Corporate finance

Main goal of financial managers

maximizing value

the capital structure decision

choice between debt or equity financing

‘raising capital’

raising long-term financing

role of CFO

supervises overall financial strategy

roles of treasurer

cash management, raising capital, banking relationships

controller

preparing financial statements, taxes, accounting

opportunity cost of capital

the minimum acceptable rate of return on capital set by the opportunities for investment available to shareholders in the financial markets

Agency problem

Managers are agents for stockholders and are tempted to act in their own interests rather than maximizing value, so must be incentivised correctly

agency cost

Value lost from agency problems or from the cost of mitigating agency problems.

How are investment decisions delegated?

authority to approve small and medium size investments are delegated by the board of directors, but large investments are approved directly by the board

blockholders

shareholders who own a substantial share of outstanding shares

activist shareholders

either major shareholders, blockholders or a large group who do a ‘wall street walk’, exercising their stake

Major intermediaries

mutual funds, pension funds, financial institutions like banks or insurance companies

What are the key advantages of mutual funds and pension funds?

funds are professionally managed, diversification, returns are not taxed until withdrawn

What are the functions of financial markets?

channels savings to corporate investment, provides liquidity and diversification opportunities for investors

Financial institutions functions

banks provide liquidity to depositors, insurance companies allow policyholders to pool risk

Primary market

where securities are sold initially by banks and companies

Secondary market

where securities are traded

capital market

for long-term financing, primary and secondary markets

money market

for short-term financing, important for liquidity management, work through instruments like commercial paper, Treasury bills (T-bills), and certificates of deposit (CDs). These instruments facilitate quick fund transfers and help to stabilize interest rates.

interest formula

(interest rate^t x initial investment) + initial investment

Present value formula

future value after t periods/(1+r)^t

Future value formula

PV x (1+r)^t

the discount factor

1/(1+r)^t

Strips

A US treasury security that pays a single cash flow at a specified date, no coupons

interest/growth rate formula

(future value/present value)^1/t - 1

difference between annuity and perpetuity

annuity is a sequence of equally spaced, level cash flows, it’s a perpetuity if it lasts forever

Perpetuity formulas for cash payment and PV

Cash payment = r x PV

PV = cash payment/r

r = cash payment/PV

how to find the value of a delayed perpetuity

PV/(1+r)^{t delayed}

Annuity formulas

PV = payment x annuity factor [1/r - 1/(r x (1 + r)^t]

Annuity factor

[1/r - 1/(r x (1 + r)^t]

PV of t-year annuity formula

payment/spending per period x (1/r) - (1/r x (1+r)^t)

Future value of annuity

(PV x (1+r)^{final t}) + ((PV x (1+r)^t2) + (PV x (1+r)^t1) … + (PV)

Future value of annuity due

FV of ordinary annuity x (1+r)

Future value of $1 annuity a year

((1+r)^t - 1)/r

APR

annual percentage rate, using simple interest

Monthly interest rate

APR/12 (months)

annual compounded interest rate formula

(1+monthly rate)¹²

future value of inflated goods

Present price x (1 + r)^t

real future value of investment

(investment x (1 + nominal interest rate))/(1 + inflation interest rate)

real interest rate formula

1 + real interest rate = 1+nominal interest rate/ 1+inflation rate

Real interest rate ≈ nominal interest rate - inflation rate

nominal interest rate formula

real interest rate x inflation ratef

finding the annual payment with annuity factor

Annual payment = PV/t year annuity factor

If a company needs money short-term, where would they get it?

A bank

If a company needs money long-term?

bonds

What are notes (bonds)

2-10 year treasury bonds

PV of a bond

PV = coupon/(1+r)^t1 + coupon/(1+r)^t2 + coupon/(1+r)^t3 + (face value + coupon)/(1+r)^t4

or

PV = coupon x [annuity factor] + face value x [discount factor]

How do you calculate the rate of return that the bond offers?

If the bond is priced at face value, the ROR is the coupon rate.

isolate r in the bond PV formula

the term structure of interest rates

the yield curve: higher yield (y) to maturity (x) for longer-term bonds, first dipping then curving up in a hill like trajectory. 

the different interest rates you would offer of different terms, due to the different risk possibilities.

secured debt

When companies borrow, they also may set aside some assets as security for the loan. These assets are termed collateral, and the debt is said to be secured.

protective covenants

Conditions imposed on borrowers to protect lenders from unreasonable risks, such as issuing more debt or spending funds irresponsibly.

Floating-rate bonds

have coupon payments that are not fixed but fluctuate with short-term interest rates.

Convertible bonds

can be exchanged for a specified number of shares of the issuing corporation’s common stock.

Yield to maturity

measures the rate of return to an investor who purchases the bond and holds it until maturity, accounting for coupon income as well as the difference between purchase price and face value. The coupon on a bond is fixed, but the yield to maturity changes as the bond’s price changes.

What happens to market capitalisation when shares decrease?

It increases; a cosmetic change, due to it being perceived as more rare and valuable.

Liquidity

ease of buying or selling assets

direct finance

issuing securities directly to investors

indirect finance

financial intermediaries channel funds between savers and borrowers (banks, funds, etc.)

Derivatives

contracts based on underlying assets (options, futures, swaps)

Commodities

physical/derivative trading of raw materials (oil, gold, wheat)

Private markets

financing outside exchanges, like venture capital, private equity

Book value

historical cost - depreciation

book equity

invested capital + retained earnings

market equity

share price x stocks outstanding

P/E ratio

Market cap/net income

What are the important things about financial institutions?

lower transaction costs, risk sharing, diversification, reduce info problems

What is the VIX and what do its movements mean?

The Volatility Index. The higher the VIX the higher the risk.

Term

the time remaining until the repayment date

Current yield

Annual coupon payments/bond price

ROR

Total income/investment

or

(coupon income + price change)/investment

Closely held companies

shares owned by founders, managers, or a small group; not traded

Public companies

shares listed & traded on exchanges

bond trades at premium when

coupon rate > yield to maturity

bond trades at par when

coupon = YTM

bond trades at discount when

coupon rate < YTM

What are investment grade bonds?

non-junk, safe

Defines a balance sheet

provides a snapshot at a specific point in time

Defines an income statement

Goodwill calculation

fair market value = assets - liabilities

goodwill = fair market value - selling price

SG&A

Selling, General and Administrative Expenses (total expenses)

Market-to-book ratio greater than 1 generally indicates

Investors expect growth and profitability

What does NPV tell us?

NPV shows how much value a project adds to the firm.

What is the weakness of the IRR rule?

It may give multiple values when cash flows change sign more than once.

What does it mean if NPV > 0

That IRR must be above 10%

What is the weakness of the payback period method?

It ignores cash flows after the cutoff period.

Profitability Index is used when?

When projects are mutually exclusive and when capital is hard rationed

Which decision rule can rank projects incorrectly when comparing mutually exclusive projects of different scale?

PI, profitability index

What are the strengths and weaknesses of NPV?

considers time value of money, clear value measure, but needs a discount rate

What are the strengths and weaknesses of the IRR method?

intuitive % return measurement, but a project can have multiple when a company’s cash-flow is irregular/non-normal

Strengths and weaknesses of PI?

Good for comparing similar projects, for hard rationing, but can misrank scale projects

Strengths of weaknesses of the payback period method?

simple, focuses on liquidity, but doesn’t consider cash flows after the end of the period (ignoring time value as well)