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Solutions to Real Options and Other Topics in Capital Budgeting

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									Topics in Financial Economics Term 2

  Lecture 1: Introduction
     –Topics and readings
     –Corporate finance
     –Review of objectives, etc.
     –Valuation, version 1

1. Weeks 1-3: Corporate finance and strategic CF
2. Weeks 4-6: Incomplete contracts/markets approach and
3. Weeks 7-9: The market for corporate control
4. [Week 10: Topics from behavioural finance, hedge funds and
   private equity, SARBOX]
•   http://www2.warwick.ac.uk/fac/soc/economics/ug/modules/3rd/ec334/details/

• Assessment – 20% Essay; 80% Examination

• Contacting me:

     – j.a.k.cave@warwick.ac.uk,

     – (02476 5) 23750,

     – Office hours: S2.98, Friday 1100-1200 or by appt.

• Lectures: 1200-1400 on Fridays in L4.

• Classes: 1500-1600 on Thursdays in LIB1
1.   Corporate finance and the value of the firm
2.   Corporate financial policy
     a)   Raising money: standard assets, leverage, Modigliani-Miller I and II, weighted
          average cost of capital
     b)   Distributing money: dividends, stock repurchases
     c)   Implications for valuation
3.   Agency theory (corporate finance incentives)
     a)   Basics: agency, signalling, mechanism design
     b)   Application to risk-shifting and debt overhang
     c)   Compensation (real and optimal)
4.   Corporate governance
     a)   Basics
     b)   Takeovers and buyouts
     c)   Quid custodiet ipsos custodiae?
     d)   Cheap talk, self-dealing and slack
5.   Governance by the market – competition and performance
6.   Topics (as time permits)
     a)   Behavioural finance
     b)   Hedge funds and private equity
     c)   Accountability and the Sarbanes-Oxley Act
     d)   Dynamic financial networks – a speculation on collateralised debt obligations
Some reading (living document)
• Useful text: Copeland, Weston and Shastri ( “CWS”)
• Journal references (on course web page and slides)
• Gale notes from NYU Stern School of Business
• Lecture notes on specific topics on web page
Topics and reading
(to follow links, double-click table to open in acrobat, then click link)
Corporate finance
• Corporate finance is:
   – Capital budgeting decisions –types and proportions of real investments
     corporation chooses;
   – Capital structure –financial instruments used to finance investment; and
   – Investor decisions and their impact on asset rates of return and therefore cost
     of capital to corporations.
• Corporation:
   –   A legal entity (can trade property, make contracts, sue or be sued)
   –   Shared ownership (allows diversification)
   –   Limited liability (allows protection of personal assets)
   –   Transferable ownership (allows share trading –long life, contestability of
       management, managerial monitoring, information exchange)
• Other forms:
   – Sole proprietorship (cheap, personal income tax, unlimited liability, limited life,
   – Partnerships (general or limited, cheap, ltd life, hard to trade, raise money)
Valuing the firm
• The value of the firm is the present discounted value
  of the returns to its activities
• You‟ve already considered the valuation of
  – Projects (by accountants (NPV) and markets (EMH))
  – Decisions (OPM, real options)
  – Portfolios and combinations of assets (with simple
• Now we‟ll consider the interaction of internal and
  external valuation and governance
Nested governance
    Input markets
  Financial capital:

   Human capital:
    Managerial,                         Output
   entrepreneurial                      markets
                       Business Units
  Physical capital

Conceptual Framework
• Incentives and information
  – Agency: the informed player moves last under contract
  – Signalling: the informed player moves first
• Solutions:
  – Equilibrium – non-cooperative rationality
  – Bargaining – choosing an agreement with threats
• The strategic space
  – Firms need financial inputs – they pay for them with a
    promises (contingent claims) and participation (control)
  – These are part of „ownership‟
  – We now consider input „cost‟ impact on „value‟
• What does the firm maximise?
  – Under certainty, the present value of the excess of
    revenues over cost (free cash flow)
  – But this is not trivial: opinions and attitudes to risk differ
    and change over time
  – Reasonable people may even disagree
• We‟ll consider how accountants, managers and
  markets value companies.
Formulaic approach to valuation
• Variables
  – EBIT (earnings before interest and taxes)
  – ROIC (return on invested capital) = EBIT/capital
  – ROE (return on equity) = (EBIT – debt service)(1-T)/Equity
  – WACC (weighted average cost of capital) = opportunity
    cost of raising capital reflecting financial structure (assets
  tc = corporate income tax
  – It = Investment at date t
  – rt = (perpetual) return on It
  – Ku = user cost of capital for unlevered firm
What is EBIT?
• Value = PDV of future free cash flow, but also (book)
  value of extant assets + value of growth
• Value of growth is 0 if r = ku
• Economic profit of unlevered firm is I(r-k)
• Economic profit of firm with debt is I(ROIC – WACC)
• Does this provide a reasonable performance target?
• To answer this, we need to reconsider the roles and
  relations of decision makers and beneficiaries
Managers v. shareholders (simple view)

• Owners delegate control
• Information, motivation, powers of action may differ
• Indirect control via directors, incentives
  (compensation, dismissal, takeovers, etc.)
• Free-riding among shareholders
Objectives and rules
• Investment decisions:
  – Net Present Value
  – Rate of Return Rule
• Rules for managers of corporations (all-equity)
  – Management and control are separated, there are many
    shareholders who may be very different
  – Corporate governance: how to get managers to maximise
  – Maximisation of NPV independent of intertemporal
    preferences - All shareholders agree the firm should
    maximize NPV (Fisher separation theorem)
Advantages of NPV
• Consider a project with the following cash flows:
           Pd 1             Pd 2                Pd 3           Pd 4
          -£925            £1000               £1400          -£1500
        Initial stake                                      Cleanup cost

•   Internal Rate of Return = 4.6%
•   Opportunity Cost of Capital = 10%
•   Should we do this?
•   Natural answer = no – but NPV = +£14.
•   IRR = rate of return that makes discounted cash flow (DCF) = 0:
                                   1000   1400       1500
                 DCF (r )  925                 
                                   1  r 1  r  1  r 3

• This is £14 at r = 10%, and £0 at r = 4.6%
Actually, the value is non-monotone:

IRR is much harder to use than Rate of return or NPV, but better
for e.g. internal planning: the opportunity cost of a project is the
IRR on the next best unfunded project.
Beyond Equity
• Recall EMH: A firm's stock market value is determined by the
  discounted value of its cash flows.
• Rests on idea of arbitrage
• Implication: a positive NPV project will increase the value of
  the firm by the project's NPV.
• This is the fundamental model of the stock market
• Alternative: technical model based on price dynamics
• Technical analysts look for cycles, but compete with each
  other – this arbitrages away profit opportunities and destroys
  cycles: weak EMH – past prices summarised in current price;
  price changes cannot be predicted.
• EMH‟s are strengthened by adding all published (semi-
  strong) or all existing (strong) information to that embedded
  in current price.

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