INSEAD Library

Includes bibliographical references and index

Digitized

CONTENTS Lectures on Corporate Finance vii Introductory Remarks Contents I Introduction to Finance 1 Finance 1.1 What is Finance? . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.2 Corporate Finance . . . . . . . . . . . . . . . . . . . . . . . . . . 1.3 Financial Markets . . . . . . . . . . . . . . . . . . . . . . . . . . xi 3 3 3 4 6 6 6 6 2 andoms of Modern Corporate Finance 2.1 The Axioms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.1.1 Financial Markets are Competitive . . . . . . . . . . . . . 2.1.2 Value Additivity . . . . . . . . . . . . . . . . . . . . . . . 2.1.3 No Free Lunches . . . . . . . . . . . . . . . . . . . . . . . 2.1.4 The Efficient Markets Hypothesis . . . . . . . . . . . . . . 7 7 8 8 8 9 I On Value Additivity s 3.1 Value Additivity . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.2 The Value of the Firm . . . . . . . . . . . . . . . . . . . . . . . . . 3.3 A Couple of Brain Teasers . . . . . . . . . . . . . . . . . . . . . . 4 On the Efficient Markets Hypothesis 4.1 The Idea . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.2 Traditional Formulation of the Efficient Markets Hypothesis . . . 4.3 What Information? . . . . . . . . . . . . . . . . . . . . . . . . . . 4.4 What Does "Correctly Reflected" Mean? . . . . . . . . . . . . . . 4.4.1 Rational Learning . . . . . . . . . . . . . . . . . . . . . . 4.4.2 Unbiased Beliefs . . . . . . . . . . . . . . . . . . . . . . . 4.4.3 Adding Compensation for Waiting and Risk . . . . . . . . 4.5 Empirical Evidence . . . . . . . . . . . . . . . . . . . . . . . . . . 4.6 Some Implications of the Efficient Markets Hypothesis . . . . . . 4.6.1 One Cannot Time the Market . . . . . . . . . . . . . . . . 4.6.2 Average Returns in Excess of the Risk Free Rate are Solely Determined by Risk . . . . . . . . . . . . . . . . . . . . . 4.6.3 Expected Returns Can Vary Over Time . . . . . . . . . . I1 Basic Finance 5 Present Value 5.1 Definition of Present Value . . . . . . . . . . . . . . . . . . . . . 5.2 Pricing in Markets for Dated Riskfree Cash Flows . . . . . . . . 5.3 Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 23 25 25 xii 5.4 5.5 5.6 5.7 5.8 5.9 5.10 5.11 5.12 CONTENTS Term Structure of Interest Rates . . . . . . . . . . . . . . . . . . Net Present Value . . . . . . . . . . . . . . . . . . . . . . . . . . Capital Budgeting . . . . . . . . . . . . . . . . . . . . . . . . . . Perpetuities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Annuities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Compound Interest . . . . . . . . . . . . . . . . . . . . . . . . . . Valuing Fixed Income Securities . . . . . . . . . . . . . . . . . . Valuing Equities . . . . . . . . . . . . . . . . . . . . . . . . . . . Risky Cash Flows . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 Capital Budgeting 6.1 Capital Budgeting . . . . . . . . . . . . . . . . . . . . . . . . . . 6.2 Evaluating Projects using NPV . . . . . . . . . . . . . . . . . . . 6.2.1 Calculation of NPV . . . . . . . . . . . . . . . . . . . . . 6.2.2 Only Cash Flows . . . . . . . . . . . . . . . . . . . . . . . 6.2.3 Accountants . . . . . . . . . . . . . . . . . . . . . . . . . . 6.2.4 After Tax Cash Flows . . . . . . . . . . . . . . . . . . . . 6.2.5 What are Relevant Cash Flows? . . . . . . . . . . . . . . 6.2.6 Inflation . . .\. . . . . . . . . . . . . . . . . . . . . . . . . 6.2.7 Projects with Different Life Lengths . . . . . . . . . . . . 6.3 Alternative Valuation Methods . . . . . . . . . . . . . . . . . . . 6.3.1 Payback Period . . . . . . . . . . . . . . . . . . . . . . . . 6.3.2 Internal Rate of Return . . . . . . . . . . . . . . . . . . . 6.3.3 Profitability Index . . . . . . . . . . . . . . . . . . . . . . 6.3.4 Accounting Measures of Return . . . . . . . . . . . . . . . 6.4 Some Fancy Acronyms . . . . . . . . . . . . . . . . . . . . . . . . 6.4.1 EVA (Economic Value Added) . . . . . . . . . . . . . . . 6.4.2 MVA (Market Value Added) . . . . . . . . . . . . . . . . 6.4.3 TSR (Total Shareholder Return) . . . . . . . . . . . . . . 7 Valuation Under Uncertainty: The CAPM 7.1 Asset Pricing Theory . . . . . . . . . . . . . . . . . . . . . . . . . 7.2 Portfolio Returns . . . . . . . . . . . . . . . . . . . . . . . . . . . 7.3 Diversifiable and Nondiversifiable Risk . . . . . . . . . . . . . . . 7.4 The Set of Efficient Portfolios . . . . . . . . . . . . . . . . . . . . 7.5 The Possibility Set with a Risk Free Security . . . . . . . . . . . 7.6 The Capital Asset Pricing Model . . . . . . . . . . . . . . . . . . 7.7 Using CAPM for Pricing . . . . . . . . . . . . . . . . . . . . . . . 7.8 Using CAPM for Capital Budgeting . . . . . . . . . . . . . . . . 7.9 Empirical Evidence . . . . . . . . . . . . . . . . . . . . . . . . . . 7.10 Experimental Evidence . . . . . . . . . . . . . . . . . . . . . . . . 7.11 The Arbitrage Pricing Theory . . . . . . . . . . . . . . . . . . . . 7.12 When the CAPM Would Fail . . . . . . . . . . . . . . . . . . . . CONTENTS xiii I11 Multiperiod Pricing and Derivatives 8 Valuing Risky C a s h Flows 8.1 Valuation of Dated. Risky Cash Flows . . . . . . . . . . . . . . . 8.2 States . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8.3 States and Digital Options . . . . . . . . . . . . . . . . . . . . . . 8.4 Expectations and Digital Options . . . . . . . . . . . . . . . . . . 8.5 Trees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8.6 Summarizing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 Introduction t o Derivatives 9.1 Derivatives . . . . . . . . . . . . . . . . . . . . . . . . . . . 9.2 Definitions . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9.3 Option Cashflows . . . . . . . . . . . . . . . . . . . . . . . . 9.4 Bounds on Option Prices . . . . . . . . . . . . . . . . . . . 9.4.1 Positivity . . . . . . . . . . . . . . . . . . . . . . . . 9.4.2 Simple Upper Bounds . . . . . . . . . . . . . . . . . 9.4.3 European Call Lower Bound . . . . . . . . . . . . . 9.4.4 Should American Options be Exercised Early? . . . 9.5 Put-Call Parity .Ir. . . . . . . . . . . . . . . . . . . . . . . . 9.6 Rounding Of . . . . . . . . . . . . . . . . . . . . . . . . . . f 69 69 70 70 72 74 74 10 Pricing Derivatives 10.1 Pricing Risky Cash Flows . . . . . . . . . . . . . . . . . . . . . . 10.2 Pricing Derivatives . . . . . . . . . . . . . . . . . . . . . . . . . . 10.3 Interpreting Equity as an Option . . . . . . . . . . . . . . . . . . 90 90 91 93 97 1 Pricing of Multiperiod. Risky Investments 1 11.1 Multiple States . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97 11.2 Getting to Two States by Adding Time Steps . . . . . . . . . . . 98 11.3 A Real-Life Example: Pricing An MCI Call Option . . . . . . . . 100 11.4 General Strategy . . . . . . . . . . . . . . . . . . . . . . . . . . . 103 2 Where T o G e t S t a t e P r i c e Probabilities? 12.1 Implementation . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12.2 Generating the Possible Future States . . . . . . . . . . . . . . . 12.3 Now the State Price Probabilities . . . . . . . . . . . . . . . . . . 12.4 Pricing Call Options: The MCI Example Again . . . . . . . . . . 12.5 State Price Probabilities and True Probabilities . . . . . . . . . . 106 106 106 109 110 112 115 13.1 Definition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115 13.2 Firm Value and Warrants . . . . . . . . . . . . . . . . . . . . . . 115 13.3 Valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 116 xiv CONTENTS 14 The Dynamic Hedge Argument 119 14.1 Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 119 14.2 Why State Prices must be Equal . . . . . . . . . . . . . . . . . . 119 14.3 The Binomial Option Pricing Model . . . . . . . . . . . . . . . . 120 15 Multiple Periods in the Binomial Option Pricing Model 15.1 Multiple Periods . . . . . . . . . . . . . . . . . . . . . . . . . . . 15.2 The Binomial Formula and the Black Scholes Model . . . . . . . 15.3 Early Exercise of Puts in the Binomial Model . . . . . . . . . . . 15.4 Adjusting for Dividends in the Binomial Model . . . . . . . . . . 15.5 Implementing the binomial option formula . . . . . . . . . . . . 16 An Application: Pricing Corporate Bonds 16.1 Corporate Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . 16.2 The Risky Part of Corporate Bonds . . . . . . . . . . . . . . . . 16.3 Risk Free Bonds with Put Option . . . . . . . . . . . . . . . . . . 16.4 Shareholder Incentives . . . . . . . . . . . . . . . . . . . . . . . . 16.5 A Solution: Convertible Bonds . . . . . . . . . . . . . . . . . . . 16.6 Callable Convertible Bonds . . . . . . . . . . . . . . . . . . . . . 1 128 128 132 132 134 136 139 139 139 141 145 146 148 IV .7 Corporate Finance Capital Structure Decisions Relevant? The Capital Structure Problem . . . . . . . . . . . . . . . . . . . The Problem with "Assets In Place" . . . . . . . . . . . . . . . . Shareholder Preferences for Firm Value . . . . . . . . . . . . . . Implications for Cost of Equity Capital: MM I1 . . . . . . . . . . What if Assets are Not In Place? . . . . . . . . . . . . . . . . . . 155 155 156 160 161 162 Are 17.1 17.2 17.3 17.4 17.5 18 Maybe Capital Structure Affects Firm Value After All? 167 18.1 Only Through Changes in Assets . . . . . . . . . . . . . . . . . . 167 18.2 Corporate Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . 167 18.3 Bankruptcy Costs . . . . . . . . . . . . . . . . . . . . . . . . . . 170 18.4 Agency Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 173 18.5 Personal Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . 173 18.6 General Equilibrium Effects Restore Irrelevance . . . . . . . . . . 174 19 Valuation Of Projects Financed Partly With Debt 19.1 Adjusting for Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . 19.2 Three Strategies That Have Been Suggested . . . . . . . . . . . . 19.2.1 Adjusted Present Value . . . . . . . . . . . . . . . . . . . 19.2.2 Flow To Equity . . . . . . . . . . . . . . . . . . . . . . . . 19.2.3 Weighted Average Cost of Capital . . . . . . . . . . . . . 19.3 The General Principle: Net Present Value Again . . . . . . . . . 177 177 177 177 178 178 179 CONTENTS 20 And What About Dividends? 20.1 Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20.2 The Miller and Modigliani Argument . . . . . . . . . . . . . . . . 20.3 Why Pay Taxes if Only the IRS Gains? . . . . . . . . . . . . . . 20.3.1 Double Taxation . . . . . . . . . . . . . . . . . . . . . . . 20.3.2 Individual Preferences for Capital Gains . . . . . . . . . . 20.4 Does the Market Agree? . . . . . . . . . . . . . . . . . . . . . . 20.4.1 The Ex-day Drop . . . . . . . . . . . . . . . . . . . . . . 20.4.2 Looking Beyond the Border . . . . . . . . . . . . . . . . . 20.4.3 The Evidence from Returns on Investment . . . . . . . . . 20.5 Share Repurchases . . . . . . . . . . . . . . . . . . . . . . . . . . 20.6 So, Why do Firms Pay Dividends? The Signalling Hypothesis . . 20.7 Irrelevance Again . . . . . . . . . . . . . . . . . . . . . . . . . . . xv 181 181 181 182 182 182 183 183 184 184 184 184 185 V Risk Management 21 Risk And Incentive Management 21.1 Hedging . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21.2 Hedging with Retdily Available Contracts . . . . . . . . . . . . . 21.2.1 Forward and Futures Contracts . . . . . . . . . . . . . . . 21.2.2 Pricing of Forward and Futures Contracts . . . . . . . . . 21.2.3 Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21.2.4 Other Derivatives . . . . . . . . . . . . . . . . . . . . . . . 21.3 Synthetic Static Hedges . . . . . . . . . . . . . . . . . . . . . . . 21.4 Synthetic Dynamic Hedges . . . . . . . . . . . . . . . . . . . . . 21.5 The Metallgesellschaft Case . . . . . . . . . . . . . . . . . . . . . . 21.6 Value At Risk (VaR) . . . . . . . . . . . . . . . . . . . . . . . . . 21.7 Should Corporations Hedge? . . . . . . . . . . . . . . . . . . . . 21.8 Managing Incentives . . . . . . . . . . . . . . . . . . . . . . . . . VI Longer Examples 22 Longer Examples 209 22.1 Determining the Maximum Bid on a Gold Mining License . . . . 209 22.2 Chippawhip . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 210 VII Appendix A Notation and Formulas 219 A.l Notation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 219 A.2 Formulas . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 220 Index Bibliography 224