Hkust Corporate Finance Teaching Note

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FINA 4104: Advanced Financial Management
Professor Xuewen Liu
Department of Finance, HKUST
Spring 2013
Email: Xuewenliu@ust.hk
Office hour: 13:30-14:30 Tuesday
Assessment: Assignments (12%), Midterm-exam (18%), Projects and presentations (15%), and Final exam (55%)
Textbooks:
1.
Corporate Finance, by J. Beck and P. DeMarzo, 2nd edition 2011, Pearson Education, Inc. Hereafter BD.
2.
Financial Markets and Corporate Strategy, by M. Grinblatt and S. Titman, 2nd edition, 2002, Irwin McGraw Hill. Hereafter GT.

I. Introduction to Corporate Finance
1. Corporations (Vs sole proprietorships, partnerships and limited liability companies) Typical features: Separation of ownership and management
Limited liability
Types: Closed-held companies
Public companies

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Organizational structure of a typical corporation:

Corporate environment:

Real asset
market of
business

(Real) product

Firm

Financial resource

Operation income

Financial
market

Payout

“Capital Markets: An Engine for Economic Growth”

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The relationship between economic efficiency and financial development (Wurgler (1999))

Finance changes personal wealth

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Volatile banking industry

Financial markets grow faster

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Corporate finance will become important

The international comparison in comparative advantages

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2. Corporate finance
It studies corporate financial decision-making, including investment decision and financing decision.
Investment
Decision

Financing
Decision

Debt
Real asset
market of
business

Financial
market

Asset
Equity

3. Outline of the course
Foundation of valuation

Firm's investment decision

Firm’s financing decision (capital structure and payout policy)

Investment and financing decision with market frictions
a. tax
b. agency problems
c. information asymmetry

Topics
a. merger and acquisition
b. risk management

Readings:
BD 1

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II. Valuation (1): CAPM - Risk and Return
Risk and return are central concepts in finance. How to deal with risk is a key issue in financial industry. In this chapter, we study risk and return systematically. Some motivation examples:
Example 1: the relationship between risk and return

Conclusion:
Small stocks had the highest long-term returns, while T-Bills had the lowest longterm returns. Why? Higher risk requires a higher return.

Example 2: what risk means

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Conclusion: Risk means the fluctuations in price. The high risk, the more volatile in price.

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Example 3: The historical tradeoff between risk (volatility) and return in 1926–2004

Conclusion: Return is increasing with risk (volatility). Also, it seems that there exists linear relationship between them. Is it true?

In deed, the central task for us in this chapter is to study how to define and measure risk, and how to quantify the relationship between risk and return. 1. Measure risk and return
1.1 Methodology
Probability Distribution When an investment is risky, there are different returns it may earn. Each possible return has some likelihood of occurring. This information is summarized with a probability distribution, which assigns a probability, PR , that each possible return, R , will occur.

Assume BFI stock currently trades for $100 per share. In one year, there is a 25% chance the share price will be $140, a 50% chance it will be $110, and a 25% chance it will be $80.

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Expected (Mean) Return
Calculated as a weighted average of the possible returns, where the weights correspond to the probabilities.

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Expected Return  E  R  



R

PR  R

E  RBFI   25%(  0.20)  50%(0.10)  25%(0.40)  10%



Risk
Two ways to measure risk


Variance: the expected squared...
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