APPLIED CORPORATE FINANCE-

WELOME TO MODIGLIANI &

MILLER WORLD!
TEACHING WEEK 1
 INFORMATION ON MODULE LEADER
(LECTURES AND SEMINARS)
Investment project evaluation credits:
• Commercial property investment projects ( Bookline
Advisory ltd., 2014-2018)- Israel, Canada, the US;
World Bank/IFC projects within CIS.
• “Sea launch” project (Boeing, Energiya, S7 Space, S7
• Andrey Artemenkov , Ph.D., MRICS Airlines group); (2018-2019)– financial advisor to the
handover of “Sea Launch”;
• Senior Lecturer, Department of Finance, WIUT • Spaceteam telematics (2019) – financial modellier;
• Room: ATB 209b • Western petroleum transportation (WPT), LUKoil
• E-mail: aartemenkov@wiut.uz group) (2019-2020) –capital budgeting, financial
modelling;
 LEARNING OUTCOMES AND
OBJECTIVES
Learning outcomes:
1) Learn and appraise Strategic role of financial managers in organizational decision-making
2) Learn about investment appraisal and evaluation of capital projects (capital budgeting)
3) Get acquainted with Capital (funding) decisions: organizational fund-raising and cost of capital
4) Be able to analyze strategic corporate decisions on capital structure, and dividend payout policy
5) Learn about strategic management tools (including derivatives, compensation warrants, insurance)
to boost corporate efficiency, stakeholder interest alignment and corporate shareholder value.
In a nut shell..
• In ACF, we will explore corporate finance issues through the medium
of (integrated) financial modelling
• For that I will have to impart financial modelling skills to you, first
• it is a very handy skill, if you apply for a serious job in a finance department ,
the odds are that the first-line test is to give to you a task to develop a trial
financial model)
• In real Finance, partial solutions to any finance problems without a
valid comprehensive financial model is almost akin to arm-waving.
Module content
• TW1: Introduction to applied corporate finance: the null of M&M World & Tax Shields
Investment decision:
• TW2: Capital budgeting 1: the notion of investment projects, their financial modelling and evaluation
• TW3: Capital budgeting 2: Investment appraisal metrics under CBA
• TW 4 Capital budgeting 3: Cost effectiveness appraisal of investment projects (costs- only projects, real options)
• TW 5 Capital budgeting 4: Financial model integration & non-cash working capital modelling
• TW 6 Capital budgeting 5: Accounting for taxes in capital budgeting & select financial modelling topics : VAT and other
taxes; asset disposals, foreign-currency aspects of financial modelling
• TW 7 Capital budgeting 6: Incorporating uncertainty into investment project analysis
Financing decisions:
• Corporate funding instruments: Debt, Equity and Hybrids
• Financing decision: What is the optimal funding mix of corporations? Leaseholds and funding.
Cash payout decisions:
• Dividend policy
Restructuring
• Company valuation as a tool for analysis of mergers, acquisitions and takeovers
• Presentation
 STUDENT ASSESSMENTS &
PRINCIPAL STUDY SOURCES

MIT Open Course wave courses for “Financial Economics”

(pdfs, video recordings)

The project part will involve: developing an investment project appraisal (team work; with some individual parts indicated) +
reviewing a third party investment project (team work)
 APPLIED CORPORATE FINANCE:
OVERVIEW DIAGRAM
Value of the firm: IC/EC value
Debt + Equity
Firms studied:
1) Public
(their equity
has stock
Investment exchange
decisions: prices/quotations
asset side )
of the 2 Private:
balance Value of their
sheet equity is
Financing evaluated, not
decisions: not directly
E+L side of observable
the balance Commonality of
sheet CF principles, but
there are some
But in reality.. the need to match the funding and investment cashflows in differences: R.
a financial model ensures that all the ACF decisions are actually joint. Slee (2005)
Corporate finance: study of financial implications of diverse corporate decisions (operating, investing, financing)
Objective function of the CF decisions (as generally accepted) -> maximize the value of the firm
 The Governing principles of ACF:
• Micro-level:
• Investment decision - The Investment Principle: Invest in assets and projects that yield an expected
overall return greater than the minimum acceptable hurdle rate. The hurdle rate should be higher
for riskier projects and should 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.
• Corporation level:
• Financing decision-The Financing Principle: Choose a financing mix (debt and equity) that
maximizes the value of the investments (including their group, a corporation) made and match the
financing to the nature of the assets being financed.
• The Dividend Principle: If there are not enough investments that earn the hurdle rate, return the
cash to the owners of the business (for a private firm -drawings). In the case of a publicly traded firm,
the form of the return—dividends or stock buybacks—will depend on what stockholders prefer.
The principal takeaway: So, as per Damodaran approach, the primacy of ACF starts with the investing decision
(e.g. to open a firm you need to have an investment idea first), but many other things -- including the Financing and
Dividend decision -- help optimize the payoff from your investing idea and those things shouldn’t be neglected and
also form a subject matter of ACF.
The Investment decision
• Firms have scarce funding resources that must be allocated among competing needs. The first and
foremost function of corporate financial theory is to provide a framework for firms to make this
decision rationally, given the explicit objective function
Types of investing decisions for real-economy companies (Finance department + Treasury employees
deal with it):
• Investments into long-term investment projects (capital budgeting);
• Investments into working capital (planned as an element of capital budgeting, but principally an
element of current (annual) budgeting);
• Managing surplus financial liquidity (financial investments);
Investment appraisal theory (capital budgeting) is a tool used to model and assess the efficiency of
investing decisions/projects:
• Smaller investment projects can be assessed on a standalone basis (using the corporate hurdle rate);
• Bigger investment projects should be modelled as built into the overall financial model (business
valuation model) of a corporate entity.
Investment project efficiency metrics are used to assess investment projects: NPV, IRR, Payback period,
etc.
 Family is Like Corporation, Person is Like an Investment project

Person is the
investment
project

Entire Family
is the
Corporation

GUIDING PRINCIPLE OF CF: A CORPORATION IS NOTHING BUT AN AGGREGATE (A

PORTFOLIO OF) ONGOING INVESTMENT PROJECTS AND EXPECTED (FUTURE) INVESTMENT
PROJECTS
Source: not my slide 10
History of investment project
appraisal
• Formal theories and practices of investment project appraisal came with
large scale mining, canal and railway construction operations in early XIX c.
• Applied academic research in them was pioneered by Irving Fisher (1867-
1947) in his works “the Nature of capital and income” (1907), which can be
rightfully regarded as the precursor of modern ACF textbooks and capital in
national Accounting textbooks and the “Theory of interest”

• Keynes (1883-1946) also made the concept of “marginal efficiency of

capital” the central concern of his framework , and reading about the
“animal spirits” underlying investment evaluation in Chapter 12 of “The
General theory” (1936) is hilarious and introduced a famous “beauty-
context” metaphor as a paradigm for the workings of a stock market.
 The Financing decision: Debt vs. Equity mix
• Up until F. Modigliani and M. Miller works authors of business finance believed that there is some
secret to unlock the optimal corporate capital structure (a mixture of debt and equity).
• Two M&M propositions about capital structure irrelevance for firms (which ,though, are applicable to
efficient markets only) upset this notion:
1st M&M proposition: the value of leveraged firms (capital structure with a mix of debt and equity) and
unleveraged firms (capital structure with only equity) are the same. If not, there would be an arbitrage
opportunity and will eventually become equal.
V(unlevered) = V(levered) Franco
2nd M&M proposition (1958): to ensure the value of corporation is the same regardless of the funding Modigliani
structure the pricing of the cost of equity on efficient markets will follow the formula: (1918-2003)
rL = ru + D/E (ru – rd) (in IRM course, it was mentioned with respect to “beta” as Hamada formula)
(where rL = cost of levered equity, ru = cost of unlevered equity, rd = cost of debt, D/E = ratio of debt to
equity)
However, in real-world markets the cost of debt (interest payment) is usually tax-deductible therefore
the “tax shields” generate additional value for business, by saving on profit taxes that would otherwise
have been payable going forward.
With these two propositions it is rightfully said that the field of modern corporate finance was born. M. Miller
(1923-2000)
However, as witnessed by the proliferation of a variety of corporate funding instruments (debt, equity, mezzanine) with various tax
advantages, and belief in less than perfect efficiency of the capital market, in ACF the search for optimal funding decisions is not
believed to be illusory.
 Costs to a company are not the same as costs to an
FINANCING DECISION 2: TAX SHIELDS- THE KEY NOTION individual. OF CF
As a corporate, you lose some, but you also gain
• Tax shields play an important role in Corporate Finance. some (the «tax shield effect»). It is like an automatic
• Every tax-deductible expense creates a tax shield cashback effect on almost every (tax-deductible)
corporate cost.
• Since interest- payments (IP) on debt (D) are tax-deductible, they reduce the taxable profit of businesses,
through the periodic tax-shields, helping to make a considerable saving on corporate tax payments
• Illustration: a single period tax-shield:
Company XYZ: Data for 2019
UNLEVERED (U) LEVERED (L) A stream of expected
Many corporate and Same asset structures on the Left-hand-side of the balance sheet future tax shields from
investment project
valuation debates IPs on current debt adds
Debt, D, $ mln 0 500
revolve around the Cost of debt, rD , % 5% 5% value to a leveraged
issue of how to reflect per annum
business, compared to
the tax shield profile EBIT 100 100
appropriately and Interest payment, IP 0 25 [=500*5%]
an unleveraged one!
which discount rate is So it seems that a lot of
correct for discounting Pre-tax profit
Corporate tax rate, t
100
20%
75 [=100-25]
20%
debt on a company’s
the debt-related tax- balance sheet (a levered
shields: Corporate tax, $ 20 [=100*20%] 15 [=75*20%]
M&M consider the After-tax profit (Net 80 60 [=75-15] company) is a good
Income, NI)
case of constant debt thing..
in perpetuity and use Total returns to 80 < 85
Invested Capital …But it is not just all
two different discount [the entire Net Income accrues as [Total return on the Invested Capital accrues
rates in M&M(1953)
(D + E Stakeholders) potential dividend to the equity in the form of contractual interest payments white, rather black &
holders; the Invested Capital of the (IP) to D [IP=$25 mln], and potential dividend
and M&M(1963) company is 100% Equity] to E [DIV=NI=$60 mln] [$25+$60=$85]; the white -- later on we will
Invested Capital of the company is part
Equity ( E ), part debt (D)] learn about a risk trade-
off involved in that!
Financing decision 3: Restatement of M&M
Propositions with tax shield effects added into the
picture Without tax deductibility of With tax-deductibility of interest
interest payments payments
(a hypothetical case) (a feature of most national
corporate tax systems, globally,
incl. Uzbekistan )
M&M P. 1 Value of leveraged (L) and unleveraged firms (U) are Values of leveraged (L) and unleveraged firms (U)
equal, leverage doesn’t create a value for the firm: differ by the amount of present values of expected
tax shields:
Vu=VL
VL=Vu + PV(TS) = Vu +t*D
(in case of the direct capitalization)

M&M P. 2 To ensure the lack of arbitrage opportunities in To ensure the lack of arbitrage opportunities in
equity pricing on public capital markets, the returns equity pricing on public capital markets, the returns
on leveraged equity (reL) and returns on unleveraged on leveraged equity (reL) and returns on unleveraged
equity (reu) should obey the following relation: equity (reu) should obey the following relation:
reL = reU +D/E(reu-rD) reL = reU +D/E*(1-t)* (reu-rD)
(the “costliness” of leveraged equity offsets the (the “costliness” of leveraged equity offsets the
cheapness of debt) cheapness of debt)

M&M P.3 -This proposition is the origin of the hurdle rate on investments prescription for the investment decision-making of a firm: to select optimal projects, we
need to compare their own (internal) rate of return (R(I), IRR) with the entire company’s average cost of capital, and select only those available projects whose IRR
exceeds the company’s cost of capital (WACC, the hurdle rate). Pre-(income) tax returns on an investment project should be compared with the pre-tax cost of capital,
whilst after-tax returns on the project should be compared with the after-tax cost of company capital (the latter is the usual practice of investment analysis in most of
the cases these days. We will discuss it in the following two chapters).
The Dividend decision
Historically, corporations used to release their earned cash
to shareholders in the form of annual or quarterly cash
dividends.
For the public companies since 2000s there is an added
popularity of shareholder buybacks (companies buy out
their own shares on the stock market). In 2018, S&P 500
companies returned to shareholders more than $1 trln. in
the form of shareholder buybacks

What does this panel tell us about the market efficiency

on which M&M assumptions rest?
 History of views on dividend
decisions
Before 1950s declaration of stable dividends was a hallmark of prosperous corporations.
Everyone believed that the stability of dividends mattered and their reductions would mean a distress signal
sent by corporations.
However, Modigliani & Miller (1961) paper, their another contribution to corporate finance theory, spelled
the irrelevance of dividend payout policy and, inter alia, launched a modern equity valuation practice based
of FCF discount models, rather than DDMs.
Unlike M&M’s financing decision view, the M&M dividend’s irrelevance view probably still persists:
• Growth & tech stocks typically pay little or no dividend.
 Whose interests corporate finance
serves? The standard
objective function of
Corporate Finance:

Since M. Jensen’s late 1970s Papers on Shareholder value optimization, the crucial idea is that if the shareholder value is
maximized through ACF decisions the interests of other stakeholders are also “Pareto-efficient” and are not made worse off.
The crucial assumptions for the classical corporate finance (M&M world) to work are the assumptions of market efficiency and
transparency.
Many things can go wrong with these assumptions, though…
Why Applied Corporate finance is important?:
“Nuances of single bottom line” :

Government
initiatives to
align corporate
behavior with
the social &
environmental
needs, e.g.
carbon tax

In reality, Corporate finance is fraught with conflicts of interest, but there are tools to try to align
them, assessing whose efficiencies and structuring also forms a part of the subject matter of ACF:
E.g. Bondholders vs Shareholders: debt covenants;
Shareholders vs. managers: reward the latter with warrants (options) on their company’s equity;
profit-sharing modes of compensation.
Alternative views on the objective
function of ACF and associated
corporate structures
• Triple buttom-line (3BL)-- economic, social & Environmental. Since large scale investment
projects (e.g. feasibility studies in mining) have impacts in all the three domains, they are
indeed evaluated under 3BL protocol, with all the three types of impacts (including social and
environmental) being monetized on par with the pure economic efficiency.
Focus on some facets of shareholder value maximization (SVM):
• Maximize Market Share (1980s Japanese firms)
• Size/Revenue Objectives- 1970s style conglomeratization.
• Profit Maximization Objective. The rationale: profits can be measured more easily than value,
and that higher profits translate into higher value in the long run (but: the emphasis on
current profitability may result in short-term decisions that maximize profits now at the
expense of long-term profits and value)
(in most instances, these operational ideas are not really far removed from the SVM idea).
So, the SVM still remains the dominant objective function in ACF decisions.
 SVM –maximizing what exactly?
• Even for public corporations with stock market quotations for their equity the answer
is not straightforward: since what is being observed on the market is the current price,
not the long-term (sustainable) value:
• Price=Value + short-term liquidity effects (for markets with other than perfect efficiency and
liquidity).
• So what is the meaning of the value being maximized:
• It is true that some corporations maintain comprehensive internal valuation/financial models for
their business, into which they also build in specific investment projects as those arise– but those
models are usually disparate between different companies in the same industry and confidential
(but Bloomberg reports consensus estimates of model parameters (like Rev, EPS, FCF) from
financial analysts of public companies).
• So the objective function is not really formalizable or even observable, like in linear programming
applications.
• For private companies with no stock quotations or external auditing of financial
statements: the question is even more illusory , and can be answered only by a
comprehensive financial model. But only a few small businesses care to develop those
formally.
 SVM – Institutional aspects
• Even though not directly measureable, the SVM objective function will be palpable
in most of ACF decisions so long as there is an alignment of stakeholder interests in
the firm and long-term orientation in management decisions.

Then managers will act as if

maximizing shareholder value
Damodaran (ACF, 2014)
 Distinction between Corporate
finance (CF) and Applied
corporate finance (ACF).
• Since the days of M&M propositions , Corporate finance has had a tenor of
normative theory (how corporation should act) based on some stringent
assumptions as to market efficiency; In contradistinction; ACF has a positive
(empirical) twist to it (how managers corporations actually act in real
(inefficient) world and what views they profess to hold with respect to
managing corporate finance?).
• In research world: ACF researchers conduct surveys of which existing CF
theories find traction with corporate managers, how capital budgeting is
actually done by them
• In business world: practitioners of ACF do capital budgeting/investment project
evaluations, advise on Capex, and also do regular (current) budgeting; they
provide
But for analytical
us, applied support
corporate finance for the
will simply majority
mean of corporate
imitating and financeofdecisions.
studying the workings Finance
departments– to a very (limited) extent afforded by this module!
SOURCES
• Ch. 1 of ACF Student Manual
• Modigliani & Miller (1958) Modigliani & Miller (1963) papers
APPENDIX TO LECTURE ONE
• REFRESHING COST OF CAPITAL THEORY BETTER…
 RETURNS AND COST OF CAPITAL
The rate of return is defined as:
r= R +v = Current return (capitalization rate) + capital gain component
(sometimes the reference is made to the “total rate of return”)
Apartments in Tashkent example:

R= 12*$500/ 60 000 + slight capital gain = 10% + 1% = 11%

We use rate of return both to compound and discount cashflows (or
what approximates them, e.g. accrual parameters, such as NI).

When we are discussing returns by default we are discussing total returns, but it may become clear out of context
that current returns are meant
Returns (for equities) illustrated
SP500 index: is the
index of capital gain (v)

But there is also an

“S&P Total returns
index”

Returns can be nominal or real . (with accuracy up to the second order: rn= rr+inf ) . But there is
also a more complex Fisher formula.
Stock and flow of debt and equity at
book value and market value
perspectives Debt:
Accounting
Market
perspective:
perspective:
Flow IP (contractual) IP(contractual)
Stock BV ( just at MV(D)
principal, or at
amortized cost)

Equity:
FLOW NI FCFE
STOCK BV of Equity Market
capitalization

Jointly – Invested
capital (IC)
 Cost of capital Let’s define cost of capital (for each of the IC
elements) as the competitive market return that
the investors into that capital would require
according to current market situation and market
valuation practices (Hence, sometimes it is called
the required rate of return)

If the LHS of the balance sheet doesn’t deliver

that return on capital the value (or even
price) of the affected capital component will
drop , to come in line, if the LHS delivers
more than enough the value will increase.
So LHS returns have primacy and their
benchmark is always the RHS required
returns (cost of capital)

WACC = cost of 1 CU of IC (regardless of the source): CoE=rE: market convention simple or adjusted
WACC= [E/D+E] * rE + [D/D+E]*rD(effective) CAPM: rE= rf + b(ERP) [+some idyosinc. premia]
Should we use BV or MV for the weights?
Value of company’s IC
• Price is the price , but we are looking at equilibrium (fundamental)
values.
• Let’s start with the simple case and consider an unlevered (debt-free)
company U:
• It can be proven that provided its EBIT has a tendency to grow as:
EBITt = [EBITt-1 *(1+g)] +et (where e(t) –is “white noise”)
Then the value of the company should be Vut= EBITt+1/ rho
Where rho is a cost of capital for unlevered company (it is 100% equity
capital, WACC of 100% equity, if you wish)
Analytical question crucial to financing decisions: will a company value be different if it levers up on debt ?
1st proposition of M&M
• If debt interest payments (IP )are not tax deductible the leverage of a
levered company will have no impacts on its value
• VL = VU
• If debt interest is however tax deductible then the tax shields help to
add value to the levered company. And its value is greater than the
unlevered company value by the amount of the capitalized value of
future expected tax shields:
• VL = VU + PV (TSIP)
• M&M (1958) review a simple case when D-constant and perpetual
going forward then:
VL= VU can
The •proposition +t*D whereusing
be proven t- isthethe
lacktax rate forargument
of arbitrage corporate tax.for complete competitive markets) .
(credible
Otherwise there will be very little to “enforce” these propositions
From M&M Proposition 1 to M&M
Proposition 2
• M&M logic sounds almost a death knell to the idea that if a debt is
cheap and equity is expensive than let’s load up on debt (the more so
that its is tax deductible).
• Because as you load up on debt the cost of equity increases pari
passu with leverage, according to M&M 2 Proposition:

In case of cheap debt and expensive unlevered equity:

Because of re increasing with leverage , loading up the
balance sheet with (cheap) debt doesn’t generate a very
cheap WACC, there is some effect on WACC but it is entirely
due to tax shields on IP –p.t.o.
HAMADA FORMULA –AN M&M2
Application
• One application of M&M2 is the Hamada formula:
• Since the cost of equity is estimated under CAPM: re= rf+b*ERP,
• Then the leverage effect on the cost of equity is accounted for
through beta-adjustments:

A good source for unlevered industry betas is Damodaran website

Example: unlevered industry beta for “Rubber and Tyres” is 0,7 , the effective tax rate of the enterprise is
21%; according to the latest data the book value of debt is $450 mln and the book value of equity is $300
mln. Equity risk premium (ERP) is 5%. The risk free rate is 2% What is the levered cost of equity for the
entity?
1) b levered= 0,7 [1+(1-21%)*450/300] = 0,7*2,185 = 1,52
2) re levered = rf+ blevered*ERP = 2%+1,52*5% = 9,6%
 M&M 1 proposition illustrated in light of
M&M 2
• If for a unlevered company U we value it as:
• Vu =EBIT(1-t)/ rE unlevered
• The levered company is valued as:
• VL= EBIT(1-t)/WACC (WACC is as described on slides above- in case
the value of D is constant and perpetual)

For other cases of D profiles and forecast periods other then perpetual there are dozens of WACC formulas explored in the
literature.
The reason WACC declines is with leverage is due to the tax shields on IP, not because of some magic with the optimal
capital structure..
How tax shields are accounted for in
WACC? M&M2 or Tax shield
Hamada adjustment
M&M3
• Considers a situation of a one company funding multiple capital
investments.
• In that instance anticipated return on an investment project should be
in excess of the overall WACC of total invested capital (IC):
• IRR>WACC overall

(The cost of just an incremental capital to fund the project is beside the point!)

So M&M 3 states the condition to make the project acceptance

worthwhile for a business with multiple investment projects