CORPORATE FINANCE
INHOUDSOPGAVE
Chapter 1: Goals and governance of the firm .................................................................................................. 5
1. Goal of a company .......................................................................................................................................... 5
1.1 Financial goal of the corporation.............................................................................................................. 5
1.2 Financial goal ............................................................................................................................................ 6
1.3 Milton Friedman, Nobel prize winner (1970) ........................................................................................... 6
1.4 Shareholders or stakeholders? ................................................................................................................. 6
1.5 Milton Friedman did care for society ....................................................................................................... 6
1.6 2022 Edelman trust barometer ................................................................................................................ 7
1.7 Beyond shareholders ................................................................................................................................ 7
1.8 Governance and ESG has positive LT shareholder effects ........................................................................ 7
2. Finance primers ............................................................................................................................................... 7
2.1 Finance vs. accounting.............................................................................................................................. 8
2.2 Economic value vs. book value ................................................................................................................. 8
2.3 Business models in financial theory ......................................................................................................... 9
2.4 Assumptions: a perfect world................................................................................................................... 9
2.5 Corporate governance ............................................................................................................................ 10
Chapter 2: The basics of valuation................................................................................................................. 11
1. Future and present values ............................................................................................................................. 11
1.1 Time value of money (TVM) ................................................................................................................... 11
1.2 Assets and valuation ............................................................................................................................... 11
1.3 (Net) present value multiple cash flows ................................................................................................. 11
2. Perpetuities ................................................................................................................................................... 11
Chapter 3: Valuing bonds and stocks ............................................................................................................. 13
1. Valuing bonds ............................................................................................................................................... 13
1.1 10-year German government bond yield ............................................................................................... 13
1.2 What do you want to pay for a bond? .................................................................................................... 13
Example + exercise: Rolls Royce ............................................................................................................... 14
Example: Nestlé ....................................................................................................................................... 14
Example: musicians .................................................................................................................................. 14
1.3 Perpetual bond vs. 50-year bond ........................................................................................................... 14
2. Valuing stocks ............................................................................................................................................... 14
2.1 Increasing dividends ............................................................................................................................... 15
Example: no-growth company ................................................................................................................. 15
Example: company with growth .............................................................................................................. 15
Quiz: Belgian Cats..................................................................................................................................... 15
Chapter 4: Capital expenditure evaluation .................................................................................................... 16
1. What is an investment? ................................................................................................................................ 16
1.1 Balance sheet ......................................................................................................................................... 16
1.2 Different steps in capital budgeting ....................................................................................................... 16
1
, 2. Investment evaluation models ...................................................................................................................... 17
Example: skI’s ........................................................................................................................................... 17
Overview of different project selection procedures .................................................................................... 17
2.1 The Net Present Value (NPV) rule .......................................................................................................... 17
2.1.1 NPV typically decreases with increasing discount (or hurdle) rate ................................................. 17
2.1.2 Why use net present value? ............................................................................................................ 17
2.2 Internal Rate of Return (IRR) .................................................................................................................. 18
2.2.1 Comparing NPV and IRR .................................................................................................................. 18
2.2.2 Problems ......................................................................................................................................... 18
2.3 The Payback Period rule ......................................................................................................................... 19
2.3.1 Disadvantages ................................................................................................................................. 19
2.3.2 Advantages ...................................................................................................................................... 19
2.4 The Profitability Index (PI) rule: budget constraints ............................................................................... 20
3. Determining the relevant cash flows ............................................................................................................ 21
3.1 Why cash flows? (not profit) .................................................................................................................. 21
3.2 Relevant cash flows = free (operating) CF .............................................................................................. 21
3.3 Why increase in WCR? ............................................................................................................................ 22
3.4 What cash flows to include? ................................................................................................................... 22
4. Inflation ......................................................................................................................................................... 23
4.1 Inflation and investment projects .......................................................................................................... 23
4.2 Basic principle: consistency .................................................................................................................... 24
5. Conclusion ..................................................................................................................................................... 24
5.1 The practice of capital budgeting ........................................................................................................... 24
5.2 Jeff Bezos (Amazon)................................................................................................................................ 24
5.3 Capital budgeting is not a purely financial exercise ............................................................................... 24
Chapter 5: Risk and expected return ............................................................................................................. 25
1. Efficient capital markets ............................................................................................................................... 25
1.1 Capital asset pricing model (CAPM) ....................................................................................................... 25
1.1.1 Efficient capital markets .................................................................................................................. 26
1.1.2 Efficient capital markets hypothesis ............................................................................................... 26
1.1.3 Technical analysis chart................................................................................................................... 26
1.1.4 Are capital markets efficient? ......................................................................................................... 26
2. Long run returns and risk .............................................................................................................................. 27
2.1 Basic idea: funding is not free ................................................................................................................ 27
2.1.1 How to measure risk? ..................................................................................................................... 27
2.1.2 How to determine the appropriate risk premium? ......................................................................... 27
2.2 Risk-averse rational investors ................................................................................................................. 28
2.3 Long run return and risk ......................................................................................................................... 28
3. Risk and diversification ................................................................................................................................. 28
3.1 Equity diversification reduces risk .......................................................................................................... 28
Situation 1: perfectly positively correlated stocks ................................................................................... 29
Situation 2: perfectly negatively correlated stocks .................................................................................. 29
Opportunity set (general) ........................................................................................................................ 29
Opportunity set if many shares ................................................................................................................ 30
Conclusion: equity diversification reduces risk ........................................................................................ 30
4. CAPM: the model .......................................................................................................................................... 30
2
, 4.1 Risky asset + risk free security ................................................................................................................ 30
4.1.1 Opportunity set risky + frisk free asset ........................................................................................... 31
4.1.2 Risky investment ............................................................................................................................. 31
4.2 The “Capital Market Line” ...................................................................................................................... 31
4.2.1 Required return for firm i ................................................................................................................ 32
4.2.2 The market risk premium ................................................................................................................ 32
5. What about other risk factors? ..................................................................................................................... 32
5.1 Small firm effect: illiquidity risk .............................................................................................................. 32
5.2 Conclusion .............................................................................................................................................. 33
Chapter 6: The weighted average cost of capital (WACC) .............................................................................. 34
1. WACC ............................................................................................................................................................ 34
1.1 Basic principles ....................................................................................................................................... 34
2. Cost of funding .............................................................................................................................................. 34
2.1 Seniority of financing instruments ......................................................................................................... 34
2.2 Cost of equity of a quoted firm: CAPM................................................................................................... 34
2.3 Alternative model for cost of equity: dividend discount model ............................................................. 35
2.4 Cost of debt: kD ....................................................................................................................................... 35
2.4.1 Cost of debt and taxes..................................................................................................................... 35
2.4.2 Estimating the cost of debt ............................................................................................................. 35
2.4.3 Ratings by rating agencies ............................................................................................................... 36
2.4.4 Spreads for unquoted corporate bonds .......................................................................................... 36
3. Weights ......................................................................................................................................................... 36
3.1 Market value of equity and debt ............................................................................................................ 36
Chapter 7: Capital structure and borrowing policy ........................................................................................ 37
Capital structure of non-financial U.S. Companies ....................................................................................... 37
1. What are advantages of the use of debt and equity (firm perspective)? ...................................................... 37
1.1 How is equity different from debt? ........................................................................................................ 37
1.2 Weighted average cost of capital ........................................................................................................... 37
1.3 Related questions ................................................................................................................................... 37
2. Static trade-off theory................................................................................................................................... 38
2.1 Perfect markets: irrelevance of capital structure ................................................................................... 38
2.1.1 Financial leverage effect ................................................................................................................. 38
2.1.2 As debt increases, cost of equity increases ..................................................................................... 39
2.2 Impact of imperfection 1: taxes.............................................................................................................. 40
2.2.1 Debt offers a tax shield, so debt adds value ................................................................................... 40
2.2.2 Taxes increase firm value with use of debt ..................................................................................... 40
2.2.3 Impact of taxes ................................................................................................................................ 40
2.2.4 Effect of borrowing on the cost of capital ....................................................................................... 41
2.3 Impact of imperfection 2: financial distress ........................................................................................... 41
2.3.1 Cost of distress: probability............................................................................................................. 41
2.3.2 Financial distress costs .................................................................................................................... 41
2.3.3 Impact of costs of financial distress: static trade-off ...................................................................... 42
2.3.4 WACC, taxes and financial distress ................................................................................................. 42
2.4 Putting it al together: static trade-off theory ......................................................................................... 42
2.4.1 M&M: static trade-off theory.......................................................................................................... 42
3
, 2.4.2 Choose optimal debt level in MM-framework ................................................................................ 42
2.4.3 Static trade-off theory ..................................................................................................................... 43
3. Pecking order theory ..................................................................................................................................... 43
3.1 Start with “easiest” sources of funding .................................................................................................. 44
3.2 From low to high info asymmetries ........................................................................................................ 44
3.3 Explains some empirical observations .................................................................................................... 44
3.4 Growth and external finance need (EFN) ............................................................................................... 44
3.5 Combining static trade-off with pecking order....................................................................................... 45
4
INHOUDSOPGAVE
Chapter 1: Goals and governance of the firm .................................................................................................. 5
1. Goal of a company .......................................................................................................................................... 5
1.1 Financial goal of the corporation.............................................................................................................. 5
1.2 Financial goal ............................................................................................................................................ 6
1.3 Milton Friedman, Nobel prize winner (1970) ........................................................................................... 6
1.4 Shareholders or stakeholders? ................................................................................................................. 6
1.5 Milton Friedman did care for society ....................................................................................................... 6
1.6 2022 Edelman trust barometer ................................................................................................................ 7
1.7 Beyond shareholders ................................................................................................................................ 7
1.8 Governance and ESG has positive LT shareholder effects ........................................................................ 7
2. Finance primers ............................................................................................................................................... 7
2.1 Finance vs. accounting.............................................................................................................................. 8
2.2 Economic value vs. book value ................................................................................................................. 8
2.3 Business models in financial theory ......................................................................................................... 9
2.4 Assumptions: a perfect world................................................................................................................... 9
2.5 Corporate governance ............................................................................................................................ 10
Chapter 2: The basics of valuation................................................................................................................. 11
1. Future and present values ............................................................................................................................. 11
1.1 Time value of money (TVM) ................................................................................................................... 11
1.2 Assets and valuation ............................................................................................................................... 11
1.3 (Net) present value multiple cash flows ................................................................................................. 11
2. Perpetuities ................................................................................................................................................... 11
Chapter 3: Valuing bonds and stocks ............................................................................................................. 13
1. Valuing bonds ............................................................................................................................................... 13
1.1 10-year German government bond yield ............................................................................................... 13
1.2 What do you want to pay for a bond? .................................................................................................... 13
Example + exercise: Rolls Royce ............................................................................................................... 14
Example: Nestlé ....................................................................................................................................... 14
Example: musicians .................................................................................................................................. 14
1.3 Perpetual bond vs. 50-year bond ........................................................................................................... 14
2. Valuing stocks ............................................................................................................................................... 14
2.1 Increasing dividends ............................................................................................................................... 15
Example: no-growth company ................................................................................................................. 15
Example: company with growth .............................................................................................................. 15
Quiz: Belgian Cats..................................................................................................................................... 15
Chapter 4: Capital expenditure evaluation .................................................................................................... 16
1. What is an investment? ................................................................................................................................ 16
1.1 Balance sheet ......................................................................................................................................... 16
1.2 Different steps in capital budgeting ....................................................................................................... 16
1
, 2. Investment evaluation models ...................................................................................................................... 17
Example: skI’s ........................................................................................................................................... 17
Overview of different project selection procedures .................................................................................... 17
2.1 The Net Present Value (NPV) rule .......................................................................................................... 17
2.1.1 NPV typically decreases with increasing discount (or hurdle) rate ................................................. 17
2.1.2 Why use net present value? ............................................................................................................ 17
2.2 Internal Rate of Return (IRR) .................................................................................................................. 18
2.2.1 Comparing NPV and IRR .................................................................................................................. 18
2.2.2 Problems ......................................................................................................................................... 18
2.3 The Payback Period rule ......................................................................................................................... 19
2.3.1 Disadvantages ................................................................................................................................. 19
2.3.2 Advantages ...................................................................................................................................... 19
2.4 The Profitability Index (PI) rule: budget constraints ............................................................................... 20
3. Determining the relevant cash flows ............................................................................................................ 21
3.1 Why cash flows? (not profit) .................................................................................................................. 21
3.2 Relevant cash flows = free (operating) CF .............................................................................................. 21
3.3 Why increase in WCR? ............................................................................................................................ 22
3.4 What cash flows to include? ................................................................................................................... 22
4. Inflation ......................................................................................................................................................... 23
4.1 Inflation and investment projects .......................................................................................................... 23
4.2 Basic principle: consistency .................................................................................................................... 24
5. Conclusion ..................................................................................................................................................... 24
5.1 The practice of capital budgeting ........................................................................................................... 24
5.2 Jeff Bezos (Amazon)................................................................................................................................ 24
5.3 Capital budgeting is not a purely financial exercise ............................................................................... 24
Chapter 5: Risk and expected return ............................................................................................................. 25
1. Efficient capital markets ............................................................................................................................... 25
1.1 Capital asset pricing model (CAPM) ....................................................................................................... 25
1.1.1 Efficient capital markets .................................................................................................................. 26
1.1.2 Efficient capital markets hypothesis ............................................................................................... 26
1.1.3 Technical analysis chart................................................................................................................... 26
1.1.4 Are capital markets efficient? ......................................................................................................... 26
2. Long run returns and risk .............................................................................................................................. 27
2.1 Basic idea: funding is not free ................................................................................................................ 27
2.1.1 How to measure risk? ..................................................................................................................... 27
2.1.2 How to determine the appropriate risk premium? ......................................................................... 27
2.2 Risk-averse rational investors ................................................................................................................. 28
2.3 Long run return and risk ......................................................................................................................... 28
3. Risk and diversification ................................................................................................................................. 28
3.1 Equity diversification reduces risk .......................................................................................................... 28
Situation 1: perfectly positively correlated stocks ................................................................................... 29
Situation 2: perfectly negatively correlated stocks .................................................................................. 29
Opportunity set (general) ........................................................................................................................ 29
Opportunity set if many shares ................................................................................................................ 30
Conclusion: equity diversification reduces risk ........................................................................................ 30
4. CAPM: the model .......................................................................................................................................... 30
2
, 4.1 Risky asset + risk free security ................................................................................................................ 30
4.1.1 Opportunity set risky + frisk free asset ........................................................................................... 31
4.1.2 Risky investment ............................................................................................................................. 31
4.2 The “Capital Market Line” ...................................................................................................................... 31
4.2.1 Required return for firm i ................................................................................................................ 32
4.2.2 The market risk premium ................................................................................................................ 32
5. What about other risk factors? ..................................................................................................................... 32
5.1 Small firm effect: illiquidity risk .............................................................................................................. 32
5.2 Conclusion .............................................................................................................................................. 33
Chapter 6: The weighted average cost of capital (WACC) .............................................................................. 34
1. WACC ............................................................................................................................................................ 34
1.1 Basic principles ....................................................................................................................................... 34
2. Cost of funding .............................................................................................................................................. 34
2.1 Seniority of financing instruments ......................................................................................................... 34
2.2 Cost of equity of a quoted firm: CAPM................................................................................................... 34
2.3 Alternative model for cost of equity: dividend discount model ............................................................. 35
2.4 Cost of debt: kD ....................................................................................................................................... 35
2.4.1 Cost of debt and taxes..................................................................................................................... 35
2.4.2 Estimating the cost of debt ............................................................................................................. 35
2.4.3 Ratings by rating agencies ............................................................................................................... 36
2.4.4 Spreads for unquoted corporate bonds .......................................................................................... 36
3. Weights ......................................................................................................................................................... 36
3.1 Market value of equity and debt ............................................................................................................ 36
Chapter 7: Capital structure and borrowing policy ........................................................................................ 37
Capital structure of non-financial U.S. Companies ....................................................................................... 37
1. What are advantages of the use of debt and equity (firm perspective)? ...................................................... 37
1.1 How is equity different from debt? ........................................................................................................ 37
1.2 Weighted average cost of capital ........................................................................................................... 37
1.3 Related questions ................................................................................................................................... 37
2. Static trade-off theory................................................................................................................................... 38
2.1 Perfect markets: irrelevance of capital structure ................................................................................... 38
2.1.1 Financial leverage effect ................................................................................................................. 38
2.1.2 As debt increases, cost of equity increases ..................................................................................... 39
2.2 Impact of imperfection 1: taxes.............................................................................................................. 40
2.2.1 Debt offers a tax shield, so debt adds value ................................................................................... 40
2.2.2 Taxes increase firm value with use of debt ..................................................................................... 40
2.2.3 Impact of taxes ................................................................................................................................ 40
2.2.4 Effect of borrowing on the cost of capital ....................................................................................... 41
2.3 Impact of imperfection 2: financial distress ........................................................................................... 41
2.3.1 Cost of distress: probability............................................................................................................. 41
2.3.2 Financial distress costs .................................................................................................................... 41
2.3.3 Impact of costs of financial distress: static trade-off ...................................................................... 42
2.3.4 WACC, taxes and financial distress ................................................................................................. 42
2.4 Putting it al together: static trade-off theory ......................................................................................... 42
2.4.1 M&M: static trade-off theory.......................................................................................................... 42
3
, 2.4.2 Choose optimal debt level in MM-framework ................................................................................ 42
2.4.3 Static trade-off theory ..................................................................................................................... 43
3. Pecking order theory ..................................................................................................................................... 43
3.1 Start with “easiest” sources of funding .................................................................................................. 44
3.2 From low to high info asymmetries ........................................................................................................ 44
3.3 Explains some empirical observations .................................................................................................... 44
3.4 Growth and external finance need (EFN) ............................................................................................... 44
3.5 Combining static trade-off with pecking order....................................................................................... 45
4
