Nottingham University Business School, China

BUSI2156 Corporate Finance

WEI HUANG

Associate Professor in Finance and Accounting

Lecture 1: Introduction to Corporate Finance, Basics of Risk and Return

Reading: B.M.A Chapter 1.2.7

Contents

 The different types of finance

 Forms of business organisation; The responsibility of finance staff
 The different types of security
 The goals of a corporation
 Agency problems in financial management
 Managers actions to maximise stockholder wealth
 Financial data; Downloading data from the internet; Calculating returns
 Risky and risk free investments
 The required rate of return
 The real risk free rate
 Factors affecting the nominal risk free rate
 The risk premium, Sources of risk, Risk aversion
 Returns as a random variable
 Expected return, variance, covariance and correlation for individual securities

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The different types of finance

 Finance consists of three interrelated areas

Money and capital markets – concerned with security markets and

financial institutions
Investments – concerned with decisions made by individual and
institutional investors
Financial management/corporate finance – concerned with decisions
made by firms

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Features of modern financial management

 During the 1940s and early 1950s, financial management became a

descriptive subject devoted to observation rather than analysis

 The 1950s saw a revolution in financial management that turned it into a

rigorous, analytical subject, and shifted interest to managerial decisions
designed to maximise the value of the firm

 Value maximisation remains the keystone of financial management, but two

additional trends are becoming increasingly important, and which have
yielded more opportunities to increase profitability and reduce risk

 The first is globalisation, and the rise of the multinational firm

 The second is advances in information technology that have revolutionised

the way in which financial decisions are made and implemented
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Types of business organisation 1

 Sole proprietorship

An unincorporated business owned by one individual. Advantages are (1)

easy and inexpensive to set up, (2) subject to few government regulations and
(3) avoids corporate taxation. Disadvantages are (1) difficult to obtain large
amounts of capital, (2) unlimited personal liability and (3) life of business
constrained by life of individual. About 80 percent of US businesses are
operated as sole proprietorships.

 Partnership

An unincorporated business arrangement operated by two or more individuals.

Same advantages and disadvantages as sole proprietorship, but added
disadvantage that one partner’s liability must be borne by all other partners.
About 13 percent of all US businesses are operated as partnerships.

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Types of business organisation 2

 Corporation

A legal entity that is separate from its owners and managers. Advantages are
(1) unlimited life, (2) easily transferred ownership and (3) limited liability.
Disadvantages are (1) earnings may be subject to double (both corporate and
personal) taxation and (2) setting up and running a corporation is expensive.
About seven percent of all US businesses are operated as corporations.

 A business’s value will usually be maximised if it is set up as a corporation

because (1) limited liability reduces owner/stockholder risk, (2) incorporation
increases capital availability and hence growth opportunities and (3)
increased liquidity increases security value

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The responsibility of finance staff in a firm

 Forecasting and planning

 Investment and financing decisions

 Coordination and control

 Dealing with financial markets

 Risk management

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The different types of security: fixed income securities

 Fixed income securities offer a contractual claim, or stream of claims,

against the issuer, and they are issued by domestic and foreign governments,
public authorities and private corporations.

 Short term fixed income securities are traded in the money market and are
known as money market instruments. Money market instruments involve a
single payment at maturity, known as the principle or face value, and are
sold at a discount. Longer term fixed income securities are traded in the
capital market and are known as bonds. A bond typically offers a series of
regular smaller claims, known as coupons, followed by a larger terminal
payment

 The issuer of a fixed income security may default, in which case the holder
of the security will receive less than the promised claim, and possibly nothing.
The likelihood of default for corporate fixed income securities varies widely.
Default may result in bankruptcy for the issuer.
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The different types of security: equities

 In contrast to fixed income securities, equities (or shares, or stocks)

represent a residual claim on the issuer. The holder of equity receives a
dividend payment only after all other claimants have been paid

 Although holders of equity have only a residual claim over a company’s

earnings, the size of this claim is unlimited

 If the company does better than expected then it is the company’s equity
holders - not its bond holders - that benefit

 Preferred stock (or preference shares) is equity that promises a dividend

payment

 However, unlike bonds, failure to pay the dividends of a preferred stock does
not result in bankruptcy, but instead the unpaid dividends accumulate
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The different types of security: derivatives

 Derivatives (or contingent claims) are securities whose value depends on the
value of some other underlying security. Derivatives include forwards, futures,
options and swaps

 A forward is an agreement to buy or sell the underlying security at some

future date, and are usually tailor made arrangements between private
individuals and/or institutions

 A future is also an agreement to buy or sell the underlying security at some

point in the future, but unlike a forward, is traded in standardised contracts on
an exchange

 An option gives the right - but not the obligation - to buy or sell the
underlying security at some future date

 A swap is an agreement to swap the cash flows on two obligations

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The goals of a corporation

 Shareholders (the owners of a firm) buy shares for their financial return.
Shareholders elect directors, who in turn hire managers, to run the firm.

 Since managers are the agents of the shareholders, they should run the firm in
such a way that maximises shareholder wealth, which means maximising the
vale of the firm

 Note that shareholder maximisation may easily conflict with the

maximisation of social welfare. Incorporating social welfare into the firm’s
business decisions will put it at a disadvantage. Significant social welfare
issues must be made mandatory, which has led to organisations such as the
Competition Commission to control the power of monopolies

 But maximising stock price (i.e. shareholder wealth) is generally good for
society since it leads to an economically efficient allocation of resources

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Agency relationships: stockholders versus managers

 Many issues in financial management arise from problems related to agency

relationships. Agency problems arise when the authority to make decisions is
delegated to someone (the agent) who is not responsible for the consequences
of those decisions.

 While the shareholders’ objective is to maximise firm value, the managers’

objectives might include (1) maximise salary, (2) maximise job security, (3)
maximise firm size or market share and (4) maximise non-pecuniary benefits
(known as perquisites), such as office and company car

 The stockholder/manager agency problem can be resolved through a variety

of mechanisms, such as (1) Managerial compensation, such as performance
related salary and equity, and executive stock options, (2) Direct intervention
by large shareholders to control major business decisions, (3) The threat of
firing, (4) The threat of takeovers

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Managers actions to maximise stockholder wealth

 The price of any security is determined by (1) the cash flows that the security
is expected to generate, (2) the timing of the cash flows and (3) the risk of the
cash flows. Managers can therefore maximise stockholder wealth by (1)
Increasing expected cash flows, (2) Increasing the timeliness of the cash
flows, (3) Reducing the risk of the cash flows

 Within the firm, the managers make decisions about production in order to
maximise profitability and hence shareholder wealth, i.e. they make an
investment decision

 But they also make decisions about how to finance the firm, i.e. the
proportion of debt and equity, i.e. they make a capital structure decision

 And they also decide how to return the firm’s profits to its stockholders, i.e.
they make a dividend policy decision

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Financial data

 Financial data come in several forms: Market data includes the prices and
dividends of equities, bonds, currencies, commodities and derivatives, and
may be for individual securities or for aggregate indices; Accounting data
includes balance sheet and income statement information for individual
companies, sectors or economies; Economic data includes information about
output and prices for individual countries or groups of countries

 There are many potential sources of financial data, such as:

Datastream International – international economic data and market and

accounting data on international equities, bonds and commodities etc since
1965
Bloomberg – international economic data and market and accounting data on
international equities, bonds and commodities etc since 1990

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Obtaining data from the Internet 1

 The data sources cited above

are not free. An alternative
source of data is the Internet:
Much of the data used in this
course is obtained from the
Yahoo Finance website, go to
http://finance.yahoo.com

 At the top there is a box that

allows you to enter the Ticker
symbol of a stock or index

 To find a ticker for a

company, click on Symbol
Lookup and enter a company
name
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Obtaining data from the internet 2

 Enter the ticker symbol in

box on the right hand side
and click on Get Quotes.
For example, here we obtain
data for IBM (whose ticker
symbol is IBM)

 Now click on Historical

Prices, which is towards
the top on the left hand side

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Obtaining data from the internet 3

 Click Daily and enter the

dates that you require (in
this case, five years of daily
data) and click Get Prices

 Go to the bottom of the

screen, click on Download
to Spreadsheet and save
the file in Excel format (by
default, Yahoo will create a
CSV format file)

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Calculating returns 1

 The return on an asset between time t-1 and t is the percentage change in
wealth that results from owning the asset (which comes from both capital gain
and from cash flows such as dividends or coupons), and is defined as

Pt  Dt  Pt 1
Rt 
Pt 1

 Note that because of limited liability, simple returns are bounded from below
by –1, in other words, an investor cannot lose more than his or her investment
in the asset

 Very commonly in applied finance, we use the continuously compounded

(or log) return, defined by
rt  ln( Pt  Dt )  ln( Pt 1 )
 ln(1  Rt )

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Calculating returns 2

 We can easily calculate simple and continuously compounded returns in

Excel as follows

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Risky and risk free investments

 Risk is defined as the uncertainty over the amount or timing of future cash
flows from an investment. The risk of an investment security can be
considered in isolation, or on a portfolio basis. This distinction is critical for
portfolio theory

 Some investments are risk free. Consider, for example, an investment in a

default free government bond. If the government bond is held until maturity
then the return that the investor receives - both coupon payments and capital
gain - is risk free. In particular, there is no uncertainty over either the amount
or the timing of the cash flows

 Most investments, however, are risky. Consider an investment in a stock,

which offers a return in the form of a dividend and capital gain. The return
that the investor receives is risky, since both the dividend and the future sale
price of the stock is uncertain

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The required rate of return on an investment

 The required return of an investment is the rate of return that investors

require in compensation for holding that investment and forgoing current
consumption

 In particular, investors require compensation for

(1) The time value of money, measured by the real risk free rate

(2) The expected rate of inflation

(3) The risk of the investment

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The real risk free rate

 The real risk free rate is the interest rate that would obtain when there is no
inflation and no uncertainty over future cash flows, and can be thought of as
the exchange rate between current consumption and future consumption,
when there is no risk

 Two factors influence the real risk-free rate, these factors tend to change
slowly over time, so the real risk free rate is typically quite stable

(1) Time preference of individuals for the consumption of income. When

individuals give up $100 of consumption now, how much consumption in
one year’s time do they demand for that sacrifice?
(2) The set of investment opportunities within the economy, which is, in turn,
determined by the real rate of growth of the economy. An increase in the
real growth rate increases the set of investment opportunities and a
corresponding change in the required rate of return on all investments

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Factors affecting the nominal risk free rate

 The nominal risk free rate is the rate at which individuals are willing to
exchange current money for future money, when there is no risk

 If goods prices were expected to be constant then the nominal risk free rate
would be the same as the real risk free rate, since any increase in the amount
of goods required in the future would be equivalent to an identical increase in
the amount of money required to buy them

 In general, however, if goods prices are expected to rise, the nominal risk free
rate will be higher than the real risk free rate by an amount equal to the
expected inflation of goods prices

Nominal risk free rate = (1 + real risk free rate)*(1 + expected inflation) – 1

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Nominal interest rates and inflation

 Expected inflation is quite variable so the nominal risk free rate is much more
variable than the real risk free rate

 Historically, we can see that the variability of nominal interest rates is very
similar to the variability of inflation

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The risk premium

 It is reasonable to assume that most investors are risk averse and so require a
higher rate of return on investments that are risky. The additional return
required over the risk free return is known as the risk premium. There are
several sources of fundamental risk

(1) Business risk. Uncertainty over cash flows caused by the nature of a
firm’s business (e.g. fluctuating demand for the firm’s output)
(2) Financial risk (or leverage). Uncertainty introduced by the method of
financing the firm.
(3) Liquidity risk. Uncertainty over the ability to sell an investment
(4) Exchange rate risk. Uncertainty over the domestic currency value of a
foreign currency denominated investment
(5) Country risk (or political risk). Uncertainty over the political or
economic environment in which the investment is located.
(6) Credit risk (or default risk). Uncertainty over whether the issuer of a
fixed income security will deliver the contractual cash flows.
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Risk aversion

 Portfolio theory assumes that investors are risk averse, meaning that given a
choice between two assets with equal rates of return, they will select the asset
with the lowest level of risk

 Not everyone is risk averse, nor are people risk averse over the entire range of
their wealth.

 For example, most people buy insurance (implying that they are risk averse)
but simultaneously enter into lotteries that have negative expected returns
(implying that they are risk loving). Most people may be risk loving over
small investments (such as the cost of a weekly lottery ticket), but risk averse
over larger investments (such as the value of their house or car)

 It is reasonable to assume that investors are generally risk averse over the
typical size of investments made in capital markets. This is borne out by
empirical evidence
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The return as a random variable

 We can define risk more precisely by recognising that the return on a security
is a random variable that is it is drawn from a probability distribution. The
probability distribution tells us the probability of achieving a particular return.

 If we consider the security in isolation, then we use its marginal probability

distribution, which is simply the function that gives the probability
associated with different return outcomes, irrespective of the returns of other
securities. Two important characteristics of the marginal probability
distribution of returns are the expected return and the variance of returns

 Alternatively, if we consider a number of securities simultaneously, we use

their joint probability distribution, which tells us the probability of a
particular return on one security, given a particular return on another security.
In addition to the expected return and variance of each security, the joint
distribution is characterised by the covariance or correlation of returns

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The expected return

 The first characteristic of a return distribution is its expected value, or the

expected return, denoted E(R), which is a measure (but not the only possible
measure) of the ‘average’ return

 Suppose that we know that a stock has the following pattern of returns and
probabilities

Outcome Return Probability

Good 10% 0.25
Medium 5% 0.50
Bad 0% 0.25

 The expected return of the stock is given by the probability-weighted average

of the three returns
n
E ( R )   pi Ri  0.25 *10%  0.50 * 5%  0.25 * 0%  5%
i 1

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The variance of returns

 The second characteristic of a return distribution is its variance, which

measures the average squared difference between each return and the mean
return or expected return, and is a measure (but not the only possible measure)
of the ‘dispersion’ or ‘spread’ of returns

 For the example above, we have

Outcome Return R-E(R) Probability
Good 10% 5% 0.25
Medium 5% 0% 0.50
Bad 0% -5% 0.25

 The variance of the stock is given by the probability-weighted average of the

squared difference between the actual return and the expected return
n
var(R)   pi ( Ri  E ( R))2  0.25 * (5%)2  0.50 * (0%)2  0.25 * (5%)2  0.00125
i 1
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The standard deviation of returns

 If returns are measured in units of ‘%’ (as opposed to being measured as a

decimal fraction), the units of variance is ‘%2’, not ‘%’

 Often, a more useful measure is the standard deviation of returns, which is

the (positive) square root of the variance, and has the same units as returns

SD ( r )   var( R )

 For the example above, we have

SD ( R )  var( R )  0.00125  3.54%

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The covariance of returns

 The joint probability distribution is characterised by the covariance of returns,

which measures the extent to which they move together

Outcome Return A Return B Probability

Good 10% 8% 0.25
Medium 5% 8% 0.50
Bad 0% 2% 0.25
We have E ( RA )  5% and E ( RB )  6.5% and so we can write
Outcome RA-E(RA) RB-E(RB) Probability
Good 5% 1.5% 0.25
Medium 0% 1.5% 0.50
Bad -5% -4.5% 0.25
n
cov(RA RB )   pi ( RAi  E ( RA ))( RBi  E ( RB ))
i 1

 0.25 * (5%)(1.5%)  0.50 * (0%)(1.5%)  0.25 * (5%)(4.5%)

 0.00075
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The correlation coefficient

 The covariance, like the variance, depends on the units of measurement of the
data. In order to know whether the covariance between two securities is
‘large’ or ‘small’, we need to know their respective variances

 It is therefore often useful to normalise the covariance by the square root of

the product of the variances of the two securities, which gives us the
correlation coefficient. The correlation coefficient is defined as
 A, B
 A, B 
 A B

 By construction, the correlation coefficient must lie between minus one

(perfect negative correlation) and plus one (perfect positive correlation)

0.00075

 For the above example, we have A, B   0.816
0.00125 0.000675

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Estimating the moments of returns 1

 The true return distribution (whether discrete or continuous) is unobservable

and so the population moments (i.e. the expected return, variance, standard
deviation, covariance and correlation) are unknown

 However, we can estimate them from a sample of returns, {rt , t  1,  , T } , using

the following estimators

Expected return Variance Covariance

T
1 T 1 T
rA 
T
r
t 1
A, t
2
ˆ 
A
1
T
 (r A, t  rA ) 2
̂ A, B   (rA, t  rA )(rB , t  rB )
T j 1
t 1

 Note that for the variance and covariance, the divisor (T – 1) is sometimes
used instead of T, but in large samples this will not make a significant
difference
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Estimating the moments of returns 2

 The moments of returns can easily be estimated using Excel’s built in

functions

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