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Corporate Finance Basics
1
...

The main topics addressed in the context of corporate finance are:
-

the investment decision, what investments should the firm make?

-

the financing decision, how can the company finance those investments?

-

the remuneration policy for capital providers, how should the company distribute its
earnings?

2
...

Financial Assets- A financial asset, also known as an intangible asset, is a liquid asset that
gets its value from a contractual right or ownership claim
...
(Source:
https://www
...
com/terms/f/financialasset
...
The opportunity cost of an
investment is the cost of not making an investment
...


Financial Statement- Financial statements are a set of documents showing the current
financial situation of the company
...
What the
company owns and how much it owes - shown on the balance sheet
...

Balance sheet- A balance sheet is a snapshot of what the company owns and what the
company owes at a particular point in time
...

The statement of cash flows- The cash flow statement is an analytical financing table that
quantifies the cash flows during a specified period, called the financial year
...
Recap:
The overall goal of a corporation is to maximize shareholder value
...
A corporation can decide to invest in either tangible assets (real assets) and/or
intangible assets (financial assets)
...
There are many ways to finance investment decisions
...
Another way is to seek external financing through
loans or through issuing equity (stocks) or debt (bonds)
...

Ultimately, those investment and financing decisions need to be taken by someone
...
The management of corporations generally includes owners, managers and
shareholders- we call them agents
...
Corporate governance is a way to protect

investors and a way to provide different agents with the incentive to work together in order to
achieve the goal of maximizing corporate value
...
But the way that the money
gets to the corporations is through financial markets and intermediaries
...
Financial intermediaries are simply organisations where money passes through
(banks, hedging funds, investment funds)
...
An
investor can invest in a company in one of two way:
-

Through the financial market where he could buy either bonds or stocks or both

-

Through a financial institution- through for example opening a pension fund, a mutual
fund
...


The reason why financial markets and intermediaries exist are to:
-

Transport cash through time (through savings and investments)

-

Risk transfer and diversification (portfolio diversification)

-

Liquidity & Payment mechanisms (the ability to sell your assets and turn them into
cash instantaneously)

-

Provide information (commodity prices, interest rates, stock prices, etc)

Corporate Finance and Accounting are tightly related but are not the same thing
...
The financial review within the financial report
comprises of a balance sheet, an income statement and a statement of cash flows
...
What that means is that assets
and liabilities are presented by their historical cost, so it is backward-looking
...
Market values are forward-looking
...

The key accounting measures of profit (found on the income statement) that we are interested
in is Earning before tax (EBIT) and net income (EBIT minus interest expenses minus taxes)
...
For the purposes of corporate
finance, cash flows give a better idea of the value of investment opportunities and the market
value of debt and equity because it provides us with the correct timing and size of payments
...
Key Takeaways:
•

The overall goal of a corporation is to maximize shareholder value
...


•

Corporate governance is the way that a corporation is directed, administered and the
legal framework in which it operates
...


•

All of the values listed on the balance sheet are book values

•

Market values are a reflexion of how markets value the future expected earning of a
company (not found in the financial review)

5
...
In the corporate governance part of corporate finances, we
call this the “agency” problem
...
Companies often
try and incentivise managers and shareholders by providing them with executive
compensation- stock options
...
*,/)0&%123 )4/)2()()
#$%&'
...
100%

The time value of money
1
...
The time value of money is a central
concept in the world of corporate finance, but also in everyday life
...

This is called the time value of money
...
Understanding how to get the future value of a given amount or find the
present value of a future amount is the corner stone of decision making when it comes to
investment choices in corporate finance
...
Glossary
Simple interest- Simple interest is interest calculated only on the principal amount of capital,
without taking into account previous interest
...

Compound interest- Compound interest means that you earn interest on top of the interest
that you have already earned in the previous year
...

Perpetuity- A perpetuity is a stream of equal cash payments that never end, and the cash flow
starts one period from now
Inflation – Inflation is a quantitative measure of the rate at which the average price level of a
basket of selected goods and services in an economy increases over some period of time
...
(Source:

https://www
...
com/terms/i/inflation
...


3
...

What also matters is when you have to get or when you have to give the money
...
In other words, the future value of your $100 is $110 with the given time
period and interest rate
...
The logic is the same, but we just need to change the point of time that we are
looking at
...
Well, that would be the $110 discounted back by the interest
rate which we said is 10%
...

To simplify matters, the future value of money is asking the question “What would the value
be of my $100 at time X in the future with a given interest rate?”
...
The present value of a stream of cashflows is the present value of each of
the individual cashflows
...

In Corporate finance we are mainly interested in 2 types of cashflows: Perpetuities and
Annuities
...
An Annuity is a stream of equal cash payments for a limited
period of time, again, the cash flow starts one period from now
...
As
such, attention needs to be paid whether the interest rate is simple or compounding and if the
interest rate is applied daily, weekly, biweekly, monthly, quarterly, semi-annually or
annually
...
Why?
Because of the compounding effect
...
This is the simple way of annualizing

-

Effective Annual Interest Rate (EAR)
...
This is annualized by using compound interest rate
...

Inflation is the last component that is taken under consideration when calculating present and
future values
...
Prices are measured using something called the consumer price index
...

So why is inflation important? So far, we have only looked at nominal interest rates
...
However, we are not only interested in the $110
dollars that we will get in a year
...
Consumers are more concerned with the growth in purchasing power rather
than the nominal growth of their investments
...

This is the rate at which purchasing power of an investment increases
...

On a larger scale we can think of real and nominal cashflows in terms of cash flows
...
Real cash flows are measured in constant
prices
...
For nominal cash flows, the nominal interest rate is used to discount the cash
flows
...


4
...

o Future cash flows can be either positive or negative
...

o An Annuity is a stream of equal cash payments for a limited period of time, again, the
cash flow starts one period from now
...

o When comparing interest rates quoted for different periods, we use the EAR
o Real interest rate: this is the rate at which purchasing power of an investment
increases
...

For real cashflows- the real interest rate
...
Further knowledge
o Future Value formula: 𝐹𝑉 = 𝑃𝑉
...
* − *(%&*)$0
o EAR formula: 1+ EAR= (1+ monthly rate) 12

o Relationship between real and nominal interest rate: 1 + 𝑟𝑒𝑎𝑙 𝑖𝑛𝑡
...
'!0
...
-0'+!

o 𝑅𝑒𝑎𝑙 𝑖𝑛𝑡
...
Overview
We know that there are 2 ways that companies can raise capital: through debt and equity
...
A security is something that can be bought and sold
that has an economic value
...
Valuing securities is a big part of the corporate finance world
...

If we can value each component, then we can value the entire package
...
Glossary
Bond- A bond is a fixed income instrument that represents a loan made by an investor to a
borrower (typically corporate or governmental)
...
investopedia
...
asp#:~:text=A%20bond%20is%20a%20fixed,(t
ypically%20corporate%20or%20governmental)
...
)
Bond maturity (maturity date)- The maturity date or the bond maturity is the date where the
last interest payment is made and the (remaining) face value is repaid
...

Bullet bond- a bond for which the face value is only repaid at the maturity date
...
e
...


3
...
The issuer of the bond is obligated to make specified payments to the buyer (or
bondholder)
...
When a firm sells a bond to investors, the firm gets
the money today and it pays back the principal (face value of the bond) and the accumulated
interest (coupon rate) at some time in the future (the bond maturity date)
...

Vice versa, buying a bond is like lending money out
...

Bonds typically have interest payments annually, bi-annually or quarterly
...
For the time being, we are solely concerned with bullet bonds
...

The price of a bond is the present value of all the cash flows it pays
...
These cash flows are discounted at the
required rate of return
...
In particular, higher interest rates lower the
bond price and vice versa
...
It is the
return that you will earn over the next period if the price of the bond is constant
...
To get a more
accurate picture, corporate finance is concerned with yield to maturity (YTM)
...
e
...
There is a one-to-one
relationship between the price of a bond and its YTM
...

The return of a bond is defined as the coupon income plus the price change divided by the
initial investment
...
However corporate bonds are subject to default risk, because corporations can get
into financial difficulties
...


Apart from bonds, another way that a corporation can raise capital is by issuing shares
...
Most
stocks pay out dividends
...

The assumption of the Gordon Growth model is that if dividends grow at a constant rate each
year, then the formula resembles the one for a growing perpetuity
...
We use the Gordon Growth model to determine the present value of a stock with a
growing dividend
...
Key takeaways
•

The price of a bond is the present value of all the cash flows it pays
...


•

Changes in interest rates change the bond price
...


•

Coupon rate > Discount rate => Bond price > Face value

•

Coupon rate= Discount rate=> Bond Price = Face value

•

Coupon rate < Discount rate=> Bond price < Face value

•

There is a one-to-one relationship between the price of a bond and its YTM
...


•

The return of a bond is defined as the coupon income plus the price change divided by
the initial investment
...


•

We use the Gordon Growth model to determine the present value of a stock with a
growing dividend
...
Further knowledge
!"#

!"#

o Formula for the present value of a bond: 𝑃𝑉 = (%&')!! + (%&')" + ⋯ +


(!"#&)*!+ -*
...
/+ #

o Formula for the return of a bond: 𝑅𝑎𝑡𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛 =

o

o

70/"0# 1#!02+
1#-+652+#5

70/"0# 1#!02+
1#-+652+#5

(%&')#
!0/"0# 1#!02+&"'1!+ !3*#4+
1#151*
...
Overview
How can Corporate Finance help firms identify the right investment decisions and maximize
corporate value? Through carefully examining different investment criteria
...
Identifying cash flows and the opportunity cost of capital
associated with them is the first step towards the perfect investment decision
...
Glossary
Net Present Value (NPV)- The net present value is the present value of all the cash flows an
investment projects generates
...

Internal rate of return (IRR)- The internal rate of return is the discount rate (r) for which the
net present value of an investment is equal to zero
...
The PI is calculated by dividing the present value of future expected cash
flows by the initial investment amount in the project
...
investopedia
...
asp#:~:text=The%20profitability%20inde
x%20(PI)%20is,investment%20amount%20in%20the%20project
...
Simply put, the payback period is the length of time an

investment reaches a break-even point
...
investopedia
...
asp
)

3
...
The net present value (NPV) is simply the present value of all the
cash flows an investment projects generates including the initial investment at time 0
...
The
discount rate is the opportunity cost of capital
...
e
...
NPV is the main criteria for
any investment decision and will often overrule other investment criteria
...

The internal rate of return (IRR) Is one of those other useful investment criteria
...
In
other words, the IRR is the discount rate for which the initial investment equals the present
value of all the future cashflows
...
In other words, investors invest in a project
if they can get a higher return on it than an alternative investment possibility
...

The next key investment criteria that we will cover is the profitability index
...
It is used to measure how profitable a
certain project is relative to its initial investment
...
Generally speaking, a higher
profitability index means that the investor is getting more value relative to the capital
invested (a higher “bang for a buck”)
...
The payback
period is simply the time until cash-flows recover the initial investment
...
Sometimes, depending on
the situation, the discounted payback period, also known as the dynamic payback period, is
used instead
...
The payback rule is
simple to use, and it gives an easy overview of when the money is earned and restored
...

Does the corporation’s financing decision impact its investment decisions? The answer is no
...
So, to understand
whether a project is worth undertaking, we must first look at the NPV and if it is positive or
negative and if viable, undertake a separate analysis, including other investment criteria, to
find the best financing strategy
...
There are
3 types of cash flows: cash flows from capital investments, cash flows from investments in
working capital and cash flows from operations and their summation equals the total cash
flows
...
It is important to back out the cashflows because
cash flows and profits are NOT the same
...
But
depreciation is important because of taxes
...
While depreciation is not a cash flow, paying taxes certainly is! Having said that,
there are 3 ways to obtain operating cash flows:
- Dollars-in minus dollars-out
- Adjusted accounting profits
- Adding back depreciation tax shield
As a last step, project analysis is a more in-depth analysis of investment projects
...
All of those questions
can be answered by the sensitivity analysis, the scenario analysis and the break-even analysis
respectively
...
Key takeaways
o The NPV, the IRR, the profitability index and the payback period rule are the main
investment criteria for evaluating projects
o The discount rate of an investment project is the opportunity cost of capital
o Investments projects worth undertaking are only the ones with a positive NPV
o Investors generally invest in any project offering an IRR that is higher than the
opportunity cost of capital
o There are 3 types of cash flows: cash flows from capital investments, cash flows from
investments in working capital and cash flows from operations, and their summation
equals the total cash flows that we use when calculating the NPV
...
Further knowledge
"

"

"

!
"
#
o Formula for NPV: 𝑁𝑃𝑉 = 𝐶! + ($%&)
+ ($%&)
+ ⋯ ($%&)
!
"
#

"

"

"

!
"
#
o Formula for IRR: 0 = 𝐶! + ($%()))
+ ($%()))
+ ⋯ ($%()))
!
"
#

*+,

o Formula for Profitability index: 𝑃𝑟𝑜𝑓𝑖𝑡𝑎𝑏𝑖𝑙𝑖𝑡𝑦 𝑖𝑛𝑑𝑒𝑥 = (-
...
-345/64-/
o Formula Dollars in minus dollars out: Operating cash flows= revenues – cash
expenses – taxes

o Formula Adjusted accounting profits: Operating cash flows= after tax profit +
depreciation
o Formula for adding back depreciation tax shield: operating cash flows = (revenuescash expenses)
...
( tax rate)

Risk Management

1
...
This theme focuses on where the
discount rate (the opportunity cost of capital) comes from and what corporations can get on
alternative investments with similar levels of risk
...


2
...
(Source:
https://www
...
com/terms/m/marketriskpremium
...

)
Variance- Variance (σ2) in statistics is a measurement of the spread between numbers in a
data set
...
(Source:
https://www
...
com/terms/v/variance
...

(Source : https://www
...
com/terms/s/standarddeviation
...
Recap
Last theme we cover the opportunity cost of capital
...
This theme focuses
on the what it means to have “similar levels of risk”
...
There is the risk-free component,
which is just the time value of money
...
It is just reflecting the fact that the present value of getting a dollar today is worth
more than getting a dollar a year from now
...
The reason why it is called “risk-free” is because this is the yield on a bond which
we know with 100% it will pay out at the maturity date (government bonds)
...
That is the compensation that investors require for
undertaking a risky project
...

Financial analysts study the historical returns to stocks and bonds, mainly because if expected
returns are constant, historical returns can tell them something about the opportunity cost of
capital for different investments
...
(ex: S&P 500, The Dow, etc)
...
The result is that the average return on a
bond is lower than the average return on a stock, because investors will require a higher
compensation for taking the risk and investing in stocks
...
In other
words, the market risk premium is the return on the stock market index in excess of treasury
bills
...
To understand why, we will look closer at the relationship between stock returns,
interest rates and the market risk premium
...
As we know, interest rates vary over time and
in this Corporate Finance course we assume that the market risk premium is a constant
...

So far, we have seen that stocks have very high returns on average relative to safer financial
assets, like bonds for example
...
How do corporations
measure risk? There are 2 types of risk that we are going to discuss in this theme:
- Interest rate risk (interest rates fluctuate over time)
- Default/credit risk (the corporation goes bankrupt and can no longer satisfy its obligations
and pay back loans/bonds)
How can corporations quantify risks? Variance is a simple statistical measure that measures
volatility
...
The idea
behind using variance is that corporations would like to measure how uncertain the return on
a particular stock is, i
...
how does it deviate from the expected return (the mean)
...
Thus, corporations typically use standard deviations as a
measure for volatility
...
It is equal to the square root of the variance
...
e
...
Vice versa, higher returns
are tied to higher risks
...
This is due to diversification
...

Stock returns are volatile since the firm has its ups and downs
...
When some firms do poorly, other do well- this
partly cancels out and thus the market return is more stable over time
...
What diversification helps
corporations do is that it helps them eliminate the unique risk or at least minimize its effect
on their portfolio
...
However, there are some risks that corporations cannot diversify
away
...


4
...

o The opportunity cost of capital for a single stock is NOT (or at least not always) just
the historical average that the stock market as a whole has shown
...
e
...

o Unique risks can be diversified by adding more stocks to the portfolio, but market
risks cannot

5
...


o Variance formula:

o Standard deviation formula:

o Extra article on the subject of diversification:
https://www
...
com/news/2009/10/07/diversification

Risk, Return and Capital Budgeting
1
...
In this theme we are going to introduce an economic model which
can tell us something about how we measure those market risks and how we incorporate that
market risk into discount rates
...
Glossary
Beta- Beta is a measure of a stock’s volatility in relation to the overall market
...
investopedia
...
(Source: https://www
...
com/terms/u/undervalued
...
(Source: https://www
...
com/terms/u/undervalued
...

CAPM is widely used throughout finance for pricing risky securities and generating expected
returns for assets given the risk of those assets and cost of capital
...
investopedia
...
asp)
Market security line (SML)- The security market line (SML) is a line drawn on a chart that
serves as a graphical representation of the capital asset pricing model (CAPM)—which

shows different levels of systematic, or market risk, of various marketable securities, plotted
against the expected return of the entire market at any given time
...
investopedia
...
asp)

3
...
This is the portfolio of all assets in the economy and it summarizes the average
“news” to all stocks
...
Having defined the market portfolio, how do corporations measure
actual risk, i
...
the risk of an individual asset in terms of market?
Firms use what is known as beta
...
On a larger scale, beta measures
the market risk of any asset/portfolio and it determines risk of well diversified portfolios
...
High
beta stocks (b>1) respond more to market changes, i
...
they are riskier
...
e
...
Consequently, if a
security fluctuates less than the market (beta <1), then investors expect to receive a return
that is lower than what the market portfolio provides
...

The Capital Asset Pricing Model (CAPM) is an economic model that specifies the
relationship between expected return and beta (market risk) and it is linked to the market risk
premium through beta
...
Corporations only get
compensated for market risk, not for the unique risk that can be diversified away
...
e
...

From the CAPM we can draw a market security line
...
The line essentially represents
that the higher returns are tied with higher risks
...
One way to detect deviations is by looking
at the security market line
...
If a stock has a lower return than the CAPM dictates, we say that the stock is
“overpriced”, and the price should go down in the future
...
e
...
Corporations can also use the CAPM model to calculate the
opportunity cost of a project
...
The opportunity cost of capital depends
on the risk of the project (i
...
the project beta) and NOT the risk of the corporation (i
...

corporation beta)
...


4
...
Further knowledge
•

CAPM Formula: 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑒𝑡𝑢𝑟𝑛 = 𝑟! + 𝛽(𝑟" − 𝑟! )

•

Market risk premium: (𝑟" − 𝑟! )

•

Extra material on CAPM: https://www
...
com/finance-andeconomics/2003/06/05/taking-stock

The WACC and Company Valuation
1
...
Corporations use
the WACC to value proposed investment projects and to value the entire corporation itself
...
Glossary
Weighted Average cost of capital (WACC)- The weighted average cost of capital (WACC) is
a calculation of a firm's cost of capital in which each category of capital is proportionately
weighted
...
(Source:
https://www
...
com/terms/w/wacc
...
In other words, the amount of cash that the
business can pay out to investors after paying for all investments necessary for growth
...
Recap
As we have covered in previous topics, the capital structure of a firm is simply its mix of debt
and equity financing
...
e
...

Equity and debtholders can also invest in other firms, so a given firm must offer a fair return
to get financing from investors
...
The cost of capital is the expected rate of return the
corporation’s investors demand to invest money in the corporation (i
...
the required return)
...
Corporations need the cost of capital to evaluate the corporation’s

investment projects (to calculate the NPV or compare it to the IRR)
...
To calculate the right expected rate of return we need the WACC
...
The company’s
cost of capital is equal to the weighted average of debt and equity required returns
...

Firstly, The WACC is an appropriate discount rate only for a project that is an exact copy of
the firm’s existing business
...
As we know from the last theme, projects should be evaluated
based on project risk, not company risk
...
And this level can be used as a good starting
point to evaluate other projects
...
e
...
It is so, because if you increase/decrease debt,
the required rate of returns change
...

To calculate the WACC, corporations use the market value of debt and equity NOT the book
values
...
Usually, we would have to
calculate the market values ourselves
...
The market value of equity is
the market price per share, multiplied by the number of outstanding shares
...

Valuing an entire business using the WACC formula is possible if we treat the corporation as
one big project and it the corporation’s debt ratio remains fairly constant, as the variables in
the WACC are endogenous
...
However, it is
impossible to calculate an infinite amount of cashflows and discount them back
...
e
...
Estimating the terminal value requires careful
attention because often it accounts for the majority of the value of the company
...
Key takeaways
•

We use the WACC to calculate the corporation’s discount rate when it is financed by
both debt and equity

•

We use the WACC to value investment projects and to value the entire corporation

•

The inputs in the WACC formula are endogenous, i
...
they affect each other, and one
cannot change without affecting the other
...


5
...
(1 − 𝑇# )
...


•

Free cash flows= Profit after tax + depreciation – investment in fixed capital –
investment in working capital

Debt Policy
1
...
In this theme
we will cover how does the WACC and the firm value depend on the relative amounts of debt
and equity and if there is an optimal capital structure (mix of debt and equity) for firms
...


2
...

Modigliani & Miller Proposition 2 (MM2)- The second proposition of the M&M Theorem
states that the company’s cost of equity is directly proportional to the company’s leverage
level
...
com/resources/knowledge/finance/mmtheorem/#:~:text=The%20second%20proposition%20of%20the,default%20probability%20to
%20a%20company
...


3
...
The use of debt
caries a lot across individual corporations and across different industries
...


The Modigliani & Miller proposition 1, also sometimes called “the debt irrelevance
proposition”, states that: In perfect markets, the market value of a company does not depend
on its capital structure
...
The value of a firm does not
depend on how its cashflows are distributed between debt and equity
...
Miller
puts it: “If you take money out of your left pocket and put it in your right pocket you are no
richer
...

Perfect markets are markets where debt is risk-free, there are no taxes, there isn’t any
bankruptcy or financial distress costs, no investor constraints and no management incentive
effect (e
...
inflating the stock price)
...
Operating risk is the risk in the firm’s operating income
...
Debt financing amplifies the effects that
changes in operating income have on the return to equity holders
...

However, leverage also increases expected return to shareholders
...
In short, with
leverage financial risk increases, but also expected returns increase (shareholders demand
higher return due to increased risk) and those two cancel each other out
...

The Modigliani & Miller proposition 2 is concerned with the return of equity
...
This is consistent with MM1, as equity return
should change in proportion to changes in risk and for a given return to assets, any increase in
expected return is exactly offset by an increase in risk
...
e
...
Taking a
step away from the Modigliani and Miller world, let’s assume that debt Is not risk-free
...
However, the increase in return to equity
tapers off as leverage increase, because holders of risky debt begin to bear part of the
corporation’s risk
...

The next step away from the Modigliani & Miller world is to allow for corporate tax
...
However,
equity income is subject to corporate tax
...
A tax shield is
the tax savings resulting from deductibility of interest payments
...
This might incentivise some corporations to cut back on equity
financing and focus on debt financing
...

The last two assumptions that we removed (that debt is risk-free and there are no taxes) lead
us to believe that corporations should be fully debt financed
...
Debt increases the probability of financial distress
...
High leverage implies high interest
payments, which may be difficult to honour
...
Now
we have to allow for financial distress to get the most realistic case
...
The directs costs might be lawyers, legal fees, accounting fees, etc
...
These costs matter at
high levels of debt
...

Other theories for choosing debt level exist, like for example the trade-off theory, the pecking
order theory and the theory of financial slack
...
Key takeaways
•

The MM1 tells us that the value of the firm is independent of its capital structure
...


•

The MM propositions demonstrate that a company which uses some amount of debt
financing will be more valuable than its otherwise equal counterpart that finances
itself completely with equity
...


5
...
economist
...
Overview
This theme focuses on the 2 ways corporations pay out equity investors: dividends and stock
repurchase
...

Payout decisions have implications for the firm’s capital structure (internal or external
financing) and are thus crucial for the wellbeing of any corporation
...
Glossary
Dividend- Simply put, a dividend is a cash payment by the corporation to its equity holders
...
The seller will keep the dividend and the buyer receives the shares with no
dividend
...
e
...

Payment date- The date on which the dividend payment is actually received by the
shareholders
...

Treasury shares- Treasury stock is a corporation’s own stock that it holds in its treasury for
later use
...


Stock split- A stock split is a corporate action in which a company divides its existing shares
into multiple shares to boost the liquidity of the shares
...
investopedia
...
asp)

3
...

A cash dividend is a cash distribution by a company to its shareholders
...
Sometimes a corporation might decide to do a stock split
...
This allows small investors to buy the now affordable shares and
drive up demand, which consequently boost the value per share
...

Stock repurchases are a popular alternative to cash dividends
...
The corporation can either choose to keep the
shares on the balance sheet (treasury shares) or cancel them (capital decrease/reduction)
...
Stock repurchases are used to pay out any excess cash and are,
thus, more volatile and unpredictable
...
e
...

The underlying notion here is the same one as in the pecking order theory from last theme,
mainly that there is some asymmetric information between the managers and the investors
...
Managers
“smooth” cash dividends around a target payout, which reflects long-run, sustainable levels
of earnings
...
In
addition, managers take into account the information content of dividends and repurchases
...


Generally speaking, dividends do not matter to investors
...
In addition, payout policy does not impact the value of the corporation
...
This is consistent with the Modigliani-Miller arguments on
the irrelevance of capital structure
...

Now that we know that in perfect markets payout policy is irrelevant, we will look at some
assumptions that would make the payout policy have an actual impact
...
:
-

Clientele effects- This is an effect where an investor, for whatever reason, prefers
high-payout stocks
...
The effect of that would be that the demand for stocks which are
paying out dividends would go higher than the demand for stocks which do not issue
dividends
...


There are also a few theories on how dividends might reduce the value of a firm
...
(In a
world where the M&M propositions do not hold)
...
The
shareholder bears the tax costs of the dividend
...
Key takeaways
•

Stock repurchases are used to change a corporation’s capital structure, i
...
replace
equity with debt financing
...


•

Dividends do not change the capital structure
...
Further knowledge
•

An extra article on dividends: https://www
...
com/finance-andeconomics/2002/01/10/dividends-end

•

An extra article on buying back stocks: https://www
...
com/finance-andeconomics/2008/06/19/from-buy-backs-to-sell-backs

International Financial Management
1
...
This theme takes
these topics to an international setup
...


2
...
(Source:
https://www
...
com/terms/s/spotexchangerate
...

Forward premium- A forward premium is a situation in which the forward or expected future
price for a currency is greater than the spot price
...
(Source:
https://www
...
com/terms/f/forwardpremium
...
It is an indication
by the market that the current domestic exchange rate is going to decline against another
currency
...
investopedia
...
asp#:~:text=A%20forward%
20discount%20is%20a,to%20decline%20against%20another%20currency
...
(Source:
https://www
...
com/terms/i/ife
...

Interest rate parity- The economic theory of interest rate parity states that the difference
between the interest rate in 2 countries is equal to the differential between the forward rate
and the spot rate of those 2 countries
...


3
...
Exchange rates represent the
relative prices of currencies and there are 2 ways that we can quote them:
-

Direct quote: amount of domestic currency you pay for one unit of foreign currency
...


There are 2 types of exchange rates: a spot exchange rate and a future (forward) exchange
rate
...
The forward
rate is for a future transaction
...
The agreement is specified in a so-called forward
contract
...
We often talk about
forward premiums and forward discounts
...
A forward discount is
when a person gets a higher amount of foreign currency when he buys forward instead of
spot
...

The international Fisher effect shows the relative difference in a given foreign currency
relative to a given domestic currency and how that is related to the difference in inflation
rates
...
The consequence of this statement is that the differences in
nominal interest rates are due to differences in inflation
...

The next rule is the purchasing power parity which relates the difference in inflation rates to
expected changes in the exchange rate
...
The PPP
should hold because otherwise if the purchasing power of 2 currencies are different, one can
make arbitrage
...
When
considering two countries, the PPP implies that a unit of currency has the same purchasing
power in each country and that for the purchasing power of each currency to remain the same
in both countries, any difference in inflation must be offset by a similar change in exchange
rates
...

The third rule is the interest rate parity links the relationship between the relative difference
in nominal interest rates in 2 countries with the relationship between the forward and spot
rate
...
The interest rate parity
implies that it does not matter if you take a given loan in domestic or foreign currency if you
at the same time sign a forward agreement to fix the exchange rate
...
The link between those two is called the Expectations
Theory of Exchange Rates
...
Similarly, the ratio between future and spot rates equals the ratio
between expected and current spot rate
...
We can measure
the expected change in the spot rate by looking at the difference in inflation rates, the
difference between spot and forward exchange rates and the difference in interest rates
...
The most commonly known currency risk that a corporation might be subject
to is transaction exposure
...
However, that carries risk because
the value can change due to exchange rate fluctuations, but it can be easily identified and
hedged with the help of forward contracts
...

Another type of risk can be economic exposure
...

For example, when the corporation operates in many different countries, exchange rate
fluctuations affect the present value of future cash flows received in foreign countries and
thus might affect the net present value evaluation of a given investment project
...
Key takeaways
•

The spot exchange rate is an exchange rate for an immediate transaction

•

The forward rate is for a future transaction
...


•

The purchasing power parity is the idea that a unit of currency of one country must
have the same purchasing power in another country
...
Further knowledge
!"#$ &'()*+,#'-
...
'/ "'()*

,#'-
...
Overview
Options are a particular type of financial derivative based on the value of the underlying
security
...

Investors often opt for options because their value lies in the flexibility they offer
...


2
...
For call options, the strike price is where the security can be bought
by the option holder; for put options, the strike price is the price at which the security can be
sold
...
investopedia
...
asp)
Call option- Call options are financial contracts that give the option buyer the right, but not
the obligation, to buy a stock, bond, commodity or other asset or instrument at a specified
price within a specific time period
...
investopedia
...
asp)
Put option- A put option is a contract giving the owner the right, but not the obligation, to
sell, or sell short, a specified amount of an underlying security at a pre-determined price
within a specified time frame
...
investopedia
...
asp)
The put-Call Parity- Put-call parity is a principle that defines the relationship between the
price of European put options and European call options of the same class, that is, with the
same underlying asset, strike price, and expiration date
...
investopedia
...
asp)
Real options- Real options are options embedded in physical or identifiable assets

3
...
We say that their value is derived from the
underlying assets
...
Derivatives are a useful tool for speculation and risk
management (hedging)
...
e “one person’s loss is another
person’s gain”
...
g
...

When investors buy an option, they have the right but not the obligation to either call or put
an option
...

Putting an option means selling an asset at a specified exercise price (again, strike price)
...
The date
where an option expires is called the expiration or maturity date
...

- A European option- it can only be exercised at maturity
...
It gives investors the possibility to gain from
favourable price movements, but also not lose on unfavourable ones
...
Options also provide an insurance on the
value of the portfolio, i
...
a safety net against e
...
a drop in prices
...

Generally speaking, buying a stock and then buying a put option on it protects investors
against losses when owning that stock
...
An option is “ at the money”
if at the current share price, calling the option would mean that the share price is at the strike
price, so you wouldn’t generate any money but you are also not loosing them
...
e
...


The Put-Call parity is a fundamental relationship for European options on a non-dividend
paying stock
...
What that means is that an investor gets
the same payoff from:
-

Owning a stock and a put option on the stock

-

Owning a call option on the stock and investing the present value of the exercise
price in a bank deposit
...

To price an option, we need the stock price, the exercise price, the stock volatility, the time to
maturity and the interest rates and how all those factors vary for the calls and the puts
...

On the other hand, we have real options
...
e
...
We can
think of those options as options to invest in to modify or dispose of a capital investment
project
...

As this flexibility is valuable to decision makers, real options improve the valuation of
projects
...
The advantage of
decision trees is that they can help determine and illustrate a corporation’s real options by
showing the various choices and outcomes
...
g
...
There are practical problems associated with valuing real options in
investment decisions using standard option pricing models like for example the complex
nature of real options and their lack of structure makes it hard to evaluate
...
Key takeaways
•

A derivative is a security whose payoffs are determined by the values of other
financial assets

•

Calling an option means buying an asset at a specified exercise price (strike price)
...


•

The Put-Call parity is a fundamental relationship for European options on a nondividend paying stock
...


5
...
economist
...
Overview
In this theme we discuss how firms can use options and derivatives in order to mitigate
various forms of risk
...


2
...

Normally, a hedge consists of taking an offsetting position in a related security
...
investopedia
...
asp)
Forward contract- A forward contract is a customized contract between two parties to buy or
sell an asset at a specified price on a future date
...
(Source: https://www
...
com/terms/f/forwardcontract
...
Most swaps involve cash flows based on a
notional principal amount such as a loan or bond, although the instrument can be almost
anything
...
investopedia
...
asp)

3
...

Firstly, identifying means being alert and planning ahead (e
...
sketching a decision tree)
...
Corporate finance mostly focuses on the last
step- i
...
controlling
...
But why should corporations
hedge risks?
Simply put, hedging is the practice of taking offsetting risks
...
g
...
A lower beta
should not make a stock more attractive and a lower idiosyncratic risk should not make a
stock more attractive either
...
The risk is passed on to someone else and the investor must
compensate that someone for taking the risk
...
Investors can diversify by themselves, so corporations do not
increase value by diversifying
...
Even though hedging is a zero-sum game, transactions,
measuring and managing risks require resources
...
Some arguments why hedging may create value
include:
-

Decreasing the probability of financial distress
...


-

Making financial planning easier and allowing your corporation to focus on its core
value chain

-

Making it easier to disentangle the source of failure (e
...
poor management or low
effort)

Options can be used to help with hedging risks when used correctly
...
This is called a protective put
...
A forward contract is written up
between 2 parties for delivery (buy or sell) of an asset at a negotiated price (forward price) on
a set date in the future
...
If we
ignore the transaction costs, the profit to the buyer of a forward/futures contract is equal to
the ultimate market price minus the initial futures price
...
Investors generally use
forwards/futures when they want a contract that makes money when prices fall
...

Swaps are yet another way to hedge risks
...
These come in various forms
...
Another example of swaps are fixed income swaps
...
Generally speaking, swaps are
typically cheaper than rearranging the balance sheet
...

The development is rapid, almost impossible to follow and regulate due to the complexity
and pace
...


4
...


•

In a completely efficient and frictionless market, hedging by publicly held firms is
unlikely to create any value

•

Options, forwards/futures contracts and swaps are the most popular derivatives used
in corporate finance to hedge risks
...
Further knowledge
•

Futures contract profit to buyer= Ultimate market price- initial futures price

•

Futures contract profit to seller= Initial futures price- ultimate market price



---