Course_Summary

Course_Summary - Course Summary Corporate Finance What...

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1 Course Summary – Corporate Finance What Distinguishes Cor porations? 1. K e y features • Limited liability. • Public trading of ownership shares. • Corporations pay a separate income tax. • The managers typically are not major owners of the firm. 2. Major consequences • Corporations can undertake long lived and risky investments. • Corporations better facilitate saving and future consumption. • Corporations allow risks to be transferred: i. employees get a relatively fixed wage despite fluctuating MP N ; ii. bond returns relatively fixed despite changing MP K ; iii. shareholders bear most of the risks of corporate investments. • Corporations have a strong incentive to minimize tax liability. • The tax deductibility of interest payments at the corporate level
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2 favors debt relative to equity financing. • The separation of ownership from management can lead to inef- ficient use of retained earnings when worthwhile investment projects for the firm are scarce. Mark ets in Cor porate Equity and Debt • A market in ownership and control pressures managers to max- imize asset market value: i. Equity holders elect directors, who in turn choose and oversee management. ii. The ability to control the firm by owning shares leads to the possibility of takeovers. Investors have an incentive to monitor managerial performance since they make a capital gain if they re- place under-performing managers. • The risks associated with corporate residual income are traded on capital markets. Those most willing to bear the risk voluntar- ily purchase shares. • Risk averse investors nevertheless desire higher mean returns to
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3 compensate for an increased variance of returns. Portfolio diversification allows investors to reduce risks by elim- inating the unsystematic or diversifiable variability of returns. In- vestors normally are compensated only for systematic risks. 1. Capital Asset Pricing Model (CAPM) • If there is a riskless, or almost riskless, asset the mean-variance efficient frontier will approximate a straight line with a slope rep- resenting a market price of non-diversifiable risk. • Specifically, CAPM measures the systematic , or non-diversifi- able , risk of asset i by its beta coefficient , which is the slope co- efficient in a regression of the return on asset i , R i , on the return on a diversified market portfolio, R M : (1) • The expected return on asset i is then a linear function of the risk- free rate r and β i : (2) β i cov R i R M , () σ 2 R M ------------------------------ = R i r β i R M r + =
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4 where R M is the expected return on the market portfolio and R M r is the market risk premium. • Viewed as a relationship between expected return and an asset’s beta coefficient, (2) leads to the security market line (SML).
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Course_Summary - Course Summary Corporate Finance What...

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