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    Corporate Finance: A Simple Introduction
    Corporate Finance: A Simple Introduction
    Corporate Finance: A Simple Introduction
    Ebook92 pages1 hour

    Corporate Finance: A Simple Introduction

    By K.H. Erickson

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    About this ebook

    Corporate Finance: A Simple Introduction provides an accessible guide to the principles and methods of corporate finance, with equations and examples, empirical evidence, and diagrams to illustrate the analysis.

    Examine the traditional theory of optimal debt and equity financing, how Modigliani and Miller’s theory on capital structure differs, and the impact corporate and personal taxes or market imperfections may have on the optimal capital structure.

    Understand dividend irrelevance theory, the factors driving the dividend decision, and why companies may prefer share repurchases to paying dividends.

    Explore option theory with long and short calls and puts explained, and the Black-Scholes option pricing model and the factors affecting it detailed. See the variety of ways traders may use options, as speculators make profits betting on price movements, hedgers eliminate risk, and arbitrageurs may make risk-free profits exploiting undervalued options.

    Look at why companies seek mergers & acquisitions, the merger process they undertake, how a firm can improve its chances of making an acquisition, and some takeover defences for resistant firms. Empirical evidence on merger performance is presented, and alternative explanations examined.

    LanguageEnglish
    PublisherK.H. Erickson
    Release dateOct 3, 2018
    ISBN9780463935965
    Corporate Finance: A Simple Introduction

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      Book preview

      Corporate Finance - K.H. Erickson

      Corporate Finance: A Simple Introduction

      By K.H. Erickson

      Copyright © 2018 K.H. Erickson

      All rights reserved.

      No part of this publication may be reproduced, stored in or introduced into a retrieval system, or transmitted in any form or by any means, including electronic, mechanical, photocopying, recording or otherwise, without the prior permission of the author.

      Also by K.H. Erickson

      Simple Introductions

      Accounting and Finance Formulas

      Applied Econometrics

      Choice Theory

      Corporate Finance

      Corporate Finance Formulas

      eBay

      Econometrics

      Economics

      Environmental Economics

      Financial Economics

      Financial Risk Management

      Game Theory

      Game Theory for Business

      International Relations

      Investment Appraisal

      Investment Formulas

      Marketing Management Concepts and Tools

      Mathematical Formulas for Economics and Business

      Methods of Microeconomics

      Microeconomics

      Security Valuation

      Table of Contents

      1 Introduction

      2 Capital Structure

      2.1 Firm Value and the Cost of Capital

      2.2 Traditional Theory of Capital Structure

      2.3 The Theory of No Optimal Capital Structure

      2.4 The Effects of Taxation

      2.5 Market Imperfections

      3 Dividend Policy

      3.1 Dividend Irrelevance Theory

      3.2 The Dividend Decision

      3.3 Share Repurchases

      4 Option Theory

      4.1 Options Contracts

      4.2 Black-Scholes Option Pricing Model

      4.3 Options Strategies

      5 Mergers and Acquisitions

      5.1 Merger Basics

      5.2 Merger Motivations

      5.3 Merger Methods and Takeover Tactics

      5.4 The Value Impact of Mergers

      6 Bibliography

      1 Introduction

      Corporate Finance is the field of a company that deals with its financial and investment decisions. A company must evaluate the relative benefits of equity and debt funding, and decide on its capital structure, and a chapter on this subject details the difference between debt and equity and how this can affect a firm’s value. First, the traditional theory is put forward, that there is an optimal capital structure and level of debt, before Modigliani and Miller’s theory that there is no optimal capital structure, as any benefits brought about by taking on debt are cancelled out by rising equity costs. The remainder of the chapter looks at the effect that the realities of corporate and personal taxes, asymmetric information, financial distress, and agency costs have on the theory of capital structure.

      Shareholders are the owners of a company, and a chapter on dividend policy looks into how managers may attempt to increase shareholder value. The theory that the dividend payout ratio is irrelevant as shareholders can create their own dividends is put forward, before the idea that investors’ interpretation of firm policy may influence the dividend decision. Share repurchases are a popular method of returning profits to shareholders, and a section explains the benefits associated with this policy.

      Companies are exposed to price volatility and risk in their daily activities, and often use financial derivatives to reduce and hedge against this risk, or to profit from it, and a chapter on options details how this is performed. European and American calls and puts are explained, with diagrams and numerical examples detailing what an investor requires to generate a profit. A section on the Black-Scholes Option Pricing Model shows how European call and put options are priced, and the factors determining increases or decreases in this price. Various option strategies are then detailed with diagrams and numerical examples, to show how speculators, hedgers, or arbitrageurs can use options to profit from price volatility, eliminate risk, or generate risk-free profits respectively.

      Mergers and acquisitions are an important field of corporate finance, and common motivations for mergers are explained, along with some situations where they may be beneficial and some where they may not. The process a firm goes through to undertake a merger or acquisition is detailed, with the relative benefits of cash and share funding assessed, relative value ratio and exchange ratio calculations explained, and possible takeover defence strategies presented. Finally, the value impact of mergers on different groups is examined, with empirical evidence on why mergers and acquisitions may disappoint looked at using alternative theories.

      2 Capital Structure

      2.1 Firm Value and the Cost of Capital

      The market value of a firm equals the market value of its equity added to the market value of its debt. Equity refers to a stock or other security which represents an ownership interest, and the equity value on a company’s balance sheet will equal the total of owners or shareholders’ funds, and retained earnings or losses. Debt refers to borrowed funds, and the debt value on a balance sheet will be the total sum of money due to be paid to others, either in the short-term (current liabilities) or loans to be paid back in the long-term (non-current liabilities).

      A firm can increase its equity value by selling more shares to investors, which gives others a share of ownership over the company in return for their money. And a firm can increase its debt value by increasing its liabilities, either privately via taking bank loans or publicly by selling investors bonds which guarantee regular interest payments and/or a payoff at maturity. As these options will both offer a future stream of earnings for a firm, either from shareholders or from a bank or bond investors, each may to be used increase a firm’s market value.

      The sum (∑) of a firm’s stream of earnings for each time period t (Xt), discounted by Q the appropriate discount rate [1 / (1+ Q)] which is weighted for the time period (t), gives a firm’s value:

      Firm Value, V = ∑ [Xt / (1 + Q)t]

      Discounting of earnings is required due to the time value of money, where a sum of money to be received in the future is worth less than if the same sum of money was received today. This is because future earnings are expected to always be higher than current earnings due to interest or other profitable investment opportunities. The appropriate discount rate, Q, to use to make earnings received at different time periods in the future comparable is a firm’s cost of capital, k (Q = k). This refers to the opportunity cost for a firm when it uses its capital (i.e. financial resources) for a specific investment, and it is the next best return (for the same level of risk) forgone when an

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