FINA0304 Advanced Corporate Finance

Prof. Keith K. P. Wong Fall 2013

Course Objective: The objective of this course is to develop theoretical and practical tools for corporate financial decisions. Topics covered include: discounting and compounding, valuation of bonds and stocks, pricing options and derivatives, capital budgeting, capital structure, and real options. Subtle elements of asymmetric information and conflict of interests among various claimants are emphasized.

 References Brealy, R. A., S. C. Myers, and F. Allen, 2006, Corporate Finance, 8th ed., McGraw-Hill. Shockley, R. L., 2007, An Applied Course in Real Options Valuation. Thomson South-Western. Grading: The course grade is made up as follows: Mid-Term Test October 24 (Thursday) 30% Homework Biweekly 10% Final Exam To Be Announced 60%

Office: Tel.: E-mail: Office hrs:

KK930 2859-1044 kitpongwong@hku.hk 2:00p.m. 3:00p.m., Friday

The study of corporate finance

Capital budgeting Process of planning and managing a firms investment in fixed assets. Capital structure Mix of debt and equity used by a firm. Working capital management Managing short-term assets and liabilities of a firm.

Balance-sheet model of a firm

Total value of assets Current assets Fixed assets Tangible assets Intangible assets Total value of the firm to investors Current liabilities Long-term debt Shareholders equity

Net working capital

Goal of financial management

Profit maximization? Current profits or future profits Profits can be calculated in different ways. Maximize the market value of shareholders claims Current stock price Forward looking objective

Separation of ownership and control

Principal-agent relationship between shareholders (principals) and management (agents). Diffuse shareholder ownership makes effective control of management difficult. Control devices used by shareholders to align managements interest with theirs: (i) Board of directors (ii) Managerial compensation contracts (iii) Takeovers (iv) Labor market competition

Lecture note 1

Discounting and Compounding

Time Value of Money

A dollar today is worth more than a dollar later. Present dollars and future dollars are different kinds of money, e.g., HK$ vs. US$. To compare present and futures dollars, we need some exchange rates. Compounding: e.g., US$1 = HK$7.8 Discounting: e.g., HK$1 = US$0.13

The One-Period Case

In the one-period (two dates, 0 and 1) case,
Present cash flow (C0) Future value (FV)

the formula for the future value at date 1 can be written as where r is the appropriate interest rate for that period. (1 + r) is referred to as the compound factor.

The formula for present value (PV) at date 0 can be written as

Present value (PV)

Future cash flow (C1)

1/(1+r) is referred to as the discount factor.

The Multiperiod Case

Compound interest vs. simple interest The general formula for the future value over T periods can be written as

Example: Suppose that you invest $10,000 at 5% interest, compounded annually, for three years. What is the total amount due at the end of the investment?

Cash flow of the investment

Year 0 10,000 Interest Year 1 10,000 500 Year 2 Year 3 10,000 500 500 25 500 25 25 1.25 11,576.25 10,000 500 500 interest on interest 25

Total amount after 3 years

 Solution: By the general formula, we obtain the same answer: FV = $10,000 (1 + 5%)3 = $11,567.25

The general formula for the present value over T periods can be written as

Example: Suppose that you want to prepare $10,000 to pay the school fee 3 years later. The bank offers 5% interest, compounded annually. How much do you need to deposit in the bank?

 Solution Let PV be the amount of deposit. By the general formula, PV = $10,000/(1.05)3 = $8,638.38 Cash flow of the deposit
Year 0 Year 1 8,638.38 8,638.38 Interest 431.92 Total amount after 3 years Year 2 9,070.29 453.51 Year 3 9,523.81 476.19 10,000

Compounding Periods
Compounding an investment m times a year for T years provides for future value of wealth:

where r is the stated annual interest rate (i.e., rate before considering any compounding effects).

 Discounting an investment m times a year for T years provides for present value of wealth:

Example (Your school fee again): Suppose that the bank offers 5% interest, compounded quarterly, this time. How much do you need to deposit in the bank?

Solution Annual interest rate: r = 5% Number of compounding periods a year: m=14=4 Total number of years: T = 3 The amount of the deposit = $10,000/(1 + 5%/4)43 = $8,615.09 < $8,638.38

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A Comparison
Compounding effects

After 5 years, the payouts are 1.276,1.2801 and 1.284 respectively.

Continuous Compounding
In the limiting case of continuous compounding, the formula for the future value in year t is

where e = 2.7182818 Proof. Note that

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Applying lHpitals rule, we have

Hence, we have

The formula for the present value in continuous discounting is

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Effective Annual Interest Rates

The Effective Annual Interest Rate (EAR) is the annual interest rate that would give us the same end-of-investment wealth:

where the equality holds when m = 1 or r = 0.

Example: Suppose that you invest $10,000 for 3 years at 12% compounded monthly. What is the EAR on this investment? Solution: r = 12%, m = 1 12 = 12 EAR = (1 + 12%/12)12 1 = 12.68%

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The Multiple Cash-Flow Case

The general formula for the future value of a stream of cash flows,
C0 C1 C2 C3 0 1 2 3 .. CN N ... FV T

over T N periods can be written as

The general formula for the future value of a stream of cash flows,
C0 C1 C2 C3 0 1 2 3 .. CN N

can be written as

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Simplifications
Perpetuity: A constant stream of cash flow, C, that lasts forever.

The formula for the present value of a perpetuity is:

Proof: Buy the perpetuity for one period and then sell, you get C in the holding period.
PV 0 C + PV 1

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 Growing perpetuity: A stream of cash flows, C, that grows at a constant rate, g, forever.

The formula for the present value of a growing perpetuity is: if g < r.

Proof: C 0 1 C(1 + g) .. 2 C(1 + g) C(1 + g)2 .. 0 1 2 3

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 PV 0

C + PV (1 + g) 1

Annuity: A stream of constant cash flows, C, that lasts for a fixed number of periods.
PV C C C . C

The formula for the annuity is:

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 Proof:
T-period annuity
C 0 1 C 0 1 C 2 C 2 C 3 C 3 .. .. C T C C ..

Perpetuity

T T+1

PV of T-period annuity = PV of perpetuity

0 0 1 2 3 T T+1 0 0 .. 0 C ..

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 Growing annuity: A stream of cash flows that grows at a constant rate for a fixed number of periods.

The formula for the present value of an annuity is :

Example Mr. Wong has recently bought a tiny apartment at a price of $ 3 million dollars. Hang Seng Bank offers a 70% 10-year mortgage at an interest rate of prime minus 2.5%. The current prime rate is 5%. 1. What is the installment amount? 2. What will be the interest paid and principal paid in the 60th installment payment? 3. What will be the outstanding balance at that time?

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 Solution 1. Interest rate = 5% 2.5% = 2.5% Amount borrowed = $3m 70% = $2.1m No. of installments = 10 12 = 120 Monthly payment = P => Annuity with 120 periods

2. The balance right after the 59th installment = PV of the annuity with 61 periods = [$19,796.68/(2.5%/12)] [1 1/(1+2.5%/12)61] = $1,132,908.20

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3. Interest paid = $1,132,908.2 (2.5%/12) = $2,360.23 Principal paid = $19,796.68 $2,360.23 = $17,436.45 Outstanding balance = $1,132,908.20 $17,432.45 = $1,115,475.75

Net Present Value (NPV) Rule

A project requires an investment of I at t = 0 and generates a certain cash flow of CFt at t = 1, 2, , T. The projects NPV is given by

where r is the riskless rate of interest. If the stream of cash flows are risky, r would be the risk-adjusted required return.

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 The NPV rule: Accept a project if its NPV > 0. Accepting positive NPV projects maximizes shareholders wealth. How to cash in the future cash flows of the project today?

Year Project
Borrow for 1 year Borrow for 2 years

0 I

1 CF1
CF1 0

2 CF2
0 CF2

3 T CF3 CFT
0 0 0 0

Borrow for T years

0 0 0 CFT

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 Net cash flow at date 0 = = NPV (Cash in pocket)

Ranking criteria: Choose the project with the highest NPV. Year 0 1 2 T Project A IA CF1A CF2A CFTA Project B IB CF1B CF2B CFTB If NPVA > NPVB, project A is preferred to project B. Objective: Replicate the future cash flows of project B using project A and riskless borrowing and lending.

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 Example: Project A requires $1.5 million to yield $0.2 million in next year and $2 million two years later. Project B requires $2 million to yield $1.25 million each year in the next two years. Both projects are risk-free. Your boss likes the constant cash flow of project B. How are you going to persuade him/her that project B is in fact dominated by project A? The riskless rate of interest is 10%. NPV(A) = $0.34m NPV(B) = $0.17m

Year Project A Lend 0.95 for 1 year Borrow 0.62 for 2 years Total Project B

0 1.5 0.95 0.62 1.83 2

1 0.2 1.05 0 1.25 1.25

2 2 0 0.75 1.25 1.25

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Investment vs. Consumption

Some people prefer to consume now. Some prefer to invest now and consume later. How do we know all shareholders prefer the NPV rule as their investment rule? As long as capital markets are complete, investment and consumption decisions are separable.

Example: Individual A wants to consume now. Individual B wants to wait and consume later. Each of them has $185 that can be consumed right away or invested in a project that returns $210 at the end of the year. The rate of return on the project is 13.5%. (1) Capital markets are incomplete in that A and B cannot borrow and lend. (2) Capital markets are complete in that A and B can borrow and lend at 5%.

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Dollars Next Year 210

B invests $185 now and consumes $210 next year

A consumes $185 now.

185

Dollars Now

Dollars Next Year 210

B invests $185 now and consumes $210 next year

194 A invests $185 now, borrows $200 and consumes now. Dollars Now

185

200

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