Corporate finance 1 to 3: Overview
Corporate finance 3 to 4: Interest Rate, Fin. Math, & Hurdle Rates
 The main goal in Finance  Maximizing corporate value by making Investment  Interest Rate  Determined by Supply (Gov) and Demand (Transaction,
Decision (Return > Hurdle), Financing Decision (minimize hurdle rate), and
Precautionary, Speculative) of Money
Capital Allocation (Dividend distribution if no investment opportunity with at
o Nominal Risk-free Rate (Rf) = Real Risk-free Rate + Inflation Rate
least Return = Hurdle rate)
o Price of Corporate Bond = Rf + Credit Spread
 Book Value (BV) = Equity as reported in Balance Sheet
o Price of Corporate Bond = Rf + Default Risk Premium + Liquidity Premium +
 Market Value of Equity = Market Capitalization = The price people willing to
Maturity Premium
pay for the equity of a company = Stock Price * #of share outstanding
 PV (Present Value), Future Value (FV), Annuity [Payment per period] (A), Discount
 Enterprise Value (EV) = Market Value of Debt + Market Value of Equity – Cash &
Rate (r), Discount Factor (DF), n (number of years or period)
Cash Equivalent
o PV = FV * DF
;
DF = 1 / (1+r)^n
;
FV = PV * (1+r)^n
 EBITDA (earnings before interest, tax, depreciation, and amortization)
o FV = A * ((1+r)^n – 1) / r
 NOPAT(Net Operating Profit After Tax) = EBIT *(1 – Tax)
 Perpetuity of Annuity with or without growth (g)
o PV = A1 / r
;
PV = A1 / (r – g)……… [g < r]
 Balance Sheet:
 Annual Percentage Rate (APR) and Effective Annual Interest Rate (EAR)
o Asset = Debt + Equity = Capital;
o e.g., interest rate 12% monthly compounding
o Debt exclude interest bearing liabilities
o APR = periodic interest rate * frequency of compounding = 12%/12 * 12 = 12%
o Borrow too much  Sudden Death; Don’t Borrow  Die Slowly
o EAR = (1 + periodic interest rate)^n – 1 = (1 + 1%)^12 – 1 = 12.68%
 Income Statement :
 CAGR (Compounded Annual Growth Rate  geometric mean
o Revenue; Gross Profit; EBITDA; EBIT (Operating Profit); EBT; Net Income
o CAGR = (End / Start)^(1/n) – 1
 Cashflow Statement:
o Operating Cashflow; Investing Cashflow; Financing Cashflow
 Risk
o Start-up: Large +ve Financing CF; Large -ve Investing CF
o Mature: Large -ve Financing CF; Large +ve Operating CF
 Price Elasticity
o Elastic: Volume Play, %Quantity increase > %Price Decrease
o Non-Elastic: Margin Play, %Quantity increase < %Price Decrease
 Economies of Scope vs Economies of Scale
o Economies of scope: focus on differentiation
o Economies of scale: focus on spreading fixed cost to more unit of sales
 Contribution Margin  stop operation or not? If +ve, continue operation.
o Contribution margin = Unit Selling Price – Unit Variable Cost
o BEP (Break Even Point) = Fixed Cost / Contribution Margin
 Leverage
o DOL (Degree of Operating Leverage) = %Change EBIT / %Change Sales
o DFL (Degree of Financial Leverage) = %Change Earning / %Change EBIT
o DCL (Degree of Combined Leverage) = %Change Earning / %Change Sales
 Analysing Common Size Financial Statement  Look for large changes
 Financial Ratio: Profitability
o Gross Margin = Gross Profit / Sales
o EBIT Margin = EBIT / Sales; EBITDA Margin = EBITDA / Sales
o PreTax Margin = EBT / Sales; Net Margin = Net Income / Sales
o Return on Asset (ROA) = Net Income / Asset
o Return on Equity (ROE) = Net Income / Equity
o Return on Sales (ROS) = Net Income / Sales
 Financial Ratio: Liquidity
o Current Ratio = Current Asset / Current Liabilities
o Quick Ratio = (Current Asset – Inventories) / Current liabilities
o Cash Ratio = (Cash + Marketable Investment) / Current Liabilities
 Financial Ratio: Asset Utilization
o Asset Turnover = Sales / Asset; Fixed Asset Turnover = Sales / Fixed Asset
o Inventories Turnover = COGS / Inventories; Inv. Days = 365 / Inv. Turnover
o Receivable Turnover = Sales / Receivable; Rec. Days = 365 / Rec. Turnover
o Payable Turnover = COGS / Payables; Pay. Days = 365 / Pay. Turnover
o CCC = Inv. Days + Rec. Days – Pay. Days
 Financial Ratio: Solvency
o Debt to Asset = Debt / Asset
o Debt to Equity (Gearing Ratio) = Debt / Equity
o Financial Leverage = Asset / Equity
o Interest Coverage = EBIT / Interest Expense
 Financial Ratio: Valuation
o Price to Earning (P/E Ratio) = Stock Price / Earning per Share (EPS);
o Price to Book Value (P/BV Ratio) = Stock Price / Book Value per Share (BVPS);
o Price to Sales (P/S Ratio); Enterprise Value to Sales (EV/S Ratio)
o Enterprise Value to EBITDA (EV/EBITDA Ratio)
o In comparing companies, usually EBITDA is preferred over Earning because
EBITDA is less noisy. EBITDA is a proxy variable of Cashflow.
 DuPont ROE Decomposition
o ROE = (Net Margin) * (Asset Turnover) * (Financial Leverage)
o ROE = (NI / Sales) * (Sales / Asset) * (Asset / Equity) = NI / Equity
 G*(Internal or Sustainable Growth Rate)
o G*= ROE * Retention Ratio (RR) = ROE * (1 – Dividend Payout Ratio (DPR))
 EVA (Economic Value Added)
o Shareholder pov.: EVA = Equity * (ROE – Cost of Equity)
o Firm pov.: EVA = Capital Employed * (ROC – WACC)
 Fair Value (FV) vs Market Value (MV)
o FV > MV  Undervalued  Buy; FV < MV  Overvalued  Sell
 RISK VS RETURN
o Risk  Volatility / Variance / Std. Dev (total Risk = Systematic + Non Sys….)
o Expected Return A / B / C (A / B / C);
o probability of return 1,2,3 (prob1, prob2, prob3);
o Weight of A / B / C in portfolio (Wa / Wb / Wc);
o Standard Deviation A / B / C (StdA / StdB / StdC);
o Correlation A and B (CorrelAB);
o A = prob1 * A1 + probA2 * A2 + probA3 * A3 + ….
o Coefficient of Variation A (CV A) = A / StdA  the smaller, the better
o Expected return portfolio (P)= Wa * A + Wb * B + Wc * C
o Standard Deviation Portfolio (StdP) = SQRT (Wa2 StdA2 + Wb2 StdB2 + Wc2 StdC2
+ 2 Wa Wb CorrelAB StdA StdB + 2 Wa Wc CorrelAC StdA StdC + 2 Wb Wc
CorrelBC StdB StdC
o Coefficient of Variation P (CV P) = P / StdP
 DIVERSIFICATION  “don’t put eggs in one basket”
o
o Maximum Diversification Benefit: CorrelAB = -1
o Diversification Benefit: -1 < CorrelAB < 1
o No Diversification Benefit: CorrelAB = 1
 HURDLE RATE = Risk-free Rate + Risk Premium
o Firm pov.  Hurdle Rate = WACC (Weighted Average Cost of Capital)
o Shareholder pov.  Hurdle Rate = Cost of Equity
 HURDLE RATE: Cost of Debt
o Cost of Debt = Rf + Credit Spread
 HURDLE RATE: Cost of Equity
o Risk Premium (Rp) = Expected Market Return (Rm) – Risk-free Rate (Rf)
o CAPM (Capital Asset Pricing Model):
o Cost of Equity (ke)= Rf + β * Rp
o DDM (Discounted Dividend Model):
o ke = Dividend1 (D1) / FairValue (Po) + growth (g)…………g < ke
 BETA (β)
o β is the relative volatility of a stock against a benchmark
o β = 2 means when benchmark increase 1%, the stock increase 2%
o Adjusted β = Raw β * 0.67 + 0.33
o Levered or Equity β = Unlevered or Asset β * (1 + (1 – taxRate)*Debt/Equity)
o Levered β is the one you use in CAPM formula
o Unlevered and Re-levered the β if there is a big change in capital structure over
the past 5 years (since β is calculated using monthly data for 5 years)
 Value Destruction or Value Creation?
o Accounting Return: considered value creation if ROE > Cost of Equity
o Accounting Return: considered value creation if Project MIRR > WACC
o TSR (Total Shareholder Return)
o TSR = Capital Gain + Dividend
o Considered value creation if TSR > Cost of Equity; TSR > Industry Index
Return; TSR > General Index
Corporate finance 4 to 6: Rational Investment Decision Making
 Return on Investment (ROI)  use weighted average for multiple projects
o ROI = Additional Profit / Additional Investment
 Basis for making investment decision
o Accounting based ROC (Return on Capital); ROE (Return on Equity)
o Cashflow based Payback; Discounted Payback
o DCF (Discounted Cash Flow) NPV (Net Present Value); IRR (Internal Rate of
Return); MIRR (Modified Internal Rate of Return); Profitability Index (PI)
o Independent Projects: invest whenever NPV positive
o Mutually Exclusive Project: Choose one or another, choose the one with
higher positive NPV
 Accounting Based
o After Tax ROC = EBIT * (1 – taxRate) / Average Book Value of Total investment
o If ROC < WACC, then Reject
o After tax ROE = Net Income / Average Book Value of Equity Investment
o If ROE < Cost of Equity, then Reject
 Cashflow Based
o Payback and Discounted Payback (r = 10%)
Year
0
1
2
3
CF
-100
10
60
80
Cumulative
-100
-90
-30
50
DCF
-100
9.1
49.6
60.1
CumulativeD -100
-90.0
-41.3
18.8
o Payback = 2 + 30 / 80 = 2.38 years
o Discounted Payback = 2 + 41.3 / 60.1 = 2.69 years
 DCF Based
o NPV = PV of Future Cashflow – Initial Cost…; +veNPV Accept; -veNPV Reject
o IRR = Rate when the NPV equals to 0…; IRR>WACC Accept; IRR<WACC Reject
o MIRR = (FV Inflows / PV Outflows)^(1/n) – 1…; MIRR>WACC Accept;
MIRR<WACC Reject
o PI = NPV / Initial Investment…; Choose the bigger one to invest in
o Use IRR for early growing firm, Use NPV for mature firm
o IRR  Reinvestment Rate = IRR, Aggressive!!!
o NPV  Reinvestment Rate = Hurdle Rate, Conservative!!!
 Theories of Capital Structure: Static Trade-Off
o Static Trade-Off focus on the balance of optimal capital structure, balancing the
Benefit of Debt (Present Value of Tax Shield) and the Risk of Debt (Present
Value of Financial Distress)
o Optimal capital structure is when Maximum Market Value of the Firm achieved,
or when WACC at the lowest
o
 Debt Levels and methods to change it
o Gearing Ratio = Debt to Equity Ratio…. too much debt or too little debt is not
good
o Method: Recapitalization (Fast), Divestitures (Fast), Off Balance Sheet (sale-and
lease-back, less relevant due to change in accounting standard), Using mix of
financing for new investment (Slow), Change dividend policy (Do not change
dividend to pay back debt, Slow)
o The higher the Debt Level, the higher the financial leverage, the higher the
ROE. Remember DuPont ROE Decomposition.
 Calculating Weighted Average Cost of Capital (WACC)
o Cost of Equity (ke)  use DDM or CAPM
o Cost of Debt (kd)  Calculate YTM (Yield to Maturity), Approach it like
calculating IRR
o WACC = (Equity / (Debt + Equity))*ke + (Debt / (Debt + Equity))*kd*(1-taxRate)
o kd < WACC < ke
o In WACC calculation, use Market Value of Equity instead of Book Value of
Equity
 Valuation of the Firm with Discounted Cash Flow
o Value of Firm = FCFyear1 / (Hurdle Rate – Growth)
 Initial Public Offering (IPO)
o Value of Firm = FCFyear1 / (Hurdle Rate – Growth)
o Assume 1 owner with 10 million shares (100%) => owner sells 5 million existing
Corporate finance 6 to 7: Financing, Capital Structure, & Capital
shares, Ownership by owner will be 50% (5 million shares) => Owner Raises
Allocation/Dividend Decisions
Money
 Financing Decisions
o Who raise money in IPO?
o Depend on life cycle. Early Start Up  Need External Financing,
o Assume 1 owner with 10 million shares (100%) => Company issues 10 million
MatureCan use Internal Financing
new shares, Ownership by owner will be 50% (10 million shares) => Company
o Service Sector tend to have lower CCC than Manufacturing Sector
Raises Money
o Source of Financing: Shareholders, Public Lenders, Banks
o Parties that are most concerned with IPO outcome: Vendors, Company,
Investors, Underwriter
 Cashflow
o Cost of IPO = Direct Cost + Indirect Cost
o EBITDA = Earning Before Interest Tax Depreciation and Ammortization
o Direct Cost: Fees for underwriters, lawyers, accountants, Roadshow, Printing,
o Operating Cashflow = NOPAT + Deprecitation & Ammortization – Changes in
Incidental Expenses (such as payment to receiving bank, listing fees, etc.)
Working Capital
o Indirect Cost: Under pricing of equity has negative
o Free Cashflow = Operating Cashflow – Capital Expenditure
o The larger the IPO, the better because you are spreading fixed cost to more
o Working Capital = Current Asset (Inventory, AR, Cash) – Current Liabilities (AP,
units of sales.
Short-term Debt)
o In IPO, you want to prioritize high quality investor such as: Institutional
o Cash Conversion Cycle = Average Inventory Days + Average Receivable
Investors, pension Fund, Asset Management Firm. You do not like retail
Collection Days (DSO) - Average Payable Payment Days (DPO)
investors because they make the stock price more volatile.
o Alternative to IPO: RTO (Reverse Take Over) “Backdoor listing”, Direct Listing
 Funding Gap
(Direct Public Offerings), SPAC (Special Purpose Acquisition Company), Roll-up
o Supplier payment term: 2/10, Net 30 [2% discount within 10 days, normal
IPO
price due in 30days]  Gap 20 days
o Bank is charging 12% per year  < 1% for 20days gap
 Dividend Theories
o In this case, Borrow bank and pay faster!!!
o Dividend are irrelevant (Investors do not care); Dividend Preference (Investors
prefer large payout); Dividend as signals (increase is +ve signal); Tax Effect
 External Financing – Debt & Equity Financing
(Investors prefer low payout); Catering theory (clientele effect, stock price
o Debt Financing Source: Bank, Corporate Bond Investors
change due to policy changes in dividend, tax, and others)
o Equity Financing Source: General Partners, Limited Partners, Public (IPO)
 Capital Allocation / Dividend Decisions
 Theories of Capital Structure: Pecking Order
o Method: Cash or Stock Dividend, Share buyback, Capital reduction
o Pecking Order: in order from most preferred to least preferred
o PAY DIVDIDEND if there is no feasible investment (IRR < WACC, NPV -ve)
o Retained Earnings (Internal Equity)
o Dividend Payout Ratio (DPR) = Dividend / Earnings
o Debt
o Dividend Yield = Dividend / Stock Price
o Hybrid Security
o Residual Dividend Model: [components are forecasted / expected]
o External Equity
o Dividends = Net Income – (Equity / Asset * CAPEX)
o The difference between internal and external equity is about Floatation Cost
o Stock price drop after dividend distribution
which consist of Direct Cost (Out of pocket cost) and Indirect Cost (Cost of
o Cum Date: The last day you can receive dividend; Ex Date: you can no longer
Underpricing). Internal Equity does not have Floatation Cost at all.
receive dividend; Record Date: List of names that have right to receive Dividend