CHAP 1: INTRODUCTION TO CORPORATE FINANCE

-Corporate finance → all the decisions are rational and those who make financial
decisions are also rational
-The role of corporate executive has changed
↘they must be willing and have confidence to implement investing and financing
decisions that fully incorporate risky outcomes
-Value creation →you sell and then your firm generates cash
⤷firm’s purpose is to create value for the owner
-A quick recap:
➢ non-current assets: those who will last a long time (ex. buildings)
○ tangible: machinery and equipment
○ intangible: patents and trademarks
➢ current assets: have short life (ex. inventory)
-Before a firm starts to invest in assets, they must obtain financing
→bonds: debt on loan agreements
→shares: certificates representing fractional ownership of the firm
-Three pillars of corporate finance:
● INVESTING: choose the best assets
⇒ capital budgeting: describe the process of making money and managing
expenditures on long-lived assets
↘in which long-lived assets should the firm invest?
-To start a firm we need inventory, machinery, land and labour
⤷all of these are investments
● FINANCING: choose the best financing for the company
⇒ capital structure: represents the portion of the firm’s financing from current and
long-term debt and equity
↘cash invested in assets must be matched in by an equal amount of cash
raised by financing
-People that buy debt from the firm are called creditors, bondholders or debtholders
-We can write the value of a firm like this:
V=D+E
where D is market value of debts (bonds) and E the market value of equity
(shares)
-Cash invested in assets must be matched by an equal amount of cash raised by
financing
● LIQUIDITY: ensure enough inventory and cash
⇒ net working capital: current assets - current liabilities
-To run a firm on an everyday basis you need current assets and current liabilities
-FINANCIAL MANAGER
-She makes decision
-To the financial manager report:
➢ the treasurer, who is responsible for handling cash flow, managing capital
expenditure decisions and making financial plan
➢ the financial controller, who handles the accounting function like taxes, financial
and management accounting
-The most important role of the financial manager is to create value from the firm’s capital
budgeting, financing and networking capital activities !!!!
-How does the financial manager create value?
ー try to buy assets that generates more cash than they cost
ー sell bonds, shares and other financial instruments that raise more cash than
they cost
ーchoose long term investments that increase firm value
ー ensure efficient tax policy
-Cash flow
-We need to take into consideration those three things:
·identification: cash flow or accounting figures?
·timing: when does cash flow occur?
·risk: are cash flows risky or certain?
⤷the financial manager objective is to identify the risk, measure it and then
optimally manage it
-Goal of financial management →make money or add value for the owners
-Goals relates to two classes:
➢ profitability: goals involving sales, market shares and cost control
➢ controlling risk: goals involving bankruptcy, avoidance, stability and safety
⇒the goal of financial management is to maximize the value of a company’s equity shares
⤷the goal is to maximize the current share price
-The total value of shares in a corporation is simply equal to the value of owners’ equity
↘our goal is to maximize the market value of the existing owners’ equity

-FINANCIAL MARKETS
-When firms need money to invest they have to decide:
● borrow money (debt)→ loans and agreements to later pay back the borrowed
amount + interests
-when borrow money, it can go to:
ー a bank for a loan
ー issue debt securities in the financial markets
⤷debt securities are contractual obligations to repay corporate borrowing
● give up a fraction of ownership in their firm (equity) →in exchange they get cash
ー equity securities are ordinary shares that represent non-contractual
claims on the residual cash flow of the firm
⇒both issuance can be sold by the firm and are then traded in the financial markets,
such as stock markets
-Financial markets are composed by:
➢ money markets, which are for debt securities that will pay off in the short-term ( less
than one year)
↘money markets has this name bc of a group of loosely connected markets
→dealer markets: are firms that make continuous price quotations for which
they stand ready to buy and sell short-term financial instruments for their
inventory and their own risk
➢ capital markets, that are for long-term debt and equities

-Primary vs secondary markets

⇒PRIMARY MARKETS
-they get used to sell securities →first share issue is called an Initial Public Offering
↘second share: a seasoned offering
⤷money that has raised goes to issuing firm
-two types of primary markets: ー public offerings
ー private placements
-publicity issued and debt equity must be registered with the local regulatory authority
↘regulations requires the corporation to disclose all material information in a
registration statement
⇒SECONDARY MARKETS
-its transactions involve one owner or creditor selling to another
↘investors trade securities with each other
⤷money that is raised goes to sellers of securities
-it provides the mean for transferring ownership of corporate securities
CHAP 3 APPENDIX: LONG-TERM FINANCIAL PLANNING

-Long term financial planning is an important use of financial statement

↘financial statement could be used to plan over the long time
-Why financial planning?
• Compute external financing needed
• Ensure feasibility and internal consistency of strategies
• Identify the determinants of a firm’s growth
• Understand how capital structure policy and dividend policy affect a firm’s ability
to grow
-Key Elements of Financial Planning
1. Investment in new assets →capital budgeting decisions
2. Degree of financial leverage →capital structure decisions
3. Cash paid to shareholders → dividend policy decisions
4. Liquidity requirements → net working capital decisions

-Financial planning process:

ー Planning Horizon - divide decisions into short-run decisions (usually next 12
months) and long-run decisions (usually 2 – 5 years)
ー Aggregation - combine capital budgeting decisions into one large project
ー Assumptions and Scenarios
➢ Make realistic assumptions about important variables
➢ Run several scenarios where you vary the assumptions by reasonable
amounts
➢ Determine, at a minimum, worst case, normal case, and best case
scenarios
-Financial planning model ingredients:
● Sales Forecast – many cash flows depend directly on the level of sales (often
estimated using sales growth rate)
● Pro Forma Statements – setting up the plan using projected financial statements
allows for consistency and ease of interpretation
● Asset Requirements – the additional assets that will be required to meet sales
projections
● Financial Requirements – the amount of financing needed to pay for the required
assets
● Plug Variable – determined by management deciding what type of financing will be
used to make the balance sheet balance

Ex. Computerfield plc

Assume all variables are a constant percentage of sale

Now, suppose a growth of 20%

 £ £ £
Sales 1200 Assets 600 (+100) Debt 300(+50)
Costs 960 Equity 300(+50)
Net income 240 Total 600 (+100) Total 600(+100)

Looking at the two IS, how can net income become £240 but equity only increases by 50?
→probably Computerfield have paid 240-50 = £190 of cash dividends
⤷here dividends are the plug variable
-Suppose that the company doesn’t pay the dividends:
⇒its equity will be £250(initial equity) + £240(net income) = £490
Since we have 600 of assets and 490 of equity, debts will be 600 - 490 = £110 .
Because we started with £250 in debt, Computerfield will have to retire £250 - 110 = £140 in
debt. The resulting statement of financial position would look like this:

→here debt is the plug variable

->divide variables that
vary with sales and
-THE PERCENTAGE OF SALE APPROACH those that don’t

⇒assume only some variables are tied to sales growth !!!

-Here we separate the IS and the BS into two groups: those that vary directly with sales and
those that do not
INCOME STATEMENT
Ex. Rosengarten

-Suppose that the company has a 25% increase in sales

800
From the IS above, we know that costs are = 80% of sales; the new IS is:
1000
 123
Net income (profit margin) in the first IS is = 13.2%
1000
165
↘we can check it also in the new IS: = 13.2%
1000
-Now, we need to project the dividend payment with the ratio:
𝑐𝑎𝑠ℎ 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠
⇒dividend payout ratio =
𝑛𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒
44 1
= = 33 %
132 3
→projected dividends paid to shareholders = 165 x ⅓ = €55
→projected addition to retained earnings = 156 x ⅔ = 110€
=> 110 + 55 = 165€
-We can also calculate the ratio of the addition to retained earnings in this way:
𝑎𝑑𝑑𝑖𝑡𝑖𝑜𝑛 𝑡𝑜 𝑟𝑒𝑡𝑎𝑖𝑛𝑒𝑑 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠
⇒ratio of addition to retained earnings =
𝑛𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒
88 2
= = 66 %
132 3
↘this ratio is called retention ratio or plough back ratio and is equal to 1 minus the
dividend payout ratio => 1 - div. payout ratio = retention ratio
=> 1 - ret. ratio = div. payout ratio
STATEMENT OF FINANCIAL POSITION (BS)
-Some items vary directly with sales and others don’t
→if vary, we express each as a percentage of sales for the year just completed
→if not, we write ‘n/a’ for not applicable

➤bisogna sempre fare la percentage rispetto ai nuovi sales trovati nel IS

-For example, inventory equals 60% of the sales →600/1000 = 60%
⤷for the next year, for each €1 increase in sales (retained earnings), inventory will raise
by €0.60
3000
-We can also calculate the ratio of total assets to sales = = 300%
1000
⤷ratio called capital intensity ratio→tells us the amount of assets needed to generate
€1 of sales
⇒it takes €3 in total assets to generate €1 in sales
-Now we can construct a partial statement of financial position
↘ex. non-current assets are 180% of sales → 1.80 x 1250 = €2250
⤷increase of 2250 - 1800 = €450 in plant and equipment
-For items that do not vary with sales we write the original amounts
-We need to pay attention in the external financial needed
↘even if assets are supposed to increase by €750, liabilities and equity will increase
only by €185 → leaving a shortfall of 750 - 185 = €565
⤷€565 are external financial needed (EFN)
-We can calculate EFN using this formula: Prima parte fino a delta sales: projected increase in sales
Parte dopo: projected addition to retained earnings

At the end, our new BS will be:

➢ ∆sales is the projected change in sales

↘sales for next year are €1250, sales of the previous year are €1000
→1250 - 1000 = €250 sales difference (increase)
➢ PM is profit margin payout ratio
➢ d is dividend payout ratio
-So for our example we will have:
3000−0 300 1
EFN =
1000
x 250 − 1000
x 250 - 0.132 x 1250 x (1 − 3
)= 565

PARTICULAR SCENARIO
-We have to consider that to get our scenario, Rosengarten has to raise €565 in new
financing
↘short-term borrowing, long-term borrowing and new equity
Borrow:
-We know that assets increased by €300 while liabilities rose only by €75
↘the firm could borrow 300 - 75 = €225 in short-term payable
⤷with €565 needed, the remaining 565 - 225 = €340 would have to come from
long-term debts
EXTERNAL FINANCING AND GROWTH
-External financing needed and growth are related

-Suppose Paradise plc is forecasting next year’s sales level at £600, a £100 increase
↘the percentage increase in sales is 100/500 = £20%
⤷at a 20 per cent growth rate, the firm needs £100 in new assets

→the project addition to retained earnings is £57.6

⇒EFN = 100 - 57.6 = £42.4
-We assume that the fir, doesn’t want to sell equity, so the £42,4 in EFN will have to be
borrowed → new total debt will be original £250 + £42.4 = £292.4
⇒debt-equity ratio will go from 1.0 (£250/250) to £292.4/307.6 = £0.95
FINANCIAL POLICY AND GROWTH
-Direct link between growth and external financing
Internal Growth Rate max growth con cose interne
-Internal growth rate is the maximum growth rate that can be achieved with no external
financing of any kind
-At the internal growth rate, the assets is exactly equal to the addition to retained earnigs,
and EFN is zero
-We can use this formula to define internal growth rate:
𝑅𝑂𝐴 𝑥 𝑏 -> ROA = net income/tot asset
Internal growth rate =
1 − 𝑅𝑂𝐴 𝑥 𝑏
where ROA is the return on assets and b is the retention ratio
-For Paradise plc, net income was £72 and total assets were £500
→ROA = £72/500 = 14.4%
-Of the £72 net income, £48 was retained
→retention ratio = £48/72 = ⅔ %
0.144 𝑥 (2/3)
⇒Internal growth rate = = 10.62%
1 − 0.144 𝑥 (2/3)
Sustainable Growth Rate max growth you can reach senza indebitarti
-Sustainable growth rate is the maximum growth rate a firm can achieve with no external
equity while it maintains constant the debt-equity ratio
↘the maximum rate of growth a firm can maintain without increasing financial leverage
-We can use this formula to define sustainable growth rate:
𝑅𝑂𝐸 𝑥 𝑏 -> ROE = net income/equity
Sustainable growth rate =
1 − 𝑅𝑂𝐸 𝑥 𝑏
where ROE is the return on equity and b the retention ratio
-For Paradise plc, net income was £72 and total equity was £250
→ROE = £72/250 = £28.8
→retention ratio = ⅔ %
0.288 𝑥 (2/3)
⇒Sustainable growth rate = = 23.76%
1 − 0.288 𝑥 (2/3)
-Determinants of growth
-We know that ROE can be written as:
ROE = profit margin x total asset turnover x equity multiplier
→anything that increases ROE will increase the sustainable growth rate
-A firm’s ability to sustain growth depends on:
➢ profit margin: + profit margin = + ability of generating internal funds
➢ dividend policy: - net income paid as dividends = + retention ratio
➢ financial policy: + debt-equity ratio = + firm’s financial leverage
➢ total asset turnover: + asset turnover = + sales generated for each unit in assets
-If a firm does not wish to sell new equity and its profit margin, dividend policy, financial
policy and total asset turnover (or capital intensity) are all fixed, then there is only one
possible growth rate !!!

FINANCIAL PLANNING MODEL: SOME CAVEATS

● financial planning models ignore cash flow, risk and timing
● financial planning should not be a mechanical process
● Financial planning should be an iterative process
CHAP 4: DISCOUNTED CASH FLOW VALUATION
VALUATION: THE ONE-PERIOD CASE
Example 1:
- Keith Vaughan is trying to sell a piece of undeveloped land in Wales. Yesterday he
was offered £10,000 for the property.
- He was about ready to accept the offer when another individual offered him £11,424.
The second offer was to be paid a year from now.
- Keith has satisfied himself that both buyers are honest and financially solvent, so he
has no fear that the offer he selects will fall through.
→which offer should Keith choose?
-We need to know the concepts of future value (FV) and present value (PV)
→Future value (FV) or compound value is the value of a sum after investing ver one or
more periods
-We write the formula for FV as:
FV = C0 x (1 + r)
where C0 is the cash you deposit (or you have) at the moment
→Present value that answer to this question: how much money does Keith put in the bank
today so that he will have £11,424 next year?
-We write the formula for PV:
𝐶1
PV =
1+𝑟
where C1 is cash flow at date 1 and r is the rate of return
↘r is referred as the discount rate
-Going back to the exercise, suppose that Keith’s financial advisor suggests him to invest the
£10,000 at bank savings rate of 12% → he will have £11,200 in one year
⇒11,200 < 11,424 → so the second option is better, but that’s not all
-We need to calculate how much money should Keith have today so that next year he could
have had (more) than £11,424 → we calculate PV
11,424
→PV = = £10,200
1 + 0.12
⇒if he wanted a better offer than the second one, the first one should have proposed to
give him ≥ £10,200
Example 2:
- Lida Jennings, a financial analyst at K&B (a leading real estate firm) is thinking about
recommending that K&B invest in a piece of land that costs €85,000.
- She is certain that next year the land will be worth €91,000, a sure €6,000 gain.
- Given that the guaranteed interest rate in the bank is 10 percent, should Kaufman &
Broad undertake the investment in land?
-We again calculate PV
91,000
→PV = = €82,727.27
1 + 0.10
↘Lida should not buy (purchase) that piece of land because it won’t be profitable
-Sometimes, people want to determine the exact cost or benefit of a decision
⇒we calculate the Net present value and its formula is:
NPV = -cost + PV
Example 2:
If we calculate NPV, we will have :
→NPV = -85,000 + 82,727.27 = €-2,273
↘since NPV is negative, Lida should not purchase the land
Example 3:
- Professional Artworks plc is a firm that speculates in modern paintings. The manager
is thinking of buying an original Picasso for £400,000 with the intention of selling it at
the end of one year. The bank interest rate is 10 percent.
- The manager expects that the painting will be worth £480,000 in one year. The
relevant expected cash flows are depicted below:
-We calculate the PV at discount rate 10%:
480,000
→PV = = €436,364
1 + 0.10
↘the 10% interest is for riskless cash flows; we need a higher discount rate to reflect
the riskiness of the investment
-Let’s try with a 25% discount rate:
480,000
→PV = = €384,000 ⇒ do not buy the painting
1 + 0.25

VALUATION: THE MULTI-PERIOD CASE

-We now calculate the PV and FV for more than one period
FUTURE VALUE AND COMPOUNDING
-Compounding is the process of leaving the money in financial market and lending it for
another year
-The formula of future value for an investment over many periods is:
𝑇
FV = C0 x (1 + 𝑟)
where C0 is cash to be invested at date 0, r is interest rate and T is the number of periods
Example 4:
- Suppose you deposit €1 for one year at a rate of 9%. How much will it amount to in
one year?
→ FV = €1 x (1 + r) = €1 x 1.09 = €1.09
- At the end of the year you have two choices; either take the €1.09 or leave it in and
let it sit for a second year. What happens if you leave it in the account for another
year?
2 2
→ FV = €1 x (1+r) x (1+r) = €1 x (1 + 𝑟) = 1 + 2r + 𝑟
2
€1 x (1.09) x (1.09) = €1 x (1.09) = €1 + €0.18 + €0.0081 = €1.1881
Example 5:
Suh-Pyng Ku has put €500 in a savings account at Barclays. The account earns 7 percent,
compounded annually. How much will Ms. Ku have at the end of three years?
3
→€500 x 1.07 x 1.07 x 1.07 = €500 x (1. 07) = €612.52
Example 6:
Carl Voigt, who recently won €10,000 in the lottery, wants to buy a car in five years. Carl
estimates that the car will cost €16,105 at that time. What interest rate must he earn to be
able to afford the car?
𝑇 𝐹𝑉
→r = 𝐶0
-1
 PRESENT VALUE AND DISCOUNTING
-Discounting is the process of calculating the present value of future cash flows
-The formula of present value for an investment over many periods is:
𝐶𝑇
PV = where 𝐶𝑇 is cash flow at date T and r discount rate
𝑇
(1+𝑟)
Example 7:
Allan will receive €10,000 three years from now. Allan can earn 8 percent on his
investments, so the appropriate discount rate is 8 percent. What is the present value of his
future cash flow?
€10,000
→PV = = €7,938.32
3
(1+0.08)

COMPOUNDING PERIODS
-Sometimes compounding may occur more frequently than just once a year
-Compounding an investment m in times a year provides end-of-year wealth of:
End of year 𝑟 𝑚
welth ->
C0 x (1 + 𝑚
) C0 is the initial investment, r is the stated annual rate interest
-m is the number of compounding: quarterly m=4, monthly m=2, ect.
-The stated annual interest rate is the annual interest rate without consideration of
compounding End of year wealth with EAR = C0 * (1 + EAR)^t
EFFECTIVE ANNUAL RATE
Example 8:
What is the end-of-year wealth if Jane receives a stated annual interest rate of 24 percent
compounded monthly on a €1 investment?
0.24 12
→ €1 x (1 +
12
) = €1.2682
-To calculate the effective annual return, we have to use this formula:
𝑟 𝑚
Effective annual return = C0 x (1 + ) -1
𝑚
→€1.2682 - 1 = 26.82%
↘this annual rate of return is called effective annual rate (EAR) or effective annual
yield (EAY)
-Due to compounding, the effective annual interest rate is greater than the stated annual
interest rate of 24%
COMPOUNDING OVER MANY YEARS
-Future value with compounding over many years formula is:
𝑟 𝑚𝑇
FV = C0 x (1 +
𝑚
)
where C0 is cash to be invested at date 0, r is the interest, T is the number of periods
Example 9:
Harry is investing €5,000 at a stated annual interest rate of 12 percent per year,
compounded quarterly, for five years. What is his wealth at the end of five years?
0.12 5𝑥4
→ €5,000 x (1 +
4
) = €5,000 x (1. 03)20 = €9,030.50
ANNUAL PERCENTAGE RATE
-Many loans have front or back end fees relating to management costs, administration etc
-In the EU, all loans must state the effective interest rate that includes all costs, not just the
interest payments
→this harmonized interest rate is known as annual percentage rate (APR), and express
the total cost of borrowing or investing as a percentage interest rate
-The reason for an APR is that a credit agreement may not just include interest payments,
but also management fees, arrangement fees and other sundry costs that will affect the total
charge for credit (TCC)
↘under EU directive all providers of credit must show APR in any document
-We can calculate the APR using this formula:

SIMPLIFICATIONS
-Many basic financie problems are potentially time-consuming→ we search for
simplifications
↘we provide simplifying formulae for four classes of cash flow streams:
1) PERPETUITY
-A perpetuity is a constant stream of cash flows that never ends
𝐶
PV =
𝑟
where C is how much wants an investor spend per year
Example 10:
Consider a perpetuity paying €100 a year. If the relevant interest rate is 8%, what is thr value
of the consol?
€100
→PV = = €1,250
0.08
Now suppose that the interest falls to 6%. What is the value now?
€100
→PV = = €1,666.67
0.06
2) GROWING PERPETUITY
-The formula for the present value of a growing perpetuity is:
𝐶
PV =
𝑟−𝑔
where C is the cash flow to be received one period hence, g is the rate of growth per period
(expressed as a percentage) and r is the appropriate discount rate
Example 11:
Imagine an apartment building where cash flows to the landlord after expenses will be
€100,000 next year. These cash flows are expected to rise at 5 percent per year. The
relevant interest rate is 11 percent. What is the present value of the cash flows?
€100,000
→PV = = €1,666,667
0.11−0.5
-There are three important points concerning the growing perpetuity formula:
➢ the numerator: one period hence, not date 0
considera dall’anno dopo, da
quello che stiamo considerando
 ➢ the discount rate and growth rate: the discount rate r must be greater than the growth
rate g
➢ the timing assumption: cash flows are received and disbursed at regular and discrete
points in time
3) ANNUITY
-An annuity is a level stream of regular payments that lasts for a fixed number of periods
↘annuities are among the most common kinds of financial instruments (ex. pension)
-The formula for present value of an annuity is:
1 1
𝑟
− 𝑇
𝑟 𝑥 (1+𝑟)
PV = C x [ ]
𝑟
Example 12:
Mark has just won a competition paying £50,000 a year for 20 years. He is to receive his first
payment a year from now. The competition organizers advertise this as the Million Pound
Competition because £1,000,000 = £50,000 x 20. If the interest rate is 8 percent, what is the
true value of the prize?
1
1− 20
(1+0.08)
→PV = £50,000 x [ 0.08
] = £400,905
-The formula for future value of an annuity is:
𝑇 𝑇
(1+𝑟) 1 (1+𝑟) −1
FV = C x [ − ] =Cx[ ]
𝑟 𝑟 𝑟
Example 13:
Suppose you put £3,000 per year into a Cash Investment Savings Account. The account
pays 6 percent interest per year, tax-free. How much will you have when you retire in 30
years?
30
(1+0.06) −1
→FV = £3,000 x [ ] = £3,000 x 79.0582
0.06
= £237,174.56
4) GROWING ANNUITY
CHAP 5: HOW TO VALUE BONDS AND STOCKS
DEFINITION AND EXAMPLE OF A BOND
-A bond is a certificate showing that a borrower owes a specific sum
↘to repay the money, the borrower has agreed to make interest and principal payments
on designated dates
-Bond: public or private, principal not normally paid until end of bond life
VS
Bank loans: private, repayments normally in the form of annuity
HOW TO VALUE BONDS
PURE DISCOUNT
⇒no coupon, only principal
-The pure discount is the simplest kind of bond
↘it promises a single payment at a fixed future date
-The date when the issuer of the bond makes the last payment is called the maturity date
↘the bond is said to mature or expire on the date of its final payment
⤷the payment at maturity is termed the bond’s face value or par value
-Value of a pure discount bond formula:
𝐹
PV = 𝑇
(1+𝑅)
Example 1:
What is the price of a pure discount bond that pays €1 million in 20 years, interest rates are
10%?
€1,000,000
→PV = 20 = €148,644
(1+0.1)
FIXED RATE BONDS
⇒coupon and principal
-Coupon→ typically bonds offer cash payments not only at the maturity date but also at
regular times in between
-Say maturity date= €1,000 → the formula of value of level coupon bond is:
𝐶 𝐶 𝐶 €1,000
PV = + 2 +....+ 𝑇 + 𝑇
1+𝑅 (1+𝑅) (1+𝑅) (1+𝑅)
Example 2:
What is the price of a 1.375% coupon bond that pays €1,000 in five years at an interest rate
of 1.48% ?
€137.5 137.5 137.5 137.5 €1,000
→PV = + 2 + 3 + 4 + 5
1+0.0148 (1+0.0148) (1+0.0148) (1+0.0148) (1+0.0148)
= €9950.1
CONSOL BONDS
⇒coupon, no principal
-Bonds that never stop paying a coupon, have no final maturity date and therefore never
mature are known as consol bonds→ consol is a perpetuity
-Value of consol bond formula is:
𝐶
PV =
𝑅
BOND CONCEPTS
INTEREST RATE AND BOND PRICES
-When interest rate goes up → bond price goes down
-When interest rate goes down → bond price goes up
-The general principle is that a level coupon bond sells in the following ways:
1. At the face value if the coupon rate is equal to the market-wide interest rate
2. At a discount if the coupon rate is below the market-wide interest rate
3. At a premium if the coupon rate is above the market-wide interest rate
YIELD TO MATURITY
Example 2:
The price of a 2-year 10% coupon bond with a face value of £100 is £103.567. What is its
yield to maturity (YTM)?
£10 £100 + £10
→£103.567 = + 2
1+𝑔 (1+𝑔)
⇒ g = YTM = 8%

THE PRESENT VALUE OF EQUITY

DIVIDENDS VERSUS CAPITAL GAINS
-Equities provide two types of cash flows:
● they may pay dividends on a regular basis
● the shareholder receives the sale price when they are sold
Example 3
The value of an equity is £100. The company earns £100 extra in cash. What is the
investor’s portfolio at t=1 ?
⇒100% dividends: - price = £100
- dividends = £100
- total = £200
⇒0% dividends: - price = £200
- dividends = £0
- total = £200
⇒50% dividends: - price = £150
- dividends = £50
- total = £200
VALUATION OF DIFFERENT TYPES OF EQUITY:
1) Zero growth
-The value of an equity with a constant dividend is given by:
𝐷𝑖𝑣1 𝐷𝑖𝑣2 𝐷𝑖𝑣1
𝑃0 = + 2 +... =
1+𝑅 (1+𝑅) 𝑅
2) Constant growth
𝐷𝑖𝑣1
𝑃0 =
𝑅−𝑔
3) Differential growth

ESTIMATES OF PARAMETERS IN THE DIVIDEND GROWTH MODEL

-Net investment will be positive only if some earnings are not paid out as dividends
↘so only if some earnings are retained
-The increase in earnings is a function of both the retained earnings and the retuen on the
retained earnings

-The ratio of retained earnings to earnings is called the retention ratio. Thus we can write:
1 + g = 1 + Retention ratio x return on retained earnings)
-At the end, the formula for a firm’s growth rate is::
g = retention ratio x return on retained earnings
Example 4
Pagemaster plc just reported earnings of £2 million. It plans to retain 40 percent of its
earnings. The historical return on equity (ROE) has been 16 percent, a figure that is
expected to continue into the future.
How much will earnings grow over the coming year?
→ g = 0.4 x 0.16 = 0.064
-Dividend yield: is the expected cash dividend divided by the current price
-Capital gains yield: the rate at which the share price grows

GROWTH OPPORTUNITIES
-Earnings per share (EPS) can be split into
➢ Dividends (DPS)
➢ Retained earnings
⇒100% dividends: - EPS = DPS
- Share price = EPR/R = DPS/R
- Value of the firm without any additional reinvestment
⇒100% dividends: - All EPS is reinvested in firm
- Dividends = £0
- Share price = EPS/R + NPVGO
FIRM VALUATION
-The price-earnings ratio

Profit of investors in stock can be:

-> dividends yield: the receive each period an
amount of money from the company (dividends)
-> capital gains: they receive money selling stocks

differenza tra a quanto lo compri e poi lo rivendi

CHAP 6: NET PRESENT VALUE AND OTHER INVESTMENT RULES

NET PRESENT VALUE METHOD

𝐶1 𝐶2 𝐶𝑡
NPV =-C0 + + 2 +....+ 𝑡
(1+𝑟) (1+𝑟) (1+𝑟)
where C0,1,2 are cash flows, r is discount rate and t is time
-The basic investment rule can be generalized thus:
➔ accept a project if NPV is greater than zero
➔ reject project if NPV is less than zero
-The key to NPV is it three attributes:
1. NPV uses cash flows: cash flows are better than earnings
2. NPV uses all cash flows of the project: other approaches ignore cash flows beyond a
certain date
3. NPV discounts cash flows: fully incorporates the time value of money
Example 1:
Alpha Corporation is considering investing in a riskless project costing £100. The project
receives £107 in one year and has no other cash flows. The discount rate is 6 percent.
What is the NPV of the project?
£107
→ NPV = -£100 + = £0.94
(1+0.06)

PAYBACK PERIOD METHOD

-The payback period rule for making investment decision is simple
↘a particular cut-off date, say two years, is selected
⤷all investment projects that have payback periods of two years or less are
accepted, and all of those that pay off in more than two years are rejected
⇒how long does it take till I earn my money back
➔ accept: payback period is less than your firm’s benchmark
➔ reject: payback period is greater than your firm’s benchmark
-Weaknesses:
● timing of cash flows→ NPV method discounts the cash flows properly
● payments after the payback period→ NPV uses all the cash flows of the period
● arbitrary standard for the payback period→ no comparable guide for choosing the
payback cut-off date
-Strengths
● very small scale investments
● firms with severe capital rationing
● exceptionally simple to understand
Example 2:
What is the payback period if you invest £100 now and receive £40 every year starting one
year from now and ending five years from now?

→ payback period = 2.5 years

DISCOUNTED PAYBACK PERIOD METHOD
-We first discount the cash flows, then we ask how long does it take for the discounted cash
flow to equal the initial investment
⇒how long does it take till I create value
⤷how long for an investment to create value for an investor
➔ accept: discounted payback period is less than your firm's benchmark
➔ reject: discounted payback period is greater than your firm’s benchmark
-Weaknesses: ignores cash flows beyond benchmark, arbitrary benchmark
-Strengths: simple, uses time value of money
Example 3:
What is the discounted payback period if you invest £100 now and receive £40 every year
starting one year from now and ending five years from now? The discount rate is 8%

→discounted payback period = 2.90 years

AVERAGE ACCOUNTING RETURN METHOD

-The average accounting return method is the average project earnings after fixed taxes and
depreciation, divided by the average book value of the investment during its life
↘it is used frequently in the real world
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒
AAR =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
-The decision rule:
➔ accept: average accounting return is greater than target return
➔ reject: average accounting return is less than target return
-Weaknesses:
-doesn’t use cash flows -doesn’t use time value of money -arbitrary target rate
-Strengths: simple return based measure
Example 4:
You are deciding whether to buy a store in a new shopping centre. The purchase price is
£500,000. The store has an estimated life of five years and will need to be completely
scrapped or rebuilt at the end of that time. The asset will depreciate using straight line
depreciation (£100,000). The Target Return on new investments is 15%.

•Step 1: determine average net income:

[£100,000 + 150,000 + 50,000 + 0 + (-50,000)] / 5 = £50,000
•Step 2: determine average investments
( £500,000 + 400,000 + 300,000 + 200,000 + 100,000 + 0) / 6 = £250,000
•Step 3: determine AAR
£50,000
→ AAR = = 20%
£250,000
⇒since AAR is greater than target accounting return (15%) we can accept

INTERNAL RATE OF RETURN METHOD

-The IRR is about as close as you can get to the NPV without actually being the NPV
↘it provides a single number summarizing the merits of a project
-Decision rule:
➔ accept: internal rate of return is greater than target return
➔ reject: internal rate of return is less than target return
-Weaknesses: no scale, arbitrary target rate
-Strengths: simple return based measure, doesn’t require an estimated discount rate like
NPV

(solve for IRR)

C0,1,2,t are cash outflows, t is the time
Example 5:

€100 €100 €100

0 = - €200 + + 2 + 3
1+𝐼𝑅𝑅 (1+𝐼𝑅𝑅) (1+𝐼𝑅𝑅)
Using trial and Error, the IRR is between 23% and
24% → the exact value is 23.37%

PROBLEMS WITH IRR APPROACH

INDEPENDENT VS MUTUALLY EXCLUSIVE PROJECTS
→Independent project: acceptance or rejection is independent of the acceptance or
rejection of other projects
→Mutually exclusive project: you can accept A or you can accept B or you can reject
both of them, but you can’t accept both of them
-PROBLEMS AFFECTING INDEPENDENT AND MUTUALLY EXCLUSIVE PROBLEMS:

-General investment rules: NPV and IRR

⇨ 1st cash flow negative: remaining cash flows positive
➢ number of IRRs: 1
➢ accept if IRR > R ; reject if IRR < R
➢ accept if NPV > 0; reject if NPV <0
 ⇨ 1st cash flow positive: remaining cash flows negative
➢ number of IRRs: 1
➢ accept if IRR > R; reject if IRR <R
➢ Accept if NPV > 0; reject if NPV < 0
⇨ Mixture of positive and negative cash flows
➢ Number of IRRs: usually more than 1
➢ no valid IRR
➢ accept if NPV > 0; reject if NPV < 0
-PROBLEMS SPECIFIC TO MUTUALLY EXCLUSIVE PROJECTS
➢Scale problem
-Consider you have two mutually exclusive projects: which one do you choose?
● Compare the NPVs of the two choices
● Calculate the incremental NPV from making the large-budget picture instead of the
small-budget picture
● Compare the incremental IRR to the discount rate
⇒IRR ignores scale !
Example 6:
Stanley Jaffe and Sherry Lansing have just purchased the rights to Corporate Finance: The
Motion Picture. They will produce this major motion picture on either a small budget or a big
budget. Here are the estimated cash flows:

Because of a high risk, a 25 per cent discount rate is considered appropriate. Sherry wants
to adopt the large budget because the NPV is higher. Stanley wants to adopt the small
budget because the IRR is higher. Who is right?
→when scale is an issue, calculate the incremental cash flows and IRR from them !!!

$25,000,000
→ 0 = -$15,000,000 +
1+𝐼𝑅𝑅
IRR = 66.67%
➢Timing problem
-Consider two mutually exclusive projects. Which one do you choose?
● Compare the NPVs of the two projects
● Compare incremental IRR to discount rate
⇒IRR ignores timing !!

PROFITABILITY INDEX MODEL

-It is the ratio of the present value of future expected cash flows after the initial investment
divided by the amount of the initial investment
𝑃𝑉 𝑜𝑓 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤𝑠 𝑠𝑢𝑏𝑠𝑒𝑞𝑢𝑒𝑛𝑡 𝑡𝑜 𝑖𝑛𝑖𝑡𝑖𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
Profitability index (PI) =
𝑖𝑛𝑖𝑡𝑖𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
-The decision rule:
➔ accept: profitability index is greater than 1
➔ reject: profitability index is less than 1
Example 7:
Consider a project that requires an investment of €20 in year 0 and results in cash inflows of
€70 in year 1 and €10 in year 2. Discount rate is at 12%
€70 €10 PV = C1/(1+r) + C2/(1+r)^2
→ PV of cash flow after the initial investment = + 2
1+0.12 (1+0.12)
= €70.5
€70.5
→ PI = = 3.53 = PV/initial investment
€20
Applications of the profitability index:
➢Independent projects:
➔ accept: PI > 1
➔ reject: PI <1
➢Mutually exclusive projects:
↘use incremental cash flows
➔ accept: PI > 1
➔ reject: PI < 1
➢Capital rationing:
⤷the firm doesn’t have enough money to fund all positive NPV projects

PRACTICE OF CAPITAL BUDGETING

-Which capital budgeting methods should companies be using?
CHAP 12: RISK, COST OF CAPITAL AND CAPITAL BUDGETING

THE COST OF EQUITY CAPITAL

-Whenever a firm has extra cash, it can take one of two actions:
1. pay out the cash as dividends
2. invest the cash in a project
↘from a managerial perspective, the project should be undertaken only if its
expected return is higher than that of a financial asset with comparable risk

⇒the discount rate of a project should be the expected return on a financial asset of
comparable risk !!!
𝑅𝐸 = 𝑅𝐹 + 𝑏 * (𝑅𝑀 − 𝑅𝐹)
where 𝑅𝐹 is the risk free rate, (𝑅𝑀 − 𝑅𝐹) is the market risk premium and b company beta
Example 1:
According to Reuters, the beta of the French bank “SG SA” is 2.05. Assume, for now, that
the firm is 100 percent equity financed; that is, it has no debt. “SG” is considering a number
of expansion projects that will double its size. Because these new projects are similar to the
firm’s existing ones, the average beta on the new projects is assumed to be equal to “SG”
existing beta. Assume that the risk-free rate is 1.5 per cent.
What is the appropriate discount rate for these new projects, assuming a market risk
premium of 5.2 per cent?
→ 𝑅𝐸 = 1.5% + (5.2% x 2.05) = 1.5% + 10.66%
= 12.16%
-We made two key assumption:
(1) the beta risk of the new projects is the same as the risk of the firm
(2) the firm is all equity financed
⇒given these assumptions, it follows that the cash flows of the new projects should
be discounted at the 12.16 per cent rate

ESTIMATION OF BETA
-Beta can be estimated as the slope coefficient in a regression of 𝑅𝑖 on 𝑅𝑀
-Theoretical formula:
𝐶𝑜𝑣(𝑅𝑖, 𝑅𝑀) 𝑆𝑖,𝑀
Beta of security i = = 2
𝑉𝑎𝑟(𝑅𝑀) 𝑆𝑀

-Problems:
1. Betas may vary over time
2. Sample size may be inadequate
3. Betas are influenced by changing leverage and business risk
-Solutions:
1. and 2. Use better statistics
3. Adjust for changes in business and financial risk
1, 2 and 3. Use average betas of comparable firms
DETERMINANTS OF BETA
-Beta is determined by characteristics of the firm
↘we consider three factors:
⇒cyclicity of revenues: performance is tied to economic cycles
-the revenues of some firms are quite cyclical
↘ex. high-tech firms, automotive firms fluctuate with the business cycle
→highly cyclical securities have high betas
⇒operating leverage: fixed costs high in relation to total costs
-differences between fixed and variable costs
↘fixed costs don’t change as quantity change, variable increases when quantity raise
⇒financial leverage: high levels of debt in capital structure
-financial leverage is the extent to which a firm relies on debt
-a levered firm is a firm with some debt is in its capital structure
↘levered firms must take interest payments regardless of the firm’s sales
⤷financial leverage refers to the firm’s fixed costs of finance
-Remember the BS equation: Assets = Equity + Liabilities
𝐸 𝐷
𝑏𝐴𝑠𝑠𝑒𝑡 = 𝐷+𝐸
x𝑏
𝐸𝑞𝑢𝑖𝑡𝑦
+ 𝐷+𝐷 x 𝑏
𝐷𝑒𝑏𝑡
where D is debt, E is equity, 𝑏 is beta of equity of levered firm
𝑒𝑞𝑢𝑖𝑡𝑦
-Since the portfolio contains both debt of the firm and equity
→beta of the portfolio is the asset beta
-The beta of debt is very low in practice → assume is zero
𝐸 𝐷
⇒𝑏
𝐴𝑠𝑠𝑒𝑡
= 𝐷+𝐸 x 𝑏
𝐸𝑞𝑢𝑖𝑡𝑦
⇒ 𝑏𝐸𝑞𝑢𝑖𝑡𝑦 = 𝑏𝐴𝑠𝑠𝑒𝑡 𝑥 (1 + 𝐸 )

EXTENSIONS OF THE BASIC MODELS

FIRM VS PROJECT
-If project is in the same industry → use firm discount rate
-If project is in a different industry → use project discount rate
COST OF CAPITAL WITH DEBT
-The project is funded with both debt and equity
↘firm uses both debt and equity to finance its investments
-To calculate the cost of capital with debt ⇒ compute weighted average cost of capital
➢Case 1: no taxes
𝐸 𝐷
𝑅𝑊𝐴𝐶𝐶 = 𝐷+𝐸
X 𝑅𝐸 + 𝐷+𝐸
X 𝑅𝐷
➢Case 2: with taxes
𝐸 𝐷
𝑅𝑊𝐴𝐶𝐶 = 𝐷+𝐸
X 𝑅𝐸 + 𝐷+𝐸
X 𝑅𝐷 x (1 − 𝑇𝐶)

where 𝑅𝐷 is the cost of debt, 𝑅𝐸 is the cost of equity (expected return on equity), 𝑅 is
𝑊𝐴𝐶𝐶
the firm’s weighted average cost of capital, D is the market value of the firm’s bond, E is the
market value of firm’s shares or equity and 𝑇 is corporation tax rate
𝐶

ex. If you have in the exercise that D/E = 0.4

=> E = 1, D/E = 0.4. -> D = 0.4
CHAP 18: CAPITAL STRUCTURE: BASIC CONCEPTS
THE CAPITAL STRUCTURE
-We define the value of the firm (V) with this formula: V = D + E
where D is the debt value and E is the equity

In this case, E are

shares and D are
bonds, so:
→V=B+S

Maximizing Firm value VS Maximizing Shareholders:

-Changes in capital structure benefit the shareholders if and only if the firm increases
-Managers should choose the capital structure that they believe will have the highest firm
value → this capital structure will be most beneficial to the firm’s shareholders

FINANCIAL LEVERAGE
-We wish to determine the optimal capital structure
↘the effect of financial leverage depends on the company's earnings before interest
(EBI) no lev -> ROA = ROE (tot equity firm)
Example with lev -> ROE > ROA

→if EBI = €1,200 ⇒ ROE is higher under the proposed structure

→if EBI = €400 ⇒ROE is higher under the current structure
CHOICE BETWEEN DEBT AND EQUITY
-Leverage also creates risk → which capital structure is better?
↘Modigliani and MIller (MM) have a convincing argument that a firm can’t change the
total value of its outstanding securities by changing proportions of its capital structure
⤷no capital structure is any better or worse than any other capital structure for the
firm’s shareholders
-MM proposition I and II assumptions:
→ no taxes, no transaction costs, individuals and corporations borrow at same rate
➢MM Proposition I: (no taxes)
-The value of the levered firm is the same as the value of the unlevered firm
-If levered firms are priced too high, rational investors will borrow on their personal
account to buy shares in unlevered firms
↘this substitution is called homemade leverage
⤷as long as the individuals borrow on the same terms as the firms, they can
duplicate the effects of corporate leverage on their own (through homemade lev)
⇒a key assumption: individuals can borrow as cheaply as corporation
➢MM Proposition II: (no taxes)
-Though the expected return rises with leverage, the risk rises as well
↘levered shareholders have better returns in good times than unlevered shareholders
⤷but have worse returns in bad times
-Levered equity has greater risk→should have greater expected return as compensation
↘MM pr II says that expected return on equity is positively related to leverage
because the risk to equityholders increases with leverage
-The required return on equity formula with this proposition is:
𝐵
𝑅𝑆 = 𝑅𝑂 + 𝑆 X (𝑅𝑂 − 𝑅𝐵)

CORPORATE TAXES
-Firm value is unrelated to debt in a world without taxes
↘but with the presence of corporate taxes the firm’s value is positively related to its debt
-The value of the levered firm is the sum of the value of debt and equity
↘a financial manager should choose the firm with higher value
⤷value is maximized for the capital structure paying the least taxes

-The proportion of the pie allocated

to taxes is less for the levered firm
than it is for the unlevered firm
⇒managers should selec high
leverage

PRESENT VALUE OF THE TAX

SHIELD

-Reduction in corporate taxes

where B is debt
-Assuming cash flows as perpetual, present value of tax shield
-This expression is called tax shield from debt and it is an annual amount
↘it means that whatever the taxes that a firm would pay each year without debt, the firm
will pay 𝑡𝑐𝑅𝐷𝐷 less with the debt of D

VALUE OF LEVERED FIRM

-The value of an unlevered firm (firm with no debt) is the PV of EBIT x (1-tc)

where Vu is the PV of an unlevered firm, EBIT x (1-tc) represents firm cash flows after
corporate tax, tc is the corporate tax rate, 𝑅𝑂 is the cost of capital to an all-equity firm
⤷𝑅𝑂 now discounts after-tax cash flows
-Leverage increases the value of firm by the tax shield, which is 𝑡𝑐𝐷 for perpetual debt
↘we merely add this tax shield to the value of the unlevered firm to get the value of
levered firm

WACC AND CORPORATE TAXES

S is equity and B is debt

-MM propositions with taxes
-Assumptions:
- corporations are taxed at the rate tc, on earnings after interest
- no transaction costs
- individuals and corporations borrow at the same rate
➢MM Proposition I
-Because corporations can deduct interest payments but not dividend payments, corporate
leverage lowers tax payments
-For a firm with perpetual debt:
𝑉𝐿 = 𝑉𝑈 + 𝑡𝐶𝐵
➢MM Proposition II
-The cost of equity rises with leverage because the risk to equity rises with leverage

PERSONAL TAXES: BASICS

-Assume an all-equity firm receives €1 of pretax earnings. If the corporate tax rate is tc, the
firm pays taxes tC, leaving itself with earnings after taxes of 1 – tc.
-Assume that this entire amount is distributed to the shareholders as dividends. If the
personal tax rate on share dividends is ts, the shareholders pay taxes of (1 – tc) × ts, leaving
them with (1 – tc) × (1 – ts) after taxes.
-Alternatively, imagine that the firm is financed with debt. Here, the entire €1 of earnings will
be paid out as interest because interest is deductible at the corporate level. If the personal
tax rate on interest is tb, the bondholders pay taxes of tb, leaving them with
1 – tb after taxes.
THE EFFECT OF PERSONAL TAXES ON CAPITAL STRUCTURE
-Ignoring costs of financial distress, what is the firm’s optimal capital structure if dividends
and interest are taxed at the same personal rate — that is, ts = tb?
-The firm should select the capital structure that gets the most cash into the hands of its
investors. This is tantamount to selecting a capital structure that minimizes the total amount
of taxes at both the corporate and personal levels.
-Beginning with €1 of pretax corporate earnings, shareholders receive (1 – tc) = (1 – ts), and
bondholders receive 1 – tb. If ts = tb, bondholders receive more than shareholders. Thus, the
firm should issue debt, not equity

-Under what condition will the firm be indifferent between issuing equity or debt?
⇒

Tax rates around the world: