Week 1: Chapter 2/6, CB1, CB4, Paper Zingales, Paper Harvey
The market value of equity is on average 2.5% higher than the book value of equity = Tangible assets
How to measure these:
By calculating the expected future revenue
Looking at peer companies
How to understand the business?
Understand the business (profile)
1. Business Return: By cash flows
2. Business Risk > Equity Risk (measure by price)
Finance Risk > Debt Risk (measure by price) WACC
A company should have a balance between business and financing risk. If this is not the case, the
financing costs of a company will increase due to the extra credit premium
Finance risk = risk to the debt holders.
Debt holders get paid first, they demand for an extra premium for the default risk
Long term
Short Term
Business risk = risk to the equity holders
Return
Risk
When it is a good investment?
Compare the WACC with the ROIC (at least 10% to make it a good investment)
Business Risk = Risk of the firm’s assets when no debt is used (market based). Factors that affect
business risk:
Sales risk
Input risk
Cost risk
Financing Risk = takes into account a company’s leverage. High leverage is high risk to stakeholders. Can
you easily pay the money back to your stockholders?
Ultimate goal of a company = Maximize the shareholders’ value
Assumptions in the neo-classical finance theory
All companies have same goal
All business cash flows are given
Perfect market; capital will flow to business opportunities
No tax, no transaction costs, no distress
Symmetric information, no agency costs
Investors are risk averse
The market value of equity is on average 2.5% higher than the book value of equity = Tangible assets
How to measure these:
By calculating the expected future revenue
Looking at peer companies
How to understand the business?
Understand the business (profile)
1. Business Return: By cash flows
2. Business Risk > Equity Risk (measure by price)
Finance Risk > Debt Risk (measure by price) WACC
A company should have a balance between business and financing risk. If this is not the case, the
financing costs of a company will increase due to the extra credit premium
Finance risk = risk to the debt holders.
Debt holders get paid first, they demand for an extra premium for the default risk
Long term
Short Term
Business risk = risk to the equity holders
Return
Risk
When it is a good investment?
Compare the WACC with the ROIC (at least 10% to make it a good investment)
Business Risk = Risk of the firm’s assets when no debt is used (market based). Factors that affect
business risk:
Sales risk
Input risk
Cost risk
Financing Risk = takes into account a company’s leverage. High leverage is high risk to stakeholders. Can
you easily pay the money back to your stockholders?
Ultimate goal of a company = Maximize the shareholders’ value
Assumptions in the neo-classical finance theory
All companies have same goal
All business cash flows are given
Perfect market; capital will flow to business opportunities
No tax, no transaction costs, no distress
Symmetric information, no agency costs
Investors are risk averse
