Week 1 1

Introduction to corporate finance

CORPORATE FINANCE 1

UNIVERSITY OF EXETER

MARK FREEMAN, 2004

Week 1 2

Stakeholders in a company

Every company has many “stakeholders” – people who depend

on the success and operations of the firm:

1) The employees

2) The general community

3) The executives

4) The investors

i. Stockholders

ii. Bondholders and banks …

“Corporate Finance” or “Financial Management” looks at the

firm from the perspective of what investors – and particularly

stockholders – require from the firm.

Week 1 3

Don’t all stakeholders want the same thing?

Surely all stakeholders want the same thing? Don’t they all

wish the company to be successful?

This is not the case since they will not all agree on what is

“successful”. As examples:

1) Employees want a high salary irrespective of the

effect on profits

2) The community will want high environmental

protection

3) Executives may want expensive offices and

corporate jets. They also often want companies to be

as large as possible, even if that is not economically

efficient.

4) Investors want profit maximization

The fact that executives may not always act in shareholders

best interests is known as agency conflict.

Managers’ compensation is often designed to align their

interest with those of shareholders. This is one reason for

executive stock options and performance shares.

Week 1 4

So why worry about investors?

So why should managers worry about maximizing shareholder

wealth?

1) It is the stockholders, not the managers, who own the

firm. The CEO is just another employee

2) If you do not consider investors you will never get

funding for future projects

3) If you ignore shareholders, they have various ways

of punishing you:

i. They control executive compensation

ii. They have the ability to have you taken

over

iii. They can sack the board

iv. They can fail to support your plans at general meetings and otherwise lobby you

(“direct intervention”)

You should also worry about bondholders / banks since they

can make you bankrupt.

REMEMBER: You need investors more than they need you!

You need to market yourself to investors in the way that you

market yourself to any other potential group of clients.

Week 1 5

Do all investors have shared objectives?

For the purposes of this course, yes. The “Net Present Value”

method that we use in this course will discriminate between

projects that are attractive and those that are not for all

investors.

In more advanced corporate finance, it will be shown that there

are situations where this is not the case.

In general stockholders prefer risk to banks. This is because

banks can only get their money back (with interest) so do not

participate in very high profits. Shareholders, on the other

hand, have limited liability but unlimited upside.

This conflict is particularly important for firms in financial

distress. Banks then want companies to take much less risk

than would be optimal for shareholder wealth maximization.

Week 1 6

Who are investors?

Source: ProShare for the LSE, http://www.investinginbonds.com/info/bondbk3.htm for US

bond data and the NYSE fact book. Mutual funds figure for LSE is Investment trusts (not unit

trusts)

0% 10% 20% 30% 40% 50%

Other

Foreign

Mutual funds

Insurance

companies

Pension

funds

Private

investors

LSE

NYSE

All US Bonds

Week 1 7

The three key topics

In introductory corporate finance, there are three main issues:

1) If we have a new project that we wish to fund, are

investors going to find it attractive?

2) If we have an attractive project, what is the best

source of funding?

3) Once a project is running, how do we financially

manage it

i. How do we manage financial risk?

ii. How do we liaise with investors?

Week 1 8

When do investors view a project as being

attractive?

When applying to an investor for finance, you should be

aware that you are competing against many other firms for

this money. The main things that investors looks for in a

project are:

1) The expected post-tax cashflows that will result from the

project

2) The timing of these cashflows

3) The uncertainty associated with the cashflow

4) How the cashflows interact with other risks within the

investor’s portfolio – “diversification”

5) The rates of return available on other investment

opportunities

Week 1 9

Funding the project

Having established that your project is financially sound, you

next need to decide how to fund it. Usually funding from

retained earnings is cheapest. However, if you have to

generate external capital, you have two main sources:

Debt Equity

Borrow money Ownership of firm

(Usually) finite length Indefinitely lived

Interest must be paid Dividends need not be paid

No voting rights Voting rights

“Seniority” Non-senior

Interest: tax deductible Dividends: non-tax deductible

Here “seniority” means that debt holders have full claim to

any money up to the amount they are owed at any point in

time. The equity holders have claims to the residual.

Week 1 10

Debt financing

It is likely that you will at least want some debt financing. As

well as deciding whether we want to take direct bank

borrowing or issue tradable corporate debt, there are other

questions that you must answer:

1) What “maturity” of debt do you require? That is, how

long do you want to borrow the money for?

2) Do you want to take out “fixed rate” or “floating rate”

debt?

3) Do you want to borrow all your money in GBP (Great

British Pounds), or do you want to borrow some money

in foreign currency?

The answers to these questions will depend on:

1) The timing of the cashflows from your projects

2) On how the cashflows generated by your projects will be

influenced by changes in the interest rate

3) How much international business you undertake

Week 1 11

Managing financial risks

Most companies are susceptible to changes in financial

conditions over which they have no control.

1) International organisations are subject to fluctuations in

foreign exchange rates.

2) Companies with high levels of debt will suffer if interest

rate rises.

3) Certain companies have a high exposure to commodity

prices – for example, airlines and oil prices.

These risks can be managed using both strategic and

“hedging” approaches.

Hedging involves the use of “derivative securities” – futures,

forwards, options and swaps. A corporate treasurer must

know how to implement risk management techniques in this

area.

There have been many recent corporate “disasters” caused by

poor hedging strategies. Chief Executives should be aware of

the risks and opportunities in this area.

Week 1 12

Ongoing relationships with investors

Once you have raised capital, you must decide how you are

going to liaise with your shareholders.

Certain issues that you will need to address are:

1) How much information you release

2) What your dividend policy will be

3) Mergers and acquisitions strategy

Week 1 13

Key issues in managerial finance

Is the project sufficeintly profitable?

Estimate the risk

Estimate the expected post-tax cashflows

Is the project attractive?

What maturity of debt do we want?

Do we want private or traded securities?

What combination of debt/equity is optimal

How do we fund the project?

Working capital management

Adapting and refining the project

Managing changes in interest/FX rate

Managing the project

Mergers and acquisitions

When do we pay dividends?

Liasing with investors

Running the project

Starting the project

Week 1 14

Provisional lecture (tutorial) syllabus

[Not MSc FAFM]

Week 1 Introduction (No tutorial)

Week 2 Treasury bills and Gilts (Week 1 questions)

Week 3 The term structure (Week 2 questions)

Week 4 Capital budgeting 1 (Week 3 questions)

Week 5 Capital budgeting 2 (Week 4 questions)

Week 6 Capital budgeting 3 (Week 5 questions)

Week 7 Capital structure (Week 6 questions)

Week 8 Dividend policy (Case study 1)

Week 9 Mock examination (No tutorial)

Week 10 Managing transaction risk (Case study 2)

Week 11 Managing strategic risk (Mock exam solutions)

Week 12 Real options (Revision tutorial)

One written assessment (4,000 words): 40% and one exam: 60%

Week 1 15

Provisional lecture (tutorial) syllabus

[MSc FAFM]

Lectures and tutorials as other students for weeks 1 – 8

In addition, two-hour classes on Tuesdays for week 2 - 7

Weeks 2 – 5 Financial Ethics

Week 6 Portfolio Theory and the CAPM

Week 7 Market Efficiency

No teaching after Week 8.

Mock examination in Week 10.

One written assessment: 20% and one exam: 80%. Details to be

confirmed.

We will NOT cover the learning outcomes of the CFA line-by-line in

this (or any other) course. However, the main topic areas will all be

covered. It is the student’s responsibility to ensure they are familiar

with the CFA required readings and learning outcomes.

Week 1 16

Reading list

Brealey & Myers = Brealey & Myers, “Principles of Corporate Finance”,

Seventh Edition, Irwin McGraw-Hill

BH = Brigham & Houston, “Fundamentals of Financial Management”, Eighth Edition, South Western

Fab. = Fabozzi, “Fixed Income Analysis for the CFA Program”, AIMR

DMPR = DeFusco, McLeavey, Pinto & Runkle, “Quantitative Methods for

Investment Analysis”, AIMR.

Week MSc FAFM Others (From Brealey &

Myers)

1 BH pp.18-22 Chs. 1&2

2 – 3 Fab. Chs. 5&6

DMPR pp.60-72

Chs. 3&24

You may need some

additional reading

4 – 6 BH Chs. 9-12

DMPR pp. 54-60

Chs. 5,6&9

7 BH Ch. 13 Chs. 17&18

8 BH Ch. 14 Ch. 16

10 N/A No reading

11 N/A Chs. 20&27

12 N/A Ch. 22

Week 1 17

Laws!

1) Turn up ON TIME for all classes. The start time means

the door will be closed and the lecturer will start

teaching. Do not be late – arrive at least 5 minutes

before the published start time. Come back promptly

from class breaks.

2) Do not talk in class unless invited to do so by the lecturer

or tutor. PLEASE do not “chat”.

3) Turn up to the lecture / tutorial to which you are

allocated. You MAY NOT attend at times to suit you –

it important that the numbers are balanced so that you all

receive the best quality tuition.

4) Always prepare fully for tutorials. Be keen to ask

questions and make contributions in lectures and

tutorials.

5) Make sure you abide by the department’s “honour

codes”. In particular, make sure you understand the

University regulations on plagiarism and cheating.

6) Mobile phone OFF. If a phone goes off in a lecture it

will be answered by the Lecturer! No texting.

Week 1 18

Discounting, rates of return and all

that

CORPORATE FINANCE 1

UNIVERSITY OF EXETER

MARK FREEMAN, 2004

Week 1 19

Rate of return

When looking at investments, the most important thing is to

be able to calculate the rate of return.

Suppose that we invest £100 today and then received £105 in

three month’s time. What is the rate of return? In this case,

with only one future cashflow, the rate of return is easy to

calculate:

Rate of return = Selling price – Buying price

Buying price

= 105 – 100 = 5%

100

This equation can be rearranged as follows…

Buying price = Selling price

(1+rate of return)

… or in this case, £100 = £105/1.05. Notice that the rate of

return of 5% must be expressed as 0.05 when being put in this

calculation.

Week 1 20

Annualised rates of return

The rate of return that we have calculated is for three months.

In order to compare projects of different maturities it is

useful to convert the rate of return to some “standard” time

period – usually one year.

There are three main ways of doing this conversion. Let t

denote the number of time periods in a year.

1) rtar =

2) 1)1( −+= trar

3) 1−= rtear

In our example, there are four periods of three months within

one year, so t=4. The annualised rates of return are:

1) %2005.0*4 ==ar

2) %55.2114)05.1( =−=ar

3) %14.221)05.0*4(=−=ear

Notice that, although these give different answers, they are all

similar.

Week 1 21

Which do we use?

So, which is the right answer? The first is the easiest to

calculate and is therefore often used as a convention in

financial markets. We will see this next week when we look

at the way bond yields are quoted. However, this method of

annualisation does not have good economic motivation.

The third method is correct in situations where there is

“continuous compounding”. This method turns out to be very

important in certain, more advanced, types of finance –

particularly when it comes to valuing options and other

derivatives. For the purposes of this course we will only rarely

– if ever – use this method.

The second method will be the preferred technique within this

class. Essentially this method assumes that the asset would

continue to give a 5% return every three months. Therefore,

had we not sold the asset, in six months it would have been

worth 105*1.05 = 110.25. After nine months it would be

worth 110.25*1.05 = 115.76. After twelve months it would be

worth 115.76*1.05 = 121.55. Therefore the annual rate of

return = (121.55-100)/100 = 21.55%, as given by the second

method. We call this “discrete” or “simple” compounding.

Week 1 22

Example

On 31/12/03, you bought shares of company A for £50 and

shares of company B for £25. On 31/1/04, you sold the

shares of company A for £51. On 30/4/04 you sold the shares

in company B for £27. Which gave you the higher annualised

rate of return?

Company A. Rate of return = (51-50)/50 = 2%. There are

twelve months in the year, so t=12. The annualised rate of

return is therefore (1.02)12 – 1 = 26.82%

Company B. Rate of return = (27-25)/25 = 8%. There are

three periods of four months in a year, so t=3. Therefore the

annualised rate of return is (1.08)3 – 1 = 25.97%

So, the investment in company A is slightly better than the

investment in company B.

Week 1 23

Example –2

What happens if we reverse this problem? Suppose that I told

you that you had bought a share for £50, held it for six

months, and received an annualised rate of return of 15%.

How do you calculate your selling price?

You need to know the actual six-month rate of return that you

received. Since six months is ½ of a year, the six month rate

is just 1.151/2 – 1=7.238%. Therefore

Selling price - £50 = 0.07238

£50

So, selling price = £53.62.

Week 1 24

The rate of return on multiple cashflows

Consider the rate of return on an asset that pays multiple

cashflows.

You bought shares in company A on 31/12/2003 for £50. On

30/6/2004 you were paid a dividend of £2 and then you sold

the share for £58 on 31/12/2004. What annualised rate of

return have you received on this share?

The answer, r, solves the following equation:

rr +

+

+

=

1

58£

2/1)1(

2£50£

The easiest way to calculate this is to use either a financial

calculator1 or a spreadsheet.

1 Having a financial calculator is not necessary for this course. I don’t own one.

Week 1 25

The rate of return on multiple cashflows - 2

Within Excel, for example, we can set this up as follows:

A B C D

1 Time Cashflow Discounted

2 Cost 0 -50 -50

3 Dividend 0.5 2 2

4 Sale 1 58 58

5 6 r 0 10

1) b2..b4 Time until the cashflows arrive (in units of

one year)

2) c2..c4 Value of the cashflows (notice that the original

cost is a negative value)

3) b6 Put in “0” as an initial guess

4) d2 Formula =c2/(1+$b$6)^b2

5) d3..d4 Copy the formula from d2

6) d6 Formula =SUM(d2..d4)

Week 1 26

The rate of return on multiple cashflows - 3

Go to “Tools”, “Goal Seek”.

“Set Cell” d6

“To Value” 0

“By changing cell” b6

Hit “OK” and the correct value of r will then be given in b6.

A B C D

1 Time Cashflow Discounted

2 Cost 0 -50 -50

3 Dividend 0.5 2 1.823 4 Sale 1 58 48.177

5

6 r 0.203889 0

You can see that the rate of return is 20.39% in this case.

Week 1 27

Example

You lend a friend £200 today. She promises to pay you

interest of £10 in both six and twelve months. In eighteen

months she will repay the £200. What is the rate of return

(“interest rate”) on this loan?

Time Cashflow Discounted

Loan 0 -200 -200

Interest 1 0.5 10 9.672 Interest 2 1 10 9.355

Repayment 1.5 200 180.97

R 0.068919 0

We just repeat the same process – except that we now have an

additional cashflow to worry about. By using Tools/Goal

Seek in Excel we can see that the interest rate is just under

6.9% on an annualised basis.

Week 1 28

Starting with the rate of return

Often we will wish to reverse this argument.

An investor promises you cashflows of £100 for each of the

next three years if you invest in her project. We require a rate

of return of 10% per annum. How much are you prepared to

invest in the project?

Investment = £100 + £100 + £100 = £248.68

1.1 1.12 1.13

This is, at its simplest level, the way in which we value

investments. We say that £248.68 is the present value of

these cashflows.

Week 1 29

Treasury bills and Gilts

Government borrowing comes in the form of Treasury bills

(short term) and bonds (long term)2. In the UK Treasury

bonds are sometimes called Gilts – which is short for “Gilt-

edged security” because of the low risk of the Government

defaulting on its repayment obligations.

Gilts have a face value of £100 (in the US, the standard is

$1,000). That is, when the asset matures, the government will

repay £100. In addition, there are coupon payments. Coupon

payments are interest payments paid on these bonds.

If the price of a Gilt is above £100 then you will receive a

capital loss on this asset. It is said to be at a premium. Such

Gilts pay high coupons so that investors are still willing to

buy them despite the capital loss.

If the price of a Gilt is below £100 then you will receive a

capital gain on this asset. It is said to be at a discount. Such

Gilts pay low coupons so that investors need capital

appreciation as well as the coupon to make the bond an

attractive investment.

2 Investors sometimes talk of Treasury “notes”, which are medium-term investments;

maturity between a bill and a bond.

Week 1 30

T-bills

With Treasury bills (maturity up to one year), there are no

coupon payments. The gain comes completely in the form

of capital appreciation.

For example, today we might see the price of the six-month t-

bill quoted at £97.00. The only future cashflow to come from

this bill is £100 in six months time.

So, the rate of return to this t-bill is:

r = (£100 - £97) / £97 = 3.093%.

Annualising using r*t gives 6.19% (since t here = 2) or using

(1+r)t-1 gives 6.28%.

We will return to this subject next week.

Week 1 31

Gilts

Gilts have funny names – for example: “Cn 9 3/4pc ‘06”. The

first two letters “Cn” are not important; you can ignore this.

The “9 3/4pc” tells you the coupon. The Government will

pay you 9.75% each year. This is paid “semi-annually”; that

is, at six monthly intervals. So for every £100 of face value,

the interest payment is 9.75% * 100 / 2 = £4.875 every six

months.

Finally the “’06” tells you that the bond matures in 2006. On

the day the bond matures you receive the £100 of face value

together with a final coupon payment of £4.875.

The exact date of maturity / coupon payments cannot be

determined from this information. Again, we will return to

this next week.

Week 1 32

Questions – Week 1

CORPORATE FINANCE 1

UNIVERSITY OF EXETER

MARK FREEMAN, 2004

Week 1 33

Question set 1

1) You lend a friend £100 today. She repays the £100 in three months and

buys you a £2 beer to thank you for your help. What is the interest rate

on the loan? What is the annualised interest rate on the loan?

2) You buy a share for £50. Which of the following would you prefer: (a)

to sell the share for £60 in six months or (b) to sell the share for £70 in twelve months?

3) If a bond promises to repay £100 in two months and you require an

annual interest rate of 6%, how much are you prepared to pay for it

today?

4) You buy a share for £20, it pays you a £5 dividend in six months and you sell it for £18 in twelve months. What annualised rate of return have you

received on this share?

5) During last year you undertook the following share transactions.

Calculate the annualised rate of return that you received on each of these shares.

Date Transaction Asset Quantity Price per unit

Jan 1 Buy A 100 £70 Feb 1 Buy B 50 £55

Mar 1 Buy C 300 £120

Apr 1 Dividend A - £2 per share

May 1 Sell C 100 £130 Jun 1 Dividend B - £1 per share

July 1 Sell B 50 £55

Aug 1 Sell C 100 £140

Sep 1 Dividend C - £5 per share

Oct 1 Dividend A - £3 per share Nov 1 Sell C 100 £100

Dec 1 Sell A 100 £75

Week 1 34

6) A relative asks you to choose one of the following as a birthday present

for this year and next. Rank these in order from most attractive to least

attractive to you:

a. £110 for your birthday this year but nothing next year

b. Nothing this year but £110 for your birthday next year

c. You can spin a coin. If it comes up heads you will get nothing at all

for your next two birthdays. However, if it comes up tails, you will get £110 for both of the next two years.

d. You can spin a coin. If it comes up heads you will get nothing at all

for your next two birthdays. However, if it comes up tails, you will

get £150 for both of the next two years.

7) Suppose that on 2nd January 2003 the price of the Tr 3pc ’04 was £98.00. This bond pays coupons on 1st January and 1st July and will mature on

1/7/04. What rate of return is this Gilt offering?