20110321 principles of corporate finance part1

1
Principles of Corporate Finance
tenth edition
2011/3/21

2
What do you want to learn from "Principles of
Corporate Finance"
•  To understand what financial managers do
and why.
•  How to make financial decisions.
•  To understand of how finance theory
translates into practice.

3
Brief Contents
•  Part One: Value
•  Part Two: Risk
•  Part Three: Best Practice in Capital Budgeting
•  Part Four: Financing Decisions and Market Efficiency
•  Part Five: Payout Policy and Capital Structure
•  Part Six: Options
•  Part Seven: Debt Financing
•  Part Eight: Risk Management
•  Part Nine: Financial Planning and Working Capital
Management
•  Part Ten: Mergers, Corporate Control, and Governance
•  Part Eleven: Conclusion

4
Part One Index
Chapter1 Goals and Governance of the Firm
Chapter2 How to Calculate Present Values
Chapter3 Valuing Bonds
Chapter4The Value of Common Stocks
Chapter5 Net Present Value and Other Investment Criteria
Chapter6 Making Investment Decisions with the Net Present
Value Rule

5
Chapter 1 
Goals and Governance of the Firm
1-1 Corporate Investment and Financing Decisions

1-2 The role of the financial manager and the opportunity cost
of capital

1-3 Goals of the corporation

1-4 Agency problems and corporate governance

6
Two principle financial decisions
•  What investmensts should the corporation
make?
•  How should it pay for the investments?

7
There themes
1. Maximizing value
2. The opportunity cost of capital
3. The crucial importance of incentive and
governance

8
1-1 Corporate Investment and Financing Decisions 

Company(revenue in
billions for 2008)
Reccent Investment
Decision
Recent Financeing
Decision
Toyota(￥26,289billion)
In 2008 opened new
engineering and safety
testing facilities in Michigan.
Returned ￥431 billion
to shareholders in the
from of dividends.
Wal-Mart(＄406 billion)
In 2008 announced plans to
investt over a billion dollars
in 90 new stores in Brazil.
In 2008 raised ＄2.5　
billion by an issue of
5years and 30 years
bond.
Wells Fargo(＄52 billion)
Acquired Wachovia Bank in
2008 for ＄15.1　billion.
Financed the aquisition
by and exchange of
shares.

9
1-1 Related topic of 
corporate investment and financing decisions 

•  project analysis(Chap10)
•  how to issue securities(Chap15)
•  payout decision(Chap16)
•  debt finance(Chap23)
•  hedge and insurance(Chapter26,27)

10
1-2 The role of the financial manager and 
the opportunity cost of capital 

•  financial maneger
：anyone responsible for an investment or financing decisions.
•  opportunity cost of capital
：investment opportunies available to investers in financial markets
Financial
manager
Firm's
operations(a
bundle of
real assets)
Financial
markets
(investors
holding
financial
assets)
1
4a
4b
3
2
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
4 a cash reinvested
4 b cash returned to investors

11
Fundamental trade-off for corporate
investment decisions
Cash
Investment
opportunity
(real asset)
Financial
manager
Shareholders
Investment
opportunity
(financial asset)
investment
alternative
pay dividend
to shareholders
Shareholders
invest for themselves

12
1-3 Goals of the corporation
•  The goal of maximizing shareholders value is widely
accepted in both theory and practice.
•  "Anglo-Saxon "economies,the idea of maximizing
shareholder value is widely accepted as the chief financial
goal of firms.
•  In other countries,workers' interests are put forward much
more strongly.

13
Should firms be managed for share holders or all
Stakeholders?
Whose company is it?
Which is more important?
-job security for employees or shareholder dividends?

14
1-4 Agency problems and  
corporate governance
Separation of owership and control
→conflicts between shareholders' and managers' objectives
→agency problems!!
1)managers do not attempt to maximize firm value
2)shareholders incur costs to monitor the managers and
constrain their actions

→to design to help align managers' and shareholders' interest
→necessity for corporate governance

15
Good system of corporate governance
•  legal and regulatory requirements
•  compensation plans
•  board of directors
•  monitoring
•  takeovers(Chap32)
•  shareholder pressure(Chap33)

16
Chpter2 How to calculate present value
2-1 Future values and present values

2-2 Looking for shortcuts perpetuities and annuities

2-3 More shortcuts-growing perpetuities and annuities

2-4 How interest rate is paid and quoted

17
2-1 Future values and present values
•  money has a time value
•  a doller today is worth more than a doller tomorrow
•  Present Value<Future Value
t
t
r
C
)1(
PVValuePresent
+
=＝
today
100
year2
114.49
×1.07^2

÷1.07^2
discount rate
hurdle rate
opportunity cost of capital
・・・（1）

18
Net Present Value
0)at timeflowcash(the0
)1(
investment-PV
NPV
0
1
0
<
+
+=
=
C
r
C
C
・・・（2）

19
Discounted cash flow(DCF)
∑ =
+
=
+
++
+
+
+
+
+
=
T
t t
t
T
T
r
C
r
C
r
C
r
C
r
C
1
3
3
2
21
)1(
)1()1()1()1(
PV ・・・
∑=
+
+=+=
T
t
t
r
C
CC 1 t00
)1(
PVNPV
・・・（3）
（2）に（3）を代入

20
2-2 Looking for shortcuts 
perpetuities and annuities 

•  Consols:bonds that goverment is under no
obiligation to repay but that offer a fixed income for
each year to perpetuity.
•  Annuity:an asset that pays a fixed sum each year
for a specified number of years.

21
Perpetuities and Annuities
r
C
PV
PV
C
luepresent va
flowcash
Return(r)
=
==
⇔

22
2-3 More shortcuts-growing 
perpetuities and annuities
gr
C
r
gC
r
gC
r
C
r
C
r
C
r
C
PV
−
=
+
+
+
+
+
+
+
+
=
+
+
+
+
+
+
=
1
3
2
1
2
11
3
3
2
21
)1(
)1(
)1(
)1(
1
)1()1(1
・・・
・・・

23
Some useful shortcut formulas

24
2-4 How interest rate is paid and quoted
rr
m
e
m
r
==⎥
⎦
⎤
⎢
⎣
⎡
+
∞→
)718.2(1lim
m
•  We need to distinguish between the quoted annual interest
rate and the effective annual rate.
•  Effective interest rate is higher than the quated rate.
•  The figure 2.718 or e is the base for natural logarithms.

25
Chapter3 Valuing Bonds
3-1 Using the present value formula to value bonds

3-2 How bond prices vary with interest rates

3-3 The term structure of interest rates

3-4 Explaining term structure

3-5 Real and nominal rates of interest

3-6 Corporate bonds and the risk of default

26
3-1 Using the present value formula 
to value bonds
opportunity cost of capital
3%
year
1
2
3
4
1
principal
0
0
0
100
2
coupon
8.5
8.5
8.5
8.5
3
Cash Flow(=1+2)
8.5
8.5
8.5
108.5
4
Present Value
8.25
8.01
7.78
96.4
5
Total PV
120.44
PV(bond)
=PV(annuity of coupon payments)+PV(final payment of principal)

=(coupon×x year annuity factor)+(final payment×discount factor)

27
3-2 How bond prices vary with interest rates
•  The price of long term bonds is affected more by changing
interest rate than the price of short term bonds.

28
Duration and Modified duration
•  Duration is measured the exposure of the bond's price to
fluctations in interest rates.
PV
)PV(CT
・・・
PV
)PC(C
PV
)PC(C
PV
)PC(C T×
++
×
+
×
+
×
= 321 321
Duration
yield1
duration
(%)volatilitydurationModified
+
==
•  Modified duration measured how bond prices change
when interest rates change.

29
3-3 The term structure of interest rates
•  The relationship between short and long term interest
rate is called the term structure of interest rates.

30
The law of one price applied government bonds
Year(t)
1
2
3
4
Bond
Price
(PV)
Yield to
maturity
(y,%)
Spot rate
0.035%
0.04%
0.042%
0.044%
Discount facotors
0.966
0.925
0.884
0.842
Bond A(8% coupon)
Payment(Ct)
80
1,080
1160
PV(Ct)
77.29
998.52
1,075.82
3.98%
Bond A(11% coupon)
Payment(Ct)
110
110
1,110
1330
PV(Ct)
106.28
101.70
981.11
1,189.10
4.16%
Bond A(6% coupon)
Payment(Ct)
60
60
60
1,060
1240
PV(Ct)
57.97
55.47
53.03
892.29
1,058.76
4.37%
Bond D(Strip)
Payment(Ct)
1,000
1000
PV(Ct)
841.78
841.78
4.40%

31
3-4 Explaining term structure
Why didn't everyone rush to buy long term bonds?
1.  You believe that short term interest rate will be higher in the future.
2.  You worry about the greater exposure of long term bonds to change in
interest rates
3.  You worry about the risk of higher inflation

32
3-5 Real and nominal rates of interest
•  Does the relation between inflation and interest rates affect
our decisions?
•  How does the inflation outlook affect the nominal rate of
interest?
•  A strategy of rolling over short term investments affords
some protection against uncertain inflation.

33
3-6 Corporate bonds and the risk of default
•  States and local governments
and corporations also borrow by
selling bonds as well as federal
government.
•  The firm will never pay more than
the promised cash flows,but in
hard times it may pay less.
•  The safety of most corporate
bond can be judged from bond
ratings provided by rating
companies.
Moody's
Standard & Poor's
Fitch
Aaa
AAA
Aa
AA
A
A
Baa
BBB
Ba
BB
B
B
Caa
CCC
Ca
CC
C
C

34
Chapter4 The value of common stocks
4-1 How common stocks are traded

4-2 How common stocks are valued

4-3 Estimating the cost of equity capital

4-4 The link between stock prices and earnings per share

4-5 Valuing a business by discounted cash flow

35
4-1 How common stocks are traded
•  Primary markets:
sales of shares to raise new capital
•  Secondary market:
the place where investors buy and sell
ex)NYSE,Nasdaq,Euronext,Tokyo stock exchange,
London stock exchange etc

36
4-2 How common stocks are valued
•  market value VS book value
Market to Book Value Ratio
Price Eanings Ratio
Company
Competitiors
Company
Competitors
Johnson&Johnson
3.4
3
11.3
10.9
Pepsico
6.4
3
15.6
12.9
Cambell soup
9
4.6
8.8
11.3
Wal-Mart
3
2.1
14.6
13.4
Exxon Mobil
2.9
1.2
7.6
5.3
Dow Chemical
0.5
3
12.5
10.6
Dell Computer
4.5
3.7
7.9
5.3
Amazon
11.2
2.7
46.9
22.2
GE
1
1.7
4.6
8.8
PBR=株価÷1株あたり株主資本
PER=株価÷1株あたりの利益

37
The determinants of stock prices
∑
∑
∞
=
=
+
=
+
+
+
=
+
+
++
+
+
+
=
+
+
==
−+
==
1
1
H
2
21
11
0
0
01
)1(
)1()1(
)1()1(1
1
Price
rreturnExpected
t t
t
H
HH
t t
t
H
H
r
DIV
r
P
r
DIV
r
PDIV
r
DIV
r
DIV
r
PDIV
P
P
PPDIV
・・・
•  PV(stock)=PV(expected future dividends)
income gain
capital gain

38
Applying the stock valuation formula to
Fledgling Electronics
Expected Future Values
Present Values
Horizon
Period(H)
Dividende
(DIVt)
Price(Pt)
Cumulative
Dividends
Future Price
Total
0
-
100
-
-
100
1
5
110
4.35
95.65
100
2
6
121
8.51
91.49
100
3
6
133
12.48
87.52
100
4
7
146
16.29
83.71
100
10
12
259
35.89
64.11
100
20
31
673
58.89
41.11
100
50
534
11,739
89.17
10.83
100
100
62,639
1,378,061
98.83
1.17
100

39
4-3 Estimating the cost of equity capital
g
P
DIV
r
r
gr
DIV
P
+=⇔
>
−
=
0
1
1
0 g)(
dividend yield
expected rate of growth in dividends
※this formula rests on a very strict assumuption:
constant divident growth in perpetuity

40
4-4 The link between stock prices  
and earnings per share 

Expected return=dividend return=earnings-price ratio
0
1
P
EPS
=
0
1
P
DIV
=
r
EPS
r
DIV
P 11
0 ==
• Stock price of the case of a company that does not grow at all

41
Net present value of growth opportunities
⎟⎟
⎠
⎞
⎜⎜
⎝
⎛
−=⇔
00
1
P
PVGO
r
P
EPS
earnings-price ratio
PVGO1
0 +=
r
EPS
P
Net present value of growth opportunities
earning power of the firm's current
and future asset

42
4-5 Valuing a business by discounted cash flow
H
H
H
H
r
PV
r
FCF
r
FCF
r
FCF
PV
)1()1()1(1 2
21
+
+
+
++
+
+
+
= ･･･
PV(free cash flow)
PV(horizon value)
•  The value of business computed as the discounted value of free cash
flow out to a valuation horizon(H),plus the forecasted value of the
business at the horizon.
•  Free cash flow is the amount of cash that a firm can pay out to
investers after paying for all investment necessary for growth.
•  Forecasting reasonable horizon values is particularly difficult.

43
Chapter5 Net present value and other
investment criteria
5-1 A review of the basics

5-2 Payback

5-3 Internal(or DCF) rate of return

5-4 Choosing capital investments when resources are limited

44
5-1 A review of the basics
NPV rules
•  A dollar today is worth more than a dollar than a dollar
tomorrow.
•  Net present value solely on the forecasted cash flows from
the project and the opportunity cost of capital.
•  Because presnt value are all measured in today's
dollars,you can add them up.
AssetsBook
incomeBook
returnofrateBook =
cash flows and book income are often very diferent

45
The theory and practice of finance
Figure5.2：Survey evidence on the percentage of CFO's who always,
or almost always, use a particular technique for evaluating investment projects.

46
5-2 Payback
•  The payback rule states that a project should be accepted if its pay
back period is less than some specified cutoff period.
【reason for misleading of payback rule】
1.  The payback rule ignores all cash flows after the cutoff date
2.  The payback rule gives equal weight to all cash flows before the
cutoff date

Cash Flows(＄）
Project
C0
C1
C2
C3
Payback
Period
(years)
NPV at 10%
A
-2,000
500
500
5,000
3
＋2,624
B
-2,000
500
1,800
-
2
-58
C
-2,000
1,800
500
-
2
＋50

47
5-3 Internal(or DCF) rate of return
Internal Rate of Return(IRR):
the project rate of return is the discount rate that gives a zero
NPV

0
)1()1(1 2
21
0 =
+
++
+
+
+
+= T
T
IRR
C
IRR
C
IRR
C
CNPV ・・・

48
IRR and the opportunity cost
•  The internal rate of return is a profitability measure that
depends solely on the amount and timing of the project cash
flows.
•  The opportunity cost of capital is a standard of profitability
that we use to calculate how much the project is worth.
•  The opportunity cost of capital is established in capital
markets.

49
Misapplied IRR rule
•  If a project offers positive cash flows by negative
flows,NPV can rise as the discount rate is
increased.
•  If there is more than one change in the sign of the
cashflows,the project may have several IRRs, or no
IRR at all.
•  The IRR rule may give the wrong ranking of
mutually exclusive projects that differ in economic
life or in scale of required investment.

50
5-4 Choosing capital investments  
when resources are limited
•  Capital rationing:
there are limitations on the investment program that prevent
the company from undertaking all such projects.
investment
luepresent vanet
IndexityProfitabil =
Project
C0
C1
C2
NVP
at 10%
Profitability index
A
-10
30
5
21
2.1
B
-5
5
20
16
3.2
C
-5
5
15
12
2.4

51
Capter6 Making investment decisions with
the net present value
6-1 Applying the net present value rule

6-2 example IM&C's Fertilizer project

6-3 investment timing

6-4 Equivalent annual cash flows

52
6-1 Applying the net present value rule
•  the problem of what to discount:
rule1:Only cash flow is relevant
・Depreciation is not a cash flow.
・Exclude debt interest or the cost of paying a loan from the project cash flow.
・Remenber the investment in working capital.
rule2:Always estimate cash flows on an incremental basis
・Include all indirect effects of the project.
　・Forget sunk cost.
　・Include opportunity cost.
rule3:Be consistent in your treatment of inflation
　・If cashs flow are forecasted in nominal terms,use a nominal discount rate.
　・Discount real cash flow at a real rate.

53
6-2 example IM&C's Fertilizer project
Net cash flow
=cash flow from capital investment and disposal
+cash flow from changes in working capital
+operating cash flow
Perod
0 1 2 3 4 5 6 7
1 Capital investment and disposal - 10,000 - - - - - - 1,442
2 Change in working capital - 550 - 739 - 1,972 - 1,629 1,307 1,581 2,002
3 Sales - 523 12,887 32,610 48,901 35,834 19,717 -
4 Cost of goods sold - 837 7,729 19,552 29,345 21,492 11,830 -
5 Other costs 4,000 2,200 1,210 1,331 1,464 1,611 1,772 -
6 Tax - 1,400 - 1,434 828 3,550 5,778 3,902 1,586
7 Operation cash flow(3-4-5-6) - 2,600 - 1,080 3,120 8,177 12,314 8,829 4,529
8 Net cash flow(1+2+7) - 12,600 - 1,630 2,381 6,205 10,685 10,136 6,110 3,444
9 Present value at 20% - 12,600 - 1,358 1,654 3,591 5,153 4,074 2,046 961
10 Net present value 3,520 (sum of 9)

54
Project Analysis
•  to undertake a sensitivity analysis
•  to construct a diferent scenarios
•  break even analysis- to expolre how far sales could
fall short of forecast before the project went into
the red
※In Chapter10, we practice using each of these
"what if" techniques.

55
6-3 Investment timing
year of harvest
0
1
2
3
4
5
Net Future Value
50
64.4
77.5
89.4
100
109.4
Change value from
previous year
28.8%
20.3%
15.4%
11.9%
9.4%
Net Present value
50
58.5
64
67.2
68.3
67.9
•  The optimal point to harvest the timber is year becauses
this is the point that maximizes NPV.
•  Delaying the harvest further just reduces shareholder
wealth.
•  We return to the problem of investment timing under
uncertainty in Chapter 10 and 22.

56
6-4 Equivalent annual cash flows
•  It's helpful to reverse the calculation,transforming an
investment today into an equivalent stream of future cash
flow.
•  Which machine shuould we take, A or B?
Machine
C0
C1
C2
C3
FV
PV at6％
A
15
5
5
5
30
28.37
B
10
6
6
22
21

57
Choosing the lowest equivalent annual cost
•  Machine A is better because its equivalent annual cost is
less(10.61 VS 11.45).
•  Our rule for choosing between plant and equipment with
differnt economic lives to select the asset with the lowest
fair change,that is, the lowest equivalent annual cost.
C0
C1
C2
C3
PV at6%
MachineA
15
5
5
5
28.37
Equivalent annual cost
10.61
10.61
10.61
28.37
C0
C1
C2
PV at6%
MachineB
10
6
6
21
Euqivalent annual cost
11.45
11.45
21

58
Summary
1) Goals and Governance of the Firm
maximizing value/the opportunity cost of capital/incentive and governance

2) How to Calculate Present Values
future values/present values/net present value/DCF/perpetuities/annyuities

3) Valuing Bonds
duration/modified duration/interest term structure

4) The Value of Commons Stocks
EPS/PVGO/horizon value

5) Net Present Value and Other Investment Criteria
book rate of return/pay back/IRR

6) Making Investment Decisions with the Net Present Value Rule
Equivalent annual cash flows

59
Reference
【コーポレートファイナンス関連】
•  マッキンゼーアンドカンパニー他（2006）「企業価値評価　第4版」ダイヤモンド社
•  鈴木一功（2004）「企業価値評価　実践偏」ダイヤモンド社
•  伊藤邦雄（2007）「ゼミナール企業価値評価」日本経済新聞社　
•  保田隆明（2008）「実況LIVE 企業ファイナンス入門講座―ビジネスの意思決定に
役立つ財務戦略の基本」ダイヤモンド社
•  森生明（2001）「MBAバリュエーション」日経BP社
•  森生明（2006）「会社の値段」ちくま新書
•  石野雄一（2005）「道具としてのファイナンス」日本実業出版社
•  石野雄一（2007）「ざっくり分かるファイナンス経営センスを磨くための財務」光文
社
•  砂川伸幸（2004）「コーポレートファイナンス入門」日経文庫
•  中沢恵・池田和明（1998）「キャッシュフロー経営入門」日経文庫
【その他応用編】
•  笹山幸嗣・村岡香奈子（2008）「M&Aファイナンス」金融財政事情研究会
•  齊藤誠「金融技術の考え方・使い方―リスクと流動性の経済分析」有斐閣
•  内藤伸浩(2003)「アセット・ファイナンス-資産金融の理論と実践」ダイヤモンド社
•  磯崎哲也（2010）「起業のファイナンス」日本実業出版社

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