B40.2302 Course Review

1. B40.2302 Course Review • Modified 12/5/2001 by Jeffrey Wurgler

2. Topics Covered • Course overview • “Key slides” from Classes #1-11

3. Principles of Corporate Finance Brealey and Myers Sixth Edition • Finance and the Financial Manager Slides by Matthew Will, Jeffrey Wurgler Chapter 1 Irwin/McGraw Hill • The McGraw-Hill Companies, Inc., 2000

4. Role of The Financial Manager (2) (1) Financial Firm's Financial (4a) manager operations markets (4b) (3) (1) Cash raised from investors (external finance) (2) Cash invested in firm (3) Cash generated by operations (4a) Cash reinvested (internal finance) (4b) Cash returned to investors

5. Principles of Corporate Finance Brealey and Myers Sixth Edition • Present Value and The Opportunity Cost of Capital Slides by Matthew Will, Jeffrey Wurgler Chapter 2 Irwin/McGraw Hill • The McGraw-Hill Companies, Inc., 2000

6. Net Present Value

7. Risk and Present Value • Higher-risk projects require higher discount rates. • Higher discount rates cause lower PVs.

8. A Fundamental Result • Investors with free and equal access to borrowing and lending markets will always invest in positive NPV projects, no matter what their preferred time pattern of consumption. • Corollary: Shareholders A and G both agree that firm should maximize its NPV.

9. Principles of Corporate Finance Brealey and Myers Sixth Edition • How to Calculate Present Values Slides by Matthew Will, Jeffrey Wurgler Chapter 3 Irwin/McGraw Hill • The McGraw-Hill Companies, Inc., 2000

10. Short Cuts Perpetuity - A constant cash flow is received forever, starting at the end of the first period.

11. Short Cuts Growing perpetuity - A cash flow growing at rate g is received forever. The first cash flow, arriving at the end of the first period, is C1.

12. Short Cuts Annuity – A constant cash flow that arrives only for t periods. The first cash flow arrives at end of first period.

13. Discount nominal cash with nominal rate, real cash with real rate • NPV rule gives same answer whether discounting nominal cash by nominal rate or real cash by real rate. • Just don’t mix them up!

14. Principles of Corporate Finance Brealey and Myers Sixth Edition • The Value of Common Stocks Slides by Matthew Will, Jeffrey Wurgler Chapter 4 Irwin/McGraw Hill • The McGraw-Hill Companies, Inc., 2000

15. Valuing Common Stocks Dividend Discount Model - Model of today’s stock price which states that share value equals the present value of all expected future dividends. H - Time horizon for your investment. Can be infinity.

16. Valuing Common Stocks Constant Growth DDM - A version of the dividend growth model in which dividends grow at a constant rate g. When you use the growing perpetuity formula to value a stock, you are using the “Gordon Growth Model.”

17. EPS, P/E, and share price • Rearranging, • “Growth stocks” sell at high P/E ratios because PVGO is high. • But utilities sell at high P/E ratios because r is low

18. FCF and PV Valuing a Business The value of a business is often computed as the present value of FCF out to a valuation horizon (H). • The value at H is sometimes called the terminal value or horizon value

19. Principles of Corporate Finance Brealey and Myers Sixth Edition • Why Net Present Value Leads to Better Investment Decisions than Other Criteria Slides by Matthew Will, Jeffrey Wurgler Chapter 5 Irwin/McGraw Hill • The McGraw-Hill Companies, Inc., 2000

20. Principles of Corporate Finance Brealey and Myers Sixth Edition • Making Investment Decisions with the Net Present Value Rule Slides by Matthew Will, Jeffrey Wurgler Chapter 6 Irwin/McGraw Hill • The McGraw-Hill Companies, Inc., 2000

21. Topics Covered • What To Discount • IM&C Project • Project Interaction • Timing • Equivalent Annual Cost • Replacement • Cost of Excess Capacity • Fluctuating Load Factors

22. Principles of Corporate Finance Brealey and Myers Sixth Edition • Introduction to Risk, Return, and the Opportunity Cost of Capital Slides by Matthew Will, Jeffrey Wurgler Chapter 7 Irwin/McGraw Hill • The McGraw-Hill Companies, Inc., 2000

23. Measuring Risk

24. Principles of Corporate Finance Brealey and Myers Sixth Edition • Risk and Return Slides by Matthew Will, Jeffrey Wurgler Chapter 8 Irwin/McGraw Hill • The McGraw-Hill Companies, Inc., 2000

25. Security Market Line / CAPM Expected return SML rf Beta 1.0 SML/CAPM: E[ri ] = rf + Bi (E[rm] - rf )

26. Principles of Corporate Finance Brealey and Myers Sixth Edition • Capital Budgeting and Risk Slides by Matthew Will, Jeffrey Wurgler Chapter 9 Irwin/McGraw Hill • The McGraw-Hill Companies, Inc., 2000

27. Company Cost of Capitalsimple approach The overall company cost of capital is based on the weighted-average beta of the individual asset / project betas. The weights in the weighted average are determined by the % of firm value attached to each asset / project. Example: Say firm value is split as: 1/3 New ventures investment (B=2.0) 1/3 Expand existing business investment (B=1.3) 1/3 Plant efficiency investment (B=0.6) Average asset beta = (1/3)*2.0 + (1/3)*1.3 + (1/3)*0.6 = 1.3 This average beta determines the company cost of capital.

28. Risk and DCF:Putting it all together Example Project A is expected to produce CF = $100 mil for each of three years. Given a risk free rate of 6%, a market risk premium of 8%, and an asset beta of .75, what is the PV of the project?

29. Principles of Corporate Finance Brealey and Myers Sixth Edition • Spotting and Valuing Options Slides by Matthew Will, Jeffrey Wurgler Chapter 20 Irwin/McGraw Hill • The McGraw-Hill Companies, Inc., 2000

30. Option Value Determinants of Call Option Price 1 - Underlying stock price (+) 2 - Exercise (“strike”) price (-) 3 - Standard deviation of stock returns (+) 4 - Time to option expiration (+) 5 - Interest rate (+)

31. Black-Scholes • Our examples have just been simple up-or-down movements • In these cases, the binomial method is perfect • In reality, there may be a continuum of outcomes • Black-Scholes formula uses a replicating portfolio • argument to derive European call option value under these circumstances VCall = N(d1)*P- N(d2)*PV(S)

32. Principles of Corporate Finance Brealey and Myers Sixth Edition • Real Options Slides by Matthew Will, Jeffrey Wurgler Chapter 21 Irwin/McGraw Hill • The McGraw-Hill Companies, Inc., 2000

33. Topics Covered • Real Options • Follow-on investments • Abandon • Wait (and learn) • Vary output or production methods • Valuation examples mixed in

34. Principles of Corporate Finance Brealey and Myers Sixth Edition • An Overview of Corporate Financing Slides by Matthew Will, Jeffrey Wurgler Chapter 14.1-14.3 Irwin/McGraw Hill • The McGraw-Hill Companies, Inc., 2000

35. Patterns of Corporate Financing • Two ways to finance investment: • Raise equity or debt (external finance) • Plow back profits rather than distribute them to shareholders (internal finance)

36. Principles of Corporate Finance Brealey and Myers Sixth Edition • An Overview of Corporate Financing Slides by Matthew Will, Jeffrey Wurgler Chapter 14.4 Irwin/McGraw Hill • The McGraw-Hill Companies, Inc., 2000

37. Corporate Debt General features of debt • Borrower (stockholder) promises a certain stream of interest and principal payments • But borrower may choose to default • Lender doesn’t usually have voting rights, but in case of default lender gets assets • Asset administration handled by bankruptcy court

38. Principles of Corporate Finance Brealey and Myers Sixth Edition • The Many Different Kinds of Debt Slides by Matthew Will, Jeffrey Wurgler Chapter 24 Irwin/McGraw Hill • The McGraw-Hill Companies, Inc., 2000

39. Topics Covered • Domestic Bonds and International Bonds • The Bond Contract • Interest, Security, Seniority • Asset-Backed Securities • Repayment/Retirement Provisions • Covenants • Private Placements and Project Finance

40. Principles of Corporate Finance Brealey and Myers Sixth Edition • Warrants and Convertibles Slides by Matthew Will, Jeffrey Wurgler Chapter 22.1-22.3 Irwin/McGraw Hill • The McGraw-Hill Companies, Inc., 2000

41. Warrants Warrant - Right to buy a security (usually shares) from a company at a stipulated price, on or before a stipulated date. - A call option!

42. Convertible Bonds Convertible Bond - Bond that the holder may exchange for a specified amount of another security (usually shares). • Convertibles are thus a combined security, combining a straight bond and a call option • Like bond-warrant combo, except in bond-warrant combo you don’t have to surrender one to get the other: you have both • Example to understand terms: ALZA • 5% Convertible 2006, face value $1000 • Convertible into 26.2 shares • Conversion ratio 26.2 • Conversion price = 1000/26.2 = $38.17 • Market price of shares = $28

43. Principles of Corporate Finance Brealey and Myers Sixth Edition • Valuing Debt Slides by Matthew Will, Jeffrey Wurgler Chapter 23 Irwin/McGraw Hill • The McGraw-Hill Companies, Inc., 2000

44. Topics Covered • The Term Structure • Term Structure Theories • Risk: Duration and Volatility • Risk: Default

45. Principles of Corporate Finance Brealey and Myers Sixth Edition • How Corporations Issue Securities Slides by Matthew Will, Jeffrey Wurgler Chapter 15.2-15.6 Irwin/McGraw Hill • The McGraw-Hill Companies, Inc., 2000

46. Topics Covered • The Initial Public Offering • The Underwriters • Underpricing and “The Winner’s Curse” • General Cash Offers

47. Principles of Corporate Finance Brealey and Myers Sixth Edition • The Dividend Controversy Slides by Matthew Will, Jeffrey Wurgler Chapter 16.1-16.4 Irwin/McGraw Hill • The McGraw-Hill Companies, Inc., 2000

48. M&M Dividend irrelevance • Modigliani & Miller dividend proposition Dividend policy is irrelevant in perfect capital markets

49. M&M Dividend irrelevance • Some key assumptions: • Investment policy held constant • No transaction costs (e.g. repurchasing premium for company, cost of mailing dividend checks) • Dividends and capital gains taxed at same rate • … • If you claim dividends do matter, one or more of these assumptions must be violated. That is the power of the theorem: it clarifies how dividends could matter.

50. Principles of Corporate Finance Brealey and Myers Sixth Edition • Does Debt Policy Matter? Slides by Matthew Will, Jeffrey Wurgler Chapter 17 Irwin/McGraw Hill • The McGraw-Hill Companies, Inc., 2000