CORPORATE FINANCE – PART 1

Prof. Jos van BOMMEL

CLASS 1: INTRODUCTION
Course objectives:
• Become familiar with financial statements.
• Understand how firms make investment decisions.
• Describe the basic sources of finance and companies’ interactions with financial markets

Bibliography:
Brealey, A.R., Myers C.S., Marcus, J.A. (2020) Fundamentals of Corporate Finance.
10th edition, McGraw Hill

Assessment:
• Continuous Assessment – class participation, quizzes, assignments (50%)
• Written Exam (50%)
But: you need a passing mark for both components!

Class plan:
Week 1: Goals and Governance of the firm; Financial Markets and Institutions; Accounting and Finance
Read: Chapter 1 until 1.5; Chapter 2; Chapter 3 until 3.3.

Week 2: Accounting and Finance; Measuring Corporate Performance

Read: Chapter 4.

Week 3: Time Value of Money; Valuing Bonds

Read: Chapters 5 and 6.

Week 4: Valuing stocks

Read: Chapter 7.

Week 5: Capital Budgeting

Read: Chapters 8 and 9.

Week 6: Capital Budgeting, continued

Read: Chapter 10.

Week 7: The Cost of Capital

Read: Chapters 11, 12, 13.

Week 8: Sources of Finance

Read: Chapters 14 and 15.

Week 9: Capital Structure

Read: Chapters 16 and 17.
 08/10/2021

CHAPTER 1: GOALS AND GOVERNANCE OF THE CORPORATION

Summary:
1.1 Investment and Financing Decisions
1.2 What is a Corporation?
1.3 Who Is the Financial Manager?
1.4 Goals of the Corporation
1.5 Agency Problems, Executive Compensation, and Corporate Governance

1.1 Investment and Financing Decisions

Capital Budgeting Decision:

• Decision to invest in:
• tangible assets (for an airline to purchase new planes) or
• intangible assets ()
…also called:
• Investment Decision
• Capital Expenditure (CAPEX) decision

Financing Decision:
• Decision on the sources and amounts of financing (where do we get the money from?)
Capital Structure:
• The mix of debt and equity
financing

Real Assets:
– Assets used to produce goods and services (can be tangible, or intangible)
Financial Assets:
– Financial claims to the income generated by the firm’s real assets – if traded “securities”
Are the following capital budgeting or financing decisions?
a. Intel decides to spend $7 billion to develop a new microprocessor
b. BMW borrows 350 million euros (€350 million) from Deutsche Bank
c. Royal Dutch Shell constructs a pipeline to bring natural gas onshore from a production platform in
Australia
d. Avon spends €200 million to launch a new range of cosmetics in European markets
e. Pfizer issues new shares to buy a small biotech company

Are the following real assets or financial assets? → confirm answers!

a. A patent → real asset (intangible)
b. A share of preferred stock of BMW → financial asset
c. A Blast Furnace of Arcelor Mittal → real asset (tangible)
d. A mortgage loan taken out to buy a new home → financial asset
e. A brand, built by advertising and design → real asset (intangible)
f. An IOU (I Owe You) from your uncle → financial asset
g. Knowledge of Finance → real asset (intangible)
h. A share of stock → financial asset
i. A trademark → real asset (intangible)
j. A truck → real asset (tangible)
j. Undeveloped land → real asset (tangible)
k. The balance in the firm’s checking account → financial asset
l. An experienced and hardworking sales force → real asset (intangible)
m. A bank loan agreement → financial asset

1.2 What is a Corporation?

Corporation:
– A business organized as a separate legal entity (it can contract, employ, buy, sell, sue) owned by
shareholders, who have limited liability.

Pros and Cons of “incorporation”:

+ Limited Liability
- Strict regulation, costly governance and administration
- (double) taxation
+ Continuity, infinite life
+ more sources of finance

Types of Business Organizations:

• Sole Proprietorships
• Partnerships
• Limited Liability
Partnerships
◦ LLP (or LLC), Ltd,
SaRL, GmbH, BV
• Corporations
◦ Corp. (or Inc.), S.A.,
Plc, AG, NV, SpA
Sole proprietorship and Partnerships:
• Unlimited liability
• Personal tax on profits

Corporations:
• Limited liability
• Corporate tax on profits + personal tax on dividends

LLC,Ltd / SaRL / GmbH:

• Lower taxation (not always), but still “double”
• Less regulation, fewer constraints (on capital)
• “Privately held” shares are illiquid

Corp.,plc / S.A. / AG:

• Anonymous shareholders
• Listed on the stock market
• Lower ‘cost of capital’
• Easier to raise money (sell additional shares)
• More regulated – Annual audited reports

1.3 Who Is the Financial Manager?

Chief Financial Officer (CFO):

– Responsible for financial policy and corporate
planning
Treasurer:
– Responsible for cash management, raising of capital
and banking relationships
Controller:
– Responsible for preparation of financial statements,
accounting and taxes
Below the CFO are usually a treasurer and a controller. The treasurer looks after the firm’s cash, raises new
capital and maintains relationships with banks and other investor’s that hold the firm’s securities. The
controller prepares the financial statements, manages the firm’s internal budgets and accounting and looks
after its tax affairs.

(2) Cash invested in firm (1) Cash raised from investors

(3) Cash generated by operations (4a) Cash reinvested
(4b) Cash returned to investors
1.4 Goals of the Corporation

• Shareholders desire wealth maximization

• Corporations should maximize market value
• Profit maximization?
◦ Maximize profits? Which year’s profits?
◦ Earnings manipulation
• Opportunity cost of capital:
◦ The minimum acceptable rate of return on capital investment is set by the investment
opportunities available to shareholders in financial markets

The Investment Trade-Off → Opportunity Cost of Capital:

1.5 Agency Problems, Executive Compensation, and Corporate Governance

• Do managers maximize shareholder wealth or manager wealth?

• Managers are the ‘agents’ of the shareholders, the ‘principal’. They have conflicting interests. (??)
• Managers deal with other “stakeholders” → actors that have a part in the firm and therefore care
about it.
• Stakeholder: anyone with a financial interest in the corporation, such as : suppliers (want to get paid),
clients (want a good service), employees, investors, the government (the firm pays taxes, local
employment), banks.

Agency problem:
– Managers are agents for shareholders and are tempted to act in their own interests rather than maximizing
market value

Agency costs:
– Value lost from agency problems or from the cost of mitigating such agency problems
– Examples? Wirecard went bankrupt because the manager stole from the company.

Ownership vs. Management:

How can we reduce Agency Costs?
Corporate governance:
– The laws, regulations, institutions, and corporate practices that protect shareholders and other investors

Elements of good corporate governance:

1. Legal requirements
2. Incentive schemes – if they reach a goal they get a reward, usually stock option
3. Board of directors – the ultimate representatives of the shareholders (voted by the shareholders and they
can choose and fire the CEO)
4. Activist shareholders – shareholders that protest
5. Takeovers
6. Information for investors

Ethics of Maximizing Value

Is it ethical to maximize shareholder value?

“It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from
their regard to their own interest. We address ourselves, not to their humanity but to their self-love, and
never talk to them of our own necessities but of their advantages.” Adam Smith, 1776

Does value maximization justify unethical behavior?

• Volkswagen
• Charles Ponzi
• Bernard Madoff

Is it ethical?
• Short selling
• Corporate raiders
• Tax avoidance
 CHAPTER 2: FINANCIAL MARKETS AND INSTITUTIONS

Summary:
2.1 The Importance of Financial Markets and Institutions
2.2 The Flow of Savings to Corporations
2.3 Functions of Financial Markets and Intermediaries
2.4 The Crisis of 2007-2009

2.1 The Importance of Financial Markets

Businesses have to go to financial markets and institutions for the financing they need to grow:
• Financing Decision
◦ Source of Funds (“Capital”)
◦ Capital Structure
• Investing Decision
◦ What is the Cost of Capital?

2.2 The Flow of Savings to Corporations

Financial Markets : stock markets, fixed-income markets, money markets

Financial Institutions: commercial and investment banks and insurance companies
Financial intermediaries: mutual and pension funds, finance and investment companiesThe financial
markets and intermediaries help bring together those who have money (lenders/investors) and those who
need money (borrowers – individuals or businesses).
Primary market transactions is when a company issues securities.
Secondary market transactions is when a bond holder sells his bond - traded between investors.
The primary bond market is bigger, because
companies need capital often and they issue
bonds much more often than they issue
equity, because bonds expire and stocks don't.
People don't buy and sell bonds so often, they
usually only sell them at maturity, that's why
the secondary bond market is not so big.
On the other hand, the secondary share
market is bigger, because people buy/sell
shares often, but companies don't issue equity
all the time.
OTC = Over The Counter Markets → when a
bank makes a tailored made security for an
investor.
Financial Market
– Market where securities are issued and traded
Primary Market
– Market for the sale of new securities by corporations
Secondary Market
– Market in which previously issued securities are traded among investors

• Fixed-income market : market for debt securities – it’s a type of investment security that pay
investors fixed interest or dividend payments until its maturity date. At maturity, investors are repaid
the principal amount they had invested. [Investopedia]
◦ Examples: government and corporate bonds
• Capital market: refers to long-term debt and equity instruments
◦ Examples: common and preferred stocks, corporate bonds, treasury bond
• Money Market: refers to debt instruments with maturity of one year or less
◦ Examples: treasury bills (T-bills), commercial paper

Foreign exchange markets → Chapter 22

Commodities markets → Chapter 24
Markets for options and other derivatives → Chapters 23 and 24
Financial Intermediary
– An organization that raises money from investors and provides financing for individuals, companies, and
other organizations, and invests these in financial assets.
– Examples: finance and investment companies, mutual funds, hedge funds and private equity companies

Financial Institution
– A bank, insurance company, or similar financial intermediary

Mutual Fund
– An investment company that pools the savings of many investors and invests in a portfolio of securities.
– It’s professionally managed according to a stated investment objective.
– Individuals can invest in mutual funds by buying shares in mutual fund at the net asset value (NAV).
– NAV is calculated daily based on the total value of the fund divided by the number of mutual fund shares
outstanding.

Hedge Fund
– A private investment pool, open to wealthy or institutional investors, that is only lightly regulated and
therefore can pursue more speculative policies than mutual funds
– Similar to mutual funds, but tend to take more risk and are generally open only to high net worth investors.

Private Equity Firms

Private equity firms include two major groups:
– Venture Capital firms raise money from investors (wealthy individuals and other financial institutions)
that they then use to provide financing for private start-up companies when they are first founded.
– Leveraged Buyout firms (LBOs) acquire established firms that typically have not been performing very
well with the objective of making them profitable again and selling them. An LBO typically uses debt to
fund the purchase of a firm.

Pension Fund
– Fund set up by an employer to provide for employees’ retirement

The company issues obligations to financial

intermediaries in exchange for funds, then the
intermediaries themselves offer the obligations to
investors in exchange of funds.
2.3 Functions of Financial Markets
• Channel Savings to real Investments
• Transporting cash across time
• Risk transfer and diversification
• Liquidity
• Payment mechanism
• Provide information

Information Provided by Financial Markets:

Commodity prices (also future prices)
Interest rates → they set the benchmark on whether we should invest or not (it’s the safe rate)
Cost of Capital → it’s a very important information provided by the financial markets.
Company Values → how much is a company worth

Interest rates on long-term corporate bonds, March 2016:

The higher the credit rating, the less risky the investment, and therefore the
interest rates are lower.
The lower the credit rating, the riskier the investment and as a consequence
the higher the interest rate → recompense for the extra risk taken

What is Cost of Capital?

Cost of capital represents the return a company needs to achieve in order to justify the cost of a capital
project, such as purchasing new equipment or constructing a new building.
Cost of capital encompasses the cost of both equity and debt, weighted according to the company's preferred
or existing capital structure. This is known as the weighted average cost of capital (WACC).
A company's investment decisions for new projects should always generate a return that exceeds the firm's
cost of the capital used to finance the project. Otherwise, the project will not generate a return for investors.
https://www.investopedia.com/terms/c/costofcapital.asp

2.4. The crisis of 2007-2008

• Easy money → it started with a period when it was very easy to borrow money, so many people did
it and invested.
• Subprime mortgages
• Mortgage backed securities (MBS) → it’s a market for mortgages, where they sell mortgages to
banks and insurance companies. They started making money from this, so they started to issue
mortgages even to people that couldn’t afford it.
• Lehman Brothers → they started to package mortgages that were too risky and went bankrupt
• Greece (sovereign debt crisis)
• Covid crisis …
Lessons one can take from this:
➢ “There is no such thing as a free lunch.”
➢ “If it’s too good to be true, then it isn’t true.”
Movie to watch on this: The Big Short

Bull and Bear markets:

• Markets are run by human beings
• And hence are “irrational”
• Period of greed are followed by periods of fear

Quiz (true/false) → CHECK ANSWERS

1. Previously issued securities are traded among investors in the secondary markets. → TRUE
2. Hedge fund managers, unlike mutual fund managers, do not receive fund-performance-related fees. →
FALSE
3. The markets for long-term debt and equity are called capital markets. → TRUE
And markets for short-term debt are called money markets
4. A financial intermediary invests in financial assets rather than real assets. → TRUE
5. Financial markets and intermediaries allow investors and businesses to reduce and reallocate risk. →
TRUE
6. Once Apple Computer had become a public company, it was able to raise financing from venture capital
companies. → FALSE
7. The cost of capital is the interest rate paid on a loan from a bank or some other financial institution. →
FALSE
8. The cost of capital is the minimum acceptable rate of return for capital investment. → TRUE
 CHAPTER 3: ACCOUNTING AND FINANCE

Summary:
3.0 Introduction
3.1 The Balance Sheet
3.2 The Income Statement
3.3 The Statement of Cash Flows
3.4 Accounting Practice and Malpractice

3.0 Introduction

► The Balance Sheet

Financial Accounting
The accounting equation: Assets = Liabilities + Owner's Equity
Assets – Liabilities = Equity
Assets = what the company owns
Liabilities = what the company owes
What the company owns – what company owes = what the owners (shareholders) own
In other words: Total Assets – Total Liabilities = Equity
This gives the Statement of Financial Position, better known as the Balance Sheet.

Owner’s Equity is also known as (a..k.a.):

• Capital and Reserves
• Net Worth
• (Shareholder’s) Surplus

Balance Sheet equation in French? Bilan: Actif = Passif + Capitaux Propres

Balance Sheet equation in German? Bilanz = Aktivseite – Passivseite
Vermögen = Fremdkapital + Eigenkapital

► The Income Statement

The Income Equation : Income = Revenues – Costs
Revenues – Cost = Income = Sales – Expenses = Profit

Synonyms:
Income = Earnings = Profit
Revenues = Sales = Turnover
Costs = Expenses
Operating income = EBIT
Income Statement = P+L = Profit and Loss
Gross Profit = Gross Margin (UK)
Differences between European and American financial statements :

The Balance Sheet above is American and there are some differences comparing with the European ones
regarding the names and order of the data.
Inventory is called stocks in the UK.
Prepaid expense is something you pay for in advance and have the right to use, for example a prepaid rent.
Accumulated depreciation is the loss of value of a fixed asset, which is recognized in the Balance Sheet →
it’s always a negative number on the asset side, and we can call it a “counter-asset”.
Intangible assets are usually not in the Balance Sheet, because it’s hard to know the true value of a brand, for
example. But if you know the value it can appear in the BS, like if you bought a research, a brand or data.
Accounts payable is what you owe to the suppliers.
Notes payable is a loan, or a short-term debt.
Accrued expenses is something that you know you owe, you recognize a debt, but you didn’t receive the bill
yet, like a heating bill, for example.
Deferred revenue is a short-term liability, when you owe something to your clients. The airline industry has
a lot of this, because the clients usually pay in advance and the airline owes the client a flight, and only after
the flight this can be booked as a revenue.
A long-term debt is a loan from the bank or bonds outstanding.
Everything that is in the Shareholders’ Equity belongs to the shareholders.
Additional paid-in capital is a contributed capital, something the shareholders physically put into the
company.
Retained Earnings is what the company earned but has not yet taken out, like a profit that has accumulated
over time and was not distributed, but was reinvested into the company.
What differences do you see with the Balance Sheet on the previous page?
(U.S. vs. UK/Europe)

The Balance Sheet on the right is an European example.

Contrary to the US, the European Balance Sheets start with the
fixed assets and then go to current assets.
Stocks ~ Inventory
Debtors ~Accounts receivable
Prepayments ~ Prepaid Expenses
Cash in hand + Bank account = Cash
Trade creditors ~ Accounts payable
Bank overdraft is a negative cash, so they owe a short-term
bank loan
VAT + Corporate tax ~ Taxes payable
Accruals ~ Accrued expenses
Profit and Loss account ~ Retained Earnings

Income = Earnings = Profit

Revenues = Sales = Turnover
Costs = Expenses
Income Statement = P+L = Profit and Loss

Sales = Revenues
Cost of goods sold (how much it costs to produce them)
Gross profit (how much profit was made with the sale)
Gross Profit = Gross Margin (UK)
Operating expenses are the expenses necessary for all the
work in the company. Depreciation is another expense,
because it’s a loss of value.
Operating income = Operating profit = Gross profit =
EBIT (Earnings Before Interest and Taxes)
Net Income = Earnings after interests and taxes
Income Statement = P+L = Profit and Loss

The I/S also reports “in between steps” → What ‘in between
steps’ do you see? It’s gross profit and operating
profit/income which are the values before the taxes.
 15/10/2021
CLASS 2 – 3.1 THE BALANCE SHEET

Definition: the Balance Sheet is a financial statement that shows the value of the firm’s assets and liabilities
at a particular time. It has a date and contains “snapshot” values.

Accounting principles: Reliability, Conservativeness.

Because of these accounting principles we don’t see some assets on the BS, such as reputation or skills or
knowledge. Even though they are real assets, we cannot reliably estimate their value. The moto of the
accountants is: “When in doubt, leave it out”.
Another example of conservativeness is the fact that we try to estimate the depreciation, that is the loss of
values of the assets. But for example if we bought something for $100, that now costs $200, we leave the
first price on the BS. On the other hand, if the price goes down and it now costs $50, we put the new value
on the BS. So the rule is to put always the lowest price possible. “The Balance Sheet always shows the
lowest cost and realizable value”.

The Main Balance Sheet Items:

The book that we use in this course is that we start with the most liquid assets and then go to the most
permanent ones, because it’s an American book. But in the European countries it’s usually the opposite.
Common-Size Balance Sheet : all items in the balance sheet are expressed as a percentage of total assets

Home Depot’s Balance Sheet (on December 31, 2017):

In this BS, the intangible asset "goodwill" is something like the reputation the company has with their
clients. You only put this sort of thing in the BS if you actually paid for it.
The Basic Accounting Model

Book Values and Market Values

Book Values: value of assets or liabilities according to the balance sheet
Market Values : value of assets or liabilities were they to be resold in a market
Equity and asset “market values” are often (not always!) higher than their “book values”
→ Why? Because of the expected profits, since the market value depends on the future and not so much in
the past like the book values.
Generally Accepted Accounting Principles (GAAP): procedures for preparing financial statements in the
US → it’s super conservative
International Financial Reporting Standards (IFRS): required in 140 other countries → it’s less
conservative and tries to reflect a little more the market value. More and more countries are starting to use it.

Example:
According to GAAP, your firm has equity worth $6 billion, debt worth $4 billion, assets worth $10 billion.
The market values your firm’s 100 million shares at $75 per share and the debt at $4 billion.
The market value of the equity can be very different from the book values. On the other hand, the market
value of the debt tends to be worth the same as the book values.
Q: What is the market value of your assets?
A: The equity market value is worth the value of the shares multiplied by the total amount of shares, so: $75
x 100 million = $7.5 billion
Since (Assets = Liabilities + Equity), your assets must have a market value of :
$7.5 billion + 4 billion = $11.5 billion

“Finance looks at the future and Accounting looks at the past.”

3.2 The Income Statement

Definition: Financial statement that shows the revenues, expenses, and net income of a firm over a period
of time. The Income Statement has flow-values.

Accounting principles: Reliability, Conservativeness,

“Time period principle” (flow-values need to correspond to the time period)
“Matching principle” (need to match with each other (i.e. Revenues with Costs))
“Accrual principle” (recognize changes in value, not just cashflows)

Home Depot’s Income Statement (year ending December 31, 2017):

The important role of the income statement is to show the EBIT, because it gives a measure of the profits by
operations and it does not say anything as to how the profit is distributed between the taxman, the bond
holders and shareholders.

Earnings Before Interest and Taxes (EBIT) a.k.a. “Operating Profit”

= total revenues + other income – costs – depreciation
= 100,904 + 325 – (66,547 + 17,864) – 2,062 = $ 14,755 million

French: “Résultat Opérationnel” or “Bénéfice d’exploitation”

German: “Operativesergebnis, Betriebsgewinn, Geschäftsergebnis, Konzernerfolg etc.
Operatives-, Betriebs-, Geschäfts-, Konzern- → followed by: -Ergebnis, -Erfolg, -Gewinn, -Ertrag
Revenues – Expenses = Profit = Income Statement

Profits vs. Cash Flows

Differences:
– “Profits” subtract depreciation (a non-cash expense)
– “Profits” ignore cash expenditures on new capital (these expenditures are “capitalized” not “expensed”)
– “Profits” record income and expenses at the time of sales, not when the cash exchanges actually occur.
– “Profits” do not consider changes in inventory and other working capital
The working capital corresponds to the “Fonds de roulement”. The definition according to the book is:
Working Capital = Current Assets – Current Liabilities
3.3 The Statement of Cashflows

The Cashflow Statement is a financial statement that shows the firm’s cash receipts and cash payments
over a period of time. Like the Income Statement, it consists of “flow-values”, that is a flow during a period
of time.
The cash comes from (or goes to) 3 different activities:
1. Cashflow from Operations
2. Cashflow from Investing
3. Cashflow from Financing
The sum of these 3 cash-flows is the change in the cash-balance during the period.

Cashflow from Operations tends to be positive and should be positive in the long-run. But for young
companies it can be negative, because they can make losses and loose money for a few years, before they
actually start making money.
The Cashflow from Investing is almost always a negative number, because you need to use money to
invest. However, it can be positive if you sell a building, for example, but then it would be “divesting”,
which is the opposite of investing.
The Cashflow from Financing is usually negative for established companies, because they make profit and
tend to pay out a percentage of their earnings to the shareholders. On the other hand, for startup companies
it’s the opposite, the cashflow is positive, because they get a lot of money from financing, since it takes
them a while to actually start making profits.
negative numbers → negative cashflow = cash outflow
positive numbers → positive cashflow = cash inflow

Home Depot Statement of Cash Flows (for the year 2017, published on December 31 2017):

Cash flows from Investments:

Depreciation was expensed, but it’s not a cash outflow, so we add it back.
If the Accounts Receivable goes down, it’s a good thing, because it increases the cash.
If the Inventory goes up the company bought more inventory, so it’s a cash outflow → that’s why it’s in
brackets, because it’s a negative number.
If the Current Assets goes up, it’s also a cash outflow, because we paid for it.
If the Accounts Payable goes up, it means we delayed payment, so this increases our cash.
If the Other Current Liabilities goes up, it’s also a cash inflow.
The Cash provided by operations is a positive number, which is a good thing (cash inflow).
Home Depot Statement of Cash Flows (for the year 2017) → continuation:

Cash flows from Investments:

The Capital expenditure shows what they invested in equipment or lorries, for example → cash outflow
The Sales of long-term assets shows that they also sold some assets that they had → cash inflow
The Cash provided by (used for) investments is negative, which means a cash outflow.

Cash flows from Financing activities:

The payment of dividends and the repurchases of stocks (it’s another way to return money to shareholders)
are cash outflows.
Buying back stocks is another way of returning money to shareholders, because you buy back the stocks and
retire them, so the remaining stocks become more valuable
The Cash provided by (used for) financing activities is negative, because they paid lots of dividends and
repurchased a certain amount of stocks. It’s normally negative for established companies, but it’s positive for
startup companies.

Total cash flows :

In the end you get all the cash flows from operations, investments and financing and sum them up, taking in
consideration which numbers are positive and negative. The Net increase (decrease) in cash and cash
equivalents is the sum of the cashflows from all 3 activities:
+ Cash provided by operations
- Cash used for investments
- Cash used for financing activities
= Change in cash balance or Net increase/decrease in cash
3.4 Accounting Practice and Malpractice

Despite Accounting “Principles” (reliability, conservativeness, matching, time-period, accrual), firms

(financial managers and their controllers) have some discretion with respect to (w.r.t.) reporting.
• Revenue recognition
• Expensing vs. capitalizing → you can choose to expense or capitalize something depending on the
situation. Some managers choose to capitalize something to increase assets and profits.
• Depreciation (quick or slow) → if you depreciate an asset too quickly, you risk decreasing your
profit, because the value goes down too fast.
• Making reserves and provisions
• Off-balance sheet assets and liabilities → companies can also make contracts and not put them on the
balance sheet

Channel Stuffing
Channel stuffing is a deceptive business practice used by a company to inflate its sales and earnings figures
by deliberately sending retailers along its distribution channel more products than they are able to sell to the
public. Channel stuffing typically would take place just before quarter-end or year-end so that management,
fearful of bad consequences to their compensation, can "make their numbers."
Key takeaways:
• Channel stuffing refers to the practice of a company shipping more goods to distributors and retailers
along the distribution channel than end-users are likely to buy in a reasonable time period.
• By channel stuffing, distributors temporarily increase sales figures and related profit measures for a
particular period.
• Regulators frown on the practice and consider it deceptive. In some cases, legal action can be
brought to the offending comp

https://www.investopedia.com/terms/c/channelstuffing.asp

Often the Cashflow from Operating Activities does not start with “Collections from Customers” but with
“Net Income” and then makes adjustments to arrive at the “Cash from Operations”. This is the Indirect
Cashflow Statement:

Depreciation is the loss of value for tangible assets (plant, building, equipment etc).
Amortization is the same but for intangible assets (patents, software etc)
Property, plant, and equipment (PP&E)
PP&E are long-term assets vital to business operations. Property, plant, and equipment are tangible assets,
meaning they are physical in nature or can be touched; as a result, they are not easily converted into cash.
The overall value of a company's PP&E can range from very low to extremely high compared to its total
assets.
Key takeaways:
- Property, plant, and equipment (PP&E) are long-term assets vital to business operations and the long-term
financial health of a company.
- Equipment, machinery, buildings, and vehicles are all types of PP&E assets.
- (PP&E) are also called fixed or tangible assets, meaning they are physical items that a company cannot
easily liquidate.
- Purchases of PP&E are a signal that management has faith in the long-term outlook and profitability of its
company.
- Investment analysts and accountants use the PP&E of a company to determine if it is on a sound financial
footing and utilizing funds in the most efficient and effective manner.
Examples: machinery, computers, vehicles, furniture, buildings, land.
https://www.investopedia.com/terms/p/ppe.asp

Research and Development (R&D)

Research and Development (R&D or R+D), known in Europe as Research and Technological Development
(RTD), refers to innovative activities undertaken by corporations or governments in developing new services
or products, or improving existing ones. Research and Development constitutes the first stage of
development of a potential new service or the production process.
R&D is separate from most operational activities performed by a corporation. The research and/or
development is typically not performed with the expectation of immediate profit. Instead, it is expected to
contribute to the long-term profitability of a company. R&D may lead to patents, copyrights, and trademarks
as discoveries are made and products created.
Key takeaways:
- R&D represents the activities companies undertake to innovate and introduce new products and services or
to improve their existing offerings.
- R&D allows a company to stay ahead of its competition.
- Companies in different sectors and industries conduct R&D—pharmaceuticals, semiconductors, and
technology companies generally spend the most.
https://www.investopedia.com/terms/r/randd.asp

In your opinion: Is R&D a cost or an investment?

It depends on the outcome. If it doesn’t work out, and it ended up being a complete waste of time it can be
considered a cost. But normally people would consider it an investment in the future, in order to gain new
technologies and skills.
Then why would we “expense” it? Instead of “capitalizing” it? (give two reasons)
- Out of conservativeness principle → it’s hard to determine the value of the knowledge/skill acquired
- To reduce reported profits and, with that, the tax bill → expenses make profit smaller and many managers
like to make smaller “book profits” in order to pay less taxes.
Sometimes companies can and do ‘capitalize’ R&D. → If you actually paid for it, you know the current
value of it. In this case, you can decide to capitalize it in order to increase your profits with the goal of
attracting new investors, for example.
Case Study – Tom and Henry
On a Sunday morning in 2000, while enjoying a healthy hangover, students Tom and Henry make a business
plan: They decide to start a beer brewery…
They learn that to get started they needed equipment such as tanks, filters, cookers, bottles, etc.. And raw
materials such as barley and hops.
The initial investment needed would be approximately €1,500. To finance their venture they both chip in
€500 of pocket money. After that, they would borrow €500 from Tom’s dad.

► They issue themselves 500 shares of common stock each (‘par’ = €1), and record their first transaction as
follows (number 0):
Assets = Liabilities + Owner’s Equity
€1000 (cash) €0 + €1000 (“common stock”)

► During the next week, they complete the following transactions:

1. They borrow €500 from Tom’s dad
2. They buy, for cash, €900 worth of equipment → Property, Plant, and Equipment (PP&E)
3. They buy, on credit, €100 worth of barley and hops
4. They rent a garage for €50 per month, to be paid a month in advance.

Assets = Liabilities + Equity

Cash Inventory Prepaid Rent PP&E Accounts Loans Common
payable (A/P) Stock
0 €1,000 €1,000
1 €500 €500
2 - €900 €900
3 €100 €100
4 -€50 €50
€550 €100 €50 €900 €100 €500 €1,000

5. When moving into the garage, they spill some of the hops. About €10 worth of hops flies away and is
considered lost.
6. In the following five months, they produce four batches of beer, each batch using €15 of raw
material. Although these first brews were considered failures, and were thrown away, Tom and Henry
slowly increased their brewing skills. → Research and Development (R&D)

Assets = Liabilities + Equity

Cash Inventory Prepaid Rent PP&E Accounts Loans Common Profit & Loss
payable (A/P) Stock Income
Statement
0 €550 €100 €50 €900 €100 €500 €1,000
5 -€10 -€10
(extraordinary
loss)
6 -€60 -€60 (R&D
expense)
Continuation of the transactions:
7. The fifth batch (also using €15 of raw materials) was considered successful and was used to fill 100
bottles. Henry believed they could sell each bottle for €1. → 2 transactions
8. To celebrate their new beer they organized a new year’s party at a cost of €80, (paid cash) which was
booked as marketing expense.
9. During the party they sell their 100 “LuxBeers” for €1 a bottle. (all sales are in cash)

Before closing their books, they recorded the following:

10. They paid their utility bills of €50 for the months July-November. They recognized a further utility
expense of €10 for December.
11. They paid their raw material suppliers (A/P -€100), then bought another €150 worth of barley and
hops, again on credit. → 2 transactions
12. They paid (cash) interest of €25 to Tom’s dad. He charged 5% per 6 months.
13. They recognized depreciation of €90 (life of equipment is 5 years, depreciated straight line (so €90
every 6 months)
14. Finally, they also paid 6 months of rent.

Assets = Liabilities + Equity

Cash Inventory Prepaid Rent PP&E Accounts Loans Common Profit & Loss
payable Stock / Income
(A/P) Statement
Raw Mat Final Prod
0 €550 €100 €50 €900 €100 €500 €1,000
5 -€10 -€10
(extraordinary
loss)
6 -€60 -€60 (R&D
expense)
7 -€15 €15
7 -€80 -€80 (marketing
expense)

8 €100 €100 (Sales /

Revenues)
9 -€15 -€15 (CoGS)
10 -€50 €10 -€60 (Utility
expense)
11 -€100 -€100
11 €150 €150
12 -€25 -€25 (Interest)
13 -€90 -€90
(Depreciation)
14 -€300 -€300
(Rent expense)
€95 €165 €0 €50 €810 €160 €500 €1,000 -€540
→ CoGS = Cost of Goods Sold
This is called the “ledger”:

Assets = Liabilities + Equity

Cash Inventory Prepaid Rent PP&E Accounts Loans Common Profit & Loss
payable Stock
Raw Mat Final Prod
0 €1,000 €1,000
1 €500 €500
2 - €900 €900
3 €100 €100
4 -€50 €50
5 -€10 -€10
(extraordinary
loss)
6 -€60 -€60 (R&D
expense)
7 -€15 €15
7 -€80 -€80 (marketing
expense)
8 €100 €100 (Sales /
Revenues)
9 -€15 -€15 (CoGS)
10 -€50 €10 -€60 (Utility
expense)
11 -€100 -€100
11 €150 €150
12 -€25 -€25 (Interest)
13 -€90 -€90
(Depreciation)
14 -€300 -€300
(Rent expense)
€95 €165 €0 €50 €810 €160 €500 €1,000 -€540

CASHFLOW BALANCE SHEET P&L

STATEMENT INCOME STATEMENT
Tom & Henry’s – Income Statement (for 6 months ending December 31st 2000):

SG&A = Sales, General and Administrative Expenses → include: R&D, Marketing//Utility/Rent expenses
and Depreciation
CoGS = Cost of Goods Sold
Gross Profit = Sales – CoGS
Operating profit/earnings/income = Gross Profit – (R&D + Marketing/Utility/Rent expenses +
Depreciation)
Net Income = Operating Profit – Interest

Tom & Henry’s – Cashflow Statement (for 6 months ending December 31st 2000):

In the indirect method you start with the Net Income and then add the Depreciation.
Tom & Henry’s – Balance Sheet (on December 31st 2000):

What’s the value of Tom & Henry’s on December 2000?

When you talk about the value of the company, you often (not always) mean the value of the equity (in other
words the value of the owner’s stake), meaning:
Value of company = Total Equity = Total Assets – Total Liabilities
So the value of the company (book value) is: 1,120 – 660 = €460
The book value of T&H’s Equity (‘net worth’, ‘share capital’) is €460.
What is the real economic value?
What determines the real economic value, or market value? The prospects for the future! → so the investors
would consider how good is the beer, how was the party, that are Tom and Henry’s plans for the future of the
company.
Accounting looks at the past, Finance looks at the future.
So, what’s the market value of Tom and Henry’s?

What if I tell you that Tom’s dad agrees to invest €1,500 in exchange for one third of the equity?
He will be ‘issued’ new ‘primary’ shares. How many?
Remember Tom and Henry hold 500 shares each, and the father will also get 500 shares. market value
After the issue, there are 1,500 shares @ €3 outstanding (market value).
Hence, post-financing, the equity is worth €4,500.
But pre-financing the equity’s market value is €3,000.
Tom & Henry still own a majority-stake and stay in control. However, their stake is diluted.

Pre-Money vs. Post-Money

The pre-financing value of a start-up company is the implied value without the ‘financing’ (i.e. without the
new money).
Often it is easier to compute the post-financing value:
E.g. Laura invests €500,000 in exchange for ¼ of the equity.
If ¼ is worth €500,000, the whole company is worth €2 mio. But that includes Laura’s money!
The pre-financing value is then €1,500,000.
Conundrum
Jill and Judy run a small ice cream shop. They want to expand their very successful business, and they pitch
their business plan to two potential investors. Postfinance Prefinancing Joisstale
Jack issu
• Investor "A" offers €90,000 for 40% of the business. qq.az soixassiss

• Investor "B" offers €50,000 for 25% of the business.Frank zouk isok g sooo
s
a) Compute the pre- and post-financing valuations of both offers. Frankofferismoreattractiveibutstillitoepenoswhattheybringtoneta
b
b) What offer is most attractive?

Back to Tom and Henry

Tom & Henry’s made a loss in their half year. They had put in €1000 each, but the book value of their
investment went down to €460 (they made a loss of €540)
→ The book value per share was €0.46
Nevertheless, Tom’s dad agreed to pay €3 per share in second financing round…
Three times as much as the boys had paid just six months earlier…
Why did the father pay more than 6 times the book value for the new shares? Because he believes that the
company will become more profitable in the future.

Some people expect that when they invest in a start-up company, they will soon start to have returns and
they will be big and constant for the remainder of the investment, but it's almost never like that.
The most likely scenario when you invest in a start-up company is that you invest once, and the owners will
ask for more and more investment, and you will actually start having returns a lot later.
Something that we also have to consider is that nobody knows how much the investments will need to be to
keep the company afloat in the initial years, and the profits later can also vary between very small amounts
to very large ones.

The picture on the right illustrates well the

concept of risk in investments:
Tom and Henry first full year (2001)
1. In January 2001, dad bought 500 new primary shares for €1,500.
2. Tom&Henry bought new equipment for €1,400 (paid in cash).
3. Sales for the year were €2,845 (mostly to friends and family), Costs of Sales €428 (reflecting raw
materials only).
4. During the year T&H spent €750 cash on legal fees (to register their company and brands) and €450
on marketing (labels, posters, parties, etc.)
5. They paid their outstanding bills and bought €500 worth of raw materials.
6. At year-end they still owed €150 to their suppliers.
7. The utility expense for the year was €185. Of this €15 was still unpaid in December.
8. Rent was €600, depreciation €380, and interest (to dad) €50.
9. In November €120 was spent on various repairs, which were capitalized.

Assignment 2 – part 1: Prepare the financial statements for 2001…

The Balance Sheet looked like this:

What is Tom & Henry’s book value per share? It’s the owner’s equity divided by the number of shares, so:
1,962 ÷ 1500 = €1.308 l9621500 130
What’s the market value per share? We don’t know, it depends on many things.
What if I tell you that Michael R. Gabriel, a wealthy acquaintance, agreed to buy 3,000 new shares for
€18,000? Michael Gabriel paid €6 per share.

Michael Gabriel:
What kind of investor is Michael R. Gabriel? Michael R. Gabriel is an angel investor (which is something
like a venture capitalist, but a little different, because they offer more than just cash).
What is Michael’s middle name? Raphael (another angel name)
Angel Investors are rich individuals, who provide capital for start-up businesses. They contribute cash for
equity stakes.
Angel investors contribute more than just money. What else do they offer? They also offer connections,
business experience, know-how, advice, ideas, introductions etc.

L
Mr. Gabriel invested because Tom & Henry showed him a detailed business plan requiring a cash-outlay of
€60,000 : Project “brewcat” – Micro-brewery with capacity 5,000 liters/month:

→ According
to this plan, it’s clearly a good investment, because in 3 years the investment would be already paid off.

Mr. Gabriel offered to invest €18,000, if an additional €12,000 would come from the current partners.
The remaining €30,000 would be raised through a bank loan (Michael had connections with several banks).
Their agreement stipulated that:
• Michael R. Gabriel would buy 3000 (primary) shares at €6
• Dad would buy 1000 shares at €6
• Tom and Henry would each buy 500 shares at €6
• Tom and Henry would each get a salary of €500 per month, plus €0.05 per bottle sold.

Why did Michael R. Gabriel demand that the current partners participate in the financing round?
To show commitment, to incentivize them.

After the equity investment, Tom&Henry’s moved to a larger (still rented) space, and immediately started
installing the new equipment.
By December 2002 they were selling 150 crates per week to bars, restaurants, and local shops.
They could not keep up with local demand and received several inquiries from merchants in Brussels and
other cities.
The Net Income for the year was €5,760 on Sales of €81,450.
In July, Tom and Henry graduated, but without honors.

Assignment 2 – part 2: Construct the Balance Sheet on 31st December 2002, and the indirect method
cashflow statement, based on the Income Statement and Cashflow Statement.
The inventory at that date is €2,150.
What two new balance sheet accounts are created? 2 new Balance Sheet accounts were created:
• Accounts Receivables = Sales – Received from Customers
• Tax Liabilities or Accrual Taxes

After their second full year, 2B! partners, a Venture Capital firm, agreed to buy 12,000 primary shares for
€144,000? (that’s €12 per share)
What is a Venture Capital Firm? It’s a company with investors that invest in risky capital, typically start-up
companies.
 Exit Ittresale
What is Mr. Gabriel’s return? His return is 100%, because he bought 12,000 shares for 6€ each and now
they are worth 12€ each.
Does he have a lot of cash now?
No, this is a paper return, because he didn’t cash out yet, that is his money is still in the company in the
shape of his shares.
If Mr. Gabriel wants to buy more shares at 12€, he can, because if some shares are sold at a certain price to a
new investor, the current investors should also be able to buy more shares at the same price, if they wish.

After the third financing round, Tom and Henry’s Sales quadrupled:

During 2003 they hired 5 full time employees.

Tom and Henry themselves worked full time, and each took away €28,135 in salary and bonuses. And that
was only the beginning…

F2 D GTX

Their spectacular growth was thanks to new investments.

They introduced two new beers (“Lux White” and “Lux Black”), improved operations management, and
their marketing was brilliant.

Is Tom and Henry’s profitable?

We can’t say if the company is profitable by looking only at the income statement, we need to look also at
the balance sheet. We need to understand what is necessary to make the profits stated in the net income.
 22/10/2021
CLASS 3 – CONTINUATION OF CHAPTER 3
Profit Margins

“common sizing”
Common sizing is expressing everything in the income statement as a percentage of the sales.
Is T&H profitable? To answer that question we need to look not only at the profits, but also at the assets we
needed to make those profits.
Is Michael Gabriel happy? To answer this question you have to look at the balance sheet as well.
How do we use these numbers?
Gross Margin = Gross Profit

to memorize
Sales
Operating Margin = Operating Profit Noneed
Sales
Profit Margin = Net Income
Sales

In the next few years, to finance its growth, shareholders had to invest additional funds:

How much was invested?

Look at the add paid-in capital.
At what share prices?
You need to sum “add paid-in capital +
common stock” for the year and subtract
this sum for the previous year, and if you
divide this result by the total number of
shares, you will get the share prices.
Were they profitable investments?

How many shares did they issue in 2004?

60 – 29 (from 2003) = 31,000 new shares
Profitability Ratios
To assess profitability we need data from the Income Statement and from the Balance Sheet !
Return on Equity (ROE) = Net Income
Owner’s Equity

Return on Assets (ROA) = After Tax Operations Profit

Total Assets

Return on Capital = After Tax Operating Profit

Total Capitalization

Three drivers of Corporate Profitability

ROE can be decomposed into several components:
Net Income × Sales × Assets = Net Income = ROE
Sales Assets Equity Owner’s Equity
Profit Margin × Asset Turnover × Equity Multiplier (Leverage Factor)

This is called the original DuPont Model (also known as the DuPont Analysis) is a framework for analyzing
fundamental performance popularized by the DuPont Corporation. DuPont Model is a useful technique used
to decompose the different drivers of return on equity (ROE). The decomposition of ROE allows investors to
focus on the key metrics of financial performance individually to identify strengths and weaknesses.
https://www.investopedia.com/terms/d/dupontanalysis.asp

Profit Margin = Net Income

Sales

Asset Turnover = Sales

Assets

Equity Multiplier = Assets

Equity

Can we increase all three at the same time?

We would like that, but it’s difficult. Companies typically specialize either in profit margin or in asset
turnover and it’s very hard to focus on both at the same time.
How can we increase each of them?
• To increase the profit margin: decreasing costs and increasing prices
The profit margins in companies that produce luxury products are very high, because the cost of
production is almost as low as other brands, but the prices are higher due to the status they represent.
An example of companies that have very high profit margins: Louis Vuitton, Ferrari etc
• To increase asset turnover: decrease prices and increase sales
An example of a company that has high asset turnover : Ryanair → they use their planes in a very
efficient manner to get the most profit of each plane, while keeping the tickets at very low prices.
If we can increase one, while keeping the others constant, which one we would go for? How can we do this?
Having a high Equity Multiplier can increase your ROE, but this is the same thing as having high Debt,
because if you use more assets and less equity, it means that you borrow more money. The problem with this
strategy is that if you borrow a lot, you pay more interests and you may not be able to pay your debt. So,
sometimes it can be interesting, but it’s not always a good idea.
My favorite profitability measure: Return On Capital

Return on Invested Capital = EBIT (1–t) = EBIAT = NOPAT = ATOP

Invested Capital = Capital Employed = Total Capitalization
The numerator is the after-tax “free cashflow” if the company does not grow. The money that the
company could give back to its financiers (debt and/or equity), or invest in new Invested Capital.
The denominator is the Invested Capital, that is financed with Debt and Equity, both of which require a
return: the “cost of capital”.
Notice that : EBIAT = EBIT(1 – t) = NOPAT = Net Income + Interest × (1 – t)
EBIT (1 – t) – Interest (1 – t) = EBT (1 – t) = Net Income
Where : t = Effective Tax Rate

ATOP = After Tax Operating Profit

NOPAT = Net Operating Profit After Tax

The ROIC = Return On Invested Capital

is a.k.a.: RONA = Return On Net Assets
ROCE = Return On Capital Employed
ROC = Return on Capital (BMM-book)

ROIC = EBIAT → ROIC gives the most effective measure of operating performance!
Invested Capital

Return On Invested Capital (ROIC)

Return on invested capital (ROIC) is a calculation used to assess a company's efficiency at allocating the
capital under its control to profitable investments.

The return on invested capital ratio gives a sense of how well a company is using its money to generate
returns. Comparing a company's return on invested capital with its weighted average cost of capital
(WACC) reveals whether invested capital is being used effectively. This measure is also known simply as
return on capital. https://www.investopedia.com/terms/r/returnoninvestmentcapital.asp

Earnings Before Interest After Taxes (EBIAT) :

Earnings before interest after taxes (EBIAT) is one of a number of financial measures that are used to
evaluate a company's operating performance for a quarter or a year. EBIAT is the same as after-tax EBIT.
EBIAT measures a company's profitability without taking into account its capital structure, which is the
combination of debt and stock issues that is reflected in debt to equity. EBIAT is a way to measure a
company's ability to generate income from its operations for the period being examined while considering
taxes. https://www.investopedia.com/terms/e/ebiat.asp
EBIAT = EBIT x (1 – Tax rate)

Earnings Before Interest and Taxes (EBIT):

EBIT = Revenues – Operating Expenses + Non-operating Income
Invested Capital :
Invested capital is the total amount of money raised by a company by issuing securities to equity
shareholders and debt to bondholders, where the total debt and capital lease obligations are added to the
amount of equity issued to investors. Invested capital is not a line item in the company's financial statement
because debt, capital leases, and stockholder’s equity are each listed separately in the balance sheet.

• Invested capital refers to the combined value of equity and debt capital raised by a firm, inclusive of
capital leases.
• Return on invested capital (ROIC) measures how well a firm uses its capital to generate profits.
• A company's weighted average cost of capital calculates how much invested capital costs the firm to
maintain.
https://www.investopedia.com/terms/i/invested-capital.asp

Working Capital:
Working capital, also known as net working capital (NWC), is the difference between a company’s current
assets (such as cash, accounts receivable, and inventories of raw materials and finished goods and its
current liabilities (such as accounts payable and debts).
https://www.investopedia.com/terms/w/workingcapital.asp

Working Capital = Current Assets – Current Liabilities

T&H’s Profit Ratios

In class exercise (Excel sheet 2) → Compute, for Tom and Henry’s years 2003-2006:
• the Gross Margin, the Operating Margin and the Profit Margin
• the Return on Equity, the Return on Assets, Asset-Turnover, and the Equity Multiplier
• the ROC = Return On Capital : 2003: 8% / 2004: 10% / 2005 : 10% / 2006: 11%
How would you interpret the results?
You have to compare the ROIC result with the cost of capital. If it’s higher than the cost of capital it’s good,
otherwise not. In this case the 10% is probably higher, but not by much.
The fact that the ROC is increasing over the years is a good sign.
In general 10% is a good number, but this varies a lot from company to company. Some companies have a
ROIC of 30%, while other have much lower numbers.

Growth costs Cash

How much has been invested into Tom & Henry’s ?

The sum of all the cashflow from financing: €4,173,000 ≈ €4 million
How much has been taken out ?
Not much or close to zero. The shareholders didn’t receive anything from Tom&Henry’s, they only put
money into the company. The banks gave loans and received a little interest back.
How is Tom and Henry’s solvency?
Solvency means how well a company can pay their loans back to the debt holders.
How is Tom & Henry’s liquidity?
Liquidity is how well a company can pay their bills.

Solvency
Refers to how well can a company meet its (long term) financial obligations. We look at ratios, such as:
Long-term Debt Ratio = LT Debt
LT Debt + Equity

LT Debt to Equity Ratio = LT Debt

Equity

Total Debt Ratio = Total Liabilities

Total Assets

Times Interest Earned = EBIT

Interest Payments

Cash Coverage Ratio = EBITDA

Interest Payments

The Cash Coverage Ratio is a measure of a firm’s liquidity. Specifically, it gauges how easily a company
comes up with the cash it needs to pay its current liabilities.
https://assetsamerica.com/cash-coverage-ratio-guide/

Liquidity
Refers to how well can a company meet its short-term payment obligations. We look at ratios, such as:
Net Working Capital Ratio = Current Assets – Current Liabilities
Total Assets

Current Ratio = Current Assets

Current Liabilities

Quick Ratio = Cash&Equity + Accounts Receivables

Current Liabilities

Cash Ratio (or ‘Acid Test’) = Cash&Equity

Current Liabilities

The Cash Ratio (also known as the cash coverage ratio) is a measurement of how well can the company pay
its short-term debt in the form of cash and cash equivalent (investment items that immediately available to
be turned into cash e.g. treasury bills & short-term government bonds). This ratio is useful for creditors to
decide how much money they can loan to a company.
https://studyfinance.com/cash-ratio/
In-Class Exercise (Excel sheet 2):
Assess the Solvency and Liquidity of Tom and Henry’s over 2003 – 2006, by computing the relevant ratios.

Who uses these ratios? Which, how and why?

♦ The managers compare across firms (benchmark) and over time.

• They compare the ROIC with the Cost of Capital to monitor the business and see where they can
improve.

♦ Equity investors:
• Same thing: they compare the ROIC with the Cost of Capital to monitor the business.
• They also look at ratios not yet discussed. Which ones? Price-to-Earnings (P/E) Ratio → it’s the ratio
for valuing a company that measures its current share price relative to its Earnings Per Share (EPS).

♦ Debt-investors, such as banks look mostly at liquidity and solvency ratios. They may even use these
ratios in the debt-contracts. → they are the creditors, so they want to know if the company can pay its debts
• Debt rating agencies also work with ratios.
• To compare apples with apples they may need to make adjustments.

♦ Suppliers, clients, employees and other stakeholders are mostly interested in liquidity and solvency.
→ the suppliers want to know if you can pay your bill, the clients want to know if the product s they bought
will get support and parts for example, employees want to know if you will be able to pay their salaries, etc.

Liquidity of the Shareholders

The shareholders also care about liquidity!
Tom, Henry, Dad, Michael Gabriel and 2B! have much of their wealth tied up in the company.
How could they ‘liquidate’ their investment and ‘harvest’? They could sell the company or go public and get
listed on the stock market.

Liquidity of financial assets is called “Market Liquidity” →how easy investors can liquid their investment

The company’s liquidity is called “Funding Liquidity” → how easy companies can make pay??

How would we gauge (measure) Market Liquidity?

If the stock is traded on the stock market, we can look at the trading volume to see how liquid the stock is.
The bigger the volume, the more often the stock is traded, so it should be easier to sell the stock. The other
thing we can check is the ask-spread.
 CHAPTER 5: THE TIME VALUE OF MONEY

Summary:
5.1 Future Values and Compound Interest
5.2 Present Values
5.3 Multiple Cash Flows
5.4 Reducing the Chore of the Calculations: Part 1
5.5 Level Cash Flows: Perpetuities and Annuities
5.6 Reducing the Chore of the Calculations: Part 2
5.7 Effective Annual Interest Rates
5.8 Inflation & The Time Value of Money

5.1 Future Values and Compound Interest

Future Value: Amount to which an investment will grow after earning interest
Compound Interest: Interest earned on interest

Example — Compound Interest

Interest earned at a rate of 6% for five years on the previous year’s balance
Interest earned per year = prior year balance × .06
Interest earned at a rate of 6% for 5 years on the previous year’s balance

Value at the end of Year 5 = $133.82

Future Value = FV
FV = $100 × (1 + r)t
Where: r = interest rate
t = time (in how many years)

Example — FV
What is the future value of $100 if interest is
compounded annually at a rate of 6% for 5
years?
FV = $100 × (1 + r) t
FV = $100 × (1 + .06) 5 = $133.82
FV increases over time, so when you calculate it you say “compounding”. In the graph above you can
clearly see how FV changes over a certain number of years.
5.2 Present Values

Present Value: Value today of a future cash flow

Discount Factor: Present value of a $1 future payment
Discount Rate: Interest rate used to compute present values of future cash flows

Present Value = PV:

PV = Future value after t periods
(1 + r)t
Where: r = interest rate
t = time (in how many years)
For example: 1 year and a half would be t= 1.5

Discounted Cash Flow (DCF)

Method of calculating present value by discounting future cash flows

Example
You just bought a new computer for $3,000.
The payment terms are 2 years or cash (i.e. you can pay in 2 years if you want. (do you?)) If you can earn
8% on your money, how much money should you set aside today in order to make the payment when due in
two years?
PV = FV = 3,000 = $2,572
(1 + r)t (1.08)2

Discount Factor = PV of $1
DF = 1
(1+ r)t
Discount factors can be used to compute the present value of any cash flow

In the graph above we can see how the PV graph is the opposite of the FV graph. That is, the longer the
time, the more PV will be “discounted”.
Drawing a time line can help us to calculate the present value of the payments to Kangaroo Autos (down
payment of $8,000 plus $12,000 in two years) :
$12,000

The PV of the car is

$17,917.36.

Time Value of Money (Applications)

The PV formula has many applications. Given any variables in the equation, you can solve for the remaining
variable.
PV = future payment × 1
(1+ r)t
Example:
The US Government borrowed money for 10 years, but it did not announce an interest rate. It simply sold
zero-coupon Bonds with face-value $1,000 for $777.40.
What is the interest rate?
777.40 = 1,000 × 1 => r = 0.0255 or 2.55%
10
(1+ r)

PV = future payment × 1
(1+ r)t
• Value of Free Credit (the computer)
• Implied Interest Rates (the bond)
• Time necessary to accumulate funds.
(If the interest rate is 3%, how long does it take to double your money?)

5.3 Multiple Cash Flows

Future Value of Multiple Cash Flows

Example:
You are able to put $1,200 in the bank now, and another $1,400 in 1 year. If you earn an 8% rate of interest,
how much will you be able to spend on a computer in 2 years?

FV 1 = 1,400 × 1.08 = 1,512.00

FV 2 = 1,200 × 1.08 2 = 1,399.68
FV1 140071.08 1512
Total FV = $2,911.68 F V2 1200 11.085 1399,68

TotalFF2911168
Present Value of Multiple Cash Flows
PVs can be added together to evaluate multiple cash flows:
PV = C1 + C2 + …
(1+ r)1 (1+ r)2

Example:
Your auto dealer gives you the choice to pay $15,500 cash now, or make three payments: $8,000 now and
$4,000 at the end of the following two years. If your cost of money is 8%, which do you prefer?
Immediate payment 8,000.00
PV 1 = 4,000 = 3,703.70
1
(1 + .08)
PV 2 = 4,000 = 3,429.36
(1 + .08)1
Total PV = $15,133.06

5.5 Perpetuities and Annuities

Perpetuity : A stream of level cash payments that never ends

Annuity : Level stream of cash flows at regular intervals with a finite maturity
PV of Perpetuity Formula:
PV = C
r
Where: C = cash payment
r = interest rate

Example:
In order to create an endowment, which pays $100,000 per year forever, how much money must be set aside
today in the rate of interest is 10%?
PV = 100,000 = $1,000,000
.10

If the first perpetuity payment will not be received until 4 years from today, how much money needs to be
set aside today?
PV = 1,000,000 = $751,315 ?
(1+.10)3
5.8 Inflation

Inflation: Rate at which prices as a whole are increasing

Nominal Interest Rate: Rate at which money invested grows
Real Interest Rate: Rate at which the purchasing power of an investment increases

Annual US Inflation Rates from 1900 – 2015:

The relationship between the nominal and the real interest rate is:
1 + Real Interest Rate = 1+ Nominal Interest Rate
1+ Inflation Rate

Approximation formula:
Real int. rate ≈ nominal int. rate − inflation rate

Example :
If the interest rate on one year government bonds is 6.0% and the inflation rate is 2.0%, what is the real
interest rate?
1 + real interest rate = 1+.06
1+.02
1 + real interest rate = 1.039
1 + real interest rate = .039 or 3.9%
Approximation = .06 − .02 = .04 or 4.0%

Remember:
• Current dollar cash flows must be discounted by the nominal interest rate
• Real cash flows must be discounted by the real interest rate

In-class exercise (Excel): calculate the PV of the cash flows in the Project Brewcat tab.
 29/10/2021
CLASS 4 – CHAPTER 6: BONDS

This lecture covers Chapter 6, but simplified:

• No need to deal with semi-annual coupons
• No need to deal with financial calculators or excel formulas, except one…

Bonds:

Unlike dividends, paying coupons is compulsory !

Borrowing money = selling bonds

A bond is the simplest ‘promise of future payments’.
The advantage of this simplicity is that bonds can be traded in the secondary market.
When a firm issues a bond, it is a “primary market” transaction.
When an investor sells a bond (or another security) to another investor, it’s a “secondary market”
transaction.
Who are the biggest biggest bond issuers? Governments!

Government Bonds
Government bonds (or treasuries, or sovereign bonds) are considered the safest of all investments.
Treasury bills, or T-bills, are short-term (<1 year) bonds.
Notes have maturities from 2 – 10 years
Bonds have maturities > 10 years
In Germany they are called ‘bunds’, in France ‘obligations’, in Spain ‘bonos’, in the Netherlands
‘obligaties’, and in the UK they are called gilts..

Valuation of bonds
PV = $60 + $60 + $60 + … + $1060
2
(1+r1year) (1+r2year) (1+r3year)3 (1+r10year)10
Where the r’s, the appropriate discount rates, depend on:
1) the risk free interest rate.
2) The credit risk* of the issuer (Company, e.g. MGM)
Notice that (annualized) interest rates are not necessarily the same for each maturity.*
We often use the yield to maturity (YTM) to value bonds :
PV = $60 + $60 + $60 + … + $1060 = Price
(1+y) (1+y)2 (1+y)3 (1+y)10
If we know the YTM (or simply yield) we can find the price … If we know the price, we can find the YTM.

Example:
A bond with face value €1000, coupon of 2%, and maturity in 5 years, has a YTM of 1%. What is its price
(in % of face value)?  Spreadsheet
A bond with coupon 1% of face value, and a maturity of 10 years, has a price of 95% of face value. What is
the YTM?  Spreadsheet: use trial and error and the IRR-formula

A bond with 20 year maturity, coupon is 2%, has a yield of 2.5%.

Will the price be higher or lower than face value?
Will the bond be trading at a premium or a discount of face value? At a discount.
What will happen to the price of the bond if the interest rates in the market increase? If the interest rates on
the market increase, then the bond prices go down, because the yield goes down.

Quick Quiz
1) When interest rates rise, what happens to bond prices? (up / down)
2) When the yield is higher than the coupon rate, the bond trades at a discount / premium?
3) When you know coupon, the time to maturity, the yield to maturity, you can compute the price with the
IRR formula (yes / no) → You can compute price with the DCF formula!
4) When you know the principal, coupon-rate, expiration date and the price, you can compute the YTM with
trial and error (yes / no)
5) Zero coupon bonds are issued a discount and become more valuable as time goes by ( yes / no )
→ In general, not the case today in Europe!
Zero coupon bonds are bonds without coupons, so you y get your money back. So they are issued at a
discount and the closer to the time of payment, tonlhe more valuable they become.
6) When interest rates rise, a 10-year bond decreases in value more / less than a 20-year bond.

Prices, yields, and duration

We have seen that LT bonds are more sensitive to interest rate changes than short term bonds.
Investors want to know the sensitivity of bond prices to yields.
The sensitivity measure they use is the duration.
Duration is closely related to the bond’s maturity.
In fact, it can be shown that a bond’s duration is its weighted average maturity, where the weights are the PV
of the payments.

Quick Quiz
1) A 10-year bond is more / less sensitive to interest rate changes than a 5-year bonds. → Longer term
bonds are more sensitive to changes in interest rate
2) The duration of a 10 year coupon-bond is higher / equal / lower than a 10 year zero coupon bond. →
Because part of the payments are done before bond maturity with the coupons.
3) When interest rates suddenly fall, the duration of a 10 year coupon bond goes up / down.
The Risk Free Interest Rate (rf)
Governments auction bills, notes, bonds, gilts, etc.
The clearing price determines the interest rates.
In the Netherlands they use a Dutch auction: all bidders submit demand curves (E.g. for = €940, I want
10,000 bonds, for €930 I want 25,000).
The highest price that fetches the bonds on offer, the clearing price, is paid by all successful bidders.
If a one year “note” fetches €960, r1year = 4.17%
…Also in the U.S., the U.K. and many other countries the governments use Dutch Auctions.→ they call it
Dutch Auctions because it’s a very cheap and efficient way of selling things.
Central banks influence the interest rates by setting ‘prime-rates’, at which central banks lend and borrow to
their member banks.
The most important determinant for interest rates are expectations about future price-levels, or inflation.

Real and Nominal Interest Rates

Irving Fisher decomposed interest rate as follows:
(1+rnominal) = (1+E[inflation-rate])(1 + rreal)
For small r’s, a good approximation is: rnominal = E[inflation-rate] + rreal.
The real interest rate is determined by households’ “impatience to spend and (economy-wide) opportunities
to invest” (i.e. supply and demand)
The ‘real’ interest rate on ten-year treasuries has been around 2.5% over the last 25 years or so. Over the last
10 years it’s been 2%, roughly.

Inflation Linked Bonds (ILBs)

U.S.: “TIPS” (Treasuries, Inflation Protected)
Every year the face value is
increased by the Price Index.
You receive a fixed coupon
(typically 0 - 3%) of the face
value.
Currently these inflation
bonds make more sense to
buy in Europe, because the
nominal bonds are not worth
with such high inflation and
the negative interest rates that
are now.
The Term Structure
Last week, the interest rates (‘spot-rates’) for U.S. treasury securities were as follows:

The term structure is a table and if you put the data in a graph,
it’s called the yield curve.

The relation between spot rates and maturities is called the ‘term structure’. The term structure can be
depicted graphically:

The ‘yield curve’

It’s the annualized rates as a function of the
term. Typically 30 year rates are higher than
shorter ones. But the yield curve is not
always the same, it changes all the time.

The X-year interest rate is the yield on a zero coupon security or ‘strip’ which matures in X years.
The yield curve changes all the time → and it’s not always upwards sloping.
The rates represented on the yield curve are important because they provide the benchmark for companies
on what they have to earn on capital.

What does the yield curve tell us?

It tells a little bit about the future: if it’s upward sloping the yields are expected to go up, if it’s downward
sloping, they are expected to go down.

The yield curve

The pure expectations theory says that: yield curve is sloping up rates are expected to go up
yield curve is sloping down rates are expected to go down
Historically, the prediction of the yield curve has been extremely poor!
Also historically, the yield curve has been upward sloping most of the time.
The the average term premium was about 1%.
Did we believe rates to go up most of the time?
Is there an alternative explanation for the term premium?

Liquidity Preference Theory

The liquidity preference hypothesis says that borrowers (governments, firms) have an inherent preference
for Long Term borrowing. Why?
..and that the average lender (household) has a natural preference for Short Term lending. Why?
To entice risk-averse lenders (households) to lend long term we have, in equilibrium, borrowers pay more
for borrowing long term (compared to rolling over short term loans)
There’s evidence that term premium may be declining… Why?
Yields and Credit Risk
When we talk about a bond’s yield, we really refer to the promised yield.
Issuers may default on coupon and principal payments... → so you may not get what you were promised
Therefore: yield ≥ expected return
Investors always want: expected return ≥ risk free rate
So for corporate bonds we have: (promised) yield ≥ risk free rate
We call the difference (yield – rf) the ‘default risk premium’ or ‘credit spread’, or ‘spread over treasuries’.

What determines the credit spread?

Supply and Demand in the market for corporate bonds!!!
How can we explain the risk premium? Is there a magic formula?
How does one measure a firm’s default risk?
You have to look at: Ratios of Solvency and Liquidity, but also of profitability.
Risk-factors: product liabilities, pension liabilities, accounting policies, overseas income, environmental
factors, etc.
Debt contract: seniority, maturity, is it secured, etc.
A helpful guide are the 5 C’s of credit analysis:
Cash, Cashflow, Capacity (to repay), Capital (how much money the shareholders put and how much long-
term assets there are), Collateral (what the bank gets if the company can’t pay its debts), Covenants,
Conditions, Cyclicality, Character…

What about Bond Ratings?

There are companies (Moody’s, Standard & Poors, Fitch,..) that get paid to rate debt. They use ratings such
as AAA for very safe bonds and BB+ for speculative bonds. → when it comes to countries Luxembourg,
Germany and the Netherlands have the highest ratings.
Who pays these companies? The companies themselves.
After the financial crisis of the 1930s caused by banks investing in risky stuff, which made the people stop
trusting banks. The Ratings Companies gained authority when regulators stipulated that certain institutions
(e.g. bank and pension funds) can only invest in debt of certain ratings (e.g. BBB and up or “investment
grade”).
Empirical studies show that by the time of a down- (up-) grade, the bad (good) news is already incorporated
in the yield.
In fact, the evidence suggests that rating agencies are too slow with up- and down-grading. Case in point:
Enron. The importance of bond ratings is highly overrated…
Ratings, ratios and “credit spreads”:

If you have a higher rating, you pay a lower spread over the interest rate.

The Bond Contract

a.k.a. “term sheet”,
“indenture”

Collateral and Seniority

If a firm defaults on its debt, creditors (debt-holders) take over control.
If this happens, the value of the assets < face-value of the debt. Debt holders now scramble for the assets.
Holders of secured debt get the collateral which was pledged. Senior debt holders are paid first, then comes
the subordinate debt, followed by junior debt. Then comes the preferred stock, and if there’s anything left
over, (there rarely is) it is for the stockholders.
Covenants / Conditions
Restrictive covenants:
MGM shall not pay dividends that are higher than earnings.
MGM shall not issue new senior debt
MGM shall not divest its Casino-business.
MGM shall not sell its rights to “James Bond 007”, “The Pink Panther” or “Rocky”.

Prescriptive covenants or ‘tests’:

MGM shall keep a liquidity ratio higher than 1.
MGM shall keep an interest coverage ratio higher than 2.
MGM shall keep a positive book value of equity.
Prescriptive covenants are more common in privately placed or bank debt.

Syndicated loans and privately placed debt

There is an inherent conflict of interest between equity and debt. Equity has the vote, debt protects
itself through the debt-contract.
If the potential conflicts are more severe, firms
recur to privately placed debt, or bank debt.
Then, ‘monitoring’ (e.g. prescriptive covenants)
becomes cheaper. And issuing costs are saved,
but the debt is less (not) liquid for the bank…

Bank Debt
Companies in Continental Europe and Asia rely more on bank landing (than on bonds).
Bank loans are often short term in denomination, but long term in practice (loans tend to roll over, or
‘revolve’).
Through a long term relationship with a ‘house-bank’, equity-debt conflicts (and associated costs!) are
reduced.
When a company falls on hard times, this can be very beneficial. In good times however, banks may be more
expensive.
“Bank countries” have smaller and less liquid markets with less ‘risk-sharing’ but more ‘monitoring’.
 CLASS 4 (Continuation) – CHAPTER 7: VALUING STOCKS

Summary:
7.1 Stocks and the Stock Market
7.2 Market Values, Book Values, and Liquidation Values
7.3 Valuing Common Stocks
7.4 Simplifying the Dividend Discount Model
7.5 Valuing a Business by Discounted Cash Flow
7.6 There Are No Free Lunches on Wall Street
7.7 Market Anomalies and Behavioral Finance

7.1 Stocks and the Stocks Market

• Primary Market
◦ Market for the sale of new securities by corporations
• Initial Public Offering (IPO)
◦ First offering of stock to the general public
• Seasoned Equity Offering (Primary Offering)
◦ The corporation sells shares in the firm
• Common Stock
◦ Ownership shares in a publicly held corporation
• Secondary Market
◦ Market in which previously issued securities are traded among investors → Bid/Ask spread.
• Dividend
◦ Periodic cash distribution from the firm to the shareholders (not obligatory)
• P/E Ratio
◦ Ratio of Stock Price to Earnings Per Share (EPS)

FedEx Corporation (FDX) – NYSE

Bid price is the price that investors want to pay for each share, while Ask price is how much the investors
that own stocks want to sell each of them for.
Day's range : how much the price has varied
during the current day
52 week range: how much the stock price has
varied during the last year
Volume: how many stocks were traded
Market cap: Market Capitalization = Number of
outstanding shares * the share price → it’s the
value of the company, for example Fedex is
worth $64,318 Billion
PE Ratio = Price per Earnings Ratio
EPS = Earnings Per Share → it’s the net
income divided by the number of shares
TTM = Trailing 12 months is a term used to
describe the past 12 consecutive months of a
company’s performance data, that’s used for
reporting financial figures.

Not all shares may be on the market, some shares are part of the Market cap but are not likely to be traded
anytime in the near future. In Europe many shares are held by the governments, but they don’t normally
trade them. Example: many shares from the luxembourgish satellite company are held by the government.
On the other hand, free flow are the shares that are freely traded. For American companies, the free flow can
be very close to the market cap, but for European companies many shares are held by institutions, families
or by the government.

Example
If an investor wishes to purchase 100 shares of FedEx with a bid price of $239.98 and an ask price of
$240.10, how much could the investor expect to pay for the shares?
What is the P/E Ratio and Dividend Yield?

Payment: number of shares × Ask price = 100 × 240.10 = $24,010

P/E Ratio: Last trading transaction price = 239.98 = 22.11

10.86

Dividend Yield: Dividend = 2.00 = .80 %

Bid price 239.98

Share Price History for FedEx:

Stocks are risky!

They go up and down all the time, but their
average return is generally good.

Stocks are riskier than bonds, but they also

have a higher expected return.
Stocks for the Long Term

$100 invested in the S&P in 1960

The T-Bills are the safest investment of all

If there is a crisis, the corporate bonds are the ones that suffer most, since nobody know if the companies
will or not go bankrupt.

$100 invested in the S&P 500 in 1928

This graph depicts an even longer horizon from 1920 to 2020. Over the long run the risks cancel out.
Even before the 1930s crisis, the stocks tend to make you a lot richer than bonds.

Risk – Equity Premium

Stocks are risky. Stocks are riskier than bonds.
Investing in T-bills gives a safe 1-year (nominal) return.
If you invest in a typical stock, the risk of the probability of ending up with less 75% (losing 25% of your
investment) is about 15% (the Standard Deviation of a typical stock is about 30%) → some stocks are
much riskier than average, and others are safer. The risk of an index is smaller, because the diversification
makes it safer.
To compensate for this risk, stocks earn, in expectation, 5% more than T-bills. R averagestock ≈ rf + 5%
This is the Equity Premium, it’s about 5%, IMHO (= in my honest opinion) → the stock market is a social
science.
Risk of a stock-index
Every week you play the following coin-toss
game:
→ This game is very similar to the risk of
investing in the stock market.

Histogram of real 1-year stock-market returns since 1871:

The “Normal” or “Gaussian” distribution describes annual stock returns very well.
The expected return E[!!̃] (or µ) of the Stoxx50 today is about 5% (IMHO), the standard deviation is about
20%.
 This means that if you invest €100 in the Stoxx50 today, your value will be €65 and €150 with €95%
probability.
7.2 Market Values, Book Values, and Liquidation Values

• Book Value: Net worth of the firm according to the balance sheet
• Liquidation Value: Net proceeds that could be realized by selling the firm’s assets and paying off its
creditors → how much you would receive if the company sold all of its assets and paid its creditors
• Market Value Balance Sheet : Financial statement that uses market value of all assets and liabilities

The difference between a firm’s actual market value and its liquidation or book value is attributable to:
• Extra earning power
• Intangible assets : knowledge, skills, brand name, loyal customers
• Value of future investments

7.3 Valuing Common Stocks

Stock Valuation Methods

– Valuation by comparables: Price-Ratios → “Multiples”
– Intrinsic Value:
• Piece wise Asset Valuation → it’s not at all precise
• Present value of future cash flows
– Dividend Discount Model

Valuing common stocks: V0 = Div1 + P1

1+r
Where : V0 = The intrinsic value of the share
Div1 = The expected dividend per share at the end of the year
P 1 = The predicted stock price in year 1
r = The discount rate for the stock’s expected cash flows
Example:
What is the intrinsic value of a share of stock if expected dividends are $3/share and the expected price in 1
year is $81/share? Assume a discount rate of 12%.
#0 = Div1 + $1 = 3 + 81 =$75
1+! 1.12

Expected Return:
The percentage yield that an investor forecasts from a specific investment over a set period of time.
Sometimes called the holding period return (HPR).
Expected return = ! = Div1 + $1 − $0
$0
The formula can be broken into two parts: Dividend yield + Capital appreciation
Expected return = ! = Div1 + $1 − $0
$0 $0
Yield is typically used for bonds, and return for stocks.
Example (continued): Using the prior example:
♦ What is the expected return assuming the stock price is $75, the dividend $3 and next year’s expected
price $81 ?
Expected return = r = 3 + 81 − 75 = .12 => Expected return = 12%
75

♦ What is the expected dividend yield and capital gain?

Expected return = r = 3 + 81 – 75 = .04 +. 08 = .12
75 75
Expected dividend yield = 4%
Expected capital gain = 8%

Dividend Discount Model

Discounted cash-flow model which states that today’s stock price equals the present value of all expected
future dividends
P0 = Div1 + Div2 + … + Divt + Pt
(1+ r)1 (1+ r)2 (1+ r)t
t = Time horizon for your investment

Example
Current forecasts are for XYZ Company to pay dividends of $3, $3.24, and $3.50 over the next 3 years,
respectively. At the end of 3 years you anticipate selling your stock at a market price of $94.48. What is the
price of the stock given a 12% expected return?
PV = 3.00 + 3.24 + 3.50 + 94.48 => PV $75.00
1 2
(1+ .12) (1+ .12) (1+ .12)3

7.4 Simplifying the Dividend Discount Model

If we forecast no growth, and plan to hold the stock indefinitely, we will then value the stock as a
PERPETUITY.
Perpetuity = P0 = Div1 or EPS1
! !
Since there is not growth, all earnings are paid to shareholders, because there is no need to retain or plow
back earnings to invest in growth.

Constant-Growth DDM
A version of the dividend growth model in which dividends grow at a constant rate (Gordon Growth
Model) :
Gordon Growth Model → important formula: P0 = Div 1
r–g
Given any combination of variables in the equation, you can solve for the unknown variable.

Example:
What is the value of a stock that expects to pay a $0.86 dividend next year, and then increase the dividend at
a rate of 4.75% per year, indefinitely? Assume a 7% expected return.
P0 = Div1 = $0.86 = $38.22
r–g .07 – .0475
Valuing Non-Constant Growth
PV = Div1 + Div2 + DivH + PH
(1+ r)1 (1+ r)2 (1+ r)H (1+ r)H
PV of dividends from year 1 to horizon PV of stock price at horizon

Example
Given the following earnings and dividends, an 8.5% discount rate and a perpetual growth rate of 6%,which
begins in year 6, what is the value of the stock?

P0 = 10.24 + 134.00 = $99.36

(1.085)5

7.6 There are No Free Lunches on Wall Street

Stock markets are efficient! You cannot predict returns! You cannot get rich by buying and selling stocks!
Technical Analysts :
– Investors who attempt to identify undervalued stocks by searching for patterns in past stock prices
– Forecast stock prices based on watching the fluctuations in historical prices (thus “wiggle watchers”)
On average retail investors under-perform the index! (by about 1% per year)
Professionally managed mutual funds also underperform on average the index. Why?
Because of the funds’ operating costs, like the administrative fees, salaries of the fund-managers etc.
What’s the take-away?
It’s better to invest in INDEX funds, because they often outperform actively managed funds.

Random Walk Theory

• Security prices change randomly, with no predictable trends or patterns
• Statistically speaking, the movement of stock prices is random
 Coin Toss Game :

S&P 500 Five Year Trend or Five Years of the Coin Toss Game? It’s pretty similar actually.

→ The market is very

efficient and as soon as a
pattern is identified it
disappears.

Efficient Market Theory

Weak Form Efficiency:
– Market prices reflect all historical price information (no use doing technical analysis)
Semi-Strong Form Efficiency:
– Market prices reflect all publicly available information (no use doing fundamental analysis)
Strong Form Efficiency:
– Market prices reflect all information, both public and private (no use having private information)
So what do you think? How efficient is the stock market? Weak, semi-strong, or strong-form efficient?
The market prices reflect a semi-strong to weak efficiency.

Impact of leaked information :

There are people that try to make money by selling

or buying confidential information about
companies that influence the stock prices.
Market Anomalies
Existing Anomalies :
• The Momentum Factor
• The Book-to-Market Factor → if a company has a higher book value compared to the market value,
on average it does well.
Old Anomalies :
• The Small Firm Effect
• The January Effect → historically October is a bad month (so good time to buy stocks) and January
is a good month (to sell stocks)
• The PE Effect
• The Neglected Firm Effect
No anomaly (old or new) is “arbitrage-proof” (You cannot make money after transactions costs)

Behavioral Finance
• Attitudes towards risk
• Beliefs about probabilities
• Sentiment
People are normally sentimental, they are not good in math and
tend to behave as in a herd, that is, they follow what the other
people do, even if they don’t understand much about what they
are doing.
 CORPORATE FINANCE – PART 2
Prof. Jos van BOMMEL
12/11/2021

CLASS 5 : CAPITAL BUDGETING (CHAPTERS 8 AND 9)

Case Study Empirical Chemicals
Capital Budgeting is about choosing in what to invest and what not to invest.

A comparison of investment decision rules:

Criterion Definition Investment Rule Comments

Net present Present value of Accept project if NPV is The “gold standard” of investment criteria. Only
value (NPV) cash flows minus positive. For mutually criterion necessarily consistent with maximizing the
initial investment exclusive projects, choose the value of the firm. Provides appropriate rule for
one with the highest (positive) choosing between mutually exclusive investments. Only
NPV. pitfall involves capital rationing, when one cannot
accept all positive-NPV projects.

Internal rate of The discount rate at Accept project if IRR is If used properly, results in same accept-reject decision
return (IRR) which project NPV greater than opportunity cost as NPV in the absence of project interactions. However,
equals zero. of capital. beware of the following pitfalls: IRR cannot rank
mutually exclusive projects—the project with higher
IRR may have lower NPV. The simple IRR rule cannot
be used in cases of multiple IRRs or an upward sloping
NPV profile.

Profitability Ratio of net present Accept project if profitability Results in same accept-reject decision as NPV in the
index value to initial index is greater than 0. In case absence of project interactions. Useful for ranking
investment of capital rationing, accept projects in case of capital rationing, but potentially
projects with highest misleading in the presence of interactions or in
profitability index. comparing projects of different size.

Payback period Time until the sum Accept project if payback A quick and dirty rule of thumb, with several critical
of project cash period is less than some pitfalls. Ignores cash flows beyond the acceptable
flows equals the specified number of years. payback period. Ignores discounting. Tends to
initial investment improperly reject long-lived projects.

Review Quiz
►Items on a Balance Sheet:
On the left: Assets → Cash, Marketable Securities, Accounts Receivable, Inventory, Property Plant &
Equipment, Buildings, Land, Patents, Accumulated Depreciation.
On the right: Liabilities and Owner’s Equity → Accounts Payable, Unearned Revenue, Taxes Payable,
Loans, Long-term Debt, Bonds Outstanding, Common Stock, Additional Paid-in Capital, Contributed
Capital, Retained Earnings.
►Income Statement:
1. Revenue / Sales / Turnover
2. CoGS: Costs of Goods Sold
3. SG&A: Sales, General and Administrative
4. Depreciation (can be included in SG&A)
5. Operating Profit
6. Interest Expenses
7. Earnings Before Tax
 8. Tax Expense
9. Net Income

►Where do we find the book value? Financial Statements/Balance Sheet

►What matters much more than the book value? Market Value / Future / real value
►Shareholders don’t receive coupons, but receive … Dividends (and voting rights)
►How do investors value stocks? Price per Earnings

Assignment 3 : Empirical Chemicals

Questions + Excel
Empirical Chemicals have 2 plants that produce polypropylene, which is a type of hard plastic.

Capital Budgeting
Capital Budgeting is the art of allocating capital within the firm.
Most (large) firms have capital budgeting procedures to make investment decisions.

What are the procedures at Empirical Chemicals?

1. Net Present Value (NPV)
2. Internal Rate of Return (IRR)
3. Payback period
4. Average Annual Addition to EPS → managers and CEOs are very concerned about this

What Is a Corporate Raider?

A corporate raider is an investor who buys a large number of shares in a corporation whose assets appear to
be undervalued. The large share purchase would give the corporate raider significant voting rights, which
could then be used to push changes in the company's leadership and management. This would increase share
value and thus generate a massive return for the raider.
Corporate raiders may use a variety of tactics to affect the changes they desire. This can include using their
voting power to install handpicked members to the board of directors. They could also buy the outstanding
shares under the pretense of pushing for changes the current leadership is not amenable to, but then offer to
sell back those shares at a premium price in order to turn a profit for themselves.
Key Takeaways:
• A corporate raider is an investor who buys a large interest in a corporation whose assets have been
judged to be undervalued.
• The usual goal of a corporate raider is to affect profitable change in the company's share price and
sell the company or their shares for a profit at a later date.
• Though corporate raiders usually seek to somehow improve and profit from a company, their
ultimate motives may be very personal.
Other motivations for corporate raiders can include positioning the company for a sale or merger that they
believe will provide a lucrative return. Such action may come in response to existing leadership at the
company rejecting acquisition offers that the corporate raider believed were suitable and sufficient.
Source: https://www.investopedia.com/terms/c/corporate-raider.asp

Why is it a bad thing that a Corporate Raider bought a lot of shares of the company?
Because Corporate Raiders normally buy the majority of the shares of a company that currently has lower
value, because it’s badly managed. Then they take over the company and try to make it more profitable,
before re-selling the shares at a profit.
But in order to make the company more profitable, they have to replace the managers, which is why
managers are particularly afraid of corporate raiders. On the other hand for the shareholders it’s a good thing
if the company is taken over, because like this they get rid of the bad managers and make a profit themselves
as well.

Contribution to Earnings (per share)

Shareholders look at Earnings per Share (EPS) to value their equity investments (their shares of common
stock). So managers care about reporting high EPS. But smart investors do not only look at (current) EPS.

What else do they look at? What should they look at?
Managers should not maximize EPS, instead they should maximize current and future cashflows → They
should undertake positive NPV projects!
“Cash is King, Earnings is an Opinion”

1. Should companies appraise projects based on contribution to EPS? (yes/no)

Possible exam question: Should you choose a project with a positive NPV or one that contributes to EPS?
Positive NPV projct.

The payback method

The payback counts the number of years until the investment is paid back. However, it ignores the time
value of money and cashflows after the payback period.

What project would you take? (assume r = 13%)

The second project is better,

because the total incoming cash
flows are much higher.

Yet, the payback is a very popular rule of thumb. Why?

Because it’s a simple way ; when you get money back sooner, it’s an indication of less risk ; if you have
capital constraints, you need to look at the payback rule.

2. Should companies appraise projects based on the payback method? (yes/no)

The NPV Rule
It compares the Present Value of the future Cashflows (attributed to the project), with the initial outlay.

NPV in French: Valeur Actuelle Nette (=VAN)

NPV in German: Nettokapitalwert, Nettobarwert

What should be the discount rate?

The Opportunity Cost of Capital → it’s the return that investors (or the firm itself) could earn on projects of
similar risk!
Financial managers estimate this rate (perhaps once per year). It’s then called the hurdle rate.
In French: taux de rendement minimal; In German: Hürdenrate
It matters what discount rate you use, because :
• when you use a higher discount rate, present value looks lower
• when you use a lower discount rate, present value looks higher
What was the hurdle rate for Empirical Chemicals? 13%

Internal Rate of Return

The IRR is the discount rate

for which the NPV is zero.
If we increase the discount
rate, the present values, and the
NPV goes down…

What is the IRR for this

project?
The IRR is the discount rate for which the NPV is zero → 15.25%
If a project has an IRR > discount rate, what does this mean for the NPV?
How can we compute the IRR?
NPV or IRR
For the go/no_go decision, the IRR rule and NPV rule are equivalent.
When choosing between two mutually exclusive projects, which would you choose? The one with the higher
NPV of the higher IRR ? The one with the higher NPV.
NPV rule: Go for it if the NPV is positive.
IRR rule: Go for it if the IRR is higher than the discount rate.
Example of a comparison of projects by IRR or NPV:
IRR NPV
Project A: You give me €1, I give you back €2 (r = 0%, no risk) 100% €1
Project B: You give me €100, I give you back €175 75% €75

When choosing between mutually exclusive projects, look at NPVs, not IRRs! Even when the size of the
project is fixed.

3. When choosing between two mutually exclusive projects, should companies choose the project with
the highest NPV or with the highest IRR? (NPV or IRR)

Assume: All cashflows are certain; Interest rate is 10%

You should go for the second project, because you would make 0,50 cents more (NPV 1.78 > 1.28).

Empirical Chemicals (Project A): Merseyside

If it was a standalone project, shall we take the project, or not?

Yes, because the NPV was positive.
Any adjustments?
If you consider the inflation, you need to adjust the prices, costs and profits also. As a result the whole
project would look better if you consider the inflation.
Should the Engineering Study be included?
No. These are costs that are already spent in the past, and should not be included! They are an example of a
“sunk cost”.
4. For the Merseyside project, should the engineering study be included? (yes/no)
What is a Corporate Overhead?
Corporate overhead is comprised of the costs incurred to run the administrative side of a business. These
costs include the accounting, human resources, legal, marketing, and sales functions. When corporate costs
are incurred, they are considered to be period costs, and so are charged to expense as incurred.
https://www.accountingtools.com/articles/2017/11/28/corporate-overhead

Should the Corporate Overhead be included in the project?

You should always ask yourself: Is the charge a genuine incremental cashflow?
Will the Intermediate Chemicals Group hire more support staff? If yes, then include.
Will the rent, heating and light bills of office buildings go up? If yes, then include.
Is it just a margin of safety? If so, then don’t include.
If there are real incremental cashflows, then leave the overhead charge in! If not, take it out.

5. What is the best course of action to deal with the overhead charge?
A. Remove it from the Merseyside proposal or B. Include it in the Rotterdam proposal
We can choose either to take the overhead charges out of both projects or add them to both projects,
like this the comparison of the two projects would be more just.

The Tank Cars

If the project requires us to bring a cash outflow
forward (from year 4 to year 2), does it affect the
NPV? Yes, it affects the NPV negatively.

Tank cars may be subject to inflation… → but in this

case it was said on the question to ignore it.

Tank Car Depreciation:

Depreciation of £1 reduces taxable income by £1, and reduces the tax bill by tc×£1… and hence increases
cashflows by tc×£1

By depreciating early (fast), free cashflows are brought forward, which is valuable!! → we should
depreciate faster whenever possible, because a dollar saved today is better than a dollar saved tomorrow.

6. What should we do with the Tank car issue? Add the costs of the tank cars and depreciate the cost over
a period of 10 years.
Depreciation and Taxes
We can reduce the tax bill by “accelerating” depreciation!
Why? The total depreciation is fixed: it’s the cost of the equipment. Depreciation reduces our income and
hence our tax-bill!
The total reduction in taxes is fixed. But a $ saved today is worth more than a $ saved tomorrow!

Taxes
Notice that in capital budgeting we estimate the cash outflow due to taxes by multiplying the operating
profit by the tax rate… In other words, we do as if operating profit is ‘taxed’. Is it?
How else can we reduce the tax bill (apart from depreciation)? By taking on debt, and paying interest.
The decision to take on debt is a financing decision, taken by somebody else (by the CFO/CEO, not
Hawkins and Silver). Firms take the tax advantage of debt into account in the discount rate… → (we’ll get
back to this, next week, or next).

Harry Mulvaney’s EPC project

What was Harry’s suggestion? To add his negative NPV project to the Merseyside project. He argued that
nobody would find out that his project was included, because nobody would check once the main project
had been approved.
Did Frances Trelawney include the EPC project? No.
What arguments could/should Harry use to accept his project? He should do his work and find a way to
show that his project had a positive NPV.

Empirical Chemical (Project B): Rotterdam

Where there any ‘sunk costs’?

Did they charge the project with overhead costs? No, they didn’t add any overhead costs.
What did they take into account and what are your thoughts? They tried to make the project look as good as
possible by removing anything that could hurt the NPV.
Rotterdam or Merseyside?

Cannibalization
If the Merseyside project affects Rotterdam’s sales, it should be taken into account!
Will there be cannibalization? Maybe…
A conservative approach would be to look at worst case scenario: full cannibalization.
Probably, EC’s competitors will also suffer from the increase in industry capacity. Instead of reducing
turnover (a.k.a. revenue, or sales), an increase in industry capacity is more likely to lead to a decrease in
price → because price is determined by supply/demand and an increase in supply tends to lead to a decrease
in price.
In a commodity business it’s not easy to differentiate yourself by quality, price is all that matters, so the best
way to convince your clients to buy plastic from you and not your competitors is to offer a better price.
How big is the increase in industry capacity?
If a complete price war breaks out, the price can fall to as low as $560/ton (the cost-price of the least
competitive players), for a drop of 8%…
Currently the market buys 1,515,000 tons, and paid 925.7 mio$ per year. If the market pays the same amount
for the total new production (1,524.5 tons), the price per ton will go to 607.2 for a price decrease of 0.6%…
What is most likely situation ?
A (0%)
B (100%) → this is the worst case scenario, it’s a very conservative answer.
C (10%)
D (price -1%) → the teacher’s preferred answer, justified by: supply ↑ => price ↓

Inflation
Andrew Deakins talks about the real rate of return. Huh?
When the bank offers us an interest rate of 10%, we can exchange $10 today for $11 next year. (that’s a
nominal rate).
But not 10 apples today for 11 apples next year… Why not?
If apples cost $1 today, and $1.03 next year, the apple rate of return is approximately 7%.
If all prices go up by 3%, and the bank pays an interest 10%, the real rate of return is 7%…
(Approximately! More precisely it’s 6.8%)
If we do not account for inflation in the cashflows (and discount real (apple) PP-prices and costs), we should
use the real (apple) target rate of return…
However, it is slightly better to forecast and discount nominal cashflows, at a nominal target rate of return.
Why?
Not all cashflows would increase if you consider inflation, for example depreciation isn’t affected by
inflation.

Were the forecasted Revenue figures “real” or “nominal”?

Revenue did not increase in the budget… even though Deakins of headquarters expected inflation.
Which means that the cash-flows were forecasted in real terms.
Best correction to make is to let prices (and costs) increase with 4% every year… Answer (B)
Alternatively, reduce the discount rate (for Merseyside to 9%) → Answer (A).
Answer C is wrong and Answer B is a bit better than A…

The Right-of-Way
If we do not exercise the option (to buy the right-of-way), should we sell it (the option)? Yes, because the
option has value.
How much would we get for it? At least $3 Million.
Hence, if we exercise the option, we incur an opportunity cost!! → because if choose the Rotterdam project,
we must exercise the option, and in this case we can no longer sell the option.
This is a real incremental cashflow: If we go with Rotterdam, we forego (i.e. lose) a cashflow of 3 mio$! →
we should take this into account when deciding which project is better.
What about the “Terminal Value, Land” of 35 mio$? The terminal value should be removed from this
project. It’s not an actual cashflow, it’s an expected future value, which was determined by a consultant, but
it’s something rather uncertain (after 15 years) and suspicious, because a consultant is someone that is paid
to tell you what you want to hear. Since it changed the NPV dramatically it should not be included in the
Rotterdam project. The land cashflows should be considered as a whole different project.
Rotterdam Land
project:

Rotterdam PP Project:

Appropriate discount rate for PP project is 13%…

Rotterdam Land Project:

Appropriate discount rate?
We don’t know the discount rate, but
since land purchases and sales go
beyond their expertise, it’s highly
unlikely that they would make a profit
from this transaction (NPV is probably
0).
What’s the Cost of Capital for buying
and selling land??

Right-of-Way
The Right-of-Way investment is probably zero-NPV for EC! Why? Because it’s not their ‘core competence’.
So, it’s best to take out the Right-of-Way cashflows! (answer D)
The fact that Rotterdam needs the Right-of-Way, could be seen as a “qualitative negative” for Rotterdam. →
because they will build a pipeline connecting their factory to a single supplier, making them dependent on
this supplier. This is naturally a situation worse than having multiple suppliers, because then you can
actually negotiate the best price.
In general: For projects that require buildings or land, it is best to forecast the rent-expense (unless you’re in
the real estate business…).
The Technology Option
No investment proposal is cast in stone. The flexibility to modify or change a project is called a real option.
Any project undertaken in the future will be positive-NPV.
So, a project with more flexibility, with more real options, is more valuable – has a higher NPV – than a
project without flexibility!
By making a model we can estimate the value of a real option. But this is beyond the scope of this course.

Example of a Real Option:

You want to produce and sell skateboard jet engines. Sales-price: €1,000/engine. Length of project: 2 years.
Turnover is uncertain: Either 10,000 or 20,000 units p/a (if turnover is 10,000 in year 1, it will be 10,000 in
year 2).
What’s the expected revenue?
• Machine A produces at a unit cost of €500
• Machine B produces at a unit cost of €550
Both machines cost 10 mio €, and have zero salvage value after 2 years.
Machine B can be sold for 8 mio € after one year.

Without a Real Option:

In this analysis (not

considering the real
option) Machine A
seems to be better,
because it has a
higher NPV than
Machine B.

With Real Option

(Machine B):
The green ball represents a dice
rolled by nature (chance) but the
orange square means we can
choose.
If the demand is high the revenue
of producing the engines will be
higher, we can keep producing
them. But if the demand is lower
and it’s more profitable to sell the
machine, we can choose to do
that instead. We can always
choose the best option.
The NPV of machine B
considering its real option is
3.16, which is higher than the
NPV of machine A (3.02)
Flexibility – “Real Options”:
The Skateboard JetEngine story is an example of an option to abandon. (Machine B).
Other real options are:
• Option to expand.
• Option to delay.
• Option to switch technologies → example of the Merseyside project in Empirical Chemicals
 Flexibility has value!

Intellectual capital
Silver argues that the Rotterdam project moves EC down the learning curve when using advanced control
systems. Learning (or ‘intellectual capital’) is valuable, but difficult to value.
Silver accounts for learning by assuming exponentially increasing margins until it reaches 16.5% of per
year. There exist sophisticated models, gauged by empirical evidence that learning occurs exponentially.

Which project would you take after the adjustments and discussions?

Took out engineering study, overhead Took out RoW cashflows

r = 13%, prices & costs increase with 4% yearly r = 13%, prices & costs increase with 4%
Tank car effect (+depreciation) Cannibalization: prices drop by 1%
Cannibalization: prices drop by 1% Inflation in CAPEX too

After the adjustments mentioned above, the results are as follows:

Merseyside Rotterdam
NPV 5.27 5.98
IRR 24.8% 21.8%
Payback 4 years 8 years

Risk? Trustworthiness? Rotterdam is riskier (longer payback means more uncertainty) and Merseyside is
more trustworthy.
Flexibility? Merseyside is more flexible, because we can choose to switch technologies in the future.
Dependency on one refinery instead of on three? On this aspect also Merseyside is better, because it doesn’t
depend on a single supplier.

Conclusion: Merseyside is the best choice, because although they have a slightly lower NPV, they have a
shorter payback period, and they have several advantages in comparison with Rotterdam, such as:
• Merseyside project does not make any compromises in flexibility of the technology adopted → for
example if the German technology comes out in the future they can adopt it and largely improve their
productivity
• Merseyside is not bound by a pipeline to a single supplier, they can choose between several
suppliers, that is, whoever offers the best prices and reliability.
Another reason to choose Merseyside is because Frances Trelawney seems more reliable than Johan Silver,
because:
• Frances Trelawney made some mistakes in her project that actually made the project look worse, like
not considering the inflation and adding the overcharge costs → they seem like honest mistakes
• Johan Silver has hired a consultant that gave a very high estimation for the price of the land where
they would build the pipeline → but was it an honest estimate?
• Johan Silver has been lobbying his project with the board of directors for some time.

Games people play

Who made the proposals? Should we trust them?
Whose budget do you trust more? Frances Trelawney seems to be more trustworthy.
Johan Silver has lobbied extensively to influence the decision:
1. He sought approval or support from more than one supervisor. He ‘sold’ his budget at a cocktail
reception to the board of directors.
2. He supported the request with voluminous data (which still had some silly mistakes in the proposal’s
advantage).
3. He justified the analysis in terms of subjective and lofty benefits (e.g. ‘technological learning’) while
condemning competing alternatives (‘myopic enhancements’, ‘sticking one’s head in the sand’)
What other ‘games’ did you see? Harry Mulvaney tried to convince Frances Trelawney to add his negative
NPV project to the Merseyside project.

Agency Costs
The tendency of managers to invest in negative NPV projects is what is meant by term ‘agency costs’.
How can we minimize agency costs?
• By having a good ‘corporate governance’ system in place
• The presence of debt also helps.
Firms with low leverage have more “discretionary cash”. This in turn tempts managers to invest in private
jets, luxurious offices and worse, ‘empire-building acquisitions’.
What kind of company will, do you think have more internal conflicts of interests?
a) Large multi-divisional firms → biggest in-fighting, politics and negative-NPV projects
b) Small specialist firms

The Post-Audit
Once a project is undertaken, controllers and managers conduct a post-audit.
A post-audit is a check to see whether the forecasted costs and sales are achieved. A post-audit helps us to
learn from mistakes, and monitor budget-submitting managers and divisions.
Is Empirical Chemical regularly doing post-audits? It doesn’t seem like they do it.
Capital Rationing
It’s when you have a limited amount of money to
spend.
If you have €100 mio to spend, and have access to
the following projects, which would you choose?
(you can choose more than one)
Project 6 has the highest profitability index, which
means you can get the most money for the money
invested.

In a capital rationing situation, we want to get the largest possible combined NPV. To find the best
combination we:
a) order projects on NPV and puzzle
b) order projects on IRR and puzzle
c) order projects on profitability index and puzzle
Profitability Index = NPV ÷ Investment

Unequal lives
Example: to produce EPC,
Empirical Chemical can
choose between two
different installations (both
have the same capacity)

Which installation do we
take?
One trick is to make strings to create equal lives. For our example we could compare a string of 5 projects A
with and 7 projects B → this would make the duration equivalent: 5x7 = 7x5
Another trick is to compute the Annual Equivalent Cost: The annuity of which equals the NPV of the
project:

Is it possible to solve for the question marks? Yes, because the annuity is the same every year, and the
question marks would be called the annual equivalent costs.
Main points this class:

• Although we use mathematics, Capital budgeting is an art, not a science.

• What matters is discounted cashflows. So, compute IRRs and NPVs, not payback periods and
accounting earnings.
• Only consider all incremental cashflows
• Don’t let Real Estate investments contaminate your calculations.
• Consider flexibility → it has value!
• When choosing, take project with highest NPV, not IRR.
• Capital Rationing (many projects, little money) → Profitability Index
• Unequal Lives → Annual Equivalent Cost (or A.E. Cashflow)
• Capital budgeting is an art, not a science. Can we trust the numbers? → the numbers are helpful,
but we have to take other things into consideration as well.
 19/11/2021

CLASS 6: THE DISCOUNT RATE

RISK AND RETURN (CHAPTERS 11 AND 12)

What should we use for the discount rate?

Should it be the risk free interest rate in the market (rf) ? No
Should it be the interest rate that the company has to pay to its banks and bond-holders ( rf + “a credit
spread”)? No, because the company is not only financed by the banks and bond-holders ??
The discount rate should it be the return that the company can earn on projects of similar risk → “the
opportunity Cost of Capital”!
The discount rate should be the hurdle rate or the opportunity cost of capital.

Risk and Expected Return

Most people prefer safe investments over risky investments.
The safest investment in the market are government bonds (depends on the government though)
We shall call the return on safest investment rf, the risk-free rate
Investors can be enticed to hold a risky investment if its expected return is higher.
For a company, the required return equals the expected return in the market.
In equilibrium, the expected return is: E[r] = rf + risk premium
What is risk? Risk is defined as the chance that an investment's actual gains will differ from an expected
outcome or return. Risk includes the possibility of losing some or all of an original investment.
https://www.investopedia.com/terms/r/risk.asp
How do we measure risk? Beta

Risk and Return, a historical perspective

2008-2009 → financial crisis triggered by sub-prime mortgages. Banks and people were buying and selling
loans that were backed by house mortgages that people would never be able to pay. This crisis contaminated
also the stock market.
2020 → Covid Crisis: Suddenly the countries started to go on lock down, which caused a lot of insecurity
among investors.
Risk and Return, a historical perspective (continuation)

Stocks or Equities (blue)

offer the highest returns, but
are also the riskiest. They tend
to be very profitable in the
long- term.
T-Bills (green) are the safest
form of investment, but they
also tend to offer the lowest
returns.
Bonds (red) are safe in
monetary terms, but in reality
they are not so safe, because if
interest rates go down, bond
values can go down a lot.
There seems to be a relation between risk and long term average return.

Can we measure risk?

Consider the following dice Game A. You pay €10 to throw
a dice, and receive:

The expected return, E[!], is 10%. It’s the average of all

(equally likely) outcomes.
It is a.k.a. the mean (this game is roughly as risky as
‘playing’ the stock market for a year).

Game A vs. Game B: Consider the following dice games. You pay €10 to throw a dice, and receive:

The expected return is 10% in both

games. Which of the two games is
riskier? Game B is riskier, because
there is a higher variation in the
possible outcomes.
How can we measure risk? We
measure risks using statistics and
standard variation.

Game A vs. Game C:

This is an illustration to show that

range is not a good risk measure →
neither is the probability of loosing or
the worst case scenario.
Game C is clearly riskier, even though
it has a smaller range.
A risk measure
What about the expected difference from the average (= average deviation from the mean) ?
The average deviation from the average is zero (of course!).
So we look at the average squared deviation. This is called the variance, symbol σ2. The variance is always
positive.
We then take the square root and call it the standard deviation, symbol σ [sigma].
Game B is more risky, because you can either win more or loose more, which means that the standard
deviation is higher.

What’s the standard deviation of Games B and C?

Go to the spreadsheet …

Diversification
If you invest €100 in dice game A, the probability distribution (think ‘histogram’) of your return is:

There are 6 different

outcomes, each with 1/6
probability.

If you invest €100 in two dice games

A, (€50 in each), the probability
distribution (think ‘histogram’) of
your total return is:

If you invest €100 in hundred dice games A, (€1 in each),

the probability distribution of your total return is on the
left → as you can see the more risks you add, the more
your expected return will look like a normal distribution.
Adding Risks
If we spread our investment over more and more games, two things happen:
1) The distribution of this average starts looking like a “Bell Curve”, a Normal, a.k.a. Gaussian “The
Central Limit Theorem”
2) The variance of our total return decreases… “The law of Large Numbers”
(the variance becomes σ 2 the standard deviation becomes σ where σ is the standard deviation of one
" "
game (22%), and " is then number of games you spread your investment over).

The “Normal Distribution”

What’s the expected annual return on an average stock? (the E[rm])

Currently it’s about 6% !
At least is we base ourselves on historical evidence. Historically, stockholders received a return that was
about 6% higher than rf, on average!!
This historic ‘excess return’ relative to rf is roughly the average over all stocks over about 100 years, in
many different countries. I believe that we can expect similar expected equity premiums in the future too!
Why? Currently the dividend yield on the Stoxx 600 ≈ 3.3%, adding inflation and economic growth, and
we’re there…

What’s the standard deviation of a stock?

daily monthly annual
BMW 2.3% 10.7% 37%

What does this mean?

If I invest €1000 in BMW today, tomorrow the value of my investment will be between €997.71 and
€102.31 with 68% probability. (in-between -2.31% and +2.31%).
If I invest €1000 in BMW stock today, the probability that, next month, my investment is less than €785
(loss of 21.5%) is about:
a) 5% b) 95% c) 2.5% d) 60%
What is the (approximate) probability that next year, my investment is worth more than €1400.
If today BMW stock goes up with 2.3%, what will be the return tomorrow? We can’t tell! Stock returns are
unpredictable. Why? → There is no free lunch! Markets are efficient !
Where do we get BMW’s annualized return standard deviation (volatility) ? From historical data ! Typically
from the past 150 days, then we annualize.
Is volatility stable and predictable? Yes! (not perfectly though!)

Which of these has the highest volatility?

daily monthly annual
BMW 2.3% 10.7% 37%
Facebook 2.4% 11.0% 38%
Ferrari 2.0% 9.2% 32%
Stoxx50 1.8% 8.1% 28%
Tesla 5.4% 24.8% 86%

Order from high to low : Tesla → Facebook → BMW → Ferrari → Stoxx50

In class exercise (use the Stock Returns spreadsheet)

1) Compute the average monthly return on Ahold stock during the period 2000 – 2014, using the =
average(.) function
2) Compute the standard deviation, the “hard way”: ‘insert’ two columns next to Ahold returns.
In the first column compute the ‘deviation from the average’, in the second column the squared deviation.
Take the average of the squared deviations, and take the square root…
3) Compute the standard deviation with the =stdev(.) formula
4) Now compute historic average monthly returns and standard deviations for all stocks. What do you see?
Did riskier stocks have higher returns?
5) Map the stocks are in a graph with on the vertical axis Return (average past return) and on the horizontal
axis Risk (historic stdev)
Formulas and solutions in: Week6_part2_Discount-Rate-Games-and-Stocks.xlsx

In Class Exercise and Quick Quizzes

Assuming that:
i. the historic average returns are the future expected future returns
ii. the historic standard deviations are the future standard deviations
iii. you are “risk-averse”

1) You have to choose, only one of the two (which will be your only investment)
a) BMW or Continental? Continental → higher return and lower risk
b) Heineken or Fortis? Fortis → higher return, but slightly higher risk
c) L’Oréal or Lufthansa? L’Oréal → higher return and lower risk
2) What would be the E[r] and the σ of a portfolio consisting of Heineken and Fortis in equal proportions
(50% – 50%)
E[r] = (0.5*1.1%) + (0.5*0.7%) = 0.9%
σ : we inserted an extra column between Heineken and Fortis and put the formula: (0.5*Expected Return
Fortis) + ((1–0.5)*Expected Return Heineken) → we pulled the formula down all the way. Then we
calculated the standard deviation of this column with the formula =stdev.p and we got the result 4.9%.
Here we can see how investors benefit from diversification, since the portfolio of 50-50% is even less risky
than the least risky stock involved.
Formulas and solutions in: Week6_part2_Discount-Rate-Games-and-Stocks.xlsx

3) Compute the annualized average return and standard deviation for portfolios of Heineken and Fortis in
proportions 10%, 25%, 50%, 75%, 90%. Make a graph.
4) How can you explain the shape of this picture? This shape is because of diversification, that is you reduce
the risk if you combine 2 or more assets, so you move to the right (less risk = northwestern direction of the
curve).
5) What is the best combination of Heineken and Fortis? In this case it’s about 50-50%.
Formulas and solutions in: Week6_part2_Discount-Rate-Games-and-Stocks.xlsx

FYI: there is another way to construct this picture, with a formula:

The first formula means that the expected return of the portfolio is the weighted average of the expected
returns of each asset in the portfolio.
The second formula means that the variance of the portfolio is the weighted average of the variances + the
weighted average of the covariances of the 2 stocks?

Which of these efficient portfolios is best?

The one with the highest “Sharpe Ratio”

# [!$] = expected portfolio return

σ $ = portfolio standard deviation

The pink area is the efficient frontier, which

shows all the most efficient portfolios,
because they represent the highest return for a
given standard deviation (or the lowest risk for
a given return).
The yellow star is the best portfolio and it’s
called the tangent portfolio, because it has the highest Sharpe Ratio, which means it provides the highest
return for the lowest risk.
Diversification
By spreading your ‘investment’, you reduce risk → Spreading risk is called diversification.
If you can play dice game A infinitely many times, you can turn €100 into €110 almost for sure! (“the law of
large numbers”). The standard deviation of the total return decreases in the number of (independent) throws.
Diversification in the stock market works also, but not as good as in dice games:

Why does the standard deviation of stocks not go to zero??

Because stock returns are not independent of each other, but are correlated!
The risk that cannot be diversified away is called market risk, undiversifiable risk, or systematic risk.
Systemic risk is not the same thing, it’s actually the risk that a system would break down.
Diversification is hindered by correlations:

A risk measure
A stock’s contribution to a portfolio’s risk (its s) is due to the covariances with all the other stocks.
More precisely, for a well diversified portfolio, the stock’s risk contribution is due to the average covariance
with the other stocks, which equals the covariance with the average..
A stock’s relative contribution to the risk of a large market portfolio is called the stock’s beta:

The average b (of all stocks in the market) = 1, so, the Beta of the market → β m = 1
Low beta, high beta

If all stocks had the same expected return, what kind of stock would you rather have? High beta or low beta?
Lower β, because β is an indication of risk and it’s always better to have the lowest risk for a given expected
return.
So, probably, high beta stocks are cheaper, and have higher expected returns. It can be shown that, in
equilibrium, there is a linear relationship between a stock’s Beta and its expected return.

The Capital Asset Pricing Model (CAPM)

William Sharpe and John Lintner came up with the following formula:
E[ri] = rf + βi × Risk Premium
Because we typically measure beta w.r.t. a large portfolio of stocks (e.g. FTSE-100, S&P500, Nikkei, etc.) :
E[ri] = rf + βi × Equity Premium → remember this formula!
This equation also holds for the market portfolio:
E[rm] = rf + βm × Equity Premium
E[rm] = rf + Equity Premium
Equity Premium = E[rm] – rf
So that: E[ri] = rf + βi × (E[rm] – rf)
Equity premium is the excess return on the market and is sometimes called the Market Risk Premium.

In class exercise
1) Compute the betas of the stocks, in your spreadsheet, using the covar (.) and
var(.) excel formulas
2) Compare the betas with the (historically) average returns. Do you see a pattern
now?

“Asset Pricing” (= discount rate pricing)

We estimate the asset’s beta w.r.t. a large (market) portfolio (the beta is the asset’s contribution to the
portfolio’s risk)
We multiply this with the (estimated) equity premium, and add the risk-free rate.
This gives us the expected rate of return on the asset : E[ri] = rf + βi × Equity Premium
What’s the equity premium (for the Stoxx-50, say), approximately?
CAPM in a picture

Beta

Which stock has the highest beta? Red or blue? (black =

market)
The red stock has the highest beta, because it’s the one
that varies most.

Assumptions underlying the CAPM

1) Standard deviation is the relevant risk measure, returns follow the “Normal” (i.e. we don’t care about
skewness, or kurtosis … (huh?) Kurtosis is ‘fat tails’.
It turns out that, although the ‘Normal’, is a very good approximation, the Stock returns are slightly
negatively skewed and have “fat tails”. Negative fat tail events are called “Black Swans”.
2) Markets are efficient market in equilibrium, where prices reflect everybody’s information.

Estimating beta
BMW’s beta lies between 0.944 and 1.250 with
95% probability!
Notice: our estimation assumes that the beta is
stationary.
This is a beta-estimate

Testing the CAPM

Black, Jensen and Scholes (1972)
Conclusion: high beta-stocks performed better than
low beta-stocks, on average, historically.
But zero-beta stocks perform better than rf
This showed that, relatively, the low beta portfolios
did worse than the high beta portfolios.
From the Book

What else (other than beta)

matters? (other than beta)
→ Price: Cheap stocks (cheap
compared to ‘book’) do better than
expensive ones.
High Book-to-Market are cheap
stocks (they are also called value
stocks)
Low Book-to-Market are
expensive stocks (glamour stocks)
‘Value vs. Glamour’ → Over-
optimistic investors are over-
represented.
→ Size: Small stocks do better than big stocks on average
‘Liquidity is priced’, apart from a risk premium, there may be an illiquidity premium.
A possible explanation is that small stocks have less liquidity and that this has a price.
Big stocks (with big names like Unilever) have a very high liquidity.

The Cost of Capital

The CAPM also holds for projects (like the PP-expansion at EC)
How would we estimate the beta of the Polypropylene business? We don’t!
There are no historic market prices for PP-plant expansions to regress on the market portfolio..
Many companies estimate a company-wide Cost of Capital. Others have divisional Costs of Capital.
→ But let’s first assume a single business Company or Enterprise

The Weighted Average Cost of Capital (WACC)

=>

The value of the firm, or the Enterprise Value “EV” is the sum of the PV(FCF)’s of the firm’s many
projects.
All projects are financed with both debt and equity (not with accounts payable, and other non-interest
bearing liabilities).
The appropriate discount rate or Cost of Capital is the WACC, the Weighted Average Cost of Capital:
The discount rate is the Weighted Average Cost of Capital:
WACC = wd × (1 – tc) rd + we × re → important formula!
Where : (1 – tc) rd is the after tax cost of debt,
re is the (after tax) cost of equity, and the w’s are the market weights
!" = #$% &$'% and !$ = ()*+$% ,)-.
./ ./
And : EV = Net Debt + Market Capitalization

The after tax Cost of Debt: (1 – tc) rd

The after tax cost of debt is lower than the interest rate (the before tax cost of debt), because interest
payments come with a tax shield.
Interest payments reduce the company’s tax bill, and increases the cashflows to investors.
Or, if we have €1 of after tax operating profit, we can “give” more than €1 to debt-holders ( to be precise
€1/(1-tc) ).
It turns out that, if debt-holders require a ‘true’ return of rd ( 10%, say), and the tax rate is tc ( 25%, say ), it
costs us only 1-tc) rd ( 7.5% ) in terms of after tax operating profit.
Debt is less risky, because you have to pay it. When the company goes bankrupt, debt gets paid first, and
what is left is considered equity. So debt is safer than equity.
Interest payments are tax deductible.

WACC and taxes: an example

Slides 58-60 from Week 6 Course.
WACC = wd × (1 – tc) rd + we × re
Why do we account for the interest tax shield in the discount rate? (While we account for depreciation tax
shields in the cashflows?) Because depreciation belongs to the project, and interest tax shields to the firm.
Where do we get the rd? We call the bank! (or a couple of banks) “What’s the interest we would have to
pay if we would borrow £7 mio?” → then you choose the cheapest offer
Most likely the rd is higher than the rf Why? We call the difference between the rd and the rf. the credit
spread.→ Because companies are risky, then can go bankrupt, while governments don’t normally go
bankrupt. Credit spread is what companies pay more than the government.

Credit Spread = rd – rf
Credit spread is the difference between the yield (return) of two different debt instruments with the same
maturity but different credit ratings. In other words, the spread is the difference in returns due to different
credit qualities. https://corporatefinanceinstitute.com/resources/knowledge/credit/credit-spread/
How does ‘the market’ determine the credit spread?
How would ING set a credit spread for a client?
They probably have a secret credit scoring model, that looks at:
• Ratios of Leverage, Profitability, Liquidity
• Diversifiable risk: product liabilities, accounting policies ...
• Systematic risk: What’s the company’s beta?
• Debt contract: seniority, maturity, collateral, conditions, is it secured …
Remember the 5 C’s of credit analysis:
Cash, Cashflow, Capacity (to repay), Capital, Collateral, Covenants, Conditions, Cyclicality, Character…
Where do we get the re? Probably, the portfolio managers will use the CAPM!

The Cost of Equity

E[ri] = rf + βi × Equity Premium
 What should we use for rf ?
The return (a.k.a. yield) on one-month Treasury bills? Or the return on 30 year Government bonds?
If we are looking for the WACC for 15-year PP projects? Most companies use the yield on 10 year
government bonds.

 Where do we get the βi ?

We can do a regression (look at the historic average return) of the company’s stock on the market or use the
formula. But this only gives us an estimate, based on historic observations.
What if we do not have historical data? (or if we don’t trust our regression estimate?)
If you regress the company i’s return on the market return, it is the coefficient of the X-variable, or the slope.
When we don’t have reliable historical returns of a company, we can look at comparable companies:
• estimate the betas of comparable firms, then calculate the average.
• use a “Beta-book” with “industry betas” → use common sense!
• What does beta measure? It measures “market risk”, “systematic risk”,
“cylicality”
The average beta is dependent on leverage, which is the use of debt in the capital structure. That is, if you
have a lot of debt, you are high on leverage and this has a negative effect on the β.
Beta also depends on operating leverage. A company has a high operating leverage if it has a lot of fixed
costs and few variable costs, and this also has a negative effect on β.

In Class Quiz
1. Beta is increasing in leverage.

2. Beta is increasing with operating leverage.

3. Beta of Luxair Tours is higher than Beta of Auchan.

The tourism sector is riskier than the supermarket sector, because if there is a crisis, people will delay their
holidays, but they won’t stop going to the supermarket to buy essential goods.

4. Beta of growth companies (e.g. Tesla) is higher than beta of low-growth companies (e.g. Shell).
Start-up and tech companies are much riskier than established companies, so β of the first ones is higher.

The CAPM beta

Don’t trust website’s beta! They are regression estimates →on a single day different websites can show
different betas for the same company.
Estimated betas change over time.
Use common sense and better judgment and don’t blindly trust betas found in websites!
Industry betas

The industry betas depend on the cyclicality.

When you don’t have enough historic data for a company you can search the average beta of the concerned
industry to have an estimate.
re = rf + βi × Equity Premium

Estimating the Equity Premium (1)

The equity premium is the excess return that the ‘marginal’ investor requires to invest in equities instead of
treasuries. It is a risk premium (if equities become riskier, the EP is likely to … ??)
One way of estimating the equity premium is by taking the historic average of the monthly excess returns,
the (rm – rf)’s. Over the 986 months from 07.1926 until 07.2018, the average rm - rf in the U.S. was 0.628%.
That’s annualized 7.8%. The monthly standard deviation was 6% (annualized 20.7%).

The equity premium

Is the equity premium stationary? No, it varies in different periods due to historical events. Therefore in
order to get a reliable estimate we should look at a longer period of time.
What happened, intuitively, to the equity premium in 2020?
Did investors require a higher or a lower risk premium to invest in the stock market than in 2019? Investors
required a higher risk premium, because they became more worried. As a result, the prices fell a lot, because
if the discount rate is high, the prices will be low.
In March the stock market went down by 20% for two reasons:
1) the expected cashflows (dividends!) went down
2) the risk-premium went up!
However, in March 2019 the historical average risk premium went down!
Estimating the Equity Premium (2)
Another way of estimating the equity premium is by backing out the discount rate from prices and future
dividends.
We know that a perpetually growing dividend stream can be valued as follows: P0 = Div1
r–g
→ The discount rate that the market uses to discount the perpetual dividend stream.
Hence: !% = &'(%)!*+, + - Equity Premium = .*,&'(/'+01 + - − !2
$0
Currently, the dividend-yield on the Stoxx600 is about 3.3%
The rf = -0.2%. g is the LT economic growth in nominal terms

Estimating the Equity Premium (3) – Consumption and Risk Theory

People live quite long, and can smooth consumption over time.
When we look at how consumption varies with market returns, and consider realistic “risk aversion
coefficients”, we find that the equity premium should be around 2% or less.
The historically achieved equity premium (U.S. 7%) is very high.
It is considered a ‘puzzle’. The “equity premium puzzle”.

Estimating the Equity Premium (4) - Surveys

We can ask professional analysts where they think the (S&P500) index will be next year.
Business Week asks this question every December. The average return tends to be +/- 5% higher than the rf
Professor Ivo Welch asked 400 Finance professors → The average estimate was 5.7%... (last year 5.3%)

Summary
The discount rate = opportunity cost of capital = return available (‘in the market’) on investments of similar
risk.
Risk is measured by standard deviation (“s”, of annual returns) → Because stock returns follow the
“Normal” distribution (approx.).
The risk of large portfolios (and indices) ≈ 20%.
The Equity-premium ≈ 5%. But that’s for the stock market as a whole.
The relevant risk measure for stocks is not their σ, but the β, the contribution to market risk. The average β =
1. Cyclical stocks, with high leverage, and growth have β > 1. Non-cyclical non-growth stocks have β < 1 →
it can be as low as 0.75
The Cost of Capital for projects (and entire ‘enterprises’) is the WACC = wd * (1-tc) rd + we*re
Where:
tc = corporate tax
re = cost of equity
rd = cost of debt
!" = Net Debt and !$ = Market Capitalization
./ ./
EV = Net Debt + Market Capitalization
 26/11/2021

CLASS 7 : SOURCES OF FINANCE (CHAPTERS 14, 15, 16)

Summary of Last Class (Chapters 11, 12, and 13)

Chapter 11: Risk is measured by standard deviation (“s”, of annual returns)
Stock returns follow the “Normal” (approximately).
Stocks are risky, stdev of market portfolios (S&P500, Stoxx600, CaC40..) ≈ 20% (annual)
Historically (U.S.), the stocks did about 7% better than T-bills. (annual)
Internationally, and going forward, the Equity Premium = E[rm-rf] ≈ 6% (IMHO)

Chapter 12: Clever Investors Diversify! To move North-West in the E[r] – s space.
There is a limit though: The “Efficient Frontier”. ooixo7ro notre5.12
Investors chase the best portfolio so that in equilibrium we have:
The CAPM: re = rf + bi × Equity Premium
Where bi is a measure of a stock’s correlation with the market (and the economy)
30 1101313,27016.3 5.08
Chapter 13: The Cost of Capital for projects is the WACC = wd (1 – tc) rd + were
TÜtpfx6 6
CHAPTER 14 : INTRODUCTION TO CORPORATE FINANCING

14.1 Creating Value with Financing Decisions

14.2 Patterns of Corporate Financing
14.3 Common Stock
14.4 Preferred Stock
14.5 Corporate Debt
14.6 Convertible Securities

14.1 Creating Value with Financing Decisions

Firms look for the cheapest form of financing (how?), but cannot create value with financing decisions.
No free lunch for investors, no free lunch for firms either in the competitive capital markets. Firms normally
create value on the left side of the balance sheet.
Only very few firms can create value on the right hand side of the Balance sheet. What kind of firms? Banks
and insurance companies, because they get financing very cheaply from the customers and they invest it.

Sources of Funds (FedEx) :

What balance sheet item went
up showing the internally
generated funds? Retained
earnings
What’s a negative net issue of
Common Stock? It means they
bought back stocks → there is
fewer stocks outstanding and
their price goes up.
Debt Ratio (FedEx):
Which of these two lines is the w d in the
WACC formula?
The red line = the Market debt ratio → which
means it corresponds to: value of the debt ÷
(debt value + equity value).

Equity (From Fedex Balance Sheet)

Which of these numbers is the most important to

compute the market value of equity (the we in the
WACC formula) ?
The number of outstanding shares, which we
multiply by the share price to get the market value
of equity.

What two rights shareholders have?

- Dividends (“residual cashflow right”)
- Right to vote (“control right”)

Debt
Bank Loans
Bonds outstanding (“notes”, “debentures”…)
Commercial Paper (it’s a very short term debt)

Something else apart from Equity and Debt?

Preferred Stock → legally it’s equity but it looks more like Debt
- Promised payments (preferred dividend, stipulated in advance)
- No voting rights (normally)
- Preference in liquidation (bankruptcy) → the order of payments in liquidation is: employees → tax man →
→ bank → bondholders → preferred stockholders → common stockholders
…But, preferred dividends are not tax-deductable

Convertible Debt → legally it’s debt, but looks more like

Equity.
- Has a coupon and maturity, but can be converted, at the choice
of the holder, into common stock.

Convertible Debt and Preferred stock are sometimes called

Mezzanine Financing.
 CHAPTER 15 : CAPITAL RAISING = ISSUING SECURITIES

15.1 Venture Capital

15.2 The Initial Public Offering
15.3 General Cash Offerings (Seasoned Equity Offerings)
15.4 The Private Placement

15.1 Venture Capital

Sources of Venture Capital:
Friends, Family and Fools (the 3 F’s) ; Angel Investors; Private Equity; Crowdfunding
Crowdfunding is when you go to people (usually your clients) and ask for investment in return of an early
delivery of the product, for example.
Needed: Business Plan – Signal (of faith in your company – like showing that you have already invested in
your own company) – Incentives.
Investors provide more than just $$$ → they also sometimes provide their experience and contacts
Financing comes in stages (separated by contractual milestones) → investors often offer an initial amount
and say that if and when you reach a certain point, they will give you more.
Very risky: 7 out of 10 start-ups fail... Only 1 becomes successful.

15.2 Initial Public Offering

An IPO is an event where a company issues shares to the public at large, and obtains a stock market listing.
Why would a firm go public?
• To raise money! (most important reason)
◦ To finance growth (in case they sell new or “primary” shares)
◦ To let early investors cash out (in case they sell existing or “secondary” shares)
• Make future capital-raising easier / cheaper !
• Visibility, Image (also in the “product market”)
• Obtain a continuous valuation from the market
◦ To offer managerial incentives (e.g. offer them shares or stock-options)
◦ To estimate beta and WACC → when you are listed on the stock market you see your relationship
to it, such as with the beta.

Are there any costs to going (and being) a public company?

Yes, it’s expensive to become a public company
• Costs → underwriter “spread” of 5-10% of fees and indirect costs
◦ Indirect cost 1: attention, time
◦ Indirect cost 2: in order to sell a lot of shares we need to give a discount or “underprice”
If you are an uninformed investor it’s better not to invest in IPO shares, because the price tends to go up very
quickly and become over-valued.
• Loss of confidentiality → you need to tell everything even to competitors
• Costs of being public → regulatory, reporting and other fiduciary duties
• Loss of control and private benefits → you become more limited, for example, when you want to
invest in something you have to think first about the shareholders, therefore you can invest only in
positive NPV projects.
How do firms go public?
• Formalize corporate governance, increase transparency → get a “Big 4” (KPMG, EY, PwC, Deloitte)
auditor and increase visibility in financial markets.
• Retain an underwriter (listing agent, investment bank). Example of the largest investment banks: JP
Morgan Chase, Deutsche Bank, Citigroup, Goldman Sachs, Morgan Stanley, Barclays etc.
We want an underwriter that has a strong reputation with the buy-side. These banks specialize in
buying securities and selling them in what is called the buy-side (insurance companies and mutual
funds). The underwriter is a key person in the IPO process, because they guarantee that the company
will get the securities and then they sell them to the buy-side.
• Prepare a prospectus (a.k.a. “Offering Circular”) → It includes the risk factors, what is the strategy
of the company, the balance sheet, the background of the CEO etc. In the USA, the prospectus is the
only form of advertising and it’s highly regulated.
• Register with the Regulator (in Luxembourg it’s the “CSSF”, in the USA it’s called “SEC”) and with
stock marketing
• Do a Road Show → to present the firm to potential investors and allow them to ask questions about
the company → normally you go to Boston, Frankfurt, Zurich…
• Book-building: it means taking orders (over the phone, e-mail)
• Then they decide the final price and allocate the shares → most IPOs are heavily oversubscribed
(2-10 times)
• Opening Bell rings → then provide liquidity, provide analyst coverage

Time line and

Summary of the
IPO process:

15.3 Seasoned Equity Offerings

When a company is already listed (and the price is already known), it is much easier and cheaper to sell new
shares.
Quick quiz:
Company ABC SA. has 100 mio shares outstanding, the share is trading at around €10. It needs to raise €200
mio (e.g. to pay back the “Covid-loan”). How many new shares does it need to issue?
a) 20 mio shares
b) 22 mio shares
c) 200 mio shares
20 mio shares at around €10 would not be enough, because in order to make people buy these many shares
you normally need to sell them at a discount.
Announce: “We plan to raise €200 mio using accelerated book-building, underwritten by X-Bank”.
→ Share price will probably drop (to €9.52) → Why? Because equity issue is bad news, since there will
probably be dilution in the horizon, and the company is saying they need more money, which doesn’t exactly
incite trust.
Prepare offering document, distribute to large institutional shareholders only (big buy-side clients).
Make phone calls (no roadshow necessary), build book, and sell 22 mio shares for €9 (institutions get a
discount of €0.52 from market price).
How would you feel if you were a small shareholder? You feel betrayed, cheated, because it’s not fair. The
solution around it is following the Rights Issues method.

Rights Issues
• Main method to raise equity capital in most countries → except in the US (this method is more fair)
• Firms “give” all current shareholders a right to buy new shares at a discount from the last traded
price. Example: in 2017 Deutsche Bank shareholders received, for every 2 shares held, the right to
buy one new share for €11.65 (market price at that time was €18)
• Advantage :
◦ Equal treatment to all shareholders! The discount does not matter! → Why? Because on one
hand you get a discount in one share, but all shares will be diluted (price will fall)
• Disadvantages:
◦ Shareholders have to undertake action: exercise their right or sell the right
◦ Shareholders who missed the e-mail may sue the company (or broker)
◦ It’s a bit cumbersome (that’s why rights issues are uncommon in the U.S.)

Rights Issue – Example:

The company ALTAREA launches a capital increase with preferential subscription rights. The subscription
rights are admitted to trading until 30/11/2021 on the Paris stock exchange under the symbol ALTDS and
can be exercised in multiples of 22 to subscribe for 3 new shares at a price of €143.75 per share.
Current market price of ALTDS was : €161→ so the rights are valuable!
What is the value of a right?
(161 − 143.75) × 3 ≈ €2.34 Exam question
22

15.4 Capital Raising = Issuing Securities

Private Placement:
When a company sells new shares to a single (or a small number of new shareholders) → this tends to be a
good thing, because it means these shareholders also believe in the company

Corporate Bonds are sold in a similar way → they are sold through an underwriter, who makes phone calls
to potential investors and builds a book.
However, no “roadshow” is necessary, the discount given is much lower, and the process is much simpler.
Why? Because bonds are less risky, since when you buy a bond, you know exactly what you are getting.
Bonds are also less information sensitive, because you don’t need to know everything about the company
when you know what you are getting back.
 CHAPTER 16 : CAPITAL STRUCTURE

Key Question:
Can we do our shareholders a favor by changing the right hand side
of the balance sheet?
Example: by borrowing money, and paying it out as a dividend (or
doing a rights issue and use the proceeds to pay off the debt)

Capital Structure, Leverage, Gearing

Mature, non-growing, and debt-free Tom and Henry’s expects an EBIT of either €30, €80, or €130 Mio (bad,
average, and good years)
The EPS (and hence the dividend!!) will be (with equal probabilities): €0.23, €0.60, or €0.98
Expected EPS = €0.60; T&H’s 100 mio shares are trading at €8.

What’s the re? From $!'3+ = #[!1'( +] → !+ = #[1'(] = €0.60 = 7.5%

!+ $!'3+ €8

Or they could borrow €480 mio, at an interest rate of 8%, to buy back 60 mio shares. The new perpetual EPS
(= dividend) would become:
(€0.16), (in bad years) €0.78 or €1.72 (in good years)

Tom and Henry wonder what their optimal gearing is :

Bad-year EPS Expected EPS Good-year EPS St dev
No Debt €0.23 €0.60 €0.98 €0.38
Some Debt €0.17 €0.70 €1.24 €0.54
High Debt (€0.16) €0.78 €1.72 €0.94

They notice the risk expected_return trade-off …

But what Capital Structure would result in maximum shareholder value? What would shareholders prefer?
It turns out that it doesn’t matter! Why?
The reason is that shareholders can leverage their returns themselves (at home)! How? By borrowing money
from the bank themselves and buying more shares than they normally would, thus they would incur a larger
risk-return.

Modigliani and Miller (1958)

They assumed that:
• There are no taxes
• The operating cashflows (EV) are independent of the capital structure
◦ Investment is given: Managers take all +NPV projects
◦ Bankruptcy (financial distress) is not costly:
◦ If PV(FCF) < Debt, then the company passes costlessly to the Debt holders
• There are no transaction costs
◦ Not for investors
◦ Not for the firm (markets are efficient)
And showed that, if these assumptions hold, then : A Firm’s Capital Structure is irrelevant! (MM,
proposition I)

Proof of MM “proposition I”
Assume two companies in the same risk-class: Lever and NoLever. Both have risky, non-growing operating
profits with expectation $10 Mio per year. Because of ‘non-growth’ both pay out an expected $10 Mio,
perpetually. Both companies have 1 mio shares.
NoLever’s equity is trading at $100 Mio, $100 per share (its re = 10%).
Lever has a debt of $50 Mio, it requires an annual interest payment of $4 Mio. i.e. its rd = 8%.
Why is rd < NoLever’s re ? Because there is less risk for the bank.
→ Lever’s expected dividends are thus $6 Mio/year. What is the value of Lever’s equity? $50 Mio ! If not,
you would be able to arbitrage (= make risk-free profit)
You would buy a share of NoLever for $100 and borrow $50, at a net cost of $50.
The net payoff is an expected $10 per year in NoLever dividends, minus $4 in interest, or an expected $6.
This is exactly the expected payoff on a share of Lever! So a share of Lever has to cost $50 too!
So: Leverage doesn’t matter, because investors can add leverage themselves!
MM Proposition II
!+ (4) = !+ (5) + & (!+ (5) − !1)
#
Where:
!+ (4)→ Levered Cost of Equity
!+ (5)→ Un-Levered Cost of Equity
The required return on the Levered Cost of Equity is the same as the required return on the Un-Levered Cost
of Equity + the formula of the increase in the Debt/Equity ratio.
Cost of Equity increases linearly in the D/E ratio…
Intuition: more leverage → equity payments riskier → higher required return
Indeed: more leverage → higher beta → higher required return
Although !+ increases in leverage, the WACC does not! It depends only on the business risk

!+ → expected return on equity

!1 → expected return on debt
WACC = expected return on assets
As we can see in the picture, the Cost of Equity goes up
with leverage, but the WACC stays the same.

Nobel Prize Winning Ideas

Enterprise Value is determined by riskyness of the cashflows, not by the capital structure (proposition I)
The cost of capital (WACC) does not depend on leverage (!!), even though rd and re do!
More debt increases the portion of cheap financing but makes left-over equity riskier and more expensive
(prop. II) → Financial policy is irrelevant… But what were their assumptions?

First assumption to drop: Taxes exist!

(and interest payments are tax-deductible)
Consider a completely riskless firm that generates an operating profit of $100
every year, forever. The risk-free rate is 5% ( re = rd = rf )
Unlever: The perpetual dividends of $75 are worth $1,500 (divide by 5%)

Lever: If the firm borrows $400, it pays interest of

$20 per year.
The perpetuity of $60 is worth $1200 (divide by 5%)
We add the borrowed $400 that is paid out to the
shareholders as a dividend.
Total is $1600, making shareholders better off by
$100…

Hi Lever: If the firm borrows $800, it pays interest of

$40 per year, tax deductible!
Now shareholders are better off by $200 !
Where does this added value come from? With more debt and more interest, the company pays less taxes.
What’s the slope? It corresponds to the
corporate tax rate, because interest is tax
deductible.
The more debt, the lower the taxes paid,
the higher the EV!
(This was pointed out by Modigliani and
Miller in 1963)

What about personal taxes?

On the corporation level, interest outflows are shielded from tax.
However, on the receiver’s end, cash inflows from debt income (coupons!) are taxed. Often interest income
is taxed higher than equity income.
According to Merton Miller (1977), the tax disadvantage of debt on the personal level offsets the tax
advantage of debt on the corporation level (at least in “equilibrium”) → Capital structure is irrelevant again!

Debt and all taxes (corporate and personal taxes)

Established “cash-cow” firms pay more tax (they have a very stable and predictable income) than “growth
firms” (the latter have low income, or even losses)
Tax on dividend- and coupon-income tends to be higher than tax on capital gains.
Academics after Miller show that, in theory and in practice:
1) High income tax individuals hold mostly
growth stocks (capital gains > dividends)
2) ‘Widows and Orphans’ hold bonds and high-
dividend stocks → they have no income
3) Growth firms are predominantly equity-
financed (this makes sense only from a tax-
viewpoint: it’s silly for loss-making growth firms
to pay interest, as it does not reduce their tax-bill,
while it burdens the receivers with income-tax)
4) Cash-cow firms (VW, Unilever, Nestlé) are
predominantly debt-financed → they can increase
their value by increasing leverage, but for growth
companies it does not make sense to increase
leverage, because they have no income to deduct
the tax from.

Costs of Financial Distress

Consider an unlevered firm with a going concern value of €500, and a liquidation value (‘fire sale value’)
of €300. Its levered equivalent has a debt of €400.
What would happen if the ‘going concern value’ drops to €350 and the firm defaults?
Bank will call the receiver*, and incur fees (lawyers, auditors, auctioneers, etc.) of, say, €250 (“bankruptcy
costs”), so that their loan recovery is a mere €50 (fire sale value – fees) → the bank doesn’t recover much
What would be the value of the unlevered firm, if its going concern value would fall to €350?
*Receiver (UK-English); Repossession man (U.S. English); Séquestre (Fr); Zwangsverwalter (DE) Síndico (P & ES);
Deurwaarder (NL)
Even before liquidation, the cashflows
of a financially distressed company are
negatively affected. Why?
We can see that the levered company is
“pulled” to the cliff. Because it’s more
likely to go bankrupt, the employees
may decide to leave for the blue
company that is safer, the providers
mat decide that the risk of not getting
paid is too big and stop doing business
with them, etc.

Over-investment in bad risky projects

Zombie Inc.’s non-cash assets are worth €100. It still has €100 cash.
On the liability side it has 10%-interest loan with face-value €200 which matures next year.
Zombie pays the coupon, and invest the remaining €80 in the following project:
Is it ‘positive NPV’? No
Will shareholders support taking the project? Yes, because this is a last
opportunity of not going bankrupt. If the company takes the project,
there is 50% chance that they will manage to pay their debt and get a
small profit, but there is 50% chance that they will loose everything.
On the other hand, if they don’t take it they will certainly go bankrupt.
Do these projects exist? Yes
This is called the risk-shifting or over-investment problem → you try to gamble your way out

Debt Overhang
We’re a year later, and Zombie’s gamble failed.
Zombie’s managers find a fantastic +NPV project
It still has assets worth €100, but no cash … 
They tell their bank about this project, asking them for another €80.
What would you say if you were their bank? “No, I don’t trust you”
If you were their shareholder would you cough up the €80? (e.g. angel investor) No!! Before getting any
dividend, the loan needs to be repaid… Therefore the NPV goes to the bank, not to me…
This is called the debt-overhang or under-investment problem.

Debt Restructuring
Zombie still owes €200 (face value), and cannot borrow more.
Equity holders see positive NPV projects but are reluctant to contribute cash into an insolvent firm.
Bank is about to seize the assets, which they know to be worth only €80, after receiver’s fees...
Is there a way out of this “debt overhang” or “Financial Trap”?
Typically the debt holders agree to write down the face value of the debt (“loan forgiveness”) in exchange
for new equity financing.
Examples: EuroDisney, TUI, Greece, etc.
Other costs of financial distress
Other stakeholders’ change of behavior
What other stakeholders impact the firm’s value? Employees may search for a new job and suppliers may
search for other clients when they no longer trust the company’s ability to survive.
Cash In and Run
When a company is in trouble, equity (the owner-managers) raid the firm’s assets, before debt-holders find
out. This is fraud, but it happens all the time… Examples: Wirecard, Rover, Greece
Playing for Time
When a company is about insolvent, equity wants to hide it as long as possible (i.e. Wirecard, Enron).

Agency costs of Equity

Next assumption to drop: Managers act in shareholders interest… Guess what: They don’t!
Debt Disciplines : Equity is soft, debt is hard.
Equity is forgiving, debt is insistent.
Equity is a pillow, debt a stick.
With more debt, managers have access to less discretionary free cashflows.
With more debt we see fewer private jets, Bentleys, Rolls Royces, and other perquisites or perks.
With more debt, managers (and other employees) work harder.
Conclusion: too much debt is not good!

Considering all taxes and all agency costs:

If the balance sheet is too “strong” there may not be

enough discipline, which explains the value lost.

“Cash-cow” companies – with all taxes and all agency costs:

- Higher tax burden (because of the ↑

operating profit)
- Lower cost of financial distress
- Higher fire-sale value
- Less risk of over-investing in risky -
NPV projects and under-investing in
safe +NPV projects
Hi-Tech “Growth” firms – with all taxes and all agency costs:

Perhaps some companies should have negative debt? Huh?

Capital Structure in Practice

By bench-marking and judgment, firms set a rough target capital structure, e.g. 40% debt
Market leverage changes every day…
What should you do if your target is 40% debt, you you 50% debt, and need external financing?

The Pecking Order

Because of ‘issuing costs’, firms prefer ‘internal financing’ (e.g. cut dividends), then debt-financing, finally
equity financing.
Raising equity finance is expensive and painful. Direct costs are 5-12% (IPO), 3-5% (Seasoned Equity). And
then there is an announcement effect…
Issuing debt (borrowing money) is much cheaper. Issuing costs are between 0.1% to 2%.
“Debt is only a phone call away”
→ “debt-capacity” or “financial slack” gives firms more flexibility to undertake positive NPV opportunities
when they arise.
Differences in issuing costs give rise to a pecking order: Firms prefer internal finance, then debt, then
equity.
Firms that have leverage > target, may still go for debt…!!

The Pre-M&M Approach

Minimize the weighted average
cost of capital!
The pink line is the average
between the red and the blue
line, which is the optimal
capital structure, because it
minimizes the average cost of
capital.
Minimize the cost of capital
The Enterprise Value equals the present value of all future cashflows that accrue to the firm’s financiers,
discounted at the ‘appropriate discount rate’. Or:
So, to maximize firm-value, we should minimize
the WACC ? → this is wrong!
Of course the CFO will try to minimize the
WACC. But it’s not going to change a lot!
We must also consider how the capital structure
affects the Cashflows! (the FCFs above)

Quick Summary
Chapter 14: Firms finance themselves with Equity and Debt (and mezzanine financing).
There is variation over time and across firms and industries, but no free lunches.

Chapter 15: Raising equity financing takes time, negotiation, effort, and inter-mediation.
More so than raising debt-financing. We looked at Venture Capital, IPOs, and SEOs.

* Chapter 16: Taking on more debt, levers returns to equity. It increases the expected return, but also the
risk!! Leverage at the firm adds no value, as investors can ‘lever’ themselves!
In a world with no taxes, perfect information, no “frictions”. Capital Structure is Irrelevant.
In a world where interest payments are tax-deductible, firms with stable taxable income can increase
shareholder value by using more debt-finance.
Firms with too much debt incur costs of financial distress.
Firms with too little debt incur “agency costs of free cashflow” (perks, laziness)..
When firms need money, they first turn to internal financing, then to debt, finally to equity.
 03/12/2021
CLASS 8 – CHAPTER 17: PAYOUT POLICY

Dividends
Dividends are important. A long time ago, Jan Tinbergen and John Hicks (Nobel-prize laureates), argued that
the value of the firm is, at the end of the day, only determined by its future dividends.
$!'3+ = # [&'(1] + # [&'(2] + # [&'(3] + …
1+!+ (1+!+) 2 (1+!+) 3
Gordon and Shapiro (1956) Simplified this to: p0 = #[&'(1] → This is the Gordon Growth model
!+ – g or the growing perpetuity formula

Dividends: First observations – Lintner (1958)

1) Firms set a target payout ratio.
This is the dividend/Net Income → Dividends are benchmarked by Net Income ( = Earnings)
2) Firms smooth dividends.
→ If earnings are high (relative to past and future expectations), payout ratio is relatively low
→ In low earnings years, payout ratio is relatively high.
3) Firms hate to cut dividends.

Dividends: Latest observations – From Book

Firms’ policy:
• 93.8% of firms try to avoid reducing the dividend
• 89.6% of firms try to maintain a smooth dividend stream
• 88.2% of firms look at the current dividend level
• 77.9% of firms are reluctant to make a change that may have to be reversed
• 66.7% of firms consider the change in dividend-yield
• 65.4% of firms rather than reducing dividends, raise new funds to undertake a profitable project

First theory on dividend policy – Miller and Modigliani (1961)

Under the MM assumptions:
1. No taxes
2. Investment policy is given, and is not influenced by the financing policy.
→ Managers take all +NPV projects
3. No transaction costs. Not for the firm, not for shareholders
→ Information is symmetric
Dividend policy is… irrelevant! (i.e. it doesn’t matter)

Hicks & Tinbergen or Miller & Modigliani ?

→ Both are right!

The M&M-expression is more precise:
For a given enterprise, there’s only one sequence of Xt – It …
But with this stream of Xt – It , several dividend streams (D1, D2 … ) are attainable!!
If a firm decides to pay out less this year, it will pay more next year, or do a stock-buyback, so that the
dividend per share will increase…

X-I, Free Cashflows

Free cashflows are (after tax) operating cashflows, minus all positive NPV investments.
What else (except paying dividends) can a firm do with free cashflows?
1) Repurchase shares (a.k.a. stock buybacks).
With fewer shares outstanding, future dividends per share will increase (ceteris paribus)
2a) Hoard it. Keep it in excess cash.
2b) Pay down the debt (hence generate debt-capacity)

Dividends or Buybacks?
Drop first M&M assumption: What if there are taxes?
At first sight, buybacks are better if capital gains taxes are lower than taxes on dividends (which depends on
the country, shareholder-clientele).
However, if there are both high and low dividend stocks in the economy, the high dividend stocks will be
held by ‘widows and orphans’ (low taxes), while ‘buyback stocks’ are held by young professionals.
Hence there is a ‘global’, ‘Miller’ equilibrium, and the dividend/buyback decision is again irrelevant, at
least in (Merton Miller’s) tax-equilibrium.
When the government increased dividend tax, we see a (slow) move towards buybacks, and vice versa.
When shareholders receive dividends, they have to pay taxes at the source. But if the company buys
back stocks, they drive the stock price up, which is called capital gain → the good thing is that the
shareholders don't pay taxes on capital gain. You only pay taxes when you sell the stocks and capital gain
taxes tend to be lower, because most investors can delay selling the stocks.
If you die, then you don't have to pay taxes on capital gains, because it resets for your heirs. The only free
lunch is for charities, because they never pay taxes.
What if there are transaction costs?
Best to keep dividend payouts ‘smooth’ and not switch from dividends to buybacks too often.
What if there are ‘agency costs’ (manager-shareholder conflicts)?
Managers have a tendency to invest in negative NPV projects.
Dividends may provide a better commitment to disgorge cash.
What would managers prefer? Pay dividends or buy back shares?
It doesn’t matter!! (M&M)→ If tax on capital gains < tax on dividend, go for buybacks.
If the managers pay 2$ dividend this year, they are making an unsaid promise to pay 2$ the next year as
well. But in general managers prefer buyback, because then the stock price goes up and they get a stock
premium.
Some investors prefer dividends (due to their tax situation), some prefer buyback stocks. Shareholders self-
select. In equilibrium both groups are satisfied.
For any individual firm it doesn’t matter. Still, it’s not recommended to switch too often between strategies,
because clientele-migration induces transaction costs.
If managers have a tendency to squander money and enrich themselves, go for dividends (a $ dividend is a
stronger commitment than a $ spent on buybacks).
Should a company do cash distributions or keep excess cash?
M&M: It doesn’t matter!
With taxes: Distribute all free cashflow! → firms have to pay tax on interest that they earn on excess cash,
probably more than shareholders. Currently (2021), firms have lots of cash. Why?
With agency costs: Distribute all free cashflow! → Managers may be tempted to use excess cash for perks
and negative NPV projects.
With transaction costs (for the firm): Do not distribute all free cashflow! → Build a buffer of excess cash
to avoid transaction costs associated with raising external financing in the future.

Good reasons for excess cash

Transaction costs are quite high: Issuing equity cost can be 2% to 5% of the proceeds.
Issuing debt is cheaper but still costly.
Issuing costs are incremental to the project, and must be taken into account when calculating the NPV!!
This means that an otherwise +NPV project can become –NPV if the firm doesn’t have cash or ‘debt
capacity’.
The main reason for high issuing costs is information asymmetry.
A ‘transparent’ firm will find it easier to raise external financing.
Apart from $/€/£ costs, capital raising also costs loss of speed, confidentiality, managerial time & attention.
Case in point: Microsoft → Microsoft has a lot of cash stored. Bill Gates said that cash is a strategic asset,
and the money they have is worth more than what they actually have. This is because they invest a lot of
money to become the market leader and destroy or buy out the competition, but in order to do this you have
to have a lot of cash available.

Asymmetric Information → A Nobel prize idea (George Akerlof)

Selling equity is like selling second hand cars.
Selling second hand cars is difficult because buyers always assume that your car is a ‘lemon’.
Assume there are three types of second hand cars:
1) worth $3,000 → peach (=good car)
2) worth $2,000
3) worth $1,000 → lemon (= bad car)
→ They co-exist in the economy in equal proportions. You can’t distinguish peaches and lemons.
Question: How much would you pay for a used car?
Answer: $1,000!! Why? Because you can’t really know if what you are buying is a lemon or a peach …
Perhaps you would pay a little bit more, depends on assumptions…
Moral: in a market of asymmetric information, transaction costs are high.

Issuing costs and Asymmetric Information

Firms suffer the lemon’s problem, when it comes to issuing new shares. Managers know more than the
financial markets.
When a firm announces an equity issue, its stock price drops → by 3%, on average!
The more ‘asymmetric’ the information (the lower the transparency), the greater the price drop.
How can firms reduce the lemon’s problem (a.k.a. adverse selection)?
1) Hire a reputed investment bank to underwrite the offering→ Certification: Investment banks, auditors,
law firms put their reputation on the line
2) Explain, in a press-release, the reason for the offering → may be seen as Cheap Talk, it doesn’t help a lot
3) Send a credible “signal” to the market → Bringing a sacrifice that cannot be mimicked by the lemons, e.g.
through dividend-policy

Signaling – Another Nobel prize idea (Michael Spence)

In the market for executive talent, there are two types (with equal probabilities)
• Good managers worth €400,000 (PV of salary)
• Bad managers worth €300,000
Recruiter can’t distinguish them (they all say they’re good)
→ How can good managers signal that they are good? Get an MBA!! Go to Harvard!
You pay €40,000 in tuition and you learn nothing (well, nothing useful)!!
For the bad types Harvard is horrible: They suffer a non-pecuniary cost of €20,000.
3 possible outcomes:
1) Nobody goes to Harvard. → Both types earn €350,000 (pooling)
2) All go to Harvard. → Payoffs: Good type €310,000 – Bad type €290,000 (pooling)
3) Good types go to Harvard → get €360,000. Bad types don’t → get €300,000 (separating)
The only Nash equilibrium is 3 :
Given that bad types don’t go to Harvard, good types will go to Harvard to signal.
Given that good types go to Harvard, bad types don’t.

Signaling Information in Finance

In a market with asymmetric information, firms signal to that they are good. For a signal to be credible, it
needs costly to fake.
Which signal is stronger?
We’ll initiate cash distributions to shareholders and plan to buy back shares in the open market for €20 Mio
over the next 6 months.
Or → We’ll pay a €20 Mio dividend tomorrow.
Or → We’ll pay an extraordinary dividend worth €500 Mio, financed by debt.

Summary
1) Firm value is determined by future free cashflows (in fact, firm value is FCFs discounted at WACC)
2) What should firms do with their free cashflows? Hoard ‘excess cash’ or Give it back to shareholders
It doesn’t matter!! (M&M)
If external financing is expensive (and if firm is likely to need cash) → Hoard excess cash
If taxes are high and/or if agency costs are high → Give it back to shareholders
3) How should a firm distribute cash to shareholders? Buy back shares or Pay Dividends
It doesn’t matter! If personal dividend taxes are high? If agency costs are high?
4) Firms can ‘signal’ by taking actions that are costly to mimic by the bad type.
 REVIEW

Chapter 1: Introduction
What is the goal of a corporation?
To maximize shareholder value (the free cash flows that go to the shareholders)
Agency problems is when the managers try to maximize their own profits, and do things that help their own
interests instead of those of the shareholders.
Corporate governance corresponds to the ways the shareholders find to make the managers make decisions
that are valuable for them. The board of directors are part of the corporate governance, but it’s not a very
efficient way, because they are sometimes friends with the managers.
Recommended film : Barbarians at the gate
Nabisco was involved in one of the biggest takeover battles, and whoever wins tends to replace all
managers.

Real assets: assets to produce goods and services (can be tangible or intangible)
Financial assets: financial claims to the income generated by the firm’s real assets. If financial assets are
traded, they are called securities. Example: stocks, bonds …

Chapter 3 is very important!

Review the content of the balance sheet, income statement, as well as the Tom and Henry’s case.
Know what goes where in the 3 statements and the synonyms (e.g. Income = Earnings = Profits)

The Cashflow statement is split into:

1. Cashflow from Operations
2. Cashflow from Investing → normally negative
3. Cashflow from Financing
→ The sum of these is the change in cash-balance.

Chapter 4: Measuring performance

The DuPont system: Profit margin and Asset turnover

ROIC = ROCE = RONA = ROC

ROIC = EBIAT → ROIC gives the most effective measure of operating performance!
Invested Capital
▪ Numerator: EBIAT = EBIT × (1 – tax rate)
NOPAT = Operating Profit × (1 – tax rate)
≈ After tax operating income → (1 – tax rate) × interest expense + net income
→ It is the Free Cashflow available to all financiers (Debt and Equity)
▪ Denominator: Invested Capital = Operating Working Capital + Long Term
Assets = Net Debt + Market Capitalization
a.k.a. “Capital Employed”, or “Net Assets”
≈ Total capitalization = long-term debt + shareholder’s equity
→ It’s the Capital Invested by all financiers
▪ It’s the return on the sum of Debt and Equity.
▪ It can compared with the WACC.

Working Capital = Current assets – Current liabilities Debt (Liabilities)

Long term assets Equity

EBT (1 – t) = Net Income

Interest (1– t) +
EBIT (1– t)
Course: EBIT (1 – t) – Interest (1 – t) = EBT (1 – t) = Net Income

Chapter 5: The Time Value of Money

Future Value: Amount to which an investment will grow after earning interest
Compound Interest: Interest earned on interest

Future Value: FV = $100 × (1 + r)t

Present Value: PV = Cashflow

(1+r)t
Discount Factor: DF = 1
(1+ r)t

Perpetuity: PV = CF Perpetuity
r
Perpetuity example:
10 20 40 40 … forever
____________|____________|___________|___________|____________________
40 = 800 10 + 20 + 800 = ???
5% 1.05 1.05 2 1.05

Gordon Growth Model → important formula: P0 = Div 1 => PV = CF

r–g r–g
Interest → coupon → remains constant
→ yield → changes all the time

The relationship between the nominal and the real interest rate is:
1 + Real Interest Rate = 1+ Nominal Interest Rate
1+ Inflation Rate

Incremental Cash Flows

▪ Discount incremental cash flows
▪ Include all indirect effects
▪ Forget sunk costs
▪ Include opportunity costs
▪ Recognize the investment in working capital
▪ Remember terminal cash flows
▪ Beware of allocated overhead costs
Incremental cashflow = Cashflow with project – Cashflow without project
Indirect effects to incremental cashflows: example Merseyside and Rotterdam had an effect on each other.

Chapter 10 : Project Analysis

Real Options and the Value of flexibility → it’s important to recognize the flexibility as valuable

Chapter 11 : Risk
Rates of Return:
Percentage Return = capital gain + dividend
initial share price

Dividend yield = dividend

initial share price-level
Capital gain yield = Capital gain
initial share price

Risk and Return exercise will be in the exam:

Daily Monthly Yearly
E[r] 0.0% 0.5% 6%
sigma 2% 10% 35%

If I invest €100 today:

1. Tomorrow the value of my investment will be between €98 and €102 with 68% probability → it stays
within 1 standard deviation (the middle part of the normal probability graph)
2. The probability that, next month, my investment is less than €80.5 is 2.5% → Because the normal
distribution is symmetrical, and since we are outside of the 95% area, which means there is 5% and 2.5% on
each side. You are getting 2 standard deviations less than the 10% monthly standard deviation.
3. The probability that next year my investment is worth more than €141 is 35% is the yearly standard
deviation ???

Beta is a very important measure of the risk of a stock.

If a portfolio has a stock that has a high beta it contributes to increase the risk of the portfolio.
A portfolio with high beta stocks will have high risk.

Risk and Return : the CAPM

Review the efficient frontier graph. By combining stocks, we can move north-west → which are the stocks
that have the highest returns and lowest risk.

Equity Premium formula: re = rf + βi ∙ Equity Premium

The Equity premium today is around 5-6%
Check the WACC formula in the book!!

Initial Public Offering: it costs money to earn money

Rights Issues: when they need to give shareholders the right to buy shares at a special price.