Notes CF

CFIVO1002U.
LA_E22 Corporate Finance Autumn 2022
TABLE OF CONTENTS
1 Brush-up and Introduction ............................................................................................................ 3
1.1 Chapter 1: Corporations............................................................................................................................... 3
1.2 Chapter 2: Financial Statement Analysis ..................................................................................................... 3
1.3 Chapter 3: Financial Decision Making ........................................................................................................ 4
1.4 Chapter 4: Discounting ................................................................................................................................ 4
1.5 Chapter 5: Interest Rates .............................................................................................................................. 5
1.6 Chapter 6: Valuing Bonds ........................................................................................................................... 5
1.7 Chapter 7: Investment Decision Rules......................................................................................................... 6
1.8 Chapter 8: Fundamental of Capital Budgeting ............................................................................................ 6
1.9 Chapter 9: Valuing Stocks ........................................................................................................................... 7
1.10 Chapter 10: Capital Markets and the Pricing of Risk .............................................................................. 7
2 CAPM and Cost of Capital ............................................................................................................ 8
2.1 Chapter 11: CAPM and Optimal Portfolio Choice ...................................................................................... 8
2.2 Chapter 12: Estimating Cost of Capital ..................................................................................................... 10
3 Capital Structure in Perfect Captial Market ............................................................................. 11
3.1 Equity Versus Debt Financing ................................................................................................................... 13
3.2 Modigliani-Miller I: Leverage, Arbitrage, and Firm Value ....................................................................... 13
3.3 Modigliani-Miller II: Leverage, Risk, and the Cost of Capital .................................................................. 14
3.4 Capital Structure Fallacies ......................................................................................................................... 15
4 Debt and Taxes .............................................................................................................................. 16
4.1 Valuing the Interest Tax Shield ................................................................................................................. 16
4.2 Recapitalising to Capture the Tax Shield................................................................................................... 17
4.3 Personal Taxes ........................................................................................................................................... 17
4.4 Optimal Capital Structure with Taxes........................................................................................................ 18
5 Financial Distress .......................................................................................................................... 19
5.1 Default and Bankruptcy in a Perfect Market ............................................................................................. 19
5.2 The Cost of Bankruptcy and Financial Distress ........................................................................................ 19
5.3 Optimal Capital Structure: The Trade-Off Theory .................................................................................... 20
5.4 Agency Costs of Leverage ......................................................................................................................... 20
5.5 Agency Benefits of Leverage .................................................................................................................... 21
5.6 Agency Costs and the Trade-Off Theory ................................................................................................... 21
5.7 Asymmetric Information and Capital Structure ......................................................................................... 22
6 Payout Policy ................................................................................................................................. 23
6.1 Dividends and Share Repurchases ............................................................................................................. 23
6.1.1 Cum-Dividend Price and Ex-Dividend Price with No taxes ................................................................................ 24
6.2 Optimal Dividend Policy With Taxes ........................................................................................................ 24

6.3 Adjusting for Investor Taxes and Tax Clienteles....................................................................................... 24
6.4 Retaining Cash versus Payout ................................................................................................................... 25
6.5 Issuing Rights ............................................................................................................................................ 25
6.6 Signalling with Pay-out Policy .................................................................................................................. 26
6.7 Stock Dividends, Stock Splits, and Spin-offs ............................................................................................ 26
7 Capital Budgeting and Valuation with Debt .............................................................................. 27
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CFIVO1002U.LA_E22 Corporate Finance Autumn 2022
7.1 The Weighted Average Cost of Capital (WACC) Method ........................................................................ 27

7.2 The Adjusted Present Value (APV) Method ............................................................................................. 27
7.2.1 APV with Other Leverage Policies ...................................................................................................................... 28
7.3 The Flow-to-Equity (FTE) Method ........................................................................................................... 28

7.4 Project-Based Cost of Capital .................................................................................................................... 29
7.5 Advanced Topics in Capital Budgeting ..................................................................................................... 29
8 Banz and Miller............................................................................................................................. 30
8.1 Valuing a Project in the Trinomial Model ................................................................................................. 30
9 Financial Options .......................................................................................................................... 32
9.1 Option Basics ............................................................................................................................................. 32
9.1.1 Option Payoffs at Expiration............................................................................................................................... 32
9.2 Put-Call Parity ........................................................................................................................................... 32

9.3 Factors Affecting Option Prices ................................................................................................................ 33
9.3.1 Arbitrage bounds on Option Prices..................................................................................................................... 34
9.4 Exercising Options Early ........................................................................................................................... 34

9.5 Options and Corporate Finance ................................................................................................................. 35
10 Option Valuation........................................................................................................................... 37
10.1 The Binomial Pricing Model ................................................................................................................. 37
10.2 The Black-Scholes Option Pricing Model............................................................................................. 37
10.3 Risk-Neutral Probabilities ..................................................................................................................... 38
10.4 Risk and Return of an Option................................................................................................................ 39
10.5 Corporate Application of Option Pricing .............................................................................................. 40
11 Real Options .................................................................................................................................. 41
11.1 The Option to Delay: Investment as a Call Option ............................................................................... 41
11.2 Growth and Abandonment Options....................................................................................................... 42
11.3 Investments with Different Lives .......................................................................................................... 43
11.4 Optimally Staging Investments ............................................................................................................. 43
11.5 Rules of Thumb and Key Insights ......................................................................................................... 43
12 Raising Equity Capital ................................................................................................................. 45
12.1 Venture Capital Investing ..................................................................................................................... 45
12.2 Initial Public Offering (IPO) ................................................................................................................. 46
12.3 Seasoned Equity Offering (SEO) .......................................................................................................... 46
13 Debt Financing .............................................................................................................................. 47
13.1 Corporate Debt ...................................................................................................................................... 47
13.2 Other Types of Debt .............................................................................................................................. 47
13.3 Bond Covenants .................................................................................................................................... 48
13.4 Repayment Provisions, Callable bonds ................................................................................................. 48
14 Leasing ........................................................................................................................................... 49
14.1 Accounting, Tax and Legal Consequences of Leasing.......................................................................... 49
14.2 The Leasing Decision............................................................................................................................ 50
14.2.1 Evaluating a True Tax Lease .............................................................................................................................. 51
14.2.2 Evaluating a Non-Tax Lease ............................................................................................................................... 51
14.3 Reasons for Leasing .............................................................................................................................. 51

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15 Short-Term Financing .................................................................................................................. 53

15.1 Working Capital Management .............................................................................................................. 53
15.1.1 The Cash Cycle ................................................................................................................................................... 53
15.1.2 Trade Credit ........................................................................................................................................................ 53
15.1.3 Managing Receivables, Payables, Inventory and Cash ....................................................................................... 53
15.2 Short-Term Financial Planning ............................................................................................................. 54

16 Mergers and Acquisitions ............................................................................................................ 56
16.1 Market Reaction to a Takeover ............................................................................................................. 56
16.2 Reasons to Acquire ............................................................................................................................... 56
16.3 Valuation, Offer and the Takeover Process........................................................................................... 57
16.3.1 The Offer ............................................................................................................................................................. 57
16.3.2 Takeover Process ................................................................................................................................................ 59
16.4 Takeover Defences ................................................................................................................................ 59

16.5 Who Gets the Value Added from a Takeover? ..................................................................................... 60
4) Formulas from slides .................................................................................................................... 61
5) Derivation WACC......................................................................................................................... 67
1 BRUSH-UP AND INTRODUCTION

Berk & DeMarzo (2017): Chapter 1-13 + Session I
1.1 Chapter 1: Corporations

Unlimited liability firms do not pay corporate tax, but owners pay income tax on pay-outs.
Limited liability indicates a limit to the shareholders’ liability in case of, e.g., a bankruptcy.
Tax differences between C Corporations (commercial) and S Corporations (savings, partnerships): C corporations
pay corporate tax and shareholders pay dividend tax and capital gains tax. S corporations do not pay corporate tax,
but shareholders (owners) pay income tax on the company’s earnings. S corporations typically have unlimited
liability.
● Thus, shareholders in a C corporation effectively pay tax twice.
The ownership of a corporation is divided into shares of stock collectively known as equity. Corporate bankruptcy
can be thought of as a change in ownership and control of the corporation. The equity holders give up their ownership
and control to the debt holders.
1.2 Chapter 2: Financial Statement Analysis

The balance sheet shows the firm’s current assets, liabilities, and equity. The two sides must balance:
𝐴𝑠𝑠𝑒𝑡𝑠 = 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 + 𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠′ 𝑒𝑞𝑢𝑖𝑡𝑦 = 𝐸𝑉 + 𝐶𝑎𝑠ℎ
Net working capital is the capital available in the short term to run the business as the difference between current
assets (e.g., receivables, inventory) and current liabilities (e.g., payables).
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Stockholders’ equity is the book value of the firm’s equity, while the market value of the firm’s equity is its market
cap. The enterprise value is the total value of its underlying business operations:
𝐸𝑛𝑡𝑒𝑟𝑝𝑟𝑖𝑠𝑒 𝑣𝑎𝑙𝑢𝑒 = 𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 + 𝐷𝑒𝑏𝑡 − 𝐶𝑎𝑠ℎ
On the income statement, the operating income is revenues less cost of goods sold and operating expenses. After
adjusting for non-operating income and expenses, we have earnings before interest and tax, or EBIT. Deducting
interest and taxes gives net income, from which earnings per share (EPS) can be calculated. EBITDA measures the
cash a firm generates before capital investments
𝐸𝐵𝐼𝑇𝐷𝐴 = 𝐸𝐵𝐼𝑇 + 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑎𝑛𝑑 𝑎𝑚𝑜𝑟𝑡𝑖𝑠𝑎𝑡𝑖𝑜𝑛
Net debt measures the firm’s debt in excess of its cash reserves
𝑁𝑒𝑡 𝑑𝑒𝑏𝑡 = 𝑇𝑜𝑡𝑎𝑙 𝑑𝑒𝑏𝑡 − 𝐸𝑥𝑐𝑒𝑠𝑠 𝑐𝑎𝑠ℎ 𝑎𝑛𝑑 𝑠ℎ𝑜𝑟𝑡 − 𝑡𝑒𝑟𝑚 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡𝑠
ROE is return on equity and can be expressed in terms of profitability (net profit margin), asset efficiency (asset
turnover), and leverage (equity multiplier), i.e.,
𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 𝑆𝑎𝑙𝑒𝑠 𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠

𝑅𝑂𝐸 = × ×
𝑆𝑎𝑙𝑒𝑠 𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠 𝐵𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦
1.3 Chapter 3: Financial Decision Making

When evaluating a decision, we value incremental costs and benefits associated with it. A good decision has the
value of benefits exceeding the value of costs.
A competitive market is one in which a good can be bought and sold at the same price.
Arbitrage is the process of trading to take advantage of price discrepancies in different competitive markets. The Law
of One Price state that if equivalent goods and securities trade simultaneously in different competitive markets, they
will trade for the same price in each market. No arbitrage opportunities should exist, which implies that all risk-free
investments should offer the same return.
1.4 Chapter 4: Discounting

The present value today of a cash flow stream 𝐶 received in 𝑛 years is
𝐶
𝑃𝑉 =
(1 + 𝑟)
The future value in 𝑛 years of a cash flow stream with a present value of 𝑃𝑉 is
𝐹𝑉 = 𝑃𝑉 × (1 + 𝑟)
A perpetuity is a constant cash flow 𝐶 paid every period forever. The present value is 𝐶/𝑟. An annuity is a constant
cash flow 𝐶 paid every period for 𝑁 periods. The present value of an annuity is
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1 1
𝑃𝑉 = 𝐶 × 1−
𝑟 (1 + 𝑟)
The future value of an annuity at the end of the annuity is
1
𝐹𝑉 = 𝐶 × ((1 + 𝑟) − 1)
𝑟
The periodic payment on an 𝑁-period loan with principal 𝑃 and interest rate 𝑟 is
𝑃
𝐶=
1 1
𝑟 1 − (1 + 𝑟)
The internal rate of return (IRR) of an investment is the interest rate that sets NPV equal to zero.
1.5 Chapter 5: Interest Rates

The effective annual rate (EAR) indicates the actual amount of interest earned in one year. This may be used as a
discount rate for annual cash flows. The annual percentage rate (APR) indicates the total amount of interest earned
in one year without considering the effect of compounding. This may not be used as discount rates. Given an APR
with 𝑘 compounding intervals per year, the EAR is given
𝐴𝑃𝑅
1 + 𝐸𝐴𝑅 = 1 +
𝑘
Quoted interest rates are nominal interest rates, indicating the rate of growth of the money invested. The real
interest rate indicates the rate of growth in purchasing power after adjusting for inflation. Given a nominal rate 𝑟 and
an inflation rate 𝑖, the real interest rate is
𝑟−𝑖
𝑟 = ≈𝑟−𝑖
1+𝑖
Interest rates differ with investment horizon according to the term structure of interest rates. Plotting interest rates
against the horizon is the yield curve. Cash flows should be discounted using the discount rate that is appropriate for
their horizon. If the interest of an investment is taxed at rate 𝜏, or if the interest on a loan is tax deductible, then the
effective after-tax interest rate is 𝑟(1 − 𝜏)
1.6 Chapter 6: Valuing Bonds

Bonds pay both coupons and principal or face value payments to investors. Zero-coupon bonds make no coupon
payments, so investors receive only the bond’s face value. The internal rate of return of a bond is its yield to
maturity, which is the discount rate that sets the present value of the promised bond payments equal to the current
market price of a bond. For a zero-coupon bond, this is
/
𝐹𝑉
𝑌𝑇𝑀 = −1
𝑃
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The risk-free rate for an investment until date 𝑛 equals the yield to maturity of a risk-free zero-coupon bond maturing
on this date. A plot of the rates against maturity is called the zero-coupon yield curve.
A bond will trade at a premium is the coupon rate exceeds its YTM, at a discount is the coupon rate is less than its
YTM, and at par if they are equal. Bond prices changes with interest rates. When interest rates rice, bond prices fall.
Long-term zero-coupon bonds are more sensitive to changes in interest rates, along with low coupon rate bonds.
The price of a coupon-paying bond can be determined on the zero-coupon yield curve using the law of one price (boot
strap method), i.e.,
𝐶𝑃𝑁 𝐶𝑃𝑁 𝐶𝑃𝑁 + 𝐹𝑉

𝑃 = 𝑃𝑉(𝐵𝑜𝑛𝑑 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤𝑠) = + …+
1 + 𝑌𝑇𝑀 (1 + 𝑌𝑇𝑀 ) (1 + 𝑌𝑇𝑀 )
The difference in yields on Treasury bonds (risk-free) and corporate bonds is the credit spread, compensating
investors for the difference in promised and expected cash flows and the risk of default.
1.7 Chapter 7: Investment Decision Rules

The net present value (NPV) of a project is the present value of its benefits subtracted the present value of its costs.
When choosing among alternatives, the one with the highest (positive) NPV should be chosen. NPV of a project is
equivalent to the cash value today of the project.
Other criterions for evaluating projects are…
… internal rate of return (IRR), where an investment, whose IRR exceeds the opportunity cost of capital, is
accepted. Unless all negative cash flows precede the positive ones, this may be wrong
… payback investment rule calculates the amount of time it takes to pay back the initial investment, and if it is less
than a prespecified length of time, accept the project.
In friction-less markets, positive NPV projects should always be initiated.
NVP calculation: The numerator should have (estimated) free cash flows for each period (without benefits and costs
of financing). The denominator (discounting) should have the yield for the period.
● With no uncertainty, the denominator is found by the yield curve for the given maturity.
● With uncertainty, the denominator is harder, and the risk of the free cash flows (beta) is relevant.
1.8 Chapter 8: Fundamental of Capital Budgeting

Capital budgeting is analysing investment opportunities and deciding which ones to accepts – usually based on the
NPV rule. The incremental earnings of a project comprise the amount by which the project is expected to change the
firm’s earnings. When evaluating a capital budgeting decision, we first consider the project on its own separate from
the financing decisions.
● The separation principle: Investments and financing decisions can (and should) be separated when there is no
uncertainty and friction. Thus, financing sources are in most cases irrelevant.
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Free cash flows are computed from incremental earnings by eliminating all non-cash expenses and including all
capital investments: (1) Depreciation is not a cash expense, so it is added back, (2) actual capital expenditures are
deducted, (3) increases in net working capital (cash + inventory + receivables – payables) are deducted. The basic
calculation for free cash flow is then
𝐹𝐶𝐹 = (𝑅𝑒𝑣𝑒𝑛𝑢𝑒 − 𝐶𝑜𝑠𝑡 − 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛) × (1 − 𝜏 ) + 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 − 𝐶𝑎𝑝𝐸𝑥 − 𝛥𝑁𝑊𝐶
𝐹𝐶𝐹 = 𝐸𝐵𝐼𝑇 × (1 − 𝜏 ) + 𝐷𝑒𝑝 − 𝐶𝑎𝑝𝑒𝑥 − 𝛥𝑁𝑊𝐶
1.9 Chapter 9: Valuing Stocks

The Law of One Price states that the value of a stock is the present value of dividends and future sales price the
investor will receive. As these cash flows are risky, they must be discounted at the equity cost of capital, i.e., the
expected return of other securities available in the market with equivalent risk.
The total return of a stock is the dividend yield plus the capital gain rate. The expected total return should equal its
equity cost of capital, i.e., 𝑟 = (𝐷𝑖𝑣 + 𝑃 )/𝑃 .
When investors have the same beliefs, the dividend discount model states that for any horizon 𝑁, the stock price
satisfies the equation below.
𝐷𝑖𝑣 𝐷𝑖𝑣 𝑃
𝑃 = + ⋯+ +
(1 + 𝑟 ) (1 + 𝑟 ) (1 + 𝑟 )
The total payout model is more reliable for valuing the firm when the firm repurchases shares. Here, the value of
equity equals the present value of future total dividends and repurchases. The stock price:
𝑃𝑉(𝐹𝑢𝑡𝑢𝑟𝑒 𝑡𝑜𝑡𝑎𝑙 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 𝑎𝑛𝑑 𝑟𝑒𝑝𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑠)

𝑃 =
𝑆ℎ𝑎𝑟𝑒𝑠 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔
The discounted free cash flow model is more reliable when the firm has leverage. First, calculate future free cash
flows. The enterprise value is the present value of the future FCF. The cash flows are discounted with the weighted
average cost of capital (WACC), i.e., the expected return to investors to compensate them for the risk of holding the
firm’s debt and equity together. The stock price is:
𝑉 + 𝐶𝑎𝑠ℎ − 𝐷𝑒𝑏𝑡
𝑃 =
The efficient markets hypothesis states that competition eliminates all positive-NPV trades, which securities with
equivalent risk have the same expected returns.
1.10 Chapter 10: Capital Markets and the Pricing of Risk

Historically, small stocks have had higher volatility and higher average returns than large stocks. There is no clear
relationship between volatility and return of individual stocks.
Unsystematic risk (idiosyncratic risk, diversifiable) is the variation in a stock’s return due to firm-specific news, i.e.,
risk independent of other shocks in the economy. Systematic risk (market risk, undiversifiable) is due to market-wise
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news that affects all stock simultaneously. Diversification eliminates unsystematic risk, but not systematic risk. Thus,
investors require a risk premium for holding systematic risk, but not unsystematic risk (as it can be diversified away)..
An efficient portfolio contains only systematic risk and cannot be diversified further, i.e., risk cannot be reduced
without lowering the expected return. The systematic risk of a security is measured by its beta, which is the sensitivity
of its returns to the return of the overall market.
The market risk premium is expected excess return of the market portfolios, i.e., 𝐸[𝑅 ] − 𝑟 . The Capital Asset
Pricing Model (CAPM) states that the risk premium for an investment equals the investment’s beta times the markets
risk premium:
𝑟 = 𝑟 + 𝛽 × 𝐸[𝑅 ]−𝑟
2 CAPM AND COST OF CAPITAL
2.1 Chapter 11: CAPM and Optimal Portfolio Choice

Investors can choose between different asset classes with varying risk and return trade-off. Risk is measured as
standard deviation (or variance) of return and is traded off with ex ante expected return. Ex ante expected return is
estimated by historic average return.
The expected return of a portfolio is the weighted average of the expected returns of investments using the portfolio
weights. Covariance and correlation measure the co-movements of stock returns in a portfolio. The variance of a
portfolio depends on the covariance of the stocks within it. See p 425.
Calculating correlation through Variance:
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Efficient portfolios have the highest possible expected return for a given level of risk. The set of efficient portfolios is
called the efficient frontier. Below are risk-return combinations from combining a risk-free investment and a risky
portfolio. The most optimal portfolio is the tangent portfolio.
An investor
seeking the
highest
expected
return given a
level of
volatility
should choose
the portfolio with the steepest line when combined with the risk-free investment. The slope is the Sharpe ratio:
𝑃𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝐸𝑥𝑐𝑒𝑠𝑠 𝑅𝑒𝑡𝑢𝑟𝑛 𝐸 𝑅 − 𝑟

𝑆ℎ𝑎𝑟𝑝𝑒 𝑅𝑎𝑡𝑖𝑜 = =
𝑃𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝑉𝑜𝑙𝑎𝑡𝑖𝑙𝑖𝑡𝑦 𝑆𝐷 𝑅
The portfolio with the highest Sharpe ratio is the efficient portfolio independent of the risk preference
Capital Market Line (CML) represents portfolios that optimally combine risk and return, i.e., portfolios that
optimally combine the risk-free rate and the market portfolio of risky assets.
Security Market Line (SML) displays the expected return on an individual asset as a function of systematic, non-
diversifiable risk. That is, it states that the risk premium of any security is equal to the market risk premium multiplied
by the beta of the security. Thus, a visualisation of the CAPM.
The Capital Asset Pricing Model (CAPM): Three main assumptions:
1) Investors can buy and sell all securities at competitive market prices (without incurring taxes or transactions
costs) and can borrow and lend at the risk-free interest rate.
2) Investors hold only efficient portfolios of traded securities – portfolios that yield the maximum expected return
for a given level of volatility.
3) Investors have homogenous expectations regarding volatilities, correlations, and expected returns of securities,
i.e., all investors have the same estimates about future investments and returns.
Thus, we can link the expected return for each individual stocks. Given an efficient market portfolio, the expected
return of an investment is
𝐸[𝑅 ] = 𝑟 = 𝑟 + 𝛽 𝐸[𝑅 ]−𝑟
Where the second term is the risk premium for security 𝑖. The beta corresponds to the risk premium:
𝑆𝐷(𝑅 ) × 𝐶𝑜𝑟𝑟(𝑅 , 𝑅 ) 𝐶𝑜𝑣(𝑅 , 𝑅 ) 𝑟 −𝑟

𝛽 = = =
𝑆𝐷(𝑅 ) 𝑉𝑎𝑟(𝑅 ) 𝐸[𝑟 ] − 𝑟
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2.2 Chapter 12: Estimating Cost of Capital

CAPM in equation is used to estimate the cost of capital – the investors’ required return to provide the capital needed.
So, we need to either estimate expected return or beta. Beta can be efficiently estimated by plotting excess return of
the stock against excess return of the market. The slope of the best-fit line is beta. Thus, we have obtained the cost of
equity capital.
The debt cost of capital can be found by assessing the expected return of a corporate bond as
𝑟 = (1 − 𝑝)𝑦 + 𝑝(𝑦 − 𝐿) = 𝑦 − 𝑝𝐿
where 𝑦 is the yield (to maturity), 𝐿 is a loss given default, and 𝑝 is the probability of default.
The cost of capital of a project can be calculated given a target leverage ratio based on the market value of the firm’s
equity and debt. The firm’s unlevered (asset) cost of capital is
𝐸 𝐷
𝑟 =𝑟 = 𝑟 + 𝑟
𝐸+𝐷 𝐸+𝐷
The beta of a project is the unlevered (asset) beta of a comparable firm
𝐸 𝐷
𝛽 =𝛽 = 𝛽 + 𝛽
𝐸+𝐷 𝐸+𝐷
Cash as Negative Debt: Cash de facto works as negative debt as it reduces the equity beta. Thus, 𝑁𝑒𝑡 𝑑𝑒𝑏𝑡 =
𝐷𝑒𝑏𝑡 − 𝐸𝑥𝑐𝑒𝑠𝑠 𝑐𝑎𝑠ℎ 𝑎𝑛𝑑 𝑆ℎ𝑜𝑟𝑡 − 𝑡𝑒𝑟𝑚 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡𝑠. Used when un-levering betas.
WACC: If the project is financed in part with debt, the firm’s effective after-tax cost of debt is less than its expected
return to investors. The weighted average cost of capital (WACC) can be used:
𝐸 𝐷
𝑟 = 𝑟 + 𝑟 (1 − 𝜏 )
𝐸+𝐷 𝐸+𝐷
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3 CAPITAL STRUCTURE IN PERFECT CAPTIAL MARKET
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Berk & DeMarzo (2017): Chapter 14 + Session II

In perfect capital markets all securities are fairly priced, there are no taxes or transactions costs, and the total cash
flows of the firm’s projects are unaffected by how they are financed. The Law of One Price implies the choice of debt
or equity financing does not affect the value of a firm, its share price, or its cost of capital. While leverage increases
Page 12 of 73
the risk and cost of capital of equity, the weighted average cost of capital (WACC), total value, and share price are
unaltered by a change in leverage.
3.1 Equity Versus Debt Financing

The relative proportions of debt, equity, and other securities constitute a firm’s capital structure.
Financing with Equity: If a project’s cash flows contain market risk, investors demand a risk premium. If a project
is financed using unlevered equity, the market value of equity today is the present value of future cash flows. The
project’s NPV is the value to the initial owners of the firm created by the project. The expected return on equity is
given as
𝐸[𝐸𝑞𝑢𝑖𝑡𝑦] ÷ 𝐸𝑞𝑢𝑖𝑡𝑦 − 1
Financing with Debt and Equity: If a project’s cash flow always will be enough to repay the debt, the debt is risk-
free. Equity in a firm that also has outstanding debt is called levered equity. Promised payments to debt holder must
be made before any payments to equity holders.
Modigliani-Miller argue that with perfect capital markets, the total value of a firm should not depend on its capital
structure, as the firm’s total cash flows still equal the cash flows of the project and therefore has the same present
value.
The effect of Leverage on Risk and Return: Leverage increases the risk of the equity of a firm making it
inappropriate to discount cash flows of levered equity at the same discount rate used for unlevered equity. Investors in
levered equity require a higher expected return to compensate for its increased risk. Thus, leverage increases the risk
of equity even when there is no risk that the firm will default. While debt may be cheaper when considered on its own,
it raises the cost of capital for equity. However, the firm’s average cost of capital with leverage is the same as
unlevered.
3.2 Modigliani-Miller I: Leverage, Arbitrage, and Firm Value

The result that leverage does not affect the total value of the firm, but merely changes the allocation of cash flows
between debt and equity, holds under perfect capital markets:
1) Investors can trade securities at market price equal to the present value of future cash flows.
2) No taxes, transaction costs, or insurance costs associated with security trading
3) A firm’s financing decisions do not change the cash flows generated by its investments, nor do they reveal new
information about them.
MM Proposition I: In a perfect capital market, the total value of a firm’s securities equals the market value of the
total cash flows generated by its assets and is not affected by choice of capital structure.
In the absence of taxes or other transaction costs, the total cash flow paid out to a firm’s security holders is equal to
the total cash flow generated by the firm’s assets. Therefore, by the Law of One Price, the firm’s security and its
assets must have the same total market value.
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Homemade leverage: When investors use leverage in their own portfolios to adjust the leverage choice made by the
company, they are using homemade leverage. If investors can borrow or lend at the same rate as the firm, homemade
leverage is a perfect substitute for the use of leverage by the firm. Investors can thus alter the leverage choice of the
firm to suit their taste by either borrowing and adding more leverage or by holding bonds and reducing leverage.
Market Value Balance Sheet: A market value balance sheet is like an accounting balance sheet, where (1) all
assets are liabilities of the firm are included (even intangible assets) and (2) all values are current market values rather
than historical ones. Then, the total value of all securities issued by the firm must equal the total value of the firm’s
assets. The value of equity is then:
𝑀𝑉 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 = 𝑀𝑉 𝑜𝑓 𝑎𝑠𝑠𝑒𝑡𝑠 − 𝑀𝑉 𝑜𝑓 𝑑𝑒𝑏𝑡 𝑎𝑛𝑑 𝑜𝑡ℎ𝑒𝑟 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
3.3 Modigliani-Miller II: Leverage, Risk, and the Cost of Capital

Although debt has a lower cost of capital than equity, this cost may not be considered in isolation. We now calculate
the impact of leverage on the expected return of a stock, or the equity cost of capital.
Leverage and the Equity Cost of Capital: Let 𝐸 and 𝐷 be the market value of equity and debt, let 𝑈 be the market
value of equity if the firm is unlevered, and let 𝐴 be the market value of the firm’s assets. Then, the total market
value of the firm’s securities is equal to the market value of its assets:
𝐸+𝐷 =𝑈 =𝐴
As the return of a portfolio equals the weighted average of returns of the securities in it, the following relationship
between the returns of levered equity (𝑅 ), debt (𝑅 ), and unlevered equity (𝑅 ) holds:
𝐸 𝐷
𝑟 =𝑟 = 𝑟 + 𝑟
𝐸+𝐷 𝐸+𝐷
MM Proposition II: The cost of capital of levered equity increases with the firm’s market value debt-equity ratio.
Thus, the cost of capital of levered equity is
𝐷
𝑟 =𝑟 + (𝑟 − 𝑟 )
𝐸
where 𝑟 and 𝑟 is the expected return of levered equity and debt and 𝑟 is expected return on unlevered equity. The
first term is risk without leverage, and the second is the risk due to leverage
Capital budgeting and the Weighted Average Cost of Capital: If a firm is financed with both equity and debt, the
risk of its underlying assets will match the risk of a portfolio of its equity and debt. The appropriate cost of capital for
the firm’s assets is simply the weighted average of the firm’s equity and debt cost of capital. Thus, the unlevered cost
of capital (Pretax WACC) is:
𝐸 𝐷
𝑃𝑟𝑒𝑡𝑎𝑥 𝑊𝐴𝐶𝐶 = 𝑟 = 𝑟 + 𝑟
𝐸+𝐷 𝐸+𝐷
With perfect capital markets, a firm’s WACC is independent of its capital structure and is equal to its equity cost of
capital if it is unlevered, which matches the cost of capital of its assets.
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Levered and Unlevered Betas: A firm’s asset beta is the weighted average of its equity and debt beta
𝐸 𝐷
𝛽 =𝛽 = 𝛽 + 𝛽
𝐸+𝐷 𝐸+𝐷
Beta measures the market risk of the firm’s underling assets, and thus can be used to assess the cost of capital for
comparable investments. When a firm changes its capital structure without changing its investments, its unlevered beta
will remain unaltered. The equity beta is given as
𝐷
𝛽 =𝛽 + (𝛽 − 𝛽 )
𝐸
If the debt is risk-free, then
𝐸+𝐷 𝐴 𝐸𝑉
𝛽 =𝛽 =𝛽 =𝛽
𝐸 𝐸 𝐸
3.4 Capital Structure Fallacies

The results so far can be interpreted as: With perfect capital markets, financial transactions neither add nor destroy
value, but instead represent a repackaging of risk (and therefore return). We look two incorrect arguments cited in the
favour of leverage.
Leverage And Earnings per Share: Leverage can increase expected earnings per share. An argument sometimes
made is leverage should also increase the firm’s stock price. However, leverage impacts the risk of earnings and not
just the expected earnings per share. Because the firm’s earnings per share and price-earnings ratio are affected by
leverage, these measures are not comparable to peers.
Equity Issuances and Dilution: Another fallacy is that issuing equity will dilute existing shareholders’ ownership, so
debt financing should be used instead. Dilution is if the firm issues new shares, the cash flows must be divided among
a larger number of shares, reducing the value of each individual share. However, this ignores that cash raised by
issuing new shares will increase the firm’s assets.
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4 DEBT AND TAXES

Berk & DeMarzo (2017): Chapter 15 + Session II
Capital structure does matter due to market imperfections, e.g., taxes deductibility of interest payments. A firm can
enhance its value by using leverage to minimise the taxes it and its investors pay.
The value of a firm is the total amount it can raise from all investors, not just equity holders. Because leverage allows
the firm to pay out more in total to its investors – including interest payments to debt holders – it will be able to raise
more total capital initially.
Note that a firm’s debt capacity is given as 𝑑 × 𝑉 , where 𝑑 = 𝐷/(𝐷 + 𝐸). This is also the maximum debt a firm can
take. Also given as 𝐸𝐵𝐼𝑇 ÷ 𝑟
4.1 Valuing the Interest Tax Shield

Interest tax shield is the additional amount that a firm would have paid in taxes if it did not have leverage, and thus
represents the gain to investors from the tax deductibility. The amount each year is:
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑡𝑎𝑥 𝑠ℎ𝑖𝑒𝑙𝑑 = 𝜏 × 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠 = 𝜏 × 𝐷 × 𝑟
𝜏 ∗ 𝑟 ∗ 𝑙𝑒𝑣𝑒𝑟𝑎𝑔𝑒 𝑟𝑎𝑡𝑖𝑜 ∗ 𝑀𝑉
PV of tax shield =
𝑟
The Interest Tax Shield and Firm Value: Each year a firm pays interest, the cash flows to investors will be higher
than they would be without leverage by the amount of the interest tax shield:
(𝐶𝑎𝑠ℎ 𝑓𝑙𝑜𝑤𝑠 𝑡𝑜 𝑖𝑛𝑣𝑒𝑠𝑡𝑜𝑟𝑠 𝑤𝑖𝑡ℎ 𝑙𝑒𝑣𝑒𝑟𝑎𝑔𝑒 )

= (𝐶𝑎𝑠ℎ 𝑓𝑙𝑜𝑤𝑠 𝑡𝑜 𝑖𝑛𝑣𝑒𝑠𝑡𝑜𝑟𝑠 𝑤𝑖𝑡ℎ𝑜𝑢𝑡 𝑙𝑒𝑣𝑒𝑟𝑎𝑔𝑒 ) + (𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑡𝑎𝑥 𝑠ℎ𝑖𝑒𝑙𝑑)
By letting 𝑉 and 𝑉 represent the value of the firm with and without leverage, we have:
MM Proposition I (revised): The total value of the levered firm exceeds the value of the firm without leverage due to
the present value of the tax savings from debt:
𝑉 = 𝑉 + 𝑃𝑉(𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑡𝑎𝑥 𝑠ℎ𝑖𝑒𝑙𝑑)
The Interest Tax Shield with Permanent Debt: Suppose a firm borrows debt 𝐷 and keeps it fixed permanently (in
$). The tax rate is 𝜏 , and the debt is riskless with a risk-free rate 𝑟 . If the debt is fairly priced, no arbitrage implies its
markets value equals the PV of future interest payments:
𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑑𝑒𝑏𝑡 = 𝐷 = 𝑃𝑉(𝐹𝑢𝑡𝑢𝑟𝑒 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠)
If the firm’s marginal tax rate is constant, the value of interest tax shield with permanent debt is:
𝜏 ∗ 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝜏 ∗ 𝑟 ∗𝐷
𝑃𝑉(𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑡𝑎𝑥 𝑠ℎ𝑖𝑒𝑙𝑑) = = == 𝑃𝑉(𝜏 × 𝐹𝑢𝑡𝑢𝑟𝑒 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠)
1+ 𝑟 𝑟
= 𝜏 × 𝑃𝑉(𝐹𝑢𝑡𝑢𝑟𝑒 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠) = 𝜏 × 𝐷
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Weighted Average Cost of Capital with Taxes: When a firm uses debt financing, the cost of the interest it must pay
is offset to some extent by the interest tax shield. With tax-deductible interest, the effective after-tax borrowing rate is
𝑟(1 − 𝜏 ). We can account for the benefit of the interest tax shield by calculating the After-tax WACC using the
effective after-tax cost of debt:
𝐸 𝐷
𝑟 = 𝑟 + 𝑟 (1 − 𝜏 )
𝐸+𝐷 𝐸+𝐷
This represents the effective cost of capital to the firm, after including the benefits of the interest tax shield. It is
therefore lower than the pre-tax WACC. The higher the firm’s leverage, the more the firm exploits the tax advantages
of debt, and the lower its WACC is.
Interest Tax Shield with a Target Debt-Equity Ratio: Many firms target a specific debt-equity ratio. We compute
the firm’s value with leverage, 𝑉 , by discounting its free cash flow using WACC. The value of the interest tax shield
is found by comparing 𝑉 to the unlevered value 𝑉 of the free cash flow discounted at the firm’s unlevered cost of
capital (the pretax WACC). If the free cash flow (FCF) is expected to grow at a constant rate, the firm is valued as a
constant growth perpetuity.
𝑉 = 𝑉 =
Pre-Tax WACC
𝐸 𝐷
𝑟 = 𝑟 + 𝑟
𝐸+𝐷 𝐸+𝐷
4.2 Recapitalising to Capture the Tax Shield

When a firm makes a significant change to its capital structure, the transaction is called a recapitalisation. One option
is the firm issues large amount of debt and uses the proceeds to pay a special dividend or to repurchase shares. The
conclusion is that when securities are fairly prices, the original shareholders of a firm capture the full benefit of the
interest tax shield from an increase in leverage. Q15.20 shows the distribution of benefits between equity holders
and debt holders!
Analysing the Recap: The market value balance sheet states that the total market value of a firm’s securities must
equal the total market value of the firm’s assets. In the presence of corporate taxes, we must include the interest tax
shield as one of the firm’s assets.
Note the share price rises at the announcement of the recap. This increase in share price is due to the present value of
the anticipated interest tax shield. Even though leverage reduces the total market cap of the firm’s equity, shareholders
capture the benefits of the interest tax shield upfront.
4.3 Personal Taxes

For individuals, interest payments received from debt are taxed as income. There are also taxes on dividends and
capital gains. What are the consequences to firm value of these additional taxes?
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Including Personal Taxes in the Interest Tax Shield: The amount of money an investor will pay for a security
depends on the cash flows the investor will receive after all taxes. Personal taxes reduce the cash flows to investors
and diminish firm value. The actual interest tax shield depends on the reduction in taxes paid. A tax advantage to
debt remains, but not as large as with only corporate taxes.
Let 𝜏 ∗ be the effective tax advantage of debt. If the corporation paid (1 − 𝜏 ∗ ) in interest, debt holders would receive
the same amount after taxes as equity holders would receive if the firm paid $1 to equity holders. This gives us the
effective tax advantage of debt as:
(1 − 𝜏 )(1 − 𝜏 )
𝜏∗ = 1 −
(1 − 𝜏 )
$1 received after taxes by debt holders from interest payments cost equity holders $(1 − 𝜏 ∗ ) after-tax. When there are
no personal taxes, or when personal tax on debt and equity income are the same (𝜏 = 𝜏 ), we have 𝜏 ∗ = 𝜏 . When
equity income is taxed less heavily (𝜏 > 𝜏 ), then 𝜏 ∗ is less than 𝜏 .
Valuing the Interest Tax Shield with Personal Taxes: If 𝜏 ∗ > 0, then despite any tax disadvantage of debt at the
personal level, a net tax advantage for leverage remains. In the case of permanent debt:
𝑉 = 𝑉 + 𝜏 ∗𝐷
Determining the Actual Tax Advantage of Debt: It should be considered that (1) capital gains taxes are only paid
when the gain is realised (lower effective capital gains rate), (2) dividend and capital gains tax rate may be different,
and (3) personal tax rates vary with investors.
4.4 Optimal Capital Structure with Taxes

The use of leverage varies by industry and firms retain large cash balances to reduce their leverage effect. Further,
not all investments are externally funded, but can also be sourced by retained earnings.
Limits to the Tax Benefit of Debt: To receive the full tax benefits of leverage, a firm need not use 100% debt
financing, as a tax benefit is only received if it has taxable earnings. We can quantify the tax advantage for excess
interest payments by setting 𝜏 = 0, giving:
(1 − 𝜏 ) 𝜏 −𝜏
𝜏∗ = 1 − = <0
(1 − 𝜏 ) (1 − 𝜏 )
𝜏 ∗ − 𝑡ℎ𝑒 𝑒𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝑡𝑎𝑥 𝑎𝑑𝑣𝑎𝑛𝑡𝑎𝑔𝑒 𝑜𝑛 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑖𝑛 𝑒𝑥𝑐𝑒𝑠𝑠 𝑜𝑓 𝐸𝐵𝐼𝑇
The optimal level of leverage from a tax saving perspective is the level such that interest equal EBIT.
Growth and Debt: For a firm with no earnings, a tax-optimal capital structure does not include debt. For a firm with
positive earnings, growth will affect the optimal leverage ratio. To avoid excess interest, this firm should have debt
with interest payments that are below its expected taxable earnings:
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 = 𝑟 × 𝐷𝑒𝑏𝑡 ≤ 𝐸𝐵𝐼𝑇 or 𝐷𝑒𝑏𝑡 ≤ 𝐸𝐵𝐼𝑇 | 𝑟
The optimal ratio of debt in the capital structure (𝐷/[𝐸 + 𝐷]) is lower, the higher the growth rate.
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5 FINANCIAL DISTRESS
Berk & DeMarzo (2017): Chapter 16 + Session III
When a firm cannot meet its debt obligations, it is in financial distress. The choice of capital structure affects the cost
of financial distress and alter managers’ incentives.
5.1 Default and Bankruptcy in a Perfect Market

A firm failing to make the required payments on the debt is in default. After a firm defaults, debt holders are given
certain rights to the assets of the firm.
If a firm has access to capital markets and can issue new securities at a fair price, it need not default if the market
value of its assets exceeds its liabilities. Thus, whether default occurs depends on the relative value of the firm’s
assets and liabilities, not on its cash flows.
When a firm declares bankruptcy, attention is paid to the loss to investors, but the decline in value is not cause by
bankruptcy. The decline is the same whether or not the firm has leverage.
With perfect capital markets, MM Proposition I applies: The total value to all investors does not depend on the firm’s
capital structure. Thus, there is no disadvantage to debt financing, and a firm will have the same total value and will
be able to raise the same amount initially from investor.
5.2 The Cost of Bankruptcy and Financial Distress

Bankruptcy is a complicated process imposing direct and indirect costs on the firm and its investors.
Direct costs of bankruptcy: When a firm is in financial distress there are direct costs to outside professionals, e.g.,
legal consultants. These costs reduce the value of the assets that the firm’s investors will receive. It is possible to avoid
filing for bankruptcy by negotiating directly with creditors.
Indirect costs of bankruptcy: These costs are difficult to measure accurately and includes …
… loss of customers, as it encourages firms to walk away from customer commitments
… loss of suppliers, as they will not be willing to provide inventory fearing no payment. This may be alleviated
through the senior debtor-in-possession (DIP) financing.
… loss of employees, due to unsure job future
… loss of receivables, as financially distressed firms tend to have a hard time collecting money
… fire sales of assets, where assets are sold for below value to raise fast cash
… cost to creditors if the firm was a significant asset for the creditor
As bankruptcy is a choice, the costs related should not exceed the cost of renegotiating with the firm’s creditors. There
are no limits on the indirect costs arising from customers, suppliers or employees.
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Financial Distress Costs and Firm Value: Contrary to MM, levered firms risk incurring financial distress costs that
reduce cash flow. So, the cash flows of assets do depend on the choice of capital structure. It holds true that when
securities are fairly priced, the original shareholders of a firm pay the present value of the costs associated with
bankruptcy and financial distress.
5.3 Optimal Capital Structure: The Trade-Off Theory

The trade-off theory weighs the benefits of debt from shielding cash flows from taxes against the cost of financial
distress associated with leverage. The total value of a levered firm is given:
𝑉 = 𝑉 + 𝑃𝑉(𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑇𝑎𝑥 𝑆ℎ𝑖𝑒𝑙𝑑) − 𝑃𝑉(𝐹𝑖𝑛𝑎𝑛𝑐𝑖𝑎𝑙 𝐷𝑖𝑠𝑡𝑟𝑒𝑠𝑠 𝐶𝑜𝑠𝑡𝑠)
Thus, leverage has costs (financial distress risk and costs) and benefits (tax shield).
Present Value of Financial Distress Costs: Depends on three key factors:
(1) Probability of financial distress: Increases with the firm’s liabilities and the volatility of the firm’s cash flows
and asset values
(2) Magnitude of the financial distress costs: Depends on the relative importance of the indirect costs, varies
significantly by industry.
(3) Appropriate discount rate for distress costs: Depends on the firm’s market risk. The beta of distress costs has
opposite sign to the firm. The PV of distress costs is higher for high beta firms.
Optimal leverage: The trade-off theory states that firms should increase their leverage until it reaches the level 𝐷 ∗ for
which 𝑉 is maximised. Note the interest tax shield has present value 𝜏 ∗ 𝐷. The optimal debt choice for a firm with
low costs of financial distress is indicated by 𝐷 ∗ , etc.
5.4 Agency Costs of Leverage

Agency costs arise when there are conflicts of interest between stakeholders. In a levered firm, a conflict exists if
investment decisions have different consequences for the value of equity and debt.
Asset substitution problem: When a firm faces financial distress, shareholders can gain from decisions that increase
the risk of the firm sufficiently, even if they have a negative NPV. Thus, it is an incentive to replace low-risk assets
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with riskier ones. If the firm increases risk through a negative-NPV decision or investment, the total value of the firm
will be reduced.
Debt overhang (under-investment problem): When a firm faces financial distress, it may choose not to finance new,
positive-NPV projects. The failure to invest is costly for debt holders and the overall value of the firm. The debt
overhang can be estimated, i.e., how much leverage before a debt overhang problem occurs. Let 𝐷 and 𝐸 be the
market value of debt and equity and let 𝛽 and 𝛽 be their betas. Equity holders will benefit from the new investment
if the project’s profitability index excess the relative riskiness of the firm’s debt times its debt-equity ratio:
𝑁𝑃𝑉 𝛽 𝐷
>
𝐼 𝛽 𝐸
Agency costs and the Value of Leverage: It is the shareholders who ultimately bear the agency costs, as the initial
share price is reduced by the negative NPV of decisions. Agency costs represent a cost of increasing the firm’s
leverage affecting the optimal capital structure.
Leverage ratchet effect: Once existing debt is in place (1) shareholders may have an incentive to increase leverage
even if it decreases the value of the firm, and (2) shareholder will not have an incentive to decrease leverage by buying
back debt, even if it will increase the value of the firm.
Debt Maturity and Covenants: To mitigate the agency costs of debt, there are two actions. (1) The magnitude of
agency costs depends on the maturity of debt, so agency costs are smallest for short-term debt, and (2) loan restrictions
placed by creditors known as debt convents may be a condition.
5.5 Agency Benefits of Leverage

The separation of ownership (shareholders) and control (managers) create management entrenchment, i.e., that
managers may make decisions that benefit themselves at investor’s expense. Here, leverage can provide incentives for
managers to run the firm more efficiently.
Concentration of ownership: The use of leverage allows the original owners of the firm to maintain their equity
stake. The costs of reduced effort and excessive spending on perks are agency costs that arise when ownership is
diluted with the use of equity finance.
Reduction of wasteful investments: Managers may make negative-NPV investments motivated by empire building.
To do so, they must have cash to invest as wasteful spending is more likely when firms have high levels of cash flow
(free cash flow hypothesis). Leverage increases firm value as it commits the firm to making interest payments,
reducing excess cash flows and wasteful investment.
5.6 Agency Costs and the Trade-Off Theory

We now have the following value of a leveraged firm:
𝑉 = 𝑉 + 𝑃𝑉(𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑇𝑎𝑥 𝑆ℎ𝑖𝑒𝑙𝑑) − 𝑃𝑉(𝐹𝑖𝑛𝑎𝑛𝑐𝑖𝑎𝑙 𝐷𝑖𝑠𝑡𝑟𝑒𝑠𝑠 𝐶𝑜𝑠𝑡𝑠) − 𝑃𝑉(𝐴𝑔𝑒𝑛𝑐𝑦 𝐶𝑜𝑠𝑡𝑠 𝑜𝑓 𝐷𝑒𝑏𝑡)

+ 𝑃𝑉(𝐴𝑔𝑒𝑛𝑐𝑦 𝐵𝑒𝑛𝑒𝑓𝑖𝑡𝑠 𝑜𝑓 𝐷𝑒𝑏𝑡)
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As the debt level increases, the firm benefits from interest tax shield and improved incentives from management. If the
debt level is too high, firm value is reduced due to loss of tax benefits (interest exceeds EBIT), financial distress costs,
and the agency costs of leverage.
The Optimal Debt Level: The optimal debt level varies with the characteristics of the firm. R&D-intensive firms
often have low levels of leverage, while low-growth, mature firms have high levels.
5.7 Asymmetric Information and Capital Structure

There is asymmetric information between managers and investors, which may motivate managers to alter the firm’s
capital structure.
Leverage as credible signal: The use of leverage to signal good information (confidence) to investors is the
signalling theory of debt. It follows from the credibility principle, saying that claims in one’s self-interest are only
credible if supported by actions that would be costly if the claims were true.
Issuing equity and adverse selection: The lemons principle says that when a seller has private information about the
value of a good, buyers will discount the price they are willing to pay due to adverse selection. Applying this to equity
markets, issuing new shares when management knows they are under-priced is costly for the original shareholders.
Managers who know securities have high value will not sell, and those who know they have low value will sell. Due
to this adverse selection, investors will be willing to pay a low price for the securities. If the firm tries to issue equity,
investors will discount the price to reflect the possibility that managers are privy to bad news.
Implications for equity issuance: Adverse selection leads to implications for equity issuance:
(1) The stock price declines on the announcement of an equity issue (signals overpricing)
(2) The stock price tens to rise prior to the announcement of an equity issue
(3) Firms tend to issue when information asymmetry is minimal, e.g., post earnings announcements.
Implications for capital structure: It is costly is issue equity that is under-priced. Thus, managers who perceive the
firm’s equity is under-priced will prefer to fund investments using retained earnings or debt rather than equity, and
vice versa. This is the pecking order hypothesis. The market timing view of capital structure says that the firm’s
overall capital structure depends in part on the market conditions when it sought funding in the past.
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6 PAYOUT POLICY
Berk & DeMarzo (2017): Chapter 17 + Session V
The way the firm chooses between the alternative uses of free cash flow is its payout policy. The alternative uses
include retaining cash and (1) investing in new projects or (2) increasing cash reserved, or paying out cash and (3)
repurchasing shares or (4) paying dividends
Dividends: If you purchase the stock on or after the ex-dividend date will not receive the dividend.
● Ordinary dividends: Very little variation, gradual adjustments, reputational commitment

● Special dividends: Only under special circumstances, usually much larger.
In a stock split or stock dividend, the firm issues additional shares rather than cash to shareholders.
Share repurchases: The firm uses cash to buy shares of its own outstanding stock. Three types:
● Open market repurchases: Most common. The firm announces its intentions and then proceeds to buy over time,
however, it must not be done in a way that might appear to manipulate the price
● Tender offer or Dutch auction: Shares are bought back at a prespecified price during a short period of time,
usually at a premium to the market price. Dutch auction is slightly different.
● Targeted repurchase: Shares are bought from a large shareholder and negotiates price directly.
6.1 Dividends and Share Repurchases

The fair price for the shares is the present value of expected dividends given the firm’s cost of capital. Just before the
ex-dividend date, the stock is traded cum-dividend.
MM dividend irrelevance says that in perfect capital markets, holding fixed the investment policy of a firm, the
firm’s choice of dividend policy is irrelevant and does not affect the initial share price. In other words, with perfect
capital markets, the choice of dividends or share repurchases is irrelevant.
There are three (identical in perfect capital markets) policy alternatives:
Alternative 1: Pay dividend with excess cash. In a perfect capital market, the share price drops by the amount of the
dividend when the stock begins to trade ex-dividend.
Alternative 2: Share repurchase with excess cash. In PCM, an open market share repurchase does not affect the stock
price, and the stock price is the same as 𝑃 if dividends were paid instead.
● In perfect capital markets, investors are indifferent between the choice of dividends or share repurchases. By
reinvesting shares or selling shares, they can replicate either pay-out method.
Alternative 3: High dividend (equity issue). We issue equity to finance a larger dividend. The initial share value is
unchanged, and increasing the dividend has no benefit to shareholders. The number of shares increases and the
dividend increases 𝑃 stays the same.
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6.1.1 Cum-Dividend Price and Ex-Dividend Price with No taxes

𝑃 before the dividend is paid out is given as, where 𝑅𝑅 is the retention rate (what fraction of earnings not paid
out) and 𝑔 = 𝑅𝑅 × 𝑟
𝐷 𝐷 (1 − 𝑅𝑅)(1 + 𝑔)
𝑃 = 𝐷 (1 − 𝑅𝑅) + 𝑃𝑉(𝐹𝑢𝑡𝑢𝑟𝑒 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠) = 𝐷 (1 − 𝑅𝑅) + = 𝐷 (1 − 𝑅𝑅) +
𝑟 −𝑔 𝑟 −𝑔
𝑃 after the dividend payout is
𝐷
𝑃 = 𝑃𝑉(𝐹𝑢𝑡𝑢𝑟𝑒 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠) = =𝑃 − 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑
𝑟 −𝑔
6.2 Optimal Dividend Policy With Taxes

In reality, market imperfections affect firm dividend policy particularly taxes. When the tax rate on dividends exceeds
the tax rate on capital gains, shareholder will prefer share repurchases to dividends:
𝜏 >𝜏 → 𝐼𝑛𝑣𝑒𝑠𝑡𝑜𝑟′𝑠 𝑝𝑟𝑒𝑓𝑒𝑟 𝑛𝑜 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠
The optimal dividend policy then the dividend tax rate exceeds the capital gain tax rate is to pay no dividends. The
fact that firms still issue dividends despite tax disadvantage is the dividend puzzle.
6.3 Adjusting for Investor Taxes and Tax Clienteles

The preference for share repurchases depends on the difference in dividend and capital gains tax rate.
The Effective Dividend Tax Rate: The price before the stock goes ex-dividend, 𝑃 , exceeds the price just after,
𝑃 . The price drop and dividends must be equal after taxes:
1−𝜏
𝑃 − 𝑃 = 𝐷𝑖𝑣 × = 𝐷𝑖𝑣 × (1 − 𝜏 ∗ )
1−𝜏
The effective dividend tax rate, 𝜏 ∗ , is the net tax cost to the investor per dollar of dividend income:
𝜏 −𝜏
𝜏∗ =
1−𝜏
Arbitrage argument: Prior to the ex-dividend date, the share price is 𝑃 . At the ex-dividend date, the investor
receives the dividend but must pay dividend tax. They receive a capital gains tax subsidy (a negative capital gains tax)
as the share price drops from 𝑃 to 𝑃 . Finally, the investor still owns the share which now has the price 𝑃 . As all
investors have the same tax rates, there are arbitrage opportunities around the ex-dividend date unless the equation
above is fulfilled.
Tax Differences Across Investors: The effective dividend tax rate varies across investors due to, e.g., income level,
investment horizon, tax jurisdiction and type of investment account. This creates clientele effects where the dividend
policy of a firm suits the tax preference of its investor clientele:
● Individual investors: Tax disadvantage for dividends, generally prefer share repurchase
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● Institutional investors: No tax preference, prefer dividend policy that matches income needs
● Corporations: Tax advantage for dividends
Dividend capture theory states that absent transaction costs, investors can trade shares at the time of the dividend so
that non-taxed investors receive the dividend.
6.4 Retaining Cash versus Payout

With market imperfections there is a trade-off between retaining cash and paying it out. Retaining cash reduces the
future cost of raising capital but increases taxes (negative leverage) and agency costs.
Adjusting for Investor Taxes: The decision to pay out versus retain cash also affect the taxes paid by shareholders.
Corporate taxes make it costly for a firm to retain excess cash. Even after adjusting for investor taxes, retaining excess
cash brings a substantial tax disadvantage for a firm. We have
𝐷𝑖𝑣 ∗ (1 − 𝜏 ) (1 − 𝜏 )(1 − 𝜏 )
𝑃 = =𝑃 × (1 − 𝜏 ∗ )=𝑃 ∗
𝑟 ∗ (1 − 𝜏 ) (1 − 𝜏 )
𝐷𝑖𝑣 = 100 ∗ 𝑟 ∗ (1 − 𝜏 )
(1 − 𝜏 )
𝑃 = 𝑃 + 𝐷𝑖𝑣 ∗
1−𝜏
The intuition is that when a firm retains cash, it must pay corporate taxes on interest, and the investor will earn capital
gain tax on the increased value of the firm. If the firm paid cash to the shareholders instead, they could invest it and be
taxed only once on the income (single tax on interest income). The effective tax disadvantage of retaining cash is
(1 − 𝜏 )(1 − 𝜏 )
𝜏∗ = 1−
(1 − 𝜏 )
Issuance and Distress costs: Despite tax disadvantages, firms accumulate cash balances to help minimise
transactions costs of raising new capital when they have future potential cash needs. There is no benefit to
shareholders from firms holding more cash than future investment needs.
Agency costs of Retaining Cash: Agency costs may arise when holding cash, as managers may be tempted to spend
it on inefficient investments or to reducing leverage to increase job security. Dividends and share repurchase minimise
the agency problem of wasteful spending.
6.5 Issuing Rights

If a firm plans to issue rights to buy back shares, the number of shares to be bought back is the amount of cash to be
distributed (or principal of debt) divided by buy-back price, that is:
𝐶𝑎𝑠ℎ 𝑡𝑜 𝑏𝑒 𝑑𝑖𝑠𝑡𝑟𝑖𝑏𝑢𝑡𝑒𝑑
𝑆ℎ𝑎𝑟𝑒𝑠 𝑡𝑜 𝑏𝑒 𝑏𝑜𝑢𝑔ℎ𝑡 𝑏𝑎𝑐𝑘 =
𝐵𝑢𝑦 − 𝑏𝑎𝑐𝑘 𝑝𝑟𝑖𝑐𝑒
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Then, the number of shares to be bought back is given below. If the firm buys back 10%, a shareholder must have 10
rights to buy one share
𝑆ℎ𝑎𝑟𝑒𝑠 𝑡𝑜 𝑏𝑒 𝑏𝑜𝑢𝑔ℎ𝑡 𝑏𝑎𝑐𝑘

𝑆ℎ𝑎𝑟𝑒𝑠 𝑏𝑜𝑢𝑔ℎ𝑡 𝑏𝑎𝑐𝑘 =
The price per right is given as
𝑃𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑟𝑖𝑔ℎ𝑡 = 𝑃 −𝑃
6.6 Signalling with Pay-out Policy

Dividend Smoothening: Firms adjust dividends relatively infrequently, and dividends are much less volatile than
earnings, as dividends are generally set at a level the firm expects to be able to maintain based on the firm’s earnings
prospects. Referred to as dividend smoothening.
Dividend Signalling: The idea that dividend changes reflect manager’s views about firm’s future earnings prospects
is called the dividend signalling hypothesis.
● Increase dividends when confident that the firm can afford higher dividends in the future
● Cut dividends when they have lost hope that earnings will improve
Share repurchases may be used to signal positive information, as repurchases are more attractive if management
believes the stock is undervalued at its current price.
6.7 Stock Dividends, Stock Splits, and Spin-offs

With a stock dividend, shareholder receive either additional shares of stock (stock split) or shares of a subsidiary
(spin-off). The stock price generally falls proportionally with the size of the split.
With a stock dividend, a firm does not pay out any cash to shareholders, meaning that the total market value of the
firm’s assets and liabilities, and therefore its equity, is unchanged. As there are more shares outstanding, the stock
price will fall. Stock dividends are not taxed.
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7 CAPITAL BUDGETING AND VALUATION WITH DEBT

Berk & DeMarzo (2017): Chapter 18-19 + Session VI+XII
Capital budgeting is a method of estimating the financial viability of a capital investment over its life focussing on
cash flows. In general, there are three methods for valuating project. For now, the all assume (1) the project has the
same risk (beta) as the rest of the firm's assets, (2) the firm’s debt-equity ratio is actively maintained to stay constant,
and (3) corporate taxes are the only imperfection (no investor taxes, no financial distress costs, etc.)
7.1 The Weighted Average Cost of Capital (WACC) Method

When the market risk of the project is similar to the average market risk of the firm’s investment, then its cost of
capital is equal to the firm’s weighted average cost of capital (WACC). The interest tax shield is accounted for by
using the after-tax cost of capital as discount rate. The steps are:
(1) Determine unlevered free cash flows of the investment, excl. those from financing (tax shields)
(2) Compute the weighted average cost of capital (required return)
𝐸 𝐷
𝑟 = 𝑟 + 𝑟 (1 − 𝜏 )
𝐸+𝐷 𝐸+𝐷
(3) Compute the value with leverage, 𝑉 , by discounting the free cash flows of the investments using the WACC. In
other words, calculate NPV of the project using WACC as the discount rate, i.e.:
𝐹𝐶𝐹 𝐹𝐶𝐹
𝑉 = + +⋯
(1 + 𝑟 ) (1 + 𝑟 )
The debt-equity ratio must be kept constant, otherwise 𝑟 , 𝑟 and 𝑟 will change over time. Personal (investor)
taxes are accounted for implicitly when estimating 𝑟 and 𝑟 using market data.
Calculating WACC
𝐷
𝑟 =𝑟 − ∗𝜏 ∗𝑟
𝐸+𝐷
𝑟 =𝑟 +𝛽 ∗𝑟
7.2 The Adjusted Present Value (APV) Method

With the adjusted present value (APV) method, the levered value 𝑉 of an investment is determined by first
calculating its unlevered value, 𝑉 , and then adding the value of the interest tax shield.
𝑉 = 𝐴𝑃𝑉 = 𝑉 + 𝑃𝑉(𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑇𝑎𝑥 𝑆ℎ𝑖𝑒𝑙𝑑)
There is a circularity requiring a simultaneous solution. The value of a levered investment with APV:
(1) Determine the investment’s value without leverage, 𝑉 , by discounting its free cash flows at the unlevered cost of
capital, 𝑟 , given by the pretax WACC, which with constant debt-equity is:
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𝐸 𝐷
𝑟 = 𝑟 + 𝑟 = 𝑃𝑟𝑒𝑡𝑎𝑥 𝑊𝐴𝐶𝐶
𝐸+𝐷 𝐸+𝐷
(2) Determine the present value of the interest tax shield. The interest paid in year 𝑡 is based on the amount
outstanding in the prior year, giving a tax shield of 𝜏 × 𝑟 × 𝐷 .When a firm maintains a target leverage ratio,
its future interest tax shield has similar risk to the project’s cash flows, so they should be discounted at the
project’s unlevered cost of capital.
(3) Add the unlevered value 𝑉 to the present value of the interest tax shield to determine the value of the investment
with leverage, 𝑉
The APV method calculates the PV of the tax shield making it better for other leverage policies.
7.2.1 APV with Other Leverage Policies

With a leverage policy different than a constant debt-equity ratio, the APV method is best suited. In general, the
WACC method is the easiest to use when a firm has a target debt-equity ratio that it plans to maintain over the life of
the investment.
With a constant interest coverage policy, the firm actively manages debt, so interest payments are a constant
fraction, 𝑘, of its free cash flow. The levered value of a project with such leverage policy is
𝑉 = 𝑉 + 𝑃𝑉(𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑇𝑎𝑥 𝑆ℎ𝑖𝑒𝑙𝑑) = (1 + 𝜏 𝑘)𝑉
With pre-determined debt levels, there is a fixed dollar amount of debt (or interest payments). We can discount the
predetermined interest tax shields using the debt cost of capital, 𝑟 . If a firm chooses to keep the level of debt at a
constant level, 𝐷, permanently, then the levered value of the project is:
𝑉 = 𝐴𝑃𝑉 = 𝑉 + 𝑃𝑉(𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑡𝑎𝑥 𝑆ℎ𝑖𝑒𝑙𝑑)
With infinite maturity (perpetual) debt is simplifies to
𝑉 =𝑉 +𝜏 ×𝐷
7.3 The Flow-to-Equity (FTE) Method

In the flow-to-equity (FTE) valuation method, we explicitly calculate the free cash flow available to equity holders
(𝐹𝐶𝐹𝐸) after accounting for all payments to and from debt holders. These cash flows are discounted using the equity
cost of capital. This method is well-suited to include other imperfections related to leverage such as financial distress
costs, agency costs or agency benefits. This method is best when the firm’s capital structure is complex. The key steps
are:
(1) Determine the free cash flow to equity of the investment:
𝐹𝐶𝐹𝐸 = 𝐹𝐶𝐹 − (1 − 𝜏 ) × (𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑃𝑎𝑦𝑚𝑒𝑛𝑡) + (𝑁𝑒𝑡 𝐵𝑜𝑟𝑟𝑜𝑤𝑖𝑛𝑔)
(2) Compute the contribution to equity value, 𝐸, by discounting the free cash flow to equity using the equity cost of
capital, 𝑟 .
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7.4 Project-Based Cost of Capital

If the project’s risk is different from the firm’s, we estimate its cost of capital separately. The project’s unlevered cost
of capital is estimated by the unlevered cost of capital for other firms with similar market risks as the project. From
here, any of the three methods may be used. To calculate 𝑟 use
𝐷
𝑟 =𝑟 − 𝜏 𝑟
𝐷+𝐸
The project’s financing is the incremental financing that results if the firm takes the project. It is the change in the
firm’s total debt (net of cash) with versus without the project. Remember that…
… cash is negative debt, so if the project uses excess cash, it corresponds to debt financing (𝑑 = 1)
… fixed equity pay-out policy implies 100% debt financing (𝑑 = 1)
… optimal leverage depends on project and firm characteristics, e.g., risk characteristics and financial distress
costs of the firm and how it correlated with the rest of the firm.
7.5 Advanced Topics in Capital Budgeting

Periodically adjusted debt: If a firm adjusts its debt annually to a target leverage ratio, the value of the interest tax
shield is enhanced by the factor (1 + 𝑟 )/(1 + 𝑟 ). Other valuation methods may be adjusted in the same way, e.g.,
WACC and the constant interest coverage model.
Leverage and the Cost of Capital: If the firm does not adjust leverage continuously, some of the interest tax shields
are known and safe. These will reduce the effect of leverage on the risk of the firm’s equity. To account for this, the
value of the ‘safe’ tax shields should be deducted from the debt.
Personal Taxes: For individuals, interest income from debt is generally taxes more heavily than income from equity.
Equity and debt cost of capital in the market already reflects the effects of investor taxes. This means the WACC
method does not change in the presence of investor taxes.
The APV method needs adjustments. Define 𝑟 ∗ as the expected return on equity income that would give investors the
same after-tax return. We have the following in place of 𝑟 :
(1 − 𝜏 )
𝑟∗ = 𝑟
(1 − 𝜏 )
The unlevered cost of capital with personal taxes is given as
𝐸 𝐷
𝑟 = 𝑟 + 𝑟∗
𝐸+𝐷 𝐸+𝐷
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8 BANZ AND MILLER

Banz-Miller is an alternative approach to valuation and capital budgeting overcoming most of the shortcomings of
standard approaches, including…
… assumptions needed to use risk-adjusted cost of capital (e.g., CAPM), i.e., normally distributed cash flows,
stationarity over time, constant interest rates, and constant ‘risk’
… using unconditionally expected cash flows
… no dynamic decisions (real options approach)
Standard method: You estimate unconditional expected futures cash flows and their correlation with the market
(CAPM thinking). Then, you use an appropriate discount rate
Banz-Miller approach: You estimate conditional expected future cash flows (given macro states) and use market
data to figure out how to discount the conditional cash flows. It has the advantages:
(1) Easier to estimate the conditional expected future cash flows (given macro states)
(2) No (less) guess work with respect to how to discount cash flows
(3) Fairly easy to expand to real options opportunities
The state prices (in a binominal setting) are given as
and
8.1 Valuing a Project in the Trinomial Model

Trinomial Model for Systematic Risk: We introduce three systematic states of nature (boom, normal, depression)
with almost equal probability and state-contingent claims, that is, claims whose existence and size depend on the
future state of nature. With these, the systematic risk can be managed.
Then, the value of the project is given as
𝑉𝑎𝑙𝑢𝑒 = 𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝑒𝑎𝑐ℎ 𝑠𝑡𝑎𝑡𝑒 × 𝐸[𝑃𝑎𝑦𝑜𝑓𝑓/𝑉𝑎𝑙𝑢𝑒|𝑆𝑡𝑎𝑡𝑒]
The NPV using state prices, 𝑆𝑃, is given as
𝑁𝑃𝑉 = 𝑆𝑃 × 𝐶𝐹 + 𝑆𝑃 × 𝐶𝐹 + 𝑆𝑃 × 𝐶𝐹
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Systematic versus Unsystematic Risk: Calculate conditional expected cash flows given the systematic state (of
nature). Within each systematic state, investors will be risk neutral, since the `remaining' risk, i.e., the conditional risk
given the state, is diversifiable for the investors.
Banz and Miller (1978): They define…
… boom is return on market portfolio ≥ 20.42%
… normal is return on market portfolio between 0.06% and 20.42%
… depression is return on market portfolio ≤ 0.06%
This gives us one-year state prices (given we start in normal state): Boom $0.1672, normal $0.2912, and depression
$0.5398. The sum is $0.9982, corresponding to a real interest rate of 0.18%.
Note the great effect of that the state price of the bad states are greater than those of good states.
Further, Banz and Miller (1978) set up a three-state Markov model, where state prices depend on which initial state
the economy is in.
This could be simplified to a two-states Markov model (i.e., good and bad) where the risk-neutral probabilities from
the binomial model can be used to calculate the value.
An Alternative Way of Calculating State Prices: From Black-Scholes, we have:
( / ( ) √ ( / ( ) √
𝐾 ≤𝑋≤𝐾 : 𝑃𝑉 𝑁 − −𝑁 −
√ √
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9 FINANCIAL OPTIONS
Berk & DeMarzo (2017): Chapter 20 + Session VII+IX
9.1 Option Basics

A call option gives the holder the right (but not the obligation) to purchase a predetermined underlying asset for a
predetermined price (strike price) at a predetermined future date (expiration date). A put option gives the holder the
right to sell an asset. The option buyer has a long position holding the right to exercise the option, and the seller has a
short position and an obligation to fulfil the contract.
An American option can be exercised on any date up to and including the exercise date. A European option can be
exercised only on the expiration date.
If the payoff from exercising the option immediately is positive, the option is in-the-money (ITM). For calls this
means that strike price is below the stock price and vice versa for puts. If the stock price equals the strike price, the
option is at-the-money (ATM). Finally, if you would lose money by exercising an option immediately, the option is
out-of-the-money (OTM).
9.1.1 Option Payoffs at Expiration

Long position in an option contract: Given the stock price 𝑆 and strike price 𝐾, the payoff of a call:
𝐶 = (𝑆 − 𝐾, 0)
The value of a put option at expiration is
𝑃 = 𝑚𝑎𝑥(𝐾 − 𝑆, 0)
Payoff is never negative, but profit may be as pay-out may be less than the initial cost of the option.
Short position in an option contract: The investor has an obligation to take the opposite side of the contract to the
investor who is long, given cash flows that are negative of the long positions.
Combinations of options: A straddle consists of a long put and a long call with the same strike price and should be
used if high volatility is expected. A butterfly spread should be used when the stock and strike price are expected to be
far apart. A protective put is owning the stock and the put.
9.2 Put-Call Parity

Constant dividend growth model
𝐷𝑖𝑣
𝑃 =
𝑟 −𝑔
𝐷𝑖𝑣
𝑟 = +𝑔
𝑃
The put-call parity for European options written on a non-dividend-paying stock is given as:
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𝑆 + 𝑃 = 𝑃𝑉(𝐾) + 𝐶
𝑃 = 𝐶 − 𝑆 + 𝑃𝑉(𝐾)
K is strike price of the option, C be the call price, P is the put price, S is the stock price.
The put-call parity for European options written on a stock paying discrete dividends is given as:
𝐶 = 𝑃 + 𝑆 − 𝑃𝑉(𝐷𝑖𝑣) − 𝑃𝑉(𝐾)
Expression for the price of a European call option for a non-dividend-paying stock:
𝐶 = 𝑃 + 𝑆 − 𝑃𝑉(𝐾)
𝑆 + 𝑃 = 𝑃𝑉(𝐾) + 𝑃𝑉(𝐷𝑖𝑣) + 𝐶
The value of an option generally increases with the volatility of the stock.
Understand by considering two portfolios. Portfolio 1 consists of one European put and one underlying stock. We sell
the dividends of the stock until the option expires. Portfolio 2 consists of one European call and 𝑃𝑉(𝐾) in the riskless
security. At the time 𝑇 the realised value from either strategy is
{0 + 𝑆 = 𝑆 − 𝐾 + 𝐾 = 𝑆 𝐾 − 𝑆 + 𝑆 = 0 + 𝐾 = 𝐾 𝑖𝑓 𝑆 ≥ 𝐾 𝑖𝑓 𝑆 < 𝐾
Both portfolios have the same realisation values. None of the portfolios has any payoff during the life of the option (as
we sold the dividends of the stock). Using a no-arbitrage argument, the cost of entering the two portfolios initially is
equal, i.e., 𝑝 + 𝑆 − 𝑃𝑉 (𝐷𝑖𝑣 ) = 𝑐 + 𝑃𝑉 (𝐾)
Replicating a call: Long stock (+𝑆), long put (+𝑃), and short risk-free debt (−𝑃𝑉(𝐾))
Replicating a put: Long call (+𝐶), short stock (−𝑆), and long risk-free debt (+𝑃𝑉(𝐾))
9.3 Factors Affecting Option Prices

Generally, option price is affected by (1) price of the underlying, (2) strike price, (3) time to maturity, (4) volatility,
(5) risk-free rate, and (6) dividends on the underlying during the life of the option as:
The effect on the price of a stock option of increasing one variable while keeping all others fixed
Variable European Call European Put American Call American Put
Current stock price + - + -
Strike price - + - +
Time to expiration ? ? + +
Volatility + + + +
Risk-free rate + - + -
Amount of future dividends - + - +
The value an option would have if it expired today, it its intrinsic value. The time value of an option is the difference
between its current value and its intrinsic value. From the put-call parity
𝐶 = 𝑆 − 𝐾 + 𝑃 + 𝑑𝑖𝑠(𝐾) − 𝑃𝑉(𝐷𝑖𝑣)
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𝑃 = 𝐾 − 𝑆 + 𝐶 − 𝑑𝑖𝑠(𝐾) + 𝑃𝑉(𝐷𝑖𝑣)
𝐼𝑛𝑡𝑟𝑖𝑛𝑠𝑖𝑐 𝑣𝑎𝑙𝑢𝑒 + 𝑇𝑖𝑚𝑒 𝑣𝑎𝑙𝑢𝑒
Where 𝑑𝑖𝑠(𝐾) = (𝐾 × 𝑟 )/ 1 + 𝑟
9.3.1 Arbitrage bounds on Option Prices

For American options it holds true that (1) it cannot be worth less than its European counterpart, (2) it cannot be
worth less than its intrinsic value, and (3) an option with a later exercise date cannot be worth less than an otherwise
identical American option with earlier exercise date.
Option Bounds on European Call options:
[0, 𝑆 − 𝑃𝑉(𝐾) − 𝑃𝑉(𝐷𝑖𝑣)] ≤ 𝑐 ≤ 𝑆 − 𝑃𝑉(𝐷𝑖𝑣)
If the stock has no dividends during the life of the option we have
[0, 𝑆 − 𝑃𝑉(𝐾)] ≤ 𝑐 ≤ 𝑆
Option Bounds on European put options:
[0, 𝑃𝑉(𝐾) − 𝑆 + 𝑃𝑉(𝐷𝑖𝑣)] ≤ 𝑝 ≤ 𝑃𝑉(𝐾)
As 𝑃𝑉(𝐷𝑖𝑣) ≥ 0, we have
[0, 𝑃𝑉(𝐾) − 𝑆] ≤ 𝑝 ≤ 𝑃𝑉(𝐾)
Option Bounds on American Call options: Given the bound for European call options and the fact we know that
𝑐 ≤ 𝐶 (the same or more rights with American), we have
[0, 𝑆 − 𝑃𝑉(𝐾) − 𝑃𝑉(𝐷𝑖𝑣)] ≤ 𝑐 ≤ 𝐶 ≤ 𝑆
For a non-dividend paying stock (assuming positive interest rates), we have
𝑆 − 𝐾 < 𝑆 − 𝑃𝑉(𝐾) ≤ 𝐶
Hence, it is never optimal to exercise an American call on a non-dividend paying stock early.
Option Bounds on American Put options: Given the bound for European put options and the fact we know that 𝑝 ≤
𝑃 (the same or more rights with American), we have
[0, 𝑃𝑉(𝐾) − 𝑆 + 𝑃𝑉(𝐷𝑖𝑣)] ≤ 𝑝 ≤ 𝑃 ≤ 𝐾
The upper bound is 𝐾 and not 𝑃𝑉(𝐾) as it may be optimal to exercise early and get 𝐾 immediately.
9.4 Exercising Options Early

Non-dividend-paying Stocks: The price of a call on a non-dividend-paying stock always exceeds its intrinsic value.
It is never optimal to exercise an American call option on a non-dividend-paying stock early, meaning this type of
call has the same price as its European counterpart. It can be optimal to exercise a deep ITM American put option
(e.g., with bankruptcy).
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Dividend-paying Stocks: It can be optimal to exercise an American call option just before the stock goes ex-
dividend. It is only optimal is exercise a call just prior to an ex-dividend date. Put options may be optimal to exercise
if the price of the underlying is low, but not just prior to ex-dividend date.
9.5 Options and Corporate Finance

Equity as a Call Option: A share is a call option of the asset of the firm with a strike price equal to the value of debt
outstanding. Thus, equity can be viewed as a call option on the firm’s assets with a payoff below (L). This means
that equity holders have incentives to increase volatility (agency issues)
Using a call option, we have
𝐸𝑞𝑢𝑖𝑡𝑦 = 𝐶𝑎𝑙𝑙(𝐴, 𝑃, 𝑇)
Using a put option, we have
𝐸𝑞𝑢𝑖𝑡𝑦 = 𝑃𝑢𝑡(𝐴, 𝑃, 𝑇) + 𝐴𝑠𝑠𝑒𝑡𝑠 − 𝐷𝑒𝑏𝑡
Equity value can be calculated as long put with exercise price equal to the debt, long firm’s equity and short in a loan
corresponding to the debt amount.
Debt as an Option Portfolio: Debt holders effectively own the firm’s asset and have sold a call option with a strike
price equal to the required debt payment. If the value of the firm (assets) exceeds the debt payment, the call is
exercised, and debt holders receive the strike price and give up the firm.
Alternatively, corporate debt is a portfolio of riskless debt and a short position in a put option on the firm’s cash
flow with a strike price equal to the required debt payment. The put option is also referred to as a credit default swap.
The pay-off for debt as an option portfolio is seen above (R).
Using a call option, we have
𝐷𝑒𝑏𝑡 = 𝐴𝑠𝑠𝑒𝑡𝑠 − 𝐶𝑎𝑙𝑙(𝐴, 𝑃, 𝑇)
Debt can be calculated as long the firm’s assets and short in a call on the firm’s equity with strike as debt’s principal.
Using a put option, we have
𝐷𝑒𝑏𝑡 = 𝑅𝑖𝑠𝑘 − 𝑓𝑟𝑒𝑒 𝑑𝑒𝑏𝑡 − 𝑃𝑢𝑡(𝐴, 𝑃, 𝑇)
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Debt value can be calculated as long in a risk-free debt and short a put on the firm’s equity. Risk free debt is
equivalent as the principal to be paid at maturity, and the debt is the strike of the put.
Pricing Risky Debt: Option valuations can be used to estimate the appropriate yield for risky debt, as well as to
estimate the magnitude of the agency cost problems within the firm.
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10 OPTION VALUATION
Berk & DeMarzo (2017): Chapter 21 + Session VII+IX
10.1 The Binomial Pricing Model

The Binomial Option Pricing Model assumes the stock price only has two possible values in the next time-period
(up or down) given today’s state. Under this assumption, an option can be valued using a portfolio that replicates the
payoffs of the option in different states.
A replicating portfolio is a portfolio of other securities (usually the underlying and risk-free debt) that has the same
value in one period as the option. As they have the same payoff, the Law of One Price implies that the current value of
the option and the replication portfolio must be equal.
● Note that by using the Law of One Price, we can solve the price of the option without knowing the probabilities
of the states in the binomial tree.
The Binomial Pricing Formula: We replicate an option’s payoff using a replicating portfolio containing the stock
and bonds. Let 𝜟 be the number of shares purchased and 𝑩 be the initial investment in bonds. The current stock
price is 𝑆 which will either go up to 𝑆 or down to 𝑆 next period. We aim to determine the price of an option with
value 𝐶 in the up-state and 𝐶 in the down-state.
To replicate the payoff, we must solve for 𝛥 and 𝐵 in the equations below:
𝐶 = 𝛥𝑆 + (1 + 𝑟 )𝐵 and 𝐶 = 𝛥𝑆 + (1 + 𝑟 )𝐵
Finding 𝐵 from the second equation and inserting it into the first equation gives us the solution for the portfolio
weights in the replicating portfolio:
𝛥= and 𝐵= ( )
The option price in the binomial model is then:
𝐶 = 𝛥𝑆 + 𝐵
10.2 The Black-Scholes Option Pricing Model

Let 𝑆 be the current stock price, 𝑇 be time to maturity, 𝐾 be the strike price, and 𝜎 be the annual volatility of the stock
(standard deviation). Then the Black-Scholes option pricing formula for the price of a call or put on a non-
dividend-paying stock is
𝐶 = 𝑆 × 𝑁(𝑑 ) − 𝑃𝑉(𝐾) × 𝑁(𝑑 )
𝑃 = 𝑃𝑉(𝐾) × 𝑁(−𝑑 ) − 𝑆 × 𝑁(−𝑑 )
where 𝑁(𝑑) is the cumulative normal distribution and
𝑙𝑛 [𝑆/𝑃𝑉(𝐾)] 𝜎√𝑇
𝑑 = +
𝜎√𝑇 2
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𝑑 = 𝑑 − 𝜎√𝑇
S – price; T – years, K- exercise price, 𝜎 − 𝑎𝑛𝑛𝑢𝑎𝑙 𝑣𝑜𝑙𝑎𝑡𝑖𝑙𝑖𝑡𝑦, t - time
We don’t need the expected return on the stock or risk-neutral probabilities to calculate option price.
Black-Scholes Price of a European Put Option on a Non-Dividend-Paying Stock:
𝑃 = 𝑃𝑉(𝐾)[1 − 𝑁(𝑑 )] − 𝑆[1 − 𝑁(𝑑 )]
Stock Paying Discrete Dividends: A European option on a stock that pays discrete dividends may be priced using the
Black-Scholes formula with 𝑆 (𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑠𝑡𝑜𝑐𝑘 𝑒𝑥𝑐𝑙𝑢𝑑𝑖𝑛𝑔 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠) in place of 𝑆, where
𝑆 = 𝑆 − 𝑃𝑉(𝐷𝑖𝑣)
If the underlying pays continuous dividends, we have
𝑆 = 𝑆/(1 + 𝑞)
𝑞 𝑖𝑠 𝑡ℎ𝑒 𝑠𝑡𝑜𝑐𝑘 𝑠 (𝑐𝑜𝑚𝑝𝑢𝑛𝑑𝑒𝑑) 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑦𝑖𝑒𝑙𝑑 𝑢𝑛𝑡𝑖𝑙 𝑡ℎ𝑒 𝑒𝑥𝑝𝑖𝑟𝑎𝑡𝑖𝑜𝑛 𝑑𝑎𝑡𝑒
Replicating Portfolio: The Black-Scholes replicating portfolio is…
… for a call option on a non-dividend-paying stock 𝐶 = 𝛥𝑆 + 𝐵
𝛥 = 𝑁(𝑑 )
𝐵 = −𝑃𝑉(𝐾)𝑁(𝑑 )
… for a put option on a non-dividend-paying stock 𝑃 = 𝛥𝑆 + 𝐵
𝛥 = −[1 − 𝑁(𝑑 )]
𝐵 = 𝑃𝑉(𝐾)[1 − 𝑁(𝑑 )]
The replicating portfolio must be continuously updated. 𝛥 is the option delta giving the option price’s sensitivity to
changes in stock price, i.e., the change in option price given a $1 change in stock price.
10.3 Risk-Neutral Probabilities

Under risk-neutral probabilities the expected return of all securities is the risk-free rate. These probabilities can be
used to price any other asset if the payoffs in each state are known. Given these, we can calculate the expected payoff
of the option and discount is at the appropriate cost of capital.
● Risk-neutral probabilities are not needed in the Binomial or BSM models, as they are based on a replication
argument. Thus, they disregard risk preferences and expected stock returns
It is important to note that the risk-neutral probability is not the actual probability of stock price increases. It
represents how the actual probability should have to be adjusted to keep the stock price the same as in a risk-neutral
world. Also called state-contingent or martingale prices.
In the binomial model, we can calculate the risk-neutral probability, 𝑞, as

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1+𝑟 −𝑑 1+𝑟 𝑆−𝑆

𝑞= =
𝑢−𝑑 𝑆 −𝑆
Now, the price of any derivative security can be obtained by discounting the expected cash flows computed using
the risk-neutral probabilities at the risk-free rate. The price of the call option is
𝑞 1−𝑞
𝐶= 𝐶 + 𝐶
1+𝑟 1+𝑟
We can compute the risk-neutral probability that makes the stock’s expected return equal to the risk-free rate:
p𝑆 + 𝑆 (1 − 𝑝)
𝑟 = −1
𝑆
Solving this equation for the risk-neutral probability p we get:
1+𝑟 𝑆−𝑆
𝑝=
𝑆 −𝑆
Using risk-neutral probabilities to value Equity and Debt: Assume a firm has debt with principal 𝑃 and yield 𝑦.
The value of the firm’s assets is determined by a binomial tree. Usually, the firm will incur bankruptcy costs 𝐵𝐶 in the
down state, so 𝐸 = 0 and 𝐷 = 𝐴 . Then we have:
𝐸 = 𝐴 − 𝑃 × (1 + 𝑦) + 𝑇𝑎𝑥 𝑠ℎ𝑖𝑒𝑙𝑑
𝐸 = 𝐴 × (1 − 𝐵𝐶) − 𝐷
Then the present value of equity is given as
𝑞 × 𝐸 + (1 − 𝑞) × 𝐸
𝐸=
1+𝑟
Note that in the case of issuing debt with principal 𝐸 to buy back shares, the price after the announcement but before
the buy-back transaction is given as
𝐸+𝑃
𝑃𝑃𝑆 =
𝑆ℎ𝑎𝑟𝑒𝑠 𝑏𝑒𝑓𝑜𝑟𝑒 𝑏𝑢𝑦𝑏𝑎𝑐𝑘
10.4 Risk and Return of an Option

The beta of an option is a measure of the risk of an option and can be calculated by computing the beta of its
replicating portfolio. For stocks with positive betas, calls will have larger (positive) betas than the underlying stock,
while puts will have negative betas. The magnitude of the option beta is higher for options that are further out of the
money. The beta of an option is given as
𝑆𝛥 𝐵
𝛽 = 𝛽 + 𝛽
𝑆𝛥 + 𝐵 𝑆𝛥 + 𝐵
where 𝛽 is the stock’s beta and 𝛽 is the bond’s (debt’s) beta.
Option beta:
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𝑆𝛥
𝛽 = 𝛽
𝑆𝛥 + 𝐵
If we have 𝛽 = 0, we get
𝑆𝛥 𝑁(𝑑 )𝑆
𝛽 = 𝛽 = 𝛽
𝑆𝛥 + 𝐵 𝐶
𝑆𝛥 −𝑆[1 − 𝑁(𝑑 )]
𝛽 = 𝛽 = 𝛽
𝑆𝛥 + 𝐵 𝑃
The fraction is the ratio of the amount of money in the stock position of the replicating portfolio to the value of the
replicating portfolio (option price). This is options leverage ratio.
𝑆𝛥
Leverage ratio =
(𝑆𝛥 + 𝐵)
10.5 Corporate Application of Option Pricing

Beta of Risky Debt: To derive an expression for the beta of equity when debt is risky (𝛽 ≠ 0), we need to recall that
equity is a call option on the firm’s assets. We have a replicating portfolio of the firm’s assets and a risk-free bond
𝐸 = 𝐴𝛥 + 𝐵. Applying this to the formula for the beta of an option:
𝐴𝛥 (𝐸 + 𝐷)𝛥 𝐷 𝐴
𝛽 = 𝛽 = 𝛽 = 𝛥 1+ 𝛽 =𝛥 𝛽
𝐴𝛥 + 𝐵 𝐸 𝐸 𝐸
where 𝛽 is the beta of equity and 𝛽 is the beta of unlevered equity (asset).
The beta of debt is given:
𝐸 𝐴
𝛽 = (1 − 𝛥) 1 + 𝛽 = (1 − 𝛥) 𝛽
𝐷 𝐷
Thus, when debt is risky, the betas of equity and debt increase with leverage. The unlevered beta is
𝛽
𝛽 =
𝐷
𝛥 1+𝐸
Agency Costs of Debt: The magnitude of agency costs may be assessed using option valuation. The NPV of a project
must be higher than the profitability index given from D and E with corresponding betas. If the NPV is lower (but still
positive) the firm will reject the project because of debt overhang. This means that equity holders benefit from new
investment only if
𝑁𝑃𝑉 1 − 𝛥 𝛽 𝐷
> =
𝐼 𝛥 𝛽 𝐸
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Beta and cost of capital
11 REAL OPTIONS
Berk & DeMarzo (2017): Chapter 22 + Session X
A real option is the right to make a particular business decision after new information is learned. Real options usually
have a physical rather than financial underlying asset. Further, the underlying does not have to be a traded security
(replication argument may not apply)
● We think of investment projects as opportunities, i.e., options.
As real option allows a decision maker to choose the most attractive alternative after new information becomes
available, the presence of real options adds value to an investment opportunity. Thus, the flexibility in investment
projects is valuable. The most common real options in capital budgeting are
(1) the option to wait for the optimal time to invest,

(2) the option to grow in the future, and
(3) the option to abandon a poorly performing project.
Real options typically have (some kind of) dividends, therefore the optimal timing of when to exercise is an integral
part of the valuation.
Why use real options? (1) Cash flow uncertainty creates option value (not just a downside), (2) decisions can be
taken dynamically, and (3) it tries to decouple income risk and investment risk.
11.1 The Option to Delay: Investment as a Call Option

The option to delay an investment is the option to (1) invest now or (2) postpone the decision to potentially invest
later (i.e., after having received more information).
● Trade-off between costs from delaying investment decision (lost interim profits, etc.) and the benefit from
gaining information regarding the value of the investment by delaying.
The Decision to Invest: Use the graph below as an example. Red line is the NPV of investing today, yellow line is the
value of waiting one year to make the decision (value of call option), and black line is the value of the contract that
gives the option to invest or not invest.
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Applying Black-Scholes to Real Options: Real options can be valued using the BSM formula. We first compute the
current value of the asset without the dividends to be missed. Then 𝑆 is the current market value of the underlying
asset, 𝐾 is the upfront investment cost, 𝑇 is the final decision date, 𝑟 is the risk-free rate, 𝜎 is the volatility of asset
value, and 𝐷𝑖𝑣 is the FCF lost from delay. Note that
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑖𝑛𝑖𝑡𝑖𝑎𝑡𝑖𝑛𝑔 𝑡𝑜𝑑𝑎𝑦 = 𝑆 − 𝐾
That is, the value of the project subtracted the cost (NPV at time 0). Using BSM, the value of waiting 𝑡 years can be
calculated (NPV at 𝑡 = 1)
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑤𝑎𝑖𝑡𝑖𝑛𝑔 = 𝑂𝑝𝑡𝑖𝑜𝑛 𝑝𝑟𝑖𝑐𝑒
Factors Affecting the Timing of Investment: When you have the option of deciding when to invest, it is usually
optimal to invest only when the NPV is substantially greater than zero.
Faced with mutually exclusive choices, we should choose the project with the higher NPV, i.e., invest today only if
the NPV of investing today exceeds the value of the option of waiting. Given the option to wait, an investment that
currently has a negative NPV can have a positive value.
Volatility: The option to wait is most valuable when there is a great deal of uncertainty regarding what the value of
the investment will be in the future.
Dividends: In the real option context, the dividends correspond to any value from the investment that we give up by
waiting. Absent dividends, a call option should not be exercised early.
11.2 Growth and Abandonment Options

A growth option is the option to expand, that is, start projects in small scale to get valuable information to figure out
whether to make a full-scale investment. By undertaking a project, a firm may get the chance to make investments that
it would not have otherwise, i.e., future expansion options. The opportunity to invest in projects in the future – the
firm’s growth options—is worth something today.
An abandonment option is the option to scaling down and/or closing non-profitable projects, which can be a positive
NPV decision. When firms find themselves in a project that is losing money, they can exercise their abandonment
option and walk away.
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Valuing Growth Potential: Future growth opportunities is a collection of real call options on potential projects. The
growth component of firm value is likely riskier than the ongoing assets of the firm.
11.3 Investments with Different Lives

When choosing between investments with different lives, it is important to consider that while longer-term
investments may have cost or return advantages, shorter-term investments include reinvestment options that should
not be ignored. Thus, a firm’s option to replace or extend shorter-term project at the end of its original life must be
accounted for (impacts NPV of project)
Equivalent Annual Benefit Method: Compares projects of different lengths. The EAB of a project is the constant
annuity payment over its life that is equivalent to receiving its NPV today. It implicitly assumes that the projects can
be replaced at their original terms. Using the equivalent annual benefit method might produce different
recommendations when future uncertainty is accounted for.
11.4 Optimally Staging Investments

The advantage of staging is it allows to postpose investment until after important new information is learned. The
cost, time, and risk of each project will decide the optimal order to invest. By making smaller, riskier investments in a
multi-stage investment decision, we gain additional information at the lowest cost. If the projects are mutually
dependent so all projects must succeed for the firm to benefit, the optimal order can be determined by ranking the
projects according to the failure cost index:
1 − 𝑃𝑉(𝑠𝑢𝑐𝑐𝑒𝑠𝑠)
𝐹𝑎𝑖𝑙𝑢𝑟𝑒 𝐶𝑜𝑠𝑡 𝐼𝑛𝑑𝑒𝑥 =
𝑃𝑉(𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡)
where 𝑃𝑉(𝑠𝑢𝑐𝑐𝑒𝑠𝑠) is the value at the start of the project of receiving $1 if the project succeeds (PV of risk-neutral
probability of success) and 𝑃𝑉(𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡) is the PV of the required investment.
11.5 Rules of Thumb and Key Insights

The concept of real options is difficult to implement. The rules of thumb try to incorporate the insights from real
options without thinking in terms of cost benefits of waiting. The two most common:
Profitability Index Rule: Invest in a project whenever the profitability index exceeds a specific level.
𝑁𝑃𝑉
𝑃𝑟𝑜𝑓𝑖𝑡𝑎𝑏𝑖𝑙𝑖𝑡𝑦 𝐼𝑛𝑑𝑒𝑥 =
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
When the investment cannot be delayed, invest when the PI is greater than zero. This method accounts for the option
to wait when there is cash flow uncertainty.
Hurdle Rate Rule: Compute NPV using the hurdle rate, a discount rate higher than cost of capital. Invest when the
NPV computed using this rate is positive. The hurdle rate is found using the callable annuity rate, i.e., the rate on a
risk-free annuity that can be repaid at any time to the risk-free rate.
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𝐶𝑎𝑙𝑙𝑎𝑏𝑙𝑒 𝐴𝑛𝑛𝑢𝑖𝑡𝑦 𝑅𝑎𝑡𝑒

𝐻𝑢𝑟𝑑𝑙𝑒 𝑅𝑎𝑡𝑒 = 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 ×
𝑅𝑖𝑠𝑘 − 𝑓𝑟𝑒𝑒 𝑅𝑎𝑡𝑒
This method accounts for the option to wait when there is interest rate uncertainty. The rule helps determine whether
investing may be a cost efficient, but it does not give an accurate measure of value
Key Insights from Real Options…
● Out-of-the-money real options have value: As long as there is a change that the investment could have a
positive NPV in the future, the opportunity is still worth something.
● It may not be optimal to exercise in-the-money real options immediately: The option to delay may be worth
more than the NPV of undertaking the investment immediately.
● Waiting is valuable: Waiting resolves uncertainty by accumulating information.
● Delay investment expenses as much as possible: Waiting is valuable, thus only incur investment expenses at the
latest possible moment.
● Create value by exploiting real options: The firm must continually re-evaluate investment opportunities and
optimise its decision taking.
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12 RAISING EQUITY CAPITAL

Berk & DeMarzo (2017): Chapter 23 + Session XIII
Private companies have multiple sources of equity financing closely tied to the lifecycle of the firm:
● Angel investors (individual investors, usually successful entrepreneurs providing capital exchange for a share or
convertible note in the business),
● Crowd funding (GoFundMe or ICO),
● Venture capital firms (limited partnerships raising money to invest in private equity of startups)
● Private equity firms (invests in equity of existing privately held companies rather than start-ups and mainly do
leveraged buy-outs to take a public firm private),
● Institutional investors (e.g., pension funds investing directly or through a limited partnership) or
● Corporate investors (established corporations investing in equity of younger, private FIRMS).
When stock is sold to raise capital, the founder’s ownership and control of the company are reduced.
12.1 Venture Capital Investing

Venture capital investments in private firms are negotiated in terms of the pre-money valuation of the firm, which is
the number of prior shares outstanding times the share price in the funding round.
𝑃𝑟𝑒 − 𝑚𝑜𝑛𝑒𝑦 𝑉𝑎𝑙𝑢𝑎𝑡𝑖𝑜𝑛 = 𝑁𝑜. 𝑠ℎ𝑎𝑟𝑒𝑠 𝑏𝑒𝑓𝑜𝑟𝑒 𝑓𝑢𝑛𝑑𝑖𝑛𝑔 × 𝑃
𝑃𝑟𝑒 − 𝑚𝑜𝑛𝑒𝑦 𝑉𝑎𝑙𝑢𝑎𝑡𝑖𝑜𝑛 = 𝑃𝑜𝑠𝑡 − 𝑚𝑜𝑛𝑒𝑦 𝑉𝑎𝑙𝑢𝑎𝑡𝑖𝑜𝑛 − 𝐴𝑚𝑜𝑢𝑛𝑡 𝐼𝑛𝑣𝑒𝑠𝑡𝑒𝑑
𝑃𝑟𝑒 − 𝑚𝑜𝑛𝑒𝑦 𝑉𝑎𝑙𝑢𝑎𝑡𝑖𝑜𝑛 = 𝑃𝑜𝑠𝑡 − 𝑚𝑜𝑛𝑒𝑦 𝑉𝑎𝑙𝑢𝑎𝑡𝑖𝑜𝑛 − 𝐴𝑚𝑜𝑢𝑛𝑡 𝐼𝑛𝑣𝑒𝑠𝑡𝑒𝑑 + 𝐷𝑒𝑏𝑡
Given the pre-money valuation and the amount invested, the post-money valuation. i.e., the value of the whole firm
at the funding round price, is:
𝑃𝑜𝑠𝑡 − 𝑚𝑜𝑛𝑒𝑦 𝑉𝑎𝑙𝑢𝑎𝑡𝑖𝑜𝑛 = 𝑃𝑟𝑒 − 𝑚𝑜𝑛𝑒𝑦 𝑉𝑎𝑙𝑢𝑎𝑡𝑖𝑜𝑛 + 𝐴𝑚𝑜𝑢𝑛𝑡 𝐼𝑛𝑣𝑒𝑠𝑡𝑒𝑑 − 𝐷𝑒𝑏𝑡
𝑃𝑜𝑠𝑡 − 𝑚𝑜𝑛𝑒𝑦 𝑉𝑎𝑙𝑢𝑎𝑡𝑖𝑜𝑛 = 𝑃𝑟𝑒 − 𝑚𝑜𝑛𝑒𝑦 𝑉𝑎𝑙𝑢𝑎𝑡𝑖𝑜𝑛 + 𝐴𝑚𝑜𝑢𝑛𝑡 𝐼𝑛𝑣𝑒𝑠𝑡𝑒𝑑
𝑃𝑜𝑠𝑡 − 𝑚𝑜𝑛𝑒𝑦 𝑉𝑎𝑙𝑢𝑎𝑡𝑖𝑜𝑛 = 𝐴𝑚𝑜𝑢𝑛𝑡 𝐼𝑛𝑣𝑒𝑠𝑡𝑒𝑑 ÷ 𝑆ℎ𝑎𝑟𝑒 𝑜𝑓 𝑓𝑖𝑟𝑚 𝑝𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑑
The percentage ownership held by the new investors is equal to
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑂𝑤𝑛𝑒𝑟𝑠ℎ𝑖𝑝 = 𝐴𝑚𝑜𝑢𝑛𝑡 𝐼𝑛𝑣𝑒𝑠𝑡𝑒𝑑/𝑃𝑜𝑠𝑡 − 𝑚𝑜𝑛𝑒𝑦 𝑉𝑎𝑙𝑢𝑎𝑡𝑖𝑜𝑛
Venture capital investors hold convertible preferred stock. If issued by mature companies, it usually has preferential
dividends, liquidation and voting rights. The typical features of these securities are:
● Liquidation preference specifying a minimum amount that must be paid to the security holder before any
payments to common stockholders in case of bankruptcy, sale or merger of the firm
● Seniority over other investors to ensure they are repaid first in case of, e.g., bankruptcy
● Participation rights allowing the holder to receive both their liquidation preference and any payments to
common shareholders as though they have converted their shares.
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● Anti-dilution protection lowering the price at which investors in earlier rounds can convert their shares to
common, effectively increasing their ownership percentage.
● Board membership rights
Exiting an investment: Equity investors in private firm can exit via acquisition or a public offering.
12.2 Initial Public Offering (IPO)

An initial public offering (IPO) is the first time a company sells its stock to the public. The shares sold may be either
a primary offering (if the shares are being sold to raise new capital) or a secondary offering (if the shares are sold by
current shareholders (as a part of their exit strategy).
● Advantages: Greater liquidity, better access to capital, ability to diversify for private equity investors, and access
to much larger amounts of capital though the public markets.
● Disadvantages: Regulatory and reporting requirements, undermining of the investors’ ability to monitor the
company’s management as the equity holders become more widely dispersed.
Types of Offerings: Best-effort IPO (no guarantee shares are sold, underwriter tries to get the best price), firm
commitment IPO (most common, underwriter guarantees all stock is sold at offer price), auction (tender offer), or
direct listing.
Underwriters: An underwriter is an investment bank that manages the IPO and helps the company sell its stock.
Usually, the underwriter purchases the entire issue at a slight discount and resells at offer price. This creates risk
which is managed by intentionally under-pricing the IPO or using a greenshoe provision, which allows the
underwriter to issue more stock at the IPO offer price.
IPO Puzzles: (1) IPOs are under-priced on average, (2) the number of new issues are cyclical, (3) high transaction
costs, and (4) long-run performance after an IPO is poor on average.
12.3 Seasoned Equity Offering (SEO)

A seasoned equity offering (SEO) is the sale of stock by a company already publicly traded to finance growth
opportunities. There are two kinds: a cash offer (new shares are sold to investors at large) and rights offer (new
shares are offered only to existing shareholders). Rights offers protects existing shareholders from under-pricing,
assuming that all shareholders participate.
● Primary shares are ‘new’ money, secondary shares are existing block holders wanting to sell
Price reaction to SEO: In general, price drops and also long-run under performance due to adverse selection (p. 888).
For real options and investments, returns are riskier before capital for a new investment is injected than after. The cost
of SEO is usually 5% of raised capital.
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13 DEBT FINANCING
Berk & DeMarzo (2017): Chapter 24 + Session XIII
13.1 Corporate Debt

Companies can raise debt using different sources. In general, there are two types of debt:
(1) Public Debt: Corporate bonds, i.e., securities issued by companies when raising debt. Build around a prospectus
and indenture as the formal contract between bond issuer and a trust company.
● If a bond is a bearer bond, you are only eligible for coupons if you can provide proof of ownership. If it is a
registered bond, the issuer maintains a list of all holders.
Types of corporate debt: Four typical kinds including notes, debentures, mortgage bonds, and asset-backed bonds.
Notes and debentures are unsecured; mortgage and asset-backed bonds are secured.
Seniority: As multiple unsecured bonds may exist, a bond’s seniority is important. In case of bankruptcy, senior debt
is paid in full first before subordinated debt is paid.
Bond markets: Domestic bonds are traded in a local market and denominated in a local currency but purchased by
foreigners. Foreign bonds are issued in a local market by a foreign entity denominated in a local currency.
Eurobonds are international bonds not denominated in the local currency of the country in which they are issued.
Global bonds trade in several markets simultaneously.
(2) Private Debt: Private debt is negotiated directly with a bank or a small group of investors in the form of term
loans or private placements. A term loan is a bank loan that lasts for a specific term. A private placement is a bond
issue that is sold to a small group of investors. The private debt market is larger than public debt, usually with lower
registration costs but very illiquid.
13.2 Other Types of Debt

Corporations are not the only entity using debt. Government entities also issue bonds.
Sovereign Debt: Debt issued by governments. The US Treasury issues 4 different securities: Treasury bills, Treasury
notes, Treasury bonds, and TIPS (outstanding principal adjusted for inflation).
Municipal Bonds: Issued by state and local governments. Their distinguishing characteristic is that the income on
municipal bonds is not taxable at the federal level. Often pays a semi-annual floating or fixed coupon. Differ in terms
of the source of funds that guarantee them.
Asset-Backed Securities: An asset-backed security (ABS) is a security made up of other financial securities, i.e., the
security’s cash flows come from the cash flows of the underlying financial securities that “back” them. A mortgage-
backed security (MBS) is an ABS backed by home mortgages. Holders of these face prepayment risk – the risk that
the bond will be partially (or wholly) repaid earlier than expected. Holders of privately issued mortgage-backed
securities also face default risk.
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A collateralized debt obligation is an asset-backed security backed by other asset-backed securities.
13.3 Bond Covenants

Covenants are restrictive clauses in the bond contract that limit the issuer from taking actions that will increase the
default risk and reduce the value of the bonds. They restrict pay-outs (dividends and stock buybacks), asset
substitutions, further debt issues and working capital.
13.4 Repayment Provisions, Callable bonds

A bond is repaid via coupon and principal payments specified in the bond contract. Alternatively, they can be repaid
by exercising a call provision, which gives the issuer of the bond the right (but not the obligation) to retire the bond
after a specific date (but before maturity) for the call price. In other words, the call provision allows the issuer to
repurchase the bonds at a predetermined price.
A callable bond will generally trade at a lower price (and therefore a higher yield) than an equivalent non-callable
bond, as the holder of a callable bond faces reinvestment price exactly when market rates are lower than the coupon
rate, she is receiving making callable bonds less attractive.
The yield to maturity (YTM) is defined as the discount rate that sets the present value of the promised payment equal
to the current price, i.e., ignoring the call feature. For a bond callable at par (100)
𝐶 1 100
𝐵𝑜𝑛𝑑 𝑝𝑟𝑖𝑐𝑒 = ∗ 1− +
𝑌𝑇𝑀 (1 + 𝑌𝑇𝑀) (1 + 𝑌𝑇𝑀)
The yield to call (YTC) is the annual yield of a callable bond assuming that the bond is called at the earliest
opportunity. YTC will be higher than an identical non-callable bond maturing on the call date. For a bond callable at
par (100), where 𝑇𝑇𝐶 is time to call.
𝐶 1 100
𝐵𝑜𝑛𝑑 𝑝𝑟𝑖𝑐𝑒 = ∗ 1− +
𝑌𝑇𝐶 (1 + 𝑌𝑇𝐶) (1 + 𝑌𝑇𝐶)
Sinking Funds: Another way in which a bond is repaid before maturity is by periodically repurchasing part of the
debt through a sinking fund. In this way, the amount of outstanding debt is reduced without affecting the cash flows of
the remaining bonds.
Convertible Provisions: Some corporate bonds, convertible bonds, have a provision that allows the holder to
convert them into equity. This is an option to convert each bond owned into a fixed number of shares of common
stock at the conversion ratio. This is a regular bond plus a special type of call options (warrant, call on new stock).
As options always have a positive value, a convertible bond is worth more than an identical straight bond.
Consequently, the convertible debt carries a lower interest rate than other comparable non-convertible debt.
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14 LEASING
Berk & DeMarzo (2017): Chapter 25+ Session XV
A lease is a contract between two parties. The lessee is liable for periodic payments in exchange for the right to use
the asset. The lessor is the owner of the asset, who is intitled to the lease payments upfront in exchange for lending the
asset. There are many types of lease transactions…
● In a sales-type lease, the lessor is the manufacturer or primary dealer of the asset.
● In a direct lease, the lessor is an independent firm specialised in purchasing and leasing assets.
● In a leveraged lease, the lessor finances the asset by debt using the lease payments to pay off
● A synthetic lease is an operating lease for accounting or tax purposes, usually made through special-purpose
entities (SPE), which are created by the lessee for the sole purpose of the lease.
If a firm owns an asset it would prefer to lease, it can arrange a sale and leaseback transaction, where the lessee
receives cash from the sale of the asset and makes lease payments to retain its use.
End-of-Term Options: The lessee often has an option to buy the asset at the termination of the lease, e.g., in a fair
market value (FMV) lease, a $1.00 out lease, a fixed price lease or a FMV cap lease.
Lease Payments and Residual Value: The cost of the lease will depend on the asset’s residual value, which is its
market value at the end of the lease. In a perfect market, the cost of leasing is equivalent to the cost of purchasing and
reselling the asset, that is
𝑃𝑉(𝐿𝑒𝑎𝑠𝑒 𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠) = 𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒 𝑝𝑟𝑖𝑐𝑒 − 𝑃𝑉(𝑅𝑒𝑠𝑖𝑑𝑢𝑎𝑙 𝑣𝑎𝑙𝑢𝑒)
Leases Versus Loans: In a perfect market, the cost of leasing and then purchasing the asset is equivalent to the cost
of borrowing to purchase the asset, that is
𝑃𝑉(𝐿𝑒𝑎𝑠𝑒 𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠) + 𝑃𝑉(𝑅𝑒𝑠𝑖𝑑𝑢𝑎𝑙 𝑣𝑎𝑙𝑢𝑒) = 𝑃𝑉(𝐿𝑜𝑎𝑛 𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠)
14.1 Accounting, Tax and Legal Consequences of Leasing

With perfect markets, leasing is a zero-NPV financing alternative for the firm. The decision to lease is often driven by
market imperfections such as the leasing’s accounting, tax, and legal treatment.
Lease Accounting: The FASB recognizes two types of leases based on lease terms. In general, a lease is viewed as an
operating lease if the leasing period is shorter than the economic life of the asset
● An operating lease is viewed as a rental for accounting purposes. The lessee reports the lease payments as an
operating expense, depreciation cannot be deducted, and the asset (or the lease payment liability) is not reported
on its balance sheet.
● A capital lease (finance lease) is viewed as an acquisition for accounting purposes. The asset is listed on the
lessee’s balance sheet and the lessee incurs depreciation expenses for the asset. The present value of future lease
payments is listed as a liability, and the interest proportion of the lease payment is deducted as an interest expense.
Tax treatment: The IRS separates leases into two broad categories
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● In a true tax lease, the lessor receives the depreciation deductions associated with the ownership of the asset, and
the lessee deducts lease payments as an operating expense (operating lease).
● A non-tax lease is treated as a loan for tax purposes, so the lessee must depreciate the asset and can expense only
the interest portion of the lease payments (capital lease).
Bankruptcy: The treatment of the assets with bankruptcy depends on the lease type:
● In a true lease, the lessor retains ownership rights of the asset so it can be seized absent payments
● In a security interest lease, the lessor is treated like any other creditor with secure debt.
14.2 The Leasing Decision

The leasing decision concerns a cost-benefit analysis of leasing, buying, and borrowing.
Lease Versus Buy (Unfair Comparison): The comparison of leasing versus buying is unfair, as leasing is a form of
financing (commitment to an obligation, could trigger financial distress), so it should be compared with other
financing options.
Lease Versus Buy-and-Borrow (Fair Comparison): To compare leasing to buy-and-borrow, we must determine the
lease-equivalent loan, that is, the loan required on the purchase of the asset that leaves the purchaser with the same
obligations as the lessee would have. We first compute the incremental cash flows from leasing versus buying. The
future incremental cash flows are the after-tax payments the firm will make on the loan. Then, the initial balance of
the lease-equivalent loan is the present value of the cash-flows using the after-tax cost of debt.
Because the incremental cash flows from leasing are relatively safe, 𝑟 = 𝑟 , and so 𝑟 = 𝑟 (1 − 𝜏 ) – note that
slides say 𝑟 = 𝑟 . Thus, we can compare leasing to buying the asset using equivalent leverage by discounting the
incremental cash flows of leasing using the after-tax borrowing rate.
NPV of buying and borrowing: The benefits of buying and borrowing are tax benefits of depreciation costs, tax
benefits of borrowing, and the opportunity of keeping the asset after the leasing period. The costs are the acquisition
costs, 𝑃. So, the NPV of buying-and-borrowing is:
𝑆 1 1 𝑆
𝑁𝑃𝑉 = 𝜏 𝑃𝑉 (𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛𝑠) + −𝑃 =𝜏 𝑑 1− + −𝑃
(1 + 𝑟 ) 𝑟 (1 + 𝑟 ) (1 + 𝑟 )
NPV of leasing: The cost of leasing are the periodic leasing costs. So, the NPV is
1 1
𝑁𝑃𝑉 = −(1 − 𝜏 )𝐿 1 + 1−
𝑟 (1 + 𝑟 )
NPV of the difference in leasing and buy-and-borrow: Combined we have the following. If the is negative, we
should choose to lease over buy-and-borrow
1 1 1
𝑁𝑃𝑉 = (1 − 𝜏 )𝐿 1 + 1− + 𝜏 𝑃𝑉 (𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛𝑠) + 𝑆 −𝑃
𝑟 (1 + 𝑟 ) (1 + 𝑟 )
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Lease Equivalent Loan: Given as the incremental NPV excluding year 0, that is lease payment in year 0 and initial
investment costs:
1 1 1
𝑃𝑉 = (1 − 𝜏 )𝐿 + ⋯+ + 𝜏 𝑃𝑉 (𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛𝑠) + 𝑆
(1 + 𝑟 ) (1 + 𝑟 ) (1 + 𝑟 )
Break-Even Lease Rate: From the lessor’s point of view, we have a leasing income 𝐿 at 𝑡 = 0,1, … , 𝑛 − 1, tax value
of depreciations 𝑑 at 𝑡 = 0,1, … , 𝑛 − 1, 𝑛 (or shorter), acquiring the leasing object −𝑃 at 𝑡 = 0, and a scrap value of
leasing object 𝑆 at time 𝑛. The cost of capital us 𝑟 = (1 − 𝜏 )𝑟 . So, the free cash flows are
1 1 1
(1 − 𝜏 )𝐿 1 + 1− + 𝜏 𝑃𝑉 (𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛𝑠) + 𝑆 −𝑃 = 0
𝑟 (1 + 𝑟 ) (1 + 𝑟 )
1 1 1 1 1
(1 − 𝜏 )𝐿 1 + 1− +𝜏 𝑑 1− +𝑆 −𝑃 =0
𝑟 (1 + 𝑟 ) 𝑟 (1 + 𝑟 ) (1 + 𝑟 )
14.2.1 Evaluating a True Tax Lease

To evaluate the leasing decision for a true tax lease, we should compare the cost of leasing to a purchase that is
financed with an equivalent leverage. Follow the approach:
(1) Compute the incremental cash flows for leasing versus buying, and include the depreciation tax shield (if
buying) and the tax deductibility of the lease payments (if leasing)
(2) Compute the NPV by discounting the incremental cash flows at the after-tax borrowing rate
If the NPV is negative, the firm should not lease but rather acquire the asset using an optimal amount of leverage. If
the NPV is positive, leasing is ad advantage over traditional debt financing.
14.2.2 Evaluating a Non-Tax Lease

For a non-tax lease, the lessee still receives depreciation deductions. The cash flows of a non-tax lease are directly
comparable to the cash flows of a traditional loan, so a non-tax lease is attractive if it offers a better interest rate than
a loan. To determine this, we discount the lease payments at the firm’s pretax borrowing rate and compare to the
purchase price of the asset.
14.3 Reasons for Leasing

Valid Reasons for Leasing: These include…
(1) tax differences, as with a true tax lease, the lessee replaces depreciation and interest tax reductions with a
deduction for the lease payments. Generally speaking, a true tax lease is beneficial if…
…if lessor is in a higher tax bracket than lessee, and the asset depreciates quicker than the payments
… if lessor is in a lower tax bracket than lessee, and the asset depreciates slower than the payments
(2) reduced resale costs if the firm only needs to use the asset for a short time.
(3) efficiency gains from specialization as lessors often has efficiency advantages over lessees
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(4) reduced distress costs and increased debt capacity as lease obligations effectively have higher priority and
lower risk than even secured debt, so it is more attractive.
(5) mitigating debt overhang, as because of the lease’s effective seniority, it allows the firm to finance its expansion
wile segregating the claim on new assets, thus overcoming the debt overhang.
(6) transferring risk as leasing allows the party best able to bear the risk to hold it.
(7) improved incentives if the lessor is the manufacturer, as a lease provides the manufacturer with an incentive to
produce a high-quality, durable product.
Suspect Reasons for Leasing: These include…
(1) avoiding capital expenditure controls. Some managers will choose to lease rather than purchase to avoid
scrutiny from superiors that accompanies large capital expenditures.
(2) preserving capital. A lease is not 100% financing (no down payment), but only has an advantage from its
differential treatment for tax purposes and in bankruptcy.
(3) reducing leverage through off-balance-sheet financing. By having a capital lease, the firm can avoid listing the
long-term lease as a liability and thus increase leverage without increasing the debt-to-equity ratio. However, lease
commitments are liabilities and have the same effect on return of risk as other forms of leverage do.
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15 SHORT-TERM FINANCING
Berk & DeMarzo (2017): Chapter 26-27
15.1 Working Capital Management

Net working capital is current assets minus current liabilities and is thus the capital required in the short-term to run
the business. Working capital management involves managing the short-term assets (cash, inventory, and accounts
receivable) and short-term liabilities (accounts payable).
15.1.1 The Cash Cycle

The Cash Cycle: A firm’s cash cycle is the length of time between when the firm pays cash to purchase its inventory
and when it receives cash from the sale of the output. The longer a firm’s cash cycle, the more working capital it has,
and the more cash it needs to carry to conduct its daily operations. The operating cycle is the length of time between
when a firm originally purchases its inventory and when it receives the cash from selling its product.
Firm Value and Working Capital: Reducing working capital requirements generates a positive free cash flow to be
distributed to shareholders. Manging working capital will maximise firm value.
𝐶𝐶𝐶(𝐶𝑎𝑠ℎ 𝐶𝑜𝑛𝑣𝑒𝑟𝑠𝑖𝑜𝑛 𝑐𝑦𝑐𝑙𝑒) = 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 𝐷𝑎𝑦𝑠 + 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝐷𝑎𝑦𝑠 − 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑃𝑎𝑦𝑎𝑏𝑙𝑒 𝐷𝑎𝑦𝑠
𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒
𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 𝐷𝑎𝑦𝑠 =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐷𝑎𝑖𝑙𝑦 𝑆𝑎𝑙𝑒𝑠
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝐷𝑎𝑦𝑠 =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐷𝑎𝑖𝑙𝑦 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐺𝑜𝑜𝑑𝑠 𝑆𝑜𝑙𝑑
𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑃𝑎𝑦𝑎𝑏𝑙𝑒
𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑃𝑎𝑦𝑎𝑏𝑙𝑒 𝐷𝑎𝑦𝑠 =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐷𝑎𝑖𝑙𝑦 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐺𝑜𝑜𝑑𝑠 𝑆𝑜𝑙𝑑
15.1.2 Trade Credit

Trade credit is effectively a loan from the selling firm to its customer, which creates an accounts receivable for the
firm and account payable for the customer. This is in essence a loan, where the price discount represents an interest
rate. So, the cost of trade credit depends on the credit terms.
● A firm should compare the cost of trade credit with the cost of alternative sources of financing in deciding
whether to use the trade credit offered.
Reasons for trade credit: (1) An indirect way to lower prices for only certain customers, and (2) may be advantages
in making loans to customers relative to other potential sources of credit due to their ongoing business relationship.
Float: The delay between the time a bill is paid and the cash is actually received.
15.1.3 Managing Receivables, Payables, Inventory and Cash

Accounts Receivables: Determining the credit policy (credit standards, credit terms and collection policy).
Monitoring accounts receivables is important to analyse the credit policy effectiveness:
● Accounts receivable days: Average number of days for the firm to collect its sales.
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● Aging schedule: Categorises accounts by number of days they have been on the firm’s books.
Accounts Payables: A firm should only borrow using accounts payable if trade credit is the cheapest source of
funding. Further, a firm should monitor accounts payable and ensure that they are making payments at an optimal
time. This can be done by calculating accounts payable days outstanding.
Inventory Management: Firms hold inventory to avoid lost sales due to stock-outs and because of factors such as
seasonal demand. Excessive inventory uses cash, so efficient inventory management increases the firm’s free cash
flow and thus increases firm value. The costs of inventory include acquisition costs, order costs, and carrying costs
(storage, insurance, etc.).
Cash Management: Holding excess cash has a tax disadvantage. Still, a firm will hold cash to meet its day-to-day
needs, to compensate for cash flow uncertainty and to satisfy bank requirements. If the need to hold cash is reduced,
the funds can be invested in different short-term (alternative) securities.
15.2 Short-Term Financial Planning

The first step in short-term planning is to forecast future cash flows allowing the firm determine if it has cash flow
surplus or deficit and whether it is short term (temporary) or long term (permanent).
Reasons for Short-Term Financing: Seasonal working capital requirements, negative cash flow shocks, or positive
cash flow shocks.
The Matching Principle: Specifies that short-term needs for funds should be financed with short-term sources of
funds, and long-term needs with long-term sources of funds.
● Permanent working capital is the amount the firm must keep invested in its short-term asset to support is
continuing operations.
● Temporary working capital is the difference between the actual level of investment in short-term assets and the
permanent working capital investment.
Financing Policy Choices: Financing permanent working capital with short-term debt is an aggressive financing
policy. Financing short-term needs with long-term debt is a conservative policy.
Short-Term Financing with Bank Loans: Bank loans are a primary source of short-term financing, especially for
small firms. The types are:
(1) Single, end-of-period payment loan, which is the most straightforward type of bank loan. The firm pays interest
on the loan and pay back the principal in one lump sum at the end of the loan.
(2) Lines of credit allow a firm to borrow any amount up to a stated maximum. The line of credit may be
uncommitted, which is a nonbinding informal agreement, or may more typically be committed. Lines of credit is
often used to finance seasonal needs.
(3) A bridge loan is a short-term loan used to bridge the gap until long-term financing is arranged.
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Short-Term Financing with Commercial Paper: Commercial paper is a method of short-term financing that is
usually available only to large firms. A low-cost alternative to a short-term bank loan for firms with access to the
commercial paper market.
Short-Term Financing with Secured Financing: Short-term loans may also be structured as secured loans, which
are loans collateralised with short-term assets – most typically the firm’s accounts receivable and inventory.
Accounts receivable may be either pledged as security for a loan or factored. In a factoring arrangement, the accounts
receivable are sold to the lender (or factor), and the firm’s customers are usually instructed to make payments directly
to the factor.
Inventory can be used as collateral for a loan in several ways: a floating lien (also called a general or blanket lien), a
trust receipts loan (or floor planning), or a warehouse arrangement. These arrangements vary in the extent to which
specific items of inventory are identified as collateral; consequently, they vary in the amount of risk the lender faces.
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16 MERGERS AND ACQUISITIONS

Berk & DeMarzo (2017): Chapter 28 + Session XIX
When a firm acquires another, there is a buyer, the acquirer, and a seller, the target firm. This can either happen by
another corporation acquiring the target firm, or the target firm can merge with another firm. In both cases, the
acquiring entity must purchase stock or existing assets of the target firm. This is general referred to as a takeover.
The takeover market is characterised by merger waves, which are peaks of heavy activity following by quiet periods
of few transactions. Merger activity is greater during economic expansions.
Types of Mergers: If the target and acquirer are in the same industry, the merger is a horizontal merger. If the
target’s industry buys or sells the acquirers industry, it is a vertical merger. If the target and acquirer operate in
unrelate businesses, it is a conglomerate merger.
16.1 Market Reaction to a Takeover

Most acquirers pay an acquisition premium, which is the percentage difference between the acquisition price and the
pre-merger price of the target firm. This is usually 40-45% over pre-merger price.
Consequence for shareholders: Depends on target shareholder or acquirer shareholder
● When the bid is announced, target shareholders enjoy a gain of 15% on average in stock price
● Acquirer shareholders see an average gain of 1%, in half the transactions the price decreases.
16.2 Reasons to Acquire

Why is the target worth a premium over current market price? The answer is that acquiring a firm can create
synergies which are usually either cost reducing or revenue enhancing. These are…
Economies of Scale and Scope: Mergers can create economies of scale, i.e., cost savings from producing in large
volumes, and economies of scope, i.e., cost savings from removing redundancies.
Vertical Integration: When two companies in the same industry making products required at different stages of the
production cycle merge, there is a synergy from improved supply chain coordination
Expertise: The skilled labour, talent, local knowledge, etc. gained from the acquired company
Monopoly Gains: Merging with a major rival creates monopolistic power and reduces competition, enabling the firm
to increase prices and profit. Society bears the cost, so anti-trust laws against it.
Efficiency Gains: Improvements in operating efficiency through elimination of duplication. However, takeovers
relying on improvement of target management are difficult to complete.
Tax Savings from Operating Losses: A conglomerate has tax advantages as losses in one division can be offset by
profits in another. Thus, you reduce variance on earnings.
Diversification: The justification for the benefits are:
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● Risk reduction: Large firms carry less idiosyncratic risk. However, this ignores that investors can do their own
diversification in their portfolios. Further, large firms may increase agency costs.
● Debt capacity and borrowing costs: Larger debt capacity and larger tax savings due to the lower bankruptcy
costs (that is, lower probability of bankruptcy).
● Liquidity: Owners of privately held targets can benefit from being able to cash out and reinvest in a diversified
portfolio. Often an important incentive to get target shareholders to agree.
Earnings growth: It is possible to merge two companies and increase the earnings per share even when the merger
itself created no economic value. However, this key figure is tainted, which can be seen from the price-to-earnings
ratio (would fall).
Managerial Motives to Merge: While all other reasons are economically motivated and shareholder-driven,
managers may have their own reasons to merge.
● Conflicts of Interest: Managers may want to build an empire due to additional pay and prestige.
● Overconfidence: Managers are often overconfident in their abilities. They believe they are acting in the interest
of shareholder, but irrationally overestimate their abilities.
16.3 Valuation, Offer and the Takeover Process

Valuation: Using multiples based on comparable firms does not account for the synergies created com the takeover.
So, a key issue is quantifying and discounting the value added from the merger – this is referred to as takeover
synergies. The price paid for a target can be separated as
𝐴𝑚𝑜𝑢𝑛𝑡 𝑝𝑎𝑖𝑑 = 𝑇𝑎𝑟𝑔𝑒𝑡 𝑠 𝑝𝑟𝑒 𝑏𝑖𝑑 𝑚𝑎𝑟𝑘𝑒𝑡 𝑐𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑧𝑎𝑡𝑖𝑜𝑛 + 𝐴𝑐𝑞𝑢𝑠𝑖𝑡𝑖𝑜𝑛 𝑝𝑟𝑒𝑚𝑖𝑢𝑚s
From the bidder’s standpoint, the benefit from the transaction is given as
𝑉𝑎𝑙𝑢𝑒 𝑎𝑐𝑞𝑢𝑖𝑟𝑒𝑑 = 𝑇𝑎𝑟𝑔𝑒𝑡 𝑠𝑡𝑎𝑛𝑑 𝑎𝑙𝑜𝑛𝑒 𝑣𝑎𝑙𝑢𝑒 + 𝑃𝑉(𝑆𝑦𝑛𝑒𝑟𝑔𝑖𝑒𝑠)
From the bidder’s perspective, the takeover is a positive NPV project if the premium paid does not exceed the
synergies created. The bidder’s stock price reaction to the announcement of the merger is one way to gauge investors’
assessments of whether the bidder overpaid or underpaid for the target.
16.3.1 The Offer

After the valuation, the acquirer may make a tender offer is a public announcement of an intention to purchase a large
block of shares for a specified price. Two methods of paying…
… (1) cash or (2) a stock-swap, where the bidder issues new stock and gives to target shareholders
The “price” offered is determined by the exchange ratio – the number of bidder shares received in exchange for each
target share – multiplied by the market price of the acquirer’s stock.
A – the premerger or stand alone, value of the acquirer; T – the premerger (stand-alone) value of the target. S
– the value of the synergies created by the merger. If the acquirer has 𝑵𝑨 shares outstanding before the merger,
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at share price 𝑷𝑨 , and issues x new shares to pay for the target, then acquirer’s share price should increase
post-acquisition if
𝑨+𝑻+𝑺 𝑨
> = 𝑷𝑨
𝑵𝑨 + 𝒙 𝑵𝑨
The following condition for an acquirer to earn a positive NPV:
𝑥𝑃 < 𝑇 + 𝑆
Maximum exchange rate that the acquirer should offer is on the book… if you need it!
In a cash offer: Let 𝑃 denote the share price for the target and 𝑃 for the acquirer. Then we have
𝑃 = 𝑂𝑓𝑓𝑒𝑟 𝑃𝑟𝑖𝑐𝑒
𝑀𝑎𝑟𝑘𝑒𝑡 𝑐𝑎𝑝 − 𝑀𝑎𝑟𝑘𝑒𝑡 𝑐𝑎𝑝 + 𝑆𝑦𝑛𝑒𝑟𝑔𝑖𝑒𝑠 − 𝑂𝑓𝑓𝑒𝑟 𝑝𝑟𝑖𝑐𝑒 × #𝑠ℎ𝑎𝑟𝑒𝑠 𝑓𝑜𝑟 𝑡𝑎𝑟𝑔𝑒𝑡
𝑃 =
#𝑠ℎ𝑎𝑟𝑒𝑠 𝑓𝑜𝑟 𝑎𝑐𝑞𝑢𝑖𝑟𝑒𝑟
In a stock offer: The price offered is determined by the exchange ratio – the number of bidder shares received in
exchange for each target share – multiplied by the market price of the acquirer’s stock. Let 𝑃 denote the share price.
Then we have
𝑃
𝐸𝑥𝑐ℎ𝑎𝑛𝑔𝑒 𝑟𝑎𝑡𝑖𝑜 =
𝑃
# 𝑠ℎ𝑎𝑟𝑒𝑠 𝑖𝑠𝑠𝑢𝑒𝑑 = # 𝑠ℎ𝑎𝑟𝑒𝑠 𝑓𝑜𝑟 𝑡𝑎𝑟𝑔𝑒𝑡 × 𝐸𝑥𝑐ℎ𝑎𝑛𝑔𝑒 𝑟𝑎𝑡𝑖𝑜
𝐸𝑞𝑢𝑖𝑡𝑦 𝑎𝑓𝑡𝑒𝑟 𝑚𝑒𝑟𝑔𝑒𝑟

𝑃 =
# 𝑡𝑜𝑡𝑎𝑙 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 𝑠ℎ𝑎𝑟𝑒𝑠
𝑃 = 𝑃 × 𝐸𝑥𝑐ℎ𝑎𝑛𝑔𝑒 𝑟𝑎𝑡𝑖𝑜
In a cash AND stock offer: Same procedure as a regular stock offer, but remember to subtract the cash payments from
equity and the share price of the target at the very end should have this added to their share price as cash per share.
E.g., 10 cash over 1 share would mean that the share price should be 10 more than the one calculated from the
exchange ratio!
From the slides: Let 𝐴 be the premerger value of the acquirer and 𝑇 be the premerger value of the target. Let 𝑆 be the
value of the synergies created by the merger. If the acquirer has 𝑁 shares before the merger at share price 𝑃 , and
issues 𝑥 new shares to pay for the target, then the acquirer’s share price post-acquisition (the merged firm), 𝑃 , should
increase if
𝐴+𝑇+𝑆 𝐴
𝑃 = > =𝑃
𝑁 +𝑥 𝑁
The condition for the acquirer to earn a positive NPV is that the value of the shares offered 𝑥𝑃 must be less than the
value of the target plus synergies creates, that is
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𝑥𝑃 < 𝑇 + 𝑆
Let 𝑃 = 𝑇/𝑁 be the pre-merger value of the target, then the maximum exchange ratio the acquirer should offer is
given as
𝑥 𝑁 𝑃 +𝑆 𝑃 𝑆 𝑃 𝑆
𝐸𝑥𝑐ℎ𝑎𝑛𝑔𝑒 𝑟𝑎𝑡𝑖𝑜 = < = 1+ = 1+
𝑁 𝑁 𝑃 𝑃 𝑁 𝑃 𝑃 𝑇
Merger Arbitrage: A tender offer is no guarantee that the takeover will take at this price. Even if the acquirer offers a
premium, the board or regulators may not approve. This uncertainty means the market price generally does not rise
by the amount of the premium when the takeover is announced. The uncertainty creates opportunity for risk
arbitrageurs to speculate on the outcome of the deal. It is not true arbitrage as there is risk the deal will not go
through. The difference between the target’s stock price and the implied offer price is the merger-arbitrage spread.
Tax and Accounting Issues: The method used to pay for the acquired firm has implications. Cash triggers an
immediate tax liability for target shareholders. With stock swaps, the tax is deferred.
16.3.2 Takeover Process

Board and Shareholder Approval: For a merger to proceed, both the target and the acquiring board must approve
the merger and put the question to a vote of the shareholders of the target.
● Friendly takeovers: Target board supports the merger and negotiates with the acquirers
● Hostile takeovers: Target board opposes the merger (the board should act in its shareholders’ interest). The
acquirer must garner enough shares to take control and replace the board
The board may reject if (1) they legitimately believe the offer price is too low, (2) if the offer is a stock-swap the
target management may believe the acquirer’s share are overvalued, or (3) they are acting in their own self-interest –
especially if the motivation for the takeover is efficiency gains.
16.4 Takeover Defences

In a hostile takeover, the acquirer must appeal directly to target shareholders with a tender offer usually coupled with a
proxy fight, where the acquirer attempts to convince target shareholders to unseat the target board using their proxy
votes. Target companies can defend against a hostile takeover by…
Poison Pill: A rights offering giving existing target shareholders the right to buy shares in the target at a deeply
discounted price once certain conditions are met. Because target shareholders can purchase shares at less than market
price, it dilutes the value of any shares held by the acquirer.
By adopting a poison pill, a firm entrenches its management by making it much more difficult for shareholders to
replace bad managers. A firm’s stock price typically drops using this strategy.
A poison pill increases the cost of a takeover (for the acquirer), so a target company must be in worse shape to justify
the expense of waging a takeover battle. The equilibrium price after poison pill is
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𝑇𝑒𝑛𝑑𝑒𝑟 𝑜𝑓𝑓𝑒𝑟 + 𝑃𝑜𝑖𝑠𝑜𝑛 𝑝𝑖𝑙𝑙 𝑝𝑟𝑖𝑐𝑒

𝐸𝑞𝑢𝑖𝑙𝑖𝑏𝑟𝑖𝑢𝑚 𝑝𝑟𝑖𝑐𝑒 =
2
Staggered Boards: Prevents a bidder from acquiring control over the board in a short period of time. This means that
only one third of board members are up for election each year. Thus, if a bidder’s candidates win board sets, they only
control a minority of the board.
White Knights: When a hostile takeover appears inevitable, a target company will sometimes look for a friendly
bidder to acquire it (a white knight),
Golden Parachutes: These are lucrative severance packages to senior management as an incentive to not work
against a takeover. These lessens the likelihood of management entrenchment.
Recapitalisation: Changing the capital structure of the firm to make themselves a less attractive target by e.g.
reducing unused debt capacity or paying out cash in a dividend.
Other Defensive Strategies: Super majority among existing shareholders needed for merger approval
16.5 Who Gets the Value Added from a Takeover?

The premium the acquirer pays is approximately the value the merger adds, which means that target shareholders
ultimately capture the value added by the acquirer.
The Free Rider Problem: When a bidder makes a tender offer, the target shareholders can benefit by keeping their
shares and letting other shareholders sell at a low price (because the merger creates synergies and increase value).
However, all shareholders have the incentive to keep their shares, so no one will sell unless they also get a share of the
benefits. So, there are no benefits left for the acquirer.
Toeholds: Acquirers can try to secretly buy up a toehold on the market before declaring their intension to mitigate the
free rider problem. Typically 10% of the shares can be acquired this way.
The Leveraged Buyout: Borrowing money to buy the shares through a shell corporation by pledging the shares
themselves as collateral on the loan. If takeover is successful, the shell can be merged with the target, so the loan will
be serviced by the target, and the acquirer effectively never pays for them.
𝐷𝑒𝑏𝑡 𝑛𝑒𝑒𝑑𝑒𝑑 = 𝑀𝑎𝑗𝑜𝑟𝑖𝑡𝑦 𝑠ℎ𝑎𝑟𝑒 𝑛𝑒𝑒𝑑𝑒𝑑 × # 𝑠ℎ𝑎𝑟𝑒𝑠 𝑜𝑓 𝑡𝑎𝑟𝑔𝑒𝑡 × 𝑂𝑓𝑓𝑒𝑟 𝑝𝑟𝑖𝑐𝑒
𝐸 = 𝑀𝑎𝑟𝑘𝑒𝑡 𝑐𝑎𝑝 − 𝐷 + 𝑆𝑦𝑛𝑒𝑟𝑔𝑖𝑒𝑠
𝐸
𝑆ℎ𝑎𝑟𝑒𝑠 𝑡𝑜 𝑟𝑒𝑡𝑎𝑖𝑛 =
𝑃
The number of shares needed to retain to reach the equilibrium price – the price at which shareholders are indifferent
between tendering and not tendering their shares is seen above.
The Freezeout Merger: The acquiring company can freeze existing shareholder out of the gains from merging by
forcing non-tendering shareholders to sell their shares for the offer price.
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4) FORMULAS FROM SLIDES
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5) DERIVATION WACC
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Interest tax shield
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CFIVO1002U.

LA_E22 Corporate Finance Autumn 2022

6.2 Optimal Dividend Policy With Taxes ........................................................................................................ 24

7.1 The Weighted Average Cost of Capital (WACC) Method ........................................................................ 27

7.3 The Flow-to-Equity (FTE) Method ........................................................................................................... 28

9.2 Put-Call Parity ........................................................................................................................................... 32

9.4 Exercising Options Early ........................................................................................................................... 34

14.3 Reasons for Leasing .............................................................................................................................. 51

15 Short-Term Financing .................................................................................................................. 53

15.2 Short-Term Financial Planning ............................................................................................................. 54

16.4 Takeover Defences ................................................................................................................................ 59

1 BRUSH-UP AND INTRODUCTION

1.1 Chapter 1: Corporations

● Thus, shareholders in a C corporation effectively pay tax twice.

1.2 Chapter 2: Financial Statement Analysis

𝐴𝑠𝑠𝑒𝑡𝑠 = 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 + 𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠′ 𝑒𝑞𝑢𝑖𝑡𝑦 = 𝐸𝑉 + 𝐶𝑎𝑠ℎ

𝐸𝑛𝑡𝑒𝑟𝑝𝑟𝑖𝑠𝑒 𝑣𝑎𝑙𝑢𝑒 = 𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 + 𝐷𝑒𝑏𝑡 − 𝐶𝑎𝑠ℎ

𝐸𝐵𝐼𝑇𝐷𝐴 = 𝐸𝐵𝐼𝑇 + 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑎𝑛𝑑 𝑎𝑚𝑜𝑟𝑡𝑖𝑠𝑎𝑡𝑖𝑜𝑛

𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 𝑆𝑎𝑙𝑒𝑠 𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠

1.3 Chapter 3: Financial Decision Making

1.4 Chapter 4: Discounting

The future value of an annuity at the end of the annuity is

1.5 Chapter 5: Interest Rates

1.6 Chapter 6: Valuing Bonds

𝐶𝑃𝑁 𝐶𝑃𝑁 𝐶𝑃𝑁 + 𝐹𝑉

1.7 Chapter 7: Investment Decision Rules

Other criterions for evaluating projects are…

In friction-less markets, positive NPV projects should always be initiated.

1.8 Chapter 8: Fundamental of Capital Budgeting

𝐹𝐶𝐹 = (𝑅𝑒𝑣𝑒𝑛𝑢𝑒 − 𝐶𝑜𝑠𝑡 − 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛) × (1 − 𝜏 ) + 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 − 𝐶𝑎𝑝𝐸𝑥 − 𝛥𝑁𝑊𝐶

𝐹𝐶𝐹 = 𝐸𝐵𝐼𝑇 × (1 − 𝜏 ) + 𝐷𝑒𝑝 − 𝐶𝑎𝑝𝑒𝑥 − 𝛥𝑁𝑊𝐶

1.9 Chapter 9: Valuing Stocks

𝑃𝑉(𝐹𝑢𝑡𝑢𝑟𝑒 𝑡𝑜𝑡𝑎𝑙 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 𝑎𝑛𝑑 𝑟𝑒𝑝𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑠)

1.10 Chapter 10: Capital Markets and the Pricing of Risk

2 CAPM AND COST OF CAPITAL

2.1 Chapter 11: CAPM and Optimal Portfolio Choice

Calculating correlation through Variance:

𝑃𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝐸𝑥𝑐𝑒𝑠𝑠 𝑅𝑒𝑡𝑢𝑟𝑛 𝐸 𝑅 − 𝑟

The Capital Asset Pricing Model (CAPM): Three main assumptions:

𝐸[𝑅 ] = 𝑟 = 𝑟 + 𝛽 𝐸[𝑅 ]−𝑟

𝑆𝐷(𝑅 ) × 𝐶𝑜𝑟𝑟(𝑅 , 𝑅 ) 𝐶𝑜𝑣(𝑅 , 𝑅 ) 𝑟 −𝑟

2.2 Chapter 12: Estimating Cost of Capital

The beta of a project is the unlevered (asset) beta of a comparable firm

3 CAPITAL STRUCTURE IN PERFECT CAPTIAL MARKET

Berk & DeMarzo (2017): Chapter 14 + Session II

3.1 Equity Versus Debt Financing

3.2 Modigliani-Miller I: Leverage, Arbitrage, and Firm Value

𝑀𝑉 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 = 𝑀𝑉 𝑜𝑓 𝑎𝑠𝑠𝑒𝑡𝑠 − 𝑀𝑉 𝑜𝑓 𝑑𝑒𝑏𝑡 𝑎𝑛𝑑 𝑜𝑡ℎ𝑒𝑟 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

3.3 Modigliani-Miller II: Leverage, Risk, and the Cost of Capital

If the debt is risk-free, then

3.4 Capital Structure Fallacies

4 DEBT AND TAXES

4.1 Valuing the Interest Tax Shield

𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑡𝑎𝑥 𝑠ℎ𝑖𝑒𝑙𝑑 = 𝜏 × 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠 = 𝜏 × 𝐷 × 𝑟

(𝐶𝑎𝑠ℎ 𝑓𝑙𝑜𝑤𝑠 𝑡𝑜 𝑖𝑛𝑣𝑒𝑠𝑡𝑜𝑟𝑠 𝑤𝑖𝑡ℎ 𝑙𝑒𝑣𝑒𝑟𝑎𝑔𝑒 )

𝑉 = 𝑉 + 𝑃𝑉(𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑡𝑎𝑥 𝑠ℎ𝑖𝑒𝑙𝑑)

𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑑𝑒𝑏𝑡 = 𝐷 = 𝑃𝑉(𝐹𝑢𝑡𝑢𝑟𝑒 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠)

= 𝜏 × 𝑃𝑉(𝐹𝑢𝑡𝑢𝑟𝑒 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠) = 𝜏 × 𝐷

4.2 Recapitalising to Capture the Tax Shield

4.3 Personal Taxes

4.4 Optimal Capital Structure with Taxes

𝜏 ∗ − 𝑡ℎ𝑒 𝑒𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝑡𝑎𝑥 𝑎𝑑𝑣𝑎𝑛𝑡𝑎𝑔𝑒 𝑜𝑛 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑖𝑛 𝑒𝑥𝑐𝑒𝑠𝑠 𝑜𝑓 𝐸𝐵𝐼𝑇

𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 = 𝑟 × 𝐷𝑒𝑏𝑡 ≤ 𝐸𝐵𝐼𝑇 or 𝐷𝑒𝑏𝑡 ≤ 𝐸𝐵𝐼𝑇 | 𝑟

5.1 Default and Bankruptcy in a Perfect Market