Introduction EC Borja Larrain

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Introduction

EC 1745

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Today:

1. Personal introduction.

2. Syllabus and course policies (read this!).

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1 Personal introduction

• Borja Larrain

—

Originally from Chile (close to the kingdom of far

faaaar away).

—

Ph.D. Economics Harvard ’04.

—

Research on impact and determinants of equity

issues, macro implications of

fi

nancial frictions.

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2 Syllabus and course policies

• See course website.

• Everything is in there: rules, course outline, required

readings, grading, etc.

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Preliminary version 09/12/2008

Harvard University

Economics 1745

Corporate Finance

Fall 2008

Meeting time: Monday and Wednesday, 1:00-2:30 p.m. Location: Harvard Hall 201

Borja Larrain, [email protected]

Office: Littauer 226, Tel: 6-3180

Office hours: Monday 3-4pm.

Teaching Fellows and sections’ time and location:

Sergey Chernenko (Head TF), [email protected], Fri 2-4pm Lowell B13.

Stefano Giglio (Head TF), [email protected], Wed 6-8pm Northwest B104. Soojin Yim, [email protected], Thu 4-6pm Science Center 216.

Course Administration:

Economics TEAM: [email protected]

Littauer M-4 and M-5

Course Overview

This course is an introduction to three main areas of corporate finance: (1) valuation (the valuation of projects and firms), (2) capital structure (the distortions associated with different ways of financing), and (3) corporate governance (optimal governance structures of firms).

Prerequisites: Economics 1010a or 1011a, Mathematics 20, and Statistics 100.

In words: An introductory economics class is required. There are lots of formulas and equations in this course, but an advanced knowledge of math or statistics is not required. We will use only basic algebra/calculus, although being comfortable with math will make your life easier. Some basic knowledge of statistics is assumed (mean, variance, correlation, and little else). Also, some really basic knowledge of Excel is necessary for the assignments.

Course Materials

- Class notes: available on the class website.

- Main text book: Corporate Finance: An Introduction (2008), Ivo Welch. Available at the COOP starting on 10/01. Copies of the first 6 chapters of the book are available to pick up for free at Gnomon Copy (only for students on the list of Ec1745) starting on 09/16. Please, be a good citizen; do not take a copy if you do not plan to stay in this class.

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In class we will follow closely the structure of the book, but the treatment of several topics may be different at times. Some topics, in particular towards the end of the course, are not covered in the book. Class notes are the definitive source of required knowledge for the class.

Grading

Three things go into your course grade: - Midterm

- Final

- Assignments

The course grade will combine these in the following way:

Grade = 0.70 max[0.5(midterm + final), final] + 0.30 [best 6 assignments]

Midterm/Final: As implied by the formula, the midterm is optional. If you do not take the midterm, the final will account for 70% of the course grade. If you take the midterm, you have the option to improve the grade on your final. There will be no make-up midterm. Please note that if you take this class Pass/Fail you have to take the midterm.

After an exam is graded and returned to you, you will have the option to request a re-grade for a short period of time following each exam. However, please be aware that we reserve the right to re-grade the entirety of your exam.

Most exam questions will be in the same format and level of difficulty as the assignments, although remember that time pressure can make things more complicated. Assignments: There will be seven assignments distributed throughout the semester. They will typically be due the following week. The course policy will be not to accept late assignments or grant extensions: a late assignment will translate into a grade of zero. The assignments will be graded according to the following scale:

- 0 (no credit): most key answers are missing. Late assignments. - 1 (check minus): many key answers are missing.

- 2 (check): a few key answers are missing.

- 3 (check plus): none of the key answers is missing.

Of course, there is discretion in where to draw the line between, say, a check minus and a check, but we will try to err on the side of generosity. In part for this reason there is no re-grading of assignments. Note that the assignments account for 30% of your course grade and are important enough to affect the final letter grade. Only your best 6 assignments count for the course grade.

You are permitted to collaborate on the homework assignments. However, each person must submit a separate write-up. If you select to work within a group, each person is asked to list the members of the group atop their submission.

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How to get a good grade in this class:

1. Read the book chapter before class. 2. Come to class.

3. Read again the class notes and the book after class. 4. Do the assignments.

If you do this, you will most likely do very well in this class. Do not wait until one week before the mid-term to start reading the book or class notes. Be responsible; keep up with the readings and assignments. This is a demanding class. And if you have trouble, seek help from the TFs or myself. That’s why we are here.

Other course policies

- Class attendance: Attendance on-time is proper business etiquette and a minimal requirement for classroom participation. Please try to be in your seats by 1:05. The class will start promptly at 1:07. If you are more than 7 minutes late, please do not bother to show up. Coming late interrupts the class.

- Electronic attendance: Each student is required to check the class website at least once every day. Students are responsible to have read posted notes. They may even contain new assignments, and it is not an excuse if you have not read it there.

- Pass/fail policy: Only a limited number of students will be allowed to take the course pass/fail. To apply for this particular status, please send an email to Prof. Larrain stating the reason for the request by 09/22.

- Email: Please include EC1745 in the subject line of all e-mails regarding the course, and if you have any questions or concerns regarding the course policies feel free to send an e-mail to any of the TFs.

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COURSE OUTLINE

Date Topic Readings Assignment

September 15 (M) Introduction Welch Ch 1 September 17 (W) Time Value of Money Welch Ch 2

Section:

Week of Sept 15

Sections to be set up

September 22 (M) Perpetuities, annuities Welch Ch 3 September 24 (W) Capital budgeting (logic,

IRR, PI, payback)

Welch Ch 4

Section:

Week of Sept 22

Sections to be set up

September 29 (M) Yield curve, YTM, duration Welch Ch 5 Assignment 1 is due October 1(W) Uncertainty, default, and risk Welch Ch 6

Section:

Week of Sept 29

Discussion of assignment 1 and related topics

October 6 (M) History of returns and institutions

Welch Ch 7 Assignment 2 is due October 8 (W) Risk and reward Welch Ch 8

Section: Week of Oct 6

October 13 (M) Holiday – Columbus day

October 15 (W) More risk and reward Welch Ch 8 Assignment 3 is due

Section:

Week of Oct 13

October 20 (M) CAPM Welch Ch 9 October 22 (W) Market imperfections Welch Ch 10

Section:

Week of Oct 20

Q & A sessions

October 27 (M) Efficient markets Welch Ch 11 Assignment 4 is due October 29 (W) Capital budgeting Welch Ch 12

Section:

Week of Oct 27

November 3 (M) More on capital budgeting Welch Ch 12 November 5 (W) Mid-term examination

Section: Week of Nov 3

Discussion of mid-term

November 10 (M) From financial statements to cash flows

Welch Ch 13

November 12 (W) Valuation from comparables Welch Ch 14 Assignment 5 is due

Section:

Week of Nov 10

November 17 (M) Corporate claims Welch Ch 15, 16

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November 19 (W) Capital structure with taxes Welch Ch 17

Section:

Week of Nov 17

Q & A sessions

November 24 (M) Financial distress Welch Ch 18 Assignment 6 is due November 26 (W) Agency costs and

expropriation

Welch Ch 18

Section:

Week of Nov 24

Thanksgiving Recess

December 1 (M) Asymmetric information Welch Ch 18 December 3 (W) Payout policy Welch Ch 19

Section: Week of Dec 1

December 8 (M) Corporate Governance Welch Ch 24 Assignment 7 is due December 10 (W) Comparative Financial

Systems No reading is required Section: Week of Dec 8 Discussion of assignment 7 and related topics

December 15 (M) Wrap-up and discussion of the final exam

No reading is required

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My teaching philosophy:

• Finance is a lot of fun. I’d like you to get as excited

as I am about

fi

nance.

• Why is

fi

nance so much fun? As an academic

dis-cipline, it contains the perfect blend of theory and

practice that keeps everyone interested.

• I’d like to help you understand the world of

fi

nancial

markets, not just learn a couple of formulas. Think

in

fi

nancial terms or with the language of

fi

nance.

• Some

fi

nance jargon is necessary. Please stop me if I

use jargon that I haven’t de

fi

ned. And don’t assume

the meaning is obvious, because it rarely is (e.g.,

short sellers, bullish market, CDOs, ABCP, I can go

on for hours....).

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• Hopefully, what you learn in this class will help when:

—

you invest in your 401k plan.

—

you buy a house (i.e., mortgage).

—

you apply for a job in Wall Street.

—

you try to understand how corporations,

invest-ment banks, and others decide.

—

you read the WSJ.

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3 Big picture: Valuation

• The integrating theme of

fi

nance is

Valuation

.

• We want to

fi

nd today the value (price) of a project,

fi

rm, or

fi

nancial asset that delivers cash

fl

ows in the

future.

• Valuation is forward looking, not backward looking.

• Valuation will help us to answer 3 sets of questions:

—

Capital budgeting: Should we take a particular

project? What is the value of the project?

—

Investments: Where should you put your dollars

among many projects or assets? How to

struc-ture an investment portfolio?

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—

Capital structure: To undertake project

invest-ments, should you borrow from a bank or sell

shares to partners?

What are the advantages

and costs of di

ﬀ

erent ways of

fi

nancing?

• Of course, these 3 areas are interrelated (through the

issue of valuation!)

• To answer these questions

fi

nance combines tools

from:

1. Economics (the science of tradeo

ﬀ

s, aka

cost-bene

fi

t analysis)

2. Statistics (the science that studies uncertainty)

3. Accounting (the language of business — book

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3.1 Valuation is Relative

• All

fi

nancial valuation is relative to alternatives.

• The

Law of One Price

: similar things should cost

similarly.

• Valuation is easy when the alternatives are very close

to the thing we are trying to value.

• Valuation is hard when good substitutes are not

avail-able.

For example, it is easy to

find the price for an apartment

if the apartment next door was sold 3 weeks ago for $X. It is

very hard to value the White House.

• From "easy" to "hard" things to value:

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—

One share of IBM vs. one option of IBM.

—

One share of PepsiCo vs. one share of Coca-Cola.

—

One share of PepsiCo vs. one share of IBM.

—

One 3BR, 2 BT, 2,000 sqft apartment in

Cam-bridge vs. 3BD, 1BT, 2,500 sqft apartment in

Somerville.

—

One house in Cambridge vs. one house in Fifth

Ave NYC.

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3.2 Projects, Firms, and Financial Assets

• A project is anything that generates a series of cash

fl

ows in the future:

—

Set up a repair shop. Cost $500. Expected

earn-ings $1,000 per month, starting next month, for

24 months.

—

Buy one share of IBM today and sell it at the

end of the year.

—

Buy a lottery ticket for $1 and get $14,000,000

with some (small) probability.

—

Get an MBA: pay tuition and forego salary for

two years. Then get an extra X dollars in salary

for 30 years with some (hopefully not too small)

probability.

• Projects can be from physical investments (the

re-pair shop), to

fi

nancial investments (buy shares), to

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gambles. From the point of view of

fi

nance we will

care about the

timing and uncertainty

of the cash

fl

ows that the project delivers. Explaining how these

cash

fl

ows are produced is the domain of de

fi

nitely

"more boring" disciplines (e.g., engineering or

mar-keting). For us, a project will be a black box that

consumes cash (investment) and delivers cash.

• A

fi

rm invests in many di

ﬀ

erent projects

simultane-ously.

• A

fi

rm gets

fi

nancing for these projects by issuing

fi

nancial claims: loans from banks, bonds, shares,

etc.

• After paying production costs (e.g., labor), the

fi

rm

needs to pay back to the asset holders from whom

the

fi

rm borrowed money to invest in projects: pay

interest to the bank, pay dividends to shareholders,

and so on.

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• So,

fi

nancial assets are claims to the cash

fl

ows

pro-duced by the projects of

fi

rms.

• The sum of the value of all claims is, by de

fi

nition,

the value of the

fi

rm:

Firm

=

Debt (loans, bonds)

+

Equity (Owners)

=

All future payouts

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