Corporate Finance and

Financial Institutions
Professor Yuliy Sannikov
Spring 2015

Todays Class
Practical information about the class
See the syllabus

Overview of class
Financial Decisions and Goals of Corporations
Firms and Financial Markets

Review: Present value formulas

starting Thursday, bring a financial calculator to
class if you have one

Online Resources
Blackboard: http://blackboard.princeton.edu/
Lecture notes
Homework assignments and solutions
Additional reading
Exam information (e.g. practice exams)

Discussion website: http://www.piazza.com/

If you have a question, go to Piazza
You will get an answer from Piazza from me, one of the
preceptors or classmates much faster than through e-mail

Readings
Lecture notes on Blackboard
Berk and DeMarzo Corporate Finance, 3rd edition
1st and 2nd editions OK also
Skim Chapters 1 through 6 (you should know the material
from 362)

Case Studies (handouts)

Read Callaway Golf: The FX-1 Project for next
week

Newspapers/magazines:
If you find an article related to a recent lecture, e-mail
it to your preceptor and explain how it is related

Problem Sets
Solving problems is crucial to learning
There will be about eight problem sets
I will indicate due date as we go along
Problem Set 1 due next week (4pm on Friday in your
preceptors mailbox)

Group discussion is encouraged (you may use piazza)

Turn in your own solutions
Show how you get your result
Late problem sets are not accepted

Grades
Precept (incl. problem sets & articles)
Midterm (Thu March 12 in class)
Final

20%
30%
50%

Overview of Corporate
Finance

What is Finance about?

Finance is about Decision Making
You are an investor. Should you invest in Microsoft stock
at its current price of $41/share?
You are a manager at Toyota. Should a vehicle part be
manufactured in-house or outsourced?
You are the CEO of The GAP. Should you open new
stores, or close existing ones? Should you buy or lease
the properties?
You are the CFO of Apple. What should Apple do with its
$150 billion in cash: pay out dividends, repurchase shares,
acquire companies, or just hoard it?
You are on the Board of Google. Should Google become
a wireless service provider?

What is Finance about?

In making these decisions
What is your objective?
What information do you need?

Strategic Goals and Objectives

Corporate Decisions
Financial Tools and Analysis

Good decisions
Every decision has future consequences
Costs
Benefits

What is a good decision?

Value of Benefits > Value of Costs

Decision making follows from valuation

The net benefit of a decision is referred to as its Net Present Value:
NPV = Value of Benefits - Value of Costs =
Contribution to Shareholder Value
Good decisions have positive NPV

How can we determine NPV?

Depends on investor preferences/financial markets

Financial Markets and Investor Preferences

Example 1: Ford shareholders meeting, three very
different shareholders
Impatient type: retiree, wants short-term profit
Ford should invest more in current best selling line

Patient type: childs trust fund representative, wants

money a long way in the future
Ford should invest in fuel cell technology for electric cars

Intermediate type: pension fund representative

believes an oil crisis is likely in near future
wants Ford to build small cars

How can the interests of all 3 shareholders be reconciled?

Financial Markets and Investor Preferences

Example 2: Four entrepreneurs, with $100K each
Bob: wine lover. Can buy a small vineyard for $100K,
which will be worth $400K in five years
but his daughter just got into Princeton, needs money now

Alice: loves food, wants to open a restaurant. For $100K

now, gets $300K in five years
needs money in 5 years, when her son goes to college

Bill and Greg: want to co-invest to run an ice-cream

company. For $100K now, each gets $150K in five years
need money in five years when they retire

Should they do these projects?

Financial Markets and Investor Preferences

Example 2: Four entrepreneurs, with $100K each
Bob: wine lover. Can buy a small vineyard for $100K,
which will be worth $400K in five years
but his daughter just got into Princeton, needs money now

Alice: loves food, wants to open a restaurant. For $100K

now, gets $300K in five years
needs money in 5 years, when her son goes to college

Bill and Greg: want to co-invest to run an ice-cream

company. For $100K now, each gets $150K in five years
need money in five years when they retire

There are two fiercely competitive banks in town, that will

take deposits and make loans at close to 15% per year
(so that $100K now is worth about $200K in five years)

Financial Markets and Investor Preferences

Example 2: Four entrepreneurs, with $100K each
Bob: wine lover. Can buy a small vineyard for $100K,
which will be worth $400K in five years
but his daughter just got into Princeton, needs money now
NPV > 0: invest $100, borrow $200 against the project

Alice: loves food, wants to open a restaurant. For $100K

now, gets $300K in five years
needs money in 5 years, when her son goes to college
NPV > 0, invest!

Bill and Greg: want to co-invest to run an ice-cream

company. For $100K now, each gets $150K in five years
NPV < 0, put money in the bank instead (so Bob can invest)

This is called frictionless financial markets

Financial Markets and Investor Preferences

Example 2: with frictionless markets, decisions which
projects to take do not depend on investor preferences

Take projects with NPV > 0!

Example 1, ford shareholders: with frictionless markets,
unanimously agree to take projects with NPV > 0, even
though they have different preferences:
What should impatient shareholders do if Ford invests in
long-term projects with NPV > 0?

Frictionless markets and Frictions

In frictionless markets investors agree to
take projects with NPV > 0
Frictionless (perfect) markets: no frictions

Private information
Agency frictions
Bankruptcy costs
Taxes
Transaction costs
Mispriced securities

bloomberg.com/news/articles/2015-01-29/brazil-s-petrobras-corruption-scandal-a-web-comic

Unanimity and
Separation of Ownership and Control
Shareholders

agree that managers should maximize NPV

set incentives so that managers follow the NPV rule
do not to intervene to day-to-day running of the firm
can diversify their wealth across many different
companies (would be impossible if shareholders
needed to run companies day-to-day)

Valuation
Determining value (NPV): need to get information about
market preferences/beliefs (well do this a lot in class)
- Interest rates
- Measures of Risk (volatility, Beta)
- Expected growth
We will also get a lot of info from Financial Statements
- Cash flows we start talking about them on Thursday
What happens when market/prices are wrong?

Valuation
Determining value (NPV): need to get information about
market preferences/beliefs (well do this a lot in class)
- Interest rates
- Measures of Risk (volatility, Beta)
- Expected growth
We will also get a lot of info from Financial Statements
- Cash flows we start talking about them on Thursday
What happens when market/prices are wrong?
- Frictions, bubbles, market crashes and endogenous
risk
We will talk about these issues later in the course

Review: Present Value

Formulas

The Main Formula

0
PV

PV =

4
...

C1

C2

C1
1

(1+r)

C4

C3

C2
(1+r)

CT

CT

+ .... (1+r)T

Calculating Ct and r
Well talk more later about how to
compute Ct and r
Use financial statements
Use market prices, interest rates
For now, just take them as given

Shortcuts
Shortcuts allow us to cut through the
calculations quickly
Annuity: an asset that pays a fixed sum each
year for a specified number of years
Ex: Mortgage loans

Perpetuity: an asset that pays a fixed sum

forever
Ex: Preferred stock. Stockholder promised a fixed
cash dividend every quarter, forever.

Perpetuity
1

4
. . .. . .

PV

PV =

C
(1+ r )

C
(1+ r ) 2

C
(1+ r ) 3

...

(1)

...

(2)

multiply by 1+r

(1+ r)PV = C +

C
(1+ r )

C
(1+ r )2

Subtracting (1) from (2), we have r PV = C.

Therefore,

C
PV of perpetuity =
r

Growing perpetuity (r > g)

0
PV

4
. . .. . .

C(1+g)

C(1+g)2

C
C(1 + g) C(1 + g) 2
PV =
+
+
...
2
3
1+ r
(1 + r)
(1 + r)

C(1+g)3

Growing perpetuity (r > g)

0
PV

4
. . .. . .

C(1+g)

C(1+g)2

C(1+g)3

C
C(1 + g) C(1 + g) 2
PV =
+
+
...
2
3
1+ r
(1 + r)
(1 + r)

1+ r
C
C
C(1+ g)
PV =
+
+
...
2
1+ g
1+ g 1+ r
(1+ r)
# 1+ r
&
C
1(PV =
(1+ r (1+ g)
)PV = C
%
1+ g
$1+ g '

1+ r
times
1+ g
subtract

C
PV of growing perpetuity =
rg

Present Value of Annuity

1

T
...

PV

difference between two perpetuities

0

T+1

T+2

...
C

C
PV = ?
r
1
C
A.
T
(1+ r) r

...
C
T

C
T+1

...
-C

or

C
T+2

1
C
B.
?
T +1
(1+ r)
r

-C

Present Value of Annuity

1

T
...

PV
0

C
1

C
T

C
T+1

T+2

...
C

...
C
T

C
T+1

C
T+2
...

-C

#
1 &C
PV of annuity = %1
T (
$ (1+ r) ' r

-C

Present Value of Growing Annuity

0
PV

T
...

C(1+g)

C(1+g)2

C(1+g)3

C(1+g)T-1

# (1+ g)T & C

PV of growing annuity = %1
T (
$ (1+ r) ' r g

Present Value of Growing Annuity

0
PV

T
...

C(1+g)

C(1+g)2

C(1+g)3

C(1+g)T-1

# (1+ g)T & C

PV of growing annuity = %1
T (
$ (1+ r) ' r g
1. Getting all annuity/perpetuity formulas from this one
2. Assumptions about r and g
3. The timing of cash flows

Example: Mortgage
What is the monthly payment on a 30-year
mortgage of $100,000 with 4.2% APR?

Example: Terminal Value

Consider a company in stable growth. Assume that
company earnings grow at the real GDP growth rate of
2.5% and it pays out a fixed fraction of earnings as
dividends. Assume the real discount rate of 7.5%.
What percentage of company value comes from cash
flow in years 1 through 5? What percentage comes
from cash flows after year 5? After year 10?
Useful website with GDP data: www.bea.gov

Terminal Value, Growth Company

Consider a company that reinvests 2/3 of its earnings in
years 1-10, and grows at the real rate of 10%. Starting
in year 11, it reaches stable growth, reinvests 1/3 of
earnings and grows at the rate of 2.5%. The real
discount rate is 7.5%. Assuming that the company pays
out earnings that it does not reinvest, what percentage
of its value is in terminal value (after year 10)?

Persistence of Growth
If the terminal value contains a huge percentage of company
value(especially for growth companies), then a good estimate of
growth is crucial to valuation. How easy is it to estimate?

Source: Fuller, Huberts and Levinson (1993), JPM

Example: Saving for Retirement

Ann is now 25 years old and she is planning to start
saving for retirement. She expects her income of
$60,000 in the coming year to grow at the (nominal)
rate of 5% a year until she retires at the age of 65.
She wants to save a fixed percentage of her income
per year. She wants to save enough money to be
able to consume per year 50% of her income (in real
terms) just before retirement (at age 65) for 20 years.
Assume the inflation rate of 3%, and a nominal rate of
return on Anns savings of 6%. What fraction of
income should Ann be saving?
Note: Survey of Consumer Finances has lots of useful info, at
www.federalreserve.gov/pubs/oss/oss2/scfindex.html

Note 1: Real vs. Nominal Rates

rate of inflation i
real rate of return rR
then the nominal rate of return can be found
from
1 + rN = (1 + i) (1 + rR)
Approximately, rN = i + rR.

Note 2: Continuously Compounded

vs. Yearly Rates
r is annual rate
rc is continuously compounded rate

exp(rc) = 1 + r
r = exp(rc) 1
rc = ln(1 + r)

Should You Pay Cash?

Read the LA Times article, Should You Pay Cash
for a New Car?
What is the monthly payment Keppel will need to make
on his car loan?
What is the Total Interest Paid on the loan?
How much interest will he earn on his savings?
What is Sperlings Rule? What is the right decision?
Why?

Mellon Banks Cornerstone Gold Card

Read the brochure describing Mellon Banks Cornerstone
Gold Card
Suppose you
keep the card for 20 years
maintain a $5000 monthly balance
dont pay the balance in full each month (so that you do incur
interest charges)

Consider:
With a 14.9% APR, what are your cash flows?
Can Mellon Bank claim that the card charges a 0% effective rate
Is the IRR a useful way to evaluate this card? What effective
interest rate would you associate with the card?
Under what circumstances is this card a good deal?
Can you see any potential problems for Mellon Bank associated
with this card?