Corporate Financial
Click Management
to edit Master title style 1
Jan Vlachý <vlachy@atlas.cz>
Brigham, E.F., Ehrhardt, M.C. Financial Management:
Theory and Practice, 13th Edition
Basic Concepts
Chapters 1-3
Corporate Financial Management
Is the Art/Science of Creating and
Maintaining the Value of a Company.
Gives a Firm its Common Language.
It Consists of
Investment Decisions
Financing Decisions
Managerial Decisions
Corporate Financial Management 1
2
Investment Vehicle Model
Money × Real Assets
Money × Financial Assets
Financial
Markets
The World
The Firm
Invest- Financments ing
Corporate Financial
Management
Investors
Financial
Intermed.
Financial
Markets
F I N A N C E
Investments
The Set of Contracts Model recognises imperfections
and includes the assumption of both explicit and implicit
contracts, incl. Corporate Organization.
Corporate Financial Management 1
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The Financial Environment
Competitive Economic Environment
Two-Sided Transactions (Buyer×Seller Equil.)
Risk-Return Tradeoff
Signalling/ Behavioral Principle
<= Market Efficiency (Information, Transactions)
Value (How can some people become rich?)
New Ideas, Expertise
Financial transactions
Options
create an equilibrium; Real
Time Value of Money
investments create value
Corporate Financial Management 1
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Accounting, Cash Flows & Taxes
Purposes of an Accounting System
Reporting the Firm’s Financial
Activities to Stakeholders
Providing Information to Firm’s
Decision Makers
Financial Management strives to use
and interpret the information
Accounting - historical view
Finance - current and future
Corporate Financial Management 1
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Limitations of Accounting
Why don’t shares trade at Book Val.?
Market×Book Value of Assets/Liabs
Historical Accounting (depreciation)
Inflation (value benchmarks have changed)
Liquidity (can it readily be sold?)
Time Value of Money (relates to Maturity
and Terms)
Note: Finance prefers to deal with cash flows
in a time perspective.
Corporate Financial Management 1
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Taxes
Income Tax
Make analyses on after-tax basis
For financial decisions, use marginal
tax rate (relavant if tax is progressive
or unsymmetrical on negative base)
Capital Gains Tax
Dividend/Interest Income Treatment
System Biases (Loss Carry-forwards,
Exemptions, Deductions)
Corporate Financial Management 1
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Time Value of Money
Chapter 4
Any Present Value has a greater
Future Value.
... i.e.
People generally prefer having any
amount of money at their disposal
earlier rather than later.
... i.e.
Investors require positive returns as
compensation for the inconvenience.
Corporate Financial Management 1
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On Present and Future Values
You deposit $1,000 today with a bank
that pays 5% interest per year.
FV1= PV+r×PV= PV(1+r)=
$1,000×1,05= $1,050 (Simple Interest)
FV2= FV1(1+r)= PV(1+r)×(1+r)=
PV(1+r)2= $1,102.50 (Compound Interest)
Discounted Cash Flow Framework
FVt= PV(1+r)t
Corporate Financial Management 1
PV= FVt / (1+r)t
9
Return, Net Present Value
Return of an Investment (Rate of
Return, Yield):
CashFlow  (EndValue  BegValue)
Return 
BegValue
NPV = Present Value of expected
cash flows (+positive-negative)
C0
C1
C2
C3
Corporate Financial Management 1
C4
t
10
Practical Issues
Distinguish:
Realized Return
Expected Return (<= Risk)
Required Return (<= Unperfect Mkts)
Financial securities are usually
priced “fairly” (Market Equilibrium).
Investment projects (and other
entrepreneurial decisions) should
bring value, i.e. have positive NPV.
Corporate Financial Management 1
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Valuing Single Cash Flows (Ex.)
What is the Future Value of $2,000
invested at 3% per year for five years?
What is the Present Value of CZK 10m
to be received two years from now if
the required return is 4% per year?
What is the Expected Return for an
investment costing €10,000 today and
offering €12,000 in three years?
Corporate Financial Management 1
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Valuing Multiple Cash Flows
You can invest $10,000. As a result, you
expect to get $2,000, $8,000, and $5,000
over the next three years, respectively. If
the required return is 10%, what is the
NPV of your investment?
t
0
1
2
3
Ct
$ -10,000
$ 2,000
$ 8,000
$ 5,000
Total PV:
PV(Ct)
-10,000.00
1,818.18
6,611.57
3,756.57
$ 2,186.33
What is the return if you know the NPV?
Corporate Financial Management 1
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Annuities
Types of Annuity
Ordinary Annuity (Payments at end of period)
Annuity Due (Payments at beginning of period)
Deferred Annuity (First repayment more than
one period after drawing)
n
PVAn  PMT 
t 1
1
1  r 
t
 1  r n  1
 PMT 

n
 r 1  r  
FVAn = PVAn(1+r)n; PVAn[due] = PVAn(1+r);
PVAn[defd] = PVAn/(1+r)d
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Amortization Schedules
A $1,000 loan yielding 8% requires equal
payments at the end of the next three yrs.
How much principal will be rpd. in Year 2?
PMT = $1,000×[.08(1.08)3/(1.083-1)] = $388.03
t
Vt-1
It
Vt-1 + It
PMTt
Vt
1
2
3
$1,000.00 $691.97 $359.30
80.00
55.36
28.74
1,080.00
747.33
388.04
-388.03 -388.03 -388.03
691.97
359.30
0.01
P2 = V1 - V2 = |PMT2| - I2 = $332.67
Corporate Financial Management 1
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Perpetuities
Problem 4-27
 1  r n  1
PVperp  lim PVAn  lim PMT 

n
n 
n 
 r 1  r  
 PMT   PMT   PMT
 
 lim 


n
n 
r
 r   r 1  r   
PV = $100 / 7% = $1,428.57
Growth Perpetuities:
PMTt = PMT0(1+g)t
PVgrowth = PMT1/(r-g)
(... r > g)
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Compounding Frequency (1)
Compare annual return on deposit
with 6% interest paid annually and
monthly.
FVA = PV×(1 + 6%) = PV×1.06
rA = (FVA-PV) / PV = .06×PV/PV = 6%
FVM = PV×(1 + 6%/12)12 = PV×1.00512
= PV×1.0617
rM = (FVM-PV) / PV = 6.17%
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Compounding Frequency (2)
Compare the cost of a 6% (nominal
rate) loan with monthly and quarterly
interest.
Nominal Rate×Effective Annual Rate
NR = m×rm
EAR = (1 + rm)m - 1
EAR M = 1.00512 - 1 = 6.17%
EAR Q = 1.0154 - 1 = 6.14%
Corporate Financial Management 1
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Bond and Stock Valuation
Chapters 5,7
Main sources of capital for Company
Bond: Debt Capital
Stock: Equity Capital
Claim on fut. cash flows for Investor
Bond: Contractual interest and principal payments (or proceeds of sale)
Stock: Dividends (theoretically forever)
or proceeds of sale
Corporate Financial Management 1
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Valuation Procedure
Based on discounted cash flow
concept:
Estimate expected future cash flows
Determine required return (depending
on the riskiness of the expected cash
flows)
Compute the present value
Other possibilities: Market price of
same or comparable asset
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Features of Bonds/ Stocks
 Par (Face, Princ.) Value  ???
 Coupon (Interest) Rate
 Dividends
 Coupon Payment
 Dividend Payment
Frequency
Frequency
 Maturity: Original (Issue),  N/A
Remaining (Residual)
 Terms of Repayment:
 N/A
Bullet, Sinking Fund,
Zero-Coupon (Pure
 Common/Preferred
Discount)
 Call Provision (Option);  Rights (Warrants,
Convertibles)... See
other Rights;
Chapt. 19, Hybrid
Junior/Senior
Financing
Corporate Financial Management 1
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Bond Valuation
t
1
2
3
4
...
8
9
10
11
12
Ct
$ 80
$ 80
$ 80
$ 80
...
$ 80
$ 80
$ 80
$ 80
$1,080
r= 9%
PV
$ 73.39
$ 67.33
$ 61.77
$ 56.67
...
$ 40.15
$ 36.83
$ 33.79
$ 31.00
$ 383.98
$ 928.39
Corporate Financial Management 1
Problem 5-1
n
V 
t 0
Ct
1 r 
t
For bond w/semi-annual
coupons n=24, Ct=$40.
To put required return on
same basis as annual
bond, one should
assume EAR = 9% =
(1+rS)2 - 1, i.e. rS = \/1.09 1 = 4.4%.
22
Yield to Maturity/ Yield to Call (1)
Assume Johnson Co. has a bond with a
face value of $1,000 that matures in
12 years, has a coupon rate of 8%, and is
currently selling for $928.39. What is the
required return to buy the bond (YTM =
9.00%)?
Assume it can be called in 10 years at a
call price of $1,100. What would be the
required return to buy the bond if we knew
the option would be excercised (YTC =
9.79%)?
Corporate Financial Management 1
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Yield to Maturity/ Yield to Call (2)
Yield to Maturity= Promised Return
Yield to Call= Return if Called
N=12; PV=-928.39; PMT=80; FV=1,000 => I
(YTM) = 9.00%
N=10; FV=1,100 => I (YTC) = 9.79%
Expected Return= YTM minus Risk
Credit (Default) Risk <= Rating
Interest Rate Risk/ Reinvestment Risk
FX Risk, Liquidity Risk...
Corporate Financial Management 1
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Market Interest Rates/Yield Curve
4
3,5
3
2,5
r
2
1,5
1
0,5
0
0
2
4
6
8
10
12
t
Corporate Financial Management 1
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Stock Valuation
Problem
 Value a share which is expected to pay dividends
of $2.72 and $3.10, respectively, over the next two
years, and sold thereafter for $48, if the required
return is 10%?
 V=$2.72/(1.1)+$3.10/(1.1)2+$48/(1.1)2= $44.70
 But... How did I estimate the market price in 2
years?
 Let us assume constant dividends of $4.80 after
Year 2.
 Using perpetuity valuation: V2=$4.80/10%= $48
Corporate Financial Management 1
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Constant Growth Model
Dt = D0(1+g)t
V = D1/(r-g)
(... r > g)
e.g. V = $36(1.05)/(13%-5%) = $31.5
e.g. r = $1.30/$21.25 + 6% = 12.12%
CG formula can also be used for
determining a horizon (terminal) value or
for valuing declining growth stock.
For erratic or supernormal growth stock,
split cash flows into two parts.
Corporate Financial Management 1
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Risk and Return
Chapters 6, 7
Risk refers to the chance that some
unexpected event would occur.
In business, that would mean the decrease
of value of the firm, in financial markets
any change in the value of financial
instruments etc.
In other words, actual returns will differ
from expected returns.
The expected return should therefore
compensate an investor for the perceived
risk.
Corporate Financial Management 1
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Investments with Risk
Economy
Prob. T-Bill
Eq 1
Eq 2
Problem
Gold
Bond
Recession
0.10
5.0% -25.0% -15.0%
20.0% 10.0%
Below avg.
0.20
5.0
-5.0
-5.0
7.0
7.0
Average
0.40
5.0
15.0
10.0
0.0
6.0
Above avg.
0.20
5.0
25.0
20.0
-2.0
5.0
Boom
0.10
5.0
50.0
30.0
-10.0
2.0
1.00
Corporate Financial Management 1
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Expected Return
E(r) = Σwiri
E(rEQ1) = .10(-25%) + .20(-5%) +
.40(15%) + .20(25%) + .10(50%) =
12.5%
Eq 1 Eq 2 Bond T-bill Gold
E(r) 12.5% 8.5% 6%
5%
2%
Eq 1 has the highest expected return.
Is it the best investment?
Corporate Financial Management 1
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Stand-Alone Risk
σ = \/Σ(wi(ri-E(r))2
σEQ1 = \/[.10(-25-12.5)2 + .20(-5-12.5)2 +
.40(15-12.5)2 + .20(25-12.5)2 + .10(5012.5)2] = 19.4%
Volatility
σ
E(r)
T-bill Bond Gold Eq 2 Eq 1
0% 1.9% 7.5% 12.9% 19.4%
5%
6%
2% 8.5% 12.5%
Corporate Financial Management 1
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Probability Distributions
Prob.
T-bill
Eq
2
0
5
8.5
12.5
Corporate Financial Management 1
Eq
HT1
Actual Return (%)
32
Portfolio Risk (1)
Assume portfolio with 50% invested in
Eq 1, and 50% in Gold.
Economy
Recession
Below avg.
Average
Above avg.
Boom
Prob.
0.10
0.20
0.40
0.20
0.10
Eq 1
-25.0%
-5.0
15.0
25.0
50.0
Gold
20.0%
7.0
0.0
-2.0
-10.0
Port.
-2.5%
1.0
7.5
11.5
20.0
E(rP) = 7.25%
σP = 6.1%
Corporate Financial Management 1
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Portfolio Risk (2)
p (=6.1%) is much lower than:
either Eq 1 (19.4%) or Gold (7.5%).
average of Eq 1 and Gold (13.5%).
The portfolio offers a decent return
(average of Eq 1 and Gold returns) with
low risk.
The key is low (actually negative)
correlation between Eq 1 and Gold
returns, facilitating diversification.
Corporate Financial Management 1
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Managing Portfolio Risk
Systematic and Specific Risk [Law of
Large Numbers] (Insurance,
Consumer Credit)
Equilibrium Theories, e.g. Capital
Asset Pricing Model [Sharpe, Lintner]
(Equity Markets, Capital Investments)
Portfolio Theory [Markowitz] (Market
Portfolios), based on function
σP=ƒ(w1,w2,w3,..,σ1,σ2,σ3,..,ρ12, ρ13,
ρ23,..)
Corporate Financial Management 1
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Effect of Diversification
 (%)
Specific (Diversifiable)
Risk
35
Total Risk
20
Systematic Risk
0
10
20
30
Corporate Financial Management 1
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N
36
Capital Asset Pricing Model
In an efficient market, the required return
will equal the expected return.
efficient market => equilibrium price
transactional, informational efficiency
efficient market  arbitrage
An asset’s required return is the sum of
the riskless return and an asset-specific
risk premium.
Beta (β) is a measure of the asset’s market
(systematic, undiversifiable) risk.
SML: ri = rF + β(rM - rF)
Corporate Financial Management 1
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Beta as a Sensitivity Measure
ri = rF + β (rM - rF)
ri
β=1
0<β<1
rF
β=0
45°
Corporate Financial Management 1
rM
38
CAPM Utilization
Problem
Two shares (in the same market) with
known rF, βA, βB, rA, looking for rB.
rA = rF + βA (rM - rF)
rB = rF + βB (rM - rF)
14% = 6% + 1.4(rM-6%) => rM = 11.7%
rB = 6% + 1.1(11.7%-6%) = 12.3%
Note: The beta of a portfolio equals the
weighted average of its component
betas (VP bP = VA bA + VB bB + ...)
Corporate Financial Management 1
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Options
Chapter 8
Option = Right (Financial and Embedded
Options, i.e. Contracts) or Opportunity
(Real Options)
Financial options are traded contracts,
derivatives of Underlying Assets (Equities,
FX, Bonds, Commodities, Indices...)
Financial Derivatives include Options,
Warrants, Forwards, Futures, Swaps,
Repos...
Financial Derivatives are used primarily
for Risk Management (Hedging,
Speculation) ... See Chapt. 23
Corporate Financial Management 1
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Applications
Financial Options
American vs. European Options
Call vs. Put Options
Exotic Options (various terms of exercise,
caps, floors; exchange options, compound
options,...)
Embedded Options... Constitute Contracts
Real Options... In Business Decisions ...
See Chapts. 11,25
Corporate Financial Management 1
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The Value of Options
 Intrinsic Value (would the option be executed if
nothing changed till excercise date?) = ƒ(p; r; t)
...usually easy to assess; can be used for designing
option strategies
 Time Value = ƒ(t; ) ...calculated by means of models
(using market equilibrium assumption and replication)
Intrinsic Value (Call Option)
Total Value (Call Option)
V
V
out-of-the-money
in-the-money
S
p
at-the-money
Corporate Financial Management 1
p
Time Value
42
Using the Replication Principle
Call Option: S = $40, p = $32, d = $16 or u = $64 at
time t; rt = 2%.
d: Option out of the money, i.e. Vd = 0
u: Uption in the money, i.e. Vu = 64 - 40 = $24
 Income structure can be replicated with N forward
transactions. These must have zero value if
underlying asset costs $16, and must therefored
be issued with forward price F = $16. Their
present value is VF = p - F/(1+rt) = $16.31.
 Value of N forward transactions at settlement if
underlying asset costs u is Vu = N(u - F). To
replicate u = 64  Vu = 24, N = 24/(64-16) = 0.5.
 The option value is thus VC = 0.5×16.31 = $8,16.
Corporate Financial Management 1
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Numerical Model (Binomial, CRR)
 Call Option S = 1 100; p = 1 000; r = 5%; 4 periods
1 215,51 F = 1 100; N = 1
115,51 VF = 1157,63 - 1100e-0,25×5%
1 157,63
= 71,29
71,29
VC = N VF = 71,29
1 102,50
43,99
1 102,50
2,50
F = 1 000
N = (u - S)/(u - d) =
1 050,00
1 050,00
27,14
1,52
2,50/102,5 = 0,0244
1 000,00
1 000,00
1 000,00 V = 1050 - 1000e-0,25×5% =
F
16,74
0,93
0,00 62,42
952,38
952,38
VC = N VF = 1,52
0,56
0,00
907,03
0,00
907,03
0,00
863,84
0,00
N = 0 => VC = 0
Corporate Financial Management 1 822,70
0,00
44
Analytical Model (Black-Scholes)
VC = p N(d1) - S e-rt N(d2)
d1 = [ln(p/S) + (2/2) t] / ( t)
d2 = d1 -  t
p= $500; S= $510; r= 3%; t= 3months (=0,25);  =20%
d1 = [ln(500/510)+(0,04/2)×0,25]/(0,2×0,5) = -0,0730
d2 = -0,0730 - 0,2×0,5 = -0,1730
N(d1) = N(-0,0730) = 0,4709; N(d2) = N(-0,1730) = 0,4313
(cummulative distribution function for a standardised
normal random variable)
VC = 500×0,4709 - 510×e-20%×0,25×0,4313 = $17,12
VP = VC - p + Se-rt = 17,12-500+510×e-3%×0,25 = $23,31 (using putcall parity)
Corporate Financial Management 1
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Cost of Capital
Chapter 9
Cost of Capital = Required Return for
Capital Budgeting Project
2 possible approaches
Use CAPM
Firm Value = Equity Value + Debt
Value.
In a perfect market, a company cannot affect
its value by changing the way it is financed - it
just influences the distribution of risks and
returns between different classes of investors.
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Risk/Return of Real Assets
CAPM can be extended to include
real assets (i.e. capital budgeting
projects)
Pure Play Method (Finding singleproduct companies in the same line of
business as project being evaluated)
Accounting Beta Method (Regression
of return of assets against average
return on assets in the whole market)
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Weighted Average Cost of Capital
WACC = (1-L)re + L(1-T)rd
L = D/(D+E)
... Leverage
T
... Marginal Income tax Rate
Always based on opportunity, not
historical costs and values!
After-tax cost must be used for all
components!
Correct risk assumptions have to be
made for individual projects!
Corporate Financial Management 1
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WACC
Problems 9-4, 9-7
r = $3.6 / $70 = 5.14%
c = $3.6 / ($70×(1-5%)) = 5.41%
WACC = 30%×6%×(1-40%)+
5%×5.8%+ 65%×12% = 9.17%
Corporate Financial Management 1
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Component Cost of Equity
Ways to estimate required return:
DCF Method
CAPM Approach (b of equity, not project!)
Bond Yield + Risk Premium Method
Equity for new projects may come from
retained earnings or new issue.
New issues incur flotation costs. In this
case, the component cost of capital is
higher than required return.
Corporate Financial Management 1
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Application of DCF Method
QST stock is trading at $30 a share. QST
will pay a $3 dividend at the end of the
year and expects 5% annual growth. Costs
of flotation amount to 10%. What is the
required return and cost for new equity?
r = D1/V + g = $3/$30 + 5% = 15%
Vnet = V(1-F) = $30(1-10%) = $30×90% = $27
re = D1/[V(1-F)] + g = $3/[$30(1-10%)] + 5%
= 16.1%
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Risk, Leverage, Beta and WACC
Operating Leverage: influences rA, i.e. both
rE and rD <=> an increase in operating risk
increases bA and WACC.
Financial Leverage: in efficient markets, an
increase should increase bd, but leave bA and
WACC unchanged.
(1-TL)bA = L(1-T)bD + (1-L)bE (= portfolio)
Assuming low risk of debt, it is possible to
approximate bA = bE (1-L)/(1-TL)
... on Leverage more in Chapt. 15
Corporate Financial Management 1
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Distinguish Risks
Operating (Business) Risk (depends on
structure of firm’s assets, not structure of
financing) <= Operating Leverage
Financial Risk (based on firm’s capital
structure) <= Fin. Leverage
Profit
Shldr.
Return
Units Sold
Corporate Financial Management 1
L=0
L = 50%
Co.
Return
53
Basics of Capital Budgeting
Chapter 10
Generate ideas
Estimate the expected future cash flows
from the project.
Assess the risk and determine a required
return (cost of capital, hurdle rate, discount
rate).
Compute present value of cash flows; if
project has a positive NPV, it creates value
=> should be accepted.
Alt.: Find market price or compare with similar asset
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Types of Projects
Capital budgeting projects include:
New products and new businesses
Maintenance projects
Cost saving/ revenue enhancement
Capacity expansion
Projects required by regulation/ policy
Independent/Exclusive Projects
Conventional/Nonnormal Cash Flows
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Alternative Budgeting Measures
Net Present Value
Internal Rate of Return (=Expected Rtrn)
Profitability Index
Modified IRR (includes cost of capital)
Payback ... ignores time value of
money and cash flows beyond payback
Discounted Payback
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Investment Criteria
Problem
Year
0
1
2
3
4
CF
-70,000 30,000 30,000 30,000 20,000
DCF -70,000 27,273 24,793 22,539 13,660
PB = 2 + (10,000/30,000) = 2.3 years
DPB = 2 + (17,934/22,539) = 2.8 years
NPV = ΣDCF = $18.266
PI = ΣDCF[1-4] / |CF0| = 1.26
IRR = 22.24%
MIRR = (129,230/70,000)1/4 - 1 = 16.56%
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Issues
IRR brings same results as NPV with
independent and conventional projects
only
Unequal lives of exclusive projects, e.g.
replacement projects ... use common
horizon calculation or Equivalent Annual
Annuities (EAA = NPV[r(1+r)n/(1+r)n-1])
It is realistic to assume some kind of
capital budget constraint ... use artificially
high discount rate or capital rationing (e.g.
ranking by Profitability Index)
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Estimating Cash Flows
Chapter 11
Cash flow  income (includes e.g.
depreciation, ignores time value)
Measure on incremental (marginal)
basis
Only future expenditures/revenues
are relevant (avoid sunk costs)
Include taxes; not financing costs
(they are reflected in cost of capital)
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Types of Budgeting Cash Flows
Net Initial Investment Outlay
new assets purchase, old assets
sale, increase in net working capital
Net Operating Cash Flow
Nonoperating Cash Flows
overhauls, changes in working capital
Net Salvage (Termination) Value
Tax Adjustment (Capitalizing×Expensing)
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Est. Cash Flows
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Problems 11-1,2,3
61
Budgeting Cash Flows
Problem 11-9
NPV= - 7,160 + 2,000/1.15 + 2,384/1.152 + 1,968/1.13 +
1,744/1.154 + 1,712/1.155 + 3,232/1.156 = $921.36
Note: Different remaining lives, working capital investment
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Analyzing Risk
Market Risk
Measured by b (see CAPM) impacts
discount rate
Stand-Alone Risk
Break-even Analysis
Sensitivity Analysis
Scenario Analysis
Monte Carlo Simulation
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Simple Example
Project costs $100,000, expected sales 1,000
units, price $80/unit, cash op. exp.
$40/unit, 5-year life, fully amortized,
terminal value $10,000. Cap. cost 12%, tax
rate 25%. What is its NPV?
V = -I + [N×(P-U)×(1-T)+D×T][((1+r)n-1)
/r(1+r)n] + [F×(1-T)]/(1+r)5 = -100,000 +
[30,000+5,000]×3.60 + 7,500/1.76 = $ 30,423
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Break-even Analysis (Sales)
V = -I + [N×(P-U)×(1-T)+D×T]×3.60 + [F×(1T)]/(1+r)5
What N* would result in V = 0?
-I + [N*×(P-U)×(1-T)+D×T]×3.60 + [F×(1T)]/(1+r)5 = 0
N* = [(100,000-7,500/1,76)/3.60-5,000]/30 =
720 pcs.
i.e. the project breaks even at 720 units sold.
Usually easier to use numerical iteration.
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Sensitivity Analysis (Price)
V = -I + [N×(P-U)×(1-T)+D×T]×3.60 +
[F×(1-T)]/(1+r)5
V/P = [N×(1-T)]×3.60 = 750×3.60 =
$ 2,700
i.e. a price cut of $1 will result in a project
value decrease by $ 2,700.
Almost always easier to use numerical
simulation.
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Scenario Analysis (Sales, U.Cost)
Scenario
Unit
Sales
Unit
Cost
NPV
Worst
Case
850
Most
Likely
1,000
Best
Case
1,100
45
40
38
2,711
30,423
47,185
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Real Options
Flexibility to adjust plans based on newly
acquired information may increase NPV.
Growth/development options
Contraction/abandonment options
Investment timing options
Exchange options
Valuation methods:
Closed-form (analogy w/B-S)... rare
Decision trees
Monte Carlo
... further reading in Chapt. 25
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Financial Planning
Chapter 12
Pro-Forma Financial Statements
Forecast the amount of external
financing that will be required
Evaluate the impact that changes in
the operating plan have on the value
of the firm
Set appropriate targets for
compensation plans
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Steps in Financial Forecasting
Forecast sales
Project the assets needed to support
sales
Project internally generated funds
Project outside funds needed
Decide how to raise funds
See effects of plan on ratios and
stock price
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Additional Funds Needed
Problem
Cash
$360 Accts. pay.
$1,200
Accruals
600
Accounts rec.
2,400 S.-Term Loan
800
Inventory
1,800 Total CL
$2,600
Total CA
$4,560 L-T debt
1,000
Net FA
3,000 Equity
3,960
Total assets $7,560 Tot. liab.&eq. $7,560
Sales = $12,000; M = NI/Sales = 6%; P = D/NI =
25%.
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Key Assumptions
Operating at full capacity last year.
Each type of asset grows proportionally
with sales.
Payables and accruals (i.e. current
liabilities) grow proportionally with
sales.
Existing profit margin (6%) and payout
(25%) will be maintained.
Sales are expected to increase by $3
million. (%S = 25%)
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Graphical Illustration
Assets
Assets = 0.63 × Sales
9,450
7,560
0
Assets =
(A/S)×Sales
= 0.63($3,000)
= $1,890
12,000 15,000
Sales
A/S = $7,560/$12,000 = 0.63 = $9,450/$15,000
(i.e. Capital Intensity Ratio remains unchanged)
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Calculating AFN
AFN = Required Increase in Assets Spontaneous Increase in Liabilities Increase in Retained Earnings
AFN= A×(ΔS/S0)- L*×(ΔS/S0)- M×S1(1-P)
= $7,560×25% - $1,800×25% 6%×$15,000×75% = $1,890-$450-$675
= $765,000
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Projected Balance Sheet
Cash
$450 Accts. pay.
$1,500
Accruals
750
Accounts rec. 3,000 S.-Term Loan
1,565
Inventory
2,250 Total CL
$3,815
Total CA
$5,700 L-T debt
1,000
Net FA
3,750 Equity
4,635
Total assets $9,450 Tot. liab.&eq. $9,450
DR0=3,600/7,560=48%; DR1=4,815/9,450=51%
CR0=4,560/2,600=1.75; CR1=5,700/3,815=1.49
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Corp. Valuation & Governance
Chapter 13
 Corporate Valuation Model (×Dividend
Growth Model)
 Based on Free Cash Flow Estimation
(instead of dividends)
 Can be used when dividends are not paid
(e.g. startups, subunits of firm)
1. Estimate the Value of Operations
(discount FCF = NOPAT – Required Net
Operating Working Capital)
2. Add Value of Nonoperating Assets and
Growth Options
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Value Based Management
Value-based Management involves the
systematic use of the corporate valuation
model to evaluate a company‘s decisions.
Value drivers:
Growth rate of sales
Operating profitability (NOPAT/Sales)
Capital requirements (Operating
Capital/Sales)
WACC
Company creates value when EROIC (i.e.
NOPAT/Capital) > WACC
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Corporate Governance
 Shareholder wealth may be adversely influenced
by management behavior (agency problem)
 Corporate governance is a set of laws, rules and
procedures influencing managers in a way that
maximizes the firm‘s intrinsic value.
 Monitoring
 Litigation
 Threat of removal
 Compensation plans
 Hostile takeovers (avoid managerial
entrenchment)
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