The manager (agent) will not entirely work in the interest of the shareholders (principals) agent (Manager).
 Not work hard, exploit private benefits, avoid risk
o This conflict between shareholders and managers implies that firms with outsider shareholders are less efficient
than owner - managed companies.
o Shareholders can try to improve the manager’s performance with an incentive contract, but as long as they have
imperfect information about the manager’s actions the problem will not disappear.
Example: Insufficient Incentives with outside Equity
Two options:
- Fly economy class:

ticket costs: 200, Value of frequent flyer miles 50
- Fly first class:
ticket costs 1000, Value of frequent flyer miles 250
100% Management Ownership: Cost/Benefit to Manager
Economy class: -200+50=-150
Business class: -1000+250=-750
He chooses economy.
15% Management Ownership: Cost/Benefit to Manager

Economy class: 0.15* (-200) + 50= 20
First Class: 0.15 *(-1000) + 250= 100
He chooses first class.
Examples of Manager-Shareholder Conflicts
 Private benefits / perquisites (perks): see above.

 Quiet life: low effort can be understood as another form of private benefits.
 Entrenchment: Contractual or organizational arrangements that make it difficult to replace existing management.
 Empire building: Management wants size, shareholders profitability.
 Overinvestment: Invest in negative NPV projects to increase company size
 Prestige Projects: Add to the management’s reputation but not necessarily to firm value.
 Excess Risk aversion: Management wants low risk because their human capital is tied to the company.
Reducing Manager Shareholder Conflicts with incentive contracts
In principle agency conflicts can be reduced by providing incentives. These incentives will work better if there is less asymmetric
information. Incentive contracts:
- Provide management with a share in the value they contribute to the firm.
- Bonus payments, stock options, partial ownership.
Empirical evidence on management incentives
Jensen, M. C., & Murphy, K. J. (1990). Performance pays and top-management incentives. Journal of political economy, 98(2), 225-264.
“CEO wealth changes $3.25 for every $1,000 change in shareholder wealth”
Jensen’s conclusion: Top Management Incentives are insufficient.
Problems: Management should not be remunerated for an increase in value that is not related to their actions, incentive contracts
cannot achieve “first best”, provide “informational rents” to agents (Management).
Terminology
 The mathematical analysis of incentives i.e., the “moral hazard problem” is called “agency theory”, which is part of a field of
Microeconomics/ Game theory called “contract theory”.
 Agency Theory: How to provide someone (an “agent”) with the incentives to do what somebody else (the “principal”) wants
him to do
 Contract Theory: Because incentives are normally specified in a contract (implicit or explicit).
 Moral Hazard: Because the agent does not exactly do what the principal wants him to do.
 Imperfect Information: Because if you have perfect information about what the agent does it is possible to provide perfect
incentives.
The 2016 Nobel Price in Economics for Contract Theory
- (actually, Sveriges Riksbanks Prize in Economic Sciences in Memory of Alfred Nobel 2016)
- Oliver Hart and Bengt Holmström have worked in particular on the tension between insurance and incentives and ssymmetric
Information vs. incomplete contracts.
Example: Reducing Agency conflicts with incentive contracts

Field can produce wheat with value of 50 or 100.
Agent (farmer) has two effort levels:
 High: cost of effort 5, Probability of 100= 80%, probability of 50=20%

 Low: cost of effort 0, Probability of 100= 50%, probability of 50=50%
“First best” solution with symmetric information: Pay 5 to farmer if he works hard: Overall Surplus: 0,8*100+0,2*50-5=90-5=85
“Inefficient” solution with asymmetric information: Pay 5 to farmer: Inefficient surplus: 0,5*100+0,5*50=75
Example: Agency conflict
“Second best” solution with incentive contract: Pay contingent wage w50 > 0, w10 0> 0.
Agent only invests effort if (Incentive constraint): 0.8*w100+0.2*w50-5 > 0.5*w50+0.5*w100.
Agent only accepts job if (Participation constraint): 0.8*w100+0.2*w50-5 > 0.
The solution is w100=8.3, w50=-8.3 but negative wages are normally not feasible. This solution means that all the risk is absorbed by the
agent/worker.
Solution with non-negative wages:
The cheapest solution with non-negative wages is w50=0, w100=16,6. (give 50 +1/3 or remaining harvest) The agent makes an average
gain (information rent) of 8,3.
The owner receives 90-8,3=81,7 which is still better than 75 without effort
Solution for reducing the risk
Reduce the risk for the worker, by increasing w50 and decreasing w100=16,6. but then, he will again not work hard.
In more realistic models with more than 2 effort levels and risk averse agents
- the agent will never invest the optimal effort level.

- the principal will never pay a wage of zero.
Takeaway: Normally incentive contracts cannot achieve optimal –” first best” outcome and provide informational rents (Holmström,
1979).
Only solution: Reduce asymmetric information
If the information asymmetry is reduced, 1) more surplus is generated and 2) informational rents are reduced.
Example: Amazon.
Summary: Agency Theory/Understanding Incentives
In a world with perfect information, delegation of tasks has no negative effects.

 The “principal” specifies a task, the “agent” perfectly executes this task according to these specifications and gets
compensated for his costs.
 Example: Unload a truck
With imperfect information about the agent’s actions this is not possible anymore:
 The principal cannot observe how well the task is carried out; he only sees the result which is imperfectly correlated with
the quality of the work.
 An “incentive contract” may improve the agent’s effort but leads to “informational rents.”
 Example: grow wheat
Where would we expect to see important management/shareholder conflicts?
l Firms that are likely to suffer from managerial agency costs.

- (Partial) Separation between Ownership and Management
- Asymmetric Information concerning the Management’s actions
- High Free Cash-Flow that can be turned into private benefits (“Free Cash Flow Problem”, Jensen,1986)
l Examples
- listed companies with fragmentent uniformed shareholders.
- Mature industries with profitable businesses and few investments.
Reducing Managerial Agency Costs
l “Free Cash Flow” problem.

 Can be solved with high leverage:
 Debt reduces the cash flow that can potentially be wasted by the management.
l Focus on Core business.
 The performance of a company with only one business line is easier to evaluate.
 Manager’s payoff is more tightly tied to the business performance.
l Invest in easily understandable/short term strategies.
 Principals may prefer businesses with low information asymmetries.
Leverage and Firm Value with risk shifting
Applications: Stock Options

 Stock Call Options are call options on the firm’s shares, given to the management.
 This is a simple form of incentive payment.
 Normally the strike price is equal to the current stock price.
 Until recently this form of remuneration had no impact on accounting costs.
Corporate Governance: is the set of mechanisms that are destined to ensure that the firm is managed in the interests of the
shareholders.
o Executive Contracts (to provide incentives)

o Board structure and (to reduce asymmetric information)
8. Asymmetric Information I: Adverse Selection
9.Recent Research on Capital Structure
10.Course Wrap-up

Advanced Corporate Finance

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ADVANCED CORPORATE FINANCE Prof.

 Advanced Corporate Finance

 What else for starting a successful career in Finance

Course Philosophy: Concepts not techniques

 Understand the “why” not the “how”

 Economic mechanisms behind financial operations

 Motivations behind financial strategies

 Origin of value creation

 We will review but not focus on

 Basic tools and techniques

 Institutions and procedures

Examples: Recent Financial Transactions

 Exemple 1: Iliad going private

 Why does the bond value decline?

 Exemple 2: 20 year old Jake Freedman makes 80 million in 3 months

 Activist investment strategy

 Realize that convertible bonds increase in value with risk

Stock is azioni in Italian

Is it good if a company goes private?

 Financial Statements+ Ratios

2. Present Value and its pitfalls

 Alternative ways to determine discount factors

3. Valuing Bonds, Stocks and Investment Projects

 Expected and promised yields

 The Gordon Growth Model and its implications

4. How not to create value (Modigliani Miller)

 Leverage and EPS games

 Basic Merger Economics

5. Risk and Capital Structure

 Valuing Tax shields

 Bankruptcy and its costs

6. Option Theory of Capital strucure

 Another way of valuing risk debt and equity

 Risk and Value

7. Applied Valuation and its Pitfalls

 Basic valuation methods

8. Moral Hazard and Agency Costs

 Management Shareholder conflict

 Creditor Sharehodler conflict

9. Adverse Selection and Pecking Order

 Announcement effects of financing decisions

10. Current Topics

 Capital strucutre and strategy

 Behavioural corprorate finance

What should you know?

 Accounting and Financial Modelling

 Financial Mathematics and Basic Asset Pricing

 We will review most of this quickly

 Applied Investment Banking

 Financial Institutions Management…

The three Theoretical Frameworks used in Finance

1. Classic Finance with perfect markets

 Identically informed and rational decision makers

 Modigliani Miller Theorems, CAPM, Option Pricing

2. Asymmetric information: Incentives and adverse selection

 Agency Theory, Signaling, Market Failures…..

 Irrational decision makers

 Class participation & Wooclap: 20% of the final grade

 If you hand in part of the assignments they will contribute pro-rata.

 Corporate Finance, Jonathan Berk Peter DeMarzo

 A First Course in Corporate Finance, Ivo Welch,

 Case Studies in Finance, Robert E. Bruner,

 Advanced Corporate Finance, Ogden, Jen, O’Connor