Summary of Courses in Finance (Revision for the State Exam)

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Summary of Coursesin Finance (Revision for
the State Exam)

• Mihály Ormos

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Business Economics Corporate Finance

• 9. Financing corporations
• Pure equity financed mini-firm approach
• Effects of capital structure in a perfect market
• Effects of capital structure in a slightly
  imperfect market
• 10. Dividend policy
• Significance of indifference of dividend policy
  in financial analyses
• Explaining the indifference of dividend policy in
  a perfect market
• Explaining the indifference of dividend policy in
  a slightly imperfect market

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Business Economics Corporate Finance

• 11. Determination of cash flow streams
• Relevant cash flows
• Consideration of inflation
• Consideration of taxation
• 12. Determination of opportunity cost
• Determination of opportunity cost by the CAPM
• Country risk approach
• Opportunity cost by WACC
• 13. Business economic analyses
• Net present value
• Internal rate of return
• Profit index and annual equivalent

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Business Economics Corporate Finance

• 14. Options
• Properties of options
• Factors influence put and call option prices
• Real-options
• 15. Companies in the modern market economies
• Main types of modern market economies
• Shareholders value stake holders approach
• Mechanism of shareholders value

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Financing Pure equity financed mini-firm approach
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Financing Pure equity financed mini-firm approach

• If perfect capital market is assumed, the
  influence of debt policy on the value (Net
  Present Value) is negligible, therefore in
  economic analyses of projects pure equity
  financed mini-firm will be assumed.

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Financing Effects of capital structure in
perfect market

• Nine different factors should be investigated
• Value, Expected return and Risk of the
• Firm, Equity, Debt
• The Firm
• The value of the firm is equal to the sum of the
  value of equity and the value of debt VED (the
  capital structure can be characterised as the
  financial leverage of the firm which is shown by
  the D/E ratio)
• The expected return of the firm E(rV) and the
  risk of the firm ßV are given by the projects
  of the firm
• Therefore the value, the expected return and the
  risk of the firm is independent from the capital
  structure of the company, so from the D/E ratio

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Financing Effects of capital structure in
perfect market

• Debts
• The risk of the debts (ßD) in a low leveraged
  situation is 0, because the equity covers the
  debts, thereforethe required return of the debts
  (rD) is equal to the risk free return.
• After a certain leverage the risk and therefore
  the required return of the debts begin to
  increase,because the probability of debt
  trapping is increased.

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Financing in perfect market
rf
10
Financing Effects of capital structure in
perfect market

• Equity
• Rearranging the previous two equations (Firm) to
  the expected return and to the risk of the equity
  the next relations can be found

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Financing in perfect market
rf
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Financing Effects of capital structure in
perfect market

• Equity (Stocks)
• The leverage increases the risk (ßE) and the
  expected return (E(rE)) of the stocks,
• however, the value of the stocks is not affected
  (the risk and the expected return is increasing
  together in the function of D/E,
• so it is just sliding up on the security market
  line of the CAPM), therefore the capital
  structure is indifferent for the shareholders.

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Financing in perfect market
rf
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Financing Effects of capital structure in
perfect market

• Conclusion
• The changing D/E ratio has no effect on the value
  of the firm, the equity and the debt (MM. I.)
• The expected return of the equity is
  proportionally increasing with the D/E ratio.The
  rate of increase in the beginning is linear, then
  due to the increasing required rate of debt
  return (rD) the increase slows down. (MM. II.)
• This is why the pure equity financed mini-firm
  approach is adequate in corporate financial
  analyses.

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Financing Effects of capital structure in a
slightly imperfect market

• I. Corporate tax ()
• Financing the corporation by debts is
  advantageous, because interest connected to the
  debts can be cleared in the books as financial
  expenditure so the tax base is reduced and with
  this the tax liability is decreased.(annual tax
  saving tcDrD)
• The tax saving means cost reduction, so raises
  the expected cash flow and return of the firm.
• It can be derived that the present value of a
  leveraged firm is increased by tcD.
• This increase is due to the shareholders.

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V
rf
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Financing Effects of capital structure in a
slightly imperfect market

• I. Corporate tax ()
• II. Personal income tax as well ()
• All elements of the capital structure are taxed
  with almost the same rate, therefore it is
  indifferent in capital structure decisions.
• III. Financial distresses ()
• Financial distress occurs when the company is not
  able to cover its liabilities due to the high
  financial leverage and in this case the legal
  regulation over-defenses the state and the
  debtors and over-weakens the position of the
  shareholders.
• The probability of this kind of situation is
  increased by the D/E ratio, so decreasing the
  value of the stocks.

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Financing Effects of capital structure in a
slightly imperfect market
Even in case of slight market imperfection, the
value changing effect of the financial leverage
is negligible, so the pure equity financed
mini-firm approach is appropriate.
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Dividend policySignificance of indifference of
dividend policy in financial analyses

• If the indifference of dividend policy is
  assumed, then the project analyses can be derived
  through the cash flow steams of a pure equity
  financed mini-firm, so the shareholders cash
  flows resulted from dividend pay offs can be
  neglected.
• If above hypothesis can be proved, the corporate
  financial analyses are highly simplified, because
  the mini-firm approach can be used.

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Dividend policyExplaining the indifference of
dividend policy in a perfect market

• The suppositions (circumstances)
• the firm has settled on its investment program
  (i.e. it is already worked out that how much of
  this program can be financed by borrowing, and
  the plan meets other funds requirements)
• perfect market (fair issuing price, zero
  transaction cost, equal tax rates dividend and
  price earnings)
• What happens if the dividend wanted to be
  increased without changing the investment and
  borrowing policy?
• The only solution is to print some new shares and
  sell them.
• Miller and Modigliani states that the dividend
  policy has no affect to the value of the firm in
  the above circumstances.
• Investment and borrowing policy is determined so
  to increase the value of dividend new shares have
  to be offered so one part of the company become
  the property of the new owners.

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Dividend policyExplaining the indifference of
dividend policy in a perfect market
It is indifferent for the old owners how they get
money by dividend or by selling some of their
stocks.
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Dividend policyExplaining the indifference of
dividend policy in a perfect market
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Dividend policyExplaining the indifference of
dividend policy in a slightly imperfect market

• Arguments usually presents some kind of market
  imperfection (tax differences, transaction cost)
• Reasons to pay higher dividend
• There is a conservative group which believes that
  an increase in dividend payout increases firm
  value
• In lack of information the high dividend is a
  good sign
• The paid dividend is certain while the price
  increase is uncertain
• Reasons to pay lower dividend
• High transaction cost of issuing
• Higher taxation of divined incomes

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Dividend policyExplaining the indifference of
dividend policy in a slightly imperfect market

• Even in case of slight market imperfections the
  indifference can be defended.
• Empirically it can be proven that a supply-demand
  equilibrium is created between investors
  preferences to dividend and corporations
  dividend policies.
• If there existed better dividend policy, all
  company would use this,
• however many kind of policies can be found in
  the market.

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Determination of cash flow streams Introduction

• What is the aim of determination of cash flows?
• Corporate financial analyses are based on the
  future cash flows created by the project.
• These cash flows will be examined through the
  analyses

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Determination of cash flow streams Relevant cash
flows

• Cash flows should be estimated on change base
• All derivative effects have to be considered
  (with or without)
• Opportunity cost has to be taken into
  consideration
• Sunk Cost
• Careful separation of overheads
• Working capital needs
• Sub-versions should be separated
• Financing effects should be considered separately

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Determination of cash flow streams Consideration
of inflation

• Using nominal values.
• All cash flows are considered on current price,
  so the estimated price changes tendencies of
  e.g. material costs, payments to personnel,
  selling price are calculated. Of course the
  opportunity cost should be considered in the same
  way.
• Using real values.
• Unchanging, today prices are considered, but in
  this case the opportunity cost should be
  estimated on the same way.

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Determination of cash flow streams Consideration
of taxation

• Most taxes are taken into account as costs, i.e.
  they are considered as indirect or general
  expenditures for which the base is the net
  profit.
• General rule that is in the estimation of cash
  flows and in the estimation of opportunity cost
  the same calculation procedure should be used.

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Determination of opportunity cost Determination
of opportunity cost by the CAPM

• The opportunity cost gives the reference return
  in economic analyses.
• The projects expected return have to exceed this
  to be worthy for the owner to accomplish the
  investment.
• In the determination of the opportunity cost we
  have to start from the CAPM.
• There exists risk-free asset
• There is a premium accompanied to risk taking
• The required, expected and average returns are
  equal

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Determination of opportunity cost Determination
of opportunity cost by the CAPM
rf

• By definition the return of the risk free asset
  (time premium) is the return of any real asset
  with zero standard deviation. (There is no asset
  like this)
• In the estimation the return of that financial
  asset should be considered, which certainly pays
  back the claim with its interest. There is only
  one issuer which can guarantee that this will
  happen and this is the government.
• Therefore some kind of government security should
  be considered.
• The risk of inflation can be eliminated in two
  ways
• inflation indexed government security
• modifying with the estimated inflation rate
• If the return of government security is changing
  in time, the return of zero-coupon bonds, or the
  return of security with similar maturity to the
  project life time.

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Determination of opportunity cost Determination
of opportunity cost by the CAPM
rM

• By definition the return of the market portfolio
  can be given by the expected return of that
  portfolio which represents the capitalization
  weighted average return of all securities traded
  in the world.
• This can be approximated with the global
  portfolios e.g. MSCI world index
• However it would be rational to hold the global
  portfolio (MSCI), however there are many factors
  against the rational behaviour. Therefore a
  segmentation of the global market can be
  discovered.
• In this case separate CAPM worlds can be found.
• and the return of the market portfolios of these
  worlds depends on the expectations of the
  investors in the given world.

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Determination of opportunity cost Determination
of opportunity cost by the CAPM
?

• We are always interested in the opportunity cost
  of projects, (but the risk of a specific project
  and the risk of a specific stock (company) is not
  necessarily equal) nevertheless capital market
  information is available only on stocks.
• Two step procedure
• Estimation of unlevered betas
• From unlevered calculation of project betas
• Main factors cause the differences
• Sales revenues sensitivity to fluctuation of the
  whole economy
• Effect of operating leverage Fix Cost / Total
  Cost
• Financial leverage MM II.
• For starting point we can choose the beta of the
  given company if the function of the project is
  similar to the function of the firm, otherwise
  industrial averages can be used.

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Determination of opportunity cost Country risk
approach

• This approach can be used in those countries
  which has a fairly young capital market.
• In this case developed capital market data can be
  used as the basis of the estimation.
• The above data should be modified by the country
  risk factors which can be defined by the
  characteristics of the capital markets and other
  factors.
• This modification is a three step procedure
• Determination of the country risk factor which
  can be found by the credit-ratings of financial
  consulting companies like the moodys or
  blomberg.
• From this rating the extra return connected to
  government securities can be found so this has to
  be converted to the extra premium of stocks i.e.
  companies.
• Determination of the relationship between the
  firm and the country concerning the risk.

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Determination of opportunity cost Opportunity
cost by WACC

• The expected return of the firm can be expressed
  as the weighted average of the expected return on
  equity and debt, this is called the Weighted
  Average Cost of Capital

WACC is used in opportunity cost estimation in
case of the investigated projects business
activity (risk) is close to the business activity
(risk) of the firm. The idea behind the
calculation shows that the project should create
a profit at least which covers above the interest
on debt the required return of equity. If the
corporate income tax is considered as well then
the above expression is modified to
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Business economic analyses Introduction

• The main steps of a corporate financial analyses
  are
• Determination of opportunity costs
  (identification of the return of alternative
  capital market investment possibility with
  similar risk) ?
• Determination of future cash-flows (this is the
  sum of economic effects of the project) ?
• Economic analyses (comparison between the
  profitability of the project and the alternative
  investment possibility)
• NPV, IRR, PI, AE

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Business economic analyses Net present value

• Net Present Value is the sum of discounted
  cash-flows of a given project by the opportunity
  cost.
• So in this way the economic value of a project
  can be compared to other investment possibility
  with the same risk. The result of NPV calculation
  shows the value increase above the alternative
  investment possibility.
• Therefore, the project will be implemented if the
  NPVgt0.

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Business economic analyses Internal rate of
return

• Internal Rate of Return is defined as the rate of
  discount which makes the NPV0.
• In this case the average return of the project is
  determined and this is compared to the
  opportunity cost.
• So the IRR rule is to accept an investment
  project if the opportunity cost of capital is
  less then the IRR.
• Pitfalls of IRR
• It shows the average return of the project i.e.
  the increase of unit equity in unit time
• Lending or borrowing
• Multiple rates of return
• Mutually exclusive projects
• Short- and long term interest rates may differ

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Business economic analyses Profit Index and
Annual Equivalent

• Profit index is the quotient of the Net Present
  Value and the investment cost of the project

It is used in case of limited capital, for
mutually exclusive projects.
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Business economic analyses Profit Index and
Annual Equivalent

• Annual equivalent can be used to compare mutually
  exclusive and repeating projects with different
  life time.
• In this case the future cash-flows of the project
  converted to annuity and these annuities will be
  compared (NPV of the normal cash flows has to
  give the same result as the NPV of the annuity)

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Companies in the modern market economy
Introduction

• Development of public limited corporations
• Early capitalism
• individuals and families
• unlimited liability
• the owner and the manager is the same
• Development of technology and mass production
  required the concentration of capital
• Limited liability
• legal entity
• shares are tradable
• More owner one company
• management and ownership are separated, but
• the goals are different
• agency problem

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Companies in the modern market economiesMain
types of modern market economies

• The types are connected to the degree, the
  manner, and the function of intervention of the
  state into the economic processes.
• The three form of modern market economy
• Corporate (market) controlled (Anglo-Saxon)
• State controlled (Asian capitalism)
• Negotiation based market economy (Rhenish)

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Companies in the modern market economiesMain
types of modern market economies

• Corporate (market) controlled (Anglo-Saxon)
• The role of the state is narrow
• USA, Great-Britain
• Weak feudalism
• Parliamentary political system
• Smooth and continuous industrialisation

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Companies in the modern market economiesMain
types of modern market economies

• State controlled
• Relatively the highest state coordination
• intervenes the microeconomic processes
• selectively influences the operations of
  companies
• plays a significant role in the allocation of
  recourses like
• state owned firms
• financing RD
• reduced rate credits
• Japan and France
• Strong feudalism and aristocracy
• Late but rapid industrialisation, therefore
• High industrial concentration
• The bank system has a significant role
• The state in sight of the international
  competition strengthened its position.

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Companies in the modern market economiesMain
types of modern market economies

• Negotiation based market economy
• The economic processes are based on the
  negotiations of the leading economic roles.
• The main idea is social partnership i.e.
  political consensus between the employers, the
  employees, and the bureaucracy.
• The negotiations include
• wages
• prices
• taxes
• employment
• economic stability and growth

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Companies in the modern market economiesMain
types of modern market economies

• by the financing system of the economy
• By the role of the bank system three types can be
  distinguished
• Capital market based financing system
• New recourses can be obtained by issuing stocks
  or bonds, bank loans are used mainly for
  temporary financing
• Credit based financing system with administrative
  dominance
• Small and moderate exchanges so the firms have to
  use the banks for financing.
• Subsidies through the banking system
• Credit based financing system with institutional
  dominance
• Some large banks, and they have shares in the
  firms, investment funds are owned

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Companies in the modern market economiesSharehold
ers value stake holders approach

• Share holders value approach
• Only the growth of the companys value counts
• The firm works as a revenue producing machine
• From the 90s this form became the major approach
• Capital market based financing system
• Stake holders value
• They are the buyers, the suppliers, the
  investors, the creditors, the employees, the
  government
• Their interests should be considered
• More comfortable, and humane
• Credit based financing system

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Companies in the modern market economiesMechanism
of shareholders value

• If there are dominant shareholders of the
  company, the board of directors and carrier
  competition work well.
• If the ownership is crumbled (because of the
  demand of capital new issues happened,
  diversification of owners, etc.) then the
  intervention of owners to the business activity
  of the firm is decreased even the members of the
  board could be delegated by the management.
• However, if the shareholders is pushed into the
  background, then the firm is usually pushed to
  the edge, so the owners are gladly sell their
  stocks and by this the buyout of the company can
  happen, and the new owners are easily fire the
  management.

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DerivativesProperties of options

• Derivative instruments are financial assets with
  returns depend on value of other factors.
• Two basic types
• Termins (forwards and futures)Termin
  transactions are basically sales contracts for a
  predefined future date, however the seller does
  not have to own the asset of the contract.
• OptionsOptions give the opportunity to buy or
  sell an asset on a specified price.

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DerivativesProperties of options

• Types of option
• Call is the opportunity or obligation to buy
• Put is the opportunity or obligation to sell
• Short positions are obligations to sell or buy
  (writer)
• Long positions are rights to sell or buy

• Option price or premium is the value which have
  to be paid by the buyer for the opportunity.
• Exercise of Strike price is the predefined
  (contracted) price of the asset (K).
• X0 is the actual price of the asset
• The owner of an option can
• sell the option on actual price
• at expiration draw the option
• wait until expiration and do nothing
• American vs. European option

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• Value of Call and Put options at expiration

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• Profit on Call and Put options

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DerivativesFactors influence option prices

• Actual stock price
• Strike or Exercise price
• Intrinsic value (relation of X0 and K)
• Call ITM situation the intrinsic value X0-K
• Call ATM and OTM situation this value is 0
• Volatility of the stock returns (standard
  deviation of annual returns)
• Time to option expiration
• Mature dividend until expiration
• Risk free return (i.e. the present value of
  exercise price)
• Time value of option
• The difference between the value of the option
  (c) and its intrinsic value

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DerivativesFactors influence option prices
K
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DerivativesReal-options

• Real options are option analogies fitted to
  corporate investments by which those parameters
  can be evaluated that cannot be included in NPV
  calculations.
• Likederivative investment possibilities (Call
  option)
• possibility of leaving a business (Put option)