CORPORATE FINANCE

Lecture notes
Lecture 1. Introduction
The key responsibilities of the CFO
The two main parts of CF are allocation (investment) and financing, corresponding to the !L sides
of the balance sheet" The ultimate ob#ective is to ma$imi%e the shareholders& wealth' achieve the
highest return on the pro#ects and ensure the cheapest financing" (valuation of the investment pro#ects
is based on the discounted cash flows, which are different from the accounting profits (e"g" because of
depreciation)" The real options approach takes into account that managers can influence the CFs after
the beginning of the pro#ect" pplying similar methods, one can value the company"
The company can be restructured from private to a public one via IPO, and vice versa" nother type
of structural change comes from MAs" The company&s goal is to ac)uire the companies bringing
synergy gains and those undervalued due to the inefficient management" The best defence from the
ac)uisition is to ma$imi%e its own value"
The goal of cor!orate go"ernance is to internali%e the e$ternal effects, balance the economic interests
of all stakeholders" *n well+functioning financial markets, this ma$imi%es shareholder value"
T#!ical CF $uestions'
,ow to measure the pro#ect&s worth for the company-
re companies. market prices #ustified- (e"g", dot+coms)
,ow to choose among the pro#ects given the budget constraint and e$ternal effects-
,ow to account for risks associated with the pro#ect-
o /ystematic vs company+specific risks
re risks always bad-
*s it good to have volatile oil prices-
o 0es, if managers have fle$ibility in the future decisions"
/hould we invest now in a pro#ect, which seems unprofitable (has negative 123)-
o 2robably, yes" *t may yield high profit in certain future scenarios (oil pipeline)
/hould we invest now in a pro#ect, which is profitable (has positive 123)-
o 2robably, not" *t may be even more profitable ne$t period (gold e$traction)
/hould we give managers higher salaries or higher bonuses-
o 4onuses encourage higher performance, but may also lead to the manipulations and e$cessive
risk+taking"
5oes it matter how to finance the pro#ect' by debt or by e)uity-
6ould you like the company to have much debt-
o 0es, to minimi%e ta$es and to discipline the managers" 1ot too much, to avoid bankruptcy"
/hould the company borrow money from banks or issue bonds-
o The company can renegotiate the terms of bank credit"
6ould you like the company to pay high dividends- (e"g", 7icrosoft)
o 0es, if too much managerial discretion (/urgut)" 1o, because of double ta$ation and signalling
that the company has no valuable inv pro#ects"
,ow will the market react to the share buyback-
o The company signals that its shares are undervalued"
,ow will the market react to the new e)uity issue-
8
o 9sually negatively' either the company&s shares are overvalued, or it needs to finance a new
inv pro#ect"
,ow should the company communicate with the market- lways provide precise info in time-
6hat drives the company&s decision to go public- 6hy are there hardly any *2Os in :ussia-
6ould you like the company to grow via ac)uisitions-
o 0es, if the main motivation comes form synergy gains, and not empire+building"
/pecifics of corporation
5o not take the current form of corporations and stock markets as given, it is an endogenous outcome;
dvantages of cor!oration in comparison with sole !ro!rietorshi! and !artnershi!'
Ltd liability' lesser risks for investors
o Crucial for development of stock markets and diversification
(asy transfer of ownership
o 2romotes li)uidity
9nlimited life
o 7akes it easier to attract financing
5isadvantages'
/eparation of ownership and control, the agency conflict
o /olved in two ways' 9/ vs <ermany
5ouble ta$ation
,istory' 8=88, general act of incorporation in 10, specifying that all investors of 10 corporations
have limited liability
1ot so obvious that limiting the freedom of contracts is good
,ot discussion at the time' could spur e$cessive risk taking
California was the last to copy in 8>?8
The Ob#ective in Corporate Finance
If you dont know where you are going,
it does not matter how you get there
The Classical 3iewpoint'
%an &orne' @*n this book, we assume that the ob#ective of the firm is to ma$imi%e its value to its
stockholders@
'reale# M#ers' @/uccess is usually #udged by value' /hareholders are made better off by any
decision which increases the value of their stake in the firm""" The secret of success in financial
management is to increase value"@
Co!eland (eston' The most important theme is that the ob#ective of the firm is to ma$imi%e the
wealth of its stockholders"@
'righa) and *a!ens+i' Throughout this book we operate on the assumption that the
management.s primary goal is stockholder wealth ma$imi%ation which translates into ma$imi%ing the
price of the common stock"
(h# focus on )a,i)i-ing stoc+holder wealth.
/tock price is easily observable and constantly updated (unlike other measures of performance,
which may not be as easily observable, and certainly not updated as fre)uently)"
*f investors are rational (are they-), stock prices reflect the wisdom of decisions, short term and
long term, instantaneously"
A
The ob#ective of stock price performance provides some very elegant theory on'
o how to pick pro#ects
o how to finance them
o how much to pay in dividends
The Classical Ob#ective Function
6hat can go wrong-
Traditional corporate financial theory breaks down when the interestsBob#ectives of the decision
makers in the firm conflict with the interests of stockholders"
o 4ondholders (Lenders) are not protected against e$propriation by stockholders"
?
o Financial markets do not operate efficiently, and stock prices do not reflect the underlying
value of the firm"
o /ignificant social costs can be created as a by+product of stock price ma$imi%ation"
/olutions0
Choose a different mechanism for corporate governance
Choose a different ob#ective'
o 7a$imi%ing earnings B revenues B firm si%e B market share
o The key thing to remember is that these are intermediate ob#ective functions" To the degree
that they are correlated with the long term health and value of the company, they work
well" To the degree that they do not, the firm can end up with a disaster
7a$imi%e stock price, but reduce the potential for conflict and breakdown'
o 7aking managers (decision makers) and employees into stockholders
o 2roviding information honestly and promptly to financial markets
Counter reaction
The strength of the stock price ma$imi%ation ob#ective function is its internal self correction
mechanism" ($cesses on any of the linkages lead, if unregulated, to counter actions which reduce or
eliminate these e$cesses
managers taking advantage of stockholders has lead to a much more active market for corporate
control"
stockholders taking advantage of bondholders has lead to bondholders protecting themselves at the
time of the issue"
firms revealing incorrect or delayed information to markets has lead to markets becoming more
CskepticalD and CpunitiveD
firms creating social costs has lead to more regulations, investor and customer backlashes"
The Modified O12ecti"e Function
For publicly traded firms in reasonably efficient markets, where bondholders (lenders) are
protected'
o 7a$imi%e /tock 2rice' This will also ma$imi%e firm value
E
For publicly traded firms in inefficient markets, where bondholders are protected'
o 7a$imi%e stockholder wealth' This will also ma$imi%e firm value, but might not ma$imi%e
the stock price
For publicly traded firms in inefficient markets, where bondholders are not fully protected
o 7a$imi%e firm value, though stockholder wealth and stock prices may not be ma$imi%ed at
the same point"
For private firms, ma$imi%e stockholder wealth (if lenders are protected) or firm value (if they are
not)
Relation to in"est)ent theor#
9se of C27 to estimate the cost of capital
Option pricing approach for valuing investment pro#ects (real options), e)uity of the firm, and
bonds& credit risk
Lecture 3. Anal#sis of financial state)ents
The Fir)4s Financial /tate)ents
4alance /heet
*ncome /tatement
/tatement of Cash Flows
Functions' providing
current status and past performance information to owners and creditors
a convenient way for owners and creditors to set performance targets ! to impose restrictions
on the managers of the firm
a convenient template for financial planning
4alance /heet
Assets 5 Lia1ilities 6 /hareholder4s E$uit#
Tabulates a company&s assets and liabilities at a specific point in time
o *nfo on value of the assets and the capital structure
/orting of
o ssets by li)uidity
o Liabilities by maturity
ssets and liabilities are represented by historical costs
o The original cost ad#usted for improvements and aging F 4ook 3alue
o void using market value, since is too volatile and easily manipulated
o 2reference for underestimating value
/trict categori%ation into ( or L' the liability must satisfy
o The obligation will lead to CF at some specified or determinable date
o The firm cannot avoid the obligation
o The transaction behind the obligation has already happened
,owever, important liabilities may be under+stated or omitted
Assets
Current ssets (GHIJIKLMN OJNPOKQR)' will convert into cash within a year
o Cash
S
o ccounts :eceivable (TUNKR V WIXYUNLZ[)
:ecogni%ing not collectible ones' reserves (danger of manipulation;)
o *nventory (\]^)' valued by F*FO, L*FO, wdt+avg
L*FO increases costs and reduces ta$es
L*FO reserve' difference between L*FO and F*FO valuations
*nvestments and 7arketable /ecurities (_MLIULMN `H)
o 7inority passive B active investment (aAbc B Ab+Sbc of the ownership)' 43 or 73
o *f ma#ority active investment (dSbc)' include in the consolidated balance sheet
*ntangible ssets (eNfRKNJZRXgLMN RVKZQM)' amorti%ed over e$pected life (say, Eb years)
o 2atents and trademarks' valuation depends on whether generated internally or ac)uired
o <oodwill' the difference between 43 and 73 of the ac)uired firm (purchase accounting)
Fi$ed ssets (GOLIQLMN OJNPOKQRh Land, 2lant and ()uipment)' 43 with ad#ustment for aging
o 5epreciation' straight line or accelerated (improves the earnings in the first years)
Lia1ilities and /toc+holder4s E$uit#
Liabilities
Current Liabilities (iJRKVIOJIULMN IHjkRKNXgOKQR)' valued as the amount due
o ccounts 2ayable (TUNKR V IWXRKN)
o /hort+term 4orrowing
o Other' ccrued 6ages, 4enefits, and Ta$es
Long+Term 5ebt' 4ank Loans, 4onds
o 3alued as 23 of future obligations at the time of borrowing (usually at par)
o The premium or discount over the par is amorti%ed over the bond&s life
Other Long+Term Liabilities
o Leases
Capital lease (transfer of ownership)' recogni%ed as asset (depreciated) and
liability
*f operating lease' balance not affected, lease payments treated as operating
e$pense
o (mployee 4enefits' 2ension 2lans, ,ealthcare 4enefits
5C' fi$ed contribution each yearh
54' contributions change depending on whether the plan is over+ or
underfunded
o 5eferred Ta$es
5ifference between the ta$es on income reported in fin statements and actual
ta$es
Shareholders Equity (lV`ZILNJLMm VRWZKRX) F Total ssets + Total Liabilities
2referred /tock
o ,ybrid' fi$ed (cumulative) dividend, but cannot result in bankruptcy
o 3alued at the original issue price n cumulated unpaid dividends
Common /tock at 2ar
Capital /urplus
o :esults from earnings on buying and selling stocks
o Treasury /tock' repurchased shares, reduce 43 of e)uity
:etained (arnings (eNJROWJNPNXNLLRj WJZHMXg)
*ncome /tatement
Re"enue 7 E,!enses 5 Inco)e
o
/ummari%es the company&s profitability during a time period
o :ecords sales, e$penses, ta$es, and net income
7atching principle of the accrual accounting'
o :evenues and e$penses are recogni%ed when the good is sold
4ecomes complicated for long+term contracts and buyers with credit risk
o *n contrast to the cash+based approach' recogni%ing revenues when received and e$penses
when paid
company&s accounting income and cash flow are two different things
Categori%ation of e$penses'
o Operating' provide benefits only for the current period (cost of labor and materials)
lso included' depreciation (based on historical cost) and :!5
o Financing' arising from non+e)uity financing (interest e$penses)
o Capital' generate benefits over multiple periods (buying land and buildings), written off as
depreciation
To improve forecasting, separately' nonrecurring items
o *ncome from discontinued operations, e$traordinary gains ! losses, ad#ustments for
changes in accounting principles
:etained earnings are not added to the cash balance in the balance sheet, but are added to
shareholder&s e)uity
*nflation distorts the measuring of income and the valuation of assets
Total o!erating re"enues
+ Cost of goods sold
+ /elling, general, and administrative e$penses
+ 5epreciation
O!erating inco)e
n Other income
E'IT ((arnings before interest and ta$es)
+ *nterest e$pense
Ta,a1le inco)e
+ Ta$es' Current n 5eferred
Net inco)e F :etained earnings n 5ividends
The /tatement of Cash Flows
CF8fir)9 5 CF8de1t9 6 CF8e$uit#9
:eports how much cash is generated during a period"
o *ndicates where the cash comes from and what the firm did with that cash"
9nlike the balance sheet and income statement, cash flow statements are independent of
accounting methods
o ccounting rules have a second+order effect on cash flows through ta$es
O!erating CF F (4*T n 5epreciation + Ta$es
+ Capital /pending (net ac)uisitions of fi$ed assets)
+ dditions to the 1et 6orking Capital (current assets + current liabilities)
Cash Flow of the Fir)
CF of de1tholders F *nterest p net long+term debt financing
CF of e$uit#holders F 5ividendsp net e)uity financing
q
Financial :atio nalysis
Trend nalysis
Cross+/ectional nalysis
Profita1ilit# Ratios
:eturn on ssets (:O) F (4*T(8+ta$) B Total ssets
:eturn on ()uity (:O() F 1et *ncome B 43(e)uity)
<ross 2rofit 7argin F <ross 2rofit B T
Operating 2rofit 7argin F (4*T B /ales
1et 2rofit 7argin F 1et *ncome B /ales
Acti"it# Ratios' measuring the efficiency of working capital management
r ccounts :eceivable Turnover F /ales B vg ccounts :eceivable
r *nventory Turnover F Cost of <oods /old B vg *nventory
r Total sset Turnover F /ales B Total ssets
Li$uidit# Ratios' measuring short+term li)uidity
Current :atio F Current ssets B Current Liability
suick :atio F (Current ssets p *nventory) B Current Liability
Financial Le"erage Ratios
5ebt+to+Capital :atio F 5ebt B (5ebt n ()uity)
5ebt+to+()uity :atio F 5ebt B ()uity
o Can be based on 43 or 73
o /imilarly' long+term debt ratios
*nterest Coverage :atio F (4*T B *nterest ($penses
Cash Fi$ed Charges Coverage :atio F (4*T5 B Cash Fi$ed Charges
Mar+et %alue Ratios
r 2rice+to+(arnings :atio F 2/ B (2/
p /tock market price to earnings per share
r 5ividend 0ield F 5iv B 2/
p Latest dividend to current stock price
r 7arket+to+4ook 3alue F 73 B 43
p /imilarly' 7arket+to+4ook ()uity F 7( B 4(
r Tobin.s s F 73 B :eplacement 3alue
Lin+s 1etween the Ratios
:O F 2rofit 7argin t sset Turnover
o 4oth for 1et and <ross :O and 2rofit 7argin
o *ncreasing :O' trade+off between 2rofit 7argin and sset Turnover
:O( F :O t ()uity 7ultiplier
o where ()uity 7ultiplier F ssets B ()uity
o ,igher fin leverage magnifies :O( when :O(gross) e$cess the interest on debt
Non:Financial Measures of O!erating Effecti"eness
*nnovation
Customer /ervice
2roduct suality
=
:eputation
<ood (mployee :elations
/eg)ented Financial /tate)ents
:eports revenues, operating profits, and identifiable assets for each line of business
llows managers and shareholders to identify cross+subsidi%ation
The 5CF approach to bond and stock valuation
Co)!uting Present %alue
Time value of money' discount rate :
/ingle cash flow at T' CF
T
o 23
b
F CF
T
B(8n:)
T

2erpetuity' C
t
F

C, tdb
o 23
b
F C B :
<rowing perpetuity (with const rate g)' C
tn8
F (8ng)C
t
o 23
b
F C B (: + g)
nnuity' C
t
F

C, t F 8,u,T
o 23
b
F (CB:) v8 p 8B(8n:)
T
w
<rowing annuity (with const rate g)
o 23
b
F (CB(:+g)) v8 p (8ng)
T
B(8n:)
T
w
Co)!uting *rowth Rate of ;i"idends
ssume that the company does not grow unless a net investment is made" Then the company needs to
retain part of its earnings to grow'
(arnings
tn8
F (arnings
t
n :etainedx (arnings
t
t :
where : is the return on the retained earnings, usually estimated by :O(
5ivide by (arnings
t
to get /ustainable <rowth :ate '
8 n g F 8 n :etention :atio t :O(
where :etention :atio F :etained (arnings B (arnings
Pricing A!!lications
4ond with coupon C and face value F (at T)
o 2
b
F (CB:) v8 p 8B(8n:)
T
w n F
T
B(8n:)
T
/tocks with dividends growing with const rate g
o 23
b
F 5iv
8
B(:+g)
2ro#ect' 123 F y
t
CF
t
B(8n:)
t
3alue of the firm with 5ivF(2/'
o Discounted CF's' 23
b
F (2/B: + !"#$
(2/ F earnings per share, <O F growth opportunities
o %ultiples' 2B(z23
b
B(2/ F 8B: + !"#$&'!(
2B( F price to earnings ratio
Lectures <:=. Ca!ital 1udgeting
4lack+/choles approach to the valuation of real options
>
;ifferences 1etween real and financial o!tions, which are crucial for the 4lack+/choles approach'
)* +he underlying asset is not traded
Option pricing theory is built on the premise that a replicating portfolio can be created using
the underlying asset and riskless lending and borrowing"
,* +he price of the asset may not follow a continuous process
*f there are no price #umps, as it is with most real options, the model will underestimate the
value of deep out+of+the+money options"
o One solution is to use a higher variance estimate to value deep out+of+the+money
options and lower variance estimates for at+the+money or in+the+money options"
o nother is to use an option pricing model that e$plicitly allows for price #umps, though
the inputs to these models are often difficult to estimate"
-* +he .ariance may change o.er the life of the option
The assumption that option pricing models make, that the variance is known and does not
change over the option lifetime, is not unreasonable when applied to listed short+term options
on traded stocks"
6hen option pricing theory is applied to long+term real options, there are problems with this
assumption, since the variance is unlikely to remain constant over e$tended periods of time and
may in fact be difficult to estimate in the first place"
/* '0ercise is not instantaneous
The option pricing models are based upon the premise that the e$ercise of an option is
instantaneous" This assumption may be difficult to #ustify with real options, where e$ercise
may re)uire the building of a plant or the construction of an oil rig, actions which are unlikely
to happen in an instant"
The fact that e$ercise takes time also implies that the true life of a real option is often less than
the stated life"
Valuing Natural Resource Options/ Firms
*nput (stimation 2rocess
8" 3alue of vailable :eserves of
the :esource
($pert estimates (<eologists for oil"")h The present
value of the after+ta$ cash flows from the resource are
then estimated"
A" Cost of 5eveloping :eserve
(/trike 2rice)
2ast costs and the specifics of the investment
?" Time to ($piration
:elin)ushment 2eriod' if asset has to be relin)uished at
a point in time"
Time to e$haust inventory + based upon inventory and
capacity output"
E" 3ariance in value of underlying
asset
based upon variability of the price of the resources and
variability of available reserves"
S" 1et 2roduction :evenue
(5ividend 0ield)
1et production revenue every year as percent of
market value"
o" 5evelopment Lag Calculate 23 of reserve based upon the lag"
'0ample1 2 gold mine
Consider a gold mine with an estimated inventory of 8 million ounces, and a capacity output rate of
Sb,bbb ounces per year"
The price of gold is e$pected to grow ?c a year"
The firm owns the rights to this mine for the ne$t twenty years"
The present value of the cost of opening the mine is {Eb million, and the average production cost of
{ASb per ounce" This production cost, once initiated, is e$pected to grow Ec a year"
8b
The standard deviation in gold prices is Abc, and the current price of gold is {?Sb per ounce" The
riskless rate is >c, and the cost of capital for operating the mine is 8bc" The inputs to the model are
as follows'
In!uts for the O!tion Pricing Model
3alue of the underlying asset F 2resent 3alue of e$pected gold sales (| Sb,bbb ounces a year) F
(Sb,bbb t ?Sb) t (8+ (8"b?
Ab
B8"8b
Ab
))B("8b+"b?) + (Sb,bbbtASb)t (8+ (8"bE
Ab
B8"8b
Ab
))B("8b+"bE) F { EA"Eb
million
($ercise price F 23 of Cost of opening mine F {Eb million
3ariance in ln(gold price) F b"bE
Time to e$piration on the option F Ab years
:iskless interest rate F >c
5ividend 0ield F Loss in production for each year of delay F 8 B Ab F Sc
o 1ote' *t will take twenty years to empty the mine, and the firm owns the rights for twenty years"
(very year of delay implies a loss of one year of production"
%aluing the O!tion
4ased upon these inputs, the 4lack+/choles model provides the following value for the call'
d8 F 8"Ebo>, 1(d8) F b">AbA
dA F b"S8AE, 1(dA) F b"o>S=
Call 3alueF EA"Eb e$p(+b"bS)(Ab) (b">AbA) +Eb (e$p(+b"b>)(Ab) (b"o>S=)F { >"qS million
The value of the mine as an option is { >"qS million, in contrast to the static capital budgeting analysis
which would have yielded a net present value of { A"Eb million ({EA"Eb million + { Eb million)" The
additional value accrues directly from the mine.s option characteristics"
'0ample1 "aluing an oil reser.e
Consider an offshore oil property with an estimated oil reserve of Sb million barrels of oil, where the
present value of the development cost is {8A per barrel and the development lag is two years"
The firm has the rights to e$ploit this reserve for the ne$t twenty years and the marginal value per
barrel of oil is {8A per barrel currently (2rice per barrel + marginal cost per barrel)"
Once developed, the net production revenue each year will be Sc of the value of the reserves" The
riskless rate is =c and the variance in ln(oil prices) is b"b?"
In!uts to the 'lac+:/choles Model
Current 3alue of the asset F / F 3alue of the developed reserve discounted back the length of the
development lag at the dividend yield F {8A t Sb B(8"bS)A F { SEE"AA
o *f development is started today, the oil will not be available for sale until two years from now" The
estimated opportunity cost of this delay is the lost production revenue over the delay period"
,ence, the discounting of the reserve back at the dividend yield
($ercise 2rice F 2resent 3alue of development cost F {8A t Sb F {obb million
Time to e$piration on the option F Ab years
3ariance in the value of the underlying asset F b"b?
:iskless rate F=c
5ividend 0ield F 1et production revenue B 3alue of reserve F Sc
%aluing the O!tion
4ased upon these inputs, the 4lack+/choles model provides the following value for the call'
d8 F 8"b?S>, 1(d8) F b"=E>=
dA F b"Ao8?, 1(dA) F b"ob?b
88
Call 3alueF SEE "AA e$p(+b"bS)(Ab) (b"=E>=) +obb (e$p(+b"b=)(Ab) (b"ob?b)F { >q"b= million
This oil reserve, though not viable at current prices, still is a valuable property because of its potential
to create value if oil prices go up"
Valuing product patents as options
*nput (stimation 2rocess
8" 3alue of the 9nderlying sset
23 of Cash *nflows from taking pro#ect now
This will be noisy, but that adds value"
A" 3ariance in value of underlying
asset
3ariance in cash flows of similar assets or firms
3ariance in 2F from capital budgeting simulation"
?" ($ercise 2rice on Option
Option is e$ercised when investment is made"
Cost of making investment on the pro#ecth assumed
to be constant in present value dollars"
E" ($piration of the Option Life of the patent
S" 5ividend 0ield
Cost of delay
(ach year of delay translates into one less year of
value+creating cashflows
Valuing Equity as an option
2 simple e0ample
ssume that you have a firm whose assets are currently valued at {8bb million and that the standard
deviation in this asset value is Ebc"
Further, assume that the face value of debt is {=b million (*t is %ero coupon debt with 8b years left to
maturity)"
*f the ten+year treasury bond rate is 8bc, how much is the e)uity worth- 6hat should the interest rate
on debt be-
Model Para)eters
3alue of the underlying asset F / F 3alue of the firm F { 8bb million
($ercise price F } F Face 3alue of outstanding debt F { =b million
Life of the option F t F Life of %ero+coupon debt F 8b years
3ariance in the value of the underlying asset F A F 3ariance in firm value F b"8o
:iskless rate F r F Treasury bond rate corresponding to option life F 8bc
%aluing E$uit# as a Call O!tion
4ased upon these inputs, the 4lack+/choles model provides the following value for the call'
d8 F 8"S>>E, 1(d8) F b">ES8
dA F b"??ES, 1(dA) F b"o?8b
3alue of the call F 8bb (b">ES8) + =b e$p(+b"8b)(8b) (b"o?8b) F {qS">E million
3alue of the outstanding debt F {8bb + {qS">E F {AE"bo million
*nterest rate on debt F ({ =b B {AE"bo)8B8b +8 F 8A"qqc
2pplica3ility in .aluation
*nput (stimation 2rocess
3alue of the
Firm
Cumulate market values of e)uity and debt (or)
3alue the firm using FCFF and 6CC (or)
9se cumulated market value of assets, if traded"
3ariance in
Firm 3alue
*f stocks and bonds are traded,
8A
Afirm F weA eA n wdA dA n A we wd ed ed
where eA F variance in the stock price we F 73 weight of ()uity
dA F the variance in the bond price wd F 73 weight of debt
*f not traded, use variances of similarly rated bonds"
9se average firm value variance from the industry in which company
operates"
7aturity of the
5ebt
Face value weighted duration of bonds outstanding (or)
*f not available, use weighted maturity
7onte+Carlo approach to the valuation of real options
/tochastic Processes for Oil Prices
*eo)etric 'rownian Motion /i)ulation
The real simulation of a <47 uses the real drift a" The price at future time t is given by'
2
t
F 2
b
e$p~ (a + b"S s
A
) 5
t
n s 1(b, 8)
s is the "olatilit# of P
6ith real drift use a risk+ad#usted (to 2) discount rate
The risk+neutral simulation of a <47 uses the risk+neutral drift a& F r + d " The price at t is'
2
t
F 2
b
e$p~ (r + d + b"S s
A
) 5
t
n s 1(b, 8)
d is the con"enience #ield of P
6ith risk+neutral drift, the correct discount rate is the risk+free interest rate"
Mean Re"ersion Process
Consider the arithmetic mean reversion process
The solution is given by the e)uation with stochastic integral'
6here h is the reversion speed" The variable $(t) has normal distribution with mean and
variance given by'
6e want a mean reversion process for the oil prices 2
with lognormal distribution with mean (v2(T)w F e$p~(v$(T)w
Ris+:Neutral Mean Re"ersion Process for P
The risk+neutral process for the variable $(t), considering the :(8) e$act discreti%ation (valid
even for large t) is'
The variable $(t) reverts to a long run mean
2rices reverts to a long run e)uilibrium level, say {AbBbbl
8?
*n order to get the desirable mean is necessary to subtract from $ the half of variance 3arv$(t)w, which
is a deterministic function of the time' 2(t) F e$p~ $(t) + (b"S t 3arv$(t)w)
This is necessary due the log+normal properties
9sing the previous e)uation relating 2(t) with $(t), we get the risk+neutral mean+reversion sample
paths for the oil prices"
Ris+:Neutral /i)ulation "s Real /i)ulation
For the underlying asset, you get the same value'
/imulating with real drift and discounting with risk4ad5usted discount rate r F a n d
Or simulating with risk+neutral drift (r + d) but discounting with the risk+free rate (r)
For an optionBderivative, the same is not true'
:isk+neutral simulation gives the correct option result (discounting with r) but the real simulation
does not gives the correct value (discounting with r)
6hy- 4ecause the risk+ad#usted discount rate is Cad#ustedD to the underlying asset, not to the
option
:isk+neutral valuation is based on the absence of arbitrage, portfolio replication (complete market)
E,cer!t fro) ;ias:Rocha 83>>19
One practical Cmarket+wayD to estimate is taking the net convenience yield () time series
(calculated by using futures market data from longest maturity contract with li)uidity)
8
, together with
spot prices series, estimating by using the e)uation' 8t9 = 8t9 + 8 P 7 P8t9)" ,ere is #ust the
difference between the discount rate (total re)uired return) and the e$pected capital gain ((d2B2), like
a dividend" The parameter is endogenous in our model and, from a market point of view, is used in
the sense of /chwart%&s (8>>qb, p"A) description' CIn practice, the con.enience yield is the ad5ustment
needed in the drift of the spot price process to properly price e0isting futures pricesD" ,igh oil prices 2
in general mean high convenience yield (positive correlation), and for very low 2 the net
convenience yield can even be negative" There is an offsetting effect in the e)uation (even though not
perfect), so we claim as reasonable the appro$imation of constant" s compensation, we do not need
to assume constant interest rate (because it does not appear in our model) or constant convenience
yield (this implicitly changes with 2)" The time series (2, r, ) generate the time series" *n this way,
the value of depends of the assumed values for 2 and " 9sing 8b+year oil futures data (from
ulyB=> to uneB>>) and 8A+month T+4ond interest rates, we found the time series for both and , and
the standard deviation of was about the half of the , confirming our intuition of more stability for "
The simple regression 2 $ permits us to estimate CmarketD values for and " 6e found = >"?c
and F b"b? (used in the base case)" 6e get the same value = >"?c p"a" at the e)uilibrium level
{AbBbbl (for 2 F
P
, F ) using the e)uation of regression"
8
The known formula for a commodity futures prices is F(t) F e
(r ) t
2" This e)uation is deduced by arbitrage and assumes
that is deterministic, so it looks contradictory with our assumption of systematic #ump and with our model that implies
that is as uncertain as 2" 4ut we want an implicit value for and so for , to get a market reference for " *t is only a
practical Cmarket evaluationD for the discount rate that is assumed constant in our model"
8E
Lectures ?:@. Ca!ital structure
Treatment of 6arrants and Convertibles
6arrants and conversion options (in convertible bonds, for instance) are long term call options, but
standard option pricing models are based upon the assumption that e$ercising an option does not affect
the value of the underlying asset" This may be true for listed options on stocks, but it is not true for
warrants and convertibles, since their e$ercise increases the number of shares outstanding and brings
in fresh cash into the firm, both of which will affect the stock price" The e$pected negative impact
(dilution) of e$ercise will make warrants less valuable than otherwise similar call options" The
ad#ustment for dilution in the 4lack+/choles to the stock price involves three steps'
/tep 8' The stock price is ad#usted for the e$pected dilution from warrant e$ercise"
5ilution+ad#usted / F (/ n
s
n6 n
w
) B n
s

where,
/ F Current value of the stock
n
w
F 1umber of warrants outstanding
6 F 7arket value of warrants outstanding
n
s
F 1umber of shares outstanding
6hen the warrants are e$ercised, the number of shares outstanding will increase, reducing the stock
price" The numerator reflects the market value of e)uity, including both stocks and warrants
outstanding"
/tep A' The variance used in the option pricing formula is the variance in the value of the e)uity in the
company (i"e", the value of stocks plus warrants, not #ust the stocks)"
/tep ?' The call is valued with these inputs"
5ilution+ad#usted value F Call 3alue from model
Lecture 1>. Pa#out 8di"idend9 !olic#
Lecture 11. IPOs
Lecture 13. Mergers and ac$uisitions
'0ample on the accounting for ac6uisitions
ssume that there are firms and 4 with the current value and number of shares given in the first
columns of the table" Together, firms and 4 are worth qbb" The shareholders of 4 re)uire half of the
synergy gain, i"e", at least 8Sb for their shares"
4 t after the merger n4 after the merger
7arket value, { Sbb 8bb SSb qbb
shares AS 8b AS ?8"=8=
/hare price, { Ab 8b AA AA
8" The purchase method' makes a cash offer of 8Sb for 4&s shares"
*n this case, the combined firm t is worth qbb+8SbFSSb or {AA per share after the merger"
A" !ooling of interest' issues n new shares in e$change for 8b shares of 4, such that n shares of the
combined firm are worth 8Sb"
/olving the e)uation 8SbBqbb F nB(ASnn), we find nFo"=8=" 1aturally, the share price is the same as in
the previous case' {AA, as &s shareholders must be indifferent between the two methods given a fi$ed
premium for 4&s shareholders"
<iven the probability of merger ), say, e)ual to b"o, one can compute the pre+merger price of '
2re+merger 2() F b"o2t() n b"E2
b
() F b"otAb n b"EtAA F {Ab"="
8S
Lecture 1<. Cor!orate go"ernance
Enron (orldCo)
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