Summary of Courses in Finance Revision for the State Exam

1
Summary of Coursesin Finance (Revision for
the State Exam)

• Mihály Ormos

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Business Economics Corporate Finance

• 9. Dividend policy
• Indicators of dividend, practices
• Indifference of dividend policy in perfect and
  imperfect market
• Significance of dividend policy indifference in
  financial analyses, consequences
• 10. Financing decisions
• Business activity and debts in the function of
  leverage
• Shares in the function of leverage in equilibrium
  and nonequilibrium taxation
• Consequences of Miller and Modiglinai theorems on
  corporate finance analyses

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Business Economics Corporate Finance

• 11. Cash flow estimation
• Principles of Cash flow estimation
• Consideration of the inflation, taxes and
  exchange rates
• Separation of expected value and risk
• 12. Determination of opportunity cost
• Determination of opportunity cost by the CAPM
• Determination of the parameters of the market
  portfolio
• Determination of betas
• 13. Companies in the modern market economies
• Main types of modern market economies
• Shareholders value stake holders approach
• Mechanism of shareholders value

4
Business Economics Corporate Finance

• 14. Business economic analyses
• Net present value
• Internal rate of return
• Profit index and annual equivalent
• 15. Options
• Valuation of European call and put options,
  influencing factors
• Case of the American dividend paying option
• Real-options

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Dividend policyIndicators of dividend, practices

• Dividend yield ratio
• (dividend/price, Div/P)
• Dividend payout ratio
• dividend/income
• Practices
• Positive correlation can be found between the
  annual income and the dividend,
• but there is a time lag between the two
  parameters.
• Never decrease the dividend!
• what if the firm will not be able to pay that
  much next year
• This is why the volatility of the dividends is
  much less than that of the incomes.
• The practices can be connected to the PVGO of the
  company
• Huge differences can be found in the practices of
  the firms

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Dividend policyIndicators of dividend, practices
7
Dividend policyIndifference of dividend policy
in a perfect market

• The suppositions (circumstances)
• the firm has settled on its investment program
  (i.e. it is already worked out that how much of
  this program can be financed by borrowing, and
  the plan meets other funds requirements)
• perfect market (fair issuing price, zero
  transaction cost, equal tax rates dividend and
  price earnings)
• What happens if the dividend wanted to be
  increased without changing the investment and
  borrowing policy?
• The only solution is to print some new shares and
  sell them.
• Miller and Modigliani states that the dividend
  policy has no affect to the value of the firm in
  the above circumstances.
• Investment and borrowing policy is determined so
  to increase the value of dividend new shares have
  to be offered so one part of the company become
  the property of the new owners.

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Dividend policyIndifference of dividend policy
in a perfect market
It is indifferent for the old owners how they get
money by dividend or by selling some of their
stocks.
9
Dividend policyIndifference of dividend policy
in a perfect market
10
Dividend policyIndifference of dividend policy
in an imperfect market

• Arguments usually presents some kind of market
  imperfection (tax differences, transaction cost,
  information, etc.)
• Reasons to pay higher dividend
• There is a conservative group which believes that
  an increase in dividend payout increases firm
  value
• In lack of information the high dividend is a
  good sign
• The paid dividend is certain while the price
  increase is uncertain
• Reasons to pay lower dividend
• High transaction cost of issuing
• Higher taxation of divined incomes

11
Dividend policyIndifference of dividend policy
in an imperfect market

• Even in case of slight market imperfections the
  indifference can be defended.
• Empirically it can be proven that a supply-demand
  equilibrium is created between investors
  preferences to dividend and corporations
  dividend policies.
• If there exists a better dividend policy, all
  company would use that,
• however many kind of policies can be found in
  the market.

12
Dividend policySignificance of indifference of
dividend policy in financial analyses

• If the indifference of dividend policy is
  assumed, then the project analyses can be derived
  through the cash flow steams of a pure equity
  financed mini-firm, so the shareholders cash
  flows resulted from dividend pay offs can be
  neglected.
• Nevertheless the cash flow streams can be assumed
  as dividends.
• By the above hypothesis (which is already proved)
  the corporate financial analyses are highly
  simplified, because the mini-firm approach can be
  used.

13
Financing decisions Effects of capital structure
in perfect market without taxes

• Nine different factors should be investigated
• Value, Expected return and Risk of the
• Firm (business activity), Equity, Debt
• The Firm (business activity)
• The value of the firm is equal to the sum of the
  value of equity and the value of debt VED (the
  capital structure can be characterized as the
  financial leverage of the firm which is shown by
  the D/E ratio)
• The expected return of the firm E(rV) and the
  risk of the firm ßV are given by the projects
  of the firm
• Therefore the value, the expected return and the
  risk of the firm is independent from the capital
  structure of the company, so from the D/E ratio

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Financing decisions Business activity and debts
in the function of leverage

• The capital structure can only have a slight
  affect on the value of the business activity.
• These effects can be gained by the financial
  difficulties produced by the increasing leverage.
• Efficiency of the projects decreases
• buyers, sellers, employees become cautious (decr.
  revenues, incr. costs)
• Business decisions are not made on the value
  maximization
• only short return investments are implemented
• Danger of bankruptcy
• Increasing cost of control (managers vs. owners)
• Effect of information
• The above losses are mainly connected to the
  owners so the value of the business activity is
  decreasing due to
• the decreasing return of the projects while the
  risk is constant.

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Financing decisions Business activity and debts
in the function of leverage

• Assuming an efficient financial (debt) market
• The price of the debts (credits and bonds) are
  adjusted to their risk
• The risk of the debts (ßD) in a low leveraged
  situation is 0, because the equity covers the
  debts, thereforethe required return of the debts
  (rD) is equal to the risk free return.
• After a certain leverage the risk and therefore
  the required return of the debts begin to
  increase,because the probability of debt
  trapping is increased.

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Financing decisions Shares in the function of
leverage in equilibrium and nonequilibrium
taxation

• If the taxation is equal on the owner and debtor
  side

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Financing decisions Shares in the function of
leverage in equilibrium and nonequilibrium
taxation
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Financing decisions Shares in the function of
leverage in equilibrium and nonequilibrium
taxation
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Financing decisions Shares in the function of
leverage in equilibrium and nonequilibrium
taxation
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Financing decisions Shares in the function of
leverage in equilibrium and nonequilibrium
taxation

• The value of taxes connected to the debt side are
  usually lower than the equity side

• Until this point the lower leveraged seemed to be
  better
• the costs of financial difficulties (bankruptcy)
  decreased the equity side
• If the taxation of the debt side is advantageous
  (lower) this makes an opposite effects
• the excess return remain in the pocket of the
  owners

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Financing decisions Shares in the function of
leverage in equilibrium and nonequilibrium
taxation
T
E
D
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Financing decisions Shares in the function of
leverage in equilibrium and nonequilibrium
taxation
23
Financing decisions Shares in the function of
leverage in equilibrium and nonequilibrium
taxation
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Financing decisions Shares in the function of
leverage in equilibrium and nonequilibrium
taxation

• An additional affect gained by taxation
  differences of debts (e.g. revenues from
  government securities)

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Financing decisions Shares in the function of
leverage in equilibrium and nonequilibrium
taxation

• Summarizing the 5 effects
• Increasing leverage increases the possibility of
  bankruptcy, therefore the return of the business
  activity decreases with constant risk so the
  value of the firm decreases while the value of
  the debts is constant the value and return loss
  is connected to the owners, ie. to the equity.
• By the leverage increase the risk end the return
  is increased of the equity but these increases
  are in equilibrium so the value of the equity
  does not change
• The advantageous debt side taxation creates a
  tax-shield and this excess return is connected to
  the owners of the firm, while the risk is
  unchanged therefore this creates a value surplus
  of the equity
• Rearranging the debts and the equity through
  tax-shield the leverage decreases, which has no
  affect the value
• The non-tax investment opportunities on the debt
  market increases the required return on the
  corporate debts, so the increasing leverage
  decreases the expected return and the value of
  the equity.

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Financing decisions Effect of leverage in the
CAPM
E(r)
E(rV)
rf
ß
ßV
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Financing decisions Effect of leverage with
increasing financial difficulties in the CAPM
E(r)
E(rV)
rf
ß
ßV
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Financing decisions Effect of leverage with
taxation in the CAPM
E(r)
E(rV)
rf
ß
ßV
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Financing decisions Effect of leverage with
preferred debts in the CAPM
E(r)
E(rV)
rf
ß
ßV
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Financing decisions All effects together in the
CAPM
E(r)
E(rV)
rf
ß
ßV
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Financing Effects of capital structure in
perfect market

• Conclusion
• The changing D/E ratio has no effect on the value
  of the firm, the equity and the debt (MM. I.)
• The expected return of the equity is
  proportionally increasing with the D/E ratio.The
  rate of increase in the beginning is linear, then
  due to the increasing required rate of debt
  return (rD) the increase slows down. (MM. II.)
• This is why the pure equity financed mini-firm
  approach is adequate in corporate financial
  analyses.

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Financing Pure equity financed mini-firm approach
33
Cash flow estimation Introduction

• What is the aim of determination of cash flows?
• Corporate financial analyses are based on the
  future cash flows created by the project.
• These cash flows will be examined through the
  analyses

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Cash flow estimation Principles of Cash flow
estimation

• Relevant cash flows
• Cash flows should be estimated on change base
• All derivative effects have to be considered
  (with or without)
• Opportunity cost has to be taken into
  consideration
• Sunk Cost
• Careful separation of overheads
• Working capital needs
• Sub-versions should be separated

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Cash flow estimation Consideration of inflation

• Using nominal values.
• All cash flows are considered on current price,
  so the estimated price changes tendencies of
  e.g. material costs, payments to personnel,
  selling price are calculated. Of course the
  opportunity cost should be considered in the same
  way.
• Using real values.
• Unchanging, actual prices are considered, but in
  this case the opportunity cost should be
  estimated on the same way.

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Cash flow estimation Consideration of taxation
and currencies

• Most taxes are taken into account as costs, i.e.
  they are considered as indirect or general
  expenditures for which the base is the net
  profit.
• General rule that is in the estimation of cash
  flows and in the estimation of opportunity cost
  the same calculation procedure should be used.
• However the opportunity cost is estimated on an
  after all taxes base, the cash flow streams
  should be done in a similar manner.
• Any currency can be used for cash flow estimation
  (international financial equilibrium)

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Cash flow estimation Separation of expected
value and risk

• In case of cash flow streams only the expected
  value has to be found, while the risk is built in
  to the opportunity cost of the project.

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Determination of opportunity cost Determination
of opportunity cost by the CAPM

• The opportunity cost gives the reference return
  in economic analyses.
• To determine this reference return the CAPM can
  be used.
• Why the CAPM?

The projects expected return have to exceed this
to be worthy for the owner to accomplish the
investment.
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Determination of opportunity cost Determination
of the parameters of the market portfolio

• In the determination of the opportunity cost we
  have to start from the CAPM.
• There exists risk-free asset
• There is a premium accompanied to risk taking
• The required, expected and average returns are
  equal

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Determination of opportunity cost Determination
of opportunity cost by the CAPM
rf

• By definition the return of the risk free asset
  (time premium) is the return of any real asset
  with zero standard deviation. (There is no asset
  like this)
• In the estimation the return of that financial
  asset should be considered, which certainly pays
  back the claim with its interest. There is only
  one issuer which can guarantee that this will
  happen and this is the government.
• Therefore some kind of government security should
  be considered.
• The risk of inflation can be eliminated in two
  ways
• inflation indexed government security
• modifying with the estimated inflation rate
• If the return of government security is changing
  in time, the return of zero-coupon bonds, or the
  return of security with similar maturity to the
  project life time.

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Determination of opportunity cost Determination
of the parameters of the market portfolio
rM

• By definition the return of the market portfolio
  can be given by the expected return of that
  portfolio which represents the capitalization
  weighted average return of all securities traded
  in the world.
• This can be approximated with the global
  portfolios e.g. MSCI world index
• However it would be rational to hold the global
  portfolio (MSCI), there are many factors against
  this rational behavior.
• The security market returns gives information of
  the expected return of leveraged business
  activities therefore it has to be unlevered by MM
  II.

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Determination of opportunity cost Determination
of the parameters of the market portfolio
rM
ME,Si
ME,G
ME/D,Si
MSi
MME/D,G
Segmented market portfolios
Unlevered segmented security market portfolios
Unlevered segmented market portfilos
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Determination of opportunity cost Determination
of betas
?

• We are always interested in the opportunity cost
  of projects, (but the risk of a specific project
  and the risk of a specific stock (company) is not
  necessarily equal) nevertheless capital market
  information is available only on stocks.
• Two step procedure
• Estimation of unlevered betas
• From unlevered calculation of project betas
• For starting point we can choose the beta of the
  given company if the project is similar to the
  function of the firm, otherwise industrial
  averages can be used.

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Companies in the modern market economy
Introduction

• Development of public limited corporations
• Early capitalism
• individuals and families
• unlimited liability
• the owner and the manager is the same
• Development of technology and mass production
  required the concentration of capital
• Limited liability
• legal entity
• shares are tradable
• More owner one company
• management and ownership are separated, but
• the goals are different
• agency problem

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Companies in the modern market economiesMain
types of modern market economies

• The types are connected to the degree, the
  manner, and the function of intervention of the
  state into the economic processes.
• The three form of modern market economy
• Corporate (market) controlled (Anglo-Saxon)
• State controlled (Asian capitalism)
• Negotiation based market economy (Rhenish)

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Companies in the modern market economiesMain
types of modern market economies

• Corporate (market) controlled (Anglo-Saxon)
• The role of the state is narrow
• USA, Great-Britain
• Weak feudalism
• Parliamentary political system
• Smooth and continuous industrialisation

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Companies in the modern market economiesMain
types of modern market economies

• State controlled
• Relatively the highest state coordination
• intervenes the microeconomic processes
• selectively influences the operations of
  companies
• plays a significant role in the allocation of
  recourses like
• state owned firms
• financing RD
• reduced rate credits
• Japan and France
• Strong feudalism and aristocracy
• Late but rapid industrialisation, therefore
• High industrial concentration
• The bank system has a significant role
• The state in sight of the international
  competition strengthened its position.

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Companies in the modern market economiesMain
types of modern market economies

• Negotiation based market economy
• The economic processes are based on the
  negotiations of the leading economic roles.
• The main idea is social partnership i.e.
  political consensus between the employers, the
  employees, and the bureaucracy.
• The negotiations include
• wages
• prices
• taxes
• employment
• economic stability and growth

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Companies in the modern market economiesMain
types of modern market economies

• by the financing system of the economy
• By the role of the bank system three types can be
  distinguished
• Capital market based financing system
• New recourses can be obtained by issuing stocks
  or bonds, bank loans are used mainly for short
  term financing
• Credit based financing system with administrative
  dominance
• Small and moderate exchanges so the firms have to
  use the banks for financing.
• Subsidies through the banking system
  (preferential loans)
• Credit based financing system with institutional
  dominance
• There are only a few large banks, and they have
  shares in the firms, investment funds are owned
  by them.

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Companies in the modern market economiesSharehold
ers value stake holders approach

• Share holders value approach
• Only the growth of the companys value counts
• The firm works as a revenue producing machine
• From the 90s this form became the major approach
• Capital market based financing system
• Stake holders value
• They are the buyers, the suppliers, the
  investors, the creditors, the employees, the
  government
• Their interests should be considered
• More comfortable, and humane
• Credit based financing system

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Companies in the modern market economiesMechanism
of shareholders value

• If there are dominant shareholders of the
  company, the board of directors and carrier
  competition work well.
• If the ownership is crumbled (because of the
  demand of capital new issues happened,
  diversification of owners, etc.) then the
  intervention of owners to the business activity
  of the firm is decreased even the members of the
  board could be delegated by the management.
• However, if the shareholders is pushed into the
  background, then the firm is usually pushed to
  the edge, so the owners are gladly sell their
  stocks and by this the buyout of the company can
  happen, and the new owners are easily fire the
  management.

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Business economic analyses Introduction

• The main steps of a corporate financial analyses
  are
• Determination of opportunity costs
  (identification of the return of the similar risk
  capital market investment possibility) ?
• Determination of future cash-flows (this is the
  sum of economic effects of the project) ?
• Economic analyses (comparison between the
  profitability of the project and the alternative
  investment possibility)
• NPV, IRR, PI, AE

53
Business economic analyses Net present value

• Net Present Value is the sum of discounted
  cash-flows of a given project by the opportunity
  cost.
• So in this way the economic value of a project
  can be compared to other investment possibility
  with the same risk. The result of NPV calculation
  shows the value increase above the capital market
  opportunity.
• Therefore, the project will be implemented if the
  NPVgt0.

54
Business economic analyses Internal rate of
return

• Internal Rate of Return is defined as the rate of
  discount which makes the NPV0.
• IRR is the average return of the project which
  has to be compared to the opportunity cost.
• So the IRR rule is to accept an investment
  project if the opportunity cost of capital is
  less then the IRR.
• Pitfalls of IRR
• It shows the average return of the project i.e.
  the increase of unit equity in unit time
• Lending or borrowing
• Multiple rates of return
• Mutually exclusive projects
• Short- and long term interest rates may differ

55
Business economic analyses Profit Index and
Annual Equivalent

• Profit index is the quotient of the Net Present
  Value and the investment cost of the project

It is used in case of limited capital, for
mutually exclusive projects.
56
Business economic analyses Profit Index and
Annual Equivalent

• Annual equivalent can be used to compare mutually
  exclusive and repeating projects with different
  life time.
• In this case the future cash-flows of the project
  converted to annuity and these annuities will be
  compared (NPV of the normal cash flows has to
  give the same result as the NPV of the annuity)

57
OptionsIntroduction

• Derivative instruments are financial assets with
  returns depend on value of other factors.
• Two basic types
• Termins (forwards and futures)Termin
  transactions are basically sales contracts for a
  predefined future date, however the seller does
  not have to own the asset of the contract.
• OptionsOptions give the opportunity to buy or
  sell an asset on a specified price.

58
DerivativesValuation of European call and put
options, influencing factors

• Types of option
• Call is the opportunity or obligation to buy
• Put is the opportunity or obligation to sell
• Short positions are obligations to sell or buy
  (writer)
• Long positions are rights to sell or buy

• Option price or premium is the value which have
  to be paid by the buyer for the opportunity.
• Exercise of Strike price is the predefined
  (contracted) price of the asset (K).
• X0 is the actual price of the asset
• The owner of an option can
• sell the option on actual price
• at expiration draw the option
• wait until expiration and do nothing
• American vs. European option

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• Value of Call and Put options at expiration

60

• Profit on Call and Put options

61
DerivativesValuation of European and American
call and put options, influencing factors

• Actual stock price
• Strike or Exercise price
• Intrinsic value (relation of X0 and K)
• Call ITM situation the intrinsic value X0-K
• Call ATM and OTM situation this value is 0
• Volatility of the stock returns (standard
  deviation of annual returns)
• Time to option expiration
• Mature dividend until expiration
• Risk free return (i.e. the present value of
  exercise price)
• Time value of option
• The difference between the value of the option
  (c) and its intrinsic value

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DerivativesFactors influence option prices
K
63
DerivativesReal-options

• Real options are option analogies fitted to
  corporate investments by which those parameters
  can be evaluated that cannot be included in NPV
  calculations.
• Likederivative investment possibilities (Call
  option)
• possibility of leaving a business (Put option)