International MSc in Finance

Advanced Corporate Finance

Session 0
Guilherme Almeida e Brito

International MSc in Finance

Finance: General Overview

1. Financial Investments

1.1 Portfolio Theory

1.2 Asset Valuation

1.2.1 Stocks / Firms

1.2.2 Bonds

1.2.3 Futures, Options and other derivatives

1.2.4 International Markets Financial Assets

1.3 Market Efficiency and Investment Policies

1.4 Performance Valuation / Risk Management

1.5 Financial Markets and Institutions

Advanced Corporate Finance

Guilherme Almeida e Brito

International MSc in Finance

Finance: General Overview

2. Corporate Finance

2.1 Investment Decisions / Project Valuation

2.2 Financing Decisions / Capital Structure

2.3 Financial Analysis / Firm Valuation

2.4 Special topics: Mergers & Acquisitions, Governance, ...

2.5 International Corporate Finance

3. Management of Financial Institutions

3.1 Commercial Banking

3.2 Investment Banking

3.3 Insurance

Advanced Corporate Finance

Guilherme Almeida e Brito

International MSc in Finance

Capital Budgeting, Project Valuation

Three Different Perspectives

Economic: Costs
Statement)

and

Financial Commitments:
Expenses (Balance Sheet)

Benefits

(Income

Revenues

and

Cash Flows

Project Valuation is based on Cash Flows
Advanced Corporate Finance

Guilherme Almeida e Brito

International MSc in Finance

Cash Flows

Relevant flows are cash flows; not accounting profits.
Note: cash-flow is different from earnings + depreciation
+ provisions or from EBITDA.

Examples of differences between cash flow and net

income:
Costs are considered when the expense occurs, cash
flows are considered when the expense is paid;
Net income gives special treatment to fixed assets: the
initial investment is not considered, only the
depreciation.

Advanced Corporate Finance

Guilherme Almeida e Brito

International MSc in Finance

Cash Flows

Always considerer
(incremental base).

the

differential

project

Past cash flows are irrelevant sunk costs.

The right perspective is to consider cash flows with the
project versus without the project, not before and
after the project.
Dont forget to include opportunity costs: example land
sale which is not realized (or value the alternatives
individually and make the decision knowing that they
are mutually exclusive).

Advanced Corporate Finance

Guilherme Almeida e Brito

International MSc in Finance

Cash Flows

Include the cash flows regarding taxes.
In order to do so (and, preferably, only to do so) it is
necessary to compute the Income Statement.

Dont forget to include the investment in working

capital and its partial recovery at the end of the project:
2 alternatives: cash inflows and cash outflows; or, most
commonly, sales, cost of goods sold, investment in
working capital.

Advanced Corporate Finance

Guilherme Almeida e Brito

International MSc in Finance

Cash Flows

Beware of allocated overhead costs or general expenses.
Examples: rent, administration wages, ... Right perspective:
with versus without the project.

Dont consider interest payment: separate the investment
decision from the financing decision (exceptions considered
in chapter 19).

Remember to include the projects terminal value
(equipment/property) at the end of the project (and the
associated taxes).

Advanced Corporate Finance

Guilherme Almeida e Brito

International MSc in Finance

Cash Flows

Timing of Cash Flows (Time Value of Money)

Incremental Cash Flows
Sunk costs
Opportunity costs
Externalities / Cannibalization
With /without project versus before / after

Advanced Corporate Finance

Guilherme Almeida e Brito

International MSc in Finance

Cash Flows

Working Capital

After-Tax Basis

Beware of Allocated Overhead Costs

Financing Costs Ignored (included in cost of
capital)

Consider the Terminal Value

Advanced Corporate Finance

Guilherme Almeida e Brito

10

International MSc in Finance

Inflation

Consistency
Constant Prices Real Rate
Nominal Prices Nominal Rate
Commom mistake: constant prices at a nominal rate.

Nominal Cash Flows Dominate

Inflation does not impact equally all cash-flows:
prices, wages, raw materials,

Advanced Corporate Finance

Guilherme Almeida e Brito

11

International MSc in Finance

CAPM
Return

Risk Free
Return =

rf

Security Market
Line (SML)
BETA

Security Market Line:

Advanced Corporate Finance

ri = rF + ( rM rF ) i
Guilherme Almeida e Brito

12

International MSc in Finance

Measuring Betas

Advanced Corporate Finance

Guilherme Almeida e Brito

13

International MSc in Finance

Measuring Betas

Advanced Corporate Finance

Guilherme Almeida e Brito

14

International MSc in Finance

Measuring Betas

Advanced Corporate Finance

Guilherme Almeida e Brito

15

International MSc in Finance

Valuation of Stocks

(simple version)

Generic Model to value real and financial assets:

P0 ( = PV = V0 ) =

CF1
(1 + r01 )

CF2
(1 + r02 )

CF3
(1 + r03 )

+ ... +

CFt
(1 + r0 t )t

+ ...

To value a stock, the relevant cash flows may be dividends (or

free cash flow to equity or free cash flow to the firm) and future
market price.

International MSc in Finance

Dividend Discount Model

Div1
Div2
Div3
DivH + PH

Generically: P0 = (1 + r ) + (1 + r ) 2 + (1 + r )3 + ... + (1 + r ) H

or P0 = Div1 + Div2 + Div3 + ... + Divt + ... = Divt

t
(1 + r ) (1 + r )2 (1 + r )3
(1 + r )t
t =1 (1 + r )

Advanced Corporate Finance

Guilherme Almeida e Brito

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International MSc in Finance

Gordon s Model

Simplifying assumption: dividends grow at a fixed rate g.
P0 =

Div1
rg

Modified Gordons Model

P0 =

Div1
Div2
Div3
DivH + PH
+
+
+ ... +
2
3
(1 + r ) (1 + r ) (1 + r )
(1 + r ) H

PH =

DivH +1
rg

International MSc in Finance

Estimating g
g=

Div
Div

Definition:

Long run additional assumptions :

a)

Dividend policy is stable in the long run.

b)

Return on Equity is stable in the long run.

International MSc in Finance

Estimating g
.

g=

Div a ) Earnings b) E Ret.Earn. Ret. Earn Earnings

=
=
=
=

Div Earnings E
E
Earnings
E

g=

Ret. Earn
ROE = Plowback Ratio ROE
Earnings

Therefore g depends on:

Plowback Ratio (reinvestment capacity).

Return on Equity for the new investments.
Advanced Corporate Finance

Guilherme Almeida e Brito

20