Corporate Finance

Corporate Finance Everything….. R Srinivasan

Corporate Finance • Valuation and Cost of capital • Capital budgeting • Capital structure, financing and dividend policy • Working capital

Valuation • Generalised valuation Arbitrage and value additivity • Patterns Level perpetuity Growing perpetuity Level annuity Growing finite cash flow

Valuation Growing finite [t years] cash flow C1/(r-g){1-(1+g)t/(1+r)t}

Valuation • Compounding intervals (1+r/m)m-1 Continuous compounding • Stated and effective rates • Nominal and real rates 1+rnominal=(1+rreal)(1+inflation rate)

Valuation: Straight Bonds • YTM • Duration Sensitivity of value to changes in interest rates [1*PV(C1)/V]+[2*PV(C2)/V]+[3*PV(C3)/V] V/V = (1+r)/(1+r)*D

Valuation: Common Stock • Perpetual growth models Sustainable growth P0=No-Growth +PVGO No-growth =EPS1/r PVGO=NPV1/(r-g) where NPV1 =-INV1 +INV1*ROE/r g=Ploughback*ROE EPS1/P0 interpretation

Valuation • Multiple stages Supernormal stage plus PV of normal growth • Free cash flow NOI approach

Cost of Capital • Security return and standard deviation • Portfolio return and standard deviation • Diversification Portfolio variance= 1/N Average Var+(N-1)/N Average covariance • Systematic and unsystematic risk • CAPM • Opportunity cost of capital r [rA]and Adjusted cost of capital r*

Cost of Capital 1. VL = VU +Tc *D 2. WACC = D/V * (1-Tc) * rD+E/V * rE [Definition of WACC] 3. rE = rA + (rA - rD ) * (1- Tc) * D/E [MM Proposition II] 4. bE = {1+ (1- Tc) * D/E} *bA [If debt is risk free] 5. rE = rf + (rM - rf) *bE[CAPM] 6. WACC= rA *(1- Tc * D/V) MM

Valuation • Contingent cash flow Call/Put American/European Binomial Black-Scholes Underlying asset price, Exercise Price, Risk-free rate, Volatility, Time

Capital Budgeting • NPV and IRR not payback and accounting rate of return • Accept/reject single project use NPV or IRR, unless no/multiple IRR • Mutually exclusive projects: Same life and risk Use NPV [or IRR of difference between projects]

Capital Budgeting • Mutually exclusive projects: Different lives same risk Use NPV-assumes replacement projects have zero NPV. OK for projects with long lives Use NPV-with specific replacements that make project with comparable lives Use replacement chain or EAC Care: Use only real cash flows for EAC

Capital Budgeting • Incremental nominal cash flows with empirically measured discount rate • Components of cash flow Investment in fixed assets, salvage value Investment in working capital, release Operating revenues/expenses NO INTEREST

Capital Budgeting • NPV assumes “now or never” • Real Option framework Abandonment Follow-up Wait and learn Flexibility

Capital structure • Market Efficiency • MM-1 No taxes • MM-2 Corporate taxes • Miller Both corporate and personal taxes GL= {1-(1-TC)*(1-TpE)/(1-Tp)} • Bankruptcy costs • Agency costs

Dividends • MM Does not matter • Lintner behavioural model DIV1-DIV0=Adjustment rate*(target ratio*EPS1-DIV0) • Agency costs/signalling

Working Capital Management • Operating cycle, cash conversion cycle, weighted cycles and supply chain management • Investment in receivables • Cash management EOQ and Miller-Orr models

Corporate Finance