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Business 35200

Corporation Finance

Professor Kelly Shue

Kelly Shue Corporation Finance 35200

Course Material
Text: Berk and DeMarzo
(1st, 2nd, 3rd, 4th editions ALL ARE OKAY TO USE!)
Lecture notes refer to 2nd edition, readings for other editions
are in the class schedule posted online
Course packet: notes and cases
Chalk site: http://chalk.uchicago.edu
Lecture notes
Case questions
Problem sets & solutions
Announcements
Sample midterms and finals

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Course Requirements
Final grade based on
1. Final Exam (40% or 70%)

2. Midterm (optional 30%) NO RESCHEDULING

3. Case Write-ups (20%)

4. Class Participation (10%)

The four components above are curved separately


and then used to compute the final grade

Kelly Shue Corporation Finance 35200

Cases
Case write-ups
All cases weighted equally
3 cases (of my choosing) graded on a 10 point scale
Other cases (including first case) graded on a credit/no credit basis

Groups for cases and problem sets


Up to 4 people per group (across sections allowed)
One write-up per group
Exact answers to case studies will not be distributed

Submit cases in hard copy (paper) at start of class


Must submit at start of EARLIEST class registered or attended by
any member in the group
If theres a problem with submission, email solutions to the TA
before the deadline
Include typed honor code in submission
NO EXTENSIONS!

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Problem Sets
Problem sets are optional and not to be handed in
Discussed in review sessions
Most similar to midterm and final exam

Posted each week:


Monday: problem set questions for current week
Friday: problem set solutions for previous week
Critical to do!
In the week before the midterm and final, I will
post problem set questions and solutions on the
same day so that you can reference the solutions
before taking the exams
Kelly Shue Corporation Finance 35200

Exams
You MUST take the midterm and final exam in the
section you are registered for

Readings: lecture notes, cases, textbook, and a few


additional notes
Relatively little reading for this course
Focus on understanding and working with the key concepts

Allowed materials
Calculator (no cell phones)
One 8.5 X 11 in, double sided page of notes for midterm
Two 8.5 X 11 in, double sided pages of notes for final

YOU MUST ADHERE TO THE BOOTH HONOR


CODE
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Make-up Exams
Exams cannot be rescheduled unless you
have a documented medical emergency,
documented conflict with your personal Booth
graduation ceremony, or a documented
conflict with an internship start date

Kelly Shue Corporation Finance 35200

Early Final Exam Option


If you have an internship conflict, email
academicservices@lists.ChicagoBooth.edu with
verification of your internship start date
Verification can be an email or pdf or scanned letter from
employer specifying your internship start date
DO NOT EMAIL ME!
In your email, specify whether you want:
1. Remote proctoring during the regularly scheduled final exam date
2. Early exam option: Tuesday May 30, 6-8pm Gleacher 200

All lecture notes, problem sets, problem set solutions,


case assignments, and sample exams will be posted
by week 7 to allow you to prepare early for the final
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Administrative Information
Office Hours: by appointment
Email: kelly.shue@chicagobooth.edu

Teaching Assistant:
Ariel Almeida
Content or case questions, first email
ariel.almeida@chicagobooth.edu

TAs will be conducting review sessions


Not mandatory, but highly recommended
See Section Schedule on Chalk website

Kelly Shue Corporation Finance 35200

Main Goal of Course


To acquire the tools necessary to evaluate the
profitability of investment projects

To acquire a conceptual framework for analyzing


financing decisions

To apply this body of knowledge to cases in more


complex situations

These skills are fundamental tools when making


business decisions across areas
I-Banking
Consulting
Marketing
Private Equity
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Overview of the Course
Part I: Capital Budgeting
What real assets should the firm invest in?
Project valuation will give us an answer to this question
PV, discount rates, valuation in practice (WACC and APV)

Part II: Financial Policy


How should projects be financed?
Debt, equity, information problems, taxes
Payout policy

Part III: Additional Topics


How should firms make M&A decisions?

Kelly Shue Corporation Finance 35200

Who Am I?
Education
A.B, Harvard University, Applied Mathematics
Ph.D., Harvard University, Economics

Research focus: Corporate Finance


Behavioral biases
Executive compensation
M&A
Corporate social responsibility
Executive social networks

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Executive Social Networks

Randomly assigned social ties formed at HBS affect


executive compensation and M&A at S&P1500 firms
Kelly Shue Corporation Finance 35200

Money Illusion and CEO Pay


20

15
Percent

10

0
-1 0 1 2
Proportionate Change

Histogram of the proportional change in the number of at-the-


money options granted this year relative to the previous year

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The Peter Principle

Firms promote based upon current job performance, at the expense of promoting
the best potential managers
Every employee tends to rise to his level of incompetence

Kelly Shue Corporation Finance 35200

Lecture 1A: Cash Flows and


Present Value

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Overview
Cash Flows (CF) and Present
Value (PV)
These are two fundamental concepts
in Corporate Finance
This is partly a review
Readings: BD 4.1-4.5; 7.1-7.4
May want to brush up on Ch. 1-3

Kelly Shue Corporation Finance 35200

Understanding Cash Flows


Value of a investment project determined by
the cash flows it generates for investors
Treat firm as collection of projects
Discounted cash flow (DCF) method treats
the cash flows from a firm or project like a
financial security (stock or bond)
Present value (PV) of cash flows calculated
similar to how one calculates the PV of a
financial securitys cash flows
Business 35000

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Present Value
Cash received in the future is worth less
(time value of money)
Suppose you have a cash flow that
continues to time T
C1 C2 CT
PV0 = C0 + + + ... +
(1 + r ) (1 + r )2
(1 + r )T

Now suppose you have a cash flow with a


fixed sum (C) that lasts forever. This is called
a perpetuity. Lets price one ...
Kelly Shue Corporation Finance 35200

PV formulas: Perpetuity
C C C
PV = + + + ...
(1 + r ) (1 + r )2 (1 + r )3

Multiply both sides by (1+r):


C C
(1 + r )PV = C + + + ...
(1 + r ) (1 + r )2

Subtract the first from the second and rearrange:


C
PV =
r
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PV formulas: Perpetuity and Annuity
PV today of perpetuity starting tomorrow:
PV = C/r
PV today of perpetuity that starts paying C
tomorrow which grows at rate g:
PV = C/(r-g)
PV today of annuity that pays a fixed sum (C)
each year for a given number of years (T)
C 1 C 1 1
PV = =C T
r (1 + r )T
r r r (1 + r )

Kelly Shue Corporation Finance 35200

Making Decisions: The NPV Rule


If you are considering investing in a machine
or buying a company, the key number is the
Net Present Value (NPV) of the investment

NPV Rule
Take all projects with NPV > 0 and
Reject all projects with NPV < 0

Equivalent Statement
Buy the security if the PV of its future cash flows is
greater than the purchase price

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A DCF Example
You are the CEO of a microchip
manufacturing company
You know the cash flows of an investment in
a new technology will be:
$35M from investment today (year 0)
$20M annual after-tax cash flow starting in year 1
and growing at a 5% rate
Final cash flow comes at the end of the 7th year
No salvage value of new technology at the end
Investing in an alternative project with
equivalent risk has an expected return of 9%
9% is therefore the opportunity cost of capital in
this example
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Cash Flows from the New Technology


Microchip Project
time 0 1 2 3 4 5 6 7
date Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13

Cash Flow*
*in millions

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Cash Flows from the New Technology
Microchip Project
time 0 1 2 3 4 5 6 7
date Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13

Cash Flow* $(35.00) $ 20.00 $ 21.00 $ 22.05 $ 23.15 $ 24.31 $ 25.53 $ 26.80
*in millions

Kelly Shue Corporation Finance 35200

Cash Flows from the New Technology


Microchip Project
time 0 1 2 3 4 5 6 7
date Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13

Cash Flow* $(35.00) $ 20.00 $ 21.00 $ 22.05 $ 23.15 $ 24.31 $ 25.53 $ 26.80
*in millions

20.00 21.00 22.05 23.15 24.31 25.53 26.80


NPV = 35 + + + + + + +
(1.09) (1.09)2 (1.09)3 (1.09)4 (1.09)5 (1.09)6 (1.09)7
= 80.13
So these cash flows are worth $80.13M.

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Questions
What does the NPV rule tell us about whether
we should build the microchip factory?
What if the project had a negative NPV at the
9% opportunity cost of capital?
Suppose the project had a negative NPV at
9% but a positive NPV at 8%, and a banker
approaches us who is willing to loan us
money at 8%?
What if the best loan rate we can get from a
bank is 10%?

Kelly Shue Corporation Finance 35200

What is Cash Flow?


NOT accounting earnings

We are interested in actual cash flows


that accrue to investors

Why might these be different?

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Some Cash Flow Rules
Four basic ingredients in cash flows are:
Revenues, costs, investments, taxes

Depreciation is NOT a cash flow


But, it does affect taxes

Interest expense is NOT a cash flow (for now)


We want to separate the investment and financing decisions.
So, for now, evaluate projects as if they are all equity financed

Only discount incremental cash flows


Either discount total firm cash flows with vs. without project OR
discount incremental cash flows of project only

Dont forget opportunity cash flows


Real estate
Own time

Kelly Shue Corporation Finance 35200

Finding the Right Cash Flows


Think about the following project:
Investment $10 million up front
Can be dismantled and sold for $1.949
million after 7 years
Forecasts of sales, costs, depreciation,
pretax and after-tax profits are available
What are the cash flows?

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Income Statement to Cash Flows
Projected Income Statement for the Project ($ thousands)

0 1 2 3 4 5 6
Sales 0 523 12,887 32,610 48,901 35,834 19,717
Cost of goods sold 0 837 7,729 19,552 29,345 21,492 11,830
Startup and SG&A costs 4,000 2,200 1,210 1,331 1,464 1,611 1,772
Depreciation 0 1,583 1,583 1,583 1,583 1,583 1,583
Pretax profit (EBIT) -4,000 -4,097 2,365 10,144 16,509 11,148 4,532
Interest 0 0 0 0 0 0 0
Tax -1,400 -1,434 828 3,550 5,778 3,902 1,586
Profit after tax -2,600 -2,663 1,537 6,593 10,731 7,246 2,946

Typical format of income statement that analysts get


Question: Can we take the profit after tax line and plug it
into the present value equation to get the NPV?
? 2663 1537 6593 10731 7246 2946
NPV = 2600 + + + + + + ?
(1 + r ) (1 + r ) (1 + r ) (1 + r ) (1 + r ) (1 + r )6
2 3 4 5

Answer: No.
Kelly Shue Corporation Finance 35200

Free Cash Flow


= Revenues Costs Investments Taxes

= Revenues Costs Investments


tc*(Revenues Costs Depreciation)

= (1 tc)(Revenues Costs) Investments + tc*Depreciation

= (1 tc)(Revenues Costs Depreciation) Investments


+ tc*Depreciation + (1 tc)* Depreciation

= EBIT*(1 tc) + Depreciation Investments

= EBIAT + Depreciation Investments

Note: EBIT= Revenues Costs Depreciation


EBIAT= EBIT*(1 tc)

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Components of Investments
Four main investment cash flows:
1. Initial capital expenditures
2. Required ongoing capital expenditures
3. Change in net working capital (NWC)
Generally, NWC = CA - CL
In this class, NWC = Inventories +
Accounts receivable Accounts payable
Why is change in NWC an Investment?
4. Terminal value

Kelly Shue Corporation Finance 35200

More About Terminal Value


Idea is that at horizons end, a project
may still have some value.
If project is liquidated or sold at the end of
the horizon, we calculate its salvage
value (Liquidation Method)
If the project will continue indefinitely, we
calculate its continuation value
(Perpetuity Method)

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Method 1: Salvage Value (Liquidation)
Appropriate method if machine or project will be
sold off at the end of the horizon
Best for slow growing companies
Start with estimate of sale price of machine in
the year after the final forecasted cash flow
Consider tax implications
Salvage Value
= SALEPRICE TAX LIABILITY
= SALEPRICE
taxrate*(Saleprice Depreciated Book Value)

Kelly Shue Corporation Finance 35200

Cash Flow in the Fertilizer Example


0 1 2 3 4 5 6 7
Note: Balance Sheet Information
Net Working Capital 0 550 1,289 3,261 4,890 3,583 2,002 0
Accumulated Depreciation 0 1,583 3,167 4,750 6,333 7,917 9,500 0

Cash Flow Calculation


EBIT -4,000 -4,097 2,365 10,144 16,509 11,148 4,532 0
Tax at 35% -1,400 -1,434 828 3,550 5,778 3,902 1,586 0
EBIAT -2,600 -2,663 1,537 6,594 10,731 7,246 2,946 0
Depreciation 0 1,583 1,583 1,583 1,583 1,583 1,583 0
1. Initial Expenditures 10,000 0 0 0 0 0 0 0
2. Ongoing Expenditures 0 0 0 0 0 0 0 0
3. Change in NWC 0 550 739 1,972 1,629 -1,307 -1,581 -2,002
4. Terminal Value 0 0 0 0 0 0 0 -1,442
Investments 10,000 550 739 1,972 1,629 -1,307 -1,581 -3,444
Cash Flow -12,600 -1,630 2,381 6,205 10,685 10,136 6,110 3,444

Note: In the cases that we will do in this course, the terminal value is
usually recognized during the final year of the operating cash flows.
Note: All NWC is recovered in the final year of operating cash flows
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Method 2: Continuation Value (Perpetuity)

Appropriate method if investment continues


beyond the horizon where components of
cash flow easily calculated
Best to use if cash flows have settled into a
pattern of steady growth at the end of the forecast
horizon
Take the cash flows at time T, calculate (or
assume) a growth rate g for them, and apply
the growing perpetuity formula

Kelly Shue Corporation Finance 35200

Example of Continuation Value


Suppose that r is 14% and we have the
following cash flows
0 1 2 3 4 5
Cash Flows Excluding
Terminal Value -3500 1000 1150 1158 1212 1275
Continuation Value CV
Total Cash Flows -3500 1000 1150 1158 1212 1275+CV

Growth rate of cash flows?


roughly 5%
What is continuation value (CV) here?
CF(1 + g) 1275(1.05)
= = 14,875
(r g) (0.14 0.05)
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Takeaways
Make valuation decisions based on the NPV rule:
Take all projects with NPV > 0 and Reject if NPV<0
Cash flow are DIFFERENT from accounting earnings
CF = EBIAT + Depreciation Investments
Investments = Initial CAPX + Ongoing CAPX + NWC +
Terminal Value
Terminal Value:
Salvage value (liquidation method) or
Continuation value (perpetuity method)
Only count cash flows that are additions or subtractions
to what the firm is already doing
Ignore sunk costs

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