COURSERA

LECTURE NOTES

AN INTRODUCTION TO CORPORATE FINANCE

Franklin Allen

Wharton School

University of Pennsylvania

Fall 2013

WEEK 6 (Part 2)

Section 9

Exam Review

Copyright 2013 by Franklin Allen

1

COURSERA AN INTRODUCTION TO CORPORATE FINANCE

PREPARATION FOR EXAM

BASIC CONCEPTS: Sections 2-8

(i) Section 2

What should a corporation's objective be?

- Maximize NPV since this makes all shareholders better off no matter what their preferences.

What assumptions are required for this result to hold?

- Perfect capital markets. (ii) Section 3

How are PV's calculated?

Basic Formula:

C

COA

Y

point that maximizes NPV

D

E

preferences 1

preferences 2

)r + (1C = PV t

t

tT

1=t

2

)r + (1

Dividend = P tt

1=t0

Special cases: Perpetuity Growing perpetuity Annuity Growing annuity These all assume payments are made at the end of the year. What happens when payments are made more frequently? - Compounding (iii) Section 4 How do we value bonds and stocks? - Prices of securities must be equal to their PV's. If this wasn't the

case, what would there be? An arbitrage possibility. Basic Formula: Stock with constant growth rate:

If growth is in stages then we have to adapt the basic formula to take

account of this. What do the formulas imply for price/earnings ratios? - If a stock has a high price/earnings ratio does that mean it's a good

buy? No it means it has a lot of growth opportunities.

g-r

Div = P1

0

3

(iv) Section 5 Why is NPV the best investment criterion? - Superior to IRR because IRR has following difficulties Lending and borrowing problem Multiple roots Relative measure - Superior to Profitability index because this is Relative measure - Superior also to Payback and accounting measures such as Average

Return on Book because these are incorrect (v) Section 6 How do you make investment decisions using NPV rule? - Discount cash flows - Transform accounting data into cash flows Cash flow = $'s received - $'s paid out Work in after-tax terms Estimate cash flows on an incremental basis Be consistent in your treatment of inflation (vi) Sections 7 and 8 Beta and the Capital Asset Pricing Model Hold stocks in portfolios - Unique risk is diversified away - Market risk remains Variance of well-diversified portfolio depends on covariances of stocks in it, i.e, it depends on their market risk

4

Measure of a stock's market risk is β where βstock = Cov(stock, M)/Var M CAPM

If CAPM assumptions are satisfied the expected return on an asset is determined by it's market risk r = rF + β(rM - rF) The security market line plots r against β. If the CAPM is satisfied all stocks and portfolios lie on the security market line. This contrasts with the capital market line above where the diagram is r against SD. Unique risk is included so all stocks and portfolios do not lie on the capital market line.

Mean

Standard Deviation

Market portfolio

π = 1

π < 1

Borrowing

Lending

0 < π < 1

r f

Capital

Market

Line