Principles of corporate finance
w w w
H. Zhong, P. Frantz, R. Payne, J. Favilukis
w w w w w w w
FN2191
2021
Undergraduate study in Economic
w w w
s, Management, Finance and the S
w w w w w
ocial Sciences
w
Thiswsubjectwguidewiswforwaw200wcoursewofferedwaswpartwofwthewUniversitywofwLondo
nwundergraduatewstudywinwEconomics,wManagement,wFinancewandwthewSocialwScie
nces.wThiswiswequivalentwtowLevelw5wwithinwthewFrameworkwforwHigherwEducation
QualificationswinwEngland,wWaleswandwNorthernwIrelandw(FHEQ).wForwmorewinformation
,wsee:wwww.london.ac.uk
,ThiswguidewwaswpreparedwforwthewUniversitywofwLondonwby:
DrwHongdawZhong,wAssistantwProfessorwofwFinance,wThewLondonwofwEconomicswandwPoliticalwS
ciencewandwDr.wJ.wFavilukis,wLecturer,wThewLondonwSchoolwofwEconomicswandwPoliticalwScience
ThiswiswonewofwawserieswofwsubjectwguideswpublishedwbywthewUniversity.wWewregretwthatwd
uewtowpressurewofwworkwthewauthorswarewunablewtowenterwintowanywcorrespondencewrelati
ngwto,worwarisingwfrom,wthewguide.wIfwyouwhavewanywcommentswonwthiswsubjectwguide,wfavou
rableworwunfavourable, wpleasewusewthewformwatwthewbackwofwthiswguide.
UniversitywofwLondon
wPublications wOffic
ewStewartwHouse
32wRussellwSquarew
LondonwWC1Bw5DNw
UnitedwKingdom
london.ac.uk
Publishedwby:wUniversitywofwLondon
©w Universityw ofw Londonw 2018w reprintedw withw minorw revisionsw 2021
ThewUniversitywofwLondonwassertswcopyrightwoverwallwmaterialwinwthiswsubjectwguidewexceptwwhe
rewotherwisewindicated.wAllwrightswreserved.wNowpartwofwthiswworkwmaywbewreproducedwinwany
wform,worwbywany wmeans, wwithoutwpermissionwin wwritingwfrom wthewpublisher.wWe wmakewever
yweffortwtowrespectwcopyright.wIfwyouwthinkwwewhavewinadvertentlywusedwyourwcopyrightwmateri
al,wpleasewletwuswknow.
, Contents
Contents
Introductionw tow thew subjectw guide ...................................................................... 1
Aimswofwthewcourse .......................................................................................... 1
Learningwoutcomes ......................................................................................... 1
Syllabus ....................................................................................................... 2
Essentialwreading ............................................................................................ 2
Furtherwreading .............................................................................................. 2
Onlinewstudywresources ..................................................................................... 4
Subjectwguidewstructurewandwuse ......................................................................... 5
Examinationwadvice ......................................................................................... 6
Glossarywofwabbreviationswusedwinwthiswsubjectwguide ............................................... 7
Chapterw1:wPresentwvaluewcalculationswandwthewvaluationwofwphysicalwinvestme
ntwprojects ...................................................................................................... 9
Aimwofwthiswchapter ......................................................................................... 9
Learningwobjectives ......................................................................................... 9
Essentialwreading ............................................................................................ 9
Furtherwreading .............................................................................................. 9
Overview ..................................................................................................... 9
Introduction ................................................................................................ 10
Fisherwseparationwandwoptimalwdecision-making .................................................... 10
Fisherwseparationwandwprojectwevaluation ............................................................ 13
Thewtimewvaluewofwmoney ................................................................................ 14
Thewnetwpresentwvaluewrule ............................................................................... 15
Otherwprojectwappraisalwtechniques .................................................................... 17
Usingwpresentwvaluewtechniqueswtowvaluewstockswandwbonds .................................... 21
Awreminderwofwyourwlearningwoutcomes ............................................................... 23
Keywterms .................................................................................................... 23
Samplewexaminationwquestions ......................................................................... 23
Chapterw2:wRealwoptions................................................................................... 25
Aimwofwthewchapter ........................................................................................ 25
Learningwobjectives ....................................................................................... 25
Essentialwreading .......................................................................................... 25
Furtherwreading ............................................................................................ 25
Introduction ................................................................................................ 25
Decisionwtree,wsourcewofwoptionwvaluewandwearlywexercise ....................................... 26
Threewtypeswofwrealwoptions .............................................................................. 30
Awreminderwofwyourwlearningwoutcomes ............................................................... 36
Keywterms .................................................................................................... 36
Samplewexaminationwquestions ......................................................................... 37
Chapterw3:wThewchoicewofw corporatewcapitalw structure ....................................... 39
Aimwofwthewchapter ........................................................................................ 39
Learningwobjectives ....................................................................................... 39
Essentialwreading .......................................................................................... 39
Furtherwreading ............................................................................................ 39
Overview ................................................................................................... 39
Basicwfeatureswofwdebtwandwequity ..................................................................... 40
ThewModigliani–Millerwtheorem ........................................................................ 41
Modigliani–Millerwandwcorporatewtaxation ........................................................... 43
i
, FN2191wPrincipleswofwcorporatewfinanc
e
Modigliani–Millerwwithwcorporatewandwpersonalwtaxation ........................................ 46
Summary .................................................................................................... 48
Awreminderwofwyourwlearningwoutcomes ............................................................... 48
Keywterms .................................................................................................... 48
Samplewexaminationwquestions.......................................................................... 49
Chapterw 4:wLeverage,wWACCw andw thew Modigliani-Millerw2ndw proposition ............ 51
Aimwofwthewchapter ........................................................................................ 51
Learningwobjectives ....................................................................................... 51
Essentialwreading........................................................................................... 51
Furtherwreading ............................................................................................ 51
Overview ................................................................................................... 51
Weightedwaveragewcostwofwcapital ...................................................................... 52
ModiglianiwandwMiller’sw2ndwproposition ............................................................. 54
AwCAPMwperspectivew(optional) ......................................................................... 58
Summary .................................................................................................... 59
Keywterms .................................................................................................... 60
Awreminderwofwyourwlearningwoutcomes ............................................................... 60
Samplewexaminationwquestions.......................................................................... 61
Chapterw 5:wAsymmetricw information,wagencyw costsw andw capitalwstructure .......... 63
Aimwofwthewchapter ........................................................................................ 63
Learningwobjectives ....................................................................................... 63
Essentialwreading........................................................................................... 63
Furtherwreading ............................................................................................ 63
Overview ................................................................................................... 64
Capitalwstructure,wgovernancewproblemswandwagencywcosts ...................................... 64
Agencywcostswofwoutsidewequitywandwdebt ............................................................ 64
Agencywcostswofwfreewcashwflows ........................................................................ 71
Firmwvaluewandwasymmetricwinformation ............................................................... 71
Summary .................................................................................................... 75
Keywterms .................................................................................................... 76
Awreminderwofwyourwlearningwoutcomes ............................................................... 76
Samplewexaminationwquestions.......................................................................... 76
Chapterw6:wEquitywfinancing ............................................................................. 79
Aimwofwthewchapter ........................................................................................ 79
Learningwobjectives ....................................................................................... 79
Essentialwreading........................................................................................... 79
Furtherwreading ............................................................................................ 79
Introduction ............................................................................................... 79
Privatewequitywfinancing ................................................................................... 80
Initialwpublicwofferingswandwseasonedwequitywofferings ............................................ 85
IPOwunderpricingwandwwinner’swcurse ................................................................. 89
Awreminderwofwyourwlearningwoutcomes ............................................................... 92
Keywterms .................................................................................................... 92
Samplewexaminationwquestions.......................................................................... 93
Chapterw7:wDividendw policy .............................................................................. 95
Aimwofwthewchapter ........................................................................................ 95
Learningwobjectives ....................................................................................... 95
Essentialwreading........................................................................................... 95
Furtherwreading ............................................................................................ 95
Overview ................................................................................................... 96
ii
w w w
H. Zhong, P. Frantz, R. Payne, J. Favilukis
w w w w w w w
FN2191
2021
Undergraduate study in Economic
w w w
s, Management, Finance and the S
w w w w w
ocial Sciences
w
Thiswsubjectwguidewiswforwaw200wcoursewofferedwaswpartwofwthewUniversitywofwLondo
nwundergraduatewstudywinwEconomics,wManagement,wFinancewandwthewSocialwScie
nces.wThiswiswequivalentwtowLevelw5wwithinwthewFrameworkwforwHigherwEducation
QualificationswinwEngland,wWaleswandwNorthernwIrelandw(FHEQ).wForwmorewinformation
,wsee:wwww.london.ac.uk
,ThiswguidewwaswpreparedwforwthewUniversitywofwLondonwby:
DrwHongdawZhong,wAssistantwProfessorwofwFinance,wThewLondonwofwEconomicswandwPoliticalwS
ciencewandwDr.wJ.wFavilukis,wLecturer,wThewLondonwSchoolwofwEconomicswandwPoliticalwScience
ThiswiswonewofwawserieswofwsubjectwguideswpublishedwbywthewUniversity.wWewregretwthatwd
uewtowpressurewofwworkwthewauthorswarewunablewtowenterwintowanywcorrespondencewrelati
ngwto,worwarisingwfrom,wthewguide.wIfwyouwhavewanywcommentswonwthiswsubjectwguide,wfavou
rableworwunfavourable, wpleasewusewthewformwatwthewbackwofwthiswguide.
UniversitywofwLondon
wPublications wOffic
ewStewartwHouse
32wRussellwSquarew
LondonwWC1Bw5DNw
UnitedwKingdom
london.ac.uk
Publishedwby:wUniversitywofwLondon
©w Universityw ofw Londonw 2018w reprintedw withw minorw revisionsw 2021
ThewUniversitywofwLondonwassertswcopyrightwoverwallwmaterialwinwthiswsubjectwguidewexceptwwhe
rewotherwisewindicated.wAllwrightswreserved.wNowpartwofwthiswworkwmaywbewreproducedwinwany
wform,worwbywany wmeans, wwithoutwpermissionwin wwritingwfrom wthewpublisher.wWe wmakewever
yweffortwtowrespectwcopyright.wIfwyouwthinkwwewhavewinadvertentlywusedwyourwcopyrightwmateri
al,wpleasewletwuswknow.
, Contents
Contents
Introductionw tow thew subjectw guide ...................................................................... 1
Aimswofwthewcourse .......................................................................................... 1
Learningwoutcomes ......................................................................................... 1
Syllabus ....................................................................................................... 2
Essentialwreading ............................................................................................ 2
Furtherwreading .............................................................................................. 2
Onlinewstudywresources ..................................................................................... 4
Subjectwguidewstructurewandwuse ......................................................................... 5
Examinationwadvice ......................................................................................... 6
Glossarywofwabbreviationswusedwinwthiswsubjectwguide ............................................... 7
Chapterw1:wPresentwvaluewcalculationswandwthewvaluationwofwphysicalwinvestme
ntwprojects ...................................................................................................... 9
Aimwofwthiswchapter ......................................................................................... 9
Learningwobjectives ......................................................................................... 9
Essentialwreading ............................................................................................ 9
Furtherwreading .............................................................................................. 9
Overview ..................................................................................................... 9
Introduction ................................................................................................ 10
Fisherwseparationwandwoptimalwdecision-making .................................................... 10
Fisherwseparationwandwprojectwevaluation ............................................................ 13
Thewtimewvaluewofwmoney ................................................................................ 14
Thewnetwpresentwvaluewrule ............................................................................... 15
Otherwprojectwappraisalwtechniques .................................................................... 17
Usingwpresentwvaluewtechniqueswtowvaluewstockswandwbonds .................................... 21
Awreminderwofwyourwlearningwoutcomes ............................................................... 23
Keywterms .................................................................................................... 23
Samplewexaminationwquestions ......................................................................... 23
Chapterw2:wRealwoptions................................................................................... 25
Aimwofwthewchapter ........................................................................................ 25
Learningwobjectives ....................................................................................... 25
Essentialwreading .......................................................................................... 25
Furtherwreading ............................................................................................ 25
Introduction ................................................................................................ 25
Decisionwtree,wsourcewofwoptionwvaluewandwearlywexercise ....................................... 26
Threewtypeswofwrealwoptions .............................................................................. 30
Awreminderwofwyourwlearningwoutcomes ............................................................... 36
Keywterms .................................................................................................... 36
Samplewexaminationwquestions ......................................................................... 37
Chapterw3:wThewchoicewofw corporatewcapitalw structure ....................................... 39
Aimwofwthewchapter ........................................................................................ 39
Learningwobjectives ....................................................................................... 39
Essentialwreading .......................................................................................... 39
Furtherwreading ............................................................................................ 39
Overview ................................................................................................... 39
Basicwfeatureswofwdebtwandwequity ..................................................................... 40
ThewModigliani–Millerwtheorem ........................................................................ 41
Modigliani–Millerwandwcorporatewtaxation ........................................................... 43
i
, FN2191wPrincipleswofwcorporatewfinanc
e
Modigliani–Millerwwithwcorporatewandwpersonalwtaxation ........................................ 46
Summary .................................................................................................... 48
Awreminderwofwyourwlearningwoutcomes ............................................................... 48
Keywterms .................................................................................................... 48
Samplewexaminationwquestions.......................................................................... 49
Chapterw 4:wLeverage,wWACCw andw thew Modigliani-Millerw2ndw proposition ............ 51
Aimwofwthewchapter ........................................................................................ 51
Learningwobjectives ....................................................................................... 51
Essentialwreading........................................................................................... 51
Furtherwreading ............................................................................................ 51
Overview ................................................................................................... 51
Weightedwaveragewcostwofwcapital ...................................................................... 52
ModiglianiwandwMiller’sw2ndwproposition ............................................................. 54
AwCAPMwperspectivew(optional) ......................................................................... 58
Summary .................................................................................................... 59
Keywterms .................................................................................................... 60
Awreminderwofwyourwlearningwoutcomes ............................................................... 60
Samplewexaminationwquestions.......................................................................... 61
Chapterw 5:wAsymmetricw information,wagencyw costsw andw capitalwstructure .......... 63
Aimwofwthewchapter ........................................................................................ 63
Learningwobjectives ....................................................................................... 63
Essentialwreading........................................................................................... 63
Furtherwreading ............................................................................................ 63
Overview ................................................................................................... 64
Capitalwstructure,wgovernancewproblemswandwagencywcosts ...................................... 64
Agencywcostswofwoutsidewequitywandwdebt ............................................................ 64
Agencywcostswofwfreewcashwflows ........................................................................ 71
Firmwvaluewandwasymmetricwinformation ............................................................... 71
Summary .................................................................................................... 75
Keywterms .................................................................................................... 76
Awreminderwofwyourwlearningwoutcomes ............................................................... 76
Samplewexaminationwquestions.......................................................................... 76
Chapterw6:wEquitywfinancing ............................................................................. 79
Aimwofwthewchapter ........................................................................................ 79
Learningwobjectives ....................................................................................... 79
Essentialwreading........................................................................................... 79
Furtherwreading ............................................................................................ 79
Introduction ............................................................................................... 79
Privatewequitywfinancing ................................................................................... 80
Initialwpublicwofferingswandwseasonedwequitywofferings ............................................ 85
IPOwunderpricingwandwwinner’swcurse ................................................................. 89
Awreminderwofwyourwlearningwoutcomes ............................................................... 92
Keywterms .................................................................................................... 92
Samplewexaminationwquestions.......................................................................... 93
Chapterw7:wDividendw policy .............................................................................. 95
Aimwofwthewchapter ........................................................................................ 95
Learningwobjectives ....................................................................................... 95
Essentialwreading........................................................................................... 95
Furtherwreading ............................................................................................ 95
Overview ................................................................................................... 96
ii
