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Corporate Finance

Everything…..
R Srinivasan
Corporate Finance
• Valuation and Cost of capital
• Capital budgeting
• Capital structure, financing and dividend
policy
• Working capital
Valuation
• Generalised valuation
Arbitrage and value additivity
• Patterns
Level perpetuity
Growing perpetuity
Level annuity
Growing finite cash flow
Valuation
Growing finite [t years] cash flow

C1/(r-g){1-(1+g)t/(1+r)t}
Valuation
• Compounding intervals (1+r/m)m-1
Continuous compounding
• Stated and effective rates
• Nominal and real rates
1+rnominal=(1+rreal)(1+inflation rate)
Valuation: Straight Bonds
• YTM
• Duration
Sensitivity of value to changes in interest
rates
[1*PV(C1)/V]+[2*PV(C2)/V]+[3*PV(C3)/V]
V/V = (1+r)/(1+r)*D
Valuation: Common Stock
• Perpetual growth models
Sustainable growth
P0=No-Growth +PVGO
No-growth =EPS1/r
PVGO=NPV1/(r-g)
where NPV1 =-INV1 +INV1*ROE/r
g=Ploughback*ROE
EPS1/P0 interpretation
Valuation
• Multiple stages
Supernormal stage plus PV of normal
growth
• Free cash flow
NOI approach
Cost of Capital
• Security return and standard deviation
• Portfolio return and standard deviation
• Diversification Portfolio variance=
1/N Average Var+(N-1)/N Average covariance
• Systematic and unsystematic risk
• CAPM
• Opportunity cost of capital r [rA]and
Adjusted cost of capital r*
Cost of Capital
1. VL = VU +Tc *D
2. WACC = D/V * (1-Tc) * rD+E/V * rE [Definition of WACC]
3. rE = rA + (rA - rD ) * (1- Tc) * D/E [MM Proposition II]
4. β E = {1+ (1- Tc) * D/E} *β A [If debt is risk free]
5. rE = rf + (rM - rf) *β E [CAPM]
6. WACC= rA *(1- Tc * D/V) MM
Valuation
• Contingent cash flow
Call/Put
American/European
Binomial
Black-Scholes
Underlying asset price, Exercise Price, Risk-
free rate, Volatility, Time
Capital Budgeting
• NPV and IRR not payback and accounting
rate of return
• Accept/reject single project use NPV or
IRR, unless no/multiple IRR
• Mutually exclusive projects: Same life and
risk
Use NPV [or IRR of difference between
projects]
Capital Budgeting
• Mutually exclusive projects: Different lives same
risk
Use NPV-assumes replacement projects have zero
NPV. OK for projects with long lives
Use NPV-with specific replacements that make
project with comparable lives
Use replacement chain or EAC
Care: Use only real cash flows for EAC
Capital Budgeting
• Incremental nominal cash flows with
empirically measured discount rate
• Components of cash flow
Investment in fixed assets, salvage value
Investment in working capital, release
Operating revenues/expenses
NO INTEREST
Capital Budgeting
• NPV assumes “now or never”
• Real Option framework
Abandonment
Follow-up
Wait and learn
Flexibility
Capital structure
• Market Efficiency
• MM-1 No taxes
• MM-2 Corporate taxes
• Miller Both corporate and personal taxes
GL= {1-(1-TC)*(1-TpE)/(1-Tp)}
• Bankruptcy costs
• Agency costs
Dividends
• MM Does not matter
• Lintner behavioural model
DIV1-DIV0=Adjustment rate*(target ratio*EPS1-DIV0)
• Agency costs/signalling
Working Capital Management
• Operating cycle, cash conversion cycle,
weighted cycles and supply chain
management
• Investment in receivables
• Cash management
EOQ and Miller-Orr models