summary in finance, mba20011 summary of courses in finance (revision for the state exam) mihály...

Summary in finance, MBA2001 1

Summary of Coursesin Finance

(Revision for the State Exam)

Mihály Ormos


9. Financing corporations–Pure equity financed mini-firm approach–Effects of capital structure in a perfect market–Effects of capital structure in a slightly imperfect market

10. Dividend policy–Significance of indifference of dividend policy in financial

analyses –Explaining the indifference of dividend policy in a perfect

market–Explaining the indifference of dividend policy in a slightly

imperfect market

Business Economics & Corporate Finance


11. Determination of cash flow streams– Relevant cash flows– Consideration of inflation– Consideration of taxation

12. Determination of opportunity cost –Determination of opportunity cost by the CAPM–Country risk approach–Opportunity cost by WACC

13. Business economic analyses –Net present value–Internal rate of return–Profit index and annual equivalent




14. Options–Properties of options

–Factors influence put and call option prices

–Real-options

15. Companies in the modern market economies–Main types of modern market economies

–Shareholder’s value – stake holder’s approach

–Mechanism of shareholder’s value


Financing Pure equity financed mini-firm approach

E(F1)E(F2)

E(Fn)

E(FN)

F0

… …Nn21

0

βproject IRR

E(r)

piaci portfolió

értékpapír-piaci egyenes

E(rM)

1

rf

β

ralt

0)1(

)(

0

nn

alt

n

r

FENPV altrIRR

Firm

Shareholder

Project

Investmentdecision

Dividend

Tőkepiaci alternatívaCapital m.alternative


Financing Pure equity financed mini-firm approach

If perfect capital market is assumed, the influence of debt policy on the value (Net Present Value) is negligible, therefore in economic analyses of projects pure equity financed mini-firm will be assumed.


Financing Effects of capital structure in perfect market

Nine different factors should be investigated:– Value, Expected return and Risk of the– Firm, Equity, Debt

The FirmThe value of the firm is equal to the sum of the value of equity and the

value of debt V=E+D (the capital structure can be characterised as the financial leverage of the firm which is shown by the D/E ratio)

The expected return of the firm [E(rV)] and the risk of the firm [βV] are given by the projects of the firm

Therefore the value, the expected return and the risk of the firm is independent from the capital structure of the company, so from the D/E ratio



DebtsThe risk of the debts (βD) in a low leveraged situation is 0, because the equity covers the debts, thereforethe required return of the debts (rD) is equal to the risk free return.

After a certain leverage the risk and therefore the required return of the debts begin to increase,because the probability of debt trapping is increased.


rM

rD

E(rV)

rf

D/E

E(r)

10

rD

βV

Risk-freeDebt

RiskyDebt

Risk-freeDebt

RiskyDebt

β

D/E10

βD

Financing in perfect market



EquityRearranging the previous two equations (Firm) to the expected return and to the risk of the equity the next relations can be found:


E(rV)

rf

D/E

E(r)

10

rD

βV

Risk-freedebt

Riskydebt

Risk-freedebt

Risky debt

β

D/E10

βD

E(rE)

βE




Equity (Stocks)The leverage increases the risk (βE) and the expected return (E(rE)) of the stocks,

however, the value of the stocks is not affected (the risk and the expected return is increasing together in the function of D/E,

so it is just sliding up on the security market line of the CAPM), therefore the capital structure is indifferent for the shareholders.


E(rV)

rf

D/E

E(r)

10

rD

βV

Risk-freedebt

Riskydebt

Risk-freedebt

Riskydebt

β

D/E10

βD

E(rE)

βE

β

E(r)

βV

E(rV)V

D

E

rf




ConclusionThe changing D/E ratio has no effect on the value of the firm, the

equity and the debt (MM. I.)

The expected return of the equity is proportionally increasing with the D/E ratio.The rate of increase in the beginning is linear, then due to the increasing required rate of debt return (rD) the increase slows down. (MM. II.)

This is why the pure equity financed “mini-firm” approach is adequate in corporate financial analyses.


Financing Effects of capital structure in a slightly imperfect market

I. Corporate tax (*)Financing the corporation by debts is advantageous, because

interest connected to the debts can be cleared in the books as financial expenditure so the tax base is reduced and with this the tax liability is decreased.(annual tax saving= tc•D•rD)

The tax saving means cost reduction, so raises the expected cash flow and return of the firm.

It can be derived that the present value of a leveraged firm is increased by ~tcD.

This increase is due to the shareholders.


D

E(rV)

rf

D/E

E(r)

10

rD

βV

Risk-freedebt

Riskydebt

Risk-freedebt

Riskydebt

β

D/E10

βD

E(rE)

βE

β

E(r)

βV

E(rV) V

D

E*

rf

E(rE)*

E(rV)*

rD(1-tc)

D/E10

P

E

E

D

V

E*

D

V*

V*



I. Corporate tax (*) II. Personal income tax as well (**)

All elements of the capital structure are taxed with almost the same rate, therefore it is indifferent in capital structure decisions.

III. Financial distresses (***)Financial distress occurs when the company is not able to cover

its liabilities due to the high financial leverage and in this case the legal regulation over-defenses the state and the debtors and over-weakens the position of the shareholders.

The probability of this kind of situation is increased by the D/E ratio, so decreasing the value of the stocks.



D/E

V

0

PValue losses due to Financial distresses

D/Eopt

V***

V**

E***

Even in case of slight market imperfection, the value changing effect of the financial leverage is negligible, so the pure equity financed mini-firm approach is appropriate.


E(F1)E(F2)

E(Fn)

E(FN)

F0

… …Nn21

0

βproject IRR

E(r)

piaci portfolió

értékpapír-piaci egyenes

E(rM)

1

rf

β

ralt

0)1(

)(

0

nn

alt

n

r

FENPV altrIRR

Firm

Shareholder

Project

Investmentdecision

Dividend

Tőkepiaci alternatívaCapital m.alternative

Dividend policySignificance of indifference of dividend policy in financial analyses If the indifference of dividend policy is assumed, then

the project analyses can be derived through the cash flow steams of a pure equity financed mini-firm, so the shareholder’s cash flows resulted from dividend pay offs can be neglected.

If above hypothesis can be proved, the corporate financial analyses are highly simplified, because the mini-firm approach can be used.


Dividend policyExplaining the indifference of dividend policy in a perfect market

The suppositions (circumstances)the firm has settled on its investment program (i.e. it is already worked out

that how much of this program can be financed by borrowing, and the plan meets other funds requirements)

perfect market (fair issuing price, zero transaction cost, equal tax rates – dividend and price earnings)

What happens if the dividend wanted to be increased without changing the investment and borrowing policy?

The only solution is to print some new shares and sell them.

Miller and Modigliani states that the dividend policy has no affect to the value of the firm in the above circumstances.

Investment and borrowing policy is determined so to increase the value of dividend new shares have to be offered so one part of the company become the property of the new owners.



It is indifferent for the old owners how they get money by dividend or by selling some of their stocks.

Before dividendT

otal

val

ue

of f

irm

After dividend

New stocks

moneyprice

decrease



Shares

Firm

Cash

Cash

New stockholders

Old stockholders

New stockholders

Old stockholders

No dividend no stock issue

Dividend financed by stock issue

Cash Shares


Dividend policyExplaining the indifference of dividend policy in a slightly imperfect market

Arguments usually presents some kind of market imperfection (tax differences, transaction cost)

Reasons to pay higher dividend–There is a conservative group which believes that an increase

in dividend payout increases firm value

–In lack of information the high dividend is a good sign

–The paid dividend is certain while the price increase is uncertain

Reasons to pay lower dividend–High transaction cost of issuing

–Higher taxation of divined incomes


Dividend policyExplaining the indifference of dividend policy in a slightly imperfect market

Even in case of slight market imperfections the indifference can be defended.

Empirically it can be proven that a supply-demand equilibrium is created between investors’ preferences to dividend and corporations’ dividend policies.

If there existed better dividend policy, all company would use this,

however many kind of policies can be found in the market.


Determination of cash flow streams Introduction

What is the aim of determination of cash flows?– Corporate financial analyses are based on the future cash

flows created by the project.– These cash flows will be examined through the analyses


Determination of cash flow streams Relevant cash flows

• Cash flows should be estimated on change base• All derivative effects have to be considered (with or

without)• Opportunity cost has to be taken into consideration• Sunk Cost• Careful separation of overheads• Working capital needs• Sub-versions should be separated• Financing effects should be considered separately


Determination of cash flow streams Consideration of inflation

Using nominal values.All cash flows are considered on current price, so the estimated

price changes tendencies – of e.g. material costs, payments to personnel, selling price – are calculated. Of course the opportunity cost should be considered in the same way.

Using real values.Unchanging, today prices are considered, but in this case the

opportunity cost should be estimated on the same way.


Determination of cash flow streams Consideration of taxation

Most taxes are taken into account as costs, i.e. they are considered as indirect or general expenditures for which the base is the net profit.

General rule that is in the estimation of cash flows and in the estimation of opportunity cost the same calculation procedure should be used.


Determination of opportunity cost Determination of opportunity cost by the CAPM

The opportunity cost gives the reference return in economic analyses.

The project’s expected return have to exceed this to be worthy for the owner to accomplish the investment.

In the determination of the opportunity cost we have to start from the CAPM.

–There exists risk-free asset–There is a premium accompanied to risk taking–The required, expected and average returns are equal

averagehistoricalfMaveragehistorical

fMf

premiumriskf

risktimealt

)r(rβ

rrEβr

rEr

rrrEr

fr

))((

)(

)(

0)1(0

nn

alt

n

r

FNPVF0

F1

F2

Fn Fn+1


By definition the return of the risk free asset (time premium) is the return of any real asset with zero standard deviation. (There is no asset like this…)

In the estimation the return of that financial asset should be considered, which certainly pays back the claim with its interest. There is only one issuer which can guarantee that this will happen and this is the government.

Therefore some kind of government security should be considered.

The risk of inflation can be eliminated in two ways:– inflation indexed government security–modifying with the estimated inflation rate

If the return of government security is changing in time, the return of zero-coupon bonds, or the return of security with similar maturity to the project life time.

alt f historical average M f historical averager r (r r )


rf



By definition the return of the market portfolio can be given by the expected return of that portfolio which represents the capitalization weighted average return of all securities traded in the world.

This can be approximated with the global portfolios e.g. MSCI world index

However it would be rational to hold the global portfolio (MSCI), however there are many factors against the rational behaviour. Therefore a segmentation of the global market can be discovered.

In this case separate CAPM worlds can be found.and the return of the market portfolios of these worlds

depends on the expectations of the investors in the given world.

rM

alt f historical average M f historical averager r (r r )


alt f historical average M f historical averager r (r r ) We are always interested in the opportunity cost of projects,

(but the risk of a specific project and the risk of a specific stock (company) is not necessarily equal) nevertheless capital market information is available only on stocks.

Two step procedure– Estimation of unlevered betas– From unlevered calculation of project betas

Main factors cause the differences:– Sales revenues sensitivity to fluctuation of the whole economy– Effect of operating leverage Fix Cost / Total Cost– Financial leverage MM II.

For starting point we can choose the beta of the given company if the function of the project is similar to the function of the firm, otherwise industrial averages can be used.



Determination of opportunity cost Country risk approach

This approach can be used in those countries which has a fairly young capital market.

In this case developed capital market data can be used as the basis of the estimation.

The above data should be modified by the country risk factors which can be defined by the characteristics of the capital markets and other factors.

This modification is a three step procedure:1. Determination of the country risk factor which can be found by the

credit-ratings of financial consulting companies like the moody’s or blomberg.

2. From this rating the extra return connected to government securities can be found so this has to be converted to the extra premium of stocks i.e. companies.

3. Determination of the relationship between the firm and the country concerning the risk.


Determination of opportunity cost Opportunity cost by WACC

The expected return of the firm can be expressed as the weighted average of the expected return on equity and debt, this is called the Weighted Average Cost of Capital:

WACC is used in opportunity cost estimation in case of the investigated project’s business activity (risk) is close to the business activity (risk) of the firm.

The idea behind the calculation shows that the project should create a profit at least which covers above the interest on debt the required return of equity.

If the corporate income tax is considered as well then the above expression is modified to

DEValt rV

DrE

V

ErEWACCr )()(

DcEValt rtV

DrE

V

ErEWACCr )1(

**)(

*

*)*(**


Business economic analyses Introduction

The main steps of a corporate financial analyses are–Determination of opportunity costs (identification of the return

of alternative capital market investment possibility with similar risk)

–Determination of future cash-flows (this is the sum of economic effects of the project)

–Economic analyses (comparison between the profitability of the project and the alternative investment possibility)

• NPV, IRR, PI, AE


Business economic analyses Net present value

Net Present Value is the sum of discounted cash-flows of a given project by the opportunity cost.

So in this way the economic value of a project can be compared to other investment possibility with the same risk. The result of NPV calculation shows the value increase above the alternative investment possibility.

Therefore, the project will be implemented if the NPV>0.

nn

n 0 alt

E(F )NPV 0

(1 r )


Business economic analyses Internal rate of return

Internal Rate of Return is defined as the rate of discount which makes the NPV=0.

In this case the average return of the project is determined and this is compared to the opportunity cost.

So the IRR rule is to accept an investment project if the opportunity cost of capital is less then the IRR.

Pitfalls of IRR:–It shows the average return of the project i.e. the increase of

unit equity in unit time–Lending or borrowing–Multiple rates of return–Mutually exclusive projects–Short- and long term interest rates may differ


Business economic analyses Profit Index and Annual Equivalent

Profit index is the quotient of the Net Present Value and the investment cost of the project:

0

NPVPI

F

It is used in case of limited capital, for mutually exclusive projects.


Business economic analyses Profit Index and Annual Equivalent

Annual equivalent can be used to compare mutually exclusive and repeating projects with different life time.

In this case the future cash-flows of the project converted to annuity and these annuities will be compared (NPV of the normal cash flows has to give the same result as the NPV of the annuity)


Companies in the modern market economy Introduction

Development of public limited corporationsEarly capitalism

• individuals and families• unlimited liability• the owner and the manager is the same• Development of technology and mass production required

the concentration of capital

Limited liability• legal entity• shares are tradable

More owner one company• management and ownership are separated, but• the goals are different• agency problem


Companies in the modern market economiesMain types of modern market economies

The types are connected to the degree, the manner, and the function of intervention of the state into the economic processes.

The three form of modern market economy:–Corporate (market) controlled (Anglo-Saxon)

–State controlled (Asian capitalism)

–Negotiation based market economy (Rhenish)



Corporate (market) controlled (Anglo-Saxon)

The role of the state is narrow

USA, Great-Britain–Weak feudalism

–Parliamentary political system

–Smooth and continuous industrialisation



State controlledRelatively the highest state coordination

– intervenes the microeconomic processes–selectively influences the operations of companies–plays a significant role in the allocation of recourses like

• state owned firms• financing R&D• reduced rate credits

Japan and France–Strong feudalism and aristocracy–Late but rapid industrialisation, therefore–High industrial concentration–The bank system has a significant role–The state in sight of the international competition strengthened

its position.



Negotiation based market economy

The economic processes are based on the negotiations of the leading economic roles.

The main idea is “social partnership” i.e. political consensus between the employers, the employees, and the bureaucracy.

The negotiations include:–wages–prices–taxes–employment–economic stability and growth



by the financing system of the economyBy the role of the bank system three types can be

distinguished:Capital market based financing system

–New recourses can be obtained by issuing stocks or bonds, bank loans are used mainly for temporary financing

Credit based financing system with administrative dominance

–Small and moderate exchanges so the firms have to use the banks for financing.

–Subsidies through the banking systemCredit based financing system with institutional

dominance–Some large banks, and they have shares in the firms,

investment funds are owned


Companies in the modern market economiesShareholder’s value – stake holder’s approach

Share holder’s value approach:–Only the growth of the company’s value counts–The firm works as a “revenue producing machine”–From the 90’s this form became the major approach–Capital market based financing system

Stake holder’s value–They are the buyers, the suppliers, the investors, the creditors,

the employees, the government–Their interests should be considered –More comfortable, and humane–Credit based financing system


Companies in the modern market economiesMechanism of shareholder’s value

If there are dominant shareholders’ of the company, the board of directors and carrier competition work well.

If the ownership is crumbled (because of the demand of capital new issues happened, diversification of owners, etc.) then the intervention of owners to the business activity of the firm is decreased even the members of the board could be delegated by the management.

However, if the shareholders’ is pushed into the background, then the firm is usually pushed to the edge, so the owners are gladly sell their stocks and by this the buyout of the company can happen, and the new owners are easily fire the management.


DerivativesProperties of options

Derivative instruments are financial assets with returns depend on value of other factors.

Two basic types:– Termins (forwards and futures)

Termin transactions are basically sales contracts for a predefined future date, however the seller does not have to own the asset of the contract.

– OptionsOptions give the opportunity to buy or sell an asset on a specified price.


DerivativesProperties of options

Types of option:– Call is the opportunity or obligation to buy– Put is the opportunity or obligation to sell– Short positions are obligations to sell or buy (writer)– Long positions are rights to sell or buy

Buyer Seller

Call option Right to buy asset Obligation to sell asset

Put option Right to sell asset Obligation to buy asset

Option price or premium is the value which have to be paid by the buyer for the opportunity.

Exercise of Strike price is the predefined (contracted) price of the asset (K).

X0 is the actual price of the assetThe owner of an option can

– sell the option on actual price– at expiration draw the option– wait until expiration and do nothing

American vs. European option


Value of Call and Put options at expiration

LC

X

K

K

K

K

K

K

K

K

LP

X

SP

X

SC

X


Profit on Call and Put options

Profit on LC

X

K

K

Profit on LP

K

KX

Profit on SP

K

K X

Profit on SC

K

K X

FV(c)

FV(c)

FV(p)

FV(p)


DerivativesFactors influence option prices

• Actual stock price• Strike or Exercise price• Intrinsic value (relation of X0 and K)

– Call ITM situation the intrinsic value = X0-K– Call ATM and OTM situation this value is 0

• Volatility of the stock returns (standard deviation of annual returns)

• Time to option expiration• Mature dividend until expiration• Risk free return (i.e. the present value of exercise price)• Time value of option

The difference between the value of the option (c) and its intrinsic value


DerivativesFactors influence option prices

Value of LC

X0K

Intrinsic value: X0-K

PV(K)

K-PV(K)

Modified intrinsic value: X0-PV(K)

Value of option: c

PV(K)+PV(D)

PV(D)

Value of option: c

Actual price: X0

PV(K)+PV(D) X0-PV(K)-PV(D)

Value of option: c


DerivativesReal-options

Real options are option analogies fitted to corporate investments by which those parameters can be evaluated that cannot be included in NPV calculations.

Likederivative investment possibilities (Call option)

possibility of leaving a business (Put option)

summary in finance, mba20011 summary of courses in finance (revision for the state exam) mihály...

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