Lecture Notes in Introduction to Corporate

10275_9789813149885_TP.indd 1 6/2/17 9:25 AM World Scientific Lecture Notes in Finance

ISSN: 24249955

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Published: Vol. 1 Lecture Notes in Introduction to by Ivan E. Brick (Rutgers Business School at Newark and New Brunswick, USA)

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Lecture Notes in Fixed Income Fundamentals by Eliezer Z. Prisman (York University, Canada)

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Shreya - Lecture Notes in Introduction to Corporate Finance.indd 1 02-02-17 8:52:06 AM World Scientific Lecture Notes in Finance – Vol. 1

Lecture Notes in Introduction to Corporate Finance

Ivan E Brick Rutgers Business School at Newark and New Brunswick, USA

World Scientific

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Library of Congress Cataloging-in-Publication Data Names: Brick, Ivan E., author. Title: Lecture notes in introduction to corporate finance / Ivan E Brick (Rutgers Business School at Newark and New Brunswick, USA). Description: 1 Edition. | New Jersey : World Scientific, [2017. | Series: World scientific lecture notes in finance ; Volume 1 | Includes bibliographical references and index. Identifiers: LCCN 2017001764| ISBN 9789813149885 (hardcover) | ISBN 9789813149892 (pbk.) Subjects: LCSH: Corporations--Finance. Classification: LCC HG4026 .B6676 2017 | DDC 658.15--dc23 LC record available at https://lccn.loc.gov/2017001764

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CONTENTS

About the Author ix

Chapter 1. Introduction 1 WhatisFinance?...... 1 WhatdoInvestorsWant?...... 2 What are the Concerns of Corporate Management? . . 8 WhatistheObjectiveoftheFirm?...... 13 WhyMaximizetheValueoftheStock?...... 15 EfficientMarkets...... 17 Remaining Misgivings Concerning Value Maximization...... 18

Chapter 2. Time Value of Money 21 TheTimeValueofMoney...... 21 Finding the Present Value of Future Cash Flows . . . . 21 UsingExceltoCalculatePresentValue...... 24 LumpSumExample...... 25 Using a Financial Calculator to Calculate Present Value...... 27 LumpSumExample...... 27 ThePresentValueofAnAnnuity...... 29 InternalRateofReturn-YieldtoMaturity...... 43 ValuingPerpetuities...... 49

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FutureValue...... 54 MoreAdvancedProblems...... 60 SolutiontoMoreAdvancedProblems...... 62

Chapter 3. Risk and Return 69 Introduction...... 69 ExpectedReturn...... 71 Risk...... 73 The Mean-Standard Deviation Framework ...... 74 IntroductiontoPortfolioFinance...... 77 RiskandReturnProblems...... 89

Chapter 4. The Capital Asset Pricing Model 97 Introduction...... 97 WhatistheObjectiveofthisChapter?...... 98 Assumptions...... 99 TheCapitalAssetPricingModel...... 105 BacktotheInterview...... 106 SomeObservations:EfficientMarkets...... 109 AdvancedTopics-CalculatingBeta...... 110 CAPMProblems...... 115 AnswerstotheProblemSet...... 116

Chapter 5. Capital Budgeting and Company Valuation 119 WhatisCapitalBudgeting?...... 119 WhatisNetPresentValue?...... 120 InternalRateofReturn...... 122 WhatCouldGoWrong?...... 124 Will NPV and IRR Always Give the Same Answer?...... 124 Does NPV Always Work? — Capital Rationing . . . . . 126 Does NPV Always Work? — Unequal Lives ...... 128 How Do We Find the Cost of Funds? ...... 132 CapitalAssetPricingModel...... 137 MoreComplicatedATWACOC...... 138 February 6, 2017 14:30 Lecture Notes in Introduction to Corporate Finance 9in x 6in b2704-fm page vii

Contents vii

HowDoWeDefineCashFlows?...... 143 IncrementalCashFlows...... 146 CaseStudy-FirmValuation...... 150 SolutionforCaseStudy...... 150 CapitalBudgetingAppendix...... 153 Do the Various Capital Budgeting Approaches Yield IdenticalNPVs?...... 155 CapitalBudgetingProblems...... 161 More Advanced Capital Budgeting Problem ...... 164 SolutiontoProblemSet...... 165

Chapter 6. The Financing Decision 169 WhatistheFinancingDecision?...... 169 OperatingversusFinancialLeverage...... 173 Question: What Happens to EPS as Leverage Changes?...... 176 What Are the Factors that Determine the Optimal FinancingMix?...... 177 CostofCapitalandLeverage...... 186 FinancingDecisionProblems...... 192 Solution to the Financing Decision Problem Set . . . . 193 AdvancedFinancingDecisionProblems...... 196 Solution to the Advanced Financing Decision ProblemSet...... 198

Chapter 7. Leasing versus Buying or is it Leasing versus Borrowing? 203 Introduction...... 203 LeasingforCorporations...... 205 TrueLeaseorInstallmentSale...... 216 WhyisthereLeasing?...... 217 Subsidized Loans ...... 218 Bond Refunding ...... 220 MultipleChoiceQuestions...... 223 February 6, 2017 14:30 Lecture Notes in Introduction to Corporate Finance 9in x 6in b2704-fm page viii

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AdvancedProblems...... 227 SolutiontotheAdvancedProblems...... 228

Chapter 8. Mergers and Acquisitions 233 TheBoardMeeting...... 233 TypesofMergers...... 234 Issues Concerning GEM’s Acquisition Policy ...... 238 EvaluationofMergers...... 239 GEM’sAcquisitionPolicyRevisited...... 242 MergerProblem...... 244 SolutiontotheProblem...... 245

Epilogue 247 ConcludingRemarksandAppreciation...... 247

Index 251 February 6, 2017 14:30 Lecture Notes in Introduction to Corporate Finance 9in x 6in b2704-fm page ix

ABOUT THE AUTHOR

Professor Ivan Brick joined Rutgers Business School at Newark and New Brunswick in 1978. He has been the Chair of the Finance and Economics department since 1996. Professor Brick has pub- lished numerous papers in academic journals such as the Journal of Finance, Journal of Financial Quantitative Analysis, International Economic Review, Review of Economics and Statistics, Journal of Industrial Economics, Journal of Corporate Finance,andFinan- cial Management. His research interests include corporate finance, optimal security design and corporate governance. Currently, he is an associate editor for the Review of Quantitative Finance and Accounting. Previously, he has served as an Associate Editor of Financial Management and Multinational Finance Journal.Profes- sor Brick has received several teaching awards at the Rutgers Busi- ness School. He received the “Outstanding Educator Award” by the 1995 Executive MBA Class. Professor Brick was awarded the “Far- rokh Langdana Excellence in Teaching Award” by the 2011 MBA Class. In 2012, the Newark Undergraduate Program awarded him the Dean’s Advisory Council Award for the “Most Knowledgeable Finance Professor”, “The Most Caring Finance Professor”, as well as “The Most Motivational Finance Professor”. For his outstanding service, Professor Brick was awarded the RBS Dean’s Service Award in 2013 and 2016.

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CHAPTER 1 INTRODUCTION

What is Finance? Consider a Euro coin. On the right side of the coin are the investors who wish to invest. They invest in financial securities such as stock and debt securities. They also invest in commodities, real estate and securities such as options. Many investors invest their money in banks in the form of deposits. The left side of the coin rep- resents the issuers. The government that supplies Treasury securities and municipal debt are the issuers. Issuers also include corporate entities that issue both stock and debt securities to the public. The proceeds of these sales are used to finance the business operations of the issuers. The thickness of the coin represents the medium where the two meet. We can think of the thickness of this ‘coin’ as the Financial Institutions. The job of the Financial Institutions is to match the investors demand for investment with the supply offered by the issu- ing entities. Financial institutions include banks that take savers’ deposits and lend them to a homeowner who wants to buy a house or to a business that uses the money to expand operations. They include investment banks, which “sell” new securities issued by corporations to the public. Now that you know something about the players of finance, we can now answer the question “What is finance?” Finance studies the interaction of investors and issuers of securities and how it impacts upon the return received by investors and the price obtained by

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issuers. It examines how investors make decisions regarding the choice of investments. Finance seeks to explain the factors that determine how firms finance their operations and whether to expand or contract. Finance also explains how firms use the markets to learn something about themselves. Finance describes how the organization of finan- cial markets impacts upon the prices of securities. Finally, finance explains the operations of financial institutions as they perform the important function of bundling of investors’ funds and transforming their investments into financing vehicles that are essential for the well-being of firms and governments. In this course, we provide an introduction to finance. There are chapters that describe some of the financial securities that are avail- able for investors. We will explain how risk and return are related and their impact upon choices made by firms and investors alike. We will provide you with basic tools to make rational decisions. We believe that mastering the subject matter will enable you to do your job better and help you plan your own personal investments. We will examine how firms allocate their resources and how they finance their operations. Finance is somewhat technical and it requires under- standing of the use of spreadsheets. We will provide you with a tuto- rial for that purpose. In addition, you will need to learn accounting fundamentals because the language of firms is accounting and you cannot evaluate firms without understanding income statements and balance sheets. We believe that you will learn much about finance and hopefully, you will enjoy the experience of working through this textbook.

What do Investors Want? One of the first questions you face as an employee is how you want to allocate the contribution to your 401(k) retirement plan. (Your employer will also ask about health care plans but that is another course. More importantly, you should figure out who will be your mentor and how to manage your career! But that is also for another day.) Your 401(k) retirement plan may offer several alternatives. One plan invests in the stock of your company. Another invests in the February 6, 2017 14:28 Lecture Notes in Introduction to Corporate Finance 9in x 6in b2704-ch01 page 3

Introduction 3

US domestic stock market. A third plan invests in overseas equities. A fourth plan only offers choices of treasury securities. A fifth plan invests in corporate bonds. How do you decide which plan is best for you? Before deciding, let us give a brief description of some basic investment vehicles. Savings Accounts: Most people have their own checking account. Many banks offer a minimal interest rate for keeping money in the checking account. Banks also offer Certificates of Deposits (CDs), with greater yields provided that you are willing to tie up your money for 1 year or more. For the most part, these investments are secure because of government insurance offered by the Federal Deposit Insurance Corporation (FDIC). Treasury Securities: These securities are offered by the US gov- ernment and are considered essentially free of any chance of default. Why? Because the government has the unique privilege of being able to run the printing press to pay its bills. They are very liquid and have current maturities from 1 month to 30 years. Treasury Securities with more than 1-year maturity pay interest twice a year and you receive the final principal payment on the last day of maturity. The current yield of 10-year Treasury as of June 6, 2016 is 1.723%. To find the current yield of a 10-year Treasury go to http://finance.yahoo.com/. Why are some bank CD rates higher than the treasury securities? For example, Discover is offering a 7-year CD for 2.10% as of June 6, 2016. One reason is that the CDs are not liquid (cannot be sold by the holder) and banks have to offer a higher yield to attract depositors. Municipal Bonds: These securities are issued by municipalities like states, counties and cities. The current yield of AAA (triple A) rated 10-year municipal bond as of June 6, 2016 is 1.65%. First, what do we mean by triple A rated? And why are municipal bonds offered at a lower rate than treasury securities? To answer these questions, one must realize that municipalities can default on their debt. New York City almost defaulted on its debt back in the 1970s. Orange County, California, the wealthiest county in the US as measured by per capita annual income, defaulted in the late 1980s. Remember, the US government can always print money to February 6, 2017 14:28 Lecture Notes in Introduction to Corporate Finance 9in x 6in b2704-ch01 page 4

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ensure payment of the loan, but municipalities cannot. If taxes and fees collected by the municipality are insufficient to pay off the loan, the municipality is not required to raise taxes and it has the right to default on the loan. There are rating agencies such as Moody’s and Standard & Poor’s (S&P) that rate the safety of such bonds. Triple A rated bonds are considered to be the safest. This answers the first question, but what of the second question? Income from municipal bonds are tax exempt from federal taxes and frequently exempt from state and local income taxes. As a result, the required yield of highly rated municipal bonds can be lower than treasury securities because the holder of municipal bonds does not have to pay taxes on the interest income. Corporate Debt: Most corporate debt securities have original maturities of greater than 5 years, pay interest semi-annually, and repay the principal amount at the final maturity date. Cor- porations enjoy limited liability, which means if the firm cannot make the payments it owes the debt holders, the owners of the firm do not have to make up the difference. Instead, the corpo- ration can default on its loan obligations. Moody’s, S&P and oth- ers agencies provide credit ratings for all of these bonds. The cur- rent yield of triple A rated 10-year corporate bond as of June 6, 2016 is 2.28%. To find current yields of triple A rated bonds go to http://finance.yahoo.com/bonds/composite bond rates. The average yield of high yield, or “junk bonds”, (bonds that the rating agencies do not regard to be safe bets) as of June 6, 2016 is 7.40%. The source for this yield is the Federal Reserve Bank of St. Louis at https://research.stlouisfed.org/fred2/series/BAMLH0A0HYM2EY. Common Stock: Holders of common stock are the theoretical own- ers of the firm. The shareholders appoint the board of directors who oversees management on behalf of shareholders. The return of com- mon stock is made up of two components: dividends and capital gains. Dividends come out of the firm’s earnings. Capital gains rep- resent the percentage change in the stock price from the time of purchase. The average return of stock as measured by the S&P 500 Index has been over 12% per annum since its inception more than