Week 1 1 Introduction to corporate finance CORPORATE FINANCE 1 UNIVERSITY OF EXETER MARK FREEMAN, 2004
Week 1 1
Introduction to corporate finance
CORPORATE FINANCE 1
UNIVERSITY OF EXETER
MARK FREEMAN, 2004
Week 1 2
Stakeholders in a company
Every company has many “stakeholders” – people who depend
on the success and operations of the firm:
1) The employees
2) The general community
3) The executives
4) The investors
i. Stockholders
ii. Bondholders and banks …
“Corporate Finance” or “Financial Management” looks at the
firm from the perspective of what investors – and particularly
stockholders – require from the firm.
Week 1 3
Don’t all stakeholders want the same thing?
Surely all stakeholders want the same thing? Don’t they all
wish the company to be successful?
This is not the case since they will not all agree on what is
“successful”. As examples:
1) Employees want a high salary irrespective of the
effect on profits
2) The community will want high environmental
protection
3) Executives may want expensive offices and
corporate jets. They also often want companies to be
as large as possible, even if that is not economically
efficient.
4) Investors want profit maximization
The fact that executives may not always act in shareholders
best interests is known as agency conflict.
Managers’ compensation is often designed to align their
interest with those of shareholders. This is one reason for
executive stock options and performance shares.
Week 1 4
So why worry about investors?
So why should managers worry about maximizing shareholder
wealth?
1) It is the stockholders, not the managers, who own the
firm. The CEO is just another employee
2) If you do not consider investors you will never get
funding for future projects
3) If you ignore shareholders, they have various ways
of punishing you:
i. They control executive compensation
ii. They have the ability to have you taken
over
iii. They can sack the board
iv. They can fail to support your plans at general meetings and otherwise lobby you
(“direct intervention”)
You should also worry about bondholders / banks since they
can make you bankrupt.
REMEMBER: You need investors more than they need you!
You need to market yourself to investors in the way that you
market yourself to any other potential group of clients.
Week 1 5
Do all investors have shared objectives?
For the purposes of this course, yes. The “Net Present Value”
method that we use in this course will discriminate between
projects that are attractive and those that are not for all
investors.
In more advanced corporate finance, it will be shown that there
are situations where this is not the case.
In general stockholders prefer risk to banks. This is because
banks can only get their money back (with interest) so do not
participate in very high profits. Shareholders, on the other
hand, have limited liability but unlimited upside.
This conflict is particularly important for firms in financial
distress. Banks then want companies to take much less risk
than would be optimal for shareholder wealth maximization.
Week 1 6
Who are investors?
Source: ProShare for the LSE, http://www.investinginbonds.com/info/bondbk3.htm for US
bond data and the NYSE fact book. Mutual funds figure for LSE is Investment trusts (not unit
trusts)
0% 10% 20% 30% 40% 50%
Other
Foreign
Mutual funds
Insurance
companies
Pension
funds
Private
investors
LSE
NYSE
All US Bonds
Week 1 7
The three key topics
In introductory corporate finance, there are three main issues:
1) If we have a new project that we wish to fund, are
investors going to find it attractive?
2) If we have an attractive project, what is the best
source of funding?
3) Once a project is running, how do we financially
manage it
i. How do we manage financial risk?
ii. How do we liaise with investors?
Week 1 8
When do investors view a project as being
attractive?
When applying to an investor for finance, you should be
aware that you are competing against many other firms for
this money. The main things that investors looks for in a
project are:
1) The expected post-tax cashflows that will result from the
project
2) The timing of these cashflows
3) The uncertainty associated with the cashflow
4) How the cashflows interact with other risks within the
investor’s portfolio – “diversification”
5) The rates of return available on other investment
opportunities
Week 1 9
Funding the project
Having established that your project is financially sound, you
next need to decide how to fund it. Usually funding from
retained earnings is cheapest. However, if you have to
generate external capital, you have two main sources:
Debt Equity
Borrow money Ownership of firm
(Usually) finite length Indefinitely lived
Interest must be paid Dividends need not be paid
No voting rights Voting rights
“Seniority” Non-senior
Interest: tax deductible Dividends: non-tax deductible
Here “seniority” means that debt holders have full claim to
any money up to the amount they are owed at any point in
time. The equity holders have claims to the residual.
Week 1 10
Debt financing
It is likely that you will at least want some debt financing. As
well as deciding whether we want to take direct bank
borrowing or issue tradable corporate debt, there are other
questions that you must answer:
1) What “maturity” of debt do you require? That is, how
long do you want to borrow the money for?
2) Do you want to take out “fixed rate” or “floating rate”
debt?
3) Do you want to borrow all your money in GBP (Great
British Pounds), or do you want to borrow some money
in foreign currency?
The answers to these questions will depend on:
1) The timing of the cashflows from your projects
2) On how the cashflows generated by your projects will be
influenced by changes in the interest rate
3) How much international business you undertake
Week 1 11
Managing financial risks
Most companies are susceptible to changes in financial
conditions over which they have no control.
1) International organisations are subject to fluctuations in
foreign exchange rates.
2) Companies with high levels of debt will suffer if interest
rate rises.
3) Certain companies have a high exposure to commodity
prices – for example, airlines and oil prices.
These risks can be managed using both strategic and
“hedging” approaches.
Hedging involves the use of “derivative securities” – futures,
forwards, options and swaps. A corporate treasurer must
know how to implement risk management techniques in this
area.
There have been many recent corporate “disasters” caused by
poor hedging strategies. Chief Executives should be aware of
the risks and opportunities in this area.
Week 1 12
Ongoing relationships with investors
Once you have raised capital, you must decide how you are
going to liaise with your shareholders.
Certain issues that you will need to address are:
1) How much information you release
2) What your dividend policy will be
3) Mergers and acquisitions strategy
Week 1 13
Key issues in managerial finance
Is the project sufficeintly profitable?
Estimate the risk
Estimate the expected post-tax cashflows
Is the project attractive?
What maturity of debt do we want?
Do we want private or traded securities?
What combination of debt/equity is optimal
How do we fund the project?
Working capital management
Adapting and refining the project
Managing changes in interest/FX rate
Managing the project
Mergers and acquisitions
When do we pay dividends?
Liasing with investors
Running the project
Starting the project
Week 1 14
Provisional lecture (tutorial) syllabus
[Not MSc FAFM]
Week 1 Introduction (No tutorial)
Week 2 Treasury bills and Gilts (Week 1 questions)
Week 3 The term structure (Week 2 questions)
Week 4 Capital budgeting 1 (Week 3 questions)
Week 5 Capital budgeting 2 (Week 4 questions)
Week 6 Capital budgeting 3 (Week 5 questions)
Week 7 Capital structure (Week 6 questions)
Week 8 Dividend policy (Case study 1)
Week 9 Mock examination (No tutorial)
Week 10 Managing transaction risk (Case study 2)
Week 11 Managing strategic risk (Mock exam solutions)
Week 12 Real options (Revision tutorial)
One written assessment (4,000 words): 40% and one exam: 60%
Week 1 15
Provisional lecture (tutorial) syllabus
[MSc FAFM]
Lectures and tutorials as other students for weeks 1 – 8
In addition, two-hour classes on Tuesdays for week 2 - 7
Weeks 2 – 5 Financial Ethics
Week 6 Portfolio Theory and the CAPM
Week 7 Market Efficiency
No teaching after Week 8.
Mock examination in Week 10.
One written assessment: 20% and one exam: 80%. Details to be
confirmed.
We will NOT cover the learning outcomes of the CFA line-by-line in
this (or any other) course. However, the main topic areas will all be
covered. It is the student’s responsibility to ensure they are familiar
with the CFA required readings and learning outcomes.
Week 1 16
Reading list
Brealey & Myers = Brealey & Myers, “Principles of Corporate Finance”,
Seventh Edition, Irwin McGraw-Hill
BH = Brigham & Houston, “Fundamentals of Financial Management”, Eighth Edition, South Western
Fab. = Fabozzi, “Fixed Income Analysis for the CFA Program”, AIMR
DMPR = DeFusco, McLeavey, Pinto & Runkle, “Quantitative Methods for
Investment Analysis”, AIMR.
Week MSc FAFM Others (From Brealey &
Myers)
1 BH pp.18-22 Chs. 1&2
2 – 3 Fab. Chs. 5&6
DMPR pp.60-72
Chs. 3&24
You may need some
additional reading
4 – 6 BH Chs. 9-12
DMPR pp. 54-60
Chs. 5,6&9
7 BH Ch. 13 Chs. 17&18
8 BH Ch. 14 Ch. 16
10 N/A No reading
11 N/A Chs. 20&27
12 N/A Ch. 22
Week 1 17
Laws!
1) Turn up ON TIME for all classes. The start time means
the door will be closed and the lecturer will start
teaching. Do not be late – arrive at least 5 minutes
before the published start time. Come back promptly
from class breaks.
2) Do not talk in class unless invited to do so by the lecturer
or tutor. PLEASE do not “chat”.
3) Turn up to the lecture / tutorial to which you are
allocated. You MAY NOT attend at times to suit you –
it important that the numbers are balanced so that you all
receive the best quality tuition.
4) Always prepare fully for tutorials. Be keen to ask
questions and make contributions in lectures and
tutorials.
5) Make sure you abide by the department’s “honour
codes”. In particular, make sure you understand the
University regulations on plagiarism and cheating.
6) Mobile phone OFF. If a phone goes off in a lecture it
will be answered by the Lecturer! No texting.
Week 1 18
Discounting, rates of return and all
that
CORPORATE FINANCE 1
UNIVERSITY OF EXETER
MARK FREEMAN, 2004
Week 1 19
Rate of return
When looking at investments, the most important thing is to
be able to calculate the rate of return.
Suppose that we invest £100 today and then received £105 in
three month’s time. What is the rate of return? In this case,
with only one future cashflow, the rate of return is easy to
calculate:
Rate of return = Selling price – Buying price
Buying price
= 105 – 100 = 5%
100
This equation can be rearranged as follows…
Buying price = Selling price
(1+rate of return)
… or in this case, £100 = £105/1.05. Notice that the rate of
return of 5% must be expressed as 0.05 when being put in this
calculation.
Week 1 20
Annualised rates of return
The rate of return that we have calculated is for three months.
In order to compare projects of different maturities it is
useful to convert the rate of return to some “standard” time
period – usually one year.
There are three main ways of doing this conversion. Let t
denote the number of time periods in a year.
1) rtar =
2) 1)1( −+= trar
3) 1−= rtear
In our example, there are four periods of three months within
one year, so t=4. The annualised rates of return are:
1) %2005.0*4 ==ar
2) %55.2114)05.1( =−=ar
3) %14.221)05.0*4(=−=ear
Notice that, although these give different answers, they are all
similar.
Week 1 21
Which do we use?
So, which is the right answer? The first is the easiest to
calculate and is therefore often used as a convention in
financial markets. We will see this next week when we look
at the way bond yields are quoted. However, this method of
annualisation does not have good economic motivation.
The third method is correct in situations where there is
“continuous compounding”. This method turns out to be very
important in certain, more advanced, types of finance –
particularly when it comes to valuing options and other
derivatives. For the purposes of this course we will only rarely
– if ever – use this method.
The second method will be the preferred technique within this
class. Essentially this method assumes that the asset would
continue to give a 5% return every three months. Therefore,
had we not sold the asset, in six months it would have been
worth 105*1.05 = 110.25. After nine months it would be
worth 110.25*1.05 = 115.76. After twelve months it would be
worth 115.76*1.05 = 121.55. Therefore the annual rate of
return = (121.55-100)/100 = 21.55%, as given by the second
method. We call this “discrete” or “simple” compounding.
Week 1 22
Example
On 31/12/03, you bought shares of company A for £50 and
shares of company B for £25. On 31/1/04, you sold the
shares of company A for £51. On 30/4/04 you sold the shares
in company B for £27. Which gave you the higher annualised
rate of return?
Company A. Rate of return = (51-50)/50 = 2%. There are
twelve months in the year, so t=12. The annualised rate of
return is therefore (1.02)12 – 1 = 26.82%
Company B. Rate of return = (27-25)/25 = 8%. There are
three periods of four months in a year, so t=3. Therefore the
annualised rate of return is (1.08)3 – 1 = 25.97%
So, the investment in company A is slightly better than the
investment in company B.
Week 1 23
Example –2
What happens if we reverse this problem? Suppose that I told
you that you had bought a share for £50, held it for six
months, and received an annualised rate of return of 15%.
How do you calculate your selling price?
You need to know the actual six-month rate of return that you
received. Since six months is ½ of a year, the six month rate
is just 1.151/2 – 1=7.238%. Therefore
Selling price - £50 = 0.07238
£50
So, selling price = £53.62.
Week 1 24
The rate of return on multiple cashflows
Consider the rate of return on an asset that pays multiple
cashflows.
You bought shares in company A on 31/12/2003 for £50. On
30/6/2004 you were paid a dividend of £2 and then you sold
the share for £58 on 31/12/2004. What annualised rate of
return have you received on this share?
The answer, r, solves the following equation:
rr +
+
+
=
1
58£
2/1)1(
2£50£
The easiest way to calculate this is to use either a financial
calculator1 or a spreadsheet.
1 Having a financial calculator is not necessary for this course. I don’t own one.
Week 1 25
The rate of return on multiple cashflows - 2
Within Excel, for example, we can set this up as follows:
A B C D
1 Time Cashflow Discounted
2 Cost 0 -50 -50
3 Dividend 0.5 2 2
4 Sale 1 58 58
5 6 r 0 10
1) b2..b4 Time until the cashflows arrive (in units of
one year)
2) c2..c4 Value of the cashflows (notice that the original
cost is a negative value)
3) b6 Put in “0” as an initial guess
4) d2 Formula =c2/(1+$b$6)^b2
5) d3..d4 Copy the formula from d2
6) d6 Formula =SUM(d2..d4)
Week 1 26
The rate of return on multiple cashflows - 3
Go to “Tools”, “Goal Seek”.
“Set Cell” d6
“To Value” 0
“By changing cell” b6
Hit “OK” and the correct value of r will then be given in b6.
A B C D
1 Time Cashflow Discounted
2 Cost 0 -50 -50
3 Dividend 0.5 2 1.823 4 Sale 1 58 48.177
5
6 r 0.203889 0
You can see that the rate of return is 20.39% in this case.
Week 1 27
Example
You lend a friend £200 today. She promises to pay you
interest of £10 in both six and twelve months. In eighteen
months she will repay the £200. What is the rate of return
(“interest rate”) on this loan?
Time Cashflow Discounted
Loan 0 -200 -200
Interest 1 0.5 10 9.672 Interest 2 1 10 9.355
Repayment 1.5 200 180.97
R 0.068919 0
We just repeat the same process – except that we now have an
additional cashflow to worry about. By using Tools/Goal
Seek in Excel we can see that the interest rate is just under
6.9% on an annualised basis.
Week 1 28
Starting with the rate of return
Often we will wish to reverse this argument.
An investor promises you cashflows of £100 for each of the
next three years if you invest in her project. We require a rate
of return of 10% per annum. How much are you prepared to
invest in the project?
Investment = £100 + £100 + £100 = £248.68
1.1 1.12 1.13
This is, at its simplest level, the way in which we value
investments. We say that £248.68 is the present value of
these cashflows.
Week 1 29
Treasury bills and Gilts
Government borrowing comes in the form of Treasury bills
(short term) and bonds (long term)2. In the UK Treasury
bonds are sometimes called Gilts – which is short for “Gilt-
edged security” because of the low risk of the Government
defaulting on its repayment obligations.
Gilts have a face value of £100 (in the US, the standard is
$1,000). That is, when the asset matures, the government will
repay £100. In addition, there are coupon payments. Coupon
payments are interest payments paid on these bonds.
If the price of a Gilt is above £100 then you will receive a
capital loss on this asset. It is said to be at a premium. Such
Gilts pay high coupons so that investors are still willing to
buy them despite the capital loss.
If the price of a Gilt is below £100 then you will receive a
capital gain on this asset. It is said to be at a discount. Such
Gilts pay low coupons so that investors need capital
appreciation as well as the coupon to make the bond an
attractive investment.
2 Investors sometimes talk of Treasury “notes”, which are medium-term investments;
maturity between a bill and a bond.
Week 1 30
T-bills
With Treasury bills (maturity up to one year), there are no
coupon payments. The gain comes completely in the form
of capital appreciation.
For example, today we might see the price of the six-month t-
bill quoted at £97.00. The only future cashflow to come from
this bill is £100 in six months time.
So, the rate of return to this t-bill is:
r = (£100 - £97) / £97 = 3.093%.
Annualising using r*t gives 6.19% (since t here = 2) or using
(1+r)t-1 gives 6.28%.
We will return to this subject next week.
Week 1 31
Gilts
Gilts have funny names – for example: “Cn 9 3/4pc ‘06”. The
first two letters “Cn” are not important; you can ignore this.
The “9 3/4pc” tells you the coupon. The Government will
pay you 9.75% each year. This is paid “semi-annually”; that
is, at six monthly intervals. So for every £100 of face value,
the interest payment is 9.75% * 100 / 2 = £4.875 every six
months.
Finally the “’06” tells you that the bond matures in 2006. On
the day the bond matures you receive the £100 of face value
together with a final coupon payment of £4.875.
The exact date of maturity / coupon payments cannot be
determined from this information. Again, we will return to
this next week.
Week 1 32
Questions – Week 1
CORPORATE FINANCE 1
UNIVERSITY OF EXETER
MARK FREEMAN, 2004
Week 1 33
Question set 1
1) You lend a friend £100 today. She repays the £100 in three months and
buys you a £2 beer to thank you for your help. What is the interest rate
on the loan? What is the annualised interest rate on the loan?
2) You buy a share for £50. Which of the following would you prefer: (a)
to sell the share for £60 in six months or (b) to sell the share for £70 in twelve months?
3) If a bond promises to repay £100 in two months and you require an
annual interest rate of 6%, how much are you prepared to pay for it
today?
4) You buy a share for £20, it pays you a £5 dividend in six months and you sell it for £18 in twelve months. What annualised rate of return have you
received on this share?
5) During last year you undertook the following share transactions.
Calculate the annualised rate of return that you received on each of these shares.
Date Transaction Asset Quantity Price per unit
Jan 1 Buy A 100 £70 Feb 1 Buy B 50 £55
Mar 1 Buy C 300 £120
Apr 1 Dividend A - £2 per share
May 1 Sell C 100 £130 Jun 1 Dividend B - £1 per share
July 1 Sell B 50 £55
Aug 1 Sell C 100 £140
Sep 1 Dividend C - £5 per share
Oct 1 Dividend A - £3 per share Nov 1 Sell C 100 £100
Dec 1 Sell A 100 £75
Week 1 34
6) A relative asks you to choose one of the following as a birthday present
for this year and next. Rank these in order from most attractive to least
attractive to you:
a. £110 for your birthday this year but nothing next year
b. Nothing this year but £110 for your birthday next year
c. You can spin a coin. If it comes up heads you will get nothing at all
for your next two birthdays. However, if it comes up tails, you will get £110 for both of the next two years.
d. You can spin a coin. If it comes up heads you will get nothing at all
for your next two birthdays. However, if it comes up tails, you will
get £150 for both of the next two years.
7) Suppose that on 2nd January 2003 the price of the Tr 3pc ’04 was £98.00. This bond pays coupons on 1st January and 1st July and will mature on
1/7/04. What rate of return is this Gilt offering?