Corporate Finance Summary

The Law of One Price (LOOP) is the main idea in corporate finance, providing a consistent way to value things. It says that if two assets or portfolios have the same cash flows and risks, they must sell for the same price, no matter how they were created. This removes arbitrage opportunities and means financial decisions are about present value calculations. LOOP helps value complex financial tools by breaking them into simpler parts. It ensures that a firm's investment decisions focus on getting the most present value from future cash flows, instead of looking for 'bargains' that don't exist in efficient markets. Understanding LOOP helps make good capital budgeting, financing, and dividend policy decisions.

The Separation Principle is a key idea in corporate finance. It says that in perfect capital markets, a firm's investment decisions (capital budgeting) can be judged separately from its financing decisions (how it gets money). This is because any financial transaction, like issuing debt or equity, has a zero-NPV in a perfect market. A project creates value by generating cash flows that are more than its costs, not by how it is funded. Managers should first find projects with positive Net Present Value (NPV). Then, separately, they should decide on the best capital structure to fund these projects. This principle simplifies decision-making by letting managers focus on the operational and strategic value of investments without getting distracted by financing details.

The Net Present Value (NPV) rule is the most reliable way to make capital budgeting decisions because it directly measures how much a firm's value changes. By bringing all future cash flows of a project back to the present and subtracting the initial investment, NPV shows exactly how much value a project adds to the firm. A positive NPV means the project is expected to create more value than it costs. This makes it a good investment that will increase shareholder wealth. Unlike other measures, NPV considers the time value of money and the project's size, giving a clear rule for maximizing value. Using the NPV rule helps a company consistently take on projects that increase value.

The main idea of finance is the balance between risk and return. Investors are rational and dislike risk, meaning they will only take on more risk if they expect a higher return. This relationship is shown through ideas like the Capital Asset Pricing Model (CAPM). This model shows how an asset's expected return depends on the risk-free rate, the market risk premium, and the asset's systematic risk (beta). Understanding this is important for investors choosing portfolios and companies evaluating projects. Firms must make sure that the expected returns from their investments pay enough for the systematic risk they add, matching shareholder expectations and the cost of capital.

The Efficient Market Hypothesis (EMH) says that in a truly efficient market, asset prices quickly and fully show all public information. This means investors cannot consistently make extra returns using past prices (weak form efficiency), public information (semi-strong form efficiency), or even private information (strong form efficiency). While strong form efficiency is often debated, semi-strong efficiency suggests that analyzing public data is unlikely to consistently lead to better performance. For company managers, EMH means that trying to 'trick' the market is pointless; the market will quickly price in the true economic value of decisions. It reinforces the need to focus on real value creation rather than speculative trading.

A firm's capital structure—the mix of debt and equity it uses—is an important decision that affects its cost of capital and total value. While the Modigliani-Miller (MM) ideas suggest that in perfect markets, capital structure doesn't matter, real-world issues like taxes, financial distress costs, and agency costs make it very important. Debt offers a tax shield, as interest payments are tax-deductible, which can lower a firm's weighted average cost of capital (WACC). However, too much debt increases the chance of financial trouble and bankruptcy, raising the cost of equity and debt. Finding the best capital structure means balancing the benefits of debt's tax shield against the rising costs of financial trouble. The goal is to minimize WACC and maximize firm value.

A firm's payout policy decides how it gives extra cash back to shareholders. The two main ways are dividends and share repurchases. In perfect capital markets, Modigliani and Miller say that payout policy doesn't matter, as shareholders can create their own 'homemade dividends.' But in reality, things like taxes, agency costs, and signaling effects make payout policy important. Dividends give a regular income but can be less tax-efficient for some investors. Share repurchases offer flexibility, can signal that a company is undervalued, and are often more tax-efficient. The best policy balances these factors, aiming to maximize shareholder wealth by returning capital efficiently while keeping enough for future good investments. Firms must consider their investment chances, financial flexibility, and shareholder preferences.

While the Law of One Price provides the theory, practical valuation uses different methods. The Dividend Discount Model (DDM) values equity based on expected future dividends. The Free Cash Flow to Equity (FCFE) and Free Cash Flow to Firm (FCFF) models value equity or the whole firm by discounting the cash available to equity holders or all capital providers. Multiples-based valuation (e.g., P/E, EV/EBITDA) uses similar companies to estimate value, assuming similar firms should have similar valuations. Each method has good and bad points, and the choice depends on the company's traits, industry, and data availability. All these methods try to apply the Law of One Price by estimating the present value of future cash flows or by finding similar assets.

Standard NPV analysis often assumes a fixed plan, but managers can actually change decisions based on future events. These 'real options'—like the option to expand a project if it works, stop it if it fails, or delay it until more information is available—add value to a project that static NPV calculations might miss. Recognizing and valuing these options, often using option pricing models, gives a clearer picture of a project's true worth. Ignoring real options can lead to not investing enough in projects with high strategic value or high uncertainty, because the value of flexibility isn't included. Including real options encourages a more flexible approach to capital budgeting.

Agency problems are common in corporate finance. They happen because ownership (shareholders) and control (managers) are separate. Managers, as agents, might not always act in the best interest of shareholders (the principals). This can lead to decisions that prioritize personal gain, perks, or building a bigger company over increasing shareholder wealth. These conflicts can be reduced through things like good corporate governance (e.g., independent boards), incentive pay (e.g., stock options, performance bonuses), and the threat of hostile takeovers. Understanding agency costs helps design good corporate structures and pay schemes that align manager incentives with creating shareholder value, ensuring firms run well and ethically.