Corporate Finance
Professor Siegel
Fall 1995
1.Problems with net present valuation
a.Uncertainties in future cash flows
b.Opportunity costs in making investment decisions
2.Risk -> expected variability in future payments
3.Cash flow (prospective) vs. net income (retrospective)
a.Objectivity
i.Cash flow is an objective value
ii.Net income includes non-cash charges, and can vary depending on the accounting rules used to
value those charges (LIFO vs. FIFO, useful life for depreciation, etc)
b.In the long run, change in cash flow = change in net income
i.Income statement does not have info concerning the actual amounts or timings of the cash flows
ii.But it shows how cash was used, and can be useful to predict future cash flows
4.Methods of valuating companies
a.NI, EPS and P/E ratios (retrospective)
b.Cash flows and NPV (prospective)
5.Problems with EPS and P/E ratios
a.Calculating the # of shares outstanding is difficult (ex., how do you treat convertible bonds)
b.P/E ratio is "like dividing apples by oranges"
i.Numerator is current closing price
ii.Denominator is last published EPS
6.Four types of investment decision-making methods/rules
a.Payback method
i.Straight payback
ii.Discounted payback
b.Return on equity
c.Internal rate of return
d.Net present value
e.[Generally, NPV is best method and can be used as sole measure to choose between
investments, but other tests provide useful additional information]
7.Payback method
a.Payback is simply the amount of time it takes for you to receive your initial investment back
b.Problems:
i.Straight payback doesn't take the time value of money into account
ii.Discounted payback addresses this problem and is just like NPV, but:
(1)It still ignores cash flows after the payback period
(2)So payback and NPV may give different results for investments that are backloaded
c.Benefits
i.Payback is very useful when the investor faces a liquidity constraint
(1)Keeps cash available for emergencies
(2)Money can be continually put to its best use
ii.So payback is best used as a hurdle or filter in conjunction with another rule (such as NPV)
8.Return on equity (generally sucks)
a.Problems with using average projected net income
i.Projecting net income forward is just as difficult as predicting cash flow
ii.Averaging the net incomes together fails to take account of time value of money
b.Problems with using book value
i.Book value is based on historic values and is not adjusted to take account of current costs
ii.But a simple fix would be to use aggregate value of company's stock
9.Problems with using internal rate of return
a.It doesn't take account of differing levels of project risk (treats all projects the same)
b.It will have more than a single value, especially where cash flows very between payments and
disbursements
c.IRR doesn't give a quantitative basis for evaluation (doesn't tell you "value additivity")
d.IRR makes erroneous assumptions about reinvestment rates
i.IRR doesn't take into account the alternative market rate available
ii.You'd want to lock in a higher than market interest rate for longer
iii.IRR doesn't deal with this
10.Net present value test
a.Benefits
i.NPV not only tells you whether to take a project, but also how valuable it is to take it
b.Problems with NPV
i.You need to know the proper risk-adjusted interest rate to use
11.Profitability index (differences in scale)
a.NPV/-C0
b.The higher the index the better
c.No value additivity is calculated and you might get results different from NPV rule
d.This tells you have much "bang" you get per "buck"
12.Calculating cash flows
a.Usual practice is to only project cash flows for a ten year period
b.At the ten year mark, you make an estimate of the company's going-concern value based on net
income
c.Cash flow components (exclude non-cash items such as depreciation and allocations for
overhead)
i.Sales
ii.Cost of labor
iii.Working capital
iv.Taxes
v.Capital expenditures
13.Term structure of interest rates ( /~~ ) is caused by:
a.Liquidity risk (or transactions cost to liquidate) for longer investments
b.Expectation of future inflation and uncertainty related to inflation
c.When market expects inflation to drop, the term structure shifts ( \... )
14.From least to most risky:
a.T-Bills
b.Gov't bonds
c.Corp bonds
d.Common stock
15.Components of risk
a.Systemic (i.e. macroeconomic risk)
b.Idiosyncratic
c.[You can generally know out most idiosyncratic risk with 5 investments]
16.Components of CAPM
a.Market risk premium is a generally stable number (rf and rm move together)
b.Beta
i.Defined as the level of a security's riskiness relative to the riskiness of the market portfolio
ii.Beta of a given investment tends to remain constant over time
iii.Betas change when the investments of the underlying company changes
17.CAPM generally
a.Re = Rf + ß(Rm-Rf)
b.Rf
i.Risk free rate which translates into X-axis
ii.Usually the 90 T-bill rate is used
c.ß: position along the capital market line
d.(Rm-Rf): risk premium is the slope of the line
e.Stock should be based not on its idiosyncratic risk, but its risk in-portfolio
18.Analysis of CAPM
a.Benefits
i.It's a simple model
ii.Data necessary for the model is easy to obtain
iii.Studies show that CAPM holds over a normal range
b.Criticisms
i.Makes a false assumption that you can lend and borrow at the risk-free rate
ii.There are variations in the risk-free rates (3 month T-bills vs. 5 year bill); which do you use?
19.Fama/French criticisms of CAPM
a.Beta in isolation does not account for all the variability between returns among different
securities
b.The argument is that size of the company is a better indicator
i.Big companies have low Bs and low returns
ii.Small companies have high Bs and high returns
iii.[So we are really using B as a surrogate for size]
c.If you isolate size from B
i.Strong negative correlation between size and return
ii.No correlation between B and return
d.Two ways to measure size
i.Market capitalization (SH price x # of shares) + (Bond price x # bonds)
ii.Ratio of book equity to market equity (even stronger relationship)
(1)Increase in ratio increases expected return
(2)High ratio indicates start-up or small company
(3)Low ratio indicates mature or big company
e.Problems using size
i.B remains stable over time; size does not
ii.B will give you expected return in absence of a market; you need market to evaluate size
(market equity figure)
iii.Book equity is a non-objective number and can be manipulated using different accounting
conventions
20.How do you get beta?
a.Company history (B will be stable over time)
b.Use beta of comparable companies that are publicly traded
21.Arbitrage Pricing theory
a.APT methodology
i.Identify list of macroeconomic factors
(1)Inflation
(2)Exchange rate of foreign currency
ii.Measure expected risk premium on each factor
iii.Measure sensitivity of each stock to these factors
b.Generally
i.APT allows you to beat the market, but at great cost
ii.EMH -> the average investor can't do better than the market
22.Beta and capital structure
a.The entire firm beta gives rise to the WACC
i.WACC = return on firm assets
ii.Changing the firm capital structure doesn't change WACC; it only changes who is entitled to
the return, not what the return is
iii.WACC only changes by varying the firm's underlying investments
b.Stock and debt beta will vary with firm capital structure
i.When you increase debt, both stock and debt beta will increase
ii.When you decrease debt, both stock and debt beta will decrease
c.Company bonds will have betas close to zero
23.Sensitivity analysis
a.Break out components of cash flow:
i.Revenues
ii.Cost of revenues
b.Measure sensitivity in ultimate project value to changes in the components
24.Decision tree analysis
a.Lay out alternative courses of action
b.Give percentage likelihood to different cash flows as a result of the action
c.Taking an action opens up new opportunities but forecloses old ones
25.Monte Carlo simulation
a.Basically, a decision true with infinite branches
b.You run all possible outcomes, assigning proper probability to each
c.Very expensive to do, but possible using computer simulation
26.Efficient market hypothesis
a.Generally, the price of a security will rapidly reflect all info. bearing on that price
i.Weak form -> will rapidly reflect historical price movements (random walk of stock prices)
ii.Semi-strong -> will rapidly reflect publicly available data (so doing fundamental analysis will
not be profitable for ordinary investor)
iii.Strong -> will rapidly reflect all info (public and non-public)
b.Studies show new info is generally reflected within 15 minutes:
i.So technical analysis may work during very short time periods
ii.EMH only says that normal outsiders can't profit by trading on public info (so 15 minute period
doesn't violate EMH)
c.Fact that market acts quickly doesn't necessarily mean it acts accurately
d.Why should you need regulated market disclosures if EMH is true?
i.No element of EMH says that info will be produced and disseminated
ii.Siegel argues that presentation of data effects its understanding in the marketplace, so
regulation should focus on the data's assembly:
(1)Reporting current value of firm assets
(2)Reporting inflation effects on cash flows (sensitivity analysis)
iii.Better assemble = better digestion (see below)
e.Data on semi-strong form:
i.There is a change in price before and after information disclosures
ii.Markets generally see through stupid accounting tricks (LIFO v. FIFO)
iii.BUT there is always info out there which has not been digested (attorney who traded on court
case outcomes got higher return then market)
iv.So theory is an overstatement, but is generally true for the ordinary investor
f.Data for strong form show its true in the long term, but not in the short term (so you can profit
on insider trading)
27.Phenomena going against the EMH
a.Stock splits or dividends cause stock price to rise
b.Existence of market "corrections"
c.Companies diversify even though individual investors can do this for themselves
28.Why does price rise after stock split?
a.Smaller denomination of stock is more liquid
b.Stock split carries implicit signaling effect to market
29.Why do companies diversify if investors can do so
a.Selfishness -> executive compensation is larger in bigger companies
b.Diversifying minimizes firm's risk
i.Not helpful to shareholders
ii.Helpful to creditors, jobholders, communities
c.Current trend actually is to undiversify (Novell, AT&T, etc.)
30.Miller/Modigliani indifference theory
a.It is a matter of indifference to the company and to shareholders whether or not the company
pays dividends
b.Assumptions
i.No difference in taxation of capital gains and taxation of dividends
ii.Rasing capital is cost free
c.U.S. Taxation
i.Discount on capital gains
ii.Not declaring dividends allows investors to determine timing of taxation
(1)If you leave taxable income in the co., you're getting a return on the government's money
(2)If you die, donee gets step up in basis
iii.Cash dividends are a taxable event, but stock dividends are not
iv.[So tax rules argue against giving cash dividends]
d.Non-severance dividends (stock dividends and stock splits)
i.Difference between two is the ratio between new shares and old
ii.After stock dividend, stock price usually rises:
(1)Market practice is to keep dividends/share constant, even if there are more shares
(2)So market interprets stock dividend as a signaling effect that co. is doing better than before
iii.After stock split there may be a rise, but not as dramatic
(1)Stock split creates more liquidity for shares
(2)But market practice is to split the dividends
(3)So signaling effect is not as pronounced
e.Severance dividends (stock repurchase/redemption + cash/property dividend)
i.Why does price rise after stock buyback
(1)Signaling -> mgt thinks stock price is too low
(2)Reduced equity holdings reduces need to pay distributions to equity holders, so mgt has more
wiggling room
f.Is the company indifferent
i.Company can declare dividend and issue new stock to cover the difference, or declare nothing-effect will be the same
ii.MM theory is partly dependent on board's authority to issue new shares (so works in U.S., but
not abroad)
iii.BUT there are transactions costs (registration, underwriting, etc.), so there should be hostility
to policy requiring issuance of new shares
g.Is the shareholder indifferent
i.Tax effect (against dividends)
ii.BUT gains on stocks held for short duration are taxed just like ordinary income (indifferent to
dividends)
iii.Transaction costs if you wish to use cash dividend to purchase more shares (against)
iv.But would face transactions costs if wished to sell anyway (indifferent)
h.Dividend preference
i.Institutional investors face no adverse tax effects on receiving dividends because they don't pay
taxes (life ins. co's, pension plans, etc)
ii.Dividends held them make distributions to beneficial owners without transactions costs of
selling shares
iii.Ins. investors comprise 1/2 of the market and are highly diversified, so their influence carries
over to the entire market
iv.Dividends foster liquidity in capital markets and trading transactions (global dividend
preference)
v.If return available to corp < return available to investors, economically efficient thing to do is
to pay dividend
i.Empirical evidence / studies
i.Where co. declares cash dividend, share price drops exactly by dividend amount
ii.Tax effects generally have little effect (when taxes fell, dividends did not increase)
31.Option theory
a.Every financial instrument is made up of two forms of option, one form of ownership, and one
form of debt:
i.Call (right to buy)
ii.Put (right to sell)
iii.Stock
iv.Risk-free pure discount bond (zero coupon with continuous compounding)
b.Pure stock is ownership in a company without a residual interest
c.Option is a contract right that can be exercised at holder's discretion
d.Components of an option:
i.Underlying object
ii.Term (European vs. American)
iii.Strike price
e.Redeemable preferred stock
i.Corp holds call option on stock in case deal becomes unfavorable
ii.Holders demand the call be out of the money so they get some profit
f.Machine w/salvage value = machine + put
g."Naked" options
i.Option held by person not holding the underlying security
ii.Naked puts are settled through cash difference payments
h.Deep in the money call is equivalent to investment in underlying asset
i.Normal options are written out of the money
j.ESOP
i.Covered options (co will just issue stock)
ii.Option is written at the money
iii.Generally long term options (5 yrs)
iv.Generally not tradable
k.Writer of call option:
i.Has unlimited downside risk
ii.So option will be writing for short period of time
iii.Writer can buy a share of stock to freeze his loss ("covered" loss)
l.The bond component
i.You use continuous compounding because we're talking about instantaneous pricing
ii.Discount rate you use is the short-term risk free rate
m.The value of risk
i.The riskier the underlying asset is, the more valuable the option is
ii.This is because the option holder is not exposed to downside risk
(1)Unlimited potential for gains with higher volatility
(2)Potential for loss is capped at a payoff of zero (you only get one half of the bell curve)
iii.So option holders are risk seeking even though normal investment holders are risk averse
iv.This explains the existence of highly leveraged companies
n.For a leveraged company
i.Stock is really a call option on the company's assets with an exercise price of the outstanding
bonds
ii.Bond is really:
(1)Company's assets less the value of a call option with exercise price of the bond face value; or
(2)Bond face price less the value of a put option with exercise price of the bond face value
iii.So by increasing riskiness of company, shareholders can shift firm value from debt to stock
(this is contrary to CAPM)
o.Factors effecting option price:
i.Exercise price (inverse)
ii.Stock price
iii.Time
iv.Risk free rate
v.Risk of underlying asset
p.Assumptions of option pricing models:
i.Underlying asset is tradable
ii.Option is tradable
iii.No dividends are paid
q.In the money option will always be worth more than payoff. Why?
i.In the money component: equals the payoff
ii.Borrowing component: why pay X now when I can pay it later
iii.Risk component: potential for stock price to go up
r.Key to producing valuable option portfolio is to buy idiosyncratic risk
s.Options and investment valuation:
i.Most investments carry options
(1)Out of the money put option (abandonment decision)
(2)Call option (new opportunities due to prior investment decision)
ii.Options always add value to the investment, so ignoring them understates value of investment