Topics in Financial Economics Term 2 Lecture 1: Introduction –Topics and readings –Corporate finance –Review of objectives, etc. –Valuation, version 1 Housekeeping 1. Weeks 1-3: Corporate finance and strategic CF 2. Weeks 4-6: Incomplete contracts/markets approach and signalling 3. Weeks 7-9: The market for corporate control 4. [Week 10: Topics from behavioural finance, hedge funds and private equity, SARBOX] Housekeeping • http://www2.warwick.ac.uk/fac/soc/economics/ug/modules/3rd/ec334/details/ • Assessment – 20% Essay; 80% Examination • Contacting me: – email@example.com, – (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 Topics 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, equity) – 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 objectives) • Now we‟ll consider the interaction of internal and external valuation and governance Nested governance Input markets Financial capital: Equity, Debt Loans Human capital: Board Managerial, Output Manager(s) entrepreneurial markets Business Units Physical capital Relational, organisational 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‟ Valuation • 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 used) 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? Remarks • 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 NPV? – 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 2 • 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.