corporate finance in a nutshell 2010

Corporate Finance in a NutshellCorporate Finance in a Nutshell

Corporate Finance

in a Nutshell

Daniel Smith – June 7th, 2010

in a Nutshell


1

How to get

money

Firm

Investor

Financial

MarketsBonds

Stocks

How to

spend

Goods

Markets

4

5

910

11

12


Toolkit

NPV Risk

Definition

Shortcuts

Extensions

<-> other methods

IRR, Payback, etc

Variance

Covariance

Beta

1

Owner Manager

2

36

7

8

13


How to get

money

Firm

Investor

Financial

MarketsBonds

Stocks

How to

spend

Goods

Markets


Toolkit

NPV Risk

Definition

Shortcuts

Extensions

<-> other methods

IRR, Payback, etc

Variance

Covariance

Beta

Owner Manager


The Need for a Firm

Money Talent

The Firm

1


• Legally distinct – pays its own taxes

• Limited Liability

4

Principal-Agent-Conflict

Investors Managers


The Managers Decisions

How to pay

for it

Investment

Decision

1


What to

buy

for it

The Firm

Financing

Decision


How to get

money

Firm

Investor

Financial

MarketsBonds

Stocks

How to

spend

Goods

Markets


Toolkit

NPV Risk

Definition

Shortcuts

Extensions

<-> other methods

IRR, Payback, etc

Variance

Covariance

Beta

Owner Manager


The Concept of Present Value

Assume we can lend or borrow at 10%

100 € 110 € 121 € 133,10 €

x 1,1x 1,1 x 1,1x 1,1 x 1,1x 1,1

2


t=0 t=1 t=2 t=3

100 € 110 € 121 € 133,10 €

/ 1,1/ 1,1 / 1,1/ 1,1 / 1,1/ 1,1




100 € 110 € 121 € 133,10 €

/ 1,10/ 1,10 / 1,11/ 1,11 / 1,12/ 1,12 / 1,13/ 1,13

2


t=0 t=1 t=2 t=3

100 € 100 € 100 € 100 €= = = =




97,67€ 107,44 € 118,18 €

/ 1,1/ 1,1

2


t=0 t=1 t=2 t=3

-100 €

/ 1,1/ 1,1 / 1,1/ 1,1

130 €


• Net Present Value Rule:


Cash Flow at time i

2


• NPV > 0: accept

• NPV < 0: reject

Opportunity rate of return

from 0 to i

Depends on:

Risk and time of alternative

investments


Why is NPV ideal for everyone?


109,09€ / 1,1/ 1,1

2


t=0t=1

-100 € 120 €

NPV =

9,09€


consume



Want to consume now:

Pay Back

120€

x 1,1x 1,1Borrow

109,09€

2


consume

12

t=0 t=1

-100 € 120 €NPV =

9,09€

9,09 €

invest

120€109,09€




Want to consume later:

Pay Back

110€

x 1,1x 1,1Borrow

100€

2


consume

13

t=0 t=1

-100 €NPV =

9,09€

10 €invest

110€100€

120 €


How to get

money

Firm

Investor

Financial

MarketsBonds

Stocks

How to

spend

Goods

Markets


Toolkit

NPV Risk

Definition

Shortcuts

Extensions

<-> other methods

IRR, Payback, etc

Variance

Covariance

Beta

Owner Manager


Shortcuts for calculating NPV

C C C C C C ...C

3


t=0 t=1 t=2 t=3 t=4 t=5 t=6 ...

C C C C C C ...

Perpetuity



C C C C C C ...

C C ...

3


t=0 t=1 t=2 t=3 t=4 t=5 t=6 ...

C C C C

C C C C C C ...

Annuity



C C(1+g) C(1+g)2 C(1+g)3

3


t=0 t=1 t=2 t=3 t=4 t=5 t=6 ...

C C(1+g) ...

Growing

Perpetuity

C(1+g)2 C(1+g)3 C(1+g)4 C(1+g)5


How to get

money

Firm

Investor

Financial

MarketsBonds

Stocks

How to

spend

Goods

Markets


Toolkit

NPV Risk

Definition

Shortcuts

Extensions

<-> other methods

IRR, Payback, etc

Variance

Covariance

Beta

Owner Manager


The Managers Decisions

Investment

DecisionBonds

Stocks

How to pay

for it

4


What to

buy

The Firm

Financing

Decision

for it


Ways of Financing

Bonds Stocks

• Fixed payout• No fixed payout

Debt Equity

4


• Fixed payout

• Fixed running time

• Payout guaranteed (save for bankruptcy)

• No control involved

• No residual claim

• No fixed payout

• Runs indefinitely

• No guarantees

• Shared control

• Residual claim


Ways of Financing

The Firm

Debt

4


Equity


Valuing Bonds

5 year

4% couponReturn on equivalent

investment: 5%

3,80 3,63 3,46 81,493,29

4


2011 2012 2013 2014 2015

4 4 4 44

100Bond Price = 95,67


Valuing Bonds

Bond Characteristics

• Coupons

Return on equivalent investment

4


• Coupons

•Maturity Bond Price

Yield to maturity


Valuing Bonds – The Term Structure

2011 2012 2013 2014 2015

1/

1+r1

1/

(1+r2)2

1/

(1+r3)3

1/

(1+r4)4

1/

(1+r5)5

2010

4


2011 2012 2013 2014 20152010

r1

r2

r3

r4

r5

Spot

Rates


Valuing Bonds – The Term Structure

2011 2012 2013 2014 20152010

Forward

Rates(1+r4)4/(1+r1)

(1+r5)5/(1+r3)3

4


2011 2012 2013 2014 20152010

r1

r2

r3

r4

r5

Spot

Rates


Valuing Stocks

Return on equivalent

investment: 10%

2,85 3,17 3,43 3,923,70 31,05

5


2011 2012 2013 2014 2015

3 3,50 4 54,50

Stock Price = 48,15

...

5


Valuing Stocks - alternatively


investment: 10%

2,85

45,30

5


2011

3

2,85

Dividend

Stock Price49,82Stock Price = 48,15


Valuing Stocks


investment: 10%

2,85 3,17 3,43 3,923,70 31,05

5


2011 2012 2013 2014 2015

3 3,50 4 54,50

Next Years Stock Price = 49,82

...

5

45,30


Valuing Stocks – Constant Dividend Growth

5


2011 2012 2013 2014 2015

D D(1+g) D(1+g)2

...

...D(1+g)3 D(1+g)4

constant dividend growth


Valuing Stocks - Growth

Assume we know the next dividend and the current price

For the growth rate g, we

can either guess or assume:

The company retains a fraction

5


The company retains a fraction

of earnings

Plowback ratio =

1 – payout ratio

This is invested, earning the

return on equity

ROE = EPS/Book equity per

share

So we have

g = plowback ratio x ROE


Valuing Stocks - PVGO

If the company always paid out

all its earnings without

growing, we would have

However, the firm reinvests a

part to grow, so it is actually

5


Knowing r and EPS, we can easily calculate PVGO


How to get

money

Firm

Investor

Financial

MarketsBonds

Stocks

How to

spend

Goods

Markets


Toolkit

NPV Risk

Definition

Shortcuts

Extensions

<-> other methods

IRR, Payback, etc

Variance

Covariance

Beta

Owner Manager


Other valuation techniques - Payback

-10 5 5 11 A

Payback is simply the time until we‘ve recouped our initial investment

6


2011 2012 2013 2014 2015

-10 3 4 32

-10 2 5 14 B

C


Other valuation techniques - Payback

-10 5 5 11 A

What if we had:

6


2011 2012 2013 2014 2015

-10 3 4 32

-10 2 5 14 B

C1000


Other valuation techniques - IRR

6


0 1 2 3 4

-10 3 4 32

IRR is the rate r that sets the NPV = 0



1.0

1.5

2.0

2.5

IRR = 8%

6


-1.5

-1.0

-0.5

0.0

0.5

0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13%

NPV

r



-8.0

-6.0

-4.0

-2.0

0.0

2.0

4.0

-50% -45% -40% -35% -30% -25% -20% -15% -10% -5% 0% 5% 10% 15%

IRR = ?

6


0 1 2 3 4

-14 2 2 -510

Assume we had had:


How to get

money

Firm

Investor

Financial

MarketsBonds

Stocks

How to

spend

Goods

Markets


Toolkit

NPV Risk

Definition

Shortcuts

Extensions

<-> other methods

IRR, Payback, etc

Variance

Covariance

Beta

Owner Manager


Other valuation techniques – Profitability Index

-10 30 5 A

Assume we can only invest 10

NPV = 21

Examine the NPV per dollar invested

PI = 2.1 3

7


2010 2011 2012

-5 5 15

-5 5 20 B

C

NPV = 16

NPV = 12

PI = 3.2

PI = 2.4

1

2


Other valuation techniques – EAC

-4 4 4Machine A

NPV = 2.94

-4 4 4

NPV = 5.15

NPV = 5.93

7


2011 2012 2013

-4 7Machine B

2010 2014 2015

NPV = 2.36

-4 7 -4 7

NPV = 5.93


Other valuation techniques – EAC

-4 4 4Machine A

NPV = 2.94

1.24 1.24

1.08 1.08 1.08EAC is the cash flow

that, constant over the

investment

7


2010 2011 2012

-4 7Machine B

2009 2011 2012

NPV = 2.36

1.24 1.24 investment

period, yields the same

NPV


How to get

money

Firm

Investor

Financial

MarketsBonds

Stocks

How to

spend

Goods

Markets


Toolkit

NPV Risk

Definition

Shortcuts

Extensions

<-> other methods

IRR, Payback, etc

Variance

Covariance

Beta

Owner Manager


Risk – Expectation and standard deviation

0

2

4

6

8

10

2002 2003 2004 2005 2006 2007 2008

Stock

8


2004 2005 2006

0,10 0,08 0,12

2003 2007 2008

0,09 0,13 0,11Returns

5,00 5,50 5,94 6,65 7,25 8,19 9,10

2002 2003 2004 2005 2006 2007 2008

2002



2004 2005 2006

0,10 0,08 0,12

2003 2007 2008

0,09 0,13 0,11

Expectation EX = 0,105

8


Expectation EX = 0,105

Variance



0,10 0,08 0,12 0,09 0,13 0,11

x - EX -0,005 -0,025 0,015 -0,015 0,025 0,005

(x – EX)2 0,000025 0,000625 0,000225 0,000225 0,000625 0,000025

x

8


σ2

(x – EX)2 0,000025 0,000625 0,000225 0,000225 0,000625 0,000025

0,0035



The covariance formula is

8


(1) Calculate the mean for X and Y

(2) Calculate the sum of the products

(3) Divide by (N-1)

Correlation coefficient:



8

X

Cov(X,Y)

Correlation

coefficient

Y


EX EY

Var(X) Var(Y)

Standard

deviation of X

Standard

deviation of Y

coefficient

of X and Y



1

2

3

4

5

1

2

3

4

5

1

2

3

4

5

1

2

3

4

5EX = 0

σ2 = 1

8


-5

-4

-3

-2

-1

0

1

-5

-4

-3

-2

-1

0

1

-5

-4

-3

-2

-1

0

1

-5

-4

-3

-2

-1

0

1



EX = 0

σ2 = 0,25

1

2

3

4

5

1

2

3

4

5

1

2

3

4

5

1

2

3

4

5

8


-5

-4

-3

-2

-1

0

1

-5

-4

-3

-2

-1

0

1

-5

-4

-3

-2

-1

0

1

-5

-4

-3

-2

-1

0

1



For a portfolio of X and Y, we have

aX

8


bY



Assume we keep adding stocks to our portfolio

0.8

1

1.2

Variance

Unique risk

8


0

0.2

0.4

0.6

0.8

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

Number of stocks

Market risk

Unique risk



What if securities are uncorrelated?

Variance

0.8

1

1.2

8


Number of stocks

0

0.2

0.4

0.6

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

No market risk


However, we can‘t

measure every stock‘s

correlation with every

other stockIdea: Measure the

correlation of every stock

with all of the other


8


with all of the other

stocks, i.e. the market

β tells us how much a stock moves up

(on average) if the market moves up

by 1%


How to get

money

Firm

Investor

Financial

MarketsBonds

Stocks

How to

spend

Goods

Markets


Toolkit

NPV Risk

Definition

Shortcuts

Extensions

<-> other methods

IRR, Payback, etc

Variance

Covariance

Beta

Owner Manager


Risk – Combining Portfolios

11

12

13

14

Expected

Return B

9


8

9

10

11

0 5 10 15 20 25 30 35

Standard deviation

A

Corr = 0


11

12

13

14

11

12

13

14


11

12

13

14

11

12

13

14

BExpected

Return

Corr = 0

9


8

9

10

11

0 5 10 15 20 25 30 35

56

8

9

10

11

0 5 10 15 20 25 30 35

8

9

10

11

0 5 10 15 20 25 30 35

8

9

10

11

0 5 10 15 20 25 30 35

A

Standard deviation

Corr = 0

Corr = -0,3

Corr = -0,7

Corr = -1


11

12

13

14


11

12

13

14

11

12

13

14

11

12

13

14

BExpected

Return

Corr = 0

Corr = 0,3

Corr = 0,7

Corr = 1

9


8

9

10

11

0 5 10 15 20 25 30 35

57

8

9

10

11

0 5 10 15 20 25 30 35

8

9

10

11

0 5 10 15 20 25 30 35

8

9

10

11

0 5 10 15 20 25 30 35

A

Standard deviation

Corr = 0


11

12

13

14


Expected

Return

C

BCapital Market Line

M

9


8

9

10

11

0 5 10 15 20 25 30 35

58

Standard deviation

Arf


Risk – CAPM

11

12

13

14

Expected

Return

M

Security Market Line

9


8

9

10

11

0 0,5 1 1,5 2

Beta

rf


Risk – APT

By APT, we have

expected risk-free factor x premium

9


expected

return

risk-free

returnfactor x premium

Specialization: Fama-French-Three Factor Model

market correlation size factor book-to-market


How to get

money

Firm

Investor

Financial

MarketsBonds

Stocks

How to

spend

Goods

Markets


Toolkit

NPV Risk

Definition

Shortcuts

Extensions

<-> other methods

IRR, Payback, etc

Variance

Covariance

Beta

Owner Manager


The cost of capital

For financing, the company has both equity and debt available

10

Bonds Stocks


Fixed at rd

Interest

Payments

Dividend

PaymentsCAPM

Variable


The cost of capital

10

Debt D

WACC


Equity ECAPM


The cost of capital

10

Other important points:

Don‘t use fudge factors

If beta isn‘t available, it can be approximated


If beta isn‘t available, it can be approximated

Certainty equivalents are an alternative


How to get

money

Firm

Investor

Financial

MarketsBonds

Stocks

How to

spend

Goods

Markets


Toolkit

NPV Risk

Definition

Shortcuts

Extensions

<-> other methods

IRR, Payback, etc

Variance

Covariance

Beta

Owner Manager


Insert: Accounting crash course

11

Balance sheet:

Assets Liabilities and Equity

Current Assets Current Liabilities


Fixed Assets Long-Term Liabilities

Equity



11

Profit and Loss Statement

Revenues

- Operating Expenses

Operating Profit


- Other Expenses

- Interest Expenses

- Taxes

Net Income

Income Before Taxes



11

Profit and Loss Statement

Revenues

- Operating Expenses Operating Expenses:

Cost of Sales

General & Administrative


- Other Expenses

- Interest Expenses

- Taxes

Net Income

General & Administrative

Depreciation



11

Cash Flow Statement

Revenues


Net Cash Flow


- Other Expenses

- Interest Expenses

- Taxes

Net Income Net Income

+ Depreciation

- Capital Expenditure

- Change in Working Capital



11

Cash Flows – Top Down

Sales

- Cost of Sales

- Other Costs

Depreciation


- Other Costs

- Taxes

- Change in Working Capital

Net Cash Flow

- Capital Expenditure

Revenues


- Other Expenses

- Interest Expenses

= Income Before Taxes X Tax Rate


Project Analysis

11

Basically, NPV analysis can be used to determine the

advantageousness of a certain project

However, the future cash flows are often uncertain and

the company needs to examine a wide variety of


the company needs to examine a wide variety of

scenarios to determine potential threats


Project Analysis

11

Sensitivity Analysis

0

2

4

6

x

NPVBreak even


0 1 2 3 4

-10 3 4 x2

-4

-2

0

1 2 3 4 5 6 7 8 9 10 11x


Project Analysis

11

Monte Carlo Analysis

Model the

projectSpecify probabilities

for forecast errors


projectfor forecast errors

Run simulation


Project Analysis

11

Options

2

5

3,5


0 1 2 3

-10 3 4

3


How to get

money

Firm

Investor

Financial

MarketsBonds

Stocks

How to

spend

Goods

Markets


Toolkit

NPV Risk

Definition

Shortcuts

Extensions

<-> other methods

IRR, Payback, etc

Variance

Covariance

Beta

Owner Manager


Investment, Strategy and Economic Rents

12

Machine leads to cash flows of

Assuming a

discount rate

of zero, what

When should I buy the

machine?


1 2 3

3 3 3of zero, what

will the price

of the

machine be?

9


If a project has positive NPV for me, I must have some

competitive advantage or others would have already

undertaken the project

Investment, Strategy and Economic Rents

12

If I know the market value of an asset, I should use that


If I know the market value of an asset, I should use that

as a starting point for my analysis


How to get

money

Firm

Investor

Financial

MarketsBonds

Stocks

How to

spend

Goods

Markets


Toolkit

NPV Risk

Definition

Shortcuts

Extensions

<-> other methods

IRR, Payback, etc

Variance

Covariance

Beta

Owner Manager


Agency problems and performance measurement

13

Money Talent

The Firm


Principal-Agent-Conflict

Investors Managers

Want

maximum

return

Want an

easy lifeNeed to measure

performance


Agency problems and performance measurement

13

Incentive alignment make managers want high returns, through

compensation in stock and options

bonus scheme based on performance


Net Return on

InvestmentEconomic Value Added

ROI – cost of capital

ROI = Operating Income /

Asset Book Value

Income earned – cost of capital x investment

Depend on accounting data!


How to get

money

Firm

Investor

Financial

MarketsBonds

Stocks

How to

spend

Goods

Markets


Toolkit

NPV Risk

Definition

Shortcuts

Extensions

<-> other methods

IRR, Payback, etc

Variance

Covariance

Beta

Owner Manager


Efficient Markets and Behavioral Finance

14

1,04Pt

Pt

probability 0,5

Random Walk:


0,97Pt probability 0,5

The stock either moves up by 4% or down by 3% every

day, independent of the previous history



14


Random walk simulations seem very similar to real

stock prices



14

Efficient Market Hypothesis

Weak: All previous

price information

incorporated Strong: All


Semi-Strong: All public

information incorporated

84

incorporated Strong: All

information

incorporated


The End


The End

corporate finance in a nutshell 2010

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