Corporate Financial
Decisions
Introduction
Timothy A. Thompson
Goal of the Course
• Application of Financial Principles to
Strategic Decision Making
Principles of Finance
• Valuation
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Discounted cash flow (DCF)
Option valuation
• Risk and return models
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Capital asset pricing model (CAPM)
• Capital structure theory
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Tradeoff theory/pecking order hypothesis
• Risk management
Valuation
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What is the valuation principle?
• Value of an asset (security, strategy,
firm, etc.) is the present value all the
future cash flows (expected) deriving
to the owners of the asset discounted
at a rate of return (expected)
commensurate with the riskiness of
the future cash flows
What are strategic corporate
decisions?
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What investments should firm make?
• Capital budgeting
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Identity of the firm
• Should firm conglomerate or focus?
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Growth vs. harvesting
• Grow via acquisitions vs. internal growth
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Financing policy
• Target debt/equity policy
• Internal/external equity
• How to finance current plans?
What does “value” have to do with
strategic decision-making?
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Should corporate decisions pursued
with a goal of maximizing
shareholder value?
• If so, we need to know how to
calculate SHV and how to assess the
impact of our strategic decisions on
SHV.
What about other constituencies?
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Employees
Communities
Unions
Management
Board of directors
We need to understand SHV
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Stakeholders framework
• Even if decisions are made to weigh the
interests of different groups, we need to
be able to value alternative courses of
action from the perspective of
shareholders
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Shareholder influence
• Hostile acquisitions relatively rare, but
• Shareholder proxies, activist
institutional holders, etc.
Is shareholder value the same as
stock price?
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If markets are strong form efficient,
yes.
Are markets strong form efficent?
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No. Corporate insiders often have important
information about strategy, etc., that market
doesn’t have.
Maybe not. Sometimes it looks like the
market is really out to lunch (e.g., Internet
stocks).
Sooner or later, stock price is arbiter. But
how soon?
Valuation and risk
Probability
E(CFt)
CFt
DCF and risk
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We discount expected cash flows
• Not pessimistic, not optimistic
• Expected cash flows weigh all the possibilities
by their respective probabilities (total risk)
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Discount these at a discount rate that is
appropriate for the risk of the cash flows
• V0 = E(CFt)/(1+ri)t
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Matching principle: match the
discount rate to the riskiness of the
cash flow
Capital asset pricing model
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CAPM asserts that the discount rate
should be based only on systematic
risk
• Non-diversifiable, general economic risk
• Measured by beta
• Not total risk, because much of the
“risk” of the cash flows can be
diversified away
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ri = rf + ßi (rm – rf )
Certainty equivalent method
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DCF assumes that the “riskier” a future
cash flow is the higher the discount rate
should be applied to the “expected value”
of the future cash flow.
Alternatively, we could ask “what cash
flow received with certainty at time t
would make you indifferent between that
certain cash flow and the risky CFt?”
Call the certainty equivalent cash flow
CECFt and discount it at rf.
Which is better?
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In theoretical models typically
applied (e.g., CAPM) they are
equivalent
DCF for project/firm valuation
typically uses the first method
(expected cash flows and a riskadjusted discount rate)
Option pricing, in contrast, uses the
certainty equivalent method
Capital structure and valuation
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What is the impact of capital structure on
valuation?
• No impact? (Modigliani-Miller, 1958)
• Interest expenses are tax deductible to the
corporation, whereas payments to equity are
not
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We can calculate the value of tax shields of debt
policy
• Higher debt leads to greater expected costs of
financial distress
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Difficult to estimate, but conceptually offset some of
benefits of debt such as tax shields
Syllabus goals
Bed Bath & Beyond
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Consider pros and cons of using leverage in
capital structure
Valuation of tax shields of debt in the capital
structure
• Estimate in dollars: uses Adjusted Present Value
Method (define later)
Syllabus goals, continued
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Marriott
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While BBBY allows us to calculate the value added to
the company by use of debt in its capital structure,
this is normally not done using APV, but via the
weighted average cost of capital (WACC)
Nuts and bolts of estimating WACC as the cost of
capital
John Case Company
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What cash flows do you use to calculate the
enterprise value of a company?
What is the difference between DCF valuation of a
project and the DCF valuation of a company?
Contrast this method to entrepreneurial/venture
capital/private equity methods
Syllabus goals, continued
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Pinkerton (A)
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Valuation in M&A
• Multiples: Comparable transactions method
• Premiums paid
• Discounted cash flow depends on perspective and
strategy (Value to the acquirer)
 Stand alone plus synergy value plus value
added/lost due to financing terms
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Pepsi-Quaker
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Puts together all the pieces.