Docsity Corporate Finance Inglese
Docsity Corporate Finance Inglese
Finanza Aziendale
Università degli Studi di Firenze (UNIFI)
26 pag.
Corporate finance
Chapter 1:
The financial view of the firm:
- assets —> assets in place (existing investments, generate cashflows today, long lived
and short lived assets) and growth assets (excpected value that will be created by future
investments);
- liabilities —> debt (fixed claim on cash flows, little or no role in management) and equity
(residual claim on cash flows, significant role in management).
The first principle of finance is to maximize the value of the business (firm); we can reach
this object in different ways (3 principles):
- investment decision —> invest in assets that earn a return greater than the minimum
acceptable hurdle rate (E(R) > cost of capital);
- financing decision —> find the right kind of debt for your firm and the right mix of debt
and equity (mix able to minimize the cost of capital and so to maximize the value of the
business) to fund your operations;
- dividend decision —> if you cannot find investments that make your minimum
acceptable rate, return the cash to owners of your business.
Investment decision: the hurdle rate (soglia di rendimento) should reflect the riskiness of
the investment and the mix of debt and equity (struttura del finanziamento), used to fund it;
the return should reflect the magnitude and the timing of the cashflows as well as all side
effects.
Financing decision: the optimal mix of debt and equity maximizes firm value; the right kind
of debt matches the tenor of your assets.
Dividend decision: how much you can return depends upon current and potential
investment opportunities; how you choose to return cash to owners will depend whether
they prefer dividends or buybacks.
Finance is “common sense” and everything is based on the maximization of the firm value;
as a result of this singular objective we can:
- choose the right investment decision rule to use, given a menu of such rules;
- determine the right mix of debt and equity for a specific business;
- examine the right amount of cash that should be returned to the owners of a business
and the right amount to hold back as a cash balance.
To maximize the firm value we can maximize the cash flows (selecting good projects —>
massimizzazione dei flussi di cassa attesi) or minimize the cost of capital (identifying the
optimal capital structure —> minimizzazione dei rischi). The maximization of the firm value
is achieved (raggiunto) with an active risk management.
The focus in corporate finance changes across the life cycle.
Every business has to make investment, financing and dividend decisions so corporate
finance is universal and the objective for all of the business is the same, maximizing value.
If you violate this principle you will pay a price: the strategies that violate the principle,
sooner or later, will blow up and create huge costs.
Another objective is the maximization of stock price (maximize stockholder wealth); when
the stock (stock = azioni) is traded and markets are viewed to be efficient, the objective is
Chapters 3&4:
Since financial resources are finite, there is a hurdle that projects have to cross before
being deemed acceptable. This hurdle will be higher for riskier projects than for safer
projects. A simple
We can link risk and return (relazione tra rendimento di un titolo e sua rischiosità
sistematica) with the Capital Asset Pricing Model
(CAPM):
Ke = cost of equity
E(Ri) = required return on common stock
Rf = risk-free rate of return
Beta = the beta measures the historical volatility of an individual stock’s return relative to a
stock market index. A beta greater than 1 indicates greater volatility (price movements)
We start from the assumption that the investors are rational and they don't like risk (they
want to maximize return and minimize the risk); they have to be well diversified.
The marginal investor in a firm is the investor who is most likely to be the buyer or seller on
the next trade and to influence the stock price; in a stock, he has to own a lot of stock and
also trade a lot. The largest investor may not be the marginal investor, especially if he is a
founder/manager of the firm.
In all risk and return models in finance, we assume that the marginal investor is rational
and well diversified; the marginal investor could be an institutional investor.
Assuming diversification costs nothing (in terms of transactions costs), and that all assets
can be traded, the limit of diversification is to hold a portfolio of every single asset in the
economy (in proportion to market value). This portfolio is called the market portfolio. The
consequence of this is that an individual investors will adjust for risk, by adjusting their
allocations to this market portfolio and a riskless asset.
The risk of any asset is the risk that it adds to the market portfolio. Statistically, this risk
can be measured by how much an asset moves with the market (called the covariance).
Beta is a standardized measure of this covariance, obtained by dividing the covariance of
any asset with the market by the variance of the market (COV(im)/VAR(m)). It is a
measure of the non-diversificable risk for any asset can be measured by the covariance of
its returns with returns on a market index, which is defined to be the asset's beta.
The CAPM has some limitations:
- the model makes unrealistic assumption;
- the parameters of the model cannot be estimated precisely —> market index cannot be
exactly estimated;
- the model does not work well —> the model use only one factor, the beta of the market.
So we introduce another model, Arbitrage Pricing Model (APM). It is built on the premise
that two investments with the same exposure to risk should be priced to earn the same
expected returns. APM considers only the market risk. The arbitrage pricing model
requires estimates of each of the factor betas and factor risk premiums in addition to the
riskless rate. In practice, these are usually estimated using historical data on stocks and a
statistical technique called factor analysis. Intuitively, a factor analysis examines the
historical data looking for common patterns that affect broad groups of stocks (rather than
just one sector or a few stocks). It provides two output measures:
- it specifies the number of common factors that affected the historical data that it worked
on;
The CAPM, has survived as the default model for risk in equity valuation and corporate
finance. The alternative models (APM, Multifactor model..) have made inroads in
performance evaluation but not in prospective analysis because they (which are richer) do
a much better job than the CAPM in explaining past return, but their effectiveness drops off
when it comes to estimating expected future returns (because the models tend to shift and
change) and they are more complicated and require more information than the CAPM.
default spread corrected by relative standard deviation of equity and bond markets —>
while default risk premiums and equity risk premiums are highly correlated, one would
expect equity spreads to be higher than debt spreads. This approach multiply the bond
default spread by the relative volatility of stock and bond prices in that market
There are three approach to pass from country equity risk premiums to corporate equity
risk premiums:
ERP: If you can observe what investors are willing to pay for stocks, you can back out an
expected return from that price and an implied equity risk premium.
Estimating Beta: the standard procedure to estimate betas is to regress stock returns (Rj)
against market returns (Rm) —> Rj = a + b * Rm, where a is the intercept and b is the
slope of the regression.
The slope of the regression corresponds to the beta of the stock and measures the
riskiness of the stock.
R^2 —> indicates how much variance of the return of a stock is explained by the variance
of the market. It provides an estimate of the proportion of the risk (variance) of a firm that
can be attributed to market risk.
The total risk is 1 and it is divided in market risk and specific risk; so (1-R^2) is the firm
specific risk (the firm-specific risk is diversifiable and will not be rewarded).
The intercept of the regression provides a simple measure of performance during the
period of the regression, relative to the capital asset pricing model.
CAPM —> Rj = Rf+ b (Rm - Rf) = Rf (1-b) + b * Rm
Regression equation —> Rj = a + b * Rm
We can see three different cases:
- if a > Rf (1-b) —> stock did better than expected during regression;
- if a = Rf (1-b) —> stock did as well as expected during regression;
- if a < Rf (1-b) —> stock did worse than expected during regression.
The difference between the intercept and Rf (1-b) is Jensen's alpha. If it is positive, your
stock did perform better than expected during the period of the regression.
Now we have seen the regression beta, that is one of the three approach to estimate beta.
Another approach, the bottom-up beta, is based on some determinant of beta:
The Beta of cash is zero (no market risk); since the market betas incorporate the cash
position of the firms, we need to adjust as
follows:
To convert a discount rate in one currency to another, all you need are expected inflation
rates in the two currencies:
About estimating Betas for Non-Traded Assets (private firms), the conventional
approaches of estimating betas from regressions do not work for assets that are not
traded; there are no stock prices or historical returns that can be used to compute
Cost of capital: the cost of capital is a composite cost to the firm of raising financing to fund
its projects; in addition to equity, firms can raise capital from debt and debt should include
any interest-bearing liability (whether short term or long term) and any lease obligation
(whether operating or capital).
Cost of debt (Kd) —> Kd = (risk free rate + default risk premium) * (1-tc)
If the firm has bonds outstanding, and the bonds are traded, the yield to maturity on a
long-term, straight (no special features) bond can be used as the interest rate. If the firm is
rated, use the rating and a typical default spread on bonds with that rating to estimate the
cost of debt.
If the firm is not rated:
- and it has recently borrowed long term from a bank, use the interest rate on the
borrowing;
- estimate a synthetic rating for the company, and use the synthetic rating to arrive at a
default spread and a cost of debt.
The cost of debt has to be estimated in the same currency as the cost of equity and the
cash flows in the
valuation.
The rating for a firm can be estimated using the financial characteristics of the firm. In its
simplest form, we can use just the interest coverage ratio:
Interest Coverage Ratio = EBIT / Interest Expenses
EBIT = operating income
Either the cost of equity or the cost of capital can be used as a hurdle rate, depending
upon whether the returns measured are to equity investors or to all claimholders on the
firm (capital):
- if returns are measured to equity investors, the appropriate hurdle rate is the cost of
equity;
- if returns are measured to capital (or the firm), the appropriate hurdle rate is the cost of
capital.
Chapter 5:
Now we are going to talk about the measuring investment returns that could be based on
earning or on cash flows.
Earning measurements are based on:
- accrual accounting (bilancio di competenza) —> show revenues when products and
services are sold or provided, not when they are paid for; show expenses associated
with these revenues rather than cash expenses;
- operating versus capital expenditures —> only expenses associated with creating
revenues in the current period should be treated as operating expenses. Expenses that
create benefits over several periods are written off over multiple periods (as depreciation
or amortization).
To get from accounting earnings to cash flows:
- you have to add back non-cash expenses (like depreciation);
Net Present Value (NPV): the net present value is the sum of the present values of all
Internal Rate of Return (IRR): the internal rate of return is the discount rate that sets the
net present value equal to zero. It is the percentage rate of return, based upon incremental
time-weighted cash flows. We accept an investment if IRR > hurdle rate (if we use FCFF
we have to compare IRR with WACC; if we use FCFE we have to compare IRR with Ke).
The IRR and the NPV will yield similar results most of the time, though there are
differences between the two approaches that may cause project rankings to vary
depending upon the approach used. They can yield different results, especially why
comparing across projects because:
The exchange rate risk should be diversifiable risk (and hence should not command a
premium) if the company has projects in a large number of countries or the investors in the
company are globally diversified.
The same diversification argument can also be applied against some political risk, which
would mean that it too should not affect the discount rate. However, there are aspects of
political risk especially in emerging markets that will be difficult to diversify and may affect
the cash flows, by reducing the expected life or cash flows on the project.
Capital expenditures are not treated as accounting expenses but they do cause cash
outflows and it can generally be categorized into two groups:
- new (or growth) capital expenditures are capital expenditures designed to create new
assets and future growth;
- maintenance capital expenditures refer to capital expenditures designed to keep existing
assets.
Both initial and maintenance capital expenditures reduce cash flows. The need for
maintenance capital expenditures will increase with the life of the project. In other words, a
25-year project will require more maintenance capital expenditures than a 2- year project.
A sunk cost is any expenditure that has already been incurred and cannot be recovered;
when analyzing a project, sunk costs should not be considered since they are not
incremental.
About allocated costs, firms allocate costs to individual projects from a centralized pool
(such as general and administrative expenses) based upon some characteristic of the
project (sales is a common choice, as is earnings). For large firms, these allocated costs
can be significant and result in the rejection of projects.
To the degree that these costs are not incremental (and would exist anyway), this makes
the firm worse off. Thus, it is only the incremental component of allocated costs that should
show up in project analysis.
About the consistency rule for cash flows, the cash flows on a project and the discount rate
used should be defined in the same terms: if cash flows are in dollars, the discount rate
has to be a dollar discount rate; if the cash flows are nominal (real), the discount rate has
to be nominal (real). If consistency is maintained, the project conclusions should be
identical, no matter what cash flows are used.
The investment analysis can be done entirely in equity terms, as well. The returns,
cashflows and hurdle rates will all be defined from the perspective of equity investors.
If using accounting returns, Return will be Return on Equity:
(ROE) = Net Income/BV of Equity, ROE has to be greater than cost of equity
If using discounted cashflow models, cashflows will be cashflows after debt payments to
equity investors and hurdle rate will be cost of equity.
Chapter 6:
In all of the examples we have used so far, the investments that we have analyzed have
stood alone. In the real world, most investments are not independent. Taking an
investment can often mean rejecting another investment at one extreme (mutually
exclusive) to being locked in to take an investment in the future (pre-requisite).
More generally, accepting an investment can create side costs for a firm’s existing
investments in some cases and benefits for others.
In some cases, though, firms may have to choose between investments because:
- they are mutually exclusive —> taking one investment makes the other one redundant
because they both serve the same purpose;
- the firm has limited capital and cannot take every good investment (i.e., investments
with positive NPV or high IRR).
Using the two standard discounted cash flow measures, NPV and IRR, can yield different
choices when choosing between investments.
When comparing and choosing between investments with the same lives, we can:
- compute the accounting returns (ROC, ROE) of the investments and pick the one with
the higher returns;
- compute the NPV of the investments and pick the one with the higher NPV;
- compute the IRR of the investments and pick the one with the higher IRR.
While it is easy to see why accounting return measures can give different rankings (and
choices) than the discounted cash flow approaches, you would expect NPV and IRR to
MIRR—>
NPV and IRR can be different even if projects have the same lives. A project can have
only one NPV, whereas it can have more than one IRR. The NPV is a dollar surplus value,
whereas the IRR is a percentage measure of return. The NPV is therefore likely to be
larger for “large scale” projects, while the IRR is higher for “small-scale” projects.
The NPV assumes that intermediate cash flows get reinvested at the “hurdle rate”, which
is based upon what you can make on investments of comparable risk, while the IRR
assumes that intermediate cash flows get reinvested at the “IRR”.
NPVs cannot be compared when projects have different lives; to compare the NPV, we
have to replicate the projects till they have the same life or to convert the net present
values into annuities. The IRR is unaffected by project life; we can choose the project with
the higher IRR.
We can compare projects with different lives by converting their net present values into
equivalent annuities. These equivalent annuities can be compared legitimately across
Note that the NPV of each project is converted into an annuity using that project’s life and
discount rate and that the second term in the equation is the annuity factor. Thus, this
approach is flexible enough to use on projects with different discount rates and lifetimes.
Most projects considered by any business create side costs and benefits for that business.
The side costs include the costs created by the use of resources that the business already
owns (opportunity costs) and lost revenues for other projects that the firm may have. The
benefits that may not be captured in the traditional capital budgeting analysis include
project synergies (where cash flow benefits may accrue to other projects) and options
embedded in projects (including the options to delay, expand or abandon a project). The
returns on a project should incorporate these costs and benefits.
An opportunity cost arises when a project uses a resource that may already have been
paid for by the firm. When a resource that is already owned by a firm is being considered
for use in a project, this resource has to be priced on its next best alternative use, which
may be:
- a sale of the asset, in which case the opportunity cost is the expected proceeds from the
sale, net of any capital gains taxes;
- renting or leasing the asset out, in which case the opportunity cost is the expected
present value of the after-tax rental or lease revenues;
- use elsewhere in the business, in which case the opportunity cost is the cost of
replacing it.
There also may be positive consequences when there are more than one project; it is the
case of project synergies. A project may provide benefits for other projects within the firm.
In investment analysis, however, these synergies are either left unquantified and used to
justify overriding the results of investment analysis. If synergies exist and they often do,
these benefits have to be valued and shown in the initial project analysis.
Another thing we have to consider when there are more than one project are the project
options. One of the limitations of traditional investment analysis is that it is static and does
not do a good job of capturing the options embedded in investment; there are 3 kinds of
options:
- the first of these options is the option to delay taking a project, when a firm has exclusive
rights to it, until a later date (possibilità di ritardare l'assunzione di un progetto, quando
un'impresa ha diritti esclusivi su di esso);
- the second of these options is taking one project may allow us to take advantage of
other opportunities (projects) in the future (sfruttare altre opportunità in futuro);
- the last option that is embedded in projects is the option to abandon a project, if the
cash flows do not measure up.
These options all add value to projects and may make a bad project into a good one.
The option to delay (ritardare): when a firm has exclusive rights to a project or product for
a specific period, it can delay taking this project or product until a later date. A traditional
The option to expand/take other projects: taking a project today may allow a firm to
consider and take other valuable projects in the future. Thus, even though a project may
have a negative NPV, it may be a project worth taking if the option it provides the firm (to
take other projects in the future) has a more than compensating value.
The option to abandon: a firm may sometimes have the option to abandon a project, if the
cash flows do not measure up to expectations. If abandoning the project allows the firm to
save itself from further
losses, this option can
make a project more
valuable.
While much of our discussion has been focused on analyzing new investments, the
techniques and principles enunciated apply just as strongly to existing investments. For
existing or past investment, we can try to address one of two questions:
- post-mortem —> we can look back at existing investments and see if they have created
value for the firm;
Chapter 8:
There are only two ways in which a business can raise money:
- debt —> the essence of debt is that you promise to make fixed payments in the future
(interest payments and repaying principal). If you fail to make those payments, you lose
control of your business;
- equity —> with equity, you do get whatever cash flows are left over after you have made
debt payments.
When we decide to raise financing for a business we have to find an optimal mix of debt
and equity to maximize the shareholders value.
There are some different approaches to reach the optimal capital structure:
- the cost of capital approach —> the optimal debt ratio is the one that minimizes the cost
of capital for a firm; we can use this approach when there aren’t bankruptcy costs (costi
di insolvenza);
If the cash flows to the firm are held constant and the cost of capital is minimized, the
value of the firm will maximized.
The cost of capital depends on the portion of debt and equity (Kd < Ke, debt costs lower
than equity) and it may increase or decrease; the benefits of debt is up to a point and this
point represents the optimal capital structure (in this point the cost of capital is the lowest
and the value of the firm is maximized).
To identify the optimal capital structure we have to:
- estimate the cost of equity at different levels of debt —> equity will become riskier, beta
will increase and the cost of equity will increase; estimation will use levered beta
calculation;
- estimate the cost of debt at different levels of debt —> default risk will go up and bond
ratings will go down as debt goes up, cost of debt will increase; to estimating bond
ratings, we will use the interest coverage ratio (EBIT/Interest expense);
- estimate the cost of capital at different levels of debt;
- calculate the effect on firm value and stock price.
We can pass from firm value to value per share; because the increase in value accrues
entirely to stockholders, we can estimate the increase in value per share by dividing by the
total number of shares outstanding. Implicit in this computation is the assumption that the
increase in firm value will be spread evenly across both the stockholders who sell their
stock back to the firm and those who do not and that is why we term this the “rational”
solution, since it leaves investors indifferent between selling back their shares and holding
on to them.
When we have a buyback price, we start with the buyback price and compute the number
of shares outstanding after the buyback:
Increase in Debt = Debt at optimal – Current Debt
Shares after buyback = Shares before - (Increase in Debt / Share Price)
Then we compute the equity value after the recapitalization, starting with the enterprise
value at the optimal, adding back cash and subtracting out the debt at the optimal:
Equity value after buyback = Optimal Enterprise value + Cash – Debt
After we divide the equity value after the buyback by the post-buyback number of shares.
Value per share after buyback = Equity value after buyback/ Number of shares after
buyback
We also have to see how capital structure changes the operating income.
Chapter 9:
We will consider how firms should choose the right financing vehicle for raising capital for
their investments. We argue that a firm’s choice of financing should be determined largely
by the nature of the cash flows on its assets. Matching financing choices to asset
characteristics decreases default risk for any given level of debt and allows the firm to
borrow more.
At the end of the analysis of financing mix (using whatever tool or tools you choose to
use), you can come to one of three conclusions:
- the firm has the right financing mix;
- it has too little debt (it is under levered);
- it has too much debt (it is over levered).
The next step in the process is deciding how much quickly or gradually the firm should
move to its optimal and, assuming that it does, the right kind of financing to use in making
this adjustment.
There are some ways to change debt ratio quickly:
- to decrease the debt ratio —> the firm can sell operating assets and use cash to pay
down debt or it can issue new stock to retire debt or get debt holders to accept equity in
the firm;
- to increase the debt ratio —> the firm can sell operating assets and use cash to buyback
stock or pay special dividend or it can borrow money and buyback stock or pay a large
special dividend.
To change debt ratios over time, you use the same mix of tools that you used to change
debt ratios gradually:
- dividends and stock buybacks —> dividends and stock buybacks will reduce the value
of equity;
- debt repayments —> will reduce the value of debt.
The complication of changing debt ratios over time is that firm value is itself a moving
target.
The objective in designing debt is to make the cash flows on debt match up as closely as
possible with the cash flows that the firm makes on its assets. By doing so, we reduce our
risk of default, increase debt capacity and increase firm value.
To choose the right financing instruments, we lay out a sequence of steps by which a firm
can choose it:
- examination of the cash flow characteristics of the assets or projects that will be
financed; the objective is to try matching the cash flows on the liability stream as closely
as possible to the cash flows on the asset stream;
The duration of a bond will increase with the maturity of the bond and decrease with the
coupon rate on the bond.
Choosing the financing maturity, the basic idea is to match the duration of a firm’s assets
to the duration of its liabilities.
Rather than look at individual projects, you could consider the firm to be a portfolio of
projects; calculating the duration in case of more than one project could be more
complicated.
The firms have also to choice between a fixed rate or a floating rate. The interest rate on
floating rate debt varies from period to period and is linked to a specified short-term rate;
for instance, many floating rate bonds have coupon rates that are tied to the London
Interbank Borrowing Rate (LIBOR). The use of floating rate debt should be more prevalent
for firms that are uncertain about the duration of future projects and that have cash flows
that move with the inflation rate.
If cash flows move with inflation, increasing (decreasing) as inflation increases
(decreases), the debt should have a larger floating rate component.
Another important choice is the currency choice. If any of a firm’s assets or projects
creates cash flows denominated in a currency other than the one in which the equity is
denominated, currency risk exists. The liabilities of a firm can be issued in these
currencies to reduce the currency risk.
The forth problem is related to the choice between straight and convertible bonds. Straight
bonds create large interest payments and do not gain much value from the high growth
perceptions. Furthermore, they are likely to include covenants designed to protect the
bondholders, which restrict investment and future financing policy.
Chapter 10:
For the dividend decision the starting point is the cashflow from operations; the dividend
decision can be represented with the following scheme (with the stock buybacks we are
selling our stocks, with the dividends not):
In Italy dividends are paid on an annual basis, in the United State they are paid every
quarter. Dividends in publicy traded firms are usually set by the board of directors and paid
out to stockholders a few weeks later.
There are several ways to classify dividends. First, they can be paid in cash or as
additional stocks; stock dividends increase the number of shares outstanding and
generally reduce the price per share. Second, the dividend can be a regular dividend
which is paid at regular intervals, or a special dividend which is paid in addition to the
regular dividend.
There are some empirical evidences about dividends:
- they are very stables year by year and their increases and their decreases are not very
commons;
- they tend to follow earnings but earnings don’t change our dividends policy;
- they are affected by tax laws;
- more and more firms are buying back stock rather than pay dividends —> the problem is
related by the higher volatility of the firms than the past years (companies prefer to
reduce the amount of dividends);
- there are a lot of differences across countries.
We can measure the dividend policy for a company in two ways:
- Dividend Payout Ratio = Dividends / Net Income —> it measures the percentage of
earnings that the company pays in dividends; if the net income is negative, the payout
ratio cannot be computed;
- Dividend Yield = Dividends per share / Stock price —> it measures the return that an
investor can make from dividends alone; it becomes part of the expected return on the
investment. The dividend yield is significant because it provides a measure of that
component of the total returns that comes from dividends, with the balance coming from
price appreciation (trade off between dividend yield and price appreciation).
Expected Return on Stock = Dividend Yield + Price Appreciation
The payout ratio is used in a number of different settings. It is used in valuation as a way
of estimating dividends in future periods, because most analysts estimate growth in
earnings rather than dividends. Second, the retention ratio, the proportion of the earnings
reinvested in the firm (Retention Ratio = 1 – Dividend Payout Ratio), is useful in estimating
future growth in earnings; firms with high retention ratios (low payout ratios) generally have
higher growth rates in earnings than firms with lower retention ratios (higher payout ratios).
Growth in earnings = ROE * (1 - payout ratio)
The cash flows from selling before ex-dividend day are: Pb-(Pb-P)tcg