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Financial Management - Lecture notes, lectures 1 - 10

Financial Management (Monash University)

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FINANCIAL MANAGEMENT AFF2631

SEMESTER 2, 2011

Heading 1: What is Financial Management?

The Financial Management function is centered around corporate finance, which

attempts to find answer to the following questions:

1. What investments should the firm take on?

The Investment Decision

2. How can cash be raised for the required investments?

The Finance Decision

3. How should wealth be redistributed to shareholders?

The Dividend Decision

The Corporate Objective

Primary goal is to maximize the value of the firm, which is same as maximizing
shareholder wealth.

Every decision that we make as financial managers needs to come back and answer
this question:

“Have we added value?”

If the answer is “yes” then we should undertake the decision.

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Heading 2: Financial Mathematics Part I

The Time Value of Money

A dollar today is worth more than a dollar tomorrow. This is because if I receive a
dollar today, I can invest it for the period up until I would have received the dollar in
the future. The present value technique uses discounting to find the present value of
cash flows, whereas the future value technique uses compounding to find the future
value of each cash flow.

Four Important Cash Flow Patterns

1. Single Sum or Lump Sum Cash Flow

Future Value (Compounding Techniques)

The total amount due at the end of the investment is called the Future Value (FV).

Compounding results in interest that is accrued in previous periods, earns further

interest.

Future Value Formula

FVn = PV x (1 + i)n

Where;

(PV) is the cash flow at date 0,

(i) is the appropriate interest rate, and
(n) is the number of periods over which the cash is invested.

E.g. Investment $1,000, interest rate 6.00%, period of 5 years.

FVn = $1000 x (1.06)5 = $1,338.23

On Calculator

Note: Always clear the memory of the calculater ([2ndF] > [alpha] > [0] > [0])

Input each value in the calculator as ‘n’, ‘PV’ and ‘I/Y’ then hit ‘comp’ ‘FV’.

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FVIF Determination

(1 + i)n is also called the future value interest factor.

 FVIF is the FV of 1 dollar at i% per annum after n periods,

 Future value is due to the number of periods in which interest can be
compounded. The larger the number of periods, the greater the future value,
 Future value also depends critically on the interest rate - the higher the
interest rate, the greater the future value.

Using Financial Tables (Table A-1 Page 776)

Using a table only gives an estimation as the rate is only 3 decimal places, i.e. 6%
for 5 years is 1.338.

FV6%,5yrs = $1,000(1.338) = $1.338.00.

Present Value (Discounting Techniques)

The use of discounting techniques aids in finding the current dollar amount of a
given future value.

The general formula for the present value of a multi period case for a single cash
flow can be written as:

FV n
PV =
(1+i)n

Where:

(PV ) is the cash flow at date N=0,

(i ) is the appropriate interest rate per period,
(n) is the number of periods over which the cash is invested.

E.g. How much would you have to set aside today in order to have $20,000 five
years from now assuming the current interest rate is 7.00%?

$ 20,000
PV = =$ 14,259.72
(1.07)
5

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On Calculator

Clear the memory, then:

20000 [FV]
7 [I/Y]
5 [N]
[COMP] [PV]

PV = -14259.72. This does not mean the answer is a negative, but rather that it is in
a prior period to the future.

PVIF Determination

1/(1 + i)n is also called the present value interest factor.

 PVIF is the PV of 1 dollar at i% per annum after n periods

 Present value is due to the number of periods in which interest can be
discounted. The larger the number of periods, the smaller the present
value.
 Present value also depends critically on the assumed interest rate
(discount rate) - the higher the interest rate, the smaller the present
value.

Working out ‘n’ or the Time Period

If you deposit $5,000 today in an account paying 10%, how long does it take to
grow to $10,000?

FVn = PV(1 + i)n

$10,000 = $5,000(1.10)n
(1.10)n = $10,000/$5,000
ln(1.10)n = ln(2)
n×ln(1.10) = ln(2)
n = ln(2)/ln(1.10)
n = 0.6931/0.0953
n = 7.27 years

On Calculator

Clear the memory, and then:

5000 [+/-] [PV]

10000 [FV]
10 [I/Y]
[COMP] [N]

N = 7.27

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The Rule of 72

This rule is an approximation. If you earn r% per year, your money will double in
roughly 72 / r years.

For example, if property sales grow at 10% per year, it takes about 7.20 (72 / 10)
years to double your investment.

Test it: Assuming we double our money in 7.20 years, n = 7.2. As we did not specify a
PV or FV amount, doubling our money assumes that we will get $2 (FV) for every $1
invested (PV). Thus, using these figures to solve for (i) – as below;

FVn = PV x (1 + i)n

$2 = $1 x (1 + i)7.2
(1 + i)7.2 = $2 /$1 = 2
(1 + i) = 21/7.2
i = 21/7.2 – 1
i = 0.10 or 10%

Working Out the Interest Rate

Assume the total cost of a 3-year commerce university education will be $100,000
when your child (hopefully yet to be conceived) enters university in 20 years.
Assume you have $5,000 to invest today. What rate of interest must you earn on
your investment to cover the cost of your future child’s education?

PV = $5,000
FV = $100,000
N=5
i=x

FVn = PV x (1 + i)n

$100,000 = $5,000 x (1 + i)20

= (1 + i)20 = $100,000/ $5,000 = 20
(1 + i) = 201/20
i = 201/20 – 1
i = 0.1616 or 16.16%

5000 [+/-] [PV]

100000 [FV]
20 [N]
[COMP] [I/Y]

Nominal Interest Rates

 The nominal interest rate (NIR) is known as the stated, or quoted, rate (e.g.,
10% pa compounded annually),

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 The NIR is simply equal to the interest rate charged per period multiplied by
the number of periods per annum,
 For example, if a bank charges 1% per month on a car loan, the NIR is 1% x
12 = 12%.

Compound Growth Rates

Compound growth occurs when the initial value of a number increases or decreases
each period by the factor (1 + growth rate). The future value of a number after n
periods will equal the initial value times (1 + growth rate) n. The growth rate
formula substitutes g, the growth rate, for i, the interest rate.

FVn =PV ´( 1+ g)
n

For example, suppose that because of an advertising campaign, a company's sales

increased from $20 million in 2011 to more than $35 million 3 years later. What
has been the average annual growth rate in sales? Here, the future value is $35
million, the present value is $20 million, and n is 3 since we are interested in the
annual growth rate over 3 years.

Compounding Frequency

 So far, compounding frequency has been assumed to be annual. In reality

compounding frequency is greater than one in any given period.

m´n
æ iö
FVn =PV ´ç1+ ÷
è mø
 (m) is the frequency of compounding in a period
 (i) is the stated/quoted annual interest rate, and is commonly called the
annual percentage rate or the nominal interest rate.

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Compounding Periods

Compounding an investment m times a year for n years provides for future value of
wealth:

m´n
æ iö
FVn =PV ´ç1+ ÷
è mø

For example, if you invest $50 for 3 years at 12% compounded semi-annually, your
investment will grow to:

æ 0.12 ö
2´3

FV =$50 ´ç1+ ÷ =$50 ´(1.06)6 =$70.93

è 2 ø

Comparing Annual Rates with Non-Annual Rates

For example, a bank is offering 12 percent interest compounded quarterly, if you

put $200 in an account, how much will you have at the end of year 2?

Given PV = 200, m = 4, n = 2, I =0.12,

æ 0.12 ö
4´2

FV 2 =$200 ´ç1+ ÷ =$253.35

è 4 ø
Effective Annual Interest Rates

The EAR (or effective annual yield) is the true interest rate expressed as if it were
compounded once per year.

The EAR is the return on $1 in 1 year.

m
æ iö
EAR =ç1+ ÷ - 1
è mø
Where;
i = the quoted annual interest rate,
m = the number of compounding periods in a year.

Effective Annual Rate

You have $10,000 to invest for one year and the following choices are offered by the
banks in your area:

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(a) 6% p.a., compounded annually;

(b) 5.90% p.a., compounded daily;

Which of the alternatives would you choose?

m
æ iö æ 0.06 ö
1

a) EAR =ç1+ ÷ - 1 =ç1+ ÷ - 1 =6.00%

è mø è 1 ø
m
æ iö æ 0.0590 ö
365

b) EAR =ç1+ ÷ - 1 =ç1+ ÷ - 1 =6.08%

è mø è 365 ø

Note: (a) is not entirely necessary because we are told that 6% is compounded
annually, thus the EAR is going to be 6%.

As a borrower, (a) is more favourable because we are paying less in interest each
year.

If we are an investor, lending our money to the banks, than (b) is more favourable
because it yields a higher interest rate on our deposit.

On Calculator

Clear the memory, and then:

365 [ (x, y) ]
5.9 [2ndF] [PV]
365, 5.9 => EFF = 6.08

Continuous Compounding

 Frequency of compounding (or discounting) within a period of time

approaches infinity (i.e., interest is charged so frequently that the time
between two periods approaches zero),
 Interest is compounded instantaneously.

FV =PV ´ei´n

FV
PV =
ei´n
Where:

(n) = The number of periods,

(i) = The one-period interest rate,
(e) = 2.71828182846, a constant (base of natural logarithms – also known as
Euler’s constant).

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For example, you invest $1,000 in an account today. The interest is 10% p.a.,
compounded continuously. What will the balance be in the account at the end of
five years?

Given: PV = $1,000, i = 0.10, n = 5;

FV5 =PV ´ei´n =$1, 000 ´e0.10´(5)

=$1, 000(1.64872) =$1, 648.72

For example, suppose you want a balance of $1,000 at the end of five years. If
interest on the account is 10% p.a., compounded continuously, how much must you
deposit today?

PV =FV / ein
=$1, 000 / e0.10(5)
=$1, 000 /1.64872 =$606.53
2. Mixed Stream (or Multiple Cash Flow)

Future Value of a Mixed Stream

The approach to calculating the future value of a known mixed stream involves a
two step process.

Step One: Calculate the future value of each future amount to be received at a
comparable point in time.

Step Two: Sum all future values at a comparable point in time together to
determine the future value of the known mixed stream.

For example, you deposit $1,000 now, $1,500 in one year, $2,000 in two years and
$2,500 in three years in an account paying 10% interest per annum. How much do
you have in the account at the end of the third year?

Draw a timeline for time comparability.

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Total = $7,846.00

Present Value of a Mixed Stream

The approach to calculating the present value of a known mixed stream also
involves a two step process.

Step One: Calculate the present value of each future amount to be received at
a comparable point in time (usually T=0).

Step Two: Sum all present values at a comparable point in time to determine
the present value of the known mixed stream.

For example, you deposit $1,500 in one year, $2,000 in two years and $2,500 in
three years in an account paying 10% interest per annum. What is the present
value of these cash flows?

Once all values have been taken back to the same time period, they are comparable
and can be summed.

Total = $4,894.82

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Heading 3: Financial Mathematics Part II

Perpetuities

Perpetuities relate to a perpetual cash flow stream of equal amounts, equally

spaced in time.

0 1 2 3 4 5 6 ...
$PMT $PMT $PMT $PMT $PMT $PMT …

The PV of a perpetuity:
PV = CF/(1+i)1 + CF/(1+i)2 + CF/(1+i)3 + …

CF
PV =
i
Where CF = the cash flow period (i.e. payment)
i =the interest rate per period

Note: The formula values cash flows one period before the first cash flow.

Example 1: Perpetuity

A government security promises to pay $3 per annum forever. If the interest rate is
10% per annum and a payment of $3 has just been made, how much is the security
worth?

Given: CF = $3, i = 10%

PV = CF / i = $3 / 0.1 = $30.00

The present value of the perpetuity is worth $30.00. Present value of receiving
$3.00 forever is $30.00. Indifferent as to which option. $3 forever seems preferable,
but consideration must be made to the devaluation of $3 over time.

‘Has just been made’: a payment that has just been made is irrelevant, because it
relates to all the future cash flows.

Example 2: Perpetuity

Assume an 8 percent interest rate; calculate the present value of the following
streams of payments:

(a) $1,000 per year forever, with the first payment one year from today
(b) $500 per year forever, with the first payment two years from today
(c) $2,420 per year forever, with the first payment three years from today

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Solution

(a) $1,000 per year forever, with the first payment one year from today

PV = Perpetuity = CF/i = $1,000/0.08 = $12,500

Timeline
T=0 T=1 T=2 T=3 T=4 etc.
$0 $1,000 $1,000 $1,000 $1,000 etc.

Present value of the perpetuity at T=0.

(b)$500 per year forever, with the first payment two years from today

CF/i $500 / 0.08

PV = = =$5, 787.04
1+ i 1.08
Timeline
T=0 T=1 T=2 T=3 T=4 etc.
$0 $0 $500 $500 $500 etc.

Note: Valuing perpetuity and brings back to time 1. Must be discounted using PV =
FV/(1 + i)n in order to bring it back to PV or T=0.

(c) $2,420 per year forever, with the first payment three years from
today

CF/i $2,420 / 0.08

PV = = =$25,934.50
(1 + i) 2 1.082

Timeline
T=0 T=1 T=2 T=3 T=4 etc.
$0 $0 $0 $2,420 $2,420 etc.

Note, the future value of perpetuities is infinite because we don’t know when they
finish.

Annuities

An annuity is a cash flow stream of equal amounts, equally spaced in time for a
finite period of time (i.e. 6 years). The number of periods is fixed, this is the
difference between perpetuities (which are for an infinite number of periods).

0 1 2 3 4 5 6 .
$CF $CF $CF $CF $CF $CF

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In other words, a cash flow pattern where the owner receives a regular (FIXED)
payment, at a regular (FIXED) point in time for a known (FIXED) period of time.

 Ordinary Annuity (Annuity in Arrears): Pays a constant amount at the

END of each period for a finite number of periods. The whole period begins
and lapses before the annuity is paid.

 Annuity Due (Annuity in Advance): Pays a constant amount at the

BEGINNING of each period for a finite number of periods. First payment is
made today (i.e. the start of each year if the period starts in January and
runs through December).

Important: Always assume that an annuity is ordinary, that is, assume that the
cash flow is at the end of the period.

Ordinary Annuity

 The first C occurs at the end of the first time period:

0 1 2 3 4 … T
$CF $CF $CF $CF

 The time period from the date of valuation to the date of the first C is equal
to the time period between each subsequent C

 Also known as an annuity in arrears

Present Value of an Ordinary Annuity Formula

The present value of an annuity:

CF  1 
PVA n = 1 -
i  (1 + i) n 
Where:
PVA = the discounted or present value of the annuity
CF = the cash flow received/paid under the annuity (sometimes
referred to as pmt)
n = the time period over which the annuity occurs (number of
payments)
i = the per-period interest rate

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Example 3: What’s the PV of a 3-year annuity of $100 at 10%?

CF  1  $100  1 
PVA =PVA = 1 - = 1 - =$248.69
i  (1 + i) n  0.10  (1 + 0.10)3 

Thus, there is 3 payments, CF = 100 and I = 0.10.

Example 3: On Calculator

Clear the memory before any operation [2ndF] then [ALPHA] then [0] then [0]

0 [FV]
100 [PMT]
10 [I/Y] PV = -248.69
3 [N]
[COMP] [PV]

Future Value of an Ordinary Annuity Formula

CF 
FVA n =  (1+ i) n
- 1
i
Where:

FVA = the accumulated or future value of the annuity

CF = the cash flow received/paid under the annuity
n = the time period over which the annuity occurs
i = the per-period interest rate

Example 4: Future Value Ordinary Annuity

The annual cash flow from an asset is $2.3m from year 1 to year 6. The cash flows
occur at year-end. The interest rate is 10% p.a. compounded annually, what is the
accumulated (future) value of this asset?

Given PMT (cash flow) = $2.3m, i = 10%, and n = 6

0 1 2 3 4 5 6
$CF $CF $CF $CF $CF $CF

CF
FVA n =
i

(1 + i) n - 1 = 
$2,300,000
0.10
(1.10) 6 - 1  
FVA =$17,745,903.00

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FVA = CF ´FVIFA n i = $2,300,000 ´7.716

= $17,746,800 (from Table A - 3 page 780)

See from this example that a rounding table gives a $1,000 difference.

Clear the memory before any operation [2ndF] then [ALPHA] then [0] then [0]

0 [PV]
2300000 [PMT]
10 [I/Y] FV = 17,745,903.00
6 [N]
[COMP] [FV]

Annuity Due

 An annuity where the first PMT occurs immediately:

0 1 2 3 … n-1 n
$CF $CF $CF $CF … $CF

 Also known as an annuity in advance.

The difference here is that you earn an extra period of interest.

Annuity vs. Annuity Due

Value of an Annuity Due: Value of Ordinary Annuity x (1 + i)

CF  1 
PVA = 1 - ´(1 + i )
i  (1 + i) n 

FVA =
CF
i

(1 + i) n - 1 ´(1 + i) 

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Example 5: Annuity Due

Kathy’s rich uncle promises her $1,000 per month, starting today, with a final
payment to be made 6 months from today. If the interest rate is 0.50 percent per
month, what is the present value of the cash flows?
Given: CF = $1,000 (or pmt) , n = 7, i = 0.50%

N = 7 because the first payment occurs today, with the last payment in six months
from today.

CF  1 
PVA = 1-  ´(1+ i)
i  (1+ i)n 
$1000  1 
= 1- 7
´(1+ 0.005)
0.005  (1+ 0.005) 
=$6,896.38

Example 5: On Calculator

Clear the memory before any operation [2ndF] then [ALPHA] then [0] then [0]

Need to convert to BGN mode: Beginning ([2ndF] > [FV]) Will come up with BGN.
Usually the calculator is in END. Do the save to change it back.

0 [FV]
1000 [PMT]
0.5 [I/Y] PV = -6896.38
7 [N]
[COMP] [PV]

Applications of Annuities

 Equivalent Annuities
o Unequal life problem

 Growth Annuities
o Cash flows that increase each year at a constant rate

 Loan Amortisation
o Paying off your mortgage

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Example 6: Equivalent Annuity

If interest rates are 5% p.a. which asset would you rather have?

 One way to solve this problem is to find the PV of both cash flow streams

CF  1 
PVA Asset1 = 1 - ´(1 + i)
i  (1 + i) n 
$2  1 
= ´1 - ´(1 + 0.05)
0.05  (1 + 0.05)5 
=$9.09

FV $7
PVA Asset2 = = =$6.67
(1 + i) n
(1.05)1

 An alternative is to find an equivalent annuity for Asset 2

 Step 1: Find the present value of the cash flow stream of Asset 2.

FV $7
PVA Asset2 = = =$6.67
(1 + i) n
(1 + 0.05)1

 Step 2: Determine PMT (cash flow from annuity) as a 5 year annuity in

advance with the same PV.

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CF  1 
PVA = 1- ´(1 + i)
i  (1 + i) n 


CF  1 
$6.67 =  1- 5
´(1 + 0.05)
0.05  (1 + 0.05) 

So, CF =$1.47

Asset 1

Asset 2

Growth Annuity

A growth annuity is an annuity for which the cash flows increase at a constant rate
over time.

CF1  æ 1+g ö 
n

PVA = 1- ç ÷ 
i-g  è (1+ i) ø 

Where:
PVA = the present value of the growing annuity
CF1 = the cash flow one period in the future
g = the constant growth rate per period
i = the per-period interest rate, or discount rate

Example 7: Growth Annuity

Hill Enterprises is expecting tremendous growth from its newest boutique store.
Next year the store is expected to bring in net cash flows of $675,000. The company
expects its earnings to grow annually at a rate of 13 percent for the next 15 years.
What is the present value of this growing annuity if the firm uses a discount rate of
18 percent on its investments?

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 n
CF1  æ 1+ g ö 
PVA = 1- çç ÷÷
i-g  è (1 + i) ø 
 

 15 
$675,000  æ 1.13 ö 
PVA = 1- ç ÷
0.18 - 0.13  çè (1.18) ÷ø 
 
=$6,448,519.47

Loan Amortisation (Will be a question on this in exam and mid-semester)

Amortised loan - requires the borrower to repay both the principal and interest
over time (usually, the amount paid each period is equal).

Example 8: Loan Amortisation

Suppose you borrowed $5,000 at an annual interest rate of 9%, and you have to
repay it over five years with equal amounts each year. What will the annual
repayment be?

CF  1 
PVA =  1- 
i  ( 1+ i) n 

CF  1 
$5,000 = 1- 
0.09  ( 1+ 0.09) 5 
CF =$1,285.46

Example 8: Loan Amortisation Schedule

Year Beginning Total Interest Principal Ending

Balance Payment Paid Paid Balance
1 $5,000.00 $1,285.46 $450.00 $835.46 $4,164.54

2 $4,164.54 $1,285.46 $374.81 $910.65 $3,253.89

3 $3,253.89 $1,285.46 $292.85 $992.61 $2,261.28

4 $2,261.28 $1,285.46 $203.52 $1,081.94 $1,179.34

5 $1,179.34 $1,285.46 $106.12 $1,179.34 $0.00

Totals $6,427.30 $1,427.30 $5,000.00

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Example 9: Solving for Unknown Interest Rate

A five year ordinary annuity with coupon payments of $100 has a present value of
$350. Compute the discount rate.

CF  1 
PVA = 1 - 
i  (1 + i ) n 

$100  1 1 
$350 =  - 5
i  i i ´(1 + i ) 

Clear the memory before any operation [2ndF] then [ALPHA] then [0] then [0]

350 [+/-] [PV]

100 [PMT]
0 [FV] I/Y = 13.20
5 [N]
[COMP] [I/Y]

If you don’t have the financial calculator you can’t solve for i.

Example 9: If You Don’t Own Calculator

 Cannot solve for i by using algebra and rearranging equation.

 Must use either;

o Trial and Error, or

o Interpolation

$100  1 
$350 =  1 - 
i  (1 + i ) 5 

 Try i = 10% Þ PV = $379.08 (To high)

o Note: Inverse relationship between PV and i, Hence, i must be > 10%

 Try i = 14% Þ PV = $343.31 (To low)

o Note: Hence, i must be < 14%

 Try i = 13% Þ PV = $351.72 (To high JUST)

o Note: Which means i must be between 13% and 14%

 Now, use Interpolation which requires:

o a value of i such that PV > $350 (i.e. i=13%)
o a value of i such that PV < $350 (i.e. i=14%)

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CF  1 
A = 1 -  - PV
i  (1 + i ) n 

 A1 = Positive A at i1
 A2 = Negative A at i2

 A1 = $351.72 – $350.00 = $1.72 at i1 = 13%

 A2 = $343.31 – $350.00 = -$6.69 at i2 = 14%

You make the positive difference A1 and the negative difference A2.

l = A1/(A1 – A2) = $1.72/($1.72 – (-$6.69)) = 0.2045

 i = i1 + l(i2 - i1)
 = 13% + 0.2045(14% - 13%)
 = 13.20%

o Recall i = 13.20% Þ using calculator

 If you find 2 closest interest rates you will obtain correct answer.

Example 10: TVM Past Exam

Michelle has just won a $20 million lottery, which will pay her $1 million at the end
of each year for the next twenty years. An investor has offered her $10 million for
this annuity. She estimates that she can earn 10 percent per annum interest. She
has come to you for advice. What will you tell her? Should she accept or reject the
offer made to her?

 Compare the present value of lump sum ($10m) with the PV of the
annuity:

CF  1 
PVA = 1 - 
i  (1 + i ) n 
$1m  1 
= 1 - 20 
0.10  (1 + 0.10 ) 
=$8,513,563.72

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This is less than $10 million, so she should accept the offer.

Solution using FV technique:

 Compare future values

(1) The FV of the lump sum:

FV =PV (1 + i ) n =10m(1 + 0.10) 20 =67,274,999.49

(2) The FV of the annuity:

FVA =
CF
i

(1 + i) n - 1 =
1m
0.10

(1.10) 20 - 1  
=57,274,999.49

The FV of lump sum > FV annuity therefore accept the offer.

Solution using EAA as a comparison:

CF  1 
PV =$10 m =  1 - 
i  (1 + i ) n 
10m ´0.10 1m
PMT = =
 1   1 
1 - n 1 - 20 
 (1 + i )   (1 + 0.10) 
=$1,174,596.25

This is more than $1 million, so she should accept the offer.

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Heading 3: Valuation of Bonds and Stocks

The Financial Management function is centered around corporate finance, which

attempts to find answer to the following questions:

Definition and Features of a Bond

Bond Payments

There are two cash flow streams:

1. Repayment of the principal at maturity,

2. Coupon interest payments throughout the life of the bond.

Bond Issuer
 Person who issues the bond and must repay the face value at maturity,
i.e. the borrower

Bond Holder
 Person who holds the bond certificate and will receive the face value at
maturity
 Coupons will also be paid to the holder at a constant rate. The last
coupon is to be paid on the date of maturity.

A bond is a tradeable financial instrument

 i.e. a bond can be bought and sold

Cash Flows for a Bond

 Coupon (C)
 Face Value (F)
 Time to Maturity (n)

Cash flows of a typical bond:

Bond Value

Bond Value (B0) = PV(Coupons) + PV(Face Value):

C 1  F
PB = 1 - +
i  (1 + i ) n  (1 + i )
n

Note: Second part of the equation is the present value of a single sum (PV ss)

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Pure Discount (Zero Coupon) Bonds

Information needed for valuing pure discount bonds:

 Time to maturity (n) = Maturity date - today’s date

 Compounding frequency (m)
 Face value (F)
 Discount rate (i)
 This bond does not pay coupons.

Present value of a pure discount bond at time 0:

Fmn
PB =
i
(1 + ) mn
m
Example 1: Pure Discount Bonds

Find the value of a 30-year zero-coupon bond with a $1,000 par value and a
required rate of return of 6%.

F $1,000
PB = = =$174 .11
(1 + i) n
(1.06 ) 30

Because there is no coupon, the equation is simply the present value of a future
payment.

Level Coupon Bonds

Information needed to value level coupon bonds:

 Coupon payment dates and time to maturity (n)

 Coupon payment (C) per period and face value (F)
 Discount rate (i)

Value of a level coupon bond

= PV of coupon payment annuity + PV of face value

C 1  F
PB = 1 -  +
i  (1 + i ) n  (1 + i ) n

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Example 2: Bond Valuation with Coupon Rate = i

A bond with a face value of $1,000 and a coupon rate of 5% has 10 years to
maturity. What is the market price of this bond if the required rate of return (k d) is
5%?

$50  1  $1,000
PB = 1 - 10 
+
0.05  (1.05)  (1.05)10
PB =$1,000.00

Note: The coupon rate (i) is only used to determine the coupon payment. i.e.
Coupon payment = 0.05 x 1,000 = $50. Therefore, coupon payments are $50.

Because the coupon rate is the same as the required rate of return, therefore
investors in these bonds are trading at par. Investors are willing to pay the entire
$1,000 for the bond.

• Using Financial tables:

PB = $50 x PVIFA105 + $1,000 x PVIF105
= $50 x 7.722 + $1,000 x 0.614 = $1,000.10 (rounding error)

• If the coupon rate is the same as the required rate of return (i), then the
bond trades at par.

Example 3: Bond Valuation with Coupon Rate < i

A bond with a face value of $1,000 and a coupon rate of 5% has 10 years to
maturity. What is the market price of this bond if the required rate of return is 6%?

$50  1  $1,000
PB = 1 - +
0.06  (1.06)10  (1.06)10
PB =$926.40

Note: If the required rate of return is higher than the coupon rate, than the bond
price must fall to compensate investors.

• If the coupon rate is less than the required rate of return (i),
then the bond trades at a discount.

Example 4: Bond Valuation with Coupon Rate > i

A bond with a face value of $1,000 and a coupon rate of 5% has 10 years to
maturity. What is the market price of this bond if the required rate of return is 4%?

$50  1  $1,000
PB = 1 - 10 
+
0.04  (1.04)  (1.04)10
PB =$1,081.11

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Note: The price of the bond will increase because the required rate of return is less
than the coupon rate.

• If the coupon rate is greater than the required rate of return (i), then the
bond trades at a premium.

On Calculator

Clear the memory before any operation [2ndF] then [ALPHA] then [0] then [0]

1000 [FV]
50 [PMT] PV = -1081.11
4 [I/Y]
10 [N]
[COMP] [PV]

Example 5: Semi-Annual Coupons

A bond with a face value of $1,000 and a coupon rate of 6% has 10 years to
maturity. What is the market price of this bond if the market interest rate is 10%?
Assume coupon payments are paid semi-annually (i.e. half yearly)

$30  1  $1,000
B0 = 1 - +
0.05  (1.05) 20  (1.05) 20
 
B0 =$750.76

Note:
C = 0.06 x 1000 = 30
i = 0.1/2 = 0.05
n = 10 x 2 = 20

What is the Effective Annual Yield of the Bond in Example 5?

Note: Interest rates should always be quoted on an annualised basis.

Recall that the effective annual interest rate EAR measures the return of $1 in one
year.

= (1+ 0.10/2)2 - 1 = 10.25% p.a.

Note: The exam questions will generally require the ‘yield’ to be phrased in terms
of the effective annual yield on the bond.

Bond Yields

Yield to maturity is the interest rate that equates a bond’s present value of interest
payments and principal repayment with its price.

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“The YTM measures the average rate of return obtained by investors if the bond is
purchased now and held until maturity and if there is no default on any of the
promised payments.”

There is an inverse relationship between market interest rates and bond price.

 Why? Because the bond price is a present value and there is always a
negative relationship between PV and interest rates.

Bond Concepts Summary

1. Bond prices and market interest rates move in opposite directions.

2. When coupon rate = YTM, price = par value.

When coupon rate > YTM, price > par value (premium bond)
When coupon rate < YTM, price < par value (discount bond)

3. A bond with longer maturity has a higher relative (%) price change than
one with shorter maturity when the interest rate (YTM) changes. All other
features are identical.

Thus bonds with longer maturities are a lot more interest rate sensitive.

4. A lower coupon bond has a higher relative price change than a higher
coupon bond when the YTM changes. All other features are identical.

Yield-to-Maturity (YTM) and Bond Value

Assume face value = $1000, and N = 4 years.

When the YTM > coupon, the bond trades at a discount.

Interest Rate Risk

• Interest rate risk is the risk that arises for bond owners from unexpected
changes in interest rates.

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• All other things being equal, the greater the time to maturity, the greater
the interest rate risk.
• All other things being equal, the lower the coupon rate, the greater the
interest rate risk.

Interest Rate Risk and Maturity

Consider a $1,000 face value bond with a 10% coupon rate.

Time to Maturity
Market Interest Rate 1 Year 30 Year
5% $1,047.62 $1,768.62
10% $1,000.00 $1,000.00
15% $956.52 $671.70
20% $916.67 $502.11

Interest Rate Risk and Coupon

Consider two 30 year bonds (A and B), both have $1,000 face value. Bond A has
coupon rate of 5% and Bond B has a coupon rate of 10%.

Time to Maturity
Market Interest Rate 1 Year 30 Year
5% $1,000.00 $1,768.62
10% $528.65 $1,000.00
15% $343.40 $671.70
20% $253.16 $502.11

Ordinary Share Valuation

In principle, shares can be valued in exactly the same way as bonds by calculating
the PV of all future CFs.

However, share valuation is more difficult than bond valuation for two reasons:
o Uncertainty of promised cash flows
o Shares have no maturity

 The value of a share is the present value of all expected cash flows to be
received from the share, discounted at a rate of return (R) that reflects the
riskiness of those cash flows.
 The expected cash flows to be received from a share are all future dividends.
 Dividend growth is an important aspect of share valuation.

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We will consider three cases:

(1) Zero Growth (or Preference share valuation)

(2) Constant Growth
(3) Variable Growth

(1) Zero Growth Valuation

Shares have a constant dividend (D) into perpetuity, with no growth in dividends.
This implies that:

Div = Div0 = Div1 = Div2 = Div3 …

The value of a share (P0) is then the same as the value of a perpetuity:

D
P0 =
R
Example 6: Preference Share Valuation

Assume Wave Industries is expected to pay a constant annual dividend of $3 per

share indefinitely. If the discount rate is 15 percent, what is the value of the share?

D $3.00
P0 = = =$20.00
R 0.15
(2) Constant Growth Valuation (DDM)

• Dividends grow at the same rate each time period, g, forever.

D t =D 0 ´(1 + g) t

• The value of a share (P0) is then the same as the value of a growing
perpetuity.

D t +1 D ´(1 + g) D
Pt = Þ P0 = 0 = 1
R -g ks - g ks - g

D1
P0 =
Or,
ks - g

• This is the Dividend Growth Model (an application of a growing perpetuity)

Example 7: Constant Growth Valuation

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Assume Alpha, Inc. has just paid an annual dividend of 15 cents per share, which is
expected to grow at 5% per annum forever. What price should you pay for the
share if the required rate of return on the investment is 10%?

D 0´(1 + g)
P0 =
R- g
$0.15(1.05)
=
0.10 - 0.05
=$3.15
Note: When the dividend has just been paid, then it is dividend ‘0’. ‘Forever’ is
interchangeable with ‘expects a steady growth rate’.

We know what last period’s dividend was, but not next period (the equation
requires next payment). Then next period’s dividend is this period (0) dividend
times by the rate of growth times by the number of periods, i.e. 0.15(1.05)^1.

Components of Required Return

D1
P0 =
R- g
D
(R - g) = 1
P0
D1
R= +g
P0

R = dividend yield + capital gains yield.

What are the dividend yield and the capital gains yield in Example 6?

D1 =$0.15 ´(1 + 0.05) =$0.1575

D1
R= +g
P0
R =5% + 5% (thus, 5% Dividend Yield and 5% Capital Gains)
R =10%

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(3) Variable Growth Valuation

• Allows for different growth rates.

• Dividends cannot grow at a rate above the required rate of return
indefinitely but can do so for a number of years.
• Dividends will grow at a constant rate at some time in the future.

D1 D2 Dt Pt
P0 = + 2
+... + +
(1+ R) (1+ R) (1+ R) (1+ R)t
t

Example 8: Variable Growth Valuation

A company has just paid an annual dividend of 15 cents per share and that
dividend is expected to grow at a rate of 20% per annum for the next 3 years and at
a rate of 5% per annum forever after that.

Assuming a required rate of return of 10%, calculate the current market price of
the share.

D0 = 15%.
Company’s growth is not constant (20% for 3 years, 5% forever).
RRoR = 10%.

Valuable Growth Valuation 4-Step Approach (MAKE SURE YOU CAN DO

THIS, ONE OF THE MOST IMPORTANT QNS)

Step 1:

 Calculate the value of the dividends at the end of each year, DT (during the
initial growth period) i.e. the first three years.

Note: Dividend 4 calculates price of dividend 3 etc.

D1 D2 D3 P3
P0 = + + + ....
(1+ R) (1+ R)2 (1+ R)3 (1+ i)3

Year Expected Dividend

1 D1 = $0.15(1.2)1 = $0.18
2 D2 = $0.15(1.2)2 = $0.216
3 D3 = $0.15(1.2)3 =$0.2592

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Step 2: Find the PV of expected dividends during the initial growth period.

Year Expected Dividend PV

1 $0.180 PV0(D1) = $0.180 ÷ (1.10)1 = $0.164
2 $0.216 PV0(D2) = $0.216 ÷ (1.10)2 = $0.179
3 $0.259 PV0(D3) = $0.259 ÷ (1.10)3 = $0.195

Step 3: Find the value of the share at the end of the initial growth period.

Heading 4: Efficient Market Hypothesis

Efficient Market Hypothesis (EMH)

An investment theory that states it is impossible to "beat the market" because stock
market efficiency causes existing share prices to always incorporate and reflect all
relevant information. According to the EMH, stocks always trade at their fair value
on stock exchanges, making it impossible for investors to either purchase
undervalued stocks or sell stocks for inflated prices. As such, it should be impossible
to outperform the overall market through expert stock selection or market timing,
and that the only way an investor can possibly obtain higher returns is by
purchasing riskier investments.

Meanwhile, while academics point to a large body of evidence in support of EMH,

an equal amount of dissension also exists. For example, investors, such as Warren
Buffett have consistently beaten the market over long periods of time, which by
definition is impossible according to the EMH.

 EMH contends that the price of a security (such as a share) quickly and
accurately reflects all information available.

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 If the market processes new information efficiently, the reaction of market

prices to new information will be instantaneous and unbiased.

 Buyers and sellers should not be able to trade on information that is not
available in the market, hence insider-trading.

A Non-Instantaneous Price Reaction

 An instantaneous price reaction would, in practice, means that after new

information becomes available it should be fully reflected in the next price
established in the market. The price of the share should react immediately.

 If the market fails to react instantaneously to an announcement of good

news, share traders can develop simple rules to generate excess profits.

A Biased Price Reaction

An unbiased price reaction would take the price to the correct level after
information is released.

Overreaction
 A biased response of a price to information in which the initial price
movement can be expected to be reversed.

Under-reaction
 A biased response of a price to information in which the initial price
movement can be expected to continue.

Reaction of Stock Price to New Information

“Event study methodology”. Announcement is made at time zero.

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Information Efficiency

 The EMH implies that investors cannot earn abnormal returns by using
information that is already available.
 The market may be efficient with respect to some sources of information,
but not with respect to others.
 It is therefore common to distinguish between 3 forms of market efficiency:

Weak Form
 One of the different degrees of efficient market hypothesis (EMH) that
claims all past prices of a stock are reflected in today's stock price.
Therefore, technical analysis cannot be used to predict and beat a market.
Security prices reflect all information that can be derived from market
trading data i.e. past prices and volume.

Semi-Strong Form
 This class of EMH suggests that only information that is not publicly
available can benefit investors seeking to earn abnormal returns on
investments. All other information is accounted for in the stocks price and,
regardless of the amount of fundamental and technical analysis one
performs, above normal returns will not be had. Security prices reflect all
publicly available information i.e. product line, quality of management etc.

Strong Form
 The strongest version of market efficiency. It states all information in a
market, whether public or private, is accounted for in a stock price. Not even
insider information could give an investor the advantage. This degree of
market efficiency implies that profits exceeding normal returns cannot be
made, regardless of the amount of research or information investors have
access to.

The information content of each successive classification is cumulative. The

implication of strong-form efficiency is that an investor cannot earn abnormal
returns from having inside information. If this were true, investors would have no
incentive to seek information.

Paradox: The capital market can be efficient only if at least some investors believe
it to be inefficient.

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However, if the market is less than strong-form efficient, there are incentives for
investors to seek information.

Fundamental Analysts

 Research the value of stocks using NPV and other measurements of cash
flow.
 Based on the idea that the value of a share is the present value of all future
cash flows.

Fundamental analysis is the study of the various factors that affect a company’s
earnings and dividends. It is a forward-looking analysis of where future cash flows
are going to come from.

Implications of the EMH for Fundamental Analysis

 The EMH predicts that most fundamental analysis will fail – given that
analysts employ current public information in estimating their evaluation.

 There are also MANY analysts conducting this type of research so it is

unlikely that one will have some additional information above the rest.
 Profiting from fundamental analysis is therefore difficult. Your analysis
needs to be better than that of your competitors in order benefit as the
market will already reflect what is common knowledge (but possible).

Technical Analysts

 Forecasts stock prices based on watching the fluctuations in historical

prices (thus “wiggle watchers”; also called “charists”.

 A.k.a searching for recurrent and predictable patterns in prices.

Implications of the EMH for Technical Analysis

 They “key” to technical analysis is really that the market will be sluggish to
adjust to new information, so that a trend can be identified and acted upon
profitably.

 This contradicts efficient market theory and is therefore not very highly
regarded.

 (Whilst the Bodie et al. chapter therefore spends a bit of time on this we are
not interested in technical analysis apart from knowing what it is and its
impact for the EMH).

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In Summary

 The EMH suggests that active portfolio management is a waste of time and
money.

 It proposes a buy-and-hold strategy is the best and to invest in a well-

diversified portfolio of economically sound stocks.

 i.e. Investing in Index or Mutual funds.

 We are not saying simply to invest in any random stock though (since they
should all be accurately valued)

 Portfolio management still has a role in efficient markets:

o Selecting a well-diversified portfolio

o Consistent with the investor’s tax position
o And the investor’s risk profile

Testing For Market Efficiency

Statistical Tests for Patterns

Statistical correlation tests:

 Measure the correlation between successive price changes or, more

frequently, the correlation between yields in one period and yields in a prior
period
 Runs tests
 An alternative test for independence, in which one examines the sign of
price changes, or yields, during a specified sample period

In general, tests for patterns suggest that successive price changes (yields) are
uncorrelated.

Returns on Microsoft Shares

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Each dot shows a pair of returns for Microsoft shares on two successive days
between August 1993 and August 1998 – is this random or is there a pattern?

Semi-Strong Form Market Efficiency

Event studies are one type of test of the semi-strong form of market efficiency.

Basic questions to be answered:

 What is the (new) information?

 When was it announced?
 Were there abnormal returns associated with its announcement?

The arrival of new information?

 An annual profit figure provides information only if the announced profit

differs from the profit expected by investors.

 The effects of the expected profit will already be reflected in the share price
before the announcement.

 Only the unexpected part of the reported profit should cause the share price
to react.

When was it announced?

 Ideally, the exact moment of the event needs to be identified

 Important because the market may react in anticipation of the

announcement as investors revise their expectations

 The market should also react at the time of the announcement to any
unanticipated information

Were there abnormal returns associated with its announcement?

 Need to calculate the response of the market to the announcement

 In essence, the response is the percentage change in share price in excess of

(or below) the percentage change that would normally be expected

 Some model of ‘normal’ security price movement is needed

Most studies use some variant of the market model as a basis for estimating the
normal rate of return on a security.

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The standard market model:

Rit = ai + biRmt + uit
Where;
Rit = rate of return on security i in period t
Rmt = rate of return on the market index in period t
at = constant in regression equation
bt = slope of regression equation (beta of security i)
uit = disturbance term

How Tests are Structured

 Returns are adjusted to determine if they are abnormal by taking into

account what the rest of the market did that day

 The abnormal return on a given stock for a particular day can be calculated
by subtracting the market’s return on the same day (RM) from the actual
return (R) on the stock for that day:

AR = R – RM

Tests of market efficiency are, therefore, simultaneous tests of the pricing model
used to estimate what is ‘normal’ and of market efficiency.

This is referred to as the joint hypothesis assumption of market efficiency

Most studies use some variant of the market model as a basis for estimating the
normal rate of return on a security.

Reaction of a Share Price to an Announcement

39
Cumulative Abnormal Return

34
29
24
19
(%)

14
9
4
-1
-6
-11
-16
Days Relative to annoncement date

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An announcement of a takeover attempt seems to be fully reflected in the stock

prices on the announcement day.

39

Cumulative Abnormal Retur

34
29
24
19
(%)
14
9
4
-1
-6
-11
-16
Days Relative to annoncement date

An announcement of a takeover attempts seems to be fully reflected in the stock

prices on the announcement day. However, the generaly trend upwards prior to the
release of the information is a sign of insider trading.

Event Study Analysis

 Over the years, this methodology has been applied to a large number of
events including:
o Dividend increases and decreases
o Earnings announcements
o Mergers
o Capital Spending
o New Issues of Stock

 The studies generally support the view that the market is semi-strong-from
efficient
 In fact, the studies suggest that markets may even have some foresight into
the future - in other words, news tends to leak out in advance of public
announcements

The Strong Form of the EMH

 One group of studies of strong form market efficiency investigates insider

trading
 A number of studies support the view that insider trading is abnormally
profitable
 Thus, strong form efficiency does not seem to be substantiated by the
evidence

Strong form market efficiency requires that abnormal returns be available even to
investors who have private (inside) information about a company.

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However, it is impossible to identify the date on which private information becomes

available.

Therefore, the methodology used to test semi-strong form efficiency cannot be

applied directly to studies of strong-form efficiency.

Reappraisal of the Efficient Market Hypothesis

 For many years the dominant view among researchers was that stock
markets were efficient.
 By the mid- to late-1970s, researchers began to find results that seemed
incompatible with the EMH.
 These results were labelled ‘anomalies,’ leaving the possibility that at some
later stage they could be explained in a way compatible with the EMH.

Some Anomalies

• P/E Effect – low P/E stocks earn superior returns

• Small Firm Effect – small firms consistently outperform large firms
• January effect – abnormally high return in the first two weeks of January
• Post-earnings announcement price drift
• The accrual anomaly

Do Anomalies Suggest the Market is Inefficient?

Interrelations between anomalies may imply that if one can be explained, then
much of the mystery of other anomalies may disappear.

Examples of interrelation:

 The turn-of-the-month effect is strong in January

 Portfolios of losing firms tend to earn high returns in January
 The P/E ratio is a major factor in Value Line’s investment selection method
 The Monday effect has not weakened for small firms but it has for other
firms

Empirical studies of market efficiency require three inputs:

1. Data on returns
2. A model that specifies expected or normal returns
3. Tests of abnormal returns to determine whether the market is efficient

Accordingly, when an anomaly is observed, there are at least three possible

interpretations. There could be:

 Something wrong with the data

 Something wrong with the asset pricing model used to measure normal
returns

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 Something wrong with the market (it is inefficient, perhaps due to irrational
behaviour by market participants).

Data Problems

 The sheer volume of data makes occasional recording errors virtually

inevitable.
 Share prices are artificially affected by dividend payments, bonus issues,
rights issues, and so on. Some means of adjusting for these effects must be
found and implemented.
 Trading in shares is never continuous, so the most recent price at any given
time will nearly always be dated (thin trading).

Problems with Asset Pricing Models

 Despite modern portfolio theory and the CAPM, our understanding of asset
pricing is still far from perfect.
 Apparent evidence of market inefficiency may instead be nothing more than
evidence of the researcher’s imperfect knowledge of asset pricing.
o The joint hypothesis assumption of market efficiency

Problems with Markets

 Although inefficiency is an inference that can be drawn from the evidence, it

is not the only inference.
 If markets are inefficient, numerous questions immediately follow:
o Chiefly, why in a competitive market would unexploited profit
opportunities remain unexploited (institutional constraints, zero
marginal utility of wealth, irrationality)?

Bodie, Chapter 12 Page 363

Computer modelling of trends in stock prices is only a forecast. If everyone had

access to the forecast modelling, they would all act on the information, causing
favourable or unfavourable movements in the share prices prior to new
information being known.

Thus, a forecast about favourable future performance leads instead to favourable

current performance, as market participants all try to get in on the action before
the price jump. More generally, any information that could be used to predict stock
performance should already be reflected in stock prices.

New information, by definition, must be unpredictable; if it could be predicted, then

the prediction would be part of today’s information.

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Two economists are walking down the street. They spot a $20 note and on starts to
pick it up, but the other says, ‘Don’t bother; if the bill were real someone would
have picked it up already’.

A doctrinaire belief in efficient markets can paralyse the investor and make it
appear that no research effort can be justified. The market is competitive enough
that only differentially superior information or insight will earn money; the easy
pickings have been picked.

Portfolio Diversification

A risk management technique that mixes a wide variety of investments within a

portfolio. The rationale behind this technique contends that a portfolio of different
kinds of investments will, on average, yield higher returns and pose a lower risk
than any individual investment found within the portfolio.

Diversification strives to smooth out unsystematic risk events in a portfolio so that

the positive performance of some investments will neutralize the negative
performance of others. Therefore, the benefits of diversification will hold only if the
securities in the portfolio are not perfectly correlated.

Studies and mathematical models have shown that maintaining a well-

diversified portfolio of 25 to 30 stocks will yield the most cost-effective level of risk
reduction. Investing in more securities will still yield further diversification benefits,
albeit at a drastically smaller rate.

Further diversification benefits can be gained by investing in foreign securities

because they tend be less closely correlated with domestic investments. For
example, an economic downturn in the U.S. economy may not affect Japan's
economy in the same way; therefore, having Japanese investments would allow an
investor to have a small cushion of protection against losses due to an American
economic downturn.

Most non-institutional investors have a limited investment budget, and may find it
difficult to create an adequately diversified portfolio. This fact alone can explain
why mutual funds have been increasing in popularity. Buying shares in a mutual
fund can provide investors with an inexpensive source of diversification.

Summary

1. Statistical research suggests that stock prices seem to follow a random walk
with no discernible predictable patterns for investors to exploit. Such
findings are now taken to be evidence of market efficiency, that is, evidence
that the market prices reflect all current available information.

2. Weak form asserts that all information to be derived from past trading data
is already reflected in stock prices. The semi-strong form claims that all
publicly available information is already reflected. The strong form, which

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generally is acknowledged to be extreme, asserts that all information,

include insider information, is reflected in prices.

Heading 5: Capital Budgeting: Alternative Decision Rules

What is Capital Budgeting?

Capital budgeting is an analysis of potential additions to fixed assets. It involves

long term decisions and involves large expenditures.

Capital budgeting is very important to a firm’s future and involves:

1. Estimating CFs (inflows & outflows)

2. Assessing the riskiness of CFs
3. Determining an appropriate discount rate
4. Finding NPV and/or IRR
5. Acceptance of project if NPV > 0 and/ or IRR > r (WACC)

Types of Investment Decisions

Independent Projects

Projects that, if accepted or rejected, will not affect the cash flows of another
project. Take on all projects if they reap the business with expected profits.

Mutually Exclusive Projects

Projects that, if accepted, preclude the acceptance of competing projects. i.e. where
a business doesn’t have the necessary cash flows to invest in all projects.

Types of Project Cash Flows

Conventional Cash Flow Project (C)

A negative cash flow (initial cost outlay) is followed by a series of positive cash
inflows – hence there is one change of signs (-ve to +ve).

Non-Conventional Cash Flow Project (NC)

Two or more changes of signs – the most common is an outlay, followed by positive
cash flows, then a terminal cost in order to complete the project (e.g. repair
damaged site).

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Inflow (+) or Outflow (-) in Year

0 1 2 3 4 5 C NC
- + + + + + C
- + + + + - NC
- - - + + + C
+ + + - - - C
- + + - + - NC

Decision Methods

Non-Discounting Methods

 Average Accounting Return (AAR)

 Payback

Discounting Methods

 Net Present Value

 Internal Rate of Return (IRR)
 Discounted pay back

Non-Discounting Methods

Average Accounting Return (AAR)

Average Net Income

AAR =
Average book value

Average Net Income = Average projects earnings after taxes and depreciation.

Average book value = Average book value of the investment during its life.

Decision Rule: An investment is acceptable if its AAR is greater than a pre-

specified cut off rate.

Step 1: Determine the average income = Cash flow – Depreciation – Tax.

Step 2: Determine the average investment.

Step 3: Determine the AAR.

Example 1: AAR

A new machine requires an initial outlay of $80,000 and promises cash flow of
$26,000 each year for the next five years (the life of the machine). Tax rate is 30%.
What is the AAR?

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Step 1: Determine the average annual income

CF Dep. Tax Income

Average $26,000 $16,000 $3000 $7000

Workings:
Depreciation (Dep.) = $80,000 / 5yrs = $16,000 per year
Tax = ($26,000 – Dep.)*30% = $10,000*30% = $3,000
Average Income = CF – Dep. - Tax = $7,000

Step 2: Determine the average investment

Year Investment ($)

0 $80,000
1 $64,000 *the value of our investment
2 $48,000 decreases each year due to
3 $32,000 depreciation.
4 $16,000
5 $0

Average investment (000`s) = 64 + 48 + 32 + 16 + 0 = 32

5
Average investment = $32,000

Step 2: Determine the average accounting return

7,000
AAR = =21.88%
32,000
*Decision will depend on our pre-set cut-off rate (it is thus arbitrary and
subjective).

Note: Some financial texts calculate BV as follows (Gitman et al):

Average investment (000`s) = 80+64 + 48 + 32 + 16 + 0 = $40,000

6

7,000
AAR = =17.50%
40,000

Average Accounting Rate of Return

Advantages

 A screening measure to ensure that new investment will not adversely affect
net income
 To ensure a favourable effect on net income so that profits can be earned.

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Disadvantages

 Ignores the time value of money

 Arbitrary choice of a cut-off rate
 Does not use cash flows
 Ignores the risk differences between projects
 Subjectivity associated with depreciation and calculation of denominator.

Payback Period Method

 The number of years required to recover the project’s cost.

 How long it takes to get our money back.

Example 2: Payback Period Method

Cash flows for projects L and S are given below: (This slide will be used to
explain Payback, NPV and IRR concepts).

Assume cost of capital (when required) = 10%

Year Project L Project S

0 (100) (100)
1 10 70
2 60 50
3 80 20

Payback Period for Project L

Payback Period for Project S

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Advantages of Payback Period Method

1. Provides an indication of a project’s risk and liquidity

2. Easy to calculate and understand

Disadvantages of Payback Period Method

1. Ignores the time value of money

2. Ignores CFs occurring after the payback period
3. Arbitrary choice of a cut off date

Example 2: Discounted Payback – Uses discounted rather than raw CFs

Project L

Net Present Value (NPV) Method

 The required rate of return is the minimum return that a project must earn
in order to be acceptable.

 The cost of capital is often used as the minimum required rate of return for
capital budgeting purposes.

 The cost of capital is the cost of investment funds, usually viewed as a

weighted average of the cost of funds from all sources.

NPV: The sum of the PVs of inflows and outflows minus the cost CF0 which is
often negative.

n
NCFt
NPV =
t =0 (1 + k)
t

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Example 2: What’s Project L’s NPV?

Using the EL735s

Clear the memory before any operation

[2ndF] then [ALPHA] then [0] then [0]

100 [+/-] [ENT]
10 [ENT]
60 [ENT]
80 [ENT] ▲NET_PV =
[2ndF] [CFi] 18.78
10 [ENT]
[▼] [COMP]

What is Project S’s NPV? (Using EL735s)

Clear the memory before any operation

[2ndF] then [ALPHA] then [0] then [0]

100 [+/-] [ENT]
70 [ENT]
▲NET_PV =
50 [ENT]
19.98
20 [ENT]
[2ndF] [CFi]
10 [ENT]
[▼] [COMP]

Rationale for the NPV Method

NPV = PV inflows - Cost

= Net gain in wealth.

Choose between mutually exclusive projects on the basis of higher NPV. (Recall
Corporate Objective – lecture 1 Intro).

• The project with the highest NPV adds greatest value

– If Projects S and L are mutually exclusive: Accept S because NPVs
> NPVL .
– If S & L are independent: Accept both as NPV > 0 for both projects

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Advantages of NPV Method

1. Uses cash flows (not earnings)

2. Uses all cash flows of a project
3. Discounts cash flows properly

Disadvantages of NPV Method

1. Projects likely to be replicated with maturity of differing lengths (will

discuss later)

Excel Application – Calculating NPV at various discount rates (Project L)

Creating the NPV Profile for Project L

 From the menu bar on the top of the screen in Excel (Microsoft office 2007),
choose insert tab and then select XY (scatter) and then follow the steps in
Chart Wizard.

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Internal Rate of Return (IRR)

 IRR is the discount rate that forces PV inflows = cost

o This is the same as forcing the NPV = 0

 IRR is popular because it provides a single number that summarizes the

merit of a project.

IRR: Enter NPV = 0, solve for IRR

Example 2: What’s Project L’s IRR?

Using Sharp EL735s

Clear the memory before any operation

[2ndF] then [ALPHA] then [0] then [0]

100 [+/-] [ENT]
10 [ENT]
60 [ENT] ▼RATE(I/Y) =
80 [ENT] 18.13
[2ndF] [CFi]
[COMP]

Rationale for the IRR Method

If IRR > k, then the project’s rate of return is greater than its cost – some return is
left over to boost stockholders’ returns.

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Illustration: If k = 10% and IRR = 15%, the project is profitable.

 IRR = 18.13%

Decision Rule

 If IRR > k, accept project.

 If IRR < k, reject project.

Decisions on Projects S and L using the IRR Method

 If S and L are independent:

o Accept both because IRRs > k, if k = 10%.

 If S and L are mutually exclusive:

o Accept S because IRRS > IRRL

Note: There are some potential errors with the use of IRR in deciding between
mutually exclusive projects.

Construct NPV Profiles

Find NPVL and NPVS at different discount rates assuming projects are mutually
exclusive:

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About the Crossover Point

 Crossover Point is the discount rate at which the NPV for the two projects
are equal (it can be thought of as the rate of indifference).

 It is also the IRR of the incremental cash flows.

Mutually Exclusive Projects

Conflict Between IRR and NPV

 When k is larger than the crossover rate, IRR & NPV leads to the same
decision.
 When k is smaller than the crossover there is conflict between IRR and NPV

Which should we use?

 NPV is always preferred as it measures additional wealth obtained.

To Find the Crossover Rate

1. Find cash flow differences between the projects. See data at beginning of
the case (refer to slide 16).
2. Incremental CF’s L-S

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YR CF
0 $0
1 -$60
2 $10
3 $60

Calculate and find IRR = 8.68% (This is the crossover rate).

3. You Can subtract S from L or vice versa, but better to have first CF negative

4. If profiles don’t cross, one project dominates the other.

Two Reasons NPV Profiles Cross

1. Size (scale differences)

Smaller project frees up funds at T = 0 for investment. The higher the

opportunity cost, the more valuable these funds, so high k favours small
projects.

2. Timing Differences

Project with faster payback provides more CF in early years for

reinvestment.

If k is high, early CFs are especially good, NPVS > NPVL

Reinvestment Rate Assumptions

• NPV assumes reinvestment at k (opportunity cost of capital).

• IRR assumes reinvestment at IRR.
• Reinvestment at opportunity cost, k, is more realistic, so NPV method is best.
• NPV should always be used to choose between mutually exclusive projects
(CASH IS KING).

Problems with the IRR Method

1. Mutually exclusive projects

2. Multiple rates of return

3. Lending or borrowing

4. No solution to IRR

1. Mutually Exclusive Projects: NPV versus IRR

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When NPV and IRR produce different rankings for mutually exclusive projects, the
NPV method correctly identifies the best alternative.

2. Multiple Rates of Return (Illustration)

Using Sharp EL735s

Clear the memory before any operation [2ndF] then [ALPHA] then [0] then [0]

a) We know 4 potential IRR’s exist!

b)

[+/-] [ENT] 40 [ENT]

1431 [ENT] [2ndF] [ENT]
3035 [+/-] [ENT] [COMP] 42.86%
2850 [ENT] 50 [ENT]
1000 [+/-] [ENT] [2ndF] [ENT]
[2ndF] [CFi] [COMP] 42.86%
[COMP] 25% 60 [ENT]
30 [ENT] [2ndF] [ENT]
[2ndF] [CFi] [COMP] 66.67%
[COMP] 33.33%

c) We have four IRRs. Non-conventional CFs – Four sign changes

1. At very low discount rates, the PV of CF2 is large & negative, so NPV < 0.

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2. At very high discount rates, the PV of both CF1 and CF2 are low, so CF0
dominates and again NPV < 0.

3. In between, the discount rate hits CF2 harder than CF1, so NPV > 0.

4. Result: 2 IRRs.

 Rates < 25% REJECT

 25% < Rates < 33.33% ACCEPT
 33.33% < Rates < 42.86% REJECT
 42.86% < Rates < 66.66% ACCEPT
 Rates > 66.66% REJECT

3. Lending or Borrowing Illustration

Consider the following projects A and B

Project A B
CF0 -$1000 +$1000
CF1 +$1500 -$1500
IRR 50% 50%
NPV at 10% +$364 -$364

Each project has an IRR of 50%. Does this mean that they are equally
attractive?

4. No Solution to IRR

Consider Project A:

Year Cash Flow

0 $1000
1 -$3000
2 $2500

NPV at 10% = $339

IRR = None

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Heading 6: Application of Project Evaluation Methods

This lecture is based upon how to determine the cash flow. A project is nothing more
than a long term business decision.

Mutually Exclusive Projects with Different Lives

There are times when direct application of the NPV rule can lead to a wrong decision.
Consider a factory, which must have an air cleaner.

There are Two Project Choices:

 “Cleaner X”, which costs $4,000 today, has annual operating costs of $100
and lasts for 10 years.
 “Cleaner Y”, which costs $1,000 today, has annual operating costs of $500
and lasts for 5 years.

Which one should we choose assuming a cost of capital for this investment is 10%?

At first glance, project Y appears to be the best:

æ - $ 100  1 ö
NPV X ,0 = - $ 4 ,000 + ç 1 -  ÷ = - $ 4 ,614 .46
ç 0 .10  (1 + 0 .10 )  ÷ø
10
è 

æ - $ 500  1 ö
NPVY ,0 = - $ 1,000 + ç 1 -  ÷ = - $ 2 ,895 .39
ç 0 .10  (1 + 0 .1)  ÷ø
5
è 

However, Cleaner X lasts twice as long. When we incorporate that, Cleaner X is

actually cheaper. Both NPVs are negative (but we don’t reject both), we must invest
in one and maximising shareholder wealth means choosing the project that reduces
shareholder wealth the least.

Two Approaches to Overcome the Mismatch in Life Cycle

Matching Cycle or Replacement Chain Approach

 Repeat projects until they begin and end at the same time,
 Compute the NPV for the “repeated projects”.

The Equivalent Annual Cash Flow Method (EAC)

 Where projects aren’t easily rolled over to match cycles, i.e. when there are
projects that have, e.g. a 7-year life cycle and a 13-year life cycle.

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Matching Cycle or Replacement Chain Approach Illustrated

Note: Cleaner Y incurs a $1,500 cost at time period 5, as it is the initial start-up cost
for the project, plus the cost of the project for the year.

æ - $100  1 ö
NPVX =- $4,000 + ç 1 -  ÷ =- $4,614.46
ç 0.10  (1 + 0.1)10  ÷
è  ø

- $2,895.39
NPVY =- $2,895.39 + =- $4,693.20
1.15

We already know that the NPV of project Y over a 5-year period is -$2,895.39. Thus,
for the second period of 5 years, the NPV at time 5 is -$2,895.39, thus at time zero, we
discount it back 5 periods.

Decision: Cleaner X is Cheaper

The Equivalent Annual Cash Flow Method

 EAC method puts costs on a per-year basis.

 EAC is the value of the payment annuity that has the same NPV as our original
set of cash flows.

 (1 + k) n 
EAC0 =k ´NPV0  
 (1 + k ) n - 1
OR
NPV0 ´k
 æ 1 ö
1 - ç ÷
 çè (1 + k) t ÷ø 
 

Find the NPV for Project X (Can Do on the Calculator Using Cash Flows)

æ - $ 100  1 ö
NPV X = - $ 4 ,000 + ç ´ 1 -  ÷ = - $ 4,614 .46
ç 0 .10  (1 + 0 . 1 )10  ÷
è  ø

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- $4,614.46 ´0.10
EAC X = =- $750.98
1
1-
(1 + 0.10 )10
 (1.10)10 
EAC X =0.10 ´- 4614.46   =- $750.98
 (1.10)10 - 1

If using the calculator, if we find the NPV of the life period, then we can enter in the
payments and the NPV and compute the PMT using the bond method on calculator.

Find the NPV for Project Y

æ - $500  1 ö
NPVY =- $1,000 + ç ´1 -  ÷ =- $2,895.39
ç 0.10  (1 + 0.10 )5  ÷
è  ø

- 2,895.39 ´0.10
EACY = =- 763.80
1
1-
(1 + 0.10 )5

 (1.10)5 
EACY =0.10 ´- 2895.39   =- $763.80
 (1.10)5 - 1

Decision: Cleaner X is cheaper ($750.98 per year, whereas Y is $763.80)

Realism of the Chain of Replacement Method

The assumption that the machines replaced and the services they provide are identical
in every aspect is unrealistic.

Cash Flow Analysis – Generating Cash Flow

Cash flows come from:

 Sales and revenues

 Costs
 Depreciation
 Working capital
 Taxes (income and CGT)

Revenue

Contribute to cash flow positively by a factor of (1 – tc). Tc being the corporate tax
rate. $1 increase in revenue, means $(1 – tc) increase in cash flow.

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Cost

Costs contribute to cash flow negatively by a factor of (1 – tc). Every $1 increase in

costs means a decrease in cash flow of $(1 – tc).

Depreciation

Depreciation is not a real cash flow. However, it is important because it provides a tax
shelter and tax savings. Depreciation affects cash flow positively by reducing taxable
income. Every $1 increase in depreciation means an increase in cash flow of $tc.

The straight-line method is an annual allowance calculated at a fixed percentage of

the historical cost of the asset. The straight-line method was historically applied to
buildings and other permanent structures.

The diminishing value basis is an accelerated allowance. With the exception of the
final year of the useful life, depreciation is a percentage of the written down value of
the asset. (The written down value or book value is the original cost less depreciation
deducted in previous years.) In the final year of its useful life the balance of the un-
deducted cost, less any residual or salvage value, may be deducted.

Working Capital

Working capital is cash employed to run day-to-day operations of a firm (e.g.

investment in inventory). It is not consumed but rather employed for a period of time.
Working capital is the employment of cash.

Increase in working capital during a periods means more cash is employed, i.e. a
higher cash outflow (and vice versa).

Consider net working capital separately as sales must be recorded on the income
statement when made, not when cash is received. Have to records the cost of goods
sold when corresponding sales are made, regardless of whether our suppliers have
been paid yet.

Finally, have to buy inventory to support sales although cash hasn’t been collected
yet.

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Suppose working capital required for a project, increases from period t – 1 to period t.
A change (increase) in working capital is a negative cash flow to the project.

Suppose working capital required for a project, decreases from period t – 1 to period t.
Then change (decrease) in working capital is a positive cash flow to project.

Taxation

Three major impacts:

1. Income tax represents a cash outflow

2. Tax shield – depreciation provides a tax deduction which results a tax saving.
3. Capital gains tax (CGT)
a. Lowers net profit made from the sale of an asset
b. May result in a tax saving when a loss is made from the sale of an asset

Cash Flow Analysis – Discounting

Four general rules:

1. Only cash flow is relevant,

2. Always estimate the cash flows on an incremental basis (CF results from
taking one project at expense of another),
3. Watch out for… (below),
4. Be consistent in your treatment of inflation (doesn’t impact as long as
consistent – i.e. all real cash flows (or nominal) at real rates (or nominal rates).

Rule 1: Relevant Cash Flows

• The only relevant CFs are the ones we get to keep!

• Relevant CFs to be included in a capital budgeting analysis are those that will
only occur if project is accepted
• These are called incremental CFs

Rule 2: Incremental Cash Flows

To identify an incremental cash flow ask the following question

“Will this CF occur ONLY if project accepted?”

 “Yes”, then include in analysis because it is incremental

 “No”, then exclude because it will occur anyway
 “Part of it”, then include part that occurs because of project

Rule 3: Watch Out For…

Ignore Sunk Costs

• Costs already incurred are irrelevant to future decision-making.
• Decisions on whether to continue a project should be based only on expected
future costs and benefits

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Beware of Allocated Overheads

• Don’t allocate existing overheads (fixed costs)

• Only assign any change in fixed costs to a proposed project

Examples: - increase/decrease salaries

- increase/decrease rent
- increase/decrease power etc

Include Opportunity Costs

• If project uses a resource which could be put to some other use (i.e., has an
opportunity cost), then $ value of alternative use must be included as cash
outflow
• If accepting a project means foregoing some revenue, then this should be
charged to the current project

Exclude Financing Costs

• The required rate of return used to discount cash flows incorporates the cost of
equity and debt.
• Including financing charges in the cash flows would be double counting.

Do Not Forget Net Working Capital

• Most projects involve some degree of investment in NWC.

• Recognise this increase in cash flow forecasts.
• When a project comes to an end you usually recover some of the investment in
NWC.
• In AFF2631 assume all NWC is recoverable.

Rule 4: Treat Inflation Consistently

• Inflation is an important fact of economic life, and it must be considered in

capital budgeting.
• Interest rates can be expressed in either nominal or real terms.
• Nominal cash flows must be discounted at the nominal rate.
• Real cash flows must be discounted at the real rate.

Shields Electric forecasts the following nominal cash flows on a particular

project:

Year 0 1 2
CF -$1,000 $600 $650

The nominal interest rate is 14%, and the inflation rate is forecast to be 5%. What is
the value of the project?

NPV = -$1,000 + $600/1.14 + 650/(1.14)2 = $26.47

Note: If you want to do real, deduct the inflation rate (given) from the nominal rate
but must have real cash flows given.

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Example 2: Real Required Rate of Return

Assume that an investment of $10,000 is expected to generate real cash flows of

$5,000 at the end of each year for next three years; the inflation rate is 10% per
annum; and that the nominal required rate of return is 15% per annum. What is the
project’s NPV?

Real rate = (1.15)/1.10 - 1 =0.0455 = 4.54545%

æ $5,000  1 ö
NPV =- $10,000 + ç 1 - ÷
ç 0.0454545 
è  (1 + 0.0454545)  ÷ø
3

=$3,733.05

Finding the Real Interest Rate (It’s Not Simply Deducting!)

1+ n
r= -1
1+ i
Where n: nominal interest rate (nominal rate of return)
r: real interest rate (real rate of return)
i: inflation rate

Cash Flow Analysis – Replacement Decision

If the answer is that the replacement provides an increase in shareholder value

compared to keeping the same equipment, then undertake the investment.

There Are Three Parts to a Standard Cash Flow

1. The initial investment,

2. The operating cash flows
3. The terminal cash flows

1. Calculating Incremental Initial Cash Flows

Must include where appropriate:

 Purchase price
 Additional capital expenditure (i.e. transportation etc. can add to purchase
price for depreciation)
 Net working capital contributions
 Disposal of the assets (and tax implications – i.e. whether market value > book
value)
 Note: also maintenance that can occur at time period 0.

2. Incremental Operating Cash Flows

There are two methods available (only need to know ONE):

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1. Add back depreciation method (method 1)

2. Depreciation tax shield method (method 2)

Example

• Suppose Splash Ltd plans to replace equipment which will result in additional
revenues of $9,000 but will also increase costs by $4,000 per annum.
• Splash is able to claim additional depreciation of $3,000.
• What will its after-tax cash flow be if the company tax rate, Tc is 30%?

Method 1

Method 2

3. Calculating Terminal Cash Flows

Include (when appropriate):

• Final years operating cash flow,

• Recovery of Net Working Capital Contributions (100% recovery unless told
otherwise),
• Disposal of Asset (i.e. salvage value) => taxation implications (i.e., Salvage v.
book value – if SV exceeds BV we pay capital gains, if BV exceeds SV tax
shield).

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Comprehensive Exam Problem

Nutson Bolz is an assembly business run by a sole proprietor whose marginal tax rate
is 47% (CT). The owner is considering the purchase of a new fully automated
machine to replace an older, manually operated one. The machine being replaced,
now five years old, originally had an expected life of ten years, and it was being
depreciated using the straight-line method from a cost of $20,000 down to zero, and
could be sold for $15,000 . The old machine was operated by one operator who
earned $15,000 per year in salary and $2,000 per year in fringe benefits. The annual
costs of maintenance and defects associated with the old machine were $7,000 and
$3,000 respectively. The replacement machine being considered has a purchase price
of $50,000, a salvage value after five years of $10,000, and would be fully
depreciated over five years using the straight-line depreciation method. To get the
automated machine in running order, there would be a $3,000 shipping fee and a
$2,000 installation charge.

Old Machine: V: $20,000. Depreciated at $2,000 per year. Book value today:
$10,000. Market value: $15,000 (this means $5,000 capital gains). Operator earned
$17,000 per year operating (cost). $10,000 maintenance.

New Machine: V: $50,000. Salvage value after 5-years is $10,000 (meaning life of
only 5-years). Further, $3,000 and $2,000 as capital expenditure (not operational
unless spent), thus capital expenditure is $55,000.

In addition, because the new machine would work faster than the old one, investment
in raw materials and goods-in-progress inventories would need to be increased by a
total of $5,000. The annual costs of maintenance and defects of the new machine
would be $2,000 and $4,000, respectively. The new machine also requires
maintenance workers to be specially trained; fortunately, a similar machine was
purchased three months ago, and at that time, the maintenance workers went through
the $5,000 training program needed to familiarize themselves with the new
equipment. The firm’s management is uncertain whether to charge half of this $5,000
training fee to the new project. Finally, to purchase the new machine, it appears the
firm would have to borrow an additional $20,000 at 10% interest from its local bank,
resulting in additional interest payments of $2,000 per year. The required rate of
return on projects of this kind is 20%.

New Machine: Investment in raw materials of $5,000 (NWC), assume 100%

recovery. Maintenance and defects cost $6,000 ($4,000 better off). Fully automated
$17,000 better off (no need for worker). Don’t need to analyse cost of borrowing
because it is included in rate of return (20%)

(a) What is the project’s initial investment?

New unit ($55,000)

Old unit $15,000 BV(t=0) = $10,000
Less Tax ($2,350)  Tax on CG $5,000 is 47%
NWC ($5,000)
($47,350)

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(b) What are the incremental cash flows over the project’s life?

(c) What is the terminal cash flow?

Is there an opportunity to sell the new machine? Yes of $10,000, but

completely depreciated to $0 book value, meaning the whole machine salvage
value is depreciable.

(d) What is the NPV? The IRR?

 1 1  $25,660
NPV =- $47,350 + $15,360 - 4
+
 0.2 0.2(1.2)  1.25
NPV $2,725.14

IRR 22.41%

(e) Should the project be accepted? Why or why not?

The project should be accepted as it generates wealth for shareholders

(i) NPV > 0
(ii) IRR > Cost of Capital

Note: We don’t accept the project because it has a positive NPV, but it is
because it generates positive wealth for shareholders.

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Heading 7: Risk and Return

Fundamentals to know from week 7:

Individual Securities and Probability Distribution

Expected Return on an Asset

n
E(R Asset ) =E(R) =  (R i ´pi )
i =1

Variability of Expected Return

n 2
Var(R) =σ R =   R i - E(R) ´pi
2
i =1
Note: Standard Deviation is the square root of the variance and is the proxy for risk.

Individual Securities and Time Series Approach

Expected Return on an Asset

n
 Ri

E(R Asset ) =E(R) =i =1

n
Variability of Expected Return

n
  R i - E(R) 2
Var(R) =σ 2R = i =1
n- 1

 is crucial for working out variance of portfolios as below. But using the standard
deviation or root of variance.

Portfolio of 2 Risky Assets

Expected Portfolio Return =x E(R 1 ) + x 2 E(R 2 )

1

Equals: Weight of x times expected return x + weight of y times expected return y

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Portfolio Variance =x12 σ12 + x 2 2

2 σ 2 + 2x1x 2 σ1σ 2ρ12

Equals: risk of x in isolation (weight x times standard deviation) (squared) + risk

of x2 in isolation (weight x2 times standard deviation) (squared) + 2 times weight
x times weight x2 times standard deviation x times standard deviation x2 times
ρ
1,2

r 1,2
Where (the correlation coefficient)=

 R1,2
r1,2 =Corr(R1, R2 ) =
 R1 ´ R2

 R1,2 =r R R ´ R1 ´ R2
1 2

Heading 8: Portfolio Theory and the CAPM

Diversification with Multiple Assets

For a diversified portfolio, the variance of the individual assets

contributes little to the risk of the portfolio.

The risk depends largely on the covariance between the returns on the assets.

Portfolio Variance – The Case of 3 Risky Assets (Expanding)

Note: Unlikely that in the exam we will encounter portfolio of more than 3 risky
assets.

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Diversification and Portfolio Risk

 As more shares are added, each new share has a smaller risk-reducing impact.
 By forming portfolios, we can eliminate some of the riskiness of individual
shares.
 However, there is a minimum level of risk that cannot be diversified away and
that is known as systematic risk.

Eugine Fama (1976)

In practice p falls very slowly after about 12-16 shares are included in a portfolio.

Markowitz Portfolio Theory (1952)

The Efficient Set for Two Assets

The idea of diversification is the basic idea behind modern portfolio theory (also
referred to as Markowitz Portfolio theory after it’s found).

Modern portfolio theory (MPT) is the theory of selecting an optimal combination of

assets that are expected to provide the highest possible expected return for a given
level of RISK (or least risk for a given level of return).

Portfolios Markowitz constructs only includes risky assets to create a rational

portfolio that everyone would invest in.

Assumptions of Markowitz Portfolio Theory

1. Investors consider each investment alternative as being presented by a

probability distribution of expected returns over some holding period. i.e. a
linear distribution of returns over long-term.

2. Investors maximise one-period expected utility, and their utility curves

demonstrate diminishing marginal utility of wealth. Always look to maximise
return.

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3. Investors estimate the risk of the portfolio on the basis of the variability of
expected returns. Implying we all have same set of beliefs. BUT we don’t all
have same access to information (i.e. insider trading).

4. Investors base decisions solely on expected return and risk, so their utility
curves are a function of expected return and the expected variance (or SD) of
returns only.

5. Given risk level, investors prefer high returns to lower returns and less risk
than more risk.

Calculating Portfolio Risk and Return (Two Stock Case)

The point is to find the optimal portfolio make up to determine the highest risk return
pay off.

The risk and return for a portfolio made up of AGL and FOA stocks, (where WAGL
is the proportion of stock of AGL in the portfolio) calculated as:

AGL FOA
Mean return, ki 0.0016 0.0025
Stand deviation i 0.0154 0.0187
Covariance, AGL,FOA 0.00011

To illustrate let us examine the mean and standard deviation of al possible portfolios,
assuming the weights range from 0 to 1 in increments of 5% (using formula above).

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The Efficient Set for Many Securities

Consider a world with many risky assets; we can still identify the opportunity set of
risk-return combinations of various portfolios much like we did in the case of 2 risky
assets.

Given the opportunity set we can identify the minimum variance portfolio.

Risk averse investors will want to invest in a portfolio that is situated on he efficient
frontier.

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The Capital Market Line

 Introducing a risk-free asset, the opportunity set for investors is expanded and
results in a new efficient frontier: the Capital Market Line (CML).

 The CML represents the efficient set of all portfolios that provides the investor
with the best possible investment opportunities when a risk-free asset is
available.

Riskless Borrowing and Lending

Now investors can allocate their money across the Risk free asset and a balance
managed fund.

Three Important Facts

 Risk free asset (Ri) has a standard deviation of zero,

 The minimum variance portfolio (MV) lies on the boundary of the feasible set
at a point where the variance (SD) is at a minimum,

 The optimal (market) portfolio (O) lies on the feasible set and on a tangent
from the risk-free asset.

Note: the optimal portfolio will have the highest Sharpe measure.

To attain a higher expected return than is available at point O (the trade-off is an

exchange for accepting higher risk), either:

1. Invest along the efficient frontier beyond point O, such as point D, or

2. Add leverage to the portfolio by borrowing money at the risk-free rate and
investing in the risky portfolio at point O.

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The CML is the new efficient frontier. No interested in any other return off the CML
frontier. Low preference for risk means we choose portfolio lying lower on the CML
line. Moving up the line means changing the weighting of investment in risk free asset
or optimum portfolio. Note: the portfolio consists of ONLY risk assets.

How do we get a return greater than the optimal portfolio? The answer is in
leveraging the investment.

Markowitz suggests we can all borrow at the risk-free rate (if we want to exceed O
returns).

Implications of the Market Portfolio

 Because portfolio O lies at the point of tangency, it has the highest portfolio
possibility line.
 Everybody will want to invest in portfolio O and borrow or lend to be
somewhere on the CML.
 Therefore, this portfolio must include all risky assets and is called the market
portfolio.

Example 1

Assume that the risk-free rate of return is 8% per annum. The risky market portfolio
provides an expected return of 16% per annum and has a standard deviation of 22%.
Mr Pink has chosen a complete portfolio composed of risk-free assets and the risky
market portfolio which provides an expected return of 10% per annum with a standard
deviation of 5.50% Graph the CML

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Mr Black thinks he can do better than the market by restricting his investments to
three risky stocks which he thinks will provide the best returns. He chooses a portfolio
which provides an expected return of 18% per annum and 28% standard deviation.
Making use of the Sharpe Measure demonstrate that Mr Black has not found a risky
portfolio which is better than the market.

Solution

Definition of Risk When Investors Hold the Market Portfolio

 Researchers have shown that the best measure of the risk of a security in a
large portfolio is the beta of the security.
 A measure of a security’s systematic risk.
 Measures the responsiveness of a security to movements in the market
portfolio.

Interpreting Beta

 If beta = 1.0, the stock is as risky as the market.

 If beta > 1.0, stock is riskier than the market.
 If beta < 1.0, stock is less risky than the market.

Relationship Between Risk and Expected Return (CAPM)

The Capital Asset Pricing Model uses macro level information (as below) to
determine expected return on the market and thus on individual securities.

Expected Return on the Market:

Expected return on an individual security:

Where;
kM = return on the market (investing in any security in the market)
RF = Risk free rate
Beta = Sensitivity of the security to a change in market conditions
kM – RF = Market Risk Premium

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Expected Return on an Individual Security

Security Market Line

The SML is a graphical representation of the CAPM.

It is the line, which describes the linear relationship between expected returns for
individual securities (and portfolios) and systematic risk, as measured by beta. In
equilibrium, all securities must be priced such that their returns lie on the Security
Market Line (SML).

If a stock is not prices on the SML, then it is said to be mispriced. If you don’t own a
security that is underpriced, want to put it into a portfolio, if it is overpriced we want
to sell it to avoid the loss when the price falls (sell at a premium).

SML and Inflation

If investors raise inflationary expectations by 3%, what would happen to the Security
Market Line?

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SML and Risk

Suppose inflation did not change, but risk aversion increased enough to cause the
market risk premium to increase by 3 percentage points.

What would happen to the Security Market Line?

Capital Asset Pricing Model

The capital market will only reward investors for bearing risk that cannot be
eliminated by diversification. CAPM states that the reward for bearing systematic risk
is a higher expected return.

Thus, according to the CAPM, the only thing that affects the expected return of a
security is its beta.

Portfolio Beta

This beta is calculated as a weighted average of the betas of the individual assets in
the portfolio:

Where;
N = number of assets in the portfolio
Wi = Proportion of the current market value of portfolio p constituted by the
ith asset.

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Example 2

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Example 3

You are given the following variance, covariance matrix for Sifty Sasha’s Burbon Bar
(SSBB), Warren’s Winery (WW) and the market portfolio.

Note: In the yellow is the Variance, Covariance is in white.

Additionally, you are informed that the expected return (standard deviation) for SSB
and WW are 10.4% (14.87%) and 9.20% (12.85%) respectively. The risk free rate of
interest is 8% per annum. The expected market return is 14% and you have a total of
$500,000 available for investment.

(a) Justify that the risk and return estimates quoted are correct.

Beta calculated by dividing the variance of return on SSBB by market covariance and
same with WW.

(b) Assume that you are required to create a portfolio consisting of 40%
investment in SSBB and 60% investment in WW. Calculate the Expected return
and standard deviation for this portfolio.

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(c) Assume that you are now required to create a new portfolio that consists of
investing 200,000 in SSBB shares, $200,000 in WW shares with the balance being
invested in the risk free asset. Calculate the expected return and standard
deviation of this portfolio.

(d) Which portfolio combination is best? Justify your decision

Heading 9: Capital Structure

1. Leverage and risk

2. Capital Structure
3. Capital Structure Theory
a. 1958 MM Propositions (Important)
b. 1963 MM Proposition (Also Important)
4. Bankruptcy
5. Agency Costs
6. Optimal Capital Structure

1. Leverage

 Results from use of fixed-cost assets or funds to magnify returns to the firm’s
owners.

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 The extent of leverage in a firm is positively associated with risk and

potential return.

 Capital restructuring involves changing the amount of leverage (L) without

changing the amount of assets (A). When a firm does a ‘capital raising’ they
make the firm bigger through raising more funds, capital restructuring is
changing the composition of debt and equity

↑LEVERAGE by issuing debt and repurchasing shares ( ↓E)

↓LEVERAGE by issuing new shares (↑E) and retiring debt (lower debt)

Note: as a result of increasing or decreasing leverage, the firm is not getting

any bigger.

Levered and Unlevered Firms

 Value of the firm = value of debt + value of equity

 BUT not all firms have both debt AND equity

 Some firms are 100% equity firms

o These are called unlevered firms.

 Most firms have a mix of debt AND equity

o These are called levered firms.

 The term “levered” is thus given to a firm that has some debt → we will now
see that by adding debt we increase the financial leverage (or risk) of a
firm.

Business Risk vs. Financial Risk

Business Risk stems from uncertainty about future operating income (EBIT). It
depends on how accurately operating income is predicted.

Business risk is affected mainly by:

 Uncertainty about demand (sales)
 Uncertainty about output prices
 Uncertainty about costs
 Product & other types of liability

Operating Leverage stems from the use of fixed rather than variables costs. When
demand falls (and thus production) the fixed costs don’t decrease. A firm with a
large % of fixed costs is therefore said to have HIGH operating leverage.

In the case of bankruptcy debt holders have a prior claim on the cash flows of the
firm. Equity holders have a residual claim.

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The more debt in the firm’s capital structure, the higher the financial leverage of
the firm.

Financial risk is the additional risk concentrated on ordinary shareholders as a

result of financial leverage.

With higher financial leverage, bankruptcy is more likely and so equity holders
(shareholders) are more likely to loose out (because they have a residual claim).

Business Risk depends on business factors

• i.e. competition, product liability & operating leverage

Financial Risk depends only on the capital structure mix

• The more debt is issued – the greater the financial risk.

Because equity holders have a residual claim in the case of bankruptcy, financial
risk concentrates business risk on equity holders.

The Capital-Structure Question and the Pie Theory

Value of Firm (VCompany) = Value of Assets (Vassets)

Value of Firm = Value of Debt (D) + Value of Equity (S)

V = Debt + Equity = D+S

* To maximise the value of the firm we need to pick the combination of debt (D)
and equity (S) that maximises the size of the pie.

The question is therefore: “What ratio of debt to equity

maximises the size of the pie (and thus maximises shareholder
value)?”

Effect of Leverage on ROA, ROE & EPS

Consider an unlevered firm that is considering introducing debt in its capital

structure.

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D/E = 0.5
D/V = 0.5/1.5 = 1/3

EPS & ROE under both capital structures (Using Above Table)

2. Capital Structure

• Capital structure refers to the way in which the 2company’s assets are
financed (excluding current liabilities).
• Debt capital generally requires a lower return than equity capital since
debt-holders have the first claim in bankruptcy and can exert greater legal
pressure against the company.
• It is important since it influences cost of capital and as such the NPV of
potential projects.

WACC= K D S P
A=¿ Kd ( 1−Tc ) + + Ks+ Kp¿
V V V

3. Capital Structure Theory

• Miller and Modigliani wrote a paper in 1958 entitled “The cost of capital,
corporate finance and the theory of investment”.

• They make 3 propositions in regards to capital structure and its effect on

the value of the firm. What are they?

• In 1963 they published a second paper, which relaxes a number of the

assumptions made in their first paper. They reassess their propositions from
1958 with these relaxed assumptions.

• They use the concept of homemade leverage to prove their propositions.

Homemade Leverage – Illustration A

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Consider two Firms: They generate the same operating income and only differ via
their capital structure.

One Levered (Firm L) One unlevered (Firm U)

Recall EL = VL – DL (Equity of firm L = Value of firm L – Debt of firm L)

Assumption One: You do not want to expose yourself to too much risk

Note: Make use of information about firms U and L above, but additionally: assume
EBIT = $2,000.00

An Illustration Extended

Consider two Firms: They generate the same operating income and only differ via
their capital structure.

One Levered (Firm L) One unlevered (Firm U)

Recall EL = VL – DL

Assumption Two: You are now willing to take a little more risk

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With homemade leverage we can make the risk of the investment in the levered
firm the same as the risk of the investment of the unlevered firm.

 To do this we need to remove financial risk (lend money).

This is the fundamental insight of M&M.

MM 1958 – Assumptions

 No taxes,
 Homogenous expectations of the firm’s future EBIT,
 Homogenous business risk classes,
 All cash flows are perpetual and all earnings are paid out as dividends (PV =
EBIT (1−Tc)
C/R – or ),
R UL
 Perfect capital markets,
o i.e. perfect competition, no transaction costs, investors &
corporations can borrow & lend at the same rate.

Proposition I – 1958

The value of the firm is independent of its capital structure.

VL = VU

 VL = Value of levered firm

 VU = Value of unlevered firm

Implication: Changing the mix of debt and equity financing (capital structure) does
not affect the value of the firm.

Proposition II – 1958

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The cost of equity (return investors demand from investing in a company – higher
levels of debt financing require higher return) of a levered firm is equal to:

(a) The cost of equity of the unlevered firm in the same risk class, plus
(b) A risk premium

KsL = KsU + (D / S) (KsU - Kd)

KsL is the return on (levered) equity (cost of equity)

KsU is the return on unlevered equity (cost of capital)
D is the value of debt
S is the value of levered equity
Kd is the interest rate (cost of debt)

Proposition III – 1958

Discount rate for NPV will be completely unaffected by the capital structure of the
firm.

WACC-U = WACC-L
Implication: An increase in leverage (debt financing) doesn’t affect the discount
rate used for a project.

The Cost of Equity, the Cost of Debt, and the Weighted Average Cost of
Capital: MM Proposition II with No Corporate Taxes

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MM 1963 – Assumptions

New assumptions:

 There are corporate taxes, and

 Debt interest is tax deductible.

Note: Personal tax is ignored, but the other assumptions from 1958 is held.

Proposition I – 1963

Firm value increases with leverage.

VL = VU + TD

Implication:
The value of the levered firm is equal to:

(a) The value of an unlevered firm in the same risk class, PLUS
(b) The gain from leverage (this is the value of the tax saving and is calculated
as tax rate (T) times debt (D)).

Levered vs. Unlevered Firm

 The value of the levered firm is higher because a smaller piece of the pie is
“lost” to tax.
 Tax saving associated with debt is realised as long as interest is paid on the
firm’s debt.

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Proposition II – 1963

Some of the increase in equity risk and return is offset by the interest tax shield.

KsL = KsU + (D / S) (KsU - Kd)(1-T)

Implication:
The cost of equity of a levered firm is equal to:

 The cost of equity of an unlevered firm in the same risk class, PLUS
 A risk premium to compensate financial risk
• The premium is less in a tax world due to tax savings than in a non-tax
world.

Proposition III – 1963

With the introduction of tax, there is now an additional advantage to gearing-up:

the tax relief obtained on the debt interest.

rWACC =( D / V )(kd )(1 - T ) + ( S / V )ks

Implication:

 The more highly geared the company becomes, the more tax relief it obtains
and the smaller its tax liability.
 In a world with tax relief on debt interest we would expect a company’s
after tax WACC to be progressively lowered as it increases its gearing.

Proposition II & III – 1963

In a world
where there is
tax relief on debt
interest, we
would expect a
company’s after-
tax WACC to be
progressively
lowered as it
increased its
level of gearing.
(1-T) brings cost
of equity
(capital) down.

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Cash Flow To Investors Under Each Capital Structure

Note: Adding on $640 which is the cash flow to bond holders.

M&M suggest financial leverage doesn’t matter, or imply that taxes cause the
optimal financial structure to be 100% debt.

In practice, most executives do not like a capital structure of 100% debt because
that is a state known as “bankruptcy”.

We will introduce the notion of a limit on the use of debt: financial distress.

Miller and Modigliana Exam Question

 CBI has $200,000 in debt due to financing their business at a cost of 8%. The
EBIT of an otherwise identical but unlevered firm is $30,000 and cost of
equity 10%. Assume that the tax rate is 30%.

 Calculate the weighted average cost of capital.

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WACC= K D S
A=¿ Kd ( 1−Tc ) + + Ks¿
V V

$200,000/ ? 0.08(1-0.3) + _______

EBIT ( 1−T ) $ 300,000 ( 1−0.3 )

V UL = = =$ 210,000
K SU 0.10

V L=V UL +TD=$ 210,000+0.3 ( $ 200,000 )=$ 270,000

$ 200,000 $ 20,000
Fill in first equation = 0.08 ( 1−0.3 ) +
$ 220,000 $ 270,000

Critique of MM – 1963

 Borrowers incur costs, such as bankruptcy and agency costs that largely
offset the value of the interest tax shield.

4. Bankruptcy Costs

 Debt provides tax benefits but puts pressure on the firm - Why?
 Interest and Principal payments are obligations & if not met, might result in
bankruptcy
 Bankruptcy costs thus tend to offset the advantages of having debt

Example:

Firms A and B plan to be in business for one more year. They forecast a cashflow of
either $100,000 or $50,000 in the coming year, each occurring with 50%
probability. The firms have no other assets. Previously issued debt requires

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payments of $49,000 of interest and principal in Firm A. Previously issued debt

requires payments of $60,000 of interest and principal in Firm B. Assume that
stockholders and bondholders are risk neutral and expect 10% return. Show the
impact of bankruptcy costs.

If the cash flow is only $50,000 bondholders will be informed that they will not be
paid in full. These bondholders are likely to hire lawyers to negotiate or even sue
the company.

The firm is likely to hire lawyers to defend itself. Assume legal costs of $10,000.

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 The possibility of bankruptcy has a negative effect on the value of the firm.
 It is not the risk of bankruptcy itself that lowers the value but the cost
associated with bankruptcy that lowers the value.

 WHO BEARS THE FUTURE BANKRUPTCY COSTS? - Stockholders

5. Agency Costs & Selfish Strategies

When a firm has debt, conflicts of interest arise between stockholders and
bondholders. These conflicts of interests (called AGENCY COSTS) are magnified
when financial distress is incurred.

Why? – Agency costs tempt shareholders to become involved in selfish strategies.

Examples:
1. Incentive to take large risks
2. Incentive toward underinvestment
3. Milking the property

These three distortions can occur when there is a probability of bankruptcy or

distress

1. Incentive to take large risk

Eg: Consider two mutually exclusive projects, a low risk one and high risk one.
There are two equally likely outcomes, recession and boom. Previously issued debt
requires a payment of $100,000 of interest and principal.

Value of the firm if the low risk project is accepted

Prob. Value of firm
R 0.5 $100,000
B 0.5 $200,000

Value of the firm if the high-risk project is accepted

Prob. Value of firm
R 0.5 $50,000
B 0.5 $240,000

Stockholders will select the high-risk project.

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2. Incentive Toward Underinvestment

Stockholders of a firm with a significant probability of often find that new

investment helps the bondholders at the stockholders expense.

As investments are mainly funded through shareholders, yet benefit bondholders

directly (through increased cash flow) shareholders might be tempted to reject
some positive NPV projects.

Example:
Consider a firm with a $40,000 payment of principal and interest due at the end of
the year. It will be pulled into bankruptcy by a recession because its cashflow will
be only $24,000 in that state. The firm could avoid bankruptcy in a recession by
raising new equity to invest in a new project. The project costs $10,000.

3. Milking the Property

To pay out extra dividends in times of financial distress. In other words equity is
withdrawn through dividend payments.

There is thus less left for bondholders, who have the first claim to the assets in
case of bankruptcy.

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Can costs of debt be reduced?

 Because stockholders must pay higher interest rates as insurance against

their own selfish strategies, they frequently make agreements with
bondholders in the hope of lower rates.

 These agreements are called protective covenants and they are

incorporated into the loan document (or indenture) between shareholders
& bondholders.

6. Optimal Capital Structure

There is a trade-off between the tax advantages of debt and the costs of financial
distress. This is often called the static trade-off theory of capital structure.

Integration of Tax Effects and Financial Distress Costs

The Pie Model Revisited

Taxes and bankruptcy costs can be viewed as just another claim on the cash flows
of the firm.

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Let G and L stand for payments to the government and bankruptcy lawyers,
respectively.

V = S+ D + G + L

The essence of the M&M intuition is that V

depends on the cash flow of the firm; capital
structure just slices the pie.

Heading 10: Cost of Capital

So far it has been employed to discount cash flows, calculate the NPV, compared to
the IRR and employed as the required rate of return.

The cost of capital (COC) is the rate of return the firm must earn to maintain its
market value and attract investors.

It is also how much it costs the firm to finance its assets (the cost of debt and equity
financing).

 Projects with a return > COC will improve the firm’s value.
 Projects with a return < COC will harm the firm’s value (have a negative
NPV).

Therefore, the discount rate of a project should be the expected return on a

financial asset of comparable risk.

Cost of Capital is abbreviated WACC, as it is the weighted average rate.

Estimated the COC

COC is estimated:

 On an after-tax basis (cost of debt),

 At a point in time
 Based on expected future values
 Holding business and financial risk fixed.

Target capital structure is the optimal mix of debt and equity financing for the
firm:

• Most firms seek to maintain a desired mix of debt and equity funding
• Each new chunk of capital should fit with the overall mix

Why Cost of Capital is Important

• We know that the return earned on assets depends on the risk of those
assets, the riskier assets are, the higher the required rate of return,

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• The return to an investor is the same as the cost to the company, investors
will require a return at least compensating them for the risk they take in
investing,
• Cost of capital provides us with an indication of how the market views the
risk of the companies assets
• Knowing the cost of capital can also help us determine the required return
for capital budgeting projects

Required Return

• The required return is the same as the appropriate discount rate and is
based on the risk of the cash flows
• We need to know the required return for an investment before we can
compute the NPV and make a decision about whether or not to take the
investment
• We need to earn at least the required return to compensate our investors
for the financing they have provided.

Overall Cost of Capital of the Firm

Cost of Capital is the required rate of return on the main types of financing:

(1) Cost of debt (kd = YTM on bonds)

(2) Cost of Preference Shares (won’t always have – treat like a perpetuity)
(Dividend/ price – valuing a perpetuity)
(3) Cost of Ordinary Equity (ks E(Ri) i.e. CAPM or ks from DDM)

The overall cost of capital is a weighted average of the individual required rates of
return (costs).

Cost of Debt (kd)

• The cost of debt is the required return on our company’s debt

• We usually focus on the cost of long-term debt or bonds
• The required return is best estimated by computing the yield-to-maturity on
the existing debt
• The cost of debt is NOT the coupon rate

Point out that the coupon rate was the cost of debt for the company when the bond
was issued. We are interested in the rate we would have to pay on newly issued
debt, which could be very different from past rates.

Taxes and the Cost of Debt

• We are concerned with after-tax cash flows, so we need to consider the

effect of taxes on the various costs of capital.

• Interest expense reduces the tax liability

– This reduction in taxes reduces the cost of debt

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– After-tax cost of debt, ki = kd(1-T)

– Dividends are not tax deductible, so there is no tax impact on the cost
of equity

Point out that if we have other financing that is a significant part of our capital
structure, we would just add additional terms to the equation.

Example 1: Cost of Debt

• Suppose there is a bond issue currently outstanding that has 25 years left to
maturity. The coupon rate is 9% and coupons are paid semiannually. The
bond is currently selling for $908.72 per $1,000 bond. What is the cost of
debt?

– n = 25yrs x 2 = 50
– Coupon = $1,000 x (0.09/2) = $45
– M = $1,000
– Pb = $908.72

1. Find the YTM (recall from teaching week 3)

• Must use Trial and Error OR Interpolation (If you don’t know how to do this
by now – seek help)

C 1  FN $45  
PB = 1 - + $908.72 = 1 -
1
+
$1,000
i  (1 + i ) n  (1 + i )
n
kd  (1 + k )  (1 + k )50
 d
50
 d

• YTM = kd = 5%

2. Convert to an annual cost of debt

kd = (1+0.05)2 – 1 = 10.25% (this is because a semi-annual equation
provides a semi-annual result)

3. Find the after-tax cost of debt

ki(1 – T) = 10.25(1 – 0.3)
= 7.18%

Cost of Preference Share Capital

Reminders:
• Preference shares generally pay a constant dividend every period.
• Dividends are expected to be paid every period forever.

Preference shares are a perpetuity, so we take the perpetuity formula, rearrange

and solve for kp:

Kp = D1/P or Kp = DP/NP

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Where:
DP = the annual preference share dividend
NP = the net proceeds from sale of preference share.

Example 2: Cost of Preference Shares

A company has preference shares that have an annual dividend of $3. If the current
price is $25, what is the cost of the preference share?

Kp = 3/25 = 12%.

Cost of Equity

The cost of equity is the return required by equity investors given the risk of the
cash flows from the firm.

There are two major methods for determining the cost of equity.

• Dividend growth model (week 3)

• SML or CAPM (week 9)

The Dividend Growth Model Approach

Start with the dividend growth model formula and rearrange to solve for k s.

Dt +1
P0 =
R- g

Dt +1
R = +g
P0

Where R is the same as ks, the cost of equity. i.e. cost of equity = D1/ P0 + Growth

Example 3: Dividend Growth Model

Suppose that a company is expected to pay a dividend of $1.50 per share next year.
There has been a steady growth in dividends of 5.1% per year for this company and
the market expects this to continue. The current price is $25. What is the cost of
equity using the DGM?

$1.50
kS = + 0.051 =0.111 or 11.10%
$25

Thus, investors currently require a return of 11.1% on their capital. This is

assuming that growth is constant, i.e. ‘steady growth in dividends’.

Illustration: Estimating the Dividend Growth Rate

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One method for estimating the growth rate is to use the historical average (if we
don’t know the growth rate).

Our historical growth rates are

reasonably close, so we could feel
reasonably comfortable that the
market will expect our dividend to
grow at around 5.1%. Note that when
we are computing our cost of equity, it
is important to consider what the
market expects our growth rate to be,
not what we may know it to be
internally. The market price is based
on market expectations, not our
private information.

Another way to estimate the market consensus estimate is to look at analysts’

forecasts and take an average.

Advantages and Disadvantages of the Dividend Growth Model (Favourite

Exam Question)

Advantage – Simple and easy to use.

Disadvantages

• Only applicable to companies currently paying dividends (i.e. never has, not
just not at present).

• Not applicable if dividends aren’t growing at a reasonably constant rate.

• It is extremely sensitive to the estimated growth rate – an increase in

growth of 1% increases the cost of equity by 1%. This is an issue because if
the estimate is wrong, the cost of equity will be even more wrong.

• It does not explicitly consider risk, i.e. Beta, Sharpe, SD ratio etc. Cost of
equity should include risk, but it doesn’t explicitly state it.

The Capital Asset Pricing Model (CAPM) or SML Approach

Use the following information to compute our cost of equity.

• Risk-free rate, RRF

• Market risk premium,
• Systematic risk of asset, b

E ( Ri ) =RRF + b i ( E ( RM ) - RRF )

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Where E(Ri) is our ks.

Example 4: CAPM

Suppose the same company introduced in Example 3 has an equity beta of 0.58.
Additionally assume the current risk-free rate is 6.1% and the expected market risk
premium is 8.6%. What is the cost of equity capital for this company using the
CAPM?

kS = 6.1 + 0.58(8.6) = 11.09%

Since we came up with similar numbers using both the Dividend growth model and
the SML approach, we should feel pretty good about our estimate (Refer to
Example 3).

Note: Return on market portfolio or market risk premium is this part;

( E(RM ) - RRF ) of the CAPM equation.

It is telling us how much the market portfolio earns ( E(RM )), in addition to what
can be earned Risk Free (RRF). The premium is the whole bracket above, the return
on the market is only (RRF) part of the equation.

Advantages and Disadvantages of CAPM/ SML

Advantages

• Explicitly adjusts for systematic risk.

• Applicable to all companies, as long as we can compute beta.

Disadvantages

• Have to estimate the expected market risk premium, which does vary over
time.
• Have to estimate the beta, which also varies over time.
• We are relying on the past to predict the future, which is not always
reliable.

Example 5: Cost of Equity

Suppose a company has a beta of 1.5. The market risk premium is expected to be
9% and the current risk-free rate is 6%. Analysts’ estimates have been used to
determine that the market believes the dividends will grow at 6% per year. The last
dividend was $2. The stock is currently selling for $15.65. What is the cost of equity?

Note: We can use either CAPM or DGM because all information is present.

Using SML: kS = 6% + 1.5(9%) = 19.50%

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Using DGM: kS = [2(1.06) / 15.65] + 0.06 = 19.55%

Note: D1 = current dividend ($2) x 1 + growth rate 6%
Both are assumptions based on estimations that will likely result in different
outcomes or presumptions. It is only reasonable that estimations used in
calculations will come up with different answers.

Weighted Average Cost of Capital

We can use the individual costs of capital that we have computed to get our
“average” cost of capital for the firm.

This “average” is the required return on the assets, based on the market’s
perception of the risk of those assets.

The weights are determined by how much of each type of financing is used.

Notation:
S = market value of equity – No. outstanding shares times price per share.
D = market value of debt – No. bonds times bond price.

Weights:

S S
= =x the proportion (weight) financed through equity
S+ D V os

Value of the firm (VF) = Value of the firm’s equity (Vs) + Value of Debt (Vd)
Thus in order to determine weight of equity (Ws) in capital structure; Vs/ Vf, same
applies for debt, Vd/Vf (Wd).

D D
= =x DPT proportion (weight) financed through debt
S +D V

Example 6: Capital Structure Weights

Suppose you have a market value of equity equal to $500 million and a market
value of debt of $475 million. What are the capital structure weights?

V = S + D - $500m + $475m = $975m.

S/V = $500m/$975m = 51.28% = Ws

D/V = $475m/$975m = 48.72% = Wd

What is more relevant, market values or book values?

The market value of the firm is more important as the market value of equity and
debt is used by the market to determine other assumptions.

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After Tax WACC – With Preference Shares

Preference shares and other forms of financing must be including in the formula

WACC =x D k DPT (1 - t ) + x ps k ps + x os k os
= Wd x Kd (1-T) + Wp x Kp + Ws x Ks

Weight of debt x cost of debt (1-T – after tax) + weight of preference shares x cost
of preference shares + weight of equity x cost of equity.

What Happens if There is Only Debt and Equity

If there is no preference shares, the formula reduces to:

WACC = X os k os + xDBT k DBT ´( 1- T )

This is the standard WACC formula (under capital structure on formula sheet) just
omit preference shares.

After Tax WACC – Equity Only Firm

If the firm is an all equity firm and has no debt, then the WACC formula collapses
to:

WACC =xos k os
Since the firm is equity only, S/V = 1. Hence,

WACC =k os

That is, the WACC for an all equity firm is just the cost of equity capital .

Example 7: Comprehensive Problem (Best Revision for The Exam)

Kolkata Knight Riders (KKR) Ltd. want to determine their WACC. Their 11% semi-
annual bonds (par value $1,000) are selling for $942.65 with 10 years remaining
until maturity. KKR has 10,000 bonds currently on issue. The preference shares
issued at $2.00 per share, pay $0.20 dividends and are currently selling in the
market for $1.60. There are 5 million preference shares outstanding. The firm also
has 5 million ordinary shares on issue, which have a current market price of $5.00
each. Assume that the current risk-free rate is 7% and the return on market
portfolio is 12%. KKR has a beta, which has been recently estimated at 1.2. The tax
rate is 30%.

Calculate KKR’s weighted average cost of capital.

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Must calculate cost components (of debt Kd, of equity Ks, preference shares Kp)
Then must estimate capital structure/ weight (Wd, Ws, Wp)

Step One: Calculate Cost of Capital Components

Cost of Debt:

55  1  1000
942.65 = 1 - +
k d  (1 + k ) 20  (1 + k d ) 20
 d
Þ kd =0.06 or 6.00%

recall this is the cost of debt before tax

The cost of bonds = 6% per six months, so 12.36% compounding annually;

kdpt = (1+0.06)2 – 1 = 12.36%

Therefore, the after-tax cost of debt,

kd = 0.1236(1 – 0.3) = 0.08652, or 8.65%

Cost of debt (on bonds) is just the yield to maturity on the bond!!
Must write down the formula despite whether or not calculator is used.

Cost of Preference Shares:

The cost of preference shares,

DP 0.20
= =0.125 or 12.50%
kps =
N P 1.60

We use $1.60 (and not $2) because $1.60 is the current market value (price).

Cost of Equity:

Using CAPM, the cost of equity:

kos = RFR + bi [E(Rm) – RFR)]

= 0.07 + 1.2(0.12 – 0.07) = 0.13, or 13.0%

Step Two: Calculate Weights of Capital Components

Value of bonds = 10,000 x $942.65

= $9.4265 m

Value of preference shares = 5m x $1.60

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= $8.00 m

Value of ordinary shares = 5m x $5.00

= $25.00 m

Total value of firm = $42.4265m

Weight of Capital Components =

Bonds: $9.4265m/$42.4265m = 22.2%

Preference shares: $8m/$42.4265m = 18.9%

Ordinary shares: $25m/$42.4265 = 58.9%

Complete Weighted Average Cost of Capital Formula

WACC =xD k DPT (1 - t ) + x ps k ps + x os k os

WACC = 0.222(0.0865) + 0.189(0.125) + 0.589(0.13) = 11.94%.

Divisional And Project Cost of Capital (RADR)

 Using the WACC as our discount rate is only appropriate for projects that
are the same risk as the firm’s current operations (assumption made).
 If we are looking at a project that is NOT the same risk as the firm, then we
need to determine the appropriate discount rate for that project.
 i.e. divisions also often require separate discount rates.

The WACC is not very useful for companies that have several disparate divisions.

Capital Budgeting & Project Risk

A firm that uses one discount rate for all projects may over time increase the risk of
the firm while decreasing its value.

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The dotted hurdle line is the WACC. Will incorrectly rejected positive NPV because
with lower risk, of course they are going to offer a lower return, but why wouldn’t
we accept it?

Incorrectly accept negative NPV projects because higher return than the WACC
looks acceptable but it has a negative NPV because it does not meet the SML
requirements. With higher risk, we should require a higher rate of return, by the
WACC wouldn’t incorporate this.

Subjective Approach

 Consider the project’s risk relative to the firm overall,

 If the project is more risky than the firm, use a discount rate greater than
the WACC,
 If the project is less risky than the firm, use a discount rate less than the
WACC,
 You may still accept projects that you shouldn’t and reject projects you
should accept, but your error rate should be lower than not considering
differential risk at all.

Risk Level Discount Rate

Very low risk WACC – 8%
Low risk WACC – 3%
Same risk as firm WACC
High risk WACC + 5%
Very high risk WACC + 10%

Example 8: Capital Budgeting & Project Risk

Suppose the Conglomerate Company (financed by equity only - unlevered) has a

cost of capital, based on the CAPM, of 17%. The risk-free rate is 4%, the market risk
premium is 10% and the firm’s beta is 1.3.

17% = 4% + 1.3×[14% – 4%]

This is a breakdown of the company’s investment projects:

1/3 Automotive retailer β = 2.0

1/3 Computer Hard Drive Mfr. β = 1.3
1/3 Electric Utility β = 0.6

Average β of assets = 1.3

When evaluating a new electrical generation investment, which cost of capital

should be used?

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β of return is 1.3. At 10%, because we have lower risk, we will expect lower return.

Heading 11: Dividend Policy

How Dividends are Paid

Dividends are periodic cash payments made by companies to their shareholders.

The ability of a company to pay dividends will be related both to profitability &
liquidity.

 Distributable profits,
 Cash available.

Dividends are not always in the form of cash. Frequently companies declare share
dividends.

Some companies declare a dividend in kind.

 Wrigley’s Gum sends around a box of chewing gum.

 Dundee Crematoria offers shareholders discounted cremations

Two types of shares paid; regular or special dividends. In the US, dividends are paid
quarterly, where as in the UK, Australia and NZ, dividends are paid semi-annually.

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Share Dividends vs. Share Splits

Share dividend: Firm issues new shares in lieu of paying a cash dividend. If 10%,
receive 10 shares for each 100 shares owned.

Share split: Firm increases the number of shares outstanding, say 2:1. Thus, sending
shareholders more shares.

Both share dividends and share splits increase the number of shares outstanding, so
“the pie is divided into smaller pieces.”

Unless the share dividend or split conveys information, the share price falls so as to
keep each investor’s wealth unchanged.

US Procedure for Cash Dividend Payment

Declaration Date: The Board of Directors declares a payment of dividends.

Cum-Dividend Rate: The last day that the buyer of a share is entitled to the
dividend. US convention has this as 3 business days before record date.

Ex-Dividend Date: Anyone holding share before this date is entitled to a dividend
(2 business days before Record Date in the US).

Record Date: The corporation prepares a list of all individuals believed to be

shareholders (and will thus receive the dividend).

Australian Procedure for Cash Dividend Payment

Declaration Date: The Board of Directors declares a payment of dividends.

Cum-Dividend Rate: The last day that the buyer of a share is entitled to the
dividend.

Ex-Dividend Date: Anyone holding share before this date is entitled to a dividend
(4 business days before Record Date).

Record Date: The corporation prepares a list of all individuals believed to be

shareholders.

Price Behaviour Around the Ex-Dividend Date

In a perfect world, the share

price will fall by the amount of
the dividend on the ex-dividend
date.

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Taxes complicate things a bit. Empirically, the price drop is less than the dividend
and occurs within the first few minutes of the ex-date.

How Do Companies Decide on Dividend Payments?

Lintner (1956) interviewed corporate managers:

 Firms have long run target dividend payout ratios.

 Managers focus more on dividend changes than on absolute levels.
 Dividend changes follow shifts in the long-run, sustainable earnings.
 Managers are reluctant to make dividend changes that have to be reversed.

Dividend Change

Managers avoid making a change in their level of dividend payments if it will have
to be reversed later. Thus, the level of dividends is more stable than the level of
earnings. Firms smooth out changes in their dividends relative to changes in their
earnings. We call this dividend smoothing.

Shareholders prefer steady progression in dividends.

The Lintner (1956) Model:

Dividend change = adjustment rate x target change (not on formula sheet, but may
be asked):

Div1 – Div0 = s(tE1 – Div0)

Where:
t = target payout ratio
s = adjustment rate
Div1 = Dividend per share in year 1
Div0 = Dividend per share in year 0
E1 = Earnings per share in year 1

Lintner’s simple model suggests that the dividend depends in part on the firm’s
current earnings and in part on the dividend for the previous year.

The probability of an increase in the dividend rate should be greatest when current
earnings have increased and the company believes the increase is sustainable.

• Fama and Babiak (1968) study confirmed this hypothesis.

Do Investors Prefer High or Low Payouts?

1. Dividends are Irrelevant: Investors don’t care about payouts.

2. Tax Preference: Investors prefer a low payout, hence prefer growth as they
pay capital gains tax on price increases.

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Investors are indifferent between dividends and retention-generated capital gains.

If they want cash, they can sell shares, if they don’t want cash, they can use
dividends to buy shares.

 Notion supported by Miller-Modigliani reports.

Miller & Modigliani (1961) Dividend Irrelevancy

In MM’s world dividend policy is irrelevant in the sense that it cannot affect
shareholder’s wealth. The effect of any particular dividend policy can be offset
without cost by managers adjusting the firm’s sale of new shares and by investors
adjusting their dividend streams through share repurchases.

Assumptions of MM (1961)

 Investment decisions are not influenced by dividend payments

 No information costs: All traders have equal and costless access to
information.
 No share issue costs.
 No taxes. Consequently investors are indifferent to receiving dividends or
capital gains.

MM (1961) Homemade Dividends

 Miller and Modigliani base this theory on the concept of homemade

dividends.
 Concept: Whether a firm pays a dividend or not is irrelevant.
 If an investor wanted a dividend (and did not receive one) they could sell
shares to recreate a dividend payment.
 If investors did not want a dividend, but received one, they could reinvest
that dividend by buying new shares.

Firms should never forgo positive NPV projects to increase a dividend (or to pay a
dividend for the first time).

Example 1: Dividends and Investment Policy

Suppose firms A and B are all-equity firms with a 10% cost of equity capital.
Initially, both firms have $1000 in assets and can earn a 10% return on assets with
certainty. Firm A pays out all of its earnings in dividends while Firm B has a 60%
dividend payout. Assume that there are no taxes and that the first dividend is paid
at the end of the first year. Find the market value of equity for both firms.

Firm A has a growth rate of 0%, value = $1,000

Firm B has a growth rate of 4% (HOW? Lecture ~36minutes in) (g = ROE x
Plowback Ratio) $60/(0.1 – 0.04) = firm value = $1,000.

The fact that both companies have the same value is consistent with the
Miller-Modigliani dividend irrelevance proposition.

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Share Repurchases

Instead of declaring cash dividends, a firm can rid itself of excess cash through
buying shares of their own share.

Recently, share repurchases have become an important way of distributing

earnings to shareholders, referred to as a ‘share buyback’ in Australia.

This is limited by Corporations Law (why? ~40 minutes in).

Tax Preference Theory

Retained earnings lead to capital gains. Since capital gains can be deferred (i.e. not
paid until the asset is sold), the tax rate on dividends is greater than the effective
rate on capital gains. This could cause investors to prefer firms with low payouts.

Firms With Sufficient Cash to Pay a Dividend

Consider a firm that has $1 million in cash after selecting all available positive NPV
projects.

The firm has several options:

 Select additional capital budgeting projects (by assumption, these are

negative NPV).
 Acquire other companies
 Purchase financial assets
 Repurchase shares

Taxes, Issuance Costs, and Dividends

In the presence of personal taxes:

 A firm should not issue share to pay a dividend.

 Managers have an incentive to seek alternative uses for funds to reduce
dividends.
 Though personal taxes mitigate against the payment of dividends, these
taxes are not sufficient to lead firms to eliminate all dividends.

Real World Factors Favouring a High Dividend Policy

 Desire for Current Income - i.e. pensioners or investors without a real

income or wage from work. Invest in businesses with frequent or high
simulated regular income.

 Tax and legal benefits from high dividends – Some organisations that
pay no tax, or low tax. So receiving a dividend isn’t a disincentive.

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 Tax Arbitrage – Individuals invest in high dividend companies but through

arbitrage they don’t have to pay tax.
 Agency Costs – Inappropriate practices by management or perception of
poor management practices may act as an incentive for a firm to provide
high proportions of income as a means of transparency. Further, agency
costs may cause high dividends as a corporation may be about to hit
bankruptcy so shareholders vote for a high dividend payout because they
are residual claimants on debt.
Imputations System (1987 in Australia)
A system under which Australian resident equity investors can use tax credits
associated with franked dividends to offset their personal tax. The system
eliminates the double taxation inherent in the classical tax system.

After a company has paid tax on their earnings and then pay dividends,
shareholders can apply for a tax credit to offset the tax the company has already
paid and then not pay tax on dividends (applies if individual pays tax at the same or
lower rate than the company).

Taxes and Dividends in the US

In the US, shareholders are taxed twice. Once at the corporate level and once at the
personal level. Here is a two individual comparison:

Rate of Income tax

0% 39.6%
Operating Income $100 $100
Corporate tax (Tc = 0.35) $35 $35
After Tax income (paid as div) $65 $65
Income tax $0 $25.70
Cash to Shareholder $65 $39.30

Taxes and Dividends in Australia

Under imputation tax systems shareholders receive a tax credit for the company
tax paid by the firm.

Rate of Income tax i.e. if you pay 20%

income tax, credit for
20% 30% 47% $10 because they have
Operating Income $100 $100 $100
Corporate tax (Tc = 0.30) $30 $30 $30
a tax credit covering
After Tax income $70 $70 $70 30% even when they
Dividend paid $70 $70 $70 only pay 20% tax.
Grossed up Dividend (D/(1-Tc) $100 $100 $100
Income tax $20 $30 $47
Tax credit for Corp Pmt -$30 -$30 -$30
Tax due from shareholder -$10 $0 $17
Cash to Shareholder $80 $70 $53

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Company tax is assessed on corporate profits in the normal way, at the corporate
tax rate (Tc).

For each dollar of franked dividends paid by the company, resident shareholders
will be taxed at their marginal rate (Tpe) on an imputed dividend of $Div/(1-
Tc). This is referred to as the grossed-up dividend. The grossed-up dividend is equal
to the dividend plus the imputation credit.

Franked Dividends

 These dividends carry the imputation credits.

Unfranked Dividend

 There is no imputation credit attached to unfranked dividends,

 Unfranked dividends are taxed at the investors’ marginal rate (double
dipping taxation system, tax on company and on individual dividends).

The result is that franked dividends are effectively tax free to Australian residents,
if the investor’s marginal tax rate is equal to the corporate tax rate.

If the investor’s marginal tax rate is less than the corporate rate, then the investor
will have excess tax credits which can be used to reduce tax on other income.

If the investor’s marginal tax rate is greater than the corporate rate, some tax will
be payable by the investor on the dividend.

Investors pay tax, at their marginal rate, on any unfranked dividends received.

Imputation and Capital Gains Tax

If companies retain profits, their share price is likely to rise relative to companies
which distribute profits, giving rise to capital gains tax liabilities for shareholders if
and when the shares are sold.

If all company shares were held by resident investors with marginal tax rates less
than company tax rates, then the optimal dividend policy for an Australian
company is one which at least pays dividends to the limit of its franking account
balance.

This policy will benefit resident investors in two ways:

 The imputation credits attached to franked dividends can be used to reduce

investors’ personal tax liabilities.

 Since the alternative to dividends is capital gains, which are subject to

company tax and CGT, higher dividends will mean that less CGT is payable
by investors.
Complicating factors for optimal dividend policy:

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 Shares are held by both resident and non-resident individuals. If non-

resident individuals receive a dividend, they must pay tax and cannot apply
for a credit. This is because the Australian government receives corporate
tax income from the business, but the American government won’t have and
will want to tax the income of the American dividend receiver instead.

 Many individuals have personal marginal tax rates that are greater than
the company tax rate and may have a tax-based preference for retention of
profits.

Do Dividend Change Announcements Have an Impact on Share Prices?

An announcement of a dividend payout will not affect the share price. But an
announcement of a change in dividend payout will. This is because of “information
content” or “signalling” hypothesis to investors.

 Managers hate to cut dividends, so they won’t increase dividends unless they
think the increase is sustainable. So, investors view dividend increases as
signals of management’s view of the future.

 Therefore, a share price increase at the time of a dividend increase could

reflect higher expectations for future EPS.

Information Content Hypothesis

 Dividends anticipate future earnings,

 Thus, dividend increases are good or positive signals of news,
 On the contrary, dividend decreases are poor signals, i.e. future income will
be consistently lower.

Residual Dividend Policy

A policy whereby a dividend (consistent with the target payout ratio) is declared
from whatever is left of earnings after expenditure have been netted.

Example 2: Residual Dividend Policy

ABC has a residual dividend payout policy with a 40% target payout ratio. If
revenue was $12,000,000, expenditure $4,000,000 and the company has
10,000,000 issued shares. What would the dividend per share be?

$8million x 0.4 = $3.2million / 10million = 32c per share.

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