Corporate Finance: Key Concepts and Valuation Methods
Lecture 1
Fisher Separation Theorem
The optimal investment decisions of a firm are unrelated to the consumption desires of its shareholders. The capital market serves to separate the two decisions. Thus, a firm can best act in its shareholders’ interest by investing in projects with the highest Net Present Value (NPV).
Annuity
Capital Budgeting Rule
Take all projects with a positive NPV. Between mutually exclusive projects, pick the project with the highest NPV.
Principles of Valuation
- Value additivity
- No arbitrage
- Irrelevance of financing
Pricing Model
- Arbitrage pricing: Find replicating portfolios
- More often used in fixed income and derivatives pricing
- Asset pricing: Use risk-adjusted discount cash flows
- Equity pricing and present value analysis
Efficient Markets
The purchase or sale of any security at the prevailing market price is never a positive NPV decision.
Firm Market Value
Firm Market Value = PV of assets + PV of growth opportunities = PV of investments undertaken + NPV of potential investments
Old shares are not diluted by new shares. Even though earnings per share (EPS) may drop right after issuance, additional earnings generated by new capital will rebound EPS.
MM Proposition I
The total value of the securities issued by a firm is independent of the firm’s choice of capital structure. The firm’s value is determined by its real assets and growth opportunities, not by the types of securities it issues.
MM I Assumptions:
- Capital structure does not affect investment policy
- No taxes
- Bankruptcy is not costly
- Managers maximize shareholder wealth
- Perfect and complete capital markets
- Symmetric information
Example P17.
When a firm levers up, it increases the riskiness of its equity. The cost of capital reflects the riskiness of the underlying assets and is independent of the capital structure.
MM Proposition II
In the same firm, 
is always less than 
, because the debt has higher priority and thus less risk.
EPS and P/E ratios can be manipulated by changing capital structure alone.
Example P.25
Valuation in Practice
- Discount true cash flows, not accounting earnings
- Discount nominal cash flows at nominal rates and real cash flows at real rates
After-tax cash flows = Revenues – Costs – Investments – Taxes
= Revenues – Costs – Investment – 
(Revenues – Costs – Depreciation)
= (1-
)(Revenues – Costs) – Investment +
Depreciation
Net Working Capital
Net working capital (NWC) is the difference between current assets and liabilities.
NWC = Cash + Inventory + Accounts Receivable + Prepaid Expenses (taxes, insurance) – Accounts Payable
Increases in NWC represent a negative cash flow.
Only consider incremental costs when analyzing investment projects.
Economic Value Added
Economic Value Added (EVA) essentially collapses NPV into a period-by-period number.
Lecture 2
CAPM
CAPM produces nominal rates.
Expected cash flow reflects idiosyncratic and systematic risk, while the discount rate only reflects systematic risk.
Discount rate = 
= WACC = Cost of Capital
Identical twin method: Search for assets that are similar to those of the project so that we can determine the asset beta.
Covariance is a linear operator: 
Business Risk + Financial Risk
Financial risk is the risk that equity holders must bear in the presence of higher-priority debt.
Valuation by multiples
State Price Approach
Information not needed to use this approach:
- The probability that firm X will default in the next two years
- The term structure of risk-free interest rates
- The true model used by the market to price risk
is always true
Example P.51
Lecture 3
Arbitrage valuation for options: Construct a portfolio of traded assets that replicates the payoff of the real option.
Risk-Neutral Pricing
The no-arbitrage present value of the future cash flows is given by 
risk-neutral probability
Risk-Neutral Valuation: Applications
Black-Scholes Formula
Lecture 4
Corporate Taxes
If debt is perpetual, PV debt tax shield = 
Personal Taxes
Debt holder gets 
of every dollar of operating profit, 
is his personal tax rate. Equity holder gets 
of every dollar of operating profit, 
is his personal rate on equity income.
If debt is perpetual, 
is free cash flow before taxes, 
is the market value of debt
PV of debt tax shields = 
should be the debt capacity contributed by the project.
Financial Distress
Under MM, there are no costs to bankruptcy. A firm is in economic distress when its assets are generating a net economic loss. Financial distress occurs when the financial claims on the firm cannot be serviced.
The costs of financial distress:
- Direct costs: Legal fees
- Indirect costs: Assets are sold at low prices; intangible assets may be destroyed; diverted managerial attention; no commitment to stakeholders; loss of flexibility when monitored closely by creditors; games played by shareholders
Games stockholders play: Engage in risk-shifting or over-investment where stockholders take high-risk, negative NPV projects to realize upside potential and leave the bondholders to bear the downside risk.
Example P82.
Lecture 5
Adjusted Present Value Method
The adjusted present value (APV) method first values firms as if they are all-equity financed, and then “adjusts” the value by including the present value of the debt tax shields, and other financing costs and subsidies.
of cash flows assuming all-equity financed + Subsidies to financing – Costs of financing + 
. Free cash flows if all-equity financed = EBIT – Corporate tax if no debt existed (= Taxes + Interest * Tax rate) + Change in deferred taxes + Depreciation expense – Increase in NWC – Capital expenditure. 
WACC
cost of levered equity. 
Assumptions:
- Debt is permanent and a constant fraction of the market value
- Project risk matches the replicating portfolio of debt and equity. If WACC is estimated for the firm, then the project should be identical in risk and financing.
WACC vs. APV
- APV is flexible
- WACC assumes a constant debt-to-total capital ratio
- WACC assumes interest tax shields are used in the year they accrue
-
is the expected return on debts, difficult to get for firms with multiple debt layers and varying potential for default
Examples: