1 Course Overview Finance: what is it? Corporations Investors Financial Markets: Banks, Stock Exchanges Corporate Finance Money and capital marketsInvestments

2 Valuation is the central concept zIn corporate finance we are concerned with making decisions that enhance firm value. zIn investments we week to value securities and maximize the value of our portfolio.

3 BUS 785: course organization BUS 785 Module 1 Valuation of financial assets Module 2 Valuation of real assets Module 3 Options theory and its applications Module 4 Capital structure theory Portfolio theory Mean-variance analysis Risk and return CAPM and WACC Multi-factor models APT Discounting and valuation Binomial valuation, replication and risk-neutral probabilities Investing in risk-free projects Investing in risky projects Bankruptcy costs and the conflict between debt holders and equity holders Tax, dividend and share repurchase (not be covered in this class) Modigliani-Miller theorems 1 and 2 Black-Scholes valution Valuing managerial flexibility using real option methodology

4 Valuation of financial assets zThis module is the foundation of corporate finance yCorporate finance is simply the application of asset pricing theories zIt covers the most fundamental theories in finance yPortfolio diversification, mean-variance analysis, risk and return yCAPM, how to calculate cost of capital

5 Valuation of real assets zThis part is about the application of asset pricing theory in capital budgeting. zIt covers yPresent value and NPV rule yInvesting in risky projects

6 Option pricing theory and its applications zThis module, together with the first module, provides a complete picture about asset pricing. zIt covers yBlack-Sholes valuation and its use in industries yReal options: Applications of option theory in valuing managerial flexibility: waiting, expansion, and shutting down

7 If you are the CEO of an industrial company yyou can make your company more valuable by choosing “better” projects ( capital budgeting decision ) yyou can make your company more valuable by changing the mixture of your financing, i.e. the ratio of debt to equity ( capital structure decision )

8 Financial decisions zCapital budgeting decisions (how to invest money) yReal capital investments yMergers; acquisitions zCapital structure decisions (how to raise and return money) yEquity yDebt yDistribution (Dividend, share repurchase)

9 Balance-Sheet of the Firm What long-term investments should the firm engage in? The Capital Budgeting Decision Current Assets Fixed Assets 1 Tangible 2 Intangible Current Liabilities Long-Term Debt Shareholders’ Equity

10 Balance-Sheet of the Firm How can the firm raise the money for the required investments? The Capital Structure Decision Current Assets Fixed Assets 1 Tangible 2 Intangible Current Liabilities Long-Term Debt Shareholders’ Equity

11 Chapter 1 Business Forms Sole Proprietorships Corporations Partnerships Limited Liability Corporate tax on profits + Personal tax on dividends Unlimited Liability Personal tax on profits

12 A Comparison of Partnership and Corporations CorporationPartnership LiquidityShares can easily be exchanged. Subject to substantial restrictions. Voting RightsUsually each share gets one vote General Partner is in charge; limited partners may have some voting rights. TaxationDoublePartners pay taxes on distributions. Formationdifficulteasy LiabilityLimited liabilityGeneral partners may have unlimited liability. Limited partners enjoy limited liability. ContinuityPerpetual lifeLimited life

13 What should be the financial Goal of a company? zMaximizing revenue, cut cost, secure market share? zThe primary financial goal is shareholder wealth maximization, which (generally) translates to maximizing stock price.

14 Is stock price maximization the same as profit maximization? zNo, despite a generally high correlation amongst stock price, EPS, and cash flow. zSome actions may cause an increase in earnings, yet cause the stock price to decrease (and vice versa). E.g., cut R&D.

15 Agency relationships zAn agency relationship exists whenever a principal hires an agent to act on their behalf. zWithin a corporation, agency relationships exist between: yShareholders and managers yShareholders and creditors

16 Shareholders versus Managers zManagers are naturally inclined to act in their own best interests (Shirking, empire building, corporate jets, entrenchment). zTo mitigate the problem: yBonus, stock options yDirect intervention by shareholders yThe threat of firing yThe threat of takeover

17 Shareholders versus Creditors zShareholders (through managers) could take actions to maximize stock price that are detrimental to creditors. zFor example: taking too risky projects. (Are you willing to lend money to someone who gamble a lot?)

18 zWhen the outcome is very good, shareholders enjoy the fruit. zWhen the outcome is bad, shareholders are protected by limited liability. E.g., can get away by declaring bankruptcy.

19