The key responsibilities of corporate finance include maximizing shareholder wealth through achieving high returns on investments and low-cost financing. Projects are evaluated using discounted cash flow analysis rather than accounting profits. A company can be restructured through an IPO, going private, or mergers and acquisitions seeking synergies or undervalued targets. Corporate governance aims to balance interests of stakeholders to maximize shareholder value in efficient markets.
The document discusses key topics in corporate finance including maximizing shareholder wealth, evaluating investment projects, valuing companies, mergers and acquisitions, corporate governance, and analyzing corporate financial statements. It also discusses the objective of corporate finance as maximizing shareholder value and the potential issues that can arise when manager and shareholder interests are not aligned.
Signaling theory and window of opportunity theory are two theories of capital structure. Signaling theory suggests that managers have better information about a company's prospects than outside investors. Companies with positive prospects will avoid stock offerings, while those with negative prospects will want to issue stock to share losses. The window of opportunity theory proposes that managers time the market when issuing securities, such as issuing equity when stock prices are high and debt when interest rates are low. Capital structure choices also impact lenders and rating agencies.
This presentation was created by Babasab Patil, and all copyright belongs to him. Please visit his website at: http://sites.google.com/site/babambafinance/
The document discusses corporate finance and financial management. It introduces corporate finance as the process of planning and controlling a firm's financial resources, including procuring funds and utilizing them efficiently. It describes the role of the financial manager in coordinating treasury, accounting, and other financial functions to make decisions regarding long-term capital budgeting and investments, capital structure and financing, and working capital management. It also outlines different forms of business organization including sole proprietorships, partnerships, and corporations.
This document provides a summary of key topics covered in various chapters of the textbook "Corporate Finance" by Stephen A. Ross, Randolph W. Westerfield, and Jeffrey Jaffe. It outlines the major concepts from 26 chapters, including introduction to corporate finance, accounting statements, net present value, valuation of bonds and stocks, capital budgeting, capital structure, and mergers and acquisitions. The summary is organized by chapter and provides high-level bullet points on the essential information and concepts covered in each chapter.
This document discusses how to analyze common stocks through fundamental and technical analysis. It provides details on four methods of fundamental analysis: earnings per share, price to earnings ratio, dividend yield, and revenue per employee. These metrics use a company's financial data to evaluate its stock and predict future market performance. The document also briefly mentions technical analysis, which analyzes stock price trends, patterns, and market indices to predict future stock performance.
The document outlines a successful investing strategy of buying a low-cost index fund and holding it forever. It explains that most actively managed mutual funds fail to beat the market after fees, which average 2.5% annually. Over long periods of time, these costs overwhelm returns and compound, so that an initial $100,000 investment grows to only $1,450,400 in 50 years at a net 5.5% return in a mutual fund, versus $4,690,000 at an 8% gross market return in a low-cost index fund. Therefore, the best strategy is to keep costs low by investing in broad-based index funds.
The document discusses key topics in corporate finance including maximizing shareholder wealth, evaluating investment projects, valuing companies, mergers and acquisitions, corporate governance, and analyzing corporate financial statements. It also discusses the objective of corporate finance as maximizing shareholder value and the potential issues that can arise when manager and shareholder interests are not aligned.
Signaling theory and window of opportunity theory are two theories of capital structure. Signaling theory suggests that managers have better information about a company's prospects than outside investors. Companies with positive prospects will avoid stock offerings, while those with negative prospects will want to issue stock to share losses. The window of opportunity theory proposes that managers time the market when issuing securities, such as issuing equity when stock prices are high and debt when interest rates are low. Capital structure choices also impact lenders and rating agencies.
This presentation was created by Babasab Patil, and all copyright belongs to him. Please visit his website at: http://sites.google.com/site/babambafinance/
The document discusses corporate finance and financial management. It introduces corporate finance as the process of planning and controlling a firm's financial resources, including procuring funds and utilizing them efficiently. It describes the role of the financial manager in coordinating treasury, accounting, and other financial functions to make decisions regarding long-term capital budgeting and investments, capital structure and financing, and working capital management. It also outlines different forms of business organization including sole proprietorships, partnerships, and corporations.
This document provides a summary of key topics covered in various chapters of the textbook "Corporate Finance" by Stephen A. Ross, Randolph W. Westerfield, and Jeffrey Jaffe. It outlines the major concepts from 26 chapters, including introduction to corporate finance, accounting statements, net present value, valuation of bonds and stocks, capital budgeting, capital structure, and mergers and acquisitions. The summary is organized by chapter and provides high-level bullet points on the essential information and concepts covered in each chapter.
This document discusses how to analyze common stocks through fundamental and technical analysis. It provides details on four methods of fundamental analysis: earnings per share, price to earnings ratio, dividend yield, and revenue per employee. These metrics use a company's financial data to evaluate its stock and predict future market performance. The document also briefly mentions technical analysis, which analyzes stock price trends, patterns, and market indices to predict future stock performance.
The document outlines a successful investing strategy of buying a low-cost index fund and holding it forever. It explains that most actively managed mutual funds fail to beat the market after fees, which average 2.5% annually. Over long periods of time, these costs overwhelm returns and compound, so that an initial $100,000 investment grows to only $1,450,400 in 50 years at a net 5.5% return in a mutual fund, versus $4,690,000 at an 8% gross market return in a low-cost index fund. Therefore, the best strategy is to keep costs low by investing in broad-based index funds.
IB Business and Management (Standard Level)
All material taken from the IB Business and Management Textbook:
"Business and Management", Paul Hoang, IBID Press, Victoria, 2007
Fundamental of Corporate Finance, chapter 1Yin Sokheng
The objective of the course is to provide an understanding of both the theory of corporate finance fundamentals and how it applies to the “real” world. The main focus of this course is on the corporate financial manger and how he/she reaches decisions. We will cover many issues that are important to a modern financial manager including various advance topics in corporate finance fundamentals such as the essential concepts and understanding of the uses of financial statements and cash flows, ratio analysis, financial planning and growth, time value of money, bonds and stocks valuation, and project valuation.
IB Business and Management (Standard Level)
All material taken from the IB Business and Management Textbook:
"Business and Management", Paul Hoang, IBID Press, Victoria, 2007
Corporate finance deals with arranging funds for corporations and increasing shareholder value through financial decisions related to capital budgeting, capital structure, working capital management, and dividend policy. This course provides a framework for analyzing major financial decisions through concepts like the time value of money, capital budgeting, and working capital management. Chapters cover topics such as sources of finance, capital structure, leverage, and dividend policy.
This document provides an overview of business finance. It defines finance and different sources of finance such as internal sources like retained profits and external sources like bank loans. It explains the purposes of short-term, medium-term, and long-term finance and gives examples of different sources for each time period. Key factors that influence a business's choice of finance are outlined, including the type of business, amount of control desired, available security, existing debt levels, and cash flow.
This document summarizes key points from a chapter that discusses whether stock market valuations are truly driven by fundamentals like return on capital and growth. It finds that:
1) In the long-run, stock prices are driven by factors like return on invested capital and growth. However, short-term price movements can deviate from fundamentals.
2) The stock market generally focuses on long-term economic fundamentals rather than short-term fluctuations. It rewards investments in areas like R&D.
3) Accounting differences do not affect market valuation as much as underlying economic realities. The market sees through to fundamentals.
4) Significant deviations from intrinsic value are relatively rare and short-
The document discusses the importance of maximizing value for shareholders as the primary financial objective of firms. It explains that managers should focus on strategies that create real economic value over the long run through investing capital at rates of return above the cost of capital. While short-term earnings are tempting for managers, the document emphasizes that capital markets reward companies dedicated to long-term value creation, which also benefits other stakeholders through stronger economies and employment growth. Both the Internet and leveraged buyout bubbles are used as examples of what can happen when value creation principles are ignored.
This document provides an overview and introduction to key concepts in corporate finance. It discusses the main tasks of corporate finance including capital budgeting, capital structure, and working capital management. It also covers the goals of financial management, including maximizing shareholder value. Agency problems that can arise between managers and shareholders are explained. The roles of the CFO, treasurer, and controller are outlined. Ethical considerations and corporate governance mechanisms are also summarized.
The document discusses two theories of capital structure - the pecking order theory and the trade-off theory. The pecking order theory states that firms prefer internal financing, then debt, and lastly equity if external financing is needed. This is due to problems with adverse selection and managerial preference for internal funds. The trade-off theory views capital structure as a trade-off between tax benefits of debt and costs of financial distress, predicting an optimal debt level where benefits equal costs. The document provides details on both theories and their implications for company financing decisions and performance.
This document discusses four principles of corporate finance that CEOs can use to make good financial decisions even without the CFO present. The four principles are: 1) the core-of-value principle which establishes that value is created through returns on capital and growth, 2) the conservation-of-value principle which states that only improving cash flows creates value, 3) the expectations treadmill principle which explains how stock prices reflect changes in expectations rather than just performance, and 4) the best-owner principle which says that a business's value depends on its owner and strategy. The document provides examples of how CEOs can apply these principles to decisions around mergers and acquisitions, divestitures, project analysis, and executive compensation.
Valuation of Private vs. Public Companies. Private company valuations are discounted based on several risk factors associated with private sector investing, which results in a marked difference between the valuation of a privately held company, subsidiary or a division and a publicly traded corporation.
This chapter discusses return on invested capital (ROIC) and growth as fundamental drivers of company value. It provides the following key points:
1. ROIC measures a company's ability to generate returns from its capital investments and should be compared to its cost of capital and returns on alternative investments.
2. The value creation formula shows that higher long-term ROIC and growth rates lead to greater company value.
3. Sustainable competitive advantages allow some companies to maintain high ROIC for extended periods, while others see ROIC decline over time as advantages erode.
4. Empirical analysis shows ROIC and growth tend to decrease as companies mature, with 50% of high-ROIC companies
This document discusses business finance, including the meaning, scope, traditional and modern approaches to financial management. It covers the major financial decisions around investment, financing, and dividends. Key aspects of financial management are discussed such as capital budgeting, working capital management, and capital structure. The objectives, importance and types of both fixed and working capital are also summarized. Finally, the document outlines various instruments that can be used to raise funds for business such as shares, retained profits, debentures, institutional finance, public deposits and bank finance.
This document provides an introduction to managerial finance. It defines finance as the science and art of managing money at both the personal and business level. It outlines the three main legal forms of business organization: sole proprietorships, partnerships, and corporations. It then discusses the goals of corporations in maximizing shareholder wealth through increasing earnings per share. Finally, it introduces some key financial tools used in managerial finance, including the three main financial statements (balance sheet, income statement, statement of cash flows), financial ratios, and the financial planning process of developing short-term plans from sales forecasts.
The document provides an introduction to cost of capital, which includes the cost of debt, cost of equity, and weighted average cost of capital (WACC). It discusses how to calculate the cost of debt, cost of equity using the capital asset pricing model, and WACC. It also explains different models to value equity such as the dividend discount model and two-stage growth model.
This document provides definitions for various financial terms beginning with A through E. Some key terms defined include:
- Accretion/Dilution Analysis - Determines the impact of an M&A or capital markets transaction on a company's projected EPS.
- Agent - The bank responsible for administering a project's financing.
- Analyst - Entry level position in an investment bank, typically filled by graduates for 2-3 years until promotion to Associate.
- Arranger - A bank responsible for originating and syndicating a loan transaction, often having a senior role and largest share.
- Asset Class Breakdown - Percentage of holdings in different investment types like stocks, bonds, etc.
20110321 principles of corporate finance part1FED事務局
This document provides a summary of the "Principles of Corporate Finance" textbook. It discusses the textbook's 11 parts which cover various topics related to corporate investment and financing decisions. These include valuation, risk, capital budgeting, financing, payout policy, options, debt financing, and mergers and acquisitions. The summary highlights the key goals of understanding what financial managers do, how to make financial decisions, and how finance theory applies to practice.
Ten principles that form the foundations of financial managementNur Dalila Zamri
The document outlines 10 principles that form the foundations of financial management. The first principle discusses the relationship between risk and return, noting that investors will only take on additional risk if there is potential for higher return. The third principle emphasizes that cash flow, not profits, is most important when evaluating investments as cash indicates when money is actually received. The fifth principle explains that it is difficult to find exceptionally profitable projects due to competition driving down prices and profits over time in efficient markets.
1. Capital expenditure means expenditure to acquire or improve assets and bring them into working condition. Examples include purchasing machinery or paying customs duty for imported machinery.
2. Revenue expenditure maintains assets in working condition or operates the business. Examples include repairs, salaries, or purchasing stationery.
3. Deferred revenue expenditure provides benefits over multiple years, such as heavy research or advertising costs, and is treated as revenue expenditure despite its multi-year benefits.
The document then provides examples to classify expenditures as capital, revenue or deferred revenue and discusses accounting for fixed assets including cost, revaluation, depreciation methods, and disposal.
IB Business and Management (Standard Level)
All material taken from the IB Business and Management Textbook:
"Business and Management", Paul Hoang, IBID Press, Victoria, 2007
Fundamental of Corporate Finance, chapter 1Yin Sokheng
The objective of the course is to provide an understanding of both the theory of corporate finance fundamentals and how it applies to the “real” world. The main focus of this course is on the corporate financial manger and how he/she reaches decisions. We will cover many issues that are important to a modern financial manager including various advance topics in corporate finance fundamentals such as the essential concepts and understanding of the uses of financial statements and cash flows, ratio analysis, financial planning and growth, time value of money, bonds and stocks valuation, and project valuation.
IB Business and Management (Standard Level)
All material taken from the IB Business and Management Textbook:
"Business and Management", Paul Hoang, IBID Press, Victoria, 2007
Corporate finance deals with arranging funds for corporations and increasing shareholder value through financial decisions related to capital budgeting, capital structure, working capital management, and dividend policy. This course provides a framework for analyzing major financial decisions through concepts like the time value of money, capital budgeting, and working capital management. Chapters cover topics such as sources of finance, capital structure, leverage, and dividend policy.
This document provides an overview of business finance. It defines finance and different sources of finance such as internal sources like retained profits and external sources like bank loans. It explains the purposes of short-term, medium-term, and long-term finance and gives examples of different sources for each time period. Key factors that influence a business's choice of finance are outlined, including the type of business, amount of control desired, available security, existing debt levels, and cash flow.
This document summarizes key points from a chapter that discusses whether stock market valuations are truly driven by fundamentals like return on capital and growth. It finds that:
1) In the long-run, stock prices are driven by factors like return on invested capital and growth. However, short-term price movements can deviate from fundamentals.
2) The stock market generally focuses on long-term economic fundamentals rather than short-term fluctuations. It rewards investments in areas like R&D.
3) Accounting differences do not affect market valuation as much as underlying economic realities. The market sees through to fundamentals.
4) Significant deviations from intrinsic value are relatively rare and short-
The document discusses the importance of maximizing value for shareholders as the primary financial objective of firms. It explains that managers should focus on strategies that create real economic value over the long run through investing capital at rates of return above the cost of capital. While short-term earnings are tempting for managers, the document emphasizes that capital markets reward companies dedicated to long-term value creation, which also benefits other stakeholders through stronger economies and employment growth. Both the Internet and leveraged buyout bubbles are used as examples of what can happen when value creation principles are ignored.
This document provides an overview and introduction to key concepts in corporate finance. It discusses the main tasks of corporate finance including capital budgeting, capital structure, and working capital management. It also covers the goals of financial management, including maximizing shareholder value. Agency problems that can arise between managers and shareholders are explained. The roles of the CFO, treasurer, and controller are outlined. Ethical considerations and corporate governance mechanisms are also summarized.
The document discusses two theories of capital structure - the pecking order theory and the trade-off theory. The pecking order theory states that firms prefer internal financing, then debt, and lastly equity if external financing is needed. This is due to problems with adverse selection and managerial preference for internal funds. The trade-off theory views capital structure as a trade-off between tax benefits of debt and costs of financial distress, predicting an optimal debt level where benefits equal costs. The document provides details on both theories and their implications for company financing decisions and performance.
This document discusses four principles of corporate finance that CEOs can use to make good financial decisions even without the CFO present. The four principles are: 1) the core-of-value principle which establishes that value is created through returns on capital and growth, 2) the conservation-of-value principle which states that only improving cash flows creates value, 3) the expectations treadmill principle which explains how stock prices reflect changes in expectations rather than just performance, and 4) the best-owner principle which says that a business's value depends on its owner and strategy. The document provides examples of how CEOs can apply these principles to decisions around mergers and acquisitions, divestitures, project analysis, and executive compensation.
Valuation of Private vs. Public Companies. Private company valuations are discounted based on several risk factors associated with private sector investing, which results in a marked difference between the valuation of a privately held company, subsidiary or a division and a publicly traded corporation.
This chapter discusses return on invested capital (ROIC) and growth as fundamental drivers of company value. It provides the following key points:
1. ROIC measures a company's ability to generate returns from its capital investments and should be compared to its cost of capital and returns on alternative investments.
2. The value creation formula shows that higher long-term ROIC and growth rates lead to greater company value.
3. Sustainable competitive advantages allow some companies to maintain high ROIC for extended periods, while others see ROIC decline over time as advantages erode.
4. Empirical analysis shows ROIC and growth tend to decrease as companies mature, with 50% of high-ROIC companies
This document discusses business finance, including the meaning, scope, traditional and modern approaches to financial management. It covers the major financial decisions around investment, financing, and dividends. Key aspects of financial management are discussed such as capital budgeting, working capital management, and capital structure. The objectives, importance and types of both fixed and working capital are also summarized. Finally, the document outlines various instruments that can be used to raise funds for business such as shares, retained profits, debentures, institutional finance, public deposits and bank finance.
This document provides an introduction to managerial finance. It defines finance as the science and art of managing money at both the personal and business level. It outlines the three main legal forms of business organization: sole proprietorships, partnerships, and corporations. It then discusses the goals of corporations in maximizing shareholder wealth through increasing earnings per share. Finally, it introduces some key financial tools used in managerial finance, including the three main financial statements (balance sheet, income statement, statement of cash flows), financial ratios, and the financial planning process of developing short-term plans from sales forecasts.
The document provides an introduction to cost of capital, which includes the cost of debt, cost of equity, and weighted average cost of capital (WACC). It discusses how to calculate the cost of debt, cost of equity using the capital asset pricing model, and WACC. It also explains different models to value equity such as the dividend discount model and two-stage growth model.
This document provides definitions for various financial terms beginning with A through E. Some key terms defined include:
- Accretion/Dilution Analysis - Determines the impact of an M&A or capital markets transaction on a company's projected EPS.
- Agent - The bank responsible for administering a project's financing.
- Analyst - Entry level position in an investment bank, typically filled by graduates for 2-3 years until promotion to Associate.
- Arranger - A bank responsible for originating and syndicating a loan transaction, often having a senior role and largest share.
- Asset Class Breakdown - Percentage of holdings in different investment types like stocks, bonds, etc.
20110321 principles of corporate finance part1FED事務局
This document provides a summary of the "Principles of Corporate Finance" textbook. It discusses the textbook's 11 parts which cover various topics related to corporate investment and financing decisions. These include valuation, risk, capital budgeting, financing, payout policy, options, debt financing, and mergers and acquisitions. The summary highlights the key goals of understanding what financial managers do, how to make financial decisions, and how finance theory applies to practice.
Ten principles that form the foundations of financial managementNur Dalila Zamri
The document outlines 10 principles that form the foundations of financial management. The first principle discusses the relationship between risk and return, noting that investors will only take on additional risk if there is potential for higher return. The third principle emphasizes that cash flow, not profits, is most important when evaluating investments as cash indicates when money is actually received. The fifth principle explains that it is difficult to find exceptionally profitable projects due to competition driving down prices and profits over time in efficient markets.
1. Capital expenditure means expenditure to acquire or improve assets and bring them into working condition. Examples include purchasing machinery or paying customs duty for imported machinery.
2. Revenue expenditure maintains assets in working condition or operates the business. Examples include repairs, salaries, or purchasing stationery.
3. Deferred revenue expenditure provides benefits over multiple years, such as heavy research or advertising costs, and is treated as revenue expenditure despite its multi-year benefits.
The document then provides examples to classify expenditures as capital, revenue or deferred revenue and discusses accounting for fixed assets including cost, revaluation, depreciation methods, and disposal.
Este documento contiene una lista de apellidos de estudiantes, divididos en tres columnas. Algunos apellidos aparecen marcados con una "x", posiblemente indicando algún tipo de estatus especial.
The document provides an overview of sales management, including the key functions and skills required. It discusses the transition experienced by salespeople who are promoted to sales management positions. Sales management involves planning, staffing, training, leading, and controlling sales personnel to effectively achieve organizational goals. Common challenges for new sales managers include lack of preparation for management responsibilities and needing to adapt to a new role and perspectives.
This document provides answers to questions about corporate finance fundamentals. It discusses key topics like capital budgeting, capital structure, and working capital management. The answers describe things like the advantages and disadvantages of different business forms, the goals of for-profit versus not-for-profit organizations, and how agency problems can arise between managers and shareholders. The document also addresses questions about financial statements, taxes, cash flow, and issues like executive compensation.
This document provides an introduction to finance, covering key topics such as defining finance, the evolution of finance, the finance function, the firm's goal of maximizing shareholder wealth, the role of financial managers, financial markets and systems, and agency theory. It discusses how finance exists to create value by substituting financial wealth for real assets. The role of financial managers is described as making investment, financing, dividend, and liquidity decisions. Agency theory addresses potential conflicts of interest between managers and shareholders.
Fundamental Financial Management instruction manual C1LeSonDai
This document provides an overview and learning objectives for Chapter 1 of a financial management textbook. It discusses key topics like business organization forms, stockholder value, intrinsic vs market stock value, business ethics, executive compensation, and officer responsibilities. The lecture suggestions recommend spending the first day reviewing the syllabus and briefly introducing chapter topics. Students should print slides, buy a calculator, and be prepared to use time value of money concepts from Chapter 2.
This document provides information about capital budgeting. It begins with an introduction to capital budgeting, defining it as a firm's process for acquiring and investing capital in long-term projects. It then discusses the capital budgeting process, which includes project generation, evaluation, selection, and follow-up. Key factors that influence capital budgeting decisions are also outlined, such as business risk, tax exposure, financial flexibility, and growth rate. Finally, traditional capital budgeting methods like payback period, accounting rate of return, and discounted cash flow methods are explained.
This document provides an overview of key concepts from several finance chapters. It includes definitions of finance, the three major financial decisions of investment, financing, and asset management. It also discusses why wealth maximization rather than profit maximization should be the main goal of a firm. Key concepts like agency problem, how it is solved, corporate social responsibility, risk and return, types of risk, and attitudes toward risk are summarized. The document is a study guide providing questions and answers on these topics from various textbook chapters.
The first chapter introduces us to Corporate finance is essential .docxoreo10
The first chapter introduces us to Corporate finance is essential to all managers as it provides all the skills managers need to; Identify corporate strategies and individual projects that add value to the organization and come up with plans for acquiring the funds. The types of business forms are; sole proprietorship, corporation and partnerships. A sole proprietorship form of business possesses different advantages and disadvantages. A partnership maintains roughly similar pros and cons of a sole proprietorship. A corporation is a legal entity that is separate from its owners and managers. Advantages include a smooth transfer of ownership, limited liability, ease of raising capital. The disadvantages include; double taxation, and a high cost of set-up and report filing. The chapter then deals with Objective of the firm, which is to maximize wealth. The final topic is an in-depth look at Financial Securities, which are markets and institutions.
In the second chapter, we are introduced to financial statements, Cash flow and taxes. Financial statements include; the Income statement and the Balance sheet. An income statement is a financial statement that shows a company’s financial performance regarding revenues and expenses, over a particular period, mostly one year. A balance sheet, on the other hand, is a financial statement that states a company’s assets, liabilities and capital at a particular point in time. Under the cash flow, the chapter covers on the Statement of cash flows, indicates how various changes in balance sheet and income statement accounts affect cash and analyses financing, investing and operating activities. A free cash flow shows the cash that an organization is capable of generating after investment to either maintain or expand its database. Under taxes, Corporate and personal taxes are well explained and the scenarios under which they apply.
Chapter Three analyzes Financial Statements. This analysis is broken down into; Ratio Analysis, DuPont equation. The effects of improving ratios, the limitations of ratio analysis and the Qualitative factors. Ratios help in comparison of; one company over time and one company versus other companies. Ratios are used by; Stockholders to estimate future cash flows and risks, lenders to determine their creditworthiness and managers to identify areas of weaknesses and strengths. Liquidity ratios show whether a company can meet its short-term commitments using the resources it has at that particular time. Asset management ratios exemplify how well an organization utilize its assets. Debt management ratios, leverage ratios as well as profitability ratios are explained.
The DuPont equation focuses on several issues. These are; Debt Utilization, Asset utilization and the Expense Control. Consequently, Ratio analysis has various problems and limitations. These include; Distortion of ratios from seasonal factors, various operating and accounting practices can distort comparisons and also it i ...
This document provides an introduction to contemporary managerial finance. It discusses the goal of financial management, which is to maximize the value of owners' equity for for-profit organizations. It also examines agency problems that can arise between shareholders and managers due to conflicting interests. The document outlines different forms of business organization and notes that as businesses grow, the corporate form allows for easier raising of capital. It describes the role of the financial manager is to make decisions that increase stock value for shareholders.
1 the role of managerial finance(modified 4)Ahmed Elgazzar
1-The Role of Managerial Finance(Modified 4)
2-Time value of money(modified 1)
3-Capital Budgeting(Modified 1) [Repaired]
4-Stock Valuation(modified 1)
MBA Assignments
10
66 harvard business review | hbr.org
t’s become fashionable to blame the pursuit of
shareholder value for the ills besetting corporate
America: managers and investors obsessed with next
quarter’s results, failure to invest in long-term growth,
and even the accounting scandals that have grabbed head-
lines. When executives destroy the value they are sup-
posed to be creating, they almost always claim that stock
market pressure made them do it.
The reality is that the shareholder value principle has
not failed management; rather, it is management that has
betrayed the principle. In the 1990s, for example, many
companies introduced stock options as a major compo-
nent of executive compensation. The idea was to align the
interests of management with those of shareholders. But
the generous distribution of options largely failed to mo-
tivate value-friendly behavior because their design almost
guaranteed that they would produce the opposite result.
To start with, relatively short vesting periods, combined
with a belief that short-term earnings fuel stock prices, en-
couraged executives to manage earnings, exercise their
options early, and cash out opportunistically. The com-
mon practice of accelerating the vesting date for a CEO’s
Companies profess devotion to shareholder value but rarely follow the practices
that maximize it. What will it take to make your company a level 10 value creator?
by Alfred Rappaport
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P
E
M
B
E
R
T
O
N
Ways to Create
Shareholder Value
Y
E
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M
A
G
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Y
A
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B
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september 2006 67
Te n Wa y s t o C r e a t e S h a r e h o l d e r Va l u e
options at retirement added yet another incentive to
focus on short-term performance.
Of course, these shortcomings were obscured during
much of that decade, and corporate governance took a
backseat as investors watched stock prices rise at a double-
digit clip. The climate changed dramatically in the new
millennium, however, as accounting scandals and a steep
stock market decline triggered a rash of corporate col-
lapses. The ensuing erosion of public trust prompted a
swift regulatory response–most notably, the 2002 passage
of the Sarbanes-Oxley Act (SOX), which requires compa-
nies to institute elaborate internal controls and makes cor-
porate executives directly accountable for the accuracy of
financial statements. Nonetheless, despite SOX and other
measures, the focus on short-term performance persists.
In their defense, some executives contend that they
have no choice but to adopt a short-term orientation,
given that the average holding period for stocks in profes-
sionally managed funds has dropped from about seven
years in the 1960s to less than one year today. Why con-
sider the interests of long-term shareholders when there
are none? This reasoning is deeply flawed. What matters
is not investor holding periods but rather the market’s val-
uation horizon – the number of years of expec.
The document discusses key concepts in finance including the roles of a financial manager, business forms, goals of the firm, and financial markets and institutions. Specifically, it defines the roles of a financial manager, compares basic business forms like sole proprietorships, partnerships and corporations, explains that the goal of the firm is to maximize shareholder wealth, and outlines the money market, capital market, and how securities are issued in primary and secondary markets.
- The document contains concept questions and answers related to corporate finance topics like capital structure, dividend policy, and market efficiency.
- It discusses key concepts such as the efficient market hypothesis, agency costs, bankruptcy costs, and the tradeoff between debt and equity financing.
- The questions assess understanding of valuation models like APV and WACC, as well as theories including MM propositions, pecking order theory, and the irrelevance of dividends under perfect market conditions.
This document provides an overview of the topics covered in a financial management course, including definitions of key terms, understanding financial statements and cash flows, valuation of financial assets and capital budgeting, capital structure and dividend policy, and working capital management. The chapter summarized discusses capital structure theory, including the independence hypothesis, dependence hypothesis, and moderate view of how leverage impacts a firm's weighted average cost of capital and stock price. It also covers agency costs, free cash flow, and tools for capital structure management, such as EBIT-EPS analysis.
The document discusses the traditional corporate finance objective of maximizing firm value and stockholder wealth. It notes some limitations of this approach, including potential conflicts between stockholders, bondholders, managers, and society. Alternative objectives and governance systems are proposed to better align these interests, such as choosing objectives other than stock price or implementing stakeholder systems like in Germany and Japan.
The document discusses the traditional corporate finance objective of maximizing firm value and stockholder wealth. It notes some limitations of this approach, including potential conflicts between stockholders, bondholders, managers, and society. Alternative objectives and governance systems are proposed to better align these various interests, such as choosing objectives other than stock price or implementing codetermination systems like in Germany.
1. The document discusses capital structure, which refers to the mix of long-term financing sources like equity, debt, and retained earnings.
2. It provides definitions of capital structure and discusses factors that determine an optimal or appropriate capital structure, including profitability, risk, flexibility, and control.
3. An optimal capital structure maximizes firm value and minimizes average cost of capital, but this is difficult to achieve due to various conflicting considerations. The document examines various capital structure theories.
This chapter introduces key concepts in financial management. It discusses that financial management focuses on wealth creation and value-maximizing decisions. It also outlines different forms of business organization like sole proprietorships, partnerships, and corporations. Additionally, it presents 10 principles of finance, including that risk and return are positively correlated, cash flows rather than profits matter, taxes impact decisions, and ethics are important in finance. The goal of financial managers is to maximize shareholder wealth over the long run.
Equity Research 16 December 2002AmericasUnited Stat.docxYASHU40
Equity Research
16 December 2002
Americas/United States
Strategy
Investment Strategy
Assessing the Magnitude and
Sustainability of Value Creation
Illustration by Sente Corporation.
• Sustainable value creation is of prime interest to investors who seek to
anticipate expectations revisions.
• This report develops a systematic way to explain the factors behind a
company’s economic moat.
• We cover industry analysis, firm-specific analysis, and firm interaction.
Investors should assume that CSFB is seeking or will seek investment banking or other business from the covered
companies.
For important disclosure information regarding the Firm's ratings system, valuation methods and potential conflicts of interest,
please visit the website at www.csfb.com/researchdisclosures or call +1 (877) 291-2683.
research team
Michael J. Mauboussin
212 325 3108
[email protected]
Kristen Bartholdson
212 325 2788
[email protected]
Measuring the Moat 16 December 2002
2
Executive Summary
• Sustainable value creation has two dimensions—how much economic profit a
company earns and how long it can earn excess returns. Both are of prime interest to
investors and corporate executives.
• Sustainable value creation is rare. Competitive forces—including innovation—drive
returns toward the cost of capital. Investors should be careful about how much they
pay for future value creation.
• Warren Buffett consistently emphasizes that he wants to buy businesses with
prospects for sustainable value creation. He suggests that buying a business is like
buying a castle surrounded by a moat—a moat that he wants to be deep and wide to
fend off all competition. According to Buffett, economic moats are almost never stable;
competitive forces assure that they’re either getting a little bit wider or a little bit
narrower every day. This report seeks to develop a systematic way to explain the
factors that determine a company’s moat.
• Companies and investors use competitive strategy analysis for two very different
purposes. Companies try to generate returns above the cost of capital, while investors
try to anticipate revisions in expectations for financial performance that enable them to
earn returns above their opportunity cost of capital. If a company’s share price already
captures its prospects for sustainable value creation, investors should expect to earn
a risk-adjusted market return.
• Studies suggest that industry factors dictate about 10-20% of the variation of a firm’s
economic profitability, and that firm-specific effects represent another 20-40%. So a
firm’s strategic positioning has a significant influence on the long-term level of its
economic profits.
• Industry analysis is the appropriate place to start an investigation into sustainable
value creation. We recommend getting a lay of the land—understanding the players, a
review of profit pools, and industry stability—followed ...
The document discusses different models of corporate governance and ownership. It describes how companies may start as privately owned but later go public, separating ownership and management. The dominant goal in Anglo-American markets is shareholder wealth maximization, but other models exist that also consider stakeholders such as employees and communities. Corporate governance structures use internal boards and external regulators and markets to guide companies and ensure accountability.
This document contains a student's assignment submission for a course in financial management. It includes the student's details, the assignment questions, and the student's answers to two of the questions. The first question defines financial management and discusses the goals of a firm in detail. The second question defines 20 key financial terms. The student provided thorough definitions for each term. The assignment was submitted on time and received positive feedback from the tutor based on the quality of the responses.
This chapter provides an overview of key concepts in financial management. It discusses the primary goal of maximizing shareholder value and agency relationships between shareholders, managers, and creditors. It also covers the importance of financial management skills for managers, factors that determine the value and cost of capital for firms, and types of financial securities and their typical rates of return.
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Forrester’s Digital Transformation Framework
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MIT’s Digital Transformation Framework
Gartner’s Digital Transformation Framework
Accenture’s Digital Strategy & Enterprise Frameworks
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Capgemini’s Digital Transformation Framework
PwC’s Digital Transformation Framework
Cisco’s Digital Transformation Framework
Cognizant’s Digital Transformation Framework
DXC Technology’s Digital Transformation Framework
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18. Toyota’s Six Steps of Kaizen
19. Microsoft’s Digital Transformation Framework
20. Design for Six Sigma (DFSS)
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1. CORPORATE FINANCE
Lecture 1. Introduction
The key responsibilities of the CFO
The two main parts of CF are allocation (investment) and financing, corresponding
to the A&L sides of the balance sheet. The ultimate objective is to maximize the
shareholders’ wealth: achieve the highest return on the projects and ensure the
cheapest financing. Evaluation of the investment projects is based on the discounted
cash flows, which are different from the accounting profits (e.g. because of
depreciation). The real options approach takes into account that managers can
influence the CFs after the beginning of the project. Applying similar methods, one
can value the company.
The company can be restructured from private to a public one via IPO, and vice
versa. Another type of structural change comes from M&As. The company’s goal is
to acquire the companies bringing synergy gains and those undervalued due to the
inefficient management. The best defence from the acquisition is to maximize its
own value.
The goal of corporate governance is to internalize the external effects, balance the
economic interests of all stakeholders. In well-functioning financial markets, this
maximizes shareholder value.
Typical CF questions:
How to measure the project’s worth for the company?
Are companies' market prices justified? (e.g., dot-coms)
How to choose among the projects given the budget constraint and external
effects?
How to account for risks associated with the project?
o Systematic vs company-specific risks
Are risks always bad?
Is it good to have volatile oil prices?
o Yes, if managers have flexibility in the future decisions.
Should we invest now in a project, which seems unprofitable (has negative NPV)?
o Probably, yes. It may yield high profit in certain future scenarios (oil pipeline)
Should we invest now in a project, which is profitable (has positive NPV)?
o Probably, not. It may be even more profitable next period (gold extraction)
Should we give managers higher salaries or higher bonuses?
o Bonuses encourage higher performance, but may also lead to the
manipulations and excessive risk-taking.
Does it matter how to finance the project: by debt or by equity?
Would you like the company to have much debt?
o Yes, to minimize taxes and to discipline the managers. Not too much, to avoid
bankruptcy.
Should the company borrow money from banks or issue bonds?
o The company can renegotiate the terms of bank credit.
Would you like the company to pay high dividends? (e.g., Microsoft)
1
2. o Yes, if too much managerial discretion (Surgut). No, because of double
taxation and signalling that the company has no valuable inv projects.
How will the market react to the share buyback?
o The company signals that its shares are undervalued.
How will the market react to the new equity issue?
o Usually negatively: either the company’s shares are overvalued, or it needs to
finance a new inv project.
How should the company communicate with the market? Always provide precise
info in time?
What drives the company’s decision to go public? Why are there hardly any IPOs
in Russia?
Would you like the company to grow via acquisitions?
o Yes, if the main motivation comes form synergy gains, and not
empire-building.
Specifics of corporation
Do not take the current form of corporations and stock markets as given, it is an
endogenous outcome!
Advantages of corporation in comparison with sole proprietorship and partnership:
Ltd liability: lesser risks for investors
o Crucial for development of stock markets and diversification
Easy transfer of ownership
o Promotes liquidity
Unlimited life
o Makes it easier to attract financing
Disadvantages:
Separation of ownership and control, the agency conflict
o Solved in two ways: US vs Germany
Double taxation
History: 1811, general act of incorporation in NY, specifying that all investors of NY
corporations have limited liability
Not so obvious that limiting the freedom of contracts is good
Hot discussion at the time: could spur excessive risk taking
California was the last to copy in 1931
The Objective in Corporate Finance
“If you don’t know where you are going,
it does not matter how you get there”
The Classical Viewpoint:
Van Horne: "In this book, we assume that the objective of the firm is to maximize
its value to its stockholders"
Brealey & Myers: "Success is usually judged by value: Shareholders are made
better off by any decision which increases the value of their stake in the firm... The
secret of success in financial management is to increase value."
Copeland & Weston: The most important theme is that the objective of the firm is
to maximize the wealth of its stockholders."
Brigham and Gapenski: Throughout this book we operate on the assumption that
2
3. the management's primary goal is stockholder wealth maximization which translates
into maximizing the price of the common stock.
Why focus on maximizing stockholder wealth?
Stock price is easily observable and constantly updated (unlike other measures of
performance, which may not be as easily observable, and certainly not updated
as frequently).
If investors are rational (are they?), stock prices reflect the wisdom of decisions,
short term and long term, instantaneously.
The objective of stock price performance provides some very elegant theory on:
o how to pick projects
o how to finance them
o how much to pay in dividends
The Classical Objective Function
What can go wrong?
3
4. Traditional corporate financial theory breaks down when the interests/objectives
of the decision makers in the firm conflict with the interests of stockholders.
o Bondholders (Lenders) are not protected against expropriation by
stockholders.
o Financial markets do not operate efficiently, and stock prices do not reflect
the underlying value of the firm.
o Significant social costs can be created as a by-product of stock price
maximization.
Solutions:
Choose a different mechanism for corporate governance
Choose a different objective:
o Maximizing earnings / revenues / firm size / market share
o The key thing to remember is that these are intermediate objective
functions. To the degree that they are correlated with the long term health
and value of the company, they work well. To the degree that they do not,
the firm can end up with a disaster
Maximize stock price, but reduce the potential for conflict and breakdown:
o Making managers (decision makers) and employees into stockholders
o Providing information honestly and promptly to financial markets
Counter reaction
4
5. The strength of the stock price maximization objective function is its internal self
correction mechanism. Excesses on any of the linkages lead, if unregulated, to
counter actions which reduce or eliminate these excesses
managers taking advantage of stockholders has lead to a much more active
market for corporate control.
stockholders taking advantage of bondholders has lead to bondholders
protecting themselves at the time of the issue.
firms revealing incorrect or delayed information to markets has lead to markets
becoming more “skeptical” and “punitive”
firms creating social costs has lead to more regulations, investor and customer
backlashes.
The Modified Objective Function
For publicly traded firms in reasonably efficient markets, where bondholders
(lenders) are protected:
o Maximize Stock Price: This will also maximize firm value
For publicly traded firms in inefficient markets, where bondholders are protected:
o Maximize stockholder wealth: This will also maximize firm value, but
might not maximize the stock price
For publicly traded firms in inefficient markets, where bondholders are not fully
protected
o Maximize firm value, though stockholder wealth and stock prices may not
be maximized at the same point.
For private firms, maximize stockholder wealth (if lenders are protected) or firm
value (if they are not)
Relation to investment theory
Use of CAPM to estimate the cost of capital
Option pricing approach for valuing investment projects (real options), equity of
the firm, and bonds’ credit risk
5
6. Lecture 2. Analysis of financial statements
The Firm’s Financial Statements
Balance Sheet
Income Statement
Statement of Cash Flows
Functions: providing
current status and past performance information to owners and creditors
a convenient way for owners and creditors to set performance targets & to
impose restrictions on the managers of the firm
a convenient template for financial planning
Balance Sheet
Assets ≡ Liabilities + Shareholder’s Equity
Tabulates a company’s assets and liabilities at a specific point in time
o Info on value of the assets and the capital structure
Sorting of
o Assets by liquidity
o Liabilities by maturity
Assets and liabilities are represented by historical costs
o The original cost adjusted for improvements and aging = Book Value
o Avoid using market value, since is too volatile and easily manipulated
o Preference for underestimating value
Strict categorization into E or L: the liability must satisfy
o The obligation will lead to CF at some specified or determinable date
o The firm cannot avoid the obligation
o The transaction behind the obligation has already happened
However, important liabilities may be under-stated or omitted
Assets
Current Assets (Оборотные средства): will convert into cash within a year
o Cash
o Accounts Receivable (Счета к получению)
Recognizing not collectible ones: reserves (danger of manipulation!)
o Inventory (ТМЗ): valued by FIFO, LIFO, wdt-avg
LIFO increases costs and reduces taxes
LIFO reserve: difference between LIFO and FIFO valuations
Investments and Marketable Securities (Рыночные цб)
o Minority passive / active investment (<20% / 20-50% of the ownership): BV
or MV
o If majority active investment (>50%): include in the consolidated balance
sheet
Intangible Assets (Нематериальные активы): amortized over expected life (say,
40 years)
o Patents and trademarks: valuation depends on whether generated
internally or acquired
o Goodwill: the difference between BV and MV of the acquired firm (purchase
accounting)
6
7. Fixed Assets (Основные средства; Land, Plant and Equipment): BV with
adjustment for aging
o Depreciation: straight line or accelerated (improves the earnings in the first
years)
Liabilities and Stockholder’s Equity
Liabilities
Current Liabilities (Краткосрочные обязательства): valued as the amount due
o Accounts Payable (Счета к оплате)
o Short-term Borrowing
o Other: Accrued Wages, Benefits, and Taxes
Long-Term Debt: Bank Loans, Bonds
o Valued as PV of future obligations at the time of borrowing (usually at
par)
o The premium or discount over the par is amortized over the bond’s life
Other Long-Term Liabilities
o Leases
Capital lease (transfer of ownership): recognized as asset
(depreciated) and liability
If operating lease: balance not affected, lease payments treated as
operating expense
o Employee Benefits: Pension Plans, Healthcare Benefits
DC: fixed contribution each year;
DB: contributions change depending on whether the plan is over-
or underfunded
o Deferred Taxes
Difference between the taxes on income reported in fin
statements and actual taxes
Shareholder’s Equity (Акционерный капитал) = Total Assets - Total Liabilities
Preferred Stock
o Hybrid: fixed (cumulative) dividend, but cannot result in bankruptcy
o Valued at the original issue price + cumulated unpaid dividends
Common Stock at Par
Capital Surplus
o Results from earnings on buying and selling stocks
o Treasury Stock: repurchased shares, reduce BV of equity
Retained Earnings (Нераспределенная прибыль)
Income Statement
Revenue – Expenses ≡ Income
Summarizes the company’s profitability during a time period
o Records sales, expenses, taxes, and net income
Matching principle of the accrual accounting:
o Revenues and expenses are recognized when the good is sold
Becomes complicated for long-term contracts and buyers with credit
risk
o In contrast to the cash-based approach: recognizing revenues when
received and expenses when paid
A company’s accounting income and cash flow are two different
things
7
8. Categorization of expenses:
o Operating: provide benefits only for the current period (cost of labor and
materials)
Also included: depreciation (based on historical cost) and R&D
o Financing: arising from non-equity financing (interest expenses)
o Capital: generate benefits over multiple periods (buying land and
buildings), written off as depreciation
To improve forecasting, separately: nonrecurring items
o Income from discontinued operations, extraordinary gains & losses,
adjustments for changes in accounting principles
Retained earnings are not added to the cash balance in the balance sheet, but are
added to shareholder’s equity
Inflation distorts the measuring of income and the valuation of assets
Total operating revenues
- Cost of goods sold
- Selling, general, and administrative expenses
- Depreciation
Operating income
+ Other income
EBIT (Earnings before interest and taxes)
- Interest expense
Taxable income
- Taxes: Current + Deferred
Net income = Retained earnings + Dividends
The Statement of Cash Flows
CF(firm) ≡ CF(debt) + CF(equity)
Reports how much cash is generated during a period.
o Indicates where the cash comes from and what the firm did with that cash.
Unlike the balance sheet and income statement, cash flow statements are
independent of accounting methods
o Accounting rules have a second-order effect on cash flows through taxes
Operating CF = EBIT + Depreciation - Taxes
- Capital Spending (net acquisitions of fixed assets)
- Additions to the Net Working Capital (current assets - current liabilities)
Cash Flow of the Firm
CF of debtholders = Interest – net long-term debt financing
CF of equityholders = Dividends– net equity financing
Financial Ratio Analysis
Trend Analysis
Cross-Sectional Analysis
Profitability Ratios
Return on Assets (ROA) = EBIT(1-tax) / Total Assets
Return on Equity (ROE) = Net Income / BV(equity)
Gross Profit Margin = Gross Profit / TA
8
9. Operating Profit Margin = EBIT / Sales
Net Profit Margin = Net Income / Sales
Activity Ratios: measuring the efficiency of working capital management
• Accounts Receivable Turnover = Sales / Avg Accounts Receivable
• Inventory Turnover = Cost of Goods Sold / Avg Inventory
• Total Asset Turnover = Sales / Total Assets
Liquidity Ratios: measuring short-term liquidity
Current Ratio = Current Assets / Current Liability
Quick Ratio = (Current Assets – Inventory) / Current Liability
Financial Leverage Ratios
Debt-to-Capital Ratio = Debt / (Debt + Equity)
Debt-to-Equity Ratio = Debt / Equity
o Can be based on BV or MV
o Similarly: long-term debt ratios
Interest Coverage Ratio = EBIT / Interest Expenses
Cash Fixed Charges Coverage Ratio = EBITDA / Cash Fixed Charges
Market Value Ratios
• Price-to-Earnings Ratio = PS / EPS
– Stock market price to earnings per share
• Dividend Yield = Div / PS
– Latest dividend to current stock price
• Market-to-Book Value = MV / BV
– Similarly: Market-to-Book Equity = ME / BE
• Tobin's Q = MV / Replacement Value
Links between the Ratios
ROA = Profit Margin * Asset Turnover
o Both for Net and Gross ROA and Profit Margin
o Increasing ROA: trade-off between Profit Margin and Asset Turnover
ROE = ROA * Equity Multiplier
o where Equity Multiplier = Assets / Equity
o Higher fin leverage magnifies ROE when ROA(gross) excess the interest on
debt
Non-Financial Measures of Operating Effectiveness
Innovation
Customer Service
Product Quality
Reputation
Good Employee Relations
Segmented Financial Statements
Reports revenues, operating profits, and identifiable assets for each line of
business
Allows managers and shareholders to identify cross-subsidization
9
10. The DCF approach to bond and stock valuation
Computing Present Value
Time value of money: discount rate R
Single cash flow at T: CFT
o
PV0 = CFT/(1+R)T
Perpetuity: Ct = C, t>0
o PV0 = C / R
Growing perpetuity (with const rate g): Ct+1 = (1+g)Ct
o PV0 = C / (R - g)
Annuity: Ct = C, t = 1,…,T
o PV0 = (C/R) [1 – 1/(1+R)T ]
Growing annuity (with const rate g)
o PV0 = (C/(R-g)) [1 – (1+g)T/(1+R)T ]
Computing Growth Rate of Dividends
Assume that the company does not grow unless a net investment is made. Then the
company needs to retain part of its earnings to grow:
Earningst+1 = Earningst + Retained_ Earningst * R
where R is the return on the retained earnings, usually estimated by ROE
Divide by Earningst to get Sustainable Growth Rate :
1 + g = 1 + Retention Ratio * ROE
where Retention Ratio = Retained Earnings / Earnings
Pricing Applications
Bond with coupon C and face value F (at T)
o
P0 = (C/R) [1 – 1/(1+R)T ] + FT/(1+R)T
Stocks with dividends growing with const rate g
o PV0 = Div1/(R-g)
Project: NPV = Σt CFt/(1+R)t
Value of the firm with Div=EPS:
o Discounted CF's: PV0 = EPS/R + NPVGO
EPS = earnings per share, GO = growth opportunities
o Multiples: P/E≡PV0/EPS = 1/R + NPVGO/EPS
P/E = price to earnings ratio
Lectures 3-6. Capital budgeting
Black-Scholes approach to the valuation of real options
Differences between real and financial options, which are crucial for the
Black-Scholes approach:
1. The underlying asset is not traded
Option pricing theory is built on the premise that a replicating portfolio can
be created using the underlying asset and riskless lending and borrowing.
2. The price of the asset may not follow a continuous process
If there are no price jumps, as it is with most real options, the model will
underestimate the value of deep out-of-the-money options.
10
11. o One solution is to use a higher variance estimate to value deep
out-of-the-money options and lower variance estimates for
at-the-money or in-the-money options.
o Another is to use an option pricing model that explicitly allows for price
jumps, though the inputs to these models are often difficult to estimate.
3. The variance may change over the life of the option
The assumption that option pricing models make, that the variance is known
and does not change over the option lifetime, is not unreasonable when
applied to listed short-term options on traded stocks.
When option pricing theory is applied to long-term real options, there are
problems with this assumption, since the variance is unlikely to remain
constant over extended periods of time and may in fact be difficult to
estimate in the first place.
4. Exercise is not instantaneous
The option pricing models are based upon the premise that the exercise of an
option is instantaneous. This assumption may be difficult to justify with real
options, where exercise may require the building of a plant or the
construction of an oil rig, actions which are unlikely to happen in an instant.
The fact that exercise takes time also implies that the true life of a real option
is often less than the stated life.
Valuing Natural Resource Options/ Firms
Input Estimation Process
Expert estimates (Geologists for oil..); The
1. Value of Available
present value of the after-tax cash flows
Reserves of the Resource
from the resource are then estimated.
2. Cost of Developing Past costs and the specifics of the
Reserve (Strike Price) investment
Relinqushment Period: if asset has to be
relinquished at a point in time.
3. Time to Expiration
Time to exhaust inventory - based upon
inventory and capacity output.
based upon variability of the price of the
4. Variance in value of
resources and variability of available
underlying asset
reserves.
5. Net Production Revenue Net production revenue every year as percent
(Dividend Yield) of market value.
6. Development Lag Calculate PV of reserve based upon the lag.
Example: A gold mine
Consider a gold mine with an estimated inventory of 1 million ounces, and a
capacity output rate of 50,000 ounces per year.
The price of gold is expected to grow 3% a year.
The firm owns the rights to this mine for the next twenty years.
The present value of the cost of opening the mine is $40 million, and the average
production cost of $250 per ounce. This production cost, once initiated, is expected
to grow 4% a year.
The standard deviation in gold prices is 20%, and the current price of gold is $350
per ounce. The riskless rate is 9%, and the cost of capital for operating the mine is
10%. The inputs to the model are as follows:
11
12. Inputs for the Option Pricing Model
Value of the underlying asset = Present Value of expected gold sales (@ 50,000
ounces a year) = (50,000 * 350) * (1- (1.0320/1.1020))/(.10-.03) - (50,000*250)* (1-
(1.0420/1.1020))/(.10-.04) = $ 42.40 million
Exercise price = PV of Cost of opening mine = $40 million
Variance in ln(gold price) = 0.04
Time to expiration on the option = 20 years
Riskless interest rate = 9%
Dividend Yield = Loss in production for each year of delay = 1 / 20 = 5%
o Note: It will take twenty years to empty the mine, and the firm owns the rights for
twenty years. Every year of delay implies a loss of one year of production.
Valuing the Option
Based upon these inputs, the Black-Scholes model provides the following value for
the call:
d1 = 1.4069, N(d1) = 0.9202
d2 = 0.5124, N(d2) = 0.6958
Call Value= 42.40 exp(-0.05)(20) (0.9202) -40 (exp(-0.09)(20) (0.6958)= $ 9.75
million
The value of the mine as an option is $ 9.75 million, in contrast to the static capital
budgeting analysis which would have yielded a net present value of $ 2.40 million
($42.40 million - $ 40 million). The additional value accrues directly from the mine's
option characteristics.
Example: Valuing an oil reserve
Consider an offshore oil property with an estimated oil reserve of 50 million barrels
of oil, where the present value of the development cost is $12 per barrel and the
development lag is two years.
The firm has the rights to exploit this reserve for the next twenty years and the
marginal value per barrel of oil is $12 per barrel currently (Price per barrel -
marginal cost per barrel).
Once developed, the net production revenue each year will be 5% of the value of the
reserves. The riskless rate is 8% and the variance in ln(oil prices) is 0.03.
Inputs to the Black-Scholes Model
Current Value of the asset = S = Value of the developed reserve discounted back the
length of the development lag at the dividend yield = $12 * 50 /(1.05)2 = $ 544.22
o If development is started today, the oil will not be available for sale until two
years from now. The estimated opportunity cost of this delay is the lost
production revenue over the delay period. Hence, the discounting of the reserve
back at the dividend yield
Exercise Price = Present Value of development cost = $12 * 50 = $600 million
Time to expiration on the option = 20 years
Variance in the value of the underlying asset = 0.03
Riskless rate =8%
Dividend Yield = Net production revenue / Value of reserve = 5%
Valuing the Option
12
13. Based upon these inputs, the Black-Scholes model provides the following value for
the call:
d1 = 1.0359, N(d1) = 0.8498
d2 = 0.2613, N(d2) = 0.6030
Call Value= 544 .22 exp(-0.05)(20) (0.8498) -600 (exp(-0.08)(20) (0.6030)= $
97.08 million
This oil reserve, though not viable at current prices, still is a valuable property
because of its potential to create value if oil prices go up.
Valuing product patents as options
Input Estimation Process
PV of Cash Inflows from taking project
1. Value of the Underlying
now
Asset
This will be noisy, but that adds value.
Variance in cash flows of similar assets or
2. Variance in value of firms
underlying asset Variance in PF from capital budgeting
simulation.
Option is exercised when investment is
made.
3. Exercise Price on Option Cost of making investment on the project;
assumed to be constant in present value
dollars.
4. Expiration of the Option Life of the patent
Cost of delay
Each year of delay translates into one less
5. Dividend Yield
year of value-creating cashflows
Valuing Equity as an option
A simple example
Assume that you have a firm whose assets are currently valued at $100 million and
that the standard deviation in this asset value is 40%.
Further, assume that the face value of debt is $80 million (It is zero coupon debt
with 10 years left to maturity).
If the ten-year treasury bond rate is 10%, how much is the equity worth? What
should the interest rate on debt be?
Model Parameters
Value of the underlying asset = S = Value of the firm = $ 100 million
Exercise price = K = Face Value of outstanding debt = $ 80 million
Life of the option = t = Life of zero-coupon debt = 10 years
Variance in the value of the underlying asset = 2 = Variance in firm value = 0.16
Riskless rate = r = Treasury bond rate corresponding to option life = 10%
Valuing Equity as a Call Option
Based upon these inputs, the Black-Scholes model provides the following value for
the call:
d1 = 1.5994, N(d1) = 0.9451
13
14. d2 = 0.3345, N(d2) = 0.6310
Value of the call = 100 (0.9451) - 80 exp(-0.10)(10) (0.6310) = $75.94 million
Value of the outstanding debt = $100 - $75.94 = $24.06 million
Interest rate on debt = ($ 80 / $24.06)1/10 -1 = 12.77%
Applicability in valuation
Input Estimation Process
Cumulate market values of equity and debt (or)
Value of the
Value the firm using FCFF and WACC (or)
Firm
Use cumulated market value of assets, if traded.
If stocks and bonds are traded,
2firm = we2 e2 + wd2 d2 + 2 we wd ed e d
where e2 = variance in the stock price we = MV weight of
Variance in Equity
Firm Value
d2 = the variance in the bond price wd = MV weight of debt
If not traded, use variances of similarly rated bonds.
Use average firm value variance from the industry in
which company operates.
Maturity of Face value weighted duration of bonds outstanding (or)
the Debt If not available, use weighted maturity
Monte-Carlo approach to the valuation of real options
Stochastic Processes for Oil Prices
Geometric Brownian Motion Simulation
The real simulation of a GBM uses the real drift a. The price at future time t is given
by:
Pt = P0 exp{ (a - 0.5 s2) Dt + s N(0, 1) }
s is the volatility of P
With real drift use a risk-adjusted (to P) discount rate
The risk-neutral simulation of a GBM uses the risk-neutral drift a’ = r - d . The
price at t is:
Pt = P0 exp{ (r - d - 0.5 s2) Dt + s N(0, 1) }
d is the convenience yield of P
With risk-neutral drift, the correct discount rate is the risk-free interest rate.
Mean Reversion Process
Consider the arithmetic mean reversion process
The solution is given by the equation with stochastic integral:
Where h is the reversion speed. The variable x(t) has normal distribution with
14
15. We want a mean reversion process for the oil prices P with lognormal distribution
with mean E[P(T)] = exp{E[x(T)]}
Risk-Neutral Mean Reversion Process for P
The risk-neutral process for the variable x(t), considering the AR(1) exact
discretization (valid even for large Δt) is:
The variable x(t) reverts to a long run mean
Prices reverts to a long run equilibrium level, say $20/bbl
In order to get the desirable mean is necessary to subtract from x the half of
variance Var[x(t)], which is a deterministic function of the time: P(t) = exp{
x(t) - (0.5 * Var[x(t)])}
This is necessary due the log-normal properties
Using the previous equation relating P(t) with x(t), we get the risk-neutral
mean-reversion sample paths for the oil prices.
Risk-Neutral Simulation vs Real Simulation
For the underlying asset, you get the same value:
Simulating with real drift and discounting with risk-adjusted discount rate r = a
+d
Or simulating with risk-neutral drift (r - d) but discounting with the risk-free rate
(r)
For an option/derivative, the same is not true:
Risk-neutral simulation gives the correct option result (discounting with r) but
the real simulation does not gives the correct value (discounting with r)
Why? Because the risk-adjusted discount rate is “adjusted” to the underlying
asset, not to the option
Risk-neutral valuation is based on the absence of arbitrage, portfolio replication
(complete market)
Excerpt from Dias-Rocha (2001)
One practical “market-way” to estimate is taking the net convenience yield ( time
series (calculated by using futures market data from longest maturity contract with
liquidity) 1 , together with spot prices series, estimating by using the equation: (t)
(t) ( – P(t)). Here is just the difference between the discount rate (total
required return) and the expected capital gain E(dP/P), like a dividend. The
parameter is endogenous in our model and, from a market point of view, is used
in the sense of Schwartz’s (1997b, p.2) description: “In practice, the convenience
yield is the adjustment needed in the drift of the spot price process to properly price
existing futures prices”. High oil prices P in general mean high convenience yield
(positive correlation), and for very low P the net convenience yield can even be
1
The known formula for a commodity futures prices is F(t) = e (r ) t P. This equation is deduced by
arbitrage and assumes that is deterministic, so it looks contradictory with our assumption of
systematic jump and with our model that implies that is as uncertain as P. But we want an implicit
value for and so for , to get a market reference for . It is only a practical “market evaluation” for
the discount rate that is assumed constant in our model.
15
16. negative. There is an offsetting effect in the equation (even though not perfect), so
we claim as reasonable the approximation of constant. As compensation, we do
not need to assume constant interest rate (because it does not appear in our model)
or constant convenience yield (this implicitly changes with P). The time series (P, r, )
generate the time series. In this way, the value of depends of the assumed
values for and . Using 10-year oil futures data (from July/89 to June/99) and
12-month T-Bond interest rates, we found the time series for both and , and the
standard deviation of was about the half of the , confirming our intuition of more
stability for . The simple regression P x permits us to estimate “market” values
for and . We found 9.3% and = 0.03 (used in the base case). We get the
same value 9.3% p.a. at the equilibrium level $20/bbl (for P = = using the
equation of regression.
16
17. Lectures 7-9. Capital structure
Treatment of Warrants and Convertibles
Warrants and conversion options (in convertible bonds, for instance) are long term
call options, but standard option pricing models are based upon the assumption
that exercising an option does not affect the value of the underlying asset. This may
be true for listed options on stocks, but it is not true for warrants and convertibles,
since their exercise increases the number of shares outstanding and brings in fresh
cash into the firm, both of which will affect the stock price. The expected negative
impact (dilution) of exercise will make warrants less valuable than otherwise similar
call options. The adjustment for dilution in the Black-Scholes to the stock price
involves three steps:
Step 1: The stock price is adjusted for the expected dilution from warrant exercise.
Dilution-adjusted S = (S ns+W nw ) / ns
where,
S = Current value of the stock
nw = Number of warrants outstanding
W = Market value of warrants outstanding
ns = Number of shares outstanding
When the warrants are exercised, the number of shares outstanding will increase,
reducing the stock price. The numerator reflects the market value of equity,
including both stocks and warrants outstanding.
Step 2: The variance used in the option pricing formula is the variance in the value
of the equity in the company (i.e., the value of stocks plus warrants, not just the
stocks).
Step 3: The call is valued with these inputs.
Dilution-adjusted value = Call Value from model
Lecture 10. Payout (dividend) policy
Lecture 11. IPOs
Lecture 12. Mergers and acquisitions
Example on the accounting for acquisitions
Assume that there are firms A and B with the current value and number of shares
given in the first columns of the table. Together, firms A and B are worth 700. The
shareholders of B require half of the synergy gain, i.e., at least 150 for their shares.
A B A* after the A+B after the
merger merger
Market value, $ 500 100 550 700
# shares 25 10 25 31.818
Share price, $ 20 10 22 22
1. The purchase method: A makes a cash offer of 150 for B’s shares.
In this case, the combined firm A* is worth 700-150=550 or $22 per share after the
merger.
2. Pooling of interest: A issues n new shares in exchange for 10 shares of B, such
that n shares of the combined firm are worth 150.
17
18. Solving the equation 150/700 = n/(25+n), we find n=6.818. Naturally, the share
price is the same as in the previous case: $22, as A’s shareholders must be
indifferent between the two methods given a fixed premium for B’s shareholders.
Given the probability of merger q, say, equal to 0.6, one can compute the
pre-merger price of A:
Pre-merger P(A) = 0.6P*(A) + 0.4P0(A) = 0.6*20 + 0.4*22 = $20.8.
Lecture 13. Corporate governance
Enron & WorldCom
Энергокомпания Enron завысила прибыль более чем на $1 млрд и скрывала
долги на $8 млрд на счетах офшорных структур. В декабре 2001 г. Enron
стала крупнейшим банкротом США с активами $63,4 млрд.
В июле 2002 г. обанкротился телекоммуникационный гигант WorldCom с
активами $107 млрд. Масштабы махинаций с бухгалтерской отчетностью в
WorldCom достигли $11 млрд.
В конце прошлой недели было объявлено о двух громких соглашениях, в
рамках которых члены советов директоров поступились личными деньгами,
чтобы отвести от себя обвинения акционеров. Десять независимых
директоров WorldCom согласились в рамках внесудебного соглашения
выплатить $18 млн, а 10 директоров Enron — $13 млн.
С 2002 г. введена персональная ответственность генерального и финансового
директоров публичных компаний за достоверность бухгалтерской отчетности.
Если они сознательно завизируют поддельную отчетность, им грозит до
20 лет тюрьмы и штраф в $5 млн; неумышленная подпись под недостоверным
документом грозит 10 годами и $1 млн.
18