Theory Flashcards
Name the corporate finance models of lu1
Shareholder model (only FV)
Refined shareholder model (FV + b * Sv + C * EV) (B and C < 1)
Stakeholder model = FV + b* Sv
Integrated model FV + SV + EV
What are externalities
Cost or benefits created by the organisation that are borne by others
How do we align FV, SV and EV?
Charge ‘‘true prices’’ that include hidden EV and SV
Why is integrated value advantageous for companies?
Ethical case -> companies are expected to be ethical, both by employees and consumers
Business case -> Companies that create SV and EV are more likely to be healthy FV-wise in the long run
Four driving forces between internalisation of SV and EV into FV
License to operate
Regulation and taxation
Technological advancement
Customer preferences
Formula for expected transition losses (ETL) for company i in sector j (ETLij)
ETLij = EATij * PT * LGT
EAT = exposure to transition
PT = probability of transition
LGT = loss given transiction
Can be further broken down into
b * vi * pt * (1-a)
With b = level of transition in sector j, and
vi = value of company i
a= adaptability of company a
Current and future benefit should be treated the same. If so, why is there even a discount rate for social/environmental value?
Growth rate of consumption and elasticity of marginal utility of consumption
so accounting for productivity and consumption increases ( I think )
Name social factors
Labour practices
combatting poverty
Interaction with commonuities
Name environmental factors
Pollution
Use of scarce resources
Restoration of nature
How to calculate consumer surplus?
DeltaP * Q * 1/2
So difference between current price and price where Q = 0
Somewhere else it says Sales / Price elasticity * 1/2
Name two types of valuation
Relative valuation (e.g., P/E)
Absolute valuation (E.g., DCF)
What could be a problem with relative valuation and integrated value?
It doesn’t account for integrated value and future performance as a result of possibly lacking EV and SV.
What is a problem with measuring integrated value?
We can hardly measure sustainability -> ESG ratings are poor, so we need to go deeper
Describe double materiality
Financial materiality only looks at how E and S values can impact finance -> e.g., by decreasing long-term cashflows?
Impact materiality only looks at outward impact, so co2 emissions
Double materiality equals integrated value, you look at FV + EV + SV = IV
So you don’t only take into account possible future effects on FV, but you take the values into account separately.
What are steps for calculating integrted value?
1 Analysing social and environmental factors (purpose + stakeholder map)
2 Materiality
3 Quantification
4 Monetisation
5 Integrated valuation
6 Conclusions
What is the 2.2% discount rate made up of?
2% social discount rate
0.2% risk premium
What is the paradox for strong form EMH?
For strong form EMH, all information is incorporated immediatly, and thus stock analysis has no use.
However, information can only be incorporarted through analysis / information discovery.
What valuation methods are best for integrated value?
Fundamentals -> better understanding of company
Comparables lack detail
Summarize adaptive markets hypothesis
Price efficiency of markets depends on number of analysts + quality of analysis -> can lead to inefficiences and not fully incorporating S&E values
Debt to equity ratio
D/E
Debt to value ratio
D/(D+E)
How does S&E relate to MM propositions?
Financially material S and E externalities are already incorporated in the basic MM model
Because future cashflow predictions incorporate the possibilities of impacts
However, if we know there will never be a carbon tax, the externalities are not financially material, thus not incorporated.
How should we record unpriced positive and negative externalities on an integrated balance sheet?
Positive externalities are assets, negative externalities are debt
Explain economic and financial distress
A firm that makes significant losses is in economic distress
Whether economic distress results in in financial distress depends on the firm’s leverage
What are direct cost of bankruptcy?
Legal expenses, court costs, advisory fees
What are indirect costs of bankruptcy?
Missed investment opportunities
ability to compete in product markets
Loss of customers, employees and suppliers
Fire sale of assets
Delayed liquidation
Loss of receivables
costs to creditors
Explain who bears financial distress costs (hint: ex-post; ex-ante)
Ex-post; debt holders pay for the cost of financial distress.
However, this is priced in ex-ante with higher interest rate to keep ER for debt holders acceptable
So shareholders pay the cost of financial distress if they need to raise new financing. But if debt was issued in the past at a fixed rate, the value of debt will drop and thus debt holders pay the cost.
What is the tradeoff theory?
Trading off the benefits of the tax shield to the costs of financial distress to find optimal capital structure
Explain how debt can make equity resemble a derivative
Limited liability gives equity a call-option like payoff function
Describe moral hazard in relation to debt
Shareholders may take excessive risk at the expense of debt holders. While firm value may decrease, equity value can increase because debtholders bear losses.
Describe debt overhang
Shareholders may forgo positive NPV projects. They do this because positive NPV projects will mostly benefit debtholders in case of high leverage. So in contrast to risk shifting where negative NPV projects are chosen, positive NPV projects are foregone -> under-investment.
Describe agency benefits of debt
-May incentivize owner to work harder than with equity financing
-Reduces wasteful spending by managers
If a company is highly leveraged managers have the incentive to operate in the best way for shareholders to not go bankrupt and lose their job
Describe the participation constraint
The amount of equity investors need to break even, assuming high-effort.
So if payoff is 9.6m and financing requirement is 6m, you need a 6/9.6 = 62.5% stake
However, if a 37.5% stake for the owner is not sufficient to incentivize high-effort, this does not work.
What happens if the share investors require will imply low effort?
The original owner/manager will pay for moral hazard, it’s priced in.
What is the leverage ratchet?
Shareholders may not reduce or even increase leverage even if that increases firm value
Name IPO advantages and disadvantages
-Greater liquidity: private equity investors and initial foundres can diversify
-Better access to capital for the compnay itself
but;
-Equity holders become more widely dispersed making monitoring of the firm more difficult
-The firm must satisfy regulatory requirements
Describe the types of underwriting agreements
-Best effort: no guarantee, best-effort to sell
-Firm commitment: guarantee to sell the stock; or buy it themselves
-Auction IPO: takes bids and then sets price in a way that clears the market (e.g., google 2004)
Describe IPO underpricing and winne’s curse
Stocks are being sold for less than they should be on average, large first-day gains, costing original shareholders
-an explanation for this is that good IPOs are oversubscribed and bad ones are undersubscribed. So, investment in good IPOs is rationed while fully investing in bad IPOs
-Furthermore, winner’s curse is the saying that the highest bidder likely overestimated the value of the item being bid on. You win, but probably pay too much.
What is the pecking order under adverse selection
Firms prefer to use cash, then debt then equity to finance investments
The least information-sensitive source of financing reduces the adverse selection costs (cross-subsidy from good to bad firms)
Name two outcomes from the indistinguishable lemon principle
How can we solve cross-subsidiy due to moral hazards?
- external equity financing -> stil cross subsididy
- debt -> less so, but probably still cross subsidy
- internal funds -> implies risk free debt, no cross-subsidiy as lemons will not want to invest themselves
- collateral/risk-free debt -> same as before, debtors know its a good firm if it offers collateral
Theoretically, dividend policy is irrelevant as shares should appreciate and investors can sell shares to free up cash. Why may investors still like dividends?
-Transaction costs: homemade dividends require time and fees
-Mental accounting: spend the interest, keep the principal
-Agency costs: commiting to dividends keeps manager from excessive spending
What is a tax advantage for share repurchases compared to dividends?
-Capital gains are often less taxed
-Selling shares can be timed, dividends can’t
Explain dividend signalling
Dividend increase signals good earnings expectations, and decrease the opposite
Indirect costs of financial distress
Indirect costs of financial distress
* Losing valuable (customers), employees, and suppliers in anticipation of financial distress
* Inability to invest into the right projects
* Inefficient liquidation of assets (i.e., below market prices because there is not much demand or too specific)
* Inability to respond to competition
Time and focus wasted on negotiating with creditors
Describe the asset-substitution problem
Leverage incentivizes shareholders to replace low-risk assets with risker ones, despite possibly negative NPVs
What is the the company’s integrated value (IV) equation?
Max IV: FV + SV + EV
The traditional goal is maximising financial value for shareholders. The goal function is broadened toward steering on financial value (FV), social value (SV), and environmental value (EV) in an integrated way.
What are the four driving forces behind the internalisation of SV and EV into FV:
License to operate
Regulation and taxation
Technological advancement
Customer preferences
Dynamic perspective, but timing is uncertain
Why is it in companies’ interest to manage for integrated value?
Two reasons
If company management neglects SV or EV, that will hurt long-term FV as well. Two reasons:
- Ethical case - license to operate -> corporate responsibility (case for SV and EV)
- Business case – long-term value creation (case for FV)
Companies that create value on SV and EV are more likely to be value creative on FV in the long run
As external impacts are being internalised, they affect FV
I. Planetary Boundaries
What is the purpose of the planetary boundaries?
A. Defines the limits in nine areas of the planet which humanity must not exceed to maintain a liveable planet.
B. Outlines the maximum GDP levels beyond which climate change will be irreversible.
C. Shows the amount of import / export that a country should not exceed, to protect domestic companies.
D. Indicates the annual date when the earth’s yearly resources have been exhausted.
A. Defines the limits in nine areas of the planet which humanity must not exceed to maintain a liveable planet.
II. Integrated shareholder model
How does the integrated stakeholder model differ from the traditional version?
It recognises that good relations with stakeholders might boost financial firm value.
III. Social and ecological value creation
A company that generates economic profits, will likely…
A. Create social and ecological value.
B. Destroy social and ecological value.
C. Create social value but destroy ecological value.
D. Destroy social value but create ecological value.
E. All of the above are possible.
E. All of the above are possible.
IV. Price Internalisation
If the negative externalities of a product are internalised into the price, but the cost of sales remains the same, how does a firm’s gross profit margin change?
A. Increase
B. Decrease
C. Remain
D. Not possible to say based on the provided information.
A. Increase
V. Corporate Governance
Which of the following broad statements about corporate governance issues is false?
A. The two core problems of corporate governance aggravate one another.
B. Information asymmetry can be broken by social and ecological reporting.
C. Amount of debt does not impact the main corporate governance problems.
D. Corporate governance must consider non-financial factors.
B. Information asymmetry can be broken by social and ecological reporting.
VI. Governance and company value
How does governance impact the valuation of a company?
Strong governance reduces the risk of a firm and accordingly its cost of capital.
Why are EV and SV necessary when there is already FV
EV and SV focus on externalities that are not priced in FV but are necessary. Regulation will not be perfect
* Record unpriced positive externalities as assets
* Record unpriced negative externalities as debt
* Residual value is equity = net externality
What are examples of priced E and S externalities that are financially materialised
- (Expected) carbon pricing and other regulations
- Consumers’ higher willingness to pay for environmentally friendly products
- Positive reputational effects on marketing and brand
- Technological risks associated with operating carbon-intensive assets
What is value creation? And what is the difference in value creation for a responsible company and “irresponsible” company
In financial terms, value creation is defined as an increase in the net present value (NPV) of a company’s projects
Currently, FV is often generated at the expense of SV and EV as resources are depleted without sufficient investments in maintaining them
Responsible companies manage for integrated value creation (profit and impact) rather than merely shareholder value (profit)
What is the the planetary boundaries framework? How would integrating SV and EV for companies around to world help manage this framework?
It is defined a safe operating space for humanity within the boundaries of 9 productive ecological capacities of the planet
The planetary boundary lies at the intersection of the green and orange zones
Currently, many companies are value destructive on SV or EV. For society and the economy to operate within social and planetary boundaries, we need companies on aggregate to stop being value destructive on SV and EV
What is the difference between a succesful and unsuccesful transition
What is the formula to calculate expected transitionloss
Expected transition loss =
B = between 0 and 1. if b is very small the industry is not in transaction, 1 whole sector is moving
PT = how likely will it happen
LGT = if it happens, how quick is your loss
(1-a) = a: 0, not prepared at all (working in an old economy), fully prepared a = 1
What does the societal discount rate consist of?
How do we measure SV and EV?
*Value flow formula and dcf formula
Example: What are the steps of calculating the value flow of a carbon emission project?
* from CF to VF
Example: What are the steps of calculating the IV of a project?
How do you calculate the consumer surplus? and what is it used for?
Well-being of customers – calculated as consumer surplus, which is the difference between the price of a product and what consumers want to pay
perpetuity formula
What are the responsibilities of the General Partner (GP), Investment Manager and Limited Partners (LPs) within a PE
What is the cost of capital of each company
a) The WACC of A: 5% - calculated as 90/1503% + 60/1508%
b) The integrated cost of capital of B: 4.5% - calculated as 90/1803% + 60/1808% + 30/1802%
c) The integrated cost of capital of C: 6.5% - calculated as 90/1003% + 60/1008% + -50/1002%
How do you calculate carbon emission value flow?
mn metric of tons * quantity
II. Consumer surplus
Assuming a company has a revenue of €200 million and a price elasticity of demand of 1.67. What would be the estimated consumer surplus?
Modigliani-Miller (MM) Proposition 2
Let 𝐸 = market value of equity, 𝐷 = market value of debt, 𝑈 = market value of unlevered equity, and 𝐴 =market value
of the firm’s assets
MM Proposition 2: The cost of capital of levered equity increases with the firm’s market value debt-equity ratio
(4) Fallacy: ”Paying out cash through share repurchases is better than dividends because repurchases support the share price.”
There is no “Mechanical effect” that shows why is better than the other.
What is the updated MM Proposition 1 (with taxes)
the total value of the levered firm exceeds the value of the firm without
leverage due to the present value of the tax savings from debt:
What is the MM Proposition 2 with taxes
With tax-deductible interest, the effective after-tax borrowing rate is
𝑟(1 − 𝜏c) and the weighted average cost of capital becomes:
What is the tradeoff theory?
Tradeoff theory tells us the firm should balance the cost of financial distress against the benefit of the tax shield
* (+ other agency costs/benefits)
Why can equity seen as a call option on the firm’s assets with strike
price (1 + r)𝐷
Equity represents ownership in a company and is likened to a call option on the firm’s assets. A call option gives the holder the right (but not the obligation) to buy an asset at a predetermined price (the strike price) by a certain date.
Limited liability gives equity a call option-like payoff function
Why is risky debt like risk-free debt with face value 𝐷 and a short position
in a put option on the firm’s assets with strike price(1 + r)𝐷:
Risky Debt as a Short Position in a Put Option: Risky debt holders are compared to being in a short position in a put option on the firm’s assets. A put option gives the holder the right (but not the obligation) to sell an asset at a predetermined price (the strike price) by a certain date.
What prevent banks from levering up too much and taking excessive risk ?
financial regulation mandates high capital requireme
