Business 35200
Corporation Finance
Professor Pascal Noel
Pascal Noel – Corporation Finance 35200
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Who Am I ...
• Education
➢ B.A., Yale (Economics; and Ethics, Politics, and Economics)
➢ M.Sc., London School of Economics (Economics)
➢ Ph.D., Harvard (Economics)
• Worked as an economic advisor to President Obama
on the White House National Economic Council
➢ Dodd-Frank financial regulatory reform bill
➢ Response to foreclosure crisis
•
Research focus: Household finance
➢ Apply concepts of corporate finance to households
➢ Ex: Mortgage debt restructuring, response to financial stress
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Course Material
• Text: Berk and DeMarzo (4th or 5th ed.)
• Canvas site: http://canvas.uchicago.edu
➢ Syllabus and class schedule
➢ Zoom links
➢ Lecture slides
➢ Cases and case questions (not solutions)
➢ Additional readings
➢ Problem sets & solutions
➢ Announcements
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Course Requirements
• Final grade based on
➢ Final Exam
➢ Midterm (optional)
➢ Case Write-ups
➢ Valuation project
➢ Course Participation
40%
30%*
10%
10%
10%
• Note 1: I will occasionally cold call, especially during case discussions
• Note 2: Answering classmate questions on canvas counts for this
• Two types of cases
➢ 2 “star cases” graded on ten-point scale
➢ 3 “normal cases” credit/no-credit
• Valuation project
➢ Details on syllabus and in week 9 Module on Canvas
• Readings: textbook, lecture notes, cases, and a few
additional notes
➢ Relatively little reading for this course
➢ Focus on understanding and working with the key concepts
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Administrative Information
• You must take midterm and final exam, in person, in the section you
are registered for
➢ Only exception: medical emergency
➢ Allowed cheat sheets (1 front/back for midterm, 2 for final)
• Groups for cases
➢ Up to 4 people per group; one submission per group
➢ Answers to case studies will not be posted or distributed
➢ No late submissions are accepted
➢ Sign up for groups online before first case is due
• Groups for valuation project
➢ 10 groups (6-7 people per group). Choose by week 7.
• Problem sets are optional and not to be handed in
➢ Discussed in review sessions
➢ Most similar to midterm and exam
• YOU MUST ADHERE TO THE BOOTH HONOR CODE
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Administrative Information
• Office Hours: by appointment
• Teaching Assistant
➢ Bhanu Koduru (bkoduru@chicagobooth.edu)
• Where to direct questions outside of class
➢ Course material or logistics: discussion section of Canvas
site (do not email me or the TA, post questions instead)
➢ Personal questions (e.g., medical emergency necessitating
exam rescheduling): email me directly
• Review sessions not mandatory, but highly
recommended
➢ Held over zoom
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Other Administrative Information
• After each lecture:
➢ Case questions for following week
➢ Problem set questions and solutions for current
week
• For class each week
➢ Cases/group project (except weeks 5 & 6)
➢ Reading
➢ Do not hand in problem sets (but do them!)
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How You Can Help
• Please speak up if you can’t read my whiteboard
notes. This is my fault, not yours!
• (Legitimate) complaints about this will count as
positive class participation
• I will post a copy of the whiteboard notes after class
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Overview of the Course
Part I: Capital Budgeting (Assets side)
➢
➢
➢
What real assets should the firm invest in?
Project valuation (cash flows & discount rates)
Tools: WACC, APV, real options
Part II: Financial Policy (Liabilities side)
➢
➢
➢
How should projects be financed?
Debt, equity, information problems, taxes
Payout policy
Part III: Additional Topics
➢
➢
M&A
Valuation group project
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Main Goal of Course
1. Acquire the tools necessary to evaluate the
profitability of investment projects
2. Acquire a conceptual framework for analyzing
financing decisions
3. Apply this body of knowledge to cases in more
complex situations
•
These skills are fundamental tools when making
business decisions across areas
➢ I-Banking, Consulting, Private equity, Startups
• Note: This is not an accounting class
➢ Focus on applying the concepts taught in this course with
reasonable accounting assumptions
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After Corporate Finance ...
• BUS 35201: Cases in Financial Management
➢ Case course, everybody should take this course
• BUS 35202: Financial Markets and Institutions
➢ Theoretical analysis of banking and bankruptcy
• BUS 35206: Advanced Topics in Corporate Finance
➢ Deeper analysis of selected topics
• BUS 35210: International Corporate Finance
• BUS 35211: The Analytics of Financial Crises
• BUS 35214: Debt, Distress and Restructuring
• BUS 34101: Entrepreneurial Finance and Private Equity
➢ Structuring and evaluating entrepreneurial projects
• BUS 35213: The Fintech Revolution
• BUS 35215: Behavioral and Institutional Finance
• BUS 35902: Theory of Financial Decisions II/III
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Student Introductions
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Lecture 1A: Cash Flows and
PV
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Overview
• Cash Flows (CF) and Present
Value (PV)
➢These are two fundamental concepts
in Corporate Finance
➢This is partly a review
• Readings: 4.1-4.5; 8.1-8.4
➢May want to brush up on chapters 1-3
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Valuing a project: DCF
• Valuing a project requires a comparison of benefits
and costs
• In finance, benefits and costs of a project are
measured in cash flows
• Problem: cash flows often occur in the future, at
different points in time
• Solution: convert all cash flows to a common point in
time => Present Value (PV)
➢ Treat project cash flows like a financial security. Similar to
PV of a financial security’s cash flows (Business 35000)
➢ What counts as cash?
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Present value
• Cash received in the future is worth less
(time value of money)
• Suppose you have a cash flow that
continues to time T
C1
C2
CT
PV0 =
+
+ ... +
2
(1 + r ) (1 + r )
(1 + r )T
• Now suppose you have a cash flow with a
fixed sum (C) that lasts forever. This is called
a perpetuity. Let’s price one ...
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PV formulas: Perpetuity
C
C
C
PV =
+
+
+ ...
2
3
(1 + r ) (1 + r )
(1 + r )
• Multiply both sides by (1+r):
C
C
(1 + r )PV = C +
+
+ ...
2
(1 + r ) (1 + r )
• Subtract the first from the second and rearrange:
C
PV =
r
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PV formulas: Perpetuity and Annuity
• PV today of perpetuity starting tomorrow:
➢ PV = C/r
• PV today of growing perpetuity starting
tomorrow:
➢ PV = C/(r-g) Example
• PV today of annuity that pays a fixed sum (C)
each year for a given number of years (T)
➢
1

C
1
C
1
PV = −
 =C −
T
T 
r (1 + r )
r
r
r
(1
+
r
)


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Making Decisions: The NPV Rule
• Present value of all cash flows of a project is
called the Net Present Value (NPV) of the
investment
• NPV Rule
➢ Take all projects with NPV > 0 and
➢ Reject all projects with NPV < 0
• Equivalent Statement
➢ Buy the security if the PV of its future cash flows is
greater than the purchase price
Example
• What if we have to choose among projects?
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A DCF Example
• You are the CEO of a microchip
manufacturing company
• You know the cash flows of an investment in
a new technology will be:
➢ –$35M from investment today (at time=0)
➢ $20M annual after-tax cash flow starting in a year
(at time=1) and growing at a 5% rate
➢ Final cash flow comes at the end of the 7th year
➢ No salvage value of new technology at the end
• Investing in an alternative project with
equivalent risk has an expected return of 9%
➢ 9% is therefore the opportunity cost of capital in
this example
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Cash Flows from the New Technology
time
date
0
Jan-06
1
Jan-07
Microchip Project
2
3
4
Jan-08 Jan-09 Jan-10
5
Jan-11
6
Jan-12
7
Jan-13
Cash Flow*
*in millions
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Cash Flows from the New Technology
Microchip Project
2
3
4
Jan-08 Jan-09 Jan-10
time
date
0
Jan-06
Cash Flow*
$(35.00) $ 20.00 $ 21.00 $ 22.05 $ 23.15 $ 24.31 $ 25.53 $ 26.80
1
Jan-07
5
Jan-11
6
Jan-12
7
Jan-13
*in millions
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Cash Flows from the New Technology
Microchip Project
2
3
4
Jan-08 Jan-09 Jan-10
time
date
0
Jan-06
Cash Flow*
$(35.00) $ 20.00 $ 21.00 $ 22.05 $ 23.15 $ 24.31 $ 25.53 $ 26.80
1
Jan-07
5
Jan-11
6
Jan-12
7
Jan-13
*in millions
NPV = −35 +
20.00 21.00 22.05 23.15 24.31 25.53 26.80
+
+
+
+
+
+
2
3
4
5
6
(1.09) (1.09) (1.09) (1.09) (1.09) (1.09) (1.09)7
= 80.13
So these cash flows are worth $80.13M.
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Questions
1. What does the NPV rule tell us about
whether we should build the microchip
factory?
2. What if the project had a negative NPV at
the 9% opportunity cost of capital?
3. Suppose the project had a negative NPV at
9% but a positive NPV at 8%, and a banker
approaches us who is willing to loan us
money at 8%
4. What if the best loan rate we can get from a
bank is 10%?
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What is Cash Flow?
• NOT accounting earnings
• We are interested in actual cash flows
that accrue to investors
• Why might these be different?
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Example: Fertilizer project
• Think about following project:
➢ Investment up front of $10 million
➢ Can be dismantled and sold for $1.949
million after 7 years
➢ Forecasts of sales, costs, depreciation,
pretax and after-tax profits are available
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Income Statement to Cash Flows
Projected Income Statement for the Project ($ thousands)
Sales
Cost of goods sold
Startup and SG&A costs
Depreciation
Pretax profit (EBIT)
Interest
Tax
Profit after tax
0
1
0
0
4,000
0
-4,000
0
-1,400
-2,600
523
837
2,200
1,583
-4,097
0
-1,434
-2,663
2
12,887
7,729
1,210
1,583
2,365
0
828
1,537
3
32,610
19,552
1,331
1,583
10,144
0
3,550
6,593
4
48,901
29,345
1,464
1,583
16,509
0
5,778
10,731
5
35,834
21,492
1,611
1,583
11,148
0
3,902
7,246
6
19,717
11,830
1,772
1,583
4,532
0
1,586
2,946
• Typical format of income statement that analysts get
• Question: Can we take the profit after tax line and plug it
into the present value equation to get the NPV?
?
NPV = −2600 +
Answer: No.
−2663 1537
6593
10731
7246
2946
+
+
+
+
+
(1 + r ) (1 + r ) 2 (1 + r )3 (1 + r ) 4 (1 + r )5 (1 + r )6
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Important Cash Flow Rules
• Four basic ingredients in cash flows are:
➢ In: Revenues
➢ Out: Costs, investments, taxes
• Depreciation is NOT a cash flow
➢ But it does affect taxes
• Interest expense is NOT a cash flow (for now)
➢ We want to separate the investment and financing decisions.
So, for now, evaluate projects as if they are “all equity financed”
• Only discount “incremental cash flows”
➢ Either discount total firm cash flows with vs. without project OR
discount incremental cash flows of project only
• Don’t forget opportunity cash flows
➢ Real estate
➢ Own time
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Free Cash Flow
= Revenues – Costs – Investments – Taxes
= Revenues – Costs – Investments
– tc*(Revenues – Costs – Depreciation)
= (1 – tc)(Revenues – Costs) – Investments + tc*Depreciation
= (1 – tc)(Revenues – Costs – Depreciation) – Investments
+ tc*Depreciation + (1 – tc)* Depreciation
= EBIT*(1 – tc) + Depreciation – Investments
Note:
EBIT= Revenues – Costs – Depreciation
tc = marginal corporate tax rate
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Components of Investments
Four main investment cash flows:
1. Initial capital expenditures
2. Required ongoing capital expenditures
3. Change in net working capital (NWC)
•
Generally, NWC = CA – CL
•
In this class, NWC = Inventories + Accounts
receivable – Accounts payable
•
Why is change in NWC an Investment?
4. Terminal value
→ Investments = Initial CAPX + Ongoing CAPX +
Change in NWC - TV
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More About Terminal Value
•
Idea: at the end of the planning horizon, a
project may still have some value
➢
If project is liquidated or sold at the end of the
horizon, we calculate its salvage value
(“Liquidation Method”)
➢
If the project will continue indefinitely, we
calculate its continuation value (“Perpetuity
Method”)
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Method 1: Salvage Value (“Liquidation”)
• Appropriate method if machine or project going
to be sold off at the end of the horizon
• Best for slow growing companies
• Start with estimate of sale price of machine in
the year “after” the final forecasted cash flow
• Consider tax implications
➢ If book value > selling price, the firm realizes a tax
shield on capital loss
➢ If selling price > book value, the firm pays tax on
capital gain
➢ Simplest case: selling price = book value → no tax
liability
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Back to Fertilizer Project Example
• Think about following project:
➢ Investment up front of $10 million
➢ Can be dismantled and sold for $1.949
million after 7 years
➢ Forecasts of sales, costs, depreciation,
pretax and after-tax profits are available
• What are the cash flows?
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Practice at home: Fertilizer project
0
1
2
3
4
5
6
7
Note: Balance Sheet Information
Net Working Capital
0
Accumulated Depreciation
0
550
1,583
1,289
3,167
3,261
4,750
4,890
6,333
3,583
7,917
2,002
9,500
0
0
Cash Flow Calculation
EBIT
Tax at 35%
EBIAT
Depreciation
1. Initial Expenditures
2. Ongoing Expenditures
3. Change in NWC
4. Terminal Value
Investments
Cash Flow
-4,097
-1,434
-2,663
1,583
0
0
550
0
550
-1,630
2,365 10,144 16,509 11,148
828 3,550 5,778 3,902
1,537 6,594 10,731 7,246
1,583 1,583 1,583 1,583
0
0
0
0
0
0
0
0
739 1,972 1,629 -1,307
0
0
0
0
739 1,972 1,629 -1,307
2,381 6,205 10,685 10,136
4,532
1,586
2,946
1,583
0
0
-1,581
0
-1,581
6,110
0
0
0
0
0
0
-2,002
-1,442
-3,444
3,444
-4,000
-1,400
-2,600
0
10,000
0
0
0
10,000
-12,600
Note: In the cases that we will do in this course, the terminal value is
usually recognized during the final year of the operating cash flows.
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Method 2: Continuation Value (“Perpetuity”)
• Appropriate method if investment continues
beyond the horizon where components of
cash flow easily calculated
➢ Best to use if cash flows have settled into a
pattern of steady growth at the end of the forecast
horizon
• Take the cash flows at time T, calculate (or
assume) a growth rate g for them, and apply
the growing perpetuity formula
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Example: CV Using Perpetuity method
• Suppose that r is 14% and we have the
following cash flows
Cash Flows Excluding
Terminal Value
Continuation Value
Total Cash Flows
0
1
2
3
4
5
-3500
1000
1150
1158
1212
-3500
1000
1150
1158
1212
1275
CV
1275+CV
• Growth rate of cash flows?
➢ roughly 5%
• What is continuation value (CV) here?
CF(1 + g)
1275(1.05)
=
= 14,875
(r − g)
(0.14 − 0.05)
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Takeaways
• Make valuation decisions based on the NPV rule:
➢ Take all projects with NPV>0 and reject all projects with NPV<0
• Cash flows available to firm owners different from
accounting earnings
➢ CF available to a firm’s shareholders is CF from operations and
investments: EBIT(1-tc) + Depreciation – Investments
➢ Investments = Initial CAPX + Ongoing CAPX + ΔNWC Terminal Value
➢ Terminal value:
• Salvage value (liquidation method) and
• Continuation value (perpetuity method)
➢ Only count cash flows that are incremental to what the firm is
already doing
➢ Ignore sunk costs
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