CorpFinance Cheat Sheet v2.2
CorpFinance Cheat Sheet v2.2
Cashflow
C
PV =
rg
Discount rate
PV =
1
Growth
rate
(1 + r )t
Potential problem:
multiple IRRs
NPV
r such that
NPV = 0
DFt =
Annuity
(1 + rt )t
IRR
equivalent
annual cost
Project Valuation
EAC
Interest Rates
also known as
break-even rental
(1 + r )(1 + ) = (1 + i )
inflation
r + i
nominal
APR
r = EAR = 1 +
T
effective
RoI
CashOut
1
InitialInvestment
C1 + L + Ct
1
RoI =
C0
RoI =
annual rate
b = plowback ratio
Dividends = E(1-b)
RoE > r : positive growth opportunities
RoE < r : value being destroyed
Market Value
D0 (1 + g )
(RE g )
Dividend
Growth Model
PV (COSTS )
AnnuityFactor
RoE =
Ratios
FCF
Equity FCF
(EFCF)
VE + VD = VA
Corporate
Valuation
Cost = Cash PV (B )
Gain Cost = PV ( AB ) PV ( A) Cash
Cost = x PV ( AB ) PV (B )
Gain Cost = PV ( AB ) PV ( A) x PV ( AB )
Valid Motives
Shareholders are better off
Value Creation
Operating synergies horiz:
market power and vert: market
foreclosure.
Complimentary resource
synergies
Cheaper external financing
Correct management failure
Wealth Transfers
Bondholders to shareholders
Employees to shareholders
(wage concessions)
Customers to shareholders
(market power)
Taxes to shareholders (unused
taxshield)
R D
WACC = R A 1 T D
RTS V
TS = T RD D
Dubious Motives
Agency empire building, larger
companies, prestige, perks, compen.
Diversification declining cash rich
industry. Funds should be returned to
shareholders.
Increase EPS number of shares
traded may not be equal.
PV (TS ) =
VU = VL PV (TS )
Real additional
cashflows from TS
When T=0
T RD D
RTS
R A = RD
D
E
+ RE
V
V
RE = R A +
When RTS
= RA
To UK
$1
+1 year
Back to US
No riskless arbitrage
1
1
(1 + r ) 1 (1 + r )F$
S$
S$
S$
(1 + r$ )
$1
Expected
future
spot rate
(1 + r$ ) = F$
(1 + r ) S$
Estimating
future
forward
rates
) E(S$
)
F$ = E(S$
Purchasing
Power Parity
Bonds
coupon
%
terminal
period
coupon
Zero-Coupon Bonds
Use ZCBs to get r-values for each
year (spot values) when
calculating bond prices if there is
non-flat term structure.
(could use annuity only when
term-structure is flat)
P=
t =1
RE = RA +
PSEMI =
t =1
Forward
Rates
(1 + ) (1 +
rt
F
r2 T
Expected interest
rates in the future $1
(1+ r2 )2
2T
Discount Factor
Interest Rate Term Structure
Graph of YTM for
ZCBs over time
Market
price T
D
E
+ RE
V
V
Only consider
Interest bearing
debt
(1+ 2 r3 )
Taxes Paid
EBT
CAPM
RE = RF + E (RM RF )
Earnings
before tax
+ ST Debt
D = t wt
Bonds &
Fixed Income
t =1
wt =
Duration
The weighted average of the
time taken to get payments
C
F
P=
+
t
(1 + YTM )T
t =1 (1 + YTM )
ZCB Duration
Treasury Securities
Forward Rates
Nomenclature:
r f (0,2,3)
2 3
cashflow
at time t
used
for working capital
it could be used to
pay off debt
holders)
V
r
= D
V
1+ r
ratio of change
in interest rate
Cash
(if cash is not
1 Ct
P (1 + rt )t
ratio of change
in value
Risk Shifting
2 +ve NPV projects with different risk
D fear funds will be allocated to hi-risk
(ltd liability of E means D loses)
D thus require higher RD and no
projects now have +ve NPV
Soln: Debt covenants etc
Tax
Debt
Actual Returns:
Standard Deviation:
i = Ri [RF + i (RM RF )]
[w1 + w2 = 1]
[V (R ) = 2 ]
Leverage
Gearing = Leverage = D/V
D1 , E1
D2 , E2
E1, D1, A1 E 2 , D2 , A2
L=
D1
D
L= 2
V1 w %
V2 w2 %
1
DC , EC , EC , DC , L =
DC
VC
Beta
P = w1 1 + w2 2 + 2w1w2 1, 2
2
Company
Portfolio Theory
wacc
D/V
AC = w1 A1 + w2 A2
RP = w1 R1 + w2 R2
RA
Divisional Leverage
D
E
+ E
V
V
Equity Beta
Variance: V
Abnormal Returns
Modigliani-Miller
MMI Capital Structure Irrelevant
Perfect Capital Markets:
Individuals can borrow at the same
rate as corporations.
No bankruptcy costs / distress costs
No agency problems
Symmetric information
NO TAXES
D
( A D )
E
Typically ~ 5%
Expected Returns:
Efficient Market
Hypothesis
Optimum Leverage
Equity
D = LT Debt
D/E
Can be assumed to
be 0 if debt is risk-free
Notes on FCF
Essentially cash generated before
payment is made to debt holders
E = A +
Debt
VU
A = D
Yield to
Maturity
PV(TS)
PV(TS)-PV(BCFD)-PV(AC)
(1 + r3 )3
3
(1+2 r3 ) = (1 + r3 )2 = DF2
(1 + r2 ) DF3
Debt Overhang
New E raised goes to D shortfall if project
successful. E insures D.
Soln: Issue more D, use E to buy back D,
convertibles
Overinvestment
FCF which should go to D is risked by E on
risky project.
Downside goes to D, upside to E (ltd liability)
= RD
D
( R A RD )
E
RD = YTM on the
debt of the company
Tax Rate
r3
ZCB
Pricing
1
B(0, t ) =
(1 + rt )t
Company Value
Optimum Leverage
RA = RF + A (RM RF )
r2
(1 + rt )t (1 + rT )T
2T
B(0,t) is equivalent to
$1 ZCB for t years
yield
curve
face
P = PV (C ) + PV ( F )
(1 + r$ ) S
(1 + r ) $
P$
P S $ P S $
P
)
E (1 + i$ ) E (S$
E (1 + i )
S$
Price = P(C,T)
WACC = RD (1 T )
P(ExpectedCost )
RBC
D
(RA RD )(1 T )
E
R A RTS RD
Leverage
Interest Rates
PV( BC ) =
RAVU + T RD D = RD D + RE E
= T EBIT T RD D
Difference between
MV and value as
separate entity (PV)
Unlevered
R A RTS RD
Tax Shields
1
FCFT (1 + g )
(1 + WACC )T (WACC g )
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FCF1
FCF2
FCFT
V = FCF0 +
+
+ L+
(1+ WACC) (1+ WACC)2
(1 + WACC)T
Terminal Value
Stock Acquisitions
Gain = PV ( AB ) [PV ( A) + PV (B )]
EBIT (1 T )
( RE g )
[WACC = RA = RE ]
Free Cash
Flows
VE =
MV = PV + P*C
Revenues
Costs
EBITDA (operating income)
Depreciation
EBIT (operating profit)
Interest Expense
Pretax Income
Taxes
Net Income
Dividends (& share buy-backs)
Addition to Retained Earnings
VA VD = VE
(WACC g )
Accounting Statement
=
=
=
=
=
[NOPAT = EBIT (1 T )]
Operating FCF
(FCF)
V=
Net Income
Stockholders Equity
P (1 b )
(1 b )
=
=
E RE g RE RoE b
V / EBITDA
Firm Value
Comprises of value of all
its projects - The present
discounted value of all its
cashflows.
(rate of return)
T
Plowback Ratio
Payback
Equivalent to
perpetuity at time 1 perpetuity at time t
real
Ratios / Perpetuities
Ratios can be equivalent to a
perpetuity resulting in
Ratio = r g
=> beware same assumptions as
DGM
V=
discount
factor
C
C (1 + g )t
PV =
(r g) (r g) (1 + r)t
Cost of capital
Perpetuity
1, 2
= 1, 2 1 2 ]
[ rho]
Correlation
between two
stocks
Risk of
share
Risk of
portfoli
o
I x Rm
Market
risk of
share
Market
risk of
share
p x Rm
Major Part
Specific
risk of
share
Specific
risk of
share
i =
Negligible
mkt
Portfolio Terms
Risk = covariance / correlation
Abnormal Returns
Abnormal returns: i
Ri = RF + i (RM RF )
E ( ARi ) = 0
Market
Risk
Idiosyncratic Risk
Specific Risk
(Diversifiable Risk)
Portfolio Performance
RP
RP
Correlation
rho = -1 (max benefits from
diversification)
-1 < rho < 1 (some benefits
from diversification)
Market Risk
(Systematic Risk)
# Stocks
20
A portfolio of about 20 stocks can diversify
almost all specific risk
0%
100% w1:w2
(Mix)
Risk
(StdDev)
= mean return =
VAR =
1 T
rt
T t =1
1 T
2
(rt )
T t =1
StdDev = SQRT(VAR)
Call Option
S>K = In the money
S=K = at the money
S<K = out of the money
Long Call
C
K
Long Put
P = Max{0, K - S}
St
St
Black-Scholes
1-P%
d1 =
St
P = S N( d1 ) + PV(K ) N( d 2 )
= Long C(X)
+ 2 x Short C(Y)
+ Long C(Z)
= $
K S
+$
K
S
Equity Issues
IPO = Initial Public Offering, a
companys first offering of shares to the
general public.
Primary Shares new shares
issued by company where money
raised is invested in the firm
Secondary Shares insiders selling
stake in company where money
raised goes to the previous owners
SEO = Secondary/Seasoned Equity
Offering, an equity issue by a firm that is
already public.
Pecking Order:
(1) Internal Funds,
(2) Debt, (3) Equity
Underwriters
Investment banks which advise the firm
and provide independent monitoring of
quality of firm to the market.
Also handles:
Roadshows for signalling
considerations and demand
evaluation
Bookbuilding bids during BB
period (~2 weeks) can be revised
and cancelled.
Price and Allocation following BB
period.
Alternatives to BB might be allocations by
auctions, but no discretion to underwriter
on final price and allocations (Google)
UW formally buy shares from firm and sell
to public at higher price.
Various sales models:
Firm commitment all shares (see
Underwriters put)
Best Efforts sale and return
All-or-none
Price premium covers UW responsibility:
Market maker liquidity in first
trading days
Research coverage after IPO
Price premium covers UW risks:
Stabilising prices if they fall below
offer price
Buying unallocated stock
Mitigated by green shoe option
(option to purchase additional ~15%
shares from company at offer price if
demand high within ~30 days of
IPO)
IPO Fees usually a fixed % of the issue
(~7% in US, ~5% in UK, ~3.5% in Europe)
SEO fees about half IPO very varied
Rights fees usually ~2%
Underpricing IPOs (-12% UK, -15.8% US)
UW favour current / potential clients
Signalling/Reputation (future SEO)
Dispersion/Liquidity on lower prices
Attract less informed investors
(mitigating winners curse problem)
Black-Scholes Shorthand
+
+
+
+
Advantages of IPO
Disadvantages of IPO
Costly admin fees (4%) & underwriters fees
Loss of control
Legal reqs. disclosure rules etc
Value of firm subject to external perception
Easier target for hostile takeovers
E0
ET
S0
ST
Value of exercising
a right now
ET = E0 + nK
ST =
FUW
= underwriters fees
V0
W0
Valuing Rights
Black-Scholes Assumptions
V0 < W0
S 0 = ST + V0 i
Options increase
value of the rights
Shareholders are
not bothered
C right owner
K*
ST
P firm
V (S1D )
Full Hedge
F = S0 (1 + r )
V (S1U ) V (S1U F ) = V (F )
V0
1-P%
V (S1D ) V (S1D F ) = V (F )
Futures Swaps
No
Yes
No**
No
High
High***
Low
High
Options
No*
Yes
High
Low
F
(1 + r )T
F = S0 (1 + r )
FD/
holds
bonds
converts
to shares
ET > F
KD =
Discount at RF
Discount at RP
PV0(FCF)
FCFT+1 FCFT+2
S1U
S0
1-P%
S1D
Payout Policy
This is how a firm distributes cash to the
shareholders in one of two ways:
InvT
PV0(inv)
S = Value of project
D = cashflows from project
during period 1
Rf = Risk free rate
P% = chance of going high
(S + D )
(S + D1U )
RP = P% 1U
1 + (1 P%) 1D 1D 1
S0
S0
C = P% max{0, S1U - K}
Cashflows equivalent to
dividends from a stock. When a
projects forecasted cashflows
are sufficiently large the
investment is made right away
(option is called)
Real Options
PV(FCF) PV(Inv)
Abandonment Options
Hedging Instruments
Forwards
Yes
No
Low
High
Tax Clienteles
Investors with different dividend tax treatment
will hold shares of firms with different
dividend-payout ratios.
Underwriters Put
Preferred Stocks
Optimal hedging
Futures
S0 =
C = C BS (S , K , T , R f , )
upside of
investment
V (F )
V0 =
1+ r
FD
Follow-On Investment
Timing Options
V (S1U )
monies raised
by convertible
issue
Real Options
(*) Unless traded OTC, but then they are (much) less liquid.
(**) However they do require a margin account.
(***) Huge demand for swaps makes them extremely liquid.
P underwriter
Cost of carry:
F S0 > 0 Market is in Contango
F S0 < 0 Market is in Backwardation
No Hedge
P%
* F
= max ET D ,0
UP
S1D
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CB = max ET FD ,0
coupons before
*
E0 = E0 PV
PV (dividends)
maturity
E0 = (n S0 ) + (m FB )
P%
Rights issues where K is closer to
ST have higher (W0) option values
since the downside is more limited
(value of a call option decreases
as K is further from S)
RS =
FD
( )
E0 = PV ET
W0 = C BS (E0 , nK , T , R f , )
1-P%
V0 = ST K
WT = max[ET nK ,0]
S0
default
VT = ET + mrK
S1U
FD
KD
E0
E0*
ET *
(1 + R )
f
V0
1
W0 = C BS (E0 FUW , nK , T , R f , )
m
existing
equity
Hedging
1-P%
ET
(n + mr )
P%
Value of option of
exercising a right at
maturity
W = C BS E0 , K D , T , R f ,
V0 = E0 + m (price of warrants)
mr
=
n + mr
d2 d1
ln S
PV(K ) + T
2
T
PV(K ) =
Rights Issue
E0 = S 0 n
C = C BS (S , K , T , R f , )
Payoff
American Options
B(0, K )
(1 + RF )T
P(K ) = C(K )
CB = W + B(C , T )
Need to solve
recursively
[where F = CB
???]
d 2 = d1 T
Incorporating
dividends into BS
P = (S PV(D )) N( d1 ) + PV(K ) N( d 2 )
PV(K ) =
Value of all
warrants
Incorporating
dividends into BS
e.g. Butterfly
St
= S2 D + (1 + RF ) B
n
m
r
FB
FB/r
KB
Equivalent to a package of a:
straight bond + warrant
Derived from
binomial with
infinitely small
periods (and
assumptions)
Put-Call Parity
= S2M + (1 + RF ) B
European Call
option
C1D = S1D + (1 + RF ) B
= S1D + B
C0 = S 0 + B
P%
-X
C(X)
+
P(X)
= S2M + (1 + RF ) B
Convertible Bonds
C1U = S1U + (1 + RF ) B
Binomial Model
Warrants
= S2U + (1 + RF ) B
= S1U + B
V = S + B
Payoff
Profit
If two combinations of
assets have same
cashflows in every period
and every outcome, then
they must have the same
price.
Arbitrage Principle
+ $
C0 = S0 + B
Option
Pricing
Short Put
maturity = expiration
C = Max{0, S - K}
St
American
Can exercise any time up
to (and on) the given
maturity date.
value of
option
St
Option types
European
Can exercise only on
given maturity date
Options
Short Call
Replicating Portfolio
Put Option
S<K = In the money
S=K = at the money
S>K = out of the money
Value of
Convertible (CB)
Terminology
Long = Buy the right to
Short = Sell the right to
Swaps
A swap is an agreement by which 2 parties exchange
cash-flows of 2 securities (without changing their
ownership)
Interest Rate Swap is an exchange of interest
payments on debt (most commonly the coupon swap:
fixed rate with floating rate)
Currency Swap is an exchange of payments in
different currencies.
Interest Rate Swap Example
Assume that the floating coupon is 8% in first
semester and increases 1% every period
The net payments from X to firm Y are
Floating rate
Xs payment
Ys payment
Y pays to X
S1
8%
$5
$4
$1.0
S2
9%
$5
$4.5
$0.5
S3
10%
$5
$5
$0.0
S4
11%
$5
$5.5
-$0.5
Signalling Methods
Dividends: most effective since they set future
commitment.
Shares repurchases with auction: very effective, if the
shares are bought at a premium and management
precommits not to tender (i.e. not selling own stock at
a premium).
Open-market share repurchases: weakest signal.
Shares are bought at their current market price.
50% of announcements do not follow through, and
10% repurchase less than 5% of the value announced.
Stock Splits
Stock Splits: Increasing the number of the
outstanding shares by reducing its nominal value.
Example: In a 2:1 split, investors receive two new
shares in exchange for each old one. The stock price
drops by 50% (no money ever changes hands!).
A rationale for a stock split is that it makes stocks
cheaper for small investors.
However, this liquidity effect is not well supported
by the existing empirical evidence: there is no
significant price response to a stock split.