Corporate Finance Essentials, Certification link.
- Returns, Volatility, and Beta
- Correlation and Diversification
- CAPM and the Cost of Capital
- Project Evaluation: NPV & IRR.
- Corporate Value Creation: EVA.
1. Returns, Volatility, and Beta
Periodic return source : (1) capital gain or loss; (2) cash flow.
- Arithmetic Mean Returns: representing a simple average.
- Geometric Mean Returns: reflects the average rate at which an investment grows over time, considering compounding effects.
- Arithmetic Mean Returns is always higher than Geometric Mean Returns. Misleading information can lead to poor investment decisions.
Volatility (SD - Standard Derivation) of returns. measure of variability,
Beta measure of relative risk (referencing the market), reaction of an asset to fluctuations in the market. $StockRisk = \beta^{2} SystematicRisk + IdiosyncraticRisk $
2. Correlation and Diversification
Portfolio risk - we want to reduce fluctuation, with diversified correlation.
- Correlation (Rho) the sign and the strength of the relationship between two variables. 👍 Country Correlation Matrix
- Diversification : usually thought of in terms of risk reduction.
- Investers do not really want to reduce risk. As high risk is linked with high expected return.
- Investers do not really want to maximize returns. which would also maximize risk.
- Investers want to maximize risk-adjusted returns. (a “best” combination, thought diverification)
- The lower the correlation between assets, the higher the benfits of diverification.
3. CAPM and the Cost of Capital
- Cost of captial is related to RISK (not cash flows).
- The weighted-average cost of capital (WACC).
- From the point of view of investors, the average required return on the capital provided.
- From the point of view of the company, the average cost of raising capital.
- A hurdle rate : the minimum required return on the company’s investments.
- $R_{WACC} = x_{D} (1-t_{c})R_{D} + x_{E}R_{E}$
- $R_D$ $R_E$ are the required return on debt and equity.
- $t_c$ is the corporate tax rate, $ (1-t_{c})R_{D}$ is the after-tax cost of debt.
- x are proportions of the debt and equity. (we want to find the best proportions)
The debt tax shield $ (1-t_{c})R_{D}$. We debt we will pay fewer tax, since we pay the interest, which has a effect of discount on the required return of debt.
Required returns: (1) The corporate tax rate; (2) The cost of debt; (3) The cost of equity and the CAPM; (4) The proportions of debt and equity.
The objective of CFO : get the lowest possible Cost of captial.
3.1 The cost of debt
The cost of debt : Bond represents a promise to pay back a principal amount (face value) along with interest payments over a specified period until maturity.
- When the perceived risk of a company increases, investors are willing to pay less for the bond, leading to a higher required return. (high risk - high return, low risk - low return)
- The return on a bond can be calculated based on the cash flows received and the price paid for the bond.
- Yield to maturity (YTM) is the mean annual return from holding a bond until maturity and is a more accurate measure of the cost of debt. (Since the interest rate will not change.)
- objective : observable for the investors (it can be directly obtained from market data or bank quotes)
3.2 The cost of equity
The cost of equity is subjective : not observable, hence must be estimated using models like the CAPM, with large uncertainty.
Capital Asset Pricing Model (CAPM) : $R_{Ri} = R_{f} + MRP \cdot \beta_{i}$
- $R_{E}$: required return of the cost of equity.
- $R_{f}$: risk-free rate - the return expected from an investment with zero risk, often represented by the yield on long-term government bonds.
- But the mature day people used varies a lot. more details
- MRP: Market(or Equity) Risk Premium. the historical difference between equity returns and debt returns.
- Market Risk Premium (MRP) = Expected Market Return − Risk-Free Rate.
- The additional return that investors demand for investing in the stock market (equities) instead of risk-free securities, such as government bonds.
- 5% to 6% for US.
- $\beta$ : measure of relative risk - company’s sensitivity to market fluctuations.
- The only thing, different among companies.
4. Project Evaluation
Using NPV & IRR. To decide which project to invest.
4.1 Net Present Value (NPV)
\[NPV = CF_{0} + \frac{CF_{1}}{(1+DR)} + \frac{CF_{2}}{(1+DR)^{2}} + ... + \frac{CF_{T}}{(1+DR)^{T}}\]- $CF_{0}$ : the first cash flow.
- The subsequent expected cash flow : $CF_{1}$, …, $CF_{T}$.
- DR : discount rate. The later the money received, the higher the discount.
4.2 The Internal Rate of Return (IRR)
\[CF_{0} + \frac{CF_{1}}{(1+IRR)} + \frac{CF_{2}}{(1+IRR)^{2}} + ... + \frac{CF_{T}}{(1+IRR)^{T}} = 0\]- The IRR is the discount rate that makes the NPV of a project equal to zero, requiring the input of initial investment and expected cash flows. Useful but has limitations.
- The equation might have multiple solutions or no solution. In which case, higher IRR does not always mean a better project.
- In such cases, relying on NPV is essential.
- Scale problem, IRR is a relative rate, scale is not considered.
- example : [CF0 = -100, CF1 = 150] v.s. [CF0 = -200, CF1 = 280]
- Bias to invest in small project, since smaller projects are easier to get higher return.
4.3 More discount rates
- Discount rates across countries or divisions.
- Discount rates over time. NPV become more complicated, and IRR will be useless.
5. Corporate Value Creation
5.1 Three Underlying Issues:
- Shareholder (owner) value v. Stakeholder (who a role to play) value.
- It there really a conflict? Can you benefit both?
- Reasons to focus on shareholder : (1) It is a boarder criterion; (2) It is “objectively” quantifiable; (3) shareholders are the owner of the company.
- Common managerial mistakes :
- Focusing on short-term market reactions. (particularly on reactions to earning announcements)
- Aiming for Growth for the Sake of Growth. (disregarding the return of that growth)
- What to do with the capital entrusted is clear, the way to get there is far less clear.
- How to find “good” project.
- Value-based management.
5.2 Economic value added (EVA)
EVA a measure of profitability that differs from traditional accounting profits. Idea : (1) To ‘charge’ managers for the use of capital; (2) To claim profits only if cash is left after this charge.
- EVA = NOPAT - (Capital × WACC)
- Return on Capital = NOPAT / Capital
- NOPAT: Net Operating Profit After Taxes.
- Captial : Debt + Equity + …
- WACC : Cost of Capital
- NOPAT & Captial subject to proprietary adjustments.
Pros | Cons | |
---|---|---|
Level of EVA | Easy to measure; reflects profitability. More sustainable (if the moat persists). | Can lead to an unequal endowment problem, where executives may be rewarded for doing little if the division is already profitable. |
Change in EVA | Encourages improvement; rewards executives for turning around underperforming divisions. | Not sustainable in the medium or long term. In competitive markets, it may be challenging to consistently increase EVA, potentially leading to lower compensation for executives. |