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Summary Lecture notes week 1-7 - Corporate Finance and Behavior (ECB2FIN)
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Corporate Finance and Behavior (ECB2FIN) Lecture notes of weeks 1-7 *Examples with solutions included
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Corporate Finance and Behavior NotesWeek 1:
Chapter 8: Portfolio Theory and Capital Asset Pricing Model (CAPM)
Diversification: the act of investing in a variety of different industries, areas, and financial instruments,
in order to reduce the risk that all the investments will drop in price at the same time.
Considerations for setting up a portfolio of investments to reduce risk:
1. Covariance between two components in a portfolio
2. Correlation between two components with respect to their return. The correlation between 2
shares can be between -1 < 𝜌 < 1. (Preference for investments in companies who are negatively
correlated ( 𝜌= −1) like ice creams and umbrellas)
Systematic risk: risk that influences a large number of assets also known as ‘market risk’
(Has to do with the market)
Unsystematic risk: Risk that affects at most a small number of assets. Also referred to as ‘unique’ or
‘asset specific’ risk. (risk that can be eliminated by diversification)
(Firm specific e.g. firms’ CEO gets fired)
How to reduce the Risk (i.e. the S.D.) of an investment?
- By DIVERSIFICATION: investing in a number of companies and not just 1 company.
- Risk of overall investment will go down
Beta:
σ im
β= covariance with market / variance of market
βi = 2
e.g. The correlation coefficient between a stock and the market portfolio
is +0.6. The standard deviation of return of the stock is 30 percent and
that of the market portfolio is 20 percent. Calculate the beta of the
stock. σm
Answer:
Cov(Rs, Rm) = (0.6)(20)(30) = 360
Var(Rm) = 20^2 = 400.
Beta = [Cov(Rs, Rm)]/Var(Rm)
= 360/400 = 0.9
,CAPM: describes the relationship between systematic risk and expected return for assets
Formula:
𝐸(𝑟)=𝑅𝑓+ 𝛽 𝑥 (𝑅𝑚−𝑅𝑓)
Required return = risk-free rate of return + beta (market return - risk-free rate of return)
SML: is a visualization of the CAPM that can help to determine whether an investment product would
offer a favorable expected return compared to its level of risk. The x-axis of the chart represents risk (in
terms of beta), and the y-axis of the chart represents expected return.
Chapter 9: Risk and Cost of Capital
The Cost of Equity Capital:
To estimate the Cost of Equity Capital you need to know:
- The Risk-Free Rate
- The Market Risk Premium
- The Company Beta
,Example:
The Equity of Delta Air Freight has a Beta of 1.2. Market risk premium is 7% and the risk free rate is 6%.
What is the cost of equity for DAF?
Answer:
Beta =1.2
(𝑅𝑚−𝑅𝑓) =7%
(𝑓) =6%
𝑅𝑒= 𝑅𝑓+ 𝛽 𝑥 (𝑅𝑚−𝑅𝑓) = 6%+1.2 𝑥 7% = 𝟏𝟒.𝟒% = 𝐷𝐴𝐹′𝑠 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦.
When calculating the Cost of Capital to the company:
1) Calculate the cost of equity (use CAPM, 𝑅𝑒 )
2) Calculate the cost of Debt (weighted average cost of debt in case of various types of debt in the
company’s financing, 𝑅𝑑 )
3) Take into consideration the fact that interest payments are tax deductible. Make sure to
examine the cost of capital before or after tax. (In case profit is 0, no difference.)
4) The cost of capital then becomes the weighted average cost of the cost of equity (𝑅𝑒 ) with the
(weighted average) cost of debt (𝑅𝑑 ).
5) Using fudge factors for a WACC will lead to improper results! (see page 241 table 9.2)
Week 1 Tutorial notes:
- Type of risk that can be eliminated by diversification is called unique risk
- Unique risk is also called firm-specific risk
- Correlation coefficient can take range of values between -1 to +1
- Beta is a measure of market risk
- Beta of the market portfolio is +1.0
- Investors demand higher expected rates of return from stocks with returns that are: highly
exposed to macroeconomic risks/very sensitive to fluctuations in the stock market.
*(Check Week 1 tutorial questions)*
Week 2:
Chapter 13: Efficient Markets and Behavioral Finance
• The objective with Investment and Financing activities is to maximize the NPV.
NPV: Net present value is the difference between the present value of cash inflows and the present
value of cash outflows over a period of time. Used to analyze the profitability of a projected investment
or project.
Investment activities take place with respect to the Debit side (left-hand side) of the Balance sheet
whereas Financing activities focus on the Credit side (right-hand side) of the Balance sheet where the
funding activities take place.
, Because Financial markets are more competitive than the Product markets, it is more difficult to find
positive NPV financing strategies than positive NPV investment strategies!
Efficient Capital Markets: refers to how well current prices reflect all available, relevant information
about the actual value of the underlying assets. Also called – Efficient Markets Hypothesis (EMH)
Note: As the quality and amount of information increases, the market becomes more efficient reducing
opportunities for arbitrage and above market returns.
Arbitrage: the purchase and sale of an asset in order to profit from a difference in the asset's price
between markets.
OR
The simultaneous buying and selling of securities, currency or commodities in different markets or in
derivative forms in order to take advantage of differing prices for the same asset.
Note: The efficient market hypothesis recognizes that investors read financial statements and
understand the impact of taxes.
3 Levels of Market Efficiency:
1. Weak Form Efficiency: suggests today’s stock prices reflect all the data of past prices and that
no form of technical analysis can aid investors. (Successive changes are independent)
2. Semi-strong Form Efficiency: prices will react immediately to new public information
3. Strong Form Efficiency: prices reflect all information that can be acquired analysis of companies
and the economy, and no type of information can give an investor an advantage on the market.
Week 3:
Chapter 18: Capital Structure: Limits to Borrowing
Leverage Ratio = Total Debt / Market Value Firm
Value of the firm = Value all equity + PV tax shield – PV financial distress
Trade-off Theory:
Benefits:
- Low costs of debt (e.g. as a result of the Tax-deductibility of interest payments)
- Limiting the discretionary power of managers / management
- Monitoring activities of managers by Banks (reducing Agency Costs)
Costs:
- Costs due to ‘Financial Distress’ (direct and indirect) possibly leading to Bankruptcy
- Agency Costs (e.g. focus on risky projects)
- Personal Taxes on interest earnings
Bankruptcy costs
In principle a firm goes bankrupt when the asset value equals its debt. The value of equity is zero, and
shareholders give control to bondholders.
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