Introduction to

Corporate Finance
Dr. Dustin R. Schütte

MSc. Finance 2020-2021 1

0.
Introduction to CF –
Setting the scene

2
Who will accompany you through this course?

Dr. Dustin R. Schütte

Education
• Bachelor and Master in Business Administration from Mannheim University
• Master in International Management from Macquarie University
• PhD in Finance from St. Gallen University with Visiting Scholarships at
• New York University: Stern School of Business
• Harvard University: Graduate School for Arts and Sciences
• Research area: Corporate Financial Aspects of the Financial Crisis

Profession
• Corporate Consultancy in Financial Services
• Specializing in Financial Services: Treasury Management
• Liquidity Management
• Funding Management
• Capital Management

3
What are the “house rules”?

ESADE’s Honour Code

• No: Lying, cheating, stealing etc.

• Most important: Respect Each Other

• True Leadership is lived through helping & supporting others

− → be a Leader and support your colleagues

• There are no stupid questions in this course.

− → if you haven’t fully understood a topic: Ask!
− → want to look outside of the box? Ask!
− → you have experience in this topic? Sharing is caring!

4
Learning mechanisms

Questions + Answers + Application

• Questions – Always be aware of the “so what?” regarding the topic that is
being discussed

• Theory – we need to know our theory in order to ask the right questions

• Application – practice makes perfect. Exercises and cases serve to

substantiate theory and apply what we have learned. Also serve as a basis to
“ask questions”.

5
Where, within the realm of Finance, are we, when
speaking about Corporate Finance?

Setting the scene: The Key Questions of Corporate Finance

Finance

Financial Markets / Alternative

Banking Corporate Finance
Investments Investments / others

• How do banks work?
• How do banks generate their
income?
• What's the role of banks
within the financial system?
• What is maturity
transformation? Why is it
important for the economy?
• Why are banks risky?
• How are banks regulated?
• What is the difference
between banks and central
banks?
• Etc.
• What are the most important
players in the financial
system?
• What are the mechanics of
financial markets? (e.g.
trading rules)
• How do investments work?
What kind of investment
alternatives do markets
offer? What kind of securities
/ assets are there?
• How are assets priced
(“Asset Pricing”)?
• Etc.
• Valuation: How do we
distinguish between good
investment projects and bad
ones?
• Financing: How should we
finance the investment
projects we choose to
undertake?
• Information: What are the
key information bases that
we need to look at a firm
from a corporate financial
perspective?
• Analysis: What is the
interplay of balance sheet,
cash (flows), P/L?
• What is and how does it
work?
− Hedge Funds
− Private Equity
− Venture Capital / Start-up
financing
− Bad debt restructuring
− Etc.
• What do market participants
behave in the market?
• What is behavioural finance?
(Psychology meets finance)

Focus
6
What are we going to look at in this course? # Sessions

Corporate Finance
Time value Capital
1 of money
2 3
Corporate Finance
structure
Valuation 4 IPOs

• What is the time value of • What are equity and debt? • How does capital structure • What is an IPO?
money? What is the value of a • How do these instruments affect valuation? • What are the benefits and costs
Offline

project? What is the value of a differentiate? • What is the FCFF concept? of IPOs?
firm? • Deep Dive: what are the costs • How to assess the • Do IPOs leave money on the
• What is NPV, IRR, Payback and benefits of debt? corresponding discount factor? table?
method? … • What is the agency problem?
What are corresponding costs?
• What are “perfect capital
• Exercises on the time value of markets”? • Exercises on Capital Structure • Exercises Valuation of cash
− Using the MM theorem
Online

money • How do the concepts of Equity / flows and firms

− NPV calculations Debt behave in perf cap − Calculating FCFF − Using FCFF for valuations
− IRR markets? What is the Modigliani − Tax shield calculations − GGM
− Payback Miller theorem?

Treasury Case: Group Presentations

5 Pay-out Policy 6 management
7 Extensive Case Study
8/9 + Guest Speaker

• How are funds being returned • What is a (Corporate) • Extensive case study covering • Group presentations on
to investors? Treasury? multiple areas of Corporate selected firms
Offline

• What is the impact of taxes and • The corporate side of banking Finance • Guest speaker on selected
asymmetric information on pay- • Regulatory boundaries of topic
out policies? capital structures (Snapshot of • Wrap Up
banking)

• Case on IPOs • Case on cash and payout policy • Revisiting Corporate Finance:
Online

Behavioural Corporate Finance

Theory Session Practice Session

7
 What are the key buildings blocks along
the way of evaluating a firm?

Discussion of valuation
3 concepts and ingredients

Adding the • FCFF

corporate • The concept of risk
• Risk free rates
context
• Capital Asset Pricing Model
2 Capital Structure • Factor Models (Fama-French)

• Concepts, differentiation,
costs and benefits of equity
and debt
• Agency theory
1 Basics • Asymmetric information
theory Application to
• Time value of money valuation
• Mechanics of discounting context
• Simple interest versus
compound interest
• Net present value calculations
• IRR and payback method

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CONTENTS

1. The time value of money

2. Adding the the business context: project evaluation
3. Alternative methods to project evaluation: Payback and IRR

9
1.
The Time Value of Money

10
What is the principle underlying the valuation of any asset?

Intertemporal consumption shifts are costly

• General principle: intertemporal consumption shifts are costly

− Giving up a meal today will require a reward → reflected in a
higher consumption volume tomorrow
− Having a bigger meal today will come at a cost → reflected in
less consumption potential tomorrow

• Impact factors that affect the price of intertemporal consumption

shifts:
− Individual utility functions (in terms of meals: “how hungry are
you?”)

11
What is the difference between the value of money today
and the value of money in the future?

Time value of money is priced as interested rates

• If consumption potential is measured in monetary units, this automatically

implies: 1 Euro today is worth more than 1 Euro tomorrow = The “time
value” of money

• In monetary terms, consumption shifts are exchanged into cash flow shifts:
The price of giving up cash flows today for a cash flow tomorrow is the
interest rate

• Impact factors that affect the price of intertemporal cash flow shifts:
− Inflation risk
− Default risk
− Opportunity costs (e.g. giving up alternative investment opportunities)

12
What is the difference between the value of today
and the value in the future? The interest rate!

Interest rates allow for intertemporal connection of cashflows

• If you require an annual interest rate of 8% on a 1-year

deposit of 100 euros, this implies that:

• You are indifferent between holding €100 today and the bank’s
“promise” to pay you €108 in one year
• The banks’ “promise” to pay you €108 in one year has the same value
as holding €100 today
• €100 euros is the present value of a promise to pay €108 in one year
• The €108 promised payment is the future value in one year’s time of
€100 today

13
 Reality
What is the LIBOR Scandal?
Check

What is the LIBOR Scandal?

• What is the
LIBOR Scandal
and why was this
so relevant to the
global economy?

Source: theguardian.com

14
 What is the difference between simple and
compound(ed) interest rate?

Simple and compound interest. Equivalent interest rates

• Assume we invest our savings in a bank deposit according to the following

conditions:
− Starting date t=0
− End date t=N
− N time units (days, months, quarters, years).
− C capital invested at t=0
− I total interest
− i agreed interest rate (we assume no change during the period of reference).

• The interest rate depends on whether you have:

− Simple interest: interest payments will be received at the end of each
period (and can be used freely). Interest earned only on the original C.
− Compound interest: interests will be received at the end of the
operation. Interest earned on interest and the original C.
15
How does simple interest work?

Simple and compound interest. Equivalent interest rates

Simple interest : t Capital Interests earned

• At the beginning of each period invested at and paid out
the beginning during t
we always have C invested.
of t
• iC is the interest that 1 C iC
corresponds to each period.
2 C iC
• Total interest during the 3 C iC
operation: I=niC
…
• Total amount obtained after N N C iC
periods: C+I=C+niC=C(1+in)

16
How does compound interest work?

Simple and compound interest. Equivalent interest rates

Compound interest:
• Total investment grows at the end t Capital
invested at
Interests earned
during t
of each period since interests are the
accumulated. beginning of
• Interest rate applies to the t
principal + interests received so 1 C iC
far 2 C(1+i) iC(1+i)
• Total amount to be received by the 3 C(1+i)2 iC(1+i)2
investor is C(1+i)N
• Total interests generated during the
…
N C(1+i)N-1 iC(1+i)N-1
lifetime of the loan is C(1+i)N -C

17
What is discounting?

Present and Future Values

• Compound interest allows us to establish a very simple

correspondence between present and future values

• V0 today is equivalent to (1+i)NV0 in N periods →

establishes a direct intertemporal connection between a
value in the present and a value in the future

• Discounting (bringing a future value into present): V0 is

the present value of (1+i)NV0 received in N periods

• Compounding (bring a present value into the future):

(1+i)NV0 is the future value in N periods equivalent to
investing V0 today.
18
What is discounting?

Present and Future Values

Example: Calculate compound and
Looking from the present into the discount factors for 1, 2, 3, 4 and 5 years
future: with interest rates of 1%, 2%, 3%, 4% and
• (1+i)N is the compound factor 5% respectively.
• It is the future value in N periods of PERIOD (YEAR)
investing €1 today INTEREST 1 2 3 4 5
compound factors
1% 1.010 1.020 1.030 1.041 1.051
Looking from the future into the past: 2% 1.020 1.040 1.061 1.082 1.104

• (1+i)-N is the discount factor 3%

4%
1.030
1.040
1.061
1.082
1.093
1.125
1.126
1.170
1.159
1.217
• It is the present value of an investment 5% 1.050 1.103 1.158 1.216 1.276
that produces €1 in N periods discount factors
1% 0.990 0.980 0.971 0.961 0.951
2% 0.980 0.961 0.942 0.924 0.906
• i is also known as the discount rate 3% 0.971 0.943 0.915 0.888 0.863
4% 0.962 0.925 0.889 0.855 0.822
5% 0.952 0.907 0.864 0.823 0.784
• Obviously, time value of money (i>0)
implies that: (1+i)-N <1< (1+i)N
19
2.
Adding the business
context: Project valuation

20
How do we value a project?

Introduction to Valuation

• Companies create wealth when investing in real assets

− Real or Productive Assets: assets that generate cash in the future and,
as opposed to financial investments, like stocks and bonds, are not
traded in the financial markets

• Corporate decision making focus on investment decisions in real assets

(location, machinery, hiring, advertising, etc)

• Financial managers spend most of their time analysing and selecting the
main corporate investment projects, whose future payments are uncertain
and whose strategical impact is crucial (e.g. whether to open or not a new
production plant)

• How does the finance director know if an investment project will create
value? 21
What is a Net Present Value? How does it help to
value a project?

Introduction to Valuation

• Net Present Value (NPV)

− Measures the monetary flows that a project will generate in the future,
calculates its present value (PV)
− Compares it with the costs needed to implement the project (NPV)

• Those with a positive NPV should be implemented since they create

wealth (future flows are higher than the costs)

• NPV theory appears to be simple, but some difficulties arise:

− Estimate future cash-flows (we assume we know them)
− Estimate the discount factor for each cash-flow
o The appropriate discount factor for each expected flow is the return
offered by the best alternative investment with similar risk

22
How do we discount cashflows to create an NPV?

NPV of an investment project – General formula

• The Present Value (PV) of an investment project is the present value of the
net incremental cash-flows of the project.

CF1 CF2 CF3 CFN

PV = + + + ... +
(1 + i1 ) (1 + i2 ) 2 (1 + i3 ) 3 (1 + iN ) N

• The Net Present Value (NPV) of an investment project is the difference

between the Present Value and the initial costs to implement the project.

CF1 CF2 CF3 CFN

NPV = CF0 + + + + ... +
(1 + i1 ) (1 + i2 ) 2 (1 + i3 ) 3 (1 + iN ) N

23
How can NPVs be used to help in business decision
making?
Exercise

NPV of an Investment project – An example

Example: An investment bank, is currently suffering from slowdown in sales and temporary
overstaffing
− The bank could reduce personnel expenses by €600,000/year for the next three
years if 25 employees are made redundant
− However, the market is expected to recover in 4 years and these 25 employees
need to be re-hired. Hiring and training costs for these employees are estimated
to be €100,000/employee
− If the discount rate is 10%, should the company maintain or reduce its workforce?

24
How are present values calculated for non-ending
payments?

In case of perpetual cash flows, the formula converges

• If the cash flows remain constant (CF1 = CF2 = CFN), we apply a flat yield
curve (i1 = i2 = iN), and payments are made infinitely (N→), the formula
converges to:

𝐶𝐹1 𝐶𝐹2 𝐶𝐹3 𝐶𝐹𝑁 𝐶𝐹

𝑃𝑉 = + +
(1 + 𝑖1 ) (1 + 𝑖2 )2 (1 + 𝑖3 )3
+. . . +
(1 + 𝑖𝑁 )𝑁
𝑃𝑉 =
𝑖

• If the cash flows are growing at a constant rate g, then a simplified

calculation is still possible
𝐶𝐹 ∗ (1 + 𝑔)
𝐶𝐹 ∗ (1 + 𝑔) 𝐶𝐹 ∗ 1 + 𝑔 2
𝐶𝐹 ∗ 1 + 𝑔 𝑁−1 𝑃𝑉 =
𝑃𝑉 = + +. . . + 𝑖−𝑔
(1 + 𝑖1 ) (1 + 𝑖2 )2 (1 + 𝑖𝑁 )𝑁

25
 How can the infinite CF formula be used to calculate
growing annuities?

Growing annuities can be calculated as differences of infinite annuities

t=0 t=1 t=2 t=3 t=4 t=5 … t=N

𝐶𝐹 ∗ (1 + 𝑔) CF*(1+g) CF*(1+g)2 CF*(1+g)3 CF*(1+g)4 CF*(1+g)5 … CF*(1+g)N

𝑃𝑉 =
𝑖−𝑔

CF*(1+g) CF*(1+g)2 CF*(1+g)3 CF*(1+g)4

𝐶𝐹 ∗ (1 + 𝑔) 4
𝐶𝐹 ∗ (1 + 𝑔) 1 + 𝑔
𝑃𝑉𝐺𝐴 = 𝑖−𝑔 − / 1+𝑖 4
𝑖−𝑔

4
𝐶𝐹 1 + 𝑔 1+𝑔
𝑃𝑉𝐺𝐴 = ∗ 1− 4
𝑖−𝑔 1+𝑖

𝐶𝐹 1 + 𝑔 1+𝑔 𝑛 Generalized formula, with n as

𝑃𝑉𝐺𝐴 = ∗ 1−
𝑖−𝑔 1+𝑖 𝑛 number of growing annuities
26
How to interpret NPV?

A positive NPV adds value to the firm

• How do we interpret NPV=0?

− The PV of the future cash flows is equal to the initial costs (“break-even”)
− The expected return on the project compensates for its level of risk
− We are indifferent between conducting the project or not

• How do we interpret NPV>0?

− The PV of the future cash flows is higher than the initial costs
− The expected return on the project is above the minimum required for the level
of risk it generates
− In colloquial terms, we can say that this investment makes us “richer” or
increases the value of the company

• How do we interpret NPV<0?

− The PV of the future cash flows is lower than the initial costs
− The expected return on the project is below the minimum required for
assuming such a risk
− We can say that this investment reduces our wealth or the overall value of the
company → should not invest 27
What are the properties of NPVs?

State of the art fin. modelling still uses principles of NPV calculations

• NPVs are additive

− NPVs of different projects can be added → allows to use for firm valuation
− Value of a firm is PV of all current projects plus the NPV of all future projects
• NPV calculations are flexible
− Management can build in all available project information into CF projections
− Allow for expected term structure and interest rate shifts
− Risk characteristics of projects may change
− Possible regime switches in interest rate environment (e.g. financial
crisis)
− Financing mix for the project may change, resulting in direct changes of
the discount factor

• Possible limitations of NPV method

− NPV = absolute number → Ratio of NPV / initial investment is ignored
− NPV acceptation rule does not control for the lifetime of the project BUT higher
lifetime can mean more risk
28
 Reality
Do markets evaluate NPVs differently?
Check

Markets update firm value based on new investment projects (NPVs)

• Tesla is holding a press conference about a new battery

project

• Investment decisions are made → NPV of corresponding is

assumed to be positive

• Positive NPVs add to the corporate value

• Yet, firm value decreases after press conference → Why?

29
3.
Alternative methods to
project evaluation: Payback
and IRR

30
Are there other methods than NPVs in order to
evaluate / compare projects?

Payback method and IRR

• The NPV is used by many companies, however other techniques to

evaluate investment projects are also used in order to have a more
complete picture

• These techniques do not generate better results; they are simply

different and need to be interpreted

• Example of other techniques:

− Payback method
− IRR (Internal Rate of Return)

31
What is the Payback method?

Payback exclusively concentrates on the breakeven period

• The Payback period is the number of years needed to recover the initial
investment (i.e. years needed to break even)

• The objective is to accept projects with a payback period < K years

• Weaknesses of this method:

− Time value of money is not taken into account
− Cashflows that take place after K are ignored (penalizing long term
projects)

t=0 t=1 t=2 t=3 t=4 Payback NPV (10%)

Project A -2,0 2,30 0,00 0,00 0,00 1 0,09
Project B -2,0 1,25 1,25 1,25 1,25 2 1,96
Project C -2,0 0,75 1,25 1,50 1,75 2 2,04

• Often implicitly applied in real estate when using annual rent multiples
32
What is the Payback method?

Payback exclusively concentrates on the breakeven period

• An “improved” payback method considers discounted cash flows

• In this case, time value of money before K is taken into account (however
whatever happens after K is still ignored)

t=0 t=1 t=2 t=3 t=4 Payback NPV (10%)

Project A -2,0 2,30 0,00 0,00 0,00 1 0,09
Project B -2,0 1,25 1,25 1,25 1,25 2 1,96
Project C -2,0 0,75 1,25 1,50 1,75 2 2,04
Discounted
Cash Flows

t=0 t=1 t=2 t=3 t=4 Payback (d) NPV (10%)

Project A -2,0 2,1 0,0 0,0 0,0 1 0,09
Project B -2,0 1,1 1,0 0,9 0,9 2 1,96
Project C -2,0 0,7 1,0 1,1 1,2 3 2,04

33
Why is the Payback method used?

Easy calculation & communication; limited horizon

• Easy to understand (do not underestimate the value of easy

communication)
• Usually used as complementary method (e.g. accept projects with certain
return on capital AND payback horizon below x years)
• Uncertainty makes it difficult to estimate distant cash flows, particularly
in changing and highly inflationary environments; hence ignoring cash
flows beyond K can make sense
− Note: this argument is remediated somewhat by higher discounting of
cash flows in the far future within discounted payback method
• As long as there are capital restrictions, additional cash flows need to be
generated very quickly, for the firm to be able to start new projects. Hence:
Deadlines (K) matter.
• It is attractive to managers that are assessed based on short term results
34
What is the Internal Rate of Return method?

The Internal Rate of Return sets the NPV to 0

• The NPV of a project is the function of a discount rate (d).

CF1 CF2 CF3 CFN
NPV ( d ) = CF0 + + + + ... +
(1 + d ) (1 + d ) 2 (1 + d ) 3 (1 + d ) N
• The Internal Rate of Return of a project (IRR) is the discount rate that makes
the NPV = 0, i.e.:
𝐶𝐹1 𝐶𝐹2 𝐶𝐹3 𝐶𝐹𝑁
0 = 𝐶𝐹0 + + + +. . . +
(1 + 𝐼𝑅𝑅) (1 + 𝐼𝑅𝑅)2 (1 + 𝐼𝑅𝑅)3 (1 + 𝐼𝑅𝑅)𝑁

BUT:
• There can be more than one IRR
• No simple pen & paper calculation method: As soon as the project lasts for
more than two periods, we need to use a trial and error method or a
financial calculator to find the IRR 35
What is the Internal Rate of Return method?

IRRs bigger than the hurdle rate hint towards prosperous projects

• The IRR method implies a comparison between the IRR of a specific project
and a reference/hurdle rate: the return obtained in alternative investment
with a similar risk level

• If IRR > reference rate → accept the project. It implies that the return of the
project is above the alternative investment with similar risk

• Observations about the IRR:

• In many cases, NPV and IRR lead to the same conclusions. But this is not
always the case
• Computing the NPV is easy and it always leads to the correct result.
However, the IRR summarizes the results in one single figure and this is
attractive to managers (do not underestimate the value of easy
communication)

36
 How to solve for the IRR using Excel

Longer period IRR can easily be solved using Excel

• Assume the following CF stream

• t = 0 → -5000$
• t = 1 → +1000$
• t = 2 → +2000$
• t = 3 → +3000$
• t = 4 → +4000$

• Using Excel: what is the IRR for this project?

37
What is a potential short coming of IRR?

Projects can have multiple IRRs → then method cannot be applied

• Assume following project cash flows

500,000 500,000 500,000 1,000,000

𝑁𝑃𝑉 = 550,000 − − 2
− +
1 + 𝑟 (1 + 𝑟) (1 + 𝑟)3 (1 + 𝑟)4

By setting the NPV equal to zero

and solving for r, we find the IRR.
In this case, there are two IRRs:
7.164% and 33.673%. Because
there is more than one IRR, the
IRR rule cannot be applied

38