Corporate Finance in a global

world
Part 1
Questions
Concepts
& Definitions
Corporate Finance

Investment Questions

What is value?
How is it measured?

What is risk?
What is an example of a risk free
investment?

Why might investors be risk adverse

Corporate Finance

Investment Questions

What is a company?
How do companies:
Finance their investments & operations?
Create value?

Who are the owners of a public company?

In a financial sense, what is an employee?

Corporate Finance

Investment
Definition of investment:

Choosing among market alternatives in order to

achieve a financial objective
Choosing among competing investment options
based on a explicit investment goal

Financial objective or investment goal:

maximizing investor wealth

In real estate context: maximizing property

value

Corporate Finance

Investment
Definition of investment decision:
The decision to commit certain current or
future cash outflows in return for risky (or at
risk) cash inflows

Here at risk has two components:

Expected required outflows (especially future,
undefined outflows) may not match actual required
outflows
Actual inflows may not equal expected inflows

Corporate Finance

Risk vs. Uncertainty

Uncertainty: do not know what may happen or

have no way of estimating the probability of

various states occurring

Risk: have a formal, or informal, measure of the

probability of various states occurring

Have some means of quantifying risk or estimating

probabilities
Probability that certain outcomes will (or will not) occur

Basic Principle: Investors Are Risk Averse

Other Things Equal: Prefer less risk to more
To Accept More Risk: Require compensation
Corporate Finance

Risk: Two Major Categories

Systematic or Market
Non-diversifiable
Change in asset prices due to shifts in:
General economic conditions
Market wide movements

Insurance:
Asset Allocation

Corporate Finance

Risk: Two Major Categories

Unsystematic, specific or
idiosyncratic risk
Specific to company
Independent of shifts in:
General economic conditions
Market wide movements

Insurance:
Diversification
???
Corporate Finance

Risk
Market compensates for systematic risk
Can diversify to lessen specific risk

Diversification does not lower systematic risk

Overall economic and market trends affect all
investments
The issue is how much they effect each investment
And, the overall effect on a portfolio (covariance)

So: the risk of a well diversified portfolio

depends on the weighted market/systematic
risk of the securities in that portfolio

Corporate Finance

5 Classic Risks: Operating/Market

Definition:

The possibility that expected net income is not equal to

actual net income due to changes in market
Sensitivity of firm operating c/f to general economic
conditions

Result:

Decreased income to meet financial obligations

Causes:

Shifts in supply and/or demand, or rates, or. ..

Corporate Finance

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5 Classic Risks: Inflation

Definition:

possibility price increases will exceed

expected price increases.
Sensitivity of firms assets change in
price due to general economic conditions

Result: decreased future purchasing

power
Causes:

Changes in monetary policy

Change in economic cycle
Corporate Finance

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5 Classic Risks: Political/Country

Definition:

Relative risk of country in which a firm is located.

Sensitivity of firms results to changes in legal structure
or to changes in the country credit rating

Result: increased expenses and/or decreased

income (or expropriation?)

Causes include:

Taxes and duties

Zoning & Operating Rules
Social legislation
Downgrade of country credit

Corporate Finance

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5 Classic Risks:
Financial/Borrowing
Definition:

the possibility that investment income will not be

sufficient to cover financial (debt) obligations
Additional variability in firms c/f due to the use of debt

Result:

Default, restructure, bankruptcy and/or decrease in

investor wealth
Magnifies results (good times better, bad times worse)

Causes:

Many and varied

Corporate Finance

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5 Classic Risks: Liquidity

Definition:

Possibility an investment cannot be converted to cash in

a timely manner or to do so will incur a significant cost
Sensitivity of firms results to timing and liquidity
conditions

Result: inability to use resources to pursue

alternate investments or in case of financial
distress
Causes:

Time required for investment to mature or restrictions

on withdrawing funds
Changes in: demand for this type of investment,
currency or investor preferences

Insurance: hedges and options

Corporate Finance

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Risk: Five Classic Types

Systematic events

Interest rates increased (decreased)

9/11 and/or war
Investors exit the stock market

Many other specific risks:

Embezzlement
Competitor develops new process
Managers fail to formulate or execute strategy
Big event:

Microsoft fine for competitive practices

Arthur Andersen senior partners role in Enron scandal
Conrad Hilton sale of large block of stock

Corporate Finance

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Risk and return tradeoff

Investors demand/expect to be compensated
for real (or perceived) risk of the market
The level of compensation depends on
quantifying risk:
Probability that estimated returns may not be
realized
The pricing of alternative investments
The sensitivity of the firm/stock to systematic
risk
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Risk and return tradeoff

Key risks are operating/market and
financial risks
Line between systematic & unsystematic
Not clear, a matter of degree
Ask: to what degree does the event affect
the entire market?

Corporate Finance

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Degree Markets Are Efficient

Perfect: market always correctly prices all assets
at all times
Perfect in the long run
Pricing mistakes may occur, but do not endure
Arbitrage opportunities may exist, but only for very
extremely short periods and on a limited basis

Imperfect

Pricing mistakes occur and endure over significant time

periods
Opportunities for arbitrage (???) exist (& exist over
extended period of time)

Corporate Finance

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3 Views of Return: Actual &

Expected
Actual return

(ex post or after the fact)

The realized yield

Risk and time adjusted relation between actual
cash outflows in relation to cash inflows

Expected Return

(ex ante or before the fact)

The forecast yield

The anticipated risk and time relation between
cash outflows in relation to cash inflow

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3 Views of Return: Required

The required yield for an investor to
select this investment
The minimum actual return that is
acceptable to an investor

given the risk associated with an

investment
versus other investment opportunities)

Corporate Finance

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Investment Decision Rules

Rule 1: (very weak): invest in project X if
and only if (iff):
Expected return of project X
return of project Y

>

expected

Rule 2 (better): invest in project X if and

only if:
Expected return > or = required return

Corporate Finance

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Investment Decision Rules

Rule 3: (better still): invest in project
X if and only if:
Expected return >= required return and:
Required return accurately reflects the risk
of project X
Expected return reflects the best return
per unit of risk among investment
alternative

Corporate Finance

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Investment Decision Rules

Theoretical and practical issues
with rule #3:

A. How do we know when the

required return accurately reflects
the risk of project X?
B. How do we measure return per
unit?
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Investment Decision Rules

Suggested answer to A:

Stay tuned in during the course.

Probably never have certaintyor else
there would not be risk!

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Investment Decision Rules

Suggested answer to B:

Mean estimated/probable return divided

by standard deviation
Coefficient of variation

Statistical measure:

Information that may not be readily

available
Approach: simulations

Corporate Finance

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Some Basic Concepts of

Finance
= profit = revenue minus cost
Time value: an amount received today has
more value than a promise (for the same
amount) in the future*

Assumes inflation is generally the case

Assumes individuals would rather consume today with
certainty than bear the risk of waiting

Corporate Finance

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Some Basic Concepts of

Finance
Risk and return: investors require

compensation for real (and perceived) risks.

That compensation involves a return of and a
return to invested capital.

Corporate Finance

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A Corporation As A Balance
Sheet
Current Assets

Net
working
Capital

Fixed Assets:

Current
Liabilities

Long-term
Debt

Tangible
Intangible

Shareholders
Equity

Corporate Finance

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Balance Sheet View of Corporate

Finance
Issue 1: Invest in which long-term assets?
Capital budgeting and capital expenditures
Left hand side: Fixed Assets
Issue 2: Method to acquire resources required for

investments in long term assets:

Capital structure
Right hand side: current & long term liabilities plus
equity

Corporate Finance

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Balance Sheet View of Corporate

Finance

Issue 3: Management of operating

cash-flow

Address the mismatch between inflows and

outflows, or conservation of net working
capital
Both sides: current assets minus current
liabilities

Corporate Finance

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To Impact Firm Value

An Action Must Affect:
1. Current cash flow

2. Or, future growth

3. Or, length of growth above long-term
average
4. Or, discount rate (cost of capital)

If an action does not affect these

items, it cannot affect value
Corporate Finance

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#1: Increase Cash Flow On

Assets
Category

Potential Action

* Operating Margin

Cut costs or increase efficiency

= EBIT

Sell assets with negative EBIT

- Tax Rate * EBIT

.

Decrease tax rate (move to low

tax area, manage risk)

+ Revenues

= EBIT (1- tax rate)

+ Depreciation
- Capital Expenditures

Use past over-investment

- Change in work. Cap.

.

Change inventory management

and/or credit policy

= Free Cash Flow From Operations

Corporate Finance

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#2: Increase Future Growth

Category

Potential Action

+ Reinvestment Rate
additional
.

Increase to acquire

* Return on Capital

Increase operating margins

Increase capital turnover

productive assets

= Expected Growth Rate

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#3: Increase Period of

Growth
Build on existing competitive advantages or barriers
to entry, or find new ones.

Category

Potential Action

Brand
.

Use to generate above market

returns

Legal protections
.
.

Obtain patents or licenses or

government sanctioned
monopolies

Switching costs
.

Make customer switch to

competitor more expensive

Economies of scale or own

distribution or get exclusive rights
or reduce product development
costs/cycle

Cost advantages
.
.
.

Corporate Finance

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#4: Decrease Cost of

Capital
Category

Potential Action

Cost of equity

Differentiate product (actual or by

Make it more of a necessity

marketing)

Cost of Debt

Match debt to assets (reduce default

.
.

Use swaps, derivatives, etc.

Consolidate debt

Either (or both)

.
.
.

risk)

Reduce operating leverage

Outsource
Use flexible labor contracts and costs
Change mix of debt & equity
Corporate Finance

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Many Actions Are Value Neutral

(to the firm)

Stock splits

Issue new share for each share outstanding

Cuts price per share, but should not impact
value

Stock dividends
Return money to the shareholders
Does mean the funds are not available for
investment by the firm
Corporate Finance

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Many Actions Are Value Neutral

(to the firm)

Accounting choices that affect reported
earnings (not taxes or cash flow)

Shift inventory valuation (LIFO to FIFO)

Changes in depreciation methods for reporting
Non-cash, non-deductible restructuring charges
Pooling vs. purchase method for reporting
acquisitions

Creating new securities for existing assets

Tracking stocks
New classes of bonds (with no cash effects)
Corporate Finance

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Time Value
Part 2

PV & FV, Annuities

Return Measures
Computations

Corporate Finance

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Return Measures

Many different measures of

return

Some specific to an industry or investment

type
Some favored by certain groups or
professions

Corporate Finance

39

Return Measures
Criteria for a good measure of return

1.

Cash flow: based on cash flow

2. All-inclusive:
Incorporates all cash flow
regardless of when received
3. Time:
and inflows

adjusts for timing of outflows

4. Unambiguous:

one answer

5. Guidance:

provides clear guidance for selection

Independent Options: acceptance independent of other

project choices
Mutually Exclusive Options: if accept A, then have
rejected B
Corporate Finance

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Common Return Measures

Payback period
Time until initial cash outflow is offset by
cash inflows
Discounted payback also used, but does not
incorporate all cash flow

Average accounting return

Average net income/average book value
Cut-off arbitrary, not all cash & does not use cash

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Common Return Measures

Cash-on-cash
Cash flow/ invested cash (equity)

Discounted Cash Flow

Net Present Value
Internal Rate of Return

Corporate Finance

42

Time Value Conversion Factors

Present value factor:
1
t
(1 i)
The present value factor is a fraction or a PV factor <1
i.e. a current amount loses value over time by the

Future value factor:

(1 i)t

The future value factor is a multiple or FV factor >1

i.e. a current amount invested at a positive rate of interest
increases in value over time

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Time Value Computations

Present Value of an amount A received n
periods in the future
PV A

i
t
A

=
=
=

1
A
(1 i ) t

the discount rate

number of periods
single, lump sum payment

PV (1millionCHF ) 1,000,000

1
72.57CHF
100
(1.1)

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Time Value Computations

Future Value, n periods in the future, of
an amount that is received now:
FV A A(1 i)t
i
t
A=

=
the investment rate
=
number of periods
a single, lump sum amount
100

FV (1millionCHF ) 72.57 * (1.1)

Corporate Finance

1,000,000CHF

45

Building Blocks: annuity factors

An annuity is a cash flow received (paid
or credited) in equal increments over
equal increments of time
Examples include:
An amortizing mortgage
A fixed rate bond or a zero coupon bond
Lottery winnings (lump sum is not selected)

1 (1 i) t
Value of annuity PVa a

Corporate Finance

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Building Blocks: annuity factors

The formula for the present value of an
annuity is:

1 (1 i)
Value of annuity PVa a

a = the amount received each period

i = the interest rate earned on an
investment or the required return
t = number of equal time periods
Note: (1+i)-t = 1/(1+i)t
Corporate Finance

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PV of an Annuity
The PVA formula:
1 (1 i) t a a a
*
PVa a

t
i

i (1 i) i

A two part valuation formula:

Part 1: 1/i is the fundamental formula of

valuation
i is called the capitalization rate (it is the rate
that translates a cash flow into a capital
amount)

Corporate Finance

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PV of an Annuity
Part 2:
a/(1+i)^n = a/FV factor (or a * discount rate)
Translate the annuity payment with the future
value factor as a capitalization rate

So: PVA = is

value of the annuity amount given the interest

rate
minus increment of value lost due to receipt of
payment over time

Corporate Finance

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Key Terms
Concepts

Risk and return

Value
Investment
At risk
Risk Averse or aversion
Arbitrage

Return measures & Decision Rules:

Net Present Value (NPV)
Internal Rate of Return (IRR)

Corporate Finance

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Key Terms
Classes of risk:

Systematic or Market
Unsystematic or specific or firm

Types of risk:

Market/Operating
Inflation
Political or Country
Financial
Liquidity

Types of Return
Actual
Expected
Required

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Key Terms
Symbols
or profit
or root of a number
product operator
equivalency
approximately
summation operator
change or delta
> greater than
less than
Lne and Log10
ex

Others
Exponents
Logarithms
Annuity
Annuity factor
Annuity payment

Present Value & Future

Value
PV or FV Factors

Discount rate
Discounted Cash Flow
Analysis
Yield
Interest rates

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