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) 20% Midterm (Thu March 12 in class) 30% Final 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

Financial Tools and Analysis

Corporate Decisions

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 1 2 3 4

PV C1 C2 C3 C4

PV = C1(1+r)1 +C2

(1+r)2 + ....CT

(1+r)T

. . .

T

CT

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

Calculating Ct and r

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.

Shortcuts

0 1 2 3 4

PV C C C C . . .

rC

=perpetuity of PV

. . .

Perpetuity

PV = C(1+r) + C(1+r)2 + C(1+r)3 ... (1)multiply by 1+r

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

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

0 1 2 3 4

PV C C(1+g)

. . . . . .

Growing perpetuity (r > g)

C(1+g)2 C(1+g)3

PV = C1+ r +C(1+ g)(1+ r)2 +

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

0 1 2 3 4

PV C C(1+g)

. . .

PV of growing perpetuity = Cr g

. . .

Growing perpetuity (r > g)

C(1+g)2 C(1+g)3

1+ r1+ g PV =

C1+ g +

C1+ r +

C(1+ g)(1+ r)2 ...

PV = C1+ r +C(1+ g)(1+ r)2 +

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

times 1+ r1+ g

subtract

1+ r1+ g 1#

$ %

&

' ( PV = C1+ g 1+ r (1+ g)( )PV = C

Present Value of Annuity

0 1 2 3 4

PV C C C C . . .

T

C

difference between two perpetuities

0 1 2 T+1 T+2

C C C C

. . .

T

C . . .

TT+1 T+2

-C -C

. . .

PV = Cr ?

A. 1(1+ r)TCr or B.

1(1+ r)T +1

Cr ?

Present Value of Annuity

0 1 2 3 4

PV C C C C . . .

T

C

0 1 2 T+1 T+2

C C C C

. . .

T

C . . .

TT+1 T+2

-C -C

. . .

PV of annuity = 1 1(1+ r)T#

$ %

&

' ( Cr

Present Value of Growing Annuity

0 1 2 3 4

PV C C(1+g) C(1+g)2 C(1+g)3

. . . T

C(1+g)T-1

PV of growing annuity = 1 (1+ g)T

(1+ r)T#

$ %

&

' ( Cr g

Present Value of Growing Annuity

0 1 2 3 4

PV C C(1+g) C(1+g)2 C(1+g)3

. . . T

C(1+g)T-1

PV of growing annuity = 1 (1+ g)T

(1+ r)T#

$ %

&

' ( Cr g

1. Getting all annuity/perpetuity formulas from this one 2. Assumptions about r and g 3. The timing of cash flows

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

Example: Mortgage

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

Example: Terminal Value

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)?

Terminal Value, Growth Company

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

Persistence of Growth

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

Example: Saving for Retirement

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 1: Real vs. Nominal Rates

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?