Objective of a Firm

• Maximize the value of the firm (stock price)

• Maximize sales, profits, market share???
• But how to measure the value of a firm?
– Through efficient markets (stock price)?
– By adding the present values of the projects
undertaken?
– By its growth opportunities?
 Corporate Finance
• Attempts to measure return on proposed
investment decision and compare it to minimum
acceptable Hurdle rate.
• Hurdle rate has to be set higher for riskier projects
and reflect the financing mix used (Equity, Debt)
• Chapter 3 defines risk and its measures
• Chapter 4 looks at converting risk into a hurdle
rate – minimum acceptable rate of return both
for the entire business and individual projects.
 Three Principles of Corporate Finance

1. Investment principle: which project to accept?

How to evaluate projects?
2. Financing principle: debt (borrowed money),
equity (owners’ funds), hybrid (preff. stock )
3. Dividend policy:
– Return earnings to owners as dividends or stock
buybacks?
– Or reinvest in new projects?
 Question.
• An investment opportunity - office building venture -
allow you yield a certain return of $420,000 two
years later. It costs $50,000 for purchasing the land.
The construction will take two years and the request
payment on the following schedule:
• $120,000 down payment now.
• $100,000 progress payment after one year.
• final payment of $100,000 at the end of second year.
• Should we implement this investment project?
 In order to answer we need:
• Formulas to find the Present Values (PV) of the
cash flows.
• Discount rate for discounting to PV.
• Decision tools and rules.
PV formulas
PV formulas
 Example
• As a successful business person, decided to give a
lump sum donation to IUJ to establish a permanent
chair professor position with your name on.
• The position should pay annual $110,000 for the
professor’s salary and a secretary.
• The university did some calculation and requested
you to donate $5.5 million now.
• Is it a reasonable amount? (assume discount rate is
6%)
 How to find discount rate?
• Discount rate will depend on the risk involved
in particular project or asset.
• Thus we need to understand what is risk and
how to measure it.
• Using risk measure we can calculate discount
(hurdle) rate for the project.
 What is risk?
• In simple terms risk can be defined as: “spread
of actual returns around expected return”
• Risk is measured by Variance or Standard
Deviation
• The greater the deviation of actual returns
from expected returns, the higher the risk
 What is portfolio?
• A portfolio is a collection of various
assets/liabilities (i=1,2,... n) whose shares, wi ,
in the portfolio are calculated based on the
market value (Vi = Present Value of expected
cash flows associated with the asset/liability)
Risk types
Firm-specific risk vs Market risk
 Firm Specific and Market Risk
• The R squared (R^2) of the regression provides
an estimate of the proportion of the risk
(variance) of a firm that can be attributed to
market risk.
• The balance (1 – R^2) can be attributed to firm
specific risk.
• The firm-specific risk is diversifiable and will
not be rewarded
Risk levels
 Challenge question
• Suppose a Bank offers interest of 1% per
month.
• This quoted monthly rate really means that
you are paying 1% per month, and this will
cumulate over the year.
• If you accept the offer and get $1000 credit,
What would be your total interest expense at
the end of the year?
 Risk free rate
• The risk-free rate is usually represented by
one of the U.S. Treasury securities.
• If the unit of the period for the analysis is one
year, the one-year maturity Treasury-bill rate
will be used; if the unit period is 6 months, we
will use the 6-month maturity Treasury bills
 Discount rate
• The discount rate, r, is assumed to be constant
over time for simplicity (otherwise, we must
take into account the term-structure effects).
• CAPM: r = rf + Beta*(risk premium)
• The risk premium is how much market
investors require, as an additional rate of
return over the risk-free rate, to compensate
for their risk-taking with the asset.
 CAPM
• The Capital-Asset-Pricing Model (the CAPM) is a market-equilibrium model
which captures the idea of the risk premium reflecting the
correlation/covariance of the asset return with the overall portfolio return.
• The Capital-Asset-Pricing Model is based on following assumptions:
– Investors judge portfolios according to the mean and variance values,
– All risks are tradable
– No taxation and no transactions costs,
– Full and symmetric information regarding the probability distributions of security
returns, among others.
• CAPM concludes that the risk premium of the individual asset can be
related to market-portfolio risk premium , by the relative-volatility measure
of the asset which is called the “beta” of the asset: market portfolio.

• The CAPM also tells us the risk premium is calculated based on covariance
 Beta
• Beta is sensitivity of a stock returns to the return on the market portfolio.

• The risk of any asset is the risk that it adds to the market portfolio
Statistically, this risk can be measured by how much an asset moves with the
market (called the covariance)
• Beta is a standardized measure of this covariance, obtained by dividing the
covariance of any asset with the market by the variance of the market. It is a
measure of the non-diversifiable risk for any asset can be measured by the
covariance of its returns with returns on a market index, which is defined to
be the asset's beta.
 Equity Beta and leverage
• The beta of equity alone can be written as a function
of the unlevered beta and the debt-equity ratio
• βL = βu (1+ ((1-t)D/E))
where
• βL = Levered or Equity Beta
• βu = Unlevered or Asset Beta
• t = Marginal tax rate
• D = Market Value of Debt
• E = Market Value of Equity
 Financial leverage
• As firms borrow, they create fixed costs
(interest payments) that make their earnings
to equity investors more volatile.
• This increased earnings volatility which
increases the equity beta.
 Unlevered beta example
• The regression beta for Disney is 0.95. This beta is a levered
beta (because it is based on stock prices, which reflect
leverage) and the leverage implicit in the beta estimate is the
average market debt equity ratio during the period of the
regression (2004 to 2008)
• The average debt equity ratio during this period was 24.64%.
• The unlevered beta for Disney can then be estimated (using a
marginal tax rate of 38%)
• Unlevered beta = Current Beta / (1 + (1 - tax rate) (Average
Debt/Equity))
• = 0.95 / (1 + (1 - 0.38)(0.2464))= 0.8241
 Betas are weighted Averages
• The beta of a portfolio is always the market-value
weighted average of the betas of the individual
investments in that portfolio.
• Thus,
– the beta of a mutual fund is the weighted average of
the betas of the stocks and other investment in that
portfolio
– the beta of a firm after a merger is the market-value
weighted average of the betas of the companies
involved in the merger.
 Bottom-up versus Top-down Beta
• The top-down beta for a firm comes from a regression
• The bottom up beta can be estimated by doing the following:
– Find out the businesses that a firm operates in
– Find the unlevered betas of other firms in these businesses
– Take a weighted (by sales or operating income) average of these
unlevered betas
– Lever up using the firm’s debt/equity ratio
• The bottom up beta is a better estimate than the top down beta
for the following reasons
– The standard error of the beta estimate will be much lower
– The betas can reflect the current (and even expected future) mix of
businesses that the firm is in rather than the historical mix
 Calculating risk premium
• This is the default approach used by most to arrive at
the premium to use in the CAPM model
• In most cases, this approach does the following
– Defines a time period for the estimation (1928-Present,
1962-Present....)
– Calculates average returns on a stock index during the period
– Calculates average returns on a riskless security over the
period
– Calculates the difference between the two averages and uses
it as a premium looking forward.
 Intercept and Jensen’s Alpha
• The intercept of the regression provides a simple measure of
performance during the period of the regression, relative to the
capital asset pricing model.
• If Intercept > Rf (1-b) Stock did better than expected during
regression period
• If intercept = Rf (1-b) Stock did as well as expected during
regression period
• If Intercept < Rf (1-b) Stock did worse than expected during
regression period
• The difference between the intercept and Rf (1-b) is Jensen's
alpha. If it is positive, your stock did perform better than expected
during the period of the regression.
 Jensen’s Alpha example
• Intercept = 0.47%
• This is an intercept based on monthly returns for Disney. Thus, it
has to be compared to a monthly riskfree rate.
• Between 2004 and 2008
– Average Annualized T.Bill rate = 3.27%
– Monthly Riskfree Rate = 0.272% (=3.27%/12)
– Riskfree Rate (1-Beta) = 0.272% (1-0.95) = 0.01%
• Jensen’s Alpha = 0.47% -0.01% = 0.46%
• Disney did 0.46% better than expected, per month, between
2004 and 2008.
• Annualized, Disney’s annual excess return = (1.0046)12-1= 5.62%
 Cost of Capital
• The cost of capital is the “market” required rate of
return with the appropriate amount of risk premium
which reflects the uncertainty of the project cash flows.
• It is not a subjective discount rate set by any individuals
in the management team. Consider this: In the case of
internal financing, which is the most popular method of
project financing, shareholders’ money is used. Retained
earnings could also be used to pay shareholders’
dividends.
– the opportunity cost of the retained earnings should be
judged based on the shareholders’ investment opportunities
in the market.
– The management team has the fiduciary duty to maximize the
shareholders’ wealth
 Company Cost of Capital
• Company Cost of Capital: the expected return on
a portfolio of all the company’s existing
securities.
• It is the opportunity cost of capital for investment
in the firm’s asset.
• Firm Value = PV(AB) =PV(A) + PV(B)
• Note: Project A and B are discounted at a rate
reflecting the risk of each project.
• Question: If there is a new project C, HOW TO
PICK the discount rate?
 SUM UP
• What is cost of equity?
• What is cost of debt?
• What is cost of capital?

• What is value of company?

• What is value of project?