Advanced Corporate

Finance
Ronald F. Singer
FINA 7330
Review of Financial
Management
Lecture 1
Fall 2009

Administration
Instructor: Ronald F. Singer
Phone: 713-743-4771
Office Hours: Wednesday 2:30 to 4:00 or
by appointment
Room 210F Melcher Hall
Webpage: www.bauer.uh.edu/singer

Class Administration

Exams
Late Entrants
Reading, Eating, etc.
Attendance
Texts:
Brealey, Myers and Allen, Principles of Corporate
Finance, 9th ed.
Wall Street Journal

Valuation Problem
Groups, presentation, study

Outline
Capital Budgeting Decision

Financial Statement Analysis

NPV Rule
Arbitrage and Risk
Time Value of Money
Complicated Decisions

Investments
Risk versus Return
Optimal Portfolio Selection (CML)
Equilibrium Prices (SML and CAPM)

Review of Corporate Finance

Three areas of inquiry
Capital Budgeting
Capital Structure
Payout policy

Capital Budgeting
What is to be discounted?
How do we discount?
What is the decision rule and why?

Macintosh Enterprises
Pro-Forma Income Statement
(Year ending December 31, 2008)
($ thousand)
Sales
$5,000
Less: Operating Expenses (COGS)
Depreciation & Amortization
Allocated G & A Costs
Operating Income (EBIT)
Less: Interest Expense
800
Earnings Before Tax (taxable income)
Less Tax (@ 35%)
490
Net Income (Earnings after Tax)
Earnings per Share (EPS) = Net Income/Shares = $0.91
Assuming 1 million shares outstanding

2,000
500
300
$2,200
1,400
$910

Macintosh Enterprises
Pro-Forma Cash Flow Statement
(Year ending December 31, 2008)
($ thousand)
Earnings Before Interest and Taxes
$2,200
Less: Tax on Operations (@ 35%)
(Note: not $490)
Operating Income after Tax (EBIT(1-t)
)
1,430
Plus: Non-Cash Expenses (Depreciation & Amortization)
Less: Change in Working Capital
{Increase a/c receivable
200
increase in Inventory
100
Increase other ST Assets 100
Less: increase in a/c payable
150
Decrease ST Liabil.
(50))}
Change in Working Capital
+300
Cash Flow from Operations
$1,630
Plus Interest Tax Shield
(800 times 0.35)
CASH FLOW
Less: Net New Investment (net of capital gains tax)

280
$1,910
200

Less: Cash Flow to Bondholders (Interest, principal, Bond Repurchase, Call)

Less: Cash Flow to Preferred stockholders
Free Cash Flow to Common Stockholders
EBITDA

1, 270
100
340
$2,700

770
500
- 300

Firm Valuation
What determines the value of the Firm?
In a perfect capital market setting
In an efficient market setting
In the Real World

What determines the value of

securities
Security Pricing Models
Capital Asset Pricing Model (CAPM)
Arbitrage Pricing Model (APT)
Multifactor Model
Option Pricing or Contingent Claims Pricing

Capital Budgeting
The Net Present Value Rule
What is it?
Why does it work?
Why would all investors regardless of their
personal preferences for current versus future
consumption agree on the NPV Rule?
Present Value and the No-Arbitrage Price
Why securities should sell at a price that is equal
to the PV of the Cash Flow to the holders.

First Separation Principle

The firm can make a capital budgeting
decision independently of how the project
will be financed.
Eventually, the firm will have to worry
about how to finance the project, but the
simple question right now is:
Are the benefits from investing greater than
the cost?
i.e. is the NPV of the project positive?

Risk
Securities are priced as if the market in general
is risk averse. That is, the typical investor
appears to prefer a less risky alternative to a
more risky alternative.
So in order to induce investors to hold risky
investments, the investment must be priced so
as to reward the investor for the risk he takes on.
This reward is called the risk premium
associated with the expected return of risky
securities, and projects.

Risk versus Return

That is:
E(Return of a risky venture)
= The reward for waiting plus
compensation for taking on risk.
= Risk free return plus a risk premium.

Present value of what?

We talk about the Value of something
being equal to the present value of
something.
What is this something?

CASH!!!
So, when we consider the value of a
security or of a project, or of a firm, or any
investment activity, we want to know what
the Cash Flow will be and how to discount
it.

Central Role of Cash Flow

Capital Budgeting: Must consider
Incremental Cash Flow
Bonds and Stock (Dividends, interest,
repurchases, principle)
Investments (Free Cash Flow)
Firm Valuation (Free Cash Flow)

Bond valuation
What is the cash flow expected from a typical
bond?
You must be careful here to distinguish between the
Coupon Rate and the Required Return.
The coupon rate describes how the bond gets some of its
cash flow out to the holders. It reflects the risk and interest
rate of the Bond at the time the bond was originally issued,
and may or may not be representative of the risk and level of
interest rates today.

Stock
Again, we need to find the Present Value
of the Dividend stream.
Predicting the dividend stream is not easy.
We generally rely on fundamental analysis of
the value of the issuer.
Then value the firm and subtract the nonequity securities issued by the firm to get the
value of the Equity.

Investments
Here the real question is how does a rational
investor choose a portfolio of securities?
There are three things that needs to be
considered:
The Efficient set of Risky Assets
Diversification

The Efficient Risky Portfolio (CML)

the Relationship Between Risk and Expected Return
for:
Portfolios
Individual Securities

return

Efficient Set of Risky Assets

minimum
variance
portfolio
Individual Assets

return

Efficient Risky Portfolio

CM

L
efficient frontier

M
rf

Relationship between Risk and

Return
Efficient Portfolios (Capital Market Line)
Rp = Rf + Risk Premium
= Rf + (Rm - Rf) p

Relationship between Risk and

Return
Individual Securities (Capital Asset
Pricing Model)
Ri = Rf + Risk Premium
= Rf + (Rm - Rf) i

Capital Structure
What is the Capital Structure Decision?
What are the determinants of a firms
capital structure
What do we have to consider?

Payout Policy
What is payout policy?
What are the Issues?
What factors are important?

Generally
We look to violations of Perfect Capital
markets: In particular:
Costly Information
Taxes
Agency Problems
Failure to align
managements with stockholders interest
Market for corporate control