Advanced Corporate Finance

💼Advanced Corporate Finance Unit 1 – Corporate Finance Fundamentals

Corporate finance focuses on maximizing shareholder value through investment, financing, and dividend decisions. Key concepts include agency theory, asymmetric information, and signaling theory, which address conflicts between managers and shareholders. Financial statements provide crucial information for analysis. The balance sheet shows assets and liabilities, the income statement reports revenues and expenses, and the cash flow statement tracks cash movements. Ratio analysis helps assess a company's financial health and performance.

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=FV(1+r)nPV = \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)nFV = 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[1(1+r)nr]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=PMTrPV = \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(Ri)=Rf+βi[E(Rm)Rf]E(R_i) = R_f + \beta_i[E(R_m) - R_f]
    • RfR_f is the risk-free rate, βi\beta_i is the security's beta (sensitivity to market movements), and E(Rm)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=t=0nCFt(1+r)tInitial InvestmentNPV = \sum_{t=0}^n \frac{CF_t}{(1+r)^t} - Initial\ Investment
    • CFtCF_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=t=0nCFt(1+IRR)tInitial Investment0 = \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=PV of future cash flowsInitial investmentPI = \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=wdrd(1T)+wereWACC = w_d r_d (1-T) + w_e r_e
    • wdw_d and wew_e are the weights of debt and equity in the capital structure, rdr_d is the cost of debt, rer_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: rd(1T)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: re=Rf+βe[E(Rm)Rf]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=Dividends per shareEarnings per shareDividend\ 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=Annual dividend per shareCurrent stock priceDividend\ 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=t=1FCFFt(1+WACC)tEnterprise\ 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: P0=D1regP_0 = \frac{D_1}{r_e - g}
    • P0P_0 is the current stock price, D1D_1 is the expected dividend per share next year, rer_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=Current stock priceEarnings per shareP/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


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© 2024 Fiveable Inc. All rights reserved.
AP® and SAT® are trademarks registered by the College Board, which is not affiliated with, and does not endorse this website.