Corporate Finance (ECON GU4280)

Lecture 6

Tri Vi Dang

Columbia University

Spring 2018

Corporate Finance, Tri Vi Dang, Columbia University, Spring 2018 1

 I. The theory of corporate finance II. The practice of corporate finance

I.1. Valuation concepts II.1. Internal finance, corporate

control and merger analysis

I.2. Financial structure decisions II.2. Private equity and venture

capital finance

I.3. Taxes and the costs of financial II.3. Business analysis and
distress financial analysis

I.4. Financial decisions and conflict II.4. Enterprise valuation

of interests

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Midterm Exam

The midterm exam is on 3/1

- during regular class time and place

It is an open book exam.

- Textbook, lecture notes and your own notes can be used

- Scientific and graphic calculator is allowed

- NOT allowed are all other electronic devices

(e.g. laptops, tablet PCs, smartphones)

Only materials discussed in class will be tested.

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 Lecture 6

I.1. Valuation concepts

L. Real Options
M. Risks and Returns
N. Portfolio Mechanics and Diversification

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 I.1.L. Real Options

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Investment decisions

A firm makes investment decisions at different dates.

Typically, all such investment decisions exhibit a call option feature.

 Firm has “right” but no obligation to make some investments

Optimal sequential decision making is called

 Real options

Real options are not options in the sense of the previous section.

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Real Options

A firm can undertake or extend a project but has no “obligation” to do so.

The option to

Expand if the immediate investment project succeeds

Wait and delay additional investment

Shrink or abandon a project

has (real) value.

Options to modify projects are known as real options

 optimal sequential decision making

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The Model

t=0,1,2

At t=0, the firm decides whether to invest the amount I.

Marketing, product quality, design, etc.

At t=1, demand can be high (H) or low (L)

Prob(H)=0.6 prob(L)=0.4

At t=2, demand can be high or low

Prob(H|H)=0.8 prob(L|H)=0.2

Prob(H|L)=0.4 prob(L|L)=0.6

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 H (0.6) 200 H (0.8) 1000

L (0.2) 400

H (0.4) 400

I L (0.4) 100 L (0.6) 200

H (0.8) 600
0 H (0.6) 100
L (0.2) 300

H (0.4) 200

L (0.4) 40 L (0.6) 100

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Suppose r=10% and I=280

Should the firm invest?

Solution by Backward Induction

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 H (0.6) 200 H (0.8) 1000

L (0.2) 400

H (0.4) 400

I L (0.4) 100 L (0.6) 200

H (0.8) 600
0 H (0.6) 100
L (0.2) 300

H (0.4) 200

L (0.4) 40 L (0.6) 100

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Suppose the firm invests at t=0

At t=1

Given demand t=1 is H: E ( H , Inv)  0.8  1000  0.2  400  880

Given demand t=1 is L: E ( L, Inv)  0.4  400  0.6  200  280

At t=0:

 200 880   100 280 

E ( Inv)  0.6    2   0.4    2   674.38
 1.1 1.1   1.1 1.1 

NPV(Inv)=E(Inv)-I=674.38-280=394.38

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 H (0.6) 200 H (0.8) 1000

L (0.2) 400

H (0.4) 400

I L (0.4) 100 L (0.6) 200

H (0.8) 600
0 H (0.6) 100
L (0.2) 300

H (0.4) 200

L (0.4) 40 L (0.6) 100

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Suppose the firm does not invest at all

At t=1

Given demand t=1 is H: E ( H , NoInv)  0.8  600  0.2  300  540

Given demand t=1 is L: E ( L, NoInv)  0.4  200  0.6  100  140

At t=0:

 100 540   40 140 

EU (0)  0.6    2   0.4    2   383,14
 1.1 1.1   1.1 1.1 

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Implication

If the firm does not invest, its market value is 383.14

If the firm invests, its market value is 394.38

The investment at t=0, generates a net gain of 11.24.

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Remark

The investment yields a particular high payoff if demand is high.

If demand is low, the beneficial effect of the investment is smaller.

So the firm may want to wait and invest after observing the first demand.

The option to wait can be valuable.

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 H (0.6) 200 H (0.8) 1000

L (0.2) 400

H (0.4) 400

I L (0.4) 100 L (0.6) 200

H (0.8) 1000
I L (0.2 ) 400
0 H (0.6) 100
0 H (0.8) 600

L (0.2) 300
H (0.4) 200

L (0.4) 40 L (0.6) 100

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Suppose the firm does not invest at t=0 and decides at t=1 again

At t=1

Given demand t=1 is H: E ( I , H , I 0  0)  0.8 1000  0.2  400  880

Given demand t=1 is L: EU ( L,0)  0.4  200  0.6 100  140

At t=0

 100 880 280   40 140 

E( I 0  0, I1H  1)  0.6    2   0.4    2   399.01
 1.1 1.1 1.1   1.1 1.1 

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Implication

If the firm does not invest at all, its market value is 383.14

If the firm invests at t=0, its market value is 394.38

If the firm waits and invests at t=1 if demand is high, its market value is 399.01

The option to wait to invest increases the market value of the firm

Remark

The Option Value to wait  E ( I 0  0, I1H  1)  E ( I 0  1)

OV=4.63

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Remark

This type of (backward induction) reasoning typically applies to many sequential

investment decisions of a firm.

The same logic of reasoning applies to the valuation of a project when you have
the option to expand, shrink or abandon a project

It is difficult to price a project and ultimately value of firm which can be

interpreted as a collection of projects.

The estimates of the distribution of cash flows at t=1, the distribution of cash
flow at t=2, etc. requires a lot of judgments which is subjective by definition.

When reading estimated income statements and projection of cash flows you
should take real options into account.

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Remark

This framework is also very useful in other economic decision making.

Venture capital finance uses staging of capital.

Leverage buyout fund restructures firms sequentially to make profits.

Special situation private equity funds (e.g. Goldman Sachs Special Situation
Group) use this type of event tree technique to price distressed debt.

We discuss debt restructuring and distressed investing in section I.3.

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 I.1.M. Risks and Returns

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Remark

This section discusses an alternative view on the payoff matrix X.

 x 11  x 1S 
X      
x N1  x NS 

Using this perspective, we will derive an equilibrium model that tells you which
interest rate to use to discount future cash flow.

In this framework we need probabilities.

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Framework

The cash flow of an asset is modeled as a random variable.

A random variable x is characterized by its distribution F(x).

Some important characteristics of a random variable are its

- mean

- variance.

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Remark

If investors are not risk neutral, then they care about uncertainty and risk.

Example

S=1 S=2 S=3 S=4

Alternative
Prob=0.2 Prob=0.2 Prob=0.3 Prob=0.3
A 10 20 30 40
B 20 20 30 30

E ( X A )  0.2 10  0.2  20  0.3  30  0.3  40  27 X-Matrix

E ( X B )  0.2  20  0.2  20  0.3  30  0.3  30  26

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Remark

Asset A has a higher mean (expected payoff) but also “fluctuates” more.

S=1 S=2 S=3 S=4

Alternative
Prob=0.2 Prob=0.2 Prob=0.3 Prob=0.3
A 10 20 30 40
B 20 20 30 30

If investors dislike “fluctuations” or “downside risks”, then project B might

be “better”.

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Remark

A possible adjustment of risk aversion:

E ( X )  Var ( X )
PV 
(1) 1  rf (rf is risk free rate)

E[ x]
(2) PV  (increase r for riskier x).
1 r

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Remark

A famous equilibrium asset pricing model is the Capital Asset Pricing Model
(CAPM).

CAPM is an asset pricing theory which determines the (equilibrium) interest

rates of assets as a function of its characteristics (i.e. its covariance)

This and the next section will provide the tools to derive the CAPM.

CAPM is important for the DCF valuation.

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Properties of Random Variables

Mean
S
E[X]   π i  x i
X discrete : i 1

X continuous :
E[X]   x  f(x)dx


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Standard deviation

σ x  Var[X]

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Covariance

X and Y are two random variables and F(x,y) the joint distribution

Discrete
S
Cov[X, Y]  EX  E[X]  Y  E[Y]   π i  x i  E[X]  y i  E[Y]
i 1

Continuous

Cov[X, Y]  EX  E[X]  Y  E[Y]   x  E[X]  y  E[Y]dF(x, y)


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Correlation coefficient

Cov(X, Y)
ρ xy 
σx  σY

Remark

ρ xy  [1,1]

It measures how strong X and Y „move together“.

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Example
S1 S2 S3
(0.25) (0.5) (0.25)
X1 10 20 30
X2 30 40 10

Interpretation

X1 generates a return of 10% in state 1, 20% in state 2, 30% in state 3.

X2 generates a return of 30% in state 1, 40% in state 2, 10% in state 3.

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 1 1 1
E[X1 ]  10  20  30  20
4 2 4

1 1 1
E[X 2 ]  30  40  10  30
4 2 4

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Table (summary)

S1 S2 S3  2 12 12
(0.25) (0.5) (0.25)
X1 10 20 30 20 50
50 0.57
X2 30 40 10 30 150

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 I.1.N. Portfolio Mechanics and Diversification

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Remark

Technically speaking, portfolio theory is about combining random variables.

Suppose investors care about mean and variance of asset returns.

This section discusses mean-variance portfolio management and introduces the

key tools for deriving desirable portfolios.

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Properties of the mean

Suppose 1,...., N R, and X1,...., XN random variables

(M1) E[1X1]= 1E[X1]

(M2) E[X1+....+XN]= E[X1]+….+E[XN]

(M3) E[1X1+….+NXN]= 1E[X1]+….+NE[XN]

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Covariance-Matrix V

X1,....,XN are random variables, i² is variance of Xi and ij is covariance

between Xi and Xj.

Note, ij=ji.

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Properties of Variance

Suppose 1,...., NR, =(1,...., N) a N-vector, X1,...., XN random variables

and V the Covariance Matrix.

Remark

Formula (V2) plays a central role in portfolio theory (and asset management).

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Example (2 assets)

Y=1X1+2X2.

Var[Y]=Var[1X1+2X2]= V

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Motivating Example

Investing $10K in

Apple

AT&T

Exxon

Walmart

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Share Price

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Daily Returns

Apple AT&T Exxon Walmart

E[r] 0,13% 0,05% 0,01% 0,06%
Var[r] 0,035% 0,008% 0,009% 0,011%
Sigma[r] 1,860% 0,894% 0,946% 1,027%

COVAR (X100) Apple AT&T Exxon Walmart

Apple 0,03515 0,00385 0,00501 0,00303
AT&T 0,00385 0,00803 0,00393 0,00226
V= Exxon 0,00501 0,00393 0,00906 0,00234
Walmart 0,00303 0,00226 0,00234 0,01076

Rho Apple AT&T Exxon Walmart

Apple 1,00 0,23 0,28 0,16
AT&T 0,23 1,00 0,46 0,25
Exxon 0,28 0,46 1,00 0,24
Walmart 0,16 0,25 0,24 1,00

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Corporate Finance, Tri Vi Dang, Columbia University, Spring 2018 45
Porfolio = (0.3,0.2,02.,03)

- Less volatile?
- Expected return?

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Corporate Finance, Tri Vi Dang, Columbia University, Spring 2018 47
Porfolio = (0.3,0.2,02.,03)

 Less volatile than single stocks

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Porfolio = (0.3,0.2,02.,03)

Apple AT&T Exxon Walmart Portfolio

E[r] 0,1264% 0,0474% 0,0128% 0,0583% 0,0675%
Var[r] 0,0346% 0,0080% 0,0090% 0,0105% 0,0072%
Sigma[r] 1,8604% 0,8939% 0,9461% 1,0271% 0,8501%

Corporate Finance, Tri Vi Dang, Columbia University, Spring 2018 49

Remark

Investing

$3K in Apple
$2K in AT&T
$2K in Exxon
$3K in Walmart

generate an expected return of 0.0675% and variance of 0.0072% per day

Expected return is higher than AT&T, Exxon and Walmart

Variance is lower than any single stocks

What is the smallest possible variance?

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Example
S1 S2 S3  2 12 12
(0.25) (0.5) (0.25)
X1 10 20 30 20 50
50 0.57
X2 30 40 10 30 150

Y= 0.4X1+ 0.6X2
Z= 0.2X1+ 0.8X2

Interpretation
The (new) random variable Y can be interpreted as a portfolio consisting of asset
X1 and X2 with the weights 0.4 on X1 and 0.6 on X2.

 Invest 40% of your wealth in asset 1 and 60% in asset 2.

Portfolio Z: invest 20% in X1 and 80% in X2.

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 S1 S2 S3  
(0.25) (0.5) (0.25)
X1 10 20 30 20 50
X2 30 40 10 30 150

Y= 0.4X1+ 0.6X2 22 32 18
Z= 0.2X1+ 0.8X2 26 36 14

1 1 1
E[Y]  22  32  18  26
4 2 4
1 1 1
E[Z]  26  36  14  28
4 2 4

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Using the formula

(M3) E[1X+2X2]= 1E[X1]+2E[X2]

E[Y]= 1E1+2E2=0.420+0.630=26

E[Z]= 0.220+0.830=28

(V2) Var[Y]=Var[1X1+2X2]= V

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Table (summary)

S1 S2 S3  
(0.25) (0.5) (0.25)
X1 10 20 30 20 50
X2 30 40 10 30 150

Y= 0.4X1+ 0.6X2 22 32 18 26 38
Z= 0.2X1+ 0.8X2 26 36 14 28 82

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Remark

The portfolio Y has a higher mean and a lower variance than asset X1 (as in the
motivating example.

Risk averse investors might prefer this.

Diversification

Holding a portfolio of different assets can reduce the variance.

This is called Diversification.

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Remark

By varying the portfolio weights (1,2), we can trace out the whole mean-
variance- frontier.

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The Mean-variance (  , ) - frontier
2

Example

Asset 1: 1  0.1 and 12=0.3

Asset 2:  2  0.2 and 22=0.4

12=-0.2

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 Portfolio Frontier (Rho=-0.2)

Mean
0,30

0,25

0,20

0,15

0,10

0,05

0,00
0,10 0,20 0,30 0,40

Variance

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Remark

If you combine more and more assets, you can shift the portfolio frontier to the
left.

If there is a riskless asset, then you get the following (efficient) portfolio frontier
line.

M
 asset j
rf

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Remark

The set of portfolios in (  , ) space is a line if one asset is riskless.

Suppose asset 1 is riskless:  1  0 and  12  0 .

Note α1  α 2  1  α1  1  α 2

  PF  α 2  σ 2

  PF  (1  α 2 )  rf  α 2  2  rf   2 (2  rf )

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Remark

The tangent point between the line and the curve is called the market portfolio.

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Mean Variance Portfolio Management (N assets)

Suppose you want a portfolio with E[r]=x%

Which portfolio with E[r]=x% has minimal variance.

Minimization problem:

min V subject to

(1 ,.., N )
N


i 1
i  E[ri ]  x


i 1
i 1
N N
min L  V  1 ( i  E[ri ]  x)  2 ( i  E[ri ]  1)
(1 ,.., N )
i 1 i 1

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FOC
dL
0
d1

dL
0
d 2

dL
0
d N

Solution to the equation system with N equations and N unknowns is the optimal
portfolio.

Remark: See Exercise 3.

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