Fall 2016
Corporate Finance
"The best source of capital is to be highly
profitable."
Tidjane Thiam, CEO of Credit Suisse
Tuesday & Thursday 1011:15am
Skinner 216
Office hours: Monday & Wednesday 8:30AM10:30AM
Satya J. Gabriel
Professor of Economics and Finance
email:
sgabrielatmtholyoke.edu
FAX: 4135382323
The course in corporate finance describes the corporation and its operating environment, the manner in which corporate boards and management evaluate investment opportunities/projects and arrange for financing such investments, create (or, alternatively, destroy) value for shareholders by planning and managing the transformation of a set of variable inputs (labor efforts, including the creative efforts required for innovations, raw materials, components and other forms of technology consumed in production processes) into a more highly valued set of outputs (embodying both the original investment value and any surplus value generated), and develop strategies for meeting the claims of financial market participants who are sought as financiers (and, therefore, residual claimants to net cash flows/surplus value) of such investments. It is understood that the shares of surplus value received by various claimants and retained by corporate boards of directors for investment and other uses results from complex social interactions, including, but certainly not limited to, transactions in various markets. Thus, the course provides students with a basic analytical framework for understanding how the various strategies for transforming variable inputs into more highly valued outputs, combined with struggles over corporate surplus value (in the form of cash flows) may be understood and resolved. In this context, the course is designed to provide students with analytical tools that allow them to determine the "intrinsic value" of a corporation (or any economic institution, including a stateowned enterprise that is to be privatized) and to assess the effectiveness of corporate management in maximizing that value, given specific competitive, regulatory, and market conditions.
Because the future surplus value/cash flows of any set of corporate investments are sensitive to constantly changing political, macroeconomic, competitive, and other conditions, students will be taught analytical techniques for taking into consideration alternative macroeconomic and competitive environments. After all, estimated value is a function of the particular model employed and each model is constructed around a specific stylized context (a model structure where elements are limited to a subset of possible phenomena). The model serves as a proxy for the real world: the overdetermined interactions of actual phenomena, whether identified/defined within the model in question or the vast expanse of other phenomena not defined within and therefore invisible to the model. This is important for anyone interested in predicting outcomes of corporate projects. In other words, it matters what type of model you use (and, therefore, what paradigms you employ in constructing models). Models constructed within the conceptual framework of specific paradigms (e.g. neoclassical, Marxian, Institutionalist, PostKeynesian economics) provide alternative ways to predict the future (specific events in future time periods). Students are advised to read broadly (history, psychology, sociology, etc.) and to learn multiple paradigms with which to construct models for predicting future corporate cash flows, stock prices, index prices, option prices, housing prices, prices of commodities, paintings, and any number of other assets.
Financial models are designed to predict economic outcomes. How do you know if a model works? The model must provide results which allow reasonably accurate predictions of economic outcomes, such as the future revenue of General Electric. Your model does not have to be perfect. Indeed, it is impossible to be perfect. To succeed in the world of finance, you just have to be very good at building models (perhaps even excellent) in comparison to other people's models. In the case of financial models, we want to predict outcomes that would shape the results of financial statements, such as future cash flows, earnings, and various growth rates of variables that are measured within financial statements. Once you have chosen a particular model to test against empirical data, it is possible to use statistical analysis to verify that the model has utility (can achieve acceptable results). One of the more common forms of models are simulations. Simulations may be used to project alternative cash flow streams for firms under varying conditions of aggregate demand, inflation, tax rates, interest rates, and exchange rates, among other variables. While these techniques provide students with the tools for valuing enterprises under a wide range of conditions, one must also recognize that the shortterm movements in equity valuations in the various stock markets are even more complexly determined. Such stock price movements are not always determined strictly by intrinsic value, even when intrinsic value is estimated in the context of the aforementioned range of macroeconomic, competitive, and sociopolitical conditions. As behavioral finance, and even earlier, John Maynard Keynes, has argued, investors in financial markets are capable of emotional buys and sells (in violation of consistently rational behavior dreamed of in neoclassical economic theory), panics, and herd behavior. Thus, at any given moment, certain (and sometimes most) stocks can be and are mispriced, i.e. significantly divergent from any reasonable calculation of intrinsic value. During bubbles and crashes this mispricing can reach extremes. The valuation techniques learned in this course provide students with a means for identifying such mispricing. Mispricing is addressed by research in behavioral finance, an alternative paradigm to neoclassical economics and rejects the fictions of rationality and representative agents in favor of incorporating psychological research and empirical studies. This is a positive move by finance economists and may represent a tentative step towards more widespread adoption of the scientific method in economics, writ large.
If an economist is unable to use his or her theoretical tools to make predictions about future developments in financial markets or has no clue about whether an economy is likely to boom or bust, then it is best to spend very little time with that economist. It is one of the goals of this course to provide students with tools that improve their ability and confidence in using publicly available data and events for predicting changes in macroeconomic conditions, corporate share price growth or decline and the future direction of financial markets, more generally. In the spring of 1999, the corporate finance class discussed the coming end to the "speculative bubble" in internet stocks (which dramatically deflated in 2000). In 2006 and 2007, we discussed the bubble in the housing market and predicted the bursting of that bubble, which had severe and still lingering consequences for global financial, labor, and goods markets. More recently, we discussed the manner in which the U.S. bond market was bolstered by decisions of the Chinese central bank (the People's Bank of China) to purchase billions of dollars worth of U.S. treasury bonds, accumulating approximately $1.5 trillion of U.S. dollars in U.S. treasury bonds, pushing up government bond prices and and pushing down the interest rates on those bonds (and putting downward pressure on all the related interest rates, including mortgage interest rates, that influence investment and housing construction in the U.S. economy). Our prediction that the bond market bubble would burst this summer has proven incorrect and we will further discuss the likely course of interest rates over the next three plus months (which still gives us time to be correct) and in 2016, examining which factors are likely to shape the Federal Reserve Board's decision. What factors might have shortsighted a bursting of the bond bubble and what are the identifiable factors that might be used in a model for predicting interest rate decisions? Among the factors that might be included in such a model are the future course of international political crises and military conflicts, the continued struggle to push back ISIS/ISIL, the progress of the ECB in combating recession in the Europe, and the related debt/insolvency crises in Greece, Portugal, Italy, Ireland, and Spain.
For each week of class, you will find readings on this web page and on the underlined links from this web page. Please do the assigned reading from the text and readings from this website to properly prepare for future lectures and exams.
Some financial data sources can be accessed from the course's own corporate finance hotlinks page. If you notice dead links or mistakes on the hotlinks page, please bring them to the attention of Professor Gabriel.
Course Objectives:
SyllabusFall 2016 
Course calendar 

Sept. 813  Intro to Finance Read chapter 1 of Berk, et. al. (The Text). We begin with the long introduction to corporate structures and value creation. Read the following introductory questions on finance: Questions to Ponder. Also, read the following Intro to Finance. The questions and introduction will help us in our discussion of the role of finance in society. We will use a heuristic diagram of a firm and discuss various component parts of the overall social and technical processes that determine the success or failure of the firm: financing and access to tangible and intangible assets, nexus with labor markets and access to necessary skillsets, the immediate process of production, transportation of products, marketing of products, final sales by which cash flows are generated, the receipt and distribution of the surplus value flows necessary to meet the demands of claimants. Click on "Intro to Finance?" above to read the introduction to the course. Read chapter one of text. Read the following short introductory essays on the cash flow cycle (click here) and cash flows, more generally, (click here). 
Sept. 15 
Financial Statements and Cash Flow Estimation:
The Text, chapter 2 Cash flow represents the receipt (positive) and distribution (negative) of money. In a highly monetized economy, value is mostly in the form of received money and, as such, provides access to commodities and assets. Corporations live and grow on positive net cash inflow. However, to generate positive net cash inflows requires investments (negative corporate cash flows) in assets, the purchase of variable inputs (negative corporate cash flows), including the hiring of workers and staff (paid in wages and salaries, measured in cash), as well as benefits (which may also be measured in cash terms, although some benefits may be inkind). Investment in new projects and the continuation of existing projects requires the expenditure of money. Workers, whose productivity potential is the basis for corporate value creation, must be paid in cash. Other variable inputs must be obtained in order for worker/staff productivity potential to be realized and these inputs typically require cash outflows. In other words, before a corporation can generate cash inflows, it needs to have the cash to obtain the prerequisites for value creation. In addition, cash is required to satisfy a wide range of economic agents whose cooperation is required for the corporation to receive future cash inflows, including various agencies of the national and local governments, landlords and other owners of land and buildings (rental or leasing payments are denominated in cash units), the government often requires taxes and fees (in cash) in exchange for its cooperation (including providing the legal basis for the corporation to exist, have exclusive ownership rights to property, and to act as a "legal person"), managers (including the inhabitants of the executive suites) supervise a wide range of workers/staff and expect to be well compensated in cash for their stellar management skills, and bankers and other creditors want cash for providing capital (in the form of money) to the corporation. In other words, corporations exist, in part, because of the cash flows received and distributed by corporate management, securing in the name of the corporation a wide range of cooperative behavior from other corporate managements, governments, and a wide range of individuals. Practice Question: In the U.S., corporate senior management is expected to actA) so as to maximize their own utility. B) in the best interest of the employees. C) so as to maximize the gain to the community. D) in the best interest of the shareowners. Discussion Questions: Explain the rationales for choosing sole proprietorship, partnership, or incorporation as the legal form of a startup business. 
Sept. 2022 
The Rental (Time) Value of Money and Interest Ratebased Valuation:
The Text, chapters 35 This week we will have our first quiz on Thursday, September 22nd. More importantly, we will explore some of the concepts at the foundation of corporate finance, generally, and valuation, specifically. You will want to make certain that you understand the meaning of cash flow, present value, capital, and the related concepts of discounting, time value of money, and opportunity cost. General Formula for Valuation: Value = Σ CF_{t} * (1 + r)^{t} Future Value and Present Value Formulas: FV_{t} = PV_{0} * (1 + r)^{t} FV and PV under Continuous Compounding
FV_{t} = PV_{0} * (e^{rt}) Valuation of a Single Future Cash Flow: Simple Interest Future Valuation Formula: FV_{m} = PV_{0} * [1 + (t * r)]Compound Interest Future Valuation Formula: FV_{m} = PV_{0} * (1 + r)^{m}Continuously Compounding Interest Future Valuation Formula: FV_{m} = PV_{0} * e^{r*t} 
Sept. 27 
Perpetuities and Annuities
: The Compendium, chapters 3 and 4 In this class meeting, we will derive the perpetuity and annuity formula. Always remember that the value of assets is determined by future cash flows received by the asset owners (the timing of receipt of future cash and the probability that future cash will equal investors' expectations are key determinants of value). This value exists but is unknown, since future cash flows and the risk of not receiving 100% of expected cash flows depends on future and substantially unknown, events. Although actual intrinsic value of future cash flows are unknown, models may be constructed with which to predict such value. In other words, financial value is not a subjective phenomenon, but is, rather, a function of actual cash received and the opportunity cost and risk of receiving that cash in future. Perpetuity Formula: PV_{0} = CF/r,where CF is the CF paid each period and r is the required return. Growing Perpetuity Formula: PV_{0} = CF * (rg)^{1}, 
Sept. 29Oct. 4  Bonds, The Text, Chapter 56
Bonds: The most popular annuity used in corporate finance. Executive Summary: Bonds are securities representing loans by the
purchasers of the primary issue of bonds to the corporation or
government entity that issues the bonds. The primary issue of bonds may
be executed by merchant banks, who provide the proceeds minus a merchant
(investment) banking discount and merchant banking fees. Bonds may be
purchased by firms, institutions, and individuals.
The Broader Bond Landscape:
A bond is a financial contract. This contract stipulates that, in
exchange for the purchase price of the bond, the holder has a right to
receive specific cash payments. These cash payments are usually in the
form of periodic coupon payments (aka interest payments) and the
time definite repayment of principal. The dates for the periodic
coupon payments and the repayment of principal at maturity are clearly
stipulated in the contract (which is also called a bond
indenture). In Europe, the coupon payments are sometimes annual.
However, in the United States, these payments are typically made
semiannually (twice a year at six month intervals). where CP_{i} is the first coupon payment and is equal to all other coupon payments. The last coupon payment CP_{m} is paid at the same time as the principal is returned at the end of period m (the maturity period), and r is the required return or yield to maturity on the bond. Par value for most bonds issued in the U.S. is $1,000. This is the issuance price of the bond. If the bond is priced below this $1,000 in the security markets, then the bond is selling at a discount (to par value). If the bond is selling for $1,000 then it is selling at par value. If the bond is selling for more than $1,000 then it is said to be selling at a premium. A mortgage is an amortizing loan, meaning that we amortize the interest and principal payments over a specified time span (for housing mortgages this term is usually 15 or 30 years). Early in the life of the mortgage most of the payment is to cover interest due and a very small amount goes to reducing principal. However, over time the principal has been reduced and therefore the interest due on the remaining principal decreases for each payment period, with principal repayment amounts increasing to fill the gap. Typically, the person taking out the mortgage will make a down payment (perhaps 20%, which is common in the U.S.A.) plus fees (including closing costs) and then borrow the remainder. The mortgage formula is given by: Monthly Payment = ^{A}⁄_{(B  C)},where A = Loan Principal; B = (1 * r^{1}) and C = ^{1}⁄_{{[r * (1 + r)m]}.} Furthermore, r = mortgage interest rate and m = maturity month (360 in the case of a thirty year mortgage). Preferred stock is not an equity share. It is more
properly described as a perpetual bond subsumed to all other credit
obligations. In other words, preferred stock may last forever
(theoretically) but is always inferior to other cash obligations.
Preferred stock dividends are only paid if the firm has positive net
cash flow (i.e. firm management has made all obligatory payments and has
cash left over with which to pay the preferred shareholders).
Valuation of a Preferred Stock: PV_{0} = Div_{1} * (r_{pref})^{1}where PV_{0} is the current value of the preferred stock (which should be approximately equal to the current stock price, since the value of preferred stock is unambiguously linked to the constant stream of dividends management of the issuing firm is required to pay if the firm has this money available after meeting all other cash obligations; r_{pref} is the required return on the preferred issue. It can always be derived from the perpetuity formula, given that dividend payments (Div) are fairly predictable and the current price (P) is an observable. Thus, it is reasonable to assume that P = PV_{0}. Div_{1} is the forward dividend for valuing the preferred stock at t=0. Zero Coupon Bond: Single Future Cash Flow Valuation Equation: PV_{0} = Par Value * (1 + r)^{t},where t is the number of periods until maturity, when the par value of the zero coupon bond (usually $1,000) is received by the bondholder. Practice Problem: Zero Coupon Bond The par value on a zero coupon bond is $1,000. The bond expires in exactly 10 years. Assume that current traders/investors in these bonds require a return of 10%. What market price would you estimate for this zero coupon bond? 
Oct. 6 (NB: No class on Oct. 11) 
Stock
Valuation: The Text, chapter 7
Modern Portfolio Theory: Modern portfolio theory (MPT) argues, in a nutshell, that you can avoid being exposed to significant companyspecific risk by building a diversified (relatively uncorrelated securities) portfolio. It is possible to minimize exposure to unique (companyspecific) risk without lowering your expected portfolio return. The mathematical algorithm for selecting this portfolio is determined based, in part, on statistics, including identifiable correlations between variables. It is also, however, dependent (on diving deeper into the theory) upon certain faulty assumptions (based on an expanding body of observations and experiments) about the underlying decisionmaking of traders in securities and the meaning of posited relationships that do not come directly out of statistical work, e.g. expected utility theory and the capital asset pricing model. In other words, MPT combines some elegant and empirically verified relationships (such as the ability to reduce risks unique to particular securities without damaging portfolio returns) with fantasy relationships (such as the idea that investors have the omniscience and mathematical ability to construct optimal portfolios by combining long and short positions without encountering frictional costs and context driven changes in risk), resulting in strategies that, in the macro (diversification), can have very positive benefits for investors while in the micro (individual decisionmaking rules) leading investors into mistakes in valuing individual securities. We will discuss this paradox in more detail this week. Stock Valuation: Stock valuation is the most prominent subset within the corporate finance toolset. As with other assets, equity shares derive value from the cash flow generated over time, discounted at an appropriate rate. Nonconstant Growth Stock Valuation Model: P_{APPL0} = Σ[FCF_{t} * (1 + r)^{t}] + P_{APPLT} * (1 + r)^{T}where P_{APPL0} is the estimated current price of Apple equity shares; Σ[FCF_{t} * (1 + r)^{t}] is the sum of free cash flows (FCF) in periods 1 through T (where T is the year when the nonconstant growth period ends) discounted back to the present (t=0) at the discount rate (1+r)^{t}; P_{APPLT} * (1 + r)^{T} is the estimated future price (in period T) of Apple after the nonconstant growth period ends. This value is calculated as a growing perpetuity with a constant growth rate into perpetuity. This constant growth rate is difficult to predict but must be constrained by the growth rates of the markets within which Apple generates sales and related cash flow growth. Why are Apple, Google (now Alphabet), and Facebook good candidates for valuation with the nonconstant growth model? Back to the Future: Estimating Future Cash Flows: Book Value (BV) vs Market Value (MV): 
Oct. 1320 
Investment Decision Rules and Opportunity Cost:
What motivates capital investors to purchase bonds, stock, real estate, or other assets? In finance, we assume these investors are chasing returns (the ability to transform idle cash into capital). These future returns are in the form of cash controlled by the investor. What determines the required return of bondholders, shareowners, or preferred stockholders? The present value rule requires that future cash receipts generated by corporate projects and/or nonoperational assets be discounted back to the present and then summed to obtain present value. However, to carry out this discounting process to estimate present value necessitates a required return for the various contributors of capital (equity holders, longterm debt holders, and preferred stockholders). Firms with existing bonds outstanding and/or preferred stock can surmise the current required returns on those instruments by referencing market prices. The current yield to maturity on bonds (adjusted for flotation costs) provides a good estimate of the cost of debt capital and the preferred stock dividend yield provides a good estimate of the cost of raising funds via preferred stock (again, adjusted for flotation costs) If firm management has not issued bonds or preferred stock, then the required return of equity holders (shareowners) is still needed to discount corporate projects and by aggregating them determine the value of the corporation. How do we estimate these required returns? What is the difference between systemic and unsystemic risk? How does diversification affect these risks? Can you solve the problem below? What is the relationship between your answer and the concept of required returns? If you paid $100 for XYZ, Inc. in t=0 and receive a dividend of $.25 in t=1, and then sell the stock for $125 in t=1, what is your return? Back to the Future: Estimating Future Cash Flows: Scenario, Sensitivity, and Simulation Analysis Expected Value Function: where E(CF_{1}) is expected nominal value of the cash flow realized in period 1; Ρ_{a} is the probability of scenario a occurring, CF_{a} is the cash flow expected under scenario a, Ρ_{b} is the probability of scenario b, CF_{b} is the cash flow expected under scenario b, Ρ_{c} is the probability of scenario c, and CF_{c} is the cash flow expected under scenario c. We assume that these are the only three scenarios faced by the corporation in the upcoming period. Practice Expected Value Problem: Estimate APPL stock price a year from now (t=0 to t=1) if the stock price is treated as a cash flow: 
Oct. 2527  Capital Budgeting and Financing: The Text, chapter 9. Investment/Merchant Banking Fees Senior management must submit project proposals that are estimated to generate sufficient cash flow to satisfy the required returns of the suppliers of firm (or specifically projectrelated) capital (equity or longterm debt). The cost of financing begins with these required returns but management must incorporate any and all additional costs of raising capital. Most corporations raise capital through the good services of investment (or merchant) banks. Investment banking services include consulting with the corporation issuing the securities, arranging dog and pony shows where firm management is able to pitch their securities, with the help of the ibankers, to high networth individuals and buyside financial corporations (such as mutual fund companies, pensions, and sovereign wealth funds), identifying which of these potential buyers is serious, how much they are willing to pay for the securities, and the possible allocation of a portion of the issuance to these potential buyers, and then pricing the securities in line with the price expectations of these potential investors, writing the prospectus for the security issuance, and filing all necessary legal documents. The price of these good services are, typically, a discounted purchase of the securities to be issued (the cost of underwriting) and fees. The ibanking cost of issuing these securities (also called flotation costs) is usually between 3 and 7% of the retail price of the securities. The discount and fees, therefore, reduce the amount of capital provided by the securities issuance and raise the corporation's cost of capital.An alternative to issuing equity shares through the ibanking process is to use retained earnings to finance capital budgeting projects. Retained earnings do not require flotation costs and are therefore cheaper sources of equity financing than new share issues through an ibank. Indeed, most project financing is with retained earnings. Weighted Average Cost of Capital (WACC): wacc_{i} = ω_{id} * r_{d} + ω_{ie} + r_{e}wacc_{i} is the weighted average cost of capital for firm i; r_{d} = YTM * (1t_{i}) with YTM defined as the yield to maturity for firm i bonds and t_{i} is the effective tax rate for firm i; r_{e} is the required return on firm i common stock; ω_{id} is the weight (percentage) of debt in total capital of firm i = D_{i} * (D_{i} + E_{i})^{1} ω_{ie} is the weight of equity in total capital for firm i = E_{i} * (D_{i} + E_{i})^{1}. D_{i} is total long term debt for firm i; E_{i} is equity for firm i; Return on equity (ROE): ROE = Net Income * BV^{1}where ROE is return on equity, BV ≡ Book Value = Total Assets  Total Liabilities. 
Nov. 13  Market Efficiency,
Nonconstant Growth, and Behavioral Finance: The Text, chapter 6 Risk Adjusted Abnormal Returns (seeking alpha): RAAR_{i} = r_{i0}  α_{i} + β * MRP;where RAAR is the risk adjusted abnormal return; r_{i0} = the observed return on stock i; α is the alpha intercept of a linear regression of stock i returns against market returns. If β = 1, then the stock return for stock i is perfectly correlated (in the linear regression) with market returns; MRP is the market risk premium, which is estimated based on past divergences between market returns and the returns on 91day tbills. Note that when α is significantly greater than zero the result contradicts efficient market trading in stock i. Hedge fund managers are always seeking alpha. This is the mission of most hedge fund managers and models that identify stocks with alpha are greatly prized. Modern Portfolio Theory: 
Nov. 810 
Stock Valuation and Behavioral Finance
The Text, chapter 10 Risk Adjusted Abnormal Returns (seeking alpha): RAAR_{i} = r_{i0}  α_{i} + β * MRP;where RAAR is the risk adjusted abnormal return; r_{i0} = the observed return on stock i; α is the alpha intercept of a linear regression of stock i returns against market returns. If β = 1, then the stock return for stock i is perfectly correlated (in the linear regression) with market returns; MRP is the market risk premium, which is estimated based on past divergences between market returns and the returns on 91day tbills. Note that when α is significantly greater than zero the result contradicts efficient market trading in stock i. Hedge fund managers are always seeking alpha. This is the mission of most hedge fund managers and models that identify stocks with alpha are greatly prized. Modern Portfolio Theory: 
Nov. 15  Risk and Return in Capital
Markets The Text, chapter 11 Weighted Average Cost of Capital (WACC): wacc_{i} = ω_{id} * r_{d} + ω_{ie} + r_{e}wacc_{i} is the weighted average cost of capital for firm i; r_{d} = YTM * (1t_{i}) with YTM defined as the yield to maturity for firm i bonds and t_{i} is the effective tax rate for firm i; r_{e} is the required return on firm i common stock; ω_{id} is the weight (percentage) of debt in total capital of firm i = D_{i} * (D_{i} + E_{i})^{1} ω_{ie} is the weight of equity in total capital for firm i = E_{i} * (D_{i} + E_{i})^{1}. D_{i} is total long term debt for firm i; E_{i} is equity for firm i; Return on equity (ROE): ROE = Net Income * BV^{1}where ROE is return on equity, BV ≡ Book Value = Total Assets  Total Liabilities. 
Nov. 17 
Midterm Exam

Nov. 2224 
Systematic Risk and the Equity Risk Premium: Nonconstant Growth Stock Valuation Model: P_{APPL0} = Σ[FCF_{t} * (1 + r)^{t}] + P_{APPLT} * (1 + r)^{T}where P_{APPL0} is the estimated current price of Apple equity shares; Σ[FCF_{t} * (1 + r)^{t}] is the sum of free cash flows (FCF) in periods 1 through T (where T is the year when the nonconstant growth period ends) discounted back to the present (t=0) at the discount rate (1+r)^{t}; P_{APPLT} * (1 + r)^{T} is the estimated future price (in period T) of Apple after the nonconstant growth period ends. This value is calculated as a growing perpetuity with a constant growth rate into perpetuity. This constant growth rate is difficult to predict but must be constrained by the growth rates of the markets within which Apple generates sales and related cash flow growth. Why are Apple, Google (now Alphabet), and Facebook good candidates for valuation with the nonconstant growth model? 
Nov. 29 
The Cost of Capital: Discuss the agentprincipal relationship. Agents are required to act in the interest of a principal. Corporate directors are elected by shareowners and have a fiduciary responsibility to act in the interest of shareowner value maximization (acting so as to generate dividends and/or capital gains for these shareowners). Senior managers, who are responsible to the board of directors, are also supposed to be acting in the interest of shareowners. In practice, these agents are likely to violate this responsibility to some extent. After all, pilfering paperclips is, technically, a violation but no one gets punished for pilfering paperclips. In fact, directors and senior managers may regularly engage in spending from corporate accounts that are not in the interest of value maximization for shareowners. After all, it is not just Chinese government officials who like taking "clients" out to banquet. Therefore, there are agency costs associated with directors and senior managers and, technically speaking, agency costs are a form of theft. The agent plays out of sight of the principal, spending lavishly on expense and travel accounts, taking home company notebook computers for the kids, getting excessively expensive compensation packages, proposing and approving acquisitions of businesses for more money than the businesses are worth, perhaps because the acquisition provides the agent with additional status, income, and/or a larger staff to order around. When directors and senior managers arrange these negative net present value acquisitions, they destroy shareowner value. In fact, corporate strategies and related capital spending that is done to protect the agent's position, status, or excess compensation (agency rents) at the expense of shareowners is as surely stealing as using the company car for personal (noncorporate) purposes. These and other agency costs, including costs associated with trying to minimize other agency problems, further erodes shareowner value. Boards of directors approve cash payments to shareowners in the form of dividend payments. These dividend payments are announced after approval at a board meeting, including specifying the date when a shareowner must own the stock to be eligible for the dividend payment (exdividend date). This dividend payment is assumed to be one of the factors driving stock prices. General Formula for Valuation: Value = Σ CF_{t} * (1 + r)^{t} Future Value and Present Value Formulas: FV_{t} = PV_{0} * (1 + r)^{t} FV and PV under Continuous Compounding
FV_{t} = PV_{0} * (e^{rt}) Capital Asset Pricing Model (CAPM) where r_{xyz} is the required return, as estimated by CAPM, β_{xyz} is the derivative of xyz returns with respect to a unit change in the market return (usually proxied with the S&P 500), r_{m} is the estimated return on the market (S&P 500), and r_{f} is the estimated risk free rate (usually proxied with the 91day tbill rate). William Sharpe received the Nobel Prize for Economics in 1990 for developing CAPM. In CAPM, Sharpe assumed that portfolio managers, including individuals managing their personal portfolio, are Spocklike beings, capable of evaluating the entire universe of potential securities (for long and short positions), the expected returns and probability distribution of these returns, and the correlations between all securities. Of course, these Spocklike beings are none other than the neoclassical homo economicae. Homo economicus, the epitomy of neoclassical rationality, is able to select (from the universe of possible portfolios) the optimal portfolio. These (professional and amateur) portfolio managers are assumed, at a minimum, to dominate the market with their optimally chosen portfolios. They select optimal portfolios comprised of risk free assets and risky assets, longs and shorts, in an institutional environment with minimal friction (low or no fees, no liquidity problems). This portfolio is constructed in such a manner as to eliminate companyspecific risks by diversification. Given that these rational portfolio managers follow a set pattern of logical buys and sales of various weakly correlated securities under conditions of rational expectations where the price of equity shares of company XYZ are equal to the intrinsic value of XYZ. This portfolio of relatively uncorrelated, but correctly priced securities generates optimal returns Rational portfolio managers are assumed to earn a portfolio return that is perfectly (or near perfectly, if we allow for some market drift around normally distributed returns) related to expected portfolio returns. Because the return distributions are assumed to be normal, it is never anticipated that actual returns will dramatically diverge from expected returns (in other words, booms and busts in the market are precluded). What is the evidence for or against CAPM? Empirical research in finance has clearly demonstrated the inadequacy of CAPM. Research has shown that CAPM results in bad estimates of intrinsic value (which means bad estimated security prices leading to bad trades and suboptimal portfolio returns). The realization of CAPM's failings led to the construction of alternative models and further empirical testing (leading to further improvements in the models). The discovery of previously hidden (from the general investing public) determinants of required returns has led to growing acceptance of such relatively more (than CAPM) complex models. Capital Asset Pricing calculator Stock Valuation with Dividend Valuation and CAPM Method 
Dec. 1  Capital Financing, The Text, chapter 14. 
Dec. 68  Mergers, Acquisitions, and Corporate Control,
The Text, chapter 22
Special Showing of Wall Street. 
click symbol above to search SEC database
Home Page  Courses  Research & Online Papers  Finance Jobs & Internships 