Professional Documents
Culture Documents
Introduction To Corporate Finance
Introduction To Corporate Finance
Objective
● Maximise firm value
CF
○ Measured by →
risk
■ Increase cash flow = value goes up
■ Decrease risk = value goes up
Value
● Problem → How do you determine the premium for something that’s better (e.g. rooms that are
closer to lifts)?
○ E.g. isochrones for location differences
■ Focus on the objective (where the value lies) → to get to the place faster
Investment Selection
● Determines the Project CF (adjusted for risk)
○ A discount rate takes account of the time value of money to commensurate dollars earned in
the future with their purchasing power today
○ In addition to the time horizon, the level of risk involved in an investment or project that can
create volatility in future cash flows should be taken into account
○ There are several ways to incorporate risk into the discount rate; but in any case, the greater
the perceived risk, the higher the discount rate adjustment
Investment Criteria
● Use IRR & NPV
○ NPV discounts using WACC
○ IRR is compared against WACC
● WACC indicates a level of risk → determined by the market (look at the history, based on how they
think the company will fare in the long run)
● WACC is adjusted (made higher/lower) according to the project (e.g. human capital assets vs
cryptocurrency project)
Risks
● Differs in the Investment Selection & Financing Sources
○ Investment Selection → risk the company takes on (projects’ risks)
○ Financing Sources → risk involved in investing in the company itself (determines the amount
at which people are willing to pay)
Private Equity
● Not open to public/not traded on public exchanges
● Accessible to a select group of investors
Investment Decisions
● Capital Budgeting (long-term decisions)
○ How to identify the most productive assets & opportunities to invest in, to maximise returns
(& lower risk if possible)
● Working Capital Management (short-term decisions)
○ How to balance short term assets & liabilities to ensure that we can meet day-to-day
expenses without holding too much idling assets & sacrificing revenue
Dividend Decisions
● How much profits to keep in the business to reinvest in new opportunities
● How much to return to the equity holders (owners) when the expected returns on new opportunities
are not attractive
Decision Rule
● If NPV is positive, accept the project
● NPV = the difference between the expected revenue less costs, represented in the free cash flow form
(not the accounting form) & adjusted for time value of money
○ A negative NPV of -5,000 means that we are paying 5,000 to invest in a project that returns
no cash inflows in the future
○ Thus, a positive NPV means that the project is expected to add value to the firm and will
therefore increase the wealth of the owners
● Since our goal is to increase owner wealth, NPV is a direct measure of how well this project will meet
our goal
Example
● Based on the NPV method, should you accept a project with the following cashflows?
Discount rate: 12%; Year 0: -$100, Year 1: $8, Year 2: $45, Year 3: $90
○ (use CF function of financial calculator) → Yes, the NPV is +ve at $7.08
BOND VALUATION
Key Components
● Par value/face value
○ Principal amount that issuers promise to repay bondholders
○ Value differs from the market value of the bond
● Coupon rate
○ Interest payments quoted as a % on par value
Annual Coupon
○
Par Value
● Maturity date
○ Date that the issuer redeems the bond at face value
● Yield to maturity (YTM), i.e. bond “yield”
○ Required market interest rate on the bond
○ Vs Yield to call: While YTM provides a measure of the average annual return if the bond is
held until maturity, YTC accounts for the possibility of an early call and calculates the
potential return based on that scenario
■ Early call happens when market risk becomes lower than agreed risk → company
does refinancing, e.g. returns all bond priced at 8% coupon rate & resells bond at 6%
(current market) coupon rate
Concept
● Primary principle for computing value of financial securities → Value of security = PV of expected
future cash flows
● Bond has 2 cash flow streams → coupons & par value
● Bond value = PV of coupons + PV of par value
○ I.e. Bond value = PV of annuity + PV of lump sum at maturity
● Recall: when interest rates increase, bond prices (PV) decrease & vice versa → PV = FV / (1 + r)t
Example
● FTY Inc's bond has a YTM of 6% (APR). What should be its current price to the nearest dollar if the
bond matures in 8 years, pays a 5% semi-annual coupon? Assume the par value is $1000.
○ N=8x2=16, I/Y=6%/2=3%, PMT=2.5%x1000=$25, FV=$1000, CPT PV=-937
STOCK VALUATION
Concept
● Value of a stock = PV of the future dividends expected to be generated by the stock
○ Reduced to:
● As it increases, the following will increase the current value of a stock according to the dividend
growth model → dividend amount (D); number of future dividends, given the current number is <
infinite (t); dividend growth rate (g)
○ X discount rate (r)
● SML → representation of market equilibrium, with its slope = to the reward-to-risk ratio
● Since the beta for the market is always 1 (i.e. the risk of the market to itself is 1), the slope can be
written as simply E(RM) – Rf, which is known as the market risk premium
Concept
● The risk premium for any security is proportional to its beta with the market – William F. Sharpe
(Nobel Laureate, 1990)
● Recall: only systematic risk should be priced & we can measure systematic risks using beta (the
sensitivity of a stock’s return to the market returns)
○ Thus, if we know an asset’s systematic risk, we can use the CAPM formula to determine its
expected return
Illustration
Efficient Frontier
● Comprises investment portfolios (containing only risky assets by default) that offer the highest
expected return for a specific level of risk
● Illustrates the trade-off between risk and return for a portfolio of risky assets
● Dots (including suboptimal ones): different portfolio combinations where only systematic risk is
considered
○ Because of CAPM assumption: investors are rational, risk-averse, and well-diversified; they
hold portfolios that eliminate idiosyncratic risk
Capital Market Line
● Represents all the portfolios that optimally combine the risk-free rate of return & the market portfolio
of risky assets
○ While the theoretical concept of the CML is often associated with the entire market, in
practice, a broad market index might serve as a practical approximation of the market
portfolio (e.g. S&P 500 index as proxy for the market portfolio in the U.S.)
● A special case of the capital allocation line (CAL) where the risk portfolio is the market portfolio
○ Slope of the CML → Sharpe ratio of the market portfolio
● Points
○ Rf → 100% invested in risk-free asset
○ Between Rf & M → mixed investment in risk-free asset & risky assets
○ M → 100% invested in risky assets
■ Tangency portfolio → intercept point of CML & efficient frontier, most efficient
portfolio
○ Points above M along CML → use leverage (debt): borrow at RF (allowed by CAPM
assumption, though in reality not always at RF rate & can alter CML’s slope) & invest in
market
■ Increased return & risk
■ Leveraged portfolio includes both risk-free & risky assets
● Slope of CML → Sharpe ratio of the market portfolio
○ Slope: influenced by the expected return of the overall market portfolio
○ If you are considering different combinations of risky assets in your portfolio, the slope of the
CML would generally stay the same as long as the market risk premium remains constant
● As a generalisation, buy assets if Sharpe ratio is above CML and sell if Sharpe ratio is below CML
● The decision between investing in a combination of risky assets only (on the Efficient Frontier) /
combining risky assets with a risk-free asset (along the CML) depends on the investor's risk tolerance,
return objectives, and financial situation
○ Combination of Risky Assets Only: suitable for investors who are comfortable with taking on
more risk in pursuit of potentially higher returns; might be appropriate for those with a
higher risk tolerance & a longer investment horizon
○ Combination of Risky Assets + Risk-Free Assets: suitable for investors who seek a balance
between risk and return; provides a more diversified approach, allowing investors to benefit
from both the guaranteed return of the risk-free asset and the potential upside of the risky
portfolio; often considered a more conservative approach
● The CML does encompass total risk (std dev), which includes both systematic and idiosyncratic risk;
However, the diversification assumption is that investors are actively managing and minimising
idiosyncratic risk by constructing well-diversified portfolio
EF & CML
● EF → about finding the best mix of risky assets
○ The Efficient Frontier is a curve that illustrates the trade-off between risk and return for a
portfolio of risky assets. It represents all possible combinations of risky assets in a portfolio,
and each point on the curve represents a different level of risk and return.
○ The curve is typically upward-sloping, demonstrating that, in general, higher expected
returns come with higher levels of risk. As you move along the Efficient Frontier, you are
adjusting the allocation of assets to find the optimal mix that maximises return for a given
level of risk or minimises risk for a given level of return.
○ The curvature of the Efficient Frontier is due to the fact that the returns of individual assets
in the portfolio are not perfectly correlated, and by combining them in different proportions,
investors can achieve various risk-return profiles.
● CML → builds on the EF by introducing the option of a risk-free asset; shows the optimal
combinations of a risk-free asset & a risky portfolio, considering the entire market's risk & return
○ The CML is a straight line that represents the risk-return trade-off when a risk-free asset is
combined with a risky portfolio. It is derived from the Capital Asset Pricing Model (CAPM),
which assumes a linear relationship between the expected return of an asset or portfolio and
its systematic risk (beta).
○ The CML starts at the risk-free rate and slopes upward, reflecting the additional return an
investor expects for taking on systematic market risk. The straight-line shape of the CML
results from the assumption that the risk-free rate represents the baseline return without
any systematic risk, and the additional return is a linear function of systematic risk.
○ The line is straight because, under CAPM assumptions, all investors are assumed to hold a
combination of the risk-free asset and the market portfolio (a well-diversified portfolio
representing the entire market). This combination results in a straight-line relationship
between expected return and beta.
Example (CAPM)
● You would like to combine a risky stock with a beta of 1.68 with U.S. Treasury bills in such a way that
the risk level of the portfolio is equivalent to the risk level of the overall market. What % of the
portfolio should be invested in the risky stock?
○ Beta of market = 1; Beta of risk-free = 0
○ Target beta portfolio: 1 = [Ws x 1.68] + [(1 - Ws) x 0]
○ Ws = 60%
WEIGHTED AVERAGE COST OF CAPITAL (WACC)
Cost of Debt
● Cost of debt → the interest rate (required return) on the company’s new borrowing
○ Interest rates on existing debt → technically the company’s current cost of debt, but may not
represent the company’s future borrowing power
○ WACC is a forecasting calculation → using average yield-to-maturity (YTM) on the company’s
long-term debt is more accurate
● We usually focus on the cost of long-term debt/bonds
● Main methods to calculate cost of debt
○ If company already has outstanding debt, use the YTM on those bonds as estimate for cost of
debt / use the company’s bond ratings to check the interest rate on the bonds with such
rating
○ Divide total interest expense over total debt (preferably expense for long-term debt over
long-term debt)
■ Assumes book value cost of debt = market value cost of debt
Cost of Equity
● Cost of equity → the return required by equity investors given the (business/financial) risk of the cash
flows from the firm
● Main methods for determining the cost of equity: dividend growth model, SML/CAPM
Weights
● We can use the individual costs of capital that we have computed to get our "average" cost of capital
for the firm
● This "average" is the required return on the firm's assets, based on the market's perception of the risk
of those assets
● The weights are determined by how much of each type of financing is used
● Notation
○ E = market value of equity = # of outstanding shares times price per share
○ D = market value of debt = # of outstanding bonds times bond price
○ V = market value of the firm = D + E
● Weights
○ wE = E/V = percent financed with equity
○ wD = D/V = percent financed with debt
Concept
● We are concerned with after-tax cash flows, so we need to consider the effect of taxes on the various
costs of capital
● Interest expense reduces our tax liability (i.e. tax shield / “refund”/”subsidy” from taxation)
○ Reduction in taxes → reduces our cost of debt
○ After-tax cost of debt = RD(1 – TC)
● Dividends are not tax deductible, so there is no tax impact on the cost of equity
● WACC = wERE + wDRD(1 – TC)
ADDITIONAL CONCEPTS
Return & Pricing
● Higher returns in the future implies higher risk
● Higher risk now means that assets require a lower price (low PV because of high risk)
Holding Companies/Special Purpose Vehicle (SPV)
● Project company → value: 10M
○ 50% loan-to-value (LTV) → secured
○ 50% (5M) equity from holding company
● Holding company
○ Can invest in multiple projects
○ 5M from
■ 2M equity
■ 3M debt (bonds) → unsecured → higher rates
Beneficial Interest
● Refers to a right to income / use of assets in a trust
● People with a beneficial interest do not own title to the property, but they have some right to benefit
from the property