Investment and Financial Decisions for Doctoral Studies Part 1

1. Investment and financialdecisionsclasses for doctoralstudiesPart 1. Jacek Mizerka Department of Corporate Finance

2. Investment and financialdecisions Investment and financialdecision – importantconcepts in the framework of corporatefinance Corporate finance meansfinancing of a firm—not simply an asset, not simply an individual,but that unique combination of assets and individuals that constitutesa firm.(L. Zingales, In Search of New Foundations, Journal of Finance, The Journal of Finance, no. 4, August 2000) Jacek Mizerka Decyzje inwestycyjne i finansowe

3. WhatisCorporate Finance about? • In a narrowsense, Corporate Finance means a disciplinewhichdeals with a way the activity of a firm (corporation) isfinanced • In a broadsense, Corporate Finance is a disciplinewhichcoversatleastthreeareas: • Capital structure, • Corporategovernance, • Valuation. Jacek Mizerka Decyzje inwestycyjne i finansowe

4. Twoapproaches to Corporate Finance • Normativeapproach – affirmshowthingsshould be and whichactionsaregood and whicharewrongfromthe point of view of thedecisioncriterion. • Descriptive, "disinterested" approach – approach which aims primarily at gathering knowledge (i.e. descriptions and explanations) about financial phenomenabut does not wish to improvedecisionmaking. Jacek Mizerka Decyzje inwestycyjne i finansowe

5. Neoclassical Finance • Predecessor – old finance theorybefore 1958 – inthistheory capital market does not exist; focus on accounting – decisionsmade on thebasis of accountingstatements. • Mainparadigm:capital market isworkingsmoothly. • Decisioncriterion: value of a firm; thanks to thegoodfunctioning of the capital market, thevalue of a company can be deriveddirectlyfromthecashsurplus • Importance of thefirm’svaluecriterion – Fisher’sseparationtheorem Jacek Mizerka Decyzje inwestycyjne i finansowe

6. Neoclassical Finance cont. Fisher’sseparationtheorem Jacek Mizerka Decyzje inwestycyjne i finansowe

7. Neoclassical Finance cont. • What is of particular importance inFisher’s separation theorem: • The wishes or preferences ofowners can be separated from investment decisions and delegated tomanagers. • Whenmaking a decisionconcerning a projectwhichgenerates a positive net presentvalue (NPV), the manager maximizestheowners’ utilityindependently of their own preferences. • Anincreaseinthefirm’svalue (determined by cashflows) = anincreaseinowners’ wealth • It is possible to separate a firm's investment decisions from the firm's financial decisions. Jacek Mizerka Decyzje inwestycyjne i finansowe

8. Neoclassical Finance cont. • Mainconcepts NOPAT • Net PresentValue Free Cash Flow (FCF) = After-tax operating income [EBIT(1-T)] + Depreciation – Capital expenditures (I) ± Change in net operating workingCapital Jacek Mizerka Decyzje inwestycyjne i finansowe

9. Neoclassical Finance cont. • Mainconcepts, cont. • Capital AssetPricing Model where: E(rj) – expectedrate of return on securityj, rf – rate of return on riskfreesecurity, E(rm) – expectedrate of return on securities listed on a capital market cov(rj, rm) – covariancerjand rm, s2(rm) – variancerm E(rj) = rf + bj[E(rm)- rf ]; Jacek Mizerka Decyzje inwestycyjne i finansowe

10. Neoclassical Finance cont. • Mainconcepts, cont. • Fama French 3 Factor Model – supplement to CAPM RPM: difference between returns on a diversified market portfolio and a risk-free return SMB (small minus big): difference between returns on diversified portfolios of small and large capitalization stocks HML (high minus low): difference between returns on diversified portfolios of high and low B/M stocks Jacek Mizerka Decyzje inwestycyjne i finansowe

11. Neoclassical Finance cont. • Mainconcepts, cont. Modigliani&MillerTheory (MM Theory) Basic assumptions: no taxes, all investors have the same information as management Proposition 1 (economy without taxes) The market value of a firm is unaffected by its capitalstructure. Jacek Mizerka Decyzje inwestycyjne i finansowe

12. Neoclassical Finance cont. Jacek Mizerka Decyzje inwestycyjne i finansowe

13. Neoclassical Finance cont. • Mainconcepts, cont. Valuationmethods - remarks Thevalue of a company isdriven by itsability to produceeconomicbenefits for owners and creditors The income approach, generally speaking, is based onfuture expected benefitsdiscounted at the current moment A neccesaryconditionfor applying the income approach - the company should be able to generate benefits to creditors and owners Thebenefitsaremeasured by cashflows Additionalremarks- see P. Fernandez, Valuing Companies by Cash Flow Discounting: 10 Methods and 9 Theories Jacek Mizerka Decyzje inwestycyjne i finansowe

14. Neoclassical Finance cont. • Mainconcepts, cont. Option valuation – Black-Scholes Model Call = Buying D of the Underlying Asset+Borrowing Put = Selling Short D on Underlying Asset + Lending Theinitialversion of Black-Scholes model for calloptionvaluation, ct presentvalue of borrowing Thebasicversion of Black-Scholes model for call (c) and put (p) option where: X - strikeprice e – base for natural logarithm rf– riskfreerate T – time to theexpirationdate of theoption Jacek Mizerka Decyzje inwestycyjne i finansowe

15. Neoclassical Finance cont. • Mainconcepts, cont. Optionvaluation – Black-Scholes Model, cont. N(d1), N(d2) – cumulativedistributionfunctioninpointsd1 i d2respectively. where: • – standard deviation of an underlyingasset. Put- callparity: Jacek Mizerka Decyzje inwestycyjne i finansowe

16. Option’s value 0 Strike price Value of an underlying asset CallOption (right to buy) Total value of an option Intrinsic value of an option Jacek Mizerka Decyzje inwestycyjne i finansowe

17. Option’s value 0 Strike price Value of an underlying asset Putoption (option to sell) Intrinsic value of an option Total value of an option Jacek Mizerka Decyzje inwestycyjne i finansowe

18. Neoclassical Finance cont. • Mainconcepts, cont. Determinants of an option value • Value of an underlyingasset:if, the right to buy at a fixed price(calls) will become more valuable, and the right to sell at a fixed price (puts) willbecome less valuable. • Variance in that value:if, both calls and puts will becomemore valuable because all options have a limited downside and depend upon pricevolatility for upside. • Expected dividends on the asset, which are likely to reduce the price appreciationcomponent of the asset, reduce the value of calls and increase the value of puts. • Strike Price of Options: if , the right to buy (sell) at a fixed price becomes less (more)valuable. • Life of the Option; both calls and puts benefit from a longer life. • Interest Rates; if rates, the right to buy (sell) at a fixed price in the future becomes more (less) valuable. Jacek Mizerka Decyzje inwestycyjne i finansowe

19. Neoclassical Finance cont. • Mainconcepts, cont. Main differences between DCF methods and option valuation models • DCF methodswhich are based on the expectedvalues ​​of cash flowsinsomecases do not adequatelycaptureuncertainty. Theincreaseinrisk (volatility) isregarded as a threat risk (σ) ↑ => discountrate ↑ => V (on thebasis of DCF) ↓ As part of theoptionapproach, theincreaseinriskistreated as an opportunity(chance) risk (σ) ↑ => value of an option ↑ • The essence of options is that they include flexibility in decision makingwhilethe DCF methods do not takeflexibilityintoaccount Jacek Mizerka Decyzje inwestycyjne i finansowe

20. Neoclassical Finance cont. • Mainconcepts, cont. Cox-Ross-Rubinstein (binomial) model • Calculation of arbitrageprobabilities where: V0 - presentvalue of an underlyingasset; Vincrease, Vdecrease– valueof underlyingasset in the next period assuming increase(decrease) in the asset’svalue, rf-- riskfreerate Jacek Mizerka Decyzje inwestycyjne i finansowe

21. Neoclassical Finance cont. • Mainconcepts, cont. Cox-Ross-Rubinstein (binomial) model, cont. • Calculation of theintrinsicvalue of an option c(V)i,T= c(V)intrinsic,i,T=max(Vi,T-X;0); i=1…nT(No. of nodes in binomiallattice in period T), T- no. of years to the expirationdate, X – strikeprice • Calculationof thetotalvalue of an option Jacek Mizerka Decyzje inwestycyjne i finansowe

22. Neoclassical Finance cont. • Mainconcepts, cont. Real optionsapproach Disadvantages of NPV • NPV is based on the values ​​of expected cash flows.NPV does not sufficiently take uncertaintyinto account. • NPV does not allowusto operatewith time;the set of possible alternativesislimited to: yesorno. • NPV does not sufficiently take into account the fact that investments are at least partially irreversible. There is an analogy between investment projects and financial options Investment projectscan be identified and valued as options Jacek Mizerka Decyzje inwestycyjne i finansowe

23. Investment Calloption Cash flowgenerated by a project Value of an underlyingasset Volatilty of an underlyingasset Cash flow’svariability (volatilty) Investment (capital) expenditure Strikeprice Expiration time of an investment Expiration time of an option Riskfreerate Neoclassical Finance cont. • Mainconcepts, cont. Real optionsapproach Investment treated as a calloption Riskfreerate Net PresentValue - NPV Intrinsicvalue of an option Jacek Mizerka Decyzje inwestycyjne i finansowe

24. Neoclassical Finance cont. • Mainconcepts, cont. Real optionsapproach Expanded NPV (ENPV) = NPV + optionsvalues + (-) value of interdependenciesbetweenparticularoptions Maindifferencebetween NPV and realoption In thediscountedexpectedcashflowapproach, an inrcreaseinvolatility of cashflowsmeans a higherrisk, whichcauses a decreasein NPV In theoptionapproach, an increaseinvolatilitycauses an increaseintheoption’svalue. According to theoptionapproach, a highervolatilityistreated as a higherchance. Jacek Mizerka Decyzje inwestycyjne i finansowe

25. Neoclassical Finance cont. • Mainconcepts, cont. Real optionsapproach Problemswiththeapplication of realoptions: • Many sources of risk, • Theassumptionsconcerning market completenessare not fulfilled, • Lack of twin security, • Advancedmathematicalmethodsused for valuation. Jacek Mizerka Decyzje inwestycyjne i finansowe

26. Moving away from complete market assumptions, cont. Equity as a calloption Stockholders and bondholders have different objective functions, whichcan lead to agency problems, where stockholders can expropriatewealth from bondholders. The conflict can manifest itself in a number of ways - for instance,stockholders have an incentive to take riskier projects thanbondholders do, and to pay more out in dividends than bondholderswould like them to. This conflict between bondholders and stockholders can be illustrated dramatically using the option pricing model.Since equity is a call option on the value of the firm, an increase in thevariance in the firm’s value, other things remaining equal, will lead to anincrease in the value of equity. It is therefore conceivable that stockholders can take risky projects withnegative net present values, which, while making them better off, maymake the bondholders and the firm less valuable. Jacek Mizerka Decyzje inwestycyjne i finansowe

27. Equity=option’s value 0 Value of debt = strike price Value of firm as a whole = value of an underlying asset Moving away from a complete market assumptions, cont. Total value of firm’sequity = option’s total value Intrinsic value of firm’s equity = intrinsic option’s value Jacek Mizerka Decyzje inwestycyjne i finansowe

28. Moving away from a complete market assumptions, cont. An example Underlyingasset: Presentvalue of Company X as a whole: 10 000 thous. PLN Strikeprice: Presentvalue of debt: 11 000 thous. PLN Option’svalue: Value of equity of Company X: ? Assumptions: • (yearlyvolatility) = 20%, No. of years to theexpirationdate (finaldate of debtrepayment) – T = 2, Riskfreerate (yearly)- rf = 5% c0(V)= Presentvalue of equity of Company X (on thebasis of theBlack-Scholes model) = ca PLN1.146 million Jacek Mizerka Decyzje inwestycyjne i finansowe

29. Thankyou for yourattention! Jacek Mizerka Decyzje inwestycyjne i finansowe