Corporate finance summary
Table of Contents
Chapter 16- Corporate Claims ................................................................................................ 3
The basic building blocks ................................................................................................................3
Liabilities .......................................................................................................................................5
Financial claims (debt) .......................................................................................................................................... 5
Non-financial liabilities ......................................................................................................................................... 9
Equity (stocks) ............................................................................................................................. 10
Preferred equity ................................................................................................................................................. 10
Observations on the evolution of Intel’s Capital Structure ................................................................................ 11
Chapter 17- Capital Structure in a perfect market ................................................................. 11
Maximization of equity or firm value ............................................................................................ 11
Modigliani-Miller ......................................................................................................................... 13
Reflecting on arbitrage argument ...................................................................................................................... 14
Perceived vs. real value ...................................................................................................................................... 14
Weighted Average Cost of Capital (WACC) .................................................................................... 15
Risk aversion and higher equity cost of capital .................................................................................................. 15
In terms of Capital structure WACC ................................................................................................................... 17
WACC formula without taxes ............................................................................................................................. 17
Leverage, Cost of capital, and quoted interest rates ......................................................................................... 17
Graphing finance schemes against leverage ratios ............................................................................................ 18
If all securities are riskier, is the firm also riskier? ............................................................................................. 18
Leverage, earnings per share, and price/ earnings ratio.................................................................................... 19
Cost of capital nuances and non-financial liabilities....................................................................... 19
Value irrelevance with nonfinancial liabilities? .................................................................................................. 19
Marginal vs. average cost of capital ................................................................................................................... 20
Chapter 18- Taxes and Capital Structure ............................................................................... 21
Relative Taxation of debt and equity ............................................................................................ 21
Hypothetical equal taxation and capital budgeting ........................................................................................... 21
Realistic differential taxation of debt and equity ............................................................................................... 21
Firm value under different capital structures ................................................................................ 21
Formulaic valuation methods: APV and WACC .............................................................................. 22
Adjusted Present Value (APV): Theory ............................................................................................................... 22
Tax-adjusted weighted average cost of capital (WACC) valuation: Theory ....................................................... 23
Comparing flow-to-equity, APV, WACC, and avoiding bad ideas....................................................................... 25
Sample applications of tax-adjusted valuation .............................................................................. 25
Flow-to-equity direct valuation from the pro forma financials ......................................................................... 25
The APV Valuation .............................................................................................................................................. 26
, The WACC Valuation........................................................................................................................................... 27
Contemplating corporate taxes and leverage ................................................................................ 27
Which tax-adjusted valuation method is best? .................................................................................................. 27
A quick-and-dirty heuristic tax-savings rule ....................................................................................................... 28
Are investment and finance decisions separate now?....................................................................................... 28
The average and marginal cost of capital........................................................................................................... 29
Combining tax adjusted WACC and CAPM ......................................................................................................... 29
Personal income taxes and clientele effects .................................................................................. 29
The tax code for securities owners ............................................................................................... 29
Principle should be “Joint tax avoidance” .......................................................................................................... 30
Tax clienteles ...................................................................................................................................................... 30
Arrange clienteles .............................................................................................................................................. 31
Chapter 19- More imperfect-market capital structure ........................................................... 31
What really matters? ................................................................................................................... 31
Operating policy in bad times (distress) ........................................................................................ 32
The trade off in the presence of financial distress costs .................................................................................... 32
Direct losses of firm value .................................................................................................................................. 32
Operational distortions of incentives ................................................................................................................. 34
Strategic considerations ..................................................................................................................................... 35
Operating policy in good times (agency) ....................................................................................... 35
Bondholder expropriation ............................................................................................................ 36
Project risk changes ............................................................................................................................................ 36
Issuance of bonds of similar priority .................................................................................................................. 37
Counteracting forces against expropriation ....................................................................................................... 37
Private information and adverse selection .................................................................................... 38
Other important concerns ............................................................................................................ 39
Liquidity .............................................................................................................................................................. 39
Transaction costs ................................................................................................................................................ 39
Behavioral issues ................................................................................................................................................ 40
Static capital structure summary .................................................................................................. 40
The effect of leverage on the cost of capital and value .................................................................. 41
Valuing formulas with many market imperfections ....................................................................... 42
Do we need other valuation (WACC and APV) formulas? .................................................................................. 43
Capital structure dynamics ........................................................................................................... 44
Chapter 27- Options and Risk Management ......................................................................... 44
Options........................................................................................................................................ 44
Call options ......................................................................................................................................................... 45
Put options ......................................................................................................................................................... 46
More institutional stock option arrangements .................................................................................................. 46
Option payoffs at expiration .............................................................................................................................. 47
Static No-arbitrage relationships .................................................................................................. 49
Simple no-arbitrage requirements ..................................................................................................................... 49
, Put-call parity...................................................................................................................................................... 50
American early exercise feature ......................................................................................................................... 50
Valuing options from underlying stock prices ................................................................................ 51
The Black-Scholes inputs .............................................................................................................. 54
Obtaining Black-Scholes formula inputs............................................................................................................. 54
Comparative statics for the Black-Scholes formula............................................................................................ 55
Value prior to expiration .................................................................................................................................... 56
Option riskiness .................................................................................................................................................. 57
Corporate applications ................................................................................................................. 57
Securities as financial options ............................................................................................................................ 57
Real projects as options...................................................................................................................................... 58
Risk management ............................................................................................................................................... 58
Employee stock options...................................................................................................................................... 59
Chapter 20- Equity payouts: Dividends and Share Repurchases ............................................. 60
Background .................................................................................................................................60
Dividend mechanics ............................................................................................................................................ 61
Share repurchase mechanics .............................................................................................................................. 62
Perfect-market irrelevance ........................................................................................................... 63
Dividends and share repurchase ................................................................................................... 64
Personal Income Tax Differences and Investor Clienteles ................................................................................. 65
Non-tax related differences................................................................................................................................ 66
Empirical evidence .............................................................................................................................................. 67
Market reactions ................................................................................................................................................ 69
Survey Evidence ........................................................................................................................... 72
Chapter 16- Corporate Claims
The basic building blocks
• Corporate charter lays down the basics of a firm
o Specifies who holds decision power, how the firm can engage in further
contracts, and how the charter can be amended
o Also addresses how the firm may be governed in the future
o The charter facilitates the creation of financial and nonfinancial claims, each with
its own cash flow rights and control rights
o Can indicate how the capital structure of a firm is established
• Firms assets are owned by multiple claimants
o Liabilities (leverage) and equity (stocks)
• Shareholders are in charge but there are clear limits as to what they can do
o Such limitations are imposed by covenants that are accepted by the
shareholders
o Covenants are what is accepted when a firm borrows money
, o Example, most covenants on bonds prevents the firm from destroying or not
maintaining their assets, or selling the selling and paying out cash to
shareholders
• The set of all claims of the firm’s future payoffs is known as its capital structure
• Claims often classified as financial or nonfinancial
o Financial claims
▪ Debt and equity
▪ Loosely called securities as they are registered with the SEC
o Nonfinancial claims
▪ Are obligations such as corporate income taxes due, pension obligations
and accounts payable
• In order to fully own the firm and do whatever you want you must own all the claims
that the firm has issued
o It is not enough to own all the stock or just all the financial claims
o Can never really own all the claims as the government is entitled to some future
cash flows through taxes
• Every claim has two important aspects
o Cash flow rights
▪ How cash generated by the firm will be allocated
o Control rights
▪ Allow the claim owners to enforce their cash flow rights
▪ Example, creditors can force firm into bankruptcy if it doesn’t pay its
obligations
• Main tool for analysis of cash flow rights is a payoff diagram
Table of Contents
Chapter 16- Corporate Claims ................................................................................................ 3
The basic building blocks ................................................................................................................3
Liabilities .......................................................................................................................................5
Financial claims (debt) .......................................................................................................................................... 5
Non-financial liabilities ......................................................................................................................................... 9
Equity (stocks) ............................................................................................................................. 10
Preferred equity ................................................................................................................................................. 10
Observations on the evolution of Intel’s Capital Structure ................................................................................ 11
Chapter 17- Capital Structure in a perfect market ................................................................. 11
Maximization of equity or firm value ............................................................................................ 11
Modigliani-Miller ......................................................................................................................... 13
Reflecting on arbitrage argument ...................................................................................................................... 14
Perceived vs. real value ...................................................................................................................................... 14
Weighted Average Cost of Capital (WACC) .................................................................................... 15
Risk aversion and higher equity cost of capital .................................................................................................. 15
In terms of Capital structure WACC ................................................................................................................... 17
WACC formula without taxes ............................................................................................................................. 17
Leverage, Cost of capital, and quoted interest rates ......................................................................................... 17
Graphing finance schemes against leverage ratios ............................................................................................ 18
If all securities are riskier, is the firm also riskier? ............................................................................................. 18
Leverage, earnings per share, and price/ earnings ratio.................................................................................... 19
Cost of capital nuances and non-financial liabilities....................................................................... 19
Value irrelevance with nonfinancial liabilities? .................................................................................................. 19
Marginal vs. average cost of capital ................................................................................................................... 20
Chapter 18- Taxes and Capital Structure ............................................................................... 21
Relative Taxation of debt and equity ............................................................................................ 21
Hypothetical equal taxation and capital budgeting ........................................................................................... 21
Realistic differential taxation of debt and equity ............................................................................................... 21
Firm value under different capital structures ................................................................................ 21
Formulaic valuation methods: APV and WACC .............................................................................. 22
Adjusted Present Value (APV): Theory ............................................................................................................... 22
Tax-adjusted weighted average cost of capital (WACC) valuation: Theory ....................................................... 23
Comparing flow-to-equity, APV, WACC, and avoiding bad ideas....................................................................... 25
Sample applications of tax-adjusted valuation .............................................................................. 25
Flow-to-equity direct valuation from the pro forma financials ......................................................................... 25
The APV Valuation .............................................................................................................................................. 26
, The WACC Valuation........................................................................................................................................... 27
Contemplating corporate taxes and leverage ................................................................................ 27
Which tax-adjusted valuation method is best? .................................................................................................. 27
A quick-and-dirty heuristic tax-savings rule ....................................................................................................... 28
Are investment and finance decisions separate now?....................................................................................... 28
The average and marginal cost of capital........................................................................................................... 29
Combining tax adjusted WACC and CAPM ......................................................................................................... 29
Personal income taxes and clientele effects .................................................................................. 29
The tax code for securities owners ............................................................................................... 29
Principle should be “Joint tax avoidance” .......................................................................................................... 30
Tax clienteles ...................................................................................................................................................... 30
Arrange clienteles .............................................................................................................................................. 31
Chapter 19- More imperfect-market capital structure ........................................................... 31
What really matters? ................................................................................................................... 31
Operating policy in bad times (distress) ........................................................................................ 32
The trade off in the presence of financial distress costs .................................................................................... 32
Direct losses of firm value .................................................................................................................................. 32
Operational distortions of incentives ................................................................................................................. 34
Strategic considerations ..................................................................................................................................... 35
Operating policy in good times (agency) ....................................................................................... 35
Bondholder expropriation ............................................................................................................ 36
Project risk changes ............................................................................................................................................ 36
Issuance of bonds of similar priority .................................................................................................................. 37
Counteracting forces against expropriation ....................................................................................................... 37
Private information and adverse selection .................................................................................... 38
Other important concerns ............................................................................................................ 39
Liquidity .............................................................................................................................................................. 39
Transaction costs ................................................................................................................................................ 39
Behavioral issues ................................................................................................................................................ 40
Static capital structure summary .................................................................................................. 40
The effect of leverage on the cost of capital and value .................................................................. 41
Valuing formulas with many market imperfections ....................................................................... 42
Do we need other valuation (WACC and APV) formulas? .................................................................................. 43
Capital structure dynamics ........................................................................................................... 44
Chapter 27- Options and Risk Management ......................................................................... 44
Options........................................................................................................................................ 44
Call options ......................................................................................................................................................... 45
Put options ......................................................................................................................................................... 46
More institutional stock option arrangements .................................................................................................. 46
Option payoffs at expiration .............................................................................................................................. 47
Static No-arbitrage relationships .................................................................................................. 49
Simple no-arbitrage requirements ..................................................................................................................... 49
, Put-call parity...................................................................................................................................................... 50
American early exercise feature ......................................................................................................................... 50
Valuing options from underlying stock prices ................................................................................ 51
The Black-Scholes inputs .............................................................................................................. 54
Obtaining Black-Scholes formula inputs............................................................................................................. 54
Comparative statics for the Black-Scholes formula............................................................................................ 55
Value prior to expiration .................................................................................................................................... 56
Option riskiness .................................................................................................................................................. 57
Corporate applications ................................................................................................................. 57
Securities as financial options ............................................................................................................................ 57
Real projects as options...................................................................................................................................... 58
Risk management ............................................................................................................................................... 58
Employee stock options...................................................................................................................................... 59
Chapter 20- Equity payouts: Dividends and Share Repurchases ............................................. 60
Background .................................................................................................................................60
Dividend mechanics ............................................................................................................................................ 61
Share repurchase mechanics .............................................................................................................................. 62
Perfect-market irrelevance ........................................................................................................... 63
Dividends and share repurchase ................................................................................................... 64
Personal Income Tax Differences and Investor Clienteles ................................................................................. 65
Non-tax related differences................................................................................................................................ 66
Empirical evidence .............................................................................................................................................. 67
Market reactions ................................................................................................................................................ 69
Survey Evidence ........................................................................................................................... 72
Chapter 16- Corporate Claims
The basic building blocks
• Corporate charter lays down the basics of a firm
o Specifies who holds decision power, how the firm can engage in further
contracts, and how the charter can be amended
o Also addresses how the firm may be governed in the future
o The charter facilitates the creation of financial and nonfinancial claims, each with
its own cash flow rights and control rights
o Can indicate how the capital structure of a firm is established
• Firms assets are owned by multiple claimants
o Liabilities (leverage) and equity (stocks)
• Shareholders are in charge but there are clear limits as to what they can do
o Such limitations are imposed by covenants that are accepted by the
shareholders
o Covenants are what is accepted when a firm borrows money
, o Example, most covenants on bonds prevents the firm from destroying or not
maintaining their assets, or selling the selling and paying out cash to
shareholders
• The set of all claims of the firm’s future payoffs is known as its capital structure
• Claims often classified as financial or nonfinancial
o Financial claims
▪ Debt and equity
▪ Loosely called securities as they are registered with the SEC
o Nonfinancial claims
▪ Are obligations such as corporate income taxes due, pension obligations
and accounts payable
• In order to fully own the firm and do whatever you want you must own all the claims
that the firm has issued
o It is not enough to own all the stock or just all the financial claims
o Can never really own all the claims as the government is entitled to some future
cash flows through taxes
• Every claim has two important aspects
o Cash flow rights
▪ How cash generated by the firm will be allocated
o Control rights
▪ Allow the claim owners to enforce their cash flow rights
▪ Example, creditors can force firm into bankruptcy if it doesn’t pay its
obligations
• Main tool for analysis of cash flow rights is a payoff diagram
