Corporate Finance in a Nutshell

(Part I)

interest rates, and we compute present values by

multiplying cash flows times discount factors.
When cash flows are uncertain we compute
present values by multiplying expected cash
flows times discount factors built using the
expected rates of return for investments of
similar risk.

Han Ozsoylev
EFIN/MFIN 301, Fall 2014

This note is intended to provide a brief overview

of what we have covered in Corporate Finance The recipe for valuation is simple. Break an inso far. It is not intended to provide an exclusive vestment down into a series of expected cash
guide as to what you need to know for the exam. flows. Multiply each expected cash flow times
the appropriate discount factor to obtain the
present value, or PV, of the corresponding cash
Time Value of Money
flow. The total value of the investment (net
One of the most important questions faced by of required disbursements), known as its net
a firm, if not the most important, is where to present value, or NPV, is simply the sum of
invest, which projects to undertake and which these PVs:
not. The simple answer to this question is that
T
X
E [CF t ]
firms should undertake investments that create
NPV =
.
(1 + r)t
value for investors.
t=0
Positive NPV investments create value for
investors and therefore should be undertaken.
The general rule is then: Accept positive NPV
investments (and reject all others) . As long as
investors can borrow, lend and transfer risk in
well functioning capital markets we know that
all of them will agree on this rule.

To figure out what those investments are we first

need to understand what investors want/expect
of their investments. Generally speaking, investors want money, but money (or cash flows)
occurring at different points in time and with
different degrees of certainty are not all equally
valuable to investors, so we cannot simply add
them up to decide whether an investment is
worth undertaking or not. Fortunately, we can
resort to (capital) market prices and interest
rates to infer investor preferences in this regard.
Those prices tell us how much money investors
are willing to give up today in order to obtain
more money tomorrow, and they also tell us
how much compensation investors demand to
bear risk. Equipped with that information
we can easily value cash flows associated to
investments. We do that by expressing those
cash flows in terms of a common comparable
unit: present values.

There are a couple of things we need to be aware

of when using discount factors and discount
rates. Are we using nominal or real (inflation
adjusted) rates? Are our assumptions about
compounding frequency correct? There are also
some special formulae which are quite helpful
in computing some present values (perpetuities,
growing perpetuities and annuities) which is
convenient to keep in mind.

Recapitulating; companies should attract capital

if they can create value for their investors. To
decide if that is the case we need to compute
We compute present values with the aid of dis- the net present value (NPV) of their cash flows.
count factors, which we build from discount We do this by discounting those cash flows (at a
rates as follows. If the discount rate is r per rate that is appropriate for their risk). Positive
NPV investments create value for investors and
year, then the t year discount factor is
are the ones that should attract funding. How
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should those investments be funded? We will
DF =
.
(1 + r)t
discuss that later.
In the simplest possible case, when all cash
flows are certain, discount rates are simple
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Risk and Return

returns and somehow include a penalty for that.

But that is not entirely correct. As portfolio
theory points out, individual stocks, as well as
other investments, are rarely held in isolation;
rather they are held as elements of a portfolio.
And therefore their riskiness should not be
evaluated in isolation. In general, combinations
of two different investments will benefit from
portfolio effects. That is, part of their risk
will be diversified away by combining them with
other investments in a portfolio. The magnitude
of those portfolio effects will depend on the
extent to which investments move together, that
is, on their correlation. In general, the lower the
correlation between portfolio components the
larger the diversification benefit. So, the variance of returns for a portfolio comprising
several investments will depend not only on the
variance of its individual components but also
on the correlations among them.

To figure out how to obtain discount rates to

be used in the valuation of risky investment
projects, we need to better understand risk and
return.
Investors generally care about both, expected returns and the risk of those returns. Expected
returns are unbiased estimates of future returns.
Formally, if an investment has possible returns
r1 , r2 , . . ., rN , with respective probabilities p1 ,
p2 , . . ., pN , its expected return is:
E[r] p1 r1 + p2 r2 + . . . + pN rN
=

N
X

pi ri

i=1

But what is risk? Risk in finance is usually associated to the idea of volatility or dispersion and
frequently measured using the variance or the
standard deviation of returns. The variance is
the expected squared deviation from the mean.
Formally, if an investment has possible returns
r1 , r2 , . . ., rN , with respective probabilities p1 ,
p2 , . . ., pN , its variance of returns is

A measure that is intimately related to the

correlation coefficient is the beta. Beta is not
only a more financy name than correlation
but it is also going to be very important in this
course. Betas, like correlations, are basically
cleverly scaled covariances. Betas measure a
N
X
stocks sensitivity to price movements in the
2 =
pi (ri )2 ,
portfolio to which they belong. They also
i=1
measure the risk contribution of the stock to
where is the investments expected return. the portfolio. Most of the time in finance we are
The investments standard deviation of interested in betas with respect to the market
portfolio.
returns is the square root of the variance.
Summing up, most investors enjoy higher expected returns and they prefer to get them with
the smallest possible risk. Building portfolios
reduces risk through diversification.
After
diversification the contribution that a stock
makes to a portfolios risk is measured by its
beta. In coming lectures we will see how this
term affects the cost of capital and shareholder
value.

The general consensus is that variance and

standard deviation are not necessarily synonymous with risk but that they are a reasonable
approximation to our idea of risk (although
probably not all individuals care about). When
we assume investors care only about expected
returns and the variances of those returns,
we say that investors have mean variance
preferences. This means that the only information they need to choose between alternative
investment portfolios is precisely their mean and
variance of returns.

Capital Asset Pricing Model

At this point we are ready to start answering two
important questions: a) what sort of portfolio
should an investor with no inside information
hold? b) what does this tell us about the cost of
capital? Lets think about them.

Based on this discussion, it would seem that all

investors need to do when evaluating different
investment alternatives is to look at their
returns and the volatility (variance) of their
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compensation for bearing risk is spelled out in

CAPMs equation: the equilibrium relationship
between investment is expected return and its
beta i is as follows:

When only risky assets are available there are

infinitely many feasible risk-return combinations
available to investors; the set of these combinations is called the feasible set. But the typical
investor will not be interested in all of them.
For the typical investor the hull or frontier of
this set, what we call the minimum variance
frontier (MVF), seems more appealing. The
MVF shows, for each level of expected return,
the lowest amount of risk/variance that would
be required to attain it. A rational risk-averse
investor will restrict himself to holding portfolios
in the upper part of the MVF. This upper part
is called the efficient frontier. The efficient
frontier is the set of efficient portfolios; portfolios that attain the maximum possible expected
return given their risk. Which point in the
efficient frontier rational risk averse investors
will prefer will depend on their degree of risk
aversion or risk tolerance.

i = E [r] = rf + i (M rf ) ,
where rf is the risk-free rate of return and M
is the expected return on the market portfolio.
M rf is often referred to as the market risk
premium. The risk contribution of an individual
investment to the market risk is measured by its
market beta, and this determines the expected
return from the security.

It should be clear now that CAPM can be

used to estimate the cost of capital, or required
rate of return, of a firm or project. If a
firms owners have well diversified portfolios,
how will they measure the risk of the firms
investment project? By the projects beta.
What return will they need to be promised
to be willing to provide the firm with funds?
Introducing a risk free asset changes the shape
E [r] = rf + i (M rf ). Hence, the firms cost
of the efficient frontier but not the logic. With
of capital can be calculated from CAPM.
a risk free asset the efficient frontier becomes
a straight line (sometimes named capital
It is important to keep in mind that CAPM is
allocation line). In this situation the best any
not perfect. Quite a bit of evidence suggests
investor can do is to hold combinations of the
that it does not capture absolutely everything
risk-free portfolio with the tangency portfolio
that matters. But it remains the standard
(the tangency portfolio lies at the tangency
workhorse for establishing the cost of capital for
point between the straight line that starts in
new investments.
the risk free asset and is tangent to the efficient
frontier of all risky assets). When this is the
Summing up: investors think about investments
case, we say that two-fund separation obtains.
in terms of their impact upon portfolio riskiness.
Investors without inside information should hold
What happens when all investors behave in
the market portfolio. So the return that they dethe same way? If all investors have the same
mand for an investment depends upon the coninformation about risk and return, we can ignore
tribution that investment makes to their total
transaction costs, investors can borrow and lend
risk. You are not rewarded for assuming risk that
securities, and they can borrow and lend at
can be diversified away. The relevant measure of
the risk free interest rate, then everyone holds
risk from the perspective of shareholders is beta.
the same tangency portfolio. So the tangency
Hence the cost of capital for any investment is:
portfolio must be the market portfolio.
rf + i (M rf ). This is the rate that has to be
used to discount risky cash flows. An important
The Capital Asset Pricing Model (CAPM)
lesson from CAPM is that there is no need for
predicts that investors hold the risk-free asset
companies to seek diversification. Investors can
and the market portfolio. How much of each
attain diversification themselves (after all, they
will depend on their risk preferences. CAPM
are supposed to hold the most diversified portalso predicts that investors are only rewarded for
folio possible, the market portfolio!).
bearing risk that is not diversified away in the
market portfolio. How much is the reward? The
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