FIN320
Important Issues by chapter for Damodaran's
Corporate Finance, 2nd ed.
Prof.
P.V. Viswanath
| Chapter |
Important Issues |
| Chapter 2: Firm Objectives
|
- What is the correct objective of the firm manager? Ex-ante
? Ex-post?
- In what way can managerial objectives differ from shareholder
objectives?
- In what way can shareholder objectives differ from bondholder
objectives?
- In what way can the firm's objectives differ from society's
objectives?
- How can we try to align everybody's objectives so that the ex-ante
goal of resource value maximization for all is achieved?
|
| Chap. 4: Understanding Financial Statements
|
- Market Value is more important than book value for financial analysts
- Cash flow is more important than earnings
- A Balance-Sheet prepared according to GAAP principles does not always
represent all the assets and liabilities of a firm; similarly, an Income
Statement prepared according to GAAP does not always represent all
operating expenses
- How to capitalize operating leases and include them in
the balance sheet
- How to capitalize Research and Development expenses and
include them in the balance sheet
|
| Chapters 3 and 5: Value and Price: An Introduction
|
- Time-Value of money is crucial
- The discount rate for an asset is the opportunity cost of investing
in that asset; i.e. what rate of return is demanded in the market to
hold an asset that generates cashflows with risk similar to that
asset?
- Valuing an asset with guaranteed cashflows
- Valuing an asset with promised cashflows and default risk
- Valuing an asset with equity risk
- Valuing an asset with equity risk -- a finitely lived asset
- Valuing an asset with equity risk -- the infinite life case; the
Gordon Growth model
- Using FCFE to value stock
- Using FCFF to value the firm
|
| Chapter 6: Equity Risk and Expected Return
|
- How to measure risk -- standard deviation
- Population characteristics and sample characteristics.
Estimating population characteristics with sample values
- Diversifiable and non-diversifiable risk
- A statistical analysis of how diversification reduces risk:
- A population example
- A sample example
- Variance of a portfolio with three assets; and more than three
assets
- Demonstration of the mean-variance frontier
- Implications of everybody holding diversified portfolios
- Beta as a measure of risk of a single asset in a
diversified portfolio
- The CAPM
|
| Chapter 7: Estimating Hurdle Rates for Firms |
- Estimating the cost of equity
- Riskless rate (ignore --currency choices and real rates; --riskless
rates when there is sovereign risk)
- Risk Premium (ignore references to foreign countries)
- Betas
- Historical Market beta
- Fundamental beta
- Bottom-up beta
- Estimating the cost of debt
- Calculating the weights of debt and equity components
|
| Chapter 16: An Overview of Financing Choices
|
- The distinction between debt and equity
- Equity choices for private firms:
- Owner's equity
- Venture Capital and Private Equity
- Equity choices for public firms
- Common stock
- Warrants
- Contingent Value Rights
- Debt Financing Options
- Bank Loans
- Bonds
- Leasing
- Hybrid Financing Options
- Convertible Debt
- Preferred Debt
- Option-linked bonds
|
| Chapter 17: Financing Choices and a Firm's Life Cycle
|
- Internal Financing versus External Financing
- Lifecycle pattern of financing
- Raising Equity
- Venture Capital
- IPOs (Going public: NASDAQ CD)
|
| Chapter 18: The Financing Mix: Tradeoffs and Theory
|
- Costs and benefits of debt (My webnotes)
- Benefits
- Taxes
-
Discipline characteristics of debt
- Costs
-
Expected Bankruptcy Costs
-
Agency costs of debt -- the conflict between bondholders and stockholders
-
Manifested in three ways:
-
To protect themselves, bondholders either
-
incur the costs of monitoring directly (which reduces the amount they are
willing to pay for debt securities) or
-
demand debt covenants, which reduce managerial flexibility.
|
| 19: The Optimal Financing Mix: The Cost of Capital
Approach
|
(p. 574 - 592)
- Webnotes
|
Chapter Summaries and short explanatory notes for Damodaran's
Corporate Finance, 1st ed.
Corporate Finance is the study of decisions that affect the
finances of the firm:
- Investment Decisions
- Financing Decisions
- Dividend Decisions
- Decisions affecting short-term cash flows: management of
working capital
What is the objective of Corporate Finance?
To Maximize Firm Value: the larger the pie, the better off is
everybody.
How do we do this? By ensuring that each decision serves to
maximize firm value. If markets operate efficiently, this is done
by maximizing the net present value associated with each
decision. To do this, we use the tools of Corporate Finance
- Present Value
- Financial Statement Analysis
- Risk and Return
- Option Pricing
- The need for an objective function
- Maximize wealth, but whose?
- Conflicts between different constituencies of the firm.
- Assumptions underlying the wealth maximization objective
- Stockholders and managers
- Stockholders and bondholders
- Managers and financial markets
- Firm and Society
Concept checks: p. 12, p. 13
Real World Problems:
- Stockholders and Managers
Inadequacy of Institutions designed to provide power to
stockholders
- Annual Meeting
- Board of Directors
- Greenmail
- Golden Parachute
- Poison Pill
- Synergy
- Stockholders and Bondholders
- Source of the Conflict
- Increases in financial leverage
- Increases in dividends
- Bond Covenants
- Firm and Financial Markets
- Information Asymmetry
- Inefficient Markets
Solutions to these conflicts
Problems
6, 7
Assignment
Find examples from the pages of business journals, newspapers
etc. that illustrate the conflict between different classes of
security holders
Webnotes on The
Objective Function in Corporate Finance
- Time Lines and Notation
- Time Value of Money
- Discount rate
- Interest rate
- Effective Interest Rate
- Formulae
- Annuity
- Growing Annuity
- Amortization factor
- Sinking fund
- Perpetuity
- Growing Annuity
Problems
2, 3, 8, 20, 21
Webnotes on
Present Value
Principal Financial Statements
Income Statement
Balance Sheet
Statement of Cash Flows
Webnotes
on Understanding Financial Statements
Asset Pricing Models
- The Capital Asset Pricing Model
- Measuring Risk
- What portion of risk is rewarded?
- The concept of diversification
- Covariance and diversification
- Construction of minimum variance
portfolios
- Construction of efficient portfolios
using risky assets
- Construction of efficient portfolios
using risky and riskless assets
- The Capital Market Line
- The Arbitrage Pricing Model
Problems
2, 3, 6, 8, 9, 11, 14, 15.
Computer Exercises
Webnotes on
Risk and Return
- Background
- Term Structure of Riskless Interest Rates
- Term Structure of Risky Interest Rates
- Estimation
- Estimation of the risk free rate
- Estimation of the market risk premium
- Beta Estimation
- Determinants of beta
- Cyclical Nature of business
- Degree of Operating Leverage
- Degree of Financial Leverage
- Weighted Average Cost of Capital
Problems
Problem 4, 8, 14, 20, 21, Concept Check p. 141
Computer Exercises
Webnotes on
Estimation of Discount Rates
Capital Budgeting Decision Rules or Investment
Decision Rules are attempts to allocate the firm's resources in
the most efficient way possible.
A project is any decision that results in using
the scarce resources of a firm.
Types of Investment Decisions
- Separately Analyzable from other projects
or Mutually Exclusive
- Revenue Generation or Cost Reduction
Approaches to Investment Decision Making
- Firm Approach
- Equity Approach
Categories of Decision Rules
- Accounting Income-Based
- Return on Capital
- Return on Equity
- Cash Flow-Based
- Cash Flow to the Firm
- Cash Flow to Equity
- Payback
- Discounted Cash-Flow Based
- Discounted Payback
- NPV
- IRR
- Profitability Index
Problems
1, 3, 4, 7, 13, 14, 15
Webnotes
on Capital Budgeting Decision Rules
Cash-Flow Ingredients for a Project
First Principles of Cash-Flow Estimation
Cash Flows should be after taxes
- Tax Rate
- Dealing with Losses
- The Effect of Noncash Charges
Cash Flows should be incremental
- Sunk Costs
- Working Capital
- Opportunity Costs
- Allocated Costs
- Product Cannibalization
Cash Flows should be estimated consistently
- Dealing with Leverage
- Dealing with Inflation
- Dealing with Hyperinflation
Problems
4, 6, 9, 15.
Capital Rationing
- When is there Capital Rationing?
- When is there no Capital Rationing?
- Sources of Capital Rationing
- Empirical Evidence on Capital Rationing
Constraints
- Dealing with Capital Rationing
Mutually Exclusive Projects
- Projects with Equal Lives
- Projects with Unequal Lives
Problems
1, 2, 4, 5, 9
The Choices: Types of Financing
- The Continuum between Debt and Equity
Equity
- Equity Choices for Private Firms
- Equity Choices for Publicly Traded Firms
Debt
- Bank Debt
- Bonds
- Debt Innovations
Hybrid Securities
- Convertible Debt
- Preferred Stock
- Option-Linked Bonds
The Historical Experience: How Firms have
actually raised funds
- A Cross-Cultural Comparison of Financing
Ratios
Ways of Raising Funds
- Internal vs. External Equity Financing
- From Private to Publicly Traded Firms: The
Initial Public Offering
The Choices for a Seasoned Firm
Problems
1, 2, 5, 8
The Benefits of Debt
- The Tax Advantage of Debt
- The Discipline of Debt
The Costs of Debt
- Bankruptcy Costs
- Agency Costs
- Loss of Flexibility
The Modigliani-Miller Theorem
- Balance Sheet Proof
- Alternative Proof
- The Effect of Taxes
- The consequences of Debt Irrelevance
There is an Optimal Capital Structure
- The Case for an Optimal Capital Structure
- The Empirical Evidence
How Firms Choose Their Capital Structure
Problems
2, 4, 6, 8, 10, 11, 14, 16.
Webnotes
on Capital Structure: Tradeoffs and Theory
Webnotes on
Perspectives on Diversification
The Cost of Capital Approach
- Definitions
- The Role of the Cost of Capital in Investment Analysis
and Valuation
A Practical Framework for Analyzing Capital Structure
- Cost of Equity
- Cost of Debt
- Cost of Capital
- General Assumptions
- Caveat Emptor - Some Considerations in Using the Model
- Building Constraints into the Analysis
- Determinants of Optimal Debt Ratios
- Extending the Cost of Capital Approach
Problems
1, 2, 4, 10, 13, 19, 22
Webnotes
on Capital Structure: Models and Applications
Webnotes
on Equity Valuation
Empirical Characteristics of Dividends:
- Dividends follow earnings
- Dividends are smoother than earnings
- Dividends are sticky
- A firm's dividend policy tends to follow the life cycle
of the firm
Measures of dividend payment:
- Dividend Yield = Dividend/Price
- Dividend Payout Ratio = Dividend/Earnings
Sufficient Assumptions for Dividend Irrelevance
- The issue of new stock (to replace excess dividends)
is costless and can, therefore, cover the shortfall
caused by paying excess dividends.
- Firms that face a cash shortfall do not respond by
cutting back on projects and thereby affect future
operating cash flows.
- Stockholders are indifferent between receiving
dividends and price appreciation.
- Any cash remaining in the firm is invested in
projects that have zero net present value (such as
financial investments) rather than used to take on
poor projects.
Implications of Dividend Irrelevance:
A firm cannot resurrect its image with stockholders by
offering higher dividends when its true prospects are bad.
Taxation of Dividends:
- Some History on Tax Rates
- The Tax Timing Option
- Measuring the Dividend Tax Disadvantages
Reasons for paying dividends:
- Wrong:
- Bird-in-the-hand Fallacy
- Temporary Excess Cash
- Good:
- Dividend Clienteles based on age, tax bracket and
income.
- Signalling
Problems
2, 4, 10, 13, 19, 22.
Webnotes on
The Determinants of Dividend Policy
Determinants of Dividend Policy:
- Investment Opportunities: A firm with more investment
opportunities should pay a lower fraction of its
earnings.
- Stability of earnings: A firm with more volatile
earnings should pay, on average, a lower proportion
of its earnings, so that it will not have to cut
dividends.
- Alternative sources of capital: To the extent that a
firm can raise alternative capital at low cost, it
can afford to pay higher dividends
- Signalling incentives: To the extent that a firm can
signal using other less costly means, for example
debt, it should pay lower dividends.
- Stockholder Characteristics: If a firm's stockholders
want higher dividends, it should provide them.
A Framework for Analyzing Dividend Policy
- How Much can a Firm Afford to Pay Out to its
Stockholders?
- What kind of Projects Does the Firm Have?
- Dividend Policy, Free Cash Flow to Equity and Project
Quality
- The Effects of Financial Leverage
Poor Projects and Low Payout
- Consequences of Low Payout
- Stockholder Reaction
- Management's Defense
Good Projects and Low Payout
- Consequences of Low Payout
- Stockholder Reaction
- Management Responses
Poor Projects and High Payout
- Consequences of High Payout
- Stockholder Reaction
- Management Responses
Good Projects and High Payout
- Consequences of High Payout
- Stockholder Reaction
- Management Responses
Problems
2, 4, 6, 8, 13.
Webnotes
on A Framework for Analyzing Dividend Policy
What is an Option?
- Call Options
- Put Options
- Payoff Diagrams
Determinants of Option Value
- Variables relating to the underlying
asset
- Current value of the underlying asset
- Variance in value of the underlying asset
- Dividends paid on the underlying asset
- Variables relating to the Option
Characteristics
- Strike Price of Option
- Time to Expiration on Option
- Variables Relating to Financial Markets
- Riskless Interest rate corresponding to life of
option
American versus European Options
Option Pricing Models
- The Binomial Model
- The Black-Scholes Model
- Limitations of the Model with respect to
dividends and fixes
Problems
1, 2, 6, 9.
Webnotes
on Option Pricing
Caveats on Applying Option Pricing Models in Corporate
Finance
- The Underlying Asset May not be Traded
- The Price of the Asset may not follow a Continuous
Process
- The Variance of the Return on the Asset May change in an
unknown fashion
- Exercise may not instantaneous
Options in Capital Budgeting
- Option to delay a project
- Option to expand a project
- Option to abandon a project
Valuing Equity as an Option
Options Applications in Capital Structure and Dividend Policy
- The Conflict Between Bondholders and Stockholders
- Taking on Risky Projects
- Conglomerate Mergers
- Security Design and Valuation
- Warrants
- Convertible Bonds
- Callable Bonds
Problems
4, 8, 9, 14.
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