This blog post is a continuation from my last post, which provided an overview of the first four lessons for Corporate Finance; I will now summarise the second half of the module. As a reminder, the first half provided a refresher of some of the important concepts taught previously in the Accounting and Financial Management module, as well as introducing some new topics such as short- and long-term sources of debt, IPOs, and valuation of equity.
Lesson 5 introduced a topic that is central to many of the key corporate finance concepts, Risk and Return. The textbook reading explored the volatility and returns of various markets/investments over the last century, and then highlighted two types of risk that a stock is subject to: firm-specific risk (which affects only an individual stock), and systematic risk (which affects all firms in a market or economy). This led to an in-depth discussion around diversification, and highlighted the very interesting point that stock prices do not need to reflect or take into account risks that are specific only to that firm, as investors can effectively eliminate that risk through diversification.
The chapter then introduced the concept of Beta – this is a term I had heard of in the past without knowing the context, so it was interesting to understand what it represents and how it can be used. Finally, this lesson talked about the Capital Asset Pricing Model (CAPM), which is one of the key concepts in corporate finance that links the expected returns from a firm with its risk (using the Beta). Although this was quite a complex topic (three chapters in the textbook!), the online lesson notes provided a very succinct summary that simplified the topic considerably.
Lessons 6-9 formed the core of the Corporate Finance module, and investigated the three key questions of the module:
- Capital Budgeting decision
- Financing decision
- Payout Policy decision
Two lessons focussed on Capital Budgeting; the first was relatively straightforward, explaining how to compare different investment opportunities based on NPV and IRR. However, lesson 7 was much more in-depth, looking at the impact of leverage (ie. how increasing debt can reduce your tax bill) and how different project risks can affect the decision on where to invest. There was also a discussion around options: the textbook went into lots of detail to explain financial options on the stock market (referred to as calls and puts), and then this was extended to investment decisions; real options allow decision makers to consider the implication of having an ‘option’ to expand or abandon a project in the future, which is particularly important when evaluating projects that can be deployed in phases.
Lesson 8 looked at the second decision, relating to Financing Policy. Although at a high-level this is separate to that of Capital Budgeting, the two decisions are very closely interlinked. The lesson focussed on Modigliani and Miller and other theories, which conclude that:
- The leverage ratio (ie. ratio of debt to equity) does not affect returns in a simplified world with no taxes or bankruptcy risk
- Taxation of interest means that there is a ‘tax shield’ associated with debt, which would suggest that all firms should be fully financed by debt
- The potential for bankruptcy (financial distress) means that the tax shield benefit needs to be offset against the increased risk of bankruptcy that debt introduces
- The existence of asymmetric information (ie. managers knowing more than shareholders) causes something known as the ‘lemons problem’, resulting in a generic ‘pecking order’ for investment which starts by using retained earnings, followed by debt, and finally equity
Lesson 9 considered the the final decision, relating to Payout Policy. I found this topic interesting as it explained the reasons behind companies splitting stocks and buying their own shares (repurchasing), and the benefits this can bring to shareholders. It also discussed the reasons why some companies issue dividends and others do not, despite having large unused cash reserves.
The final lesson of this module provided an overview of the topic of Mergers and Acquisitions, explaining both the actual benefits of undertaking an acquisition, as well as the more questionable benefits. It provided an overview of the process involved in an acquisition, explained the differences between friendly and hostile takeovers, and introduced some of the defence mechanisms companies can employ to protect against hostile takeovers. Finally, the lesson closed with a quantitive look at M&A by assessing the resulting value created (or not) by an acquisition. Overall, this was another interesting lesson, and particular relevant given that as I was reading it, most news outlets were discussing the proposed takeover of AstraZeneca by Pfizer.
In addition to the lessons, this module also included a case study that looked at the decision by Diageo to sell off Pillsbury and Burger King. What was particularly interesting with this case was it showed how a change in corporate strategy not only impacted, but was also steered and influenced by the corporate finance strategy.
That’s all the lessons completed for Corporate Finance – I’m now putting this into practice to write the final assignment. Overall this has been an interesting module, and although it has been very heavy with some of the mathematical equations, it has in general been balanced by a good discussion around the practical insights that can be observed from the results. Another notable aspect I found interesting was in the textbook, where there were a number of interviews with senior financial executives who talked about their real-life roles and decisions; these were fascinating to read, and helped bring many of the concepts to life.