Corporate Finance (Lecture)

Corporate Finance
Prof. Dr. Peter Reichling

Otto-von-Guericke University Magdeburg
Faculty of Economics and Management
Chair in Banking and Finance
Corporate Finance Prof. Dr. Peter Reichling www.finance.ovgu.de
Corporate Finance
Lecture Program
A
1
2
Term Structure
Forward Rates
Swaps
B
3
Capital Structure
Capital Structure
Corporate Finance
Recommended Literature
Basic
Literature
Ross, S.A.; Westerfield, R.W.; Jordan, B.D.

(2008): Corporate Finance Fundamentals,
8th ed., Boston
Brealey, R.A.;Myers, S.C.;Allen, F. (2008):
Principles of Corporate Finance, 9th ed.
Further
Readings
Bodie, Z.; Kane, A.; Marcus, A.J. (2005):

Essentials of Investments, 7th ed., Boston
Corporate Finance
1 Forward Rates
1 Forward Rates
Structure
1.1
Goal of the Session
1.2
Spot and Forward Rates
1.3
Hedging of Forward Rates
1.4
Formulae for Bond Prices
1 Forward Rates
1.1 Goal of the Session
Given the spot curve, the interest rates for financial investments on
the capital market starting in the future (so-called forward rates)
are also determined implicitly; correspondingly, forward rates
concern the price for a capital commitment which takes place in
some future point in time
Forward rates represent the re-investment assumptions of the NPV
method if there is a non-flat term structure; we show, how forward
rates can be hedged
1 Forward Rates
1.2 Spot and Forward Rates
Notation
rt
Spot rate p.a. of a credit risk-free financial investment with

(remaining) maturity t ; corresponds to the yield of a zero
bond with (remaining) maturity t
ft
forward rate p.a. (fixed today) for a credit risk-free

financial investment which will begin at point in time t ;
therefore, ft is valid for period t
Remark:
Forward rates can also refer to several periods; therefore, you will
also find the notations ft (T ) and ft,T , where t denotes the beginning
and T denotes the end of the future financial investment
1 Forward Rates
Spot Rates
r2
r1
t=1
t=0
f1
rT
t=2
f2
t=T
f3
Forward Rates
1 Forward Rates
From the definition, the 1st year spot rate and the forward rate
for the 1st year (actually, the 1st period forward rate does NOT
refer to a future financial investment) are equal:
r1 = f 1
Under the assumption of an arbitrage-free market, in case of a

total investment period of T = 2 the return of a two-year
investment at interest rate r2 p.a. must correspond to the return
of a rolling one-period investment (of same amount) at interest
rates f1 and f2 :
1 r2
1 f 1 1 f 2
1 Forward Rates
Because of r1 = f1, for f2 we have:
1 r2
f2
1 r1
Analogously, it holds for any time horizon t = 1,2,...,T :
1 rt
1
t 1
1 rt 1
t
ft
10
1 Forward Rates
Assume, the 3-year spot rate for financial investments amounts to

10 % p.a. and the 2-year spot rate is 6 % p.a.
What is the forward rate for one year, that starts at point in time 2
(forward rate for the 3rd period)?
1 r3
1.13
f3
1
1 18.46 %
2
2
1.06
1 r2
3
11
1 Forward Rates
If the spot curve is normal, then forward rates are above the
corresponding spot rates:
rt rt 1
(1 rt )t
(1 rt )t
1 ft
1 rt
t 1
t 1
(1 rt 1 )
(1 rt )
f t rt
If the spot curve is inverse, then forward rates are below the
corresponding spot rates
If the spot curve is flat, then forward rates and corresponding

spot rates are identical (and equal to the yield)
Note:
Future spot rates must NOT be identical to todays forward rates
12
1 Forward Rates
Euro Yields, Spot and Forward Rates

at Dec 31, 2003
Rate
5%
Yield
Spot Rate
Forward Rate
4%
3%
2%
1
Maturity [Years]
5
13
1 Forward Rates
1.3 Hedging of Forward Rates - Example
In this example, we hedge the forward rate for the 2nd period using
zero bonds with a maturity of 2 years and 1 year, resp.
Assume, there are the following zero bonds traded on the bond
market (all face values amount to 100):
Maturity t
Price P (t )
1 Year
96.15
2 Years
90.70
A hedge is a position established in one market segment in the

attempt to offset an exposure to price risk of an equal but opposite
position in another market segment
14
1 Forward Rates
We (short-) sell a 1-year zero bond and invest the amount in a 2-year
zero bond
Short Position
Zero Bond 1
96.15
100
Long Position
Zero Bond 2
96.15
96.15
(= 90.7090.70 )
106.01
96.15
(=10090.70 )
100
106.01
Sum
By this strategy, the forward rate f2 = 6.01 % for the 2nd year is
hedged
15
1 Forward Rates
Forward rates can also be hedged by means of forward rate

agreements (FRAs)
Forward rate agreements ensure a fixed interest rate for a future

loan
In practice, forward rate agreements are applied in the form of

forward loans
16
1 Forward Rates
1.4 Formulae for Bond Prices
On an arbitrage-free bond market the price P of a bond with

(remaining) maturity T must be equal to the present value of its
cash flows (C = coupon, N = nominal value)
Formula using spot rates:
1 r1
1 r2
t 1
1 rt
...
C N
1 rT
1 rT
17
1 Forward Rates
Formula using forward rates:
C
1 f1
t 1
1 f1 1 f 2
...
C N
1 f1 1 f 2 1 fT
N
T
(1 f j ) (1 f j )
j
j
1
18
1 Forward Rates
Formula using yields:
C
C
C N
...
T
y
1 rTy 1 r y 2
1 rT
T
T
t 1
1 r 1 r
y
T
y
T
where rTy denotes the yield to maturity of a bond with

maturity T
But the valuation of bonds based on yields is NOT consistent with the
assumption of an arbitrage-free capital market if the term structure is
non-flat
19
Corporate Finance
2 Swaps
2 Swaps
Structure
2.1
Goal of the Session
2.2
Plain Vanilla Interest Rate Swaps
2.3
Valuation of Interest Rate Swaps
21
2 Swaps
Since the introduction of swaps in the early 1980s, these

contracts exhibited rapid growth rates
Swaps are widely used by financial institutions and corporations
for managing interest rate and currency risks
Interest rate swaps represent the largest component of the
global over-the-counter (OTC) market for derivative contracts
22
2 Swaps
Notional amounts outstanding of OTC derivatives (in $ billions)

Instrument
Total contracts
Dec. 2006
Dec. 2007
Dec. 2008
418,131
100%
595,341
100%
591,963
100%
40,271
9.6%
56,238
9.45%
49,753
8%
291,581
70%
393,138
66%
418,678
71%
18,668
4.5%
26,599
4.5%
39,262
7%
229,693
55%
309,588
52%
328,114
55%
43,221
10%
56,951
10%
51,301
9%
Equity linked contracts
7,488
2%
8,469
1.5%
6,494
1%
Commodity contracts
7,115
2%
8,455
1.5%
4,427
1%
Credit default swaps
28,650
7%
57,894
8%
41,868
7%
Other
43,026
10%
71,146
12%
70,742
12%
Foreign exchange contracts

Interest rate contracts:
FRA
Interest rate swaps
Options
23
2 Swaps
2.2 Plain Vanilla Interest Rate Swaps
A swap represents an agreement between two parties to

exchange a series of cash flows in the future
Various types of swaps include interest rate swaps, currency
swaps, equity swaps, commodity swaps, etc.
The most common swap type is the (plain vanilla) interest
rate swap
24
2 Swaps
In a (plain vanilla) interest rate swap one party pays interest

at a predetermined fixed rate on a certain principal amount
for a fixed number of periods
The other party pays interest at a floating rate on the same
principal amount for the same number of periods
The EURIBOR (Euro Interbank Offered Rate) is commonly
employed as a floating interest rate
25
2 Swaps
Payer:
Receiver:
The party paying the fixed rate of interest

The party receiving the fixed rate of interest
The principal amount is not exchanged in a swap transaction,

therefore the term notional principal is used. Actually, parties
exchange only the net amount
Commercial banks and investment banks usually serve as a
financial intermediary in swap transactions
The fixed rate of interest that banks offer in exchange for a
variable interest rate is called swap indication
26
2 Swaps
Swap indications for EUR interest swaps from WestLB

(6m EURIBOR April 21, 2009)
Maturity (years)
WestLB receives
WestLB pays
1.696
1.646
1.957
1.907
2.283
2.233
2.553
2.503
2.771
2.721
2.964
2.914
3.121
3.071
3.250
3.200
3.361
3.311
10
3.459
3.409
27
2 Swaps
Swaps can be used to change the exposure to interest rate

fluctuations by converting floating rates into fixed rates and vice
versa (hedging)
Additionally, swaps can be employed in order to cope with interest
rate expectations (speculation)
By exchange of comparative advantages on distinct financial
markets, swap contract partners may alleviate their financing
costs (arbitrage)
Actually, the vast majority of transactions on the swap market
comes from risk controlling of banks (risk management)
28
2 Swaps
2.2 Plain Vanilla Interest Rate Swaps Side Note
David Ricardo (*1772, 1823)

England may be so circumstanced, that to
produce the cloth may require the labour of 100
men for one year; and if she attempted to make
the wine, it might require the labour of 120 men
for the same time. England would therefore find
it her interest to import wine, and to purchase it
by the exportation of cloth.
To produce the wine in Portugal, might require
only the labour of 80 men for one year, and to
produce the cloth in the same country, might
require the labour of 90 men for the same time.
It would therefore be advantageous for her to
export wine in exchange for cloth.
On the Principles of Political Economy and
Taxation (1817)
29
2 Swaps
Example:
Companies A and B each seek for a credit amounting to 10m.
Banks offer the following terms for floating and fixed credit
financing
Fixed rate
Floating rate
Company A
6.0 %
6-month-EURIBOR + 2.4%
Company B
7.1 %
6-month-EURIBOR + 2.9%
Spread
1.1 %
0.5%
The spread differential amounts to 1.1 % 0.5% = 0.6%. If the

spread differential is positive, both parties (and the bank) can
benefit from entering into an interest rate swap
30
2 Swaps
Cash flows in a plain vanilla interest rate swap

Original loan
Pays in a
swap
Receives in a
swap
Net payment
6%
EURIBOR
3.9%
EURIBOR+2.1%
EURIBOR+2.9%
3.9 %
EURIBOR
6.8%
Interest savings for A : EURIBOR+2.4% (EURIBOR+2.1%)=0.3%

Interest savings for B : 7.1% 6.8%=0.3%
Thus, both parties benefit from entering into a swap contract. The
total amount of interest savings is equal to the spread differential.
31
2 Swaps
The following graph depicts an example of a swap

transaction involving a financial intermediary, which
demands ten basis points for its service
3.9 %
A
6.0 %
4.0 %
Bank
6mEURIBOR
6mEURIBOR
6m-EURIBOR
+ 2.9 %
32
2 Swaps
Cash flows in a plain vanilla interest rate swap involving a bank

A pays
Bank receives
B pays
Initial situation
EURIBOR +
2.4%
7.1 %
Credit contract
6.0 %
EURIBOR+2.9 %
Swap contract
EURIBOR
ERiBOR 3.9 %
4.0 %
3.9 %
4.0 %
EURIBOR
EURIBOR
EURIBOR +
2.1%
0.1 %
6.9 %
Total
Interest savings for A : EURIBOR+2.4% (EURIBOR+2.1%)=0.3%

Interest savings for B : 7.1% 6.9%=0.2%
Profit to bank: 0.1%
33
2 Swaps
2.3 Valuation of Interest Rate Swaps
At the point of initiation, an interest rate swap is structured so

that it has a NPV of zero (off-balance). However, its value can
fluctuate during the life of the contract
Although principal payments are not exchanged in an interest
rate swap, one can assume identical principal payments to be
both received and paid at the termination of the swap
This allows the valuation of interest rate swaps in terms of bond
prices
Thus, the value of a receiver swap can be represented as a long
position in a fixed rate bond and a short position in a floating rate
bond (floating rate note)
S B fix B float
34
2 Swaps
Valuation of the fixed rate bond involves discounting the fixed

payments and the principal at the prevailing term structure
The floating rate note is worth the notional principal
immediately after an interest payment
Let L denote the notional principal, t the point in time where
the next payment exchange takes place, and k the interest
payment to be made at that point in time. If r denotes the spot
rate for maturity t , the present value of the floating rate note
can be calculated as
B float
L k
(1 r )t
35
2 Swaps
Assume the following interest rate swap:
Fixed interest rate: 10% with semi-annual compounding

Floating interest rate: 6m-EURIBOR
Notional Principal: 100m
The swap has a remaining life of 21 months
The (discretely compounded) EURIBOR for 3 months, 9
months, 15 months and 21 months are 10.25%, 10.75%,
11.25%, and 11.75%, resp.
The 6m EURIBOR rate at the last payment date was equal to
10.5% (with semi-annual compounding)
What is the current value of the swap for each party?
36
2 Swaps
The value of the fixed rate bond amounts to
5
5
5
105
(1 0.1025)0.25 (1 0.1075)0.75 (1 0.1125)1.25 (1 0.1175)1.75

100.3353
B fix
The value of the floating rate note equals
B float 1 0.5 0.105
100
102.7135
0.25
(1 0.1025)
The value of the swap amounts to Bfix Bfloat, leaving the

receiver with 2.3782m and the payer with 2.3782m
Option Pricing Prof. Dr. Peter Reichling uni-magdeburg.de/finance
37
Corporate Finance
3 Capital Structure
3 Capital Structure
Structure
3.1
Goal of the Session
3.2
Modigliani-Miller Proposition I
3.3
Modigliani-Miller Proposition II
39
3 Capital Structure
Under the assumption of an arbitrage-free market, the value of a

firm is independent of its capital structure
In addition, the expected rate of return of equity investors is a

linear function of the debt-equity ratio of the firm (if there is no
credit risk)
These statements are known as the Modigliani-Miller Propositions I

and II (Corporate finance guys just use the abbreviation MM )
Remark: The company value is considered as the market value of the

firms total capital
40
3 Capital Structure
Choosing an optimal capital structure

Companies and industries vary in their capital structures
Industry
Debt ratio in %*
Electric and Gas
43.2
Food Production
22.9
Paper and Plastic
30.4
Equipment
19.1
Retailers
21.7
Chemicals
17.3
Computer Software
3.5
Average overall industries
21.5
*Debt/(Debt+Market value of equity)

41
3 Capital Structure
3.2 Modigliani-Miller Proposition I
Franco Modigliani
(*1918, 2003, Nobel price winner 1985)
Merton H. Miller
(*1923, 2000, Nobel price winner 1990)
the market value of any firm is independent of its
capital structure and is given by capitalizing its

expected return at the rate k appropriate to its
class.
the average cost of capital, to any firm is
completely independent of its capital structure and is
equal to the capitalization rate of a pure equity
stream of its class.
The Cost of Capital, Corporation Finance,
and the Theory of Investment,
American Economic Review (1958)
42
3 Capital Structure
The total market value of a firm is independent of its capital

structure
if the following assumptions hold:
Investors possess homogeneous expectations regarding the
distribution function of future cash flows
There are neither institutional constraints regarding the trade of
securities nor transaction costs on the perfect capital market (i.e.
borrowing and lending rates are equal)
Investors and companies have the same access to the capital
market (i.e. the capital market is arbitrage-free)
Remark: There is no equilibrium assumed
43
3 Capital Structure
Investors
Balance Sheet
Equity
Expected return
Cost of equity
Equity holders
Debt
Interest
Cost of debt
Debt holders
Assets
Cost of capital can be measured by the corresponding opportunity cost:

Without credit risk, the interest rate of debt equals the risk-free
rate of return
The opportunity cost of equity holders equals the expected return
of a well-diversified risk-adequate investment on the capital market
44
3 Capital Structure
Assume two identical firms, F U and F L, which differ only in their

financial leverage, i.e. cash flows are equal in all possible states (CtU
= CtL = Ct for t = 1, 2,...)
F U represents an unlevered firm
(i.e. the company is completely equity financed);
F L represents a leveraged firm
(i.e. the company is partially credit financed)
E and D denote the market value of equity and debt, respectively,
of a levered firm;
rD denotes the interest rate on debt capital;
E U and E L denote the value of equity of an unleveraged and of a
leveraged firm, respectively
45
3 Capital Structure
MM and Arbitrage (Strategy 1)

Two firms, an unlevered firm, F U, and a levered one, F L,
produce the following cash flows in $:
Recession
Normal
Expansion
Probability
1/3
1/3
1/3
Firm cash flow
800
1,800
2,800
Suppose that
Value of unlevered firm: V U= $1,500 (100 shares at $15)
Levered firm has D L= $600 of risk free debt at rD= 10%, with
principal and interest repayable next period
Show that the value of the equity of the levered firm E L must be
$900.
46
3 Capital Structure
F Us payoff in $
Recession
Normal
Expansion
Probability
1/3
1/3
1/3
Firm cash flow
800
1,800
2,800
F Ls payoff in $
Recession
Normal
Expansion
Probability
1/3
1/3
1/3
Firm cash flow
800
1,800
2,800
Cash flow to debt
660
660
660
Cash flow to equity
140
1,140
2,140
47
3 Capital Structure
For example, an investor who holds either 1% of the unlevered

equity or 1% of the debt and the equity of the levered firm would
obtain an identical cash flow profile in $:
Recession
Normal
Expansion
1/3
1/3
1/3
To debt
6.60
6.60
6.60
To equity
1.40
11.40
21.40
Total
8.00
18.00
28.00
Total
8.00
18.00
28.00
Payoffs
Buy xL:
Buy xU:
Hence, the cost of holding such portfolios (i.e., their market values)
must be identical: Cost of unlevered position: 1% 1500 = $15
Cost of levered position: 1% (E L + D L) = 0.01 E L + 6
Therefore: 0.01 E L + 6 = 15 which gives: E L = 900
E U= E L+ D
48
3 Capital Structure
MM and Home-made leverage (Strategy 2)

Instead of purchasing shares of the leveraged firm, the investor
can purchase the same fraction x of the unleveraged firms
shares and borrow on his own account
Borrow xD = Buy xL to debt
Investor should be indifferent to the firms action. If investors can
freely reverse a firms financial decisions, these decisions are
immaterial
U
U
L
L
Let V = E and V = E +D denote the value of an
unleveraged and a leveraged firm, respectively
Then, it holds: V U = V L
A firms market value is unaffected by its capital structure
49
3 Capital Structure
3.3 Modigliani-Miller Proposition II
rWACC E rEL
EL
EL D
rD
D
EL D
where rWACC : the firms weighted average cost of capital (WACC)

E(rEL ): expected return on equity of a leveraged firm
WACC represents a minimum return a firm must earn on its total

assets
Under the previous assumptions, WACC is independent of capital
structure
50
3 Capital Structure
Leverage effect
E rEL rWACC
rWACC
D
rD
EL
The expected return on equity is a linear function of the

debt-equity ratio. E(r L ): increases with the leverage ratio
E
As an investor, what do you prefer to get (on average) 10%,
15% or 55%?
As a firm manager, what do you prefer to generate (on average)
for your equity holders: 10%, 15% or 55%?
We use leverage to provide our customers with a more
attractive return (from a senior partner in an important
private equity fund)
51
3 Capital Structure
r
E rE
E (rEL )
rT rWACC
rD
D
E
As the debt-equity ratio increases, equity becomes more risky

and the investors expected rate of return on equity rises
In other words, levering-up an investment makes it riskier,
consequently its return should also increase
rD and rT are independent of leverage
52
3 Capital Structure
F Us payoff in $
Recession
Normal
Expansion
Probability
1/3
1/3
1/3
Firm cash flow
800
1,800
2,800
46.7%
20.0%
86.7%
Return on equity
Expected return to equity = 1/3 (46.7%) + 1/3 (20%) + 1/3 (86.7%) = 20%
F Ls payoff in $
Recession
Normal
Expansion
Probability
1/3
1/3
1/3
Firm cash flow
800
1,800
2,800
Cash flow to debt
660
660
Cash flow to equity
140
1,140
2,140
-84.4%
26.7%
137.8%
Return on equity
660
Expected return to equity = 1/3 (84.4%) + 1/3(26.7%) + 1/3(137.8%) =

26.7%
53
3 Capital Structure
Expected cash flow to the firm:

1/3 (800) + 1/3(1,800) + 1/3(2,800) = $1,800
Owning all of the firms debt and equity should give also rT:
(Expected cash flow to the firm/Market value of the firm) 1
= (1,800/1,500) 1= 20%
Check MM Proposition II
rWACC E rEL
EL
EL D
rD
D
EL D
= 0.267 (900/1,500) + 0.10 (600/1,500)
54
3 Capital Structure
WACC Fallacy
Debt is better because debt is cheaper than equity
Because (for essentially all firms) debt is safer than equity,
investors demand a lower return for holding debt than for holding
equity. (True)
So, companies should always finance themselves with debt
because they have to give away less returns to investors, i.e.
debt is cheaper. (False)
WACC fallacy ignores the hidden cost of debt: Raising more
debt makes existing equity more risky.
55

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Corporate Finance

Prof. Dr. Peter Reichling

Corporate Finance Prof. Dr. Peter Reichling www.finance.ovgu.de

Corporate Finance Prof. Dr. Peter Reichling www.finance.ovgu.de

Ross, S.A.; Westerfield, R.W.; Jordan, B.D.

Bodie, Z.; Kane, A.; Marcus, A.J. (2005):

Corporate Finance Prof. Dr. Peter Reichling www.finance.ovgu.de

Corporate Finance Prof. Dr. Peter Reichling www.finance.ovgu.de

Goal of the Session

Spot and Forward Rates

Hedging of Forward Rates

Formulae for Bond Prices

Corporate Finance Prof. Dr. Peter Reichling www.finance.ovgu.de

Corporate Finance Prof. Dr. Peter Reichling www.finance.ovgu.de

Spot rate p.a. of a credit risk-free financial investment with

forward rate p.a. (fixed today) for a credit risk-free

Corporate Finance Prof. Dr. Peter Reichling www.finance.ovgu.de

Corporate Finance Prof. Dr. Peter Reichling www.finance.ovgu.de

Under the assumption of an arbitrage-free market, in case of a

Corporate Finance Prof. Dr. Peter Reichling www.finance.ovgu.de

Because of r1 = f1, for f2 we have:

Analogously, it holds for any time horizon t = 1,2,...,T :

Corporate Finance Prof. Dr. Peter Reichling www.finance.ovgu.de

Assume, the 3-year spot rate for financial investments amounts to

Corporate Finance Prof. Dr. Peter Reichling www.finance.ovgu.de

If the spot curve is flat, then forward rates and corresponding

Euro Yields, Spot and Forward Rates

Corporate Finance Prof. Dr. Peter Reichling www.finance.ovgu.de

A hedge is a position established in one market segment in the

Corporate Finance Prof. Dr. Peter Reichling www.finance.ovgu.de

Corporate Finance Prof. Dr. Peter Reichling www.finance.ovgu.de

Forward rates can also be hedged by means of forward rate

Forward rate agreements ensure a fixed interest rate for a future

In practice, forward rate agreements are applied in the form of

Corporate Finance Prof. Dr. Peter Reichling www.finance.ovgu.de

On an arbitrage-free bond market the price P of a bond with

Corporate Finance Prof. Dr. Peter Reichling www.finance.ovgu.de

Formula using forward rates:

Corporate Finance Prof. Dr. Peter Reichling www.finance.ovgu.de

Formula using yields:

where rTy denotes the yield to maturity of a bond with

Corporate Finance Prof. Dr. Peter Reichling www.finance.ovgu.de

Corporate Finance Prof. Dr. Peter Reichling www.finance.ovgu.de

Goal of the Session

Plain Vanilla Interest Rate Swaps

Valuation of Interest Rate Swaps

Corporate Finance Prof. Dr. Peter Reichling www.finance.ovgu.de

Since the introduction of swaps in the early 1980s, these

Corporate Finance Prof. Dr. Peter Reichling www.finance.ovgu.de

Notional amounts outstanding of OTC derivatives (in $ billions)

Equity linked contracts

Credit default swaps

Foreign exchange contracts

Corporate Finance Prof. Dr. Peter Reichling www.finance.ovgu.de

A swap represents an agreement between two parties to

Corporate Finance Prof. Dr. Peter Reichling www.finance.ovgu.de

In a (plain vanilla) interest rate swap one party pays interest

Corporate Finance Prof. Dr. Peter Reichling www.finance.ovgu.de

The party paying the fixed rate of interest

The principal amount is not exchanged in a swap transaction,

Corporate Finance Prof. Dr. Peter Reichling www.finance.ovgu.de

Swap indications for EUR interest swaps from WestLB

Corporate Finance Prof. Dr. Peter Reichling www.finance.ovgu.de