Corporate Finance

Lecture 1
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Chapter 1 – Introduction to Corporate Finance

Accounting, Finance and Forecast

Accounting deals with past records, all data and no future, work with real amounts
Finance is about discounting future cashflows, works with forecasting

What is corporate finance?

- Investment: what long-term investments will you make
- Financing: where will you get long-term financing for your long-term projects?
- Working capital Management: how will you manage your everyday activities?
Financial goals:
1. Profitability
2. Liquidity
3. Security
4. Independence

Most important to financial goals is profitability because it is the reason why you have a
company
Liquidity is just a means to this upper goal, you are running the company to make profits, not to
be liquid, however, you do need it to obtain your goal

(he makes a big jump to a new topic, but still chapter 1)

Financial Markets and the cooparations

You need to see the company as a small piece within its environment, all kinds of factors such as
politics, economy, households etc. can influence the company

Financial markets:
- Primary markets: where the company has a link to the financial market for the first time
When a company makes their shares public for the first
time (IPO), then you speak of a primary market, so
only once!

- Secondary market: when investors trade with each

other, most common market. As a company you are
more concerned with the primary market since the
trading on the secondary market is not including the
company (if you buy coca cola shares, you do not buy
them from coca cola).
Chapter 3 – Financial Statement Analysis

Annual report

Annual report consists of:

(check slide for images with examples)

1. Balance sheet
o Needs to be in balance
o Assets = liabilities + equity
Net Working Capital: difference between currents assets and current liabilities, you want this to
be positive since it means you have enough cash available to pay off liabilities (depts) arising
Example question: answer A because its current assets-current liabilities

Book value: based on Accounting Figures drawn from Accounting Standards

Market value: we deal with only this value in this course, based on prices or market
valuations

2. The Income statement

Types of profit
EBT: earnings before tax, net income before tax
EBIT: earnings before interest and tax
EBITD(A): earnings before interest, tax and depreciation

Taxes
Average Tax rates
• Percentage of income that is paid in taxes
• Tax bill divided by your taxable income

Marginal Tax rates

• The tax you would pay if you earn one more unit of currency

Example:
 3. Statement of cashflows

Cashflow is not the same as working capital because NWC is a snapshot, not a flow
Cashflow is also not profit since depreciation decreases profit but not the CF
Lecture 2 – chapter 3 and 4
Chapter 3

Ratio analysis
Putting numbers in perspective in order to look at the state of a company
‘It is important to be able to analyze a firm’s financial statements and compare them to other
firms’
You need ratio’s to be able to compare companies with different sizes

Profitability ratio’s
Profit margin = Net Income / sales  operating efficiency, what we earn in comparison to the
sales and how successful we are
Return on asset – Net income / total assets  asset use efficiency
Return on equity = net income / total equity  equity efficiency

Financial leverage ratio’s

Debt-equity ratio = Debt / equity
Total debt ration = debt / (equity + debt) = Debt/ total assets
Equity Multiplier = Total Assets/ equity
Answer quiz: C

Market Value Ratio’s

Earnings Per Share (EPS) = Net income / shares outstanding  what is the income per share
for the company?
(Price to earnings) PE ratio = price per share / EPS  use to measure how expensive shares
are compared to other companies, used to predict future prices (if stock is for example
overpriced), the higher the PE ratio, the lower the short-term return. So: the lower, the better

The Du Pont Identity

Long term

Return on Equity (ROE) = profit margin x total asset turnover x equity multiplier

Also calculated: EM: 1 + D/E

(dept/equity)

How efficient is our operation?

Short term

Here you take away sales in the equation

 ROE = net income / equity because

ROE = ROA x (Assets / Equity)

Asset/equity is always larger then 1! What you earn on your assets is always lower

Using Financial statement information

For own reading

Chapter 4

Future value and compounding

Future Value (FV) = the amount an investment is worth after one or more periods

Watch time convention closely! If they start at the end of the year, you have to calculate until the
end of the next year

€100 invest two years, 10% interest  100 x 1.1^2

Value=v Time=t r=interest rate

Types of interest
- Simple interest: earned only on the original principle amount
invested
- Compound interest: Interest earned on both the principal and
the interest reinvested from prior periods

Future value interest factor (FVIF)

- 561,97
- 884,27
- 484,27
- 484,27 – (7 x 400 x 0.12) = 148.27

Compound interest with different periods

Banks frequently offer savings accounts that compound interest every day, month or quarter.
More frequent compounding will generate higher interest income for the savers if the annual
interest rate is the same.

You earn more if interest is calculated in shorter periods due to compounding, since you simply
build up more (see example slide 41)

Annual percentage rate (APR) = interest earned in one year without compounding, so the
nominal or stated interest rate

In order to compare different loans, the compounding period needs to be equal, so to make them
comparable, we calculate their equivalent rate using an annual compounding period. We do this
by calculating the effective annual rate (EAR)

Present value and discounting

Present value (PV): current value of future cash flows discounted at the appropriate discount
rate
Discount: calculating the present value of some future amount

(in order to get this money in the future, how much should I invest now?)
(so instead of multiply, you divide)

Present value Interest factor

1/(1+r)^t

Relationships and further calculus

Instead of using this:

Present value interest factor → Present value factor
(PVF) Future value interest factor → Future value factor (FVF)

Another thing you can calculate instead of the amount is time, so how long will it take to have
this amount in the future?

So you are looking for the N in this equation: FV = PV (1+r)n

 n = [ln(FV/PV)] / [ln(1+r)] (In being LOG on calculator!)

Easier equation: Rule of 72:

The “Rule of 72” is an approximate formula to determine the number of years it will take to
double the value of your investment.

Years to double investment: n = 72 / (r x 100)

Example: if I have an investment of 9%, the amount to double my investment is 72/9

Only use as rule of thumb, so approximately

Finding the rate of return

What rate of interest will allow your investment to grow to a desired future value?
So, the last thing you can calculate next to time or amount, you calculate r

You want to solve the r in the following equation: FV = PV (1+r)n

 r = r = (FV/PV)^(1/n) – 1

Tutorial 1
Current equity value incorporates shirt-term and long-term profits. It reflects risk, timing, and
magnitude of all future cashflows

Lecture 3 – Chapter 2 and 5

Chapter 2

Agency Theory: Relationships

(conflicting interest)

Type 1: Relationship between managers and shareholders

- Managers want to maximize their own wealth and power
- Shareholders want to maximize the value of the company
 Conflicts

Direct Costs:
- Corporate expenditures that benefit managers at the expense of shareholders
- Corporate expenditures to monitor and control manager activities
- E.g.: private jet, payment of auditors

Indirect Costs
- Lost opportunities because of more risk averse managers (want to keep their job and is
less likely to take risks, while shareholders can benefit from risks)
- E.g.: Shareholders want to invest in new product development (risky); managers fear
higher chance of bankruptcy and losing their job (don’t want to invest too much).

How to align the interests?

Managerial compensation
- Performance based pay (so more inclined to take risks)
Shareholder rights
- Shareholders facility to call managers to account
Control of the firm
- Power of shareholder to control firm ((e.g. board structure, voting rights)
Proxy voting
- A grant of authority by a shareholder allowing another individual to vote his or her shares
Type 2: Relationship between majority shareholders and minority shareholders
- Minority of shareholders want to maximize value per ordinary share
- Majority shareholders want to take advantage of their power of control
- Bondholders want to maximize bond value (investors that lend money to company, so no
shares and do not own a part of the company, just want to be payed back)

Cost examples

- Majority shareholder makes one of her firms trade on attractive terms with another of her
firms. Known as a Related Party Transaction.
- Majority shareholder can force the company to declare a large dividend because she
needs the cash

Two types of voting systems:

International corporate governance

Corporate law
- Law is developed through court rulings
- Flexible and can adjust quickly to events

Civil law
- Law is developed through regulations and code laws
- Based on code of principle does not/slowly change

Bank based systems

- Banks are central to the process of moving funds between demanders and suppliers of
capital
- More active monitoring
- Ownership often more clustered
Market based systems
- Securities markets are as important as banks and are often significantly more important
- External market discipline
- Ownership often rather fragmented

Some assumptions:
Corporate executives are acting in the interest of the shareholders
- No self-dealing or investment in particular projects to maximize the managers own
wealth
- No financing decisions to minimize the risk for the firm but not necessarily for
shareholders
Chapter 5

Multiple cash flows

Up to now we looked at a single payment:

- You make a single payment now and ask yourself what it will be worth in the future
- You receive a single payment in the future and ask yourself what it would be worth today
(year 0)

Now we look at multiple payments or cash flows, that occur periodically, and are always of the
same amount.

Perpetuities

Perpetuities = forever, so if you do not know the year until you are investing

(how he got to the

calculation will not
be in the exam!)

Something about geometric series, re-watch!

IN SHORT:

Delayed perpetuities

- .

Growing perpetuities
Rewatched – Chapter 5

Multiple cash flows:

Looking at multiple payments instead of just one, for both future value and present value

 perpetuities and annuities

Perpetuities

When you receive an amount of money ( C ) until forever (no not know when it stops,
example: a SHARE)
So:

Present value of perpetuities

PV:
Delayed perpetuities

So, when a perpetuity (the payment) does not start immediately but for example starts after 3
years
 Example

You firstly calculate the

‘normal perpetuity, and
then put that in a present
value formula
Growing perpetuities

When you for instance get an interest rate of 2% every year apart from the discount rate

Only applicable if r (discount rate) is bigger than the interest (g = growing rate)

However: if the growth starts in the first year the formula would be

(since C already grows in the first year)

Lecture 4 – Chapter 5
Chapter 5

Annuities can start at the beginning or the end of the period!  influences the value since
at the beginning you don’t get interest over it but at the end you get interest

Delayed annuity
When you don’t start getting your annuity right at the beginning but after some years
Example:

You always start calculating from a year before the first annuity!!

Growing Annuity
When an annuity grows every year with a certain growing percentage (g)

Future value of annuity

FV of Annuity =

Compounding more than once per year

Sometimes interest is paid more frequently than once per year

 causes different amounts since the compounding happens more often

Quoted interest rate: rate expressed in terms of the interest payment made each period
Effective annual rate (EAR): rate expressed as if it were compounded once per year

Q being the quoted interest rate

M being the number of periods
The effective rate is always larger
when compounding happens more times a year
Example:

APR= Annual percentage rate, usually APR=EAR, unless there are extra fees or cost from a
bank which are not calculated in the EAR  in U.S they call it stated (simple) interest rate

Loan Types and & Amortization

Types of loans

If you want to calculate the monthly payments of an amortized loan, you should see them as
annuities

With partially Amortized there is an delayed annuity, since you pay first like amortized, but after
that you pay the ‘baloon’ like pure discount

Lecture 5 – Chapter 6 and 7

Bond = a tradable loan
Can only be simple interest, not compounding

- A bond is a (mostly tradable) certificate showing that a borrower owes a specified sum
- To repay the money, the borrower has agreed to make interest (“coupon”) and principal
payments on designated dates

Three types of bonds:

1. Pure discount bond (zero coupon bond)
No interest paid, only pays you the face value at the end of maturity

2. Level coupon bond/plain vanilla (Most standard)

Pays you coupon payment (interest) and at the end the face value
Pays about 5% every time

3. Consol (perpetual bond)

Only pays you the coupon payment, never the face value

Comparing the bond types (lecture 4) to loan types:

Pure discount loan: same as discount bond

Interest Only: same as level coupon bond

Bond valuation (how much do you pay for a bond)

Pure discount bond

If a T-bill promises to repay £10,000 in 3 years, and the market interest rate is 7%, how much
will the T-bill sell for in the market today? (in other words: What is the PV?

You pay less now than you will receive in the future, so that’s why people would choose a Pure
discount bond.

Level coupon

PV of Face Value + PV of Annuity = Bond value (for level coupon bond)

You receive a constant payment every year = annuity

+
You receive back the PV of the money you loaned

(FV= FACE VALUE NOT FUTURE VALUE)

(A= annuity formula, so )

Whenever a bond is placed with a coupon rate below the market discount rate, you will see
that the price of a bond goes down, otherwise no one will buy the bond and will buy the
other bonds in the market that give a higher rate.

At par value: price of the bond is equal to the face value

Price above face value: premium

Price below face value: discount

To summarize:
Par Bond
- A bond that sells at its face value
- Coupon rate equals market discount rate

Premium Bond
- A bond that sells above its face value
- Coupon rate is more than market discount rate

Discount Bond
- A bond that sells below its face value
- Coupon rate is less than market discount rate

Time to maturity - What is the influence of time of maturity on the price of a bond?

What is the price of the bond t years before maturity:

Whenever the time to maturity gets shorter, the difference between face value and price of a
bond gets smaller
Whenever a marker interest rate increases, the value of a bond decreases as later payments are
discounted at a higher factor, since other bonds become more attractive, yours goes down in
value

To summarize:

- All other things being equal, the longer the time to maturity, the greater the interest rate
risk, because the face value of the bond is discounted much stronger over longer periods.
- All other things being equal, the lower the coupon rate, the greater the interest rate risk,
because the bond has a relatively larger portion of its cash flow (face value v. coupons)
later in its life

Yield to Maturity

Effective return that you will see on a bond

Yield to maturity (YTM) is the total return anticipated on a bond if the bond is held until it matures. Yield to
maturity is considered a long-term bond yield but is expressed as an annual rate. In other words, it is the internal
rate of return (IRR) of an investment in a bond if the investor holds the bond until maturity, with all payments made
as scheduled and reinvested at the same rate

you should be able to indicate whether the YTM is higher or lower than the coupon  has to do with premium /
discount / par bond

Current yield: the annual interest/the bond price = x% (sadly the bond price can change over the years)
.
When the current yield > YTM because the current yield ignores the built-in loss of the premium
value of the bond

When the current yield < YTM it is because the bond is priced at a discount

Tutorial – 4th of October

Lecture 6 – Chapter 6 and 7
Continuing yield of maturity
You can’t solve the yield to maturity by formula, only when you can fill in the multiple choice
questions

Different interest rates

Nominal Interest Rate

Rate that has not been adjusted for inflation
- Percentage change in the amount of cash you have
- Cannot be lower than zero

Real Interest Rate

Rate that has been adjusted for inflation
- Percentage change in your buying power
- Can be lower than zero when inflation is bigger than nominal rates

Term structure

Term structure of interest rates is the relationship between nominal interest rates on default-
free, pure discount securities and time to maturity

Term structure conducts of:

Interest you pay over a loan

The amount you pay because you have to

compensate the inflation

The amount you pay because the loaner is

taking a risk
Example term structure:

Bond Ratings

It could be that two bonds which cost the same have a very different coupon rate
 can be caused because of different times of maturity

 can also be caused by bond credit rating shows how risky a bond is

Chapter 7

Equity markets

Calculating your return:

D (t+1) means the dividend you get after 1 year

of buying the stock

Pt is the price you paid when you bought the

stock

P (t+1) the price after one year

PV of dividend payments
The price you will be willing to pay for an equity

If you knew the future price and the dividend, you could simply use the following formula:

However, you don’t usually know these

So: Thus, it is a perpetuity  cashflow = dividend, so C/r

Share price

For:
- Zero growth: dividend always stays the same
Calculating share price: (use normal perpetuity formula)

- Constant growth: dividend is increasing

Calculating share price: (use growing perpetuity formula)
Warning:
when
question
states ‘next dividend, you should leave (1+g) out of the
formula

- Differential growth: dividend’s increasing differs

Example:

Consider the equity of ‘Irresistible SnoepNV’, which has a new candy bar and is
enjoying rapid growth.
o The dividend per share a year from today will be €2.
o Beginning in year 2 dividends will grow at 15% p.a. for 4 years
o After that, growth will equal 10% per year. Calculate the present value of the
equity if the required return is 20%
 look at slides for
explaining, steps:
In real life, you hardly ever know the dividend etc. so it is way more uncertain what the CF,
return of life of investment is

Lecture 7 – Chapter 8
How to determine whether to invest or not?
Here will follow a list of investment criteria

NPV
NPV: Net Present Value, is pre
Example:

NPV gives us information about whether to invest in a project or not  Investment rule:

- NPV > / = 0 (greater or equal than zero): Accept

- NPV < 0 (less than zero): Reject

Strengths of NPV
- Cash Flows are better than earnings (accounting measure)
- Other approaches ignore cash flows beyond a certain date
- Fully incorporates the Time Value of Money

The Payback Rule

The amount of time required for an investment to generate cash flows sufficient to recover its
initial cost.

Calculate how long it will take to earn your costs back in an investment

- Payback Period < / = benchmark (set by yourself): Accept

- Payback Period > benchmark: Reject

Problems with Payback Rule:

It is not reliable since you don’t know how far in the future you can predict and if there will be
losses in the future
Discounted Payback Rule
The length of time required for an investment’s discounted cash flows to equal its initial cost.

Same as payback only takes discount into consideration

- Discounted Payback Period < / = benchmark (set by yourself): Accept

- Discounted Payback Period > benchmark: Reject

Problems with Discounted Payback Rule:

- May reject positive-NPV investments
- Looks into future until cut-off point and doesn’t consider possible losses after that point
- Not suitable for long terms projects

The Average Accounting Return

An investment’s average net income divided by its average book value

(Average book value = (start + in between values… + end of a period) / V  the value of
periods

- AAR > / = target return: Accept

- AAR < target return: Reject

Problems with AAR

- It’s not really a rate of return
- Also uses cut-off rate
- Based on books, not on CF or market value

The Profitability Index

The present value of an investment’s future cash flows divided by its initial cost (benefit-cost
ratio)

- PI > / = 1: Accept
- PI < 1: Reject
Problem with PI
- Generally leads to same decision as NPV however sometimes differs from NPV when
you calculate it, so could make wrong decisions

The Internal Rate of Return

The discount rate that makes the NPV of an investment equal to zero

So, When is NPV=0

Use trial and error here, so fill in the IRR options in the following formula

- IRR > / = discount rate: Accept

- IRR < discount rate: Reject

Problems with IRR

- From the loaner point of view, the IRR will be negative as the first CF will be positive
and the rest is negative, which would mean no loaner would ever be wise to loan
Therefor new rule from loaner perspective:
o IRR < / = discount rate: Accept
o IRR > discount rate: Reject
- When there is a mixture of positive and negative, the IRR is not valid
- May result in multiple answers

Lecture 8 – Chapter 9
So far cash flows were given, now we are going to look at how to calculate them

Incremental cash flows

Directly connected with project, influence by doing a certain project or not
- The difference between a firm’s future cash flows with a project and those without the
project
- Incremental CFs are all changes in the firm’s future CFs that are a direct consequence of
taking the project

Sunk costs
a cash flow that has already occurred
 ignore all sunk costs

Opportunity costs
Opportunity costs are things like warehouses you could use to store things and if you decide not
to, it could be a loss of revenue
 take into account

Side effects
A side effect is classified as either erosion or synergy.
- Erosion is when a new product reduces the CFs of existing products.
E.g., introducing a new car may cause that the sales of another car will decrease
- Synergy occurs when a new project increases the CFs of existing projects
E.g., introducing an expensive campaign to attract customers which will eventually lead
to incomes higher than the costs

After-Tax CFs

 buildings, equipment, vehicles

 4 approaches to calculate Operating Cash Flow

1. Standard Approach

OCF = EBIT (earnings before interest and taxes) + depreciation - taxes

2. Bottom Up Approach

OCF = Net income + depreciation

3. Top Down Approach

OCF = Sales - Costs -Taxes

4. Tax-shield Approach

OCF = (Sales – costs) * (1 – T) + Depreciation * T (T being taxes)

Small Detour: Depreciation Mechanisms

Straight line depreciation: reduce the same amount every time

Reducing balance: reduce a fixed percentage of the left worth every time

Important example:
Staple Supply Ltd has just purchased a new IT system with an installed cost of €160,000. Staple
uses 20 per cent reducing balance depreciation over 4 years and expects a salvage value of
€10,000.
- What are the tax consequences of the sale if the tax rate is 34 per cent?
- Sale for €10,000 at end of Year 4
o Loss of €55,536 for tax purposes.

Two things happen here:

1. .Staple saves 34% x €55,536 = €18,882 in taxes.
2. Staple gets €10,000 (non-taxable) from the buyer. The total after-tax cash flow from the
sale is a €28,882 cash inflow
 Thus: they seem to have a loss since they only get 10.000 for a machine that is still worth
65.536, this is not what cash flows look at!! They look at the two points above!!

Change in Net Working Capital

To run a project, you need money: working capital, for the project to stay on track.
So for example you start by putting in +20.000 and after the project is done you will have paid
that 20.000  for cash flow this means that at the beginning you will have a CF of -20.000
and at the end a cash flow of +20.000

VERY HELPFUL EXAMPLE IN LECTURE!

Chapter 10 – Project Analysis and Evaluation

Fixed costs: Costs that do not change when the quantity of output changes during a particular
time period.

Variable costs: Costs that change when the quantity of output changes

Contribution: Contribution of a sale to cover fixed costs

Quantity: Goal is to determine the number of units that is needed to earn fixed costs back
(break-even)

Types of break-even
1. Cash break-even: sales level that results in a zero OCF
 2. Accounting break-even: sales level that results in zero project net income
3. Financial break-even: sales level that results in a zero NPV

1. Cash break-even | OCF = 0

Look at how much you are earning and at what variable and fixed costs  at what quantity will
you cover your fixed costs?

OCF= S – V – F = 0 (Sales: P x Q) (Variable: v x Q)

 Cash break-even: OCF = O  Q = F/(P-v)

2. Accounting break-even | OCF = Depreciation

At what quantity will the OCF be equal to the depreciation? Keep the depreciation into
account!

 Accounting break-even: OCF = D  Q = (F+D)/(P-v)

Problem: does not take the investment costs (opportunity costs) into account which could lead to
false decisions  financial break even does:

3. Financial break-even |
At what quantity is the net present value equal to zero?

 Financial break-even: Q = (F+OCF)/(P-v)

In order to calculate the OCF, you need to calculate the factor of annuity (PVIFA) and fill it in
the NPV factor in order to calculate it.

Very good example question:

Suppose Wettway Yachts Ltd is considering whether to launch its new Margo-class yacht.

•The selling price will be £40,000 per boat.

•The variable costs will be £20,000 per boat.
•The fixed costs will be £500,000 per year.
•Initial Investment £3,500,000 Wettwayhas a 20 per cent required return on new projects.

Calculate the financial break-even

Degree of Operating Leverage (DOL)
The degree to which a firm or project relies on fixed costs
 the higher the degree of operating leverage, the more the firm relies on fixed costs

(no fixed costs  DOL = 1)

If quantity sold rises by x% what will be the % change in OCF?

DOL = (% change in OCF) / (% change in Q)  DOL = 1 + (F/OCF)

In general:
- High DOL: High fixed costs and low variable costs
- Low DOL: Low fixed costs and high variable costs

Lecture 9 – Chapter 11
Recap on calculating returns:

Bought a share for €25, ends with price of €35, €5 dividend

- What is dividend yield? 5/25= 20%
- What is capital gain? 10/25= 40%
- What is total & return for the year? 15/25= 60%
Average returns
You can calculate average returns by summing up the growth percentages over the years and
divide them by the number of years (Arithmetic Average return)

You can also use geometric return:

Arithmetic average returns are always higher than geometric returns

Both used but give other returns, Solution?

 Blume’s formula
(takes the average of
both)

T= how many years calculating N= how many years in total

Variability of returns
 using deviation

Variance (VAR): The average squared difference between the actual return and the average
return

Standard Deviation: the square root of the variance

Example:
Distribution of Stock Returns
Distribution of stock returns mostly bell shaped (fat tails) most people in the midle of returns,
just very few people very low or very high return.

Black swans: extreme events in which the stock market was influenced dramatically

Risk Premium
Why don’t we all invest in small US companies? Because of big risks

Stock returns – treasury bills = equity premium

Risk premium: return on a risky asset less the return on the risk free security
 the higher, the more risk

Market Efficiency

An efficient capital market is one in which assets prices fully reflect available information
 known as the Efficient Markets Hypothesis (EMH):

1. Because information is reflected in prices immediately, investors should only expect to

obtain an “average” rate of return.
2. Awareness of information when it is released does an investor no good.
3. The price adjusts before the investor has time to trade on it.

Envelope with money example:

Once you know how much there is in the envelope, you are most likely to be willing to pay more

Three forms of market efficiency:

1. Weak form: stock prices predicted based on history, is not sufficient enough
2. Semi-strong form: stock prices predicted with all publicly available information
(historical and current), there will not be a delayed response to information as it is
available to everyone
 3. Strong form: stock prices predicted based on all information (private and public), there
will be a delay since the news needs to spread

Lecture 10 – Chapter 12 – Return, Risk and the Security Market Line

(recall from last lecture)
Can we systematically beat the market?
 Richard Thaler said there are two components:

1. You cannot beat the market (no free lunch): market prices are impossible to predict and
so it is hard for any investor to beat the market after taking risk into account.
2. The price is always right: asset prices will, to use Mr. Fama’swords “fully reflect”
available information, and thus “provide accurate signals for resource allocation.

Chapter 12
Single Assets

Economist think in different states of the economy

- Recession
- Boom
And look at the probability of it happening
In order to calculate the average in both cases  very theoretical!

How to calculate expected return of a single asset

(Probability state 1 x rate of return) + (Probability state 2 x rate of return) = return

Expected return, variance & SD of portfolio

Portfolio: more than one asset

Portfolio weight: percentage of a portfolio’s total value that is in a particular asset

Re-watch the lecture part for explanation and look at notes previous lecture

Systematic and unsystematic risk

Total return = expected return + unexpected return (surprises)

Systematic risk
A risk that influences a large number of assets. Also referred to as ‘market risk’
Unsystematic risk
A risk that affects at most a small number of assets. Also referred to as ‘unique’, ‘idiosyncratc’
or ‘asset-specific’ risk.
- As the unsystematic risk is unique to the asset, it is also unrelated to another asset’s unique risk
If you diversify your portfolio, you can reduce the asset-specific risks and are only left with the
market risk

The higher the average standard deviation of returns, the higher the risk is

Beta
Because unsystematic risk can be diversified, only systematic risk is priced by the market
- The expected return on a risky asset depends only on that asset’s systematic risk.
So, what the market will pay you as a risk premium is only based on systematic risk

That brings us to the Beta Coefficient

You don’t look at standard deviation, but how the asset moves in the market, so relatively to the
market
 The amount of systematic risk present in a particular risky asset relative to that in an
average (market) risky asset

If the market goes up by 1%, how much does your asset goes up?

- When the Beta is high, risk is high but you can expect a higher return
- When the Beta is low, risk is low but you can expect a lower return

How to calculate with them

- What is the beta of portfolio x?

(Weight asset 1 x beta) + (weight asset 2 x beta) + … = Portfolio Beta

Which means when the market goes up 1% your port will go up Beta p %

Security market line and CAPM (Capital Asset Pricing Model)

Reward to risk ratio: shows you how much additional expected returns you can get for a certain
level of risk (slope of the curve of correlation between expected return and the Beta)
In the market:

The Beta Coefficient of the market must always be B = 1

 So the formula becomes:

 the reward to risk ratio of the SML = market risk

premium

SML: The Security market line: the curve from the correlation between expected return and
the Beta of the market

In theory, the reward to risk ratio of all assets should be the same
 however, this is not the case and that is how the market works! Question and Demand

Capital Asset Pricing Model (CAMP): shows the relationship between expected return and
beta
Reward to risk of one share = market risk premium
Thus:
(risk premium)

Lecture 11 – Chapter 13

Calculating the cost of acquiring equity capital for a firm:

1. The Dividend Growth Model Approach

Calculate a firms cost of acquiring equity capital by calculating Return for shareholders

Since the R is the return that shareholders get on equity, it can be seen as a firms cost

2. Security Market Line

Calculate firms cost of equity by looking at:
- Risk-free rate
- Market risk premium
- Company Beta
And using the CAPM

Calculating the cost of debt and preference shares

Preference shares: shares that get paid dividend first, after that come common shares
 results in a fixed dividend paid each period so is a perpetuity

To calculate cost preference share for the loaner (Rp):

D= fixed dividend and P0 is current preference share price

Weighted Average Costs of Capital (WACC)

To calculate WACC, you need
1. Cost of equity (above)
2. After-tax cost of debt (above)
3. Capital Structure
3. Capital structure: how much debt do you have compared to how much equity?

- Amount of equity: number of shares outstanding x share price = E

- Amount of debt: market price of single bond x number of bonds outstanding = D

 Value (V) = E + D
If we divide both sides by V, we can calculate the percentages of the total capital represented by
the debt and equity:

E/(E+D) + D/(E+D) = capital structure weights

So: To calculate WACC, you need

1. Cost of equity
2. After-tax cost of debt
3. Capital Structure

= Weighted Average Cost of Capital

(or yield to maturity)

Or

Required return versus cost of capital

The cost of capital depends primarily on the use of the funds, not the source

Pure play approach

You can use the companies Beta as a means to calculate the WACC within the company, but it
you want to calculate a WACC of a specific project outside of the company’s specialty
 use the Beta of another company in similar lines of business: Pure play approach

Subjective Approach
Adding an adjustment factor based on whether the new project has a high or low risk

Flotation Costs

Costs of issuing stocks (for the first time (IPO))

- Professional Fees: includes those for attorneys, as well as certified public accountants.
- Commissions: underwriters that place the securities with investors will charge both fees
for this service as well as sales commissions.
- Clerical: includes both administrative and clerical costs associated with preparing
regulatory filings as well as registrations.
- Filings: expenses and fees associated with filing the issue with the Securities and
Exchange Commission.
- Marketing: advertising, mailing, and marketing costs associated with promoting the
securities to investors

If a company accepts a new project, it may be required to issue, or float, new bonds, and shares.
This means that the firm will incur some costs, which we call flotation costs

NPV and Flotation Costs

Lecture 12 – Chapter 14 – Raising Capital
Private Equity: used for the rapidly growing area of equity financing for nonpublic (small;
stocks not traded) companies

 Banks are generally not interested in making loans to start-up companies, especially ones:
- with no assets (other than an idea) or
- run by entrepreneurs with no track record.
- There is high risk and a lot of search costs involved.
Firms with this profile search for venture capital (VC), an important part of the private
equity markets.

Venture capital: the financing of new, often high-risk start-ups

 Individual venture capitalists invest their own money
Sources like:
- Individuals
- Pension funds
- Insurance companies
- Large corporations
- University endowments

Usually small chance of succeeding, but when it does it succeeds very highly

Stages:
1. Seed money
2. Start-up
3. Later stage capital
4. Growth capital
5. Replacement capital
 6. Buy-out financing

IPO: Initial Public Offering  taking your firm from the private stage to the public state for the
first time
 Steps:

Underwriters: banks that perform the IPO for a company

Different methods to use to publicly share your shares

1. Private Placing
When you hold shares of a company that is not public and you want to trade them so doing it
privately before going public

2. General Cash Offer

Selling your stock for cash

3. Right Issue
Discussed later

Going public for the very first time is IPO, when you see the need to raise more capital and
bring more shares on the market is called Seasoned Equity Offering (SEO)

What happens to shares in IPO process?

 Company’s earning
point

 company doesn’t
profit from this
Disadvantages of going public
- Need to fulfill a lot of criteria and regulations: need to publish information, statistics etc.
Takes a lot of effort

General Cash Offer

3 types of bringing shares to the public:

1. Firm commitment
Underwriters (banks) promise you to buy all your shares, take all the risks but also the
benefits. Because they take all the risk you might get a lower price

2. Best Efforts
The underwriters will put in their best offers to sell your shares but do not promise to buy
them from you. You are partially receiving money per share you sell, the underwriter
earns more money the more they sell  you share the risks and benefits

3. Dutch Auction
Sell shares in an auction. Is not used frequently.

Green shoe: an option by the underwriters to purchase up to 15% more shares from the old
owners than initially planned. Give the underwriters the option to sell more once you notice the
IPO was very successful.  introduced because it is very hard to estimate how interested stock
buyers will be in your company, so possibility to match a little bit better to demand.

 it is very difficult to estimate the question and demand of your stocks and the price
That’s why IPO’s are usually underpriced:
To make it surer that you sell all the shares

Costs of New Issues

- Spread or underwriting discount
- Other direct costs
- Indirect costs
- Abnormal returns
- Underpricing
- Green shoe option

Costs of SEO New Issues

SEO’s also cost money because you have to issue new shares and have to come up with
perspectives and new information
Rights Issues
- An issue of equity to existing shareholders is called a rights issue or rights offering.
E.g., you are shareholder of a company and the company tells you that they are going to bring
out more shares. You firstly owned 20% but this is going to dilute since the total share amount
will go up.
 Each shareholder is issued an option to buy a specified number of new shares from the firm at
a specified price within a specified time, after which the rights expire.

E.g.,
Let’s say an investor owns 100 shares of Arcelor Mittaland the shares are trading at $10 each.
The company announces a rights issue in the ratio of 2 for 5, i.e., each investor holding 5 shares
will be eligible to buy 2 new shares. The company announces a discounted price of, for example,
$6 per share. It means that for every 5 shares (at $10 each) held by an existing shareholder, the
company will offer 2 shares at a discounted price of $6.
- Investor’s Portfolio Value (before rights issue) = 100 shares x $10 = $ 1,000
- Receives 100 rights and can buy 40 new shares (100 x 2/5 = 40) at subscription price of
$6•Price paid to buy rights shares = 40 shares x $6 = $ 240
- Total number of shares after exercising rights issue = 100 + 40 = 140
- Revised Value of the portfolio after exercising rights issue = $ 1,000 + $240 = $1,240
- Should be price per share post-rights issue = $1,240 / 140 = $8.86→Value of SR = $10 -
$8.86 = $1.14.
- Investor can either use SR (with additional cash) or sell SR.
- Wealth without using SR: 100 x $8.86 + 100 x $1.14 = $1000•Remember(!!): Each
shareholder receives 1 SR for each share, but needs usually more SR to purchase new
shares, her

 creates no disadvantages for the existing shareholders

Lecture 13 – Chapter 20 – Financial Risk Management

Volatility: risk, wispelturigheid

Two types of Volatility Exposure:

1. Transaction Exposure
Short-run financial risk arising from the need to buy or sell at uncertain prices or rates in
the near future, Airline company that needs to buy gasoline and price of that could go up

2. Economic Exposure
Long-term financial risk arising from permanent changes in prices or other economic
fundamentals, China becomes more powerful which changes the macro economics

 cause that prices go up and down

Risk profile: plot showing how to value of a firm is affected by changes in prices or rates, the
flatter the plot, the better

Hedging: reducing a firm’s exposure to price or rate fluctuation (reduce risk)

 Derivative security: a financial asset that represents a claim to another financial asset, used
for hedging

Hedging with Forward Contracts

Forward contract: (non-tradable) agreement to buy/sell an asset at some future date at a price
agreed today
E.g., you will be buying 5000 barrel for a fixed price of €1.000 today

- Both buyer and seller are obligated to perform under the terms of the contact

Payoff Profile: a plot showing the gains and losses that will occur on a contract as the result of
unexpected price changes

The Forward’s Payoff Profile looks like a 90 degree line because the price is fixed
- When prices go up, the buyer profits from it (reversed for seller)
- When prices go down, the buyer has a loss (reversed for seller)

Hedging with Futures Contracts

Futures contract: (tradable on an exchange)
- highly standardized contract (so it is tradable)
- prices of future contracts are ‘marked to market’ every day. This means gains and losses
are realized each day rather than only on the settlement date
- specifying the amount of a contract is very important, not just the price

Buyer and seller want to avoid the risks of fluctuating prices  hire clearing house  set a price
together,
- When actual price goes below fixed price, seller receives difference from clearing house
But clearing house receives the difference from buyer
- When actual price goes above fixed price, buyer receives difference from clearing house
But clearing house receives the difference from seller

what marked to market means to the seller: on every day you will settle the price and adjust it
to how the market moves
 reduces the risk since rising of prices for both buyer as seller

Hedging with Swap Contracts

Swap contract: an agreement between two parties where you exchange (swap) certain
payments, exchange specified cash flows at specified intervals in the future
Company A and B both get a loan with a rate. Company A a floating rate of 1%, company B a
fixed rate of 9.5%. They swap the rates because they both benefit from it.
 reduces risks

Types of Swaps
1. Currency swaps
2. Interest Rate Swaps
3. Commodity Swaps (grondstof/handelswaar)

Hedging with Options

Option: a contract giving its owner the right to buy or sell an asset at a fixed price on or before a
given date

1. Start with agreeing on a price: the strike/exercise price

2. Set an expiration date
3. Exercise the option
a. American options: any time up until the expiration date
b. European options: only on the expiration date
 you need to pay for the right of the option

Call and Put options

Call option: gives the owner the right to buy an asset at a fixed price during (or at) a particular
period.
- use this option when the price of the thing you are buying is higher than the fixed price

Put options: gives the owner the right to sell an asset at a fixed price during (or at) a particular
period
- Use this option when the price of the thing you are selling is lower than the fixed price