💼Advanced Corporate Finance Unit 1 – Corporate Finance Fundamentals

Key Concepts and Definitions

• Corporate finance focuses on financial decisions that maximize shareholder value including investment, financing, and dividend policy decisions
• Investment decisions involve selecting projects or assets that generate the highest risk-adjusted returns and increase the firm's value
• Financing decisions determine the optimal mix of debt and equity to fund operations and investments while minimizing the cost of capital
• Dividend policy decisions involve distributing a portion of earnings to shareholders as dividends or retaining earnings for reinvestment
• Agency theory addresses conflicts of interest between shareholders (principals) and managers (agents) due to misaligned incentives
  • Managers may pursue personal benefits at the expense of shareholder value (empire building, excessive perks)
• Asymmetric information occurs when managers have more information about the firm's prospects than investors leading to adverse selection and moral hazard problems
• Signaling theory suggests that financial decisions (dividend changes, share repurchases) convey information about the firm's future prospects to investors

Financial Statements and Analysis

• The balance sheet provides a snapshot of a company's assets, liabilities, and shareholders' equity at a specific point in time
  • Assets include current assets (cash, inventory) and non-current assets (property, plant, and equipment)
  • Liabilities include current liabilities (accounts payable) and non-current liabilities (long-term debt)
  • Shareholders' equity represents the residual claim of owners after liabilities are subtracted from assets
• The income statement reports a company's revenues, expenses, and net income over a period of time (quarterly, annually)
  • Gross profit equals revenues minus cost of goods sold
  • Operating profit equals gross profit minus operating expenses (selling, general, and administrative expenses)
  • Net income equals operating profit minus interest expense and taxes
• The cash flow statement tracks the inflows and outflows of cash from operating, investing, and financing activities
  • Operating cash flows come from a company's core business operations (collecting from customers, paying suppliers)
  • Investing cash flows relate to the purchase or sale of long-term assets (capital expenditures, acquisitions)
  • Financing cash flows involve transactions with providers of capital (issuing stock, paying dividends, borrowing funds)
• Ratio analysis assesses a company's liquidity, profitability, leverage, and efficiency by comparing financial statement items
  • Liquidity ratios (current ratio, quick ratio) measure a company's ability to meet short-term obligations
  • Profitability ratios (gross margin, operating margin, return on equity) evaluate a company's ability to generate profits
  • Leverage ratios (debt-to-equity, interest coverage) assess a company's use of debt financing and ability to meet debt obligations
  • Efficiency ratios (inventory turnover, receivables turnover) measure how effectively a company manages its assets

Time Value of Money

• The time value of money (TVM) is the concept that a dollar today is worth more than a dollar in the future due to its potential earning capacity
• Present value (PV) is the current value of a future sum of money or stream of cash flows given a specified rate of return
  • PV is calculated by discounting future cash flows at the appropriate discount rate: $PV = \frac{FV}{(1+r)^n}$
  • FV is the future value, r is the discount rate (or required rate of return), and n is the number of periods
• Future value (FV) is the value of an asset or cash flow at a specified date in the future that is equivalent to a specified sum today
  • FV is calculated by compounding the present value at the appropriate interest rate: $FV = PV(1+r)^n$
• Annuities are a series of equal payments or receipts that occur at fixed intervals for a specified period of time
  • The present value of an ordinary annuity (payments occur at the end of each period) is calculated as: $PV = PMT \left[\frac{1 - (1+r)^{-n}}{r}\right]$
  • PMT is the periodic payment, r is the interest rate per period, and n is the total number of payments
• Perpetuities are a series of equal payments that continue forever
  • The present value of a perpetuity is calculated as: $PV = \frac{PMT}{r}$

Risk and Return

• Risk refers to the uncertainty or variability of returns associated with an investment
  • Systematic risk (market risk) affects all securities and cannot be diversified away (interest rates, inflation)
  • Unsystematic risk (firm-specific risk) is unique to a particular company or industry and can be reduced through diversification
• Return is the gain or loss on an investment over a specified period, including any income (dividends, interest) and capital appreciation
• The risk-return tradeoff suggests that higher expected returns are associated with higher levels of risk
• The Capital Asset Pricing Model (CAPM) describes the relationship between systematic risk and expected return for a security or portfolio
  • The expected return on a security is a function of the risk-free rate, the market risk premium, and the security's beta coefficient: $E(R_i) = R_f + \beta_i[E(R_m) - R_f]$
  • $R_f$ is the risk-free rate, $\beta_i$ is the security's beta (sensitivity to market movements), and $E(R_m)$ is the expected return on the market portfolio
• Beta measures a security's volatility relative to the overall market
  • A beta greater than 1 indicates higher volatility than the market (aggressive), while a beta less than 1 suggests lower volatility (defensive)
• Standard deviation measures the dispersion of returns around the mean return
  • A higher standard deviation indicates greater variability and risk

Capital Budgeting Techniques

• Capital budgeting is the process of evaluating and selecting long-term investments (projects, acquisitions) that maximize shareholder value
• The net present value (NPV) method calculates the present value of a project's expected cash inflows minus the present value of its expected cash outflows
  • A positive NPV indicates that a project is expected to increase shareholder value and should be accepted
  • NPV is calculated as: $NPV = \sum_{t=0}^n \frac{CF_t}{(1+r)^t} - Initial\ Investment$
  • $CF_t$ is the cash flow at time t, r is the discount rate (cost of capital), and n is the project's life
• The internal rate of return (IRR) is the discount rate that sets a project's NPV equal to zero
  • A project is acceptable if its IRR exceeds the company's required rate of return (hurdle rate)
  • IRR is calculated by solving for r in the NPV equation: $0 = \sum_{t=0}^n \frac{CF_t}{(1+IRR)^t} - Initial\ Investment$
• The payback period is the length of time required to recover the initial investment in a project
  • Shorter payback periods are preferred, but this method ignores the time value of money and cash flows beyond the payback period
• The discounted payback period is the length of time required to recover the initial investment using discounted cash flows
  • This method considers the time value of money but still ignores cash flows beyond the payback period
• The profitability index (PI) is the ratio of the present value of a project's future cash flows to its initial investment
  • A PI greater than 1 indicates that a project should be accepted: $PI = \frac{PV\ of\ future\ cash\ flows}{Initial\ investment}$

Cost of Capital and Capital Structure

• The cost of capital is the minimum return that a company must earn on its investments to satisfy its providers of capital (debt and equity)
• The weighted average cost of capital (WACC) is the average cost of all sources of capital, weighted by their respective proportions in the company's capital structure
  • WACC is calculated as: $WACC = w_d r_d (1-T) + w_e r_e$
  • $w_d$ and $w_e$ are the weights of debt and equity in the capital structure, $r_d$ is the cost of debt, $r_e$ is the cost of equity, and T is the corporate tax rate
• The cost of debt is the effective interest rate a company pays on its debt, adjusted for taxes
  • The after-tax cost of debt is calculated as: $r_d (1-T)$
• The cost of equity is the return required by shareholders to compensate for the risk of investing in the company
  • The cost of equity can be estimated using the CAPM: $r_e = R_f + \beta_e[E(R_m) - R_f]$
• The optimal capital structure minimizes the WACC and maximizes firm value
  • The trade-off theory suggests that firms balance the benefits (tax shield) and costs (financial distress, agency costs) of debt financing
  • The pecking order theory proposes that firms prefer internal financing, followed by debt, and then equity due to information asymmetry and signaling considerations

Dividend Policy and Share Repurchases

• Dividend policy involves the decision to distribute a portion of earnings to shareholders as dividends or retain earnings for reinvestment
• The dividend payout ratio is the percentage of earnings paid out as dividends: $Dividend\ payout\ ratio = \frac{Dividends\ per\ share}{Earnings\ per\ share}$
• The dividend yield is the annual dividend per share divided by the current stock price: $Dividend\ yield = \frac{Annual\ dividend\ per\ share}{Current\ stock\ price}$
• Modigliani and Miller (MM) argue that dividend policy is irrelevant in perfect capital markets as it does not affect firm value
  • Shareholders can create their own "homemade" dividends by selling shares if dividends are too low or reinvesting if dividends are too high
• The bird-in-the-hand theory suggests that investors prefer current dividends due to uncertainty about future cash flows
• The tax preference theory argues that investors may prefer lower dividend payouts if dividends are taxed at a higher rate than capital gains
• Signaling theory proposes that dividend changes convey information about a firm's future prospects
  • Dividend increases signal management's confidence in future cash flows, while decreases signal pessimism
• Share repurchases are an alternative to dividends for distributing cash to shareholders
  • Repurchases can signal undervaluation, increase earnings per share, and provide tax advantages over dividends
  • However, repurchases may be viewed as a lack of profitable investment opportunities

Corporate Valuation Methods

• Discounted cash flow (DCF) valuation estimates the intrinsic value of a company by discounting its expected future cash flows at the appropriate cost of capital
  • The enterprise value (value of operations) is calculated by discounting free cash flows to the firm (FCFF) at the WACC: $Enterprise\ value = \sum_{t=1}^{\infty} \frac{FCFF_t}{(1+WACC)^t}$
  • The equity value is calculated by subtracting net debt (debt minus cash) from the enterprise value
• The dividend discount model (DDM) values a company's equity by discounting its expected future dividends at the cost of equity
  • The constant growth (Gordon) model assumes a constant dividend growth rate (g) in perpetuity: $P_0 = \frac{D_1}{r_e - g}$
  • $P_0$ is the current stock price, $D_1$ is the expected dividend per share next year, $r_e$ is the cost of equity, and g is the constant dividend growth rate
• The multiples approach values a company based on comparable firms' multiples (price-to-earnings, EV/EBITDA)
  • The price-to-earnings (P/E) ratio is the current stock price divided by earnings per share: $P/E = \frac{Current\ stock\ price}{Earnings\ per\ share}$
  • The EV/EBITDA multiple is the enterprise value divided by earnings before interest, taxes, depreciation, and amortization
• The asset-based approach values a company based on the fair market value of its assets minus its liabilities
  • This approach is more relevant for firms with significant tangible assets (real estate, natural resources)
• The contingent claim (option pricing) approach values a company's equity as a call option on its assets
  • This approach is useful for valuing firms with significant flexibility (growth options, abandonment options) or in financial distress