1. Corporate Financial Theory
Lecture 1

2. Corporate Financial Theory
Introductions
Faculty
Students
Syllabus & Website
Tests
Homework (CONNECT)
Supplements

3. Course Goals Put meanings to words
Transform the complex into the simple
Make HBR readable
Make WSJ readable
Allow you to identify “BS”
Improve critical thinking skills

4. What is “Finance” Economics Theoretical Applied Economics
Microeconomics
Supply
Demand
Consumer
The Firm
Macroeconomics
Econometrics
Monetary Policy
Fiscal Policy
Classical Economics
Adam Smith
Karl Marx
John Keynes
Milton Friedman
Financial Economics ( “Finance” )
Capital
Markets
Investments
Corporate Finance
Asset
Valuation
Risk Management
Financial Institutions

5. Same Principles apply to all
What is “Finance”
Create value by…
Efficiently Allocating Resources which …
Grows the economic pie
Economic Level
Corporate Level
Individual Level
Same Principles apply to all
The Role of Finance in Society

6. We Must Grow The Economic Pie
What is “Finance”
We Must Grow The Economic Pie
Population
Unemployed
1970 = 203 mil
2007 = 301 mil
1970 = 4.1 mil
2007 = 7.1 mil
Employed
1970 = 78.6 mil
2007 = mil
86 %

7. Maximize the value of the firm
What is “Finance”
Goal of Finance
Maximize the value of the firm
Ethically

8. What is “Finance”
Finance
Accounting
Statistics
Economics
Accounting

9. What is “Finance” Finance uses … For purposes of … Finance is not …
Accounting data
Statistics
Economic principles
For purposes of …
Critical Thinking
Analysis
Decision making
Economics
Accounting
Statistics
Finance is not …
Math
Regurgitation

10. Critical Thinking & Analysis
Creativity
NOT Functional Fixation
Other
* Identifying relevant information
* Data interpretation
* NOT plug and chug

11. How to Teach Critical Thinking
DOES NOT WORK
TECHNIQUES
Memorization
Root practice
Pattern matching
Examples
Formulas
See numerous new situations
Learning via different methods
Non-repetitive practice
Review CONNECT

12. $100 (today) = $110 (next year)
Time Value of Money
Q: Which is greater?
$100 today or $110 next year
A: It Depends on Inflation.
Example
Bike Cost (today) = B0 = $100
Bike Cost (next year) = B1 = $110
B0 = B1
$100 (today) = $110 (next year)
100=

13. $100 (today) = $110 (next year)
Time Value of Money
Example
Bike Cost (today) = B0 = $100
Bike Cost (next year) = B1 = $110
B0 = B1
$100 (today) = $110 (next year)
100=

14. Time Value of Money
Modified formula for unknown time frame:

15. Net Present Value Example
Q:Suppose we can invest $50 today & receive $60 later today. What is our profit?
A: Profit = - $ $60
= $10

16. Net Present Value Example
Suppose we can invest $50 today and receive $60 in one year. Assuming 10% inflation, what is our profit?

17. Net Present Value For multiple periods we have the
Discounted Cash Flow (DCF) formula

18. Net Present Value Terminology C = Cash Flow t = time period
r = “discount rate” or “cost of capital”
Notes
C is not an accounting number
r is not inflation
r is the cost at which you can raise capital. The cost depends on the risk.

19. Net Present Value Example
If you can invest $50 today and get $60 in return one year from now. What is your profit? (assume you can borrow money at 12%)

20. Valuing an Office Building
Step 1: Forecast cash flows
Cost of building = C0 = 370,000
Sale price in Year 1 = C1 = 420,000
Step 2: Estimate opportunity cost of capital
If equally risky investments in the capital market
offer a return of 5%, then
Cost of capital = r = 5%

21. Valuing an Office Building
Step 3: Discount future cash flows
Step 4: Go ahead if PV of payoff exceeds investment

22. Net Present Value

23. Risk and Present Value
Higher risk projects require a higher rate of return
Higher required rates of return cause lower PVs

24. Risk and Present Value

25. Risk and Net Present Value

26. Decision Time

27. Net Present Value Rule
Accept ALL investments that have positive net present value
Example
Suppose we can invest $50 today and receive $60 in one year. Should we accept the project given a 10% expected return?

28. Net Present Value Rule
Accept ALL investments that have positive net present value
Example
Suppose we can invest $50 today and receive $60 in one year. Should we accept the project given a 25% expected return?

29. Rate of Return Rule
Accept investments that offer rates of return in excess of their opportunity cost of capital
Example
In the project listed below, the foregone investment opportunity is 12%. Should we do the project?

30. Additivity Principle Good Company Bad Company Project NPV A $ 12 mil B
Total Value .….
$ 45 mil
Project
NPV A
$ 12 mil B
$ 28 mil C
- $ 5 mil
Total Value ….
$ 35 mil
Project
NPV A
$ 12 mil B
$ 28 mil
C (discontinue)
Total Value ….
$ 40 mil
Stop negative
NPV Project

31. Short Cuts
Sometimes there are shortcuts that make it very easy to calculate the present value of an asset that pays off in different periods. These tools allow us to cut through the calculations quickly.

32. Short Cuts
Perpetuity
Constant Growth Perpetuity
Annuity

33. Short Cuts
Perpetuity - Financial concept in which a cash flow is theoretically received forever.

34. Present Values Example
What is the present value of $1.2 billion every year, for all eternity, if you estimate the perpetual discount rate to be 8%??

35. Present Values Example
Tiburon Autos offers you “easy payments” of $5,000 per year, at the end of each year for 5 years. If interest rates are 7%, per year, what is the cost of the car?
5,000
5,000
5,000
5,000
5,000
Year
Present Value at year 0

36. Short Cuts
Annuity - An asset that pays a fixed sum each year for a specified number of years.

37. Annuity Short Cut Example
You agree to lease a car for 4 years at $300 per month. You are not required to pay any money up front or at the end of your agreement. If your opportunity cost of capital is 0.5% per month, what is the cost of the lease?

38. Annuity Short Cut Example - continued
You agree to lease a car for 4 years at $300 per month. You are not required to pay any money up front or at the end of your agreement. If your opportunity cost of capital is 0.5% per month, what is the cost of the lease?

39. Annuity Short Cut Example
The state lottery advertises a jackpot prize of $295.7 million, paid in 25 installments over 25 years of $ million per year, at the end of each year. If interest rates are 5.9% what is the true value of the lottery prize?

40. Constant Growth Perpetuity
g = the annual growth rate of the cash flow

41. Constant Growth Perpetuity
NOTE: This formula can be used to value a perpetuity at any point in time.

42. Constant Growth Perpetuity
Example
What is the present value of $1 billion paid at the end of every year in perpetuity, assuming a rate of return of 10% and a constant growth rate of 4%?

43. Opportunity Cost of Capital
How much “return” do you EXPECT to earn on your money?

44. Opportunity Cost of Capital
Example
You may invest $100,000 today. Depending on the state of the economy, you may get one of three possible cash payoffs:

45. Opportunity Cost of Capital
Example - continued
The stock is trading for $ Next year’s price, given a normal economy, is forecast at $110
The stocks expected payoff leads to an expected return.

46. Opportunity Cost of Capital
Example - continued
Discounting the expected payoff at the expected return leads to the PV of the project
NPV requires the subtraction of the initial investment

47. Internal Rate of Return Rule
Example - continued
Accept the project only if the expected return exceeds the opportunity cost of capital

48. Internal Rate of Return
IRR is related to Opportunity Cost of Capital
Pay Attention to Math

49. Internal Rate of Return
Example
You can purchase a turbo powered machine tool gadget for $4,000. The investment will generate $2,000 and $4,000 in cash flows for two years, respectively. What is the IRR on this investment?

50. Internal Rate of Return
Example
You can purchase a turbo powered machine tool gadget for $4,000. The investment will generate $2,000 and $4,000 in cash flows for two years, respectively. What is the IRR on this investment?

51. Internal Rate of Return
IRR=28%

52. Internal Rate of Return
Pitfall 1 - Lending or Borrowing?
Pitfall 2 - Multiple Rates of Return
Pitfall 3 - Mutually Exclusive Projects
Pitfall 4 - Term Structure Assumption

53. Application of PV, NPV, DCF
Value bonds
Value stocks
Value projects (Capital Budgeting)
Value companies (M&A)
Value Capital Structure (debt vs. equity)

54. Valuing Common Stocks
Return Measurements

55. Valuing Common Stocks
If we forecast no growth, and plan to hold out stock indefinitely, we will then value the stock as a PERPETUITY.
Assumes all earnings are paid to shareholders.

56. Valuing Common Stocks
Capitalization Rate can be estimated using the perpetuity formula, given minor algebraic manipulation.

57. Valuing Common Stocks
Dividend Discount Model - Computation of today’s stock price which states that share value equals the present value of all expected future dividends.
H - Time horizon for your investment.

58. Valuing Common Stocks Example
Current forecasts are for XYZ Company to pay dividends of $3, $3.24, and $3.50 over the next three years, respectively. At the end of three years you anticipate selling your stock at a market price of $ What is the price of the stock given a 12% expected return?

59. Valuing Common Stocks Example
Current forecasts are for XYZ Company to pay dividends of $3, $3.24, and $3.50 over the next three years, respectively. At the end of three years you anticipate selling your stock at a market price of $ What is the price of the stock given a 12% expected return?

60. Valuing Common Stocks Example
If a stock is selling for $100 in the stock market, what might the market be assuming about the growth in dividends?
Answer
The market is assuming the dividend will grow at 9% per year, indefinitely.

61. Valuing Common Stocks
If a firm elects to pay a lower dividend, and reinvest the funds, the stock price may increase because future dividends may be higher.
Payout Ratio - Fraction of earnings paid out as dividends
Plowback Ratio - Fraction of earnings retained by the firm.

62. Valuing Common Stocks
Growth can be derived from applying the return on equity to the percentage of earnings plowed back into operations.
g = return on equity X plowback ratio

63. Valuing Common Stocks Example
Our company forecasts to pay a $8.33 dividend next year, which represents 100% of its earnings. This will provide investors with a 15% expected return. Instead, we decide to plowback 40% of the earnings at the firm’s current return on equity of 25%. What is the value of the stock before and after the plowback decision?

64. Valuing Common Stocks No Growth With Growth Example
Our company forecasts to pay a $8.33 dividend next year, which represents 100% of its earnings. This will provide investors with a 15% expected return. Instead, we decide to plowback 40% of the earnings at the firm’s current return on equity of 25%. What is the value of the stock before and after the plowback decision?
No Growth
With Growth

65. Valuing Common Stocks Example - continued
If the company did not plowback some earnings, the stock price would remain at $ With the plowback, the price rose to $
The difference between these two numbers is called the Present Value of Growth Opportunities (PVGO).

66. Valuing Common Stocks
Present Value of Growth Opportunities (PVGO) - Net present value of a firm’s future investments.
Sustainable Growth Rate - Steady rate at which a firm can grow: plowback ratio X return on equity.
Constant Growth DDM - A version of the dividend growth model in which dividends grow at a constant rate (Gordon Growth Model).

67. * FCF and PV *
Free Cash Flows (FCF) should be the theoretical basis for all PV calculations.
FCF is a more accurate measurement of PV than either Div or EPS.
The market price does not always reflect the PV of FCF.
When valuing a business for purchase, always use FCF.

68. Valuing a Business Valuing a Business or Project
The value of a business or Project is usually computed as the discounted value of FCF out to a valuation horizon (H).
The valuation horizon is sometimes called the terminal value and is calculated like PVGO.

69. Valuing a Business Valuing a Business or Project PV (free cash flows)
PV (horizon value)

70. Valuing a Business Example
Given the cash flows for Concatenator Manufacturing Division, calculate the PV of near term cash flows, PV (horizon value), and the total value of the firm. r=10% and g= 6%

71. Valuing a Business Example - continued
Given the cash flows for Concatenator Manufacturing Division, calculate the PV of near term cash flows, PV (horizon value), and the total value of the firm. r=10% and g= 6%

72. Valuing a Business Example continued
Given the cash flows for Concatenator Manufacturing Division, calculate the PV of near-term cash flows, PV (horizon value), and the total value of the firm when r = 10% and g = 6%.

73. Alternatives to NPV Payback Method Average Return on Book Value
Internal Rate of Return
Equivalent Annual Annuity
Profitability Index

74. CFO Decision Tools
Survey Data on CFO Use of Investment Evaluation Techniques
SOURCE: Graham and Harvey, “The Theory and Practice of Finance: Evidence from the Field,” Journal of Financial Economics 61 (2001), pp

75. Book Rate of Return
Book Rate of Return - Average income divided by average book value over project life. Also called accounting rate of return.
Managers rarely use this measurement to make decisions. The components reflect tax and accounting figures, not market values or cash flows.

76. Payback
The payback period of a project is the number of years it takes before the cumulative forecasted cash flow equals the initial outlay.
The payback rule says only accept projects that “payback” in the desired time frame.
This method is flawed, primarily because it ignores later year cash flows and the the present value of future cash flows.

77. Payback
Example
Examine the three projects and note the mistake we would make if we insisted on only taking projects with a payback period of 2 years or less.

78. Payback
Example
Examine the three projects and note the mistake we would make if we insisted on only taking projects with a payback period of 2 years or less.

79. Problems with CB & NPV 1 – Determine relevant cash flows
2 - Cash flows not guaranteed
3 - Projects with different lives
Timing
Equivalent annual annuity (cost)
Profitability Index
Linear Programming

80. Equivalent Annuities Proj 0 1 2 3 4 NPV Eq. Ann. A -15 4.9 5.2 5.9 6.2B
assume 9% discount rate

81. Equivalent Annuities Proj 0 1 2 3 4 NPV Eq. Ann.B
assume 9% discount rate

82. Equivalent Annuities Proj 0 1 2 3 4 NPV Eq. Ann.B
assume 9% discount rate

83. Profitability Index
When resources are limited, the profitability index (PI) provides a tool for selecting among various project combinations and alternatives
A set of limited resources and projects can yield various combinations.
The highest weighted average PI can indicate which projects to select.

84. Profitability Index
Cash Flows ($ millions)

85. Profitability Index
Cash Flows ($ millions)

86. Profitability Index Example
We only have $300,000 to invest. Which do we select?
Proj NPV Investment PI
A 230, ,
B 141, ,
C 194, ,
D 162, ,

87. Profitability Index Select projects with highest Weighted Average P.I.
Example - continued
Proj NPV Investment PI
A 230, ,
B 141, ,
C 194, ,
D 162, ,
Select projects with highest Weighted Average P.I.
𝑊𝐴𝑃𝐼 𝐵𝐷 =1.13× × ×
=1.01

88. Profitability Index Select projects with highest Weighted Average P.I.
Example - continued
Proj NPV Investment PI
A 230, ,
B 141, ,
C 194, ,
D 162, ,
Select projects with highest Weighted Average P.I.
WAPI (BD) = 1.01
WAPI (A) = 0.77
WAPI (BC) = 1.12

89. Linear Programming Maximize Cash flows or NPV Minimize costs
Example
Max NPV = 21Xn + 16 Xb + 12 Xc + 13 Xd
subject to
10Xa + 5Xb + 5Xc + 0Xd <= 10
-30Xa - 5Xb - 5Xc + 40Xd <= 12

90. Capital Budgeting Rules
Valuing a project = capital budgeting
4 Rules of Capital Budgeting
1 - Consider all cash flows
2 - Discount all CF at opportunity cost of capital
3 - Select project that maximizes shareholder wealth
4 - Must consider projects independent of each other = “Additivity Principle”
NPV is used to evaluate projects because its satisfies all rules

91. Capital Budgeting Rules
Only Cash Flow is Relevant

92. Capital Budgeting Rules
Points to “Watch Out For”
Do not confuse average with incremental payoff
Include all incidental effects
Do not forget working capital requirements
Forget sunk costs
Include opportunity costs
Beware of allocated overhead costs

93. Capital Budgeting Rules
INFLATION RULE
Be consistent in how you handle inflation!!
Use nominal interest rates to discount nominal cash flows.
Use real interest rates to discount real cash flows.
You will get the same results, whether you use nominal or real figures 12