The McGraw-Hill Companies, Inc.

, 2000 Irwin/McGraw Hill

14- 1
B40.2302 Course Review
Modified 12/5/2001 by Jeffrey Wurgler
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Topics Covered
Course overview
Key slides from Classes #1-11
Finance and the Financial Manager
Principles of Corporate Finance
Brealey and Myers Sixth Edition
Slides by
Matthew Will,
Jeffrey Wurgler
Chapter 1
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14- 4
Role of The Financial Manager
Financial
manager
Firm's
operations
Financial
markets
(1) Cash raised from investors (external finance)
(2) Cash invested in firm
(3) Cash generated by operations
(4a) Cash reinvested (internal finance)
(4b) Cash returned to investors
(1) (2)
(3)
(4a)
(4b)
Present Value and The Opportunity
Cost of Capital
Principles of Corporate Finance
Brealey and Myers Sixth Edition
Slides by
Matthew Will,
Jeffrey Wurgler
Chapter 2
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14- 6
Net Present Value
r
C
+
+
1
C = NPV
investment required - PV = NPV
1
0
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14- 7
Risk and Present Value
Higher-risk projects require higher discount
rates.
Higher discount rates cause lower PVs.
374
.07 1
400
PV
7% at $400 C of PV
1
=
+
=
=
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14- 8
A Fundamental Result
Investors with free and equal access to
borrowing and lending markets will always
invest in positive NPV projects, no matter
what their preferred time pattern of
consumption.

Corollary: Shareholders A and G both agree
that firm should maximize its NPV.
How to Calculate Present Values
Principles of Corporate Finance
Brealey and Myers Sixth Edition
Slides by
Matthew Will,
Jeffrey Wurgler
Chapter 3
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Short Cuts
Perpetuity - A constant cash flow is received
forever, starting at the end of the first period.
r
C
PV =
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14- 11
Short Cuts
Growing perpetuity - A cash flow growing at rate g is
received forever. The first cash flow, arriving at the
end of the first period, is C
1
.
g r
C
PV

=
1
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14- 12
Short Cuts
Annuity A constant cash flow that arrives only for t
periods. The first cash flow arrives at end of first
period.
( )
(

+
=
t
r r
r
C
1
1 1
annuity of PV
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14- 13
Discount nominal cash with nominal rate,
real cash with real rate
NPV rule gives same answer whether
discounting nominal cash by nominal rate or
real cash by real rate.

Just dont mix them up!
The Value of Common Stocks
Principles of Corporate Finance
Brealey and Myers Sixth Edition
Slides by
Matthew Will,
Jeffrey Wurgler
Chapter 4
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Valuing Common Stocks
Dividend Discount Model - Model of todays stock
price which states that share value equals the present
value of all expected future dividends.





H - Time horizon for your investment. Can be infinity.
P
Div
r
Div
r
Div P
r
H H
H
0
1
1
2
2
1 1 1
=
+
+
+
+ +
+
+ ( ) ( )
...
( )
The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill
14- 16
Valuing Common Stocks
Constant Growth DDM - A version of the dividend
growth model in which dividends grow at a constant
rate g.



When you use the growing perpetuity formula to
value a stock, you are using the Gordon Growth
Model.


g r
Div
P

=
1
0
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14- 17
EPS, P/E, and share price
Rearranging,



Growth stocks sell at high P/E ratios
because PVGO is high.

But utilities sell at high P/E ratios because r is
low
|
|
.
|

\
|
=
0 0
1
P
PVGO
r
P
EPS
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14- 18
FCF and PV
Valuing a Business
The value of a business is often computed as the
present value of FCF out to a valuation horizon (H).

The value at H is sometimes called the terminal value
or horizon value
H
H
H
H
r
PV
r
FCF
r
FCF
r
FCF
PV
) 1 ( ) 1 (
...
) 1 ( ) 1 (
2
2
1
1
+
+
+
+ +
+
+
+
=
Why Net Present Value Leads to
Better Investment Decisions than
Other Criteria
Principles of Corporate Finance
Brealey and Myers Sixth Edition
Slides by
Matthew Will,
Jeffrey Wurgler
Chapter 5
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Making Investment Decisions with
the Net Present Value Rule
Principles of Corporate Finance
Brealey and Myers Sixth Edition
Slides by
Matthew Will,
Jeffrey Wurgler
Chapter 6
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Topics Covered
What To Discount
IM&C Project
Project Interaction
Timing
Equivalent Annual Cost
Replacement
Cost of Excess Capacity
Fluctuating Load Factors
Introduction to Risk, Return, and the
Opportunity Cost of Capital
Principles of Corporate Finance
Brealey and Myers Sixth Edition
Slides by
Matthew Will,
Jeffrey Wurgler
Chapter 7
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14- 23
Measuring Risk
0
5 10 15
Number of Securities
P
o
r
t
f
o
l
i
o

s
t
a
n
d
a
r
d

d
e
v
i
a
t
i
o
n
Market risk
Unique
risk
Risk and Return
Principles of Corporate Finance
Brealey and Myers Sixth Edition
Slides by
Matthew Will,
Jeffrey Wurgler
Chapter 8
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14- 25
Security Market Line / CAPM
Expected return
Beta
r
f
1.0
SML
SML/CAPM: E[r
i
] = r
f
+ B
i
(E[r
m
] - r
f
)
Capital Budgeting and Risk
Principles of Corporate Finance
Brealey and Myers Sixth Edition
Slides by
Matthew Will,
Jeffrey Wurgler
Chapter 9
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14- 27
Company Cost of Capital
simple approach
The overall company cost of capital is based on the weighted-
average beta of the individual asset / project betas.

The weights in the weighted average are determined by the %
of firm value attached to each asset / project.

Example: Say firm value is split as:
1/3 New ventures investment (B=2.0)
1/3 Expand existing business investment (B=1.3)
1/3 Plant efficiency investment (B=0.6)

Average asset beta = (1/3)*2.0 + (1/3)*1.3 + (1/3)*0.6 = 1.3
This average beta determines the company cost of capital.

The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill
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Risk and DCF:
Putting it all together
Example
Project A is expected to produce CF = $100 mil for each of three years.
Given a risk free rate of 6%, a market risk premium of 8%, and an asset
beta of .75, what is the PV of the project?
% 12
) 8 ( 75 . 6
) (
=
+ =
+ =
f m f
r r B r r
240.2 PV Total
71.2 100 3
79.7 100 2
89.3 100 1
12% @ PV Flow Cash Year
A Project
Spotting and Valuing Options
Principles of Corporate Finance
Brealey and Myers Sixth Edition
Slides by
Matthew Will,
Jeffrey Wurgler
Chapter 20
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14- 30
Option Value
Determinants of Call Option Price
1 - Underlying stock price (+)
2 - Exercise (strike) price (-)
3 - Standard deviation of stock returns (+)
4 - Time to option expiration (+)
5 - Interest rate (+)
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14- 31
Black-Scholes
V
Call
= N(d
1
)*P- N(d
2
)*PV(S)

Our examples have just been simple up-or-down movements
In these cases, the binomial method is perfect

In reality, there may be a continuum of outcomes
Black-Scholes formula uses a replicating portfolio
argument to derive European call option value under these
circumstances
Real Options
Principles of Corporate Finance
Brealey and Myers Sixth Edition
Slides by
Matthew Will,
Jeffrey Wurgler
Chapter 21
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14- 33
Topics Covered
Real Options
Follow-on investments
Abandon
Wait (and learn)
Vary output or production methods

Valuation examples mixed in
An Overview of Corporate
Financing
Principles of Corporate Finance
Brealey and Myers Sixth Edition
Slides by
Matthew Will,
Jeffrey Wurgler
Chapter
14.1-14.3
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Two ways to finance investment:

Raise equity or debt (external finance)

Plow back profits rather than distribute them to
shareholders (internal finance)

Patterns of Corporate Financing
An Overview of Corporate
Financing
Principles of Corporate Finance
Brealey and Myers Sixth Edition
Slides by
Matthew Will,
Jeffrey Wurgler
Chapter 14.4
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14- 37
Corporate Debt
General features of debt

Borrower (stockholder) promises a certain stream of
interest and principal payments

But borrower may choose to default

Lender doesnt usually have voting rights, but in case of
default lender gets assets

Asset administration handled by bankruptcy court

The Many Different Kinds of Debt
Principles of Corporate Finance
Brealey and Myers Sixth Edition
Slides by
Matthew Will,
Jeffrey Wurgler
Chapter 24
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14- 39
Topics Covered
Domestic Bonds and International Bonds
The Bond Contract
Interest, Security, Seniority
Asset-Backed Securities
Repayment/Retirement Provisions
Covenants
Private Placements and Project Finance

Warrants and Convertibles
Principles of Corporate Finance
Brealey and Myers Sixth Edition
Slides by
Matthew Will,
Jeffrey Wurgler
Chapter
22.1-22.3
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14- 41
Warrants

Warrant - Right to buy a security (usually shares)
from a company at a stipulated price, on or before a
stipulated date.

- A call option!

The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill
14- 42
Convertible Bonds
Convertible Bond - Bond that the holder may exchange for a
specified amount of another security (usually shares).
Convertibles are thus a combined security, combining a straight bond
and a call option
Like bond-warrant combo, except in bond-warrant combo you dont
have to surrender one to get the other: you have both

Example to understand terms: ALZA
5% Convertible 2006, face value $1000
Convertible into 26.2 shares
Conversion ratio 26.2
Conversion price = 1000/26.2 = $38.17
Market price of shares = $28

Valuing Debt
Principles of Corporate Finance
Brealey and Myers Sixth Edition
Slides by
Matthew Will,
Jeffrey Wurgler
Chapter 23
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14- 44
Topics Covered
The Term Structure
Term Structure Theories
Risk: Duration and Volatility
Risk: Default
How Corporations Issue Securities
Principles of Corporate Finance
Brealey and Myers Sixth Edition
Slides by
Matthew Will,
Jeffrey Wurgler
Chapter
15.2-15.6
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14- 46
Topics Covered
The Initial Public Offering
The Underwriters
Underpricing and The Winners Curse
General Cash Offers
The Dividend Controversy
Principles of Corporate Finance
Brealey and Myers Sixth Edition
Slides by
Matthew Will,
Jeffrey Wurgler
Chapter
16.1-16.4
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M&M Dividend irrelevance

Modigliani & Miller dividend proposition

Dividend policy is irrelevant in perfect capital
markets

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14- 49
M&M Dividend irrelevance
Some key assumptions:

Investment policy held constant
No transaction costs (e.g. repurchasing premium for
company, cost of mailing dividend checks)
Dividends and capital gains taxed at same rate



If you claim dividends do matter, one or more of
these assumptions must be violated. That is the
power of the theorem: it clarifies how dividends
could matter.
Does Debt Policy Matter?
Principles of Corporate Finance
Brealey and Myers Sixth Edition
Slides by
Matthew Will,
Jeffrey Wurgler
Chapter 17
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14- 51
M&M Debt Policy Proposition I

Modigliani & Miller debt policy proposition:

The market value of a company is independent of its
capital structure.
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14- 52
r
D
E
r
D
r
E
M&M Debt Policy Irrelevance
r
A
Risk free debt Risky debt
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14- 53
Corporate Taxes
Taxes dont change the total size of the pretax pizza.
But now the government gets a slice.
Governments slice is smaller (and investors slices are bigger)
when debt is used.

M&M proposition I with corporate taxes:
Firm Value = Value of All Equity Firm
+ PV(Tax Shield)

and in special case where debt is permanent
Firm Value = Value of All Equity Firm + Tc*D
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14- 54
Costs of Financial Distress
Costs of Financial Distress - Costs arising from
bankruptcy or distorted business decisions on the
brink of bankruptcy.


Firm value = Value of All Equity Firm
+ PV(Tax Shield)
- PV(Costs of Financial Distress)

The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill
14- 55
Trade-off Theory
Debt ratio
M
a
r
k
e
t

V
a
l
u
e

Value if
All Equity

PV of interest
tax shields
Costs of
financial distress
Value of levered firm
Optimal amount
of debt
Financing and Valuation
Principles of Corporate Finance
Brealey and Myers Sixth Edition
Slides by
Matthew Will,
Jeffrey Wurgler
Chapter 19
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14- 57
After-Tax WACC vs. APV
With consistent assumptions, get same answer.

WACC assumes constant debt ratio , but then
dont have to value tax shield explicitly

APV lets tax shields vary over time , but have
to calculate them yourself .
APV more flexible: can handle other financing
effects besides interest tax shields


Leasing
Principles of Corporate Finance
Brealey and Myers Sixth Edition
Slides by
Matthew Will,
Jeffrey Wurgler
Chapter
25.2-25.6
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Operating Leases
Bottom line for lessee: Operating lease or buy?

Buy if the lessees equivalent annual cost of ownership and
operation is less than the best available operating lease
rate

Otherwise lease

Complication: If operating lease includes option to
cancel/abandon, need to factor that in

The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill
14- 60
Financial Leases
Bottom line for lessee: Financial lease or buy-
and-borrow?

Buy-and-borrow if can devise a borrowing plan
that gives same cash flow as lease in every future
period, but higher immediate cash flow
(equivalently, buy-and-borrow if incremental
lease cash flows are NPV<0)

Otherwise lease


Managing Risk
Principles of Corporate Finance
Brealey and Myers Sixth Edition
Slides by
Matthew Will,
Jeffrey Wurgler
Chapter 26
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14- 62
Topics Covered
Insurance
Futures contracts
Forward contracts
Swaps
How to set up a hedge
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14- 63
Hedging
Hedging
Taking on one risk to offset another

Some basic tools for hedging
Futures
Forwards
Swaps


Managing International Risk
Principles of Corporate Finance
Brealey and Myers Sixth Edition
Slides by
Matthew Will,
Jeffrey Wurgler
Chapter 27
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14- 65
Exchange Rate Relationships
In simplest world (people are risk-neutral and face no
transaction costs for international trade), they are all equal (!)

$
foreign
r + 1
r + 1
) i + E(1
) i + E(1
$
foreign
foreign/$
foreign/$
s
f
foreign/$
foreign/$
) E
s
(s
=
=
= =
The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill
14- 66
International Capital Budgeting
Equivalent Intl. Capital Budgeting Techniques
1) (Easy) Discount foreign CFs at foreign cost of capital.
(Can then convert this present value to $ using spot
exchange rate.)
2) (Hard) Convert to $ assuming all currency risk was hedged
(use forward exchange rates), and then discount with $ cost
of capital.
These techniques are equivalent (verify BM6 p. 806-807)
Thus, hedging allows you to separate the investment
decision from decision to take on currency risk
Corporate Financing and the Six
Lessons of Market Efficiency
Principles of Corporate Finance
Brealey and Myers Sixth Edition
Slides by
Matthew Will,
Jeffrey Wurgler
Chapter 13
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14- 68
Return to NPV
How does market efficiency affect financing?

But in inefficient markets, maybe NPV(financing) >0
Financing may be relevant if firm can find ways to finance at
below-market costs, i.e. ways to finance below its rational cost of
capital

So market efficiency is central to M&M conclusion

Are markets efficient or not?
A controversial issue in finance
Evidence that markets are approximately efficient
However, can find exceptions if one looks carefully at the data
These may be important enough to affect financing decisions
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14- 69
Market Efficiency: 3 versions
Weak Form Efficiency
Market prices reflect past price information.
Prices move as a random walk
Semi-Strong Form Efficiency
Market prices reflect all publicly available
information, not just past prices
Strong Form Efficiency
Market prices reflect all information, both public
and private.
The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill
14- 70
Pecking Order Theory
Pecking Order Theory of Incremental Financing
Decisions - Theory that uses asymmetric
information to argue that firms prefer to fund their
investments using internal finance, then (if internal
finance is insufficient) by debt issues, then (as a last
resort) by equity issues.

Pecking Order Theory of Capital Structure
Theory in which capital structure evolves as the
cumulative outcome of past incremental financing
decisions, each of which is taken using the above
rule.
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14- 71
Market Timing Theory
Market timing theory of financing decisions

Financing theory when markets are not semi-strong efficient, e.g.
when investors underreact to the bad news in equity issue or the good
news in a repurchase
Says raise whatever form of finance is currently available at the
lowest risk-adjusted cost. (In M&M efficient markets, this makes no
sense, since all forms of finance are efficiently priced at the same
risk-adjusted cost.)
For example, issue equity if it is relatively overpriced, or long-term
debt if it is relatively overpriced, or short-term debt if it is relatively
overpriced
Consistent with empirical evidence that firms can time the market

Making Sure Managers Maximize NPV
Principles of Corporate Finance
Brealey and Myers Sixth Edition
Slides by
Matthew Will,
Jeffrey Wurgler
Chapter 12.3
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The Principal-Agent Problem
Shareholders = Owners = Principals
Managers = Control = Shareholders agents
The problem:
How do owners
get managers to
act in their
interests?
(i.e. to maximize
NPV)

The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill
14- 74
The Principal-Agent Problem
Low effort (slacking/shirking)
Expensive perks (corporate jets)
Empire building (overinvestment)
Entrenching investment (to keep job)
Avoiding risk (so as not to lose job)

How might managers interests differ from
shareholders interests?
The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill
14- 75
Potential solutions

Incentives
Monitoring
Debt finance
Takeover pressure
Managerial outside labor market
Proxy fights
Mergers
Principles of Corporate Finance
Brealey and Myers Sixth Edition
Slides by
Matthew Will,
Jeffrey Wurgler
Chapter 33
The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill
The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill
14- 77
Topics Covered
Sensible Motives for Mergers
Some Dubious Reasons for Mergers
Estimating Merger Gains and Costs
Takeovers: Unsolicited/hostile mergers