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Financial Theory and Corporate Policy (4 Edition) by Copeland Chapter 2: Investment Decisions: The Certainty Case
Financial Theory and Corporate Policy (4 Edition) by Copeland Chapter 2: Investment Decisions: The Certainty Case
Introduction
In the investment decision, must decide how much to not consume today so as to enjoy
more consumption in the future
Should maximize expected utility over the planning horizon
Individuals, corporate managers, and public sector managers must all make the allocation
between current and future consumption
Initially interest rates are known and constant
Also assume there are no imperfections in capital markets
The firm objective is to maximize the wealth for its shareholders
The above formula works if the dividends and discount rates are known with certainty
The effect of capital gains is effectively in the formula above
If the dividend stream is growing at a rate g,
Div1
S0 =
ks - g
The accounting definition does not deduct gross investment; rather, it deducts a portion as
depreciation (dep)
NIt = Revt - (W & S )t - dept
Using the table above, just multiply the product cash flows by the discount factors
Should accept projects that have a NPV greater than zero
Project C has the highest NPV of 530.85
If the projects are mutually exclusive, then only Project C is accepted
If the projects are independent but not mutually exclusive, then accept Projects B, C, and
D since they all have positive values
Cash flows for capital budgeting purposes is free operating cash flows minus taxes on
free operating cash flows
( DRev - DVC - DFCC ) - t c ( DRev - DVC - DFCC - Ddep ) - DI
= ( DRev - DVC - DFCC )(1 - t c ) + t c Ddep - DI
= EBIT (1 - t c ) + Ddep - DI
Notice the cash flows are independent of the capital structure (debt and equity mix); that
is taken into account in determining the WACC
Discounting at the WACC separates the investment decision of the firm from its
financing decision
Must assume the capital structure stays constant or the cost of capital would change each
period
The definition of cash flows includes working capital requirements
Recommended Problems
You can certainly work all the problems, but the ones below are particularly valuable in
your exam preparation.
1, 4, 5, 8, 9
10
28, 000
NPV = - 100, 000 = 58, 200
(1.12 )
t
t =1
Note there is no tax effect because this portion of the investment was never
deducted for tax purposes; only 88,000 was deducted over the life of the new
machine
NPV = -75,000 + 104,328 + 4,847 = 34,175
t =1
9. First calculate the cash flow difference with and without the proposal
CF = ( DRev - DVC - DFCC )(1 - t c ) + t c Ddep
= ( 0 - -290 - 0 )(1 - 0.5 ) + ( 0.5 )(180 ) = 235
Then calculate the NPV at the weighted average cost of capital
5
NPV = (1.10 ) 235 - 900 = -9.12
-t
t =1
Introduction
Learning Objectives
1. Distinguish between managerial incentives and shareholder incentives
2. Understand how differences affect ownership structure, capital structure, and
investment policies
3. Describe ways to design compensation contracts that minimize managerial-
shareholder incentive problems
Purposes of Chapter
1. View how financial decisions are actually made in light of incentive problems
2. View how financial decisions should be made in light of incentive problems
The $100 additional investment in the bad state of the economy should not be
made because it will lose $25
To prevent management from making the second investment in the bad economy
state, could structure the initial $100 investment to restrict future choices
For example, the initial investment could be $70 of senior debt and $30 of
subordinate debt
The value with the additional investment (the first row in the table above)
must first pay back the $70 of senior debt
Then only if there are sufficient funds could it support the additional $100
investment
In the bad state of the economy, there would only be $55 remaining, which is
clearly not enough to support the $100 additional investment
Thus, management is prevented from investing in a negative NPV project
This restriction will only work if the internal cash flows of the company are not
sufficient to cover the additional investment
Introduction
Learning Objectives
1. Understand how financial decisions are affected by well-informed managers
2. Indentify situations in which managers may want to distort accounting information
3. Explain how dividend choice, capital structure, and real investments affect stock price
4. Interpret empirical evidence regarding stock price reaction to financing and investing
decisions
Introduction
The stock market reacts greatly to dividend changes and other financial restructurings
Managers often have inside information that cannot be disclosed to investors
The information could give the company a competitive advantage or the management
team may simply want to hide unfavorable news
Investors strive to interpret indirect news from management called signals
These actions (e.g. management purchasing shares) often speak louder than words
Managers often want to maximize the short-term stock price simply to boost their own
pay
Must distinguish between decisions that create value and decisions that simply signal
positively to shareholders
Introduction
Primarily focused on principals in business parties that engage in asset-related (e.g.
lending) and liability-related (e.g. deposit taking) activities
Distinguishing features of principal financial firms
1. Credit-sensitivity of customers
Because customers can be major liabilityholders
Customers prefer high credit quality
2. High cost of capital
Because of opaqueness to customers and investors
The detailed asset holdings and business activities are not publicly disclosed
Changes can occur quickly and cannot be easily monitored by customers and
investors
This causes high agency and information costs
3. Profitability is highly sensitive to cost of capital
Because operate in competitive financial markets
Must correctly charge for the capital commitments
Difficult to allocate capital to business units
Assets Liabilities
Bridge Loan $100 Note (default free) $100
Asset insurance 5 Risk Capital 5
(from note holder)
The accounting balance sheet for the above three examples could be different, but the
risk-capital balance sheets are all very similar
The debtholder and customer asset insurance is simply the par value minus the market
value (1000 900 = 100 and 1000 990 = 10)
The equityholder asset insurance is just the plug to make the total equal $500, which
is the value of complete insurance on the risky assets
Technical Appendix
The risk capital in Table 1 (on page 450) is based on the price of a put option
If the net assets were invested risklessly, they would grow to ( A0 - L0 ) erT
Introduction
The approach in this article is similar to the risk-adjusted return on capital (RAROC)
Risk capital is determined by the loss exposure of its stakeholders
It is very important to financial firms because customers only want policies from highly-
rated entities
Most of the risk is borne by equity-holders and uninsured debt holders, not customers
who purchase low-default-risk liabilities
Low-default-risk (cash capital) and risk-bearing (risk capital) funding is provided by
the various stakeholders
Firms should try to most efficiently manage risk capital (i.e. minimize blended
deadweight costs)
Sources of deadweight capital costs
1. Information costs
Financial firms are secretive and can change quickly, thus making it impossible
for outsiders to adequately monitor them
2. Higher taxes and agency costs of free cash flow
The tendency of companies to waste excess cash flow on low-return projects
Decreasing firm-wide risk can reduce the cost of guarantees
Diversified firms have more investment opportunities because the risk capital is reduced
Should not operate a transparent business (e.g. S&P 500 index fund) within an opaque
financial firm
Outsiders cannot clearly see the holdings and strategies of opaque financial firms
Risk Capital
Often calculated with value at risk (VaR)
Merton and Perold definition of risk capital
Smallest amount that can be invested to insure the value of the firms net assets
against a loss in value relative to a risk-free investment
Using the above definition, the risk capital for a treasury bond is the price of a put option
struck at the forward price of the bond
VaR ignores the magnitude of the loss in the extreme tail of the distribution
Diversification benefits can be very large
The fully allocated risk capital for both businesses is 1002 + 1002 = 141.4
The marginal capital for each is 141.4 100 = 41.4
Different investment decisions will be made based on the choice of capital allocation
Many firms only recognize diversification within business units, not between them
Valuation
NPV = (1 - d ) V {S + } - ( C - m ) - (1 + m ) V {S - } = m - dV {S + } + mV {S - }
So the net present value is the firms operating profits less the value of the deadweight
capital
s [ n( z ) + zN ( z )] s [ n( z ) - zN (- z )]
V {S + } = V {S - } = , where
1+ r 1+ r
C (1 + r )
z= and n( ) and N( ) are the standard normal and cumulative standard
s
normal distributions
is the risk-neutral standard deviation of the hedging error
Numerical Example
Risk-free rate = r = 10% = 150 = 250 d = 10% m = 100%
s 150
R= = 90.7 , which means the return on capital is 165% =
2p (1 + r ) 90.7
Z ( d m+ m ) s Z ( 0.909 )( 250 )
C* = = = 303
1+ r 1.1
N(1.335) = 0.909
2p
s [ n( z ) - zN ( - z ) ] ( 250 ) [ 0.0425]
V {S - } = = = 9.66
1+ r 1.1
Guarantee Cost = (1 + m ) V {S - } = 19
Capital Budgeting
If k is constant, then for any project just need the marginal effect on the profits and firm-
wide risk capital
Should accept the project if Dm - k D R > 0
The incremental risk capital can be approximated with DR = bR , where b is the
correlation coefficient of the projects profits with firm-wide profits
If b is negative, then the project will act like a hedge
Risk Management
Any risk that can be costlessly hedged should be hedged
Costly hedges should be evaluated like any other project
Introduction
Corporate finance theory usually assumes perfect capital markets
A countrys legal, cultural, and historical environment affect finances
Successful countries (e.g. US, Japan, and Germany) have different structures
An economic system must simultaneously promote competition and cooperation
Companies must be monitored and disciplined
2. Translation
If A is a constant,
Risk ( X + A ) = Risk ( X ) - A
The risk measure should be reduced as noted above because we are concerned
with downside risk, not just uncertainty
3. Monotonicity
If X Y in all states of the world, then Risk ( X ) Risk (Y )
Again, the focus is on downside risk; this means the risk of Y is greater than the
risk of X because it is always worse
4. Subadditivity
The risk of a portfolio is never more than the sum of the risks of its constituents
Risk ( X + Y ) Risk ( X ) + Risk (Y )
Conclusion
CVaR is the superior risk measure
1. Introduction
Required Economic Capital is the amount of economic capital a business thinks it needs
Available Economic Capital is the amount of economic capital the business actually has
Economic capital can be used to value the business or manage the risk
Regulatory pressure from banks (Basel II) and insurers (Solvency II) encourage the use
of economic capital analyses
Difficult to calculate embedded value at insurance companies
Diversification Effect
The total capital required is likely less than the sum of the individual risks
Correlation assumptions can be used to determine risk dependencies
However, should consider how correlations change in extreme scenarios
Copulas is a technique to measure dependency between risks
Often used in default risk modeling
Copulas are not easy to use; also difficult to determine goodness of fit
Regulators are aware of tail dependencies and are thus reluctant to give too much
diversification credit
Insurance companies that engage in various activities benefit from diversified risk
Regulators are concerned about the solvency of each legal entity, so diversification may
not be beneficial for a conglomerate
Whether to Allow Negative Cumulative Surplus in the Middle of the Time Horizon
Must decide if only to check surplus at the end of the horizon
More capital is required if do not allow negative surplus in the middle of the time horizon
Could allow negative surplus in the middle but use a realistic borrowing rate
8. Illustrative Examples?
Example 1: Deterministic Stress Test
Apply instantaneous shock to various risk factors
Simulates impact to economic balance sheet before management has time to react
Common way to determine capital requirements in the UK and Switzerland
Shocks could be to such factors as equities, volatilities, or interest rates
Could standardize the shocks by making them the same number of standard deviations
The economic capital required is the change in capital position after the stress test
The stress test can be used to determine the effect of various hedging programs; if
effective, they can greatly reduce the capital required