Principles of finance

Chapter 1: Introduction to corporate finance:

Definitions:
Corporation: A form of a business operation with public ownership. The owners are not
involved in the decision making and management.
Corporate Finance: Is concerned with how businesses fund their operations to maximize
profits and minimize costs. It deals with:
 Capital budgeting: investment decisions  how to select the right project (based on
net present value).
 Source of capital: Financing decision  debts (private loans) / IPO (issuing bonds) /
SEO (equity).
 Working capital management: Managing of cash-inflows/outflows.

- Current assets: All assets that are expected to be converted to cash within 1 year
(inventories, Cash and cash equivalents, Accounts receivable, marketable
securities…)
- Fixed assets: LT asset (lifespan>1) that are bought to generate income and are not
easily convertible into cash (property, equipment, goodwill…)
- Current liabilities: Company’s ST financial obligations that are due within 1 year.
- LT Debt: Matures in more than one year.
- Shareholders’ equity / Net worth: Corporation’s owners’ residual (leftover) claim on
assets after debts have been paid.
A debt is a promise to repay a fixed amount by a certain date. The shareholder’s claim on
firm value is the residual amount that remains after the debtholders are paid.
If Value of the firm < promised amount to debtholders  shareholders get nothing.
To create value: Smart investment decisions + smart financing decisions.
* In a start up the CEO can also be the COO and the CFO at the same time.
* The corporate form of business is the standard way of solving the problems of raising large
amounts of cash.

The types of firms:

* 1st time: taxes paid when profits are made (corporate level) / 2nd time: on dividends
Financial markets: a place where money is raised and shared are traded.
First, the company gain money from its issued securities on the financial markets. Then, the
company does investments. And finally, the company generates some cash-flows used to
pay taxes for the government, dividends, and debts and then, it retains a part of these cash-
flows.

Goals of Corporate Firms: Maximize shareholder’s wealth.

Ownership VS Control:
Board of directors are elected by shareholders and have ultimate decision-making authority.

Debtholders are not holders. While the

loans outstanding, the lenders put some
conditions to make sure the company
will pay back its debts.

Different goals (managerial/shareholder): ↗ Growth and size of company ≠ ↗ Shareholder wealth.

Ex: Expensive perquisites, survival, independence. Managers can waste corporate resources
(maybe for personal reasons) or engage in empire building (Acquisitions of other
companies).
The Set-of-contracts Perspective: The managers will usually act in the shareholders’
interests. The shareholders can monitor the managers’ behavior. (Costs)
The Agency Problem:
Will the managers work in the shareholders’ best interest? It could be the case due to:

 Managerial compensation (Contracts constructions)

 Reputational concerns/jobs prospects (this may provide market discipline to the
managers)
 Control of the firm (If the managers fail to maximize share price, they may be
replaced in a hostile takeover)
Stakeholders and CSR:
Often, corporate decisions that increase the value of the firm’s equity benefit other parties
(Employees, customers, suppliers, community, environment,…) with an interest in the firm’s
decisions as well.
Regulation:
 Registration of securities issues
 Disclosure of relevant information by corporations to existing and potential investors
 Restrictions on insider trading
 Accuracy of financial statements

Chapter4: Discounted Cash Flow Valuation:

The one-period case:
Future Value: The total amount due at the end of the investment.

In the one-period case, the formula for FV can be written as: FV = C0 × (1 + r)

Where C0 is cash flow at date 0 and r is the appropriate interest rate.
Net Present Value: The present value of the expected cash flows, less the cost of the
investment.

In the one-period case, the formula for NPV can be written as: NPV= PV – Cost
The timeline: Is a linear representation of the timing of potential cash flows. Drawing it will
help visualize the financial problem.
 Inflows are positives cash flows
There are 2 types of cash flows 
 Outflows are negative cash flows

The Multiperiod Case:

Future value: The general formula can be written as: FV = C0 × (1 + r)T

This operation is called “compounding”

Present value and Discounting:

To find the present value of a stream of cash flows, we add up the present values of each.

Finding the period:

Finding the rate:

 Compounding Periods:

Effective Annual Interest Rates:

It’s the annual rate that would give the same end-of-investment wealth after n years.

Back to the
example:

So investing at 12,36% compounded annually is the same as investing at 12% compounded

semiannually.

Compounding Frequencies:
The EAR increases with the frequency of compounding.

Continuous Compounding:
Formula: FV = C0 × erT

Simplifications:
 Perpetuity: A constant stream of cash flows that lasts forever.

The formula of the present value of a perpetuity is: PV=C/r

Example: What is the value of a British consul that promises to pay £15 each year, every
year until the sun turns into a red giant and burns the planet to a crisp? The interest rate is
10-percent.

 Growing perpetuity: A stream of cash flows that grows at a constant rate forever.

g = Growth rate

The formula for the present value is: PV=C/(r-g)

When g>r the formula doesn’t work because you get an infinitely large number. It’s not
sustainable.
Example: The expected dividend next year is $1.30, and dividends are expected to grow at
5% forever. If the discount rate is 10%, what is the value of this promised dividend stream?

 Annuity: A stream of constant cash flows that lasts for a fixed number of periods.

Formula for present value: PV =C /r [1−1/(1+r )T ]

Formula for future value: FV =C /r [(1+r )T −1]

Example: If you can afford a $400 monthly car payment, how much should the car cost if
interest rates are 7% on 36-month loans?

2 types of annuity: (see notes)

- Ordinary annuity: CF come at the end of the period
- Annuity due: CF come at the start of each period
 Growing annuity: A stream of cash flows that grows at a constant rate for a fixed
number of periods.
Formula for the present value: P V =C /(r −g) [1−(( 1+ g)/(1+ r))T ]
Formula for the future value: FV =PV (1+r )T
Example: You want to begin saving for your retirement. You plan to contribute $12,000 to the
account at the end of this year. You anticipate you will be able to increase your annual
contributions by 3% each year for the next 45 years. If your expected annual return is 8%, how
much do you expect to have in your retirement account when you retire in 45 years?

Loan Amortization:
 The process of providing for a loan to be paid off by making regular principal
reductions.
Example: Construct an amortization schedule for a $1,000, 10% annual rate loan with 3
equal payments.

 Constant payments

 Declining interest payments

 Declining balance

Example: Loan Amortization Schedule: $100000 at 6% for 5 years:

Firm Worth:
 A firm should be worth the present value of its cash flows.

Chapter 8: Interest Rates and Bond Valuation:

Bonds and Bond Valuation:
Definition: A bond is a fixed income instrument that represent an agreement between an
investor/lender (bondholder) to a borrower (bond issuer). It’s an interest-only loan with the
principal repaid at the end of the loan.
 Face (or par) value: the amount repaid at the end of the loan
 Coupon payment: promised interest payment
 Coupon rate: annual coupon divided by the face value
 Maturity date: final repayment date
 Time to maturity: the number of years remaining until the repayment date
 Yield to maturity: the current interest rate in the market for similar bonds
Bond valuation: First, we identify the size and timing of cash flows. Then we discount at the
correct discount rate.
 If the face value, the size, and the timing
of cash flows (coupons) are known, the
YTM is the discount rate.

Valuing a Discount Bond with Annual

Coupons:

Dynamic Behavior of Bond Prices:

Finding the YTM with Semiannual Coupons:

Interest Rate Risk:

 It’s the risk that arises for bond owners from fluctuating interest rates.
 The price of the bond is sensitive to interest rate risk.
All other things being equal
 The longer the time to maturity, the greater the interest rate risk. (We don’t know
what could happen in such a long time)
 The lower the coupon rate, the greater the interest rate risk
 The lower the coupon rate, the greater the price of the bond
Current Yield / Yield to Maturity:

Tell the investors what they would earn if

they buy a bond and hold it for one year

Example: We are still looking at the 10% coupon bond, with semiannual coupons and 20
years to maturity, that has a face value of $1,000, but is selling at a price of $1,197.93.
◦ Current yield = 100 / 1,197.93 = .0835 = 8.35%
◦ Price in one year, assuming no change in YTM = 1,193.68
◦ Capital gain yield = (1,193.68 – 1,197.93) / 1,197.93 = -.0035 = -.35%
◦ YTM = 8.35% – .35% = 8%, which is the same YTM computed earlier.

Bond Pricing Principles:

- Bonds of similar risk (and maturity) will be priced to yield about the same return,
regardless of the coupon rate.
- If we know the price of one bond, you can estimate its return and use that to find
the price of the second bond.
Zero Coupon Bonds: (Or pure discount bond) Does not make coupon payments and always
sells at a discount.

Example: Find the value of a 30-year zero-coupon bond with a $1,000 par value and a
YTM of 6%.

Government and Corporate Bonds:

- Treasury Securities - Municipal Securities
 Federal government debt  Debt of state and local
 T-bills – pure discount bonds with original governments
 Varying degrees of default
maturity of one year or less
risk, rated similar to
 T-notes – coupon debt with original maturity
corporate debt
between one and ten years  Interest received is tax-
 T-bonds – coupon debt with original maturity exempt at the federal level
greater than ten years
After-tax Yield Comparison:
A taxable bond has a yield of 8%, while a municipal bond has a yield of 6%.
 If you are in a 40% tax bracket, which bond do you prefer?
8% × (1 – .4) = 4.8%
The after-tax return on the corporate bond is 4.8%, compared to a 6% return on the
municipal bond.
 At what tax rate would you be indifferent between the two bonds?
8% × (1 – T) = 6%
T = 25%
Bond Markets :
 Primarily over the counter transactions with dealers connected electronically
 Large number of bond issues, but low daily volume in single issues
 Getting up-to-date prices on individual bonds can be difficult
 Treasury securities are an exception
Clean vs Dirty Prices
If the bond is purchased between coupon payment dates, the price paid is more than
the quoted price.
 The quoted price is called the clean price
 The price actually paid is called the dirty price (full/invoice price)
Inflation and Interest Rates:
 Real rate of interest – change in your purchasing power.
 Nominal rate of interest – quoted rate of interest, e.g. percentage change in the number of
dollars you have.
 The ex-ante nominal rate of interest includes our desired real rate of return plus an
adjustment for expected inflation.

The Fisher Effect: Defines the relationship between real rates, nominal rates, and inflation.

Example: If we require a 10% real return, and the expected inflation rate is 8%, what is the nominal
rate?
 R = (1.1) × (1.08) – 1 = .188 = 18.8%
 Approximation: R = 10% + 8% = 18%
Because the real return and expected inflation are relatively high, there is significant
difference between the actual Fisher Effect and the approximation.
Determination of Bond Yields:
Term structure of interest rates is the relationship between short- and long-term interest
rates.
Yield Curve: Graphical representation of the term structure
Normal – Upward-sloping: Long-term Inverted – downward-sloping: Long-term
yields are higher than short-term yields yields are lower than short-term yields

Factors affecting Bond Yields:

 Default risk premium: When investors demand higher yield as compensation for
credit risk
 Taxability premium: When investors demand extra yield as compensation for
unfavorable tax treatment
 Liquidity premium: Less liquid bonds will have higher yields than more liquid bonds
 Anything else that affects the risk of the CF to the bondholders will affect the
required returns
Summary:
Chapter 9: Stock valuation:
The present value of common stocks:
Valuation of different types of stocks:
 Zero Growth:
In this case, dividends will remain at the same level forever: Div 1=Div2=Div3=…=Divn
Since future CF are constant, the value of a zero-growth stock is the present value of a
perpetuity:

Example: ABC Corp. is expected to pay $0.75 dividend per annum, starting a year from
now, in perpetuity. If stocks of similar risk earn 12% annual return, what is the price of a
share of ABC stock?
The stock price is given by the present value of the perpetual stream of dividends:

 Constant Growth:
 Dividends will grow at a constant rate g forever:

Since future cash flows grow at a constant rate forever, the value of a constant growth stock
is the present value of a growing perpetuity:

Example: XYZ Corp. has a common stock that paid its annual dividend this morning. It is
expected to pay a $3.60 dividend one year from now, and following dividends are
expected to grow at a rate of 4% per year forever.
If stocks of similar risk earn 16% effective annual return, the price of a share of XYZ stock
is:

 Differential growth:
Dividends will grow at different rates in the foreseeable future and will grow at a constant
rate thereafter.
To value the differential growth stock, we:
- Estimate future dividends in the foreseeable future.
- Estimate the future stock price when the stock becomes a Constant Growth Stock
(case 2).
- Compute the total present value of the estimated future dividends and future stock
price at the appropriate discount rate.

Assume that dividends will grow at rate g1 for N years and grow at rate g2 thereafter:

We can value this as the sum of an Plus the discounted value of a perpetuity
N-year annuity growing at rate g1 growing at rate g2 that starts in year N+1
Example: A common stock just paid a dividend of $2. The dividend is expected to grow at 8%
for 3 years, then it will grow at 4% in perpetuity.
If stocks of similar risk earn 12% effective annual return, the stock worth is:

Limitations of the dividend discount model:

 Uncertainty associated with forecasting a firm’s dividend growth rate and future
dividends
 Small changes in the dividend growth rate can lead to large changes in the stock
price
Estimates of Parameters in the Dividend Discount Model:
The value of a firm depends upon its growth rate and its discount rate
- Where does g come from?
The firm experiences earnings growth when its ne investment (Total investment –
depreciation) is positive.
To grow, the firm must retain some of its earnings

Dividing both sides by the year’s earnings:

g = Retention ratio x Return on retained earnings

The return on retained earnings can be estimated using the firm’s historical return on equity
(ROE)
Example: Ontario Book Publishers (OBP) just reported earnings of $1.6 million, and it plans
to retain 28-percent of its earnings.
If OBP’s historical ROE was 12-percent, the expected growth rate for OBP’s earnings is:

Or,

- Where does R come from?

From the constant growth case, we can write:

The discount rate can be broken into two parts.

◦The dividend yields
◦The growth rate (in dividends)

Example: Manitoba Shipping Co. (MSC) is expected to pay a dividend next year of $8.06 per
share. Future Dividends for MSC are expected to grow at a rate of 2% per year indefinitely.
If an investor is currently willing to pay $62.00 per one MSC share, its required return for
this investment is:

Growth opportunities:
 Are opportunities to invest in positive NPV projects.
The value of a firm can be conceptualized as the sum of the value of a firm that pays out
100% of its earnings as dividends and the NPV of the growth opportunities.

The Dividend Growth Model and the NPVGO Model:

There are 2 ways to value a stock:
 The dividend discount model:

 The price of a share of stock can be calculated as the sum of its price as a cash cow
plus the per-share value of its growth opportunities.

Example: Consider a firm that has EPS of $5 at the end of the first year, a dividend-payout
ratio of 30-percent, a discount rate of 16-percent, and a return on retained earnings of 20-
percent.
 The dividend at year one will be 5$ x 0,30 = 1,50$ per share
 The retention ratio is 0,70 (1-30%), implying a growth rate in dividend of
0,70x20%=14%
 The price of a share is:

For the NPVGO model, we must first calculate the value of the firm as a cash cow

Second, we must calculate the value of the growth opportunities:

Finally, P0 = 31.25 + 43.75 = 75$

Dividend vs Investment and Growth:
A firm can do one of two things with its earnings:
 It can pay them out to investors.
 It can retain and reinvest them.
To increase the share price, should a firm cut its dividend and invest more, or cut investment
and increase its dividend?
 The answer depends on the profitability of the firm’s investments.
 Increase investment will raise the stock price only if the new investments have
positive NPV
Comparables:
Comparable firms are assumed to have similar multiples.
Many analysts relate earnings per share to price
The price-to-earnings ratio is calculated as current stock price divided by annual EPS and is a
function of three factors:
- Growth opportunities. Companies with significant growth opportunities are likely to
have high PE ratios.
- Risk. Low-risk stocks are likely to have high PE ratios.
- Accounting practices. Firms following conservative accounting practices will likely
have high PE ratios.
Stock valuation with PE Ration: Best Buy Co. Inc. (BBY) has earnings per share of $2.22. The
average PE of comparable companies’ stocks is 19.7.
What is the value of Best Buy’s stock using the PE ratio as a valuation multiple?

 The share price for Best Buy is estimated by multiplying its earnings per share by the
P/E of comparable firms  P0 = $2.22 ×19.7 = $43.73
Other Price Ratio Analysis:
Price can be related to variables other than earnings per share:
 Price/Cash Flow Ratio
 Cash flow = net income + depreciation = cash flow from operations or operating cash
flow
 Price/Sales Ratio
 Current stock price divided by annual sales per share
 Price/Book (Market-to-Book Ratio)
 Price divided by book value of equity, which is measured as assets –liabilities
Enterprise Value Ratios:
Practitioners often use ratios involving both equity and debt. The most common is the
enterprise value (EV) to EBIDTA ration  EV = Market value of equity + Debt –Cash
As with PE ratios, similar firms have similar EV/EBIDTA ratios.
Valuing the Entire Firm:
The stock markets:
 Primary Market: When a corporation issues and sells securities to investors, cash
flows from investors to the firm.
  Secondary Market: Involves the sale of “existing” shares from an investor to another.
And securities may be exchange-traded or traded over the counter in a dealer
market.
Organization of Stock Exchange:
Dealers and Brokers; New York Stock Exchange; …
Exchange members must purchase trading licenses to be able to buy and sell securities.
Three types of license holders:
 Designated market makers
 Floor brokers
 Supplemental liquidity providers
Operations; Floor Activity; …
NASDAQ: Not a physical exchange –computer-based quotation system
 Multiple market makers

 Three levels of information access:

 Level 1 –freely available over the Internet

 Level 2 –view inside quotes, brokers & dealers

 Level 3 –view and update quotes, dealers only

 Large portion of technology stocks

 Electronic Communications Networks

Summary:

Chapter 10: Risk & Return: Lessons from Market History:

Returns
 Dollar Returns: The sum of the cash received and the change in value of the asset
  Cash coming in the form of dividend + cash of the sale of stock
 Percentage Returns: Dollar returns divided by the original investment.
 Dividend yield + Capital gains yield

Example: Suppose you bought 100 shares of BCE one year ago today at $25. Over the last
year, you received $20 in dividends (= 20 cents per share × 100 shares). At the end of the
year, the stock sells for $30. How did you do?
 Quite well. You invested $25 × 100 = $2,500. At the end of the year, you have stock
worth $3,000 and cash dividends of $20. Your dollar gain was $520 = $20 + ($3,000 –
$2,500).
520
 Your percentage gain for the year is: =20.8 %
2500
 Dividend yield 0.8%
 Capital gain 20%

Holding Period Returns

It’s the return that an investor would get when holding an investment over a period of n
years. The return during year i is given as Ri

Example: Suppose your investment provides the following returns over a four-year period:

An investor who held this investment would have actually realized an annual return of
9.58%:
So, our investor made 9.58% on his money for four years, realizing a holding period return
of 44.21%.

Note that the geometric average is not the same thing as the arithmetic average:

 Geometric average gives the average compound return per year over a particular
period.
 Arithmetic average gives the return in an average year over a particular period .

Return Statistics:

 The average return:

 The standard deviation of returns:

 The frequency distribution of returns:

Risk Statistics:
Risk measurements: variance and standard deviation
Average Stock Returns and Risk-free Returns:
The risk premium: The additional return resulting from bearing risk
 Rate of return on T-bills is essentially risk-free.
 Investing in stocks is risky, but there are compensations.
  The difference between the return on T-bills and stocks is the risk premium for
investing in stocks.

Chapter 11: Return & Risk - CAPM:

Individual securities:
The characteristics of individual securities that are of interest to us are:
 Expected Return
 Variance and Standard Deviation
 Covariance and Correlation
Expected Return, Variance and Covariance:
Consider 2 risky asset. In 3 states of economy, there is a 1/3 chance of each one of them,
and the only assets are a stock fund and a bond fund.

 The expected return is the probability times the rate of return:

 The squared deviation is the square of the difference of the Rate of return and the
expected return: (-7% - 11%)2 = 3.24%
 The variance is the sum of the squared deviations divided by 3
 The standard deviation is the square root of the variance
Covariance and Correlation: Measure the relationship between the return on one security
and the return on another.
If the two returns are positively related to each other, they will have a positive covariance
(and correlation); if negatively – the covariance will be negative.
The correlation is always between +1 and -1.

Examples of different correlation coeafficients:

The Return and Risk for Portfolio:

Note that stocks have a higher expected return and thus, a higher risk.
Let us turn now to the risk-return tradeoff of a portfolio that is equally invested in bonds and stocks.
(50% in bonds and 50% in stocks)

The rate of return on the portfolio in each state of the economy is a weighted average of the returns
on the stocks and bonds in the portfolio:
The variance of a portfolio composed of two risky assets is:

We observe a decrease in risk that diversification offers!

 An equally weighted portfolio has less risk than stocks or bonds held in isolation.

The Efficient Set for Two Assets:

Portfolio Risk and Return Combinations

Return

Risk
Opportunity Sets for Two-Securiity Portfolios with Various Correlations:

Diversification:
Annoucements and news contain both an expected component and a surprise component. It is the
surprise component that affects a stock’s price and therefore its return.
 Realized returns are generally not equal to expected returns.
 Total Return = Expected returns + unexpected return
 Unexpected return = Systematic portion + unsystematic portion
Risk: Systematic and Unsystematic:

 A systematic risk is any risk that affects a large number of assets, each to a greater or lesser
degree. (Changes in GNP, inflation, interest rates, etc)
 An unsystematic risk is a risk that specifically affects a single asset or a small group of assets.
(Labor strikes, shortages of supplies, competitor’s release of new product, unexpected death
of CEO,…)

Diversification can
eliminate some, but not all
of the risk of individual
securities. There is a
minimum level of risk that
cannot be diversified
away, and that is the
systematic portion.
The efficient Set for Many Securities:

Consider a world with

many risk assets. We can
still identify the
opportunity set of risk-
return combinations of
various portfolios.

Given the opportunity

set, we can identify the
minimum variance (MV)
portfolio.

The section of the

opportunity set
above the
minimum variance
portfolio is the
efficient frontier.

Riskless Borrowing and Lending:

In addition to stocks and

bonds, consider a world
that also has risk-free
securities like T-bills.
Now investors can
allocate their money
across the T-bills and an
optimal risky portfolio
Market Equilibrium:

With the capital allocation

line identified, all investors
choose a point along the line
some combination of the
risk-free asset and the
market portfolio ( M)M). In a
world with homogeneous
expectations, M is the same
for all investors.

The Separation Principle:

The Separation Property

states that the market
portfolio, M, is the same
for all investors they can
separate their risk
aversion from their choice
of the market portfolio.

Investor risk aversion is

revealed in their choice of
where to stay along the capital
allocation line not in their
choice of the line. The main
point is that all investors have
the same CML because they all
have the same optimal risky
portfolio given the risk-free
rate.

Optimal Risky Portfolio with a Risk-Free Asset:

Note that the optimal

risky portfolio depends
on the risk-free rate as
well as the risky assets.

2
Definition of Risk when Investors Hold the Market Portfolio:
Researchers have shown that the best measure of the risk of a security in a large portfolio is the beta
β of the security.
Beta measures the responsiveness of a security’s return to movements in the market portfolio.

Estimating β with Regression:

Relationship between Risk and Expected Return (CAPM)

Expected return on the market: Expected return on an individual security:

This formula is called the Capital Asset Pricing

Model: Assume bi = 0, then the expected
return is RF.

Assume bi = 1, then

Relationship between Expected Return and Beta of the Security:

.