Corporate Finance II: Financing Investments and Managing Risk

Professors Heitor Almeida and Stefan Zeume

Module 4: Finance, Governance, and Society

Table of Contents
Module 4: Finance, Governance, and Society .......................................................................... 1
Lesson 1-0: Objectives and Overview ............................................................................................... 2
Lesson 1-0.1: Objectives and Overview ............................................................................................................... 2

Lesson 1-1: The Agency Cost of Debt ................................................................................................ 5

Lesson 1-1.1: The Agency Cost of Debt................................................................................................................ 5

Lesson 1-2: Excessive Risk Taking ................................................................................................... 11

Lesson 1-2.1: Excessive Risk Taking ................................................................................................................... 11

Lesson 1-3: Under Investment ........................................................................................................ 21

1-3.1: Under Investment.................................................................................................................................... 21

Lesson 1-4: Finance & Society: Corruption ...................................................................................... 30

Lesson 1-4.1: Fina nce & Society: Corruption .................................................................................................... 30

Lesson 1-5: Violations of the Law of One Price................................................................................ 44

Lesson 1-5.1: Violations of the Law of One Price............................................................................................... 44

Lesson 1-6: Module 4 Review and Graded Activities ....................................................................... 57

Lesson 1-6.1: Modu le 4 Review ........................................................................................................................ 57

Lesson 1-7: Conclusion ................................................................................................................... 62

Lesson 1-7.1: Conclusion ................................................................................................................................... 62

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

Lesson 1-0: Objectives and Overview

Lesson 1-0.1: Objectives and Overview

Ultimately, all we do in finance day-in, and day-out is discount future cash flows. That's
our course summary, we calculate NPV, that's NPV, and to do that, we need to consider
some initial investment, we call it an investment that it takes to start the project. Then
we need to figure out all the future cash flows, FCF, and then we calculate the present
value. So, this means, we discount them at the discount rate, which we call the back,
this is all we do in finance. So, if you were to get our course tattoo, it might look
something like the equation on the slide. If you followed the course sequence, then in
module three we discussed that we accept a project, if NPV is greater than zero, and in
that same module as well as in module one of one, we discussed the importance of
maximizing the stock price, and the relationship between maximizing the stock price
and maximizing NPV. Also, in module three, we discussed that we care about free or
incremental cash flows, and we discussed how to predict the future in model two. So,
we looked at financial planning and we used the percentage to sales model, to figure
out future income statements, balance sheets and cash flow statements. PV, what
about PV? The present value, well, what we do is we discount future cash flows at the
discount rate, what's the discount rate? It's the back, the weighted average cost of
capital. We covered the back in module four of one, and we discovered in the first
module of two, that leverage determines the WACC. We drove a little bit deeper in the
second module of two. And in the third module of two, we discussed the importance of
risk management for both the back and the future free cash flows. So in finance, we

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

take projects when they're NPV is positive, we try to maximize NPV, that's all there is to
it, easy, we are basically done here, end of the module, end of this class.

Well, not so fast, this equation here, this NPV equation is math, and in math it is very
easy to maximize what comes out of this equation, but there are other considerations
outside of this equation, there are some challenges. A first consideration that goes way
beyond this equation, is potential conflicts of interest between shareholders and debt
holders. We call this agency costs of debt. It is possible that shareholders want to take
on a negative NPV project, or that they want to reject a positive NPV project. That's the
opposite of maximizing NPV, so let me repeat it. With a lot of debt, it's possible that
shareholders want to accept negative NPV projects or reject positive NPV projects,
that's the opposite of maximizing NPV. So, we must deal with situations where negative
NPV projects are taken and positive NPV projects are rejected. A second consideration
that goes beyond our NPV equation, is the impact of maximizing NPV on society, and
those that aren't shareholders of the firm. We discussed this very briefly in module one,
but here we will use our new tool, this NPV equation to go into much more detail, we will
discuss this topic finance and society with respect to the corporate decision to pay a
bribe, to engage in corrupt behavior. The last consideration we will discuss in this
module, is one where we use this NPV equation to uncover the possibility of injustice.
We will discuss why it might be that the NPV equation does not hold, and what it
means. The one topic we will not discuss separately in this last module, is corporate
governance, agency conflicts, the idea that managers are hired by shareholders to
maximize shareholder value, but that managers also need to be incentivized. After all,

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

it's costly for managers to exert effort, their corporate decisions may affect their
personal well-being, and it might just be too lucrative to steal right away from the
company. Remember those corporate jets if you like? Lots of fun to use them as a
manager, but maybe quite costly to shareholders. We discussed these ideas in module
one, lesson four, we will not repeat them here, so we will discuss the limitations of using
the NPV equation and we will start with the agency costs of debt.

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

Lesson 1-1: The Agency Cost of Debt

Lesson 1-1.1: The Agency Cost of Debt

So far in this course, we said we will invest if NPV is positive. When the sum of some
initial investment and all future cash flows discounted to today exceeds zero, we invest.
Now we will discuss situations where we invest, even though NPV is negative, and
situations where we do not invest, even though NPV is positive. These situations arise
due to debt. You need to look out for these situations in firms that have a lot of debt.

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

In order to understand the problem, we need to remind ourselves who gets what when a
company goes bankrupt. There are equity holders, these are shareholders, and then
there are debt holders. For instance, the bank. When a company goes bankrupt, the
question is, who gets what in bankruptcy? What do the debt holders get? What do the
shareholders get? It turns out, and you will know this, that debt holders get repaid first.
Among these two claimants, the equity holders and the debt holders, debt holders are
first in line. Once they are repaid, the equity holders get whatever is left if there is
anything left. Debt holders first, then shareholders. It turns out that this simple idea can
lead to the destruction of NPV, the acceptance of positive NPV projects, the rejection of
negative NPV projects. We call these situations excessive risk-taking and
underinvestment. We will talk about them in much more detail. But first, let's look at
some examples of who gets what in bankruptcy.

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

Here's an example. The XX corporation currently has total assets valued at three million
dollars, of which one million dollars are debt. Let's assume that this company was
dissolved today and let's see who gets what. Well, it turns out, since there are three
million in assets, the bank will get one million, that's what they are owed. Then there is
something left, there are two million dollars left that go to equity holders. Really, if you
think of the value of equity as the maximum of assets minus debts or zero, its assets
minus debts we're talking about here, 3 million minus 1 million, that's 2 million.

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

Here's another example. The YY cooperation currently has assets valued at one million
dollars and they hold one million dollars in debt. If this company, the YY corporation, if
they were dissolved today, it turns out that the bank gets a million dollars and the equity
holders get nothing. There is nothing left once the bank has been paid off.

Here's our third example, and you probably guessed the company name. The ZZ
corporation currently has assets that are valued at $0.5 million and they hold one million

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

dollars in debt. What does this mean if this company, the ZZ corporation gets dissolved
today? Well, it means that the bank gets $0.5 million, that's all that there is left. Then the
equity holders, well, they get nothing. The value of equity here is the maximum of
assets minus debt, but that's a negative number and zero, so they get zero.

This table summarizes our three examples. You have three rows for the free
corporations, and then you have total asset value, total debt value, and total equity
value in the three columns. It turns out that the shareholders really like XX corporation
and between YY and ZZ Corp, they don't care. Debt holders, they really dislike ZZ Corp,
and they are indifferent between the other two, XX and YY. Now, of course, neither
equity holders nor debt holders can decide which company they are. But suppose you
are YY corporation, and you have a project that either turns you into XX corporation or
ZZ corporation. It moves you from the company in the middle, either up or down. Well,
shareholders will like this project because shareholders will not be worse off, they can
only be better off. Debt holders will dislike this project because they can only be worse
off, not better off.

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

This last example is an example of excessive risk-taking. It arises with debt where
shareholders can only win and debt holders can only lose. We will discuss it in the next
lesson and in the lesson thereafter, we will discuss a very related example where
shareholders can only lose and debt holders can only win and we called this
underinvestment.

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

Lesson 1-2: Excessive Risk Taking

Lesson 1-2.1: Excessive Risk Taking

We said that in finance, we maximize NPV. We invest if NPV is bigger than zero. But
there are some challenges and we will discuss the first one, excessive risk-taking in this
lesson.

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

Here's an anecdote. It turns out that the founder of FedEx at some point had to pay a
gas bill after the weekend. He took the company's last $5,000 to Las Vegas, $127,000,
and saved the company. He was able to pay the bill. What's the rationale for this? Well,
had the founder done nothing, he would have lost the company. He didn't have enough
money to pay for gas. Had he gone to Las Vegas and lost all the $5,000, the company
would have been lost as well, so no difference there. Turns out he went to Las Vegas,
he won, and saved the company. This is an example of excessive risk-taking. It is also
known as gambling for resurrection. What are the features of this example? Well, you
have a very risky bet that is negative NPV. Going to the casino in case you didn't know
is negative NPV for you, not for the casino, the casino always wins, you lose. But in this
case, the company was lost anyway so he could afford to just take the last $5,000 to go
to Las Vegas.

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

Here's the key idea of excessive risk taking. Shareholders take on risky projects that
have negative NPV because they don't bear all the cost if the project fails. What
happens is, if the project succeeds, shareholders get something out of it. In our case,
this founder, he still has a company. If the risky project fails while it's someone else's
money, it's FedEx's money in our anecdote. It's really someone else that is bearing the
cost, mostly the debtholders.

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

Here is a more relevant example. So this is Scooter Inc. and they are facing financial
distress. Let's say they have a loan of one million dollars that is due at the end of the
year. Their assets, they are expected to be worth $900,000 at the end of the year.
Really, if they don't do anything, they will default in one year. They are worth less than
their debt. But here's the deal.

They actually have access to a project. In fact, let's say they don't even have to invest

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

today. So, this is a project where i equals 0, they don't have to invest. There's a 50%
probability of succeeding. If they succeed, the value of assets goes up and it's now $1.3
million. If they are not successful, if the project fails, the value of their assets is going to
be only $300,000. For simplicity, we will assume that there's no discounting, we can
ignore discounting for once.

Really the question now is, should Scooter Inc. take this risky project? We already know
if the project is not taken, the company is worth $900,000. But we can also calculate the
value of this company. If the project is taken, there's a 50 percent chance of being worth
$1.3 million, 50 percent chance of being worth 300K. Really, the company value can be
expected to be $800,000 if the project is taken. Well, so turns out that this project would
actually destroy $100,000 in firm value, which means we should reject it. We learned in
finance so far that we should reject negative NPV projects.

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

But the question here really is, what about the debtholders, and what about the
shareholders? That's where we move next.

Let's talk about the debtholders first. If this project is not taken, they will get all the
$900,000. They have a loan worth a million, while at least they get $900,000 out of this.
If the project is taken, well, they only get $300,000 of the project fails because the whole
company is now only worth $300,000. They get the full loan amount, which is a million

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

dollars in this case, if the project succeeds. What do they expect? They expect to get
$650,000 if the project is taken. You can again compare the numbers without the project
900K with Project 650K. If the project has taken, debtholders will lose money. They do
not like this project.

Let's turn to the equity holders. If we don't take the project, the shareholders, the equity
holders, they get nothing. All the company value, all the $900,000, it goes to the
debtholders. What if the project is taken? Well, if it fails, they still get nothing. These
equity holders, they still get zero because everything goes to the debtholders. If the
project is successful, well, the company is worth $1.3 million. They pay off the debt of
one million, there's $300,000 left. Really here, this is a positive NPV project. There's a
50 percent chance that equity holders walk away with $300,000. NPV for equity holders
is $150,000. Equity holders, they liked this project.

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

So, what's really going on here? We have a negative NPV project that really objectively
should be rejected. Equity holders like this project because they have nothing to lose.
We call this limited liability. But they might also win big, just like our FedEx founder.
Debtholders on the other side, they bear all the cost, they cannot be better off when this
project is taken, they can only be worse off. Really if managers act in shareholders'
interests, in this case, they will take the project, they cannot lose, they can only win and
it costs the debt holders.

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

How could we possibly fix this? Well, you will know that in real life there are covenants,
among other things. Banks, when they provide a loan, will have a long list of covenants.
What is it the company can and cannot do? One of these covenants might be, you
cannot invest in risky projects. There might be a cap on how risky projects can be.
Then, of course, you can also engage in monitoring. You can try to control what the
managers are doing.

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

Really, the key takeaway is that excessive risk-taking leads to investments in negative
NPV projects. This is a result of debt overhang of high indebtedness, of high leverage. It
can be fixed for monitoring and covenants.

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

Lesson 1-3: Under Investment

1-3.1: Under Investment

All right, so once again in finance we maximize NPV, we invest if NPV is bigger than
zero, but then there are some challenges and one of them is underinvestment.

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

So here's the key idea, shareholders reject positive NPV projects because shareholders
do not reap all of the benefits. It turns out that in these types of situations shareholders
pay out of their own pocket to sponsor the project. If the project succeeds, someone
else, the bank gets all of the benefits. If the project fails, shareholders get nothing,
okay? Now, I wish I had an anecdote here, but really these are projects that are not
taken, so no one lives to talk about it, okay?

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

So, here's an example, a hypothetical example, we're looking at scooter Inc, again and
again, they are facing financial distress, okay? So, they have a loan of $1 million that is
due in a year, and their assets are expected to be worth only 900,000, okay? So, if they
do nothing now, they will have to default in one year. So here's the project, let's say they
actually have access to a riskless project. If they invest 100,000 today, they can
generate 150,000 in one year. Again, our discount rate is zero just to simplify things.
This is the only time you don't have to discount on finance, okay? So what's the NPV of
this project? It's $50,000, okay? No risk, it will deliver $50,000 for sure. However, it turns
out that Scooter Inc. has absolutely no cash, okay? So shareholders will have to invest
from their own money, in this case $100,000 into the company in order to conduct this
project, okay? So that's our situation, it's a positive NPV project, it should be taken.

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

So let's talk about the debtholders first. The debt holders, if this project is not taken, will
get $900,000, okay? That's the value of the company, their loan is worth $1 million, they
only get 900,000 because that's all there is left. If the project is taken, this whole
company is worth 1.05 million, so they will actually get their million dollars back, okay?
They get 100,000 out of this project. They want this project, okay? Debtholders want
this project because it increases their NPV.

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

Let's look at shareholders or equity holders, and let's see what happens if this project is
not taken first. While if the project is not taken, they get zero, all the assets, the
900,000, they go to the debtholders. What if the project is taken? Well, we said that it's
the shareholders that have to come up with the $100,000 investment, so all they get out
of this is actually nothing, less than nothing, okay? It turns out they invest 100,000 of
their own money, the project will be successful, but the debtholders are paid off first, so
there's only 50,000 left for shareholders, they lose $50,000 in total. They would like to
reject this project, and if they are sitting behind the steering wheel, if they make the
decisions, they will reject this project.

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

So let's summarize what's going on here, shareholders would reject this positive NPV
project. Why is that? Well, it's the bank the debtholders that reaps all the benefits,
shareholders bear the cost of this initial investment. So really in this case a positive
NPV project is foregone because shareholders do not reap all the benefits.

Okay, now, the question of course is how can we fix this problem? There is a positive
NPV project that is not taken, Maybe we can fix that problem. One idea out there is for

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

equity holders for shareholders to just set up a separate company, they take their
$100,000, set up a separate company, invest into this riskless project And make
150,000. So in total they take home $50,000. This is something we call it project
finance. Okay, the alternative is to take a haircut.

Okay, so let's talk about the haircut. So what's the idea of the haircut? Well, without the
project, the bank gets 900,000 with the project, they get $1 million dollars in our
example. Okay, so the idea of a haircut is for the bank to give up some of the potential
gain. Okay, They are gaining 100,000, maybe they can give up some of that. So here,
the idea is to possibly reduce the face value of the $1 million dollar loan.

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

Okay, so let's see what happens. Let's assume that the bank is actually willing to take
the haircut to reduce the loan from $1 million $925,000. So with the project debt holders
now get $925,000, okay versus the 900,000 before, so they actually like this. Okay With
the project. What about equity holders? Well, they would actually get $25,000 out of
this. Okay. It turns out that now they invest $100,000 today. But they make $125,000.
So why is that, why do they make $125,000? Well the company will be worth 1.05
million. Debt holders are paid off at $925,000. What's left is $125,000. Okay, so really
here equity holders are also happy, Both the bank and equity holders are happy. The
bank would be unhappy without the project. They are happy with the project and the
haircut. The equity holders are happy with the haircut as well. This is a win-win.

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

Okay, so really the summary of under investment is that it results in the rejection of
positive NPV projects? It's the result of that overhang? Of a lot of debt. Okay and it can
potentially be fixed through project finance or haircut.

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

Lesson 1-4: Finance & Society: Corruption

Lesson 1-4.1: Fina nce & Society: Corruption

Once again, we are in finance. We're maximizing NPV. We invest if NPV is bigger than
zero. Now let's talk about a third challenge to all this. Let's talk about finance and
society. We talked about excessive risk-taking under investment. Now let's talk about
finance and society.

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

The question really is, is maximizing stockholder wealth consistent with social
responsibility? Is it consistent with caring about society? While we mentioned some
examples very early on if you took this whole course, in the very first module. We talked
about unhealthy products like tobacco, alcohol, we talked about pollution, we talked
about the outsourcing of labor, we talked about taxes, about firms avoiding taxes and
governments struggling to pay for infrastructure. There's actually a fifth topic that we can
discuss. It's related to corruption and bribery.

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

What's the social cost of corruption? Let's talk about society first. There are actually two
competing ideas. One idea is that corruption is just sand in the wheels. It slows down
the whole machinery. Lowest bribes are involved, nothing moves or nothing moves fast.
There is a competing idea and that's that corruption is actually greasing the wheels.
Without side payments, without kickbacks and so on, nothing works. Now it turns out
that most evidence out there supports this sand-in-the-wheels idea and actually the
figure on this slide gives you some indication of what that means. What does the figure
do? It shows you on the horizontal axis the GDP per capita by country and then on the
vertical axis, it shows you the corruption level of the country. Indeed, it turns out that
countries with high GDP per capita, wealthy nations, so to speak, are the ones that are
less corrupt. On the other hand, countries that have low GDP per capita but are less
developed tend to have higher corruption levels. For Illustration, you see Germany, you
see Brazil on there, and you also see India and Yemen and you will see why in just a
moment.

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

Again on the social cost of corruption, even the World Bank has weighed it in. They say
corruption costs $2.6 trillion a year, five percent of global GDP any given year. In fact
others have documented that corruption explains slow growth. Again, the figure gives
you a clue. This figure shows changes involved against changes in corruption levels
over the last 15 years, so from 2005-2020. The horizontal axis shows you whether a
country has seen an increase in GDP per capita or a decrease and then the vertical axis
shows you whether corruption has gone up or down. It turns out that on average,
countries that have become wealthier have also seen a decrease in corruption and vice
versa. Look at Yemen. They've seen a huge decrease in GDP per capita, a huge
decrease in wealth essentially, and also a massive increase in corruption. There is other
evidence. There is evidence that corruption lowers imports, but there's also evidence
that corruption can actually help when taxes are very high. What's the idea? If you can
pay your side payment to avoid taxes, that might actually increase business activity. But
generally the evidence is that corruption is sand in the wheels. Why do I talk about
corruption? Well, this is very related to corporate decisions. We got to talk about the
company.

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

Here's our company. Our company is going to try to maximize NPV. They have an initial
investment and then they discount all of these future cash flows. If you don't want to
look left and right, here's what you should do. If investment means that you have to pay
a bribe to get the project, you should invest. You should bribe if it maximizes NPV.
Similarly, if there is anti-bribery regulations out there, you have to invest if it maximizes
NPV.

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

Let me illustrate this. We have the right tool, we have our NPV calculation. Firms may
have to resort to paying bribes in order to do business in some countries. That's the
idea. Let's say there's some contract out there and it's worth $10,000 and that's already
discounted to today. Let's also say that if you don't bribe, you will never ever get this
contract, zero chance. If you bribe $1,000, there is a 20 percent chance of winning the
contract. So the question is to bribe or not to bribe?

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

Well, here's the math. If you just look at NPV, if you don't look left and right, don't do this
at home. If you do this, just be aware that there is regulation against bribery in most
countries, but if you do this at home, NPV of not bribing is essentially 0, because you
won't get the contract. If you pay the bribe, yes, you spend $1,000, but there's a 20
percent chance of getting $10,000. NPV of bribing is $1,000. You should bribe in this
case. I said, don't do this at home because there is anti-bribery regulations out there.

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

Let's say there is monetary punishment of $100,000, if you are detected to be using this
bribe. There's a 1.5 percent chance of being detected. Regulators are busy. They don't
detect everyone. Again, the question is, should we bribe or not?

Just using our tools. If we don't bribe, we don't get the contract. We don't get punished.
We don't pay the bribe. We don't get the contract. NPV is 0, if we do not bribe. What
happens if we bribe? Well, as before, we spend $1,000 to get a 20 percent shot at

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

$10,000. But then there's also this 1.5 percent chance of spending $100,000 in
monetary fine. What this means is that your overall NPV of paying the bribe is negative
$500. In this case, your decision should be not too bribe. NPV is negative if you bribe. If
you don't bribe, your NPV is 0.

Let's put all of this together. Let's actually talk about the effect of this anti-bribery
regulation on firm value. We said that before the regulation, you should bribe in order to
have a shot at $1,000 in expectation. You would expect to get NPV of $1,000. After the
regulation, a company that follows what we've learned in this course would not bribe.
They would walk away with 0. What this means is, this regulation actually reduces firm
value.

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

Now you might wonder whether bribery is actually out there. Depending on your
background, you might wonder. Well, it turns out you could ask companies directly. Do
you bribe? What do you get out of it? Chances are the answer is going to be no, we
don't bribe. Turns out the World Bank sent an anonymous survey to ask companies
whether they believe their competitors to use bribes. This is how you got to ask a
question. Turns out that one in three companies believe their competitors to use bribes.
Bribery is clearly out there. We know it's bad for society, but the company might have
NPV calculations in their mind that explain why they should pay the bribe.

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

There's actually some evidence from research on this. It's my own research. I want to
talk about it very briefly. It turns out that it's incredibly hard to observe who's using
bribes and what they get out of it. But you can look at companies that are likely to use
bribes around the time they get regulated. It's very close to our illustration. Turns out
there was a UK Bribery Act in 2017, and you can study firms around the time this Act,
this bribery regulation, was passed. Here's what you will find.

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

If you look just at stock prices around the passage of the UK Bribery Act, you will find
that UK companies that operate in oil, and gas, and aero-defense, all the typical
suspects, they suffer a decline in stock prices. They have negative stock returns. Also
UK companies that operate in what we call perceivably corrupt countries have negative
stock returns around that time. This tells you that likely they used to generate NPV prior
to the anti-bribery act. Now they create less NPV. It's reflected in stock prices. What's
ironic is that there are positive returns for non-UK companies that compete very directly
with UK firms. Imagine a couple of companies competing for an oil contract somewhere
in the vault. The UK firms get potentially punished. They withdraw from fighting for the
contracts. It's the non-UK firms that actually benefit. It's one of the side effects of
unilateral regulation. You might say, I don't trust stock returns. I mean who does?

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

But there are also some real implications. Turns out that UK firms suffered slower sales
growth in perceivably corrupt countries. They conducted fewer M&As.They really just
withdrew or at least suffered a slowing down in sales growth. What's the takeaway? We
saw that corruption likely reduces welfare while in most settings, but that firms might
actually use bribes to create net present value. Costly regulation destroys some of that
net present value. This is an example of finance and society where our NPV calculation
can explain why firms act the way they act.

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

Really maximizing NPV can have externalities on society. Here the example was
corruption, but there are many other examples out there. The key takeaway really is
whose NPV is it? Is it the companies NPV we are looking at, or societies NPV? They
don't have to be the same.

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

Lesson 1-5: Violations of the Law of One Price

Lesson 1-5.1: Violations of the Law of One Price

So for the last time in this module, our starting point is that we want to maximize NPV,
we want to invest if NPV is bigger than zero. Now we want to talk about cases but we
can't really calculate NPV over. Something seems to be wrong with our math. Okay, so
what if we discount all of these future cash flows and it doesn't make any sense.

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

Okay, so here's our starting point. We want to calculate NPV by just counting future
cash flows and subtracting this initial investment. If you consider two projects, they have
the same initial investment, the same cash flows and the same risk. So the same
discount rate, they should have the same NPV according to the math. Okay, that's our
starting point.

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

There's actually a fancy name for that. This is called the Law of One Price, the same
good or acid or whatever that is trading in two different markets at the same time,
should have the same price. Okay, in both of these markets.

So here are two examples. One is a finance example, let's say an ounce of gold is
trading at $2,000 in New York While it should also trade at $2,000 in London, if it's
exactly the same ounce of gold. Okay, similarly a toothbrush might cost you a dollar and

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

a toothpaste might cost you $4. Well, a bundle of the two should cost $5. Okay,
according to the law of one price, there is no reason why the price for the bundle should
be different and you can already tell that this likely doesn't always hold in reality.

Okay, so really if it doesn't hold then we would call this an arbitrage. Okay, it's the idea
that we can buy and sell at the same time in two different markets in order to make
money. Okay, it's the idea that we buy sheep and we sell at a higher price. Okay, If such
arbitrage, if it exists, you can make money today without any risk, okay, without any
exposure to future cash flows.

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

Alright, so back to our finance example, Let's say one ounce of gold is trading at $2,000
in New York, but only at $1900 in London. Okay, so my question is this an arbitrage?
And if so, how would you make money from this? Okay, I will give you a little hint,
though, many of you might not find it very useful. I will give you some time to think about
this example.

Okay, is this an arbitrage? And how would you make money? The hint is Kenny Rogers

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

not the picture, but the country singer. Okay, Alright, so how do we make money? Well,
I gave you a hint, Kenny Rogers, and you might be thinking the gambler, what does that
have to do with anything? I should have talked about it much earlier when the FedEx
founder went to las Vegas. Right, But it turns out Kenny Rogers has many things to
teach about finance. One of the things shows up in his Slow Dance More song. It says
buy low, sell high.

Okay, if you want to make use of an arbitrage, you need to buy low and sell high. This is
not really what this song is about, but it's in there. Okay. So really you could fly to
London, buy an ounce of gold for $1,900, fly to New York, sell it, sell high for $2,000,
you would pocket $100. Okay, You don't actually have to get on a plane. You could also
do all of this online. Buy in London southern New York, make $100.

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

Okay, now there are some challenges to this. If it was too easy to make money like this,
we would all be rich. Okay. But you will already know if you all try to get rich. None of us
gets rich. Okay. So what are the challenges? But one of them is transaction costs. This
is most obvious. If you try to fly to London and then to New York this is costly. Okay, But
even transactions online will cost you some fee, then there's price risk. You're sitting on
that plane back to New York and in the meantime the gold price adjusts. You bought
your gold for 1,900 When you land in New York suddenly it's only trading at 1,500, well
you lost money. Okay, there's price risk, the same is true for online trading. Okay. If you,
if you're late by a few seconds you might miss your chance, then there's competition.
Now, I don't know how many of you are watching this video right now, but some of you
have already started Googling. Okay. Some of you are trading already probably. So
there will be competition. And what happens is that someone will trade away this
difference in $100. There will be a lot of buying, there will be a lot of selling and slowly
the prices will approach each other. They will be the same. Okay, so it also turns out
that none of this is really scalable. You can't just buy a million ounces of gold in London
and then sell them in New York. There's supply and demand. Okay. It's also difficult to
take those ounces of gold onto the plane in this magnitude at least.

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

Alright, so let's move to the other example. Let's move to product markets and I
switched it around a little bit. Okay, let's say CVS sells toothbrushes for $2 and
Walgreens for $1.95. You could buy at Walgreens, run over to CVS sell the toothbrush
and pocket five cents. You could do this 1,000 times. Okay, the challenges are exactly
the same as before. I mean it looks like you could make money. The challenges are as
before. Plus, you might actually also not be able to sell to CVS. Who are you to sell
toothbrushes to CVS. Okay, so really there are some real life challenges to these
arbitrage.

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

Now let's see where society comes in, where this idea of the law of one price helps us
uncover injustice. Okay, so it turns out that colleges and universities regularly issue
bonds. So let's say you observe two very comparable schools, Okay. Both of them have
more or less the same size, the same location, more or less, they have similar ranking
and so on. Okay. And let's say they also issue comparable bonds, say majority same
amount and so on. If you use the Law of One Price, the bond price and the underwriting
fee, they should be the same for these two schools. Okay, They should be exactly the
same because it's the same product.

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

Now, let's say that one of these two schools is an HBCU okay, a historically black
college or university and the other one is not, again, if you use the Law of One Price,
the bond price and the underwriting fee, they should be the same. Okay, well, it turns
out that this is not the case empirically.

Okay, so there's some amazing research done by Duggal, Gao, Mayew and Persons

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

that shows that HBCUs pay more to issue bonds than other colleges and universities.
Okay, the underwriting fees are higher. The bond prices are also slightly lower.
Okay, so what makes HBCUcu bond cash flows? Riskier than cash flows of other
college bonds? That's kind of the question, is it a risk story?

Okay. While the offers of this research study are actually extremely careful to rule out
that it's a risk story. They look at many, many courses. Okay, they control for many
things. They are essentially comparing two schools that are the same. They are unable
to rule out that it's race that is driving the difference.

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

There is another example, a very similar example actually in the car loan market. So in
the US if you look across consumers with the same credit score, so the same riskiness
presumably, you will find that Black and Hispanic borrowers are approved for loans at a
lower rate than white borrowers. Okay. They also pay 70%. Sorry, seven basis points
per year more in interest. So they are less approved, they pay more in interest and yet
they default less. Well, this does not make a lot of sense if you think of the Law of One
Price. Okay, If they are the same in terms of credit score, in terms of riskiness, they
should be paying the same fee, they should be approved at the same rate, they should
also default at the same rate. So there's a working paper by Butler, Mayer and Weston
that uncovers this. Okay. There are other examples in research, there are examples on
the wage gap and so on. Many, many examples where essentially the Law of One Price
is being used to uncover injustice.

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

Okay, so really the summary of this lesson is what happens if NPV is not equal to minus
i plus the present value of future cash flows. It's possible that there is a violation of the
so called Law of One Price, that there is an arbitrage possibility, but it can also indicate
biases, Okay, which in turn has far reaching implications for society.

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

Lesson 1-6: Module 4 Review and Graded Activities

Lesson 1-6.1: Modu le 4 Review

In finance, we discount future cash flows. NPV equals minus I, the initial investment,
plus the present value of future cash flows. We invest if this NPV is bigger than zero.
Well, in this module, we discovered that there are agency costs of debt, there's finance
and society considerations, and there are instances where NPV is not equal to minus I
plus PV(FCF). That's really what we discussed in this module. I want to illustrate this a
little bit more by covering some examples.

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

Here's one example. This is Jerome Kerviel, and he used to be a trader with Society
General. When you google his name, you will find that he lost roughly five billion dollars
of company money by trading. Now you might wonder how does this link into our
finance module. Well, it turns out he was trading using his own NPV calculation. What
would happen if he traded with risky bets and made a lot of money? Possibly, he may
have gotten a huge bonus. What happens if he makes these bets, and he doesn't lose
anything? Well, he doesn't lose salary. Relieve of bonuses, you make a lot of money if
you do extremely well. But you don't lose a terribly lot if you don't do too well. In his
case, he lost quite a bit. I mean, he went to prison for his actions, but it wasn't his
money, it wasn't his five billion dollars that he lost. It was someone else's, it was the
investor's money. Really, what I'm trying to say is this is an example where you might
have in mind NPV of shareholders and NPV of the decision-makers, and these two are
not the same. The trader is trying to increase their bonus, shareholders would just be
happy with a standard investment, with a diversified investment.

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

Then we have this example. This picture is taken from the Exxon Valdez catastrophe in
1989, massive environmental catastrophe. What potentially happened here is, that the
company was saving on the tanker they were using to transport oil. Turns out there's
one-hull and there's two-hull tankers. The one-hull tanker is cheaper to produce, can
also possibly carry more oil. So, the company is going to go with that, it's cheaper to
produce, it can carry more oil. What about society? Well, society might prefer the two-
hull tanker because it's safer. I mean, in this case, it would probably still have burst, but
there are estimates that the oil spill would not have been quite as bad. This is a very
good example of how NPV of the company, trying to minimize cost, trying to maximize
revenues, might not agree with NPV of society. Society would be better off with a
smaller oil spill, or with no oil spill whatsoever.

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

Really, I want you to take 10 seconds to look at this picture. Sometimes this NPV
consideration, this NPV of the company consideration, it can overlook what's going on
outside of the company with devastating consequences.

Then there is this example. This is Larry Gies and Beth Gies, in case you didn't know.
They gave millions of dollars to the college. If you think only about NPV, this is very
hard to explain. It's like giving money away, so the money is no longer yours. If you only

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Professors Heitor Almeida and Stefan Zeume

think about NPV and you don't look left or right, this sounds like negative NPV. But in
this case, really for one thing, society gets something out of it, and very clearly, the Gies
family also gets something out of it. They are giving back and so they get something out
of it. Really sometimes NPV calculations are missing these things. If you're wondering
why, you do something for charity, it sounds like you're using your own time to work for
charity, well this is something that you can't really turn into dollar trumps.

Really, I would like you to think not just about NPV, but to look left and right a little bit as
well. Think beyond NPV. Ask whose NPV is it and it might explain why certain decisions
are taken. Why do companies take certain decisions that make no sense for society?
Then also it's very important to think about things that aren't just dollar signs. Think
about doing good for society. You can rarely turn this into dollar signs, but it's
nevertheless very important.

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

Lesson 1-7: Conclusion

Lesson 1-7.1: Conclusion

In this course, we learned a lot about how companies make financial management
decisions. Here, what I want to remind you are the key concepts to remember. What are
the key ideas to take away from this course?

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

First of all, don't get fooled by mechanical and shallow arguments about payout and
financing decisions. Remember, dilution is an illusion. That does not mechanically
reduce the cost of capital and changing the number of shares outstanding has
absolutely no effect on stock prices. Dilution is an illusion, very important.

We also talked about the trade-off model of capital structure which I think has this very
nice visual representation with some numbers that come from recent research. A

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Professors Heitor Almeida and Stefan Zeume

company can create five percent of value by moving from 0-30 percent leverage. This is
the median US public company which is at the 30 percent leverage ratio. Then we can
use this model to think about what if the right leverage ratio for different companies and
consider credit rating as we learn and other ideas as well.

Next, we looked at actual evidence from research. We saw that debt is the most
important source of marginal funds for most companies. We also saw that investors
respond when firms issue equity or cut their dividends. They respond to financial policy
decisions. Stock prices tend to decrease if firms issue equity and they increase when
firms repurchase equity. We also saw that investors care about credit ratings. Credit
ratings have real impact, they matter. They contain information.

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

Then we talk about the payout. The key trade-off in payout policies that paying out cash
can help companies control over-spending. By paying out cash, you avoid investing in
bad projects. As we learned, a company that have too much cash can waste it. Paying
out cash also signals good prospects to investors. For example, increasing dividend is
going to tell investors that the company doesn't need the cash so you expect future
cashflows to be high and stock prices might react positively to that information. The
trade-off is payout competes with other uses of cash, for example, debt repayment.
When companies are short of cash then it might be difficult to continue paying out. For
example, we know that in times of financial crisis, aggregate payouts in the US and
other countries decrease.

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

Next, we looked at the good and the bad of hedging. We saw that hedging is really all
about choosing which risks to take. It's not about reducing overall risk. It's about
choosing not to face currency risk or distress risk. It's about reducing volatility. It's also
about the varying of speculation.

Then we talked about violations of the basic idea of NPV. This is one of the key ideas
that we learned in this course is the idea of net present value which is basically there is

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Professors Heitor Almeida and Stefan Zeume

an investment today and then there is the present value of future cash flows. We invest
if the net present value is positive. But then in Module 4 we talked about situations in
which the NPVs might be positive, but there might be other considerations that make
the NPV different from this simple equation, for example, agency cost of debt, there
may be conflicts between debtholders and shareholders, or there may be conflicts
between finance and society.

We talked about things that we should not forget. Conflicts between management and
society, for example and things that are not necessarily monetary. We learned how to
take those into account in Module 4 and really broaden our notion of NPV in order to
make better financial decisions.

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