Corporate Finance MIB 2008

Corporate Finance
MIB Program –
François Desmoulins-Lebeault
Christophe Bonnet
Simon Brillouet
Emmanuelle Saint-Supéry
and the finance teachers of the Accounting, Law , and Finance
department.
Grenoble Ecole de Management

• What is finance for you ?
• Who wants to work in finance in the future ?
• Who thinks she/he will work with finance ?
• What differentiates your studies & an

investment decision ?
MIB – Corporate Finance- Grenoble Ecole de Management 2

CORPORATE FINANCE 1
Session 1 : The financing cycle

1-Introduction to finance
2-The financial cycle and value creation
3-Compounding and discounting
Session 2 Investment decisions - The DCF method
1-Investment decisions : DCF method, calculation of the future cash-flows
Session 3 – Investment decisions - Net present value and other criteria
1-Investment decisions : net present value, IRR, other criteria
2-Small cases
Session 4 - Exercises and cases
1-Investment decisions: additional exercises and cases
Reading
• Brealey and Myers, Principles of Corporate Finance
• Class notes

CORPORATE FINANCE 2
Session 1 : The financing resources of corporations

1-The financing resources of corporations : equity and debt
2-The financial markets
Session 2 - Equity
1-Equity : various types of equity, how to raise equity, estimation
of the cost of equity (Gordon-Shapiro model, capital asset pricing model)
Session 3 – Debt financing and the WACC
1-Debt financing : various types of debt, how to issue debt, the cost of debt
2-The weighted average cost of capital
Session 4 - Exercises and cases
1-Additional exercises and cases

CORPORATE FINANCE 1
• Introduction to corporate finance

• The financial cycle and value creation
• Compounding and discounting

1- Introduction to corporate finance

Introduction to corporate finance
 Finance relates to dealing with money and time
 Concerns all economic agents:

 Individuals, households
 Companies
 States
 Finance for companies:

 Cash management (treasury, banking relationships)
 Control and accounting (accounts, tax,..)
 Corporate Finance (financial policy, investments)

Corporate finance
• Investment policy
How the firm spends its money (real and financial assets)
• Financing and payout policy

How the firm obtains funds (debt, equity, …) and disposes of excess cash
• Valuing a firm

What is corporate finance about ?
 Cash
Corporations need cash in order to invest in real assets. Cash is
obtained by issuing financial assets (securities).
 Value creation
Corporations create value if the return they produce exceeds their
cost of financing

Corporate finance is management, and involves…
 Taking decisions
 Financing decisions (incl. dividends distribution)
 Investment decisions
 Managing information
 Internal information and decisions processes
 External information to shareholders and other stakeholders
 Competition
 The companies are competing for finding financial resources

Objectives of the course
 Being able to identify the various sources of financing available for

companies
 Being able to calculate the cost of financing (i.e.: cost of capital)
 Being able to take investment and financing decisions

Types of questions
Investment decisions
• At the end of 2001, GM had $18.6 billion in cash. Should it invest in new projects or
return the cash to shareholders? If it decides to return the cash, should it declare a
dividend or repurchase stock? If it decides to invest, what is the most valuable
investment? What are the risks?
Financing decisions
• In 1998, IBM announced that it would repurchase $2.5 billion in stock. Its price
jumped 7% after the announcement. Why? How would the market have reacted if IBM
increased dividends instead? Suppose Intel made the same announcement. Would we
expect the same price response?
• Your firm needs to raise capital to finance growth. Should you issue debt or equity or
obtain a bank loan? How will the stock market react to your decision? If you choose
debt, should the bonds be convertible? callable? Long or short maturity? If you choose
equity, what are the trade-offs between common and preferred stock?

2- The financial cycle and value creation

The financial cycle and value creation
Finance is really about value

• Firms
• Projects and real investments
• Securities
Central question
How can we create value through investment and financing decisions ?
 In finance, as well as in liberal economic theory, the main goal of a company

is to maximise shareholders wealth
 But the objectives and interests of the other stakeholders have also to be
taken into account: employees, suppliers, customers, state and community

Balance sheet view of the firm
 A company is a bundle of assets :

 brands, patents, buildings and equipment, inventories,…
 but also reputation, know-how, market shares,…
 and, before all, teams of people
 In order to build / purchase these assets, a company needs financial resources

Dividends
& capital
gains
Shareholders
Equity Interests
Creditors
Decision
Salary &
benefits
Debt Employees
Invest
ments
Taxes
State
- Customers
- Raw materials
- Consumption Wealth

The financial manager’s role
(2) (1)
Financial
Firm’s Financial (4b) Markets
Operations Manager
(3) (4a)
investors providing
A bundle of financial resources
real assets in exchange of
financial assets
(1) Cash raised by selling financial assets to investors

(2) Cash invested in the firm’s operations and used to purchase real assets
(3) Cash generated by the firm’s operations
(4a) Cash returned to investors
(4b) Cash reinvested

3- Compounding and discounting
« Time is money »

Compounding and discounting
Discounting :Taking time into account
 Investing is a mechanism through which a company tends to increase its

wealth, but cash flows will be generated along time, in the future
 Because money has a cost and can be borrowed or lend, it is more

interesting to get a cash flow now than tomorrow
 Thus it we want to compare cash flows paid or received at a different

points of time, we need to convert all of them at their value of today (:
present value)
This operation is called “discounting”

 The cost of money takes the form of a rate, applied to the sums borrowed
or lent. It is the interest rate
 This rate can be decomposed into its components.
 The first and more obvious component is the risk premium
 The second and more complex component is called the risk free rate
This notion of “interest rate” is at the heart of finance

 There is a “risk free rate” because agents do massively prefer immediate

consumption to delayed consumption.
 The contribution of this preference to the risk free rate is measured

through the “inter-temporal rate of substitution”.
 The expected change in the value (or purchasing power) of money is the
other component of the risk free rate. This is called “anticipated inflation”.
 Each of these three elements is proportional to the length of time.
The sum of all these components is the interest rate and is specific
to each flow of money.

Time value of money
• t = 0, 1, …. , n time
• V0 = present value of a cash flow (at time 0)
• Vt = future value of a cash flow (at time t)
• r = interest rate = cost at which money can be borrowed or lent
V0 = present value Vt = future value
V0 = Vt (1+r) -t Vt = V0 (1+r) t
or V0 = Vt / (1+r) t

Time value of money
A €1 received in the future is always worth less than €1 received today.

If the interest rate is r, then the ‘present value’ of a riskless cashflow CFt received in t years is :
Present value =
You have €1 today and the interest rate on riskfree investments

(Treasury bills) is 5%.
How much will you have in …
1 year … €1 × 1.05 = €1.05
2 years … €1 × 1.05 × 1.05 = €1.103
t years … €1 × 1.05 × 1.05 × … × 1.05 = €1.05t
These cashflows are equivalent to each other. They all have the
same value.
⇒ €1 today is equivalent to €(1+r)t in t years
⇒ €1 in t years is equivalent to €1 / (1+r)t today

PV of €1 received in year t
Year when €1 is received

Discounting - Examples
• Future value of a cash flow of 100 € (Exercise 1)

• Exercises 2 to 4
• Case of successive cash flows over time :
Present value
Perpetuities
Growing perpetuities
Net Present Value
• Exercises 5 to 9

Discounting : Perpetuities and growing perpetuities (Shortcuts formula)
• Present Value of subsequent cash flows :

n
PV   (1CF t
 r)t
t 1
• Present value of a constant perpetual cash flow (Level cashflow

stream forever) :
CF
PV 
r
• Present value of a growing perpetual cash flow (Cashflows grow
by a fixed percent forever) :
PV  CF
rg

Discounting : Growing perpetuities (example)
Firms in the S&P 500 are expected to pay, collectively, $20

in dividends next year. If growth is constant, what should
the level of the index be if dividends are expected to grow
5% annually? 6% annually? Assume r = 8%.
Growing perpetuity

Discounting : Net Present Value
n
CFt
NPV  
t 0  1  r  t
The NPV of a cash flow stream is equal to the sum of the discounted cash
flows, each cash flow having been discounted at the interest rate r
n
n
CFid t
NPV   NPV   CFid t   1  r 
t
 1 r
t
t 1 t 0
 1 r 
n 1
1  1 r 
n
1
 CFid   CFid 
r r

Net Present Value : example
Your firm spends $800,000 annually for electricity at its Boston headquarters.
A sales representative from Johnson Controls wants to sell you a new computer-controlled
lighting system that will reduce electrical bills by roughly $90,000 in each of the next three
years. If the system costs $230,000, fully installed, should you go ahead with the investment?





CORPORATE FINANCE 1
Session 2 : Investment decisions - the DCF Method
• Investment decisions : DCF method, calculation of the future cash-flows

The DCF method : investment decisions
 Why would you want to invest ?

… to be richer
 Investing is a mechanism through which an economic agent tends to increase

his wealth
 As the company belongs to shareholders investing, for a company, is a way
to create wealth for shareholders
 An investment decision aims at maximizing the firm’s value

On which criteria are we going to take the decision to invest ?
The expected cash flows have to exceed the initial funds invested but this is not
enough, because money has a cost
The expected return of the investment has to exceed the cost of the
financial resources
Example:
• Suppose you can borrow money at a cost of 8%. You have an investment
opportunity offering a 6% return. Do you invest ?
• Suppose you can borrow money at a cost of 4%. You have an investment
opportunity offering a 6% return. Do you invest ?
If the return on the investment is lower than the cost of your financial resources,
you will not create value but destroy value


A company can increase its wealth through different kinds of investments:
• Industrial investments: equipment, buildings, ...

– to increase production
– to reduce operating costs
Assets:
• Commercial investments: marketing, development,…
– to increase sales
– to gain market shares, brand value,…
- Fixed assets
- tangible • Financial investments: acquisition of other companies
- intangible – to improve competitive position, enter new markets
- financial
• R&D: patents, know-how
– To create new technologies, processes, products
- Working
Capital
• Staff education

Main steps in the investment process
Operational level (project planning)

 feasibility study Before decision
 final studies
 implementation: launch
 follow-up: periodic controls After decision
Financial level (role of financial headquarters)

 set-up profitability goals, in view of the financial market
 study profitability of projects submitted by other Before decision
headquarters, according to technical, commercial,…
studies
 elaborate financing plan if a project is accepted
 provide funds on time
 check that goals have been reached After decision

When do you take an investment decision ?
 If you need it
Operational matters -
assumed from now on
 If you create wealth, i.e.

if the return is higher
than the cost of financing Financial matters:
 If you have the money our focus

In order to take investment decisions, we need to:
 Choose a blend of financial resources for the company and calculate

their cost (cost of capital) => WACC
Financing decisions
 Check if the returns of the investment projects are higher than the
cost of capital
Investment decisions

• The cost of the financial resources of the company can be calculated

(WACC, or cost of capital)
• The company creates value only if its investment projects deliver a return
greater than the WACC
• Thus we have to compute the return of the project
• And compute the consequences in terms of cash flows of the project

1. Evaluate the costs of investment and/or disinvestment

2. Evaluate future cash flows
generated by invested funds in order to determine the economic wealth
surplus freed by the project
3. Check if this wealth is sufficient to remunerate investors: shareholders &
creditors (wealth or return of the project > WACC)

Forecasting cash flows

• Draw up a flow chart of the investment :

1. At the beginning of the project
2. During the project
3. At the end of the project’s life
Money inflows
1 3
Money outflows

• Ignore sunk costs

Remenber opportunity costs
Consider marginal costs not average costs

• Ignore sunk costs
• Remenber opportunity costs
• Consider marginal costs not average costs

Cash flows
• Investment flows:
1. At the beginning of the project:

• Acquisition costs of assets
• Installation / implementation costs
• Marketing costs
• Possible disposal of old equipment
• Taxes, registration fees, tax credits,…
2. During the project:
• Depreciation tax shield
• WCR (Working Capital Requirements), investments in operations
3. At the end of the project:
• Possible disposal of used goods
• Repairing and cleaning locations costs
• Recovery of NWC

Working capital – Net working capital NWC

Cash flows
• Operating flows (evaluation of economic flows generated by the

investment):
1. At the begining of the project:

• No operating flow at the begining
2. During the project:
• (Surplus of sales induced by the project) – (incremental
expenses to make the investment run)
• … including taxes on those elements
  Gross operating margin of the project = EBITDA
3. At the end of the project:
• Same as during the project
• Total flows:
– Sum of investment flows & operating flows from year 0 (date of
acquisition) to the end of the project

Example
• You have the opportunity to invest in a wine distribution network. Forecasts after
market studies are the following :
• Selling price € 30
• Unit cost € 15
• Volume: 12,000 / year
• Truck purchase: € 200,000
• Duration: 5 years
• Depreciation: 5 years, linear
• Working capital requirements: 1 month of tunover
• Tax rate: 30%
• Fixed costs € 60,000 / year
• Evaluate the flows of such a project.

Example
• Investment flows :
– The truck costs € 200 K

• On a straight line basis, the annual depreciation is 200 / 5 = € 40 K per
year.
• It provides a tax credit of 40 * 30% = € 12 K a year.
– The turnover has to be 30 * 12 K = € 360 K / year

• One month of WC means that 360 / 12 = € 30 K are required during the
whole project to finance inventories & customer credits. The firm will
recover those € 30 K when liquidation occurs.

Example
• Investment flows:
Year 0 1 2 3 4 5
Acquisition,
-200
equipment
Tax credit,
12 12 12 12 12
depreciation
WCR -30 0 0 0 0 30
Investment
-230 12 12 12 12 42
flow

Example
• Operating flows:
– In-flows
• Sales: 30 * 12 K = € 360 K / year
– Out-flows:
• Variable costs: 15 * 12 K = € 180 K / year
• Fixed costs: € 60 K / year
• Income tax is applied on gross operating margin, 120 * 30% = € 36 K /year
– The operating cash flow is then 360 – 180 – 60 – 36 = € 84 K / year

Example
• Operating flows
Year 0 1 2 3 4 5
Turnover 360 360 360 360 360
- variable
180 180 180 180 180
costs
- fixed
60 60 60 60 60
costs
Gross
operating 120 120 120 120 120
profit
- Income
36 36 36 36 36
tax
Operating
84 84 84 84 84
flow

Example
• Total flows
Year 0 1 2 3 4 5
Investment
-230 12 12 12 12 42
flow
Operating
0 84 84 84 84 84
flow
Net flows -230 96 96 96 96 126
• Can I take a decision now ?

– No, I need to make these cash flows comparables  NPV and other
decision criteria

Traps
• Always deal with marginal (incremental) costs & sales

• It is the ADDITIONAL wealth due to the project that we want to
evaluate
• Already paid costs & general expenses are to be set apart, record
only costs & earnings induced by the project
• Use accounting loss as an immediate tax credit source
• Work with current currency, take inflation into account
• The rate of taxes on capital gains & losses can be different than corporate
tax
• The financing structure of the firm (or the project) is NOT to be taken into
account
• When evaluating the flows of a project, the evaluation only concerns
revenues & expenses due to the single project

Complication 1 : inflation



Complication 2 : currencies




CORPORATE FINANCE 1
Session 3 : Investment decisions - Net present value and other

decision criteria
• Investment decisions : net present value, IRR, other criteria

• Small cases

Investment decisions : NPV and other criteria
Decision criteria
• Can we make a good investment decision with the project flow information ?
• How are we going to compare different projects if we have several choices ?
• We need decision criteria to check that the wealth due to the project exceeds
the required remuneration of shareholders & creditors
• Decision criteria must take different deadlines into account: they must satisfy
the debtors & the shareholders
• Several criteria meet these requirements:

– Net Present Value (NPV)
– Internal Rate of Return (IRR) & complementary approaches: payback
period, profitability rate,…

NPV - Net Present Value
n n
CFt CFt
NPV  I 0   NPV  
t 1  1  r  t
t 0  1  r  t
• Principle
• Compares the sum of the present values of a project’s cash flows to
the one we would get by investing in the capital market
• Process
• Net present value = discounted sum of all cash flows generated by
the project
• Discount rate = cost of capital
• If initial investment expenses < future flows: PV is > 0, the
shareholders & creditors will get money
• NPV rule: NPV > 0

• NPV immediately measures the wealth surplus induced by the
project

IRR – Internal Rate of Return
n
CFt
NPV  I0   0
t 1  1  IRR 
t
• IRR is the rate of discount which equates the NPV of the cash flow to 0.
• Shareholders’ required remuneration + creditors’ required remuneration = an
overall constraint on the firm: investment costs (= cost of capital)
• The project is good only if
• the wealth earned > cost of capital
• The Internal Rate of Return measures the profitability of the project
• How much do I get back if I invest € 100 ?
• Decision rule:
– Project implemented if
• IRR > cost of capital (WACC)


1. IRR = measurement of the profitability, so a standard (reference) is

required : cost of capital
2. The implicit assumption of the reinvestment rate is strong
3. Possibility to have several rates when solving for IRR
4. Possible absence of IRR
5. Rate variations do not influence IRR

PBP – Payback Period : How long it takes to recover the firm’s original investment (or how
long the project takes to pay for itself). Break even point
PBP
CFt
I0  
t 1 1  r  t
• Period at which the sum of discounted cash flows exceeds the amount
invested.
• Cost of capital is the discount rate
• Use linear interpolation to find the payback period

PI – Profitability index
PVCF
PI 
I0
• Measures the relation between future wealth & the amount invested
• Measures the wealth created by € invested
• If PI > 1, the project is profitable
• Useful for the comparison of projected with different durations

Rules for decision
• A project will be accepted when
– NPV of economic flows > 0

• Discounted with cost of capital
– IRR > cost of capital
– Profitability Index > 1
– Pay Back < threshold set up by the firm
• NPV is the most RELEVANT: other criteria are complementary

CORPORATE FINANCE 2 : FINANCING DECISIONS
Session 1 : The financing resources of corporations

1-The financing resources of corporations : equity and debt
2-The financial markets
Session 2 - Equity
1-Equity : various types of equity, how to raise equity, estimation
of the cost of equity (Gordon-Shapiro model, capital asset pricing model)
Session 3 – Debt financing and the WACC
1-Debt financing : various types of debt, how to issue debt, the cost of debt
Session 4 - Exercices and cases
1-Additional exercises and cases

CORPORATE FINANCE 2
Session 1 : The financing ressources of corporation
1- The financing resources of corporations : equity and debt

2- The financial markets

1- The financing resources of corporations : equity and debt

The financing resources of corporations : financing decisions
 From the day of its creation, a company needs to find financial resources
in order to be able to invest
 Any kind of financial resource has a cost (similar to a “renting” price). This cost
will depend on the global economic and financial conditions as well as on
characteristics of the company (size, market, operating and financial risk,…)
We need to be able to select financial resources and to calculate

their cost

First principles
 Invest in projects that yield a return greater than the minimum acceptable hurdle rate (cost of
capital). (part 1)
• The hurdle rate should be higher for riskier projects and reflect the financing mix used -
owners’ funds (equity) or borrowed money (debt)
• Returns on projects should be measured based on cash flows generated and the timing of
these cash flows; they should also consider both positive and negative side effects of these
projects.
Choose a financing mix that minimizes the hurdle rate and matches the assets being
financed. (part 2)
• If there are not enough investments that earn the hurdle rate, return the cash to stockholders.
• The form of returns - dividends and stock buybacks - will depend upon the stockholders’ characteristics.
Objective: Maximize the Value of the Firm

There are only two ways in which a business can make money.
• The first is debt. The essence of debt is that you promise to make fixed
payments in the future (interest payments and repaying principal). If you
fail to make those payments, you lose control of your business.
• The other is equity. With equity, you do get whatever cash flows are left
over after you have made debt payments.
The equity can take different forms:

• For very small businesses: it can be owners investing their savings
• For slightly larger businesses: it can be venture capital
• For publicly traded firms: it is common stock.
The debt can also take different forms

• For private businesses: it is usually bank loans
• For publicly traded firms: it can take the form of bonds

Cost of debt :
Interest
W
A
C
C
Cost of equity
Return on > WACC

investments
 In order to build / purchase assets, a company needs financial resources
 Financing = finding a set of resources more or less expensive and risky for the firm
 The financing decision is linked to the choice of the firm’s optimal financial / capital
structure

The financing resources of corporations : sources of funds
Equity Debt
• Internal financing • Bank debt

– Retained earnings • Leasing
• Bonds: “Public”debt
• External financing
– Private equity
– Public equity
Management needs to find the appropriate financial structure for the company.
The cash flows from the projects will have to remunerate these resources.

The financing resources of corporations : sources of funds
Sources of funds, International

The financing resources of corporations : the financing mix question
Capital structure, International

The financing resources of corporations : the financing mix question
In deciding to raise financing for a business, is there an optimal mix of debt and equity?
• If yes, what is the trade off that lets us determine this optimal mix?
• If not, why not?
The simplest measure of how much debt and equity a firm is using currently is to look at
the proportion of debt in the total financing. This ratio is called the debt to capital ratio:
Debt to Capital Ratio = Debt / (Debt + Equity)
• Debt includes all interest bearing liabilities, short term as well as long term.
• Equity can be defined either in accounting terms (as book value of
equity) or in market value terms (based upon the current price). The resulting debt ratios can
be very different.

2- The financial markets

The financing resources of corporations : financial markets
A financial market is any mechanism for trading financial assets or securities. Frequently there is no
physical market-place. It provide mechanisms through with the corporate financial manager has access
to a wide range of sources of finance and indtruments. The financial markets acts in two importants ways :
 Primary market :
 As a primary market, its main function is to enable business to raise new capital by
issuing shares to new shareholders or to existing shareholders or to the issue of loan
capital or debentures.
Contract and cash flow between company and market
Direct impact on company cash
ie IPO, shares issue, bonds issue
 Secondary market:
 As a secondary market, the function of the financial market is to enable investors to
transfer their securities (shares and loan capital) with ease.
Contract and cash flow between investors on the market
No direct impact on company cash
ie when an investor purchases shares or bonds on the market

Companies
•Entreprises •7
•4
•5
•institutions financières •8 •Marchémarkets

Financial financier
Financial institutions
•6 •1 •2
•3
Government
•ETAT Administration Households
•ménages

long term short term
Spot Equities 1-2 Bonds 1-2 Monetary Exchange

(stock exch) (stock exch) Market 1-2 (Forex)1
Forward Forward
Interest rates
1-(2)
organized or OTC
option Equities options Interest rates Currency
1-2 options options1-(2)
DOMESTIC
INTERNATIONAL
Euro-equities Euro-bonds 1-2 Eurocurrencies 1
1-2
Euro-facilities 1-2

CORPORATE FINANCE 2
Session 2 : Equity
1- Various types of equity, how to raise equity.

2- Estimation of the cost of equity (Gordon-Shapiro model, capital asset
pricing model)

Session 2 : Equity
1- Various types of equity, how to raise equity.

Equity : various types of equity
Equity Debt
• Internal financing • Bank debt

– Retained earnings • Leasing
• Bonds: “Public”debt
• External financing
– Private equity
– Public equity

• Internal financing (retained earnings)
– Principle:
• Retained earnings are earnings from past projects which have not been
reinvested nor distributed as dividends
– Advantages
• the firm is independent
• less costly because no financing process outside the firm
– Limits
• Taxation
– Available liquidity = previous net incomes = gross income already taxed
• Tends to delay the implementation of projects : firms rarely have the total
amount required by the investment

• External equity financing (increase in equity)
 Principle
 The company offers new shares in exchange of cash
 Shareholders provide cash since they expect future profits
 An increase in equity can be done with either existing or new shareholders
 The process and costs differ whether the company is public or private
 Advantages
– Investors are ready to invest in attractive companies / projects
– The firm is not obliged to distribute dividends in case of difficulties
 Limits
– Dilution of existing shareholders
– Possible loss of control (issue for family firms)
– Take over risk for public companies
– Cost, information, minimal size,...

• External equity financing (increase in equity)
 Each equity investor (shareholder) is owner of the company and of its

investment projects, pro rata to its contribution
 Shareholders have the right to participate to key decisions and to participate to

profits
 Decisions are taken at majority during shareholders general meetings

 Dividends may be distributed, but with no certainty
 Shareholders expect a return, but this return is not fixed, nor guaranteed. The
return comes from dividends and/or capital gain.

Equity : how to raise equity ?
Private equity
 Private companies are not listed on a stock market, which implies limitations
on liquidity and on information
 They are owned by:

• Founders, managers, business angels, families
• Private equity funds (venture capital, LBOs)
 Why are they private?

• Choice of he shareholders
• Inability to be listed : small, young, risky,…
 Examples: Bertelsmann, Memscap, Legrand …

Equity : how to raise equity ?
Public equity
 Public companies are listed on a stock market. Their shares are
negotiable (liquid)
 Evolutions since the ’80s:

 more funds
 more markets (segmentation: size, technology)
 more public companies
 increased power of institutional investors (corporate governance)
 International integration (ex: Euronext)

Session 2 : Equity
2- Estimation of the cost of equity (Gordon-Shapiro model,

capital asset pricing model)

Equity : the cost of equity
 For the shareholders of the firm :

An investment project aims at increasing their wealth: they expect a
return
 For the managers of the firm:
An investment project should provide, at least, the return which investors
expect
The return expected by shareholders is the cost of equity
 Evaluating the cost of equity is not straightforward because the return

shareholders will finally get is uncertain and based on the future (which is not
the case for debt)
 Investors being considered as rational, we can suppose they will base their
expectations on:
 Future growth in earnings
 Risk

Equity : the cost of equity
• The cost of equity can only be estimated.

• The basic methods are :
 Dividend approach : future growth in dividends

• Based on future growth in dividends, i.e. future long term economic
growth of the company
• Cf. ch 4
 Market approach : link between risk and return

• Link between the company’s stock and market’s fluctuation, i.e. based
on expected return and risk
• Cf. ch 7 & 8

Cost of equity : dividend approach
 A share (stock) is an asset generating cash flows along time

(dividends)
 Consequently the value of a share is equal to the sum of the

discounted future dividends
= present value of all future dividends
 Empirical observations show some tendencies

– firms prefer stability concerning dividends
– very often, dividends are linked to Earnings Per Share (EPS)

E(Ri )
 P 1 
 P0  D1
P0 Expected rate of return
D1  P1
P0  E(Ri) = expected rate of return from
1 E(Ri ) the shareholder
D2  P2 P0 = share price (present value)
P1  D1 = next expected dividend
1 E(Ri )
D1 D2 P2
P0   
1 E(Ri ) (1 ERi ) 2
(1 ERi )2
n Dt Pn
P0    Present value of expected
t 1 (1 ERi )t (1 ERi )t Cash flows (div. + capital gain)

n Dt Pn
P0   
t 1 (1  ER i ) (1 ERi )t
t
Present value of the share =
 Dt Discounted sum of dividends
P0   forever
t 1 (1  ER i ) t
D1 D1 Present value of a constant perpetual

P0  Ri  dividend
Ri P0
D1
P0  avec Ri  g
Ri  g Present value of a growing perpetual
dividend
D1 (GORDON-SHAPIRO)
Ri  g
P0

Method for estimating the cost of equity (Gordon – Shapiro, 1956):
 Assumption: the dividend will grow at a constant rate g

 In this case a share can be considered as an asset generating a perpetual
cash flow growing annually at a rate g
P0 D1 re D1  g

P0 Dt
t 1 (1r)t re g P0
P0= present price of the share
D1= dividend expected in next year
g = future growth rate of dividends
re = cost of equity

• Advantages of the dividend approach

 model providing a simple way to estimate the cost of equity, based on
future growth
• Limits of the dividend approach
 Works only if g (growth rate) < r (cost of equity)
 g assumed to be constant
 infinite horizon
 some firms do not pay dividends (ex Microsoft until 2002)
 P0 not available for private companies (need to find comparable
companies)

Practical application of the method:
 Observe P0, price of a share, on the market during several sessions

 Calculate the mean to reduce share price volatility (i.e. deviation from
average)
 Observe the previous dividend policy and extrapolate it into the future
 Evaluate the perspective of growth of the firm and of the related industrial
sector in order to estimate g
Calculate the cost of equity

Cost of equity : market approach
 Approach based on the CAPM : Capital Asset Pricing Model
 CAPM: best known model linking risk & return, built in the mid 60’s by
Sharpe, Lintner & Treynor
 Basic assumptions: investors are rational, the return they expect on a

financial asset is linked to its expected risk
 This method requires to analyse the risks of a project
 Risk: exists because future returns are uncertain
 Each financial asset has a specific level of risk. Some are risk-free (Treasury
bills).
 Historical observations show a link between risk and return on the long term
(see Brealey & Myers, ch.7)

The CAPM model says that the relationship between risk and return is linear:
 Treasury bills are risk free (risk=0) and produce a return Rf (risk free rate)
 A stock market portfolio bears a certain risk (average market risk), and
produces a return Rm (average return of the stock market)
 Rm – Rf = market risk premium
 As Rf and Rm are observable, it is possible to draw a line linking risk and return. This
line is called the security market line
Expected return on
investment
lin e
arket
m
urity
Sec
Rm:average
return of the
stock market Market portfolio
Rf: risk free

rate of return
Treasury bills Corporate Stocks Risk

bonds


• In a certain situation (no risk)

 Cost of equity = risk free rate of the market
 i.e. interest rate offered on Treasury bills
• In an uncertain situation (reality)
 Cost of equity = return demanded by investors =risk free rate + risk
premium
 The risk premium of a specific share depends on:
• the market risk premium
• the specific (non-diversifiable) risk of the share (ß)

ß and non diversifiable risk
• In CAPM, the ß is used as a proxy for the non diversifiable risk of a share
• ß measures the volativity of a specific share returns compared to the volatility of
the market returns
• ß measures the sensibility of a share returns to the market returns
ßi  im2
m


The equation derived from the model is :
E  return   rf   rm  r f  * 
We are able to estimate the return expected by investors, ie the cost of equity,
for any listed share.
E(return) = cost of equity

(Rm - Rf) = market risk premium
Examples:
• ß calculations (Brealey & Myers, Ch. 9)
• Isicomp
Isicomp Utilities  : 0,5
Isicomp Technologies  : 1,7
Calculate the cost of equity of each company assuming a risk free return of
3,5% and a stock market return of 7,5%

Session 3 : Debt financing
1-Debt financing : various types of debt, how to issue debt, the

cost of debt

Cost of equity : conclusions
 Equity has a cost, equal to the return expected by shareholders
 The cost of equity is not equal to the yield (dividend/price), because future
capital gains have to be taken into account
 The cost of equity is linked to future growth and to the level of risk of the
share
 The cost of equity is based on future expectations and can only be estimated

CORPORATE FINANCE 2
Session 3 : Debt financing and the WACC
1-Debt financing : various types of debt, how to issue debt, the cost of
debt

Debt financing : various type of debt
• Principle
 the firm borrows cash for a certain time, at a given interest rate
 the firm must pay the interest and reimburse the loan (principal), according
to the terms of the contract
 Debt can finance a part of the project
• Advantages
– No dilution of existing shareholders

– Interests paid are tax deductible for the company
– In general cost of debt < cost of equity
• Disadvantage
– Increased risk for the company

– Drain on cash-flows (but good discipline for managers?)
– Risk of loss by shareholders and other stakeholders if company is unable
to pay its debt (restructuring, bankruptcy)

Debt can be classified according to 3 criteria
– bank debt / bonds
– fixed rate debt / floating rate debt
– term: short, medium, long
The firm may choose between these categories according to its needs.

Bank debt
 Contract by mutual agreement between the firm & a bank (or a bank
syndicate)
 Because of the risk of default, warranties are granted to the bank
(generally on assets)
 The loan may be short, medium, or long term
 The bank determines the interest rate in view of market conditions, risk
level of the company /project, and the terms of the contract (maturity,
warranties,…)
 The contract includes covenants (limitations to the use of funds, ratios to
be met,…)

Bonds
 A bonds issue consists of debt split up in n parts (bonds), subscribed by
numerous investors and negotiable on a financial market
 The term can be medium or long
 The issue is generally advised by an investment bank which determines
the conditions and markets the bonds to investors
 Characteristics of a bond:
• Nominal value (the par)
• Issue premium, redemption premium
• Coupon (interest)
• Redemption date(s)

Debt financing : Price of a bond
Price of a bond =
– discounted future cash flows
– present value of future coupons using the market rate r
– price varies in the opposite way to r
n
Ck VRn
P0  
k 1 (1  r ) k

(1  r ) n
P0 = price of the bond

Ck = coupon to be paid in year k
VRn = value on redemption

Debt financing : cost of debt
Cost of debt
 The cost of debt for the company is the IRR of all cash flows (positive
and negative) generated from the borrower’s point of view. Corporate tax
& expenses (fees, administrative costs) have to be included
n
n
CFt CFt
V0   NPV  V0   0
t 1 1  IRR  t 1  1  IRR 
t t
 Tax has to be taken into account because interest is tax deductible for
the company, and thus generates tax savings
 If there are no expenses linked to the financing, the cost of debt is simply
equal to the interest rate of the debt, after tax

Debt financing : cost of debt
 Examples
 Vision Corp. is negotiating a 5 years bank loan, with the following conditions:
• amount $6 m
• interest rate 6% p.a., paid annually at year end
• arrangement fee $120 000, paid to the bank in year 0
• repayment : $2m end of years 3, 4, and 5
• The corporate tax rate of Vision Corp. is 30%
– Calculate the cost of this loan for Vision Corp.

– What would be the cost of the loan assuming no arrangement fee?
 Cost and yield of a bond: exercise Bablock (ex 17)

Debt financing : Lease
The lease is a contract by which the owner of a good agrees to let another
have the use of it for a specified period of time
During the contract: the user is not the

owner of the good and pays a rent that is At the end of the contract: the
tax deductible user can use a purchase option &
become the owner of the good

Characteristics
 the user is not the owner: shift of ownership risk

 in case of bankruptcy, this “debt” can’t be demanded (not payable). The
owner can recovers the asset
 easy use for the company
 the asset & the “debt” are not reported on the balance sheet (NB:they are
in consolidated statements)
 in finance leasing is considered as bank debt (accounts are corrected to
report leasing if needed)

 The lease creates a flows (the rent), which is tax deductible, but the
depreciation tax savings are lost as the asset is not purchased
 It is possible to forecast all the cash flows related to a leasing

contract (including the loss of depreciation tax savings). The IRR of
the cash flows gives the cost of leasing
 Leasing is an alternative to debt: need to compare the cost of debt

with the cost of leasing

Session 3 : Debt financing
2-The weighted average cost of capital (WACC)

The weighted average cost of capital (WACC)
 A company is always financed by a combination of equity & debt
 Their cost are different, so we need to calculate the WACC (Weighted

Average Cost of Capital)
 The WACC is the cost of the financing resources of the company

• WACC = weighted costs of the means used to finance the project

The weighted average cost of capital (WACC)
re & rd = cost of equity and cost of debt (pre tax)

Equity Debt
E D E = value of equity
re rd D = value of debt
T = marginal rate of corporate tax
Pool of
ressources
WACC re E rd(1T) D

ED ED
Pool of
projects

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Corporate Finance

Grenoble Ecole de Management

• Who wants to work in finance in the future ?

• Who thinks she/he will work with finance ?

• What differentiates your studies & an

MIB – Corporate Finance- Grenoble Ecole de Management 2

Session 1 : The financing cycle

MIB – Corporate Finance- Grenoble Ecole de Management 3

Session 1 : The financing resources of corporations

MIB – Corporate Finance- Grenoble Ecole de Management 4

Session 1 : The financing cycle

• Introduction to corporate finance

MIB – Corporate Finance- Grenoble Ecole de Management 5

1- Introduction to corporate finance

MIB – Corporate Finance- Grenoble Ecole de Management 6

 Finance relates to dealing with money and time

 Concerns all economic agents:

 Finance for companies:

MIB – Corporate Finance- Grenoble Ecole de Management 7

• Financing and payout policy

MIB – Corporate Finance- Grenoble Ecole de Management 8

What is corporate finance about ?

MIB – Corporate Finance- Grenoble Ecole de Management 9

Corporate finance is management, and involves…

MIB – Corporate Finance- Grenoble Ecole de Management 10

Objectives of the course

 Being able to identify the various sources of financing available for

 Being able to calculate the cost of financing (i.e.: cost of capital)

 Being able to take investment and financing decisions

MIB – Corporate Finance- Grenoble Ecole de Management 11

MIB – Corporate Finance- Grenoble Ecole de Management 12

2- The financial cycle and value creation

MIB – Corporate Finance- Grenoble Ecole de Management 13

Finance is really about value

 In finance, as well as in liberal economic theory, the main goal of a company

MIB – Corporate Finance- Grenoble Ecole de Management 14

Balance sheet view of the firm

 A company is a bundle of assets :

MIB – Corporate Finance- Grenoble Ecole de Management 15

MIB – Corporate Finance- Grenoble Ecole de Management 16

The financial manager’s role

(1) Cash raised by selling financial assets to investors

MIB – Corporate Finance- Grenoble Ecole de Management 17

3- Compounding and discounting

MIB – Corporate Finance- Grenoble Ecole de Management 18

Discounting :Taking time into account

 Investing is a mechanism through which a company tends to increase its

 Because money has a cost and can be borrowed or lend, it is more

 Thus it we want to compare cash flows paid or received at a different

This operation is called “discounting”

MIB – Corporate Finance- Grenoble Ecole de Management 19

Discounting :Taking time into account

 This rate can be decomposed into its components.

 The first and more obvious component is the risk premium

This notion of “interest rate” is at the heart of finance

MIB – Corporate Finance- Grenoble Ecole de Management 20

Discounting :Taking time into account

 There is a “risk free rate” because agents do massively prefer immediate

 The contribution of this preference to the risk free rate is measured