Chapter 5

What is return?
Return is the gain or loss achieved by making an investment.
q Figure 5.1 shows the historical annual returns on Australian shares and
Commonwealth Treasury bonds with a 10-year maturity.

Calculating returns
q There are two types of returns we can calculate.
q The first is measured after the return has occurred (ex post returns).
q The second involves estimating returns that are expected to occur in a future time
period (ex ante returns).
q It is important to remember that investors are interested in after-tax returns.
Ex post returns
q Ex post or realised returns are those returns that relate to past periods.
q The following discussion relates to calculating the returns on shares.
q We use equation 5.1 to calculate the percentage return on a share for a single period:

Ex post returns
q A capital gain arises when the price of an asset increases.
q A capital loss arises when the price of an asset decreases.
q A small capital loss can be offset by a relatively large dividend payment, giving the
investor a positive return in aggregate.
 q Equation 5.1 gives us the holding period return.
q The holding period return is the return an investor would earn if the share was
purchased at the start of the period and sold at the end of the period.
q Not only should holding period returns be expressed in the same length of time for
comparison, they should also occur at about the same point in time.
q Ex ante returns are those that investors expect to receive in the future.
q It is the investor’s estimation of ex ante returns that drives the decision to make an
investment.
q While ex post returns are observable from past data, ex ante returns have not
happened yet so they cannot be observed.
Calculating the expected return on an investment is more difficult because it is subjective
q The expected return is the probability-weighted average of possible outcomes
associated with the investment.
q This process is captured in the application of equation 5.2.

What is risk?
q Risk is the chance that the actual outcome from an investment will be different from
the expected outcome.
q The definition of risk tells us that the realised (or ex post) returns over the life of a
risky investment can be different from the expected (or ex ante) returns that were
forecast at the outset of the investment.
How different the ex post return can be depends on the probability distribution of possible
returns
q Two different probability distributions are shown in figure 5.3

q Clearly, panel A represents a much riskier distribution of possible outcomes than

panel B.
Measuring risk
 q When the outcome of a future event cannot be known with certainty, as is the case
with investment returns, the measurement of the outcome of an event is called a
random variable.
q Random variables can take on any value within a possible range of values.
q Combining all possible outcomes for a random variable with their associated
probabilities gives us the probability distribution of the random variable.
q Figure 5.4 shows a probability distribution.

q The probability distribution in figure 5.4 is called the normal distribution.

The normal distribution is a symmetric and bell shaped curve centred on the expected value
of a variable
q The symmetry of the normal curve tells us that some actual outcome, say five above
the expected value, is just as probable as an actual outcome of five below the expected
value.
q The shape of the normal distribution tells us that small deviations are much more
likely than large deviations from the expected value.
q The measurement of risk is about determining how probable it is that a realised
outcome will deviate from the expected one.
q The variance is the squared deviation of the variable from its expected value.
q The variance gives us a measure of dispersion, but that number measure is not on the
same measurement basis as the variable of interest.
q To convert the variance to the same measure of the variable, we take the square root
of the variance. This measure is the standard deviation.
q A normal distribution always has the majority of its possible outcomes within the
range of the expected value plus and minus three standard deviations.
q Approximately 68% of all outcomes lie within plus and minus one standard deviation
from the expected value.
q Approximately 95% of all outcomes lie within plus and minus two standard
deviations from the expected value.
q Approximately 99.7% of all outcomes lie within plus and minus three standard
deviations from the expected value.

Ex ante standard deviation

q The ex ante variance is the probability-weighted average of squared deviations of
possible returns from the expected return.
q Equation 5.3 is used to compute the ex ante variance.
 Ex ante standard deviation
q The ex ante standard deviation is the square root of the ex ante variance.
q Equation 5.4 is used to compute the ex ante variance.

q The ex post variance is the weighted average of the squared deviations of observed
returns from the mean return.
q Equation 5.5 is used to compute the ex post variance.

q Before we can use equation 5.5, we need to calculate the mean return for our
observations. Equation 5.6 is used to do this.
q The ex post standard deviation is the square root of the ex post variance.
q Equation 5.7 is used to compute the ex post standard deviation.

q A large standard deviation indicates that many of the observations were very different
from the mean outcome.
q Conversely, a small standard deviation indicates that returns fall within a relatively
narrow range and indicates lower risk.
q The standard deviation provides us with a useful measure of risk when possible
outcomes follow a normal distribution.

Attitudes to risk
q A risk preference represents a person’s attitude to risk.
q A fair game is one where the expected value of participating is zero.
q A risk-averse person will not participate in a fair game.
q A risk-neutral person is indifferent to participating in a fair game.
q A risk-seeking person will reject a certain outcome in favour of a riskier game that
has an equal or lower expected return.
q Market participants have different risk tolerances and these influence their investment
choices.
q Traditional finance theory is based on the assumption that market participants are risk
averse.

The relationship between risk and return

q In figure 5.1 risk is positively related to average annual (ex post) return.
q The risk-return relationship that is of real interest in finance is the positive
relationship between risk and ex ante return.
q The ex ante relationship should hold because risk-averse investors will take on risk
only if the expected return is high enough to compensate them for the discomfort of
holding higher risk investments.
q However, this relationship won’t necessarily be observed in historical data.
 Required rates of return
q The required rate of return (on an investment) is the minimum level of return that is
acceptable to an investor given the level of risk associated with that investment.
q If the expected return on an investment exceeds the required return, then investors
will make the investment because they expect to be fully compensated for the risk of
the investments.

Reducing risk
q A portfolio is a collection of different assets.
q Diversification is the spread of different assets held in a portfolio.
q The main objective of holding a diversified portfolio is to reduce the risk of
investment.
q Correlation is a measure of the way two variables move relative to each other.
q Positive correlation means that the variables increase together and fall together.
q Perfect positive correlation means that the variables increase and decrease by the
same amount.
q Negative correlation describes the situation where two variables move in opposite
directions.
q Perfect negative correlation means that the variables move in the opposite direction to
each other and they move by the same amount as each other.
q If you construct a portfolio of assets that are perfectly positively correlated you will
not achieve any risk reduction.
q If your portfolio contains assets with less than perfect positive correlation then there
will be at least some risk reduction.
q In general, for portfolios constructed using long positions, the less positively
correlated the asset returns the greater will be the level of risk reduction.
q A major implication of the risk reduction that comes from diversification is that
investors will gain higher returns only from taking more systematic risk.
q Systematic risk is the risk that is common to all businesses.
q Unsystematic risk (or firm-specific risk) comes from the way a particular business
conducts its activities.
Figure 5.5 shows how increasing the number of assets in a portfolio reduces the total
level of risk

q The diagram shows the total risk of two portfolios a and b, distinguishing between
systematic and unsystematic risk.
q Total risk includes both systematic and unsystematic risk.
Portfolio a has the higher level of total risk because the relatively low level of
diversification means that a significant amount of unsystematic risk remains
q Portfolio b has a lower level of portfolio risk because the variations attributable to
unsystematic risk factors on one asset are offset by the variations in unsystematic risk
factors on other assets in the portfolio.
q Investors cannot expect to get higher returns by taking on unsystematic risk.
The owner of portfolio a should not expect higher returns than the owner of portfolio
b as both portfolios have the same level of systematic risk

The Capital Asset Pricing Model

The Capital Asset Pricing Model (CAPM) generates an expected return for a risky
asset based on the asset’s level of systematic risk, the expected return on the market
portfolio and a risk-free asset.
q The CAPM provides a quantifiable relationship between expected return and
systematic risk. The CAPM is shown in equation 5.8:

q The CAPM is derived from portfolio theory, which states that the optimal portfolio to
hold consists of an investment in the market portfolio of all risky assets and an
investment in the risk-free asset.
q Theoretically, the market portfolio should be consistent with holding all types of risky
assets from around the world.
q However, as it is not possible to identify all of these assets, the return on the market is
usually approximated by a domestic share price index.
q The risk-free rate represents the return an investor could gain without taking on any
risk.
q Subtracting the risk-free rate from the market portfolio gives the equity risk
premium (ERP) which indicates how much additional return can be expected by
moving from the risk-free asset to the market portfolio of risky assets.
q The usual explanation for the risk premium required to hold shares is based on
investor risk aversion.
q The ex ante ERP is always positive.
q The risk-free rate is observable in the market via the returns on government-issued
debt with different maturities
q The expected return on the market is much more difficult to assess. Historical average
ERP is sometimes used rather than estimating the return on the market.
q This method relies on the assumptions that the ex ante ERP will be in line with the ex
post average, and that past market returns are a good indicator of future market
returns.
q Beta is a relative measure that describes how the return on the asset is related to the
return on the market portfolio. It is a measure of the risky asset’s level of systematic
risk.
q The asset specific beta is used to weight the ERP, so the expected return reflects the
level of systematic risk for the asset.
q The market portfolio has a beta of 1.
q A risky asset with a beta of 1 must move with the market.
 q Assets with betas greater than 1 have higher levels of systematic risk than the market
portfolio.
q Assets with betas less than 1 have less systematic risk than the market portfolio does.
q A beta of zero indicates that the expected return on the risky asset is not related to
changes in the expected return on the market.
q Figure 5.6 shows how expected return on the risky asset relates to the expected return
on the market for some different levels of beta.

Example 5.6
q The inputs for this problem are as follows: Rf = 4%; β = 0.522 and; E(RM) = 8%.

Using CAPM to identify over- and underpriced shares

q Figure 5.7 is the graphical representation on the CAPM where Rf = 4% and E(RM) =
8%.

Using CAPM to identify over- and underpriced shares

q This line is called the security market line (SML) and it shows the expected returns
for a given level of beta.
q We say that assets are fairly priced if they generate an expected return that lies on the
SML.
q In figure 5.7 share A is underpriced and therefore lies above the SML.

Using CAPM to identify over- and underpriced shares

q In figure 5.7, Share B is overpriced and therefore lies below the security market line.
Is CAPM the best model of risk and return
q There exists much academic work, both theoretical and empirical, which questions the
applicability of CAPM.
q The CAPM is a single factor model – it rests on the assumption that market risk fully
describes the relevant risk when pricing risky assets.
q Multi-factor models have since been introduced to more fully explain the relationship
between risk and return.

Is CAPM the best model of risk and return

q These multi-factor models are often variants of Arbitrage Pricing Theory (APT)
which states that systematic risk comes from a number of factors.
q Unfortunately, the theory does not identify what the individual risk factors are, or
even how many individual risk factors are needed to explain returns.
q Although the flaws in the CAPM demonstrate that the model is imperfect, it is the
model most widely embraced by practitioners.

Chapter 6- Valuation of bonds and shares

Price and value

q Price is the amount of money needed to acquire an asset.
q Value is the worth of an asset to an individual.
q Price and value can be quite different amounts.

How are security prices set?

q Securities are tradable instruments that represent an ownership interest or the right to
receive payment on a debt.
q An important characteristic normally found in securities is that they are easily
interchangeable.
q The price of a security is easy to observe when it is traded in an active market.
q A bid is the price a trader is willing to pay for a security.
q An offer is a price a trader is willing to accept to sell a security.
q The number of bids for a security (at a certain price) indicates the demand for that
security at that price.
q The number of offers for a security (at a certain price) indicates the supply of that
security at that price.
q The market price represents the most widely held view of the value of the security at
that point in time.
Principles of security valuation
q Book value is the accounting measure of an asset’s worth.
q The book value of a share is given by equation 6.1:

Book value does not provide us with a good representation of future cash flows
q The cash flows of a security can come from dividends, coupon payments,
redemption by the issuer or from the sale of the security on the secondary market.
q Coupon payments are the regular interest payments received by the holder of a bond.
q Intrinsic value of a security is the PV of expected future cash flows discounted at the
investor’s required rate of return.
q A higher (lower) discount rate will lead to a lower (higher) intrinsic value calculation.
q The amount of uncertainty about cash flows varies between securities.
q For instance, ordinarily it is much simpler to forecast the cash flows associated with
debt instruments than it is to forecast the cash flows associated with ordinary shares.
q An investors’ required return, the amount and timing of the security’s cash flows and
the level of risk associated with these cash flows are the key elements in determining
a security’s value.
q The basic security valuation model is given in equation 6.2:

Valuing bonds
q A bond normally pays a regular income stream (the coupon) and has a face value that
is repaid to the holder at maturity.
The coupon is the stated rate of interest paid on the bond
Zero coupon bonds
q As the name suggests, zero coupon bonds pay no coupons but rather pay a lump sum
(face value) at maturity.
q In this sense, a zero coupon bond is similar to a discount security.
q The purchase price at the time of issue will be at a deep discount to the face value of
the bond.
q A deep discount is a purchase price for a security that is well below its face value.
q Equation 6.3 shows us that the intrinsic value of a zero coupon bond is equal to the
PV of the maturity cash flow.

Example 6.2
q The inputs for this problem are as follows:
F = $100000; rb = 0.05/2 and; n = 3*2.
q The cash flows of a fixed interest coupon bond form an annuity plus a single sum
when the face value is repaid.
q Fixed interest means that the coupon received on the bond stays the same over the
bond’s life.
q The abovementioned cash flow pattern is used in equation 6.4 to calculate a coupon
bond’s value:

q The first part of equation 6.4 calculates the PV of the annuity that is made up of
coupon payments.
The last half calculates the PV of the face value of the bond
Example 6.3
q The inputs for this problem are as follows:
F = $100000; Ct = $2500 rb/m = 0.06/2; t = 1,2,3,4 and; nm = 2*2.
 Valuing preference shares
q Preference shares are hybrid securities that have features of both debt and equity.
q We can value the cash flows associated with a typical preference share as a
perpetuity.
q The formula for calculating the intrinsic value of a preference share is given in
equation 6.5:

Example 6.4
q The inputs for this problem are as follows: D = $0.5 and; rp = 8%.

Valuing ordinary shares

Dividend discount model
q As for bonds and preference shares, the intrinsic value of an ordinary share is the
present value of the future cash flows using the investor’s required rate of return.
 q Equation 6.6 gives the dividend discount model used for computing the intrinsic value
of an ordinary share.

Dividend discount model

Example 6.5
q The inputs for this problem are as follows:
D1 = $0.35; D2 = $0.37; D3 = $0.42; D4 = $0.45;
P = $40 and; re = 0.11/2.

Constant growth model

q A major problem with valuing an ordinary share is associated with its infinite life.
q If we make the assumption of a constant growth rate in dividends, we can use
equation 6.7 to calculate the value of a share:

Constant growth model

Example 6.7
q The inputs for this problem are as follows:
D1 = $0.15; g = 0.02/2 and; re = 0.06/2.

Applying dividend valuation models

q The dividend discount and constant growth valuation models can not be applied to all
companies.
q These models are applicable to the valuation of blue chip companies as opposed
valuing companies which exhibit unpredictable variability in dividends.
 q Blue chip companies are well established and have a good track record for financial
stability and a fairly predictable pattern of dividend payments.

Price-earnings ratio
• Market capitalisation is the total dollar value of all issued shares. Market value is
used to determine the dollar value per share.
q Earnings per share is the total forecast earnings of the firm divided by the number of
ordinary shares on issue.
q The Price-earnings ratio compares the price per share to the forecast EPS:

q Analysts pay a lot of attention to earnings results and devote considerable resources to
developing earnings forecasts.
q Earnings indicate profitability, but before we can compare the profitability of two
firms we need to take the size of each of the operations into consideration.
q Calculating the EPS standardises the total earnings for companies and puts them on a
more comparable per share footing:

q It is important to note that a change in the historical PE of a company can be due

solely to a change in the general level of prices in the share market rather than with
changes in the value of a company.
q Analysts use a PE multiple based on the
PEs of comparable firms and make adjustments for differences attributable to risk and
gearing and any other factors they consider relevant.

Chapter 7- Cost of capital

The cost of capital concept

q The cost of capital is expressed as a weighted average that reflects the costs of
permanent sources of finance.
q Therefore, the cost of capital is the minimum rate of return on the firm’s investments
that will compensate the suppliers of capital to the firm.
q If the company can earn more than the minimum rate of return on the firm’s
investments that will compensate the suppliers of capital to the firm, the share price
should increase.
Determinants of the cost of capital
q Each of the different sources of finance used by the company contributes to its total
cost of funds.
q The requirement for regular interest payments and the legal provisions that allow
creditors to call for the winding up of a business mean that those supplying debt
capital face the least risk.
q Therefore, we can expect creditors to have a relatively low required return.
q As ordinary shareholders are the residual claimants, and therefore have the riskiest
cash flows from their investments, we expect that they’ll have the highest required
rate of return.
q The required rate of return for preference shareholders will fall in between that of the
creditors and the ordinary shareholders.
q Hence, we can conclude that the risk for each source of capital drives the investors’
required returns
q The cost of capital is a composite measure that includes the cost of each component
(or source) of finance.
q For example, assume a firm is financed using 50% debt and 50% equity. Assuming
the cost of debt is 8% and the cost of shares is 14%, the cost of capital would be 11%
(0.5*8 + 0.5*14).
q The marginal cost of a particular source of capital is the cost associated with raising
the next dollar from that source.
q The historic cost of funds raised is irrelevant when comparing how much a new
project would have to earn to satisfy the suppliers of capital

Taxation regimes and the cost of capital

q Dividends are taxed in the hands of owners of companies in Australia, with
shareholders receiving tax credits for the full amount of corporate tax paid.
q The value of imputation credits is higher for resident shareholders than for foreign
shareholders.
q Resident shareholders live (and pay tax) in the same country as the company paying
the dividends.
q Foreign shareholders live (and pay tax) in a different country from that of the
company paying the dividends.
q Resident shareholders can extract the full value of tax paid for them by the company.
q Foreign shareholders will not gain from receiving fully franked dividends unless the
taxation office of the country in which they are a resident allows Australian
imputation credits to be counted as tax paid by the shareholder on dividend income.
q The common alternative to imputation is the classical taxation system.
q Rational investors assess their returns on an after-personal-tax basis.
q We would expect to find that shareholders who can utilise all the benefits from
receiving fully franked dividends will demand a lower before-tax required return than
they would under a classical tax system.
q The implication is that the cost of equity capital would decrease if companies paying
fully franked dividends were owned by shareholders who could fully utilise the
imputation credits.
q Black et al found evidence consistent with a lower cost of capital after the
introduction of imputation for firms with high dividend payout ratios.
q The dividend payout ratio is the proportion of after-tax profit that is paid to
shareholders as dividends.
q A company with a shareholder register that consists only of investors who can fully
utilise their imputation credits is considered to be fully integrated with the taxation
system.
q Australian tax paid by a fully integrated company is passed on to shareholders and
profit distributed as dividends is taxed only at the shareholders’ personal tax rate.
q In this case, none of the imputation credits distributed by the company are lost and
corporate taxes are not relevant in the determination of the cost of capital.
q For fully integrated companies, the component costs should be calculated on a before-
tax basis.
q Companies that do not pay dividends are not integrated into the dividend imputation
tax system, as any available franking credits are not passed on to shareholders.
q Foreign shareholders may gain no benefit from receiving fully franked dividends.
q For both companies that pay no dividends and foreign shareholders, as well as
business structured as sole traders and partnerships, the after-tax cost of capital is
relevant.
q Between the two extremes of shareholders who can fully utilise imputation credits and
those who gain no benefit from them lie cases where some of the company’s
shareholders cannot gain much from receiving fully franked dividends.

Estimating the component costs

Finding the margin cost of funds
q Issues costs are the costs associated with bringing an issue of securities to the market.
q These costs include any underwriting fees and costs for preparing a prospectus, in
addition to costs associated with the advertising and promotion of the issue. If an
issue of new equity securities is issued at a discount to the current market price, this
discount is also considered a cost.
q The net proceeds are the amount of cash received from investors minus any costs
associated with the issue.
Finding the margin cost of funds
q Equation 7.1 shows the relationship between net proceeds and issue costs.

q When estimating the component costs it is important to remember after-tax costs are
for use by businesses that are not integrated with the dividend imputation system and
marginal tax rates should be used in these circumstances.
q On the other hand, the before-tax costs are for use by companies that are fully
integrated with the dividend imputation system.
Cost of debt
q The cost of debt is the level of return that must be generated in order to meet the
required return of debtholders.
q The cost of previous issues is not relevant when we use the cost of capital as a
yardstick for assessing new projects. Therefore, we measure the marginal cost of debt
or the cost associated with a new issue.
q For ease of computation, we use zero coupon bonds initially for which to calculate the
cost of debt.
q Substituting the net proceeds for the intrinsic value in the zero coupon valuation
equation gives:
q Solving equation 7.2 for rb will give us the before tax cost of debt, denoted kz,bt.
q Clearly, to find the required return or cost of debt, we need to find the discount rate
that makes the PV of the future cash flows equal to the net proceeds of the bond. This
discount rate is also called the internal rate of return (IRR).
q Interpolation is the process of approximating an unknown return using trial and
error.
The interpolation method is easiest to implement using the IRR function embedded
within a financial calculator or a spreadsheet package such as Excel
q Without a spreadsheet or financial calculator, a less tedious way to approximate the
cost of debt is to use equation 7.3:

q The cost of debt calculations presented so far have been on a before-tax basis.
q When imputation credits are not available, maximising owners’ wealth is achieved by
maximising the after-tax return to owners.
q We convert the before-tax cost of debt to an after tax cost of debt using equation 7.5:

q For a company, the nominal marginal tax rate is the statutory tax rate for corporations.
q The nominal marginal tax rate for partnerships and sole traders is the tax rate that
applies to the next dollar of income in the hands of the individual owner.
q Given a non-zero marginal tax rate, the after-tax cost of debt is always lower than the
before-tax cost of debt. This reflects the tax deduction allowed for interest payments
made by a business.

Cost of preference shares

q The cost of preference shares is the level of return that must be generated in order to
meet the required return of preference shareholders.
q Substituting the net proceeds for the intrinsic value in the preference share valuation
equation and rearranging gives equation 7.7 which is the cost of preference shares:
q Dividends are paid from after-tax profits of a company. This means that the cost of
preference shares estimated from equation 7.7 is the after-tax cost.
q The before tax cost of preference shares is calculated using equation 7.8:

Cost of ordinary equity

q The cost of ordinary equity is the level of return that must be generated in order to
meet the required return of the ordinary shareholders.
q The ultimate purpose of company earnings is to be paid as dividends or to be
reinvested in the company on the shareholder’s behalf.
q Retained earnings represent the accumulated profit of the company that has not been
paid out to shareholders as dividends.
q Retained earnings are not a free source of funds for new projects.
q Retained earnings belong to the ordinary shareholders and the ordinary shareholders
expect to get their required return on this source of funds.
Cost of retained earnings
q The cost of retained earnings is the required return of ordinary shareholders on
shares that have already been issued.
q Assuming that the constant growth assumption is applicable to the company in
question, we can rearrange the constant growth model to obtain the cost of retained
earnings As in equation 7.10:

Cost of retained earnings

q The before-tax cost of retained earnings for a company that pays a fully franked
dividend uses the grossed up dividend amount. Equation 7.11 gives this cost:
 Cost of new share issues
q The cost of ordinary shares is the required return of shareholders on a new issue.
q The formula for calculating the after tax cost of ordinary shares is given by equation
7.12:

q To obtain the before-tax cost of a new issue we gross up the dividend to reflect the
100% franking credits. The equation for the before-tax cost of a new issue is:

q We can use the CAPM as an alternative to the dividend discount model to calculate
the cost of ordinary shares.
q The after-tax cost of ordinary shares is given by equation 7.14:

Cost of new share issues

 q While the CAPM does not require forecasts of dividends or assumptions about a
dividend growth rate, it does need a forecast of the equity risk premium, E(RM)-Rf, a
measure of the risk-free rate, Rf, and a measure of systematic risk, β, of the firm.
Another complication with applying the CAPM to calculate the cost of ordinary
shares is that the model does not incorporate floatation costs
q However, this complication can be overcome by adjusting project cash flows for issue
costs rather than adjusting the component cost of capital.
q A serious difficulty arises if we attempt to use the CAPM to calculate the before-tax
cost of ordinary shares.
q The ERP should be higher under an imputation system but the magnitude of the
difference is difficult to determine.

Under-utilisation of imputation credits

q Imputation credits can be lost when a company has shares held by foreign investors
who are not Australian residents.
q With the exception of certain investors in the USA, UK and NZ, foreign investors
have withholding tax deducted from any receipts of interest or dividends originating
in Australia.
q Foreign shareholders do not get a cash rebate for unused franking credits.

Under-utilisation of imputation credits

q Instead, the receipt of fully franked dividends means they are not liable for
withholding tax.
q In general, foreign residents won’t have access to excess franking credits and thus,
foreign investors are likely to prefer unfranked dividends.
q Officer argued that Australia is a small open economy so the marginal investor is a
foreign one.
q In this case, imputation credits cannot be fully utilised by foreign shareholders and
will not be reflected in the price of the share.
q When the marginal investor in a company cannot use imputation credits, we would
expect the company would focus on generating capital gains, rather than maximising
the size of a franked dividend.
q When the marginal investor is a resident shareholder, we would expect to see the
company paying out the largest possible fully franked dividend.
q Australian companies can generate a credit in the franking account only when the pay
Australian tax on income.
q Australian companies that generate offshore income are only partially integrated with
the dividend imputation taxation system because they are unable to pay out all of their
profits as fully franked dividends.
q The calculation of the component costs of capital in this chapter have been based on
the implicit assumption that the company paying the dividend has Australian-sourced
income, allowing for the payment of fully franked dividends

The weighted-average cost of capital

q The weighted-average cost of capital (WACC) is the sum of each component cost of
capital weighted by each component cost’s proportion of the firm’s capital structure.
q When we assess a project to determine its impact on the value of the firm, we need to
take a wider view than determining if the project is expected to return more than the
component cost of finance that would be used to fund the project.
q Equation 7.15 shows how the weighted cost of capital is derived from the component
costs.
q It tells us to take each component cost (kx) and multiply it by the proportion, Wx, that
kx represents in the firm’s capital structure.

q We need to have calculated the component costs and the proportion that each
component represents in the firm’s capital structure in order to determine the WACC.

Alternatives for weighting

q The two main alternatives for weighting the component costs of capital to obtain the
WACC are ‘book value’ weights and ‘target’ weights.
q The book value weighting method bases the weights on the firm’s current balance
sheet. This results in a weighting scheme that reflects how the firm has been financed
in the past.
q However, the book values shown in the balance sheet do not reflect the current value
of the firm.
q Book value is the accounting measure of an asset’s worth.
q Current market values are more relevant to decisions that will impact on future market
value.
q A better weighting alternative is to use target weights (based on market values) for
each source of funding.
q Target weights are based on management’s future plans for financing the company’s
operations.
q A weighting system based on a target funding structure will provide a better yardstick
for assessing projects.
q To reflect the finite amount of funding investors are willing to supply at a given
required return, we should recalculate the WACC for each band of dollar financing
the firm can raise before one of the component costs changes.

Cost of capital in practice

q Truong et al (2005) surveyed Australian companies to find out what financial
managers do in practice.
q They report that 88% of respondents use the cost of capital as the discount rate for
project evaluation and that the majority of these estimated the cost of capital ‘in
house’.
q They also found that 72% of companies use the CAPM to calculate the cost of equity
and 60% use target weights.
q The survey also found that when estimating the cost of equity through the CAPM, the
majority of companies reported that they use the return on Treasury bonds as the risk-
free rate and an ERP between 5% and 8%.

Capital structure
q When calculating the WACC, the weighting of each source of funds is determined by
the firm’s capital structure.
 q Capital structure is the mix of contracted debt and equity used by a firm.
q Where the financial structure includes long- and short-term funds, the capital structure
excludes short-term funding.
q As retained earnings are included in the firm’s capital structure, capital structure is
also affected by profitability and dividend decisions.
q If a profitable firm is financed with debt and equity, we would expect that the equity
holders would receive relatively higher returns than the debt holders.
q If debt holders retain their securities until maturity, they only receive the return
specified in their contracts, no matter how profitable the firm becomes.
q This implies that the more debt used by the firm, the higher the returns to shareholders
will be.
q Financial leverage is the use of debt in a firm’s capital structure to increase returns to
equity holders.
q Financial leverage is measured by the debt-to-equity ratio.
q The debt-to-equity ratio is a measure of the proportion of debt relative to the amount
of equity in the firm’s capital structure.
q Financial leverage creates higher financial risk, which is the risk involved in using
debt as a source of finance.
q While a firm is not contractually bound to pay a dividend to ordinary shareholders,
the obligation to the holders of debt securities remains.
q This can lead to financial distress which occurs when a firm’s financial obligations
can not be met or can be met only with major difficulty.
q Hence, no financial leverage would normally be associated with lower returns to
shareholders and too much financial leverage would normally be associated with
financial distress.
q The optimal capital structure is the mix of contracted debt and equity that
maximises the value of the firm.
q The optimal capital structure would include the ‘right’ proportion of debt to minimise
WACC without decreasing the value of the firm. Maintaining the value of the firm
with lowest possible WACC is consistent with maximising shareholder value.

Capital structure in Australian companies

q Twite (2001) examined the capital structure of Australian companies and found that
the introduction of imputation resulted in:
• lower leverage
• lower retained earnings
• relatively more new equity issues

Evaluating changes in capital structure

q Agency theory suggests capital structures will be influenced by the desire to reduce
costs arising from managers acting in their own interests.
q The pecking order hypothesis suggests that capital structure will be the result of
managers’ preferences for using firstly retained earnings, then debt, followed by new
equity issues in a classical tax system.
q The life cycle approach modifies the pecking order hypothesis by suggesting that the
firm’s maturity will influence capital structure.
q f earnings are expected to remain at a constant level, issuing new shares will reduce
the of EPS.
q The reduction in EPS is called dilution.
 EBIT-EPS analysis
q Investors are interested in the firm’s past and future EPS amounts.
q It makes sense to evaluate the impact of a capital structure change on EPS, given that
the market is so interested in this particular figure.
q EBIT-EPS analysis relates earnings before interest and tax to the after-tax income
entitlement of each ordinary share.
q EBIT-EPS analysis relies on the existence of a tax advantage to debt, so is most
appropriate in a classical taxation system or where shareholders are not integrated
with the imputation system.
q The indifference point is the level of EBIT that generates the same EPS for all
financing alternatives under consideration.
q The indifference point for EBIT-EPS analysis is found using equation 7.16:

q When considering an equity plan or a debt plan it is important to note the following.
q For EBIT lower than any given indifference point, the equity plan will generate higher
EPS.
q For EBIT higher than the indifference point, the plan that uses debt will have the
higher EPS.
q The relationship between the indifference point and the preference for either a debt or
equity plan will always hold.

Limitations of EBIT-EPS analysis

q EBIT-EPS analysis is not appropriate when shareholders are fully integrated with a
dividend imputation tax system.
q Under a classical tax system, EBIT-EPS analysis has the following disadvantages:
• higher EPS from increasing leverage does not take the increased financial risk
into consideration
• higher leverage will lead to shareholders having higher required returns, so
new shares need to be issued at a relatively lower price when more debt is
used
• EBIT-EPS analysis ignores the variability of EBIT and focuses solely on the
size of EBIT
• maximising EPS is not consistent with maximising shareholder wealth.
q Taken together, these limitations mean that EBIT-EPS analysis should not be the only
consideration in the choice of capital structure.

Chapter 8 – Planning investments – DCF techniques

Investment and the business of the firm

q An investment is the outlay of capital made with a view to gaining future benefits.
q The appraisal of new projects is an important part of the role of managers.

Four common characteristics of investment decisions

1. Relatively large initial outlay.
2. Relatively long horizons.
3. Projects can be difficult to reverse.
4. Projects have risk.

Where do project proposals come from?

q Investment decisions fall into two main categories:
i. new projects undertaken to increase cash flows
ii. replacement of existing assets.

Investments and the firm value

q An important way to add value, or increase shareholder wealth, is by growth in
operations and the firm needs to make investments to grow.
q Growth can be achieved by expanding the scale of current operations.
A second way to achieve growth is for the business to begin new activities

Appraisal techniques and maximising wealth

q Analysis of cash flows rather than profits is consistent with the objective of
maximising owners’ wealth.
q Hence, the techniques we use should be based on cash flows rather than profits.
q Cash flows represent real resources available to the firm.
q Profit figures are constructed by the application of accounting rules.
q In addition to using cash flow rather than profits as the basis for project evaluation,
the chosen technique should consider the time value of money.
q Our analytical technique needs to have the capacity to include differences in risks
between competing projects.
q The discounted cash flow (DCF) techniques are consistent with shareholder wealth
maximisation.
q Net present value (NPV) and internal rate or return (IRR) are the two of the most
important DCF techniques.

Estimating cash flows

q The most difficult aspect of using the NPV and IRR techniques is the estimation of
future cash flows for a project.
q We generally don’t expect our forecast cash flows to be ‘accurate’ unless we have the
unusual case of having the cash inflows and outflows for a project specified in
contracts.

Identifying relevant cash flows

q Marginal analysis is a method for making decisions to maximise our objective by
comparing additional (marginal) benefits with additional relevant costs.
q The relevant cash flows for investment evaluation are the marginal ones.
q We call these the incremental cash flows and they result from the acceptance of a
project.
q Only incremental cash flows are important in
DCF techniques, total cash flows are irrelevant.
q Operating costs are the cash outflows required in the daily activities of the project.
q Opportunity costs are the cash flows forgone when one path of action is chosen.
q Sunk costs are cash outflows that occur prior to the evaluation of a project.
q Sunk costs are not relevant cash flows and therefore should not be included when
applying DCF analysis.
q The cost of finance for the project should not be included in the project’s cash flows.
q The cash flows of a proposed project with the same level of risk as the firm’s existing
projects are discounted using the firm’s cost of capital.
Discounting at the cost of capital means we are already charging the project for its
financing costs

Estimating the initial outlay

q The initial outlay of the project is often the cash flow that can be identified with the
highest degree of certainty.
q Changes in net working capital are also included in the initial outlay.
q Net working capital is the excess of current assets over current liabilities.
Outlays for any special training staff needed to operate the project should be included
in the initial outlay of an expansion project
q The costs of hiring new staff who will work on the project specifically should also be
included.
q Determining the initial outlay for a replacement decision requires one additional
element to be included.
q The cash flows from an asset that is being replaced will usually decrease, but can
sometimes increase, the installed cost for a replacement decision.
q A project to adopt new technologies to save costs should be classified as a
replacement decision where existing technology is being exchanged for the new
technology.

Estimating the net operating cash flows

q The most important thing to remember when constructing a series of operating cash
flows is to look at the incremental cash flows.
q If inflows will be diverted from other areas of the firm, these lost cash flows should
be deducted from those of the new project.
q If there are synergistic increases in cash flows to other areas of the firm from the new
project, then these should be added to the cash flows for the analysis of the new
project.
q Similarly, costs should also be incremental.

Estimating the terminal value

q The terminal value of a project is the cash inflow or outflow that is expected at the
end of the project’s life.
q The main sources of terminal cash flows are the salvage value of any assets used by
the project and the return of net working capital.

Identifying annual cash flows

q We organise each of the cash flow components in sequence so we can properly adjust
for the time value of the cash flows.
q Time zero is when the initial outlay of the project is made.
q When measuring cash flows on an annual basis, the first operating cash flows occur at
the end of the first year.
q The terminal value is usually included in the final year’s cash flow.

Net present value

The net present value (NPV) of a proposed project is the sum of the discounted net
cash flows over the life of a project, minus the project’s initial outlay.
q We can calculate the NPV of a project by applying equation 8.1 to the project cash
flows.

q A positive NPV tells us how much of the project’s forecast net cash inflows are left
after the debt and equity holders of the firm have been compensated and the initial
outlay has been recovered.
q If the project being evaluated has the same level of risk as the projects that the firm
currently operates, the decision rules for use with the NPV technique are:
• Accept a project if NPV >= 0
• Reject a project if NPV < 0
q Positive NPV projects increase the value of the firm because they make more cash
available for distribution to shareholders or for reinvestment in the firm.
q A project with a zero NPV will leave the value of the firm unchanged because the
suppliers of capital are receiving their required returns from the investment in the
project.
A project with a negative NPV will decrease the value of the firm
q The cost of capital is not the appropriate benchmark when a project has more or less
risk than the average risk of the projects currently being undertaken by the firm.
q If management have adopted all the available positive NPV projects and have
shareholder funds in excess of investment requirements, the excess funds should be
returned to the owners.

Internal rate of return

The internal rate of return (IRR) is the discount rate that equates the present value
of the project’s cash flows to the initial outlay of the project.
q Therefore, the IRR tells us the rate of return that the project is expected to earn.
q We apply equation 8.2 to the project’s cash flows to determine the IRR.
 q The decision rule to use with the IRR technique is to compare the project’s IRR to the
hurdle rate:
• Accept a proposed project if IRR >= hurdle rate
• Reject a proposed project if IRR <= hurdle rate
q The hurdle rate is the minimum rate of return generated that will make a project
acceptable.
q The cost of capital is the appropriate hurdle rate for the IRR technique when the
project risk is the same as that of current projects.
Comparing NPV and IRR
q The NPV and IRR methods both share the disadvantage or requiring preparation of
detailed estimates of cash flows.
q Because the IRR is the discount rate that equates the PV of the project’s cash flows to
the initial outlay, an IRR that is equal to the cost of capital will have a zero NPV for
typical cash flow pattern projects.
q Typical cash flow patterns involve an initial outflow followed by a series of inflows.
q A negative NPV project would have an IRR that is less than the cost of capital, while
a positive NPV project would have an IRR greater than the cost of capital.
q Some projects have different patterns of cash flows and this can mean that the IRR
and NPV relationship for typical cash flow patterns will not hold.
q When a project’s cash flows have a reversal of sign the IRR technique will fail to give
a clear-cut decision that will maximise the value of the firm.
q Hence, the NPV technique is superior for projects with net cash outflows occurring
during the life of the project.
q When a project does not require an initial outlay, the IRR cannot be calculated
because no investment is made on which to base the return.
q Again, the NPV technique is superior here.
q The NPV technique is based on the assumption that the net cash flows are invested at
the discount rate we use to determine the PV of the future cash flows. For a project
with the same risk as those currently operated by the firm, this will be the cost of
capital.
q The IRR technique is based on the assumption that the cash flows are reinvested at the
IRR of the project being analysed.
q Clearly, where the IRR differs substantially from the cost of capital (especially where
this difference is positive), it becomes increasingly less likely that cash flows can be
reinvested at the IRR.
q Once again, this factor makes the NPV technique preferable to the IRR technique.
q Surveys about project appraisal techniques indicate that IRR is used as often as NPV.
q This fact brings us to the one advantage of IRR over NPV – it is easier for people
without a formal finance background to interpret a rate of return than it is to
understand what the dollar NPV means.
q It is important to realise that managers have nothing to lose and perhaps more support
to be gained by presenting both NPV and IRR measures.