Corporate Finance

Everything…..

R Srinivasan

Corporate Finance

• Valuation and Cost of capital

• Capital budgeting

• Capital structure, financing and dividend policy

• Working capital

Valuation

• Generalised valuation

Arbitrage and value additivity

• Patterns

Level perpetuity

Growing perpetuity

Level annuity

Growing finite cash flow

Valuation

Growing finite [t years] cash flow

C1/(r-g){1-(1+g)t/(1+r)t}

Valuation

• Compounding intervals (1+r/m)m-1

Continuous compounding

• Stated and effective rates

• Nominal and real rates

1+rnominal=(1+rreal)(1+inflation rate)

Valuation: Straight Bonds

• YTM

• Duration

Sensitivity of value to changes in interest rates

[1*PV(C1)/V]+[2*PV(C2)/V]+[3*PV(C3)/V]

V/V = (1+r)/(1+r)*D

Valuation: Common Stock

• Perpetual growth models

Sustainable growth

P0=No-Growth +PVGO

No-growth =EPS1/r

PVGO=NPV1/(r-g)

where NPV1 =-INV1 +INV1*ROE/r

g=Ploughback*ROE

EPS1/P0 interpretation

Valuation

• Multiple stages

Supernormal stage plus PV of normal growth

• Free cash flow

NOI approach

Cost of Capital

• Security return and standard deviation

• Portfolio return and standard deviation

• Diversification Portfolio variance= 1/N Average Var+(N-1)/N Average covariance

• Systematic and unsystematic risk

• CAPM

• Opportunity cost of capital r [rA]and

Adjusted cost of capital r*

Cost of Capital

1. VL = VU +Tc *D

2. WACC = D/V * (1-Tc) * rD+E/V * rE [Definition of WACC]

3. rE = rA + (rA - rD ) * (1- Tc) * D/E [MM Proposition II]

4. E = {1+ (1- Tc) * D/E} * A [If debt is risk free]

5. rE = rf + (rM - rf) * E [CAPM]

6. WACC= rA *(1- Tc * D/V) MM

Valuation

• Contingent cash flow

Call/Put

American/European

Binomial

Black-Scholes

Underlying asset price, Exercise Price, Risk-free rate, Volatility, Time

Capital Budgeting

• NPV and IRR not payback and accounting rate of return

• Accept/reject single project use NPV or IRR, unless no/multiple IRR

• Mutually exclusive projects: Same life and risk

Use NPV [or IRR of difference between projects]

Capital Budgeting

• Mutually exclusive projects: Different lives same risk

Use NPV-assumes replacement projects have zero NPV. OK for projects with long lives

Use NPV-with specific replacements that make project with comparable lives

Use replacement chain or EAC

Care: Use only real cash flows for EAC

Capital Budgeting

• Incremental nominal cash flows with empirically measured discount rate

• Components of cash flow

Investment in fixed assets, salvage value

Investment in working capital, release

Operating revenues/expenses

NO INTEREST

Capital Budgeting

• NPV assumes “now or never”

• Real Option framework

Abandonment

Follow-up

Wait and learn

Flexibility

Capital structure

• Market Efficiency

• MM-1 No taxes

• MM-2 Corporate taxes

• Miller Both corporate and personal taxes

GL= {1-(1-TC)*(1-TpE)/(1-Tp)}

• Bankruptcy costs

• Agency costs

Dividends

• MM Does not matter

• Lintner behavioural model DIV1-DIV0=Adjustment rate*(target ratio*EPS1-DIV0)

• Agency costs/signalling

Working Capital Management

• Operating cycle, cash conversion cycle, weighted cycles and supply chain management

• Investment in receivables

• Cash management

EOQ and Miller-Orr models