Lecture 1: Introduction

FNCE201 Corporate Finance

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Class Schedule
Week Topic Case Remarks
1 Admin & Intro
2 Advanced Cost of Capital
3 Capital Structure 1 Online
4 Capital Structure 2
5 Capital Structure 3 1
6 Capital Structure 4 2
7 Payout Policy 1 3
8 No Lecture Recess
9 Payout Policy 2
10 Financing 4
11 M&A 1 5 G3&G4 (29 Oct)
12 M&A 2 6
13 Fireside Chat 7&8
14 Study Week
15 Final Exam
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Assessment
Final Exam. 2-hour online closed-book exam.
Case Analysis. Presentation and case report.
Participation. Attendance, discussion forum, lecture sessions
(with greater weight during case analysis).

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Case Analysis
Team Size. Form 8 teams with no more than 5 members per
team. Additional members will be approved on a first come first
serve basis.

Team Leader. Appoint a team leader to coordinate with the

TA. Team Leader to submit the list of members to the TA by 12
noon on 24 Aug 2022.

Preparation. All teams will be given about two weeks to

prepare for the case analysis.

Order of Presentation. All teams will be numbered for case

presentations. The order for presentation and information on the
first case will made known during Lecture 3.

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References

– Jonathan Berk. and Peter DeMarzo, Corporate Finance 5th Global

Edition 2020, Pearson Education.
– Robert F. Bruner, Kenneth M. Eades and Michael J.Schill, Case
Studies in Finance: Managing for Corporate Value Creation, 7th and
8th International edition.
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Consultation
Time. Fridays, 10.00am to 12.00noon (other times – email or
call for an appointment).

Location. Level 4, Room 4045, LKCSB.

Contact. Phone: 68289569. Email: [email protected]

Mode. Zoom call or Face-to-Face.

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 Part I

Discounted Cash Flow Models

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Discounted Cash Flow (DCF) Models
Discounted Cash Flow Models
The value of any asset is the present value of its (expected) future
cash flows.
n
CF1 CF2 CFn X CFn
P0 = + + ... = (1)
(1 + r ) (1 + r )2 (1 + r )n i=1
(1 + r )n

where CF1 refers to cash flows paid in period 1, and r is the discount
rate.
For stock, the expected cash flows are dividends and free cash
flows.
Since forecasts of cash flows cannot be made through infinity,
several versions of the DCF model have been developed based
on different assumptions about future growth.
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Dividend Discount Models
The simplest forecast when the future cash flows are dividends,
assumes a constant growth rate (g ) forever, such that:

Divt = Divt−1 (1 + g ) (2)

where Divt refers to dividends paid in period t.

Substituting (2) as the cash flow in (1) results in the Gordon

Growth Model:
Div0 (1 + g ) Div0 (1 + g )2
P0 = + + ...
(1 + rE ) (1 + rE )2
Div0 (1 + g ) Div1
P0 = or where rE > g (3)
rE − g rE − g
rE , the cost of equity, is the the appropriate discount rate.
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Two-Stage Dividend Discount Models
Companies whose growth rate is not constant, can be valued by
applying the Gordon growth model to estimate the terminal
value (TVN ) of the company once its expected growth rate
stabilizes at time N. This results in the two-stage Dividend
Discount Model:

Div1 Div2 DivN TVN

V0 = + 2
+ ... + N
+
1 + rE (1 + rE ) (1 + rE ) (1 + rE )N

TVN is the present value of perpetual dividends that begin at

the end of year N and grows forever at a constant rate g :
DivN+1 DivN (1 + g )
TVN = =
rE − g rE − g
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Free Cash Flow to the Firm (FCFF) Models
A DCF model in which the cash flows are Free Cash Flows to
the Firm (FCFF). The FCFF model estimates the enterprise
value (EV) of the firm.

Since Equity Value = EV + Cash − Debt, the share price of the

firm may be estimated by dividing Equity Value by the number
of shares outstanding.
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How is EV estimated?
The EV of a firm is estimated as the present value of the FCFF
generated by its business assets i.e. net working capital (NWC)
and net fixed assets (NFA). The appropriate discount rate is the
weighted average cost of capital (WACC ).

FCFF1 FCFF2 FCFFN + TVN

EV = + + ... +
(1 + WACC ) (1 + WACC )2 (1 + WACC )N

The terminal value, TVN , is the present value of a perpetual

FCFF that begins at the end of year N and grows forever at a
constant rate g :
FCFFN+1 FCFFN (1 + g )
TVN = =
WACC − g WACC − g
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What is FCFF?

FCFF are cash flows that the company has available to pay both
debt and equity holders i.e.

FCFF = EBIT (1 − τc ) + Depreciation − Net CAPEX

− ∆NWC (4)

where EBIT is the firm’s earnings before interest and taxes, τc is

the corporate tax rate, ∆NWC is the increase in net working
capital, and Net CAPEX is the firm’s capital expenditure net of
any asset sales.

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Free Cash Flow to Equity (FCFE)

Another version of the DCF model estimates the value of a

firm’s equity directly by discounting the cash flows that equity
holders are entitled to, at the cost of equity (rE ).

This cash flow, referred to as the Free Cash Flows to Equity,

(FCFE ), is the amount available for payout to equity holders. It
is generated by the firm’s business assets less interest payments
to lenders (adjusted for taxes) plus any increase in debt:

FCFE = FCFF − Interest payments × (1 − τc )

+ Increase in Debt (5)

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Free Cash Flow to the Firm (FCFE)

Using FCFE as the cash flow and rE as the discount rate in a

DCF model, results in the FCFE model to estimate Equity Value
(VE ) directly:

FCFE1 FCFE2 FCFEN + TVN

VE = + 2
+ ... +
(1 + rE ) (1 + rE ) (1 + rE )N

TVN (terminal value) is the present value of a perpetual FCFE

that begins at the end of year N and grows forever at a constant
rate g :

FCFEN+1 FCFEN (1 + g )
TVN = =
rE − g rE − g

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FCFF Computation

Question 1
Calculate the share price of the GPC Limited using the FCFF model
and the information provided below. All values in the table are in $m.

Now In one year In two years In three years

EBIT 500 600 660
NWC 3,000 3,200 3,400 3,500

Debt outstanding is $1,200m and cash is $150m. The corporate tax

rate is 25% and GPC’s WACC is 10.5%. Capital expenditure is equal
to depreciation expense, and FCFF is expected to grow at 3 percent
after the third year. GPC has 300m shares outstanding.

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Workings

Yr 0 Yr 1 Yr 2 Yr 3
EBIT
Tax
EBIT(1 − τc )
NWC
∆NWC
FCFF

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Workings

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 Part II

Event Studies

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Event Studies

An event study attempts to measure the effect of a corporate

event by examining the response of the stock price around the
announcement of the event. It assumes that the market
processes information about the event in an efficient and
unbiased manner.

The event that affects the firm’s stock value may be within its
control (e.g. announcement of a stock split) or outside of its
control (e.g. macroeconomic announcement).

Mainly used in corporate finance with the first application in

Fama, French, Jensen and Roll (1969) for stock splits.

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Steps in an Event Study
➀ Event Definition
➁ Selection Criteria
➂ Normal and Abnormal Return Measurement
➃ Estimation Procedure
➄ Testing Procedure
➅ Empirical Results
➆ Interpretation

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➀ Event Definition

Event date. Time when the market first learns of the new
relevant information (the event).

Event window. The period over which the stock price of the
firm associated with the event is examined.
– Typically includes the day before and after the
announcement.
– The size of the event window depends on the certainty of
the event date.
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Event Definition

Event frequency. Daily data is most commonly used since:

– Monthly data is too infrequent to isolate the event from the
period before and after the event.
– With intraday data, it is difficult to pinpoint the exact event
time.

Leakage. Where someone involved with the event has leaked

information to another who ultimately purchased shares in the
affected firm. This results in the firm’s share price increasing in
value well before any public information is available to justify the
price increase.

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➁ Selection Criteria

Determining which firms should be included in the final sample.

The criteria may include data availability, liquidity of the stock,

etc.

Contagion Effect. The inability to distinguish between events

when the firm experiences more than one major event over the
estimation period or the event window because both occurred
around the same period.

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➂ Normal and Abnormal Return Measurement

Abnormal returns (ARt ). Measures the impact of the event

as the difference between the actual return and the normal
return of the stock over the event window.

Normal returns. The stock returns that would be expected if

the event did not take place. It is usually derived from either a
statistical or economic model.

The most popular statistical model is the Market model.

Economic models like the Capital Asset Pricing Model
(CAPM), simply apply restrictions to a statistical model
motivated by theory.

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The Market Model
The market model is given by the following:
ri,t = α̂ + β̂rm,t (6)
where ri,t is the return of stock i at time t, rm,t is the market
return at time t, and α̂ and β̂ are the estimates of the model.

α̂ and β̂ are obtained by regressing ri,t against rm,t over the

estimation window, which is the period of time over which no
event has occurred. It is used to establish how the stock returns
should behave in the absence of the event.

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➃ Estimation Procedure
Using α̂ and β̂, the normal return (ˆ
ri,t ) is obtained by
substituting the actual market return (rm,t ) over the event
window into equation (6).

The abnormal return is finally computed as ARi,t = ri,t − rˆi,t ,

where rit is the actual stock return of stock i at time t.

Data Contamination. Occurs when the estimation window

and the event window overlap. Could result in a biased estimate
of stock price behaviour.
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AARs and CAARs
Since an event study usually involves a large number of firms,
the abnormal returns for each firm in the sample is aggregated
across time and across all firms.

Cross-sectional Aggregation. The average abnormal returns

(AARt ) for all firms in the sample at time t:
AR1,t + AR2,t + ... + ARn,t
AARt = (7)
n
where AR1,t is the abnormal return for firm 1 at time t, and n
refers to the total number of sample firms.

Time Series Aggregation. The AARt in each period is

summed across the event window to obtain the cumulative
average abnormal return (CAAR).
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➄ Testing Procedure

Null Hypothesis. The event has no impact on returns i.e. no

statistically significant abnormal returns.

H0 : CAAR = 0

Statistical Test. Traditional t-statistics over the event window

are used to test the significance of the abnormal returns, where:
CAAR
tCAAR = √ (8)
σCAAR / n

where σCAAR is the standard deviation of CAAR. CAAR is

statistically significant at the 5% level if | tCAAR |≥ 1.96.

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➅ Empirical Results
Stylized CAAR for an event that has a one-time positive
impact on stock returns.

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Empirical Results
Stylized CAAR for an event that has a one-time negative
impact on stock returns.

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Empirical Results
Stylized CAAR for an event that is anticipated.

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Event Studies in Economics and Finance

Quarterly earnings announcements for 30 firms in the Dow Jones

Industrial Index over the period Jan 1989 – Dec 1993 (600
announcements).

Each earnings announcement is categorized as follows:

– Good News: (Actual−Expected) >2.5%
– Bad news: (Actual−Expected)< −2.5%
– No News: −2.5%<(Actual−Expected)< 2.5%

41-day event window: 20 pre-event and 20 post-event days and

a 250-trading day estimation window for each announcement.

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Empirical Study

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➆ Interpretation

The results support the hypothesis that earnings announcements

convey information useful for the valuation of firms.

On day zero, the AAR for the good-news firm is 0.97% and is
statistically significant, rejecting the null hypothesis that the
event has no impact. For the bad-news firm, the AAR is
−0.68% and is also statistically significant.

The CAAR plots show that, to some extent, the market

gradually learns about the forthcoming announcement. The
CAAR of the good-news firm gradually drifts up in days −20 to
−1, while the CAAR for bad-news firms gradually drifts
downwards over the same period.

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Suggested Readings

R. Schweitzer.
How do stock returns react to special events? Federal Reserve
Bank of Philadelphia Business Review, July/August 1989,
pp17–19.

A. MacKinlay.
Event Studies in Economics and Finance Journal of Economic
Literature, Vol XXXV (March 1997), pp13–39.

J. Berk. and P. DeMarzo.

Corporate Finance 5rd Edition, Global Edition, Pearson
Education, 2020, Chapter 9.

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 Part III

Capital IQ Demonstration

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