1. Introduction

Question 1

I. What is the main objective of a firm?

Answer 1

To create Value

Question 2

I. Name the different kinds of value:

Answer 2

• Equity Value
• Enterprise Value
• Firm Value

Question 3

I. Name the different measures of Value.

Answer 3

• Accounting/Book Value
• Fundamental/Intrinsic Value
• Market Price (usually, referred as market value)
• Liquidation Value

Question 4

I. What is a good proxy for the Liquidation Value?

Answer 4

Liquidation value: if we sell all the assets one by one, how much will someone be willing to pay for it
Sometimes as a proxy of this value we tend to use the accounting value.

Question 5

I. Explain the different measures of Value.

Answer 5

• Market Price: We tend to use market price as a proxy of the Fundamental Value
  -Book Value: We tend to use book value as a proxy of liquidation value

Question 6

I. When financial markets are efficient market price can be used as …

Answer 6

a proxy of the fundamental value (the real market value)

Question 7

I. If the company is listed, we can calculate Net Debt as …

Answer 7

(Nº of bonds* Bonds price) - MNVOA

Question 8

Please explain in more detail the liquidation value

Answer 8

Liquidation value is the value which would be obtained if all assets were sold, and debt and all liabilities were paid back.

Question 9

I. Anytime the liquidation value is persistently higher than the financial value,

Answer 9

the company will be worth more “dead” than staying “alive”, for its shareholders.

Question 10

I. What is the goal of financial management?

Answer 10

To maximize the value of the owner’s equity.

Question 11

I. What is the objective in conventional corporate financial theory?

Answer 11

To maximize the value of the firm.

Question 12

I. Are these objectives compatible?

Answer 12

Yes, but only if debt holders protect themselves from expropriation of value
- Debt holders are not the only stakeholders of a company

Question 13

I. Concept of stakeholders

Answer 13

All individuals or entities affected by the firm’s actions, objectives and policies.

Question 14

I. Describe the management shareholders’ agency relationship.

Answer 14

Managers act on the behalf of shareholders. However, they also have their own utility function to maximize.
In other words, they want to keep their job, and receive the higher income possible, this results in a problem: managers have different interests from shareholders.

Question 15

I. Is it possible to eliminate agency costs?

Answer 15

It is not possible to eliminate agency costs, but it is possible to reduce it.
For instance, Stock options may be a solution for this problem.

Question 16

I. How is the relationship between managers and creditors?

Answer 16

Creditors cannot control management, therefore, they will be exposed to the risk of wealth expropriation by managers or shareholders.
Managers are on the same side as shareholders. However, for the best interest of shareholders, they have to maintain a good relationship with debt holders.

Question 17

I. Explain the relationship between managers and Financial Markets.

Answer 17

Managers might manipulate
information in order to misinform
the markets.

Question 18

I. If debt holders are protected, is there a way to create value for shareholders?

Answer 18

The only way to do so is by increasing the Enterprise Value. Equity Value increase comes from an increase in Enterprise Value.

Question 19

I. If I look to the increase of share price, can I ensure that the Enterprise value as also increased?

Answer 19

No. EV will only reflect share price if I am able to ensure that:
1. Markets are efficient (share price as a good proxy of share value)
2.Managers are not able to expropriate value from debt holders.

Question 20

I. Regarding the relationship between managers and society, what is the main problem that needs to be solved?

Answer 20

Firms might jeopardize the interests of society as a whole and those costs might be difficult to allocate to firms (e.g. pollution).
Sometimes companies can increase EV, by expropriating society’s value
- Managers are not responsible to protect society.
- Governments should act in the interest of society, by imposing laws, regulations and implementing fines.

Question 21

I. What type of value should a firm maximize?

Answer 21

The main objective must be to maximize stock prices.
Even though the main objective of the firm is to maximize firm value, value creation may be measured by changes in stock prices, providing
that agency costs are minimized:
- Creditors are protected against the risk of wealth expropriation by shareholders;
- Management decisions do not impose costs (externalizes) on society;
- Managers do not manipulate information and do not succeed in cheating the markets (efficient markets).
If so, share price can be used to monitoring if managers act in the interest of shareholders.

Question 22

I. How can a firm create value?

Answer 22

Through 3 types of decisions.
1. Investment Decisions
2. Financing Decisions
3. Dividend Decisions

Question 23

I. How can a firm create value using investment decisions?

Answer 23

The firm can invest in assets offering a return higher than the required rate of return (hurdle rate).
- The hurdle rate must reflect the investment risk and the financing mix.
- The return on the asset must take into consideration the amount and timing of cash-flows.

Question 24

I. How can a firm create value using Financing decisions?

Answer 24

By finding the optimal capital mix to finance investments and the nature of debt which better meets the needs of the corporation.
- The optimal mix of equity and debt maximizes enterprise value.
- The nature of debt depends on the characteristics of the enterprise assets.

Question 25

I. How can a firm create value using Dividend decisions?

Answer 25

The firm should return to shareholders any cash exceeding investments offering a return higher than the expected rate of return
- It will have to understand how much cash to return will depend on present and future investment opportunities.
- Dividend policy will depend on shareholders preference for cash or stock dividends.

Question 26

II. Explain the effective rate of return.

Answer 26

Effective rate of return: serves as an ex-ante measurement of the performance of an investment; it is the investment´s internal or implicit rate of return, the one that equals the value of the investment to its price or cost.

Question 27

II. Explain the required rate of return.

Answer 27

The required rate of return is the one that allows us to determine the value of an investment. The required rate of return is based on the idea that any investment must provide a rate of return equal to a risk-free rate plus a risk premium, depending on the degree of uncertainty affecting the investment´s future cash flow.

Question 28

II. Explain the expected rate of return.

Answer 28

The expected rate of return is a function of the investment’s price (or cost) and future cash flows. Being these cash flows uncertain, the expected rate of return is also uncertain, possibly a random variable. Here lies its risk, which will have to be measured to be considered in estimating risk premiums to be included in the required rates of return.

Question 29

II. What is the importance of discounted value.

Answer 29

It allows the company to compare cash-flows obtained in different periods of time.
The value of any asset is the present value of expected cash
flows on it.

Question 30

II. What is an annuity? And a growing annuity?

Answer 30

-Annuity: a constant CF that occurs at constant intervals for a limited period of time.
- Growing annuity: A CF that grows at a constant rate (g)–lower than r–for a limit period of
time (n).

Question 31

II. What is perpetuity? And growing perpetuity?

Answer 31

• Perpetuity: A constant CF that occurs at constant intervals forever.
• A (constant) growing perpetuity: A CF that grows at a constant rate (g)–lower than r–forever.

Question 32

II. What are the main points about the expected return and Price (P)?

Answer 32

Expected return main points:
- Similar to internal rate of return (IRR), i.e., the rate of return that equals the value of an investment to its market price or cost;
- It is a function of the price (or cost) of the investment and of the future cash-flows to be generated by that investment.
- Cash-flows are uncertain, that’s why the expected rate of return is also uncertain (uncertainty = risk, must be measured)

Question 33

II. In what consists the random nature of the expected rate of return.

Answer 33

The random nature of the expected rate of return requires that a probability distribution is assigned to it.

Question 34

II. What are the main points about the required return and value (V)?

Answer 34

Main points about the required return:
- Rate of return required by an investor to buy/invest in a specific asset.
- It allows the determination of the value of an investment;
- It is equal to the risk-free rate of return* plus a risk premium which must be a function of the degree of uncertainty affecting the investment future cash-flows.

Question 35

II. What is the historical return:

Answer 35

• A performance evaluation measure of an investment, an ex-post measure.