COURSERA

LECTURE NOTES
AN INTRODUCTION TO CORPORATE FINANCE

Franklin Allen
Wharton School
University of Pennsylvania
Fall 2013
WEEK 6 (Part 2)
Section 9
Exam Review

Copyright 2013 by Franklin Allen

COURSERA
AN INTRODUCTION TO CORPORATE FINANCE
PREPARATION FOR EXAM
BASIC CONCEPTS: Sections 2-8
(i)

Section 2
What should a corporation's objective be?
-

Maximize NPV since this makes all shareholders better off

no matter what their preferences.

OA

point that maximizes NPV

preferences 1
D

preferences 2
E

What assumptions are required for this result to hold?

-

Perfect capital markets.

(ii) Section 3
How are PV's calculated?
Basic Formula:
T

PV =
t =1

Ct
(1 + r t )t

Special cases:

Perpetuity
Growing perpetuity
Annuity
Growing annuity

These all assume payments are made at the end of the year.
What happens when payments are made more frequently?
-

Compounding

(iii) Section 4
How do we value bonds and stocks?
-

Prices of securities must be equal to their PV's. If this wasn't the

case, what would there be? An arbitrage possibility.

Basic Formula:

P0 =
t =1

Dividendt
(1 + r )t

Stock with constant growth rate:

P0 =

Div1
r-g

If growth is in stages then we have to adapt the basic formula to take

account of this.
What do the formulas imply for price/earnings ratios?
-

If a stock has a high price/earnings ratio does that mean it's a good
buy? No it means it has a lot of growth opportunities.

(iv) Section 5
Why is NPV the best investment criterion?
-

Superior to IRR because IRR has following difficulties

Lending and borrowing problem
Multiple roots
Relative measure

Superior to Profitability index because this is

Relative measure

Superior also to Payback and accounting measures such as Average

Return on Book because these are incorrect

(v) Section 6
How do you make investment decisions using NPV rule?
-

Discount cash flows

Transform accounting data into cash flows
Cash flow = $'s received - $'s paid out
Work in after-tax terms
Estimate cash flows on an incremental basis
Be consistent in your treatment of inflation

(vi) Sections 7 and 8

Beta and the Capital Asset Pricing Model
Hold stocks in portfolios
- Unique risk is diversified away
- Market risk remains
Variance of well-diversified portfolio depends on covariances of stocks in it, i.e, it depends on their
market risk
3

Measure of a stock's market risk is where

stock = Cov(stock, M)/Var M
CAPM
Borrowing
<1

Capital
Market

Mean

Line
=1
Lending

Market portfolio

0<<1

Standard Deviation

If CAPM assumptions are satisfied the expected return on an asset is determined by it's market risk
r = rF + (rM - rF)
The security market line plots r against . If the CAPM is satisfied all stocks and portfolios lie on
the security market line. This contrasts with the capital market line above where the diagram is r
against SD. Unique risk is included so all stocks and portfolios do not lie on the capital market
line.