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FINM7402: Corporate Finance (Advanced)
Tutorials:
• There are no tutorials in Week 1. See the subject outline for further details.
You are expected to read a wide range of source materials and thus help
understand the topics well (see the course outline).
Textbook and Supporting Materials
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Course Structure
Lecture / Seminar
• Theory development seasoned with practical applications.
• Prepare with required and recommended readings (see course profile and Blackboard).
Tutorial
• Discuss solutions to tutorial questions as needed.
• Additional practical applications.
• Participation will assist in preparation for exams
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Summary of Assessment
Mid-semester exam (30%)
• Wednesday mid-semester exam: Aug 31 in class
• 90 minutes
• MCQs & short answer
• Topics covered: 1-4
Individual assignment (20%)
• Case study on cost of capital/valuation
• Submission by the due date (Oct 5, 2023) via Blackboard.
• Zero marks for late submission
• Topics covered: 1-4
Final exam (50%)
• Centrally administered during exam block
• 120 minutes, 10 minutes perusal
• MCQs, problem solving and short answer
• Topics covered: all with emphasis on 5-10
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Course Objectives & Teaching Plan
Capital Budgeting
NPV, IRR
Cost of Capital
Capital Structure
Capital Structure – MM Theory
Debt, Taxes & Financial Distress
Payout Policy
Risk Management
Financial Options
Real Options
Special Topics
Corporate Governance
Mergers & Acquisitions
Raising New Capital
CRICOS code 00025B
Tips to succeed in FINM7402
• Read the course outline carefully.
• Review the lecture note before each lecture.
• Attempt tutorial questions before the tutorial.
• Study relevant chapter/s related to each topic.
• See your tutor promptly if you’re having difficulties.
• To succeed, there is no alternative to HARD WORK.
• The course is progressive (don’t fall behind).
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Week1: Learning Objectives
• Overview of corporate finance as a field
• Describe the market portfolio and how it is constructed in practice.
• Describe common proxies for the market return and the risk-free rate.
• Define alpha and beta and explain how they are generally estimated.
• Estimate a company’s cost of equity using the CAPM equation
• Estimate the cost of debt, given a company’s yield to maturity, probability of default, and
expected loss rate.
• Asset beta, equity beta, levered and unlevered beta
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Corporate Finance: what is it?
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• Broadly speaking, any decision that a business makes has financial
implications, and affects the finances of a business is a corporate finance
decision.
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First Principles & the Big Picture
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Corporate finance is focused on…
• Maximizing the value of the business (firm). As a result of this singular objective, we can
- Choose the right investment decision rule to use amongst a menu of such rules (NPV,
IRR, payback …)
- Determine the right mix of debt and equity for a specific business
- Examine the right amount of cash should be returned to the owners of a business and the
right amount to hold back as a cash balance.
• This certitude does come at a cost. To the extent that you accept the objective of
maximizing firm value, everything in corporate finance makes complete sense. If you don’t,
nothing will.
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Corporate finance is universal
• Every business, small or large, public or private, Australian or Emerging market, has to
make investment, financing and dividend decisions.
• The objective in corporate finance for all these businesses remains the same: maximizing
the value.
• While the constraints and challenges that firms face can vary dramatically across firms, the
first principles does not change.
- A public traded firm, with its greater access to capital markets and more diversified investor base,
may have much lower costs of debt and equity than a private business, but they both should look
for the financing mix that minimizes their costs of capital.
- A firm in an emerging market may face greater uncertainty, when accessing new investments, than
a firm in a developed market, but both should invest only if they believe they can generate higher
returns on their investments than they face as their respective hurdle rates.
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Hurdle Rate: Cost of Capital
• Also referred as cost of funds used for financing a business.
cost of equity & cost of debt
• Cost of capital represents a hurdle rate that a company must
overcome before it can generate value.
• Input in the capital budgeting process to determine whether the
company should proceed with a project. NPV analysis
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Cost of Capital: risk return model
• Since financial resources are finite, there is a hurdle that projects have to
cross before being deemed acceptable. This hurdle should be higher for
risker projects than for safer projects.
• A simple representation of the hurdle rate is as follows
Hurdle rate = riskless rate + risk premium
• The two basic questions that every risk and return model in finance tries to
answer are:
- How do you measure risk?
- How do you translate this risk measure into a risk premium?
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A good risk and return model
• It should come up with a measure of risk that applies to all assets and not
be asset-specific.
• It should clearly delineate what types of risk are rewarded and what are
not, and provide a rationale for the delineation.
• It should come up with standardized risk measures, i.e., an investor
presented with a risk measure for an asset should be able to draw
conclusions about the asset is above or below-average risk.
• It should translate the measure of risk into a rate of return that the investor
should demand as compensation for bearing the risk.
• It should work well not only at explaining past returns, but also in
predicting future expected returns.
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The Capital Asset Pricing Model
• Uses variance of actual returns around an expected return as a
measure of risk.
• Specifies that a portion of variance can be diversified away, and
that is only the non-diversifiable portion that is rewarded.
• Measure the non-diversifiable risk with beta, which is standardized
around 1.
• Translates beta into expected return
Expected rate = riskless rate + beta * risk premium
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ri=rf +βi × (E[RMkt ]-rf )
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• For an investment to be risk free, i.e. to have an actual return be equal to the expected
return, two conditions have to be met
- No default risk, which generally implies that the security has to be issued by the
government. Note: not all governments can be viewed as default free.
- There can be no uncertainty about reinvestment rates, which implies that it is a zero
coupon security with the same maturity as the cash flow being analyzed.
• Definition: The risk free rate is the rate on a zero coupon default-free bond matching the
time horizon of the cash flow being analyzed.
• Practically, we use returns of Treasury Securities as proxy for risk free rate. In corporate
finance, almost everything is long term. So, using a long-term default risk free treasury
bond return as the risk free rate makes sense.
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CAPM: Risk-free rate
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• Risk premium: Expected return on the market portfolio – risk-free rate
Historical premium approach: In principle, market portfolio should be the value weighted entire
universe of stocks. In practice, a stock market index return is often used as a proxy of market
performance. For example, S&P 500 index is often used as a proxy of US market performance,
S&P/ASX200 index is used as a proxy of Australian stock market performance.
Table 1: Historical Excess Returns of the S&P 500
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CAPM: Risk premium
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Alternative Approach for Market Risk Premium
Using historical data has two drawbacks:
• Standard errors of the estimates are large
• Backward looking, so may not represent current expectations.
• Alternative: We can get a forward looking measure of risk premium implicit in stock
prices:
• Forecast dividends (D1) for a broad sample of existing firms (i.e. forecast market
dividend yields)
g is the long-term growth rate for all stocks obtained from analyst forecasts; D/P is the
market dividend yield
MRP = (Market Div. yield + growth) - rf
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gr
DP
e −
= 10
+=+= g
P
Drhenceg
P
Dr me
0
1
0
1 ;
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Market Risk Premium
Survey estimates
Experts are surveyed as to their estimates of the MRP going forward
Many different expert groups have been asked
CFOs
Financial analysts
Academics
There is little evidence that any of these groups have expertise that is relevant to estimating
MRP
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The risk of an individual asset
• Use variance of actual returns around an expected return as a
measure of risk.
• Specifies that a portion of variance can be diversified away,
and that is only the non-diversifiable portion that is rewarded.
• Total Risk = Systematic risk + Unsystematic Risk
• Risk diversification: firm-specific risk can be reduced by increasing
the number of investments in your portfolio. Market-wide risk cannot.
• Measure the non-diversifiable risk with beta, which is standardized
around one.
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7/13/2023
No of assets
Total Risk
systematic risk
unsystematic risk
TOTAL RISK = SYS RISK + UNSYS RISK
Diversification
Keeping return constant
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• Total Risk = Systematic risk + Unsystematic Risk
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Beta
• A measure of a security’s systematic risk, describing the amount
of risk contributed by the security to the market portfolio.
βi = Cov(Ri, Rm) / σ2m
• Cov(Ri, Rm) is a raw measure of systematic risk, can be scaled by
dividing it by the variance of the return on the market.
• This gives the asset’s beta (βi)
If beta = 1 … same risk as market portfolio
if beta > 1… riskier than market portfolio
if beta < 1 … safer than market portfolio
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2012
Given Rf equals 8% and E(Rm) equals 15%, what is the
required return for a project which has a Beta of 1.5?
E(Ri) = .08 + 1.5(.15 - .08) = .185 or 18.5%
[ ]E R R E R Ri f i m f( ~ ) ( ~ )= + −β
Example One
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Cost of Equity
Monthly Returns for Cisco Stock and for the S&P 500, 2000-2015
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Cisco mean annual ret: r = 3.3% Volatility: σ = 9.6%
95% confidence interval: 3.3% ± 1.96 ∗ 9.6% (−15.5%, 22.1%)
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Cost of Equity re
• Estimate expected returns directly, i.e., using historical average
return, is too noisy to be useful.
• A more robust alternative is CAPM
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ri=rf +βi × (E[RMkt ]-rf )
Market Risk Premium
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Estimating Beta
• Under the CAPM, beta reflects the systematic (market-related) risk of
owning shares in the company and cannot be diversified away.
• Betas are usually estimated using regression analysis to estimate the
relationship between returns for a particular stock and returns on the
broad market.
• Regress asset excess return (Ri – Rf) on market excess return (Rm- Rf).
• The R squared of the regression provides an estimate of the proportion
of the risk (variance) of a firm that can be attributed to market risk. The
remaining (1 – R2) can be attributed to firm specific risk.