Corporate

Finance
LECTURE 2
TOPIC 2: CORPORATIONS AND CAPITAL
MARKETS
Corporations | Ownership vs Control | Capital Markets | Federal
Reserve System | The NPV Decision rule | No-Arbitrage Principle
or The Law of One Price | No-Arbitrage Pricing | Risk Premium

Chapters covered: 1,3,4

Corporations: Organizational Chart

Ownership vs Control

In corporations, ownership (shareholders) and control

(financial manager or CEO) are typically separated

Board of directors represents the interest of the

shareholders in the firm and monitor the major decisions
of the financial manager

Financial manager responsible for corporate investment,

financing, and shareholders payout policies

The objective of the financial manager should be to

maximize the net worth of the shareholders

Capital Markets

Capital markets allow investors who own a claim to a

firms assets to trade that claim with other investors
interested in acquiring such claim (e.g., stocks)

Capital markets can be transparent or opaque depending

on whether the prices at which investors trade are made
public or not

Transparent markets include stock markets and equity

options markets

Opaque markets include corporate bond markets and

credit default swaps markets

Federal Reserve System

Responsible (among other things) for setting and

implementing the nations monetary policy in pursuit of
maximum employment, stable prices and moderate longterm interest rates

The Federal Reserve (Fed) implements the monetary

policy by controlling the federal funds rate - the rate at
which depository institutions (e.g., banks) trade balances
(e.g., bank reserves) - in at least two ways:

Open market operations (purchase and sale of bonds)

Setting the reserve requirements for depository institutions

Time Value of Money

An insurance company approaches you with an

investment opportunity which promises $10,500, riskfree, next year, in exchange for $10,000 today. If the
savings (risk-free) rate is 3%, should you take it?

Time Value of Money

First note that $10,500 next year is not comparable to

$10,000 today

We need to transform today $ into next year $ or the

other way around

$10,000 today are equivalent to $10,300 = $10,000

*(1 + 3%) next year

Next year $ = compounded today $

Time Value of Money

$10,500

next year are equivalent to $10,194.175 =

$10,500/(1 + 3%) today

Today

$ = discounted next year $

To

answer the question we have to compare either

$10,500 and $10,300 or $10,000 and $10,194.175

Compare

$ values only if contemporaneous

Time Value of Money

1 2 3 are called the 3 rules of time travel

$10,500>$10,300

- take the opportunity

The

amount $10,300 can be thought of as the

opportunity cost

Opportunity

cost is the value of pursuing a riskequivalent alternative investment opportunity

In

our case, the alternative is saving

Time Value of Money

More generally, when evaluating an investment

opportunity, the discount rate used to transform future
$s into today $s is called the opportunity cost of
capital (OCC)

In our example, OCC = 3%

Net Present Value Decision Rule

An investment opportunity promises cash flows C0 at

time 0, C1 at time 1, ..., and CT at time T

The OCC for this opportunity is r

Then, the net present value (NPV) of this investment

opportunity is
C1
CT
NPV = C0 +
+
.
.
.
+
(1 + r)1
(1 + r)T

C0 is usually negative and captures the initial cost of the

investment opportunity

C1, ..., CT are usually positive, but not always

Net Present Value Decision Rule

Previous

example:

NPV = PV($10, 500)

PV($10, 000)

$10, 500
=
$10, 000
1 + 3%
= $194.175 > 0
Thus, our

investment opportunity has a positive NPV

Net Present Value Decision Rule

NPV Decision Rule: When choosing between

alternative investment opportunities, take the investment
opportunities with positive NPV

Investing in a positive-NPV investment opportunity is

equivalent to receiving its NPV in cash today

In other words the owner of the investment opportunity

is wealthier

Net Present Value Decision Rule

Example (Capital Budgeting and Ownership):

Firm ABC has $10 million in cash and an investment

opportunity that requires an immediate investment of
$10 mil in return for $15 mil, risk-free, next year.

ABC has two owners: Charles Sr (Mr. C) and Charles Jr.

(Chuck). Mr C is 80-years old while Chuck is 20-years
old.

Mr. C says that ABC should not take the investment

opportunity, but rather distribute a one-time dividend
of $10 million. Chuck says whatever. If the risk-free
rate is 5%, what should ABC do?

Net Present Value Decision Rule

Note the NPV of the project is positive:

NPV = PV($15mil)

PV($10mil)

$15mil
=
$10mil
1 + 5%
= $4.286mil > 0

Thus, according to the NPV Rule, ABC should take the

project. But...

Net Present Value Decision Rule

ABC has to make sure that its owners (Mr C and

Chuck) are better off as a result of taking the project

Is taking the project a better alternative to paying out

$10 mil in a one-time dividend?

The answer is YES

Net Present Value Decision Rule

ABC makes the following argument: If ABC takes the

project and the shareholders borrow (on their own
account) $10 mil at 5% for one year, then the
shareholders are better off compared to the alternative
of no investment and one-time dividend

To see this lets compare the cash flows

Net Present Value Decision Rule

Cash flows from investment + borrowing

Today

Next Year

$10 mil $4.5 mil = $15 mil - $10 (1 + 5%) mil

Cash flows from no investment + dividend

Today

Next Year

$10 mil

$0

Net Present Value Decision Rule

Regardless of shareholders preferences for the timing of

dividend distributions, firms should always invest in
positive NPV projects

To satisfy their time preference, shareholders can

borrow or lend on their own account against the NPV
of the project

Arbitrage in Capital Markets

Investment opportunities considered so far involve

trading (e.g., buying) real assets (e.g., projects)

Investment opportunities can also involve trading in

financial assets (e.g., stocks) or commodities (e.g., oil) on
specialized financial markets (e.g., NYSE or CBOE)

Arbitrage in Capital Markets

Notice that real assets do not trade on any market

(e.g., there is no market for projects)

An important consequence of this fact is that a real

asset can be worth different things to different firms

A positive NPV project for a firm can be a negative

NPV project for another firm

Arbitrage in Capital Markets

Unlike real asset, financial assets trade on a centralized

market

An important consequence of this fact is that all

investors agree on the value of the financial asset

A stock of IBM trading for $125 on NYSE is worth

$125 to everybody

Arbitrage in Capital Markets

We say that there are no arbitrage

opportunities in financial markets if one
cannot make a risk-free profit by purchasing/selling
financial assets in capital markets (i.e., no free lunches!)

An important consequence of the absence of arbitrage

opportunities is that the NPV of any investment
opportunity that involves purchasing/selling financial
assets is always zero.

The concept of no-arbitrage is related to the concept

of the informational efficiency of capital markets (to be
discussed later)

The Law of One Price

The Law of One Price (LOOP):

Two financial assets that have the same

payoffs must have the same prices

When there are no arbitrage opportunities in capital

markets the LOOP must hold!

The LOOP is sometimes called the No-Arbitrage

Principle

The Law of One Price

If the LOOP does not hold then there are arbitrage

opportunities

With no LOOP, two financial assets that have the same

exact payoffs can have different prices

An investor could make a quick risk-free profit by

short-selling (shorting) the expensive asset and
buying the cheap asset (longing).

Since this investment opportunity generates risk-free

profits, it is an arbitrage opportunity

The Law of One Price

A US T-Bill with maturity of 1 year and face value of

$1000 trades for $940 at the issuance. If the borrowing
rate is 5% per year, can you spot an arbitrage
opportunity?

The Law of One Price

Look for a financial asset with similar payoffs as the T-Bill

Today
-$940

Next Year
$1000

If you save (or lend) today X, your savings next year

equal X(1 + 5%)
Today

Next Year

-X

X*(1 + 5%)

The Law of One Price

We want a financial asset with similar payoffs as the TBill

X*(1 + 5%) = $1000 X = $952.38

If you save today $952.38 your savings next year will be

exactly $1000

However, you could get $1000 next year cheaper, by

just paying $940 for the bond

The Law of One Price

This

is an arbitrage opportunity

How

do you make money off it?

Go

short the expensive asset and long the cheap

asset

The

expensive asset is the savings opportunity.

Shorting this is equivalent to borrowing at 5%.

The Law of One Price

So

your arbitrage strategy is: Borrow $1000 at 5%

for 1 year and purchase a T-Bill with maturity 1-year
and face value $1000

Cash

flows:
Assets

Today

Next Year

Save at 5% (-1)

+$952.38

-$1000

T-Bill (+1)

-$940.00

+$1000

Risk-free Profit

+$12.38

$0

No-Arbitrage Pricing

The arbitrage strategy yields $12.38 today, risk-free

Of course you wont be the only one spotting this

opportunity

As more and more investors ride this opportunity, the

price of the bond approaches $952.38

Thus, the bond cannot trade for less or more than

$952.38, or else we have an arbitrage opportunity

We call the value $952.38, the no-arbitrage price

of the bond

No-Arbitrage Pricing

Recall the way we arrived at $952.38

$1000
$952.38 =
1 + 5%

Thus, the no-arbitrage price of the bond is the present

value of all the future cash flows promised by the bond,
discounted at the savings rate

More generally:

The No-arbitrage Price of a financial asset is the present

value of the future cash flows promised by the asset,
discounted at the appropriate discount rate

No-Arbitrage Pricing

One of your clients needs a price for the following stream

of sure flows
Asset
A

Today
?

6 months
$10 mil

1 year
$15 mil

You plan to use two US T-Bills with maturities of 6-month

and 1-year, respectively
Asset

Today

6 months

1 year

B1

$970

$1000

B2

$950

$1000

No-Arbitrage Pricing

You notice that you can use B1 to match the payoff of

asset A in 6 months and B2 to match the payoff of asset
A in 1 year

The necessary number of units are:

$10mil
Units of B1 =
= 10, 000
$1000
$15mil
Units of B2 =
= 15, 000
$1000

No-Arbitrage Pricing

The cash flows of the bonds portfolio are:

Asset

Today

6 months

1 year

+B1 (10,000)

-$9.7 mil

+$10 mil

+B2 (15,000)

-$14.25 mil

+$15 mil

Portfolio

-$ 23.95 mil

+$10 mil

+$15 mil

Notice that the bonds portfolio has the same exact payoffs
as asset A

Thus, by LOOP, it must be that the no-arbitrage price of A

is exactly $23.95 million

The Price of Risk

So far weve worked with sure or certain cash flows

In general cash flows are risky

Does the price of a financial asset with risky cash flows

reflect the risk of its cash flows?

The answer is YES, in general

The answer is no when investors do not care about risk

(we call them risk-neutral investors)

The Price of Risk

Consider the following example

Market index has different payoffs across states of the

economy risky cash flows

Average cash flow of the market index is

1100 = 800 * 0.5 + 1400 * 0.5

The Price of Risk

Notice that both the risk-free bond and the market

index have the same expected cash flows of 1100

However, market index trades at a discount relative to

risk-free bond

The price discount of 58 = 1058 - 1000 is

compensation demanded by investors for bearing the
cash flow risk of the market index

Notice that the price discount depends on the price of

the financial assets, and cannot be used to compare the
risk of two financial assets

The Price of Risk

The U.S. T-Bill has sure payoffs and consequently the rate of
return of the T-Bill is called the risk-free rate and is
denoted with rF
1100 1058
In our example, rF =
= 4%
1058

The Market Index has risky payoffs, and its rate of return is
risky as well

In this case we typically compute the average or expected

rate of return of the Market Index, denoted Er(Index)
800 0.5 + 1400 0.5
Er(Index) =
1000

1000

= 10%

The Risk Premium

The

difference between the expected return on the

Market Index and the risk-free rate measures the
compensation to the investors for bearing the risk of
the Market Index, when they invest in the Market
Index rather than the T-Bills
difference is called the Risk Premium and we
denote it with RP

This

In

our example, RP(Index) = Er(Index) - rF

RP(Index)

= 10% - 4% = 6%

The Risk-Adjusted Discount Rate

Recall that in order to compute the no-arbitrage price

of a financial asset we need to discount the future cash
flows of the asset with the appropriate discount rate

This discount rate is called the risk-adjusted

discount rate, denoted simply with r

When we know the risk premium of the asset, we can

compute the r as follows
r = rF + risk premium

Risk premiums can be computed with the Capital Asset

Pricing Model, or the CAPM (to be discussed later)

The Risk-Adjusted Discount Rate