REVISION for MIDTERM

Chapter 1: Introduction to corporate finance

- Financial decisions: 3 decisions:

o Investment (capital budgeting) decision
o Financing (capital structure) decision
o Short-term asset management decision
- Financial managers
- Business organization:
o Sole proprietorship owners =managers
o Partnership
o Corporation: owners =/= managers
- Goal of financial management  to maximize shareholders’ wealth.
- Agency problem: conflict of interest  managers may not act for shareholders’
interest.
In corporation, separation between shareholders and managers --> agency
problem  agency cost (direct cost and indirect agency cost)

Chapter 2: Financial statements and Cash flows

Financial statements:
+ Balance sheet:
Balance sheet equation: TA = TL + TE
CA + FA = CL + LTD + TE

o Liquidity:
o Debt vs Equity:
o Market value and Book value
 To make financial decision : market value
+ Income statement:
Income statement equation: Earnings (Profit) = Rev – Expenses
 o GAAP (accrual accounting method)
o Non cash items  Earnings/Net income is not cash
o Time vs cost
+ Tax: marginal tax vs average tax  marginal tax rate should be used to make financial
decisions

+ Net working capital (NWC):

NWC = CA – CL
NWC varies with sales

ΔNWC = NWCt – NWCt-1  represents investment in short-term assets

+ Financial Cash flows:

CF(A) = CF(B) + CF(S)

CF(A) = OCF - NCS - NWC

CF(B) + CF(S) = OCF – NCS - NWC

OCF = EBIT + Dep – Current tax  starts with EBIT

 Finance treats interest expense as financing cash flow + Accounting cash

flow statement:

o Cash flows from operating activities (CFO)  starts with net income (NI)
o Cash flows from investing activities (CFI)
o Cash flows from financing activities (CFO)
 Accounting treats interest expense operating cash flows

Chapter 3: Financial statement analysis and long-term financial planning

+ Why do we have to standardize financial statements?

 To enhance comparison
+ Common sizing financial statements  present financial statements in percentage

o Common sized balance sheet  presents all balance accounts as

percentage of TOTAL ASSETS
o Common sized income statement  presents all income statement line
items as percentage of TOTAL SALES.
+ Ratio analysis:

o Liquidity
o Leverage
o Asset management
o Profitability
o Market value
+ Some potential problems
+ Dupont identity:
𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 𝑆𝑎𝑙𝑒𝑠 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠
𝑅𝑂𝐸 = = 𝑥 𝑥
𝑇𝑜𝑡𝑎𝑙 𝐸𝑞𝑢𝑖𝑡𝑦 𝑆𝑎𝑙𝑒𝑠 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 𝑇𝑜𝑡𝑎𝑙 𝐸𝑞𝑢𝑖𝑡𝑦

+ Long-term planning:  prepare pro forma financial statements

o Simple model: all accounts and line items vary with sales
o Percentage of sales approach:
 Estimating EFN (external financing needed)
EFN = projected assets – projected (liabilities + equity)

+ Growth rates:

o Internal growth rate

o Sustainable growth rate

Chapter 4: Discounted cash flow valuation

 learn to calculate PV and FV
+ Single cash flow, single period
PV = FV/(1+R)
FV = PV*(1+R)
+ Single cash flow, multiple periods

o Simple interest  interest on principal only

o Compound interest  interest on interest

+ Multiple cash flows, multiple periods

+ Due cash flows (beginning cash flows):  calculate the ending PV or FV and then
multiply the result by the (1+R).
+ Effective Annual Rate of Return (EAR): Actual return taking into account number of
compounding period effect

 EAR is more relevant to use to make decision, instead of APR (quoted interest
rate)
+ Simplifications:

o Perpetuity: constant cash flows last forever

o Growing perpetuity: cash flows grow at constant growth rate (g) forever
o Annuity: constant cash flows last for a fixed maturity
 o Growing annuity: cash flows grow at constant growth rate (g) for a fixed
maturity

Chapter 5: Net present value and other investment rules

Principles:
+ If NPV > 0, then accepting the project creates value. So, to maximize value, choose
projects with the highest NPV
+ Payback period – length of time until the accumulated cash flows equal or exceed the
original investment. -> Find the lowest number.
+ Same for Discounted Payback period with discounting method.
+ Internal Rate of Return (IRR) – the rate that makes the present value of the future cash
flows equal to the initial cost or investment. The investment is acceptable if its IRR
exceeds the required return.

Chapter 8: Bond valuation

Bond is a legally agreement between borrowers and lenders
In a bond agreement specifies some following features of bond:

• Face value (FV)/Par value  an amount bondholder get back at the maturity date.
($1,000)
• Coupon rate (c%): annual interest rate that the bond issuer commit to pay to
bondholders
• Coupon payment (C): amount of interest bondholders receive periodically
C = c%*FV
EX: c% = 8%; FV = $1,000  C= 8%*1,000 = $80
• Maturity date (T): the date the bond is expired and the bondholders get back the face
value
 Yield to maturity (YTM):
o the required market rate of return on the bond  bond issuers (borrowers)
o the actual return the bondholder earns if he/she buys the bond today at
market price and hold it till maturity  bondholders (lenders)
 Why do we need to price a bond?  to make investment decision

Eg.: J. Bond has following features:

- coupon rate: 8% maturity: 5 years FV: $1,000

yesterday, market price of J.Bond: $1,000  $900 today

What is the true value of the bond? (how much is this bond worth with?)

- Face value: determined by issuers

- Market value (market price): determined by buyers and sellers
- Intrinsic/true/long-term/fundamental/theory value: the value analyst estimates using
analytical techniques
To make decisions  compare market value with intrinsic value

- MV > Intrinsic value: sell

- MV < Intrinsic value: buy

 VALUATION PRINCIPLE:
(Intrinsic) Value of financial asset = PV of its expected future cash flows

1/ COUPON BOND:  Bond pays periodic interest (coupon)

Ex: J. Bond: FV: $1,000 c%: 8% annually C: $80 T: 5 years R = 10%
1 2 3 4 5
C 80 80 80 80 80
FV 1,000
C= c%* FV

EX: Suppose that the Youth Corporation issues a 10-year zero-coupon bond to raise funds to finance a
plant expansion. The bond’s face value is $1000; coupon rate is 12 percent annually.

- If the required is 14 percent what is the value of the bond now?

- If the required return on the Youth Corporation’s bond is 10 percent what is the value of the
bond now?
 - If the required return on the Youth Corporation’s bond is 12 percent what is the value of the
bond now?

Answer:

R (YTM) = 14%  P = $895

R (YTM) = 10%  P = $1,124

R (YTM) = 12%  P = $1,000

+ Relationship between YTM and bond price: There is the negative (inverse) relationship
between market required return (YTM) and bond price
 Bond concepts:
YTM (14%) > c% (12%)  P< FV  Discount Bond
YTM (12%) = c% (12%)  P= FV  Par Bond
YTM (10%) < c% (12%)  P> FV  Premium Bond

+ Interest rate risk

 Price Risk: Change in price due to changes in interest rates

+ Long-term bonds have more price risk than short-term bonds

+ Low coupon rate bonds have more price risk than high coupon rate bonds.

 Reinvestment Rate Risk: Uncertainty concerning rates at which cash flows can be
reinvested

+ Short-term bonds have more reinvestment rate risk than long-term bonds.

+ High coupon rate bonds have more reinvestment rate risk than low coupon
rate bonds.

Calculate YTM:

If you know R (YTM)  P : intrinsic price

If you have market price (P)  R (YTM)
Ex: Suppose J.Bond which has FV: $1,000; c%: 8% annually; T: 5 years is trading at 700$
(market price)  YTM?

• YTMJ= 17.5%
YTM = current yield + capital gain yield.

Current yield = annual coupon/ market price

Capital gain yield = (P1 – P0)/P0

2/ ZERO COUPON BOND (PURE DISCOUNT BOND Bond pays NO periodic interest (coupon)
1 2 3 4 5
C 0 0 0 0 0
FV 1,000

Bond theorem: Bonds of similar risk (and maturity) will be priced to yield about the
same return (the same YTM), regardless of the coupon rate.

 If you know the price of one bond, you can estimate its YTM and use that to find
the price of the second bond. This is a useful concept that can be transferred to
valuing assets other than bonds.
Ex: Your company K is going to issue a new bond which has FV: 1000$ c%=6% T=5
years  What should be the issuance price?
Suppose K. Bond has the same risk with J. Bond K can take J. Bond’s YTM to be its
YTM (17.5%)
How to know K and J have the same risk?  we have to look at credit rating
 • Inflation and Interest Rates
(1 + R) = (1 + r)(1 + h), where
o R = nominal rate
o r = real rate
o h = expected inflation rate
Approximation
oR=r+h

Chapter 9: Stock valuation

Buy buying a stock, an investor may expect to get:

• Dividend (Dt): a part of income the company pays to shareholders

• Capital gains/loss (Pt – P0): an increase (decrease) in share price
0 1 2 3 4 5 6 7 8 ………
D1 D2 D3 D4 D5 D6 D7 D8
P1 P3 P7

EX: Buy Stock: VNM  expect to get:

My expected future CFs: D1 & P1 (R is given)


 Discounted Dividend Model (DDM)

Share price depends on dividend and required return (R) (length of time investor hold the
share)
Dividends may not fixed and unknown because they depend on both firm’s performance
and dividend policy.
1/ Case 1: zero growth dividend (g=0)  Dividends are constant forever  perpetuity
0 1 2 3 4 5 6 7 8 ………
D D D D D D

EX: A Company promise to pay dividend of $2/share forever and the R = 10%:

P = 2/0.1 = $20

b/ Constant growth case (g=const.): Dividends grow at constant growth rate (g: const.) forever
Growing perpetuity
0 1 2 3 4 5 6 7 8 ………
D0 D1 D2 D3 D4 D5 D6 D7 D8

D1 = D0*(1+g)

D2= D1*(1+g)= D0*(1+g)2

D3= D2*(1+g)= D0*(1+g)3

 Dividend Growth Model (DGM) or Gordon Model

EX: Suppose Big D, Inc., just paid a dividend of $.50. It is expected to increase its
dividend by 2% per year. If the market requires a return of 15% on assets of this risk
level, how much should the stock be selling for?
c/ Differential growth (multi-stage) case:
Ex: A common stock just paid a dividend of $2. The dividend is expected to grow at 8%
for 3 years, then it will grow at 4% in perpetuity. What is the stock worth? The discount
rate is 15%.

g1 = 8% g2= 4% (const. forever)

HOW TO ESTIMATE R AND g

The required return consists of 2 components: dividend yield (D1/P) and dividend
growth rate (g)

 g: sustainable growth rate:

g = ROE*b (refer the chapter 3)
b: retention ration
b = 1- payout ratio.
2/ COMPARABLES
Price to earnings ratio (PE) = share price / EPS

P = EPS1*(P/E)industry
EX: VNM ---Next year EPS of VNM = vnd 9,000
PE of dairy industry : 18x

 PVNM = 9,000* 18 = VND 162,000